FTSE Global Markets

ROUNDTABLE: SECURITIES LENDING, RISK & REGULATION

ISSUE 56 • NOVEMBER 2011

Revamping corporate actions for a new era After a patchy year sukuk issuance likely to rise Righting the risks in repo The wedding planners: the ins and outs of cap intro

CAN DRAGHI CONTROL THE REINS OF THE NEW EUROPE? WESTLB/HELABA MERGER: GERMANY’S LANDESBANKS FEEL THE HEAT

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FTSE GLOBAL MARKETS • NOVEMBER 2011

HE CURRENT OF fast-flowing eurozone debt winds through this edition.

It has been an inescapable element in the discussions of most segments of the global investment markets for too long. The inevitable rally across the main indices in the wake of the announcement of a European deal on debt is to be welcomed. While the deal looks to be a spatchcock of agreements, and the issue of sovereign debt payments will scar the political debate of Europe for some time, two important things emerged. One is the absolute commitment (the United Kingdom aside) of the member states of the union to save both the euro and the European project. While imperfect and bureaucratic, the agreement shows that most members see the EU as still a nascent entity that is yet to take on its vital form as a confederation of states with much to unite them in terms of outlook, business and culture.

Two, the euro crisis has highlighted the fact that not all members of the euro were able to cope with it, lacking the infrastructure and commitment to structural change that the currency requires at this stage. Italy, Spain and Greece are obvious examples of this fact. What is also clear is that the EU will now move forward on a dual track, with a core of states fully committed to the next stage of political and economic integration and a smattering of peripheral states (the United Kingdom among them) that will remain on the sidelines. Whether that is sustainable over the long term is debatable and will underscore tensions in the European region at a time of immense change in the global economy.

Our cover story this month covers the bare bones of the deal and discusses the political ramifications of the agreement; not only on the relations between eurozone leaders and the formal institutions within the EC, but also the longerterm impact on European politics and banking. As with all prognostications right now, the term of their applicability might ultimately be measured in weeks rather than months as the markets rise and fall with the monotony of a metronome. In any case, we are giving our two-pennies’ worth.

Having said this, we offer a broad church in this month’s coverage. The overall mood is suitably dour as befits the still-parlous state of the global markets; though recent figures showing that the US economy grew by 2.5% in Q3 gives cause for cautious celebration (it could have been much, much worse). With that in mind we have punctuated the coverage with more leavened articles; including an overview of the prospects for the Manchester United IPO, which could as likely excite or kill off entirely your interest in the rest of the magazine, depending of course on your football affiliations.

On a less arcane level, our corporate profile this month clearly illustrates that while the global finance superstructure is undergoing stresses, some corporations are managing to get on with their day-to-day business operations very nicely indeed, thank you very much. As Art Detman explains, US-based Grainger, a leader in the $580bn maintenance, repair and operating (MRO) business, is making hay while the provision of supplies to keep large facilities running across the world remains highly fragmented.

Matt Lynn’s article on capital introductions is a lively bellwether of the main strains and opportunities running through the business segment. Equally, David Simons provides a useful round-up of the multiple initiatives that will refocus and revitalise corporate actions reporting. Enjoy.

T

Francesca Carnevale, Editor, November 2011 Cover photo: Mario Draghi, the new President of the European Central Bank during a hearing at the Committee on Economic and Monetary Affairs at the European Parliament building in Brussels, June 2011. Photograph supplied by Yves Logghe/AP/Press Association Images, October 2011.

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CONTENTS COVER STORY

THE CHANCE FOR A NEW START

..................................................................................Page 6 The agreement reached by eurozone leaders in October may not be the answer to all of Europe’s systemic problems but it has achieved a number of important things. Among other things, it has proven that the EU project remains sacrosanct to most members and has laid down the foundations for a new treaty. With the appointment of Mario Draghi as the new head of the ECB, Francesca Carnevale reviews the options of this new Europe.

DEPARTMENTS

MARKET LEADER

THE LME: HAVE CLEARING SYSTEM, WILL TRAVEL ............................Page 12 Buyers line up in an unexpected bid for the LME. Vanya Dragomanovich reports.

LANDESBANKS SEARCH FOR VIABLE BUSINESS OUTLOOK ........Page 16 German landesbanks struggle to overcome their exposure to toxic assets.

IN THE MARKETS

IS THE VIX A PROPER FIX FOR VOLATILITY? ..............................................Page 22 Are volatility index-based products here to stay? Ian Williams looks for answers.

MAN UTD IPO STALLED BY AN INDIFFERENT SEASON ....................Page 24 The global crisis has left the club’s $1bn IPO on ice. Lynn Strongin Dodds reports.

MANDATES FX VIEWPOINT

THE MONTH’S LATEST CONTRACTS....................................................................Page 27 ICBC opts for BNY Mellon Asset Servicing and other mandates.

TO BE, OR NOT TO BE? THE EURO IN QUESTION

..............................Page 29 Erik Lehtis, president of DynamicFX, reflects on the next stage of the euro evolution.

CONVERTIBLE BONDS KEEP THE ROOF DOWN

DEBT REPORT

....................................Page 30 Why do they have more mileage than high-yields or equities? By Andrew Cavenagh.

SUKUK: A PATCHY YEAR IN VIEW ......................................................................Page 33 Can 2012 revive the fortunes of the international sukuk market?

FACE TO FACE

SETTING BENCHMARKS IN FI FUND RAISING ............................................Page 38 Hulya Kefeli, head of international banking, Akbank, explains the dynamics.

ICB SETS CLASSIFICATION BENCHMARKS ......................................................Page 41

INDEX REVIEW

FTSE licenses NASDAQ QMX with ICB across seven European exchanges.

WILL THE EURO’S PROBLEMS RESURFACE YET AGAIN? ................Page 42 Simon Denham, managing director of Capital Spreads, takes the bearish view.

COMMODITIES

DATA PAGES

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SOFT COMMODITIES: WALK BUT DON’T RUN ........................................Page 43 Liquidity impacts on soft commodity finance. Vanya Dragomanovich reports.

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

NOVEMBER 2011 • FTSE GLOBAL MARKETS

CONTENTS FEATURES COMPANY PROFILE:

GRAINGER SETS OFF ON GLOBAL GROWTH ........................................Page 45 In the $580bn worldwide maintenance, repair and operating (MRO) supplies industry, USbased Grainger is the leader. And despite the sluggish global economy, the company expects to grow between 7% and 10% annually by taking market share from smaller competitors. Art Detman reports.

TRADING REPORT:

WHY TECHNOLOGY IS THE KEY TO TRADING ANONYMITY ..........Page 49 As post-trade transparency improves, some traders fear that anonymity will be compromised. The fear of being “gamed” or losing a price advantage is at the heart of the desire to remain anonymous, but there is more to anonymity than simply staying out of sight. Ruth Hughes Liley reports.

HFT DOES NOT INCREASE VOLATILITY, SAY EXPERTS ....................Page 53 Some fear that high-frequency trading and volatility go hand in hand and that it has been a toxic development in market structure in recent years. However, recent studies seem to confirm a theory established by Adam Smith almost 200 years ago where speculation has the effect of reducing long-term volatility. Ruth Hughes searches for some answers.

SECURITIES SERVICES:

HONING THE CAP-INTRO SKILL SET FOR A NEW ERA..........................Page 59 Capital introductions (cap intro) specialists are the matchmakers of the capital markets. It is a finely-honed balancing act that requires detailed knowledge of the sides of the business divide as well as subtle shifts in investor trends. It has become a discrete and highlycompetitive business with cap-intro teams fighting for market share. Matt Lynn reports.

MANAGING RISK IN CORPORATE ACTIONS: ALL ABOARD? ......Page 65 Increased risk awareness around sophisticated strategies has renewed the industry’s focus on improving corporate-actions methods and technologies. Despite positive changes, weak links persist. Getting data faster remains a top priority but also requires that participants have the resources as well as the willingness to work together, writes David Simons.

REVAMP IN REPO ....................................................................................................Page 68 After the financial crisis, liquidity management took centre stage, while capital constraints forced banks to rein in proprietary trading. Regulators have cast their eyes on the repo markets and discovered long-standing market practices had introduced unacceptable systemic risks, particularly in the US. Neil O’Hara reports.

CHANGING METHODS FOR COLLATERAL MANAGEMENT

........Page 71 In this era of hyper-transparency, the advantage has shifted towards firms that not only have the best collateral management tools at their disposal, but also the wherewithal to handle the anticipated mountain of collateral needed to cover increased margin calls and other requirements in the making. By David Simons.

REGULATIONS SHAKE-UP FOR SEC LENDING ......................................Page 75 The move to force OTC derivatives trading into a cleared environment will create new demand for collateral eligible at clearinghouses, which typically insist on cash or G7 government bonds. Meanwhile, the mooted disclosure of short positions and leverage caps on hedge funds could curtail demand for equities, writes Neil O’Hara.

ROUNDTABLE:

SECURITIES LENDING, RISK & REGULATION ..............................................Page 79 According to Jeff Molitor, chief investment officer of Vanguard Europe: “One of the biggest hindrances in the securities lending arena is that there is still a lot of residual concern among investors about problems that happened a couple of years ago.” What did the rest of the roundtable panel think of Molitor’s assertion?

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NOVEMBER 2011 • FTSE GLOBAL MARKETS

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COVER STORY

EUROPE: THE BEGINNING OF THE END, OR THE END OF THE BEGINNING?

French President Nicolas Sarkozy, right, and German Chancellor Angela Merkel participate in a media conference at an EU summit in Brussels on October 23rd, 2011. Photograph supplied by Michel Euler/AP/Press Association Images, October 2011.

The chance for a new start The top line tripartite agreement, reached under stressed conditions, by eurozone leaders in late October is not a panacea for all Europe’s systemic problems. However, it has achieved some very important things.

The agreement clearly demonstrated that the EU project remains sacrosanct to most members of the community (barring perhaps the United Kingdom, which may move eventually to renegotiate the terms of its membership). Moreover, the admittedly spatchcock nature of the agreement has not only staved off capital markets meltdown in the last quarter of this very challenging year, but also laid the foundations for a new EU treaty and discussions around strengthening the infrastructure of the union going forward.

What now? Francesca Carnevale reviews the options.

ITH ANY LUCK, history will look back on October 26th 2011 as the day that Europe finally got serious about the union. As with many watersheds, this particular one was created under duress. The terms of the tripartite agreement, which by now are familiar to us all, involve a 50% haircut on Greek debt, the boosting of the European Financial Stability Facility (EFSF) to a value of €1trn and the requirement that European banks raise around €106bn in new capital by June next year.“We have reached an agreement, which I believe lets us give a credible and ambitious and overall response to the Greek crisis,” French president Nicolas Sarkozy told reporters after the meeting to formulate the agreement ended.

There are other bells and whistles: the EFSF can provide insurance to buyers of eurozone member debts and a special investment vehicle will be set up which should provide a useful

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conduit for sovereign, public and private sector investors. Now the hard work starts on making this all gel together into a cohesive whole.

The significance of this agreement is about underscoring to the global financial markets that the European Union (EU) project is a very real and achievable object and that countries such as Germany would make many of the required sacrifices involved to ensure it worked.

Make no mistake. The brouhaha over the euro had something, but not that much, to do with Greek debt. Even now, a solution which wipes 50% off the value of Greek government obligations and only brings down the country’s deficit to 120% of GDP by some indeterminate date after 2020 is no solution to the Greek problem at all. That the markets and political commentators should acquiesce to this pantomime is palpably nonsense. The toughest discussions in this regard involved Greek’s main creditors. Once

they were mollified, the issue of Greece went to the sidelines for the duration.

That should not come as a surprise; you cannot realistically describe the collapse of the euro and/or the union based on the fortunes of a country which can barely scrape together 1.8% of the union’s combined GDP (at last year’s count). That fact weighed heavily on all participants and ultimately forced a deal that would provide a firewall should economies such as Italy or Spain be brought to the brink. Italy accounts for 17% of the eurozone’s GDP, altogether a different order of magnitude. Better then to fix any relatively minor leaks now (no matter the cost) than face Armageddon should the coalition government of Silvio “Bunga Bunga” Berlusconi fail to put its own house in order and stimulate sustainable economic growth.

But then again, Italy has lived with similar levels of debt for decades and its central bank governors and finance ministers by and large have been highlyrespected fiscal conservatives. Italy’s

NOVEMBER 2011 • FTSE GLOBAL MARKETS

WWW.BBH.COM

COVER STORY

EUROPE: THE BEGINNING OF THE END, OR THE END OF THE BEGINNING?

problem is that its economy needs a complete overhaul; its tax collection needs to be seriously upgraded and good corporate governance imposed on many of its corporate and municipal institutions. The country has averaged an abysmal annual economic growth rate of 0.75% over the past 15 years. That’s a generational and structural issue which will not find a ready solution, at least not with the Northern League in a position to influence matters; but this is a story for another day.

Back to Europe: that it took two years for EU leaders to reach this point is, of course, an indication of the arthritic nature of the union’s institutional infrastructure. It is also symptomatic of the fact that some states remain less enamoured of the union than others. The UK is a particular case in point and there are ominous signs that it will seek to redraw its relationship with Europe at a pivotal point in the affairs of the union should the other countries move to closer integration. This is extremely likely should Europe proceed with a string of regulations that will closely circumscribe banking and capital markets activity.

Powerful momentum Should German chancellor Angela Merkel succeed in her aims to tax capital markets transactions, for instance, it could provide the UK’s vocal eurosceptic groups with enough firepower to successfully push for a distancing of the UK’s economy, which is still dominated by financial services, from that of the emerging euro-club.

No government in the UK will accept any regulation that might kill off the golden goose that is the City.

Even so, the current UK chancellor, George Osborne, told the BBC that political union, with a new president and presumably a new euro chancellor, was the only way that the single currency could be sustained. It is a clear signal that, whatever the outcome of the UK’s deliberations on its approaches to the EU project, the project itself now has a momentum of its own.

It is difficult to sometimes relate to

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GREEK PUBLIC DEBT BY TYPE OF HOLDER (€bn) PSI PLUS ELIGIBLE DEBT Greek debt Greek pension funds Foreign accounts Total

(€bn) 47 23 137 207

NON PSI ELIGIBLE DEBT ECB Holdings T-Bills Troika loans Other debt (inc loans to public enterprises) Total

(€bn) 55 16 65 17 153

Total Greek government debt

360

Source: Platon Monokroussos, head of financial research, Eurobank EFG paper on Greece: Debt sustainability outlook post the October 26th summit.

the visceral attachment that many countries have to the European project, even though the sometimes sclerotic and financially incontinent nature of some of its members have occasionally impacted adversely on the methods of its institutions. However, it is equally difficult not to be moved by the idealistic and thoughtful postSecond World War functionalist movement that underpinned the beginnings of the union. Also, it is salutary to remember the human and economic costs of the wars that have riven continental Europe for centuries.

In that regard, the peace dividend inherent in the union is beyond price.

The union is still in its infancy in historical terms and this two-year hiatus has probably focused the minds of proEuropean politicians more than we can imagine at this point. The litmus test of that vision will be the methodology and speed with which the next rounds of integration discussions proceed.

These discussions are unavoidable, as the next logical stage for the evolution of the European project is a redrawing and likely strengthening of its key institutions. Among the topics for discussion will be how the role of the European Central Bank (ECB) will be described for the coming decade and a strengthening of the role of EC commissioners relative to their counterparts in the rising confederation. The

structure of the US legislature and the relationships between federal and state agencies will be studied carefully over the next period. The EU will likely want to achieve union its own way; but if someone else has a viable template, it might make good sense to study it.

In the coming weeks the European Commission will present proposals on ways to improve surveillance of the budgets and policies of eurozone members should they breach Maastricht criteria. The commission is also expected to present proposals on improving policy coordination within the eurozone, and organise its external representation.

These actions are well within the bailiwick of current treaty agreements.

Lessons learned The lessons of the past two years will be difficult to apply going forward, at least in the medium term, while Europe’s institutions have still to take on their final form, an issue key to the future of the ECB. Italian central bank governor Mario Draghi has been appointed the next president of the European Central Bank. Draghi has been governor of the Italian central bank since 2005. His pedigree is fair: he has been chairman of the Financial Stability Board since 2006 and a member of the board of directors for the Bank of International Settlements, which sets the Basel accords, since

NOVEMBER 2011 • FTSE GLOBAL MARKETS

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COVER STORY

EUROPE: THE BEGINNING OF THE END, OR THE END OF THE BEGINNING?

2005. However, Draghi arguably has a supremely difficult task ahead of him.

The threats facing him are manifold.

He must tackle some of the troubling indicators in the union. The eurozone economy continues to slow, and he may well need to keep cutting interest rates to stop that turning into a full-blown recession. At the same time, he also needs to keep the lid on inflation—the latest figures show prices in the eurozone rising 3% a year, the fastest rate for three years.

Finding the right path to tread

between these objectives will be daunting enough, even without the other issues affecting the euro.

Some commentators think that Draghi will follow Jean-Claude Trichet’s conservative path and that he will try to avoid printing money and that this will be his downfall and ultimately that of the euro. More pertinently perhaps, Draghi’s problem will be defining a role for the ECB that does not conflict with the new structures that might emerge in the new European order. Finally, the incoming governor will have to deal

with the inevitable impact of the avalanche of regulation which will fall on the European capital markets in 2012.

Up to now, Draghi has shown he is able to front up to crises: he has certainly had experience of walking the tightrope that comes with the governorship of Italy’s central bank. The question is: will that experience be enough to guide European policy through another few years of crisis management as Europe redefines itself and the issue of euro viability will inevitably recurr?I

PRINCIPAL ELEMENTS OF THE OCTOBER 26TH AGREEMENT & ITS IMPACT A NEW BAILOUT PLAN FOR GREECE G A new EU/IMF loan programme, worth around €100bn and €30bn in eurozone contributions for a new voluntary private sector involvement programme (PSI) involving the rollover of Greek bank debt is in place; around €42bn of the current Greek loan facility is still available.

G Enhanced structural adjustments to the economy must be applied, though these have not been spelled out and do nothing to either reflate the economy or reduce overall Greek indebtedness until at the very least 2026. Public debt is reduced to 120% of GDP by 2020. It will continue to have a detrimental impact on the country’s sovereign ratings and discourage inward investment. A new growth plan will have to be formulated at some point. Some €15bn in privatisation revenue has to be raised.

G There are credit enhancements in place to improve the quality of collateral used by Greek banks in the Eurosystem’s liquidity operations.

EFSF: AN ENHANCED ROLE/LEVERAGE G An insurance scheme that guarantees “first loss” on new

eurozone sovereign bonds is in place.

G A special purpose vehicle (SPV) that will be a conduit for IMF, public sector, private sector financial institutions which will supplement and “maximize” the funding activities of the EFSF is to be set up, though where this money will come from and how much it will generate has yet to be described.

Neither has the EU outlined, in detail, who will guarantee this SPV. G Substantial levels of leverage based on the enhanced EFSF and the SPV will be allowed. The question is: what does this mean for the ECB and its Securities Markets Programme (SMP)?

G EFSF funds can be used to help recapitalise eurozone banks, but only as a last resort.

GEOPOLITICAL CHANGES ANTICIPATED G A two-tier Europe emerges.

G A core euro-club will likely seek closer political, institutional and economic union, through negotiation of new treaty elements.

G Eurosceptic countries, such as the United Kingdom, will likely redraw their treaty-defined relationship with the EC. Issues such as human rights, the capital markets

transaction tax, immigration and EC budget contributions will provide likely flashpoints.

G A new round of parliamentary ratification procedures will now have to be put in train.

TIGHTER ECONOMIC GOVERNANCE ACROSS EUROPE G EU deficit and indebtedness rules should be embedded in national legislations by the end of 2012.

G The European Commission (EC) has enhanced powers to monitor national budgets, but there is no mention of what will happen if states, such as Italy, fail to meet the new criteria.

G Fiscal probity is to be encouraged in countries experiencing tensions in the sovereign debt markets. Cost of funding in the capital markets will remain high for countries such as Ireland, Spain and Italy.

LOOKING AFTER EUROPE’S BANKS G European banks exposed to Greek sovereign debt must endure a 50% haircut. Help with pressure on bank capitalisation is promised however.

G Banks are required to ensure that core tier-1 funds are increased to 9%. This new threshold has to be reached by June 30th 2012.

Source: Various newspaper reports and EC bulletins.

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NOVEMBER 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

BUYERS LINE UP IN AN UNEXPECTED BID FOR THE LME

The LME ring. Photograph kindly supplied by the LME, October 2011.

The LME: have clearing system, will travel The first anybody knew that the London Metal Exchange was potentially for sale was a sparsely-worded press statement sent out late on a Friday at the end of September saying that it had hired boutique bank Moelis & Company to advise it on “expressions of interest” it had received. Vanya Dragomanovich reports on the runners and riders and the possible outcome of this unexpected race.

HILE OTHER EXCHANGES have hurried through a flurry of mergers and acquisitions (M&A) activity over the past few years in an effort to stave off losses in market share to alternative trading venues, the London Metal Exchange (LME) stubbornly kept up a “Not For Sale” sign.

However, when the exchange started looking to build its own in-house clearing system, following in the footsteps of NYSE and ICE, its peers started viewing it with fresh interest.

Within a week of the notice the number of potential suitors rose from a few to double digits, according to Chris Evans, the LME’s head of business development. It should come as no surprise. The 130-year-old stalwart of City commodity trading and the last London exchange with open outcry trading is the biggest and the most respected metals exchange in the world. It has the broadest offering of metals contracts, including steel, copper, aluminium, zinc,

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nickel, tin and lead as well as a number of minor metals.

The LME has not named any of the interested parties, but industry insiders say that the top three on the list are metals rivals CME Group, the Singapore Exchange—which is believed to be co-operating with the London Stock Exchange on a joint bid—and Intercontinental Exchange (ICE), which is mainly focused on energy commodities. Other contenders are believed to be the Dubai Mercantile Exchange, the interdealer broker ICAP and the Shanghai Futures Exchange, but none has so far confirmed an interest.

At a seminar held during LME week in October, the biggest metal shindig that gathers all of the great and the good of the metals industry from around the world, LME chief executive Martin Abbott said the LME was approaching this process without necessarily needing to sell. The exchange could be sold “if somebody provides us with a fabulous

reason to sell,” adding: “This is not a small mountain to climb and I am looking forward to seeing somebody try and climb it.”

Currently, the LME has five levels of membership, each involved in different stages of the metals trade, from being a market maker and having a booth on the floor of the exchange to being a physical trader of metal. All of the trading has to go through member companies (and there are more than 90 of them), most of which are also shareholders of the exchange.

For years, trading in metals was carried out only on the floor of the exchange (or the ring as it is called) and over the phone, but in the past decade the bulk of trading has been occurring off the floor. Still, ring-dealing remains vital because daily prices for metals are at the end of five-minute bursts of trading in the early part of the day and those prices then become reference prices for metals deals around the globe.

Fees are kept lower than at similar exchanges and consequently the profits the exchange generates are smaller than some of its peers.

“The valuation of the LME being bandied about [sic] is around £1bn, 80 times last year’s pre-tax profit of £12.5m,” says Herbie Skeete, managing director of Mondo Visione, an intelligence provider on global exchanges and the co-founder of the FTSE Mondo Visione Exchange Index. The number “is not far off the mark” when taking into account the value of the trading floor, the chain of warehouses the exchange owns and the LME brand, according to Skeete.

The LME’s pre-tax profit of £12.5m in 2010 was down almost 28% on 2009’s £17.3m. The LME has more than 70 shareholders and for the deal to go ahead “75% of the shareholders would have to approve it”, explains the LME’s Evans. Assuming that the £1bn figure was correct and for simplicity’s sake assuming that there were 70 shareholders, then a company such as Goldman Sachs, which holds around a 9% stake in the exchange, would be looking at a payout of around £130m.

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So far, LME board members have said that the price of the exchange would not be the only issue on which they would base a decision on whether it should be sold or not.“Price is a consideration, but only one of many,” says Gavin Prentice, managing director of large commodity broker Marex, which was bought by former Lehman Brothers executive Jeremy Isaacs.

Other issues that are important to members include access to the LME’s extensive warehouse network across the globe, low fees, the trading ring and the flexibility to price metal on any given day.“Many other exchanges don’t have that,” says Prentice. On most other exchanges the prices for metals futures are quoted in one-month increments.

The LME is the only one where the price is set daily. It is important, agrees Fabian Somerville-Cotton, head of listed commodity sales at HSBC and shareholder representative director to the boards of LME Holdings and the LME. He says: “The forward date structure, the warehousing is unique. We want to safeguard that,” adding that it was by no means clear that a deal would be done.

LME has warehouses worldwide, which have been used to create an additional source of earnings for several financial institutions involved in the metals trade, as they have tied up large quantities of aluminium in warehouses in North America. Access to finance with extremely low interest rates has made it easy to buy metal at the exchange using high leverage, store it in warehouses, and sell later at a higher price. The practice has provoked concern from aluminium buyers, including companies that use the metal to produce drink cans or cars which have had difficulty getting the metal as it is now tied up in large-scale forward deals.

Interest in the exchange has been sparked by the LME’s decision to expand its services into clearing. Currently, the clearing is still being carried out by LCH.Clearnet, but last year the LME started looking into setting up an inhouse clearing system. An industry insider says that during the consultation

14

process the LME talked not only to member firms but also other exchanges, including the CME Group and Deutsche Börse, to discuss the feasibility of the system. The reasons are manifold.

In May, when it started its public consultation on in-house clearing, the LME said it was concerned that the decisions

by ICE, NYSE Liffe and the LSE to selfclear would undermine LCH.Clearnet’s viability as a horizontal clearinghouse for exchanges. Then, the LME also noted: “With its diminishing exchange portfolio, LCH.Clearnet is focusing on the growing market in OTC derivatives clearing. This could be to the detriment of those exchanges that remain.”

Also, the exchange is less than pleased that LCH.Clearnet launched products in steel independently of the LME, thus competing with the LME’s steel future contract, which had only been introduced a few years ago and was still in the process of building volume.

Serious competition The idea of a vertically-integrated and well-organised commodities exchange that has no serious competition in its space outside the copper and aluminium futures obviously appeals to several buyers. Of those, CME Group seems the most serious contender. The powerful commodities exchange has a market capitalisation of $17.8bn and would certainly be able to finance the deal. It is prominent in oil, energy and agricultural commodities but its metals portfolio consists only of copper in base metals, and gold, silver, platinum and palladium in precious metals. The acquisition of the LME would consolidate its position as the biggest commodity exchange in the world and give it coverage of all key base and ferrous metals. However, some players would prefer the LME to remain independent and feel that the untrammelled growth of the CME Group is something of a concern, rather than being an optimal solution. CME’s director of communications Allen Schoenberg would not comment on the issue.

Meanwhile, the Singapore Exchange, a growing player in Asia with market

capitalisation of $5.4bn, showed interest in expanding into the metals market earlier this year when it started trading joint LME-SGX contracts in copper, aluminium and zinc futures.

Both exchanges are looking over their shoulder at rival Shanghai Metals Exchange, which has direct access to the largest and fastest-growing metals customer base in the world. The importance of China in the metals market cannot be overstated given that it is by far the world’s largest consumer of most raw materials. Singapore Exchange is keen to compete with the larger Hong Kong exchange, recently made a bid for Australia’s ASX—which was blocked by the Australian government—and is keen to establish a more prominent footprint in the region.

However, there are questions about the feasibility of its plans.

The powerful Deutsche Börse Group may also be a contender as in the past it has tried to make inroads into the commodities market, but its main commodity contract at present is XetraGold, a gold bond. It is no stranger to competition against the CME Group via its derivatives platform Eurex. However, the likely tie up with NYSE-Euronext might keep the vertical exchange group occupied for the short term.

In the interim, LME’s Abbott is promising a long period of silence as negotiations go to and fro. The exchange will open its data room in early December, allowing prospective bidders to view confidential information before deciding whether to make a formal offer. If an offer is made it will be put before shareholders in the first or second quarter of next year and the exchange doesn’t expect a decision before the third quarter of 2012, at the earliest. This will allow the exchange to work on its clearinghouse plans, which are expected to take 24 months once approved.

Although not a significant period in M&A terms, given the speed at which the debt and equity markets are currently changing direction, this seems a very long time in which both runners and riders might change tack. I

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IN THE MARKETS

DEFINING THE FUTURE OF GERMANY’S LANDESBANKS

Exposure to toxic assets has dogged the German banking system for some years now. The entire banking system came under sustained pressure through 2008-2009 because of the significant levels of exposure to toxic US mortgage debt, a fact which severely strained the fortunes of the landesbanks. Now it is the turn of Greece to threaten the stability of the landesbank segment. The system’s stability ultimately came via substantial government support measures. Nonetheless, it looks something of a temporary patch as Germany’s landesbanks continue to exert pressure on the whole system as they strive to develop a viable business model. Continued weak capitalisation in much of the segment will encourage continued consolidation. Lynn Strongin Dodds reports.

Landesbanks searching for a long-term viable business outlook ERMANY’S LANDESBANKS MAY have passed the European Union’s (EU’s) stress tests this past spring but the road to recovery continues to be painfully slow. Even so, “I think it is important to distinguish between the different landesbanks and not place them all in one basket,” says Michael Dawson-Kropf, senior director, financial institutions at Fitch. Over the past six years a differentiation has taken place but this has been ignored when analysts write about the sector.

However, all banks are looking for new profit-generating businesses because of the decline in profits from investment banking and retail operations.” Even those landesbanks which are viable “might need to do more to adjust their balance sheet in light of their wholesale funding profile,” he adds.

The landesbanks’ original remit was to help regional governments to support local business as well as to offer wholesale services to local German savings banks. The sector also catered to large corporate clients. That relationship with Germany’s states has not always been easy. Historically, the states provided a cast-iron guarantee to the landesbanks, which allowed significant leeway in lending. Those hallowed days came to an end in 2005 when the states no longer issued a guarantee covering the liability of the landesbanks (the so-called Gewährträgerhaftung) or ensured the maintenance of landesbanks on state books (the Anstaltslast). The move was

G

16

Dietrich Voigtlaender, chief executive officer of WestLB in front of the company’s HQ in Düsseldorf, Germany. Photograph supplied by Rolf Bernd Venne/dpa/Press Association Images, October 2011.

overdue, as many observers of the German banking system regarded the landesbanks as either tools of state industrial policy or at worst means of patronage for regional and local politicians. Even so, the landesbanks still benefit from the guarantee on their back lending book, which (under duress from external regulators, such as the EC) will expire in 2015.

With the withdrawal of state backing, the competitive funding position of the landesbanks has been eroded and their cost of funds today is at market rates. To offset the new regime the landesbanks issued a higher than average number of guaranteed bonds to build a liquidity reserve for the times when they refinanced their loans with bonds without state guarantees.

They also invested in rated securitised debt instruments. While landesbanks have been active investors in pfandbrief, they also ventured into other, less successful securitised instruments. This diversification ultimately resulted in buying product tied to the US sub-prime mortgage market, and Greek sovereign debt, in the hope of generating above-average returns. Timo Klein, an economist at IHS Global Insight, an international research company, says: “When the state guarantees were lifted, the landesbanks wanted to raise their profitability and went into riskier assets such as US subprime assets. One of the problems was that they did not have the experience to assess these instruments partly because their boards had a high proportion of

NOVEMBER 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

DEFINING THE FUTURE OF GERMANY’S LANDESBANKS

politicians who did not have the expertise [to understand the risks involved].”

When the sub-prime mortgage crisis exploded the Landesbanks were caught in the maelstrom. Four months before Lehman collapsed in September 2008, the sector reported writedowns of $21bn, which accounted for 43% of total losses incurred by German banks.

This was almost double the sector’s market share based on total assets in the banking industry.

Fast forward to today and the sector not only has to grapple with its exposure to Greek debt, but also impending regulations such as Basel III and the newly-introduced German Bank Restructuring Act. Alexander Hendricks, a research analyst at Deutsche Bank, explains that the funding activities of the landesbanks were largely based on credit-rating arbitrage, which was fine, as long as they enjoyed state guarantees, asset-liability mismatching, and other non-client-related profit streams.

However, Basel III with its liquidity as well as capital requirement and leverage ratios makes these businesses unattractive, with an attendant negative effect on the future profit potential of the landesbanks.

According to Hendricks, the new proposed regulatory requirement on liquidity, for example, eliminates the eligibility of a meaningful portion of assets currently held for liquidity purposes, such as bank bonds. Landesbanks will need to replace these instruments in order to comply with the new rules which in turn will reduce asset yields and overall profitability.

Not surprisingly, the sector is under intense scrutiny by the EU policymakers as well as credit agencies. In May, ratings agency Moody’s put the sector on review for a downgrade. Its view was that the long-term debt ratings of the public lenders in most cases could be lowered by one or two notches although this analysis, noted the ratings agency, is not based upon the deterioration in financial strength as several banks are showing a degree of recovery. Instead, the reassessment is tied to the slower-than-expected

18

Timo Klein, economist, IHS Global Insight.

Photograph kindly supplied by IHS Global Insight, October 2011.

Michael Dawson-Kropf, senior director, financial institutions at Fitch. Photograph kindly supplied by Fitch, October 2011.

pace of growth and concerns over support by regional governments and savings banks.

In consequence, the sector will have to undergo radical reform. Actually, reform has been on the cards since the turn of the century, although precious little has been achieved in the interim. More recently, the IMF has insisted that the sector be restructured, given that public ownership has not resulted in strong returns. A number of initiatives have since been in train. The German Council of Economic Experts, a group of economists that advises the German government and parliament on economic policy issues, has also recommended a fundamental restructuring of the sector.

Andreas Dombret, a member of the executive board of Germany’s national bank, Deutsche Bundesbank, recently put out a statement calling for a closer partnership between the landesbanks and savings banks. He argues that landesbanks should offer banking services for the small and medium-sized enterprises (SMEs) and act as payment transactions manager for regional savings banks. Not everyone thinks this is a panacea for the landesbanks. An Institute for Monetary and Financial Stability paper entitled On a fundamental reorganisation of the landesbanks and savings bank sector in Germany, by Hilgert, Krahnen, Merl and Siekmann, notes: “There will be increased competitive pressure in savings bank-dominated market segments (private banking and SMEs). The private sector is largely consolidated through the merger of

Unicredit and HVB, Commerzbank and Dresdner Bank and Deutsche Bank and Postbank. There are also formidable competitors from other countries (ING, Santander/SEB and Credit Mutuel/Targobank) whose privateclient-focused business models in their respective home markets have clearly demonstrated their ability to succeed in these markets.”

Consolidation is also another option.

“Ideally, landesbanks should consolidate both vertically, but more important, horizontally, as new regulation benefits traditional banking, (particularly retail banking). But savings banks are unlikely to be supportive, in our opinion,” says Dombret.

While mergers are not a new theme, various merger proposals over the years have typically been scuppered by local officials. However, leading policymakers such as finance minister Wolfgang Schaeuble and economy minister Rainer Bruederle have put it firmly on the table once more. Harm Semder, an analyst at Standard & Poor’s, says consolidation is an imperative and some landesbanks will have no choice over the matter. “It is because most of the landesbanks operate in wholesale banking and the conditions continue to be difficult. Most lack access to a stable retail funding base and while some operate in niche sectors such as shipping, they too are cyclical and are prone to risk.”

The Helaba/WestLB merger There is hope that the proposed integration between Hessen-Thüringen (Helaba) with the revamped WestLB

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IN THE MARKETS

DEFINING THE FUTURE OF GERMANY’S LANDESBANKS

could trigger other mergers and acquisitions. WestLB, which is owned by the German state of North Rhine-Westphalia and local savings banks, has enjoyed a roll call of suitors and restructuring strategies, but has often been left alone at the altar. Last November, it looked as though Bayerische Landesbank (BayernLB) was going to make a move to create German’s third-largest lender, but it pulled out of talks because it said a combination wouldn’t “sufficiently” boost profitability. In March, potential suitors Apollo and Lone Star were slated to make non-binding bids for the bank, but this came to nothing also.

