FTSE Global Markets by FTSE Global Markets

ASIA TRADING: THE NEW FRAGMENTATION CHALLENGE

ISSUE 54 â&#x20AC;˘ SEPTEMBER 2011

Roundtable: a new era of securities services dawns UK debt: the art of the possible vs the probable Bahrain: can it return to its glory days? The slow return of Dutch banking

European sovereign debt

Can Trichet stave off euro meltdown? IF IT WALKS LIKE A DUCK IT IS PROBABLY AFLAC

OUTLOOK EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152 email: francesca@berlinguer.com SENIOR EDITORS: Ruth Hughes Liley (Trading); David Simons (US) CONTRIBUTING EDITORS: Art Detman; Neil O’Hara; Lynn Strongin Dodds CORRESPONDENTS: Rodrigo Amaral (Iberia/Emerging Markets); Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Matt Lynn (UK Markets); Ian Williams (Supranationals/Emerging Markets) PRODUCTION MANAGER: Mariangel Gonzalez, tel: +44 [0]20 7680 5161 email: mariangel.gonzalez@berlinguer.com SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5157 email: roy.shipston@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Paul Hoff; Jerry Moskowitz; Andy Harvill PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel: +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com AMERICAS, AFRICA & RUSSIA SALES MANAGER: James Ikonen, tel: +44 [0]20 7680 5158 email: james.Ikonen@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel: +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: DHL Global Mail, 15, The Avenue, Egham, TW20 9AB TO SECURE YOUR OWN SUBSCRIPTION: Register online at www.berlinguer.com Single subscriptions cost £497/year for 10 (ten) editions Multiple company subscriptions are also available FTSE Global Markets is now published ten times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2011. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but not responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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FTSE GLOBAL MARKETS • SEPTEMBER 2011

S THE WEARY cadre of global investment banks rushed to downgrade global growth in mid-August, even wearier equity market traders continued to slash holdings. It wasn’t only Japan that was hit by another 6.5 Richter scale shock; seismic shifts have been tailgating both Asian and Western markets for seemingly weeks on end. Further downward shifts were inevitable after a slew of negative US economic data added its own momentum in late August to the tectonic shocks that have reawakened fears of a double-dip crisis. President Obama may lay much of the blame on the intransigence of the Republican right to add more solid fiscal stimuli into a currently moribund US economy; though others will more rightly look at the seeming inability of the European Union states (members of the eurozone or otherwise) to introduce those much-promised (and still awaited) determined incisions in government spending and borrowing. In China, too, statements by government officials to reassure the markets could not help arrest the general downward slide in stock prices after Deutsche Bank downgraded its China growth outlook. The loss of momentum in the US economy, coupled with a three-decade low in consumer confidence—as measured by a recent Thomson Reuters/University of Michigan consumer sentiment index—bodes nothing but a wind-tossed autumn for the markets. For our part, we are doing our own bit to spread around the general air of doom and gloom. Our cover story highlights the complex mix of solutions required for Italy, the euro and the EU to get back on track. Andrew Cavanagh mixes it with investors and market commentators to raise the horns on which European dilemmas over the approaches to the sovereign debt crisis can be safely unhung. It won’t be an easy task. On the other hand, Matt Lynn explains how the UK’s own debt crisis management appears to have escaped censure, of any kind: from market commentators, to return hungry investors who are still piling into UK gilts. As market currents slowly erode the value in UK plc holdings, how long can the UK’s“boyish”chancellor hang on to his particular debt amortisation strategy? We offer you not just one, but two roundtables in this edition: one on the growing impact of market fragmentation in the Asian trading markets; the second on the reformations flowing through the asset servicing product set. Despite the ructions rioting through the global capital markets, a more fundamental shape shift is under way. There is a strong sense that what we are now undergoing is the last gasp of the sometimes flawed (but undoubtedly strong and dynamic) global financial structure that took its own revolutionary shape in the confluence of the Chicago School’s free market economics and the capital markets Big Bang in 1980s. What will emerge? Who knows: unlike some commentators, we do not think it is the end of capitalism. However, the question for us is whether the raft of incoming legislation will herald the stultifying winter of Sarbanes Oxley; or the flowering spring of UK financial deregulation under the Thatcher government. The jury is well out. We have a supplemental to this edition, largely concerned with the incoming raft of capital markets and investment regulation. These themes are also contained in the main magazine. We hope you enjoy the mix.

Francesca Carnevale, Editor, September 2011 Cover photo: European Central Bank President Jean-Claude Trichet gestures as he arrives for an EU Finance Ministers meeting at the EU Council in Brussels, Tuesday July 12th, 2011. Photograph by AP Photo/Geert Vanden Wijngaert, supplied by Press Association Images, August 2011.

CONTENTS COVER STORY

CAN GIULIO TREMONTI HELP SAVE ITALY AND THE EURO?

..............Page 6 Much has been said about the role of Germany in bolstering the euro and certainly chancellor Merkel has taken centre stage to propose institutional changes to help the cause. However, all those good intentions might unravel if Italy does not play ball. All of Europe now rests its hopes on Giulio Tremonti.

DEPARTMENTS

MARKET LEADER

IS THE UK IN CONTROL OF ITS SOVEREIGN DEBT? ............................Page 14

IN THE MARKETS

TEQUILA’S LONG SUNRISE

Matt Lynn reports on the efforts of the UK government to cap the rise in debt stock.

..........................................................................................Page 22 Cool dudes and US wannabees extend Tequila’s appeal. Ian Williams reports.

COMMODITIES REPORT

INVESTING IN COMMODITIES IN EXTREMIS ..............................................Page 26

SPOTLIGHT

NEW REPORT HIGHLIGHTS DC MARKET GROWTH ............................Page 32

Vanja Dragomanovich on the need for a long-term outlook in commodities investment.

This month’s round up of investment market news.

BAHRAINI BANKING: PROFITS UP BUT ASSETS DOWN

................Page 34 The steady bounce back underpins a hopeful second half for the country’s banks.

SECTOR REPORT

LIVING IN THE AFTERMATH........................................................................................Page 38 How are Spain’s banks faring as the euro remains under strain?

NORDIC BANKS DIMMED BY GLOBAL DOWNTURN ..........................Page 42 Profits are generally up, but the outlook is mixed.

FACE TO FACE

WITH GORAN FORS, SEB ..............................................................................................Page 46

FX VIEWPOINT

THE CHF AND FX MARKET CYCLES

REAL ESTATE INDEX REVIEW

DATA PAGES

SEB’s asset servicing chief discusses ways to address the challenges of regulation.

..................................................................Page 48 Erik Lehtis, president of DynamicFX, analyses the rise in the value of the Swissie.

TOWER POWER REVIVAL IN LONDON ............................................................Page 50 Mark Faithfull reports on the return to form of London’s office market.

FEARS OF CHEAPER VALUATIONS STALK THE MARKETS

............Page 53 Simon Denham, managing director of Capital Spreads, takes the ultra-bearish view.

DTCC Credit Default Swaps analysis ............................................................................................Page 107 Fidessa Fragmentation Index ......................................................................................................................Page 108 BlackRock ETFs ..................................................................................................................................Page 110 Market Reports by FTSE Research..............................................................................................................Page 112 Index Calendar ..................................................................................................................................................Page 116

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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CONTENTS FEATURES TRADING REPORT:

TACKLING THE DANGERS IN DARK TRADING ....................................Page 54 A trader who accepts small fills will find that other traders can sniff out his intentions and drive the price against him before he has finished. How to get around it? Neil O’Hara goes in search of some answers.

BANKING ON THE PROMISE OF RUSSIAN STOCKS ..........................Page 59 The impending merger between MICEX and RTS will redraw the Russian trading landscape should it survive concerns over market concentration and regulatory hurdles. Ruth Hughes Liley reports.

ROUNDTABLE: ASIAN TRADING LEVERAGES FRAGMENTATION..Page 65 “Fragmentation is now bringing more liquidity into the markets. We see spreads reducing; trying to deal at mid, trying to get access to bigger liquidity venues,” explains Steve Mantle, regional head of trading, State Street Global Advisors.

CHANGING THE RULES IN OTC TRADING ..............................................Page 75 Regulation looks to ultimately force many over-the-counter (OTC) derivates on to exchanges and through clearing houses. Ruth Hughes Liley reports on the practical implications of change.

COMPANY PROFILE:

AFLAC FLIES THROUGH STORMY WEATHER ........................................Page 79 Art Detman admires the way the insurer manages almost always to find a soft landing. Today, the specialist medical insurer dominates the Japanese market; an unusual feat for a foreign firm. Art explains how it was done.

SECTOR REPORT:

STEERING DUTCH BANKS TOWARDS SUSTAINED GROWTH

....Page 83 Lynn Strongin Dodds reports on the efforts of Dutch bankers to steer through the skittish global financial markets. They’ve worked hard at putting their houses in order; but is it enough to meet the challenges ahead?

PRIME BROKING:

GROWING COMPETITIVE PRESSURES ........................................................Page 86 Prime broking is in flux, with long established players and now custodians angling for market share. However, not everyone can win in the increasingly competitive game of prime services. Lynn Strongin Dodds reports.

SECURITIES LENDING:

STEADY GAINS UNDERCUT BY FINANCIAL UNCERTAINTY ........Page 90 Despite weathering recent financial storms with brio, Canada’s hedge funds are treading carefully under the shadow of impending regulation. Neil O’Hara reports on impact on securities lending.

THE INEXORABLE RISE OF SEC LENDING IN LATIN AMERICA

Page 94

Interest in securities lending has grown as the region is awash with national budget surpluses and borrowers exploit new investment strategies. Neil O’Hara reports on the hot spots.

ROUNDTABLE:

SECURITIES SERVICES EVOLUTION IN AN AGE OF CHANGE ......Page 97 Incoming regulation in Europe will change the face of asset servicing and asset management for ever. Does the industry look to this future with gladness or trepidation? Read the roundtable to find out.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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COVER STORY

EUROPE: MARTIALLING COUNTRIES & INSTITUTIONS TO SAVE THE EURO

Italian finance minter Giulio Tremonti looks on prior to a vote on a crucial €70bn ($99bn) austerity package aimed at convincing investors that the eurozone’s third-largest economy won’t be swept into the debt crisis, at the lower house of parliament, in Rome, Friday, July 15th, 2011. Photograph by AP Photo/Andrew Medichini, supplied by Press Association Images, August 2011.

Can Guilio Tremonti help save Italy and the euro? The eurozone came as close it has yet to break-up in the first week of August, when it looked as if fixed-income investors were no longer prepared to buy Spanish and Italian sovereign debt at a price their governments could sustain. That point had long been identified as one of no return for the euro (at least in its present form), and it was only the intervention of the European Central Bank—which started buying up both countries’ bonds in the secondary market—that averted disaster. How long can the ECB’s support stave off the threat of financial Armageddon? Andrew Cavenagh reports. HE EUROPEAN CENTRAL Bank’s (ECB’s) decision on August 7th to “actively implement” its Securities Markets Programme the following day in respect of Italian and Spanish debt (although it did not specifically name the countries) has brought Europe’s politicians some breathing space. Within two days, the yields on ten-year Spanish and Italian sovereigns had fallen back to 5.09% and 5.19% respectively from the euro-

era highs of over 6% they had reached the previous week to return the borrowing costs of both countries’ cost to affordable levels—at least temporarily. “Spain and Italy are solvent for the time being, at these yields or lower,”explains John Stopford, head of global fixed income at Investec Asset Management in London.“The ECB’s intervention has been effective so far, but I think it is an open question as to how much more will be necessary.”

The ECB’s move came at the end of a week that saw the United States lose its triple-A rating from Standard & Poor’s and $2.5trn wiped off the value of global stock markets. An uncontrollable run on the sovereign debt of the third and fourth largest countries in the eurozone threatened to precipitate a financial meltdown that would have eclipsed anything that occurred in 2008, and there was intense pressure from across the G7 and beyond for the central bank to act swiftly and decisively. Fraught with division on its governing council, however, the ECB demanded (and got) concessions from the four main governments in the eurozone before it agreed to re-implement and extend its bond purchases. The bank’s statement on the night of August 7th stressed that it had done so “on the basis” of commitments by the Italian and Spanish governments to step up their fiscal austerity pro-

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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COVER STORY

EUROPE: MARTIALLING COUNTRIES & INSTITUTIONS TO SAVE THE EURO

grammes, and a pledge from France and Germany to secure parliamentary approval by the end of September for important changes to the European Financial Stability Facility (the European Union bailout fund for beleaguered member states). These were agreed at the European Union (EU) summit in late July and will not only expand the facility’s lending capacity to €440bn but also enable it to buy the sovereign bonds of distressed member states (and in theory absolve the ECB of this obligation). While the ECB’s intervention gave immediate respite to the Spanish and Italian sovereign markets, however, too many uncertainties still hang over the future of the euro for the central bank’s move on its own to restore market confidence in the longer term. One leading question is how much support the central bank will need to provide for Spain and Italy over the next two years, and whether it can muster the necessary political backing for what will be required. Analysts at Royal Bank of Scotland suggested that the ECB would have to be prepared to buy up to €850bn of Italian and Spanish bonds, a sum equivalent to the entire financing requirement of both governments over the next two years, to convince the markets. The RBS team points out that

those countries and that all three had ultimately been obliged to seek EU/IMF bailouts. In the absence of a long-term (and sufficiently large) commitment from the ECB to support Italian and Spanish sovereign debt, analysts argued that fixed-income investors would simply view the present drop in yields as no more than a selling opportunity. “Over time, we believe that ongoing selling pressure will force the ECB/EFSF to eventually hold close to half of the traded Italian and Spanish debt or around €850bn,” their research note concluded.

Alarm bells continue to ring

John Stopford, head of global fixed income at Investec Asset Management in London. “Spain and Italy are solvent for the time being, at these yields or lower. The ECB’s intervention has been effective so far, but I think it is an open question as to how much more will be necessary,” he says. Photograph kindly supplied by Investec Asset Management, August 2011.

the central bank’s purchase of €76bn of Greek, Irish, and Portuguese sovereign bonds between May 2010 and March this year had failed to restore confidence in the sovereign debt of any of

That is a figure that is bound to set alarm bells ringing. For if Spain and Italy need that level of support, the lending capacity of the EFSF will need to be increased by up to three times the enlarged limit that was agreed at the most recent EU summit. Given real doubts that individual member states will actually be able to deliver fully on the commitments that their leaders gave there, the prospect of an even bigger EFSF seems remote indeed. If all investors were not convinced of the magnitude of the problem, it is useful to remember that Greece accounts for 0.3% of the total GDP of the European Union; Italy some 17%. That puts the requirement of the EFSF to provide support and the role of Giulio

Key OECD government debt as a % of GDP 2000

2010

180 160 140 120 100 80 60 40 20 0

Spain

France

Portugal

USA

Ireland

Italy

Greece

Japan

Source: OECD, supplied August 2011.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COVER STORY

EUROPE: MARTIALLING COUNTRIES & INSTITUTIONS TO SAVE THE EURO

the ECB council, seems particularly significant in this regard. Actually, Weidmann was appointed in April following the resignation of Axel Weber who had courted controversy by objecting to the ECB’s bond purchases to support Greece and Ireland in 2010. Weidmann’s rapid adoption of his predecessor’s stance confirms that the Bundesbank remains firmly against monetising government debt and views such a course as too high a price to pay for saving the euro; an interesting approach given recent pronouncements by German chancellor Angela Merkel and French president Nicolas Sarkozy, and may go some way to explaining why their solutions to Europe’s debt problems were institutional and fiscal, rather than financial.

Further trouble expected

French president Nicolas Sarkozy and German Chancellor Angela Merkel giving a press conference about Europe’s debt crisis at the Elysee Palace in Paris, France on August 16th, 2011. Photo by Nicolas Briquet/ABACAPRESS.COM, supplied by Press Association Images, August 2011.

Tremonti, Italy’s finance minister, of ensuring that fiscal probity is maintained over the foreseeable future into stark perspective. Moreover, Justin Knight, head of European rates strategy at UBS in London, points out that some of the proposed changes to the EFSF would face “major political and legal hurdles” in being converted into detailed policy, prior to securing parliamentary approval. Given the EFSF’s remit does not allow it legally to pre-fund the needs of member states (but only intervene in “exceptional”market circumstances), for example, he says it was uncertain how it would be able to assume the marketsupport operations of the ECB. As a consequence, Knight says any amendments to the EFSF’s scope that ultimately might come into force are likely to be heavily watered down when set against the markets’ perception of

the summit announcements and— assuming recent estimates on the scale of the necessary intervention were halfway accurate—might also well be redundant. “There’s a good chance that market events might overtake that policy anyway,” he notes. It all adds up to the following: if the EFSF cannot provide the necessary degree of market support for whatever reason, be it legal impediments or insufficient size, the solvency of Spain and Italy (and future of the euro) will depend on the ECB continuing to buy their debt in the necessary volumes for up to another two years. Given the evident divisions on the central bank’s governing council—with the four German and Benelux members coming out strongly against the latest market intervention— there can be no certainty that it will do so. The opposition of Jens Weidmann, the Bundesbank president who sits on

These messages have clearly not been lost on the markets, as the credit default swaps on Spanish and Italian sovereign debt did not follow the underlying bond spreads down in the second week of August. “CDS levels are still high for the dynamic duo, suggesting credit markets expect further trouble down the line,”comments Suki Mann, credit strategist at SGCIB.“Few are convinced we have even the initial makings of a solution to the European sovereign debt problem.” Investors endorse this view. “The diverging CDS spreads tell me that things are still on the edge for these countries,” says Nicola Marinelli, portfolio manager at Glendevon Asset Management. “I think this central bank buying is important to counter market sentiment right now, but it is not a long-term fix.” Stopford at Investec added that it was likely to become evident within the next few weeks if the ECB’s action had been effective in stabilising the spreads and yields on Spanish and Italian sovereign debt.“The big test will be what happens when they come back to the market in the autumn,” he says. Given the doubts over the extent and efficacy of ECB support, there is a

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COVER STORY

EUROPE: MARTIALLING COUNTRIES & INSTITUTIONS TO SAVE THE EURO

If the EFSF cannot provide the necessary degree of market support for whatever reason (legal impediments or insufficient size), the solvency of Spain and Italy—and future of the euro—will depend on the ECB continuing to buy their debt in the necessary volumes for up to another two years. growing consensus across the financial markets that the only long-term solution to the difficulties in the eurozone will be a form of fiscal union that provides a common umbrella for the issuance of euro-denominated sovereign debt.“I think we are getting close to the point where some form of common bond market is probably the only option that will be sustainable in the long term,” says Stopford. While this idea has been a topic of discussion among public-policy analysts and economists for over a year, it will surely rise up the political agenda as the crisis gets worse. It came as close as it has yet to the core of the eurozone in the second week of August, when France become the latest victim of market jitters; with French bank shares falling sharply on mass sell-offs and rumours that the country’s sovereign rating was under threat. The details of such a common bond scheme (which would require amending the European Treaty) have yet to be worked out let alone finalised. The principle would be to limit such jointly and severally guaranteed debt to probably 60% of a country’s GDP. Above that level, member states would still have to issue debt on the strength of their own individual credit. The plan would have the obvious advantage of creating a clear distinction between the credit quality of the two classes of debt, which would enable the markets to price them accordingly. A further benefit would be that sovereign issuers in the eurozone would no longer have any incentive to overspend as some have done in the past (as the debt they incurred to do so would become progressively more expensive). At the same time, systemically important financial institutions should receive suf-

ficient early warning signals (about any individually-issued debt) to avoid overinvesting in sovereign bonds that would potentially threaten them with bankruptcy in the event of a default. One problem of implementing such a system now is that most of the euro states currently have levels of debt that are well above 60% of their GDP, so that issuing subordinated sovereign debt may not be feasible (and it is quite possible that countries other than Greece, Ireland and Portugal will find they cannot issue such debt at sustainable cost in the near future).

Necessary fiscal adjustments A possible solution, however, would be for all of the euro-area governments to issue 100% of their future requirements in the form of the jointly guaranteed euro bonds until the outstanding issuance of such instruments reaches 60% of GDP level (at which point they would have to start issuing on an individual subordinated basis). In the time it took the governments to amass debt equivalent to the 60% of GDP threshold—at least six years— most should have been able to make the necessary fiscal adjustments and structural changes to regain the confidence of the fixed-income markets in their stand-alone bonds. For those countries unable to achieve that position by the time they reach the threshold—Greece is the obvious case, but there could be others—some restructuring of existing debt would need to accompany the move to the new eurobond financing. The exercise would also have to include the harmonisation of social benefits such as retirement age across the eurozone, as German taxpayers can hardly be expected to guarantee preferential

pension terms in the southern Mediterranean countries; although the erosion of such differentials is already happening as part of the austerity programmes. While the eurobond concept may look increasingly like the only way of preserving the single currency in its current form, however, that is no guarantee that it will come into force. Securing the necessary agreement from all member states in the present political climate—with nationalist sentiment on the rise in the face of the widespread fiscal austerity measures and mounting opposition to bailouts of profligate neighbours, it will be an immense challenge. “We are at the worst time to try any kind of union in Europe,” claims Marinelli at GAM. Germany’s finance minister Wolfgang Schaeuble certainly rejected the idea of eurobonds recently, saying he would rule it out as long as individual states continued to conduct their own financial policies. German opposition to the concept was no doubt the reason why president Sarkozy did not raise the issue at his meeting with chancellor Merkel on August 16th as some had predicted. Nevertheless, the markets’ lukewarm response to the loosely-defined commitments for closer economic integration (along with a proposed tax on financial transactions) that did emerge from their meeting reinforced the argument that it is probably the only way to preserve the euro. Given Germany’s critical importance to a common eurobond market, whether or not one comes into being will depend on the country’s politicians—and probably its electorate— ultimately deciding that it will be a lesser evil than allowing the euro project to collapse. Either way, the future of the euro, at least for the time being, lies more in the hands of crisis-stricken finance ministers, such as Giulio Tremonti, than chancellor Merkel or president Sarkozy. That’s a conundrum that either the Germans (or the French for that matter) or investors will be too happy with. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

UK DEBT: JUGGLING THE POSSIBLE VS THE PROBABLE

It was, in a small way, a significant turning point in Britain’s recent economic history. On August 9th, with the United States market still reeling from the decision by the ratings agency Standard & Poor’s to downgrade US debt from triple-A, and with the main eurozone markets still rocked by attacks on the creditworthiness of Spain and Italy, the cost of insuring against a default on UK gilts fell below the cost of insuring against German government bunds. In other words, the market was more worried about the possibility of Germany defaulting on its debts than it was about the UK. Matt Lynn reports on the reduction in spreads between German and UK government debt and its near and medium-term implications.

How long can the UK continue with its current debt management strategy?

Chancellor George Osborne arrives at 11 Downing Street in Westminster, Central London, as optimism among manufacturers in the UK fell for the first time in two years, a key survey revealed, as industrial orders and production eased. Photograph by Sean Dempsey/PA Wire, supplied by Press Association Images, August 2011.

T WAS QUITE a turnaround. In 1976, according to Bank of England figures, the spread between bunds and gilts hit 8%. Throughout most of recent history, the markets have demanded a significant premium to buy British government debt vis-à-vis US or German government debt. That is no longer true. The spread between the two has fallen to all-time lows: the yield on ten-year UK government debt was 2.52% by early August, compared with 2.28% on German bunds. What was perhaps more extraordinary was that the switch came against the backdrop of the largest budget deficits the country had run in peacetime. Despite racking up vast debts, and despite the fact that the number of gilts on the market has roughly doubled over a period of just three years and keeps climbing massively every year, the British government has so far met no significant resistance from the market. The more paper it issues, the more investors lap it up. So how has the UK managed to raise such vast sums from the debt markets, and, moreover, been able to do so without seeing any significant spike in the interest rates it has to pay? Has it been skilful, or just lucky? Is it going to be able to carry on funding its vast budget deficit—or will it one day find itself in the same position as Greece and Ireland, forced by the markets to seek some form of bailout. “It is fifty-fifty,” says Marc Ostwald, a strategist with Monument Securities. “Investors have given the UK a lot of credit for setting out a clear austerity plan which made sense to investors. On the other hand, circumstances have clearly been very

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

UK DEBT: JUGGLING THE POSSIBLE VS THE PROBABLE

favourable, most of all over the euro, but latterly over the US as well.” True enough. Even so, the amount of paper the UK government now needs to sell every year is unprecedented. When Gordon Brown became chancellor in the Labour government of 1997 he put in place a“golden rule” which stated that the budget had to be balanced over the economic cycle. There was some debate about when the economic cycle started and stopped, and it seemed to shift according to Brown’s preferences. Still, there was an intention to get rid of deficits, and actually pay back debt in the good years. Among some City strategists there was a worry that there might be a shortage of gilts and institutions would have to find somewhere else to park risk-averse cash. That seems very distant now. Borrowing, which was already running at dangerously high levels during the relatively strong growth of the mid-2000s, exploded after the credit crunch. The UK had to pay for one of the world’s most extensive bank bailouts. As the economy contracted sharply, tax revenues collapsed and the cost of welfare soared. In 2008-2009, the budget deficit jumped to 6.7% of GDP, according to figures published by the Office for Budget Responsibility (OBR). Then, in 2009-2010, it went up again to 11.1% of GDP, one of the highest rates in the developed world. In 2010-2011, it should be down to 9.9% of GDP, but that is only a very modest decline, and historically a very high figure. The OBR forecasts that a mix of spending cuts and tax rises—mostly a huge hike in VAT to 20%—will bring the deficit down to 6.2% of GDP by 2012-13, to 2.5% of GDP by 2014-15, and to just 1.5% of GDP by 2015-16. That would be an impressive achievement. The question is, however, can those targets be achieved? Can the coalition government keep funding itself cheaply until it finally gets the budget back into some sort of balance? It looks in reality as if things will get worse before they get better.

UK government spending (2011 - 2012) £74bn Others

£200bn Debt interes £33bn Public order and safety

£200bn Social protection

£24bn Housing & environment

£32bn Personal social services

£20bn Industry, agriculture and employment

£126bn Health

£40bn Defense £89bn Transport

£23bn Transport

Source: Office of Budget Responsibility, 2011-12 estimates. Allocations to functions are based on HMT analysis. Supplied August 2011.

UK government receipts (2011 - 2012) £26bn Council tax

£25bn Business rates

£100bn VAT

£48bn Corporation tax

£85bn Other £158bn Income tax

£101bn National insurance

£46bn Excise duties

Source: Office of Budget Responsibility, 2011-12 estimates. Other receipts include capital taxes, stamp duties, vehicle excise duties and some other tax and non-tax receipts—for example, interest and dividends. Supplied August 2011.

The number of gilts in circulation has risen dramatically. By this year, there were £1.03trn in issue, according to figures from the Debt Management Office (DMO), which manages the sale of government debt. In 2000, the total outstanding was just £290bn, and even in 2008 it was less than £500bn. In less than three years the government has racked up more debt than it managed in the last century combined. There is a lot more to come. In the year ahead, the UK government plans to sell £57bn of short-dated gilts, £34bn of medium-dated, £37bn of long-

dated, and £38bn of index-linked gilts. “We have a strong investor base, so it is our policy to supply into that,” says Steve Whiting, a spokesman for the Debt Management Office. “We have seen strong investor demand right along the curve.” The composition of the debt has been subtly changing as well. The DMO has been selling more index-linked gilts, which pay a fixed interest rate over and above whatever the inflation rate happens to be. Of the £1trn in debt outstanding, £233bn is now index-linked. There is a huge amount of demand for

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UK DEBT: JUGGLING THE POSSIBLE VS THE PROBABLE A looter emerges from a branch of Western Union on Clarence Road that was broken into on the third day of violence in Hackney, London. Photograph by James Crease / Demotix/Demotix/Press Association Images, supplied by Press Association Images, August 2011.

that kind of paper. Pension funds in particular like it because it protects them against rising prices. However, as Monument’s Ostwald points out, it can also be expensive. Every uptick in the inflation rate—and even the Bank of England now admits it may creep up to 5% before finally coming under control—adds to the government’s annual interest bill. Perhaps more significantly, the government has been pushing out more and more long-dated bonds. In 2005, it issued 50-year gilts, and this year there has been a flurry of issues at that

end of the spectrum. “The average maturity of the UK gilt and Treasury bill portfolio is 13.5 years, whereas most other countries have a much shorter profile,” says Whiting. Indeed so. In the US, average debt maturity is about four years. In Germany and France it is between six and seven years. The advantage for the UK is twofold. First, it is selling very long-dated debt at a time when interest rates are at record lows. Secondly, it is selling debt that will last for half a century at a time of relatively benign market conditions. Investors are

worried about equity markets, and UK sovereign debt is still perceived as safe. Take some of the most recent issues. In July, it sold £5bn of 50-year gilts at an interest rate of 4.1%. What will interest rates look like during the five decades between now and then? No one can really say. If you think though of the 50 years between, say, 1910 and 1960, it is clear that an awful lot can happen over that sort of timescale. Even so, the government will have locked in its borrowing for the long term and the current crops of politicians—even the youthful UK chancellor George Osborne—will have long since departed the stage. Political calculations aside:“The fact that the UK has a longer maturity on its debt has been an important technical factor in supporting the gilts market,” says Nicholas Spiro, managing director of Spiro Sovereign Strategy, a consultancy specialising in sovereign risk. “So has the fact that the bulk of the debt is held by domestic institutional investors. Then again, you could say the same thing about Italy or France, and look at what has happened there.” Although the UK has done extraordinarily well with managing its debts up to now, it won’t necessarily be quite so easy going forward. “Sterling is clearly perceived as something of a safe haven right now,”says Ostwald.“This is not the Swiss franc but clearly, there is no immediate threat.” The gilts market has benefited hugely from the troubles in the eurozone. Global investors are fleeing countries such as Italy and Spain and now even France and Germany. The US has been downgraded already. Japan has a worse debt profile than anyone. Against that backdrop, the UK looks a relatively good bet. “What we have seen in ‘euro-land’ and in the US is a lack of credibility,” says Spiro. “George Osborne has very cleverly been able to sell a story to the markets about the scale of the fiscal retrenchment. But ultimately, he has been saved by the fact that the UK is seen as a safe haven,” he adds.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

UK DEBT: JUGGLING THE POSSIBLE VS THE PROBABLE

Investors in UK debt (2011) 17.8% Other financial institutions 1.5% Other

39.8% Insurance companies and pension funds

2.9% Banks 35.1% Overseas investors

2.9% Households

Although the majority of gilts are held by British institutions, the amounts held overseas has risen sharply since 2011. Currently, just over 35% of UK national debt is owed to foreign government and investors. Source: The UK Debt Management Office, supplied August 2011.

That might not necessarily be the case forever. There are three sticky problems. Firstly, overseas demand may not hold up. Global investors have been absorbing vast quantities of British debt. A third of all gilts are held by foreigners. The total is £309bn, compared with £86bn at the start of 2005. So non-UK investors have bought more than £200bn of gilts in just six years. The problem with foreign holdings is that they can be volatile. Just ask the Greeks. Although right now gilts may be a core holding for British institutions, they are not for foreign ones. There was already a slight drop in overseas holdings in the latest quarter for which the DMO has published figures. “One quarter of figures does not mean a great deal,” cautions Whiting. True enough. Then again, a decline has to start somewhere. A small drop can very quickly turn into a big one if a trend gets established. For the moment, and with most markets in turmoil, let’s look at the bright side. Next, the economy may not perform as well as hoped. UK government budget projections are critically dependent on growth holding up, which will help to lift tax revenues. That may well not happen. The Bank of England has just cut its growth forecast to 1.5% this year, from 1.8%, and to 2% next year, down from 2.5% and more down forecasts are likely. Morgan Stanley

economist Melanie Baker, for one, thinks the Bank of England estimates are optimistic. She estimates growth of just 1.8% next year.“The main drivers of our forecast for subdued GDP growth remain weak consumer spending, a weak recovery in investment (here we remain significantly below-consensus) and fiscal tightening,” she argues in a report published in early August.

Wildly off course That matters for the deficit. Lower growth translates into lower tax revenues and higher spending. Knock a couple of tenths of a per cent from growth, project forward a couple of years, and suddenly those optimistic forecasts of a budget getting back close to balance by the middle of the decade are blown wildly off course. On the other and perhaps more unlikely hand, the economy may recover faster than expected. The fact that the economy is so weak has helped the gilt markets. Investors assume interest rates are going to stay at record low rates for a very long time. The Bank of England may well engage in more quantitative easing: last time around, that involved the UK’s central bank buying massive quantities of gilts for its own account, and if it does so again that can only help demand. With the economy weak, equities don’t look

very attractive, even if the FTSE 100 index offers a far better yield than gilts and probably better growth prospects as well, over the long term. Even so, current market volatility shows no signs of abating and any continuation in the falloff in the value of the world’s leading equity indices over the all-important fourth quarter of this year (when by most reckonings, the markets should begin to pull back into the sane zone), could scupper all but the best laid plans. By the third week of August, most commentators reckoned that the falloff in equity prices had cost the UK exchequer some £40bn; a figure which puts on shaky ground most of its current calculations. Equally, once and when the UK economy shows clear signs of pulling out of the slump, and interest rates look as if they might start to rise, then an entirely different market scenario comes into play. Gilts will look a lot less attractive; and possibly other assets even more so. Investors will focus a lot more on the fact that inflation means they are losing money on their gilts in real terms—not something bond investors are usually willing to accept. Indeed, the fact that it has been so easy to fund the UK’s huge deficit could have dangers of its own for investors.“It may well be lulling them into a false sense of security,” cautions Ostwald. “We haven’t seen negative real interest rates like this since the dark days of the 1970s and the early 1980s.” So far, it has been so good for the UK government. “Relative to other assets there is an enormous appetite for gilts,” says Spiro. “We are living in a world where everything is relative, and we are seeing a stampede for safe havens. The UK is not part of the euro; it has its own currency and can set its own interest rates, and those all make it relatively attractive.” So long as that is true, the UK can almost certainly fund its deficit. Even so, if the UK does not bring its fiscal policies into a more acceptable balance by 2013 (and right now, that is a big, big ask) there may be yet more trouble ahead. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

THE TEQUILA FACTOR: LOOKING FOR EM GROWTH

Mexico survived the “gringo crash” relatively unscathed; and so did its renowned spirit. Global sales of tequila carried on growing during the crisis, but the premium brands sales soared. From 2009 to 2010, in the depths of the recession, sales of the premium category rose by 28% and this year managed a still impressive 22%. Tequila consumption in the United States has increased 45% over the past five years so it is no surprise the Central American nation is waking up to the tourism power of tequila the drink and the place, the farming region where the prickly Weber blue agave plants are distilled in the production of the liquor. From an exotic and dubious upstart in the cocktail cabinets of the world, the Tequila makers, in conjunction with the Mexican government, have been jointly and severally successful in raising the prestige of the category and their individual brands. Ian Williams reports on the bristling fortunes of the agave-based spirit.

Part of the tour of Herradura Tequila in Tequila, Mexico, which includes a demonstration by a jimador, who uses a flat-bladed knife called a “coa” to remove the spiny leaves from the centre pina of an agave, which is baked until the starches inside turn to sugar. Photograph by Tracie Cone/AP for Press Association Images, supplied by Press Association Images, August 2011.

Tequila’s growing global appeal EQUILA SELLS TO more than 100 countries worldwide. While the US remained a large and growing market last year, taking 77.6% of exports, that is a smaller proportion than the previous year despite an impressive 9% annual growth. In other markets the growth is incredible; 76.7% in Canada, for example. Despite the odd surge in selected developed markets, growth rates have been particularly impressive in the BRICs. For example, in 2009-2010, premium sales grew by an astonishing 46% in Russia, where the customers are newly-affluent women wanting to

drink something more prestigious and more flavourful than the indigenous vodka. Interestingly, Germany is listed as the second-largest export market for tequila, though its producers point out that the drink is often sold on from there across Eastern Europe. Even so, as the market heats up direct sales are becoming more common. While the BRIC nouveaux riches’ seemingly insatiable appetite for global luxury brands can explain the attraction for expensive tequilas, the drink and its brands need some explanation for unaccustomed customers. Producers worldwide still have to point out that

the agave is not a cactus and that it is mezcal, not tequila, that sometimes contains a worm. On the other hand, that could be an advantage, since a common worry of many of the high-end makers in the US until recently, and even now in the European Union (EU), is that if consumers knew about tequila at all, it was from cheaper brands used as an adjunct to binge-drinking, epitomised in the postcard slogan “Tequila! Have you hugged your toilet yet?” At least cheap tequila and binge habits had not imprinted such folk memories outside the US and the EU! Tequiladores take comfort not only from the stunning growth rates in sales, but also from the relatively low global penetration of the spirit. That implies lots of room for expansion. Even in Mexico it accounts for 34% of local spirits consumption; and surprisingly it is often more expensive in its home market than its foreign rivals. The big attraction is that even in the US (by far the largest market for the spirit) tequila only accounts for 6% of the spirits market, leaving plenty of sales space, while in the rest of world there is even more room for growth. Global liquor groups have been working hard to leverage that fact. Over the past decade when the major liquor providers shuffled their decks of brands to avoid anti-competition litigation, they had all acquired a tequila brand, whether by outright acquisition or by contracting for distribution rights. Diageo, for example, bought Herradura a decade ago and has concentrated on the premium end of the market. It is now the US market leader with more than a third market share.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Commercially, there are pluses and minuses to the industry. Unlike various whiskies, brandies and rums, tequila does not generally need large inventories of spirits that mature over years and decades. Most brands are aged less than two years and many less than two months, although that is increasing for the premium brands. On the other hand, from a maker’s point of view, each bottle of tequila incurs a long-term investment in nurturing the agave plants from which it is made. They can take from eight to ten years to grow to maturity. Spearheading the global charge are business groups such as Pernod Ricard with its Olmeca brand, Brown Forman which produces Herradura, Fortune Brands sells its Sauza tequila, and Diageo distributes Cuervo.

