FTSE Global Markets

MANAGING RISK IN FIXED INCOME TRANSITIONS

ISSUE 58 • FEBRUARY 2012

New business opportunities for European fund admin US regulators on the warpath Russia's capital markets take new shape Hedge funds feel the pinch

FATCA

Is Uncle Sam softening on his global tax demand?

THE PROCESS OF ENSURING EFFECTIVE DUE DILIGENCE

OutlOOk EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152 email: francesca@berlinguer.com SENIOR EDITORS: Ruth Hughes Liley (Trading); David Simons (US) CONTRIBUTING EDITORS: Art Detman; Neil O’Hara; Lynn Strongin Dodds CORRESPONDENTS: Rodrigo Amaral (Iberia/Emerging Markets); Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Matt Lynn (UK Markets); Ian Williams (Supranationals/Emerging Markets) PRODUCTION MANAGER: Luke W. Cleary, tel: +44 [0]20 7680 5161 email: luke.cleary@berlinguer.com SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5157 email: roy.shipston@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Paul Hoff; Jerry Moskowitz; Andy Harvill PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel: +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel: +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION: Register online at www.ftseglobalmarkets.com Single subscriptions cost £497/year for 10 issues.

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FTSE GLOBAL MARKETS • FEBRUARY 2012

HERE IS A real sense that 2012 is a pivot for the financial markets; at least in the West. The Asian and Latin markets, despite a marked period in the doldrums over the Christmas and Chinese NewYear period, seem irrevocably set on their own rapid growth trajectories, come what may. Witness the sustained growth in securities services in those regions which tell a more buoyant story than the cash-strapped providers in Europe and the US. In the US and Europe at present, regulation looks to be strangling anything that moves—particularly if it has the word money attached to it. Rather an irony really, given that the financial sector has been the engine of growth in the Atlantic countries for well over a century. Certainly, no one doubts the sincerity behind much of the legislation in its efforts to put in place mechanisms that effectively control counterparty and systemic risks in financial markets, in particular in the OTC segment. However, much remains to be done to strengthen those institutions upon which rests the efficacy of legislative moves to introduce rigour and transparency into markets, such as clearing houses and trade repositories. If the debacle of the MF Global collapse has taught the markets anything it is that, right now, exchanges and clearing houses are not ready to do the work of controlling counterparty risk.

How these pillars of the global trading system can be bolstered to do this work has yet to be explained, and this theme will be expanded and explored ad nauseam in subsequent editions. In this issue, however, we confine ourselves to the potential bane of asset managers’ lives the world over, namely the Foreign Account Tax Compliance Act (FATCA), which came into being in 2010 as part of the equally tendentious Hiring Incentives to Restore Employment (HIRE) Act and which is expected to come into force in its final form by the end of this year.

As if existing regulation did not raise the level of accountability in the system by enough, FATCA threatens another source of intrusive market surveillance by the US Inland Revenue Service on an ongoing basis in the hope of catching out rich American tax-dodgers. Ian Williams reports on both the impact of FATCA on the global investment community in our cover story. And, he warms to the regulatory theme by looking at the reasons why American regulators are now clamping down on market indiscretions with no small degree of vigour. All in all, for many firms on either side of the investment divide, it means more money spent on compliance, internal monitoring, hugely expanded reporting requirements, and all that before any thought of market return comes into the equation. Joy unconfined for retail investors everywhere as all this eats into the already meagre returns they have come to expect from their investment plans!

To help prepare the asset management community for the shape of things to come, we come full circle at the end of this edition with a timely reminder of the importance and scope of due diligence in the modern age. Patrick McCurdy, partner and head of capital development at Merlin Securities, shows how effective due diligence provides all-important clarity to the investor’s investment decision.

To cheerier thoughts: Ruth Hughes Liley injects an optimistic note about the long-term prospects for the equities trading fraternity in Latin America. Like Asia, seasonal distemper has dulled markets in the immediate term, but as the year progresses, it is likely that with the plethora of new electronic platforms, new market entrants must win out, offering investors positive returns and market liquidity. If we wish anything this year it is that positive returns and market liquidity come back in force for everyone.

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Francesca Carnevale, Editor, February 2012

Cover photo: Uncle Sam. Photograph kindly supplied by Dreamstime.com, supplied January 2012.

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COntents COVER STORY

YOU MIGHT RUN, BUT YOU CANNOT HIDE FROM FATCA

..................Page 6 Who would have thought that a piece of pesky tax legislation passed in 2010 in the United States and designed to combat tax avoidance would mean a whole heap of bothersome bureaucracy for foreign financial institutions. Pity not US tax dodgers: can anyone save the rest of the world from the IRS?

DEPARTMENTS

MARKET LEADER SPOTLIGHT

THE LONG AND LENGTHENING ARM OF US REGULATION ...............Page 12 Ian Williams reports on the search for retribution by US financial markets regulators.

NEWS AND MARKET REVIEWS

..............................................................................Page 16

IOSCO update clarifies use of trading platforms for OTC derivatives.

MIDDLE EAST ETFS: CAN THE FIRES BE RE-LIT? ......................................Page 18 Lynn Strongin Dodds explains why the sector has failed to ignite and what should be done.

PRIVATE SHARES GO PSEUDO-PUBLIC

IN THE MARKETS

............................................................Page 23

Neil O’Hara assesses the outlook of this nascent market.

LATIN AMERICAN DRS — A BUDDING PIPELINE? ................................Page 26 Lynn Strongin Dodds on the new issuance prospects for 2012-01-27.

A MIXED YEAR FOR HEDGE FUNDS IN 2011: WHAT’S IN STORE NOW? Page 30 Francesca Carnevale talks to Peter Laurelli at eVestment about his latest research.

SECURITIES SERVICES FX VIEWPOINT FACE TO FACE INDEX REVIEW

SUB-CUSTODY IN EMERGING MARKETS: DOWN & DIRTY THE INEXORABLE RISE AND RISE OF THE RMB

....................................Page 35

Francesca Carnevale reports on the latest developments.

WITH NICKY NEWTON-KING, CEO, JSE LTD

..............................................Page 37

Francesca Carnevale reports on the new ways the JSE is approaching business development.

MARKET VOLATILITY? NOT RIGHT NOW SIR!

........................................Page 40

Simon Denham, managing director of Capital Spreads, takes a surprisingly optimistic view.

EQUITIES ON A ROLL IN THE ELECTION AFTERMATH

COUNTRY REPORT

........Page 32

David Simons explains where service providers see new business opportunities.

....................Page 41

Egypt is breaking expectations as its equity markets enjoy a bull run.

RUSSIA CLEARING PREPARES FOR CHANGE

............................................Page 42

The new structure of the Russian equity markets is taking shape.

DEBT REPORT 2

EUROZONE’S SLOW RESTRUCTURE WILL IMPACT YIELDS AGAIN Page 43 Andrew Cavenagh gives a pessimistic prognosis to Europe’s chronic woes.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

COntents

OIL PRICES REMARKABLY STABLE DESPITE WORLD WOES ........Page 47

COMMODITIES REPORT

What will it take to push up oil prices? Vanja Dragomanovich reports on the possibilities.

PRECIOUS METALS IN THE SPOTLIGHT — AGAIN ................................Page 50 Vanja Dragomanovich suggests a Q1 rally after the December 2011 sell-off.

COMPANY PROFILE

TO CATCH A FALLEN STAR ..........................................................................................Page 55 Can Carl Icahn steer Navistar to a better future? Art Detman reviews the options.

FEATURES SECURITIES SERVICES:

ARE THESE THE HALCYON DAYS OF ASIAN SEC-LENDING? ............Page 59 A tremendously diverse, highly dynamic and fiercely competitive region, Asia is no place for the faint of heart. Those seeking to secure a piece of the region’s nascent securities-lending business must come armed with a thorough understanding of the regulatory nuances within each locale, and getting up to speed can be a considerable task. It is no surprise, then, that demand continues to outweigh supply in the region. David Simons reports.

RAISING THE STAKES IN FUND ADMINISTRATION ................................Page 66 The financial crisis has created new business opportunities for fund administrators. Asset managers are hiring fund administrators to take over middle office tasks, which used to be handled in-house but were never the managers’ core competency. It’s a win for both sides: the managers get an essential service at lower cost thanks to the administrators’ economies of scale, while the administrators book incremental revenue at higher margins than their core business, observes Neil O'Hara.

TRADING REPORT:

STREWTH! IT’S ALL CHANGE FOR AUSSIE TRADING ............................Page 71 Australia’s equity trading market has been through two form-changing years. Last year began with ASX, the national stock exchange, in merger talks with the Singapore Stock Exchange (SGX). Ultimately, the SGX deal was blocked by an Australian government running scared of change. Nonetheless, the exchange and the country have had to face up to the inevitable and ASX accelerated improvements to its platforms in preparation for the new trading landscape.

Ruth Hughes Liley reports on the current status of a market in transition.

CAN ANYONE STOP LATIN AMERICA’S EQUITIES CARNIVAL? ........Page 75 Actually, why would they? Investors are looking with interests at the fast growing region.

Brazil’s central bank has reported surging net month dollar inflows during 2011 including the second highest on record in July at $15.83bn. The region’s rich commodity base is a source of succour and comfort for investors looking for hard won return. What does it all mean for the region’s trading infrastructure? Ruth Hughes Liley reports on the key trends.

INVESTOR DUE DILIGENCE:

THE RIGHT WAY TO APPROACH INVESTOR DUE DILIGENCE ..........Page 84 Ultimately, while the hedge fund industry is still a story about people—and investors want to entrust their assets to someone they believe to be an expert with a differentiated process—the due diligence process helps provide additional clarity to investors’ investment decisions.

Patrick J McCurdy, partner and head of capital development at Merlin Securities, explains the exhaustive process of proper due diligence.

DATA PAGES 4

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

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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cover story

THE IMPLICATIONS OF FATCA House Minority Whip Representative Steny Hoyer (a Maryland Democrat) centre, Representative Carl Levin (Democrat, Michigan) left, and Representative Chris Van Hollen, also a Maryland Democrat, hold a news conference on the payroll tax cut on Capitol Hill on Thursday, December.

22nd, 2011 in Washington. Photograph by Evan Vucci. Photograph kindly supplied by Press Association Images, January 2012.

UNCLE SAM’S GLOBAL TAX DEMAND: ONE STEP TOO FAR? It is election year in the United States, and no matter how helpful incoming regulation that will chase down tax avoidance by Americans abroad might be to the country’s exchequer, pragmatism now looks to trump necessity. US officials appear to have begun to recognise the potentially onerous reporting requirements placed on foreign financial institutions (FFIs) abroad by the Foreign Account Tax Compliance Act (FATCA), sometimes in breach of local privacy laws. However, firm indications of what that might constitute as legislators continued work on refining the act had yet to be finalised at the time this edition went to press. Ian Williams reports on the strength of global concerns over the general requirements of FATCA and what the core tenets of the act will mean for asset managers.

S LEGISLATORS PASSED the Foreign Account Tax Compliance Act (FATCA) in 2010 as part of the equally tendentious Hiring Incentives to Restore Employment (HIRE) Act. With the congressional love of sloganeering populist acronyms, FATCA was clearly designed to win applause from across the political spectrum, from Occupy Wall Street to the Tea Party.

Former House of Representatives speaker Tip O’Neil famously said:“ All politics is local,”and this act was clearly more

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designed to appease voter sentiment than it was to win friends abroad.The fine detail of the proposed regulation was supposed to be issued before Christmas 2011, but rule makers were digesting the many objections from across the globe.

Those objections appear in part to have been listened to. News of the pending changes followed remarks made to a New York State Bar Association meeting in late January by acting assistant secretary for tax policy, Emily McMahon, which are now posted on the US Treasury website. The

final FATCA regulations are expected to be released in early February, though the IRS has not confirmed this. "We believe that these proposals will substantially address the many comments we have already received regarding administrative burden, and will do so in a manner consistent with ensuring that the underlying objectives of FATCA are met," she stated.

While the promise of a more openhanded approach to the spirit of FATCA is no doubt welcomed and should make it simpler for foreign financial institutions to

FEBRUARY 2012 • FTSE GLOBAL MARKETS

cover story

THE IMPLICATIONS OF FATCA

comply with incoming legislation, groups such as financial advisers will still need to know exactly which clients are US persons, as the tax consequences of advising a US person can be dire unless an investment product is US tax friendly. It is important to recall, noted McMahon, "that FATCA came about as the result of a series of events in 2008 and 2009 involving very serious instances of offshore tax evasion. Earlier this month, the IRS released statistics on its 2009 and 2011 Offshore Voluntary Disclosure Programs that provide some indication of the magnitude of the problem: Together, those programs have resulted in collections of $4.4bn so far, a number that will continue to grow as the 2011 cases are processed".

Moreover, US tax is and will remain complex once FATCA comes into being which could ultimately restrict accounts that are offered to American account holders outside of the United States.

Foreign financial institutions (FFIs) will still have to locate accounts held by US individuals to minimize any institutional risk that may emerge from the final form that FATCA takes.

The tone of the submissions from foreign financial institutions by and large remained restrained. While many institutional have had no objections in principle to Americans abroad paying their dues to the Internal Revenue Service in the US, the Act will likely still put foreign institutions between a rock and hard place; they cannot comply with FATCA in some instances without breaking domestic law—on issues such as data privacy and contracts, particularly in Europe.

Following talks in Paris during the last week of January US officials reportedly proposed a significant change in how it will implement stringent reporting rules for foreign banks. Moreover, the speech

by McMahon stresses that the US understood the need to comply with FATCA was“burdening many institutions”, which were having to reconfigure their computer systems and make other time-consuming changes, and vowed that the Treasury would take steps to "further focus the FATCA implementation efforts on higher-risk institutions".

Compliance and reporting are important pillars in FATCA. To conduct relations with any US institution, or indeed any other compliant FFI, foreign financial institutions will be required to identify their clients’ nationality and, if American, declare them to the United States’ IRS or withhold deemed tax on payments to them. If they do not register and comply, they will be assumed to be harbouring American tax evaders; and any payments to them from the US are subject to withholding (which could be as much as 30%).

In its original form FATCA deemed banks compliant only if they did not work or solicit account holders in other countries, which European bankers pointed out, even under the present strained state of European unity, was as if US banks could only function in their own states. In addition, domestic regulators and contract laws meant that FFIs could not just drop clients who fail to respond to enquiries about their nationality whether on principle or from neglect.

The most dangerous part of the Act for FFIs is that they can only become compliant if they do not deal with other non-compliant FFIs. In a global economy, in which the US, despite its travails, still plays such a major role, this threatens to put a spoke in the world financial system.

For example, British underwriters worry voiced concerns that the premiums paid by US clients to Lloyds of London for insurance would be subject to 30% withholding.

The discussions with US regulators appear to have focused on the scope of bilateral agreements, under which European banks will transfer data relating to US citizens to their national authorities which would relay the information to Washington. The back-down appears to be in response to concerns that forcing overseas institutions to report details of their US clients directly to the IRS would breach privacy laws. The issue for banks is that FATCA seemed indifference to European Union (EU) data protection rules for clients, and, as German bankers have pointed out, its failure to recognise the EU passport concept, which allows a bank based in one EU member state to provide services across the continent. Even so, FATCA’s reach is far greater than banks, more of which later.

For Americans abroad, who are already supposed to file tax returns to the IRS even if they never set foot in their homeland, FATCA does not change much—if they stay within the law, that is. However, for those who have been evading the US inland revenue, the Act rustles up a veritable posse of bureaucracy to catch US tax-dodgers. In effect, the IRS is deputis-

IMPLEMENTATION TIMELINE FOR FATCA OTICE 2011-53, ISSUED in late July last year by the Treasury and the IRS, provides a workable timeline for FFIs and US withholding agents to implement the various requirements of FATCA. Specifically, the notice phases in the implementation of FATCA in the following manner:

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• An FFI must enter an agreement with the IRS by June 30th 2013 to ensure that it will be identified as a participating FFI in sufficient time to allow withholding agents to refrain from withholding beginning on January 1st, 2014.

• Withholding on US source dividends and interest paid to nonparticipating FFIs will begin on January

1st 2014, and withholding on all withholdable payments (including on gross proceeds) will be fully phased in on January 1st 2015.

• Due diligence requirements for identifying new and pre-existing US accounts (including certain high-risk accounts) will begin in 2013. Reporting requirements will begin in 2014.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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cover story

THE IMPLICATIONS OF FATCA

ing every foreign financial institution to help with the chase.

American institutions also can live with FATCA, since the requirements for reporting transactions to the IRS have been an intrusive but accustomed part of business life for generations. However, in addition to the unwelcome novelty for them, FFIs have run up against that special mix of parochialism and indifference to others’ sovereignty that so often characterises the dealings of Washington’s political elite.

As Faye Polayes, Ernst &Young’s executive director, international tax, explains: “The main concern with FATCA is its extraterritoriality; the conflicts of law issues and the extent of the burden imposed on foreign financial institutions, in particular.

Massive process and systems changes affecting all business lines are required.

Institutions are understandably concerned about the costs of implementation as well as the relatively short time frame within which these changes are required.”

Although the United States has shown some flexibility, the question in the minds of many institutions remains whether any amendments will ultimately go far enough. Denise Hintzke of Deloitte

reports: “We are starting to see pressure from the financial markets, where financial institutions are considering whether they will do business with someone who is not compliant. No decisions yet, but they are looking at it. There will be some companies that will decide it is not necessary, but most I’ve spoken to intend to comply.”

Some companies have talked of selling off US assets, but even that will not save them.“It’s not their proprietary assets, but their clients’ assets that are involved,” explains Hintzke. It is, she says, hard to estimate what the total cost of compliance is, but it is an unfunded mandate. FFIs have to pick up the tab themselves.“It’s a big undertaking, requiring them to revise their procedures, especially about new accounts. Hopefully, when the new regulations come in it will be just a case of modifying existing procedures rather than starting from scratch,”she adds.

The wait for the detailed regulations means that no one can actually start implementation yet, nor even make informed decisions on compliance.

Hintzke reports: “Some of our clients have set up project management teams, where they are beginning to work, for

example on GAAP assessments, so they are ready for their implementation plan.

Others have just identified who will be responsible—but some are just sitting and waiting.”This, she suggests is not a good idea, “The longer these regulations take to come out, the shorter the time will be left to make the changes.”

Among those foreign institutions most affected will be the British insurers, whose business is global. Megan McInally, policy adviser in the taxation department at the Association of British Insurers, says: “There is absolutely no way we can currently comply. It is not just the data privacy issues, but also we do not have the information required on existing customers and the suggestion that we can close down existing accounts is just not possible for legal reasons.”

The association suggested the inclusion of a grandfather clause that exempts existing clients, since, adds McInally: “British insurers have never had to ask for a customer’s citizenship. British Revenue and Customs tax policies when a chargeable event occurs, such as when people take money out of it, but FATCA requires an annual evaluation. The main problem

EXPLAINING FATCA AND WHAT IT MEANS TO ASSET MANAGERS HE TREASURY DEPARTMENT and the Internal Revenue Service (IRS) drafted the Foreign Account Tax Compliance Act (FATCA) to target noncompliance by American taxpayers through foreign accounts held directly or indirectly. Beginning January 1st 2013, FATCA will impose a 30% US withholding tax on any USsourced income and the gross proceeds from the sale of investments that produce US sourced interest or dividends (withholdable payments) received by any offshore fund or other foreign financial institution (FFI). This withholding tax is avoided if the FFI enters into an agreement with the US government and agrees to comply with new documentation requirements, due diligence procedures, and reporting obligations.

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"FATCA is an important development in US efforts to combat offshore noncompliance. At the same time, the IRS recognises that implementing FATCA is a major undertaking for financial institutions," noted IRS commissioner Doug Shulman, at the time that notice of FATCA was issued.

He explained the Act was a “reflection of our serious commitment to implementation of the statute, but also a serious commitment to listen to the implementation challenges of affected financial institutions and make appropriate adjustments to ensure a smooth and timely roll-out."

FATCA requires FFIs to report to the IRS information about financial accounts held

by US taxpayers, or by foreign entities in which US taxpayers hold a substantial ownership interest. To avoid withholding, a participating FFI will have to enter into an agreement with the IRS to identify US

accounts, report certain information to the IRS regarding US accounts, and withhold a 30% tax on certain payments to nonparticipating FFIs and account holders who are unwilling to comply and provide the required information.

For asset management firms, FATCA is a nightmare. It will increase the types of payments that could be subject to US withholding tax, such as direct or indirect payments of gross proceeds, or payments on certain swaps, and the number of entities that could have liability for US tax on these payments, including offshore funds and offshore distribution channel intermediaries that hold, or through which others hold, direct or indirect interests in US investments.

Compliance with FATCA will involve a revamp of much of a firm’s operations.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

is that we will not know who is a US person and therefore subject to FATCA.” The Act holds FFIs responsible for all their subsidiaries, which means that even if a UK insurance group was compliant in the UK and EU, if it has subsidiaries in other countries where data protection laws do not allow them to be complaint, the whole group falls foul of FATCA. Like many of the FFIs making submissions, the ABI is being constructive.“One of the main concerns is existing customers, both identifying them and assessing the financial details FATCA is asking for. We can do a search on addresses, but, for example, there are a number of British citizens who retire to the US, but we don’t know unless they tell us. But for new policies, we could set up procedures to ask for ID and value their policies annually,”says McInally.

It is always difficult to read the runes in US government decision making, but the ABI says it has been reassured by the recent signs that the Treasury and the IRS “seem interested in what we had to say and appreciates that there is a difference between banks and insurers. Especially in the UK it is highly unlikely that these

Offshore funds focused on alternative investments will face particular challenges in this regard, as FATCA’s requirements cover the spectrum of identification and documentation of investors, to the fund's portfolio and information technology (IT) systems. FATCA will ultimately impact multiple functions, such as tax, legal, back office administration, operations, and IT. FATCA will also involve significant ancilliary costs as firms will have to incorporate US tax documentation requirements on direct and indirect US and non-US investors in their dayto-day operations. It will inevitably force many asset management firms to modify internal systems, control frameworks, processes, and procedures to meet its compliance requirements.

According to a recent paper by PWC, “FATCA generally will require funds (generally through their asset managers,

FTSE GLOBAL MARKETS • FEBRUARY 2012

policies would be used for US tax evasion.

We are hopeful that the scope of FATCA will be reduced to target those insurance products that could possibly be used for tax evasion purposes.”

Barbara Angus, Ernst & Young’s principal of international tax, has only guarded optimism and feels that the spirit of the law will prevail: “The government has been clear in its commitment to move forward with FATCA. The reporting requirements of FATCA will provide the IRS with a new source of information for use in enforcing the US tax obligations of Americans.”

She says her view is carved out of the “countless meetings” between the IRS and the Treasury with the affected industries suggests an“intention to continue to focus on ways to curtail the burden imposed on financial institutions while maintaining the benefits to the IRS of this new reporting regime,” and she maintains that the Notices issued since the Act passed reflect this.

She is hopeful however that continued discussions between the US government and the governments of some major US trading partners will lead to refinements in the approach

administrators and/or other service providers) to search for specific investor attributes within their information repositories and assign tentative FATCArelevant classifications. Since many of the data attributes are likely to be new to many offshore funds, many will require changes to both data management systems and client on-boarding processes. Moreover, searching and aggregating information across multiple repositories may be an extremely complex exercise given the various operating models involving service providers and functional utilities”.

Notice 2011-53, issued in late July last year by Treasury and the IRS, provided a workable timeline for FFIs and US withholding agents to implement the various requirements of FATCA. In the original timetable, FFIs were expected to reach agreement with the IRS by June 30th 2013 to ensure that it would be identified as a

under FATCA that "alleviate the potential conflicts with applicable statutory and regulatory rules regarding data privacy and consumer protection”. She adds: “Given the breadth and scope of the impact of FATCA across the whole range of customer accounts and interbank relationships, financial institutions need more certainty around all the implementation requirements so that they can move forward with the systems changes that will be required to make them FATCA-compliant by the key deadlines in 2013 and beyond.”

The final regulations, expected this year for implementation in 2013, will reveal the extent to which the US has been prepared to temper domestic political grandstanding with pragmatic approaches that secure FFI cooperation, or whether it is prepared to risk possible confrontation with other jurisdictions—and possibly inhibit overseas institutions from investing in the US, which some smaller FFI’s are already considering when calculating the costs of FATCA compliance. It remains to be seen how much revenue it raises for Uncle Sam. One sure thing is that the FFIs will have to spend a lot of money raising it for him. I

participating FFI. This was supposed to allow sufficient time for withholding agents to refrain from withholding beginning on January 1st, 2014.

Withholding on US source dividends and interest paid to non-participating FFIs was also expected to begin on January 1st 2014, "and withholding on all withholdable payments (including on gross proceeds) will be fully phased in on January 1st 2015," according to a Treasury statement in July 2011.

However, "In order to provide sufficient lead time to develop reporting and withholding systems, the proposed regulations will phase in the FATCA reporting requirements, as well as the rules relating to pass thru payments, gradually, over an extended transition period,” she notes, although clarification on this extension had not been published at the time of going to press with this edition. I

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Market leader

US REGULATORS BARE THEIR TEETH Robert Khuzami, director of the Securities and Exchange Commission's division of enforcement (left) stands with Preet Bharara, United States attorney for the Southern District of New York, during a news conference on New York on January 18th, 2012 as they announce charges against seven people arrested by the FBI, the latest salvo in a sweeping probe of suspicious trading at hedge funds. The seven were charged with a scheme to allegedly reap nearly $62m in illegal profits on trades on Dell Inc shares. Photograph by Mike Segar supplied by Reuters, January 2012.

US REGULATORS INTENSIFY PROSECUTIONS It might appear simpler to pay lobbyists in Washington to keep the regulators away from your company; but these days the US Securities and Exchange Commission (SEC), the FBI, or any ambitious state attorney will, likely as not, still get on your case. The answer to companies wanting to know how to avoid a threatened wave of federal action is almost naive: “Be good!”

The increasing big stick wielded at any and all transgressions means that top management in firms not only have an incentive not to break the law, but that they should now invest in the technology and managerial expertise to ensure their subordinates don’t either. Ian Williams reports on the bandwagon of retribution sweeping through the US financial markets.

T THE END of January, the SEC sent a frisson down the spines of Wall Streeters by prosecuting not only BankAtlantic in Florida, but also its chief executive officer Alan Levan. Announcing the action, SEC enforcement director Robert Khuzami alleged: “BankAt-

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lantic and Levan used accounting gimmicks to conceal from investors the losses in a critical loan portfolio.

This is exactly the type of information that is important to investors, and corporate executives who fail to make that required disclosure will face severe consequences."

Levan is the first person, as opposed to corporate entity, to be arraigned in connection with the financial crisis.

This latter-day adherence not only to the wording, but also the spirit of laws, has led some market watchers to ask: why has the watchdog only just started barking? Equally, they are

FEBRUARY 2012 • FTSE GLOBAL MARKETS

FTSE GLOBAL MARKETS • DECEMBER 2011 / JANUARY 2012

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Market leader

US REGULATORS BARE THEIR TEETH

wondering: how long will it carry on?

Levan, BankAtlantic's chairman and chief executive, said that when the case is over, "the SEC's credibility as a neutral enforcer of securities laws will be tarnished".

For its part, the SEC boasts that it has levied about $2bn in penalties and disbursements for firms’ bad behaviour during the crisis. Even so, up to now the management leading some of these companies seems to be blessed with impunity, not least since the SEC’s preferred way of working has been consent decrees which until now have allowed the companies neither to admit nor deny wrongdoing.

Mike Mayo, managing director of Credit Agricole Securities, recently published a book about his time as a bank analyst. He had previously lost jobs for his critical analysis of banks, which has, of course, since been vindicated by events. He laments that the perpetrators were not prosecuted and also, usually, they are not even fired.“It is amazing. They are all still there!”

Professor David Zaringer, of Wharton Business School, shares his astonishment.“I’m as surprised as everyone else at the lack of the individual prosecutions. I’m not a big advocate of criminalising bad business decisions, but how can you have this size of a financial crisis causing this much pain with so little culpability for the financial institutions at the centre of it?”

However, he thinks the BankAtlantic prosecution might be significant in this regard. “So far, the SEC has been working with consent decrees rather than going after individuals. It is supposed to protect investors, but the consent decrees and big fines penalise existing shareholders, and are more like a wealth transfer from current to previous holders!”

