FTSE Global Markets

US TRADING: REDRAWING HIGH-TOUCH SERVICES

I S S U E 5 3 • J U LY / A U G U S T 2 0 1 1

RYAN’S US BUDGET CHALLENGE

Capping the deficit

Next generation trading algos emerge The growing appeal of equity swaps Has the US corporate bond bonanza peaked?

Why broad-based equity tracker ETFs are so popular

GCC ASSET SERVICING ROUNDTABLE: PREPARING FOR THE NEW DECADE

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

HILE POLITICIANS HAVE made huge capital from the financial crisis and used the well-spring of public discontent to systematically blame and justify the imposition of penalties, restrictions and sometimes restructuring upon the banking sector, it appears the same disciplinary tendencies are unlikely to be unleashed on themselves. The $14.3trn of Federal borrowing has backed credit ratings agencies against the wall and forced both Moody’s and Standard & Poor’s to signal their dismay at the seeming inability of the US government, and it’s federal agencies to work together to put their house in order.

Meanwhile on the other side of the disciplinary divide, the Basel Committee on Banking Supervision is considering a capital surcharge for systemically important financial institutions (aka SIFIs), reported a number of news agencies in late June. It looks as though large banks will face an extra capital requirement, possibly as much as 3.5 percentage points more, if they grow even bigger. The committee has not disclosed which banks would be affected, but it is likely to encompass some of the world’s top banks.

Back on the laxer political front, it looks likely that the EU’s increasingly ambivalent approach to the impending meltdown of Greece will result in the latest round of banking stress tests which will not take into account the possibility of the country defaulting. It has become self-evident that Greece cannot possibly avoid default without further large-scale support from other EU states; the Greek government cannot maintain a challenging austerity programme while cabinet ministers and advisers cut and run as soon as the population begins its own political lobby with Molotov cocktails.

As Ian Williams notes in our cover story, the financial community is not emulating Chicken Little and screaming nervously at the sky. However, the same financial community is looking with anxious concern at the possibility of banks having to writedown more debt exposure at this sensitive junction on the motorway to recovery and, at the same time, cope with increased allocations to their reserve accounts. No surprise then that across the pond, master-bear Simon Denham is sounding ever more ursine by the sentence.

Lest the climate of fear and doom threatens to overwhelm our readers, we offer a sprinkling of green shoots. The luxury car market is booming; good news for those professionals who still enjoy hefty bonuses. Even so, as the author notes:“The launch of new models is almost a paradigm for the global markets, its possibilities and also its dead ends.” For everyone else, like me you can look, even if you cannot buy.

Our features divide neatly into two sections: the first on trading, the second on securities services. They are two diverse and rapidly changing businesses, yet linked by back office functions which are themselves undergoing reformation.

It is interesting to see the parallels between the two: both coming to terms with changing business volumes and the growing complexity of both their market and their internal business models. Equally, in both instances, the relationship between the provider of services and the client user are being redrawn. A closer, deeper and more understanding relationship is emerging.

I do not want to overstate the case. However the parallels are laid bare.

W

Francesca Carnevale, Editor, July/August 2011 Cover photo: House Budget Committee Chairman Paul Ryan (R-Wisc.) speaks at a 2011 fiscal summit on "Solutions for America's Future." organized by The Peter G. Peterson Foundation at the Mellon Auditorium May 25 2011 in Washington D.C. Photo by Olivier Douliery/ABACAUSA.com for Press Association Images, supplied by PA Images, June 2011.

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CONTENTS COVER STORY

RYAN’S US BUDGET GAUNTLET

......................................................................................Page 6 US Congress set a limit of $14.3trn on Federal borrowing; but that limit has long been passed. If Congress does not lift the ceiling by the end of July, the US Treasury risks going into default on its obligations to taxpayers, employees and/or bondholders.

Are the two sides in this political tussle in deadlock; or can a solution be found?

Ian Williams reports.

DEPARTMENTS

MARKET LEADER

THE RESTRUCTURING OF IRELAND’S BANKS

..........................................Page 12 David Craik looks at the mechanics of change in Ireland’s stressed banking system.

SPOTLIGHT

AON MAPS WARNINGS ON TERRORISM........................................................Page 16

INDEX REVIEW

DEBT HANGS OVER LOW-VOLTAGE ECONOMY ....................................Page 20

Key stories from the global and capital markets.

Simon Denham, managing director, Capital Spreads, considers the outlook for the UK.

TAKING STOCK OF EQUITY SWAPS

..................................................................Page 21 David Simons explains why the outlook is positive for equity swaps.

IN THE MARKETS

OPTIONS OVERHAUL ........................................................................................................Page 23 The revolution in options trading.

TRILLION DOLLAR TRADING ......................................................................................Page 26 Neil O’Hara reports on the rapid evolution of the ETFs trading market.

FX VIEWPOINT SECTOR REPORT

THE MATURING OF THE HFT SET

........................................................................Page 28 Erik Lehtis explains why high-frequency trades are beneficial to the FX market.

SUPER MODELS DRIVE THE LUXURY MOTOR MART

......................Page 30

Ian Williams reports on a burgeoning business line.

SOVEREIGN ISSUERS DOMINATE DEBT AGENDA ..................................Page 32 Can the EU really come to terms with Europe’s debt problems?

BRAZIL’S ISSUERS LOOK ABROAD ........................................................................Page 35

DEBT REPORT

Brazilian firms search offshore for cheaper finance.

HAS THE CORPORATE BOND BONANZA PEAKED? ............................Page 38 David Simons reports on the fuel in the US corporate bond engine.

THE RISE & RISE OF CANADIAN HIGH-YIELD DEBT ............................Page 40 Andrew Cavenagh says Canada’s high-yield bonds are on the crest of a wave.

BANKING REPORT 2

THE ADVANTAGE OF BEING A FLOW MONSTER

................................Page 44 David Simons on the prospects for investment banking in the second half of the year.

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CONTENTS FEATURES TRADING REPORT:

BROKERS FIGHT A WAR IN THE TRENCHES ..........................................Page 47 With a sustained slump in trading volumes, it has been a hairy couple of years for execution-only brokers; particularly as 71% of business and commission in the US goes through less than ten brokers; in Europe the comparable figure is 72%. What now? Ruth Hughes Liley reports

TECHNOLOGY: THE CHARGE FOR SUPREMACY ................................Page 51 As the market place becomes more electronic, market participants need to ensure they are supplied with the most sophisticated and flexible trading systems, and are supported by the right applications. Ruth Hughes Liley surveys the options.

US TRADING ROUNDTABLE: DEFINING A NEW BUY SIDE/SELL SIDE RELATIONSHIP ......................Page 55 The partnership between the buy side and the sell side has definitely grown and is only going to become more important, thinks Dan Royal, co-head of global trading, Janus Capital Group. However, he says: “I think we have enough brokers and enough saturation in each category.” What did the rest of the panel think?

SECURITIES SERVICES REPORT:

THE PROBLEM WITH COMPLEXITY ............................................................Page 64 Are there too many elements now brought to bear on the provision of securities services? Can they be all things to all investors? A discrete group of the top six or seven global players thinks the answer to both questions is yes. How do they square the challenging dynamic?

RUSSIA EDGES NEARER POSITION OF POWER

..................................Page 69 The Russian government has big dreams for the country and wants to turn its major cities into financial power hubs. So much will have to change if this is to be achieved. however; not least a crackdown on bureaucracy, outdated regulations and an endemic culture of corruption. Lynn Strongin Dodds assesses the likelihood of change.

ALPHA-GENERATION, DEMAND & SECURITIES LENDING

..........Page 72 Brooke Gillman, managing director, client relationship management at eSecLending, looks at the continued evolution of the industry and outlines the need to take a detailed, nuanced and proactive approach to the new generation of securities lending opportunities.

MAJORS TARGET ASIA ........................................................................................Page 74 Changing investment patterns have not always translated into an increase in revenues for transition managers but they signal the further development of TM in the region, reports Lynn Strongin Dodds.

HOW TO TRANSITION €3bn INTO MANAGED ACCOUNTS

......Page 78 Karin Russell, executive director, transition management, Morgan Stanley, outlines the mechanics of a high-value transition of LD Pension funds into three managed accounts. We also asked LD Pensions what they thought of the transition.

GCC ASSET SERVICING ROUNDTABLE: RISK & REWARD IN HIGH-GROWTH MARKETS

................................Page 81 The return to robust growth in Gulf Co-operation Council (GCC) markets is refilling investment coffers and providing new opportunities to indigenous service providers. So what’s left for global providers? We invited comment from some of the region’s experts in securities services provision to provide us with insight on local market reforms and new business opportunities.

DATA PAGES

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

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COVER STORY

US FEDERAL BORROWING: HOW FAR CAN IT WORK OUTSIDE CONGRESSIONAL LIMITS?

House budget committee chairman Rep. Paul Ryan, R-Wis., left, walks with Rep. Charles Boustany, R-La., as they arrive for a House GOP caucus on Capitol Hill in Washington, Thursday, June 2nd, 2011. Photograph by Harry Hamburg/AP for Press Association Images, supplied June 2011.

Swirling towards a perfect storm?

As part of its perennial posturing, the US Congress set a limit of $14.3trn on Federal borrowing. With the financial crash, the wars, TARP and the stimulus package, the limit has already recently been passed and the US Treasury is creatively dipping into Federal pension funds to pay its way. If Congress does not lift the ceiling by the end of July, the Treasury risks going into default on its obligations to taxpayers, employees, or bondholders. Both sides are locked in seemingly irreconcilable positions on whether raising revenue through taxation should be part of the deficitreduction package. Ian Williams reports on the implications.

OODY’S AND STANDARD & Poor’s have both sounded alarm bells. Even the IMF has cautioned its largest national shareholder, while economist Nouriel Roubini has warned that a Treasury default could help precipitate a “perfect storm”. The financial community is not saying the sky is about to fall in, but it is casting around more than the usual quota of anxious glances at it.

With confidence still fragile, it would

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not take much to start an avalanche.

Jack Flaherty, investment manager for GAM’s fixed income team, cautions: “People in Washington are pushing to the brink of default and over. It is not likely, but you cannot totally discount it and say it is not going to happen. It is scary, since, when we’ve had budget impasses before, we have not had this high a deficit.”

Indeed, he points out the markets have begun to factor in the possibility,

no matter how remote, of a default.

“Investors have been buying credit default swap (CDS) spreads on oneyear bonds. The cost is quite low but it has risen discernibly. CDS trading on the US government is kind of absurd— after all, it’s their own currency and they can print it, so how can they default? But, of course, when they do silly things in Washington, investors are increasingly nervous.”

Kris Kowal from DuPont Capital Management agrees: “I think it can go pretty far, because up to now they are not really talking. I’m not sure it will go all the way, but it will get close to the wire and some people would be very upset if there is a default on the bonds.”

Although there are real macroeconomic issues for the US, the issue here is political. Indeed, it is almost theological. The newly-elected conservatives in the Republican Party have a visceral aversion to government and a determi-

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COVER STORY

US FEDERAL BORROWING: HOW FAR CAN IT WORK OUTSIDE CONGRESSIONAL LIMITS?

Health and human services secretary Kathleen Sebelius speaks at a news conference about GOP Medicare cuts on Capitol Hill in Washington on Thursday, May 19, 2011. Photograph by Harry Hamburg/AP for Press Association Images, supplied June 2011.

nation to reverse the New Deal and its social programmes. They inspired the budget proposal put forward by neophyte House of Representatives finance chair Paul Ryan, which was supported by all but four Republicans in the house. However, it failed to garner even a single vote from the“Blue Dog”fiscalconservative Democrats. It slashed everything but defence spending, and excluded any new taxes, while maintaining the Bush tax cuts many economists blamed for much of the current deficit which replaced the Clinton surplus. Above all, at the core of his budget was a proposal to phase out Medicare, the government health programme for retirees.

Luc de Clapier, formerly New York head of the French finance house, CDC-Ixis, and now with New Dawn Advisors, deals with Asian investors, whose collective view of the US might well determine just how big a storm the

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Capitol gridlock precipitates, and he suggests: “Nobody in America, nobody in his right mind, would think that the US government could default on its obligations this summer, so terrifying are the consequences for the ordinary investor, and ultimately for the common man.”

Budget crisis/debt crisis?

Even so, he adds, it now seems almost possible and therefore: “This budget crisis could become a debt crisis, with consequences American citizens aren’t prepared to face if congress continues to play Nero when the fire has started. If the trust of the ‘bond vigilantes’ is broken, the US risks paying everincreasing interest rates to sustain its access to world markets. More immediately, expect an already fragile stock market to take a dive, consumer consumption to stall, investment to freeze, unemployment to accelerate and the

double-dip recession so much feared by the Fed to take root. Compared to the US, the Greece of today, with its government bonds in the junk category, and having to pay more than 15% to borrow, would be only a small offender.”

Less apocalyptic, but still deeply concerned, Mark Zandi, chief economist of Moody Analytics explains: “We issued a statement warning that if certain things do not happen by a particular time, we would put the US on warning for a downgrade, and if they still do not happen, then of course, we would consider what rating was appropriate.” So far, market response to the warnings has been modest, he says.

Zandi admits however: “I do think investors are becoming gradually more nervous with each passing day, especially as we move into July.”

Like most people, he considers it to be “most likely political brinkmanship, so that at the end of the day they will sign on the dotted line for an increased debt ceiling, and might even succeed in bringing about a budget mechanism to deal with the underlying problem, but it is going to be an uncomfortable process, with ups and down”.

Zandi offers some reassurance: “Look at overall Treasury rates. The market is not really panicking. Instead, investors are lining up to buy longterm bonds at 3% yield. Real rates, adjusted for inflation—something we follow closely—are still negative, so you would need to see effect there to consider it to be a ‘probable’ event. That signals expectations that US policy makers will, as they have done historically, follow through and we will be able to work through our fiscal problems, despite occasional problems with nervousness.”

Interestingly, Zandi and others hold up not so much the American economy but the US markets as the saving grace.

“Our problems are severe, but they are equally so in other parts of the world, and it’s difficult to invest on the same scale in China. We still have the deepest, liquid, well-run market economy in the world, so global

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COVER STORY

US FEDERAL BORROWING: HOW FAR CAN IT WORK OUTSIDE CONGRESSIONAL LIMITS?

investors are willing to give the US a lot of latitude and benefit of the doubt, but we do have to make those changes,” says Zandi.

Cooper Abbott, co-chief operating officer and executive vice president of investments at Eagle Asset Management, is similarly bullish, though cautious, about the prospects for the US. “It is not so much that the US has declined but more that others have stepped up. The US share of global GDP hasn’t gone down that much since 1995. There is an argument about the benefits of being a reserve currency, [particularly] when you look beneath the hood at the euro and the renminbi (RMB). Now there is talk of countries coming out of the euro, and the RMB. China might be the second-largest economy, but it’s centrally controlled.”

Room for optimism Abbott sees room for optimism in the current crisis in “the very first steps in what is a very long-term and challenging discussion about the capital markets in the global system and the US challenge”. He adds: “There are a lot of theatrics about the ceiling, with rhetoric pretty high across the board because of the electoral cycle we’re coming into [sic]. But at least the topic is now in the arena while two to three years ago everyone was on autopilot.

At the end of the day adult decisions will be made and fiscal decisions about taxes and spending will clearly have implications for equities. There will be fewer social services and we will be paying more taxes. We will be getting less and we will be paying more for it but is not really the end of the world.”

Abbott qualifies his position, given that his funds’ fortunes are not hitched to the overall US economy: “Our portfolio managers view the investable universe. We are not investing in indexes and the capital markets in the US are so deep and so varied there are always opportunities out there. We can go in and find companies with particular points of view and competitive

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advantages. The US has proven time and time again that its rule of law and innovation can overcome challenges.”

Flaherty thinks that alternative reserve currencies are “a logical conclusion over time, probably based on an Asian and a European bloc as well as the dollar, but it will take a long, long time as the issues on europeriphery show”. He adds: “It just makes it a long process. The US consumer has been the driver of the world economy for a long time, but when you look at the current trade deficit, which is the real imbalance that drives everything, that’s just not sustainable.”

In the medium term, Flaherty hopes to reassure by stating: “The larger part of the stimulus, the Keynesian part, is already largely spent and is going to get smaller. So there will be no QE3 but the Fed is going to stay accommodative and not going to be raising interest rates any time soon, despite commodity price rises.” However, that position assumes of course that there is no default.

For his clients, the longer-term message is: “On average the dollar is going to weaken, but against what?

We think you shouldn’t just have dollars, but have more of a diversified approach. We look at it on a case-bycase basis: we have currencies we like such as the Asian currencies, the Korean won, or the Singapore dollar.

The RMB is difficult to get big movement in as it is controlled. But it would be hard to make a case for the euro right now.”

Taking a slightly longer view, de Clapier is more convinced that the US is on the verge of losing the protection of being the sole reserve currency, which means that congressional indifference to foreign reaction is now unsustainable. “There is competition now, and it will accelerate as other economies grow faster than the US. It’s not as if the US has the only possible currency to settle trade flows, as in the past: the euro is strong and has slowly become an accepted alternative. China is diversifying its investments out of the US dollar and seeking to barter

deals in RMB against the currencies of other trading partners. For the last ten years at least, the US dollar has weakened—except during the financial panic of 2007-2009—against most non-pegged currencies, especially those of the emerging countries.

Beyond the event horizon of the budget black hole, Kris Kowal suggests: “The US doesn’t have much idea what do with the dollar, it has had too much easy money for too long. The budget is, after all, about how and what the government spends, which has a major influence on the economy. I think the policies are wrong: monetary policy is subsidising banks at the expense of savers and the dollar looks cheap undervalued on PPI, but if at some point if the Fed starts revising the rates, if the US Treasury gets hit, so you cut spending then I don’t see how the economy can grow.”

Elementary mistake?

One factor that makes a settlement more likely is an elementary political mistake that is weakening the resolve of the hitherto solid Republican phalanx.

Ryan’s budget deftly deferred the issue of social security, thereby avoiding falling onto the third rail of US politics.

But they discovered quickly that they were instead swinging from the overhead power cable with Medicare. The most active group of voters in the country, retirees and near-retirees, who are all anxiously scanning their everexpanding doctors’ bills and crisisshrunk pension fund statements, have seen a threat to their future and reacted strongly, causing consternation among Republicans more anxious about their seats than ideological purity.

However, despite a widespread belief in the basic integrity of the US economy and markets, what is worrying for global markets is the implication that the world’s largest economy and its reserve currency are drifting with no effective navigation. It might miss this reef, but there will be others and each near-miss will have more investors jumping ship. I

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MARKET LEADER

IRISH BANKING: WILL REFORM CREATE OPPORTUNITY?

Restructuring for a focused future In early April the Irish government announced plans to reorganise and recapitalise the nation’s banks following a series of stress tests which Ireland’s central bank had commissioned from third-party, US money manager BlackRock. The banks would be smaller, more focused on core operations, better funded and better capitalised, involving the sale or run-off of in excess of €70bn of non-core assets. There will be two fullservice domestic banks as the “core pillars” of the system—Bank of Ireland (which sold off its custody and fund administration business to Northern Trust in February) and a new bank forged by a merger of government-owned banks Allied Irish Bank and the EBS Building Society. What can we expect the Irish financial structure to look like at the end of this year? Will the two-pillar banking structure survive, and what will be the role of foreign banks in Ireland? David Craik looks at the likely repercussions of wholesale restructuring of the country’s banking segment.

ANKS ARE CLEARLY a sensitive issue in Ireland. One analyst describes a “very different shaped” banking structure by the year’s end as a result of a raft of asset disposals. “It is a very sharp and aggressive deleveraging of the system, almost a third of the banking system’s total assets will be run down or sold over the next two and a half years,” the analyst states. “They will [include] everything from UK mortgage books to corporate books. The reason for doing this is that the loan to deposit ratio in Ireland at present is on average running at 280%.

It will be run down to 122.5%. It means releasing liquidity back to the European Central Bank (ECB) and moves the system off the life support machine it has been on for the last two years.”

Despite Patrick Honohan, the governor of the Central Bank of Ireland, stating that it was likely that all Irish banks would end up in full state ownership, Bank of Ireland remained defiant. It has declared that it is determined to remain private and to raise the sums through private sources, pos-

B

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sibly a rights issue. It recently appointed UBS, Deutsche Bank and Credit Suisse to advise on its options.

Even so, the entire system will be reformed. “You go in with six banks and effectively come out with two. The background strategy is that in case a foreign buyer does not come in for one of these banks then you have solidified their balance sheets and ensured that they can finance themselves for the next few years. It is to get them into a position where they will either be attractive for a buyer or are attractive as a standalone entity for foreign investors to lend money into [a portion] of the wholesale funding.”

The banks though will all become much more “domestic focused” as their most “saleable assets are their international assets”. The analyst adds: “It will be much more centred on Ireland Inc. It is also inevitable that they will become more retail focused in their operations.

They may retain a reasonable level of corporate work on the Irish domestic side but their international corporate exposure will be greatly reduced.”

The analyst warns of many “threats” within the new system, particularly that of further interest rate, hikes by the ECB. “They are happy to increase the heat on the periphery to keep the central core cool. You’re trying to tame down the French and Germany economies while toasting the others with higher rates.

There is probably limited room for the ECB to aggressively increase them because they will put certain economies such as Greece, and I’m not mentioning Ireland here, into default. Then they would have to cut them again to re-stimulate the system.”

Emer Lang, analyst at Davy Stockbrokers, is more optimistic.“It appears likely that we will get some break on the bailout cost. We are obviously watching developments in Greece closely as a renegotiated deal for them may help our case. A 1% reduction in the punitive 5.8% rate is worth €400m a year to us,” she says.

Even so, the crisis looks set to dig in for another few years at least. “It depends on the progress of the sovereign debt,” says the analyst. “You can

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Taoiseach Enda Kenny (left) and Tanaiste Eamon Gilmore at the Government Press Centre in Dublin, after the central bank published figures compiled using forensic bank stress tests on Allied Irish Bank (AIB), Bank of Ireland, Irish Life and Permanent (IL&P) and the EBS. Photograph by Julien Behal/PA Wire for Press Association Images, supplied by Press Association Images, June 2011.

stabilise the banking sector and the economy but will the sovereign recover in international markets? That is a significant task because there is so much work to be done and we are so dependent on what happens internationally. I think that if you consider that the crisis started in 2008 and it is now 2011 then we are probably well over halfway through, but the problem is that there are no certainties when you are in a post-crisis environment.” On the other hand, Lang prefers not to even “hazard a guess” over the likely timescale.

Pat Farrell, chief executive of the Irish Banking Federation, welcomes the “clarity” provided by the government’s reorganisation. “It makes the task of getting our economy back into growth much easier,” he says. “The stress tests and the subsequent capital requirements put our banks at the very top tier. There has been a general acknowledgement from the international bodies including the ECB that the stress tests were very severe and that our banks are now carrying very high

levels of capital. That is designed to get them to a situation where they can access international markets again.”

Farrell agrees that the banks will have a larger domestic focus but is keen to stress that they will not just become “savings and loans institutions”. He says: “We have to remember that the Irish economy remains very sophisticated. There is a huge amount of multi-national activity and within Ireland the Irish banks will still have to provide foreign exchange services, loans for the SME sector and a certain amount of investment banking activity and mergers and acquisitions activity.

So they will still be providing a broad range of services.”

A third pillar?

Farrell talks about a third pillar in the new Irish banking structure—overseas banks which will help maintain the sector’s competitive nature. “RBS for example has a significant investment in Ireland and presence with Ulster Bank.

You also have KBC Bank Ireland, Danske, and ACC Rabo. Okay you have

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

had the departure of HBOS but a foreign presence will remain committed to Ireland,” Farrell says. “That is important because they have global reach and you need to have banks in your economy which have that. Competition-wise you will have four or five big players. That is adequate for a market of 4m people. We need that diversity of ownership.”

The overseas commitment, he argues, will be strengthened by an improving economy.

“The next couple of years will be tough and challenging but our indigenous export sector is growing very strongly again and the FDI sector has continued to grow quite strongly through the crisis. In a couple of years’ time the economy will be back at sustainable growth levels with a market where people will have good quality business to do,” he states.

Farrell also thinks that in two years’ time the state-owned banks will have become private again. “The government does not have an ideological position on this. They don’t want to be owning banks on behalf of the taxpayer. State control has been a necessity,” Farrell states. “They want banks to stand on their own two feet both in terms of being able to raise capital privately and access funding in the international markets. They will return banks to private ownership at the earliest possible date.”

The question has invariably been asked whether the status of Ireland as one of a discrete group of global centres of fund administration services can be sustained over the near term. Rachel

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MARKET LEADER

IRISH BANKING: WILL REFORM CREATE OPPORTUNITY?

Patrick Honohan, governor of the Central Bank of Ireland, listens to media questions at the Central Bank, Dublin, Ireland, Thursday, March 31st, 2011. Photograph by Peter Morrison/AP for Press Association Images, supplied by Press Assication Images, June 2011.

Turner, head of fund services, BNY Mellon Asset Servicing, Ireland, in Dublin, gives a resounding yes.

“There is a clear separation between the international funds industry and Ireland’s domestic economic issues,” she says. “It remains one part of the economy that has not lost its bite.

There is good governance, good regulation, tax structure and tax rates to position your business here. Ireland ticks all the right boxes and that can’t be eroded overnight.”

Turner explains that the only drawback is the reduced levels of new money which is leading to increased competition amongst asset managers, custodians and fund administrators.

“This however applies to all fund domiciles not just Ireland and despite the headwinds facing the funds industry Ireland continues to see a number of new fund launches, particularly hedge funds. The Irish funds industry should continue to grow providing it

14

can contain costs,” Turner states. “Our plans for Ireland remain unchanged.

We expect to grow employee numbers by 5% in the years ahead on the asset servicing side and are exploring options to introduce new products here.”

In terms of future growth BNY is seeing a lot more qualifying investor funds (QIF), ETFs and money market funds. “We are also seeing a lot more interest in the US and Asia. These are good rich geographies,” Turner says.

Paul Daly, managing director of BNP Paribas Securities Services in Ireland, is equally positive. “Dublin has never been busier in relation to the funds industry. That goes for us and our competitors. I sit on the Irish Funds Industry Association council and recent figures show that assets under administration in Ireland are at an alltime high,” he explains. “We have also upped our workforce by a third this year and doubled our number of subfunds. It’s been very positive.”

Daly describes a ‘two-tiered’ economy. “Our exports, and I would put funds in that category, are doing extremely well. We are pretty far removed from the banking crisis,” he states. “Our client base is not Irish.

About 85% to 90% of the assets which are administered here or are in global custody here belong to fund promoters who are domiciled either in the UK or US. These clients are sophisticated and they understand how their assets are held. Given their knowledge of how stable a bank such as BNP Paribas is then the Irish crisis is a non-issue.”

A shift from a full employment era to one of rising unemployment has also been an advantage. “Staff turnover is down and that leads to increased quality in service and increased client satisfaction,” he states.

The immediate market reaction to the government’s moves was generally positive. Bank of Ireland and Allied Irish Bank’s shares responded well, the amount of deposits withdrawn from the banks reduced and ratings agency Standard & Poor’s removed Ireland from its CreditWatch. The agency said: “The outlook is now stable. The Irish economy has stronger growth prospects than the Portuguese and Greek economies considering its openness, flexibility and its competitiveness.”

The next step of the new government will be to try and renegotiate the terms of its European Union bailout especially given the European Central Bank’s recent hike in interest rates.

There is also talk that the government is considering forcing bank bondholders, both on senior and junior bonds and including UK, US and German banks, to take a haircut on their investments in Ireland’s banks.

One possible cloud on the horizon is a change in Ireland’s very favourable corporation tax of 12.5%. “The government has resolutely fought that issue. We’re confident that will remain,” he says. There is many an Irishman and woman who would cherish such stability. It should be an interesting few months and years ahead.I

J U LY / A U G U S T 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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SPOTLIGHT

Aon Map charts political risk changes

DTCC’s new P&I processing methodology

Political violence, strikes and war join terrorism as key threats to businesses POLITICAL VIOLENCE, STRIKES, riots, civil war and war threaten the sustainable growth, continuity and profitability of businesses as much as terrorism, according to Aon Risk Solutions, the risk management business of Chicago-based Aon Corporation. Aon’s annual Terrorism Threat Map now also takes these factors into account in assessing the severity of threats businesses face around the world. The map acts as a ready gauge of the intensity of the threat of political violence to international business in individual countries. It uses three icons to indicate whether the forms of political violence likely to be encountered are either based on terrorism and sabotage; strikes, riots, civil commotion and malicious damage to property; or political insurrection, revolution, rebellion, mutiny, coup d’etat, war and civil war.

“While terrorism remains a very real threat around the world, the reality is that threats to business continuity are also coming from political violence in all its many forms. The change in the way the map is scored should not be seen as a decrease in the incidence or severity of terrorist threats, but rather the fact that it provides businesses with a more inclusive view of some of the risk management issues they are facing around the world,” says Neil Henderson, head of terrorism in Aon Risk Solutions’ crisis management team.

The 2011 map shows increased risk of political violence across the globe.

In this iteration, the map highlights the Arab Spring uprisings in the Middle East and North Africa, as well as the heightened risk of coup d’etat and rebellions in Africa, a continent according to Aon that presents a significant political violence risk.

16

Moreover, terrorism continues to severely afflict established conflict zones such as Iraq, Afghanistan, Pakistan and Somalia as well as parts of Nigeria and the Sahel region.

However, political risks extant in emerging and frontier markets are not the only ones highlighted. Civil unrest and labour disputes arising from austerity measures in Western European nations such as Greece, France, Spain and the UK are also reflected on the map. Additionally, the continuing threat of occasional acts of international terrorism remains significant for most western nations and major powers.

The map, produced by Aon in collaboration with the security consultancy firm Janusian, which is part of The Risk Advisory Group, reflects data recorded by Terrorism Tracker. This monitors global indicators of terrorism threat, including attacks, plots, communiqués and government countermeasures. Aon’s WorldAware service, which provides country risk information for business travellers and an expert assessment of the security situation in more than 200 countries, also contributes intelligence into the analysis within the map. Each country is assigned a threat level, starting at negligible, and rising through low, medium, high and severe. “Businesses should, as a first step, identify the threats they face and implement a comprehensive risk management programme to protect their employees, physical assets and ultimately, their bottom line. As the insurance market for terrorism insurance is very mature and can cope with complex international risks, it should be considered as part of a sound risk management programme,” adds Henderson. I

DTCC says new initiative reduces risk and boosts efficiencies THE DEPOSITORY TRUST & Clearing Corporation (DTCC) says its new methodology for processing principal and income (P&I) payments has made significant progress since its implementation in early February this year in reducing systemic risk, increasing efficiency and enhancing accountability in the allocation of several trillion dollars annually.

The number of on-time and correctly identified payments by issuers and paying agents to The Depository Trust Company (DTC), a DTCC subsidiary, has risen to 98.7% in the first four months since implementation, compared to 96.7% for 2010.

The percentage of P&I entitlements allocated on the payable date—including those identified payments received just after the 3pm cut-off time—has also increased since the February implementation, to more than 99.3%, compared to 98.81% for 2010. In 2010, DTC collected and allocated more than 5m payments worth $2.5trn to its participant firms and ultimately to investors.

The new methodology allocates only those entitlements that are received on time and with the identifying CUSIP number. Under the previous long-standing industry practice, DTC collected and allocated virtually all payments on the payable date, regardless of whether the payments were received on time or correctly identified. DTC withheld payment only if it determined that the entitlement would not be funded by the agent or issuer. I

J U LY / A U G U S T 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

SPOTLIGHT

Shanghai to become world’s largest financial centre China continues to open its capital markets, finds KPMG report.

SHANGHAI IS ON track to becoming the world’s largest financial centre within the next decade, as China continues to open up its capital markets and expand its investor base, says a new KPMG, Dagong and FTSE Group report. In absolute size, China’s equity markets have now grown to a significant level, from $400bn in 2005 to $4trn in 2010. This growth has been fuelled by more than 500 initial public offerings, including the listings of China’s largest banks. Shanghai now has some of the world’s largest companies represented on its bourse.

A joint report by KPMG, FTSE Group and Dagong Global Credit Rating, China’s Capital Markets – The Changing Landscape, highlights the importance of the internationalisation of the renminbi (RMB) and progress towards the launch of the International Board on the Shanghai Stock Exchange. The new board aims to enable foreign organisations to access the Chinese markets allowing domestic investors direct access to foreign-listed companies for investment purposes.

Simon Gleave, regional head,

financial services, KPMG China, says: “We expect to see the launch of the new international board occur in the near future, but we note that no timeline has been indicated, although there are clear indications regarding the areas of regulation that need to be resolved as a precursor to any launch.”

These include regulations on financial reporting, accounting and auditing, cross-border supervision and stock exchange disclosure requirements.

Once appropriate listing rules have been developed and published, there will also be a need for clarifications around capital account convertibility, dividend payments and arbitrage.

Meanwhile, the formal introduction of ChiNext and of Stock Index Futures has significantly helped to broaden the market for domestic investors. As China’s stock market evolves, the investor base continues to expand, with products for qualified foreign institutional investors (QFIIs) playing a more prominent role. The report notes that as the QFII pool has continued to grow, the total quota is expected to expand to $30bn in the near future.

Donald Keith, deputy chief

executive, FTSE Group, says:“At FTSE, we’ve seen growing demand for market access products for QFIIs, including those based on the FTSE China Index Series and we anticipate continued interest. It will be paramount for index providers, issuers and exchanges to continue to expand the breadth and depth of products available to meet the needs of investors, as QFII quotas expand.

“With their index trading experience in international capital markets, QFIIs could help to broaden the investor base of China’s financial markets through the increasing use of indexlinked vehicles, such as exchangetraded funds (ETFs), futures and, more recently, stock index futures,”adds Keith. The focus is on China’s capital account liberalisation and the potential implications for the future development of equities, bonds and derivative products. The rapid development of both the stock and bond markets could generate a huge demand for derivative and hedging products.

The internationalisation of the RMB is capital to China’s ambitions to transform Shanghai into an international financial centre. The country may need to fast forward full capital account convertibility, and the opening of RMB-denominated AShares to foreign investors.I

SWIFT reports on automated fund orders Automation of cross-border fund orders on the rise, says annual EFAMA/SWIFT report THE LATEST REPORT by The European Fund and Asset Management Association (EFAMA) and SWIFT, on the evolution of automation and standardisation rates of fund orders received by transfer agents (TAs) in the cross-border fund centres of Luxembourg and Ireland in 2010, shows the total automation rate of orders topped 75% in the fourth quarter (Q4) 2010.

The report also says that the adoption rate for ISO messaging increased by a further 3% compared to the same period in 2009. The report is meant to support efforts by the European Commission, the European Parliament and other interested stakeholders to

18

encourage greater standardisation and automation in the funds industry.“It is very encouraging to see continued progress towards standardisation and automation. It is also important to note that although numbers of manual orders fell as a percentage of the whole, they grew in absolute terms. This means firms’ operations are still being put under great strain—strengthening the business case to standardise and automate further,”says Marco Attilio, head of funds at SWIFT. Overall, says the report, some 5.9m orders were processed manually last year, and 17.6m orders were processed through automated order processing systems. According to Peter De Proft, EFAMA’s director general: “Achieving an automation rate of 80% for cross-border fund orders in a not too distant future.” I

J U LY / A U G U S T 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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INDEX REVIEW

THE EMERGING CARBON ECONOMY

On the face of it, as with much of this year so far, it is hard to be either massively negative or solidly positive. While macrodata is verging on the grim, corporate margins appear to be holding up, dividend yields continue to be attractive whilst returns elsewhere are likely to remain in the doldrums. Much of the disquiet is focusing on inflation and overall growth and the persistent impact that commodity price rises (particularly energy) are having on both of these plus, of course, the ongoing Greek drama. In the short term, consumers will just have to dig deeper and pay more for less. Simon Denham, managing director, of spread betting firm Capital Spreads, provides a particularly bearish view this month.

