FTSE Global Markets by FTSE Global Markets

THE ENDURING APPEAL OF PFANDBRIEFE ISSUE 49 • MARCH 2011

The new landscape of EM derivatives trading How best to access the offshore RMB market The latest ETF launches The drivers of Canadian prime broking

COUNTING THE COSTS OF TOMORROW’S WORLD ROUNDTABLE: TOWARDS AN ASIAN UCITS-STYLE SOLUTION

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 (Europe); Ian Williams (US/Emerging Markets/Sector Analysis); David Craik (Securities Services). PRODUCTION MANAGER: Mariangel Gonzalez, tel: +44 [0]20 7680 5161 email: mariangel.gonzalez@berlinguer.com SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5157 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 • MARCH 2011

OLITICAL STRATEGISTS IN the advanced economies have patently been taken by surprise by the rise of the new political-economic paradigms by emerging nations with nothing to lose but their autocratic and outdated masters. Increasingly fluid communications technology continues to bypass national boundaries and in consequence redraws the possibilities of a new regional/global political consensus. It seems that we really are in a new dawn of revolution and the current ructions across MENA are just one aspect of it. That is because by luck or judgment, popular uprisings have come at a time when the global financial and capital markets are also mired in deep, deep flux; threatening to overturn systems and institutions carefully honed in the advanced markets since, oh, at least 1986. It seems that the world is mired in gloop: heck, even the world of rock ‘n’ roll is traumatised by a full year in which no music star of note has issued an album of any note (but more of that next month). Is it the end of the world as we know it? Highly unlikely, but change is definitely in the rough winds shaking the final weeks of the winter season. The cover story this month naturally ponders most possibilities emanating from the various strands of the jasmine revolution. The lead story looks at political risks: Vanja Dragomanovich highlights the impact on key commodities. Elsewhere, the month’s themes focus on the seemingly inevitable slough towards a globally defined derivatives market structure. Ruth Hughes Liley examines the growing partnerships between leading derivatives exchanges in advanced economies and the diffusion of innovation into the emerging markets. Equally, Ian Williams views the efforts by Asian exchanges to meet evolving global standards on central counterparty clearing structures for derivatives transactions. Important questions now turn on whether the United States which is leading much of the charge towards full transparency in the OTC derivatives market, can actually keep up with its promises to introduce change. Ian Williams reports in this month’s Market Leader that in a recent speech to an open meeting, CFTC Commissioner Michael Dunn acknowledges that “in essence, we face an unfunded mandate—a situation where the CFTC has been given enormous responsibilities, without the corresponding increase in resources necessary to fulfill them”. He cautions: “The only way to fulfill our duties under the law with our current budget constraints is to become a restrictive regulator, rather than a principles-based one, which may be detrimental to the current swap industry.” Moreover, he says: “Without adequate staff and resources, my fear is that applications from entities we are unfamiliar with will take substantially longer than applications from entities we are familiar with.” The rules need to be finalised by the summer. It would be a tremendous loss of face if a lack of resources were to undermine such an effort to tame what is sometimes a chaotic spectrum of transactions. It would also be tremendously dangerous and detrimental to the industry as a whole if regulators botch the job because of a lethal mix of time pressure and too few resources. On a lighter note, it seems that pension funds assets are on the rise once more: a welcome development for the segment and also for the asset services industry. David Simons reports on the obvious relief among custodian providers of higher values of assets under custody. Our roundtable too highlights the positive trends in Asia; reinforced by Hong Kong’s financial secretary John Tsang’s announcement that the jurisdiction had recorded a $6bn surplus (three times the expected total) for 2010. Hong Kong’s reserves are a healthy 34% of GDP. As 2011 unfolds it is clear that the global economy faces a completely new set of challenges. The heart of the matter is rising imbalances: intra-national, regional and now global. The question for all participants in the financial markets is whether they are prepared to take these new challenges face on.

Francesca Carnevale, Editor March 2011 Cover photo: Families, kids and youths photographed attending huge demonstrations in Tahrir square, buying flags and food and sleeping in tents as they protested against the regime of President Mubarak. Cairo, Egypt. Photograph by Demotix / Adham Khorshed/Demotix/Press Association Images, supplied by Press Association Images, February 2011.

CONTENTS COVER STORY

THE OPPORTUNITY COSTS OF CHANGE ..........................................................................Page 46 The spread of the Jasmine revolution’s flame across North African and the Middle East asks disconcerting questions about the future evolution of liberal democracy through the region. Worrisome are signs of rising Islamic radicalism in Tunisia, Libya’s descent into anarchy and a distinct whiff of investors re-assessing their emerging markets investment strategies. We review the key trends and expected developments. DEPARTMENTS

MARKET LEADER

AN UNDERFUNDED CFTC? ......................................................................................................Page 6

SPOTLIGHT

GLOBAL PENSIONS ASSETS UP 8% IN 2010 ................................................................Page 10

Ian Williams asks whether the timeline for full market transparency is feasible.

Key stories around the global investment and capital markets.

ETFS STRIKE A CHORD WITH INVESTORS

....................................................................Page 16

How long can investors’ love affair with ETF last? By David Simons.

IN THE MARKETS DRS GROW IN STATURE IN THE ASIA-PACIFIC ............................................................Page 22 Can 2011 issuance volumes outstrip last year’s strong performance?

EXPANDING THE COVERED BOND FRANCHISE ........................................................Page 24 Why pfandbriefe retain investor confidence.

DEBT REPORT RECAPITALISATION HELPS SPANISH BANKS’ COVERED BOND ISSUES ........Page 30 Issuance levels underscore the strength of covered bonds.

REAL ESTATE

SUNKEN TREASURE OR JUST PLAIN SUNK? ................................................................Page 33 The slowly improving fortunes of Spain’s real estate segment.

THE NEED TO CONSOLIDATE UKRAINE’S BANKING SECTOR

..........................Page 34

Vanya Dragomanovich reviews the outlook for the sector.

COUNTRY REPORT AUSTRIAN BANKS STAY THE COURSE IN EASTERN EUROPE ............................Page 38 Under strain at home, Austrian banks look for growth abroad.

INDEX REVIEW

INFLATION WORRIES STALK BANK OF ENGLAND POLICY APPROACHES ..Page 40 Simon Denham, managing director of spread betting firm Capital Spreads takes the bearish view.

METAL PRICES STRONG DESPITE VARIABLE DEMAND ..........................................Page 41 Vanya Dragomanovich surveys hardening prices in the metals commodity segment.

COMMODITIES INDUSTRIAL USE HONES GOLD’S LUSTRE ....................................................................Page 44 Steady global recovery boosts new technology’s use of gold.

FX VIEWPOINT

DATA PAGES

STRUCTURAL INEQUITIES LEAD TO MANIPULATION ............................................Page 45 Simon Lehtis, president of Dynamic FX Consulting, takes the high road.

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

MARCH 2011 • FTSE GLOBAL MARKETS

CONTENTS FEATURES TRADING REPORT:

THE TECHNOLOGICAL TIPPING POINT OF EM DERIVATIVES ..................Page 55 Daily trading turnover on derivatives exchanges in emerging markets is rising rapidly, having quadrupled over the last ten years. The markets of Asia, South America, India and Russia are proving a magnet for the more established exchanges looking for market share abroad. Which exchanges are leading the charge? What challenges might they now face from an increasingly confident emerging markets segment? Ruth Hughes Liley went in search of some answers.

MIFID II BEGINS TO EXERT ITS INFLUENCE ......................................................Page 60 A cloud of uncertainty gathered over electronic trading in Europe through 2010 as firms awaited impending regulation. Finally in December, the European Commission finally launched a public consultation on the review of MiFID. With regulation a key driver of market structure in Europe it looks like 2011 will be a watershed year when proposals are adopted in May. By Ruth Hughes Liley.

ASIAN CCPS TAKE HOLD ..........................................................................................Page 63 Asian regulators have not been complacent about the lessons learned from the financial crisis. Derivatives need careful handling though they represent a tremendous business opportunity. The message from Asian regulators is that to maintain transparency and to avoid catching ‘Euro-American flu’, central counterparty clearing arrangements are the way forward. Ian Williams reports on individual country efforts.

BOUTIQUE EXCHANGES SEEK THE RIGHT NICHE ........................................Page 65 Whether onshore or offshore, boutique exchanges provide an important service which major global players are either unable or uninterested in offering. In practice though, exchanges in the Caribbean and at certain locations in Europe that rely on listing fees rather than trading flow for their revenue are thriving despite, or even because of, the clamour for heightened investor protection; something in which boutique exchanges are well honed. Neil O’Hara reports on their various specialisation.

PRIME BROKING:

CANADIAN BANKS BULK UP..................................................................................Page 68 Following the financial crash hedge funds scrambled to diversify their prime broking relationships. Moreover, they began to look in detail at the financial health of their prime broking providers. It was an opportunity which Canadian banks were quick to seize upon. Neil O’Hara reports on the evolution of the prime broking service set in Canada.

SECURITIES SERVICES:

A FAIR WIND FOR US CUSTODY ..........................................................................Page 72 Global custodians have taken heart in the sustained wave of market optimism over the last year (North African tempests notwithstanding) and the steady return of pension fund asset values. The challenge now is service provision in the heat of regulatory reform.

THE EVOLUTION OF EMERGING MARKETS SUB-CUSTODY ....................Page 75 Pity the poor regional sub-custodian in emerging markets. His landscape is increasingly competitive as the large global custodians try to muscle in on local business volumes. Not only that, they have the financial and technological clout to beat him out of the market. Is it fair? Will some houses manage to survive the onslaught. David Craik reports.

ROUNDTABLE:

LEVERAGING ASIAN FRAGMENTATION

............................................................Page 79 According to Colin Lunn, head of business development at Asia-Pacific Fund Services HSBC Securities Services, “There’s a lot going on in Asian right now, in the main driven by two themes: regulation and China.” What did the rest of the roundtable panel think of Lunn’s assertion?

MARCH 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: THE TIMELINE FOR FULL MARKET TRANSPARENCY

An under-funded CFTC? TABB group’s senior analyst Kevin McPartland states: “The question is: not what but when?” The Commodity Futures Trading Commission (CFTC) continues to wrestle with the daunting mandate given to it by Dodd-Frank; namely to bring the estimated $580trn in OTC trades out into the open where they will be bought and sold on exchanges open to qualified traders. Almost as daunting is the timeline in which it has to be completed. The rules need to be finalised by the summer, but that deadline is unlikely to be met as the commission and the other regulatory agencies try to write the rule book from scratch for a huge and sometimes chaotic universe of transactions. Do the CFTC and other regulatory agencies have sufficient resources to do the job well and on time? Ian Williams reports. N A SPEECH to a recent open meeting, Commodity Futures Trading Commission (CFTC) Commissioner Michael Dunn acknowledges: “In essence, we face an unfunded mandate—a situation where the CFTC has been given enormous responsibilities, without the corresponding increase in resources necessary to fulfill them.” He cautions that “the only way to fulfill our duties under the law with our current budget constraints is to become a restrictive regulator, rather than a principles-based one”, which, he warns, “may be detrimental to the current swap industry”. Moreover, he says: “Without adequate staff and resources, my fear is that applications from entities we are unfamiliar with will take substantially longer than applications from entities we are familiar with.” TABB Group’s Kevin McPartland is in sympathy with Dunn’s worldview. “From a technology perspective, there is an astronomical amount of very complicated data needed to identify systemic risk and on top of that you need to check the balance sheets of all these massively complex organisations. Not only do they lack the technology needed, but also they do not have the budget to create it. They will not be able to hire the brightest and best in competition with Wall Street bonuses.” He adds, piously: “There are some

At times, the rule-making process has looked like a sumo wrestling match, with commissioners and teams of lobbyists grunting and heaving but with no perceptible signs of movement. Some rule proposals seem deadlocked since CFTC chair Gary Gensler cannot sway the vote. A former Goldman Sachs partner, Gensler was a key advisor to the then-Senator Paul Sarbanes in drafting Sarbanes-Oxley, so he is no stranger to the difficulties of persuading corporate managements to take their medicine. However, while that legislation laid out many of the rules, Dodd-Frank devolved the detail to agencies such as the CFTC. In that respect, the biggest threat to full implementation is that congress could limit funding for oversight. “That’s shortsighted, we accept that there is going to be regulation and that would just complicate things,” states McPartland, adding: “I am as free market as they come. However, I think we have to come to accept, if we are going to have oversight and regulation let’s make it work efficiently.”

Dominating themes

Kevin McPartland of TABB Group. “The new rules create a huge number of opportunities for people who could never get in before,” he says. Photograph kindly supplied by TABB Group, February 2011.

civic-minded people out there, but they are few and far between.” It all contributes to a feeling of unstated paranoia. Regulators know the type of people they are dealing with. They also know that their own side is outgunned. There are cross currents, practical and ideological, and as one would expect of Washington, proponents’ declared principles are not always reflected in the outcomes they seek. One problem is shortage of funding for the commission, where an ostensible concern for government spending can mask an anti-regulatory ideology.

Two themes dominate the debate and have done so since the turn of the year. The first is access to the over-thecounter (OTC) markets, with the major banks and traders—having for the time being given up on keeping their trading private—now fighting off attempts to open up the business on the clearing exchanges. Gensler points out that the OTC swaps Dodd-Frank wants the CFTC to regulate amount to $20-worth for each dollar in the US economy and the $300trn in trades “remains dominated by a small number of dealers, and pricing and transaction data is not made generally available to the public.” He adds that with its intent “to promote competition amongst trading platforms”, the Dodd-Frank Act requires clearinghouses to provide non-discriminatory open access to trading facilities: “This includes both swaps that are executed bilaterally and those on unaffili-

MARCH 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

OTC DERIVATIVES: THE TIMELINE FOR FULL MARKET TRANSPARENCY

ated trading platforms. We’ve incorporated this requirement into proposed rule-makings. It will promote competition in and amongst trading platforms.” While there is clear self interest in the campaign by the major institutions to restrict access to trading, there is also a practical need to ensure that those engaged in the business have sufficient capital and margin to avert the systemic risk which is, after all, what Dodd-Frank was designed to mitigate. While competition might diminish the earnings of some of the big guys, MacPartland agrees with Gensler on the competitive possibilities for newcomers. “The new rules create a huge number of opportunities for people who could never get in before. In clearing, trading, service provision, and with so much demand for information with the required reporting, the technology has to come from somewhere. A lot of this is about clearing and the huge capital requirements for clearing houses now.” McPartland points out that now the CFTC is talking about $50m minimum requirement. “We’ve always thought a billion is more than necessary, but $50m is frighteningly low in face of the amounts traded.” So it seems that the $50m is the entry price, “with the amount going up proportionately to risk”, he explains.

A level playing field The challenge appeals to what McPartland calls his “technology side”. The new regime brings “a level playing field in the markets, with ingenuity, with clearing houses and trading desks competing, so we come out with much better technology to track the markets”. Another anticipated beneficiary is Tradeweb, whose chief executive officer Lee Olesky says: “We’re closing in on the final rules, and so we are getting a good look at the future of the derivatives markets. It’s clear that electronic platforms will play a major role in the trading of swaps, which we think will benefit institutional clients by providing greater price transparency and more efficient trade exe-

cution. One size certainly does not fit all derivatives transactions, and we anticipate a broad range of trading approaches and entrants to register as swap execution facilities once the rules are final.” Another major issue still in contention is whether the regulations should distinguish between “end users” who hedge their business risks against changes in commodity, fuel or foreign exchange risk, and traders who are playing the market. There is a strong feeling that with the highly-rewarded minds of Wall Street on the case, any loophole would soon have torrents of greenbacks pouring through it, so commissioners are weighing the need to impose the same regulations on all derivatives against the considerable negative of tying up manufacturing industry capital in margins instead of in job-creating investment. McPartland is “of two minds”, adding: “On the one hand I think best to have a single rule for all, which would simplify everything so everyone knows where they stand and have to make their best arrangements. With fewer loopholes, it would be simpler for regulators.” On the other hand, he admits: “The reason Dodd-Frank came into being in the first place was essentially to reduce systemic risk, so do we need to force mandates and regulations on companies that are truly hedging, or small hedge funds which pose no systemic risk?” Everyone agrees there is a need to allow companies to hedge their risks, but the unsurprising paranoia after the global crisis makes rule-makers nervous. Robert Reilley of Shell Energy North America told a recent Securities and Exchange Commission (SEC) public meeting that new margin requirements were unnecessary because banks and other companies that brokered swap transactions “do a pretty good job” of scrutinising the trades. For many, any statement implying such trust in bankers is far from reassuring. It is an issue that is still in dubious battle, with hundreds of corporate lobbyists calling for an enduser exemption, arguing about legislative

wording drafted in haste which exempts end users from clearing houses, but, say CFTC staff and commissioners, still allows margins to be mandated. Deeply involved in delivering the industry view, Chatham House senior analyst Luke Zubod says: “We help clients hedge about $350bn of exposure a year. So we wanted the world and policy-makers to become familiar with the world of derivatives beyond credit default swaps, AIG etc. We wanted to show how companies use them to manage risk, so that they do not try to fix things that already work well.”

Breakneck speed Zubod admits: “The agencies have been very positive, eager to take in feedback, and we can see the results incorporated, but the speed at which they are working ... breakneck with hundreds of pages coming out every week. I hope that at some point that there’s an extension of time limits, so that they can be thorough.” Even so, it is up and down. “The end users were happy to avert a tight definition of commercial risk that would have caught end users in the same rules as financial institutions, for example, hedging balance sheet risk,” he says, adding:“We have had to worry about things that we didn’t anticipate, such as whether or not uncleared trades that qualified for the end-user exemption would need bilateral margins on those transactions.” There are indications from commission staff that they would impose a “non-zero” margin requirement. In which case, thinks Zubod, the fight back will go right back to congress. Kevin McPartland points out that “between November and January, [the emergence of] hundreds more pages in rules has made things a little clearer, but we’re still not sure where it will go”. He adds: “We have a better flavour of what the regulators plan to tackle these issues, but in those rules there are a lot of requests for comment, so clearly there’s a lot of work to be done. There is still good room for change.” I

MARCH 2011 • FTSE GLOBAL MARKETS

SPOTLIGHT

Global pension assets up 8% in 2010 7.6% real return on UK pension funds ACCORDING TO THECITYUK, an independent membership body which promotes the UK financial and related professional services segment, the total value of pension assets managed globally rose by an estimated 8% to $31.1trn in 2010, building on an 11% upturn in 2009. However, pension assets have still to recover the high of $31.9trn reached in 2007. The Pension Markets report by TheCityUK says that UK defined benefit (DB) schemes are still focused on “de-risking”, even though many UK pension schemes report an improved funding position. Recovering equity markets contributed to the record £201bn deficit of DB pension schemes in 2009 being turned into a £22bn surplus in 2010. Concern about long-term growth in liabilities linked to rising life expectancy is the prime driver of de-risking. A central strategy has been closure of DB schemes to new members: employees in open DB schemes have fallen by three quarters from 4.1m in 2000 to one million in 2009. The share of UK DB private

sector schemes remaining open to new members has declined to 21% in 2010 from 35% in 2006. Other means of de-risking include lowering allocation to equities, down to 42% from 75% over the past ten years. Some companies are transferring responsibility for DB pension schemes to insurance companies: the insurance buyout market was worth around £7bn in 2008 and 2009. Costs have also been reduced with contributions to DC schemes, says the report, at 9% of salary, running at less than half the 20% of salary to open DB schemes. The UK government has been legislating to put financing of pensions on a sustainable basis. The state pension age is being raised to improve affordability and the default retirement age is being removed to facilitate ongoing employment for those who wish to keep working. The CPI is to replace the RPI as the legal minimum for pension indexation, reducing the cost to employers of DB commitments and decreasing

pensions of DB beneficiaries. The National Employment Savings Trust (NEST) is being introduced to encourage a broader spread of pension provision among those on low and middle incomes. As a first step in reviewing the financing of public sector pensions, the Independent Public Service Pensions Commission, chaired by John Hutton, has established a set of principles against which long-term options for reform should be judged. Duncan McKenzie, head of research at TheCityUK, said: “The real rate of return on UK pension funds was 7.6% in 2010, building on the 15.7% rise in 2009. However, four years of negative returns over the past decade mean that real returns during that period have averaged only 1.7% a year, well below the long-term average real return of 4.3% a year over the past half century.” The UK, with pension assets totalling $2.5trn, remains the second largest market, accounting for 9% of total assets worldwide. UK assets are only exceeded by the dominant US market where assets of $18.1trn make up nearly two thirds of the global total. I

Investors call for sustainability disclosure Aviva leads demand for stock exchanges to address company reporting A TOTAL OF 24 institutional investors, representing $1.6trn in assets under management, led by Aviva Investors–—including Allianz Global Investors Investments Europe, AP7, Australian Council of Super Investors, and BC Investment Management Corporation–—have written to 30 of the world’s largest stock exchanges asking that they address inadequate sustainability reporting by companies. The letter is part of a broader initiative launched by Aviva

Investors and facilitated by the UNbacked Principles for Responsible Investment (PRI) in 2008, which has taken stock exchanges to task in the hope of improving the quality of sustainability reporting by companies. Aviva Investors says that companies considering listing should take into account how responsible and sustainable their business model is, and put a sustainability strategy to the vote at their annual meetings. Paul Abberley, chief executive officer of Aviva Investors London, holds: “Markets are driven by information. A lack of information as a result of limited or non-

disclosure of ESG [environmental, social and governance] data makes it difficult for long-term investors such as us to assess the wider ESG risks and opportunities associated with a company.” Developed using Bloomberg data, the letter also ranks individual listing authorities on a sustainability league table that assesses the current level of ESG [environmental social and governance] disclosure among listed companies. Euronext Paris, Tokyo Stock Exchange, Helsinki, Euronext Amsterdam, Euronext Lisbon and Borsa Italiana, are ranked highest for company disclosure of ESG data. I

MARCH 2011 • FTSE GLOBAL MARKETS

SPOTLIGHT

IOSCO identifies benefits of organised platform derivatives trading Report looks at costs, advantages and challenges

Geoff Cook, chief executive, Jersey Finance. Photograph kindly supplied by Jersey Finance, February 2011.

Jersey company law changes New provisions for mergers NEW REGULATIONS HAVE been approved by the States Assembly in Jersey, which simplify the process for mergers between Jersey and foreign companies. The improvements to the merger provisions in Jersey Companies Law should prove an attractive feature to international investors looking at the opportunities to invest in western markets. The regulations enable Jersey companies to merge with both foreign companies and other foreign bodies incorporated outside of Jersey. They also allow Jersey companies to merge, in any combination, with other Jersey companies or bodies incorporated in Jersey. Previously it was only possible to merge a Jersey company with a foreign one indirectly, through a procedure that was cumbersome and more costly. Any proposed merger involving a body other than a Jersey company will require the consent of the Jersey Financial Services Commission. Geoff Cook, chief executive, Jersey Finance, says: “These provisions will provide institutional investors in India and elsewhere with more options when they establish entities in Jersey to meet investment objectives.” Jersey Finance has a representative office in Mumbai opening in mid-March. I

THE TECHNICAL COMMITTEE of the International Organisation of Securities Commissions (IOSCO) has published a Report on Trading of OTC Derivatives. The report analyses the benefits, costs and challenges associated with increasing exchange and electronic trading of over-thecounter (OTC) derivative products and contains recommendations to assist the transition of trading in standardised derivatives products from OTC venues onto exchanges and electronic trading platforms (organised platforms) while preserving the efficacy of those transactions for counterparties. “IOSCO believes that it is appropriate to trade standardised derivatives contracts with a suitable degree of liquidity on organised platforms, provided that a flexible approach encompassing a range of entities that would qualify as such platforms is taken by regulators,” says Hans Hoogervorst, chair of IOSCO’s Technical Committee. The task force preparing the report has identified a number of benefits that will result from a move to organised platforms, including greater competition, increased participation, better transparency, and improved market oversight. “All of these will contribute to the realisation of the G20 Leaders’ objectives as well as benefiting market participants and regulatory authorities,” explains Hooogervost. “Finally, while there is debate amongst regulators regarding the characteristics that an entity should exhibit to qualify as an eligible organised platform, the overriding principle that regulators must observe is that they need to coordinate their efforts in facilitating the transition of OTC derivatives trading to organised

platform trading to ensure that the objectives of the G20 are achieved, and not undermined,” he adds. The report identifies seven characteristics of organised platforms, including registration of the platform with a competent regulatory authority, including requirements relating to financial resources and operational capability; access for participants based on objective and fair criteria that are applied in an impartial, non-discriminatory manner; and pre-trade and posttrade transparency arrangements which are appropriate to the nature and liquidity of the product and the functionalities offered by the platform; operational efficiency and resilience including appropriate linkages to post-trade infrastructure and measures to handle potential disruption to the platform and transparent rules governing the operation of the platform. In addition, the IOSCO says the platform should allow participants to seek liquidity and trade with multiple liquidity providers within a centralised system. However, it appears that members of the task force were not in full agreement as to whether organised platforms must exhibit all eight characteristics, or only the first event characteristics, in order to achieve the G20 Leaders’ objectives of improving transparency, mitigating systemic risk, and protecting against market abuse in the derivatives market. The task force on OTC derivatives regulation was launched in October 2010 and will produce two further reports, one on data reporting and aggregation and another on international standards. Copies of this latest report can be found on the IOSCO website. I

MARCH 2011 • FTSE GLOBAL MARKETS

SPOTLIGHT

2010 a good year for funds, says EFAMA Asset levels bounce back to pre-2008 figures POSITIVE NEWS IS emerging from the European Fund and Asset Management Association (EFAMA), the representative association for the European investment management industry. It seems 2010 was a good year for European investment funds. The investment fund industry bounced back to the asset levels reached at the onset of the global financial crisis and the recovery has benefited all categories of long-term funds, despite the euro crisis, according to the association’s newlypublished 2010 statistical review. The association reports a strong increase in investment fund assets, which had risen by 13.7% to €8.025trn by year end, something of a turnaround, given that the value of investment fund assets had tumbled to almost €6trn in early 2009. Investment fund assets in Europe now represents some 66% of the European Union’s GDP, says the association, confirming the now growing contribution of investment funds to the European economy and acting as a vehicle for providing funding to other economic sectors. UCITS registered net inflows of €166bn over the year, compared with inflows of €150bn in 2009. Total net sales of long-term UCITS (UCITS excluding money market funds) reached €292bn last year, compared to about €195bn in 2009. Money market funds, unsurprisingly however, saw outflows of €126bn over the period. Very low, short-term interest rates as well as an increase in competition from banks seeking to strengthen their balance sheets by increasing the share of the deposits, has encouraged investors to shift assets away from money market funds.

Eurex confirms it will take a majority share in EEX Eurex Zurich AG’s stake will grow to more than 50% EUREX HAS CONFIRMED it will become the new majority shareholder in the European Energy Exchange (EEX). The derivatives exchange agreed to the acquisition of Landesbank BadenWürttemberg’s (LBBW’s) 22.96% share in the EEX by Eurex at the end of last year. However, under the pre-emption rights laid out in the consortium agreement, LBBW was obligated to offer its shares on a pro rata basis to other EEX shareholders. The first round of the tender process was finalised on February 22nd. Some 31 of the 40 eligible EEX shareholders declared that they would forego a proportional increase in their stake, thereby opening the way for Eurex to increase its shareholding in EEX to over 50%. The final price of the shares has been agreed at €7.75 per share, involving a strike price of €7.15 per share and a premium of €0.60, because Eurex becomes majority shareholder. The exact shareholding will be determined in the second stage of the tender. However, the supervisory board of EEX has still to agree to the

Special funds reserved to institutional investors gathered a record €149bn in 2010, and real estate funds another €5bn. Overall, total net sales of UCITS and non-UCITS reached €335bn in 2010, compared to €190bn in 2009. EFAMA also notes a buoyant crossborder fund business over the course of the year: UCITS domiciled in Luxembourg and Ireland recorded total net sales of €215bn in 2010, thereby increasingly their market share in the UCITS industry to 44.1%.

Photograph © Solarseven / Dreamstime.com, supplied February 2011.

transfer of LBBW’s shares. The transaction also requires regulatory approval. The Exchange Supervisory Authority in Saxony and Germany’s Federal Cartel Office have already given their consent. Eurex is now set on expanding the reach of EEX. Having agreed with the State of Saxony and the City of Leipzig to maintain EEX jobs in Leipzig and help the city develop as a centre of expertise for energy products, it has also agreed to allow EEX to use Eurex’s international locations in Europe, America and Asia and benefit from its global participant network. I

Moreover, the wide range of funds following different types of investment strategies offered investors opportunities to shift their portfolio between fund categories according to changes in the global economic outlook and the perceived investment risks, says the association. For example, the sustained sovereign debt crisis in the euro area led to outflows from bond funds in December, whereas equity funds benefited from the encouraging economic outlook for 2011. I

MARCH 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

RIDING THE ETF WAVE: HOW LONG CAN IT LAST?

Photograph © Triling Anna / Dreamstime.com, supplied February 2011.

ETFs strike a chord with investors A niche market at best a decade ago, exchange-traded funds continue to maintain almost 30% annual growth through good times and bad. What factors have fuelled their widespread popularity of late—and, above all, how long can the momentum be maintained? David Simons reports from Boston.

UST BACK FROM the annual Inside ETFs conference in Florida, Joseph Keenan, managing director at BNY Mellon Asset Servicing, is feeling unusually upbeat about the state of exchange-traded funds (ETFs). While basking in the Florida sun, Keenan got to witness first-hand the ongoing enthusiasm for ETFs among sponsors, service providers, and end users alike. “The degree to which the entire industry has embraced ETFs is quite extraordinary,” offers Keenan. “I think back to some of the conferences I attended ten years ago, when there couldn’t have been more than about 25 people in the room. Compare that to the roughly 900 who turned out for this year’s event,

and that gives you some idea about the progress that’s been made.” Those like Keenan who have worked in the trenches from the start have been extremely pleased with the progression of these highly liquid, value-oriented products over the past several years. Barely a blip on the radar screen a decade ago, ETFs today encompass a wide range of strategies covering numerous indices and markets, offering a relatively pain-free approach to working with familiar benchmarks as well as commodities, fixed-income products and other innovations. Newly-released findings from ETFindustry leader BlackRock suggests that assets under management covering

both ETFs as well as exchange-traded products (ETPs) could rise as much as 30% annually to 2013 on a global basis. According to BlackRock’s Global ETF Research and Implementation Strategy Team, at the end of 2010 combined ETF and ETP products exceeded 3,500 worldwide—more than 30% higher than in 2009— totalling $1.48trn in assets. ETFs alone are expected to reach $1trn in the US by the end of 2011, and $2trn worldwide by the following year, boosted by trends that include greater use of fixed income and commoditybased products, an increased uptake among fee-based advisors, as well as new product launches within the major exchanges. Additionally, favourable regulatory conditions will probably pave the way for larger ETF fund allocations over the near term. BlackRock team leader Deborah Fuhr sees both professional and retail investors continuing to be enticed by the “unique combination of benefits” that have long been the calling card of ETFs, including versatility, transparency and significant cost savings. “The availability of these flexible and diversified investment products that enable rapid implementation of a comprehensive range of investment strategies has struck a chord with investors, during both bull and bear markets,” concurs Fuhr. From an investment-performance standpoint, 2010 wound up being “a spectacular year” for ETFs, adds Tom Anderson, global head of ETF strategy and research at State Street Global Advisors (SSgA). “ETF assets in the United States were up 28%, volumes as a percentage of overall trading continued to be significant, and investors have been expanding their use of these products as a means of gaining both broad-based exposure as well as more tactical kinds of allocations.” While market appreciation has certainly helped, Anderson points to the four previous years—not all of them rosy by any stretch—in which ETFs attracted on average $100bn in new investor funds annually. “For most of 2010, investors were not significantly devoting funds to

MARCH 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

RIDING THE ETF WAVE: HOW LONG CAN IT LAST?

US equities. It really shows that it isn’t all about market movement. It is investor demand as well.” Though often commanding higher fees than the average ETF product, socalled performance-based products, such as those weighted towards specific region or fundamentals, have gained traction among investors seeking higherthan-normal rates of return. These types of innovative products continue to push the industry’s envelope, compelling even companies that have long relied on industry-standard-type indices to begin to broaden the product offering in order to stay competitive. Meanwhile, fixedincome ETFs, which have a tendency to trade at a much tighter spread within any given portfolio, have greatly benefited investors by adding diversity to an historically opaque market. John Fletcher, technical analyst of derivatives, ETFs and equities with London-based Charles Stanley & Co, attributes a good portion of ETF’s popularity to innovation, including the opening up of newer regions of investment. “Not only are they transparent, easy to trade, and highly liquidity, they also allow investors to one-stop shop for an entire region or asset class, and can be used tactically as part of an overall plan.”

Tactical use With expense ratios averaging around 50 basis points (bps) or less, ETF investors have the ability to get in on some fairly extraordinary regional plays such as Asia and other emerging areas that have long been historically difficult to access due to local laws and, above all, lack of liquidity, says Keenan. He adds: “For instance, one can now conceivably allocate 5% of the portfolio to a country such as Vietnam, and still have it cost less than 1% in terms of ongoing fund expenses, which is pretty amazing, considering that just a few short years ago that type of market was practically off limits, and even if you could get in, you’d be paying a lot more for the exposure.” Though a plausible gateway to traditionally challenging sectors, Fletcher

Joseph Keenan, managing director at BNY Mellon Asset Servicing. Photograph kindly supplied by BNY Mellon, February 2011.

Tom Anderson, global head of ETF strategy and research at State Street Global Advisors (SSgA). Photograph kindly supplied by SSgA, February 2011.

warns of the potential negative impact on transparency, one of the key benefits of ETF usage. Additionally, he believes that product innovation should ultimately go hand in hand with increased investor education. “Innovation, after all, shouldn’t only come in the form of new products,” Fletcher adds. “Better tracking, lower total expense ratios [TERs], and reduced counterparty risk, for instance, could also be considered building upon innovation within the exchange-traded space.” At present, domestic ETF assets exceed $1trn, with industry stalwarts such as iShares, Vanguard and SSgA accounting for the lion’s share of activity. That doesn’t quite paint the whole picture, says Keenan, who sees smaller, niche-oriented providers garnering a much higher rate of growth, “which is really indicative of the pronounced shift from an institutionally focused business, to one that is more retail oriented”. Accordingly, there have been a number of products launched that are more tactical than broad based, says Keenan. “While they’re not Russell 2000 or S&P 500, particularly for fee-based planners, they still represent a very good opportunity to use passive products in an active manner.” Contrasting the notion that ETFs are purely retail vehicles, Anderson points to the number of foundations and endowments that continue to accumulate and hold ETFs in their investment portfolios. “These types of investors are discovering that ETFs can often be the most convenient and efficient means of gaining exposure to certain industries,

sectors, commodities or individual countries—so what may at first appear to be a temporary or tactical position often winds up becoming a long-term, multi-year strategy for the institution.” To date, the SEC’s often lengthy exemptive-relief evaluation process, which can take anywhere from six months to two years before an ETF is deemed fit for launch, has helped keep a lid on ETF output: currently there are less than 30 ETF sponsors in the US total. Regulators also continue to take a dim view of derivatives usage within ETFs, causing many in the exemptiverelief line to rethink any product bundle that may have included over-the-counter (OTC) strategies. Add to that a sharp increase in demand from traditional asset-management firms, and the result has been an extraordinarily long queue for prospective ETF sponsorship. “Nearly all of the top 25 mutual-fund managers have filed for exemptive relief, even if most of them aren’t quite sure how they would even approach the ETF market at this stage,” says Keenan.