Even before the BankAtlantic case, there had been other changes in wind direction. Judge Jed Rakoff in New York showed which way it was blowing back in November. When the SEC and Citigroup presented him with a consent decree for him to

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rubber-stamp, which did not require the company to admit it had actually done anything wrong, the judge did not do what was expected of him.

Instead he banged his gavel and gave vent to some legal bile. He made it quite clear that he thought the penalty was too light; not least because when he scrutinised this and earlier consent decrees he found that the decree’s boilerplate language included a pious promise not to sin again.

Rakoff pointed out that they did, repeatedly, and that this was, in effect, contempt of court. The case goes to trial in July.

Yet another avenue of litigation opened this year when the New York Court of Appeals rejected an argument from JP Morgan Investment management that New York's little known Martin Act—itself a comprehensive and versatile 90-year-old law that Eliot Spitzer used to crack down on financial fraud—pre-empts investors from launching their own private commonlaw claims. The decision put investment houses at risk of civil claims from disgruntled clients.

It is clear that regulators and judges are increasingly tapping into a mood out on Main Street, and among occupiers on Wall Street, which is threatening to make prisoners of transgressors. If the current spate of judgments emanating from the SEC is anything to go by, the signs are that the regulator has clearly got the message.

Round-ups of insider traders at hedge funds are growing in number, and in January 2011 the SEC brought cases against the former New York State Comptroller over kickbacks for investing state pension funds with private equity firms and hedge funds.

Significantly it worked in conjunction with New York’s attorney general who also brought criminal charges. Most recently the SEC filed insider-trading charges against Diamondback, a second hedge fund advisory firm, and seven individuals, including a former Diamondback analyst and former Diamondback portfolio manager.

Ultimately, Diamondback reached a settlement with the regulator, in timehonoured tradition, but the SEC felt moved to note that it considered the substantial cooperation that Diamondback provided, including conducting extensive interviews of staff, reviewing voluminous communications, analysing complex trading patterns to determine suspicious trading activity, and presenting the results of its internal investigation to federal investigators, were strong mitigations.“We are pleased to have reached a prompt resolution of the charges against Diamondback,” says George Canellos, director of the SEC’s New York regional office.“If approved by the court, we believe that the proposed settlement appropriately sanctions the misconduct while giving due credit to Diamondback for its substantial assistance in the government’s investigation and the pending actions against former employees and their co-defendants.”

“BankAtlantic and Levan used accounting gimmicks to conceal from investors the losses in a critical loan portfolio. This is exactly the type of information that is important to investors, and corporate executives who fail to make that required disclosure will face severe consequences."

As part of the proposed settlement, the Stamford-based hedge fund adviser has also submitted a statement of facts to the SEC and federal prosecutors, and entered into a non-prosecution agreement with the United States Attorney’s Office for the Southern District of New York. Under the proposed settlement, Diamondback will give up more than $6m of alleged gains and pay a $3m civil penalty. In addition, Diamondback consented to a judgment that permanently enjoins it from future violations of federal anti-fraud laws. The proposed settlement would resolve charges of

FEBRUARY 2012 • FTSE GLOBAL MARKETS

insider trading by Diamondback in shares of Dell Inc. and Nvidia Corporation in 2008 and 2009.

Faced with what it terms “a dramatic number of new investigations” into businesses by the SEC, Department of Justice, and FBI, the Directors’ Roundtable is mounting a panel to help directors avoid being caught in the dragnet, which it points out includes wiretaps, informants and data-mining techniques.

One reason for previous relative inactivity is that for some time before the crisis—and indeed even since, although less overtly—legislators with deregulation as their mantra have tried to starve the agencies, accusing them of impeding enterprise. Zaringer notes that the agencies tend to be chronically underfunded, and:“Congressmen like the idea that they can call up and put on the brakes. The SEC has been trying to get an independent funding stream from licensing fees from broker dealers, like the Federal Reserve, but in the wake of the disaster, it has secured greater funding from Congress.

Those resources are now being deployed and coming on stream.”

Judge Rakoff may indeed have made a difference and set an important precedent. Zaringer says:“The SEC has now agreed that it will not allow settlements that ‘neither admit nor deny’ wrongdoing and that it will get tougher. After Madoff, it looked like it was going after hedge funds, but there are some signs it is now considering looking into the financial crisis.”

However, he still has reservations: “After all, the hedge funds weren’t the cause of the crisis and you could almost consider chasing insider traders as a diversion from looking into who caused the crisis. My hope is that the agencies will be focusing more on them as well.

I don’t think we’ve seen it yet from the Department of Justice, but the other agencies seem to be dusting off their enforcement tools and bringing some cases against some of the wrongdoers.”

Despite the worrying flurry of activity, Zaringer thinks: “The government

FTSE GLOBAL MARKETS • FEBRUARY 2012

has probably not solved the coordination problem between the agencies and regulators, but there are signs they are looking more deeply at the crisis. I predict a modest increase in action; but not a lot. In fact, it is running out of time to bring these cases, with time limitations, and fading memories.”

Accepting there is some chance, if not overwhelming, that previous perpetrators will be facing the collar at some time, what can be done to avoid future legal mayhem for companies?

Zaringer suggests: “It is not the most exciting advice, but companies who do get caught up in prosecutions need to be able to tell a story that they made the same type of mistakes their peers made—and above all stay away from insider trading, since that seems to be the favoured charge at the moment.”

Worst of all worlds Credit Agricole’s Mayo has a strong preference for the industry to clean up its own act, but, he adds: "I can understand the debate between encouraging more checks on actions by the capital markets versus involving more regulation. Unfortunately, what we've had is the worst of both worlds where both sides have been inadequate. I wish that the regulators were not needed but actions such as these are the inevitable outcome if markets don't function more the way that capitalism intends."

Looking at the recent wave of actions, he maintains: "By the time that regulators take action against a bank or its chief executive, there must have been a litany of red flags and chances for correction. The general problem is an inadequate tone set at the top. Partly this is a function of incentives—do top managers get paid based on long-term performance (even after they leave a firm) and what are the appropriate measures for performance? If so, there is less desire by mangers to cut corners in the short term. There needs to be a board of director and top management mentality that there is a long-term purpose to an organisation with core principles that are followed and enforced when participants deviate."

Vincent Walden, partner in Ernst & Young’s Fraud Investigation and Dispute Services group, weighs in with new technology for responsible managements not to act like a wayward cruise ship captain and to run a tight ship. “Financial services companies are demanding more effective and less costly compliance monitoring techniques that go beyond traditional, rules-based tests for transaction monitoring or email keyword hit analysis for rogue trader behaviour.”

He explains: “From a risk perspective, most of the available tools used for monitoring follow a rules-based query or keyword-driven approach.

This means you have to ‘ask questions of the data based on what is currently known’ and that can be challenging given the number of false positives this approach generally produces for compliance professionals. Rules-based tests, especially when conducted over email and instant message data, often require both time and luck to uncover potential anomalies. Unfortunately, perpetrators know most of the ‘don’t dos’ and rules, which is why they seek to circumvent the rules, avoid certain language or perhaps operate with code words or vague terms to conduct their illicit acts.”

Even so, the new technology is catching up, he claims. “Recent innovations in linguistic analysis, combined with data visualisation and text analytics techniques, are helping financial services companies improve their rogue-trader detection by incorporating a more sophisticated, model-based mining and visual analytics approach, which allows the data to define itself. When combined with traditional rules-based analytics already in place at many financial services firms, this new approach can be a powerful tool in identifying anomalies that are only evident when taking into account the multi-dimensional attributes in the data, especially in the intersection of written communications and trading data.” I

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spotlight

IOSCO update clarifies use of trading platforms for OTC derivatives A follow-up report from IOSCO’S February 2011 Report on the Trading of OTC derivatives

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

OSCO’S 2011 TRADING report made significant progress in reaching international agreement on the factors regulators should consider when implementing policy initiatives in OTC deritives. Specifically, the trading report concluded that it is appropriate to trade standardised derivatives contracts with a suitable degree of liquidity on “exchanges or electronic trading platforms,” provided that a flexible approach encompassing a range of platforms that would qualify as “exchanges or electronic trading platforms” for derivatives trading is taken.

In its updated report, Follow-On Analysis to the Report on Trading of OTC Derivatives, IOSCO has sought to highlight the different approaches global regulators are taking, or envisage taking, to mandate the use of organised platforms for trading OTC derivatives.

Importantly, the report also explains how single and multi-dealer platforms address key issues such as the ability to customise contracts; the approach to the provision of pre and post-trade

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transparency information; and market monitoring capabilities.

There are at present several types of trading platforms being used to trade OTC derivatives in IOSCO-member jurisdictions. These platforms fall into two broad categories: those with multiple liquidity providers (multi-dealer platforms) and those with single liquidity provider (single-dealer platforms).

While these platforms are broadly similar in terms of the function they fulfil, there are variances in the execution models used to effect transactions, the participant coverage, the degree of automation, the scope of asset class or product coverage, and the geographic coverage.

The report is a useful reference point for buy side traders anxious to leverage liquidity in these stressed markets. While the contributors to the report found that anecdotal evidence reflects a broad range of views as to the preference of market participants for one platform over another during times of market stress, the report finds only two elements that might influence traders in stressful periods.

The first is whether the counterparty to a trade is known prior to its execution and, two, whether there is an element of voice negotiation in the transaction. However, the report does not identify any material difference in the ability of single and multi-dealer platforms to provide operational efficiency and resilience.

The trade execution models utilised by some multi-dealer platforms are anonymous counterparty models, such as fully-electronic order books, periodic electronic auctions, and hybrid methods that combine elements of both voice and electronic execution, which provide anonymity of counterparties prior to trade execution.

These types of models are typically used in the inter-dealer market space.

Other multi-dealer platforms use request-for-quote and click-to-trade execution models that feature full disclosure of counterparties prior to trade execution. The single-dealer platforms on the other hand use the request-

for-quote and click-to-trade execution models with full disclosure of counterparties. Both multi-dealer and single-dealer platforms provide a wide range of OTC derivatives products that cover the interest rate, credit, commodity, equity and foreign exchange markets. Generally, platforms with a higher degree of automation tend to offer trading in more standardised products for which there is a sufficiently liquid market.

The report notes the ability to customise contracts varies considerably across the different types of platforms with some types of platforms providing minimal customisation and others offering a very broad range of customisation.

Similarly, there is a wide variance in the approach that trading platforms for OTC derivatives take to providing pre-trade transparency; that is, the ability of market participants to see information relating to trading interest prior to transactions being executed.

The degree of automation in the trading process of OTC derivatives also varies across the different types of trading platforms and is driven in part by the nature of the products offered on each platform and the needs of market participants. Post-trade transparency, (that is, the dissemination of price and volume information on executed transactions to participants other than the executing parties) is currently very limited for OTC derivatives transactions, and generally is only available, if at all, to the participants of a given platform.

Within this framework, regulators have taken different approaches, with the Dodd-Frank reforms in the United States introducing swap execution facilities and the European Union (EU) proposing a regime that would include the use of organised trading facilities. In both cases these platforms are intended to provide a facility on which appropriate, standardised OTC derivatives contracts can be traded. Other jurisdictions, says the report, are considering what regulatory steps should be taken in relation to trading of OTC derivatives on organised trading platforms. I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

eU’s threatened financial transaction tax could magnify FX costs An EU financial transaction tax (FTT), could increase FX transaction costs, says Oliver Wyman research.

ESEARCH BY OLIVER Wyman, commissioned by the Global Financial Markets Association’s (GFMA’s) global FX division, suggests that, given the tight margins that exist in foreign exchange markets, any increase in transaction costs will, in turn, hit the real economy as these costs would largely be passed on to all end users. The report, Proposed EU Commission Financial Transaction Tax; Impact Analysis of Foreign Exchange Markets’, evaluates the impact of the European Union’s proposed financial transaction Tax (FTT) on European FX markets, estimating its impact on FX cash and derivatives users in particular.

The report not only recognises that the primary impact of the tax will be an increase in transaction costs, relocation of trading and reduction in notional turnover, but also it suggests the tax will result in a potential reduction in liquidity leading to a widening of bid/ask spreads.

The research suggests that a proposed FTT could directly increase transaction costs for all transactions by three to seven times and by up to 18 times for the most traded part of the market. It could eventually result in the relocation between 70% and 75% of tax eligible transactions outside of the EU tax jurisdiction. This possible outcome, combined with reduced transaction volumes (of approx 5%), could reduce market liquidity and increase indirect transaction costs by up to a further 110%, the report suggests.

Inevitably however, the tax will predominantly hit the real economy and

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FTSE GLOBAL MARKETS • FEBRUARY 2012

the institutional market, comprising pension funds, asset managers, insurers and corporations, as both direct and indirect costs are largely passed on to end‐users, which will be least able to move transactions to jurisdictions not subject to the tax.

While the tax is expected to only have a limited impact on speculative trading, as this activity will most likely relocate outside the EU tax jurisdiction, it will result in an inefficient tax on the economy as raising €1 of tax would likely cost the economy more than €1, due to the indirect costs associated with reduced and more fragmented liquidity.

James Kemp, managing director of GFMA’s global FX division, says: “It is essential to fully understand the impact of the proposed financial

transaction tax and the Oliver Wyman study is an important contribution to the debate. “The foreign exchange industry is an essential part of a stable and sustainable economy, underpinning international trade and investing. This study shows that the proposed tax would in effect penalise Europe’s businesses for sensible risk management—by using FX products to manage currency fluctuations—and also threaten to impose further costs on the investment returns of pension funds and asset managers.”

UK premier David Cameron led a charge against the tax at the Davos World Economic Forum in late January, telling Eurozone members that it was no time for tinkering in the financial markets and that the tax was “madness”.I

indian court ruling on vodafone Photograph kindly supplied by Dreamstime.com, supplied January 2012.

India's Supreme Court ruling in Vodafone tax case brings clarity to international investors According to the Emerging Markets Private Equity Association (EMPEA), India’s Supreme Court last month ruled in favour of Vodafone Group ending a four-year legal battle over $2.2bn in taxes and bringing clarity to rules governing the taxation of foreign investment made through offshore investment vehicles.

At question was Vodafone’s 2007 acquisition of the Indian operations

of Hong Kong-based Hutchison Whampoa Ltd for $10.7bn.

The Indian government had argued that since the assets themselves were based in India, taxes from the transaction were owed to the Indian government. In contrast, Vodafone argued that the Indian government had no jurisdiction over the transaction since it took place between two foreign companies.

In its decision in favour of Vodafone, the Supreme Court required that the Indian government repays a deposit of approximately $482m that Vodafone had made on the disputed tax bill, with 4% interest.

Market watchers have reacted positively to the news, stating that the decision not only makes it easier for the company to launch an initial public offering (IPO), but also goes a long way in calming the fears of foreign investors. Vodafone says it has plans for an IPO, but hasn't announced the date yet. I

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in the Markets

MIDDLE EAST ETFS: IN SEARCH OF LIFT-OFF

WAITING ON THE EM UPGRADE Emerging markets may offer some of the hottest investment tips but interest in Middle Eastern exchange-traded funds (ETFs) has failed to explode.

The offering remains small and enthusiasm has been further dampened by the global market turmoil as well as the uncertainty wrought by the Arab Spring. Attitudes could change if the MSCI upgrades these frontier markets to its coveted emerging market index fold. Lynn Strongin Dodds reports on the prospects for the asset class.

TUMBLING BLOCKS AND problems mean that investors could have a long wait for some of the Gulf Cooperation Council (GCC) region’s countries to enter any of the benchmark emerging markets indices.

Just before Christmas 2011, Qatar and the United Arab Emirates, two of the region’s more notable markets, were refused entry by index provider MSCI for the second time running.

One of the main reasons for the refusals was the lack of effectiveness of both countries’ delivery versus payment (DVP) models, which were implemented last year. There have been ongoing problems and the index provider last June delayed its decision in order to see how the land lies. MSCI found that although progress had been made, significant concerns remained over “the effectiveness of the new framework to fully ensure the safeguarding of investors’ assets under certain circumstances”. This was particularly the case for failed trades where a forced sale of assets, without the owner's consent, remains a possibility.

Qatar also came under fire for its failure to lift its stringent foreign-ownership limits which currently stand at

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Photograph kindly supplied by Dreamstime.com, supplied January 2012.

25%. Although both countries would like to merit a promotion, views are mixed as to whether Qatar will loosen the reins and if both will bolster their DVP systems in time for the next review in June this year.

Market participants were disappointed because MSCI emerging market status is seen as an important step to allay investors’ concerns over the region’s seemingly weak corporate governance structures and lack of transparency. The hope was that foreign fund inflows would have increased, revitalising the fortunes of both markets. “The Gulf Cooperation Council is still viewed as a frontier market and is not included in the MSCI emerging market indices,” says Daniel Rudd, head of Middle East for HSBC’s asset management unit.

“Institutional investors are waiting for Qatar and the UAE to be included and one of the stepping stones they need to take is to meet the criteria. I think it will happen but the big question that no one can answer is when.

When they do, investors will become more interested in investing in the ETFs and other passive investment vehicles that cover the region.”

“Most fund management groups and global banks have asset allocation models that use ETFs but they typically do not have any sub-set for the frontier markets. They stop at the emerging market level and even there they only allocate a small bucket of the overall total to these countries,” notes Ed McRedmond, senior vice president, director of institutional and portfolio strategies at Invesco PowerShares.

Deborah Fuhr, an independent ETF analyst and consultant, says: “One of the problems is that there is limited research in English about the companies in the GCC region because they are not part of the MSCI emerging market benchmark but rather frontier markets. MSCI and FTSE are two of the most closely followed families of global benchmarks and if fund products are launched on non-standard benchmarks it is difficult to gain interest from investors. This explains why there is so little money being put into these products. At the moment there are about nine ETFs in the US providing exposure to the Middle East and Africa.” Six of those cover the Middle East while three focus on Africa, the largest being BlackRock’s iShares

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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in the Markets

MIDDLE EAST ETFS: IN SEARCH OF LIFT-OFF

South Africa index fund with $486.3m assets under management. Investment manager Van Eck’s Market Vectors Africa ETF follows with $74.3m while WisdomTree Dreyfus South African Rand has a seemingly paltry $7.5m, according to research complied by Fuhr.

In the MENA camp, the funds which were launched around five years ago have much smaller coffers than the two main African products.

Fuhr’s research shows that the biggest ETF is State Street’s SPDR S&P Emerging Middle East & Africa ETF (GAF US) with assets of $105m, followed by iShares MSCI Israel Capped Index Fund (EIS) with $83m. Market Vectors Egypt ETF comes in next at $44.2m while Invesco’s PowerShares MENA Frontier Countries (PNMA) has $19.6m. Market Vector Gulf States (MES) and WisdomTree Middle East Dividend Fund also have relatively diminutive sums of only $18.5m and $17.7m, respectively.

However, despite the MENA label, Fuhr recommends that investors take a closer look at the underlying holdings to see whether the funds are deserving of the title. For example, the vast majority of stocks in the GAF portfolio, which aims to replicate the S&P Mid-East and Africa BMI Index, have a connection to Africa but not the Middle East. In fact, the top ten holdings of the portfolio as of January 18th 2012 were based in South Africa.

These included gold mining group AngloGold Ashanti, precious metal company Gold Fields, leading platinum producer Impala and the financial service firms First Rand and Standard Bank. Also in the mix were multinational media company Naspers, international services, trading and distribution company Bidvest, telecom provider MTN Group, food retailer Shoprite Holdings plus integrated chemicals and energy firm Sasol.

In contrast, EIS does have the vast majority (more than 99%) of its assets inside the Middle East, but only confined to Israel. There is no exposure to

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Daniel Rudd, head of Middle East, HSBC’s asset management unit. Photograph kindly supplied

by HSBC , January, 2012.

Ed McRedmond, senior vice president, Invesco PowerShares. Photograph kindly supplied by Invesco PowerShares, January, 2012.

any company in the Arab countries which comprise the overwhelming majority of the MENA region. The fund, which tracks the MSCI Israel Capped Investable Market Index, invests in Israeli blue chip companies traded on US exchanges, with Teva Pharmaceuticals (25%) and Israel Chemicals (9% ) representing the two biggest holdings.

However, others such as PNMA, based on the NASDAQ OMX Middle East North Africa Index, and MES, which follows the Dow Jones GCC Titans 40 Index, are true to their name.

Financial, telecommunication and property companies dominate but they are based in the Middle East. Popular groups such as Qatar National Bank, National Bank of Kuwait Ahli United Bank BSC, headquartered in Bahrain,

Emaar Properties and Kuwait’s Mobile Communications feature in both funds.

PNMA has ventured out of this relatively narrow sector spectrum with Egypt-based Orascom Construction Industries, while MES has a holding in DP World, a marine terminal operations and development, logistics and related services firm.

The funds have little choice but to follow a limited remit. “The main reason why financials followed by telecommunications are the largest components of the index that the PMNA is replicating is that most of the energy companies in the region are government controlled and there are almost no public shares available for purchase by outside investors,” says McRedmond.“The heavy weighting of financials though has hurt the

FTSE GROUP’S WATCH LIST COUNTRIES The following markets have been confirmed as Watch List countries for this review: • China ‘A’ Share – Possible inclusion as Secondary Emerging • Greece – Possible demotion to Advanced Emerging • Kazakhstan – Possible inclusion as Frontier • Kuwait – Possible inclusion as Secondary Emerging • Poland – Possible promotion from Advanced Emerging to Developed • Taiwan – Possible promotion from Advanced Emerging to Developed • Ukraine – Possible inclusion as Frontier

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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in the Markets

MIDDLE EAST ETFS: IN SEARCH OF LIFT-OFF

Haissam Arabi, chief executive officer, fund manager, Gulfmena Investments, Dubai. Photograph kindly supplied by Gulfmena Investments, January, 2012.

returns. One of the problems has been that all these ETF funds came out at around the same time—right before the financial crisis; and the heavy weighting in banks has had an impact on their performance. Today, the pressure is on banks due to their exposures to sovereign countries in the eurozone.”

Performance has also been hampered by the stalled global economic engine, the eurozone debacle and the continued uprisings in the Middle East, which have had an impact on South Africa and the relatively stable Gulf states of Qatar, UAE and Kuwait which these funds are mainly invested in. Stock markets across the world have been battered and it came as no surprise when all MENA ETFs

reported poor results. MES was down by 15%, GAF off by 9.72% and EIS showed the biggest loss at 28.98%, according to figures from Bloomberg.

However, it is still early days in the Middle East ETF world, according to Joseph DiVanna, managing director of Maris Strategies, a UK-based research and advisory group. “ETFs covering the region are still in their infancy and it will take time for the market to develop. They do not have a track record and have so far not lived up to their expectations in terms of performance.”

McRedmond is optimistic about the future. “In the near term, there’s uncertainty and investors are shying away from these markets but the long-term trends continue to be favourable. We believe markets in the Middle East have the ability to generate above-average returns but investors need a three to five-year investment horizon.”

There is also activity on the local front although again, as research from BlackRock shows, the MENA tag can be misleading. The latest report from the fund manager shows that there are 358 products valued at $19bn but South African fund managers dominate the scene. Satrix Managers accounted for the largest chunk of assets under management at 58% followed by STANLIB with 16.1%. Israeli firms are also active although data is not available for listed ETPs. “Israel has a large number of products and providers but the country’s regulations will only allow exchange-

MIDDLE EAST COUNTRIES IN FTSE GLOBAL EQUITY INDEX SERIES COUNTRY CLASSIFICATION DEVELOPED Israel

ADVANCED EMERGING None

SECONDARY EMERGING Egypt

FRONTIER

Morocco

Jordan

UAE

Oman

Bahrain

Qatar

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traded notes and not exchange-traded funds,” says Fuhr. “There is hope that the regulations will change but it is unclear as to whether that will happen in the immediate future.”

In the meantime, National Bank of Abu Dhabi and Saudi Arabi’s Falcom Financial Services are hoping to take a piece of the action with their newlyminted, regionally-traded ETFs. HSBC also resurrected its plans for a domestic product in Saudi Arabia having shelved them in 2010 due to market conditions. The bank’s Amanah Saudi 20, which made its debut at the end of 2011, tracks the top 20 sharia-compliant Saudi companies on a custom-made index designed by Standard & Poor’s.

“We do not believe there is a mass market yet for this product but felt there was strong interest from local institutional and retail investors who wanted a low-cost product, and ETFs fit into that bracket,” says Rudd. “We are taking a long-term view and are looking at this as a potential investment over five to ten years. We looked at creating a single country product because most investors overweight their own country and we asked S&P to create an index for us that captures 53% of the market capitalisation of Saudi Arabia’s stock market.”

Other market participants are more circumspect about the prospects for the local ETFs. Haissam Arabi, chief executive officer of fund manager Gulfmena Investments in Dubai, says: “You need to have more individual players and asset managers to boost the concept of ETFs and the culture in Saudi is very different. For example, 80% of the equity markets is dominated by the retail investor which is very active and likes to buy shares directly. The same holds true for the long only institutional investor who only accounts for about 15% of the market. There is also no inventory to short and it is not part of the MSCI Emerging Market index. As a result of all these factors I do not see an appetite for MENA ETFs.”I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

in the Markets

PRIVATE TRANSACTIONS IN SECURITIES: WHERE NOW?

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Private shares go pseudo-public In the highly illiquid market for private company shares, a mechanism to facilitate trading did not exist until the backlog of companies unable to go public ballooned after the financial crisis. It wasn’t long before technology platforms designed to streamline private share transfers popped up, making it easier for investors to tap into the burgeoning market.

A raft of smaller private companies is also searching for ways to provide liquidity to current and former employees as well as their venture capital backers. This nascent market could take off and transform capital formation in the US—provided the regulators don’t stifle it.

Neil O'Hara reports.

RIVATE TRANSACTIONS IN securities are not new. Institutional investors have long traded private equity and venture capital partnership interests in the secondary market, for example. In the past decade however the demand for liquidity among shareholders in private companies has soared, a direct result of the decline in initial public offerings (IPOs).

A recent study by Jay Ritter, Cordell Professor of Finance at the University

P

FTSE GLOBAL MARKETS • FEBRUARY 2012

of Florida, counted just 81 American companies that took a bow in 2011, less than 20% of the 450 annual average during the 1990s. Companies that do come to market tend to be larger and older than before: the average holding period before a venture capital-backed company goes public has stretched to ten years, up from about 4.5 years in 2000.

The extended timetable to a public offering has created a bottleneck that

threatens to hamper funding for startup companies. The capital markets have become constipated—angel investors cannot get out of existing positions and recycle the money to new growth companies. The delay has cut average returns on venture capital funds, too, which inhibits their future fund-raising.

“Venture capitalists struggle to start their next fund until they have generated significant liquidity from the

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in the Markets

PRIVATE TRANSACTIONS IN SECURITIES: WHERE NOW?

“Our system recognises each investor asking to access a company's confidential information or bulletin board. It gives them only the level of access the company assigns to that particular investor.” current one,” says Lou Kerner, head of the private shares group at Liquidnet, which drew on its experience in trading public company shares among institutional investors to design a companion platform for private company shares.

Liquidnet’s public platform already serves more than 600 institutions that manage some $13trn—including venture capital funds, which use it to sell large blocks of their remaining interest in post-IPO companies with minimal effect on the market price.

Regulatory changes, in particular the Sarbanes-Oxley act, have raised the direct cost of being a public company and the indirect cost of senior management time diverted from running the business. A platform that enables early-stage companies to satisfy shareholders’ need for liquidity without incurring these costs has obvious advantages for both companies and shareholders. It also satisfies pent-up demand from third-party investors who want to tag along for the fastest growth phase in a company’s development, which often occurs in the early years before a company can go public in today’s market. Even venture capitalists, who are natural sellers, sometimes want to buy more shares in their preferred investments.

“Alternative assets need a central location to trade,” says Vincent Molinari, founder and chief executive officer of Gate Technologies, which has created an electronic platform to facilitate trading in illiquid assets in the United States and has launches pending in India and Brazil. “We want to be a utility in the middle

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between buyers and sellers. We will bring them together on an agency basis.” In the US, Gate is a registered broker dealer that operates an electronic venue on which institutional investors can trade limited partnership interests, warrants or private company shares in both primary and secondary market transactions.

The two largest private share platforms, SharesPlus and SecondMarket, started operations about three years ago and probably account for more than 90% of the transactions that occur on all active platforms. Greg Brogger, chief executive, president and founder of SharesPost, says the over-arching objective was to create a scalable, efficient marketplace for private company shares by using the internet to connect buyers and sellers. In order to make it work, Brogger knew he had to work with the companies to streamline the clearing of transactions.