Debt hangs over low voltage economy HERE IS PARTICULAR disquiet on the energy front in the UK right now. As playwright George Bernard Shaw once famously espoused, it is generally the poor who pay for middle-class morality and, in Britain, with energy prices soaring through the roof, the UK’s misplaced evangelical morality surrounding Green Energy is likely to come back to haunt us with a vengeance.

The low carbon programme through which the various UK governments (of either hue) justify their virtual total inactivity is really not a programme at all. No political party has the courage to force through power generation projects (i.e., new power stations) and instead warble about the fantasy of vast offshore wind farms in the rather pathetic hope that “something will turn up”.

The only thing vast about low carbon-based ideas is their cost. We have seen wind technology projects across the globe and the startling thing about nearly all of them is how (for some reason never quite explained) they always seem to fail to achieve their projected power outputs.

The dwindling contribution of coal power is massively driven by the new religion’s ecological desire to be seen

T

20

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

to be cutting carbon emissions. This in turn means that the UK will be increasingly reliant on external supply sources. It is a recipe for entrenched energy inflation, which was one of the triggers for the UK’s woes through the 1960s and 1970s.

While the Bank of England’s monetary policy committee (MPC) claims to have, as its central ethos, a remit to keep inflation under wraps, we can see from its actions over the past two or three years that there are quite a few other items that are more important. The UK has a rather disquieting debt pile which is rapidly getting bigger. At the moment the Treasury is in a rather wonderful position of issuing debt in the two to ten-year period at rates varying from 1.5% to 3.5% while inflation is actually running at 5.5%. As we suspect that inflation is unlikely to fall substantially over the next year or so, we have the very unusual situation where, even if you actually just add interest payments into the debt pile, the total GDP/debt ratio will be lower next year than this!

To put it another way, all the pension funds busily investing investor money into gilts and/or short-term bonds know that it will be worth less, in real terms, in two years’

time than it is now! How’s that for a compelling investment argument? Of course we all hope that over a longer period the swings and roundabouts of the global economy will eventually move in favour of the fixed-income investor but this pre-supposes that we can rely on the various global central banks to actually fulfill their espoused fiscal duties. At the moment there is a whiff in the air of 1970’s-style debt reduction.

Added to this is the problem that the Bank of England has a number of other quite large issues with which it either has to deal with either directly or to contribute to finding a solution. Not least of these is the ongoing lack of growth in the UK economy and the never-ending train crash that appears to be the UK’s sovereign debt position.

The central point of all of this is that this will mean more issuance: that includes printing money and the attendant inflationary risk, higher bond yields and lower growth. None of which is particularly attractive to the equity markets. Actually this is not particularly attractive to any asset class, including cash.

Hold on to your hats and, as ever ladies and gentlemen, place your bets.I

J U LY / A U G U S T 2 0 1 1 • F T S E G L O B A L M A R K E T S

IN THE MARKETS

EQUITY SWAPS: AN ALTERNATIVE TO CASH

Taking stock of equity swaps Equity swaps have long been the darling of the hedge fund industry, providing managers with economic and strategic stock-ownership benefits without actually taking stock in the target company. As regulators move to tighten loopholes—and with alternatives increasingly utilising these vehicles to access fund structures that permit derivative-based synthetic ownership but not the actual shorting of stock—the near-term outlook remains quite positive for the swaps market.

From Boston, David Simons reports.

RENCH LUXURY GOODS manufacturer LVMH Moet Hennessy Louis Vuitton last autumn accumulated a 20% stake in apparel maker Hermes International SCA as part of an apparent takeover ploy—largely through the use of equity swaps. Likewise in the US, hedge fund Pershing Square Capital Management, in conjunction with real-estate firm Vornado Realty Trust, carved out a 27% chunk of retail giant JC Penney, financed in part through total return swaps (Pershing’s William Ackman and Vornado’s Steven Roth were not-so-coincidentally awarded board seats by JC Penney a short time later).

Equity swaps—aka total-return or synthetic-equity swaps in the US, contracts-for-difference (CFD) in the UK—have long been the darling of the hedge-fund industry, providing managers with the economic and strategic benefits of stock ownership without actually taking stock in the target company. Data shows equity swaps becoming more prominent as hedge funds increasingly turn to synthetic solutions as an alternative to cash.

With good reason: to date, the unfettered plundering of shares through equity swaps remains legal in the US and France, to the extent that accumulating firms observe proper disclosure protocol. In the US, investors with an economic interest in a company totaling in excess of 5% must disclose their provisions. However, there are loopholes aplenty, including the ability for investors to wait ten full days to disclose amounts above the 5% threshold, during which time they can literally shop to their heart’s content.

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Photograph © Oleksii Rudenko / Dreamstime.com, June 2011.

Adam Emmerich and William Savitt, partners at Wachtell, Lipton, Rosen & Katz, suggest that the LVMH and Pershing Square buying sprees were likely predicated on the belief that both US and French disclosure rules governing share accumulations “can be evaded through derivatives and other synthetic and structured ownership arrangements, even when they involve ownership of actual shares by counterparties, up until the point when such trades are settled by taking options on or physical delivery of the underlying shares”.

For the takeover targets of the acquiring parties, current law offers little protection.“Until lawmakers and securities regulators in the US adopt disclosure requirements in accord with what is now the global consensus toward full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques, US corporations are well advised to adopt such self-help measures as are available.”

Not surprisingly, the strategy has triggered alarms at a number of global regulatory agencies. Two years ago the UK’s Financial Services Authority (FSA)

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issued rulings over the use of CFDs, aimed at discouraging sudden and massive accumulations of undisclosed stakes in targeted UK-based firms. In February, the Dodd-Frank Wall Street Reform and Consumer Protection Act announced it would augment the Securities Exchange Act of 1934 with Section 13(o), stating that a person “shall be deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a securitybased swap”if it is determined that the purchase or sale of the security-based swap “provides incidents of ownership comparable to direct ownership of the equity security”.

Debt detonator Additionally, the US Securities and Exchange Commission (SEC) voted concurrently to propose rules defining swap execution facilities (SEFs) with the goal of promoting transparent security-based swaps activity within regulated trading environments.

While regulators move to tighten loopholes and set new guidelines, recent events highlighted the positive

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IN THE MARKETS

EQUITY SWAPS: AN ALTERNATIVE TO CASH

uses of equity swaps, including the ability to eradicate mountains of debt in one fell swoop.

In April, UK prepared food company Uniq finalised a plan to discharge some $770m in pension debt by having shareholders relinquish 90% of their stake in the company through equity swaps. The restructuring is the first time that a swaps-for-debt agreement has been used in connection with a defined benefits programme, and could lead to similar arrangements involving other companies encumbered by large unfunded liabilities.

Although swaps schemes may not be appropriate for dealing with all deficits, Philip Hertz, a partner with London-based legal firm Clifford Chance, says that in the case of Uniq “it offered the stakeholders an option, where otherwise there would have been no real alternative other than a liquidation of the company”.

With hedge funds increasingly utilising these vehicles to access fund structures that permit derivative-based synthetic ownership—and with oversight gradually working its way into the picture—the near-term outlook remains quite positive for the swaps market. In its report in association with the Royal Bank of Scotland The Alternative Emerging Market: Equity Swaps and Synthetic Prime, Boston-based TABB Group forecast a year-over-year compound growth rate of 22% for emerging-markets equity swaps trading through 2011, and 15% growth for developed-market equity swaps through the same period (the latter reaching an estimated $2.1trn in outstanding notional amounts).

Post-Lehman, clients are increasingly looking to diversify across multiple swaps counterparties, hence “regimes like UCITS III have been driving the need to use synthetic means of shorting,” argues Finian Bilocca, director, synthetic equity, Deutsche Bank, at a recent web conference hosted by Traiana, a New York-based provider of post-trade solutions.

Stuart Neale, synthetic equity product development, Barclays Capital, suggests

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William Ackman, Pershing. Photograph kindly supplied by Pershing Square Capital Management, June 2011.

Kevin McPartland, TABB Group analyst.

Photograph kindly supplied by TABB Group, June 2011.

that a rise in direct market access (DMA) has helped fuel equity swaps growth.

“Start-up hedge funds often want to avoid having a prime-brokerage style relationship. As such, financing positions synthetically using equity swaps has been one of the single-biggest drivers we’ve seen to date.” In Europe, trades have been increasingly executed outside of swaps providers, which has also had an impact, adds Neale.

From a vendor’s standpoint, Roy Saadon, co-founder of Traiana, says that the increase in the number of clearing or swap counterparties has magnified the emphasis on mitigating counterparty risk.“This requires an STP process that can address manual inefficiencies—settling for T+1 is not good enough. So as equity swaps flows increase and complexity sets in, automation becomes a much more compelling factor, making it easier to work through these markets.”

Opportunities abound for many other providers equipped to handle the expected surplus in swaps trading. Last month, Traiana announced that it would offer fully automated equity swaps clearing through global clearing agent LCH.Clearnet for members of Traiana Harmony, the world’s ranking CFD post-trade network. By direct clearing through LCH.Clearnet, Traiana’s roster of brokers, equity swap counterparties and buy side trading desks will be able to avoid risks associated with traditional bilateral broker-counterparty settling, while promoting further growth through process efficiencies.

Also joining the queue is clearinghouse Eurex, which is set to augment its Eurex OTC Clear service to support both equity and interest-rate swaps in

anticipation of new US/EU clearing regulations governing OTC products.

Among the products in the offing is a new portfolio-based risk methodology that will facilitate cross-margining between Eurex-listed derivatives and OTC equity and interest-rate swaps.

Responding to the increased demand, TABB believes that the number of broker/dealers handling swaps could possibly triple by year’s end. Along the way, traditional bulge-bracket firms will face stiff competition from new dealers sporting innovative methods and breaking technologies. These include niche players such as pure-synthetic prime brokerages capable of delivering hightouch solutions at a much lower cost.

Meanwhile, SEC-sanctioned swap execution facilities are expected to flourish, says Kevin McPartland, a TABB analyst, as the imposition of new regulations ensures that “everyone looks only to SEFs and exchanges for that same liquidity, kicking dealers off their current perch for all but the most unclearable of swaps”.

Not that it will be smooth sailing.

According to TABB’s Will Rhode, swaps users face a myriad of potential obstacles, including currency turbulence, insufficient technologies, and underdeveloped clearing and settlement platforms. New regulatory regimes bear watching as well. “Hedge funds are driven by a desire to understand risk in order to maximize return,”says Rhode.

“While equity swaps are proving to be a flavour of choice in this regard, they will need to tread carefully when it comes to managing the most unquantifiable and difficult to evaluate risk of all, that of regulation.” I

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Photograph © Petr Vaclavek / Dreamstime.com, supplied June 2011.

Options overhaul E LECTRONIC PLATFORMS NOT only facilitate high-frequency trading but also make it possible for the exchanges to extend their product offerings. For example, in August 2009, the CME Group introduced index options with expiration dates on the first and second Friday of every month to complement the conventional monthly cycle that expires on the third Friday. Those products proved so popular that in July 2010 it added contracts that expire on the fourth Friday of each month. The new contracts allow market participants to fine tune hedges and result in more trades with intraday duration that do not show up in open interest figures compiled at day’s end.

The off-cycle weekly expiration options now account for 15% of CME

Group equity index options trading volume, according to Tom Boggs, director of equity index products at CME Group.“People trade on a shorter duration with our weekly options,”he says.

“The products attract a new type of customer who can trade with more precision in timing. If they want to trade the unemployment number, they can use an option that expires on the day it is released.”Contracts introduced in 2006 that expire on the last business day of each month, which appeal to hedge funds and institutional investors, account for another 9% of index option trading volume.

The options exchanges have introduced new strike prices as well, creating $2.50 and $1.00 intervals in addition to the standard $5 increments for equities. The number of options

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TRADING OPTIONS: VOLUMES ON THE RISE

Forces that have revolutionised equity trading in the past ten years have now spilled over into the options arena. The ability to process orders and execute trades in milliseconds has attracted high-frequency trading shops and other players who add liquidity intraday but do not hold open positions overnight. Although options trading volume waxes and wanes with volatility, volume has increased relative to open interest in recent years as electronic trading has permeated the options market. Neil O’Hara reports. series traded has increased exponentially as a result, from about 100,000 to an estimated 350,000 series today— and there are now nine US options trading venues instead of four.

“Without technology it would not have been possible,” says Jeromee Johnson, head of BATS Options, a division of BATS Global Markets.“Market makers have to trade better and faster. It is a self-reinforcing relationship: volume begets more volume.”

Dividend-related trades have also boosted volume relative to open interest. Professional traders buy huge positions in high-dividend stocks just before the ex-dividend date and sell deep in the money call options as a hedge, knowing that a small but significant portion of investors who are long calls will not exercise early to pick up the dividend. The assignment process is random, which means the bigger the position, the more likely it is that some of the calls will not be exercised—so traders keep the dividend without taking any market risk.

The professional activity significantly reduces the likelihood that retail investors who hold covered calls will get the dividend on stock that is not called away. The strategy generates big volume but tends to reduce rather than increase open interest.“Dividend trades are a solid 5% of average daily volume this year,”says Boris Ilyevsky, managing director of the options market at International Securities Exchange (ISE).“It is a low margin trade but it happens almost every day.” ISE has published a white paper decrying the practice, arguing that it harms retail investors, distorts trading volume statistics and adds no value to the market.

The regulators have so far taken no action to curb dividend trades. The US Securities and Exchange Commission

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IN THE MARKETS

TRADING OPTIONS: VOLUMES ON THE RISE

(SEC) nevertheless facilitated the upheaval in the options market when it extended the trade-through protections in Regulation NMS to options two years ago. The agency also launched the Penny Pilot Program in 2007, which requires certain actively traded options to be quoted in smaller increments. The programme has expanded to cover more than 360 names, which account for an estimated 90% of options trading volume today.

Penny pricing While penny pricing has tightened spreads for retail investors, it has also squeezed margins for market makers and other liquidity providers. Ilyevsky says that less liquidity is displayed on the screen in active names such as options on the SPDR Standard & Poor’s 500 Index ETF or Microsoft.

Instead of showing 10,000 contracts on each side of a five cent spread, the market is typically 1,000 or fewer contracts—although the spread is only one or two cents. Ilyevsky says:“For a small player it’s the best thing since sliced bread, but if an institution wants a large position they are more likely to trade over the counter.” The new market structure may explain why institutional participation in the listed option markets is not growing as fast as it was a couple of years ago.

Institutions are the most active participants in the full size Standard & Poor’s 500 options contract thanks to its high notional value—$250 times the index, more than $300,000 today.

These options, still exclusive to CME Group, trade primarily through open outcry on the floor, while the companion e-mini contract, representing $50 times the index, trades only electronically. Although the bigger contract trades in lower volume—50,000 per day on average versus 150,000 for the emini—the higher contract value means that more than 60% of the aggregate notional amount in Standard & Poor’s 500 options still trades on the floor.

“We have a robust floor environment for institutional firms who trade mostly

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Boris Ilyevsky, managing director, options market, International Securities Exchange (ISE). “Dividend trades are a solid 5% of average daily volume this year. It is a low margin trade,” he says. Photograph kindly supplied by ISE, June 2011.

large spreads,” says Boggs. “Globex appeals to active retail investors, smaller institutions and market makers. It is a different investor segment by venue.”

Electronic trading is even more widespread in foreign exchange options.

Craig LeVeille, head of FX options at CME Group, says about 75% of volume now trades electronically, up from 63% just last year. The notion that trades like calendar and vertical spreads need to be executed on the floor is eroding as systems have become more flexible, allowing both investors and market makers to price complex strategies.“We have worked on that aspect of the market with our electronic trading platform, CME Globex,” says LeVeille.“We are seeing positive results, where even spreads are now being traded electronically, at least in FX.” The improved functionality has attracted new players, as market makers who used to trade only equity or index options have picked up FX options as well. They already have the

electronic infrastructure in place, so it isn’t hard to add another asset class— options characteristics are much the same, no matter what the underlying asset is. “That has helped the market grow as liquidity has grown,”says LeVeille. “We are trying to increase coverage to 23 hours per day. We are seeing good growth in European trading hours. The next step is to increase liquidity in Asian hours.”

Electronic trading has drawn new participants to the equity and index option markets, too. Paul Finnegan, a senior vice president at NYSE Euronext and co-chief executive officer of NYSE Arca, says firms that used to focus on futures have applied for permission to trade options on NYSE Arca and other options exchanges. CME Group’s licence to trade options on the Standard & Poor’s 500 Index does not extend to options on ETFs that track the index, which trade on multiple exchanges.

Russell and other index providers have also embraced multiple listings for options products, which typically result in higher trading volume and liquidity—an environment in which high-frequency trading firms thrive.

Although high-frequency trading of options is growing, it has not yet come close to the market share it commands in the cash equity markets. Finnegan estimates that high-frequency trading accounts for 10%-15% of options trading volume today, compared to about 35% of volume in US equities.

High-frequency traders gravitate toward the trading venue that has the lowest latency infrastructure and fastest execution, features on which NYSE Arca has built its reputation. The exchange also boasts a simple fee structure—no bandwidth charges or order cancellation fees, for example— does not permit flash orders and has no directed order programme.“Arca is one of the cleanest and simplest market centres out there,” says Finnegan. “We treat everyone the same and keep it transparent to everybody.”

The race to improve speed and lower latency never ends, however. In

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late June, ISE completed the roll out of its new options trading platform, Optimise™, based on technology developed in conjunction with its parent, Deutsche Börse. ISE’s legacy system was state of the art when it was first introduced ten years ago, but although the exchange kept tweaking the system, other venues eventually caught up. “It was time for us to make another leap forward,” says Ilyevsky. “On the new platform, latency is measured in microseconds rather than single digit milliseconds on the legacy system.”

The biggest increases in trading volume on ISE in the past year have been in commodity-related ETF options, including contracts on the SPDR Gold Shares fund, the iShares Silver Trust and some energy funds.

Trading in single stock names has lagged, in part because popular names like Apple and Google have high stock prices.“If these companies would split their stock—if Apple were $50 instead of $300—you would see options volume rise dramatically,”Ilyevsky says.

Switch to listed products To a limited extent, the exchanges have picked up market share relative to trading in over-the-counter (OTC) options in the aftermath of the financial crisis. Johnson of BATS Trading says some sophisticated players who were accustomed to trade OTC contracts have switched to listed products instead.

“People are worried about counterparty risk,”he says.“Now they are trading fully fungible contracts instead of facing off against Bear Stearns.”

Regulatory efforts to shift OTC derivatives from bilateral agreements into central clearing won’t necessarily give exchange trading another shot in the arm, however. For banks and other wholesale market participants, the most liquid options and other derivatives already trade on electronic platforms run by the interdealer brokers that operate central limit order books, just like an exchange.

In less liquid markets where traders

Craig LeVeille, head of FX options at CME Group. “We are trying to increase coverage to 23 hours per day. We are seeing good growth in European trading hours. The next step is to increase liquidity in Asian hours,”he says.

Photograph kindly supplied by CME, June 2011.

Matt Woodhams, head of eCommerce at GFI. “It focuses liquidity into concentrated periods of time. Buyers and sellers come out of the woodwork and trade if they want to,” he says. Photograph kindly supplied by GFI, June 2011.

don’t want to reveal their intent for fear the market will move against them, GFI and the other interdealer brokers have developed electronic auction markets that allow participants to join in whenever a trade takes place. If two participants put up a trade at the current price, they can increase the size of the trade, which is then opened up for a brief period at the same price to other potential buyers and sellers who are watching the market but have not displayed bids or offers. In the ensuing melee, the broker matches up as many orders as possible, giving priority to those who displayed liquidity on the screen. “It focuses liquidity into concentrated periods of time,”says Matt Woodhams, head of eCommerce at GFI. “Buyers and sellers come out of the woodwork and trade if they want to.”

This episodic trading model has taken off in a big way. A year ago, GFI was running perhaps ten matching sessions per day across its entire product range; today, it runs about 80 each day

in everything from options to freight, power, interest rates and credit derivatives—any market in which liquidity is too thin to support a central order book. “It is the sweet spot at the moment,” says Woodhams.

By definition, products that trade this way are unlikely to migrate to an exchange, where traders have to tip their hand—and in OTC markets that already have an electronic central order book the exchange model offers few advantages. ISE and the other options exchanges may enhance functionality in an attempt to draw liquidity to their platforms, but traders need a reason to switch. Ilyevsky says: “We hope there will be demand from institutions that may not otherwise trade listed products but it’s easier said than done to move OTC trading to an exchange.” ISE’s new platform may help, but its technical wizardry will more likely boost the firm’s market share among participants who already trade listed options—a pie set to grow along with electronic trading anyway. I

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IN THE MARKETS

EXCHANGE-TRADED FUNDS: BACKING IN THE US

Photograph © Kheng Ho Toh / Dreamstime.com, supplied June 2011.

Trillion dollar trading The US ETF industry boasted almost $1.1trn in assets under management at the end of May, an increase of 10.3% over the 2010 year-end figure. Investors continue to pour money into these vehicles, which offer tax-efficient access to a wide range of asset classes in an inexpensive and highly liquid format. All ETFs are not created equal, however. Large ETFs tend to trade in bigger volume than smaller funds, but some products attract disproportionate trading activity based on their appeal to different types of investor. Neil O’Hara looks at how the ETF sector is developing.

HILE THE ORIGINAL Standard & Poor’s 500 index tracker ETF, the SPDR Trust—now call the SPDR S&P 500 ETF—is both the largest US ETF ($89bn at May 31st this year) and the most actively traded ($21.7bn average daily volume), the next most active is the iShares Russell 2000 index tracker ($5.4bn average daily volume), which ranks only tenth in assets ($16.7bn).

The iShares Silver Trust took third place in May with $4bn in average daily volume but did not even make the top ten by assets. “ETFs are put under one big umbrella,” says Ben Fulton, head of global ETF business at Invesco PowerShares. “The reality is different products are created for institutions, the trading community and long-term investors.”

Products such as the broad-based

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equity index trackers appeal to every constituency, as do commodity funds, which are often the most convenient way for any investor to participate in those markets. Leveraged funds, which typically offer a multiple of the return on an underlying index, and inverse funds, which offer short exposure so that the net asset values zig when the market zags and vice versa, appeal primarily to active traders—and exhibit much higher trading volume relative to their asset base.

The differences show up even among products targeted at longerterm investors. Scott Ebner, global head of exchange-traded fund product development at State Street Global Advisors (SSgA), points out that an ETF that invests in long-term bonds may have a large asset base but typically has

low trading activity compared to equity sector funds.

By definition, sector rotation strategies, which try to beat returns on the overall market by cherry-picking the top performers will generate aboveaverage trading volume as investors switch from one sector to another. “It is important to have a broad family of liquid products so that investors can be in the sectors or industries they want,” says Ebner. SSgA has seen robust asset flows into its technology, real estate and healthcare ETFs this year—and high trading volumes as well. The firm had $241bn in US ETF assets on June 9th, including $56.8bn in 41 sector/industry products.

Fixed-income ETFs, introduced much later than equity products, are growing fast for all the leading ETF sponsors. In the past few months, Ebner says investors have snapped up more specialised fixed-income products, including ETFs that focus on convertibles, preferred stocks and high-yield bonds. The SPDR DB International Government Inflation-Protected Bond ETF has also seen strong inflows this year as investors have become more concerned about rising inflation—especially in the emerging markets—and potential weakness in the US dollar.

An ETF that taps into prevailing investor sentiment can turn into a home run. Vanguard’s ETF that tracks the MSCI Emerging Markets index, launched in March 2005, has grown to become the third largest US ETF with $48.7bn in assets amid persistent enthusiasm for an asset class that has in recent years outperformed the Standard & Poor’s 500 index by a country mile.

Yet it appeals to traders as well as long-term investors, ranking tenth in trading volume in May. Like other Vanguard ETFs, the emerging markets tracker is a share class of a larger mutual fund with a longer track record, a structure unique in the US. The firm’s reputation for providing low-cost investment products makes ETFs a natural extension of its core business; it is now the third-largest sponsor, with

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$177bn in ETF assets. “We offer both ETFs and index funds. Investors can choose the one that best suits their needs,” says Joel Dickson, head of the active quantitative equity department at Vanguard. “Some people want the ETF for the convenience of flexible trading, certainty, and at times lower cost.

Others prefer a mutual fund for regular investment programmes, automated withdrawals and automatic dividend reinvestment, features that are either expensive or not available in an ETF.” Vanguard’s product development efforts focus on investment concepts not already represented in ETF form for which it perceives latent demand among investors. For example, in April 2009, Vanguard launched an ETF that tracks the FTSE All-World ex-US SmallCap Index, which now has $1.3bn in assets. “It filled a gap for people who wanted to have a broadly diversified, developed and emerging markets small-cap portfolio,”says Dickson. Early indications are also encouraging for the Vanguard Total International Stock Index ETF launched in late January 2011, a one-stop shop for investors seeking non-US exposure to large and small capitalisation stocks in both developed and emerging markets.

The draw of Vanguard The Vanguard name is a big draw even for a “me-too” product. The firm last autumn launched an ETF share class of its $100bn mutual fund that tracks the Standard & Poor’s 500 and has seen strong inflows even though market leaders State Street and iShares have identical products. For financial advisers who already use Vanguard funds to implement their investment strategies, it is a more convenient alternative—and Dickson sees ETF distribution through that channel still at an early stage.

Financial advisers at both wire houses and independent brokers are the core customer base for First Trust, a relatively new entrant in the ETF market whose asset base grew fourfold in just 17 months to $8bn at the end of May, making it the tenth largest US ETF

sponsor. Eric Anderson, an ETF analyst at First Trust, says the firm offers products that occupy a middle ground between conventional index trackers and activelymanaged ETFs. Thirty of the 59 First Trust ETFs track customised indices that modify market capitalisation weightings by applying fundamental analysis.

For example, the First Trust Large Cap Core AlphaDEX fund tracks the Standard & Poor’s 500 Index—with a twist. The index constituents are ranked by measures including price momentum, sales growth, return on assets, price to cash flow and price to book value; the names are then selectively incorporated into the custom index, which is rebalanced every quarter. “We do not own all 500 stocks and we don’t hold them in their market cap proportions,” says Anderson.“The stocks that look worst we don’t even hold. The ones that look best we have a slight overweight position.”

The methodology has worked well over the past two years, performance that has caught the attention of financial advisers. A quantitative approach that deviates from market capitalisation weightings in a repeatable, risk-controlled manner appeals to people who justify their fees in part through robust performance. Anderson says: “Relative to benchmarks, AlphaDEX ETFs deviate much less than a typical active manager, but these products have a strong historical track record of beating their benchmarks in a tax-efficient vehicle, one of the chief benefits of the structure.”

Despite the capital constraints affecting the securities houses that act as designated market makers and authorised participants (who exchange baskets of ETF assets and shares in the funds to keep the market price tied to net asset value), First Trust has not encountered any difficulties in recruiting backers for its funds. ETF sponsors expect market makers to put up seed capital for a new fund, which firms are reluctant to do unless they get their money back quickly. A sponsor with a track record of successful fund raising in

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its ETFs will find it easier to sign up market makers for a new product.“It is a symbiotic relationship,” says Anderson. “If you can sell your product, the market maker is happy. It is hedged business, which they like, even if they only make a fraction of a cent per share.”

Sponsors such as Invesco PowerShares ($65bn in ETF assets) have little trouble finding authorised participants, although Fulton admits the firm now staggers launches to avoid tapping out market maker capacity. An innovator in ETF design from its earliest days, PowerShares also markets a series of leveraged and inverse exchange-traded note (ETN) products managed by Deutsche Bank. The ETN structure eliminates tracking error in exchange for credit risk on the note counterparty, in this case Deutsche Bank.

Tracking error Tracking error is a notorious, if mischaracterised problem for some leveraged and inverse ETFs that rebalance daily. These funds track perfectly well day-by-day but are not designed to do so over an extended period. The DB PowerShares products rebalance monthly, which attracts investors looking for directional moves over a somewhat longer time frame. The products are still trading chips, however, and have high trading volume relative to their asset base.“So many problems are removed if the product is designed the right way in the beginning,”says Fulton.

“Product structure is the key to success in the long run.” PowerShares sells a suite of futures-based commodity exchange-traded notes managed by Deutsche Bank, too. As an asset class, commodities attract more traders than long-term investors, even though modern asset allocation models often incorporate commodities because the returns exhibit low or negative correlation to other asset classes under most market conditions. Says Fulton: “We have a base of investors who hold commodities as core assets, but a portion of commodity investors are more speculative. Volumes have been very strong.” I

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FX VIEWPOINT

THE CHANGING FACE OF HIGH-FREQUENCY TRADING

Time to upgrade to HFT version two

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

This column last month debated the question of whether banks can come to terms with the HFT dynamic in the FX market. Erik Lehtis, president of DynamicFX Consulting, argued that to be successful they will have to, and the most successful banks in FX have already done so. In this issue, that debate is turned on its head and the changing role of the high-frequency trading (HFT) community is highlighted.

UCH HAS CHANGED since the early days of HFT trading in FX. I launched a HFT desk for Allston Trading back in late 2004, right after EBS exposed its API [application programming interface], and it was a lot of fun being one of the first firms into the space. Learning our way around the electronic domain was a challenge, but there was no denying the trading opportunities, and we soon became one of the big market makers in FX. In a very real way, banks became our customers, and we interacted with them on EBS and Reuters.

Other firms entered the market, and while many took advantage of latencyriddled bank price feeds, we never pursued that trade. FX has always been a relationship-based market and it is vital to maintain a sustainable business model. However, the backlash against the HFT space was one felt to some degree by all members regardless of their trading style.

Other dynamics have influenced market conditions adversely for the HFT community: the arms race of low-latency has become hugely expensive, not only with respect to the continual need to invest in the latest servers and high-priced switches, but also with other hardware upgrades such as high-end NICs, nanosecondaccurate, time-stamping technology, FPGAs, and the like.

However, the mother of all money pits for the low-latency crowd are the

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network circuits themselves. In particular, the New York-Chicago segment that is essential to cashfutures arbitrage. Thanks to an investment in the hundreds of millions of dollars, Spread Networks now offers a dark fibre service that is almost a three milliseconds faster round trip than anything else, since they have created a direct route across the Amish farmlands and Pennsyltucky mountains that lie between the two centres; existing circuits run along highways and rail lines that take a more circuitous route.

Access to this service comes at a price, of course. It is a very high one that only a few firms can justify.

Consequently, the HFT world has become divided into two groups: those players without a structural speed disadvantage, and those with. The first group can continue to compete among themselves in the cash-futures arb speed game, which means they will have to continue to invest in the other aspects of the arms race while at the same time presumably leveraging some manner of intellectual capital.

The second group, however, now faces an important question. How do they intend to compete in a space wherein they face a structural speed disadvantage to a cadre of highly sophisticated players? One can always look for inefficiencies elsewhere in the execution chain, and there are certainly speed gains

available to the clever software engineer, but two to three milliseconds is an eternity in the arbitrage game.

Is this class of HFT participant now irrelevant to the FX game?

I say no. True, there are certain arbitrage strategies that will not be effective trading on large volumes, but those kinds of approaches by themselves were never really sustainable anyway. Even the firms that are on Spread will learn that speed alone is not sufficient, and that a clever approach is essential to success, even for the arb.

Ultimately, one must have an appetite for some form of short-term directional risk. This is what trading is all about. One must still become proficient at market microstructure analysis, and diligently search for and eliminate bottlenecks in the execution framework. Even so, accepting that there will always be someone bigger and faster than yourself, you can set yourself free to explore the possibilities outside of the realm of pure arbitrage.

In FX, that realm has many nooks and crannies worth exploring. By combining old-fashioned fundamental and technical analysis with the latest HFT techniques, the diligent trader can construct an entire portfolio of strategies that can exploit inefficiencies and opportunities across a wide range of intraday market dynamics, and deliver consistent returns. These returns will depend on the ability of enterprising traders to leverage their intellectual property (not their networking budget) and will reward them for building bridges into the banking community, not burning them. HFT version two is here. Version one is rapidly proving obsolete. Are you ready to upgrade?I

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SECTOR REPORT

ASIA BOOSTS THE HIGH-PERFORMANCE CAR MARKET

Photograph © Alexei Sviridov / Dreamstime.com, supplied June 2011.

Super models drive the luxury motor mart Austerity might be hitting some people hard in Europe and the US, but globally the luxury car market is booming, with more and flashier vehicles gliding gracefully off the production lines.

Moreover, it is one of the few sectors in which the old West is running a positive balance of trade with the new world BRICs and emerging markets. The secret is the mystique of the marque. Ian Williams reports from New York on a burgeoning business line.

T THE NEW York Auto Show in April, Jaguar held a parade of its vintage models to celebrate the 50th anniversary of the E-Type and to mark the US launch of the XKR-S. Its sister company Land Rover launched the fuel-efficient Range Rover Evoque at $45,000 along with its most expensive and exclusive Range Rover Autobiography Ultimate Edition, whose 500 models cost $170,000 each.

The people who are rushing to buy the Rovers, Jaguars, BMWs, Audis, Rolls-Royces, Bentleys and the rest of the luxury brands are not just buying a means of transport. They are buying the insignia on the bonnet as much as the engine beneath. The Jaguar XKR-S can do 186mph but while its owners

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will rarely have that opportunity, it is the public knowledge of that potential that titillates the buyers.

The harbinger of things to come is that after the UK and US, Jaguar and Rover’s biggest market is China. The launch of the new models is almost a paradigm for the global market, its possibilities and also its dead ends. Rover and Jaguar epitomise the modern world of luxury cars. They are iconic British and European marques, owned by an emerging market company (the Indian conglomerate Tata), using the US as a launch platform to target sales in China and other emerging markets.

Land Rover executive vice president of marketing and sales, Christopher Marchand, returned to the company

from Rolls-Royce, and Wayne York Kung of Jaguar sang in tandem: “In real numbers the Chinese market could potentially surpass the United States but the US market still sets the stage for luxury brands. Our perception is that to be a successful luxury brand in China, you have to be successful in the US.” It is also true in the rest of the BRICs where, for example, Land Rover in March posted record sales in Russia and India while Jaguar posted record sales in China and Russia. In this sector, corporate ownership brands and successful marques are often best kept segregated. How many of those rushing to buy the new Jags and Range Rovers in the UK, US and China know that they are owned by India’s Tata?

If Tata had designed and made Rovers and Jaguars in India, and sold them globally under its own name, it might have cast doubt in some minds over their marketability. It would certainly not benefit from association with the Nano, Tata’s main auto brand and the world’s cheapest car. Auto analyst Jack W Plunkett, of Plunkett Research, suggests: “If customers are aware that Tata owns Rover and Jaguar, they are certainly willing to overlook it and to think very highly of the brands themselves.”