Anchor product Meanwhile, the proliferation of socalled cheap beta ETF products—or, in some instances, ETFs that are totally commission-free—has had a dramatic impact on the ETF business as a whole. Keenan says: “There is the view among many of these firms that, even if fees have to be lower or non-existent, it is still better to get in on the ETF action now, in hopes of capturing a larger piece of the pie.” Hence, brokerages that once

MARCH 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

RIDING THE ETF WAVE: HOW LONG CAN IT LAST?

benefited from the imposition of 12b-1 fees now find it increasingly difficult to turn a profit on the ETF trade. While some have expressed concern that these lower-cost products could wind up cannibalising their successful franchise, others have adjusted their expectations and now view ETFs as an anchor product, one that can be used to boost other parts of the service offering. “In other words, if you can get the client to get in on these low-cost or no-cost ETFs, then there’s a chance that they’ll buy other products once they’re aboard,” says Keenan. Given the tremendous surge in activity that has occurred over the past few years, Fletcher believes that the industry may experience some difficulty maintaining

its current rate of expansion. He points to recent bar-chart data provided by BlackRock, showing exponential ETP growth tailing off to a flatter, if still rising, trend line going forward: “I would still envisage growth to continue for many more years, though with an inevitable slowing of momentum.” Either way, Anderson, like many of his colleagues, sees a continued broadbased movement from active to passive investing strategies in the years ahead. Over the past decade, combined ETF and mutual fund indexed assets more than doubled, and today represent around 23% of the overall market. “Interestingly, ETF assets have been responsible for nearly all of that increase,” says Anderson. “It’s

John Fletcher, technical analyst of derivatives, ETFs and equities at Charles Stanley & Co. Photograph kindly supplied by Charles Stanley & Co., February 2011.

simple—investors are telling us that ETFs are their preferred index vehicle, because, in general ETFs offer great value, have tremendous liquidity, and are extremely tax efficient as well.”I

UK ETF REVIEW SSETS UNDER MANAGEMENT (AUM) in exchange-traded funds (ETFs) and exchangetraded products (ETPs) with primary listings in the UK increased by 49% in 2010, and totalled $93.4bn as of year end, according to a new report on the UK market produced by BlackRock’s Global ETF Research and Implementation Strategy Team. The report, ETF Landscape – United Kingdom Industr y Review, which covers all ETFs and ETPs listed in the UK, notes that the AUM increase for 2010 is considerably more than the 5.2% increase in the FTSE 100 index in US dollar terms over the same period. The average daily reported trading volume in US dollars for all UK listed ETFs/ETPs was $550.4m at year-end 2010, up 24% from $445.3m at the end of 2009. “In the UK, as is the trend globally, all types of institutional and retail investors including advisers are increasingly embracing ETFs as a

tool that should be considered and used when implementing asset allocation,” says Deborah Fuhr, global head of ETF Research and Implementation Strategy at BlackRock. By the end of 2010, the UK ETF/ETP industry had 764 unique ETFs/ETPs listed in the UK with 1,125 listings from 23 providers across three exchanges/MTFs (London Stock Exchange, Chi-X and Turquoise). There were 520 ETFs/ETPs with their primary listing in the UK, compared with 293 primary listings at the end of 2009, an increase of 77.5%. Nineteen ETFs/ETPs listed in the UK had assets greater than $1bn, while 112 ETFs/ETPs had assets greater than $100m. A key factor encouraging more advisers in the UK to embrace ETFs is the Retail Distribution Review (RDR) of the Financial Services Authority (FSA), the report notes. The RDR outlines proposals by the FSA to establish new levels of consumer trust and confidence

Deborah Fuhr, global head of ETF Research and Implementation Strategy at BlackRock. Photograph kindly supplied by BlackRock, February 2011.

within the UK’s retail investment market. “ETFs are ‘RDR ready’ and fit into the new adviser charging model proposed by the FSA,” says Fuhr. “As such, we have seen an increasing number of requests for information on ETFs that are both listed and registered for sale in the UK as well as having UK tax status, which can make them more efficient for UK domiciled investors.”

MARCH 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

ASIA-PACIFIC DRS: THE NEW ISSUANCE OUTLOOK

Depositary banks expect to see continued growth in depositary receipt (DR) capital raising across the Asia Pacific region in 2011. Three trends look set to develop through the year: Hong Kong’s DR market is expected to grow in popularity as a destination for global companies to tap the local finance markets; a continued deepening of the Asian capital market, and, finally, a steady stream of DR issuers emerging from China and Singapore eager to tap the nascent DR listings market on the Taiwan Stock Exchange.

DRs grow in stature in Asia-Pacific markets HINA-BASED INFORMATION technology firm iSoftStone Holdings Limited—lining up a $161.96m initial public offering (IPO)— is the latest company to ask JP Morgan to be its depositary bank. The firm is listing an American Depositary Receipt (ADR) programme on the New York Stock Exchange, placing 12,458,334 ADRs at an offer price of $3 per ADR. The capital raised included the exercise of the underwriters’ overallotment option. According to Kenneth Tse, Asia Pacific head of depositary receipts at JP Morgan: “With the continued recovery of capital markets globally and an improvement in corporate earnings generally, we are expecting 2011 to deliver another strong year of growth in the Asia Pacific depositary receipts space. China and India will undoubtedly remain key players, but we are also expecting to see some of the smaller markets [such as] Mongolia and Vietnam begin to assert themselves on the global stage over the next 12 to 24 months. Tse also notes that the bank expects to see continued growth in the various DR markets across the Asia Pacific. “We think that local market DRs will continue to evolve quickly and it is a segment that offers significant growth opportunities going forward.” He explains that local market DRs offer companies with significant operations in the Asia Pacific better access to a

growing base of investors within each market. Tse says: “These are investors who are seeking local currency denominated investment vehicles and exposure to a wide range of international names”. JP Morgan was the depositary bank supporting Brazilian miner Vale’s landmark Hong Kong DR (HDR) in December last year. The mining giant had been planning to come to market almost as soon as the jurisdiction began offering HDRs. The Hong Kong market has been slow to gain traction, despite attractive listing fees (compared with, say, the United Kingdom). However, a DR listing in Hong Kong for foreign issuers is a long, two-step process. The first step involves acceptance by the issuer’s own regulator that the issue is compliant with local regulatory requirements, which in the case of Vale took over a year. Only if and when the listing in Hong Kong is accepted by the issuer’s domestic regulator will the Hong Kong Stock Exchange begin to consider the listing application. Vale, with a market capitalisation well in excess of $160bn, was already listed on the NYSE, through an American DR; its primary listing is on the Bovespa in Brazil. The HDR made sense for the mining giant as it already secures over 40% of its revenue from the Greater China region. The importance of listing in

Photograph © Andreas Meyer / Dreamstime.com, supplied February 2011.

Hong Kong right now is emphasised by the jurisdiction’s emergence as an offshore renminbi centre; although over the longer term, once the Chinese currency becomes fully convertible, this advantage might be lost. A hint of what is to come is provided by impending regulatory changes in China, which may allow foreign companies to list on mainland stock exchanges. Singapore Exchange (SGX) has followed Hong Kong’s lead in encouraging foreign firms to trade on the exchange, having launched a platform allowing investors to trade ADRs in Asian companies. The board, called GlobalQuote, was launched in cooperation with NASDAQ OMX in October last year. BNY Mellon is acting as depositary bank for the platform. According to JP Morgan’s latest Year in Review report, issued in mid-February, China and India will continue to dominate IPO capital raising after a record number of deals in 2010 while the value of DR trades in the Asia Pacific region grew by double digits to $882bn, over some 36bn trades. The bank warns, however, that some obstacles remain in the region which could dampen growth in the DR segment, including moves by some emerging markets to tighten policy over continued inflows of foreign funds as well as uncertainty created by escalating commodity prices.I

MARCH 2011 • FTSE GLOBAL MARKETS

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KEYNOTE SPEAKER Romnesh Lamba Executive Vice President and Head of Market Development HKEx

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Interactive sessions: Drill deeper into the core challenges raised in the guest presentations and panel discussions

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DEBT REPORT

SPANISH COVERED BONDS: REFORMS IMPROVE OUTLOOK

Recapitalisation plans will help save Spain’s banking system The outlook for Spanish covered bonds is far stronger than it was 12 months ago. Over the first six weeks of 2011, the country’s first and second-tier banks have been able to take advantage of the surge in demand for all European covered bonds and issue new debt—albeit at a high premium because of the continuing concerns about Spain’s public finances—while the government’s plans to press ahead with a restructuring of the country’s banking sector should see the resumption of a more normal market for cédulas by the year end. Andrew Cavenagh reports. HEREAS AT THIS point in 2010 virtually the sole focus of the market was to secure liquidity for Spain’s banks via European Central Bank repo operations—as the crash in the country’s property market threatened to paralyse its banking system—this year, financial institutions had sold more than €10bn of cédulas to investors by mid-February. Santander and BBVA, inevitably led the way with €1bn and €1.5bn issues respectively in the first week of January, both of which offered investors a generous spread of 225 basis points (bps) over the mid-swaps benchmark. La Caixa and second-tier institutions Banco Popular and Banco Sabadell followed their lead in late January and early February, with the bonds of the last two pricing at 270bps over mid-swaps. By February, there was significant downward pressure on cédulas spreads, despite the constraints of Spain’s sovereign debt situation. BBVA issued its second covered bond of the year—a €2bn, five-year offering—at 200bps to mid-swaps after drawing orders of more than €8bn, and secondary-market pricing on longer-term bonds also came in sharply. Caja Madrid’s 30-year bonds were trading at 210bps in mid-February, while its ten-year cédulas were at 250bp and its five-year instruments at 280bps. “We have a totally inverted

Elena Salgado, Spain’s second vice president and minister of economy and finance. Photograph kindly supplied by government of Spain, February 2011.

curve,” says Fernando Cuesta, the bank’s head of funding. The high premium that Spanish issuers are having to pay relative to their French, Italian and UK covered bonds as a result of Spain’s sovereign position will probably restrict primary issuance to around €20bn in 2011. For this is only an estimated €25.8bn of outstanding debt in the sector due to mature over the year, and not all of it will necessarily be replaced by new covered bonds. Caja Madrid, for example, has a €2bn cédulas maturing on March 25th, but Cuesta says the bank may refinance the debt from other sources. Spanish banks are reportedly holding around €100bn in potentially difficult

real estate assets according to Spain’s central bank. However, at the end of February, Miguel Ángel Fernández Ordóñez, central bank governor, claimed the exposure does not endanger the country’s financial sector as a whole. While there is clearly no incentive for banks with shrinking assets and balance sheets to raise additional funding in the current spread environment, the decisive steps the government is taking to restructure the country’s banking sector should ensure the return of a more normal market from 2012 onwards. The government in February pressed ahead with plans for the banks to begin recapitalisation programmes. The key element in this process will be the recapitalisation and consolidation of Spain’s regional and local savings banks (cajas), and the government set out its provisional programme to achieve this in January. Spain’s finance minister Elena Salgado says all banks will have to increase their core capital ratios by between 8% to 10% probably by late September or be forced into stock-market listings in which the government would acquire stakes in partial nationalisations. Spain’s central bank says it will publish an estimate of each bank’s financing requirements in March. More specifically, listed banks will have to hold core capital levels of 8%, while unlisted banks are required to hold core capital levels of 10%. “I think what you can say is that the government is determined to save the banking system,” says Jose Sarafana, a fixed-income analyst at SG Corporate and Investment Banking in London, who covers the sector. The government and the Bank of Spain also seem confident the sector will require only around €20bn of fresh capital to achieve its target; whereas many industry analysts have suggested

MARCH 2011 • FTSE GLOBAL MARKETS

DEBT REPORT Spanish market share in jumbo covered bonds

SPANISH COVERED BONDS: REFORMS IMPROVE OUTLOOK

that the exercise will need up to four times that amount. Cuesta at Caja Madrid says the difference probably reflected the central bank’s superior understanding of provisioning in Spain’s banking system and historical recovery rates. “They have shown that they know the system better than anyone else—and we have had similar real-estate crises to this.” The oversupply of housing (and default rates on property loans) varies considerably in different parts of the country. While some cajas on Spain’s southern coast may have 25%-30% of their loan book in default, the figure for banks in and around Madrid is just 7%. Cuesta says some new construction is even likely to start in certain districts of Madrid over the next 12 months. Even if official recapitalisation forecasts prove too optimistic, there is always the back-stop of the Fund for Orderly Bank Restructuring (FROB) that the Bank of Spain set up to support restructuring of the sector in 2008 and which has so far committed €11bn to recapitalising regional cajas. While this represents most of the FROB’s current capital (€9bn initial set-up and a recent €3bn bond issue), the central bank has indicated it will support the fund up to around €100bn if necessary, and this

2% Portugal 3% Sweden 3% Ireland 3% Italy

Evolution of outstanding jumbo cédulas volume 2% Norway 5% Others 28% Spain

300 250 200 150

4% Denmark

100 22% France

8% UK

Jumbo cédulas territoriales Jumbo multi cédulas Jumbo cédulas hipotecarias

20% Germany

50 0

Dec 2006

Dec 2007

Dec 2008

Dec 2009

Dec 2010

Source: Unicredit 2011, from a presentation to fixed income investors by Banco Popular, December 2010, supplied February 2011.

Source: Deutsche Bank 2011, from a presentation to fixed income investors by Banco Popular, December 2010, supplied February 2011.

has underscored the improving confidence in both the Spanish banking sector and its covered bond market. “My view is that there is no way that the Spanish government will allow the cédulas market to collapse,” says Tim Skeet, adviser at AmiasBerman and board member at the International Capital Markets Association. Additionally, a much larger domestic investor base for cédulas has emerged over the past year, which partly reflects the enhanced status of covered bonds across the institutional investment community.

Whereas in the run-up to the financial crisis Spanish issuers could not count on selling more than 10% of their offerings to domestic buyers, they can now realistically expect to place up to 30% of an issue in the home market. “They have become a lot better at supporting their own issuance recently and that’s been hopeful,” adds Skeet. While the projected consolidation of the 45 unlisted cajas into 17 larger banks will need to be completed before the established multi-seller cédulas programmes can resume issuing. I

MOODY'S UPDATES SET-OFF RISK ANALYTICS FOR ITALIAN STRUCTURED FINANCE ATINGS AGENCY MOODY’S Investor Services says it has reviewed Italian covered bond transactions that are exposed to set off risk. There will be no rating actions following the implementation of revised methodology used in transactions backed by residential mortgage loans, commercial loans, public-sector exposures, leases, consumer loans and loans made to small and medium-sized enterprises (SMEs). Set-off risk occurs when a debtor can reduce the outstanding amount of its securitised debt by the amount of any unpaid claims it has

against a defaulting originator. The unpaid claims could take the form of bank deposits, bonds or amounts owed under other contracts. Set-off risk is most likely to arise where the originator is a deposit-taking institution. Under Italian law, reciprocal debt obligations may be set off against each other if they are both due and payable. After a debt is assigned to a third party, such as a securitisation issuer, the debtor may still set off claims owed to it by the originator. However, set-off rights against securitised debt (other than

consumer loans) are limited to the amount of claims that exist when the notice of assignment is published in Italy’s Official Gazette. In Moody's view, issuer's exposure to set off in relation to deposits is substantially reduced where debtors are entitled to compensation from one of Italy's deposit compensation funds. In this regard, a debtor will not assert set off in respect of deposits for which it has received a compensation payment. Debtor-bydebtor deposit data is required to give full benefit to any compensation available.

MARCH 2011 • FTSE GLOBAL MARKETS

REAL ESTATE

Sunken treasure or just plain sunk? ARACK OBAMA’S NOTORIOUS 2008 slight requires little in the way of tinkering to make its point: “You can put lipstick on PIIGS, but they are still PIIGS.” Yet while Greece, Ireland and latterly Portugal have had to take drastic measures to shore up their sinking economies, Spain seems neither fully to have faced its property demons nor to have lost its allure for retail real estate investors. On residential there is little but worrying data. The Bank of Spain recently requested that all 17 of the country’s regional savings banks, which account for about half of all lenders, supply details of their exposure to the collapsed real estate market. The nation’s seven main banks held €45bn in risky assets and the 15 of the savings banks that had published their figures by the end of the first week in February accounted for around double that, largely due to the huge mortgage loans (€164.9bn) the savings banks handed out during the property boom. At €135bn, total risky assets were actually much less than the Bank of Spain’s €180.6bn estimate at the end of June. Even so, consumers will hardly be cheered. The country’s second-largest bank, BBVA, forecasts that the Spanish economy will post a “weak” recovery this year, with growth of 0.9%, picking up to 1.9% in 2012. The Bank of Spain estimates the economy shrank by 0.1% in 2010 after contracting 3.7% the previous year. Against such a backdrop, unsurprisingly Spain’s National Statis-

FTSE GLOBAL MARKETS • MARCH 2011

tics Institute reported that retail sales fell to their lowest level in over a year in December as unemployment hit 20.33%, the highest jobless figure in the industrialised world, and a rise in inflation eroded purchasing power. With such weak consumer fundamentals, it would be reasonable to assume that retail real estate would have taken a tumble but returns have stabilised. Primary monthly rents for shopping centres sit in the region of €90/sqm and retail parks are trading at around €16/sqm, consistent with 2009 levels, says agent Savills. More international retailers have entered the market and expansionist Primark for one has identified Spain as one of its major targets. “The consumer market in Spain remains ideal for the fashion retailer’s value offer and Primark will continue to expand in the right locations across the country,” asserts Thomas Meager, Primark’s property director. The investment market has also shown signs of revival, with a 40% increase on signed transactions between January and October 2010, compared with the previous year at €540m. In all, 42% of that investment volume is concentrated in supermarket and hypermarket sale and leaseback transactions, principally designed to help retailers unlock cash or deleverage. Larger portfolio transactions have seen international players buying from Spanish sellers, with the US, Netherlands and UK accounting for 89% of the total.

SPANISH REAL ESTATE: RESIDENTIAL, RETAIL & REALITY

While the Spanish residential real estate market has been hammered by the country’s economic meltdown, prime commercial retail property continues to exert an ongoing allure for investors which seemingly flies in the face of all the financial indicators. Mark Faithfull questions whether this apparent dichotomy between consumer and consumption can be squared.

In prime shopping centres, gross initial yields stand at between 6.75%7% and John Welham, head of European retail investment at agent CBRE, says that with the once struggling UK investment market turning upwards very suddenly, investment funds are looking intently at those markets on the cusp. “Rents bottomed-out very suddenly in the UK. Investors don’t want to miss out on Spain if the same happens,” he adds. Peter Todd, director at Resolution Property, which has bought and sold assets in Spain, believes it is a country of two market speeds. “Spain has divided and the better performing assets now seem to be in the north of the country,” he says. More deals are in the offing. UK-based private equity firm Orion Capital Managers is thought to be close to clinching the acquisition of a 50% stake in the massive Puerto Venecia shopping centre project in Zaragoza, northern Spain. The vendor is Spanish developer and investor Copcisa Corporación, which owns the €420m shopping centre and retail park scheme in a joint venture with UK REIT British Land through Eurofund Investments Zaragoza. The acquisition of the half interest is expected to amount to net equity of around €55m.

Long-term potential Meanwhile, Henderson Global Investors, on behalf of Warburg-Henderson’s RZVK-Immo-Fonds, has acquired the Meixueiro Retail Park in Vigo, northern Spain, from Oralco, for €35m. Henderson also acquired the Nervión Plaza de Sevilla shopping centre a year ago, again on behalf of Warburg-Henderson. Madrid-based Fernando San Juan of developer and investor Doughty Hanson, which is working on the huge Valdebas project just outside Madrid with developer Multi, says that the company had determined that it was the right time to buy in Spain. “Shopping is very integrated into the culture of Spain and we believe in its longterm potential,” he insists. I

COUNTRY REPORT

BANKING IN UKRAINE: CHANGE REQUIRED

Photograph © Nortivision / Dreamstime.com, supplied February 2011.

A need to consolidate Though far from being back to full health, the Ukraine banking system continues to make gentle steps towards recovery. During the credit crunch, the country was one of the worst hit in Europe. At the height of the crisis in late 2008 and 2009, retail customers queued unsuccessfully in front of several banks to withdraw their savings, and apart from Latvia, which reached junk bond status, Ukraine had the unenviable glory of being downgraded by Standard & Poor’s to the lowest rating in Europe, on a par with Pakistan. By Vanya Dragomanovich. WO YEARS AND two IMF loan tranches later, the situation in Ukraine is improving—in industry, in the general economy, and by extension in banking. Standard & Poor’s has changed its rating to B+ with a stable outlook, Fitch Ratings has a B rating on Ukraine, and Moody’s a B1. GDP grew by about 4% in 2010 and this growth is expected to be replicated in 2011. Even so, the banking sector remains weak, and non-performing loans on the banks’ books are anywhere between 20% to 35%, depending on the scepticism of the analyst. Very basic reporting standards make it difficult to obtain real figures and while official central bank statistics state that

non-performing loans (NPLs) are around 11%, this number is given very little credence by those who follow Ukrainian banks closely. Having battened down the hatches in 2009, the Ukrainian banking system has navigated through the worst of the financial maelstrom and emerged blinking at the other end. Retail banking has not quite recovered yet but corporate lending is showing signs of improvement and is expected to produce reasonable growth this year. “We are past the bottom point of the cycle in banking,” says Dimitry Sologoub, head of research for Raiffeisen Bank Aval in Kyiv. “There is no immediate threat for large banks and a lot of

medium-sized banks are part of business groups. Those are frequently large exporters who are now doing well so their banks will also be better supported,” says Sologoub. “The health of the local banking continues to improve. If you look at 2010 results for the sector as a whole you will see that the situation is stable,” says Margot Jacobs, a banking analyst for Swedish fund management firm East Capital. The company’s Eastern Europe and Convergence Eastern Europe funds have allocations to Ukraine. “The situation is incrementally more positive than in the last six months. The pace of recovery in banking will depend on macroeconomics, the recovery in macroeconomic needs to keep happening,” adds Jacobs. Ukraine is still in a relatively fragile state. It is currently the second largest debtor to the IMF after Romania and ahead of Greece. Partially thanks to nudges from the IMF, the country’s cabinet this year plans to discuss a new, simplified tax code, as well as pension reform, liberalising the energy sector, downsizing the public sector and rationalising state-owned enterprises. The country’s second two-and-a-half-year IMF $15.5bn facility is running with a total fund credit use of $15.4bn. The loan

MARCH 2011 • FTSE GLOBAL MARKETS

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COUNTRY REPORT

BANKING IN UKRAINE: CHANGE REQUIRED

approvals under the second programme and under Ukraine’s new government have been fairly smooth and the fund has maintained a positive assessment on the country’s progress throughout last year, according to Commerzbank. The fund is now running the policy agenda with a focus on fiscal stability. The main weak point for the banking system remains non-performing loans, which were much higher than in neighbouring countries such as Russia. Whereas in Russia, banks typically took provisions for 10% to 15%, in Ukraine they had to take at least 20% or more. Anastasiya Golovach, an analyst at Renaissance Capital in Kyiv, says: “In some cases this could have been between 30% and 35%.” Before the credit crunch the country went through an expansionist boom, much of it fuelled by large investment in property and construction. Once the crisis began to affect the Ukraine property sector, sales ground to a halt; the natural result was a slew of half-finished, high risers and uninhabited houses in its wake. “Most of the non-performing loans were related to mortgages and consumer lending,” explains Golovach. The property market has stabilised in the meantime but remains tarnished by mistrust. When it comes to consumer

lending the banks have burnt their fingers so severely that they are still not willing to underwrite mortgages. “The loan-to-deposit ratio before the crisis was 250%. The banks want to bring this down before they start lending again,” says Jarno Nurminen, fund manager of the FIM Ukraine fund run by Nordic investment firm FIM. He says that there are signs of the property market improving, which will bode well for banking, as will the 9.7% industrial growth in January. Last year, total deposits grew by 26% while lending rose only 1%, demonstrating the banks’ reluctance to go back into lending. “Banks are still sceptical. They will go as far as to finance car purchases or car leasing but rarely anything more expensive than that. Even with financing cars, the banks will try and get a third party to finance the leasing because they want to avoid any risk,” says Raiffeisen Bank’s Sologoub.

Challenges for the segment Of the 176 banks in the country, six are under receivership and 18 are in liquidation. “The government has recapitalised four ailing banks (Ukrgasbank, Rodovid, Kyiv and Nadra) that presented systematic risk,” says Sologoub. The government has injected UAH17bn ($2.1bn)

into those banks but it estimates it will have to add another UAH12.5bn on top. “In our view the prospects for these banks, except for Ukrgazbank, to return to normal business are rather vague,” says Sologoub. Golovach believes that the government may try and sell the first three of the banks within a year or two once confidence in the banking system returns. Privately-owned Nadra bank is a slightly different case. The situation here is still unresolved as the IMF and the World Bank continue to insist that the bank should be either recapitalised by a private investor who could invest upfront cash, or put up for liquidation. Nadra is the country’s 11th largest bank and, spectacularly and publicly, went into default in 2009, since when its name has been synonymous with bad banking. It has since been put under temporary administration appointed by the central bank. The local press has speculated that local tycoon Dmytro Firtash, who financed some of president Viktor Yanukovich’s election campaign in 2010, is interested in buying the bank. Recently the central bank has allowed Nadra to raise capital from a private investor but has not confirmed that the person in question is Firtash. The bank has such a bad reputation that “people

UKRAINE’S CREDIT-RATING EXPECTS BOND REVIVAL IN 2011 KRAINE’S OWN RATING agency, Credit Rating, thinks the Ukraine debt market is due for a recovery this year, marked by a return of non-government issuers. A number of private companies are expected to come to market this year. In late February it assigned its long-term credit rating of uaB+ with a stable outlook to registered housing bonds (series A-I) issued by Donetskbased Don Stroy Com, worth UAH150m and due December 31st 2013. The company’s principal activity is investing and

construction. An obligor or a debt liability with uaB credit rating is characterised with low creditworthiness as compared to other Ukrainian obligors, however, due to the fact that the issuer does not have experience in investing and construction projects neither in redemption of housing bonds and the fact that the company has operated at a loss for the past few years because of a moribund real estate sector. The rating agency concedes that the deeply plummeting yield from government bonds by end-2010

and rising liquidity in the banking system have created preconditions for restoring investor interest in corporate securities. Considering high demand for credit from potential Ukrainian borrowers, Credit-Rating anticipates firms that have survived the recent financial crisis and retained a positive credit history will turn to the local capital markets through 2011. However, the firm warns that investors should research the credit history of borrowers thoroughly and only invest in highquality securities.

MARCH 2011 • FTSE GLOBAL MARKETS

Margot Jacobs, a banking analyst for Swedish fund management firm East Capital. “The situation is incrementally more positive than in the last six months. The pace of recovery in banking will depend on macroeconomics, the recovery in macroeconomic needs to keep happening,” adds Jacobs. Photograph kindly supplied by East Capital, February 2011.

will be sceptical about banking with them again”, says Golovach. There are other challenges facing the sector, which will have to be addressed over the short-to-medium term if the segment is to have a sustainable future. “Ukraine still has an excess of banks,” explains Jacobs, adding that too many banks are not conducive to the overall health of the sector. “In Russia there are good consolidation candidates,” he explains. “There are about 300 banks that are not of a significant size and the central bank will most likely allow for those to wither and die as it continues to push up banking requirements. The situation in Ukraine is different. There are far fewer banks there, but there is not much by way of middlesized banks and there are only a few good regional banks,” Jacobs says. Ukraine’s central bank attempted to bring in a new rule that would require minimum capital requirement for banks to rise from UAH75m to UAH120m from 2012 in the hope of thinning out the sector. However, it faced staunch opposition from the country’s banking association, which managed to overturn the requirement in court on the grounds that it would force dozens of small banks out of business. Inevitably then, the country is marred by a slew of banks that are neither very profitable, nor good candidates for acquisition.

FTSE GLOBAL MARKETS • MARCH 2011

“To bother to take a bank over there has to be something worth buying. There will be some medium-sized banks worth buying but the quality of the banks drops sharply once you go beyond the first 25 to 30 banks,” says Jacobs. Those banks that have weathered the storm relatively well are foreign banks with large parent companies elsewhere such as Unicredit, Commerzbank, Raiffeisen Bank, BNP Paribas or Russia’s Alfa-Bank. According to the National bank of Ukraine, there were 55 banks with foreign capital in the country in 2010, up from 51 in 2009, and the share of foreign capital out of the total capital of the banking system has risen to 40.6% in 2010 from 35.8% the year before. During the worst of the crisis, a number of foreign banks were looking to pull out of the local market, but at the time there were almost no takers, either foreign or local. “There were no buyers for this type of asset until fairly recently when we have seen some sniffing around. It is still a big ask to sell the foreign operations; they have big franchises, a lot of branches and large non-performing loans,” says Jacobs. However, those banks are in a better shape than they were a year or two ago and their share of the overall market has increased. One of the key trends in 2010 has been the divergence

between Russian-owned banks and western-owned banks in Ukraine, says Raiffeisen Bank Aval. Russian-owned banks used an aggressive growth strategy in the loan market backed by large-scale parent funding. In the same period, westernowned banks were much more cautious and continued to shrink their loan book. On top of that, Russia’s stateowned bank VTB issued a loan worth $2bn to Ukraine’s finance ministry and “they have indicated that if there is more money needed they would issue another loan this year”, says Golovach at Renaissance Capital in Kyiv. For this year at least, retail lending will likely remain thin on the ground but the picture on the corporate side is significantly better. Here the loan book is growing in line with the industrial recovery. Ukraine has a strong metals industry—in particular, steel— is one of the biggest grain producers in Europe and the gateway for Russian gas distribution. With commodities prices rising, the state of the domestic industry is improving. Moreover, corporations are increasingly keen to raise new loans to be able to finance production and potential expansions. Total deposits have also shown an increase in January and were up 2.3% month-on-month both on the corporate and retail front. Year-on-year growth in deposits is now at 30.5%. Although there are signs of improvement in the segment, foreign investors should step carefully into the market which still has its own idiosyncrasies in both banking and politics. “There are opportunities in the country for foreign investors but the problem is that the political environment is small and that most of the business is run by six oligarchs with interlinked interests. It is hard to find somebody who is not part of it,” explains Philip Worman, a partner at political risk consultancy GPW. Anybody wanting to invest in the country has to be very clear about those links and be careful about navigating them, he adds. I

COUNTRY REPORT

AUSTRIAN BANKS: PASTEURS OLD AND NEW

Austrian banks seek a new place under the sun Austria’s place in Mitteluropa beside the economic powerhouse of Germany and the nascent East has put its banking system in a fortuitous strategic position. Even so, the nation’s providential situation was not enough to shield it from the consequences of the global financial crisis. Austria’s biggest banks, Raiffeisen Bank International and Erste Group Bank, both accepted financial aid from the Austrian government during the crisis. Meanwhile, Klagenfurt-based Hypo Group Alpe Adria was nationalised after it was forced to announce an annual loss of at least €1bn in 2009. What now for the sector? By Joe Morgan. HILIP READING , THE director of the financial stability and bank inspections at the Oesterreichische Nationalbank, the central bank in Austria responsible for supervising about 850 banks in the country, says banks have “beefed up” their risk management capabilities in the aftermath of the financial crisis. Some have also scaled back their exposure to Eastern Europe. Volksbank, a Vienna-based bank, has taken the decision to retreat completely from Eastern Europe, putting its operations in the region up for sale. Even so, the crisis has not resulted in the Austrian banking system retreating from the CEE region. “They [Austrian banks] could not exit a market suddenly because the mood in Eastern Europe changed back in 2008 and 2009. This is because they had substantial retail banking businesses in the region. They were not just there for speculative venture, they were there invested in a brand with branches in customer relationships,” says Reading. Indeed, Austria’s place as a financing hub for the rapidly developing CEE economies has left the country’s major banks in a relatively strong position in comparison to many of their peers in Western Europe. “From a strategic business set-up, the Austrian banks are probably among the best, at least the top three or four in Europe, because

their business model is structurally sound and they will always benefit for at least the next 15 or 20 years from the structural catch-up potential of the CEE region which is still underpenetrated in terms of banking services,” says Dr Rainer Polster, chief country officer, Austria, for Deutsche Bank in Vienna. The CEE region is expected to enjoy an economic growth rate of about 3% in 2011, surpassing that of the eurozone, which is predicted to have an economic growth rate of about 1.5%, according to data published by the European Commission last November. Reading says Austrian banks sufferered a “considerable increase” in loan-loss provisions in the aftermath of the financial crisis but this rise came from a “very low level”. He says: “Banking operations [of Austrian banks] in the CEE region remain profitable and have always been so.” While the profligate countries of southern Europe remain on an operating table that could still see them require further injections of financial support from the European Central Bank, the CEE region is in largely robust health. For example, Raiffeisen last year arranged a €4bn bond issue on behalf of Slovakia, which has an A1 credit rating from Moody’s and an A+ rating from Fitch Ratings and Standard & Poor’s. Patrick Butler, the managing board

member responsible for markets and investment banking at Raiffeisen in Vienna, points to a “wave” of privatisations in the CEE region, along with continuing demand from corporations in the region to raise money, in the form of syndicated loans, secondary initial public offerings (IPOs) and bond issues. “Many of the bond issues that we oversee for Austrian companies such as OMV [the major oil and gas company] are strongly represented in the CEE region. So we are financing not only their activities in Austria but also this region as well,” explains Butler. Raiffeisen provides a variety of custody and cash management services to financial institutions in the West which are active in the CEE region. “It may be that a western customer has bought securities in the CEE and wants somebody to be a custodian for them. They may want to make an investment or an acquisition in the region,” explains Butler. “One of our subsidiaries, Raiffeisen Investment, is involved in a lot of M&A activity there. Raiffeisen Investment, working together with its partner Lazard, was involved in Danone’s sale of its stake in Russia’s Wimm-Bill-Dann.” The Vienna Stock Exchange continues to be the focus of global investment banks based in the US and UK, with foreign banks accounting for two thirds of trading volumes, according to sources at the exchange. Of the 96 trading members at the Vienna Stock Exchange, 55 are international financial institutions. There was of course significant outflows from Austria and CEE stocks as a result of the crisis, but not over-proportionately to the Austria investor base. The investor split [in the stock market] is roughly 60% or 70% international and 30%-40% from Austria or closer to Europe. We are now seeing investors from the US and Asia looking to buy into the Austria and CEE story again. This is a very good sign. The Vienna Stock Exchange is a wholly-owned subsidiary of the CEE Stock Exchange Group (CEESEG), which also includes the exchanges of

MARCH 2011 • FTSE GLOBAL MARKETS

Budapest, Ljubljana and Prague, making it the largest group of exchanges in the region with almost half of the total market capitalisation and around two thirds of all share turnover. “We see the Austrian equities markets coming back as a hub, as an investment opportunity—on one hand for issuers to issue their finance and expand into the CEE region and also for investors who increasingly buy back into the CEE story via Austrian listed stocks,” says Polster of Deutsche Bank. According to sources at the exchange, 15 market-makers are active in a variety of asset classes, including shares, exchange-traded funds (ETFs) and futures and options. Erste Group Bank, Raiffeisen Centrobank, UniCredit Bank and Timber Hill (Europe) are among the main market-makers at the exchange. Butler of Raiffeisen says the biggest threat facing the Vienna Stock Exchange is not the global giants based in Frankfurt, London and New York but the increasing volumes of equities trading fermenting in so-called dark pools, where stocks are bought and sold outside exchange markets. “This is not something specific to Austria of course, and I think it is something that the European Union is looking at,” he says. In a move to beef up its systems to better compete in a global trading environment increasingly dominated by algorithmic trading systems, the Vienna Stock Exchange will this year roll out high-speed interfaces on to its trading systems. Yet the exchange has no plans at present to implement socalled proximity hosting or co-location services, which are increasingly being demanded by the growing numbers of high-frequency trading firms driving global trading volumes. The Vienna exchange has its backend servers located at Deutsche Börse and its powerful German neighbour has a major influence over stock trading in the country. For example, Eurex accounted for 58% of equity options trading on Austrian stocks last year, according to sources at the Frankfurt-based derivatives exchange.