Current SEC regulations deem any company that has more than 500 shareholders to be public and subject to all the reporting requirements under the Securities Exchange Act of 1934. Everybody counts in that number: founders, employees, accredited investors and qualified institutional buyers. The count also looks through any collective investment scheme set up for the purpose of skirting the limit if the company is complicit in the arrangement. In a limited partnership that owns shares in just one private company, for example, each partner would count as a separate shareholder.

Private companies need to keep track of the number of shareholders in order to avoid becoming public companies by default, without an IPO and at a time not of their choosing. SharesPost creates a dedicated portal that enables a company to vet anyone who expresses interest in their shares and allows access only to approved potential buyers and sellers. The company can upload financial information and restrict access to that as well. “Our system recognises each investor asking

to access a company's confidential information or bulletin board,” says Brogger.“It gives them only the level of access the company assigns to that particular investor.”

The description of SecondMarket given by Ali Byrd, senior vice president of the private company market team in New York, is almost indistinguishable: “We provide a platform for companies to offer their shareholders liquidity by allowing a companyapproved group of buyers and sellers to transact on the secondary market.”

Other platforms, including Gate and Liquidnet, also say they work with the companies and provide controlled access. They all claim to have superior technology, too.

So what are the real differences?

Both SharesPost and SecondMarket focus on secondary market transactions. Buyers are either high net worth individuals or institutions and most sellers are current or former employees.

Liquidnet makes no effort to serve individuals—they do not fit its institutional business model—while Gate requires individuals to participate through a broker that will vouch for their status as accredited investors.

“We provide a platform for companies to offer their shareholders liquidity by allowing a companyapproved group of buyers and sellers to transact on the secondary market.”

SharesPost started out as an electronic bulletin board, while SecondMarket was a registered broker dealer from the outset and relied on voice brokers to facilitate contact between buyers and sellers and seek permission for trades from the companies. The two business models are beginning to converge, though: SharesPost now has a broker

FEBRUARY 2012 • FTSE GLOBAL MARKETS

dealer licence, while SecondMarket is moving towards an automated platform similar to the one SharesPost uses.

SecondMarket has posted information on some 16,000 private companies, although it has only worked on share transactions with about 50 of them. Byrd won’t disclose the names, but the total value traded since the 2008 launch exceeds $1bn.

Although SecondMarket has ambitions to develop share liquidity programmes in partnership with companies, it has handled only one so far—for its own shareholders.

Most trades on SharesPost are secondary market transactions, but it can facilitate primary capital raising as well. In late 2011, TrueCar, an online service that publishes prices for new and used cars, raised $50m in a private placement conducted through the SharesPost platform. SharesPost has also handled company-originated secondary share sales for TrueCar, Twitter and LinkedIn. “We have moved beyond a demo to offer a real business of providing liquidity,” says Brogger.

SharesPost makes no secret of the companies it works with—all 156 are posted on its website, including headline names such as Facebook and Twitter. It worked with LinkedIn before its public offering, too.

“LinkedIn used our portal to consolidate its shareholder base,” says Brogger. “They restricted access to their SharesPost bulletin board just to buyers who were already shareholders. This meant that in general small holders were selling to existing larger ones, which reduced the overall number.”

Another private company trading venue, Xpert Financial, has set itself apart by concentrating on the primary market. The five companies currently traded on Xpert all chose to list on its platform, which required them to file what Xpert calls an X-1, a strippeddown version of the S-1 registration statement used by public companies.

FTSE GLOBAL MARKETS • FEBRUARY 2012

It includes a description of the business, audited financial statements and a capitalisation table listing the existing shareholders. Companies can also upload a virtual roadshow or investor presentation and even host a question and answer session for approved potential investors on the Xpert platform.

“It is completely different from everything else out there. The others put together buyers and sellers and then ask the company for permission to trade. In our system, the companies initiate the listing and host the information,” says Thomas Foley, founder and chief executive officer of Xpert Financial.

In order to simplify trading, Xpert requires companies to waive the right of first refusal normally attached to private company shares. Companies control who can buy or sell the shares anyway—and companies that list on Xpert alter their by-laws to invalidate trades conducted on any other platform. Settlement documentation is standardised and Xpert is trying to create digital shares to speed up the settlement process. As a practical matter, it is hard to settle trades in less than two weeks, the standard notice period for venture capital calls.

“Venture funds don’t have cash on hand, they have the right to call it,” says Foley. “We’d like to tighten up areas where there is inefficiency in the system.”

Regulators have taken a keen interest in the private company market, particularly after Goldman Sachs’ abortive effort to syndicate a $1.5bn trade in Facebook shares in early 2011. The regulators must protect retail investors while recognising that the entities permitted to participate in the private share market are all sophisticated investors, at least in theory.

It is not clear whether the self-certification of accredited investor status used by certain venues is effective, however. People have begun to circumvent the look-through rules, too.

SharesPost conducts an auction of Facebook shares almost every week in which people who wish to invest less than $250,000 are aggregated through a limited liability company.

“Each purchase is isolated into a separate class of LLC capital but the LLC generally owns shares in multiple companies,” explains Brogger. “The LLCs are a lot like venture funds, they aggregate capital from many investors into a single entity to give those investors access to the asset class.”

The lawyers have blessed the structure, and while the SEC has not expressed an opinion it knew what was happening before it granted a broker dealer licence to SharesPost.

“It is completely different from everything else out there. The others put together buyers and sellers and then ask the company for permission to trade. In our system, the companies initiate the listing and host the information,” Perhaps in part due to extensive lobbying by market participants, attitudes in Washington have shifted toward encouraging further development of the private company share market.“The companies that benefit from the growth of the market are the ones driving the majority of job growth around the world,” says Kerner at Liquidnet.“The regulatory environment is getting more favourable.”

Proposals making their way through Congress would amend the 500 holder rule, either to increase the absolute number or to exclude employees and perhaps sophisticated investors from the count. The SEC appears more inclined to clamp down on the market but the agency may be reluctant to pick a fight with the legislators who determine its budget. It may be too late to stuff the genie back in the bottle anyway.I

25

in the Markets

POSITIVE INVESTMENT OUTLOOK FEEDS LATAM DRS

IS A DR PIPELINE BUILDING UP?

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Although the depositary receipt market felt the undertow of last year’s maelstrom of events, there was still a steady, albeit slower, stream of activity than in 2010. BRIC countries once again dominated the landscape, accounting for the lion’s share of transactions, but corporations from Peru, Chile, Argentina and Colombia in Latin America are hoping to join the fray once market conditions improve. Lynn Strongin Dodds reports.

IVEN THE STATE of the world economy, it is no surprise it is difficult to predict when the tide will turn. Political leaders in the eurozone have been wrangling over a resolution, tensions continue to permeate parts of the Middle East, and China’s economic engine looks sluggish. In fact, emerging markets last year went into reverse with both the MSCI World Index and MSCI Emerging Market Index dropping 8% and 20% respectively after hefty gains in the previous two years.

Institutions led the march, withdrawing $47.7bn from emerging equity funds, according to figures from fund tracker EPFR Global. Latin American was particularly hard hit with equity fund redemptions rising to $10.8bn, easily surpassing the record of $4bn plus inflows in 2008. Brazil, which has been the darling of the region, particularly felt the sting with record outflows of $2.3bn versus $3.7bn from Chinaoriented funds.

“Latin American markets are viewed favourably but they are not immune from general market conditions,” explains Nuno da Silva, director and head of Latin America for BNY Mellon's depositary receipts (DR) business.“We are seeing a lot of interest from the US followed by European institutions and are working with several companies in the region which are thinking much more strategically and globally about what they do in terms of investor relations."

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Candice Teruszkin, head of ADR Latin America new business development for JP Morgan, agrees, adding:“I do not see particular challenges to the region but it is impacted by worldwide conditions. As a result, there was a backlog of deals on the NewYork Stock Exchange by the end of last year. The second and third quarters were much better than the fourth quarter but we expect to see an improvement this year and we have several companies which have approached us. A couple of mandates are looking to close early this year.”

Those postponed initial public offerings (IPOs) took their toll. The total DR capital raised dropped 28% to $14.6bn in the first 11 months of 2011 from the $20.3bn raised during the same period of 2010, according to the recent JP Morgan Depositary Receipts Year in Review 2011.

Breaking it down, 40 new issuers raised $7.1bn through IPOs in New York, London, Luxembourg, Hong Kong and Singapore versus 72 issuers garnering $6.9bn in the same period of 2010. As for existing issuers, 14 raised $7.5bn via followon offerings, down from 21 issuers at $13.4bn two years ago.

The picture was brighter on the DR trading volume front with records being broken. The JP Morgan report showed a 16% hike to 160bn during the 11-month span from 138bn in 2010 while the value of DRs traded jumped

12% to $3.6trn from $3.2trn. Collectively, BRIC markets accounted for approximately 48% or 77bn shares of the total trading volume and 49% or $1.74trn of the value in the first 11 months of 2011.

Brazil leads the way Brazil’s DR programmes led the pack representing 18% of both global DR trading volume and value. In fact, oil giant Petrobras and mining group Vale were two of the most actively-traded DRs through 2011.

In contrast, programmes from China generated 12% of DR trading volume and 15% of value while Russia produced 18% and 13% of global DR trading volume and value, respectively.

Even so, Brazil proved not to be as active on the capital raising scene and was eclipsed by India and China which together comprised more than 76% of IPOs and 70% of follow-on capital raised in 2011. Only two companies from Brazil—steel producer Gerdau SA and telecom group Tim Participacoes—raised follow-on capital of roughly $1.1trn.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

Edwin Reyes, managing director and global product head of depositary receipts at Deutsche Bank, believes the numbers have to be put into context. “In 2010, Brazil accounted for about 50% of DR capital-raising activity with Petrobras being the largest DR offering, raising slightly over $10bn. That skewed the numbers for 2011.”

While the soothsayers are keeping their counsel about this year’s DR sums, many expect issuers to emanate from a wider pool of industries than in the past. The traditional sectors that have been the hallmark of Latin America’s programmes are the same as other regions. According to the JP Morgan review, DR investments in the oil and gas sector topped the list accounting for a quarter of the total at approximately $233bn, with pharmaceuticals, telecommunications, mining and banks also featuring prominently.

“Oil and gas, telecoms and banking will continue to be the most dominant but I also see new companies from sectors such as travel, medical, agricultural and retail,” says Roy

FTSE GLOBAL MARKETS • FEBRUARY 2012

Marmelo, regional director for DRs at Citi. “I think Latin American companies will take advantage of the favourable economic conditions in their home countries and come to the markets this year.”

This is particularly true in Brazil where Reyes believes that a growing middle class will open opportunities for credit card companies, airlines, retailers and other consumer-related organisations. In fact, the government has been loosening its monetary policy since last August and for the fourth time running recently cut the interest rate by half a percentage point to 10.5%. This is to both encourage spending but also protect the country’s still fragile growth rate.

Unemployment remains low at a record rate of 5.2% but industry estimates show that the country’s economy expanded by less than 3.0% in 2011, after soaring 7.5% in 2010.

Although Brazil is likely to remain the forerunner in the region, market participants also expect other countries to eventually share the DR spotlight. "At the moment, the two markets that dominate Latin America are Mexico and particularly Brazil as investors see the country as a safer destination,” says da Silva.“However, I think we will see increased activity from Spanish-speaking countries such as Peru and Colombia because their companies want to attract more international investors.

Citi’s Marmelo believes:“We will see more activity from countries such as Peru, Colombia and Chile. There are several companies in these countries which are growing and seeking to reach new international investors.”

However, corporate Latin America will have to raise it game if it wants to attract a more global investor following, if a study conducted last year

by JPMorgan’s Depositary Receipts (DR) business is anything to go by.

The report, which canvassed the opinions of 40 US and European institutional investors with combined asset under management of $57.3bn,

showed that while progress and improvement is being made, further work needs to be done.

“We will see more activity from countries such as Peru, Colombia and Chile. There are several companies in these countries which are growing and seeking to reach new international investors.”

Not surprisingly perhaps Brazil is the exception. The country received top marks for its efforts with over 50% of survey participants claiming it had the best corporate governance standards in Latin America. This was mainly attributed to the creation about ten years ago of the Novo Mercado , a special market for companies that voluntarily adhere to a set of governance guidelines that more closely track recognised best practices.

These range from increased investor communication to better management accessibility and disclosure.

Mexico also won praise but positive comments were confined to its blue chip companies. The tier below was criticised for their collective lack of transparency and the aloof demeanour of many managers.

Investor caution: long-term outlook positive Investors had reservations about companies across the board in Colombia, Argentina, Venezuela and Peru. Concerns mainly revolved around executive compensation disclosure, related party transactions and share structures. The composition of boards was also cited as a major issue because controlling shareholders are a common feature in Latin American corporate life and many companies do not have majority-independent boards.

In fact, data from GMI, a New York City-based corporate governance research firm, reveals that the 124

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in the Markets

POSITIVE INVESTMENT OUTLOOK FEEDS LATAM DRS

28

Dennis Bon, global head of DR business, JP Morgan. “We expect the number of unsponsored programmes on the Brazilian exchange to increase gradually in 2012. ”Photograph kindly supplied by JP Morgan, January 2012.

Roy Marmelo, regional director for DRs, Citi. “I think Latin American companies will take advantage of the favourable economic conditions in their home countries.” Photograph kindly supplied by Citi, January 2012.

Nuno da Silva, director and head of Latin America, BNY Mellon. “Latin American markets are viewed favourably but they are not immune from general market conditions.” Photograph kindly supplied by BNY Mellon, January 2012.

largest companies in Brazil, Chile, Colombia, Mexico and Peru have an average level of board independence of only 31%. In contrast, the 1,742 largest publicly-listed companies in the United States have an average level of board independence of 75%.

Overall, respondents were optimistic about the investment prospects in Latin America over the next three years on the back of a relatively robust economy and favourable demographic trends. As Ricardo Chichizola, head of ADRs, Latin America, at Deutsche Bank, notes: “Selectively, Latin America will continue to be an attractive place for investors to put their money and where investors will find value. This will not just be for countries such as Brazil and Chile but increasingly for others, including Peru and Colombia. The region has shown more resilience to the current market conditions, a more robust internal market and better growth prospects than found in other regions.”

Other drivers, according to Dennis Bon, global head of JP Morgan's DR business, include improving corpo-

rate governance standards, the prevalence of natural resources, growth and increased consumption of the region’s middle-class citizens. The continued development of capital markets and infrastructure were also strong factors.

The majority in the JP Morgan institutional survey also believed that a US listing for Latin American companies would be beneficial in terms of their attractiveness and raised profiles. The New York Stock Exchange and NASDAQ were seen as the preferred destinations by 75% of the respondents primarily due to the depth of their liquidity as well as strict reporting and disclosure requirements.

Although the US maybe a favoured listing locale, Brazil is hoping the traffic will flow both ways. Over the past couple of years its stock market, the BM&FBovespa, has been trying to attract foreign companies to offset falling volumes—the market closed 2011 down 18.1%—and give local investors access to a more diversified group of highquality global brand names.

Its efforts are paying off. Last summer the São Paulo exchange wel-

comed a new crop of unsponsored DRs from the US including Nike, Coca-Cola, Chevron, Amazon, Caterpillar, Chevron, Colgate-Palmolive, MasterCard, Monsanto, Nike, Oracle, Schulumberger. Unsponsored DRs, which were introduced in 2010, have become more popular than traditional Brazilian DRs (BDRs) since they are issued by banks and do not require the underlying foreign company to comply with local regulations such as publishing financial results in Portuguese.

According to JP Morgan’s DR review, by the end of November 2011, 30 unsponsored BDRs were trading on the BM&FBovespa last year. The goal this year is to increase that number to about 100, including European companies. “We expect the number of unsponsored programmes on the Brazilian exchange to increase gradually in 2012,” says Bon. “The main problem though is the liquidity.

Investors transact in the market where there is liquidity but building liquidity in the BDRs will be the ultimate challenge.”I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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in the Markets

MIXED RESULTS FOR HEDGE FUNDS IN 2011

Last year will be remembered as a difficult one for the hedge fund industry. Throughout 2011, aggregated exposures shifted away from volatile equity and emerging markets, but aggregate returns were still highly influenced by the defensive positioning of asset which remained, says an eVestment|HFN hedge fund industry report.

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

CREDIT AND GLOBAL MACRO STRATEGIES OUTRUN EM AND COMMODITIES IN 2011 HE SECOND HALF of 2011 witnessed a significant contraction in the hedge fund segment, according to eVestments|HFN annual industry report. Even so, hedge funds managed to finish the year with a net increase in assets under management (AUM) from investors. “Net investor flows in Q4 were firmly negative and the trend indicated investor redemptions increased towards year end,” explains Peter Laurelli, vice president of research at eVestment. “Amid the difficulty there were clear winners, which stood to solidify the fact that investor success in the hedge fund industry is not guaranteed, but rather requires an acute understanding of macro-economic trends and the ability to access and allocate to funds which are positioned to take advantage.”

According to Laurelli: “What came out of 2011 was the lack of a broad market environment where there was a

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lack of a single market-defining event that impacted the sector; it was a series of events which caused substantial market volatility. In that environment, some funds found it difficult to generate positive returns. The challenge then is to find synergies which will work in these persisting conditions.”

The research by eVestment shows that credit strategies outperformed their equity and commodity peers in December and did so significantly for the year, while foreign exchange-led strategies ended the year mixed, but rose in December on the back of the weakness in the euro. Meanwhile, global macro strategies extended November losses amid volatile commodity markets and finished the year only slightly outperforming the broad industry. Multi-strategy fund returns were near flat in December and down over 4% in 2011.“A lot of the industry relies on the beta in certain markets,”

explains Laurelli. “In the credit area, for instance, there was a decent market to perform in. In commodities, however, on aggregate hedge funds found difficulty in outperforming,” he adds.

In terms of investor preferences through the year, Laurelli says his research found net flow coming out of equities and emerging markets strategies, moving instead into global macro and commodity funds.“Those areas are traditionally less correlated exposures relative to equity markets. Moreover, asset flow trends in the commodity segment also tend to play out over a longer period of time,” he says.

Within commodities, Laurelli says that energy commodities tend to gather higher levels of assets:“There is a broad cross-sector in overall exposure, but there is a discernibly larger amount of assets focused on energy, then precious metals, such as gold,” he adds.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

UCITS hedge funds performed better than their non-compliant counterparts in December, but for the year the group, especially long/short equity focused, underperformed by a wide margin. Ultimately the winners in the industry were concentrated among mortgage/securitised credit, agrifocused and short-biased strategies while emerging markets, metals and energy sector exposures created the greatest downside risks, says the report.

“UCITS tend to have concentrations of long equity bias compared with noncompliant funds,” notes Laurelli.

“Actually the segment performed better in December, but over 2011 UCITS hedge funds tended to perform less well than the industry as a whole.

Most probably the monthly outperformance was due to the fact that the S&P 500 was up more than 1% and global equity markets are up slightly through December, and UCITS hedge funds do tend to track certain benchmarks. The upshot was a 21 basis points (bps) return in the month, compared with the hedge fund aggregate index offering 19bps. On an annualised basis however, UCITS hedge funds were down 8.38% over the year, compared to the sector as a whole.

Equally, last year was not kind to emerging markets focused funds.

Funds in all regional classifications, excepting emerging markets debt, were down says eVestment research. More than 75% of emerging markets funds posted losses, with funds focused on India producing the worst returns.

However, funds investing in Brazil outperformed their peers on both “an absolute and risk-adjusted basis in 2011, showing smaller losses and less volatility than the average emerging markets fund,” says Laurelli.

The largest hedge funds generally outperformed in 2011, a trend which held across most strategies, commodity funds being the primary exception. It speaks to a slow but steady underlying trend of greater participation of institutional investor funds in the hedge funds segment, which tends to gravitate to the

FTSE GLOBAL MARKETS • FEBRUARY 2012

larger hedge funds. “It’s all about growing investor demand with, among other things, strong back office operations,” explains Laurelli. “These cost money to develop and maintain.

Smaller funds are more expensive to run in that regard. I believe there will be, but not necessarily in 2012, a trend for larger funds to receive larger investor allocations. Ultimately it will result in a bifurcation of the industry, which will be dominated by a group of very large funds and a handful of smaller operations with less than $5bn in AUM.” There are other drivers in play propelling this particular trend, not least capacity considerations. “Larger funds tend to have more diversified strategies. They have to be, because it is extremely difficult to be a $10bn mortgage strategy fund because at a certain level you become too big to participate in a discrete market,”explains Laurelli.

In terms of general patterns of investor inflows, eVestment’s research found that total estimated hedge fund assets fell 0.46% in December to $2.461trn, a decline of $11.4bn. Performance accounted for an increase of $2.0bn and investors accounted for a net outflow of $13.4bn, the fourth straight month of investor influenced industry contraction. “In the first six months of 2011, investors added an estimated $73.6bn to the industry, but withdrew an estimated $44bn in the second half of the year and $19.5bn in Q4 alone,”says Laurelli. Even so, hedge funds experienced core growth (growth due solely to net investor flows) of 1.20% in 2011, a marked slowdown from the post-crisis rebound in 2010 when investor allocations increased AUM of 3.71%.

“One of the surprises of the year,” notes Laurelli, is that investor inflows for October and November were near flat or on the negative side. “I would normally have expected that pattern in December. Then in December itself, industry outflows were much greater than expected.”

Specifically, Asia-based fund flows turned negative in December and Q4,

but still ended 2011 as the fastestgrowing hedge fund market. The European hedge fund industry shrank in 2011 while the North American hedge fund market grew nearly 4% from new allocations.

Despite mediocre returns, investor allocations into commodity funds were strong in Q4 and throughout 2011.

Mortgage and municipal/sovereign credit strategies saw an uptick in allocation in Q4 while investors’ corporate credit exposures were reduced.

“Those areas are traditionally less correlated exposures relative to equity markets.

Moreover, trends in the commodity segment also tend to play out over a longer period of time.”

Meanwhile, global macro was a Q4 and second-half favourite for investors as were merger arbitrage and volatilityrelated strategies. Emerging markets and event driven were two major classifications where investors reduced exposures throughout the year, confirming the trend away from higher beta strategies.

In terms of size, 46% of very large funds (with greater than $5bn) had net outflows in Q4, while 57% of large funds (between $1bn and $5bn) had net outflows over the period. So did 55% of medium size funds ($500m$1bn) also suffered net outflows over the last three months of 2011.

However, Laurelli ends on a positive note:“I don’t expect this outflow trend to persist. People go into the process expecting returns over the long term.

Obviously if funds underperform then this understanding can change very quickly. However, there is some expectation that investors are beginning to look for returns and if no untoward market events impact badly on the markets, I would expect to see a return to net positive inflows in the first quarter of this year. ”I

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secUrities services

COMPETITION HEATS UP IN EMERGING MARKETS SUB-CUSTODY

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

SUB-CUSTODY AIMS FOR RICH PICKINGS IN THE NEW MARKETS Competition in emerging areas such as Asia and Latin America has reached a fever pitch of late and with fund flows down and the number of players on the increase, profitability within the sub-custody trade has been significantly impacted. For those hardy enough to stay afloat, however, the emerging markets offer a raft of opportunity. From Boston, David Simons reports. ub-custody is undergoing something of a renaissance. This rebirth is firmly rooted in the emerging markets, as the service set is refined to cope with fast growing markets ripe with assets.. As the big guns jockey for position in areas such as Asia and Latin America, mainstay regional providers with years of experience but smaller operating budgets have taken the necessary steps to retool their business models in an effort to keep pace in an increasingly competitive landscape. Special skills such as acting as liaison between investment clients and regulatory agencies, as well as working to improve corporate-actions processing on behalf of time-sensitive traders, are a few of the special attributes that can help set these players apart from the pack.

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Given the incessant demand for top-tier technologies, as well as the ability to comply with much tougher regulatory requirements, for many, sub-custody in the developing markets has become an inordinately expensive proposition. Can niche players hope to keep pace with those with much deeper pockets?

Despite concerns over inflation and the overheating of some local markets, Asia continues to garner significant investor interest, says Andrew Rand, global head of network management, Brown Brothers Harriman, even if demand is not nearly as strong as it has been in the recent past.

“China’s market is tightly controlled and is therefore difficult to access, though other emerging

markets in Asia have performed well on a relative basis,” says Rand.

The Asian markets are unique and will present interesting prospects in the years ahead, affirms Rowena Romulo, global head of direct custody and clearing for JP Morgan Worldwide Securities Services, with international fund managers increasingly focused on opportunities in the likes of China, India, Vietnam and Indonesia. “We are also seeing a rise in alternative forms of trading, including a resurgence in interest in asset classes such as OTC derivatives,” adds Romulo.

For its part, JP Morgan continues to build capabilities to support its in-house book of business, ensuring proper scale and credibility needed to attract thirdparty business. Says Romula: “Our

FEBRUARY 2012 • FTSE GLOBAL MARKETS

global, regional and local risk controls emphasise asset safety, while our product breadth offers clients end-toend capabilities including treasury and securities services, investment banking and asset-management support covering a wide range of asset classes and investment strategies.”

The emerging markets of Central and Eastern Europe (CEE) continue to be inexorably tied to the movements of the more mature surrounding regions.

“These markets have relied upon the major European markets for liquidity, guidance on legal and regulatory matters, and infrastructure development,” says Rand.

“Further, some of these CEE markets are trying to gain access to the eurozone, despite the recent difficulties of several of the eurozone members,” adds Rand. “Russia finally obtained a CSD law, albeit an imperfect one, and the country is ever so slowly moving toward a more traditional Western model. The recent events in Moscow are generally viewed as good news, but other markets in the region, such as Hungary, have been ubiquitous in the headlines for all the wrong reasons, and therefore are overshadowing the few bits of good news emanating from the region.”

Toxic-debt fallout As Latin America has managed to avoid the toxic-debt fallout that has plagued many of the major markets, investor sentiment there remains favourable. Higher interest rates in countries like Brazil have allowed domestic investors to keep their money in the home market, and with the exception of Venezuela and Ecuador, the political scene has been relatively stable,” notes Rand.

Despite the many positive plays on the map at present, BBH’s Rand believes that investors often seek opportunities in emerging areas for all the wrong reasons.

“Investor interest in certain regions or markets at times seems to be piqued by political instability, financial degradation,

FTSE GLOBAL MARKETS • FEBRUARY 2012

or concern about the stability of market infrastructure,”says Rand.

Case in point: the Middle East, where ongoing instability has made the region suitable for only the hardiest of investors. “The Middle East uprisings last year, while politically stimulating, did little to further the cause of the regional capital markets,” says Rand.

“The indices are down sharply across the board. These markets are attracting lots of negative attention.”

Unlike their peers in the West, Asian brokers have typically been reluctant to cede control of their business activities, and, accordingly, have taken a dim view of outsourcing,“Markets [such as] Hong Kong and Singapore have a very strong retail heritage and are extremely customer-focused, so instinctively they have real problems with just handing these duties over to a third party,” says Barnaby Nelson, head of Asian client development for banks, broker dealers and corporate issuers, BNP Paribas Securities Services.

That could be changing, according to a recent survey conducted by BNP Paribas Securities Services in conjunction with SWIFT, which found that three in four Asian brokers viewed outsourcing as an effective means of managing complexity while dealing with the rising costs of post-trade processing. Third-party clearing in particular has gained traction among Asia’s brokers, according to the survey.

More than one-third of Asian market participants are currently outsourcing or are making plans to do so in the near future, an eightfold increase over the past two years alone, according to the study.

Competition in Asia in particular has reached a fever pitch of late, and with fund flows down and the number of brokers on the increase, profitability has been significantly impacted. “Our survey bears this out—brokers have to work much harder in order to remain viable,” says Nelson.“Whereas in the past it was all about dealing with market changes, from a macro perspective the biggest

Andrew Rand, global head of network management, Brown Brothers Harriman. “China’s market is tightly controlled and is therefore difficult to access, though other emerging markets in Asia have performed well on a relative basis.”

Photograph kindly supplied by Brown Brothers Harriman, January 2012.

consideration among brokers today is differentiation—how to set themselves apart from their peers.”

“Investor interest in certain regions or markets at times seems to be piqued by political instability, financial degradation, or concern about the stability of market infrastructure.”

“Hong Kong is a classic example,”he adds. “There was a time when you could get four bips for execution-only DMA. But all of these entrants who are competing purely on price have created tremendous attrition within the market, to the point that today we’re now down to around one-half to threequarters of a bit for execution only.”