The investments by Ford, BMW and

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now Tata in the luxury range are starting to look as though they will pay off.

“In 2009 we took a hit and sold just over 26K, but last year it reached 31K, and this year, the new models’ reception has been incredible,” says Marchand.

“We are comfortable looking forward to 2011 and that our business is going to take off.”

While Tata definitely picked up low hanging fruit with the two luxury brands during the crisis when western companies had their fire sales of “none-core” assets, it has built on its investment. Marchand explains: “They have given us the level of investment that meets our needs; substantial amounts in the last few years. They definitely have a longterm plan with us. We look at them and the 40 major product actions over five years is unlike anything we’ve ever had in our company’s history, whether we were owned by BMW or Ford Motor Company [sic]. They are really stepping up their investment in these brands.”

So who is buying these prestige vehicles? To begin with, high-end car sales in the US are rising quickly, despite the fallout of what Plunkett calls “aspirational buyers”. The US is now the biggest market for the Range Rover, and Plunkett reports: “It may have become the ultimate buy for guys in the US, if you are an over-45, testosterone-driven male. It has a certain amount of panache.”

Like Columbus, Europeans see America as en route to China, which is now the world’s biggest auto market and possibly also the biggest producer, seemingly poised to do to western mass-market auto-makers what it did to other consumer industries.

China’s potential volume of car production might be a huge cloud on the horizon for western car manufacturers, but ironically its insatiable demand for Audis, BMWs, Ferraris, Lamborghinis, Jaguars and Range Rovers is sustaining the profitability of the western auto industries.

Plunkett points out that “Audi

Jack W Plunkett, of Plunkett Research. “The global market for luxury car expansion is in the BRICs and developing markets, where the boom will continue for a while. When people there do well, the first thing they want is a luxury car to show people how well they are doing so there are vast numbers of luxury cars in Shanghai and Rio,” he says.

Photograph kindly supplied by Plunkett Research, June 2011.

already expects China to be its single biggest market. Their cars and their ads are everywhere, they are very conspicuous”. He adds: “BMW’s Chinese sales also went up 80% over the past year and all the luxury marques of Europe are racing to Shanghai and Beijing. These are not loss-making ventures carried out for prestige. These flagships bring home the loot.”

According to Plunkett: “The global market for luxury car expansion is in the BRICs and developing markets, where the boom will continue for a while. When people there do well, the first thing they want is a luxury car to show people how well they are doing so there are vast numbers of luxury cars in Shanghai and Rio. These are niche markets, since the cars are expensive to buy and run so the market is limited in that sense, but those numbers are growing in the emerging markets.”

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The West actually has an intangible but real comparative advantage in this sector. Europe in particular has the more than half century lead it takes to accrete the patina of a serious luxury brand. Despite the seismic shifts in the global economic centre of gravity, the twin characteristics for a luxury brand in the BRICs are design and manufacture in Europe and big demand and appreciation in the US. Plunkett says: “The Chinese would be very challenged to sell a luxury car, mostly because there would be no perception of it as such among global consumers, and even at home Chinese buyers want brands with a global reputation.”

BMW, probably the world’s most successful upmarket car company, generally allows its marque and brand to be coterminous, and, according to corporate branding consultant, Jim Gregory, “had the highest brand power ranking for the auto industry in our database”. He adds: “Its products have very consistently high engineering and are very well liked vehicles, renowned for their quality.” Indeed, this spring BMW beat Lexus in the US for top spot in high-end cars with a 19.6% increase in sales in April.

However, even BMW is careful to let its Rolls-Royce marque cruise alone under the silver lady, just as, even more wisely, Volkswagen does not let its VW Beetle folk memories crawl over its Bentleys. VW’s disastrous attempt at an own-brand upmarket car at $80,000 soon sent it back to its Audi marque for that market segment. Similarly, Fiat would certainly lose revenue if it sold Alfa Romeos and Ferraris under its own name, let alone that of Chrysler.

So the entry into this market would have to be through purchase of existing marques, but Tata’s astute purchase of Ford’s and BMW’s inopportune castoffs has probably lost Chinese companies the most obvious opportunity, unless Fiat is forced into a fire sale of Maserati and Alfa Romeo or other icons such as Ferrari and Aston Martin come up for sale. I

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DEBT REPORT

GLOBAL BOND INVESTING: TESTING CONFIDENCE

Photograph © Christos Georghiou / Dreamstime.com, supplied June 2011.

Postponing the day of reckoning The headlong rush of global bond investors in the first half of 2011 into corporate credit, investment-grade, high-yield and covered bonds has so far proved resilient to shocks that might well have been expected to undermine it, most notably the political upheavals in the Middle East and the combination of natural and nuclear catastrophes in Japan. Even so, macroeconomic considerations threaten to subject the market’s confidence to sterner tests in the second half of the year.

Andrew Cavenagh reports.

OR A WHILE the bond markets, at least at the start of the year, were very much focused on inflation risk and economic recovery—as yields on “core” government bonds were low or negative. Investors piled predictably into the corporate sector in search of yield.

Since late April, however, the overriding concern has been the fragility of the global economic recovery. Not only has weaker-than-expected economic data been emerging out of the United States and most of Europe in recent weeks, but also China, the world’s great growth engine, is now beginning to rein back its growth expectations for the year.

Growth in US manufacturing output in May recorded its steepest one-month decline since 1984, as the Institute of Supply Management’s Purchasing Managers Index fell from 60.4 to 53.5 in April. There was a similar trend across the eurozone, where the Markit PMI came down from 58 to 54.6 as levels of

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production dropped in Greece and Spain, and slowed sharply in Ireland and Italy. Meanwhile, the Bank of China announced on June 14th that it would raise the reserves requirement ratio of the country’s largest banks to 21.5%; their highest-ever level.

If these trends persist through July, they will fuel the mounting fears that the recovery could begin grind to halt, against the background of an environment in which both governments and consumers in the western economies still face years of de-leveraging (and are unlikely to generate great demand).

Investors may well then decide that current credit-risk premiums for corporate credit are way too low, and the spectacular flow of funds into the sector so far this year could rapidly reverse.

“We are in a very different position now from January,” explains Mark Nash, senior portfolio manager at Invesco Asset Management in London.

“People really do not think inflation is the main problem right now. Worries over the recovery have really taken over, and we do predict that over the next six months the credit rally will come under pressure.”

The unresolved problem of sovereign debt in the peripheral eurozone countries could, of course, precipitate an investor flight to safety a lot sooner than that. The worsening problems in Greece brought the festering crisis to a head once again in the run-up to July. At this point, the Greek government will need to draw down a further €12bn of the €110bn EU/IMF rescue package agreed last year if it is not to run out of money.

In mid-June, the country’s internal political crisis began to deepen, as prime minister George Papandreou struggled to establish discipline within his own party a day after failing to secure a unity government amid a national uproar over unpopular austerity measures and the defections of two more lawmakers.

Papandreou was expected to cobble together a new ruling cabinet to help refocus the party and the country on much-needed austerity measures; though it is not thought likely that he will be forced into announcing elections any time soon.

Other EU member states, some themselves cash-strapped, are looking on in dismay. It has become evident that Greece cannot possibly avoid default without further large-scale support from other European Union (EU) member states. Following the drastic spending cuts imposed in line with the conditions of the initial EU/IMF package, the country’s GDP crashed by 5.5% in the first quarter of 2011 and this has created a €30bn shortfall in its 2012 budget. Measures to address this will need to be in place before Greece can draw the next instalment of the existing support facility. To make matters worse, Standard & Poor’s on June 13th dropped its sovereign credit rating for Greece to triple-C—the ratings agency’s lowest sovereign rating in the world. The announcement sent the yield on ten-year Greek bonds to a

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record high of 17.175%. As riots in protest against the austerity measures imposed last year paralysed Athens and the beleaguered administration tried unsuccessfully to form a new government of national unity, the chance of any democratically electable (and removable) government being able to force through additional spending cuts and tax increases in the country appeared to be zero.

In terms of the EU, a further substantial package of assistance, which is reckoned will have to be worth around €90bn including asset disposals, needs to be put in place urgently. However, there remain fundamental disagreements between EU politicians (particularly German ministers whose taxpayers will ultimately have to bankroll any settlement) and the European Central Bank on how to structure the additional aid to enable Greece to survive without defaulting on its debt.

The United Kingdom is also reluctant to provide additional funds, particularly as Portugal and other states hardly look to have their roaring deficits anywhere near under control.

Equally, however, the doomsday scenario, should it come to pass, is distinctly unpalatable. If Greece were to default, the European Central Bank (ECB) could no longer accept the country’s sovereign debt as collateral for its repo financing programmes and the Greek banking system would go bankrupt overnight. The country would then have to hastily re-introduce its own heavily-devalued currency, and those holding its euro-denominated debt would face massive writedowns.

Avoiding contagion To avert this outcome and, at the same time, ensure European taxpayers do not meet the entire cost of Greece’s profligacy, the German government, supported by its Dutch, Austrian, and Finnish counterparts, is pushing a proposal under which holders of outstanding Greek debt would agree to extend the maturity on their bonds by up to seven years. Crucial to the

Mark Nash, senior portfolio manager at Invesco Asset Management. Photograph kindly supplied by Invesco, June 2011.

plan is that private-sector bondholders (primarily banks) would agree to the restructuring on a purely voluntary basis. The distinction is important: as it would theoretically enable the move to avoid the potentially fatal description of constituting an event of default.

However, both the ECB and the rating agencies have cast doubt on whether “voluntary” agreement would actually be possible in these circumstances.

While everyone is once again focusing on Athens, it is not a Greek default in isolation that is the real concern.

Assuming the country’s present levels of disclosure are correct, large haircuts on Greek sovereign debt should not cause serious problems even for those banks (apart from Greek and Cypriot institutions) that are most exposed to the country. These include Credit Agricole, Société Générale, Dexia and Banco Comercial Portuguese (BCP). It is the risk of the default contagion spreading to other beleaguered peripheral eurozone countries, particularly large economies such as Spain or Italy, which is too great for the politicians to countenance. That would certainly precipitate a secondary (and possibly worse) European banking crisis and undoubtedly spell the end of the euro in its current form.

“The main threat would be possible contagion, especially if this led to debt restructuring in much bigger economies such as Spain,” confirms Simon Adamson, senior European

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financial services analyst at the international research firm CreditSights.

The magnitude of this threat has persuaded the financial markets so far in 2011 that the EU authorities will ultimately devise some way of keeping Greece solvent though to 2013, when the present bailout programme for the country expires. While that sentiment was still just about holding good in midJune, the failure of EU politicians and the ECB to agree a solution just a week ahead of their self-imposed deadline for doing so (June 24th) clearly heightened the risk of the type of shock announcement or development that would send bond investors running for cover into the sovereign debt of core countries to the immediate and dramatic detriment of corporate credit. The high-yield sector would most likely be the worst affected, and would signal something of a turnaround, as it has been so buoyant on both sides of the Atlantic over the first half of 2011.

“Were there to be a further unexpected sovereign crisis, I think there would be a significant degree of risk aversion and that would certainly place the high-yield market under pressure,” confirmed Kevin Anderson, global chief investment officer for fixed income and currency at State Street Global Advisors (SSgA). “I think the focus of fixed-income investors in the months ahead is going to be on politics rather than credit.”

The current priority of the European politicians, as evidenced in the German proposals for Greece—to postpone for as long as they possibly can the day of reckoning when someone has to pay the price for the unsustainable levels of sovereign borrowing in the eurozone— is adding to the uncertainty.

Despite hints in early June of an emerging deal for a new €105bn rescue, European ministers failed to clear the main obstacle to a settlement, namely persuading private investors to chip in one third of the bailout. The International Monetary Fund (IMF) also warned it will not readily provide its share of a €12bn tranche of last year’s €110bn

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GLOBAL BOND INVESTING: TESTING CONFIDENCE

bailout without new money from partners. In a nutshell, Germany and the ECB disagree over how much to ask banks, pension funds and insurers to stump up by way of a rollover or any more radical restructuring of Greece’s €350bn debt.

“I think the market’s uncomfortable with the lack of firm decision-making at the present time,” said Anderson at State Street.“There is going to have to be some pain felt by investors somewhere. Attempts to fudge the issue will increase the risk of contagion.”

At the insistence of Germany, the EU earlier this year rejected a proposal for the European Financial Stability Fund to lend Greece ten-year debt at an interest rate of around 5% to allow the country to buy back its bonds at the substantial discount of prevailing market price (at a face value of between 50% and 60% of par). This would have potentially reduced the total outstanding Greek sovereign debt to a serviceable level, but would obviously have crystallised provisions into writeoffs at institutions that sold the

heavily-discounted bonds. The concern clearly was again that if other peripheral states—particularly Spain—had then demanded the same terms, the losses sustained by German, French and other banks could have sparked a secondary financial crisis.

The present“rescheduling”or “re-profiling” proposals, by contrast, all rely on the premise that GDP growth will ultimately enable Greece to manage and reduce its indebtedness. That position is looking increasingly untenable as more evidence emerges of the detrimental impact of the austerity measures on the country’s GDP and the frailty of the global economic recovery. Certainly this argument is fast losing any conviction it may have had with investors “None of these measures addresses the issue of the country’s solvency,” explains Nash at Invesco Asset Management. “No other country has got out of this situation without devaluing its currency, and that is not an option as long as Greece remains in the euro.”With the lack of any clear resolution of the eurozone’s sovereign problems allied to the

downturn in the economic data coming out of the US, Europe and Asia, Nash says he expects in consequence the fixed-income markets to retreat to established safe havens over the next six to 12 months.“I do see core government bonds doing well over the next six months.”

He adds that on the sovereign side Invesco has long been out of Greek, Portuguese and Irish debt and is currently short on Spanish and Italian bonds. The firm has also moved from being overweight in corporate bonds to a neutral-to-short position over the past six weeks for two reasons: the worsening macro situation and end of central-bank asset purchases (under QE2) that has driven up the price of such risk assets. “A deteriorating economy will likely spark credit concerns and increase the default risk priced into the market,” he said.

“Clearly non-financial corporates are safer than financials, given their stronger balance sheets, and opportunities will no doubt arise over the next six months to buy corporate bonds at better levels than their current ones.”I

WHY ING IS A RISING FORCE IN EURO CORPORATE BONDS ECOVERING DUTCH BANK ING is currently among the top five bookrunners for eurodenominated investment-grade corporate bonds in 2011, having taken at least a joint role on 15 deals over the first five months of this year.

The bank’s position in the rankings so far in 2011 represents a dramatic improvement over its record for the five preceding years—when its highest position in the annual tables was 14th in 2009.

Its current achievement comes just 18 months after the ING Group reached an agreement with the EU authorities to shrink its balance sheet by 45% and refocus on Europe, in return for the €10bn state aid it needed to survive the financial crisis at the end of 2008. ING Commercial Banking has also acted

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as joint bookrunner on three highyield deals in the eurozone this year. This has brought it into the top ten table of banks acting on all international euro-denominated corporate bonds. It is the only Dutch institution to make it into the top ten of either table.

The investment-grade issuers for which the business banking division of ING has acted as bookrunner came from different countries and industry sectors across Europe.

They also covered companies with credit ratings that ranged from triple-B minus to strong single A. Following the agreement with the European Commission in October 2009—which required what had been the ninth ranked company in the Forbes Global 2000 listing only the year before to reduce the size

of its balance sheet by €600bn— chief executive Jan Hommen told the markets that in future the bank’s activities would be “predominantly focused on Europe with selective growth options elsewhere”.

The enforced disposals that the group is required to complete by 2013 include the sale of its US online banking subsidiary ING Direct USA—which it announced on June 16th it would sell to Capital One Financial in a cash-and-shares deal worth $9bn—and its worldwide insurance business. On top of the disposals, ING also had to repay €1.3bn to the Dutch government, after the commission determined that the scheme the latter set up to acquire the rights to 80% of the bank’s illiquid RMBS assets had valued the bonds too generously.

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BONDS: BRAZILIAN FIRMS RAISE FUNDS OVERSEAS IN LARGER NUMBERS

Brazilian firms ignore government efforts to stymie overseas bonds In May, OGX Petroleo e Gas Participacoes SA raised $2.56bn through an overseas bond issue, managed by JP Morgan, HSBC, Credit Suisse and Bank Itaú, helping keep Brazilian corporate bond issuance at an all-time high, as Brazilian issuers remain keen to tap into the lower interest rates available in foreign jurisdictions. The Brazilian government has tried to clamp down on local firms tapping external credit; however corporate bond issuance volumes out of Brazil continue to outstrip even last year’s record breaking run, worth $40bn. Rodrigo Amaral reports.

CCORDING TO AN official release by data provider Dealogic, Brazilian offshore corporate bond issuance between January 1st and April 26th this year rose to $18.8bn (comprising 35 deals) compared with the $15.5bn raised in more or less the same period in 2010. It seems that the cost of borrowing in dollars is so low, compared to local interest rates, that it has encouraged Brazilian firms to borrow offshore. The country’s benchmark interest rate currently stands at 12.25%.

Eduardo Borges, head of domestic and international credit at Banco Santander in Brazil, comments: “Brazilian companies are eager to tap international bond markets, which offer them attractive costs and especially, longer maturity periods. Markets remain open, companies are still looking at international investors to raise capital, and, most importantly, investors continue to be extremely interested in buying Brazilian risk. Brazilian blue chips, [such as] Vale, Petrobras and Gerdau, have been raising money abroad for some time already. But we have noticed in the past year or so that firms and financial groups that don’t enjoy investment grade status are accessing the markets too.”

Then in May, overseas bonds issued

by Brazilian companies rose by a further 19.25%, reported Dow Jones.

Overseas debt issues totalled $6.92bn.

While the first-quarter results were boosted by Petrobras’ jumbo $6bn issue in late January, the underlying

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trend shows no sign of abating. The trend remains of concern to the government and the central bank in particular, which continues to raise the country’s benchmark interest rate (or Selic) by incremental quarter of one per cent increases as it tries to combat inflation, estimated at 6.55% and rising. The central bank wants inflation down at a more manageable 4.5% by the end of 2011.

At the same time the central bank wants GDP growth above 4%. It is a tough balancing act. Other palliative measures, including an increase in taxes on offshore borrowings (the socalled IOF tax) which mature in less than year, have variously been introduced through the first half of this year to help curb dollar inflows and the continuing appreciation of the real (BRL) against the dollar. The real has gained 45% against the dollar over the past two years. Issues with longer maturities do not pay the IOF tax. Local companies had been paying an IOF tax of 5.38% for debt issues due in up to 90 days; but this was increased earlier this year to 6% and the tax was extended to cover loans of up to two years maturity; thereby encouraging issuers to source funds on longer terms.

Brazilian companies have been able to place bonds in the market with maturation periods that they could only dream about a few years ago, when Brazil’s then chaotic economy closed off access to international markets for most of them. A $1bn tranche of Petrobras’ $6bn bond issue

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in January has a tenor of 30 years.

Other firms have made successful issues of 20-year bonds, while tenyear bonds are now very much a run-of-the-mill affair for non-financial entities. Extended maturities are a direct consequence of the growing maturity of the BRIC economies and their image as a safe haven among investors. Brazil now enjoys investment grade status and perceptions of country risk have fallen accordingly.

“Many of the companies that have access to foreign funding have a considerable share of their revenues in dollars, are very active in export markets and maintain significant operations in other countries,” Borges says. The likes of Petrobras, Vale and Gerdau, of course, are large Brazilian multinationals with lots of operations abroad and who are well known by international investors.

Even so, Borges points out those smaller and less famous firms, with less enticing credit ratings, have also taken the international road to raising money. For example, in January, Energisa, a midsized energy company, raised $200m of perpetual notes (rated Ba2 by Moody’s and BB- by Fitch) sold in Luxembourg.

Meanwhile Hypermarcas, a consumer goods group, raised $750m in ten-year bonds in April (rated Ba2 by Moody’s, BB

by Fitch and BB- by Standard & Poor’s).

The issue was 12 times oversubscribed, according to the firm.

How different the fund-raising profile of Brazilians issuers is now, compared to a decade ago. In 2002, the election of left wing president Lula da

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BONDS: BRAZILIAN FIRMS RAISE FUNDS OVERSEAS IN LARGER NUMBERS

Silva spooked both the markets and investors. Country risk, measured by the JP Morgan EMBI+ index reached a whopping 14.46 points. Almost ten years on, the number has fallen to less than two points. Equally, Petrobras, which was one of the few Brazilian companies that could realistically raise money abroad back in 2002, had to offer a full range of guarantees, including political risk insurance, to raise a few hundred million dollars. A large credit operation painfully engineered

by BBVA, the Spanish bank, for Petrobras in 2002 raised a mere $400m, paying a 4.85 basis points (bps) premium. This year’s $6bn issue was accompanied by no guarantees, and the company offered only a 2.2bps premium to attract more than $15bn in offers for its bonds, $1bn of which have a 30-year maturity.

Even so, the interim has not been plain sailing. In 2008, some local companies suffered substantial financial losses when dollar-denominated debt escalated because of a rapid depreciation of the Brazilian real against the dollar.

However, since 2009 the Brazilian currency has been steadily appreciating. To international investors, however, the appeal of Brazilian corporate bonds remains strong and it is easy to grasp when one considers the returns offered by the companies. Hypermarcas’ bond will pay a 6.5% annual rate, and Energisa offered a 9.5% annual rate for its perpetual bonds.

Overseas expansion Many firms are raising money to expand international operations. More likely, most are taking advantage of lower dollar interest rates to help ease individual company debt burdens. In a statement released to coincide with its bond issue, Hypermarcas’ chief financial officer, Martim Prado Mattos specifically remarked that funds raised: “will be used mainly in the amortization of some of the company’s debts.” Moreover, the facility will allow the company to restructure its debt maturity profile from an average 2.5 years to 4.1 years, and to

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Eduardo Borges, head of domestic and international credit at Banco Santander in Brazil. Photograph kindly supplied by Banco Santander, June 2011.

bring down the net interest rates that Hypermarcas pays on its debt.

Firms in retail and consumer goods sectors, and banks, will likely dominate the new issuance calendar for the remainder of this year. In 2010, Brazilian financial firms raised $18.5bn abroad (although this number also includes syndicated loans), according to Valor Econômico, a Brazilian newspaper. The number represents a 300% increase over 2009, and almost doubled the previous record of $9.3bn posted in 2003.

Even so, mid-sized banks have recently reported that conditions have been hardening up a bit in recent months. That did not stop Banco Votorantim, the financial arm of the eponymous mining and construction group, approaching the international capital markets for some $1.3bn, a large amount for Brazilian standards, earlier this year. Another group company, Votorantim Cimentos SA, raised $750m from an overseas bonds issue due in 2041, in April say local paper reports.

The company will pay an annual yield of 7.3%. The issue was rated at “Baa3”

by Moody’s Investors Service and at “BBB-” by Fitch Ratings.

Infrastructure, which is receiving unprecedented amounts of investments from the Brazilian government, will likely be the cause of much of the fund raising in the eurobond markets and elsewhere in 2012. The country needs to improve its transport links,

especially roads, ports and airports, in order to keep on with the booming economy. Brazil is also hosting the 2014 football World Cup, and the 2016 Olympic Games, and both events demand large investments too.

Infrastructure requirements motivated the launch last year of the country’s first project bond, which was structured by Banco Santander for the Odebrecht construction group. The $1.5bn bond was linked to the construction and operation of two deep-sea drilling ships by Odebrecht Óleo e Gás, an oil subsidiary of the group. “We sold to institutional investors the risk of a project,” Borges says. “They purchased a mixed set of risks including the construction of the ship, and its operation by Odebrecht Oil & Gas, as well as its charter contract

by Petrobras.”

The 6.35% senior secured notes are due in 2021. Petrobras will pay a daily fee for the chartering of the ship, and the bond is completely independent from the cash flow generated by the asset, Borges explains. In the end, investors were actually buying Petrobras risk, a much-coveted asset due to the firm’s newly-found pre-salt oil reserves. “The market has so much appetite for this kind of risk that we identified the opportunity and put the bond in the market. It was an unmitigated success that attracted demand for more than $5bn,” Borges adds.

As Petrobras is expected to spend a large share of its pre-salt budget with Brazilian firms, which will have to raise the required money somewhere, more operations of this kind could very well hit the market.

While it is unlikely that the Brazilian growth story will be derailed any time soon, the administration of president Dilma Rousseff has been rocked by the forced resignation of chief minister Antonio Palocci, who has long been regarded as a judicious hand in government policy. Moreover, the country’s current account deficit continues to widen, reaching $5.7bn in March, compared to $3.4bn in February. I

J U LY / A U G U S T 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

US CORPORATE BOND ISSUANCE: DEBT END?

Those who called for a big year in corporate bond issuance have, to date, been right on the money. May registered the secondhighest monthly total for corporate issues as companies of all sizes queued up en masse to grab some of the cheapest financing in history. What’s been fuelling the corporate bond drive? Is a cooling-off period in order? From Boston, David Simons reports.

Bond bonanza could have peaked OW LOW CAN you go? It is an obvious question that springs to mind while watching the continuing freefall in US Treasury yields. Cresting at around 3.75% last winter, the ten-year note opened the month of June just south of 3% for the first time since the close of last year. Plunging Treasury yields have had a major impact on the market for corporate bonds, which spent the first half of 2011 in near-record territory. In May, sales of new corporate issues reached a hefty $109.6bn, as corporations queued up en masse to grab some of the cheapest financing in history. The month’s issuance total was just shy of last September’s record $115.1bn, and more than three times the $32bn recorded in May of 2010, according to Dealogic.

In general, tighter credit spreads, combined with bottom-scrapping rates, have been responsible for this year’s corporate bond bonanza. Additionally, observers believe that companies want in on the action before the Federal Reserve Board this summer concludes its QE2 $600bn Treasury purchase programme. It naturally prompts speculation of a long-anticipated rise in interest rates. With rates at all-time lows, others have looked to new issuance as a way to refinance current debt, including private equity firms, which have earmarked more than 60% of the estimated $120bn in newlyissued leveraged loans specifically for refinancing purposes.

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Photograph © Sergey Drozdov / Dreamstime.com, supplied June 2011.

Data suggests that the new-issue boom has worked wonders for the corporate markets in general. Just two years ago, the number of firms struggling to make payments on credit obligations sent defaults rates soaring over 11%. By contrast, to date Standard & Poor’s (S&P’s) projected trailing 12-month speculative-grade default rate stands at a mere 1.6%, due in large part to the favourable climate for debt issuance.

“There were some who felt that last year’s volume couldn’t be topped,” says Stefan Selig, executive vice chairman and head of global corporate and investment banking at Bank of America Merrill Lynch. Through May of this year, issuance was well ahead of the figures recorded during the first half of 2010, “which is due in no small part to index yields hitting all-time lows,” says Selig.

Though the end of QE2 may well impact the markets on some level, corporations will likely continue to see favourable conditions for bond issuance for an extended period. New JP Morgan market analysis calls for ten-year Treasuries to remain on the lower end of a 3% to 3.7% range, perhaps slightly higher as QE2 winds down, combined with an expected refinancing deal for Greece as well as a likely rebound in economic data in Q3.

So strong is the pent-up demand for deal refinancing that, post-QE2, domestic leveraged-loan issuance is likely to approach $300bn by the year’s end, according to figures from Bank of America Merrill Lynch.

Not surprisingly, the corporate-bond boom has lured investors away from treasuries in greater numbers, and, should current conditions persist, corporate issuance will likely continue to weigh on the Treasury market as investors increasingly opt for higheryielding securities, notes TD Securities analyst Richard Gilhooly. Rather than run a short position, bond bears can voice their dissatisfaction with bottomscraping Treasury yields, he says, “by picking up yield in corporates”instead.

Stocking up Even companies with no apparent need to borrow have not been able to resist the urge to issue. May’s fertile market conditions even prompted Google to make its corporate-debt debut, despite having an estimated $37bn in available cash on hand.

Google’s $3bn offering, issued in three, five and ten-year increments, helped pace the month’s issuance totals, as did companies including Texas Instruments ($3.5bn in new notes) and Chrysler Group ($3.2bn).

Historically, large-cap, high-growth players have steered clear of debt accumulation, preferring instead to utilise their vast cash reserves to fund expansion opportunities. In the current climate, however, bond issuance has enabled Google (and other technology titans) to engage in M&A activity on the cheap, using loans established at the bottom of the yield curve. With analysts already pricing in potential future

J U LY / A U G U S T 2 0 1 1 • F T S E G L O B A L M A R K E T S

issuance, Google and others can post more bonds without negatively impacting their credit standing. Additionally, by issuing new bonds, companies can avoid incurring taxes from tapping into cash reserves held overseas. Google, for instance, keeps nearly half of its entire cash stash in offshore accounts.

As Bank of America credit strategist Oleg Melentyev observes, for such companies, borrowing works best when you do not need the money.“This is a great time to be a corporate debt issuer, when everyone wants to be your lender and you don’t have a pressing need to borrow.”

Even with the frenetic pace of debt issuance, the first half of 2011 revealed no real signs of imminent danger. Data from Russell Financial Services showed continued improvement in the allimportant option-adjusted spread (OAS) indicator. As of March, the OAS rating on investment-grade corporate debt stood at a mere 1.38%, its lowest rating in nearly four years, and a major drop from the November 2008 peak of 6.07%. The OAS is used to evaluate yield differences between similar-maturity, fixed-income products with different embedded options; higher OAS readings indicate increased default risk, while lower numbers are associated with satisfactory credit availability and greater operational flexibility.

More recently, however, indications of a potential period of consolidation have begun to surface. After bottoming at around 136 basis points (bps) in

April, as of early June, the Barclays Capital US corporate investment grade OAS index had climbed to around 151bps, while the high-yield OAS index (measuring option-adjusted spreads over Treasuries) widened to 522bps from a low of 436bps set in February.

That the most recent pause coincides with a softening of macro data and the approaching cessation of the Fed’s QE2 programme suggests that “risk assets are in for a period of heavy sledding,” says research firm CreditSights.

Equally, in its Global Financial Stability Report issued in April, the International Monetary Fund (IMF) forewarned that an increase in corporate and financial leverage, along with rising asset valuations and inflationary pressures in emerging-market regions,“raises concerns about the gradual build-up of imbalances, calling for increased vigilance by policymakers and adroit use of policy tools”.

For investors, the infusion of $100bnworth of investment-grade bond supply, combined with a spate of lessthan-rosy economic data, bears watching, says Tammy Karp, managing director, US fixed-income for international asset-management firm TCW Group. “Despite continued inflows into high-grade credit funds, dealers found themselves even longer as accounts shed exposure to make room for supply,” says Karp.

At the same time, she admits that the continued slide in Treasury yields has made bond issuance much too tempting for corporations to pass up, particularly when one considers that “dividend yields for many of the issuers are higher than the after-tax cost of issuing debt”. For instance, at 4.5%, Xerox’s ten-year yield topped the Treasury’s by a whopping 145 basis points; McDonalds’ and Google’s ten-year 3.625% bond ranked a full 58bps better.

The intense pace of issuance volume is expected to ease over the near term, paving the way for the resumption in spread tightening, offers Dave Sekera, senior securities analyst with Morningstar. Should issuance activity remain

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

Tammy Karp, managing director, US fixedincome, TCW Group. “Despite continued inflows into high-grade credit funds, dealers found themselves even longer as accounts shed exposure to make room for supply,” she says. Photograph kindly supplied by TCW Group, June 2011.

unchecked or credit spreads suddenly come unglued, however, all bets are off. “That could set the tone for a correction and lead to a ten to 20 basis-point widening in credit spreads.” says Sekera.

Markets in good shape Increased volatility has already materialised as a result of May’s bond-buying spree, says Sekera. As of the first week of June, Morningstar’s Corporate Bond index stood at 190 basis points, a full 50bps over Treasuries since the start of May. Even with the potential for weaker economic data on the horizon, however, stabilisation has already begun to take place, says Sekera. “We could still see some blips here and there, however as long as we don’t have any real new negative news headlines, I think that the credit markets will continue to keep grinding tighter from here.”

While companies may in fact think twice before continuing to issue in the face of further negative economic news, higher cash-balance sheets, lower debt-to-equity ratios and drastically reduced leverage will help keep the markets in good shape and lead to a resumption of credit tightening in the near term, says Sekera. I

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DEBT REPORT

CANADA’S BOND MARKET: ON THE CREST OF A WAVE

Photograph © Manakhova / Dreamstime.com, supplied June 2011.

The rise and rise of Canadian high-yield debt Canadian high-yield bonds are currently riding the crest of a wave. Issuance of the instruments resumed 22 months ago in response to the tax changes that spelt the demise of income trusts, which were the main source of high-yield returns for domestic investors over the past decade. Overwhelming demand has seen the market grow at a spectacular rate.

Confidence is now strong that high-yield debt will become a permanent and sustainable feature of Canada’s broader financial markets. Andrew Cavenagh reports.

ARRETT XPLORE, CANADA’S largest broadband Internet service provider to rural areas, was able to raise CAD230m from a high-yield issue in May in a transaction that cuts to the growing maturity of the Canadian market. The company is still very much in its build-out stage, having just hit break-even on an EBITDA basis, and the issue was sold to investors on the strength of projected future earnings. “This was the biggest deal so far that illustrated the debt-to-asset-value play,” says Neil Mohammed, head of Canadian corporate coverage in the debt capital markets division at BMO

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Capital Markets. Road shows for the offering took place in New York and Toronto, and there were four US investors among the 16 final participants who accounted for 38% of the issue by volume.

The dissolution of income trusts, which finally took place at the end of last year (by which time all had reverted to corporate status) has, at a stroke, created huge potential demand for domestic high-yield bonds in Canada. It is estimated that at least 40% of the CAD174bn invested in income trusts at their height in 2006 is now seeking an alternative home and that alone could

sustain around CAD10bn of high-yield issuance a year. The balance, of course, remains in equities. “High-yield in Canada is now demand driven,” explains Neil Mohammed, at lead bookrunner BMO Capital Markets.

“With the elimination of the incometrust market, high-yield will fill that hole on a constant basis.”

There is every chance that the market will go a long way to meeting that annual target in 2011. In fact issuance volumes have been expanding at a dramatic rate ever since the large Canadian grain-handler Viterra kicked off the present round of issuance with a CAD300m bond in July 2009. Neither does it show any sign of abating.

From the four deals worth a total of CAD1.2bn in 2009, the rate of issuance climbed to 14 transactions worth CAD3.4bn in 2010 and looks set to exceed CAD6bn this year, with ten transactions worth just under CAD2bn coming to the market by May 11 [please see table].“I wouldn’t be shocked if the market hit CAD7bn this year,” said Mohammed.

There is already a substantial home investor base for such offerings. The 35 deals that have come to the market since the Viterra issue have attracted more than 170 investors, about 95% of whom have been Canadian funds denominated in the domestic currency. “Your average deal in Canada now has between 40 and 50 buyers,” explains Craig Wilson, managing director of high-yield trading for North America at CIBC. “There is going to be demand for yield from investors for some time, and given where interest rates are—and even where investment-grade corporate debt currently trades—high-yield bonds fit that demand very nicely.”

The surge in Canadian high-yield issuance from the middle of 2009 led Moody’s in October to launch a dedicated web page to the market, which includes weekly up-dates on issuer lists, rating news, and research. By the time the agency took the decision, it had rated CAD3.7bn of speculative-grade Canadian company capital-market debt

J U LY / A U G U S T 2 0 1 1 • F T S E G L O B A L M A R K E T S

along with $15bn of additional bonds that the companies had issued in the US high-yield market.