Diageo is wooing Cuervo with the intention of buying the brand outright but the family is playing hard to get. In any case, the global distributors all appreciate the need for a distinctive identity for their high-end brands, regardless of ownership. They maintain historical haciendas and promote the history and continuity of their brands. Homogeneity does not work at the luxury end, and the global liquor groups know that they should not impinge on the distinctive identities of the brands while using their worldwide distribution networks to push the product. Specialised high-end brands such as Patrón and Casa Noble have carved a niche as boutique luxury brands and have had to build their own distribution networks, bottle by bottle. John McDon-

nell, chief operating officer of Patrón Spirits International, muses: “Take Germany, our second-biggest market, the biggest brand is a cheaper one, but in London with its mixology culture, they have really taken up Patrón. All good things take time. We’ve come from nowhere to [this point] in a short time.”

Commitment to quality Common to all the premium producers is an insistence on quality not to be compromised by bean-counting. McDonnell says:“We do not stint on making it. If you don’t have a good liquid, then no amount of packaging and marketing can make it up. Ours is a fantastic liquid. We only use the best agaves, and we sell the ones we reject to our competitors. We cook it in clay ovens for 72 hours; we use

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FTSE GLOBAL MARKETS • SEPTEMBER 2011

IN THE MARKETS

THE TEQUILA FACTOR: LOOKING FOR EM GROWTH

a tahona wheel along with a roller mill.” To leverage an old Western chestnut: there is money in them thar mills. Patrón is private, incorporated in Switzerland, and McDonnell comments:“We are not beholden to shareholders, and every year we have grown, even during the recession, at high prices and our expansion is self financed based on private money.” Patrón’s expansion was based on its existing customer base being affluent travellers, and, says McDonnell: “When they fly into major cities and can’t find Patrón, they might try something else and then we could end up losing them, so we made sure that Patrón was available at all the high-class restaurants, bars and hotels.” He adds:“Our duty-free strategy was different. Duty-free is for luxury and we are a premium white spirit that happens to be a tequila. So we went to the dutyfree operators and pointed out that they only offered cheaper tequilas. They accepted the concept and it worked and I would say we’re now in 45 of the top 50 airports around the world.”

Global protection While rum, whisky, vodka and other spirits have strayed far from their original homes, nature and nurture tie tequila production to Mexico, as the only home to blue agave plant from which it is made. Its national origin is reinforced with strict government regulation backed by international legal protections that restrict production not just to Mexico but specify the states, centred on Jalisco, where it can be produced. The legally-empowered Tequila Regulatory Council ensures that every bottle has the number of its distillery, which is monitored constantly to ensure that they all meet the exacting, mandated standards. The National Chamber for the Tequila Industry, representing the major producers, also runs a comprehensive advertising and educational campaign to educate the world’s consumers and bartenders about their drink as well as pushing the government to ensure market access and name protection. It is more than their good names at

stake. Tequila manufacturers directly employ 30,000 people in the agave fields and distilleries and many more in transport and similar industries. In that regard, tequila is a significant element in the Mexican economy, all the more so because it cannot be off-shored to China, unlike the maquiladores on the US border strip, nor overwhelmed by NAFTA competition. Aside from the traditional high markup and taxation that characterises the spirits industry, the grit in tequila’s bottle is that while the US has agreed that all tequila had to be made in Mexico according to Mexican government requirements, it none the less insisted that US companies and plants could continue to bottle it. Indeed, not only do they bottle it, the Americans export it under a wide variety of brands, after which the Mexicans lose track of the market, and estimates put global demand much higher than the official figures. It is indicative of the terms of trade that while the Mexican government estimates the value of tequila exports to the US was $748m in 2010, representing a 20.8% growth over 2009, liquor trade figures value Tequila and Mezcal global sales at $2.7bn in 2009 alone. At the spearhead of the expansion are the tequileros, the Mexican makers, who, whether employees of multinationals or local families, share an almost quasi-religious reverence for the drink and its manufacture. Casa Noble’s Jose Hermosilla and several other local families have taken 20 years from buying the initial fields to bringing the product to market and invested heavily in producing a product that would appeal to the high-end market. They experimented with different woods for ageing before settling on French oak. Based in a centuries old distillery near the town of Tequila itself, they have tapped into the tourist market to educate people about what is distinctive in their attractively-sited complex. The latest product is aged five years, which, he points out, represents the equivalent of 15 years in other products.“We grow our agave in the mountains, to stress

them, and they take ten years to be ready,” he points out. The fruits of that labour are now available in 23 countries, and he considers its price of $130 a bottle to be very reasonable with all that care and capital invested in it. The premium brands keep more of the value added inside the country. Jesus Fernandez, manager of Pernod Ricard’s Olmeca Tequila plant, comments: “It took some time for a lot of companies in the tequila business to realise that there’s a lot of benefits in making premium tequilas. First of all, you don’t have to sell a lot of cases to make good money, so it’s better to make quality tequila and get a better margin instead of just continuing to make bulk tequila and ship it to the United States, and bottle it with the Safeway brand.”

Asia bulks up on the high end As ever, Asia is the holy snifter for luxury brands. The thought of billions of Indians and Chinese knocking back tequila are enough to get everyone out planting agave down near Jalisco. However, some roadblocks to entering these markets remain firm. Many tequila brands hover close to the permitted methanol levels. Beijing bureaucrats, says Casa Noble chief executive officer Jose Hermosilla, put tequila in a category of drink that has a very low permitted level allowance for methanol—only 2 grams per litre in fact, while the Mexican government norm is 3 grams. Some producers are reformulating to meet the lower standard, but reluctantly so, since premium brands are particular sedulous of their profile. In the longer term the industry and the Mexican government are trying to persuade China to change the definition. However, even in a country with a fair tradition of bureaucracy of its own, they are having difficulties working out which buttons to push. The Mexican government for its part is sympathetic to their plight and is using its diplomatic clout worldwide to protect and promote tequila. Aside from its obvious economic benefits, tequila certainly lends a better spirit to the country’s image than gang warfare and shootings. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COMMODITIES

SAFE HAVEN THAT REQUIRES AN ACTIVE APPROACH

Investing in commodities in extremis August is notorious for wild price swings—bankers and fund managers are on holiday, market volume is thinner than usual and any moves are exaggerated—but even for a typical August this year’s proved exceedingly volatile, courtesy of S&P and Greeks bearing gifts. The upshot of the turmoil has been a wild search for assets that can act as a safe haven while the storm blows. The Swiss franc, the yen and gold have become a few of the immediate beneficiaries of that search. Vanya Dragomanovich reports on the new approaches to commodities. ITH EQUITIES DROPPING 15% one day and then rising 5% the next, and bonds the playground for only the bravest investors, commodities have presented themselves as a good choice for those seeking diversification. Many commodities have very little or no correlation to the moves in bonds and equities although they have some correlation to the currency markets in that a higher dollar typically has a slight negative impact on commodities, as these are traded worldwide in the US currency. For some commodities, such as base metals or oil and gas, the relationship to equities has risen over recent years as investors have increased their allocations, but “as global growth returns, these correlations will reduce somewhat and the longer run average will re-assert itself,” holds Iain Armitage, head of the commodity investment products at Citigroup. “Commodities need to be viewed in a longer run context. In tail risk events, commodities are often the only asset that will perform when others falter, witness for example the fallout of the Arab Spring,” he adds. Fundamentally, commodities, except for gold, are driven by supply and demand, the latter being directly linked to the state of economic wellbeing in major commodity-consuming countries. The whole complex was heavily bought earlier this year reflecting expectations that the global economy would recover—and in response to the fallout from the Arab Spring and the Japan earthquake—but as the year progressed, and particularly since May,

An historical gold, silver and copper mine. Photograph © Tomas Sereda / Dreamstime.com, supplied August 2011.

investors have become more cautious. After S&P’s downgrade of the United States, commodity funds, particularly precious metals funds, have again attracted massive inflows from investors seeking security and a degree of upside potential. “I would say that given what is happening in the markets, now is even more a time to look at commodities because the fundamental outlook remains positive,” says Koen Straetmans, senior investment strategist at ING Investment Management, arguing that if anything, the lower prices present a good buying opportunity. Meanwhile, Frank Holmes, chief executive of specialist commodity fund manager US Global Investors, says: “Being optimistic in today’s difficult

market is certainly not travelling with the herd.”Holmes argues that demand from the world’s 7bn people for food, clothes, housing and everything in between will remain a driver for commodities, and that countries such as China and India with a large and increasingly well off consumer base will continue to play a huge role in keeping demand high. While sharp increases in prices have put commodities on the radar for many investors over the past few years, they have also influenced investment strategies. Approaches to asset allocations have been changing significantly both because of market volatility and because some of the instruments on offer, particularly the first generation of commodity indices, have proved too

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COMMODITIES

SAFE HAVEN THAT REQUIRES AN ACTIVE APPROACH

Koen Straetmans, senior investment strategist at ING Investment Management. “I would say that given what is happening in the markets, now is even more a time to look at commodities because the fundamental outlook remains positive,” he says. Photograph kindly supplied by ING Investment Management, August 2011.

Iain Armitage, head of the commodity investment products at Citigroup. “Commodities need to be viewed in a longer run context. In tail risk events, commodities are often the only asset that will perform when others falter, witness for example the fallout of the Arab Spring,” he says. Photograph kindly supplied by Citigroup, August 2011.

clumsy or have had structural disadvantages, which have resulted in lower than expected returns. The first change came about because the credit crunch (perhaps now best referred to as the first credit crunch) has made investors more risk averse. “Investors have increasingly been moving into ETFs instead of more complicated strategies as counterparty risk weighs heavily these days when investment decisions are being made,”claims Ole S Hansen, senior manager and commodities expert at Saxo Bank.

However, those indices have not performed as well as actively-managed portfolios because the performances of various commodities bear little relation to one another. The price of silver pays no heed to the price of coffee or soybeans and with the two groups moving in different directions profits and losses can annul one another. The whole commodities asset class consists of several unrelated subgroups: energy (oil, gas, gasoline, power); precious metals (gold, silver, platinum, palladium); industrial metals (copper, aluminium, nickel, zinc, tin); soft commodities (coffee, cocoa, sugar), and agricultural commodities (wheat, corn, soybean, cotton and various livestock). While commodities in a subgroup can move as a group (like the grains for example), this is not always the case, and there is very little link in terms of price performance or supply and demand dynamic between the subgroups. Those initial indices have in the meantime been replaced by a more sophisticated second generation and much nimbler third generation of indices, which have some long and some short allocations and can change

Reviewing investment approaches Secondly, it has become clear that an investment strategy that is simply a long allocation across a range of commodities would not provide the best approach. The main commodity indexes, or rather the first set of indexes that have been key until recently, such as the S&P GSCI Commodity Index, the Dow Jones-UBS Commodity Index and the Thompson Reuters/Jeffries CRB Commodity Index, have a set long allocation across most commodities and are typically energy commodities heavy.

depending on the moves in the market. “Innovation and sophistication have certainly progressed dramatically over the past few years, with simple index solutions that merely track the market by rolling the front month futures contract becoming a very blunt instrument based on old technology,” says Citigroup’s Armitage. All the key providers such as Dow Jones, FTSE Group, Citigroup and Goldman Sachs now offer either new indices or bespoke indices (or both) which are tailor-made for individual clients and reflect their appetite for risk exposure and views on the market. Intelligent quantitative strategies that take advantage of specific commodity trends have made this space a very real opportunity for investors to extract alpha from the markets in a systematic way. At present there is approximately $175bn in commodity index investments and a roughly equivalent amount in the exchange-traded fund market.“Futures markets are populated by consumers and producers, in addition to investors, so data on this market is less relevant to this discussion. We believe that the growth of the index market will continue at double digit levels for the coming years, with investors accessing these products either through OTC swaps, structured notes, or exchange-traded products,” says Armitage.

Market turmoil Given the current level of turmoil in the market, Armitage recommends the Citi’s Risk Mitigator Index, which“takes the temperature of individual commodity markets and adopts full market beta exposure in bullish environments, and more defensive alpha positions when signals are more bearish”. He adds: “This allows investors to be exposed to and benefit from the commodities markets, while protecting against large drawdowns.” Other new products in the market include the third-generation index Dow Jones-UBS Roll Select Commodity Index, which tracks a variety of

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COMMODITIES

SAFE HAVEN THAT REQUIRES AN ACTIVE APPROACH

different contract months for the various commodities it follows. The aim is to minimize the profit-eating “roll penalties” that occur when investors must close out a futures contract the front-month and buy a more expensive contract for the subsequent month. Goldman Sachs and Clive Capital have also launched a dynamic index which will aim to reduce the risk of large losses by altering its exposure to individual commodities over time. FTSE Group has also brought its own offering into the market, the FTSE Physical Industrial Metals Index Series, which is the world’s first Shari’a-compliant series of industrial metals indices. For investors keen to go for specific commodities rather than a basket, ETFs are likely to be a better option. One of the drawbacks with ETFs is the cost of rolling over a contract from month to month which somewhat reduces the profit. Even so, the simplicity of ETFs, the ease with which they can be assessed and valued, added to their low cost, will continue to make them appealing to large scale investors. Here, products in the pipeline include two major copper ETFs, one by BlackRock and one from Goldman Sachs.

Looking for outperformance The question that remains is which commodities will do best over the next six to 12 months? After the S&P downgrade, gold has asserted itself as the most obvious choice. Banks such as JP Morgan have forecast that it could rise as high as $2,500 a troy ounce from the current $1,800/oz, which is already $200/oz higher than at the beginning of the summer. Gold has historically performed well in periods of weak economic growth and low interest rates. Speculative buying will be the key driver of the market over the coming months and should be enough to overrule potential negative influences such as central banks potentially selling a part of their gold reserves to repay their debts or some scrap gold making it back into

Francisco Blanch, Bank of America Merrill Lynch’s commodities strategist. He expects copper to drop to $8,000 a tonne in the second half of this year but adds that “any drop in commodity prices should be short-lived”. His forecast is for copper to trade on average at $10,175/t next year, up from around $9,000/t in August. Photograph kindly supplied by Bank of America Merrill Lynch, August 2011.

the market—pawn shops in the UK are attesting to this becoming an attractive practice. Germany has recently urged Spain, Italy, Portugal and Greece to sell their gold reserves in order to raise money to repay their debts and while Spain already said that it no longer holds enough gold, this strategy certainly would be an option for Italy which is the world’s fourth largest gold holder with 2.45 tonnes. Nevertheless, Deutsche Bank analyst Michael Lewis expects that gold will hit $2,000 a troy ounce and says: “Financial markets will be vulnerable to recurring bouts of risk aversion for the next few years as governments in the US and Europe struggle to bring down debt levels to more sustainable levels.” If the US is unable to regain its triple-A sovereign credit rating, this would reduce the appeal of US Treasuries as a diversification asset while enhancing gold. It may also help to sustain the steady decline in US dollar holdings of FX reserves which has been under way in both the advanced and emerging economies.”

In oil, the trend is expected to be sideways rather than have a clear direction and most analysts prefer the London-traded Brent crude to the NYMEX-traded WTI as Brent has become more indicative of the global supply and demand dynamic while WTI trades slightly differently because of Canadian and Mexican oil supplies. Bank of America Merrill Lynch’s commodities strategist Francisco Blanch expects Brent crude to average $102 a barrel in the last quarter of this year. That’s down from around $115/bbl before the S&P downgrade, and to briefly touch $95/bbl. However, if the global economy slides into a recession he expects Brent crude to potentially fall below $80/bbl and to only start rising if the Organization of Petrol Exporting Countries (Opec) decides to cut down its output. With the current feeble global economic forecasts, the outlook for industrial metals such as copper is also deteriorating. Blanch expects copper to drop to $8,000 a tonne in the second half of this year but adds that “any drop in commodity prices should be short-lived”. His forecast is for copper to trade on average at $10,175/t next year, up from around $9,000/t in August. Deutsche Bank favours aluminium futures over copper, Brent Crude over WTI and gold over silver, while Saxo Bank’s Hansen, says: “We believe that a diversified exposure to the entire commodities group is the optimal base from which to start, before overlaying any specific views that an investor might have. Right now, we like copper, thermal coal, nickel and wheat for example.” The size and liquidity of commodities futures markets, coupled with their relative efficiency, attracts the kind of highly-systematised trading strategy that investors are increasingly coming to favour. With volatility in other markets likely to remain a feature in the last quarter of this year, the safe haven aspect will continue to be a plus for commodities. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

SPOTLIGHT

DC pensions on the rise Cerulli predicts the European corporate DC market will grow by 11.5% annually to 2014. THE LATEST ISSUE of The Cerulli Edge--Europe Edition predicts that the corporate defined contribution (DC) market in Europe will increase by 11.5% each year up to the end of 2014. While DC plans have become more sophisticated, offering, in some cases, a wider range of investment options and/or solutions that are better targeted to savers’ needs, this is an area where more work still needs to be done, suggests the report. Even so, Cerulli analysts contend that asset managers in Europe should be taking a serious look at the DC opportunity. A great deal of recent attention has focused on the default fund, where the vast majority (80%) of savers will end up. Key developments in this area include life styling, dynamic asset allocation, absolute return strategies, targetdate funds, and a move away from passive investment. The development of dynamic asset allocation strategies goes hand-inhand with another trend, says the report, that towards the inclusion of a wider range of assets in corporate DC funds. It is significant, says the report, that DC funds are beginning to incorporate asset classes previously only seen in defined benefit (DB) plans, such as real estate and hedge funds. This, clearly, facilitates a move towards absolute return as opposed to relative return strategies.“Although the move towards more complex and better planned DC schemes has largely been confined to more mature markets, such as the Netherlands and the United Kingdom, the future must surely lie in this direction,” posits Barbara Wall, editor of the quarterly publication. “In the meantime, asset managers must ready themselves in both mature and less mature markets

New benchmark for QDII fund FTSE EPRA/NAREIT Developed REITs Index to be point of reference for new QDII real estate fund FTSE GROUP IS licensing the FTSE EPRA/NAREIT Developed REITs Index to Lion Fund Management. The index has been chosen as the benchmark for the first-ever Qualified Domestic Institutional Investor (QDII) fund specialising in real estate. The FTSE EPRA/NAREIT Developed REITs index is part of the FTSE EPRA/NAREIT Global Real Estate Index Series. Developed in partnership with trade associations for real estate investing, the European Public Real Estate Association (EPRA) and the National Association of Real Estate Investment Trusts (NAREIT), the index series to become a market standard for listed real estate and REITs worldwide. According to Jessie Pak, FTSE director of Asia: “Evolving regulatory changes are enabling Chinese investors to access new and dynamic asset classes such as real estate, as well as furthering opportunities for portfolio diversification.” Real estate has long been a key component of sophisticated institutional investor portfolios

to make the most of business opportunities as they arise,” she adds. Almost everyone agrees that DC pensions will increasingly be distributed through platforms in Europe, however, says the report, in this still-emerging area of the pensions business, definitions rapidly become blurred once this single certainty is left behind. There are also national distinctions in play. The report suggests, for instance that, managing the impact of interest rate and inflation changes on their liabilities is very much at the forefront

Photograph © Marish / Dreamstime.com, supplied August 2011.

globally, with liquid REITs offering an efficient means to access this asset class. With the FTSE EPRA/NAREIT Developed REITs index as its benchmark, the fund gives Chinese investors under the QDII scheme an opportunity to gain exposure to international real estate assets such as hospitals, shopping malls and offices.I

of German investor concerns, presenting an opportunity for fund managers with expertise in the field. In Italy, too, the market is dynamic. Despite discontent over its development and the fact that it is still dwarfed by the rival insurance industry, the Italian pensions industry is showing signs of resilience and change. At the end of the first quarter of this year, the fund management industry as a whole attracted €1.4bn inflows with pension flows accounting for €538m, says the report.I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

SECTOR REPORT

BAHRAIN BANKS: PROFITS UP, BUT OVERALL ASSETS DOWN

World Trade Centre in Bahrain. Photograph © Ian Walker / Dreamstime.com, supplied August 2011.

Bahrain’s new banking challenge Wholesale Bahraini bank Securities and Investment Company’s (SICO’s) August market note suggests that the country’s stock market performance is more tied to the performance of neighbouring Gulf Cooperation Council (GCC) stock markets and eurozone debt concerns than the underlying economy which, it states, has been marked by strong half-year results. Even so, National Bank of Abu Dhabi’s most recent research note on the Bahrain banking segment points out that assets of wholesale and retail banks on a consolidated basis were down 5.7% yearon-year in June and assets of wholesale banks are back to 2005 levels, while retail bank assets have been resilient. AHRAIN’S BANKS ARE looking to a fruitful fall after a bear of a first half, which severely challenged the sector and the national economy. Al Baraka Islamic Bank underscores the trend with total operating income up by 57.97%, and net operating income increasing by 48.94%, while total assets were 8.46% higher in the first half of the current year. The bank reports net income for the period of BHD1.28m ($3.4m), compared with a loss of BHD96,000 a year ago. The bank’s total assets reached BHD550.6m as of June 30th this year. In the second quarter net income amounted to BHD601,000 compared to BHD131,000 for the same period last year, a significant increase of 359%, albeit from a relatively low base. According to Al Baraka Islamic bank chairman Khalid Rashid Al Zayani:“Despite the continu-

ing difficult international and regional economic and financial conditions in the first half, we have continued to achieve good financial results and we were able to achieve satisfactory returns to our shareholders as a result of a steady and clear improvement in the performance of the Bahraini economy, which quickly returned to normal.” In the mainstream sector, Ahli United Bank (AUB) is a benchmark for the sector, having reported a net profit of $161.7m in the first half, a 19% increase over the same period in 2010. Net interest income increased by 16.8% to $279.5m over the six months and the bank’s Qatar and Omani operations apparently did rather well, reporting a £32m consolidated profit, compared with $23.6m over first half 2010. Nonperforming loans (NPLs) remained stable at 2.4% with provision coverage

increased to 128% (including collective impairment provision) against 106% at the end of June last year. Fahad AlRajaan, AUB’s chairman, posits a strong performance “against the backdrop of unsettled regional political and economic conditions”. AUB’s growth story is a microcosm of the wider sector, and the growing role of the International Finance Corporation (IFC) in Middle East, the Levant and Turkish banking affairs. In this instance, AUB group’s assets grew by 4.1% to $27.6bn over the half year, attributable mainly to rising customer deposits and “prudent deployment in assets with a focus on maintenance of solid liquidity given the prevailing regional business climate,” notes AUB chief executive Adel el Laban. “The results were made possible by strong support from AUB’s stakeholders evidenced by capital funding from the International Finance Corporation and the IFC capitalisation equity and debt funds during the period.” IFC capitalisation funds provided AUB with $125m new Tier I qualifying equity and $165m Tier II qualifying subordinated debt. An agreement was also executed with the IFC to extend the maturity date of its existing Tier II $200m subordinated debt from December 2016 out to December 2018. The transactions have been important for the bank as it has emerged in recent years as a major player in the region’s project finance market, which is noted for its big ticket lending. The mood is underscored, notes SICO, by the fact that there has been a “sequential improvement in Bahrain’s listed companies’ profits over the last three quarters”. This uptrend was extended through the second quarter of this year with the reported profits announced so far up overall across the listed company segment by 2% year-onyear and 42% quarter-on-quarter, driven by aluminum corporate ALBA, and telecoms firm Batelco and AUB Group. Moreover, several firms have announced plans to diversify revenue streams and focus strongly on growth.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

SECTOR REPORT Bahrain: balance sheet of the banking system, up to end June 2011

BAHRAIN BANKS: PROFITS UP, BUT OVERALL ASSETS DOWN

Consolidated balance sheet of Banking System ($m) Ratio to GDP Consolidated balance sheet of retail banks ($m) Ratio to GDP Consolidated balance sheet of wholesale banks ($m) Ratio to GDP Consolidated balance sheet of Islamic banks ($m) Ratio to GDP Total domestic assets of the banking system ($m) As % of GDP Total foreign liabilities of the banking system ($m) As % of total liabilities Ratio to GDP Total equity of the banking system ($m) As % of total liabilities

Q2 2010 211,536.2 9.6 61,841.1 282.0 149,695.1 6.8 25,055.4 114.3 44,663.3 203.0 162,751.0 76.9 7.4 26,908.0 12.7

Q3 2010 216,391.1 9.9 63,281.4 288.6 153,109.7 7.0 24,927.3 113.0 45,201.9 206.1 167,982.0 77.6 7.7 26,834.2 12.4

Q4 2010 2,221,777.7 10.1 65,452.9 298.5 156,724.8 7.1 25,356.5 115.6 45,826.6 209.0 171,339.8 77.1 7.8 26,499.1 11.9

Q1 2011 201,011.1 9.2 66,077.7 301.3 134,933.4 6.2 24,623.4 112.3 43,717.3 199.4 152,892.6 76.1 7.0 25,670.7 12.9

Q2 2011 199,438.2 9.1 64,872.0 295.8 134,566.2 6.1 24,641.0 112.4 44,542.0 203.1 151,552.4 76.0 6.9 26,645.7 13.4

Source: Central Bank of Bahrain, August 2011

Some of that growth is expected to come from overseas, as Bahrain Emirates Insurance, for instance, is hoping to set up in Abu Dhabi, while National Bank of Bahrain has diversified into SME finance (the new focus du jour across much of the Middle East). Ithmaar Bank has meantime announced plans to expand its branch network in the country, while AUB and United Gulf Bank have also announced expansion plans and a deepening of their relationships with strategic stakeholders. Despite the emergence of good news overall as early-spring news headlines attested, it has been a bug of a year for Bahrain, which is expected to undergo at least a 1.4% to 1.6% contraction as a result of those political ructions. Most market analysts agree that the economy had lost as much as $2bn in revenue as a result of civil unrest. While government ministers continue to flag business as normal, investment inflows, consumption and trade volume are all expected to trend lower through the remainder of this year. Even so, the government is still on track to post a budget surplus both this year and next, due mainly to the effect of high oil prices and continued grants from other Gulf Cooperation Councile (GCC) members. Bahrain’s GDP, variably estimated at some $14bn, had already slowed down

to 1.8% on the back of civil strife, well down on analysts’ expectation of a 3.5% lift in the economy through this year. Bahrain is anxious to get its economy back on track and to provide a calm political front to traditionally jittery investors, which are reckoned to have placed in excess of $10bn in investment funds ($9bn of which are mutual funds) in the jurisdiction. Bahrain is the smallest of the GCC economies and depends on a diverse economic base, which includes, but is not dependent on, oil. Tourism is a key revenue generator and has suffered badly this year through the cancellation in June of its annual Formula One Grand Prix (by which the kingdom sets much store) and the European Tour has dropped the Volvo Golf Championship which was scheduled for January 2012. With so many of Bahrain’s banks now with strong international franchises, it has minimized any vulnerability in relation to their dependence on domestic market developments. Even so, at the top of many a Bahraini bank’s meeting agendas must be analysis of the repercussions of the proposed merger between Bahrain Islamic Bank and Al Salam Bank Bahrain. If the deal goes ahead, it would raise the bar in that it will be the largest single financial institution in the country, backed by estimated net assets

worth $4.5bn. The management of both banks cite the recent economic slowdown and increasing competitiveness of the GCC banking sector as key reasons for the merger. The merger will also help cement the island as a key financial hub for Islamic finance. The Bahrain central bank has developed a deep and expansive regulatory infrastructure that supports the expansion of Islamic banking and finance and takaful (insurance) services. It has been reported in the local press that the central bank has given its approval for the merger, though the central bank did not confirm this. Bahrain has made much of the fact that it has lost no banks since the outbreak of civil hostilities in the spring. Most recently, the central bank announced that it had issued a number of new banking licences, which will underscore the government’s efforts to deepen the country’s financial services sector and create a regional financing hub. Certainly, historically Bahrain has had the reputation of caring for substantial quantities of investment funds, again backed by the central bank’s strong regulatory credentials. How the next year plays out will be key for both investors and bankers in the jurisdiction; much will depend on the government’s ability to portray political as well as economic liberality. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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SECTOR REPORT

SPANISH BANKS: THE LONG ROAD BACK

Low interest rates fueled 10 years of real estate expansion, private debt and loss of competitiveness in the Spanish economy; irrespective of the effects of the financial crisis, the groundwork was set for a testing time for the banking sector. The current crop of half year results and the tepid reception to recent bank IPOs testifies to continuing pressure on the sector. What next?

While speaking on Tuesday, 23 August, at the Plenary Session of the Lower House of Parliament, José Luis Rodríguez Zapatero announced the Government’s desire to include provisions in the Constitution as soon as possible that would guarantee budgetary stability and oblige all Public Administration Services to comply. Photograph kindly supplied by the government of Spain (lamoncloa.gob.es), August 2011.

The steady rebuilding of Spain’s banks ESPITE TWO YEARS of reform of Spanish banking, the segment remains in the doldrums. Santander and Banco Sabadell typify the trend. Spanish lender Banco Santander’s second-quarter net profit fell 38% as growth in Latin America was offset by weaker results in Europe and a one-time charge in the United Kingdom. Santander, which is the eurozone’s largest bank market capitalisation says net profit fell to €1.39bn between April and June this year (compared to €2.2bn this time last year), due to provisions totalling €620m it had to set aside in Britain to refund clients for personal loan insurance that a court this year ruled had been mis-sold by banks in the country. Since the acqui-

sition of Banco Real (now, Santander Brazil) last year, the bulk of Santander’s PPI is derived from Brazil, followed by the contribution of its Spanish operations, and those in the UK (equal to just under 18% of the total). Meanwhile Banco Sabadell posted a 30% fall in first-half net profit, hit by heavy provisioning needs and lower one-off gains. Like most debt related issues in Spain, things are expected to get marginally worse before they get better. No surprise then that Sabadell says that bad loans rose to 5.55%, up marginally on the first quarter’s ratio and just below the Spanish sectorwide average level of 6.5% in May. The bank said it expected the rate to reach 6% by year-end.

After ten years building up imbalances it was inevitable that the sector would have to adjust to sustained and constrained market conditions. Back in the summer of 2009, the so-called Royal Decree Law was passed, creating a special Fund for the Orderly Restructuring of the Banking Sector (FROB), to help finance the restructuring of the sector. To date, the FROB has invested €11.56bn in Spanish savings banks and has €4.5bn left in its coffers. The FROB also has the capacity to arrange up to €99bn of government backed financing, should the banking situation deteriorate; though for the time being, Spanish banks are resorting to plan and still raising money in the capital markets. Even so, the involvement of the FROB in the process of changes has enabled an orderly entry of private investment in the savings bank sector. Since the fund was established, some 45 savings banks have been reduced by two-thirds, with an attendant constriction in branches (down by an average 15%) and personnel (down by an estimate 16%). Even now, the exposure of savings banks to the real estate sector continues to be in the region of €217bn, of which 46% remains classified by the central bank as doubtful assets. “Accumulated specific loan loss provisions represent 31% of these ‘extended’ troubled assets, and if we add the general provisions this percentage reaches 38%,” noted central bank governor, Miguel Ángel Fernández Ordóñez in a recent speech:“the requirements of the Banco de España [forced] the banks to also record as potentially troubled investments, and make the necessary provisions for, assets acquired in payment of debt, as well as standard loans under surveillance owing to some observed weakness, even if payments are up to date.” Ordóñez also noted that writedowns in the last three years by the

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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SECTOR REPORT

SPANISH BANKS: THE LONG ROAD BACK

Spanish banking system have amounted to some €96bn (around 9.5% of GDP). “Moreover, in that same period, thanks to FROB resources, but also, especially, to the efforts by banks, the latter have increased the capital held in excess of minimum requirements by approximately €53bn,” he added. In June last year, the central bank applied a number of stress tests to all listed and savings banks and stepped up reporting requirements over the exposure of savings banks to real estate developments, doubtful assets and standard risk exposures, requiring them to quality the type of collateral that secured that exposure and to fully declare any provisions. That combined with the FROB set a core capital level of at least 10%, with any capital requirements raised in the capital markets. FROB funds must be repaid or replaced by private capital as required by the Royal Decree Law. One of the largest tests of Spanish banking stability was be the IPO of

Bankia in July. Bankia is Spain’s largest caja, with some €344.5bn in assets, and the fourth largest financial institution in Spain behind BBVA, Caixabank and Santander. Like much of everything else happening in Europe right now, the IPO was much vaunted as a litmus test of the viability of something: in this instance Spanish banking in general and the restructuring of the cajas in particular. Likely as a result of this pressure, both Bankia (which is the result of a merger of Caja Madrid and six regional cajas) and Banca Civica, offered steep discounts to investors in their IPOs an effort to raise a combined €5.5bn (of which Bankia was set to raise €4.6bn) from both deals. Timing was obviously an issue: at the time both banks were book-building Europe was failing to take strong action over Greece, which increased the jitteriness of investors. Added to the mix was the news that six Spanish banks failed industry stress tests

because the European Banking Authority (EBA) did not accept generic provisions as part of the definition of core capital (which has been allowed in previous stress tests). In the event, the IPOs were something of a curate’s egg: good in parts. Civica set its IPO prices at €2.7, at the low end of expectations. The IPO saw good retail support, but much less institutional support, though the latter tranche was oversubscribed by a ratio of 1.3. The retail tranche was covered by a ratio of 2.3. Bankia, formed from the merger of seven regional banks, managed to raise €3.1bn after it cut its IPO price to €3.75, with the price falling further to €3.51 in early trading. Although disappointing, the IPO generated enough funds to save the bank from partial nationalisation. While most economic projections point to a stronger economic recovery for Spain in the second half of 2012 and in subsequent years, right now any upturn seems a long time in coming. I

SPAIN’S CONSTITUTIONAL COMMITMENT TO A CAP ON BUDGET SPEND VOIDING A EUROPEAN bailout at all costs seems to be behind the Spanish government attempts to halt the rise in the national debt through constitutional means; all for the sake of international investors. The somewhat startling step crossed political lines to help win back investor confidence by introducing an amendment to the Spanish constitutions to force a cap on the country’s budget deficit, a move which will come into effect in 2020. Strong cross party support for the move could see a change in the country’s constitution agreed in September, before parliament is dissolved prior to impending elections; although it is not expected to come into law until some time in July next year. The amendment is expected to state that the spending cap can either be set by the EU or by the Spanish parliament and will apply to all levels of government in the country, including municipalities

and regional authorities, which govern spending on health and education. However, there is a get out clause: the draft states that the cap can be overridden at times of national crisis. Although the move was aimed at buoying investor sentiment, some politicians in Europe see the amendment as a stepping stone to further economic and political integration across the eurozone. The amendment brings Spain in line with Germany. In mid August, German chancellor Angela Merkel and French president Nicholas Sarkozy called for eurozone countries to impose constitutional limits on sovereign debt. Actually, the joint statement, coupled with moves by the ECB to buy Spanish and Italian bonds on a large scale in early August, helped calm investors and give the government valuable breathing space to think through the constitutional amendment proposals. (please refer to the Cover Story in this issue, on page 6, for more details.)

Even so, Spain’s debt is expected to end the year at some 65% of GDP, below the eurozone average and behind Germany, France, Britain and the US. The country’s economy is in dire straits: unemployment is a whopping 21% and economic growth is negligible. It is hard to see how Spain can fend off market fears, and from this vantage, it looks like things will get worse before they get better: the IMF recently estimated Spain’s sovereign debt will top 75% of GDP by 2016. While the new measure is meant to calm markets, it will have no impact on Spain’s current deficit. Spain hopes to bring its budget deficit down to 6% of GDP this year from 9.2% in 2010, with the ultimate goal of hitting the EU limit of 3% in 2013. If the constitutional amendment goes ahead most commentator think the cap on the budget deficit will be set at around 0.4% for the period covering 2012-2015; after which time it will be reviewed again.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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SECTOR REPORT

NORDIC BANKS: HOW LONG CAN THE GOOD TIMES ROLL?

Will global trends call the end of the long summer for Nordic banks? Nordic banks appear to have remained resilient in the face of the stresses on the euro and European sovereign debt woes and the sector looks set for steady growth. Even so, the region’s banks have been through their own share of troubles in the near past. Nordic banks have worked hard to extend funding maturities away from short-term debt, recover losses and build liquidity and by and large sailed through the European Banking Authority’s (EBA) health check of 90 European banks in July. However, it looks like the current rosy picture will be marred by the impact of the global economic slowdown; a development which has already impacted on some of the second quarter’s reporting banks. WEDBANK, NORDEA AND HANDELSBANKEN all reported solid earnings over the second quarter of this year benefiting from strong economic growth in Norway and Sweden, where margins are on the rise and capital is building up once more. It is a distinct contrast to the fortunes of other banks in Europe. However, any well earned crowing on the part of the region’s banks might soon be curtailed. Swedbank’s economic outlook paper suggests that while Swedish growth continued strong in the first half of 2011, the downturn in global markets is expected to dim the picture somewhat in the second half of the year: “we are seeing a significant slowdown for the remainder of the year. Exports will be affected by a slowing of global growth, and falling confidence of households and companies will limit consumption and investment growth.” In consequence, the bank has revised the country’s growth rate downwards for 2012 to 2.2%, and, for 2013: “we expect growth to reach 2.3%. The current economic situation presents a policy challenge, and we expect monetary policy to scale back rate increases, but fiscal policy to become too tight. Thus, targeted, timely, and temporary actions will be required to push unemployment down.” For its part, Swedbank reported an operating profit of SKR4.32bn

Archive photo of Swedbank CEO Michael Wolf talks to the media during a news conference in Stockholm, Photograph kindly supplied by pressassociation images, August 2011. Photograph by Jonas Ekstromer.