There are more encouraging signs in the Heleba transaction. Helaba has started the due diligence process and the EU has given its blessing to the deal.

In addition, the government of the German state of Hesse has offered its seal of approval for the group to act as a central bank for the savings banks in Hesse, Thuringia and North RhineWestphalia.

The Frankfurt-based Helaba is among the few landesbanks that emerged from the financial crisis relatively unscathed. Aside from acting as a savings bank for its region, its main focus is on wholesale business, private customers and SMEs as well as public development and infrastructure business. It did not place risky bets on asset-backed securities or other derivatives and did not need state aid. Only in 2008, the year at the peak of the financial crisis, did the bank report a relatively small loss in terms of net attributable profit, while it made positive results in all other years from 2006 to 2010.

In contrast, West LB, which was the most globally ambitious landesbank, was hit the hardest. Since the subprime crisis, it has received several bailouts, including €3bn in Tier 1 capital from Germany’s Sonderfonds Finanzmarktstabilisierung (SoFFin), the country’s financial market rescue fund.

It was also given a helping hand from its key shareholders. According to a Deutsche Bank report, in April 2007

20

WestLB suffered major losses from proprietary trading involving spreads due to sharp price movements tied to a takeover bid as well as from a violation of internal trading limits.

WestLB also has the unenviable reputation of being one of two banks in the country that had to parcel off unwanted assets into a “bad bank” or Erste Abwicklungsanstalt (EAA) to be wound down. The nationalised property lender Hypo Real Estate is the only other landesbank to be forced down this route.

After several restructuring drafts, West LB shareholders in June approved a plan that hived off business related to the savings banks (Sparkassenverbundgeschäft), including mid-cap corporate lending activities, with a total balance sheet of €40bn-€45bn to a new credit institution, Verbundbank. The group will be established and capitalised by the Savings Banks Finance Group on June 30th 2012. All assets that are not sold by that date will be transferred to the EEA.

A helping hand As for other landesbanks, BayernLB, HSH Nordbank and Landesbank Baden-Württemberg (LBBW), Germany’s largest landesbank, have all needed a helping hand from the state and are in various stages of restructuring. The fate of others however is still hanging in the air. This is particularly true of BayernLB, the second-biggest Landesbanken and among the ten biggest German banks, with total assets of €316bn. It has variously needed a €10bn capital infusion and a €4.8bnguarantee for a portfolio of asset-backed securities from its home state of Bavaria during the financial crisis.

BayernLB launched the restructuring programme “Hercules” with a renewed regional focus on Bavaria, Germany and selected European regions as well as an emphasis on the core customer segments. This includes the Mittelstand, corporates and institutional clients, savings banks, commercial real estate and retail

clients. However, the EU isn’t close to reaching a decision on the plan and in September, European competition commissioner Joaquin Almunia reportedly said that it was “taking much longer than I wish”and that“we are still far from giving our support to a viable business model”.

Bavaria’s savings banks, whose stake in the lender fell to about 6% following the bailout, may also be required by the commission to convert €40m in so-called silent participations into core capital.

Although BayernLB appears to be on the right track, it has been sideswiped by the Greek debt crisis and had to take writedowns in the first half which caused half profits to plunge by 56% as part of the revamp.

“At the end of the day, [BayernLB] needs to develop a sustainable business model for the long term,” says Klein. “They need new equity capital and that will only be received if they have a model that can withstand the test of time and allows them to stand on their own feet without state aid. At the moment, they are still in limbo.”

This however is not the case for HSH Nordbank, one of the world’s largest providers of shipping finance. The EU approved its plan ending state aid while allowing the state of Hamburg and Schlewig-Holstein to continue as controlling shareholders. The bank is required to make a one-off payment of €500m to its two majority shareholders for a €10bn “risk shield” they put in place to protect it from losses on impaired assets. It also received €3bn of capital and benefited from €17bn of liquidity guarantees.

Under the plan, the bank, which has already cut jobs to 2,100 from 3,300, will have to whittle down its balance sheet by more than 40% from its 2008 figure to €120bn by the end of 2014. It is also expected to withdraw from asset-backed aviation finance and it will limit property finance to its home market. Its shipping book will also have to be halved from €30bn to about €15bn.I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

WHY VIX TEACHES US TO LOVE VOLATILITY

Is the VIX a proper fix for volatility?

Throughout 2011, CBOE Futures Exchange (CFE) has logged repeated month-over-month record volumes for Volatility Index (VIX) futures, with August reaching a peak of 1,826,241 contracts.

August 4th and 5th were its two most active trading days ever, and even the 41% drop in September left volumes up 154% over the previous September. CBOE’s VIX options contracts also notched records. Whatever form volatility index-based products take, and at least while the global markets continue to cause concern, volatility is very much a part of the financial atmosphere. The question is: how easily or how long can we live with volatility? Ian Williams goes in search of some answers.

REUTERS’ HEADLINE in July said it all:“Wall Street posts worst day in a month, VIX jumps.”

Reflecting falling levels of the S&P 500 Index last summer, volatility in the equity markets jumped to higher levels.

With equity market participants looking for a risk management tool to offset those drops, CBOE Volatility Index (VIX) futures and options trading and other volatility products grew in volume and in a very volatile August, about 13.4m VIX options changed hands, up 178% over August 2010.

With deep uncertainty in equities, fund managers and others were invariably trying to hedge their positions, but, of course, active traders also saw volatility as an opportunity. In that regard, with outflows in domestic equities over the same period exceeding $100bn, it was something of an opportunity. There are still signs that retail continues to pull out of stocks in the face of continued uncertainty, but equally they are unhappy at catastrophically-low bond yields with the kind of returns you would expect from stuffing your mattress with greenbacks.

VIX, aka the“Wall Street fear gauge,” was designed by the CBOE back in the 1990s, and its reflection of volatility is studied closely even by investors who do not trade in its variants. Its mathematics appears to the uninitiated to have as much to do with astrophysics as with finance, but it has gained wide acceptance. CBOE introduced the VIX futures in 2004, to great effect. CBOE director of research and product development John Hiatt notes that usage

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Photograph © Sergey Ilin / Dreamstime.com, supplied October 2011.

has grown in scope since then.“When VIX futures was launched in 2004, the product was used mainly by institutions. Hedging credit market exposure was fairly common, since there was a high correlation between the VIX and the prices and credit markets. Over the past few tumultuous years and months, the user market for VIX futures and for VIX options—which began in 2006— has grown dramatically as these products are useful tools for those looking to hedge against declines in their equity portfolios.”

Long-time options trader Sal Gilbertie concurs: “The volatility is the thing to trade, so the opportunists will seize the opportunity, getting in and out quickly to generate returns using the leveraged products, but also since you can hedge with them, portfolio managers use them to hedge against volatility, usually with unleveraged products. It means that while you’ll

always have uncertainty, you can manage the volatility.”

He comments on CBOE’s product range:“Their extreme popularity shows that they hit it right. It takes a long time to get these products to market, so it depends on the vogue by the time you do.”

One of the keys to their success, explains Hiatt, is their accessibility in the United States, the result of working productively with US regulatory agencies. “Our goal was to have the VIX index itself classified as a broad-based security index so that we could list both futures and options.”

The accessibility of VIX products was further enhanced with the launch of an exchange-traded note (ETN). As an example, Hiatt states: “I can trade the ETN in my 401(k) account here at the CBOE because it is a cash account, but I can’t trade the option or future. So, in terms of new product being brought

NOVEMBER 2011 • FTSE GLOBAL MARKETS

in, I think that the two biggest things were the options and the ETN, as well as a larger class of investors, which underlies the recent growth.”However, he admits that, building on that basis, “the biggest factor in such high volumes, especially in August of this year, was the market volatility and how much the VIX would move with it”.

Although they are mostly institutional products, they are available in retail, but indicatively, VelocityShares, which has a bundle of VIX-based products, warns ominously: “The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day. Accordingly, the ETNs should be purchased only by knowledgeable investors who understand the potential consequences of investing in volatility indices and seeking inverse or leveraged investment results, as applicable.”

For Steve Quinn, head of distribution for Connecticut-based VelocityShares, this clearly means institutional investors, and he says: “Our products have only been out for less than a year, and they have grown to more than $500m in assets, as volumes have picked up.” He points out:“At times the volumes of the products themselves are greater than the volume in the underlying futures, which is unique compared to other ETN products. Historically, the VIX volatility has been rather high, and for people who have used similar exchange-traded products, the key factor has been the shape of the curve, and we spend a lot of time with our users on how best to use our products. It’s usually for portfolio protection.”

At first glance, VIX options seem to epitomise what George Soros called amplifying “reflexivity”, the self-reinforcing tendency of market traders to chase their own collective tail. So are VIX and its offspring creating or reflecting the volatility we see, or at least are they boosting it? Hiatt replies: “If we had the same equity market volatility and didn’t see some of the issues that we’re dealing

FTSE GLOBAL MARKETS • NOVEMBER 2011

with now on a broader economic sense, it would be a more interesting argument.

I don’t think you could say that now, given the things happening in the eurozone and even in the United States, when we’ve got such a troubled path in the US budget, and the way the economy is in general. I think that has more to do with equity market volatility than any volatility product.”

He explains: “The level of the VIX is really ultimately driven by the volatilities implied by the S&P 500 index options. Those option-implied volatilities typically are reflecting the realised volatility of the S&P 500 Index itself. It is more complicated to make a direct connection between the optionimplied volatility driving volatility in the stocks themselves.”

Future prospects So, apart from more volatility, what does the future hold? The products based on it do indeed seem to reflect accurately investors’ apprehensions about market conditions, which is why, according to some observers, they are becoming too expensive as insurance as volatility expectations rise. Seth Masters, chief investment officer of AllianceBernstein, is one of those who considers the cost of insurance too high and concludes: “Right now, equitymarket risk is so high relative to its short-term return potential that it makes sense to reduce (but not eliminate) equity exposure.” Indeed, earlier he had recommended selling exposure to the euro as a cheap and effective way to hedge equity-market risk since the transaction costs for selling the euro forward are minimal. But even then, he cautions, such an indirect hedge has risks “if the high correlation between the euro/dollar exchange rate and the S&P 500 broke down”.

Serious defaults on the euro could of course precipitate that, in which case the historically minded calculate that the VIX that reached its record of 89.53 on October 24th in 2008 could go over a 100, the level it would have reached if it had been around in the 1930s.

Future prospects might be enhanced by the high probability that the variance swaps used as an alternative strategy by some are highly likely to come under closer regulation if and when Dodd-Frank is rolled out in its entirety. Hiatt suggests: “It’s probable that something like that, a variance swap, is going to be considered a contract that needs to be cleared and can’t be a bilateral over-the-counter swap any more. In that case, that type of product is likely to move to a swap execution facility, or even something like a contract that we list now, which is a futures contract that pays you the difference between applied and realised volatility, or variance.”

Andrew Keene, a trader who comments regularly on the CBOE website, says: “The CBOE, CBOT, and CME continue to release products hoping they’ll ‘catch on’ and generate more volume and profit; similar to CocaCola’s strategy when releasing Coke Zero, Coke Zero Cherry, etc. The more products the company has, the better chance it has to maximize profit.”

Even so, the strategy seems to have succeeded, since. He recalls:“When the VIX was first released there were three market makers in the pit. Now, there is probably closer to 60. The VIX is such a great product for many reasons. These days, people can lose 20% of their 401k within weeks; hence, investors, retail customers, and speculators can use the VIX to hedge their portfolio. For example, the general population owns stocks; no one ever shorts stocks in their 401k. Now, an investor can buy calls in the VIX hoping to hedge their portfolio.”

He also explains the thrill for traders: “Just as gold, oil, and silver has speculators, the VIX has traders off the floor trying to predict the market’s direction by using the ever-popular VIX options.

In general, traders like to trade stocks, options, and indexes that have large movements and spikes. Like gambling, traders do not want to play bingo and sit and wait; they want to play craps because it is fast, exciting, and actionprone, just like the VIX.”I

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Man Utd IPO stalled by an indifferent season Football finance is a touchy subject. Fans, typically, do not like the idea of their club having a commercial focus: for them it is all about the “beautiful game”. The UK’s most high-profile football club, Manchester United (Man Utd), rocked fans and investors alike this year planning a relatively modest $1bn IPO on the Singapore Stock Exchange to leverage the club’s popularity across Asia. It hasn’t quite worked out that way and the question now is when will the IPO actually make its debut?

It was slated for later this year but turbulent market conditions tied to the eurozone debt crisis and fears over the global economy have forced Man Utd as well as several other companies to put their listings on ice. What now for the club?

Lynn Strongin Dodds reports.

CCORDING TO FIGURES from Dealogic, more than 200 IPOs worth an estimated $44.1bn have been shelved so far this year. In Singapore, Manchester United (Man Utd) joins India’s Fortis Healthcare Group, Singapore’s CPG Capital Partners investment banking and funds management group, as well as the UK’s Fitness First, in having to postpone fund-raising plans, at least for the last quarter of this year and probably until the first quarter of 2012.

Reports are that the club owners, the Glazer family, who are also owners of the American football team Tampa Bay Buccaneers, are still setting their sights on the end of this year or early next, providing markets stabilise. It may not be an easy sell. Both fans as well as investors have held up the red card over the family’s desire to retain control of England’s premier football club. As it stands, around a third of the equity in the club—with an approximate value of $3bn—will be sold but only 12% will be in the form of ordinary shares with full voting rights; the minimum free float required by the SGX. The balance will be non-voting perpetual preference stock without dividend guarantees or the right to sell the

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shares back to the club, both common features of preference share issues.

In fact, SGX’s main attraction was that it allows these types of offerings.

Until June, the Glazers were eyeing Hong Kong but they switched their allegiance when the Hong Kong Stock Exchange, which banned dual share listings in 1991, is believed to have refused a waiver. One of the only other markets which allow dual share structures is the US, which is home to Chinese internet search giant Baidu, Google and Rupert Murdoch’s News Corp, all of which have two classes of shares. Geoff Mesher, a forensic partner in Grant Thornton’s sports advisory team, says: “We have seen other companies follow a two-tier structure but Man Utd is breaking new ground for a football club although it has been controversial.”

The Glazers’ defence is that they do not want to bow to short-term financial pressures and a controlling stake enables them to be nimble for the long-term benefit of the business. They have said that this structure works best due to the rapid nature of decisions required and specialist knowledge of the football transfer market, according to Rajiv Biswas, Asia-Pacific chief econ-

omist at the IHS Global Insight consultancy in Singapore.

Fans as well as investors are not that convinced. These two-tier structures have typically come under criticism because of corporate governance issues and risks that a controlling shareholder will place their own interests ahead of others which could negatively impact performance. In fact some believe that the dust this topic has raised may be the real reason behind the delayed IPO. Duncan Drasdo, chief executive of the Manchester United Supporters’ Trust (MUST), says that apparent nervousness about the timing was down to the reluctance among proposed cornerstone investors to sign up for a chunk of the equity ahead of the IPO because of the structure; moreover, that the valuation at £3bn is seen as too ambitious.

Other reports in the press however state that talks with these potential investors are still ongoing, although so far only Temasek, the Singapore state investment agency, has been named.

Additionally, the club’s recent set of figures indicate that the $3bn pricetag might be too optimistic. Even so, the club’s fortunes are improving with pretax profit for the year to June 30th this year moving into the black at £30m

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Manchester United’s team warms up before a friendly match against a Malaysia XI side at the National Stadium, Kuala Lumpur, July 2009. Photograph © Jaggat ... / Dreamstime.com, supplied October 2011.

after a loss of £15m the previous year.

However, net profit was only £9.8m, which some analysts see as a poor return on group revenue of £331m. In addition, interest payments of £43m on the gross debt of £515m accounted for two-thirds of the club’s operating profit, while accounting measures such as an unrealised £16m foreign exchange gain helped boost the bottom line.

The family issued a £526m bond to refinance their loan last year and paid off £220m of punitive, high-interest, payment-in-kind (PIK) loans taken out in 2006, which had accrued more than £20m of interest. Details were not disclosed but some analysts believe that proceeds from the bond offering were used.

Although opinion is clearly divided, Roger Tan, chief executive at Singaporebased SIAS Research, an independent research firm, believes the “delay of the IPO is down to a mixture of reasons”. He adds: “The market is definitely against them and they will not get a good valuation if they list today. However, there has been some controversy over the way they are trying to raise funds. Fans as well as some investors were not happy with the mixture of preference and ordinary shares because it would dilute their

FTSE GLOBAL MARKETS • NOVEMBER 2011

voting rights. The Glazer family wants to keep control and this two-tier system allows them to do that.”

Biswas adds: “Financial markets are currently going through considerable stress and I think that is the main reason why the IPO was pulled.

However, the two-tier structure could have an impact on investors, especially large institutions which will want voting rights. I do not think this will affect the retail investors who are more interested in buying shares of their favourite club.”

300m fans and counting This is particularly true in Asia Pacific, which is home to an estimated 190m of Man Utd’s roughly 300m fans worldwide. Dave Chattaway, head of sports brand valuation at Brand Finance, says: “I believe Man Utd used the Singapore base for the listing because of the less stringent corporate governance requirements as well as the fact it provides a gateway to Asia. The funds raised will allow the club to further expand into the Asian market through shops, licensing, football schools tours and potentially franchised teams. In addition, the other benefit is that media intrusion as well as fan activism will be less with a Singapore than a London listing.”

The Glazers have been under a barrage of criticism in the UK press from the minute they walked onto the pitch with their £790m buyout of the club in 2005. The debt rankled and hard-core fans have continually protested their opposition to the Glazers by wearing the green and yellow colours of Newton Heath, the club’s original incarnation until 1902.

Even so, there is no doubting the impressive performance the club has enjoyed under the Glazers’ tenure. Man Utd is not only considered to be the second-best club in the world behind FC Barcelona but last season overtook Liverpool FC (another top-five English club) to become the most successful club in English football by winning a record 19th domestic title. There has also been the UEFA Champions League title in 2008 and runners-up positions in 2009 and this year.

In addition, the club has scored a winning goal in the all-important branding stakes. Figures from the latest Brand Finance survey, which assesses the top 30 European clubs, show that Man Utd has overtaken Spain’s Real Madrid with a valuation of £412m; up 11% over 2010. Real’s brand is estimated to be worth £401m followed by Barcelona at £392m. The Glazers have signed deals with over 20 global partners (including Nike, Aon, Audi and DHL) which together pay £110m a year to be affiliated with the club.

The bottom line according to Chattaway is that the hard-edged business side of football is at odds with fans.

“Man Utd is at the forefront of the business side of football. They strive to be the best, most consistent, creative but also ruthless club on and off the pitch. It has an incredibly strong brand that is valued on a global basis and the Glazers have set the benchmark and blueprint of how to run a football club

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Rajiv Biswas, Asia-Pacific chief economist at the IHS Global Insight consultancy in Singapore. Photograph kindly supplied by IHS Global Insight, October 2011.

Roger Tan, chief executive at Singaporebased SIAS Research. Photograph kindly supplied by SIAS Research, October 2011.

Geoff Mesher, a forensic partner in Grant Thornton’s sports advisory team.

Photograph kindly supplied by Grant Thornton, October 2011.

as a business. Many clubs are already following in their shadow, such as Chelsea and Liverpool, but I think many would be wise to devise their own strategy, such as pursuing a local rather than global approach, like Aston Villa, or viewing themselves more as a national team such as Bayern Munich [which has] less global ambitions.”

Kevin Alavay, director at consultancy, Initiative Futures Sports and Entertainment, agrees, adding:“There needs to be a clear distinction between the business of football and the game itself. Fans have to stop letting their hearts rule their heads. Man Utd is a professionally-run business and like many other companies it is going to the market and raising capital to pay down debt. It also wants to get closer to its Asian fan base. However, it is dangerous to think about the Man Utd experience and then generalise about the football industry overall. I do not expect to see other football clubs following in their lead and listing on exchanges.”

Mesher echoes these sentiments.

“We have also already had an experimentation of football clubs listing in the 1990s and that was disastrous because overall they were run inefficiently. One issue is that there is a real blur between the emotional and rational. This is why perhaps we have

seen successful businessmen, such as Alan Sugar, who took over London side Tottenham Hotspur, ultimately end in them leaving the club. Overall, at the current time, it is questionable as to whether a rational investor would put money into the sector in the anticipation of making a profitable return, with the possible exceptions of Man U, Liverpool, Arsenal and Chelsea; that is, the biggest brands. The main reason that the industry is not currently a good investment is due to the high wage-toincome ratio in some clubs.”

The pressure to succeed at all costs is not exclusive to UK clubs. According to the latest tome on the industry’s finances by Deloitte, cost control remains the biggest industry challenge with the wages of the“big five”leagues jumping 8% or €400m to over €5.5bn in 2009-2010. Italy and France exceeded the absolute level of revenue growth while revenues and wages in England and Germany both grew by similar amounts. By contrast, Spanish aggregate wages (excluding Barcelona and Real Madrid) fell with the overall wages/revenue ratio of 60% representing a ten-year low.

Taking a closer look at England’s Barclays Premier League, in general clubs are not in robust health. The Deloitte report shows that the 2009-2010

season ended with pre-tax losses spiralling to £445m from £275m the previous season. In contrast, total wages continued to climb, outstripping revenue growth for the second year running with a 5% or £64m hike to over £1.4bn, propelling the league’s wages/revenue ratio to a record 68%.

Chelsea tops the league as the highest spender, splashing out £174m on wages, followed by Manchester City at £133m. Manchester City has usurped Man Utd, which is now in third place at £132m. City has been on a wild spending spree since being bought in 2008 by Sheikh Mansour bin Zayed Al Nahyan, the brother of the ruler of Abu Dhabi, the richest of the United Arab Emirates.

Next year’s results though could look very different. There is hope that that the UEFA financial fair play regulations will level the playing field for the 660 top division clubs scattered across 53 European countries. The rules, which are being gradually phased in starting next year, will require clubs to break even over a rolling three-year period if they want to play in the Champions League or Europa League. Going forward, it will no longer be down to the size of the club’s wallet but a sharper financial acumen will be needed in order to stay in the game. I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

MANDATES

DATE

MANDATE/ VALUE

WINNING FIRM/ CONTACTS

CLIENT/ CONTACTS

COMMENTS

13 September 2011

Securities lending mandate. The mandate covers, fund accounting, transfer agency, global custody and securities lending./$4bn

Citi

Diamond Hill Capital Management

Laird says that Citi won the mandate because of the value the bank puts on “fitting seamlessly into our operations with a consolidated service model.”

14 September 2011

16 September 2011

21 September 2011

Investment operations outsourcing agreeement, covering investment teams in Asia-Pacific, Europe & North America.

Services include posttrade support, valuations and data management./ Mandate value was not available, though RCM has $154bn AUM globally.

Fund accounting & transfer agency services./n.a.

ETF custody mandate including fund administration, fund accounting and custody.

Also JP Morgan Clearing Corp will provide prime broking for four of the seven new funds./n.a.

Joseph Rezabeck, managing director, Fund Services

James Laird, chief financial officer & president of Diamond Hill Funds

Northern Trust

RCM

Peter Cherecwich, head of global fund services

Michael Hooper, executive chairman UK & chairman of RCM Global Operations Group

Phoenix Fund Services

Chelverton UK Equity Income Fund

John Rice, managing director.

William van Heesewijk, principal

JP Morgan

FFCM

Robert Caporale, head of new business development, Americas and Devon George-Eghdami, head of prime custody solutions

Bill De Roche, founder of FFCM LLC, a Boston based advisor to QuantShares

RCM is an Allianz Global Investors company.

Members of RCM’s operations in Hong Kong will join NT. NT won the mandate on the basis of its “global operating model” and “commitment to Hong Kong” said RCM.

The fund is a Chelverton Asset Management’s UK OEIC. The fund specialises in UK small and mid cap equities.

The mandate is to provide securities services to FFCM’s newly launched family of ‘market neutral’ ETFs QuantShares. Reportedly, they are the first ETFs to engage in shorting physical securities.

21 September 2011

Subcustody for Deutsche Bank’s proprietary and client assets in Egypt.

Services will include custody and settlement/ n.a.

Société Générale Securities Services (SGSS)

Deutsche Bank

This mandate builds on SGSS’s claim to have a growing role in the provision of sub-custody services in the MENA region. SGSS claims a leading market position in Morocco.

27 September 2011

ETF services, fund accounting, fund administration, global custody, securities lending and TA services./ n.a.

BNY Mellon Asset Servicing

Teucrium Commodity Funds (The Teucrium Wheat Fund, the Teucrium Soybean Fund & the Teucrium Sugar Fund)

The funds are designed to provide investors with the opportunity to invest directly in soybeans, wheat or sugar without having to trade futures contracts.

28 September 2011

Securities lending services OFM is a long time participant in securities lending on a third party basis./n.a.

FTSE GLOBAL MARKETS • NOVEMBER 2011

Joseph Keenan, managing director and global head of ETF service.

Deutsche Bank Tim Smollen, global head of agency lending

Sal Gilbertie, president of Teucrium Trading.

The Office of Financial Management of the government of Kentucky (OFM)

The mandate was won by Deutsche Bank’s Trust & Securities Services division. “Our approach addresses the evolving needs of investors who are demanding greater sophistication and transparency from their provider,” says Smollen.

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MANDATES

DATE

MANDATE/ VALUE

WINNING FIRM/ CONTACTS

CLIENT/ CONTACTS

COMMENTS

4 October 2011

Global custody and trustee services for Dublin registered funds./n.a.

Citi

Eaton Vance International

Eaton Vance and its affiliates manage $199bn in assets. The firm chose Citi so it could access their proprietary, local sub-custodian network and wanted an integrated custody solution.

Chandresh Iyer, head of global custody and investment services at Citi

6 October 2011

Depositary bank and valuations/€300m

Société Générale Securities Services (SGSS)

Edifice Capital

Edifice Capital is establishing a French domiciled real estate fund (FCPR). SGSS already services some 60 asset managers working in this segment.

Edifice Capital develops its funds in the eurozone, Morocco and Central and Western Africa.

12 October 2011

Custody services.

It is a full service mandate, including tax, accounting and regulatory reporting./ AUD24bn

Northern Trust

Commonwealth Superannuation Corporation

CSC was established on July 1st this year, following the merger of Australian Reward Investment Alliance (ARIA) & Military Super boards and the Defence Force Retirement and Death Benefits Authority. CSC is NT’s third client in Australia and its first full service mandate. NT is also custodian for the AUD75.1bn Future Fund and the NZD17.4bn New Zealand Superannuation Fund and provides outsourced middle office services to the AUD60.2bn fund manager QIC.

Jeremy Hester, head of sales NT Australia

13 October 2011

Depositary bank services/€3bn

Société Générale Securities Services (SGSS)

LBO France Gestion

SGSS will provide depositary bank services for 54 French-domiciled venture capital funds (FCPR). Over 100 non-listed stocks representing over 600 positions were migrated in one month as part of the mandate. LBO France manages (on non-listed and real estate markets) varous FCPR reserved for qualified investors.

20 October 2011

Global custody mandate/n.a.

Bank of New York Mellon Asset Servicing

Industrial and Commercial Bank of China (ICBC) for its new qualified domestic institutional investors (QDII) fund, launched by Harvest Fund Management.

The new fund is called the Harvest Gold Fund.

Harvest Fund Management was founded in 1999 and is headquartered in Shanghai. “With prevailing challenging global markets, exposure to commodities is in demand,” says Chong. Moreover, he adds: “We expect the number of QDII funds approved by the regulator to potentially double by the end of 2011.”

FrontFour Capital Corporation

FrontFour Capital is a privately-owned investment fund manager. Its FrontFour Opportunity Fund is a value, event-driven fund which invests in credit and equity securities.

Chong Jin Leow, head of Asia.

25 October 2011

28

Michael O’Brien, CFA, head of global trading for Eaton Vance

Hedge fund servicing and administration/ n.a.

CIBC Mellon Tom Monahan, president and chief executive officer

26 October 2011

Custody and prime broking services, including margin financing, clearing, securities lending and borrowing facilities & custody services./n.a.

Newedge UK/ the wholly-owned subsidiary of Newedge Group

BIA Funds, including the BIA Pacific Macro Master Fund and BIA Pacific Master Fund

Newedge UK is jointly owned by Société Générale and Credit Agricole.

26 October 2011

Additional hedge fund services, including custody, financing & reporting services./n.a.

Deutsche Bank

Jupiter Asset Management

Jupiter already works with Credit Suisse, which is the asset gatherer’s current prime broker and custodian; this new agreement with Deutsche Bank depends on the type of assets acquired by Jupiter.

NOVEMBER 2011 • FTSE GLOBAL MARKETS

FX VIEW

What is a currency, anyway? Is it a proxy for a nation’s economy? Is it a medium through which to facilitate an exchange of payments between parties? Is it simply something to trade and speculate on? If you answered “all of the above” then you are probably in good company, and you are also likely questioning the provenance of this whole euro thing, writes Erik Lehtis, president of DynamicFX Consulting.

REFLECTIONS ON THE NEXT STAGE OF EURO EVOLUTION

To be, or not to be?

The euro in question Erik Lehtis, president of DynamicFX Consulting. Photograph kindly supplied by DynamicFX Consulting.

currency would depreciate in response to negative investment and speculative flows. This would lead to inflationary pressures on imported goods and services in the country, which would floating sovereign currency gives is NE OF THE other functions inspire either domestic production of the ability to separate the impact of of a currency in a market such items, a renewed commitment to external pressures from internal economy is to help adjust budgetary discipline, or both. Either consequences. If the market doesn’t internal prices to reflect the action of response is fine and exactly how a like your bonds, it can sell them. If it external forces. Real, hard assets go wants to short your country, it can sell functional market mechanism is up and down in price in response to supposed to work. In effect, the euro your currency. If it can’t short your supply and demand. The supply and country, it has to pick on a hard asset, subverts the market mechanism by demand function is itself an outcome creating the appearance of an economic of many inputs, including perception. such as real estate, or sovereign union that doesn’t really exist. In a lot of bonds, or equities. A lower exchange There are a great many things that ways, it is surprising the euro has lasted rate insulates citizens of a country can alter the perception of value, and as long as it has. The lack of alignment somewhat from external selling sometimes these perceptions get between these disparate fiscal entities rather one-sided. Lately, we have seen pressure, since much of that pressure ends up reflected in the exchange rate and their monetary singularity makes it immense downward pressure on a fundamentally-flawed construct, rather than the price of the hard Greek government bonds, stemming destined to suffer from repeated tests assets themselves. from the complete inability of the and crises. Thus, now German taxpayers In the case of the euro, there is no Greek government to meet its are arriving at the point where they no way for member countries to short obligations. The market in effect each other’s currencies, since they share longer want to underwrite the wants to punish Greece, but cannot, because there is no drachma. The only the same one. So while individual fiscal consequences of southern European fiscal irresponsibility. way to “sell Greece” is to sell the euro. policies exist and vary widely on a A disclaimer of sorts is in order country-by-country basis, they sink or With the fears of contagion building somewhere here. As a former trader and spreading to Ireland and Portugal, float together in the same leaky of EMS currencies, I am most currency lifeboat. Thus as a matter of we have the makings of a dominodefinitely talking my own book, in the self-defence, they must each sell the like chain reaction as banks and sense that I derived a very good hard assets of the other instead, governments throughout Europe go exaggerating the already negative price livelihood from trading the various down in sequence, with Spain and constituent currencies of the EMS for action on those assets. This results in Italy to follow shortly thereafter. a number of years. I miss those days.

If these countries still had their own more pain domestically, and more Is a return to separate currencies in stress internationally on the currency currencies, there would be a firewall the offing? No, I don’t believe so. As that suffers from perceived weakness around each of these crises which obvious as the inherent flaws in the even as it attempts to stand united. In could be contained by coordinated effect, it is not a whole greater than the euro now are, to me they always were, central bank intervention, individual sum of its parts, but a chain that is only and yet the politicians overlooked said monetary policy prescriptions, and flaws then—they will continue to other mechanisms designed to isolate as strong as its weakest link, and vulnerable to mass flu epidemics every follow the path of least resistance the fire and put it out, along with a even as they wrestle with the time one member sneezes. realignment of currency values. With consequences of this misbegotten A return to individual floating time, value would be discovered in the thing. Hopefully, the benefits of this currencies would mean that as one new exchange rate, and the process country goes off the fiscal reservation its euro are worth it.I would reverse. One of the benefits a

O

FTSE GLOBAL MARKETS • NOVEMBER 2011

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DEBT REPORT

CONVERTIBLE BONDS: MORE MILEAGE THAN HIGH-YIELDS OR EQUITIES

While the capital markets have witnessed an accelerating stampede out of risk assets during the third quarter of 2011, the sell-off of convertible bonds has not been anywhere near the same levels sold at the onset of the financial crisis in 2008. That might be because the investor base in the convertibles segment has fundamentally changed. Andrew Cavenagh looks at the reasons why long-only investors have gravitated to the securities.

Photograph © Chernetskiy / Dreamstime.com, October 2011.

Convertible bonds keep the roof down HEREAS THE MASS exodus from high-yield—which investors could not get enough of at the start of this year—has led some funds in the sector to experience losses of more than 20% in the past four months, the impact of the flight to safety has been much less pronounced on convertible-bond funds. Most have recorded only single-digit losses, and a few have even managed to achieve marginal gains. “So far the convertibles market has not been severely damaged, unlike other sectors of the capital markets,” says Yacine Amor, head of equity-linked origination for EMEA at Bank of America Merrill Lynch (BoAML).

It is easy to see how the combination of protection and upside that convertible bonds offer has made the asset class more appealing than either highyield or equities in the current environment. Even so, the greater resilience of convertibles, compared to the problems the segment faced in the

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downturn of 2008, owes more to changes in the make-up of the segment’s investor base over the past four years than fundamentals in the securities themselves. That fact leads David Clott, convertibles fund manager at Aviva Investors, to state: “By and large convertibles have held up well this year. They are clearly performing as one might have modelled, maybe even better. This is definitely due to the underlying ownership shift that occurred in 2008-2009.”

Even three years ago, hedge funds with highly-leveraged positions accounted for about three-quarters of the European convertible market. They rapidly became forced sellers as the cost of funding soared, which in turn made investments in convertibles either too expensive or risky to hold. By contrast, it is now more traditional, long-only investors who dominate the market. “It has changed completely from where we were pre-crisis,”

explains Amor. “By the first half of 2011, 70% of the investor base was made up of long-only investors.”

While primary issuance certainly dropped off across the board in the third quarter, as mounting fears that the debt crisis in the eurozone would precipitate a secondary worldwide recession sent share prices tumbling once again, up to that point the market outside of Europe had actually been improving in 2011.

Non-European companies launched more convertible bonds in the first half than they had in either of the two preceding years.“It has only been over the last two or three months that issuance has really tailed off,” relates Davide Basile, who manages the global convertibles fund at asset management firm RWC Partners in London.

While secondary market prices have also fallen appreciably, particularly in Europe and Asia, Basile maintains that this trend has simply reflected the wider market trend in all but the safest assets.

“I think right now the secondary market is simply trading in line with the general risk aversion that we’re seeing,”he says.

“But there’s no hedge fund deleveraging this time, and for the most part convertible bonds are doing what they’re meant to do; performing as investors expect them to perform.”

Falling values have also created worthwhile investment opportunities.