“We are getting to the point where we’re starting to acquire some critical mass, if we’re not quite there yet,” says Ed Sustar, senior Moody’s analyst in Toronto. Canada’s leading banks have played a decisive role in reviving the domestic high-yield market. Identifying the opportunity that the disappearance of income trusts would create, they have all set up extensive operations to originate, market, distribute and trade bonds denominated in Canadian dollars.

Enhanced capabilities Scotia Capital was the institution that took the lead and was book-runner on 12 of the first 17 deals that have come to the market since mid-2009, but other houses have been rapidly catching up.

“All six of them have staff that is now focused on trying to push this market,” said Sustar.

In the last two months, for example, BMO Capital Markets brought in a pair of derivative specialists to its Toronto office to enhance the capabilities of its high-yield trading operation. The result has been the creation of a market, albeit small and at a relatively early stage of development, that can offer a wide range of Canadian companies a viable alternative to raising the debt they need from either banks or the US high-yield market. It certainly offers distinct advantages over its much larger

erable expense.” Mohammed at BMO Capital Markets said that for companies with no requirement for US dollars, issuing on the Canadian market was now a complete no-brainer for that reason.“There’s nobody who’s going to make that [swap] trade. It’s just too expensive.”

For those Canadian companies that do need to raise US dollars as well as their domestic currency (such as most of those in Canada’s natural resources sector) the domestic market offers the ability to raise debt from a single issue in both currencies by wrapping a US dollar tranche, privately placed on the US 144a market, into the offering. The large packaging company Cascades, which employs more than 15,000 in Canada, the US and Europe, was the first company to do this with a $300m/CAD150m split issue in November 2009.

neighbour, given that the pricing differential between the two is minimal.

One significant benefit is that domestic bond issues do not have to comply with the onerous requirements of the Sarbanes-Oxley Act and other US regulations. Greg Woynarski, global head of debt capital markets at Scotia Capital, says this could reduce transaction costs by as much as 50% and means that issues as small as CAD125m are viable in Canada, against the minimum issue size of around $250m in the US. Issuing in Canadian dollars also obviates the need for a long-term currency swap, which can not only be a substantial ongoing cost expense but may also prove hard to obtain in some cases. “For a lot of companies, getting clean ten-year swap lines is a problem,”explained Woynarski.“And if you’re going to swap a $150m deal for ten years, it’s also going to be a consid-

Top ten bookrunners: Canadian high-yield debt issuance (2011 YTD)

1 BMO Capital Markets 2 RBC Capital Markets 4 National Bank Financial 3 CIBC 5 Scotia Capital Inc 6 UBS 7 CS 8 TD TOTAL

Market Share

Total Volume

Deal Count

25% 18% 16% 14% 14% 6% 3% 3% 100%

(C$MM) $487 $358 $325 $288 $279 $115 $67 $67 $1,985

4 4 2 2 2 1 1 1 10

*Full credit to Bookrunner (Equal Economics)

Some recent issues in the Canadian high-yield market (January through May 2011) Pricing Date 11-May-11 26-Apr-11 8-Apr-11 31-Mar-11 10-Mar-11 10-Mar-11 8-Mar-11 8-Mar-11 3-Feb-11 27-Jan-11

Company Principal Barrett Xplore Inc. 230 Mobilicity (Data & Audio Visual Wire) 195 Trident Exploration Corporation 175 Canadian Satellite Radio 130 Precision Drilling Corp.

200 Perpetual Energy Inc. 150 Skylink Aviation Inc. 110 Ford Credit Canada Limited 500 Vermilion Energy Inc. 225 Paramount Resources Ltd. 70

Issue Senior Secured 1st Lien Senior Secured 1st Lien Senior Unsecured Senior Unsecured Senior Unsecured Senior Unsecured Senior Secured 2nd Lien Senior Unsecured Senior Unsecured Senior Unsecured - Re Open

Maturity May-17 Apr-18 Apr-18 Jun-18 Mar-19 Mar-18 Mar-16 Mar-14 Feb-16 Dec-17

Bookrunners UBS, BMO NBF CIBC NBF RBC, CS, TD BMO RBC, BMO RBC, BMO, BNS BNS, CIBC RBC

Source: BMO Capital Markets, supplied June 2011.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

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DEBT REPORT

CANADA’S BOND MARKET: ON THE CREST OF A WAVE

A further consideration for Canadian issuers is the strength of domestic demand for their product relative to that in the US high-yield market. Woynarski said this had ensured strong order books for all the issues that had come to market since the inaugural Viterra offering—in contrast to the reception that Canadian companies often received from American investors in the US high-yield market. “When Canadian issuers participate in these Yankee issues, they typically do not get great fills,” he maintained. “For both the issuers and investors, the Canadian high-yield market makes a lot of sense.”

The domestic high-yield bond market also offers Canadian companies a significant operational advantage over the banking market, in that its financial covenants are much less restrictive. The covenants on the bonds are incurrence-based, requiring the issuer to demonstrate compliance with their terms only in instances where it has incurred further debt; as opposed to the financial maintenance covenants that apply to banking facilities and which require quarterly evidence of compliance.

Wilson at CIBC said that while high-yield would not replace bank debt in the speculative-grade corporate sector, it could offer companies a valuable additional source of funding.

“This is a layer of capital that is complementary to bank financing.” he explained. “It will definitely relieve some of the pressure on the banking market, as it opens up another source of capital for Canadian corporations.”

Despite being less restrictive than the banking counterparts, the covenants on Canadian high-yield bonds still afford investors meaningful protection, through provisions that place restrictions on the issuer’s ability to distribute cash to shareholders, dispose of assets, incur liens, or take any other actions that might impair its ability to service the debt. A change of control at the issuer also triggers the obligatory repurchase of the bonds at 101% of par.

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While the covenants are not radically different from those in the US high-yield market, however, they are noticeably less uniform. Mohammed said this reflected “the history of standardised sets of covenants” in the US and that the Canadian market should hopefully move in the same direction.

Canadian high-yield bonds also offer a high degree of liquidity. Woynarksi points out that that “virtually every issue” that has been launched since mid-2009 was trading at or above par and that Scotia Capital for one could offer investors all products needed to hedge a long-only book. “They have been extremely impressed by the liquidity of the market,” he added.

Cynics might point out that is hardly surprising in a situation where demand so heavily outstrips supply and that tougher tests of the market’s liquidity almost certainly lie ahead. Nevertheless, there are convincing reasons to believe that this time the market for Canadian high-yield bonds will grow to the point where it will become a permanent feature of the country’s financial landscape.

Growing role of US investors The surge in activity over the past 18 months has increased the total volume of outstanding high-yield debt to more than CAD30bn, while the investor base has grown rapidly into three figures.

Tenors have stretched out to ten years in some cases and are generally now close to those in the US market, while American investors—seeking protection against further declines in the value of their dollar as well as diversity—have begun to provide significant support for Canadian offerings in the past few months.

While American buyers may have accounted for only about 10% of post2009 Canadian high-yield issuance overall, the figure has exceeded 20% on some recent issues. CIBC has set up high-yield trading teams in Toronto and New York to cater for this demand.

“We have most of the asset managers in North America covered from a high-

yield perspective,”says Wilson.“We are now receiving a lot of calls from US asset managers who are trying to buy Canadian high-yield assets.”

A further ground to be optimistic about the outlook for high yield has been the expansion of the wider Canadian credit market over the last three years. This has seen the volume of triple-B rated debt increase from just 7% of the overall bond market three years ago to around 25% today. Then there is the amount of debt that Canadian speculative-grade companies will need to refinance between now and 2016, which is worth around CAD30bn

by Moody’s estimate. Sustar points out that even if the bond market met only 40% of this requirement, it would still boost annual issuance by around CAD2.5bn a year. “These maturity ‘towers’ coming up over the next few years should ensure the market continues to grow,” he says.

Yet another potential source of growth is a revival of corporate activity.

Most of the transactions that have taken place since mid-2009 involved the refinancing of existing debt—either bank facilities or maturing bonds. Use of the Canadian high-yield market to raise cash for M&A deals as and when companies decide to hit the acquisition trail once more could significantly increase annual rates of issuance.“One of the main drivers for the market’s growth will be when the M&A market picks up again,”maintained Woynarski at Scotia Capital. “We can now offer companies in those situations the full range of products they want—from bridge loans through to bond refinancing—in Canadian currency.”

What would really enlarge the Canada’s high-yield market on a longterm basis, of course, would be if a lot of the smaller companies across the global mining and oil and gas sectors decide that it is the place to raise their debt in the same way that they currently view the country’s stock market as their prime source of equity.“Then it could definitely grow much bigger,” confirms Mohammed at BMO. I

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BANKING REPORT

US INVESTMENT BANKING: THE ROAD AHEAD

Photograph © Christophe.rolland1 / Dreamstime.com, supplied June 2011.

The advantage of being a flow monster Barring a cataclysmic event, the balance of 2011 could turn out to be very much like the year’s first half, featuring higher levels of capital issuance, an uptick in mergers and acquisitions activity, and, hopefully, rates remaining at or near their 45-year lows. It is the kind of speculation that the heads of leading investment banks hope becomes reality. David Simons reports from Boston.

LOBAL MARKETEERS CAN take some measure of comfort in the substantial gains that have been made since the arrival of the mortgage-backed meltdown, now approaching its third anniversary. Leverage has lessened; capital is king, and, for the most part, investors have been satisfied with the various efforts to improve the clarity of internal fund operations.

Despite these and other modifications, all eyes continue to follow the progress of one of the most significant of market barometers—the investment-banking (IB) sector. The once untamed gang of lenders and spenders

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that helped script the global-market unravelling has long since vanished; in its place, leaders-through-acquisition such as JP Morgan, Bank of America (BofA) and Barclays, as well as original IB survivors Morgan Stanley and Goldman Sachs, are a far different lot, rarely missing an opportunity to publicly discuss ongoing battles with old demons such as mortgage debt, while at the same time trumpeting accomplishments in areas such as fee-based revenue, FX and fixed income.

Getting back on track, however, remains something of a challenge for these global investment banks. In the most recent quarter, total revenues at

top IBs (that also include the likes of Citi, UBS and Credit Suisse) tumbled 5% to $52bn, according to figures compiled by London-based consultancy group Coalition. Declines in fixed income, a by-product of geo-political upheaval as well as lower consumer confidence, shouldered much of the blame, said the research firm.

Last year, income generated by the leading global investment banks dropped to $167bn, a 23% decline from 2009, according to Coalition, as banks sought to increase personnel following a spate of post-crisis staffing cuts.

Having a huge footprint doesn’t necessarily guarantee future success, and, to date, boutique IBs have continued to carve out a small but perceptible niche within the global marketplace.Yet with the need to fund newer technologies and maintain capital reserves for potential acquisition targets, size continues to be a key factor—hence the continued advantage held by well-capitalised firms with diversified business models, which will facilitate the buildout of new services, while allowing firms to leverage expertise across their investment banking divisions. These so-called“flow monsters”will hold the greatest advantage going forward, say experts, and will compel mid-size

J U LY / A U G U S T 2 0 1 1 • F T S E G L O B A L M A R K E T S

players to sharpen their strategic focus in order to remain competitive.

Paced by a buoyant mergers and acquisitions (M&A) market, as well as a robust capital-markets business, banks recorded $10bn in fee-based revenue during the quarter, up from $9bn during Q1 of last year. High-yield issuance, which hit new peaks during the first half of 2011, accounted for nearly half of all origination revenues during the quarter. Fee leaders included top-ranked JP Morgan (which recorded $1.39bn in fee revenue during Q1, according to Thompson Reuters data), followed by Bank of America Merrill Lynch ($1.36bn) and Morgan Stanley ($1.2bn).

The market for high-yield issuance, which has performed beyond all expectations, continues to save the day.

“There were some who felt that last year’s volume couldn’t be topped,” notes Stefan Selig, executive vice chairman of global corporate and investment banking at Bank of America Merrill Lynch. In fact, through May of this year, issuance was well ahead of the figures recorded during the first half of 2010—”which is due in no small part to index yields hitting all-time lows,” says Selig.

The strength of the leveraged finance and high-yield markets has been a key factor in increasing fees paid to the Street. “The leveraged finance feemargin structure is very attractive to Wall Street, and that’s one of the things that continues to fuel fee-pool growth,” says Selig.“Due to their dominant positions in the business, Bank of America, as well as JP Morgan, have disproportionately benefited from this activity.”

The correlation between fee pools and the health of the global equity markets have long subjected investment banks to some abrupt twists and turns. After bottoming out during the early part of the previous decade, investment-banking fee pools rebounded strongly, reaching north of $80bn by 2007. Then the roof caved in; in 2008, fees were effectively cut in half.

Though fee-based revenue has once again shown signs of strength particu-

Stefan Selig, executive vice chairman of global corporate and investment banking at Bank of America Merrill Lynch. “While the major financial sponsors are still quite active, they’re just not doing the megadeals that were so prominent prior to the onset of the crisis,” he says. Photograph kindly supplied by Bank of America Merrill Lynch, June 2011.

larly during the past 18 months, progress remains tenuously linked to news impacting the markets in general.

With market dynamics constantly in flux, no one can afford to rest on their laurels. After making great strides during the first five months of 2011, in June the capital markets suddenly soured following a spate of negative economic data that sent equity indices reeling and left many questioning the credibility of the overall recovery. “As a politician once put it, ‘It’s the economy, stupid,’” says Selig. “The recent pullback suggests that this data has more of an impact on corporate issuance, than, say, the onset of new financial legislation.”

M&A activity, itself inexorably tied to the vitality of the capital markets, represents another integral part of the investment-banking growth engine.

Following a reasonably strong second half of 2010, through May, M&A continued to move forward with deal volume increasing approximately 25% year-over-year. In the first quarter, global mergers and acquisitions volume reached $809bn, up 28% from

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

the same period last year, according to research firm Dealogic.

Post-crisis, deals have been largely strategic in nature. “While the major financial sponsors are still quite active, they’re just not doing the megadeals that were so prominent prior to the onset of the crisis,” says Selig. Though recent deals have averaged in the vicinity of $3bn instead of $30bn, most have been unusually well received by the markets, even those that were somewhat aggressively priced and financed.

“When the markets applaud CEOs after announcing a big transaction, it boosts confidence, and other companies are then more likely to follow suit,” says Selig. “Positive market reaction has obviously been supportive to the continuation of strategic M&A activity.”

Though not nearly as prevalent, headline makers such as Berkshire Hathaway/Lubrizol and Duke/Progress Energy suggest that investors are still open to the occasional mammoth deal, and also underscore the growing cash reserves within the private-equity sector.

Jeffrey Golman, vice chairman, investment banking, with Chicago-based

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BANKING REPORT

US INVESTMENT BANKING: THE ROAD AHEAD

financial services firm Mesirow Financial, sees M&A activity continuing to trend upward through 2011, led by a growing “supply of appealing acquisition targets” resulting from owners having delayed M&A transactions in recent years while waiting for the markets to recover.

Other growth prospects include revenues derived from advisory services, which, according to London-based investment-banking boutique JP Morgan Cazenove, could increase approximately 4% in the coming quarter.

Meanwhile, the market for IPOs, while not yet back to its halcyon preLehman days, also continues to move ahead, with current activity suggesting that 2007 levels are not that far off.

“Not only that, but a larger percentage of the deals that have been getting done have been coming in at or above the anticipated price range, which, of course, is the kind of thing the markets like to see,” says Selig.

While the ultra-low interest rate climate has been welcome news for corporate borrowers, it has been tough on investment banks with huge mortgage divisions still digging out from the storm of 2008-2009. JP Morgan, for instance, recently reported a provision for $1.1bn in credit losses, as well as a $1.1bn fair value writedown on the firm’s mortgage servicing rights. In the bank’s recent quarterly assessment, a customarily frank Jaime Dimon said that the extraordinarily high losses will unfortunately continue for a while, despite ongoing efforts to “address our mistakes from the past”.

The mortgage clean-up has certainly been a drag on share prices (resulting in a 15% to 20% across-the-board knee-capping so far this year), luckily the investment-banking divisions of firms such as JP Morgan and Bank of America have seen little to no adverse impact. In April, JP Morgan posted a 67% rise in first-quarter earnings, due in no small part to investment banking-related fee growth.

The same goes for BofA’s IB division, which, by its own estimation, continues to hold down the number two spot

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M&A activity, itself inexorably tied to the vitality of the capital markets, represents another integral part of the investment-banking growth engine. Following a reasonably strong second half of 2010, through May, M&A continued to move forward with deal volume increasing approximately 25% year-over-year. worldwide. “Obviously we’re quite pleased with the way things have been going from that perspective,”says Selig.

“Given the importance of debt underwriting in terms of the overall fee pool—and when considering the combined market share that Bank of America and JP Morgan hold in those products—there is a tremendous gap separating the leaders from the number three player.”

Having played a key role in the deconstruction and subsequent rebuilding of the IB sector, regulators aren’t yet finished putting IBs through the ringer.

Recent initiatives include the imposition of new enforcement guidelines governing mortgage-servicing and foreclosure processes that will likely require banks to dramatically increase staffing in order to comply. Meanwhile, Goldman Sachs finds itself in potential legal hot water, having received a subpoena from the Manhattan district attorney concerning allegations of mortgage-market shorting and other possible misdeeds in the period leading up to the start of the financial crisis.

New rules contained within DoddFrank requiring IBs to spin off portions of their derivatives operations, as well as unwind hedge-fund investments and put an end to proprietary trading, could help shift the balance of power to certain European competitors, according to research from JP Morgan Cazenove.

Additionally, capital-adequacy requirements included within DoddFrank and other initiatives could serve as a winnowing mechanism, forcing those with balance-sheet issues to fatten the coiffures in a hurry. In its Outlook for Global Wholesale and Investment Banking report issued last spring, Morgan Stanley Research, in conjunction with interna-

tional management consultancy firm Oliver Wyman, suggested that regulation is rapidly changing the basis of competitive advantage. “Infrastructure, client service, scale, and use of capital” will become critical factors as automation lowers margins in trading and clearing of OTC derivatives, credit, and rates, and as funding costs hit financing activities. The group estimates that the average global investment bank today “faces $4bn of quasi-fixed costs,” and, accordingly, will need to make “hard-headed portfolio and investment decisions” as well as improve efficiency in order to reduce costs by upwards of 8% over the next 12 to 18 months in order to keep pace, according to the report.

Looking ahead While all eyes remain focused on the Federal Reserve Board as it wraps up its QE2 $600bn Treasury purchase programme, prompting speculation of a long-anticipated boost in interest rates, for the time being returns on high-yield instruments remain strong, spreads are still reasonably tight and money continues to roll into the markets. Cash balances of leading US corporations (estimated to be in excess of $1trn) continue as a source of encouragement, as does an increase in major acquisitions—including isolated instances of hostile deals—which are consistent with a bullish-leaning market. Barring the arrival of a cataclysmic event, the balance of 2011 could turn out to be very much like the year’s first half, with higher levels of capital issuance, an uptick in M&A activity, and, hopefully, rates remaining at or near their 45-year lows. It is the kind of speculation that the heads of investment banks hope becomes reality. I

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AGENCY TRADING

Photograph © Dana Rothstein / Dreamstime.com, supplied June 2011.

BROKERS FIGHT A WAR IN THE TRENCHES It has been a tough 12 months for execution-only agency brokers following a slump in volumes after last year’s Flash Crash and the continuing sovereign debt crisis. Between May 2010 and May 2011, NYSE Euronext recorded a 45.5% drop in volumes in the US and a 22% drop in Europe.

What now? Ruth Hughes Liley reports.

URE EXECUTION-ONLY agency trading houses depend on volumes for their existence and it is “becoming tougher and tougher for the pure agency brokers,” Richard Hills, global head of quantitative electronic services team, Société Générale corporate and investment banking (SG CIB), points out. While there has been a recent rebound in volumes, volatility too is down, with the Chicago Board of Trade’s volatility index (VIX) hovering around 20 since last September. By comparison, between September and December 2009 it averaged around 60, spiking to 80 at the end of October. “If there is no volatility, there is less opportunity to trade,”explains Ray Tierney, chief executive officer at Bloomberg Tradebook. “Lower volumes are driven by lower volatility.”

With almost 700 stock exchange members in Europe and 2,000 US members of the Financial Industry Regulatory Authority (FINRA), the commission pool should in theory be shared out widely between agency brokers and full-service brokers alike, in proportion. Historically

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between 15% and 20% of the commission pool has been allocated to agency houses, but agency houses have been hit disproportionately as commissions have been squeezed.

According to a TABB Group report published in February 2011, Trading for Alpha 2011: CSA in US and Europe, 71% of business and therefore commission in the US goes through an average of just ten core brokers. In Europe it is 72%.

Additionally, half of US firms use fewer than ten brokers with commission-sharing arrangements. Report author Laurie Berke says: “Across the UK and Europe, the average is just a bit higher, at 10.2 brokers. The big have gotten bigger, while the balance of firms is heatedly competing for a smaller piece of the pie. Mid-tier and execution-only brokers are fighting trench warfare to maintain and capture market share of the commission wallet.”

In a survey last year, research firm Integrity Research Associates found that commission-shaping agreements (CSAs) had gained in popularity over the previous five years, accounting for 30% of research commission

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payments among survey respondents. The average equity commissions paid out by survey participants was $26.2m.

Respondents typically used five CSA providers, although some large investment firms used 12 or more. Richard Hills explains:“Three years ago there was a strong focus on CSAs and unbundling. Since then, with the shrinkage in the commission pool, the buy side has had to be careful to adequately reward its research providers and to direct flows accordingly. This has a knock-on impact on liquidity provision. Of course, some firms remain strictly segregated along the unbundled regime.”

TABB Group’s Berke reports: “About half of head traders predict that the percentage of CSA commission that stays with the executing broker in compensation for their trading coverage and technologies will fall by year-end 2011 versus year-end 2010. The largest firms with the largest commission budgets are at the head of the trend. One-third of large asset managers with at least $150bn under management and half of mid-sized managers with $25bn to $150bn in assets predict that payments will increase and compensation for trading will decrease.”

Although many fund managers have cut broker lists, Scottish Widows Investment Partnership (SWIP), which has £145.39bn in assets under management, traded with around 85 different brokers last year. Tony Whalley, investment director, SWIP, says: “There could be ten or so who we have only traded with once, but that one time they were able to fill part of an order and so added value to the process. We have completely split execution and research and pay separately for them. We do have CSAs and were one of the first firms to use them, but only use them with our top dozen brokers. Go back five years and around 70% of our business was bundled research and execution conducted with our top ten brokers. Now we have research from a lot more thirdparty providers, so only 60% of research comes from our top ten brokers but 80% of execution is with them, and now we are getting better quality research than we did before.”

Execution firms widen offering In response, execution-only firms have been widening their offering to the buy side, including offering research and corporate access, characteristics usually found under one roof in a bulge bracket firm. Some with a strong technology base have turned themselves into more specific technology houses, all in the fightback against the competition from full-service firms.

Indeed, third-party research providers are flourishing and recent estimates suggest the number of firms has doubled in the past three years. The integrity survey found that on average, a quarter of commissions directed through CSAs were allocated to independent research providers not affiliated with investment banks.

The June 2011 Thomson Reuters Extel Survey, has identified the reason:“The buy side puts independent thinking as the most prized attribute they look for from the sell side.”

One of the latest agencies to recognise the strength of the independent research offering is Bloomberg Tradebook. In

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Richard Hills, global head of quantitative electronic services team, Société Générale corporate and investment banking. “With the shrinkage in the commission pool, the buy side has had to be careful to adequately reward its research providers and to direct flows accordingly. This has a knock-on impact on liquidity provision,” he says. Photograph kindly supplied by SG CIB, June 2011.

May 2011, it expanded the number of third-party research firms which it works with by seven. Clients receive research reports and can contact the analysts directly as well as being able to make use of consultants, part of its execution consultancy offering it launched last year.

Tierney says: “We have gone from execution-only to execution-everything. No one is predicting whether the current storm is cyclical or permanent, but agency broking as I know it has changed. Capital markets are an enormous draw at getting business, which compounds the problems that the agencies are having. Having said that, agencies are in a privileged position because they are going to get flow regardless, because of buy side concerns around where flow is going.”

Rival agency broker Instinet has also expanded its offering and has worked with third-party independent research firms for some years.“They are good at what they do and should get paid for it and we are good at what we do and should get paid for it,” says chief executive officer of Instinet Europe, Richard Balarkas.“Having said that, our edge is in execution services and it won’t get to the point where we blur our model by having analysts on our cost base.”

The firm also last year launched a corporate access product in the US called “Meet the Street”. A corporate

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Ray Tierney, chief executive officer at Bloomberg Tradebook. “We have gone from execution-only to execution-everything. No one is predicting whether the current storm is cyclical or permanent, but agency broking as I know it has changed. Capital markets are an enormous draw at getting business, which compounds the problems that the agencies are having,” he says. Photograph kindly supplied by Bloomberg Tradebook, June 2011.

Laurie Berke, analyst, TABB Group. “About half of head traders predict that the percentage of CSA commission that stays with the executing broker in compensation for their trading coverage and technologies will fall by year-end 2011 versus year-end 2010. The largest firms with the largest commission budgets are at the head of the trend,” she says.

Photograph kindly supplied by TABB Group, June 2011.

access web-based platform which took 15 months to develop, it is used by investor relations officers to schedule non-deal roadshow meetings with targeted investors.

Balarkas says: “We think there is a demand for corporate access services outside that provided by banks, because some companies would prefer to meet their investors without a bank analyst in the room.”

His assertions are backed up by the Thomson Reuters Extel Survey, which found that corporate access services and advice was “more highly valued by asset managers than ever before”. It also found that fund managers relied on meetings with chief executives and chief financial officers to evaluate companies better and wanted those meetings to take place at the buy side’s offices.

of equities trading in the US, according to consulting specialist Aite Group, and traditional market makers being replaced by high-frequency traders, “the sheer complexity of today’s market structure makes it almost impossible for any market participant to approach it manually,”says Sang Lee, co-founder and managing partner at Aite Group.

Whalley agrees: “The collapse of Lehmans pushed the buy side into electronic execution because of the anonymity it gave. In the six months afterwards, about two-thirds of our business was traded through algos or crossing networks because of liquidity issues. Now we are executing around 15% electronically. It has come back down because a degree of capital commitment is there again.”

As risk capital makes a reappearance it puts greater pressure on the agency models, as Hills explains: “The buy side’s key requirement for choosing a broker is still liquidity but with risk appetite as a part of that. They expect their brokers to be there to offer risk, so that puts a squeeze on agency brokers.”

There is a view that the investment banks have not yet felt the full impact of the financial crisis and the subsequent regulation that will put pressure on their capital requirements. The set of regulations known as the Basel Accords states that banks should hold capital in direct proportion to

Execution consulting In addition to extending their offering to clients, some agency firms are changing their desk structure models and becoming more flexible towards their clients, so that clients have fewer touch points to deal with their demands instead of having to speak to several different desks.

It is not surprising that execution consulting is being added to the list of benefits agency brokers offer clients.

With algorithmic trading now representing more than 60%

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Tony Whalley, investment director, Scottish Widows Investment Partnership (SWIP). ”A lot of agency brokers tend to be the smaller brokers and a lot haven’t connected to all the venues, so if we were to try and trade a large stock we would tend not to get such a good execution,” he says. Photograph kindly supplied by SWIP, June 2011.

Richard Balarkas, chief executive officer of Instinet Europe. “”We think there is a demand for corporate access services outside that provided by banks, because some companies would prefer to meet their investors without a bank analyst in the room,” he says. Photograph kindly supplied by Instinet Europe, June 2011.

the level of their risk position. Under Basel III the proportion of capital they must hold must equal 7% of their riskbearing assets. Many believe this will affect bigger banks which put up capital and some agency brokers believe it will lead banks to charge more in risk premiums.

Balarkas points out: “As a bulge bracket firm, as long as you have the ability to commit some capital and can trade reasonably effectively, you will win a share of the commission pool simply to pay for the bank’s bundled services. As a pure agency broker, we live or die by how well we execute, so there’s an argument that the level of technological sophistication is more important in an agency firm.”

Whalley concurs:“The benefits of agency are that it is pure and you know the only business they have will be natural business, not market-making. However, a lot of agency brokers tend to be the smaller brokers and a lot haven’t connected to all the venues, so if we were to try and trade a large stock we would tend not to get such a good execution.”

To combat this, some agency houses have ramped up their technology offering. So ConvergEx offers not only high-touch and portfolio execution for example, it calls itself “a leading technology firm, offering mission-critical proprietary software products and technology-enabled services”.

Meanwhile, Rob Maher, head of advanced execution services sales, EMEA, Credit Suisse, says: “The lines between

full service offering and agency have blurred. A lot of full service brokers offer competitive services which five years ago would likely have been considered agency-only products.

Algorithmic trading is one of them, for example.”

Agency brokers are increasingly eyeing the developing markets of Asia and in June CITIC Securities, a Chinese investment bank, announced it is to buy a 19.9% stake in Asian brokers CLSA and CA Cheuvreux to create a global institutional brokerage platform and an Asia-Pacific focused investment bank. A full merger of the two would in turn create a research-driven, agency-only equity house.

Jean-Paul Chifflet, chief executive officer of Credit Agricole SA and chairman of CACIB, comments:“Given the increasing cross-border strategies of our clients, this combination will allow us to consolidate CACIB’s equity model and to focus on our key international clients consistently with our medium-term plan.”

Global reach is one of the characteristics which will differentiate the winners and losers, as Tradebook’s Tierney, whose experience spans 30 years on both buy side and sell sides, concludes: “Agency broking is not taking over the world, but it is on solid footing. As long as agency brokers have global reach, a strong technology platform and excel in service—if you have those three things you are in a position to be an efficient partner with your client.” I

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ALGORITHMIC TRADING

Photograph © Artcp5 / Dreamstime.com, supplied June 2011.

THE CONSTANT BATTLE FOR TECHNOLOGICAL SUPREMACY In the world of high speed and low latency, both providers and investors seek the benefits of faster and faster tools and techniques. Tony Whalley, head of derivatives and dealing at Scottish Widows Investment Partnership (SWIP), says: “It is a constant technology battle as people bring in new metrics. They are all trying to get ahead of each other. There is always going to be change and algorithms will get smarter as people try to keep one step ahead and cast their net across different markets. It is just a natural progression.” As the marketplace becomes more electronic, it is becoming vital that everyone involved is armed with the most sophisticated and flexible systems and applications available. Ruth Hughes Liley reports on where it’s all heading.

ITH THE NEWS in June 2011 that high-frequency market maker Getco is providing institutional investors in the US with an algorithm for microexecutions, faster, more sophisticated trading tools have moved into the mainstream. “It is clear investors want tools to help keep them competitive in today’s rapidly evolving financial markets,” says Daniel Coleman, head of client services, who joined Getco in September 2010 after 24 years at UBS, where he had been global head of equities and a member of the investment bank’s executive committee. He says the algorithm, GETAlpha, will give customers “microalpha with reduced market impact”.

This is not something that all the buy side are demanding, however, and innovation in algorithms has been thin on the ground over the past year. Tony Whalley, head of derivatives and dealing at Scottish Widows Investment Partnership (SWIP), says:“It is not at all important for us to keep up with the speed of the high-frequency traders.

We are making investment decisions that we believe will deliver value in up to a three-year time period. Many buy

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side feel they do not want to trade against high-frequency traders, but they do provide liquidity so we are perfectly happy trading against them.”

Indeed, advances in algorithms are not just confined to the world of high speed and low latency. In January, Bloomberg Tradebook launched a portfolio trading algorithm which it says is the first to help traders automate global equity portfolio trading and is expected to appeal to small and midtier brokers. Connecting to 70 liquidity venues across more than 40 countries, it incorporates real-time currency rates to keep dollar neutrality. Traders can also set urgency levels and specify the level of aggression for seeking liquidity. Traditionally, portfolios are split across desks according to the individual stocks or currency-linked assets traded, which can involve expensive currency transactions across multiple time zones.

Similarly, Bank of America Merrill Lynch (BofAML) a year ago launched ETF-aX, an exchange-traded fund (ETF) algorithm which analyses market depth and price data across an ETF’s underlying portfolio to identify the most efficient combination of ETF, stock, and futures and then

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automatically trades them to source liquidity and find the best prices. “The primary challenge with trading ETFs is market fragmentation; liquidity is limited outside of the top-ranked ETFs,”says Charlie Whitlock, an execution consultant at BofAML. “By using ETF-aX, clients are able to leverage our in-house ability to trade a combination of the component parts in different markets, gaining liquidity at more efficient pricing.”

Whalley says such algorithms can make life a lot easier but should be used with care.“They are a glorified spreadsheet and so are slightly less important than the individual algorithm you are using for each stock. What you use for one stock is different from what you will need to use for another because each stock has its own individual trading characteristics.”

Richard Hills, global head of the quantitative electronic services team, Société Générale Corporate and Investment Banking (SG CIB), has seen algorithms develop in stages: “The first generation of algos made available to clients ten years ago were simple percentage of volume and timeslicing strategies. Then a few years later, the second generation introduced real-time indicators (such as index-relative movements and order book balance) as ways of identifying mis-pricing and being more dynamic in changing the participation rate. The third generation was concerned with market fragmentation, bringing in integrated and intelligent lit and dark routing techniques built on low-latency infrastructures. The next generation has even greater complexity built into the core engines that use ever more sophisticated correlation models to cope with persistent low volumes and volatility, which remains two to three times its historical norm. Plus, of course, clients are demanding ever more customisation as part of the service.”

It is a view subscribed to also by Tony Nash, head of execution services at brokers Execution Noble, now part of Espirito Santo Bank. He says: “Clients are much more tuned into the electronic space than they used to be and they like to know whose algorithms they are using and where they are trading. These days they can choose their algorithms, choose their strategy, but what they don’t do yet is choose their venue and I think in the next year or two we will see a lot more functionality to choose venues embedded into each algorithm. Clients will literally be able to tick a box for where they want to trade.”

Today’s algorithms are being programmed to think like traders, and SunGard’s acquisition last year of Fox River Execution brought to the company a suite of equity and exchange-traded fund algorithms using embedded “trader logic” that mimics the experience, logic and knowledge of a trader, says the firm.

Ron Santella, president of SunGard’s Fox River Execution, says: “We devote substantial resources to enhancing our core execution engine so that we can continue to deliver on our goal of best-in-class performance.”

Nonetheless, Hills points to the expense of keeping technology updated and says it is significant that the established players have cut back on investment. “The squeeze on the commission pool makes me wonder whether there is going

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Yves Charles, chief executive of technology company NovaSparks.

“High-frequency trading has moved the market towards higher execution speeds. As a consequence everybody is investing in lowlatency solutions to some degree. If you want to be competitive you can’t go back. Inevitably, two businesses with the same algo will compete against each other,” he says. Photograph kindly supplied by NovaSparks, June 2011.

to be a big move to next-generation algorithms after all. It seems like innovation has dried up with volumes,” he says.

