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TRADING ROUNDTABLE: THE IMPACT OF MiFID II & OTHER REGULATIONS

I S S U E 5 1 • M AY 2 0 1 1

Qatar’s vision of the perfect future What lies ahead for OTC derivatives clearing? KSU shows why the South can rise again The continuing mayhem of Western sovereign debt

NORTHERN TRUST:

The importance of being earnest HIGH RETURNS FROM HIGH-YIELD DEBT

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F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

ITH ALL THE brouhaha that has marked the global political climate and financial markets through the first trimester of the year, it was hard to discern whether April would spring its own peculiar surprises. We had to wait until almost the month-end before what was perhaps the most seminal event of this first half year, namely the sinking of the US dollar to its lowest level in three years against major currencies, as a mixture of rising inflation, cheap debt and weak economic growth figures scuppered the greenback. A premonition of the dip came on April 18th when Standard & Poor’s revised the outlook on its ‘AAA’ rating for the United States to negative. As a result the ratings agency naturally revised its outlooks on certain US public finance housing ratings to negative too. The global markets continued in an uneasy state as any and all currencies appeared to rise in comparison to the US dollar. Should the government fail to act and underpin the economy the day is ever so gradually nearing when another currency might have to accept either equal billing with the US dollar as a reserve currency—or supercede it. Unless the US government can find a way to cross party lines, and work in coalition to get the country out of the mire, that day will come sooner rather than later. Other markets are certainly on the ball and we will be highlighting those countries able to leverage the global supercycle that is beginning to change trading and investment patterns across the globe over the coming months. We make a small start with Qatar and will move on to Latin American, Asian and other Middle Eastern economies in subsequent editions. Many investors have taken the recent market sell-off as a buying opportunity, many of which who missed the original late-2010 rally feared they would not see again. “This has been aided by both the Fed and the Bank of England (BoE) failing to follow the European Central Bank in beginning the interest rate squeeze as policy makers in London and Washington continue to focus on weakness in growth rather than fears over inflation,” explains Simon Denham, managing director at spread betting firm Capital Spreads and erstwhile commentator for this magazine. “At some point, the ‘independent’ BoE will have to turn its attention back to its original remit (the fight against inflation) rather than the more populist concentration on jobs and the economy. With RPI and PPI over 5% (and accelerating) it is difficult now to justify such low rates and we risk the inflation genie becoming entrenched in our national psyche as it did through most of the seventies, eighties and nineties. It is reasonably, concerning that the BoE might be going native and operating a politicallymotivated agenda rather than an economic one,” he adds. David Craik takes up the theme in his polemic on the inevitability of rising interest rates across Europe and its impact on individual sovereigns. Next month, expanding on our foreign exchange coverage, we look in depth at the globalisation of the renminbi (RMB) and the ways that the Chinese government is managing to apply the brakes to appreciation and global availability of the currency. It looks to be a slowly losing game.

Francesca Carnevale, Editor May 2011

Cover photo: Rick Waddell, CEO, Northern Trust. Photograph kindly supplied by Northern Trust, April 2011.

CONTENTS COVER STORY

THE IMPORTANCE OF BEING EARNEST

..................................................................Page 74 Northern Trust is the paradigm for customer-focused services. But these days is that enough to remain centre stage in a fast-changing and rough and tumble custody market where margins are superfine and where the definition of asset servicing itself is in flux? Francesca Carnevale spoke to Rick Waddell about the challenges of modern day banking.

DEPARTMENTS

MARKET LEADER

HIGH RETURNS FROM HIGH-YIELD DEBT ......................................................Page 6

SPOTLIGHT

PRIVATE EQUITY’s STEADY FIGHTBACK ........................................................Page 12

Andrew Cavenagh reports on the sustained appeal of high-yield debt.

Key stories around the global investment and capital markets.

HARMONISING EU FINANCIAL REGULATION

..........................................Page 14 Sean Tuffy, VP of Brown Brothers Harriman, reviews the impact of the ESFS initiative.

IN THE MARKETS

CENTRAL CLEARING: PROVING ITS WORTH IN A NEW ERA ......Page 18 What lies ahead for OTC derivatives? Neil O’Hara reports.

MIXED VIEWS IN THE RATE DEBATE ..................................................................Page 24 David Craik discusses the implications of a rate rise on European nations.

NEARING THE TIPPING POINT ..................................................................................Page 28 The sovereign debt crisis may result in mayhem, writes Andrew Cavenagh.

DEBT REPORT

FACTORING RISK INTO EM DEBT

........................................................................Page 31 Is the boom of emerging market debt the beginning of a bubble, asks Ian Williams.

A VISION OF THE PERFECT FUTURE ....................................................................Page 34 Francesca Carnevale reports on the long-term growth plan of Qatar.

COUNTRY REPORT

CBQ ALIGNS WITH GOVERNMENT POLICY ................................................Page 44 Andrew Stevens, CEO of Commercial Bank of Qatar, on the bank’s business dynamics.

RICH AND CONTINUOUS TRADING ....................................................................Page 46 Erik Lehtis, president of Dynamic FX Consulting, on the ideal FX trading platform.

FX VIEWPOINT

WHO WILL BEAR THE BRUNT OF A SWITCH TO CLEARING? ....Page 47 Neil O’Hara reports on foreign exchange risks as the markets become more volatile.

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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CONTENTS

INDEX REVIEW

FTSE BUTTS AGAINST ITS TOP-END BARRIER ............................................Page 49 Simon Denham, MD of spread betting firm Capital Spreads takes the bearish view.

THE RISING APPEAL OF SECONDARY ASSETS ..........................................Page 50 Key market trends shine despite economic and political volatility, by Mark Faithfull.

REAL ESTATE AS SAFE AS HOUSES?........................................................................................................Page 52 Mark Fathfull writes on the value of real estate as an asset class.

FEATURES SECTOR REPORT:

BACK TO THE FUTURE ........................................................................................Page 54 The transformation of KSU into the most dynamic railroad in the US. Art Detman reports.

CANADIAN CUSTODY:

DEMANDING CLIENTS, COMPETITIVE LANDSCAPE ..........................Page 58 Dave Simons writes on the outlook of one of the most efficient custody markets.

SECURITIES LENDING:

CAN BORROWERS BE TEMPTED BACK TO THE TABLE?

..............Page 62

Lynn Strongin Dodds reports on how regulatory uncertainty has dampened the industry.

ISLAMIC FUNDS:

GROWING SOPHISTICATION IN ISLAMIC FUND STRUCTURES ..Page 68 Francesca Carnevale reviews the evolution of the Islamic fund market.

TRADING:

THE POWER OF FOUR ..........................................................................................Page 87 Execution consulting and the real advantage for buy side clients.

EUROPEAN TRADING ROUNDTABLE:

AN EVOLVING UNIVERSE & THE IMPACT OF MIFID II

......................Page 77 The supposed benefits to buy side traders of MiFID I turned out to be a chimera as markets have coalesced and pan-European trading options diminish. Will MiFID II and an incoming raft of European regulation make things better?

DATA PAGES

DTCC Credit Default Swaps analysis ..............................................................................................Page 91 Fidessa Fragmentation Index ........................................................................................................................Page 92 BlackRock ETFs ....................................................................................................................................Page 94 Market Reports by FTSE Research................................................................................................................Page 96 Index Calendar ..................................................................................................................................................Page 100

M AY 2 0 1 1 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

MARKET LEADER

JUNK BONDS: THE SUSTAINED APPEAL OF HIGH-YIELD DEBT

Photograph © Cornelius20 / Dreamstime.com, supplied April 2011.

High returns from high-yield debt Junk is king, as high-yield bonds shape up to be the fixedincome draw of 2011 after record-breaking primary issuance in the opening quarter of the year. Despite a marked drop in yields from the heady levels of 2009, the market continues to offer investors historically high returns relative to other fixedincome assets while the underlying credit of the sector seems to grow stronger by the month. Andrew Cavenagh reports. HE FIRST QUARTER of this year broke new issuance records in both Europe and the US, confirming the current strength of demand for high-yield paper. American sub-investment-grade companies issued $102bn of bonds over the three months, while their European counterparts sold €11.2bn worth. European issuers then went one better with some €7.2bn issued in March alone, representing an all-time monthly record for the smaller market. In the US, there was also a significant increase in the volume of lower-rated debt (please see the chart on page 10), as more companies with single-B and triple-C ratings found that they were able to access the market at an acceptable cost—further evidence of how important yield ranks among investor

priorities at present with interest rates remaining at all-time lows. “We expect the trend to lower-rated issuance to continue, especially when the number of leveraged buyouts starts to increase,” says Hans Stoter, head of the highyield and investment-grade credit boutique at ING Investment Management in The Hague. Perhaps an even more impressive sign of investor confidence than the high levels and scope of primary activity so far this year has been the market’s muted reaction to the political upheavals in the Middle East and the natural and nuclear disasters in Japan during February and March. There was no dramatic widening of spreads and certainly no suggestion of any hiatus in issuance, such as the two-month shut-

down of the European high-yield market in the first half of last year when sovereign debt concerns in the eurozone reached their height. Investor appetite has not diminished despite the significant decline in average yields over the past two years (as secondary market prices have edged up towards par and higher in some cases). Yields were around 7% at the end of March, compared with the gains of 57.5% and 15.2% that the Bank of America Merrill Lynch US High Yield Master II Index registered in 2009 and 2010 respectively. Nevertheless, the sector is still widely seen to be offering strong relative value. One consideration here is that average spreads on high-yield bonds over comparable sovereign benchmarks remain slightly above their historical average, at around 500 basis points (bp). This is considerably higher than the prevailing differential in the lead-up to the financial crisis in 2007 (when the average spread was nearer to 250bp). Andrew Jessop, executive vice-president and high-yield portfolio manager at Pimco, says in a recent market update that the current spreads over sovereigns means the high-yield market (along with emerging-market debt) is currently offering what his firm considers to “safe spread” opportunities. These opportunities are defined as those sectors “most likely to withstand the vicissitudes of a wide range of possible economic scenarios”.

Dramatic improvement At the same time, the strength of highyield credits has improved considerably as companies have taken advantage of the burgeoning demand for their debt since 2009 to reduce their exposure to refinancing risk and short-term squeezes on liquidity—the most common immediate causes of corporate default. Over the past two years, noninvestment-grade corporations have issued almost $500bn of bonds. This is equivalent to almost 40% of the total outstanding debt in the global highyield markets, which has reduced the

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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MARKET LEADER

JUNK BONDS: THE SUSTAINED APPEAL OF HIGH-YIELD DEBT

volume of bonds due to mature between 2012 and 2014 by some $79bn. This mitigation of short-term refinancing risk has had a dramatic impact on default rates, which by the end of 2010 had come down to 2.4% from a high in 2008 of 15%. All the rating agencies are now forecasting that defaults will be even lower in 2011. Fitch, for example, is expecting a default rate of between just 1.5% and 2%, assuming that the US economy achieves GDP growth of 3.2% over the year. Furthermore, recovery rates have picked up significantly in instances where companies do default. Whereas in the first quarter of 2009 investors were likely to receive only about 20 cents back on the dollar, the figure had risen to around 60 cents in the first three months of this year. Underpinning the stronger and more secure financial position of most high-yield companies is the promising short-tomedium-term outlook for corporate earnings. Most companies reported improved results in the first quarter of 2011, with the quality of earnings picking up as demand has increased for a wide range of manufactured goods (as opposed to the inventory restocking that boosted sales initially).

Hans Stoter, head of the high yield and investment-grade credit boutique at ING Investment Management. “We expect that trend [to lower-rated issuance] to continue, especially when the number of leveraged buyouts starts to increase,” he says. Photograph kindly supplied by ING Investment Management, April 2011.

Macro forecasts The macro-economic forecasts that GDP will grow by an average of 1.5% across Europe and by 3% in the US are also favourable for speculative-grade debt. While the figures are obviously a lot lower than those for other regions of the world (notably Asia) these rates of growth will be sufficient to support increases in company earnings without inducing the sort of corporate spending sprees (whether on M&A, expansion of production capacity, share buybacks, or a combination of the three) that inevitably precede a rise in defaults. “Companies remain alert to the risks in their business and look to prefer to pay down debt rather than increase it,” explains Stoter at ING. “This de-risking plays into the hands of high-yield investors. There are still a lot of uncer-

Arnaud Tresca, head of high-yield capital markets at BNP Paribas in London. “Our guys are simply looking for sufficient cash flows to pay their interest and principal,” he says. Photograph kindly supplied by BNP Paribas, April 2011.

tainties out there, which have nothing really to do with high-yield markets, but which will keep management focused on the needs of their bondholders as well as those of their shareholders,” he adds.

Arnaud Tresca, head of high-yield capital markets at BNP Paribas in London, made the further point that high rates of GDP growth are not the boon to high-yield investors that they are to the equity markets.“Our guys are simply looking for sufficient cash flows to pay their interest and principal,” he says. On top of the strong current fundamentals of the market, there is also now clear evidence of a structural shift that will be to its long-term benefit, as impending new regulation for the banking sector (led by the Basel III capital accords) will make it increasingly more expensive for banks to lend to subinvestment-grade borrowers. One of the central planks of Basel III will substantially increase the levels of regulatory capital that banks have to assign to riskier assets, which will include such lending. This will not only oblige banks to increase the margins they charge on such debt to compensate for the higher (regulatory capital) cost but it is also likely to lead many to scale back such operations in order to devote more of their resources to less capital-intensive—and potentially more profitable—use. “Companies that have traditionally relied on the bank-loan market are now looking to refinance with a more balanced use of secure debt and highyield securities,” comments Jessop at Pimco. “This has certainly been true for the last 12 months in the US market and we are now starting to see the trend appear in Europe, where there was minimal high-yield bond issuance in 2007 and 2008, as most companies took advantage of the very lenient terms available in the loan market.” The shift will be potentially more significant in Europe, where speculative-grade companies have relied on the banking market to a much greater extent than their US counterparts, thereby ensuring that the European high-yield bond market has remained relatively small and illiquid by comparison. “Medium-size corporations are finding banks less willing to provide financing and are being forced

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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MARKET LEADER

JUNK BONDS: THE SUSTAINED APPEAL OF HIGH-YIELD DEBT

Dollar high-yield issuance by rating 2011 YTD

17% CCC

31% BB

52% B

2010

13% CCC

39% BB

48% B

important to remember that there were “no additional returns without additional risks” and those current global developments—such as the eurozone crisis, the political unrest in the Middle East, and the problems in Japan—certainly presented real risks for highyield investors. He points out, for example, that the damage to Japan’s industrial infrastructure could yet have a significant impact on manufacturers elsewhere in the world. “All those sectors that rely on Japanese components could face disruption to their production,” he says.

Source: Creditsights, Thomson Financial, Dealogic. Supplied April 2011.

European market weaknesses to turn to the bond markets as an alternative source of funding,” confirms David Watts, senior European fixedincome analyst at the international research firm CreditSights. Virgin Media is a good example. In early 2009, the company had about £4bn of bank debt on its balance sheet. Since then it has cut this to just under £1bn through a series of bond issues. In the wake of its latest £958m high-yield issue in February, all three rating agencies upgraded the company’s senior issuer rating back to the lowest investment-grade level. Many more companies with the ability to launch bond issues of €200m or more are following Virgin’s lead (20% of the primary market in 2010 came from first-time issuers), and the trend seems certain to enlarge the European high-yield market on permanent basis and enhance its depth and liquidity. While it will clearly not match the size of the US market for the foreseeable future, most banking analysts believe the total volume of outstanding European high-yield debt could almost double from the €110bn that was in place at the end of 2009 to around €200bn by 2013. The third week in April saw an unprecedented 11 deals launched in Europe, almost half of them from firsttime issuers, and—despite the obvious crowding of the market—all were oversubscribed. Tresca at BNP Paribas

Andrew Jessop, executive vice-president and high-yield portfolio manager at Pimco. “Companies that have traditionally relied on the bank-loan market are now looking to refinance with a more balanced use of secure debt and high-yield securities,” he says. Photograph kindly supplied by Pimco, April 2011.

says the annual European primary market was now on course to break through the €50bn mark for the first time, as funds kept pouring into the sector. “The inflows that we’ve seen since the beginning of the year will continue,” he maintains. Despite all the positive signals coming out of high yield, it is not a market that offers risk-free investment. Stoter at ING observed that it was

Macro-economic developments such as unexpectedly large hikes in interest rates, slower-than-expected growth in employment and, in particular, a sustained surge in fuel prices could also swiftly undermine economic recovery in Europe and the US. In its latest assessment of the high-yield sector in mid-March, Fitch warned that in these circumstances defaults could rapidly rise to 5%. “The price of oil is clearly the leading concern,”the agency added. “It is well documented that in 2008 consumer spending collapsed, when oil and subsequently gas prices soared.” Rising fuel costs will immediately hit companies in the transport sector and other energy-intensive industries such as bulk chemicals. Costs will also impact on a lot more who will face higher prices for materials, such as packaging business. It is highly unlikely that such companies will be able to pass on the increase in their overheads immediately, to the detriment of cash flows and profitability. Investors are tailoring their strategies to take account of these concerns. John Stopford, head of global fixed income at Investec Asset Management in London, says he was currently wary of retailers’ debt and focusing more on that of capital goods manufacturers, telecoms companies, commodity producers and their related industries. “The more consumer-oriented parts of the market are vulnerable to a squeeze in incomes,” he explains. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

SPOTLIGHT

Private equity’s steady fightback PE firms that take a back seat do better than proactive PE managers THE GLOBAL MANAGEMENT consulting firm AT Kearney says in its latest study of the European private equity (PE) market that many private equity portfolios are staging a postrecession comeback and are outperforming non-PE-owned industry peers. The report analyses PE transactions in four core European markets, the United Kingdom, DACH (Germany, Austria & Switzerland), France and the Nordic countries, and illustrates the meteoric rise and fall of the industry in recent years, basing its results on the financial performance of more than 100 European PE portfolios versus their public-industry peers. The research has identified the rise of two distinct governance models for PE firms which AT Kearney has labelled “supervisor” and “operator” models. Supervisors are deemed to exhibit trust in the management of the firms in which they invest, and tend to be less involved in tactical decision making. Many of these funds, particularly traditional houses with banking roots, work actively with management at board level. In some jurisdictions, tax considerations

might favour this governance model, which maintains the status of wealthadministrating vehicles. Operators on the other hand are more proactive and add their own dedicated teams to review company strategy and manage operations. Operational teams comprise three to seven professionals for an average European portfolio. Contrary to accepted wisdom, PE firms that take on a supervisory role—giving the deal partner responsibility from acquisition through exit—deliver more value by balancing growth and profitability as this report shows. Success factors such as cash management and managerial discipline are transferable into other industries for those willing to learn from the PE owners. Philip Dunne, partner in the private equity practice at AT Kearney, however, says: “Our study shows that private equity works—period. They’ve taken a PR hit in the recession but the numbers don’t lie—private equity ownership is a successful way of running companies. The PE houses encourage managers to behave like owners, make capital work hard, create an

adaptable investment plan and become an active shareholder.“ The results of the study are telling. Since 2006, PE portfolio companies have outperformed their publicindustry peers on key financial metrics. This has been seen primarily in slow growth industries, such as chemicals (0.3% growth), large consumer goods and retail (4.5%), manufacturing (2.6%) and business services (5.4%). PE portfolios have a higher share of value growers (31% compared to 25%) and a lower proportion than the peer group of underperformers (20% versus 28% in the peer group). Even during 2009 average decline in revenues for PE was 3.8% compared to 9.1% for peers. Michael Ostroumov, one of the authors of the study and a principle in the private equity practice, explains: “At a time when the entire global finance industry is under scrutiny, this study shows that the PE model drives value well beyond wealth creation for the job owners. PE firms rejuvenate portfolio companies, create jobs and open new markets that benefit customers, employees, supplies and the communities in which they operate.” I

Supercycle opens trade corridors Treasury function significantly impacted by rapid growth in emerging markets THE SO-CALLED global supercycle will impact corporate treasuries in a number of ways, as fast growing developing market trade corridors require supply chains to extend into new markets, says Standard Chartered Bank. The growth in these trade corridors is a well established trend but the rate of growth is escalating and over the next 20 years they will be instrumental in driving overall

global trade growth in the same period, says the bank. Developing market corridors such as China-Africa, China-Latin America (LatAm) or Middle East and North Africa (MENA) and India will grow at 13% to 18% per annum, while developing-to-developed market corridors, such as China-US, will grow at 13% a year. However, the EU-US trade corridor is expected to show the fastest decline in global importance from 2010 to 2030. George Nast, global head, product management, transaction banking, Standard Chartered, says: “The

change in the relative importance of the various regions is striking. In 2008, the US and EU were at the centre of the most important trade corridors, [but] by 2030, developing market trade will represent 40% of global trade versus 18% today and only 7% in 1990.” The supercycle will invariably present challenges for corporate treasury strategy. Traditional western locations of treasury functions such as London and New York will almost certainly start to cede precedence to developed Asian locations including Singapore and Hong Kong. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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IN THE MARKETS

ESFS: ONE STEP TOO FAR IN FINANCIAL OVERSIGHT?

Since the onset of the financial crisis in 2008, the European Union has pursued an agenda of reform for the European financial markets, including proposals to curb the use of short selling and credit default swaps, the creation of a framework for alternative funds through the passage of the Alternative Investment Fund Managers’ (AIFM) Directive and proposals to restructure the remuneration of bankers and asset managers alike. While these topics have grabbed the headlines, it is a much less publicised regulatory change that may end up having the biggest long-term impact. Sean Tuffy, vice president, Brown Brothers Harriman, reviews the impact of the European System of Financial Supervisors (ESFS) initiative on the financial markets.

Photograph © Drizzd / Dreamstime.com, supplied April 2011.

Harmonising EU financial regulation T THE BEGINNING of this year, the European Union (EU) implemented a radical overhaul of its financial regulatory framework. The new framework was created to address perceived flaws in the EU regulations that were credited with contributing to, and intensifying, the financial crisis. Two key flaws were identified. First, there was a lack of

coordination between the existing EU agencies and national regulators, which created a gap in the oversight of systemic issues at the EU level. Second, there was an inconsistent approach to the application of EU regulation between various EU member states. The European System of Financial Supervisors (ESFS) was established to address these flaws.

The objective of the ESFS is to ensure harmonisation and consistency in the application of financial regulation across the EU. The introduction of the ESFS represents a fundamental shift in the approach to financial regulation in the EU, with authority transferring from national regulators to EU authorities. The new framework introduces a host of new organisations, and corresponding abbreviations, to the EU lexicon. The first new organisation is the European Systemic Risk Board (ESRB), which is based in Frankfurt. The ESRB is responsible for the macro-prudential oversight of the EU financial system and providing an early warning of any developing system-wide risks. The ESRB does not have any direct legislative or supervisory powers. Instead, it will make recommendations to the other bodies of the ESFS on how to deal with developing systemic risks. In addition to the ESRB, the ESFS created three new European Supervisory Authorities (ESAs). The ESAs coordinate the work of the national supervisors in the areas of banking, pensions and financial markets. The goal of the coordination is to create a harmonised set of rules across the EU and to reduce the opportunity of regulatory arbitrage. The three new ESAs are: the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA). The EBA is based in London and is responsible for the banking sector. The EBA is the successor of the Committee of European Banking Supervisors. The EIOPA is based in Frankfurt and is responsible for the insurance and occu-

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

IN THE MARKETS

ESFS: ONE STEP TOO FAR IN FINANCIAL OVERSIGHT?

pational pensions sector. It is the successor group of the Committee of European Insurance and Occupational Pensions Supervisors. The ESMA is based in Paris and is responsible for the securities sector and other areas such as credit rating agencies and alternative investment fund managers. The ESMA is the successor group of the Committee of European Securities Regulators. When the ESFS was first drafted, it was envisioned that all the ESAs would be based in Frankfurt. However, in order to get the ESFS passed, ultimately the ESAs were located in various EU cities. The geographic dislocation of the ESAs creates challenges for the overall ESFS, ensuring that all the ESAs behave as European bodies and are not, for instance, unduly influenced by any member state. The fact that member states insisted that the location of the ESAs not be in Frankfurt suggests that this is not a small concern. The actions of the ESAs will be closely monitored by the market, to see if there is any national bias. The ESAs are responsible for drafting specific rules and guidelines for the national regulatory authorities to follow when they implement EU legislation. The ESAs are also responsible for ensuring that the rules are being enforced and consistently applied by national regulatory authorities. In addition, the ESAs are empowered to act as arbitrators in any dispute between national regulators in relation to interpretation of EU law. Further, ESAs have emergency powers, which enable them to implement bans and restrictions on financial activity where developments seriously jeopardise the functioning of the financial markets.

The extensive reach of ESMA Of all the ESAs, it is the ESMA that is likely to be both the most influential and the most controversial. The reason for this is that its remit is intentionally wide and includes securities, markets and credit rating agencies. It is possible, if not likely, that the ESMA’s remit will be expanded to include clearing houses and

The ESMA’s enhanced powers mean that it can act in ways that have traditionally been only available to national regulators. In fact, in specific circumstances, the ESMA is able to supersede national regulators. fund managers. In addition, the ESMA has also been conferred with enhanced powers and, unlike the other ESAs, it can introduce its own intervening measures. The ESMA can do this if it deems that intervention is necessary to address a threat to the orderly functioning, stability or integrity of the financial markets. The ESMA’s enhanced powers mean that it can act in ways that have traditionally been only available to national regulators. In fact, in specific circumstances, the ESMA is able to supersede national regulators. It is permitted to take such action only when there are cross-border implications, and if the relevant national regulators have not taken sufficient measures to address the issue. No one would argue that the harmonisation of financial regulation in the EU is not a welcome objective. What remains to be seen is how that objective is achieved. If properly implemented, the ESAs should become independent and objective bodies that are free from political pressures. This would be a welcome development. However, there is a risk that the opposite will be true and that the ESAs will become polarising bodies that are seen to be imposing political will upon the marketplace. The new ESFS does not suffer from a lack of ambition. It is an extensive overhaul of the EU financial supervisory framework, the scope of which is unprecedented, and fundamentally alters the landscape. At its core, the ESFS represents the first step toward creating pan-EU regulatory governance, which may diminish the role of national regulators. Though the ESFS is a departure from the past financial regulatory framework, it is not without precedent. One just has to look to the European Monetary Union (EMU) and the European System of Central Banks (ESCB) more specifically,

the Eurosystem. With the creation of the euro, participating member states’central banks ceded monetary policy to the ECB. In effect, the ECB has become the lead central bank for those within in the EMU, with the local central banks serving in a reduced capacity.

Growing pains Given the scope of the change, there are sure to be growing pains as the balance of power between the EU and national regulators is recalibrated. In dealing with this recalibration, industry participants will need to adjust to two key points. First, that regulatory change will not solely be the prerogative of national regulators; going forward, the broader European impact of all regulation must be considered. Second, that the guidance from the ESAs, on implementing measures for specific legislation, will not be open to interpretation. This is a marked difference from before, when the guidance from groups such as CESR could be interpreted differently or ignored by local regulators. In short, to borrow a phrase, when it comes to the ESAs the “buck stops here”. For the ESFS, there are plenty of challenges. In particular, the new ESAs will need to convince the market that they can act free of political pressure and are not beholden to one, or a group of, EU member states. The ESFS will need to ensure that it can overcome the geographic distribution of the ESAs and deliver a pan-EU framework. Finally, the EU needs to demonstrate that the ESFS has sufficient resources to fulfill its responsibilities effectively. Overall, the ESFS goal of ensuring harmonisation of financial regulation in the EU is welcome. However, the ESFS will be judged a success or failure based on its execution of the goals it is trying to achieve. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

IN THE MARKETS

OTC DERIVATIVES: GROPING IN THE DARK?

Daylight is coming to the OTC derivatives, but nobody knows how brightly the sun will shine. The demise of Lehman Brothers and the near death of AIG exposed the critical risk of bilateral contracts: that the failure of a major counterparty could wreak havoc throughout the financial system and the economy at large. Legislators around the globe are determined to prevent any recurrence. Neil O’Hara reports.

Photograph © Cybrain / Dreamstime.com, supplied April 2011.

Central clearing: proving its worth in a new era T BOTTOM, REGULATORS have three primary objectives: data capture, mitigation of counterparty risk through central clearing, and a transparent trading environment that promotes reliable price discovery. Never again do regulators want to confront a lack of information about trades in over-thecounter (OTC) derivatives so acute that they cannot even estimate the extent of systemic risks, one of their greatest frustrations in 2008. Central clearing has proved its worth time and again in preventing the failure of a single entity from destroying confidence in financial markets, but clearing houses need good price data on which to base their margin requirements—hence the mandate that if a derivative contract is eligible for clearing, it must be traded on what the Dodd-Frank Act calls a “swaps execution facility”. Central clearing solves the data capture problem, of course: by definition, a clearing house has a record of every trade processed through its

system. Nothing about OTC derivative contracts makes them ineligible per se for clearing, either. The SwapClear division of LCH.Clearnet, for instance, has been clearing interest rate swaps since 1999 and already handles an estimated 85% of dealer-to-dealer plain vanilla interest rate swap trades. ICE Trust in the United States and ICE Clear Europe began clearing selected credit default swaps in 2009, too, although to date the business is heavily concentrated on index trades rather than single names. “It is not a question of what should be cleared, but what can be cleared,” says Kevin McPartland, a principal at TABB Group, a New York and Londonbased financial services research and consulting firm. “Valuation is important. The clearing house protects itself by setting the margin and it can only do that if it understands the value.” Derivatives contracts do not have to be standardised to be eligible for clearing, however. For example, a $500m five-year dollar-denominated interest rate swap entered into today is not fun-

gible with a contract on otherwise identical terms dated yesterday or a month ago. They can both be cleared because everything is priced off a widely available benchmark yield curve with minor adjustments to reflect the different contract dates. Credit default swaps pricing is more complex: it incorporates the probability of default, for which no direct measure exists. Contracts based on the CDX or iTraxx credit default swaps indices trade in sufficient volume to generate prices a clearing house can rely on for margin calculations. Arbitrage activity between the indices and the single name components allows at least some of the latter to be cleared as well, but liquidity in names that are not in the indices is seldom adequate to support clearing. “We had a severe test of the interest rate swaps clearing through 2008 with SwapClear, but the credit default swaps models are all very new,” says McPartland. “It is in the best interests of the clearing houses to be as conservative as possible in the less liquid single names.” Although the Dodd-Frank Act allows clearing houses to choose which derivatives contracts they will clear, some observers have proposed that regulators should make that decision instead. The clearing houses oppose the idea, arguing

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

IN THE MARKETS

OTC DERIVATIVES: GROPING IN THE DARK?

Jesús Benito, managing director of Regis-TR. “If the final regulations require clearing houses to report trades through the trade repositories, it will help our business,” he says. Photograph kindly supplied by Regis-TR, April 2011.

Jeffrey Hogan, head of business development at BGC. “The post-trade reporting will also affect dealers’ desire to show tight prices because they know they will get run over as soon as the trade is done,”he says. Photograph kindly supplied by BGC, April 2011.

that confidence in the central counterparty guarantee could erode if they are forced to accept instruments that do not meet their customary standards. The regulators will not take the responsibility lightly though. The Federal Reserve and an industry working group have conducted a detailed study of liquidity in both the credit default swaps indices and single names based on data at the DTCC’s credit default swaps trade information warehouse. The proposed regulations are likely to generate new opportunities for various service providers, including Regis-TR, a Madrid-based joint venture between Iberclear and Clearstream, which launched a derivatives trade repository in December 2010. The project was conceived two years earlier to provide the equivalent of a central securities depository for the OTC derivatives market. Jesús Benito, managing director of Regis-TR, believes its services will be

particularly attractive to non-financial counterparties because no other provider is addressing their needs. The repository is open to dealers and the buy side as well, and will offer registration, matching and reconciliation services to all. Initially, Regis-TR will record contract details only for interest rate swaps, but it plans to extend coverage to foreign exchange, commodities and equity swaps later this year. Credit default swaps will follow in 2012, when Regis-TR will add valuation and collateral management to its product line. “We will offer services that automate what back offices now do manually,” says Benito. “If the final regulations require clearing houses to report trades through the trade repositories, it will help our business.”