Mike Reed, manager of the global convertible fund at BlueBay Asset Management, says: “We think the implied credit spreads you are getting with convertibles are particularly attractive at this time, and we’re finding quite a lot of instances where the fall in price of a company’s convertible has overshot that of its straight bond.”

Reed explains that—barring a disorderly sovereign default and consequent widespread recession in Europe— default rates in the high-yield sector

NOVEMBER 2011 • FTSE GLOBAL MARKETS

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DEBT REPORT

CONVERTIBLE BONDS: MORE MILEAGE THAN HIGH-YIELDS OR EQUITIES

were likely to be a lot lower than current pricing implied, as yields on sub-investment-grade convertible debt hover in the 10% to 15% range and those on even some investment-grade companies have risen into high single figures.

He points to the example of an Australian insurer with a single-A credit rating, whose bonds were offering a yield of 8% in the first week of October.

Investors in convertibles are nevertheless now extremely wary of the debt of European companies, as the continuing failure to devise, never mind implement, a credible long-term solution to the sovereign debt crisis in the eurozone has racked up the pressure on banks in the European Union (EU). “It does really feel like credit has frozen in the European banking system over the last two months,”says Reed. “We as a firm have been very cautious on Europe for some time.”

RWC Partners has long taken a circumspect view. “We completely sold out of southern European names about a year and a half ago, and our eurozone exposure is now only about 8% of the fund,” says Basile. “Based on recent additions, most of that is in Germany, with risk exposure that is more focused on credit dynamics than equities.”

Given the impact the eurozone worries are continuing to have on stock markets around the world, the outlook for further primary issuance of convertibles over the next three to six months is understandably bleak. No company is willingly going to issue convertible debt when its share price is hovering at 52-week lows or worse and heighten the dilution risk for its existing shareholders.

On the contrary, the current environment is encouraging companies, particularly in Asia, to buy back and cancel convertible issues. United Microelectronics Corp, the Taiwan-based chip manufacturer, announced in a stock exchange filing at the start of October that it had done this with respect to $30m of the $500m zero-coupon convertible shares maturing in 2016 that it had issued at the beginning of June.

32

Ku6 Media, an internet television company in China, did the same at the end of September with $50m of senior convertible bonds with a three-year maturity that it placed at the end of June with media entertainment company, Shanda Interactive Entertainment.

Some investors see the same opportunity. First Reserve Corporation, for example, sold convertible bonds in Glencore with a face value of $800m in the first week of September for $1.07bn and then re-invested $956m of the proceeds in 141m of the Swiss commodities giant’s ordinary shares (the same number it had under the convertible option). In effect, the deal meant First Reserve relinquished its downside protection for $118.4m—clearly implying it believed that Glencore’s share price (27% and 28% off its Hong Kong and London peaks respectively at the time) had bottomed out.

Emerging market issuance Companies in the emerging markets will probably be responsible for most of the convertible issuance that will ultimately take place before the end of this year. GD Power Development, a subsidiary of state-owned China Guodian Corp, in August announced plans, for instance, to issue CNY5.5bn ($860m) of convertibles to finance five hydropower projects and 11 wind-turbine schemes across the country.

Meanwhile, the giant Russian metals company Norilsk Nickel is planning to launch an even bigger convertible Eurobond to finance a $4.5bn buyback of its own shares (to resolve a long-standing dispute with rival metal company Rusal).Vladimir Strzhalkovsky, Norilsk’s chief executive, told a conference at the Black Sea port of Sochi on September 16th that the company had selected banks for the exercise and indicated they were hoping to initiate the process before the end of October.

Further ahead, an Indonesian cellular-phone company PT Smartfren Telecom has announced plans to issue IDR2.7trn ($300m) of convertible bonds next year to help meet its

working capital and capex requirements (on top of a $175m loan from the China Development Bank that it expects to draw before the end of this year). The company issued IDR2trn of convertibles in the first half of 2011 to refinance bonds issued by its PT Mobile-8 Telecom subsidiary.

Basile at RWC Partners says that the emerging markets, particularly those in Asia, are likely to account for an increasing percentage of primary issuance in the longer term, too, as it is difficult to see growth dynamics developing in Europe for the foreseeable future. “The US looks more attractive than Europe, and Asia looks much stronger,”he says.

“I think you will start to see more divergence between regions.”

Nevertheless, Amor at BoAML believes that primary activity in Europe, which had totalled the equivalent of just $10.3bn for the year up to the first week of October, will pick up at some point over the next six to 12 months as a big wall of corporate refinancing approaches in 2012 and 2013. He points out that many companies are going to discover that the cost of both high-yield bonds (and even lower, investment-grade ones) and bank debt will be considerably higher than the facilities they are looking to replace.

“There is a growing realisation among CFOs that the funding environment has radically changed,” he says. “That should lead many to start looking at convertibles as a relatively cheap option once again.”

This should produce more sectoral diversity in the European convertibles market, the lack of which up to this point has been a problem for some investors. “As credit becomes tougher, the appeal of the product will hopefully widen beyond real estate, metals and mining,” says Amor.

He adds that there are currently between €4.5bn and €5bn of further deals “in the pipeline” in Europe that could conceivably go ahead before the end of the year—provided the credit markets stabilise and the equity markets recover some of their recent losses. I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Will sukuk make a comeback in 2012?

Although it has been a patchy year for sukuk issuance, transactions that have come to market have stretched the application of the asset class. Not least was the mid October debut in the renminbi denominated sukuk market by Malaysia’s strategic sovereign vehicle, Khazanah Nasional Berhad (Khazanah), which came to market with a three-year benchmark offshore RMB500m issue. Moreover, the new issue pipeline for 2012 looks to be increasingly healthy. After something of a hiatus, will the sukuk market finally fulfill its promise? Or will other factors continue to impede its growth? What is clear from Malaysia’s example is that a clearly defined infrastructure and a flexible legal regime underpinning sukuk issuance are as important as new issue volumes. Francesca Carnevale reports.

HAZANAH CAME TO market with its Emas RMB denominated sukuk via a Malaysian-incorporated special purpose vehicle, Danga Capital Berhad (Danga). The sukuk was issued under SPV’s own multi-currency Islamic Securities Programme. The transaction was successfully priced through a book building process and achieved the tightest end of price guidance at 2.90%.

The deal drew a demand of 3.6 times book size, enabling Khazanah to upsize the deal from an earlier announced size of RMB300m to RMB500m. BOC Inter-

K

FTSE GLOBAL MARKETS • NOVEMBER 2011

national, CIMB, and The Royal Bank of Scotland were the joint lead managers for the offering with CIMB Islamic as the Shari’a advisor.

A diverse group of investors comprising financial institutions, asset management companies, private banks and statutory bodies from Malaysia, Singapore, Hong Kong, the Middle East and Europe, came into the deal says a Khazanah spokesman. The sukuk are now listed in Malaysia on the Bursa (through the exchange’s socalled Exempt Regime) as well as

BENCHMARK DEALS LIFT SUKUK MARKET

Photograph © Virtuelle / Dreamstime.com, supplied October 2011.

offshore in the Labuan Financial Centre. Tan Sri Dr. Zeti Akhtar Aziz, Malaysia’s central bank governor and chairman of the MIFC executive committee underlined the significance of the first ever RMB denominated sukuk: “This is a major step forward for the sukuk market in Malaysia [as] a multicurrency sukuk origination centre” The deal also builds on the Malaysian government to establish the national capital markets as a hub for global Islamic sukuk. While issuance volumes remain buoyant in the Malaysian market, the country has some way to go in this regard, as Malaysian sukuk issuance remains domestically focused. Nonetheless, Khazanah continues to diversify its transactions and set new benchmarks in sukuk structures and Malaysia continues to enhance the local Shari’a compliant fund raising market.

A significant, if not intrusive factor in Malaysia’s rapid development as a centre of dynamic sukuk issuance, at least from a Middle Eastern point of view, is the rather more liberal approach and interpretation adopted by Malaysia, which still means that certain structures or certain instruments (e.g. murabaha sukuk which are traded) will not likely gain wider acceptance outside the country. However, that consideration, in itself, is not likely to worry the Malaysians one jot.

There are other considerations in play which feed Malaysia’s ambitions. In part, its success is predicated on a shift of fund and trade flows eastwards.

Moreover, Malaysia boasts a well-established, flexible legal and regulatory regime, described under the Malaysia Islamic Finance Centre (MIFC), which is run and driven by the central bank, Bank Malaysia Negara (BMN), and the local regulator, the IFSB to cement the country’s Islamic finance credentials.

The central bank has also established a central Shari’a council to issue fatwa, which serves as a benchmark for what is and is not Shari’a compliant. This has helped substantially to reduce the uncertainty and differences of opinion

33

DEBT REPORT

BENCHMARK DEALS LIFT SUKUK MARKET

that still remain a part of the Middle Eastern market.

In addition, Malaysia has set up an electronic trading platform, with a matched order based system, to allow market participants to trade short tenor sukuk and other liquid Shari’a compliant instruments, with a view to creating an effective liquidity management tool; a perennial issue affecting Islamic banks and financial institutions.

A year punctuated by high profile deals Elsewhere and also in October Goldman Sachs registered a $2bn Islamic bond programme with the Irish Stock Exchange, via a Cayman Island SPV, the Global Sukuk Company Ltd, in a transaction advised by Dar Al Istithmar Ltd. Goldman Sach’s debut in the sukuk market follows on from HSBC’s sukuk, issued back in May. That five year $500m Islamic bond priced at 155 basis points (bps) above midswaps.

Pricing on the Goldman Sachs sukuk has not been made public.

Despite being punctuated by some high profile deals this year, the sukuk market is still heavily weighted towards a discrete number of national markets.

Malaysia dominates the issuance calendar to date, though most of the issues emanating from the jurisdiction are denominated in ringgit. In terms of international issuance however the majority are issued out of the GCC region.“The sukuk market is still heavily weighted toward only a few issuing countries—but predominantly Malaysia.

78% of all sovereign and quasi-sovereign issuances in 2010—and 63% of cumulative amounts over 1996-2010 – originated from Malaysia. {However,] It is likely that we will see an increase in issuance coming particularly from areas that have not been as active in the market in the past such as Europe and the US,”says Nigel Denison, director and head of asset management, at Bank of London and the Middle East (BLME).

The sukuk market has historically been and seemingly still is, largely the preserve of sovereign issuers, govern-

36

ment related entities (GREs) and banks and other financial institutions.

Among corporations, such as GE Capital and the Saudi Bin Laden group, issuance has been predominantly confined to the best credits and/or those structuring benchmark sized deals Whether the benchmark deals of October will spell an uptick in new issuance is yet to be established. The market is giving mixed messages. “We expect to see more international conventional banks starting to issue sukuk,” adds Denison. “These institutions will not necessarily issue sukuk to grow their Islamic business, but in order to access alternative funding streams and diversify their investor base, these products will need to be Sharia’a compliant.”

However, he concedes that: “The fact that sukuk can trade at a premium over conventional bonds and the lack of familiarity with the concept of sukuk may somewhat limit growth.”

Although the October deals underscore that issuance at the top end of the market is the rise, issues outside those circles and in the $500m or less range are few and far between and it still seems likely that significant legal and/or structural changes may be required if a deeper corporate/SME issuer market for sukuk is to develop.

No surprise then that the universe of sukuk remains much smaller than that of conventional bonds. As a result, most investors tend to be buy-and-hold investors and there are very few trades in the secondary market. Recently however, notes Denison, the market has gained momentum and: “ as we have seen from the last couple of years that when the global economy gets hit, the sukuk market in general, has been more robust and less volatile than the conventional market. This performance has buoyed the secondary market. As more people recognise this, we would not be surprised to see more conventional investors enter the market and hence the idea of a purely buy and hold market would vanish very quickly.”

These are heady words. However, the reality remains that the sukuk market

needs more issuance, in varying maturities and currencies, with more secondary trading and liquidity in order to reach volume levels that would put in on a par with conventional bonds.

Nonetheless, Denison maintains that progress is being made as, “borrowers become more aware of the liquidity available from investors in the GCC. Standardisation also allows for cheaper structuring and therefore more issuers become interested. There are still some obstacles to the issuance of sukuk which are preventing the market growing even faster such as vagaries surrounding the underlying assets and structures”.

According to Neale Downes, an expert in Islamic finance at international law firm, Trowers and Hamlins, a number of factors have, individually and collectively, operated over the last two years or so, to delay the development of the sukuk market and depress previously fast growing levels of issuance.

These include, concerns voiced as to the Shari’a compliance of certain sukuk structures, the effects of the global financial crisis, the crash in real estate markets and asset values in Dubai and then across the MENA region and finally those problems: “flowing from defaults (or averted near defaults) and/or restructuring of sukuk transactions; particularly those concentrated on the real estate sector,” he says. Downes also points to the impact of structural questions, which have affected sukuk originators,”which involved a close and often uncomfortable scrutiny of the legal robustness of sukuk as an instrument, the assets underpinning sukuk (or not) and the enforceability of rights of sukuk holders or trustees on their behalf, in local markets, particularly in an insolvency scenario.”

One particular reason for this, he says, is the asset-based versus assetbacked debate. Sukuk are regularly referred to as analogous to assetbacked securities. However, explains Downes, “asset-backed instruments involve a transfer of the assets (or their inherent value) which ‘back’ the securities in question, from the originator (or

NOVEMBER 2011 • FTSE GLOBAL MARKETS

EMERGING INTEREST IN ISLAMIC FINANCE AS A VIABLE ALTERNATIVE TO THE GLOBAL FINANCIAL SYSTEM UK

Germany

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Government sets an objective to ‘entrench’ London as a global gateway for Islamic finance

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5 FSA-approved Islamic banks and Takaful operators

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Plans to issue sovereign sukuk, amend tax law on IF

Turkey

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Saxony-Anhalt state issued government sukuk

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First Islamic bank to operate in 2010

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Announced IFC Istanbul in September 2009 with focus includes interest-free financial business

South Korea ●

France ●

Passed rules/regulations to support Islamic finance activities

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In process of licensing Islamic banks

Japan ●

Malta ●

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Made fiscal and legal adjustment for IF transaction, ie taxation guidelines on sukuk and murabaha

3 1 2

Plans to position an Islamic finance hub for the Mediterranean

6

Saudi Arabia Qatar Iran UAE Kuwait Bahrain Pakistan

7

4 5

Sudan 1 2 3 4 5 6 7

Parliament expected to pass the law related to offering of tax waiver on foreign investors interest income from sukuk issued

Thailand

Hong Kong

Malaysia

Tapped sukuk market to finance its deficit

Singapore Established first Islamic bank

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Introduced tax neutrality for Islamic finance

Brunei

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Aspiring to be centre of Islamic finance

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Non-muslim countries starting to offer IF Muslim-majority countries offering Islamic finance (IF)

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Launched Islamic ETF

FTSE GLOBAL MARKETS • NOVEMBER 2011

Aims to become Islamic finance gateway to China

●

Plans to issue sovereign sukuk

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Hang Seng Islamic China Index Fund in 2001

Indonesia

●

ultimate borrower) to a bankruptcy remote, SPV or trust. This requirement also accords with the Shari’a standards applicable to sukuk, which require a transfer and that each holder of a sukuk thus becomes a part owner of the asset(s) transferred, with the ability to control and determine their usage, either directly or through an agent.”

However, he maintains, in reality, only a handful of sukuk that have come to market are truly “asset backed”. Any “transfer” as such, is one of “economic rights or simple cash flows through contractual security and recourse become limited to unsecured claims against originators for payment of a certain sum”, he explains. In other words, asset-based sukuk operate much like any bond or “IOU” and the rights of sukuk holders represent simple, unsecured claims.

“From a Shari’a perspective, the return (or not) from the sukuk should be directly referable to the assets transferred and not simply referable to the credit or balance sheet of the intended transferor ie sukuk holders should take risk in the performance of the asset

●

Jordan ●

Law passed allowing banks to do Islamic finance

pool. However, this approach makes investors more akin to providers of equity and less like buyers of debt. That equity risk profile is not aligned to the interests of investors typically accustomed to the structure and behaviour of conventional bonds and other fixed income instruments,” he elucidates.

Even so, there are other more prosaic elements in play. The fact remains that even now, sukuk are time consuming instruments and costly to bring to market. Moreover, real estate and project related sukuk have diminished in popularity; the challenge being says Downes, “to identify other attractive, revenue generating asset classes.”

New issue pipeline Downes’ hopes may start to become reality. The World Bank is reportedly considering issuing Islamic bonds to fund low carbon development or environmental projects, its senior counsel was quoted as saying by Malaysia’s official Bernama news agency in late October.

The World Bank’s foray into the Islamic finance market looks in turn to

Aims to become Islamic financial hub for Asia

Source: Bank Negara Malaysia, supplied October 2011.

be supplemented by a stronger than expected new issuance calendar that includes Abu Dhabi based Al-Hilal Bank, which local press reports say is planning to raise some $500m. Bahrain is also expected to come to market with a $1bn sukuk, signalling a return of the jurisdiction to the capital markets after a nine month hiatus.

Unsurprisingly, Malaysia dominated the September issuance calendar, racking up some $5.7bn worth of issues. So far this year the country has accounted for some 69% of total sukuk issuance. Even so, eleven other countries have managed to bring issues to market, including Yemen, Iran, and Jordan. The Arab Spring and its aftermath (unsettling issuers and investors alike) is an oft cited reason for the less than stellar issuance out of GCC markets this year. Al Baraka, is said to want to lead a small corporate charge, with an so far undisclosed sukuk planned for the last quarter of 2011. In Qatar meanwhile, QIIN, Masraf Al Rayan and QIB are all said to be planning new issues. I

37

FACE TO FACE

AKBANK: THE DYNAMICS OF A SUCCESSFUL BORROWING STRATEGY

Hulya Kefeli, executive vice president and head of international banking at Akbank, is a multi-award winning banker; holding the Middle East Business Woman of the Year for 2011 award.

Kefeli has been instrumental in defining the Turkish banking borrowing market, having led at least three benchmark international capital markets borrowing transactions through last year and this. FTSE Global Markets spoke to Kefeli in early October about her market outlook and new issue pipeline.

Setting benchmarks in capital markets funding TSE GM: You have been the driver now of a number of benchmark deals in the Turkish debt capital markets. What have been the key lessons learned from the structuring of the larger deals last year and this year?

HULYA KEFELI: Our July 2010 Eurobond transaction paved the way for further unsecured FI issuances out of Turkey. Based on our experience we recognised that debut issuance has its own challenges such as high execution risk. Being the first Turkish FI issuer to tap the markets for a direct issuance was a challenge in itself. Despite indepth pre-issuance studies there is always a degree of uncertainty, which we tested internally as a means to succeed. The bank’s management was convinced we could do it, backed up by an extremely strong underlying business story and brand. As a result of all these factors Akbank managed to successfully close a milestone Eurobond issuance amounting to $1bn, with a record $3bn book which is still the highest figure among all non-sovereign deals out of Turkey.

Our first Eurobond issuance boosted our self-confidence in many ways.

F

38

Frankly, we were proud that we set a path that was followed by other Turkish banks, and it sometimes seemed like a long and lonely path in July 2010! The bank’s March 2011 issue was different in many ways. The global investment environment was quite volatile; North African and Middle Eastern states including Libya, Tunisia and Egypt were in the midst of what looked like significant political and financial turmoil. It certainly provided a challenging backdrop to our primary objective, which was to be able to raise the precise amount of funding we had initially planned on securing. We were able to raise $500m in new money US treasuries (UST) plus 360bps with a tenor of seven years. We believe extending the maturity by a further two years at 10bps on top of our July 2010 Eurobond (priced at UST + 350bps) in volatile market conditions is a great story, demonstrating the quality work which was put together by our team.

FTSE GM: What governs the choice of banks you work with to help raise finance for Akbank? Do you always work with the same banks?

HULYA KEFELI: Akbank has a very

strong global correspondent banking network. We have had extensive cooperation with some names for years and in consequence have built a tight circle of close cooperation with our partners. The banks we work with closely not only deliver superior quality service to Akbank but also support us in many fields. Clearly we take into consideration a number of factors including the extent of our relationship, quality of service, experience, and league tables; actually they are quite important for us.

FTSE GM: You have achieved exceptional pricing in your deals: what impact has this had on the wider bank borrowing market in Turkey?

Do you think you have set the pace in this regard?

HULYA KEFELI: I like to think so. We initiated a number of pioneer deals which has cemented Akbank’s position as a leader in the Turkish banking sector across a broad range of debt and capital market transactions. We are one of the most active banks in the Turkish syndicated loan market with two outstanding facilities, one maturing in March, another one in August. We tend to set the benchmark pricing in

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Hulya Kefeli, executive vice president and head of international banking, Akbank.

Photograph kindly supplied by Akbank, October 2011.

the market. I would also say Akbank dominates in the Eurobond market where we successfully closed two transactions, one in July 2010 and another one in March 2011, which also set a clear benchmark for other issues out of Turkey. In addition, in August 2010 we closed the first diversified payment rights (DPR) securitisation since 2009. This is quite important as there was no DPR issuance from Turkish banks and it opened the DPR market for other Turkish banks.

FTSE GM: Dual currency transactions have been the order of the day for many recent debt transactions.

How might the eurozone crisis impact on the currencies preferred by borrowers?

HULYA KEFELI: We continuously study the feasibility of dual currency structures, however the current outlook in the eurozone is not easing prospects for further euro-denominated issuance right now. By the same token it is equally difficult to close Turkish liradenominated paper as investors tend to prefer investing in local currency transactions in bull markets. Nevertheless we will continue to monitor the markets for potential opportunities.

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2011

FTSE GM: Might you consider raising funds in RMB, even as a small tester?

HULYA KEFELI: We believe that for the time being RMB market is a valuable funding consideration for corporates with active investments in the region, but which have activities in RMB. For the rest of us capital market issuers the commercial advantage of issuing RMB paper is relatively limited due to the current outlook of the basis swap market which renders swaps to USD and TRY quite expensive compared to direct USD issuance. Our view is then that any RMB-denominated issuance is more appropriate for financial institutions which have lending capabilities in RMB. FTSE GM: What have been the main changes in the make-up of investors in your transactions?

HULYA KEFELI: Our internal research shows that the share of asset managers in our transactions has risen from 42% in our first Eurobond issuance to 62% in our March 2011 deal. Mind you, it appears hedge fund allocation was quite high in July 2010 with approximately 30% of the total book. While these trends have been

extremely satisfying, in terms of geographical diversification we would like to do more. In both of our recent deals some 60% to 70% of our books were allocated to UK and US accounts.

Going forward we would like to see more accounts from Asia and the Middle East and will work towards this.

Even so, it is reasonable to assume that US accounts will continue to be a driving force. With the strong economic prospects of our country, we believe the award of investment grade is long overdue. Once we achieve it, it will help us in our efforts to underscore the creditworthiness of both Turkey and Akbank and to broaden our investor base to Asia and other regions.

FTSE GM: Why is it so important for Turkish borrowers to now extend debt maturities even further out in the debt capital markets?

HULYA KEFELI: Given the current outlook of Turkish capital markets, long-term borrowing options are rather limited, with short-term customer deposits and local bonds with maturity of six months representing the bulk of funding. It is therefore very important for Turkish borrowers to extend maturities via long-term international funding opportunities. Although the Turkish banking sector will manage this maturity gap it is always a plus to have long-term financing as well. Indeed, it also helps to diversify the investor base and ensure sound borrowing. Since our aim and strategy is to ensure sustainable borrowings, investor diversification is an important theme for us.

FTSE GM: Longer maturity loans have been commonplace among Turkish bank borrowers from NGOs, such as the IFC, EBRD etc. Is it now time for Turkish banks to move out of this arena? Or, is it a useful adjunct to the bankâ&#x20AC;&#x2122;s capital market forays?

39

FACE TO FACE

AKBANK: THE DYNAMICS OF A SUCCESSFUL BORROWING STRATEGY

HULYA KEFELI: Multilateral institutions have played a major role in the development of local markets. Their role in SME lending as well as project finance transactions including renewable energy and energy efficiency themes has been quite supportive. In addition, for the development of local capital markets, again the support of multilateral institutions is important.

Therefore, our intention is to further develop areas of mutual cooperation with multilateral institutions and create value for our economy together.

FTSE GM: What are your plans in the NGO funds market?

HULYA KEFELI: We have really good relations with a range of multilateral institutions, including the EIB, EBRD, IFC, KfW, OPIC, and Proparco; moreover we would like to build on this in 2012. We continue to develop new projects which are in line with the lending mandates of multilateral institutions and any funds we raise in this way are allocated to the specific needs of our clients.

FTSE GM: Can you talk a little please about the anticipated issue calendar for 2012?

HULYA KEFELI: Our intention is to renew our syndicated loan facilities in March and August 2012. We continue to monitor developments in the capital markets, looking for potential fundraising opportunities. However, I should say that Akbank has ample liq-

uidity, mainly funded by healthy local retail deposits and in that regard we are not reliant on the wholesale funding markets. We have a sound funding strategy that allows us to consider wholesale funding opportunities selectively and in line with the bank’s prudent risk management policies.

FTSE GM: Do you see more interest in your transactions from investors in either the Middle East/Asia/Latin America? Might we see more shifts over the next few years?

HULYA KEFELI: At the moment our allocation to the Middle East, Asia and Latin America is quite limited.

However, these three regions offer exceptional opportunities going forward and our objective is to reach out to the investors and share the bank’s strong business story.

FTSE GM: What in your view are the main challenges facing Turkish bank borrowing this year and next?

HULYA KEFELI: One could argue that with solid financials and sound growth plans Turkish bank borrowers are in a much better position than peer banks elsewhere in Europe. In other parts of the world the global macroeconomic picture is dulled and some of our relationship banks in the eurozone face significant challenges. We hope to stick to our current levels of borrowing; though depending on the outlook of the global markets it is likely that costs may rise. However, when you look at

other parts of the world, Turkey is one of the very few safe havens investors can comfortably invest in. Overall, the banking system remains strong and we expect the government to put in a strong budgetary performance next year and that should significantly bolster any bank borrowings next year.

FTSE GM: Do you see potential for substantial asset-backed issuance market either in or out of Turkey?

HULYA KEFELI: Perhaps not in the immediate future; as Turkish FI issuers we are currently concentrating our efforts on unsecured issuances; therefore it might be a bit early for more complex structures. It is however quite important to develop asset-backed structures since any healthy banking system requires diversified borrowing tools which include structured products such as asset-backed securities. Therefore, we expect and support the development of such products locally.

For capital markets products such as covered bonds and existing asset securitisations, a well-established regulatory framework is already in place. However, investor capacity is still limited. On the other hand, the recently announced medium-term programme of the Turkish government encourages savings and by extension, the development of private pension funds. As such, we expect the local capital markets to develop in tandem with policy-led developments in savings.I

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NOVEMBER 2011 • FTSE GLOBAL MARKETS

INDEX REVIEW

NASDAQ OMX will be adopting the widely-used global standard for company classification, the Industry Classification Benchmark (ICB) under license from index provider FTSE Group.

The global classification system will be adopted across Stockholm, Copenhagen, Helsinki, Reykjavik, Tallinn, Riga and Vilnius, aligning the exchanges with the classification system currently employed by NASDAQ OMX in the US. ICB has come a long way since it was launched in 2005 and is now regarded as a leading analytical measure in the global markets.

ASDAQ OMX WILL replace its current company classification system with ICB, to aid the classification and analysis of companies listed on seven exchanges. The change will be made effective as of the beginning of February 2012. As a result,“our listed companies can more effectively benchmark with global peers, a total of 75,000 securities, compared to 40,000 previously,” says Jenny Rosberg, senior vice president global corporate client group at NASDAQ OMX. “It also enables us to create consistent and comprehensive global indices, enabling individual and institutional investors to quickly, accurately, and objectively measure and invest in the market.”

The adoption of ICB by NASDAQ OMX follows closely the announcement that FTSE has also licensed the Kuwait Stock Exchange (KSE) to utilise the classification system. In the KSE’s case the introduction of ICB opens up a range of new sector-based investment strategies in the domestic market. The Kuwaiti investment landscape is undergoing a significant period of change. Its fund management industry is fast becoming one of the biggest in the Gulf region, with assets under management now standing at $54bn.

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FTSE GLOBAL MARKETS • NOVEMBER 2011

Issam Alusaimi, head of KSE’s project management office, explains that the exchange is revising many aspects of its activities, “in order to better serve the national economy and to provide investors and listed companies with better products and services”. Alusaimi adds: “Critical to these changes is improved technical analysis and better indices. ICB’s globally-recognised sector classification will be fundamental in delivering these improvements.”

A vital standard in the global investment market, the ICB is a tightlydescribed, comprehensive system categorising over 70,000 companies and 75,000 securities around the world, enabling the comparison of companies across four levels of classification and national boundaries. The ICB system is supported by the ICB Database, a data source for global sector analysis, maintained by FTSE Group.

In 2005 FTSE Group joined forces with Dow Jones Indexes to create ICB. Now a definitive and highly-technical corporate classification system, it comprises four levels of analytical granularity, including 10 industries, 18 supersectors, 40 sectors and 114 subsectors classes. The underlying rationale behind the establishment of

FTSE LICENSES NASDAQ OMX WITH ICB ACROSS SEVEN EUROPEAN EXCHANGES

ICB sets classification benchmarks in Nordic & Gulf regions

ICB is that in the past, market trends indicated that stocks within the same geographical area performed similarly.

For that reason, investors have found it useful to compare stock performance by region or country. More recently, while some investors still find geographic comparisons important, more often than not fund managers find it more useful to compare stock performance by industry.

ICB also forms an independent investment tool, providing pension funds, managers, consultants, stock exchanges, sell side research teams and more, with the ability to better define, analyse, and implement sectorbased strategies. The ICB’s industry and supersector tiers are designed to reflect and facilitate sector-based investment strategies. Moreover, the quality and timeliness of the data make it an important reference source for validation, compliance and other reporting processes.

Up to now, the system has been adopted by a substantial number of stock exchanges around the world, representing over 65% of the world’s market capitalisation, including NASDAQ OMX, Borsa Italiana and the exchanges of Kuwait, London, Athens, Singapore, Taiwan, Cyprus and Johannesburg. ICB provides a significant level of geographic reach, offering investors a creditable choice, for the purposes of benchmarking, performance measurement or research/analysis.

“When launched, ICB was designed as a sector analysis tool offering investors the ability to tailor exposure to companies globally. Today, it continues to be a leading sector classification system for financial products including indices, exchange-traded funds and derivatives contracts,” explains Sudir Raju, managing director of ICB at FTSE Group. “NASDAQ OMX’s global adoption of ICB further acknowledges our efforts in providing market participants with reliable, innovative and state-of-the-art sector classification. Going forward, we will to continue to develop ICB.”I

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INDEX REVIEW

ARE INVESTORS STILL CAUGHT BETWEEN A ROCK AND A HARD PLACE?

Which way should investors turn? Run to the hills and hide or take the ultimate gamble and get into stocks before they return to the highs of earlier in the year? The European Union has reached agreement over a haircut on Greek debt and stability funding worth $1.4trn. In the run up to this tumultuous event and ever since France and Germany announced that plans would eventually be agreed (after weeks of pushing back the date), equity markets have broken free from their narrow trading ranges, to the upside. Even so, Simon Denham, managing director of spread betting firm Capital Spreads, continues with his ultra-bearish view.

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

A year-end rally is likely, but will the euro’s problems resurface yet again?

HE FTSE 100 HAS been struggling time and time again to get beyond 5400, but has finally broken through. However, judging by the trading pattern of the past few months, by the time this article is printed we could quite easily be in crisis mode again, plummeting to new lows. It has been very hard to predict what the market is going to do next during these turbulent times. One minute you expect the FTSE 100 to hit 4000 and the Dow to dip below 10,000, only to find the next day the bulls are in full control pushing us back higher again.

As they say, fortune favours the brave and it would seem that the braver investors out there are benefiting from taking the contrarian view and have picked up some mighty cheap stocks.

However, if things turn nasty again the bears will likely be out like a flash. There is a sense that much of the rally is due in part to the market gearing up for the year-end rally.

November and December are historically bullish months for equity markets and December in particular always seems to see gains. The FTSE 100 has rallied during 23 out of its 27 Decembers in existence, so if history is anything to go by the

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chances are that we will see that again, but only if investors are optimistic about the prospects for equities in 2012.

The outlook for next year is still uncertain because we simply do not know what the long-term consequences of the EU resolution plan will be. It is unlikely that the $1.4trn bailout will be enough if markets decide that the haircuts to Greek debt will impact badly on both French and German banks which are loaded with Greek debt.

Invariably the yields of other heavily indebted European states will spike in the aftermath of this agreement.

With Greece’s lenders taking such a big hit on their loans they will be reluctant to lend to anyone going forward and we are already seeing the credit markets drying up again.

Both Italy and Spain will be coming to market with their sovereign borrowing requirements at a trying time in the debt markets; it is unlikely that they will find the going entirely bloodless.

It is inevitable that government bond yields for the Mediterranean countries will rise in any case as the structural changes required to underpin the eurozone will take time to implement. Time is exactly what the markets do not have at the

moment. Stopping contagion will come at a hefty cost and the sluggish growth that will result hardly makes investment prospects in their debt very appealing.

Sadly, market focus will not just rest on the eurozone in coming weeks. The US is on the verge of another credit downgrade from one of the big ratings agencies. We are nearing another situation as we did a few weeks ago when US politicians couldn’t agree on the raising of the nation’s debt ceiling and once again we will see a stalemate between Republicans and Democrats. Even so, the majority still believes that the US will avoid another recession; though from this vantage point, it is not so clear cut.

Equally, consumer and business confidence is at a term low and will take time to recover. Inflation is still too high, adding to the squeeze. It’s not a pretty picture I’m painting and so while the markets might rally into the New Year, 2012 will almost certainly throw up as much uncertainty as 2011. So enjoy the good times now while they last because things are probably going to get tougher I’m afraid.

As ever ladies and gentlemen, place your bets! I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

COMMODITY REPORT

Soft commodities walk but don’t run Liquidity is becoming an issue across all financial services. Less so, it seems, in commodity finance. Trade financing for agricultural and soft commodities is keeping up and deals are still going ahead, be they pre-export finance, revolving credit facilities or other types of structured finance. However, the segment is not out of the woods quite yet and a tightening of dollar liquidity generally is giving some pause for thought.

Vanya Dragomanovich reports on the key trends.

O FAR, SO good, say financiers of soft commodities, but since the end of the summer the tightening of liquidity in the interbank markets and the higher cost for dollar funds has meant it is “becoming more difficult to raise financing, even if based on commodity financing structures,” acknowledges Thomas Oehl, global head of commodity financing at WestLB. Even so, Oehl puts a positive spin on the underlying market dynamic.

Bankers are just beginning to look at margins, he says; that is, the percentage at which lending deals are priced over the London Interbank Rate (Libor), and these margins have been coming down in the course of this year as lending has improved and more banks have

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FTSE GLOBAL MARKETS • NOVEMBER 2011

started offering financing in the commodities space. Liquidity problems, he continues, while apparent, are not nearly on the scale seen in 2008 and 2009 and though margins are predicted to rise over the coming months the move is more likely to be a notch upwards than an ecstatic jump. Overall, commodity financing is seen as “a rather risk-resilient form of lending,” says Oehl.

The tightening process is most pronounced for dollar funds, particularly for banks with a heavy European focus.

Both financiers and lenders are adjusting to this new reality by either structuring loans partly in euros or other currencies, or by accepting higher margins on dollar-financing. “Yes, dollar

LIQUIDITY CONCERNS IMPACT SOFT COMMODITY FINANCE

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

liquidity is an issue but there is no sense in over-egging it,” holds Jonathan Pughe, head of EMEA loan syndication at RBS, adding that liquidity issues in commodity financing are not nearly as acute as have been reported recently.

