FTSE Global Markets by FTSE Global Markets

THE RAPID INTERNATIONALISATION OF THE RENMINBI

ISSUE 55 • OCTOBER 2011

Quantifying performance in transition management Why the buy side prefers high touch trading Low rates crimp securities lending What’s the point of Pure FX?

Isbank’s bid for regional emerging markets leadership

The long distance run ASSET ALLOCATION IN AN AGE OF CHANGE

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 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.ftseglobalmarkets.com Single subscriptions cost £497/year for 10 issues. 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 no 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.

ONTINUED WEAKNESS IN the US economy, and by extension the dollar, added to chronic disarray in the eurozone over a unified solution to sovereign debt amortisation inevitably brings into focus the role of the RMB in the financing of trade and capital market fund raising. Only 18 months ago, the interpolation of the RMB in the affairs of capital markets professionals was still a pipedream. That cannot be said any longer. The growing popularity of the RMB as a viable trade financing currency (CNY) and the virtual explosion of the offshore RMB capital markets in Hong Kong (CNH) proves its worth as an investible currency. In trade finance circles, the RMB is gaining the same kudos as the pre-euro Deutschemark; which used to finance something like 30% of world trade before the euro unhappily took its place. It is unlikely to take long before the RMB is ubiquitous. HSBC now offers RMB denominated accounts in London, Bank of China is opening branches across Europe, and Singapore is already the second largest pool of RMB liquidity outside the mainland. While dollar and euro weakness continue, it is inevitable that discussion of the RMB’s future role as a reserve currency will be writ large. In reality it is some way off: you need full convertibility before that can happen, as well as a whole host of other developments and China is reluctant to give away any price advantage to competing advanced emerging economies because of a potentially massive hike in the conversion rate of the RMB—not yet anyway. The one problem China may have in retaining capital controls is the fact that sovereign wealth funds, central banks and financial institutions are just starting off in a race to accumulate RMB on the basis that it is an appreciating currency and that it is not the dollar. With the current penchant for one quantitative easing program to follow another, who can blame those stalwarts of the currency markets for worrying about the effects of the inevitable debasement of the current global reserve currency. Our market leader talks through the impact of the inexorable rise of the renminbi. Another important theme in this issue, articulated tangentially in the coverage of the Middle East banking segment and more specifically in the cover story is the growing understanding in high growth economies that the balance of power must shift to the markets and the consumer and away from political elites, if economic development is to be sustained. There are examples at both ends of the economic spectrum; over-zealous regulation in the West and excessive corruption in under-regulated economies in some notable frontier markets. Adnan Bali, chief executive at Turkey’s Isbank thinks that banks have a social and moral duty to reform to aid the common good. It’s a rare and much-needed polemic. We hope you enjoy the stimulation of the debate it should foster. After a torrid August, in which the equity markets often looked close to immolation, we thought it would be timely to test the waters around current approaches to asset allocation. Our roundtable discussion touches on common themes, which have been popular this year and last, such as investments in precious metals and alternatives. Equities continue to worry investors; the question is will they recover their appeal; or will pension funds wholesale, have to completely rethink traditional approaches to asset allocations and look much further afield for returns? The truth is out there.

Francesca Carnevale, Editor, October 2011

ISSN: 1742-6650 Journalistic code set by the Munich Declaration.

FTSE GLOBAL MARKETS • OCTOBER 2011

Cover photo: Adnan Bali, chief executive officer, Isbank. Photograph kindly supplied by Isbank, September 2011.

CONTENTS COVER STORY

ISBANK AND EMERGING MARKETS GROWTH

................................................Page 33 Isbank CEO Adnan Bali thinks bankers have responsibility to foster economic growth both at home and abroad. In a climate of socio-political change in many emerging markets, he calls into question the traditional role of bankers. Can he lead a charge of change?

DEPARTMENTS

MARKET LEADER SPOTLIGHT

THE INTERNATIONALISATION OF THE RENMINBI ..................................Page 6 The offshore RMB market threatens to overturn the capital markets: how exciting is that?

NEWS & MARKET REVIEWS ........................................................................................Page 12 Are bankers keeping up with real time risk analysis?

MANDATES

THE MONTH’S ASSET SERVICING CONTRACTS ........................................Page 17

IN THE MARKETS

RTS/MICEX: MARRIAGE RUSSIAN STYLE ........................................................Page 18

CCB opts for BNY Mellon and other mandates

Is the merger a step-change to a more efficient market? Vitaly Pojarsky reports.

DO WE NEED BANK-ONLY LIQUIDITY POOLS?

FX VIEWPOINT

......................................Page 20

Neil O’Hara reports on the fluid fortunes of PureFX.

THE NEW AGE OF BRINKMANSHIP ....................................................................Page 23 Erik Lehtis, president of DynamicFX, says there are too many gambits in play.

REAL ESTATE

CEE REAL ESTATE STILL SIMMERS ........................................................................Page 24 Mark Faithful highlights the bright and the moribund in eastern and central Europe.

TURKEY BROADENS BORROWING OPTIONS

..........................................Page 28 Sekerbank debuts in asset-backed market/Akbank reduces cost of funding.

ALL CHANGE FOR TURKISH SECURITIES SERVICES ..............................Page 36 Nelson Fernandes, manager, TEB Securities Services on a market evolution.

FORTUNES DIVIDE IN INFRASTRUCTURE SPENDING ..........................Page 38

REGIONAL REPORT

UAE project spend down while Saudi spend increases.

STEADY BUILD UP IN SUKUK ISSUANCE OVER THE YEAR ..........Page 40 Investor demand outstrips supply.

CBQ LEVERAGES QATARI GROWTH....................................................................Page 42 Andrew Stevens, chief executive officer of CBQ discusses market dynamics.

EMIRATES NBD AM: NEW INVESTMENT APPROACHES ..................Page 43 Deon Vernooy, head of asset management, Emirates NBD explains his investment outlook.

DEBT REPORT 2

QUASI-SOVEREIGN ISSUES BEGIN TO SUFFER

........................................Page 45 As investors become more risk averse, sovereign issues lose their lustre.

OCTOBER 2011 • FTSE GLOBAL MARKETS

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Societe Generale Corporate & Investment Banking (SG CIB) is a marketing name for the corporate and investment banking businesses of Societe Generale and its subsidiaries worldwide. Societe Generale is a credit institution and an investment services provider (entitled to perform any banking activity and/or to provide any investment service under the Markets in Financial Instruments Directive (MiFID) except the operation of multilateral trading facilities) authorised and regulated by the French Autorité de Contrôle Prudentiel (the French Prudential Control Authority) and the Autorité des Marchés Financiers (the French Financial Markets Authority). Societe Generale is subject to limited regulation by the Financial Services Authority for the conduct of its business in the United Kingdom. Details of the extent of its regulation by the Financial Services Authority are available from us on request. Societe Generale benefits from the European Commission passport authorising the provision of investment services within the European Economic Area. This material has been prepared solely for information purposes, and does not constitute an offer, a solicitation of an offer or invitation, or any advice or recommendation, from Societe Generale to buy or sell any security or financial instrument or product, or participate in any trading strategy, activity or arrangement. Not all securities or financial instruments or products offered by Societe Generale are available in all jurisdictions. This communication is not intended for or directed at retail clients/investors. It is for professional clients/investors only. Please contact your local office for any further information. © ArnoLam.com -

CONTENTS

COMMODITIES

TRADING COMPANIES DOMINATE SUPPLY CHAINS ........................Page 50

INDEX REVIEW

DEPRESSING DEBT & DIRTY FLOATS ..................................................................Page 53

FACE TO FACE

WITH PATRICK COLLE, BNP PARIBAS ................................................................Page 54

DATA PAGES

Vanja Dragomanovich looks at the resurgence of trade finance in commodities.

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

Never mind the volume of assets; look at the quality and how they got there.

DTCC Credit Default Swaps analysis ..............................................................................................Page 89 Fidessa Fragmentation Index ........................................................................................................................Page 90 Market Reports by FTSE Research................................................................................................................Page 92 Index Calendar ....................................................................................................................................................Page 96

FEATURES ASSET SERVICING:

LOW RATES CRIMP SECURITIES LENDING ..............................................Page 57 For securities lenders used to earning their reviews from the interest paid borrowers collateral balances, rock bottom interest rates are a disaster. Borrowers are doing fewer trades in any case. Is there light at the end of this particularly dark tunnel?

CLIENTS PUT TRANSITION MANAGERS UNDER SCRUTINY ........Page 62 It is the best of times and the worst of times for transition managers. Markets are too volatile for comfort. Competition for business volumes remains intense. The service set is constantly expanding and to cap it all, beneficial owners are now looking for empirical proof of performance. Lynn Strongin Dodds reports.

TRADING REPORT:

WHY THE BUY SIDE IS STILL CAGEY AFTER ALL THESE YEARS ......Page 66 Technology has released the buy side trading desk from dependency on the sell side. However, as trading markets become more complex, competitive and fragmented, the buy side doesn’t always like going it alone, and with good reason.

TRADING STRATEGIES: THE JP MORGAN AM WAY ........................Page 69 Ruth Hughes Liley talks to Kristian West, head of European trading at JP Morgan Asset Management about his team’s trading strategies.

BUY SIDE TRADERS GO BACK TO BLACK ..............................................Page 71 High touch trading looks to have rediscovered its mojo. It might yet be a temporary phenomenon, but DMA, SOR trades and trades through broker crossing networks are down. Ruth Hughes Liley looks at the reasons.

VENTURE CAPITAL:

THE LONG TERM IMPACT OF A CAPITAL SHORTFALL....................Page 74 A shortfall of capital, a surfeit of government regulation, ambiguity over immigration and inflated company values are testing venture capitalists. Is it time for a rethink? Art Detman reports from California.

ROUNDTABLE:

ASSET ALLOCATION STRATEGIES IN AN AGE OF CHANGE ........Page 79 “The recent breakdown in equity markets leads us to question whether sufficient value has returned to justify a long term commitment to the asset class,” says Neill Nuttall, managing director of GMAG at JP Morgan. Did other participants agree with him?

OCTOBER 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

THE CAPITAL MARKET IMPACT OF THE EMERGING RMB

The game changer: dim sum market sets new pace for RMB acceptance The speed of the emergence of the offshore renminbi (CNH) continues to surprise. There’s a shedload of apocryphal noise about how renminbi (RMB)-denominated securities will outstrip issuance volumes in other capital markets already piled up; though in the short term, the only currency with any real worries about its ranking in the global debt league tables is the Hong Kong dollar (HKD). In value terms, issuance in RMB-denominated bonds outstripped those denominated in Hong Kong dollars by the end of June. At this rate of growth in CNH denominated debt by this time next year, the already humbled Hong Kong dollar bond could be well and truly swamped, if not obliterated altogether. Francesca Carnevale looks at the market impact of the rising power of the RMB. F ANYONE EVER doubted the commitment of China to establishing the RMB as a global currency they were rapidly dispelled by the country’s vice premier Li Keqiang’s speeches during a mid-August visit to Hong Kong, ostensibly promoting investment into China via offshore renminbi funds. Hard on the heels of Li’s statement the ministry of commerce (MOC) published draft rules governing a consultation that could ultimately lead to further simplifications of the inward investment approval process. Currently, approval must be sought from both the MOC and the central bank, the People’s Bank of China (PBOC), which can be lengthy and unpredictable. However, changes to the central bank approval process look to be some way off. Changes to the MOC approval process are quite detailed. The MOC has local offices which can now review proposed investments, though if these are worth RMB300m or more, or involve investments in finance guarantees, finance leases, microfinance or auction industries, the application will move up the central MOC authority. This is also true if the transaction involves investment in foreign invested holding companies, VC firms or equity funds or involves investment in any macro-control/strategic industries, such as cement, iron, steel, electrolytic aluminium or ship-building.

Photograph © Baurka / Dreamstime.com, supplied September 2011.

The new rules will allow foreign investors to use offshore RMB funds raised through “legitimate channels”, including funds raised from crossborder trade settlement, the issue of RMB securities, dividends and the sale of equity, registered capital or through the liquidation of a PRC foreign invested enterprise. Evidence must be provided, as well as a written statement as to the source of the funds. Foreign direct investments involving RMB funds must still comply with China’s existing foreign investment regulations and requirements, including ownership restrictions for certain industries, national security and merger control reviews. Equally, offshore RMB funds cannot be used, either directly or indirectly, in China to invest in securities or financial derivatives, or for the purpose of trust loans or repayment of

loans. The MOC will require a written commitment to this effect from the investors as part of the approval process. The process reflects PBOC governor Zhou Xiaochuan’s repeated statements this year that government’s approach to the internationalisation of the RMB and the easing of foreign investment regulations will remain “cautious”. Even so, Zhou has conceded at every occasion that easing of restrictions on crossborder usage of the currency and policy barriers are being driven by market requirements. Structurally as well, China needs to extend the reach of its current to match that of its economy. While expectations of a gradual move to full convertibility linger, the rise of the offshore RMB market provides an attractive outlet to counter speculative inflows. The fact is that the financial market in renminbi-denominated securities is

OCTOBER 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER DIM SUM BONDS REGULATORY FRAMEWORK

THE CAPITAL MARKET IMPACT OF THE EMERGING RMB

ISSUER

PRODUCTS

RULES

REGULATOR

CDS

Any institution authorised under the Banking Ordinance to carry on the business of taking deposits 128 such authorised institutions engaged in RMB business

Hong Kong Monetary Authority (HKMA)

Bonds

Any offshore financial institutions

Not available

Bonds

Policy bank and commercial bank incorporated in PRC Onshore regulatory approval required Funds can be used onshore

People’s Bank of China (PBOC) National Development & Reform Commission (NDRC)

Need repatriation

Bonds

For shareholder’s loan Onshore settlement bank needs PBOC approval The borrower (onshore entity) needs to get SAFE’s registration certificates For equity injections Need MOFCOM approval to use RMB as currency of capital injection Onshore settlement bank needs PBOC approval The borrower (onshore entity) needs to get SAFE’s registration certificates

No repatriation

Bonds

No regulation constraints

Not available

Bonds

Need to get SAFE approval of the guarantee Funds cannot be sent back onshore

SAFE

OFFSHORE FINANCIAL INSTITUTIONS

ONSHORE FINANCIAL INSTITUTIONS

OFFSHORE CORPORATIONS

Offshore Issuer/ Garantor

Onshore garantor

For shareholder’s loan PBOC State Administration of Foreign Exchange (SAFE) For equity injections The Ministry of Commerce (MOFCOM) PBOC SAFE

Source: HSBC Renminbi Breakfast, Speaker presentation, September 6th 2011, London.

developing into a substantive force well in advance of full convertibility. To all intents and purposes, convertibility does not matter. The emergence of the CNH market, while touted as an interim stage to full convertibility, has created a market in which the RMB is investible and usable to foreign investors and trade financiers. Moreover, since July last year the market has sufficiently diversified to include spot and forward FX trading, options and most recently RMB denominated IPOs. Spot and forward trading has already reached a volume slightly in excess of $2bn/day of equivalent value; while offshore deposits of RMB are reckoned to total more than RMB600bn ($80bn-$90bn) in Hong Kong alone. This is just the start: according to David Bloom, global head of foreign exchange strategy at HSBC, the markets are witnessing “the flowering of a new reserve currency”. The Big Bang in the offshore RMB bond market came in July last year, when the Chinese government allowed offshore borrowers to tap RMB through debt instruments issued in Hong Kong and repatriated into China on a case-bycase approval basis. While the launch of the dim sum market echoes that of the eurobond market in the 1980s, the former is still tightly regulated, says

Stephen Williams, head of global capital markets, Asia-Pacific at HSBC. “New issue volume has increased from CNH16bn in 2009 to CNH40bn in 2010 and to date in 2011 it has reached CNH135bn. We anticipate it will end the year at around CNH200bn. The YTD volume also overtook the new issue volume in Hong Kong dollars, Singapore dollars and Thai baht markets,” says Tee Choon-Hong, regional head of capital markets for North Asia at Standard Chartered Bank.

Dim sum bond issuance China’s ministry of finance (MOF) RMB20bn (just over $3.1bn) sovereign RMB bonds came to market midAugust through Hong Kong’s Central Moneymarkets Unit. This is the third round of sovereign issues in the dim sum market. The bonds came in four main tranches: RMB6bn in three-year bonds, RMB5bn in five-year bonds, RMB3bn in seven-year bonds and RMB1bn in ten-year bonds were sold to institutional investors through competitive tender. Around RMB15bn went to institutional buyers; the remainder to retail buyers. The retail tranche’s twoyear notes carry a yield of 1.6%. Over 84,000 applications were received for the retail tranche, which ended up subscribed four times over.

The issue was overbought by a factor of four, underscoring the appeal of exposure to RMB that continues to appreciate against the US dollar (around 3.5% this year so far) and the fact that demand for RMB denominated securities far outstrips supply. Moreover, yields on the sovereign offer higher credit quality and returns than US treasuries right now. Corporate issues in the dim sum market offer even higher rates, with coupons this year ranging between 4% and 8%. MOF’s issue came hot on the heels of CITIC Pacific’s RMB1bn five-year bond, which carried a coupon of 2.7%; a transaction led by Agricultural Bank of China (ABC), and the second foray into the dim sum market by ABC. Previously the bank’s Hong Kong branch together with ABCI Capital Limited had underwritten China Chengtong Development Group’s RMB600m bond, due May 2014, which carried a coupon of 4.5%. These transactions typify the current character of the dim sum market. While offering higher rates than US treasuries, funding through RMB bonds issued out of Hong Kong remains cheaper than domestic bonds, explains HSBC’s Williams, which is a function largely of demand: “The recent MOF three-year bonds carry a yield of 0.6%, compared with onshore cost of funds at 3.7% for

OCTOBER 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

THE CAPITAL MARKET IMPACT OF THE EMERGING RMB

comparable tenors,” he says; although corporate issues attract much higher rates. The drive right now is to push tenors out to ten years, a feat already achieved by the sovereign; but yet to be tested by corporate issues, though Williams thinks that this will come. Currently, as many political as market forces underpin Hong Kong’s evolution as a CNH issuance centre. Although the central Chinese government has said it is committed to issuing RMB bonds out of Hong Kong over the long term to help reinforce the jurisdiction’s position as a global financial centre and an offshore renminbi centre, there is no doubt that other financial markets will move to try to offer RMB-denominated bonds in the near future. There is a noticeable build up of RMB-denominated deposits already building up nicely in Singapore for instance; one pre-requisite for the emergence of a liquid RMB-denominated capital market. Bank of China has opened offices in the country, helping local banks deposit RMB reserves in the local market and support trade payments. In the interim, Singaporean investors are well represented among the global buyers of current CNH issues; and the Singapore markets continue to benefit from the growing internationalisation of the main ASEAN currencies (the Thai baht, Malaysian ringgit and Singapore dollar). Ironically, Hong Kong must, perforce, also voice worries about the future of its own currency should the penchant for RMB ultimately overcome any residual fondness for the HKD. Even so, HSBC is offering RMBdenominated deposit accounts in London; while Chinese banks have opened branches in Germany to help facilitate trade payments. It is a movement that is increasingly fed by China itself, as it steadily dominates export and import trading relationships on both north-south and south-south axes. “By 2015, half of China’s trade with the emerging markets will settle in RMB, which will result in $2trn-equivalent worth of transactions per annum,” explains Ben Chan, deputy

Dim sum bonds: supply dynamics Issuer by issuer type (2001-YTD) 1% Supranationals 4% Foreign Financial Institutions 37% Chinese Financial Institutions

42% Corporations

16% Ministry of Finance

Source: HSBC Renminbi Breakfast, Speaker presentation, September 6th 2011, London. HSBC quoted Bloomberg sourced on September 2nd 2011. The figures exclude a recent MOF institutional tranche & synthetic RMB issuance which has been moribund since March this year.

head of business planning and strategy, at HSBC in Hong Kong. RMB trade settlement capabilities are extant in some 50 countries, he adds. Bloom states: “Trade is often the underlying basis of the internationalisation of a currency, which is then built upon by the emergence of investible securities.” HSBC already provides quotes for RMB against all the major currencies. Standard Chartered, meantime, the other stalwart of the offshore RMB market, has also extended its RMB capabilities to over 30 markets with a particular focus on Africa, Asia and the Middle East. “We see tremendous potential for growth in trade between emerging economies with China as their largest trading partner and settling invoices in RMB without the need to transit through the US dollar will improve a corporation’s ability to increase its control on its foreign exchange and interest rate risks,” says Neil Daswani, regional head of transaction banking, North Asia, at Standard Chartered Bank. The internationalisation of the RMB over the past few years has been a fascinating test case. Ultimately the question is how soon will the RMB sit side-by-side with the US dollar and the euro to become a mainstay of the foreign exchange markets and ultimately the world’s reserve currency? Even 12 months ago, that prospect appeared 20 years off. From the vantage point of the last quarter of 2011

that particular horizon looks much closer. According to HSBC’s Bloom: “The milestones are happening much more quickly than everyone expected.” Moreover, he sees the continued liberalisation of the RMB as a fast moving and inexorable process: “In stark contrast toward the regulatory inhibitions in many markets.” China is continuing to liberalise its own markets at a clip. According to Daswani: “The internationalisation of the RMB while progressing faster than expected is in line with the Chinese government’s fiveyear plan and we don’t expect the path to be a straight line and there will be some bumps along the way. The important thing for a corporate treasurer is to understand the real benefits that can be gained by switching invoicing currency to gain a competitive advantage.” In the meantime, channels for onshore RMB outflows into Hong Kong’s CNH market will continue to expand. Keeping the offshore RMB market as a form of safety valve when too much liquidity piles up on the mainland will continue to feed Hong Kong’s evolving role as a RMB financing centre. Equally important is that China’s financial liberalisation will continue to accelerate, paving the way for full convertibility, eventually. Convergence between onshore and offshore foreign exchange rates and curves is unlikely to occur for some time as China’s capital account continues to separate the two; which will offer issuers, both local, Chinese and foreign investors, convergence will only occur when all capital controls have been lifted. While the Chinese government remains skittish about the potential for a rush of speculative inflows of foreign investment funds, with an attendant surge of inflation and RMB appreciation, that is some way off. Capital controls will only be lifted when the Chinese government decides that a free floating RMB will not result in one-way appreciation and “external imbalances become negligible,” says a May 2011 HSBC research paper, Offshore renminbi growth spurt: Milestones in CNH market development. I

OCTOBER 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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dŚĞ D ĂůŐŽƌŝƚŚŵ ŝƐ ƵƐĞĚ ŝŶ ƌĂĚŝŽ ĂƐƚƌŽŶŽŵǇ ƚŽ ĐůĂƌŝĨǇ ƚŚĞ ŽďũĞĐƚƐ ƵŶĚĞƌůǇŝŶŐ Ă ŵĂƐƐ ŽĨ ĚĂƚĂ͖ ǁŝƚŚ ŝƚƐ ĂďŝůŝƚǇ ƚŽ ŚĂŶĚůĞ ŵŝƐƐŝŶŐ ĚĂƚĂ ĂŶĚ ƐŚĞĚ ůŝŐŚƚ ŽŶ ƵŶŽďƐĞƌǀĂďůĞ ǀĂƌŝĂďůĞƐ͕ ŝƚ ŝƐ ǁĞůůͲƐƵŝƚĞĚ ƚŽ ƉƌŝĐŝŶŐ ĂŶĚ ŵĂŶĂŐŝŶŐ ƚŚĞ ƌŝƐŬ ŽĨ ŝŶǀĞƐƚŵĞŶƚ ƉŽƌƞ ŽůŝŽƐ͘ dŚĞ D ƉƉůŝĐĂƟ ŽŶƐ ƌŝƐŬ ŵŽĚĞů ĂŶĚ ĂƩ ƌŝďƵƟ ŽŶ ƚĞĐŚŶŝƋƵĞƐ ĂƌĞ ďĂƐĞĚ ŽŶ ŽƌŝŐŝŶĂů ǁŽƌŬ ďǇ ů ^ƚƌŽǇŶǇ ĂŶĚ ƌ dŝŵ tŝůĚŝŶŐ͘

ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

SPOTLIGHT

Real-time risk reporting still limited Banks struggle to calculate market and credit risk in real time, says report QUARTET FS, A provider of business intelligence and analytics technology, says in a new study, the Risk in Global Banking Report, which global risk managers in banks still struggle to calculate market and credit risk in real time. The study is based on research conducted with senior risk managers from global banking operations and provides insight into current views on risk management trends, practices and challenges in the new financial services era. According to Xavier Bellouard, co-founder, Quartet FS: “If one lesson has been learnt from the experiences of the past few years it is that navigating today’s markets without the ability to understand and manage risk intraday is the biggest risk of all.” Even so, the drive to change is being fuelled by external, rather than internal elements. The burden of regulatory pressure is seen as the strongest reason to innovate in risk management, according to more than two-thirds of respondents (68%); however, internal drivers, such as the need to better manage risk, is cited by only half (50%) the respondents. The study has found that the two most important drivers for real-time risk management in the industry are pricing both portfolio impact and counterparty exposure impact into quotes or trades. The top two limitations of traditional risk management systems, on the other hand, are the lack of flexibility (62%) and the fact that they are too slow (57%) to deal with today’s market requirements. When asked to expand on this latter theme and highlight how difficult it is

Photograph © Antkevyv / Dreamstime.com, supplied September 2011.

to manage the different types of risk, 68% of respondents in the study think counterparty risk is by far the most difficult type of risk to manage, followed by liquidity (59%) and then credit risk (54%). While market risk is viewed as the least difficult to manage, the research finds that half of all respondents want market risk calculations per new deal to be conducted in under ten seconds, that is, true real-time reporting. However, at present, only 20% can conduct market risk calculations per new deal in real time and 40% are only able to conduct the calculations overnight. The research finds that nearly a third of the risk managers surveyed say they would like sub-ten second calculations for Credit: PFE Impact and Credit: CVA Impact per new deal. However, in reality, none of the respondents can calculate Credit: CVA Impact per new deal in real time and 79% are still conducting calculations overnight. Similarly, for Credit: PFE Impact per new deal, only 15% can achieve less than tensecond calculations with 55% still processing overnight.

The business implications of these findings are clear: the majority of financial institutions cannot calculate the true risk of new deals to their business intraday, which means that they continue to work with stale, inaccurate data. “We have witnessed changes in behaviour with real-time risk intelligence becoming a strategic goal for many financial institutions, particularly within the trading and capital markets arena,” underscores Bellouard. Backing up this assertion, some 86% of respondents believe the financial crisis has strongly increased the influence of risk management with 81% agreeing that board members these days take a much greater interest in risk. The crisis has also led to new risk management processes being introduced, according to 63% of respondents. Moreover, the same number of respondents strongly believes that risk management processes are now more widely used in the front office and 54% think the crisis has led to greater collaboration between traders and risk managers.I

OCTOBER 2011 • FTSE GLOBAL MARKETS

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SPOTLIGHT

CSAs in Asia: is it the right time? New Celent report says CSAs help achieve best execution in Asia The Asia-Pacific cash equity market has grown quickly and reached higher levels of maturity through algorithmic trading, direct market access, smart order routing, and alternative trading systems (ATS), notes a new report by Boston-based consultant Celent. The consultancy says that the current trading environment is conducive to best execution, which commission sharing agreements (CSAs) can help to achieve, according the newly published report, Commission Sharing Agreements in Asia: The Right Idea at the Right Time? The report highlights potential conflicts of interest when asset managers rely on their brokerages for both execution and research. The lack of transparency is not beneficial to the market as a whole, claims the consultant. The use of commission sharing agreements (CSAs) for increasing transparency and reducing conflicts of interest in the role of the asset manager has been an important development in the Western markets of the UK, the US, and Europe. By using CSAs, the buy side can ensure that it incentivizes both execution and research adequately. “Independent research firms benefit from this scenario and can sustain themselves in spite of not being execution providers. However, while CSAs have started making an appearance on the Asian equity market horizon, they are a long way from being commonplace,” notes an official release on the report. The report notes that there are any number of reasons for the slow adoption of CSAs in Asia. For starters, regulators in the leading markets have yet to explain how they would like CSAs to function.

Do you want more rules on international swaps? US regulators seek comment for joint CFTC-SEC study The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have approved a request for comment on their joint study on regulation of international swaps. The decision will be tabled in the Federal Register. According to Section 719(c) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires that the CFTC and the SEC jointly study and then report to Congress on swap regulation and clearinghouse regulation in the United States, Asia, and

Europe. The report to Congress must identify areas of regulation that are similar and other areas of regulation that could be harmonized. In addition, the report must identify major swap contracts, dealers, exchanges, clearinghouses, and regulators in each geographic area, and must describe the methods for clearing swaps and systems used for setting margin in each area. If you want to comment on the need for further regulation, you have up to 60 days following the notice’s publication in the Federal Register. I

Photograph © Kheng Ho Toh / Dreamstime.com, September 2011.

While Hong Kong has dealt with the issue of soft dollars, other regulators, such as the FSA in Japan, have been handling with the issue with kid gloves because it may lead to loss of business for smaller, domestic brokerages. There have been no clear guidelines in markets such as Taiwan, Singapore, India, and Korea. Finally, notes the report, CSAs are becoming more sophisticated, and this is a good time for the Asian markets to adopt them. The CSA model could evolve into more of a

consortium model. Under that model several large firms could come together and anoint a single firm or product to manage an aggregated pool of CSAs. Another option could be the emergence of third party CSA managers, suggests the report. A large commercial bank that is not already in the CSA or trading business, for example, could form a new subsidiary to provide CSA management services backed by a consortium. Another interesting development has been the rise of multi-asset CSAs.I

OCTOBER 2011 • FTSE GLOBAL MARKETS

The FTSE Infrastructure Index Series: Defining Global Infrastructure A Q&A with Mike Bruno, Director of Index Research, FTSE Group Earlier this year, FTSE launched the FTSE Infrastructure Index Series (FIIS). What sets this family of indices apart from other infrastructure investment products? Before creating the FTSE Infrastructure Index Series (FIIS), FTSE worked with a number of market participants to create a definition of infrastructure which includes companies that own, operate or manage physical structures or networks used to process and move goods, services, information/data, people, energy, and life necessities. FTSE also expands this definition to include the suppliers and support services essential to these core infrastructure industries, as well as businesses that rely on infrastructure networks. This expanded definition, which allows the index series to represent the broader infrastructure space – while avoiding the sector concentrations that characterize some infrastructure investment products – is what sets it apart.

How many indices does the FTSE Infrastructure Index Series Include?

FTSE’s Definition of Infrastructure Core Infrastructure Sectors

Transportation

Infrastructure-Related Sectors

Related Materials & Engineering

Related Conveyance Services

Telecommunications

Energy

Related Communications Services

The FTSE Infrastructure Index Series includes a total of nine indices, diversified across six FTSE-defined infrastructure sectors, to reflect performance in core infrastructure and infrastructure-related listed securities globally. The FTSE Core Infrastructure Indices are based on FTSE’s definition of infrastructure, while the FTSE Infrastructure Opportunities Indices also include the conveyance and maintenance services that go hand-in-hand with the core networks and physical structures. These indices include: • FTSE Global Infrastructure Index

• FTSE Global Infrastructure Opportunities Index

• FTSE Emerging Infrastructure Index

• FTSE Developed Infrastructure Opportunities Index • FTSE Developed Core Infrastructure Index

• FTSE Developed Infrastructure Index • FTSE Emerging Infrastructure Opportunities Index

• FTSE Global Core Infrastructure Index • FTSE Emerging Core Infrastructure Index

Are the FTSE Infrastructure Indices suitable for the creation of ETFs? The index series readily supports the creation of ETFs in that it is transparent, replicable, and screened for both free-float and liquidity. It also makes an attractive index on which to base infrastructure ETFs because of its modular construction. In addition to the “off the shelf” Core and Opportunities indices, the series can be customized in a number of ways. For example, indices can be based on Large, Mid, and/or Small-cap companies; Global, Developed, and/or Emerging markets; infrastructure Sectors or Subsectors; and percentage of company revenue attributable to infrastructure business lines. Specific country indices can also be easily created.

For more information about the FTSE Infrastructure Index Series, please visit: www.ftse.com/Indices/FTSE_Infrastructure_Index_Series “FTSE®” is a trademark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited (“FTSE”) under licence. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE or its licensors for any errors or for any loss from use of this publication. Neither FTSE nor any of its licensors makes any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Infrastructure Index Series or the fitness or suitability of the Index for any particular purpose to which it might be put. No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of FTSE. Distribution of FTSE Index values and the use of FTSE Indices to create financial products requires a licence with FTSE and/or its licensors.

SPOTLIGHT

Photograph © Threeart / Dreamstime.com, supplied September 2011.

last year to nearly 9.0% in the first half of this year.