($666m), almost double the profit of the same period last year; helped in large part by Sweden’s swift economic recovery up to now, export growth and strong domestic demand. Moreover, margins on lending are expected to

rise as the Swedish central bank is expected to raise interest rates. The bank noted in its performance statement that funding costs were easing, as the bank rebuilds its balance sheet following restructuring resulting from loan losses from its Baltic businesses. Two years ago, Swedbank posted second quarter losses of SKR2bn (around $300m) losses as it suffered loan losses from exposure to the troubled economies of the Baltics and the Ukraine. In the event, those losses have been lower than expected and some of the provisions have been written back into the bank’s balance sheet. It is a positive note over the outlook for the Baltic states; a view mirrored by competitor bank DnBNor in its second quarter statement, where it anticipates that over the next two years, growth in the Baltic States will again surpass European levels. Swedbank has continued to refinance state loans, extended through the financial crisis, with capital market financing at lower cost and undertake some small level share buybacks. Chief Executive Michael Wolf noted in a journalists conference call that. “We continue to believe that there will be some margin expansion on the lending side and cost control is also going to be very helpful.” Nordea meantime reported second quarter operating profit of €949m, better than forecast, which helped buoy its stock after competitor SEB reported less

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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SECTOR REPORT

NORDIC BANKS: HOW LONG CAN THE GOOD TIMES ROLL?

than stellar earnings over the same period, of which more later. Even so, Nordea’s performance statement could not hide the fact that its second quarter profits were down on the first quarter of the year, when operating profits had risen by 21% over the last quarter of 2010. The bank noted that the continuing crisis elsewhere in Europe and continued “imbalances in the global economy have increased economic uncertainty. “Income from customer areas increased by 5% in the quarter and both operating and risk-adjusted profit are higher than last year. Loan losses are at the lowest level since 2008 and credit quality. At the same time, the trading result decreased from last quarter’s high levels due to volatility in the financial markets and interest income was affected by increased and prolonged funding,” highlights Nordea chief executive officer Christian Clausen. Nordea said lower income in treasury due to higher funding costs offset increased customer activity, and its CEO said the bank would need to be more efficient to reach its goal of 15%

returns on equity (ROE). “Nordea’s relationship strategy has laid a solid foundation for our New Normal [sic] ambition to reach an ROE in the top leave of European banks of around 15%. In the autumn, we will continue to improve capital efficiency and implement plans to contain cost growth in the latter part of 2011 and thereafter keep costs largely unchanged for a prolonged period of time.” Elsewhere in the region, DnBNOR achieved a profit of NOK3, 546m in the second quarter of 2011, an increase of NOK723m on the same period a year earlier, an uptick of almost 500%. “This is our second best quarterly performance since the financial crisis, surpassed only by the particularly healthy profits recorded in the fourth quarter of 2010. Rising interest rate levels and low write-downs had a positive impact on the quarter, though there is still intense competition for both loans and deposits in the Norwegian market,” noted Rune Bjerke, DnB NOR group chief executive in the bank’s performance statement.

“Norway is doing well, with low unemployment and strong growth, both in GDP and in the population. This provides a sound basis for our growth ambitions, as we are influenced by increased investment willingness among our customers. In the personal customer market, intense competition and pressure on home mortgage margins will continue,” noted Bjerke. Against expectations however, Swedish banking group SEB’s second quarter earnings were SKR4.3 billion crowns ($665.2m), down 2% on the first quarter, with net interest income down at SKR4.2bn. Most of the bank’s business (over 60%) is sourced from the Swedish market; though it has expanded operations to cover Germany (a key market for the bank) and the Baltics. “In the wake of the uncertain global environment and the potential negative impact on funding markets, we have continued to safeguard balance sheet resilience,” chief executive Annika Falkengren noted in the bank’s performance statement. I

MOODY'S SURVEY REVEALS NORDIC BANKS' HIGH, SINGLE-CLIENT CONCENTRATIONS OODY'S INVESTORS SERVICE published a Special Comment in early August that underscored the relatively high levels of average concentrations across the region, between 2008 and 2010, although in some cases, these levels are reducing. According to the ratings agency, this means that many of the rated Nordic banks score poorly in terms of credit risk concentration on the agency's banking scorecard, with this weakness reflected in their bank financial strength ratings (BFSRs). The survey captures the 20 largest exposures of banks rated by the agency in the Nordic region. As the survey only considers rated banks, the results of the survey should not be construed as indicative of the region as a whole, says Moody's. According to the comment, the Nordic region, defined by the survey

included Denmark, Finland, Norway and Sweden. Iceland was excluded due to a small sample size. The high levels of single client concentrations primarily reflect the limited size of many rated banks, which increases their sensitivity to a small number of large exposures; the desire of many small banks to be involved with corporations of all sizes within their regional footprint; and the general trend for relatively low banking profitability, which affects metrics that investigate profits in relation to exposure size. In terms of Nordic regional disparities, the survey suggests that Swedish banks' concentrations are, on average the lowest, followed by Finland and then Denmark and Norway. However, the exact ranking is less clear and depends on the metric used. The agency quotes, for example,

the ratio of the top 20 exposures to either tier I capital; gross loans to customers; total assets; or preprovision income (PPI)). The survey also shows that the Nordic banking systems have relatively high concentration levels compared to other, similarly developed banking systems, although well below some of the more developing systems. The survey also shows a general trend of improving concentration metrics in the Nordic region over 2010 following a much more mixed story during 2009, due in part to movements during 2010 in the metric denominators such as Tier 1 capital (from capital raisings during the financial crisis) and improved profitability. However, it also reflects actual reduced exposure concentrations as banks looked to reduce their risks in this area.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

FTSE4Good ESG Ratings – The Next Generation in ESG Risk Management A Q&A With David Harris, Director, Responsible Investment, FTSE Group Q: What are the FTSE4Good ESG Ratings? A: The FTSE4Good ESG Ratings system is an investment tool that provides a quantitative measure of companies’ risk and performance across Environmental, Social and Governance (ESG) issues. The ratings data can be used in a variety of ways, including building a basis for active portfolio management, research and analysis, advocacy and voting, or customised indices.

Q: How is the FTSE4Good ESG Ratings System Constructed? A: The ratings cover around 2,300 securities, including all constituents of the FTSE All-World Developed indices. Similar to the FTSE4Good Index Series, the six ESG criteria themes cover environmental management, climate change, human and labor rights, supply chain labor standards, countering bribery, and corporate governance. The ratings present three different levels of risk and performance scores that allow investors to understand ESG practices in multiple dimensions and with increasing granularity, as illustrated. The rules-based methodology is overseen by an independent, external committee and is freely available on the FTSE website.

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incorporated into investment decision making and stewardship. Asset owners and their managers worldwide have made commitments under the United Nations Principles for Responsible Investment to integrate ESG into their investment practice and analysis, and are now developing approaches to implement these commitments. When FTSE launched the FTSE4Good Index Series in 2001, our goal was to create a transparent and measurable benchmark that would capture companies with strong ESG practices. The FTSE4Good ESG Ratings system is an innovative new tool and data set for investors looking to account for ESG factors in other ways beyond benchmarking and passive management. Explore the FTSE4Good ESG Ratings at

www.ftse.com/Indices/FTSE4Good_ESG_Ratings © FTSE International Limited (‘FTSE’) 2011. All rights reserved. FTSE ® is a trade mark owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.

FACE TO FACE

DEFINING STRATEGIC PRIORITIES IN ASSET SERVICING

Forging a role in the new Europe Göran Fors, global head of GTS Banks at SEB talks through the chief challenges in providing asset servicing in the Nordic region against a background of extreme change pulsing through the global investment markets. Custodian providers have to grapple with new regulation on a European level and changes within the Nordic landscape itself. Fors is well placed to deliver his tuppence worth, current servicing, in addition to his day job, as chairman of Euroclear Sweden Market Advisory Committee, T2S National User Group Sweden, the Swedish SWIFT National Member Group and Board member of SWIFT. Fors talks to Francesca Carnevale about SEB’s plans to leverage the evolving European market. YPICALLY BRISK, GÖRAN Fors is in full flow: “There has been an enormous flow of regulatory initiatives in Europe, with the attendant risk that the asset management industry might not be able cope with the implementation of such a large body of regulation. I am not sure that everyone understands the full implications of much of what is proposed by regulators.” Fors believes that the changes resulting from the avalanche of regulation are far-reaching, with particular consequence for the both the mutual fund industry and in turn,“on the provision of asset services.” That clear consideration has encouraged SEB, like some other leading houses, to review its core business strategy to ensure that it is sufficiently well placed to thrive in a dynamic European environment. It requires a relatively long term outlook, maintains Fors, while acknowledging the immediate requirements that regulation puts on both providers and clients. Up to now SEB has enjoyed a prominent footing in the four Nordic and three Baltic countries where the bank provides its core service offering; supplemented by a growing custody/sub-custody business in Germany, Russia and the Ukraine. Germany has particular resonance for SEB as an area for new business growth, servicing clients with a

strong cross-border focus. The bank has in part, benefitted from extreme consolidation in the securities services segment in the wider Nordic region and the Baltic hinterland that both SEB and Nordea (the region’s key players in this regard, ahead of Swedbank which focuses on the Baltic markets and its home market in Sweden) serve over recent years. Though that relatively comfortable state of affairs is hardly likely to continue in an era of change, agrees Fors. He clearly states the potential for a substantive restructuring of the fund management industry per se across the continent, with winners and losers within the European theatre and outside it. Among the considerations in play is whether regulation will make it more attractive say for asset gatherers, such as mutual funds, to locate outside of their home markets and if that is the case, where are the jurisdictions that might benefit from any fund migration? “Will these firms move to Luxembourg or Ireland, for instance, or elsewhere? Then again, what are the new requirements of in terms of risk monitoring and safeguards if investment firms move outside their home markets? I don’t think these considerations have been fully calculated,”he states. T2S, UCITS IV and the second iteration of the Markets in Financial Instruments Directive (MiFID II) in the context of the Nordic markets are

perhaps three of the most influential regulatory developments as drivers of these changes, stresses Fors. “If, for instance, a fund company has a European fund in Sweden say, and one in Luxembourg, the master-feeder structures embedded in UCITS IV may encourage a merger of the funds with the fund manager looking to locate the fund in the most beneficial market. Luxembourg has some advantages in this regard, for example,” he notes. With that in mind, Fors anticipates clients will, as a consequence of the emerging new world order, require service providers to handle a wider variety of fund structures and/or product:“added to that, customers will be looking for more information on market risk or developments.”

Key regulatory drivers UCITS IV and AIFMD in particular says Fors will involve an“enormous effort for individual asset management firms to implement. Larger fund companies with substantial legal resources will be able to follow and absorb the implementation of UCITS IV and AIFMD; but I doubt that some of the smaller fund will be able to cope. In that regard, as SEB we will have to step up to the plate and provide the best service possible and here we see opportunity to provide outsourcing services to these entities.” Equally, Fors anticipates the post trade segment as a key consideration in the evolution of the European securities markets, particularly if Nordic CSDs embrace the notion of seamless connectivity to the proposed T2S platform. T2S will, once implemented, create a standardised settlement hub that could cross up to 25 markets or even more; the idea being that the cost of settlement will be cheaper. According to Fors, an advantage of the initiative is the creation of a wider “European market infrastructure which I believe will be very important for the future.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Naturally, this has to be done taking into account the set-up of endinvestor accounts as well as the very efficient market structure that is already in place today”. Even so, Fors acknowledges that“there is always the possibility that international clients will link to the platform directly as well. T2S provides CSDs with a mandate to move up the value chain, which could result in competition between CSDs and custody banks”. He also acknowledges the likelihood of unintended consequences of its eventual implementation. “Just as there has been unintended consequences with the first iteration of MiFID, for instance,” he muses, “and instead of cheaper settlement, there will be little or no change or even higher costs involved, particularly for domestic transactions. That’s a possibility too.” Articulating and working through the nuts and bolts of the project, Fors believes, will help ensure that any potential glitches are anticipated from the getgo. Part of that exercise must involve understanding the requirements of Europe’s smaller players and smaller markets, as well as the big financial houses and the dominant trading markets across the continent. “The Eurosystem needs to show how the wishes and expectations of the potential users of the platforms, which include banks and brokers/dealers, both from smaller markets and from non-euro markets, will be catered for in the governance structure ofT2S. So far, it is not sufficiently clear how these markets will make their voices heard onceT2S is in operation,” he posits.

Emerging opportunities While Fors acknowledges that the future of the investment industry remains bright over the longer term, Nordic providers will inevitably face sustained tussles and confrontations over market share from pan-European and/or global custodians anxious to develop market share; if not at home then certainly in designated growth markets such as Germany.

FTSE GLOBAL MARKETS • SEPTEMBER 2011

Göran Fors, global head of GTS Banks at SEB. Photograph kindly supplied by SEB, August 2011.

Fors is adamant that despite the changes, SEB is unlikely to dilute its principal strengths and its expertise in the carefully designated markets in which it specialises. “We are ultimately a regional provider, honing our service delivery to maximum efficiency and offering expertise in those markets; it would be foolish to restructure ourselves as something we are fundamentally not.”Despite maintaining SEB’s adherence to its business USPs, Fors acknowledges that in addition to new outsourcing opportunities, the bank sees potential new business, particularly from corporate treasury operations resulting from new regulations governing derivatives.“Traditionally we have looked at building our market share in the pension fund and mutual fund segments; increasingly we see potential new business from the treasury offices of large corporations.” Fors believes that growth must also emanate from within and with that in

mind, SEB“is continuing to develop its product set in order to compete with both local and global competitors.”Part of that is honing internal processes; part of that is developing a workable business strategy; part of that is careful diplomatic positioning. In that context, SEB and Fors himself have never been shy of placing themselves at the heart of the polemic underpinning the current crop of market change. The bank was recently invited to join as the eleventh member of the Association of Global Custodians (AGC), an informal group that works to address regulations and issues affecting market structure. Fors will be representing the bank at the association. For some it is a merit badge; for SEB it is an acknowledgement of its specialist position in the international ranking of the asset servicing industry. Totems aside, and outside of the natural caution that successful business leaders carry with them, Fors believes in his product set and wholeheartedly believes that the custody business in general, will continue to grow: “because it has to, in order to meet the needs of markets and clients. Those requirements will become more demanding,” states Fors. Current considerations over the future of the euro project aside, Fors has a clear vision of how the European theatre will play out and SEB’s role within it: “We see more consolidation in Europe as a single financial market. It is inevitable. We also see an attendant consolidation of the infrastructure and processes within Europe and this will invariable affect the way that all institutions will work over time. Union is progressing slowly, but it is moving. Therefore we feel we must be involved in the centre of the discussions on issues such as T2S, the future of CSDs, the harmonisation of regulation framework and taxation as all of these will combine and encourage a consolidation of platforms where securities are issued and traded. In our market context, we need to be an integral part of that process.”I

FX VIEWPOINT

THE GROWTH STRENGTH OF THE SWISS CURRENCY

The foreign exchange market has absorbed a great deal of the current stresses, with risk aversion punishing those currencies that were profiting most from the commodity boom (Aussie dollar foremost) and the euro for its attachment to the toxicity of the Old European bond markets. The Swiss franc has thus experienced a meteoric rise over the past several months as capital flees the tumult. Even sterling has taken on the aura of safe haven, which has to be a source of amusement for those who remember how George Soros once took on the Bank of England and won billions, shorting sterling during the ERM crisis of 1992 in one of the most audacious plays in memory. How long can the Swiss franc stay on its upward trajectory? Erik Lehtis, president of DynamicFX Consulting, muses on the trend to watch.

Hard cheese for swiss franc INCE APRIL 6TH, the “Swissie” has appreciated from over 1.32 to the euro to near parity below 1.01 on August 9th. This sea change in valuation is causing considerable pain in the Swiss equities markets, where share prices have responded by collapsing during that same time frame—the Swiss Stock Market Index has fallen from over 6550 on April 6th to below 4750 on August 9th. For foreign investors, the net change in value of an un-hedged long in equities has been negligible, but for domestic investors who have realised no currency appreciation, the shift has been cataclysmic. Officials at the Swiss National Bank (SNB), the central bank, have responded with open market intervention and other liquidityadding measures that have caused short-term interest rates to move into negative territory—investors are now actually paying for the privilege of holding Swiss francs on deposit. Additionally, there has been talk of pegging the franc to the euro, thereby eliminating the risk that investors and holders of Swiss francs face that their money might become too valuable. While desperate times call for

desperate measures, one must conclude that this sort of jawboning is really only that: talk. The notion that the SNB would act unilaterally to impose artificial restrictions on such a critical market-based mechanism is somewhat surreal; it would imply a tipping point in the relationship between the public interest and free markets that one would hope we never reach. Perhaps it is worth taking a moment at this time to reflect on the importance of free-floating exchange rates within the context of the greater market mechanism. Once again, we have seen that liquidity and equilibrium are both fleeting characteristics in an open market system when sentiment shifts predominantly to the negative side. As volatile as equity and bond markets have been, imagine the magnitude of losses if exchange rates were not freely traded and therefore available to absorb some of these imbalances in supply and demand. One of the great benefits of floating exchange rates is the ability of an economy to externalise imbalances, and thereby cushion disturbance in domestic markets. The

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

floating currency also encourages correction, as there will come a point in the life cycle of a dislocation when the currency becomes so cheap that it actually acts as a magnet for fresh investment. This dynamic plays out on the other side of the coin as well. The Swiss franc is (or soon will be) overpriced relative to economic factors, and this fact will cause profit taking and the closing out of speculative long CHF positions. As the franc loses value, the Swiss equity market will become more attractive to foreign investors, and balance will be restored. The mechanisms are less than perfect; nor are they immune to sometimes-grotesque overshoot. Nevertheless, in a free market economy such as the one that dominates international commerce, floating exchange rates are an essential feature. They provide the valves for excess pressure to be released, protecting the greater vessel from damage. Perhaps if we gave the mobs of London iPads with access to retail forex, they’d take their frustrations out on sterling. Who knows, maybe we’d find the next George Soros?I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

TO OPPORTUNITY IN THE GLOBAL MARKETS

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REAL ESTATE

LONDON OFFICE PROPERTY: A RETURN TO FORM

Tower power revival in London The latest iconic skyscraper set to put its imprint on the London skyline was unveiled in late July, reflecting the renewed confidence in the England capital’s commercial property market. While investment floods into the city’s prime locations, the divergence between primary and secondary property continues to widen and a North-South divide also appears to be opening up, mirroring the UK’s residential market. Mark Faithfull reports on an uneven recovery and the risk of more occupier jitters. T HAS BEEN a long time coming but this spring the pendulum finally swung back in favour of development in central London, made tangible with cranes once again puncturing the capital’s skyline. Estimates hold that as much as 6.4m sq ft of property is under construction in the capital, compared with just 2.7m sq ft at the end of last year, representing a 137% leap in activity and the first rise in overall office construction for three years. In the latest Crane Survey by consultant Drivers Jonas Deloitte (DJD), figures also pointed to developers opting to build big this cycle, with almost half the schemes on site totalling more than 100,000 sq ft. The average scheme in the City of London is 474,000 sq ft, while in the West End developments average around 110,000 sq ft. New developments make up almost three-quarters (4.7m sq ft) of space under construction—the largest amount of new speculative space recorded in a single Crane Survey. Anthony Duggan, head of research at DJD, reflects: “The race is on to deliver schemes to take advantage of the dwindling supply of grade A space in 2012 and 2013.” Agent CB Richard Ellis (CBRE) warns that the supply squeeze is set to continue with new development completions on track to be one of the lowest on record for Central London, with only 1.9m sq ft scheduled for com-

pletion this year. The City pipeline is expected to deliver only 1.2m sq ft and the West End only 436,200 sq ft— making it the lowest annual completion rate ever recorded. With short-term supply so low, the City is largely accountable for the fresh wave of construction across the capital, with development doubling over the past six months to 2.8m sq ft in what is the first new activity in the Square Mile for 18 months. London’s new towers account for 80% of the space currently under construction in the City, with The Pinnacle, 20 Fenchurch Street and The Leadenhall Building all scheduled for delivery in 2013 and 2014.

Low take-up in the City Matthew Elliott, DJD’s head of transactions, says: “If all are built, we could see more than 200 tower floors coming to the market at a similar time in 2014/15—an unprecedented situation—and this excludes The Shard being built on the other side of the Thames. “Some will worry that this will lead to oversupply and falling rents, but others say that this is a further sign of confidence, a sign that London remains the global financial centre. Everyone is talking about it but the market doesn’t yet know how this will play out,” adds Elliott. Such concerns will be heightened by news that a total of just 744,000 sq ft of space was leased in the City in the

three months to the end of June, a quarter below the same period in 2010 and 35% less than the ten-year average, says CBRE. The figure for central London, including the West End retail and theatre district, fell 19% to 2.2m sq ft. Large office moves in London have fallen since the last quarter of 2010, when there was a flurry of credit crisis-delayed deals, including JP Morgan’s move into a Canary Wharf building once occupied by Lehman Brothers. “We are seeing the London leasing market reconnect with the economic fundamentals after a series of deals last year that were driven by pent-up demand,” says Kevin McCauley, head of central London research at CBRE. There is also more construction work under way in the West End than at any point over the past two years, with 13 schemes totalling 1.4m sq ft starting over the past six months, bringing the total volume of office space under construction to just under 2m sq ft. DJD says that this is a clear sign that developers are taking note of low levels of grade A space and rapidly rising rents. Just 8% of available space in the West End is grade A-quality, which has prompted developers to seek out opportunities to refurbish older space. However, activity in London’s submarkets remains thin, focused on The Place, Sellar Property Group’s “mini

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Overview of The Leadenhall Triangle. Photograph kindly supplied by Mark Faithfull, August 2011.

Central London: Major investment deals

Aviva Tower 10 Aldermanbury Leadenhall Triangle

Purchaser Private JP Morgan Henderson Global Investors

£m 288.3 260.0 195.0

Source: CB Richard Ellis, supplied August 2011.

Shard”, which is being built close to The Shard in Southwark, south-east London. Also in the same area, The £2bn London Bridge Quarter development, designed by Renzo Piano—who is also the architect for the neighbouring Shard—will comprise 430,000 sq ft of office space spread over 17 floors. The Place, which is costing £136.5m to build, is London’s largest speculative office building being developed for delivery in April 2013. Irvine Sellar, chairman of Sellar Group, hopes the scheme will have an end development value of £500m, based on rents of £55 per sq ft, and says: “I prefer multi-let buildings because you get better growth. But I wouldn’t say no to a single tenant either.”

Mixed story across country Yet the story of London is not typical amid a patchwork recovery across the UK. The increasing regional variation in the commercial property market became particularly apparent in the most recent reporting period for the three months to the end of June, as London’s real estate strongly outper-

FTSE GLOBAL MARKETS • SEPTEMBER 2011

formed the rest of the UK. Marked differences in the levels of available floor space across the UK also reflected the differing state of the market across the country. In London, availability stabilised at a net balance of 2%; however, in northern England it rose to 22%, according to RICS. As a result, the number of incentive packages offered by landlords to secure a letting continued to increase in the second quarter, albeit at the slowest pace in almost four years. Throughout the UK, the Midlands and Wales saw the greatest number of incentives, whereas London experienced a fall, driven mainly by the office sector. In addition, a spike in distressed sales in the second quarter (Q2) of 2011 could signal a surge in bank-held assets being brought to market, according to Lambert Smith Hampton (LSH). It notes £6.6bn of deals in the period and distressed sales accounted for almost £1bn. More than half of the distressed assets sold in Q2 were in the regions. However, London accounted for 90% of the total by value. LSH chief executive Ezra Nahome says he expects to

see more bank-driven sales over the coming months. “The banks have focused considerable resources at their loan book and decisions are being taken to sell,” he says. Despite the rise in distressed sales, overall volumes were down by 21% on the first quarter. However, Q1 figures were skewed by the £1.6bn sale of the Trafford Centre in Manchester in a complex retail property deal. Central London offices remained the lead indicator for the market, with yields now below 5%. Outside London, offices failed to perform, with yields moving out by 126 basis points to 8.77%. While UK institutions were major buyers during Q2, they were squeezed into second place by overseas investors, which bought more than £2bn of assets during the three-month period. Listed property companies and REITs were the biggest sellers during the quarter. Agent Jones Lang LaSalle also expects an extra inflow of distressed sales but believes that while receivership and workout sales will remain a key supply driver in the investment market, there is a sense that the market has seen, or is aware of, the more significant distressed assets. Neil Prime, director, head of UK office agency for JLL, adds: “There is a belief that we are in the ‘non-prime’ phase of real estate workout and while this will still have direct implications for investable opportunities we believe buy side activity will be dominated by specialist funds and private equity vehicles rather than more traditional physical real estate players.” According to JLL, investment volumes in Central London totalled £3.1bn in the second quarter of 2011, up 19% on the previous quarter. The year to date total of £5.7bn is 36% ahead of the equivalent period last year and volumes were dominated by over-

REAL ESTATE

LONDON OFFICE PROPERTY: A RETURN TO FORM

seas private investors, which accounted for 36% of the total. The 12-month rolling total of £12.3bn is 13% ahead of the ten-year average. Seven significant transactions took place over the quarter with £1.3bn traded in lot sizes over £100m, equivalent to 42% of the total. Prime yields remained stable across both West End and City sub-markets. In the West End, prime benchmark yields for sub£10m lot sizes remained stable at 4.00% and have been at this level for 12 months. Yields for intermediate lot sizes (£10m-£80m) remained at 4.25%. In the City, yields for all lot sizes remained at 5.25%, however these are coming under pressure for sub-£40m lot sizes. Prime adds: “We are seeing strong competition between institutions, Far Eastern managed funds and private high net worth individuals and investors are now willing to take on higher levels of risk—particularly in the West End, driven by forecast rental growth rather than any anticipated yield compression.”

Creative industries buoy West End Even so, the news is not all good even for the capital’s prime properties and the impact of slow growth in the UK economy has started to feed through to corporate take-up of space. Central London take-up fell to 2.2m sq ft in the second quarter as leasing activity remained subdued. This represented a slight decline on the previous quarter, down 4%, and was 26% below the longterm average. However, the West End bucked this wider trend as take-up rose 18% over the quarter to reach an above trend 1.2m sq ft, according to CBRE. Demand for new space from the creative industries was the primary factor. Deals involving Google, Double Negative and MPG were all completed during the quarter, meaning the West End experienced seven successive quarters of trend or above-trend takeup, which has taken supply levels to 3.9m sq ft—its lowest level since Q1

Google’s new headquarters. Photograph kindly supplied by Mark Faithfull, August 2011.

Investment transactions: London Q2 2011/2010

City

West End

Midtown

South Bank

Central London

UK buyers Overseas TOTAL UK buyers Overseas TOTAL UK buyers Overseas TOTAL UK buyers Overseas TOTAL UK buyers Overseas TOTAL

Q2 2011 (£bn) 0.65 0.78 1.43 0.55 0.23 0.78 0.00 0.06 0.06 0.00 0.00 0.00 1.19 1.07 2.27

Q2 2010 (£bn) 0.47 0.08 0.55 0.52 0.68 1.21 0.06 0.39 0.46 0.00 0.00 0.00 1.06 1.15 2.21

Source: CB Richard Ellis, supplied August 2011.

2008 and only 1.1m sq ft higher than the low point of the last cycle. This has taken the West End vacancy rate to a recent low of 3.8%. Phillip Howells, executive director, West End business team, CBRE, reflects: “Creative industries occupiers have played a significant role in supporting West End leasing activity in the second quarter, and over much of the last year, particularly in locations outside of Mayfair and St James’s.” Yet even in London the real estate

economy and the real economy remain inevitably entwined and the amount of new office space leased in London’s financial heartland fell to a two-year low, with global economic fears deterring some firms from moving and worrying others, such as Swiss bank UBS. The moratorium on development should compress supply enough to create a good environment for the speculative schemes as they come online but Britain’s flat economy could yet jolt the market. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

INDEX REVIEW

MARKET FRAGILITY CONTINUES: SECOND DOWNTURN A WORRY

Markets are likely to remain fragile as a result of any bad news event for some considerable time to come with rallies swiftly turning into routs and vice versa. On a price analysis basis we can see that the low 4700s (which the FTSE 100 hit twice in recent sessions only to bounce back violently) is actually a very strong technical support level right now. A return to this price area must be viewed with trepidation as any close below this mark would trigger some hefty selling. While we remain above that mark we are likely to see cautious portfolio building. What next? Simon Denham, managing director of spread betting firm Capital Spreads, takes the ultra-bearish view.

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

Fears of even cheaper valuations stalk the markets T APPEARS THAT the cost of carrying all the baggage of a civilised society has finally become too great for virtually everyone at the same time. When you are no longer rich and powerful the modern democratic model struggles to adjust as politicians seem to be no longer in power, either through conviction or ability. In this situation, they are in office, but not in power. In that context, harsh but often correct policies are not deemed expedient (as they fear they will lose the next election). Now it seems we are still in the realms of printing ever more money to try to protect the credit worthiness of money already in existence. Equally, the news continues to turn increasingly worse for many of the more indebted European Union (EU) members and the woes of these countries seem likely to drag even the more fiscally prudent nations into the mire alongside them. The problems of the currencylinked, but not fiscally-linked, union have been analysed ad nauseam. I do not wish to retread old territory here, but any prognosis of the outlook for the FTSE 100 and FTSE 250 must contain at least a mention of the issues in mainland Europe. There appear to be only two solutions: either

FTSE GLOBAL MARKETS • SEPTEMBER 2011

members of the EU become ever closer and issue debt under a unified umbrella (EU-guaranteed issuance) as a means to bolster sovereign bonds, or certain members must dislocate from the whole. Easier to say than to do perhaps; but if dislocation is on the cards, we may find it is stronger countries such as Germany, Holland and France that leave. This would enable the euro to devalue and therefore not bankrupt, at a stroke, all the weaker members. In reality, as politicians have so much invested in the euro project, the most likely solution will eventually be the issuance of supra-sovereign debt or quasi-sovereign debts of the lives of, say, EBRD issues, which can underpin all other sovereign issuance. The one problem with this is getting Germany to agree to it as it would certainly be heavily dependent on its monetary power. So what are the immediate prospects for the FTSE? In recent days we have hammered as low as 4725, some 20% off the highs of the year. This is generally considered to be the sign of an official bear market, but as with most downward shifts it feels much worse than that. Rallies which take years to build are destroyed in one week of chaos and confidence is

crushed to a level that can take months to regain. Right now we are not sure if the European banking system is ruined (if they are found to hold too much Greek/Irish/Portuguese debt) or whether S&P’s decision on US debt will actually make a blind bit of difference. Either of these problems easily has the ability to push the world into a second, even bigger, downturn and the underlying worry is that nobody has any powder left for another fiscal injection. In the long run, the equity values currently on offer should be well worth a dabble, but this is not what is worrying investors at the moment; it is the fear that they will get to an even cheaper valuation over the autumn of 2011. In Europe, the signs are not good but the recent FOMC decision in the US gives me much more confidence. Mainly because they made no decision! They were not railroaded into another stupid bout of QEIII or a blaze of liquidity issuance in a “painless” attempt at using other people’s money to solve a problem. We may just have reached a watershed moment where debt returns to being an obligation, not an easy option. More than ever it is hard out there. Place your bets, ladies and gentlemen.I

TRADING

Photograph © Tamás Gerencsér/Dreamstime.com, supplied August 2011.

Ever since electronic execution and deregulation transformed equity markets, traders have yearned for a way to replicate the block trades that once dominated institutional trading through the brokers’ upstairs desks. In a world where the average ticket size on conventional exchanges and lit alternative trading systems has shrunk to less than 300 shares, traders who handle large orders are more exposed to information leakage than ever before. Just as an army commander who sends out scouts runs the risk that a man may be captured and give away crucial information, a trader who accepts small fills will find that other market participants sniff out his intention and drive the price against him before he is finished. How to get around it? Neil O’Hara reports.

TACKLING THE DANGERS IN DARK TRADING UY SIDE TRADERS pine for a haven where they can trade in peace with others of similar mind, which is precisely the purpose of block crossing networks such as Liquidnet and Pipeline. Open only to the buy side, these dark pools allow traders to expose orders without revealing either their identity or the true size of their interest to anyone before the trade is executed. Trades on Liquidnet generally print at the middle-market price, which conveys no information about which way the price is likely to move afterward, unlike an execution that crosses the spread, which may imply a trader has more to do in the same direction. “Even more important, there is no leakage when we don’t have the other side of the trade,” says Per Loven, the London-based head of international corporate strategy at Liquidnet. That is a huge improvement over the old days; if a broker’s upstairs block desk called an institution that happened to be on the same side of a trade, the original client got nothing done but tipped the second institution that another buyer was in the market. In a trading venue without market maker intermediaries, the odds of getting a match are relatively low. This is why

Liquidnet allows participants, at their option, to interact with other dark pools, including those run by sell side brokers. Traders who do so must accept a higher risk of leakage, because the small, average size traded in broker dark pools may include high-frequency trading firms and other players trying to make money as electronic market makers or short-term momentum traders. They employ algorithms that send out and cancel hundreds of small orders every second and analyse the fills to detect the possible presence of large buyers or sellers. The high-frequency flow does provide liquidity, but to a large investor such as Pennsylvania-based Vanguard Investments it has little value. “If I have a million shares to buy, I probably will not go to the broker dark pools,”says Michael Buek, a portfolio manager at Vanguard. “All I will get is a couple of hundred share prints that may indicate a buyer is around. But if I have only 300 shares to do, I will scrape through the broker pools to see if I can pick up stock between the bid and the offer before I go to the lit markets.” Vanguard specialises in passive investment strategies, so its portfolio managers typically don’t expect big price moves

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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Buy-Side Technology Awards 2010

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Winner

Liquidnet

Z/Yen 2010

TRADING

shortly after trades are completed. In the absence of urgency, Buek prefers to build a position through a block crossing network if he can. When managers are in a hurry, he will estimate how much the price is likely to move to get the trade done on time. “If the manager thinks the stock is going up 12% and I tell him it might cost 1%, it could be worth incurring the trading costs,”he says. “If he doesn’t have that much information value, he may say forget it and buy something else.” Traders don’t live by hard and fast rules, though. In principle, dark pools are the perfect venue for small or midcap stocks because the potential market impact of a large trade is so much higher than for a blue chip such as IBM. For many smaller companies, a regional brokerage house has the axe—jargon for the lion’s share of order flow—in which case Buek may try his luck in the block networks, but then go directly to that broker rather than using an algorithm.“If it is a broker we like and they have the other side, we may even call them first,” he says. To Kevin Cronin, head of equity trading at Invesco, every trade is different—and so is the optimum execution strategy. In the United States he has more than 40 trading venues to choose from, each of which has characteristics best suited to particular types of trade. Some dark pools are darker than others, too, so Cronin will scale back the size he shows as the risk of information leakage increases, just as traders did in the pre-electronic era. If a buy side trader told his upstairs broker to buy 100,000 shares, the broker might give 50,000 to his position trader, who passed 25,000 on to a floor broker, who showed just 5,000 to the specialist. At every step, the leakage risk ratcheted up, as it does today when a trader works his way from secure buy side block crossing networks through exchange and broker-sponsored dark pools to the open-kimono lit markets. “How much liquidity is to be found, and how much risk are you taking?” asks Cronin.“That is the nuance and value traders bring: to unravel this contorted web.”

Per Loven, London-based head of international corporate strategy at Liquidnet. Photograph kindly supplied by Liquidnet, August 2011.

Broker dark pools protect investors The broker dark pools are essentially internalisation engines that flag whatever matches occur within client order flow so that brokers can cross the trades without ever displaying orders in the public markets. The price at which trades print has to be equal to or better than the best bid or offer available in the lit markets, which protects investors and offers them a chance to beat the public market price. Indeed, most dark pool trades take place at the middle-market price, which gives investors a better price than they would get in the lit markets, where participants usually pay or receive the far side of the spread. Exchange-sponsored dark pools occupy the middle ground, open to both buy and sell side firms but seeking to capture volume that might otherwise flow to an internalisation engine. Lee Hodgkinson, head of European sales and relationship management, NYSE Euronext, and chief executive officer of SmartPool, the European dark pool launched in March 2009 by NYSE Euronext in partnership with HSBC, JP Morgan, and BNP Paribas, says broker algo-

Michael Buek, a portfolio manager at Vanguard. Photograph kindly supplied by Vanguard, August 2011.

rithms designed to sweep dark pools deliver the greatest flow to SmartPool. Dark pools account for just 3.5% of equity trading volume in Europe (against 10% in the US), and SmartPool is now the fourth largest, with a 9% market share. Hodgkinson says traders used to run through the various dark pools in succession to pick up whatever fills they could. The technique often resulted in small executions, which might alert other market participants.“Now, people typically place business in all the dark pools simultaneously,”he says. “When they get a hit, they pull the orders from all the others

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Kevin Cronin, head of equity trading at Invesco. Photograph kindly supplied by Invesco, August 2011.

and direct it to the dark pool they got the best hit from.” It all happens so fast that the signalling risk is reduced—the cancelled orders resemble high-frequency trading flow rather than institutional interest.