Going forward, liquidity issues will continue to be present and bankers will respond by “being a bit more disciplined”and likely to lend to core clients rather than spreading their slightly scarcer resources too thinly, adds Pughe.

Unlike prices for copper, oil or gold which have all dropped recently, prices for some of the agricultural commodities are still relatively high and agricultural commodities provide one of the strongest prospects for price increases over the long term. A recent report by Rabobank argues that although a number of important factors might change conditions over the coming months, such as a double-dip recession, they “do not undermine the conclusion that global agri-commodity prices are expected to shift higher and become more volatile”.

Farmers have reached a plateau in being able to increase productivity gains and new frontier agricultural land awaits substantial investment. “A strong supply response is not expected soon. As a result, the global food system has been brought to a tipping point, and the battle for agri-commodities will only intensify,”notes the report.

For banks, higher commodity prices will translate into larger volumes of finance as producers and exporters will need to raise more money to finance the trade of the same tonnages as now.

“Higher commodity prices also mean higher margin call requirements or financing requirements” for trading houses that hedge their exposure on the futures markets, says Oehl.

Supply pressures on some soft commodities will continue to encourage more skittish producers to try and fend off foreign buyers, to either hoard or defend their resources. While this sounds harsh, it was clearly illustrated in the summer of 2010 when a drought in Russia encouraged the government

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COMMODITY REPORT

LIQUIDITY CONCERNS IMPACT SOFT COMMODITY FINANCE

to ban wheat exports. This year it was the turn of the Ivory Coast, which decided to ban the export of cocoa so that opposition leaders would not have access to funding.

While Russia and the Ivory Coast are likely exceptions to the rule, any signs that other producers might take similar drastic action are unlikely to elicit either sympathy or support from financiers, who will just as soon turn to provide financing for those countries that are easier to deal with and where they are guaranteed predictable returns. Countries that are thinking of restricting foreign access either through taxes, export bans or in other ways should take note. Going forward, it will involve a fine balancing act to protect legitimate income from their natural resources and prices at optimal levels and keep foreign investors and financiers interested in working with local companies.

Risk-weighted assets As with most of the capital markets, the long arm of regulation is beginning to stretch its reach even over traditional trade financing of soft commodities.

Basel III is a particular concern. Incoming rules will result in higher minimum capital requirements for banks as a percentage of risk-weighted assets and there will be a non-risk-based leverage ratio to avoid the build-up of excess leverage. One of the rules that will particularly affect the commodities trade is that banks will need to monitor the physical flow of goods which represent the main collateral in commodity deals.

They will also have to reserve capital against exposures to OECD governments, a significant change of the pricing model that has been in place globally since 1945.

The final points are still being negotiated and there is no set implementation date, but the requirements are already widely reviled in the banking community because they will mean additional costs in financing deals.

Another permanent change in the commodity financing space is the increased presence of Chinese and

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African, mainly Nigerian, banks, according to Ian Stern, deputy head of natural resources structured finance for SubSaharan Africa at Credit Agricole CIB. The development is welcome. Stern notes the positive effect of combining the local understanding of African banks with the structuring track record of the international banks. “Commodity finance deals are often done in challenging parts of the world and local banks can add a lot of value as finance structures are adapted for local borrowers,” says Stern. He adds: “Local banks, often encouraged by their governments, are keen to increase their involvement and experience in such financings.”

The introduction of liquidity is also helpful. Chinese banks are able to take large tickets in deals and so can be “a force in the market”, says Stern, adding: “Don’t always look at price and structure in the same way as a western bank.” He notes that Chinese banks will typically follow their own borrowers and can make an assessment based more on the reputation of the borrower than on the economics of the transaction.

Nonetheless, longer term there may be less beneficial consequences. African markets could become a key battleground for Chinese and western banks.

They continue to be important for western banks because margins are significantly higher than in the highly competitive Asian market, which is heavily populated with highly liquid banks. At the same time the abundance of oil, gas, gold, copper and agricultural commodities makes Africa increasingly important for China, resulting in thriving trade between the two regions. A survey by Standard Bank estimates that the value of Chinese investment into Africa will rise to $50bn per year by 2015, up 70% from the level in 2009, and that the volume of bilateral trade between China and Africa will rise to $300bn in the next four years, double the trade volume registered in 2010.

In spite of the growing challenges facing the sector, commodity trade finance is likely to remain one of the

more stable parts of financial services in the western banking segment, no small feat at this time of continued economic uncertainty. Moreover, deal flow and deal sizes remain healthy. For instance, the Ghana Cocoa Board (Cocobod) in September signed, with relative ease, a $2bn pre-export finance loan in one of the largest soft commodity deals this year. It involved 25 banks, including Citi Group, HSBC and Nedbank. In a pre-export finance deal of this type banks lend funds to an exporter against confirmed orders from a foreign buyer and the money is then used to produce, transport or buy the goods. In a typical situation, banks are repaid by the buyer rather than the lender.

Political turmoil In Cocobod’s specific case the state cocoa merchant wants to buy at least 1m tonnes of cocoa from local growers by the end of next year’s growing season to be able to sell to foreign trade houses. Ghana is the world’s secondlargest producer after Ivory Coast, which is embroiled in domestic political turmoil. Cocobod wants to position itself so it can benefit from a rise in cocoa prices to a 30-year high of more than $3,700 a tonne caused by the Ivory Coast’s ban on exports imposed briefly in the early part of this year.

The key markets for pre-export finance are among the big agriculture exporters, including Russia, Ukraine and Kazakhstan, which are major producers of grains, Brazil for soy, corn, sugar and ethanol, African countries for coffee, cocoa and to a lesser extent grains, and China for imports of most of those commodities and others such as pork bellies and livestock.

Other large deals this year include a $500m pre-export facility for Brazilian company Multigrain, a producer and distributor of soybeans, corn, wheat, cotton and sugar, with bookrunners ING, ABN AMRO and Credit Agricole CIB, and a similar-sized facility for Kernel Holding, a sunflower oil producer in Ukraine, arranged by ING Bank, Deutsche Bank and UniCredit.I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

COMPANY PROFILE: GRAINGER

Photograph © Norebbo / Dreamstime.com, October 2011.

GRAINGER SETS OFF ON GLOBAL GROWTH From making cars and candy to running department stores and hotels, industries of all kinds have consolidated, driving costs down and profits up. In contrast, the seemingly mundane business of providing maintenance, repair and operating supplies to keep large facilities running is still fragmented. That’s good news for US-based Grainger, the leader in the $580bn worldwide MRO industry. Despite a sluggish global economy, Grainger expects to grow between 7% and 10% annually by taking market share away from smaller competitors. Art Detman reports.

HE FINANCIAL CRISIS of 2008/2009 was almost a catastrophe for many businesses, but not WW Grainger (GWW), which provides hundreds of thousands of products, ranging from light bulbs, safety goggles, electric pumps, hand soap, tools and fasteners, to factories, warehouses, office buildings, hotels, hospitals and the like. Although GWW’s sales declined in 2009, its visibility increased and that became a safety line as big companies began to cut costs in earnest. Maintenance, repair and operating (MRO) supplies, which had once been just a line item on a company’s budget, became a cost-cutting opportunity.

“Our category has been starting to get a lot more visibility lately as companies are trying to figure out how to get more productive,” says James T Ryan, Grainger’s chief executive officer. “The largest distributors are growing two

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FTSE GLOBAL MARKETS • NOVEMBER 2011

or three times faster than the overall industry because customers are changing the way they buy MRO products.

They are buying from a smaller number of distributors who have a larger product line and are using e-commerce to place orders,”he says. “What we are driven to do is have the broadest product line in the industry available the quickest so as people consolidate their supply base they can consolidate to us [sic].”

This trend is clearly reflected in Grainger’s financial results.

For 2010 the company reported sales of nearly $7.2bn, up 17% over 2009’s depressed results and up 30% over the past five years. Earnings per share were $6.81, up 85% over five years. What’s more, GWW’s balance sheet is rock hard.

Its $420m in long-term debt at the end of 2010 was dwarfed by nearly $1.4bn in working capital. The company has increased its quarterly cash dividend for 40 consecutive

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COMPANY PROFILE: GRAINGER

years, to $2.08 per share in 2010, which is expected to increase to $2.64 for all of 2011.

Analysts expect GWW revenue to grow briskly. Terry Darling at Goldman Sachs, for example, has boosted his projections and now expects 2011 sales to be around $8.05bn, up 12%. This, he believes, will grow to $8.68bn in 2012 and $9.14bn in 2013. These increases will handily outpace likely growth in the gross domestic product of the US (which is still by far GWW’s biggest market) and reflects the consolidation in the MRO industry now under way.

Grainger is America’s largest industrial distributor, employing more people than its two largest competitors combined. GWW’s dominance reflects its almost passionate desire to serve customers, something that dates to the founding of the company in 1927 by William Grainger. Back then, US manufacturers were committed to long production runs and selling product by the truckload or trainload.

Inevitably this meant that most manufacturers had odd lots of goods left over that they had to dispose of. Working out of a single location in Chicago, Bill Grainger saw an opportunity to buy odd-lot electric motors and sell them to small and medium-size companies that didn’t need large quantities. He created a catalogue, the “Motor Book,” and used direct mail and postcards to build the business.

“He provided a great service,” says Ryan.“He was selling electric motors to small companies that otherwise would have had a hard time getting their hands on electric motors.

As he built his business, customers started asking him for other kinds of products because they loved the service.”

Grainger expanded by offering products that used motors: electric fans, pumps, compressors and so forth.

“To make the company more convenient, we built more branches,” Ryan continues. “We added more sales people.

We continued to expand the product categories offered, the kinds of things needed to keep facilities running. So they’re important to our customers; but most companies don’t like to keep the kinds of products we sell in stock, so when they run out they need it quickly. That’s a pretty simple formula and concept, but one that’s increasingly more and more difficult to implement.”

Under pressure As recently as 30 years ago an entrepreneur could rent a warehouse, hire a few sales representatives, finance a small inventory of parts, and get into the industrial distribution business. Typically, these operations were product-line specific or customer specific: electrical components, tools, cleaning supplies, and so on.“Today that business model is under a lot of pressure,” says Ryan.

Grainger’s size and breadth of product offerings give it leverage over both its suppliers and its customers. “For some of its suppliers, Grainger is their largest customer,” says Ajay Kejriwal, an analyst with FBR Capital Markets in New York.

“This means they have pricing power over the vendors and are able to get good prices.” On the customer side, availability rather than low prices is paramount. “If you’re an operating manager of an industrial or commercial facility, you’re not

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James T Ryan, Grainger’s chief executive officer. “The largest distributors are growing two or three times faster than the overall industry because customers are changing the way they buy MRO products. They are buying from a smaller number of distributors who have a larger product line and are using e-commerce to place orders,” he says. Photograph kindly supplied by Grainger, October 2011.

going to shop around, for example, for cleaning supplies.”

Finding the right product, and being able to get it quickly, is more important than finding the lowest price. “So Grainger is able to get good pricing from their suppliers and good prices from their customers, and that helps margins,” Kejriwal says.

Since 2001, GWW’s operating profit margin has grown from 10.1% to 13.9% in 2010, according to Nira Maharaj at Value Line Securities, who expects it will be a solid 15% both this year and next.

A 31-year veteran of Grainger, Ryan concedes that most people just don’t get as excited about motors, mops, buckets and bolts as he and his company’s other 19,000 employees do. The fact is that the MRO supply business is the most important industry most business people have never heard of. Running out of ordinary but essential items can upset production schedules, put a company in violation of safety or environmental laws, and otherwise hamper operations.

Companies such as Grainger are middlemen, buying supplies of all sorts from myriad manufacturers and then reselling them to end-users. It might seem that these endusers could buy more cheaply directly, but almost always just the opposite is true. Tracking down vendors for supplies as varied as fasteners, work gloves and zinc air batteries can account for 40% of the product’s cost, reckons Grainger. For inexpensive and infrequently-ordered items, the ratio can be much higher. Even with the internet, the

NOVEMBER 2011 • FTSE GLOBAL MARKETS

time required to continually find suppliers and compare products and prices on most MRO items is uneconomic for large facilities.

“In most cases it is not an option for the end-user to buy the product directly from the manufacturer,”says Brent Rakers, an analyst with Morgan Keegan in Memphis, Tennessee.“If you are a customer of Grainger’s and you’re buying one of a product just once a year, it doesn’t make sense to go to the manufacturer to buy a truckload or even a pallet-load.”

Shopping at big-box hardware stores is rarely a viable option because their products, intended primarily for doit-yourself enthusiasts, are likely to be different. “The product that is for sale at a home improvement centre, such as a hammer, more likely than not, will be a different grade of hammer to that being sold to the professional user,” Rakers explains. “These are different products for different customers.”

Industrial distributors such as GWW streamline the process of finding and ordering supplies. In the US and Canada, Grainger (which is based in Lake Forest, just north of Chicago) sells through a field-sales force of 2,500 representatives who call on prospects, a nationwide network of nearly 600 branches (open to the public as well as trade customers), over the phone and, of course, online.

The current Grainger catalogue is 1,584 pages thick, including 189 pages for two indices: a list of products— abrasives to zippers—and a roster of manufacturers, ranging from Abanaki (coolant mixers and oil skimmers) to Zurn Industries (backflow preventers and faucets). Altogether, catalogue number 402 includes 350,000 stock keeping units (SKUs), among them 114 claw hammers, 132 paint removers and 164 rechargeable batteries. Not enough for you? Then just call the company’s toll-free number for additional items. Or wait for the 2012 edition, which will list more than 400,000 SKUs.

An aggressive expansion All told, GWW offers 900,000 products in the US alone and still more in Canada, Latin America, Europe and Asia. The higher demand products are stocked at the branch stores; less-used items are at distribution centres, where they are shipped directly to customers.

The US and Canadian retail stores are supplied by 21 distribution centres, including an 800,000 square feet (sq ft) facility that recently opened near San Francisco.“We already have a large distribution centre in Southern California and we have a smaller distribution centre—we call it a master branch—up in Seattle. So with these three facilities, we are going to have great coverage of the West Coast,” Ryan says enthusiastically. “We have added almost 5m square feet to our distribution centres in the last five years, and we are going to bring online a 1.1m sq ft distribution centre southwest of Chicago in 2012.”

Meanwhile, GWW has been expanding its sales force.

Even through the financial crisis it added hundreds of sales people worldwide, and it is still hiring. “This is a customerservice business and a relationship business,” says Ryan.

FTSE GLOBAL MARKETS • NOVEMBER 2011

Going through the catalogue at a Grainger store. Photograph kindly supplied by Grainger, October 2011.

An onsite Keepstock at one of Grainger’s clients. Photograph kindly supplied by Grainger, October 2011.

“The customers we do best with are those we have covered by sales reps. So we have been doing a lot of work over the years trying to figure out ways that we can get more sales people in front or more customers.”

The push to add sales reps is just part of an aggressive expansion programme that has given Grainger firm beachheads in Mexico, Colombia, Panama, China, India, Japan and—with the recent acquisition of Fabory Group, a Dutch distributor of fasteners and related products—Europe.

“The European MRO market is the largest in the world,” says Ryan. “There are a number of high-quality industrial distribution companies in Europe that we know very well and have been following for years. We felt that if we ever had an opportunity to partner with one of those companies, that would be the way to enter that market and when we got the opportunity to acquire Fabory, we got very excited because they are a great company that we have known for years. They have already started expanding into the heavy manufacturing markets of Eastern Europe, and our plan is to support that growth.”

Even so, Ryan sees Latin America and Asia as its top two overseas growth markets. He likes Latin America because much of Grainger’s existing product line can be sold there. The company is in the final stages of building out a computer information platform that will serve all its operations in North and South America. As for Asia, today it is the world’s workshop and factories are big MRO users. With such a wide constituency to service, Grainger is quite flexible in its expansion methods. In Japan it started with a joint venture (GWW now owns 53% of a publicly-traded Japanese MRO

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COMPANY PROFILE: GRAINGER

GRAINGER: INVESTING IN PROVEN GROWTH DRIVERS Product line expansion

eCommerce revenue

Increasing ROIC

Total company catalogue product offering (in thousands)

Data as a percentage (%) of total company sales

Total company ROIC from 2005 to future (excluding unusual items)

1,200

45% 40% 35% 30% 25% 20% 15% 15% 10% 5% 0

40%

1,000+ 1,000 800 615 600 400 210 200 0 2005

2010

Future

2005

40%+

35%

35% 30%

28.7% 25.5%

25%

25%

20% 15% 10% 5% 0 2010

Future

2005

2010

Future

Source: Grainger, supplied October 2011.

distributor); in China, Grainger built its business from scratch; and in India, like Europe, its entry was by acquisition.

In the US and Canada, Grainger occasionally acquires a company, such as it did with Imperial Supply, a Wisconsin outfit that is America’s leading MRO distributor to transportation companies. It has also acquired service companies, including one in the energy-management business, as part of its growing emphasis on providing services as well as merchandise to its customers.

For decades other MRO companies, mainly categoryspecific distributors, have gone on site to restock customers’ parts bins, conduct supply audits and the like. Grainger didn’t offer this service until about five years ago, but now it is a fast-growing part of its US business. The service, which Grainger calls KeepStock, ranges from regularly-scheduled stops by Grainger reps to refill bins etc, to operating what amounts to a fully-stocked branch store on the customer’s premises. These inventory management agreements reduce a customer’s overheads and increase Grainger’s sales (which, Grainger says, grow about 17 percentage points faster at a KeepStock account).

Ironically, for a company that is benefiting from its customers’ desire to reduce the number of vendors, Grainger has been increasing its vendor base, which now comprises about 3,000 suppliers worldwide, up from around 2,500 five years ago. Some of these companies also manufacture products under Grainger’s own private labels, a practice that dates to 1938 when Bill Grainger started selling motors under the company’s own Dayton brand.

“We were one of the first distributors to start a private label programme,” says Ryan, who compares the practice to the private labels of supermarket chains. “Just like in retail operations, private label products are able to coexist with national-branded products. National branded products will typically offer features or functions that perhaps aren’t available on the private label product.”

For all of its products, Grainger is ramping up its technical support for customers, something that Ryan concedes is

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much easier for category-specific distributors to provide.

“One of the great challenges for a broad line company like Grainger is providing technical support across 350,000 products. We have experts within the company for all of our major product categories, and we make their expertise available in a lot of different ways—over the internet, in-person at our branches, and on the phone.” Grainger now uses voice-over-internet protocol to link its branches by phone with its technical experts, wherever they may be and it is now extending this capability to video counselling.

Grainger’s healthy profit margins have allowed management to reinvest in the business, putting money into everything from bricks-and-mortar to software at an average of $145m annually for the ten years through 2010. “Size and scale in this business are, of themselves, competitive advantages,” says Rakers of Morgan Keegan, who notes that increasingly national companies are consolidating their supplier base. “Obviously, you have to have full national coverage in order to really compete,” he adds.

Despite Grainger’s first place ranking and many competitive advantages, Ryan is quick to note that the company has won only 5% or 6% of the North American market (and not even 1.5% of the global market). Ryan is confident that organic growth, not acquisitions, will remain the company’s main driving engine and that 7% to 10% annually is a reasonable target for revenue growth. It is a big ask: and is after all much greater than the growth rate of most economies, especially America’s. The difference however, says Rakers, is that the balance will come from taking away business from smaller competitors that can’t match Grainger’s wide product line, fast delivery, and technical assistance.

To support the growth plan, Grainger recently launched a radio advertising campaign in the US. It is aimed at prospective clients who know the Grainger name but aren’t aware of all the products and services that Grainger offers. It will, of course, also reach many others. Once it does, it is highly likely that Grainger will no longer be the most important company people have never heard of.I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

ANONYMITY

When traders want to remain anonymous it is because they are afraid their orders might be seen and be attacked in the marketplace. The fear of being “gamed” or losing a price advantage is at the heart of the desire to remain anonymous, but there is more to anonymity than simply staying out of sight.

Photograph © © Norebbo / Dreamstime.com, October 2011.

WHY TECHNOLOGY IS THE KEY TO TRADING ANONYMITY

NONYMITY MEANS DIFFERENT things to different people, according to Mark Goodman, Société Générale Corporate and Investment Banking’s (SG CIB’s) head of quantitative electronic services, Europe.

“When we use algorithms or DMA, there are some clients who would expect no human contact at all, although this is probably the most extreme definition. On the other hand, some clients are willing to sacrifice some anonymity in their order so as to have the opportunity to cross blocks with the wider floor. One of the key things we discuss with clients is ‘what is your expectation of anonymity?’ It’s important to understand that from the client’s point of view.”

Anonymity of client identity is closely linked with anonymity of strategy, according to Goodman: “If certain clients are known to take large positions, the anonymity of the firm is crucial.You can’t really separate the anonymity of the firm from the anonymity of the stock.”

On the other hand, Richard Gray, head of European trading, Liquidnet, says: “It’s critically important to conceal your trading intentions particularly with large block orders. Clients with large blocks are very concerned about what happens when they divulge their intentions to trade and often want to know who is on the other side of the trade. From the point of view of the high-frequency trader, it is irrelevant who has placed the order. They just want to detect patterns.”

Goodman agrees: “With high-frequency traders, the risk with them is not who owns a stock, but that they will try to find a buyer or seller and position themselves to take advantage of that fact. Placing a passive order in the market may seem to be saving you the spread but it is also used as a signal by the high-frequency players to position themselves ahead of you. This is all part of the anonymity of your flow.”

Some clients take extraordinary steps to monitor what happens when their orders reach the market place, according to Gray.“They record the price before a call and then again afterwards. If they are disclosing to two or three houses, they want to be sure this has not created market impact.

Sometimes they see a stock move violently against them as

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soon as they call a broker. Of course, there may be a number of reasons, but it is still market impact and they want to understand the cause.”

Liquidnet, a closed buy side-to-buy side crossing network, has built “powerful”anti-gaming technology into its platform according to Gray. “Certain behaviour will result in an automated response from the system. As all our members have signed up to behave a certain way, it is important to monitor this closely. The intention is to help members.”

Non-display venues are attracting around 5% of electronic order flow in Europe and in November 2010 UBS launched a non-display multilateral trading facility (MTF) with an anonymous clearing model. In July 2011, UBS MTF activated a second anonymous clearing house for interoperable clearing between SIX x-clear and EuroCCP. Anonymous orders on the platform grew from orders of around 300 to 600 names a day with around 50 executed and cleared, to orders in around 1,500 names with around 750 names traded daily.

High confidence in confidentiality “We are 100% dark with no signals, messages or pre-trade displays of any kind,” says Robert Barnes, chief executive officer of UBS MTF. “In a lit pool, one has the advantage of certainty but the downside of market impact; in a dark pool, there’s no certainty pre-trade but high confidence in confidentiality and minimum market impact. UBS MTF growth statistics suggest that members are increasing significantly their matching by extending the diversification of their orders by geography and down the market cap table with the pleasant result of interacting with the vast anonymous liquidity available in this pool,” he adds.

Goodman says: “Whilst it is tempting to view lit books as not anonymous and dark pools as anonymous, our research shows that this is not so clear cut. We have applied a proprietary measure to dark pools called Quality of Venue Measure (QVM). One example is to measure what happens immediately after we have executed in the dark book: in principal there should be no related reaction to our trade in the lit

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ANONYMITY

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Mark Goodman, head of quantitative electronic services, Europe, SG CIB. Photograph kindly supplied by SG CIB, October 2011.

Robert Barnes, chief executive officer of UBS MTF. Photograph kindly supplied by UBS, October 2011.

book if our trade is anonymous. In fact our observations show that on average in specific dark pools there is an immediate reaction in the volatility of the mid-price in the lit, indicating that the information has leaked. We are not as dark as we thought.

“What we conclude is that on average in these pools we are trading with counterparties who are seeking to identify our trade and then take advantage of this to position themselves. As a result we conclude that the nature of the counterparties in a venue will influence how anonymous our trading there is or not and that dark should not be assumed to be anonymous,” he says.

Richard Parsons, head of trading and sales at Instinet Europe, says:“There is a popular belief that liquidity goes to dark venues, but liquidity is not necessarily shifting away from the lit. Although you may be getting large blocks traded in the dark, the lit is still very important.”

Indeed, pre-trade anonymity does not necessarily have unambiguously positive benefits. A study in 2009 by Arto Thurlin of the Hanken School of Economics, in Finland, found that after NASDAQ OMX Helsinki introduced anonymity of broker identities in March 2006, there was no significant change in average bid-ask spreads and there was a significant increase in intraday volatility. However, a corresponding increase in trading volume mitigated these two negative effects.

On the other hand, in 2010 a report was published following the Australian Stock Exchange’s (ASX’s) removal of broker identifiers from the limit order book in November 2005. It found that consecutive buyer or seller-initiated transactions by the same broker had a relatively high permanent price impact, implying that broker identity conveys information to market participants.

The study points to other evidence that anonymity of limit orders (ie, a form of pre-trade anonymity) leads to a tightening in market bid-ask spreads (Foucault, Moinas, and Theissen, 2007) and improvement in market quality. It continues: “However, it is unclear whether anonymity of market orders (in other words, a form of post-trade anonymity) will have a similar effect.”

In October 2010 the Istanbul Stock Exchange (ISE) introduced measures to improve liquidity including the introduction of order cancellation, buyer and seller anonymity for executed transactions and a reduction in tick size. Following this, World Federation of Exchanges statistics record ISE as one of the few markets with larger on-order book value traded in December compared with November or other months in 2010.

The Hong Kong Stock Exchange is also considering introducing broker identity anonymity as part of a three-year plan and following consultation is also proposing re-introduction of an anonymous closing auction. Barnes points out that with increasing activity concentrating towards the end of each trading day, the closing auction is a significant event. “The closing auction is a liquidity point and serves as a reference price for constituents of indices. With such a concentration of anonymous flow, it is considered to have less impact risk particularly in less liquid names than at times earlier in the day.

Exchanges have seen a trend where the amount of value traded has steadily increased in the last few hours. In some cases up to 20% of a stock’s average daily volumes (ADV) is traded in these last few minutes of the trading day.”

In markets which display brokers’ identity, broker identity aggregation services exist to allow traders to identify who to contact, especially regarding stocks with low liquidity.

Parsons says:“The majority of market participants will trade

NOVEMBER 2011 • FTSE GLOBAL MARKETS

in their own name. If you are visible, you attract flow. On the other hand, where the broker is not visible, you are anonymous until the point of trade and then all visibility takes place post-trade.”

Barnes agrees: “The search for liquidity is a legitimate reason why one might want to see a broker’s identity. But the question is how to do this and still minimize signalling risk?

The industry’s response is to split the challenge into its two components: the search for liquidity; and the minimization of market impact during order execution. Where the introduction of anonymity can minimize market impact, a separate Named Market Share service, like that of the London Stock Exchange or Course of Sales Reports provided by ASX, can address the search for liquidity by identifying on T+3 the brokers with most recent activity in a particular security. In an increasingly competitive landscape, brokers also are providing innovative, improved information services for clients.”

As post-trade transparency improves, some traders fear that anonymity will be compromised. A new rule adopted in the United States in July by the Securities and Exchange Commission (SEC), the US financial markets regulator, requires firms whose transactions exceed 2m shares or $20m a day, or 20m shares or $200m a month to identify themselves to the SEC. The SEC will then assign each trader a unique identification number. Large traders will provide this number to their broker-dealers, who will be required to maintain transaction records for each large trader and report that information to the SEC upon request.

Some traders are worried that anonymity will disappear, but SEC chairman Mary L Schapiro says it will bolster the regulator’s ability to oversee the markets: “This new rule will enable us to promptly and efficiently identify significant market participants and collect data on their trading activity so that we can reconstruct market events, conduct investigations, and bring enforcement actions as appropriate.”

Market impact What is undisputed is that in low volume markets, it takes less to move them: small orders can create big movements in thin markets and this has intensified the need for anonymity, as Goodman points out: “The increase of fragmentation means that if you are not accessing all the venues where a stock is traded, and you are trading a large proportion of average daily volume on the primary market only, that gives away information. So market impact has become more of an issue in recent years because of fragmentation and high-frequency traders. Clients end up paying a higher price than they would need to so their execution cost rises.”

Barnes adds: “Introducing anonymity is about increasing the probability of delivering a fair result to market participants, particularly where orders are deployed on to an exchange electronic limit order book in multiple trades and even more if these need multiple fills to complete.

Anonymity attracts incremental orders that clients would otherwise not have placed.”

Kristian West, head of European trading desk, at JP Morgan Asset Management, sees advantages in using sell

FTSE GLOBAL MARKETS • NOVEMBER 2011

Richard Gray, head of European trading, Liquidnet. Photograph kindly supplied by Liquidnet, October 2011.

side sales desks specifically in order to remain anonymous: “We wish to interact in the market as efficiently as possible, with the least amount of market impact. This requires us to remain anonymous where possible.

However, to source deep liquidity the relationship with sell side brokers is invaluable. They are able to go into the market and represent our interests in an anonymous fashion. This protects us from unwanted information leakage and reduces market impact.”

Meantime Steve Wood, chief executive officer and founder, Global Buyside Trading Consultants, cites a recent report in which more than 60% of market participants believe the biggest source of information leakage is the sales trading desk. He says:“Anonymity is king. The largest part of the cost of the trade can often be put down to information leakage. It is part of the reason that buy side traders like to do the trade themselves through direct market access—and that in turn is good for the investment banks, who supply the route.”

Rob Shapiro, global head of trading, Bloomberg Tradebook, agrees: “Full service broker has benefits, but it’s also the place where some information leakage and order content is compromised. Client trading anonymity is paramount to our model. We never make flow calls because once you do that, some of the honest mistakes that lead to information leakage can take place.”

Instead, Bloomberg Tradebook has a technological solution to finding block trades while reducing information leakage, a system called IOI utility. Shapiro says this is a way in which buy side partners are empowered to own and control where information is disseminated. Indeed it is technology which holds the key to anonymity, concludes Parsons. “Technology has been a driver in the lit/dark space. It’s the only way you can get there.”I

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Sponsored statement

Adaptive Smart Order Routing: the path to execution quality Regulatory changes and technological innovation in western countries have increased competition and encouraged the fragmentation of liquidity through the growth of alternative trading venues and off-exchange order books that operate in direct competition with the existing primary exchanges.

LOBe DualITy Many brokers claim that their routers have the smartest order routing logic, but most standard SOR strategies just focus on aggressive orders to achieve best execution. In addition, the way aggressive orders are handled becomes commoditised as they remain dependent on standardised and largely IT-based processes.

Aggressive execution strategies are too often reduced to liquidity-seeking algorithms looking for hidden and visible liquidity across both incumbent and alternative markets. Most of them sweep venues after having analysed the available stock quantity at the respective far touch within a few milliseconds. Less often, and for smarter order routers, factors like certainty of execution, trading costs (including market impact) and clearing fees are integrated into the decision making. Far less unified, passive orders require even more sophis-

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Spread, Voltatily and CLOB size vs Fragmentation Spread 160% 140% 120% 100% 80% 60% 40% 20% 0%

May 2011

Volatility

June 2011

CLOB Size

July 2011

Fragmentation

August 2011

September 2011

106% 104% 102% 100% 98% 96% 94% 92% 90%

Fragmentation normalised by its average over the period

Bid-ask Spread, Volatility and CLOB Size normalised by their respective avg. over the period

I

N EUROPE, MiFID has dramatically changed the regional market structure. Instead of a single central limit order book (CLOB) by country, the directive has given way to the emergence of a glut of competing public limit order books (PLOBs) run by MTFs, dark midpoint books and internal crossing networks.

In order to sweep all venues where a stock is traded, order routing technologies rose to prominence. But let’s look at some recent European markets statistics, here all normalised by their period average value (see figure). We find that bid/ask spreads have widened in a comparable proportion to the higher volatility seen over the last few months owing to the EU sovereign debt crisis. Simultaneously, the size available at the touch of the CLOB has declined to the benefit of a greater fragmentation.

These observations help us understand that access to an effective smart order router (SOR) to source liquidity in any market circumstances across displayed and un-displayed pools of liquidity is now crucial for traders in their quest for best execution. Volatility, as well as others factors, could be a permanent feature of the markets that need further study, especially when building a so-called “smart” router. In other words, to be efficient, an SOR algorithm must be fully adaptive to the evolution of the market microstructure. Too often, the ‘S’ in ‘SOR’ stands for Static rather than for Smart.

Source: Société Générale, supplied October 2011.

Michel Kurek, Head of Quantitative Trading, Execution Service Europe, SG CIB. Photograph

by SG CIB, supplied October 2011.

ticated quantitative models and innovative algorithms. However, standard SORs generally adopt a herd behaviour, posting liquidity according to each venue’s overall historical—or, in the best case, real time—market share of stock’s volume.

At Société Générale Corporate & Investment Banking, we believe that routing algorithms, much like the two synchonised hemispheres of the human brain, must have two collaborative and well-balanced components: aggressive and passive execution—the right lobe with its ‘calculated spontaneity’, for aggressive liquidity consumption—the left lobe, much more analytical, supplying liquidity by posting passive orders to reach the highest execution profitability, but not reluctant to become aggressive if needed.

From IQ to QVM… Smarter brokers are able to couple both historic and real-time stock/venue profiles to new quantitative and predictive models to determine which specific queues or markets to access at time ‘t’. Probability of execution, and therefore lifespans of limit orders, for each venue should be one of the key factors of any broker’s SOR posting strategies. Basically the question is: How long is this queue and how fast is it moving? But do not confuse speed with haste.

Assuming you want to spare the spread, you can choose to post passive liquidity. Posting in a multi-lit/dark environment is very complex. By placing an order too deep in a LOB, or in a wrong LOB, you run the risk of not being filled and so having to trade at a less favourable price (opportunity cost).

Conversely, by posting liquidity, you bear the risk of being hit by an informed contra-side aggressive flow that will drive the stock price against you (adverse selection). Finally, it is also realistic to assume that by posting you open the field for ‘gaming’. Avoiding those pitfalls is a challenge that can be addressed by the proper real-time monitoring of market metrics, models and dynamic rebalancing of orders. Neglecting even one of these aspects can lead to a poor decision that could be akin to taking the wrong lane on a motorway.

SG CIB QVM (Quality Venue Measure) determines the quality of executions both in terms of price deviation and information leakage to give another dimension to SOR decisions. Brokers must ensure that the strategies are adjusted to the nature and the potential toxicity of the opposite flow with which they interact.

While there is no “one-size-fits-all” solution, the ability to customise or trigger bespoke behaviours within SORs is another key differentiating factor. Similarly, the modularity of a broker’s algorithmic trading suite (SOR included) can help its clients adapt to the constantly changing landscape, while allowing them to ride the smoothest motorway lane.I

For more information, please contact: Michel Kurek, Head of Quantitative Trading, Execution Service Europe Email: michel.kurek@sgcib.com

NOVEMBER 2011 • FTSE GLOBAL MARKETS

HIGH-FREQUENCY TRADING

New, best-selling novel The Fear Index by Robert Harris is about a mathematical genius who creates a high-speed trading programme, VIXAL, and the events that unfold as the algorithm takes control over one day in May. With echoes of the so-called “Flash Crash” in May 2010 in the US, when the Dow Jones plunged 600 points in five minutes only to regain them 20 minutes later—and the volatile spikes in August’s markets—some fear high-frequency trading and volatility go hand in hand and that it has been a toxic development in market structure in recent years. However, more than 200 years earlier, another author came to a rather different conclusion. Adam Smith stated in Wealth of Nations that speculation has the effect of reducing long-term volatility. Modern day analysis also confirms this trend. Fact or fiction? Ruth Hughes Liley goes in search of answers.