New burden on the back office The switch to clearing swaps will put a heavy burden on back offices in any

case. Ray Kahn, head of OTC clearing at Barclays Capital in New York, argues that eligibility for clearing is a sideshow relative to the operational challenge of calculating daily margin requirements for large swaps portfolios. Unlike most listed products, which have a single price point, swaps have multiple inputs to the pricing and margin calculation. Processing all that information for a portfolio that may have thousands of swaps in multiple currencies is a complex task, and the clearing house and clearing dealers must account for wholly or partially offsetting positions—long a five-year swap and short a ten-year, for example—before they come up with a final margin call for the day. “It is the biggest operational infrastructure challenge the industry has faced in many years,” says Kahn. Margin requirements for particular types of contract could have a significant impact on their liquidity. The less reliable the price, the higher the clearing house will set the margin, which could choke off trading altogether in some cases. Market participants are keen to see netting across products as well; they don’t want to put up margin on both sides of offsetting trades in futures and swaps, for example.

No move to standardise swaps Kahn says regulators have backed away from efforts to standardise swaps and make them more like futures contracts. Major buy side players including BlackRock, DE Shaw and PIMCO fear the loss of flexibility in standardised contracts would hobble liquidity in the swaps market. End-users could no longer tailor hedges to their precise needs and would be exposed to either market risk between the nearest contract expiration date and the date the hedged transaction takes place or basis risk when they unwind the hedge. Past efforts by derivatives exchanges to offer listed instruments that compete with swaps have largely failed because users were unwilling to accept the necessary constraints. The swaps market as it exists today bears no relation to the way futures

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

bu Re F y g R 15 sid istra EE fo % e t i r n D at on on is ten fo 7-8 June 2011 bu c o de r y un es The Westin Tokyo, Japan si t de www.tradetechjapan.com Leveraging Japanese fragmentation and trading system upgrades to maximize domestic trading opportunities

...the one with the buy side The entire team at WBR express our sincere sympathy and support for the people of Japan in the aftermath of the earthquake and tsunami. TradeTech Japan 2011 will still be going ahead and will be contributing a portion of the event’s revenue to the recovery and rebuilding operations in Japan. The content will inevitably adapt to cover the new issues thrown up by the market turmoil, but will still bring together the leading minds in Japanese equity trading to discuss the new market conditions and trading opportunities and challenges.

KEY SPEAKERS INCLUDE: DOMESTIC BUY SIDE TRADERS

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HIGHLIGHTS FOR 2011

Sadakazu Osaki Head of Research Center for Knowledge Exchange & Creation NOMURA RESEARCH INSTITUTE Principal Partner

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IN THE MARKETS

OTC DERIVATIVES: GROPING IN THE DARK?

trade anyway. Transactions are relatively infrequent and in sizes that dwarf the futures markets—even a large futures trade is smaller than most standard interest rate swaps, particularly for users like GECC or Ford Motor Credit that swap out entire portfolios of loans. Kahn points out that most interest rate swaps stay on the books for months or even years, whereas futures trade in small sizes at a frenetic pace. Breaking up big notional trades into thousands of smaller ones executed on an electronic platform might open up the market to high-frequency traders, but it is not clear whether that will lead to greater overall liquidity. “If someone is hedging, they need someone to take and hold the other side,” says Kahn. High-frequency trading shops prefer to go home flat at the end of every day—which means they must lay off any position they take to someone else. At best, they might facilitate some swaps trades intraday, but in a market based on longer holding periods, such short-term intermediation, adds little value—the fleeting liquidity serves no useful purpose except to those who provide it. The Dodd-Frank Act imposed a deadline of July 15th this year for regulators to publish final rules on OTC derivatives, but nobody expects the work to be completed by that date. Jeffrey Hogan, head of business development at BGC, one of the five large interdealer brokers, applauds the way regulators have consulted market participants as they develop the new rules. He is optimistic about the final outcome, too. “In the US, it is probable that the mandated clearing rules won’t go beyond US dollar interest rate swaps, CDX indices and related single names this year,” Hogan says. “The authorities are proceeding with care rather than rushing to meet unreasonable deadlines.” Once the question of what can be cleared is settled, attention will turn to what constitutes a swaps execution facility (SEF) and how trades will be executed. In the US, jurisdiction is split between the Commodities Futures

Trading Commission (CFTC), which regulates interest rate swaps, FX swaps and credit default swaps indices, and the Securities and Exchange Commission (SEC), which regulates single name credit default swaps and equity derivatives. Preliminary proposals that specified that an SEF must either have a central order book or use the request for quote (RFQ) model caused such an uproar that the regulators backpedalled and now seem willing to give SEFs more flexibility in how their markets operate. The two agencies have published proposals that differ in important respects, however, including how many quotes a market participant must seek before executing within an RFQ framework: the CFTC proposed five, while the SEC settled for at least one. Market participants argue that telegraphing a large trade to five dealers would adversely affect the execution price because the four losers would know a competitor had a sizable position to hedge and could trade against the winner.

Possible information leakage Users are also opposed to a proposal that would require dealers to flash a non-block order for 15 seconds before it is executed. Again, the information leakage could discourage dealers from showing their best price if the whole world knows about the trade. The definition of a block trade has not yet been resolved, but if it were set too high— perhaps $250m for interest rate swaps—dealers might be reluctant to bid on trades that fell just below the threshold. Proposed rules also require dealers to report block trades within 15 minutes of execution, a relatively short time if the block represents a significant proportion of average daily volume. “Both end users and dealers find the proposed pre-trade transparency unnecessary,” says Hogan. “The posttrade reporting will also affect dealers’ desire to show tight prices because they know they will get run over as soon as the trade is done.” Interdealer brokers are well-placed to establish SEFs, which are a natural

extension of their existing businesses. BGC launched an electronic trading platform for euro-denominated interest rate swaps last September even though the regulators had not—and still have not—said what qualifies as a SEF. “We did that irrespective of the legislation,” says Hogan. “We have about 200 businesses and 75 of them have electronic trading capability.” BGC and its competitors have every incentive to set up SEFs, too. In a bilateral trading environment, interdealer brokers offer dealers a way to lay off risk without disclosing their position to competitors. For example, Deutsche Bank won’t sell a swap directly to, say, Goldman Sachs, but it is happy to trade with BGC and let the broker find the other side. In a cleared environment, anonymity is guaranteed and the dealers will have no need for a broker to intermediate—but they will have to trade on an SEF. How many SEFs will gain traction in the market remains to be seen. Besides the interdealer brokers, the dealers may open up their internal crossing facilities to others in order to qualify as SEFs, which must accept bids and offers from multiple participants. Newly-formed independent entities such as Jarvis and Eris are gunning for a piece of the business, too, although Hogan is sceptical that significant liquidity will move to these venues. “We feel that there will be fewer SEFs than originally envisioned, and the core of the roster will be the existing major interdealer brokers,” he says. “Scale is critical. Companies that have a single product in a single jurisdiction will find it hard to absorb the costs we can allocate over many products in multiple jurisdictions.” The devil is in the details, however, and lawmakers punted much of that work to regulators, who have yet to finalise the new derivatives trading regime. Meanwhile, industry participants are racing to adapt to rules that don’t yet exist even as they lobby against provisions that might impair a market vital to modern risk management.I

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Diversification Based Investing: A New Strategy for Global Equity Market Investment A Q&A Session with James Norman, President, QS Investors, LLC FTSE and QS Investors recently launched the FTSE Diversification Based Investing Index Series. Can you explain the concept behind Diversification Based Investing? Diversification Based Investing (DBI) seeks to apply the principles of portfolio diversification across asset classes to international equity markets. Our research has shown that investors often become overly excited by the growth opportunities of countries, regions and industries, and allocate too much capital to them leading to bubbles, meanwhile under-valuing other parts of the market. Over-allocations – or bubbles – include Japanese stocks in the 1980s, technology stocks in the 1990s and financial stocks in the 2000s. Under-allocations include energy and healthcare stocks in the last five years.

What process do you use to address these sentiment driven bubbles? We believe that country, currency and industry are key drivers of risk and return in global and international equity indexes. These drivers are subject to momentum and sentiment effects, which lead to concentration risks that build and collapse. We seek to mitigate concentration risk by building groups of countries and industries that have been highly correlated to each other over the last five years using Principal Components Analysis (PCA). We then equal weigh these risk “clusters” or themes in the market. Thus, we tend to overweight a bubble when it is building and underweight it once it has become large and more highly correlated to other parts of the market. This creates a diversified portfolio across countries and sectors.

Is there any academic foundation for your approach? The conceptual basis for DBI is supported by a growing body of research. Academics such as Paul Samuelson, Jeeman Jung and Robert Shiller, have argued that although equity markets show considerable efficiency at the stock level – micro efficiency – that they are inefficient at the macro level, as evidenced by stock market booms and busts1. This is because changes in country or industry growth rates are hard to forecast. We believe national economic and industry growth are driven by monetary, fiscal and regulatory policies, and their affects are hard to forecast across countries and industries. This leads to a large potential for investors to become overly optimistic – or pessimistic – about country or industry earnings prospects. We believe that this is why it is so hard to market time and why a diversification based approach makes so much sense.

How has the FTSE DBI Index Series performed to date? The FTSE DBI Indices have consistently outperformed their market-cap weighted equivalents over the last 10 years as outlined below. 1M(%)

3M(%)

6M(%)

YTD(%)

12M(%)

3YR(%)

5YR(%)

10YR(%)

FTSE DBI Developed Index

-0.68

4.93

10.90

4.93

14.43

-2.81

26.79

122.77

FTSE Developed Index

-0.62

4.96

14.25

4.96

14.04

1.68

15.45

62.79

FTSE DBI Developed ex Japan Index

0.99

6.78

12.13

6.78

15.08

-0.06

35.99

136.28

FTSE Developed ex Japan Index

0.24

5.96

15.00

5.96

15.38

2.99

20.47

68.65

FTSE DBI Developed ex US Index

-0.46

4.81

10.86

4.81

14.74

9.63

45.14

169.92

FTSE Developed ex US Index

-1.23

4.20

11.69

4.20

12.89

-3.78

16.10

93.88

SOURCE: FTSE Group, data as at 31 March, 2011 Past performance is not a guarantee of future results. Performance is shown gross of fees and does not reflect investment advisory or other fees. Had such fees been deducted, returns would have been lower.

For further information about the FTSE Diversification Based Investing Index Series, please visit: www.ftse.com/Indices/FTSE_Diversification_Based_Investing_Index_Series 1 “Samuelson’s Dictum and The Stock Market”, Jung and Shiller, 2006

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IN THE MARKETS

ECB RATE RISE: PIIG NATIONS COULD FEEL THE HEAT

Mixed views in the rate debate

Photograph © Bilderbaron / Dreamstime.com, supplied April 2011.

On April 7th this year the European Central Bank announced its first interest rate rise since the 2008 collapse of Lehman Brothers. The increase, 25 basis points (bps) to 1.25%, had been anticipated for some months, but after all these years of stagnant rates, it felt like a transformational moment. The driver was a need to keep inflation in check. The challenge was to ensure that it catered to the needs of Europe’s two different strands of recovery—the fast growth exhibited best by Germany and that exhibited by Portugal, Ireland, Greece and Spain. David Craik reports on the implications. ERMANY CERTAINLY WANTED a rise in interest rates to combat inflation but what of countries such as Portugal, Ireland and Greece and their European bailouts, so fresh in the case of Portugal, only 24 hours prior to the ECB’s decision? What would an increase in the rate of borrowing do to them and their hopes of escaping from their respective economic and social crises? ECB President Jean-Claude Trichet notes: “The stance of monetary policy remains accommodative and thereby continues to lend considerable support to economic activity and job creation. We will continue to monitor very closely all developments with respect to upside risks to price stability.” The language used by Trichet hints at possible future rises; though he stresses that the move was an indication that the central bank understood the needs of those states in crisis and concerns that further hikes could choke off any

hope of a recovery in these countries. Gernot Griebling of Landesbank Baden-Wurttemberg’s macro research team for one thinks the ECB decision was correct.“The ECB is closely monitoring the inflation expectations derived from inflation-linked swaps. These inflation expectations told us in the days before the rate hike that markets were anticipating an annual inflation rate of 2.5% in the next five years. So the ECB had to conclude that the markets doubted it would meet its goal for price stability. With respect to its own creditworthiness, the ECB couldn’t tolerate this.” Even so, Griebling sees small need for the ECB to consider Europe’s differing growth rates. “The disparity between growth in Germany and the peripheral countries won’t narrow in the near-term future; but this is not the ECB’s responsibility,” he says. “The countries with weak economic growth have to implement structural reforms

to strengthen innovation and economic growth. At the same time they have to restore their competitiveness which has been lost due to strong increases in unit labour costs, particularly in comparison to Germany, since the start of the European Monetary Union.” However, Dan Morris, market strategist with JP Morgan, takes a different tack and questions the sense behind the rise. “You have over-heated European economies with even Germany slowing. European core inflation is 1.1%, which is well below the ECB’s target. So it doesn’t make sense to raise them from that perspective,”he says. “It doesn’t make sense to raise rates, which is a monetary response, to deal with a non-monetary cause of inflation, which is oil.” Morris believes the real reason behind the increase has nothing to do with economics. “The ECB has made more than a few mistakes during the sovereign debt crisis. This may be a way of trying to re-establish credibility with the markets to show that they are still on the ball, aggressive and not afraid to take action, but that doesn’t mean that you take action for the sake of it,” he states.“On a financial basis it is hard to see why the rise happened.” Morris says Germany will cope with the rise but at the periphery of Europe it may be a different story. “It goes back to the fundamental dilemma of the euro as a whole of having one currency, one interest rate and one bank. The rise may not matter too much for the governments directly because they don’t need to raise debt but it is going to matter to the banks and the consumer. It’s the last thing they need,” he states. Eric Chaney, chief economist at AXA Group, also believes the rate rise was as much a statement of intent as anything else. “The ECB wanted to make clear that despite its forced involvement in the euro debt crisis, it remains firmly committed to its first mission, which is price stability,” he says. “It is also a warning to any union tempted to raise wage demands on the heels of German wage increases.”

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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IN THE MARKETS

ECB RATE RISE: PIIG NATIONS COULD FEEL THE HEAT

He also praises the ECB for leading the world in returning interest rates to a more normal level. “The return of global inflation is a serious threat for the global economic recovery. Coordinated action from key central banks such as the Fed, the Peoples Bank of China (PBoC) and the ECB would be a first best. Since neither the PBoC nor the Fed are ready to act, a move by ECB is a second best. If it has an impact on the price of commodities, it would prove positive including the euro area. If not then it would be more harmful than useful.”

Another hike in July? In a Reuters poll taken after the rate increase, almost half of 62 economists surveyed said the ECB wouldn’t raise rates again until at least July. Then, they predicted, there would be another 25 basis point (bps) increase to 1.50%. Chaney agrees. He sees the 25bp hike coming either then or September,“followed by several months of stable rates”. Griebling goes further, forecasting a 2% rate by the start of 2012. However, Morris is cautious, even mentioning the possibility of retrenchment. “The banks have to fund themselves on a regular basis but can they do so at reasonable rates? There is a lot of dodgy government debt on their books. If there is anxiety in the markets over the banks then the ECB could backtrack,” he argues. “They want to make incremental increases but I don’t think it will go that neatly for them.” If that is the scenario for Europe, what about the rest of the world, particularly the UK and the US? The UK perfectly sums up the dilemma faced by decision makers when setting interest rates in this shakily post-recession climate. On the same day the ECB lifted its rates, the Bank of England held its rate at the record low of 0.5% for the 25th month in a row despite inflation being on a seemingly upward curve of 4.4%. The bank is nervous about an interest rate rise choking the UK’s recovery and sending the country back into recession. Consumer confidence, as seen by

plunging retail sales figures, is nervous enough, it argues, without the further constraints of higher rates. The bank’s stance came under further pressure only a day later when figures from the Office for National Statistics (ONS) revealed that the surging cost of oil had sent factory-gate prices, the amount manufacturers charge for their products, up by 0.9% to 5.4% in March, the highest figure since the start of the recession. This worse-than-forecast jump raised fears that inflation would increase further perhaps to 5%. At this level the Bank of England would surely have to act. However, then followed more ONS figures which stated that the Consumer Prices Index (CPI) measure of inflation had fallen from 4.4% to 4%, driven by supermarkets cutting prices of food and drink. The pressure on the Bank of England was off, at least temporarily, but City watchers remain adamant that rates will go up to 1% by the end of this year and 2% in 2012. Morris states: “Even at 4%, inflation is too high and the Bank of England should have been the first to raise [rates] in response but didn’t. What the bank will particularly look at are the next GDP figures. If they are strong then we may see some changes to the rate.”

The lag in the US The US is predicted to lag on rate raising until at least the fourth quarter of this year or even early next year. says Griebling: “Improved labour market conditions together with rising inflation pressures will pave the way for these hikes, but if headline inflation should accelerate towards 4% then the Fed will raise sooner.” Griebling stresses that it is difficult to seriously evaluate the direction for global interest rates over the next five years. There are just too many variables. “We can’t rule out that in the course of an intensifying government debt crisis we see a number of state defaults which in turn could lead to a credit crunch and deflationary pressures. Also, the opposite scenario might

happen with central banks being too hesitant to reduce monetary accommodation and letting inflation rates jump to levels of 7% to 10%,” he says. So what will the effect of rates rises have on the markets and investor assets? The market reaction to the ECB rise was sanguine with little movement in the FTSE 100 index. Morris says: “Initially equity markets don’t like rate rises. Equities get a little bit weaker but eventually they adjust to them as long as they feel that the central bank is on the ball and keeping inflation under control. That means company growth is fine and earnings growth is fine. However it is different in Europe. There is limited economic growth there; it isn’t the factor driving higher inflation. Rate rises will hurt the relative performance of European equities.“ The rise also helps the strength of the euro against the pound and dollar, but given the economic problems within the eurozone, Morris asks: “Is it getting ahead of itself?” Griebling says bond yields of the core European AAA-rated countries such as Germany, Netherlands, France and Austria will suffer from further hikes and are even more at risk if the eurozone “moves further in the direction of a transfer union”. It is a fluid picture but it appears that the low interest era is in its death throes. It is a trend that Morris welcomes.“You like low rates because you think they help stimulate the economy but you distort credit allocation and create problems somewhere else,” he says.“You can’t see it but you just have a hunch something is going wrong, perhaps with inflated asset prices. Companies looking to invest and allocating capital want an accurate price and likely return. If you have artificially depressed short-term rates you won’t come to the right decision.“ The moral is, enjoy low interest rates while you can. Chaney says only “exceptional times” such as another global liquidity crisis will bring back low interest rates. “This is a very remote possibility, for the time being,” he states. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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DEBT REPORT

SOVEREIGN DEBT CRISIS: STRAINING THE LEASH ON THE EUROZONE

Photograph © Buccaneer / Dreamstime.com, supplied April 2011.

Nearing the tipping point The sovereign debt crisis thrust itself firmly back into the global spotlight in April as Portugal’s request for a European Union (EU) bailout in the first week of the month—despite repeated earlier assurances that such a move would not be necessary— rekindled fears that the eurozone may fall apart. Then, barely two weeks later, Standard & Poor’s warned that the US government could lose its triple-A rating within two years unless Republicans and Democrats agree a firm plan of action to address the ballooning debt of the world’s largest economy. Andrew Cavenagh reports on the potential for mayhem. TANDARD & POOR’S decision to place the US government’s rating on “negative” outlook predictably produced a dramatic knee-jerk response, as US share prices dropped immediately on the news and Treasury yields rose. While no one should underestimate the immense implications for the global economy if the US

was to lose its top rating and the dollar cease to be the world’s main reserve currency, it is developments in Europe that threaten to create greater problems in the near term. Portugal’s approach to the European Union (EU) and International Monetary Fund (IMF) for up to €80bn of emergency aid came just a few months

after the two organisations agreed a bailout of similar scale for Ireland. The failure of a third euro country to put its own financial house in order once again raised doubts over how strong political commitment to the single currency remains and where the breaking point might be. Portugal’s move was inevitable after premier Jose Socrates resigned on March 23rd, after the Portuguese parliament rejected the latest package of austerity measures that his minority government had proposed to deal with the budget deficit. Two weeks later, Socrates—by then in a caretaker role—admitted defeat and made the request for EU assistance. “I have always said that asking for aid would be the final way to go, but we have reached that moment,” he conceded in an address to the nation. The sequence of events in Portugal also highlighted how difficult it will be for democratically electable (and deposable) governments to implement austerity programmes of the severity and length that will be required to rectify the public finances of the peripheral eurozone countries. This has fostered the growing belief in many quarters that the task will prove impossible and ensure that defaults and restructurings (and which are bound to involve losses for bond investors) are now inevitable. Professor Michael Ben-Gad, head of economics at City University London, says that there had to be serious doubt that the Portuguese public would accept the austerity measures that will be a condition of the EU aid. “If not, restructuring will be the next step, something the EU and European Central Bank are anxious to avoid,” he adds. The reason the EU authorities, the ECB and individual member states are so desperate to avoid this step is that it will inevitably precipitate a secondary banking crisis across Europe, as many banks (particularly German, French and UK institutions) will have to declare big losses on their holdings of the affected sovereign debt. In some cases, these writedowns could wipe

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

out, or at least significantly impair, the fresh core capital the banks have raised to strengthen their balance sheets in the wake of the financial crisis and once more leave them vulnerable to collapse. The longer the EU authorities can postpone any sovereign restructuring through bailouts, the better the chances that banks will be able to build up sufficient profits and reserves in the meantime to cope with the hit when it comes. “I’m sure that’s one of the reasons they’re trying to postpone it as long as possible,” says John Stopford, head of global fixed income as Investec Asset Management. The necessary aid up to 2013 will come from the €440bn European Financial Stability Facility (EFSF) that EU member countries set up in May 2010 to calm market fears that the currency was about to implode. After that, it will come from the European Stabilisation Mechanism (ESM), which is designed to replace the EFSF on a permanent basis.

Can Greece avoid restructuring?

Professor Michael Ben-Gad, head of economics at City University London. “If you look at the current yields on Greek debt, I think it is clear that everyone assumes Greece is not going to be able to repay it,”he says. Photograph kindly supplied by City University London, April 2011.

In the case of Greece at least, however, it is clear that the market does not believe the evil moment can be put off for much more than another year despite recent statements to the contrary from senior Greek and EU officials. The country’s sovereign debt has been trading at about 50% of par for several months, and the yields on ten-year bonds hit an all-time high of 13.83% on April 15th this year. Four days later, the government had to offer a yield of 4.1% to sell €1.625bn of 13week treasury bills. “If you look at the current yields on Greek debt, I think it is clear that everyone assumes Greece is not going to be able to repay it,” said Professor Ben-Gad. “It is therefore fair to assume that there will be a restructuring.” It is difficult to fault the market’s logic. The country’s gross national debt now stands at €340bn and is expected to rise from 152% of GDP this year to 157% in 2012. With inflation and unemployment rising and GDP con-

tracting, it will soon become impossible to service this level of debt and maintain essential government services. The recently agreed 1% cut in the interest rate on €110bn of emergency loans that the EU and IMF advanced to Greece last year and the €50bn privatisation programme that the government announced in April will not be enough to bridge the widening gap in the public finances. “While I think restructuring is very much the last resort, we’ll probably get there with Greece next year,”says Justin Knight, head of European rates strategy at UBS in London. “When the country runs out of money, it’s either debt restructuring or a second aid package.” At some point in 2012, Greece will exhaust the EU/IMF aid and unless further EU assistance is forthcoming via the EFSF, the government will at that point have no further access to external finance. Its priority will then be to ensure that it has sufficient tax receipts to cover

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

the vital functions of government, and repayment of foreign debt will go on hold. Any rescheduling/restructuring plan that subsequently emerges is certain to involve considerable writeoffs, and the leading question is who will bear the cost? The hope of the euro’s supporters, led by Germany and France, is that the mechanisms of the EFSF and later the ESM will allow the pain to be spread as widely as possible and so mitigate the impact on individual investors, particularly commercial banks. To be able to do this effectively, however, the EFSF would need to be able to buy the sovereign debt of distressed countries and there was no indication of political consensus for such a step at the EU Council summit on March 24th and 25th, which deferred decisions on expanding the remit of the EFSF until June. Knight at UBS said it would be vital to effect such change ahead of any defaults in the eurozone. “If the expansion of the EFSF is not in place by then, the crisis could go from bad to critical within a very short space of time,” he warns.

Holding off a political backlash Far from the EU membership moving as one in this direction, however, it is a political backlash against bailouts of the more profligate member states that currently appears to be gaining momentum across Europe. In Germany, for example, the ruling CDU party lost its former stronghold of Baden-Wuerttemberg in the state election during the final week of March to an alliance of Greens and Social Democrats. This will further weaken Chancellor Angela Merkel’s ability to support the peripheral eurozone countries (although the election setback itself was attributed more to the CDU’s energy policy than its support for bailouts). More recently, the success of the anti-bailout True Finns party in Finland’s parliamentary elections on April 17th (more than tripling its share of the vote to 19%) threatens to have a more immediate impact, as it has put a question mark over whether an

DEBT REPORT

SOVEREIGN DEBT CRISIS: STRAINING THE LEASH ON THE EUROZONE

EU rescue loan for Portugal can go ahead. The rules of EFSF state clearly that any decision to provide assistance to a euro country in trouble must be unanimous. Depending on how significant a role the True Finns play in the next government, it is quite possible that the country will not support the Portuguese bailout. “We need to bear in mind that such a restructuring will affect European banks in different countries differently, so we can expect governments in Scandinavia or Eastern Europe to take a harder line with Portugal than Spain, France or Germany,” warns Professor Ben-Gad. Despite the nervousness that the recent events in Portugal, Germany, and Finland has aroused, the majority view still seems to be that the sovereign problems of the eurozone will be containable—whether or not they deteriorate from bailouts to defaults and restructurings—provided they do not extend beyond Greece, Ireland and Portugal. For most, Spain remains the potential breaking point, not only for the EU’s support mechanisms for the euro but also for the future of the single currency itself, at least in its present form. “If Spain suffers the same problems, I think the game is up,” insists Professor Ben-Gad. The Spanish authorities had managed to improve confidence in the country’s financial outlook during the first quarter of 2011, with the Bank of Spain announcing that the nation’s beleaguered banks required only around €20bn of recapitalisation as opposed to some analysts’estimates of up to €100bn. Even so, there was a worrying dip in investor sentiment towards Spain in the third week of April as spreads on Spanish sovereigns widened by 30 basis points (bps). “Structurally, demand for these bonds is much lower than it was before,” said Knight at UBS. “A lot will depend on the pretty fragile supplydemand balance for Spanish government bonds later in the year.” Given such lukewarm appetite, the country’s financing requirements for 2011 are alarmingly big. The Spanish

The outgoing Portuguese Prime Minister Jose Socrates during a speech at the inauguration of a school in Portugal, last 25 April. Photograph by Miguel Pereira / Demotix/Press Association Images, supplied by Press Association Images, April 2011.

The majority view still seems to be that the sovereign problems of the eurozone will be containable—whether or not they deteriorate from bailouts to defaults and restructurings— provided they do not extend beyond Greece, Ireland and Portugal. Spain remains the potential breaking point, not only for the EU’s support mechanisms for the euro but also for the future of the single currency itself, at least in its present form. government needs to raise a further €94bn of sovereign debt before the end of the year, while the regional administrations will be looking for another €25bn and the banking system a further €100bn.

Will CDS pay up? As the spectre of a sovereign default looms closer, a further concern for those holding the debt of beleaguered eurozone countries is uncertainty over whether the credit default swaps (CDS) that they have bought to hedge against this risk will actually pay up. The net protection bought on the debt of Greece, Ireland, Portugal and Spain currently amounts to $34bn, according to DTCC, which warehouses the trades. With the CDS contracts on Western European sovereign debt under standard ISDA trading terms, there are three forms of credit event: failure to

pay; a repudiation or moratorium on repayments; and restructuring. While the first two are reasonably straightforward, a question has arisen as to whether “restructuring” is sufficiently open to interpretation to allow government debt to be restructured without triggering this clause under the CDS contract. For example, if Greece borrowed (cheap) money from the EFSF and used the proceeds to buy back its own bonds at a discount, it would clearly reduce the outstanding total (principal) of its debt. However, this action would not constitute a restructuring credit event under the 2003 definitions for CDS contracts, which requires “reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates”on a bond. For those terms would still be the same as before for the bonds remaining in circulation. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

EMERGING MARKET DEBT: THE BEGINNINGS OF A BUBBLE?

Factoring risk into EM debt So many investors are rushing to put money into emerging market (EM) local currency fixed-income instruments that the cynical might wonder if it is a boom with legs or a bubble racing to a likely burst? Increasingly, even those with ancestral memories of previous EM debt crises think that both recent history and future fundamentals of EMs might be aligning for good auguries. Might the markets be storing up too much of a good thing? Ian Williams reports on the outlook. ARD CURRENCY DEBT is paying minimal interest rates and the currencies don’t look so hard any more, spurring investors to be much bolder than they would have been a decade or so ago. EM loans offer much bigger yields than dollars with less currency risk and less political and economic risk than used to characterise emerging markets. “De-dollarisation” has become the latest linguistic barbarity inflicted by the finance sector to describe how emerging countries have moved out of dollar bonds. Indeed, the amounts of cash flowing towards EMs have led to a differentiation of what used to be lumped as a homogenous category into separate sectors: EM corporate bonds, EM sovereign debt in hard currency, and EM local currency instruments, which are the fastest growing. EM bond ETFs and FX overlay funds’ interest in the category also suggest a coming of age. Standard & Poor’s warning on US debt, coming as it does from the people who gave top-ratings to mortgage junk, might not be significant in itself, but it does add to the relative attraction of the EM local currency fixed-income markets. For locals, of course, at the beginning of the decade, the East Asian currency crisis provided a potent example of what could happen to countries faced with tsunamis of hard currency movement, so local authorities had a pertinent reason to favour local currency issues. Jack Flaherty, investment manager, fixed income, GAM, argues: “A big part

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

Anders Faergemann, senior portfolio manager, EM fixed income, Pine Bridge Investments. Photograph kindly supplied by Pine Bridge Investments, April 2011.

of the overall perception is the continued weakness in the dollar. Obviously it’s hard to ignore the policy mix of high deficits and loose monetary policy in the US and investors are trying to get protection from that. We position our strategies to benefit from the revaluation of emerging currencies. In general, emerging markets offer stronger fundamentals than developed countries: better growth prospects, healthier fiscal dynamics and lower debt levels.” Local emerging market bonds offer more attractive yields, he says, and have low correlations with developed markets, enhancing portfolio diversification, “while currencies have good appreciation potential because of those relative fundamentals,” he adds. “Insti-

tutional investors still only have very small allocations to the asset class and they are looking to rectify this.” Also emphasising the attractions of EMs rather than the perils of the dollars, Anders Faergemann, senior portfolio manager, EM fixed income, Pine Bridge Investments, suggests:“It is not nervousness about the dollar per se, but there is a structural change that favours developing markets over the G3 and we see that continuing.” He summarises the trend: “Firstly, local issues have grown into an asset class in their own right, and this has provided strong returns to investors. From December 31st 2002 to the end of 2010, we have seen 13.5% annualised returns, along with decreasing volatility, and secondly, we’ve seen strong improvement in fundamentals. The global financial crisis was a severe test of developing markets, but they passed with flying colours. The macro picture, including growth and debt sustainability, now favours developing overdeveloped markets.” Faergemann points to the clearly obvious fact that EM debt is now a substantive force. “These are big markets,” he underscores. “We’ve seen an increase over the last five years from $2.6trn locally-denominated debt in 2006 to a current $4.3trn.” In fact, just under a decade ago the amount was a mere $250bn. Flaherty meanwhile points to the sector’s resilience, particularly in the face of “a volatile US Treasuries market, political upheaval in the Middle East and the uncertainties created by the Japanese quake and tsunami.” He adds: “We believe this is because investors are recognising the solid fundamentals of the emerging market asset class and many are making allocations for the first time.” Nonetheless, both commentators acknowledge a market in flux. Faergemann notes: “There has been a

DEBT REPORT

EMERGING MARKET DEBT: THE BEGINNINGS OF A BUBBLE?

structural change over the last ten years, aligning the interests of local issuers, the EM authorities, attempting to build out their yield curves and develop local markets so they don’t have the problem of having too much foreign denominated debt, and the investors, attracted to the growth story and the improving fundamentals and high interest rates in the emerging markets.” If anything, the financial crisis has exacerbated flows from the OECD since the debt to GDP ratio “has gone up massively in developed countries, leading to the current crises in the peripheral EU countries”. He adds:“Brazil has really been at the forefront. Investors were worried when [Luiz Inacio] Lula [da Silva] was elected, but his measures reassured them. Brazil’s bonds built the local yield curve. Another success story is Mexico whose local authorities are issuing paper for 20/30 years, which is liquid enough for investors. Local pension funds dominate here since in many ways local issuance removes a risk factor, and it’s all about minimizing liabilities, while for the foreign investor there’s the chance for currency appreciation as well as in the capital gains in the market.”