Potential for price improvement The potential for price improvement in dark pools means that traders often tap the public markets only after they have swept the dark pools. The best execution obligation leaves them little choice. They must explore every opportunity to secure the best price available and to minimize the market impact of their trades.“There is no market impact in a dark pool because it is not part of the quote,” says Oliver Sung, a director and head of Americas execution consulting at Bank of America Merrill Lynch. “It is not that traders don’t want to go to the exchanges. They are just trying to minimize market impact, which only happens in the lit markets.” Many broker dark pools have links to other dark pools, which makes it difficult for buy side traders to track exactly where their orders go and who is able to see them. The link typically isn’t an automatic cascade from one pool to another, but users of one broker’s algorithms may be able to route orders to third-party dark pools as well as the broker’s own. Adam Inzirillo, a director in the global execution services group at Bank of America Merrill Lynch, says the buy side has caught on and wants to know exactly how orders are handled at each venue and how each algorithm routes their orders. “Everyone is creating more transparency about where the order is going,”he says. “Sometimes you can see it in real time, in messages going back to the buy side.” Of particular concern to Vanguard is whether a broker’s algorithm routes orders in a sequence designed to maximize revenue to the broker rather than best execution for the client. Maker-taker pricing creates an incentive for brokers

FTSE GLOBAL MARKETS • SEPTEMBER 2011

to favour venues that pay the most or cost the least. “I would much rather have them route for best execution and charge me a higher commission rate than find out they are not taking stock offered at my price because they don’t want to pay the access fee,” says Buek. Buy side traders can compare the fills they receive after the fact to aggregate execution statistics. If anomalies show up—a broker dark pool that typically accounts for 1% of volume repeatedly fills a much higher percentage of the trader’s order flow, for example—they will investigate.“That would be a red flag,”says Mat Gulley, head of global trading at Franklin Templeton Investments. “If that does not show up in trade cost metrics I would be very surprised.” Like Franklin Templeton, Invesco looks at what happened after the fact, both to verify that the routing worked as anticipated and to see how well the overall execution strategy panned out. If the portfolio manager did not expect an immediate price change, did the execution move the market? If a move was anticipated, how much occurred before the order was filled? Would a different trading strategy have reduced the market impact?“We are trying to improve our skills from transaction cost analysis,” says Cronin. “We spend a lot of time worrying about venue selection and unintended consequences.” While he applauds the regulators for introducing competition to the legacy exchanges, Cronin worries that the increasing use of dark pools erodes the reliability of price discovery in the lit markets. He points out that although volume in dark pools represents only 10% of US equity trading, that figure does not include internal crosses in broker dark pools, which he estimates could account for another 10%-15% of volume. “If 20%-25% of trades are never seen in the market, how well do we really understand supply and demand?” he asks. “We might be looking at prices in the lit markets that don’t reflect the true picture.” Gulley points out that public quotes drive prices in the dark pools, where most trades take place inside the public bidoffer spread. However useful the block crossing networks are when they do have a match, the average daily volume on Liquidnet and Pipeline in the US is only about 20m shares— a cipher compared to the billions of shares that trade every day. The overwhelming majority of dark pool flow is internalisation, which typically involves trades similar in size to the average ticket in the lit markets. “It does not seem like dark pools are affecting price discovery,” says Gulley. In today’s markets, liquidity that is visible in the lit markets may not tell the whole story. Some exchanges have introduced hidden order types that algorithms can tap, while other liquidity may lurk in the dark venues. The biggest reservoirs of undisclosed liquidity sit upstairs at the brokers—and on the buy side trading desks.“Traders show just a fraction of large orders for fear of information leakage,” says Gulley. “We and the upstairs sell side desks are a big dark pool that is not in any system.” The buy side knows far more about what happens to its orders than it used to, but traders, who are paranoid by nature, still keep their cards close to their vest. I

Sponsored statement

Venue selection in a fragmented market The response of brokers to venue selection post-MiFID has been characterised by two distinct phases. Initially, the concern, driven to some extent by the buy side, was to ensure all available liquidity was accessible to the broker’s smart order router. Venue selection was based on market share, latency and (incorrectly in our view) fees. This has become more sophisticated with dynamic allocation of liquidity based on concepts such as heat mapping. Even so, it has remained a very narrow approach. Mark Goodman head of quantitative electronic services, Europe, at Société Générale Corporate and Investment Bank (SG CIB), explains the dynamics.

LIENTS HAVE BEGUN to take a more granular view of trading, increasingly questioning why their orders are going to a specific venue. Concerns include how pricing structures influence routing decisions and the nature of the participants in a venue, particularly high frequency. There is also recognition that the quality of a pool is heavily driven by the nature of the counterparties who are active there. The two concerns are linked, as venues with favourable fee structures tend to attract high-frequency trading strategies. The debate has summarily moved from accessing quantity of liquidity to the inclusion of a second dimension—the quality of liquidity. This presents a particular challenge to brokers; while quantity is relatively easy to measure and can be incorporated into venue selection in a straightforward manner, there is no common measure of quality or approach to implementing this into smart order routing (SOR) logic. Broadly speaking, high-quality liquidity is characterised by a low level of information leakage and a low level of adverse selection. Most brokers provide some type of analysis around price reversion to judge adverse selection with the assumption that this is associated with information leakage, particularly when accessing dark pools. Although these measures are informative, they are outcomefocused and tend to be influenced by many factors such as market movements and the impact of the order itself. In contrast, SG CIB has developed a proprietary approach, a Quality of Venue Measure (QVM), which provides a systematic measure of behaviour in both lit and dark pools.Taken as a whole, QVM provides for the categorisation of each venue according to quality as well as quantity, and gives more transparency to the reaction of counterparties in a trade. This is vital, as outcome-focused measures only provide insight when there is a negative impact. A second feature of this approach is the ability to measure changes in quality over time. Quality

Mark Goodman head of quantitative electronic services, Europe, at Société Générale Corporate and Investment Bank (SG CIB). Photograph kindly supplied by SG CIB, August 2011. in an individual pool can vary significantly over time as counterparties connect or strategies are cut. A pool which may have been low quality one month may be more attractive the next; without regular systematic analysis, important liquidity opportunities may be missed.

Quality measures in order routing decisions The addition of quality as a second dimension to order routing decisions has multiple applications both in venue selection and what behaviour to deploy on each venue. One application is to vary factors such as minimum quantity. With QVM you can find the optimal point to exclude less desirable counterparties while ensuring that the trader interacts with the maximum quality liquidity available. In the context of venue selection, the simple response to the data is to exclude certain

venues. Our view is that all liquidity is useful some of the time and the aim of the QVM is to provide a way to differentiate between venues so we access the right venue, at the right time, in the right way. To do this, the order’s objectives are incorporated into SOR behaviour, for example, limiting interaction to venues categorised as high quality for low urgency orders or using the widest possible selection of venues when taking advantage of short-term favourable price movements. SG CIB has already deployed these approaches into its strategies such as Eclipse, a liquidity-seeking algorithm, which adapts its behaviour when accessing dark pools, based on the categorisation of the venue in terms of quality. In addition, one of the most important applications of QVM is to monitor and maintain quality in our internal crossing network, Alphax. By monitoring quality effectively, new liquidity can be introduced into the pool with any negative impact being identified and addressed immediately so the pool can grow and at the same time maintain quality. Probability of execution can’t be ignored, meaning that large pools will still be a key destination for order flow as well as factors such as queue size being important when posting flow into lit venues. However, to ignore the quality of a pool or to have an inadequate way of systematically measuring this factor means excluding a key dimension in delivering execution performance. While a venue deemed low quality should not be automatically excluded, a venue which is not properly understood should be. I

For more information, please contact: Mark Goodman, Head of Quantitative Electronic Services, Europe Email: mark.goodman@sgcib.com Tel: +44 (0)20 7762 5751

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

TRADING

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

Direct access to Russian financial markets is difficult, if not impossible, for a significant portion of the trading community, limiting foreign participants to indirect access through depositary receipts (DRs), swaps and exchange-traded funds (ETFs). However, the opportunity set in trading cash equities and futures in Russia is in the process of being reformed radically. Additionally, the upcoming merger between MICEX and RTS, should it survive regulatory hurdles and concerns over market concentration, will redraw Russia’s trading infrastructure, eventually impacting on the clearing and settlement of trades. Ruth Hughes Liley reports on a market in flux.

BANKING ON THE PROMISE OF RUSSIAN STOCKS R USSIA HAS THE financial markets highest futures/cash market turnover at present, of 1.2 times. Similarly, the ratio of trading in the RTS Index compared to its market capitalisation, at $1.5trn, is the highest among the BRIC markets. Market watchers say these are portents of an increase in trading volume on the local futures and equity exchange platforms. TABB Group, for instance, expects more than 20 foreign systematic proprietary trading firms to be trading directly on one of the major Russian markets by the end of this year and will account for up to 15% of market volume. Even through the early August market ruction, and according to online data provider Advisoranalyst.com, Russia’s market decline (around 9.31% by August 12th), was the lowest among the BRIC nations. Brazil’s main index had fallen by a whopping 26.19%; India’s by 17.8%; China 10.04%. Also, at the time of going to press, the UK’s main index had fallen by 12.46%, Italy’s by 22.07% and the US by 6.77%. It is not a lack of interest or opportunity that will handicap access into Russia. Instead, the rate of change will be governed by the speed with which the authorities tackle regulation, taxes, currency, exchange membership, customs and data centre facilities.

FTSE GLOBAL MARKETS • SEPTEMBER 2011

The country was also not immune to market turmoil through the first half of August. The planned merger of Russia’s two largest stock exchanges, RTS and MICEX, brings with it another small but significant development. This year, the stock exchanges are jointly organising the yearly best company annual report competition, expected to receive more than 140 entries by the closing date in October. This growing confidence of companies to disclose information runs in parallel with the increasing confidence of brokers and exchange participants to trade shares in those companies. While most of the liquidity still resides with the top blue chip names, interest in trading Russian securities has never been higher. Russia’s market capitalisation has grown almost eight-fold since 2004, from around $150bn to $950bn by the end of 2010. Other benchmarks record similar growth. For example, trading on the FTSE Russia IOB (International Order Book) Index has trebled in value since 2008. Direct access to Russian markets by external participants, however, is not for the faint-hearted, according to Andy Pryer, ING’s execution sales director. “It is not simple. You cannot have remote access. There’s a T+ zero settlement, meaning you have to

TRADING

Tim Bevan, director, global electronic trading services, at Otkritie. Photograph kindly supplied by Otkritie, August 2011.

Roman Goryunov, chief executive at OJSC RTS. Photograph kindly supplied by OJSC RTS, August 2011.

deposit funds and inventory in advance.You have to be long your account. Trades are almost solely executed in rubles, so there is a foreign exchange cost to your trades and you also have to do various risk assessments on your counterparty. However, all forms of execution are still possible providing the right intermediary is chosen.” Research firm TABB Group has identified 20 foreign systematic proprietary trading firms expecting to trade in Russia directly by the end of this year, and accounting for up to 15% of volume. In his paper Trading Russia: Access and Arbitrage, author Adam Sussman, a TABB partner, says: “The increasing facilitation of direct access into Russia creates opportunities for shorter-term trading opportunities. The combination of a strong domestic retail market, the influx of institutional players and the rise of ETFs will generate demand for cross-border market making.” Russia has the financial markets highest futures/cash market turnover at present, of 1.2 times. Similarly, the ratio of trading in the RTS Index compared to its market capitalisation is also the highest among the BRIC markets. Sussman says: “If regulations, exchange officials, brokers and other service providers continue to narrow the requirements gap of Russian capital markets, all signs point toward an increase in trading volume on the local futures and equity exchange platforms.” Sussman points out six complications that could delay or prevent trading: regulation, tax, currency, exchange membership, customs and data centre facilities. With parliamentary elections due in December this year and the presidential election in March 2012, political uncertainty is also creating unease and will affect pricing, believes ING’s Pryer. For the time being, Russian politicians are stepping up to the proverbial plate. Since the government announced in April 2008 that

it wanted to create an international financial centre, rules and regulations have been changing at an accelerating pace. In January this year insider trading was outlawed. By May, formal recognition of foreign sub-brokers by the Russian regulator, the FFMS, was introduced. In June, capital gains tax regulations changed. The following month president Dmitry Medvedev announced that by September he wanted restrictions lifted on the listing of Russian securities abroad, which limits the amount of GDRs to less than 25% of the share capital of a firm. By the same time, he also wanted foreign investors to be able to open accounts to allow them to trade directly in Russia. Up until now, foreign firms have had to have their own subsidiary firm registered in Russia or use a Russian-based intermediary, which is expensive. Yury Plechko, deputy chief executive officer, UniCredit Securities, Moscow, says: “Now, if I have a Western client, I can disclose him to the exchange and in theory funds will be ring-fenced against possible broker bankruptcy. This is an important step because it serves to create more confidence in the whole chain of relationships accessing the exchange.” One helpful change has been the extension of trading hours of the foreign exchange (FX) market since early July. Previously, the FX market closed almost two hours before the equities market, which in a country where trading is conducted largely in rubles but settled in dollars, could cause problems at the end of the trading day. Tim Bevan, director, global electronic trading services, at Otkritie, Russia’s largest broker, believes that for the first time, this has created a fully automated FX market that will make it much easier to be able to change into dollars in a DMA model. “There is now an electronic order book for the equity leg and an electronic order book for the FX leg. So now you can pull the automated FX mechanism into the DMA flow.”

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

TRADING

Trading values of CIS stocks on IOB (2002 - June 2011) Year

CIS Trading

Total IOB Trading

CIS Trading

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 YTD

Value ($bn) 25 36 64 80 207 375 477 215 286 215

Value ($bn) 55 85 114 131 290 438 523 236 313 227

Value (%) 45 42 56 61 71 86 91 91 91 95

2011 Total($) CIS($) Jan 41,751,323,598 38,768,487,827 Feb 46,780,283,866 44,026,701,283 Mar 53,771,006,338 51,367,915,899 Apr 37,967,319,868 35,884,900,982 May 47,012,877,190 44,784,255,603 Total 2011 YTD 227,282,810,860 214,832,261,593 Avg/month 45,456,562,172.05 42,966,452,318.62 Source: London Stock Exchange, supplied August 2011

% 93% 94% 96% 95% 95% 95%

*To date

Another change will be the creation of one central securities depositary. Currently there are the two main depositaries on RTS and MICEX. In addition, US firms are compelled to hold stock directly with registrars, of which there are more than 60, because of strict compliance regulations under the US Investment Company Act of 1940, rule 17f-7. Moves to set up one central securities depositary will make trading simpler and cheaper. A significant privatisation programme is planned by the Russian government, forecast to be worth $10bn a year for the next five years. The new shares will feed through to the secondary markets, although its effect will depend on how the stock is placed, according to Bevan. “There could be quite big block placements, where the stock will be locked up, but the expectation is that the numbers are so big that it will definitely hit the liquidity profile.” The biggest change in the short term will be the merger between Moscow’s two stock exchanges, RTS and MICEX, which received shareholder approval on August 5th. An IPO for the joint firm is planned for early 2013 with the aim of raising £300m. It is expected that business departments will be brought together by the end of 2011 although IT platforms will operate separately for the time being and the future deputy leader of the merged exchange, Roman Goryunov, chief executive at OJSC RTS, believes it could take up to two years to merge technology. Goryunov says: “One of the main tasks is to maintain the rate of development that we are experiencing now. We are participating in a global competition and our fellow global exchanges are rapidly developing. Electronic trading has evolved very quickly and the entire financial market has

Yury Plechko, deputy chief executive officer, UniCredit Securities. Photograph kindly supplied by UniCredit, August 2011.

recently also made dramatic developments. A year or even a six-month delay would lead to such a tremendous backward slip that catching up would be practically impossible. We all expect to continue working on existing projects while also developing new ones. The success of the merger depends on our consistency in this process.” Bevan warns brokers should not underestimate the changes required by the merger, such as if the new exchange adopts a T+ model, following the example set by RTS Standard market which operates a T+4 days settlement period. “With the T-zero model, if you really look at it, the entire brokerage community has outsourced risk management to the exchange. So every broker in Russia will have to reconfigure their platforms. It is not just changing the matching engine. Local participants have a voice and change aimed at international participants is going to have an impact on domestic players.” Indeed, complexity is driving some investors to use overthe-counter (OTC) derivatives products. According to TABB estimates, non-domestic investment managers and hedge funds traded $189bn of Russian OTC equity-linked derivatives in 2010, or 23% of the exchange-traded market. “Pensions and international funds are the main customers for OTC structured products,” points out Evgeny Serdyukov, RTS’s head of derivatives market. “Recent changes in pension legislation will bring new participants into the market. Since last year, pension funds have been allowed to trade in derivatives and we are expecting open interest to grow.” Competition also comes from trading in depositary receipts (DRs) on the London Stock Exchange’s (LSE’s) International Order Book (IOB). Nicolas Bertrand, head of

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Andy Pryer, ING’s execution sales director. Photograph kindly supplied by ING, August 2011.

Andrew Powell, head of the electronic trading product, ING. Photograph kindly supplied by ING, August 2011.

equities and derivatives markets at the London Stock Exchange Group, believes this is for the good: “The IOB in a certain way is the secondary market as Russia is the primary local market. As the main market gets more efficient it can only help the secondary market. Liquidity on one market benefits the other. These two markets are basically fulfilling different needs of different customer bases. We believe competition is a very good thing for everybody, including exchanges. It forces exchanges to look at their offering. It drives innovation, efficiency and development.” Sberbank, one of the most highly-traded Russian companies, listed on the DR market in June and brokers are waiting to see whether this has a further impact on its trading volumes. After Russian bank VTB listed DRs in June 2010, trading value rose from $600m to $1.5bn a year later. With good technology a prerequisite for exchange trading, Douglas Watts, deputy chief operating officer at Russian brokers Aton, points out that all the technology used by the West is already in place.“The infrastructure data centres are resilient, dark fibre channels exist, co-location is also available. So the technology is there and it’s the same that the West is using. There’s a huge drive to build platforms, just as everywhere else.” However, he cautions that because of the structure of the market, it is connectivity which is the challenge as foreign firms are obliged to connect to exchanges via a local broker, unless they have their own Russian subsidiary. Stuart Adams, FIX Protocol EMEA regional director, says:“If Russia is to drive forward, it needs to have greater regulation in place, establishing a new baseline from which can come innovation. The Russian authorities are aware that there will be

competition and, culturally, this could be quite challenging but may generate significant benefit longer term. The algo trading side is pretty low right now, but it will evolve and for a new market like Russia it is going to help them if they are already working with tried and tested standards.” Adams compares the development of the Russian market with that of Latin America, where the MILA initiative drew together three exchanges from Chile, Colombia and Peru to create a routing network using FIX.“Developing an understanding of the huge benefits that standards present to emerging markets for global recognition is very important. If you look at the Middle East, a high percentage of trade on exchange is based on FIX, but if you take one step away to the brokers, the connectivity is more based on telephone, proprietary trading. Yet this is something you don’t discover until you get into the market. We haven’t really had these conversations in Russia so far. A lot of firms do use FIX for their front office, but I think they want to see it driven further down into the system.” ING’s Pryer notes:“International DMA flow is still absent at the moment. It does not mean that DMA to MICEX is not possible. In fact, it would be quite the reverse if your broker can access liquidity and cash within Russia. International access to MICEX will grow and it is still the largest venue for Russian stocks. When the international brokers are not trading over-the-counter they are executing through the International Order Book. The real paradox is that while all the international community players are trading outside MICEX, the best liquidity is inside.” Andrew Powell, head of the electronic trading product, ING, says: “The big houses and the high-frequency traders

FTSE GLOBAL MARKETS • SEPTEMBER 2011

TRADING

Total money raised by the CIS companies on the LSE’s Main Market between 2004 and 2011 (to date) 30,000 24,449.6

Money raised ($m)

25,000

19,548.6

20,000

15,000

10,000 5,921.4

5,725.6

5,000

3,082.7 1,710.7 178.0

2004

2005

2006

2007

2008

Source: London Stock Exchange, supplied August 2011

565.5 2009

2010

2011* *To date

are keen to get access to MICEX to take advantage of the deep liquidity, but there are hardly any Tier One brokers offering DMA to Russia. The key to it all at the moment is inventory to enable funding of the trade and MICEX only trades in roubles.” UniCredit’s Plechko agrees that DMA is still undeveloped, but sees it growing.“DMA is seen as a good proposal for someone who is concerned about some brokers making too much money on their trade. There is not a lot of confidence in the brokerage machine. DMA takes that barrier away and clients can see what is happening to their trade on the exchange. The second point is you need to look closely at the whole execution flow because, by default, you have a

Douglas Watts, deputy chief operating officer at Russian brokers Aton. Photograph kindly supplied by Aton, August 2011.

local brokerage house involved at the final stage. Some of our competitors have done a good job at building technology platforms that cater to the needs of high-frequency traders from the West. However, if you are a long-term investor, you might be concerned with the credit risk of the local broker involved.” Bevan is expecting market cap to grow strongly and local liquidity even more.“For everyone who thinks a fully westernised model will be adopted by 2012, it’s not. This is a big project and some of the infrastructure changes will take some time. But the growth and liquidity profile makes this market too important to ignore and Russia will form a larger part of everyone’s investment and trading universe in the future.”I

THE LSE’S INTERNATIONAL ORDER BOOK HE LONDON STOCK Exchange’s International Order Book (IOB) is ten years old and demand has grown constantly since 2008 for access to securities from 46 countries trading on one central order book. In the first six months of 2011, volume was up 57% and it is now a $1bn-a-day market with an average 16% share of total daily trading on LSE markets. The FTSE Russia IOB Index is a market-cap weighted index and measures the performance of the 15 biggest and most liquid Russian companies trading on the LSE’s IOB under the form of depositary receipts (DRs). Depositary receipts are negotiable certificates representing ownership of company shares and can be listed and traded separately from the underlying securities. There are currently 38 stocks eligible for the

Nicolas Bertrand, head of equities and derivatives markets at the London Stock Exchange Group. Photograph kindly supplied by LSE, August 2011. FTSE RIOB out of 180 Russian GDRs that trade on the platform, but this belies the volume. Eligibility is based on how liquid a share is and 91% of the volume on the IOB is from Russian companies. The FTSE RIOB Index is limited to the top 15 stocks. With the inclusion of Sberbank in July 2011, the

smallest cap and least liquid security was removed from the index. Not all the stocks eligible for the index are registered in Russia. Integra Group, for example, is registered in the Cayman Islands, Globaltrans Investment in Cyprus. The index was launched in October 2006 and climbed to 1600 points before the 2008 financial crisis (base 1000 in May 2006). Between June 2009 and March 2011 it doubled in value from 541 to 1196. However, by August 12th it stood at 847.83. Even so, Bertrand at the London Stock Exchange Group says: “The market has not fully realised that growth in the cash market is being followed by growth in the derivatives markets especially on the index side. There are 22 new clients trading in the IOB and the interest in Russian stocks is very high.”

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

ASIAN TRADING ROUNDTABLE

GREAT EXPECTATIONS: TRADING THROUGH GROWTH AND FRAGMENTATION

Photograph © Francesca Carnevale/FTSE Global Markets, supplied August 2011.

Attendees

Supported by:

(From left to right) ANDREW FREYRE-SANDERS, head of execution services, RBS YANG XIA, head of electronic trading, Asia-Pacific, UBS CHRISTOPHER BROWN, business development, Chi-X Global KENT ROSSITER, head of trading, RCM STEVE MANTLE, regional head of trading for State Street Global Advisors

FTSE GLOBAL MARKETS • SEPTEMBER 2011

ROUNDTABLE

THE SEARCH FOR BEST EXECUTION YANG XIA, HEAD OF ELECTRONIC TRADING, ASIA-PACIFIC, UBS: Best execution is an interesting challenge for us all; for both the buy side and the sell side. As a global brokerage house, UBS always tries to maximize our global expertise and import best practices into the Asia Pacific region. However, Asia is a diverse market; it is not really a single market. There are a lot of different challenges to be faced: different exchanges and regulations pose their own issues for instance; and we have a very varied client base to service as well. Actually, any global expertise you bring into this region also needs to be highly customised to local requirements; I think everyone around this table recognises that. Technology is a particular challenge in that regard, in terms of coping with various new rules and changes in the market, such as the emergence of ATSs, MTFs and other new venues. On the client side, how to get to best execution is even more of a challenge, given that the definitions for best execution are very different from firm-to-firm and from country-to-country. KENT ROSSITER, HEAD OF TRADING, RCM: Let me highlight how Asia is different from the US. Obviously, spreads in Asia are wider and liquidity is thinner. These considerations play an important part in how we trade and execute our orders, which are often done differently to the way it is done in Europe and the US. There are more frictional costs in Asia, for instance. Add this to the fact that there’s often not enough liquidity in some markets, plus additional hurdles such as high stamp duty or levies and transaction taxes, and you can see how we need to modify our behaviour to ensure best execution. These are some of the elements which, for the most part, you do not see in more developed markets. Our main challenge in that regard is to source liquidity. Most times, we simply need to wait for it; it is a game of patience instead of blindly participating in the market and following volume without discretion. A static inline“auto-pilot”strategy indifferent to news flow and market conditions could possibly suit some orders, but it is certainly not appropriate for most. STEVE MANTLE, REGIONAL HEAD OF TRADING FOR STATE STREET GLOBAL ADVISORS: I agree with all that: the main point being that best execution is very difficult to define. Everybody seems to have a different view on what constitutes best execution. Getting a lower price in a small amount: is that as good as paying slightly more for a much bigger amount, if you’ve got a much bigger order? For me, it is all about liquidity. Fragmentation is now bringing more liquidity into the markets. We see spreads reducing; trying to deal at mid, trying to get access to bigger liquidity venues. I guess it is all about expanding one’s choices to achieve best execution. The fundamental makeup of Asian markets is also important. We don’t have a NASDAQ or S&P. We have literally nine or ten markets that all trade independently of each other. They all have their own anomalies; they all have their own nuances. Moreover, volumes in places such as South Korea, Taiwan and

obviously Shanghai, illustrate that these are big, standalone markets. In other words, there is not one huge meeting place for us to execute our orders. We have to make sure that we have the skill set and access to all these markets to ensure we can fulfil our fiduciary responsibilities. CHRISTOPHER BROWN, BUSINESS DEVELOPMENT, CHI-X GLOBAL: From our conversations with the buy side, we see them upgrading EMSs and OMSs, taking a closer look at benchmarking, looking at emerging alternative venues and ultimately making sure that via their brokers they have as wide an access to venues and liquidity as possible. What the sell side are doing in response is really listening to their buy side clients and trying to understand exactly what that firm’s particular definition of best execution is and then adapting their products and their services to reflect that. We obviously spend a good deal of time talking to the both the sell side and buy side about how MiFID brought about changes in Europe, the lessons learnt, what it is that we do and the benefits that we provide as a recognised venue. In this region specifically we feel that it’s important to focus on at least one of the lessons learnt from MiFID and ensure that the market is as educated and prepared for the changes concerning alternative venues as possible. Thankfully most have taken stock. Tighter spreads, smaller tick sizes, speed, reliability and price improvement are some of the benefits we hope to be ultimately providing the buy side. That said, the conduits to accessing us are really the sell side brokers and they are the ones that intimately understand what the buy side want and are able to discuss the market fragmentation and their own solutions to it with them. ANDREW FREYRE-SANDERS, HEAD OF EXECUTION SERVICES, RBS: How do we help to meet best execution? As everybody has said there are probably lots of different definitions so if I was to focus purely on, let’s say, the electronic world, we ensure that we facilitate clients’ access to liquidity in a very fast and sensible manner. Our biggest responsibility is to make sure that the client is connected; be it in India, or be it Thailand, or in new venues, in a sensible way across the region, perhaps irrespective of an advisory decision on trading or the technology we use. While there is plenty of value you can add along the way, ultimately we have to be connected for clients. Asia is a collection of countries and trading technology is far ahead of maybe where the regulations and where markets are right now. I’m sure if Chi-X launched in other markets, they’d have a single platform everywhere. The fact that there is not one available is a particular challenge. Equally, while clients can trade regionally, in terms of settlement the back end infrastructure is, in my view, still the new big test for us all. In Europe, all that evolved around the emergence of a single market, and a single currency, which ultimately facilitated (intellectually and practically) the emergence of crossborder structures. The experience in Asia looks to be very different. YANG XIA: Fragmentation and difficulty accessing liquidity are a result of different countries operating separately, with different rules. Moreover, there is a lot of resistance to estab-

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

lishing a single market. As Andrew has noted, technology is probably already ahead of that particular development. If regulation begins to allow the emergence of a pan-Asian exchange and/or cross-border clearance and settlement, one of the responsibilities of the major brokers is to not only build technology but also to work with the different markets on honing regulations, on educating different market participants and facilitating change. That’s the topic of today: continuous evolution, not only of technology but also in people’s understanding of necessary developments to facilitate better liquidity for clients. KENT ROSSITER: Many Asian markets, such as South Korea for example, have a very high percentage of retail flow. While institutions may be trading blue chips in decent size, smaller-cap stocks are often the domain of individual traders. From an institutional standpoint if we can access that liquidity it is a pocket that we really cannot ignore. We can source that through our relationships with local brokers, as well as some foreign brokers or bulge bracket type firms which have alliances and agreements with those retail brokers to get that flow into their systems and internalisation crossing engines. This helps RCM get best execution if we have access to all these different liquidity pockets where trades get done.

THE EVOLUTION OF BUY SIDE/SELL SIDE RELATIONSHIP YANG XIA: At UBS we think that choice is important for our clients. We want to provide full-service care order management and electronic trading to enable them to get to liquidity. Earlier in this discussion we emphasised that our markets are diverse; with different markets requiring sometimes very different types of trading strategies. In the old days there was a conversation over whether we should avoid taking on too much “low-touch” business because there was a fear that it could normalise the high-touch desk and we would risk losing revenue. However, as we have seen in other markets, the growth of electronic trading means the overall market grows in line with it and if clients want to use different methods to trade, we will have to do it anyway. Obviously scale comes into play for the major brokers. Even so, we still think it is our responsibility to access liquidity for our clients. We must build technology, staff desks and provide the best consultations across all trading mechanisms. That means our buy side colleagues also access different trading assets, and they are quite sophisticated already because they are facing all the markets all the time. The PT basket here means you have to trade in developed markets such as Japan, but also deal in developing markets such as the Philippines. Those markets are very different in terms of cost. Even if the buy side uses automated trading, they still need to understand all the markets in the region and know how to trade well in them. KENT ROSSITER: Five or ten years ago, top management in the broking world were concerned about how the high growth of low touch—that is, PT algo and DMA business—

FTSE GLOBAL MARKETS • SEPTEMBER 2011

Yang Xia, head of electronic trading, Asia-Pacific, UBS.

could cannibalise their other activities. However, I’ve seen a big shift, at least from the senior guys at the brokerages. They are now pretty indifferent as to the form with which commissions are paid. To them, a dollar’s commission is a dollar. Yes, there are some fixed costs which mean that a dollar of low touch might be less valuable, but at the same time they get more flow, they gain more market share, they get to see what’s going on a bit better, so it is a trade-off. Actually, I’m happy to see that, because we may have an order which is quite appropriate for a low-touch venue but at other times, especially on the trickier, more illiquid names, we would rather just work it on the cash desk. Furthermore, some brokers may have really talented staff in one market, but for that firm it’s a new growth area and they don’t have the flow to match up, or the franchise to do much business. We appreciate the servicing from that office but may decide to pay the firm in another. STEVE MANTLE: The bigger firms have done a good job of balancing low-touch and high-touch business. Algo trading, DMA, whatever guise you want to give it, is the future. It is huge in the US. It is massive in India. As liquidity grows here, and liquidity events, aggregated dark pools etc, grow as well, algo trading is going to become even bigger. Does it have a cap? It probably does. Nevertheless, it is certainly a growing business over the last two or three years, and the brokers have apportioned the correct amount of resources to this evolution. For the buy side it has been fantastic. It is made our life a lot easier. It is given us quick access to markets we didn’t have before and it has improved our TCA. However, we must also remember that high touch is very important. This is a very fragmented market. A good sales trader is worth his weight in gold. He has access to good liquidity, large blocks and there’s no way that algo trading has marginalised these high-touch traders. They are very important. They sit along the spectrum and they’re the key to providing a very good service for us. YANG XIA: To be honest, all the electronic trading tools we create are used not just for clients to trade directly; they are also being used by our internal traders as well to different

ROUNDTABLE

degrees. So they need to learn about each of the markets as well and probably should make an effort to know them better than the buy side in terms of details of each market, because that’s where the scale provides benefit—with multiple clients and different types of trading strategies and so forth. ANDREW FREYRE-SANDERS: I would look at it as the evolution of the two services together. I experienced this previously in Europe many years ago where the first point of call, once we had algos up and ready, was to look at all these so-called—and it is a terrible word to use—easy orders; or should we say vanilla orders? The first two years I did electronic trading the initial focus was not to offer electronic services to clients. However, they saw the value internally of enhancing the sales trader’s time and adding value back to clients. That’s still true today. Once again, it is not to say it is an easy order but, be it the buy side doing it themselves or whether we do it internally, there is value to the sales trader. From a liquidity standpoint, certain markets—and the Philippines is a great example—it is mostly a block market. Yes, there are certain hidden algorithms, passive strategies that can do a good job, for instance, but to source that liquidity you absolutely have to have a sales trader. Obviously, it is a call dependent on the market you are in; however, we should at least allow that sales traders enhance and focus on the important things with clients. KENT ROSSITER: Andrew is right and I’d go one step further. I’ve seen a bit of a morphing between the full service cash execution trading desk and the algo and DMA desk. Five years back, it would have been pretty unthinkable for a broker to call up a DMA and algo client and say: “I know you’ve got an order in our pipes; I’ve got a guy on my cash desk that’s looking to buy some stock. Would you like to sell?” In those days they kept it very segregated and there was a belief that no one should be able to see any details or client participation if trades were executed as DMA and algo orders. Even so, in transparent markets such as Hong Kong, where you can see which broker is buying and selling, you cannot ignore seeing one broker up there six or seven times on the offer. Right now what happens is the broker will call those clients self-executing their electronic orders, even though some clients basically make it known they don’t want to be rung about anything. However, other DMA and algo clients are more receptive and they might decide to stop executing via algo’s or DMA in the engine and switch their balances to the cash desk right there. I’d also like to touch on a second point. DMA and algo tools available to clients are different than those used by that firm’s cash dealers. I’ve had some instances in Japan where the DMA and algo tools can access PTS whereas the cash desk still doesn’t have that ability. It is a very odd and disturbing finding. I think those brokers realise this isn’t ideal and are making efforts to change this. CHRISTOPHER BROWN: That is consistent with some of our own findings, but it is a matter of time and they’re definitely moving in that direction. Certainly, the growing sophistication of the buy side trader in Asia is quite clear. They

Andrew Freyre-Sanders, head of execution services, RBS.

have had to equip themselves with the skills to understand multiple markets. They’re far more versed in regulation and how that impacts their day-to-day than in some other regions. However, one of the key things that they’ve had to really grapple with is the liquidity management space, what they’re trying to do and how they’re trying to do it and through which particular broker they want to source that liquidity. There is an increasing sophistication within the buy side on that front and that kind of morphs itself into a trading desk and not just compliance-led willingness to understand how TCA is impacting their trading business. These days, you’re seeing specialised independents as well as brokers pushing it as a way to really analyse performance. It is going so far as having the buy side develop internal systems looking at broker performance management, which look at how brokers actively access liquidity on primary and alternative venues and ultimately how successful they are. For those that want to control their own dealing more the upshot is that the buy side are going to, albeit in small steps, begin to take some of the algo development or customisation in-house for certain types of orders in certain markets, and or continue to use broker algorithms in others.

THE EMERGENCE OF NEW TRADING VENUES ANDREW FREYRE-SANDERS: The evolution of the exchange market is cyclical. In the UK, for instance, at one time you had the London Stock Exchange; you had exchanges up in Manchester, you had an exchange maybe in Liverpool, a little trading place here and there, and latency was defined by the fastest hundred metre runner you could find. The point being that in all industries, there comes a point in time where a monopoly becomes relevant and important as you have huge disparate prices due to— literally—distance. At that point everyone starts to think that liquidity needs to be centralised, where everybody is in the same place to negotiate. Everybody wants liquidity in one place without price leakage, so that you can find fair value.