Photograph © Michael Sangoyo / Dreamstime.com, supplied October 2011.

HFT DOES NOT INCREASE VOLATILITY, SAY EXPERTS ONTRARY TO POPULAR expectation, a group of experts including a former head of the London Stock Exchange, Dame Clara Furze, Kevin Houstoun, cochair, FIX Protocol’s global technical committee, and a professor of computer science at the University of Bristol in the UK, Dave Cliff, notes: “Economic research thus far provides no direct evidence that high-frequency, computerbased trading has increased volatility.”

In September the group published a working paper on the future of computer trading in financial markets for the UK Foresight project, an analysis of trends projecting 20 years into the future. It also found high-frequency trading (HFT) provides the bulk of liquidity in the markets and that it“has not harmed and may have improved price efficiency”. It also notes that changes in transaction costs have declined in the past decade due to changes in market structure, which are invariably closely related to the development of HFT. Nonetheless, HFT is a convenient whipping boy and it looks as though regulation will be brought in to curb highfrequency trading as a result of the review of the European

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Markets in Financial Instruments Directive (MiFID II).

Already delayed, widely-leaked aspects of the final draft include the strong possibility that HFTs may have to keep algorithms trading continually throughout the day. This would be brought in to prevent “periodic illiquidity” if HTFs withdraw from markets suddenly.

High-frequency trading has different definitions. In a report published in September by research firm Celent, authors Anshuman Jaswal and Muralidhar Dasar accept there is confusion between electronic trading, algorithmic trading and high-frequency trading and divide HFT into three categories: low-latency strategies using high speeds to search limit orders or trade on events; market-making which exploits price discrepancies and is rewarded for posting liquidity on trading venues; and statistical arbitrage where traders spot discrepancies between price movements of two instruments or use differences in the volatility of an index and its underlying stock.

Many believe that any regulation would have to take account of the particular type of HFT in order to be fair and

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effective. “There’s a continuum from very fast trading through to long-only who execute fast,” agrees Bradley Wood, a partner at consultancy firm Greyspark Partners.

“Really what you are talking about when you talk about high-frequency trading is algorithmic trading. So when you talk about regulation you are really looking at what an algorithm is doing rather than HFT in and of itself.”

He goes on to explain: “There are hedge funds which have a variety of funds; they might be long-only and in a position once a week, or they might use statistical arbitrage or quant strategies as HFT strategies, jumping into positions many times a day. It is quite common to see all types under one roof, but at the other end of the spectrum, some are just a couple of guys in a garage with a big server.”

Active firms: the numbers During the last quarter (Q4) of 2010, Celent estimates that 50% of US equities HFT flow was from proprietary trading firms, while 22% came from automated market makers and 28% hedge funds. Other estimates put the amount of volume conducted by HFT in Europe at between 30% and 50% and up to 70% in the US, with investment banks constituting 46% of active firms.

In an analysis of London Stock Exchange (LSE) data into how high-frequency flow is directed, Elvis Jarnecic and Mark Snape, two Australian researchers, found that HFT flow was strongly correlated with market capitalisation: the bigger the stock, the more HFTs participated. They also found a positive correlation between HFT participation and volume on multilateral trading facilities, suggesting that high-frequency traders smooth prices between the LSE and multilateral trading facilities (MTFs).

Leading MTF Chi-X Europe briefly overtook the LSE as the largest exchange in Europe by turnover traded during August. Its chief executive officer Alasdair Haynes believes HFTs have become scapegoats for wider issues. “There are other issues [such as] Greece that make markets volatile,”he says.“High-frequency trading is like the hedge fund industry in the 1990s—very misunderstood. They have been quite secretive, but they are not now. There needs to be better education and better regulation.”

Bradley Wood agrees: “When something goes wrong in the markets it is not from the presence of HFT, but possibly from a bad algorithm. The jury is out as to whether HFTs cause volatility in markets. There are papers out, some saying it is good, and some not; but what really affects volatility are macroeconomic fundamentals: interest rates, bad news and so on.”

Tim Bevan, director, global electronic trading services, Otkritie, admits that there is an element of risk.“I do think the nature of HFTs has introduced some systemic risk. Just the sheer volume they generate: a black box can go wrong.

So you have to have a new set of risk controls to regulate this type of flow. This is relatively new and there needs to be a sensible debate about how to manage these risks.”

Research by global broker Instinet which looked at trading volumes during July and the volatile month of

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Alasdair Haynes, chief executive officer, Chi-X Europe. Photograph kindly supplied by Chi-X, October 2011.

August found a correlation between lower levels of HFT activity early in the day in August and higher volatility.

Instinet gives several possible reasons: that HFTs disengaged from the market causing the volatility; that heightened volatility led to HFTs disengaging; non-inclusion of other possible reasons in the data; or that secondary causes contributed to HFT disengagement.

Technology and ever lower latency Certainly, speed is still king. For example, in August, despite the high volatility in the markets at the time, NovaSparks reached down to speeds of 400 nanoseconds (400-billionths of a second) in tests of their hardware processing data feed handler for NASDAQ OMX’s equity platform.

One way firms have tried to reduce their latency is by locating their servers as close as possible to the exchange; a process called co-location. Whether these data centres would be regulated is open to debate. According to Rob Flatley, chief executive officer of data provider Netik, some firms are suspicious because they feel they have been disadvantaged: “But the long-only firms were never really competing with those guys. The HFTs compete with other HFTs. A long-only trader sends his order to the broker anyway and that takes time. And once the broker has the order the client is not going to be disadvantaged because most of the brokers are in co-located premises anyway.”

“Technology has been the big game changer,” explains Rajesh Nagella, head of algorithmic products, EMEA, at Citi, where a “vast majority” of all trading execution flow through London is done electronically. “Technology has made markets extremely fast; access to real-time information is extremely fast. It is technology which has changed markets, not high-frequency trading. Trading has stayed the same; there are still people trying to figure out who’s on the other side of the trade.” Nagella’s desk at Citi saw a noticeable increase in the volume of clients choosing

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Rajesh Nagella, head of algorithmic products, EMEA, at Citi.

Photograph kindly supplied by Citi, October 2011.

DMA and algos as market volatility in August and the sovereign debt crisis drove clients towards electronic trading: “There’s a dearth of liquidity and when they see it they want it and they want it fast. All this requires continued investment in technology.”

Many fear that a financial transaction tax (FTT) proposed on September 28th by the European Union (though this is being strongly opposed by the UK government) will dramatically reduce liquidity, possibly by more than half with potentially “disastrous consequences”, according to one broker. It would tax each transaction with shares, bonds and foreign currency taxed at 0.1% and derivatives contracts at 0.01%. The move, which is expected to become law on January 1st 2014, could generate €57bn a year. However, past examples of such a tax proved an out-and-out failure. Introduced in Sweden in 1984, a similar tax failed to raise revenue as FX and equity trading moved out of the country and it was finally abandoned in 1991.

Others are more sanguine. Wood believes that the effect of any tax would be priced in. “There will still be stat arb opportunities over and above the effect of the tax, but it may curtail the number of profit-generating algos. It could also shake-up houses and we could see consolidation of HFT firms, with the smaller ones finding it harder to compete.”

In response to upcoming regulation, HFTs in Europe in June 2011 formed a lobby group, the Futures Industry Association’s European Principal Traders Association (FIA-EPTA), but even its own chairman, Remco Lenterman, a managing director of IMG, asserted: “The members of FIA EPTA have a vested interest in well-regulated markets and strongly support regulatory initiatives to protect the stability and integrity of the markets.”

Okritie’s Bevan says: “There is a lot more openness today and to a large extent the system is self-regulating. HFTs are liaising closely with the exchanges and exchanges are liaising with regulators and that feedback loop works. Many exchanges have dedicated business units to deal with highfrequency funds.”

“We comply with high standards of MTF regulation,”adds Chi-X’s Haynes. “We have extremely high surveillance in place against market abuse and are as tightly regulated by the FSA as national exchanges. So just like budget airlines are as safe as full service airlines, people should always feel safe to trade at Chi-X because we have been subject to stringent scrutiny since launch.”

Knee-jerk reaction Wood adds to the debate saying: “I think there is definitely a knee-jerk reaction from politicians who will make political capital out of regulation. Once all the politicisation has died down and the expert regulators consult with the industry, I am hopeful it is going to end up with sensible regulation rather than onerous. However, algorithms may need to meet certain kinds of rules. We may find that one will have to register what class the algorithm is in and meet certain types of rules accordingly. Additionally, if you are running a market making algo you should probably be obliged to

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FTSE GLOBAL MARKETS • NOVEMBER 2011

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Tim Bevan, director, global electronic trading services, Otkritie.

Photograph kindly supplied by Otkritie, October 2011.

Robert Hegarty, global head of market structure, Thomson Reuters.

Photograph kindly supplied by Thomson Reuters, October 2011.

make markets regardless of market conditions—you shouldn’t just be able to pull out your algo when it suits you.”

Bevan agrees there are good and bad HTFs with the“good” ones using good technology and being sensitive to the impact they are having on the matching engine.“On the other hand there are some who go in and put a million orders a second in and the engine grinds to a halt and have very poor risk controls. Pre-trade risk checks cost time; but we are moving towards a situation where the exchanges are insourcing this from members. It naturally sits at the exchange level.”

Ultimately, however, Bevan concludes: “The whole question of whether HFT is good or evil is fundamentally wrong. It is the latest development that new technology has enabled.You can’t turn back the clock and say ‘this is the market model for ever’. Markets are constantly evolving.”

Paul Squires, head of trading at Axa Investment Managers, where the proportion of electronic trading is 15% and growing, says some sort of regulation of HFT would make sense and that the buy side has a crucial role to play in holding the industry to account.“We have a responsibility to make sure that the sell side smart order routers are not posting liquidity and cancelling orders so it resembles HFT. We need to govern the way our own flow is treated and direct the sell side to make sure our own flow doesn’t contribute to the fragmentation of liquidity that we have been complaining about since MiFID 1.”

For Squires and similar long-only based firms dealing with large order sizes, the fact that spreads have narrowed is less relevant to their overall strategy.“We are not a quant house. We trade for fund managers who meet with the management of companies and take the long-term investment view. It’s not about latency arbitrage,” he says.

Rob Flatley acknowledges: “There is more pressure on the buy side. It depends on the strategy of the firm, but if a portfolio manager’s decisions are based on reasons of volatility, then you will want to get in and out as quickly as possible.”

He talks of Bank of America Merrill Lynch which has newlyenhanced its algorithm Instinct so it now has five levels of urgency that can trade across different market caps, using realtime signals. “It’s an algo for people who hate algos,” says Flatley.“The buy side do need these types of tools.”

With HFTs a demanding client of exchanges and MTFs, they have pushed exchanges to innovate and extend their platforms, forcing firms down the line to upgrade. Flatley explains: “MTFs charge to take liquidity and give rebates.

That’s what high-frequency traders need. This brought costs down on the LSE and commissions have come down tenfold. Once the MTFs came in they built new clearing relationships and those costs came down. So people spend time talking about the evil or the good from high-frequency trading, but no one is complaining that costs have come down. HFTs are the founding fathers of MTFs.”

The new normal Some talk about the “new normal” and Thomson Reuters’ global head of market structure, Robert Hegarty says: “We are not going to be using the term high-frequency trading soon because everybody will be doing it that way. Do I see them legislating to slow down trading? No, because it’s no different than the last 200 years. We are just talking about microseconds and nanoseconds rather than hours and days.”

However, for US and European equities “the honeymoon period for HFT is over,” says Celent, with market participants taking a good look at profitability and the impact of strategies.

In a report published on October 12th this year, the firm states: “The growth of high-frequency trading in equities has reached its limits, having achieved a desired reduction in inefficiencies.

This has led to a profitability plateau which is driving the firms to explore HFT opportunities in other asset classes.”

Indeed the firm estimates that last year around 25% of proprietary trading desk volumes in the $4trn foreign exchange market were through HFT strategies.I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Sponsored statement

The Transaction Cost Analysis (TCA) landscape has evolved to date with a variety of service providers positioning different value offerings.

These range from the independent specialists analysing their client’s total trading activity across the entire investment process to brokers who provide supporting execution reports, albeit restricted by the transparency of their own time stamps and executions, through to OMS/EMS technology vendors, providing lighter pattern-based analytics in an integrated manner to strengthen their offering. From a specialist’s perspective, the benefits of TCA are touted to be varied, ranging from alpha capture through to regulatory compliance, with a growing migration of users focusing on extracting more value to improve execution quality. However, irrespective of the service provider and offering, the use of TCA has encountered several challenges to date, and a common criticism which has emerged from the sophisticated user group has been in regard to drawing recommendations from the analytics in a clear and actionable manner.

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The premise of this approach is that each buy side organisation, be it aligned by Investment Teams, Strategies or the Individual Portfolio Manager themselves, may have a particular style.

And if one is able to identify a discernible and repetitive pattern, this can be valuable information to the desk which can reveal the most appropriate trading strategy at a high level.

Part of this value serves to reaffirm what Buy Side Traders intuitively know in relation to the orders they handle and their associated difficulty, but often not able to show tangibly. “The manager timing shapes are definitely useful in identifying patterns, with the key being to have something on paper to reinforce our conviction about our different Portfolio Manager Styles, and backup what we are already communicating internally”, says Tony Whalley, Head of Trading at Scottish Widows Investment Partnership.

So what kind of patterns are we talking about?

Figure 1 depicts a momentum price trend shape where stocks rise rapidly on buy orders and vice versa for sells. The supporting key identifies the most commonly observed patterns.

“It’s fascinating when one starts to build a pattern of the different styles, and I have often seen traders intuitively smile because they

FTSE GLOBAL MARKETS • NOVEMBER 2011

Figure 1: Arrival Chart depicting Momentum Style Portfolio Manager Counter

Momentum

Neutral

Optimal

Reversion

200 150 100 Basis Points

A

BEL/NOSER CORP introduces a new area of analytics within its Pre and Post Trade integrated environment, which has expanded the focus and way of thinking about TCA measurement for its clients.

50 0 -50

-100 -150 -5 days

-2 days

Open

Arrival at Desk

+5 Minutes

+15 +30 Minutes Minutes Time Horizon

Nupen Shah, Head EMEA Sales at Abel/Noser Corp. Photograph kindly supplied by Abel/Noser, October 2011. recognise the portfolio manager by the style of their timing. Of additional value, which is not always transparent, is that the momentum trend continues after arrival, even through to five days after with no identified reversion. Now this is a great basis for discussion since it can enable a debate regarding the level of discretion on the desk, and in this case whether an Implementation Shortfall-based approach, other decision

+60 Minutes

+90 Minutes

Close

+2 days

+5 days

Source: Abel Noser Sample Manager, supplied October 2011.

making variables aside, is more of an appropriate trading strategy to suit the style of the portfolio manager in question”, says Nupen Shah, Head EMEA Sales at Abel/Noser Corp.

What’s very apparent in reviewing the commonly identified patterns is that an organisation can have multiple shapes or styles embedded. In effect one is handed a playbook of different styles for fit within the decision making process. “It’s another tool in the box and is there to add value as one of the many pieces of the overall decision making process. For example, for the momentum managers, you know that you usually need to get the trade done quickly, whereas for the value managers, you know you often have more time to implement the right trading strategy”, says Tony Whalley.

Empowering the Buy Side Trader with Actionable Information To make the PM styles relevant and highlight the most opportunities for alpha generation, one needs to account for the actual implementation.

By overlaying execution, one is effectively visualising the actual interaction that took place, to

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Sponsored statement

Figure 2: Manager Styles Web Interface Arrival Chart - Price Change vs. Arrival Price in basis points

Principal /K: Pct. of Principal: Avg. Variance: Momentum Index: Avg. Order Durantion: Peer I.S. Rank:

5,543,905 71% 87.51 83% 285 min.

64%

Breakdown by Style SMALL CAP: MID CAP: LARGE CAP:

12% 18% 71%

Breakdown by Order % of Avbl. Vol. Under 1%: 1 to 1.99%: 2 to 4.99%: 5 to 9.99%: 10 to 19.99%: 20 to 49.99%: 50% and up:

34.5% 17.22% 14.54% 12.61% 10.54% 5.90% 4.69%

Weighted Average

Variance Up/Down

Imp Shortfall

Avail VWAP

20% Vol Part

Peer I.S.

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+30 Min.

+60 Min.

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Time Horizon Source: Abel Noser Sample Manager, supplied October 2011.

first assess execution quality efficiency, and then begin to identify areas and opportunities for improvement in tune with how the organization is aligned and their associated workflow. “It would be interesting to visually see the interaction between the portfolio managers and associated execution by the desk to highlight how effective my traders are in handling the different styles of the PM’s”, says Tony Whalley.

Further, when one bears in mind that the order dynamic or instructions are not always well recorded in the OMS, but tacitly known, if multiple transaction cost metrics are overlayed, it enables a scenario analysis of the impact of different trading strategies in reference to the particular PM style.

In talking to Michelangelo Ivaldi, Senior Trader at Generali Investments Italy SGR SpA, he comments: “We think the manager shape can be a great guideline in deciding the execution strategy to be implemented. Of course the order received has to be similar to the typical order for that manager.”

It seems that at a high level the shapes present good value, but one can see why the nonbelievers may wonder how often the trend lines hold. Abel/Noser has therefore taken the route to empower its users with the flexibility to access these visuals on demand. Further clients are able drill down into the identified patterns to validate the consistency of the shapes. “Our clients have taken a strong interest in these diagnostics and in order to make this information actionable, it was important to allow them to marry our analytics with their intuition to determine a fit within their work flow which can be used to their advantage”, says Shah.

Figure 2 shows the same sample portfolio manager as represented in Figure 1, but this time

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with multiple transaction cost metrics. As one sees from the graph, multiple transaction cost metrics have been overlaid to scenario analyse execution quality versus arrival price.

From an interpretive standpoint, Nupen Shah highlights: “When analyzing execution quality versus Available VWAP it’s possible that execution quality would look good given depending upon the order sizes since the momentum trend continues on. But at what expense? In our experience we have seen that one transaction cost metric can be achieved at the expense of the other, so being able to visualise the opportunity makes it simpler to draw recommendations. In this case what was up for discussion was to review the PM’s timing ability to pass orders earlier to try and capture the alpha prior to arrival with the true order size revealed to the desk, and further an increase in the participation rate to maximize alpha preservation.”

Using Manager Styles to Customise Execution As desks seek to build their analytical support models and execution capabilities, and proceed to manage and vary the use of their execution method selection, what appears to exist is the opportunity to capitalise upon client specific information described above to customize the execution strategy.

“Traders have been intuitively doing this in some shape or form, but what exists here is the opportunity to do this in a more transparent methodical manner or by passing this information to a preferred algorithmic broker for use as one of the input parameters”, says Peter Weiler, Global Head of Sales at Abel/Noser Corp. In discussing the fit with Michelangelo Ivaldi, he comments that “we are very active in the use of

Tony Whalley, Head of Trading at Scottish Widows Investment Partnership. Photograph kindly supplied by Scottish Widows Investment Partnership, October 2011. algorithms and we value the inputs of the manager shapes in supporting the choice of the appropriate algorithm”.

Abel/Noser believes this can be taken a step further and has recently launched a series of Signature Algorithms, which leverage off a framework of proprietary algorithm suite to customise an algorithm to suit the PM’s historical timing style and pattern.“As the timing pattern and trading process evolves, the programme will re-evaluate each custom algorithm and continue to make changes when necessary. Our market lab team has also added a backtesting function within our analytics to prove the actionable opportunity here,” says Peter Weiler.

So with the above outlined potential applications in mind, does TCA still remain an art as well as a science? Possibly, given there is still the process of reviewing these patterns and applying qualitative and quantitative information to extracting tangible recommendations, a process which typically forms part of the consultancy review process provided by the Independent Specialists. Although, however a trading desk chooses to rationalise how to apply TCA analytics within its workflow, what’s clear is that with more relevant analytics which bring to light the PM’s impact on a desk’s ability to contain transaction costs, and with improvements in recording the order dynamics within the OMS dataset, the user is more empowered to make TCA actionable, and does bring TCA a step closer to be being a science than an art. I

For a free trial to see your Portfolio Manager Shapes, please visit www.abelnoser.com or contact info@abelnoser.com

NOVEMBER 2011 • FTSE GLOBAL MARKETS

CAP INTRO

Photograph © Michael Brown / Dreamstime.com, supplied October 2011.

HONING THE CAP-INTRO SKILL SET FOR A NEW ERA Capital introductions have become crucially important in helping to oil the wheels of the alternative investment segment in the past couple of years, though cap intro specialists are keen to distinguish between capital introductions and capital raising. Cap intro specialists are the matchmakers of the capital markets, not the direct means of hedge funds raising funds. It is a finely-honed balancing act and skill set that requires detailed knowledge of both sides of the business divide as well as subtle shifts in investor trends. Already a discrete and highly competitive business set, the tempo of competition has heated up as investor attention shifts towards higher-growth Asian markets, with cap intro teams building out their overseas operations and fighting for market share. Matt Lynn reports.

HERE WERE 280 new hedge fund launches in the second quarter of this year, down slightly on the 298 launched in the first quarter, according to HFR’s latest Market Microstructure report: Q2 2011. Even so, the launch of 578 hedge funds in the first half of 2011 is the largest clump of new launches since the first half of 2007—bringing total assets under management in the industry to a record $2.04trn. In contrast, there were 372 fund liquidations over the first six months, with the liquidation total for the second quarter representing an attrition rate of 2.07%, says HFR.

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FTSE GLOBAL MARKETS • NOVEMBER 2011

The figures show that while markets remain volatile, hedge funds have managed to hold their own and continue to attract investors. Not all are perhaps as lucky as Breton Hill Capital, a Toronto-based global macro hedge fund with investments in equities, commodity and financial futures, and currencies, which recently secured $100m in seed capital from the California Public Employees’ Retirement System (CalPERS).

CalPERS, as of the end of June this year, had assets worth $237.5bn. This was CalPERS’ first foray into providing seed capital in a hedge fund, though it has already committed

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CAP INTRO

some $500m in customised funds of hedge funds focused on emerging markets; with some $5.3bn invested in absolute return strategies as of the end of June this year. Breton Hill’s investment approach is reportedly based on using momentum to earn risk-adjusted returns in a variety of asset classes.

Actually, CalPERS has its own methodology for investing in funds; but most hedge funds wanting to raise capital need to utilise capital introduction services as part of the overall fund raising process. In part, that is because launching a hedge fund is no longer quite the simple route to riches it once was. Through the boom years of the past decade, a couple of traders with a dozen years at one of the big investment banks on their CV between them could rent a small office off London’s Berkeley Square, plug in a Bloomberg terminal or two, put in some phone calls to Zurich and Singapore, and have a few hundred million dollars to speculate with by the end of the week.

True, a few superstars can still raise money relatively easily.

At the end of last year for instance, Stanley Druckenmiller, who has achieved legendary status in the investment world

after nearly two decades of consistently out-performing the markets, raised $5bn for his new firm Point State Capital, and did so without much apparent effort. In that example though Druckenmiller put in $1bn of his own money, and had a track record of generating average returns of 30% over a twodecade period. Not many people have that kind of following in the markets, and, not surprisingly, not many can raise that kind of money so easily. So far this year, most hedge fund launches have been far more modest.

Even so, all the main brokers have devoted a huge amount of energy to beefing-up their capital introductions service in the past few years. “For a start-up fund, capital raising is crucial, and capital introduction can play an additive role,” says Mairead Kenny, the head of EMEA Capital Introductions for Bank of America Merrill Lynch in London. “When choosing a prime broker, the capital introduction team’s experience is one of the many important factors to consider. However, over the last couple of years, we have seen a lot more interest from the more established firms as well.”

CAPITAL INTRODUCTIONS: THE CHALLENGES AND THE OPPORTUNITY AP INTRO IS offered for free to hedge funds. It is a bit like the free air miles you get with a credit card. It is free only in the notional sense that you don’t pay for it directly. In reality, a hedge fund also has to be able to deliver plenty of business for their prime broker once they have raised the cash—after all, if they don’t, it is hardly worth paying for all those business trips that are needed to keep the cap-intro team’s contact book up to date.

If you are a hedge fund, you have to be running the right kind of fund to get the best service from your cap intro provider. They can only introduce a limited number of new or established outfits to their clients in any one year; try to arrange too many presentations and the clients will soon get tired of them.

Cap intro is specialised in three areas: start-up/early stage funds; growth or mature funds and finally well-established institutions. Start-up or early stage funds are deemed to be good at managing money but new to raising assets. This is a highly-

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specialised segment, and investors in them are dominated by so-called seeders and some fund of funds. As we mentioned at the beginning of this article, CalPERS now has a seeder capability.

Most hedge fund managers are at present mostly chasing pension funds.

There’s a big focus on the Street right now to do more research with pension funds and pension fund consultants.

Very large pension funds, such as CalPERS or the Florida State Board, tend to make direct investments.

Smaller funds tend to work via agencies and go through fund of funds or consultants.

In this regard many cap-intro specialists do not see pension fund consultants as competition. “Generally, large pension funds do not have large staff to analyse hedge funds, or their varied strategies, so pension fund consultants play an important role without conflicting with the role of a cap intro specialist.

The good news is that in Canada, CIBC’s Robillard says the bank has

seen an increase in activity of late and an increasingly “engaged audience.

This includes high net worth investors, sovereign wealth funds; in fact generally across the investment segment. We are dealing with sophisticated audiences on both sides of the table. The key is for the fund manager to present the investment thesis in a clear and succinct manner; despite the potential complexity in their approaches. A healthy investor/manager dialogue bodes well for the alternative space.”

Tick the following boxes then, and cap intro will be a useful way of raising additional funds. It won’t guarantee success—not much ever does. It should however get a fund onto the radar screens of a lot of investors, and at least make sure it has capital to play with.

FEND OFF THE MADOFF FACTOR Any new fund faces two big issues: one is security; the second is credibility. Bernie Madoff did a huge amount of damage to the industry.

Charming wealthy investors on the golf and charity dinner circuits allowed Madoff to raise billions of dollars for a hedge fund that turned out to be nothing more than a Ponzi scheme.

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Capital introduction (cap intro) is a modern version of very old and very basic financial skill; finding the people with lots of money to invest and introducing them to people with good ideas about how to make it work productively. Claude Robillard, executive director with CIBC’s prime services group, describes it as “bridging an informed conversation between stakeholders”. He adds:“We play an important yet unbiased role in presenting the alternative investment lanscape to target investors.”

Cap intro has re-invented the task for a world where money moves around very quickly and the range of possible investments has exploded. Nobody can expect to have all the contacts they need in their Rolodex. Nor can they expect to be experts in every type of financial instrument. When it comes to finding the people they need to talk to, they need help.

“After the credit crunch, capital introduction became even more important,”explains Anita Nemes, global head of capital introduction at Deutsche Bank.“Just about every hedge fund was open to investors, and even those who were not were looking to broaden and diversify their existing investor base.”

Even a few of the industry’s big names were caught out by him. The result has been that there is a lot more scrutiny of every claim that a fund makes, and the kind of controls it has in place to make sure the money is managed exactly as it is meant to be.

SHOW THAT YOU KNOW HOW TO MANAGE MONEY A fund has to establish credibility. One lesson investors learned from the crash is that hedge funds don’t always hedge against anything. A few of them did well as the markets went down: they’d seen it coming and positioned their portfolios accordingly. Many didn’t. They suffered along with everyone else. One consequence of that lack of outperformance is that investors have become a lot more selective about who they give their money to. After all, there is not much point in paying a 2% annual management charge and a 20% performance fee for a fund that doesn’t do any better than a low-cost tracker.

“These things go in cycles,” says James Parker, head of Aravis Partners.

“Currently, investors have low appetite for risk and cash is seen as a good option.

So right now it’s tough to raise money.”

The main task of a bank’s cap-intro department is to come up with a list of potential investors in a fund and introduce them to the managers. The banks restrict themselves to introductions, with no commitment to actually raise any money.

The main task of a bank’s cap-intro department is to come up with a list of potential investors in a fund and introduce them to the managers. Whether they actually make an investment is up to the investor. The banks restrict themselves to introductions, with no commitment to actually raise any money. As long as a hedge fund has a reasonable story to tell, and a track record to back up their ideas, they should come away from a round of cap-intro meetings with a decent sum of money.

The investor side, too, makes gains, in almost a textbook set. According to Robillard: “The story is the same every-

TELL THE RIGHT STORY A hedge fund needs the right story to tell. When the industry was getting going, hedge funds mainly raised money from wealthy individuals or from family trusts. They often knew their investors well, and kept in touch with them regularly. Now hedge fund investing these days is mainstream; just about every investment house in the world is going to allocate at least some proportion of its assets to hedge funds.

In turn, that means they want the fund to be run on far more conventional lines, with clear mandates and investment strategies that are stuck to, no matter what happens. There is a lot more money to go after, but the hoops that would-be hedge fund managers have to jump through to get it are a lot higher as well.

HAVE THE RIGHT INVESTMENT STRATEGY The appeal of alternative investment strategies to institutional money is not only based on that ongoing search for alpha, it is also based on the policy of some institutional investors to diversify their holdings outside of a long-only strategy. In the near past, hedge funds pursuing multi-strategy-based investments, relative value; long-short

FTSE GLOBAL MARKETS • NOVEMBER 2011

equity, distressed credit and macro strategies have tended to have most appeal to investors. After 2008, notes Bank of America Merrill Lynch’s Jon Yalmokas, “demand for long-short moved into macro” as stock pick-based approaches did not resonate as much.

This year, Yalmokas says that if anything, the trend has been gravitating back to long-short strategies.

CHOOSE YOUR CAP-INTRO SPECIALIST WISELY In reality only a limited number of funds are going to get the best service from their broker. Usually they will be the ones with the best track record, the most convincing back office and impeccable personal credentials. Says Deutsche Bank’s Nemes: “Investors always have a macro view, but the manager-selection process is really bottom-up. Investors are looking at the manager and asking whether this is someone who can really generate good risk-adjusted returns over the medium and long term with the appropriate infrastructure.” Once you can track all these, all you have to do is ensure your cap intro provider can set up meetings with your investment soulmate.

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where; investors are looking for absolute return, while they are focused on due diligence, transparency, and diversification in an effort to reduce overall risk.”

All the main prime brokers offer it, though Goldman Sachs and Morgan Stanley are still reckoned to be market leaders, particularly in the new high-growth markets in Asia. However, Citi, UBS, Deutsche Bank, Credit Suisse, Bank of America Merrill Lynch and CIBC have been jockeying for market share (rather successfully, too) over the past few years; with various cap-intro specialists playing musical chairs, depending on the opportunities and remuneration packages available in competitor institutions.

The role of cap-intro specialists in these troubled and volatile market trading days has come to the fore. Traditionally, the job of a prime broker was to provide a suite of services, typically handling much of the back office work as well as providing dealing services and, importantly, leverage.

Gearing was one of the keys to hedge fund performance, and it was the job of the prime broker to make sure the credit lines were available when they were needed. However, in the wake of the credit crunch, the industry has changed.

Regulations have made it harder for the banks to simply lend unlimited money to their hedge fund clients. Moreover, capital has not been in such plentiful supply. As a result, the other services that prime brokers offer have become a lot more important, and cap intro has been foremost among them. “I think prime brokers will always be important, but mainly for initial capital,” holds James Parker, who runs Aravis Partners, a firm that specialises in raising new money for hedge funds. “They tend to lose interest fairly quickly.”

Parker’s view may be rather extreme, but even if it were true the number of new funds getting started means there is not likely to be any shortage of demand for prime broking services. One reason for the explosion in new funds is regulation. In the wake of the credit crunch, investment banks find they are far more tightly controlled than they ever were before. In the US, the Volcker Rules, named after the former Federal Reserve chairman Paul Volcker, have put strict curbs on proprietary trading. Star traders, who manned the dealing desks, playing the markets with the bank’s own capital, are gradually getting squeezed out of existence.

That’s not all. If proposals such as the Vickers reforms in the UK become law, and retail banks are ring-fenced from investment banks, there will be even less spare money for the prop traders to play with. No surprise then that some of them are quitting banks and setting up their own hedge funds. For example, in April this year Kay Haigh, who’d been a star trader at Deutsche Bank, left the firm (with a team of bankers) to launch his own hedge fund. Elsewhere, Pierre-Henri Flamand stepped down in 2010 as head of a Goldman Sachs unit that traded equities to start Edoma Partners. Traders from Citgroup and Barclays Capital have made similar moves.

All of them need money to play with; and the cap-intro departments of their old employers are useful adjuncts to their formal capital raising activities. “In the past year, new hedge fund launches have picked up again,” says Kenny.

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Claude Robillard, executive director with CIBC’s prime services group.

“We play an important yet unbiased role in presenting the alternative investment lanscape to target investors,” he says. Photograph kindly supplied by CIBC, October 2011.

“There have been a number of high-pedigree funds that have launched with significant assets, and in general investor interest in emerging managers has picked up significantly in the past six to 12 months.”

Name any high-level cap-intro house and the hiring strategy is pretty much the same. Citi is (for the purposes of this article) a useful template for the key trends running through the evolution of cap-intro teams right now. The bank began an aggressive hiring programme in December last year that involved the expansion of its Asian footprint in the hedge fund servicing space and has focused in particular on expanding the bank’s cap-intro advisory set. The bank announced a hiring spree at the beginning of the year that would increase headcount by as much as 20%. In that regard, Citi has followed Deutsche Bank, UBS, Morgan Stanley and others which have been building their Asia-Pacific cap-intro teams since the start of 2010. These banks and others have all reportedly built new business and taken market share from Goldman Sachs and Morgan Stanley.

Industry tracker AsiaHedge reckons that before 2008, Goldman Sachs and Morgan Stanley had a combined 60%-plus market share in the prime brokering space, which has now declined by around half. At the same time, Asia has witnessed steady growth of the hedge fund business, domiciled mainly in both Singapore and Hong Kong; though activities stretch wider than those two financial capitals. Citi, for example, recently hired Rob Baigrie (previously at HDH Capital) and Carol Teng (from Nomos Capital Partners) for its Australian capital-introductions team serving the Asia-Pacific region.

NOVEMBER 2011 • FTSE GLOBAL MARKETS

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CAP INTRO

Mairead Kenny, the head of EMEA Capital Introductions for Bank of America Merrill Lynch. “When choosing a prime broker, the capital introduction team’s experience is one of the many important factors to consider,” she says. Photograph kindly supplied by Bank of America Merrill Lynch, October 2011.

In reality there is much to play for in Asia. Hedge fund assets under management there stand at a speck above $90bn at the midpoint of this year, compared with $14bn in 2000, according to HFR, with some $2.6bn of new capital flowing into Asia-focused hedge funds in the second quarter.

Some of the local funds have been highly successful in raising big blocks of money. Azentus, the Hong Kong-based hedge fund launched earlier this year with assets under management (AUM) of $1bn, for example has now reached $2bn and has subsequently closed to new investments.

Moreover, the outlook for the Asian segment is good with the growing number of high net worth investors providing a fillip to hedge funds looking for investor funds. A recent report by high net worth investment specialist Julius Baer projected the number of high net worth investors across the region doubling to 2.82m by 2015, far outstripping the high net worth segment in Europe.

Even so, opportunities are extant in traditional financial centres. Citi has also expanded its EMEA team, with Christy York now heading the region’s capital-introductions effort in London. York joined from TRG Management, where he was head of capital raising.York joins Beth Neely, head of capital introductions for the Americas, and Martin Visairis, head of capital introductions and sales for Asia, all reporting to Chris Greer, global head of capital introductions.