Flattening of government yield curves

ADB reports uptick in Asian domestic bonds Expansion of local currency bond markets in East Asia Local currency bond markets in emerging East Asia continued to expand in the first half of this year as demand from foreign investors increased, with the region’s economic growth set to outpace much of the rest of the world, says the latest Asian Development Bank’s (ADB) Asia Bond Monitor. Asian countries reported some $5.5trn in local currency bonds outstanding at the end of June, 2.4% higher in local currency terms than at the end of the first quarter (Q1), and 7.7% up on the first half of 2010. It has to be said that East Asia is a gift that just keeps on giving to investors in the local Asian currency bond markets right now, particularly as it comprises the People’s Republic of China (PRC); Hong Kong; Indonesia; the Republic of Korea; Malaysia; Philippines; Singapore; Thailand; and Viet Nam. Overall, the fastest growing markets in the second quarter of 2011 were Viet Nam (up 5.0%), Singapore (up 4.3%) and Malaysia (up 3.7%) versus the previous quarter. The PRC, which has driven swift expansion in the region’s markets in the past, grew 2.7% reflecting a modest 1.6% increase in its government bond market. Growth was driven by corporate

bonds, which grew by 4.4% to $1.8trn in Q2 over Q1. Fears of a global growth slowdown and worries over US and European debt saw credit spreads on emerging Asian sovereign bonds widen between March and the end of June. However, the appetite for sovereign debt paper remains resilient given the region’s relatively sound fiscal position and positive growth outlook. Emerging Asian borrowers issued $29.5bn of G3 currency-denominated bonds in the first quarter of 2011, up from $24.5bn over the same period in 2010. Mainland China’s corporate bond market grew at a clip, rising 6.3% in the same period and is now the region’s largest corporate bond market overtaking the Republic of Korea. Foreign holdings of the region’s government bonds have also risen, driven by global investors chasing yields, interest rate differentials and expectations of appreciation in regional currencies. By the end of June, overseas investors held 34% of Indonesian government bonds. By the end of March, overseas investors held 22% of Malaysian bonds, and 10% of bonds issued by the Republic of Korea. The share of foreign investment in the Thai market has also doubled over the

“There has been a bullish flattening of government yield curves in most markets. We are seeing compression of yields at the long end, reflecting market concerns of slowdown in growth. We expect monetary authorities to adopt a more neutral policy stance as they move to cushion against any anticipated slowdown in mature markets,” according to Iwan Azis, head of ADB’s Office of Regional Economic Integration, which produces the report. However, as with most nicesmelling roses, there are some thorns to take in account. Risks include the now very real possibility of a sustained and severe economic slowdown in mature economies that could hit Asian exports, destabilising capital flows. The report criticises what it calls: “poorly timed policy action by mature markets” as presenting potential problems to the nascent Asian markets. It also points to the potential fallout of commodity price fluctuations on both Asian economies and local borrowing patterns. “Emerging Asian markets remain vulnerable to abrupt changes in global investor sentiment,” says Azis.“The knock-on effects from events in the US and Europe will go far beyond portfolio returns, as a weakening global economy will hurt our exports.” Even so, right now the going is good, concedes the report, with returns on local currency bonds buoyant this year in most of East Asia’s emerging and advanced-emerging economies. Moreover, while emerging Asia’s markets have not been immune to developments in advanced economies, the region’s strong fundamentals and interest rate differentials compared with advanced economies are expected to reignite capital inflows to the region later this year.I

OCTOBER 2011 • FTSE GLOBAL MARKETS

ASSET SERVICING MANDATES

DATE

MANDATE/ VALUE

WINNING FIRM/ CONTACTS

CLIENT/ CONTACTS

COMMENTS

7th September 2011

Hedge fund administration and custody services

Citi

Sandalwood Securities Ken Chapple, chief financial officer, Sandalwood Securities Inc.

Founded by Martin Gross in 1990, the hedge fund manager adopts fundamental value, event driven, debt-oriented strategies. The firm also invests in distressed securities, high yield, capital structure as well as merger arbitrage and long/short equity.

Nedgroup Investments (IoM) Ltd

Nedgroup is a collective investment schemes fund manager.

No value available

5th September 2011

Full asset servicing suite (trustee and custody, fund administration, transfer and FX)

Neeraj Sahai, global head, securities and fund services, Citi GTS

Citi Robert Ernesti, global head of investor client sales management at Citi

Andrew Lodge, managing director, Nedgroup Investments (IoM) Ltd

No value available 23rd August 2011

22nd August 2011

18th August 2011

Asset servicing mandate

Northern Trust

Baerum Kommune

NOK606m

Madeleine Senior, managing director of Northern Trust, Nordic region

Astrid Auran Nesbo, director of finance at Baerum Kommune

Strategic outsourcing

State Street Corporation

GBP200bn (approx)

Joe Antonellis, vice chairman State Street Corporation

Scottish Widows/Scottish Widows Investment Partnership Part of Lloyds Banking Group

State Street will be the single provider of middle office, custody, fund accounting, depositary, securities lending and investment administration services for Scottish Widows & SWIP, following a Lloyds Banking Group review of its outsourced services and has opted for a single operating model for the whole group. Other providers will migrate the assets to State Street during the next 18 months.

Transition management

Northern Trust

Northumberland County Council Pension Fund

This latest mandate builds on a 10-year relationship between the two entities. The bank also provides the fund with custody, securities lending and commission recapture services. The bank has a strong UK municipal pension fund clientele, with an estimated 36% market share.

GBP40m

Ray Bloom, head of government institution, Northern Trust Simon Hutchinson, head of transition management, EMEA, Northern Trust

17th August 2011

Custody services

JP Morgan

Value not available

Robert Caporale, head of new business development, Americas

Global custody for QDII fund

Bank of New York Mellon

Value not available

Chong Jin Leow, head of Asia BNY Mellon Asset Servicing

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2011

Derek Kennedy, chairman Northumberland County Council Pension Fund Panel

Federal Home Loan Bank of Chicago (FHLB)

NT has enjoyed success of late in the Nordics and its client base in the region is diversifying. In this mandate, the municipal authority cited the bankâ&#x20AC;&#x2122;s securities lending programme and processes were a key factor (among others) in the decision to award the bank the mandate.

FHLB is a $77bn wholesale bank and government sponsored enterprise providing housing finance to 760+ financial institutions in Illinois and Wisconsin.

John Stocchetti, executive vice president of operations and technology. Manulife Teda New Economic Pattern Fund, which will be launched by Manulife Teda Fund Management Co Ltd (Manulife Teda FMC).

The mandate was awarded by China Construction Bank, which was acting on behalf of Manulife Teda FMC, which was founded in June 2002 and is one of the first JV fund management companies in China. It has 16 open-ended funds under management.

IN THE MARKETS

MICEX/RTS MERGER: THE IMPLICATIONS

Photograph © Thomaspajot / Dreamstime.com, supplied September 2011.

Unified stock exchange: a step towards Moscow as an international financial centre On August 5th, 2011 the shareholders of MICEX and RTS voted for the merger of the two largest Russian stock exchanges. Corporate procedures relating to the integration of the two companies are expected to be completed by the end of 2011, and the IPO of the combined exchange is planned for 2013. Vitaly Pojarsky reports on the implications of the transaction. HE EAGERNESS OF the Russian Federation to move ahead with the modernisation of the country’s financial infrastructure is clear. The Russian Federal Antimonopoly Services (FAS) gave the green light to the merger of RTS and MICEX in early September, a month earlier than expected. Competitive parity with global exchanges is the rationale behind the merger between MICEX and RTS, says Ruben Aganbegyan, MICEX president. He explains that the creation of a single trading venue that is“competitive on the global stage and which provides advantages to market participants and its shareholders as well as modernising the Russian financial markets,”is fundamental to the success of Russia establishing Moscow as a major financial centre. Even so, the merged entity has yet to be given a name. “The integrated exchange team is working on it at the moment, developing the new brand and corporate style,” acknowledges

Varvara Inozemtseva, managing director of communications, MICEX-RTS. Neither has it been decided where the new exchange will be located, she adds. The companies will merge legally at the end of 2011 and the process will be completed by the end of 2012. This will involve integrating the platforms of both exchanges, which, says Inozemtseva, “will adopt the best features of the existing platforms”. While RTS is deemed to have a more advanced derivatives platform than MICEX: “Both exchanges have derivatives markets divisions and it will be the task for the integrated exchange team to join expertise and maintain the level of development that we currently have. The markets are likely to work separately at first and then merge into one trading floor while taking the best of the technologies, innovations and guarantees that have been developed at both MICEX and RTS. We all expect to continue working on the existing proj-

ects while also developing new ones,” Inozemtseva explains. There is a lot riding on the outcome of the merger; for instance, eliminating the duplication of tradeable securities that has fragmented liquidity in the market. MICEX and RTS have been widely criticised for duplicating each other’s services and products. The competition between them, critics say, stopped being constructive and began to limit the development of the stock market in Russia. “This is a very complementary merger,” notes Steven Dashevsky, founder and chief investment officer of Dashevsky & Partners investment boutique. “It is better to have one big trading platform than two small floors.” The merged exchange will be one of the biggest in Europe, which it is hoped will help increase and sustain liquidity levels in the market, and at the same time improve capital raising opportunities for expanding local firms. The integrated exchange also intends to address high-priority issues, which among others, says Inozemtseva, “will undoubtedly include the issue of a cash-equity market and its settlement cycle”. She adds: “Together, MICEX and RTS will offer a new T+N solution that will suit the interests of the majority of market players, meet global trading standards and simplify trading for cross-border investors. Before the end of the year the exchange’s team shall offer a new model of the cashequity cycle [sic].” Equally important, the merged exchange opens the way for the creation of a single central securities depositary (CSD) in Russia“that would eliminate risks in the existing registrars systems and simplify trading for crossborder investors”. She explains: “If the exchange owns its own integrated clearing house, it can offer more competitive margin terms against contracts and can offer cross-margining against a portfolio of traded products, which is a more cost-effective way of using collateral. This encourages dealers to trade through a single exchange and the

OCTOBER 2011 • FTSE GLOBAL MARKETS

ABOUT THE EXCHANGES

exchange’s own clearing house. Central counterparty clearing is essential in maintaining market confidence and liquidity by creating a ‘one-stop’ shop for the market participants. When an exchange operates its own clearing house, it results in a highly efficient, low-cost processing chain allowing for improved product and service introduction. These are all the factors that raise reliability of the exchange and improve trading environment for brokers.” Another expected benefit of the merger will be the consolidation of foreign investor participation in the new exchange. Grigory Birg, co-director of research at Investcafe, an independent research firm based in Moscow, believes that foreign investors will ultimately benefit from a single trading floor. In his opinion, up to now the interest of foreign investors in Russia’s stock market is speculative rather than fundamental. They do not come to the market with long-term investments and prefer playing on oil, gas and metals prices instead. Until Russia’s economy is diversified, it is hard to expect proper development of the stock market, he adds. Equally, there are too few dollar instruments existing on Russia’s market, says Birg, explaining that although the rouble is a stable currency at the moment, many foreign traders are cautious about investing in it. The merger per se does not improve access of foreign investors to Russia’s market, but it will provide every chance to it by introducing better connectivity and improving the clearing and settlement infrastructure. “The merger will increase effectiveness of the trading as investors will start using the single consolidated platform, and their interest in futures contracts on the RTS Index will be combined with trading volumes in stocks and bonds of the MICEX,” says Birg. While expectations around the merger are generally positive, some commentators warn that the deal may lead to a reduction of competition in the market and result in increased costs for

FTSE GLOBAL MARKETS • OCTOBER 2011

MICEX: G Leader of the stock, bond and foreign exchange markets G Trading volume in 2010: - Stocks: RUB13.3trn - Bonds: RUB10.5trn - Foreign exchange: RUB79.5trn G Revenue in 2010: RUB11.2bn G National Settlement Depositary (NSD) as head depositary

RTS: Derivatives market leader G Trading volume in 2010: - Stocks: RUB3.1trn - Derivatives: RUB29.3trn G Revenue in 2010: RUB3.1bn G Depositary Clearing Company (DCC): a major player in clearing operations with its central counterparty G

MERGER TIMELINE 2011

2012

I I I

FAS approval MICEX EGSM RTS EGSM

2013 Legally acknowledged End of merger, deal integration process closure

IPO

Source: MICEX and RTS, supplied September 2011.

brokers. In the end, they say, it is the users that will have to pay the costs of the single platform. Alexander Zalko from Finam Investment Holdings is one who believes that the consolidated exchange is likely to have monopolistic characteristics. He also thinks however that the benefits of the merger will outweigh cost considerations.“At present, our main task is to attract more investors to the Russian exchange market. The more players on the market you have, the more it is diversified, and the earnings are also growing,” he explains. In his opinion, it is very important to create a single structure that would set standards for oncoming alternative trading venues in Russia. Agris Preimanis, senior economist at the European Bank for Reconstruction and Development (EBRD), also believes that given the stage of development of the Russian capital markets, the benefits associated with increased liquidity and efficiency of trading and post-trading infrastructure are likely to outweigh any potential effects of reduced competition. “The merger will provide a strong platform for improving capital markets in Russia and potentially the wider region. It will pool trading liquidity and create a better scale, as well as facilitate integration of the two security depositaries in the country and help introduce a central counterparty clearing infrastructure,”he says. Dashevsky deems the merger an “extremely important political deal” for

the Russian authorities, who are eager to create a global financial centre in Moscow. He points out that the main shareholder of MICEX is Central Bank of Russia, and without its approval the merger would not be possible at all.“It’s Russia’s response to the plans of the New York Stock Exchange and Germany’s Deutsche Börse to merge by the end of 2011”, adds Yulia Massenkoff, an independent Moscow-based analyst. “The Russians are trying to potentially compete with the other large stock exchanges by becoming bigger; [but] bigger is not always better.” “The merger will provide a platform for improving liquidity and overall attractiveness of Moscow as a listing and trading location and its competitiveness compared to other international financial centres,”says Preimanis.“If the merger is successful in delivering the expected improvements then Moscow could become a significant financial centre and be a listing location of choice for Russian and other CIS companies. In the foreseeable future, however, it is not likely to challenge the pre-eminence of London and New York”. Investcafe’s Birg thinks that an integrated exchange is only one step in the process of deepening the capital markets in Russia.“To become a global financial centre Moscow needs to solve much more important problems than creating a single trading platform, it is a long and complicated process,” he points out.I

FX VIEW

PURE FX: THE BANKS FIGHT BACK FOR MARKET SHARE

Photograph © Soldeandalucia / Dreamstime.com, supplied September 2011.

Why the need for bank-only liquidity pools in FX trading? Is Pure FX, a banks-only liquidity pool, a retrograde reaction at a time when new concepts are in high demand, given an environment of enhanced regulatory scrutiny? While it is accepted that the market share enjoyed by banking majors has shrunk in recent years, and electronic trading and high-frequency trading firms have taken up the role of providing liquidity, whose interest is served by creating a liquidity pool in which only banks can play? Some commentators claim that FX volumes have grown by leaps and bounds since non-bank participants gained API access in 2004. So why is the Pure FX initiative now seen as vital? Equally, why is the initiative polarising the market? Neil O’Hara goes in search of some answers. OREIGN EXCHANGE TRADING has always been a huge moneymaker for banks, and especially a handful of dominant dealers, including Deutsche Bank, UBS, Barclays, Citi and Royal Bank of Scotland. The majors’ market share has eroded in recent years as electronic trading transformed the foreign exchange (FX) markets and high-frequency trading firms became a significant source of liquidity. Last year, for the first time, spot FX trading by non-bank market participants exceeded

dealer-to-dealer flow. In an attempt to reclaim their former dominance, the leading players now threaten to take their marbles elsewhere and create an exclusive club where banks can trade only among themselves. The initiative, tentatively called Pure FX, was first floated in late 2010. Rumours of its demise circulated earlier this year, but although the participants have not set a launch date, those reports appear to have been premature. Whether the FX market needs another

trading venue, or what purpose it would serve, is less clear.“Traders have always wanted a way to get out of ‘long and wrong’ or ‘short and caught’ positions,” says Justyn Trenner, chief executive officer of ClientKnowledge, a Londonbased research and advisory firm that serves financial institutions. “If the banks’ idea is to give traders a short cut to help them do their job, they are whistling in the wind.” Under normal market conditions, dealers have no difficulty in offloading

OCTOBER 2011 • FTSE GLOBAL MARKETS

risk positions they assume to accommodate client transactions; indeed, they usually earn a profit from the bidask spread. Dealers get stuck with unwanted inventory only when the market makes a big move, in which case, as market makers, they are all typically on the wrong side at the same time. The odds that another dealer would have the opposite position in a fast-moving market are low indeed; not quite zero, but close. The demand for a bank-only venue may become moot if EBS Spot, the electronic trading platform owned by interdealer broker ICAP, goes ahead with plans to introduce a bank-only trading forum. A sense of déjà vu pervades the Pure FX project: The banks set up EBS in the early 1990s to provide competition for Reuters, and in the early years it was their exclusive preserve. EBS has changed with the times and embraced proprietary traders, but the banks still hanker for the fat profit margins they enjoyed in an earlier era. “The need for a new platform is not evident,”claims Sreekrishna Sankar, an analyst in the Bangalore office of Celent, a Boston, Massachusetts-based research and consulting firm. “A bankonly panel on EBS will probably satisfy the banks,” he adds.

Best available price In the pre-electronic world, bid-offer spreads in FX were naturally wide because customers had to call each bank for a quote. Smaller accounts often took the price their principal bank offered without question and even large corporations had limited ability to find the best available price. Electronic multi-dealer quote platforms tipped the balance back toward customers—and spreads tightened across the board. The additional transparency attracted new players who are now nipping at the banks’ heels. High-frequency trading firms, whose rapid-fire order flow has already supplanted traditional market makers as the default liquidity source in equity markets, have begun to do the same in spot FX. The major

FTSE GLOBAL MARKETS • OCTOBER 2011

Sreekrishna Sankar, an analyst in the Bangalore office of Celent. “The single dealer platforms are evolving to accommodate large traders, while the multi-dealer platforms are garnering the highfrequency trading volume,” he says. Photograph kindly supplied by Celent, September 2011.

banks complain that high-frequency traders skim off profits by getting in the middle of trades that would occur without intermediation. They also argue that the liquidity provided is toxic to market participants who trade in large size. A buyer who takes the offered side of the market in a few small fills may tip the market to his interest and see the price move up long before he can complete the order. For most market participants, including banks other than the major dealers, the advent of high-frequency trading creates few difficulties—and may even be a blessing. As Trenner explains, banks that don’t make a market in FX still profit from fulfilling client orders on an agency basis. In that model, a bank quotes a price to the client that is slightly inferior to the best price available in the interdealer market and lays off any risk immediately after the trade. “A corporation may be happy to pay half a pip to lay off risk,” says Trenner. “The banks can capture that without ever having

significant market risk.” The tighter spreads that accompany high-frequency trading allow these banks to quote a finer price to their customers and/or pocket a larger mark-up. Even banks that are willing to take on market risk can choose when and how they interact with high-frequency trading flow. For example, a bank that focuses on internalising order flow among customers can lay off residual exposure through the market whenever it chooses—and a high-frequency trading firm will often display the best price.

Orderly trading For the major FX banks that trade with all comers, high-frequency trading does create obstacles, but they are not insuperable. These institutions have the resources to avoid being picked off by matching any technology deployed against them. They can also twist arms at the principal dealer-oriented trading venues—EBS, Reuters, HotSpot and Currenex, of which they are important

FX VIEW

PURE FX: THE BANKS FIGHT BACK FOR MARKET SHARE

customers—to adopt rules that foster transparency and orderly trading. “If banks choose to make markets against high-frequency trading firms, it is reasonable to expect that they have the capability and technology to do so,” says Trenner.“The venue managers also have an obligation to ensure that participants play fair.” Trenner also points out that flash orders shown briefly and then withdrawn existed in the FX markets long before electronic trading arrived. Reputable participants frowned on that and other techniques designed to initiate unjustified price movements, or “spoof the market”. Manipulative practices are just as harmful on an electronic trading venue, so it is incumbent on managers to curb them. The big dealer banks complain that high-frequency trading firms use small orders to detect significant buy or sell interest and then front run those large orders. To counter that, trading venues can set minimum size requirements and minimum-quote duration to prevent aggressive, high-frequency traders from playing the market, provisions likely to feature in any bank-only platform, whether bank-backed or run by EBS.

Multi-dealer platforms The FX market already has a variety of trading venues designed for different types of user. Buy side customers are big users of FX Connect and FX All; the latter also attracts corporations. These are multi-dealer platforms designed with end-users in mind. For example, they make it easy for a money manager who aggregates trades to break up a block and allocate pieces to multiple funds or managed accounts. Other venues, including EBS and Reuters, are matching engines better suited to banks and high-frequency trading firms. With so many choices already available, it is not obvious that another venue would necessarily attract liquidity, notwithstanding backing from the major dealers. The spot FX market is one of the

Robin Poynder, head of FX and money markets, EMEA, at Reuters. “It is likely we will see growth in the number of customers accessing prices through multi-bank platforms that conform to the regulatory framework,” he says. Photograph kindly supplied by Reuters, September 2011.

most liquid markets anywhere: the Bank for International Settlements (BIS) estimated daily turnover at $1.5trn in its 2010 triennial survey. The dealer-oriented platforms handle big volumes—Reuters sees about $150bn per day. In total, the banks’ own single dealer platforms account for a larger share of the market. Celent finds that the banks have upgraded their technology in recent years to improve internalisation, which has enabled them to recapture some volume that had previously migrated to multidealer platforms. “The single dealer platforms are evolving to accommodate large traders, while the multi-dealer platforms are garnering the high-frequency trading volume,” Sankar says. Competition between trading venues of a similar type is fierce. For example, during the past year EBS Spot added a fifth decimal place to quotes on its market, a move that Reuters has not matched. “For spot FX, we have chosen not to add the additional

decimal. We don’t feel it is best suited to a professional market,” says Robin Poynder, head of FX and money markets, EMEA, at Reuters. “Market feedback so far is strongly in favour of our approach.” Regulatory overhaul in Europe and the US is sure to affect FX trading but until the rules are finalised the likely changes remain shrouded. Even if spot and forward currency transactions are excluded from the new regime, as many observers expect, the migration of currency options and swaps to multilateral trading facilities in Europe and swaps execution facilities in the US could spill over into the unregulated products. “It is likely we will see growth in the number of customers accessing prices through multi-bank platforms that conform to the regulatory framework,”says Poynder. That would be one more obstacle to an exclusive bankowned trading venue, an idea that may yet prove to be a temper tantrum worthy of a two-year old rather than a serious proposal.I

OCTOBER 2011 • FTSE GLOBAL MARKETS

PLAYING HARDBALL IN THE MARKETS

The Age of Brinksmanship Erik Lehtis, president of DynamicFX Consulting, wonders if too many desperate players out there are betting the shirts off their backs. E’VE SEEN SOME desperate measures in play of late. There are so many that I wonder if we are entering a new age of brinksmanship. The game of chicken played by Republican Congressional leaders over the US debt ceiling certainly qualifies. Who doubted the GOP’s willingness to throw the nation into default for the sake of adhering to their nocompromise position? They may have achieved 98% of their goals, as US House of Representatives Speaker John Boehner was quoted claiming, but the victory came at the cost of investor confidence, and market upheaval. Future prospects for bipartisan cooperation received a severe blow as well. One of the many effects of that doomsday scenario was a further investor flight to safety that carried the already-strong Swiss franc to previously unimaginable levels versus the euro and US dollar. The chilling deflationary effect this undesired currency strength has had on the Swiss economy prompted the Swiss National Bank (SNB) to jawboning and actual intervention in the market over the past as eurozone issues started to appear endemic. Unfortunately, they were unable to move the dial on aggregate demand for francs, and as a consequence lost an estimated CFH30bn on their acquired portfolio of euros and dollars. As matters worsened, the SNB took the unprecedented step of aggressively intervening not just to slow the market’s direction, but

FTSE GLOBAL MARKETS • OCTOBER 2011

reverse it—dramatically. On September 6th with EUR-CHF in the 1.10 area, they bought EUR and indicated a level of 1.20 as a target, which it immediately achieved. This not only dealt great pain to anyone long Swissie, it improved the value of their foreign exchange holdings. It was also, in the words of the Financial Times, “the last card available to the bank”. While a spectacular success in the short term, one can only wonder at the tests awaiting this “line in the sand” down the road. Once speculators finish licking their wounds, they will no doubt begin licking their lips at the prospect for revenge—and a Soros-like confrontation. The sense that the SNB has no other cards left to play will only feed that dynamic, and many spectators hope the SNB gets more help from its friends than the Bank of England received in 1992 when George Soros led his successful assault on the lower end of the GBPDM band of the ERM. Not quite as extreme but nevertheless just as uncompromising is the position of the banking community in its pursuit of a foreign exchange wholesale market unfettered by equal participation of the buy side. The initiative, begun last year under the name Pure FX and temporarily shut down in the face of withering criticism, has never truly gone away and will now reportedly flower under the aegis of ICAP (EBS). Once the private plaything of banks, FX liquidity is now produced by a

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

new generation of traders who, while lacking the tradition and expertise for structured products, nevertheless have a significant edge in technology and knowledge how that can be used to provide pricing and risk management for the more liquid spot currency pairs. Larger proprietary trading houses now make better, stickier prices in spot FX, and they are closing the gap in options as well. Banks still, byand-large, insist on the multiparticipant platforms, of having a “last look” at trades: they want the ability to reject those that look like they may be unprofitable. On bankrun platforms, this is of course the norm, since in those venues customers are trading against the liquidity of the entity that manages the match itself. In effect, they are playing football against the referee. In all its aspects, the liquidityprovision game is one banks only want to play when they control it. Level playing surfaces are apparently for other pursuits, such as casinos and football. This is not to say the EBS-managed bank-only liquidity pool won’t be a short-term success. I can see Reuters even getting in the game at some point with a competitive offering, as the banks all glom onto this latest fad in their usual herd-following manner. In the long run, however, transparency in the price-discovery process will suffer, liquidity will be reduced and customers ill-served. If that’s a victory for anyone, I’d like to know who.I

REAL ESTATE

CENTRAL & EASTERN EUROPE: A WHOLE NEW BALL GAME

Photograph © Mariia Pazhyna / Dreamstime.com, supplied September 2011.

The slow burn of CEE real estate The real estate market in Europe’s central and eastern countries has been on a roller-coaster ride over the past five years, soaring to unprecedented heights before collapsing as concerned investors dumped stock, schemes and future plans for the region during the economic downturn. An uneven recovery has followed, with Poland and Czech Republic leading a new boost to inward investment, but not all markets are made equal and some investors already fear that commercial property prices have become uncompetitive. Mark Faithfull reports. ICKING A PATH through the prospects for Central and Eastern Europe (CEE), often erroneously considered as a single entity, has probably never been more problematic. Poland and Czech Republic—especially the former—have driven the market upwards yet already some key investors have questioned pricing. Alexander Otto, chief executive officer of influential German retail investor and shopping centre operator ECE,

declares, in obvious frustration: “Much of the prime Polish retail pricing has lost touch with reality.” Hungary, too, remains an enigma. Sporadic interest and poor economic fundamentals look to be undermining a genuine recovery, while hero-tozero markets Bulgaria and Romania have shown glimmers of an uptick, albeit high on the risk curve for would-be investors. If you then throw in the other Balkan states and the

easterly outpost Ukraine, which, along with Poland, should receive an economic boost from co-hosting next summer’s UEFA Euro 2012 football championships, suddenly determining where to acquire or develop is less than obvious. What is clear is that the CEE’s real estate market has broadly benefited from continuing stagnation in most of the core Western European markets and the uncertainty and collapse in peripheral eurozone nations, which might otherwise have attracted emerging markets funding. Commercial property investment turnover in the CEE had reached €6.9bn by mid-August, an increase of 20% compared with the whole of last year. Those figures make 2011 already the fourth strongest year in CEE history, according to adviser CB Richard Ellis (CBRE). Poland and Russia (the latter a market of a scale and cycle that broadly disconnects it from the rest of the CEE) have proved to be the growth engines across the region, representing over 70% of property investment volume, equivalent to some €5bn worth. Meanwhile, Czech Republic registered more

OCTOBER 2011 • FTSE GLOBAL MARKETS

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REAL ESTATE

CENTRAL & EASTERN EUROPE: A WHOLE NEW BALL GAME

than €1bn of property investment in the period—a 50% increase compared with the whole of 2010. For the first time since the global financial crisis hammered the market in 2008, retail property investment has attracted the most investment activity in the region at more than €3bn, representing 44% of the total property investment market. This investment in real estate has been mirrored by an upswing in interest from the retailers themselves, with fashion giants Zara and H&M at the start of September announcing fresh plans to expand in Bulgaria. Belgian giant Delhaize is another would-be player in the CEE, snapping up local retail and real estate player Delta Holdings as it ramps up its activity in the south and east of Europe. Recent deals include Olympia Shopping Centre in Brno, Czech Republic, and, in Poland, Magnolia Park in Wroclaw and Galeria Mokotow in Warsaw. Encouragingly, several of these large-scale shopping centres were traded from the developer to specialised retail investors such as Unibail-Rodamco and ECE Real Estate Partners. These moves tend to suggest that liquidity is gradually returning. Industrial property investment has also registered a strong performance in 2011 on the back of several large portfolio trades, including Pramerica’s venture with Panattoni Europe for a high-quality logistics scheme leased to strong tenants.

The modest rise in office prices More schemes are on the drawing board: Hungarian developer TriGranit has received consent for the €160m redevelopment of Poznan rail station and a 60,000 sqm shopping centre, with the first part of the investment, the station, to be finished next May in time for the Euros, some of which will take place in the west Poland city. US-based Blackstone has concluded its first deal in the CEE with the €200m purchase of the Magnolia shopping centre in Wroclaw, Poland, for a net initial yield estimated at 6.85%.

View of Warsaw. Photograph kindly supplied by Cushman & Wakefield, supplied September 2011.

Poland’s commercial property market has been led by new schemes such as Europa Centralna shopping centre near Gliwice, which opens next year. Photograph kindly supplied by Jones Lang LaSalle, supplied September 2011.

Even so, while retail has been king in the CEE’s re-emergence, office stock has also grown modestly during the first half of 2011, although development completions remain at the lowest level on record, according to the latest data from agent CB Richard Ellis (CBRE). Despite a recent increase in development starts across the CEE, the agent says that relatively low levels of completions are expected over the next 12-18 months. Weak occupational fun-

damentals coupled with continued challenges in securing financing mean that developers have been reluctant to launch new projects. Although most lenders still require pre-lets in order to finance new developments, a number of speculative projects were registered again, while limited new office supply and increasing demand has meant average vacancy rates are in decline, dropping below 14% following a 2% decline since Q4

OCTOBER 2011 • FTSE GLOBAL MARKETS

2010. The majority of this decrease was the result of positive vacancy trends in Eastern European capitals, where net absorption has been particularly strong. However, differences in vacancy rates remain significant across the region. Warsaw still has the lowest vacancy rate in the region (slightly above 6%) which has encouraged developers to launch new projects. Belgrade, by contrast, is still struggling with a vacancy rate close to 24%. Jos Tromp, head of CEE research and consulting at CBRE, adds: “Although take-up has been on the rise in most markets, net absorption has remained rather weak or has even turned negative in some cases. These low levels of net absorption can be explained by the increasing share of pre-lets mostly in Prague and Warsaw. Another reason is the limited new demand, as a growing element of take-up is generated by relocations.” Poland has seen a corresponding uplift in income, with prime rents in Warsaw up by 13% compared with the first half of 2010 although increases have slowed recently. Most other markets have not seen any rental growth over the past 12 months and some capitals, such as Sofia and Zagreb, are still coping with downward rental pressure. The CBRE CEE weighted average prime office yield index (including Eastern Europe) compressed further in the first half (H1) of 2011 to 8.8%. This is 52 basis points (bps) lower when compared with the end of the last quarter (Q4) of 2010; 85bps down on Q2 2010. Compression has in the main been driven by prime yield movement in Eastern Europe, while prime yields have remained mostly stable in Central Europe during H1 2011. However, despite the industry’s obsession with yield, UK property group Hammerson’s chief executive officer David Atkins warns that this focus on yields across Europe risks skewing investment fundamentals. He believes that income pressure remains downward across the continent and that yields on asking prices do not take into account the

FTSE GLOBAL MARKETS • OCTOBER 2011

likely fall in future property income. “Yields on many properties are completely unrealistic,”he warns.“Investors need to look at other factors to determine the merit of an investment.”

Poland, Russia drive office volumes In the CEE, total office investment turnover in H1 2011 amounted to €2.2bn, slightly lower than the €2.5bn achieved in all of 2010. This figure includes the office element of the CA Immo purchase of Europolis. Russia and Poland have driven office investment volumes thus far, accounting for more than 75% of regional investment activity in the year to date. Tromp explains: “Recovery is mainly visible in the top-tier of the market, while the socalled secondary segment has remained mostly illiquid in the majority of countries. Central Europe has re-emerged strongly, while Ukraine and Serbia are still waiting for the first transaction to close on the open market.” Tromp goes on to explain that Prague has seen an increase of investment activity as a result and markets such as Budapest are likely to follow suit in H2 2011 on the back of this trend. “This increase in activity could lead to some prime yield compression in a wider number of markets in the coming quarters,” he says. Poland is where much of the attention is, with the investment volume in Poland’s commercial real estate market reaching just over €1bn in the first half of 2011, according to research by international real estate adviser Savills. The H1 total represents almost 60% of the total investment volume in 2010 (€1.73bn) and Savills predicts that turnover in Poland is still on track to exceed €2bn by the end of 2011, representing a return to 2007 levels. In terms of the number of transactions in Q2 2011, the retail sector dominated the market with eight transactions signed, compared with seven in the office sector and five warehouse transactions. Significant deals included the acquisition of Promenada

shopping centre by Atrium for over €170m, the acquisition of the remaining 50% share in Wars Sawa Junior department stores by ING for €79m and several shopping centres in Polish regional and secondary cities. The real estate adviser expects the retail sector to further increase its market share in the second half of 2011 through a number of pending investment transactions, but believes that prime office buildings in Warsaw will remain the most-targeted stock despite shrinking availability of such investment product. Savills has also continued to observe an increased interest from investors in the regional office market where they can benefit from relatively good quality properties offering long leases at a 50bps-75bps discount to Warsaw. Michal Cwiklinski, head of investment at Savills Poland, says: “The dominance of retail deals in the second quarter of 2011 confirms a growing interest of investors in well-established retail assets, particularly in Poland’s regional markets and smaller cities. We expect to see this trend become more visible in the coming months, especially in view of the shrinking availability of prime office properties.” Overall, Warsaw continued to be the most targeted location for investors in Q2 2011 according to Savills, where both prime office yields and prime retail yields remained stable at approximately 6.5%. In the major regional markets, Savills research indicates that prime office yields stand at approximately 7.25% and prime retail yields at between 6.5%-7%. The most active investors in Poland in the quarter continued to be Austrian, German and UK buyers. So is the time finally right for the CEE? A return to some sort of reality after the crazy days of the boom has undoubtedly helped the markets to build again on fundamentals and even those most tarnished by the economic collapse have begun to reappear on the investment radar. Yet value and liquidity must go hand-in-hand and few markets across the CEE can lay claim to both as we enter the closing months of 2011.I

REGIONAL REPORT

TURKISH BORROWERS: LEVERAGING LOW FUNDING COSTS

Despite gnawing worries about a runaway current account deficit, the future’s bright for Turkey, evinced most clearly in the growing diversity and cheapness of the capital markets borrowing of its major banks. There’s been a lot of talk this year about Turkish issuers achieving investment grade status by 2012; the jury is still out. However, the country’s steady growth (HSBC thinks it will grow by at least 5% a year for the next nine years, at least) backed by a growing population, an increasingly efficient export segment and a plan to develop Istanbul as a regional financial centre, thereby creating and sustaining liquidity. Against all this promise is a burgeoning bank borrowing market, encouraged by ever-lower margins on debt and a broadening set of debt instruments to choose from. Three transactions: two in the capital markets; one a project financing highlight seminal changes in the Turkish market. Francesca Carnevale surveys the growing confidence of Turkish borrowers and the expanding volume and range of new debt. Photograph © Roman Smitko / Dreamstime.com, supplied September 2011.