SG CIB’s algorithms originate from their statistical arbitrage and volatility desks; that should come as no surprise, given that the firm is Europe’s number one in derivatives. Hills explains:“Three to four years ago, we took some quant traders and built a client-facing trading operation around our in-house quantitative trading techniques and software. They spend a lot of time on empirical observation of the market and adapting their trading models to support standard client trading patterns. This is a dynamic, ongoing activity that keeps pace with changes in the way the market behaves. That level of sophistication is what will drive algo innovation in the future.”

The innovation and customisation mix SG CIB’s new algo, Relative Value, looks at the correlation between the value of the underlying stock and the value of its index, or, optionally, sector. If the index is going up more quickly than the underlying stocks, then the algo will be aggressive for a buy order and passive for a sell order because the underlying stock is likely to revert to the behaviour of the index or sector. It then takes account of other factors to decide how much to quote or hit, where the order should be sent, and it factors in sophisticated anti-gaming technology based on continual measurement of venue quality. The algorithm is proving “very popular” with clients, says Hills, who claims it outperforms the VWAP benchmark.

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Rob Maher, head of advanced execution services sales for EMEA, Credit Suisse. “I wish we could say that every six months we release a new killer application, but that is simply not the case. It’s much more about continued innovation and customisation as clients are more familiar with the strategies and have unique requirements. Customisation is an important part of our business,” he says. Photograph kindly supplied

by Credit Suisse, June 2011.

Intricate correlation algorithms may be at one end of the spectrum, but even the humble implementation shortfall algorithm has been enjoying something of a return to popularity thanks to revisions and updates. Mike Seigne, Goldman Sachs’ head of electronic trading for Europe, says: “The passive strategy of our new Implementation Shortfall (IS) algorithm reduces risk by 37% and only increases cost by 2% when compared with VWAP. Many clients still think of IS algorithms as being overly aggressive front end-loading strategies with associated initial high-impact costs. With the IS benchmark continuing to grow in importance for our clients, we felt that focusing on finding smart solutions to match their needs would be helpful at this time.”

Meanwhile, Rob Maher, head of advanced execution services sales for EMEA, Credit Suisse, believes the concepts which underpin the new algorithms are similar to older ones.“I wish we could say that every six months we release a new killer application, but that is simply not the case. It’s much more about continued innovation and customisation as clients are more familiar with the strategies and have unique requirements. Customisation is an important part of our business.”

Indeed, customisation is becoming an assumed part of the process and some 63% of buy side traders consider it an important feature, according to TABB Group figures. This has involved empowering the buy side, according to Maher.

“There are clients who are technically inclined and want to know everything so they can do it themselves, but there are

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also a lot of traders who will explain their strategy conceptually and then have us do the legwork.”

Customisation is particularly important in Asia where brokers are jostling for position as they roll out new algorithms. Morgan Stanley, for example, has been running Algorithm Manager in Asia for a year. Using it, traders can switch an order between different algorithms depending on market conditions, time or quantity executed. “This is an important step in our goal towards providing clients with a full suite of customisable and intelligent trading solutions,” says Zach Tuckwell, head of Asia electronic trading, Morgan Stanley. “As the marketplace in Asia becomes more electronic, it is more important than ever that our clients are armed with the most sophisticated and flexible tools available to react to various factors and changes in market conditions.”

Meanwhile, in November 2010, Instinet launched its Execution Experts suite of ten event-driven strategies, specifically tailored for the Asian market. Glenn Lesko, chief executive officer for Instinet in Asia, says the algorithms represent the new breed of intelligent algorithmic trading strategies necessary in Asia. “Asia-Pacific markets have developed to a point that the simple algorithmic strategies historically employed here are no longer adequate. Exchange speeds and liquidity access have improved dramatically, and new venues are competing with primary exchanges across the region.”

Algorithms are moving from their traditional ground of equity trading into other asset classes. Trade-along FX, for example, is a Credit Suisse algorithm that allows the client to trade a stock in one currency, but settle in another.

Similarly, in March 2011, Morgan Stanley launched Fix, an over-the-counter algorithmic trading product, giving clients flow-weighted average pricing (F-WAP) in currencies. Fix estimates foreign exchange volumes taking into account intra-day liquidity cycles. “Products that address transaction costs in FX are a necessary tool for international investment managers and traders seeking best execution in the foreign exchange markets,” says the firm.

With a question mark over where algorithmic trading ends and electronic trading continues, one of the big issues is surveillance technology and TABB Group estimates that the percentage of expenditure on external solutions to monitor flow will rise from 28% of total expenditure to 35% in 2013 as brokers use and incorporate new third-party products.

Technology to deal with gaming Providing technology to deal with gaming is expensive and although firms are still investing and developing antigaming algorithms, Seigne at Goldman Sachs questions the concept of gaming. “When we think about protecting our clients from being ‘gamed’ we think about two basic ideas.

Firstly the idea that we need to protect our client orders from leaving footprints in the market that might allow other participates to predict what might happen next; secondly we think about protecting our clients from trading parts of their orders at prices that might be less favourable due to short-

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Glenn Lesko, chief executive officer for Instinet in Asia. “Asia-Pacific markets have developed to a point that the simple algorithmic strategies historically employed here are no longer adequate. Exchange speeds and liquidity access have improved dramatically, and new venues are competing with primary exchanges across the region,” he says.

Photograph kindly supplied by Instinet, June 2011.

Mike Seigne, Goldman Sachs’ head of electronic trading for Europe.

“We have also built into our algorithmic and SOR strategies the potential for us to use some of the same data signals other market participants use, in order to benefit our clients executions by using short-term timing and pricing discretion,” he says. Photograph kindly supplied by Goldman Sachs, June 2011.

term price spikes. We approach both of these concerns in several ways; with the core solution being centred on making sure our algorithm has more discretion to trade at times and prices that are favourable to it, rather than having to follow too prescriptively to a pattern determined by the market.”

Some brokers believe the perception of gaming and the reality of gaming are two different things and that it is responsible behaviour for the sell side to keep checking all the market data—legally obtainable information—to ensure they are looking after their clients’ orders in the most appropriate manner. Even high-frequency traders could be gamed by being run over by a large order, points out one broker.

market towards higher execution speeds. As a consequence everybody is investing in low-latency solutions to some degree. If you want to be competitive you can’t go back.

Inevitably, two businesses with the same algo will compete against each other. The one with the lowest latency will win the trade and profit. It’s not optional; it’s becoming mandatory to consider FPGA-based technologies for running a successful HFT business.”

So in April, NovaSparks launched an upgrade of its Field Programmable Gate Array (FPGA) circuit board, in which clients can embed their own algorithms, hosted within the appliance. The hardware has millions of logical parts, but is programmable in a very low-latency language—FPGA keeps latency constantly at 1.5 microseconds.

Charles says: “Non-HFT buy side businesses might continue to use software-based systems, but any HFT will inevitably have to move towards 100% hardware solutions such as FPGA.” Certainly, plenty of money is still being spent on technology, largely by the large broker dealers. Aïte Group expects the average capital markets firm’s technology budget to rise 6% during 2011, taking global spending to $44bn, rising to an estimated $51bn in 2013.

Whalley at SWIP sums up: “It is a constant technology battle as people bring in new metrics. They are all trying to get ahead of each other. There is always going to be change and algorithms will get smarter as people try to keep one step ahead and cast their net across different markets. It is just a natural progression.” I

Smart order routers built in Smart order routers are today routinely built into algorithms and Seigne says:“We have also built into our algorithmic and SOR strategies the potential for us to use some of the same data signals other market participants’ use, in order to benefit our clients’ executions by using short-term timing and pricing discretion.”

In the enthusiasm for launching new algorithms, the platform supporting ought to receive an equal amount of attention. With high-frequency trading strategies constantly resetting benchmarks for speed and lower latency, hardware rather than software processing is moving into the limelight as the technology of choice for running algorithms.

Yves Charles, chief executive of technology company NovaSparks, says: “High-frequency trading has moved the

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US TRADING ROUNDTABLE

DEFINING A NEW BUY SIDE/ SELL SIDE PARTNERSHIP IN AN AGE OF CHANGE

Photograph © Hechler, supplied June 2011.

Attendees

Supported by:

(From left to right) MATTHEW WEITZ, head of electronic sales & trading, Nomura Securities (Americas) DAN ROYAL, co-head of global trading, Janus Capital Group ROBERT KISSELL, executive director, execution & portfolio analytics, UBS JAMES B FRANCIS, director, Deutsche Insurance Asset Management ROB McGRATH, global head of trading, Schroders Investment Management North America Inc SETH HOENIG, head trader, Glenhill Capital

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THE FLASH CRASH: ONE YEAR ON & LESSONS LEARNT DAN ROYAL, CO-HEAD OF GLOBAL TRADING, JANUS CAPITAL GROUP: The Flash Crash was a bit of a wake-up call. It was probably on everybody’s radar that things were headed down a path where something like this could occur, though maybe not of this magnitude. People who were focused on market structures certainly anticipated something of this kind. Even so, it brought to light (to both the general public and regulators) that markets have changed and evolved into something quite different. What’s changed?

Obviously, some regulatory changes have occurred and rightly so. The Crash sparked a lot of discussion about market structure and about what’s right and what’s wrong. Whether we get to the right place or not, I don’t know. It has forced a lot of people to come to the table and express their views and try to understand market dynamics. Additionally, it has prompted many of us to strengthen our risk controls. With our algos, we now impose limits on adverse price movement on our order placements, whereby the order is paused if specific thresholds are breached. We also have certain requirements for explicit price limits on algos over a certain level of aggressiveness. That said, market structure is not fixed and still continues to go down the path of this arms race of technology and with that comes substantial risk.

MATTHEW WEITZ, HEAD OF ELECTRONIC SALES & TRADING, NOMURA SECURITIES (AMERICAS): As a sell side broker, we have been tasked with implementing additional pre-trade checks, for our own purposes as well as for the benefit of our clients. Between the Flash Crash last year and now, we have received several requests for additional pretrade checks from clients. Although most buy side accounts have clearly defined risk controls, they have put an additional onus on the sell side to provide even more. We have also noted an increase in requests for education about the controls we have in place to help our clients.

ROB McGRATH, GLOBAL HEAD OF TRADING, SCHRODERS INVESTMENT MANAGEMENT NORTH AMERICA INC: I believe none of us had any trades cancelled. Although no one could have predicted the Flash Crash, Schroders already had procedures in place to avoid issues associated with it; so we were prepared and could protect ourselves in such an event. We have circuit breakers in place and subsequently have applied limit up/down, which gives us the protection we need in the market. There were over 20,000 trades cancelled, though it seems few were from the institutional world. As such, while I feel the Crash created greater political awareness, I am not really sure if it is going to affect the way institutional desks do business. The biggest concern I have with the Flash Crash is the damage to investor confidence that resulted from it.

JAMES B FRANCIS, DIRECTOR, DEUTSCHE INSURANCE ASSET MANAGEMENT: Those of us in this room are aware of the dangers of technology moving too fast, both for the market and for users. While technology is generally a very good thing and can remove some ineffi-

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ciency, it can at the same time also create some very scary inefficiency. Right now, over the last year, there is an awareness of new technology among the investment community which perhaps didn’t exist before the Crash.

Hopefully over the long term we’ll see some permanent regulation that at least requires sell side oversight for clients that still do not perhaps fully understand the cause of what did happen and what might happen again.

SETH HOENIG, HEAD TRADER, GLENHILL CAPITAL: I am more concerned about some of the players in the box and how that situation will evolve over time. I am not a micro-market structure expert. I manage a desk and I have to worry about different asset classes. I am concerned that 50% to 55% of the volume today is high-frequency trading (HFT). Rob talked about the arms race in regard to latency and co-location. There are many jobs that are a second and third derivative of the HFT business in IT. I was taught the business in an old-school fashion and there is a very seasoned group of people in this room that understand what the business was like back then. I'd like to see us get back to that world a little bit where we can simplify things; maybe widen bid ask spreads, tighten up liquidity on the nickel increment and get some of these guys out of the box. Apparently that’s going to mean a lot of people will lose jobs with regard to HFT, however the high-touch business could thrive again.

ROB McGRATH: There is some data that I think you may find interesting. It appears 98% of US stock tickers have not had a significant change in their trading volume over the past few years. So when we examine high-volume trades, we are only talking about 2% of the names involved.You can probably guess what most of those names are. The point I am trying to make is there hasn’t been a significant change in volume in the overwhelmingly majority of tickers over that period of time.

SETH HOENIG: Since the proliferation of HFT, you’re saying that volumes are essentially flat over the past six years?

ROB McGRATH: On 98% of the names. Robert can you confirm that?

ROBERT KISSELL, EXECUTIVE DIRECTOR, EXECUTION & PORTFOLIO ANALYTICS, UBS: Yes I can. Your point can also be further illustrated if we just look at the S&P500 index. If we take the top five or even ten most-traded names we find that they account for about 20% to 25% of the total volume in the S&P500, and that’s a big index. Of course, many of these are lower-priced stocks.

However, once you start getting down to lower levels of liquidity, these percentages and levels have been pretty stable. We have not seen the big bumps in volume that we would expect if there was that much high-frequency trading.

DAN ROYAL: Actually, I think it comes down to the way in which HFT affects this business and the staggering amount of money that is involved at every level. Taking into account trading profits and exchange fees, technology spend and the impact on regional real estate, this business is not likely to go away anytime soon. Regulating technology isn’t feasible. You can, at best, try to create a level playing field.

Exchanges, having gone public, have become very efficient at extracting revenue from many facets of this business.

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Efforts to attract low latency activity and maximize revenues through rebates, order types, co-location and information dissemination has in some cases put the institutional participants at a potential disadvantage. Yet it is going to spread globally and it is going to spread across additional asset classes. I don’t necessarily think you can stop it, but you can (somehow) try to put institutions and HFT at least on a little bit more of a level playing field and, potentially, take some of the economics out of it.

MATTHEW WEITZ: One of the things that the Flash Crash brought to light is that as a sell side provider, we need to make sure we are aware and adept to the HFT community's role in the market place as we assist with serving buy side orders. This level of service requires we make a huge investment in technology to help the buy side achieve its trades and keep pace with the HFT crowd. I agree with Dan, it is a technological arms race and we cannot change that fact. Even so, we continue to adapt and evolve our product offering to keep pace with our clients’ needs, offering them flexible customisable solutions that enable them to conduct their trades safely.

ROB McGRATH: There have always been traders trying to figure out our activity. Today trades are being done very quickly electronically.Years ago, it was done more openly on the exchanges, so I feel like it still comes back to understanding the market structure and using it to our benefit in order to protect ourselves accordingly. It also makes buy side traders more strategic to the investment process.

THE EVOLUTION OF THE BUY SIDE/SELL SIDE RELATIONSHIP ROBERT KISSELL: Traders have a high comfort level with our offerings and algorithms. Algorithmic trading products have also allowed us to be more available for our clients. In the past, as traders, we had been spending so much extra time trying to manoeuvre complex markets. Now, we can spend the time partnering with our clients to ensure that we are meeting their needs in the best possible ways. Many of the micro level or order submission rules require answers to a new array of questions. For example, how should we best source liquidity? Should it be via limit order or market order?

If limit, what is the appropriate price point and what is the right size to post? Also, what’s the best destination to route the order, exchange, displayed market, or dark pool, and where would I be in the queue? What do I have access to, and what don’t I have access to? Nowadays, with computers addressing these issues, we are now able to address what is happening in the market in real time and are able to make changes to the algorithms based on real-time changing market dynamics, prices, and liquidity. Naturally enough, we are likewise expanding our TCA execution consulting services for clients and connecting a lot of dots with research, and interacting better across different areas of trading, programme, cash, and algorithms.

JAMES B FRANCIS: It has been interesting to see the evolution of technology and the consequences of its expansion. Currently we do not use DMA directly, but we

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Matthew Weitz, head of electronic sales & trading, Nomura Securities (Americas). Photograph © Hechler, supplied June 2011.

trade with sell side programme desks that use algorithms to implement our baskets. A trading desk that was initially all high-touch in terms of servicing the buy side is today something very different, providing a broader menu of services that combine high and low-touch coverage. These days I see the sell side trying to better themselves to the point where they are able to still make money from designing algorithms, making their technology better and educating their clients. It is still a critical relationship but it has inevitably evolved to where it is necessary for the sell side to protect their client base from themselves. Sell side desks realise that they need to do a much better job with research, with technology, and also oversee the process with their client because the buy side desk itself has also evolved over the last decade. It used to be that you talked to your broker, you gave them your order and they’d execute. Now it is more like: “Well I am going to use DMA and I’ll be working my order with the following algorithms throughout the next hour.” At that point all the risk of the transaction is sitting on my desk and not with the sales trader that I am speaking to. Therefore, I do need to be educated to a higher level in the ways that this technology works because it can be very dangerous when it’s placed in inexperienced hands.

MATTHEW WEITZ: James has made some good points. If you look at the interaction between the sell side and the buy side, the level of detail in conversations around smart order routing, order placement logic, and algorithmic tactics is much more granular than it was three to five years ago. The level of detail and transparency that the buy side demands from the sell side is very different these days. For its part, the sell side offers transparency and if someone wants to choose the types of liquidity their orders interact with (i.e. dark pools), we can provide that as well. We routinely provide clients with a list of the venues we access, the way we access each venue, the rationale for choosing one venue over another, a description of how our smart order router works, and so on. These detailed conversations are pretty common nowadays, whereas a few years ago they were one-offs.

DAN ROYAL: The partnership has certainly grown and is only going to become more important. However, I think we have enough brokers and enough saturation in each category.

It also seems we are on the cusp of what might become a technological arms race and that could solidify the partnership between the buy side and the sell side. To Rob’s point regarding customisation, you can build something that’s great, but if it doesn’t suit my needs it means nothing and it doesn’t solidify our partnership. Customisation around my needs versus Rob’s, versus Jim’s or Seth’s needs, can be (potentially) something different in each case. The ability to develop more specific, more detailed and more intelligent products moving forward creates opportunities for some partners to win and potentially leave others behind. Yet, it creates a commitment to technological

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spending that is not suitable for everyone. This technological commitment combined with the trusted high-touch relationship, capital commitment, risk transfer and so forth, will define who survives in the long run.

SETH HOENIG: If there is anything from the Flash Crash that can be viewed as positive, it is that we have been forced to become more intelligent about market structure. When something bad happens we need to be able to learn from it.

The market structure consulting business at the sell side firms has grown exponentially because of this need for understanding. The sell side has been a huge help to us in this regard.

WORKING WITH AND AROUND HFT SETH HOENIG: There are a lot of smart people in the box that are fighting against me, that are looking for my electronic footprint and to scalp off me, so I need to implement the best anti-gaming logic on the street. The only other way that I can protect myself is to educate myself, and to randomise my execution behaviour. I've always been a feel player. If I see something that is not working I will send a lot of cancel/replaces. I will try to be as random as I possibly can and be on top of anti-gaming logic. Moreover, I tend to work extremely passively, even when we have a large order. Is the stock coming to me? Is it working against me? Is the strategy working? I might even switch broker sponsors. However, there is one question I pose to the table. Matthew alluded to the fact that you need to spend money in order to be competitive. We used to live in the world of microseconds for example, and now we route in nanoseconds. The question is: how can I beat the high-frequency players on speed? If it is a latency race, that’s okay (and I am assuming most broker- sponsored routes are not co-located at exchanges in the same fashion HFT is). Even so, how can I beat them to liquidity if they are just going to beat me on speed every single time?

ROBERT KISSELL: I am going to frame my answer around Dan’s comment that customisation is different for every fund.

I don’t want to get into a best execution discussion, but I’ve always viewed best execution as not only how close I get to zero slippage from my benchmark, but also as a means or process of determining which strategy is going to provide me with the highest probability that I will implement my investment objective within my expectations. Now that’s something that is definitely going to change from fund to fund, from PM to PM, from trader to trader, and also from day-to-day. First, I recommend we look at performance and evaluate the degree to which latency is affecting overall performance. Then let’s look at what we are trying to accomplish. Say you have a limit order or a price limit. The logical follow-up questions are: is this limit price right for the fund? More importantly, is it right for the overall execution of the order? What is it that we are trying to accomplish with the price limit? In other words, is the price limit in place as a means to define the algorithmic strategy or is it in place because the portfolio manager is unwilling to accept prices outside of this range—these are two different questions. We can also talk about volume limits, and then that drills down to where we execute and how

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Seth Hoenig, head trader, Glenhill Capital. Photograph © Hechler, supplied June 2011.

much we execute? We should always take a step back and look at the investment objective and select the optimal trading strategy or trading algorithm. Many of these questions are also based on an alpha signal—the amount of shares you need to trade and your urgency level.

SETH HOENIG: That’s what I am talking about. You also have the luxury of internalisation; you have a lot of internal flow that you can pair me off with. I wasn’t looking to compare you on speed; I just know how fast these players are. My concern is how do I compete with them? I just wonder how can I be as fast as they are (HFT) in this environment? I can't beat them on speed myself.

MATTHEW WEITZ: Actually, we can help you win in two ways. Because we have co-located our smart order router at various exchanges, for instance, we can help you compete very effectively with the high-frequency traders on speed. We can give you that edge. Second, we can customise trading solutions so that when we help you make a trade decision, it is based upon venue and investment objectives. Now that the markets have become more nuanced, perhaps even more complex, effective trading support requires enormous infrastructure, and it is costly. Fewer and fewer people can really play in this space and so, as we mentioned earlier, it is bringing the buy side closer to those firms with better capital, better technology and better understanding of how to interact with the HFT crowd and help you beat them.

ROBERT KISSELL: We are starting to hear more about smart order routers and co-location with the high-frequency trader in mind. If you are not a high-frequency trader and you are constructing a market-impact model just based on your own trades, it is going to be biased towards your investment goals and trading style since it will only be looking at what you have done in the past. If you are also using another party, such as a broker-dealer model, which has a large cross-section of different traders and investment objectives, and more order flow, that model will allow you to perform high-level sensitivity analysis. It lets you ask: what if I didn’t trade this way?

What if I deviated from my strategy? What if I try something I have never attempted in the past? However, if you constructed the model based only on what you have done in the past, you are really not well positioned to answer those types of questions because statistically speaking it is out of sample and does not allow you to evaluate alternative scenarios.

Now, let’s relate that to a smart order router and highfrequency traders who are always trading in a certain manner.

This creates the same situation as a market-impact model.

They are interested in learning if their approach is the best. It might be for them at times; but there is no way for them to determine if they should try something different or deviate due to market conditions, because they do not have any data points available to evaluate alternative scenarios that may provide useful insights. A full experiment for HFT to

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determine accurately the answers can be extremely costly and resource intensive. Let us look also at a broker-dealer smart order router. The major brokers are all co-located, so this is not a large concern any more. The biggest advantage here is the large and abundant dataset available to train the smart order router and allow for full sensitivity analysis. We can accurately determine the best path for execution. Because of the amount of flow that we are seeing, we are able to better answer these micro-order questions and determine the appropriate plan of attack. However, if you are just that single trader and always trading in the same manner, it is hard to know what benefits could potentially arise if you kept an order in the market a little longer than you have in the past or if you routed to a completely different venue. In the end there are trade-offs, and advantages for both ways.

ROB McGRATH: I don’t feel like we are necessarily competing against the high-frequency traders but we do need to fully understand the cost of interacting with the liquidity they provide. They operate under a completely different investment horizon than we do. We are longer term.

Therefore I think that if we better understand the cost, we can make a better decision whether to access that liquidity or not.

DAN ROYAL: The only thing I want to mention regarding Seth’s point was along the lines of consulting. Again, we have this technological arms race whereby Rob may be winning one day, and Matt’s winning it another day, and somebody else is winning it another day. At some point if somebody builds a better mousetrap, the technological advantage is short-lived, meaning someone replicates it six months later.

The differentiation in the equation is a consultant to the partnership. Those who truly align themselves with the institutional client, to educate them and give them good advice, help them navigate the markets, yet limit the economic conflicts, should flourish. We all have partners out there that have potential economic conflicts in terms of their pool participants, their routing practices or their risk book. Sometimes you sense that you are getting the story that that they tell the institutional client, and here’s the story they tell the HFT client.You have to sift through those structures at some level to help determine the plausibility of those stories. In that respect the execution consultancy part is very important.

MATTHEW WEITZ: The consultation process is now integral to the trading process and it involves a high level of trust. You are reviewing and analysing different order flows and the spectrum of trading venues that the client is interacting with and it can become very specific. The client can be profiled to interact with only certain types of order flows for example and can review the execution stats on a daily, weekly and monthly basis. The consultation process brings clarity and transparency to the trading process. You can see who the client is trading against, or whether his/her trades were crossed on the exchange or in a particular dark pool.

Once you have that depth of understanding of the type of flow your client wants to interact with and the trading strategies that best suits their requirements, it requires a high level of mutual trust. You really want to make sure that the folks you deal with are folks you trust.

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ROBERT KISSELL: When we talk about high-frequency trading I just want to categorise where the concerns are.

First, there are market makers who are continuously buying and selling stocks at the bid and offer and are providing liquidity to the market. They are also more eager now to net out their positions by the end of the day rather than holding overnight risk. So they may account for more trading around the close. Second, there are the statistical arbitrage players who are always in the market, looking for price discrepancies across products: either between futures and the underlying, inconsistencies across ETFs, pairs trades, and so on. With more instruments in the market there are more arbitrage opportunities, so these traders may potentially account for a little more liquidity. Now, these two parties are very often described as high-frequency traders, because they are in and out of the market, but there’s a signal and/or a reason they are trading. These parties are not trying to gain any knowledge of anyone’s trading. Third, we have the new era quants. These are the same participants who used to be the longer-term quant funds, where they run quantitative models at night and then come in the next morning and know what to buy and sell over the day. The next night they run the models again and the buying and selling process starts all over again. Now, however, due to computational power, the availability of real-time data, access to market exchanges and venues, these players are able to run their models every hour, half-hour, ten minutes, five minutes, or even quicker. It is allowing them to make better real-time investment decisions based on their models as well as implement those decisions. I wouldn’t necessarily say that this third group is hurting the market either. They are trading, trying to earn a return, just like the traditional, long-term investor based on a structured approach. The fourth category of high-frequency traders are the rebate traders. These are the players who are willing to provide liquidity only when it is in their best interest to do so and in most cases are seeking to earn the rebate plus the bidoffer spread. These are the parties who are also looking to infer information about the trading intentions of others by watching the tape and real-time order flow hoping to uncover some buying or selling signal. These rebate traders are those high-frequency players who we find participants are most worried about, because they feel these traders are jumping in front of their orders and causing them to get less favourable prices. This is important, because much of my research has also focused on the TCA side looking at trends and the evolution of trading costs. If you look at what those costs were pre-2007 (before these four categories of faster traders emerged) you find that trading costs are lower now than they were then (after holding size and volatility constant). There have been a lot of studies showing that those costs have been decreasing, some of it is better market structures, some of it is more efficiency and increased competition across brokers.

Now even if high-frequency trading accounts for say 50% of the market volume, we have to ask if it is having such a dire effect on fund performance by pushing trading costs up as many would lead us to believe. The market definitely appears to be a more efficient trading environment now—even

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looking at how that volume has changed and how these new categories of traders have emerged.

WHAT MAKES A GOOD SELL SIDE BROKER DEALER? IS THE BUY SIDE CHOICE OF BROKER DEALER TOO BIG OR TOO SMALL? JAMES B FRANCIS: For us, the relationships are usually very long term in nature and we have a fairly small pool of sell side trading desks that we speak to. The buy side/sell side relationship has so many aspects to it, and of course best execution is going to be number one, and, as Matt said, transparency is becoming more and more critical; whom we are facing up against and so forth. A sell side desk must keep up with the latest technology so that they are able to optimise our baskets versus our benchmark and ensure best execution. They must also have some sort of research capability that we can benefit from. I don’t necessarily see the scope of the relationship itself narrowing, in fact I see it broadening; but I do perhaps see a narrowing of the field going forward because the firms that purely specialise on one aspect of the business may begin to get forced out by the firms that have deep resources and can approach the relationship from several angles.

DAN ROYAL: I guess at some level today’s big boy could be tomorrow’s little guy and vice versa. So you never really want to burn bridges when you are on the sell side. You manage your resources accordingly and hopefully there’s some trajectory to it. At some level, to Jim’s point, there are a lot of pieces of the puzzle and components to a relationship. Algorithms, technology, the quality of a relationship in a hightouch world, research, and corporate access, and other things are all part of that. Also at times multi-asset class relationships play into it as well. That said: there are likely too many brokers out there and too much saturation within broker types.

There’s certainly a need for niche players, there’s certainly a need for a bulge bracket, there’s a need for all types out there, there are just too many in each space at some level. This again could be on the cusp of something that truly is a consolidating factor, but, yes, I do think at some level there is consolidation, because the costs have probably gone up exponentially. I mean you guys would know better than I would, but the cost to stay in the game certainly has increased, certainly commissions haven't gone up, and people will likely get squeezed out, and it will be tough to survive exclusively, in a high-touch environment, on relationships alone.

VENUE CONSOLIDATION: HOW INEVITABLE IS IT? ROBERT KISSELL: While we have been talking about contraction for a while now there are actually more venues, exchanges, and dark pools than, say, a couple of years ago. Each venue is offering a different level of pricing, services, and access. What attracts participants to one venue over another?

A lot of it comes down to the customisation of the offering and

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James B Francis, director, Deutsche Insurance Asset Management.

Photograph © Hechler, supplied June 2011

the value of the service. If I was trading for my own fund, I’d use a combination of lit exchanges and dark pools, market and limit orders, and appropriate order routing logic. Even so, there will be times when based on my investment objective I would be actively seeking liquidity and in this case would utilise the displayed markets and use market orders more often because I may be more sensitive to potential price momentum. Other times, my investment objective may not be as urgent to implement and I may utilise dark pools more often and seek to capture the spread via limit orders. Additionally, I may shift the allocation of my shares across venues or change my order submission and rules if I observe that I am interacting with the high-frequency rebate traders, in order to better disguise my trading intentions. Other times I may want to limit my executions to certain venues. What then will ultimately determine if there’s going to be contraction of exchanges or venues? It is likely going to come down to the main need of investors and the flow of liquidity. Is the number of venues available, lit, exchanges, dark, etc, sufficient enough for the various investment objectives of investors? This will be one of the primary drivers of the number of venues. Next, if liquidity is still scattered or fragmented across market exchanges but with consistent patterns and high predictability then this is not necessarily bad and may not force a change because in the US everyone is pretty good at, for the most part, solving that fragmentation problem through smart order routers, probability models, micro-placement rules, and with co-location. Now, if liquidity starts shifting towards a smaller subset of venues, then that will force change, but I don’t know if that will happen quickly, slowly, or stay at the levels we are now.

SETH HOENIG: It is becoming extremely Darwinian in the sense that if you don’t have the resources, then you can't attract flow. Also, if you do not change your pricing model as aggressively enough as the next exchange, then we are back to what Robert was talking about: either you are going to trade, or you are not. If you are incentivised to trade on a venue because it lowers your explicit costs, do you understand where you are going? Is it in your best interests? From that perspective then, those smaller guys who do not have a more aggressive pricing model on the destination level are going to drop off a little bit, and inevitably we are going to see consolidation.

Whether that’s good or bad, I don’t know. I’d like to think that less fragmentation makes my life a little bit simpler.

ROBERT KISSELL: I just want to clarify: I don’t necessarily feel fragmentation is bad. Sure, there is fragmentation, but there is some predictability on how much is going to trade and at what locations. And these trading patterns are more stable now than a few years ago. Additionally, a few years ago dark liquidity was dark liquidity. If two parties were continuously routing to various dark pools there was a chance that they would keep missing each other, where there was a potential cross in the dark you may have just

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Rob McGrath, global head of trading, Schroders Investment Management North America Inc. Photograph © Hechler, supplied June 2011

missed the opportunity because the order flow into these pools was not very consistent. Now for the most part, dark pool liquidity has become more predictable, more stable.

There is a much higher likelihood that two parties with potential matches will meet in the same dark pool because participants have learned when and how liquidity is attracted to these pools. Fragmentation is only harmful for investors if liquidity patterns in these pools are not stable enough for us to manage. If there is stability, then there is a certain volume that will be in each venue at a certain point in time.

This allows me to better structure trades, achieve better prices and help improve smart order routing capabilities.

SETH HOENIG: So because of your predictability model, fragmentation is a moot point because you know where to source liquidity?

ROBERT KISSELL: That’s some of it, yes, and from a couple of years ago you’d see even more variation in performance. If you looked at two parties; one day you do terrifically well, and one day you wouldn’t. Now today you know where liquidity is going to be so you are not getting those lower performance days and you are not getting those terrific performance days, you are getting somewhere in the middle. But executions are more consistent across days. So that’s why I am saying that fragmentation isn't necessarily hurting us right now and I don’t mind it at this level, because stability is higher now than it was previously. And it is the stability that matters more at this point.

MATTHEW WEITZ: We have seen the proliferation of execution venues, the contraction, and then proliferation once more. If you go back to late 2000/2001 you had a number of ECNs and ATSs. Then they consolidated to three, and now if you include all the dark pools, exchanges and ATSs, we are north of 40. The barrier to entry for new venues, from a technology perspective, has gone down substantially. Europe is experiencing similar trends. The market over time will dictate what the right number of venues is.

Moreover, to Rob’s point earlier, liquidity is what we are all after, so people are trying to become creative in ways to attract it. We have seen this trend with inverted pricing models; venues can go from no market share to significant market share. The real challenge comes into play when determining good liquidity or bad liquidity at that particular point in time. That’s when the choice of your broker and their routing methodology can be a real differentiating factor.

JAMES B FRANCIS: Seth’s description of it being Darwinian is a good one. What is happening is that everything related to trading is rapidly evolving, and there are many moving parts in that evolution. The one thing that does not change from my point of view, however (and I do not think that it ever will) is that, no matter what boxes I have sitting on my desk, I still do not know what each person around this table is trading on any given day. We are still blind to each

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others’ order flow. We know that every day in the markets is different and that we choose our algorithms and trading strategies based on our experience and we can speculate on the activity that is going on around us. That’s the best we can do. We might observe some consistency of activity over time, and then all of a sudden that consistency goes away. So now we have to rethink our approach. In other words, the market is constantly redefining itself every day, or every month, or from one year to the next, and we still can’t look through to each others’ trade lists. I would not be surprised if a couple of years from now technology will have taken us to a new place where we have very few destinations again until it splits up and we then have many venues five years from now.

DAN ROYAL: I look at the maker/taker model as being one of the core components that might not necessarily be in our best interest from an institutional perspective. If you remove maker/taker, or you cap it, you begin to level the playing field and would expect to see consolidation among the venues. Is that a good thing or bad thing? The difference between 43 venues or 21 venues likely has little impact on liquidity. Many of the lower tier venues offer no advantage in seeking liquidity, yet increase the risk of information leakage. However, if you take away those venues and you take away these economic incentives for somebody to act in a way that’s not in our best interest, then you begin to level the playing field. Some HFT participants exist because of rebates, and we have brokers that make routing decisions because of rebates.Yet those decisions might not necessarily be made in our best interest and simply made in the best interest of their P&L. Yet in light of current structural conditions, it is important to find the right partners.

ROB McGRATH: I think we need to be flexible and market structure experts. Given that we can make better decisions regarding the most efficient way to trade our flow.

TRADING VOLUME: WILL VOLUMES COME BACK? ROB McGRATH: In 2008, volumes were approximately 9.8 and then roughly 8.8 last year, now 7.8 so far in 2011. My numbers might be a bit off. The point I would like to make is the names that contribute disproportionately to that level, and the volumes over that period of time, represent 2% or 3% of the US names. That means these swings haven’t affected us very much and I do not necessarily care about overall volume.