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Other institutions have also been hiring. Among the more recent appointments, Michael Terry joined Bank of America Merrill Lynch from Oakpoint Advisors as global head of capital introductions. He will be based in New York, reporting to Jon Yalmokas, head of US prime brokerage. “Michael’s capital-raising experience brings knowledge and contacts to our team which will help us to further expand our hedge fund presence and help clients navigate an increasingly complicated investor landscape,”notes Yalmokas. The hiring spree is more than adding numbers in the rush for market share. It is also about the deepening skill set required of an effective cap-intro team, he says. “Historically, cap-intro teams were built from a broad base of backgrounds. As the business has matured, it is now incumbent on a successful team to add skill sets from an investor background to the traditional skill set.” It obviously worked for them, as Bank of America Merrill Lynch’s prime brokerage platform was top ranked in capital introductions and in Europe in Global Custodian’s recent 2011 prime brokerage survey.

It is a business that is gaining sophistication, agrees CIBC’s Robillard. “Our team’s diverse skill set and experience contribute to a thorough understanding of fund-level risk and return profiles. This knowledge is critical given the investor’s focus on risk management, the infrastructure that supports each fund, and the myriad of alternative investment opportunities to consider within the backdrop of a challenging global market. A good cap intro service is underpinned by an actionable, international network that is relevant to stakeholders.”

In other words, the business set is married to rather a lot of homework. Robillard stresses:“A passive approach doesn’t work. It doesn’t lead to actionable results. People who do heavy lifting in this business tend to do very well.” He talks of a steady stream business, with growing demand from a diverse range of clients, both in the resilient Canadian market and overseas (around 40% of CIBC’s cap-intro focus is international).

Even so, the rate of expansion of capital introductions into the alternative investment space in the West generally has slowed, even while volume dollars remain high, notes Yalmokas: “It has not been the easiest of periods for managers to raise money and this year the market has been more difficult, the capital base more institutional and regulation more demanding. The result is managers working harder to get dollars.”

Whether that trend will ease in 2012 is dependent on directional fund flow statistics. Significant now on the capintro calendar is the trends evinced in the November 1st and November 15th redemption cycles, which will provide a bellwether of investor approaches to the alternative investment space over the near term. It is a nervous wait for many.

“Up to the third quarter we saw net inflows into the alternative space, now we are anxiously watching what the next cycle will show. If it shows signs of slowing, it may reverberate through December and into the New Year. We are hoping for a balance of new investors to offset redemptions,” concludes Yalmokas. I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

CORPORATE ACTIONS Photograph © Peterfactors / Dreamstime.com, supplied October 2011.

MANAGING RISK IN CORPORATE ACTIONS: ALL ABOARD? Historically given short shrift, increased risk awareness around sophisticated investment strategies has renewed the industry’s focus on improving corporate-actions methods and technologies.

Success, however, requires that participants have the wherewithal—and the willingness—to work together. David Simons reports from Boston.

F CORPORATE-ACTIONS inefficiency is, as one industry observer put it, “nearly as old as the global custody business itself”, the various initiatives aimed at addressing its ills once and for all feel like a turning point to many. For starters, this month the Depository Trust & Clearing Corporation (DTCC) begins its industry-wide rollout of the ISO 20022 corporate actions announcementmessaging standard, following a six-month pilot phase that included participants such as Brown Brothers Harriman, BNY Mellon and JPMorgan Chase.

Onboarding and adoption of ISO 20022 for DTCC clients will begin during the first quarter of 2012. Pilot testing for the next phase of its re-engineering initiative—for distribution events covering the entire lifecycle, including entitlements, settlements, and election processes for Elective Dividend Service (EDS) events—is set to begin during the third quarter of next year. Additionally, the November release will include the introduction of a new browser-based user interface capable of providing a single unified corporate-actions platform covering numerous event types.

Meanwhile, XBRL, the streamlining technology that allows issuers and their agents to electronically tag corporate-actions announcement data in a standard format, continues to play a lead role in the campaign to target and improve issuer cooperation. Tagging corporate-action information at the source reduces the chances of misinterpretation and the associated risks while supporting the goal of straight-through processing. Despite improvements to

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the corporate-actions lifecycle, weak links persist. While many markets have long since adopted SWIFT standards, others have been, well, less than swift, relying instead on native formats and thereby limiting global STP capabilities.

Hence, getting data faster remains a top priority for corporate-actions proponents going forward.

Messaging and the bottleneck Not surprisingly, the increased emphasis on corporateactions operational risk has coincided with a ramp-up in elaborate investment strategies. “These are not your plainvanilla operational processes any more,” says Susan Cosgrove, DTCC managing director and general manager, Settlement and Asset Services. “Today, events are significantly more complex and there is greater potential for operational errors as information is exchanged from the issuer, through exchanges, CSDs agents and custodians, and ultimately to the investor.”

In the realm of corporate actions, announcements represent “just the tip of the iceberg,” says Cosgrove. “For instance, payments and elections will eventually be incorporated into the standard as well, and we will annually upgrade to the new standard in an effort to keep the entire industry up to date with current market practices.

As has always been the case, fixing corporate actions will require additional energy on the part of the issuer. In a realworld context, however, issuers need to be able to clearly see the value of using XBRL. To that end, DTCC, in conjunction

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with SWIFT and XBRL US, is working with two depositary banks to pilot the use of XBRL. “An increase in XBRL adoption will facilitate accuracy in corporate-action processing by allowing the issuer to communicate the announcement using electronically-tagged data, which in turn will substantially mitigate interpretation risk,” says Cosgrove. Aligning XBRL with the ISO 20022 standard will make it much easier for investors to disseminate information around elections and related processing back up the corporate actions chain, she says.

Despite its merits, Cosgrove concedes that the outgoing 15022 messaging standard had become increasingly problematic within the corporate-actions environment due to the growing number of requisite extensions. “To the degree that once all of the add-ons were factored in, it was no longer a ‘standard’ in the real sense of the word,” says Cosgrove. “So I think the increased focus on the part of the industry, combined with DTCC’s leadership in standardisation along with the tools provided by SWIFT and the ISO 20022 format, is the perfect formula to address these deficiencies.”

DTCC will begin to close the book on its legacy formats beginning in 2015, giving participants plenty of time to make the transition. From her vantage point, Cosgrove hasn’t seen much resistance. “There may be a few stragglers here and there, but if anything, we are more likely to see a sizeable waiting list for the 20022 onboarding.”

Susan Cosgrove, DTCC managing director and general manager, Settlement and Asset Services. Photograph kindly supplied by DTCC, October 2011.

Multiple systems Having served as a 20022 connectivity test pilot, Marty Kruse, director of global corporate actions, BNY Mellon Asset Servicing, understands first-hand the importance of moving messages downstream with the least amount of resistance. “In terms of corporate actions, the US is the biggest market in the world, so DTCC’s new proprietary format is a critical step, no doubt,” says Kruse. “Hopefully as more issuers and agents start to use tagging the right way, we should begin to see real improvement in the initiation of messaging.”

Standardisation in the marketplace is essential for maintaining sustainability, says Lorrie Gordon, senior vicepresident at Brown Brothers Harriman. Like BNY Mellon, BBH continues to help DTCC perfect its 20022 re-engineering initiative, using its proprietary Infomediary platform to transmit 20022 messages between DTCC and BBH’s corporate-actions processing engine. Through Infomediary, BBH will be able to assist clients including banks and asset managers by providing “insulation from managing multiple standards across their provider networks,” says Gordon.

Kruse, like many of his peers, believes there are other pressing concerns, among them interpretation risk. “When you scrub a notification, there are multiple systems out there that will do all sorts of comparisons and then tell you that your copy is golden. But this is a market that now offers you 30 choices where you once had just three—and when you factor in all of this complexity, the reality is that technology can only take you so far.”

The answer, says Kruse, is having skilled personnel on board.“Unless your organisation is really on top of SWIFT,

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Marty Kruse, director of global corporate actions, BNY Mellon Asset Servicing. Photograph kindly supplied by BNY Mellon Asset Servicing, October 2011.

there will always be an element of interpretation that will need to be covered. And that to me is really the biggest challenge. We already have top-notch tools for handling the initial scrubs, the processing engines have been automated to the fullest extent—so that just leaves the interpretation piece. Short of having some incredibly intelligent software that is capable of comparing and contrasting all of the elements in the decision-making chain, I think that is always going to be a huge factor.”

Alan Cameron, head of client segment—broker dealer and investment banks, at BNP Paribas Securities Services, agrees

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Alan Cameron, head of client segment—broker dealer and investment banks, at BNP Paribas Securities Services. Photograph kindly supplied by BNP Paribas Securities Services, October 2011.

Neil Daswani, regional transaction banking head of North Asia for Standard Chartered Bank. Photograph kindly supplied by Standard Chartered Bank, October 2011.

that one cannot over-emphasise the importance of having experienced people on the ground. “You still have to have the resources to properly interpret all of the company data in order to have an environment that is conducive to STP. So you need people that can explain all of this data to the clients, and in a timely manner—you can’t just put it into a pile and tell them ‘I’ll have a look over the weekend’. That requires real dexterity, which is something that has become increasingly challenging for companies, particularly as processing gets split up all across the globe. The point is settlement is going to become very plain vanilla, therefore making it much harder to differentiate oneself from the rest of the pack. So although it may be harder to quantify initially, having these experienced people on board can make a huge difference in the long run.”

Kruse says: “While many organisations tend to look at risk in quantifiable terms, the real question is: how do we measure that risk? [That is] why we also need to consider adding some qualitative factors into the mix? Things like operational efficiency and head count are relatively easy to measure, but once you can systematically identify risk using those qualitative judgments, then link them back to your volumes, clients and efficiencies, you will then have the information that you need to proceed with more meaningful technology developments. In other words, by looking at corporate actions from a holistic standpoint—rather than just its individual components—you’ll be much better equipped to assess your overall risk exposure.”

In the emerging markets, SWIFT continues to make inroads, particularly among key “tiger” markets that had previously operated without a bona fide depositary system and opted for a best-in-class standard often derived from the US or EU. Traditional venues, however, appear much less willing to jump on the bandwagon. In Asia, for example, where a diverse base of depositaries must simultaneously meet the needs of both international cross-border investors as well as local clients, harmonisation of standards still has a long way to go. Though cross-border investors have, in many instances, invested heavily in SWIFT and maintain core systems inhouse, by contrast native investors tend to prefer their own local formats, none of which is SWIFT-based.

Despite the numerous regional forums charged with bolstering processes in the region, “any initiative aimed at adopting an Asia-wide standard has to start with the local stock exchanges or depositaries,” says Neil Daswani, regional transaction banking head of North Asia for Standard Chartered Bank.

Helping intermediaries bear the brunt of this divergence has become the real challenge, says Daswani.“That is the crux of the matter, really—how we can make the intermediary’s processflows smoother, as well as more consistent on a global basis.”I

Preparedness for T2S Cameron views TARGET-2 Securities (T2S) preparedness as another step on the road to full interoperability within a single platform. “By now people have had enough time to get a clearer picture of what T2S is about and how to organise their business models accordingly. For most of us, that means really having to focus on improved asset servicing, in particular around corporate actions and the complexities involved. From there we need to look at making central counterparties (CCPs) interoperable. Right now there are a handful of CCPs in Europe that can claim interoperability, but there are upwards of 24 different CCPs in the EU alone, so there is still much work that needs to be done.”

With the markets continuing to churn, reducing pre-settlement risk from three trading days to two via T+2 settlement is another area of importance. “Whereas T2S is more of a long-term interoperability effort for the securities industry, there is something quite tangible about having T+2, even though it tends to be dwarfed by all of these other initiatives,” says Cameron.

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REPO Photograph © James Weston / Dreamstime.com, supplied October 2011.

REVAMP IN REPO Hotshot proprietary traders used to sneer at their colleagues on the repo (repurchase) desk, whose humdrum efforts to meet short-term liquidity needs lacked the sex appeal associated with betting bank capital in the markets. The financial crisis turned the tables, however; liquidity management took centre stage, while capital constraints forced banks to rein in proprietary trading. Regulators have also cast their beady eyes on the repo markets—and discovered that long-standing market practices had introduced unacceptable systemic risks, particularly in the United States. What now? Neil O’Hara reports.

N PRINCIPLE, REPO is a low-risk game: one party delivers securities and receives either cash or other securities in exchange, with an agreement to reverse the transaction at a specified future date on terms that incorporate a borrowing cost. It is a collateralised loan, which is less expensive than unsecured financing and therefore popular among financial institutions that thrive on the spread between the cost of funds and the return on their assets.

Collateral may be exchanged directly between the parties, or may be held by an independent agent in so-called triparty repo. The parties or the agent mark the securities to market every day and adjust the collateral amount to keep the lender whole in the event of counterparty default. The repo term is often short—mostly overnight to 30 days— although longer-term transactions (up to a year or more) have become increasingly common in Europe.

Prior to 2008, repos in Europe were typically bilateral trades not cleared by a central counterparty (CCP). The collapse of Lehman Brothers transformed attitudes to counterparty risk at a stroke, creating a stampede among European banks to sign up as clearing members at central counterparties that could process repo trades. “Everyone who was eligible rushed to a central counterparty as fast as they could,” says Oliver Clark, product manager at MTS, an electronic trading platform for repo throughout the eurozone and in certain other countries.

“If they were not a clearing member, access to competitivelypriced cash and credit evaporated overnight.”

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The shift in sentiment created serious problems for some banks. For example, Spain did not then have a clearinghouse for repos, which obliged Spanish banks to pay a significant premium to finance their domestic bond holdings through bilateral agreements. The subsequent introduction of repo clearing restored Spanish banks’ access to cheaper funding— the June 2011 International Capital Market Association’s (ICMA’s) European repo market survey found that Spanish collateral (primarily government bonds) jumped to a record 7.1% of the market from 5.2% in December and 4.0% in June 2010. “The introduction of clearing services, even without domestic settlement in the initial phase, significantly improved the liquidity available to Spanish banks,”says Clark.

Cleared transactions now account for about 85% of trades on the MTS repo platform—and Clark says most of the balance is between clearing members in after-hours trading.

Electronic platforms, including MTS, typically handle shortterm trades of one week or less, while longer-term transactions are still done over the phone—which are usually not cleared. In the aggregate, about half the repo transactions in Europe are cleared, including most trades executed electronically and some voice trades given up for clearing.

The tri-party repo structure can accommodate market participants who are not eligible to become clearing members of central counterparties, including corporations, asset managers and hedge funds. In the United States, triparty transactions are nevertheless cleared using the services

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of two clearing banks: JP Morgan and Bank of New York Mellon. In order to facilitate daily trading activities, the clearing banks were accustomed to return tri-party collateral to the dealers every morning at 8am and take it back at 6pm with whatever substitutions the dealers made during the day.

While convenient to the dealers, the practical effect was to leave the clearing banks with only a lien on the collateral rather than possession if a dealer failed during normal business hours. The extension of up to $2trn of intraday credit on a discretionary basis by two clearing banks to fund the US tri-party repo market became a cause for concern at the Federal Reserve after 2008. If a large counterparty did fail, the losses might pose a threat to the clearing bank, which could in turn undermine confidence in the entire financial system.

In September 2009, the Fed established the Tri-Party Repo Infrastructure Reform Task Force to devise operational changes that would reduce and eventually eliminate the intraday credit altogether. In February 2011, the market adopted auto-substitution, which allows dealers access to their collateral without having the entire pool returned to them at the start of the trading day. In effect, dealers can swap out collateral during the day, but they must now give before they get: in other words, they must deposit new eligible collateral of equivalent value before the agent will release the old.

With auto-substitution in place, the daily return of collateral was progressively delayed—it now takes place at 3.30pm, leaving the clearing banks at risk for two and half hours instead of ten. “We have brought down the duration of the clearing banks’ exposure but we are not done yet,”says Mark Trivedi, managing director and chief operating officer for global clearing and custody at JP Morgan.“We have not significantly reduced the amount of the credit.”

The market has also tightened up settlement procedures to require three-way confirmation before trades settle rather than relying on input from the dealer alone. In order to accommodate both high-volume sophisticated players and occasional participants who cannot afford cuttingedge technology, the task force recommended that threeway confirmation could be effected through electronic messaging, web-based affirmation or outsourcing to a third-party, trade-processing vendor.

The task force, on which Trivedi is JP Morgan’s representative, will soon publish a road map and timetable for settlement procedures that will keep collateral at the tri-party agent for the duration of the repo contract. “We will move to a maturity model instead of a daily unwind,” he says.

“Cash will only be returned if the dealer has enough liquidity. Some of that liquidity may come from the clearing bank, but it will be capped and committed rather than open-ended and discretionary.”

The change will force lenders to pay more attention to the nature of collateral they accept against repo trades. Some lenders used to accept collateral even if they lacked the infrastructure to process or trade that type of security. In future, the clearing bank will no longer extend unlimited credit to cover any cash deficit from the dealers, and if a counterparty comes up short the lender itself will have to liquidate the collateral.

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James Malgieri, chief executive officer of BNY Mellon Broker Services.

Photograph kindly supplied by BNY Mellon, October 2011.

The task force goal will bring the US repo market into line with other countries, where daily returns of collateral do not take place and dealers must fund their own maturing repos.

That prospect has already attracted new international participants who were not comfortable with the US market structure until the reforms took effect.

Practical differences are likely to persist between the US and international repo markets, however. Bank regulators everywhere are pressing banks to lengthen the average term of their funding sources, which has spurred rapid growth in longterm repo agreements in Europe. The ICMA survey shows that European repos with a maturity of one month or less fell from 62.5% of the total in December 2010 to 50.9% in June, while maturities in excess of 12 months shot up from 1.0% to 8.7%.

The switch to longer-term repo has coincided with rapid growth in long-term collateral upgrade transactions, in which a bank will exchange lower quality assets that are not eligible collateral at the repo clearing houses for G7 government bonds, which are. The pension funds, endowments and insurance companies that own the high-quality paper earn a few extra basis points (though not as much as if they owned the lower-quality assets outright) but are not exposed to market risk if the credit quality of the collateral they accept deteriorates. Depending on the nature of the credit event and the collateral guidelines embedded in the contract, the bank must either top up the collateral or swap it out.

“The dealers have a lot of collateral that the buy side does not want to hold for an extended period,” says Larry Tabb, founder and chief executive officer of TABB Group, a New York and London-based capital markets research and consulting firm. “The buy side wants the yield, but they would rather rent than own these assets. If they perceive the value of the collateral dropping, they put it back to the dealer.”

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Mark Trivedi, managing director and COO for global clearing and custody at JP Morgan. Photograph kindly supplied by JP Morgan, October 2011.

Joe Abate, money markets analyst at Barclays Capital in New York.

Photograph kindly supplied by Barclays Capital, October 2011.

Little of this has occurred in the US, primarily due to regulatory restrictions. US money market funds, among the largest repo lenders, prefer maturities of seven days or less, which allows repos to qualify as “liquid assets”. During the recent market turmoil, for example, Joe Abate, money markets analyst at Barclays Capital in New York, says US money market funds increased their seven-day liquidity buffers from $1trn to $1.25trn, with about half the increase in short-term repo. “For the most liquid collateral, US repo has generally been less than one week,” he says.“Given the nature of the lenders, attempting to lengthen the repo term has not been a regulatory priority in the US.” Collateral swaps are also less common in the US, where cash collateral is customary, or required, in many securities lending transactions, including repo. The primary focus is on maturity spreads, like funding three-month assets with overnight repo. Collateral upgrade trades do occur, though in 2009, repo desks cashed in on a wide spread between agency mortgage-backed securities and Treasuries—a spread that has all but vanished today, in part because the Federal Reserve has acquired a huge portfolio of agency MBS. “Repo is either collateral transformation, maturity transformation or a combination of the two,” says Abate.

Persistent low short-term interest rates and a relatively steep yield curve create a strong incentive for banks to keep their funding duration, including repo, short. An observer close to the task force does not expect banks to increase the average duration until regulators take action.“Some institutions have recognised it is better to have term funding and pay more to finance their inventory, but they are a minority,” he says. “The only way to change that is to put a premium capital charge on short-term funding.” The Basel III proposals on bank liquidity, if implemented as currently proposed, would achieve a similar result through regulatory fiat.

The danger of excessive reliance on short-term funding became all too apparent in 2008, when the shadow banking sector was unable to roll over maturing asset-backed commercial paper. Repo is secured rather than unsecured financing, but in times of stress counterparties take no prisoners. “If one side gets worried about the other, they don’t say give me higher quality collateral,” says James Malgieri, chief executive officer of BNY Mellon Broker Services and a member of the ICMA task force. “They won’t renew the trade on any terms.”As a practical matter, nobody tries to break existing trades—that did not happen even in August—but funding can still dry up quickly when most repos mature in a week or less.

A repo lender bears the risk that the collateral it holds may not be worth the amount owed in the event of counterparty default. It is incumbent upon lenders to monitor credit developments that affect the collateral they hold and negotiate haircuts sufficient to cover potential losses upon default. “Lenders have to be smart enough to know what the value should be,” says Tabb.

Repo lenders are still better off than unsecured creditors in a default; worst case, the repo lender may realise less than 100 cents on the dollar for the collateral while unsecured creditors have to wait in line for resolution of the bankrupt estate.

The banking system today is heavily dependent on repo for funding—it is the mechanism by which the European Central Bank and other central banks provide emergency liquidity support to the money markets. Yet even if markets regain their composure and the central banks begin to withdraw their support, repo—and tri-party repo in particular—is likely to grow in importance as private sector institutions take up the slack and dealers seek ways to meet their collateral needs for clearing OTC derivatives.I

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COLLATERAL MANAGEMENT Photograph © Govsum / Dreamstime.com, supplied October 2011.

CHANGING METHODS FOR COLLATERAL MANAGEMENT Mounting regulatory pressure, and its expected impact on the bottom line, will lead market participants to seek the most cost-effective means available for mobilising collateral. In this era of hyper-transparency, then, the advantage has shifted toward firms that not only have the best collateral-management tools at their disposal, but also the wherewithall to handle the anticipated mountain of collateral needed to cover increased margin calls and other requirements in the making. David Simons reports from Boston.

NCE A MILD-mannered middle office function, the financial crisis has turned collateral management into a formidable weapon with which to combat counterparty, credit and operational risk. With demand for standardisation in areas such as OTC derivatives and securities lending continuing to mount, the effective quantification and accurate monitoring of counterparty positions, along with the ability to extract and report on any relevant position at any given time, has become far more important to risk managers. In a survey of various global financial institutions, 89% identified “advanced interactive cash and collateral management functionalities within payments infrastructures” as a leading area for improvement.

As current reforms do not specifically address all derivatives activity, there will likely be a continuation of a sizeable bilateral OTC trading market. To help clients work through this bifurcated period, many have extolled the virtues of socalled “enterprise-wide” management platforms, which enable organisations to manage and monitor collateral covering numerous product lines spanning worldwide jurisdictions. Using a tri-party mechanism for holding collateral to cover centrally-cleared margin calls is likely to gain favour as well, given the expected increase in central counterparty (CCP) margin requirements.

Few appear to suffer the illusion that by simply having centralised clearing in place, all collateral risk will be instantly marginalised. Collateral volumes and margin calls are sure to rise under the CCP model, and the growing number of

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clearing agencies underscores the potential for widespread fragmentation, not to mention cross-CCP interoperability, according to critics.

“A CCP has its own risks, including the extent to which it is capitalised, how prepared it is to deal with the loss or default of a participant, and so on,” says Kelly Mathieson, head of global custody and clearing, JP Morgan.“So a CCP is by no means the cure for all of the possible systemic risks that have been identified in the aftermath of the crisis.”

Esoteric instruments This is not to say that the approach doesn’t have its merits.

The focus on highly-structured, risk-reducing collateral management is forcing the same esoteric instruments that were largely responsible for the markets’ downfall to undergo a redefinition process. Though a few of these “unique” transactions may still be able to fly under the radar and re-emerge once the rules are finally in place, “they will have to do so under a significantly different construct,” says Mathieson.

LCH.Clearnet, which proved its worth as a mechanism for managing default during a real-life crisis, serves as the gold standard by which future-clearing solutions should be measured, suggests Nazir Badat, global head of global markets operations, HSBC. “It compels the industry to look for ways to control risk elements associated with the next ‘big shock,’”says Badat. “As a result, we are seeing the role of the CCP beginning to

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change, particularly as the number and complexity of products moving through CCPs continues to increase. More than ever, it is paramount that CCPs have the proper risk mechanisms in place, including the right people, processes and systems, as well as rules covering various legal jurisdictions.”

While hardly the end-all, central clearing still represents a clear departure from the bilateral element—which, says Badat, is a step in the right direction.“It certainly creates more transparency around reporting mechanisms. Obviously we can’t sit here and say: ‘Oh terrific, we’re centrally cleared—good enough, we can go home now’. Because at the same time it raises so many other questions—do we have the right collateral agreements in place? Netting agreements? Is systematic risk covered? Therefore, it is important that we continue to be vigilant, and, above all, work to ensure that these principles are applied in a harmonious manner around the world.”

At September’s SIBOS conference in Toronto, Clearstream, the Luxembourg-based post-trade services provider, discussed the details of its newly-announced strategic partnership with the Depository Trust & Clearing Corporation (DTCC). Integrating DTCC’s Loan/SERV Reconciliation Service with Clearstream’s collateral-management platform, the service offering, set to launch during the first half of 2012, will initially focus on the capture and administration of nonUS syndicated and bilateral loans. The partnership will subsequently utilise the bilateral component for collateral-management purposes.

Kelly Mathieson, head of global custody and clearing, JP Morgan.

Photograph kindly supplied by JP Morgan, October 2011.

Marginal differences Last summer, Clearstream began offering its collateralmanagement services on a third-party basis, striking backto-back deals with Brazilian CSD Cetip as well as Australia’s ASX exchange.“We trust that we will be able to bring higher efficiency, reliability and transparency to the credit-claim space, while at the same time paving the way for a further asset class to be leveraged by our customers as collateral,”says Stefan Lepp, member of the executive board and head of global securities financing at Clearstream.

“This is in line with changing market regulations and growing market demand for an optimised use of the limited amount of collateral available.”

Recognising the need for firms to be able to consolidate fragmented pools of externally maintained collateral, Clearstream continues to offer support through its Global Liquidity Hub, which, in addition to addressing collateral consolidation, serves as a collateral-allocation manager for exposures triggered by the underlying customer. The double benefit of fragmentation-reduction/collateral optimisation will lead to further cost reduction for its users, says Lepp.

One area that continues to weigh on the buy side is the potentially negative impact of maintaining huge margins needed to clear swaps, which, say critics, could force managers to abandon corporate-bond or equities positions in favour of sovereign and government debt or cash. “That analysis has already been performed, and as a result, the onus is on the exchanges to come up with wider standards in an effort to address these concerns,”says product manager Judson Baker,

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Judson Baker, product manager, derivatives and collateral management, Northern Trust. Photograph supplied by Northern Trust, October 2011.

who covers derivatives and collateral management for Northern Trust’s asset-servicing division. “However, if the exchanges agree to accept these wider forms of collateral, does this make the entire exchange network more vulnerable to risk? And I think the answer is yes, for the simple reason that it could create problems for the exchange, particularly in a situation where the redemption involves an illiquid investment-grade corporate on short notice. While it may not be an insurmountable problem, it is something that the exchanges haven’t had to deal with until now,” he adds.

This has led to a tug-of-war between the two parties, with the buy side pressing for some leeway with regard to corporate bonds and other types of non-government debt,

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Nazir Badat, global head of global markets operations, HSBC. Photograph kindly supplied by HSBC, October 2011.

and the CCPs reluctant to budge due to the potential impact on risk management.

However, by providing some creative alternatives—such as bridge financing on behalf of the CCP during these types of bond liquidations—custodians can help new and traditional market participants alike work out their differences in order to minimize the potential impact on the buy side.

“Custodians have the capacity to play a big role in terms of facilitating margin upgrades and potentially financing considerations for the end client,”says Baker.“While I wouldn’t quite call it a ‘backstop’ per se, in this situation the CCP would be allowed to hold the corporate bond with a custodian, and the custodian would in turn provide some kind of liquidity pledge to the CCP during the liquidation process. There are already talks under way to try to make this a reality across the industry.”

In a post-regulation, pro-transparency landscape, the advantage has shifted toward firms that not only have the best collateral-management tools at their disposal, but also the wherewithal to process the anticipated mountain of collateral that will be required to cover increased margin requirements. As a result, many of the same tools of the trade are now being refined in advance of this newer, more challenging environment. “For instance, those who are still relying on a hard delivery of treasuries or cash aren’t going to have the efficiencies that they’ll need to carry them over the long haul,” asserts John Vinci, managing director for BNY Mellon Broker Dealer Services.

Shoring up the data pipeline so that clients receive better and faster information, and more of it, is yet another part of the equation. “We’re not talking about overnight repos any more—this is margin needed to cover that day’s trading business,” says Vinci. “As a result, there has to be a buy-in covering multiple parties with different interests, across the entire collateral-management framework.”

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Given the intricacies of today’s markets, managers must also have an instinct for what is good collateral and what isn’t, and therefore have considerable expertise in order to decide whether a swap for eligible collateral is marketable enough to pass muster. “The manager’s methods and processes all have to be completely bulletproof, because if there are problems stemming from ineligible collateral, everyone is impacted,”says Vinci. “So while it may sound simplistic, you need to know if in fact there is a market for that collateral, otherwise the decision to include it in the mix could have unintended consequences. Most of all, as the manager you need to be able to show that you have total control on behalf of the secured party—there should not be any grey area at all.”

Be it an investment house or commercial bank, capital charges are increasingly becoming a much bigger part of the problem, says Giles Elliott, head of product management, investor and intermediaries, Standard Chartered Bank.

Therefore, optimising the way banks use money, source liquidity as well as maximize their portfolio has become a critical function. “At the same time, there has been a kind of practical realisation that there just isn’t enough collateral available, at least based on the number of contracts that had initially been laid out,” says Elliott. This in effect could lead to an entirely new problem of intense risk concentration around many different types of collateral classes. “We’ve already heard from large fund managers wanting their banks to collateralise open spot events, for example,” says Elliott.

“As an industry, we really have to be careful that this sort of thing doesn’t get out of control.”

Seeking risk solutions Collateral management has also gained considerable traction among banks involved in commodities-based trade finance that are seeking risk solutions associated with the commodities and metals sectors. “A bank’s main objective is to facilitate transactions between the buyer and seller in the most efficient way possible, including transactions of collateral,” says Robert de Picciotto, chief executive officer and director general of risk-management solutions company Brady Switzerland.

Over the past year, Brady has been tapped to provide collateral-management solutions covering the commodities and trade-finance operations for several leading banking institutions.“A large part of this effort involves offsetting the risk inherent in those types of transactions. So when it comes to trade and commodities finance, we believe that there are specific solutions that need to be applied.”

Despite mounting regulatory pressure for banks to maintain best-practice solutions for the management and optimisation of collateral, “even some of the most well-established firms still do not have the kinds of systems in place that can ensure full-process transparency,” says de Picciotto. Moreover, without a rigorous monitoring arrangement, proper scrutiny of collateral is not possible. Companies such as Brady seek to match the specific requirements of the trade operation with the client’s banking environment, using collateral-management solutions to keep a lid on counterparty risk.

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Stefan Lepp, executive board member and head of global securities financing at Clearstream. Photograph kindly supplied by Clearstream, October 2011.

Robert de Picciotto, CEO and director general, Brady Switzerland.

Photograph kindly supplied by Brady Switzerland, October 2011.

De Picciotto says: “Traders often require far more detail into the movement of collateral than what the bank is willing or capable of offering, and in order to fully understand all of the potential risks involved, you have to have a precise framework that enables the firm to track all of the movements of the goods every step of the way, from source to destination, factoring in unforeseen market circumstances as well.”

“So from our perspective, there is a real need for companies to retain a hands-on collateral manager that can take on that kind of responsibility.”

Says Baker of Northern Trust: “At one end of the spectrum you have these very sophisticated asset managers with repo desks, who can manage their pool of assets quite efficiently, but then there are other firms that don’t have the right kind of infrastructure, and therefore tend to lean on clearing firms or custodians to perform this type of work for them. Of course, picking a strategic partner in the current environment is a pretty big issue, given the considerable amount of counterparty risk linked to the bilateral market, not to mention the problems that can arise when you’re beholden to just one or two clearing merchants. So this really makes an even stronger case for the proper outsourcing of operational responsibilities, which, of course, is a theme that has been with us for several years now.”

Despite the development required to manage collateral in-house, many firms continue to be reluctant to job out.

“This will require them to have even more faith and put even more responsibility on the shoulders of their clearing firms— which, frankly, isn’t always in their best interest,”adds Baker.

When all is said and done, says Mathieson, the markets are all about the pursuit of good returns with a reasonable amount of risk tolerance. “What has happened over the past three years has been a necessary re-set, the control-altdelete for the markets, if you will. We just have to be careful that the amount of regulation does not unduly impact the time, resources and energy that companies need to continue to invest in the growth of their business.” Therefore, it is crucial that regulators remain cognisant of how their actions can adversely impact institutions within any jurisdiction because, says Mathieson:“When you come right down to it, regulation in and of itself does not make an acceptable substitute for good corporate governance.”I

Middle office outsourcing Demand remains strong for the provision of middle office outsourcing, and as companies continue to divest themselves of non-core business activities they are increasingly seeking solutions that can facilitate a more effective system of collateral management, says Terry Gibson, global head of strategy for investment services at Fiserv, a global technology solutions provider. Given the complexities of the non-listed markets, the demand has centered on automation services around OTC market-collateralisation issues including tri-party repo, as opposed to straight equity and other listed products.

When it comes to providing outsourced collateral solutions, understanding the nuances of any given organisation is paramount, adds Gibson.“Whilst you may be able to provide the requisite controls and mechanisms, it is essential that they properly interface with the client’s internal systems. Through our professional-services teams, we can go in and provide those integration services to ensure that all of the connectors are linked to the existing databases and, in turn, the firm’s front office settlement processes.”

Can the average organisation ever have what it takes to properly manage collateral within the constructs of a CCP while at the same time complying with far more stringent risk-reporting requirements? Even now, many companies still rely heavily on the use of Excel spreadsheets, says JP Morgan’s Mathieson, which are not sufficient enough to handle anything more than a small amount of transactions.

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SECURITIES LENDING

The profits on lending US Treasuries and other G7 government bonds have shrivelled in recent years as the major industrialised countries have flooded the market with paper to finance gargantuan budget deficits. Specials, which used to be common for on-the-run Treasury issues, have largely disappeared, eroding earnings in a business that has never enjoyed the margins available in lending equities. New financial regulations could alter the landscape, however. The move to force OTC derivatives trading into a cleared environment will create new demand for collateral eligible at clearinghouses—which typically insist on cash or G7 government bonds.

Meanwhile, the mooted disclosure of short positions and leverage caps on hedge funds could curtail demand for equities. Neil O’Hara reports.

Photograph © Andreus / Dreamstime.com, supplied October 2011.

REGULATIONS SHAKE-UP FOR SEC LENDING OR THOSE PENSION funds, insurance companies and endowments that own large portfolios of high-quality, fixed-income assets, increased securities lending demand would be a godsend. Before 2008, utilisation rates in US Treasury portfolios often exceeded 90% because the asset owners could exchange Treasuries for agency mortgagebacked securities (MBS) in the repo market and pick up a yield spread. Today, increased Treasury issuance combined with Federal Reserve purchases of agency MBS has driven the spread close to zero.“That trade is no longer available,” says William Kelly, managing director, global securities lending, at BNY Mellon Asset Servicing. “Industry utilisation is now

F

FTSE GLOBAL MARKETS • NOVEMBER 2011

50% to 70%. It varies by client depending on the parameters of their programme, but volume has come down.”