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In the past, people were comfortable with that and the brokers weren’t competing with the exchanges. Why is that? It is because they owned the exchanges, and therefore they benefited if the fees went up or the fees went down. Then, the exchange is floated. Then it become perhaps less efficient and you go through to the next cycle where somebody opens up Chi-X on a laptop, and you can trade as much as the 15,000 servers that XYZ exchange needs. People realise that the cost of the monopoly has gone too far and they want new and better ways of trading and constant competition, so we refragment. Look at Chi-X’s model in London when they succeeded BATS in the US. What happened? They gave all the brokers shares. All of a sudden all brokers were potentially making money again and embraced the old model once more. Where are the brokers going to put their liquidity? Obviously, they rushed to these venues. In some of the Asian models, BlockSet for instance, which launched a couple of years ago, there was no broker participation, and therefore less interest for it to take off. At some point in this cycle of evolution, technology is a big factor and clearly we have moved from manual to electronic trading. We are just at a new cycle here now and Asia is looking for that next level of efficiency. STEVE MANTLE: Just to carry on from Andrew’s point, Asia is in a unique position. The question here is: is fragmentation good? Of course, anything which provides more liquidity and tightens spreads has got to be a good thing. Is too much fragmentation good? That’s probably open for debate. If there are too many venues and they’re not adequately policed, it becomes difficult to figure out where the liquidity is coming from and whether it’s good quality. Fragmentation has arguably been good for the USA and EMEA, though everyone will acknowledge that mistakes have been made. Once fragmentation starts to gain even more traction here in Asia, it will be a fabulous opportunity for regulators and brokers and politicians, to design something new and avoid the pitfalls which have bedevilled the process elsewhere. CHRISTOPHER BROWN: Actually, many of these venues are very well policed and though we talk quite a lot about fragmentation because it is clearly growing, it is still starting from a relatively small base. When you compare Asia to Europe, we’re considerably less fragmented than Europe and Europe is considerably less fragmented than the US. A side benefit to fragmentation is that it does provide brokers with an opportunity to facilitate and concentrate access to it and that’s clearly where the brokers are able to build value added product and customised service which enables the buy side to use their brokers as a funnel to access liquidity. There are varying degrees of fragmentation across Asia. There has been an increase in the number of alternative venues in Japan where the PTS framework has been around for a number of years. That said, it only really started growing within the last year and a half.You also have some fragmentation, via the OTC market in Australia, which is relatively significant. Though in terms of exchange fragmentation, we are not there yet. In Hong Kong it’s still relatively small. On the whole, brokers are providing a very valuable service in fa-

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cilitating access to that liquidity for the buy side. As an independent alternative trading venue, we see all of these brokers as our partners. We appreciate that they have their own internal platforms but we see our platforms as alternative destinations for liquidity. On a separate note however, there are gradual changes afoot for regional platforms that address multiple markets and organisations, such as the ASEAN link, which look quite original for Asia KENT ROSSITER: It is a catch-22 situation. We want to promote innovation: a tool like Liquidnet, for instance, wasn’t around a decade ago and now it has gathered a fair amount of backing. At the same time though we don’t want to have so many different venues where it is hard to put together a trade. As Chris mentioned, we are working hard to monitor where we are achieving execution; equally I have seen some brokers adopt smart order routing technology and build a sort of heat map to predict where liquidity coalesces. If they start, say, expecting executions to be occurring on the Tokyo Stock Exchange and find out instead that they keep finding liquidity on SBI Japannext or Chi-X Japan, then they slowly shift their priority and start posting bids on those venues and pulling them from the TSE. Over the next year or two I expect the activity on Japanese proprietary trading systems to balloon. ANDREW FREYRE-SANDERS: I have to say I’m always amused by the current trend of more technology and fragmentation. I recall the Swedish stock exchange many years ago had pretty wide spreads. I participated in research with some clients to send to the exchange, pushing for a reduction in spreads and to push for exchanges to improve the operation of the marketplace. I see a lot less of that these days. Certainly the TSE has responded to broker requirements and to a lesser extent the HKEx is doing a bit more on the consultation front. However, it appears that brokers are reliant on the new exchanges to set the pace of competition. Large brokers such as ourselves can go and connect with lots of venues when maybe smaller brokers can’t. The excessive fragmentation of venues has done well to just raise the bar and raise the entry level for a lot of other competing people. It might however be too much of a good thing: fragmentation and competition is great but as Stephen mentioned, how far does it go? CHRISTOPHER BROWN: All of these things shake out. We all want innovation to continue and if other regions are anything to go by we’ll see more alternatives springing up with different pricing models, different technology platforms and so on. In Asia it is obviously going to be done on a market-by-market basis unless you try to do things offshore, with some being more successful than others, as we’re seeing in the US through mergers and acquisitions. YANG XIA: Fragmentation is obviously not a good thing by itself. With the diverse micro-structure of all country-based exchanges continuing to dominate, and almost every one of them enjoying a virtual monopoly status, it clearly explains why the barriers of frictional cost in those markets are still pretty high; not only on a trading tax or stamp duty basis on the trading side, but also on the clearing and settlement side

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as well. The limited amount of fragmentation introduced by the various alternative venues is not just about bringing extra liquidity into the market. It is about the competition it introduces to force an incumbent exchange to recognise that they are facing competition challenge to their business model and then perhaps they will narrow spreads, make more changes on the cost side and be more commercially driven in the market. Of course major brokers need to reintegrate that liquidity to make a virtual market for the buy side to access. As the cost of trading collectively goes down, that will tend to bring extra liquidity into the market. Highfrequency trading can also bring in additional “bridge” liquidity, which can help. I actually think Asia will learn from the mistakes that have happened in the US or Europe because of over-fragmentation; too many alternative venues (or too many choices) without sufficient differentiation. Being the last mover here, we will collectively, with regulation, natural market evolution and with players such as ChiX, probably have fewer alternative venues coming into these markets and forming new dynamics. ANDREW FREYRE-SANDERS: There a number of considerations to take into account. Look at SGX’s motives in the ASX bid, for example. SGX is not a very big market. It is not particularly liquid. They’ve got a multitude of programmes there to try and create liquidity. The ultimate driver of liquidity is the size of the market and the size of the investor base. When I look at China, there are perhaps fewer types of participants (for example, limited high-frequency trading), and yet it is one of the biggest markets in the world. Why is that? There are X billion people and everyone’s trading. You simply cannot convert Singapore into that capitalisation. It does not have the companies. Size isn’t there. To compete therefore, SGX has to go overseas. Would a merger with ASX have dramatically changed the liquidity in Singapore? I don’t know, unless they suddenly created this big ETF market, and tried to dominate the Asian DR space and be innovative. The interesting thing is an SGX/ASX tie up would have challenged sovereignty in Asia and that’s the bit that made everybody sit up. It was, in that sense, perhaps a missed opportunity, and a missed push to the markets. In all of this, in understanding the liquidity of the market, there’s certainly scope to increase it by improved technology. If you look at Hong Kong stocks versus its total market cap, total IPOs, it is probably one of the least liquid with respect to its size, but you have turnover, and the investor base is diverse. It is always important therefore to understand the fundamental drivers of liquidity. Improving such things as frictional costs will, of course, help but you cannot convince me that if you put high-frequency trading into the Philippines tomorrow, that it will be a big market. The stocks aren’t big enough; the market cap is not big enough. FRANCESCA CARNEVALE: We’ve mentioned the ASEAN link which has been on the table about for five years. Does it bode well for the establishment of crossborder platforms? STEVE MANTLE: It goes to the point Andrew made about motivation in Singapore. While ASEAN has very good

exchanges and they are well run, their future probably lies together rather than apart. YANG XIA: Actually, all exchanges see where their future is. In Asia they clearly feel if they don’t do anything then they lose out, right? They get left behind. The best chance for them to work together is to combine, but you can see even here right now that it could be very difficult to achieve. CHRISTOPHER BROWN: Some of those exchanges may not be able to merge, so a common platform is the quickest and lowest risk if not lowest cost solution. Moreover, they can test whether they can actually build and manage a profitable platform together. And as with all things, some will lead, some will follow and some may struggle. STEVE MANTLE: The benchmarks are tougher, right? Because Korea, big, good; Taiwan, big, good, Japan, big and good. The other benchmark, which Singapore is always looking towards, is here in Hong Kong. Hong Kong was extremely astute by aligning itself with China very early on and we’ve got renminbi listings coming on stream. The future for the Hong Kong Stock Exchange is bright and the other exchanges need to do something to keep up. ANDREW FREYRE-SANDERS: As I noted earlier, technology is already here, but regulation isn’t. You see multiple exchanges taking on OMX technology for example, but I venture that exchanges have sometimes forgotten what they are here for. Exchanges were built to list and provide capital to the marketplace. That’s why it is called the primary market; a secondary market is just there to facilitate and add liquidity so people can get out of positions. The fundamental value of a stock exchange, never mind the whole investment industry that we now have, is to grow companies, grow business and grow the economy. They look at firms such as Chi-X, whose sole purpose is to provide technology to execute, to get listing etc., and they think that now that is where they want to go. That’s the difference. If the ASEAN link means that in effect these countries throw in the towel with respect to technology and they continue to run their own business and they merge via a platform, then they should see a benefit. It will, at least, protect them (which is probably their real motive) from becoming a much smaller player in the region. CHRISTOPHER BROWN: As Andrew points out, the link is not designed to replace each country’s own domestic platforms. This is just in effect just a linkage mechanism for those countries. We have seen Thailand come out with announcements saying that it is open to alternative venues and others will too over time. This is just an opening gambit: let’s see if we can get the technology to work and put a few of us into it to try and compete with these bigger, more sophisticated markets. This could well be viewed as a more astute way to prevent being marginalised and avoid the costs and risks associated with M&A. YANG XIA: It is a lower risk for them as well. It is like an extra thing to try; it doesn’t seem likely that if they fail it will do real damage to them. It might be a lost opportunity of course, but they’re not intending to actually fundamentally change the way they run their sovereign exchanges. They’re

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Christopher Brown, business development, Chi-X Global.

not merging really; they are just trying to get a virtual exchange, offering the routing of orders to different places. This will limit the chances for so-called“regulatory arbitrage” as well. ANDREW FREYRE-SANDERS: Fortunately for them, they are small as well. I remember hearing that one of the new entrants in Europe had to achieve 12% of the European market to break even; to pay for set up and operating costs. Does that mean that the ASEAN Link would have to secure 100% of the ASEAN markets to break even? I don’t know. STEVE MANTLE: Though one can assume the set-up costs won’t be much different. CHRISTOPHER BROWN: BATS used its own technology so the rollout in Europe utilised a technology cost that had already been borne in the US, whereas for this network, they obviously have to stump up for the technology as well. STEVE MANTLE: You are saying then that it could be quite expensive because it is a greenfield project to put that technology in place? ANDREW FREYRE-SANDERS: It is not just the technology. There could be compliance, legal, and regulatory costs involved. Moreover, If you look at many global brokers they keep their seat, but there are plenty of brokers out there who themselves don’t have a seat, let alone an alternative venue in the Philippines, Malaysia, Indonesia, because of costs or their volume is not big enough, and so they then use a local broker. Chi-X and BATS face the same issue. The ASEAN link has time on its side in this regard, because of the monopolies in ASEAN itself. Unless, of course, they go the way of Europe where you have all this remote regulation where they accept somebody in Hong Kong can set up an alternative exchange to Thailand, but I don’t see that as an immediate first step. They want everything housed locally, which then pushes costs up. YANG XIA: That’s a very good point. Because we’re Asian, we see where the challenge of liquidity exists most for us. Of course their motivation is strong and they want to do something together but their liquidity is not going to be much, much bigger even if they achieve it. Ultimately, it is

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about the investor base and where and how much stock is listed on those exchanges anyway. It may be the opportunity remains elsewhere: such as Japan, Australia and the more developed markets; and that’s why, of course, Chi-X made a decision to go to Japan first. It is seemingly the easier market to start in, even if it is hard going right now. In the near future however, it is the more likely spot in this region in terms of introducing competition in venues and bringing more liquidity and bringing down trading costs. KENT ROSSITER: I’m not that optimistic that a link-up is going to increase volumes dramatically. Any one of us at this table, and all of our peers, are 100% able to trade any one of those exchanges to our heart’s content right now. We’re not held back by the fact that we can’t get an order routed from Thailand to the Philippines and vice versa. I also think one way these exchanges can get higher turnover is to, like the other exchanges, reduce frictional cost. Some of them, like the Philippines especially, have a very high stamp duty. And a lot of the companies listed on these Asean bourses have domestically-focused businesses. They’re relatively unknown to residents outside each country, and offshore investors aren’t interested or knowledgeable enough to invest in them. That’s quite a different situation from what we see with a lot of North Asian multinationals which are globally recognised names and have a strong following among investors globally. The second way some smaller exchanges can increase trading is get more interesting and international listings. At the moment the exchanges outside of Hong Kong, for the most part, haven’t been as ambitious at getting new listings. Competition to get and keep listings is very tough.

THE NEW LISTINGS OUTLOOK? STEVE MANTLE: Prada went quite well. It is interesting that it listed in Hong Kong. I’m not a luxury goods analyst, but I’m assuming Prada in Europe will trade on multiples of ten or something and it trades on probably 40 times here, doesn’t it? It is an opportunity for the company to raise a lot more capital through an IPO and that’s the concept that Hong Kong is trying to sell. Actually, it is a great concept. It certainly worked for Prada. KENT ROSSITER: You could see Hong Kong doing the same with other luxury brands and being the go-to market with the same thing they did on Prada. And it’s not just consumer goods; Hong Kong’s got a good track record on global listings with a deep enough investor base to invest in decent listings. YANG XIA: Hong Kong certainly has a very special angle backing on the Chinese investors and that entire big capital base. There are two ways to bring liquidity into the market: one is lowering the cost and making it easier to trade. Many of the investor strategies that weren’t making money in their market could now make money and that will attract more trading activities. The second way is to simply encourage more listings and increase the capital base. ANDREW FREYRE-SANDERS: That’s exactly what Hong Kong has done and its biggest focus right now is China.

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YANG XIA: They have a pretty good strategy here on that matter, actually. STEVE MANTLE: People should focus on the potential renminbi listings in Hong Kong. They could be more influential a few years down the line than people are perhaps thinking about now KENT ROSSITER: If you look back at what was listed in Hong Kong a decade or two ago, you won’t see a huge amount of difference in trading activity around those individual stocks. Hong Kong’s success has come from all of the new money, that is, new listings, many of which are global businesses and have targeted global investors. That’s why HKSE’s turnover now is so much higher than it was ten or 20 years ago. It is not because the companies which were listed at that time are trading more. These are brand new companies trading. That’s the way any exchange can work. So if you compare it back to the ASEAN model we discussed, you have big populations in Indonesia, Philippines; what they need to do is develop the capital markets a bit more.

Kent Rossiter, head of trading, RCM.

for over a year now, we just recently announced July turnover of ¥530bn a new firm record and a 2.8% increase over June 2011.

PROPAGATING NEW CAPITAL ANDREW FREYRE-SANDERS: If we talk about Asia specifically, we’re talking about fundamentals here, right? That involves growth, GDP, the size of a country and what’s happening with that population. And all I can say is looking at the trend or global brokers, and even some that are not so global brokers are investing massively in Asia. Ten or 15 years ago, maybe there were five big players, now there’s 20 servicing up, and it then becomes self-fulfilling. Several brokers have obviously got big JVs in China, investing money into the underwriting business there, putting their resources on the banking side, putting their resources into those markets, facilitating those transactions and having more people on the ground looking for deals, looking for trades, trying to encourage listings, and M&A. This is real banking; it is viable capital markets business. CHRISTOPHER BROWN: Ultimately the types of change that we bring about in the markets where we operate are very similar. We’ve taken a very considered approach to operating in specific markets; ones where we could feasibly operate, where we feel that regulation is relatively open to us, where the markets are reasonably sized and where we feel there’s the most demand ultimately by our clients and the clients of our clients. That’s logically why we have focused on Japan, and in the future Australia. We feel that the regulators have been very astute, open in their dialogue and pragmatic. They’ve done a good job of informing themselves and looking at precedent in Europe and the USA and they’ve really produced frameworks that are cautiously sensible. We’re very happy to work with that. We’ve tried to create platforms that resolve issues for the different profile of clients that we service; both lit venues and dark venues (via joint ventures). ChiEast for example is a joint venture between Chi-X Global and the SGX. In Japan where we have been up and running

HIGH-FREQUENCY TRADING: CHALLENGE OR OPPORTUNITY IN ASIA? KENT ROSSITER: It is hard to quantify how big highfrequency trading (HFT) is and in fact even to define what strategy would be included in this type of trading. Brokers, especially the big brokers, are more likely to be able to give you a good estimate of how important HFT flow is for them. My intuition is that it is a meaningful business but not a major part of Asia’s overall flow. Well, at least not that significant outside Japan. Within Japan it is a larger per cent than the other Asian markets, maybe followed by Australia. In any other markets which have the high transaction tax, it becomes a less beneficial strategy for these high-frequency trading firms to make money from. YANG XIA: If you take Hong Kong as an example, the Hong Kong market is probably hundreds of milliseconds from the market exchange latency level, but if you have some market-making strategy that can overcome stamp duty and break into the fast trading in the market, as long as the intention is to be in the market fast enough and to be the first one before other people get a particular order, then that can be defined as high frequency. If that’s the definition, then there are enough numbers of high-frequency trading in the region already. Even so, as Kent noted, Japan was trading probably more than Asian-ex Japan countries. From a broker’s experience, around the region it is still sort of below 10% of the flow that we see, but clearly in Japan and Australia, it is a higher percentage. It could go as high as 50%, even 60% someday. FRANCESCA CARNEVALE: Is it concentrated in any particular stock, or constituents of the main indices? YANG XIA: It certainly could be. It depends on how easy or how likely it is for them to have strategies that overcome

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ditional buy side in fact. There are correlation, momentum and dark pool systems that decide how a particular firm should participate based on the market opportunity. Some are specific to certain venues but most benefit by having access to as wide a pool of liquidity as possible. They are just a type of participant and it is incumbent on both the buy side and the sell side and on the venues that controls are put in place for every type of participant. We do it, the brokers do it for their buy side clients and we know that the more sophisticated buy side clients do it themselves anyway.

THE RISE IN INTERNAL CONTROLS

Steve Mantle, regional head of trading for State Street Global Advisors.

the trading cost. The liquidity point of view is highfrequency players are already in the market and they defend themselves by saying we bring extra liquidity into the market, but that is a nuanced debate. They do bring liquidity—but it is liquidity that is short term in nature. So is that real liquidity or is it intraday volume? It depends. They trade to exploit short-term inefficiency and sometimes end up competing with each other in the market. With fragmentation and some PTS destinations offering smaller spreads than the incumbent exchange, it allows some HFT strategies to be profitable and that helps bring more players into the market. Even though the Shanghai Stock Exchange is 75% retail, 20% institutional or domestic and the QFII from overseas is such a small portion that it is not statistically significant, there is actually plenty of high-frequency trading already in that market, surprisingly. We all think about Shanghai as an emerging market, but because the exchange is electronic there are various small hedge funds, which are quant driven, these are so-called “private funds” inside China which use Chinese capital to trade electronically in the Asian market. STEVE MANTLE: High-frequency trading is more prevalent in the US and in EMEA, but it certainly exists here in the markets where it is not cost prohibitive. The jury is still out as to whether they’re good for the market or bad for the market and it is not my place to say whether they are or whether they’re not. All we can do is make sure that we have access to liquidity and it is policed correctly so that we participate in the best available venues. A great responsibility for ensuring clean trading venues falls on the brokers. My interaction with brokers certainly gives me confidence that they do that job very well. That is how I make sure that I leave my footprint as light as I can and try and achieve best execution that way. HFTs are there and they’re not going away. I have to make sure that my business is clean and I’m dealing in clean areas in order to maximize my executions. CHRISTOPHER BROWN: High-frequency players come in lots of different shapes, sizes and styles, just like the tra-

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ANDREW FREYRE-SANDERS: It is always hard to show that there’s enough data around, but clearly when you trade through an exchange on the order book through one broker then there is certain visibility in some markets in Asia. In a broker dark pool, it is highly likely that a market maker going into that pool is going to know the make-up of that pool is all institutional flow. If some market makers go to all the different dark pools directly, they don’t need to ascertain information, and this is when toxic flow expressions or information leakage suddenly becomes greater. Clearly the onus is on brokers telling the client they have dark pools and they have all this liquidity. Then the question is: which ones do you want to trade against? We won’t match against market makers, we won’t match against props. The other requirement is for brokers (and this is linked to best execution) to be fast enough. Co-location is fine with certain types of strategies but on average we have a responsibility to provide equal market access. It is not a low-latency race per se, but it is a low-latency must have. YANG XIA: Brokers must keep pace assisting the buy side as they become increasingly sophisticated. We have to take the responsibility of policing and tracking different venues, and pay attention to the flow our buy side clients interact with, as part of the best execution responsibility. Obviously Andrew mentioned broker dark pools and that’s where a lot of liquidity exists as part of the food chain anyway before the order goes through the exchanges. We are also very tight about whether we allow prop order book interaction with our clients; we provide all the choices and provide all the TCA reports for best performance. However, as for highfrequency trading itself as a base of flow, it does bring some liquidity to the market. Andrew is right; they are actually pushing the envelope on behalf of everybody else in terms of technology, access, liquidity, latency etc. CHRISTOPHER BROWN: It is about style or method more than about pure frequency in my mind. As more and more of these sell side prop desks are getting spun out, a growing number of them are ending up in your rather more traditional institutional fund management firms and you’re going to find that you’ve got your historically traditional fund management firm operating a high-frequency strategy of sorts. This will make it harder to decipher activity and intent and it’s going to get tougher for some of the more conservative brokers to police exactly who’s who.

ROUNDTABLE

STEVE MANTLE: I’m a huge fan of having as many tools in your toolbox as possible. State Street runs an OMS which interacts with our internal flow, but we also have two EMSs which interact with the street and give us access to just about every algo suite in the market, internalised dark pools and aggregated dark pools. We also have access to Liquidnet. We have access to everybody. The more options you have, the better opportunity you’ve got to source your liquidity, the better opportunity you’ve got to get best execution. KENT ROSSITER: It falls into the 80/20 rule where 80% of your orders are going to be easy orders. Just by nature, you’re going to reward your biggest, strongest broking relationships. But for those 20% of more challenging orders, like Steve says, we don’t want to refrain from using a small niche broker to execute just because we don’t like him or we want to only use the big guys. If they have flow others don’t, we’re certainly going to need to be able to trade with them. Last year we traded with about 85 different brokers. I just went through my list for Hong Kong yesterday and we’ve got 48 brokers who can execute in the Hong Kong market alone. Truth be told, most of the orders are really going to be executed with our core brokers. They’ve got all the tools. It is really not that often where you have an order and you can’t find any liquidity for two weeks and finally some obscure broker comes up and they have it. YANG XIA:You talk about toxic venues. Of course, as Kent said, you have all the choices of broker venues, alternative venues, exchanges and you have to always know where your trading is taking place and what your performance looks like. Obviously you rely on some strong broker relationships to help you drive the technology or the TCA or police and tag the different fields from different venues but the buy side is still master of their fate. KENT ROSSITER: In Korea, we’ve all had the experience of accidentally using a foreign bulge bracket firm on an illiquid or small-cap stock. Invariably, a foreign broker hasn’t traded it for a week and then all of a sudden you show up with new broker activity. There’s nothing the local Korean retail crowd likes more, and they are adept at recognising new orders and front running. We are consequently careful which brokers we choose for which orders. Any big blue chip is usually suitable for foreign brokers to execute, but small or micro-cap stocks require extra care, and we often use a discreet local broker so that some retail punter looking at the screen will never know it’s a foreign institution versus a retail client behind it.

BACK TO THE FUTURE YANG XIA: Some things happen fast in Asia, others happen very slowly indeed. Over the next few years however liquidity aggregation and liquidity segmentation will be the big issues we have to face. Actually, it is mostly an educational thing, working with the regulators and exchanges and trying to allow more choices and competition in the market, not only on the trading side but also for clearing and

settlement (and other processes) to create lower trading costs as a whole for clients. The second challenge relates to the emerging markets here in the region. Some of them are still reasonably small but will potentially experience large growth in the next two years or so. There are obvious opportunities for us to work with local brokers and establish local alliances; and we can see the benefit of working in markets such as Indonesia, India or China to help develop them and promote more liquidity or provide access to liquidity. China, as a hot market, is the obvious one, but it is actually hard to get into. Indonesia and India are markets that could potentially see large growth in the next few years, and that is an area of great interest to us. CHRISTOPHER BROWN: I see two broad themes. One is around continued fragmentation and to what extent things can develop to support this growth in alternative venues. The second theme is around increased use of both transaction cost analysis by the buy side and liquidity analysis provided by the sell side so that they can actually see which venues are actually proving beneficial to them in one way and saving them money in another. KENT ROSSITER: We are likely to see continued development by brokers both to internalise flow and to improve smart order routing to access alternative trading venues. It is not relevant to many of the markets but there are some where it is critical and I think it will develop quickly in the next 12 months. How much this develops will depend on an extent how quickly exchanges or regulators in some markets such as Singapore, India, and Taiwan reduce barriers to crossing stock. STEVE MANTLE: I’m going to throw fragmentation into the mix. I’m an advocate of liquidity and tightening spreads under a policed environment and that has to be a key focus. Chris’s group is working very hard to make that happen, and it could be a strong focus in the near term. I think the next thing is to encourage the opening up of China. We’ve got the renminbi listings starting here in Hong Kong; we had a renminbi-denominated REIT a month or so ago. The more renminbi we get flowing around Hong Kong and listings there are on the Hong Kong Stock Exchange, the closer it brings us to Shanghai and Shenzhen. The quicker we can get global access to that market, the quicker you will see this place grow even faster. ANDREW FREYRE-SANDERS: The overall market structure of Asia, be it the continued evolution of regulation which opens up new doors, or be it the clearing and settlement interchanging things, is something we will have to stay on top of. There are a lot of small things that have to be put in place: HKEx, for instance, is one of the most eligibly sophisticated markets in the world, but it does not have a closing auction. I believe that it needs to happen and it will happen. The big focus then is our technology. Kent made the comment about the need to upgrade SORs. Yes, that’s a headliner, but it encompasses the whole space, market data, market access, crossing technology. It is critical. Clearly we need to keep pushing that boat up further.I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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“Be prepared” is the famous motto of The Scout Association, but a question mark hangs over whether the financial markets will be as prepared as the scouts for the massive change coming to the world’s derivatives markets during the next two years as legislators and politicians force many over-the-counter (OTC) derivatives on to exchanges and through clearing houses. The magnitude is pointed out by Paul Rowady, of research consultancy TABB Group, referring to the interest rate derivatives market: “Take the largest derivatives market on the face of the planet, place it in one of the most complex and turbulent economic times in modern capital markets’ history, and then try to change a bunch of the rules in the space of a couple of years.” Ruth Hughes Liley reports on the implications.

Photograph © Ivan Proskuryakov / Dreamstime.com, supplied August 2011.

CHANGING THE RULES: THE IMPACT ON OTC TRADES A G20 PRONOUNCEMENT in September 2009 called for improvements in regulation across international financial markets in the wake of the financial crisis. On derivatives it stated: “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”From that short paragraph, regulators in the United States and Europe have been working out how best to implement the aims, through the Dodd-Frank Act in the US and through the review of the Markets in Financial Instruments Directive (MiFID) and the European Market Infrastructure Regulation (EMIR) in Europe. In spite of almost two years’ worth of continuing brouhaha over the regulation of the over-the-counter (OTC) derivatives market, nothing is yet set in stone and Joe Kohanik,

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vice-president, fixed income and derivatives, at Linedata, a technology and services company, says: “They are still discussing for example, the definition of a ‘restructuring event’ to trigger a credit default swap (CDS) and while they are discussing it, no one knows what to do. The regulators have to convince the sell side firms of the rules because if those firms don’t adopt it, the buy side will never get it.” Changing the rules has huge implications for the development of derivatives technology. The trend for trading on exchange is already accelerating, according to the World Federation of Exchanges (WFE). More than 22.4bn derivative contracts were traded on exchanges during 2010 (11.2bn futures and 11.1bn options) against 17.8bn in 2009. At 25%, the growth rate was one of the highest since 2003 and the upward trend has continued in 2011 with stock options up 23% and securitised derivatives increasing 16.4%, for example. On the other hand, the Bank for International Settlements (BIS) records that the notional amounts outstand-

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ing of over-the-counter derivatives actually decreased 13% in the year to June 2010. Ronald Arculli, chairman of the WFE and of the Hong Kong Exchanges and Clearing, notes:“The strong volume in exchange-traded derivatives in 2010 indicates that reforms in regulation of over-the-counter derivatives markets are causing participants to shift some of their risk transfer activities to exchange-traded derivatives.” Actually, both kinds of derivatives have their uses, offering wholesale risk transfer. OTC derivatives provide companies with specifically tailored risk-transfer products while exchange-traded derivatives (ETDs) offer more standardised products useful to smaller firms and individual investors. Kohanik explains:“Listed derivatives have had infrastructure for many, many years and some of the OTC derivatives look and smell like listed derivatives, so it’s not hard to move those. But they are trying to shoehorn other types of instruments—the more exotic ones—on to platforms and in to a process that doesn’t make sense and doesn’t work. “Some of the things we have seen over the past six months have been quite shocking. Take silver commodities trading: regulators literally overnight have jacked up the margin requirements to try to tame speculators, but what they have done is raise the cost for a normal asset manager who just needs to hedge his position and that has done great harm to the industry,” he adds. “We will always need the bespoke OTC trades,”maintains Robert Hegarty, global head, market structure, Thomson Reuters.“If you do business between two countries and you want to create a hedge between volatile interest rates, you need a bespoke swap with different legs and different currencies. These are needed all the time. We need both standardised and OTC, and as some OTC move to a standardised form, the market will take on the characteristics of an equities order-driven market.”

What’s in a moniker? SEFs versus OTFs In the US, centrally-cleared OTC derivatives will move on to Swap Execution Facilities (SEFs), while in Europe new Organised Trading Facilities (OTFs) trading venues will be established alongside multilateral trading facilities, which themselves are already moving, extending out from cash equities into trading derivatives. In May this year, the London Stock Exchange’s (LSE’s) EDX derivatives exchange was merged into MTF Turquoise. Chi-X Europe, meanwhile, has advanced its own derivatives strategy through a partnership with Russell Investments to create a new series of European indices. Moreover, Dutchbased The Order Machine (TOM MFT) will this year begin derivatives trading for retail investors. A Celent report issued earlier this year on the growth of the equity options market in Europe stated that Chi-X and The Order Machine are “giving indication that their market entry is desirable as it could have the positive effects seen in the cash equity market, such as much lower costs and latency”. It is now a commonly held view, particularly as “the competition is very heated and it’s first mover advantage on the

Joe Kohanik, vice-president, fixed income and derivatives, at Linedata. “They are still discussing for example, the definition of a ‘restructuring event’ to trigger a credit default swap (CDS) and while they are discussing it, no one knows what to do. The regulators have to convince the sell side firms of the rules because if those firms don’t adopt it, the buy side will never get it,” he says. Photograph kindly supplied by Linedata, August 2011.

trading side,”explains Hegarty.“In the US, there is a massive land-grab going on right now with dozens of firms filing to apply to run Swap Execution Facilities. Just as Reg ATS formed the electronic crossing network in the US with all its algorithmic trading and high-frequency trading spin-offs, the DoddFrank Act and EMIR will create a new SEF industry.” Even so, there are fears that the 2012 deadline does not give enough time for firms to comply. There are even fears that firms are resisting the drive towards exchanges. Thomson Reuters research has found that uncertainty surrounding OTC derivatives regulation is causing banks particular concerns in four areas: capital requirement, workflow, the cost to trade and liquidity. While banks generally accept that liquidity will shift from single bank portals to newly-regulated SEFs, MTFs and OTFs, they acknowledge that an important test will be whether banks can differentiate themselves sufficiently to customers. Another is how buy side firms will connect to multiple venues. “Our research found that banks greatly vary in their levels of preparation for the implementation of regulatory changes,” explains Jas Singh, global head of treasury, Thomson Reuters. “The smaller, non-US domiciled banks have generally adopted a ‘wait and see’ approach to regulation whereas the majority of larger banks are proactively lobbying, planning, prioritising and building the necessary capabilities.” TABB Group’s Rowady estimates that only 40% of firms trading OTC interest rate derivatives have begun to actively prepare for regulatory reform.“The majority of buy side rates

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Robert Hegarty, global head, market structure, Thomson Reuters. “We will always need the bespoke OTC trades. If you do business between two countries and you want to create a hedge between volatile interest rates, you need a bespoke swap with different legs and different currencies. As some OTC move to a standardised form, the market will take on the characteristics of an equities order-driven market,” he says. Photograph kindly supplied by Thomson Reuters, August 2011.

traders are waiting for regulatory clarity before committing resources. But they will need to learn how to handle more balance sheet pressure and intrusive reporting requests.”

The importance of the balance sheet For the sell side service providers, Rowady believes balance sheet concerns will become an increasingly important point of innovation on two levels. “They will need to enhance their technical infrastructure and process automation while preserving critical high-touch requirements of these markets. Second, in conjunction with exchanges, CCPs and vendors, they should be devising offerings to counterbalance pressures that asset managers will feel in their balance sheets when regulatory changes do occur.” The good news is that much of the technology required for trading derivatives is the same as for cash equities as Hegarty explains: “There are order management capabilities, trade execution capabilities and post-trade matching capabilities. Having said that, the industry has divided itself along the main asset classes and there’s an unnecessary line drawn when it comes to different asset classes when much of the technology is the same.” Matthias Graulich, head of clearing initiatives, Eurex Clearing, agrees: “We don’t see the technology element as one of the biggest challenges from a clearinghouse perspective. Developing risk management methodologies and models is the core competency of Eurex Clearing. I believe that more fundamental change is required on the customer

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side, the interaction between clients and clearing members regarding OTC products will significantly change.” However, this year has seen more options order flow move to low-touch channels according to Andy Nybo, a TABB principal and head of derivatives, in a report, US Options Trading 2011: Finding the Other Side of the Trade. Direct market access and options algorithms will account for 65% of total buy side order flow up from 64% in 2010, according to Nybo. “As institutional investors expand their use of options, they’re finding it increasingly challenging to find the other side of the trade. Options traders looking to trade in size are still dependent on sending instant messages and picking up the phone to get access to capital—but they’re also exploring the capabilities of low-touch trading channels, especially in more liquid names.” Innovations include spread-driven order books and smartrouting logic.“Volatility has moved into the daily lexicon and traders are craving systems that provide easy-to-use functionality to support their analytical requirements,” he adds. While the potential for technology spending in derivatives is huge because investment is starting from a lower base, the amount spent on cash equities technology business is still bigger because the whole class is broader, deeper and more fully automated. Wolfgang Eholzer, head of trading system design at Eurex, which is owned by Deutsche Börse, says the exchange will improve Eurex’s technology in an update in November 2011. He says: “We are serving the needs of our diverse community—those who want high speed and those members who are less sensitive about latency but need, for example, to have market data which does not contain every order book update but is more ‘lightweight’. We are working hard to further improve our systems and will increase the capacity of our matching engines and cut down on latency from the current level of about 1-1.5 milliseconds order round trip times for futures. Furthermore, we are moving our matching engines to our current co-location site and so will reduce latency by about 120 microseconds. In order to serve our non-latency sensitive customers better, we are also launching a native FIX interface for order routing and a FIX/FAST based ‘stripped down’ market data interface.”

Improving technology The exchanges are all improving their technology and on July 25th International Securities Exchange (ISE), the US options exchange, completed the rollout of Optimise, a new technology platform designed to serve as the common technology backbone for Deutsche Börse Group, although as yet it has not been announced which technology platform will be used following the merger of Deutsche Börse and NYSE Euronext. Optimise has the capacity to handle around 250,000 instruments traded on ISE and chief technology officer, ISE, Larry Campbell, says:“One differentiating factor between cash and derivatives is the number of the instruments that are traded. Another is the complexity of the trading where you would need to offer functionality to handle multi-legged strategy orders. The technology needs to have the capacity to offer complex business functionality and balance that with speed.”

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Larry Campbell, chief technology officer, ISE. “One differentiating factor between cash and derivatives is the number of the instruments that are traded. Another is the complexity of the trading where you would need to offer functionality to handle multi-legged strategy orders. The technology needs to have the capacity to offer complex business functionality and balance that with speed,” he says. Photograph kindly supplied by ISE, August 2011.

Paul Rowady, of research consultancy TABB Group. “Sell side service providers will need to enhance their technical infrastructure and process automation while preserving critical high-touch requirements of these markets. Second, in conjunction with exchanges, CCPs and vendors, they should be devising offerings to counterbalance pressures that asset managers will feel in their balance sheets when regulatory changes do occur,” he says. Photograph kindly supplied by TABB Group, August 2011.

Initial results show a 75% improvement in latency compared with the previous platform, Click, and the potential for even greater speeds by the end of the year.“The speed race started about five or six years ago in the cash markets, but the push for latency reduction is alive and well in the derivatives markets, too,”says Campbell.“Exchanges are always adjusting their technology. You have got to make sure you are doing it the right way and have the right balance.” A big question hanging over exchanges at the moment is what impact the merger of Deutsche Börse and NYSE Euronext will have on derivatives trading and while many welcome cross-asset mergers, brokers are left wondering about the effects of the emergence of extreme“vertical silos”, where exchanges are developing into one-stop-shops for all trading and clearing to enable them to attract more business. In a statement on August 1st this year, the Futures Industry Association European Principal Traders Association (FIA EPTA) said: “The proposed merger [of Deutsche Börse and NYSE Euronext] will create an exchange with a near monopoly in European exchange-traded derivatives including a vertical silo structure in pre-trade (co-location facilities) as well as post-trade services. The combined entity will control 91% of index derivatives, 95% of equity derivatives, and 99% of interest rate derivatives.” The FIA EPTA is made up of 17 principal trading firms representing most volume in derivatives and cash traded on Deutsche Börse and NYSE Euronext and has called for a

debate on competition issues. The agency says it supports the merger, as long as“the appropriate steps are taken to address the inefficiencies that currently exist and pave the way for a competitive marketplace”. Listing them out, FIA EPTA has concerns on cash and derivatives clearing, concentration of index products and provision of market data as well as in the area of provision of innovative trading infrastructure. The agency’s statement goes on to say: “The merger will cause a shift in focus from much-needed [technological] innovation towards migration and integration of trading infrastructure. In addition to this, the cost for market participants of migrating to the new trading infrastructure will not be inconsequential. The FIA EPTA would expect the savings from combining trading venues to be passed on to customers.” Nonetheless, all the forthcoming changes in the derivatives markets look likely to bring opportunities, as Thomson Reuters’ Hegarty concludes: “At the moment everyone can only see the restrictions and obstacles, but there is a big positive: that all the changes will bring transparency to the market and whenever you do that, you are positioning that market for bigger growth because firms are more likely to trade and invest in the market. It’s a lot of work and enormous investment in time, people and financial resources, but this is going to grow and we will see growth in trading volumes in the derivatives market as a direct result of Dodd-Frank and EMIR.” I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COMPANY PROFILE: AFLAC

Photograph © Tomislav Forgo / Dreamstime.com, supplied August 2011.