Be wary of temptation So what are the serpents in this EM garden of Eden? Faergemann suggests that investors need to be “more sophisticated, balancing risks from interest rates currency rates and duration risk; they need experience and a specialist approach to stay ahead of these rapidly changing developments”. For example, increasingly EM authorities have taken steps to slow the pace of currency markets to better manage the pace of currency adjustment and investors need to monitor that carefully. What about the risk of a potential bubble forming? Flaherty agrees:“Very low interest rates in developed markets are driving demand for higher yielding assets, so there is a risk of bubbles forming. However, we don’t believe this is the case at present and the increasing sophistication of domestic

Jack Flaherty, investment manager, fixed income, GAM. Photograph kindly supplied by GAM, April 2011.

emerging markets—often underpinned by a growing local institutional investor base—helps to offset this risk.” Faergemann bases his EM optimism not just on the relative yields but the fundamentals of the EMs. “Domestic consumption as well as investment is rising while infrastructural investment in developing markets brings investment, inflows, changes to these economies. It’s not just portfolio investment, but very much FDI [sic] and this is why we see this growth as sustainable.” The other anti-bubble protection is that most of these instruments are held by local, less fungible, investors. Faergemann explains: “The increase in domestic issuance has mostly been led by locals themselves so foreign participation is still small. Some countries like Mexico and Indonesia are up to 30% foreign participation, but in the main the growth is led by local institutions, such as insurance companies and pension funds, and this is crucial to understanding why these markets are beneficial to both investors and the local authorities. It averts the currency mismatch and provides stability to local markets and funding for local governments, giving them much more stable financial markets. We aren’t creating a bubble here. It goes to local investors. “ Part of the new acceptability of EM investments is indeed a willingness to treat each country separately rather than lump them together as Wall Street tended to

do last century. Flaherty explains: “While many investors are benchmark driven and might tolerate exposures that are high in political and economic risk, GAM uses a variety of tools, notably our proprietary crisis filter, to help us identify which countries are at greatest risk. All three of our portfolio managers, who have economics backgrounds, have extensive experience and numerous contacts in emerging markets that they can draw on to help make investment decisions and frequent country visits supplement their research.” So where is the clever money going to go now? GAM’s Flaherty says: “The local currency outlook is very important to us, and is a key source of returns to the asset class. We particularly like Asian FX at the present time. In an environment where inflation is still increasing, where most are exposed to high oil prices (the direct inflationary consequences of which will be difficult to address via rate hikes), it makes sense to allow greater FX appreciation to help fight inflation.” Many of the investors are benchmarked, and tend to align with the indices which reflect market cap. Faergemann points out: “We used to invest more in frontier markets with some success. But with the disinflation process in EM, rates have come down; G3 rates are at historical lows, so at this juncture you need more yield for the frontier market. We have seen interest rates drop from the mid-20s to low double digits, but that also means that, for example, with Zambia’s oneyear interest rates at 9.3%, it does not take a lot of volatility in the currency to take away your carry, so you need more premium in frontier markets to compensate for that risk.” Equally, explains Faergemann, investing in emerging markets is now a long-term play. He says the expansion of EM foreign investment “is going to last for ten years based on the solid fundamentals of their economies: low unemployment in EM along with strong credit expansion and the commodity cycle will really benefit them”. I

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COUNTRY REPORT

FROM FRONTIER TO EMERGING MARKET: QATAR’S LONG-TERM GROWTH PLAN

Photograph © Robert Adrian Hillman / Dreamstime.com, supplied April 2011.

A vision of the perfect future Expected to remain one of the most stable of the Gulf Cooperation Council countries in an otherwise turbulent 2011 for many MENA economies, the most pressing concern for the Emirate of Qatar is the speed with which infrastructure development takes place; both physical and financial, and the movement from a classification of being a frontier market to an emerging market is finalised. Francesca Carnevale reviews the latest development plan. HE BLUEPRINT FOR Qatar’s journey into the third decade of this century is clearly signposted by a hefty 280 page document published in March this year entitled Qatar National Development Strategy 20112016: Towards Qatar National Vision 2030. “Qatar’s tremendous progress is clear in all fields,” writes Tamin Bin Hamad Al-Thani, heir apparent and head of the Supreme Oversight Committee for implementing the Qatar National Vision 2030 (QNV2030), in the introduction. He continues: “However the stresses that accompany rapid progress are also visible. Our mission—balanced and sustainable growth—requires responsible use of resources and continuous modernisation and development of public

institutions to ensure good programme management and high-quality public services.” What is surprising is the depth and breadth of the paper, encompassing issues as diverse as healthcare, family cohesion, crime management, sports, cultural management as well as ubiquitous topics such as institutional development, strategic policy and planning.“The breadth of the coverage is a comforting sign,” says a banker in Doha, “it makes me think that there is a good chance that the vision will be implemented in its entirety.” The scope of the project has largely taken the country’s financial community by surprise. Not because of the investment required; Qatar has traditionally

thought on a long term and rather grandiose scale. Instead any admiration of the aspirations of the country’s leadership is that its commitment to change is largely unbidden. Because of the country’s immense wealth, there is hardly any expectation of or demand for political or social liberalisation in what increasingly appears to be (excepting Saudi Arabia) the most conservative of the GCC emirates. Any movement towards liberalisation of any order would have had to come entirely from the government. Moreover, Qatari society is still largely organised along tribal lines and is not particularly politically engaged. Rapid growth in the first decade of the century has given Qatar one of the world’s highest levels of per capita income. High savings rates, both public and private, is reflected in both public and private sector investment projects and the accumulation of high levels of foreign currency assets. In the early 1990s, Qatar developed a multi-directional and fast-track strategy to accelerate the commercialisation of its substantial natural gas reserves, making large-scale investments across

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

COUNTRY REPORT

FROM FRONTIER TO EMERGING MARKET: QATAR’S LONG-TERM GROWTH PLAN

the entire value chain of LNG liquefaction trains, tankers, and storage and receiving facilities. Qatar is now the leading LNG producing country in the world, having raised its annual LNG production capacity by more than 108% from approximately 37.1m tons in 2009 to approximately 77.4m tons per annum this year. Qatar’s flagship Qatargas and RasGas LNG projects, have led the development of the country’s LNG business through strategic partnerships with leading oil and gas companies,

including ExxonMobil, Shell, TOTAL and ConocoPhillips. Having invested across the entire LNG value chain, Qatar now enjoys meaningful cost advantages in the gas sector due to significant economies of scale and a low cost structure and the country is regarded as the world’s leading authority on LNG technology and distribution. Qatari LNG is now sold globally to customers in 11 countries, including Mexico, the US, the UK, France, Spain, India, Japan and of course China. Most of the LNG produced by the country’s

upstream ventures is sold under longterm take-or-pay agreements that provide certainty of volume off-take and buyers benefit from long term fixed price agreements. The supply of cheap hydrocarbon feedstock and energy has also helped prime the development of downstream industries in both the petrochemical and metallurgical sectors, with some sub-sectors such as fertilisers growing at a fast clip. Other segments such as healthcare have also picked up momentum in recent years.

A snapshot of Qatar’s infrastructure in capacity, quality and cost

Focus area

Power and water

Service quality

Efficiency

Committed capacity significantly exceeding demand

Limited number and duration of interruptions; approximately 100% network coverage

High power generation CAPEX; low plant use after 2011 (60%); transmission and distribution losses in line with the benchmarks

Water supply

2020

If RAF A in operation until 2020, no further capacity additions required

Quality of water in line with benchmarks; 98% network coverage; water stock limited to 1.5 days

High network losses (30%-50%); high per capita demand

Wastewater

+2030

Networks being developed; treatment capacity additions in 2011 satisfying needs beyond 2030

River quality of treated water; investigation of water quality upgrade

Limited treated sewage effluent use (60%); low expected treatment plant use after 2011

+2030

Current network congestion, but road expansion plans based on very high population projections

Lowest perceived quality of road in Gulf Cooperation Council (World Economic Forum); need to strengthen public transport

Construction cost in line with Gulf Cooperation Council average but low use if network realised based on current population projections

Current port operating beyond capacity; new Doha port expected with large excess capacity if phases 2-3 realised

Current port congested; new Doha port expected in line with international standards

Expected low use of new port; high share of total cost incurred in phase 1 (+70%)

Current airport operating beyond capacity; new Doha International Airport phase 1-2 required—phase 3 expansion could be postponed (from 2015 to 2020)

Current airport congested: 3 stars (out of 5) Skytrax rating; new Doha international airport expected in line with international standards

New Doha International airport with high capital expenditure per passenger; high share of total cost incurred in phase 1-2 (70%-80%)

Very large network (85 kilometres) relative to Doha transportation demand

Service quality expected in line with international standards

Expected low use; expected high lifecycle cost

Network covering main hubs in Qatar

Service quality expected in line with international standards

Low number of passengers/km of railway compared to EU average

Limited penetration gap in internet; national broadband network expected with 95% coverage

Bandwidth performance below international benchmarks; new national broadband network to increase performance to 50 megabits per second

Planning in preliminary stage

Roads

Seaports

+2030

2020b Airports

Metro

Rail

Information and communication technology

+2030

+2030 na

a Current or planned capacity is adequate and is not expected to reach saturation until the year indicated. b Refers to phases 1 and 2.

Critical issue

2020

Power supply

Transportation

Meeting Qatar’s needs by 2016?a

Attention point

Source: Qatar National Development Strategy 2011-2016, supplied April 2011.

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

Megaprojects

Adequacy of supply, quality and efficiency

COUNTRY REPORT

FROM FRONTIER TO EMERGING MARKET: QATAR’S LONG-TERM GROWTH PLAN

With this in mind, it is no surprise that QNV2030 envisages a comprehensive reform programme that will sweep through all levels of Qatari economy and society. A significant rationalisation of the functions and roles of ministries and national agencies is underway which the government hopes will result in tighter national policies, improved service delivery, enhanced public sector accountability and longer run national development planning. Inevitably however, the trajectory of both the Qatari economy and its long term outlook remains tightly linked to developments in the hydrocarbon sector. Generally the country’s economic outlook remains broadly favourable, underpinned by strong oil prices and rebounding world trade. Actually the country’s hydrocarbon income (though secure for at least the next 150 years at current consumption rates) will begin to flatten somewhat in 2012-2013 as the country’s current investment programme in hydrocarbons comes to an end. A new investment round will not be instigated until at least 2015, when a moratorium on exploration of the country’s so-called North Field expires. Even so, the country’s income levels will remain high. The government hopes through the implementation of QN2030 that robust expansion of non-hydrocarbon sectors will keep aggregate GDP growth in 2012-2016 to average just over 5% (excluding hydrocarbon income). “Confidence is key,” thinks Andrew Stevens, group chief executive officer of Commercial Bank of Qatar.“The underlying driver is helping people manage surplus in a creative way that helps build a sustainable economy diversified from hydrocarbon dependence.” This is particularly important for the emirate as Qatar has traditionally relied heavily on loans to finance its economic development projects. However, these days it has exhibited a willingness to draw on its sovereign wealth fund, the Qatar Investment Authority (QIA), to ensure that key projects proceed as planned.

Shashank Srivastava, chief executive officer and chief strategic development officer at the QFC “There are very few overlaps on the regulatory front and certainly none in reinsurance, asset management and captive insurance. There are natural synergies between us all,” he says. Photograph kindly supplied by QFC, April 2011.

Going forward, Qatar’s investment pattern will reflect the decline in hydrocarbon capital spending. During 2011-2016, suggests QNV2030, total gross domestic investment might be around QAR820bn, of which half is expected to come from the non-hydrocarbon segment. Central government, or public, investment is estimated at QAR347bn and based on current estimates is expected to peak in 2012. It is vital to remember however that much of the government’s spending plans revolve around the assumption that oil prices average $86 per barrel. In November last year, when the price of Brent crude hovered just below $84 it was something of a concern; in late April hovering at levels near $113 it appears somewhat less stressing for the emirate. Even so, gas prices are the greater swing factor for the country. In spot markets, gas and oil prices have uncoupled and while Qatar is generally shielded from short term fluctuations in spot gas prices through its long term off-take agreements with buyers, any prolonged weakness could seriously undermine the government’s ability to fulfill its investment programme.

Naturally, the current obsession in Doha is the 2022 World Cup though in the period of the current 2011-2016 five year plan, any contribution to that project will be perforce modest. However, notes Samer Eido, partner at international law firm Simmons & Simmons in Doha, the build up to a successful World Cup will in part depend upon the country opening up to foreign visitors and investors, with all the internal development that requires. “Qatar will have to build at the very least a further 15,000 to 20,000 hotel rooms to accommodate the influx of even modest levels of fans visiting the country during the games. I expect the government to invest massively in this area and it will have to set out strategies to accommodate the cultural changes this will invariably require,” Eido says. All in all, the government has taken on a gargantuan task. QNV2030 suggests that after 2012, when the current expansionary phase of hydrocarbon development ends, the structure of the Qatari economy will be such that five percentage points of additional public sector investment spending would be needed to generate a 0.5 percentage point temporary acceleration of growth in non-hydrocarbon output. That ultimately is the scale of the challenge for the country. Moreover, other countries in the GCC zone have embarked on rather similar projects; with Bahrain, Abu Dhabi and Saudi Arabia working hard to diversify their economies. Petrochemicals, air transport, logistics, real estate, finance, life sciences and telecommunications are common diversification themes across the region. There is a chance that with so many countries funnelling investment into the same sectors, each country will fall short of achieving the most efficient level of production.

Contributing to economic diversity A variety of institutions are contributing to Qatar’s diversification drive. These include Enterprise Qatar, the Qatar

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

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BUSINESS ENERGY

COUNTRY REPORT

FROM FRONTIER TO EMERGING MARKET: QATAR’S LONG-TERM GROWTH PLAN

The Qatar government plans more than $65bn in infrastructure spending through 2016 Expected infrastructure spending ($bn) 25

Qatari Diar

Roads

Sidra Hospital

Qatar-Bahrain Causeway

Airport

Water

Qatar National Bank

Port

Wastewater

Barwa

Metro & rail

Power

Education City 15

0 2011

2012

2013

2014

2015

2016

Source: MEED Project database, Qatar National Development Strategy 2011-2016, supplied April 2011.

Foundation, the Supreme Council of Information and Communication Technology (ictQATAR), the Qatar Financial Centre, the Qatar Exchange and the Qatar Development Bank. These institutions, working in tandem with the country’s banking segment will be fundamental to the effectiveness of the infrastructure investment drive. Most recently, the QIA has been the conduit by which the government has channelled capital into the country’s banks to bolster their balance sheets. This was an important move if the government was to ensure that local banks could take their place alongside foreign banks in benefitting from financing opportunities arising from QNV2030. The government has form in this regard. According to Simmons & 2 Simmons’ Eido, “Initiatives of the central bank are not a surprise. During the recent financial crisis the central bank intervened to buy up all the exposure the banks had to the local stock market and the bad loan portfolios. Moreover, the QIA was instructed by the government to make direct investments in Qatari banks to strengthen their capital and preserve confidence in the sector. This was largely achieved but on the other hand the government

through the central bank now has great influence over bank policies,”he notes. While the banking segment has taken government funds graciously, the fact remains that both government and central bank policy is authoritative and directional and taken without consultation. The central bank has a sometime quixotic approach to decision making, “issuing regulation and then sometimes changing its mind. It looks like trial and error, and it can be difficult to understand the rationale,” says one banker in Doha. Controversy still rages at the central bank’s recent decision (or more accurately order) that conventional banks stop offering Islamic banking services. “In 2005 the central bank authorised the establishment of Islamic windows,” owns Eido. “Some five years on the model worked well and attracted lots of clients, thereby competing with local Islamic banks. The announcement came as a complete surprise.” "The loss of Islamic banking franchise is credit-negative for Qatari conventional banks, which derive 10-15 [sic] per cent of their yearly earnings from Shari’a-compliant banking," Moody's said in a statement at the time. Moody’s suggested that some conven-

tional banks could lose as much as 16% of their total assets and deposit base as a result of the decision. The ratings agency also suggested that Qatar National Bank (QNB), the country’s largest lender would be most adversely affected having secured an estimated 20% of the country’s Islamic banking business volume. It added that Islamic banks will invariably benefit from access to a larger pool of customers and thereby enjoy better profit margins. Conventional banks now have until the end of 2011 to wind down their Shari’a compliant operations. QInvest, chief executive officer Shahzad Shahbaz, is more sanguine.“There are lots of different stories, but ultimately the decision is an Islamic one and it is about avoiding the co-mingling of funds and to deal with various regulatory requirements,” he avers. Equally, notes Eido, the government decided some years ago to close down the brokerage operations of Qatari banks, a decision which it has now rescinded, though it has not announced “why they appear to have changed their minds on this issue. The next round of changes is likely, as QNV2030 suggests consolidation in the regulatory space. The Qatar Financial Markets Authority (QFMA) and the Qatar Financial Centre Regulatory Authority (QFCRA) will be united as separate sleeves under the supervisory authority of the Central Bank of Qatar.” The move is significant and comes at a time when the role of the Qatar Financial Centre Authority (QFCA) is centre stage. It has taken a keystone role in encouraging a nascent insurance industry in Qatar. “The government is clearly in execution mode,” acknowledges Shashank Srivastava, acting chief executive officer and chief strategic development officer at the QFC. Srivastava has no fear of the change,“there are very few overlaps on the regulatory front and certainly none in reinsurance, asset management and captive insurance. The overlap is in the banking area of course, but our role is not to either licence retail

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

COUNTRY REPORT

FROM FRONTIER TO EMERGING MARKET: QATAR’S LONG-TERM GROWTH PLAN

Qatar projects Projects awarded/forecast to be awarded 2007-2012 ($bn) 33,028

32,407

26,014

26,750

23,450

11,199

2007

2008

2009

2010

2011

2012

Source: MEED Projects, GCC Economic Outlook (January 2010), supplied April 2011.

banks or regulate Qatar’s capital markets. There are natural synergies between us all.”

Acting as a catalyst Even so, Srivastava acknowledges the importance of acting as a catalyst in the area of the QFC’s core competencies. “First, we are the conduit for foreign firms coming into the country; the QFC is not bound by buildings or a tightly defined zone; it encompasses the whole country and that’s an important differentiator from other similar jurisdictions. Two, the country and the region is a net exporter of capital and this is something we would like to reverse as asset managers tell us they want to be closer to their investments and to other asset pools in the area. Clearly then there is room for asset management to take root in centres such as Qatar. Similarly in reinsurance; some 50% to 60% of insurance premiums are written outside of the jurisdiction. The scope then for locally sited insurance and reinsurance business is tremendous.” Srivastava sees the role of institutions such as the QFC as facilitators: “after all, we are agnostic as to the source of funds, investment, insurance and/corporations. Our job is simply to provide the right platform for them to prosper in the jurisdiction.”

He stresses that the QFC works beyond the obvious and in this regard is highly attuned to the government’s overall QNV2030 strategy.“There is real opportunity for business life insurance, health insurance, medical liability and assets insurance; though clearly the obvious one is infrastructure right now,” he concedes. Qatar has also moved far along the invisible line that demarcates countries as an attractive investment, suggests Srivastava.“As recently as five years ago we were working with international organisations such as the World Bank and the focus was on social issues and we were on the road a lot explaining the financial vision. Now we are on the road much less; the firms that need to know about us know about us and they understand it is a value story, not a tax story.” Typical of the high profile entities that the QFC has encompassed is investment bank QInvest, which operates both in Qatar and outside in countries such as Turkey, India, the UAE and Saudi Arabia. The market dynamic in Qatar is active, says chief executive officer Shahbaz, acknowledging however that recent events in Bahrain took some of the sheen off first quarter 2011 capital markets activity in the country. “You have to accept that while the country is growing rapidly,

the market is only so large and many firms here need to grow cross border to expand. In this regard we are now working on several mandates, with a regional focus and financing for large scale real estate projects which are, of course, ubiquitous in the jurisdiction and in markets such as Turkey, Saudi Arabia and India.” The buzz around real estate, explains Shahbaz is coming back on a selective basis, particularly in areas such as Qatar and Dubai. “There is the growing residential real estate story in Saudi Arabia; good yields are to be had selectively available in Qatar and the UAE and some attractive development opportunities in Turkey and India. Sophisticated investment structures will take some time to develop, including REITS, for example. Shahbaz also sees the potential for the local IPO market, “In 2012 we will look to do undertake a listing ourselves, though it will depend on overall market conditions and progress in building out our franchise.” Rodney Ringrow, senior managing director, at State Street in Doha, highlights the growing differentiation between individual states in the GCC zone; “There is some decoupling involved as people begin differentiating between sovereigns.”Having said that, he concedes that of late investment inflows have tended to be static since as far back as 2008.“But it is beginning to show signs of increasing again. In this regard, jurisdictions such as Qatar and the UAE are keen to shake off their frontier market mantle and assume that of an advanced emerging market. That would really open up the floodgates once more. What’s important to achieving that is depth in regulation and financial infrastructure and increasingly liquid markets,” he says. There are still fundamentals to address however, among them to find ways to attract significant numbers of asset managers into the region and develop a consistent regulatory policy. “Easier said than done, but they are trying,” he concludes. I

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

COUNTRY REPORT

BANK PROFILE: COMMERCIAL BANK OF QATAR

CBQ aligns with government policy According to group chief executive officer, Andrew Stevens, Commercial Bank of Qatar (CBQ) is a microcosm of Qatar; which he describes as, bold, visionary, self believing, with strong core values and no small degree of humility. Clearly, he speaks from a providential vantage point as leader of a financial institution safe-harboured by an abundance of riches. This fractal quality does not dissolve all problems however, and growth in an era of plenty carries its own challenges and penalties. Stevens talks over the business dynamics with Francesca Carnevale. E LIVE IN in one of the most dynamic economies of the modern world, concedes Andrew Stevens, group chief executive of the CBQ Group. “Even so, we do not expect anything other than to earn the right to do business and success in that light is never allowed to get ahead of the organisation. We continue to work to raise the bar.” CBQ was established in 1975 as Qatar’s private sector bank with particular specialisation in the financing of trade and small and medium-sized enterprises (SMEs). However, Stevens stresses that definitions are often limiting. “Although we have a focus on private sector financing as the markets have moved so have we. We saw, for instance, the rise of public sector project financings through the 1990s and early 2000s which centered upon gas and downstream projects. We raised funding for the projects at the necessary tenors. What it did not mean is that we moved wholly to a public sector model.” It is a theme he warms to as he describes current day foci for the bank, which includes private banking and real estate financing. Even so, the bank’s direction is in no small part aligned with government policy; it is easy to see why. There is at least $150bn in further infrastructure investment planned over the next half decade, financed largely by hydrocar-

bon revenues mixed with private sector funding, offering local financial institutions a plentiful business mix. Moreover, utilising the country’s sovereign wealth fund, the Qatar Investment Authority (QIA), the government has not been backward in providing cash injections into the country’s domestic banks, in the form of equity, to help ease the strain on the country’s lending as they help finance infrastructure and, in particular, the building required to support the country’s 2022 FIFA World Cup bid. Some QAR5.5bn ($1.5bn) was sunk into the sector in the latest round in the first quarter of this year; with CBQ receiving a tranche (its third to date) worth QAR1.6bn, taking the QIA’s stake in the institution to just under 16.7%.“The fresh equity injected by the government’s investment arm will strengthen bank capitalisation and also enable banks to fund higher loan growth. Neither the government nor the banks wanted doubts over capital adequacy levels, which for us is 20.9%, well above the central bank’s minimum requirement of 10%,”explains Stevens, acknowledging that the bank now also benefits from its semi-statial association with the cornucopia that is Qatar. The evolution of a complex economic infrastructure is a unifying force in Qatar, agrees Stevens. “The government has provided a clear, long-term

vision in describing very early on a very clear development road map. Actually, everyone in the country believes the vision is achievable. Promises are made and delivered upon.” National requirements aside, CBQ is set upon its own path and one that it is not afraid to fund itself. “We were the first Qatari bank to issue in the Eurobond market back in 2006, which is repayable this year. Then in 2008 we were the first Gulf Cooperation Council (GCC) financial institution to issue a GDR on the London Stock Exchange and we returned two years later with a lower tier II and Reg 144s $1bn bond,” says Stevens. Most recently, CBQ has tapped the debt markets for a five-year, CHF275m (around $290m) denominated bond issue (in November 2010), the first Qatari credit in the currency, which pays a coupon of 3%. The issue was managed by BNP Paribas and Credit Suisse. The EMTN programme is listed on the London Stock Exchange offering the bank (and its subsidiary CBQ Finance) a framework in which to issue debt. The latest MTN programme comes against a backdrop of a healthy pipeline of bond issues from the Gulf region, notes Stevens, though he acknowledges some wariness among issuers as political ructions have rolled across the wider MENA region. However, he does not expect high-quality issuers to have any problems raising finance this year or next, an important measure being (of course) pricing.“We were not disappointed with the pricing of any of our issues, the windows opened and we took full measure of the opportunity; though we continue to be mindful of having a well diversified funding base,” he explains. With so much change in its contiguous environment, CBQ has invested in both new technology to upgrade internal systems and overhauled its internal training systems and restructured management to better meet changing market conditions. The bank recently completed the deployment of a server virtualisation project from EMC, a

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Andrew Stevens, group chief executive officer, Commercial Bank of Qatar (CBQ). Photograph kindly supplied by CBQ, April 2011.

provider of information infrastructure solutions, giving the bank an upgraded data recovery facility covering its key business applications. It has also signed a strategic partnership with the London Metropolitan Business School (LMBS) to provide staff training. Earlier this year the bank promoted Abdulla Borhani as executive general manager and chief strategic client officer and Steve Mullins to executive general manager and corporate banking officer. Both, like Stevens, are long-term CBQ employees, and the appointments will bring new focus to key segments in the bank’s day-to-day business strategy. Mullins, for example, will focus on consolidating the bank’s institutional relationships coordinating opportunities across trade finance, treasury and project finance. According to Stevens, the promotions are “integral to our domestic franchise and strategic expansion”. The promotions carefully dovetail into a tightly-crafted pan-GCC organic growth plan. “We didn’t and don’t look for branch expansion; to do that you need anchor clients and to take with you core competencies which are then limited by host nation regulations,” states Stevens. Instead, he explains: “We prefer to identify banks like us which have traditionally done well and which could benefit from alliance in an era of rapid change. Working together we can share risks and services and

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even move into neighbouring markets on a selective basis together.” Typifying much of CBQ’s crossborder strategy is its 35% stake in the Oman National Bank and a 40% shareholding in the United Arab Bank of Sharjah. CBQ’s alliances have now expanded to include the establishment of a shared service platform with Tata Consultancy, which Stevens says will provide CBQ with cost efficiencies and a“cutting edge value proposition”. The alliance with Tata could eventually lead to merging of six operational centres into three with back-up systems,“allowing us to better coordinate and provide unified treasury, R&D, and risk management services,” explains Stevens. In February, CBQ also teamed up with the Qatar Development Bank to provide a loan assurance programme, called Al Dhameen, to provide support for SMEs. The indirect loan facility programme which is now offered by CBQ helps economically-viable SMEs overcome certain financial barriers such as the lack of collateral required by banks. This facility provides SMEs with access to financing for investment and working capital and is extended to small business owners at affordable profit rates. Additionally, it helps companies with credit facility challenges to have financial independence. Going forward, Stevens says he would like to see the bank leverage its

balance sheet and tap into new markets; it is an opportunity he notes that is imperative in a market which lacks neither liquidity nor cheap finance. “Ideally we would like a greater share of cross-border assets though focusing on our competencies in key segments and industrial sectors,” he says, acknowledging that the bank’s fastest growing business segment is corporate finance, particularly corporate real estate financing, which has been the biggest element in terms of ticket size. Retail growth by comparison has been circumspect.” Wealth management is now also becoming one of the bank’s top priorities. “We’ve not yet got a fully-developed wealth operation,” notes Stevens. “We focus more squarely on the affluent market. We call it Sadara, which means Top Table in Arabic. That is very much a priority service going forward.” Equally, he notes, the bank, having received official approval, is now re-entering the brokerage business, perhaps in compensation for having to offload its Islamic window in response to a recent central bank decision to ring fence Islamic financing services within dedicated Shari’a institutions. So far, so profitable, CBQ achieved net profit of QAR446m for the first quarter (Q1), up 9% on the same period a year ago. Stevens agrees: “It’s a strong start to the year, with net operating income up 11% on Q1 2010 due, mainly, to higher net interest income and gains arising on the sale of investments. We remained focused last year on tight balance-sheet management, maintaining strong asset quality and delivering a low-cost funding base. The demand for borrowing in the first quarter has been subdued. However, the government’s spending plans, as detailed in the budget, and the recent decision by the Qatar Central Bank to lower interest rates are expected to provide a dual stimulus to the market, which should help us over the long term. Consequently, we have focused on enhancing our relationships with existing domestic corporate and retail customers while developing our presence in the public sector.”I

FX VIEWPOINT

DESIGNING THE IDEAL FX TRADING PLATFORM

The landscape for execution in FX is uniquely fragmented, both geographically and functionally. As an asset class it stands alone, since there is no particular local exchange, and since trades are settled in the countries of the currencies involved, there is no local clearing facility. It is a market at once nowhere and everywhere. Erik Lehtis, president of DynamicFX Consulting, looks at who stands out from the pack.