Turkey’s banks set new benchmarks in the debt capital markets WO DEVELOPMENTS HAVE influenced the near term Turkish bank borrowing market. The first is that banks has been less keen to buy T-bills for some time now; the second is that the cost of funds for Turkish bank borrowers has dropped to all-time low levels. The trend to buy fewer T-bills began in the second half of last year as domestic loan demand soared as real interest rates continued to fall. Banks currently hold approximately 64% of

the domestic debt stock, down from 68% a year earlier, according to Is Investment’s latest paper Soft Landing under the New Normal. On the flip side for the government, some of the shortfall has been provided by nonresident investors, whose share in the T-bill market has risen to 15% from 10% in June 2010. Government bond yields have narrowed substantially in recent years as the administration have pursued fiscally conservative policies, coupled

with increased receipts from privatisations; this has encouraged banks to lend more vigorously to preserve profits. The central bank has increased the reserve requirements for Turkish banks to try to curb lending, but the proverbial cat left its bag some months ago and the administration will find it hard to cap profitable business lines. Turkish banks have tended to approach the international markets mainly through syndicated loans and Eurobonds. Akbank’s late-August

OCTOBER 2011 • FTSE GLOBAL MARKETS

REGIONAL REPORT

TURKISH BORROWERS: LEVERAGING LOW FUNDING COSTS

$1.45bn syndicated loan, priced at just 100 basis points (bps) over bank lending rates shows how far Turkish borrowers have come in the aftermath of the global financial crisis and setting a new low in the cost of funds. This is Akbank’s second syndication this year, having raised $1.3bn in March, at only slightly higher pricing. The one year dual tranche facility came in at Euribor plus 1.1% for the €652m tranche and Libor plus 1.1% for the $406m US dollar denominated portion. It is clear that Akbank, as with Garanti Bank, is setting the pace for forays by Turkey’s banking majors into the capital markets. Although as yet unsubstantiated, it looks like Akbank will also look further afield: if not at the Asian market, then certainly at an issue in another currency, likely yen. Akbank has enjoyed consistent appeal in the capital markets, in mid 2010 it came to the market with a groundbreaking five year $1bn unsecured Eurobond, offering a yield of 5.256% and a coupon of 5.125%; still the largest security ever sold by a Turkish issuer, excepting the sovereign, and was priced with the lowest coupon at the time for a nonsovereign borrower. That deal was arranged by Citi, Bank of America Merrill Lynch, JP Morgan and Standard Chartered was over-subscribed by a factor of three.

Covered bonds Equally, a number of Turkish banks are now looking at issuing covered bonds. The option has been available to the banking segment for some years. The country’s capital markets board approved supporting legislation back in 2007. In the event, the majors were overtaken by mid-tier bank, Sekerbank, which broke the mould in more ways than one. Sekerbank cleared the path to full scale opening of a covered bond market in Turkey as it debuted a eurodenominated $135m (TRY230m) debut covered bond, backed by SME loan repayments. The bond was struc-

Sekerbank has certainly cleared the path to full scale opening of a covered bond market in Turkey as it debuted a euro-denominated $135m (TRY230m) debut covered bond, backed by SME loan repayments. The bond was structured in three tranches, priced between 200bps and 250bps over Euribor. The bonds were then swapped into Turkish lira. tured in three tranches, priced between 200bps and 250bps over Euribor. The bonds were then swapped into Turkish lira. The bonds form part of a planned TRY800m (around $447m) rolling programme of borrowing in the asset backed market that the bank will utilise to support its SME lending book. The bonds are backed by a pool of 15,000 SME loans, mainly from the Asian side of Turkey and the transaction was assigned an A3 rating by Moody’s Investor Services. Meanwhile, the security package of underlying assets includes a haircut which is 25% higher than the outstanding bonds. “The cost of funds is better than a Eurobond,”says a Sekerbank executive,“moreover, the quality of the underlying assets means the structure is attractive, even if markets are volatile.” The deal, which took a year and a half to put together was arranged by Unicredit and sold to a club of investors, including Dutch development bank FMO which took $16m; Unicredit, which took a €50m equivalent investment; and Washingtonbased International Finance Corporation (IFC), the private sector funding arm of the World Bank, which took an investment worth $25m. One tranche matures in 2019; two others (those bought by the FMO and IFC mature in 2016). A second covered bond from the issuer is expected to come to market in September, with possible investors including the European Bank for Reconstruction and Development (EBRD). Unicredit is also sole arranger of the bank’s overall programme and led discussions with the IFC and FMO. BNY Mellon is trustee.

Bonds backed by SME loans are a first for the market at large and the first for a Turkish issuer. Sekerbank’s expertise in the SME funding segment, made the asset class the most suitable for the bank’s maiden deal; though the market in these types of instrument are more used to mortgage-backed assets. Interestingly, aside from Unicredit, the club deal was dominated by quasi-sovereigns, a singular characteristic of some of the more innovative financing structures in the Turkish market; at least until they are adopted by capital markets investors at large. Sekerbank executives say that the bank will sell its covered bonds to a broader range of investors. For its part, the IFC is a ubiquitous presence in the Turkey bank borrowing market. In this particular transaction, the IFC classed its investment in the deal as a Category F1 project. The lender also has a long standing relationship with Sekerbank, which previous to this latest transaction comprised two senior loans for lending-on to SMEs, farmers and agribusiness companies, a trade line under GTFP and a 5% equity stake in the bank itself. The question now is: how soon will it take other Turkish banks to follow suit? The central bank remains keen to cap loan exposure on bank balance sheets. It may be that hiving off risk exposure to below the bottom line via asset-backed loan structures may be one way forward. While the banking sector has yet to test longer tenors in the capital markets, a number of Turkish borrowers have managed to push out tenors

OCTOBER 2011 • FTSE GLOBAL MARKETS

REGIONAL REPORT

TURKISH BORROWERS: LEVERAGING LOW FUNDING COSTS

in through working with multinationals. In June, state owned lender Halkbank was the latest borrower to tap the longer term market as it signed an agreement with France’s development agency for a €100m, 12-year

loan, with a four-year grace period. The interest rate on the loan is indexed to a six-month benchmark. The loan will be used to finance renewable energy and energy efficiency investments, the bank said in an official

statement. Again, this an example of the way that Turkish banks break new financing ground through relationships with quasi-sovereign entities, which are later taken up in the wider capital markets. I

HIGH SPEED RAILWAYS IN TURKEY: A BELLWETHER OF CHANGE ROJECT FINANCING HAS always been a big thing in Turkey. In the 1980s, the country’s investment in coal fired and hydro-electric power helped define a whole raft of new project financing structures, including Build-OwnTransfer (BOT) structures that finally found form in public-private partnership development projects in both developed and emerging markets. One pivotal deal: the Erdine to Kinale road financing, arranged by the late forfeiting specialist Midland Bank Aval in 1986 kick-started a massive round of project financed infrastructure investment in Turkey, that encompassed the Istanbul metro as well as slate of highways and hypermarkets in and around Istanbul. These projects also helped define the banking relationships that would ultimately prescribe the make-up of the country’s 33 commercial banks and the three remaining state-owned entities. Then it was a business dominated by European and American contractors, funded and supported by US and largely European banks. In late August, Turkey announced the launch of a new high speed rail link between Ankara and the Anatolian city of Konya. Built by Turkish contractors in a record breaking four and a half years, the 212km link is the first phase in an extensive programme of high speed rail construction, involving some 6000km of high speed rail tracks, worth $100bn by 2023, the 100th anniversary of the Republic. Criss-crossing the country, it is the largest land and railway strategy

Photograph © Oleksiy Mark / Dreamstime.com, supplied September 2011.

ever implemented in Turkey. Russian and Chinese contractors are lining up to bid for some of the phases of the project. China Civil Engineering, which has already won construction bids in Turkey alongside local contracting firms such as Cengiz and IC Ictas, is said to be in talks with the government about building a 2,000km high-speed railway linking Erdine on the border with Bulgaria and Greece and Kars in the northeast, near Georgia and Armenia. Turkish State Railways is in charge

of the country's HSR development and has already supervised work on the Ankara-Istanbul line. Phase 1, which runs more than 200 km from Ankara west to Eskisehir, was built by a Spanish company and opened in early 2009. When the entire line opens, travel time between Ankara and Istanbul, the country's two largest cities, will shorten from seven hours to less than four. This latest round of projects reflects the substantive changes underway in the global construction market, with Chinese and Russian companies fighting for market share in high growth markets such as Turkey, which have the wherewithal to fund big ticket infrastructure projects. The presence of contractors from the BRIC nations is also beginning to have the same repercussions on the make-up of the Turkish banking segment: China Construction Bank and Spain’s Banco Santander are already working in joint venture to offer banking services in rural areas in Turkey. Moreover, Turkey’s burgeoning export relationships with countries such as Russia, China, South Africa, Israel and other advanced emerging markets will eventually feed through into the country’s ambitions to establish Istanbul as a global financial centre. As one banker in Istanbul notes: “Turkish Airlines flights to Beijing, Shanghai, Guangdong and Moscow are full, a reflection of the changing relationship among high growth economies and Turkey is well placed to benefit from the new economic relationships that are developing.”

OCTOBER 2011 • FTSE GLOBAL MARKETS

COVER STORY

ISBANK: VOICING A NEW POLEMIC IN EM GROWTH

The importance of the long distance runner

Adnan Bali, chief executive officer, Isbank. Photograph kindly supplied by Isbank, September 2011.

It has been a taut period for Turkish banking. Caught in the market maelstrom following ructions in the Eurozone over debt; investor tension about variable market performance in the emerging markets and the rise of political instability in neighbouring markets, Turkey’s outstanding growth trajectory has been nipped at and tested in more ways than one. Moreover, Turkey has never been an easy market in which to be a banker. Although it remains relatively underbanked and still full of promise, Turkey’s bankers, more than most of their counterparts, have had to walk a sometimes sensitive political line. That has not deterred Isbank chief executive officer Adnan Bali, who has taken on a leadership mantle at a key time in the affairs of Turkish bankers, both at home and abroad. Francesca Carnevale spoke to Bali about the sea changes running through the sector and voices a new emerging markets polemic which has immense repercussions for the evolving economic order in the second decade of this century. SBANK HAS ALWAYS carried a special mantle in the Turkish banking segment; mandated personally by Ataturk in the early 1920s it has—even at an historic distance—symbolised the modernisation of the country and the easy internationalisation of its economy. Although a highly-conservative institution, it has often carried out radical change and been at the forefront of innovative thinking at home and in its business abroad. Turkey’s banks have, since the 1980s, been the first movers in developing sophisticated services, particularly for retail customers. Electronic banking,

FTSE GLOBAL MARKETS • OCTOBER 2011

telephone-based banking and relationship-based customer-sales techniques were often adopted in Turkey before the rest of Europe. In that regard, as Turkey’s largest bank, Isbank has played a leading role in modernising the country’s financial infrastructure. Taking on the mantle of general manager in April this year, after predecessor Ersin Özince moved to the job of chairman, Adnan Bali says he was keen to take on the role at full pelt: “It has been a critical time for financial institutions across the globe and we were no exception. There has been no time for navel gazing; and in that context there

has been no time to lose. The recent slowdown in economic activity in the developed economies and the fiscal challenges facing those nations has repercussions for all of us; creating uncertainty and volatility and therefore plenty of downside risk. The driver was and has been: let us get on with the job.” These are pivotal times in the global markets, and Bali holds that the most distinctive feature of the post-financial crisis period is the growing gulf between developed and the emerging highgrowth markets.“There are clear signs of decoupling among these groups. Highgrowth markets in particular as

REGIONAL REPORT

ISBANK: VOICING A NEW POLEMIC IN EM GROWTH

decoupling from the advanced economy, for the obvious reasons of unemployment, fiscal challenges and the debt overhang, which have limited the options available to those economies. The high-growth emerging markets are, on the other hand, in a strong position to continue with expansive policies, and creating global liquidity.”

Drives of growth The drivers of growth however, remain individual he says: “Developing economies such as Turkey, have different characteristics, with their own particular issues: in our case notably in 2010, a domestic demand-driven, high economic-growth momentum was accompanied by the steady appreciation of the currency which has hampered our international competitiveness. In parallel to this, in the first half of 2011, the current account deficit widened significantly.” More worrisome however, continues Bali, is the propensity of developing countries to opt for restrictive policies to limit massive capital inflows, the long-term consequences of which have yet to play out in the global capital and investment markets. In the case of Turkey however, Bali cites it as a “good example of a good recovery and a central bank that has chosen an unorthodox policy mix” to combat any imbalances in the current account, including “reduced interest rates to support financial stability, while tightening reserve requirements to inhibit any exuberant lending”. In addition, Bali states: “With the effects of the measures taken together with the global slowdown, in the second quarter of 2011, economic activity started to lose steam and growth is expected to converge to more sustainable levels in the coming period.”Even so, Turkey surprised market watchers in September as central bank figures showed the economy growing by 8.8% in the second quarter of 2011. The results are positive, he posits, opening the way for the country and financial institutions within it to leverage the opportunities presented on the path to becoming a regional financial

centre. “I am convinced that Istanbul can play a leading role, supporting a regional hinterland that encompasses the Middle East, North Africa, Central Asia and the Caucasus, even perhaps Russia,” he declaims. The regulatory reforms that were introduced after 2001 crisis, he states, underpin Turkey’s bid for a regional leadership position.“This is highly significant for the region, where Turkey is leading the way in terms of a strong internal infrastructure. This encompasses any number of elements, but must include good corporate governance, market transparency, and solid capital markets supervision. To that must be added a strong banking system, which prioritises revenue generation coupled with effective internal cost and credit controls,”says Bali. He also talks of a new world order among the emerging markets which will bring their own experience to bear on a post-financial crisis world and is replete with 21st century political overtones. He is adamant that the concept, which he concedes has been prevalent in Turkey’s near neighbourhood, of a poor population unhappily hitched to a rich state is outworn and has no place in modern political economy.“This model has truly collapsed.” Although he concedes that the model had some advantages, namely that“the process of change and purchasing power were tightly meshed and it also gave comfort to some to manage business by utilising an interface with a public authority”. However, over the longer term he sees it as unsustainable and prone to a natural if somewhat difficult death. Moreover it involves a strategic political polemic. “If you look at these demand-deficient models, we see they have no relevance in global terms. In that sense, we need to encourage the rise of the consumer in the emerging markets if growth is to be sustained. The first part of policy making is helping along the process of reconstruction and development in key countries,” he says. Bali believes this will help underpin Turkey’s increasingly positive role in the

global world order. He says:“Regulation, and the evolution of an internal infrastructure is something we can leverage within Turkey to our own benefit; but it is also something that can help create attractiveness in a wider geographic context in terms of financial flows.” He expands upon the theme that underlying trading relationships will form the backbone of initiatives, both at home and abroad. “It has become part and parcel of our regional strategic thinking. To that end we have recently acquired 100% shares of Sofia Bank in Moscow, which has 13 branches. Furthermore we opened a branch in northern Iraq and a representative office in Egypt and also we are planning to establish a representative office in Syria. Equally, the bank is also hoping to establish operations in Azerbaijan. We don’t look at these initiatives in terms only of opening a branch and facilitating trade finance. Nowadays we look at these operations in a much broader sense, which involves exporting expertise, even to helping with the establishment of regulatory bodies. We think this is a constructive approach; backed by a longterm commitment to the markets in which we operate. We want to take part in the long process of change.” Supporting these moves is not only for local governments, anxious to leverage the bank’s thought leadership. He adds: “We are also greatly influenced by a deep pool of rather dynamic customers, which already has substantial business expertise in these countries. We try to be close to our customers in this regard.”

Benefit of experience While the future’s bright, Bali is adamant that the Turkish banking system has not forgotten the temptations and mistakes of the near past. Bali admits that the 2001 banking crisis in Turkey was deep and a wake-up call to alter the terms of business: “We had to be pragmatic and take on board a lot of improvements. Looking back, of course, we have benefited from that and want to pass on the baton to other countries. It has also governed the way

OCTOBER 2011 • FTSE GLOBAL MARKETS

that we have subsequently evolved customer services; both at the corporate and retail level and extended financial loans and credit processes. At the time however, I do not mind telling you that it was extremely painful.” That caution helped the bank weather the crisis without the need to invite foreign investors to provide capital support. As a result, Isbank remains one of the few financial institutions in Turkey without a strategic foreign partner. As a listed firm however, Bali points out that foreign investors own up to 70% of the free float. However, he states: “None is what you would class as a strategic partner and therein lies the difference.” Despite the generally optimistic business outlook, Bali concedes that 2011 has not been a banner year. During the first half of 2011, the central bank raised the reserve requirement for banks’ lira liabilities, significantly setting a higher ratio for short-term deposits of one month or less, to 16%, up from 8%, which subsequently drained no small level of liquidity from the domestic market. “The central bank’s increase in reserve requirement has put pressure on interest margins, as there is no interest paid for these reserves,” acknowledges Bali. Even so, Turkey’s banking segment remains unconstrained through the sheer level of opportunity extant in the market. Although the banking sector is seeing some saturation and increasing competition from foreign banks in servicing blue chip companies, the retail and small and medium-sized enterprise (SME) segments in Turkey continue to provide greenfield opportunity. In the first half of this year total assets of the bank grew by 12.2% reaching TRY147.9bn. Net profit for the period, on the other hand, was TRY1.48bn. Lending rose 20%, (higher than the sector growth rate) and reached TRY76.79bn, raising the share of loans in the bank’s total assets to 52%. According to the bank’s official results release, Isbank also achieved a 2.0% increase in deposits, and raised its

FTSE GLOBAL MARKETS • OCTOBER 2011

Adnan Bali, chief executive officer, Isbank. Photograph kindly supplied by Isbank, September 2011.

deposit base to TRY90bn. As for the Turkish Lira savings deposits, which has the largest share in the bank’s total deposit base, there has been 5.7% increase during this period. As a result, Isbank stands out as the largest bank in the sector in terms of loans and shareholders’ equity, and the largest private sector bank in terms of total assets, deposits and number of branches. According to Bali, there remain some market concerns over liquidity for Turkish banks, as the increase in costs in deposit market has restricted the growth in net interest income in the first half of the year. “On the other hand, the flight of capital from emerging markets to developed markets due to the liquidity needs in global markets has resulted in pressure on currency rates and also increased the risks of doing business in emerging countries as well as raising interest rates.” It is not an issue that will fade away in the final quarter of this year he agrees: “Measures taken by the central bank and the regulatory authority have been aimed at curbing loan growth in 2011.

Some will see this as a restriction; I see it as an opportunity for the bank to improve the overall profitability. This will involve the renegotiation of short-term loans which will create arbitrage opportunities for borrowers.” Overall, Bali views current market volatility and continued stresses as a transitional period in the global economy, marked by a year of“unprecedented events”. Bali, like other market leaders, sees 2011 as the last gasp of last century’s sometimes outdated politicaleconomic parameters. “We are being called to reconsider all things once again. It might be a risk to do so; but we are moving at a rapid pace towards a stricter regulatory financial system. We might as well imagine and prepare for what realistically this might mean for us all,” he states. He worries: “The question is, how effective these new model economies will be. In our home market, the BRSA, the Turkish regulator has said that for the time being there are no major initiatives in train: there is little need as we have already done a lot of homework in the credit area and successfully bolstered our balance sheets, as per central bank requirements. To all intents and purposes it has left us a deleveraged economy. Basel II is planned to be put into effect by the middle of next year in Turkey. Since July 2011 BRSA has started a parallel implementation process. We will also be fully compliant with Basel II by the middle of next year and we continue with our Basel III monitoring exercises.” Also domestically, Isbank will have to find a counterbalance to a contraction in margins on local lending as competition heats up in the still (overall) underbanked Turkish market. Bali may have lofty plans abroad and be well prepped on the new business models emerging from the changing balances of power in the global financial markets. However, he will also have to manage more prosaic, though no less important issues at home. It will not be an easy equation to square; though Bali maintains that the bank will “continue to monitor all eventualities closely. It pays to do so”.I

REGIONAL REPORT

THE EVOLUTION OF SECURITIES SERVICES IN TURKEY

All change for securities services The provision of securities services in Turkey is still evolving. However, the expectation that Turkey will achieve investment grade status in 2012 is changing the terms of trade around the securities services offering. Additionally, the growth in the listed derivatives markets offers substantial opportunities to service providers, particularly in the collateral management and settlement space. FTSE Global Markets spoke to Nelson Fernandes, manager, at TEB Securities Services in Istanbul about the development of TEB’s securities services set and the efficacy of the bank’s venture with BNP Paribas. TSE GLOBAL MARKETS: How has the joint venture between TEB and BNP Paribas evolved? What are the strategic drivers of the joint venture? NELSON FERNANDES: Founded in 1927, Türk Ekonomi Bankası AS (TEB) is a strong and reputable local universal bank, active in commercial banking for retail, SME and corporate clients, investment banking, securities services, asset management, private banking, leasing and factoring. Since 2005, it is part of BNP Paribas Group, together with the local owner Colakoglu Group. After the merger with Fortis Bank Turkey, which was finalised in February 2011, TEB became the sixth largest privately owned bank in Turkey with more than 600 retail branches, 10,500 employees, 3m retail and 500 000 corporate customers. The integration project was an excellent opportunity to have people and businesses come together and build new ambitions. Evidently, with retail banking as the primary strategic driver of the partnership, the strength of the joint venture lies today in all three divisions of BNP Paribas—retail banking, corporate and investment banking and investment solutions. The three divisions work together in a locally harmonised manner, with a focus on clients and innovation, to grow their market share. They leverage TEB’s local expertise with the global knowledge of BNP Paribas and the cross selling dynamic between business lines. The provision of securities service is one of the investment solutions business lines. BNP Paribas has offered securities services in Turkey since the early 1990’s. Today, the offer is

Nelson Fernandes, manager, at TEB Securities Services. Photograph kindly supplied by TEB Securities Services, September 2011.

embedded within TEB, as the Turkish flag of BNP Paribas Securities Services’ network and benefits from the common business culture. FTSE GLOBAL MARKETS: Where do you see opportunity in the domestic market for the joint venture? NELSON FERNANDES: BNP Paribas has identified Turkey as a key market among the 85 countries it is operating in. With BNP Paribas’ expertise, TEB is very well positioned to present new and more sophisticated products to the market. Our securities services business line in partnership with BNP Paribas Securities Services is strengthening its market position in clearing and custody solutions for financial intermediaries, expanding its offer for institutional investors, both in terms of fund services and covering the growing service needs for corporates and issuers. For financial intermediaries, Turkey has been a sound growth market in the

recent global turmoil, with an 8.8% growth through the second quarter of 2011. The expectations that Turkey will reach investment grade soon trigger volumes as Turkish instruments will become eligible for collateral management and more institutional investor portfolios. The non-resident holdings in Turkish government bonds and bills have already increased more than 30% since July 2010, even though total debt value has decreased around 7%. This is contrary to the Istanbul Stock Exchange holdings where foreign shareholding fell sharply to 62% by the end of July 2011 from 66% at year end 2010. In listed derivatives, an efficient clearing environment for give-up and new products like listed options will appear with new systems currently being implemented at TurkDEX. At TurkDEX, the total trade volume of non-residents has increased by more than 25% and reached $3bn since the beginning of 2010, while the total market shrank by almost 5%. Other opportunities will arise as new instruments like covered warrants—that started in August 2010—continue to pick up. For institutional investors, lower interest rates are already pushing the asset management companies away from classic money market investments towards new sophisticated investment strategies, such as capital guaranteed funds and alternative funds. The number of independent asset managers has also increased and soon, they expect to be able to issue their own funds. Meantime, local and international asset managers and private banks are looking for turnkey fund services. The pension fund market is also expanding (with a

OCTOBER 2011 • FTSE GLOBAL MARKETS

30% increase between 2009 and 2010). We see that the demand for international investments from local institutional investors is growing slowly but surely, thereby increasing the demand for global custody and fund services; and those asset owners are looking for specialised services. Equally, the government is focusing more and more on capital markets as a means of creating value for Turkish companies and investors. The number of listed companies has increased from 325 at the end of 2009 to 370 today. The hope is to reach 1000 listed companies by 2023, the 100th anniversary of the republic. The initiatives to increase the number of listed companies will provide opportunities in equities and debt issuance services and related value added services, such as outsourcing of depository operations for issuers. Moreover, we also expect that the Istanbul Finance Centre project will open up new regional opportunities for us. FTSE GLOBAL MARKETS: How has the joint venture harnessed the growing volume of foreign investment inflows into the Turkish capital markets? NELSON FERNANDES: With the global turmoil, custody clients began to be attracted not only to the Turkish market itself but also to safety. The growing volumes in Turkey made some other names stop and take a look at the options and opportunities in the market and they liked what we were offering; safety locally with TEB and globally with BNP Paribas, our product range, our local expertise and our partnership approach. In Turkey, the securities services business used to be and still is for some players, limited to serving the settlement and safekeeping needs of non-resident institutional investors in the local market; mostly for cash equities and government bonds and bills. However, this is changing with the growing volume of foreign investment flows. For example, since 2005, we have directed some part of our energy to capture the interest of international

FTSE GLOBAL MARKETS • OCTOBER 2011

names in listed derivatives market. We have created a successful bundled offer together with TEB Investment—the brokerage arm of TEB to provide execution and clearing services for TurkDEX. This set-up is innovative, as it brings the value of a leading broker and custodian in a non give-up environment [sic]. The other missing part in the chain to harness the growing interest is to attract the off shore securities lending and borrowing volumes of non-residents locally. Together with BNP Paribas Securities Services, we met market authorities to explain the needs of institutional investors to create an effective market. With this wide product portfolio and the venture towards higher quality, we have benefited extensively from growing volumes and since 2009, our assets under custody have more than doubled. FTSE GLOBAL MARKETS: What is the makeup of your client base? How might this grow/change in the near future? NELSON FERNANDES: We service all financial client segments in the investment cycle. These days our major client base is non-resident global custodians, global broker-dealers and banks from the major markets. We are also serving names from countries that are new to the Turkish market. They all follow the growth of the local capital markets and look for providers capable to service them both now and in the future. We also see interest from market players that are new to the market, such as high frequency traders (HFT). These trends can only accelerate once Turkey achieves investment grade as it will attract more institutional investors, as has been the case elsewhere; Brazil for instance. At the same time, our local client base is growing steadily. We continue to invest in transferring our growing securities servicing know-how, built-up over years in mature markets by BNP Paribas, to local players. We know that as the economy grows and larger numbers of sophisticated players enter the market, the range of local post-trade services

provided today alongside brokerage or banking services will not be enough and we have to meet that need. Similarly, we are looking at the needs of the issuers, together with the corporate banking business line of TEB. With the increasing use of systems and new media; for example, dematerialisation, CRA portals and on line general meetings, public companies will start looking for a securities services partner to work with. We have a strong, client focused approach to market changes, backed by financial strength and willingness to help our clients grow their own businesses. FTSE GLOBAL MARKETS: How competitive is the securities services market in Turkey? How are you differentiating yourself within the segment? NELSON FERNANDES: There are good local custodians in the Turkish market servicing the needs of non-resident financial intermediaries. We differentiate ourselves with the fact that we are a securities services provider and not only a custodian. We are backed by a large group of experts in this industry and a strong bank. We are also close to the market as a local player. Our clients, local and global, trust us as their partner. We trust them as the rising stars in their own business and help them grow. We cover the whole value chain in the investment cycle. As a local custodian for non-resident clients, we provide the highest quality services maintained by an experienced team ready to go out of their way to help clients. This is supported by a robust system platform, innovative products, in addition to the size and expertise of TEB as a local bank that allows us to offer comprehensive solutions to local clients and market reach. To answer clients’ needs looking for front to back local services, for example, we have built successful cooperation with group companies – brokerage and asset management companies and fixed income desk, while all the time ensuring that we maintain appropriate Chinese walls. I

REGIONAL REPORT

GCC PROJECTS: UAE DOWN WHILE SAUDI SPEND INCREASES

The growing disparity of fortunes in the GCC project segment was starkly exposed by a Citigroup report, which highlighted the fact that while some $170bn of projects in the United Arab Emirates have been put on hold or cancelled outright, the MENA region has seen a substantial uptick in infrastructure project spend. Who are the winners and runners up in the GCC project stakes right now?

Fortunes divide in infrastructure spending in the GCC ITIGROUP’S LATEST MENA construction tracker report holds that the value of projects either delayed or cancelled rose to $170bn in August alone; a signal indication that the construction segment, particularly related to real estate in the Emirates, is still suffering from the fallout of local construction firms overstretching their credit exposure in the early years of this century. The figure is significant; the value of projects cancelled or delayed accounts for 56% of the all stymied projects across the survey area and is up 13% on July’s figures. The property boom in the Emirates has now been languishing for over 3 years, with some prices of private property estimated to have fallen by as much as 60% in Dubai. No wonder many developers have been forced to abandon projects. Projects cancelled or on hold across the wider MENA region in contrast, fell slightly to $1.69bn, compared with $1.7bn in July. However, key markets in the GCC continue on the fast track in terms of new project spend. Saudi Arabia added $81bn worth of projects to the already $100bn it intends to spend on infrastructure in general and $20bn it will spend on downstream petrochemical projects over the coming five years. Saudi Arabia, the UAE, also Jordan and Egypt are reportedly now pushing forward the idea of building nuclear power capacity across the MENA region; with the estimated value of projects topping $400bn over the next 15 years. Saudi Arabia will again dominate this segment, with a

planned $350bn spend on the King Abdullah City of Atomic and Renewable Energy project, which aims to establish a zeroCo2 emissions city using a mix of nuclear and other renewal energy sources. Around 16 separate nuclear units are planned. Kuwait ($20bn) and Qatar ($2bn) also have projects that are in preliminary stages of construction. In contrast, the UAE also showed a $12bn decline in preliminary projects to $118bn. It is a contrasting picture with the situation even two years ago. While the outlook for countries such as Saudi Arabia look strong in the near term, revised data issued by the Saudi Arabian Monetary Authority shows that the build up to the current construction pipeline was rather slow in 2009 and the first half of 2010. There was an uptick in growth in 2010, with the industry posting 3.7% year-on-year real construction industry growth, while an average growth in construction projects of some 4% a year over the next four years is expected, backed by a healthy project pipeline, strong government support, an ability to invest and local demand for infrastructure keeps the industry stable. The country’s Ninth Development Plan announced a touch over a year ago sets out an investment spend on infrastructure of some SAR1, 444bn ($385bn) between 2010 and 2014. Then, in response to stirrings elsewhere in MENA, now called the Arab Spring, the government created two packages of social benefits worth $130bn to finance further investment in educa-

tion, healthcare and housing projects. SAR250bn ($66bn) was pledged for housing alone, with 500,000 new units in the pipeline. Around 7% of development plan investment will be channelled into housing, encompassing some 1m new houses to be built on a public-private partnership basis. Another 19% will be invested in healthcare, involving the build of some 117 hospitals and 750 so-called primary care units. The government also has an $80bn 10-year investment plan for electricity infrastructure underway in parallel with the infrastructure investment plans, which run out to 2018. Some 20GW of electricity capacity is currently under construction, worth around $30bn. In a boost to local construction firms, the Saudi Industrial Development Fund has announced it will finance up to 75% of costs for investment projects in under-developed regions. The current crop of investments underway includes the SAR40bn expansion of the Grand Mosque, underscoring the Kingdom’s pivotal role in Islam. The expansion, in the northern part of the Grand Mosque will cover an estimated 356,000 square metres, ultimately accommodating up to 1.2m worshippers. It includes the construction of four giant bridges allowing access to the northern courtyards inside the Grand Mosque. It is the largest expansion project within the Grand Mosque complex to date and will showcase the country’s move into the 21st century, while retaining its sacred role as protector of the Islamic faith.I

OCTOBER 2011 • FTSE GLOBAL MARKETS

REGIONAL REPORT

SUKUK: INVESTOR DEMAND OUTSTRIPS SUPPLY

Steady build up in sukuk issuance over the year Saudi Arabia’s first floating rate Shari’a compliant project sukuk was launched in early September. The sukuk, whose ultimate value has not been announced, will have a tenor of 14 years, subject to the parties to the transaction agreeing the commencement date of the project schedule. Investors in the sukuk are expected to receive a return of 6 month SAIBOR plus a margin each year, based on profits, to be distributed semiannually. In a region rich in project investment over the coming decade, the transaction is being described as an important benchmark for Shari’a compliant financial structures. AUDI ARAMCO TOTAL Refining and Petrochemical Company (SATORP) announced the launch of its public offering of sukuk certificates in early September. The actual bonds will be issued by Arabian Aramco Total Services Company (AATSC), a company especially established for the purpose of issuing the Sukuk on behalf of SATORP. The total offering size will be determined at a later stage by SATORP. Deutsche Securities Saudi Arabia, Samba Capital & Investment Management Company and Saudi Fransi Capital have acted as joint lead managers and joint bookrunners on the transaction. The proceeds of the issue of the sukuk will used to provide fund procurement, delivery and ultimately build of two petrochemical tank farms, which will form part of the development of the SATORP refinery project, a project sponsored by Saudi Aramco and France’s Total which involves the construction of a 400,000 bpd refining and petrochemical complex, to be located in Jubail Industrial City. The sukuk is expected to be offered to financial institutions, mutual funds, insurance companies and pension funds as well as individuals, who will

be able to subscribe to the sukuk subject to the subscription terms and conditions. Foreign investment in the transaction will be limited. The offering, sale and delivery of the sukuk is confined to Saudi nationals and those other legal entities with a permanent establishment in the Kingdom holding a current commercial registration number issued by the Ministry of Commerce and Industry. Rising demand for sukuk investments was highlighted a few weeks earlier by Abu Dhabi’s First Gulf Bank issue of a five-year, $650m (AED2.387bn) sukuk to expand its Islamic operations. Bond subscriptions exceeded $3.8bn, around six times oversubscribed, said the bank in a release. The five year issue is listed in London and offers a fixed profit rate of 3.797%. Proceeds will be used by the bank to supports its Islamic finance business. Andre Sayegh, FGB’s chief executive officer noted that: “The sukuk will diversify our sources and maturities of funding, and expand our Islamic operations.” The two transactions keenly illustrate pent up demand for sukuk, although new issues this year have been thin on the ground in the wider MENA region, though, according to a

new report from Kuwait Finance House, the GCC region has dominated new issue volumes. There are signs of a wider adoption of Shari’a compliant bond structures. Egypt had been planning to announce its own Islamic debt guidelines, though the initiative has been temporarily derailed because of continuing uncertainty over political leadership in the country. Neighbouring Algeria is also reported to be examining the feasibility of Islamic bonds which can then be listed on the Algiers stock exchange. An announcement is expected in the first quarter of 2012. According to KFH the value of sukuk issued in the first half of this year is some $47bn, exceeding the record high reached last year of $45bn. The issuance of global sukuk jumped in the first half of 2011 by 34.7%. Most of that growth however is evinced in the growing popularity of Islamic financing structures in markets such as Malaysia and Indonesia. The Malaysian government issued a $2bn sukuk in June this year; after which the early momentum of issuance slowed through July. Malaysia is competing rather successfully with the GCC region in deepening its Shari’a compliant capital markets; with domestic sukuk issuance rising in popularity. Sudan however leads short term issuance volumes, says the KFH report, with Sudan, Bahrain and Brunei emerging as short term issuance specialists. Malaysia was responsible for $12.676m in sukuk, all denominated in MYR. By structure, Murabaha was the most important, accounting for $7.56bn, followed by Bai Bithaman Ajil ($2.49bn) and Musharaka ($2.2bn). The top five sukuk lead managers (excluding central banks) were: HSBC Bank Middle East (four issues worth a total of $904m); Aminvestment Bank (over 24 issues, worth $789m); Maybank (over 46 issues worth $625m); RHB Islamic Bank(in six issues worth $591m); and Standard Chartered Middle East & South Asia (over nine issues worth $402m), says the report. I

OCTOBER 2011 • FTSE GLOBAL MARKETS

REGIONAL REPORT

Q&A WITH ANDREW STEVENS, GROUP CHIEF EXECUTIVE, CBQ

Commercial Bank of Qatar (CBQ) Group chief executive officer, Andrew Stevens, says that the bank has delivered strong first half results. The realigned business is delivering operational and financial improvements and “positive trends are emerging as we continue to develop our lending and income streams.” Stevens talks over the market dynamics with FTSE Global Markets.