Barring a dramatic increase in volume, however, the ongoing

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COMPETITION HEATS UP IN EMERGING MARKETS SUB-CUSTODY

revenue squeeze could become a make-or-break point for a number of brokers, “to the point that we are regularly having conversations with many of the leading brokers in the region that have tremendous peoplebased operations and can no longer afford to conduct business as usual,” says Nelson.

To assist these clients, BNP Paribas has relied on its tri-party settlement agency (TSA) platform, a reconfigured version of the traditional LSE-based “Model B” clearing and settlement process, whereby order execution and settlement are divided into separate functions using a third-party representative, thereby removing the broker from the settlement-risk equation. The TSA model has become an enormously valuable commodity for small brokers during these tough times, says Nelson.

“From an outsourcing perspective, the model has become a significant profit generator in its own right,” says Nelson. “Take Japanese pension funds, for example, which are so risk averse that it becomes completely unfeasible for an average-sized broker to trade with them—they’re typically not rated, and even when they are, the rating usually isn’t very high. By going through us, however, brokers can suddenly gain access to a much wider range of clients than they would have on their own. So in this respect, outsourcing isn’t simply about cost savings, but revenue generation as well.”

According to Nelson, large Chinese banks are keen on tapping experienced sub-custodians like BNP Paribas to handle regional mandates over the near term, and will likely appoint direct custodians in the years that follow. “I think we still have a way to go until we get to that point, as they are rather dipping their toe in the water at present,” says Nelson. “But with the Chinese government actively working to make the likes of ICBC and Bank of China global powerhouses, things should continue to move forward.”

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Regulatory inconsistencies, along with general market instability, have made it exceedingly difficult for investors to get acclimated to any one region. “It would seem that investors just don't know where to put their money when it comes to the emerging markets,” says Rand. The fact that the major markets are no longer the safe haven they once were has only exacerbated the problem. Hence, investors appear to be hand picking individual markets, as opposed to entire regions, concurs Rand.

Given the volatile nature of the markets—emerging or otherwise— firms like BBH require strategies that can eliminate as many of the potential hazards as possible. “Global players that want to go directly into many more markets are often buying into a single-provider, captive model,” says Rand,“with the assumption that they will have sufficient scale, can do a better job, and can do it more cheaply.”

Despite the apparent convenience of using this method, firms may not be obtaining the best provider in each market. “By comparison, our multiprovider, non-captive approach gives us active service benchmarking, multiple sources of information, and enhances both our sub-custodians' and our own competitive positioning,” says Rand.

Expensive proposition Given the incessant demand for toptier technologies, as well as the ability to comply with much tougher regulatory requirements, sub-custody has become an inordinately expensive proposition. Can niche players hope to keep pace with those with much deeper pockets?

“If one defines the term ‘niche’ as, unlike BBH, a single-market provider of sub-custody services, then the answer is likely ‘no’,” offers Rand.“It is simply no longer realistic to think that one can keep pace with global players who are more sophisticated and who have deeper pockets. Their only hope

Barnaby Nelson, head of Asian client development for banks, BNP Paribas Securities Services.

“From an outsourcing perspective, the model has become a significant profit generator in its own right.” Photograph kindly supplied by BNP Paribas Securities Services, January 2012.

for survival is to find a partner with a complementary strategy, sufficient scale, top-tier technology, top quality service and the savvy to navigate today's rough regulatory waters. The same probably applies to regional players, but at least they can split their systems and regulatory costs over multiple markets.”

JP Morgan’s Romulo agrees that the next two to three years will be tremendously challenging for the industry as a whole, as new regulatory measures will force companies to invest in internal resources in order to remain compliant.

“This will put additional pressure on those with a traditional local or single custodian model,” says Romulo. “Niche players will have to reassess their business strategies, taking into account the resources needed to mine potential opportunities, and then decide whether they want to stay in the business, perhaps specialising in specific services or growing regionally, versus outsourcing or selling the business altogether.” I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

FX vieW

2012: THE YEAR OF THE CNH DRAGON he CNH market took another positive turn in mid-January as the Hong Kong Monetary Authority (HKMA) announced that it had eased rules on open yuan positions and risk limits, moves that analysts say will increase liquidity in the dim sum market, for CNH denominated debt.

The HKMA has raised the limit on yuan open positions to 20% of their yuan balance sheet, up from 10%, providing banks with more flexibility to manage their risk. The move is also expected to increase liquidity by giving banks more room to lend yuan and allows them to invest in more RMB securities. The HKMA also included Chinese government bonds and interbank bonds in the list of assets that banks can include to meet the 25% liquidity requirement, making it easier for them to manage risk.

The increase in the open position limit had been expected as many banks reported that they had already reached their 10% limit as far back as February last year. The limit meant that the banks often routed trades through Singapore, which does not impose limits.

Hong Kong and London also took some steps to work together in the offshore yuan market this week by setting up a private sector forum of officials from banks in both centres. London is keen to ensure that it plays a role in the emergence of CNH denominated debt

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FTSE GLOBAL MARKETS • FEBRUARY 2012

issuance. The forum will explore cooperation in clearing and settlement systems, market liquidity and development of new renminbi-denominated financial products. To help, the HKMA has extended the operating hours of its CNH payments system by five hours, making it easier for renminbi transactions in London to be settled.

Hong Kong can afford such largesse; it is basking in its role as the largest offshore RMB bond market. The jurisdiction conducted more than 86% of RMB trade settlement in the first quarter of 2011 alone. Moreover, Hong Kong's CNH market is designed to allow the effective circulation of RMB funds. This includes 'outer circulation' (involving RMB funds between Hong Kong and the overseas market) and 'inner circulation', (RMB funds between the Hong Kong and the mainland).

More developments are underway.

In September 2011, China’s central bank, the People’s Bank of China (PBOC), announced the trialling RMB Qualified Foreign Institutional Investor (RQFII), allowing RMB funds raised in Hong Kong to be invested in the mainland’s securities markets. So far the authorities have designated a modest quota of RMB20bn (about $3.173bn).

However, this quota is expected to rise; particularly as RMB deposits in Hong Kong are soon likely to top $1trn, and are looking for returns.

CNH MARKET SPREADS IT’S WINGS

To support and protect Chinese exporters; to limit imports to mainly industrial components and resources that feed Chinese industry and construction, the Chinese maintain non-convertibility and set an official exchange rate which maintains the country’s competitiveness despite inflationary pressures and growing demand for its currency. In effect there are three currencies: the official currency (RMB), an offshore currency (CNH) and a trade finance currency (CNY). The government keeps a tight lid on the conversion value and usage of each. The CNH market has been the overseas face of the RMB for the last two years and now looks to expand its reach even more.

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Hong Kong investors have had only limited options open to them to invest in mainland securities and are mainly confined to buying RMB denominated bonds. The RQFII programme will broaden the channels for RMB in the offshore market to flow back into the mainland.

A key question now for Hong Kong is how much longer its dominance of the CNH market will continue. According to a statement by China's National Development and Reform Commission in late January, the government has clearly designated Shanghai as a potential a global centre for yuan trading by 2015, and its intention to open its markets wider to foreign investors and non-currency financial transactions.

According to the statement, the city will allow“significantly more”foreign participation in its financial markets.

Shanghai’s currency market is largely limited to domestic clients because of strict exchange and capital controls.

Although foreign investors can buy RMB in the Hong Kong offshore market, investors still need to seek approval to bring the currency into mainland China for investment purposes (please see box). The announcement also signals that ultimately the Shanghai interbank offered rate will become the benchmark interest rate for pricing yuan-denominated assets at home and abroad.

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FX vieW

CNH MARKET SPREADS IT’S WINGS

For the time being Hong Kong is the face of change for the RMB and for a few years at least will remain the key conduit for foreign investors to access the currency.

A signal indication of this was made in early December, with CME Clearing announcing it was accepting offshore renminbi (CNH) as collateral for futures trading. Moreover, Standard Chartered, Bank of China Hong Kong and HSBC have started quoting yuan interbank offer rates as reference rates for investors on the Treasury Markets Association's website, the Asian trade body.

The establishment of an interbank rate will inevitably lead to banks designing derivative products such as interest rate swaps that can be used by portfolio managers to guard against interest rate

risk. However, while the move by banks with specialised knowledge of the yuan to quote reference rates has been welcomed, a swap market based on interbank rates take some time to materialise. It is also important for bankers to establish a single reference rate to price RMB denominated loans.

Even as the yuan-denominated debt or "dim sum" market has grown rapidly in recent months in response to growing demand up to now, speculators have had utilise non-deliverable forwards and currency swaps to hedge their interest rate risk.

Nonetheless, demand for hedging interest rate exposure has grown. The offshore RMB has broadly traded at a discount to its mainland counterpart since September and deposit growth has

slowed from the double digit rates seen at the start of 2011. However, the continuing swathe of new initiatives out of both Hong Kong and Shanghai will likely spur a resurgence of deposits in the near terms.

China continues to diversify routes to bringing the RMB into wider international use. At the close of 2011, China and Japan signed a trade pact this year which will pave the way for Japan buying Chinese government debt and more trade being settled in renminbi and yen.

China has been Japan's biggest trading partner since 2009 and the redenomination of larger chunks of its trade in yuan will invariably sustain the development of the CNH markets. I

HFT HK GAINS RQFII LICENCE FT Investment Management Co's Hong Kong subsidiary HFT HK has been granted a RMB Qualified Foreign Institutional Investors (RFQII) licence by the China Securities Regulatory Commission (CSRC) at the end of 2011. HFT HK is now awaiting approval of its first RMB mutual fund by the Hong Kong Securities and Futures Commission (SFC).

HFT HK will be the investment manager of the Hong Kong domiciled RMB public fund, which will be raised in Hong Kong and invested in Mainland Chinese securities markets. In accordance with the rules jointly released by the CSRC, the People's Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) on December 16th last year.

RMB funds raised in Chinese exports were in line with consensus forecasts, with y/y growth down slightly from 13.8% in November to 13.4% in December (consensus 13.4%).

In level terms, exports amounted to $174.72 billion in December, little changed from November and only a little below the record level of $175.32 recorded last July, though this number seems somewhat "below par" as Chinese

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exports are normally at seasonal highs at the end of the year. Looking at the destination of Chinese exports, y/y growth fell for most major trading partners (including the US, Japan and other major Asian markets), but the EU was the notable exception, with y/y growth picking up from 5.0% to 7.2%. Looking ahead, further deterioration in external demand over the first half of 2012 seems likely, but based on our US and EU growth forecasts we do not expect to see exports fall as sharply as they did three years ago.

Imports were weaker than expected, with y/y growth dropping from 22.1% to 11.8% (consensus 18.0%), though the level of imports remains high at $158.2bn, down modestly from the record high of $159.8 in November. Detailed data on import volumes suggests that China's commodity demand remains relatively solid, with crude oil, copper and iron ore volumes all spiking up in December to near record highs. Key to watch in coming days when more detailed data are released will be what is happening with the "imports for processing trade" component - this measures imports of raw materials and goods

that then have "value added" before they are re-exported. This component tends to give a leading indicator of export performance but has been solid in recent months.

Overall then, today's data suggest that trade flows are clearly continuing to soften as growth in developed markets falters, but does little to suggest that China is facing another collapse in exports and imports similar to that seen in late 2008/ early 2009, in line with our view that headline GDP growth is likely to slow to around 8.4% in 2012. This suggests that Beijing will retain a cautious approach to any shift in policy settings, with further cuts in banks' reserve requirements likely to be the preferred means to provide support to credit conditions and activity. Today's data also reinforce our view that modest CNY appreciation is likely over 2012, in contrast to the modest appreciation implied by NDF pricing. With Chinese exports holding up reasonably well , we expect Beijing will continue to face pressure to deliver some CNY gains against USD, particularly in the lead-up to the US presidential elections at the end of the year. We continue to forecast a move in USD/CNY to around 6.10 by end-2012. I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

Face to Face

NICKY NEWTON-KING, CHIEF EXECUTIVE, JSE LTD

Despite foreign investors being net sellers of local equities in the South African market, by the end of 2011 (to the value of ZAR17.2bn), JSE Ltd had much to celebrate. In a bloody year for most stock exchanges, the number of trades overall on JSE Equities Market was up 11.6%, demand for currency derivatives had soared and, in particular, the exchange’s commodity derivatives markets trading volume hit an all-time record number of contracts. Nicky Newton-King, JSE’s chief executive, talks to Francesca Carnevale about the trend dynamics underlying this performance.

JSE: A SPRINGBOARD FOR AFRICA SE LTD HAS always been able to exploit effectively the fact that while it is a discrete exchange in a global context, it remains a regional giant. In that context, Nicky Newton-King, recently appointed as chief executive of the exchange, explains: “We have to make sure the lights are on.”It is a neat catch-all term for an exchange in transition. Adjustments are taking place across the board, all to support the expansion of the bourse’s range of services and attract new business, albeit in a tricky market.

“The starting premise is a difficult global environment,” acknowledges Newton-King. “It is certainly not the best time globally for new listings; however, there is discernible investor appetite for new investible product.

Some of that will, of course, be new listings; some will be African product and tradable securities such as ETFs. In the services space, new product will invariably be around risk. These uncertain markets and the advent of Basel III will inevitably focus our clients on managing risk in relation to their investments. I would suggest we have a big role to play in that regard,” she says.

On the Johannesburg Stock Exchange’s (JSE’s) interest rate market, foreign purchases of South African bonds year-on-year were up

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FTSE GLOBAL MARKETS • FEBRUARY 2012

24.3% from ZAR722.2bn in 2010 to ZAR897.7bn in 2011. The total value of bonds traded on the interest rate market is up year-on-year (2011: ZAR20.8trn; 2010: ZAR16.8trn).

Derivatives are a key area for the exchange, with few limitations on the potential for new product development, acknowledges Newton-King.

On the JSE’s commodity derivatives market volumes of commodity futures increased by 23.2% year-onyear to ZAR2.261m. In the same period, volumes of commodity options increased 25.7% year-onyear off a lower base.“With increased price volatility in the commodities markets, we experienced continued growth to reach a new all-time record number of contracts traded.

This was largely driven by the grain products as market participants looked to manage their price risk with the cash settled metals and energy products also experiencing improved traction,” she explains.

Overall, says Newton-King, in these uncertain times,“overall volume in the derivatives segment has been good for our business model”, adding: “While market volatility continues, investors have become much more cautious about taking on risk, which has helped us grow leveraged products such as derivatives.”

The volumes of currency futures contracts traded on the exchange were 106% higher year-on-year last year. In the same period, volumes of currency options contracts traded were up 48.7% year-on-year off a lower base, with 1,869,604 contracts traded over the year. “Growth has been particularly strong since May last year,” explains Newton-King, following the restructuring of trading fees to incentivise large trades. “Trade costs are levied according to a sliding scale, making it cost-effective for smaller traders and encouraging large transactions which have traditionally been carried out with the country’s big banks,” she adds.

Additionally, she explains, South Africa’s exchange controls have been relaxed to allow a wide group of qualifying clients from trading on the JSE’s currency derivatives market. These include South African and non-resident individuals and corporates, hedge funds and resident financial service providers, as well as collective investment schemes subject to their foreign portfolio allowance.

The attractiveness of the JSE for foreign companies received another significant boost in November last year when the South African finance minister Pravin Gordhan announced that local investors were allowed to

37

Face to Face

NICKY NEWTON-KING, CHIEF EXECUTIVE, JSE LTD

trade in foreign-domiciled companies.

Ghordan made the announcement in his medium-term budget policy statement in parliament, specifying that inward-listed companies would be treated as domestic assets for local investors rather than as foreign holdings.

The step has a twofold benefit to the market. It enhances the role of the JSE as a springboard for foreign companies to expand into Africa, and also means institutional investors are able to invest more offshore. "The move enables the JSE to more aggressively pursue a wider range of investment possibilities," acknowledges Newton-King, who points out it will strengthen the appeal of the exchange’s benchmark indices, which will now include foreign companies. The changes to the JSE foreign share rules emerged from a discussion document released by the treasury a year ago on the prudential regulation of foreign exposure for institutional investors. "It will provide institutional investors with choice and more local opportunities and will hopefully lead to increased liquidity," she says.

Equally, as institutional investors will no longer have to include these "domestic" investments within the prudential limits on foreign investment imposed by the treasury, their capacity to invest offshore will increase. In December the treasury raised these limits for retirement funds to 25%, and for collective investment schemes, investment managers and long-term insurers to 35%. However, prudential institutions will still be required to report their foreign exchange exposures to authorities.

Excluded from the new dispensation are the five companies with dual listings in London—Old Mutual, Anglo American, BHP Billiton, SABMiller and Investec—since they are already treated as domestic assets.

Newton-King is excited by the possibilities.“We have a team that speaks

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to potential African issuers. These are companies that are perhaps vibrant entities in their local market, but which are not perhaps gaining as much traction as they like among institutional investors. If you put it in a regional context, a day’s trading on the JSE might be the same as annual trading volume on a smaller exchange, let’s say Kenya, just for argument’s sake. So you can see the potential for these firms at first hand.

We already have 14 African issuers on the exchange, two African debt issues and one ETF, so we hope for some substantial uplift from this starting point,” she says.

Even so, despite sitting in a sweet spot, the JSE has suffered slings and arrows of its own of late. In 2011 some 15 firms delisted off the exchange, though this was counterbalanced by another 16 issuing listed IPOs. While the exchange ended the year above in real terms, the JSE is aware that it is working in an increasingly competitive environment, particularly for listings and in that context the decision by the treasury to ease listing restrictions is extremely welcome.

However, Newton-King is nothing if not expansive in her competitive drive: “We would certainly like to partner with an African exchange.

There are 24 or 25 exchanges on the continent, but few that have scale. You cannot underestimate nationalist zeal; but I think many exchanges understand that we are all moving into a different economic space. We’ve had some good talks with them and over time I think you will see us working together very effectively.”

She understands this is a long-term play: “It is definitely a five-day game.

We are not in a position to become the focal point for the regional space and I am not sure that ultimately is an option. We would however genuinely like to be a regional champion; a peer among peers. That is the goal.”

It is a unique approach, particularly set against the current trend. The

world’s largest exchanges have set a particular agenda in train over the past few years, with cross-border market consolidation the cornerstone of new business structures. NewtonKing prefers a decidedly different tack. “I think you can achieve the same benefits of cross-border business through cooperation rather than consolidation. I think it hangs on vision, opportunity and offering the best possible service at a good price.

That is our cornerstone.”

The second element in being switched on is inevitably technology.

For some eight years or so, JSE ran its electronic platform out of London, “which had its obvious downside in terms of its connectivity via a subterranean cable running alongside the continental shelf”, explains NewtonKing. “We are now bringing it back and will run it in South Africa. The technology is 400 times faster than the previous platform and once we have opened up planned co-location facilities, that will allow us to support high-frequency trading more effectively,” she says.

The exchange suffered a couple of outages through 2011 and it is hoped that once it is no longer dependent on the subterranean cable, it will offer technology that is less likely to fail.

“There is no failsafe,” concedes Newton-King, however, she notes: “We have to build stickiness and liquidity and therefore must invest in technology and product.”

While the future remains bright for the JSE, it will carry challenges peculiar to the exchange business model, which is being felt across the globe, not only in South Africa. “I think exchange business models will come under increasing attack,” cedes Newton-King.“And it is coming from a number of quarters. On the client side, as they have suffered a decrease in margins, they are exerting a downward push on the fees they pay us. If we don’t accede they have shown they are quite prepared to support alternative trading venues.”I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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indeX revieW

ARE MARKETS BUYING THE RUMOUR AND SELLING THE FACTS?

Volatility? Not today Sir At the end of last year I attended a number of analysts meetings, commentator love-ins and snake oil salesmen seminars. Everyone agreed 2012 was going to be volatile.

Frankly, I was a bit of a beggar at the banquets. My general comment to all was “if everyone agrees on something then they are probably wrong”. The problem for the doomsayers is that virtually every worst case scenario is already known.

Hardly anything that can happen over the next few months could honestly be described as surprising and the fact is, it is unpleasant “surprises” that cause volatility. Simon Denham, managing director of spread betting firm Capital Spreads, takes an unusually benign market view. Is this really a sign of better days ahead?

INCE STANDARD & POOR’S downgraded, the respective yields of a whole swathe of eurozone countries are lower today than before the downgrade. It’s as classic an example of buying the rumour and selling the fact as you will ever get.

The UK confirms Q4 2011 GDP growth slipped into the negative, but the FTSE was at 5792 recently, the highest it has been since July last year. There are threats over the Strait of Hormuz but oil refuses to get excited with the price of Brent stuck around $110, which is pretty much the average since February last year. Japan records its first trade deficit for over 30 years and the Nikkei and yen are unmoved; and despite warnings from the OECD and the IMF about world growth, the market’s dogs of war remain firmly on the leash.

One problem (or support, take your pick) is the ever-diminishing yields on cash and high-rated fixed income assets. The US says low rates will be with us until 2014 at the earliest. The BOE says the same and the ECB, with austerity packages all the rage, is likely to see deflationary impacts from all quarters. It would be surprising if they did not begin to push rates towards zero in the coming year.

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This is concentrating investors’ minds over returns and asset allocations to the current benefit of the equity markets. Additionally, FTSE 350 payouts (from all sources) hit an alltime high in 2011 and this is with the sector 10% to 15% off its highs and with many alternative investments giving all-time low returns. It all helps to keep a support to the markets in the face of increasingly negative news.

While some investors will pay any price for security—yields on shortterm US, Swiss and German sovereigns have flirted with negativity for quite a while—this still leaves a pile of money looking for a home.

Equities have been the poor relation for almost 15 years now as they continue to rebase from the 1980s and 1990s surge but the simple fact is that, on some currently high-profile levels, corporate risk is actually lower than sovereign. In an extreme case a corporate can move its jurisdiction, which is not an option open to either the Greek or Italian states!

Yields for a generic FTSE 100 stock are currently around 3.8% and this is with cash levels and margin returns at historic highs. This equates to a similar dividend yield when competing investment assets in bonds or cash were giving much better returns of 4% to 5%.

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

If the calculation were this simple, the FTSE would probably be on a bull run of epic levels but the worry that is exercising investor minds is: can this economic state of affairs continue? Or will the woes of the eurozone finally start to impact on profit margins?

Through 2012, the narrow path between disaster and chaos is likely to prove ever harder to follow, but follow it we probably will. Greece may be forced out of the euro and maybe Ireland and Portugal, too, but we could find that fear of the event is actually worse than the event itself.

Moreover, if we can get through the first month or so of the year without anything too drastic happening we may well find the market finally acquiring the appetite for a bull run and the instinct to sell might start to abate.

Of course the one thing that we cannot control is politicians.

However, just recently we have heard some mutterings about Basel III from the French and German authorities and we might see some unloosening of the straitjacket that is this misguided piece of legislation. If this happens the oil for the engines of growth may begin to flow once again—maybe.

As ever ladies and gentlemen, “place your bets”... I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

coUntry report

EGYPT: THE LONG ROAD BACK TO NORMAL

Can Egypt stick to a viable economic programme?

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Having fallen by 9.69% in November and 9.87% through December of last year to close at 3622 points at the year end, the Egyptian Stock Exchange's (EGX's) benchmark EGX30 index soared through the first month of this year, surging 14.59% in the last full week of January to 4432.9 after a peaceful 25th January anniversary —the highest for 10 months. The stock market continues to be a bellwether for the country's variable fortunes; and mixed performance data could continue to spur market swings for at least the first half of 2012. gypt's stock exchange had a good start to 2012, though of the countries that spurred the Arab Spring, it is the Tunisian stock exchange that has turned in the best performance of the last six months.

Having fallen by 30% in the wake of the unrest at the end of 2010, Tunisian stocks staged something of a recovery, fuelled by resilient corporate earnings growth in the second half of last year, growing trade with Libya and forecasts for robust economic growth this year.

Egypt's story, though equally promising, has darker undertones.

Standard and Poor’s (S&P) and Fitch Ratings downgraded Egyptian currency ratings to negative last October as wavering political policies have taken longer than expected. The move to electoral democracy is not so much an issue; it is what any incoming government will do. If the government retains a superficial economic liberal cast, as in Turkey, then inward investment will likely re-ignite.

However, if any incoming government adopts a radical Islamist approach to development, then the country will find it difficult not to revert to frontier status.

Even so, as this edition went to press, the country passed another

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milestone as the electorate cast their votes for members of Egypt's upper house of parliament. Politics have weighed heavily on investors' minds for the past year, with everyone watching the first stage of voting for the advisory body that is the Shura Council. Once elected, both houses of parliament will nominate a 100strong body that will debate the terms of the country's new constitution. Islamists have dominated voting for the People's Assembly in elections up to now and that trend is likely to be underscored in a second stage of voting for the Shura Council, which is due to take place on February 14th and 15th.

However, the final stage in the country's democratic transition is slated to take place by the end of June when the military council that took over after the departure of President Mubarak's cedes power to an elected civilian president.

However, while debate continues over what is deemed the best way to enforce the will of the people in Egypt, any incoming government must put the economy at the forefront of strategy. With unemployment running at 40% for people under 25 in the country, a

widening government budget deficit coupled with a (to date) ambivalent strategy or approach to foreign borrowing and in fact foreign inward investment (both direct and indirect) could cause problems, both internally and externally for the country. The government's budget deficit has swelled to 8.6% of GDP: in the current scheme of things, that's not too bad. However, tourism receipts, one of the country's revenue mainstays, are down 30% through 2011 and so far no one has articulated a straightforward and comprehensive government investment programme that can soak up a growing mass of unemployed.

An IMF debt package, worth $3.2bn is being discussed. The IMF has been relatively benign in its approach to the country, reportedly offering as much as $5.2bn in June last year. However, the interim military council rejected the loan in favour of local borrowing and aid from the Gulf States. With the government burning through reserves rapidly, an IMF facility is now a priority; though it is highly unlikely that, as reported by the government, the loan is without any conditions. I

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coUntry report

MEDVEDEV SEES IN THE SATELLITE LAW

RUSSIA’S NEW TRADING INFRASTRUCTURE TAKES SHAPE The Russian trading market is in flux as its key institutions reform and work to improve market efficiencies. In late January MICEX-RTS stock exchange reported that it intends to amend the procedure for delisting of securities, while late last year, President Dmitry Medvedev enacted the Central Securities Depository law, which had been approved by the Duma in mid-November 2011.

The signing of the law was a watershed in the evolution of the Russian securities market and helps describe the country’s re-emerging trading infrastructure.

USSIA’S PRESIDENT Dmitry Medvedev signed the country’s so-called CSD law into being in early December last year. The law establishes the particular legal status of the central securities depositary.

According to the law the CSD may be any joint stock company which is a non-banking credit organisation appropriately authorised to conduct depositary activities in the securities market and has been acting as a settlement depositary for at least three years. Any entity wishing to become a CSD in the country will have to submit an application to the ministry of finance, a process which is expected to take approximately four months.

Interestingly however, it is also prescribed in law that there can only be one CSD in the country. It is expected that there will be at least a full year transition period before the new CSD is fully operational and active.

The next Russian government is expected to adopt a much more proactive strategy to try and attract greater international corporate involvement and more investment in the economy. As well, it looks likely to continue with internal reforms to encourage the evolution of Moscow as an international financial centre. While reform is high on the government’s agenda right now, anti-Putin demonstrations late last year will ensure that for the first half of 2012 at least, politics and the pace of economic liberalisation will remain at the forefront of assessments of the attractiveness of the Russian equity markets.

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Many local brokers view the prospect with optimism. According to a broker the government's response to the recent protests offers encouragement that there will be political reform, while WTO membership at least provides a timeline for companies to become more efficient and competitive”.

Among the plethora of rules in the CSD law, it seems accounts can be opened at the registrars either by the CSD or by beneficial owners. Additionally mandatory reconciliation of the CSD’s records with those of the registrar should be undertaken each time that securities transactions are conducted over the nominee holder account of the CSD; to ensure finality of settlement at the CSD. The nominee concept for foreign entities is also part of the CSD law and will come into force from the beginning of July this year. ICSDs and foreign CSDs will be able to open accounts directly with the national CSD. Other foreign entities wishing to be nominees will be able to do so via their accounts with local custodians.

The president also signed another mouthwateringly titled law, Amending Certain Legislative Acts of the Russian Federation in Connection with the Adoption of the Federal Law on the Central Securities Depository. In more straightforward parlance, this is now referred to as The Satellite Law. This particular law regulates the activities of the professional securities market and ensures compliance with the CSD Law. It covers the types of accounts that can be opened by

local depositaries and registrars as well describing some record-keeping features for the safe-keeping of securities of foreign companies operating on behalf of third parties.