Fixed-income utilisation rates would be even lower but for a sharp uptick in the use of non-cash collateral for US securities lending transactions. Kelly says fixed-income lending, which used to rely entirely on cash collateral, is now about evenly split between cash and non-cash. Instead of swapping Treasuries for agency MBS through the repo market to earn the spread, dealers are putting up agency MBS directly as collateral against Treasuries in securities lending trades. “It eliminates one step,” says Kelly. “Cash is not as inexpensive a form of collateral as it once was.”

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In bilateral trading of OTC derivatives, the parties sometimes accept collateral in smaller amounts and of lower quality than a central counterparty is likely to require.

The switch to clearing will oblige dealers to upgrade their existing collateral and put up more, both of which will boost demand for US Treasuries and G7 bonds. In addition, dealers will no longer be able to rehypothecate collateral as they do now. It will be locked up at the central counterparty.

“The collateral dealers own today may require a transformation,” explains Kelly. “In addition, an end to rehypothecation will reduce the circulation velocity so dealers will need more collateral. From a securities lending standpoint, we see this as a potential opportunity.”

The net effect will be to increase the cost of borrowing high-quality, fixed-income assets, which in turn may render trades that are now marginally profitable uneconomic. If the attempt to reduce systemic risk related to OTC derivatives causes banks to forego trades that bloat their balance sheets for a minimal return, the regulators won’t shed any tears. It merely reinforces the regulatory pressure banks already face to curtail leverage. “The banks need to calculate what the increased cost of capital to their balance sheet will be and whether they want to continue in certain businesses,” says James Reichert, a senior consultant and securities lending expert at NEPC, a Boston-based investment consulting firm.“It could lead to some consolidation in the banking industry.”

Mergers increase the risk in securities lending because they reduce diversification among counterparties, but lenders will tolerate that in exchange for higher intrinsic value in their G7 bond portfolios. Like most securities lenders, NEPC clients have shifted their focus toward intrinsic value rather than general collateral in recent years, a reaction to unexpected losses some cash reinvestment pools suffered during the financial crisis. “Any regulation that increases demand for assets that have a low spread should be positive for our clients,” says Reichert. “Bonds that are not being lent today may be lent tomorrow and potentially at a higher spread.”

Greater transparency The new regulations may not be an unalloyed benefit to asset owners and lending agents, however. European regulators have proposed limits on hedge fund leverage and a requirement for greater transparency, including disclosure—albeit on a confidential basis only to regulators—of their short positions. Whether the US will take a similar tack remains to be seen: the Dodd-Frank Act obliged the Securities and Exchange Commission (SEC) to conduct a study of securities-lending practices, including confidential disclosure of short positions, but although public comments were due by late June the agency has not yet published its report and is not expected to propose new rules until next year.

Even if hedge funds escape a leverage cap, disclosure alone may prompt some funds to cut back short positions, at least until they are convinced regulators will respect confidentiality. Hedge funds borrow far more equities than fixed income, so any cutback will skew towards the most profitable

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James Reichert, a senior consultant and securities lending expert at NEPC, a Boston-based investment consulting firm. “Any regulation that increases demand for assets that have a low spread should be positive for our clients. Bonds that are not being lent today may be lent tomorrow and potentially at a higher spread,” he says. Photograph kindly supplied by NEPC, October 2011.

business for lenders and agents. “A reduction in equity demand is the opposite of the G7 debt situation,” says Reichert. “Spreads could be lower on equities, although it’s hard to be sure without knowing what the controls will be and how each country will implement them.”

Increased dealer demand for high-quality collateral could radically alter their funding strategies, too. Shawn Sullivan, managing director and head of prime services trading at Credit Suisse, points out that if the dealers need all the government bonds they have to pledge to central counterparties, that collateral will no longer be available for use in the repo market. In fact, the dealers will be reverse repo borrowers of G7 bonds rather than lenders. Leading mutual fund managers, who are naturally long cash, will no longer be able to invest the excess in repos with cash-hungry dealers secured against the highest quality collateral. “What will asset managers do with their money?” asks Sullivan. “They will have to forego repo and buy commercial paper instead.”

Sullivan would like to see central counterparties broaden the range of eligible collateral to include other asset classes, including selected equities. The major dealers have to finance substantial inventories of stocks in the Standard & Poor’s 500, FTSE 100, DAX and CAC indices every day. “Those

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Mergers increase the risk in securities lending because they reduce diversification among counterparties, but lenders will tolerate that in exchange for higher intrinsic value in their G7 bond portfolios. assets are sitting on dealer balance sheets unutilised [sic],” says Sullivan. “Using them would be more efficient for the broker dealer and make it easier for them to absorb the increased costs associated with additional haircuts.”

It may be a forlorn hope, however. Looser collateral guidelines would no doubt benefit dealers, but central counterparties will never do anything that might prejudice confidence in their settlement guarantee. Nevertheless, industry participants are preparing a brief to the SEC that will seek permission for dealers to pledge equity as collateral in equity lending trades, a longstanding practice in Europe that did not cause any problems even in 2008.

Increased demand for G7 government bonds will propel further growth in the burgeoning market for collateral swaps

in Europe, too. Insurance companies and some hedge funds that hold large G7 bond portfolios lend them to dealers in exchange for lower quality collateral that offers a higher yield. The dealer gets high-quality collateral it can pledge against cash, effectively financing its book of lower quality assets for a fee paid to the swap counterparty while raising cash to reduce the size of its balance sheet.

Paul Wilson, managing director and global head of client management and sales for financing and markets products at JP Morgan Worldwide Securities Services, expects collateral swaps to become more widely used by dealers and the buy side alike. They won’t always be on opposite sides of the trade, either. For example, if an asset manager that handles only equity portfolios enters into a cleared equity swap, the central counterparty probably won’t take equities as collateral—and the manager doesn’t have any G7 bonds it can pledge. “Securities lending becomes a potential solution,” says Wilson. “The fund could lend equities against highquality government bonds and use some of those to provide the acceptable collateral to the central counterparty.”

Pension funds and traditional asset managers can use collateral swaps to boost returns if they have high-quality assets

Securities Lending Tailored solutions to meet each client’s needs.

For more than 25 years, J.P. Morgan has been helping clients to enhance returns with lending programs tailored to their unique profile. We believe that clients should have choices with respect to program design, parameters, collateral, loan distribution and oversight. Our clients benefit from customized and comprehensive lending options and one-stop access to a range of solutions, supported by the world-class expertise and execution of our entire firm. jpmorgan.com/securitieslending

The announcements above appear as a matter of record only. J.P. Morgan is the marketing name for JPMorgan Chase & Co. and its VXEVLGLDULHV DQG DIÀOLDWHV ZRUOGZLGH - 3 0RUJDQ 6HFXULWLHV //& LV D PHPEHU RI 1<6( DQG 6,3& -30RUJDQ &KDVH &R All rights reserved.

FTSE GLOBAL MARKETS • NOVEMBER 2011

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In addition to boosting demand for high-quality collateral, OTC derivatives clearing may create back office logjams at sell side firms. JP Morgan’s Wilson says that while some small to mid-size European firms exchange collateral every day under ISDA agreements with broker dealer counterparties, they often extend credit to their clients. The new rules will force brokers to take collateral from clients, so instead of calculating daily margin calls for a handful of sell side accounts, they will have to do it for their entire client list, which could run to hundreds of names.

That is a huge operational challenge; it is a business opportunity as well. Brokers will take margin from clients based on the gross account balances, but will subtract offsetting positions before they settle net amounts with sell side counterparties. The difference is available to the broker, which can use the money to generate additional revenue.

“For these smaller firms, collateral will not only be a risk mitigation tool, it can also be a profit centre if they get the collateral optimisation right,” says Wilson.

Collateral optimisation

Paul Wilson, managing director and global head of client management and sales for financing and markets products at JP Morgan Worldwide Securities Services. “Securities lending becomes a potential solution. The fund could lend equities against high-quality government bonds and use some of those to provide the acceptable collateral to the central counterparty,” he says. Photograph kindly supplied by JP Morgan, October 2011.

to lend—or to borrow these assets for margin purposes if they do not. The major risk in collateral swaps arises in the event of counterparty default, when credit spreads typically blow out and investors snap up government bonds in a flight to quality. The lender is left with inferior collateral that has declined in value while the government bonds it lent are worth more, so unless it negotiated a generous haircut the collateral proceeds may come up short. “The further out you go on the risk scale, the greater the chance that you won’t have enough money to replace what you lent out,”says NEPC’s Reichert. “It comes down to the likelihood of counterparty default and good credit analysis.”

Collateral swaps are restricted in the US by SEC Rule 15c3, which permits dealers to put up only cash, US Treasuries or a letter of credit against securities borrowed from a customer. It is possible for an investor to achieve the equivalent economic result if the dealer does a reverse repo with a buy side institution for Treasuries and the institution takes lower quality collateral against cash in a second repo trade. From the dealer’s perspective, though, it is a round trip because both legs show up on its balance sheet. Sullivan at Credit Suisse says: “It doesn’t do much for you. It is like kissing your sister.”

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Regulations raise costs, and collateral optimisation is one way for brokers to offset the burden. Major dealers are setting up global funding desks to maximize the use of collateral already available within the firm. Wilson has seen a sharp increase in rehypothecation of collateral from one legal entity to another or one region to another under the same corporate umbrella. “The big firms have financing needs in repo, OTC derivatives clearing, securities lending and prime brokerage,” he says. “It is cheaper for them to rehypothecate assets internally than to borrow them from third parties.”

The move toward clearing OTC derivatives has revived a discussion of whether securities lending itself ought to take place through a central counterparty, as it does in certain Latin American countries, including Brazil. The big agent lenders oppose the idea, as do their major customers, the prime brokers. Indeed, bilateral securities lending has a robust track record. Nobody took a bath through the collapse of Lehman Brothers due to securities lending. The losses that did occur were attributable to imprudent collateral reinvestment, not the securities lending transaction per se. “In all the defaults I have seen—Barings, Drexel Burnham Lambert, Yamaichi and Lehman—the open stock borrows were unwound in an orderly manner shortly after their demise,” says Sullivan at Credit Suisse.

That history is hardly surprising. Markets never go up when a financial firm goes bust, after all. A US investor who has lent stock worth $100 holds $102 in cash as collateral; if the counterparty defaults the stock may drop to $85 and the lender can buy it back in the market with money to spare. In the pecking order of systemic risks to the financial markets, securities lending lies near the bottom of the heap. “If regulators do force it into a cleared environment, it will be nothing more than a political move to satisfy Congress,” says Sullivan. “Securities lending is sound as the pound.”I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

SECURITIES LENDING ROUNDTABLE

SECURITIES LENDING, RISK & REGULATION

Photograph © FTSE Global Markets, supplied October 2011.

Attendees

Supported by:

(From left to right) TONY HOLLAND, manager, securities lending, Russell Investments JEFF MOLITOR, chief investment officer, Vanguard Europe SONJA SPINNER, senior consultant, Mercer KEITH HABERLIN, head of European securities lending, Brown Brothers Harriman JAYNE FORBES, head of securities finance, AXA DON D’ERAMO, regional business head, securities finance, EMEA & Canada, State Street

FTSE GLOBAL MARKETS • NOVEMBER 2011

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ROUNDTABLE

QUANTUM MOVES: REGULATIONS & SHORT STORIES JEFF MOLITOR, CHIEF INVESTMENT OFFICER, VANGUARD EUROPE: One of the biggest hindrances in the securities lending arena is that there is still a lot of residual concern among investors about problems that happened a couple of years ago. There were risks that asset owners didn’t really understand, and they had to come to terms with the idea that securities lending was not a free lunch. It is probably safe to say that a number of regulators did not understand securities lending either. The fears that result from this lack of understanding invariably feed into calls for more regulation and asset owners shying away from securities lending programmes. Securities lending activity suffers across the board when regulations which curtain or stop shorting are implemented.

JAYNE FORBES, HEAD OF SECURITIES FINANCE, AXA: We all like stability in our product frameworks, however it has become more frequent for regulators to ask for consultations, apply short-term rules or restrictions or indeed implement new rules. We all agree regulation is a good thing.

The responsiveness of an agent lender to comply with any changes (regulatory or by client request) is a priority.

KEITH HABERLIN, HEAD OF EUROPEAN SECURITIES LENDING, BROWN BROTHERS HARRIMAN: The immediate impact of regulation is more significant on the demand side, rather than on the supply side of our business. If we agree that hedge funds represent the primary demand for borrowing securities, and acknowledge that there is uncertainty around the final form that short selling and other regulations will take, it is easy to see that this uncertainty has contributed to the lack of conviction for certain hedge fund strategies. That is one of the direct causes of the depressed demand in the marketplace. Added to that is the impact of more macro-regulation, such as Dodd-Frank and Basel III, which might not be aimed at securities lending but which has consequences for the business. These regulations obviously have the potential to affect the demand side of the business as firms will need to allocate more capital against exposures which were previously reported as off-balance sheet items. We have already seen some demand leaving the business as firms close their proprietary trading desks in response to the Volcker Rule.

SONJA SPINNER, SENIOR CONSULTANT, MERCER: One of my biggest concerns around short selling regulations for my clients is the impact that it has on their general portfolio implementation costs as price discovery in the market is eroded. The 2008 short selling bans seemed to generate additional price volatility. For my clients, securities lending is a peripheral part of their whole investment strategy. The impact on price discovery and portfolio implementation costs is therefore as significant as any marginal loss of securities lending revenues.

TONY HOLLAND, MANAGER, SECURITIES LENDING, RUSSELL INVESTMENTS: Numerous communications are in the public domain regarding the Dodd-

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Don D'Eramo, regional business head, securities finance, EMEA & Canada, State Street. Photograph © FTSE Global Markets, October 2011.

Frank Act which has been in existence for over a year now; however it appears the SEC is still figuring out exactly how the rules are going to be applied to the securities lending industry.

It would appear much of the regulation up to now has had an indirect impact on our business. When Basel III implement tier capital ratios from the CRD4 regulation, borrowers will have to lock-up additional cash which may further reduce on loan balances in an already over supplied sec-lending market.

Directly, a bigger concern is the potential ESMA rule. ESMA took over the regulation oversight of securities lending in Europe from January this year. If ESMA amends the locate to a reserve requirement plus categorises a sell by a fund whilst stock is on loan as a short sell, this could prove to be a real concern for the industry especially as this also contravenes UCIT regulations. Again, this potentially could contribute to lower demand. Perhaps the knee-jerk reaction of putting the short selling bans in place has given comfort to the regulators and the politicians. Industry experience which was highlighted at the IMN conference last year shared the positives of selling short mainly surrounding price discovery and liquidity. It was refreshing to hear an external academic at the IMN from outside the industry who had undertaken an in-depth analysis on this topic. Markets such as Hong Kong do not seem to have aggressively used short sell bans. It does not appear they have fared any worse than other markets that have applied this rule.

DON D’ERAMO, REGIONAL BUSINESS HEAD, SECURITIES FINANCE, EMEA & CANADA, STATE STREET: It would be nice if we could separate politics from the academics regarding short selling or selling regulations.

A concern for the industry in general is what it may do to the cost of the business. What does Basel III imply for the costs of doing business, for instance? A simple question, for example, on the demand side is: what are the cost implications of a hard reserve versus the soft reserve? It all points to an incremental cost of doing business in general. Another is the issue of clarity. We probably won’t get the level of clarity we want, but clarity around short selling clearly would be beneficial. What defines a short sell: clarification around a sale of a security that is on loan? Is that a short sell? Do you recall it before you sell it? The answers to these types of questions vary between jurisdictions; therefore clarity or perhaps consistency would help agent lenders ensure that their clients are abiding by the proper rules.

RISK V REASON: THE BUSINESS OUTLOOK JAYNE FORBES: The impact of UCITS IV regulations on securities lending activity is an important consideration. From our perspective, the generic programme has to be aware of the effect on a fund manager. Volatile markets are also a concern, particularly as we have to be able to make sure that the invest-

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Sonja Spinner, senior consultant, Mercer.

Photograph © FTSE Global Markets, October 2011.

ment management process is not hindered by what we believe is the lowest level of investment activity. Other issues we are looking at include Solvency II for our insurance companies and the required reporting involved and, of course, collateral policies. Internally, we are also looking closely at the impact on collateral management of securities lending but also repo and reverse repo and derivatives. It is a product on its own, where you have to be able to undertake thorough exposure reporting.

JEFF MOLITOR: To the extent that there might be one issue worth thinking about more than any other, it is counterparty risk: the amount of exposure we are willing to have with any given counterparty.

SONJA SPINNER: Right now we are helping clients who are trying to get to grips with having to face over-the-counter (OTC) derivative clearing. Quite a few of them are looking at securities lending as a way of actually generating the collateral that they’re going to need to post to the CCP, both for initial margin and variation margin. That may involve doing collateral downgrade trades, or otherwise actually taking cash in on the back of stock loan and not reinvesting it but using securities lending to source liquidity.

KEITH HABERLIN:The priority for us right now is to ensure that we continue to provide our clients with securities lending programmes that are aligned with their risk appetite and goals, and that are also aligned with the current demand dynamics of the business. We are focused on closely tracking regulatory developments and assessing their impact on both the industry and our clients.

DON D’ERAMO: We are focused on regulatory changes and ensuring flexibility for clients: the first is having a hand as much as possible in the regulatory changes in the environment and ensuring that we safeguard and bring the thoughts and understanding of our clients to that forum. The second is to help continue to develop market transparency and manage programmes that meet our clients’ mandates.

TONY HOLLAND: Our main priority is to optimise our risk-adjusted returns.

TRUST: CAN REGULATION HELP REBUILD IT? JEFF MOLITOR: Since we at Vanguard are handling our clients’ securities, we’re not waiting for regulators to do things for us. We think that when we’re trading, we need to make sure we have the right alignment of interests. So for us, we are very different from anybody in the market because 100% of the net revenue in securities lending goes back to our funds. We keep zero. They are our investors’ assets and our clients get the benefit of the overall programme. We do it in a way that is more value-oriented than volume-oriented.

In terms of regulation, requiring transparency to assure asset owners understand what risks they all taking and what the

FTSE GLOBAL MARKETS • NOVEMBER 2011

revenue split is makes sense. There was an article in a London newspaper claiming that 100% of money in an ETF can be lost through securities lending. Clearly, it was nonsense. It was written by someone who really didn’t have an understanding of what the risks are and the elements of securities lending; but this misunderstanding is out there and people are reading it and taking it on board.

DON D’ERAMO: It is an interesting point. Pre-Lehman and post-Lehman, a lot of effort went into education of beneficial owners and the industry as a whole, but we still find ourselves in a situation where articles are being written, probably irresponsibly at times, and not really stating facts.

It seems we still have work to do. Industry-wise, we definitely are making progress, but we have got a long way to go in educating some sectors of the industry about securities lending and, as an example, disassociating it from the strong public correlation to short selling. It is not the drag on the market that people think it is.

KEITH HABERLIN: One of the challenges that we’re facing as an industry is that regulation is increasingly being driven by political pressure rather than solely as a function of sound policy. For example, some of the EU short-selling proposals would create unintended consequences for securities lending; yet it is very difficult for the industry to focus policymakers on the detailed impact of regulation as battle lines are being drawn on much bigger issues. The concern is that asset managers do not have to lend, it is an optional business. As things become more complicated and less clear, there is a risk that liquidity leaves the market, which is to the detriment of the broader functioning of the financial system.

JAYNE FORBES: We are a great industry. We need to continue to spend more time with clients. If you are a large lender and you have so many clients, how can you spend all of the time that’s needed to be able to educate or give comfort?

We need to ensure the product background provided and the delivered activity match up. I think we are at a stage where we see securities lending being less volume, more strategic, more structured, but you will always have a flow business at the side.

Moreover, growth in this business will definitely be around managing this as a portfolio of assets and how can we squeeze the value out, as well as being transparent.

SECURITIES LENDING: WHERE’S THE BEEF? SONJA SPINNER: It is difficult, as a consultant talking mainly to pension funds, to make the case for securities lending these days. Securities lending returns are a marginal constituent of total portfolio returns. Not all pension funds consider the returns justify the impact on the funds governance budget at the investment committee and trustee level.

It can therefore be difficult to get securities lending on the agenda. When we design a securities-lending programme for a client, we try to design something that needs a minimum of oversight and governance, because people do not have time within their governance budget to spend a lot of time actively monitoring a securities lending programme.

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Agent lenders and custodians running programmes for these types of beneficial owners need to realise low maintenance is a fundamental part of programme design. There’s no point in saying: you should be actively looking at counterparty exposures and borrower limits, or actively monitoring cash collateral reinvestment, because people do not have the time. We have also seen a trend towards clients structuring programmes to maximize the intrinsic value of their loans whilst minimizing loan balances. Clients are considering whether they wish to participate in general collateral trades.

As a consequence people are increasingly setting minimal intrinsic value hurdles such as limiting loans to only those with, for example, greater than 25 basis point intrinsic value.

KEITH HABERLIN: The financial crisis has resulted in beneficial owners having a much better understanding of the risks involved with lending and the different approaches taken to the business. Previously, there was a perception held by some that securities lending is a free lunch. Now we have a much more risk-aware beneficial owner community, which is increasingly focused on intrinsic value lending. That has always been our approach to lending, but across the industry we’re seeing (at least for the time being) a migration towards generating returns from the fees that borrowers are willing to pay for assets rather than from taking increased risks with the collateral, which is in place first and foremost to secure the loan.

Admittedly, that’s an easy decision to make when interest rates are pretty much close to zero. It will be interesting to see what happens when the yield on cash collateral reinvestment increases. Will more risk be taken at that point?

DON D’ERAMO: I would say the power of an agent lending programme is exactly that it is transparent and meets the risk requirements of your clients. Not all clients want a very low risk profile; some will step out a little bit, in accordance to their risk appetite. So it is about ensuring that you can tailor a programme to various risk appetites. Even so, there is definitely a trend towards value lending, but let’s also remember that a regulation such as Dodd-Frank is probably going to limit counterparty exposure to capital, or at least a percentage of capital depending on how exposure is calculated. That kind of move will put a premium on exposures and add cost to it. So there may be other factors that may move the industry to a more value-style programme.

TONY HOLLAND: From our perspective asset management is the core business, securities lending is ancillary whereby my role is to remain seamless within the bigger picture. We work towards balancing the efficiency of riskadjusted returns. We have invested in dedicated resources to manage the programme in order to promote consistency and transparency for our business as a whole. At past conferences it’s often been said that the beneficial owner needs educating, it would be good for the lending fraternity to clearly point out exactly what needs to be understood by the beneficial owner as to address these concerns and mitigate product knowledge gaps within the industry. Within my role I interact with portfolio managers to engage them and keep them updated with regards to what is going on in their funds from a sec-lending perspective; it is powerful and

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Jeff Molitor, chief investment officer, Vanguard Europe.

Photograph © FTSE Global Markets, October 2011.

aids our goal of transparency. We do not dictate to portfolio managers it is a partnership and a dialogue which has added a lot of value and gives them visibility into the programme.

JAYNE FORBES: I totally agree with that. I’m quite lucky that I am a beneficial owner as well as being an agent lender. The lessons I learn are actually from the PMs. Although the legal client is perhaps a fund management entity, underneath are all the different asset managers and they have a very different notion of what securities lending is about. So from our perspective, we manage our securities lending programme. It is not a big black box. It is literally managed, and it is time consuming, but it is absolutely worth it. If clients want to take securities or a portfolio out of a programme we actively manage the assets that are left and available. Make no mistake, clients are definitely product-educated and they can educate agent lenders as well. I mean, I’ve worked on the custodian side and had great experience, but being part of a fund management company, you learn different things as well.

WHERE HAS ALL THE VOLUME GONE? KEITH HABERLIN: It is worth looking at the supply and demand dynamics in more detail. If you look at the supply side of the business, it is back to pre-financial crisis levels and according to Data Explorers, $13trn-worth of assets are now available for loan. The return in supply is a consequence of beneficial owners returning and some new lenders entering the market for the first time. The issue is one of demand, as this side of the business remains muted. We have a perfect storm right now where practically every engine that drives the borrowing of securities is under pressure: that includes minimal M&A activity; hedge funds that are not taking on risk; reduced proprietary trading as a result of regulation and interest rates that are close to zero. The questions are then: when will demand come back? And in the meantime, how are we all going to structure our businesses in light of this current reality? There are a couple of ways that beneficial owners and agent lenders are responding and even in light of these challenges we remain very upbeat about the potential for incremental, risk-adjusted returns for our clients. One focus right now is on intrinsic value lending. The question here is: what are the opportunities to optimise the intrinsic value of your assets within the parameters of risk that you are prepared to take? In this regard, emerging markets and their enhanced spreads will continue to be a key consideration for anybody that has an intrinsic value lending programme. The second focus then becomes: how do you scale the business in a way that improves margins? That involves taking advantage of automation and of industry infrastructure.

DON D’ERAMO: Securities lending is a very resilient market. We have had challenges, whether it is tax harmoni-

NOVEMBER 2011 • FTSE GLOBAL MARKETS

sation or softening demand due to market environment. Securities lending continues to move forward, whether it’s new markets or new demand drivers like collateral financing trades.

Moreover, the ability to be highly transparent with beneficial owners has opened up the option for those beneficial owners to change, adapt their programmes to changing demand. So while supply is back and demand may be softer, there is a different dynamic in play as clients are also changing what they want out of their securities lending programmes. They may want a specials-only type of mandate. They may also prefer to lend in only certain markets. So we look to help clients capture these opportunities as they arise.

TONY HOLLAND: To Keith’s point, we now know that the low interest rate environment is likely going to be with us for an extended period of time. This will be a continuous test of how well a beneficial owner understands and can efficiently manage their programme. If you are managing an intrinsic programme, it’s also about the quality of assets that make up the funds. We focus on the demand side versus the yield over the corresponding risk-free rate and have proven it’s possible to reduce levels of reinvestment risk whilst continuing to generate income.

KEITH HABERLIN: I remember talking to beneficial owners prior to the financial crisis and for many of them, the measure of success for a securities lending programme was: how much of my portfolio can you get out on loan? The broader discussion about the risks of volume lending and the importance of collateral and contractual protections didn’t resonate with many beneficial owners. Now though, there is an understanding that it is not about maximization of a portfolio, but rather the optimisation of the portfolio. If you have the right assets then returns still remain attractive at minimal risk.

JEFF MOLITOR: The most important element for an asset owner or fiduciary to understand is: what risks do you want to take? We apply a clear corporate philosophy on securities lending. We look for opportunities to lend securities rather than trying to lend in volume. Specifically, we want our investors to earn a minimum number of basis points. We take only cash as collateral (and require over-collateralisation) to minimize risk. Moreover, we invest the cash collateral in a high-quality money-market pool. We look at securities lending in terms of the risks you want to take or not take. It makes it a lot easier to understand the issues.

DON D’ERAMO: The asset liability functions in securities lending is very, very important. We talk a lot about intrinsic lending; we talk about the value for securities, but there is a market out there for a true asset liability model, as Jeff described. However, you need to ensure that you have the proper infrastructure to manage that, whether it is in a lowrate environment or a high-rate environment, is vital.

THE SELECTION PROCESS: ONE POTATO, TWO POTATO...?

SONJA SPINNER: In terms of beneficial owners and their selection of their securities-lending agents, most people tend to be tied to their custodian as their provider. This is

FTSE GLOBAL MARKETS • NOVEMBER 2011

Jayne Forbes, head of securities finance, AXA. Photograph © FTSE Global Markets, October 2011.

partly historic. If you ask many custodians whether they will administer third-party lending programmes they will typically seek revoke contractual settlement on income and trades. For many of our clients, the certainty of cash flow forecasting is quite important to them and acts as a deterrent to the appointment of a third-party stock loan agent.

Moreover, many pension funds access passive mandates via pooled fund vehicles. If a pension fund is selecting a pooled fund the securities-lending programme is a very small part of your investment decision. Therefore these investors do not look at the securities lending programme in quite the same way and largely delegate oversight to the asset manager.

KEITH HABERLIN: It does depend upon the segment though. I would agree with Sonja, the pension fund segment—if we can generalise across that whole segment— has been slower to embrace third-party lending. However, if you look at a segment such as mutual funds, there is a much greater openness to unbundling the securities lending provider from the custodian. These days we are seeing beneficial owners reassessing their goals for the business and the approach they want to take to securities lending. They are looking at the composition of their portfolio and selecting an agent provider that perhaps best matches up to these goals and philosophy. It is essentially a specialised approach, which may or may not involve using the custodian. We’re a custodial lender but over 40% of the assets in our programme are from third-party clients, meaning we’ve been selected on our merits as a lending agent and not because we’re the custodian. We are seeing an increase in third-party lending and believe it has a place for certain pension funds, too.

JAYNE FORBES: We are third party because we are not a custodian. I agree with your sentiment Keith. We are always being told: well, you are not the custodian so operationally there must be a time delay. Actually, I agree with both of you and if your credentials and risk and operational frameworks can meet their requirements then you can usually win the client over. Occasionally though, there’s always that problem of the question: as an investment manager and not a custodian, surely there’s going to be some breakdown of the ops flow? This issue has always been there and it will always be a discussion point. However, it remains as one consideration during the RFP process and is not the dominating factor.

TONY HOLLAND: Whilst there is evidence of unbundled services becoming the norm, what are the positives around using a bundled service with a custodian? One thought may be that the custodian has the engine to cope with real-time facilitation ie, the reallocation tool versus a straight recall model is efficient and helps the role of the beneficial owner support the investment management activity. It appears some third-party agents do not have the reallocation facility whereby returns are always on a market cycle potentially

83

ROUNDTABLE

causing sell fail situations for investment managers. We do not want to be on a portfolio manager’s radar due to causing high volumes of sell fails from securities-lending activity, as mentioned we need to remain seamless in this process. If we’re talking about custodial agent lenders, it would be interesting for the agent lenders to describe the trend in terms of the percentage of their revenue that comes from accounts under custody compared to third party.

JEFF MOLITOR: We do it internally, plus we have agent lenders, namely JP Morgan and Brown Brothers Harriman.

We think this diversified approach gives us a good balance.

Our agent lenders operate under the same risk guidelines that we use internally. We see their view of the market which helps us to maximize our effectiveness.

DON D’ERAMO: From an agent lender’s perspective, you need to be able to be flexible on meeting changing mandates. The ability to tailor collateral guidelines is imperative. You have to be able to forecast for clients. You need to be able to articulate expectations, and you need to be able to communicate trends. Beneficial owners really rely on that service mix. Although the industry has made great strides in transparency it is still a somewhat opaque market; pricing is an example of increasing transparency, there are many tools out there that help you price securities optimally. Getting pricing on specials, getting pricing on GC is not as difficult, but being able to manage the risk properly, being able to tailor the programme to clients’ specific requirements is specialised work and vital to the whole process.

KEITH HABERLIN: Beneficial owners are taking different approaches to the business and with more customised requirements, so now more than ever there is room in the market for specialised providers. Each lending agent has its strengths, so for instance if you are strictly a fixed income manager, you probably wouldn’t select an intrinsic value specialist for your lending programme, but if you are a small cap manager, you would. So there will be room in the market for specialist lending agents as well as the larger volume players.

DON D’ERAMO: Regulation may have a word in this discussion, too. If reporting requirements need to change because of Solvency II rules, that may have an effect on supply. Will some insurance companies still want to lend?

And/or, will it have a cross effect on agent lenders to be able to provide enhanced or enriched type of reporting?

TONY HOLLAND: In the context of asset liability managed by an agent from a beneficial owner’s perspective it’s about being organised, understanding and being efficient.

Historically, borrowers and lenders had high thresholds around exposures whereby they would or would not move margin. In today’s environment, we want to make sure that our trades are being marked every day; again, it is a necessity that the mark has also been collected which also reduces stale marks and more importantly exposures. It is in the agent’s best interest too, because if the marks are not collected, the bigger the price becomes from the underlying initial loan and the more the indemnity will have to make up the excess shortfall. Another aspect of importance and

84

Tony Holland, manager, securities lending, Russell Investments.

Photograph © FTSE Global Markets, October 2011.

priority is for the agent to ensure that all loans are re-rated and always earning the premium rate across all borrowers.

These are basic considerations, and it goes back to what Jayne was saying about organisation, plus a good level of understanding and being efficient. From a governance and oversight perspective, we have numerous controls in place to help us identify anomalies within our programme, which have proven to add value.

THE DIAL MOVES: DE-RISKING OF COLLATERAL DON D’ERAMO: One of the trends from a client perspective post-Lehman has been the de-risking of client mandates. We have all witnessed a trend for clients to de-risk their collateral profiles, whether it is reinvestment guidelines, or non-cash collateral profiles. Client concerns still revolve around dialling in the appropriate risk appetite and certainly everyone continues to keep a close eye on where the dial moves, and that dial should be a dynamic process as conditions change. We have also seen a small trend away from cash or a more conservative approach to cash reinvestment, and some clients have clearly moved into strictly non-cash mandates. For the foreseeable future, with interest rates where they are, I do not see that changing.

JEFF MOLITOR: Prior to Lehman, securities lending was often viewed as a free lunch. Beneficial owners were able to gain an incremental return with limited perceived risk. The question was“why not?”rather than“why?”However, many securities lending programmes broke down because there was no alignment of interests. Beneficial owners often found themselves on the wrong side of a “heads I win, tails you lose” arrangement. The 50/50 profit split was fine until the profit turned to loss and the asset owners absorbed the loss.

No one wants to return to that period, which was very tough and costly to clients and ultimately to some of the agent lenders when they compensated clients for some losses.

SONJA SPINNER: We see a lot of market focus on collateral. Many people who exited the market have now returned to lending. However, before re-entering they took the chance to reconsider collateral eligibility. Equally, new market participants are giving increasing consideration to collateral.

People are assessing the risks within their collateral pools and looking at the correlation between the value of securities on loan versus eligible collateral. More borrowers are considering whether they should be taking in G7 government debt against equities due to the correlation mismatch and attainable haircuts. Some clients have been doing some risk modelling and considering taking in equity against equity loans with an exclusion against financial securities because of the higher haircuts available. People are looking

NOVEMBER 2011 • FTSE GLOBAL MARKETS

Keith Haberlin, head of European securities lending, Brown Brothers Harriman.Photograph © FTSE Global Markets, October 2011.

at cash reinvestment funds and wanting to see an appropriately constituted fund such as a UCITS vehicle. Increased attention is being given to the investment restrictions in place for cash reinvestment funds. In the past, people didn’t really pay attention to those types of risks, now they want to go deeper into the detail before they enter into a programme.

Equally, people are setting very clear collateral parameters, with the intention of restricting loans to specials.

TONY HOLLAND: Diversity of the collateral profile is just as important, as is optimisation. If your agent can optimise your collateral this is a benefit which should add value; whereby you should be in the right ballpark. Optimisation to not only ensure collateral quality but potentially increasing demand earnings by using natural resources from borrowers which comes at a cheaper cost to them, in order to raise the collateral.

JAYNE FORBES: We are a pure non-cash house. We have never taken cash collateral. In an RFP our revenues tend to be slightly lower when we come up against a cash house.

However, we have always deemed to be very, very low risk. Lehman in 2008 clearly showed that there is also risk in taking non-cash and the reality is that risk remains everywhere in the product. We are now looking to go into cash, because we believe that there are some aspects of cash reinvestment which are worthwhile doing and there is also the consideration of the diversity and flexibility of product. So we’re probably moving against the trend because we have always been non-cash. I just want to add that we do fire-test selling our collateral, because we’re part of a trade execution department. Every now and again, we provide trading with the collateral we hold and fire-test selling the collateral. It is difficult to simulate turbulent market conditions as who can predict these? Execution value is the true test of whether you have the right margins.