CBQ leverages rising business volumes TSE GLOBAL MARKETS: QATAR’S economy continues to improve and, despite recent regional events, the outlook for growth is positive. The government’s planned spending programme is expected to deliver additional stimulus through the rest of 2011 and 2012. Isn’t it just too easy to do business in Qatar? ANDREW STEVENS: Actually, the bank has faced another challenging year in which we have witnessed the lingering effects of the global financial downturn. Even so, we delivered strong first half results. We have grown our loan book by QAR6.2bn in a market in which demand for borrowing is gradually improving. It demonstrates our progress in implementing the strategic realignment of our corporate and retail businesses and the development of the bank’s domestic franchise; our strategic outsourcing partnership is on track and we have developed new revenue streams through our insurance and brokerage businesses. We remain focused on the key areas of balance sheet management, asset quality and risk management and will look to continue development and growth of the business in the remainder of the year. Even so, we do not expect anything other than to earn the right to do business and success in that light is never allowed to get ahead of the organisation. FTSE GLOBAL MARKETS: How successful have the strategic partnerships been for the bank? ANDREW STEVENS: We like to identify banks like us which have tradi-

tionally done well and which could benefit from alliance in an era of rapid change. Working together we can share risks and services and even move into neighbouring markets on a selective basis together. Each of the alliance banks, which include National Bank of Oman and United Arab Bank of Sharjah, has grown their franchise in their own domestic market in 2011, delivering increased lending and revenue. Commercialbank’s associates have contributed QR89m to the bank’s performance in the first half of 2011 compared with QR68m for the half-year ended 30 June 2010. We now also have a shared service platform with Tata Consultancy and teamed up with the Qatar Development Bank to provide a loan assurance programme, called Al Dhameen, providing support to SMEs. FTSE GLOBAL MARKETS: CBQ was established back in 1975 as a private sector bank with particular specialisation in trade and SME finance. How far have you expanded on that description? ANDREW STEVENS: Definitions are often limiting. Although we have a focus on private sector financing as the markets have moved so have we. We saw, for instance, the rise of public sector project financings through the 1990s and early 2000s which centred upon gas and downstream projects. We raised funding for the projects at the necessary tenors. What it did not mean is that we moved wholly to a public sector model. These days we are also involved in private banking and real estate development.

Andrew Stevens, chief executive officer, CBQ. Photograph supplied by CBQ, September 2011.

FTSE GLOBAL MARKETS: Where is new business coming from? ANDREW STEVENS: In the second quarter, the private sector has shown signs of recovery with the government’s planned spending programme expected to deliver additional stimulus as the year progresses. The evolution of a complex economic infrastructure is a unifying force in Qatar. The government has provided a clear long term vision and we should give credit to Qatar’s ruler in describing very early on a very clear development road map. Actually everyone in the country believes the vision is achievable. FTSE GLOBAL MARKETS: The government has injected cash into the country’s banks, as equity, to help them fund infrastructure build via the Qatar Investment Authority (QIA). Some QAR5.5bn was sunk into the sector in the latest round in the first quarter of this year; with CBQ receiving a tranche worth QAR1.6bn, taking the QIA’s stake in the institution to just under 16.7%. Has it helped? ANDREW STEVENS: The fresh equity injected by the government’s investment arm certainly strengthened bank capitalisation and also enabled banks to fund higher loan growth. However we are not dependent on the government and have been active in raising our own capital. We tapped the debt markets for a five-year, CHF275m (around $290m) denominated bond issue in November last year, the first Qatari credit in the currency. In February this year, CBQ’s shareholders provided blanket approval for a $5bn Euro-denominated medium term notes (EMTN) program, with a maximum aggregate value of some $1.5bn should the bank need to draw on it. We were not disappointed with the pricing of any of our issues. I

OCTOBER 2011 • FTSE GLOBAL MARKETS

DEON VERNOOY, HEAD OF ASSET MANAGEMENT AT EMIRATES NBD AM

It has been an eventful 12 months in the Middle East. Popular uprisings that began at the end of last year in Tunisia and became known as the Arab Spring spread quickly through North Africa and into the heart of the Gulf. The outcome has been mixed, though in many cases the markets have reverted to business as normal. Even so, the threat of continued civil war in Libya and continued unrest in Syria, illustrate that the fires of change running through the MENA region have not been entirely extinguished. What the final political landscape will look like in two or three years time is still difficult to define. Despite uncertainty, revenue from high oil and gas prices continue to flood into the region, boosting economic growth. The Bloomberg GCC200 index of the top 200 equities in the GCC region has lost at least 5% since the beginning of the year. Most of this fall can be attributed to local political risk as well as the financial upheaval taking place in Europe and the US which has depressed markets globally. As political risk begins to subside then GCC markets supported by strong demographics and underpinned by high hydrocarbon prices are likely to provide a significant investment opportunity for international institutional investors, global banks and asset managers. It will also provide opportunities for the region’s financial institutions, many of whom are well funded and can offer access to local markets, provide local brokerage services and private wealth management. As part of this report we incorporate a Q&A with Deon Vernooy, head of asset management at Emirates NBD Asset Management, looking at elements of the firm’s forward growth strategy and the opportunities that are likely to present in 2012.

MENA focus helps maintain investment returns TSE GLOBAL MARKETS: Emirates NBD AM says in its brochure that“the acquisition of undervalued assets will deliver superior investment returns and satisfied customers, and we are therefore committed to conducting diligent research to uncover the best investment opportunities that suit the needs of our clients.”What have been the salient elements/approaches in your investment strategy in 2011? What changes, if any, have been made in the investment approach over the year and what area the drivers of those changes? DEON VERNOOY: Our basic investment philosophy is based on a core belief that the best investment opportunities can only be uncovered through thorough research and analysis. Our focus has always been on finding those opportunities where expected returns adequately compensate for the risk taken. We do not expect this to change as it is a proven

FTSE GLOBAL MARKETS • OCTOBER 2011

recipe that has not only worked for us over time but also for other investors that follow a similar philosophy. Our selection of investments in individual companies follow the same basic approach but obviously emphasize a full analysis of publicly available information, regular contact with company management and a deep understanding of the expected returns and risks of the investment. Diversification is an important aspect for the management of any portfolio. We do not profess to have perfect foresight into the investment future and therefore employ diversification techniques to optimise the portfolio construction. However, we are not hesitant to emphasize strong convictions in the construction of client portfolios. Asset allocation is driven by the client mandate which will, among other matters, reflect the time horizon, risk appetite and personal preferences of the investor. However, we strongly believe that, for the foreseeable future,

client portfolios should focus on real assets that have an intrinsic value that can be expressed in terms of cash flows, profits and dividends over time. Without expressing a view on current market valuations for such assets, this portfolio will emphasize mining and resource producing companies, companies that produce basic goods and services, physical property, basic commodities and farmland. These assets can be held through public listed entities or private arrangements. At the same time we would steer away from paper assets or deposits in the currencies of governments that have clear intentions to debase the value of their currency. FTSE GLOBAL MARKETS: Does Islamic finance provide new asset allocation options? Do you employ Shari’a compliant fund structures, or assets? DEON VERNOOY: We do manage a number of Shari’a compliant fund structures including a global sukuk fund, a regional real estate fund, a global equity

REGIONAL REPORT

DEON VERNOOY, HEAD OF ASSET MANAGEMENT AT EMIRATES NBD AM

fund and an Islamic money market fund. The risk/return profiles of these funds are not necessarily materially different from the conventional comparable structures but do emphasize the employment of pure Islamic principles. In some cases this has resulted in different investment outcomes, for example the prohibition of an investment into companies that charge interest has resulted in the avoidance of investments into conventional Banks which obviously was a rather beneficial strategy over the past few years. FTSE GLOBAL MARKETS: How important is the commodities segment to your overall investment strategy? What types of commodities do you favour? DEON VERNOOY: We do make investments into commodities through our global risk profiled managed funds or through our advisory service. We tend to favour commodities that have a real demand profile rather than an investment demand profile such as base metals, energy or agricultural commodities. FTSE GLOBAL MARKETS: In your brochure you say that the firm has a strong commitment to customer service. Can you provide an example of what that entails in todayâ&#x20AC;&#x2122;s dynamic market conditions please? DEON VERNOOY: We have noted over time, that customer satisfaction is primarily driven by absolute investment returns. Obviously, when markets are volatile and unsettled, as we have experienced in 2011, clients do become uneasy and require a higher frequency of interaction. We have stepped up our interaction with clients during the past few months to keep clients informed about the market impact of the various regional and international events that impacted the portfolio assets under our control. We have recently made a considerable investment into the improvement of our systems to enhance both our portfolio management and client reporting functions. We consider that as an absolute requirement for the future of our business.

Deon Vernooy, head of asset management at Emirates NBD Asset Management. Photograph kindly supplied by Emirates NBD Asset Management, September 2011.

FTSE GLOBAL MARKETS: How useful is your location in the DIFC in terms of regulatory control and oversight? Is it a key selling point to your clients? DEON VERNOOY: We believe the regulatory environment, not only in terms of new rules and regulations, but also in the application of these rules and regulations will make the operating environment increasingly challenging to fund managers. Our company is based in the DIFC and regulated by the DFSA. Our public funds are domiciled in Jersey and regulated by the JFSC. Both regulators are highly professional in their approach and provide a very credible regulatory and control environment which is absolutely to the benefit of our investors. FTSE GLOBAL MARKETS: Globally which regions interest you the most and why? DEON VERNOOY: We have a number of specialist capabilities,

namely MENA equities, MENA fixed income and MENA real estate. We manage products for these markets on both a conventional and Sharia compliant basis. Further developments in terms of our product capabilities could be in the commodities space as well as the geographical areas of Africa and Asia. FTSE GLOBAL MARKETS: How do you view the global economic outlook? DEON VERNOOY: Markets are extremely unsettled at the moment for reasons that are well documented. However, market volatility always creates opportunities. Our global risk profiled products have been conservatively positioned for most of the year and has performed relatively well over the past few months as risky assets have declined substantially in value. Our MENA equity and fixed income products have also performed well mainly as a result of good instrument selection and prudent portfolio positioning. Our fund managers continue to assess market opportunities as they present themselves and are positioned to exploit these opportunities when considered opportune. FTSE GLOBAL MARKETS: Might we look at internal risks management for a moment please? What is the key to successfully structuring your internal risk management systems? A large scale rebalancing of an institutional investment portfolio can seriously impact short term investment returns. How do you manage this process? DEON VERNOOY: We have a comprehensive set of portfolio and business management policies and procedures in place to ensure that risks are identified and managed on a timely basis. Regarding portfolio risks, we cover, inter alia, investment risks, benchmark risks, liquidity risks and counterparty risks. A dedicated team, with a full systems backup and support are responsible for the monitoring of the relevant risks under the supervision of the investment committee.I

OCTOBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

DEBT REPORT

Quasi-sovereign issues begin to suffer as investors become more risk averse The sovereign debt crisis has inevitably influenced the quasi sovereign bond markets, whose issuers range from supranational financial institutions such as the World Bank through various categories of state-owned financial and industrial agencies to regional and even local governments in some countries. Given this diversity, it is hardly surprising that impact of the sovereign difficulties has been significantly different for the assorted market participants. Andrew Cavenagh reports. T IS A very difficult part of the bond spectrum to talk about in general terms, because it is just so diverse” explains Justin Knight, head of European rates strategy at UBS in London. The market in sub-sovereign bonds describes borrowing by any level of government below either national or central government. This definition can include regional or state authorities, provinces, and municipalities. In Europe however, the sub-sovereign market is primarily one dominated

FTSE GLOBAL MARKETS • OCTOBER 2011

by supranational institutions such as the World Bank, development banks such as Holland’s FMO or Germany’s Kreditanstalt für Wiederaufbau (KfW) and cross-border institutions such as the Asian Development Bank (ADB) or the European Investment Bank (EIB). As European countries move towards harmonised integration, the growth of the sub-sovereign bond market has been significant, particularly as member states still experience either developmental, currency-related or

QUASI-SOVEREIGN ISSUERS: ARE THEY LOSING THEIR LUSTRE?

Photograph © Kts / Dreamstime.com, supplied September 2011.

debt- related teething problems. Quasi sovereigns can play a useful role in mitigating sovereign debt exposure (in other words in helping to define what is and what is not sovereign debt); to raise finance to achieve strategic developmental goals, such as the planned pan-European Mediterranean Development Bank, or finance the day to day operations of the EU. In some ways however, the quasi sovereign debt market in Europe differs from that in the United States. For one, investors in quasi sovereign bonds in Europe tend to be institutional, rather than retail investors (who crowd the US municipal bond market for instance). However, in continental Europe retail investment in municipal bonds continues to gain traction. Equally the US government is more proactive in providing guarantees for quasi-sovereign entities, such as Ginnie Mae, the mortgage bond agency, which aside from some of the national development agencies, such as KfW, sovereign guarantees are absent. At the so called top end of the range of quasi sovereigns are multilateral lenders such as the World Bank and the EIB, which have continued to issue capital-market debt through 2011, albeit to a diminishing pool of investors as the flight-to-safety imperative has increasingly taken hold of fixed-income investors and driven them into the core sovereign markets of the US, Japan, and Germany. At the low end of the spectrum, for example, are institutions such as the semi-autonomous Spanish regional governments, two of which have been reduced since late last year to issuing short-term, high-coupon bonds to retail investors (as all other sources of finance have closed to them) in order to maintain the essential public services they are required to provide [please refer to page 48: Spanish retail bonds just a short-term fix]. While generally ranked as high quality assets, quasi-sovereign issuers have lost some of their lustre of late.“I see very little demand out there for

DEBT REPORT

QUASI-SOVEREIGN ISSUERS: ARE THEY LOSING THEIR LUSTRE?

any of the quasi-sovereign debt at the moment,” says Justin Urquhart Stewart, marketing director at Seven Investment Management. “I think all of it is just seen as an even greater risk than sovereign debt, and the whole risk-averse mentality has certainly seen demand diminish.” Urquhart Stewart thinks that the quasi-sovereign offerings likely to arouse much interest from investors in the present climate would be bonds of agencies with minimal reliance on any form of central-government support.“If it is project related—and seen as more or less self-financing—that would be regarded more constructively,” he said. “The more divorced it is from central government finances, the better.” Lux-o-rente, Robeco’s flagship global government bond fund, has historically shunned quasi-sovereign bonds. The firm’s senior portfolio manager Olaf Penninga says the events of this year had done nothing to persuade him to change his established strategy, which is focused on short-term (between one and two months) overweight investment in the core sovereign debt (German bunds, US Treasuries and Japanese government bonds). “We strongly feel that pure government bonds are the place to be, because when periods of stress arise anything else performs less well,” Penninga explained. “Swap spreads have widened, and agency spreads have widened along with them, or even more.”

Attendant decline in the secondary market The decline in interest in quasi-sovereign debt has meant even less secondary-market activity in a sector that has never offered comparable liquidity to the sovereign markets, despite its size. For although the EIB and the German development bank (KfW) represent the third and fourth largest triple-A bond markets in Europe (after those for German and French sovereign debt), for example, the bonds of neither have ever traded as freely as those of the Dutch government that

ranks behind them in fifth place and even smaller European sovereigns. This owes something to the typical size of the multilateral lenders’ issues, which tend to be smaller than sovereign offerings, and a lot more to the different composition of their investor base, in which central banks—which are more inclined to buy and hold the securities until they mature—play a more dominant role than in other asset classes. “Liquidity is lower because their investors will tend to lock the bonds up to maturity,” explained Knight at UBS.“The real difference is in the investor base.” In the limited trading that is taking place, the concerns over the sovereign situation in the eurozone have seen a discernible shift in sentiment away from those institutions that have the strongest links to Europe. So whereas the debt of the EIB and the World Bank have historically traded priced at levels that were more or less flat to each other, the latter’s is now trading 10-15 basis points inside that of the former. The same is true for bonds issued by the Asian Development Bank and the Inter-American Development Bank. “The institutions that are seen to be truly global (or non-European) are more in demand,” confirms Marc Ostwald, strategist on the institutional bond desk at Monument Securities.“It is really just the perceived credit risk, which is now seen to be slightly greater in the case of the EIB than the World Bank.” The exception has been KfW, which along with most of the German state governments, has seen the relative standing of its debt improve on the back of the perceived strength of bunds and the flight of international capital into the German sovereign. On the five-year, €5bn bond that the German development bank was due to launch September, for example, lead managers Barclays Capital, Société Générale and UBS were able to offer final price guidance of 8bp under the mid-swaps benchmark (as orders for the issue exceeded €6bn). That compared with the 10bp spread over the benchmark

that the EIB was obliged to pay on the €1bn, eight-year bond (paying a coupon of 2.5%) that DZ Bank. LLBW, Nomura and RBC Capital Markets brought to the market on August 22nd. “KfW is seen as pure German risk and that’s why more people have been buying it,” explains Knight at UBS. The issuer in the triple-A supra-sovereign arena that could potentially create a market every bit as liquid as the sovereigns, of course, is the European Financial Stability Facility (EFSF) which the EU set up last year to support member states (Ireland and Portugal in the first instance) that had become unable to access the capital markets at sustainable cost on their own account. The EFSF’s inaugural issue in January attracted a record-breaking order book of €43bn from 500 investors for the €5bn of five-year bonds it offered for sale (raising funds for a first disbursement of the rescue package that the EU agreed for Ireland in late 2010), at a price of 6bp over mid-swaps. Inevitably, the market reaction was not quite so overwhelming for the fund’s second €5bn issue in June (launched to cover an initial disbursement for Portugal). The 10-year debt priced at 17bp over mid-swaps and attracted over €8bn of orders, with particularly strong interest from Asia, as the Japanese Ministry of Finance alone signed up for €1.1bn. The third €3bn issue later the same month (again for Portugal) drew over €7bn orders for five-year bonds priced at 6bp over the benchmark. Even so, at such fine pricing the sustained appeal of the quasi-sovereign was somehow reassuring for the segment. At the time of the third issue, the EFSF said it expected to launch a fourth four bonds before the end of 2011 to raise further funds to support the Irish and Portuguese rescues.

The future of the EFSF Since then, however, considerable uncertainties have arisen over the future of the EFSF. After the leaders of the EU countries agreed to expand the lending capacity of the fund to €440bn at their

OCTOBER 2011 • FTSE GLOBAL MARKETS

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DEBT REPORT

QUASI-SOVEREIGN ISSUERS: ARE THEY LOSING THEIR LUSTRE?

summit in July, a run on Spanish and Italian sovereign debt in the first week in August (halted only by heavy intervention from the European Central Bank) prompted suggestions that it would need to be increased by up to five times that amount. Given the mounting hostility in Germany and other countries to what had been agreed at the summit, the viability of the EFSF suddenly looked under threat. Although the key rulings of Germany’s Constitutional Court on September 7th supported both the 2010 aid package for Greece and the EFSF proposals to date, the court did say the German parliament (which will vote on the EFSF enlargement at the end of September) should have more say in any future bail-out decisions. Analysts warned that if other member states adopted similar strategies, it could undermine the effectiveness of the EFSF and European Stability Mechanism, its planned permanent successor from 2013 onwards. Regardless of how future of the EFSF unfolds, it is likely to be the emerging markets that offer the most attractive opportunities for quasi-sov-

ereign investment—as it does with corporate credit—in the near to medium term. The debt of state-controlled energy and infrastructure companies in countries that have debt-to-GDP ratios of round 40% or lower, continually improving standards of corporate governance, and the strong likelihood of ratings upgrades, looks a far better bet at present than comparable quasi-sovereign exposure in the OECD countries. “Everything in the third world is surging in rating terms,” explained one analyst. “Chile’s a better credit than Italy nowadays.” The emerging market team at JP Morgan recently identified state-controlled commodity producers in high-beta countries such as Russia and Kazakhstan, investment-grade quasi-sovereigns in the Middle East with mandates to develop non-oil sectors of the economy, and companies involved in the development of infrastructure in Latin America among the opportunities that offered the best potential. India’s largest power generating utility, National Thermal Power Corporation (NTPC), on July 7th priced a

senior unsecured fixed rate $500m bond, part of the firm’s medium term note (MTN) programme, representing the first Indian quasi-sovereign corporate bond deal this year. The offering from a leading Indian quasi-sovereign provided a rare investment opportunity to global investors to gain exposure to the growing Indian infrastructure sector. The company will use the proceeds of the issue to finance new power projects. The transaction, was managed by Barclays Capital, Citigroup, Deutsche and RBS, and carries a coupon of 5.625% a year will mature in mid July 2021 and was oversubscribed. Commitments worth $2.7bn were received from more than 230 investors wanting to buy into the deal. NTPC last issued bonds in the international market in 2006. Asia-based investors bought some 65% of the deal, according to Indian press reports, followed by European investors (who bought 26%) and US offshore accounts (9%). Fund management firms accounted for the bulk of interest in the facility, receiving in total 49% of the bonds, while financial institutions accounted for the balance. I

SPANISH RETAIL BONDS JUST A SHORT-TERM FIX HE GOVERNMENT OF Valencia’s decision in May to issue a further €900m of oneyear and two-year bonds to retail investors brought the total issuance of such debt to more than €8bn since November 2010 and has raised further concerns over the ability of Spain’s 17 semi-autonomous regions to avoid being overwhelmed by the €121bn of debt they have amassed. The issuance of retail bonds has certainly cast doubt on the ability of the regions involved to meet the new budget rules, including the reduction of budget deficits to no more than 1.3% of GDP this year and in 2012, 1.1% in 2013, and 1% in 2014, which they agreed with the Spanish finance

minister Elena Salgado on July 27th. The cost of servicing the expensive short-term debt has clearly increased the likelihood that Valencia and Catalonia (which has issued €6.3bn of the bonds in total) will miss these targets. The maturities on the bonds will also substantially increase the near-term refinancing needs of any governments that issue them (with the overall requirement for the regions already estimated to be between €30bn and €35bn this year and next). At the end of July, Moody’s downgraded the long-term ratings of six Spanish regions, including Castilla-La Mancha, Murcia, Valencia, Catalonia, Andalusia and Castilla y Leon - by a single notch and

put a further seven (including Madrid and the Basque region) on review for possible downgrade. The move saw Catalonia’s rating drop to Baa1. Moody’s also warned that the Spanish central government was at risk of losing control over the regional debt, which it said would hamper Madrid’s efforts to impose the austerity measures necessary to restore market confidence in the national finances and put the government’s own Aa2 sovereign rating at risk of further downgrade. “Regional government finances may prove difficult to control due to structural spending pressures, particularly in the health sector,” the agency observed.

OCTOBER 2011 • FTSE GLOBAL MARKETS

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COMMODITIES

TRADING COMPANIES DOMINATE THE SUPPLY CHAIN

Photograph © Iaroslav Neliubov / Dreamstime.com, supplied September 2011.

Trading companies dominate supply chains The one thing that the last credit crunch brought us is a more consolidated commodities trade market. A handful of big trading companies, such as Glencore, Trafigura, Cargill, Noble Group and Louis Dreyfus, now dominate the commodity supply chain and their ever-growing financing needs are attracting a lot of attention from banks. Vanya Dragomanovich reports. HE BIGGEST DEALS of the past year in commodities financing, such as revolving finance facilities for the top commodity traders, have ranged in value between $1bn and $3bn, each deal including between 40 and 60 banks. On the one hand banks are keen to get involved in the lucrative commodities market, which promises to grow in the long term even if the global economy hits a hurdle this year. On the other hand however, financiers remain cautious about lending and continue to prefer to spread risk between their peers, hence the large number of participants.

After a difficult period in 2008 and 2009 during which the number of commodity financing deals contracted, activity in commodity financing is almost back to its pre-credit crunch dynamics. Or at least it was until this summer threw its own version of Hurricane Irene into financial markets in the shape of the European debt crisis and the US rating downgrade. Fresh concerns over liquidity, particularly dollar liquidity in Europe, are causing banks to worry about the availability of finance in the months ahead. Now, at least at the top end, commodity financing is flourishing and

large, revolving credit facilities are attracting scores of banks with syndications being regularly oversubscribed. Typifying the trend, Dutch trading house Trafigura Beheer, for example, in March this year negotiated a multi-currency revolving credit facility worth $3.175bn to refinance an existing facility of $2.325bn, attracting 45 banks in the process. In July Hong Kong bulk commodity trade company Noble Group closed a deal for $3.2bn of syndicated financing involving 68 banks. The company initially set out to raise $2.25bn but the syndication was nearly 40% oversubscribed. Similarly Stemcor, the world’s largest steel trading company, sought to raise $650m but because of oversubscription raised $1bn from a syndicate of 53 banks. Oil and gas trader Vitol is also seeking to renew its existing revolving credit facility which was set up last October. “If you look back ten years and you look at the situation now, these companies are no longer trading companies, they are supply chain managers. They increasingly need funds to invest in processing and logistics assets, logistics being one of the key requirements for them,” says Karel Valken, head of agriculture commodities at Rabobank International. The key commodity players have expanded during the credit crunch not only by picking up smaller trading companies along the way but also by investing in various stages of the commodities production process such as mines or sugar mills. They now require substantial finances not only to buy, sell, store and transport commodities but also to continue to expand their operations. Their financing requirements are getting ever bigger and the funding is being tapped not only directly from banks but also, as in the case of Glencore, which raised $10bn when it listed in London earlier this year, via an IPO. Doing some rough mathematics, and assuming for argument’s sake that each bank had the same exposure—which they don’t, by the way—a syndicate of

OCTOBER 2011 • FTSE GLOBAL MARKETS

50 banks in a loan of $1bn would mean that each bank provided a $20m credit facility. Ever since the credit crunch the banks have been cautious about lending and despite the fact that markets recovered in the past 19 months they still remain somewhat risk averse. In this climate having a large number of banks on board means less exposure from each, something the financiers welcome. “After the credit crunch banks were much more careful about how they structure deals but as the situation improved in the markets there have been pressures by borrowers and movements back to more relaxed structuring,” says Veronika Koroleva, a partner at SNR Denton, an international law firm. For Western banks the appeal of commodities comes from several aspects: the underlying businesses are doing well because there is continued global demand for their goods; loans are secured against something that is tangible and can be recovered in the unlikely case of default, and borrowers are seen as reliable big names, with a global reach and can therefore bring in additional business originating in markets in which they operate or trade.

In that regard, Rabobank’s Valken explains that over the years commodities have proved to be a healthy investment for banks, and given the global supply and demand dynamic, prices are likely to remain high. “When you look at agricultural commodities for instance there is and will be global demand, growing population and urbanisation in countries [such as] China and India. Combined with healthy GDP growth there is an exponential need for agri and other commodities such as grains or oil seeds,” says Valken. To a lesser extent this will be the case for industrial metals, gas, oil and power, which will ensure that prices will remain relatively high over the years to come. In terms of commodity financing across the globe, different regions hold different appeal for banks. Gilles Sayer, Credit Agricole CIB’s global head of structured commodities finance, explains: “Russia and CIS countries bring volume, Africa brings less volume but a bit higher margins and a lot of investment opportunity as Asian investors in particular are keen to invest in the region.”Being involved in different regions is interesting for the banks

not only as a way of diversifying but also from the point of view of gathering intelligence on trade and investment that goes on between regions such as Asia and Latin America, he notes. Anne-Marie Woolley, head of trade finance at Standard Bank, explains that big commodity trading companies are seen as good borrowers, reliable and with a good rating. Big trading companies also bring in what banks refer to ancillary services in regions that specific banks may have a particular interest in. “If you take somebody [such as] Trafigura they will have a business in Africa and a business in Asia and depending on a bank’s strategy they may be interested in that.” Standard Bank itself is heavily involved in financing South African mining as well as agriculture business across Africa. A recent example of a bank’s strategic interest in commodities is the case of Standard Chartered Bank which last month bought mining advisory firm Gryphon Partners. The bank said:“The acquisition of resource assets is a top priority for the bank’s clients especially in Asia,”and that it plans on offering an enhanced cross-border mining and metals advisory service.

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FTSE GLOBAL MARKETS • OCTOBER 2011

COMMODITIES

TRADING COMPANIES DOMINATE THE SUPPLY CHAIN

Typically, the financing is secured against the underlying commodity. Alternatively, financiers may utilise an ownership-based structure and would buy and hold commodities, possibly with an option for the seller to buy the commodity back at a later stage. This does not mean that a bank would move steel into its own warehouse, explains SNR Denton’s Koroleva, but rather that “the deal is arranged in such a way that it accounts for the cost of holding and storing the commodity”. Financiers normally prefer to hold exchange-traded commodities (ETCs), which means that in the worst-case scenario these can be delivered to the exchange.“If you structure a commodities deal properly it will be less risky than pure balance sheet-financing because you have receivables flows and an asset you can grab if there is a default,” says Koroleva. In the months ahead the biggest issue will be the pressing question of liquidity, and whether or not banks will become more reluctant to lend to one another and to other counterparties. Commodities are traded in dollars globally and European banks, awash with euros, may face an issue with dollar liquidity, says Rabobank’s Valken. Margins on lending have been going down recently, particularly in Asia where there is sufficient liquidity in the markets. Margins for large clients have also notched lower. Russia’s third-largest oil producer TNK-BP for instance recently secured a loan at 130 basis points (bps) above Libor in July while a similar deal in October last year was priced at 175bps above Libor. However, given the current situation in the wholesale money markets and potential liquidity issues the access to relatively cheap funding may not last much longer, says Standard Bank’s Woolley. As European banks struggle with the domestic debt crisis and the uncertainty that looms over the euro, large commodity companies are turning East for additional funding. Chinese banks have been happy to pick up the slack and have begun playing an increas-

As European banks struggle with the domestic debt crisis and the uncertainty that looms over the euro, large commodity companies are turning East for additional funding. Chinese banks have been happy to pick up the slack and have begun playing an increasingly vital role. ingly vital role. In the Stemcor deal for instance Bank of China was the mandated lead arranger for its revolving credit facilities (RCF), the first time a deal for Stemcor has been led by a Chinese bank. Other lead-mandated banks were BNP Paribas, ING, Standard Chartered, Société Générale, RBS and the Development Bank of Singapore.“A few years back we would have seen having a Chinese bank in a deal a competition, but now, due to the increasing tight liquidity in the global financial markets, we welcome more Chinese bank participation,” says Rabobank’s Valken.