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

Rich and continuous trading AVING SPENT THE better part of the past few months bashing one aspect or another of the now-failed bank-only FX liquidity pool code-named Pure FX, perhaps it is now time to describe and discuss what an ideal FX liquidity platform would look like. To better understand where we are going, it usually helps to know from whence we came. FX liquidity provision was originally the exclusive province of banks. If you were a corporation or investor and needed to execute a currency trade, you had to call a bank and speak with someone on the corporate sales desk. Before banks adopted the prime brokerage framework, and until the markets went electronic, that continued to be the case. It was not till about 2004 that the primary multi-bank liquidity pools (EBS, and Reuters in 2005) exposed their APIs to trading firms, and at that point the market began to transform with the growth of the high-frequency trading segment. Suddenly the banks had a new presence to contend with that was actually able to out-trade them, and, more frighteningly, might threaten their hegemony in the market-making space. Banks began pressuring exchanges to change their processes to disfavour the HFT crowd, and while some concessions were made, exchanges weren’t about to kill a new and very lucrative class of customers that were suddenly helping propel them to record volumes. EBS found itself in a particular hot spot (pun intended),

given it was created and owned by the very banks that were now complaining so bitterly about these new participants. In fact, the consortium of banks that owned EBS sold it in 2006 to ICAP, and speculation since then has centred on the notion that it was just a matter of time before the banks would form a new, more bank-friendly liquidity pool. In that sense, Pure FX was not in any way surprising, except for its timing. Pure FX itself may be dead, but the forces behind it continue and it is not unreasonable to expect another such venture in the months to come. With that in mind, and for the sake of a sustainable outcome, I would like to float some ideas about what that platform should be. First of all, it should be as global as the market itself, and thus as useful in Tokyo or Frankfurt as it is in New York or London. Therefore, an architecture that facilitates local execution in multiple time zones would be ideal. EBS already has this architecture, so there is not only a precedent, but also a successful, working example. These matching engines could all be interconnected, as EBS is, or they could stand alone, creating an arbitrage opportunity for those so inclined to play that game. Letting the market perform the equalisation task rather than attempting it internally might generate additional fee revenues, rather than accumulate networking costs. Secondly, it should provide equal access to all, without favouring any particular trading style or market

segment. Rules should be designed to create a level playing field, so that HFT players can’t game the platform, but rather serve to provide needed liquidity. In this case, the devil is usually in the details, as all the existing platforms have discovered. Paramount should be the notion that no one is inordinately disfavoured by a rule. EBS has tried to accomplish this with the imposition of a minimum quote life. This was in response to screen traders’ complaint that it was next-toimpossible to trade on the constantly changing inside prices generated by algo-driven computers. While an imperfect solution, MQLs have softened the impact of the jittery nature of HFT market making. Third, it should offer complete transparency in terms of execution and market data. Capabilities such as “last look” and “flash orders” should not exist. Trades will be matched by a disinterested third-party according to well-established rules. Market data should be rich, continuous, and free. Here is where this exchange can really separate itself from the pack. FX ECNs all give woefully-lacking market data. EBS charges $50k a month for theirs. None of them currently broadcasts trade volumes, to protect the market makers as well as those executing large trades. I assert that you can broadcast those volumes, and to anyone who doubts the viability of this, I say CME. They publish every trade instantly, and it certainly hasn’t hurt their growth. I

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International money managers have always had to cope with foreign exchange risks, but the recent investor enthusiasm for emerging markets has ratcheted up the challenge. The currencies in developing markets are typically not eligible for clearing through CLS, the industry-owned utility that handles the majority of settlement flows in the most actively-traded currency pairs. Emerging market currencies may not be fully convertible, either, forcing managers to rely on swaps or non-deliverable forwards to hedge their exposure. Managers also face elevated volatility in the currency markets—well below the 2008 peak but still above historical averages—which means decisions about whether and how much to hedge can have a disproportionate impact on investment returns. Neil O’Hara reports. OREIGN EXCHANGE TRADING is concentrated in US dollars, euros, sterling, yen, Swiss francs, Canadian dollars and Australian dollars, all of which are CLS eligible. Indeed, the 17 currencies that can clear through CLS account for an estimated 94% of the total daily value of global currency trading, of which CLS handles about 68%. Currency forwards are the instrument of choice for foreign exchange risk managers. Collin Crownover, global head of currency management at State Street Global Advisors (SSgA), estimates that 99% of activity in the currency portfolios he supervises is in forwards, which have lower transaction costs than swaps, futures or options. The contracts can be customised to match the timing of expected cash flows, too, an important consideration for many SSgA clients. “We have used futures on occasion, but they don’t cover a lot of the currencies in the portfolios,” says Crownover. “They are a partial solution at best.” Futures are not even available on most emerging markets currencies. Transaction costs are inversely proportional to liquidity, just as they are in other markets. Spreads in activelytraded deliverable emerging markets currencies such as the Mexican peso

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and South African rand (both CLS eligible) are comparable to the major currencies and non-deliverable forwards on the Korean won or Brazilian real are only a touch wider. For thinlytraded currencies in Eastern Europe or the Argentine peso, however, spreads can be more than five times as wide as the three to five basis points (bps) typical for G10 currencies. Wylie Tollette, global head of investment risk and performance at Franklin Templeton Investments, says non-deliverable forwards introduce operational complexities some custodians are not equipped to handle. In many cases, the custodian must have a banking presence in the country with authority from the central bank to conduct foreign exchange transactions. “You may have a limited number of counterparties for transactions in the local currency,” says Tollette. “You have to watch the prices and spreads they offer very carefully or else you end up a price taker rather than a price maker.” Large asset managers deal with so many custodians that they can easily check a quote in, say, Korean won, so the Korean custodian will generally make the right price to a Franklin Templeton at the outset. It may be tempted to gouge a smaller manager with a more limited network, however.

FOREX: COSTS HEAD HIGHER FOR EMERGING MARKETS

Who will bear the brunt of a switch to clearing?

Hedging currency risk is at best an inexact science for money managers. In an ideal world, the goal would be to hedge underlying economic risk, but in practice that is virtually impossible, particularly for equities. What is the true currency risk for Antofagasta, a British company quoted in sterling on the London Stock Exchange whose business operations are located in Chile but consist primarily of mining copper, a commodity priced in US dollars? The riddle is even harder for multinational companies that have disparate businesses in 100 or more countries—and investors have no idea how much currency risk the company itself may hedge. “It is hard to calculate reliable estimates of foreign currency exposure,” says Crownover. “We have to rely on accounting exposures.” Currency managers work from reports that group investments by country of origin (equities) or currency of issuance (bonds). SSgA handles currency overlay programmes on about $100bn of assets, about 25% held in custody by State Street and 75% by third-party custodians. Clients typically determine a target hedge ratio and set tolerances around the benchmark, then instruct their custodian to supply asset reports to SSgA. Overlay programmes may be either passive or active, and absent any wholesale changes in the underlying asset portfolio; the principal amounts hedged in each currency are rebalanced once a month, typically in a basket of forward contracts that mature on the same date and are rolled over every three months. “Clients don’t want a multitude of cash flows,” says Crownover. “They prefer them to be somewhat less frequent.” Other managers use longer-dated forwards, which reduce cash flows even more. Franklin Templeton prefers nine months for the initial contract term, a reflection of the medium-term investment horizon in many of its strategies. Richard Purssell, head of trading at Pareto Investment Management in London, will go out to six months in the major currencies, which are still

FX VIEWPOINT

FOREX: COSTS HEAD HIGHER FOR EMERGING MARKETS

highly liquid and have minimal bidoffer spreads at that maturity. Pareto is a quantitative shop that manages about $55bn in currency overlay programmes concentrated in the major currencies. In fact, it usually avoids minor currencies even in the developed markets, relying instead on proprietary baskets of major currencies designed to track their performance. “We will create a proxy for the Norwegian krone using, for example, euros and Australian dollars,” says Purssell. “It gives us greater liquidity.” In its principal overlay programmes, Pareto typically excludes emerging markets currencies altogether, but the firm also has a specialist currency alpha product that capitalises on temporary dislocations or mispricings in the currency markets. That strategy does include emerging markets currencies, which are traded through non-deliverable forwards. Both Purssell and Tollette have seen clients switch to shorter forward contracts in recent years, primarily to minimize the cash transfers due on settlement. In the aftermath of the financial crisis, for example, the Australian dollar sank from US$0.98 to US$0.60 in just six months. Tollette points out that an Australian client with a large book of US dollar business hedged back into AUD would have had to come up with cash equal to 40% of the hedged amount if it had sold a sixmonth USD/AUD forward that coincided with the currency movement. “That is an uncomfortable position to be in,” he says. “We still think longerdated forwards offer good value but we have a number of clients that have increased their use of one-month contracts to reduce that exposure.” Although electronic trading platforms including FX Connect and Bloomberg have added both liquidity and transparency to the foreign exchange markets, institutional trades are still mostly done over the phone. Dealers are not willing to show large size on screens where the market will know as soon as the trade goes

Collin Crownover, global head of currency management at State Street Global Advisors (SSgA). “It is hard to calculate reliable estimates of foreign currency exposure. We have to rely on accounting exposures,” he says. Photograph kindly supplied by SSgA, April 2011.

through. In addition, overlay managers trade on behalf of hundreds of clients, who often impose different restrictions on whom they will do business with. “I can’t just pool it all and do $1bn on an electronic platform,” says Tollette. “For big players like us, it is just not practical.” Nevertheless, he acknowledges that enhanced FX trading capabilities and clearing networks are making currency execution and settlement more efficient for Franklin Templeton. Forthcoming regulatory changes are likely to promote more electronic trading, too. The rules have yet to be finalised, but many observers expect CLS-eligible foreign exchange forwards to be exempt from the effort to shift OTC derivatives into a clearing environment and perhaps exchange trading. Non-deliverable forwards and currency options may not be exempt, however, which raises questions about how margin will be calculated for offsetting positions where one product is cleared and the other not.

If clearing extends to all foreign exchange forwards, the industry will face an operational nightmare of biblical proportions. The foreign exchange markets are a whole order of magnitude larger than for any other financial instrument. The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity prepared by the Bank for International Settlements pegged April 2010 foreign exchange daily turnover at $4trn, nine times the $455bn average daily volume in US Treasuries for the same month reported by the Securities Industry and Financial Markets Association (SIFMA). Foreign exchange pervades the asset management industry, too; it is the largest single category of instrument traded by Franklin Templeton, for example, outstripping bonds and equities. A dozen or so global banks dominate foreign exchange trading, and they all have huge investments in technology to keep track of their bilateral currency contracts. Clearing introduces a new central counterparty, which takes the place of the banks—and must therefore have the capacity to handle all the trades of every single clearing member. “The technology infrastructure is not completely ready,” says Tollette. “The communications pipes are simply not big enough to handle all the activity if clearing was done as a Big Bang.” If the regulators do give the major currency forwards a pass, money managers who focus on the emerging markets will bear the brunt of the switch to clearing. While the Korean won, South African rand, Israeli shekel and Mexican peso are CLS-eligible, other popular emerging markets currencies are not, including those of the BRIC countries, which trade as nondeliverable forwards. Although Franklin Templeton has already started to collateralise its currency forwards, most managers do not and will face demands for initial and maintenance margin when these contracts go to clearing. The cost of hedging emerging markets currency exposure is bound to rise when the new rules kick in. I

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INDEX REVIEW

EQUITIES LOOK GOOD AS INTEREST RATES REMAIN SUBDUED

FTSE butts against its top-end barrier With employees still struggling to push through pay rises even remotely close to the rising cost of living, members of the MPC probably feel that they have time to act, but the everdecreasing purchasing power of consumers (helped by rising inflation and taxation) threatens to do more damage to growth potential than the effect of a series of rate hikes. This is exacerbated by the continued injection of funds into various western economies—remember all the quantitative easing that seems to have disappeared off the front pages? —which is driving up asset values even as the currencies retreat. Simon Denham, managing director of spread betting firm Capital Spreads, takes the bearish view. HERE REMAINS A sense of unreality as governments from the US to Greece continue to speak of decades of restructuring and belt tightening. In the meantime, currency printing presses run red hot as politicians try to squeeze out one last turn of the wheel before the tab is finally presented. Standard & Poor’s (the rating agency) has tried to put a shot across the bows of US congress as it warns of a possible downgrade of US debt if a sensible deficit reduction policy is not agreed soon. The real problem must be that the “good ole US of A” risks a really reactionary legislature if the voters as a whole buy into anything close to the Tea Party ethos. Voters tend to get very nervy if they perceive that their tax money is not being spent wisely. How will this affect the FTSE? As mentioned, asset values will probably continue to rally as long as the alternatives look either dangerous or unremunerative, and cheap money swirls around the system looking for a home. While the dollar remains weak and in a generally downward trend versus the euro and yen, funds will continue to pour into equities, euros and commodities as quasi hedges against a rising renminb and

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rupee (which are either illiquid or non-deliverable) and against the general perception of weakness in the value of paper dollars. With rates likely to remain very subdued, the returns available from equities continue to look quite good especially as any event that is likely to lead to higher rates would be generally perceived as good for stocks anyway (i.e. a return to better growth rates). We have had several very real shocks to the financial system and to growth expectations over the past few months—oil prices, the troubles in Japan, the GDP for the UK grinding to a halt, and sovereign debt in three of the eurozone nations effectively turning into junk—none of which has done more than temporarily drive values lower. Investors are definitely very comfortable with bad news now and it is tempting to speculate favourably on what might happen if we actually start to get more bullish data! With this in mind, it is interesting to note that the technical analysis from a variety of market commentators is definitely turning universally positive and with the FTSE currently very close to the 6090 to 6120 barrier (which has proved problematical several times in recent months) there is strong

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

speculation that any confirmed break might bring out the buyers once again. Unfortunately for the bulls, we still have to break higher, as nobody likes to be seen to be buying at “the highs”—especially if they subsequently prove to be “the highs” one more time and you are left trying to explain to your investors why you did! With various hot spots still very much alive across the globe, traders can be forgiven for deciding that discretion might be the better part of valour in this instance. There are still considerable worries on the domestic market front. With personal spending power in the UK under extreme pressure, it is hard to see how the High Street is going to push rising costs onto consumers. Inflation is currently driven by events over which retailers have little control (commodities and taxes) and is generally confined to nondiscretionary spending so petrol and food can go up but clothing cannot. House prices are also struggling to rally even though there are bright spots in the South and there are fears that the North-East and Midlands have more to suffer. As ever ladies and gentlemen: place your bets! I

REAL ESTATE

PROPERTY INVESTMENT: COPING WITH MARKET VOLATILITY

The rising appeal of secondary assets First economic and now political volatility have tilted the axis of investment for the real estate industry, with investors caught between the comfort of the mature markets and the potential of those less exploited. Yet amid the uncertainty and upheaval, a number of key market trends have begun to shine through and clear winners are likely to emerge across the next two years. Mark Faithfull explains why the situation remains anything but clear cut. EAL ESTATE’S BIGGEST advantage as an asset class is also its major drawback. The very bricks and mortar intrinsic to properties, which have made it something of a safe haven for investment monies, also make it an illiquid investment in times of trouble, especially when those troubles engulf an entire country. Egypt is a prime example. As we reported in FTSE Global Markets earlier this year, the North African country had begun to nudge to the top of several key funds’ places of interest—buoyed by its young and

bountiful population and with a number of major shopping centre construction projects, created to exploit the desire for wider consumer choice. Yet those very sites had to down tools as the country went into political meltdown earlier this year, with huge chunks of investment stuck like a sitting target with no option for a Plan B. So rewards are up the risk curve for Egyptian real estate, but revolution? Not even the most dyed-in-the-wool professionals had accounted for that. Real estate, however, is nothing if

not pragmatic. Ahmad Touni, development director for Al Futtaim’s Cairo Festival City, certainly seems far from overly-phased by the extraordinary events in North Africa. “Our construction process for Cairo Festival City was interrupted for two weeks but after that we went back to normal. Personally, I believe Egypt will be a much better market to work in as we go forward and you have to remember that for long-term projects the revolution was actually quite a short period,” he says. Instead, Touni believes that a less corrupt system will outweigh the problems of a disruptive interlude and points to the fact that Kuwait’s Alshaya Group, which represents a host of retail chains as Middle Eastern franchise partner, had just committed its partners to the scheme. The reality is of course that the world has always been a volatile place and for long-term real estate projects there are likely to be a few bumps on the ride from conception to completion. Where the post-recession market has changed is in the sharp divestment between markets and even real estate sectors within those markets. So Spain remains robustly popular with investors for retail

TEN EMEA REAL ESTATE REGIONS TO WATCH I

UK: Considered to have corrected quickest of the European markets, the UK enjoyed the fruits of aggressive “right-pricing” in 2010 by attracting a strong inflow of cash. A clear flight to prime and to the south-east, notably London, has created regional imbalances and the capital remains a strong attraction. France: Paris has shared the limelight with London since the start of the recovery and French commercial real estate in general has retained its appeal for more risk-averse investors. Rental rises in the Paris office market and city regeneration will lead growth. Germany: The market that can do no wrong. Germany’s inherent stability

and lack of highs and lows has proven appealing both to cautious domestic investors and international investors looking for safe real estate with steady growth potential in both capital and income. Best value has probably gone and the secondary market is far less healthy but Germany will remain the industry’s favourite safe play. Italy/Spain: Italy’s long-term attempts to bring down debt have stood it in good stead for the more recent economic turmoil and the south of the country has become more appealing to investors of late, who traditionally favoured the north. Retail is especially strong in Italy. While Spain’s office

market remains troubled, retail remains remarkably robust. Investor sentiment suggests that, like Italy, an inherent consumer desire to shop and socialise counters the dire macroeconomic factors. Sweden: Scandinavia had somewhat disappeared from the radar during the downturn but inherent economic stability and the compact size of its real estate market has renewed investment interest, particularly in Sweden and especially in capital Stockholm. Russia: In part spurred on by the infrastructure spend which must precede the Winter Olympics and the 2018 FIFA World Cup, Russia’s

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but not for office or industrial space, while German prime commercial real estate is hugely in demand but investment money is more likely to seek primary in Central and Eastern Europe than secondary in Germany. However, Peter Damesick, EMEA chief economist at CBRE, counters: “We expect an increasing number of investors will start turning to more secondary assets in the second half of the year and into 2012 as a result of the intense competition for core assets. While some investors are starting to look for opportunities higher up the risk curve, the shortage of debt finance for investment in secondary property remains a significant constraint on activity. There may need to be some further repricing before value-added and opportunistic investors become active in a big way.” James Darkins, managing director of property at Henderson Global Investors, adds: “We believe the weight of money chasing a limited supply of prime property assets in Europe is likely to overheat this sub-sector of the market, further increasing the spread between prime and secondary properties.” Similarly, micro-markets are forming, with future investment potentially tar-

moribund real estate sector has started to spark into life. Russia remains a high-risk market but the rewards are enticing. Moscow, like Istanbul, remains one of the biggest tips for inward investment in 2011. Turkey: The bridgehead between European and Asia, Turkey and in particular its biggest city, Istanbul, have attracted increasing interest over the past five years and many believe that 2011 might just be Istanbul’s year, with long-term growth credentials throughout the country. Poland/Czech Republic: The first of the Central and Eastern European markets to attract real estate investment, Poland lost its lustre

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third in terms of investment volumes for last year will be a surprise to some people and we anticipate more international players will show interest in the city due to Sweden’s strong GDP growth and the fact its occupational market has been impacted to a lesser extent than many of the core countries.” However, London remains Europe’s powerhouse. Agent Jones Lang LaSalle (JLL) estimates that in excess of £52bn of equity is currently targeting the UK direct commercial real estate market; and that more than 80% of this equity is focused on central London, predominantly for offices. JLL also predicts that in 2011 Asian capital will be the dominant overseas purchaser. Chris Brett, director and head of JLL’s London-based international desk, says: “We expect investors to move further into ‘riskier’-style transactions such as short income and development opportunities as occupational markets improve. As 2011 progresses, demand will grow and London will witness capital sources from mainland China, Indonesia, Thailand and Taiwan, in addition to the Hong Kong, Singapore, Malaysian and Korean investors already prevalent. I

geting cities rather than nations. Agent Savills cites the UK, Germany, France, Sweden and the Netherlands as the top countries for investment and London, Paris, Stockholm, Berlin and Hamburg as the top five destinations respectively in terms of investment volume. Occupational stability and rental growth for Stockholm have positioned the Swedish capital as a lower-risk destination and a top three city. Sweden’s investment market is showing strong recovery with investment volumes up by 95% on 2009 and up 135% for foreign investment in the past year. Michael Rhydderch, head of capital markets, Cushman & Wakefield, concurs with this theme across Europe and says clear winners have emerged. “In the office occupational market Moscow, Warsaw and Stockholm are the leaders. For retail it’s Germany, and for long-term retail growth Turkey,” he reflects. “Moscow had the largest transactional office market in Europe in the second half of 2010 and there are real prospects for substantial rental growth this year.” Giles Wilcox, Savills head of European cross-border investment, adds: “The fact that Stockholm now ranks as

during the buoyant days to upstarts across the Balkans, only to come back stronger as the downturn kicked in. Further bolstered by infrastructure spend ahead of the 2012 European Football Championship, Poland has become the CEE’s power player. Similarly, the Czech Republic has emerged from several years of investor indifference to become a major target for development and inward cash flows. Egypt: Highlighted as one of the most promising real estate markets outside Europe as recently as the end of 2010, the revolution will inevitably spook would-be investors until the dust settles. Egypt’s fundamentals

remain enticing but existing developers will have to reform their political alliances (and perhaps back out of some now inconvenient relationships), while a number of land sales are likely to come under review. Sub-Saharan Africa: Africa’s potential is awakening by stealth. Walmart’s acquisition of Massmart will be used as much more than a route into South Africa but rather as a conduit to open up the whole of Africa to contemporary retail. Oil-fuelled economies are pushing forward and Rwanda was a surprise exhibitor at recent international real estate show MIPIM to promote its potential for investment.

REAL ESTATE

BRICKS & MORTAR: THE VALUE OF REAL ESTATE AS AN ASSET CLASS

If great deal-making is all about timing, then global real estate can count itself flat out on luck. This once insular old boys’ club spent years aspiring to be taken seriously within the institutional investment markets and to rub shoulders with bonds, equity vehicles and commodities as it created comparable measurement mechanisms to entice the financial world. Yet its eventual success coincided with a global boom and bust and the unprecedented debt which had fuelled real estate growth became a millstone around the sector’s neck. Mark Faithfull asks whether property can recover its appeal.

As safe as houses? F DEBT BECAME too easy a commodity in the heady days of the early and mid-2000s then nowhere was this more apparent than in real estate, where funding by previously cautious investment banks allowed the capital values of property to spiral out of control. The effect was twofold. First, a number of individual deals of an unprecedented magnitude became possible because specialist investment funds were no longer hampered by financial constraints. Second, development went into overdrive, inevitably creating too much real estate, all-too-often in secondary or unproven locations. When the crash came the results were disastrous. Huge and no longer justifiable debt levels on commercial property assets began to threaten the integrity of many long-standing property companies, which witnessed pre-agreed covenant safety nets come and go as their asset values plummeted. In addition, secondary and speculative developments became surplus to requirement as investor appetite turned 180 degrees, favouring only prime property classes in prime locations, effectively terminating the secondary market as a liquid trading environment. A changing backdrop has also altered the investment focus as some of Europe’s largest investors re-evaluate their investment strategies, with the most tangible impact CBRE Investors’ $940m recent acquisition of ING Real Estate Investment Management—the

world’s largest property fund manager and the property arm of the Dutch banking group. ING’s strategic change was forced by the EU in return for receiving financial aid during the credit crunch and it had already divested real estate portfolios in both Belgium and the Netherlands. ING REIM has €65bn of assets under management and the deal with CBRE Investors has created a company with more than €90bn of assets under management. German real estate lender Eurohypo is also to try and reduce its property holdings by another €10bn in 2011 as it struggles to reduce losses and to realign its portfolio. Loan-loss provisions rose to €1.4bn last year, driven primarily by ongoing difficulties in the Spanish real estate market and persistently high loan loss provisions in the United States. Eurohypo, which is owned by CommerzBank, has managed to reduce its commercial real estate financing portfolio by €3bn to €72bn but by the end of 2012 it wants that portfolio size down to below €60bn. Yet the biggest sovereign wealth fund in Europe (and the second largest globally) has thrown its weight behind real estate, following through on a commitment to begin building a portfolio equivalent to 5% or about $26bn of its total investment holding. The first move for the $524bn Norwegian Government Pension Fund Global was the $452m acquisition of a quarter stake in London’s Regent Street and it

has said that further $500m-plus deals are likely to form the basis of its acquisition programme. Karsten Kallevig, head of the real estate team for Forges Bank Investment Management, which manages the fund, said following the agreement on Regent Street: “We are in active dialogue both in the UK and in France. One of the two probably would be a good bet for an investment in the next six months. We will move in to France, spend some time there, see where we end up and then eventually towards the end of the year we start looking at Germany more actively.” The sovereign fund receives its inflow from state oil and gas profits and got its first capital injection in 1996, adding stocks in 1998, emerging markets in 2000 and now property. The Norwegians intend to push forward with further joint ventures but interestingly appear to favour direct investment over fund investments. Indeed, agent Jones Lang LaSalle (JLL) expects direct investment in European commercial real estate to rise by up to 30% this year compared with 2010, when the market transacted €102bn. JLL believes liquidity has returned to the market, driven by crossborder investment from equity-rich private and institutional investors, which resulted in increases in year-onyear investment volumes up 48%. The biggest frustration—in Europe at least—has been the reluctance of

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Photograph © Dreamstime.com, supplied April 2011.

incumbent institutional and banking real estate owners to divest distressed property assets: the so-called “extend and pretend” strategy. In truth, gradually rising capital values have vindicated many of these decisions but the corresponding lack of liquidity has surprised equity houses, many of which built sizeable war chests with which to snap up the anticipated bargains across the continent. Their frustrations at being unable to allocate available monies were neatly encapsulated in March by Resolution Property when it announced a €1bn investment programme. This will be focused on providing equity to unlock added-value opportunities in Europe stalled through the constrained supply of bank finance. Resolution is targeting the UK, France, Germany, Poland and possibly Spain, Benelux and Scandinavia, with its Real Estate Fund III for retail, office and selected mixed-use investments valued between €30m and €130m. The company may also look selectively at major city markets in Central Europe as well as residential property. “Our investment in assets like the Waterfront shopping centre in Bremen and Galleria Podolsk in Poland illustrate how access to new equity can add value through refurbishment, extension and re-letting,” says Peter Todd, director of Resolution. He adds:“The opportunity to add value or to kick-start completely new development will be central to our

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investment strategy.” Richard Bloat, director, EMEA Capital Markets, at JLL, adds: “A shortage of available core product in major western markets means we anticipate the investment momentum of 2010 in Central Europe and Nordics to accelerate in 2011. Europe’s two largest emerging markets, Russia and Turkey, will also witness increased investment activity. Although investors will compete on price for assets in these countries, they won’t compromise on quality; core product in major cities is still the focus.” JLL also forecasts increasing capital values across Europe but unlike 2010, this will be primarily driven by the occupational market and rising rents, although it predicts limited yield compression in CEE markets. “Although vacancy remains high across Europe, tenant activity is increasing and the limited new supply being added to the market means that the absorption of this stock will place an upward pressure on rents,” says Grant Fattener, head of EMEA Research at JLL. “We will continue to see rental growth in core markets, such as London and Paris; there will also be opportunities to acquire core assets in a wider tier of cities, such as Lyon, Stockholm, Helsinki, Warsaw and Moscow.”

European market tightens Friedrich Watering, a member of the board at Saracen, asserts: “The most important thing is the nature of the asset. We are looking to invest further but there are distressed schemes which we simply would never buy. Our focus now is on good locations within capital and important cities; we are not looking at secondary cities.” However, CB Richard Ellis (CBRE) warns that the European real estate debt market will continue to tighten this year, as lenders exercise caution and become increasingly selective on lending. Over the longer term too, the availability of debt will be constricted by regulatory changes, with Basel III seeing lenders increase the amount of capital they must retain on their balance sheets. There are

also fewer lenders, for example to date almost 40 lenders have withdrawn from the UK market. CBRE says that the European debt market witnessed a three-stage transition during 2010 with an initial easing in lending terms followed in late spring by divisions across Europe as the sovereign debt crisis spiralled, impacting countries such as Spain where economic volatility prompted lending terms to shift significantly, even for top quality assets. Over the summer maximum loan size fell from €50m to €35m, while margins increased to 275 basis points (bps). In contrast, key Western European markets, particularly Germany and France, experienced growing competition among banks to lend against prime assets, which resulted in a further easing of lending terms. In the final few months of 2010 lending activity tightened across all geographies, both in terms of active lenders and the terms available. “We remain very positive about real estate and we believe the main funding issue will be what loan to value is required against the risk profile of a given market,” counters Karla Schestauber, senior analyst, real estate at Unicredit. “In Germany that might be 20% to 25% equity, and in the CEE more like 50% and above. How much we transact is dictated by the opportunities but we would hope to grow our investment volumes by 10% to 20% in 2011 over last year.” However, Natale Giostra, head of UK and EMEA debt advisory at CBRE Real Estate Finance, believes that the hangover from the past two-and-a-half years still has to be worked through before genuine progress in real estate as an active asset class can be re-established.“The withdrawal of lenders from the market continues to take its toll,” she says. “Coupled with the challenge of a huge refinancing wall of over €500bn in Europe over the next three years, it is unlikely that new lending activity can truly restart as attention will be focused on delivering solutions to legacy problems.” I

RAILWAYS

Since taking command at Kansas City Southern Railway in 1995, Michael Haverty has transformed it from a low-profit regional line into North America’s most dynamic railroad; the only railroad in the United States that serves both the Pacific and Gulf coasts in Mexico. As more freight enters the US through Mexico’s Pacific port at Lazaro Cardenas, and more companies expand manufacturing operations in Mexico to serve the US—the “near-shoring” phenomenon—Kansas City Southern is on track to fast and profitable growth. Art Detman, a train fan since the age of five, reports.

Photographs kindly supplied by Kansas City Southern Railway, April 2011.

BACK TO THE FUTURE MERICA’S RAILROADS, SUPER-sensitive to a recovering US economy, are thriving. Nowhere is this more apparent than at Kansas City Southern (KSU), whose 6,200 route miles (9,978km) connect the middle of America to the industrial heartland of Mexico, comprising a unique franchise that promises industry-leading growth for years to come. Like its competitors, KSU suffered severely during the financial crisis. Even so, it has bounced back. On revenues of $1.8bn in 2010, KSU earned $227.5m, some $2.11 per share, a record high. The operating ratio sank to 73.2%, yielding a net profit margin of 12.5%, also a record. The big news however was KSU’s fourth quarter, when revenues rose 18% on a 12% increase in carloads and a 6% increase in average revenue per carload. The operating ratio fell to a record low of 71.8%. The strong pricing “is a testament to the value and quality of Kansas City Southern’s rail service,”says Nils Van Liew at Value Line, the US multi-dimensional investment research firm. Car loadings rose 7% from 2010’s first quarter, and analysts expect revenues to approach $2.1bn this year and $2.3bn next. Michael Haverty, now executive chairman, and David Starling, president and (since August 2010) chief executive officer, both expect an improvement of between one to 1.5

points in the operating ratio annually for an indefinite period. Most analysts have revised upward earnings estimates for 2011 and 2012. “Investors want to own railways now,” says Jeff Kauffman of Birmingham, Alabama-based investment bank Sterne Agee. “Twelve years ago I couldn’t give away a railroad stock because the railroads destroyed themselves during the mergers.” For more than a century the federal government promoted competition by discouraging mergers, which resulted in an industry of more than 100 Class I railroads (as defined by regulators). These lines were often redundant, poorly managed, and complacent.

The evolution of an independent The catastrophic merger in 1968 of the Pennsylvania Railroad and archrival New York Central resulted in a bankrupt Penn Central just two years later and wariness by both the government and railroads regarding additional mergers. By the early 1990s all the brouhaha and losses were forgotten and a new ethos had taken hold. US lines began to consolidate rapidly and, often, badly. The inevitable result was nearparalysis of nationwide rail traffic. Everyone found a partner, except Kansas City Southern. It missed merging with both Burlington Northern and Santa Fe, which instead combined

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to form Burlington Northern Santa Fe. Moreover, it failed to acquire Southern Pacific, which was bought by Denver & Rio Grande, which in turn was acquired by Union Pacific. Kansas City Southern was still a Class I line, but with 1994 rail revenues of just $509m and 3,100 route miles, it was, in the words of Trains magazine, a “perennial also-ran”. By then KSU, following other railroad firms in an illconceived industry trend of many years standing had diversified by making major non-railroad acquisitions, notably the Janus and Berger mutual fund families and DST Systems, a data-processor for the financial services industry. To Kansas City Southern Railroad’s (KCSR’s) parent, then called Kansas City Southern Industries, railways were a distraction. “Management would take the free cash flow that the railroad generated and, instead of reinvesting it in the railroad, they would buy more mutual fund assets,” recalls Kauffman. Selling the railroad appeared to be the only solution.

Viable competitor To this end the board approached Haverty, a fourth-generation railroader. Haverty adamantly opposed selling the railroad. He told KSU’s directors he would accept the top job at Kansas City Southern Railway only if his mandate were to keep it independent and build it into a viable competitor. The directors agreed. After all, as president of Santa Fe between 1989 and 1991 Haverty turned the line into the nation’s premier intermodal railroad, moving truck trailers and ocean shipping containers on its railcars in pioneering partnerships with major trucking lines. In bringing aboard Haverty, KSU’s board had found a leader who shared the vision of Kansas City Southern’s founder, Arthur Stilwell. An ambitious New York-born entrepreneur, Stilwell founded KCSR’s predecessor, the Kansas City, Pittsburg and Gulf Railroad, which by 1897 had connected Kansas City to Port Arthur (named after Stilwell) in Texas. He also envisioned extending tracks south into Mexico, which was developing a strong industrial base in Monterrey, today just 165 track miles from the US border. “Mike saw the same opportunity, the same strategy, that Stilwell saw a hundred years before,” says Patrick Ottensmeyer, KSU’s executive vice president and chief marketing officer. “Mike came on board just as the North American Free Trade Agreement was signed and saw that NAFTA was going to create a lot of trade, a lot of opportunities for cross-border movement of goods between the United States and Mexico.” The entire effort was set in motion when the Mexican government announced it would privatise the nation’s railroads. KSU joined with Grupo TMM of Mexico to attempt acquiring the Northeast Line, which terminated at Nuevo Laredo, just across the Rio Grande from Laredo, Texas. They succeeded and in 1997 Transportación Ferroviaria Mexicana began operations as a railroad owned by KSU (37%), TMM (43%), and the Mexican government (20%). Its 2,645 route miles serve Monterrey, capital of the state of Nuevo Leon, and Mexico’s industrial centre, as well as Mexico City and the Gulf ports of Tampico and Veracruz and the Pacific port of Lazaro Cardenas. After years of arduous negotiations, KSU

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Source: KSU, supplied April 2011.

acquired TMM’s interest in 2004 and the government’s in 2005, at which time the line was renamed Kansas City Southern de Mexico (KCSM). By then, KSU had sold its financial services subsidiaries. It also had acquired the Texas Mexican Railway, whose tracks cross the border at Laredo and connect KCSM with KCSR at Corpus Christi, Texas. TexMex, KCSR and KCSM are each wholly-owned subsidiaries of KSU. Operationally however, the three railroads are one.