FTSE GLOBAL MARKETS • MARCH 2011

Patrick Butler, managing board member responsible for markets and investment banking at Raiffeisen. Photograph kindly supplied by Raiffeisen, February 2011.

Rainer Polster, chief country officer, Austria, for Deutsche Bank in Vienna. Photograph kindly supplied by Deutsche Bank, February 2011.

However, Butler of Raiffeisen argues that German banks do not have an overly influential presence in Austria, or the wider CEE region. This he attributes in part to a focus of banks in West Germany on their own eastern front, following the reunification of the country in 1990. “The real German slice of the pie in terms of capital markets and financing activity [in Austria] is smaller than you might think,” he says. Unsurprisingly, Deutsche Bank is the German bank which has the largest presence in Austria, employing 163 staff in offices in Vienna and Salzburg and managing assets on the ground of €1.5bn, consisting of loans and trading portfolios. Deutsche Bank offers corporate investment banking solutions such as M&A and debt capital markets services. Germany’s largest investment bank also offers asset management, custody and transaction banking services and has a wealth management arm in Austria. “German banks were quite active in the syndicated loan market in Austria. Given what has happened with the global crisis, this business has been reduced significantly. However, that was never a business where we saw ourselves being strong, simply because we see ourselves being able to add value more in terms of arranging and advising, more than in nonbalance sheet business,” says Polster. Butler meantime says the Austrian banking system is no longer the “gateway” to the CEE region that it

once was, as a result of the increasing sophistication of banks across the neighbouring eastern border. Nevertheless, Polster of Deutsche Bank says Austrian-based banks continue to play a pivotal role in the CEE. “If you look at banking assets in the CEE region, 85% are in western European hands. Austrian banks are a dominant force behind this and consider the CEE as a central home market,” he says. “Some minor arrangements might happen. [However,] the advantages of having an integrated approach to the CEE region as a whole are very beneficial, simply because the fragmentation in all the different markets is so high that you cannot effectively run a local model.” While the global financial system has yet to fully emerge from the fallout from the global financial crisis, the Austrian banking system is in a better position than most of its European neighbours. Austrian banks’ ingrained presence in the rapidly emerging economies of Eastern Europe provides a strong base for growth and to develop new services. The current trajectory of the CEE region contrasts somewhat starkly with a relatively stagnant eurozone. “The challenges are significant,” Polster admits. “We still need to see signs of recovery materialise in 2011. The challenge for the Austrian economy is not so much from Austria or CEE, it is clearly from the global volatilities and regulatory reform,” he thinks. I

INDEX REVIEW

BANK OF ENGLAND FACES THE INFLATION CHALLENGE

Feeling the burn: austerity & Middle East unrest World food prices are stoking inflation, which is over 5% in China, above target in the eurozone and even creeping higher in the US, which is still preoccupied with concerns that there could be deflation there. In western economies, however, the options are rather limited. Many economies simply cannot increase interest rates for fear such action will snuff out even the most anaemic growth. The Bank of England is one among a handful of central banks caught between a rock and a hard place. On one hand it is seeing growing pressure from the market to raise rates with expectations of an increase in May, but on the other it has politicians leaning on it to keep rates low. What can be done? Simon Denham, managing director of spread betting firm Capital Spreads, takes the bearish view. T HAS BEEN some five years that the Bank of England has been claiming inflation will return to its target of 2%; meanwhile we are on the verge of a double dip while inflation soars to more than double the bank’s target. One thing is for certain and that is inflation will remain above target for quite a while. The spike in world food prices and other soft commodities can hardly be controlled when you are at the mercy of the weather. Last year’s cereal crop harvests were severely disrupted by terrible weather across the globe in all the major growing regions, leaving a desperate lack of inventories, which were already depleted by increased demand. If the bad weather repeats this year it really will be panic stations and prices could spike even further. The Bank of England however, cannot base its monetary policy on climatic conditions. A rise in rates in the UK will not guarantee a good harvest for cereal crops in Latin America, Europe or the US, and it will not bring down the costs of soft commodities (or oil), which have been

the main contributing factors to soaring prices. If that was not bad enough for policy makers, they also have to contend with the UK coalition’s austerity programme, which is due to get into full swing this year. The combination of rising unemployment, rising inflation, falling growth and then rising interest rates will not be good for the UK economy. It is not a palatable concoction and so you have to give all those dovish rate-setters the benefit of the doubt in their call to maintain the historically-low level of interest rates. In the meantime, markets continue to head northwards as investors see equity markets as an attractive alternative to many of the other asset classes on offer. Despite all the risks that equity investors face, dividends are growing and valuations are considered by many fund managers to be cheap. We are also seeing a boom of mergers and acquisitions in the stock exchange industry as a race has commenced to join forces in a bid to cut costs and remain competitive. Underlying market risks cannot be

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

avoided, however. The euro has seen a decent recovery from below $1.30 since mid-January, but its rally seems to have come to an end without retesting $1.40. The costs of insuring against European bank bond losses have just started to tick higher again. Even so, the headlines, which have been dominated by Middle Eastern tensions, will once again refocus on the European sovereign debt crisis. Yields on the ten-year government bonds for the peripheral states remain at rather critical levels. Portugal is well above 7%, and Spain remains well above 5%—which apparently is the “point of no return”. The already bailed-out states of Greece and Ireland each have yields above 11%. It is difficult not to see the headlines refocusing attention on the state of affairs in the eurozone as the yields creep higher and the consensus remains that Portugal is going to require a bailout sometime this year. On top of this the unrest in the Middle East, which for the time being equities have taken in their stride, is another risk that cannot be brushed under the proverbial carpet. Now that Egyptian and Tunisian leaders have been toppled, the focus is on the next dominoes and just like we have seen within Europe, a “who’s next” situation has arisen. Whatever the outcome, it could lead to a rise in volatility which has been woefully low recently. The main indices have been a little boring to say the least, so if things do start to get exciting, trading could prove to be a white-knuckle ride over the coming spring. As ever ladies and gentlemen: “Place your bets.”I

MARCH 2011 • FTSE GLOBAL MARKETS

COMMODITIES

METAL MANIA: GLOBAL RECOVERY BOOSTS DEMAND

Metal prices remain strong despite variable demand The global economy is recovering and is expected to grow by 4.4% this year, according to forecasts by the IMF. This means there will be more demand for cars, machines, houses and, by default, strong demand for metals. Commodities markets are already responding to these predictions as prices for aluminium, nickel, zinc and tin are all heading towards the dizzy highs they reached in 2008. Copper has already exceeded those levels and gone beyond, rising 60% since last summer. Market-watchers say that some of the growth expectations have already been priced in for metals such as gold and copper and that the next leg is likely to be sideways or only gently higher, rather than the furious rally seen over the past six months. While the price of gold might be running out of steam, the investment case is getting stronger for platinum and tin, the former because of rising car sales and the latter because of restricted supplies. By Vanya Dragomanovich. VERALL, IT SHOULD be 12 months of growth in 2011 as far as metals are concerned. Daniel Brebner, analyst at Deutsche Bank, says: “We expect that physical and financial fundamentals will be highly supportive of the base metals in 2011. While the group is likely to suffer from volatility caused by periodic financial and debt shocks, we anticipate expansionary monetary policy will continue to support.” All the main metals markets are showing signs of expansion. Western economies are recovering slowly, the US is expected to grow at 3% this year, while major emerging players such as China, India and Brazil are expected to grow on average by 6.5%, according to forecasts made by the IMF in January. China remains the biggest driver of demand, a trend that has been unbroken for years and is not showing signs of easing. “The country’s five-year strategic plan focuses on metal-intensive sectors such as the national grid, public housing and transport, in particular rail, planes and ships. This will provide broad support for the metals sector,” explains Koen Straetmans, senior strategist at ING Investment Management. “I am overweight metals and copper is my favourite of the group,” he adds.

FTSE GLOBAL MARKETS • MARCH 2011

Photograph © Mikhail Kukartsev / Fotolia.com, supplied February 2011.

One caveat is that all of the big four emerging economies—China, India, Brazil and Russia—have high levels of inflation and the countries will continue bringing in measures designed to curb domestic price rises for food and goods and lending. China has increased interest rates three times since October and the most recent rise, in February, is not likely to be the last bout of tightening this year. China has also increased mortgage rates and reserve requirements for smaller and medium-sized banks. “At some stage this will seep through to demand [for

metals], it only depends on how soon,” says Nic Brown, head of commodities research at Natixis. He estimates that as long as growth in China does not fall by more than 2% to 3% this year, which does not seem likely, it won’t have a negative effect on metals markets.” As long as China grows by between 7% and 8%, this won’t be a problem. If it slows more than that, it would be bad for the metals markets,” adds Brown. Other major metal consuming regions such as the US, Europe and Japan are also on the road to recovery

COMMODITIES

METAL MANIA: GLOBAL RECOVERY BOOSTS DEMAND

Commodity price data of metals and minerals* (quarterly averages) Aluminium ($/mt)

Copper ($/mt)

2,400

Gold ($/toz)

9,000

1,400

2,343 $/mt

1,367 $/toz

8,637 $/mt

2,300

1,300 8,000

2,200

1,200 2,100

1,102 $/toz

7,000 2,000

1,100 6,648 $/mt

2,003 $/mt

1,900 Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

Nickel ($/mt) 25,000 24,000 23,000 N 22,000 21,000 20,000 19,000 18,000 17,000 16,000 15,000

6,000

Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

Tin (US c/kg) / 23,609 $/toz

3,000

1,000

Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

Zinc (US c/kg) / 2,601 c/kg /

250

231.5 c/kg / 221.4 c/kg /

2,600 2,200 200 1,800 17,528 $/mt

Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

1,400 1,000

1,517 c/kg / Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

150

Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010

*Aluminium, copper, nickel, tin and zinc are included in the non-energy index (2000=100). mt=metric ton; toz=troy oz. Source: The World Bank, IFC, MIGA Office Memorandum, supplied February 2011.

but if there is a significant slowdown in China other regions may not be able to make up for a decline in demand. Brown, like other market-watchers, is cautious about what lies ahead. “For copper, tin and nickel, a lot of good news is already priced in, such as Chinese growth and the recovery in the West. The global economic picture is not bad but if anything goes wrong, if either the West does not recover or emerging economies slow down too much, there is scope for disappointment.” The base metals sector may still be impacted negatively by the tightening of monetary policy in the major developing countries or by fiscal austerity measures being implemented in a number of mature economies, especially in Europe. “You will not see the same explosive growth in the markets like last year when markets recovered from the slump they experienced in 2009,” says Brown.

At present, the outlook for copper looks the best of all the base metals apart from tin. Production has not kept up with the growth in demand and Chile, the largest mining region for copper in the world, produced slightly less copper last year than in 2009. “There is deteriorating quality of supply of copper. Some 85% of the copper comes from open pit mines”, and those are already more or less fully operational, says ING’s Straetsmans. “The deeper you go, the lower quality copper you get, and it becomes more expensive to mine,” he adds. Building new mines requires heavy capital spending, something companies are either reluctant, or not in the position, to do in the current financial climate. Despite the deficit that exists in the copper market, investors need to be mindful of the fact that copper prices have already risen by more than 60%

since June last year and are at their highest level ever. While this will prompt speculative buyers, those who need copper for a living will be reluctant to buy. For instance, China bought large amounts of copper when prices were low and then spent last year working off these stockpiles. Analysts now expect Chinese buyers will come back into the market to replenish their reserves but so far this is happening only in small doses as prices have risen above $10,000 a metric tonne from around $6,000 last summer. Alternately, a lot of copper bought by Chinese buyers is being held in bonded warehouses in Shanghai, warehouses which are used to store metal before the 17% VAT on imports is paid. There is a discrepancy in the market and it is between where prices are resting right now, and how much

MARCH 2011 • FTSE GLOBAL MARKETS

copper is available, notes Steve Hardcastle, head of client liaison at commodities futures broker Sucden Financial. Prices imply a serious shortage whereas copper is currently freely available in all the segments of the market. Prices for copper cathodes—plates of copper of 99.99% purity—are coming down and high prices are drawing sellers of copper scrap into the market. “Markets tend to operate on perception and not reality, and there is a disconnection between copper prices and the availability of the metal. I expect prices to go sideways to down, possibly as low as $9,000 a tonne,” says Hardcastle.

Significant investment Nevertheless, investors favour copper at present. JP Morgan and fund manager BlackRock Asset Management International are planning to launch two large, physical copper exchange-traded funds (ETFs) which will be US-based and listed on the NYSE. ETF Securities in London recently launched a copper ETF, but the uptake has been fairly light, possibly because of the already high copper prices. The ETF Securities instrument was based on 2,000 tonnes of copper, which will be dwarfed by BlackRock’s ETF, to be backed by 20,000 tonnes of the metal and JP Morgan’s ETF, backed by 60,000 tonnes. This is not huge compared with the overall copper market, which produces 18m tonnes of the metal per year but put together would account for about 25% of all the copper held in London Metal Exchange (LME) warehouses and would be significant at a time there is already a deficit in the market. Gold ETFs triggered a significant investment drive as investors who had been reluctant to buy physical metal or futures felt more comfortable with share-type instruments. As ETFs had to be backed by the actual gold, this created a new demand stream and had a significant impact on prices. Though existing copper ETFs are currently thinly traded, if this changes it would push the floor for copper prices higher.

FTSE GLOBAL MARKETS • MARCH 2011

There are pros and cons in investing in ETFs; they are usually simple to structure, they trade like stocks and are seen as more familiar for investors with a stock trading background. However, unlike futures, they come with a management fee. Futures, on the other hand, represent leveraged exposure, and while they require a relatively low investment to get into the market, the downside is that losses are also leveraged. Looking across the metals complex the market that is likely to be the star performer this year is tin, which is used in electronics, solder and plating. Demand for the metal grew sharply during the past few years since restrictions were brought in on the use of lead in solder. At the same time the longterm underinvestment in tin mining has meant that output has not been able to put up with increases in demand. Indonesia is one of the biggest producers and exporters of the metal but the state-owned miner PT Timah is expected to produce significantly less metal this year than in 2010. Boosted by tightening demand and supply coupled with the generally positive investment mood towards base metals, tin prices have risen to over $15,000 a tonne since last summer to hit $32,000/t in February. “The speed and extent of this surge in prices undoubtedly reflected fund buying, but the market’s fundamentals have been very supportive,” according to a metals report issued by Sucden. Throughout the year the level of tin stocks held in LME warehouses has been halved with most of the metal being withdrawn from Singapore and heading for South-East Asia and Japan. Analysts believe that tin still has some way to go and expect futures to trade as high as $34,000-$35,000 a tonne later this year. Further out, the situation is likely to change because these record high prices have already prompted a flurry of new production projects. Several smaller tin mining companies have announced drilling, exploration or acquisition projects, including Aus-

tralian-listed Minemakers, Consolidated Tin Mines and Stellar Resources. Two more metals that are set to do well during 2011 are platinum and palladium. Union Bancaire Privée forecasts that demand for the two metals will rise by 15% year-on-year in 2011 and 2012 against an increase in supply of only 2% to 3% year-on-year. Platinum has a particularly solid investment case as it is one of the key components in catalytic convertors, which are used in cars to cut pollutants from exhaust emissions. Even last year when the car industry was under more pressure than it had been in years and production declined dramatically, platinum prices still managed to move higher. Car demand, particularly in the US, has turned around since 2010, with both General Motors and Chrysler recently reporting increases in car and commercial vehicle sales of more than 20%.

Economic pickup Makers of car catalysts have experimented with using cheaper metals (platinum costs $1,800 a troy ounce compared with silver at $30/oz) but nothing has proved as efficient. With car sales increasing, there is little to stand in the way of higher platinum prices. “Unlike gold, platinum has an industrial use. We are bullish on platinum because of the economic pickup in the West,” says Eric Schreiber, head of commodities portfolio management for Union Bancaire Privée (UBP). Schreiber manages the Gold+ fund launched by UBP late last year, which invests in physical gold. “There has been an outflow from gold and silver recently and inflows into platinum and palladium,” Schreiber notes. In the near term, the prices of metals that are in deficit, such as copper, tin and platinum, are likely to increase. However, according to Natixis’ Brown: “For copper, nickel and tin, potential corrections are likely to be more extreme than for those base metals where expectations are less onerous.” As ever with commodities, the wheel turns fast and furiously. I

COMMODITIES

GOLD: GLOBAL RECOVERY BOOSTS NEW TECHNOLOGIES USAGE

There is a reason for gold’s special status. When the world economy is not doing well, gold becomes appealing as a safe haven investment. Wobbly stock markets, concerns over fiscal imbalances and currency tensions encourage the flock to gold. It would seem logical that once the world economy starts recovering there would be an outflow from gold and into other investments. While there has been an initial outflow from some investors; the slow but steady global recovery has begun to fuel demand for gold in different areas such as technology, electronics and medical applications. Vanja Dragomanovich reports.

Industrial use hones gold’s lustre NDUSTRIAL USES MAKE up 12% of the total demand for gold, the main area being electronic chips but nanotechnology, water purification and industries such as solar power are also in need of the precious metal. If a gold coin drops to the bottom of the ocean, years later it will still be pure gold and will not have eroded, unlike metals such as copper. This resistance to the elements makes it the most reliable metal in electronics. Manufacturers of computers, mobile phones, electronics in vehicles and a whole host of other gadgets use a very thin layer of gold on chips to ensure that they provide electrical contact every time they are used. “Everything that needs a reliable electrical contact every time, such as chips in phones, credit cards, in computers or in cars, will use gold,” says Richard Holliday, director of technology at the World Gold Council. “In each mobile [phone] there is around $1-worth of gold and there is about $10-worth of gold in a computer,” adds Holliday. “That in itself is not much, but if you take into account that manufacturers sell billions of units a year, you can see how it adds up. Electronics now accounts for more than 300 tonnes of gold a year, worth some $11bn annually.” Provisional figures for 2010 show use in electronics at 420 tonnes, a 12% increase over the previous year. The vast number of computers sold each year is on the rise and, in addition to what could be described as essential

Richard Holliday, director of technology at the World Gold Council. “In each mobile [phone] there is around $1-worth of gold and there is about $10-worth of gold in a computer. That in itself is not much, but if you take into account that manufacturers sell billions of units a year, you can see how it adds up,” says Holliday. Photograph kindly supplied by the World Gold Council, February 2011.

electronics such as in computers, phones and cars, our love of new gadgets including Playstations, Nintendos, iPads, and iPods will only continue to boost requirements for gold.

A relatively new area of growth for gold is nanotechnology, a technology that uses gold dispersed into tiny particles which can be applied to tasks as diverse as pregnancy tests to concentrating sunlight in solar panels, targeting the delivery of cancer drugs and detecting toxic elements in water. There is research being carried out to expand medical testing in areas other than pregnancy and to use a similar principle to detect toxins in water. In India, where water purity is a major issue and clean water is not always available, the Indian Institute of Technology is researching how to use gold nanoparticles to test water purity as the particles change colour in the presence of mercury, arsenic or pesticides. Another project being developed by Rice University in Texas is designed to purify water contaminated by the chemicals industry. A pilot programme showed a 200% improvement in removing and breaking down contaminants using gold nanoparticles and a large US chemicals company is now looking at how to make the technology commercially available, says Holliday. Though some technologies are still either only in pilot or research phase, if they do take off they could generate the kind of demand that propelled platinum into the $2,000 a troy ounce price range once it became the most popular metal to control car emissions. Irrespective of the potential for sustained high gold prices through 2011, the price of gold was again above $1,400, a seven-week high, following riots in Libya in mid-February. At the time of going to press, spot gold had risen to $1,403.38 an ounce and was sold at $1,401.30. I

MARCH 2011 • FTSE GLOBAL MARKETS

FX VIEWPOINT

Structural inequity leads to manipulation N FX, BANKS have always controlled access to price discovery. After all, it isn’t called the interbank FX market for nothing. In days of old, corporate customers got their prices from bank salespeople over the phone, and the only real check on price manipulation was their ability to insist on a two-way quote, thus ensuring that the bank was at least bound by the quoted spread to be somewhere within the realm of reality. There are still consumers of FX liquidity who receive it in that manner, but most bank customers now receive their prices via a web interface. Even still, they are only seeing quoted liquidity, rather than direct access to a central limit order book. Retail FX liquidity is the same, and only by aggregating multiple bank feeds can a consumer hope to simulate something similar to the promise of a true open-access, multiparticipant exchange. Through prime brokerage, non-bank traders have achieved access directly into the exchange-traded liquidity pools. For the high-frequency space, this access was essential. For other consumers of large quantities of FX liquidity, it wasn’t. The California Public Employees’ Retirement System (CalPERS), for one, relied for many years upon its relationship with custodial FX providers. Last October,

FTSE GLOBAL MARKETS • MARCH 2011

however, the State of California sued State Street Bank and Trust on behalf of CalPERS and the California State Teachers’ Retirement System (CalSTRS). In essence, the suit alleged that State Street systematically filled daily aggregated FX orders on the worst price traded during the preceding session, to the advantage of State Street. While this litigation remains in the court system, more suits are threatened against other custodial banks. In another recent incident, Deutsche Bank was accused, it is alleged, of having acquired large numbers of cheap, short-term, out-ofthe-money puts on Kospi futures, then pushing the underlying spot market down to increase the value of the options. The incident, which was reported to have occurred last November, appears to have triggered a 2.7% drop in the Kospi during the last 10 minutes of trading before expiration. Effectively, Deutsche Bank is accused of taking advantage of existing conditions to do what other options traders dream of doing— moving the market in their direction. Incidents of these varieties occur daily in every market to some degree— which is why transparency is so vital. Market-based solutions in a marketoriented system are always preferable, but that means all participants must have equal access to pricing and

FX: TRANSPARENCY & REGULATION

Some significant questions are trending through the foreign exchange (FX) markets: these are large questions about price discovery and transparency in markets, questions which relate to regulatory responses to the global financial crisis, the “flash crash” and other recent incidents involving market manipulation. Moreover, fears remain about the impact of high-frequency trading on access to liquidity and general market fairness. What to do? Erik Lehtis, president of DynamicFX Consulting in Chicago, gives the traders’ view.

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

liquidity at all times, and that regulatory scrutiny in the form of observation is inherent. Structural inequity leads to manipulation. Implied in the Deutsche Bank contretemps is an alleged abuse of market structure, since, of course, anyone is welcome to attempt manipulation of the market openly— traders learn early that no one is “bigger than the market”. Another handy villain has, naturally, been the high-frequency trading (HFT) community, which has been accused of being responsible for the “flash crash”, the global financial crisis, global warming, and other social ills and calamities. As usual, ignorance leads to fear, and the main victim of fear is truth. At a conference some five years ago, a fellow panellist, the chief dealer for a very large bank, claimed that HFT had created an unfair space in which banks could no longer compete. “All we want is a level playing field!” he cried. “All you want is to level the playing field,” I replied. Ironically, recently his bank released a report on HFT that demonstrated the value HFT provides to the market in terms of liquidity and price stability. Much misunderstood, HFT is not a monolith, nor is it going to replace the role of banks in FX. There is nothing, beyond their own sclerotic processes, preventing banks from becoming HFT players in their own right—and, indeed, many have. Bottom line is, the more open markets are, the less they require regulation. Our momentum as a community should be toward inclusion, not exclusion, and transparency, rather than opacity. I

COVER STORY

THE TRUE COST OF A CALL FOR CHANGE The ructions in the Middle East and North African regions bring political risks into full focus once more in the calculations of investors eager to secure full and unfettered access to funds. While the unrest in Tunisia dominated the headlines in late January and appeared to herald a long-term trend favouring the diffusion of liberal democracy across the wider region, already there are signs that the Jasmine revolution is less idealistic than it at first appeared. As contagion looks to be spreading to Oman, what now for the rest of the region? Francesca Carnevale discusses some of the possible outcomes. ACK IN 1989, IN another revolutionary year, historian Francis Fukuyama posited that a remarkable consensus concerning the legitimacy of liberal democracy was emerging, conquering rival ideologies such as hereditary monarchy, fascism and, at that particular time, communism. More than that, he argued that liberal democracy might even constitute the “end point of mankind’s ideological evolution” and as such threatened the “end of history”. Some 20-plus years on from Fukuyama’s thesis some of the remaining vestiges of the political-economic paradigms of the 20th century appear to be playing out in key states across the MENA region. The developments question the expected description of the near-term global political economy at a vulnerable time in the slow recovery from the financial crisis. Predicting the future can be a mug’s game; though few will posit the eventual outcome of this current round of dissent. Interestingly, the shock of the wave of revolutionary sentiment across MENA emphasises not so much the extent of popular discontent, but the willingness of some political systems to at least appear to accede to the inevitable (Egypt and Jordan) and engage in dialogue with the displeased. It

contrasts starkly with the unwillingness of others (such as Iran and Libya) to accept any challenge to the oppressive status quo, perhaps to their long-term detriment. Iran quickly stamped down on its popular uprising last year and at the time this magazine went to press the dictator Muammar Gaddafi looked to prefer to continue killing and maiming his fellow Libyans rather than honourably decamping into penitential exile. Talk about confusing the national interest with one’s own. Even so, whether that means that by comparison unrest in countries such as Egypt and Jordan will come to a natural end as popular demands are met is still moot. There’s still that old chestnut to consider; the one about nature abhorring a vacuum. In that respect, this year and next, nature has a lot of angst to work out across the North African coastline as the coalition of the unhappy work out that they are also unrepresented. Inevitably, then, they will continue to be dependent on benign interim rulers until an effective caucus can be established. For international investors the oil spike has changed the global investment dynamic once more; risk assets look to un-

MARCH 2011 • FTSE GLOBAL MARKETS

Archive photo of demonstrators in Tahrir Square, Cairo, Egypt. Photograph by Demotix / Nour El Refai/Demotix/Press Association Images, supplied by Press Association Images, February 2011.

money; or, rather, the perceived lack of it in the face of the ameliorating fortunes of emerging and frontier markets. In the wild blue future, everyone feels entitled to a piece of the pie and frankly, why not? It is a challenge not only in the MENA region, where the disparity between the have-yachts and have-nots widens by the hour, but also other highgrowth markets such as Brazil, Turkey, Russia, India and China, which will eventually face tough questions over resource allocation. That’s not to say that revolutionary fervour is building in those markets right now. However, it would take a leader with a heart of stone not to sweat over the prospect of managing the expectations of a rapidly growing population (heavily skewed towards easily-disaffected under-25s) where in reality only a limited percentage will truly enjoy the fruits of economic liberalism. It’s a sweat which leaders in advanced markets such as the United Kingdom and Germany have historically tempered by an extensive and expensive social security system. Social security, however, simply does not exist in many emerging markets.

Saudi Arabia: infrastructure investment

derperform commodities, and imply a continued squeeze on margins, say BNP Paribas credit analysts. The bank’s February 24th Credit Plus viewpoint suggests investors note: “The problems in the MENA region have led to a sharp widening in regional spreads. We recommend buying the best credits in the region that include Qatari Diar, TAQAUH and Mudabala which offer value on a fundamental and relative value basis.” They also expect margins at most industrial sectors, such as construction, chemicals and automotives, to suffer.

Political strategists taken by surprise Elsewhere, political strategists in the advanced economies have patently been taken by surprise by the rise of the new political-economic paradigms in emerging nations with nothing to lose but their autocratic and outdated masters. There’s a mass of analytical hustle about the relative status of Shi’a and Sunni in varied hues across the Middle East and in part, they are right. Much of the current round of hullabaloo is fuelled by a deep sense of disenfranchisement. However, make no mistake: the world is also witnessing the beginnings of an international revolution that is about

FTSE GLOBAL MARKETS • MARCH 2011

No surprise then that Saudi Arabia’s King Abdullah returned to his country in late February after three months of convalescence in Morocco, where he was recuperating from back surgery, with an abundance of largesse in tow, including a fledging but ready-made social security package. The King announced a $37bn action plan aimed at helping lower and middle-income Saudis cope with high local unemployment rates, inflation and the higher cost of housing. Undoubtedly, Saudi Arabia has been unnerved by unrest in nearneighbour Bahrain spreading across the narrow road causeway that separates them. How much that will offset any latent restlessness is yet to be seen. The country is already in the middle of an extensive $400bn infrastructure investment programme in new cities, infrastructure and downstream petrochemical projects, all of which are planned to be completed by 2013 and which so far have failed to offset growing domestic unhappiness over inflation and too few jobs. It is a chronic problem for the kingdom. Its population is projected to rise by more than 15% to just over 29m by 2015; of which almost 20% will be non-Saudi nationals, while local unemployment remains high.Youth unemployment was a whopping 27% according to the latest figures made available by Banque Saudi Fransi, and Reuters claimed (also in February) that unemployment levels among women in the country was as high as 28.3% as of June 2010. With oil prices rising (Brent crude was $106/barrel on February 23rd) the kingdom can fortuitously finance social policies. It is vital that it does so. Peaceful change in Saudi Arabia is imperative if the impact of the popular uprisings that have unsettled MENA regimes since the beginning of this year is minimised in fragile western markets. The issue goes deeper than oil supplies: though rocketing oil prices belie the strength of that particular assertion; a topic which Vanja Dragomanovich addresses in her take on

COVER STORY

the impact of the unrest on benchmark commodities through 2011 in the article accompanying this feature. If the Saudi leadership should ever be up-ended it will mean the over-turning of 20 carefully nurtured years of mutual self-interest between the West (read predominantly the United States) and the kingdom. The US military’s presence in the region hinges on a web of agreements with Arab states that allow American forces to patrol local oil shipping routes and keep a eye on unpredictable Iran. Although after the second Gulf War the US scaled back its presence in the kingdom and shifted most of its air operations to Qatar and Oman, Saudi Arabia’s rulers are keen to retain the close presence of the US military if not on its own soil then nearby in Bahrain and Oman. Some 27,000 US forces are deployed throughout the Gulf, with a remaining 50,000-strong contingent in Iraq. Air fields in Qatar, the United Arab Emirates and Kuwait, and the US Navy’s Fifth Fleet headquarters in Bahrain serve as key points in the US’s regional deployment strategies. Around 4,000 Americans are stationed in Bahrain as part of the US Navy’s Fifth Fleet headquarters covering the Red Sea, the Gulf and the Arabian Sea. The US naval base in Manama is vital for Riyadh, providing American military protection of Saudi oil installations and the Gulf waterways on which its oil exports depend. Moreover, without these vital staging points, it would be mightily difficult for the United States to continue with its military and policy strategies in the broader region. Therefore the integrity of the current political structure in Saudi Arabia is pivotal to US/western coalition interests in the region and financial stability in the West.

Libya: problems either way of a resolution In the North African theatre, Libya presents more problems than solutions. There is a very real threat that this conflict will run and run, thereby exacerbating some of the financial problems of southern Europe. The Libyan economy depends primarily upon oil revenues from the oil sector, which contribute 95% of export earnings, 25% of GDP, and 80% of government revenue. Substantial energy income coupled with a small population give Libya one of the highest per capita GDPs in Africa, but little of this income flows down to civilian society and the regime has remained repressive for its entire decades-long rule. Some light economic reforms were introduced following the lifting of UN sanctions in September 2003 and the National Oil Corporation (NOC) set a goal of nearly doubling oil production to 3m bbl/day by 2012, though this target is unlikely to be met. Non-oil manufacturing and construction account for more than 20% of GDP and have expanded from processing mostly agricultural products to include the production of petrochemicals, iron, steel, and aluminium. The arid climate and poor soils severely limit agricultural output and Libya imports about 75% of its food. The country’s principal agricultural water source remains the Great Man-Made River Project, but significant resources are being invested in desalination research to meet growing water demands (the growing topic du jour across the emerging world).

Volatility v. political unrest. A heady MENA mix

250

FTSE All-World Index

FTSE CSE Morocco All-Liquid Index

FTSE Egypt Index

FTSE Middle East & Africa Index

200

150

100

50 30 Jan 2009

30 Apr 2009

30 Jul 2009

30 Oct 2009

30 Jan 2010

30 Apr 2010

30 Jul 2010

30 Oct 2010

Source: FTSE Group, supplied February 2011.

Oil exports have stopped for now; but important questions have to be hammered out. If Gaddafi remains in power and oil starts to flow again, do western economies return to business as usual? Or will Libya become a failed state and descend into a stalemate civil war, scarring the country for years? Or, if Gaddafi flees, what sort of power struggle might emerge for control of the economy? It’s a country where tribal affiliations count but the dictator has ensured over 40 years of rule that tribal influence is severely limited. How the national power vacuum will be filled is anyone’s guess. Does the army take charge, as it essentially has done in Egypt? If so, what does that portend for the region as a whole and its supposed march towards democracy? The usual suspects stood forth as Libya descended into chaos. Standard & Poor’s moved fast as violence broke out and lowered its long-term ratings on the sovereign by one notch to BBB+, though it affirmed its A-2 short-term rating. Then, at the end of February, Arab Banking Corporation (ABC), nervous of a possible run on its assets, rushed to confirm it was business as normal as western governments began discussions on freezing Libyan assets overseas. The bank confirmed that neither ABC nor any of its subsidiaries are subject to the asset freezes specified in the US Executive Order and UN Resolution 1970 and that the ABC Group is able to transact freely both in the United States and elsewhere. ABC’s move was obvious: the Central Bank of Libya owns 59.3% of the bank (Kuwait Investment Authority also has a 29.6% stake) and the bank itself is headquartered in Bahrain—a double whammy if ever there was one. Thirdly, Saudi Arabia announced it would make up the shortfall resulting from the shutdown in Libyan output. That’s all right then. While the international markets have refused to tank completely; there are ominous signs that even good news (such as HSBC’s high profits: £11bn and counting in 2010) could not induce the FTSE 100 back up above the benchmark 6000 point. It is understandable. Europe and in particular Italy has much to mull over the unrest in Libya.