A bigger role for BRICs The BRIC countries, which are both massive producers and consumers of commodities, are beginning to play a bigger role in commodity financing. When the Noble Group negotiated its latest revolving credit facility in July alongside mandated lead arrangers ABN AMRO, Rabobank, Citigroup and a number of others was Banco do Brasil. Other banks providing finance were Bank of China and Industrial Commercial Bank of China (ICBC). It makes a lot of sense for both countries to be closely involved in commodities financing as Brazil is the world biggest producer of iron ore, coffee and sugar, and China remains the dominant global consumer of a whole host of commodities ranging from steel, iron ore and base metals, via rice, soy beans, all the way to pork bellies. Another major challenge for commodities merchants and banks will be the unprecedented volatility in commodity prices. This is particularly the case if prices move up quickly. “Banks have a finite amount they are willing to lend to a counterparty and commodi-

ties prices affect this. When prices rise there is a bigger need for financing,” Woolley explains. Upcoming changes in regulation in the shape of Basel III requirements will mean that banks will have to put more capital aside thus reducing the amount of finance available for lending.“Basel III is something that has received adverse publicity; banks which are active in the structured trade finance market view it as a problem because it failed to reflect the market needs. It may mean the banks will have to hold more reserves and will be able to lend less, therefore reducing the funds available for global trade generally,” says SNR Denton’s Koroleva. Banks have been raising this with regulators and are looking into other ways of addressing this. Banks are clearly gearing up for commodity financing to continue to play a big role. Société Générale recently replaced its outgoing global head of natural resources and energy financing Frederico Turegano with four staff dealing with four different parts of commodity business. HSBC Middle East in August signed a Memorandum of Understanding (MoU) with the International Islamic Trade Finance Corporation (ITFC) to implement Shari’a-compliant trade financing and provide related treasury products. Meanwhile, the ITFC said it expected to disburse over $2bn of trade financing to companies in Asia, Middle East, Africa and Russia. After a volatile August, September is bound to bring a clearer picture of where the money markets and equity markets are at. Amid the current uncertainty in the markets, commodities are likely to continue to look as a good source of return, both as a direct investment and through various avenues of financing. I

OCTOBER 2011 • FTSE GLOBAL MARKETS

INDEX REVIEW

Looking for Mr Goodbar N THIS ENVIRONMENT it does not take a genius to work out why some markets, over the past year, have gained startlingly at the expense of others. Safe havens, such as the Swiss franc, gold, or yen, might have served well in recent months, but are now so massively overvalued versus virtually any realistic measure of worth that it is hard to justify getting involved. If you are already in there with a nice fat cushion then it might make sense to hold on; but building a safe haven portfolio out from this point risks it being the exact opposite. Adding to the complexity is the fact that many central banks are increasingly involved in the currency and bond markets in attempts to readjust values. The Bank of Japan and the Swiss National Bank have both intervened in the currency markets in recent weeks, the Swiss most dramatically by drawing a line at 1.20 versus the euro. While central bank intervention has in the past come to grief, it is hard to disagree that selling Swiss francs or yen at current valuations will not eventually make a profit. The problem with this prognosis is that most traders do not have either the time horizons or the deep pockets of central banks.

FTSE GLOBAL MARKETS • OCTOBER 2011

The FTSE 100 has bounced alarmingly of late, generally running out of steam at any price above 5,400 but conversely struggling to set new lows since the fallout of early August. Current yields on equities look attractive versus virtually any other asset class, which is giving the markets a bit of support, but there is a natural fear that if growth slips further, companies may well look to conserve cash rather than disperse it in dividends. The overall feeling of doom is not being helped by regulators and politicians continuing to squeeze the banks at every opportunity. It might give some legislator a bit of a boost at the next election but this is nothing to the damage that is being done to the lending capabilities of banks. We might not like them, but ratcheting up ever-higher capital ratio requirements, forcing them into costly split ups or penalising them at every turn all makes it just that little bit harder for businesses to gain finance and traction. Putting every risk into a little box and regulating it to death means just one thing: flight of capital to more favourable climes. Invariably it will translate directly into weak economic activity. At the moment we are still in

MARKET OUTLOOK: THE SEARCH FOR SECURITY IN SECURITIES

Investors can be forgiven for concluding that all asset classes could currently be dubbed “toxic” as markets gyrate. Equities are particularly prone to wild market swings as confidence builds and falls, seemingly at the toss of a coin. Safe haven bonds are trading at levels that absolutely guarantee capital devaluation as gilt yields start from around 0.5%. With inflation at over 5% and deposit rates well below this, we can hardly say that “Cash is King”. Moreover, with inflation so high it takes a special type of investment plan that justifies this level of insurance cost to retain asset value security. Precious metals are moving violently too, so much so that only the seriously brave would trust too much of their “stake” to the game. Finally, property (of whatever class) seems to be once again on the slide as financing and demand continue to slip. 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.

the “kick them while they are down” phase and I fear that the desire for revenge is clouding many people’s judgment. The UK, with its floating currency, can stand aloof for the time being but the markets can be a fickle mistress. If confidence were to falter in the UK’s ability to make any impact on its deficit levels then it might be a different story. Fiscally, Italy is actually in a better position than the UK, although competitively in a worse one coupled with a far inferior debt maturity horizon. This has not stopped yield levels on its debt climbing at one point to over 6%. With consumer confidence waning across the globe it is difficult to be positive about market direction. We are still at risk of sudden sell-offs. Even so, there is good value to be had beneath 5,200 which is why we are repeatedly bouncing violently every time the market dips to these levels. While the economic situation remains weak but not recessionary, support should continue to come in. However, if some of the recent appalling data are confirmed in September then a swift exit should at least be planned. As ever ladies and gentlemen, place your bets.I

FACE TO FACE

PATRICK COLLE, CHIEF EXECUTIVE OFFICER, BNP PARIBAS SECURITIES SERVICES

Redefining asset servicing for a new world order BNP Paribas’ Securities Services set has always been more widely defined than most, something that its chief executive Patrick Colle continues to describe as being “well formed and because of that product range, we have survived better than most through the after-shocks of the financial markets. Our ability to maintain a well diversified product set that serves the buy side and the sell side as well as issuers has helped us outperform, relative to our peers.” Colle spoke to Francesca Carnevale about the bank’s four pronged business strategy for the new era of asset servicing provision. Is it enough to meet challenges of the new economic order head on? Colle seems to think so, putting strength in depth across a number of niche product areas above the traditional contest among securities services providers to amass assets under custody (AUC). HE EXPANDED ROLE of global custody firms in the funding and settling of securities transactions— through for example, the morphing of prime broking into the securities services set and the variety of fiduciary roles that they fulfill nowadays—has put them market centre fair and square. Preparing for this mix was always the bailiwick of BNP Paribas Securities Services holds its chief executive officer Patrick Colle. More than most asset services providers, historically BNP Paribas has encompassed a much broader description of services in its service offering; to which most recently have been added its expanded issuer services, outside of the bank’s traditional European markets. “We have always worked on the basis that the description of the service range must be as wide-ranging as possible, in part because our client range was itself broad and clearly defined into buy side, sell side and issuer services. Everything followed through from that understanding,”he states. The bank has taken a five year view of the evolution of the global investment

markets and carefully structured a business plan to take account of that. As soon as Colle took over running the securities services business from April in 2010, he did what most incoming business chiefs do: he re-evaluated the business set and began to exert his world view upon it. That involved expanding out the bank’s operational reach. It involved changing and expanding the management team to support this expansion and, equally importantly, it involved changing the way that the bank sold its services to customers. He points to the expansive banks of sales and client relationship managers situated on the floor of the bank’s Moorgate-based offices in London. “We’ve brought everyone together; it allows cross fertilisation of ideas. Clearly what I am trying to do here is to provide clients with a holistic 360degree solution. I do not think that the bank can approach clients through independent product silos. We have created an organisation that now provides clarity, nimbleness and responsiveness to client needs on a

transversal basis, that approaches clients through a regional and client segmented matrix. It helps enormously in the articulation of global/regional business solutions. It has already demonstrated positive results and we appear to be picking up larger mandates in Asia, Europe and the Americas, both north and south,” he says. In consequence of defining the next stage of business growth a number of elements came to the fore, he explains. The first was a geo-strategic definition of where the bank would operate: “Underlying this was a desire to become truly global. As a client driven operation, we have a global mandate, but that does not mean that we will be everywhere. We do not feel the need to take on the large US houses in their domestic home market, but instead focus on our client’s requirements, particularly those that require global coverage.” That has involved, among other things, opening custody and clearing operations in São Paulo, in Brazil, in Mumbai, in India in the latter half of 2010. “The group already has a

OCTOBER 2011 • FTSE GLOBAL MARKETS

Patrick Colle, chief executive officer, BNP Paribas Securities Services. Photograph kindly supplied by BNP Paribas Securities Services, September 2011.

strong presence in asset management, fixed income and equities in the region, giving us a broad client base to deliver asset servicing capabilities. We target both international clients looking to invest in Brazil as well as domestic institutions,” he explains. The second was to isolate the bank’s key client groupings and redefine the overall product suite to accommodate them. Colle explains that his group services six client segments: asset management, asset owners, alternative funds, broker-dealers and investment banks, banks and corporations and issuers outside of their traditional markets (where BNP Paribas has served them for a long time):“We then began to appoint client segment heads, who could work together providing cross-business solutions.” The third element was determining the bank’s unique selling points, or USPs. “Our aim right now is the provision of high value niche services, and striving for excellence within that strategy,” he avers; “We are not at this point interested in a numbers gain.” Instead

FTSE GLOBAL MARKETS • OCTOBER 2011

he highlights a number of areas of expertise the bank is increasingly keen to leverage in addition to its core custody and sub-custody offering: one is hedge fund administration,“which we are starting to build out. We recently won a big hedge fund mandate, whose platform is one of the best hedge fund administration products in the US,”he expands. This he says is incorporated into the bank’s overall fund administration offering, which Colle says has been steadily gaining traction. Others think so too: BNP Paribas shot up from last to first place in the 2011 R&M Consultants Fund Accounting Survey, reflecting a major shift in the way clients view fund accounting services (a key component of the fund administration offering). JP Morgan also saw a dramatic increase, ending in second place when last year it was in the second to last position.“This year’s results reflect a remarkable sea change in the way the leading banks with fund accounting services are viewed by their clients,” explains Richard Hogsflesh, managing director of R&M Consultants. “The

changes seem to reflect concerns in handling of derivatives and the banks which have performed best are outshining their rivals in this area of expertise.” All other participants saw their scores decline, reports Hogsflesh. HSBC was third, and State Street and Northern Trust followed in the top five. Correspondent clearing, servicing small to mid-sized broker-dealers is another burgeoning business suite: “They are keen to delegate settlement and clearing to a strong bank,” holds Colle, who goes on to explain that this business line has bolstered the bank through the thick and thin of the last few years.“Because of increased volatility in the markets, settlement volumes have been up and this has been a nice mitigating effect on our business and kept up our overall performance figures, even as other custodian providers have felt the strain of declining asset values. We outperformed in this regard,” he says. The business segment also has global ramifications.“Much of it hangs around the experience we have gained over the years in Europe, working towards the harmonisation of a highly fragmented trading landscape. Nowadays it is much more harmonised and debates around initiatives such as T2S will only drive that process forward. Equally, it appeals to markets in Asia and Latin America in particular, which are keen to harmonise themselves. However, while we can bring this expertise to bear, we always try to keep in mind that what we do must at all times make sense to our clients,” he explains. The expansion of the bank’s operational reach into Brazil in 2010 is integral to this approach, and may be extended in future to incorporate markets such as Chile, Peru and Colombia, which last year announced moves to establish cross-border trading and clearing platforms.

FACE TO FACE

PATRICK COLLE, CHIEF EXECUTIVE OFFICER, BNP PARIBAS SECURITIES SERVICES

Additionally, the bank has extended its corporate trust services (CTS) in the Asia Pacific, servicing the full range of debt securities. The bank has invested heavily in its Asia Pacific CTS business, explains Colle, including the appointment of Ben Lumley-Smith as regional client development manager for debt markets based in Hong Kong.“The initiative has already made an immediate impact in the form of a significant recent debt issuance transaction undertaken on behalf of Bank of China International,” says Colle. “Hong Kong is a centre of capital raising activities in renminbi, euro and dollar debt instruments. Its recent establishment as an offshore renminbi clearing centre has further strengthened its position as the region’s investment banking hub from a debt market perspective and that is meaningful for us if we are to leverage these developments locally and wider afield in Asia, such as Singapore, Japan, Malaysia and Australia. We have a leading position in third party clearing now in the Hong Kong Stock Exchange (HKSE), with a solid market share,” he adds The fourth element is to add to the fund product suite: a natural evolution as“new business opportunities present. “UCITs has been a particularly fertile area for us,”claims Colle, who says that his group launched the first UCITS IVcompliant, master-feeder fund solution, back in June.”Designed to help asset managers reach more end investors, the structure also introduces the concept of a cost-free feeder. It is true to say that it is a new paradigm in fund distribution, supporting a combination of masters and feeders; it is an end-toend service accessible across most of Europe.” he explains. According to the official release announcing the move, the solution provides:“asset managers a 360 degree view into the master, providing a consolidated view of each fund, while automated fund dealing reduces the number of manual functions required of asset managers.”It is an evolution of the UCITs service set, holds Colle, and helps strengthen the bank’s position

Patrick Colle, chief executive officer, BNP Paribas Securities Services. Photograph kindly supplied by BNP Paribas Securities Services, September 2011.

“It is a time of tremendous market change and business expansion, even in these difficult times for the capital markets. It is demanding, certainly. However, across a swathe of business, ranging from clearing and settlement through to the opening of the market to renminbi denominated debt, we continue to see growth and more growth,” says Colle. now as the largest UCITs service provider in Luxembourg. Equally, that funds expertise, he says, is exportable to Asia, particularly as half the funds sold in Asia are based on UCITs structures. The key difference in the definition of the bank’s asset management service set is that it encompasses: “very much a depositary bank, fiduciary-led business model; where everything is driven by a specific client mandate,”explains Colle. In this regard, he looks at the incoming AIFM directive by 2013 as an opportunity for the bank as “hedge funds will need to have a depository bank in place. There are other ramifications of this development, as it will further encourage convergence between the prime broking business models. Who will win out in that particular battle? The jury is still out. What we anticipate however is that demand for both sets of services will continue and so I guess we will find a way to live together.”

Colle acknowledges that the traditional custody services suite has now been subsumed into a much larger, wider business offering; that is more complex, more global and more cerebral. “Now that we are committed to this global view, we have an improved vision of the way we can leverage synergies in our product offering to help our clients,”he concludes.“It is a time of tremendous market change and business expansion, even in these difficult times for the capital markets. It is demanding, certainly. However, across a swathe of business, ranging from clearing and settlement through to the opening of the market to renminbi denominated debt, we continue to see growth and more growth. Equally, we are responding to client demands for more performance and risk analytics. All that feeds into new business for us. I am hopeful our reorganisation will allow us to build on these dynamics.”I

OCTOBER 2011 • FTSE GLOBAL MARKETS

SECURITIES LENDING Photograph © Aydindurdu / Dreamstime.com, supplied September 2011.

For securities lenders accustomed to earning their revenues from the interest paid on borrowers’ collateral balances, rockbottom interest rates are about as welcome as low tide to a naked swimmer. Borrowers expect to pay a premium for securities in short supply and know that in a tight market the stock loan rebate can go negative, which not only deprives borrowers of any interest on their collateral but requires them to pay an explicit fee as well. Negative rebates were once the exception, but short-term interest rates close to zero have made them the rule for any security that trades “special”, the industry term for hard-to-borrow items. Borrowers all too conscious of fees once disguised in the rebate are doing fewer trades that involve securities lending and looking for higher returns on those they do. Neil O’Hara reports.

LOW RATES CRIMP SECURITIES LENDING OLUME IN GLOBAL securities lending has tumbled from $4.5trn before the crisis to about $2.5trn today, according to James Slater, global head of securities lending at Bank of New York Mellon. “There was a lot more general collateral business done three or four years ago,” he says. “The mix between specials and general collateral across our book is more heavily weighted toward specials than it used to be.” In the mundane world of general collateral lending—a business that, by definition, has wafer-thin margins—today’s low interest rates leave little room for lenders to earn any money at all. In the US, lenders used to put out general collateral for a few basis points and top up the return by reinvesting cash collateral in instruments that offered a premium over money market yields, derived either from extended duration or credit risk. That strategy fell out of favour after the financial crisis, when certain collateral pools suffered significant losses on these investments. Every lender—whether directly affected on not—revised its reinvestment guidelines to permit only higher quality instruments of shorter duration. Less risk-averse lenders

FTSE GLOBAL MARKETS • OCTOBER 2011

adopted the qualifications for inclusion in US money market funds prescribed by Rule 2a-7 of the Investment Company Act of 1940, which permits only top quality credits, limits the maximum maturity on any instrument to 397 days and caps the dollar-weighted average maturity at 60 days. The restrictions curtail opportunities for yield enhancement, so general collateral lending has become less profitable: typically, basis point spreads are measured in single digits, compared to 75 basis points (bps) or more in 2008. The most conservative lenders reined in reinvestment to overnight repo, which eliminates any possible pickup in yield and effectively precludes general collateral lending altogether. Although US lenders have adopted more conservative reinvestment guidelines, they are nevertheless more willing to accept non-cash collateral. It is still a modest proportion of the market, in part because local regulations prohibit US broker dealers—the principal customers of the big agent lenders—from pledging equities in securities lending transactions. The dealers can pledge fixed-income securities, however, and lenders have developed creative structures to skirt the restriction on pledging equities.

SECURITIES LENDING

Paul Lynch, chief operating officer of eSecLending. “The prime brokers came out of a volatile period and saw their assets begin to stabilise and grow. Even though they started 2010 with lower balances than they had in previous years they were more interested in locking up exclusives through the auction process,” he says. Photograph kindly supplied by eSecLending, September 2011.

James Slater, global head of securities lending at Bank of New York Mellon. “There was a lot more general collateral business done three or four years ago. The mix between specials and general collateral across our book is more heavily weighted toward specials than it used to be,” he says. Photograph kindly supplied by Bank of New York Mellon., September 2011.

Nicholas Bonn, head of securities finance at State Street Global Markets, says his firm may lend IBM, for example, take cash back from a dealer and then invest that money in a reverse repo collateralised by other equities the dealer wants to finance. “We look at non-cash transactions as secured lending,” says Bonn.“It is a big part of what we do. Our counterparties are all global, so what they can’t do in the US we may do with them in Europe instead, or achieve a similar result here through a reverse repo.” State Street has maintained securities lending balances of about $400bn for several years, picking up market share as the overall market has shrunk. The big custodian banks—State Street, Bank of New York Mellon and Northern Trust—have long dominated the global securities lending business, in part because it is a natural extension of their core operations. Technology has begun to erode their advantage, however, making it easier for lending agents to service clients whose securities are in custody at a different institution. Citi bulked up its staff in third-party lending over the past year after it noticed clients were under increasing pressure to buy best in class services even if they had to unbundle custody and securities

lending. The New York-based bank also acquired Wells Fargo’s third-party lending book in July and is now shifting those clients over to Citi. “The transaction with Wells Fargo strengthens our position as a third-party provider in the industry,” says Tim Douglas, global head of securities finance at Citi Global Transaction Services. “This transaction makes us a more established player.” The prime brokers who borrow from the agent lenders have to balance the expected demand from their clients— principally hedge funds and internal trading desks— against the cost of procuring securities from different sources. The least expensive is their own securities inventory—in retail margin accounts or long positions held by prime broker clients and in-house proprietary trading desks—but that will meet only a fraction of customer demand. For the rest, prime brokers must either borrow from the agent lenders at the market rate, or pay a premium to pension plans and other large beneficial owners to gain exclusive access to their portfolios. Exclusive deals may be negotiated privately, but owners of the most attractive portfolios—equities, especially in

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SECURITIES LENDING

Jeffrey Benner, deputy head of securities lending at Northern Trust. “Once the lending spread exceeds the cost of creating new ETF units, the arbitrageurs step in. Some ETFs are more valuable than others. For example, small-cap funds generally cost more to create than the largecap funds, increasing the value to the market,” he says. Photograph kindly supplied by Northern Trust, September 2011.

Asia, other emerging markets and, in the US, small and mid-capitalisation stocks—often prefer to sell exclusive rights through auctions run by eSecLending or one of the established agent lenders. The number of auctions and the premiums paid both dropped in 2009 as hedge fund assets plunged by about 30% and the securities houses cut back proprietary trading. By early 2010, many hedge funds had bounced back and the industry again began to attract fresh assets, reviving interest in exclusive deals. “The prime brokers came out of a volatile period and saw their assets begin to stabilise and grow,” says Paul Lynch, chief operating officer of eSecLending.“Even though they started 2010 with lower balances than they had in previous years they were more interested in locking up exclusives through the auction process.” Lenders demand a premium for exclusive access to compensate for the concentrated exposure to a single counterparty. The amount dealers are willing to pay has dropped in the past three years, to the point where the compensation may no longer be compelling. Meanwhile, counterparty risk has become alarmingly real.“People in exclusives with Lehman realised how quickly that can go from an opportunity to a challenge,” says Mark Payson, managing

director of trading at Brown Brothers Harriman. “The premium over what agents assume they can make in the market today is minimal, or not even there. It is easy to walk away from the risk.” He expects dealers to raise the stakes again at some point; indeed, they are already bidding up for portfolios that have an above-average proportion of potential specials. The big money in securities lending has always been in equities, in part because fixed-income borrowers used to balk at negative rebates. That changed when the Treasury Market Practices Group (TMPG) imposed a 300bps penalty on failed trades in 2009, partly to prevent market participants from selling short without a borrow and failing to deliver at essentially no cost. “The penalty has definitely helped increase the spreads on Treasuries in this low interest rate environment,”says Jeffrey Benner, deputy head of securities lending at Northern Trust.“We have seen and should continue to see Treasuries trade below zero rebate.” Specials in the Treasury market are less common than they were, given the enormous issuance to fund the US federal deficit, but T-bills and on-the-run bonds may still attract a premium from time to time. Benner says lending spreads tend to be higher in other fixed-income sectors, including high-yield corporate bonds and certain investment grade issues. Agent lenders are doing more business in ETFs now that these products are widely used by institutional investors. The large, liquid ETFs trade as general collateral but specials have become common among the smaller and specialty issues. Unlike corporations, ETFs are open-ended, which limits how high a premium they can attract. “Once the lending spread exceeds the cost of creating new ETF units, the arbitrageurs step in,”says Benner.“Some ETFs are more valuable than others. For example, small-cap funds generally cost more to create than the large-cap funds, increasing the value to the market.” The greater emphasis on specials in today’s market has not changed the long-standing practice by which agent lenders give more generous allocations of hot stocks to their best customers—i.e. the more general collateral a prime broker takes, the more specials it will get. The allocation does not affect the pricing, however. “There is no trade-off between the value of specials versus the amount of general collateral,”says Bonn at State Street. “There never has been at State Street.” That has not always been the case at every lender, however. During the credit crisis, agents that had impaired collateral pools were desperate to preserve loan balances in order to forestall forced sales of pool assets at distressed prices. Some resorted to subsidised pricing, offering specials at a discount and paying higher rebates for general collateral, a policy that helped the agent but was not necessarily in the asset owner’s best interests. “Doing general collateral for specials is fine as long as both are priced at fair market value,” says Payson. “Brown Brothers has always priced them that way, and the market is doing that more now, too. Beneficial owners are demanding that of their agents.”

OCTOBER 2011 • FTSE GLOBAL MARKETS

Nicholas Bonn, head of securities finance at State Street Global Markets. “We look at non-cash transactions as secured lending. It is a big part of what we do. Our counterparties are all global, so what they can’t do in the US we may do with them in Europe instead, or achieve a similar result here through a reverse repo,” he says. Photograph kindly supplied by State Street Global Markets, September 2011.

Mark Payson, managing director of trading at Brown Brothers Harriman. “People in exclusives with Lehman realised how quickly that can go from an opportunity to a challenge. The premium over what agents assume they can make in the market today is minimal, or not even there. It is easy to walk away from the risk,”he says. Photograph kindly supplied by Brown Brothers Harriman, September 2011.

Rational pricing is just one indication that the securities lending market is healthier than three years ago even though returns are lower. In retrospect, the earnings in 2007 and 2008 were an aberration, a by-product of extreme market stress that could never recur in normal market conditions. “When you look at returns over ten years and take out 2007 and 2008, we are much closer to the average spread now than we were then,”says Slater at Bank of New York Mellon. “On a risk-adjusted basis, the industry is in a better place, thanks in part to less general collateral being done.” A State Street analysis of the returns on securities lending revealed that the intrinsic value component is stable over time while reinvestment returns are volatile. Bonn encourages customers to focus on maximizing the former and treat the latter as a bonus. “Lending should always capture the below-the-line spread in the security,” he says.“The above-the-line reinvestment income is incremental. Clients should get a good risk-adjusted return for that component.” Lending balances are likely to expand now that hedge fund assets under management are growing again— indeed, industry assets have surpassed the high set before the market crash. Managers remain cautious, though: most

are keeping leverage relatively low and maintain plump liquidity buffers against potential market volatility. Securities lenders do not expect to see utilisation rates back at peak levels in the foreseeable future, but the emphasis on intrinsic value has raised profit margins so that lenders can make more money off a smaller book. Short-term interest rates have nowhere to go but up, which is typically a difficult environment for securities lending. The yield on cash reinvestment vehicles responds to any move by the Federal Reserve with a lag, which makes it hard for lenders to beat the benchmark overnight rate until lower-yielding instruments roll off the books. Nevertheless, lending margins would almost certainly increase once the transition was over. If the Fed funds rate ticked up 100bps, negative rebates would be less prevalent and lenders would have more scope to enhance the yield on cash collateral. The Fed is not likely to raise rates until the economy strengthens or inflation rears its head, but whatever the cause it should benefit securities lenders. “Higher rates would help this industry,”says Citi’s Douglas. “If we had a real inflation scare, you might have a tough economy, a tough market and a lot of short selling. There would be quite a bit of opportunity in that environment.” I

FTSE GLOBAL MARKETS • OCTOBER 2011

TRANSITION MANAGEMENT

CLIENTS PUT TRANSITION MANAGERS UNDER SCRUTINY The transition management industry in Europe had been in a state of flux but today the league tables comprise roughly the same number of providers as there were in 2008. Competition is once again intense although the challenges, as demonstrated by the recent bout of volatility, are different. In today’s world, firms not only need the depth and breadth of product but also advisory and value add services to remain on top of the game. Lynn Strongin Dodds reports on a continuously dynamic specialist service segment.

FTER THE FINANCIAL crisis, we saw a number of providers, particularly those in investment banks, exit the industry, says Ben Gunnee, European director of Mercer Sentinel Group, which advises pension schemes on transition issues: “As confidence returned in the market, we have seen banks such as Credit Suisse and Citi rebuild their teams and we are now in pretty much the same position in terms of the number of providers. However, as a result of the changing landscape, clients are looking much more closely at the capabilities and commitment from each provider.” Lachlan French, managing director, and co-head of transition management Europe, Middle East and Asia Team at BlackRock, adds: “We did have a period of contraction two years ago but if the market continues as it is, we could see another period of retrenchment. This would be particularly true for the less established players where transition management is not a core service. I don’t think this would be the case for the larger providers who are today strongly competing for business.” Ironically perhaps, despite the upheaval, the individuals at the helm are mostly the same albeit at different organisations. The game of musical chairs continues with the most recent departure being senior transition manager Raymond Pestana from State Street after just a little over a year with the firm. Pestana was one of a group of seven that left en masse from Citi with the head Tim Wilkinson going to Mellon Transition Management (MTM), the transition management specialist for BNY Mellon in 2009. It was not a total loss for State Street as they re-hired Ben Mooney as vice president and transition manager for EMEA. He left the firm in 2010 to join US asset manager Welling-

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

ton Management International, where he was director and client operations manager focusing on EMEA. Wilkinson, on the other hand, has also moved on from Mellon to become managing director, EMEA at Russell Investments. Other notable veterans have simply left the business, such as John Minderides, who was instrumental in restructuring JP Morgan’s transition management group. He has not been replaced but Michael Gardner continues to lead the EMEA business and global products with Robert Saffer remaining at the helm of the US transition management business. Against this shifting landscape, it is not surprising that institutions are paying more attention to the individuals and not just the brand name of the investment bank or custodian. Steven Dalzell, who was at BlackRock but stepped into Wilkinson’s shoes at Citi as head of transition management, EMEA, explains that “the financial crisis was an unprecedented time and transition management teams were forced to make cuts”. He adds:“The investment banks were more visibly affected than the asset managers but they quickly realised how valuable the franchise was, particularly in terms of the client coverage it provided. The competition now is just as great but what has changed I think is that clients are more buyers of the individuals and their experience of transition management rather than just the reputation of the firm.” Mark Dwyer, head of Mellon Transition Management (MTM) EMEA, agrees that clients are looking for more. “Clients are not just looking at the firm but the depth and breadth of the transition team. With ever more complex portfolio structures and volatile markets, you need confidence that your transition team has the experience to deliver, whatever the market.”

OCTOBER 2011 • FTSE GLOBAL MARKETS

Despite the upheavals over the past three years, the leading firms have managed to keep their edge. There is no official league table but the general consensus is that State Street, JP Morgan and Russell Investments are in the top tier with some market participants believing that BlackRock’s star could be falling. Others disagree although most would put Goldman Sachs, BNY Mellon, Morgan Stanley, Northern Trust, Citi and Credit Suisse among the top ten. There is also a view that the market has room for specialists such as Legal & General and Nomura who are known for their equities acumen. Staying on top is of course one of the major challenges. Simon Hutchinson, head of transition management for Europe, the Middle East, Africa and Asia-Pacific at Northern Trust, says: “Although it is the same names chasing the business, the clients have become more demanding. It is a very competitive industry and there is no guarantee that if you act as a custodian for a client that you will win the transition mandate. All firms now have to prove their worth and show a strong commitment to the business. That means having the right team, processes and skill sets in place.” Rick Boomgaardt, managing director and head of transition management for EMEA at State Street, agrees, adding: “It is no longer just about the execution component. This to a certain extent has become commoditised. Clients are more interested in the value you can add because transitions have become much more complex and complicated. They are no longer plain vanilla moves but can involve de-risking of pension funds, buyouts, buy-ins and liability-driven investment (LDI) frameworks. There is also no one major theme but clients are doing different transitions depending on their long-term asset allocation strategies.” Liability-driven investing had been off the agenda in the aftermath of the financial crisis but it is back as pension funds try to better match their risks. In the transition world, it is still in its infancy and most pension schemes are still on their first mandate with LDI-to-LDI transfers still the exception rather than the rule. They can also be complex because they often involve long-dated and index-linked bonds as well as complex portfolios of cash and derivatives, including hedges against unwelcome movements in interest rates and inflation. Dwyer takes the view that the move to LDI schemes has also highlighted the importance of project management. “The timing of the move into LDI is crucial. Although the LDI asset manager may be in the best position to buy the target portfolio, because of the high percentage of OTC derivatives, you need a transition manager to execute the legacy portfolio liquidation and ensure that the fund remains fully invested during the transition”. Overall, institutional investors are also moving within asset classes. “We have seen an increase in de-risking and moving to safe havens but it has become more detailed,” says Chris Adolph, head of transition management in Europe at Russell Investment. “Clients are not just moving into fixed-income instruments but they are making moves within fixed income based on market conditions. For example, we recently switched a client’s exposure to

FTSE GLOBAL MARKETS • OCTOBER 2011

Ben Gunnee, European director of Mercer Sentinel Group. Photograph kindly supplied by Mercer Sentinel Group, September 2011.

German bunds from French government bonds because of recent concerns about the country.” Other pension funds are casting their nets wider and venturing into emerging markets. This past summer for example, JP Morgan Worldwide Securities Services completed the $12.5bn transition of emerging market assets for Dutch pension administrator and asset manager APG. The deal involved transferring assets from over 30 emerging markets into a newly-created entity, the APG Emerging Markets Equity Pool, an FGR structure which is part of the investment proposition that APG offers as a third-party asset manager. It was not only one of the biggest transitions the firm has handled but also one of the most complicated due to the tax, legal and multiple market implications. It is typical of the kind of transactions flowing JP Morgan’s way, claims Mike Gardner EMEA, head of transition management, JP Morgan Worldwide Securities Services. “Clients seem to gravitate to us with events that involve many accounts, multiple asset classes and multiple custodians.” While transition managers may have their different areas of expertise, they have all honed and enhanced their interim transition offering. This is because since the financial crisis, institutions have increasingly taken their time deciding a replacement once they fire a fund manager or change strategy gears. The portfolio is put in a holding pattern with the transition manager until a new manager is chosen. Recent research from MTM showed that institutional investors could take as long as a year to complete the transitioning of their assets away from one investment manager to another after beginning initial consultations with the firm. This is in contrast to the typical period of approximately two to four weeks before the crisis began. In times of uncertainty, many pension funds will opt for the interim or take a staggered approach to take advantage of more favourable market conditions. “In periods of volatility, clients have become more cautious and may not want to switch into as asset class on a day when markets are crashing,”says Dalzell. Instead, they set certain trigger levels and instruct us, for example, to move into bonds when yields are a certain level or into equities when the FTSE or S&P reaches a specific price.”