DAN ROYAL: The number was 6% that will come out of the market.

ROB McGRATH: All right, so there’s a good example.

Does that really affect the whole market, because they did a reverse split? I don’t see that. It probably hurts the highfrequency traders, because that’s where they play, but for me as an investor I don’t necessarily think it is a problem.

SETH HOENIG: It is a good point: 55% of daily volume is HFT. These guys go home flat at the end of the day. That means that half of that volume is in and half of that’s out. I would say 2008/2009, that was crisis volume. There was a lot of de-risking; a lot of deleveraging. Volume for the first four months of this year was down 15% year-over-year. The

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street’s quiet and I find myself gravitating more towards equity derivative desks and having cash and derivatives coverage from one single point of contact. I want to speak to somebody who can add a third dimension to the day. There is going to be a little bit of consolidation and a convergence of desks, in my opinion. I like talking to intelligent people who generate ideas when things are slow. I am in a very unique and fortunate situation, being able to trade other asset classes and speak to certain people, but I don’t understand why I can't have a single point of contact street-wide; it is not impossible. There is no reason why the cash desk cannot have derivative and convert delta cross their desk and call up a client and be able to tell them what they are seeing.

It must be that we are going to evolve there. I think that is how the sell side is going to fight back and I am very confident that they are going to do it. I believe in it.

MATTHEW WEITZ: The markets and clients will dictate appropriate coverage. Key relationships exist across various product groups and teams. Clients will determine—based on the level of service provided—the required number of people associated with coverage. The relationship is the driving factor, and the sell side will provide the appropriate monetisation channels. It will take a little bit longer to get there, but I agree with Seth, this will continue to evolve over time.

DAN ROYAL: The volume in an institutional world is dependent upon asset flows, market direction, conviction, and activity that surrounds the investment decision. I suspect a fair amount of low-latency trading exists because of the institutional activity. While HFT may provide significant volume, it does not necessarily provide suitable liquidity. Ultimately, institutions will find each other in the market, yet we go to great lengths to minimize the impact of those attempting to leverage our activity for their profit. Volume will come back when people start buying mutual funds and start investing in equities. To the point of what is the sell side doing to survive going forward in a lower volume environment, I can only reiterate Seth’s point about multi-asset class and smarter coverage, which is likely the direction we are going to go. You want to be able to talk to somebody that can look at things holistically. The markets are certainly much more correlated than they’ve ever been, and you need people that can speak to that at a macro level. Do I honestly want my equity guy doing my foreign exchange trade yet? Probably not, I’d still prefer to talk to an expert at the transaction level, but it is sort of the level of coverage, dialogue, and idea generation that is important.

ROBERT KISSELL: A real important takeaway is what Seth was saying about a single point of contact, and as an execution consultant that’s great feedback. It is not so much about strategies; it is not so much about dark or lit market allocation, or programmes or electronic trading. The need here is a single point of contact and how can we continue to add value, address your needs, and just hearing that idea generation is valued and really helpful. I will speak on behalf of execution consultants: we do really listen to the needs of our clients, and we are proactively trying to address them.

JAMES B FRANCIS: In terms of changes in trade volume there have been a lot of really good points already made. For

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Dan Royal, co-head of global trading, Janus Capital Group.

Photograph © Hechler, supplied June 2011

me, lower volume is about increased risk aversion in the markets, and a lower frequency of fund rebalancing by portfolio managers. For the buy side, trading is a cost, not a benefit; as a quant fund manager if I don’t see enough alpha in my trade, then I tend to avoid a rebalance. I also see the industry moving more toward a “best ideas” approach to rebalancing, where only the obvious winners and losers will be traded, rather than a full portfolio rebalance; this can also contribute to lower volumes. We witnessed higher volumes in 2007 as investors chased higher returns, then again in 2008 with the subsequent flight to quality. Lately I see investors being more thoughtful about portfolio turnover before going to the open market.

HOW MIGHT THE MARKETS EVOLVE OVER THE NEXT FEW YEARS? MATTHEW WEITZ: We have seen that to service clients’ needs you need to invest in systems and infrastructure, and you need to ensure you stay current with market structure and technology. I also think that as an overarching theme there’s a capital markets business associated with what we do. So, to Dan’s point: there is corporate access, and there are other elements which factor into the equation. Technology allows us to monetise the idea generation associated with execution. Consolidated coverage models work because you have more information readily available at your fingertips.

Technology enables that.

DAN ROYAL: If you take a look at the race to low latency, I have to ask: how much further can we go? You get to nanoseconds and there must be something beyond nanoseconds but I am not sure it really matters. Of course, technology does play a role in that there is going to be some type of a new mousetrap that allows us to look at things differently. Our ability to connect true liquidity points in a technological environment and at some point create this wholesale market of institutional liquidity is maybe the direction that we have to go at some point. Moreover, it is likely led by technology. High-touch services, tackling capital commitments, and all that stuff is still going to remain but I see at some point technology replacing some portions of that. You are seeing it already with some broker dealers offering capital commitments in an electronic environment and they have managed to hold their head above water and do okay with it. People have responded, but not necessarily with the understanding that it is truly revolutionary. Even so, that direction will probably be the next big thing.

JAMES B FRANCIS: That's absolutely right. It is a struggle to predict where technology is going to take us in the next five to ten years. Who would have thought even a few years ago that just about everyone would be carrying around a smart phone, dependent upon it for just about everything? We’ve all

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got one and now we can even get real-time security pricing on an iPhone or Blackberry. As for sell side trading desks, looking ahead you’ll likely see more consolidation in the way buy side desks are serviced; particularly in the case of larger brokerage firms. Trading desks will need to consolidate their operations because of a growing collaboration across business lines such as consulting, research, trading, and sales. A sell side firm is going to have to be able to do just about everything, and do it very well, and evolving technology will bring them to that point. Sales traders will still be necessary, of course, because you still need people there to manage and coordinate all of these functions to ensure seamless coverage. Moreover, the sell side will be instrumental in guiding us through the use of new technology. In the future I hope that we see an improvement in transparency, via regulation and technology, and that transparency will give us a greater ability to source liquidity around the world. Globally, I see the potential for 247 market operations; in other words, an end to the idea that markets must open at 9:30 am and close at 4:00pm. Equally, the rest of the world should not be restricted to trading in daylight hours, either.

SETH HOENIG: To Dan's point about the race to low latency, at some point as you approach zero you are going to shake some people off just because of the capital costs and you will have consolidation. History tends to repeat itself.

One of the most productive times of my day happens to be the 11:30 auction in Europe. The funny thing about it is that such a huge chunk of the day's volume on any particular mid to large-cap European name is in the auction, and this seems so efficient to me. I can pick my price, I can go in and I know that there’s going to be liquidity and I know I am not going to be alone. Not that we are all going to revert back to big opens and big closes, but maybe at some point, we can get down to crosses again or deeper pools of liquidity at set periods of time. I know it sounds very basic given where we are technologically but, in its simplest form, the auction market is almost as pure as it gets. I’d like to see some of that come back. If history is going to repeat itself, maybe we can bring back some sort of an auction process.

JAMES B FRANCIS: Do you think though that maybe that auction doesn't necessarily have to happen at those market hours? In other words, there could be a US auction that takes place overnight so that everybody can have access. I know that it has been attempted but right now where everything has become so much more real time and globalised, technology has brought us to the point where you can potentially throw out the hours that markets are supposed to trade.

MATTHEW WEITZ: With some of the exchange consolidation it is clear that existing exchanges want to attract liquidity back into their market centres. We are seeing some creativity emerge around that trend, and the introduction of crossasset exchanges are part of that process. Then obviously brokers will respond to that and you’ll see the evolution of technology once again starting to play a role in overall efficiency and price discovery. Equally, as exchanges consolidate, with fewer pure equities exchanges, by the very nature of the evolving market, you will see people becoming increasingly

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Robert Kissell, executive director, execution & portfolio analytics, UBS. Photograph © Hechler, supplied June 2011

innovative or creative around liquidity and price discovery.

SETH HOENIG: Can I just throw one thing in there? I feel like I have enough of a challenge between 9:30am and 4pm.

If we are going 24 hours, aren't we headed in the wrong direction? If we could tighten up the hours and concentrate the liquidity to fewer points in time then maybe we could find more volume.

MATTHEW WEITZ: Hong Kong is a great model in that regard. It is two hours of trading and then there's lunch and then there is another hour of trading in the afternoon.

ROB McGRATH: We will operate under any rules but currently we are set up to trade optimally for today’s environment. Schroders is currently set up to deal with global time zones, with trading desks in each region so we can access liquidity in any time zone. If requirements were to change, if it went in another direction, we would obviously revamp the way our trading desks are set up. One last point: I hope to see the industry move to providing more transparency. For example, currently we all basically know the venues were we execute and we are fed back that data in real time; however, we still do not know where our orders are shown and that is equally important for us to know. In a particular algorithm, you don't know where the trade is shown and NOT executed, so I hope that the technology will quickly advance to that point. The regulators are discussing getting involved in that as well because it is hard for us to require the brokers to provide that information.

MATTHEW WEITZ: So Rob, you are interested in the order route prior to getting execution? How many times was it routed and how it was filled or where it did not get filled, is that right?

ROB McGRATH: That's right, that's very important, and the cost of that.

DAN ROYAL: Seth is right, in terms of liquidity and expanded markets, at some level you are taking maybe a finite set of liquidity and you are spreading it out over an extended period of time so actually your points of liquidity are more diluted.

ROBERT KISSELL: Should we shrink the day; should we expand the day? I sometimes like the simplicity of having concentrated liquidity. I know there are funds preparing themselves in the event that we move towards 24-hour trading, but I honestly think that is a tough one. Expanded hours will likely result in increased fragmentation and decreased stability around trading flow. Another concern is the lack of predictability, which usually leads to decreased performance. A move towards 24-hour trading, therefore, also needs to come with benefits that we cannot get now, such as multi-regional trading capability, or the ability to trade in one region and clear at home. The market is just starting to scratch the surface of these issues. It is not easy answer to find answers right now, but it is very exciting to see it evolve. I

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Like it or not, the provision of securities services will undergo a substantive transformation over the near term (one to three years). Adjustment will be the result of a confluence of trends. These include a raft of incoming regulations, a new wave of market consolidation, changes in the clearing and settlement landscape and, most importantly perhaps, a continuing review by client groups of their overall business models, with all the attendant changes in the relationship between client and provider that entails. If that wasn’t enough, there has been a shift of a still discrete, yet substantial slug of western investment dollars into high growth/advanced emerging, emerging and frontier markets in search of high investment returns to help fund gaps in pension benefit schemes. The combination of these elements is in turn helping what securities services providers can or should realistically provide in a global context. It's a lot more than you think. Francesca Carnevale reports.

Photograph © Billdayone / Dreamstime.com, supplied June 2011.

TRANSFORMERS AINT HEARTS CAN no longer win global custody/ fund administration accounts; a natural consequence perhaps of the meeting of creeping market complexity and the sometimes onerous demands of regulators. Steve Fradkin, president of corporate and institutional business at Northern Trust, concedes that change today is much more than skin-deep:“Let’s put this in perspective: we have lived with change in this business for more than 30 years. While there is a lot of talk of regulation and technology that is intersecting with the global custody offering these days, it is the latest link in a long chain of evolution.” Nevertheless, the magnitude and rate of change has undoubted accelerated, he says:“Let’s take the hedge fund segment as one indicator. In 1990 there were approximately 600 hedge funds handling some $39bn in assets; by 2010 these figures had escalated to 12,000 hedge funds, with $2.5trn under management. That growth is equivalent to 16% CAGR, which invariably creates a series of stresses across our business.”

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Volume is not the only driver of change; regulation is creating its own dynamic.“In developed markets, custodians are being asked to accept greater liability and risk as a result of both regulatory and market changes. Global custody is, increasingly, being regarded as including a fiduciary function.

In addition to this, the increasing usage of collateralisation and centralised clearing requires that the agency nature of custody is maintained for the protection of both custodians and investors,” notes Richard Fodder, senior vice president and head of BBH’s London office.

Moreover, while providers must now follow investment firms as they seek returns in foreign high-growth markets; but it is still a mixed business model. Most providers agree that new business growth is not about blindly following money; but about following money smartly in those markets where the local agent infrastructure is reliable and/or where establishing green field operations makes financial sense. Moreover, there is a cautionary note behind the reticence that many

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houses have towards wholehearted commitment to overseas expansion. Some 80% to 85% of assets stay in home markets; there is still a noticeable bias for, say, pension funds to invest in companies they know,” says a leading custodian provider.

BNY Mellon, for example, has spent as much time expanding operations in traditional markets such as Germany, with the purchase of BHF Asset Servicing from BHF-BANK and Sal Oppenheim Jr & Cie, as they have rolling out of greenfield initiatives throughout Asia and Latin America. That pragmatism is recognition of the ubiquitous relevance of a business equation that computes both cost and complexity: in other words, it has equal resonance in home markets as it does in more exotic markets.“Continuing fragmentation of the European market remains challenging,”cedes a leading securities services provider, pointing out that it is still several times more expensive to execute in Europe than it is in the United States. Equally, he notes: “Clients now understand that global custody can cost up to three times more in emerging and frontier markets than assets that stay at home. Clearing and settlement is more fragmented. Tax regimes can be onerous and there may be ownership restrictions, as there are in countries such as India and Taiwan, which require detailed oversight to ensure that foreign exchange positions do not result in even temporary overdrafts, which in India can be problematic.”

Not everyone is dismayed by the inevitable march of costs as the securities services offering becomes more customised and varied. “Regulatory and market changes will undoubtedly introduce the requirement for greater identification and recognition of costs and risks and therefore likely to follow through into the pricing structure for global custody services. This is quite healthy and will produce a greater transparency in the value provided by custodians to underlying investors,” says BBH’s Fodder.

Nuanced approaches One of the most significant changes which benefit clients is the recognition by service providers that one shoe doesn’t fit all-wearers. After years of debate over the relative value of customised versus commoditised services, the big favour that globalisation has done for the buy side is instill in the sell side that a highly tailored service set is now de rigueur for any self regarding custodian provider.

Robert Ward, global custody product executive for the EMEA region at JP Morgan, thinks that the natural flow of business is tending towards a two-way dependency in this regard, where the truly global service provider offers clients end-to-end support in whichever markets they require, while the client relies upon and “recognises the growing knowledge set or expertise that only a true global provider brings to bear, particularly for those clients with a mandate to invest internationally”.

Invariably then, as market complexity, regulation and business volumes intertwine, says Northern Trust’s Fradkin, the provision of securities services becomes multi-layered, or “multi-streamed”as he describes it, and thereby much more nuanced. It is a theme that Paul Stillabower, global head of

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Steve Fradkin, president of corporate and institutional business at Northern Trust. “Let’s put this in perspective: we have lived with change in this business for more than 30 years. While there is a lot of talk of regulation and technology that is intersecting with the global custody offering these days, it is the latest link in a long chain of evolution,” he says. Photograph kindly supplied by Northern Trust, June 2011.

business development at HSBC Securities Services espouses with alacrity:“Of course, it all depends in what space you are playing in. Providing local fund accounting to onshore funds covering 15 different markets in a region such as Asia is very different to providing global custody to institutional investors in Asia. And this is different than the alternative hedge fund space, which tends to operate out of key centres such as New York, London, Singapore and Hong Kong; for example with funds that are often domiciled elsewhere. Proprietary insurance is another proposition entirely, and has very deep and specific requirements around GAAP and IFRS accounting. Settling a global custody trade in the US, Canada and Europe is not an issue; but handling settlement and accounting in some Asian, Middle East or South American markets is a very different business indeed.”

The nature of the beast is such that Stillabower at HSBC posits that only a handful of global providers can now stay in the game and provide support to both global clients and a discrete but emerging local asset management industry in the emerging markets.

With that duality in mind, both Stillabower and others speak to the modern-day requirement where both having a global network and a balance sheet to fund it is “mission critical”. For Stillabower, it is about understanding the dynamics and specific requirements of individual markets and having “sustained” experience in marrying local

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The challenge is managing that precarious balance that custodian providers often refer to as “acting global, thinking local” effectively. It increasingly speaks to a unified service set; where an increasingly broadening spectrum of services that encompasses transfer agency, fund accounting, depot bank services, derivatives clearing is wrapped into a consistent service structure, which offers clients a better deal in total.

For specialist players, it is an approach that has application and creates “client stickiness” in individual as well as regional markets. For example, Dinesh Kanna, head of transaction banking India & South Asia at Standard Bank, agrees that for service providers offering a one-stop solution for a complete suite of products is now mandatory for winning new business from customers looking for cost-efficient service provision, particularly in high-growth markets, where demand for increasingly sophisticated services is growing rapidly. Kanna points to Standard Chartered Bank India’s recent mandate to provide fund accounting for 15 singlemanage schemes within the ING Mutual Fund vehicle, involving the calculation of over 60 NAVs daily, as typifying the trend. The deal is also the bank’s first fund accounting mandate for a mutual fund in India.

The importance of technology Paul Stillabower, global head of business development at HSBC Securities Services. “At a very practical level it is providing either local managers with the support they need in trying to figure out how they will co-exist with UCITS funds; and then on the other side helping a global management firm distribute a UCITS structure in appropriate markets,” he says. Archive photograph, FTSE Global Markets.

knowledge with the requirements of global and local asset managers. “At a very practical level it is providing either local managers with the support they need in trying to figure out how they will co-exist with UCITS funds; and then on the other side helping a global management firm distribute a UCITS structure in appropriate markets.”

“Standardisation, automisation and rollout of global technology platforms play an increasingly important part in the global custody offering and delivery as volumes and complexity increase. As volumes increase in emerging markets, players are showing an increasing willingness to embrace standards and technology,”says Fodder at BBH. He explains that the bank has seen this most recently in Asia, where it has been working with Taiwan distributor banks to streamline fund messaging through the bank’s Infomediary® platform by converting fax-based order flows into industrystandard format messages and transmitting them over SWIFT. “The initiative has seen a great take-up and is being backed by the Asian Fund Automation Consortium (AFAC),

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Robert Ward, global custody product executive for the EMEA region at JP Morgan. “I posit there is still space in individual markets for strong local players. It could be a single market, or a sub-regional market,” he says. Photograph kindly supplied by JP Morgan, June 2011.

whose members account for approximately 80% of Asia cross-border fund flows,” claims Fodder While emerging markets show all the signs of adopting best practice and are rapidly moving to meet the processing standards extant elsewhere, ultimately they benefit from the ability of the large service providers to either develop or acquire cutting-edge technology which they can then roll out on a global basis. Fradkin explains this thinking is behind the Northern Trust’s recent acquisition of Omnium from Citadel in a deal expected to close in Q3 2011.“The result is a unique opportunity to scale a world-class business,”explains Fradkin.

While Fradkin believes that technology and market consolidation favour the larger players; none remain on their laurels and all cede that new entrants may come in and tip over the proverbial apple cart. “As the investors in the emerging economies seek to diversify their interests and invest on a cross-border basis, the product of global custody will need to be distributed far more widely, giving the opportunity for banks in those emerging economies to add this to their client proposition. In terms of ensuring they have a competitive product, a manufacturer/distributor model may well be more appropriate than building from scratch,”notes BBH’s Fodder.

“Clearly the costs of creating and maintaining a highlycompetitive global custody product are very high and we have seen consolidations in the industry driven by the desire for cost saving in the manufacturing process. However, offering

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a global custody product is an opportunity for many banks to provide a complete value proposition to their clients as well as driving incremental revenues with other associated products. The alternative of not manufacturing the custody product and rather acting as a distributor of a ready-made custody offering is a very viable and increasingly attractive one,” he adds. Ward at JP Morgan does not think the dynamic is a fait accompli. “I posit there is still space in individual markets for strong local players. It could be a single market, or a sub-regional market.” Even so, while Ward thinks that most robust financial institutions could potentially get up a rung on the securities services ladder, the very top end of the business will remain strictly governed by size and balance sheet considerations:“We are increasingly being required by regulators and clients to deploy that strength,” he avers.

However, Stillabower at HSBC states: “The ‘barriers to entry’ is somewhat over-stated. There are strong local banks that have deep penetration in some high-growth markets.

This business is about who owns the client and who is providing services that the client values. If a local bank in a market is providing a broad array of banking services, like financing and distribution, to a local client and they are helping that client grow, they will likely stick with you because they value these services more than custody or administration,” he explains. In addition, some markets, such as China, are so attractive to outsiders that the local banks offer a strong inbound proposition. “There is definitely a push from clients wanting to enter China and some other high growth emerging markets,” he says.

While clients now benefit from a much bigger value chain, as service sophistication matches the increasingly diversified and complex investment activities of clients, it looks to the outsider that this act in the overall play of securities services provision is only a staging post. For Fradkin, there is much in the future which has yet to be revealed, simply because of the sheer range of regulation that will begin to impinge on the global markets.“Dodd Frank, MiFID II, AIFM, Basel 2, UCITS IV; it is a long and growing list and there will be unintended consequences as the regulatory pendulum swings one way and then the other.”For other providers however, the crux is whether the economies of the immediate post-financial crisis world will encourage banks to review their commitment to the asset servicing business segment.“We have recently seen a number of exits, and we have benefited from some of them.

I would not be surprised to see us enter another round of consolidation and change which will continue to refine the global securities services infrastructure.”

For Stillabower at HSBC on the other hand, it is the deepening of the global capital markets and the emergence of a more sophisticated and discerning investor, which has specific market-based demands that will be a motivator of change. Whichever forces bring most change to bear JP Morgan’s Ward believes it is incumbent on providers to anticipate and help establish the most appropriate infrastructure and risk management elements that will support clients in their global search for improved investment returns, “whether that be at home or abroad”. I

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The Russian government has set its sights on becoming a major global financial hub by 2020 but industry participants believe the date could be a moving target.

Untangling the red tape and modernising the market infrastructure could take longer than expected. Progress is being made and there is hope among custodians that the proclamations made in 2008 will be turned into concrete edicts.

Lynn Strongin Dodds reports on the possibilities and probabilities of success.

Photograph © Sergey Drozdov / Dreamstime.com, supplied June 2011.

RUSSIA EDGES NEARER POSITION OF POWER HE CAMPAIGN TO elevate Russia’s status to that of a leading financial centre as well as transform its economy was launched by president Dmitry Medvedev three years ago, though until recently, the wheels of change were moving at a glacial rate. The pace has accelerated over the past six months but the main constraints on meaningful change continue to be a stifling bureaucracy, the lack of a central securities depository (CSD) and an endemic culture of corruption.

This view was underscored by a recent report by consultancy firm Oliver Wyman, which canvassed 260 leading Russian and foreign entities between February and April 2011. The general consensus was that Moscow has a long way to go before reaching the same lofty status as leading centres such as New York or London. Respondents cited the rule of law as a key area in need of regulatory reform, noting particular deficiencies in combating corruption and prosecuting economic crimes. They also wanted to see a single CSD, increased market liquidity and improved transparency. Russia was 154th out of 178 countries on Transparency International's 2010 Corruption Perceptions Index.

Other areas that needed to be reformed were the ability to trade across markets, tighter corporate governance and a broader investor base. The overriding belief was that tackling these issues properly would significantly raise investor confidence and help reduce the "Russia discount" relative to other emerging markets. Despite booming oil prices, this naturally resource-rich country experienced $21bn of capital outflows in the first quarter of this year. Russia has lost ground to other members of the BRIC club.

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“There is a somewhat lower level of interest in Russia in relation to the other BRIC countries and it is losing investments to Brazil, India and China because of its weak market infrastructure,” says Lilla Juranyi, global head of investor services, ING Commercial Bank. “There have been improvements but it has been relatively slow. I do think though that the merger of the RTS and the MICEX is a good sign and could be the first step in creating a single central securities depositary.”

Mathieu Maurier, global head of sales and relationship management at Société Générale Securities Services (SGSS), adds: “As the financial crisis proved, Russia is linked into international capital inflows and outflows and it needs to be more dynamic in attracting international investors to its home market. Too much of the liquidity is in the DR [depository receipts] market in London and not in the home markets.”

Maurier though is “very optimistic that the country is moving forward with modernising its infrastructure”. He adds: “It is always difficult to put a fixed date on Moscow becoming an international financial centre because things will take time. I will say that I have seen much more activity and discussions in the last six months than I have in the whole three years that I have been here.”

“We have definitely seen a step up in the impetus behind creating a financial centre. Instead of people talking about what they will do, they are talking about what has been done and starting to do those things," says Matthew Grabois, head of sales and relationship management, Central and Eastern Europe (CEE) and Commonwealth of Independent States (CIS), BNP Paribas Securities Services. “Part of the

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reason is that the right people are in place, such as Ruben Aganbegyan, who is now the president of MICEX. He comes from an investment background (a former chief executive officer at Renaissance Investment Management) and is helping to move things forward, such as the merger between the two stock exchanges.”

The tie-up between MICEX and RTS which was announced in February is slated to make its debut in midJuly although this is not set in stone. The newly-combined entity will bring together RTS's strong derivatives franchise—the tenth largest by number of futures and options traded in 2010, according to figures produced by the Futures Industry Association—and MICEX's equities business. MICEX accounts for around 80% of equity volume traded in the CEE and recorded $408bn in value of equities traded last year. Overall, MICEX currently comprises 65% of all Russian instruments traded globally while RTS has a 20% market share. Russian depository receipts that are traded internationally comprise the remaining 15%.

One of the most important features is the amalgamation of RTS’s Depository Clearing Company (DCC), the private sector CSD, and MICEX’s National Settlement Depository (NSD), the government-controlled CSD and clearing house, as well as state-owned VTB Bank, the de facto CSD for approximately 80%-90% of MinFin bonds.“The settlement system is an important element in how investors judge a market,” says Juranyi. “This is because the CSD with harmonised and clear procedures offers a much better perception in terms of risk than a country without one.”

Fragmented market Alexei Fedotov, head of securities funds services for Russia and the CIS at Citi, agrees, adding: “One of the biggest challenges for custodians has been the fragmented nature of the market and the split of liquidity which makes the market less efficient. There is the RTS, MICEX and over-the-counter markets, and each one has its settlement cycles and procedures. The hope is that the merger will not only make trading easier but also be the catalyst for a single CSD which will help streamline the settlement process, making it more efficient, faster and cheaper.”

To date, the disparate settlement landscape has meant that some of the transfer of share ownership occurs within securities depository systems while others take place through registrars, particularly for US fund managers, which have to comply with US Securities and Exchange Commission (SEC) Rule 17f. This covers the safeguarding of assets of US investors held abroad and requires pension plans and fund managers to keep their shares with registrars rather than depositories or the local branches of global custodian banks.

The bottom line for a custodian or broker is that the completion of the transfer of ownership of shares is a complex and time-consuming process. It typically means an operations staff member must actually visit the registrar, deliver the transfer document, wait until the registrar generates the paper confirmation and then travel back to Moscow. That process can take as long as five days if the registrar is located

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Alexei Fedotov, head of securities funds services for Russia and the CIS at Citi. “One of the biggest challenges for custodians has been the fragmented nature of the market and the split of liquidity which makes the market less efficient,” he says. Photograph kindly supplied

by Citi, June 2011.

in Moscow and more than two weeks if it is outside the city.

The prospect of a single CSD is not the only encouraging sign that Russia is making headway. On the international stage, the government is calling for companies to align themselves with international accounting standards and looking to incorporate the rules of Basel II and III to improve banking transparency. Although it is formulating its own framework, it is tapping the counsel of the global financial community. Luminaries such as Lloyd Blankfein, chief executive of Goldman Sachs, Jamie Dimon of JPMorgan Chase and Steve Schwarzman, co-founder of Blackstone, will sit on a newly-created advisory financial group. Moreover, stalwarts such as Citi and Société Générale are part of various working groups and sub-committees that are looking at best practices as well as the nitty-gritty details involved in forming a single CSD. “We are looking at a range of different issues such as how the CSD will interact with all market participants (including the registrars), the parameters that need to be set and how it will be regulated,”according to Maurier of SGSS, which looks after both international and local clients.

On the domestic front, amendments have been proposed to the tax agent functions such as switching from brokers to custodians and there are plans to further liberalise the bond market. Equally as important are the changes to the rules around the foreign nominee ownership concept which is currently not recognised. According to current regulations, only a licensed resident professional participant of the securities market may act as a nominee holder. This denies the rights those holding assets through custodians would have

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Mathieu Maurier, global head of sales and relationship management at Société Générale Securities Services (SGSS).“The financial crisis proved that Russia is linked into international capital inflows and outflows and it needs to be more dynamic in attracting international investors to its home market,” he says. Photograph kindly supplied by SGSS, June 2011.

under European or US financial systems. To help alleviate the situation, the “local nominee concept” was developed.

According to Juranyi: “This allows the local licenced banks to register the assets of clients under the nominee name of the local agent bank. It means that the names of the beneficial owners will not be reflected in the registrars’ books. To improve the settlement efficiency, the local custodians, including ING, have established the ‘bridge’ among themselves, meaning that the final settlement is much quicker and cheaper than going through the traditional external registration of transactions in the name of the beneficial owners. However, the investors are waiting for the next steps to establish the foreign nominee concept as well.

Documentation requirements, especially in Russia, can also be cumbersome not only for the underlying clients but for custodians as well.”

Another challenge being tackled is the processing of corporate actions. “Although the consolidation of the stock markets and prospect of a single CSD is important, we are also seeing talk of the harmonisation of corporate actions,“ says Juranyi. “Today, there is no central source of information or standardised processes. Small improvement in that respect would increase the attractiveness of a market.”

Goran Fors, global head of custody services at SEB, which focuses on clients in the Nordics, Baltics, UK and Germany, adds: “The lack of transparency does pose operational risks particularly on the corporate action side. Our clients look to us to use our tools to find the information. Sometimes that is difficult if a corporate event is not announced properly.”

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Against this evolving background, the expectation is that subcustody will evolve into a broader asset servicing product offering. Currently, there are a handful of players operating in the region ranging from the international players such as Deutsche Bank, Citi, Société Générale and BNP Paribas, who can leverage the depth and breadth of their global offering, the more regional players including ING, SEB, Unicredit and Raiffeisen plus local banks such as VTB. While the names may stay the same, the products will not.

“I think the merger of the stock exchanges, the creation of a single CSD and changes to foreign nominee ownership will create a different figuration of services,”says Fedotov of Citi, which caters to both the international and local asset management community. “At the moment we offer all products tied to custody and settlement but I expect that to widen in the future.”

Maurier adds: “To date, our services cover local custody and settlement for both local and international investors (global custodians, banks, asset management firms and corporates). We are also acting as local investment funds depository (trustee). Currently, there is no opportunity on the market for fund administration services because local asset management firms are responsible for calculating their own net asset value (NAV). As a result, I do not see for now that function being outsourced to a third party although I think as the markets develop there will be a broader range of instruments that will be traded and as a result a greater depth of products required.”

Juranyi also notes that clients are “increasingly looking for more sophisticated levels of reporting”. He adds: “We provide mainly custody and related services such as settlement, asset protection and segregation, full-scale asset servicing but we are seeing more compliance and risk management questions from clients in relation to the new regulations in the US and Europe. Russia may not be a member of the European Union in the short run but it tends to follow the principles of the European Union.”

Looking ahead, the one cloud hanging over the government’s goal to rival London and New York is the outcome of next year’s presidential elections. As Fors notes: “There is a strong will to push through the regulations but there needs to be the political will.” Grabois adds: “There has been enormous pressure to make things happen and although the foundations have been laid particularly with the merger between the two stock exchanges, things could slow down though if there is a change in the government” There have not yet been any official announcements, with Medvedev recently stating that he “does not rule out the possibility” of running again while his predecessor Vladimir Putin, now the prime minister, has been quoted as making the same statement. Russia’s main opposition leaders (including Mikhail Kasyanov, Boris Nemtsov, Vladimir Ryzhkov and Vladimir Milov) are also expected to throw their collective hats into the ring. They have recently signed an agreement to form a new coalition named "For Russia without Lawlessness and Corruption”, although the chances of toppling Medvedev or Putin are slim. I

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SECURITIES LENDING

AN ALPHA-GENERATING PRODUCT DRIVEN BY DEMAND Once viewed as an operational service tied to custody, securities lending is now widely recognised as an investment product. Similar to asset management decision making, beneficial owners today focus more on process, attribution and performance measurement as part of the agent selection process. In the immediate aftermath of the financial crisis, many lenders suspended or curtailed their programmes.

Subsequently, the vast majority of those lenders have re-entered the market and some are entering for the first time after having spent much of 2009 and 2010 evaluating the practice, programmes and partners.

These market events and participant reactions have shaped the evolution of the industry with a variety of trends and new considerations. Brooke Gillman, managing director, client relationship management at eSecLending, outlines the trends.

ECURITIES LENDING IS the process by which securities are temporarily transferred on a collateralised basis by one party to another for a fee. The market formally developed in the 1970s when US custody banks began lending securities on behalf of their institutional clients, including pension funds, insurance companies and endowments.

Launched initially as an operational mechanism for covering sale fails, securities lending has since evolved and is now widely recognised as a part of the investment management process allowing institutional investors to earn incremental returns on their portfolios (in other words, increase alpha).

Securities lending is a long established practice and according to statistics provided by industry data specialist Data Explorers, the balance of securities on loan exceeds $1.8trn globally. Securities lending plays a significant role in today’s capital markets as it contributes to overall market efficiency and liquidity.

The market for securities lending is driven by the demand of investment managers, large banks and broker/dealers and their hedge fund clients around the world. It is a critical element of hedging and risk management for trading and investment strategies and also helps facilitate timely settlement of securities. Beneficial owners participate to achieve incremental returns on their portfolios and increase overall performance (increase alpha) for portfolio managers. The view of securities lending has changed significantly over the past several years and particularly following the credit crisis.

When properly planned and executed, securities lending is a low-risk investment strategy. However, since all investment activities involve some risk, lenders should consider certain potential associated dangers, primarily under the

S

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Brooke Gillman, managing director, client relationship management at eSecLending. Photograph kindly supplied by eSecLending, June 2011.

counterparty, collateral, operational, and tax/legal/regulatory headings. These risks are not unique to one provider and should be properly managed regardless of programme structure or provider.

Supply continues to return to the market following the credit crisis, though at a faster pace than demand from borrowers, primarily due to regulatory uncertainty and balance sheet constraints. Lendable assets for the industry increased 13% year over year during 2010 while on-loan balances rose by nearly 6% according to market statistics from Data Explorers.

Interestingly, today’s levels can be compared to those levels experienced in 2006 and 2007. Hedge funds have, historically, been a large source of borrower demand although today they are leveraged at a level between 5% to 10% rather than 30%-plus pre-crisis. They have been mostly net long; however, that bias is likely to change over time as hedge funds look to outperform benchmarks and traditional asset managers. The chart opposite shows hedge fund strategies as of March 31st, 2011 which shows that hedge fund dedicated short bias accounts for only 0.2% of activity.

Beneficial owner views evolve Revenues have also reverted back to 2006/2007 levels.