AFLAC FLYING THROUGH STORMY WEATHER In 1970 John Amos, head of a small medical-benefits insurance company in the US, visited Japan. He saw great potential, and today Aflac Japan dominates its market. Thirty years later his nephew, Dan Amos, also took a chance, adopting a white duck as the corporate symbol and putting big advertising dollars behind it. That, too, worked out well. Then Aflac stumbled after it invested in high-yield securities issued by Greece and others. The damage is affordable and temporary, says the company. Art Detman wonders whether the duck will fly high again. ORMALLY, DANIEL P Amos, the 59-year-old chairman and chief executive of Aflac Incorporated (AFL), has only good news to report. After all, for the past 21 years he has headed one of the most successful insurance companies in the world, which, since it was founded in 1955 in Columbus, Georgia, has grown into a major seller of supplemental health, accident and life insurance with operations in Japan and all 50 US states. It closed 2010 with revenues of $20.7bn, earnings of $2.3bn and assets of $101bn, and has increased its cash dividend every year for 28 years straight. The company’s digitallyanimated duck, which quacks “Aflac” in television commercials, has become one of the best-known corporate symbols in America, with a 93% recognition rate. Aflac Japan also dominates its market segment in its eponymous market, which accounts for 77% of Aflac’s total earnings. Amos’s company consistently ranks at or near the top in a variety of soft measures. It is among the world’s most ethical companies, according to the Ethisphere Institute, a think tank. It is on Fortune magazine’s list of best places to

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work as well as its honour roll of America’s most-admired companies. The company has also been widely praised for its actions following Japan’s earthquake/tsunami in March. While many foreign nationals hurriedly left the country, Aflac Japan’s Americans stayed put, the entire company responded to the disaster with typical Japanese stoicism, and Amos visited ten days later. For all that, the duck is now being battered by stormy weather. At an analyst meeting in May, Amos had bad news. Many of the yen-denominated securities in the Aflac Japan portfolio had lost value, and the company had decided to dump them. “When in doubt, get it out,” Amos told his audience.“We believe that by de-risking our portfolio, we are better positioned to enhance shareholder value.” Chief financial officer Kriss Cloninger had more bad news: in Japan, the string was running out on improvements in claims experience and the mix of business was shifting toward lower-profit products. The upshot, Amos told his dismayed listeners, was that although Aflac’s earnings might grow by 8% this year, next

COMPANY PROFILE: AFLAC

Daniel P Amos, chairman and chief executive of Aflac. Photograph kindly supplied by Aflac, August 2011.

year they would grow by just 0.5%. Most analysts were caught unawares. Sigourney Romaine at Value Line, for example, had just a month earlier forecast a 17% pop in pershare earnings in 2011 and 11% in 2012. The day following the meeting proved once again that investors hate surprises. AFL’s trading volume, usually around 2.5m shares, shot up to 15.5m as the stock price plunged 6.3%. In June AFL drifted still lower, down 17% in less than four weeks. Aflac closed 2010 with unrealised losses in its investment portfolio of $1.4bn, and through March 31st of this year had written off $376m of that amount. Many of the losses were in securities issued by entities in Portugal, Italy, Ireland, Greece and Spain. At year-end, unrealised losses ranged from 0.4% for Italian paper to a heart-stopping 66% for Greek obligations (this was well before Standard & Poor’s downgraded Greece’s credit rating to CCC). After the May meeting, some analysts estimated that Aflac’s remaining unrealised losses could range from $1.5bn to $2bn, daunting to be sure but still less than half a single year’s pre-tax earnings. “I don’t think it is possible with any certainty to say whether or not $1.5bn is the correct number,”says executive vice president Kenneth Janke, who is Aflac’s deputy chief financial officer.“I don’t know that it will be that high.” How could Aflac have gotten itself knee-deep in a morass of securities from companies and countries with shaky credit? “These securities may seem exotic now but when they were issued, they were highly rated,” says analyst Randy Binner of FBR Capital Markets. Edward Shields, associate director of equities research at Sandler O’Neill & Partners, agrees, noting that these investments are only now perceived as risky. Colin Devine, a Citi analyst, is less forgiving, blaming management for trying to maintain its

high earnings growth rate—12% to 15% per share for many years—by seeking extra income from investments. “AFL is one of two insurers within our universe that could turn a profit even if it had no investment income,”Devine wrote in a petulant report a few days after the May analyst meeting. “We project it could still achieve a return on equity of 11.8% in 2011 even if it held 100% of Aflac Japan’s investments in cash and nearly double that at 21.4% if they were invested solely in Japanese government bonds (JGBs).” Janke rejects Devine’s premise.“Since the early 1990s we have invested the way that we have in order to match as closely as possible the liability characteristics of our policies in Japan with appropriate assets that have the same characteristics. With that elongated obligation comes an implicit return based on the pricing assumptions of our products. So there is a specific interest rate that we need to cover. We want to match our liabilities and assets by currency because we don’t want to be in the position several years down the road of having to sell dollars in order to pay yen claims.” Janke continues: “So the bottom line is that, in pursuing this asset-liability management approach, which we think is the prudent thing to do on behalf of our customers, we were in the position of having to buy long-term, yen-denominated, investment-grade securities. We didn’t want to take the risk of buying low-rated junk bonds.” The problem, as Janke notes, is twofold. First, Japan does not have a large corporate bond market; banks provide nearly all the financing companies need. Second, the interest rate on JGBs is discouragingly low, currently below 2%.“Our liability durations run 13 to 14 years, so for us to have asset durations that are comparable, we need to buy securities that have maturities of 20 to 30 years; and corporate securities like this simply don’t exist in the Japanese market.” Even so, Aflac Japan throws off $28m a day in cash flow that needs to be invested somewhere, and so the company found a variety of entities willing to issue yen-denominated securities. When the worldwide financial crisis started, Aflac began selling off perpetuals, which are subordinated instruments with no maturity dates.“We also wanted to reduce our exposure to financial names globally,” Janke says.“We have gone from about 45% of the portfolio in financial names before the financial crisis to about a third as of March. So we have been de-risking from a financial exposure standpoint. The remaining area that we have been addressing more recently would be in the larger, concentrated positions, which is something that the Citi analyst also referred to. Even if we like the name, we want to be sure that we are comfortable owning as much as we do.” So where does Aflac reinvest billions of dollars?“We have been buying a significant amount of Japanese government bonds,”Janke says.“Although we don’t find the yields terribly attractive, there is more than ample liquidity in that market for us to make significant purchases. We also will continue to look off-shore for non-Japanese companies that are willing to issue securities to us in yen, although it’s more likely to be a senior obligation rather than a subordinated obligation, and it’s more likely to be in a non-financial name

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Paul S Amos II, president and chief operating officer of Aflac. Photograph kindly supplied by Aflac, August 2011.

than a financial name. These could be industrials. We also like regulated entities, so they could be utilities—water companies, power companies, gas companies.” In addition, management has indicated that Aflac Japan might put one third of the surplus supporting its policy liabilities into dollar-denominated investments to capture higher yields. Because Aflac doesn’t hedge foreign exchange, this involves currency risk. Citi’s Devine, for one, calls it “a wholly unnecessary risk”. Unloading its unwanted investments in Greek banks and the like may take Aflac until the end of next year, but one thing is clear. Despite this costly embarrassment, Aflac remains a favorite of many security analysts. FBR’s Binner observes:“There is a lot of pressure on financial stocks right now, but there is a lot of value in Aflac if you can see to the other side of these risks.”

Hard work and good luck Aflac is one of those only-in-America success stories that combine equal parts of shrewd judgment, hard work and good luck. In 1955 three brothers—John, Paul and Bill Amos—founded the American Family Life Insurance Company of Columbus with $300,000 in capital. Its agents sold life, health and accident insurance door-to-door in Georgia and Alabama, and struggled against far larger competitors. By then, the polio vaccine had been introduced, which effectively ended the marketing of polio insurance. American Family did not sell this insurance, but chief executive officer John Amos saw an opportunity by offering coverage for another feared scourge, cancer. Consumer advocates generally deplore“dread disease”policies because of their limitations and expense (it is like buying fire

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insurance for only one room of your house), but the product quickly became a big seller. Amos had determined that most comprehensive health policies covered only 70% of the cost of cancer treatment. His early policies were designed as supplementary coverage that provided policyholders additional reimbursement up to 50% of the cost; beneficiaries could use the surplus money to cover travel expenses and offset the loss of income. This confirmed the pattern for future Aflac policies: indemnities paid in cash to the policyholder in response to a specific event. Soon, the company had expanded to Florida and in 1964 began making presentations to groups of employees at their workplace and offering insurance on a voluntary basis; premiums were paid through automatic payroll deductions. Employers who already offered group health insurance were generally receptive to these ideas, and this “cluster selling” was very effective. John Amos explained:“Sooner or later there’s going to be a cancer in the group. If he’s insured, he’s satisfied, and the word gets around to the rest of them; and if he’s not insured, he’s sorry, and we get the rest of them.” Growth was steady and profitable, but in truth Aflac was just one of many second-tier insurance companies. Then serendipity struck. On a trip to Japan in 1970, John Amos noticed that the Japanese were very health conscious (many wore surgical face masks in public). He saw that Japan was prosperous and growing; then he discovered that no one offered cancer insurance even though cancer was a feared and taboo disease. After four years of arduous efforts, Aflac Japan was licensed in 1974. The bureaucrats whom Amos worked so hard to win over were now allies. They liked the fact that

COMPANY PROFILE: AFLAC

Aflac would not compete with Japanese insurers (none of which at the time offered this insurance), that Aflac would partner with major Japanese companies to market its products, and would hire mainly retired Japanese. Today, Aflac Japan is the Godzilla of cancer insurance and an important underwriter of supplemental medical insurance, life insurance, annuities and endowments. Among these are a child endowment designed to defray college expenses and a unique hybrid whole-life policy called Ways, which can be converted to a fixed annuity, medical coverage or nursing care benefits when the policyholder reaches a predetermined age. Last year, Aflac Japan revenues rose 10.3% to $16bn (77% of Aflac’s total revenues) and pre-tax operating earnings increased by just over 17% to $3.3bn (78%). Both the child endowment and Ways products carry lower margins than the medical and accident policies. Moreover, Japan’s population is projected to decline slowly over the coming century. That does not necessarily mean that Aflac Japan’s growth will halt soon.“The countervailing force to a shrinking market is an ageing market,” notes Janke. “The change in demographics heightens the need for the products we sell. In the foreseeable future, we think there will continue to be a very good demand for our products.” As for the US market, that is more challenging, not only for Aflac but all companies that depend on worksite sales. Millions of jobs have been lost since the onset of the recession, and today many Americans are so worried about losing their jobs that they avoid spending money on things such as supplemental health and accident insurance— gripped, as Janke puts it, by “a paralysing fear”. Then, too, there is a great cultural difference between America and Japan. “Aflac’s problem in the United States is that Americans do not think like Japanese,” says Binner of RBR. “Japanese are health-conscious and risk-averse. The opposite is true of Americans.” If so, then it is vital for Aflac to distinguish itself from its many competitors in order to win a share of a small market. In the 1960s the company’s name was changed to American Life Assurance Company (“assurance” being warmer and more hopeful than“insurance”) and later the Aflac acronym was adopted for marketing purposes. In 1992 the company itself was renamed Aflac Incorporated. Through 1999 Aflac in the US was a successful but largely unknown insurance company, even though it had nearly $7.3bn in premium income. That year Kaplan Thaler Group, Aflac’s advertising agency at the time, presented Dan Amos with a daring idea: create a duck to be the company’s symbol. “Selecting a duck as a mascot was a big risk,” Amos later told The New York Times. Granted, Government Employees Insurance Company (Geico) had introduced a gecko as its mascot earlier in 1999, during an actors’ strike that hobbled production of TV commercials. However, Geico is automobile insurance, whereas Aflac deals with life and death issues including cancer. On New Year’s Eve 1999 Aflac ran its first commercial featuring the duck. Since then 52 commercials with the squawking fowl have been aired, and the duck has been in-

Kenneth Janke, Aflac’s executive vice president and deputy chief financial officer. “We have been buying a significant amount of Japanese government bonds. Although we don’t find the yields terribly attractive, there is more than ample liquidity in that market for us to make significant purchases,” Janke says. Photograph kindly supplied by Aflac, August 2011.

corporated into Aflac Japan’s marketing, along with other animated images. For many years, the emphasis in ads was on name recognition. In recent years the commercials have begun to explain specific Aflac products. As one Los Angeles master carpenter put it: “Everyone knows the company, but no one knows its products.” That is sure to change. Eventually, so will the economy. Confidence will return, hiring will pick up, and employees everywhere will increase their purchases of Aflac products, ranging from life and disability insurance to coverage for accidents, cancer, and hospital stays. Meanwhile, Aflac’s integration of its 2009 acquisition of Continental American Insurance continues. Now renamed Aflac Group Insurance, this small operation focuses on selling voluntary group insurance to companies of 100 or more employees, which makes Aflac’s products attractive to independent brokers; most of Aflac’s policies are sold through its dedicated network of more than 70,000 sales representatives. Almost certainly the days of double-digit growth are over for Aflac. Even so, it has plenty of room to grow in Japan and even more room in the US. The company has a sterling reputation and clearly is willing to take measured risks. The duck will keep gaining altitude—not as rapidly as in the past, to be sure, but it will again fly high. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

DUTCH BANKING

The road to recovery has been painful but three of the four major Dutch banks have turned the corner. They have not only passed the latest Europe-wide stress test with flying colours but have whittled down their debt obligations and strengthened their balance sheets. Even so, it is hard to predict the future of the sector with confidence, given the skittish global economic recovery and the ever present sovereign debt crisis casting a pall over the international financial services landscape. Lynn Strongin Dodds reports.

DUTCH BANKS STEER TOWARDS SUSTAINED GROWTH N THE SHORT term, events in Portugal, Ireland, Italy, Greece and Spain pose the greatest threat to the sector despite the fact that Dutch banks have a relatively small exposure to the infamous five. Government figures estimate a collective figure of around €112.6 bn ($161.6 bn) which is a proverbial drop in the bucket compared to French banks that are considered the most vulnerable at $801.1bn, according to the latest breakdown by the Bank for International Settlements. Germany is in second place at $689.2bn followed by the UK at $480.5bn. Despite the latest €109bn bailout package for Greece, markets remain rattled and question marks remain over the long-term viability of the most recent lifeline. Although the Netherlands had been enjoying faster than expected growth for the first half of the year, the unravelling of the eurozone would have a profound impact on its economy. The country is also at risk from the prevailing volatile economic winds blowing from other parts of the Western world. Fears over a double-dip recession have not subsided and concerns over a sustainable recovery remain. This perhaps explains why the De Nederlandsche Bank (DNB) believes the higher growth rates it has predicted for the Netherlands are short-lived. The regulator had raised its forecast to 2.2% from 1.6% this year, partly due to high

FTSE GLOBAL MARKETS • SEPTEMBER 2011

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

interest income and declining additions to the provisions. However this was trimmed to 1.7% against the slower than anticipated recovery across Europe and the US. The picture for 2012 is brighter, with the economy expected to bounce back to the 2.1% level on the back of improved market conditions. “Since the second half of last year, there was a positive growth story in the Dutch banking system reflecting a north and southern European divide,“says Claudia Nelson, senior director in Fitch Ratings’ Financial Institutions group. “The Dutch economy saw a moderate recovery in 2010, growing by a muted 1.8% after having shrunk by 3.9% in 2009. It is a resilient economy but it is still uncertain how the sovereign debt crisis will impact banks’ continued growth, if at all.” The other unknown is the impact of regulation. On the international stage, Basel III is front and centre, with Europe being first out of the gate with its draft guidelines detailing the finer points of the implementation of the new regulation. The proposals, which remain subject to approval by the European parliament and the 27 member states, aim to strengthen the resilience of the European Union’s (EU’s) 8,350 banks, which account for about 53% of global banking-sector assets. They will require banks to increase their core capital ratio to 7% of their assets from the current 2%. That translates into a requirement to raise some €460bn

DUTCH BANKING

($653bn) in capital by 2019. The value of banks’ assets would also be weighted according to what risk they carry, and the definition of core capital would also be tightened. As with any EU proposition, there are divisions among the ranks. At the heart of this debate is the single rule for banking regulations. Plans for a rule book by the EU’s European Banking Authority (EBA), the bloc’s financial watchdog, are part of a package of reforms which, it is hoped, will impose uniform oversight of banks and thereby help mitigate any danger of financial instability stemming from divergent national rules. The London-based EBA was launched in January of this year and has the power to approve standards that are binding on EU members. The watchdog is chaired by Andrea Enria, a former Bank of Italy official. It is unlikely that Enria will find the going easy. Several countries, including the UK and some Eastern European countries, are opposed to the moves and have expressed their concerns that the new directive would limit national authorities’ ability to set capital requirements higher than internationally-agreed levels. This is considered crucial as the financial sector’s importance and size relative to the economy varies significantly between countries, and many banks that have received state help are now tied to national budgets. Moreover, some of the directive’s critics also aver that the new rules could end up severely restricting lending to small and medium-sized enterprises. The European Commission is insistent that any divergence would distort competition. Fitch’s Nelson believes that the Dutch banking sector, particularly Rabobank, ABN AMRO and ING, are well placed to deal with Basel III. They have not only enjoyed improved profitability and funding levels but they now also have good access to the wholesale market plus the refinancing of government-guaranteed debt should be manageable.

Government levy on banks Basel III is not the only regulation that Dutch financial institutions have to contend with. On the domestic front, the Dutch government’s recently proposed plan to levy a €300m annual tax has caused a furore. This is designed to offset the cut in property sales tax from 6% to 2% in an attempt to boost the struggling housing market as well as help prevent taxpayers from being hit with bailout bills in the future. Other measures to compensate for the estimated loss of €1.2bn in revenues include closing corporate tax loopholes, reducing tax relief on savings and taxes on insurance products. The move marks a U-turn by the Dutch government which had previously insisted that imposing a bank levy on Dutch banks would leave them at a disadvantage to their European competitors. Finance minister Jan Kees De Jager, on the other hand says the turnaround in policy reflects changes in countries (such as Germany and the UK) which have also introduced bank levies, and thereby creates a more level playing field. The finer details—including how much of a levy Dutch banks will have to pay—are still being worked out. In the meantime the Dutch Banking Association is lobbying strongly against the tax, claiming it will harm the economy

Claudia Nelson, senior director in Fitch Ratings’ Financial Institutions group. “The Dutch economy saw a moderate recovery in 2010, growing by a muted 1.8% after having shrunk by 3.9% in 2009. It is a resilient economy but it is still uncertain how the sovereign debt crisis will impact banks’ continued growth, if at all,” she says. Photograph kindly supplied by Fitch Ratings’ Financial Institutions, August 2011.

by restricting the amount of credit and mortgages they can offer. The group also believes that any similar tax on banks should be pan-European rather than levied by individual EU governments. Whatever the outcome, Dutch banks will not have an easy time generating profits going forward. They have spent much of the past two years rebuilding their reputations, reappraising business lines and whittling down credit risks by divesting their portfolios. They have also wound down their trading activity and adopted much more conservative approaches to lending. While this has improved their balance sheets,“there is a real issue concerning long-term growth,” says Stephane Herndl, an analyst at Moody’s Investor Services. “There is limited potential for the banks to grow their top line and as a result, there will have to be a much greater attention to the cost base. This is likely to be a key element in maintaining profitability and generating capital. This is already reflected in the actions of many banks where there have been reductions in headcount and further restructurings.” Rabobank is already going down that route. The bank recently announced it was cutting more than 1,200 jobs in areas such as IT at its head office in an attempt to save €219m over the next two years. Unlike its main rivals ABN AMRO and ING Group, Rabobank, which has a highly-diversified business mix—including domestic retail banking, asset management and investment, wholesale banking and international retail banking, leasing and real estate—did not require state aid during the 2008 credit crisis. The bank has not only remained profitable but it is also one of the few remaining banks to boast a triple-A credit rating. During the fiscal year ended 2010, the bank’s net profit jumped by 26% to €2.8bn from €2.2bn on the back of lower bad debt costs and higher interest income. Benoit Petrarque, an analyst at Kepler Capital Markets, says: “Rabobank is well capitalised and we do not see any

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

changes to its corporate objectives and strategies. I think it will continue to position itself as a major international player. Over the years it has built a sizeable presence in the US as well as emerging countries in Latin American as well as Asia.” The bank already operates in 29 countries with 593 locations and is now looking to expand its activities in major markets with a strong food and agricultural base. It recently received approval from the Reserve Bank of India to establish a banking presence in that country with a branch to be located in Mumbai. Currently, it is present through a whollyowned subsidiary, Rabo India Finance (RIF), which is registered as a Non-Banking Finance Company (NBFC). ABN Amro, on the other hand, is being forced to abandon its global ambitions. This once mighty universal bank, which was nationalised and merged with Fortis, will only consist of a large Dutch retail franchise, a Europe-focused private banking unit and an investment bank centred on the Netherlands. It will also target certain niche markets such as energy, commodities and transport. The government injected around €26bn into the bank to rescue it from the disastrous takeover by Royal Bank of Scotland in 2007. Its health is slowly being restored. The net loss of €414m in 2010 may have compared with a net profit of €274m in 2009 but underlying net profit, excluding costs associated with its merger and other bailout-related expenses, stood at €1.1bn, up from €142m the previous year. However, several conditions such as a stabilised economy still have to be met before it re-enters the public arena. As a result, the deadline of 2014 which is being touted for an initial public offering may be a moving target. In addition, the government recently said that it might retain a 5% to 10% stake. “ABN Amro was the victim of the crisis”, says Petraque. “The government has a huge investment and they want their money back. I don’t think they will put it on the market unless they get a good price which would not be the case today. They may also not exclude the possibility of a trade sale to a European or non-European bank.“ As for the other banks, ING also has to look more inwards for opportunities. The once global financial company has had

to nearly halve its €1.3trn balance sheet as part of the €10bn bailout package it received. As a result, the group will become much more European-focused and the bulk of its profits will be generated in the Benelux countries.“ING was far too complex for the Netherlands. It was the combination of a bank and insurance company that was active in the US and different regions,”says Petrarque.“That bank-insurance will have to disappear according to the commission’s requirements and instead it will become a pretty boring Dutch/Belgian bank. It will have a presence in the region but very limited earnings generated outside of Europe.” ING still remains the Netherlands’s largest financial company by assets, though it continues to be busy divesting many of its operations and only has €3bn left to pay back to the government. So far this year, the bank has sold its auto leasing service, ING Car Lease, to BMW for an estimated €700m as well as its online bank, ING Direct USA, to Capital One Financial Corp for a combination of $6.2bn in cash and $2.8bn in stock. It has left ING with only a 9.9% stake in the US bank. Next on the agenda are two separate initial public offerings in 2012 of its US and European insurance operations which have a book value of €20bn. It is not all about retrenchment; the bank also intends to reposition its cross-border business strategy.“ING is making good progress in its divestments,”acknowledges Jan Willem Weidema, an analyst with ABN Amro. “The focus for the bank as well as SNS Reaal has been to repay the state but I think in the future we could see the new ING look at Central and Eastern European countries for growth opportunities.” As for SNS Reaal reimbursing the state for its €750m in aid, it is has been a slow-moving exercise with €565m still owed. Its property finance group has narrowed its losses, reporting a net loss of €57m in the first three months of 2011, which was a slight improvement on the €60m net loss in the corresponding period, but a much better showing than the €317m net loss in the last quarter of 2010. Weidma notes: “This is quite a different story. The bank is still suffering from problems tied to property financing activities and is faced with a challenge to free up capital.”I

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FTSE GLOBAL MARKETS • SEPTEMBER 2011

PRIME BROKING

After a period of reflection and review, prime brokers are back in the game and the rivalry is as intense as ever. Not only are the traditional investment banks in the fray but custodians are also looking to make their mark. Capturing market share and digging deeper inroads will not be that easy if Nomura’s recent retreat from the industry in Europe is anything to go by. Lynn Strongin Dodds reports.

Photograph © Skypixel / Dreamstime.com, supplied August 2011.

COMPETITION HOTS UP IN PRIME BROKING OMURA HAS MADE a handful of high-level redundancies within European prime brokerage this year, including Matt Pinnock, co-head of prime services in EMEA, as well as redeploying resources to the US and Asia. In Europe, it was believed that the Japanese bank, which had taken over Lehman Brothers’ European prime brokerage in 2008, was struggling to compete with the more established rivals in the region. Although the duopoly enjoyed by Morgan Stanley and Goldman Sachs in the pre-crisis days has been broken, investment banks still rule the roost, according to Global Custodian’s latest global prime brokerage poll. These two behemoths still feature prominently in the top ten but their share of the pie has shrunk. Morgan Stanley now accounts for 13.2% of the assets under management while Goldman Sachs has 11%. Snapping at their heels is Credit Suisse with 10.59% followed closely by Deutsche Bank with a 10.12% chunk. Bank of America Merrill Lynch (BofAML) and JP Morgan are next on the list with their near neck-and-neck rankings—9.48% and 9.43% respectively—while the rest of the leading contenders have much smaller percentages. For

example, Citi and UBS are just below 7%, Barclays Capital is at 5% and BNP Paribas is further down the list with 3.18%. The survey also notes that competition has increased despite the fact that the industry has lost its lustre. Revenues have slumped to $10bn from $12bn in the halcyon days. The main attraction though is that prime brokerage is still relatively lucrative plus it plays a key part in the overall package of services. It is seen as an important gateway to introduce hedge fund clients to the other services at the bank. “The landscape has become much more competitive and the playing field is much more level,”says Andrea Angelone, global co-head of prime brokerage at JP Morgan.“Two things happened after the Lehman default—there was a flight to quality with hedge funds moving away from banks which they thought to be in danger, and there was a move towards the multi prime model. The sole prime brokerage model has virtually disappeared. Instead of two dominant players, there are four or five players in the prime brokerage industry today with another five or six smaller ones behind them.” Axel Pierron, analyst with Celent, a member of the Oliver Wyman group and author of a recent report, New Basis for the

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Hedge Fund / Prime Broker Relationship, also believes that the financial crisis has permanently changed the dynamics between hedge funds and their prime brokers. “With the default and quasi-default of some of the leading providers in the space, funds have realised that they should diversify their prime broker relationships. There are greater opportunities because hedge funds have regained their momentum and they are increasingly turning to prime brokers to provide them with support for their business expansion.” Deutsche Bank’s ninth alternative annual survey shows that investors are expected to plough over $200bn into hedge funds this year, taking the total assets under management to a record $2.2trn. The difference this time around is that institutional investors and not the traditional high net worth individuals are the main contributors. This is good news for prime brokers in that institutional money tends to be stickier, although they can be a much more demanding client base. This is because in the post-crisis world, hedge funds are under pressure from clients as well as regulators to provide greater transparency and more detailed reporting into their inner workings. In addition, the move to central clearing for over-the-counter derivatives will mean more emphasis on the clearing and settlement components. As a result, there is a much greater emphasis on a prime brokers’ operational, risk management and compliance structures. “Prime brokers have had to reconsider what their offering is because the traditional leverage model was not viable due to regulatory constraints,”says Pierron.“They will need a high level of operating efficiency but a key differentiator will be their value-added services such as consulting, advice and capital introductions. They will also need to offer intraday business controls, a real-time view of the portfolio’s positions and exposure as well as processing and settlement.”

An extended product line In order to succeed, the Celent report notes that prime brokers will need to provide an extended product line across a wide geographic spectrum. This means being able to process multi asset classes and manage credit, risk and exposure through one platform. Hedge funds are also sensitive to re-hypothecation risk and are looking for a clear demarcation between the execution and the prime business of its provider, to avoid any information leakage. Against this demanding checklist, it is no wonder that the larger players are dominating the game. They have the deepest pockets and are able to afford the significant investments required in technology, infrastructure and headcount. “The industry has moved back to players with strong balance sheets and we have seen the major firms ramping up their capabilities,” notes Pierron.“The consequence has been the slowdown of the number of mini-primes.” Mini-primes which specialise in servicing small hedge funds came of age in the wake of the financial crisis in the hope of capitalising on the recalibration of the prime brokerage market. When hedge funds realised that the positions they held with a prime broker could be frozen if the bank failed, they became

FTSE GLOBAL MARKETS • SEPTEMBER 2011

Andrea Angelone, global co-head of prime brokerage at JP Morgan. Photograph kindly supplied by JP Morgan, August 2011.

John Addis, head of EMEA global markets financing and futures at Bank of America Merrill Lynch (BofAML). Photograph kindly supplied by BofAML, August 2011.

more selective and expanded their pool of providers including those at the smaller end of the spectrum. However, as hedge funds regained their equilibrium, the pendulum has swung back to both the well capitalised banks and custodians. Mini-primes found it harder to increase their foothold and this has led to some firms such as Lighthouse Financial Group and FRB Capital exiting the business over the past year. Others joined forces, including Cantor Fitzgerald acquiring PCS Dunbar’s prime brokerage unit, ConvergEx purchasing NorthPoint Trading and Direct Access Partners buying EFX Prime Services. This is in contrast to those at the upper end where there are two main models, according to Staffan Ahlner, managing director of broker-dealer services in Europe for BNY Mellon. There is the custodial model where custodians work in partnership with broker/dealers and the assets are segregated. There is also the bankruptcy-remote special-purpose vehicle where client assets are insulated from the failure of the wider

PRIME BROKING

Axel Pierron, analyst with Celent and author of the recent report New Basis for the Hedge Fund / Prime Broker Relationship. Photograph kindly supplied by Celent, August 2011.

firm. In addition, the universal bank model has gained traction whereby a bank has a custody division in its own right. All three have been busy jockeying for position, forging new territories and increasing headcount. For example, in the summer BNP Paribas announced it was poised to take the plunge into global prime brokerage. It has built a group of 350 employees dedicated to the business and plans to increase headcount in the US, Asia and Europe over the next year. It will initially look to win market share by positioning itself as a number two or three prime broker for hedge funds seeking to diversify their relationships. JP Morgan, on the other hand, recently debuted a full suite prime brokerage offering in Europe which will target the larger, more established fund as well as start-ups and other funds across the market. The services range from clearing and settlement to securities lending and capital introduction. The new offering dovetails not only with the recently-launched expanded swaps business in London but also its well-established European custody business. Angelone says: “We had bought Bear Stearns, which had an established prime brokerage offering, but it was very US centric and so we decided to launch our European service. We have been working towards this and have hired 25 to 30 people over the past two years. The objective is to offer both cash and synthetic exposure as a combined package, which is what hedge funds are seeking.” Angelone also believes that a prime brokerage relationship is an important part of the whole package that the bank offers its clients. “At its core, prime brokerage is relatively straightforward because it is an aspect of clearing and settlement as well as asset servicing. We differentiate through the breadth and depth of the product offering and the fact that it is integrated with our custody service.” Citi is also hoping to move up the ranks with its integrated universal banking model. “I think banks that have large custodial networks do have an advantage because they have the ability to offer a wider set of product,” notes Mark Harrison, head of European prime brokerage at Citi.“Other main differentiators are our ability to leverage our infrastructure to help pension funds and institutions who want

Staffan Ahlner, managing director of broker-dealer services in Europe for BNY Mellon. Photograph kindly supplied by BNY Mellon, August 2011.

to move into the hedge fund space. For example, we set up a platform and infrastructure for ATP (the Danish pension fund) about three years ago and have carried out similar projects for other clients since.” While Citi is making headway, HSBC is looking to break into the inner circle with its new prime services launched on the back of its prime custody model. Chris Barrow, global head of sales for HSBC Prime Services, says:“There is no doubt that the marketplace has become much more competitive, but I believe that HSBC can benefit from our financing-led strategy backed by a strong balance sheet and also our ability to segregate client assets across our global custody platform. We spent a year building infrastructure and technology as well as hiring around 100 people in Europe and Asia so we are not hampered by a legacy business and systems. We are bringing on well known clients in Europe and went live with our first Asian clients when we opened in Hong Kong earlier this month.” Not every bank believes it needs a custodial arm to break the stranglehold of the leading players. BofAML, which ranked number one on Global Custodian’s European prime broking table, is looking to become a leading global player and has been busy bolstering its capabilities as well as its personnel. In the past year, it has taken on several new recruits, the most recent ones being Martin Donnelly, Daniel Katz and Ross McDougall, who hailed from Credit Suisse, Nomura and Morgan Stanley. These follow on from the high-profile hire of Stuart Hendel, the global head of prime brokerage at UBS, and his colleagues Jonathan Yalmokas, US head of prime brokerage sales, and Charlotte Burkeman, co-head of EMEA prime brokerage, who have joined in the same roles. John Addis, head of EMEA global markets financing and futures at Bank of America Merrill Lynch, which uses subcustodians, says:“One of our advantages is that we offer the full range of prime broking and more specialist financing solutions, wrapped under the umbrella of one of the world’s largest banks. We have been investing in talent as well as value-added services. Traditional prime brokerage is no longer a standalone offering; it is part of the overall package that we offer clients in this space.” I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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CANADIAN SEC LENDING

STEADY GAINS UNDERCUT BY FINANCIAL UNCERTAINTY

Photograph © Davidarts / Dreamstime.com, August 2011.

The Canadian securities lending players may have weathered recent financial upheavals better than their US and European counterparts but they have not been immune to the aftershocks. As they have done in other markets, beneficial owners including pension funds, asset managers and insurance companies have returned in satisfying numbers; though with much more rigour about what risks can and cannot be assumed. Although demand is on the up, the truth of it is that many hedge funds are still treading carefully under the shadow of impending regulation. Lynn Strongin Dodds reports. ANADA HAS FELT the same pressures and influences as the global markets, says Don D’Eramo, senior managing director, securities finance regional business head, EMEA & Canada, at State Street.“We saw some clients step to the sidelines and reassess the goals and parameters of their programmes. All of our clients have re-engaged in securities lending and some in different ways with different mandates. Some are taking more of an opportunistic approach and those programmes are not always as large as before.” Rob Ferguson, head of global securities lending at CIBC Mellon, agrees, adding:“We found that most custody clients stayed in securities lending through the crisis and most of those who withdrew have returned. Things are also looking up on the borrower side as the outright ban on short selling disappeared in most jurisdictions and economic conditions started to improve. There was an increase in market participation and securities lending from hedge funds and the broker-dealer community.” According to figures published at the end of last year by Data Explorers, the UK-based data research firm, the Canadian industry reported CAD1.01trn of securities available for lending and CAD106bn on loan. This is down from a peak in early 2008 but a significant improvement from October 2008 when the market went into a tailspin. At that time there was about $900bn in securities available for lending with less than 10% on loan. UK industry data provider research shows that the first three months of 2011 continued much like the end of last year. The supply of equities available for borrowing equated to 6.5 times the demand to borrow while the value of inventory rose in line with the markets as did the value on loan. The average total return to lendable equities was 4.24

basis points with 95% of this income being derived intrinsic lending fee. This model, whereby returns are based upon the securities loan itself, with little incremental benefit from collateral reinvestments, is currently the preferred option among lenders and one of the main reasons why the Canadian securities lending industry did not suffer the same fallout as its nearest neighbour. D’Eramo notes:“The Canadian market has a different risk profile than the US and Europe. We did not see the same headline-grabbing news concerning reinvestment but the overall effect was somewhat muted. This is not to say that cash collateral is not a growing market but the scale is different.”

A non-cash collateral market Yvonne Wyllie, Toronto-based head of securities lending market products and services at RBC Dexia Investor Services, adds: “Unlike the US, Canada is primarily a non-cash collateral market and it did not suffer the same reinvestment problems. Historically, the split was 90% non-cash to 10% cash and this did not rise significantly even when the withholding tax on cross border rebates was lifted. There was a view that the market would move to cash but that did not happen.” The elimination of the withholding tax on arm’s-length payments from Canadian residents to US residents three years ago was seen as one of the most important development in the Canadian tax regime. However, as Wyllie points out, the move to cross border cash collateral lending did not materialise as expected. “There was a rise to 15% but the financial crisis hit at the same time as the law was repealed and as a result clients were wary to move to cash.” The other factors underpinning the Canadian industry are the strength of its financial community and economy, which

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

turned in an impressive first-quarter annualised performance of 3.9%, compared to a much weaker 1.8% in the US. “In general, we are a conservative country,”says Ferguson.“Canada emerged from the financial crisis in a very strong position for a number of reasons, but I would say prudent regulation is the overriding factor. We have a well-capitalised and wellregulated banking sector, which has helped position Canada’s banks very strongly relative to their peers in other nations.” Ferguson also believes that “Canada’s relatively strict mortgage regulations protected our market from sub-prime problems. The strong fiscal and monetary policies of Canada’s federal government played a key role, and our resource-based economy continues to benefit from high commodity prices and attracts significant foreign investment.” Dave Sedman, senior vice president and manager of securities lending at Northern Trust in Toronto, agrees adding: “I think the use of non-cash collateral as well as strength of the Canadian financial system and the banks are three of the main reasons why the securities lending industry did not experience the same impact as the US or Europe. This provided an extra layer of comfort and we did not see the same level of alarm that took place in other countries.”

This robustness also explains why the country’s enviable triple-A rating was recently renewed by the ratings agency Moody’s. It gave the country top marks for its strong fiscal controls, low federal debt stock, sound banking system and housing market. It was also seen as being at the low end of the spectrum in terms of susceptibility to event risk. Even so, Canada has always suffered some fallout from the financial maelstrom engulfing its southern neighbour. Market participants are closely watching events unfold in the US to see how the country tackles its slower than expected growth rates and its debt obligations. Although it is difficult to predict the future, the fortunes of the securities lending market has hinged upon three main elements, according to Ferguson.“First, we’ve seen a marked increase in merger and acquisition activity, driven by cash that had been sitting on the sidelines after the market downturn. A number of players had built up significant reserves since 2008, and they are beginning to put them into action. Second, fixed income lending has been consistently strong, particularly in short Canada bonds. Third, equity lending volumes have been decent even if activity around specials (high-demand securities that command premium

We’ve got the people and experience to help you navigate the unique Canadian terrain.

cibcmellon.com ©2011 CIBC Mellon Global Securities Services Company is a BNY Mellon and CIBC joint venture company and is a licensed user of the CIBC trademark and certain BNY Mellon trademarks. Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised.

FTSE GLOBAL MARKETS • SEPTEMBER 2011

CANADIAN SEC LENDING

Rob Ferguson, head of global securities lending at CIBC Mellon. Photograph kindly supplied by CIBC Mellon, August 2011.

rates) has been unspectacular. [Having said that,] we are beginning to see more specials-related activity in US and Canadian markets, which is good for client revenues.” RBC Dexia’s Wyllie notes: “We are also seeing strategies such as convertible bond arbitrage, index arbitrage as well as mergers and acquisitions activity whereby borrowers use short selling to hedge their exposure to adverse stock market movements. These are not just trends limited to the Canadian securities lending market but reflect the wider global community.” The other similarities are a renewed focus on not just the type of collateral but the quality. Typically, in Canada, bonds are collateralised at 102% and equities at 105% of the amount borrowed. “Canada remains a predominantly noncash collateral market,” says Ferguson.“Approximately 75% of agent lender transactions in the Canadian market are

backed by securities, primarily government and sovereign debt, with bank paper and equities making up the balance. We’ve seen an increasing appetite for cash collateral from borrowers and lending clients. ETFs are growing in popularity here so I can see that they might play an increased role in the future.” Wyllie also believes that ETFs will play a greater role but that for now corporate bonds and equities are proving the most popular choices. “In general, collateral continues to be one the hottest topics because for beneficial owners the quality and value form the foundation of their risk management strategy,” she says.“What we are seeing is that clients want much more flexibility in their programmes and are diversifying their pools. They are shifting away from government debt and are moving into equities for example, because there is a higher correlation and it is less expensive than debt at the moment.” Sedman also notes that clients are increasingly looking for greater control and customisation of their programmes. “Over the past three years they have wanted a much more tailored approach and are looking to expand their collateral options. Collateral flexibility is one of the key drivers of revenues and as a result Northern Trust offers a diverse range that meets the client’s requirements.” Although demands for cash collateral maybe rising, there is much more attention paid to the reinvestment end. “Overall, clients are revisiting their programmes and risk parameter,” says D’Eramo .”They are conducting greater due diligence and assessing whether their agent lenders have the right infrastructure in place and if they choose cash collateral, whether they can manage cash in all market environments. The important thing from our perspective is to have ongoing conversations with clients to better understand their goals and risk parameters whether that is in a non-cash world or a cash structure.” Doing their homework in Canada may be slightly easier for beneficial owners in that there are fewer providers in the market. Despite new entrants trying to wedge the door open wider, the four main custodial banks, CIBC Mellon, Royal Bank of Scotland, Northern Trust and State Street are a dom-

HOW CASLA HELPS IN A FINANCIAL CRISIS HE CANADIAN SECURITIES Lending Association (CASLA) was formed in April 2009 by the four major players—CIBC Mellon, Northern Trust, RBC Dexia and State Street—to give the country’s security lending industry a single, unified voice. The remit is advocate and educate on behalf of all securities lending participants in the country. Membership is not just open to industry firms and professionals but also representatives and organisations from the beneficial owner and borrower communities.