MARCH 2011 • FTSE GLOBAL MARKETS

Eni, Italy’s main oil producer has had long-standing ties in Libya stretching back to the 1960s and the country accounts for just shy of 15% of Eni’s output. The firm also has interests in Egypt, Tunisia and Yemen, and Egypt accounts for an equally significant 13% of the firm’s oil output.

The trans-Saharan - Europe pipeline network ITALY Piombino

Europe feels the pinch Already rocked by events in Cairo and Alexandria, in one of the largest falls on the Italian stock exchange since 2009, Italian stocks exposed to Libya were among the top fallers across Europe, with lenders UniCredit (in which Libyan interests have a minority stake), UBI Banca and Intesa SanPaolo and industrial stock Finmeccanica down between 2.5% and 5.8% as violence erupted in Tripoli and Benghazi. Eni stock, in comparison, fell by only 1.7% to €17.11, and recovered slightly to just over €17.61 by month-end. It was a jolt however as Italy blue-chip FTSE MIB index ended down 3.6 in what was its worst session for eight months, and given the country’s exposure to the MENA region, might not be the last the index endures this year. It was bitter fruit, given that at the end of January analysts were extolling Italian financials, which they said helped the Italian bourse stand out among European equity markets, having outperformed most of the European Union (EU) at the start of the year. Moreover, sovereign debt concerns were beginning to ease as spreads between Italian and German government bond yields narrowed. Nonetheless, investors remain focused on potential acquisition targets in the Italian financial sector, particularly as bidders continue to line up for UniCredit’s Pioneer asset management arm. Other European oil companies also saw their oil output disrupted as they down operations in the country. BP and RWE say they have suspended operations for the time being, while Statoil says it has temporarily closed its Tripoli office. Austria’s OMV, which has one of its largest production well complexes in the country in the Sirte Basin, which it exploits in conjunction with Occidental Petroleum, reports that it has withdrawn all non-essential staff from the country. Most significant though is the fact that Eni operates the Greenstream pipeline from Libya to Italy through the Mediterranean Sea (please see the accompanying map). By the end of February Libyan gas supplies to Italy were suspended. Eni said in a statement that it is still able to meet customers’ gas requirements in the near term. However, it might not be so relaxed if problems in Tunisia, Egypt and those Gulf States in which it has interests are impacted. The firm intends to maintain a skeleton staff in Libya in some of its operating plant and others in Tripoli, but it must be hoping for a rapid resolution of the conflict.

Algeria: the next domino? Next door in Egypt, the military has long been active in government, and when Hosni Mubarak was forced out, the military remained at the apex of power, providing some economic continuity. In Libya, the military has no such status and is subservient to Gaddafi, who has repeatedly purged and reshuffled leaders. With oil regions already in the

FTSE GLOBAL MARKETS • MARCH 2011

SPAIN Cordoba Almeria

Koudiet Draoucha

Mazara del Vallo

El Haouaria

Beni Saf

Gela

TUN ISIA SIA TUNISIA

MORROCCO OCCO

Mellitah Hassi R’Mel LIBYA Wafa

ALGERIA

Gas pipelines NIGER

Trans-Saharan Maghreb-Europe Medgaz Galsi Trans-Mediterranean Greenstream

NIGERIA

Others

Warry

Infographic: FTSE Global Markets from data sourced from Wikipedia, the CIA and Emerging Markets Report, April 2010, supplied February 2011.

hands of opponents or seemingly heading that way, there’s no clear idea of what will happen to oil production in a postGaddafi world. However, though it has Africa’s largest reserves, Libya isn’t a major oil producer. It exports only about 1.2m barrels a day, largely to Europe, while daily world demand totals about 88m barrels a day, according to the International Energy Agency. Libya is, however, the first member of the Organisation of Petroleum Exporting Countries to teeter on collapse. A more serious falling domino would be Algeria, which is one of Europe’s top three gas suppliers. In March this year, Algeria will begin exporting gas to Europe via the $1bn Medgaz pipeline as the EU tries to reduce its dependence on Russian gas, and Algeria continues to strengthen its position as a natural gas distributor in Europe. Construction of the

COVER STORY Overview of the energy production spectrum in the MENA region COUNTRY

SECTOR

KEY NUMBERS

ALGERIA

Population

35.4m

(Opec member)

EGYPT

GDP per capita

$4,478

Proven crude reserves

12.2bn barrels

Gas reserves

4.5trn cubic metres

Crude production

1.26m b/d

Gas production

81.34 cubic metres/year

Population

80.5m

GDP per capita

$2,771

Proven crude reserves

4.4 billion barrels

Gas reserves

n.a.

Crude production

742,000 b/d

Gas production

62.7bn cubic metres/year

IRAN

Population

74.1m

(Opec member)

GDP per capita

$4,484

Proven crude reserves

137billion barrels

Gas reserves

n.a.

Crude production

3.6m b/d

Gas production

175.7bn cubic metres/year

IRAQ

Population

31/23m

(Opec member)

GDP per capita

$2,626

JORDAN

Proven crude reserves

115bn barrels

Gas reserves

n.a.

Crude production

2.6m b/d

Gas production

1.15bn cubic metres/year

Population

6.4m

GDP per capita

$4,434

Proven crude reserves

n.a.

Gas reserves

2.97bn cubic metres

Crude production

n.a.

Gas production

250 cubic metres/year

KUWAIT

Population

3.48m

(Opec member)

GDP per capita

$32,530

Proven crude reserves

101.5bn

Gas reserves

n.a.

Crude production

2.31m b/d

Gas production

11.49bn cubic metres/year

LIBYA

Population

6.41m

(Opec member)

GDP per capita

$12,062

Proven crude reserves

46.2bn

Gas reserves

1.55 trn cubic metres

Crude production

1.58m b/d

Gas production

15.9bn cubic metres/year

COUNTRY MOROCCO

SECTOR Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

KEY NUMBERS 31.6m $2,868 100m barrels 1.5bn cubic metres 4,053 b/d 60m cubic metres/year

OMAN

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

2.97m $18,041 5.6bn barrels n.a. 810,000 b/d 24.8bn cubic metres/year

QATAR (Opec member)

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

1.64m $74,423 25.38bn barrels 25.4trn cubic metres 820,000 b/d 89.3bn cubic metres/year

SAUDI ARABIA (Opec member)

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

25.4m $16,641 264.59bn barrels 7.9trn cubic metres 8.4m b/d 78.45bn cubic metres/year

SYRIA

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

22.2m $2,892 2.5bn barrels n.a. 376,000 b/d 5.8bn cubic metres/year

TUNISIA

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

10.6m $4,160 0.6bn 2.97bn cubic metres 86,000 b/d 65.13bn cubic metres/year

UAE (Opec member)

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

4.62m $47,407 97.8bn barrels n.a. 2.34m b/d 48.84bn cubic metres/year

YEMEN

Population GDP per capita Proven crude reserves Gas reserves Crude production Gas production

23.4m $1,231 2.7bn barrels 0.49trn cubic metres 298,000 b/d 454,700 cubic metres/year

Table data is complied by energy and metals information provider Platts, from the following sources: OPEC Annual Statistical Bulletin 2009, BP Statistical Review of World Energy 2010, CIA World Factbook, International Energy Agency, US Energy Information Administration. OPEC crude production estimates are from Platts’ survey of January production. BP oil production statistics include NGLs, supplied February 2011. The tabular data is reproduced with the kind permission of Platts.

pipeline started in March 2008 and now runs from Hassi R’mel (one of Algeria’s largest gas lakes) in the south of the country through the port of Beni Saf where it goes under water for some 210 km to Spain. The pipeline can transport up to 8bn cubic metres (m3) of gas per year. Three gas pipelines

now supply Europe from Algeria: the TransMed pipeline to Italy, the Maghreb-Europe pipeline and Medgaz carrying supplies to Spain, and the country now supplies 62bn m3 of gas a year to Europe (equivalent to 20% of EU gas consumption), and plans to increase that to 85bn m3 by 2015.

MARCH 2011 • FTSE GLOBAL MARKETS

Algeria’s problem is that successive governments since the 1990s have never really got to grips with diversifying the country’s mono-economy. In part, the country is stymied by internal political strains that overspill, from time to time, into open revolt. As well, the government has been unwilling (or unable) to tackle hurdles that prevent substantial and sustained foreign investment in the country. Equally, Algeria has never been able to loosen the shackles of its dependency on state energy giant Sonatrach. The country stands as one of the few remaining command economies and its story has been writ large for decades: the government needs to show it can introduce measures to wean itself off its dependency on carbon resources, develop other industries and open up to foreign investment. It also needs to loosen the leash on its people. Not least, the government needs to loosen the leash on itself. Last year it introduced strict borrowing controls in a supplementary budget law that was designed to combat falling energy prices: price controls were reintroduced, imports reduced and severe restrictions imposed on foreign investments. Ironically at the time, the government was working from a position of strength in that it had a small but significant current account surplus that was equivalent to around three year’s worth of imports. It is difficult to see how the government can readily extricate itself from the straightjacket that it has bound itself into. Credit markets in Algeria have been ranked as the least efficient in the MENA region by the World Bank. The list of problems is long: a slew of reforms in the financial

sector have been repeatedly promised since 2003 and have still to be implemented. Sonatrach remains mired in corruption probes and the country’s Forum des Chefs d’Enterprises (FCE) regularly complains of the deteriorating business environment. The threat of an export of the Jasmine revolution across its own borders might stimulate the government to pre-empt revolution and work on behalf of its people: but then again it might not. The Algerian government is unlikely to rush, as Sultan Qaboos bin Said of Oman has done and ordered the immediate creation of 50,000 jobs; or to resign with the same alacrity that Tunisian government officials are doing in the face of continuing protests. However, there are much wider issues in play should discontent break out in Algeria. A sustained period of instability across North Africa could mean a very cold winter for mainland Europeans. It also changes the balance of energy power in Europe, adding weight to Russian efforts to extend gas sales in Europe once more; though alternative LNG suppliers such as Qatar are also presented with additional market opportunities. For now, as fluid communications technology continues to bypass national boundaries and in consequence redraws the possibilities of a new regional/global political consensus, it seems that we really are in a new dawn of revolution and the current ructions across MENA are just one aspect of it. Trouble is, while we are all quite aware of the consequences of change, none of us is very sure what form that change will take. We will soon find out. I

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COVER STORY

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UNREST TRIGGERS SHIFT IN COMMODITIES MARKETS

The contagion of unrest along the North African states and in the Middle East is already affecting the commodities markets. Oil prices have risen to the highest level in two years and look set to move higher, potentially threatening the global economic recovery; gold has returned to being the preferred safe haven asset, and wheat, the price of which has been a key factor powering the revolutions sweeping North Africa, has already moved up between 10% and 20% since the beginning of January alone. Vanja Dragomanovich reports. ORTH AFRICA AND the Middle East are going through a 1989 moment and as the uprising spreads from country to country it is not clear where it will stop. Just as the first brick hammered out of the Berlin Wall eventually led to the reunification of Germany, the Soviet Union falling apart,Yugoslavia going to war and Poland, Czech Republic and Hungary joining the European Union (EU), so the first paving stone dug out of Tahrir Square brought down rulers and may lead to a shake-up of the heartland of oil and the two key countries in the region—Iran and Saudi Arabia. What is clear though is that what is happening on the ground is already deeply impacting commodities markets. Oil prices have risen to the highest level in two years and look set to move higher, potentially threatening the global economic recovery; gold has returned to being the preferred safe haven asset and wheat, the price of which has been a key factor powering the revolutions sweeping North Africa, has already moved up between 10% and 20% since the beginning of January. Prices for those three commodities will only continue to rise, the more so the longer the unrest lasts. If oil does stay significantly above $100 a barrel, other commodities such as base metals are likely to initially follow suit, but if the upshot is a global economic slowdown, then the implications for copper, aluminium and steel will be medium-term negative rather than positive. “What we have learnt in 2008 is that oil above $100 starts putting a brake on the global economy. This oil price will incrementally start throwing grit on the wheels of the global recovery. If you have to pay £1.35 for petrol [in the UK] you

will be very careful about how you spend the rest of your money,” says Neil Dwane, chief investment officer at RCM, which is part of Allianz Global Investors. He notes that so far equity markets have ignored what is happening in the Middle East but that higher oil prices will start having implications on companies’ performances and eventually share prices. In commodities, oil is by far the most exposed to the situation on the ground and has the capacity to move several dollars per day in response to either perceived or real output or shipping disruptions. The unrest started just as oil prices had begun trending up in response to an improved global economic picture. Despite the improved demand there was, and still is, a significant discrepancy between the US and Europe. In the US, large quantities of oil are being shipped from Canada to Cushing in Oklahoma, the main hub for WTI crude oil, keeping a cap on Nymex-trade WTI crude oil futures. Europe, on the other hand, is supplied directly from the Middle East. The conflict in Libya sent panic waves through the key consumer markets as Libya supplies around a third of Italy’s oil and is one of the important suppliers to France and Germany. “All in all, the pace of change sweeping the region is truly mind-boggling, and we find it unlikely oil prices will‘settle’any time soon, as long as this kind of upheaval continues to spread,” says Edward Meir, a senior analyst at trading firm MF Global. “It will probably be Brent that will likely see the most price sensitivity in the event of a serious flare-up, as WTI still seems to be on the defensive, pressured by an unfriendly

MARCH 2011 • FTSE GLOBAL MARKETS

Commodity price data ENERGY

COMMODITY Coal, Australia Crude oil, average Crude oil, Brent Crude oil, Dubai Crude oil, West Texas Int. Natural gas index Natural gas, Europe Natural gas, US Natural gas LNG, Japan

UNIT a/ $/mt a/ $/bbl a/ $/bbl a/ $/bbl a/ $/bbl a/ 2000=100 a/ $/mmbtu a/ $/mmbtu a/ $/mmbtu

ANNUAL AVERAGE Jan-Dec Jan-Dec Jan-Dec 2009 2010 2011 71.84 98.38 137.00 61.79 79.04 92.69 61.86 79.64 96.29 61.75 78.06 92.37 61.65 79.43 89.41 153.5 156.1 170.6 8.71 8.29 9.61 3.95 4.39 4.49 8.94 10.85 11.70

UNIT b/ $/mt b/ $/mt b/ $/mt $/mt $/mt $/mt $/mt $/mt b/ $/mt $/mt

ANNUAL AVERAGE Jan-Dec Jan-Dec Jan-Dec 2009 2010 2011 128.3 158.4 195.2 165.5 185.9 264.9 555.0 488.9 516.8 458.1 441.5 467.6 326.4 383.7 405.0 n.a. 429.1 521.1 151.1 165.4 246.3 300.5 312.4 440.5 224.1 223.6 326.6 186.0 229.7 320.4

QUARTERLY AVERAGES Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010 77.66 95.19 99.49 93.55 105.30 75.50 77.06 78.18 75.51 85.42 74.97 76.65 78.69 76.41 86.79 75.46 75.86 77.98 74.04 84.37 76.08 78.67 77.85 76.08 85.09 149.4 170.3 147.5 155.1 151.6 7.81 8.84 7.51 8.26 8.54 4.36 5.15 4.32 4.28 3.80 9.33 10.32 10.95 11.22 10.91

MONTHLY AVERAGES Nov Dec Jan 2010 2010 2011 103.20 115.24 137.00 84.53 90.01 92.69 85.67 91.80 96.29 83.70 89.07 92.37 84.24 89.15 89.41 151.1 158.8 170.6 8.59 8.74 9.61 3.73 4.24 4.49 10.84 10.75 11.70

GRAINS

COMMODITY Barley Maize Rice, Thailand, 5% Rice, Thailand, 25% Rice, Thai, A.1 Rice, Vietnam, 5% (NEW) Sorghum Wheat, Canada Wheat, US, HRW Wheat, US, SRW

QUARTERLY AVERAGES Oct-Dec Jan-Mar Apr-Jun Jul-Sep Oct-Dec 2009 2010 2010 2010 2010 145.5 143.6 146.9 161.9 181.1 167.8 162.7 157.7 181.7 241.5 542.3 535.3 452.4 457.0 510.8 462.8 477.0 399.1 418.5 471.4 346.1 400.7 333.8 376.9 423.1 n.a. 433.2 366.1 411.1 506.2 163.8 156.9 142.6 153.6 208.6 283.4 279.0 260.9 326.1 383.6 205.4 195.4 177.4 237.9 283.6 195.6 193.5 186.9 253.4 284.9

MONTHLY AVERAGES Nov Dec Jan 2010 2010 2011 179.1 189.6 195.2 238.2 250.4 264.9 514.5 532.0 516.8 477.5 479.8 467.6 427.8 413.4 405.0 508.0 533.0 521.1 203.2 221.6 246.3 376.2 408.9 440.5 274.1 306.5 326.6 278.5 308.6 320.4

a/ Included in the energy index (2000 = 100): b/ Included in the non-energy index (2000 = 100); mt = metric ton; bbl = barrel; mmbtu = million British thermal units Source: The World Bank/IFC/MIGA Office Memorandum, supplied February 2011.

arbitrage and excessive Cushing inventories,” he adds. Until the conflict in Libya started escalating there was only a threat of disruption in production or in shipping through the Suez Canal and the market’s reaction was fairly mild. With the situation in Libya changing from day to day, the likelihood of a cut in supplies became much more real with reports that the country plans on cutting exports by one third. Libya is a medium-sized producer and member of the oil cartel Opec. Although it is not as big a supplier as Iran, Algeria or Kuwait—it produces some 1.6m barrels of oil a day compared with the entire market of some 88.5m barrels a day—it is still important for European countries. If there is a serious shortfall in the market it could be covered by the International Energy Agency, which controls emergency oil stocks held in developed economies. The agency says it is on red alert and would use the 1.6bn barrels of publicly-held oil stocks, which it controls in case there is a serious supply disruption, but not to manage high oil prices. Supply shortfalls could be covered from other sources, too. “There are large worries in the market about what is happening with Libya. Saudi Arabia has spare capacity to supply sour grades crude oil, but the big fear is that the political situation worsens and the protests move over to Saudi Arabia,” says Robert Montefusco, a senior broker at commodities futures and options broker Sucden Financial. Saudi exports 8.9m barrels of oil per day, Emirates and Iran around 2.5m, Algeria 1.7m and Libya 1.3m. Bahrain and Yemen are in comparison much smaller exporters but disruptions there would still add to the tightness in the market.

FTSE GLOBAL MARKETS • MARCH 2011

Two other major suppliers for Europe, Russia and Norway, are unlikely to make up the lost crude, Montefusco notes. “Russia is fairly consistent at producing 10m barrels a day and Norway had problems recently and has been losing production in the North Sea,” he says. The big question is whether the unrest will spread to Saudi Arabia, and if it starts there, how would it play out? “Thus far, there have not been any reports of protests, but we have to suspect that the government is watching the situation in Bahrain with some trepidation, as the Saudi leadership mirrors the Bahraini one in that most of its governing class are Sunnis, while the governed are Shi’ites,” says MF Global’s Meir. Zaineb Al-Assam, the head of Middle East and North Africa forecasting at consultancy Exclusive Analysis, says: “The major issue is succession, which regional events are likely to accelerate, though there is also a risk of national fragmentation.” She believes that transition scenarios are unlikely to be seriously violent or disruptive. On a practical level, Al-Assam notes: “Eastern ports with significant oil infrastructure, including King Abdul Aziz Port, Ras Tanura Port, Ju’aymah Crude and LPG Terminal, and Jubail Commercial Port, are likely to receive increased security, but will likely experience disruption and delays in the event of escalating protests restricting access to the ports.” Apart from crude oil, the region is also a key producer of natural gas. Algeria is the world’s fourth largest exporter that puts 62bn cubic metres (m3) of gas on the market. Egypt exports 8bn m3, Libya 5.2bn m3 and Iran 4bn m3. So far, there have been no disruptions to the exports although the market

COVER STORY

may start pricing in potential risk. The price reaction is likely to be milder than in the oil market because of the long-term oversupply of natural gas, particularly in the US where large amounts of shale gas have come onto the market over the past couple of years and kept prices low.

Gold: demand manageable There are two key aspects to what is likely to happen with gold prices. One is the supply and demand for physical gold for jewellery, bars or coins. When it comes to physical gold, the Middle East is one of the biggest buying regions in the world, third after India and China. Gold is routinely used in the Middle East for gifts to mark births, weddings or other major occasions and is kept as a substitute for money. Egypt has lost at least 18 working days and the corresponding income, and thus there may be a need to cover the lost income somehow; selling family gold reserves would be one way. Given the overall demand for gold this is unlikely to upset the market too much. The World Gold Council said recently that in terms of jewellery demand, 2010 was a remarkable year and that 54% of total demand came from the jewellery sector. India bought more than 745 tonnes of gold last year and China just under 400 tonnes. A stream of supply from the Middle East is not liable to upset the market very much. The buying is what Frank Holmes, the chief executive of US Global Investors who runs Meridian Global Funds, calls “the love trade”. He says: “The love trade is significant and unique to gold. People buy gold out of love and those in emerging markets are especially amorous of the metal. The four strongest markets for gold jewellery demand—India, Hong Kong, China and Russia—accounted for 60% of the entire jewellery market in 2010. The rise in Chinese gold demand goes hand-in-hand with a rise in average incomes for Chinese citizens,” says Holmes. Last year, 20m migrant workers in China saw their incomes rise 24%. Compare this to the US where the job market has shown some signs of life, but continues to sputter. “With these higher income levels, many in China’s middle class are looking to gold as a means for long-term savings and a possible hedge against inflation,” he notes. The second, and likely to be more significant, aspect to the gold trade is the changed perception of investors towards it. RCM’s Dwane says: “Up until the unrest in the Middle East, people were trumpeting the end of gold. It fell back to $1,300. The situation in the Middle East has put gold firmly into the ‘it’s back’ camp. It is beginning to capture trade caused by caution over global economic and political risk.” Prices have already moved above $1,400 a troy ounce and are close to record highs. Geopolitical concerns and particularly fears that the economic recovery might slow down will only continue to fuel gold’s trend higher.

Wheat: demand unpredictable The third key commodity for North Africa and the Middle East is wheat. Prices started rising at the beginning of the unrest in Egypt, the world’s largest grain importer, as other countries in the region began buying extra wheat in an attempt to pre-empt rising prices. Algeria recently bought

800,000 tonnes of the grain, far more than it normally purchases, Saudi Arabia said it plans to double the size of its wheat stockpile and Jordan bought another 100,000 tonnes. The wheat market is heading towards a perfect storm, similar to the one seen two years ago. The UN Food and Agriculture Organisation in February warned that a severe winter drought in the north of China might cause problems with the wheat harvest there. China is normally self-sufficient in wheat but if it had to import the grain, prices would jump. On top of that, floods in Australia have destroyed the quality of wheat in what is one of the world’s largest producing regions, and Rabobank estimates that as much as half of Australia’s expected crop of 24m tonnes will have to be downgraded. “This is coming at a time when the markets are well primed for the prospect of high food prices. A report by the World Bank last week said that 44m people have slipped into poverty because of high food prices,” says Brenda Sullivan, an analyst at Sucden Financial. Countries such as Egypt where there are political protests flaring up because of high food prices might be inclined to make sure that people are well fed. “If there are short-term disruptions [to the grain market] international agencies may help with such aspects as financing,” says Sullivan. Wheat futures traded on the Chicago Board of Trade have rallied around 20% since the beginning of January and are trading even higher than they did last year when a drought in Russia decimated exports and prompted the country to hold back some of its exports to feed the local population. Wheat futures traded in Paris have risen to €260 a tonne and at one point were at €274/t, up 12% since the beginning of January. Sullivan says it might be too early to estimate how this year’s wheat crop will pan out: “As we go through the year we might have a better crop from Russia and other regions. Weather will be the key factor to watch and will have probably the most significant influence as we go into the latter part of the year.” RCM’s Dwane says: “If you have a situation where big producers are struggling with production, they will hold back some of the grain they produce to feed their own and this will make the situation only tighter.” Ukraine, which has grown into a key player on the global market in recent years, already said it has implemented quotas on grain exports to protect domestic wheat prices after a drought last summer and that it would extend the quotas until the end of June. “What wheat comes onto the market will go to people who are prepared to pay the highest price and China will be keen to feed its population. China is so big that it may go from importing 2 million tonnes of wheat to 8 million tonnes of wheat. This in turn will make the situation in Egypt and other poor countries worse. The cold fact is that we in the UK spend 7% of our wage on food, while emerging markets countries spend 50% of their wage,” says Dwane. Dramatic news film and pictures indicate that what started in Tunisia is far from over. Political and economic implications have yet to be digested. I

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TRADING / DERIVATIVES

Turnover on international derivatives exchanges makes for eye-watering reading—$13.8trn a day in just one month in 2010 in developed markets, according to the Bank of International Settlements, and contracts worth almost two quadrillion dollars ($1,900trn) in the year to September. While daily trading turnover on derivatives exchanges in emerging market economies is smaller ($1.2trn during April 2010), it is four times bigger than it was ten years ago and the markets of Asia, South America, India and Russia are proving a magnet for the more established exchanges in more developed countries. Which exchanges are best placed to leverage this growth trend and what challenges might they face in expanding their international reach? Ruth Hughes Liley goes in search of some answers.

THE TECHNOLOGICAL TIPPING POINT OF EM DERIVATIVES P

thirdly, its education and training AUL ROWADY, A senior initiative for the Asian market. analyst at TABB group, Exchange partnerships benefit talks the trend: “There’s a both parties, as seen in the tie-up push-pull factor at work. In between Korea’s Exchange (KRX) developed markets, clients have a and Eurex. A contract based on never-ending search for new the highly liquid KOSPI 200 sources of alpha so the answer is index option traded on the KRX to go out and create alliances that was launched in August last year, will bring that in. This is a motithe Eurex KOSPI product. vating factor for establishing Currently averaging 9,000 exchange contracts with smaller contracts traded each day—with more remote players. On the a spike of 64,000 contracts on other side, you have emerging January 18th—members can markets players looking to prove transfer positions to one another that their own regulatory regimes during the day and also benefit are open enough. Some of the from trading open positions after up and coming emerging Korean trading hours in Europe markets players are trying to and North America. A further attract liquidity and technology benefit is that while Korea does and to bring in other tools to not offer block trades, this can be grow above and beyond their done on Eurex. “There’s a natural local market situation.” tremendously increasing demand “The most important factor of Photograph © Andrey Nitsievskiy / Dreamstime.com, for this,” says Schwinn. all when we go into co-operation supplied February 2011. The KOSPI 200 options index with other exchanges, for example in Asia, is that we have to create value for the appears to be the most liquid in the world with 2.9bn entire market,”states Roland Schwinn, head of business de- contracts traded in 2009, while the second-best global development, Asia and Middle East, for Eurex, the derivatives rivative contract, the E-Mini S&P Futures contract on CME, exchange within the Deutsche Börse’s group. “It’s about traded just 556m contracts. However, Rowady sounds a supplying relevant products and services to the market par- note of warning: “The KOSPI 200 contract size is tiny and ticipants.” Over the past year, Eurex has attracted 10 new if you take the notional value of the KOSPI option and members to its exchange from Asia: five from Taiwan, a normalise it with its, say, Japanese equivalent, you find it is large Chinese broker and some smaller Asian proprietary 15 times smaller.” Korea apart, other emerging market derivatives contracts trading firms. Volumes on the Eurex platform have increased are making their way on to the order books of more 30% over the same period. Schwinn says that Eurex’s success in Asia can be attributed developed exchanges, a natural development in the fight for to three factors: the partnerships and co-operations with market share between leading derivatives exchanges. Most other exchanges, Eurex’s five-year-old “trader development” prominent in this regard are CME Group and Eurex. The programme offering incentives to trade on the platform, and CME for some time has attempted to ensure that leading

FTSE GLOBAL MARKETS • MARCH 2011

TRADING / DERIVATIVES

“The most important factor of all when we go into co-operation with other exchanges, for example in Asia, is that we have to create value for the entire market,” states Roland Schwinn, head of business development, Asia and Middle East, for Eurex, the derivatives exchange within the Deutsche Börse group.

Mas Nakachi, head of business development at the employee-owned software provider, Calypso Technology. “In emerging markets there’s a cleaner slate, so it’s easier to put the right technology in place right from the start,” he says. Photograph kindly supplied by Calypso Technology, February 2011.

benchmarks, such as Bursa Malaysia’s palm oil contract and RTS’s wheat contract, can be traded on its ubiquitous Globex platform. Most recently, RTS came to an agreement with CME Group allowing it to launch a wheat futures contract on the CME, while the exchange agreed it would provide an alternative outlet for Bursa Malaysia’s US dollar-denominated palm oil contract back in March 2009. The partnership which has been in train for some time now will open up trade in Malaysia’s palm oil futures to all 1,100 entities directly connected to Globex across 86 countries. As the platform boasts almost round-the-clock electronic trading of futures and options, the partnership enhances liquidity for both parties. Market participants—food manufacturers, producers and processors of palm oil and bio-fuel companies, for example—can use the contract to hedge their price risk exposure on the same platform as the CBOT soybean oil futures and options contract. The palm oil contract is settled in US dollars rather than the Malaysian ringgit, which is worth a third of a dollar and less liquid. Rowady calls this “synthetic access” where exchanges license the rights to list products from emerging markets. The crude palm oil is one example, another is the listing of the Bombay Stock Exchange (BSE) Sensex Index of 30 leading Indian shares on Eurex. Eurex members have access to an Indian benchmark index, while BSE market participants will have derivatives on their index offered from a global exchange. “With 410 members of Eurex, we bring a global distribution network of trading firms to this market,” says a Eurex spokesman. In similar vein, the Singapore Exchange (SGX) and the London Metal Exchange (LME) launched LME-SGX copper, aluminium and zinc futures in February 2011, providing retail investors in Asia and elsewhere access to global metal markets. Liz Milan, managing director, LME Asia, says: “There is a high level of interest from retail

investors and funds looking for more accessible products that give them exposure to metals prices and help them broaden their investment portfolio.” Emerging markets exchanges are hedging their relationships, however, and few are putting all their eggs in one basket. KRX has, since 2007, also had a long standing agreement with CME Group on the distribution of its KRX KOSPI 200 index products. According to another recentlysigned agreement, RTS is cooperating with Atlanta-based ICE derivatives exchange to develop contracts on oil products. Unusually, the CME Group declined to comment. Even so, there are signs that CME, which once threatened to offer unparalleled and unfettered access to the world’s leading derivatives benchmarks, is being trumped by the coincidence of a strengthened Eurex (through the planned merger between the NYSE Euronext and Deutsche Börse groups) and the enthusiasm of emerging markets exchanges to take advantage of multiple distribution points in a rapidly changing exchange landscape. For now, the emerging markets exchanges are calling a tune of sorts.

Joining forces Evgeny Serdyukov, head of FORTS, the derivatives market of Russia-based RTS stock exchange, says: “There is a global tendency for mergers between exchanges. For example, ICE and CME groups have global status and their agreements with smaller exchanges allow them to develop global contracts on a regional level. The share of foreign investors on our market will be increasing and in our opinion the importance of their presence will rise. However, we still believe that Russian market participants have great potential for growth, too. “By joining forces with CME, RTS can develop global trading on wheat in Russia. In return, CME Group provides us with its expertise in developing agricultural commodities.” While commodity contracts can be built slowly through partnerships, trading in equity derivatives can develop more quickly. EDX London, the derivatives exchange 80%-owned by the London Stock Exchange, now trades Russian equity derivatives contracts globally on the FTSE Russia IOB index, comprising the 15 most liquid Russian IOB (International Order Book) securities. Since its launch in December 2006, this has been worth £180bn in notional value traded with 90m contracts traded. Moreover, underscoring the sustained appeal of the emerging markets, EDX London also trades options and derivatives on more than 30 individual IOB securities representing Kazkhstan, Egypt, India and South Korea.

MARCH 2011 • FTSE GLOBAL MARKETS

Safety, efficiency, diversity. Just some of the things we’re bringing to derivatives. Eurex Group provides more opportunities across a growing range of products – from pre- to post-trading, in major markets around the world. We help create a safer market where risks are managed more effectively. And we offer more efficient processes based on innovative and proven technology. For over 10 years, we have been successfully shaping the future of the derivatives industry. Today, we have a global liquidity pool trading about 10.5 million derivatives contracts every day. And we offer ground-breaking clearing services through Europe’s leading central counterparty for securities and derivatives transactions. Eurex Group includes Eurex Exchange, the International Securities Exchange (ISE), Eurex Clearing, Eurex Bonds and Eurex Repo. Eurex Group is part of Deutsche Börse Group. Find out more at www.eurexgroup.com.

TRADING / DERIVATIVES

The CME Group continues to build up and strengthening its partnerships around the world; internationalism is the cornerstone of its long-term expansion strategy. The group operates the Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT) and New York Mercantile Exchange (NYMEX) in the United States, while its crop of international partnerships (both loose and formal) include BM&FBovespa, Bolsa Mexicana de Valores, Bursa Malaysia, DME Dubai Mercantile Exchange, GreenX, Imarex, JSE (South Africa), Kansas City Board of Trade, Korea Exchange, Minneapolis Grain Exchange, National Stock Exchange of India, OneChicago and SGX (Singapore). It is a route which up to now it has largely walked alone, However, Eurex is catching up and emerging markets exchanges themselves are developing their own international strategic credentials which will play out over the coming decade. CME Group’s partnership with BM&FBovespa in Brazil is the star turn in its international rainbow of coalitions and exhibits a healthy trading “ecosystem” in the country, says Rowady. “Important factors are openness of regulation, good technology and an active underlying economy. This results in active derivatives markets as in Brazil, where there is lots of liquidity and a sufficient amount of openness.” Brazil and Korea account for 90% of all emerging market turnover of exchange-traded derivatives, estimates BIS in its December 2010 report, while Singapore remains the centre for over-the-counter (OTC) transactions. Average daily turnover in Brazil of exchange-traded FX derivatives in April 2010 was $31bn, against just $5bn in OTC markets, while that of interest rate derivatives was $126bn against $7bn conducted OTC. Through CME and BM&FBovespa’s 2008 partnership agreement, orders can be routed directly to each others’ platforms, allowing greater distribution capacity and liquidity. In 2010, for example, interest rate futures on Bovespa traded a record 293m contracts, almost double the 2009 figure. CME recorded a similar growth: trading activity outside US trading hours grew 33%, accounting for 16% of CME Globex volume.