This was followed in late January as the newly-merged MICEX-RTS stock exchange reported that it intends to amend its procedures for the delisting of securities. Currently, the removal of securities from the exchange may be initiated by the issuer. Going forward, it looks like the stock exchange will be able to suspend or even forbid a delisting procedure during meetings of its securities markets committee. If a suspension is recommended, investors will be able to leverage a special trading window, for as much as three months, to sell off their securities. Up to now investors had no such protection.

Additionally a working group on the establishment of the country’s so-called International Financial Centre (IFC) is reportedly considering a number of draft amendments to local regulations covering the listing of securities and additional requirements for delisting. According to a release issued by Deutsche Bank.:“ The amendments envisage that the delisting of securities undertaken by a stock exchange due to violations by an issuer or issuer’s agent will result in the introduction of a special six month trading window for these securities and their admission to a ‘non-listed’ securities list.

Significantly for investors, shareholders will be able to claim against the issuer’s management team for losses resulting from the de-listing. I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

debt report

IS ECB BOOST ENOUGH TO SAVE THE EUROZONE?

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Europe’s sovereigns feel benefit of ECB support The European Central Bank’s massive boost in its support for eurozone banks at the end of last year, which provided them with €489.12bn of cheap, three-year money, has had a dramatic and sudden impact on the yields of most beleaguered European countries’ sovereign debt. Andrew Cavenagh reports.

HROUGH ITS LONG Term Refinancing Operations (LTRO) programme, the European Central Bank (ECB) is lending banks money at an interest rate of 1%, creating an immediate carry trade for banks to invest in peripheral sovereign bonds of the same maturity (which offer

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FTSE GLOBAL MARKETS • FEBRUARY 2012

returns in the range of 4%-6%). As a result, yields on shorter-dated government bonds—apart from Greek and Portuguese paper—dropped in January to as much as half the level they were at in early December.

The Spanish Treasury, for example, raised €4.9bn on January 17 from the

sale of 12-month and 18-month bonds, on which it paid yields of 2.15% and 2.49% respectively after receiving orders for €16.7bn. These yields compared with the 4.09% and 4.25% it was obliged to pay in December. Four days earlier, Italy sold €4.75bn of 34-month bonds at a

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debt report

IS ECB BOOST ENOUGH TO SAVE THE EUROZONE?

Yannick Naud, portfolio manager, Glendevon King Asset Management, London. “In the short term it will help both governments and banks to refinance themselves this year. So far it seems to be working.” Photograph kindly supplied by HSBC , January, 2012.

yield of 4.83% compared with 5.62% the previous month, after seeing the yield on short-term Italian Treasury bills drop to 2.735% from 5.952% the day before.

These developments predictably led European Union (EU) politicians and officials to claim that the peripheral sovereign markets were finally beginning to stabilise. Investors, just as naturally perhaps, took a more circumspect view. While acknowledging that the decline in the cost of shortterm government borrowing was a positive development to kick-start 2012, they cautioned that the ECB’s unprecedented intervention—as with all the EU’s previous efforts to resolve the crisis—would not provide the basis for a long-term solution for the eurozone’s difficulties. “The only positive impact of the LTRO is to push the problem further down the line,” says Yannick Naud, portfolio

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manager at Glendevon King Asset Management in London (GKAM).

“In the short term it will help both governments and banks to refinance themselves this year. So far it seems to be working.”

John Stopford, head of global fixed Income at Investec Asset Management, says the huge increase in ECB support for banks may have allayed fears about their near-term liquidity of the European banking system but would do nothing to ensure the long-term solvency of struggling countries. “It is a stop-gap, not a solution,” he maintains. “What’s still missing is a plan to put the financing of European sovereigns on to a more sustainable footing.”

Stopford also points out that while the recent surge in bank buying of sovereign debt may have galvanised some other investors into the market as well, the recovery in yields at this stage is limited to short-term debt.

“The big issue in the market is who is going to buy the longer-dated bonds of Italy and Spain?”

The current stand-off is nevertheless adding to the uncertainty and also highlights what may well prove to be the most intractable problem for governments in the peripheral eurozone states as they struggle to regain the confidence of the financial markets.

The hope of the politicians is that the massive ECB support for the eurozone’s banking system—and through it, indirect support for the more vulnerable sovereign markets—will provide both with the liquidity they need until they can once more issue capital-market debt at a sustainable cost on their own accounts. However, that represents quite a gamble, given both governments and financial insti-

tutions will need to convince the markets that they have put their finances sufficiently in order before they can do so. That process could take several years.

“That’s only going to come from governments in the eurozone balancing their budgets and introducing the necessary reforms, and that’s going to be a very slow process.” confirms Naud at GKAM. He points to the experience in the 1990s of Sweden, Denmark and Finland (which took a decade or more to restore their credit ratings) and adds it would be even more difficult for the eurozone countries in the present environment.

“The big issue in the market is who is going to buy the longer-dated bonds of Italy and Spain?”

There also must be a question mark over whether the ECB’s LTRO programme will be able to keep the ship afloat through 2012. There is an immense wall of refinancing for both governments and banks to negotiate over the course of the next 12 months. They have, respectively, to refinance around €800bn and €700bn of debt with maturities of one year or longer, while governments will also have to roll over about the same volume again of short-term bills.

The ECB will announce the next tranche of funding through the LTRO at the end of February, but despite the considerable relaxation on the collateral it is prepared to accept as security— which now includes Greek sovereign debt which is trading at 25%-30% of par—it is doubtful that the banks will have sufficient eligible assets left to raise that volume of funding.

The only hope then will be for the central bank to implement the same policy of quantitative easing as its UK and US counterparts (through the direct purchase of sovereign bonds). However, Germany remains implacably opposed to such a policy

FEBRUARY 2012 • FTSE GLOBAL MARKETS

debt report

IS ECB SUPPORT ENOUGH TO SAVE THE EUROZONE?

and there is no suggestion that it is about to change its stance. Many market participants believe it will ultimately do so, if and when financial Armageddon is the only alternative, but that is also a far from certain call.

What is certain is that the EU’s bailout funds, whether the European Financial Stability Facility or its proposed permanent successor, the European Stability Mechanism, will not have the financial firepower to meet this task.

Standard & Poor’s decision to strip France of its triple-A rating on January 13th (along with downgrades of eight other European countries), destroyed the raison d’etre for the EFSF as S&P lowered the facility’s rating in line with that of France. The EFSF has to be able to issue triple-A paper to serve the purpose for which it was set up. Meanwhile, it now looks as though the ESM will struggle to raise its initial proposed funding of €500bn, let alone three or four times that amount.

As if these uncertainties were not enough, there is still a real risk this year of a disorderly Greek sovereign default. This said result in Greece’s expulsion (or voluntary withdrawal) from the single currency and could ultimately precipitate the sort of seizure in the financial markets that followed the Lehman collapse in 2008. At the time of going to press, the fate of Greece still hung in the balance. However, this article’s cautious view should be countered with the fact that the continental European press is distinctly more optimistic about the prospects for an orderly solution to the Greek situation, and the euro in general, than is reported in the UK press.

For if Greece defaults, the banks and others who had insured its eurodenominated debt in the credit default swap (CDS) market would be obliged to pay out under these contracts. While the total CDS exposure to Greece should be manageable at

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about €70bn, the continuing inability of banks to gauge each other’s individual exposure, and mounting fears over counterparty risk, could easily see interbank lending dry up again.

The increased risk of further sovereign defaults and exits from the euro would heighten such concerns.

“If there is an outright default, the credit default swaps are triggered and then other edifices will crumble,” warns the chief economist at one leading fund manager. That could potentially happen in March, when Greece will need to refinance €14.5bn of maturing bonds. It will only be able to do so if it can draw on the second rescue package, worth €130bn, that the EU approved for the country last year.

Standard & Poor’s decision to strip France of its triple-A rating on January 13th (along with downgrades of eight other European countries), destroyed the raison d’etre for the EFSF as S&P lowered the facility’s rating in line with that of France.

Before it can access this funding, however, the government in Athens will need to reach a voluntary agreement with its private creditors on the terms to reschedule its €360bn of outstanding debt. In the absence of an agreement, a CDS-triggering default will be inevitable.

The suspension of talks between the Institute of International Finance (IIF), the body that is representing the banks and other private investors, and the Greek government in the second half of January did little to inspire confidence that the two sides would reach the necessary accommodation in time. It comes down to how much of their existing debt the bondholders are prepared to write off and how much of a coupon reduction they will accept on the rescheduled debt.

The IIF is holding out for a maximum “haircut” of 50% and an interest rate of 4%, but the Greek government is arguing, almost certainly correctly, that this will not be enough to reduce its outstanding debt to the target of 120% of GDP by 2020.

Given the structure of the proposed rescheduling—under which the investors would only receive 15% in cash initially—it is hard to work out exactly what the true haircut would be. The lower the interest rate on the new 30-year bonds that would replace the existing paper, however, the higher the actual writedown will obviously be. Most market observers believe politicians will put pressure on the banks and others to accept an effective haircut of 65%-70%, and that the private investors will reluctantly acquiesce.

The current stand-off is nevertheless adding to the uncertainty and also highlights what may well prove to be the most intractable problem for governments in the peripheral eurozone states as they struggle to regain the confidence of the financial markets. As the process of balancing budgets and instituting structural economic reform inevitably imposes social hardship—and the process will have to go on for several years—will democratically-elected (and removable) governments be able to impose the necessary austerity measures over such a long period and remain in office?

This would seem to be a particularly pertinent consideration in Italy, where (as with Greece) it is now a government imposed by the EU authorities that is attempting to force through the necessary change. It would be a brave man who would bet on such an administration surviving years of declining living standards.“I think an elected government certainly has more chance of achieving the necessary reforms than an unelected one,” observes Naud at GKAM. I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

coMModities report

OIL COSUMPTION: POPULATION AND EARNINGS WILL DRIVE PRICE

Oil prices by most commodity analysts’ estimates in the City are in a surprisingly close range, anticipating that London-traded Brent crude will this year average between $100 a barrel and $120 a barrel and NYMEX-quoted West Texas Intermediate oil futures will trade on average between $90/bbl and $105/bbl.

These forecasts may end up being revised a notch lower after the World Bank in mid-January cut its world growth forecasts, saying it now expects the global economy to grow by only 2.5% and not 3.6% as anticipated in 2011. Even so, while demand for oil is slowing, geopolitical crosswinds will likely keep prices for the commodity above the $100 benchmark throughout 2012.

Vanya Dragomanovich reports.

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

GEOPOLITICS TRUMPS SLOWDOWN IN OIL DEMAND EUTSCHE BANK’S MODELS “suggest that every percentage point of lower GDP growth is worth about one percentage point less oil demand—or about 900,000 barrels a day on a base of circa 90bn barrels a day,” explains Adam Siemenski, chief energy economist at the bank. The current demand forecast for oil consumption in 2012 is 1.1m bbl/d, he says, but that may have to be revised down.

To put it into perspective, despite the negative elements in the picture, the world economy is still growing and while it may be at a slower pace of 2.5%, this is still in contrast with a 2% contraction during the sub-prime crisis.“What has kept forecasts for oil prices up has been the assumption that the developing world––if China can still be called that––would drive forward demand for all commodities, including oil,” he adds. Siemenski thinks Brent crude has the potential to make a low of around $95/bbl but expects it to average $100/bbl in the first quarter before rising later in the year.

There is a string of other elements that will have a dampening effect on oil prices such as the mild winter weather, the fact that oil producing

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FTSE GLOBAL MARKETS • FEBRUARY 2012

countries in Opec are very unlikely to cut oil output because after the Arab Spring they need the additional income, and the fact that the dollar is strengthening, making oil in other currencies more expensive. The experience is particularly unpleasant for European buyers, who, already hit by a weaker economy, have to pay higher prices for oil.

With the dollar expected to continue to firm over the next few months, “the upside for the major commodity indices seems to be limited during the first quarter with investors likely to be very selective”, says Ole Sloth Hansen, senior commodity manager at Saxo Bank.

Increasing tensions Koen Straetmans, commodity strategist at ING Investment Management, says that excluding increased geopolitical tensions, oil demand has further weakened over the past weeks and oil prices are currently at the upper end of the expected price range. Even so, geopolitical tensions are asserting themselves yet again, particularly between the US and Iran, threatening to escalate into a conflict that could close the Strait of Hormuz and cut off the flow of about 20%-25% of global oil.

According to the International Energy Agency (IEA), of the 2.5m barrels of oil Iran exports per day, one third goes to Europe–mostly to Italy, Spain, Greece and Turkey–and the rest mainly to China, India, Japan and South Korea.

Friction with Iran has escalated after US President Barack Obama signed into law the US 2012 military spending bill which blacklists Iran's central bank, the institution through which all major oil transactions are conducted, and gives the US the power to close down US operations of foreign banks that continue to deal with the country.

As with much US foreign strategy, it is precise but heavy-handed. Despite being in agreement with the US on paper on the need to sanction Iran for continuing to run a nuclear programme, Italy, Spain, Greece and Turkey utilise Iranian oil and continue to buy it. Moreover, payments are handled by the world’s largest banks, most of which also have a presence in the US and which will be impacted by the new law.

Because it is overly forceful, the US strategy will take time to implement, thereby impacting on its effectiveness.

At the time of going to press the European Union had not agreed on the implementation of full sanctions

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coMModities report

OIL COSUMPTION: POPULATION AND EARNINGS WILL DRIVE PRICE

and wanted to delay the start until the summer to give importing countries time to find alternative sources of oil. China meanwhile says it has no plans to stop buying Iranian oil, though it has urged the country to cease efforts to build a nuclear arsenal.

Iran, in turn, has threatened to close the Strait of Hormuz and says it will run more war games in the strait, a move which might ratchet up tensions in the region, but little else. Saxo Bank equity analyst Matt Bolduc explains that the US is at a major tactical disadvantage in the Gulf because of Iran’s faster and more flexible navy and onshore missile batteries.

Most analysts agree an actual shootout is unlikely—if nothing else, neither side can afford it. “It is now a matter of who will blink first,” says Bolduc.“There are basically two scenarios,” expands Francisco Blanch, head of global commodities and multi-asset strategy at Bank of America Merrill Lynch. “If the conflict is short it would be a spike and crash for the oil price,” he says. Iran is Europe's second largest supplier after Saudi Arabia, and Saudi has already indicated that it would step in and provide an additional 1m to 1.5m barrels a day if needed. If, however, the conflict is prolonged there is no indication how high prices could go. “During the conflict in Libya oil prices went up $10. The supply through Hormuz is ten times that of Libya,”says Blanch.

There are two other potential flashpoints that could impact the oil market: Iraq, where unrest has escalated since US troops withdrew, and Nigeria, where there is social unrest because of the reversal of fuel subsidies. Iraq is producing 2.7m bbl/d and Nigeria 2.2m bbl/d, both major suppliers. Into the somewhat heated geopolitical mix this year, manufacturers are launching a number of new products, both ETFs and new funds.

Although substantial price hikes are not on the cards in the segment this year, much of the enthusiasm for the sector has been generated on the back of last year's rally in commodities.

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Among the current crop of new launches is Legal & General Investment Management’s LGIM Commodity Composite Source ETF, which will be managed by ETF manager Source. The ETF will be based on an index designed

by LGIM and with a minimum of three sub-indices. The fund will invest in physical commodities and will also hold US Treasury bills.

Aviva Investors meantime has entered the fray with its Aviva Investors Investment Solutions Global Commodity Plus Fund, which will be managed by Tiberius Asset Management. This is a long-only commodities fund and for this trading strategy to work there would need to be a clear upward trend across the whole commodities sector.

With oil prices currently trading at around $110/bbl, long only strategies will remain under pressure to create returns, particularly for single futures ETFs as these lose some money on rolling over contracts from month to month if the market is in contango; that is, if the prices in the months ahead are lower than spot prices. The WTI futures contract is already in contango while Brent crude is in backwardation, the opposite condition. While investors can earn some money rolling forward the Brent contract, the differentials are fairly small and the associated costs could eat into returns.

However, there are other, more focused strategies around. “You could play the WTI-Brent arbitrage,” says Robert Montefusco, trader at Sucden International, explaining that the differential between WTI and Brent futures moved from a peak of $27 last year to about $9 this year and is expected to decline even further this year as new pipelines come on line in the US. The dynamic of domestic US supplies is expected to lead to higher WTI prices over the course of the year.

For its part, Deutsche Bank says it proposes to go short the spread between Brent futures and the Dubai crude oil. The argument behind the short Brent-Dubai crude spread is that

Brent, the benchmark European oil futures contract, will start coming under pressure as Libyan oil production continues to recover and more of the country's oil is exported (that is, excluding the Iran conflict scenario). In contrast, the Asian benchmark Dubai will gain support from still robust Asian growth and the fact that China is building refineries with capacity of 710,000 bbl/day of which 160,000 bbl/day are due to come on line in the first half of this year and will require fresh supplies of crude oil. The risk here is that an economic hard landing in China “would have ramifications for the demand-side of the Asian oil balance”, says Siemenski.

Morgan Stanley suggests holding off-the-market call options as protection against the political risks in the oil market. “If Mid-east tension recedes, the premium that has been built into crude prices will fade, sending crude prices lower. Assuming cooler heads prevail, crude fundamentals should begin to firm again as we head into the second half of 2012, driving prices higher,”says a recent research report by the bank.

Whatever the strategy, over the long term (barring any scientific discovery that overturns black gold as a leading source of energy) there is only one way for oil prices. When BP published its Energy Outlook 2030 last month, it began its discussion on the future of oil with a graph showing global population growth.

“Population and income growth are the two most powerful driving forces behind the demand for energy. Over the past 20 years world population has increased by 1.6bn people, and it is projected to rise by 1.4bn over the next 20 years. The world’s real income has risen by 87% over the past 20 years and it is likely to rise by 100% over the next 20 years,” the oil company wrote.

The most fundamental equation in energy remains intact: more people with more income equals more production and consumption of oil. Over the long term, it is inevitable that this will mean higher prices. I

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coMModities report

PRECIOUS METALS SHOULD RALLY AFTER DECEMBER SELL-OFF

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Gold outlook remains tied to political risks If 2011 was all about a strong investment case for gold, the selloff at the very end of last year heralded a more cautious approach to the yellow metal. Most analysts believe gold will continue to rise in the first half of 2012, possibly by as much as $300 to $500 a troy ounce. However, they also warn that prices are likely to start falling in the second half of this year and continue on a downward path into 2013, while platinum and palladium could climb steadily. By Vanya Dragomanovich.

HE VAST STRATEGIC allocations—not only from speculators but also from private banking and high net worth individuals— which have shaped the precious metals market over the past two and a half years have now subsided, according to Nick Moore, a commodity analyst at RBS. “To us this had always seemed inevitable. Investment demand could not expand perpetually,” he says.

Even so, this is no grounds to become bearish because the arguments in favour of investing in gold remain solid, adds Moore. Last year, it

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has to be said, was busier than most, dotted with events that inevitably propelled investors towards gold as a safe haven. In case you’ve forgotten, here’s the well-worn list: the Arab Spring; the Japan earthquake; the conflict in Libya; the downgrading of the US sovereign debt; the Greek debt crisis. Equally inevitably, gold prices shot up from $1,370 a troy ounce in January 2011 to a high of more than $1,900/oz in September. The subsequent drop to $1,670/oz by year end was as much about cashing in on the year's rally as it was about deleverag-

ing while the debt crisis exerted its wasting grip on Europe.

It is patently clear already that a lot of the uncertainty of 2011 will overhang across the market, at least for the first half of 2012. The list of reasons is again very obvious: the chronic European debt problem; fragile growth in the global economy; and unsettling political stresses emanating from Iran and the US, even potentially Syria. All of these elements will continue to inject volatility into the gold market.

With this amount of uncertainty it would be foolish to write off gold as an investment. Despite the sell-off in December, a large proportion of investors across the board—be they retail, central banks, large institutions or speculators––continue to look at gold either as an alternative currency or a diversification asset designed to protect against losses from other investments.

In the past two months investors have been divided in their approach to gold. While short-term speculators liquidated large positions in December, cashing in on a rally that happened over the course of 2011, long-term investors, particularly ETF investors, stuck faithfully to their positions. Speculative positions in Comex gold are at their lowest levels since 2009 but physical gold ETF holdings reached record levels of 2,300 tonnes in December.

Since the beginning of this year “fresh money has been put to work and the energy sector and precious metals have so far been the main recipients,”particularly gold and silver, says Ole Sloth Hansen, senior commodity manager at Saxo Bank. One of the key factors working in favour of gold is the low interest rate environment which currently exists in over half of G20 countries, he adds.

Further monetary easing in Europe, China and potentially a round of QE3 in the US will increase liquidity and drive the gold price to new records, possibly as early as the first half of 2012. “Liquidity will be a stronger influence on market performance than macroeconomic turbulence,”says

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Bjarne Schieldrop, chief commodities analyst at SEB bank.

The European sovereign debt crisis will also be supportive at the retail level because at times of crisis retail investors tend to buy gold bars and coins. While at first glance this type of demand may seem like a small driver of the market, industry consultancy Thomson Reuters GFMS says that last year bar and coin buying rivalled that of ETF investment flows.

“Private investors in Europe and the US are the biggest buyers of bars and coins; they buy it for safety because they are worried about the purchasing power of paper currencies,” says Carsten Fritsch, an analyst at Commerzbank.

Another big contributor to a high gold price in 2011 was the fact that central banks bought some 450 tonnes of the metal. Analysts expect the trend to subside this year but not to stop.

“Central banks in emerging markets are still heavily under-invested in gold,” says Fritsch.“In 2011 Mexico for instance bought 100 tonnes of gold and Russia, Turkey and South Korea were all major buyers. We don't expect to see the same amount of central bank buying this year but we do expect central banks to buy smaller amounts, for instance Russia,” he says. Fritsch argues that if Russia does come back as a buyer it will most likely absorb some of the domestic gold production but this will mean that less gold will make it onto the global market.

One of the two key risk factors for gold is the strength of the dollar, particularly when it weakens the currency of a big gold buyer such as India. When the rupee plunged against the US currency in late 2011, domestic gold buying as good as dried up. The other potential threat to gold is a recovery in equity markets which annuls the reasons for safe-haven buying.

Looking at other precious metals such as silver, platinum and palladium, there is an interesting investment case to be made—particularly for palladium. All three were

FTSE GLOBAL MARKETS • FEBRUARY 2012

sold off heavily at the end of last year to the point that they are now considered relatively cheap.

“Within the precious metals group we see palladium as the better pick given its bias to the US and China,” says Deutsche Bank's Michael Lewis.

The palladium price depends heavily on demands from the car industry which uses it to make catalytic converters, to cut CO2 emissions. In November 2011, US car sales rose by 14% and Chrysler said recently that its US sales rose 37% in December, the fastest of the top three US car manufacturers.

On the other hand, Chinese car sales slowed considerably in 2011 because of the phasing out of tax subsidies and car scrappage incentives.

Yet even with that, China's sales of 18.5m cars in 2011 still outstripped the estimated 12.8m light vehicles sold in the US. This comes at a time investors in palladium futures cut their net long positions by 77% from August 2011 highs and when ETF investors reduced their exposure by 23% for the same period.

Questions over palladium An important question this year is whether Russia will stick to current export volumes for palladium. The answer is actually a political one.

Although Russia's nickel miner Norilsk Nickel is the world's biggest palladium producer, stocks of palladium are state-controlled and sold through a government agency that never reveals how much stock it holds or plans to sell. For years analysts in the West have speculated that those stockpiles are about to come to an end, this year being no exception, but there is so far no material evidence to support this. The speculation may prove yet again to be a case of wishful thinking rather than actual fact.

Even so, Commerzbank expects palladium prices to recover noticeably over the course of this year and to hit $850 by the end of 2012, up from the current $680/oz.

There is a similar case to be argued for platinum, which is also used by the car industry and in jewellery. Platinum has traditionally traded at a higher price than gold, but with gold now the more expensive metal, jewellers, particularly in Asia, are switching to platinum as an alternative.

On the supply side, South Africa, the biggest platinum producing country, is facing problems with electricity supplies which could hamper platinum mining over coming months. However, at current prices, platinum miners are under pressure and on an all-in cost basis many are making losses. “We believe this is unsustainable in the long run and something has to give—the price has to recover or production growth will slow,” says RBS's Moore. He sees the $1,400/oz level as the floor and expects that any dips in prices below that figure will prove short-lived. In similar vein, Commerzbank forecasts platinum prices to rise to $1,850/oz by year end from the current $1,550/oz.

Silver is probably the most volatile of the three and not a market for the faint-hearted.“Silver has always been a volatile metal, but 2011 was a vintage year. The euphoria of the 89% February-April rally to a $50/oz peak was followed by the revulsion of a 35% collapse, the latter over just two weeks. A few months later, in September, an even more dramatic drop saw silver shed 40% of its value,” says Moore. This serves as a painful reminder for investors to tread cautiously, or at least not to leave their silver positions unchecked for lengthy periods.

This year the demand from the electrical and electronics industry, the key consumer of silver, will continue to support prices although consumption from solar cell makers is likely to slow after several years of fast growth.

RBS's Moore expects silver to rally from current levels to a peak of $34/oz in the third quarter, in line with gold, but to trend lower afterwards. I

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real estate

COULD OVERHEATED REAL ESTATE DESTABILISE CHINA’S COOLING ECONOMY?

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Will China’s walls come crumbling down?

Fourth-quarter growth of 8.9% hardly suggests that China’s economy is in turmoil but after several years of soaring expansion, a sustained, albeit gradual, slowdown in pace has jolted the market. Residential house prices are expected to fall by as much as a fifth this year and with a swathe of new shopping centre developments lying empty across the country, concerns are gathering that the over-heated real estate market could destabilise an already-cooling Chinese economy. By Mark Faithfull.

UCH FIGURES COULD only be dreamed of in most western economies, but in January the Chinese government announced fourth-quarter growth which left the country 0.8% down on 2010. The government also confirmed the country’s lowest increase in gross domestic product in ten quarters, equating to a full-year GDP increase of 9.2%, the same rate as in 2009, when growth slumped to a low not seen since 2002.

The slowdown has been gradual, dropping to 9.5% in the second quarter, 9.1% in the third and 8.9% in the fourth, in line with Beijing’s target for last year, when it was grappling with annualised inflation, which peaked at 6.5% in July before slipping to 4.1% by the end of 2011.

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Post the delivery of these dented results, a China National Bureau of Statistics (NBS) spokesman reflected official concerns that things are likely to get worse in the coming months.

“In terms of the domestic and international situation, 2012 will be a year of complexity and challenges so we should be fully prepared,” noted Ma Jiantang, announcing the figures in an official release.

Full-year growth for 2012 could now drop as low as 7.5%, 50 basis points (bps) below a decade-long projection from the ruling Communist party based on an assumption that 8% GDP growth is the minimum required to maintain social stability.

However, the current pace of China’s slowdown appears to remain within the government’s comfort zone and most

economists believe Beijing will achieve a controlled transition to lower long-term growth.

Even so, Beijing has less options available than in the previous slowdown three years ago, when it was able to prime growth with a $633bn stimulus package. China’s heavily indebted local governments and massive credit expansion have contributed to asset bubbles, particularly in housing, with real estate investment up 27.9% in 2011. The business segment directly represents $977bn of investment (or around 13% of GDP).

In January, NBS released data showing that home prices declined in 53 out of the 70 cities it measures and a major correction in the residential real estate market now appears inevitable after nearly two years of restrictive government policies specifically aimed at dampening the market.

Residential floor space under construction fell by a quarter in December, while floor space sold fell 8.4% from the previous year, reflecting growth of 12.1% in 2011 compared with the previous year. This translates into a year-on-year drop of 1.3% in

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real estate

Mortgage loans fall Concerned about their high exposure to the property sector and under instructions from the nation’s leaders, Chinese banks have been cutting their loans to developers and home buyers. NBS data shows mortgage loans fell 12.2% in 2011 and Chinese developers will probably have to cut prices further in 2012. Analysts expect average home prices in China to fall between 10% and 20% this year, with the biggest declines in major cities such as Beijing as well as highly speculative markets including Ordos and Wenzhou.

FTSE GLOBAL MARKETS • FEBRUARY 2012

However, Huang Yiping, chief economist for emerging Asia at Barclays Capital, says that those predicting a hard landing for China are ignoring the “still-healthy balance sheets of households, corporations, banks in China, and the external economy and government”.