Merger frenzy About the same time KSU bought MidSouth Rail, which extended Kansas City Southern service as far east as Birmingham, Alabama. An attempt in 1999 to buy Illinois Central, whose route ran from Chicago to New Orleans, failed when IC was acquired by Canadian National instead. Actually, with that particular acquisition the industry’s merger frenzy came to an abrupt stop. Kansas City Southern, never a major line in terms of revenues or route miles, was now a dwarf among giants. To the east were Norfolk Southern and CSX (which traces its origins to the Baltimore & Ohio); to the west, the Burlington Northern Santa Fe and Union Pacific (at 32,000 route miles, the largest US line); and in the Midwest were Canadian National and Canadian Pacific.

RAILWAYS

Although at a disadvantage in terms of size, KSU was in a strong strategic position. Some of its lines connect mainlines of western railroads with those of eastern railroads. What’s more, with its non-core operations gone, KSU was able to reinvest its cash flow strictly in the railroad. During a three-year period KSU bought 240 new high-performance diesel-electric locomotives, resulting, boasts Haverty, in “the youngest, most fuel-efficient road locomotive fleet in the industry”. The line between Victoria and Rosenberg in Texas was completely rebuilt at a cost of $175m, which shortened the distance to Mexico by 70 miles and, estimates Anthony Gallo of Wells Fargo Securities, reduces KCSR’s monthly operating costs by $1.4m. New sidings were built and existing ones lengthened, especially south of the border. KSU’s capital expenditures peaked at 28% of revenues in 2008, versus 15%-18% that is typical for Class I lines. Haverty and Starling pledge to reinvest 17.5% of revenues going forward. “A lot of times managers have to make investment decisions for the long term that don’t always come across as the wisest decisions when they are first announced,” observes Gallo. “But with hindsight we can see that a number of investments that management made over the past several years have positioned the company for future growth and profit margin opportunities.” Once the Mexican railroad was acquired, it took on increasing importance. Indeed, Ottensmeyer concedes that at some point KCSM will account for more than half of KSU’s revenues. This will be the natural consequence of two longterm goals: to handle the growth in traffic expected at Lazaro and take cross-border market share away from trucks.

Freight rates and revenues Most of the cross-border rail traffic now comprises bulk commodities such as coal, grains and chemicals. Last year in a sea change the railroad began transporting finished automobiles from Mexican plants north in the US. This was thanks in part to its investment in Auto-Max railcars, which have greater capacity than conventional bi-level and trilevel auto railcars. Lazaro Cardenas, 200 miles north-west of Acapulco, is Mexico’s largest deepwater port and can accommodate any container ship or dry bulk carrier now sailing. About half of the freight coming into the port is transferred to other ships and sent elsewhere. The other half moves inland aboard railcars of KCSM, the only railroad that serves Lazaro. About 95% of this freight is destined for Mexican markets, but KSU hopes to send an increasing amount north across the border into the US. “Lazaro Cardenas offers significant savings to shippers,”says Ottensmeyer. “Our rail route from Lazaro to Houston is actually 300 miles shorter than the rail route from the ports at Los Angeles and Long Beach.” What’s more, Ottensmeyer believes that companies will find that manufacturing in Mexico is becoming as cheap as manufacturing in China, once transportation costs are taken into account. He adds: “Wages in Mexico have risen more slowly than they have in China, and now are really at a point of con-

Michael Haverty, executive chairman of Kansas City Southern (KSU). Photograph kindly supplied by KSU, April 2011.

vergence.” Dong Tao, an economist for Credit Suisse in Hong Kong, believes China’s surplus of labour will soon end and labour shortages will force up wages. Li Wei, an economist for Standard Chartered in Shanghai, suspects this has already happened. Rising Chinese wages are bound to increase nearsourcing, in which companies shift production from the Far East to Mexico to serve the US market, as Samsung of Korea has done with some of its appliance manufacturing. Ottensmeyer cites a KSU study that compares the cost of shipping goods from Shanghai to Chicago with the cost from Monterrey to Chicago. Using a 40ft (12m) ocean container shipped from Shanghai, offloaded at Los Angeles/Long Beach and carried by rail to Chicago, the cost is $2.20 per cubic foot. If the goods are trucked by highway in a 53ft trailer from Monterrey to Chicago, the cost drops to 90 cents. If the goods are shipped from Monterrey to Chicago by rail, the cost is 45 cents. “That’s a pretty good argument for saying that Mexico is a good place to manufacture these goods,” says Ottensmeyer. Another is convenience. Business trips to Monterrey from almost any major US city can be made by flying in one day and leaving the next morning. In contrast, a trip to Asia requires three or more days. Then, too, all of Kansas City Southern’s Mexico destinations are in the same time zone as Houston, Kansas City and Chicago. Ottensmeyer readily acknowledges the violence in Mexico’s northern states caused by warfare among drug cartels. “It’s certainly not something to overlook. But most large, multinational companies do business in places that are considered dangerous, and it is just something that they have learned to manage. We have not seen this issue deter those companies looking favourably at locating manufac-

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10% in 2009 over 2008, when almost every other port in the world was suffering.” Ottensmeyer maintains that Lazaro is the most efficient port to serve both the consumer market of greater Mexico City (about 55m people) and the industries of Nuevo Leon. Lazaro is still a small port, with an annual container capacity of 700,000 TEUs (20ft equivalent units) compared with 14.4m at Los Angeles/Long Beach. However, work is under way to expand Lazaro’s capacity to 1.7m TEUs by the end of 2012. A second concession is expected to be awarded soon that will result in 1.5m to 2m more TEUs of capacity over the next several years. In addition, a large bulk terminal is being built at Lazaro to handle coal, grain and iron ore. “At this point, we don’t know exactly what the capacity of that terminal is going to be, but it is definitely going to generate growth for the railroad,” says Ottensmeyer.

Making progress

David Starling, president and chief executive officer, Kansas City Southern (KSU). Photograph kindly supplied by KSU, April 2011.

Patrick Ottensmeyer, executive vice president and chief marketing officer, Kansas City Southern (KSU). Photograph kindly supplied by KSU, April 2011.

turing capacity in Mexico.”Even as manufacturing grows in Monterrey, so does trade at Lazaro — 50% year over year in 2010’s fourth quarter. “For the past three or four years Lazaro has been the fastest-growing container port on the West Coast,” explains Ottensmeyer. “The volume of business coming through Lazaro actually grew by about

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Meanwhile, Ottensmeyer is working to win market share away from truckers at the Laredo border crossing. “The vast majority of traffic that moves between the US and Mexico is by truck, over the road,” says Ottensmeyer. Right now, Kansas City Southern has less than 2% of the market. Yet from this small base it is making progress. In 2010’s final quarter, its cross-border traffic was up more than 60%. Ottensmeyer believes this traffic—both truck trailers on flat cars and shipping containers on dedicated high-capacity container cars—can grow by at least 40% this year. “We have the facilities in place in both the US and Mexico, and we are developing partnerships with the major truckload carriers and intermodal carriers. I think a lot of trucking companies see this as a terrific opportunity.” When a Kansas City Southern train reaches the border, the only thing that changes is the crew. “All the containers, all the goods, are cleared prior to getting to the border, and so they cross very efficiently,” says Ottensmeyer. What’s more, Eugenio Aleman, an economist at the Wells Fargo Economics Group, expects Mexico’s economy to grow by 4.2% this year compared with 2.7% for the US Clearly, KSU is far different from the company that Mike Haverty joined in 1995. Then it was the railroad no one wanted. Today, it interconnects with every other major line in North America, and provides them with exclusive access to the growing markets of Mexico. It also fits like a missing tooth in the route maps of CSX, Norfolk Southern, and Canadian National. The government’s merger moratorium language of 2002 exempted Kansas City Southern, which means it’s fair game for a bigger railroad that sees today the opportunity Haverty saw 16 years ago. Despite an industryleading price/earnings ratio for its stock, KSU has a market capitalisation of just $5.6bn compared with $28.7bn for CSX, $25.7bn for Norfolk Southern, and $34.5bn for Canadian National. Haverty argues that KSU shareholders are better off owning the nation’s entire fastest-growing railroad instead of exchanging their shares for a small portion of a larger but slower growing line. It’s a good argument, but one that Haverty may have a hard time winning. I

CANADIAN CUSTODY

Buoyed by an unusually vibrant local economy, Canada’s custody market—featuring a mix of longstanding regional banks alongside opportunistic global players—remains among the most efficient and sophisticated of its kind. Like securities services providers everywhere, Canadian custodians proffer a much broader service range these days. Even so, assets under custody are in flux and the underlying capital markets continue to evolve. How has the rapidly evolving investment landscape continued to shape Canada’s provision of custody services of late? Dave Simons reports.

DEMANDING CLIENTS, COMPETITIVE LANDSCAPE sible for a range of duties that in HE ANNUAL GATHERING the past would have been of the world’s leading typically outside of their financial services organisapurview. “There is increasing tions, SIBOS—the Swift Internademand for the custodian to tional Banking Operations assist the full spectrum of fund Seminar—this September returns participants,” concurs Tom to North America with a stop in Monahan, president and chief Toronto, Canada’s centre for all executive officer, CIBC Mellon. things cultural and financial. For “Fund sponsors are focusing on the great northern country, the their key constituents, relying on timing seems particularly ripe: custodians to provide a range of with no bailouts to clean up after additional services to fund and a solid record of sustained managers and unit holders.” economic growth, the convention Photograph © Konstantinos Kokkinis / Some of these services include represents a bonus opportunity for Dreamstime.com, supplied April 2011. unit-holder record keeping, perCanada’s leading custodians to demonstrate how to get the job done right on their home turf. formance reporting and analytics, outsourcing, fund Over the years, investors have been unusually well served manager monitoring and investment-manager reconciliaby Canada’s economic stability, as well as by regulators’ will- tion, he adds. ingness to keep market participants on a short leash. In a market currently valued at $1.05trn and rising, having a strong Success through stability product offering, as well as a lengthy track record of client Canada’s unusually robust economy continues to be its service—not to mention a sizeable footprint—have been trump card. Through December of last year, the country had leading requirements of all of Canada’s major custody players. recorded five consecutive quarters of growth, making it the Today, firms trade on an exceedingly faster, competitive, only G7 nation with such a strong financial footing. Says and, above all, more fragmented marketplace than in the Monahan: “Investors consider Canada’s national financial recent past. The rapid deployment of trade-matching engines regulation and risk oversight requirements a positive benefit, and low-latency routing to and from the major exchanges and Canada’s commodities and natural resources sectors and alternative venues in Canada and the US has increas- remain extremely attractive to investors worldwide.” ingly bolstered cross-border activity. To ensure continued Canada’s ability to keep a relatively tight lid on its public compliance, custodians continue to place a premium on debt has been a particularly cogent selling point to outside technologies that can boost automation and streamline investors, asserts Monahan. “We have been witnessing a infrastructure, in the process promoting a cost-effective and renewed and active interest from global financial institutions transparent environment for their clients. The Canadian in the Canadian market. These clients are aligning with financustody market is relatively low cost compared to some cially stable providers that have established networks across jurisdictions. In part this is a reflection of the significant Canada and the local knowledge that can help them navigate investments made by local custodians in automating their Canadian market regulations and maximize their growth systems and streamlining their infrastructure as much as across multiple investment platforms throughout the country.” possible to keep the prices down for their clients. Despite its proximity to the US, Canada can claim a number Like their counterparts in the US and elsewhere, of distinctions. For instance, protocols reflecting the comCanadian custodians find themselves increasingly respon- plexities of corporate actions in Canada require that the two

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Weâ&#x20AC;&#x2122;ve got the people and experience to help you navigate the unique Canadian terrain. Very few providers can deliver world-class people and technology tailored to the Canadian Market. CIBC Mellon can. From our headquarters in Canada, we offer the latest technology, customised solutions and the inspired thinking of our people. Backed by the financial strength of both Canadian Imperial Bank of Commerce and BNY Mellon, we are able to remain focused on the sub-custodial needs of our clients.

For more information on Canadian sub-custody, please contact: Alistair Almeida +1 416 643 5126 cibcmellon.com ÂŠ2011 CIBC Mellon Global Securities Services Company is a BNY Mellon and CIBC joint venture company and is a licensed user of the CIBC trademark and certain BNY Mellon trademarks. Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised.

CANADIAN CUSTODY

markets operate as completely separate entities. “Canada’s corporate-actions activity is quite significant, with Canadian custodians processing a very high volume of corporate actions on an annual basis,” explains John Lockbaum, managing director, Canada, RBC Dexia Investor Services. In contrast to the US, the vast majority of Canada’s securities-lending activity has not involved the use of cash, leaving domestic participants in a much better position than many of their counterparts following the storm of 2008. “As we’ve often told clients, going into cash isn’t about increasing the potential yield,” says Rob Baillie, president and chief executive officer for Northern Trust Canada. “Rather, it is an alternative form of collateral that we can accept and then perhaps subsequently increase utilisation. The fact is, there is a risk-reward premium involved that some investors did not fully understand, and, consequently, suffered some losses as a result.” On the other hand, Canadians have been somewhat less eager to embrace the concept of outsourcing. Even as portfolios have grown in size, many have chosen to keep investment-management duties in-house, resulting in significant fee pressures. “In Canada, asset owners and managers continue to scrutinise costs and re-evaluate their operating models, and, accordingly, some have decided to outsource certain functions such as custody, accounting, performance and analytics and fund administration, while others have actually continued to insource [sic] some of these functions,” says Kevin Drynan, senior vice president and managing director for State Street in Canada.

Downward pressure However, evolving regulatory conditions, in addition to thinner margins and downward pressure on assets and returns, have made outsourcing a far more viable option of late. As fund sponsors weigh the costs of augmenting or building from scratch internal IT, they are increasingly partnering with a custodian with proven technology and servicing capabilities for a fraction of the cost. “An assetservicing provider can offer immediate savings and superior capability that can increase the efficiency and effectiveness of service delivery to their stakeholders,” says Monahan. While clients seek one-stop shopping whenever possible, bundled solutions aren’t always the best approach. “A number of clients have been considering outsourcing during the past year, with particular interest in accounting, risk management, performance and analytics, data management, derivatives processing and fund reporting.” In addition, State Street has taken on many new “flight-toquality” clients who want a large, well-established and wellcapitalised provider that operates globally and has demonstrated a long-standing commitment to the custody business, adds Drynan. Where asset owners use a range of third-party managers, all participants are increasingly expected to work together as a team. Here, custodians may demonstrate value by delivering high-quality relationship management. “Those who are willing to commit time to understanding and working with

Rob Baillie, president and chief executive officer for Northern Trust Canada. “Through our partnerships, we have been able to evolve and enhance our product offering, which we can then roll out to other clients on a global basis,” he says. Photograph kindly supplied by Northern Trust Canada, April 2011.

non fee-paying fund managers equally with fee-paying clients, and who can offer a range of servicing models to accommodate mismatches in time zones between asset owner and fund managers, are the most valued,” says Lockbaum. Increased exposure to alternative asset classes has significantly shaped Canada’s provision of custody services of late, says Monahan. “Clients are much more sophisticated in today’s market, they have an expert understanding of global investment capabilities, and they are partnering with domestic providers that offer a full breadth of services and expertise that can support their investment strategies. As clients’ investment holdings evolve, it is critical that providers support them with the ability to settle, account, value, report and monitor performance, as well as provide value-added services that help them maximize their growth potential.” In an effort to stay ahead of the curve, CIBC Mellon has actively developed its investment-servicing focus by delivering a full suite of solutions that support a range of alternative and sophisticated investment strategies, says Monahan, including exchange-traded funds, hedge funds, derivative servicing and collateral management. Canada’s pension marketplace—currently the fifth largest in the world—sports a number of forward-thinking institutional players whose approach to investment strategy and asset management, as well as adoption of supportive technologies, have been well ahead of the curve. Firms such as Northern Trust—which recently marked the 20th anniversary of its Toronto-based Canadian subsidiary—have benefited from this sophistication. “Through our partnerships, we have been able to evolve and enhance our product offering, which we can then roll out to other clients on a global basis,” says Baillie.

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Tom Monahan, president and chief executive officer, CIBC Mellon. “Fund sponsors are focusing on their key constituents, relying on custodians to provide a range of additional services to fund managers and unit holders,” he says. Photograph kindly supplied by CIBC Mellon, April 2011.

Historically, pension-plan allocations have been heavily weighted toward domestic companies. Last year’s Toronto Stock Exchange return of over 17% was due in large part to the stellar performance of domestic energy, materials and financials sectors, which account for some 80% of the Canadian marketplace. Alternative strategies, including private placement and real-estate products, have also been central to pension-plan alpha generation. “Particularly when you’re talking about a plan totalling in the tens of billions of dollars, the market for investment opportunities can become quite small,” says Baillie. “I think that is part of what has been driving the ongoing interest in these sectors, not to mention the potentially significant returns available.” As alternative-asset allocations become increasingly standard, larger pension plans in particular want service providers to be flexible enough to meet their specific needs. This in turn has compelled custodians to become far more agile when servicing alternatives. In other words, says Lockbaum, “a ‘cookie-cutter’ approach just won’t cut it anymore”.

Cognisant of risk Though alternatives seem poised for a rebound, institutional investors nonetheless remain focused on managing portfolio and operational risk, says Drynan. “We continue to see interest in tools that help clients manage risk, such as specialised dashboards that offer reporting and real time analytics. As a custodian, we must be agile, responsive and flexible enough to help our clients adapt to the current market environment, while also responding with customisable services that actually address their changing needs.” Following the financial crisis, fears of increased counterparty risk prompted hedge-fund clients to revert to traditional

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custody models in order to mitigate risk. “Like the rest of the world, Canadian clients have heightened interest in robust risk and performance analysis services as well as increased transparency within their investment portfolios,” says Drynan. “Many are also under pressure from their oversight boards to provide detail right down to security level holdings. We have worked alongside our clients to offer a wide variety of tools to help manage their risk and compliance needs. This has become a significant growth area for us.” For example, State Street recently announced a new service on its mystatestreet.com platform that allows clients to track all of their collateral across various counterparties. With investors putting equal emphasis on risk management and rate of return, today Canadian clients are more likely to establish ties with an asset-servicing provider who can offer both custody and best-in-class solutions supporting a wide range of investment strategies, says Monahan. “Clients are simply finding that there are efficiencies to be gained by having all of these services delivered by one provider.” Northern Trust’s Baillie agrees: “It isn’t enough for institutional investors to simply pursue a rate of return. They also need to be cognisant of the risks involved along the way.” Clients who are looking to minimize risk in the area of prime broking often find that using a single provider such as a custodian is the best approach, adds RBC Dexia’s Lockbaum. “In instances where we act as a prime broker, we hold collateral in an account segregated from RBC Dexia’s own assets, thereby minimizing counterparty risk for our clients,”he says. “While we still have clients who prefer best-of-breed when it comes to prime broking, we are increasingly finding that we can offer an array of services at a substantial discount to investment bank prime brokers, making us an attractive option.”

Going global Like their peers in the US, domestic investors have had to look beyond their own border for plausible investment opportunities, and are looking to partner with firms capable of providing a global reach. Maintaining strong worldwide networks and reporting systems is [crucial] to supporting these strategies, says Monahan. “Clients are increasingly seeking to align themselves with providers with solid data-integration capabilities. Clients want real-time data, superior reporting and the ability to leverage a global network with due diligence and controls in place. They want to partner with a provider that has the capabilities and the relationships to respond quickly when a shift in those strategies is required, while providing integrated systems and reporting that enables clients to monitor and control their accounts at all times.” The ability to provide timely information using an integrated custody and accounting platform that spans the globe has become increasingly important for State Street clients, adds Drynan. “As one of the world’s largest custodians with a global network spanning more than 100 markets, we feel we have a competitive advantage,” he says. State Street also focuses on providing customised solutions for its clients, regardless of which services they select, to provide them with the combination of services that best suit their needs.”I

SECURITIES LENDING

Photograph © Saporob / Dreamstime.com, supplied April 2011.

CAN BORROWERS BE TEMPTED BACK TO THE TABLE? The securities lending market in Europe is a story of two halves mirroring trends in other regions. The majority of beneficial owners including pension funds, asset managers and insurance companies are back in the game but demand remains slack. Uncertainty over the changing regulatory landscape as well as the economic climate has dampened enthusiasm and the jury is out as to whether the industry can turn the corner in 2012. Lynn Strongin Dodds reports. HIS YEAR IS unlikely to change significantly from 2010 in terms of depressed volumes and income. The picture is improving but the golden years between 2003 to mid-2008, when the value of securities for loan in the global markets was growing at a steady estimated compound annual rate of 15% to 20%, are long gone. Although it is not broken down into regions, figures from Data Explorers, an industry data provider, shows that globally, gross income earned from securities lending last year totalled just $7.6bn, down from $9.9bn in 2009 and a far cry from $20.1bn in 2008. The volume of securities on loan at any given time averaged about $1.7trn during 2010, ending the year at $1.852trn. This is actually marginally higher than in 2008 and 2009, although markets have risen significantly during this period. One of the biggest challenges for the industry is to entice the borrowers to return to the table. A new survey by Finadium, a financial markets research and consulting firm, reveals a 40% drop-off in borrowing by the hedge funds community since its peak in 2008. As Paul Wilson, international head of relationship management and business development for securities lending at JP Morgan Worldwide Securities Services, notes: “The supply side is looking fairly healthy and we are not only seeing the remaining lenders who left return back to the market back but there are also a good number of new lenders coming to the market for the first time. The bigger problem is on the demand side which has been subdued and as a result there is a mismatch between the supply side and the demand side.”

Sunil Daswani, senior vice president and head of international client relations for Northern Trust’s non-US clients involved in securities lending, adds: “The general consensus is that the supply side has definitely returned in full force and there is a considerable pool of assets sitting with lending agents. Demand though is still below the pre-crisis levels where about 20% to 25% of a client’s portfolio was lent out compared to today where that figure is between 15% to 20%; therefore, the real problem is with the demand side, which has not picked up as fast as people expected.”

What is keeping levels suppressed? There are a combination of factors keeping borrowing levels suppressed, according to Keith Haberlin, head of securities lending for Europe, Middle East and Africa at Brown Brothers Harriman. “These include hedge funds having a predominantly long bias, interest rates close to zero as well as cash and not stock driven mergers and acquisition activity. These types of deals do not create any arbitrage opportunities which fuels securities lending.” Convertible bond issuance in the US and Europe is also down, which means there are fewer chances for funds to buy debt and hedge their position by shorting the underlying equity. Another obstacle is the never ending roll call of regulation, including the European Market Infrastructure Regulation (EMIR) and Basel III, both of which will impose some type of capital requirements for banks and other financial institutions.

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SECURITIES LENDING

Paul Wilson, international head of relationship management and business development for securities lending at JP Morgan Worldwide Securities Services. “Our clients are more open to generating incremental return from their programmes but do not want to take on extensive risk,” he says. Photograph kindly supplied by JP Morgan, April 2011.

Anne-France Demarolle, head of liquidity management at Société Générale Securities Services. “Most clients continue to look primarily at the risks involved in a securities lending programme. They still don’t study various risk profiles versus revenue options,” she says. Photograph kindly supplied by Société Générale Securities Services, April 2011.

European fund managers are also looking carefully at the different national and regional short-selling proposals. According to Will Duff Gordon, a senior research analyst at Data Explorers, several EU member states have introduced ad hoc domestic regimes to restrict, and in some cases ban, short selling, while the UK’s Financial Services Authority (FSA) has recently replaced its temporary short-selling regime with a revised set of “permanent” rules. The European Commission, on the other hand, has also issued a draft directive on short selling which goes considerably further than the national laws that tend to focus mainly on disclosure and transparency. The main proposals that have put fear into the hearts and minds of both prime brokers and agent lenders are a ban on naked short selling and an obligation to disclose to regulators any net short positions exceeding 0.5% of the issued capital of a public traded company. The market view is that this would not only limit shorting activity, thereby reducing the demand to borrow stock, but it could also drain the liquidity out of markets. It is too early to predict the outcome but there is currently a great deal of lobbying taking place behind the scenes. While a complete

reversal is unlikely, there is hope that the disclosure of individual positions can be replaced with anonymous, private or aggregated disclosure.

The volume of regulation According to Rob Coxon, managing director and head, international securities, at BNY Mellon Asset Servicing: “The sheer volume of regulations is a concern and while we support the increase in investor protection, the devil is always in the detail. Our concern is that they are not too onerous and kill off the demand. At the moment, hedge funds are sitting on the sidelines waiting to see what the final outcome will be. In Europe, the public disclosure on short positions will have an impact on demand and we could see hedge funds move their business to another part of the globe.” In the meantime, there is little shorting activity taking place. Research from Data Explorers reveals that the global equities ratio of longs to shorts stands just off a six-year high at 9:3. This means there are over nine times more longs in the market than shorts. As for those hedge funds that do take on short positions, they are likely to be doing so in smaller sizes, due to the lower leverage levels being employed by the industry.

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SECURITIES LENDING

Daswani says: “There has been a process of deleveraging going on in the hedge fund industry. Certainly, the short-selling rules are having an impact and some borrowers are also going to have to put capital aside in the run-up to Basel III. Overall, borrowers are more efficient when it comes to borrowing securities. We are seeing many look in-house at their own internal pool of assets before going outside to the street.” Hedge funds are not the only participants reviewing their options. Many lenders are also reassessing and are returning to the old school “intrinsic value” model of securities lending. This is whereby returns are based upon the securities loan itself, with little incremental benefit from collateral reinvestments. In the US, Finadium found 80% of pension plan executives favour this model while only 20% supported lending that combines returns from the value of the securities on loan and collateral reinvestment. Although the figures apply more to the US, due to predominance of cash collateral, Blair McPherson, global head of portfolio solutions for market products at RBC Dexia, points out: “Europe has been mainly a non-cash market and has always seen the activity more as securities lending rather than securities financing. Their goal is to maximize the intrinsic value of their assets in a controlled and managed risk framework.” Anne-France Demarolle, head of liquidity management at Société Générale Securities Services, adds: “Most clients continue to look primarily at the risks involved in a securities lending programme. They still don’t study various risk profiles versus revenue options. They carry out due diligence based on the outward features of the set up (contractual, credit rating, collateral, operational) and then expect to gain the maximum on the income side. This can be achieved by capturing the intrinsic lending value of the securities, the percentage of the portfolio that is lent out and the spread from cash collateral reinvestment if considered appropriate.”

Rob Coxon, managing director and head, international securities, at BNY Mellon Asset Servicing. “The sheer volume of regulations is a concern and while we support the increase in investor protection, the devil is always in the detail. Our concern is that they are not too onerous and kill off the demand,” he says. Archive photograph, FTSE Global Markets, November 2010.

Minimum spread hurdle Wilson notes though: “As the markets have become more positive, our clients are more willing to re-evaluating their lending criteria. They are more open to generating incremental return from their programmes but do not want to take on extensive risk. They are more willing to accept equity collateral.” According to Coxon: “There is no one-shoe-fits-all solution. Risk appetite depends on clients. We are seeing some setting a minimum spread hurdle while others are looking to generate returns from a spread of assets, while there are still others interested in exclusives. In general though clients are broadening their non-cash guidelines and including equities. This is because G10 sovereign debt has become more expensive and there is also the realisation that clients holding equities as collateral did not have any losses after the Lehman collapse.” Some lenders though are more adventurous. Wayne Burlingham, global head of securities lending at HSBC Securities Services, is also seeing a trend whereby borrowers take high-quality collateral such as triple-A rated govern-

Allen Postlethwaite, chief executive of SecFinex, the securities lending exchange which is majority-owned by NYSE Euronext. “Although there are presently no mandates within the securities lending arena, I think we will see a renewed push towards using the CCP model,” he says. Photograph kindly supplied by SecFinex, April 2011.

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

The one trend that is gaining traction is the unbundling of securities lending from the custodian. In the past, lenders would use their custodians as a one-stop shop but they are using different providers in the wake of the financial crisis and focus on counterparty risk.

Brian Lamb, chief executive officer at EquiLend. “The CCP model has been discussed extensively for years and it’s important to remember that every market is different. So while it may be a good solution for markets that need to diminish counterparty risk, CCPs do not mitigate all risk,” he says. Photograph kindly supplied by EquiLend, April 2011.

ment securities from lenders in exchange for equities and bonds on a lock-in basis. “It is a risk step up for lenders and it is getting a mixed reception but they are willing depending on the counterparty and the level of indemnification that they receive. The value to the borrower is that they improve their liquidity position to meet impending regulatory requirements.” Although equities have become a more accepted form of collateral, ETFs have not gained traction in the securities lending world. In fact, 45% of participants at a recent Data Explorers forum felt they posed a systemic risk. Coxon reflects the views of many custodians when he says: “Although they are liquid, we don’t take them in our programme. Our main concern with some ETFs is that they may be exposed to financial derivative transactions and therefore open to counterparty risk and credit issues. We rather take the equity directly.” The one trend that is gaining traction is the unbundling of securities lending from the custodian. In the past, lenders would use their custodians as a one-stop shop but they are using different providers in the wake of the financial crisis and focus on counterparty risk. “We are definitely seeing an increase in unbundling,” says Haberlin. “For instance, about 40% of BBH’s programme of lendable assets comes from beneficial owners where we do not act as custodians.” Looking ahead, there is talk of the central counterparty (CCP) playing a larger part in the securities-lending marketplace. So far, the regulation has focused on the over-thecounter (OTC) world, but in a white paper, entitled, Planning for the Future: The Role of a Central Counterparty in Securities Lending, Citi argues that CCPs can serve to mitigate the

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

counterparty risk and the credit exposures for individual market participants, and reduce systemic risk for the market as a whole. Allen Postlethwaite, chief executive of SecFinex, the securities lending exchange which is majority-owned by NYSE Euronext, says: “Although there are presently no mandates within the securities lending arena, I think we will see a renewed push towards using the CCP model. This is because in the post-Lehman world, there is a greater focus on counterparty risk as evidenced by impending regulations such as changes to capital requirement directive (CRD), Basel III capital requirements and Solvency II implementation. “Also, as seen from European Market Infrastructure Regulation (EMIR), regulators are determined to reduce the opacity and bilateral risk of OTC markets. Together this will drive market participants to a CCP solution for securities lending.” Jonathan Lombardo, executive director of sales at SecFinex, also notes that they work closely with lenders and intermediaries to develop solutions. “We do not want to disintermediate custodians because we recognise this is a relationship business. SecFinex accommodates strategic borrowing and lending, which in essence preserves a bilateral relationship whilst receiving the benefit of a CCP.”