Technology: the partnership driver Technology is becoming the global common denominator with regard to exchange partnerships. Through the Association of Southeast Asian Nations (ASEAN), a new crossborder connection will later this year link four exchanges— Singapore’s SGX, Bursa Malaysia, the Philippines Stock Exchange and the Stock Exchange of Thailand. The long anticipated move is directed at making equities trading a more “seamless” cross-border operation. With exchangetraded derivatives growing faster than equities in emerging markets, this is a significant development. TABB Group’s Rowady says: “Technology companies are establishing connections there and trading linkages with most of the key markets in APAC. In the short term, the way is to deal with the right counterparties and set up individual linkages to exchanges, but in the long term what is important is what Hong Kong and Singapore are offering where equities and derivatives can be accessed through a single point. It’s

Paul Rowady, a senior analyst at TABB group. “Important factors are openness of regulation, good technology and an active underlying economy. This results in active derivatives markets as in Brazil, where there is lots of liquidity and a sufficient amount of openness,” he says. Photograph kindly supplied by TABB group, February 2011.

important because there are a lot of unique strategies and hedging possibilities when it is easy to access both together.” RTS Group is one example, where a position opened as a result of a futures contract settlement can be closed on the RTS standard market creating a single order book for the derivatives and cash markets. Serdyukov says this allows FORTS to establish requirements for their market participants across all their markets. Other linkages are also coming into play. Rowady says the proposed merger between the Australia Securities Exchange (ASX) and SGX is interesting because “with one connection, traders will be able to access Australia, Singapore and New Zealand and this opens up many different types of trading choices and different strategies”. He adds: “It’s the concept of unified trading platforms and unified connectivity which are the themes for the next decade and if you have them you can use them to compete to your advantage.” The combined ASX/SGX exchange will offer access to Asia Pacific equity, fixed income and commodity derivatives with over 400 contracts from over 10 countries, including Australia, Greater China, India and Japan, and covering a range of commodities, such as metals, energy and agricultural products.

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Evgeny Serdyukov, head of FORTS. “There is a global tendency for mergers between exchanges. For example, ICE and CME groups have global status and their agreements with smaller exchanges allow them to develop global contracts on a regional level,” he says. Photograph kindly supplied by RTS, February 2011.

Rowady says: “A broader product pipeline is attractive to market participants and conceptually, it should drive down costs, although it will most certainly drive up exchange profits. Having a broader product spectrum under one umbrella and centralised at one clearing house makes portfolio margining innovations possible and this capital efficiency will become another major global theme in the years ahead.” Mas Nakachi, head of business development at employeeowned software provider, Calypso Technology, says developing technology for emerging markets is not a case of “catchup” with developed markets: “We’re doing a tremendous amount of work in Brazil and China and are finding that it’s not emerging markets technology lagging the developed markets, but that we’re often putting the same technology and same components in place in both. In emerging markets there’s a cleaner slate, so it’s easier to put the right technology in place right from the start. For example, some of these exchanges have had central repositories from day one, so there’s a record of all transactions in one place. There’s no baggage.” While vertical silos have mostly disappeared from the European trading landscape, many emerging markets derivatives exchanges are rushing headlong down the vertical

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route, where trading and clearing can all take place using the same technology. It is a natural evolution given the view of regulators, from the G20 downwards, which want to mandate central clearing on exchange for OTC derivatives trading. Many believe this will encourage trading on to exchanges. Indeed, earlier this year Calypso sold a specialist system to CME Group to support OTC derivatives processing for clearing interest rates swaps. It allows CME members to clear OTC derivatives trades and manage intra-day risk. This becomes important as more OTC derivatives contracts are standardised and cleared through exchanges. Calypso’s system also allows rudimentary OTC derivatives valuations and clearing house margin valuations. As the relationship between OTC trading and clearing on exchange gets closer, Nakachi believes that those exchanges with OTC clearing capabilities will win out. “Central clearing of OTC derivatives is one thing which is not in dispute. A lot of clearing is provided by existing exchanges and exchanges are definitely going to tie up with clearing houses. It will be a more seamless market, there’s no doubt about that.” He believes that while some contracts will never go electronic, moving OTC derivatives trading on to exchanges will start with the more standardised contracts of which he estimates around 40%-60% fall within this definition: “But there is still a whole swathe that will never be cleared on these platforms, so management of this is critical.” Upon the crisis in 2008, RTS members moved almost all trading in equity derivatives on to the exchange to minimise counterparty risk and it has stayed put. Trading in currency derivatives on RTS has also been growing rapidly and constitutes around $1bn daily volume, about ten times more than two years ago, although is still dwarfed by over-the-counter trading, which is around three times greater than on-exchange activity. The FORTS team is aiming to become one of the top five most liquid derivatives markets in the next few years. In April, shareholders will vote on a merger between RTS and the Moscow Interbank Currency Exchange (MICEX), the two strongest bourses in Russia. If agreed, the merger will enable FORTS to expand its derivatives offering into interest rates and bonds in addition to commodities. MICEX president Ruben Aganbegyan says: “Integration of platforms, technologies and professional potential of our companies will allow us to create a strong trading venue in Moscow in the near future with the prospect of becoming one of the most rapidly developing exchanges in the world, with rising levels of liquidity.” Rowady believes a tipping point has been reached, made possible by an acceleration of technical investment at APAC exchanges and a more open attitude to foreign market participants. “The opportunities for derivatives trading in APAC will continue to unfold at an increasingly rapid pace. Closely monitoring alliances between eastern and western exchanges is an effective means to deduce the next moves on the chessboard. Above all, evidence is building for westernbased traders to become much more engaged in the region’s increasingly accessible derivatives markets.” I

TRADING

MiFID II BEGINS TO EXERT ITS INFLUENCE A cloud of uncertainty gathered over electronic trading in Europe in 2010 as firms awaited impending regulation. In December, the European Commission finally launched a public consultation on the review of the Markets in Financial Instruments Directive (MiFID) and with regulation being a key driver of market structure, 2011 will be a watershed year when proposals are adopted in May. Ruth Hughes Liley reports. IRMS RUSHED TO meet the February deadline to submit their reactions when the European Commission (EC) launched a public consultation on the review of MiFID (Markets in Financial Instruments Directive)—which included three different options for a mandated, consolidated tape of trade records, restraints on high-frequency traders and dark pools, which would be monitored by a new regulatory body and a new trading facility. The watchdog is to be called the European Securities and Markets Authority (ESMA); an organised trading facility (OTF) could include derivatives trading. Alasdair Haynes, chief executive officer of Chi-X Europe, believes the three key areas will be whether or how a consolidated tape of post-trade transactions is created, the degree of understanding of high-frequency trading (HFT) and how far dark pools are restricted. “In any case, the electronic trading business is still going to grow.” He says. “Technology has allowed people to do things faster, several thousand times faster than you can blink. I think we are reaching the point where technology is becoming an enabler for the whole industry rather than simply bringing advantages to the first movers.” High-frequency trading has grown to around 60% of electronic trading in the US, while in the UK it makes up around 35% of the overall market (77% of the continuous markets, according to TABB Group). Haynes believes HFT needs reviewing but stresses: “This type of trading is a strategy, not a business or a company. We see them as liquidity providers that add value.” High-speed demands up-to-the-minute technology and global spending on technology by financial services institu-

tions is this year expected to reach $363.8bn, according to figures from research and advisory firm Celent published in January, a growth of 3.7% over 2010, reaching $393bn by 2013. European and North American financial institutions spend almost equal amounts on IT, accounting for 33.6% and 34.2% respectively, and Celent estimates that while spending in the US will continue to climb, it will struggle in Europe. “We are not completely out of the woods,” says Jacob Jegher, senior analyst with Celent’s Banking Group and co-author of the report. “The good news is that overall growth projections are indicating a positive trend.” The type of spending on algorithms and smart order routers has changed in quality if not quantity, explains Brian Gallagher, head of European electronic trading at Morgan Stanley: “I believe things have flattened out in the algo space since 2008, when firms were all offering more and more commoditised core algorithms and smart order routers. Now we are taking it to the next level of customisation and creating bespoke algorithms based on how a client feels. So our index-driven clients and our benchmark-driven clients will have highly different views and we are working with them to combine financial engineering with DMA with lit and with dark trading to suit their own particular needs.” Exchanges have also come under pressure to make technology investments with an estimated 83 mandatory upgrades during 2010, putting pressure on members to maintain their own investment. Competition has been good for the industry, according to Haynes. “When you don’t have competition, as in Spain, exchanges maintain their

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

fees,” he says. “When you do have competition, fees fall. Once fees fall then data prices fall and clearing costs fall, too. When Chi-X Europe first started over three years ago, the average clearing cost of a trade was 30 euro cents. Now the average cost is three euro cents, but just because it has fallen dramatically doesn’t mean it can’t fall further.” Rob Flatley, chief executive officer of data company Netik, says: “The new game is cost control and efficient distribution. Low-touch commission rates have come down significantly over the past year. Usually once commissions come down they don’t go back up again, so firms now have to focus on costs in order to work through the margin squeeze. The broker dealer community has mature platforms. They bought a lot and built a lot over the past ten years. The battle to build the means of production is over. Trading technology has been commoditised and it is a lot cheaper because of the proliferation of those tools.” The hedge fund community, for example, he says, is paying around 60% less for electronic execution. “You can cross things internally at zero costs, but firms have all the internal costs of technology and employing quant analysts, execution traders and so on. If you really look at it, it has become bloated. People are looking to do things efficiently without having to lock themselves in where commission has come down,” adds Flatley. Equity trading volumes are low, and in August last year UK registrars Equiniti, predicted that UK equity trading volumes in 2010 would be the lowest since 2002 relative to UK plc, with only an estimated £2.5trn to be traded in 2010, compared to £4trn in 2007. The period between 2008 and

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2010 also saw most sustained market volatility in 25 years. Richard Balarkas, chief executive officer of Instinet Europe, believes reduced volumes will challenge the sell side and buy side relationship this year: “We are in a prolonged period of reduced market activity. This sets up a different set of tensions within the industry. Reduced volume means a lower commission pool which results in brokers trying to compete more aggressively for business while the buy side has to be more diligent about which brokers they use. Investors may further concentrate their commission dollars to try and maintain good relationships. Lower commissions and lower margins will also put constraints on brokers’ product development plans, especially those relative new entrants trying to build an equity franchise.” However, Gallagher is more upbeat: “If you look at the MiFID review, everyone has an agenda, but we have found that 85% of the time we have the same viewpoint as our clients on choice, transparency and so on. Plus we have worked more collaboratively as we have been customising algorithms for them. New regulation often looks to the individual retail investor and the institutional investor can get lost in the process, but as we on the sell side are having direct dialogue with all the MTFs and exchanges, we can crystallise points and can educate the buy side. Our job is as much about best execution as about best education in the changing market structure.” Finding a clear picture of volumes in the electronic market structure is not easy and new research by TABB Group in January showed that only 65% of the €3.9trn turnover in the UK was “meaningful and executable” liquidity, with 35% “noise” or reprints of already-conducted trades. Some 72% of this executable liquidity is traded on the lit order book of an exchange or MTF and 11% in electronic dark environments. Cash trading is further diluted by the plethora of execution channels as well as alternative products such as equity swaps, and by high-frequency trading, states the TABB report, Breaking down the UK Equity Market.

Differentiating the UK According to Miranda Mizen, TABB Group principal and also a co-author of the report, the UK, Europe’s largest equity market, is different from Europe partly because of its high level of trading in Contracts for Difference (CFD), primarily as they are not subject to UK stamp duty. Electronic trading on exchanges or MTFs accounts for 55% of total turnover in the UK, while electronic dark trading has risen to 7% of total turnover in the UK compared with a pan-European estimate of less than 5%. Per Loven, international corporate strategy, Liquidnet, agrees: “There is a misconception about overall volumes. Around 40% is over-the-counter trading, but not all of this is real liquidity. A large part of this is broker-to-broker trades, give-ups, internal adjustments, principal trades on behalf of clients, so there is a slightly skewed picture of reality and what is really happening.” Double counting of trades has been a concern to many over the past three years. For example, one broker may report both a swap transaction with a client and the

TRADING

exchange of the trade and another may report just the physical trade into the market. Flatley says: “This matters because the post-trade world affects the starting price and trading strategy for the next day—all that happens between market close and market open is a big part of the research backbone and affects price formation and price discovery. For everyone it is a challenge, but for broker dealers they have to deal with all the data, analyse it, clean it up and package it. They are dealing with a huge amount of information and a variety of information users across the firm.” There is also lack of clarity about what type of trade is conducted: is it agency, principal or even riskless principle?

Brian Gallagher, head of European electronic trading at Morgan Stanley. Photograph kindly supplied by Morgan Stanley, February 2011.

Miranda Mizen, TABB Group principal and co-author of the report Breaking down the UK Equity Market. Photograph kindly supplied by TABB Group, February 2011.

Trades need to be flagged clearly, says Gallagher, adding: “Capital commitment trades on block should be flagged; price reference trades such as a guaranteed opening price should be flagged. If we negotiated a transaction and agreed a price, if I then put it on without flagging it, it would be a trade that others couldn’t get in to. Getting a consolidated tape is fine, but if it’s garbage going in, it will be garbage coming out. There’s no point in getting to a consolidated tape when all you are doing is consolidating noise.” Instinet’s Balarkas believes that as the market becomes more complex, investors are becoming more discerning. “That plays into the hands of the agency model,” he says. “Investors are starting to ask questions about how brokers or banks operate. The more transparency provided, the less clients become confused and concerned about whether their interests are aligned with their brokers’. I think investors will take greater comfort from service providers who are crystal clear about how they operate in the market—where the trade was done, which venue and so on.” A recent development has been the tendency of investment banks to develop different platforms for their customer flow and their proprietary trading flow. Jesper Alfredsson, vice-president, product management, Orc Software, says: “Previously they would tend to have one piece of technology whereas now, especially with the requirements on the DMA technology enforced by MiFID and the need for high performance and low latency on the proprietary trading technology, they have separate platforms. Five years ago it was not like this and they would come to us looking to save on technology by consolidating.” Alfredsson is hopeful that fragmentation has levelled out as venues merge; Chi-X and BATS Trading are finalising terms, for example. In spite of this tendency, a new trading facility, Quote MTF, is to launch on April 4th, with an aggressive fee structure, capping commission fees at €14,000 until 2012 for early sign-ups. It is already streaming real-time quote and trade market data through Bloomberg Professional. Alfredsson says: “In the US, the market environment is very challenging with so many liquidity pools increasing costs because you have to maintain connectivity and meet all the requirements. Whether fragmentation will continue in Europe is the ten million dollar question. There might be a consolidation effect where some MTFs will have to decide whether they really want to run an exchange or build up enough volume and sell out.” Many are optimistic at the power of the market to respond to regulation with new market models in the electronic area. Gallagher believes the new OFT category for example, is broad enough to catch new models that emerge and believes this will help the market. Mizen also believes in the power of the market to adapt: “As soon the commission’s formal proposals are out then I think you are going to see new business models emerging. Implementation won’t be until 2012 or 2013 and no one is going to wait for this before they move. Regulation change stretches the full gamut and touches every participant. I can see something similar to the Big Bang happening again in Europe.” I

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Asian regulators have not been complacent about the lessons learned from the financial crisis: derivatives need careful handling, though they present a tremendous business opportunity. The message from Asian regulators is that to maintain transparency and avoid Asia catching “EuroAmerican flu”, central counterparty clearing houses (CCPs) are the way to go. Hong Kong, Singapore and Tokyo all have targets for mandatory CCPs for OTC derivatives by the end of 2012, albeit tied to the timetables for Dodd Frank and Basel III. Ian Williams reports.

ASIAN CCPs TAKE HOLD market, like the Eurobond LTHOUGH THE market, over time. Once we DETAILED regulatory have these mechanisms we regimes have to fit a will be well positioned to be global framework yet Asian the centre for clearing and exchanges are investing heavily trading [the instruments].” in the technical platforms and inRamu says Singapore laid the frastructure for their central foundations for its clearing counterparty clearing houses house when global regulators (CCPs). Even while current “pushed for central clearing for market demand in Asia is not proprietary trades, as a start,” really enough to drive extensive and then to deal with the needs development, they are preparing of end users, non-financial for the future and growth. institutions, for protection over In Singapore, AsiaClear, the Photograph © Federico Moreno / time. He says: “It was important over-the-counter (OTC) derivaDreamstime.com, February 2011. to develop the infrastructure [so tives clearing arm set up by the that global banks] could Singapore Exchange (SGX) in 2006, has moved a step closer to becoming the regional central continue to trade with Asian counterparts without falling foul counterparty clearer. It began offering clearing services for US of their home country regulations or being put under severe dollar interest rate swaps for Asian local banks in November constraints in respect of the capital they can allocate to this business. So we set out to build this infrastructure even before last year, utilising technology by Calypso. It has been a vital service for those banks that are not these things were mandated in Asia. We studied all the members of global independent clearers, such as the clearing houses, in depth, and they were all quite cooperative, LCH.Clearnet’s SwapClear. “Interest Rate Swaps and FX so we could see where we had to go.” SGX launched its platform for clearing interest rates swaps forwards offer a reasonable market at present,” holds Singapore Exchange president Muthukrisnan Ramaswami, in Singapore dollars (SGD) in November 2010, so “all the known in-house as Ramu. However, expansion into new global banks here could trade these with our Singaporean areas is still limited, he holds: “For credit default swaps and Asian banks and have a platform to clear,” Ramu there’s almost no market, and interest rate swaps don’t go explains. They have indeed been using it, he says. “Our far into the future.” That is based upon the macroeconomic volumes are fairly substantial. The numbers aren’t published fact that Asian governments do not run at a deficit, unlike yet; for a ballpark figure we’ve cleared SGD20bn ($15.7bn) their would-be western exemplars. “They have no need to in swaps, which is a substantial size compared to the market, particularly since it isn’t yet mandatory,” he says. “We’ve issue long bonds,” he concurs. Interestingly, while it is a hotly contested topic in the US about a dozen global banks [utilising the platform] and we and Europe, in Asia, margins for end-user derivatives are not think that will expand to 20 in the course of the next few a subject for debate. They are statistically insignificant, even months. Our membership will predominately be the top 16 or so global banks here plus the top 12 or so Asia banks if they do represent a potential growth area. SGX’s plans are the most developed and Ramu explains its which deal with over-the-counter traded derivatives.” Current members include the Hongkong and Shanghai long-term thinking: “We foresee the need for huge infrastructure investments in Asian countries [such as] India and Banking Corporation, Oversea-Chinese Banking CorporaVietnam beyond their domestic capital-raising capacity, and tion, DBS Bank and United Overseas Bank, as well as so they might need 20 to 30-year bonds. If that happens then founding clearing members such as Barclays Bank, Citi, the end-user community will need to use interest rate Credit Suisse, Deutsche Bank, Royal Bank of Scotland and hedging instruments. So we have to develop an Asia bond Standard Chartered.

FTSE GLOBAL MARKETS • MARCH 2011

TRADING

The choice of technology is crucial. It has to meet global standards, permit harmonisation with regional requirements and anticipate future requirements as well. Ramu says: “We tried to stay very close to international systems so we use the same trade mechanisms as the rest of the world.” The next stage, he says, is to add interest rate swaps in other currencies. “Our infrastructure supports more or less all currencies so we’ll be getting pretty active, firstly on US dollar interest rate swap clearing, because that’s the biggest and most active currency after the local dollar itself. Now we are working on the path for the future asset classes we will clear. FX forwards are the other big market that all these banks are involved in, and from then on maybe FX options.”

Tokyo in the frame Singapore is not alone in its ambitions. Tokyo is on the case. Takeshi Hirano, Tokyo Stock Exchange’s (TSE’s) head of strategic planning, clearing and settlement, claims the exchange’s CCP had already been on the drawing board before the crisis. “We’d started discussions with market participants long before the Lehman Brothers collapse happened and before the global regulators had got together, because we’d already begun to consider expanding the business beyond listed products. In the course of discussions, I must say we also paid attention to the demands of regulators and market participants in the light of the G20 commitment. The Japanese government has already passed the amendments to the Financial Instruments and Exchange Act, which mandated the CCP’s creation.” The clearing of interest rate swaps via the Japan Securities Clearing Corporation (JSCC)—with a link to LCH.Clearnet— is on the agenda, with a target date in the fourth quarter (Q4) of 2012 and the clearing of CDS on I-Traxx via the JSCC by the second quarter of this year, according to the Futures Industry Association of Japan. Hirano explains: “We have two goals: one to establish the market infrastructure for the public benefit; and two, we also are trying to expand business into new fields [such as] derivatives.” Tokyo only has a small percentage of the global derivatives market, but while Hirano hedges his bets by “not making any definite assertions”, he points out: “When you compare the derivatives trading with the size of the Japanese economy, the credit, financial and bond markets, it’s fair to make assumptions that there is room to grow,” even without a potential share of global markets. In Japan, there does not seem to be a process of open consultation and lobbying, and Hirano comments: “Officially we haven’t started discussions as to what products would be subject to mandatory clearing, which will be the subject of a cabinet order. They are carefully watching what will happen in the US and Europe, and they will take into account their regulators’rulings on this.” He anticipates that it would be between three to six months before the 2012 international deadline. “We are now also working with our banks to develop a client clearing model. We have the initial base, but we don’t want to get too far ahead of the rest of the world. We need alignment with the European Union, US etc., so the user community

does not have to pay for very different processes in Asia and elsewhere. However, we have a pretty clear idea of the direction even if the final shape is far from clear,” Hirano concludes. Hong Kong Stock Exchange (HKEx) is on a similar trajectory, and is expected to launch an over-the-counter derivatives clearing house in 2012, initially planning to clear OTC interest rate swaps and non-deliverable forwards. The exchange declined to comment further other than providing a written statement: “Thanks to Hong Kong’s strengths as an international financial centre and its unique status as part of China under the ‘one country, two systems’ arrangement, the city is well positioned to become the leading offshore RMB centre.” With great restraint, it adds: “It may be able to benefit greatly in the future by becoming involved in the clearing of RMBrelated products from the OTC market.” It is investing HKD180m ($23m) in the project, despite low current demand. Meantime, Hong Kong’s Securities and Futures Commission (SFC) intends to consult the market on the regulatory regime related to the introduction of a trade repository and a central counterparty by the end of 2012. Hong Kong has the largest OTC derivatives market in Asia although the market is still relatively small compared to Europe and the US. The SFC also expects the CCP eventually to clear other OTC derivatives traded in Hong Kong, such as equity derivatives, though details remain vague and regulatory details such as capital requirements are still under consideration. HKEx’s statement adds, somewhat stiffly, that it “is considering different operating models and shareholder structures for its OTC clearing house and will consider introducing partners that can attract participation of international and mainland players in the Hong Kong market, bring in OTC clearing and risk management skills and expertise and/or license their platforms and/or risk management systems to HKEx.” So far it admits that it has have not identified any partners, but it is early days. HKEx is focusing on a few products at the inception and seeing the market volume before expanding to other asset classes HKEx also stresses that the CCP will be run independently of HKEx’s other clearing houses. In Hong Kong, equities trading clearing is through the exchange operator HKEx’s CCASS/3 automated book-entry system in which trades are settled on a continuous bet basis or on a trade-fortrade basis. It will have different “participantship”(i.e. membership) arrangements and a new IT platform, along with risk management measures and dedicated teams and resources to support its operations. SGX’s Ramu is optimistic about the prospects for regional and global harmonisation of the CCPs, which all of them piously invoke as “interoperability”.“If you compare the futures marketplace now with 15 or so years ago, we have a mutual offset arrangement with CME and contracts can be traded with SGX or CME and cleared in either. The basis and principles we used are not very different from what we’d do in any mutual offset interoperability agreement. The key issues are where do the margins reside and who will manage the default? You have to get to grips with those and enshrine the rules you need in each country’s regulations to allow those capabilities.”I

MARCH 2011 • FTSE GLOBAL MARKETS

Photograph © Zdenek Klucka / Dreamstime.com, February 2011.

In the wake of the financial crisis, investors and regulators around the globe are demanding greater transparency and better supervision of investment products. In theory, the heightened scrutiny could pose a threat to boutique exchanges that pride themselves on light regulation and fast approval for listings. Whether onshore or offshore, these venues do not compete with New York, London or Frankfurt, but they do provide an important service the major exchanges are neither capable of nor interested in offering. In practice, though, exchanges in the Caribbean and at certain locations in Europe that rely on listing fees rather than trading volume for their primary revenue base are thriving despite—or even because of—the clamour for heightened investor protection. Neil A O’Hara reports.

NICHE WORKS FOR BOUTIQUE EXCHANGES HE RAISON D’ÊTRE for boutique exchanges derives from laws in many countries that prohibit the sale of investment products domiciled outside their jurisdiction to local investors unless they are listed on a recognised stock exchange. The idea is to co-opt the exchanges as regulatory supervisors in order to protect domestic investors from shysters and scam artists who might otherwise peddle unsavoury investment schemes. The boutique exchanges must strike a delicate balance between the demand for fast, easy and cheap listings from reputable investment product sponsors and the need to maintain credibility with both investors and global regulators. From the product sponsor’s perspective, a listing is a box they have to tick if they wish to sell an instrument in certain markets. In principle, they could use one exchange as well as another, but each boutique has developed niches in which it has become the de facto venue of choice for specific products, often tied to other services provided in that location. For example, Dublin has a flourishing business in hedge fund administration—and the Irish Stock Exchange lists more hedge funds than any other. “There will always be a need for niche exchanges that provide support and regulation to some of the more complex

FTSE GLOBAL MARKETS • MARCH 2011

and sophisticated investment products,” says Greg Wojciechowski, president and chief executive officer of the Bermuda Stock Exchange (BSX). In some respects, the BSX is the big gorilla among the offshore boutiques. It has active trading in some securities, full clearing and settlement capabilities and a central securities depository. It is also a full member of the World Federation of Exchanges, a trade association which counts among its 52 members all the major stock exchanges as well as onshore boutiques including Ireland, Luxembourg and Malta—but not the Cayman Islands Stock Exchange (CSX) or the Channel Islands Stock Exchange (CISX). Wojciechowski has ambitions to take the BSX beyond its historical dependence on listings of collective investment schemes and derivative warrants to attract more insurance-linked securities to the market. “It is clear that the convergence of the capital markets and insurance is happening,” he says. “The BSX can support transactions originated in Bermuda or elsewhere and accelerate that trend.” Bermuda is already home to 1,400 insurance companies with $442bn in total assets and $142bn in gross premiums, the third largest centre for insurance after London and New

TRADING

Tamara Menteshvili, chief executive officer of the Channel Islands Stock Exchange (CISX). “The Channel Islands and Guernsey in particular have the core skill set for property funds, their establishment and management. There is a natural fit,” she says. Photograph kindly supplied by CISX, February 2011.

York. The Cayman Islands took an early lead in listing catastrophe bonds—the CSX hosts 77 issues valued at $6.7bn— but Wojciechowski wants to bring that business back to Bermuda, where most of the deals originate. A change in Bermudan law which took effect in October 2009 eliminated the administrative advantage the Cayman Islands had enjoyed in creating and listing catastrophe bonds, and the BSX has since listed seven bonds with a combined value of $370m. “Bermuda is the logical place to list,” says Wojciechowski. “We have the Silicon Valley effect here; anyone who is in the property casualty reinsurance business is here or has a connection here.” Other exchanges have successfully used a cluster strategy to build their business. Guernsey has long been the domicile of choice for property unit trusts—and the CISX has leveraged that local expertise to attract more listings of these vehicles than anywhere else. “The Channel Islands and Guernsey in particular have the core skill set for property funds, their establishment and management. There is a natural fit,” says Tamara Menteshvili, chief executive officer of the CISX. The CISX also benefits from its proximity to London and other European financial centres. The Channel Islands are in the same time zone, but do not belong to the European Union (EU)—and are therefore not subject to the various EU investment directives that apply to competing exchanges such as Dublin and Luxembourg. In order to establish its credibility, the CISX applied for and received recognition from the US Securities and Exchange Commission, the UK

Financial Services Authority and other global regulators. “We have to ensure that our standards are high to instill confidence,” says Menteshvili. “International regulators have evaluated our rules and infrastructure and given us their seal of approval by way of formal recognition or designation. That gives us the credentials we need.” New listings on the CISX have run at about 450 per year for the past three years, not far short of the 500 per year before the market meltdown. The composition of new listings has changed, however, with more specialised debt securities and fewer collective investment schemes. CISX has become the leading exchange for listing European private equity funds and the debt used to finance European leveraged buyouts; bonds that are privately placed when the transactions close. “Major private equity houses, including Tri-Alpha, have chosen to list their acquisition vehicle debt through us,” says Menteshvili. “That has a knock-on effect in attracting private equity funds.” Like exchanges everywhere, including those in the major global financial centres, CISX has stepped up its regulatory efforts in recent years. Computers can track whether financial statements are filed on a timely basis, but CISX enlists the help of sponsoring members to monitor the timely reporting of material events that do not occur on a regular schedule. “Each member has a role in assisting the listed entities they sponsor to comply with our requirements, otherwise we would need an army of people,” says Menteshvili. CISX runs training programmes for member firms and directors of listed entities to increase awareness of their responsibilities—and if an investor asks why certain information about an issuer isn’t posted on the CISX website, the exchange will investigate.

Crucial role The boutique exchanges play a crucial role in the distribution of sophisticated investment products that meet investors’ needs and help optimise the global allocation of capital. For example, the 508 closed-end funds listed on the CISX in 2008; 2010 attracted £2.7trn at issue and another £2.9trn through secondary offerings. “People sometimes overlook the attractiveness of a listing,” says Menteshvili. “A listed entity gets more visibility, and as the fund delivers on its objectives it attracts additional investment.” In an effort to dispel criticism of their lighter regulatory touch, boutique exchanges are quick to emphasise the importance of compliance and their standing with global organisations. Gerry Halischuk, head of markets and compliance at the CSX, notes that the exchange is an affiliate member of IOSCO, the securities regulators forum, and the only offshore member of the Intermarket Surveillance Group, whose 40 members include all the major exchanges. The CSX also qualifies as a “recognised stock exchange” under UK tax rules, a prerequisite for listing eurobonds issued by UK companies. “Our listing rules emphasise the disclosure of all relevant information without imposing unnecessarily onerous conditions and restrictions,” says Halischuk.

MARCH 2011 • FTSE GLOBAL MARKETS

Greg Wojciechowski, president and chief executive officer of the Bermuda Stock Exchange (BSX). “There will always be a need for niche exchanges that provide support and regulation to some of the more complex and sophisticated investment products,” he says. Photograph kindly supplied by BSX, February 2011.

Like the CISX, the CSX has in recent years seen a shift toward specialised debt listings, including catastrophe bonds, for which it remains the market leader. The official list also features mutual funds, collateralised debt obligations and other structured debt, eurobonds and a handful of equities for a total of 1,350 securities. “Over the past year, listings have begun to pick up,” says Halischuk. “The CSX now has more listed securities than at any time in its history.” The Cayman Islands is the preferred domicile for most USbased offshore hedge funds, supported by a robust legal and regulatory infrastructure as well as fund administration services and the CSX listing capabilities. The government aims to provide “one-stop shopping” to the alternative investment industry alongside the offshore banking business that has flourished in Cayman for many years. The CSX plays its part by providing a cost effective and efficient listing process. Halischuk says: “We adapt our listing rules and procedures quickly to accommodate new structures and products.” The convenience of a single venue isn’t always enough to keep the listing business at home, however. In fact, more often than not offshore hedge funds are designed in New York, domiciled in the Cayman Islands and listed in Dublin. The Irish Stock Exchange lists more than 7,600 investment fund share classes sponsored by heavyweight asset managers on both sides of the Atlantic: Man Investments, Marshall Wace, Schroders, Threadneedle, Hermes BPK and Lansdowne Partners in the UK; BlackRock, Russell, Fidelity, Legg Mason, Vanguard and Paulson & Co in the US. Although funds domiciled in Dublin make up more than half

FTSE GLOBAL MARKETS • MARCH 2011

the total, 18.2% hail from the Cayman Islands and another 15.7% from Jersey. The manager profile is quite different, however—45.5% based in the UK, 28% in the US, 4% in Switzerland and the rest scattered around the globe. Dublin is also the European venue of choice for listing asset-backed securities, claiming 70% of the market. It has more than 22,000 debt listings as well, but in this category it plays second fiddle to the Luxembourg Bourse, which had 29,566 debt listings at the end of 2010. Luxembourg had 7,581 warrants, and a combination of investment funds, equities and depository receipts made up the balance of its 44,916 total listings. Luxembourg does not like to be considered an offshore exchange, a designation it views with disdain. It does reside within the EU, of course, but its business model is indistinguishable from the other boutiques, whether offshore or onshore. Listings rather than trading drive revenues, as the exchange itself acknowledges: its report on 2010 activities trumpeted a 20.85% increase in new listings over 2009. What little trading does occur (using an NYSE Euronext platform) is concentrated in equities and depository receipts, which accounted for €164m in trading value on December 31st, 2010, 75% of the daily total. The enormous number of bonds listed in Luxembourg rarely trade there, if ever. Compared to the billions of shares that change hands in London or New York every day, Luxembourg’s trading is a cipher—its core competence is providing an EU venue for listing debt issues, warrants and investment vehicles domiciled elsewhere. In contrast, the Malta Stock Exchange (MSA) exists first and foremost as a domestic stock exchange for retail investors in Maltese companies, most of which issue debt rather than equity. In recent years, however, Malta has begun to attract international fund listings as well; 290 share classes are listed, half of them attributable to Fidelity. Lloyds Bank, Lazard and HSBC also have funds listed there. The government of Malta, which owns the exchange, has set a target for the financial services sector to grow to 25% of GDP by 2015. “The exchange will seek to expand by attracting international issuers and investors to facilitate cross-border listings and trading of Maltese securities,” says Eileen Muscat, chief executive officer of the MSE. The continuing strength of new listings on the boutique exchanges reflects the comfort investors take from regulatory oversight. The BSX acts as the exclusive numbering agent in Bermuda for CUSIP and ISIN, the leading global securities identification schemes, but although the number of new securities created in Bermuda fell after 2008, the number of listings on the BSX did not. Entities domiciled elsewhere— the BSX gets about 30% of its listing from the Cayman Islands, the British Virgin Islands and Jersey—have driven listings on the BSX to more than 800, an all-time high. “Issuers recognise that stock exchange oversight gives investors confidence in their products,” says Wojciechowski. “Complying with internationally accepted regulatory standards shows that sponsors are serious about providing transparency and disclosure to their customers.”I

PRIME BROKING

The near collapse of Bear Stearns and the death of Lehman Brothers shook the prime brokerage industry to its core. Investors and hedge fund managers alike suddenly woke up to the unthinkable: a major Wall Street firm could fail, depriving hedge funds of a funding source and potentially tying up cash left on deposit at the firm in bankruptcy proceedings that could take years to resolve. As hedge funds scrambled to diversify their prime broker relationships, they began to look more carefully at the financial health of potential partners—an opportunity the Canadian banks have been quick to seize. By Neil A O’Hara.