TRANSITION MANAGEMENT

Risk management has also come to the fore and transition managers are expected to use derivatives, futures and exchange-traded funds to manage exposures and reduce tracking error. As a result, the transition manager is becoming involved earlier in the process and has taken on a much more advisory role, according to Adolph. “They are looking for you to advise on the best ways to de-risk the portfolio and to have the tools to mitigate the volatility and risk throughout the transition.” Gardner though warns that sometimes these tools can add confusion.“It is important to match the hedge relative to the exposure. For example, if implementing a hedging strategy will reduce the annualised tracking error estimate from 8% to 2%, the hedging strategy would be worthwhile. However, if it only reduces the tracking error estimate from 8% to 6%, then this may not warrant its use after taking into account the short duration of the hedge and increased transaction costs. Looking ahead, it is difficult to predict if the second half will see the same steady flow of business enjoyed by the industry in 2010 and the first half of 2011. As Hutchinson notes: “The volatility could make the market more challenging. One of the things we have noticed is that in the

Simon Hutchinson, head of transition management for Europe, the Middle East, Africa and Asia-Pacific at Northern Trust. Photograph kindly supplied by Northern Trust, September 2011.

past, news would come out on a security and there was a 1%-2% movement but now it could be 20%. That could have a significant impact depending on what side of the tread you are on.” Kal Bassily, head of global transition management at ConvergEx group, says:“The asset owners are not in an easy position because the market impact and opportunity costs are more significant in this type of environment. It is difficult if they are underfunded and some clients might delay the transitions until market conditions improve. Others might

TRANSPARENCY & TRANSITION MANAGEMENT Further moves towards self-regulation and good governance ESPITE THE INTRODUCTION of the T-Charter four years ago, progress on the transparency front has been slow. Transition managers are still crunching their own numbers and issuing their own report cards. However, now there are moves in the industry to accelerate the pace of change but institutional investors are also encouraged to be more proactive. According to Graham Dixon, director at performance measurement firm Inalytics, despite the T-Charter, the industry’s code of best practice, some transition managers are reluctant to release their track records to clients. However, they are happy to provide the pre-trade benchmark, calculate their own performance (implementation shortfall) and write the report that reviews the results. One of the reasons transition managers give for not releasing the data is that each transition is different and, as a result, the track record does not reveal who is the best manager. Among the various initiatives now in train, an industry working party

is looking at how to apply Global Investment Performance Standards (GIPS)—a set of standardised, ethical principles that provide investment firms with guidance on how to calculate and report investment performance—to transition management. The goal is to provide information on the cost estimates of the trades of transition managers and the realised results. In addition, Martin Mannion, chairman of the T-charter and director of pensions finance, investment and risk at GlaxoSmithKline, has put together a working group to develop the T-Charter 2.0. The group encompasses a much wider group of stakeholders such as asset owners and consultants as well as transition managers. The aim is to develop a list of detailed questions that pension funds can ask their transition managers to justify their prices and capabilities. Institutional investors are also advised to look beyond the scorecard they are given and to conduct their own rigorous due diligence. This means not only

meeting the transition management team to gain a better understanding of the managers’ model but also asking them to quantify and disclose any dealing method, venue or counterparty that allows them to generate additional revenue. Track records should also be an important factor as well as the firm’s trading acumen, access to liquidity, risk management systems and project management skills. A new study conducted by Mellon Transition Management (MTM), the transition management specialist for BNY Mellon Asset Management, also encourages investors to break down the components of the implementation shortfall which includes both implicit and explicit costs. The former comprises the market impact of the trades and the price movements of the securities during the transition period while the latter consists of spreads, commissions, taxes and fees incurred in selling the securities in the old portfolio and buying the securities in the new one.

OCTOBER 2011 • FTSE GLOBAL MARKETS

Mike Gardner EMEA, head of transition management, JP Morgan Worldwide Securities Services. Photograph kindly supplied by JP Morgan, September 2011.

change their asset allocation to bring it back to the target range or to reduce the volatility.” The volatility will make people pause for thought and review their transitions,” adds Boomgaardt. “However, generally speaking most portfolios are driven by long-term asset allocation decisions and what is right for the pension fund. For trading, one of the most important factors is whether there is liquidity in the market, and volatility can actually add to liquidity in some circumstances, so it is not necessarily all bad.”

The report also found that the price gap between the end of one trading day and the start of the next also could be a factor in the cost of a transition that extends over more than one day. How the attribution of these implicit costs are calculated and presented can have a major impact on how the success of a transition is perceived, according to Graham Cook, vice president at MTM and the report’s author. “Implicit costs are difficult to separate out, but a careful analysis can reveal additional insights into the skills of the transition manager.” Ben Gunnee, European director of Mercer Sentinel Group, which advises pension schemes on transition issues, says: “Institutions should demand a much greater level of transparency about the hidden costs. They should look more closely at the pre-trade analysis and post-trade results and ask more questions such as how the bid/ask spreads are being calculated and on foreign exchange commission and taxes.” “There is still too much focus on commissions versus the overall cost of the trade,” says Rick Boomgaardt, managing director and head of

FTSE GLOBAL MARKETS • OCTOBER 2011

In terms of activity, de-risking, LDI and emerging markets are likely to remain prevalent moves but some market participants believe defined contribution schemes could offer selective windows of opportunity. They may not be able to get involved if schemes are moving from one investment platform provider to another without changing the underlying funds. However, they could be called in if there is a shift between segregated and pooled funds or the introduction of new funds. They are not easy, according to Adolph. Managers have to ensure allocations at the unit level are correct for each member and members are treated equally in terms of the costs incurred from the move. Funds that could be commingled in a defined benefit transition may require separate accounts, and trustees will have to consider “blackout periods”during which members are prevented from making changes to their funds. Hutchinson adds:“These types or transitions are complex because pooled funds have different dealing dates and from the operational side you have to ensure that you transition the assets with minimal market exposure and tracking error.”I

transition management for EMEA at State Street. “There are the explicit costs and implicit costs. Clients need to understand the difference, and really understand how the transition manager is proposing to manage them. One of the problems is that because managing a fund is complex, clients don’t often think much about transitions until they have one to do. Education is key and as transition management has become more mainstream, we have seen a general increase in familiarity with the services available.” The MTM report notes that an important component in determining the success of the transition is how much of a trade-off is made between rapidly trading the portfolio components versus making smaller trades over a longer period of time. It found that trading a significant portion of the portfolio over a compressed time period can quickly reposition the portfolio to take advantage of market opportunities, while making smaller trades over a longer period of time could minimize the impact of the trades on the prices of the securities being traded. The report adds that analysing the implicit costs and using the right

benchmark can help identify whether the transition manager made the most of the liquidity available during the transition, while managing risk. The key to a successful transition is striking that optimal balance between the impact of the trades on the markets and the risk of prices drifting adversely. Transition managers are also stepping up to the plate and becoming more transparent. Last year, Russell Investments made its data available to its own clients and opened the door to inspection to a wider group of investors by giving Inalytics its performance data across all asset classes. Morgan Stanley and Citi have since followed suit. Most of the larger players also provide real-time, online reporting throughout the lifecycle of a transition. Lachlan French, head of transition management at BlackRock, says: “We are definitely more transparent than we were but I cannot comment on whether it is applicable across the market. I think there is debate in some areas such as foreign exchange. I do agree though that clients need to have a better understanding and ask their transition managers to provide the transparency.”

TRADING REPORT

Like most people who gain more control over some aspect of their lives, buy side traders relish the sense of empowerment it brings. Technology has released them from a slavish dependence on sell side trading desks: they can now opt for low-cost electronic execution at venues of their choice over high-touch service from a sales-trader if they see fit. With power comes responsibility however, which may be a curse rather than a blessing to people predisposed to believe that everyone is out to get them. The same technology that let buy side traders take charge has also splintered liquidity, undermined block trades and ushered in high-frequency trading (HFT). The new paradigm has forced traders to adapt their execution strategies lest other market participants detect their intentions. The buy side remains as paranoid as ever—and with good reason. Neil O’Hara reports.

BUY SIDE STILL CAGEY AFTER ALL THESE YEARS RADERS ARE LIKE taxi drivers, who leave the choice of destination to their customers—the portfolio managers—but try to avoid potholes, pedestrians, road hogs and other hazards along the way. The driver goes where he is told, but he is free to pick the best route, which may vary depending on traffic conditions and whether his fare has a pressing appointment. “We look at trading as trying to solve the execution problem,”says Robert Karofsky, global head of equity trading at AllianceBernstein, the $450bn New York-based money manager. “We want to implement the best investment ideas in the most effective manner,” he adds. In practice, the choice between electronic execution and high-touch human service usually depends on how fast the trade needs to be done. If a portfolio manager wants to accumulate a position in a stock expected to outperform its peers or the market over several months, the trader may prefer to stay on the bid in electronic trading venues and pick up stock as it becomes available. Provided the stock has good liquidity, low volatility and a tight bid-offer spread, a trader can accumulate a position with negligible impact on the price other than the background noise of market fluctuations. “We are more inclined to go down the electronic route when we don’t think a human can add value by finding a creative solution to a particular trade,” says Karofsky. A human trader has a better shot at improving execution if the

order is urgent. A portfolio manager who anticipates a jump in price following an imminent earnings release will be prepared to buy stock on the offer. If the trader crosses the spread in the public markets, it sends a signal that the buyer may have more to do in the same direction, which invites other participants to front run the order. A trader may instead pass the order to a trusted broker, who will try to find one or more sellers among its institutional customers or commit its own capital and arrange a block cross that prints only after the trade is done, minimizing the information leakage. Nothing is set in stone, however. AllianceBernstein uses pre-trade transaction cost analysis (TCA) to estimate how much a rapid execution would cost and compares that to the likely impact of market volatility over the time it would take to accumulate the desired position passively. For example, a two-sided trade—selling one stock and buying another—may be expected to cost 200 basis points (bps), but in a volatile sector such as energy the prices could move 3%-5% during a single trading day even if the stocks have good liquidity. Says Karofsky: “It may make sense to cross the spread, take liquidity and trade with more urgency, but if it is a small percentage of average daily volume and we can’t add value we’ll trade electronically with as little footprint as possible.” Traders have learned to use TCA to improve execution performance, but it is no substitute for instinct; much to the

OCTOBER 2011 • FTSE GLOBAL MARKETS

Photograph © Benjamin Haas / Dreamstime.com, supplied September 2011.

chagrin of bean counters and senior managers who hoped to bring greater accountability to the trading desk. For example, a report for a broker’s order may show it was filled without crossing the spread, but it cannot tell why. Did the broker use its discretion wisely, or merely obey strict instructions from the buy side client? In picking the best algorithm for a particular order, buy side traders will give at least as much weight to how often they have used it and how the fills compared to what they expected to get done than they will to prior execution reports. “So much of trading comes down to gut and feel,” says one buy side trader who works for a $150bn value-oriented money manager. “It’s great to have the statistics, but you have to look at the numbers with the caveat that they are never going to be perfect.” Despite their reservations, buy side traders make extensive use of TCA data, breaking it down by time of day, algorithm and even trading strategy. They look at which dark pools offer the highest percentage fill rate and best quality execution—for example, middle-market versus crossing the spread. They compare results by broker, too, but always with a pinch of salt. The execution in a liquid large-cap name cannot be compared to a small or mid-cap name in which one regional broker sees most of the flow. The first should have near-zero market impact, while the second will likely show greater impact, albeit far less than if the order was given to a different broker who was not active in the name. “We look for a broker who is a natural player in the name,” says Clive Williams, head of global equity trading at $521bn Baltimore-based money manager T Rowe Price. Although buy side traders go to great lengths to avoid leakage about their own orders, they are happy to use whatever information is available in the market about others’ trades. If a broker on the upstairs block trading desk contacts a buy side trader about a specific stock, it is more than likely

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the firm is working algorithms in electronic platforms as well. A buy side trader can seize the opportunity either to take the other side or to jump in front, perhaps using an algorithm supplied by the same broker—while still preserving anonymity. “We can use what we see in the high-touch space to our advantage,” says Williams. “We can be in their algorithm and tap that same liquidity.” Electronic execution exposes buy side traders to the risk of being picked off by high-frequency trading firms, however. While some buy side players accept the argument that highfrequency trading shops provide real liquidity that narrows bid-offer spreads—they are in effect the default liquidity providers in many stocks today—Williams will have none of it. “All they are for us and our clients is a tax,”he says.“They impinge on the natural liquidity of the market, getting in the middle of trades that would take place anyway.” Williams points out that the major securities houses are now just as committed to high-frequency trading as dedicated firms such as Getco and Tradebot. In effect, the dealers have hived off their traditional proprietary trading desks to comply with the Dodd-Frank Act only to replace them with high-frequency trading dressed up as market making or facilitation. It was an easy decision: highfrequency trading allows them to make at least as much money with fewer people and less capital employed. Frustration among buy side traders extends to the exchanges, which are seen as too accommodating to a trading technique that has jacked up exchange revenues through enormous increases in volume. “I would like to see more transparency around high-frequency trading,” says AllianceBernstein’s Karofsky. “ The exchanges cater to it, and it impacts the way we do our job every day.” He isn’t seeking a ban on high-frequency trading—he knows the genie can’t be stuffed back into the bottle—just rules that aren’t skewed to favour one set of market participants over another, such as low minimum tick sizes. To protect against toxic intermediation, buy side traders set tight limits on their orders. If a stock is trading at $49 and the portfolio manager is willing to pay up to $49.10, a trader may set the limit at $49.02 to prevent a high-frequency shop that sniffs out his interest from running the stock up to the manager’s limit. Traders also behave in an unpredictable fashion, varying which algorithms they use, the time of day they enter orders and the urgency of execution to throw the detection software off the scent. Traditional buy side managers such as T Rowe Price rely on brokers to supply algorithms and other electronic trading tools rather than developing their own or buying from thirdparty vendors. They won’t accept off-the-shelf versions, either, demanding customised versions that fit their style of trading or portfolio management. Traders also tinker with the order routing tables to exclude venues they don’t like or eliminate biases that might favour broker revenues over best execution, a significant temptation when so many trading venues use maker-taker pricing to attract liquidity. “We spend time and effort to educate our traders,” says Williams. “We lean on the brokers a lot for customisation.”

TRADING REPORT

Clive Williams, head of global equity trading at T Rowe Price. “We spend time and effort to educate our traders. We lean on the brokers a lot for customisation,” he says. Photograph kindly supplied by T Rowe Price, September 2011.

Laurie Berke, a principal at TABB Group. “Brokers have to add value to research and trading. If they can’t demonstrate their ability to differentiate on each side of the investment equation, they simply can’t compete,” she says. Photograph kindly supplied by TABB Group, September 2011.

The buy side is beginning to get more than information technology assistance from low-touch sell side trading desks, too. Laurie Berke, a principal at TABB Group, a New York and London-based capital markets research and consulting firm, says brokers can no longer differentiate themselves by technology alone; algorithms and smart order routers have become commoditised to the point where buy side clients view them as equally effective no matter which firm created them. The latest sell side strategy borrows a page from the high-touch playbook: put live bodies on low-touch electronic trading desks—but experienced traders, not IT geeks.“People are back in the game, delivering value across the board on the sell side,” says Berke. “They are not just telling clients about new order parameters for the algorithms. They cull through TCA data looking for ways to capture alpha for each client, advising them on how to optimise the trading decision.” The execution consulting concept could pose a serious threat to brokers whose trading capabilities are below par. Execution-only houses were already scrambling to add research and other content to enhance their product offerings, but now they have to demonstrate trading prowess as well—as do full-service brokers. “The next phase will knock out brokers who can’t add value to trading,” says Berke. “Brokers have to add value to both research and trading. If they can’t demonstrate their ability to differenti-

ate on each side of the investment equation, they simply won’t be able to compete.” The evolving relationship between the buy and sell sides echoes the symbiosis that prevailed when institutions did almost all their trading in blocks. Veteran buy side traders still yearn for the trusted broker they could call and expect to put up a 750,000-share print with just two or three participants on the opposite side with barely a ripple in the market price. The nearest buy side shops can get to that today is in blockoriented dark pools including Liquidnet and ITG Posit, but more often than not they won’t find a match. Indeed, Berke suggests that block trading may be a dying art: a new generation of traders has grown up without it in a market dominated by algorithms and electronic trading. Buy side traders still appreciate all the help they can get in delivering best execution, which leaves the door wide open to sell side execution consultants attuned to a particular client’s style. Traders sometimes need help managing their own portfolio managers, too. If passive electronic order handling isn’t finding fills, the next best option may be to call a broker— which may alarm portfolio managers worried about tipping their hand.“If we want to cross 5% of the daily volume at the current market price, we have to tell someone we are a buyer,” says the value-oriented trader. “It just has to be the right person. It is all about relationships with people you trust.”I

OCTOBER 2011 • FTSE GLOBAL MARKETS

Photograph © Irina Onufrieva / Dreamstime.com, supplied September 2011.

Topping the Thomson Reuters’ Extel Survey 2011 for the second year running, JP Morgan Asset Management is among the world’s top ten asset management firms (a list dominated by BlackRock’s assets under management (AUM) of $2.7trn). In Europe, although the firm is comparatively smaller, its institutional assets have risen by 35% in the twelve months up to the end of June this year, to $44.3bn, excluding money market and sovereign business. Ruth Hughes Liley looks at the trading operations of the firm, as its clients look for more diversified sources of return and less risk exposure.

TAKING ON THE ONUS FOR EXECUTION QUALITY ITH MORE WORK hitting the dealing desk as the buy side takes more responsibility for execution and quality, head of European trading desk, Kristian West, has been busy, not just with daily dealing demands, but also ensuring the firm is prepared for new demands ahead. For example, as clients look for more diversified sources of return with less risk, the firm has developed multi-asset strategies. JP Morgan Asset Management’s Global Multi-Asset Group (GMAG) made up of a network of global specialists has grown from $25.6bn AUM and supervision in June 2006 to $62.5bn in June this year. West says: “We are going through an evolution when it comes to trading complex strategies. In the past 12 to 18 months we have seen a big increase in the amount of derivative trading to the point where we are restructuring the team. We’ve moved from using derivatives as a hedge for portfolios to trading them as outright strategies. We are planning for the future and implementing new technology so as to build scale. We have taken on extra people and introduced new software to trade synthetics and swaps.” Indeed the firm is currently rebuilding its order management system and has been trading options using FIX Protocol since 2010. Its technology uses a hybrid model, a combination of off-the-shelf technology and custom-built software, supplied by around eight core vendors. Weekly meetings ensure that the firm’s vendor relationships are well managed. “A number of years ago, there was a clear decision by the leadership to invest in people and technology,”says West.“It was a strategic move and was followed up about 18 months ago by the formation of an ‘innovation council’. This has had the knock-on effect of focusing and

FTSE GLOBAL MARKETS • OCTOBER 2011

motivating the team. With support of the senior leaders we are able to push ahead with innovative ideas and projects.” So whereas in 2007, there were few desk-based technologists, now there are eight technology staff on the European trading desk focused on equity and equity trading technology in addition to the 15 traders. Indeed, at a time when some buy side firms were just starting to ask about complex event processing for use in their electronic trading, JP Morgan AM went live with its CEP platform, the Execution Optimiser, in the spring of 2009. West says they are now ”increasingly using” CEP in their technology and investors know their order has been traded using CEP because they can see the machine’s initials, EO, on their order. JP Morgan AM has a global network of trading desks in London, Hong Kong, Tokyo, New York, Taiwan and Shanghai. While each desk is autonomous, there is a deliberate overlap in trading strategy and technology. London is the largest, dealing in up to 70 markets a day across several different time zones. London also runs global portfolios alongside the pan-European and global emerging markets. Across the network of desks, trading also occurs in derivatives and synthetics. Each regional desk is able to focus and specialise on its markets. While weekly conference calls on technology updates and daily contact between regions keeps the global network of trading flowing, at the other extreme, a trade in a UK smallcap name, for example, takes place across a couple of desks. The portfolio manager and the trader sit close together on the trading floor and have daily close dialogue. “The desk structure is set up around liquidity so we have different teams for small cap, large cap, multi-asset including

TRADING REPORT

Kristian West, head of European trading desk, JP Morgan Asset Management. Photograph kindly supplied by JP Morgan Asset Management, September 2011.

derivatives and convertible bonds, and there are two emerging market traders that face the EM investment team,” explains West. This structure is partly due to what the firm calls its “style” investment approach. Each product has its own different style and how they are executed affects trading style. So an index-tracking fund, for example, would require minimum market impact, a momentum fund, and different levels of aggression. Technology assists this approach. “Four years ago you would pick up the phone and speak to a sales trader. There was a standard way of doing things. Now we have the technology to access all the markets directly across multiple providers. We typically use five types of algo including ‘participate’, VWAP, dark-seeking and pegging. This generates some consistency. Each algo can have a specific use, so some will get used far more than others.” Each trade that hits the desk goes through a three-level “cleansing process”. First if an order is of a certain profile, with few peculiarities, the technology will pick it up automatically and trade it without human intervention. The next stage is for a trader to identify any natural liquidity: how much momentum the trade has and whether any indications of interest (IoI) would lead to a decision to trade over time or trade immediately. West says:“If no natural liquidity exists, the firm itself becomes the natural liquidity and the trade would go to the single stock team.” JP Morgan AM’s use of algorithmic trading has grown from “single-digit” percentage of trade in 2007 to a current average of 40%-50%, and some days as much as 60%. This sets its own challenges.“When liquidity dries up and assets

under management grow, we become proportionately bigger in the market. These larger orders require a different execution style. It may mean less electronic trading and more discussions with a broker. This is especially true within single stock trading to reduce stock-specific risk. “With our full service providers we have a number of different touch points and it becomes very important to have a good relationship with them. They help us gain access to liquidity and improve execution performance. It pays to work closely with them,” he adds. For the past three years the firm has been conducting six-monthly reviews with its ten to 12 full-service brokers covering different aspects of trading. They rank the firm’s brokers and give the list to their investors. It’s possible that a broker could move from first place to third place if two other brokers outperform. “For us to help them structure their products to best serve our needs, we need to give clear and constructive feedback,” asserts West. The firm also does more risk trading than in the past. It’s a“double-digit”percentage of the firm’s total flow and West is concerned about the effect of new regulatory proposals in MiFID II, regarding post-trade transparency. “If we trade these securities on risk, currently we can defer publication. If the regulators reduce this time period, the risk profile of that trade will change. It will change how we do the trade and will undoubtedly push up the cost of trading. Investors could be less inclined to trade smaller names. This in turn could reduce liquidity for SMEs and may make it more difficult on roadshows to raise capital for companies.” He is also concerned about the effect of dark pool and broker-crossing network (BCN) regulation. “These venues add real value to our trading process. We seek to execute in the most suitable way, on the most suitable venues. The venues where we are able to manage the execution experience are where we see better execution performance. The flexibility of choice should be maintained. There is also no evidence yet that trades done in dark crossing networks damage price discovery. There is however a lot of evidence to say that they work in our favour.” While West acknowledges worries about toxic flow in a dark pool, he also believes that it’s the very reason he wants to protect his power to trade where he wants. “We are not against high-frequency trading: we don’t have any evidence to suggest HFT is detrimental to our trading experience. However we do see bad executions in some venues where HFTs are prevalent. This requires further investigation.” Performance measurement is a large part of the desk’s responsibility.“It’s a very important and detailed process which requires a lot of in-depth analysis, especially for some clients with global mandates,”says West.“The future holds increasing interaction with a variety of competing strategies so we need to make sure that the quality and accuracy of our performance is measured and clients can see the issues and the benefits. MiFID I created changes to the market structure, and how one operates in the market. We want to get close to regulators and to see how things are going to change further. We need to see what is coming and be prepared to be proactive.”I

OCTOBER 2011 • FTSE GLOBAL MARKETS

Photograph © Violetkaipa / Dreamstime.com, supplied September 2011.

BUY SIDE TRADERS GO BACK TO BASICS—FOR NOW The buy side looks to be rediscovering the appeal of high-touch trading. It might be a temporary phenomenon, but DMA, SOR trades and trades through broker crossing networks are down. Ruth Hughes Liley explains the how and why. HERE’S AN IRONY in the fact that the 1980s chartbuster Together in Electric Dreams was sung by a band called The Human League. In the same way, while buy side firms are using more and more low-touch electronic channels, the high-touch human league of sales traders has been back in the charts. A study by Greenwich Associates published in June 2011 saw a reversal of market share away from electronic towards high touch, largely because buy side firms needed to create larger commissions. The amount conducted through traditional high-touch trades jumped from 55% to 60% during 2010 in the US as institutions shifted priorities from minimizing trading costs to preserving the flow of research and advisory services. Although during 2010 algorithmic trading held out unchanged at 19% of total domestic equity trading, a reduction in trading was recorded in all other forms: DMA, smart order routing trades, trade executed through broker crossing networks and dark pools and also portfolio trades. Nonetheless, the research indicates that the pull-back from electronic trading will prove temporary and it points out that for the past decade the US market has become steadily more electronic while the share of business conducted through sales traders has gradually eroded. “[The results] also point to a change in allocation among the various types of electronic execution. Institutions say they plan to trim high-touch trades back to the 55% of total volume recorded in 2009-2010 within the next three years.” In Europe, the proportion done with high touch remained the same at 60%, while electronic trading grew at the expense of portfolio trades. However, the pull back in Europe is

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expected to be even steeper over the next three years with only just over half (51%) of trades expected to be done by sales trading by 2014, while electronic trading will reach 35%. Brian Gallagher, head of electronic trading, Morgan Stanley, says: “Sales trading is always going to be very important and still provides the bulk of the revenue. Yet sales trading is not just a means to an end of getting paid. It’s a very important part of the equation. There’s a role for each part of the execution food chain. You need to have a solid sales trading offering, a solid electronic offering and a solid programme offering. You need to make sure you are still represented in each one of those three to serve clients in the best way.” With volumes 20% lower than in 2007 and 2008, smaller broker-dealer firms are suffering as concentration moves to larger and more niche firms. This has in turn squeezed commissions, which is putting pressure on firms to provide added value. Rob Shapiro, global head of trading at Bloomberg Tradebook, says: “You need to take high-touch traders and equip them with knowledge of low-touch things; that is, with the nuances of electronic trading. Execution consultants have the skill set to find the best path to execution. We don’t distinguish between high touch and low touch in today’s market. “As the buy side starts to send more of its order flow to electronic execution venues, they are also assuming more responsibility for the execution quality of the trade. This implies that the providers of the execution technology have to provide more and more service back to these buy side traders to help them deal with the extra responsibility they now own.” High touch has different definitions: on one hand it is the traditional sales trader working an order in the market place

TRADING REPORT

Brian Gallagher, head of electronic trading, Morgan Stanley. Photograph kindly supplied by Morgan Stanley, September 2011.

Rob Shapiro, global head of trading at Bloomberg Tradebook. Photograph kindly supplied by Bloomberg Tradebook, September 2011.

and providing risk pricing, Steve Wood, chief executive officer and founder of Global Buy Side Trading Consultants, says: “The good old-fashioned sales trader has morphed into a solutions provider. They’re not IT consultants, but they could be called project managers; talking to the buy side and finding out how they want to trade with algorithms and sorting it out for them. They are there to source liquidity, come up with trade ideas.” Wood also sees the sales trader becoming more of a middle-man acting as a conduit between the buy side and the risk team when the buy side trader needs a risk price, or sending out Indications of Interest (IOI) via FIX or Bloomberg on behalf of the buy side desk.“In another definition, the sales trader is just another venue where the buy side goes to execute an order,”adds Wood.“In a sense the buy side trader has to be more skilled than the sales trader. He has more venues to go to, he has to be able to calculate risk pricing, to work out transaction costs on different venues, and decide whether to trade using high-touch sales trading, risk capital, dark pools, electronic trading via algorithms or DMA and other venues in the buy side traders tool box.

soared in the summer and in the last week of July it traded over 100m shares two days running in the US, the first time since November 2008, compared with average daily volume in the first half of 2011 of 55m shares. Liquidnet’s head of its European trading desk, Richard Gray, noticed during August that many of their buy side members were outsourcing their trades to sales desks because they were too busy to manage all their own order flow.“Previously they would manage the order, explain what they wanted, and asked to be kept in touch with every move, whereas in the busy times they just rely on our capability.” This pressure on buy side desks has partly come about because as many firms moved towards electronic execution of trades, they cut back on trading staff. However, job losses affected the whole industry and during 2009 the number of jobs in London’s financial services sector fell by more than 30,000 to 315,230, a loss of 9.7%, although the pace of job losses in the sector slowed noticeably in the course of 2010, according to the Office of National Statistics, December 2010. Gray says the brokerage execution service offered by Liquidnet adds something to their offering.“I think we have an advantage over the competition because a lot of desks have been cut back, which has had a detrimental effect. Many sales traders have left firms and gone to hedge funds or set up on their own, so clients may not be being offered the same level of service that they were used to.” Rob Shapiro saw record volumes hit Bloomberg Tradebook’s desk in August’s volatile period. Bloomberg Tradebook saw the volume of equity shares traded increase 250% and the number of orders in its system spike 320% from August 5th to August 10th. “When volumes were down, we suspected a lot of capacity in the buy side trading channel. In the past when desks experienced volatility, we saw the buy side send higher order flow through electronic channels. Brokers that won that flow were brokers that had highly stable systems able to clear the high flows. It calls attention to how much needs to be invested in these platforms.”

A flight to high touch Gallagher witnessed a flight to high touch during the volatile trading weeks in August. At this time, the CBOE Volatility Index (VIX) shot up to nearly 50, albeit well below the 80 reached at the end of 2008. By comparison, in 2007 its natural range was between 10 and 20. Gallagher says: “When the market moves by 500bps in a day, clients need to be able to rely on the informational content and the relationship and deeper understanding of the account. When a sales trader sees a certain stock moving, it goes back to knowing your customer and knowing when to make that phone call.” Volatile periods also demand more capital than in quieter periods, another reason why the buy side relies more heavily on the sales desk, according to Gallagher. At Liquidnet, meantime a buy side-to-buy side crossing network, volumes

OCTOBER 2011 • FTSE GLOBAL MARKETS

Steve Wood, chief executive officer and founder of Global Buy Side Trading Consultants. Photograph © FTSE Global Markets.

Bill Conlin, chief executive officer at Abel/Noser. Photograph kindly supplied by Abel/Noser, September 2011.

The sales trading advice which runs alongside electronic execution is one form of execution consultancy. It is “Sales Trading 2.0”as Shapiro describes it.“Execution consulting is the acknowledgement that high-touch and low-touch space are converging and this needs a new service support model. The service package involves getting the clients to communicate their real needs in the context of their trading objectives. It’s approaching the traditional sales trading with the consultant’s viewpoint,” he adds. “It’s also not about one thing, either TCA or the latest order management system,” continues Shapiro. “It’s about being able to discuss the entire trading process in detail and being able to provide solutions in the form of process, data and analysis. Not everyone wants just TCA, for example.” In order to cope with this demand from clients, Bloomberg Tradebook is aiming to turn its 35 high-touch sales traders into execution consultants, through a series of 20 training course modules and by issuing new job descriptions and is planning to offer these courses to its buy side trading partners as well.“These courses are a very Bloomberg concept. We’ve got a very well defined culture of training here. We find that traders value education as a part of the general value proposition we can give them,” says Shapiro. Bill Conlin, chief executive officer at Abel/Noser, says execution consulting is more than simply looking at figures on a screen.“It is very high touch. How can you consult without person to person? There’s so much data and so many ways to analyse it because of the technology which exists.You have to analyse, and then determine which areas can be improved upon. Trends are crucial to that kind of work so quarterly meetings are the only way to really do TCA consulting.” Conlin says the portfolio manager can make the biggest difference between how a trade comes out depending on the time he tells the trading desk. “Sometimes he doesn’t give the desk the whole order—when they could have gotten a better price if they had the full picture. It’s essential for the buy side and sell side to work together. We are doing a lot of

work with algorithms, asking questions like [sic]: are the traders choosing the right ones, are they tweaking as they go and is that tweaking improving the result?” Indeed the need to prove best execution means that with complicated trades where execution price may be questioned, some buy side traders are now turning them over to the sell side rather than risk being in the spotlight should anything go wrong. Steve Wood also points out that the investment horizon and demands of the fund manager figure large in terms of why the buy side uses a sell side sales desk. In turn, they are demanding of the sell side in terms of high-touch service and post-trade reporting. “If you have 15 days and you’re trading a low volume and you are in no real rush, then as a fund manager you would be happy letting your own buy side dealing desk get on with it. If however, the fund manager predicts there is going to be an investment event, they might want to get out the stock or into the stock straight away and finding liquidity and the right venue becomes very important. Why you would use a high-touch desk is really about urgency, coupled with liquidity, coupled with complexity.” Brian Gallagher agrees that high-touch trading comes into its own when the trades get more complex, one example being when the buy side needs to conduct programme trades. “When you are trading a basket, you are worried about the countries you have exposure to, the price to book, whether you are over or underweight. There are a tremendous number of variables and high touch is even more important at this time.” As Jay Bennett, a consultant with Greenwich Associates, pointed out in June:“There is no doubt that institutions remain fully committed to electronic execution as a means of lowering costs, and we expect institutional trading volumes to be flowing back to e-trading systems when volumes pick up. However, the shift back to traditional high-touch trades last year shows just how essential sell side research/advisory services are to the institutional investment process.”I

FTSE GLOBAL MARKETS • OCTOBER 2011

VENTURE CAPITAL

Venture capital’s recovery is under threat but not from whipsawing stock markets or an asset bubble. Its problems are more prosaic. American venture-backed entrepreneurism is threatened by a shortage of capital, political gridlock regarding immigration, and a surfeit of government regulations. This doesn’t mean that unfriendly stock markets and inflated company values aren’t worrisome. They are, but they are transitory. Art Detman reports on venture capital’s longer-term outlook from his vantage point in California, which now accounts for half of all venture capital financing in the United States.