Counterparty risk perspective Some market participants though are not that convinced by the merits of the CCP. As Haberlin puts it: “I expect to see some business being put through a CCP but I think a better argument needs to be made for beneficial owners to participate. For example, from a counterparty risk perspective, the incentive for a different model is not really there as, in many cases, our clients are more comfortable now than they were before the Lehman default, given the unwind process worked exactly as designed and they have complete control over allowable collateral and counterparties. Our view is that the CCP model is better suited for an inter-broker market or borrower to borrower and not a beneficial owner to borrower.” Brian Lamb, chief executive officer at EquiLend, adds: “The CCP model has been discussed extensively for years and it’s important to remember that every market is different. So while it may be a good solution for markets that need to diminish counterparty risk, CCPs do not mitigate all risk. It’s important to note that during the recent down time in the securities finance industry, the main issue revolved around other matters concerning reinvestment risk—not counterparty risk.” I

ISLAMIC FUNDS

THE SHOCK OF THE NEW The Islamic asset management industry remains fragmented. At the last official count, in mid 2010, consultants Ernst and Young found that 70% of the investment managers handling Shari’a compliant funds had under $100m in assets under management and fewer than 10% having accumulated assets in excess of $1bn. Investors in countries with mature Islamic finance industries still tend to invest through the local banking system rather than into dedicated funds. Nonetheless, the outlook for the industry is better today than it has been since 2008 and there are signs that the Islamic asset management industry is making up in diversity what it has lacked in support over the last three years. Will 2011 prove to be the turning point? T REMAINS IN doubt whether the global Islamic asset management industry is finally turning to glory days. Since 2008 the accumulation of assets in the segment has been stop start, and while the diversity of the segment continues apace, there remain structural blocks which will temper the rate of growth of the investment segment for the immediate future. While the industry has been awash with keen proponents and various conferences have claimed that as much as $1trn dollars has now been invested in the sector, the reality is that potential aside, growth in both the Islamic finance and Islamic investment segments has been patchy and piecemeal. The financial crisis impacted the Islamic finance market as much as the traditional investment segment, with asset values plummeting and investors running for cover. A small revival of sorts characterised 2009 as asset managers stretched the application of Shari’a compliance into new segments, such as hedge funds; a trend that continues today. Even so, there remain few signs that the industry is witnessing a sustained growth spurt, though asset managers continue to push the boundaries of what can be described as Shari’a compliant in order to provide sufficient returns and attract end investors. Moreover, while a number of countries have emerged as Islamic financing champions: Bahrain, Malaysia, Turkey and Indonesia among them; none of the jurisdictions have managed to translate that support into a high growth industry. In part, they are stymied by varied regulation and strictures over what is defined as Shari’a compliant. They are also limited by the general malaise in the investment industry which has redirected end investors to place funds in traditional vehicles, such as index-based investments, UCITs structures (which have been heavily sold in Asia) or ETFs rather than complex Islamic structures. In selected markets, retail investors have continued to prefer to take a punt on high profile IPOs with an active secondary trading market than slow burning fund structures to secure visible returns. Taking those considerations into account, Comgest, which has some $17bn in emerging markets assets under management, with a specialisation in the Middle East and North African (MENA) region, recently launched two new Shari’acompliant funds, one with a global emerging markets focus

Photograph © Linda Bucklin / Dreamstime.com, supplied April 2011.

and the other a European equity focused fund. The Comgest Growth Emerging Markets Shari’a and Comgest Growth Europe Shari’a are both UCITS III funds with seed capital from Comgest as well as some small external investments. Both funds are Shari’a versions of existing Comgest funds. According to the firm, investors in the fund have been pursuing a diversification strategy, with investors from the Nordic region and Japan a feature of these latest funds, which were announced at the end of last year but which only

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ISLAMIC FUNDS

recently opened up to new investors. The experience of Comgest may provide a template of what is to come for Islamic asset managers, with end investors sourced from around the globe seeking to mitigate risk through diversification, rather than having to rely on a growing Islamic investor base which is either not liquid enough or dedicated enough to channel savings into this specific segment.

Diverse sources of innovation Innovation and enthusiasm in the segment has come largely from either jurisdictions across the globe anxious to secure a specific investment niche (such as Malaysia or Bahrain) or through dedicated asset management firms which have wanted to diversify their fund structures to attract cash risk Muslim investors. In the search for investor funds, asset management firms have not been shy of pushing the envelope of new fund structures. There have been no shortage of efforts by various jurisdictions to deliver innovative access to the Islamic investment sector. The Bombay Stock Exchange announced earlier this year that it had launched an Islamic index to tempt the local Muslim community to invest on the exchange. The stock exchange claims that the index will allow both Muslim and non-Muslim investors to gain access to Shari’a compliant firms without having to verify the extent to which individual investment vehicles comply with Shari’a strictures, providing a tightly defined set of firms in the index which are deemed to be compliant. The cap-weighted free float index, named the BSE TASIS Shari’a 50, was created in conjunction with a group of Mumbai-based Islamic finance companies, including specialist Islamic consulting firm Taqwa Advisory, which will regularly review the constituent firms on a monthly basis to ensure that they continue to comply with the index’s Shari’a terms. The constituent firms in the index are those Shari’a compliant firms that are included in the exchange’s benchmark BSE-500 index. The stock exchange says the index has been back-tested from the beginning of 2008 with a base index value of 1000 and will be rebalanced on a quarterly basis. Most recently Prime Rate Capital Management illustrated just how far diversity in the construction of Shari’a compliant funds have come with the launch of its open ended liquidity fund that invests in short term instruments. Domiciled in Ireland, the fund is designated as a Qualifying Investor Fund (QIF), which eventually will be listed on the Irish stock exchange. Prime Rate Capital’s chief executive officer Chris Oulton says the fund is designed to appeal to international Islamic investors which can use their investment in the fund to manage their own liquidity and to banks and other institutions to distribute onwards to their clients providing an underlying Shari’a compliant product structure. The fund invests exclusively in commodity murabaha transactions, sourcing commodities from traditional market sources and utilises a multiple counterparty transaction structure, explains Oulton. Because there is a physical commodity, such as metals, underlying trades invested in by the fund, transactions can be structured to become Shari’a compliant.

Transactions underlying the fund involve the purchase and later sale of commodities at a profit where the buyer pays a premium because he has access to the use of the goods before he has actually had to pay for it. Although the nature of the transactions which underpin the fund appear flexible, there are limits to a fund of this type. For one, explains Oulton, there is a limit to the types of commodities that the fund is suited to invest in. High value metals, such as platinum or a base metal are suited to the Shari’s prescriptions underlying the fund, however he notes: “Precious metals, which are viewed as cash equivalents or commodities do not qualify.”The underlying must be identifiable as a physical asset and be warrantable, he adds. Commodity murabaha structures are in fact an increasingly common underpinning to Shari’s compliant funds as they have provided investors with both liquidity and return in a market where many investors have been unwilling to tie up their cash for a sustained period. In that regard, income funds have appeared to be a workable solution; “providing greater liquidity for Islamic investors than property or leasing funds, yet [offering] a better return than liquid savings accounts,” according to Nigel Denison, head of asset management at the Bank of London and the Middle East (BLME), which claims that its Shari’a dollar income fund has been ranked in the top decile of funds for 2010 by Lipper Hindsight, the fund ranking platform. However, BLME’s fund, which is managed by Jason Kabel, is more diverse than a straightforward commodity murabaha fund, by incorporating elements of trade finance as well as commodity murabaha.

The need for a consistent approach It is clear that various jurisdictions have been keen to clear the decks in spurring the development of the Islamic finance and asset management segments over the near term. Most recently, the Qatar central bank took the markets by surprise when it stipulated that commercial lenders shut down their Islamic finance activities by the end of 2011; a move that will undoubtedly limit the distribution of Islamic investment products in the jurisdiction. It also raises questions over the role that foreign banks can access investors interested in Shari’a compliant product. In the circular announcing the decision, the QCB cites the reason as being “to manage the risks”. However, some bankers in Doha say the move was motivated by pressure from the country’s own Islamic financial institutions which have been frustrated at the levels of business growth in the segment. According to others, the move reflects the central bank’s desire to ensure the purity of the country’s Islamic finance industry, forcing investors to work with firms that cannot co-mingle traditional and Islamic assets (either by accident or design). According to one banker,“the margins on Islamic business are substantial and it is clear that the Islamic banks were keen to secure this business. However, it also remains in doubt whether existing traditional banks and foreign banks will be allowed to open dedicated Islamic subsidiaries and some would undoubtedly take this option if it is allowed.”

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ISLAMIC FUNDS

Most affected are Qatar National Bank, which has the largest share of Islamic business in the country and AlKhaliji Bank, which recently announced its merger with International Bank of Qatar (IBQ) and which only last year opened an Islamic window. That leaves the three local Islamic institutions, led by Qatar Islamic Bank, as the only ones that are viable buyers for the outstanding portfolios of assets that these banks now have to offload. There are questions about their ability to step in and fill the vacuum, and provide local investors with sufficiently innovative Islamic investment product. QIB, the largest of the country’s Islamic banks is reckoned to have secured only 10% of the market to date, compared with QNB’s 30%. Moreover, there remain questions over the ability of the country’s Islamic segment to provide significant capital markets access to Qatari sovereign entities, in particular Qatar Diar, which are a key platform of the country’s financial and economic diversification strategy. Finally, most surprising perhaps is the speed with which local institutions are meant to comply with the directive. Commercial Bank of Qatar is already in talks with the country’s Islamic banks to see whether they are interested in buying the bank’s Shari’a compliant investments; though some clients will likely transfer their Islamic investments into traditional fund structures rather than take business out of the bank. “We have no problem implementing the central bank’s circular,” says Andrew Stevens, CBQ’s group chief executive.“The central bank has made it clear it wants to see us exit the business and we respect the decision and will comply with its requirements.” Indonesia took a similar line to that of Qatar back in 2008, however its bank’s have until 2023 to comply and in the interim have a clear pathway to establishing dedicated Islamic subsidiaries.

Malaysia: the clear leader Bank Negara, the Malaysian central financing authority, responded to Qatar’s move by confirming that it does not plan to take similar action; in fact Malaysia has provided a template for flexible support of its Islamic finance and asset management segments. Malaysian authorities continue to press ahead with its plan to develop the country as a worldleading Islamic financial hub, a fact not ignored by Middle Eastern financing institutions which have been sometimes stymied in their efforts to provide sustainable Islamic investable product in their home markets. Islamic banks in the Middle East have used contracts based on London Metals Exchange (LME) commodities to manage their liquidity positions for some years. In a typical commodity murabaha structure, such as the BNMN, an Islamic bank buys crude palm oil from a broker and sells it to Bank Negara at cost-plus. Then Bank Negara appoints the bank in turn as its agent to sell the commodity to a third party, takes the cash, and agrees to pay the bank on a deferred basis. The economic result is that the bank has placed out its excess funds with Bank Negara. The same transaction, carried out in reverse, would mean that the

bank becomes the borrower and needs central bank liquidity. Moreover, a commodity murabaha structure can also be transacted between two Islamic banks and often, none of the banks involved would take physical settlement of the underlying crude palm oil. The common pricing reference of the underlying crude palm oil in a commodity murabaha transaction is taken from the Malaysia Palm Oil Board, a research and development association that publishes daily spot crude palm oil pricing. Commodity brokerage houses act as intermediaries effecting such buying and selling/on-selling of the underlying crude palm oil through their connections with the supplier and buyers. Commodity murabaha structures have been evident in the country as far back as 2007 involving central bank monetary notes backed by the country’s crude palm oil supplies. The physicality of the commodity underpinning transactions means has meant that Malaysia has been able to utilise production of its key revenue generator to create investible Shari’a compliant structures for some time. Even so, the structure has been relatively slow to overtake interbank murabaha (interbank lending and borrowing based on a negotiated profit-sharing ratio) as investible product. By the end of last year, interbank murabaha volumes stood at just under $70bn, compared with the estimated $59bn worth of commodity murabaha transactions in the country. However, even in Malaysia, the industry has yet to develop irrepressible momentum. Surprisingly perhaps Islamic deposits accounted for only 19.3% of the country’s MYR1.13trn in total deposits as of November last year.

Banks remain key The manufacture of new Shari’a compliant product remains firmly entrenched in the banking sector in most Islamic countries, rather than dedicated asset management firms, underscoring the valuable distribution channels that bank’s still dominate in the wider MENASA transcontinental region. Typifying the continued value of the trend is the recent US dollar-denominated, open-ended, Shari’acompliant fund launched NCB Capital, the investment banking arm of National Commercial Bank (NCB), the largest commercial bank in Saudi Arabia. NCB Capital will invest in sukuk and murabaha issued by highly rated companies and governments to generate returns in the mid-term fund that will provide investors with an opportunity to participate in sukuk as a developing asset and which, the firm claims, will help them to balance their overall portfolio risk. NCB Capital speaks from a position of strength in the Saudi market, given that it reportedly enjoys a dominant 33.3% share of the funds market in the country . In a press conference launching the new fund, the firm told journalists that it expects to generate a higher yield than money market investments and will benefit from a diversification across countries, sectors and companies in the Gulf Cooperation Council (GCC) region. The minimum subscription amount is fixed at $10,000. I

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COVER STORY

THE BRAND VALUE OF CUSTOMER CARE The asset servicing industry continues in flux and it remains unclear how the industry will evolve in a high speed investment universe. Even in its simplest form, it is not a business for the fainthearted, involving a willingness to acquire new business and invest heavily in technology and processing hubs across the world. Moreover, as political change and new regulations continues to reverberate through the financial markets it is increasingly difficult to distinguish the secular from the cyclical. In such a potent context, defining broad brush global strategy is tricky at best; and banks such as Northern Trust, which are compactly defined in terms of business reach (private bank, asset servicing provider, asset management specialist), finding one’s clearly defined spot under a sparkling sun is an arduous task in these revolutionary times. Francesca Carnevale speaks with Rick Waddell, chief executive officer, Northern Trust, about the multiple challenges facing the bank and how he intends to meet and beat them over the coming decade. ORTHERN TRUST IS one of those peculiarly American specialist financial institutions, such as Brown Brothers Harriman, Bank of New York Mellon and State Street, which have carved a global niche based not on universal banking services (such as Citi or JP Morgan) but rather on the provision of a clearly defined service set in which they excel. In this regard, it provides a paradigm for the peculiar challenge facing the investment services segment; that of effectively redefining their business remit in a rapidly morphing investment universe. Then again, Northern Trust carries its own particular burden, being one of those financial institutions upon which history visibly weighs. It has an undoubtedly patrician clientele; numbering most lately even the US President among its customers and a goodly portion of America’s top Forbes 400 family accounts. Just how deep blue the vein runs is illustrated by the bank’s urbane chief executive Rick Waddell, who points to an antique leather bound book entitled Enduring Principles: The formative years of the Northern Trust Company 1889-1949, a collection of individual musings and reporting of the bank’s evolution and philosophy. It is a well-spring of motivation, conservative admonition and experience.“I had it specially bound and keep the master copy near,”he says:“It keeps me grounded.” Leafing through the book, it is clear that it articulates a client focused culture that still resonates along the woodpanelled rooms of Northern Trust’s executive suites. It is easy to understand its appeal to an executive as rooted in history as Waddell; it often soars on lofty heights. On page seven for instance, there is a lilting refrain which resonates with still recognisable concerns:“Since the bank’s founding, great outward changes have come in the business and social life of the nation. Business has expanded tremendously. New banking facilities and new safeguards have succeeded the old, with changes coming always at an increased rate of

speed. But as long as men trade with one another, confidence must be the basis of their relations. And confidence, in turn, rests upon a foundation of conservatism.” Therein lies the nub of the matter facing Waddell: creating sustainable and profitable harmony between the sometimes arcane and traditional and the shock of the new. Waddell comes prepared for the job, having joined Northern Trust way back in 1975 and appointed chief executive officer at the start of 2008, becoming chairman a touch under two years later. He boasts a wide-ranging internal CV which has encompassed leading the bank’s august wealth management group and Northern Trust Bank of California, as well as its institutional business, strategic planning and marketing among a range of other honed skills. In the 36 years Waddell has spent working his way up through the company, he has had to master a peculiarly hardnosed collegiate approach that sets apart the bank from its competitors. “Just because we’re nice, doesn’t mean we lack the competitive instinct,” he avers.“In that context, I want the best of Northern Trust’s enduring principles.” Waddell fairly squares up to both an internal and external dynamic. Internally he has to guard against the stasis that often mars traditionally bound institutions. Externally, he has to define a clear strategy that successfully adapts the bank to the changes resulting from the globalisation of the financial markets, with all the multi-cultural challenges involved in creating a meaningful global footprint. In that regard, holds Waddell, the collegiality that is a hallmark of the bank helps in striving for that balance. “I look for leaders who are willing to be good teammates and will sacrifice for the greater good,” he avers. “If you work effectively in a team, if you support that team and that team services the clients, you’re going to be successful.” In the pre-financial crisis era, banks such as Northern Trust could rest on the laurels of their brand value; and

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Rick Waddell, chief executive officer, Northern Trust. Photograph kindly supplied by Northern Trust, April 2011.

while the bank has plenty of that, in today’s post-crisis world it is not really enough. That fact came home to roost over the last few years as the bank had to cope with less than stellar financial results, though it was one of a handful of US banks which did not have to resort to Treasury handouts. While it took money at the government’s request it repaid the funds promptly and with interest. Even so, the global financial crisis ultimately took its toll and 2010 fourth quarter earnings typified the trend as profits fell 22%, driven down by low interest rates. Earnings per share of $0.64 failed to meet analysts’ expectations of $0.71. The bank was stymied in part by events out of its control: low lending rates from the Federal Reserve caused it, like other banks to have to waive fees on money market funds. Added to that, through 2010 assets under management dropped steadily, as securities lending collateral assets fell in line with changes in that market; although the bank recorded a meaningful 4% uptick in assets under custody over the period, of which more later.

Tackling adverse markets In its 2010 Q4 earnings release, the company said that the current provision and charge-off levels reflect continued weakness in some residential and commercial real estate loans. Even so, in a statement at the time, Waddell stressed that: “The adverse market conditions have not, however, limited our ability to continue to grow and attract new business in our targeted markets. As we move into 2011, we are confident that our strategic positioning, strong balance sheet and capital levels position us for profitable growth.” Northern Trust has found its own solution to one obvious problem for custodians which sometimes offered free safekeeping of clients’ assets in return for the leverage the bank’s could make from those assets in businesses such as prime broking and securities lending. Waddell says the sector has learnt from its mistakes, but notes that the

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bank’s enduring conservative principles helped it through the financial crisis: “and we came through on a relative basis better than most,” he holds.“Now of course it is back to basics as improved disclosure, the reduction of leverage and the mitigation of counterparty credit risk become everyday watchwords. It will increase competition for Northern Trust as we have always kept to these principles. In that context however, it is clear that we are going to have to evolve, be better and be more disciplined.” He is clear that the driver for evolution will come from clients as much as the custodian banks themselves. Both sides will have work out the measurement and management of the risks custodians and clients are prepared to take and the spreads they can reasonably expect from a range of activities, including securities lending, and the money and foreign exchange markets. “We are seeing that our clients want to establish a partnership based on solutions. That in itself is something of a challenge, because our clients are all so very different, some requiring complex solutions, other more simplicity. Even so, it is clear that our clients are looking for a well capitalised, committed firm, with the skill set to provide them with the right solutions for a changing marketplace.” The rush to alpha has been tempered, says Waddell,“There are a lot of different dynamics in play. Many of our clients are coming back to passive strategies, with reduced costs, a more simplified investment approach and where risk is taken at the edges.” In terms of the business opportunities that this suggests “there is a new rush to outsourcing of middle and back office services,”he notes,“not just for fund managers but also by both sovereign wealth funds and large public funds alike. These clients want service providers that are well capitalized, committed to the business and able to bring a set of solutions that help them address their needs. In addition, our attention to detail and conservatism have worked in our favour.”

COVER STORY

Equally, he stresses, even in such a conservative institution, there has been a need for change. “It has been particularly driven by our movement into new markets. Some 40% of Northern Trust staff are now outside the United States. It is no longer about simply exporting our culture into those foreign operations, though that is an important element for us, but it is also about what those offices have brought to Northern Trust.” In the scramble for market share Northern Trust has married organic growth with a lively if highly selective acquisition strategy. Among its most recent acquisitions the bank acquired the investment servicing unit of Bank of Ireland Group for $82m beefing up the bank’s fund administration business in Ireland, one of Europe’s largest fund administration centres and increasing the bank’s assets under administration by a hefty $96bn. The deal was a hallmark of the bank’s approach, explains Waddell, “focusing on the highestpotential opportunities for growth”. The EMEA region has been a cornerstone of the bank’s international strategy, with the UK a particularly successful market for the bank. The bank recently announced the appointment of Wilson Leech (previously head of Northern Trust’s global fund services group) to head up its EMEA business, which Waddell regards as still a high growth segment. To this end the bank has made recent strides in expanding its reach into Scandinavia and the Benelux. At the end of the first quarter of this year it had secured approval from the Finansinspektionen (the Swedish Financial Supervisory Authority) and the UK Financial Services Authority to offer asset management products and services to investors across the Nordic region, directly from its Stockholm office. Moreover, it has expanded the reach of its asset management arm, Northern Trust Global Investments Ltd. (NTGI), to offer asset management solutions to clients across Benelux Northern Trust’s Amsterdam office. In building market share, Northern Trust however is nothing if not a master of the long game. The bank, for instance, has paid particular attention over the years to the less glamorous but substantial bread and butter business provided by the UK’s local government pension market. The assiduous courting of the sector has paid off handsomely, as the bank now services 36% of the market, to which it added a further $10bn worth of mandates last year.

Redefining the service set Waddell is well aware of the multiple challenges now threatening the definition of the service set provided by custodians. First off is the regulatory challenge which is still to take on final form: “There are some 2300 pages of the Dodd Frank Act and some 300 mandates for studies that will explain the consequences of legislation and it will take some time to digest the results of that research,” he notes. At this stage however, he continues it is clear that the spread of central counterparty clearing houses across the equity, repo, over-the-counter derivative and securities lending markets, resulting from regulation, will inevitably bring changes to the status quo. If analysts were expecting

Waddell to fret over the inevitable impact on custodian providers, he shows few signs of it. “It is a terrific idea. Everyone should know who their counterparty is. Look, the level of fiduciary standards of care now being articulated are in the very DNA of this firm; when you put the client first, and put their interest before yours and pay attention to the risks inherent in a transaction and where those risks can be laid off, then you have nothing to fear from current legislation. We’ve always done that.” He acknowledges no threat from stronger CCPS which threaten to eat the transaction volumes that have been the traditional preserve of CSDs and custodians in the process of achieving a solution to the problem of credit risk. “You have to be positive,”holds Waddell.“In this market you’ve got to be good. We’ve been going up again some of the world’s biggest and best financed giants, and outgaining them on the playing field. We are all in the same game right now, facing the same challenges.” Waddell concedes that regulators have blindsided the banking industry: “The regulatory pendulum has swung towards increased oversight and perhaps that pendulum has swung a little bit too far for everyone’s taste, but I firmly believe it will come back a little.” There are still wider issues that custodian houses such as Northern Trust must face. Custodians are at risk of losing their roles as risk-taking intermediaries and gatekeepers to the market infrastructure, even in those areas where traditionally they have been without equal, namely in segregated custody, asset servicing, managed accounts, and regulated fund support and distribution. Waddell sees it as a cyclical rather than inherent mechanism, pointing to disparate but meaningful signs of market upswing: “I think we will see the cyclical return of the equity markets, particularly if the downward pressure on interest rates remain. Moreover, despite the current gloom, there are signs of upturn everywhere. Some $2bn in cash is estimated to be sitting on the balance sheets of US corporations and savings rates are rising once more.” Even so, Waddell agrees that a vital element of business going forward is optimum pricing, that feeds realistic profits to the banks while offering cost effective services to clients. “The bank which offers effective charging that covers custody, FX, cash, securities lending, and risk intermediation, and develops the asset-servicing, reporting and financing products that can facilitate institutional investment in multiple asset classes, is the custodian of the future. To achieve that we have to focus fully on our clients and on the quality of our people. We’ve had record low levels of lost business because of the close relationships we develop with our clients, and it is an approach that we will carry forward for another hundred years at least,” he holds. It is an acknowledgement of the power of a collegiate and earnest approach to business development that has cascaded down the ages at Northern Trust. The proof is to be found in Waddell’s historic manual. Also on page seven is the following statement: “An institution is said to be but the lengthened shadow of a man. The Northern Trust Company might better be termed the lengthened shadow of a family.”I

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EUROPEAN TRADING ROUNDTABLE

AN EVOLVING UNIVERSE & THE IMPACT OF MIFID II

Photograph by Mark Mathers, supplied April 2011.

Attendees

Supported by:

(Front row, from left to right) WILL RHODE, analyst, TABB Group RICHARD HILLS, head of electronic services, SGCIB NICK NIELSEN, global head of trading, Marshall Wace (Back row, from left to right) DALE BROOKSBANK, head of European trading, State Street Global Advisors STEVE WOOD, CEO, Global Buy Side Trading Consultants BRIAN SCHWIEGER, head of algorithmic trading, Bank of America Merrill Lynch

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ROUNDTABLE

SETTING THE SCENE RICHARD HILLS, HEAD OF ELECTRONIC SERVICES, SGCIB: The challenge right now is finding quality liquidity and offering services around that to our institutional client base. At the global level, the challenge is rather similar. It is keeping up with changing market structure, adapting our services, which are obviously very highly technology-driven quantitative services. Then we make sure that they are integrated with the other services that our clients require, particularly around other asset classes—ETFs in particular—and the provision of liquidity through risk management, on the back of traditional research and sales-driven businesses. WILL RHODE, ANALYST, TABB GROUP: Regulation is a key driver in the market, in terms of how market structure is developing right now, and we are doing our best to try and service our clients, to help them understand and better position themselves to meet these challenges. As you all know, TABB clients are primarily investment banks, execution venues, clearing houses, private equity firms and technology vendors. We communicate extensively with the buy side as well through lengthy interview-based studies whereby we gain an understanding of their concerns and communicate those issues to our clients in an anonymous fashion. NICK NIELSEN, GLOBAL HEAD OF TRADING, MARSHALL WACE: Marshall Wace is an asset manager that primarily trades listed equity products on a global basis. Our business is relatively high turnover across a relatively high breadth of securities, so we don’t necessarily trade sizes as big as some managers on any particular order. However, we generally trade many more orders relative to most managers. It is important for us to continue to take cost out of our business, as well as to utilise methods that we have developed to leverage new P&L opportunities through microstructure management. BRIAN SCHWIEGER, HEAD OF ALGORITHMIC TRADING, BANK OF AMERICA MERRILL LYNCH: One of the recurring themes in discussions with all market participants has been MiFID II and the likely outcome of the directive. There is still a lot of talk going on around this, much of it focused on how much the financial industry can help the politicians successfully frame this legislation so that it is practical and workable for all parties. DALE BROOKSBANK, HEAD OF EUROPEAN TRADING, STATE STREET GLOBAL ADVISORS: Market microstructure, the evolution or potential revolution of MiFID II, regulation, and Brian’s point about the interaction with current planned regulation: these are all important issues which have yet to fully play out. We continue to see market change and evolution of the electronic trading landscape. There are also other considerations; such as transaction cost analysis (TCA), execution data, and venue analysis, which continue to be of interest to us. STEVEN WOOD, CEO, GLOBAL BUY SIDE TRADING CONSULTANTS (also a member of the Consultative Working Group for ESMA and its Secondary Market Steering Committee): Obviously I am focused on

Richard Hills, head of electronic services, SGCIB.

the buy side, and for me the big move at the moment is increasing globalisation of the regulatory environment. We have seen it with MiFID II, which is an interim stage. We are now seeing reports on the Flash Crash, and planned CFTC rules on aggregate trading and market responses to that. CP145 recommendations have been launched in Australia, and both the buy side and sell side are responding very vigorously to them. It is clear that regulatory bodies across the globe are talking to each other and the community of regulators, as a consequence, is becoming more robust and more overtly political as well. In Europe we see this through the intervention of MEPs in MiFID II and the new EMIR regulations, and we will see the impact of these initiatives very soon. Elsewhere, Asia’s going to be a breaking market as far as regulatory enhancement’s concerned over the next three or four years. Moreover, you are going to see those markets open up a lot more than they have in the past. We have seen it in Japan already, with fragmentation beginning to occur. Change is happening on a global, rather than on just a European or US-centric market level.

MiFID II: A GAME CHANGER/OR PROBLEM MAKER? RICHARD HILLS: It has turned out to be a very complex subject. There is the area of pre-trade transparency to consider, then issues such as market structure. There is the subject of transaction reporting and asset class coverage. I’ve focused on two aspects: the market structure, by which I mean whether we are going to see compression of flow towards lit venues and whether there will be changes to the status of the dark pool or broker crossing networks; and what will happen to the pre-trade transparency regime. Regulators need to make sure they fully understand the way the market works, and that’s complex and can’t be over-simplified. To illustrate the point: let’s think about how we execute our clients’ larger trades, either in block form or portfolio form. To minimize market impact, we split the trade down into component parts, a highly quantitative activity that uses indicators such as volatility, index and sector correlations and order book balance to decide how quickly to trade. Venue selection is critical. We use internalisers, external broker crossing networks, dark MTFs and lit pools to find liquidity at the right price whilst trying to minimize information leakage about the overall size and direction of the trade. Different venues have different characteristics in terms of the liquidity quality and quantity. Generally though, we look to find other natural liquidity in our crossing engine so that we can speed up the trade by executing against other blocks

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Will Rhode, analyst, TABB Group.

which minimizes market impact and reduces the time we are exposed to volatility. If there’s no match we may look in an external dark pool for other blocks, but we’re risking some information leakage and therefore market impact as there is less natural liquidity in those pools. Finally we will broaden the search for liquidity to lit venues where we cannot differentiate between the types of participant we will meet, and where the risk of leakage and adverse selection is highest. If we can only trade on a lit market and not perform internal crossing, we will have to trade more slowly to minimize impact and we will be exposed to greater trading cost and volatility. I think this would remove liquidity from the market and increase risk premiums and spreads. Therefore, it’s very important that we continue to enjoy a range of options, including broker crossing networks (BCNs) and dark MTF-type venues as alternative sources of liquidity. This leads to the problem of fragmentation and how the price formation process works. In the US, we have RegNMS and a clear definition of National Best Bid and Offer (NBBO). I’d like to see a similarly clear definition of European Best Bid and Offer (EBBO) and what you can and cannot do in a dark pool to ensure a level playing field. STEVE WOOD: Price formation and price discovery are two completely different things and with most of the regulators globally, they continue to struggle with definitions. If you look at it at a very granular level, they find it hard to define a lot of the instances they want to regulate. A good example is HFTs. They can’t really define what an HFT is, and they haven’t as yet. To regulate for it is very difficult if you can’t actually define what it actually is. Now they are making some good inroads into market structure regulation, rather than trying to regulate specific entities. Again, I would argue that’s more of a global initiative than it is a localised initiative. I venture the Flash Crash has been the real catalyst for this. It has highlighted (to a large extent) where responsibility lies within the financial industry, about who actually generates and trades the order. An institutional trade allegedly instigated the Flash Crash, yet it seemed to be the high-frequency traders (HFTs) which ended up with a bad write-up over it. Although it was a catalyst of actual destruction of value, the trigger was a buy side trade that took certain parameters off an algorithm, and then went to the market. What it should bring into question is the actual expertise of that buy side trader. NICK NIELSEN: The Flash Crash was really caused by people making a few bad assumptions about the way the market worked. It really had nothing to do with the market being a bad place. Any time people are interacting in the marketplace, you kind of feel that, if they are a professional

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investor, whatever they do in the market is intentional and directed and it is kind of their own fault if they do something bad. Firms that employ people, in the UK for example, have to determine whether someone is fit and proper, or suitable as a trader or investor, in order to actually exercise these duties. So I do not understand why there needs to be another layer of complexity here, when the market could easily determine this itself. STEVE WOOD: Around this table we have some top shops: and in your institutions expertise is generated internally. People are trained on the job. Actually, the sell side has a pretty robust regime of examinations on a global basis. However, if you look at the buy side there is no exam process. The only place where there is a robust examination system is in Singapore, where you actually have to pass an exam before you can start trading. You don’t get that elsewhere in the globe. You can get a clerk from the back office sitting with a trader, and they register on the FSA and they become a trader. With the ownership of best execution being taken on more and more by the buy side through use of trading tools—be it OMS, EMS, algorithmic trading, utilising risk—how do you calculate what a proper risk price is? It is very touchy-feely right now. Another consideration in play is around price discovery; now it is more around when the trade is reported and the accuracy of the reporting. Actually, the reporting mechanism is crucial and regulators now recognise that. Previously, their focus was on pre-trade. Now there is a general realisation that post-trade is actually where the formation of the price happens and therefore trade reporting has to be very robust. The buy side has been very active in saying: “Right, we want to use transaction cost analysis, but we can’t use it in a regulatory environment because it’s ‘rubbish in, rubbish out’ with regards to the quality, and if the post-trade data is sub-optimal, that will lessen the value of the TCA.” Once data is robust, that is the point at which the regulator can start to legislate for best execution on a quantitative as well as a best process qualitative basis. They have learned the lesson from the first iteration of MiFID where the posttrade reporting was sub-optimal and the data questionable. DALE BROOKSBANK: We recently visited the European Commission (EC) and my concern is that large tracts of the equity MiFID review are seen by the EC as low-hanging fruit. MiFID II is so high level and the EC seems to be focusing in equities on the transparency aspect of the G20 initiative. One of the issues we raised with the EC was with regard to deferred publication. It is a very small subset of orders, but a change to that regime may increase the cost of capital for SMEs. Some end investors may find some institutional size liquidity prohibitively expensive, which could, in turn, preclude them from actually investing in companies. If the liquidity for that subset of orders goes down these companies may fall off the radar. From a fundamental perspective, if you are not able to source liquidity for these companies then the costs of capital will rise. When we spoke to the Commission it was not clear to me that these consequences had been considered.