CANADIAN BANKS BULK UP EFORE 2008, CANADIAN banks were hardly a significant force in prime brokerage. The local hedge fund industry was too small to support the required infrastructure on its own, and most of the banks lacked the global footprint to support funds that wanted to trade outside North America. To the dominant prime brokers in the United States, Canada was just one more country on the map and one easy to service given its proximity, advanced market infrastructure and close ties to the US—so close that 183 Canadian stocks are interlisted on exchanges in both countries. The five big Canadian banks have always had an edge in servicing local hedge funds, however. Their securities arms account for the majority of share trading in Canada, so they usually have established relationships with managers who set up on their own. The banks also have retail operations that can offer privileged and profitable access to hard-toborrow securities, a critical revenue source for any prime broker, together with long-standing relationships with custodian securities lenders in Canada. “Canadian hedge funds have a bias toward investing in Canadian assets,” explains Patrick Blessing, global head of prime brokerage at Scotia Capital in Toronto. “It is imperative to have Canadian servicing of their assets. It is a significant advantage for Canadian prime brokers.” The local hedge fund industry has grown rapidly in the past five years and now has an estimated CAD20bn to CAD25bn ($20.3bn to $25.3bn) in assets under management. That has caught the attention of prime brokers based in the US and Europe in addition to the domestic banks. At least ten Canadian hedge funds now have more than CAD1bn in assets, a tempting target for any prime broker with a global footprint. Blessing says: “So far, the global firms have not won a huge amount of business in Canada, but they are more actively marketing to potential clients here.” Scotia has extended its own capabilities internationally in the past two years by setting up prime broker operations in New York, Singapore and London. The other obvious targets for Canadian prime brokers are foreign hedge funds that want to trade in Canada. In

Photograph © Dgbomb / Dreamstime.com, supplied February 2011.

addition to the natural advantage of local market knowledge and relationships, the Canadian banks are gaining business based on their stellar credit ratings. All five came through the financial crisis in better shape than banks in either the US or Europe, which makes them attractive counterparties to hedge funds newly alert to the perils of credit risk. The bigger US hedge funds that have added prime broker relationships have not done so indiscriminately, either; risk officers have insisted that they should not all be US based. “We see a real opportunity to face off against the larger funds and use our balance sheet and credit to attract new business,” says Blessing.

MARCH 2011 • FTSE GLOBAL MARKETS

FOR RELIABLE MARKET NEWS, ANALYSIS AND DATA ANYTIME, ANYDAY: www.berlinguer.com The editorial team at FTSE Global Markets is committed to giving our readers and customers the best possible service in terms of news and analysis across multiple platforms. As part of this commitment we are in the process of upgrading the Berlinguer website. Over the coming months we will be adding new features and data sets that we hope you agree will add value and supplement your news and data requirements. As we build these additional value-added services we will keep you updated as the new features and implementation schedules. From early November you can register for regular email alerts on the website. We have divided email alerts into three initial areas: Trading, Securities Services and Securities Lending. We will be adding further alerts in the coming year, including Foreign Exchange, Prime Broking and Commodities. We hope the alerts will be a valued and invaluable supplement to our provision of analysis of the global financial markets. We have also made some changes to FTSE Global Markets magazine and we will continue to try to upgrade and expand our coverage on a monthly basis. We have expanded the number of regular editorial departments, added new journalists and columnists. We have also simplified the design to better reflect the editorial changes and enhanced coverage. As ever, your feedback and input are invaluable as we embark on a new growth stage in our business. In the New Year we will conduct on a reader survey, which we hope will help us continue to improve our services.

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PRIME BROKING

A top-notch rating also appeals to stock lenders, who in the past three years have become much more selective about the entities to which they will lend. Securities lending generates the lion’s share of prime broker revenues; up to 75% or 80% in many cases. Hard to borrow securities generate most of the securities lending revenue. Good access to lendable securities is critical to prime brokers in Canada, as it is elsewhere, and the marginal lender is likely to feel more comfortable doing business with Canadian banks than many other counterparties. “To be successful in stock lending you need a large array of counterparties from which to source,” says Tom Kalafatis, head of prime brokerage at CIBC World Markets. “We leverage relationships across our whole platform to get clients what they need.” CIBC in 2010 brought together under its prime broker umbrella equity financing, securities lending and electronic trading products. It was the first Canadian bank to embrace co-location services, which attracted new participants to the market including high-frequency trading firms that engage in statistical and index arbitrage as well as electronic market making. The incremental liquidity has largely come from outside Canada, and it has propelled CIBC from a fifth place also-ran to first place in Canadian equity trading: it now commands a 20% market share. “We are focused on Canadian-related product, both importing liquidity and clients to access Canadian markets and taking Canadian products to the world,” says Kalafatis. It is a niche strategy that lets CIBC leverage its strength in Canada rather than trying to go head-to-head with US and European prime brokers that already have a global footprint. In addition to asset servicing, CIBC runs a capital introduction programme that helps foreign hedge funds tap into pension funds and other investors based in Canada. A strong credit rating may open the door, but Kalafatis says potential clients are also looking for high quality people and a positive attitude toward solving problems. He prefers clients who have strong risk controls, a durable business model and are willing to enter into a long-term relationship that can grow along with their assets under management. “If a client wants the all-singing, all-dancing prime broker then we are not the place for them,” he says. “Our experience shows that focusing on what we do well serves our clients better.” Like CIBC, TD Securities pursues a Canada-centric strategy in prime brokerage: its business is focused on domestic hedge funds, European funds and US-managed offshore funds that trade in Canada. TD Securities doesn’t trade Asian or South American securities, so it makes no sense to market in those regions. “We would not be able to go head-to-head with the large international players on Asian or European securities,” says Lionel deMercado, head of prime brokerage at TD Securities. “We have an edge when it comes to local equities. We know what we are very good at and are comfortable in offering those services.” Through its TD Waterhouse affiliate, TD Securities has access to a large retail box, from which it derives a significant portion of its prime broker revenues. The ideal hedge fund client for TD Securities pursues an equity-related strategy

Patrick Blessing, global head of prime brokerage at Scotia Capital in Toronto. “Canadian hedge funds have a bias toward investing in Canadian assets,” he explains. “It is imperative to have Canadian servicing of their assets. It is a significant advantage for Canadian prime brokers.” Photograph kindly supplied by Scotia Capital, February 2011.

with a heavy emphasis on short selling, particularly of hardto-borrow securities. “It’s a natural fit for clients outside Canada that have an appetite for a large amount of Canadian securities,” says deMercado. “We have incredible strength in hard-to-borrow stocks.” The number of new hedge funds launched in Canada plummeted after the financial crisis, but the pace has bounced back a little over the past two years. DeMercado says the funds coming to market today are more attractive to prime brokers: they are fewer in number but have greater assets under management at the outset. As one of the few developed economies that still has sound public finances, Canada has also become a popular destination for international investors, including hedge funds. TD Securities is ramping up its marketing efforts, but deMercado wants to make sure he can service potential clients properly. “We want to grow, but I am hesitant about overpromising and under-delivering,” he says. “Senior management is comfortable with the business, and our strong balance sheet is very helpful.” The largest Canadian bank, Royal Bank of Canada, has a broader global presence than its four closest competitors. The RBC Capital Markets division has more than 6,000 employees located at 75 offices in 15 countries, including trading hubs in Toronto, New York, London, Hong Kong and Sydney. “With those trading hubs, we are covered 24/7,” says Andrew Thornhill, head of prime broker services at

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Daniel Dorenbush, chief executive officer of Merlin Securities. “A dealer may have one hot stock but not another. Merlin has direct relationships with four leading prime brokers and custodians. One of our strengths is in securities lending,” says Dorenbush. Photograph kindly supplied by Merlin Securities, February 2011.

RBC Capital Markets. “Our clients that are looking to execute globally really don’t have to look any further.” RBC’s global network not only services Canadian clients trading abroad but also acts as a conduit for foreign clients interested in trading in Canada and the US, for whom its securities lending prowess is an obvious attraction. The bank enjoys close relationships with Canadian custodial lenders and can draw from an extensive and diversified pool of margined securities held by clients as well. Thornhill says both hedge funds and banks have become more focused on risk management in recent years, a shift that has benefited both RBC and its local competitors. RBC is not afraid to compete for business against the big global prime brokers, either. “Given the size of the bank, our strong credit rating and geographical footprint, it is not a hard story to sell,” says Thornhill. “We do have to be competitive in our service offering or we won’t win the business.” RBC has a wide range of prime broker clients from large, well-established firms to small start-ups. The decision to take on a client does not depend on asset size so much as the competence of the managers and the potential for leverage across different lines of business within the bank. “We look for strong risk management capabilities and depth of experience,” says Thornhill. “We will take on a small fund if they have a solid background, good asset growth potential and are already well known to the bank.”

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The average size of hedge funds in Canada is smaller than in the US, but to Merlin Securities, the New Yorkbased introducing prime broker, that represents an opportunity. The concept of mini-prime brokers, which provide technology and support but don’t take custody of clients’ assets themselves, is new to Canada. In the US, Merlin concentrates on servicing hedge funds that have less than $1bn in assets, which means most funds based in Canada fall within its target range. In 2010, Merlin opened an office in Toronto and hired Daniel Dorenbush to run it. The choice of chief executive officer was deliberate—Dorenbush is Canadian and has spent most of his career in Toronto apart from a stint in New York in the prime brokerage division of RBC Capital Markets. It was intended to demonstrate that Merlin has made a long-term commitment to Canada and is sensitive to the sometimes equivocal relationship between Canadians and their southern neighbours. The securities owned by Merlin’s clients reside at one or more (at each client’s choice) of four entities that hold them in custody and handle trade processing: National Bank Correspondent Network in Canada; Goldman Sachs Execution & Clearing, JPMorgan Chase and Northern Trust in the US. Clients have no credit exposure to Merlin, and the prime broker of record in offering memoranda and marketing materials is the underlying custodian. The ties to the four partners help overcome a natural disadvantage: Merlin does not have a captive retail box it can draw on for securities lending. Indeed, Dorenbush argues that the Canadian banks overstate the importance of an internal box because the inventory is often used for purposes other than lending to hedge fund clients. In any case, a single bank often does not have the ability to borrow stocks its clients want—and Merlin can tap the big custodian lenders as well as anyone. “A dealer may have one hot stock but not another,” says Dorenbush. “Merlin has direct relationships with four leading prime brokers and custodians. One of our strengths is in securities lending.” Merlin has also developed a comprehensive multi-asset class, multi-currency technology platform that allows clients to consolidate holdings and see profit and loss statements, performance attribution and risk analytics on an entire portfolio, even if parts of it are not held at Merlin’s custodians. In effect, Merlin is leveraging the investment its partners have already made in global trade processing through a software interface of its own design. This powerful tool supersedes the internal spreadsheets many hedge funds use to compile a complete view of their holdings and makes the information available in real time.“No one else is doing this in the Canadian market,” says Dorenbush. “The fund doesn’t have to have a Merlin partner as its prime broker; we can still aggregate the information and generate these high-octane reports.” It remains to be seen whether other prime brokers in the US follow Merlin’s lead and set up in Toronto. Meanwhile, the Canadian banks have all bulked up, and the more internationally oriented—RBC and Scotia—are ready to muscle in on the global players’ home turf. I

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A FAIR WIND FOR US CUSTODY

Photograph © Jason Leader / Dreamstime.com, supplied February 2011.

Until very recently, the concept of alpha generation had pretty much taken a back seat to risk identification and mitigation. Even so, from dodging one bullet after another since the start of the financial crisis, the six-month, 2500-point advance of the Dow Jones Industrial Index has, to date, given US investors—as well as their custody providers—something substantive to cheer about. While helping clients seek quality opportunities in different locales and reshaping business strategies to conform to a seemingly endless array of regulatory reforms, custodians can take heart in the sustained wave of market optimism, at least for the time being. From Boston, David Simons reports. INCE SANDS, EXECUTIVE vice president of BNY Mellon Asset Servicing, claims: “We have certainly witnessed some pick up in trading volume, which tells us that investors aren’t just sitting on the sidelines, they’ve been far more active with their cash, and that is a very good sign for the markets in general. While we’re not out of the woods just yet, I think we can take some comfort in the knowledge that there is much more optimism out there than we saw just one year ago.” From his vantage point, Sands sees a “much stronger pipeline” of pension funds and other institutional clients looking to custodians to help boost efficiency and manage risk. Investors are also keen on having providers such as BNY Mellon become more involved in other aspects of the custodial process. He adds: “Take OTC derivatives, for example, in the past, clients may not have had an active interest in the relationship between the counterparties and their collateral. That has all changed—now, organisations want custodians to assume more responsibility in that regard by providing securities valuing and reconciliation services on an independent basis. So while the whole notion of risk is still front and centre, it has taken on a much deeper level of meaning for custodians.” Whether or not the rally is sustainable, Kelly Mathieson, head of global custody and clearing at JP Morgan, agrees that the psychology of business has, at least for the time being, changed for the better. “I think it is going to be quite some time before the industry is able to move beyond the kind of risk-management principles that have been set in place as a result of the market crisis; the lessons learned are still too acute,” says Mathieson. “Having said that, there has been a much more positive spin on the approach to risk manage-

ment, particularly as the markets continue to show a bit more buoyancy. At the same time, I think we’ve all become a bit wiser about the way the markets operate, and, most of all, how to manage risk more effectively.” A year ago, BNY Mellon paid $2.3bn in cash for the global investment servicing business of Pittsburgh-based PNC Financial (PNC GIS) in an effort to widen its hedge-fund and traditional-fund administration capabilities. The company officially closed the deal last July. Recent numbers suggest that the money was well spent: in its 2010 year-end report, BNY Mellon revealed a year-on-year 29% increase in security servicing fees, covering areas such as assets under custody and securities-on-loan revenue. Sands couldn’t be happier with the results. “Providing a full set of services to financial institutions and fund complexes is obviously a major part of our overall corporate strategy,” he says. “Melding BNY Mellon’s capabilities with those of GIS has not only added scale to the existing product line, but has also brought aboard a whole new range of products, while also expanding the breadth of BNY Mellon’s personnel and client roster.”

Global footprint As investors continue to seek quality opportunities in distant locales, custodians have been forced to work that much harder to stay one step ahead. Particularly as the ratio of foreign-to-domestic revenues continues to increase, it is crucial that providers not only have a common platform in place, but also maintain representation at the local level in order to assist clients that are interested in allocating into these different regions—”Which is why BNY Mellon’s acquisition of GIS coincided with a deeper expansion into areas

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including Europe, Latin America and Asia,” says Sands. Further, the company’s acquisition last August of BHF Asset Servicing GmbH in Germany made BNY Mellon the second largest provider by assets held in this key European market, extending its services for German domestic custody and the KAG fund administration platform. “It isn’t just about the product line, it’s also having the wherewithal to navigate easily through these markets, having an understanding of the political background, the industry concerns, and just being able to speak the language.” Those who cannot live up to these standards will likely be forced to exit the business altogether, maintains Sands. As a large US custodian, Chicago-based Northern Trust has a number of clients with a global footprint, who expect to be serviced accordingly. Keeping up with new regulatory measures figures highly in this regard, says Biff Bowman, executive vice president, head of Americas, for corporate and institutional services. “For instance, global custodians are responsible for helping clients comply with FATCA, which is an IRS regulation that affects US citizens who invest in non-US assets. Then there is Dodd-Frank, which impacts multinational clients with US offices, among others. To properly service these clients, we need to slice, dice and track data from around the globe, offering reporting that fits the template of these regulations.” A standard part of its custody service offering for many years, pooling allows Northern Trust to provide an investment structure for multinational pension plans or insurance companies with assets in multiple markets. This ability to govern and scale those assets appropriately on a single platform, including measuring and monitoring on a single platform, is key to helping companies grow outside of their home country, says Bowman. “For US asset managers, globalisation means looking beyond our borders, not only from an investing point of view, but from a product distribution perspective as well. Again, the custodian or fund administrator helps by consulting on non-US regulations such as UCITS or AIFM that will impact directly US managers looking to distribute their product outside of the US.” Like others in the industry, JP Morgan’s business strategies continue to be shaped by the seemingly endless stream of regulatory measures emanating from virtually every region in which the company maintains custody ties, remarks Mathieson. Although the ink has yet to dry, Europe’s recently drafted AIFM directive, as well as UCITS V, ranks among the most relevant pieces of legislation for global custodians, suggests Mathieson. “At this stage, we are seeing calls for custodians to have a much broader and specific set of responsibilities within its sub-custodian network,” he says. Because many of these markets have very thin options available for resource providers, Mathieson says: “From a risk perspective, in certain instances we are more comfortable handling local custody and clearing arrangements ourselves. This is by no means a reflection of the quality of these providers—it’s just that we believe that a custody mandate should be governed by the policies

FTSE GLOBAL MARKETS • MARCH 2011

Vince Sands, executive vice president of BNY Mellon Asset Servicing. Photograph kindly supplied by BNY Mellon, February 2011.

Kelly Mathieson, head of global custody and clearing at JP Morgan. Photograph kindly supplied by JP Morgan, February 2011.

and procedures that we’re most familiar with, which happen to be our own.” Key to this effort has been JP Morgan’s expansion of its Worldwide Securities Services (WSS) direct custody and clearing footprint. Unveiled last autumn, the plan seeks to enhance clearing, settlement, custody and asset servicing by augmenting the company’s local presence in both existing and new markets across the globe. As custody clients approach risk management with a greater level of sophistication, Mathieson sees a number of key themes emerging, including the ability for investors to take a truly global view of the risks that can exist within the total portfolio. “Unlike the period leading up to 2007/2008, events that occur within any given industry, sector or country can easily have implications on non-affiliated sectors or regions,” says Mathieson. The revolution in Egypt, and the lock-step reaction of the financial markets before, during and after the event, is the latest and best evidence of this inter-connectivity, he notes. “No longer is this a world of purely isolated events.” The phenomenal growth of and demand for real-time information is another overarching factor, Mathieson says. “This is something we’ve been discussing for quite some time, of course—no longer is it good enough to simply riskcheck on a monthly basis; instead, custody clients want to be equipped with the best methods for obtaining securities, settlement and clearing information in real time, in order to help them both assess risk or make decisions on how to take advantage of that risk.”

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Biff Bowman, executive vice president, head of Americas, for corporate and institutional services at Northern Trust. Photograph kindly supplied by Northern Trust, February 2011.

Equally important are discussions around newer types of asset classes, including derivatives products, exchange-traded bundles or carbon credits. Because they are developing in a much more risk-oriented environment, these products tend to come equipped with far more transparent mathematics and less ambiguous performance details than in the past. “In other words, by using what we’ve learned in risk management and applying it to these new opportunities, I feel that there is a whole new brand of asset-class conversation emerging, one that seeks the kind of transparency that probably should have been applied to every asset class all along.”

Demand for derivatives servicing Risk analytics, covering areas including absolute and relative risk, as well as tracking-error methodologies, have been generating a tremendous amount of client interest of late, says Alan Greene, executive vice president of State Street’s US global services business. “The same can be said for post-trade compliance as a way of helping clients navigate through single or multiple portfolios. Additionally, we continue to see strong demand for derivatives servicing, processing across both middle and back offices all the way through to settlement and reporting, using industry standard formats.” Greene also notes heightened interest in transparency among institutional clients, as well as requests for more efficient risk-management controls. Echoing a familiar theme, Greene maintains that a progressively complex investment environment will tend to favour firms with broader specialisation capabilities as well as a vast client base. “As a global firm, we are able to offer a single platform to all of our clients, no matter where they are located. It is difficult to overstate the significance of that capability.” At Northern Trust, new business opportunities have jumped 41% since 2008, and Bowman expects this trend to continue. “While not every search results in a change of provider, our own experience tells us that pensions, insurance companies and asset managers are definitely willing to move to a new custodian.”Clients often consider the strength of the value-add menu when sizing up a prospective provider. “Globalisation, regulation and risk management have been driving mandate reviews for pensions and other institutional investors who require a higher level of service in order to meet these ongoing challenges,” says Bowman. “One of the most popular service

Alan Greene, executive vice president of State Street’s US global services business. Photograph kindly supplied by State Street, February 2011.

innovations with custody clients has been our FAS 157 Resource Library, which helps to fulfill reporting requirements for securities under the fair value measurement standard.” Furthermore, asset managers are looking to custodians and operations outsourcing providers to act as a strategic extension of their business, maintains Bowman. “For example, last year a European-based manager with a successful strategy came to Northern Trust to help launch a US fund, and we were able to turn it around in three months.” A number of factors have compelled custodians to continue to build out their suite of services in recent times. Settlement services, for example, are a particularly hot topic at present, says Bowman, due in large part to regulations that will increasingly force derivatives to transition from over-thecounter to exchange-based settlement. “Custodians need to participate in these ongoing changes within the settlement market, ensuring that proper straight-through processing exists in order to facilitate the efficient settlement of these securities,” says Bowman. As investors continue their focus on information disclosure and clarity, the increased transparency will only accelerate the move toward investment-operations outsourcing among asset managers. “Global investment managers with multiple custodians for assets in many different markets around the world need to be able to report on those assets in a more detailed and specific manner, in order to satisfy the needs of their institutional investors,” says Bowman. Accordingly, a globaloutsourcing platform allows managers to consolidate their books of record in a single place, says Bowman, where fund accounting, trade matching, reporting and other middleoffice functions can be performed more efficiently. “This reduces expense, improves oversight, increases scalability, and strengthens governance.” Bowman also sees insurance companies outsourcing their middle office to asset servicers, following the path that investment managers have taken over the last decade. “Whereas in the past these firms typically handled most accounting, investment management and middle-office work in-house, in an effort to reduce costs and liability they have begun to transfer those tasks to experts in the field, allowing them to focus on distribution and growth of their product, as well as their asset-liability model.”I

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THE EVOLUTION OF EMERGING MARKETS SUB-CUSTODY Today’s wisdom has it that emerging markets provide new opportunities for global custodians as advanced markets increasingly show signs of constrained opportunity; either because of regulation or competition. The influx of new participants in these markets has led to more competitive pricing and an increase in the range of services on offer to investors. The large global custodians nowadays excitedly chant the mantra of “act global, think local” as they steadily expand their business reach into advanced-emerging, emerging and frontier markets. It is putting pressure on the few indigenous single-market custodians left, which are finding it hard to meet the modern requirement for expensive investments in technology. David Craik highlights the main trends. S INVESTMENT FLOWS into emerging markets continue to gain traction, it was inevitable that global custodians would follow their clients overseas. According to Derek Duggan, director of global custody ratings and research group Thomas Murray, the move was inevitable in a post-Lehman climate. “European regulatory initiatives are forcing change,” holds Duggan. “Both the AIFM and the pending UCITS V directives require the global custodian to take responsibility for their sub-custodians. Banks and brokers are responding to pressure from asset owners that are demanding greater transparency of their global custodian regarding potential risk to their assets at market level. It is a very sensitive issue for the industry.” Duggan explains that some global custodians have in turn expanded their own self-clearing arrangements, reducing dependency on a network and keeping the risk on their own balance sheet. “The large banks and brokerage companies are setting in place continuous and active sub-custodian monitoring, including increased regular on-site operational reviews,” he adds. “Moreover, some are taking steps to share this information more effectively with their clients, providing them with a view through to the local market in order to provide a more transparent, real-time picture of how

FTSE GLOBAL MARKETS • MARCH 2011

Photograph © Sergey Sundikov / Dreamstime.com, supplied February 2011.

sub-custodian risk, infrastructure risk or other risk sources may impact their assets.” Ramy Bourgi, head of emerging markets at Société Générale Securities Services, which has gone into 14 new emerging territories since 2007, adds: “In the past, most global custodians concentrated on the outflow from emerging markets but as they matured they realised the value of the domestic assets of those clients. Now they realise that without having that domestic foothold their international business is at stake. This is why global custodians who always outsourced domestic custody have started their own domestic operations. At Société Générale we have always done local and international.” The Middle East typifies many of today’s trends. Historically, HSBC has been a dominant player in asset servicing in the Middle East; though its business was built supporting trade, rather than securities services. Over the past decade the bank has expanded both its global custody and local subcustody operations; it’s most recent expansion being into the Kuwaiti market where the bank now provides the full range of sub-custody and securities clearing services including settlement, safekeeping and corporate actions to institutional investors. The bank’s sub-custody and securities

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clearing business now operates in ten countries in the region. “It is essential to have strong teams on the ground in each country where we offer sub-custody services, and we transfer best practices to all of the branches in the network,” explains Colin Brooks, global head of sub-custody and clearing at HSBC Securities Services. There is a huge effort under way by exchanges and clearing operators in the Middle East to upgrade their systems to be ready for a big rise in trading volumes, he says. “During the last oil boom, there was a surge in trading, and the exchanges hadn’t kept pace with growing interest from overseas investors,” Brooks explains. The infrastructure is nowadays steadily being put in place to cope with the next surge in trading volume. The bank has also built a substantial business providing sub-custody services to other asset-servicing companies across the Middle East as until recently rival global custody houses tended to export servicing of Middle Eastern client assets to offshore centres outside the region. As competitors have begun to build critical mass in the region, they have opted to bring custody of client assets in-house, even though many houses (including Northern Trust, JP Morgan, Citi, and Deutsche Bank) still process securities in administrative hubs outside the region, usually in Asia.

Ramy Bourgi, head of emerging markets at Société Générale Securities Services. “In the past, most global custodians concentrated on the outflow from emerging markets but as they matured they realised the value of the domestic assets of those clients. Now they realise without having that domestic foothold their international business is at stake,” he says. Photograph kindly supplied by Société Générale, February 2011.

Limited competition Outside the United Arab Emirates (UAE) there is still very limited competition, though Saudi Arabia is growing in popularity. The largest market in the Gulf Cooperation Council (GCC), its population of 25m compares favourably to the overall population of only 3.5m in the entire UAE. The lack of scale in the domestic fund management industry and the fact that the majority of local investor activity is still retail based, has stymied investment in extensive local operations. Retail client assets by and large remain with local brokers which charge nothing for the service, a fact to which large custody houses have not yet found a consistent and profitable response. Even so, depending on their relative product strengths, firms such as Citi, Deutsche Bank, Standard Chartered, JP Morgan, Northern Trust and State Street offer a mixed bag of services, variously ranging from depository receipt issuance, asset servicing and latterly local sub-custody. Citi initially utilised HSBC as a sub-custodian though it now has its own presence as local custodian in Abu Dhabi, Dubai, Egypt, Qatar and Kuwait and recently signed an agreement with the Bahrain Stock Exchange to act as depository to local and international investors. JP Morgan’s presence in the Middle East covers five states: Bahrain, Egypt, Saudi Arabia, and Dubai and, more latterly, Abu Dhabi. Its custody and fund administration business has one of the largest teams of any western custody bank in the region. Its processing units, however, remain outside the region. Up to now, the relative newcomers have found business opportunities as their historic client requirements have become more complex and business is increasingly focused on risk management and transparency. There has also been a steady flow of outsourcing mandates, particularly from

fund managers new to the region, who have tended to work in lean local operations. Like HSBC, Standard Chartered has been in the Middle East for decades, but only launched its asset-servicing business in the region just over two years ago, using its network across the UAE, Bahrain, Qatar, Saudi Arabia, Jordan and Lebanon. The bank provides custody and asset-servicing solutions to international investors running pan-GCC funds, as well as to local players as the trend of using independent third-party administrators has begun to take hold. “Until two to three years ago we covered every market in Asia,” explains Giles Elliott, global head of securities services at Standard Chartered Bank. “We had a very big business covering local and international clients. Over the past year and a half we have expanded across the Middle East and Africa.” Like many other global providers, the company’s clients are not held or serviced locally. Elliott explains: “We have teams on the ground, but use central processing hubs in Chennai in India as it allows fluctuation in volumes—it means we can react quickly and grow in the region using the same model we employ elsewhere.” Africa, too, is high on the securities services agenda. Standard Chartered’s own expanded network includes the recent purchase of the Barclays custody business, which covered 16 markets in Africa and which Standard Chartered completed full integration of last December. “We had a broad capability across cash and FX and treasury services in emerging markets. Custody and sub-custody was a gap in our African capability which was making it hard for us to provide the depth of services to investor style clients. We wanted to complete the proposition,” Elliott explains. “These are fast-growing areas in terms of economic growth. They

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Giles Elliott, global head of securities services at Standard Chartered Bank. “We have teams on the ground, but use central processing hubs in Chennai in India as it allows fluctuation in volumes—it means we can react quickly and grow in the region using the same model we employ elsewhere,” he says. Photograph kindly supplied by Standard Chartered Bank, February 2011.

pretty much lead the world and part of that growth will be reflected through the capital markets. We are seeing strong incremental growth coming in from Europe and the US with underlying fund products and clients really wanting more exposure to these regions.” Elliot goes on to explain: “Africa’s capital markets may be very undeveloped at present but the future there looks bright. Both international and foreign governmental aid is looking to seek more investment flow from the portfolio funds sector. The facilitation of that investment from international investors is a very important part of Africa’s growth story.” Standard Bank is the largest sub-custodian in Africa, with assets under custody of more than $300bn. It introduced subcustody services in Mauritius in July 2008 in response to growing interest from foreign investors. The bank’s regional custody service provides clients with a single point of entry into the dozen or so markets that it covers, including South Africa, Nigeria, Kenya, Zambia, Ghana, Swaziland, Zimbabwe, Botswana, Namibia, Malawi, Mauritius and Uganda. Its range certainly appealed to BNY Mellon, which had, until recently, utilised Barclays in Botswana, Ghana, Kenya, Zambia and Zimbabwe and Standard Bank in Nigeria, Namibia, Swaziland and South Africa. BNY Mellon now uses Standard Bank for all its African sub-custody services. The trend is also set large in Asia, driven substantially, says Elliot, by the mix of increased wealth among domestic clients and the liberalisation of both local pension laws and local insurance markets. “There is now more access to pension fund and mutual fund products and excess liquidity, which in turn is leading to more demand for domestic custody capabilities from providers with a ‘window internationally’,” he notes.