DON D’ERAMO: I agree with the comments of the rigour and discipline required around risk management going forward, and as always should be the case in a prudently-run programme, it continues to develop and evolve. Agent lenders ensure that even in a non-cash mandate risk management is equally important as you are looking at your portfolio of loans and your portfolio of collateral and stressing accordingly, you’ve got the proper rigour in place, proper haircuts and concentration limits. We talked earlier about the financing trade, or the collateral upgrade, downgrade, whichever view you want to take on it, it is very important to ensure that rigour around risk management is well structured to manage the key risks such as liquidity, correlation and counterparty.

KEITH HABERLIN: This roundtable is taking place three years to the day when Lehman Brothers collapsed and we are still talking about it. If the Lehman default showed

FTSE GLOBAL MARKETS • NOVEMBER 2011

anything with respect to collateral, it was the importance of liquidity. The industry lost sight of the fact that you may actually need to use the collateral at extremely short notice, either to return to the borrower, or to liquidate it in the event of a default. Obviously, the cash versus non-cash debate has merits. There are considerations with each and one is not better than the other. But what we’re seeing in the market is the renewed recognition that the principal reason for taking collateral is to secure the loan. In that regard, capital preservation and liquidity are the two most important issues. Second to that is the additional yield or pickup that you might generate from being more flexible with the collateral. To some extent, these priorities were the wrong way round for some prior to 2008 and that is why I believe the events of 2008 will have a lasting impact.

OPPORTUNITY KNOCKS: BUT WHERE PRECISELY? SONJA SPINNER: The biggest opportunity arising right now is coming out of all the regulatory change that we’re seeing. We have done three deals in the last six months which have been purely focused on the way that a long investor might deal with Dodd-Frank or EMIR regulations. The initial margin for mandatory OTC derivative clearing is not necessarily a problem; most investors have some gilts they can post with the CCP for initial margin purposes. Some of my clients are agnostic as to whether gilts are sitting with their custodian or sitting with a CCP. The struggle for fully invested clients, especially those with liability-driven investment portfolios, is sourcing variation margin. Investors are considering using term repo or term stock loan to get cash to post to the CCP to service their derivative positions.

DON D’ERAMO: One of the opportunities that may arise may revolve around the margining requirements of increasingly mandated cleared OTC derivatives where securities lending can see increasing demand from financing transactions, as an example raising gilts versus equities; hence all of the discussions around new trends like term trades and the upgrade trade. It’s an interesting point for agent lenders to ensure that offerings for clients with appropriate risk appetite can be developed. We’re seeing a lot more of that, either bespoke requirements from our beneficial owners, or even to the extent (and this harks back to collateral management) where clients are looking at securities lending as a cheaper source of funding for their internal purposes and will just raise cash and the clients will take the cash in-house and manage it for whatever purpose. In that regard, there are growth opportunities at the confluence of all this potential regulatory change.

SONJA SPINNER: Quite often, my clients seem to be more willing to undertake term trades because they are matching the term of the trades to margin requirements. I’ve seen clients, given that at LCH you can have your rates out for 50 years in some instances, wanting to do one-year trades and then have a ladder of trades that are rolling off with staggered maturities so their refinancing risk is minimized.

85

ROUNDTABLE

KEITH HABERLIN: This leads on to one of the dynamics in the marketplace right now, in that regulation is generating an increased need for high-quality collateral by borrowers. In turn, this should conceptually lead to an increase in collateral upgrade trades. However, I’m not sure that pricing in the market is compelling enough to entice beneficial owners to really engage in the trade since a collateral upgrade trade for a borrower equates to a downgrade trade for the lender. It will be interesting to see whether pricing changes start to incentivising beneficial owners to participate in that transaction.

JAYNE FORBES: The question following on from Keith’s analysis is whether we will have a kind of industrialisation of a structured trade and whether you would also have opportunities for something which is, say, a different collateral aspect to the normal programme? I ask this because I think CCPs will need to have collateral upgrade trades to facilitate demand in the market, but obviously collateral upgrade is not going to be part of a collateral policy.

However, I believe Keith is right and that’s where the growth is and it is how we as an industry respond to being the middle man, if you like.

TONY HOLLAND: The demand side may be looking to increase collateral upgrade trades but we need to be cognisant from a risk perspective that it’s a downgrade trade for somebody else. In this context the underlying flows and risks need to be understood versus potential income generated.

SONJA SPINNER: Absolutely.

JAYNE FORBES: It is exactly that, but maybe they increase the margin. That’s what I’m saying. It goes more active management rather than saying one set of margin per asset class for this trade. That’s where our time will be spent, actually upping the parameters for a structured trade.

DON D’ERAMO: I agree the pricing will change over time as balance sheet costs continue to become a factor, specifically with Basel III. Pre-Lehman, things like indemnities, on balance sheet trades, were always there but I do not know if they were fully factored in. Realistically now the pricing and the costing of the business will change.

JEFF MOLITOR: We are very stringent in our lending of securities and market to market every day. For US securities, it is 102%; it is 105% collateral for non-US securities. We take in only cash. That simplifies things. We just do not lend bonds any more, as it is not worth the effort. There’s too little value added there to do it. For us, it gets back to the value trades. Is there a demand for a stock? So it is a different, very disciplined approach that we have because we’re a type of entity that is owned by our investors. In turn, our ownership structure leads to a different dynamic in terms of how we think about lending compared with many other players in the field.

Having an alignment where all the benefit goes to the client means that we just take opportunities off the table if they involve too much risk. For example, we do not want to bother with taking different types of collateral. But even with our conservative approach, we have funds that have 16 basis points a year net added to return. That’s good money for the investors if we have done it with the right risk controls.

86

JAYNE FORBES: Securities lending is the most efficient tax reclaim process that you will ever have because you do not have to pay for someone who’s put the reclaim in; you do not have to put a process in; and your cash flow is timely.

TONY HOLLAND: In terms of future practice, improved regulation allowing the industry to efficiently work whilst reducing risk and maintaining transparency would be embraced. Emerging markets; for a long time now, people have been talking about emerging markets, and especially more so post-global financial crisis. In relation to moving into specific emerging markets in terms of risks, specific requirements and unknowns it would be difficult to say this would be a priority on our radar. Perhaps if some of the emerging markets moved towards a more standardised practice, then maybe they could potentially emerge. In addition a point was raised at the IMN conference last year by a broker who shared that it was fairly simple to get into emerging markets. Does this suggest this is simple from a brokers and Lenders perspective? Keith, maybe you could help answer this: is it more of a challenge for a lender to get into an emerging market versus a borrower?

KEITH HABERLIN: Yes, it would be. Let’s take Taiwan as an example of a market which offers attractive potential returns to investors. As it stands, you can lose your licence in Taiwan if you fail to deliver the securities on settlement date, so therefore pre-notification of sales may be required.

How many investment managers can actually tell you before they’re trading that they’re likely to sell a stock? So, yes, the emerging markets such as Taiwan and Brazil offer attractive returns, but at the moment they come with some significant challenges for most beneficial owners and having stringent risk management controls in place is critical.

TONY HOLLAND: Is it a challenge more so for a lender in terms of tax and other regulation? Is it the same as a borrower? Is it different? In the way the information was shared at the conference it gave a perception to the beneficial owner community that it sounded simple, whereby they may walk away thinking, well, why aren’t we doing that?

KEITH HABERLIN: Well, for a borrower, it is their core business to generate income in those markets, whereas for a beneficial owner, to Sonja’s point, it is an add-on to their securities lending programme, so the risk-reward trade-off can be very different. But I would say the challenges from a tax and regulatory perspective are fairly consistent although not the same.

SONJA SPINNER: I think that depends on the market. It is not going to impact portfolio management investors, but my clients will not lose their ability to hold their investment managers to deliver portfolio returns for the sake of incremental securities lending revenues.

JAYNE FORBES: It is about reputation as well. If your managers have strategic initiatives in new markets and we fail on the loan recall it can become a huge issue due to publicity and fines. An agent lender cannot repair reputational damage or exchange expulsion. Borrowers will always encourage you to put the supply in the market and offer all the information needed, but we always work on the basis if there’s any chance of reputational damage we wouldn’t go there. I

NOVEMBER 2011 • FTSE GLOBAL MARKETS

(Week ending 14 October 2011) Reference Entity

Federative Republic of Brazil United Mexican States Republic of Turkey Republic of Italy Bank of America Corporation Russian Federation JPMorgan Chase & Co. MBIA Insurance Corporation General Electric Capital Corporation Kingdom of Spain

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Financials Government Financials Financials Financials Government

Sov Sov Sov Sov Corp Sov Corp Corp Corp Sov

17,575,061,352 8,951,901,570 4,991,546,931 21,877,450,917 5,728,129,888 4,768,167,788 5,604,520,282 3,808,759,857 11,231,752,008 17,691,325,182

184,187,537,835 129,530,056,469 147,456,578,413 307,716,159,142 79,824,653,803 114,006,852,232 78,991,262,030 79,774,243,925 96,492,738,087 162,002,356,483

12,921 10,292 9,518 9,363 8,909 8,764 7,865 7,416 7,396 7,337

Americas Americas Europe Europe Americas Europe Americas Americas Americas Europe

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

24,569,472,129 21,877,450,917 19,327,221,866 17,691,325,182 17,575,061,352 12,596,730,127 11,231,752,008 9,344,555,372 9,199,299,708 8,951,901,570

127,741,165,315 307,716,159,142 113,622,631,655 162,002,356,483 184,187,537,835 71,449,764,741 96,492,738,087 63,302,219,262 58,958,152,921 129,530,056,469

6,780 9,363 4,207 7,337 12,921 4,953 7,396 6,250 6,797 10,292

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

Top 10 net notional amounts (Week ending 14 October 2011) Reference Entity

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 14 October 2011)

(Week ending 14 October 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Corporate: Financials

3,347,328,564,401

437,367

Republic of Italy

4,529,439,108

322

Sovereign / State Bodies

2,869,432,147,616

219,140

French Republic

4,397,436,380

294

Gross Notional (USD EQ)

Contracts

Corporate: Consumer Services

2,091,469,107,531

346,414

Kingdom of Spain

4,218,539,325

303

Corporate: Consumer Goods

1,625,698,859,776

258,295

UK and Northern Ireland

2,977,938,214

123

Corporate: Industrials

1,284,693,965,005

218,115

Federative Republic of Brazil

2,917,800,000

197

Corporate: Technology / Telecom

1,279,198,748,929

196,496

Japan

2,071,944,330

200

People's Republic of China

1,938,661,646

291

MBIA Insurance Corporation

1,915,109,878

252

United Mexican States

1,763,137,848

128

Federal Republic of Germany

1,632,481,723

108

Corporate: Basic Materials

983,440,872,499

157,403

Corporate: Utilities

784,851,278,602

122,196

Corporate: Oil & Gas

489,507,953,478

87,321

Corporate: Health Care

351,167,763,839

60,986

Corporate: Other

150,148,186,719

16,298

CDS on Loans

66,711,464,365

17,404

Residential Mortgage Backed Securities

58,720,259,555

11,320

Residential Mortgage Backed Securities* 16,191,153,272

1,103

Commercial Mortgage Backed Securities 15,567,055,686

1525

CDS on Loans European

4,793,461,627

679

Muni: Government

1,216,700,000

124

Other

1,044,463,813

83

827,584,643

72

Commercial Mortgage Backed Securities* CDS Swaptions

104,115,750

1

Muni: Other

100,000,000

2

Muni: Utilities

36,600,000

11

*European

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2011

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

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

87

The Fidessa Fragmentation Index (FFI) was launched to provide a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative lit trading venues. In short, it shows the average number of lit venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue.

Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues. Once a stock’s FFI exceeds 2, liquidity in that stock has fragmented to the extent that it no longer “belongs” to its originating venue.

The Fidessa Fragulator® allows you to query several billion trade records to get a complete picture of how trading in a given stock is broken down across lit venues, dark pools, systematic internalisers and bilateral OTC trades.

FFI and venue market share by index Week ending 7th October 2011 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.67 8.59%

2.24 5.38%

2.14 3.97% 0.01%

1.87 3.89%

2.02 5.20%

31.84%

23.56%

4.02% 18.83%

21.85%

0.05%

1.80%

25.77% 62.56% 0.01% 0.01% 0.54% 0.03% 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

50.90% 0.18% 0.04% 0.02%

0.12%

0.04%

61.62% 66.37% 70.31% 0.01% 7.45% 0.00%

9.01%

VENUES

6.94%

2.91%

6.20%

VENUES

INDICES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

5.11

4.70

FFI

2.05

2.07

BATS

13.19%

12.91%

Alpha ATS

20.37%

17.04%

BATS Y

3.34%

3.27%

Chi-X Canada

11.31%

13.78%

CBOE

0.08%

0.05%

Chicago Stock Exchange

0.30%

0.21%

TMX Select

1.64%

1.54%

EDGA

5.48%

4.95%

1.83%

EDGX

9.77%

8.93%

NASDAQ

24.75%

25.29%

NASDAQ BX

4.82%

3.59%

NQPX

1.72%

1.35%

NSX

0.44%

0.52%

NYSE

19.78%

23.22%

FFI

NYSE Amex

0.06%

0.17%

NYSE Arca

16.26%

15.46%

VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

1.00

Australia Hong Kong

100.00% 100.00%

S&P TSX 60

Omega ATS

1.80%

Pure Trading

3.10%

2.85%

TSX

61.78%

62.95%

VENUES INDICES

INDICES

Asia

Canada*

DOW JONES

US

INDICES

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

INDEX NIKKEI 225

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

1.33 2.52% 0.00% 0.03% 0.00% 0.00% 2.74% 87.51% 7.21% 0.00%

Figures are compiled from lit order book trades only. Totals only include stocks contained within the major indices. *This index is also traded on US venues. For more detailed information, visit http://fragmentation.fidessa.com/fragulator/.

88

NOVEMBER 2011 • FTSE GLOBAL MARKETS

COMMENTARY

By Steve Grob, Director of Group Strategy, Fidessa

D

ESPITE BEING PART of Europe and subject to the MiFID best execution requirements introduced in 2007, Spain remains a unique outlier in the global fragmentation ‘experiment’ with alternative venues still struggling to establish a foothold there. Whilst the Fidessa Fragmentation Index (FFI) for all the other major European indices has increased, a look at the 4-week average shows that for Spain’s IBEX 35 the FFI has risen from 1 in 2008 to just 1.04 today. In comparison, the average FFI for the FTSE 100 - the most fragmented of the European indices is now 2.63 (see chart at bottom of page).

Further analysis of the data highlights the marked contrast between the London and Madrid markets and their evolution over the past three years (charts 1, 2, 3 and 4).

1. Lit value breakdown, IBEX (September 2008)

2. Lit value breakdown, FTSE 100 (September 2008) 2.82% Turquoise

100% Madrid

0.0% Nasdaq Europe

17.43% Chi-X

79.75% LSE

3. Lit value breakdown, IBEX (September 2011) 0.12% Bats Europe 1.65% Chi-X

0.08% Turquoise 0.02% Milan 0.00% NYSE Arca 98.13% Madrid

4. Lit value breakdown, FTSE 100 (September 2011) 8.65% Turquoise

0.13% NYSE Arca 0.05% Equiduct

8.87% Bats Europe

51.70% LSE

30.60% Chi-X

In recent weeks the London Stock Exchange's (LSE) market share of its benchmark index has fallen to around 50%. In fact, the latter part of September saw its share fall below 50% for the first time with Chi-X, Bats Europe and Turquoise making significant

inroads (chart 5). At the same time, Spain's Bolsas y Mercados Españoles (BME) has managed to retain a near monopoly with its share in the IBEX 35 remaining close to 100%.

5. Lit value breakdown, FTSE 100 (Week ending 23/09/2011) 9.38% Turquoise

9.25% Bats Europe 0.14% NYSE Arca 0.05% Equiduct 49.70% LSE

31.49% Chi-X

Both of these markets are in Europe and both are subject to the rules introduced by the original MiFID directive. These dramatic differences cannot be explained by widely varying levels of liquidity which remain significant in both markets. So, what is behind the BME's impressive retention of market share in its domestic index?

The reason most often cited is that all Spanish trades still have to be 'put through' the BME. However, the implementation of Title V earlier this year removed this requirement, effectively opening the door to MTFs by allowing them to trade and settle in Spain as over the counter traders.

Chi-X, certainly, is setting its sights on Spain and recently introduced a three month price promotion on six blue chip Spanish stocks in a bid to break the BME's dominance in the local market.

The question is will this be enough to turn the tide? Perhaps, but as with all markets the real issue will be the enthusiasm of the high frequency liquidity providers to support the alternative MTFs. Ironically the BME holds the key because, unless the HFT community can lay off their alternative market making risk on the main market, Spain will remain unattractive to them.

The other issue, though, is that assuming Spain does follow the pattern of other countries, then it’s likely that Bats Europe, Chi-X and Turquoise will be the winners and that may not necessarily be good for Spain plc. This fact, combined with the intertwined relationships that surround the BME and its key trading members, means that Spain may remain an anomaly for a while yet.I

Fidessa Fragmentation Index (4-week average), Europe 2.63

2.80 2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00

Sep-08

Sep-09

Sep-11

1.04 AEX

BEL 20

CAC 40

DAX

FTSE 100

FTSE 250

FTSE MIB

IBEX

OMX C20

OMX H25

OMX S30

OSLO OBX

PSI 20

SMI

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 • NOVEMBER 2011

89

GLOBAL ETF SUMMARY

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

No. of ETFs 467 372 100 90 291 170 165 128 62 14 11 54 32 29 46 35 8 36 18 28 38 13 17 11 11 24 21 622 2,913

September 2011 Total Listings AUM (US$Bn) 1,659 $284.4 656 $276.9 236 $134.8 124 $69.4 972 $86.4 416 $48.3 296 $45.6 359 $47.9 121 $30.1 35 $12.8 19 $17.0 67 $16.9 38 $2.7 115 $7.9 90 $16.5 42 $8.5 13 $8.3 46 $2.5 19 $1.4 29 $2.3 48 $4.8 14 $7.3 35 $1.3 13 $0.8 13 $0.7 25 $7.9 26 $8.6 945 $93.6 6,471 $1,245.6

% Total 22.8% 22.2% 10.8% 5.6% 6.9% 3.9% 3.7% 3.8% 2.4% 1.0% 1.4% 1.4% 0.2% 0.6% 1.3% 0.7% 0.7% 0.2% 0.1% 0.2% 0.4% 0.6% 0.1% 0.1% 0.1% 0.6% 0.7% 7.5% 100.0%

ADV (US$Bn) $9.8 $44.6 $3.0 $11.5 $1.9 $1.4 $3.0 $0.5 $5.5 $0.1 $0.2 $0.0 $0.1 $0.1 $1.3 $0.1 $0.1 $0.0 $0.0 $0.0 $0.2 $0.2 $0.0 $0.0 $0.0 $0.1 $0.0 $2.5 $86.3

No. of ETFs 77 57 18 21 3 7 25 16 1 1 2 1 1 0 5 0 2 0 1 18 13 0 2 0 1 10 3 168 453

Total Listings 338 103 31 27 -4 33 41 49 21 1 3 3 5 4 10 0 6 7 1 19 15 0 2 1 3 10 4 248 981

YTD Change AUM (US$Bn) -$53.4 -$24.2 $23.6 -$11.1 -$3.6 -$6.7 -$1.9 $2.7 -$1.6 -$2.5 $2.3 $0.3 -$0.8 -$1.6 -$0.1 $0.0 $2.6 -$0.4 -$1.2 $0.3 -$1.0 -$0.4 -$0.4 $0.0 -$0.3 $1.4 $0.9 $11.2 -$65.7

% AUM -15.8% -8.0% 21.2% -13.8% -4.0% -12.1% -4.1% 6.1% -5.2% -16.3% 16.0% 2.0% -23.5% -16.4% -0.5% 0.5% 44.5% -13.1% -45.7% 18.2% -17.0% -4.8% -24.9% -4.9% -30.5% 22.4% 11.9% 13.6% -5.0%

% TOTAL -2.9% -0.7% 2.3% -0.6% 0.1% -0.3% 0.0% 0.4% 0.0% -0.1% 0.2% 0.1% -0.1% -0.1% 0.1% 0.0% 0.2% 0.0% -0.1% 0.0% -0.1% 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% 1.2%

Source: BlackRock Investment Institute - ETF Research, Bloomberg

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

4.8%

Provider

Dec-2010

% Mkt Share

Change (%)

SSgA

$18,667.3

40.3%

$40,567.1

47.0%

$21,899.8

iShares

$14,028.5

30.3%

$20,237.3

23.5%

$6,208.7

44.3%

PowerShares

$2,660.7

5.7%

$5,897.4

6.8%

$3,236.7

121.7%

ProShares

$1,860.7

4.0%

$5,199.4

6.0%

$3,338.7

179.4%

Direxion Shares

11.8% Others

117.3%

Direxion Shares

$2,413.3

5.2%

$4,146.4

4.8%

$1,733.1

71.8%

Others

$6,710.5

14.5%

$10,205.6

11.8%

$3,495.1

52.1%

Total

$46,340.7

100.0%

$86,253.1

100.0%

$39,912.4

86.1%

6% ProShares

47% SSgA

6.8% PowerShares

23.5% iShares

Source: BlackRock Investment Institute - ETF Research, Bloomberg

Top 20 ETFs worldwide with the largest change in AUM As at end September 2011 ETF iShares MSCI Emerging Markets Index Fund SPDR S&P 500 iShares DAX (DE) SPDR Gold Trust Vanguard MSCI Emerging Markets ETF iShares Russell 2000 Index Fund S&P 400 MidCap SPDR iShares FTSE China 25 Index Fund iShares Gold Trust Financial Select Sector SPDR Fund db x-trackers DAX ETF Vanguard Total Bond Market ETF iShares MSCI Brazil Index Fund Utilities Select Sector SPDR Fund Lyxor ETF Euro STOXX 50 db x-trackers MSCI Emerging Market TRN Index ETF Vanguard Dividend Appreciation ETF iShares MSCI EAFE Index Fund Energy Select Sector SPDR Fund Market Vectors Agribusiness ETF

Country listed US US Germany US US US US US US US Germany US US US France Germany US US US US

Bloomberg Ticker EEM US SPY US DAXEX GY GLD US VWO US IWM US MDY US FXI US IAU US XLF US XDAX GY BND US EWZ US XLU US MSE FP XMEM GY VIG US EFA US XLE US MOO US

AUM (US$ Mil) September 2011 $26,500.2 $81,251.0 $12,575.9 $64,298.8 $38,770.7 $12,454.9 $7,810.2 $4,925.1 $8,539.5 $4,318.3 $6,847.3 $12,075.3 $9,065.3 $6,597.1 $5,480.1 $3,533.0 $7,078.0 $34,544.9 $6,262.0 $4,709.9

AUM (US$ Mil) December 2010 $47,551.5 $89,915.3 $5,917.7 $58,498.2 $44,569.8 $17,498.4 $12,211.0 $8,131.1 $5,378.6 $7,472.5 $3,693.1 $9,054.5 $12,012.5 $3,756.9 $8,278.6 $6,263.3 $4,608.9 $36,923.1 $8,396.4 $2,631.5

Change (US$ Mil) -$21,051.2 -$8,664.3 $6,658.3 $5,800.6 -$5,799.1 -$5,043.5 -$4,400.8 -$3,206.0 $3,160.9 -$3,154.2 $3,154.2 $3,020.9 -$2,947.1 $2,840.2 -$2,798.5 -$2,730.3 $2,469.1 -$2,378.2 -$2,134.4 $2,078.4

Source: BlackRock Investment Institute - ETF Research, Bloomberg

90

NOVEMBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

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

CHANGE IN ASSETS

No. Primary Listings

New in 2010

New in 2011

Total Listings

2010

Sep 2011

US$ Bn

%

US Europe Austria Belgium Finland France Germany Greece Hungary Ireland Italy Netherlands Norway Poland Portugal Russia Slovenia Spain Sweden Switzerland Turkey United Kingdom Japan Canada Hong Kong Mexico China South Korea Taiwan Colombia India South Africa Brazil Singapore Australia New Zealand Malaysia Thailand Indonesia UAE Saudi Arabia Chile Botswana Israel Egypt Sri Lanka Philippines

1,065 1,208 1 1 1 273 430 3 1 1 23 29 7 1 3 1 0 12 24 130 12 255 86 213 47 20 30 99 17 1 20 26 8 25 30 6 4 4 1 1 2 0 0 -

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

175 163 16 60 4 1 2 6 19 48 6 57 7 1 15 37 5 1 4 1 4 11 1 -

1,065 4,204 21 28 1 501 1,284 3 1 1 560 115 15 3 3 1 0 68 88 729 12 770 90 254 76 373 30 99 20 1 20 26 8 83 51 6 5 4 1 1 2 51 1 -

$891.0 $284.0 $0.1 $0.1 $0.3 $59.9 $110.7 $0.1 $0.0 $0.4 $2.5 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.2 $2.8 $38.0 $0.2 $66.7 $32.2 $38.4 $26.3 $8.2 $10.1 $5.3 $2.8 $0.0 $0.4 $2.3 $1.9 $3.6 $3.9 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$841.0 $267.4 $0.1 $0.0 $0.2 $46.7 $105.1 $0.0 $0.0 $0.0 $2.1 $0.7 $0.6 $0.0 $0.1 $0.0 $0.0 $1.1 $2.5 $45.0 $0.2 $63.0 $33.8 $37.7 $22.6 $7.8 $12.7 $7.7 $4.1 $0.7 $0.4 $2.1 $1.4 $2.5 $3.1 $0.3 $0.3 $0.1 $0.0 $0.0 $0.0 -

-$50.0 -$16.6 -$0.1 $0.0 -$0.1 -$13.2 -$5.7 $0.0 $0.0 -$0.4 -$0.4 $0.3 -$0.1 -$0.1 $0.0 $0.0 $0.0 -$0.1 -$0.3 $7.0 $0.1 -$3.7 $1.6 -$0.7 -$3.6 -$0.4 $2.6 $2.3 $1.3 $0.7 $0.0 -$0.2 -$0.5 -$1.1 -$0.7 -$0.1 -$0.1 $0.0 $0.0 $0.0 $0.0 -

-5.6% -5.9% -49.6% -33.6% -24.3% -22.0% -5.1% -53.3% -33.1% -94.5% -16.4% 99.9% -9.2% -77.8% 108.0% -21.9% -100.0% -10.0% -10.7% 18.5% 35.8% -5.6% 4.9% -1.9% -13.9% -5.3% 26.1% 43.6% 46.4% 100.0% 3.9% -9.6% -28.0% -31.1% -19.0% -17.9% -16.1% -13.0% -14.3% -5.8% 54.1% -

ETF total

2,913

594

488

6,471

$1,311.3

$1,245.6

-$65.7

Location

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

-5.0%

No. of No. of Exchanges Planned Providers (Official) New

30 39 1 1 1 9 12 2 1 1 4 4 2 1 2 1 0 2 2 7 5 9 7 7 10 3 21 14 3 1 9 8 2 8 6 2 3 3 1 1 1 0 0 0 0 0 0

2 22 1 1 1 1 2 1 1 1 1 1 1 1 1 1 0 2 2 1 1 1 3 1 1 1 2 1 2 1 2 1 1 1 1 1 1 1 1 1 1 1 1 0 0 0 0

953 39

0 29 1 1 21 5 4 0 18 15 1 3 5 0 3 0 0 4 1 0 0 2 1 1 1 1,108

Source: BlackRock Investment Institute - ETF Research, Bloomberg

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only.

This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the Global ETF Research and Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Affiliated companies of BlackRock may make markets in the securities of ETFs and provide ETFs in the form of iShares. Further, BlackRock and/or its affiliated companies and/or their employees may from time to time hold shares or holdings in the underlying shares of, or options on, any security of ETFs and may as principal or agent buy securities in ETFs. The opinions expressed are those of BlackRock as of September 2011, and are subject to change at any time due to changes in market or economic conditions. They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed

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FTSE GLOBAL MARKETS • NOVEMBER 2011

91

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (29 September 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 Se p

1

Ju n11

10

M ar -1

-1 0

De c-

Se p

Ju n10

9

M ar -1 0

c0 De

-0 9 Se p

9

Ju n09

08

M ar -0

De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

p0

6

40 Se

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (29 September 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

140

120

100

80

60

-1 1 Se p

1

Ju n11

M ar -1

10 De c-

-1 0 Se p

Ju n10

M ar -1 0

9 c0 De

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

40

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (29 September 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 Se p

Ju n11

1 M ar -1

10 De c-

-1 0 Se p

Ju n10

M ar -1 0

9 c0 De

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

ar -0 8 M

De c07

p07 Se

Ju n07

-0 7 ar M

De c06

Se

p0

6

0

Source: FTSE Group, data as at 30 September 2011.

92

NOVEMBER 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (29 September 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

160 140 120 100 80 60

-1 1 Se p

1

Ju n11

10

M ar -1

-1 0

De c-

Se p

Ju n10

9 De

M ar -1 0

c0

-0 9 Se p

9

Ju n09

08

M ar -0

De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

40

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (29 September 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

140 120 100 80 60

-1 1 Se p

1

Ju n11

10

M ar -1

De c-

-1 0 Se p

Ju n10

M ar -1 0

9 De

c0

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

40

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (29 September 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 Se p

1

Ju n11

10

M ar -1

De c-

-1 0 Se p

Ju n10

M ar -1 0

9 c0 De

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

ar -0 8 M

7 De c0

p07 Se

Ju n07

-0 7 ar M

De c06

Se

p06

20

Source: FTSE Group, data as at 30 September 2011.

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2011

93

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (29 September 2006 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

80

60

-1 1 Se p

1

Ju n11

10

M ar -1

-1 0

De c-

Se p

Ju n10

9

M ar -1 0

c0 De

-0 9 Se p

9

Ju n09

08

M ar -0

De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

p0

6

40 Se

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 (29 September 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 Se p

1

Ju n11

10

M ar -1

De c-

-1 0 Se p

Ju n10

M ar -1 0

9 c0 De

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

20

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (30 September 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)

180 160 140 120 100 80 60 40

-1 1 Se p

Ju n11

1 M ar -1

10 De c-

-1 0 Se p

Ju n10

M ar -1 0

9 c0 De

Se p09

Ju n09

ar -0 9 M

08 De c-

Se

p08

20

Source: FTSE Group, data as at 30 September 2011.

94

NOVEMBER 2011 â&#x20AC;˘ 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 (29 September 2006 = 100) FTSE Asia Pacific Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

200 180 160 140 120 100 80

-1 1 Se p

1

Ju n11

10

M ar -1

-1 0

De c-

Se p

Ju n10

9

M ar -1 0

De

c0

-0 9 Se p

9

Ju n09

08

M ar -0

De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

60

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (29 September 2006 = 100) FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

500 450 400 350 300 250 200 150 100 50

-1 1 Se p

1

Ju n11

10

M ar -1

De c-

-1 0 Se p

Ju n10

M ar -1 0

9 De

c0

-0 9 Se p

9

Ju n09

M ar -0

08 De c-

p08 Se

Ju n08

M ar -0 8

De c07

p07 Se

Ju n07

6

M ar -0 7

De c0

Se

p0

6

0

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (31 March 2010 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

180

160

140

120

100

11 Se p-

11 Au g-

1

1

l11 Ju

Ju n1

1

M ay -1

Ap r1

1 M ar -1

-1 1 Fe b

11 Ja n-

-1 0 De c

10 ov N

Oc t10

Se p10

-1 0 Au g

Ju l10

Ju n10

-1 0 ay M

Ap r10

M

ar -1 0

80

Source: FTSE Group, data as at 30 September 2011.

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2011

95

INDEX CALENDAR

Index Reviews November - December 2011 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

30-Nov

14-Oct

01-Nov

Russell/Nomura Indices

Annual review

07-Nov

TOPIX

Monthly review - additions & free float adjustment

29-Nov

31-Oct

09-Nov

FTSE Value-Stocks China Index

Semi-annual review

11-Nov

31-Oct

10-Nov

Hang Seng

Quarterly review

02-Dec

30-Sep

16-Nov

MSCI Standard Index Series

Quarterly review

30-Nov

31-Oct

22-Nov

DJ STOXX

Quarterly review

16-Dec

30-Nov

Early Dec

ATX

Quarterly review

31-Dec

30-Nov

Early Dec

OBX

Semi-annual review

16-Dec

30-Nov

Early Dec

IBEX 35

Semi-annual review

12-Jan

30-Nov

Early Dec

OMX C20

Semi-annual review

16-Dec

30-Nov

02-Dec

BEL 20

Quarterly review

16-Dec

31-Oct

02-Dec

DAX

Quarterly review

16-Dec

30-Nov

02-Dec

PSI 20

Quarterly review

16-Dec

31-Oct

02-Dec

AEX

Quarterly review

16-Dec

31-Oct

02-Dec

CAC 40

Quarterly review

16-Dec

30-Nov

02-Dec

FTSE Global Equity Index Series (incl. FTSE All-World)

Annual review / North America

09-Dec

30-Sep

02-Dec

S&P / ASX Indices

Quarterly review

16-Dec

25-Nov

02-Dec

FTSE Vietnam Index Series

Quarterly review

16-Dec

25-Nov

n/a

FTSE Renaissance Asia Pacific IPO Index Series

Quarterly review

16-Dec

30-Nov

06-Dec

FTSE China Index Series

Quarterly Review

16-Dec

21-Nov

06-Dec

FTSE MIB

Quarterly review - shares & IWF

16-Dec

05-Nov

07-Dec

TOPIX

Monthly review - additions & free float adjustment

29-Dec

30-Nov

07-Dec

FTSE/JSE Africa Index Series

Quarterly review

16-Dec

06-Dec

07-Dec

FTSE UK Index Series

Annual review

16-Dec

06-Dec

07-Dec

FTSE techMARK 100

Quarterly review

16-Dec

06-Dec

07-Dec

FTSE Euromid

Quarterly review

16-Dec

06-Dec

07-Dec

FTSEurofirst 300

Quarterly review

16-Dec

06-Dec

07-Dec

FTSE Italia Index Series

Quarterly review

16-Dec

06-Dec

08-Dec

FTSE Bursa Malaysia Index Series

Annual review

16-Dec

30-Nov

09-Dec

S&P US Indices

Quarterly review

16-Dec

08-Dec

09-Dec

NZX 50

Quarterly review

16-Dec

30-Nov

09-Dec

Dow Jones Global Indexes

Quarterly review

16-Dec

30-Nov

09-Dec

DJ Global Titans 50

Quarterly review - no composition changes only rebalance/shares/float changes

16-Dec

30-Nov

09-Dec

S&P / TSX

Quarterly review

16-Dec

30-Nov

09-Dec

S&P Topix 150

Quarterly review

16-Dec

02-Dec

09-Dec

S&P Asia 50

Quarterly review

16-Dec

02-Dec

09-Dec

S&P Latin 40

Quarterly review - shares & IWF

16-Dec

02-Dec

09-Dec

S&P Global 1200

Quarterly review - shares & IWF

16-Dec

02-Dec

09-Dec

S&P Global 100

Quarterly review - shares & IWF

16-Dec

02-Dec

10-Dec

OMX I15

Semi-annual review

31-Dec

30-Nov

12-Dec

S&P BRIC 40

Annual review

16-Dec

18-Nov

12-Dec

Russell US & Global Indices

Quarterly review - IPO additions only

16-Dec

30-Nov

13-Dec

FTSE SET Index Series

Semi-annual review

16-Dec

30-Nov

14-Dec

Russell US & Global Indices

Monthly review - shares in issue change

16-Dec

13-Dec

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

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NOVEMBER 2011 • FTSE GLOBAL MARKETS