According to Rob Ferguson, head of global securities lending at CIBC Mellon, CASLA was established to enable lending market participants to work together with regulators to encourage best practices and ensure the long-term viability of the market. “It helps give us a shared voice on important matters like regulation and provides an opportunity for stakeholders to reach out to the industry as a whole. It also gives us an opportunity to work together to help enhance the public’s understanding of securities lending. This year, CASLA

hosted its first conference, which was a great success, and we are already looking forward to another great event next year.” In the past, the four banks would come together in an informal basis and lobby regulators but the financial crisis focused the community on developing an industry trade group in the same mould as the UK and Europe’s International Securities Lending Association (ISLA), the Australian Securities Lending Association (ASLA) and the Pan Asia Securities Lending Association (PASLA).

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Don D’Eramo, senior managing director at State Street. Photograph kindly supplied by State Street, August 2011.

Dave Sedman, senior VP and manager of securities lending, Northern Trust. Photograph kindly supplied by Northern Trust, August 2011.

inating force, accounting for roughly 90% of the business. Wyllie notes: “There are different roads to market such as principal or exclusive but to date Canada is still a very concentrated market and the custodial banks are the main providers. This may be due to the fact that unlike the US, Canada is a much smaller market and many do not have the scale to capitalise on non-agency lending even if they have an appropriate portfolio. Relationships are also very important here.

research concluded that the move was not warranted. “Overall, Canada’s regulators did a commendable job during a very trying period. They will continue to use the tools at their disposal as they see fit to ensure the stability of the market.“ Market participants are closely monitoring the developments across the border. This includes the Foreign Account Tax Compliance Act (FATCA), which has meant a significant increase in reporting requirements, as well as the DoddFrank Act, which although still pending will have an impact on the administration and reporting of security lending programmes. “I would say that regulation is one of the most important focal points going forward,”notes D’Eramo.“There is a great deal of uncertainty and several proposals need to be finalised. I think this maybe one of the reasons why demand has not returned to earlier levels. They may be waiting for the final outcome to be decided.”I

Impact of regulation Looking ahead, the main challenge as with any market is impending regulation. The Ontario Securities Commission, which oversees trading on the Toronto Stock Exchange, imposed a temporary short selling ban and the regulator has not ruled out further intervention should circumstances demand it. Ferguson point out that most post-ban academic

“Typically what would happen is that the four large custodial banks would be left on our own to form an ad hoc committee to lobby and express our views to the regulators,” says Dave Sedman, senior vice president and manager of securities lending manager at Northern Trust in Toronto. “However, the financial crisis demonstrated the need for an industry association that speaks with a unified voice specific to the Canadian legal and regulatory environment.” Yvonne Wyllie, Toronto-based head of securities lending market products and

services at RBC Dexia Investor Services, adds: “Other countries had industry associations and there was a view especially in light of market conditions that we also needed an industry association to push things forward in a formal way. I think it is an important part of the evolution and development of the industry in Canada. Over the past two years we have not only worked with regulators and selfregulating bodies but we have also educated the wider market about what securities lending is.”

FTSE GLOBAL MARKETS • SEPTEMBER 2011

To that end CASLA has recently joined forces with FinTuition to offer a one-day course designed to give attendees an introductory overview of securities lending, examining its features, characteristics and operations both in Canada and abroad. “Regulators around the world have acknowledged the critical role that securities lending plays in today’s capital markets, yet securities lending often remains misunderstood,” says Roy Zimmerhansl, owner and principal of FinTuition.

SECURITIES LENDING

SEC LENDING ON THE RISE IN LATIN AMERICA International investors have increasingly turned their attention to Latin America in recent years as many countries in the region have begun to realise their inherent economic potential. Numerous large Latin American companies have raised capital in New York through ADR issues, creating arbitrage opportunities against the underlying shares traded on local exchanges. Meanwhile, central bank coffers overflowing with cash from budget surpluses, together with privatised pension funds, have outgrown the local capital markets and started to invest abroad. Interest in securities lending has grown along with these capital flows as borrowers exploit new investment strategies and asset owners seek to boost their returns. Neil O’Hara reports. When Cavanaugh travels to Latin HE LATIN AMERICAN market America, he’s after the growing pools of has turned out to be a mixed bag of Photograph © Tino Mager / capital that own US Treasuries, ETFs tricks for the international Dreamstime.com, supplied August 2011. and other securities in demand from custodian banks that dominate securities international borrowers. Chile and Peru lending elsewhere. Even though Brazil have privatised pensions, creating funds has the largest equity market capitalisathat already own a sizable portion of tion, global custodians such as State the local equity markets and must look Street do not offer securities lending abroad for diversification—funds in services to local investors there. Brazil both countries are permitted to invest has an unusual structure, in which up to 50% of their assets abroad. BM&F Bovespa, the country’s principal The pension schemes are not an easy stock exchange, acts as a central countersell, however; they understand the party for securities lending transactions, potential reward from securities lending, in contrast to the bilateral over-thebut are afraid to step out of line. counter (OTC) arrangements that prevail “It’s a bit chicken and egg,” says in most other markets. While clearing Cavanaugh.“The asset managers know offers risk management benefits, it lending could reduce expenses and requires the central counterparty to take give them an edge over their competicustody of the collateral. This is, in fact, tors, but they all have similar performan anathema to global custodians acance and don’t want to make a miscustomed to managing their own collatstep.” Central banks, which have no eral pools in New York or London. The loss of control raises regulatory capital charges for the need to look over their shoulder, are an easier target. The absence of global lenders leaves the domestic secuinternational custodian banks as well. “The agents can’t control the collateral, so it is deemed an unsecured transac- rities lending markets to local service providers. In Brazil, tion,” explains Michael Cavanaugh, head of Latin American for example, Itaú Unibanco dominates the market, with a business development in the securities finance division at 20% market share overall and more than half the crossState Street in Boston.“That has balance sheet implications.” border lending business. Don Linford, head of the internaCentral clearing throws up regulatory obstacles to tional securities solutions group at Itaú Unibanco, says potential lenders, too. For example, US pension plans hedge funds—both local and foreign—are the principal governed by the Employee Retirement Income Security Act borrowers. The greatest demand is for large capitalisation (ERISA) cannot cede control of their assets to a third party liquid equities that also trade actively in New York, except in limited circumstances, which do not cover a including Vale and Petrobras. “The larger stocks are quite liquid in the United States as structure in which collateral is not only held by the Brazilian central counterparty but also commingled with collateral well,” says Linford. “Investors are doing arbitrage between against the other market activities of the local broker that the two markets.” High-frequency trading has pared ADR arranges the loan. Mutual funds registered in the US must arbitrage margins to the bone but with abundant liquidity in take cash collateral against stock loans, which rules out the both securities, computers can exploit trading opportunities measured in fractions of a cent. Brazilian market for them, too.

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

Securities lending in Brazil is confined to equities even though local investors have a strong preference for fixedincome instruments. Investors are attracted by the high real interest rate in Brazil—about 5.5%, a legacy of scepticism bred by years of poor economic management and hyperinflation during the 20th century. High nominal and real interest rates push the cost of borrowing fixed-income securities to levels hedge funds and other potential borrowers find prohibitive. In fact, demand for fixed-income instruments exceeds the available supply, creating a market for synthetic fixed-income products. “People who are not able to get into pure fixed income are trying to find ways to replicate it through synthetic derivatives,”Linford says.“The market is starting to use equity securities lending as part of that strategy.” Today, Brazil is a capital exporter with robust public finances that put the debt-plagued developed nations to shame. The country has become so popular among international investors that the government imposed a tax on foreign portfolio investments in fixed income, an attempt to stem the relentless rise of the real against the dollar and the euro. The levy is another incentive for financial engineers to

create synthetic alternatives. “It is extremely expensive for foreign investors to participate directly in fixed income because of the IOF tax,” says Linford. In a sense, the Brazilian securities lending model foreshadowed current regulatory efforts to shift trading of OTC derivatives into a cleared environment. BTC, the securities lending arm of Bovespa, knows exactly who the ultimate investors are behind every securities lending transaction and can assess collateral requirements based on all their activities on the Brazilian exchange. The central counterparty guarantees all transactions, which means investors can use securities as collateral even if the position has been lent out.“We apply a haircut, but if you are a lender of Vale, you can use that position as collateral if you borrow another stock,”explains Emilio Meante, securities lending coordinator at BM&F Bovespa. In practice, the overwhelming majority of collateral posted is either Brazilian government bonds or equities, to which the exchange applies different haircuts based on liquidity in the stock. The biggest borrowers in Brazil are local hedge funds (66% of outstanding loans in July 2011) and foreign investors—primarily hedge funds and prime brokers (26%).

Flexible, customised securities lending solutions to meet your changing needs When challenging markets put pressure on investment returns, it’s important to work with a proven lending agent that understands your business. As one of the world’s most experienced lending agents providing both custodial and third-party lending, State Street offers the individualised service, client-facing technology and commitment to transparency you’re looking for. Whatever the market conditions, our dedicated team can help you optimise opportunities without compromising our conservative approach to risk or your need for flexibility. For more information, contact Christopher Holzwarth: UK +44 (0) 20 3395 7689 US +1 617 664 4327

cwholzwarth@statestreet.com www.statestreet.com/securitiesfinance

FTSE GLOBAL MARKETS • SEPTEMBER 2011

SECURITIES LENDING

Don Linford, head of the international securities solutions group at Itaú Unibanco. Photograph kindly supplied by Unibanco, August 2011.

Alejandro Berney, head of securities and fund services for Latin America at Citi. Photograph kindly supplied by Citi, August 2011.

Foreign investors are also the most important source of supply (42%), followed by local mutual funds (26%) and pension funds (24%). Volume has grown rapidly; despite a downturn during the financial crisis, the number of transactions exceeded the pre-crisis peak in late 2009 and rose from that level 90% through May 2011 before easing off in the subsequent market turmoil. In value terms, the numbers are even more dramatic; by March 2011, the value in reais was more than double the pre-crisis peak, although only 72% higher in US dollar terms. BTC charges a standard fee of 0.25% per annum of the value of each lending transaction. As the central counterparty, BM&F Bovespa also arranges mandatory loans to cover settlement failures, in which case the penalty fee is 0.5%.“If an investor sells short equity and does not deliver the position, we will make a compulsory loan on behalf of the client,” says Daniel Granja, risk and securities lending manager at BM&F Bovespa. “It acts as a risk management mechanism for the cash market. The volume of trade failures that are covered by securities lending is very high.” Chile has also adopted the central counterparty model, although the level of activity is much lower than in Brazil because the Chilean hedge fund community is tiny at the moment. Just as in Brazil, movements of securities between accounts free of payment are prohibited, which rules out OTC securities lending transactions. Chilean pension funds have begun to lend their extensive holdings, so supply tends to exceed demand, which comes primarily from the proprietary trading desks of the local brokers and foreign hedge funds. “The market is still nascent,” says Alejandro Berney, head of securities and fund services for Latin America, part of global transaction services at Citi. “There are no prime brokers. Borrowers have to call around and search for securities themselves.” Portfolio managers in Latin America often feel it is their responsibility to generate additional returns from securities lending rather than outsourcing the function to a custodian bank. In the exchange-cleared structure, collateral is managed by the central counterparty and the managers get daily reports of marks and collateral movements. “The

managers like to stay involved,”says Berney.“They don’t have the operational need for someone to service the programme. It limits the opportunity for custodian banks to sell securities lending services.” In Colombia, Berney says pension funds hold ETFs and foreign government bonds that are of interest to international borrowers. The local securities lending market is at a similar stage of development to that of Chile, although Berney points out that it is almost entirely in government bonds rather than equities. “A hedge fund community is starting to play a more active role in Colombia,”he says.“We know more hedge funds there than in Chile or Mexico. In a couple of years we will see more local demand.” In Mexico, the second-largest regional market, securities lending operates much as it does in the US or Europe, where bilateral OTC transactions are the accepted practice. Citi has two programmes for Mexican securities, one based in New York for international investors that accept only cash collateral, and one for Mexican institutions managed by Banamex, its local subsidiary, which takes securities as collateral. “Demand is much greater in the offshore programme,” says Berney. “There are no local hedge funds in Mexico yet.” According to Indeval, the central securities depository for Mexico, international lending agents face few obstacles in entering the business. The rules permit foreign entities to act as both lenders and borrowers, and regulators are actively encouraging the development of a robust securities-lending market in order to improve liquidity, reduce bid-ask spreads and foster more efficient allocation of capital. Indeval itself borrows only to cover settlement failures, although it also operates an electronic securities lending platform, Valpre, which is open to third parties. A competing platform, AcciPresval, is run by Banamex. The potential for growth in Latin American securities lending is apparent from the rapid expansion in Brazil, where local hedge funds—which are mostly regulated entities that resemble 130/30 mutual funds—have propelled the market. What role the custodian banks can play remains to be seen, but as hedge funds spread through the region, demand for securities lending is bound to increase. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

EUROPEAN INVESTING & ASSET SERVICING ROUNDTABLE

DRAFTING NEW RESPONSES TO REGULATION AND MARKET CHANGE

Photograph © Mark Mather/FTSE Global Markets, supplied August 2011.

Attendees

Supported by:

(From left to right) DAMIEN GILLESPIE, executive director, head of Europe and Americas sales at Clearstream Banking FRANK FROUD, executive vice president, head of client management, BNY Mellon MARGARET HARWOOD-JONES, head of client segment for asset managers and alternative fund managers, BNP Paribas Securities Services JOHN GREGORY, group head of technology and middle office, Ashmore Group PAUL STILLABOWER, global head of business development, HSBC Securities Services

FTSE GLOBAL MARKETS • SEPTEMBER 2011

ROUNDTABLE

MARKET INFLUENCES PAUL STILLABOWER, GLOBAL HEAD OF BUSINESS DEVELOPMENT, HSBC SECURITIES SERVICES: At HSBC we spend a lot of time finding client solutions around new regulations. That involves helping our clients navigate the complex, ever-changing regulatory environment, whether it is AIFMD or Solvency II or Basel III, or UCITS IV, and I’m sure there is a five coming from somewhere! Access to emerging markets is also important and given HSBC’s footprint, we are seeing a lot of customers looking for solutions, in particular where they could have access to our local market knowledge. There is also the issue of capital. Capital and balance sheet considerations have been everpresent really since Lehman Brothers went down in 2008; though it does tend to ebb and flow depending on how our customers feel about market conditions. Even so, as we lurch from crisis to crisis, it is definitely something that keeps coming back into the picture. DAMIEN GILLESPIE, EXECUTIVE DIRECTOR, HEAD OF EUROPE & AMERICAS SALES, CLEARSTREAM BANKING: Obviously, Target2-Securities (T2S) is a huge project in terms of our CSD business in Germany. It is going to have a big impact in terms of how we position ourselves moving forward, not just for us as the CSD in Germany but also for the other CSDs around Europe. As Paul mentioned, regulation, Basel III, the EMIR regulations which is upcoming, as well around OTC derivatives, is something that’s actually created an opportunity for us. We have launched a Trade Repository service for OTC derivatives in partnership with the BME (Bolsas y Mercados Españoles). In general, access to liquidity and collateral management are key. Banks are looking for additional venues for liquidity, looking for access to collateral and cash, and they’re looking for a 24/7 global liquidity hub solution. A number of institutions require an automated collateral management partner, be it to access CCPs, be it for their custodian where they need to move underlying client’s assets in a tri-party mechanism, be it for on-exchange trading for derivatives. So we see that having a big impact moving forward. Looking ahead to Target2-Securities (T2S), it is going to be a central bank money/real-time gross settlement product, moving away from the typical model in Europe now where lots of banks have commercial money settlement with their agents. It will have a big impact over the next three to five years. FRANK FROUD, EXECUTIVE VICE PRESIDENT, HEAD OF CLIENT MANAGEMENT, BNY MELLON: The three things that are exercising us at the moment are all predicated on the 25 major infrastructure and regulatory changes that are hitting the market. One is helping our clients with distribution in the world markets; secondly, it is assisting clients with transparency and transformation of their information, using their data for different purposes, aggregating it. The third is helping our clients embrace new operating models. MARGARET HARWOOD-JONES, HEAD OF CLIENT SEGMENT FOR ASSET MANAGERS AND FOR ALTERNATIVE FUND MANAGERS, BNP PARIBAS: It is

interesting that the topics that are front of mind among us seem to be reasonably consistent. We would summarise these things as the trends both clients and the bank are responding to the changed environment post the financial crisis. Clearly, that means a lot of things: regulation certainly is very high on the agenda, irrespective of where you are positioned within the market and the activities you undertake. Moreover, operating in a low interest rate environment, the need for capital, the impact of balance sheet constraint and the need to access liquidity continue to be strong themes which exercise asset servicing providers in finding the right responses to these challenges. Another element is around, let’s say, “restructuring”, meaning the way that clients and their service providers have reacted to the new world order, post crisis. That involves revised priorities, changing business models, and adapting to better position for the future. JOHN GREGORY, GROUP HEAD OF TECHNOLOGY AND MIDDLE OFFICE, ASHMORE GROUP: We are a pure emerging markets manager. The market influences within our organisation are good ones to have. Our challenge is keeping ahead of the rapid growth that we have experienced during the last 18 months or so. This is a feature of the emerging markets perhaps being a little stronger than some of the developed markets and pension funds and sophisticated investors recognising that. We are also focused on diversifying our asset base. We have historically been a majority fixed-income house, but recently we have just acquired a business in Washington that gives us around 20% within emerging market equities. The key activity here is the integration of that business across the global platform. The influence I would point to is the impact of some of the restrictions around capital that the investment banks have imposed since the global crisis. What we are finding is that we now have to go direct into the market in some areas, rather than using derivative instruments to gain exposure. What that means for us is that we are at the frontier of some of this investing, therefore the people that support our business perhaps aren’t fully experienced in the depth that we would require and at the speed we require to get access.

COMPETITION & THE NEW BUSINESS LANDSCAPE FRANK FROUD: We have been through a period of consolidation. I see the fabric of the asset servicing infrastructure globally—and especially with EMEA— unwrapping itself. It is going to rearrange itself in ways that we can’t quite predict at the moment. There will be organisations that are not doing things today that will begin offering services to complement their value chain. There will be others that are providing some custody services in markets today that will decide that they do not particularly want to be in this business any more. We probably get a phone call every week about people thinking about doing new things. Actually, there are a lot of tensions building up in the marketplace. The quality providers, and you have got some of them around the table today, they’ll be around for the long term. There are special-

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

ist providers, and they’ll be there. I don’t think we are going to see any major changes because the days when the largest players are prepared to pay what the smaller players think that they could and should get for their businesses are gone. So we are sitting around with a bit of overcapacity in the marketplace, but that will play out naturally as the T2S infrastructure solutions start to make themselves apparent. I also think that we have got to recognise a certain truth. Visualise a graph going back 15 or 20 years. One line on the graph will show prices coming down. Then marry that with a representation of the risks inherent in providing end-to-end services, and add the cost of reinvestment and people costs. If you factor that risk into the same period, it is clear that if things continue as they have done, we’ll reach a point sometime in the next five years where my clients will be expecting us to pay them for the privilege of managing their risk. That’s not going to happen, right? That’s why the next three to five years are going to be absolutely transformational in our industry. PAUL STILLABOWER: There is clearly one end of the industry that is going to consolidate and that’s hedge fund administration. There are about 80 players in the industry, the majority have no balance sheet, and at the small end they’re often dominated by one large client who they’ve spun out of from. In that scenario it is very difficult—if you have 85% of your assets from one fund manager—to claim that you are actually independent. The small end of the industry is going to continue to consolidate pretty rapidly. I’m not saying there won’t be any independent hedge fund administrators, but I don’t think there will be many. The other trend looming in the not-too-distant future is that the Chinese banks are all quite interested in global custody and securities services. Right now, they obviously have a disadvantage in not having the technology and some of the intellectual capability. Those are attainable. They’re sitting on growth curves that have them at, just with local assets, $10trn in assets in seven to ten years’ time. China is a unique market in that it is growing so quickly and there are a handful of banks that dominate, absolutely dominate, distribution into the market. Potential clients looking to get into China or invest in China or do joint ventures are pretty much having to go through some of those organisations. That’s a really powerful card to hold. FRANK FROUD: Can I plant a teasing thought? Customers don’t talk to me about custody or fund accounting. They talk about the things we are talking about. There is a realisation in the industry that the people sitting around this table are companies that possess intellectual property in the financial services space. In the past we have been selling our products and giving our intellectual property for free. If you accept that we are intellectual property companies and we have global know-how, and you accept the fact that information technology is key because it underpins most of what we do, like me you will be watching the market with interest to see whether people make this natural connection. Instead of consolidation taking place among the traditional providers of investor services, you might begin to see some new partnerships forming. This might have to happen if clients continue to insist on us providing the front end of the business with in-

FTSE GLOBAL MARKETS • SEPTEMBER 2011

Frank Froud, executive vice president, head of client management, BNY Mellon.

formation in a timely and digestible fashion. So I would throw a teaser out there that perhaps the disruptive environment we are seeing right now might give rise to some strange bedfellows going forward. JOHN GREGORY: As an asset manager, we have two conflicting priorities. One is to manage our asset services quite vigorously; and while we have appointed entities to service our book of business, ultimately we have the responsibility and we are the ones that the regulators look to manage those asset services. The second pressure is to diversify the asset servicers for our business and not have all our eggs in one basket, which could result in the effort I mentioned earlier, from the asset manager’s side, all of a sudden doubling. So everything we have to do for provider A, we also have to replicate and respond to provider B. What would be very useful for us is to have that consistency in how the industry connects to and from our organisation so that you can almost plug and play asset service providers because changing an asset servicer is not an easy task and it is not something you take on lightly. The change would not be an easy ride for anybody involved. FRANK FROUD: Actually, the asset management industry has to accept some guidance from large investor services firms. Companies come to us and tell us they want to outsource—but that they want to do it their way. If they listen to us, we will show them how to change their processes to best effect and all in all do it cheaper and faster for them. It is beholden upon people sitting round this table to try and get some commonality because we have always overachieved as an industry. A second point is that the day is rapidly approaching where you won’t be able to fire one provider and hire another one and get a 20% reduction in your fees. JOHN GREGORY: Absolutely. FRANK FROUD: That means that the nature of the relationship in this value chain is going to be wider, it is going to be deeper, it is going to be more meaningful and will probably evolve into an arrangement that is more like the relationship one might have with one’s audit partner as opposed to a provider of services. Now, I’m not quite sure how that’s going to play out, but what it does mean is that we’ll be building ca-

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pabilities quite a long way up the value chain. Is that a good thing? A more standardised approach to doing things, decision support systems, attribution analysis and performance, all of that is really important because it allows us to really drive efficiencies in the front office. JOHN GREGORY: Yes, absolutely. Some of the primary reasons that we have middle offices is so that we can take all these disparate sets of information from different asset service providers and bolt them all together and service and present a consistent view to our front office because they certainly do not want to see the information in 15 different ways, which is a potential that we would have in our current environment. MARGARET HARWOOD-JONES: I guess it is a scary ask; as well as a big ask for John and his teams. That said, I strongly concur with Frank’s remarks. We expect the market will continue to remain highly competitive. While we may argue today that consolidation has happened, with fewer providers and lesser competition in consequence, there remains ongoing activity—whether for example it is hedge fund administration, or elsewhere in the alternative space— with new consolidations bringing new competitive pressure at every step. Perhaps the real excitement and the real level of competitive differentiation is now much more about how asset servicing providers are changing in responding to the new requirements of clients. The traditional space we operated in, where product sets are mature, and where for the reasons we have described earlier pricing is very, very tight remain the raison d’être for working with clients. It is still at the core of what we do, but that is really only the means to enable you to do much more for the client. It is that extension deep into a client’s business that is becoming more interesting. As we move forward, the individual asset services’ response will be different and will again influence the competitive landscape. Whereas in the past you could have argued that we looked pretty homogeneous we can actually see now that in today’s environment you get innovation in different directions from the different firms, dependent on particularly the type of clients they may work with or where they make a strange bedfellow, to use Frank’s turn of phrase. We are, it seems, on the verge of a period in our development where we will start to bring more choice to the market. That in turn could potentially develop or offer new value to the marketplace and to our clients—again impacting the competitive dynamic. ANDREW CAVENAGH: Where do you think that will lead you? MARGARET HARWOOD-JONES: When clients review their operational environment and their relationships, it is usually much more round taking stock rather than wholesale change asking: what can I do to take this relationship to the next stage? Can I do things smarter and better? In this period of second generation thinking in outsourced relationships, you are seeing clients looking again at end-to-end business models and how they work with this service provider or that third party administrator. What works? What doesn’t work? They ask themselves serious questions. Are there things that today they might be doing for themselves that perhaps it is

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more sensible to ask a service provider to do? Have they got the structure and the interaction between the parties perfectly formed? These are now important issues. Rather than wholesale change as a result of those deliberations though, the outcome is more likely to be one of evolution and still working with the same core providers. Typically most clients work with a range of providers anyway—some chosen, some imposed. That’s healthy for all parts of the industry. There are very few, even accepting that the providers in this space are large global banks, who can mean all things to all people. John, you talked earlier about the middle office and there is a point worth adding. FRANK FROUD: To that point, we are not going to compete on price any more. I see a lot of things coming to marketplace and I think, well this is just a glorified benchmarking exercise and I’m not going to spend $1m or $2m, which is what these cost if you are doing a number of big workshops, etc. The supply side are not going to play that game anymore. The discussion now is: am I getting what I need from my provider in order to do my job? Whatever you change, the risk for an operations manager when changing supplier is huge. All you do is move from status quo to status quo ante and in between there is a lot of risk involved. There has to be a compelling reason in terms of capability, in terms of price, in order to get organisations over that line. Would you agree? MARGARET HARWOOD-JONES: I would. You made a point earlier, John, about sometimes in your business you find it hard to find somebody that can help you with a service solution. Maybe you are pioneering in certain areas— meaning there is not yet the proven choice that you would like. Such industry innovators inspire and incentivise us [service providers] to help with those pioneering activities; both client and provider learn more through practical partnership, as opposed to spending ages going through; it is very classic, heavy, very passé. When working together on new developments the level of energy and performance is going to be right up where you guys need it to make a difference. It is a compelling way to demonstrate capability and further embed relationships. We would actually all find that more stimulating and beneficial than having to go through the standard global RFP to show credential. But I’m sure you don’t operate like that, John. JOHN GREGORY: Correct we don’t operate in that mode. However, and I’m sure that this is a difficulty that you all face, do you spend time in lots of R&D and hope your customers come to you, or do you focus where you are getting your revenue? There is a fine balance between the two and one I am glad I don’t have to wrestle with. MARGARET HARWOOD-JONES: From what we see in the market place, both approaches develop side by side. When you think about RDR, when you think about UCITS, these are mandatory developments to a large extent, ones which we all have to respond to. So even accepting that such mandatory change does bring some unique challenges, to understand and cope with Level II measures of different regulatory evolutions for example, it is easier for the providers, with their knowledge and expertise, to look, to un-

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

John Gregory, group head of technology and middle office, Ashmore Group.

derstand and to lead their clients through the consequent product or service evolution, than to let clients go it alone. In these examples we undertake investments (which we are best placed to do) knowing clients will need them, so will come. FRANK FROUD: I would also suggest that clients require us to inform regulators and inform pan-national, decisionmaking bodies as to what our views are. Rather than sitting back as passive observers of the changing landscape, we have to go from being a business to being a profession again. Start to define professional standards and in a professional, proactive manner engage with governments, engage with regulators, engage with the decision-making bodies and start to determine a little bit more what these changes will mean for everyone. MARGARET HARWOOD-JONES: I don’t think as a service provider we have a monopoly on getting it right. The quality of our solutions and our service development is much, much stronger when it is on a collaborative basis with clients. Asset servicers need to make good choices, the right choices for their business and then positively develop and deliver to the clients of their choosing in the spaces where they want to be. Again this also comes back to potentially increased differentiation between us going forward as we make those different choices, dependent on our priorities and our view of the world. ANDREW CAVENAGH: As a provider of asset services, will you have to offer a choice of service packages to different clients in future? PAUL STILLABOWER: Overarching much of what we are talking about, is the fact is that the chief executives of our customers would prefer not to be thinking or talking about asset servicing. They hire COOs and chief financial officers and IT heads etc, to manage that. If the chief executives of our customers had a wish, they’d want us to commoditise the business as quickly as possible. Today 80% of the work that we do, we have tried to standardise or automate, and 20% is really out on the edges, unautomated. In three years’ time some of the 20% will have been standardised because we have to automate and standardise or die, but there are new products that emerge and are unautomated. Pricing has a dependency on the level of automation. In addition, a client may

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want to choose best of breed providers for each service, but there will be a cost in doing that. It will have a negative economic impact versus a bundled solution which might not be as good some areas, but will be at a lower cost. This also impacts how providers are bidding. For example, some providers won’t do fund administration without custody. Transfer agency is another high-cost business. Because of these factors, it is often a harder sell for a COO to go the best of breed approach, because they are saying to their board that we are paying top dollar for each service and the CEO is saying “but I don’t really want to be paying that much for those services”. I’m not saying that the CEO doesn’t understand that there is value in securities services and they understand that there are penalties for making a mistake, it is just they would rather be thinking about other things. DAMIEN GILLESPIE: The question becomes: what else can you do to improve services while being economically efficient. A couple of people have had an idea in the corporate action space, where we are cleansing and scrubbing corporate actions, dividend payments and coupon payments. We are all doing exactly the same thing that all the global banks around here are doing. Maybe we should look at potentially providing a single solution for all our clients in the industry as a whole. We are all replicating the same product and we all review our reversal rates, we all look at how well they’re performing. Maybe it is an idea that we as an industry could get together and look at new solutions. We have done it in the front end of the business, for example, with clients outsourcing their securities back and middle office functions or in partnership with some of the big players. Why not have similar solutions in the asset servicing value chain? Going back to your point Frank, what most of the providers around the table are looking at is a good level of service and it may not be too much different in terms of our product because we are all completing the same tasks using the same benchmarks JOHN GREGORY: In years gone by, getting all the disparate information was a good check and balance for us to make sure that we understand corporate actions appropriately. Because there is better information out there, regardless of which market you are in now, this information is becoming more of a commodity, so there is little value in us receiving 15 different fees about the same corporate activity, yet we do. Of course we still reconcile them because there’d just be that one outlier that we are worried that we would misinterpret what’s happening in the market. So absolutely something like Damien suggests would definitely help us as an asset manager. DAMIEN GILLESPIE: Here again we are in a slightly different space. Most of our clients are central banks, banks and global custodians and we are not directly involved in the asset management space, except for those asset managers looking to lend cash on a secured basis through our tri-party repo service. So, we have found from a transitional situation, that probably in a slightly different sphere that we have had banks and custodians deleveraging their risk and bringing their business to us because of that. From a pure operational risk perspective the heads of operations in banks, or in asset management, tend not to want to move business due to op-

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erational risk. However, I do appreciate there are also costs involved in changing business partner.

REGULATION & ITS IMPACT ON COSTS PAUL STILLABOWER: What puzzles me about regulation is: who’s asking for all of this regulation? This run of regulation is entirely government led. A lot of it would have gone away had we reverted back to an unfettered bull market and booming economies. Unfortunately, we did not and so much of this seems to me shutting the proverbial barn door after the horse has bolted. I just don’t really see any clients or their investors asking for any of these regulations, and I wonder about the end benefit. So many regulations have emerged almost in isolation and the end result is difficult to gauge right now. So what will be the impact of say Solvency II and Basel III and all of the others in between? How will they all fit together? Is there any connectivity between agencies within nations, within regions, across regions? Yet if there is a problem it is going to quickly spread out across the whole of the world economy. I find it quite confusing that these regulations that nobody asked for are continuing to emerge in a random manner and are gathering pace unchecked, rather than in a co-ordinated fashion with an eye to the eventual impact. JOHN GREGORY: Some of the changes that are coming in, certainly around UCITS IV, have been industry led. As an asset manager, a bit like the asset servicing industry, we have continued pressures on our margins and doing things efficiently, doing it once and getting scale is the name of the game while continuing to deliver the investment returns expected from clients. If we are able to passport products and management companies through different jurisdictions, it would certainly help reduce costs. There was an element of that with UCITS III. UCITS IV takes us that one step further. I suggest that there are some very good aspects of UCITS IV that you will see over the next year and there will be changes coming into the way that we service our business and how organisations are structured. Right now, we are grappling with regulation changes in both emerging markets and developed markets, because we have products domiciled in advanced economies and we are gaining market access and investing capital in emerging economies.You could say we are getting hit both ways. The advantage in the advanced economies is at least there is lots of brainpower that goes in to interpret any changes in regulations. However, when an emerging economy changes its tax regulation on Tuesday and they actually mean last Tuesday and not next Tuesday, it can make life rather interesting. FRANK FROUD: Is regulation going to help grow the asset servicing business? Absolutely, yes. I’ve got a huge pipeline of clients and prospects, notably asset managers, wanting to talk to us about outsourcing their back and middle offices for all sorts of reasons. Interestingly enough, we are being sought out more and more to offer advice and consultancy and advisory services around the impact of regulations because clients

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Margaret Harwood-Jones, head of client segment for asset managers and alternative fund managers, BNP Paribas Securities Services.

assume, quite rightly, that large global players such as ourselves really have the horsepower to work on this stuff and provide a clear interpretation. So that’s quite exciting and as we discussed before that it is changing what we ask our people to do, and it is changing the nature of the people we hire to interact with our clients and we are going up the value chain. JOHN GREGORY: Obviously that reconciles to what you were saying earlier on about the kind of people we are now interfacing with. They are very different now than they were three or four years ago, and that trend probably will continue. PAUL STILLABOWER: At HSBC, we love uncertainty because everyone gravitates to what I would say are our structural advantages: balance sheet strength, a global footprint and a trusted brand. I can also understand why some of the regulations are, on paper, perceived as required, for example, strict liability, investor protection, a smaller number of larger, passported funds. But I still don’t see that anyone’s really thinking that much about the end investor. The upshot of these regulations is going to be that someone is going to have to pay more to invest; and that’s going to be the end investor. Then again, in assets servicing, as these regulations look today, you are going to see asset managers or other investors gravitate towards larger providers that have scale and balance sheets and global distribution networks, that can do things at a lower cost to offset otherwise increased costs of regulation. That’s probably not great for some local providers or smaller specialists. Will investors be happy with this outcome? I keep asking the question: who is actually asking for this and who’s benefiting. ANDREW CAVENAGH: In that respect, I suppose the AIFM is potentially the most damaging for the asset servicing. PAUL STILLABOWER: It might be damaging for the people that want to invest in alternative investments. JOHN GREGORY: I don’t think it threatens us too much. PAUL STILLABOWER: No, either organisations will choose not to offer the service or they will charge for the service. Providers are not going to be an insurance company for free. ANDREW CAVENAGH: No, I was thinking more for the sub-custody providers. MARGARET HARWOOD-JONES: That’s a very good

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point. I’m not sure that I disagree with some of what’s already been said and as service providers we have some responsibility to try and reduce complexity on behalf of our clients. I also think we have a very important role, irrespective of the cause of some of the regulatory developments that we are facing. We need to take ownership to try as best as we can manage the consequence of it. So when we look at the whole regulatory development cycle, our ability to be proactively involved, to be active in consultation, we must be responsible to promote an environment that is right and appropriate. You mentioned AIFM Andrew. We have to watch out that, in this example, the asset servicing industry does not become an insurance company needing to underwrite everything. So the debate is out there. Now is absolutely the time that we should rise to the challenge and use our knowledge and our experience to influence the best and the most appropriate outcome. At the same time we all need to continue doing all the good practical stuff that helps our clients through the morass and the extent of change we face. DAMIEN GILLESPIE: Obviously, there is a cost to the industry but at the same time if you have thought leadership and you are pretty well up in terms of what’s going to happen, it does create opportunities. Creating opportunities is about the partnership approach in the industry and I thought I’d mention at this point, obviously, the OTC derivative market is going to go through a lot of change in the near term, where new regulation will push OTC reviews onto exchange to be cleared. That creates opportunities for all the players round the table here. The same is true of the T2S initiative. We have got a lot of good people working in strategy, in thought leadership and these days there is definitely a consultancy approach required for selling successfully. FRANK FROUD: Just look at it from another direction. Banks exist because we should be better at managing risk on behalf of our clients, and as these various pieces of regulation come into play, we will see that risk is managed in different places. We have to make sure as an industry that we don’t stir up the law of unintended consequences because there could conceivably be (and UCITS IV might be one of them) regulation which places so onerous a burden on the industry that we decide we are not prepared or can no longer offer this service on a commercial basis and underwrite this risk via our balance sheet. We have got to engage in the debate. MARGARET HARWOOD-JONES: Having a fiduciary or oversight responsibility in a lot of what we do is part of this taking risk and is something that we do on a day-to-day basis. However, there is real concern that we are potentially being asked to step even beyond the bounds of that, that we are inadvertently being asked to undertake investment risk that should sit with the asset manager, or even the investment risk that sits with the investor himself. FRANK FROUD: I couldn’t agree more. MARGARET HARWOOD-JONES: That’s something that we must very strongly protect against for all of the right reasons. FRANK FROUD: Trustees may be required to tell fund managers that they should not be investing in four or five

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markets, for example. We need good clear regulation, not fast regulation, good, strong, international regulations, not illthought out, rapidly implemented regulations. ANDREW CAVENAGH: John, is it a concern of yours that regulation, well the raft of regulation, impending regulation, is going to increase the cost of asset servicing? JOHN GREGORY: I have two concerns. One is obviously cost. The other is risk, which is actually the larger issue. Do we have the time to interpret the regulations because they’re not black and white? Do we have the manpower and resources to invest in time doing that? Equally, how do we then adapt our systems process, risk control frameworks, disclosure, whatever it may be, to help us respond in a timely fashion? Regulations usually dictate a certain time period by which you have to come into compliance while at the same time you are trying to grow the business. Our business is certainly not on a flat line. We have a very aggressive and exciting growth trajectory ahead of us and we’d like to focus on where we add value, which is alpha to our customers. Ultimately though we also have to respond and do respond to change in regulations. So it is a challenge. DAMIEN GILLESPIE: Going back to Paul’s point, the OTC derivatives space has volumes of around $400trn, so of course the regulator does have to act upon and review the current operating model.