He points out that mortgage loans amount to only around 13% of banks’ total outstanding loans, equivalent to less than 20% of GDP and less than total household savings.“This implies that, even if house prices decline, we are unlikely to see forced and widespread deleveraging that could lead to a meltdown,” he says.

The investment profile is also changing in China’s two principal cities. Of Beijing, David Ji, head of Greater China research at DTZ UGL, says: “We estimate that the plan of land supply this year cannot be achieved. Looking forward, with no signs of policy loosening, developers may face more severe circumstances.

However, some developers still feel optimistic towards the market in the long run. Developers with good balance sheets may reach out for good opportunities.”

On Shanghai, Ji notes: “In Q4 we noticed some foreign buyer activity in the market, both from a land and an en-bloc deal perspective. Although the investment market now is dominated by local players, especially the land market, foreign investors and developers are still seeking opportunities to be had in the city’s property investment market and we expect this to be the case for the next year.”

Richard van den Berg, Greater China country manager at the Hong Kong office of CBRE Global Investors, adds: “The pattern is highly variable, with some cities falling much further (such as Shao Xing with a 25% decline year-on-year to December 2011) while certain cities, such as Ordos in Inner Mongolia and resort towns in Hainan, get all the press but they are not representative of the country as a whole.”

COULD OVERHEATED REAL ESTATE DESTABILISE CHINA’S COOLING ECONOMY?

December alone, the third straight month of decline.

Evergrande Real Estate Group, the second-biggest developer in China by sales value, has forecast flat 2012 sales and said many of its peers reported sharp double-digit annual drops in sales in December. Analysts expect Chinese real estate investment to fall below 10% in the first few months of 2012 and developers including Evergrande and Agile have halted land purchases. Construction starts fell 19.1% in December from a year earlier, the first decline since November 2010, which may lead to a short supply of homes in 2013 and a rebound in prices.

"Falling new construction means limited supply in later months and will probably reverse the supplydemand relation in 2013," says Ren Zhiqiang, chairman of Beijing-based real estate developer Hua Yuan Property, which mainly operates in north and north-west China.

The dip in sales, married to downwards price pressure, is beginning to bear down on the market, particularly as refinancing pressures continue to build. In consequence, industry consolidation is likely in 2012 with some players selling assets or quitting the business altogether. According to Thomson Reuters’ data, repayment of some $2.2bn of syndicated property loans and club deals is due this year, added to RMB117bn in payouts maturing from real estate trusts.

He points out that average prices are also coming down because a large number of medium and small-sized units are being sold rather than the larger luxury units and cites including Changsha, where the average price rose 4.9% in 2011, while some second-tier cities have also outperformed. He says that CBRE’s strategy has been to diversify by city and even developer but to target certain second-tier cities which have stronger fundamentals.

Guo Zengli, president of the Mall China Information Centre, said last year that the number of shopping centres nationwide would increase 893% between 2001 and 2015, with developers hoping that a new generation of Chinese consumers will spend far more, emboldened by rising wages and government efforts to build up the social security system.

“A consequence of government regulations has been that many end-users are taking a ‘wait-and-see’ attitude. Thus demand has been artificially suppressed,” he reflects. “In time this demand will return to the market. In a systemic shock scenario regulations may be lifted sooner but our base-case is that the tight regulations will remain at least for the next two quarters so that prices will likely fall further in many cities.”

Van den Berg believes that the current environment is favourable for market entry in those cities with strong supplydemand characteristics and says CBRE’s investment thesis sees 2012 as having a rare confluence of key factors including falling land prices and cash-constrained developers, which may prompt industry consolidation and intrinsic demand.

Nevertheless, van den Berg rails against any idea of a "bubble" to char-

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real estate

acterise what is happening in China's residential market and points out that on average only around 40% LTV is used to finance residential purchases and that urban China overall has a shortage of modern housing.

Retail development is also feeling the pinch, with a boom in the number of malls without a matching increase in actual shopping. Household consumption has fallen over the past decade to above a third of GDP, according to official data, while investment has soared to 48.6% of GDP, reflecting an imbalance in spend and investment.

Guo Zengli, president of the Mall China Information Centre, said last year that the number of shopping centres nationwide would increase 893% between 2001 and 2015, with developers hoping that a new generation of Chinese consumers will spend far more, emboldened by rising wages and government efforts to build up the social security system.

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

Chinese retail sales rose 18.1% in December, representing annual growth of 17.1% in 2011, but even that will not be enough to fill the 760 shopping centres that Guo forecasts

will open across China over the next three years.

Not that investors appear put off by his stark outlook for Chinese retail development. In January, a ten year bond issued by Singapore–based CapitaMalls Asia for about £51m was more than four-and-a-half times oversubscribed, despite the company’s heavy exposure to China. Raffles City, Chengdu, is just one of its under-construction projects and corporate marketing manager Esther Ee says: “A lot of our focus is on China, where we now have 55 schemes agreed.”

Interest in China remains among investors from Hong Kong, Taiwan and Singapore, and other Asia Pacific countries around opportunities in both the residential and commercial sectors.“Many institutional investors have been on pause for the past six months and appear to be waiting to see what will happen and what is the best strategy,” says van den Berg.“Many share the belief that the medium to long-term prospects for China are bright” I

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FTSE GLOBAL MARKETS • FEBRUARY 2012

CORPORATE REVIEW Photograph kindly supplied by Dreamstime.com, supplied January 2012.

TO CATCH A FALLEN STAR Navistar International (NAV), the truck manufacturer that traces its origins to Cyrus McCormick’s invention of the mechanical reaper in 1831, long ago faded from prominence among America’s industrial giants and nearly disappeared entirely. But billionaire investor Carl Icahn believes there is value in NAV and has become a major shareholder. Will Icahn's investment propel Navistar to a brighter future, or steer the firm into the arms of another company? Art Detman reports.

HENEVER DANIEL USTIAN, Navistar’s chairman, president and chief executive, talks to investors and analysts, he tells them that Navistar is a growing and profitable company; the first or second-best selling marque among heavy-duty and medium-duty trucks and school buses in the United States; a major force in the manufacture of diesel truck engines; a key supplier of military trucks, and well-positioned for future growth at home and abroad.

It is a message that has fallen largely on deaf ears. NAV shares have consistently been valued far lower than those of rivals such as Paccar, the maker of Peterbilt and Kenworth trucks, and Cummins, the world’s largest merchant manufacturer of diesel engines.

However, one prospective investor was listening. In November Carl Icahn disclosed that he had acquired 9.8% of all shares outstanding.

In a filing with the Securities and Exchange Commission, Icahn explained that he believes NAV is undervalued,

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FEBRUARY 2012 • FTSE GLOBAL MARKETS

but doubtless this was cold comfort to Ustian. Icahn can be a patient investor but not necessarily a passive one.

Almost immediately speculation arose that he might try to force a merger of NAV with Oshkosh Corporation (OSK), a manufacturer of big-ticket speciality vehicles that, like NAV, is cold-shouldered by investors. Icahn, however, isn’t among them. Earlier last year he acquired a 9.5% stake.

Icahn is keeping mum about his plans for NAV and OSK. Nonetheless, Navistar quickly agreed to declassify its board. By 2014 all directors will stand for election annually instead of on a staggered three-year basis. In return, Icahn agreed not to nominate candidates for Navistar’s board during this time period.

OSK was less accommodating, and Icahn announced his intention to nominate six directors to its board, whose 13 members are already elected yearly. In a letter to shareholders, Oshkosh president and chief executive Charles Szews denounced Icahn’s effort, stating that Icahn has “not discussed with us any ideas for creating value. . . .”

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CORPORATE REVIEW

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“Investors always have been sceptical of Navistar, maybe it’s their history of disappointing investors, or the legacy of International Harvester, or the ten years it took them to get their cost structure in line.”

Photograph kindly supplied by Navistar, January 2012.

“They are both very classy looking trucks, the LoneStar especially,” says Lyndon Finney, editor of The Trucker newspaper. “And both were especially attractive to the owner-operator, the independent contractor.”

Photograph kindly supplied by Navistar, January 2012.

Beyond that, Szews isn’t speaking to the press right now.

Navistar’s Ustian also isn’t talking. What can he say? After all, implicit in Icahn’s statement that the company is undervalued is the idea that changes are needed. Securities analysts and trade press editors agree that Navistar has a strong product line in both trucks and engines, so changes would focus on management or strategy. Over the years, the company often missed goals for earnings, revenues and market share. “The execution risk remains high,” warns Ann Duignan, a managing director of JP Morgan Equity Research.

“Investors always have been sceptical of Navistar,” says another analyst, who does not want to be quoted by name.

“Maybe it’s their history of disappointing investors, or the legacy of International Harvester, or the ten years it took them to get their cost structure in line, or maybe the way they communicate with Wall Street. They have been doing significantly better over the past five years, largely because of defence contracts; but that scepticism remains. As a result, valuation remains extremely low.”

In 2010's annual report Ustian made it clear that the company wants to control its own destiny. Thus, Icahn’s investment—though for the time being largely passive— represents a challenge, if not a downright threat.

There’s little doubt that investors would welcome nearly anything that would boost either stock’s price. Among large manufacturers of heavy machinery, NAV and OSK have the lowest valuations. On a sales-per-share basis, for example, other companies’ shares are valued four times

higher than NAV and OSK. Both companies are dependent on US military sales for a disproportionate share of earnings. “The thing I’m waiting for, and my clients are waiting for, are commercial profits,” says an analyst who follows NAV.

Assemblies, research & development Despite the inconsistent results of the past decade, NAV has made great progress in several areas. Each of its assembly plants can produce a variety of models, allowing the company to respond quickly to changing customer demand. Furthermore, Navistar has reduced its costs by moving much of its production from old factories in the North to new factories in the South and Mexico. One exception is the firm’s Indianapolis (Indiana) foundry recently reopened after union concessions. As one NAV executive dryly remarked: “The best way to control casting prices is to have your own foundry.”

In 2007 Navistar introduced the ProStar over-the-road tractor, used to tow semi-trailers (in America, the tractortrailer combination is known as an 18-wheeler: ten wheels on the tractor-cab, eight more on the trailer). The ProStar was Navistar’s first new truck in many years. A year later it rolled out LoneStar, a highly stylised top-of-the-line tractor. “They are both very classy looking trucks, the LoneStar especially,” says Lyndon Finney, editor of The Trucker newspaper. “And both were especially attractive to the owner-operator, the independent contractor.”

The company also is preparing to open a 1.2m sq ft head-

FEBRUARY 2012 • FTSE GLOBAL MARKETS

Over the years, the company often missed goals for earnings, revenues and market share. “The execution risk remains high,” warns Ann Duignan, a managing director of JP Morgan Equity Research.

Photograph kindly supplied by Navistar, January 2012.

quarters and research-and-technical centre Lisle, six miles from its current offices in Warrenville, a Chicago suburb.

Meanwhile, Navistar has pushed ahead with a family of big-bore diesel engines, with displacements of 11, 13 and 15 litres. For years the company has built smaller engines for medium-duty trucks and installed engines from vendors such as Cummins in its biggest trucks; however, early last year Navistar heavy-duty trucks became available only with the company’s own engines.

The engine strategy is tempting. After all, why give up the profits on manufacturing big engines? But there is risk.

Caterpillar, a supplier of big-bore engines for decades, ran into trouble meeting the new 2006 emissions standards.

Instead of trying to meet the more stringent 2010 rules, it simply stopped making heavy-duty truck engines for onroad use. It was a rare failure for a company with a golden reputation for reliability.

Meanwhile, Paccar—whose Peterbilt and Kenworth brands command top dollar—has, like Navistar, introduced its own diesel engines. According to Tim Denoyer, the trucking analyst for Wolfe Trahan though, dealers have reported unexpected problems with the engines, and some truck buyers have paid premiums of $3,000 to switch to Cummins engines in trucks already purchased but not yet delivered.

So far, Navistar engines have not had any major problems. Because Navistar’s system to reduce emissions differs from those of other manufacturers, it would be time-consuming and expensive to re-engineer its trucks to again accept outside engines.

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Despite the essentially trouble-free rollout of the new bigbore engines, Navistar has lost share in the US/Canada heavy-duty truck market. It slipped from second place in 2010 to third through November 2011, according to Ward’s Automotive. By Navistar’s own accounts, its share of overthe-road tractors fell from 24% in 2010 to 17% through November 2011. In the heavy-duty severe-service market (dump trucks, concrete mixers, refuse haulers, etc.) its share dropped from 40% to 34%. In school buses, its share declined from 59% to 48%. The medium-duty market was the one bright spot. NAV’s share grew from 35% in 2009 to 38% in 2010 to 40% through November 2011.

In the over-the-road/severe service, heavy-duty truck market, the sales leader for more than a decade has been Daimler AG, whose US nameplates are Freightliner and Western Star; its share was 32.3% through November, down from 34.4% for 2010. US-based Paccar had a 27.1% share through November, up sharply from 22.4% for 2010.

Navistar’s 11-month share was 21.4% compared with 25.9% for all of 2010 (and 28% in 2009). Volvo Group, whose brands are Volvo and Mack, had 19.3% of the market through November, up from 17.3% for 2010.

Navistar’s over-the-road market share loss may not be as alarming as it appears. From 2000 through 2006 (the year before it introduced the ProStar), Navistar was in fourth place, with a market share consistently less than 20%. The recent erosion may simply reflect the early success of the ProStar and LoneStar with owner-operators, who keep their trucks several years longer than fleets do.

Truckers log 100,000 miles or more a year, but a well maintained tractor can last for a million miles.

Sales were strong during NAV’s fourth quarter, and the company ended fiscal 2011 (October 31st) with revenues of $13.96bn, up nearly 15% from 2010's $12.16bn. Pershare earnings beat most estimates, but the adjusted net income was only $402m. This is just 2.9% of sales compared with an expected 2011 net profit margin of 8.3% for Cat and 6.7% for Paccar.

Better times should lie ahead. The heavy-duty truck market is beginning an up cycle. The average age of an over-the-road tractor is 6.8 years, the highest since such figures have been collected. Up to now though independent owner-operators have been reluctant to buy, skewing sales toward fleets, which pay as much as 10% less per truck, which doubtless reduced Navistar’s margins (Tractor prices range from roughly $100k to $130k.) In addition, military sales in 2011 fell, and these sales have been more profitable than commercial sales.

Navistar narrowly avoided bankruptcy in the early 1980s. Since then, its financial results have been uneven; in the past decade alone it reported losses in 2001, 2002, 2003 and 2007––in contrast, Paccar boasts of 71 consecutive profitable years.

A dispute with its outside auditor forced Navistar to recognise huge unfunded pension liabilities, delayed publication of its 2005 annual report by almost two years, and got NAV delisted from the New York Stock Exchange for a

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CORPORATE REVIEW

58

Daniel Ustian, Navistar’s chairman, president and chief executive, also isn’t talking. What can he say? After all, implicit in Icahn’s statement that the company is undervalued is the idea that changes are needed.

Photograph kindly supplied by Navistar, January 2012.

Andrew Cederoth, Navistar’s chief financial officer: “The opportunity for our engine strategy is to expand their margins by moving into tangential markets, where low-volume higher-content engines sell at better margins.”

Photograph kindly supplied by Navistar, January 2012.

while. From 2005 through 2010 Navistar’s shareholders’ equity was negative. Since then, NAV has paid down its pension and healthcare liabilities, and for FY2011 reported a positive shareholders’ equity (just $28m, but expected to rise geometrically in the next few years).

Does combining Navistar with Oshkosh—located in its namesake city in Wisconsin—make sense? Many analysts see synergies. There would be the elimination of redundant positions, of course. The new company’s revenues would be nearly $22bn, giving it more muscle in purchasing raw materials and finished components.

Both sell tactical trucks to the US Department of Defense, which is expected to cut back on spending in coming years. Then, too, Navistar has spent perhaps $1bn in developing its family of big-bore diesel engines and is seeking new markets for them.

Consider the remarks of Andrew Cederoth, Navistar’s chief financial officer, at the RBC Capital Markets conference last September: “The opportunity for our engine strategy is to expand their margins by moving into tangential markets, where low-volume, higher-content engines sell at better margins. Those are markets such as marine applications, gen-sets, off-road applications, low-volume specialty vehicles like cranes and fire trucks.”

What Cederoth described is pretty much what Oshkosh makes: airport emergency vehicles, fire trucks, concrete mixers, wreckers, aerial work platforms and the like.

Oshkosh doesn’t make its own engines. Instead, buyers specify whose engine they want.

The combination with Oshkosh may or may not come about, but the speculation has raised this question: are even only four independent manufacturers in the US/Canada heavy-duty truck market too many? James Hebe, Navistar’s executive vice president for North American sales, told The Trucker last summer that as the industry’s trucks become more durable, buyers will run them longer before replacing them. Never again, he said, will industry volumes reach 2006 levels, when 284,000 units were sold. In the future there won’t be enough sales for all the current original equipment manufacturers. “Not all OEMs will survive,” he added.

Will Navistar be one of those? Perhaps not. Icahn’s investment may have put the company into play. As 2011 drew to a close, NAV’s market capitalisation was only $2.6bn. Daimler, Paccar and Volvo may not be able to bid for Navistar because of antitrust considerations. However companies like MAN Group, Scania and Volkswagen may see Navistar as a bargain-priced way to expand in the US. Moreover, now that Caterpillar no longer makes diesel engines for the North American heavy-duty truck market, it too might be interested. Right now, Cat’s cash on hand outstrips Navistar’s market capitalisation, and Cat’s own market cap is north of $60bn.

Even if none of these scenarios appeals to Navistar’s CEO Dan Ustian, he may not have a choice. Carl Icahn — and probably most other shareholders — are more interested in maximizing their investment than extending the heritage of the company Cyrus McCormick founded so long ago. I

FEBRUARY 2012 • FTSE GLOBAL MARKETS

SECURITIES LENDING

Photograph kindly supplied by Dreamstime.com, supplied January 2012.

The dash for growth in Asian securities lending A tremendously diverse, highly dynamic and fiercely competitive region, Asia is no place for the faint of heart. Those seeking to secure a piece of the region’s nascent securities-lending business must come armed with a thorough understanding of the regulatory nuances within each locale, and getting up to speed can be a considerable task. It is no surprise, then, that demand continues to outweigh supply in the region. David Simons reports.

IVEN THE CONSERVATIVE tenor of their peers in Europe and the US in the wake of the financial crisis, not surprisingly Asian regulators have taken a cautious approach to the establishment of a securities-lending market.

Still, lending services have been anything but sluggish in recent times; compared to their counterparts elsewhere, Asia’s market participants are reasonably bullish about the prospects for growth. During 2011, lending revenues in Asia increased an estimated 25% year-over-year, and with a new year under way, countries such as Singapore, Hong Kong and Taiwan are expected to continue the upward trend in revenue generation.

As sec-lending momentum builds, regulators have been working to stay one step ahead in an effort to discourage the kind of opacity that prevailed pre-crisis.

As regulation typically varies from one region to the next, the market for securities services within Asia is hardly a one-size-fits-all proposition. While a huge uptick in arbitrage opportunities within India’s National Stock Exchange has fuelled sec-lending growth of late, in China

G

FTSE GLOBAL MARKETS • FEBRUARY 2012

it is as much about future opportunities as the here and now. Whereas Japan has seen tremendous growth in corporate-bond activity, elsewhere demand has been relatively muted. Hence, the ability to understand the specific opportunities and intricacies within each locale has become compulsory for regional providers.

Lending leaders While most emerging markets have strong potential for securities lending, BNY Mellon has been particularly focused on opportunities in the Far East, specifically markets such as Taiwan, Korea and Malaysia, where offshore supply continues to trail regional demand.

“We have offshore clients that have attractive positions and are ready to participate,” says Rob Coxon, head of international lending, BNY Mellon Asset Servicing.

“The drivers for securities lending in Asia haven’t really changed—hedge funds and their specific trading strategies are continuing to fuel borrowing demand,” says Coxon.

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SECURITIES LENDING

Robert Lees, Brown Brothers Harriman. “As Asia becomes increasingly relevant to the global economy and its capital markets mature, we expect to see increased opportunities for SBL growth across the region.”

Photograph kindly supplied by Brown Brothers Harriman, January 2012.

“We’ve seen many trades around recapitalisation during the past year. Regulatory and economic uncertainty does not help with the resulting volatility, but hedge funds are paid to work through these obstacles.”

The Asian markets tend to rely on much more securities-lending specific regulations, and many of their structures revolve around a central counterparty and the requirement to report positions, particularly compared to the US and Europe. Accordingly, a different approach needs to be adopted as dictated to by the local regulator, and this often leads to additional cost, says Coxon.

What makes Asia particularly attractive from a lending perspective, says Robert Lees, head of trading for Asia Pacific, global securities lending at Brown Brothers Harriman, is the potential for significant growth in more established markets including Hong Kong and South Korea, as well as in nascent regions such as India and China that remain committed to developing their securities, borrowing and lending (SBL) frameworks. “As Asia becomes increasingly relevant to the global economy and its capital markets mature, we expect to see increased opportunities for SBL growth across the region,”he says.

Event-driven and long-short strategies continue to pace regional activity, says Lees. “During the later part of 2011 we witnessed a significant uptick in markets like Hong Kong, as concerns around economic growth prevailed, corporate-accounting unease came to the fore, and sectorspecific interest drove demand.”

South Korea re-emerged as an investor target during 2011 after the country lifted its ban on short selling, and

60

Taiwan gained favour as well during the past year, despite certain restrictions placed on beneficial owners wishing to lend in that country. “The Taiwanese have taken a very practical approach to the securities finance market,” says John Arnesen, head of agency lending at BNP Paribas Securities Services.“Business has been done in a very collaborative and transparent manner.”A lack of supply in South Korea makes a compelling case for establishing one’s capabilities within that country, adds Arnesen.

Though China holds the greatest potential for growth in the region, the establishment of an onshore market is still a way off, and investors must be patient, notes Arnesen.

“When the market is finally developed, it is likely to be an exchange-based adoption of the service, using a central counterparty structure,” he says.

Fundamentals are likely to remain strong in Asia for an indefinite period, however any uncertainty surrounding the evolving regulatory environment, such as an increased focus on capital controls or further restrictions on short-selling, could negatively impact both supply and demand, says Lees.

“The regulatory environment has been a key variable within the regional sec-lending business, with Asia’s regulators generally taking a wait-and-see approach contingent on the effectiveness of policies in both Europe and America,” says Lees. This has allowed local regulators to properly assess their own country’s situation and develop a reasoned response. In many instances, only minor adjustments have been needed; some, like Hong Kong, Japan, and Singapore, have not made any major regulatory changes at all.

“Sub-custodians are increasingly called upon to play a larger role in liquidity management, including clearing and the managing of collateral, particularly as the markets continue to transition from OTC to CCP clearing.”

“It is important to note that within Asia, markets are in different stages of securities borrowing and lending development, from fully established to frontier markets, so each market will have its own distinct rules and regulations,” says Lees.“This places a much greater emphasis on understanding the overall market structure and requires firms to dedicate significant resources within the region to ensure they are involved in the regulatory conversation.”

With Asia’s securities-lending practices remaining highly restrictive, sub-custodians such as Standard Chartered Bank can often serve as a conduit in order to help investors gain access to a particular market, says Giles Elliott, head of product, investor and intermediaries for SCB. “Subcustodians are increasingly called upon to play a larger role in liquidity management, including clearing and the managing of collateral, particularly as the markets continue to transition from OTC to CCP clearing.”

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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SECURITIES LENDING

EU and the US. According to Lees, at present roughly 40% of BBH’s lendable assets are currently derived from third-party sources.“Investors are seeking out customisation, diversification and transparency, and are increasingly taking different approaches to market—now more than ever there is room for specialised providers.”

A bundled approach prevails

John Arnesen, head of agency lending, BNP Paribas Securities Services. “When the market is finally developed, it is likely to be an exchange-based adoption of the service, using a central counterparty structure.” Photograph kindly supplied by BNP Paribas, January 2012.

As beneficial owners seek plausible opportunities in Asia and elsewhere, they are more likely to be drawn to those areas with a strong regulatory policy.“The enactment of temporary short-sale restrictions, for example, would likely cause investors to ‘trade away,’” says Lees.“In regions that have demonstrated a clear, consistent approach, however, investor confidence has been much higher.”

In Asia, demand remains strong for structured and derivative-type products that require that the underlying equity be borrowed for hedging purposes. This bodes well for the region’s securities finance business, says Arnesen.

“For example, Hong Kong gives retail investors opportunities to enter the market from the short side, which in turn fuels the demand to borrow.”

Compared to their counterparts in Europe and elsewhere, Asian regulators often take a more collaborative approach to working with the market in an effort to establish practical solutions.“Some of the negative perceptions of short selling in Europe for example, where politics appear to have entered the fray, do not emerge in Asia where a longer-term, more considered view prevails,” offers Arnesen.

In the past, the custodial provider has typically served as the securities-lending agent essentially by default.

However, in the wake of the financial crisis and an increased focus on counterparty risk, more beneficial owners are looking to use best-in-class providers, suggests Lees. This has led to increased unbundling of securities lending from the parent custodian, particularly within the

62

In Asia, the bundled approach remains the primary route to market, and is perhaps indicative of the region’s relative stage of sec-lending development.“However, as beneficial owners strive for additional value in terms of revenue, enhanced risk management and transparency, we will likely witness a similar trend towards the selection of providers based on their merits rather than on a custodial or other relationship,” suggests Lees.

According to Arnesen, unbundling in Asia is typically driven by the requirements of the beneficial owner and whether the model offered by the incumbent custodian can meet their needs, rather than the type of asset available for lending. Moreover, there may be very practical constraints in some markets, where operational considerations hamper the ability to deliver assets for lending purposes when instructed by a third party.

“As new sources of supply emerge in the region, it will be interesting to see whether that development leaps ahead of the evolution that took place in the West, whereby custodial lending was the primary route to market prior to the emergence of third-party lending within the past decade.”

“As Asia becomes increasingly relevant to the global economy and its capital markets mature, we expect to see increased opportunities for SBL growth across the region.”

Brian Lamb, chief executive officer of New York-based EquiLend, a provider of trading and operations services for the securities finance industry, agrees that the regulatory differences that exist within Asia have led to a much slower and more thoughtful approach to the development of a lending industry. “Hong Kong, for example, decided years ago that all lending transactions must occur on-exchange, which is something that is fairly unique on a global basis.

The fact is that players in the region have been heavily influenced by what has been going on in the EU and the US. Hence, many have erred to the side of caution,” he says.

Prudent though they may be, government leaders understand the link between securities finance and enhanced market efficiencies.“You need to have a fluid paradigm so that prices don’t just move in one direction,” says Lamb.

“There’s a feedback loop, if you will, that helps to keep that in check—and that is a major part of what financing and lending brings to any marketplace.”

Can “over-regulation” cause participants to seek opportunities elsewhere? Case in point: just four years ago,

FEBRUARY 2012 • FTSE GLOBAL MARKETS

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SECURITIES LENDING

Australia ranked third in global securities-lending activity.

By 2009, however, the global-market unravelling had prompted the Australian Securities and Investments Commission (ASIC) to enact a nine-month ban on short selling, and since that time many of the country’s regulatory measures have been among the toughest in the world—so much so that some managers have chosen to bypass the region altogether.

Not that those regulators are about to soften their stance because it might be good for business. Despite incessant

demand from outside investors, India refuses to embrace an over-the-counter model, while Japan, home to the world’s second largest financing market, remains a sleeping giant. Experts like Lamb, however, believe that it is just a matter of time until many of these markets begin to open up, and are using this down time to prepare for the various opportunities that lay ahead.

“Our platform is all about bringing efficiencies to data transmission, be it trading, post-trade, mark-to-market, margining or billing,” says Lamb.“Which is why we remain

ONE TO ONE: FRANCESCO SQUILLACIOTI

CONTINUING TO MAXIMIZING ASIAN GROWTH In a Face to Face Q&A with Francesco Squillacioti, senior managing director in State Street's Securities Finance division and the Asia-Pacific regional business director. The Asian securities lending business has enjoyed several years of dynamic growth, accelerating more rapidly in the last couple of years. Squillacioti highlights the continuing and general air of optimism on both sides of the securities lending business in the region, involving activities within the actual lending markets as well as activities among the beneficial owners in the Asia-Pacific.

F T SE GLOB AL MAR K ET S: W ha t are t he m a in dr iver s o f len ding in t h e re gio n ?