THE LONG-TERM IMPACT OF A CAPITAL SHORTFALL FOR VC

Photograph © Vectomart / Dreamstime.com, supplied September 2011.

OCTOBER 2011 • FTSE GLOBAL MARKETS

IMES ARE AGAIN good in Silicon Valley, the world’s epicentre for technical innovation and heartwarming stories of corporate giants started by teenagers in a two-car garage. In fact, across America venture capitalbacked companies are once more raising big money from private investors and making even bigger plans to raise money from public investors. In the first half of 2011, more than $13.8bn was invested in entrepreneurial start-ups in the US, a 12.2% increase from 2010’s first half. More than 40% of the funding went to firms in Silicon Valley; an additional 10% went to firms in the rest of California, mainly in Los Angeles, Orange and San Diego counties to the south. California’s 50.27% share was followed by New England (13.13%) and the New York metropolitan area (8.95%). For all of 2011, the industry expects the upward trend to continue. Even in these blue skies however, some see storm clouds. For one thing, America’s stock markets were volatile during August. Making an initial public offering (IPO) in such a stormy market is like trying to launch a ship during a hurricane. For another, rumours about the jaw-dropping values of potential IPOs—from companies such as Facebook, Groupon, Twitter and Zynga—raise the spectre of a bubble. Both concerns look exaggerated (see box: IPOs and VCs; a lasting pairing). Mark Heesen, president of the National Venture Capital Association (NVCA), says the bubble issue is a question of perspective. A bubble today simply can’t be as big as a bubble ten years ago because the venture capital industry is much smaller now. VC dollars went from $10.6bn in 1996 to an astounding $99.2bn in 2000, only to fall off a cliff, dropping to $18.9bn in 2003. The financial crisis of 2008-2009 dampened the industry’s recovery, and for all of 2010 total VC dollars were only $23.3bn. “After having invested way too much money in the 1999-2000 period, we are seeing fewer dollars invested in entrepreneurial companies, but that doesn’t mean that there might not be a bubble.”Heesen says. “While we’ve seen a reduction in venture capital dollars, we’re seeing an increase in ‘angel’ investing dollars, and many of those dollars are invested in the information technology and social media areas. If a bubble bursts, it will be more likely that those investors will be hurt more than the venture capital firms because these firms have not invested the kinds of dollars that we have invested in the past.”

Successful start-ups Angels—individual investors who invest directly in a startup rather than through a venture capital fund—traditionally have provided seed capital for new companies. Many founders of Silicon Valley’s successful start-ups are now themselves angels. As little as $100,000 can fund an idea that develops into a company, which will later find funding by VC. Even as the amount of money invested by VC firms rose this year, the number of venture capital firms—those which raise money from limited partners, create individual funds with ten-year life-spans, and determine which start-ups to invest in—declined sharply. Only 37 firms, a 16-year low,

FTSE GLOBAL MARKETS • OCTOBER 2011

Mark Heesen, president of the National Venture Capital Association (NVCA). “While we’ve seen a reduction in venture capital dollars, we’re seeing an increase in angel investing dollars, and many of those dollars are invested in the information technology and social media areas,” he says. Photograph kindly supplied by the National Venture Capital Association, September 2011.

were active in the first half of this year, according to PricewaterhouseCoopers’ MoneyTree Report. “The smaller funds are going out of business,” says Peter Cohan, a consultant based in Marlborough, Massachusetts. “There have been a lot of funds that have invested in companies that didn’t have good exits,”he says, referring to either making IPOs or being acquired by larger companies. “Basically, they disappointed their investors and couldn’t raise new capital.” The turn-of-the-century excesses still haunt the industry. IPOs tumbled into the market. It was a time, jokes Lise Buyer, head of Class V Group, an IPO-consulting firm based in Portola Valley, California, when “two guys with a PowerPoint presentation and a dog could go public”. Inevitably, a good number of those IPOs were dogs, and the returns of the VC industry suffered accordingly. For the ten-year period ended March 31st, 2010, the industry reported a net return of minus 3.7%, compared with modest but still positive returns for the major stock market indices. Whereas investors in funds formed in 1996 averaged a distribution of $4.96 for each dollar of paid-in capital after ten years, investors in 2000 funds saw but 58 cents a decade later. “Clearly, during the bubble years too much capital was invested on the venture capital side, and that had a negative effect on the earnings of venture capital funds,”says George Arnold, managing principal of Knightsbridge Advisers in Cambridge, Massachusetts.“As a result, only the best funds

VENTURE CAPITAL

are able to attract additional venture capital in the current environment.”Arnold holds out hope that the very culling of the VC industry will result in better performance.“Given the reduced capital inflows that we have seen over the past two or three years and the abundant opportunities for disruptive technologies, I would assume that recent and future returns will be stronger than they have been in the past.” The possibility of permanently reduced capital inflows greatly concerns Heesen of the NVCA. He says that for the past three years the industry has been investing more money than it has raised from institutional investors. It has made up the shortfall from previously committed but not invested dollars. An unreceptive IPO market discourages investors, who naturally hope that the companies in which they invest will go public sooner rather than later. In recent years the trend has been for VC-backed start-ups not to go public but instead be acquired by larger companies. “Ten-plus years ago about 60% of our companies got acquired,” says Heesen. “Over the past several years, more than 90% of our companies got acquired. So very few are going public, and that’s a problem.” In addition to the uncertain stock market are regulatory requirements. The Sarbanes-Oxley Act, intended to provide investors with more reliable financial information, has deterred some start-ups from going public because of the cost of compliance. Moreover, a rule of the US Securities and Exchange Commission (SEC) that requires any company with 500 or more shareholders of record and assets of at least $10m to register publicly its shares is another, although perhaps exaggerated, problem. The NVCA favours raising the shareholder threshold to 1,000. “This would not be an endall solution by any means but it will help a handful of companies, such as Facebook,” Heesen says.

Immigration reform A bigger problem is reforming America’s immigration laws. Democrats want to change the law to allow some immigrants who entered the country illegally, such as children of undocumented Latin American immigrants, to become US citizens. Republicans meanwhile want to change the law to encourage aliens who are in the country on student visas to become citizens after graduation from college. “Many of these folks are entrepreneurial and want to start and grow a company here in the US,”says Heesen. He’s right. The fact is that in high-tech, youth rules. Steve Jobs was aged 21 and Steve Wozniak 26 when they founded Apple Inc. For now, however, any substantive changes to America’s immigration laws are unlikely. As for start-ups that seek to put themselves up for sale, there is no shortage of capital on the part of would-be acquirers. American companies have nearly $2trn cash on hand. At June 30th this year General Electric alone had $127.1bn in cash, Microsoft $52.8bn, Google $39.1bn, Pfizer $24bn, Amgen $17.2bn and Boeing $5.7bn. “A lot of the more established companies have not been doing much inhouse research and development work in recent years,”says Heesen. “The way many of them do their R&D now is by

Peter Cohan, a consultant based in Marlborough, Massachusetts. “There have been a lot of funds that have invested in companies that didn’t have good exits,” he says, referring to either making IPOs or being acquired by larger companies. “Basically, they disappointed their investors and couldn’t raise new capital.” Photograph kindly supplied by Peter Cohan, September 2011.

buying venture-backed companies. That has become part of their overall strategy.” What worries people in the VC industry are secular trends affecting the way the industry gathers investments. Most VC capital is provided by college endowments, corporate defined-benefit pension plans, and state and local government pension funds. Even so, long ago, corporate America began converting from defined-benefit plans—whose investments are determined by professional money managers—to defined-contribution schemes, typically 401(k) plans, where individual employees select the investment. Heesen says:“When you look at a 401(k) plan, there’s a box that might say Fidelity Growth Fund or Vanguard World Funds, but there’s no box for venture capital. So as more corporations move from defined-benefit plans to defined-contribution plans, it is harder for venture capital funds to be in this asset class. Now you are starting to hear calls for state and local governments to shift their pension plans from defined-benefit to defined-contribution plans. That could have a profound impact on our ability to raise money here in the United States.” The solution may be to raise more money from foreign investors. “An awful lot of investors from outside the United States want to invest in US venture capital,”Heesen says. He doesn’t like the idea though, instead preferring that

OCTOBER 2011 • FTSE GLOBAL MARKETS

crunch you sell the stocks and bonds which are liquid. That makes your asset allocation even worse. After all of that, investors began to say that 40% in alternatives was not a good idea because when things go bad they can’t sell investments in that category. So they reconsider their asset allocation and favour things that are more liquid.” Another factor that Subhedar believes is adversely impacting venture capital flows is the very success of the industry itself in financing technological progress. For decades after the founding of modern venture capitalism in the 1960s, the focus was on funding the development of core technologies. “Thirty or 40 years ago, when you started a business you first had to do R&D, then you had to do manufacturing, then sales; and you had to do it all yourself. So you would focus first on selling only in the US, and manufacturing here. Then three to five years later you would go to Europe. Seven years or so later you would go to Asia. That is how innovation was delivered globally.”

Global marketplace

George Arnold, managing principal of Knightsbridge Advisers in Cambridge, Massachusetts. “Given the reduced capital inflows that we have seen over the past two or three years and the abundant opportunities for disruptive technologies, I would assume that recent and future returns will be stronger than they have been in the past,” he says. Photograph kindly supplied by Knightsbridge Advisers, September 2011.

American venture capital firms earn money for American investors, such as college endowments and employee pension funds.

Success feeds problems The success of VC funds for so many of the past 50 years has contributed to the industry’s current problems. “Pension funds and endowments were over-allocated to the venture capital category,”explains Sanjay Subhedar, founding partner of Storm Ventures in Menlo Park, California.“Up until 1997, if you committed $1 to a venture fund, it would get called up over five years. So you didn’t have to come up with the dollar on day one. Typically what would happen is that only 50 cents of that dollar would get used because companies would go public and you’d get distributions.” Many institutional investors became accustomed to having only a portion of their commitment actually invested, and so they overallocated in order to compensate. This changed during the financial crisis of 2008-2009. Subhedar says: “Let’s say you had $100bn in assets, 60% allocated to stocks and bonds and 40% to alternative investments, and stocks and bonds went down in value. Now the portion of your portfolio that you thought was 40% becomes more like 60%. This is invested in alternatives, but you can’t sell alternatives; they’re illiquid investments. So, in a liquidity

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Today, start-ups outsource the manufacturing of even highlyadvanced products to low-cost factories in China and elsewhere—and instead of hiring an army of sales representatives to pound on the doors of prospects, they use the internet and social media to reach customers. “The whole cost of building an enterprise has gone down by at least an order of magnitude if not two orders of magnitude from what it was 30 or 40 years ago.You no longer need $100m or $200m to get innovation off the ground, begin manufacturing in volume, and launch your product into the global marketplace. Now you can do that with much less money because of all the technology that we have created earlier.” Ironically, then, the very success of the VC industry has enabled it to meet the needs of start-ups by raising fewer dollars. What’s more, even though the technology that VC firms have funded allows venture-backed companies to operate on a national and even global scale, the venture capital industry itself has become smaller and more geographically concentrated. “We are seeing a decrease in the number of venture capital firms and we believe that contraction will continue. We’re also seeing, unfortunately, that a higher percentage of firms from outside of Silicon Valley are closing down as compared with those domiciled in Silicon Valley,” says the NVCA’s Heesen. To be sure, both New England and metropolitan New York have grown in terms of venture capital investing, the former fuelled by biotech and the latter by expertise in fashion, publishing, entertainment and advertising. However, Texas, which peaked at 7.4% of the VC market in 2001, has shrunk to 3.7% despite the efforts of the taxpayerfunded Texas Emerging Technology Fund. Meanwhile, the share of VC dollars going to Silicon Valley has risen from 31% in 1996 to more than 40% in the first half of 2011. “The centre of gravity for innovation and venture-backed firms is still Silicon Valley,”says Subhedar of Storm Ventures. “This doesn’t mean that you’re not going to have a shooting star every once in a while in other geographies.

VENTURE CAPITAL

My question is: can you have sustained fireworks instead of only a comet that comes around every few years?” To illustrate, Subhedar cites the few successful technology stories that have come from outside America—the BlackBerry from Canada, Nokia from Finland, and Skype, founded by a Swede and a Dane. Only Skype, now owned by Microsoft, remains a major player. “I feel that there is so much diversity of skills and knowledge and information,

and so much depth, in Silicon Valley that it’s going to be a long while before Ireland or London, Shanghai or Beijing or Mumbai, will have sustained multiple hits,” says Subhedar, himself a native of Mumbai. Almost certainly he’s right. For many years to come, America will be at the forefront of venture-backed innovation, and at the very centre of that innovation will be California’s Silicon Valley.I

IPOS & VC: THE ACID TEST OF A BUBBLE ET’S START WITH the idea that IPOs need near-perfect market conditions to succeed. Not so, says Lise Buyer, head of Class V Group, an IPO-consulting firm based in Portola Valley, California. “The only time that companies can’t go public is when investors are pulling their money out of the market day after day, out of both mutual funds and individual stocks,” she insists. “A new issue will have a very hard time coming to market when investors are fleeing from stocks altogether. That doesn’t happen often. It did happen in late 2008 and 2009. It also happened during the Great Depression. One could argue that both instances are outlier periods.” Buyer says that institutional investors are always looking for new companies with compelling growth stories. She believes that even in choppy markets a sound company can still go public by trimming its offering price and scaling back on the number of shares offered. As an example, she cites Carbonite (CARB), a Boston-based provider of online data backup services that went public amid fierce market swings in early August. Its offering price was $10, down sharply from the $15-$17 range the company had indicated in its earlier filings. Investors liked the price and CARB shares were up 23.5% at the end of the day and roughly 50% a few weeks later. In contrast, consider the experience of Pandora Media (P), an internet radio service based in Oakland, California. Early in the year, as markets were rising, it announced intentions to go public at $7-$9, later boosted to $10-

Google executive chairman Eric Schmidt gestures as he delivers a speech at the Regional Entrepreneurship Summit in Nusa Dua, Bali, Indonesia, on Friday, July 22nd 2011. Photograph by Dita Alangkara for Associated Press, supplied September 2011. $12. The actual price was $16 when Pandora went public on June 15th, but soon the stock slid 25% to less than $12 and as August ended it was trading at $13.20. Clearly Pandora had caught a euphoric moment in the market, but Buyer warns against placing too much emphasis on timing. She says: “The biggest misconception is that there is a market window that opens and closes. There are periods when it is easier to go public, and periods when it is more challenging.” As for a bubble in pricing, that may apply to individual companies rather than the entire slate of new offerings. Two recent high-profile offerings weathered well the storms of summer. In May LinkedIn (LNKD), an online professional networking site based in Mountain View, California, offered

shares for $45 each; three months later the stock was at $85, giving the company a market capitalisation of $8.1bn. Zillow (Z), a Seattle company that operates an online real estate site, went public at $20 on July 25; a month later its shares were trading at $35, and its market cap was around $1bn. The real test of the bubble scenario may come after the IPOs of Facebook and Groupon. The value of the former, the world’s largest website, has been placed at as much as $100bn. In comparison, Google, the world’s largest search engine, is worth about $175bn, and Amazon.com (AMZN), the largest online retailer, is worth about $98bn. As for Groupon, which sells discount coupons over the internet, it has raised $950m in venture capital and reportedly turned down a $5.3bn bid from Google.

OCTOBER 2011 • FTSE GLOBAL MARKETS

ASSET ALLOCATION ROUNDTABLE

BROADENING HORIZONS IN THE QUEST FOR RETURNS

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

Participants

Supported by:

ROBERT BROWN, chairman of Towers Watson’s Global Investment Committee MARCUS GRUBB, managing director of investments, World Gold Council FREDERIC NERBRAND, global head of asset allocation, HSBC Bank NEILL NUTTALL, managing director, chief investment officer and head of the Global Multi-Asset Group (GMAG), JP Morgan COLIN O’SHEA, head of commodities, Hermes PHIL TINDALL, senior investment consultant, Towers Watson

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ROUNDTABLE

Current approaches to asset allocation FTSE GLOBAL MARKETS: In the aftermath of the financial crisis, what are the main considerations governing asset allocation strategies in your firm? ROBERT BROWN, CHAIRMAN OF TOWERS WATSON’S GLOBAL INVESTMENT COMMITTEE: We have not changed our fundamental economic view for the long term, and continue to believe we are in a period of slow developed-world growth, robust emerging-world growth and sharp spikes in risk aversion. Growth risks have increased in the past month, which increases the reliance of investment returns on uncertain policy outcomes. In this environment we continue to emphasise that all investors must ensure portfolios are well diversified and stress-tested against a broad range of economic scenarios. In general, we support rebalancing of portfolios to strategic benchmarks, although this will be less attractive if the long-term trend in asset allocation is away from equities. For investors with a medium-term approach to asset allocation, recent moves have exposed some opportunities at the margin. While we emphasise the downside risks to growth, and expect market volatility to remain elevated, we view equity markets as moderately attractive on a three-year view. The sharp falls witnessed in recent weeks appear to have outpaced the deterioration of economic fundamentals. We believe government bonds are moderately unattractive relative to cash on a short-term view. With a longer-term horizon, current depressed levels of yields are consistent with economic fundamentals. However, in the near-term, yields provide very limited upside, and non-trivial potential downside (if risk aversion fades for whatever reason). For short-term investors this return distribution is unattractive. FTSE GLOBAL MARKETS: What needs to happen for equities to reacquire their traditional appeal? NEILL NUTTALL, MANAGING DIRECTOR, CHIEF INVESTMENT OFFICER AND HEAD OF THE GLOBAL MULTI-ASSET GROUP (GMAG), JP MORGAN: The recent breakdown in equity markets leads us to question whether sufficient value has returned to justify a long-term commitment to the asset class. The case in favour lies in the rise in dividend yields across several markets; with the Eurostoxx index now offering a yield of 5.8% and the FTSE 100 3.8%. Using a simple metric originally employed by Arnott & Bernstein (A&B), a reasonable back-of-theenvelope estimate for forward-looking ten-year real returns is provided by the sum of the current dividend yield and the average per capita real GDP growth over the past ten years, less a “dilution” factor. Essentially this equates to the yield plus a proxy for real dividend growth, which A&B found to be relevant. While such an approach is highly imperfect, it suggests that the most attractive region is Europe, with an A&B prospective real return of about 5¾% per annum, followed by the UK at just over 4½% pa and the US at just under 3% pa. Although equities look appealing versus bonds,

for which current real yields suggest poor real returns over the next decade, they are not yet sufficiently compelling given the macro and policy uncertainties. We should remember that equities are an essential component of the capital structure. As an asset class, equities may be experiencing a secular bear market, but this has happened before in the last 100 years or so: between 1907–1921, 1929–1942, and 1966–1982. The average of these bear phases is approximately 14 years, and assuming that the current bear market commenced in 2000 (or even with the 1997/8 Asian/LatAm/Russian/LTCM crisis), then the bear is closer to its end than its beginning. Equities will reacquire their traditional appeal, typically after the majority of investors have capitulated, at which point they will re-emerge as the highest returning of the major asset classes. FREDERIC NERBRAND, GLOBAL HEAD OF ASSET ALLOCATION, HSBC BANK: In my view, structural equity markets are based on five main pillars: the first of which is low valuations. As a comparison, US equities are currently trading at 20.2x cyclically-adjusted price earnings (CAPE) according to Shiller data. Since 1881 the average CAPE for US equities has been 16.4. Actually, we have only seen CAPE higher than current levels 22% of the time since 1881. Second, we need high real interest rates. Virtually independent of whichever measure of real interest one looks at, rates are low. The flip side of the “Asian savings glut” is an outsized demand for western assets and bonds in particular. Coupled with a very challenging growth outlook, real rates are likely to stay low for some time. However, only once they have moved north should risk assets—such as equities—find more support from falling discount rates. The next pillar is low leverage. The global economy is still highly leveraged despite some recent consumer deleveraging. Only once balance sheets have hit a more solid footing can a sustainable growth in leverage take hold. Let us just hope that policy makers have realised that more debt added to an existing debt problem is not a solution. Four, a strong demographic outlook is also helpful. A protracted period of limited birth rates and ageing population has made much of the

Frederic Nerbrand, global head of asset allocation, HSBC Bank. Photograph kindly supplied by HSBC Bank, September 2011.

OCTOBER 2011 • FTSE GLOBAL MARKETS

Marcus Grubb, managing director of investments, World Gold Council. Photograph kindly supplied by the World Gold Council, September 2011.

West appear more and more like Japan. For example, Western Europe currently has 3.8 potential workers per pensioner. This ratio will drop to 1.9 by 2040 according to US Census Bureau estimates. By comparison, Japan’s labour-topensioner ratio is currently 1.8, down from a peak of 5.1 in 1990. Finally, we need to see the potential for deregulation. Given that policy makers are fretting about how to regulate our way out of a recession, this route for productivity gains appears shut. We live in a world of born-again regulators. In summary, the pillars are not in place for a structural equity market. That said there will be plenty of trading opportunities going forward as markets deal with the prospect of more persistent permafrost than first envisioned. FTSE GLOBAL MARKETS: As investors increasingly look towards emerging markets and ever more “alternative” asset classes, is there a limit to what can justifiably be called an investible asset class? MARCUS GRUBB, MANAGING DIRECTOR OF INVESTMENTS, WORLD GOLD COUNCIL: By grouping a very disparate range of assets together under the “alternatives” label we often risk masking the very different risk and return profiles they each represent and the different investment objectives they may fulfill. From an allocation perspective, and beyond any regulatory constraints, an asset or asset class under consideration should be examined in terms of its key drivers and its impact on the broader portfolio over time. However, in light of what we have hopefully learnt from the recent past, allocators are also increasingly sensitive to the liquidity, transparency and stability characteristics of assets being considered for inclusion in a portfolio. Investor concern regarding the counterparty risk inherent in many derivative products has also never been higher. Many so-called “alternatives” have been found to be lacking in one or more of these properties, leading them to be judged as overly risky in that regard and therefore less “investable”. The reason we have such confidence in our arguments that gold should be seen as a basic portfolio building block—what we term a “foundation asset”—is that it can be proven to have beneficial attributes in addressing most of the risks that cause investors to hesitate when considering “alternatives”. FTSE GLOBAL MARKETS: What comes first, asset allocation or fund selection? NEILL NUTTALL: In general, as we were reminded in the 2002 report by Lord Myners, market beta, and therefore

FTSE GLOBAL MARKETS • OCTOBER 2011

strategic asset allocation, typically drives 90% of performance returns. As such, it should be the first consideration in portfolio construction. We would caveat this with the fact that it is important to ensure a full review of your opportunity set, to ensure that you have a way to invest in each of the asset classes represented in your strategic allocation; otherwise, fund selection could be problematic and implicitly determine the asset allocation. We believe that allocating to an asset class that provides diversification and helps the portfolio to meet risk and reward objectives is essential, even if this must be done by investing through a sub-optimal manager—while alpha may detract from performance, beta could be beneficial. In addition, it is important to remember that in seeking to introduce diversification at every level of the portfolio construction process, fund selection (manager research, style and process) is an important component of any portfolio. MARCUS GRUBB: Many asset managers are aware of the robust body of evidence, for example, from Brinson’s landmark studies and Ibbotson’s more recent work, that asset allocation is by far the major determinant of portfolio returns over the longer term. However, the degree to which this evidence has been translated into practice is far less clear. There is, perhaps, a simple behavioural aspect to this—an understandable reluctance to put statistics above direct relationships. However, the existing research appears fairly conclusive; asset allocation strategy is the fundamental driver of returns over time. One of the key issues here may be that there are relatively few asset classes or funds or, indeed, fund managers, that can be relied upon to deliver counter-cyclical performance to the benefit of the broader portfolio. There are many assets and funds—whether mainstream or exotic—that can be pursued for specific periods for their return potential. There are, however, relatively few that exhibit sufficient counter-cyclical characteristics that they can reliably function as longer-term portfolio insurance assets, offering balance and protection during market stress and asset convergence. These are the assets, such as gold, generally independent of the tendencies of the wider market, which we believe are most valuable in offering stability to asset allocation strategies, and such strategies will then underpin the fund selection process. FTSE GLOBAL MARKETS: Does the trend towards greater diversity require improved governance? PHIL TINDALL, SENIOR INVESTMENT CONSULTANT, TOWERS WATSON: Investors should not ignore the potential high costs and governance associated with active management and illiquid, less price-transparent asset classes. In fact, they should be self-critical when considering their governance competencies before committing heavily to diversity strategies. However, the trend towards greater diversity should not preclude lower governance funds from either outsourcing to specialists, using diversified pooled funds or using better, cheaper beta. Not long ago, portfolio returns were broken down into either beta or alpha. Beta was associated with market returns on basic asset classes such as equities and bonds. Alpha was

ROUNDTABLE

anything that could not be explained by these index returns, and represented “skill”, which was (and still is) expensive. Over the last few years, academia has turned the spotlight on hedge fund returns, once regarded as the ultimate in “pure alpha”. Research suggests that a decent proportion of hedge fund returns can be reproduced with relatively straightforward trading strategies, many of which have been captured in a new wave of indices, such as reinsurance, currency carry and volatility indices. These funds are more liquid and much less expensive than traditional hedge funds making diversity potentially cheaper and more readily accessible for lower governance funds. If properly constructed, these new betas should have a strong diversifying effect on a fund’s portfolio, but critically at the right price. The risks of an equity-focused strategy are high, especially given the economic uncertainty we face going forward. While the theory of diversification has been put to the test over the last couple of years, we believe it is more important than ever, particularly over the medium to longer term. New beta opportunities can help institutional funds to build a more diversified portfolio to improve investment efficiency, but investors need to assess how much governance they have and are prepared to commit as well as the costs involved if they are to make the effort worthwhile. FTSE GLOBAL MARKETS: If your firm runs a TAA strategy inhouse: what are the critical components of a good asset allocation model? FREDERIC NERBRAND: Our dynamic asset allocation process is based on three main drivers: economic momentum, relative valuations and financial conditions. We have constructed a series of proprietary global leading economic indicators, which aim to forecast the industrial, consumer and trade cycle. In our view, most indicators are still focused on geographies. This makes limited sense as the global cycle is increasingly more integrated. There is no holy grail with regards to relative valuations but we tend to focus on implied discount rates for our cross-asset views. Finally, we run a number of financial conditions indicators such as the HSBC Clog index. In addition, we run aggregate real bank lending data in order to assess inflationary/deflationary pressures coming from money supply. NEILL NUTTALL: Diversification across asset classes, models and factors is key in the construction of a robust tactical asset allocation (TAA) model. Historically, TAA models have focused on the directional decisions, namely stock versus bond, and bond duration. In addition, the information captured has typically centred on valuation which, although an important component of any TAA model, is heavily influenced by time horizon and operates better over an intermediate period. Furthermore, the asset classes addressed have typically been the major, developed, equity and bond markets (as this is where there is the best historical data). While valuation should be taken into account, other factors such as momentum and the business cycle are also important. Momentum/technical factors tend to work better over a shorter-term horizon (say, less than 12 months). The

Robert Brown, chairman of Towers Watson’s global investment committee. Photograph kindly supplied by Towers Watson, September 2011.

opportunity set should be widened to address as many asset classes and sectors as possible. In addition, increasing weight should be given to relative value decisions within asset classes, to avoid the limited concentration of decisions across asset classes. Risk is another important consideration: to be aware of position sizing and the calibration of the risk contribution from each position is essential to long-term success. In our view, when people have experienced disappointing performance in TAA programmes the processes have been too narrowly focused.

Allocations to commodities FTSE GLOBAL MARKETS: What roles can gold play in your portfolio? FREDERIC NERBRAND: The traditionalist view of gold is for one of value storage and as a hedge to tail risks. Gold should do well in both an inflationary period, or indeed in a world of deflation and increased default risks. Similarly, the opportunity cost for holding gold is minimal given the prevailing, low, real interest rates. While all of these issues are likely to persist, our main reason for holding gold is as a diversifier. In an investment world which is dominated by “risk-on” and “risk-off”, any asset that offers uncorrelated returns should remain well bid. Almost independently of the period used for estimating the cross-asset correlation, matrix gold offers just that. For example, if we apply a two-criteria acid test for how much gold to have in a 50/50 equity bond portfolio: one, by adding gold we reduce volatility; two, by adding gold we do not want to add tracking error of say more than 1%. A balanced portfolio should then have roughly 5% in gold. If we compare this with the weight that invested gold has in comparison to global bonds and equities, the current weight in gold is only 0.21%. Hence, there is ample scope for a reweighting in global asset markets. MARCUS GRUBB: Gold has been the star performing asset over the last decade and gold market fundamentals and the macro environment are both highly conducive to a continued bullish outlook. However, this should not blind investors to its primary appeal as a strategically significant asset; that is, its long-term diversification benefits and its hedging abilities in various circumstances and conditions. To put it more simply, gold functions as portfolio insurance and is typically at its most valuable when most needed. These benefits can be proven statistically and historically, and are very much in evidence now.

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FTSE GLOBAL MARKETS: How effective is gold as a longterm inflation hedge? NEILL NUTTALL: We note that gold has been a store of value for over 2,500 years. There are short periods when this has not been the case (such as 1982-2002), but we lean very much in favour of the evidence of the longer-term history. Gold tends to have low correlation to many other asset classes and even other commodities, and is typically considered a hedge against inflation. In contrast to other commodities, gold does not perish, tarnish or corrode, which makes it attractive as a long-term store of value. It is also considered to be a currency hedge, particularly against the US dollar, to which is it negatively correlated. Investor activity in the gold market, as reported by the World Gold Council, continued to be robust in the second quarter of this year, with strong flows into exchange-traded funds and also purchases of gold bars and coins, particularly in Asia and Europe. Interestingly, demand in India as a result of rising inflation and an increase in personal wealth has led to a surge in the launch of goldbacked savings and investment vehicles. Gold is considered a safe haven as an asset that maintains an intrinsic value, particularly in an environment with falling risk appetite and a lack of conviction in the economy and banking system. Cynics point out that there is no central bank for gold, which can act to debase its currency. Historically, gold has posted strong real returns during periods of high inflation, and lesser returns during periods of low and moderate inflation. Over a long-term investment horizon, gold has clear diversification benefits. Over the shorter term, investment in gold can help against interim increases in inflation but does not tend to perform as strongly as other assets. As gold is not an income producing asset unless it is leased out, it becomes more a store of wealth in a zero interest rate environment. There is an old anecdote that a sovereign coin (just under a quarter of an ounce) has always been worth enough to pay for a meal for two at the Savoy. Using pricing as at today, this seems a reasonable indicator of the price of gold—and if gold keeps rallying, the quality of the bottle of wine accompanying the meal can be improved! FTSE GLOBAL MARKETS: Commodities are also often seen as an inflation hedge. Does this tend to overshadow the other benefits of commodities? COLIN O’SHEA, HEAD OF COMMODITIES, HERMES: Many of the developed market central banks raison d’être is low inflation. However, in light of the global recession the central banks’ policy bias is now towards more inflation to create

FTSE GLOBAL MARKETS • OCTOBER 2011

Asset class risk, return & premia vs. 10 year government Total returns

Premia

Risk

25% 20%

20% Return/Risk

Phil Tindall, senior investment consultant, Towers Watson. Photograph kindly supplied by Towers Watson, September 2011.

nominal GDP growth and employment. Similarly, developed governments now saddled with substantial debt as a result of credit crisis bailouts prefer inflation and nominal growth over deflation and stagnate growth. It is not surprising then that inflation has edged higher and pension funds are increasingly wary of inflation effects on future pensions. Just as compound interest is the eighth wonder of the world and crucial for wealth creation, inflation has the opposite compound effect and can lead to wealth destruction. While many defined benefit pensions include a promise to index benefits within their liability portfolio, it is difficult to include inflation explicitly within the strategic asset allocation of pensions’ investment portfolio. Thus inflation’s potential impact can be under-estimated for many pensions. Commodity futures are a good inflation hedge for two reasons. Commodity spot prices capture unexpected jumps in inflation, in particular jumps driven by input cost (i.e. energy and food). The cash collateral of commodity futures captures the short-term trend inflation through the return on cash and its exposure to short-term interest rates. On the other hand, gold has appreciated considerably over the last five years, not due to inflation over that time but rather due to gold’s safe haven identity amidst systemic risks. While institutional investors cite diversification and inflation hedging as the most important reasons to invest in commodities, commodity returns, especially in comparison to equity returns, have been overlooked.

15%

15% 10% 5%

10.1%

9.7% 7.8% 4.9% 2.1%

1.7% 0.0%

0% Commodities

Equities

Liabilities (10yr gov’t)

The chart above highlights that over the past 40 years commodity futures have yield returns similar to equities and in this case slightly exceeded commodities. This trend is similar over shorter time periods such as five and ten years. Commodities while acting as a suitable and robust inflation hedge can also over the long-term add returns to a diverse investment portfolio. Source: Hermes, Barclays Capital, MSCI, and Hermes, supplied September 2011.