THE ROLE OF TECHNOLOGY FRANK FROUD: Sun Tsu said that the “line between disorder and order lies in logistics”. Technology is to our business what logistics is to warfare. The competitive advantage in our industry today is the art of what technology can deliver. It is front and centre of every single thing we do these days and it is absolutely vital. We probably have not, as an industry, had our technologists close enough to the business in the past, but that has changed. JOHN GREGORY: From an asset management point of view, clearly how we interface with our service provider is key and depending on the type of instrument of trade, depending on the counterparty that you are trading with and depending on the asset service that you are settling through, you could have up to three times the complexity around how you would service transactions. Equally, as an asset manager your business comes from multiple customer streams, family officers and sovereign wealth funds for instance and they’ve all got their own asset provider. It can potentially turn the middle office function and some of the settlement, the transaction processing-type roles, into mammoth tasks, transmitting lots of data, though I use the word data loosely, and I probably mean paper in some areas. It is front and centre to what we do. It also comes back to the need for consistency/standardisation over and above beloved SWIFT. It would just help people in the asset management industry enormously. Perhaps it will be a business opportunity for service providers because we can perhaps wean ourselves off some of the things that we control ourselves. We ask ourselves why we are doing it and it is not

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because we think we are better, it is because we have to. Technology, then, is key. The trouble with technology, by the time you implement it, is it is usually obsolete so you need to invest in it continuously. PAUL STILLABOWER: I agree with both Frank and John that technology is critical and again, our clients expect us to keep investing and keep commoditising and making standardisation gains. We have put a lot of investment into streamlining our technologies so that we have a single global transfer agency system, a single hedge fund administration platform globally, two fund accounting systems globally, and one global custody platform and so forth. However, backing that is the huge intellectual capital that our people bring to the business. It is both at the most complex end of the investment spectrum, where we have people on the ground in 26 fund centres and all of the emerging markets for sub-custody where local regulatory knowledge is a huge asset. Having those people on the ground and who really understand local requirements is important and is something that our clients value. ANDREW CAVENAGH: Will the level of expenditure on technology continue to rise? Or will it eventually reach a plateau? FRANK FROUD: That’s a very interesting question and I’m not sure I know the answer. I used to run some large technology budgets and was constantly looking at the difference between what is in there to maintain the status quo and what is value-added. We spend a lot each year in technology and I think the level of spending will stay roughly the same going forward. However, given all of the trends and developments discussed today, we are going to become a whole lot smarter about how we spend on our technology. It amazed me when I worked in technology and I went to Microsoft’s labs in Seattle and there were guys with white coats doing really, really smart stuff and mixed in with them were engineers working for their competitors. I said: “Wow, I thought you were competitors.”They told me that when they go live with innovation it has got to work with HP PCs, on Compaq PCs, on Dell PCs and so on. Equally, while we will spend around the same on technology going forward we will get a lot more value for money out of it as a new generation of technologists come through. It is going to take some work, but it is achievable. DAMIEN GILLESPIE: I’m just looking back to these new regulations and T2S. You are probably aware of Link-up Markets, which is a technology company in effect, which has been capitalised by ten CSDs, Clearstream being one of them, eight in Europe and two in Africa; there has been a lot of interest from Asia as well. Clients can today complete CSD to CSD cross border settlement directly from Clearstream Banking’s Frankfurt account using the Link-up Markets technology. Again, rather than a company trying to build out the links themselves, they’re capitalising an IT company and they’re effectively doing the mapping between the CSDs in advance of T2S and in advance of the global framework that everybody is working on. Going back to technology, if you look at core custody (and you may have a core custody

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Damien Gillespie, executive director, head of Europe and Americas sales at Clearstream Banking.

platform) there are maybe two or three big releases a year and if they’re SWIFT driven, it does tie you down.

NEW BUSINESS OPPORTUNITIES DAMIEN GILLESPIE: I’ve been at Clearstream just coming up for five years and year-on-year our business has grown, both from an ICSD and CSD perspective. We feel we are winning market share as many clients look for access to liquidity, and collateral management has been a key feature of that trend. Moreover, the bank-to-bank market has moved away from unsecured to secured lending and we have seen a lot of institutions join our tri-party repo programme. Funnily enough, quite a lot of the small, medium-sized banks in Europe and beyond did not do repo transactions in the past, but have now moved into that space and now require collateral management services support. It has resulted in record volumes in terms of our outstandings for collateral management; we had record volumes of $550bn of outstandings in our Global Securities financing programme at the end of last year and hit $600bn in July of this year. Equally, our partners at Eurex have a product called Eurex GC Pooling, which has been a hugely successful. It has also helped Clearstream, which collateral manages securities for this product. We see lots of new banks using this trading platform via Eurex Clearing which is the Clearing House and Central Counterparty (CCP) for all GC Pooling transactions, thereby allowing anonymous trading and settlement netting of EuroGC baskets, it helps them gain access to new sources of liquidity and adds diversity to their range of counterparts. Our model has been very much based on partnership approaches. We recently, for example, went into partnership with CETIP, one of the largest Brazilian CSD’s. The other part of our business is the investment funds side which Paul will be familiar with. As a Luxembourg-based bank on the ICSD side of our business, that’s been quite a successful product for us. We also launched a product called Central Facility for Funds (CFF), which effectively is bringing in a DVP model to the funds industry, working on the same platform (Creation) that we have for equities and bonds. That’s been hugely suc-

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cessful and, as well as that, we have seen that banks that are looking to mobilise additional securities types for financing, going back to that collateral story again. In that light we launched our collateral management engine servicing for investment funds and equities, because we saw in the crisis that the bond market obviously was quite distressed and there were bonds you couldn’t get prices for. MARGARET HARWOOD-JONES: Firstly, just over 12 months ago at a business line level, so within Securities Services, we reorganised our efforts, creating four global business lines and importantly creating a new global client development function, which is organised around client segments and geographies. We think this has helped us to be more strongly associated with our clients and our marketplace, to even better understand clients’ needs so that client teams then working with the business lines can ensure that the bank is in a strong place to respond to client needs. These changes, partly an acknowledgement that post crisis the dynamic in our industry is even greater and the amount of change and the complexity around change is significant. This has been a positive and a good thing to do. Secondly, coupled with this, we are now collaborating very strongly with other parts of BNP Paribas. This is becoming more and more critical. There are other activities within the bank that we can be very smart in working alongside, so today many developments are joint initiatives with different parts of the investment bank, whether that’s around areas such as collateral management or OTC derivatives, for example. The process recognises that at the end of the day we have the same shareholders ultimately and we can be much smarter for ourselves and for our clients if we work effectively in delivering the broadest range of solutions that we believe the market is looking for. In terms of where our business has come from, it is proving very broadly based. We have many existing clients with whom we are doing more business and that’s about responding to the new needs that they have and to their change requirements, potentially to changing operating models, and looking for the bank to support them in a different way. We have also been fortunate enough to work with clients that have been acquisitive in their own right, so programs around execution and onboarding of new assets. At the same time, the bank’s franchise is growing strongly. We are globalising our business; a very significant investment in the last two to three years in Asia, so now we are very excited to begin to see returns on some of that investment. JOHN GREGORY: The themes we see are developed markets (in terms of investing capital) are becoming a lot more focused on emerging markets. They’ve historically under-allocated to this area and are more open to increase exposure. What we have decided to do is diversify our traditional institutional-only model and we have over the last couple of years launched two core products that we are distributing. One is a US 40 Act umbrella and by virtue therefore we are distributing quasi retail, we call it; we are not going direct to Mr and Mrs Jones but we are distributing through the private wealth mortgages, broker dealers, those sorts of institutions. Then in Luxembourg we launched a range of

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SICAV funds, utilising a similar strategy. We also have institutional share classes and that gives us the luxury of distributing in all of the countries that accept UCITS as a deemed appropriate regulatory framework. It has given us is quite a significant platform to really tackle some of the capital sourcing from these major markets. We have seen also a push coming in from Asia. While much of Asia is deemed as emerging markets, there is a lot of interest to invest in those markets and we have seen significant flows coming in. From a corporate view, historically the majority of activity has been very London-centric, but as we have expanded both our investment model in terms of access to liquidity and also access to our customers on a timely basis, this means we are expanding East and West concurrently to meet those needs. The other key strand of our growth strategy is sourcing local capital for local investing. In terms of where it is coming from, it is fairly well diversified. PAUL STILLABOWER: We all start to overlap here; like Margaret, we are similarly organised around client segments, and we are focused on delivering more specialised solutions to those client groups. However, when you step back and look at the macroeconomic trends, the shift into the emerging markets, obviously there is faster wealth creation happening in the East and in the South. There is the south-south trade, which although a geographic misnomer, the end result is the same, Europe and America are going to start getting cut out of business that is happening directly between emerging economies. There is obviously a long-term question mark around the dollar as the world’s reserve currency and you are starting to see some of the more forward planning clients, like the sovereign wealth funds, start to position for that. Then, the poor economy with continual issues in Europe, and inflation in China, debt in the US etc, are all having an impact. Besides the regulators, investors in our clients’ products face the same issues and are making the same demands, calling for transparency, segregation and independence. That’s manifested itself, in HSBC—where we are seeing the opportunity to do more trading and financing, which I would say are the higher margin businesses, with clients self-collateralising that activity through means such as custody and fund administration. It means we are actually doing more in the high value products area at a lower risk for the customer and for us. Securities services generally, has always been a business where you have to take care of your existing clients, who are launching new funds, going into new markets. This delivers 60% growth year on year. We are also focused on delivering value to strategic clients and we’d like to have deeper relationships with those clients. FRANK FROUD: We are now in a new reality, and the asset servicing business is about to go through an unprecedented period of change. If you look back 15 or 20 years, we spent five or seven years automating our industry. That set the preconditions for consolidation and a lot of the people represented around this table have been consolidators in the industry. We then went offshoring for all sorts of reasons, to cut costs down, so unless there are people in Mongolia that will cut net asset values for free, the ability to strip costs out

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ROUNDTABLE

of the value chain is coming to an end. That will mean one has to look at the entire value chain. At one end you have traditional custody and at the other end you have decision support systems for fund managers with everything else in between. All incoming regulation, such as UCITS IV and T2S, makes sense. Those new regulations all have their own logic. The challenge is when you put them all together and see what it all adds up to. We are going to have a lot of opportunity arising out of the value chain where activities that may have historically been done at the front-end—performance, risk, analytics, attribution analysis—are going to be pushed to people at the backend to do. It will require, in whatever shape it finally takes, people in the asset servicing space to take a greater degree of fiduciary oversight on what’s happening at the front-end. I also think that fund managers are going to experience the same pressure to sweat costs out of the front-end. Something has got to give because it looks as if we are going to spend in the order of $100m over the next three to five years getting our systems fit to deal with these 25 major regulations. That degree of expenditure means it has to be absorbed somewhere, which is why I don’t see there being a pricing game anymore. I also see that we are going to have to start charging for these value-added services in a slightly different way. JOHN GREGORY: Regulation is one issue. How do we ensure that front to back and through the middle as well, that we can remain joined up on interpreting the regulations because they’re not always as clear as you would hope. We are going to have to interpret those regulations and introduce some change, whether it is through reporting or the way that we will clear a particular instrument; we are duty bound to respond and be compliant. Having our asset services side-byside as opposed to behind us, is crucial for success. Transparency is a theme we are struggling with; our clients are asking us for more detailed information, where are we getting our performance from, where is the risk, what counterparties are we using? All sensible questions that you’d expect postcrisis, but our ability to respond, both from an internal point of view, but also the people that support us, can be challenging and the more sophisticated investors, their demands are extremely detailed and often unique. It would be a fool’s errand to think that they don’t use this information; they absolutely do. They analyse it to the smallest detail of data, so getting it right is important. We talk about value chain, that what’s been important to Ashmore is having the proximity to the front office and the increasing demands, but also having a middle office that are almost front office“lite”-type people. These people do interpret the information, they can speak eloquently about attribution and exposures, but they in turn have to communicate to the asset servicing organisations. People we are interfacing with today are different to the people that we have interfaced through five or six years ago. PAUL STILLABOWER: We all agree that the pricing model needs to change and we need to be compensated for the increasing cost of the capital that’s going to be required in the business, as we work through the regulations. One of the issues is, as an industry, is that there is not a good track

106

Paul Stillabower, global head of business development, HSBC, Securities Services.

record of having controlled our pricing models. It is still true today. There are firms in the securities services industry that are still following a hope-and-pray strategy and pricing on the basis that at some point in the future, the near future, they’ll be making money from the value-added services that have traditionally been the profit generators for the industry. That’s not a good strategy. In the short term clients might think they’re getting a bargain because they’re getting below cost pricing, but they need to be thinking about what happens if the provider is in financial trouble or cannot invest in the business. What’s complicated, and Frank mentioned this, is that regulations have almost emerged in isolation and it is very difficult to actually put the puzzle together and see what the overall impact is going to be and how that will impact pricing. DAMIEN GILLESPIE: In general in the custody world prices have been going down. If you look at the recent Oxera study, it reflects (from a CSD perspective) that prices have dropped on average between 25% and 35% for clearing and settlement. Pricing is always a big, big question. As Paul says, how do you actually price all the value-added services and the corporate actions? If you had a failure of a tax event, how do you price for that? There will be probably be a lot more unbundling of pricing, and clients will be looking to buy on the value-added; what else can you actually give to the client? If you are dealing with the standard global custodian who wants to place their assets with us, then yes, price is very, very important. Risk is very important, asset servicing is very, very important and we work very hard on our service levels. However, if you are speaking to a bank that’s looking for access to liquidity and access to collateral management services and access to central bank money or via a CCP, the pricing of custody and settlement doesn’t generally come into the conversation, it is quite low down their agenda. Again, going back to the liquidity side of things, it will be key, absolutely key moving forward. Aside from that, it is pretty much about what else can you bring to the table in terms of leveraging the other products and services you have, leveraging your balance sheet and bringing real value and additional functions to those clients. I

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

(Week ending 5 August 2011) Reference Entity

Federative Republic of Brazil United Mexican States Republic of Italy Bank of America Corporation Kingdom of Spain Republic of Turkey JPMorgan Chase & Co. Telecom Italia SPA MBIA Insurance Corporation Russian Federation

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Financials Government Government Financials Telecommunications Financials Government

Sov Sov Sov Corp Sov Sov Corp Corp Corp Sov

17,932,057,244 9,102,557,377 24,669,962,838 5,902,468,661 18,209,416,361 6,255,627,326 5,187,221,904 2,610,986,014 4,087,755,064 4,029,922,090

181,565,455,839 124,219,700,486 314,474,261,187 82,810,588,277 184,281,106,578 143,411,206,488 85,068,704,775 72,448,271,079 79,615,492,127 104,001,460,391

12,197 9,874 9,703 9,063 9,041 8,905 8,577 7,605 7,464 7,415

Americas Americas Europe Americas Europe Europe Americas Europe Americas 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

24,669,962,838 23,201,707,258 18,209,416,361 17,932,057,244 17,444,299,169 12,206,531,662 10,969,667,630 9,102,557,377 8,720,464,486 7,764,250,919

314,474,261,187 116,832,594,229 184,281,106,578 181,565,455,839 102,732,818,771 68,565,128,535 95,407,451,873 124,219,700,486 53,425,699,945 50,014,464,810

9,703 5,978 9,041 12,197 3,383 4,987 7,239 9,874 5,472 5,144

Europe Europe Europe Americas Europe Europe Americas Americas Japan Asia Ex-Japan

Top 10 net notional amounts (Week ending 5 August 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 People's Republic of China

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 5 August 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,446,049,315,201

442,149

French Republic

10,874,985,000

780

Sovereign / State Bodies

2,814,520,129,123

210,100

Republic of Italy

7,250,560,649

585

Corporate: Consumer Services

2,156,539,790,897

352,811

Kingdom of Spain

5,339,273,908

515

Corporate: Consumer Goods

1,672,357,533,755

260,922

UK and Northern Ireland

2,811,615,000

372

Corporate: Technology / Telecom

1,356,697,511,284

204,808

Federal Republic of Germany

2,718,180,059

161

Corporate: Industrials

1,313,203,978,518

220,564

Republic of Turkey

2,545,667,350

244

The PMI Group, Inc.

2,406,855,309

227

Federative Republic of Brazil

2,117,950,780

175

MBIA Insurance Corporation

2,078,384,244

231

Kingdom of Denmark

2,075,831,636

985

Corporate: Basic Materials

1,024,663,386,689

161,391

Corporate: Utilities

810,110,596,400

124,384

Corporate: Oil & Gas

490,081,392,989

87,040

Corporate: Health Care

352,618,740,947

60,723

Corporate: Other

147,885,446,206

15,565

CDS on Loans

68,643,732,185

17,983

Residential Mortgage Backed Securities

61,227,833,672

11,898

Commercial Mortgage Backed Securities 18,751,125,966

1,712

Residential Mortgage Backed Securities* 14,571,852,757

955

CDS on Loans European

5,047,227,525

701

Other

1,449,413,278

Muni:Government

1,207,400,000

128

Commercial Mortgage Backed Securities*

735,797,244

Muni:Other

135,000,000

CDS Swaptions

107,181,000

Muni:Utilities

27,150,000

*European

FTSE GLOBAL MARKETS • SEPTEMBER 2011

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

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

107

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 5th August 2011 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.63 7.78%

2.26 5.40%

2.13 5.26% 0.02%

1.91 4.36%

1.96 5.51%

31.16%

23.47%

4.62% 17.30%

19.12%

0.18%

1.34%

22.74% 64.06% 0.03% 0.06% 0.88% 0.06% 0.01%

Europe

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

51.51% 0.09% 0.08% 0.04%

0.17%

0.05%

61.46% 68.43% 69.94% 0.00% 8.23% 0.02%

9.21%

VENUES

6.71%

3.72%

6.63%

VENUES

INDICES

DOW JONES

S&P 500

INDICES

S&P TSX Composite

FFI

4.93

4.59

FFI

2.01

2.03

BATS

11.57%

12.07%

Alpha ATS

18.83%

18.81%

BATS Y

3.78%

3.45%

Chi-X Canada

11.58%

12.30%

CBOE

0.06%

0.04%

Chicago Stock Exchange

0.32%

0.23%

EDGA

4.95%

4.35%

EDGX

8.75%

7.75%

NASDAQ

25.76%

26.77%

NASDAQ BX

3.64%

3.10%

NQPX

2.48%

1.70%

NSX

0.70%

0.73%

NYSE

22.14%

24.18%

FFI

NYSE Amex

0.07%

0.12%

NYSE Arca

15.77%

15.53%

VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

Australia Hong Kong

100.00% 100.00%

S&P TSX 60

TMX Select

0.17%

0.31%

Omega ATS

2.37%

2.86%

Pure Trading

3.65%

3.51%

TSX

63.40%

62.20%

VENUES INDICES

INDICES

Asia

Canada*

INDICES

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

INDEX NIKKEI 225

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

1.33 2.53% 0.00% 0.07% 0.00% 0.00% 2.32% 86.31% 8.77% 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/.

108

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

HERE HAVE BEEN some interesting developments over the summer in the European equities landscape, particularly where the MTFs are concerned. The data shows that those MTFs that adopted a niche approach – Burgundy, TOM MTF and Equiduct – have proved successful. The first two opted from the start to focus on specific indices (Stockholm's OMX S30 and Amsterdam's AEX, respectively). Equiduct provides a more interesting case. Starting out as an institutional platform, it subsequently re-launched with the aim of attracting retail order flow and, from the beginning of this year, started to concentrate the majority of its trading activity on the CAC 40. For all of these venues, their total market shares may still be modest by pan-European standards (chart 1), but they are managing respectable volumes in some stocks. For the month of July, for example, Burgundy traded more than 11% of Lundin Petroleum with a market share in that particular stock greater than that of either Bats Europe or Turquoise and edging very close to that of Chi-X (chart 2). Chart 1: Lit market share by venue, Europe (July 2011) 20.48%

Bats Europe 11.79%

LSE Paris

11.14%

Deutsche Börse

10.79%

11.98% Burgundy

3.49% Bats Europe

13.15% Chi-X

3.16% Turquoise

0.01% NYSE Arca

68.21% Stockholm

*LUPE.ST

Whilst the long-term viability of these smaller MTFs is yet to be proven, it would appear that they can be at least moderately successful in establishing market share. This is good news for soon-to-be-launched PAVE which will be looking to break Madrid’s monopoly by offering a credible Iberian alternative. At the same time Xetra International, which began with a panEuropean focus, is now trying to find its own niche in the European trading landscape, concentrating its trading activity on the FTSE MIB. The pan-European MTFs have been jockeying for position over the summer too. Chi-X is continuing to grow its market share steadily across all European indices, whilst the relative market shares of Bats Europe and the LSE’s Turquoise could be starting to invert (chart 3) with Turquoise attaining eighth position in the market share league table for July.

8.43%

Milan

7.18%

Madrid SIX Swiss

5.87%

Turquoise

5.86%

Bats Europe

5.62% 3.87% 3.52%

Amsterdam Stockholm Oslo Helsinki

Chart 3: Lit market share by venue, Europe (Jan-July 2011) Bats Europe

15%

0.86% 0.67%

Equiduct

0.39%

Lisbon

0.35%

Burgundy Frankfurt

0.28% 0.10%

NYSE Arca

0.10%

Dublin

0.07%

TOM MTF

0.03%

Munich

0.01%

Hamburg

0.01%

Xetra International

0.01%

Düsseldorf

0.00%

Berlin

0.00%

0% 07-Jan

0.00% 0%

10%

Turquoise

20%

10%

Brussels

Chi-X

25%

1.32% 1.24%

Copenhagen

Hanover

Chart 2: Lit value breakdown, Lundin Petroleum* (July 2011)

15%

20%

25%

09-Feb

14-Mar

16-Apr

19-May

21-Jun

24-Jul

There are a number of factors that could account for this. It could be that the new Millennium IT technology implemented by Turquoise might now be fast enough to attract a higher percentage of high frequency traders. It is also possible that the market is simply rebalancing in anticipation of the BATS/Chi-X merger, or it could be that the aggressive price promotions introduced by Turquoise for NYSE Euronext stocks have succeeded in attracting additional order flow. It will be interesting to see if Turquoise can retain its position, particularly in light of the interoperability program introduced by Bats Europe at the end of July allowing trading participants to elect a preferred CCP - LCH.Clearnet, x-clear or EuroCCP. I

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

FTSE GLOBAL MARKETS • SEPTEMBER 2011

109

GLOBAL ETF SUMMARY

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

No. of ETFs 455 358 99 290 90 171 159 125 62 46 54 13 11 35 13 21 29 8 22 38 36 32 26 18 17 11 11 597 2,847

July 2011 Total Listings AUM (US$Bn) 1,627 $364.5 633 $321.4 234 $128.5 975 $108.0 126 $80.1 417 $59.9 288 $54.1 355 $49.2 120 $35.1 86 $16.8 67 $16.5 34 $16.3 19 $16.0 42 $10.2 14 $9.5 26 $9.0 115 $9.0 13 $8.1 23 $7.4 48 $6.5 46 $3.4 38 $3.4 26 $2.2 19 $2.0 38 $1.9 11 $1.2 13 $0.9 917 $103.9 6,370 $1,444.8

% Total 25.2% 22.2% 8.9% 7.5% 5.5% 4.1% 3.7% 3.4% 2.4% 1.2% 1.1% 1.1% 1.1% 0.7% 0.7% 0.6% 0.6% 0.6% 0.5% 0.5% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 7.2% 100.0%

ADV (US$Bn) $7.8 $33.1 $2.2 $2.4 $8.8 $1.2 $2.2 $0.4 $4.4 $0.9 $0.0 $0.1 $0.1 $0.1 $0.3 $0.0 $0.1 $0.1 $0.1 $0.2 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1.6 $66.3

No. of ETFs 65 43 17 2 21 8 19 13 1 5 1 0 2 0 0 3 0 2 8 13 0 1 16 1 2 1 0 143 387

Total Listings 306 80 29 -1 29 34 33 45 20 6 3 0 3 0 0 4 4 6 8 15 7 5 16 1 5 1 1 220 880

YTD Change AUM (US$Bn) $26.6 $20.3 $17.3 $18.0 -$0.4 $5.0 $6.5 $4.0 $3.4 $0.2 -$0.1 $1.0 $1.4 $1.7 $1.8 $1.4 -$0.5 $2.3 $0.9 $0.8 $0.6 -$0.2 $0.3 -$0.6 $0.2 $0.2 $0.1 $21.4 $133.4

% AUM 7.9% 6.7% 15.6% 20.0% -0.6% 9.0% 13.7% 8.9% 10.6% 1.0% -0.7% 6.5% 9.4% 20.1% 23.4% 17.8% -4.9% 39.7% 13.9% 13.5% 19.6% -5.3% 17.0% -23.6% 13.5% 14.3% 8.3% 26.0% 10.2%

% TOTAL -0.5% -0.7% 0.4% 0.6% -0.6% 0.0% 0.1% 0.0% 0.0% -0.1% -0.1% 0.0% 0.0% 0.1% 0.1% 0.0% -0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% -0.1% 0.0% 0.0% 0.0% 0.9%

Source: BlackRock Investment Institute - ETF Research, Bloomberg

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

4.6%

Provider

Dec-2010

% Mkt Share

Change (%)

SSgA

$18,667.3

40.3%

$30,815.6

46.5%

$12,148.3

65.1%

iShares

$14,028.5

30.3%

$17,665.5

26.6%

$3,636.9

25.9%

PowerShares

$2,413.3

5.2%

$3,663.6

5.5%

$1,250.3

51.8%

ProShares

$2,660.7

5.7%

$3,286.1

5.0%

$625.4

23.5%

Direxion Shares

$1,860.7

4.0%

$3,025.7

4.6%

$1,165.0

62.6%

Others

$6,710.2

14.5%

$7,858.2

11.8%

$1,147.9

17.1%

Total

$46,340.7

100.0%

$66,314.6

100.0%

$19,973.8

43.1%

Direxion Shares

5.0% ProShares

5.5% PowerShares

11.8% Others

46.5% SSgA

26.6% iShares

Source: BlackRock Investment Institute - ETF Research, Bloomberg

Top 20 ETFs worldwide with the largest change in AUM As at end July 2011 ETF iShares MSCI Emerging Markets Index Fund iShares DAX (DE) Vanguard MSCI Emerging Markets ETF db x-trackers DAX ETF SPDR S&P 500 Market Vectors Agribusiness ETF iShares MSCI Japan Index Fund iShares Russell 2000 Index Fund PowerShares QQQ Trust Vanguard REIT ETF iShares NAFTRAC Vanguard Dividend Appreciation ETF iShares Barclays TIPS Bond Fund iShares S&P US Preferred Stock Index Fund iShares MSCI EAFE Index Fund iShares S&P 500 Vanguard MSCI EAFE ETF Technology Select Sector SPDR Fund iShares S&P 500 Index Fund iShares MSCI Germany Index Fund

Country listed US Germany US Germany US US US US US US Mexico US US US US United Kingdom US US US US

Bloomberg Ticker EEM US DAXEX GY VWO US XDAX GY SPY US MOO US EWJ US IWM US QQQ US VNQ US NAFTRAC MM VIG US TIP US PFF US EFA US IUSA LN VEA US XLK US IVV US EWG US

AUM (US$ Mil) July 2011 $38,540.7 $14,883.1 $50,243.4 $8,139.1 $93,322.2 $6,032.8 $8,263.8 $14,305.4 $24,789.2 $9,780.5 $7,692.9 $6,720.7 $21,406.9 $8,115.4 $38,854.3 $9,800.1 $7,150.6 $7,625.7 $27,539.2 $3,603.4

AUM (US$ Mil) December 2010 $47,551.5 $5,917.7 $44,569.8 $3,693.1 $89,915.3 $2,631.5 $4,883.3 $17,498.4 $22,069.9 $7,503.7 $5,472.5 $4,608.9 $19,407.4 $6,120.7 $36,923.1 $7,905.8 $5,304.0 $5,849.3 $25,799.2 $1,881.7

Change (US$ Mil) -$9,010.8 $8,965.4 $5,673.7 $4,446.0 $3,406.9 $3,401.3 $3,380.5 -$3,193.0 $2,719.3 $2,276.8 $2,220.4 $2,111.8 $1,999.5 $1,994.7 $1,931.2 $1,894.3 $1,846.5 $1,776.5 $1,740.0 $1,721.7

Source: BlackRock Investment Institute - ETF Research, Bloomberg

110

SEPTEMBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Global ETF listings As at end July 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

July 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 Taiwan Australia Singapore South Africa Brazil India New Zealand Malaysia Thailand Saudi Arabia UAE Colombia Indonesia Botswana Chile Egypt Israel Philippines Sri Lanka

1,042 1,190 1 1 1 272 420 3 1 14 23 16 7 1 3 1 1 12 23 130 12 248 198 86 47 26 19 97 15 30 25 26 8 20 6 4 3 2 1 1 1 -

173 269 55 59 1 12 2 1 3 1 13 58 3 61 51 12 18 8 6 15 15 12 3 3 4 1 1 2 1 -

150 144 16 51 4 1 2 5 22 43 42 6 7 11 35 3 11 4 1 4 1 -

1,042 4,173 21 28 1 500 1,262 3 1 14 560 115 15 3 3 1 1 68 87 729 12 749 238 90 76 26 351 97 18 51 83 26 8 20 6 5 3 2 1 1 1 1 51 -

$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 $2.8 $3.9 $3.6 $2.3 $1.9 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 $0.0 -

$969.4 $324.4 $0.1 $0.0 $0.2 $60.4 $128.4 $0.1 $0.0 $0.4 $2.5 $0.3 $0.8 $0.1 $0.1 $0.0 $0.0 $1.4 $3.0 $50.7 $0.2 $75.8 $41.6 $32.4 $27.6 $11.8 $10.1 $8.4 $6.3 $3.9 $3.2 $2.6 $1.7 $0.5 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 $0.0 -

$78.3 $40.4 $0.0 $0.0 -$0.1 $0.6 $17.7 $0.0 $0.0 $0.0 $0.0 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.1 $0.1 $12.7 $0.0 $9.1 $3.2 $0.2 $1.3 $1.7 $1.9 $3.0 $3.4 $0.0 -$0.4 $0.3 -$0.2 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

8.8% 14.2% -25.9% -26.3% -18.1% 1.0% 16.0% -19.8% 10.2% 1.9% -0.1% 4.0% 18.2% -24.2% 141.3% 13.4% 3.4% 11.0% 5.1% 33.4% 3.9% 13.6% 8.4% 0.6% 5.0% 17.3% 22.8% 56.8% 122.4% -0.5% -9.8% 13.0% -9.1% 25.1% 2.2% -2.4% -1.3% 64.3% -2.1% 0.0% 0.0% -

30 40 1 1 1 9 12 2 1 2 4 4 2 1 2 1 1 2 2 7 5 9 6 7 10 18 3 14 2 6 8 8 2 9 2 3 3 1 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 2 1 1 1 1 2 1 1 1 1 1 1 1 1 1 -

902 39

ETF total

2,847

594

419

6,370

$1,311.3

$1,444.8

$133.4

10.2%

148

1,051

Location

*To avoid double counting, assets shown above refer only to primary listings.

23 1 21 1 5 4 5 3 15 1 18 3 1 4 1 2 1 1

Source: BlackRock Investment Institute - ETF Research, 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 July 2011, and are subject to change at any time due to changes in market or economic conditions. They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed by BlackRock and accordingly does not make any remark on their suitability. Prospective investors should take their own independent advice prior to making an investment decision. This document does not provide investment advice and the information contained within should not be relied upon in assessing whether or not to invest in the products mentioned. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this commentary may not be suitable for all investors. BlackRock recommends that investors independently evaluate each issuer, security or instrument discussed in this publication and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. The value of and income from any investment may go up or down and an investor may not get back the amount invested. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We also remind you that the levels and bases of, and reliefs from, taxation can change and is dependent upon individual circumstances. Although BlackRock endeavours to update and ensure the accuracy of the content of this document BlackRock does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from the ETF Providers and confirm any relevant information with ETF Providers before investing. Neither BlackRock, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. © 2011 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded.

FTSE GLOBAL MARKETS • SEPTEMBER 2011

111

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

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

200 180 160 140 120 100 80 60

1 Ju l1

Ap r11

Ja n11

Oc t10

Ju l1

-1 0 Ap r

Ja n-

Oc t0

Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

Oc t0

40 Ju l06

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 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

1 Ju l1

Ap r11

Ja n11

Oc t10

0 Ju l1

-1 0 Ap r

10 Ja n-

9 Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

6 Oc t0

Ju l06

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

FTSE Global Government Bond Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

FTSE Global Infrastructure Index

FTSE Physical Industrial Metals Index

250 200 150 100 50

1 Ju l1

Ap r11

Ja n11

Oc t10

0 Ju l1

-1 0 Ap r

10 Ja n-

Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

n0 Ja

6 Oc t0

Ju l06

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

112

SEPTEMBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

160 140 120 100 80 60

1 Ju l1

Ap r11

Ja n11

Oc t10

-1 0

Ju l1

Ap r

Ja n-

Oc t0

Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

Oc t0

Ju l06

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 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

1 Ju l1

Ap r11

Ja n11

Oc t10

-1 0

Ju l1

Ap r

Ja n-

Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

6 Oc t0

Ju l06

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 July 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

1 Ju l1

Ap r11

Ja n11

Oc t10

Ju l1

-1 0 Ap r

Ja n-

Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

n0 Ja

Oc t06

Ju l06

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

FTSE GLOBAL MARKETS • SEPTEMBER 2011

113

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

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

1 Ju l1

Ap r11

Ja n11

Oc t10

-1 0

Ju l1

Ap r

Ja n-

Oc t0

Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

Oc t0

40 Ju l06

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 July 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

140 120 100 80 60 40

1 Ju l1

Ap r11

Ja n11

Oc t10

Ju l1

-1 0 Ap r

Ja n-

Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

6 Oc t0

Ju l06

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (31 July 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

1 Ju l1

Ap r11

Ja n11

Oc t10

0 Ju l1

-1 0 Ap r

10 Ja n-

9 Oc t0

Ju l09

Ap r09

n09 Ja

Oc t08

Ju l08

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

114

SEPTEMBER 2011 • FTSE GLOBAL MARKETS

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 July 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

Ju l1 Ju l1

Ap r11 Ap r11

Ja n11

Oc t10

Ju l1

Ap r

-1 0

Ja n-

9 Ju l0

Oc t0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

Oc t0

Ju l06

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 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

Ja n11

Oc t10

0 Ju l1

Ap r

-1 0

Ja n-

Oc t0

9 Ju l0

Ap r09

Ja n09

Oc t08

Ju l08

Ap r08

08 Ja n-

Oc t07

Ju l07

Ap r07

Ja n0

6 Oc t0

Ju l06

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (29 January 2009 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

200 180 160 140 120 100

Ju l11

1 Ju n1

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

-1 0 Se p

-1 0 Au g

Ju l10

Ju n10

-1 0 ay M

Ap r10

ar -1 0 M

Fe b10

Ja n

-1 0

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

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2011

115

INDEX CALENDAR

Index Reviews September - October 2011 Date

Index Series

Review Frequency/Type

Early Sep 01-Sep 02-Sep 02-Sep 02-Sep 02-Sep

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

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 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

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 Asiatop / Asian Sectors FTSE Value-Stocks Taiwan Index FTSE Value-Stocks Korea Index FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Multinational Dow Jones Global Indexes DJ Global Titans 50

09-Sep 15-Sep 28-Sep 07-Oct

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 TOPIX

07-Oct 13-Oct 27-Oct

TOPIX FTSE TWSE Taiwan Index Series Russell US & Global Indices

Effective (Close of business)

Data Cut-off

30-Sep 16-Sep 16-Sep 16-Sep 16-Sep

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 Semi-annual review Semi-annual review 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 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 31-Aug 31-Aug 31-Aug

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

17-Sep 17-Sep 30-Sep 30-Sep

31-Aug 31-Aug 31-Aug 27-Sep

28-Oct 28-Oct 21-Oct 31-Oct

30-Sep 31-Aug 30-Sep 26-Oct

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 Annual review Semi-annual review Quarterly review - IPO additions only Monthly review - shares in issue change Monthly review - additions & free float adjustment Annual review - constiuents Quarterly review Monthly review - shares in issue change

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

116

SEPTEMBER 2011 • FTSE GLOBAL MARKETS