FRANCESCO SQUILLACIOTI: Being such a diverse region, the drivers really vary from market to market and the complexion of the business inevitably changes from time-to-time. That said, in general, a lot of corporate activity – IPOs, mergers, capital raising, etc.— is fully at the heart of demand. I’d love to be able to predict the coming year, but it is particularly tough to call. Despite the past year having ups and downs, we’ve seen some strong performance from some of the markets, and overall, I feel that Asia did pretty well. If there is some stability this year and a continuation of corporate activities, along with our ability to continue to work effectively with beneficial owners, I would like to look forward to at the very least a reasonable year.

F T SE GLOB AL MAR K ET S: Ho w is loc a l re gu lat o r y refo r m im pac t ing o n t h e m a rk e t ?

FRANCESCO SQUILLACIOTI: For the most part, regulatory reform has been relatively positive in the Asian markets. Again, it’s not a single, homogeneous market so it varies from location to location. Asia is in a situation where there are developed securities lending markets and developing securities lending markets. We see some markets that have been established for a few years making continual tweaks and improvements. I think of markets such as Taiwan in this category. They have continued to make refinements to their lending model.

Other markets are reviewing changes to existing models to make them accessible to offshore participants. Then, there are markets that are just beginning to explore

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implementing securities lending, such as China. So there is always plenty happening. Additionally, there are still many markets that are yet to implement lending.

FT SE GLOBAL MARK ET S: Asia seem s to be a tw o-t ier m ark et : est ablished and em bryonic. How does t his dynam ic im pact on the provision of securities borrow ing and lending services (SBL)?

FRANCESCO SQUILLACIOTI: It has a big impact.

Established markets tend to be smoother, but the trade off may be lower spreads than less established markets.

The less established markets, by virtue of their newness, could (but not always) vary from established protocols and require more individual attention, which can require extra effort from trading as well as operations, etc. At the same time, I would also say that this same dynamic applies to new beneficial owner types or markets where beneficial owners are just beginning to participate in securities lending. There can be substantial work required to engage these beneficial owners, to do the appropriate due diligence and then enrol them into the lending program. However, while there can be extra effort in this, it is also cause for encouragement since it represents the possibility of expanded opportunities for us across the region: new potential markets and potential clients, which will keep us busy.

FT SE GLOBAL MARK ET S: Of t he local beneficial ow ners involved in lending, are t heir k ey securit y requirem ent s t he sam e as in Europe or t he US? FRANCESCO SQUILLACIOTI: It truly is a case of all clients having different requirements. While there are

FEBRUARY 2012 • FTSE GLOBAL MARKETS

very focused on Japan, which clearly has a tremendous amount of data activity, given the size of its financing market. Right now we are close to bringing aboard some of the country’s top trust banks, which we believe will greatly boost our standing in the regional marketplace.”

Among EquiLend’s most recent innovations is a tradeoptimisation service suite, which allows clients to pool long and short assets and includes limits based on existing bilateral relationships, with the ultimate goal of providing complete optimisation of securities transac-

tions on behalf of the pool’s contributors. Already a stateside success, EquiLend has set its sites on bringing the platform to other regions, including Asia. A recent run of trade-optimisation in Hong Kong proved enormously successful, totalling some $45m in trade securities. “Obviously we’re excited to see that kind of activity take place,” says Lamb.“The market appears very willing to embrace new strategies, and we think this type of programme can create some interesting opportunities within the region.” I

opportunities, and I see them around the region. Some opportunities come from the size of the region; others come from the fact – as we discussed earlier – that there are nascent markets and some not even quite there. In terms of speaking with beneficial owners of assets, we continue to see across the region interest in securities lending and active engagement about securities lending. We are also seeing various developments in markets across the region that will, we hope, open up even more lending markets for us. Just the other day, for example, there were some positive changes announced in Malaysia. Our job then is to make sure that we are ready to take advantage of the changes, and that we are covering the markets, clients and potential clients well. I think we’ve done pretty well with that so far.

many commonalities, I would say there are probably variations between clients in the region and in other parts of the world–even considering similar client types globally.

The client base ranges from insurance companies, investment funds, and asset managers, to banks, pension funds and official institution type clients. They each have different ways of approaching securities lending, different expectations and requirements. I would say, though, is that most clients are quite focused on risk management, transparency and returns. On this point, I feel that we are well positioned, as we have always offered a program that placed a very high degree of emphasis on risk management and transparency. I think clients have appreciated this focus quite a lot, especially over the past few years. We focused on working closely with clients to provide a compelling lending program tailored to their requirements, and allowing them to access information about the program.

FT SE GLOBAL MARK E T S: Where do yo u see ne w o ppo rt u nit ie s in secur it ies lendin g in Asia?

FRANCESCO SQUILLACIOTI: The market is full of

FTSE GLOBAL MARKETS • FEBRUARY 2012

F T S E GL OBA L M ARK E T S : Ho w do es t h e de velo pm e nt o f t h e sec u rit ie s fin a nc e m a r k e t in Ch in a do vet a il in t o t h is visio n?

FRANCESCO SQUILLACIOTI: It’s most definitely a market of interest for us, as I’m sure it is for many others. While there is no offshore market for securities lending, the establishment of an onshore market for domestic participants is directionally quite encouraging.

It’s difficult to predict when there will be an offshore market, and I would think that the regulators would want to get comfortable with the construct and then expand it. The indications are that it will be a market worth waiting for, and so, it’s an opportunity that we will certainly continue to gauge and watch.

F T S E GL OBA L M ARK E T S : Are m a r k e t s su c h as K o re a, Ta iw an livin g u p t o e x pe c t a t ion s?

FRANCESCO SQUILLACIOTI: In a word, yes. These are examples of newer markets for securities lending. Korea isa bit older than Taiwan and both have performed quite well. We have been actively working on the trading side with these markets to find as much value as possible.

We’ve also been engaging beneficial owner clients quite regularly about opportunities in these diverse markets. I

65

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FUND ADMINISTRATION

Photograph kindly supplied by Dreamstime.com, January 2012.

RAISING THE STAKES IN FUND ADMINISTRATION The financial crisis has created new business opportunities for European fund administrators, the green eye-shade bean counters who crank out valuations and account balances for everything from UCITS-qualified mutual funds to hedge funds and private equity vehicles. Lower market values have clipped asset managers’ revenue, forcing them to re-examine costs and focus on their highest value-added skills in research, trading and portfolio management. They are hiring fund administrators to take over middle office tasks, including risk management reporting and compliance, which used to be handled in-house but were never the managers’ core competency.

It’s a win for both sides: the managers get an essential service at lower cost thanks to the administrators’ economies of scale, while the administrators book incremental revenue at higher margins than their core business, reports Neil O'Hara.

LIENTS ARE DEMANDING more from administrators in their traditional role. Philippe Ricard, head of asset and fund services at BNP Paribas Securities Services, says investors and managers now insist on independent pricing of OTC derivatives and other illiquid securities. Valuations have become more frequent, particularly for managers that have launched UCITS-qualified funds employing investment strategies similar to their principal hedge funds.

As a result, BNP Paribas built ample processing capacity and has long been able to handle short positions as well as long. “The incremental cost of higher volume is very limited because of our design,” says Ricard, who notes that other fund administrators may not be so fortunate.

The cost varies among clients depending on their own systems capabilities, too. If a manager uses a distributor that cannot send subscription and redemption information

C

FTSE GLOBAL MARKETS • FEBRUARY 2012

electronically, or the client does not use BNP Paribas’s tools for work flow, then the administrator bears higher costs for which it will charge—provided the market is receptive. “It is important to create incentives for efficiency,”says Ricard. “I will offer the best rate for an efficient client, one willing to improve with us. For a less efficient client, I will provide a fee structure that shows the difference between what it pays now and what it could pay if it were more efficient.”

Increased workload Administrators are no longer prepared to absorb the incremental costs of more frequent valuations, greater transparency, independent pricing verification and other services that have increased their workload. The bundled pricing of yore has given way to a menu of services from which clients can choose what meets their particular needs.

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FUND ADMINISTRATION

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Philippe Ricard, head of asset and fund services at BNP Paribas Securities Services. “The incremental cost of higher volume is very limited because of our design.” Photograph kindly supplied by BNP Paribas, supplied January, 2012.

Frank Froud, head of EMEA, BNY Mellon Asset Servicing in London.

“When the companies have worked out what they need, the managers will ask us for detailed solutions,” Photograph kindly supplied by BNY Mellon, supplied January, 2012.

“When a client says it wants to go from weekly to daily pricing, the answer is, ‘Of course, but there is a cost implication’,” says Hans Hufschmid, chief executive officer of GlobeOp, a fund administrator that handles $173bn of fund assets worldwide. “All the administrators are becoming more disciplined about pricing.”

While clients and investors have driven most recent changes, the European fund management industry also faces a slew of new regulations that will take effect over the next few years. The new rules typically do not apply to administrators per se, but the proposed rules will affect their clients.

In early January, for example, BNY Mellon hosted a workshop on the EU Solvency II insurance regulations in London—and found the session jammed with fund managers, who do not normally attend such events.

“Managers want to understand what data the insurance companies will demand from them,”says Frank Froud, head of EMEA, BNY Mellon Asset Servicing in London. At the time of going to press, Froud was in the last stages of his tenure in this role at the bank. His role has now been assumed by Hani Kablawi, the bank’s Middle East expert.

“When the companies have worked out what they need, the managers will ask us for detailed solutions,”says Froud. The job is tailor-made for fund administrators, who have enormous capacity to manage and massage wholesale data and deliver the results in whatever format their clients, or regulators, require.

The regulatory onslaught includes UCITS IV and the proposed Alternative Investment Fund Managers Directive (AIFMD), which Anne Deegan, managing director of SEI Investments Trustee & Custodial Services (Ireland), expects to ramp-up demand for risk management reporting. SEI, which has $250bn under administration worldwide including $60bn in Dublin, has a deep commitment to technology that gives the firm a competitive edge.“We need to offer clients timely risk–management reporting so that they can comply with AIFMD,” says Deegan. “We are keeping a close watch on that.”UCITS IV tightened up corporate governance for funds, including a requirement for close monitoring of OTC derivatives—and managers have asked their administrators to generate those risk reports, too.

Governance monitoring Administrators are paying more attention to corporate governance in the aftermath of a recent Cayman Islands judgement that held two fund directors personally liable for $111m of losses at the Weavering Macro Fixed Income Fund.

The case highlighted the risk for directors who serve in name only on multiple funds and routinely rubber-stamp fund documents presented to them without review. It emphasised the importance of maintaining proper books and records, too. “Administrators will have conversations with fund boards of directors to ensure there is clarity about what

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FUND ADMINISTRATION

Anne Deegan, managing director of SEI Investments Trustee & Custodial Services (Ireland). “We need to offer clients timely risk management reporting so that they can comply with AIFMD.” Photograph kindly supplied by SEI Investments, supplied January 2012.

William Slattery, head of European offshore domiciles at State Street Corporation. “The directive could create serious systemic instability in either individual or multiple markets.” Photograph kindly supplied by State Street, supplied January 2012.

services are and are not being provided,”says Deegan.“It will require more monitoring of governance on our part.”

AIFMD as currently proposed would also impose a fiduciary duty on custodians to supervise not only their sub-custodians but even the types of instruments and markets in which their clients invest, a requirement that could extend to regulated funds under UCITS V. In effect, the rule would import the European depot bank model into the Anglo-Saxon world—and pricing would have to reflect the enhanced business risk. “On a day-to-day, transactionby-transaction basis, we will have to exercise oversight,” Froud says. “If that risk is transferred to the investment services organisations instead of the fund managers, we have to tool up for that and be rewarded for it.”

Like all EU directives, UCITS V and the AIFMD will be subject to local interpretation when each member state enacts legislation to implement the directive. The directive language could change, too—the custody banks are lobbying hard to eliminate or water down the fiduciary obligations— but William Slattery, head of European offshore domiciles at State Street Corporation, worries that in its current form the directive could ratchet-up systemic risk.

Slattery is responsible for a business that administers $600bn—half in regulated funds and half hedge funds—in Dublin, and another $350bn of regulated funds in Luxembourg. He points out that if depositaries are held liable they

may feel compelled to require clients to abandon a particular market at the first sign of trouble, whether it is the financial distress of a local sub-custodian or a political threat to the legal environment. The herd mentality almost guarantees that if one leading player pulls the plug, others will follow—triggering a stampede for the exits.

“It could create serious systemic instability in either individual or multiple markets,” says Slattery. “Almost no economy is spared the potential threat.”

The markets have a poor track record of evaluating events that are highly improbable but devastating, which are almost always underpriced relative to the havoc they cause. Black Swan events occur in the financial markets with a frequency that belies their statistical probability, too.

“They are only supposed to happen once in 1,000 years,” observes Slattery,“but we have had 1987, 1994, 1998, 2000 and 2008.”

Unlike State Street and BNY Mellon, GlobeOp is not a custodian and would not be directly affected by the proposed fiduciary liability. Nevertheless, the firm has a well-deserved reputation for being able to handle OTC derivatives and other complex investment products, a skill that has attracted sophisticated clients whose investment strategies rely on these esoteric instruments.

Hufschmid dismisses the very notion that custodians could take fiduciary responsibility for hedge funds. “Ad-

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All the major players are preparing for central clearing of OTC derivatives, of course. Clive Bellows, country head, Ireland, at Northern Trust, which administers about $300bn in assets in Europe, has clients who expect clearing to go live during the fourth quarter of 2012—and he will be ready to support them. It requires a significant incremental investment in technology to handle the substitution of a central counterparty, but it also simplifies valuation and improves transparency. “It’s a fantastic idea. It will solve a lot of the issues surrounding OTC derivatives,”says Bellows.“It will go a long way to commoditising the funds that invest in derivatives and make it easier for fund administrators to move up the value chain.”

“Administrators can perhaps ensure that instruments and assets are priced independently, that reconciliations are independent and so on. It is one thing to take on fiduciary responsibility if you can monitor it completely, but it is naïve to think a custodian bank can supervise a hedge fund.”

Clive Bellows, county head, Northern Trust, Ireland. “It will go a long way to commoditising the funds that invest in derivitives and make it easier for fund administrators to move up the value chain.” Photograph kindly supplied by Northern Trust, Ireland, supplied January, 2012.

ministrators can perhaps ensure that instruments and assets are priced independently, that reconciliations are independent and so on,” he says. “It is one thing to take on fiduciary responsibility if you can monitor it completely, but it is naïve to think a custodian bank can supervise a hedge fund.”

The ability to handle anything a hedge fund wants to trade comes at a price to the client: GlobeOp fees run about 12basis points (bps) on average, compared to the industry norm of 6bps-7bps. Net margins are nowhere near double those of its competitors, however; the cost of administering complex instruments is higher than average and Hufschmid says the firm’s clients are “very demanding—the most demanding set of clients you can imagine in any industry anywhere”. The forthcoming shift to central clearing of most OTC derivatives will have a disproportionate impact on GlobeOp relative to its competitors but Hufschmid does not foresee any difficulty in making the transition. GlobeOp already uses DTCC’s matching service for credit derivatives trades, which operates like a clearing house but without the central counterparty guarantee.“One of our core competencies is fully functioning data pipes to all the different service providers: data vendors, exchanges and other trading venues,”says Hufschmid.“It will be just another pipe for us.”

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The ever-increasing demands for technology capacity and capability tilt the playing field in favour of large administrators who already operate on a global basis. The required investment is driving industry consolidation, too.

For example, Northern Trust bought Bank of Ireland’s security services business last year, which added $100bn in assets and the ability to service exchange-traded funds. The business was sound—clients have begged Northern Trust not to alter the legacy client service ethos—but lacked scale, and the Bank of Ireland no longer had the balance sheet strength to support it.

Northern Trust also bolstered its ability to service hedge funds when it picked up Omnium, a $70bn administrator that was sold by Citadel, a Chicago-based hedge fund.“The bigger providers who already have good technology in place, the resources to continue to invest and a strong balance sheet, will be the winners,” says Bellows.

Acquisitions have become the easiest way to bring in new clients in the current environment. The more middle office functions fund administrators perform, the deeper they are embedded in clients’ infrastructure and the harder it is for clients to contemplate a change.“A huge amount of our growth does come from our existing clients,” says Bellows. “Without a doubt, the number of managers looking to change providers has decreased. It is done only as a matter of last resort.”In fact, the best new client opportunities do not even originate in Europe: they are non-EU fund managers seeking to set up UCITS funds in Europe— which is why Bellows’ sales team now pitches primarily to managers in the United States and Asia.

In today’s European fund administration market, the global leaders stand to inherit the earth—and the meek to be swallowed whole. I

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TRADING IN AUSTRAILA Photograph kindly supplied by Dreamstime.com, January 2012.

A CHANGE FOR THE BETTER? ASX’s competition settles in Australia’s equity trading market has been through two form-changing years and last year began with ASX, the national stock exchange, in merger talks with the Singapore Stock Exchange (SGX).

Although that particular marriage failed before any vows could be taken, 2011 ended with the introduction of direct competition for ASX with the launch of Chi-X Australia. It marked the end of Australia’s monopolistic trading structure. The SGX deal was blocked by an Australian government running scared of change. Nonetheless, the exchange faced up to the inevitable even when the country’s politicians couldn’t bear to and ASX accelerated improvements to its platforms in preparation for the new trading landscape. Ruth Hughes Liley reports on the current status of a market in transition.

OR ITS PART, the Australian stock exchange (ASX) was disappointed the attempted merger with the Singapore exchange (SGX) was unable to proceed. ASX chairman David Gonski noted at the time:“We believed strongly in the merits of the proposal, but we have moved on. I do not want to appear over confident. ASX is taking nothing for granted ...

Like a sporting coach, I know our preparation has been excellent and I have confidence in our team’s ability.”

The inevitable tipping point towards irrevocable change came near year end when Chi-X Australia received approval

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to start up operations in November 2011. On day one 22 brokers signed up to use the system. Volumes rose rapidly and by the end of November the newcomer had achieved a peak market share of 2%. According to data vendor Thomson Reuters, during its first full month of trading in November, Chi-X Australia traded $757m worth of Australian equities, giving it a market share of 0.88%. The ASX accounted for the remaining 99.12%, trading $85.1bn.

After that, average volumes fell and settled at just below 1%, although some individual stocks are taking more than

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3% market share, according to the Fidessa Fragmentation Index. The platform opened with eight stocks in a weeklong soft launch and now trades all ASX 200 names. ChiX Australia chief operating officer Peter Fowler believes the platform will gradually gain traction: “There were two reasons for the downturn. The euro debt crisis has taken a lot of liquidity out of the market and December and January are the holiday season here. We expected volumes to fall, but at the end of the first quarter (Q1) this year, we would like to think we will have a good story to tell.”

In order to draw business to the Chi-X Australia platform during 2012, Fowler will be “going off-shore and knocking on a few doors in Asia and trying to attract overseas players”. He adds: “We are encouraged by the response we have received and hope to see more international business coming into Australia.”

The launch of Chi-X Australia had been expected for at least two years and ASX has used the time to reorganise and upgrade its services. ASX also benefits from Chi-X Australia using its ASX Clear and ASX Settlement facilities.

Even so, switching from the Australian Securities Exchange’s post-trade services to a third-party offering is reportedly on Chi-X Australia’s longer-term agenda.

An over-brokered market: what now?

Elsewhere in the business, the exchange has reduced its fees and now runs three platforms: TradeMatch for its traditional trades, PureMatch for high-frequency flow and VolumeMatch for block trades. It has also improved its system performance: TradeMatch is ten times faster than its predecessor and can manage around 100,000 messages a second, for example. However, with trading volumes remaining low, brokers are saying that PureMatch is not drawing the liquidity expected in spite of its lower introductory pricing schedule. ASX itself is not expecting volumes to develop on PureMatch until after February 2012 when it launches a new co-location facility called the Australia Liquidity Centre and when more of the broking community is connected.

There is substantial competition in the country’s securities broking industry. The top 12 ASX market participants accounted for 81% of the value of equities traded in 20092010, according to a recent Fidessa whilepaper. “The Australian equity market compares well against its international counterparts. It is comparatively liquid and displays a relatively early adoption of innovation and technological development. However, the costs of trading in local markets remain higher than in other jurisdictions,” says the paper.

ASX’s regulator, the Australian Securities and Investment Commission (ASIC), gave brokers 12 months from the launch of Chi-X (until October 31st 2012) to set up best execution systems, a breathing space which Fowler welcomes: “We have seen a number of firms which are keen to build up their routers as quickly as possible and to be able to tell their clients they are ahead of the game and can offer best execution. Others will drag it out and it could be August, September or October before they

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Peter Fowler, chief operating officer, Chi-X, Australia. “We expected volumes to fall, but at the end of the first quarter (Q1) this year, we would like to think we will have a good story to tell.” Photograph kindly supplied by Chi-X Australia, supplied January 2012.

implement smart order routing. As more and more flow gets switched on, we should see our market share and volumes increasing. It is all part of the story to tell.”

Apart from around ten top-tier brokers and a similar number of larger regional and local firms, there are about 80 much smaller brokers with a combined market share of approximately that of UBS, one of the leading brokers in the country. It is these smaller brokers who are expected to have difficulty meeting the new regulatory requirements.

“With so much change in the underlying marketplace, offering clients familiar trading tools is important. Clients who already rely on and are familiar with the IRESS suite of products will find the transition much easier.”

Instinet’s Kym Graham, head of Asia-Pacific sales, exJapan, agrees: “It is no secret that Australia is a very overbrokered market and it is becoming hard for the smaller ones. There is the cost of increased capital requirements, fees for regulators and low market volumes. Niche players, including some mining specialists for example, will

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survive, but if you are one of the smaller general brokers it could be tough.”

Equally, buy side firms are investing in more sophisticated execution management systems and better trading analytical tools to make sure they are getting the right price.

UBS’s head of direct execution in Australia, Steve Hammerton, says: “You either build your own, buy from a vendor or outsource. That is what we saw after the introduction of competition in Europe with MiFID. The sheer capacity of IT projects at the end of 2011, including co-location, PureMatch and Chi-X, meant brokers were stretched to keep up with all the technology requirements. The costs of all these changes are quite material and if you are one of the smaller brokers it will seriously impact your profitability.”

The bulge-bracket banks have imported the technology that they currently use in Europe and the United States.

However, competition is heating up among the vendor community and IRESS, the market data vendor and the dominant supplier of technology to the local broker market, implanted its own smart order router called Best Market Router (BMR) in its system in September 2011.

IRESS announced a special pricing structure in October 2011 to attract clients to its systems, offering the BMR for free for 12 months for anyone using its standalone trading terminal. IRESS managing director Andrew Walsh says: “With so much change in the underlying marketplace, offering clients familiar trading tools is important. Clients who already rely on and are familiar with the IRESS suite of products will find the transition much easier.”

Meanwhile, SunGard is a certified vendor of its Valdi connectivity services and smart order router to Chi-X Australia, and Fidessa has already teamed up with ASX in providing the technology for ASX Best, the exchange’s router. ASX Best will be located in ASX’s new data centre, the Australian Liquidity Centre, and will be distributed nationally through ASX Net, a low-latency, high-capacity fibre network linking participants to all Australian displayed venues, including ASX and Chi-X and to ASX’s VolumeMatch. Until the deadline of October 31st this year there is no obligation to route orders for best execution.

Georges Kunovski, of SunGard’s capital markets business, says: “Brokers are waiting to see where to spend their technology budgets. The market will move towards electronic trading, but because technology takes some time to install and implement, we will have to start seeing changes by the summer or ASIC may have to extend the deadline for compliance.”

Uniquely Australian game As to whether other venues will appear in 2012, Kunovski says: “The Australian market is unlike Europe because most equity trading is still conducted manually, especially in the larger local brokers. It’s not the same game for ChiX Australia as for BATS Chi-X Europe. It might take another year before any other venues come online. ASX has had a monopoly for so many years that Chi-X’s trading volume has barely started to increase but it has only been three months and that is really no time at all. I think

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“We have seen a number of firms who are keen to build up their routers as quickly as possible and to be able to tell their clients they are ahead of the game and can offer best execution. Others will drag it out and it could be August, September or October before they implement smart order routing.

As more and more flow gets switched on, we should see our market share and volumes increasing. It is all part of the story to tell.” venues still have time to move on this.” Fowler adds: “Any new entrants will be watching what happens with Chi-X over the coming months. If it proves to be a roaring success, then we could expect to see someone coming into the market.”

In October 2011 ASIC began a second consultation into Australia’s equity market structure, looking into automated trading and high-frequency trading, volatility controls, enhanced data, best execution and pre-trade transparency and price formation, including in dark pools. Proposals include exemption for trades from pre-trade transparency within certain liquidity limits, from AUD200,000 to AUD1m. The current threshold is AUD1m. Firms have until February 10th 2012 to submit their views.

Lower latency and higher frequency In the drive for faster trading, ASX’s co-location facility three miles north-west of Sydney opens for business on February 6th this year. Among the firms already installing equipment are UBS, Instinet, Goldman Sachs, Citi and Deutsche Bank as well as IRESS, Fidessa and BT on the vendor side and high-frequency Japanese IT service provider KVH. KVH claims to offer the lowest latency network in Japan and has 450 financial services customers. In ASX’s data centre it will be able to offer high-frequency trading between Tokyo and Sydney, and Richard Warley, president and chief executive officer of KVH, says: “ASX and KVH will address the needs of those in high-frequency trading and will contribute to the expansion of transaction volume and the improvement of market liquidity by helping more trading participants enter the markets in Japan and Asia.”

High-frequency traders currently account for a small percentage of cash equity turnover in Australia compared with estimates in the United States and Europe. Nonetheless, explains Matthew Gibbs, ASX’s general manager of media and communications: “High-frequency trading is a feature of the environment in which we operate, shaped by the market structure determined by government. ASX is responding to HFT—as we must as a commercial entity with a new domestic competitor—and also working to preserve the traditional functions of exchange markets, which remain important to many ASX stakeholders and the Australian economy generally.” Trade sizes have already started coming down with

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“The Australian market is unlike Europe because most equity trading is still conducted manually, especially in the larger local brokers. It’s not the same game for Chi-X Australia as for BATS Chi-X Europe.

It might take another year before any other venues come online. ASX has had a monopoly for so many years that Chi-X’s trading volume has barely started to increase but it has only been three months and that is really no time at all. I think venues still have time to move on this.” are looking at the number of messages and trades and recalibrating their strategies because they are not as profitable any more. The message to trade count is five to one in Australia, compared to Canada where it is around 70 to one. The reduction in HFT is an unintended consequence of the fee.”

Liquidity: the perennial issue

Steve Hammerton, UBS head of direct execution, Australia. ““You either build your own, buy from a vendor or outsource. That is what we saw after the introduction of competition in Europe with MiFID.” Photograph kindly supplied by UBS, supplied January 2012.

the Chi-X and high-frequency trading effect. The average trade size is down 21% from AUD8,450 in December 2010 to AUD6,700 in December 2011.

Nonetheless, some are sceptical about how quickly HFT will take off in Australia and although trading costs have come down, clearing costs are higher, meaning that firms will require a higher return with a higher turnover.

Another discouragement is that the regulator ASIC has mandated uniform tick sizes, although Chi-X Australia’s Fowler says: “This does not necessarily mean that there won’t be arbitrage opportunities. Since our launch we have seen both arbitrage opportunities and spreads wider than one tick.”

A further impediment could be in the much higher supervision and market surveillance cost recovery fee imposed on the cash equities market by the Australian government from January 1st 2012. It has soared from around AUD4.5m between July and December 2011 to AUD26.53m for the 18 months from January 2012 to June 2013, although some of the cost will be deferred. While 14% will be split between ASX and Chi-X, the burden of the remaining 86% will be borne by brokers.

With the fee based partially on the number of messages sent, UBS’s Hammerton says: “A lot of the HFT operators

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While increasing sophistication has certainly increased costs for all participants, finding liquidity remains the number one requirement of institutional traders and is increasing the importance of dark pools for domestic institutions. The number of non-displayed crossing systems in Australia has trebled since 2009 to 15, according to ASIC, although just three systems account for more than 70% of total crossing system turnover. In June 2011, $2.84bn was executed through these registered crossing systems, representing around 3% of total Australian equity market dollar trading value.

During that month, Instinet launched its BLX dark liquidity pool in Australia. BLX aggregates multiple orders from both buy and sell side participants, including both passive block traders and algorithmic traders, and consolidates them into block-sized trades. “Aggregation is also becoming an important tool for domestic institutions who want better work flow solutions to access dark,” says Graham.