ROUNDTABLE

It is an incredibly difficult balancing act, because on the one hand we advocate transparency, and yet on the other hand people need to be cognisant of the consequences of these directives. It was clear with MiFID that there were some unintended consequences around the first directive, even though the push for the underlying principles was positive. The other issue regards a consolidated tape. The Commission fully understands that the position right now is sub-optimal and they are going to try to move quickly to amend this situation. CESR issued recommendations late summer 2010, which will go some way to help us all piece together a solution. I worry that data and transaction costs in Europe are far higher than in the US. Competition should eventually drive costs down, although it is clear that where you have defined economic interests that are able to be protected you get inaction. The data cost and settlement cost differential between Europe and the US has been fairly consistent since the initial MiFID directive was introduced. Would a competitive consolidated tape environment be expected to deliver the same anticipated cost reductions going forward?

MEASURING COMPETITION NICK NIELSEN: The main motivation for MiFID or any sort of MiFID-related regulation has always been to increase competition, to decrease costs across the board for everybody in the marketplace. We noted that all of our cost explicit or implicit costs after the first MiFID was released, were out of whack. We also knew that US trading fees and/or market data fees were significantly lower. Even in parts of Asia they were lower, too. Even now, I guess we generally don’t think that there is enough competition and enough pressure on costs and they are still too high in Europe relative to other parts of the world. It is a concern of ours that maybe this round of regulation is putting a little bit of a speed bump on the movement towards decreasing cost across the board. We are talking about the implications of not being able to define what high frequency trading (HFT) is. I wonder: what is the difference now between HFT and automating things that people used to do manually in the past? It’s pretty hard to really say what that distinction is. So, are we just going to tell a lot of different investors that they no longer can act in the marketplace, because they have a computer doing something? Or are we trying to protect people’s jobs so that we become much less efficient as a society? I’m not sure that putting up these speed bumps gets us any way towards a more efficient state and you can see vested interests from different lobbying groups that are trying to prevent that. There are lots of examples: market data fees are way too high; even exchange fees are still too high. We still see monopolistic and anti-competitive pressures from some of the exchanges by increasing fees on closing auctions just because they can. That’s not really fair to the marketplace as a whole. Perhaps the market should find a solution to this. Another question the marketplace should be asking is: where are we going to get competition in the future to fight against derivatives fees?

Overall I’m just concerned we talk about things that have increased competition in the marketplace, such as dark pools and HFT, and have increased competition on the exchange level. They’ve increased competition on the level of service that we get from the sell side, in terms of the prices that they can actually give us on risk transfers. We are decentralising and increasing downward pressure on all of these huge fees that have traditionally been charged to each and every investor. I just hope that we do not go down a path of shutting down competition mechanisms such as HFT or dark pools just because some people don’t understand what either is. It is true that there have been quite a few requests for data from the regulators from participants, so that’s promising that they are trying to actually understand everything before they make a decision. I also hope there are no other exogenous lobbying factors that will influence their decisions against the actual data. WILL RHODE: It seems starkly ironic that at a time when exchanges have responded to competitive pressures introduced by MiFID, that MiFID II should almost be a diametrically opposite piece of legislation that sets out to protect vested interests. What’s weird as well is the scope creep the MiFID Review has over another piece of legislation in Europe, namely the European Markets Infrastructure Regulation (EMIR), which focuses on derivatives reform, and which, in essence, is creating a collateral market opportunity for exchanges to attack through verticalised clearing structures. At TABB, we believe that this will make them even more powerful and, together, the two pieces of legislation have the potential to prevent further competitive forces in equity trading. So to me, it’s a bizarre confluence of events that the MiFID Review and EMIR should come out at the same time. Even so, the buy side now tells us that its confidence in the European equity market is strong. I say that because I’m in the middle of wrapping up a major outreach to the buy side, focusing on hedge funds and their confidence in European equity market structure is very good. What’s more it looks set to improve with the MiFID Review. This is primarily because MiFID is addressing the issue of post-trade transparency and the lack of a so-called consolidated tape in Europe. There has long been a lot of concern around this issue of transparency and the fact that it is now being addressed is generally perceived as a very good thing. That said, there are a lot of people out there who are very worried about the MiFID Review. There were 4,200 responses filed in the consultation period window, which is a barometer for how focused folks are on the issue. We also have the added issue that all this has to get done by June. That’s a pretty tight deadline in which to address such a broad reaching piece of legislation that has attracted such an extensive degree of commentary and criticism from such a large number of people. To Dale’s concern over pieces of the legislation already being decided, I would agree that the equity piece is more or less written. That still leaves derivatives, fixed income, FX, and commodities, and, just for good measure, high-frequency trading as well, which has nothing to do with

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Brian Schwieger, head of algorithmic trading, Bank of America Merrill Lynch.

sense it is a very ambitious project, because the politicians need to both learn and legislate at the same time. Actually, there is a lot to learn. Even within investment banks, an expert in equity markets will not necessarily have a deep understanding of how fixed income or FX markets work. To acquire this knowledge and then to use it to create a regulatory framework in a matter of a few months is going to be a challenge.

TACKLING VESTED INTERESTS competition in equity market trading, but was thrown in because there was a Flash Crash in the US. And let’s not forget how IOSCO and the BIS have come out trying to normalise regulation on a global scale to prevent regulatory arbitrage. I just think that to put so many elements of the financial market into one bucket, to be addressed on a three, four-month deadline at a time when also all these other dynamics are occurring within the marketplace, seems to me to be a process that is prone to error. BRIAN SCHWIEGER: I would echo what Will is saying, particularly in terms of the ambitious scope of this proposed legislation. On top of all this you have to bear in mind that there is a lot of education under way among regulators. In many cases they are learning about how differently the markets function across different financial asset classes. I know that a number of them are being given tours of various trading floors, learning how fixed-income markets work, for instance. It does appear that initially there was an assumption that all financial markets work the same by many of the politicians. I believe that viewpoint may be changing, which may result in delays to the publication of their proposals. The key question for the legislators is who are they trying to protect? We talked about the man in the street, but as we said, one thing that makes Europe very different from the US is the amount of retail investment by “the man in the street”. In the US, something like 50% of US equity flow is retail investment; that’s probably five to eight times the number that we have here in Europe. So when you think about individual investors, they are a very small segment of European society. So typically, the man in the street in Europe, is investing via institutions rather than directly in the markets. In our view then, it is really these institutions that are the voices that the regulators should really be listening to. It is the likes of Dale who represent the man in the street. They are the ones that are investing in terms of the pensions, etc. These are the voices that the legislators should be heeding. STEVE WOOD: That is difficult to achieve because there is increased political awareness around what’s happening within MiFID and the structure of the capital markets. Obviously the reaction against the banking system has really speeded that up, but if you look at what’s happening within MiFID now, there is a lot of participation happening from the MEP and from parliament as far as some of the MiFID objectives are concerned as well. BRIAN SCHWIEGER: The legislators are going through a crash course in financial markets at the moment. In that

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STEVE WOOD: This is one of the things where we touched on, again, is the lobbying effect of various parts of the financial industry has had a big effect on MiFID. The FESE and other prime exchanges have got a really very good lobbying mechanism, and you can see that in the legislation coming through, which is quite ironic, considering what’s happened with LSE, the Milan stock exchange, with their market outages. I don’t think exchanges or regulators are too worried about independent dark pools; otherwise exchanges wouldn’t have created their own dark pools. Put it this way: they are more worried about the OTC trading, which can account for 20, 30 or even 40% of UK trading, for example, through facilitation to the institutional client base; and that is business that is being taken away from the light market. That is why they are really pushing, to get this type of flow back into the light marketplace. DALE BROOKSBANK: We are all being pushed to be more transparent. One concern I do have is the continuing trend of consolidation of lit venues. We have Deutsche Börse and NYSE possibly going to merge; the LSE and Borsa Italiana are already together; NASDAQ is with OMX and Chi-X and BATS are now together. We have moved from numerous regional exchanges to several pan-European exchanges. Competition is diminishing at the exchange level. From a systemic point of view the current push of most regulators is follow the G-20 initiative to reduce systemic risk leaves investors with increased concentration risk and benchmark monopolies. We need clarity on exchange outages too. The ASX went out on an MSCI review day in February, LSE also had an outage recently; Borsa Italiana and NYSE, too. Why is that? There is no clarity after the event. We need to be conscious of systemic risk borne of exchange instability. It is not positive for our clients. Without the ability to trade on other platforms it is a problem that we have to deal with. Liquidity is not readily transferable at the moment. I do not believe that we have a solution for that yet. BRIAN SCHWIEGER: To Dale’s point about systemic risk, on the day the LSE went down our cash trading floor had a fantastic day, because our cash traders stepped in, offering both block crossing and capital. Old-fashioned marketmaking, on the telephone, asking clients: “Do you need a price?”Clients were happy simply because they were able to trade in size, when they needed to, and because we were happy to make markets for them. This was a perfect example of the value that OTC trading can bring to the markets.

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WILL RHODE: When NYSE went down, there was a surge in volume on the alternative venues such as BATS and ChiX, because it occurred during the middle of the day. The difference with the LSE outage was that it occurred preauction, so there was no price formation. In other words, there was no starting gun to kick-off the races. It is something that obviously needs to be looked at. Why should there be a monopoly over the auction if there are alternative venues on which to trade stocks? The other dynamic to consider is this focus on the OTC market. We did some analysis on this at TABB. We looked at what kinds of trades get reported on the OTC print and figured out that 35% of it was actually just reprints of already-conducted trades; in other words, non-executable liquidity. There has been so much focus on this issue and lobbying by exchanges when it comes to how OTC trading should be regulated, and yet this point that the vast majority of OTC trades are actually reprints seems to get overlooked repeatedly. And there’s another dimension to consider in all of this. Exchanges have been focusing hard on attracting highfrequency trading business in recent years. As a result, highfrequency trading dominates the continuous markets today. This raises the issue of who is doing what and for whom? Exchanges say they need a level playing field, a regulated market, one in which the OTC market becomes more regulated, but at the same time we see that exchanges have become venues heavily populated by high-frequency flow. This is a challenge for the institutional investor who relies on the OTC market in order to trade large in scale block orders without negative price impact or implementation shortfall. If all trading is forced onto the regulated markets, where orders can be easily picked off by high-frequency flow, then how does that legislation benefit the pension fund market; how does it help the man on the street? That is not to say that high-frequency trading is bad, by any stretch, because we have seen spreads come down, and we have seen increased liquidity. The point is, however, that not everyone’s trading needs and objectives are the same and there needs to be a wide variety of options and tools available in the market so that different types of orders can be executed effectively. High-frequency flow has been beneficial to a lot of institutional investors looking to execute stub trades and child orders and essentially find fills for the tail end of their order, but if that first, initial block is forced straight onto the lit market and, de facto, into high-frequency flow, it will be picked off and will suffer as a result. In short, some people have got very big orders; some people have got very small orders. Everyone has different strategies, and they all need different means through which to execute those orders, they cannot all be considered the same and forced to trade in the same way. It is nonsense. RICHARD HILLS: I have a theory that the financial crisis is hiding the true effects of MiFID’s attempt to introduce competition to the exchanges by changing the underlying microstructure. At one point we had over 20 MTFs setting up in Europe and the promise of healthy competition. Instead

Nick Nielsen, global head of trading, Marshall Wace.

we have seen the exchanges take over most of the independents or launch their own, and Chi-X and BATS coming together to form the main challenge to the exchange groupings without the dramatic reduction in exchange fees and trading spreads for which we were all hoping. The fact is that when volumes disappeared from the market, two things happened. First, the independent MTFs found it very hard to make their business models work in a low volume environment. If you are running an expensive, fixed-cost IT platform but only turning over a few hundred million a day on tiny margins, you are not going to make anything like as much money as even a small DMA broker. If the model does not work on a commercial basis then clearly you are not contributing to the market structure, you aren’t going to stick around and you are not going to challenge the exchanges. Second, the commission pools came down significantly and became focused on fewer, larger brokers—particularly the ones with electronic access to their crossing networks that offered exclusive liquidity. The trend has always been there, but the rise in electronic trading has made it more systematic. This took volume away from the exchanges and MTFs and made the broker venues unmissable for client order flow seeking natural liquidity. The upshot is that the true competition to the exchanges remains the BCNs, so it is important that they remain as allowed venues. Most brokers now have one and they work in slightly different ways, but we need to have a level playing field here. Equally, coming back to price formation, it is quite perplexing to me how these have evolved because just after MiFID the idea of a client being allowed to come and rest an order to execute with no external venue participation was a no-no. Now it has become accepted practice. That is where we have got some issues—we need some clear rules about what you can and cannot do with a BCN so that brokers can compete on an equal footing. BRIAN SCHWIEGER: Now, we talked a few moments ago about the auctions, and why they are so important. The answer is because so much investment at the moment is being marked to certain indices and those indices take their benchmarks—the official open and the official close —based on the primary exchanges. Unless that changes you are going to find that a lot of buy side fund managers will say: “I need to take part in these opening and closing auctions on the primary exchange because that’s how I’m being benchmarked.”It is interesting how much influence some of these indices can have, and yet they are among a host of issues that the regulators have overlooked.

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Richard is right, broker crossing networks are totally dark without price formation, but one of the real benefits of these for clients is that we are able to control people who go in there to trade. We can do this because broker crossing networks are not MTFs. We are able to control the way in which parties interact with one another, so that gives a lot of our clients a feeling of security. Clients know that it’s being policed to a greater or higher level than an open exchange, where they could be interacting with anybody. In terms of anti-gaming measures, it is easier to police a BCN because if we suspect someone’s trying to game we can pull them out and we don’t have to give them a reason. RICHARD HILLS: I’m not suggesting that they are not highly valuable. BRIAN SCHWIEGER: Exactly, it’s a venue of choice for many clients. RICHARD HILLS: My point is that there needs to be a level playing field and that it is defined as such. BRIAN SCHWIEGER: Yes, with greater clarity around the rules governing both BCNs and dark pools. STEVE WOOD: Actually, we are getting very close to that. We are seeing MTFs being created by brokers. So now you have this sort of two-tier, dark-pooled infrastructure happening where small investors can participate, in an MTF that’s owned by a broker, whereas if you want large in-scale flow, you can do that via an internally, via brokers’ internalised pool of liquidity. It is a happy medium if you like. How does that translate though going forward? That is the interesting part. BRIAN SCHWIEGER: One of the reasons we have not gone down the MTF route until now is that anyone is allowed access. As Richard says, for an MTF it has got to be a level playing field for everyone. Within a broker crossing network, for example, we are able to give priority to client flow over our own trading. NICK NIELSEN: It is rather interesting that we have all of these exchanges popping up, which are really just the market exercising competition, because someone has decided that the existing exchange model is not good enough. Maybe it is the cost of technology, but in reality exchanges are relatively simple things. They match buyers and sellers. They send out a bunch of market data, like what the bid and ask prices are, and then they give it to someone else to clear it, to actually change the money between hands. Now, what’s a little bit frightening to me is that we have very, very good technology companies that deliver services, whether it is search, picture sharing, shopping for merchandise across the world, and they handle much more complex transactions than anything the exchanges do, in much more data-intensive transfers, without half the problems. The amount of data published and transferred on Twitter or Facebook is many times more than any of the exchanges offer. I do not understand why the exchanges are not treated like technology companies, and have good technology that’s very scalable and very cheap to operate? Instead, they try and act like financial institutions. That’s something that needs to be addressed, and hopefully will be, over time, along with the broker systems and dark pools. They should all just act that

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Dale Brooksbank, head of European trading, State Street Global Advisors.

way, and there really wouldn’t be a lot of cost in operating any of them if you actually had one that was very good at it. WILL RHODE: I have an idea as to why it’s so critical, and I’d put it down to latency.Yes, okay, you might like to see your Google search come up in a certain number of seconds, but it’s not necessarily critical. If you look at something like the Flash Crash, for example, I understood that a lot of virtual market makers withdrew from the market naturally when they saw that there was a data-latency spike, when prices were not being quoted, and they realised that there was clearly a market structure issue. This greatly exacerbated the freefall in prices. The fact that you get vast amounts of data during a market crisis means that bottlenecks occur in application processing, this leads to latencies, which alerts people to a problem and generally contributes the market failing. I think the issue may be around that. NICK NIELSEN: Google has many times more bandwidth than the exchanges. They need to pull terabytes of data very regularly, and offer a snapshot of the entire web, so they know what they are searching very accurately. They are doing millions times more and their latency is much more interesting and critical than the exchanges, because if they don’t pull up data quickly enough, they haven’t done their job and don’t keep their dominant market spot and someone can do a much better instantaneous search. That’s why Google has personally laid back-up after back-up after backup fibre across the ocean everywhere in the world, so that they can do that faster than anybody else. WILL RHODE: So is it your point then that it’s poor technology on the part of the exchanges that result in these latencies? NICK NIELSEN: Yes, because they are not very reliable. If we look at shopping online, Amazon does the same thing. Amazon has much better technology than the exchanges, and does anybody have any reliability issues with them, like matching buyers and sellers and computing? Do they get delayed? Is it reasonable to allow them to go to the US or EU governments, to say listen; don’t let anybody else compete in our space? The opposite is the Wal-Mart effect: just cut their fees and/or deliver better service levels and compete.

EXPANDING THE BANDWIDTH OF TRADING VENUES: WILL IT WORK? STEVE WOOD: MiFID II is focused on infrastructure, and obviously, as Dale said, ESMA’s impression is that the equities portion of MiFID is 90% done. The challenge for the buy side and the sell side is to make sure they have the last

ROUNDTABLE

10% done, which is very important and just doesn’t get left behind. With the next MiFID reviews in progress, they are going to start really focusing on what the implications were for the equity market after a period of time of MiFID I and how this translates to other asset types encompassed by MiFID II. That is when they are going to start focusing more on best execution and the actual elements that make up that best-execution process, rather than just a blanket processbased approach. You will also see that in the United States and in Asia as well. Best execution will be the next big focus in future regulatory initiatives DALE BROOKSBANK: That is one of the ideas that we conveyed to the European Commission. When regulators talk about small changes at the margin we feel that the central point is that actually the market is functioning as well as it’s ever functioned, particularly with regard to price formation. With the MiFID review you get to a point where you begin to ask: “Are regulators going to extrapolate the equity market model as a template that they want to put across everything else?” Do they want to do that because the equity market does function? Or do they want to do it because actually they believe that one size fits all? It would be ambitious and revolutionary if regulators do decide to go down that route. STEVE WOOD: I personally think the fixed-income market should be on exchange. It’s one of the last bastions of opaqueness, as far as price discovery is concerned. If you talk to people that deal in retail plans in the States, they get hung out to dry in the retail bond market. They get charged commission plus the spreads of 5% or 6%, because there is no transparency out there. If they do bring the on exchange light market to bear in Europe it is going to be very interesting, particular when it comes to liquidity. Marshall Wace and HFTs, for instance, have got a platform to work on another market types. However, it is questionable if they would work in the sort of corporate bond market which the regulators seem to be proposing to be the first market they want to bring into a transparent arena. When you have a very liquid government bond market in a light arena then you can probably see some liquidity coming in from different elements of the marketplace and that’s been supplied by HFT mechanisms and other forms of liquidity, this will narrow spreads and reduce costs. DALE BROOKSBANK: Is the problem that you have, for example, in the case of an individual company such as GE, so many different bonds; 20, 50 or even 100? STEVE WOOD: Yes, that’s why corporates won’t work. There are over 50,000 issues of corporate bonds in Europe. They go off the run very frequently every time they bring out a new issue. That’s why it would be more advantageous to implement government bonds first. They are also directly related to a large proportion of the CDS market, which is the first thing they wanted to focus on. However, I would have thought there will be some serious pushback from the big institutional brokers, because of their profit margins. NICK NIELSEN: There is no reason that corporate bonds couldn’t work on exchange, but you would almost need to have everything going at the same time, so you could not

Steve Wood, CEO, Global Buy Side Trading Consultants.

have the CDS market, like Steve said.You can’t say:“Let’s just try the corporate bonds without the CDS and without the equities.” If you have everything there, corporate bonds, government bonds, CDS market, equities, and so forth, you would see people arbitraging between them on the highfrequency side, and there would be significantly more liquidity across the entire run, just like you see the US options market for equities. Every symbol has multiple expirations, calls and puts, strikes, different exercise methods, and there is very, very deep liquidity in the options market and it’s a very lucrative business that people pay a lot of money to get the right to be a market maker of. Like on the ISE, for example. So that’s interesting.

LOOKING AHEAD: AN EVOLVING WISH LIST DALE BROOKSBANK: For us the key challenge is going to be, from an electronic standpoint, to continue to stay ahead of the market infrastructure and adapt to that. Our trend over the course of the last two to three years has been much more towards electronic, and that’s because of the type of stocks that we are trading. From a liquidity standpoint, I would imagine that longer term there may be a subset of orders that we would not even see, and that we will just be focusing on the high maintenance order flow that we get. Tailoring our electronic products to meet our execution needs continues to be important too. NICK NIELSEN: If I look around the room, I see people that each of us probably interacts with regularly in the marketplace. Everybody here is competent, and will respond well to any types of changes in legislation, or rules and they’ll do it to their own advantage, and will be able to figure out a way to take advantage of it in their own respect. The challenge for everybody is to hopefully get together to not let this impede too much in terms of the cost to change, and to be more pragmatic about changes with respect to implementation costs for change. So whether they are adding new cost into the business, without new benefits, or they are making things less efficient, that’s the key. Everyone here is under constant margin pressure, and it was mentioned earlier about commissions shrinking etc. That will continue to move in that direction. People say that high-frequency guys don’t turn over as much in Europe, and spreads would be tighter, there would be more turnover if the fees were lower, and that’s probably true, because you can make a corollary to the US, where it is the case. Hopefully, then, we don’t have a lack

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of education on the regulation side and we have more informed buy side traders, like Steve said, that don’t make bad assumptions that lead to dangerous events such as the Flash Crash. In reality, I guess that’s probably an opportunity for people that understand what happened to take advantage of it to their own benefit. For my own part I hope that there is not an excessive amount of regulation and that the marketplace can continue to become more efficient through its own means, and we have a less monopoly controlled trading environment. BRIAN SCHWIEGER: I suppose for anyone in the electronic trading space, whatever changes are coming will probably mean more work for us, because it’s quite clear that whatever MiFID II brings, it is going to bring more electronic trading. We continue to develop our electronic trading capabilities in equities and we are probably going to be seeing many of these platforms and techniques applied across asset classes. As Nick was saying, the challenge is going to be to help our traders and our clients adapt to the new regulatory environment. For the sell side, we have to continue to invest in electronic trading in order to remain competitive, both for our own traders, and for our clients. RICHARD HILLS: Despite our focus on MiFID II, there are a lot of interesting things in the development pipeline and I will mention a few, although the cost of technology is probably the biggest drain on innovation right now and as I talk to people in the market, it is clear that brokers are tailoring back their IT investments. The first area is around customisation and tailored services. Customisation is about how we deliver electronic trading products that fit to a client’s specific trading strategy. We are getting smarter about how we are looking at the client’s overall trading objectives and building algorithms that are a combination of macro and micro strategies. For example, traditionally a client sends in an order“Inline 20%, no auctions”. The algorithm was pretty much a black box whereas now we are able to set up an algo which will trade inline 20% but react dynamically to relative movements in the sector or index, trade within a price corridor and depending on price levels seek to capture blocks where it can. This can all be done on the fly with no development or overnight releases. It can be done by the desk and with no changes to the client’s software. Although many think that algos have become commoditised, I think that we can innovate on service levels by providing these more tailored strategies quickly and easily. The second area where there is room for innovation is the relationship between the trading strategy and the microstructure. While trading strategy engines have been using statistical indicators such as index and sector correlations for years, I am surprised to find that similar logic is not very common in the smart routers that implement the overall trading strategy. The micro level decision on where and how much to trade, whether to cross the spread or to quote, and where in the depth to quote is a highly quantitative topic and can make a big difference to overall strategy performance. Antigaming logic should be able to detect information leakage and adverse selection to steer away from potentially toxic

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participants in different venues, in real time. This is an area where we are innovating and I think it is very interesting. The third area I will mention is TCA. I think as the microstructure evolves we need to provide services to clients around advising on venue quality and how to defend against adverse selection in dark and lit markets. Our quants have been doing some quite innovative work on measuring venue quality using statistical observations and alongside the traditional, benchmark-based TCA data; this is useful information about how to set the algo up. Finally, I think we will see more use of electronic channels to trade other asset classes, possibly OTC such as ETFs and direct to capital services. WILL RHODE: It would be good to see equity market volumes return. Over the last year, in the UK, looking at January and February, we are double what we were last year, which is good, but we are still down 60% on the same period in 2008. So it might be good to encourage equity as an asset class, especially given the fact that regulators are now turning their attention to other asset classes and the benefits of automated trading in those markets are just starting to be realised. As these markets go through the structural changes that we have seen in the equity markets, such as HFT participation and new competitive pressures, for example, it might be a good time to allow the equity markets to become the attractive investment proposition. So, for example, there could be a lowering of long-term capital gains taxes; an increase in shareholder rights; a reduction of barriers to public listings; and we could encourage investment management firms to align fees with performance, and get rid of stamp duty. The big cloud that’s hanging over the equity market is low volumes, and it wouldn’t be a bad idea to maybe just get back to basics and make equities an attractive asset class for investment so that volumes and confidence can be restored. I think that would be a very good idea. STEVE WOOD: MiFID II rotates around cost: that is, cost benefits or deterioration of both the buy side and the sell side. There are certain pros and cons. The unbundling of data is a key element in reducing the cost structure. The flipside to that is we are seeing a consolidation of those actual data providers and there will be less competition in the trading venue space, as Chi-X BATS are merging and so on. As far as costs on the upside, some of the recommendations of MiFID II, regarding printing of trades within a 24-hour period could have a dramatic cost effect on liquidity or liquidity providers from the investment bank segment. If you are going to commit capital to the tune of three or four days’ volume, you want more than one day to get out of that position. So there could be an expansion in cost there. The consequence of this is that the cost structure for the buy side could actually increase as far as transaction costs are concerned. Moreover, there is going to be a definite amount of creepage into other asset classes. This is real, fertile ground for both the buy side and the sell side, to utilise their experience from the equity side within other fields. Best execution, although it’s not so much of a focus within this MiFID review, will be a focus going forward. I

EXECUTION CONSULTING

A quick check on the first page of a Google search for “execution consultants” throws up an interesting range of results from job advertisements for technical consultants to an item dating back to 2005 discussing how, even then, brokers were becoming execution consultants and offering advice on algorithms to the buy side. Six years on, execution consulting has moved on, but still confuses. Is it an extension of sales trading service, which most brokers offer anyway? Or, does it offer something deeper, giving buy side clients a real advantage? By Ruth Hughes Liley.

Photograph © Mopic / Dreamstime.com, supplied April 2011.

THE POWER OF FOUR HERE ARE FOUR reasons why buy side firms look for more hands-on guidance from their brokers, according to Sang Lee, of Aite Group, whose report on the US electronic trading market Execution Consultants Revisited came out in November 2010. Lee points to complexity in market microstructure with different lit and dark venues; changing faces of counterparties as regulated market makers move out and high-frequency firms move in; more pressure on the buy side to make the right decisions from more selfdirected trade through DMA or crossing platforms and more sophisticated technology; and fourth, regulatory uncertainty. “It is important to understand the concept of execution consultants not as single individuals, but as a group of highly-skilled professionals, each of whom can bring a specific area of expertise to the table to help the clients. Part trader, part quant, part IT and part relationship manager, execution consultants will play an increasingly important role in the future of sell side trading services,” says Lee. This picture of a multi-skilled team might have been painted of the set-up at agency broker, CA Cheuvreux, where Andrew Herriot runs a team of five execution consultants. “We are all experienced traders from a vast array of back-

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

grounds,” he explains.“In its truest form execution consulting is analysing what the client wants, bringing together all the trading details and using them to enhance the client’s knowledge of our alternative execution products and the rapidly changing marketplace.” “We strive to be proactive with clients. Our aim is to get closer to clients, perhaps suggesting execution strategies on a particular order and also by building algorithms for their specific aims where necessary.” This desire to get closer to a client is one reason why some believe execution consulting is no more than a good sell side trader should be offering in any case. Oliver Sung, head of execution consulting at Bank of America Merrill Lynch (BofA Merrill Lynch), agrees there is a thin line between the general service offering from sell side houses and execution consulting. “It is more. It is an extension of the bank’s service offering. We receive a lot of questions from clients about things such as the performance and functionality of our algos, so we tailor our analysis to meet their needs.” At BofA Merrill Lynch, execution consultants meet clients with their sales and sales trading teams. Sung believes execution consultants see themselves as complementary to

EXECUTION CONSULTING

these teams. “Our team is here to help our sales and sales trading counterparts service our clients.” Robert Shapiro, global head of trading and execution consulting at Bloomberg Tradebook, says that execution consultants are the next generation of sales traders. “Execution consulting is the ‘Sales Trading 2.0’ model for the electronic market place. You have the quant sales trader who knows about electronic trading but little about what makes stocks go up or down and you have those who know about stocks, but not about algorithms. Execution consulting brings those two types together. We’re taking the high-touch experts and training them up in the electronic side.” Indeed, training has been at the heart of the execution consultancy offering from Bloomberg Tradebook, since it was first offered in mid-2010. They have 35 execution consultants globally, who will take 15 accredited courses, from professional consulting through systems, pre and post-trade and technical analysis. Around 75 sales people are also taking the courses and they will shortly also be available to buy side client firms once the curriculum is finalised. “Doctors go to med school; lawyers have to go to law school. We feel that you have to embrace advanced training to be an expert in execution consulting. If you want to face-off against a buy side client, you have to be equally knowledgeable.” Shapiro believes that after training, incentives are an important motivator for good execution consultants. “Our team’s compensation is linked to the buy side’s success,”he says. In addition, a five-step “dynamic trade optimisation” process is followed from looking at the order acceptance rate, through pre-trade analysis and strategy planning, implementation and post-trade analysis.

TCA: the better buy side view In an interesting twist, it is in fact the buy side which has the better view of transaction cost analysis (TCA), says Sung. “It is really only the buy side which can [undertake] really great transaction cost analysis because they have a better view than we do. If a buy side client trades a million shares, but we only do 200,000 shares, our perception of that trade is only based on our universe. So our TCA is helpful in as much as we help them see how they could improve that part of the trade. The buy side is becoming more and more educated in the micro-detail. Execution consulting is raising the whole analysis game because our analysts advise on the whole of our product suite.” One of the key drivers behind the growth of execution consulting the past five years has been the parallel growth in technology, aided by the changed market structure postMiFID in Europe and the advent of high-frequency trading in the United States. Aite Group estimates that algorithmic trading now represents more than 60% of equities trading in the US, with the average trade size down to just over 200 shares. As traditional market makers are being replaced by high-frequency traders in the provision of liquidity, HTF now makes up 65%, estimates Aite, and this will increase to 67% this year, remaining at that level in 2012. “The sheer complexity of today’s market structure

Oliver Sung, head of execution consulting at Bank of America Merrill Lynch. “We receive a lot of questions from clients about the performance and functionality of our algos, so we tailor our analysis to meet their needs,” he says. Photograph kindly supplied by BofA Merrill Lynch, April 2011.

makes it almost impossible for any market participant to approach it manually,”says Sang Lee’s report. Lee Hodgkinson, chief executive officer of SmartPool, NYSE Euronext’s European dark pool, compares the environment to the growth of the mobile phone market. “Years ago we simply had a choice of two or three different types of payment plan. Fast forward to today and with so many different price plans from myriad providers you need a masters degree in applied mathematics to work out your mobile phone tariff. The same is true in the trading space. Now the lion’s share of equity trading is either fully driven, or enabled by, technology. Clients’ quant traders want access to gargantuan amounts of complex detail relating to how their algos interact with the trading platform, along with the detailed profile of non-executed liquidity.” Hodgkinson points out that as more brokers are offering execution consulting, so further up the chain, exchanges may also consider providing a similar service. “It is about leveraging the expertise you have within the firm to help your clients perform with excellence for their clients. We will start to provide services that will help clients gain an insight into the profile of our pool to maximize their trading activity with us and improve the quality of execution on behalf of their clients. It is a logical extension of the sales process.” Firms have spent millions of dollars on developing algorithms for themselves or which they have also passed on to their clients. In parallel with this, the buy side has been taking

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

“We feel that you have to embrace advanced training to be an expert in execution consulting,” says Robert Shapiro, global head of trading and execution consulting at Bloomberg Tradebook. “If you want to face-off against a buy side client, you have to be equally knowledgeable.”