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Elliott describes a “flight to quality” to major banks by emerging market asset gatherers. “In the last 12 to 24 months we haven’t seen the growth we expected to see in Asia of local fund providers growing new funds. There has been a bit of a reliance on many of the global fund managers who have the infrastructure, history and credibility to run many of the Asian funds,” he says. “They are coming to international houses to look after the fund management and the core administration rather than re-inventing the wheel.” In this regard, he holds, the creditworthiness and capitalisation of sub-custodians are becoming increasingly important. “In some parts of the world we saw some sub-custodians effectively go into default,” Elliott says. “The questions being asked included how well segregated your assets were and what would happen if an entity failed. The level of focus has gone up another bar. It’s how we safeguard assets and how we structure them with central depositories in a manner which makes the ownership even more transparent.” However, Bourgi says there are natural limitations. “If a market is not transparent, no single custodian can make it transparent. We can only influence the local regulators to adopt best practice but we cannot enforce it.” Even so, HSBC’s Brooks notes that while clients have become more cautious since the banking crisis, there is “more of a focus on subcustody” than there has ever been. We are investing very large sums of money into sub-custody to extend our product and geographical range where appropriate. Last year we entered Iraq, which was our 40th market,” he states. “Clients are looking much more closely at who it is they trust their assets to and are doing a lot more due diligence on the balance sheet of custody providers. They are also interested in using our influence in the local market and our contacts with regulators to try and eliminate as much as possible those risk areas.” Risk management is a key area in this regard and Brooks claims that HSBC has been “a net gainer from that”. BNP Paribas meanwhile has been extending its subcustody operations in Hong Kong, Singapore, and Morocco and in India for derivatives clearing. It is presently in the process of opening up in Brazil. Alan Cameron, head of client segment, broker-dealers and investment banks at BNP Paribas, says: “We have seen the globalisation of market practices with knowledge, skills and systems more easily transferred from market to market. That includes practices which were big in the developed markets such as clearing being taken up more in emerging markets. The banks which have experience in these areas have perhaps been able to get to grips with them more quickly.” Regulatory concerns following post-Lehman have added to the global banks pulling power. “Emerging market asset gatherers want to have their assets in a bank with a good credit rating. There is uncertainty over how far your regulatory responsibilities are going to be to secure your clients assets and they are looking to banks that they know and trust,” Cameron states. He agrees with Brooks that major banks “can’t just be on a par” with local providers in the products it offers as part of sub-custody. “We have to show we can do more. The services we have been providing in Europe around broker-

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Colin Brooks, global head of sub-custody and clearing at HSBC Securities Services. “During the last oil boom, there was a surge in trading, and the exchanges hadn’t kept pace with growing interest from overseas investors,” Brooks explains. Photograph kindly supplied by HSBC, February 2011.

dealer outsourcing, third-party clearing and derivatives capabilities can be offered in Asia as well,” he says. “In Morocco, for example, there is increased interest in the equity and fixed income side and there is a feeling that it is not particularly well supplied by local providers. In Brazil there are opportunities in derivatives.” Like HSBC, Deutsche Bank, JP Morgan and Standard Chartered, BNP Paribas understands that the overall approach is process driven and, in that context, acknowledges the crossover with transaction banking business. “It has had its issues but nothing like the investment or trading side the banks have seen. Transaction banking has been a steady source of revenue to the banks if they are willing to make the necessary investment. It has a healthy future,” avers Cameron. Inevitably, given the investments required in technology and client platforms, the game in these days of complex crosscurrents between securities trading, clearing, settlement and custody, it is apparent that the business is naturally gravitating to those firms with a global reach, capability to maintain segregated accounts and deep pockets. Inevitably there are casualties in this changing business world. “With the exception of just one or two markets for cross-border investors, the local providers are pretty much on their last legs. There has been a huge reduction in their numbers over the last ten years so this is not a new phenomenon. It is extremely expensive to maintain the infrastructure required offering custody services to cross-border clients and if you only have one market to support that investment it just won’t add up. You only have a hardcore left now and even they are finding things difficult,” says HSBC’s Brooks. “However, they do still have a role to play in servicing the domestic market as they very often have

extremely good contacts and close relationships with local corporations and institutions.” Cameron of BNP Paribas acknowledges that “sub-custody has become a very expensive game to be in”. He adds: “You need huge investment in systems and the banks which have spread that across many centres have squeezed out the banks that used to have one or two centres. The local banks had an advantage when you needed a lot of people on the ground but now it has become more systems driven it is the big global players competing against each other.” Elliott, in contrast, is more sanguine, citing local banks’ ability to go out and “buy a moderately good off-the-shelf custody system”, though that might be straining the case somewhat. He nonetheless highlights the partnerships seen in China between domestic local banks and western global custodians. “I think this kind of structure will continue to keep local providers credible and surviving,” he states. Bourgi meantime states that local providers can still compete in vanilla custody products, but for more complex fund administration products clients will turn to international players. He adds, however, that in some parts of the world local providers are of such quality and strength that global banks have little added value to offer domestic clients. Will more global banks want to get involved in subcustody? Brooks suggests not. “In Europe, the sub-custodian business is under threat from TARGET2-Securities, which could encourage European custodians to look elsewhere for income opportunities. Yet the high costs of entry will be a barrier. It can also be very difficult to build up critical mass in a market.” According to Bourgi, much more is at stake, not least pride. “The move into domestic custody is not motivated by the returns of that market. You are there to make sure that you grow with the domestic assets internationally. It’s a no-brainer if you want to develop the one-stop-shop service that global custodians pride themselves on doing. But I don’t want to be in every market in the world. It depends on the size of the market and the wishes of my clients. I follow them.” Inevitably then, for single sub-custodian operations in the emerging markets, the past two years have been fundamentally challenging. The drive to create greater efficiencies throughout the securities life cycle and shifts in client behaviour have resulted in a flight to quality. Investment firms and beneficial owners are often concerned about smaller, one-country or smaller regional providers versus large global banks that have reaffirmed their commitment to process-driven, transactional banking business. Equally, in these post-recession times, even clients in emerging markets are as focused on operational efficiencies as they are new investment opportunities. As more businesses outsource their local back and middle office operations, there is a natural gravity pulling them towards global rather than singularly local providers: it makes particular sense if those same firms have outsourced these operations in advanced markets as well. In that light, organisations that have invested in technology and client platforms will continue to benefit from this change. I

MARCH 2011 • FTSE GLOBAL MARKETS

ASIAN INVESTING & ASSET SERVICING ROUNDTABLE

LEVERAGING ASIAN FRAGMENTATION

Attendees

Supported by:

(From left to right) LESTER GRAY, chief executive officer, Asia-Pacific, Schroder Asset Management ELIZABETH CHIA, head of client development in Asia, BNP Paribas COLIN LUNN, head of business development, Asia-Pacific Fund Services, HSBC Securities Services VENETIA LAU, partner, Financial Services Group, Ernst & Young MICHAEL CHAN, head of business development, Asia-Pacific, BNY Mellon Asset Servicing WONG KOK HOI, chairman and chief investment officer, APS Asset Management

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH 2011

ROUNDTABLE

ALL THE WORLD’S A STAGE AND ASIA IS THE HEADLINE ACT COLIN LUNN, HEAD OF BUSINESS DEVELOPMENT, ASIA-PACIFIC FUND SERVICES, HSBC SECURITIES SERVICES: There’s a lot going on right now, in the main driven by two themes: regulation and China. The AIFMD in Europe will probably lead to some countries in Asia—in particularly Hong Kong, Singapore and Australia—being the recipients of managers re-domiciling themselves as they increasingly focus on non-EU-based investors. As China continues to liberalise the RMB regime, Hong Kong has benefited and has become the major offshore centre for RMB trade, debt issuance and now RMB funds. There is also the continued development and growth of the passive investment market in Asia, with demand for different ETF strategies continually rising. These themes alone are keeping us very busy. VENETIA LAU, PARTNER, FINANCIAL SERVICES GROUP, ERNST & YOUNG: We work with local and foreign asset management companies at the set-up stage. For example, we help them on structuring, and ensure they are cognisant of potential tax or regulatory issues that would affect them, and the requirements of various national financial reporting standards. Regulations, such as the DoddFrank Act and EU directives, are also a key focus: we want to know how they might affect our clients and ourselves. For instance, if they plan to be registered with the SEC, there are many restrictions to take into account on our side alone, to ensure we do not impair our independence. Local regulations are also important. Proposed changes to the regulatory regime for fund management companies in Singapore for instance, will affect the existing exempt fund managers in Singapore. Last year the Monetary Authority of Singapore (MAS) issued a consultation paper on it. Based on the proposed fund management companies’ regime, some fund managers may need to be licensed under the Licensed Accredited/Institutional Fund Management Companies section. Firms should start thinking now about what they need to do to meet the new requirements. MICHAEL CHAN, HEAD OF BUSINESS DEVELOPMENT, ASIA-PACIFIC, BNY MELLON ASSET SERVICING: Our clientele consists primarily of institutions, including sovereign wealth funds, central banks, national pension funds and, of course, asset managers. In addition to helping our clients with impending regulations, often our job these days is helping global clients with the “hot money”(resulting from Quantitative Easing II) coming into the Asia region, mostly from the US. In the opposite direction, there is a rush—again—to get Qualified Domestic Intuitional Investor (QDII) quotas as there is an excess of liquidity in China that is seeking to invest outside of the region. Moreover, many Asian central banks are asking us to speed up the opening of accounts to enable them to invest into countries such as Russia and Brazil. China and India are already part of their local equation. Our firm is positioned in the middle, keeping us busy on both sides, seeing money coming into Asia and helping Asian money going back out

to many emerging markets. On the funds side, we are also working hard on the Asian passport process. Important questions right now centre round whether the industry wants to build separate customised solutions in each of the countries to service investment managers or push ahead with industry participants such as PwC and Ernst & Young etc, to look at building one Asian passport structure to service the region. All this will be in the interest of the retail public. It’s going to reduce cost and increase the distribution and the recognition of funds in the local markets. WONG KOK HOI, CHAIRMAN AND CHIEF INVESTMENT OFFICER, APS ASSET MANAGEMENT: Literally from the moment I wake up and brush my teeth I am thinking about the investment implications of the information I have heard the previous day and sometimes reflect on my recent investment decisions. Are there any new ideas I can generate from all the current information that I have gathered in the previous week? Secondly, I spend a lot of time on company research work. Needless to say, investment issues take up a large amount of my time. ELIZABETH CHIA, HEAD OF CLIENT DEVELOPMENT IN ASIA, BNP PARIBAS: We are concentrating on solutions for asset owners, asset managers and alternatives. We are kept busy looking at trends in the markets affecting our clients’ space. We see asset owners changing their risk appetite, whereas asset managers are seeking to harmonise their regional operations and data centralisation to meet stricter compliance and risk governance requirements. Services providers are challenged to deploy a global operating platform with flexible localised solutions. They have to manage complexity and fragmentation, requiring them to be on the ground, close enough to markets to rapidly adapt to complex changes and deliver customised and flexible services. A pure-local player, on the other hand, will find it increasingly difficult to compete. Nor will a pure global one find its one-size-fits-all solutions getting much traction. Here the experience of Europe, surely the most fragmented region of all, will prove to be invaluable. As a leading European asset service provider, we are taking the opportunity to leverage our experiences, working closely with our clients to transform their complexity into growth. Regional asset managers are looking for expertise to help them create UCITS funds structure to expand fund distribution capability to new investors in Europe and Asia. How do we help them achieve their aspirations? Certainly, we are well positioned to bridge East and West by leveraging on our European presence and expertise. LESTER GRAY, CHIEF EXECUTIVE OFFICER, ASIAPACIFIC, SCHRODER ASSET MANAGEMENT: We spend a lot of our time working with clients to understand and meet their rapidly changing investment requirements in a very difficult financial environment. We see changes in investor risk appetite and client demands in both institutional and retail. We spend a lot of time trying to understand what we need to do from a product perspective to position ourselves for those changing needs. Echoing a couple of comments in terms of the need to deal with changing regulatory demands, we have

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businesses in eight countries across the Asia-Pacific region and the regulatory environment is changing quite rapidly in most of them. We are trying to stay on top of these changes. However, positioning the business for these changes demands a great deal of attention.

BUCKLING DOWN: REGULATION, REGULATION, REGULATION ELIZABETH CHIA: Right now, regulation is undergoing extensive change worldwide, and stricter and more onerous reporting and restrictive controls are imminent. Regulators are imposing stringent management oversight, rigorous risk analytics and stress-testing methodology. Even investors are demanding detailed portfolio analysis and greater reporting transparency. Consequently, our clients are struggling with the many revised regulations emanating from various jurisdictions. Enhancing systems to deliver the requisite changes is proving to be costly and time consuming for our clients. Increasingly we work with clients to identify key changes, their impact on processes, control, compliance and reporting, and support them with minimum disruption to their operations. As well, we have had to upgrade our own processes to seamlessly blend our services to support our clients’ changing needs and it’s not always easy. On the custody front, there are and will be more capital requirements and we, in turn, will have to meet these new challenges as it will invariably affect the way we settle and do business with our clients. LESTER GRAY: Many of the regulatory changes that we’re seeing are, in some cases, overdue. Arguably, there was too little regulation in some parts of the industry prior to 2008 and there’s been an inevitable swing of the regulatory pendulum, perhaps too far the other way, which as an industry we’re now dealing with. However, I do not think most of us would quarrel with the general direction of change. What does that mean for us in terms of our business here in Asia? There have been a number of new regulations imposed on both distributors and fund managers, in terms of the sales of funds to retail investors. While some of these are likely to be beneficial in the long term, in the short term they’re undoubtedly causing pain as distributors struggle to change their business models to operate within the new regulatory constraints. WONG KOK HOI: My views are not very different from Lester’s. Investment regulation is like frying anchovies: once they were under-fried, now definitely they are over-fried.You need to fry anchovies delicately to ensure they are tasty: too much one way or another and the taste is lost. Similarly, regulators have to achieve a delicate balance between over-regulating and under-regulating as, obviously, more regulation means more cost for fund managers, for distributors, service providers and everybody in the industry. LESTER GRAY: We also need to seek consistency of regulatory approach across markets. WONG KOK HOI: Consistency definitely. Larger firms with a strong infrastructure will be able to cope; however, some smaller firms—those three or five-man shops—will

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Michael Chan, head of business development, Asia Pacific, BNY Mellon Asset Servicing.

struggle. The majority of the smaller firms will find it hard to cope because the increased costs of compliance, risk controls, regulatory reporting and so forth, could result in a cost increase of as much as 30%. In an over-regulated environment you kill the entrepreneurial spirit and that is something you would not want to do in our business. In that respect we are more fortunate than most because we have already built the infrastructure to cope with these demands; but the newer, smaller emerging firms will struggle to meet the demands of more robust regulation. That’s why I think it is important to get the balance right: Not too much heat, not too little heat. VENETIA LAU: In terms of the changes on the new selling approaches and guidelines for this, whether it is through distributors or through banks, how are these affecting your business in terms of the sales of new product? WONG KOK HOI: For the more established firms such as Schroders and to some extent APS, they have no problem because we have the staff, systems and experience. However, for a new start-up just trying to grow, working with the banks and insurance companies, in the new regulatory regime, can be a challenge. Many of these new firms have one chief investment officer, two or three analysts and a chief financial officer: that’s it. I cannot see how they can cope with the new requirements. LESTER GRAY: I agree. Many of the changes are not that difficult for a firm like ours to deal with. What we have noted, however, is a number of banks slowing down the sale of funds very significantly. Inevitably, this has had an impact at the industry level in terms of fund flows. Moreover, in terms of the use of derivatives in products, suddenly any use of derivatives in mutual funds targeted at retail investors is considered negatively. This is an example of the pendulum swinging too far. The use of derivatives for efficient portfolio management or for actually hedging risk within in a portfolio is now being considered by some in the same way as the use of derivatives to magnify risk in portfolios. That is definitely an issue right now and approval of new product has slowed down significantly. The desire for distributors to approve new product for their platform has also reduced significantly. That works to the benefit of well-established players in the industry, as Kok Hoi just said. For new entrants that’s going to make life potentially much more difficult. VENETIA LAU: I agree with Kok Hoi and Lester about the increasing costs resulting from new regulations, though the underlying intent of that regulation is actually good. It provides the investors with more transparency as well as more comfort in terms of the quality of the fund manager that they are investing in. We have a diverse set of clients, some start-ups and then some rather large asset gatherers, and we

ROUNDTABLE

have widely differing comments on the impact of regulation from each of them. For the larger firms it is simply an additional operational process or two that has to be absorbed into the mix. For smaller firms the issue becomes one of overall performance and the increased costs involved in hiring new people to help them comply with these regulations. For instance, do I have a COO who doubles up as a CCO, who may not have the necessary experience, or do I hire an independent CCO, who has the relevant experience but will actually add on additional cost. Equally, an important question is whether the industry as a whole has enough supply of these specialist people to work on these issues right now. I personally don’t think so. With all this in mind, fund managers here in Asia may potentially face challenges these days. MICHAEL CHAN: I am going to play devil’s advocate here and say that I’m of the view that there could never be too much regulation. You don’t want to get to the point where there’s too little and the guy in the street is losing money. There could be some significant cost involved in the beginning, but as long as the regulators are doing things in the interest of the investors, I think that’s fine. However, if they do it in the interests of preventing competition from coming into their national boundaries then that is a problem. In the past we have seen some of the countries in Asia building up barriers to entry through regulations to limit funds distribution cross borders. More recently, many of those countries are asking us: “So, tell us more about UCITS? How can we do more of that? What are the countries next to us doing in this area?” We share with them the trend of UCITS funds that are domiciled in Luxemburg or Ireland and have been distributing into the region. We’ve also been asked questions such as: “What happens if Ireland goes under financially? What does that mean for all the unit holders who are investing overseas through those offshore funds?” The point is, these days more countries in the region are a little more open to bringing their regulations into harmony with the rest of the funds industry— again in the interest of protecting the public. How do we deal with that? Well, with all the additional regulations, as already noted by Elizabeth, clients are asking for more timely information. That means there is a lot more customised reporting these days. However, ultimately I see that being reduced as more countries harmonise their regulations.

HARMONISED FUND REGIMES: IS IT POSSIBLE? COLIN LUNN: The most dominant domicile in Asia is Luxembourg through the extensive distribution of UCITS in the region, particularly in the main centres of Hong Kong, Singapore, Taiwan and Korea. If a non-Asian country can have such an influence, why can’t Asia create its own passporting regime? You are effectively importing European legislation and regulation into Asia, whilst dealing with your own. Is that good for Asia long term? We all talk about the demographics, the growth of Asia and the increased savings in the region. Shouldn’t Asia now start looking at how it can create its own passport? Look at Greater China, which encompasses

Wong Kok Hoi, chairman and chief investment officer, APS Asset Management.

Hong Kong and Taiwan and how that potentially sets up a passport regime.You’ve got the South East Asia markets which generally are a lot closer to each other in terms of regulation, for example Thailand and Vietnam, so why not there? Harmonisation is now imperative across all these themes. WONG KOK HOI: It seems to me that you see there’s a need for this Asian passport regime. Do you see it happening within the next ten years? COLIN LUNN: I didn’t say need necessarily, but it could happen in ten years. You’ll probably see it driven more regionally from a Greater China aspect with China, Hong Kong and Taiwan to begin with. I would argue that groundwork has already started here with various MOUs already in place as well as cross-listing of ETFs. LESTER GRAY: I’m slightly doubtful because the competition for regional financial centre dominance is still in play and therefore there are a number of financial centres competing to be the regional fund’s hub. Harmonisation is likely to benefit one location significantly more than others in that respect and I don’t think people are ready to fold their hands yet. UCITS happened because there is the European Union. We are, in my personal view, decades away from, if ever, an Asian Union. I can understand from a service provider’s perspective why having the equivalent of UCITS in Asia is very appealing. From an Australian fund management perspective it’s incredibly appealing, giving them the ability to compete in all Asian markets, but for a Singaporebased asset manager or a Korean-based asset manager, is an industry-wide passport a good or a bad thing? I would argue for a small domestic fund manager in an individual market it’s a bad thing, because suddenly they’re open to global competition. So there are many challenges though it is quite understandable why a number of people are pushing for the equivalent of an Asian UCITS regime. ELIZABETH CHIA: I see a number of asset managers here looking at UCITS or creating funds under the UCITS structure. Why? It is because they need a regulatory environment to be acceptable in Asia for distribution across Asia. Although, one of the purposes for setting up UCITS funds is for local and regional managers to tap into European monies, their immediate objective is to distribute their funds within Asia to tap into the rapid economic growth in the region. However, a fund established, say, under the Singapore regime is not acceptable for distribution in Hong Kong or another Asian country. Indeed, this is an area where Asian regulators could jointly address in their own interests; otherwise more and more funds will be created out of Europe and then distributed here in Asia. If there is, as Colin says, an intention to introduce harmonisation it will certainly be good for Asia. Over the last three years, 40% of all net

MARCH 2011 • FTSE GLOBAL MARKETS

Venetia Lau, partner, Financial Services Group, Ernst & Young.

sales into UCITS funds have come from Asia. However, for Asia to be more vibrant; we should definitely explore the opportunities available through harmonisation. WONG KOK HOI: So you’re saying that despite the conflicting national or local interests you think that the Asian passport is more preferred than a UCITS passport? ELIZABETH CHIA: UCITS structures are not always familiar to regional fund managers, they are also more costly to establish and administer. An Asian fund manager will, therefore, be more at home with an Asian passport... LESTER GRAY: Why doesn’t Asia just adopt UCITS, period? UCITS is clearly set up to protect investors in the same way that all domestic regulators in Asia are seeking to do. So one could argue simplistically, let’s replace local fund regulations with UCITS. WONG KOK HOI: But then our Asian service providers would not benefit very much from it. LESTER GRAY: As I said earlier, there are a number of countries that are still pursuing the objective of being the dominant regional hub which would benefit the providers within that location, hence the reason I am less optimistic of this happening. WONG KOK HOI: The issue is whether in ten years’ time all the different regulators will look for a compromise. Regulators might take a pragmatic stance: yes, you lose some; you gain some. Let us reconcile our differences and adopt an Asian UCITS. MICHAEL CHAN: UCITS started in Europe in 1985, about 25 years ago. Now we’re sitting around in Asia and the question is: do you think it’s going to happen in the next decade? The point is, Asia will adapt in good time. Some even argue it’s happening right now. Why do I say that? One, we know the Australian regulator has been pushing it, because they understand that if they don’t really hitch on to the rest of Asia, they’re going to lose out. Elsewhere, some of our major global asset management clients are relaunching funds, domiciling in Hong Kong and Singapore. Perhaps they expect that one day these jurisdictions may become the next Luxemburg or Ireland. I remember these guys pulled funds out of the region six or seven years ago after tax benefits were pulled back, contributing to higher expense ratios. They are back despite a lack of harmonisation. I agree with Lester that they will likely gravitate towards a UCITS model because most of these countries have already accepted the model as these funds are already distributed there. The Asian passport model will likely spread out of Hong Kong and Singapore into places such as China, India, Taiwan and Korea. However, it is unlikely Europeans and Americans are going to be putting all their money in Asian domiciled funds and I think that European offshore funds will continue to survive.

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VENETIA LAU: If you have to set up those country-based funds it is going to be very costly. However, if you set up a UCITS fund structure it is a bit more expensive than if, say, you set up in Singapore. Even so, you get a one-time cost and it’s passport-able within the whole of Asia. So it’s the cost benefit that counts.

IMPACT OF CHANGES IN THE ASIAN CAPITAL MARKETS FRANCESCA CARNEVALE: The Asian capital markets remain highly speculative and the appeal of individual IPOs is very varied.You have periods of intense IPO activity, which seems to first exhaust the market and then gradually you see a return of activity. While regulation has its dampening effects, particularly on innovation, do you think that it will also help “normalise” or stabilise the capital markets and create a more supportive environment for the evolution of a deeper asset management industry emerging in Asia? LESTER GRAY: Absolutely. Moreover, much of it is going to be good for the industry, long term. No one is well served by investors rushing in to the thematic fund of the moment and then rushing back out of it, several months later. Interestingly, if you have a look at fund flows, over the last 18 months, the vast majority of money has gone into funds that have been established for quite some time, and that have good longer-term track records. The amount of money that’s gone into new fund launches, which used to be the mainstay of markets in Asia pre-2008, is very low by comparison. So the industry has changed significantly. The question is, will this continue? Is it the start of a long-term change in investor behaviour, or is it a cyclical reaction to the events of 2008? We’ve yet to see the answer to that. MICHAEL CHAN: My view is it is very cyclical in Asia. I’ve been in the region ten years and seen it about three times. In the case of going back to the basics, as Lester was saying, many folks are going back to established funds. At the retail level, most don’t know what exactly caused the whole US housing bubble. When the market is good, many people in Hong Kong will wait in line even during typhoon number three with an umbrella and a plastic chair for a 400+ pages IPO in the hope of flipping it for a quick 10%. Even though they may only get a couple of 1,000 shares and HKD2/HKD3 from each. When the market turns, inevitably, people return to cash once more and established funds. To encourage people to think longer-term is a challenge and goes back to the need for longer term pension savings. One way is for regulations which encourage the average saver on the street to save more by offering greater tax breaks. At this point there’s not much interest for retail investors in Hong Kong and Singapore to put more money into their personal pension plans, whether it’s MPF or CPF, because there just isn’t that much of a tax break. In Europe and the US it is very different. COLIN LUNN:You are absolutely right. I’ve been in Asia for almost 18 years now and Australia is the one market that stands out in this regard. It involves some 22m people and an $800bn superannuation industry and all its related

ROUNDTABLE

elements. However, Hong Kong is a low-tax environment and so is Singapore, so it is arguable that perhaps mandatory savings are not at the top of everybody’s agenda. LESTER GRAY: In an environment where you don’t have capital gains tax, e.g. Hong Kong, Singapore, tax advantaged, long-term savings structures are not as compelling. So that leaves compulsion: compulsion without tax advantage is not popular. In countries with high-tax regimes, the compulsion is sweetened by tax advantage. That’s a challenge for Asia. Hence many Asian investors see fund investing as taking a short-term market view as opposed to long-term savings. WONG KOK HOI: I wonder whether the solution to our problems is more investor education or more regulation of fund managers.

CHINA AND THE RISE OF THE RENMINBI FRANCESCA CARNEVALE: How do you think that the accelerated emergence of China over the last 18 months and the rise of the CNH and CNT markets will impact on investing, both long term and short term please? COLIN LUNN: The house view is that the renminbi will fully be convertible by 2020. That’s within the next ten years and therefore not all that far away! Will it become a third reserve currency perhaps? Surely convertibility has to lead to something of that order. Hong Kong has been used as a testing ground for the renminbi since 2003 when every Hong Kong resident was allowed to convert up to RMB20,000 equivalent per day. Now that a sizeable deposit base has developed, we are beginning to see the development of an offshore bond market and now managers are creating products to tap into the demand for this. This will only continue as people bet on the continuing strengthening of the renminbi. MICHAEL CHAN: While living in Hong Kong, in around 2005/2006, I still remember I used to go over the Shenzhen border and the Hong Kong dollar was worth more than the RMB. This is only five years ago… COLIN LUNN:Now they won’t accept Hong Kong dollars. MICHAEL CHAN: Exactly! Only five years later, you go across that same border which is only half an hour away, and they won’t accept it and in Hong Kong, shops are going to give you an extra 10%-plus premium for RMB. COLIN LUNN: The renminbi has appreciated over 25% in the last couple of years whereas the Hong Kong dollar has remained firmly pegged. MICHAEL CHAN: It is also about the level of China’s foreign reserves. It could hit $3trn in a few months time. It’s not good for any country to hang on to all of that. They may have also got to let the RMB rise a bit to help the rest of the world. What are they holding? Most of their assets are in overseas investments. WONG KOK HOI: Over the next ten years the liberalisation of the RMB, if it happens, will be the single largest most important event and it will have enormous implications for financial markets, not just in Asia, but probably in the

world. It will cause at least two huge ripples. One obviously is that the yuan becomes a major international currency. Today, if you want to diversify from dollars, where can you turn to? The yen? The euro? They are sometimes poor cousins.You buy yen not because you have confidence in the economic fundamentals of Japan but simply because you want to exit the dollar. The other huge ripple will be that Chinese investors can invest freely overseas. The Chinese government right now has got $2.8trn in foreign reserves and the Chinese population a further $4trn of savings. The sums are increasing every day. VENETIA LAU: We already see a deep level of interest in the renminbi, because there’s still a cap and controls. You can’t go in to China free. The only way you can get into any exposure is through corporate debt and when a bond is launched everyone just scrambles for it. This trend will continue until the controls are actually lifted. LESTER GRAY: I don’t disagree that China is on the path to eventually floating its currency, but given the global impact of such a change and, as Kok Hoi has said, what this will mean for international monetary flows, it is no surprise the Chinese are incredibly cautious about going down this path. China is 30 years into a transformation programme that has decades to run and the scale of the challenge that they face is huge. They’ve made fantastic progress, but there’s so much more to do. It is right to be excited about the opportunity, but it’s also right to be circumspect given the scale of challenge. If the gates are suddenly thrown open and all this international money rushes into China, it is likely to be a disaster. The Chinese authorities are more than aware of this and will do everything in their power to manage it to the betterment of China, as they should do COLIN LUNN: The specific challenge is that the internationalisation of the RMB is moving at a faster pace than people expected. It starts off in a relatively small way and then suddenly it’s not just Hong Kong, but it is Taiwan and then maybe it’s Singapore, maybe it’s New York. Suddenly you’re internationally trading renminbi before you know it. WONG KOK HOI: But I think Colin and I are on the same page as Lester. It’s going to be a gradual process. It is not going to happen overnight because of the huge challenges that need to be addressed. FRANCESCA CARNEVALE: Are securities services providers in the region preparing for these inevitable changes? MICHAEL CHAN: Sure. We have the entire infrastructure in place in Asia when it’s needed. Now as for the likes of the new RMB requirements and whether we’re ready to handle that, we service providers are at the end of the food chain, so to speak, and so we’ve been preparing for that the last several years. With our network of partners in the custody space, we are able to work with the RMB or any other currencies, to help flows around the world. Also, BNY Mellon was the first global custodian to support the first China QDII fund; $2bn-$3bn equivalent coming out of China. So I do not think it is a problem for those institutions like us with the scale. Lastly, we can send data feeds whether it’s to the buy side investment manager or to the ultimate asset owner. The data that comes

MARCH 2011 • FTSE GLOBAL MARKETS

Elizabeth Chia, head of client development in Asia, BNP Paribas.

into the global custodian infrastructure belongs to the client. To help investment managers’ middle office or the asset owner who wants all that data coming from several sources because they’ve been spreading concentration risk by using several service providers. Now that’s where our technology comes in. We are able to build pipes to have data feed into their record systems directly on an intraday or daily basis. Yes, it is more complex but the key theme is that we’re able to service both the asset owners and the investment managers. LESTER GRAY: I would agree. Our operating platform has been designed so that we have a consistent view of data across our operations around the world. Here in Asia, we have domestic fund platforms in seven countries, most supported by a common operating platform in terms of our own data which then plugs into various service providers across the region. That’s how we try and deal with local requirements at one level, but consistency at another level. WONG KOK HOI: Asia is not a homogeneous region. Asians speak different languages, embody different cultures, have different political systems, have different corporate governance, etc. I would argue that there are more differences than similarities and hence there will always be challenges, but I am optimistic that we can work together. COLIN LUNN: Standard processes and the presentation of data are vital to our business. We provide fund administration services across 11 markets in Asia and they are all different; and it is not just a language difference. On the one hand, we try to provide consistent service delivery across all the markets to our clients. On top of that we need to develop bespoke solutions in each market to satisfy local regulatory reporting standards. You cannot avoid this but this is where we can leverage our local presence and infrastructure to the benefit of our client base. VENETIA LAU: As auditors, we’re probably among those who will ask for data for our audits and also for financial reporting, especially, now that the accounting standards are requiring more disclosures to be made in the financial statements. One of the challenges we face is“who is responsible for providing these data?”Is it the fund administrators or the fund managers? Hence, it is actually helpful, if the service provider has a very good platform where they can capture all the data in one place. ELIZABETH CHIA: We, too, also have clients who ask us to integrate and consolidate all their data into one central database for ease of compliance monitoring and centralised management controls. Our clients are saying:“I want a global operating model, but yet locally supported.” Thus, creating and administering a central database to support three regions, Asia, Europe and the US, was key for us. Within Asia itself we all agree it’s a very fragmented region. Our value-add

FTSE GLOBAL MARKETS • MARCH 2011

Colin Lunn, head of business development, Asia-Pacific Fund Services,HSBC Securities Services.

is to harmonise our clients globally and yet support their local operating unit based in each country. In doing so, we act towards minimising the effects of fragmentation faced by our clients. We deploy a model where we match trades centrally utilising a “follow the sun concept” to ensure that all trades continue to be matched globally around the clock; centralise securities and cash position keeping; and refresh position back to clients’ front office system daily. However, fund administration is performed according to local specifics respecting local accounting policies and practices. Thailand, for instance, has very specific accounting rules, treatment of the way they settle, treatment of interest accruals are all driven by local practices. They challenge providers such as us to support bespoke local solutions using international systems. Much has to be customised and major developments have to be done, so the next challenge is cost: will the fees be sufficient to pay for the cost? FRANCESCA CARNEVALE: Because that’s much more expensive. Do you feel that it’s reasonable to ask investors to pay the real cost of that high-touch service? COLIN LUNN: It depends on the organisation’s history and infrastructure. We’ve established and built up our local operations over many years. Now if you were an international asset manager coming into Asia today you need to ask yourself; do I set up those domestic platforms in eight countries, the cost of doing which would be prohibitive? Or do I outsource as much as possible and leverage the existing service provider infrastructures? Today, most if not all new entrants do outsource so there are many opportunities. Also, at the end of the day, outsourcing non-core competencies are to the benefit of the fund so it would be logical to be charged there. ELIZABETH CHIA:You are right, but this also applies to our clients and we see new entrants having to ask for outsourcing so that they can concentrate on their core competences. So there are always opportunities when changes occur. MICHAEL CHAN: Especially over the last couple of years we’ve seen firms focusing on cutting costs. Plus we’ve seen in the last half of the decade, many of the bigger fund houses, both global and local names, centralising functions whether to India or whether to Poland and so forth; lessening the load for their offices in New York, London and Japan. We used to have separate teams to deal with these front office locations but now, what they want is for us only to support their offshore centres in those time zones, such as India. So, in a way, it helps us manage our costs; as we don’t have to do things three times as we used to. We are, however, also seeing additional demand for customisation as investment strategies become more complex, particularly among the sovereign wealth funds. That is, they want reports in a specific format or similar to the other service providers they are using. These clients often put

ROUNDTABLE

providers in a room and have us work together to create reports presented in a particular way. So for some of our clients, we ask:“How high do you want us to jump?”

ASIA: A CONTINUING OR CYCLICAL OPPORTUNITY? LESTER GRAY: Everyone is looking toward the emerging economies in this part of the world, especially China and India, given their populations and stage of economic development as major drivers of growth. They are destined to have a rapidly growing middle class that will increasingly have the means to invest in the products offered by asset manager. However, I’ve been a bit of a heretic the last couple of years in terms of saying the biggest opportunity in the region in terms of growing revenues is in the developed markets of Australia and Japan, because in terms of addressable assets under management they are significantly larger than in China or India. They are also much easier to compete in and the ability to actually raise money in those markets is significantly greater than India or China. While in the near term, there are still real opportunities in the developed markets of Asia, in the medium to long term, there are potentially fantastic opportunities in China, India and Indonesia for example. Hence this is a region where you have good nearterm opportunities as well as great longer-term opportunities, due to the different stages of economic development. That is what makes it such an interesting region to do business in. However, for those international houses looking into Asia thinking they can get lots of easy business, I would urge caution. This is a strongly competitive market as I’m sure Kok Hoi will attest to. There is lots of opportunity, but there is also lots of competition for those opportunities. VENETIA LAU: That is a good point. Because of the change in regulations and the competitive market environment, it is not as easy to set up business and just move here that many institutions think it is. We do see firms doing market studies; but few actually stay the course. The reasons are many: there are a lot of other similar firms here already, set-up costs are no longer cheap and they quickly realise when they come over and talk to people in the industry that the environment is much more challenging than they expected. MICHAEL CHAN: Europe is growing almost twice as fast as the Americas and they expect Asia to grow twice as fast as Europe. There’s about $3trn of investable assets that’s out there now from Asia accounting for roughly 15% globally. Asia has about 60% of the world’s population. In the US, with only 7% of the world’s population, they account for over 50% of the funds under management. I mean, do the math! Add that to the 30% growth rate of the sandwich class in Asia, which we talked about earlier, are the main segment that are going to be investing for their pensions. That’s what everybody is going after. ELIZABETH CHIA: I look at Asia as a great opportunity for fund administration and asset management, with obvious knock-on benefits for the custody role. I can see, too, that in Asia the use of the passport is definitely very important at

Lester Gray, chief executive officer, Asia Pacific, Schroder Asset Management

this moment, and will impact on how the market grows and evolves. I also see that new fund house entrants coming into the market are looking at outsourcing for better cost management and faster time to market. It is actually very interesting to track all these needs and help them transform their complexity into growth. WONG KOK HOI: APS is an Asia-based Asian equity specialist firm and therefore you might think that I will disagree with what Lester has said, but I do not. I agree that the biggest pools of investible funds, are still in the developed economies like the US and Europe as well as Japan. For instance, we don’t raise assets in India or China because there are limited opportunities for us to do so. In fact, 70% of our assets are sourced in the developed countries, although we are an Asian company. I would also add that the Asian market is presenting itself as a new major opportunity for asset managers. However, it is still not the single largest opportunity for either Asian or western asset management companies, but this will of course change over time. But to raise money there isn’t easy at all. Inevitably, there is ferocious competition to contend with. You need to have a rigorous investment process because that is what European and American investors demand.You need to have a quality with lots of experience. You also have to have to have risk controls, compliance and back office systems that are set up correctly. COLIN LUNN: You are right Kok Hoi, pools of assets are obviously in the main developed markets and investable assets in the emerging markets. Because of that you now see the big local managers expanding out of their home markets into the wider Asian region tapping those asset pools as well, saying that we can manage the assets within Asia. So Lester’s probably seeing increased competition from those groups, not just in their individual home markets, but also on a regional basis. That means more opportunities for us and other providers. Throw in China’s continuing ascendancy in the world, Asia is a great place to be, at least for the rest of my life anyway. FRANCESCA CARNEVALE: Do you see that individual countries are making efforts to encourage the growth of a local asset management industry, activity promoting... MICHAEL CHAN: Everybody wants a piece of the pie. I cannot think of any country which doesn’t aspire to cultivate a stronger financial services sector. LESTER GRAY: I am sure that we will see more Asian firms come out of their home countries and compete regionally and internationally. Why shouldn’t they? For the unit holders, the investors, competition is a good thing. ELIZABETH CHIA: And it’s right for your business model and ours. I

MARCH 2011 • FTSE GLOBAL MARKETS

(Week ending 11 February 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Federative Republic of Brazil

Government

Sov

15,407,170,686

160,758,396,710

11,426

Americas

Bank of America Corporation

Financials

Corp

6,029,762,025

83,789,131,018

9,181

Americas

United Mexican States

Government

Sov

7,966,267,908

115,144,342,489

9,133

Americas

JP Morgan Chase & Co.