However, the strength of demand/returns can vary considerably by asset class and lender type. Corporate earnings have been strong, which typically leads to increased mergers and acquisitions, dividends and share buy backs. These events all positively impact a beneficial owner’s potential securities lending returns. Emerging markets are also an area to watch for significant revenue opportunities. Many of these markets

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have growing economies, a large investable base, multiple constituents, good liquidity and passively-held investments, which are all positive attributes of profitable securities lending assets. While loan utilisation is typically lower in these markets, the spreads are wider and can be substantial.

Beneficial owners increasingly view securities lending as an investment management product rather than custody service.

In light of this, more beneficial owners are unbundling their custody, securities lending and cash collateral management providers with the goal of achieving a best-in-class approach for each competency. In addition, they are incorporating the use of multiple providers and routes to market for greater diversification and benchmarking. Similar to asset management decision making, beneficial owners today focus more on process, attribution and performance measurement as part of the agent selection process.

Greater customisation These days, beneficial owners seek greater customisation around trading strategies, collateral, reporting and risk management. Counterparty and collateral risks continue to be the primary areas of concern. However, there is an increased awareness and desire for education and guidance to boards and management. Fund portfolio managers are increasingly involved in the decision making process and many fund companies utilise a committee-based approach to oversight to include representation from risk, compliance, operations and portfolio management. Product sponsors have also evolved since the credit crisis. Today they are typically either the board of directors, given that they view it as a shareholder value product, the portfolio managers who are seeking to capture alpha, or the fund administrators who often own the oversight but liaise with the Board.

For many beneficial owners accepting cash collateral, particularly pension funds in the US, the cash collateral management component surprisingly can be a fund’s largest investment manager commitment, at times summing to billions of dollars in exposure. This part of the securities lending mandate is now being evaluated more carefully and often independent from the securities lending part of the transaction. Lenders are utilising a best-in-class approach when selecting managers. They are realising that securities lending encompasses two separate and distinct skill sets; lending (financing and repo activity) and collateral management (investment management function of cash).

Beneficial owners are now more focused on generating returns from the lending component (in other words, intrinsic earnings) rather than potential returns from the reinvestment of cash collateral. With a risk/return discipline, lenders are able to generate meaningful intrinsic value while maintaining a conservative, short-term and liquid cash collateral reinvestment strategy where applicable.

For those beneficial owners seeking to re-enter or enter the market for the first time there are several considerations to evaluate, all of which can be accomplished through the assistance and guidance of their service provider. This includes the need to understand the scope of the revenue opportunity

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

Hedge funds: current sector weights 5.2% Managed futures

20.6% Long/short equity

12.9% Multi-strategy

19.9% Global macro ro 0.2% Dedicated short bias 5.1% Fixed income me arbitrage

1.6% Convertible arbitrage Co

25.4% Event drivenn

2.1% Equity Market Neutral Equ

7.0% Emerging Markets

Source: Dow Jones Credit Suisse Hedge Fund Indexes, supplied June 2011.

provided by securities lending and how earnings can be attributed. It is vital to accurately gauge the key constituents’ level of understanding and provide continuous education.

Equally it is incumbent upon the beneficial owner, with the guidance of their provider, to define their program strategy, whether that is incorporating minimum spread thresholds, focused on value or general collateral lending, focused on volume, or a combination of both. The collateral management strategy should also be included in this review and evaluated frequently. Utilising best in class providers is a trend that is increasing which is why beneficial owners should regularly evaluate unbundling of custody, securities lending and collateral management.

Both parties must address key constituent sensitivities and agree to operating guidelines and parameters. Moreover, beneficial owners should understand the incentives involved; the alignment of interests is critical in this regard, and they should work with the securities lending/agent provider to eliminate or minimize real and perceived conflicts of interest, particularly with affiliates.

Strong oversight policy Clearly, all this points to the need to establish a strong oversight policy; and one that is committee based is highly recommended. In this way, securities lending is treated as any other investment product, with independent benchmarking of performance, risk, service measurements and so forth.

Securities lending is now widely recognised as an alpha generating investment product with risks similar to any other investment product. Beneficial owners are increasingly looking for customised programs built around their unique risk/return parameters and goals. They will continue educating themselves on their programs and options and practitioners are dedicating resources toward promoting sound securities lending practices and enhancing the industry’s understanding of the product.

There are many opportunities for those lenders who take a proactive approach to understanding the product and their program as there are more options and program structures available to them than ever before. Agents can be successful at capitalising on these opportunities if they are nimble and responsive to evolving client needs. I

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ASIAN TM

Changing investment patterns have not always translated into an increase in revenues for transition managers but they signal the further development of TM in the region. The financial crisis has not been the only catalyst, according to Richard Surrency, head of Asia Pacific transition management at Morgan Stanley. “Asian institutional investors were looking at risks in a more holistic way before 2008 and 2009. They have always been interested in integrated risk management systems and were looking at transition management as an integral part of this process.” Lynn Strongin Dodds assesses the developments.

MAJORS TARGET ASIA T MAY BE in the nascent stages of development, but this has not stopped the industry heavy hitters from trying to make their mark in Asian transition management. The landscape is getting ever more crowded even though activity is still limited to a handful of countries.

Their hard work and patience should be rewarded in time as institutional investors are increasingly becoming more comfortable with the process.

“The competition is as stiff as anywhere else,” notes Kal Bassily, managing director and head of global transition management, ConvergEx Group, a financial software and technologies firm. “There were not that many players five years ago but I believe the trends we have seen in Europe and the US before, will happen here. This is why it is so important for any transition manager who is serious about the business s to have staff on the ground and adapt their service to the local market.”

Mark Keleher, chief executive officer of Mellon Transitions Management, says:“The most active providers in Asia are often the global financial firms. This is because sovereign wealth funds will only do business with firms that have an international reach and broad range of capabilities.”

It is no surprise then to see the same cast of characters jostling for position in Asia as in Europe and the US. There are the asset managers such as BlackRock and Russell Investments, the custodial banks including BNY Mellon, JP Morgan and State Street, and stalwart members of the brokerage community—Citi, Deutsche Bank, Morgan Stanley, Goldman Sachs as well as ConvergEx Group,.

Just as in Europe and the US, the lines between all of these providers have blurred and the same debates are taking place over the merits of the different models. The buy side will claim that having project management, trading through third parties and pre and post-transaction measurement under one umbrella is preferable to using an

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investment bank, which is seen as creating potential conflicts of interest through trading a client’s assets with or against those on their own books. The banks argue that this is not the case especially as many have spun off their proprietary trading desks. They claim they are well placed to access liquidity and offer tools to help clients map out the best strategies as well as time frames to facilitate transitions in a risk-controlled environment.

The emphasis on relationships in Asia may make the divisions between the firms less significant. Although an important component in any region, in Asia, they can be long lasting provided the transitions go smoothly. Relationships tend to be binary so you have to get it 100% right, 100% of the time,”according to Tom Clapham, Asia head of transition management at Deutsche Bank. “There is no tolerance for any type of operational error, which is why the project management of the transition is even more important in Asia than elsewhere.”

Justin Balogh, senior managing director at State Street Global Markets, also notes that transition managers are being asked to play a more advisory role.“Clients in Asia are not just looking for a pure transactional element but also advice as well as portfolio construction research and analytics.”

Regardless of the relationship and a provider’s prowess, there are still only a handful of countries as well as client types transition managers can peddle their wares to. “The client pool is more concentrated in Asia because it does not have an extensive private pension structure,” says Duncan Klein, head of transition management Asia and Japan for JP Morgan.“This means that the industry is looking to provide solutions to similar client segment sets—the central banks, sovereign wealth funds and pension funds, among others.”

As for countries, Australia boasts having one of the most advanced transition management industries in the world.

The country is thought to account for the lion’s share of the

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Photograph © Svetap / Dreamstime.com, supplied June 2011.

region’s business followed by Japan. There are no concrete figures on the size of the transition management business in the region, but anecdotal evidence suggests that estimated flows range from around $15bn to $45bn.

Hong Kong also has an established industry but several asset owners still prefer to conduct their own transitions. For example, the Hong Kong Monetary Authority—a potentially large customer for transition managers—will often call upon its internal team to manage transitions.

Leaving Japan and Australia aside, “the business in the Asia Pacific region is highly concentrated in Hong Kong, Singapore, Korea and Taiwan,” explains Clapham.“We have not seen that much activity from countries such as Malaysia, Thailand and Indonesia. They have not grown to be as big a part of the business as we and the industry expected. The same holds true for mainland China and the QDII (qualified domestic institutional investor) funds. However, we expect that this will change in time.”

John Moore, executive director, investment services, Asia Pacific, Russell Investments, adds: “Countries in the region are at different stages of development. On the whole I would say that Asia is at the same place that Europe and the US were ten years ago. It also has different drivers. For example, the majority of the deals in the US and Europe were generated by defined benefit pension plans but in Asia, it is being driven by large pools of government and quasi-government authorities.

Klein also believes that “while transition management in Asia is in a growth phase, it is not being fully utilised because the region is fragmented with different regulations and cultures”. He adds: “There are different levels of acceptance as well as understanding about what a transition involves. However, this is changing with education and the region's growing sophistication. As a result, we have seen a pick-up in demand on the back of improving market conditions.”

A spurt of activity in 2009 was triggered by the stock market collapse which saw sovereign wealth funds as well as other institutions reviewing their portfolios and switching strategies as well as underperforming managers. This pace

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

has kept steady since and mandate sizes are growing. Balogh notes:“Immediately post-crisis institutions were focused on smaller mandate sizes, but this is changing due to improving liquidity, particularly in the fixed-income space. It does though depend on the jurisdiction with countries such as Singapore and Hong Kong being more active.”

The financial crisis though has not been the only catalyst, according to Richard Surrency, head of Asia Pacific transition management at Morgan Stanley. “Asian institutional investors were looking at risks in a more holistic way before 2008 and 2009. They have always been interested in integrated risk management systems and were looking at transition management as an integral part of this process.”

The other shift, albeit gradual, has been the move away from a domestic bias to a more international outlook. While fixed-income comprises the bulk of the transitions, Asian pension and sovereign wealth funds are broadening their horizons. “One of the ongoing trends that we have seen is the gradual diversification of strategic asset allocation,”notes Clapham. “Changes in regulation are allowing investors to look outside their borders and diversify across markets as well as the asset class spectrum.”

This is underlined in a new report by consultants Mercer which looks at global manager search patterns. In Asia, it found that search activity rose from 40 in 2009 to 70 last year, although assets placed dropped significantly from $19.2bn to $4.8bn. The most popular search category was global equities but the bulk of assets were placed in real estate.

Concerns over inflation also prompted some Asian investors to conduct searches for global inflation-linked bonds.

These changing investment patterns have not always translated into an increase in revenues for transition managers but they do signal the further development of the region. As Moore puts it: “The domestic play is a good portion of transitions with less than 5% of investors going offshore historically. However, many funds have begun shifting more and more assets offshore the past couple of years, creating new TM opportunities. Plus, those with funds offshore that are looking at global bonds and equities are making manager changes and that is creating opportunities in not just new but also existing mandates.”

Surrency adds: “There is a natural progression occurring.

Fixed income continues to be the largest asset class but institutions are moving towards international fixed-income instruments as well as global equities. This is why it is important for transition managers in the region to have a multi-asset class capability.”

Clapham agrees, adding: “Gone are the days when there was room for an asset class specialist. Today, having a multiasset class capability is a pre-requisite.”

Transition managers also need to be equipped to offer portfolio interim management services which involves managing a portfolio before an institution finds a new permanent home for the assets.“The interim transition is a two-staged process,” says Clapham.“It may start out with a client terminating an active mandate without choosing a

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ASIAN TM

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Richard Surrency, head of Asia Pacific transition management at Morgan Stanley. “Asian institutional investors were looking at risks in a more holistic way before 2008 and 2009. They have always been interested in integrated risk management systems and were looking at transition management as an integral part of this process,” he says.

Photograph kindly supplied by Morgan Stanley, June 2011.

Duncan Klein, head of transition management Asia and Japan for JP Morgan. “The client pool is more concentrated in Asia because it does not have an extensive private pension structure. This means that the industry is looking to provide solutions to similar client segment sets— the central banks, sovereign wealth funds and pension funds, among others,” he says. Photograph kindly supplied by JP Morgan, June 2011.

new manager. They will employ a transition management firm to move from the legacy portfolio into an environment that gives them a benchmark return.”

Managing the risk along the way often involves futures and derivatives but one of the fastest growing instruments is exchange-traded funds (ETFs). This mirrors the trends in Europe and the US. In fact, a recent Greenwich Associates report showed that US pension funds, foundations and endowments have significantly increased their use of ETFs in transition management, with the number jumping to 63% so far this year from 38% in 2010. The report was based on interviews with 45 institutional funds—including corporate pensions, public pensions and endowments and foundations, as well as 25 large US asset management firms.

Many institutional investors in Asia are not allowed to use futures or derivatives but if they do, it is with a clear comprehension of how the tools work, according to Bassily of ConvergEx.“We have clients that use futures to manage risk but they have to be comfortable with it and understand the nature of the investment.”

There is no magic solution, according to Keleher. “It depends on the client, the risk appetite and whether you can hedge the exposure. Sometimes it may prove too expensive.

For example, if it costs 1% to put on the hedge and 1% to take off the hedge, and it does little to reduce the overall risk of the transition, then it may not be worth it.”

While the same trends in the US and Europe are likely to find their way to Asia, there are mixed views as to whether the T-Charter, the industry voluntary code of practice launched in the UK in 2007, will take hold. Balogh says: “Clients do ask about the T-Charter and while they follow its progress, it is still early days in Asia. I do not see any consensus on whether there should be a similar panregional document.”

“It is not a topic of discussion that is brought up by our clients like it is in the UK,” says Bassily. “I think this will change as the industry matures but I do not think we will see the same type of code being transplanted. It will probably be a variation of the T-Charter to reflect the particular objectives of the local users. The one thing that is the same is that many Asian clients have adopted implementation shortfall, which is in the T-Charter to measure the success of the transition.”

Implementation shortfall is only one component of the equation though. Clients have to understand that there is no such thing as a free lunch or costless transition. There are always costs such as bid offer spreads, commissions, market impact, or even taxation and stock exchange fees, even if these costs are not readily visible, says Keleher. "This is why it is important that clients need to be aware of the different models of transition management and how managers make money. Implementation shortfall is only one way to measure the success of a transition.” I

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TRANSITION MANAGEMENT

HOW TO TRANSITION €3bn INTO MANAGED ACCOUNTS

Photograph © Sergei Popov / Dreamstime.com, supplied June 2011.

The benefits of transition management are manifold, but not always apparent. In a profile of a high-value transition, Karin Russell, executive director, transition management at Morgan Stanley, showcases elements of the theory behind the transition management service and explains how this theory is translated into practice.

D PENSION IS a foundation established in 1980 with the object of managing Denmark’s “frozen cost of living allowances”. The system was set up by the government to help adjust local wages through an automated process, to cover the inflation-driven cost of living increases.

However, as part of a political agreement in 1976 some cost of living allowances were held back by the government. In 1980, the government entrusted LD Pension with the frozen element of the allowances, which by that time amounted to €1bn, and which was duly deposited in some 2.5m member accounts. The money was then scheduled to be paid out to those employees at retirement.

In the event, LD Pension did not receive any additional contributions in the intervening period, nonetheless the assets increased substantially in value as cumulative returns exceeded payments by the fund and reached €7bn.

In 2005, LD Pension formed its own asset management company called LD Invest A/S, with the purpose of providing LD Pension and other clients with investment advisory services. At the same time LD Pension entered into a fiveyear contract regarding investment advisory services for the majority of its investment portfolio. This contract expired at the end of 2010 and consequently the fund launched an EUwide procurement process, resulting in the appointment of new investment managers for part of its assets. A number of transitions have taken place because of those changes over the intervening period and this case study involves one of them; namely the moving of equity assets from LD Invest A/S to three newly-appointed managers.

L

First phase This phase is the most important in any assignment. It was important for us to define the objectives of LD Pension in this transition, which included moving part of the equity investments to external managers; the switch to a new value investment strategy, with more diversified holdings; the

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diversification of managers and asset holdings; maintenance and adjustment of a currency overlay though the transaction; adherence to specific investment guidelines before, during and after the transition; and, of course, to implement the transition as efficiently and cost effectively as possible.

We then went on to establish contact with all parties involved, signed contracts as well as confidentiality agreements, set up accounts, requested legacy and target asset lists, and set up electronic connections to the custodian Danske Bank. Close interaction with LD Pension, its new managers Danske Bank and Danske Invest, the fund’s administrator, was paramount if we were to manage every moving part of the process throughout the transition. These moving elements included hedging overlays, market specific operational processes and investment restrictions, such as restrictions to trade on World Federation of Exchangesapproved exchanges only; a social responsibility exclusion list, and benchmark constraints.

Moreover, we developed a transition plan, which outlined all the important steps involved in the transition, its objectives and its timetable. The plan was regularly updated during the course of the project to reflect the changes required.

Second phase Once we received the client’s wish and legacy asset lists, we conducted a pre-transition analysis. This analysis, which establishes the mechanics of the transition, was important to determine any expected costs and risks in the restructure. We modelled the portfolio interaction between legacy and target assets, which provided us with a level of detail necessary to form the transition strategy. Areas of importance were liquidity, tracking error, volatility, spread and asset/currency allocation changes.

From an investment perspective, the analysis highlighted that to restructure the current portfolio we needed to transact $3.2bn of equity transactions. We were moving from a highly

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LD Pension restructure

LD Pensions The Professionelle Forening LD (The Client)

Adjustments during transition Currency Overlay

Daily reporting of cash flows

Danske Invest (Fund Administrator) Reporting

Transition Plan Pre-Post Transition Reporting

Daily reporting to client & transition manager Fund Accounting/ Reporting

Wish lists

Emerging Markets Equity Mandate Mandate C

Transition

International Value Equity Mandate Mandate B

Transaction Reporting

Morgan Stanley (Transition Manager)

Reconciliation

LD Invest A/S (Legacy Manager) SettlementSTP-SWIFT Internal transfer of legacy assets

Danske Bank (Custodian)

concentrated portfolio to a more diversified portfolio of securities and countries. The transition also brought with it an illiquid tail and a liquidity imbalance between the buy and sell portfolio. From a delta perspective, we were delta neutral in each of the regions, which was surprising, but within the regions, we had some significant country and currency shifts.

Finally (but significantly) with LD Pension running a currency overlay, this also played a focal point in the setting out of the risk management strategy.

From an operational perspective, the client required the transition to take place across the three new manager accounts instead of a designated transition account. The assets therefore had to be split and moved into the relevant accounts ahead of the restructure. This needed careful consideration due to operational implications in areas such as cash flow management. While the most suitable implementation strategy would have been to manage the transition in the three accounts independently from each other, it was important to transition all assets together for the benefit of reducing overall implementation shortfall costs. Inevitably though, it would be at the expense of direct operational risk.

Third phase The day before trade date, we received final legacy asset lists as well as wish lists from the managers, which were screened against investment and trading guidelines one more time by both the client and us. We then created the target portfolios, crossed them against the legacy assets and prepared respective trade lists.

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Handover

International Value Equity Mandate Mandate A

Transfer and splitting of legacy assets prior to transition into managersâ&#x20AC;&#x2122; accounts

The next day trades were distributed to the trading desks in each region for execution in line with the agreed trading strategy. One of the tools utilised by the traders was MS PORT, an algorithm designed to reduce risks and control implementation shortfall. MS PORT works on a portfolio level unlike most other algorithms. It optimises the buy portfolio and the sell portfolio taking into account the correlation between assets. It eliminates stock and sector specific risks by trading out of high-risk positions early on in the trading period and then passively executing the remaining portfolio in line with volumes traded while keeping the trade cash balanced at all times.

Managing cash flow Cash flow management in this transition was a key element, particularly because we were transitioning across multiple accounts and the liquidity profile of buys and sells in each account varied. As much as the overall trade was cash balanced in each region after each trading day, we suffered from cash flow imbalances within the accounts driven by the liquidity imbalance of the buys and sells. This resulted in one account being significantly over-bought while the other two accounts were oversold. This imbalance required us to adjust the standard settlement cycles of the trades to match the liquidity needs in the accounts (ie extend settlement of purchases in the overbought account and shorten settlement of the sells and vice versa in the other accounts).

Part of cash flow management involved the execution of foreign exchange transactions. These trades were executed

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simultaneously to the underlying securities to minimize currency risk. This also helps to ensure that the exchange rate prevailing at the time of each trade is locked in so that the settlement value of the underlying security does not fluctuate with exchange rate volatility or price drift.

During the implementation period, LD Pension was updated on the progress of the transactions and the costs on a regular basis during the day. We also reported on cash flow movements, so that the currency overlay could be adjusted accordingly, which was a process managed in this transition by the client.

Evaluation and settlement During this final stage of this transition, we took care of instructing and settling the transactions as well as the reconciliation of positions and handover to the new managers.

Managing operational risks in a transition is as important as managing the investment risks since failed settlement and mismatch in cash flows can result in significant interest charges in some markets as well as the risk of being “bought-in” in other markets. A“buy-in”means that an investor will have to repurchase shares of stock because the seller either failed to deliver the shares or did not deliver them in a timely fashion.

The buyer notifies exchange officials who, in turn notify the seller of the delivery failure. The exchange assists the buyer in

Karin Russell, executive director, transition management at Morgan Stanley. Photograph kindly supplied by Morgan Stanley, June 2011.

purchasing the stock again, with the original seller having to make up the price difference if the new shares are more expensive than originally agreed to. We instructed the trades in the name of LD Pension to its custodian via SWIFT, which eliminated some of the operational risks and ensured timely settlement of the underlying transactions.

During this part of the transition, we also produced a post-transition report, which provided objective attributing performance results and a qualitative commentary on the transition. These results were presented to LD Pension during a meeting following completion of the restructure.

Both pre and post-transition cost reporting followed the TCharter principles. I

LD PENSION’S ANALYSIS OF THE DEAL HE TRANSITION OF assets with a total transaction volume of more than $3bn is not to be taken lightly. At LD Pension we quickly realised that we did not possess the necessary skills to carry out this speciality within investment management. This was an easy conclusion. The tough job was finding the right transition manager with both the necessary integrity, skill set, and a thorough understanding of our way of doing business. After a thorough evaluation of multiple transition managers, we found what we were looking for, explain Claus Buchwald Christjansen, chief investment officer and Lars Wallberg, chief financial officer at LD Pension.

We have a number of observations on the transition management service offering. In our view, the quality of services provided by the world’s top transition managers is extremely high.

Thus, when it came down to choosing a transition manager, choosing the right people to interact with during the

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transition event became one of the most important selection criteria.

Moreover, we found during the transition event that these selection criteria proved to be very important.

Minor or major problems will always arise during a transition event.

A good example in our transition event would be the changes in the standard settlement cycles which created some minor challenges during the transition itself. These changes challenged the custodian in a number of ways. However, we felt that the transition team correctly weighted the trade-off between the operational risk and the investment risk associated with managing the cash flows during the transition event.

We were kept up to date about the challenges with managing the cash flows during the transition, and the post-transition analysis was totally transparent about this particular facet of the transition.

The one-point-of-entry model which characterised the transition team’s

approach worked very well for us. We felt at all times during the transition event, that we had 100% access to a key person in the team, who was integral to managing the transition event. Even though a larger team was working behind the scenes, we benefited greatly from having to communicate with one person only.

Before the transition we had some rather fierce discussions with the transition managers about the business model of a transition. We felt that it was very important to have a mutual understanding on how revenue is created, and which parties in a transition profits from it.

These discussions underlined to us that the transition management team was acting as our agent. It also created an environment during and after the transition itself in which we did not have to discuss costs associated with the transition. As a matter of fact, costs came in within the estimate outlined in the pretransition analysis.

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GCC ASSET SERVICING ROUNDTABLE Helped by a strong recovery in oil prices and attendant higher levels of government spending, the Gulf Cooperation Council (GCC) countries are witnessing a return to robust growth. The IMF estimates real GDP growth of 5.9% is achievable in 2011, and at current levels of oil production (around 14.7m barrels/day), and based on an average price per barrel of $83 (which was the average last year), GCC countries generate at least $1.2bn in oil revenues alone, each day. While this is still short of the average $2bn per day in 2007, it is sufficient to provide oil generating economies with a substantial current account surplus. Despite some political instability which has marred the overall 2011 outlook for some GCC countries, the region looks set to continue to nurture growth, sustained by population growth, a growing labour force and rising savings. Moreover, reform efforts have been moving ahead across the region. Kuwait’s privatisation programme and continuing market reforms in Qatar, UAE and Oman will likely spur further investment inflows and provide opportunities for local investment firms to leverage the region’s growth.

With this backdrop in mind, we have invited comment from some of the region’s experts in asset management and asset servicing to provide us with their insights into the continuing reforms, opportunities and challenges for their particular business segment.

We hope you find the discussion stimulating.

ASSET SERVICING IN A HIGH-GROWTH REGION: THE RISKS & REWARDS Photograph © © Madmaxer / Dreamstime.com, supplied June 2011.

Participants

Supported by:

MOHAMMED AL HASHIMI, executive director of asset management, Invest AD JONATHAN COOPER, managing director, Middle East & Africa, FTSE Group ALAN DURRANT, group chief investment officer and general manager, asset management group, National Bank of Abu Dhabi BRIAN LEDDY, head of relationship management, EMEA, BNY Mellon Asset Servicing

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THE STATE OF PLAY IN THE GCC FTSE GM: Local investment management is dominated by the region’s banks. Is a strong independent GCC fund management industry likely or will they be squeezed by the banks on one side and the international players on the other?

ALAN DURRANT, GROUP CHIEF INVESTMENT OFFICER AND GENERAL MANAGER, ASSET MANAGEMENT GROUP, NATIONAL BANK OF ABU DHABI: The GCC is probably over supplied with financial services in general. In most countries there are too many banks, too many brokers and yes, too many asset managers.

In asset management however, there is always room for truly great performance. If an asset manager can build a strong enough track record, they are likely to be rewarded with a robust business. However, for every one business in this position, there are ten with poor records, excessive cost bases, tiny funds and it is hard to see how they can compete or even survive going forward.

JONATHAN COOPER, MANAGING DIRECTOR, MIDDLE EAST & AFRICA, FTSE GROUP: Perhaps the issue is less about who dominates the industry but who actually generates the investment mandates. The GCC is home to some of the world’s largest sovereign wealth funds but lacks the depth of asset owners who could help stimulate the industry.

BRIAN LEDDY, HEAD OF RELATIONSHIP MANAGEMENT, EMEA, BNY MELLON ASSET SERVICING: If we look at mature markets in Europe or North America, it is clear that size and success are not necessarily synonymous. Investment management houses at all points on the scale continue to thrive by delivering outperformance to their clients. The independent fund managers of the GCC may face the same challenges as their peers elsewhere in the world, particularly with distribution channels which obviously favour the local banks with their extensive branch networks. Even so, sophisticated investors will seek out the manager whose philosophy best meets their requirements. The local players may experience some squeeze, but the fittest will survive.

FTSE GM: What are the benefits/limitations of having private banks as the primary source of distribution in the region?

ALAN DURRANT: Private banks can form excellent longterm partnerships for investment banks. Private bankers form decades-long relationships with their clients; relationships that can move from one employer to another. A good private banker is not just a product-pusher, they are longterm partners for the clients and therefore they will need to be thoroughly convinced that the product they are taking to their client bank is a robust one. This will usually elongate the time it takes for products to be adopted and this wait can be frustrating. However, the strength of the long-term relationship is most certainly worthwhile and this is why we devote so much time to private banks.

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FTSE GM: How can local firms compete in the investment management and asset servicing space?

MOHAMMED AL HASHIMI, EXECUTIVE DIRECTOR OF ASSET MANAGEMENT, INVEST AD: We compete by demonstrating that our physical presence in the Middle East aids our investment decisions. Having access to nearby economies, or countries gives local firms the ability to be able to visit management teams of the companies that they are investing in. Most importantly, we believe that having analysts on the ground in local markets is critical and the most effective way of truly valuing companies and making the best returns for investors.

FTSE GM: As the GCC continues to integrate, how important is it to be able to offer a pan-regional presence?

MOHAMMED AL HASHIMI: The GCC markets are relatively smaller than Latin America or the Far East. Europe is different from the GCC because of its currency integration.

Having a pan-regional presence is important in the GCC because each market still offers unique investment attributes.

Each market in the GCC still offers unique investment attributes. For example, in Saudi Arabia you can invest in sectors unique to the country, such as petrochemicals or retail stocks.

To invest in ports, you go to DP World in Dubai. Looking outside of the GCC, having an integrated pan-MENA offering is also very important, especially when it comes to investing in Africa as the countries tend to vary so much.

BRIAN LEDDY: I would suggest that it is more important to offer a pan-regional capability than presence. The key issue is to ensure that you can deliver your products and services to your target clients in each of the GCC’s markets but, as your question points out, the GCC continues to integrate. This integration has the benefit of allowing us to take a service domiciled in one market and offer it into one or more of the others. This “passporting” philosophy may currently be imperfect but it does allow service providers to deliver their products across the region without replicating offices and functions across each and every country.

ALAN DURRANT: We believe that it is very important.

National Bank of Abu Dhabi has had a strong roll-out programme in place for many years and this will continue.

Busy investors do not want to have a dozen small providers each serving a part of their wealth. Instead they want a few holistic financial service providers who can serve a wide range of their needs wherever they happen to be.

FTSE GM: How can white labelling work in practice for local firms that want to offer the widest possible product offering to their clients?

ALAN DURRANT: It all comes down to distribution. If you have a trusted brand name and strong distribution channels, there is every reason to believe that you can offer good quality, white-labelled product. If you lack distribution, what are you really bringing to the manufacturer by white labelling?

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Brian Leddy, head of relationship management, EMEA, BNY Mellon Asset Servicing. Archive photo, FTSE Global Markets.

FTSE GM: What are the key markets for investors in the region outside of the GCC? BRIAN LEDDY: The market that immediately springs to mind is Egypt. Its market capitalisation is broadly comparable to those of the GCC markets and it is a mature market with a well established regulatory environment. That being said, a number of other markets are deserving of scrutiny from investors seeking exposure to the region. Morocco continues to present interesting opportunities and the Levant is not to be ignored.

ALAN DURRANT: They are a blend of the markets and countries that they know well and feel comfortable in such as the UK and Europe with exciting markets that are likely to provide the next wave of growth such as China and India.

FTSE GM: What is the portion of Shari’a-compliant funds and products?

ALAN DURRANT: Most surveys suggest around 30% of the investor base favour Shari’a-compliant product. This will vary depending upon the expat versus local mix of clients. However, we take the view that good Shari’a product should be capable of being bought by all client types.

FTSE GM: Is there always a case where bigger is always better or does local knowledge and expertise offer something different from the global firms?

JONATHAN COOPER: Well of course you have scale as a global firm but local knowledge and understanding the culture is very important in this region.

MOHAMMED AL HASHIMI: From a regional standpoint, it is not always necessarily the case that bigger is always better. Nowadays, investors have become a lot more demanding about quality. There is much more appreciation for local presence and expertise which can offer meaningful insight such as research and coverage of companies in a specific region. There is a lot more room for boutique or local firms to grow that can offer detailed understanding of emerging markets.

ALAN DURRANT: We have little doubt that local specialists can have the edge over global firms, but you must know which areas you will choose to specialise in. We acknowledge that we will probably never be best-of-breed in Japanese small caps or Latin American debt and therefore we don’t try.

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We have chosen to outsource this. In contrast, we strongly believe that we are among the best informed people in the world when it comes to local equity, bonds and property and that we can manage these asset classes better than major asset managers based in London, New York or Tokyo with little or no resources devoted to the GCC. This is why we are entering into many reciprocal partnerships in which we will manage GCC products for global house and they in turn will manage assets that are outside of our skill set.

PRODUCTS & INVESTMENT STRATEGIES FTSE GM: How important is it that large local asset owners continue to increase their exposure to local markets rather than invest solely or primarily overseas?

ALAN DURRANT: Events of the last three years have clearly shown the importance of diversification. Most local stock markets have been both volatile and weak during this period and the experience of many investors into local real estate and private equity has not been a happy one. Of course, it has been perfectly possible to lose money in the US, Europe and even Asia during this period but in general, overseas exposure has been a good counterbalance for the losses made locally. With the US dollar having been weak recently against most major currencies and most GCC currencies having a peg, the performance of non-dollar overseas assets has been even better for GCC based investors.

FTSE GM: How important is it for international asset managers and servicers to have a significant presence on the ground rather than simply a sales operation?

ALAN DURRANT: We are indifferent and so are our clients.

We wouldn’t offer to go to California to manage GCC equities for US-based clients and see no reason why a US technology fund should be managed from the GCC. So long as the asset management and service are first-class, there is no reason for us to demand that our partners rebase here.

FTSE GM: What are the key markets for investors in the region outside of GCC? MOHAMMED AL HASHIMI: The key markets outside of GCC would be Egypt and Morocco for North Africa, and Nigeria and Kenya for sub-Saharan Africa, as they are the biggest economies.

JONATHAN COOPER: North Africa has often been a focus for investors. Earlier this year FTSE launched an initiative with the Casablanca Stock Exchange to create a series of domestic indices. Despite some of the challenges facing North Africa the FTSE CSE Morocco 15 Index has performed in excess of 10% year to date.

FTSE GM: How common are hybrid funds that allow investments in equities, pre-IPO and private firms? Are

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these more suited to the region than traditional long only equity funds?

MOHAMMED AL HASHIMI: Similar to fashion, investments go through trends as well. Hybrid funds are not as “trendy”now as they were in the 1970s. In our region, singletype equity funds are still prevalent. Although a combination of funds is feasible, there are a number of challenges in our region which makes hybrid funds less convenient and popular. There is still very limited demand for combination exposures. Liquidity is paramount when managing a public equity portfolio in an emerging market. Pre-IPO and private equity is slightly different as it is harder for investors to make redemptions. The preference now is to separate listed equities and private equity, unless there is a particular mandate for a specific client who chooses a hybrid fund. If this is the case, it is more manageable since it is a closed mandate.

JONATHAN COOPER: As an index provider this might be a difficult combination to achieve. Some IPOs and primary listings have free float restrictions which would impede upon international investors.

FTSE GM: What has been the take up of new products such as ETFs? JONATHAN COOPER: This is certainly an area where the GCC is lagging as there are some issues around access to data. ETFs provide easy and transparent exposure for investors at minimal cost. ETFs could help boast interest in local markets and increase volumes in the underlying stocks.

ALAN DURRANT: It has been slow but we have little doubt that they will be adopted in the GCC just as they have come to dominate the international markets. I think that the weakness of local equity markets has been a significant contributory factor in the slow start but with signs of life returning to local markets, we expect renewed interest.

LOCAL REGULATIONS & MARKET STRUCTURES FTSE GM: The region’s stock markets are dominated by retail investors. How can these investors be educated away from direct investments and towards investment products?

ALAN DURRANT: This is the major challenge facing asset managers. We are actually competing with many potential clients who believe that they have better insight than a fund manager. The volatility of the last few years will have pushed a few towards professional fund management but I suspect many will simply have left stock markets altogether.

MOHAMMED AL HASHIMI: Educating investors is an ongoing process driven by regulators and by participants themselves, ie, analysts, asset managers and client relationship managers. In general, it is much more efficient to have professionals managing your money. However, the process of educating investors is ongoing and will take many years to work through.

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Alan Durrant, group chief investment officer and general manager, asset management group, National Bank of Abu Dhabi. Archive photo, FTSE Global Markets.