William Conlin, chief executive officer of agency broker Abel Noser. “If the client gets the best price, the broker is not making excess money off the trade. That is the goal of TCA!” he states. Photograph kindly supplied by Abel Noser, April 2011.

on more responsibility for its own trading—self-directed trading—and so has a greater need for the knowledge to use the tools at its disposal. Aite estimates that the amount of high-touch trading has reduced from around 70% in 2000 to around 42% in 2010, while low-touch trading by the buy side, including direct market access (DMA), algorithmic trading and programme trading, has risen to around 58%. Tradebook’s Shapiro, who until eight months ago was with Morgan Stanley Investment Management on the buy

side, points out: “The brokerage business has done a very good job of delivering the technology to the buy side, but what we have not done a good job at is servicing the underlying technology. It is like opening an Apple computer store without the Genius Bar.” Ian Domowitz, managing director responsible for networking and analytical and research products at ITG, adds: “Ten years ago nearly all trades were being phoned in to the buy side desk. Now in some firms around 80% to 90% in the US is self-directed. It is human nature. Once you start to take hold of that process you are going to demand customisation.” He points out that while the buy side has the tools, most traders have not really experimented with them. “They haven’t asked the right questions. They stick with VWAP and a liquidity-seeking one and that’s it, so there’s a need to go out and educate clients in how you use these. Literally it comes down to tutorials and classes.” So while execution consultants are expected to educate clients in the ins and outs of low-touch trading and recommend strategy, they are also expected to analyse trading activity of clients and provide a suite of analytical tools. Sung points out that the more educated the clients become, the more detailed research is required by execution consultants. “The job of the execution consultant has become broader as clients become better educated themselves,” he says. “There are three aspects to it: TCA, market structure analysis, which includes exchange rules and regulation (we are walking clients through 201, the short sale

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F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

EXECUTION CONSULTING

Lee Hodgkinson, chief executive officer of SmartPool. “We will start to provide services that will help clients gain an insight into the profile of our pool to maximize their trading activity and improve the quality of execution on behalf of their clients. It is a logical extension of the sales process,” he says. Photograph kindly supplied by Smartpool, April 2011.

Ian Domowitz, managing director responsible for networking and analytical and research products at ITG. “Traders haven’t asked the right questions. They stick with VWAP and a liquidity-seeking one and that’s it, so there’s a need to go out and educate clients in how you use these,” he says. Photograph kindly supplied by ITG, April 2011.

price test regulation, at the moment, for example) and finally macro research, where we look at the market as a whole, and micro research looking at spreads and statistical analysis.” One statistical analytical tool was unveiled at a TradeTech conference in London in April this year in the form of Fidessa’s new Tradalyzer, a companion to the Fragulator, which identifies the amount of fragmentation in a stock. The Tradalyzer is a free analysis tool in which a trader can enter all the details of a trade into the system, indicating parameters and the price achieved. Using Fidessa’s data, the Tradalyzer analyses the trade against a consolidated view of all MiFID markets during the lifespan of the trade and provides a detailed assessment of the performance of that trade. “The analysis will benefit all sides of the trade,”says Robin Strong, director of buy side strategy. “The buy side will have an independent assessment of their trades and broker performance. The sell side, if they are doing a good job, will be able to prove that they are.”

sales can hurt the goal of preserving your client’s principal. Crossing may be good, but if a liquid list is exposed to price changes longer than necessary while waiting to cross, results can be poor from an execution price standpoint. He’s not quite finished there and goes on to say: “TCA consulting should be all about how well the buy side gets close to target prices, as in implementation shortfall, and whether those strategies are achieving the better prices. Quite often, TCA providers mask the cost of any delays by managers. Traditional and pure TCA only works when manager data is recorded in the process.” However, he does see value in the service set, though Conlin believes agency brokers are at an advantage over fullservice brokers when it comes to execution consulting in that they work only for the client. “We always approach it from the point of view of how well the trades are executed. If the client gets the best price, the broker is not making excess money off the trade. That is the goal of TCA!” Cheuvreux’s Herriot agrees: “The buy side is more likely to talk in-depth to agency brokers because they are assured that we are unconflicted. Execution consulting is becoming increasingly important as a differentiation.” As Aite’s Sang Lee notes: “To be an effective broker dealer in today’s complex market, developing a comprehensive execution consultancy service is vital. Broker dealers must evolve alongside the market moving from [being] order-takers and technology providers to true partners of buy side firms.” I

Healthy scepticism William Conlin, chief executive officer of agency broker Abel Noser, is sceptical of firms saying they offer execution consulting, when in fact they are just offering analysis technology. “Consulting on transitions, for example, should start with the liquidity of the names to be traded and should include a precise proposal recommending the strategy to implement the transition. It is also important to keep money balanced when the lists are two-sided. Getting ahead on either purchases or

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

(Week ending 15 April 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Corp Corp Corp Corp Sov Corp Corp

16,372,876,315 8,553,836,117 6,863,771,913 5,566,553,764 5,159,544,942 4,485,696,038 11,456,625,970 25,840,390,743 2,836,745,061 2,890,096,074

178,433,188,972 124,455,988,556 144,534,706,167 80,738,871,818 81,586,311,598 83,255,868,876 97,868,076,350 267,986,731,353 70,987,642,108 64,385,888,065

12,037 9,714 8,759 8,679 8,435 8,184 7,655 7,287 7,286 7,024

Americas Americas Europe Americas Americas Americas Americas Europe Europe Europe

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

25,840,390,743 18,818,142,541 18,688,868,593 16,574,483,230 16,372,876,315 11,769,291,395 11,456,625,970 8,553,836,117 7,716,286,462 7,280,023,138

267,986,731,353 145,045,776,523 92,990,665,484 91,500,779,157 178,433,188,972 60,151,936,873 97,868,076,350 124,455,988,556 42,426,350,235 45,351,827,196

7,287 6,899 4,671 2,940 12,037 4,418 7,655 9,714 4,633 2,408

Europe Europe Europe Europe Americas Europe Americas Americas Japan Europe

Federative Republic of Brazil Government United Mexican States Government Republic of Turkey Government Bank of America Corporation Financials JP Morgan Chase & Co. Financials MBIA Insurance Corporation Financials General Electric Capital Corporation Financials Republic of Italy Government Telecom Italia SPA Telecommunications Daimler AG Consumer Goods

Top 10 net notional amounts (Week ending 15 April 2011) Reference Entity

Republic of Italy Kingdom of Spain French Republic Federal Republic of Germany Federative Republic of Brazil UK and Northern Ireland General Electric Capital Corporation United Mexican States Japan Kingdom of Belgium

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

Ranking of industry segments by gross notional amounts (Week ending 15 April 2011) Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

Single-Name References Entity Type

Corporate: Financials Sovereign / State Bodies Corporate: Consumer Services Corporate: Consumer Goods Corporate: Technology / Telecom Corporate: Industrials Corporate: Basic Materials Corporate: Utilities Corporate: Oil & Gas Corporate: Health Care Corporate: Other

3,317,524,850,345 2,586,334,844,637 2,146,625,831,732 1,632,735,201,645 1,336,850,965,019 1,277,262,482,501 998,209,881,038 797,958,384,027 473,983,653,219 340,881,217,831 146,501,814,451

425,313 192,445 347,830 252,683 201,268 213,657 156,605 121,549 85,353 58,818 14,938

CDS on Loans Residential Mortgage Backed Securities Commercial Mortgage Backed Securities CDS on Loans European Residential Mortgage Backed Securities* Other Muni: Government Commercial Mortgage Backed Securities* Muni: Other Muni: Utilities CDS Swaptions

Gross Notional (USD EQ)

70,305,212,825 68,753,201,857 19,673,458,826 5,346,455,003 3,850,660,675 1,730,492,575 1,395,400,000 82,811,515 65,000,000 30,650,000 15,000,000

Contracts

18,560 13,560 1,799 741 250 139 145 7 3 12 1 *European

Top 10 weekly transaction activity by gross notional amounts (Week ending 15 April 2011) References Entity

Kingdom of Spain Republic of Italy French Republic United States of America Federal Republic of Germany Kingdom of Belgium Federative Republic of Brazil Ireland Portuguese Republic Republic of Peru

Gross Notional (USD EQ)

Contracts

5,750,756,780 5,136,018,314 3,601,550,000 3,301,043,742 3,007,768,514 2,911,482,130 2,313,800,000 2,168,841,775 2,132,850,460 1,507,880,000

353 214 128 84 120 172 107 156 138 141

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 1 1

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 15th April 2011 VENUES

INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.46

1.79

1.96

1.88

9.04%

1.92 3.36% 4.47%

5.38% 0.01%

4.73%

7.05%

28.54%

21.22%

6.34% 16.33%

18.07%

0.25%

1.37%

Europe

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

18.98% 72.29% 0.02% 0.06% 0.51% 0.07% 0.01%

55.88% 0.05% 0.10%

0.26%

0.07%

65.39% 70.16% 68.92% 0.04% 4.14% 0.01%

6.03%

VENUES

2.50%

3.61%

4.72%

VENUES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

4.71 10.75% 3.58% 0.07% 0.40% 6.18% 7.31% 25.78% 4.08% 2.41% 0.91% 23.93% 0.13% 14.47%

4.41 10.92% 3.76% 0.12% 0.40% 6.05% 6.56% 24.22% 3.87% 1.86% 0.87% 25.72% 0.27% 15.39%

FFI

2.20

2.24

Alpha ATS

16.76%

16.71%

BATS BYXX CBOE Chicago Stock Exchange EDGA EDGX NASDAQ NASDAQ BX NQPX NSX NYSE NYSE Amex NYSE Arca VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

Asia

INDICES

Australia Hong Kong

99.99% 100.00%

Canada*

DOW JONES

INDICES

S&P TSX 60

Chi-X Canada

11.59%

12.60%

Liquidnet Canada

0.18%

0.10%

Omega ATS

2.23%

2.72%

Pure Trading

3.48%

3.13%

TSX

61.67%

60.35%

TriAct MATCH Now

4.10%

4.38%

VENUES

INDEX NIKKEI 225

INDICES FFI

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

Chi-X Japan JASDAQ Kabu.com Nagoya Osaka SBI Japannext Tokyo ToSTNet-1 ToSTNet-2

1.22 1.53% 0.00% 0.02% 0.00% 0.00% 1.17% 90.25% 7.02% 0.00%

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/.

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

T HAS BEEN a few months now since the London Stock Exchange Group (LSEG) migrated its electronic order matching to its new Millennium Exchange trading platform (February 2011) and a little longer since the same transformation took place at the LSEG’s MTF platform Turquoise (October 2010). One of the key objectives was to attract the high frequency trading (HFT) community that has been so successfully recruited by rival MTFs such as BATS Europe and Chi-X. Many such firms are direct investors in the MTF community and much of the decline in the LSE’s market share (and that of other primary markets) has been attributed to them. The HFT community will always be attracted to the faster matching platforms because, for many of them, their business models revolve around electronic market making. This involves providing continuous, two-sided quotations, thus allowing natural buyers and sellers to immediately trade with the market makers’ quotes. In performing this role, these electronic market makers do not take directional positions in securities but, instead, make money on the spread between the bid and ask price. Such firms are effectively 'on risk' whilst their quotes are live on any platform so the ability to constantly adjust (or remove) their prices is paramount to their success and something that is naturally much easier to do on fast, low latency exchange platforms. The assumption behind the technology migration was that, by introducing a lower latency platform, both the LSE and Turquoise would see a net increase in their volumes and market share. However, the evidence so far is less than compelling. Chart 1: Lit volume share, FTSE 100 FFI (week ending 15/04/2011) = 2.46 BATS Europe

Chi-X

NYSE Arca

Turquoise

LSE

70% 60% 50% 40%

Chart 2: Lit volume share, AstraZeneca (AZN.L) FFI (week ending 15/04/2011) = 2.30 BATS Europe 70% 60% 50% 40% 30% 20% 10% 0%

Chi-X

NYSE Arca

Jan an 2010 2010

Turquoise

4 Oct Oct 2010 2010

LSE

14 F Feb eb b 2011 2011

Another highly fragmented stock, Diageo, also seems to be moving towards Turquoise but this doesn’t seem to be matched by the LSE main market (chart 3). Chart 3: Lit volume share, Diageo (DGE.L) FFI (week ending 15/04/2011) = 2.62 BATS Europe 70% 60% 50% 40% 30% 20% 10% 0%

NYSE Arca

Chi-X

JJan 2010

Turquoise

4 Oct Oct 2010 2010

LSE

14 Feb Feb 2011 b 2011

It's possible that it is simply too early to measure the real impact of the new technology platforms or it could be that other factors are at play here. Perhaps the HFT party is nearing its end and that some trading firms are now looking at other opportunities (such as Asian markets, for example). Whilst there may be some anecdotal truth in this the data (chart 4) show that the average trade size for the FTSE 100 is still decreasing (and shrinking trade sizes are typically associated with high levels of computer or algorithmically based activity).

30% 20%

Chart 4: Lit average trade size, FTSE 100

10%

3,500 00

Jan an 2010

4 Oct 2010

14 Feb 2011

3,000 00 2,500 00

The LSE’s market share of FTSE 100 trading continues to decline and there has been only a marginal improvement in Turquoise's share in the same index (chart 1). Analysis of some of the most fragmented stocks shows a more mixed picture, however. Stocks with the largest FFI will be the ones that the HFT community has been focusing its efforts on and so they should provide an early indicator of the success that the LSE and Turquoise has had in recruiting these sorts of traders. AstraZeneca does indeed show signs of recovery in terms of the LSE's share, particularly at the expense of Chi-X (chart 2).

2,000 00 1,500 00 1,000 00 500 00 0 Jun 2008

Dec 2008

Apr 2009

Jul 2009

Nov 2009

Mar 2010

Jun 2010

Oct 2010

Feb 2011

Apr 2011

So it looks like it's still early days for the LSE Group and its fight back but if it was expecting a rapid turnaround on the back of introducing faster technology then it may have to wait a little longer. 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.

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM As at end Q1 2011 Index Provider MSCI S&P Barclays Capital Russell FTSE Dow Jones STOXX Markit Deutsche Boerse NASDAQ OMX NYSE Euronext Hang Seng Topix Nikkei EuroMTS WisdomTree SIX Swiss Exchange PC-Bond Grupo Bolsa SSE Indxis Structured Solutions CSI Intellidex BNY Mellon Morningstar S-Network ISE Zacks Other Total

No. of ETFs 410 333 87 74 169 146 207 119 50 66 45 13 54 10 29 35 17 18 13 19 6 29 32 36 18 26 15 10 11 508 2,605

Total Listings 1,444 602 214 110 409 270 717 345 181 124 88 34 66 18 113 42 30 22 14 20 11 38 38 44 19 26 36 10 13 807 5,905

Q1 2011 AUM (US$ Bn) $353.7 $323.2 $116.6 $86.5 $59.7 $52.7 $50.1 $46.7 $39.2 $35.1 $16.5 $15.8 $15.3 $13.6 $9.9 $9.3 $8.8 $8.0 $7.7 $7.4 $7.1 $6.3 $3.4 $3.3 $2.3 $2.2 $2.2 $1.8 $1.0 $94.2 $1,399.4

% Total 25.3% 23.1% 8.3% 6.2% 4.3% 3.8% 3.6% 3.3% 2.8% 2.5% 1.2% 1.1% 1.1% 1.0% 0.7% 0.7% 0.6% 0.6% 0.6% 0.5% 0.5% 0.4% 0.2% 0.2% 0.2% 0.2% 0.2% 0.1% 0.1% 6.7% 100.0%

ADV (US$ Bn) 971.4% $35.4 $2.2 $8.8 $1.5 $2.5 $1.1 $0.3 $1.0 $5.0 $0.8 $0.1 $0.1 $0.2 $0.1 $0.1 $0.0 $0.0 $0.2 $0.2 $0.0 $0.2 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1.8 $72.0

No. of ETFs 20 18 3 4 8 8 -14 7 5 5 4 0 1 1 0 0 0 0 0 5 0 4 1 0 0 16 0 0 0 49 145

YTD Change AUM (US$ Bn) $15.8 $22.1 $5.4 $6.0 $4.8 $5.1 $1.4 $1.5 $7.2 $3.4 -$0.1 $0.5 -$1.2 -$1.1 $0.4 $0.8 -$0.2 $0.4 $0.1 $0.9 $1.3 $0.5 -$0.1 $0.4 -$0.4 $0.3 $0.5 $0.7 $0.1 $11.5 $88.1

Total Listings 114 36 3 9 24 12 -63 33 10 23 4 0 2 2 2 0 0 1 0 5 4 7 5 5 0 16 3 0 1 92 350

% AUM 4.7% 7.3% 4.8% 7.4% 8.7% 10.8% 2.8% 3.4% 22.4% 10.6% -0.8% 3.4% -7.5% -7.2% 4.4% 9.8% -2.0% 4.7% 0.9% 14.0% 23.1% 9.2% -3.4% 14.7% -14.2% 15.8% 28.8% 67.3% 17.1% 13.9% 6.7%

% TOTAL -0.5% 0.1% -0.1% 0.0% 0.1% 0.1% -0.1% -0.1% 0.4% 0.1% -0.1% 0.0% -0.2% -0.1% 0.0% 0.0% -0.1% 0.0% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.4%

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

Top 5 global ETF providers by average daily turnover As at end Q1 2011 Average Daily Turnover (US$ Mil) Q1-2011 % Mkt Share Change (US$ Mil)

4.0%

Provider

Dec-2010

% Mkt Share

Change (%)

SSgA

$18,667.3

40.3%

$32,777.4

45.5%

$14,110.1

75.6%

iShares

$14,028.5

30.3%

$19,379.3

26.9%

$5,350.8

38.1%

PowerShares

$2,413.3

5.2%

$4,084.3

5.7%

$1,671.0

69.2%

ProShares

$2,660.7

5.7%

$3,827.3

5.3%

$1,166.6

43.8%

Direxion Shares

$1,860.7

4.0%

$2,910.2

4.0%

$1,049.5

56.4%

Others

$6,710.2

14.5%

$8,986.0

12.5%

$2,275.7

33.9%

Total

$46,340.7

100.0%

$71,964.4

100.0%

$25,623.7

55.3%

Direxion Shares

12.5% Others

5.3% ProShares

45.5% SSgA

5.7% PowerShares

26.9% iShares

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

Top 20 ETFs worldwide with the largest change in AUM As at end Q1 2011 ETF iShares MSCI Emerging Markets Index Fund Energy Select Sector SPDR Fund Vanguard MSCI Emerging Markets ETF iShares MSCI Japan Index Fund iShares DAX (DE) PowerShares QQQ Trust iShares MSCI EAFE Index Fund iShares MSCI Canada Index Fund iShares S&P MidCap 400 Index Fund iShares S&P/TSX 60 Index Fund db x-trackers DAX ETF iShares S&P 500 iShares Russell 1000 Value Index Fund iShares MSCI Brazil Index Fund Market Vectors Russia ETF Vanguard Total Stock Market ETF Vanguard Dividend Appreciation ETF iShares S&P 500 Index Fund db x-trackers MSCI Emerging Market TRN Index ETF iShares iBoxx $ High Yield Corporate Bond Fund

Country listed US US US US Germany US US US US Canada Germany United Kingdom US US US US US US Germany US

Bloomberg Ticker EEM US XLE US VWO US EWJ US DAXEX GY QQQ US EFA US EWC US IJH US XIU CN XDAX GY IUSA LN IWD US EWZ US RSX US VTI US VIG US IVV US XMEM GY HYG US

AUM (US$ Mil) Q1 2011 $38,831.4 $11,087.2 $47,224.5 $7,340.2 $8,331.3 $24,459.4 $39,148.1 $6,486.7 $11,193.7 $13,474.2 $5,201.2 $9,267.7 $12,027.6 $13,312.3 $3,934.0 $19,527.1 $5,850.6 $27,027.6 $5,068.8 $8,561.5

AUM (US$ Mil) December 2010 $47,551.5 $8,396.4 $44,569.8 $4,883.3 $5,917.7 $22,069.9 $36,923.1 $4,622.1 $9,332.0 $11,659.0 $3,693.1 $7,905.8 $10,697.1 $12,012.5 $2,638.5 $18,236.0 $4,608.9 $25,799.2 $6,263.3 $7,376.7

Change (US$ Mil) -$8,720.1 $2,690.8 $2,654.8 $2,456.8 $2,413.6 $2,389.5 $2,225.0 $1,864.6 $1,861.7 $1,815.2 $1,508.1 $1,361.9 $1,330.5 $1,299.9 $1,295.5 $1,291.1 $1,241.7 $1,228.4 -$1,194.5 $1,184.8

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

M AY 2 0 1 1 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

Global ETF listings As at end Q1 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

Q1-2011

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 India New Zealand Malaysia Thailand Saudi Arabia UAE Indonesia Chile Botswana Egypt Israel Philippines Sri Lanka

949 1,122 1 1 1 262 396 3 1 14 23 12 6 1 3 1 1 12 31 116 12 225 171 84 43 22 19 70 21 21 14 26 7 18 6 4 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 4 1 1 2 1 -

53 68 5 27 1 2 5 8 20 14 4 3 7 8 2 2 2 -

949 3,896 21 23 1 479 1,194 3 1 14 507 108 14 1 3 1 1 68 86 626 12 733 202 88 72 22 348 70 42 79 17 26 7 18 6 5 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 -

$950.0 $307.5 $0.1 $0.1 $0.3 $63.3 $119.2 $0.1 $0.0 $0.4 $2.8 $0.4 $0.8 $0.1 $0.0 $0.0 $0.0 $1.4 $2.8 $43.1 $0.2 $72.6 $42.8 $29.6 $27.5 $11.5 $8.3 $6.3 $3.8 $3.6 $3.0 $2.4 $1.8 $0.5 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$59.0 $23.5 $0.0 $0.0 $0.0 $3.5 $8.5 $0.0 $0.0 $0.0 $0.3 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.2 $0.0 $5.1 $0.0 $5.9 $4.4 -$2.6 $1.2 $1.4 $0.1 $0.9 -$0.1 $0.0 $0.2 $0.1 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

6.6% 8.3% -24.6% 8.6% -0.5% 5.8% 7.7% 4.1% 16.8% 0.9% 10.5% 9.2% 8.1% 4.8% 6.6% 16.7% 7.0% 14.4% 0.9% 13.4% 0.6% 8.8% 11.4% -8.1% 4.6% 13.8% 1.3% 17.6% -2.3% 0.2% 6.8% 2.6% -2.0% 17.5% -2.4% -0.5% -2.0% 44.0% -10.5% 3.0% -

29 41 1 1 1 9 11 2 1 2 4 4 2 1 2 1 1 2 3 7 5 10 4 8 10 16 3 13 6 8 3 8 2 7 2 3 3 1 1 1 -

2 23 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 2 3 1 1 1 1 3 1 2 1 1 1 1 1 1 1 2 1 1 1 1 1 1 1 -

892 48*

ETF total

2,605

593

163

5,905

$1,311.3

$1,399.4

$88.1

6.7%

142

1,051

Location

*Includes five undisclosed Ossiam ETFs. To avoid double counting, assets shown above refer only to primary listings.

Planned New

24 0 1 20 1 6 6 3 4 15 1 16 0 3 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.

F T S E G L O B A L M A R K E T S • M AY 2 0 1 1

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

M ar -1 1

N ov -

Au g-

M ay -

M ar -1 0

ov -0 9

-0 9

Au g

M ay -

M ar -0 9

N ov -

Au g-

M ay -

M ar -

N ov -

-0 7 Au g

ay -0 7

ar M

N ov -

Au g-

M ay -0

40 M ar -0 6

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE RAFI Developed 1000 Index

160

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

140 120 100 80 60

M ar -1 1

N ov -

Au g-

10 M ay -

M ar -1 0

ov -0 9

-0 9 Au g

09 M ay -

M ar -0 9

08 N ov -

Au g-

M ay -

08 M ar -

07 N ov -

-0 7 Au g

ay -0 7

ar M

N ov -

Au g-

6 M ay -0

M ar -0 6

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE EPRA/NAREIT Global Index

220

FTSE Global Government Bond Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

200 180 160 140 120 100 80 60

M ar -1 1

N ov -

Au g-

10 M ay -

M ar -1 0

-0 9

ov -0 9 N

Au g

09 M ay -

M ar -0 9

N ov -

Au g-

M ay -

ar M

07 N ov -

-0 7 Au g

-0 7 M ay

-0 7 M ar

N ov -

Au g-

ay -0 6 M

-0 6

Source: FTSE Group, data as at 31 March 2011.

M AY 2 0 1 1 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

USA MARKET INDICES USA Regional Equities View (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

160 140 120 100 80 60

M ar -1 1

N ov -

Au g-

M ay -

M ar -1 0

-0 9

ov -0 9 N

Au g

M ay -

M ar -0 9

N ov -

Au g-

M ay -

M ar -

N ov -

-0 7 Au g

M ay -0 7

ar M

N ov -

Au g-

M ay -0

M ar -0 6

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE RAFI US 1000 Index

160

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

140 120 100 80 60

10 N ov -

M ar -1 1

10 Au g-

10 M ay -

M ar -1 0

-0 9

ov -0 9 N

Au g

09 M ay -

M ar -0 9

N ov -

Au g-

M ay -

M ar -

07 N ov -

-0 7 Au g

M ay -0 7

ar M

N ov -

Au g-

6 M ay -0

M ar -0 6

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100) FTSE Americas Government Bond Index

140

FTSE FRB10 USD Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance IPO Composite Index

120 100 80 60 40

M ar -1 1

10 N ov -

10 Au g-

10 M ay -

M ar -1 0

-0 9

ov -0 9 N

Au g

09 M ay -

M ar -0 9

N ov -

Au g-

-0 8

M ay -

07 N ov -

-0 7 Au g

ay -0 7 M

-0 7 M ar

N ov -

Au g-

ay -0 6 M

-0 6

Source: FTSE Group, data as at 31 March 2011.

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 1 1

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (31 March 2006 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

M ar -1 1

N ov -

Au g-

M ay -

M ar -1 0

-0 9

ov -0 9 N

Au g

M ay -

M ar -0 9

N ov -

Au g-

M ay -

ar M

N ov -

-0 7 Au g

M ay -0 7

ar -

N ov -

Au g-

M ay -0

40 M ar -0 6

MARKET DATA BY FTSE RESEARCH

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (31 March 2006 = 100)

140

FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

120 100 80 60 40

M ar -1 1

N ov -

Au g-

10 M ay -

M ar -1 0

ov -0 9

-0 9 Au g

09 M ay -

M ar -0 9

N ov -

Au g-

M ay -

08 ar M

N ov -

-0 7 Au g

M ay -0 7

07 M

ar -

06 N ov -

Au g-

6 M ay -0

M ar -0 6

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (31 March 2008 = 100)

140

FTSE JSE Top 40 Index (ZAR)

FTSE CSE Moricco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

120 100 80 60 40

1 M ar -1

10 N ov -

10 Au g-

10 M ay -

M ar -1 0

ov -0 9 N

-0 9 Au g

09 M ay -

ar -0 9 M

N ov -0 8

Au g08

-0 8 ay M

-0 8

Source: FTSE Group, data as at 31 March 2011.

M AY 2 0 1 1 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

ASIA-PACIFIC MARKET INDICES Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100)

220

FTSE Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

200 180 160 140 120 100 80 60

M ar -1 1

N ov -

Au g-

M ay -

M ar -1 0

ov -0 9

-0 9

Au g

M ay -

M ar -0 9

N ov -

Au g-

M ay -

07 N ov -

M ar -

-0 7 Au g

M ay -0 7

ar M

N ov -

Au g-

M ay -0

M ar -0 6

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 March 2006 = 100)

600

FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

500 400 300 200 100

M ar -1 1

N ov -

Au g-

10 M ay -

M ar -1 0

ov -0 9 N

Au g

-0 9

09 M ay -

M ar -0 9

N ov -

Au g-

M ay -

M ar -

N ov -

-0 7 Au g

M ay -0 7

07 M

ar -

N ov -

Au g-

6 M ay -0

M ar -0 6

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (30 September 2009 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

180

160

140

120

100

1 M ar -1

-1 1 Fe b

11 Ja n-

-1 0 De c

10 N

ov -

0 Oc t1

p10 Se

-1 0 Au g

0 Ju l1

0 Ju n1

10 ay M

Ap r10

ar -1 0 M

Fe b10

-1 0 Ja n

De c09

ov -0 9 N

Oc t09

Se p09

Source: FTSE Group, data as at 31 March 2011.

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 1 1

INDEX CALENDAR

Index Reviews May - June 2011 Date

Index Series

Review Frequency/Type

06-May

TOPIX

09-May 11-May 11-May 17-May 17-May 24-May 26-May Early Jun Early Jun Early Jun Early Jun Early Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 07-Jun 07-Jun

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 ATX KOSPI 200 IBEX 35 OBX OMX C20 CAC 40 DAX AEX PSI 20 BEL 20 S&P / ASX Indices FTSE Vietnam Index Series TOPIX

07-Jun n/a

FTSE China Index Series FTSE Renaissance Asia Pacific IPO Index Series FTSE MIB FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Italia Index Series FTSE techMARK 100 FTSEurofirst 300 FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series FTSE Bursa Malaysia Index Series DJ Global Titans 50 Dow Jones Global Indexes OMX I15 FTSE SET Index Series S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Global 1200 S&P Global 100 S&P / TSX S&P Latin 40 FTSE TWSE Taiwan Index Series NZX 50 S&P BRIC 40 VINX 30 OMX B10 Russell US & Global Indices

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 Quarterly review Annual review Semi-annual review Semi-annual review Semi-annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly Review Quarterly review Monthly review - additions & free float adjustment Quarterly review

07-Jun 08-Jun 09-Jun 08-Jun 08-Jun 08-Jun 08-Jun 09-Jun 09-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 13-Jun Mid Jun Mid Jun Mid Jun

Quarterly review Quarterly Review Quarterly review Annual review - Emgng Eur, ME, Africa, Latin America Quarterly Review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Annual review of index composition Quarterly review Semi-annual review Semi-annual review Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review Quarterly review - shares Quarterly review Quarterly review Semi-annual review - constituents Semi-annual review Semi-annual review Annual consituent review / Quarterly IPO additions

Effective (Close of business)

Data Cut-off

27-May 13-May 20-May 03-Jun 31-May 31-May 17-Jun 31-May 30-Jun 08-Jun 13-Jan 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun

29-Apr 30-Apr 30-Apr 31-Mar 31-Mar 30-Apr 29-Apr 25-May 31-May 30-Apr 31-May 31-May 31-May 31-May 31-May 30-Apr 30-Apr 30-Apr 27-May 31-May

30-Jun 17-Jun

31-May 23-May

17-Jun 17-Jun 17-Jun

31-May 31-May 07-Jun

17-Jun 17-Jun 17-Jun 17-Jun 17-Jun

07-Jun 31-May 07-Jun 07-Jun 07-Jun

17-Jun 17-Jun 17-Jun 17-Jun 30-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 17-Jun 30-Jun

31-May 31-May 31-May 31-May 31-May 31-May 09-Jun 03-Jun 03-Jun 03-Jun 03-Jun 03-Jun 31-May 03-Jun 31-May 31-May 20-May 31-May 31-May

24-Jun

31-May

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

100

M AY 2 0 1 1 • F T S E G L O B A L M A R K E T S