Financials

Corp

5,041,025,695

82,458,039,945

8,769

Americas

Republic of Turkey

Government

Sov

6,978,332,879

144,615,594,788

8,758

Europe

Republic of Italy

Government

Sov

26,403,977,303

289,512,635,988

8,668

Europe

General Electric Capital Corporation

Financials

Corp

12,068,031,281

98,290,892,732

7,791

Americas

MBIA Insurance Corporation

Financials

Corp

5,466,092,707

76,676,102,218

7,516

Americas

Telecommunications

Corp

2,549,785,692

68,117,894,306

7,305

Europe

Government

Sov

3,034,990,889

62,972,950,159

7,267

Asia Ex-Japan

DC Region

Telecom Italia Spa Republic of The Philippines

Top 10 net notional amounts (Week ending 11 February 2011) Reference Entity

Sector

Market Type

Gross Notional (USD EQ)

Contracts

Republic of Italy

Government

Sov

Net Notional (USD EQ)

26,403,977,303

289,512,635,988

8,668

Europe

French Republic

Government

Sov

18,788,658,233

89,833,068,875

4,715

Europe

Kingdom of Spain

Government

Sov

17,243,543,797

151,438,268,666

6,822

Europe

Federal Republic of Germany

Government

Sov

16,549,866,241

85,867,029,976

2,719

Europe

Federative Republic of Brazil

Government

Sov

15,407,170,686

160,758,396,710

11,426

Americas

Financials

Corp

12,068,031,281

98,290,892,732

7,791

Americas

General Electric Capital Corporation UK and Northern Ireland

Government

Sov

11,921,382,139

62,667,659,806

4,627

Europe

United Mexican States

Government

Sov

7,966,267,908

115,144,342,489

9,133

Americas

Portuguese Republic

Government

Sov

7,486,978,095

75,922,828,382

4,011

Europe

Republic of Turkey

Government

Sov

6,978,332,879

144,615,594,788

8,758

Europe

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 11 February 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

Corporate: Financials Sovereign / State Bodies Corporate: Consumer Services Corporate: Consumer Goods Corporate: Industrials Corporate: Technology / Telecom Corporate: Basic Materials Corporate: Utilities Corporate: Oil & Gas Corporate: Health Care Corporate: Other CDS on Loans Residential Mortgage Backed Securities Commercial Mortgage Backed Securities CDS on Loans European Other Muni:Government Muni:Utilities Muni:Other

3,286,949,866,426 2,593,650,799,376 2,123,696,295,434 1,558,412,704,859 1,251,280,165,489 1,308,242,950,569 988,441,205,991 758,406,789,187 453,589,342,395 331,191,434,035 145,941,813,625 71,239,990,081 71,841,971,751 20,561,302,980 5,181,224,541 2,473,658,939 1,231,400,000 32,150,000 65,000,000

432,045 194,803 351,605 247,697 214,957 202,796 158,457 118,671 83,510 58,425 14,746 18,724 14,395 1,907 760 289 127 12 3

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH 2011

References Entity

Gross Notional (USD EQ)

Contracts

Kingdom of Spain

6,340,017,659

330

Republic of Italy

4,662,640,463

237

Mbia Insurance Corporation

4,090,708,000

395

United Mexican States

2,574,839,999

142

Russian Federation

2,421,700,000

182

Federative Republic of Brazil

2,153,317,998

142

Federal Republic of Germany

1,705,478,380

Deutsche Bank Aktiengesellschaft

1,656,851,730

209

UK and Northern Ireland

1,493,700,000

185

Arcelormittal

1,408,478,631

342

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data ÂŠ 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 4th of February 2011 VENUES

INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.43

2.03 3.40%

1.93

1.86

2.02

10.25%

5.23%

6.73%

5.57%

9.76%

5.05% 15.25%

19.13%

Amsterdam

Europe

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

0.02% 26.87%

21.52%

0.28%

1.07%

20.33% 68.65% 0.07% 0.08% 0.73% 0.08% 0.01%

56.99% 0.23%

0.10% 0.14%

0.09%

3.06%

71.18% 2.85%

64.76% 67.02% 5.38%

VENUES

3.96% 0.04%

4.08%

VENUES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

4.88

4.52

FFI

2.07

2.05

BATS

12.57%

11.95%

Alpha ATS

19.00%

18.54%

BYXX

3.40%

3.15%

CBOE

0.09%

0.12%

CHXE

0.46%

0.38%

EDGA

7.07%

7.26%

S&P TSX 60

Chi-X Canada

9.78%

10.61%

Liquidnet Canada

0.55%

0.26%

Omega ATS

1.57%

2.12%

Pure Trading

3.98%

3.25%

EDGX

6.94%

6.70%

NSDQ

23.74%

23.03%

Toronto

62.59%

62.66%

NQBX

3.31%

3.19%

TriAct MATCH Now

2.53%

2.55%

NQPX

1.93%

1.66% VENUES

CINN

0.74%

0.64%

NYSE

24.40%

25.71%

INDICES FFI

AMEX

0.14%

0.28%

ARCX

15.22%

15.95%

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

1.23 0.86% 0.00% 0.06% 0.00% 0.01% 0.75% 89.97% 8.36%

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/.

MARCH 2011 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

HE TERM 'DARK pool' is now being used to cover almost every form of non-lit trading - buy-side crossing networks, discretionary broker services and the dark books operated by exchanges and MTFs. Both the complexity and the number of these pools seem to be growing, especially when compared to the lit market. While the average number of lit venues executing the constituents of major European stocks has flattened out since around July 2010, the number of dark pools has grown over the same period. The chart below compares the average number of lit venues and dark pools on which these major indices are traded (OTC and SI trades are excluded).

Dark traded volume for the major EU indices* Millions Dark traded volume

Expon. (Dark traded volume)

6,000 0 5,000 0 4,000 0 3,000 0 2,000 0 1,000 0 ov J an Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mayy Jul Se Sep N Nov Jan 08 08 08 08 09 09 09 09 09 09 10 10 10 10 10 10 11 * AEX, CAC 40, BEL 20, DAX, FTSE 100, FTSE 250, FTSE MIB, IBEX, ISEQ, OMX C20, OMX H25, OMX S30, OSLO OBX, PSI 20, SMI Source: Fidessa Fragulator®

Average number of venues per index* (2 May 2008 - 4 February 2011) EU average (lit venue)

EU average (dark pools)

10 8 6 4

One of the criticisms leveled against dark pools is that they have the potential to impact negatively on the price formation process. If too many transactions take place away from lit markets, then the prices of these transactions are not included in any consolidated view of the market and so are obscured from public view. Whilst there is a definite logic to this, the industry has been unable to reach consensus as to the real tipping point, i.e. how much trading needs to be done in the dark in order to significantly impact price formation?

2 0 May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan 08 08 08 08 09 09 09 09 09 09 10 10 10 10 10 10 11

The real issue at stake, though, is not whether dark pool trading impacts price formation per se but whether it impacts price formation negatively.

* AEX, CAC 40, BEL 20, DAX, FTSE 100, FTSE 250, FTSE MIB, IBEX, ISEQ, OMX C20, OMX H25, OMX S30, OSLO OBX, PSI 20, SMI Source: Fidessa Fragulator®

Total non-lit trading volumes are also increasing. Dark volumes, while still low in comparison to total non-lit volume, grew exponentially in the period following the introduction of MiFID.

Non-lit traded volume for the major EU indices* Millions Non-lit traded volume

Linear (Non-lit traded volume)

90,000 80,000 70,000 0 60,000 0 50,000 0 40,000 0 30,000 0 20,000 0 10,000 0 May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan 08 08 08 08 09 09 09 09 09 09 10 10 10 10 10 10 11 * AEX, CAC 40, BEL 20, DAX, FTSE 100, FTSE 250, FTSE MIB, IBEX, ISEQ, OMX C20, OMX H25, OMX S30, OSLO OBX, PSI 20, SMI Source: Fidessa Fragulator®

For traders of large size orders, the price discovery process is completely different from that undertaken by smaller, more retail shaped order flow. A large institutional trader will typically want to complete his order in a single block and with the minimum possible information leakage and market impact. The anonymity that dark pools provide is ideal for this type of trading. Dark pools, such as that operated by Liquidnet, provide exactly this sort of service - their normal trade size reports are hundreds, if not thousands, of times larger than average lit trading sizes. The crucial question, however, concerns the true size of the originating orders. In many cases larger block orders are chopped up into increasingly smaller pieces by algorithms designed to exploit the fragmentation of liquidity across lit and dark venues. Typically, these algorithms will route a number of small, probing, test orders on to dark venues precisely to see if there is any liquidity available. The challenge for the regulators, then, is to work out whether this matters and how to incorporate the original order size into their thinking. I

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

FTSE GLOBAL MARKETS • MARCH 2011

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM As at end January 2011 Index Provider MSCI S&P Barclays Capital Russell FTSE STOXX Dow Jones Markit NASDAQ OMX Deutsche Boerse Topix Hang Seng NYSE Euronext Nikkei EuroMTS SIX Swiss Exchange WisdomTree PC-Bond Grupo Bolsa SSE Indxis Structured Solutions CSI Intellidex BNY Mellon Morningstar S-Network ISE Zacks Other Total

No. of ETFs 395 320 84 72 161 221 141 115 61 45 53 13 43 9 29 17 35 18 13 16 6 26 32 36 16 10 15 10 11 478 2,501

January 2011 Total Listings AUM (US$ Bn) 1,392 $334.8 574 $311.4 211 $113.7 105 $80.1 386 $55.1 781 $52.4 260 $50.4 333 $46.0 109 $35.4 172 $34.6 64 $16.5 34 $15.5 86 $15.4 17 $13.9 111 $9.5 30 $8.6 42 $8.5 22 $7.6 13 $7.3 17 $7.0 7 $6.5 34 $5.3 38 $3.4 39 $2.9 17 $2.3 10 $2.0 33 $1.8 10 $1.1 12 $0.9 742 $84.6 5,701 $1,334.6

% Total 25.1% 23.3% 8.5% 6.0% 4.1% 3.9% 3.8% 3.4% 2.6% 2.6% 1.2% 1.2% 1.2% 1.0% 0.7% 0.6% 0.6% 0.6% 0.5% 0.5% 0.5% 0.4% 0.3% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% 6.3% 100.0%

No. of ETFs 5 5 0 2 0 0 3 3 0 0 0 0 2 0 0 0 0 0 0 2 0 1 1 0 0 0 0 0 0 17 41

Total Listings 62 8 0 4 1 1 2 21 8 1 0 0 2 1 0 0 0 1 0 2 0 3 5 0 0 0 0 0 0 24 146

YTD Change AUM (US$ Bn) -$3.0 $10.3 $2.5 -$0.4 $0.2 $3.7 $2.8 $0.9 $3.6 $2.5 -$0.1 $0.2 -$1.3 -$0.8 $0.1 -$0.3 $0.0 -$0.1 -$0.4 $0.6 $0.8 -$0.4 -$0.2 $0.1 -$0.3 $0.1 $0.1 $0.0 $0.0 $1.9 $23.3

% AUM -0.9% 3.4% 2.3% -0.5% 0.4% 7.6% 6.0% 1.9% 11.5% 7.9% -0.4% 1.1% -7.6% -5.3% 0.9% -3.7% -0.2% -0.9% -5.0% 8.7% 13.2% -6.9% -5.3% 3.3% -12.8% 4.9% 8.1% 4.1% 3.4% 2.3% 1.8%

% TOTAL -0.7% 0.4% 0.0% -0.1% -0.1% 0.2% 0.1% 0.0% 0.2% 0.1% 0.0% 0.0% -0.1% -0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

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

Top 5 global ETF providers by average daily turnover As at end January 2011 Average Daily Turnover (US$ Mil) Jan-2011 % Mkt Share Change (US$ Mil)

Provider

Dec-2010

% Mkt Share

SSgA

$18,667.3

40.3%

$19,861.8

39.7%

6.4% Change (%)

$1,194.5

Direxion Shares

6.4%

6.9% ProShares

iShares

$14,028.5

30.3%

$14,572.0

29.1%

$543.5

3.9%

PowerShares

$2,413.3

5.2%

$3,891.8

7.8%

$1,478.5

61.3%

ProShares

$2,660.7

5.7%

$3,446.7

6.9%

$786.0

29.5%

Direxion Shares

$1,860.7

4.0%

$3,219.9

6.4%

$1,359.2

73.0%

Others

$6,710.2

14.5%

$5,056.1

10.1%

-$1,654.2

-24.7%

Total

$46,340.7

100.0%

$50,048.2

100.0%

$3,707.5

8.0%

10.1% Others

39.7% SSgA

7.8% PowerShares

29.1% iShares

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

Top 20 ETFs worldwide with the largest change in AUM As at end January 2011 ETF iShares MSCI Emerging Markets Index Fund SPDR S&P 500 PowerShares QQQ Trust iShares Russell 2000 Index Fund Market Vectors Gold Miners iShares S&P 500 Index Fund SPDR Dow Jones Industrial Average ETF iShares MSCI EAFE Index Fund Financial Select Sector SPDR Fund Technology Select Sector SPDR Fund Daiwa ETF NIKKEI 225 iShares S&P 500 iShares FTSE China 25 Index Fund Lyxor Euro STOXX 50 Vanguard Dividend Appreciation ETF iShares Barclays 20+ Year Treasury Bond Fund SPDR Barclays Capital High Yield Bond ETF Market Vectors Agribusiness ETF iShares Russell 1000 Value Index Fund iShares iBoxx $ High Yield Corporate Bond Fund

Country listed US US US US US US US US US US Japan UK US France US US US US US US

Bloomberg Ticker EEM US SPY US QQQQ US IWM US GDX US IVV US DIA US EFA US XLF US XLK US 1320 JP IUSA LN FXI US MSE FP VIG US TLT US JNK US MOO US IWD US HYG US

AUM (US$ Mil) January 2011 $39,043.9 $93,496.6 $25,258.8 $15,535.4 $6,176.7 $27,173.2 $10,050.5 $37,946.5 $8,418.9 $6,761.5 $2,803.1 $8,696.7 $7,403.7 $9,004.0 $5,321.1 $3,165.3 $7,038.1 $3,284.8 $11,333.9 $8,012.4

AUM (US$ Mil) December 2010 $47,551.5 $89,915.3 $22,069.9 $17,498.4 $7,680.8 $25,799.2 $8,729.2 $36,923.1 $7,472.5 $5,849.3 $3,650.6 $7,905.8 $8,131.1 $8,278.6 $4,608.9 $2,465.9 $6,358.5 $2,631.5 $10,697.1 $7,376.7

Change (US$ Mil) -$8,507.6 $3,581.3 $3,188.9 -$1,962.9 -$1,504.2 $1,374.0 $1,321.3 $1,023.4 $946.4 $912.2 -$847.5 $790.9 -$727.4 $725.3 $712.2 $699.4 $679.6 $653.3 $636.8 $635.7

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

MARCH 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Global ETF listings As at end January 2011 ASSETS UNDER MANAGEMENT (US$ Bn)

CHANGE IN ASSETS

No. of No. of Exchanges Providers (Official)

No. Primary Listings

New in 2010

New in 2011

Total Listings

2010

Jan-2011

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 Botswana Egypt Israel Philippines Sri Lanka

913 1,085 1 1 1 259 390 3 1 14 23 12 6 1 3 1 1 12 25 110 12 209 157 80 43 18 19 65 19 21 14 26 7 6 4 16 4 2 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 -

17 13 2 3 2 2 4 3 3 3 2 -

913 3,808 21 23 1 480 1,190 3 1 14 502 106 6 1 3 1 1 68 80 610 12 685 185 83 72 18 308 65 40 74 17 26 7 6 5 16 4 2 1 1 50 -

$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 -

$907.3 $291.9 $0.1 $0.1 $0.3 $61.9 $114.9 $0.1 $0.0 $0.4 $2.6 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.3 $2.9 $37.5 $0.1 $68.6 $38.0 $31.2 $26.8 $10.6 $7.9 $5.7 $3.8 $3.4 $2.9 $2.1 $1.8 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$16.3 $7.8 $0.0 $0.0 $0.0 $2.0 $4.1 $0.0 $0.0 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.1 $0.1 -$0.5 $0.0 $1.9 -$0.4 -$1.0 $0.6 $0.5 -$0.4 $0.3 -$0.1 -$0.2 $0.1 -$0.2 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

1.8% 2.8% -1.5% 4.0% 3.3% 3.4% 3.7% 13.0% 8.0% 11.7% 2.7% -1.5% 1.5% -0.1% 4.5% 6.6% 3.0% 7.4% 2.1% -1.3% -4.4% 2.8% -1.0% -3.3% 2.1% 4.8% -4.5% 5.8% -2.6% -4.4% 4.7% -8.1% -2.5% -0.6% -0.6% -0.2% -9.9% 44.8% -6.2% -6.2% -

28 40 1 1 1 9 11 2 1 2 4 4 2 1 2 1 1 2 2 7 5 9 4 7 10 13 3 12 6 8 2 8 2 2 3 7 3 1 1 1 -

2 23 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 2 2 1 1 1 1 2 1 2 1 1 1 1 1 1 1 1 1 2 1 1 1 1 1 -

881 59*

ETF total

2,501

593

5,701

$1,311.3

$1,334.6

$23.3

1.8%

138

1,042

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

19 0 2 20 1 6 5 1 5 12 1 0 3 16 0 1 4 0 0 1 1 2 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 Global ETF Research and 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 January 2011, 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. © 2011 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded.

FTSE GLOBAL MARKETS • MARCH 2011

5-Year Performance Graph (USD Total Return) Index Level Rebased (31 January 2006=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

Ja n06 M ay -0 Au 6 g06 No v06 Fe b07 M ay -0 Au 7 g07 No v07 Fe b08 M ay -0 Au 8 g08 No v08 Fe b09 M ay -0 Au 9 g09 No v09 Fe b10 M a7 -1 Au 0 g10 No v10 Ja n11

MARKET DATA BY FTSE RESEARCH

Global Market Indices

FTSE RAFI Emerging Index

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

USD

2,839

279.98

6.5

16.8

20.1

1.5

2.30

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

USD

2,360

655.61

7.3

17.4

20.1

1.9

2.32

FTSE Developed Index

USD

2,055

260.12

7.5

17.5

19.8

2.3

2.29

FTSE Emerging Index

USD

784

734.06

0.3

12.7

22.1

-3.8

2.40

FTSE Advanced Emerging Index

USD

305

700.86

4.4

16.5

25.0

-3.2

2.76

FTSE Secondary Emerging Index

USD

479

841.30

-3.4

9.2

19.3

-4.3

2.04

USD

7,294

454.29

6.9

17.6

21.5

1.4

2.21

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

USD

5,773

425.94

7.9

18.2

21.4

2.2

2.19

FTSE Emerging All Cap Index

USD

1,521

979.32

0.2

13.0

22.5

-3.8

2.37

FTSE Advanced Emerging All Cap Index

USD

640

951.09

4.7

17.0

25.6

-3.0

2.74

FTSE Secondary Emerging All Cap Index

USD

881

1078.77

-3.9

9.3

19.6

-4.5

2.01

USD

760

194.23

-2.7

2.8

5.6

0.3

2.76

FTSE EPRA/NAREIT Developed Index

USD

283

2944.40

3.2

16.2

29.4

1.3

3.61

FTSE EPRA/NAREIT Developed REITs Index

USD

192

1015.78

4.1

15.4

31.1

2.1

4.36

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

227

2156.80

3.3

15.8

31.5

1.5

4.20

FTSE EPRA/NAREIT Developed Rental Index

USD

233

1161.20

4.1

16.5

32.6

1.8

4.11

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1192.86

0.8

15.3

21.1

-0.2

2.14

FTSE4Good Global Index

USD

658

6901.31

5.8

15.4

16.6

2.8

2.65

FTSE4Good Global 100 Index

USD

103

5680.70

5.1

13.8

13.6

3.1

2.83

FTSE GWA Developed Index

USD

2,055

4027.02

8.1

16.7

18.9

3.4

2.53

FTSE RAFI Developed ex US 1000 Index

USD

1,010

6917.29

6.5

17.4

17.8

4.1

2.88

FTSE RAFI Emerging Index

USD

359

8017.09

3.4

14.8

23.8

-0.7

2.59

SRI

Investment Strategy

Source: FTSE Group and Thomson Datastream, data as at 31 January 2011.

MARCH 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices Index Level Rebased (31 January 2006=100)

5-Year Performance Graph (USD Total Return) 160

FTSE Americas Index

140

FTSE Americas Government Bond Index

120 100

FTSE EPRA/NAREIT North America Index

FTSE EPRA/NAREIT US Dividend+ Index

FTSE4Good USIndex FTSE GWA US Index

FTSE RAFI US 1000 Index 20

Ja n06 M ay -0 Au 6 g06 No v06 Fe b07 M ay -0 Au 7 g07 No v07 Fe b08 M ay -0 Au 8 g08 No v08 Fe b09 M ay -0 Au 9 g09 No v09 Fe b10 M a7 -1 Au 0 g10 No v10 Ja n11

FTSE Renaissance IPO Composite Index

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

FTSE Americas Index

USD

835

869.57

8.5

17.5

22.3

1.8

1.88

FTSE North America Index

USD

700

948.99

9.1

18.0

22.4

2.1

1.82

FTSE Latin America Index

USD

135

1311.89

-0.5

10.7

21.7

-4.1

2.63

FTSE All-World Indices

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,501

406.18

9.0

18.5

24.5

1.6

1.78

FTSE North America All Cap Index

USD

2,317

387.97

9.7

19.1

24.7

2.0

1.73

FTSE Latin America All Cap Index

USD

184

1864.89

-0.7

11.0

22.3

-4.3

2.58

Fixed Income FTSE Americas Government Bond Index

USD

204

198.48

-1.6

0.3

5.4

0.4

2.75

FTSE USA Government Bond Index

USD

190

194.06

-1.7

0.2

5.3

0.4

2.72

FTSE EPRA/NAREIT North America Index

USD

127

3673.90

5.7

15.1

39.6

3.1

3.61

FTSE EPRA/NAREIT US Dividend+ Index

USD

1987.67

5.7

13.8

39.2

3.5

3.90

FTSE EPRA/NAREIT North America Rental Index

USD

123

1248.48

5.6

14.6

40.1

3.1

3.63

FTSE EPRA/NAREIT North America Non-Rental Index

USD

399.29

10.1

34.7

22.6

3.1

3.04

Real Estate

FTSE NAREIT Composite Index

USD

143

3562.13

6.9

15.2

39.0

3.8

4.26

FTSE NAREIT Equity REITs Index

USD

119

8691.91

6.8

15.2

40.5

4.1

3.43

FTSE4Good US Index

USD

133

5599.70

7.1

15.6

18.5

1.6

1.73

FTSE4Good US 100 Index

USD

102

5323.94

6.9

15.3

18.1

1.5

1.76

FTSE GWA US Index

USD

628

3561.47

10.2

17.7

20.9

2.5

1.86

FTSE RAFI US 1000 Index

USD

989

6547.93

10.7

18.5

26.1

2.3

1.97

FTSE RAFI US Mid Small 1500 Index

USD

1,430

6651.94

12.6

21.3

33.1

0.1

1.12

USD

209

284.04

10.0

22.0

27.9

0.1

0.83

SRI

Investment Strategy

IPO Indices FTSE Renaissance IPO Composite Index

Source: FTSE Group and Thomson Datastream, data as at 31 January 2011.

FTSE GLOBAL MARKETS • MARCH 2011

5-Year Total Return Performance Graph 200

FTSE Europe Index (EUR)

180

Index Level Rebased (31 January 2006=100) Ja n06 M ay -0 Au 6 g06 No v06 Fe b07 M ay -0 Au 7 g07 No v07 Fe b08 M ay -0 Au 8 g08 No v08 Fe b09 M ay -0 Au 9 g09 No v09 Fe b10 M a7 -1 Au 0 g10 No v10 Ja n11

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

FTSE All-Share Index (GBP)

160

FTSEurofirst 80 Index (EUR)

140

FTSE/JSE Top 40 Index (SAR)

120

FTSE Actuaries UK Conventional Gilts All Stocks Index (GBP)

100 80 60

FTSE EPRA/NAREIT Developed Europe Index (EUR)

FTSE4Good Europe Index (EUR)

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

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

3.05

FTSE All-World Indices FTSE Europe Index

EUR

568

261.64

6.1

10.9

17.4

1.9

FTSE Eurobloc Index

EUR

280

136.98

5.0

10.4

13.4

4.7

3.39

FTSE Developed Europe ex UK Index

EUR

378

260.95

6.1

11.3

16.8

2.9

3.15

FTSE Developed Europe Index

EUR

492

256.96

5.9

10.8

17.2

1.9

3.12

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,502

412.63

6.3

11.4

18.3

1.6

2.94

FTSE Eurobloc All Cap Index

EUR

743

408.64

5.1

10.9

14.0

4.3

3.26

FTSE Developed Europe All Cap ex UK Index

EUR

1,018

439.35

6.3

12.0

17.6

2.6

3.02

FTSE Developed Europe All Cap Index

EUR

1,359

407.87

6.1

11.4

18.2

1.6

3.01

Region Specific FTSE All-Share Index

GBP

627

4090.18

4.2

13.5

18.1

-0.5

2.91

FTSE 100 Index

GBP

102

3833.15

3.8

13.0

16.8

-0.6

3.02

FTSEurofirst 80 Index

EUR

5111.11

4.4

9.5

12.1

5.2

3.71

FTSEurofirst 100 Index

EUR

101

4721.05

5.1

9.8

14.1

3.2

3.50

FTSEurofirst 300 Index

EUR

313

1675.02

5.7

10.5

17.0

2.1

3.16

FTSE/JSE Top 40 Index

SAR

3254.53

4.2

13.1

19.8

-1.7

2.06

FTSE/JSE All-Share Index

SAR

164

3621.62

3.4

12.3

20.6

-2.2

2.27

FTSE Russia IOB Index

USD

1101.62

16.9

21.4

18.6

4.1

1.38

4.03

Fixed Income FTSE Eurozone Government Bond Index

EUR

245

171.83

-3.4

-2.4

0.8

-0.4

FTSE Pfandbrief Index

EUR

405

206.80

-2.8

-1.8

-0.4

-0.9

4.54

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2406.44

-2.6

-0.2

4.5

-1.9

3.95*

Real Estate FTSE EPRA/NAREIT Developed Europe Index

EUR

2116.38

-0.2

11.1

17.3

-1.4

4.23

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

751.69

-2.0

8.7

13.9

-1.3

4.90

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2701.13

-1.9

12.2

20.5

-1.8

4.75

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

833.20

-0.2

11.3

17.6

-1.4

4.32

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

537.77

0.9

6.0

9.5

0.3

1.96

FTSE4Good Europe Index

EUR

274

5058.38

5.7

9.9

15.9

2.9

3.37

FTSE4Good Europe 50 Index

EUR

4206.70

4.2

8.2

12.0

3.2

3.65

FTSE GWA Developed Europe Index

EUR

492

3643.72

6.1

9.3

15.4

4.7

3.48

FTSE RAFI Europe Index

EUR

502

5731.13

6.3

10.8

17.1

3.5

3.17

SRI

Investment Strategy

*Semi-annual redemption yield.

Source: FTSE Group and Thomson Datastream, data as at 31 January 2011.

MARCH 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 350

FTSE Asia Pacific Index (USD)

300

FTSE/ASEAN Index (USD)

250

FTSE China 25 Index

200

FTSE Asia Pacific Government Bond Index (USD)

150

FTSE EPRA/NAREIT Developed Asia Index (USD)

100

FTSE IDFC India Infrastructure Index (IRP)

FTSE4Good Japan Index (JPY) 0

FTSE GWA Japan Index (JPY)

Ja n06 M ay -0 Au 6 g06 No v06 Fe b07 M ay -0 Au 7 g07 No v07 Fe b08 M ay -0 Au 8 g08 No v08 Fe b09 M ay -0 Au 9 g09 No v09 Fe b10 M a7 -1 Au 0 g10 No v10 Ja n11

Index Level Rebased (31 January 2006=100)

5-Year Total Return Performance Graph

FTSE RAFI Kaigai 1000 Index (JPY)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

FTSE All-World Indices FTSE Asia Pacific Index

USD

1,298

325.18

5.7

16.2

21.0

-0.9

2.28

FTSE Asia Pacific ex Japan Index

USD

844

664.10

3.4

17.3

26.0

-1.4

2.54

FTSE Japan Index

USD

454

77.62

11.9

8.1

2.4

1.0

1.83

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,092

553.24

5.7

16.4

21.4

-0.9

2.27

FTSE Asia Pacific All Cap ex Japan Index

USD

1,861

824.07

3.3

17.6

26.2

-1.5

2.51

FTSE Japan All Cap Index

USD

1,231

246.34

12.3

8.1

2.8

1.1

1.83

Region Specific FTSE/ASEAN Index

USD

145

734.31

-0.7

13.8

34.1

-2.9

2.81

FTSE Bursa Malaysia 100 Index

MYR

100

11771.07

3.4

15.6

27.2

0.8

2.57

FTSE TWSE Taiwan 50 Index

TWD

8504.71

12.8

21.6

23.6

3.0

3.18

FTSE China A All-Share Index

CNY

1,156

8725.69

-8.5

9.1

1.2

-3.3

0.93

FTSE China 25 Index

CNY

24771.95

-3.7

5.3

13.0

-0.8

2.35

USD

236

159.46

-2.5

5.0

12.4

-1.6

1.29

FTSE EPRA/NAREIT Developed Asia Index

USD

2408.73

2.4

17.2

25.2

-0.4

3.38

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1562.95

2.4

17.9

24.5

-0.1

3.68

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2592.51

2.8

17.6

28.5

-0.5

4.20

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

1182.78

5.6

21.2

31.7

-0.5

5.30

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1301.88

0.4

14.6

21.2

-0.4

2.10

FTSE IDFC India Infrastructure Index

IRP

107

872.23

-16.2

-9.9

-6.4

-13.0

0.97

FTSE IDFC India Infrastructure 30 Index

IRP

987.71

-14.9

-8.2

-5.0

-12.0

0.95

JPY

178

3665.40

11.7

7.6

0.4

0.9

1.99

FTSE SGX Shariah 100 Index

USD

100

6225.57

11.1

19.6

21.2

1.0

1.95

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

12393.44

2.9

12.4

19.6

1.2

2.56

JPY

100

1079.65

12.5

10.7

4.1

1.7

1.73

Infrastructure

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

454

2809.21

12.5

8.3

3.6

1.2

1.98

FTSE GWA Australia Index

AUD

100

4223.54

3.0

7.7

7.5

1.1

4.55

FTSE RAFI Australia Index

AUD

6659.74

2.5

7.0

5.5

0.7

4.35

FTSE RAFI Singapore Index

SGD

9420.40

3.3

6.1

17.1

0.3

3.15

FTSE RAFI Japan Index

JPY

250

3953.89

12.4

9.1

4.2

1.3

1.81

FTSE RAFI Kaigai 1000 Index

JPY

1,022

4297.89

9.7

11.1

9.2

4.8

2.64

HKD

7848.65

2.4

13.6

21.0

3.2

2.75

FTSE Renaissance Asia Pacific ex Japan IPO Index

USD

165

1884.80

-3.2

8.0

17.4

-1.7

0.59

FTSE Renaissance Hong Kong/China Top IPO Index

HKD

2753.40

-0.1

12.8

18.8

1.5

0.41

FTSE RAFI China 50 Index IPO Indices

Source: FTSE Group and Thomson Datastream, data as at 31 January 2011.

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH 2011

INDEX CALENDAR

Index Reviews March - May 2011 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

Early Mar 04-Mar 04-Mar 04-Mar 04-Mar 04-Mar 04-Mar 04-Mar 07-Mar

ATX FTSE Vietnam Index Series AEX PSI 20 BEL 20 DAX CAC 40 S&P / ASX Indices TOPIX

Semi-annual review / number of shares Quarterly review Annual review Annual review Annual review Quarterly review Quarterly review Annual / Quarterly review Monthly review - additions & free float adjustment Quarterly review Quarterly Review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Annual review Semi-annual review

31-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar

28-Feb 25-Feb 31-Jan 31-Jan 31-Jan 28-Feb 28-Feb 25-Feb

08-Mar 08-Mar 09-Mar 09-Mar 09-Mar 09-Mar 10-Mar 10-Mar 10-Mar n/a 10-Mar 11-Mar 11-Mar 11-Mar

FTSE China Index Series FTSE MIB FTSE UK FTSEurofirst 300 FTSE techMARK 100 FTSE/JSE Africa Index Series FTSE Asiatop / Asian Sectors FTSE/ASEAN 40 Index STI and FTSE ST Index Series FTSE Renaissance Asia Pacific IPO Index Series FTSE Italia Index Series S&P / TSX Dow Jones Global Indexes DJ Global Titans 50

30-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar

28-Feb 21-Feb 07-Mar 08-Mar 08-Mar 08-Mar 08-Mar 28-Feb 28-Feb 28-Feb

Quarterly review Quarterly Review Quarterly review Quarterly review Quarterly review - no composition changes only rebalance/shares/float changes Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review - IPO additions only Monthly review - shares in issue change Quarterly review Monthly review - additions & free float adjustment Semi-annual Monthly review - shares in issue change Monthly review - additions & free float adjustment Semi-annual Semi-annual Quarterly review Quarterly IPO addtions Annual review Quarterly review Monthly review - shares in issue change

18-Mar 18-Mar 18-Mar 18-Mar

28-Feb 08-Mar 28-Feb 28-Feb

11-Mar 11-Mar 11-Mar 11-Mar 11-Mar 11-Mar 11-Mar 11-Mar 15-Mar 29-Mar 07-Apr 07-Apr

S&P Asia 50 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Global 1200 S&P Global 100 S&P Latin 40 NZX 50 Russell US & Global Indices Russell US & Global Indices FTSE TWSE Taiwan Index Series TOPIX

18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 18-Mar 31-Mar 31-Mar 15-Apr

28-Feb 04-Mar 10-Mar 04-Mar 04-Mar 04-Mar 04-Mar 04-Mar 28-Feb 28-Feb 28-Mar 31-Mar

08-Apr 27-Apr 06-May

FTSE Value-Stocks Korea Index Russell US & Global Indices TOPIX

29-Apr 15-Apr 29-Apr

31-Mar 31-Mar 26-Apr

09-May 11-May 11-May 17-May 17-May 24-May 26-May

FTSE Value-Stocks China Index FTSE Value-Stocks Taiwan Index Hang Seng Russell/Nomura Indices MSCI Standard Index Series DJ STOXX Russell US & Global Indices

27-May 13-May 20-May 03-Jun 31-May 31-May 17-Jun 31-May

29-Apr 30-Apr 30-Apr 31-Mar 31-Mar 30-Apr 29-Apr 25-May

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

MARCH 2011 • FTSE GLOBAL MARKETS