FTSE GM: How does regulation compare across the region, what improvements could be made?

BRIAN LEDDY: There are significant differences in the regulatory environment across the different markets of the GCC, but we should bear in mind that these regulations are supporting some very different market mechanisms in trading, clearing and settlement. While these differing market mechanisms will not represent a barrier to a local investor trading in his home market, we should acknowledge that consolidation, or at the very least homogenisation of the GCC’s markets towards a transparent, low-risk model would make them considerably more attractive to foreign institutional investors.

JONATHAN COOPER: Although there are some major differences, regulators across the region are making improvements and trying to adopt best practice and international standards. FTSE was the first index provider to announce that the UAE is classified as an emerging market in the FTSE Global Equity Index Series and that Kuwait remains on a watch list for inclusion. Improvements in foreign ownership restrictions and free float would be welcomed by institutional investors MOHAMMED AL HASHIMI: Regulations differ widely across the region. It is important to understand that regulations evolved at different times within the region. In the UAE, for example, regulations evolved in the early part of the 21st century, whereas in Kuwait it took place in the Eighties.

The key difference between countries in the GCC is the level of access that foreign investors can have in listed companies.

In Saudi, for example, foreigners can participate through Saudi-focused funds or through swap arrangements. There are a number of improvements to be made, such as providing wider foreign participation, more transparency, and improvements in settlement mechanisms such as a delivery versus payment (DVP) system. Regulatory improvements in more advanced emerging markets such as the BRIC economies should be observed and adapted in the region.

FTSE GM: How likely is regulation that encourages the use of external providers for asset servicing in order to decrease operational risk?

BRIAN LEDDY: The segregation of duties is a universal theme in regulation, and one that is already being taken up within the GCC. The fundamental requirement is that the

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investment decision maker should not be the same entity who reports the results of that investment decision.

Accounting, valuation and performance reporting must all be independent of the management function. These products in general sit along side the custody processes of settlement and safekeeping. So by definition, the regulations being considered or enacted recognise the value of an external provider of asset servicing distinct from the asset manager.

ALAN DURRANT: I believe it is increasingly likely. I would disagree that this in any way decreases operational risk. This all comes down to the quality of the people, processes and systems of the back office. If good internal people, processes and systems are in place, then the risk of operational problems could even be reduced as everything is under the control of one entity. If service standards slip, it is easier for them to be addressed. However, for weak businesses that cannot afford to invest in the best people, processes and systems, then outsourcing is probably the best option.

FTSE GM: Are UCITS-compliant funds becoming the de facto benchmark in terms of structure?

ALAN DURRANT: Not yet. I think that they should be and in the absence of any GCC-wide equivalent, I believe that they will be over time.

JONATHAN COOPER: This seems to be the case for local funds seeking foreign institutional investors who are familiar with the UCITS framework.

BRIAN LEDDY: UCITS is specifically designed to deliver a best practice solution to investors in funds. Its intention is to deliver clarity, transparency and investor protection—goals which are undoubtedly shared by regulators across the region. With UCITS already defined and readily available, is there really a need to re-invent the wheel? It is safe to say that UCITS is becoming the standard structure for funds, not least because UCITS compliance is the basic requirement to be able to access European domiciled investors.

FTSE GM: What is the likelihood of an equivalent GCC investment passport in the similar vein to UCITS? ALAN DURRANT: Very unlikely in my view. A UCITS-like scheme would require massive levels of cooperation between the various regulatory bodies. Currently I see local regulators designing local rules that fit the particulars of their respective local economies and markets.

SERVICING THE ASSETS FTSE GM: What are the prospects for transition managers in the region?

BRIAN LEDDY: Some of the larger institutions are already using transition management and it is a growth market with a growing number and range of organisations recognising the risk reduction potential that a transition manager

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Mohammed Al Hashimi, executive director of asset management, Invest AD. Photograph kindly supplied by Invest AD, June 2011.

can provide. Mature funds require a transition manager when switching asset managers or changing the fund asset allocation. However, there is also demand for transition managers to manage the funding of new portfolios and, in particular, to control the risk when allocating from cash to other asset classes.

FTSE GM: How important to international investors is having an external custodian and fund administrator?

MOHAMMED AL HASHIMI: It is very important for international investors to have an external custodian and fund administrator, as it gives comfort to investors that investment returns are being independently calculated and verified and there is professional oversight of the fund’s assets. Until recently, it was a lot harder to outsource to a fund administrator and custodian due to the lack of service providers operating in the region. Due to a recent increase in service providers this option has also become more cost efficient for asset managers.

ALAN DURRANT: In the post-Madoff era, fund governance is becoming ever more important. Most really big investors will insist on either a segregated account under their control or will demand a fund that meets international best practice.

FTSE GM: Is there sufficient competition in the asset servicing and custody space?

ALAN DURRANT: We didn’t believe so and this is why we launched our own custody service. Indeed, we were the first locally authorised custodian in the UAE and have been very successful in winning new mandates.

FTSE GM: What are the opportunities for locally managed and invested fixed-income funds?

MOHAMMED AL HASHIMI: In the case of fixedincome funds, the opportunity is limited because the number of fixed-income instruments that are tradable is still limited.

Most regional fixed-income instruments are typically held to maturity when issued but there is still a lack of depth and liquidity in the market. However, this is likely to change as more corporates, weigh up their options by looking to issue corporate debt or listing their equities, post the global financial crisis.

ALAN DURRANT: This is an area in which we have deployed a lot of our resources as we see great scope for

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growth and want to cement our position as the leading fixed-income manager. Compared with equities, fixed income has hardly been touched by either amateur or professional investors. As the market broadens we expect growing international interest.

FTSE GM: What are the opportunities in the value add space of transition management and securities lending?

BRIAN LEDDY: In the transition space, cash equitisation and interim management are areas where transition managers with portfolio management experience can add value. This is particularly true in this region where cash injections to funds can be significant. The due diligence process to invest new cash can take days or even weeks.

Creating the beta exposure for new cash can reduce the tracking error of the fund to the global benchmark, allowing time to complete the investment review and execution.

OUTLOOK FTSE GM: What are the key opportunities and challenges facing the investment and asset servicing industry in the region over the next three years and beyond?

ALAN DURRANT: The key risk evident today is simply scale. Asset servicing works best as a huge conveyor belt in which vast funds are pushed through a fixed-cost base to drive the cost per unit down to de minimis. Currently in the GCC, this cannot be applied to funds. In the West, $100m is regarded as a very small fund. In the GCC $100m is regarded as a normal-sized firm. This will make it hard for asset servicers to offer attractive pricing unless they can simultaneously take on large segregated accounts.

FTSE GM: Will the local equity markets ever be deep enough to support a large institutional investor community?

BRIAN LEDDY: A major issue with the local equity markets is that they are not employed as the first port of call for local companies to raise capital. Many large organisations remain family owned without recourse to the capital markets which certainly limits the overall market capitalisation of the local markets. There is something of a chicken and egg situation here as investors will necessarily limit their concentration in a thin equity market, and issuers will be reluctant to float on a market with limited capital. Also, the volatility these markets have witnessed over the past five years has deterred both investors and issuers. Local markets will likely experience expansion as a gradual process, which in itself should encourage confidence in their long-term stability.

ALAN DURRANT: Over time we would hope to see the buffet broaden. Many GCC stock markets are dominated by a few sectors such as banks and real estate. It would be good to see more of the real economy listed-giving people the opportunity to invest in local airlines, industry etc.

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Jonathan Cooper, managing director, Middle East & Africa, FTSE Group.

Photograph kindly supplied by FTSE Group, June 2011.

FTSE GM: What will be the impact of the inclusion of some GCC countries into the global benchmarks?

JONATHAN COOPER: As I mentioned earlier the UAE is already included by investors using the FTSE Global Equity Index Series (GEIS). However, inclusion should not be treated as a single “big bang” event. Funds tracking the series are given a period of time to implement the change and new constituents carry a smaller weighting relative to the total market cap of the index. Being included in GEIS is an important first step but markets need to maintain their standards. Negative changes may also occur as with Argentine, which is now classified as a Frontier Market.

MOHAMMED AL HASHIMI: There has been widespread coverage in the news about adding the UAE and Qatar to MSCI Emerging Markets index. The news coverage has been focusing too much on the short-term benefits for these markets. The focus should be more on long-term impact. If the UAE and Qatar are included in the MSCI index, it will have a positive impact on the GCC as it will attract greater proportions of institutional money since they will be opening up to a wider pool of foreign investors. This will be further enhanced by changes to operational mechanics towards payment systems and foreign ownership, which in turn will lead to improved liquidity.

ALAN DURRANT: There is likely to be a short-term sugar rush impact but over time, it will all come down to the underlying profitability of our companies. That is what drives share prices over time. Getting into benchmarks such as MSCI Emerging Markets will bring our companies onto the radar of international investors but (with the exception of index trackers) they will only invest in liquid, well-managed companies that can demonstrate a track record and a clear growth strategy.

FTSE GM: Is conquering the Saudi market key to being successful in the GCC? JONATHAN COOPER: Saudi Arabia has the largest stock market in the region and contributes 50% of GDP to the GCC. However, direct foreign investment is restricted and there are other areas where increased competition would be beneficial. Saudi Arabia is clearly an important market but some of the challenges facing The Kingdom are different to other members of the GCC. I

J U LY / A U G U S T 2 0 1 1 • F T S E G L O B A L M A R K E T S

(Week ending 10 June 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 Sov Corp

17,115,178,868 9,088,921,793 6,325,960,829 5,797,283,961 5,454,925,071 11,102,906,204 2,876,916,102 25,038,110,449 4,666,165,356 3,010,314,976

186,695,777,338 126,796,678,814 145,283,300,581 81,419,321,311 84,065,436,934 101,293,988,473 73,491,583,029 279,048,059,154 103,082,964,831 64,862,221,717

12,472 10,060 8,987 8,844 8,617 7,912 7,739 7,650 7,397 7,261

Americas Americas Europe Americas Americas Americas Europe 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

25,038,110,449 20,136,853,641 18,392,483,646 17,115,178,868 16,524,298,910 11,857,305,039 11,102,906,204 9,088,921,793 8,298,080,694 7,308,528,005

279,048,059,154 104,131,250,952 153,636,606,022 186,695,777,338 99,562,638,170 63,020,372,896 101,293,988,473 126,796,678,814 48,681,867,445 53,807,315,423

7,650 5,110 7,230 12,472 3,248 4,608 7,912 10,060 5,168 2,854

Europe Europe Europe Americas Europe Europe Americas Americas Japan Europe

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

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

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 10 June 2011)

(Week ending 10 June 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,412,925,119,120

441,833

Kingdom of Spain

8,298,925,095

406

Sovereign / State Bodies

2,704,663,646,517

202,540

Republic of Italy

3,806,853,040

195

Corporate: Consumer Services

2,238,103,235,051

366,635

Federal Republic of Germany

3,461,250,000

191 103

Corporate: Consumer Goods

1,697,341,748,080

264,294

French Republic

2,351,776,100

Corporate: Technology / Telecom

1,406,590,675,643

213,585

Federative Republic of Brazil

2,202,790,000

122

Corporate: Industrials

1,374,117,114,742

230,178

General Electric Capital Corporation 1,522,053,098

187

Corporate: Basic Materials

1,048,362,328,255

166,106

Hellenic Republic

1,518,242,004

177 163

Corporate: Utilities

828,141,373,788

128,144

People's Republic of China

1,500,900,000

Corporate: Oil & Gas

503,507,020,899

89,817

Portuguese Republic

1,487,050,100

146

Corporate: Health Care

365,645,613,881

62,707

Republic of Peru

1,381,875,000

209

Corporate: Other

158,934,300,520

17,938

CDS on Loans

69,964,410,726

18,390

Residential Mortgage Backed Securities

65,022,559,043

12,685

Commercial Mortgage Backed Securities 19,296,661,606

1,732

Residential Mortgage Backed Securities* 10,993,632,903

748 745

CDS on Loans European

5,322,602,200

Other

1,364,747,788

85

Muni:Government

1,222,400,000

128

Commercial Mortgage Backed Securities*

424,522,786

34

Muni:Other

135,000,000

5

Muni:Utilities

30,650,000

12

*European

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

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data Š 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

87

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 10th June 2011 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.38

1.96

1.84

1.92

8.56%

1.98 3.47% 5.27%

5.98% 0.01%

5.08%

6.86%

27.31%

20.14%

5.49% 15.01%

16.70%

0.24%

1.54%

0.12%

0.11%

Europe

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

22.10% 67.64% 0.02% 0.05% 0.48% 0.05% 0.01%

57.76% 0.18% 0.12%

0.00% 0.07% 0.07% 0.04%

0.34% 64.42%

69.75% 71.71% 0.03% 4.82% 0.00%

5.79%

VENUES

3.49%

2.59%

6.57%

VENUES

INDICES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

4.64 10.07% 4.02% 0.05% 0.42% 5.63% 8.40% 27.56% 3.81% 2.59% 0.91% 23.09% 0.10% 13.34%

4.25 10.24% 3.89% 0.05% 0.34% 4.69% 7.20% 27.89% 2.97% 1.72% 0.88% 26.13% 0.15% 13.82%

FFI

2.27

2.29

Alpha ATS

18.44%

17.47%

BATS BATS Y 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

1.00

Asia

INDICES

Australia Hong Kong

100.00% 100.00%

Canada*

DOW JONES

US

INDICES

S&P TSX 60

Chi-X Canada

12.12%

13.16%

Liquidnet Canada

0.15%

0.06%

Omega ATS

2.13%

2.70%

Pure Trading

4.54%

4.16%

TSX

59.85%

59.31%

TriAct MATCH Now

2.77%

3.14%

VENUES

INDEX NIKKEI 225

INDICES FFI

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

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

1.25 1.94% 0.04% 0.00% 0.00% 1.60% 89.27% 7.15% 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/.

88

J U LY / A U G U S T 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

HE GLOBAL INTERPLAY between regulation and technology has now created three very different forms of liquidity fragmentation. The first is the flow of liquidity away from primary markets and onto newer, alternative platforms. This is a typical 'David and Goliath' story whereby smaller, more nimble firms armed with lower cost matching platforms challenge the monopolies of national market centres. This has been especially noticeable in Europe where MTFs such as Chi-X and Bats (themselves soon to merge) have been successful in offering lower cost trading on a pan-European basis. In less than four years they have come to be responsible for around 25% of European trading (May 2011).

Chart 1: Lit value share, Europe* Primary exchanges

MTFs

100% 95.03% 80%

71.66%

60% 40% 20%

4.97% 0% Dec M Mar JJune S Sep Jun S Sep D 2008 2009

28.34% Dec M Mar D

Sep JJun S 2010

Dec M Mar JJun D 2011

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

Whilst the larger alternative venues battle it out with the primaries, new 'Davids' continue to enter the arena. One such example is PAVE which is seeking to establish itself as the alternative venue for Spanish equities trading. At one level this looks like an attractive opportunity as the Spanish market is still nearly 100% centred on the main national exchange, the BME. The challenge for PAVE will be to position itself ahead of other pan-European MTFs which are also looking to tap into this lucrative segment. Burgundy, for example, is establishing itself in a similar way as the alternative player for the Nordic markets and has been successful in Sweden although it still has a bit of work to do in other Nordic countries.

Chart 2: Lit value breakdown, OMX S30 (May 2011) 6.51% Burgundy

15.36% Chi-X 0.09% NYSE Arca

4.88% Bats Europe 3.00% Turquoise

70.16% Stockholm

Whilst this type of fragmentation continues to play itself out we are also starting to see another type of fragmentation where primaries are pitching against primaries. This type of fragmentation is well-established in Canada, for example, where

stocks are heavily traded by US-based venues. In Europe it has been less evident to date but, nonetheless, some of the primary exchanges are attempting to establish pan-European franchises.

The London Stock Exchange Group's purchase of Turquoise is one such example.

The third type of fragmentation that can be seen is the split between displayed (or lit) liquidity and non-displayed (or dark) liquidity. Of course, non-displayed liquidity is nothing new - ever since markets existed a portion of trading has taken place offexchange as bilateral OTC transactions. This traditional 'upstairs' activity was supplemented by buy-side crossing networks such as those of Liquidnet that enable buy-side firms to source liquidity directly from one another. With the advent of MiFID a number of categories were created that attempted to formalise the different types of non-lit trading activity that existed: traditional OTC, Systematic Internalisers and MTF-style dark pools. The issue is complicated by the fact that a number of brokers had automated their own crossing networks and the different categorisations have been applied inconsistently between them. Nevertheless, the growth of dark liquidity is on the rise in most geographic regions (chart 3).

Chart 3: Value share of dark pools, Europe* 2.00% 1.80% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0% May Aug Nov 2008

Jan

May Aug Nov 2009

Jan

May Aug Nov 2010

Jan May 2011

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

The issue that has exercised regulators is whether the growth of dark pools is having a negative impact on markets overall, especially in terms of their impact on price formation.

Nobody has a consistent view, however, on the level of dark liquidity that negatively impacts price formation but to some extent this is the wrong question. The issue is really whether dark pools impact price formation negatively. This is because the primary aim of trading off-exchange is either to trade in a size that is a significant portion of ADV and/or to minimise information leakage. In this way this type of trading is different to that conducted on lit markets and so the two should be able to exist comfortably side by side.

So these three forms of fragmentation - primary versus alternative venue, primary versus primary and lit versus dark each posses their own symmetry and subtleties and so provide significant opportunities to those firms best able to navigate them. 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 • J U LY / A U G U S T 2 0 1 1

89

GLOBAL ETF SUMMARY

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

No. of ETFs 433 347 94 288 90 174 151 125 61 46 13 54 10 35 29 13 18 6 20 36 36 32 26 18 16 10 11 555 2,747

May 2011 Total Listings AUM (US$Bn) 1,530 $370.9 612 $327.1 217 $123.2 934 $103.0 123 $85.8 414 $61.4 278 $55.8 350 $48.8 111 $35.5 85 $16.8 34 $16.5 67 $14.9 18 $14.3 42 $9.9 113 $9.6 14 $8.4 22 $8.3 11 $7.8 21 $7.4 45 $6.3 46 $3.6 38 $3.5 26 $2.3 19 $2.1 37 $2.1 10 $1.7 13 $1.0 849 $98.5 6,079 $1,446.6

% Total 25.6% 22.6% 8.5% 7.1% 5.9% 4.2% 3.9% 3.4% 2.5% 1.2% 1.1% 1.0% 1.0% 0.7% 0.7% 0.6% 0.6% 0.5% 0.5% 0.4% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 6.8% 100.0%

ADV (US$Bn) $8.8 $29.8 $1.7 $2.2 $8.2 $1.3 $2.3 $0.3 $3.5 $0.9 $0.1 $0.0 $0.1 $0.1 $0.1 $0.2 $0.0 $0.0 $0.1 $0.2 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $1.7 $61.9

No. of ETFs 43 32 10 0 20 11 11 13 0 5 0 1 1 0 0 0 0 0 6 11 0 1 16 0 1 0 0 105 287

Total Listings 200 46 6 -61 22 26 18 38 10 1 0 3 2 0 2 0 1 4 6 14 7 5 16 0 4 0 1 153 524

YTD Change AUM (US$Bn) $33.1 $26.0 $12.0 $13.0 $5.3 $6.5 $8.2 $3.6 $3.8 $0.2 $1.2 -$1.7 -$0.4 $1.4 $0.1 $0.7 $0.6 $2.0 $1.0 $0.6 $0.8 -$0.1 $0.4 -$0.5 $0.4 $0.6 $0.2 $16.1 $135.2

% AUM 9.8% 8.6% 10.8% 14.5% 6.6% 11.8% 17.3% 8.0% 12.0% 1.1% 7.8% -10.1% -2.6% 16.4% 1.5% 9.7% 7.8% 35.0% 14.9% 10.7% 26.4% -3.0% 20.9% -18.5% 23.3% 61.5% 21.3% 19.6% 10.3%

% TOTAL -0.1% -0.3% 0.0% 0.3% -0.2% 0.1% 0.2% -0.1% 0.0% -0.1% 0.0% -0.2% -0.1% 0.0% -0.1% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% -0.1% 0.0% 0.0% 0.0% 0.5%

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

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

4.1%

Provider

Dec-2010

% Mkt Share

Change (%)

State Street Global Advisors

$18,667.3

40.3%

$27,784.9

44.9%

$9,117.6

48.8%

iShares

$14,028.5

30.3%

$17,944.7

29.0%

$3,916.1

27.9%

ProShares

$2,660.7

5.7%

$2,909.3

4.7%

$248.6

9.3%

PowerShares

$2,413.3

5.2%

$2,827.0

4.6%

$413.7

17.1%

Direxion Shares

$1,860.7

4.0%

$2,526.4

4.1%

$665.7

35.8%

Others

$6,710.2

14.5%

$7,891.5

12.8%

$1,181.3

17.6%

Total

$46,340.7

100.0%

$61,883.8

100.0%

$15,543.1

33.5%

Direxion Shares

12.8% Others

4.6% PowerShares

44.9%

4.7%

29.0%

ProShares

SSgA

iShares

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

Top 20 ETFs worldwide with the largest change in AUM As at end May 2011 ETF iShares MSCI Emerging Markets Index Fund iShares DAX (DE) Vanguard MSCI Emerging Markets ETF iShares MSCI EAFE Index Fund Market Vectors Agribusiness ETF db x-trackers DAX ETF iShares S&P MidCap 400 Index Fund iShares S&P 500 Index Fund iShares MSCI Japan Index Fund PowerShares QQQ Trust Vanguard REIT ETF Vanguard Total Stock Market ETF Technology Select Sector SPDR Fund iShares MSCI Germany Index Fund Vanguard Dividend Appreciation ETF iShares S&P US Preferred Stock Index Fund iShares iBoxx $ High Yield Corporate Bond Fund iShares S&P 500 Vanguard Mid-Cap ETF Vanguard MSCI EAFE ETF

Country listed US Germany US US US Germany US US US US US US US US US US US UK US US

Bloomberg Ticker EEM US DAXEX GY VWO US EFA US MOO US XDAX GY IJH US IVV US EWJ US QQQ US VNQ US VTI US XLK US EWG US VIG US PFF US HYG US IUSA LN VO US VEA US

AUM (US$ Mil) May 2011 $40,204.7 $10,719.7 $48,702.2 $40,810.7 $5,254.0 $6,269.3 $11,848.3 $28,279.8 $7,252.7 $24,368.2 $9,634.5 $20,338.2 $7,877.3 $3,828.2 $6,478.7 $7,965.9 $9,092.2 $9,573.8 $5,014.6 $6,895.3

AUM (US$ Mil) December 2010 $47,551.5 $5,917.7 $44,569.8 $36,923.1 $2,631.5 $3,693.1 $9,332.0 $25,799.2 $4,883.3 $22,069.9 $7,503.7 $18,236.0 $5,849.3 $1,881.7 $4,608.9 $6,120.7 $7,376.7 $7,905.8 $3,357.9 $5,304.0

Change (US$ Mil) -$7,346.8 $4,802.0 $4,132.5 $3,887.5 $2,622.5 $2,576.3 $2,516.3 $2,480.6 $2,369.4 $2,298.3 $2,130.8 $2,102.2 $2,028.0 $1,946.5 $1,869.8 $1,845.2 $1,715.5 $1,668.0 $1,656.7 $1,591.3

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

90

J U LY / A U G U S T 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 May 2011 ASSETS UNDER MANAGEMENT (US$ Bn)

CHANGE IN ASSETS

No. of No. of Exchanges Planned Providers (Official) New

No. Primary Listings

New in 2010

New in 2011

Total Listings

2010

May 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 Taiwan Singapore South Africa Brazil India New Zealand Malaysia Thailand Saudi Arabia UAE Indonesia Botswana Chile Israel Egypt Philippines Sri Lanka

1,008 1,154 1 1 1 270 412 3 1 14 23 16 7 1 3 1 1 12 23 123 12 229 184 86 47 23 19 90 28 15 23 26 8 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 -

112 108 13 42 4 1 2 5 12 22 27 6 7 8 28 9 3 2 1 2 -

1,008 3,954 21 28 1 491 1,213 3 1 14 532 115 15 1 3 1 1 68 78 675 12 681 218 90 76 23 350 90 49 18 81 26 8 18 6 5 4 2 1 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 $2.8 $3.6 $2.3 $1.9 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$984.0 $318.2 $0.1 $0.0 $0.3 $63.9 $122.5 $0.1 $0.0 $0.4 $2.9 $0.4 $0.8 $0.1 $0.0 $0.0 $0.0 $1.4 $3.3 $46.3 $0.2 $75.5 $41.9 $29.8 $28.2 $11.4 $9.0 $7.2 $3.9 $3.4 $3.3 $2.7 $1.8 $0.6 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$92.9 $34.2 $0.0 $0.0 $0.0 $4.0 $11.8 $0.0 $0.0 $0.0 $0.4 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.2 $0.5 $8.4 $0.0 $8.8 $3.6 -$2.4 $2.0 $1.3 $0.7 $1.9 $0.0 $0.6 -$0.2 $0.4 -$0.1 $0.3 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

10.4% 12.0% -32.5% -8.1% -4.9% 6.7% 10.6% -11.1% 24.5% 8.2% 15.7% 12.6% 14.7% 10.8% 5.4% 8.5% 3.2% 14.3% 18.2% 22.0% 12.1% 13.2% 9.3% -7.3% 7.4% 13.0% 8.9% 35.6% 0.2% 21.4% -6.6% 18.4% -3.1% 67.1% 0.3% -0.8% -5.2% 51.6% 5.4% 9.0% -

29 39 1 1 1 9 11 2 1 2 4 4 2 1 2 1 1 2 2 7 5 9 4 7 10 17 3 14 6 2 8 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 2 1 1 1 1 3 1 2 1 1 1 1 1 1 1 2 1 1 1 1 1 1 1 1 -

874 49*

ETF total

2,747

593

313

6,079

$1,311.3

$1,446.6

$135.2

10.3%

142

49

1,022

Location

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

11 0 1 20 1 5 5 3 3 15 1 20 0 3 0 1 4 0 1 0 2 1 1 1

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

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only.

This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the 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 May 2011, and are subject to change at any time due to changes in market or economic conditions.

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 1

91

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

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

200 180 160 140 120 100 80 60

11

0

11

M ay -

Fe b-

10

10

N ov -1

Au g-

M ay -

-1 0

09

Fe b

09

-0 9

N ov -

Au g

09

M ay -

Fe b-

N ov -0 8

Au g08

08

8

M ay -

07

07

07

Fe b0

N ov -

Au g-

ay -

7 M

Fe b0

ov -0 6 N

Au g

-0 6

40 M ay -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 May 2006 = 100) FTSE RAFI Developed 1000 Index

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

160 140 120 100 80 60

11

0

11

M ay -

Fe b-

10

N ov -1

Au g-

10 M ay -

Fe b

-1 0

09

09

-0 9

N ov -

Au g

M ay -

09 Fe b-

N ov -0 8

Au g08

08

8

M ay -

07

07

Fe b0

N ov -

Au g-

07 M

ay -

7 Fe b0

ov -0 6 N

-0 6 Au g

M ay -0 6

40

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

FTSE Global Government Bond Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

250

200

150

100

50

11

0

11

M ay -

Fe b-

10

N ov -1

Au g-

10 M ay -

-1 0 Fe b

09

-0 9

N ov -

Au g

09 M ay -

09 Fe b-

N ov -0 8

Au g08

08 ay M

07

07

Fe b08

N ov -

Au g-

-0 7 M ay

Fe b07

ov -0 6 N

-0 6 Au g

M

ay

-0 6

0

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

92

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USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 May 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

160 140 120 100 80 60

11

11

M ay -

0

Fe b-

10

10

N ov -1

Au g-

-1 0

09

M ay -

Fe b

N ov -

-0 9

09

Au g

09

M ay -

Fe b-

N ov -0 8

08

Au g08

8

M ay -

07

07

07

Fe b0

N ov -

Au g-

7

ay M

Fe b0

ov -0 6 N

-0 6 Au g

M ay -0 6

40

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

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

160 140 120 100 80 60

11 M ay -

11

0

Fe b-

10

10

N ov -1

Au g-

-1 0

M ay -

Fe b

09 N ov -

Au g

-0 9

09 M ay -

09 Fe b-

N ov -0 8

08

Au g08

8

M ay -

Fe b0

07

07

07 N ov -

Au g-

M

ay -

7 Fe b0

ov -0 6 N

-0 6 Au g

M ay -0 6

40

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

FTSE FRB10 USD Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance IPO Composite Index

160 140 120 100 80 60 40

11 M ay -

0

11 Fe b-

10

10

N ov -1

Au g-

-1 0

M ay -

Fe b

09 N ov -

09

-0 9 Au g

M ay -

09 Fe b-

N ov -0 8

-0 8

Au g08

ay M

Fe b08

07

07 N ov -

Au g-

-0 7 M ay

Fe b07

ov -0 6 N

-0 6 Au g

M

ay

-0 6

20

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

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

93

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

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

80

60

11

11

M ay -

0

Fe b-

10

N ov -1

10

Au g-

-1 0

09

M ay -

Fe b

N ov -

09

-0 9 Au g

09

M ay -

Fe b-

N ov -0 8

08

Au g08

8

M ay -

Fe b0

07

07

07 N ov -

Au g-

7

ay M

Fe b0

ov -0 6 N

Au g

-0 6

40 M ay -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 May 2006 = 100) FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

160 140 120 100 80 60 40

11

11

M ay -

0

Fe b-

10

N ov -1

10

Au g-

M ay -

-1 0 Fe b

09 N ov -

-0 9 Au g

09 M ay -

09 Fe b-

N ov -0 8

Au g08

08 ay M

Fe b0

8

07 N ov -

07

07 Au g-

M

ay -

7 Fe b0

ov -0 6 N

-0 6 Au g

M ay -0 6

20

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (30 May 2008 = 100) FTSE JSE Top 40 Index (ZAR)

FTSE CSE Morocco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

140 120 100 80 60 40

11 M ay -

11 Fe b-

0 N ov -1

10 Au g-

10 M ay -

-1 0 Fe b

09 N ov -

-0 9 Au g

-0 9 ay M

Fe b09

N ov -0 8

Au g08

M

ay

-0 8

20

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

94

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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 May 2006 = 100) FTSE Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

220 200 180 160 140 120 100 80 60

11

0

11

M ay -

Fe b-

10

N ov -1

10

Au g-

-1 0

M ay -

09

Fe b

N ov -

-0 9

09

Au g

09

M ay -

Fe b-

N ov -0 8

08

8

Au g08

M ay -

07 N ov -

Fe b0

07

07

Au g-

7

ay M

Fe b0

-0 6

ov -0 6 N

Au g

M ay -0 6

40

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 May 2006 = 100) FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

600 500 400 300 200 100

11

0

11

M ay -

Fe b-

10

N ov -1

10

Au g-

-1 0 Fe b

M ay -

09 N ov -

-0 9

09

Au g

M ay -

09 Fe b-

N ov -0 8

08

8

Au g08

M ay -

07 N ov -

Fe b0

07

07

Au g-

M

ay -

7 Fe b0

ov -0 6 N

-0 6 Au g

M ay -0 6

0

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

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

200 180 160 140 120 100

1 M ay -1

1 Ap r1

1 M ar -1

-1 1 Fe b

11 Ja n-

-1 0 De c

10 N

ov -

0 Oc t1

p10 Se

0

-1 0 Au g

Ju l1

Ju n10

-1 0 ay M

Ap r10

ar -1 0 M

Fe b10

-1 0 Ja n

De c09

N

ov -0 9

80

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

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

95

INDEX CALENDAR

Index Reviews July - September 2011 Date

Index Series

Review Frequency/Type

07-Jul

TOPIX

Mid Jul Mid Jul 27-Jul 05-Aug

OMX H25 SMI Family Index Russell US & Global Indices TOPIX

12-Aug 17-Aug 17-Aug 23-Aug 29-Aug Early Sep 01-Sep 02-Sep 02-Sep 02-Sep 02-Sep

Hang Seng Russell/Nomura Indices MSCI Standard Index Series DJ STOXX Russell US & Global Indices ATX S&P US Indices AEX BEL 20 PSI 20 S&P / ASX Indices

02-Sep n/a

FTSE Vietnam Index Series FTSE Renaissance Asia Pacific IPO Index Series DAX CAC 40 FTSE MIB FTSE China Index Series FTSE Global Equity Index Series (incl. FTSE All-World) TOPIX

Monthly review - additions & free float adjustment Semi-annual review - consituents Annual review Monthly review - shares in issue change Monthly review - additions & free float adjustment Quarterly review Quarterly IPO addtions Quarterly review Quarterly review Monthly review - shares in issue change Semi-annual review / number of shares Quarterly review - shares & IWF Periodic review Quarterly review Quarterly review Quarterly review - shares, S&P / ASX 300 consituents Quarterly review

02-Sep 02-Sep 06-Sep 06-Sep 07-Sep 07-Sep 07-Sep 07-Sep 07-Sep 07-Sep 07-Sep 07-Sep 07-Sep 09-Sep 08-Sep 08-Sep 08-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 15-Sep 28-Sep

FTSE / JSE Africa Index Series FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE UK Index Series FTSE Italia Index Series S&P / TSX STI and FTSE ST Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Multinational Dow Jones Global Indexes DJ Global Titans 50 S&P Asia 50 NZSX 50 S&P Europe 350 / S&P Euro S&P Topix 150 S&P Latin 40 S&P Global 1200 S&P Global 100 FTSE EPRA/NAREIT Global Real Estate Index Series FTSE4Good Index Series Russell US & Global Indices Russell US & Global Indices

Effective (Close of business)

Data Cut-off

28-Jul 29-Jul 17-Sep 29-Jul

30-Jun 30-Jun 30-Jun 26-Jul

30-Aug 02-Sep 31-Aug 31-Aug 16-Sep 31-Aug 30-Sep 16-Sep 16-Sep 16-Sep 16-Sep

29-Jul 30-Jun 30-Jun 31-Jul 29-Jul 26-Aug 31-Aug 31-Aug 31-Jul 31-Jul 31-Jul

16-Sep 16-Sep

26-Aug 26-Aug

Quarterly review Quarterly review/ Ordinary adjustment Annual review of free float & Quarterly Review Semi-annual constiuents review Quarterly review

16-Sep 16-Sep 16-Sep 16-Sep 16-Sep

31-Aug 31-Aug 31-Aug 05-Sep 22-Aug

Annual review / Japan Monthly review - additions & free float adjustment Quarterly review Quarterly review Annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review - constiuents, shares & IWF Semi-annual review

16-Sep

30-Jun

29-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep

31-Aug 31-Aug 06-Sep 06-Sep 06-Sep 06-Sep 06-Sep 06-Sep 31-Aug 31-Aug

Annual review / Developed Europe Annual review Quarterly review Quarterly review - no composition changes only rebalance/shares/float changes Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF

17-Sep 17-Sep 16-Sep

30-Jun 30-Jun 31-Aug

16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep 16-Sep

31-Aug 02-Sep 31-Aug 02-Sep 02-Sep 02-Sep 02-Sep 02-Sep

Annual review Semi-annual review Quarterly review - IPO additions only Monthly review - shares in issue change

17-Sep 17-Sep 30-Sep 30-Sep

31-Aug 31-Aug 31-Aug 27-Sep

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

96

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