MARCUS GRUBB: Many investors are undoubtedly drawn to commodities because they are perceived, on aggregate, they provide inflation-hedging potential. Alternatively, however, some investors see commodity exposure as a means of access to emerging market growth and may therefore be drawn more to the corresponding potential returns. In the case of gold, viewing it primarily as part of the commodities complex means investors are likely to be adopting a somewhat one-dimensional view and are therefore potentially blinkered to its wider attributes, beyond its inflation protection benefits. Earlier in the year we

ROUNDTABLE

undertook some research, published as Gold: a commodity like no other, which showed that gold, which is typically less volatile than most commodities, and less correlated to equity markets during recessions, offers portfolio diversification and risk reduction benefits that cannot be duplicated through investment in commodity baskets. However, that is not to say we underestimate gold’s appeal as an inflation hedge. We recently commissioned independent research from the highly respected consultants at Oxford Economics modelling the impact of various inflationary scenarios on portfolios and gold’s optimal allocation within them. In the context of higher inflation outlooks, gold’s allocations were seen to increase, reinforcing the substantial body of evidence supporting gold’s reputation as a reliable and enduring store of value. FTSE GLOBAL MARKETS: When investing in commodities how should investors choose between direct physical investment, a portfolio of commodity-related stocks or commodity futures? Does this vary between different types of commodities? NEILL NUTTALL: The first consideration around investment in commodities within a portfolio would be the investment instruments permitted within client guidelines. Direct physical investment provides the purest exposure to commodities in that the performance is not impacted by investor behaviour. However, physical commodities have the obvious disadvantage of the need for storage, which can be difficult as conditions need to be appropriate to avoid devaluation of the commodity. In addition, the potential environmental impact of storage must be considered, together with the cost of insuring these tangible assets. Investment through derivatives provides an easier way of accessing the commodity market, although by nature of the market, price fluctuations through investors buying and selling the instrument and levels of liquidity will impact performance (through the backwardation or contango in the futures market), rather than this purely reflecting the supply and demand of the underlying commodity. Investment through ETFs can provide broad index exposure and simplify transactions, although it is important for investors to understand the differences in exposure within these products. For example, the Goldman Sachs Commodity Index has a heavy bias towards energy, while exposure in the UBS Dow Jones index is more diversified across broad sectors. While performance of commodity stocks can often move in line with the underlying commodity price, fundamentally these are equities and therefore are subject to added risk/return from general operations, labour costs, political risk within many regions in which they operate (for example, Africa and Asia) and regulatory changes (for example, within mining, or oil exploration). Such stocks are likely to move downwards in a broad market sell-off and may therefore be less diversifying than other means of investing in commodities. MARCUS GRUBB: While we can only comment on gold with any authority, I think there is an increased motivation among investors to seek investment vehicles backed by physical holdings of real assets. This is, essentially, driven by

Neill Nuttall, managing director, chief investment officer and head of Global Multi-Asset Group (GMAG), JP Morgan. Photograph kindly supplied by JP Morgan, September 2011.

a need for stability and security in uncertain times and a corresponding demand for greater transparency and reduced counterparty risk. For example, in the gold ETF market, we have seen investors clearly prefer physically-backed products that allow no derivative component, as distinct from synthetic-based ETFs, because they are seeking to minimize counterparty risk. Many of the investment vehicles you mention will have risk-return profiles that diverge considerably from the value of associated physical assets. Investment in commodityrelated equities and sector funds, for example, will undoubtedly increase exposure to idiosyncratic company risk (although this may also offer more upside potential) and the traditional route to commodity investment for many institutional investors, through a basket of collateralised futures, involves a completely different set of risks, including the ability of counterparties to successfully implement strategies to counter issues such as negative roll yield. COLIN O’SHEA: Today, commodity investors have many more ways to invest in commodities than even two or three years ago. The plethora of exchange-traded products has opened the door to exposure in exotic, rare earth metals such as rhodium to vanilla exposure in gold. As investors address the question why invest in commodities (see diagram in the next page), the answer will lead them to the next question: how to invest in commodities? Physical commodity exposure is more akin to private equity with long lock-ups and a high dependence on local knowhow. For example, purchasing farm land in Brazil might highlight bottlenecks in bringing the crop to market, the country’s shipping infrastructure down to the microeconomics of local labour productivity and relevant labour laws. Equity commodities typically exhibit a higher relationship with equity markets than with underlying commodity prices. For example, a basket of the top diversified oil majors has a beta of 0.7 or higher with MSCI All World but less than 0.3 to the price of crude oil. In other words the global equity market explains a substantially higher proportion of the oil majors returns than the price of crude oil. Equity valuation includes a large proportion of expectations over the long run. On the other hand, commodity futures represent the current clearing price for the supply and demand of the commodity in question. A basket of commodity futures provides the portfolio diversification investors seek. Per Barclays Capital annual

OCTOBER 2011 • FTSE GLOBAL MARKETS

investor survey the most compelling reason for commodity exposure among institutional investors is diversification; over 40% cite diversification more than any other reason to invest in commodities. Historically, the basket of commodity futures across various sectors (such as industrial metals, energy and agriculture) has exhibited low correlation with equities and bonds. FTSE GLOBAL MARKETS: Scarce resource management is focusing investors on strategic commodities. How much does the growing scarcity of resource figure in your approach to investing in commodities? FREDERIC NERBRAND: As the world looks set to remain in a subdued growth environment for the foreseeable future we believe investors will focus on two things. Productivity gains (wherever they can be found) and resource constraints. On our estimates, iron ore, copper, coal and platinum demand are all likely to outpace supply in coming years. Hence, we believe these should have a relatively large weighting in an asset allocation. In our portfolio our strategic weight to industrial, energy and agricultural commodities is 15% (on top of the 10% in gold). However, due to the deteriorating economic outlook we prefer to underweight commodities at the moment to 9% while keeping gold at 10%. FTSE GLOBAL MARKETS: How can you capitalise on the growth outlook for commodities? COLIN O’SHEA: Some academics have thrown into the question the relationship between strong GDP growth and equity valuations. Through further share issuance and or technological innovation, macro-economic growth may translate into higher overall wealth but not necessarily higher equity earnings per share. Commodity futures represent the current clearing price or supply and demand of a particular market whereas commodity equities represent anything from the present value of discounted expected earnings over many years to the capital structure of that particular company. For these reasons, commodity futures rather than commodity equities exhibit a stronger relationship to the commodity supply and demand in major emerging market economies. For example, China continues to invest in its infrastructure requiring significant amounts of copper, so much that China is the largest consumer of global copper, representing over 45% of global copper consumption. Similarly, densely-populated emerging economies such as India and China are experiencing three development trends which all lead to higher agricultural imports: one, less rural and higher urban population leading to less and a more expensive rural labour force; two, urban sprawl and higher car usage reducing arable land; three, a higher protein diet of beef and pork further up the food chain thereby requiring more grains for feedstock and leading to higher consumption per capita. Finally incremental increases in energy demand continue unabated in non-Organisation for Economic Co-operation

FTSE GLOBAL MARKETS • OCTOBER 2011

and Development (OECD) countries, in particular emerging Asia. Today the global economy is utilising more barrels of crude oil than ever before, over 89m barrels a day. Of this demand, the non-OECD represent 48%. While the OECD countries demand has declined by 2m barrels a day over the last two years the non-OECD demand has more than compensated for this drop in demand. Emerging market equities GDP growth rates may not be as important to company’s earnings per share and therefore equity investors. However higher growth rates translate directly into higher demand for commodities and therefore higher clearing prices and higher returns for commodity investors. Why invest in commodities? Why Commodities? ® Diversification ® Inflation protection ® Event risk insurance ® Positive risk premium What? Index or Active ® Benchmark (DJ-UBS, GSCI, RICI) ® Collateral (Cash, Credit, TIPs) ®

Who? Fiduciary (Fund, Pension) ® Investment Bank ® Hedge fund ® In house

How? Swaps ® Futures ® Exchange-traded fund ® Equities ® Physical ®

Source: Hermes, September 2011.

Risk and returns FTSE GLOBAL MARKETS: How must portfolios be constructed to prepare for extreme or “Black Swan” events. MARCUS GRUBB: We examined this very question in a recent report entitled Gold: hedging against tail risk, looking specifically at the impact that an allocation to gold would have on a portfolios in the event of a tail risk—i.e. market behaviour outside normal statistical probability. Through analysing different portfolio compositions and variants around a benchmark portfolio, we assessed the long-term risk profile of these combined assets in previous periods of extreme market stress, both when gold was included and when it was absent. The research found that for three quarters (18 out of 24) of the tail risk scenarios analysed (from a period between 1987 and 2010), portfolios which included gold consistently outperformed those which did not. Thus, small allocations to gold (ranging, for example, from 2% to 10%) can increase risk-adjusted returns and help reduce the weekly 1% and 2.5% VaR of a portfolio by up to 18.5%. In summary, we found a modest strategic holding of gold consistently reduces the probability of significant portfolio losses during extreme market events and, moreover, the downside protection on offer does not hinder

ROUNDTABLE

potential upside. This research supports our other analyses of optimal portfolio composition that have repeatedly shown that in multiple market conditions an allocation to gold can reduce the volatility of a diversified investment portfolio without sacrificing expected returns. FTSE GLOBAL MARKETS: When selecting funds and managers, what are some of the red flags and irregularities to note? NEILL NUTTALL: The key factors that we consider in selecting managers in our fund of fund portfolios are riskadjusted performance and consistency of alpha generation, people and process. Some investors tend to focus heavily on performance, but, of course, past performance is no guarantee of future results. An understanding of process can often be more helpful in portfolio construction, enabling diversification across investment processes, which can lead to a portfolio that is more resilient to shorter-term cycles and performance shocks. In terms of underperformance of managers, this would not automatically be a red flag, but underperformance in a period in which the process should be outperforming (for example, a value-biased manager in a period in which value is performing strongly) and in which the manager expects to be outperforming is cause for concern and alarm. This would be one indication of a major red flag, namely style drift. If the investment process is more qualitatively driven, any disruption in the portfolio management team can be a challenge. If the process takes more of a quantitative approach, the reliance on a single portfolio manager may be less evident and therefore less significant when there are portfolio management changes. FTSE GLOBAL MARKETS: How do TAAs work in practice? NEILL NUTTALL: A well-formulated tactical asset allocation strategy provides a framework for incorporating consistent market views aimed at generating a high quality alpha stream. They do so by systematically shifting asset weights relative to a benchmark to take advantage of market inefficiencies and opportunities. As such, a broad opportunity set is desirable. At the same time, an effective TAA framework has the capability to manage the incremental risk (tracking error) associated with movements away from a strategic benchmark. The means of implementation of shorter-term views is likely be dictated by the specifics of individual client guidelines. The most efficient way of implementing tactical decisions is through the use of derivatives. This is the quickest, most capital efficient and most precise method of implementation. Where investment guidelines prevent the use of such instruments, it is still possible to implement through physical holdings, although this comes with some limitations. While the benefits of TAA are perhaps greatest in low-return/high-risk markets, those strategies capable of targeting tracking error while maximizing excess returns are well positioned to be customised to meet specific risk/return objectives across a range of investments and market environments.

FTSE GLOBAL MARKETS: How can investing in non-correlated assets such as gold or real estate help hedge against a fall in an overall investment portfolio? MARCUS GRUBB: The concept of a portfolio diversification relies upon the notion of non-correlated assets and is the cornerstone of modern portfolio theory. Yet, even though the theory is half a century old and familiar to most investment professionals, implementing it in practice still seems problematic for many. So much so, in fact, that we frequently hear fund managers suggesting that, in view of globalisation and the experience of the financial crisis, the concept of diversification is primarily of academic interest rather than practical value. We suggest this argument is based on a somewhat superficial view of diversification, often due to the fact that the co-variance properties of many assets are not fully understood, possibly because their values are often studied in isolation or without sufficient examination of the underlying market fundamentals. For example, to date, professional investment in so-called “alternatives” has largely consisted of hedge funds, private equity and real estate, all of which proved to be highly correlated in the financial crisis because of the close relationship of their drivers to macroeconomic factors.Your question describes real estate as an uncorrelated asset but it was dragged down with most other assets during the crisis, and, significantly, has continued to be vulnerable to prevailing market conditions and recessionary pressures. Gold’s lack of correlation, by contrast, is underpinned by its very diverse set of drivers and can be proven to hold across markets, geographies and time.

The investment outlook FTSE GLOBAL MARKETS: What are the next frontier markets for investors? NEILL NUTTALL: We believe that frontier markets are the next wave of emerging market investing, and that the last frontier region is Africa, and more specifically, sub-Saharan Africa. Africa is clearly very diverse and individual countries are at different stages of development within their capital markets. One of the greatest challenges for the sub-Saharan region is the development of infrastructure, which is being aided by overseas investment. China, for example, has become a leading sponsor of infrastructure projects in Africa, including hydropower and railroad projects in sub-Saharan Africa. As these sub-Saharan markets (for example, Nigeria and Kenya) develop, they should offer higher returns to investors, but this will not come without elevated levels of risk. When investing into inefficient markets, it is crucial to opt for an active portfolio manager with deep knowledge of countries and industries and a comprehensive understanding of the specific risks associated with each frontier market. Africa’s status as the last remaining frontier region means it offers many exciting opportunities for long-term investors as its economies and markets play catch-up with the rest of the world. Strong GDP growth (between 2004 and 2008 real GDP growth in sub-Saharan Africa has averaged 6.5%, according to the IMF) is testament to the dramatic structural changes that are transforming the continent. Notably, the

OCTOBER 2011 • FTSE GLOBAL MARKETS

Colin O’Shea, head of commodities, Hermes. Photograph kindly supplied by Hermes, September 2011.

continent’s demographics are supportive. According to the UN, population growth in Africa through 2015 is forecast to rise faster than anywhere else in the world, at a rate of 2.2%. As a result, Africa is expected to house the largest youth population in the world, creating interesting investment opportunities as young workers spend their earnings. FTSE GLOBAL MARKETS: The European and US sovereign debt crisis looks to cross into the 2012 financial year: what impact will this have on your firm’s approach to asset allocation; particularly within the holding of assets based in advanced markets? NEILL NUTTALL: The debt crisis has an impact on several stages of the asset allocation process, including strategic asset allocation, intermediate views, cyclical views on the US and Europe and shorter-term tactical views. We believe that ongoing deleveraging in the developed world will be the dominant macro force for a number of years, and that this represents a structural headwind for markets. From a strategic perspective, the biggest impact will be on a risk basis and on our forward-looking view on volatility, particularly for sovereign bond markets. This also leads to a broader assessment of the relative risk between emerging and developed markets. Historically, the risk of default has always been a concern for emerging markets, with an associated risk premium for investing in developing markets. This recent shift in sovereign bond markets could lead to a levelling out of risk premium between developed and emerging markets. The impact of the sovereign debt crisis on asset allocation will be influenced by views on how long it will take to work through the process of resolution, and the impact across global markets. On an intermediate-term view, there are significant structural headwinds as the US and Europe deal with their debt burdens. There is also a question of how long the downward impact on global growth will last—whether this will be a three-to-five-year pressure or a longer, structural change. Our interpretation of the price action in risk assets in August is that the market is coming to terms with the view that the headwinds will last for very much longer than had previously been expected. FTSE GLOBAL MARKETS: What is the inflation outlook for the US and Europe? What impact will this have on asset allocation? FREDERIC NERBRAND: The US and Europe increasingly resemble Japan in terms of the overall economic outlook. While policy makers are keen to boost activity through unorthodox policies the underlying deleveraging takes precedence. The main issue that markets face is the lack of impact from QE on domestic activity. Labour markets and GDP have

FTSE GLOBAL MARKETS • OCTOBER 2011

seen little impact while emerging market growth has spurred inflation. In turn, this has muted real wages in the West, making the overall impact questionable. In a world where stagnation takes hold we believe bond yields will remain low and investment grade credit spreads reaching tightening further. Emerging market local currency bonds are also likely to remain well bid while equities flounder with high volatility given the uncertain growth outlook. MARCUS GRUBB: Economic growth in the developed world still appears extremely sluggish and fragile and it can be argued we are still in grave danger of sliding into a deflationary trough. Certainly the outlook for 2012 is anything but rosy, but asset allocators need to look a little further than the next 12 months. Over the medium term, rational arguments can be made for a range of outlooks, from significant inflation, through disinflation to deflation. We commissioned the aforementioned research from Oxford Economics, with an eye on the next three to five years, in order to address these uncertainties and their impact on allocation decisions. Using their well-respected modelling techniques to define a number of macroeconomic scenarios, including inflation and deflation, the researchers then examined the impact of such scenarios on optimised portfolio allocations. The results indicated that an optimal allocation to gold rises in a more inflationary scenario, as well as for more risk-averse investors in a limited growth and lower inflation scenario. FTSE GLOBAL MARKETS: Is the time still right to begin investing in gold? MARCUS GRUBB: The question here is one of investment objectives. If the motivation for investing in gold is because it is the most potent diversification asset available then there is undoubtedly a compelling argument for adding gold to any portfolio that does not already include an allocation. If, however, the question is one of opportunity—that is, how robust is the outlook for gold’s continued rise in value—then our initial response is that we are not allowed to engage in price forecasting. That said, we can confidently state that, even after a prolonged sequence of record highs, the underlying conditions that have driven the bull market thus far, both in terms of market fundamentals and the macroeconomic environment, remain very supportive of the trend. It is worth mentioning that, while gold’s price performance has now been very impressive for over a decade, outperforming virtually all other assets, this is not its primary benefit for long-hold investors. It is often difficult to get investors to look beyond price performance when considering an asset with an average annual price that has risen for ten consecutive years and when that price (at this time) is around 300% higher than on the same date five years ago and 550% higher than a decade ago.Yet even more compelling for asset allocators is the statistical evidence from portfolio optimisation research which consistently suggests there is an empirical case for holding gold in the context of a broader portfolio regardless of its immediate price profile, because over the long term its potency as a diversifier can be proven to enhance the overall risk-return balance of your investments.I

October 10‒13, 2011 | The Ritz Carlton | Naples, Florida The ORIGINAL industry-wide conference sponsored by and developed by securities lending and borrowing professionals for securities lending and borrowing professionals.

The Original Securities Lending Conference The Risk Management Association’s 28th Annual RMA Conference on Securities Lending, to be held October 10–13 at the Ritz-Carlton in Naples, Florida will have a high-level roundtable focusing on legal and regulatory issues in the current markets. A tutorial on exchange traded funds will precede the roundtable. Other sessions will cover the future of securities finance, transparency in the securities lending market, funding and fixed-income lending, counterparty risk and central counterparties, and collateral management. Keynote Speaker: Zachary Karabell, President, River Twice Research Designated a “Global Leader for Tomorrow” by the World Economic Forum, Zachary Karabell is bringing a profound and refreshingly optimistic outlook to a world economy in crisis. As the President of River Twice Research and former EVP of Alger Fund Management, Karabell provides his economic insight and experience to accurately and profoundly explore ways in which today’s economic and political landscape is changing in fundamental ways. “The opportunity to discuss recent market events and various regulatory actions impacting the securities lending industry is invaluable,” said Michael P. McAuley, Managing Director, BNY Mellon Asset Servicing, Conference CoChair. McAuley also chairs the RMA Securities Lending Committee. “This conference is the ideal opportunity for industry professionals and practitioners to discuss securities lending broadly and holistically” said Leslie Nelson, Managing Director, Goldman Sachs, New York, Conference Co-Chair. “The program addresses important topics facing our industry, ranging from the landscape of today’s market to the evolving regulatory environment.” Our Conference Sponsors: Bank of America Merrill Lynch Brown Brothers Harriman BNP Paribas BNY Mellon Broadridge Financial Solutions Cantor Fitzgerald Citi Commerzbank Credit Suisse Data Explorers Deutsche Bank EquiLend

First Clearing/Wells Fargo Advisors Frost Bank Industrial and Commercial Bank of China Financial ING Financial Markets Intuition Financial Placement LLC Investment Technology Group J.P. Morgan Kellner DiLeo & Company Mizuho Securities USA, Inc. Morgan Stanley Northern Trust

OCC Penson Financial Services Inc RBC Capital Markets RBS Global Banking & Markets RCap Securities Inc. Southwest Securities State Street

800-677-7621 www.rmahq.org

(Week ending 2 September 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Sov Corp Sov Sov Corp Corp Corp

18,378,486,970 9,087,301,154 5,396,384,303 24,357,140,457 5,972,105,248 4,176,243,309 18,317,091,759 5,593,410,509 2,663,179,758 11,105,341,314

181,579,492,600 125,046,876,716 145,756,685,820 302,069,136,662 77,624,195,156 107,442,643,586 160,847,316,893 77,071,610,460 71,581,193,216 96,752,030,557

12,223 9,893 9,252 9,181 8,314 7,860 7,623 7,586 7,489 7,352

Americas Americas Europe Europe Americas Europe Europe Americas Europe Americas

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

25,396,469,865 24,357,140,457 18,378,486,970 18,317,091,759 18,240,102,555 12,688,264,815 11,105,341,314 9,087,301,154 8,871,045,617 7,862,299,871

118,088,257,176 302,069,136,662 181,579,492,600 160,847,316,893 104,045,382,784 68,498,683,881 96,752,030,557 125,046,876,716 57,679,223,363 51,847,033,620

6,579 9,181 12,223 7,623 3,548 4,959 7,352 9,893 5,818 5,466

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

Federative Republic of Brazil Government United Mexican States Government Republic of Turkey Government Republic of Italy Government Bank of America Corporation Financials Russian Federation Government Kingdom of Spain Government JPMorgan Chase & Co. Financials Telecom Italia SPA Telecommunications General Electric Capital Corporation Financials

Top 10 net notional amounts (Week ending 2 September 2011) Reference Entity

French Republic Republic of Italy Federative Republic of Brazil Kingdom of Spain 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 2 September 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,394,860,916,019

436,062

French Republic

2,647,590,000

253

Sovereign / State Bodies

2,793,166,601,774

211,139

Federal Republic of Germany

2,085,145,548

110

Corporate: Consumer Services

2,137,446,748,254

350,024

Republic of Italy

2,081,122,391

160

Corporate: Consumer Goods

1,672,109,520,925

260,747

Bank of America Corporation

1,870,281,051

240

Corporate: Technology / Telecom

1,338,938,113,010

201,980

Commonwealth of Australia

1,792,128,406

Corporate: Industrials

1,311,343,187,559

220,397

Federative Republic of Brazil

1,315,325,462

Corporate: Basic Materials

Republic of Turkey

1,208,600,000

The Goldman Sachs Group, Inc.

1,052,220,189

146

1,025,972,993,443

161,724

Corporate: Utilities

803,610,021,481

123,481

Corporate: Oil & Gas

492,459,500,699

87,157

Corporate: Health Care

352,856,821,052

60,573

Corporate: Other

147,743,934,360

15,500

CDS on Loans

68,591,944,633

17,907

Residential Mortgage Backed Securities

61,973,636,532

12,064

Commercial Mortgage Backed Securities 17,415,748,886

1,638

Residential Mortgage Backed Securities* 15,891,992,441

1042

CDS on Loans European

5,000,195,812

701

Muni:Government

1,226,700,000

126

Other

1,126,385,700

832,519,114

Commercial Mortgage Backed Securities* CDS Swaptions

136,480,500

Muni:Other

100,000,000

Muni:Utilities

27,150,000

*European

FTSE GLOBAL MARKETS • OCTOBER 2011

Kingdom of Spain

963,164,487

Citigroup Inc.

960,788,474

117

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

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

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

FFI and venue market share by index Week ending 2nd September 2011 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.58 8.74%

2.14 6.03%

2.03 5.55% 0.02%

1.83 4.42%

1.92 5.59%

29.47%

20.90%

4.29% 16.96%

19.60%

0.07%

1.83%

20.64% 66.57% 0.02% 0.04% 0.59% 0.05% 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

53.23% 0.11% 0.06% 0.02%

0.14%

0.03%

64.38% 69.10% 71.64% 0.00% 6.74% 0.00%

8.34%

VENUES

6.39%

2.66%

5.56%

VENUES

INDICES

DOW JONES

S&P 500

INDICES

S&P TSX Composite

FFI

4.85

4.47

FFI

1.90

1.88

BATS

10.41%

11.02%

Alpha ATS

19.97%

18.89%

BATS Y

3.76%

3.84%

Chi-X Canada

8.01%

8.44%

CBOE

0.09%

0.04%

Chicago Stock Exchange

0.15%

0.13%

EDGA

5.86%

5.06%

EDGX

7.95%

6.96%

NASDAQ

22.82%

24.71%

NASDAQ BX

5.28%

4.17%

NQPX

1.66%

1.12%

NSX

0.77%

0.74%

NYSE

24.09%

26.09%

FFI

NYSE Amex

0.06%

0.12%

NYSE Arca

17.09%

16.00%

VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

Australia Hong Kong

100.00% 100.00%

S&P TSX 60

TMX Select

2.21%

1.98%

Omega ATS

2.78%

2.62%

Pure Trading

3.43%

2.44%

TSX

63.59%

65.63%

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

1.34 2.52% 0.00% 0.02% 0.00% 0.00% 2.62% 85.73% 8.87% 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/.

OCTOBER 2011 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

UGUST PROVED TO be one of the busiest trading months for exchanges around the world with equities and derivatives markets all reporting record trading levels in what is normally a quiet month. Further analysis of the week of the 8th August shows that volumes jumped across both primary and alternative venues compared to the previous week. Bats and Chi-X Europe saw volumes grow by around 50% each whilst Turquoise (now owned by the LSE) and the LSE itself reported even larger gains of 100% and 80% respectively. This may be down to the market’s perception that these venues are somehow 'safer' places to trade in times of stress or it could simply be a reflection of the fact that large liquidity providers such as GETCO have been more active on the LSE’s MTF of late. Analysis of the data also seems to show that whilst there was more trading on lit venues during the same period it was not significantly more. So, the first conclusion we seem to be able to draw is that when volatility and volumes spike there is no significant difference in where this extra liquidity spreads itself, either between primary and alternative venues or across the lit/dark spectrum. Irrespective of this liquidity surge it is evident that the level of fragmentation across lit venues is still moving inexorably upwards (with the possible exception of Canada where rates of fragmentation appear to have remained fairly static).

Japan Nikkei 225

1.4 1.3 1.2 1.1 1.0 2010-07-23

2010-12-10

2011-04-22

2011-09-02

Of particular interest is Japan, which has seen Chi-X in operation there for a little over a year now. In that time, Chi-X has been able to garner nearly 3% of the Nikkei 225 and has achieved this without the kind of regulatory commitment to market competition that has occurred in Europe, the US and Canada and that is soon to come in Australia. Chi-X Japan Nikkei 225

3.0

2.0

1.0

Europe FTSE 100

AEX

DAX

CAC 40

3.0

0.0 2010-07-30

2.5

2010-12-10

2011-04-22

2011-09-02

2.0 1.5 1.0 2009-09-04

2011-01-07

2010-05-07

2011-09-02

Ironically Chi-X’s success in Japan seems also to have helped the other key alternative venue – SBI Japannext - as the chart below shows: SBI Japannext

USA S&P 500

Dow Jones

NASDAQ 100

6.0

Nikkei 225

3.0

5.0 2.0

4.0 3.0 2.0 1.0 2010-07-23

1.0

2010-12-10

2011-04-22

2011-09-02 0.0 2010-08-13

Canada S&P/TSX 60

S&P/TSX Composite

2010-12-10

2011-04-22

2.5 2.0 1.5 1.0 2010-07-23

2011-09-02

2010-12-24

2011-04-29

2011-09-02

This seems to confirm the fact that as fragmentation enters the consciousness of any particular trading community then it develops its own momentum and, in this sense, becomes something of a self-fulfilling phenomenon. If this is the case, then it will be interesting to see whether equilibrium ever emerges and what the natural level of fragmentation for any particular regulatory environment really is. 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 • OCTOBER 2011

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

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

-1 1

Au g

M ay -

-1 1 Fe b

-1 0

ov N

Au g

M ay -

Fe b-

N ov -

-0 9 Au g

M ay -0 9

Fe b09

ov N

Au g08

M ay -0

Fe b0

ov -0 7 N

Au g07

ay -0 M

Fe b07

N ov -0

40 Au g-

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 August 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 1 Au g

11 M ay -

-1 1 Fe b

-1 0

ov N

Au g

M ay -

10 Fe b-

09 N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

M ay -0

8 Fe b0

ov -0 7 N

Au g07

7 ay -0 M

Fe b07

N ov -0

Au g-

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 August 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 1 Au g

11 M ay -

-1 1 Fe b

-1 0

ov N

Au g

10 M ay -

10 Fe b-

09 N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

ay -0 M

08 Fe b-

ov -0 7 N

Au g07

7 M ay -0

-0 7 Fe b

N ov -0

Au g06

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

OCTOBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

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

FTSE All-World ex USA Index

160 140 120 100 80 60

-1 1 Au g

M ay -

-1 1 Fe b

ov N

-1 0

Au g

M ay -

Fe b-

N ov -

-0 9 Au g

M ay -0 9

Fe b09

ov N

Au g08

M ay -0

Fe b0

ov -0 7 N

Au g07

ay -0 M

Fe b07

N ov -0

Au g-

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 August 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 1 Au g

11 M ay -

-1 1 Fe b

10 ov N

-1 0

Au g

M ay -

10 Fe b-

N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

M ay -0

Fe b0

ov -0 7 N

Au g07

7 ay -0 M

Fe b07

N ov -0

Au g-

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 August 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 1 Au g

11 M ay -

-1 1 Fe b

10 ov N

-1 0 Au g

10 M ay -

10 Fe b-

09 N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

ay -0 8 M

08 Fe b-

ov -0 7 N

Au g07

-0 7

M ay -0 7

Fe b

N ov -0

Au g06

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

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2011

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

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

-1 1 Au g

M ay -

-1 1 Fe b

ov -

-1 0

Au g

M ay -

Fe b-

N ov -

-0 9 Au g

M ay -0 9

Fe b09

ov N

Au g08

M ay -0

Fe b0

ov -0 7 N

Au g07

ay -0 M

Fe b07

N ov -0

40 Au g-

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 August 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 1 Au g

11 M ay -

-1 1 Fe b

10 ov -

-1 0

Au g

M ay -

Fe b-

09 N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

M ay -0

8 Fe b0

ov -0 7 N

Au g07

7 ay -0 M

Fe b07

N ov -0

Au g-

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (29 August 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)

160 140 120 100 80 60 40

-1 1 Au g

11 M ay -

-1 1 Fe b

10 ov N

-1 0 Au g

10 M ay -

10 Fe b-

09 N ov -

-0 9 Au g

ay -0 9 M

-0 9 Fe b

08 ov N

Au g08

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

OCTOBER 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 August 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

-1 1 Au g

M ay -

-1 1 Fe b

ov -

-1 0

Au g

M ay -

Fe b-

N ov -

Au g

-0 9

M ay -0 9

Fe b09

ov N

Au g08

M ay -0

Fe b0

ov -0 7 N

Au g07

ay -0 M

Fe b07

N ov -0

Au g-

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 August 2006 = 100) FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

500

400

300

200

100

-1 1 Au g Au g-

11 M ay Ju l11

-1 1 Fe b

10 N

ov -

-1 0

Au g

M ay -

Fe b-

09 N ov -

-0 9 Au g

M ay -0 9

Fe b09

08 ov N

Au g08

M ay -0

8 Fe b0

ov -0 7 N

Au g07

7 ay -0 M

Fe b07

N ov -0

Au g-

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (26 February 2010 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

200 180 160 140 120 100

1 Ju n1

1 M ay -1

1 Ap r1

M ar -1

-1 1 Fe b

11 Ja n-

-1 0 De c

10 N

ov -

0 Oc t1

Se p10

-1 0 Au g

Ju l10

Ju n10

-1 0 ay M

Ap r10

ar -1 0 M

Fe b10

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

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2011

INDEX CALENDAR

Index Reviews October - December 2011 Date

Index Series

Review Frequency/Type

07-Oct

TOPIX

07-Oct 13-Oct 27-Oct 01-Nov 07-Nov

TOPIX FTSE TWSE Taiwan Index Series Russell US & Global Indices Russell/Nomura Indices TOPIX

09-Nov 10-Nov 16-Nov 22-Nov Early Dec Early Dec Early Dec Early Dec 02-Dec 02-Dec 02-Dec 02-Dec 02-Dec 02-Dec

06-Dec 06-Dec 07-Dec

FTSE Value-Stocks China Index Hang Seng MSCI Standard Index Series DJ STOXX ATX OBX IBEX 35 OMX C20 BEL 20 DAX PSI 20 AEX CAC 40 FTSE Global Equity Index Series (incl. FTSE All-World) S&P / ASX Indices FTSE Vietnam Index Series FTSE Renaissance Asia Pacific IPO Index Series FTSE China Index Series FTSE MIB TOPIX

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

07-Dec 07-Dec 07-Dec 07-Dec 07-Dec 07-Dec 08-Dec 09-Dec 09-Dec 09-Dec 09-Dec

FTSE/JSE Africa Index Series FTSE UK Index Series FTSE techMARK 100 FTSE Euromid FTSEurofirst 300 FTSE Italia Index Series FTSE Bursa Malaysia Index Series S&P US Indices NZX 50 Dow Jones Global Indexes DJ Global Titans 50

09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 10-Dec 12-Dec 12-Dec 13-Dec 14-Dec

S&P / TSX S&P Topix 150 S&P Asia 50 S&P Latin 40 S&P Global 1200 S&P Global 100 OMX I15 S&P BRIC 40 Russell US & Global Indices FTSE SET Index Series Russell US & Global Indices

02-Dec 02-Dec n/a

Effective (Close of business)

Data Cut-off

28-Oct 28-Oct 21-Oct 31-Oct 30-Nov

30-Sep 31-Aug 30-Sep 26-Oct 14-Oct

29-Nov 11-Nov 02-Dec 30-Nov 16-Dec 31-Dec 16-Dec 12-Jan 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec

31-Oct 31-Oct 30-Sep 31-Oct 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 31-Oct 30-Nov 31-Oct 31-Oct 30-Nov

Annual review / North America Quarterly review Quarterly review

09-Dec 16-Dec 16-Dec

30-Sep 25-Nov 25-Nov

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

16-Dec 16-Dec 16-Dec

30-Nov 21-Nov 05-Nov

29-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec

30-Nov 06-Dec 06-Dec 06-Dec 06-Dec 06-Dec 06-Dec 30-Nov 08-Dec 30-Nov 30-Nov

16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 16-Dec 31-Dec 16-Dec 16-Dec 16-Dec 16-Dec

30-Nov 30-Nov 02-Dec 02-Dec 02-Dec 02-Dec 02-Dec 30-Nov 18-Nov 30-Nov 30-Nov 13-Dec

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

OCTOBER 2011 • FTSE GLOBAL MARKETS

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