Comparing December 2010 with December 2011, Hammerton says that the value crossed on the ASX went down from 27% to 24%. However, volume in UBS PIN, its internal non-display liquidity pool, which does not allow access for high-frequency traders, has grown over the same period.

Onlookers are watching to see whether competition will also develop in the clearing and settlement space in 2012, as it is currently run by ASX. Fowler says: “The regulators will have looked at Europe, where there is a lot of attention on interoperability. There will hopefully be more change here. We are very conscious that ASX has a number of lines of business and it is able to switch revenue from one business to another but they will be conscious of the concerns of the competition authorities. If ASX is facing competition in clearing it will be better for all of us.”I

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TRADING IN LATIN AMERICA Photograph kindly supplied by Dreamstime.com, January 2012.

Investing and buying stocks in Latin America has traditionally been considered a risky business.

In the south, Argentina’s infamous currency problems at the turn of the century blighted investment in emerging markets and in Mexico to the north, 13,000 murders in just nine months of last year point to social unrest. In spite of this, other statistics paint a different picture; one of growing investor confidence. Brazil’s central bank has reported surging net month dollar inflows during 2011 including the second highest on record in July at $15.83bn. The region’s rich commodity base has brought investment. Furthermore, a young population—a quarter of the people in Brazil, Colombia and Mexico are aged under 15—will drive home demand. Ruth Hughes Liley reports on the key trends impacting on equities trading.

LATIN AMERICA TRADING: it’s written in the stars HE ECONOMIC FUNDAMENTALS in Latin America are relatively decent, holds Nick Robinson, director and head of Brazilian equities at Aberdeen Asset Management, which has seven dedicated funds in the region. “The countries’ balance sheets are in pretty good shape. If there is a slowdown led by developed markets, these countries have a lot of firepower to boost their economies. For example, Brazil’s interest rates are 11.5%, so there’s a lot of scope for reduction. Even Chile, Colombia and Peru have rates close to 5%,”he says.“From a top down perspective, there is a large population entering the middle classes and driving demand.

If you look at Brazil, exports are only 10% of GDP, a lot smaller than people think and domestic demand is growing,” adds Robinson.

In step with the global slowdown, growth rates across the region tailed off in 2011. Brazil, the fourth-largest emerging market, grew its GDP 9.3% in the first quarter (Q1) 2010, falling to around 3.5% at the close of 2011.

However, Argentina still reached more than 8.5%, and in 2012, Chile, Colombia and Peru are forecast to lead the region with rates averaging more than 4%—far higher than the West’s recessionary rates. With the stage set for further investment, global investment banks are once again setting up shop in the region, exchanges are flexing

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their muscles and the more regional, local banks are feeling the competition.

Philippe Carré, global head of connectivity for SunGard’s capital markets’ business, indicates three types of firms which are active in Latin America. “There are small local brokers, strong in retail and without international ambitions. There are other strong brokers who are the gateway for international firms to trade. Then there are bulge–bracket investment houses which are coming back big time. They see Latin America becoming [part of the] mainstream and they want to bring liquidity to the region.”

Bulge-bracket stalwart Morgan Stanley’s electronic trading business, for one, has grown “very aggressively” in terms of revenue and number of clients, says Rupert Fennelly, head of sales, Americas, Morgan Stanley Electronic Trading group, who says the bank has taken an organic approach to business build in the region.“We have just moved someone to Brazil specifically for our electronic business,” he adds.

UBS meantime, which has nine offices in South and Central America, including Panama, has taken a somewhat different tack, having bought Brazilian financial services firm Pactual in 2006. Three years later, feeling the effect of the financial crisis, it reduced its involvement in the region, selling Pactual to BTG Investments for approximately

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$2.5bn. Now, it is once more gearing up to raise its profile in the region, which it sees as offering opportunities for growth in its investment banking and asset and wealth management businesses.

Goldman Sachs also has offices in Argentina, Mexico and Brazil, where it has grown from 30 staff in 2007 to 300 now.

According to a spokesman at the bank: “We are spending a lot of time and energy in expanding, particularly in the BRIC markets: Brazil, Russia, India and China. The company is targeting growth markets as a strategic priority.”

Alberto Ramos, managing director and co-head of Goldman Sachs’ Latin America Research, talks of Latin America as far from a homogenous reality: “There are two economic faces. We have a set of countries pursuing relatively disciplined policies and which are pursuing private investment—Brazil, Chile, Colombia, Mexico and Peru—and where the central banks are committed to pursuing low and stable inflation. On the other side of the factor we have countries where there is still a business-unfriendly policy mix that is a deterrent to private and foreign investment.”

Positive general trend Nonetheless, globally, foreign investment rose to an alltime high of $96trn in 2010, according to Cap Gemini. In Latin America, assets under management of buy side firms stood at $1.3trn. The general trend remains positive, though Robinson points to the sometimes skittish nature of foreign investors in the region. He says:“It is harder to tell what will happen in the short term, as that is driven by liquidity and fund flows from foreign investors, and because the region is seen as more risky, foreigners tend to take money out of the market when things turn down at home.”

Even so, according to Fennelly, Morgan Stanley is seeing growing interest among Brazil-based asset managers and hedge funds as well as substantial growth in flows from US and European investors into the region.

With the renewed interest in the region, the exchanges have risen to the opportunities presente. BM&FBovespa, Brazil’s exchange, is the third-largest in the world in market value and during 2011 set a new market cap record in its equity market of BRL1.61trn. It will shortly complete the first phase of the launch of its new high-speed Puma trading system, moving derivatives based on stock indices to the new platform. Phase two will see equity and equity derivatives migrate and finally fixed income government and corporate securities.

Not to be outdone, the Mexican stock exchange (BMV) is scheduled to launch a new high-speed platform supportive of cross-asset trading, migrating equities in May 2012 and derivatives in the second half of this year. It will be one of the fastest in the world, able to process 200,000 transactions a second, claims the exchange, and Aite Group estimates it could spur a growth of 15%-20% in penetration of equities high-frequency trading.

Other platforms are waiting in the wings. Direct Edge, owned by a consortium including the International Securities Exchange, Knight Capital, Goldman Sachs and JP Morgan, plans to launch Direct Edge Brazil in Rio de Janeiro

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Nick Robinson, director and head of Brazilian equities at Aberdeen Asset Management. “The countries’ balance sheets are in pretty good shape. If there is a slowdown led by developed markets, these countries have a lot of firepower to boost their economies.” Photograph kindly supplied Aberdeen Asset Managements. January, 2012.

in Q4 2012. Meanwhile, a year ago BATS partnered with Claritas, a Brazilian hedge fund, to look into creating a new stock exchange with clearing and depository services.

However, in Brazil, clearing and settlement are controlled

by BM&FBovespa and onlookers are uncertain whether they would be willing to open up that market to competitors. In November, for example, it signed a contract with a Swedish technology company for a new real-time clearing system to be implemented in 2013. It intends to market the system in the future to “strategic partners”.

“There are two economic faces. We have a set of countries pursuing relatively disciplined policies and which are pursuing private investment—Brazil, Chile, Colombia, Mexico and Peru—and where the central banks are committed to pursuing low and stable inflation.”

Outside Brazil, May last year saw the launch of Mercado Integrado Latinoamericano (MILA), the integrated Latin American market, a new marketplace with direct order routing between Colombia, Chile and Peru, allowing traders in one country also to trade stock on either of the other two exchanges—a total of more than 550 listed stocks. This will allow diversification of portfolios as Peruvian traders will be able to trade Columbia construction firms, for example.

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Rupert Fennelly, head of sales, Americas, Morgan Stanley Electronic Trading group. “The bank has taken an organic approach to business build in the region. “We have just moved someone to Brazil specifically for our electronic business.” Photograph kindly supplied Morgan Stanley. January, 2012.

Philippe Carré, global head of connectivity for SunGard. “There are small local brokers, strong in retail and without international ambitions. There are other strong brokers who are the gateway for international firms to trade.” Photograph kindly supplied by Sungard.

January, 2012.

Mexico has signalled its intention to join the network and some believe Brazil is also interested. With a combined market capitalisation of $654bn, MILA has overtaken Mexico as the second-largest market in Latin America after Brazil, although the global slowdown has not helped volumes. In its first four months it traded just $2.9m, according to Bloomberg, a fraction of the average volume traded on Bovespa of BRL142.33bn in October 2011 alone.

Apart from MILA, individually the three countries’ exchanges are also expanding and later this year, Colombia is hoping to make currency and equity index futures available while Peru hopes to launch a futures market.

Carré explains: “MILA is a basic technology link but its significance is that it has allowed Chile, Colombia and Peru to put their three exchanges on the international map.”

Carré believes that if MILA begins to gather pace, attracting international volumes, the future could see common trading platforms, common clearing houses and even a common regulatory framework.“You have the start of a panLatin American exchange. It is going to take a lot of time— they are different countries, different regulations and political structures—but what MILA has put on the table is the potential,” he says.

There are two ways of trading in Latin America: through local brokers or through global brokers which have a presence in a country. Most countries have no remote exchange membership, meaning that investment banks

have to be located in the country and accepted by the local regulator before being able to trade. This has helped local brokers, who have much to lose in competition with the global investment banks and so are positioning themselves strategically. Foreign investors only need a presence in one of the three MILA countries in order to trade.

As more international investors want exposure to Latin American markets, the networks in and out of the markets become more important. So 2010 and 2011 saw a stream of order routing agreements: Fidessa is providing technology linking Chilean brokers IM Trust, NASDAQ OMX and Bolsa Electronica de Chile have linked up and the Santiago Stock Exchange has selected technology company StreamBase’s complex event processing to deliver algorithmic trading solutions for Chilean brokers.

Furthermore, CME Group, Mexico’s stock exchange and MexDer, its derivatives exchange, have set up an order routing agreement while CME and BM&FBovespa have had a similar agreement since 2009. One of the latest order routing and market data distribution agreements is between Brazil and Chile. It is expected to help develop Chile’s derivatives market and will be implemented in Q2 2012. High-tech cloud connectivity networks have also opened up the region to the world.

SunGard has set up a hub in Chile co-located with Santiago stock exchange to provide a faster route to the market through its global network.

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TRADING IN LATIN AMERICA

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Danielle Tierney, analyst with Aite Group.“This is minuscule compared to the HFT activity seen in developed markets but BM&F-Bovespa’s efforts to improve technological infrastructure have already started to unlock liquidity in Brazilian trading.” Photograph kindly supplied by Ait Group. January, 2012.

Alberto Ramos, managing director and co-head, Goldman Sachs’ Latin America Research. “On the other side of the factor we have countries where there is still a business-unfriendly policy mix that is a deterrent to private and foreign investment..” Photograph kindly supplied by Goldman Sachs. January, 2012.

Carré says: “Now if an asset manager in the US wants to trade Chile electronically, we can connect them with a firm in Chile through the cloud. Local brokers can interact with the US easily and vice versa. Chile is strategic because the arbitrage opportunities are great. Co-location has greater benefits when the market is volatile. Chile is a small market and as trading picks up then the opportunities for arbitrage in the US and single stocks become greater. It’s a long way off the developed markets volume, but if you are faster than your competitors you have an edge.”

Morgan Stanley’s Fennelly remains cautious. “Even in Brazil most of the trading is still manual and electronic trading is still at an early stage. With Brazil being a single market, you have to be stealthy and careful how you interact with the market.You have to randomise your behaviour and be smart without giving information away. You can’t just take an algo you developed for other global markets and deploy it in Brazil,” he warns.

Even so, electronic trading language is becoming standardised and Kevin Houstoun, chairman at Rapid Addition and co-chair of FIX Protocol Limited’s Global Technical Committee, says FIX is widespread and gaining traction in the region with Brazil installing a faster version and MILA built on FIX 4.4, for example.

Houstoun explains: "The adoption of FIX is important because it enables participants to invest in these markets in a more cost effective and efficient manner. This encourages

the deployment of capital, expanding market size and levels of liquidity that in turn enhances appeal to investors, thus generating a virtuous circle. Furthermore, free, open and non-proprietary standards, such as FIX, encourage competition and lay the foundations for innovation.”

HFT at a low level but growing In addition, high-frequency trading is developing and Brazil, furthest down the line, has seen HFT equity trading volumes rise to 11.5% in September 2011, according to Aite Group.

“This is minuscule compared to the HFT activity seen in developed markets but BM&F-Bovespa’s efforts to improve technological infrastructure have already started to unlock liquidity in Brazilian trading,”says Danielle Tierney, an analyst with Aite Group, who believes developing a healthy HFT community will be key to establishing lasting market depth.

She says: “Santiago’s order routing agreement with BM&FBovespa is another step in the right direction on this matter. If MILA evolves to be able to handle low-latency trading—that is, if all platforms become HFT capable, which Chile’s and Colombia’s are already, and the exchanges work to facilitate HFT participation—they will have a good chance of garnering some attention from Brazil’s substantial HFT community.”

Peru has indeed been improving its electronic trading infrastructure. In the six months to June 2011 Lima Stock Exchange grew its electronic order book by 198% over the same period in 2010, the fastest in the world, according to the World Fed-

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Nicola Egan, head of execution US and Asia, AXA Investment Mangers, says:“The alternative to investing directly in Latin American stocks is through ADRs, but they can work out expensive. The conversion rate in Brazil from a local stock to an ADR, for example, is 1.5%.” Robinson points out that regulation directs the way investing in Latin America is developing:“When Brazil removed a foreign exchange transaction tax, this had the impact of moving people back to the local exchange from trading in ADRs in the US. Colombia had capital controls until 2008, so for every dollar invested you also had to deposit a certain amount with the central bank. This restricted investment in the country.” Similarly, many buy side firms aren’t happy investing locally in Argentina because of the lack of liquidity and the difficulties in repatriating funds.

Alison Crosthwait, managing director, global market structure research, Instinet. “Clearing costs are high and far beyond the reach of short-term trading and that needs to be addressed; it is possible that the regulators will force the issue and mandate interoperability.” Photograph kindly supplied by Instinet. January, 2012.

eration of Exchanges. The high cost of clearing and settlement could make life difficult for high-frequency traders, and Alison Crosthwait, managing director, global market Structure research, Instinet, says:“Clearing costs are high and far beyond the reach of short-term trading and that needs to be addressed; it is possible that the regulators will force the issue and mandate interoperability, but it is unlikely that the exchange will lower clearing and settlement costs of their own volition.” Nonetheless, institutional traders are gearing up to take advantage of the changing landscape and Morgan Stanley has seen a steady rise in the number of hedge funds setting up in the region, evidenced by the success of its prime broking business there.

Long-term growth prospects Having said that, trading in Latin America is not without its problems; liquidity can be hard to come by. As Nick Robinson explains: “In some countries the first largest shareholder in a company is often a controlling private shareholder. In Chile, Peru and Columbia, the second largest shareholder is often one of the state pension funds. That leaves less stock available for others to invest so shares can be expensive because of the lack of free float. In Brazil, it is easier.You still tend to get controlling shareholders but most of the companies don’t also have large government pension funds as their owners too. Plus Brazil is a more equitised market with more companies to choose from.”

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“It will be the next story, but first they have to finish managing their tale of economic woes following their bankruptcy in 2001/2. It has several stock exchanges including three derivatives exchanges, different markets, complex capital laws with requirement to provide upfront capital, and capital gains tax, all of which is not very conducive to business.”

However, Carré is optimistic about Argentina’s future. “A hundred years ago, it was one of the G8 countries of the day.”

He says.“It will be the next story, but first they have to finish managing their tale of economic woes following their bankruptcy in 2001/2. It has several stock exchanges including three derivatives exchanges, different markets, complex capital laws with requirement to provide upfront capital, and capital gains tax, all of which is not very conducive to business. However, I do think people in Argentina know this and it will come back.

It’s a big country with a lot of potential.” Brazil has a better track record of corporate governance and BM&FBovespa has promoted improvement in corporate governance on the exchange. The Novo Mercado (New Market) segment of listings for companies with higher standards of corporate governance has become increasingly popular and new companies coming to market prefer to list on this segment. Robinson says this market has performed well over the past ten years. “It has created a powerful reinforcement of the importance of wellgoverned companies and once companies get better governance, they attract international investment.”

Fennelly says external factors also affect trading in the region: “Brazil is a commodity-related market, with around 60% of the market capitalisation of the Bovespa in commodity related stocks. So last year when people were concerned about a hard landing in China it was one of the main reasons, together with the eurozone sovereign debt crisis, that Brazil ended the year badly with the iBovespa index down 18%.Yet now at the start of 2012, it is up around 10%.” As to the future, he adds: “We are expecting to see continued growth in the region and Latin America is definitely a market we are committed to and excited about.”I

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FIXED INCOME TRANSITIONS

Photograph by Rolffimages, kindly supplied by Dreamstime.com, January 2012.

MANAGING RISK IN FIXED INCOME TRANSITIONS Fixed income portfolio restructures represent a significant proportion of today’s transition management business and introduce challenges specific to the asset class which require different skills from traditional equity transitions. In all cases, the transition manager should work to preserve asset value and introduce operational efficiencies. Michael Gardner, global head of transition management at JP Morgan, compares fixed income and equity transitions and highlights important points pension funds should consider before undertaking a fixed income transition.

IXED INCOME EVENTS involve many of the same processes and face many of the same challenges as equity transitions. In this regard, the overarching objective of all transitions, particularly in the current market environment, is to manage risk effectively while restructuring a portfolio. This is manifest in all stages of a transition: from the administrative and operational set-up through to trading risk and the transition’s execution methodology. Even so, fixed income transitions present unique issues, which may require different skills from the transition manager.

Whereas, for instance, equity markets typically manifest in centralised execution venues, fixed income markets are fragmented with institutions negotiating prices bilaterally for each transaction. Agreed prices can be posted publicly (for some instruments in the US on TRACE) and accessed via tools such as Bloomberg.

However many transactions, globally, remain unreported.

Fixed income execution is a labour intensive activity es-

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pecially in times of market stress. Even so, in many ways the administrative preparation for a fixed income event is simpler than for an equity event. Many emerging market bonds trade in US dollars, thereby eliminating some currency management challenges and custody account opening delays faced by equity transitions covering the same markets. Fixed income securities settlement is also streamlined, with most bonds settling through the DTCC, the Federal Reserve or Euroclear.

However, the fixed income universe is composed of different segments––typically divided into government bonds, quasi––government bonds, mortgage/asset-backed securities and corporate bonds, also referred to as credit securities. This credit segment is quite large in comparison to equities, with multiple securities per issuer, which can present both challenges and opportunities for fixed income portfolio creation and implementation.

When a fund manager requests a bond with limited availability for instance, suitable substitutes with similar charac-

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teristics, including duration, sector, and rating, can generally be found. Nonetheless, it can be problematic when other considerations have to be taken into account, such as the quality of the issuer or the age of a bond, which generally become less liquid the further they are from their issue date.

The number of bonds that have been issued and are outstanding in the market to trade is another element, affecting availability and therefore price, as well as the percentage of the issue amount that the trade size represents, because large trades in small issues are harder to execute.

Interestingly, while crossing does occur in fixed income securities it is usually less relevant than in the equity market.

In general, because of the large number of issues involved in fixed income portfolios, crossing opportunities are limited and do not offer the same market impact savings that crossing in equities can provide. For example, there are more than 1,450 bonds in issuance by various General Electric entities. The likelihood of a target manager requesting the same bond as that held by a legacy manager is small.

Don’t forget that in transition management, maximizing in kind transfers is of greater importance, especially in today’s challenging market environment. Peripheral sovereign debt concerns have also played their part in this regard, as they continue to have a knock-on effect on corporate bond valuations and spreads. In particular, bonds in the financial sector have borne the brunt of adverse market sentiment, with subordinated paper affected the worst.

This negative tone has led to wider bid/offer trading spreads which transition managers will normally seek to mitigate through greater crossing. Transition managers try to achieve this through expansive bond analysis which, in partnership with the client and the new fixed income managers, can lead to effective substitutions to the desired target portfolio wish list and corresponding cost savings.

As fixed income trades in an over-the-counter (OTC) market, and because dealers have different niches within the

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market, bond liquidity is dealer specific, depending on the market penetration each trader seeks. Some dealers will only trade in large round lot sizes, whereas some will happily provide liquidity on even the smallest flow in a normal trading environment.

The current market environment has led to many dealers running very conservative balance sheets and they tend not to buy small positions unless they are positioned to do so or are aware of specific client interest in the segment on the other side of the trade––transition managers are often able to get better bids due to the volume of trades they execute.

Assessing trading risk While bonds remain an OTC market (that is, non-exchange traded, making pricing more opaque), fixed income restructures face many of the same risk factors as equity events. To a greater or lesser degree, the following risk factors are inherent in both equity and fixed income transitions. Mitigating these is a core focus when designing the transition trading strategy.

Some factors, such as regional allocation shifts and country and currency allocation shifts, are pretty obvious and straightforward; others less so. Greater coordination and planning, for instance, is generally required across the client’s custodian, accountant and performance team, as fixed income portfolios will often incorporate more esoteric ongoing hedging and OTC positions within them.

Economic releases and earnings announcements are important in both global equity and fixed income transitions. However, economic releases have the potential to exert a greater effect on a fixed income transition, since fixed income is more sensitive to macro level decisions of governments—such as setting key interest rates and the amount of debt the country is issuing. Corporate earnings will also affect the individual equity security, the equity sector, and the bonds that have been issued by the corpo-

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FIXED INCOME TRANSITIONS

ration. Invariably then, transition managers need to consider all these elements when transitioning both equity and credit portfolios.

In fixed income accounting prices are typically sourced from third-party pricing vendors. These prices are often based on data aggregation or, in some instances, an estimated value. The achievable price will only be known when the trader goes to the market to execute. If the accounting or custody pricing within the legacy portfolio is significantly different than the achievable prices in the market than the performance will suffer a greater variance (almost always negatively so) relative to the pre-trade estimate.

Duration exposure shifts in the transition are also among those risk factors unique to fixed income transitions. The graph on the next page shows the relative value of a €100m bond portfolio that experiences a one basis point (bps) yield move. Clearly, the duration of the bond portfolio acts as a multiplying factor

It is imperative that a transition manager monitors and mitigates duration risk throughout the trading period of an event. For example, if there is a €100m legacy bond portfolio with a duration of five years moving to a target portfolio of €100m with a duration of ten years (with no in-kind transfers between the portfolios) there will be a net duration exposure of five years.

If there is a universal negative 1bp yield move across both the legacy and target portfolios, the client would experience a positive €50,000 increase in value on the legacy portfolio, but the target portfolio with the longer duration would cost €100,000 more to purchase.

In this example you can see there is a netting effect between the legacy and target portfolio moves. There would be greater exposure if the event was one sided either a portfolio liquidation or a portfolio constructions as there would be no offsetting risk exposure.

The average daily movements in some of the periphery gov-

SHOULD YOU OPT FOR IMPLEMENTATION ON A PRINCIPAL OR AGENCY BASIS? N A PRINCIPAL solution, a brokerage firm, whether related to the transition manager or not, commits capital to take client orders into its proprietary trading book. Principal trades are traditionally used when a client seeks to sell or purchase very large positions of securities, where the trade size is detrimental to the price achievable in the market if executed on an agency basis. Sourcing multiple prices leads to information leakage and the market becomes aware of positions.

A principal trade reduces market information leakage and subsequent adverse price movements for the client. The UK Index Linked market is a good example of where a principal trade can be effective.

Trade flow can be scarce on certain parts of the maturity curve due to market sentiment. The purchase or sale of large positions in the open market has the potential to adversely affect pricing.

Sourcing a principal price where the dealer takes on the risk of the basket minimizes information leakage and therefore adverse price movement. Another reason for executing a principal trade would be to achieve a guaranteed benchmark. For example, with UK Index Linked gilts it is possible for clients to request UK Debt Management Office closing prices on a given day.

In an agency solution, on the other hand, the transition manager executes in a transparent manner with a counterpart on the client’s behalf and an explicit commission is charged based on value of assets traded.

Typically, multiple quotes are obtained and the best price selected. Multiple quotes help demonstrate best execution and provide confidence around the

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bids and offers received. However, proactively obtaining quotes, rather than observing electronically-posted indications, carries the risk of information leakage, since having more parties familiar with the intended trade can influence price.

As such, for agency execution it is imperative that the transition manager targets only those counterparties most likely to transact. This experience is vital in times of market stress as pricing differentials between best and second best can be significant.

Many transition managers provide MiFIDcompliant best execution, and will use a multi-layer screening process to select dealers. Some transition managers leverage electronic trading technology that automatically sources prices contributed by market makers on various channels where dealer bid/offer prices can be tracked. This electronic discovery process helps identify which dealers are natural buyers or sellers.

For less liquid assets, some dealers will send daily runs or levels that can be used to source the active market makers in these bonds. Transition managers may categorise dealers by sector, industry and currency, and will often have a subset of dealers for GBP bonds, inflation-linked bonds and odd lots.

In any case, transition managers will use information gathered from previous fixed income mandates and will check for previous trades of specific illiquid assets with certain market makers to avoid contacting the broader dealer base. Market stress quite often means that dealers are not able to keep their electronic prices updated. This has been particularly evident in subordinated financials, where headline news can cause daily moves of more than 3%. I

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selling by market participants ernments, such as Greece, and this eventually results in have been noteworthy. dealer balance sheets When the effect of duration becoming full. For bond is also taken into consideramarkets to run effectively, it tion the potential monetary requires dealers’ balance sheets value is significant. to be available: that is, the Then again, credit shifts dealers’ ability to buy and hold can occur during the transibonds before finding a seller. In tion itself, particularly in times of market stress, dealers volatile markets. The graph become defensive and reduce (below) shows the daily balance sheet availability. asset swap spread moves of This leads to a lack of liquidity the two subsets of the in the market, and this, JPMorgan EUR Corporate combined with volatility, causes MAGGIE index (aggregate market participants to remain index of euro-denominated on the side lines since they have corporate bonds) since Mike Gardener, global head of strategy and implementation and no confidence in predicting the September 1st 2011. regional head of transition management, EMEA, at JP Morgan. next market move. Liquidity in Intraday credit spreads have Photograph kindly supplied by JP Morgan, January, 2012. the secondary market then dries recently been volatile. In a transition, you have to also take into account the possibility that up as investors sit on cash. The knock-on effect can lead to a an index might move or that there is heightened volatility longer period of trading to complete a transition event.

When the legacy portfolio contains an illiquid tail, a transition around an individual issuer.

Sub-asset class shifts are also significant risks. When moving manager should be able to offer solutions to facilitate the client between sub-asset classes it is important to manage trade requirements. During the past two years, it has been quite timing so that the client remains fully invested. For example, common for clients to experience difficulty selling subordinated to maintain exposure in a transition out of government bonds financial securities from their legacy portfolios. Some transition into credit securities, the transition manager will likely stage the service providers are able to help clients manage illiquid tails by sells to match the speed at which target securities are located. implementing some or all of the following work out solutions.

In an ongoing transition with small illiquid tails, a tranThis action also mitigates duration risk. sition manager can hold the securities in the transition account, periodically reviewing market price levels with the Tackling illiquidity Bond liquidity is a function of the original issuance size, the client, and then selling based on the client instructions. For availability of willing buyers and sellers and the availability larger portfolios an asset manager can take over the ongoing of suitable substitutes for the target portfolio. Recent market management of an illiquid portfolio and sell the securities turmoil has often resulted in periods of sustained one-sided when market conditions improve. I

DAILY ASSET SWAP SPREADS IN THE JPMORGAN EURO CORPORATE MAGGIE INDEX (January-November 2011) (an aggregate index of euro-denominated corporate bonds).

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INVESTOR DUE DILIGENCE

Investor due diligence has evolved with the growth of the hedge fund industry; what was once a short and rather perfunctory process is now detailed and highly quantitative. For instance, in looking at historical performance data, managers can no longer just provide total return since inception, but must also provide data for customised date ranges. Moreover, when providing a composition breakdown, reporting gross and net positions is insufficient, full delta-adjusted exposures are also necessary. Equally, attribution analysis does not stop at Alpha from long and short positions, but should be broken down by sector, analyst, stock selection, market capitalisation and liquidity to form a true picture of returns. Ultimately, while the hedge fund industry is still a story about people (and investors want to entrust their assets to someone they believe to be an expert with a differentiated process), the due diligence process helps provide additional clarity to the investor’s investment decision. By Patrick J McCurdy, partner and head of capital development at Merlin Securities.

ENSURING EFFECTIVE DUE DILIGENCE Even just working at a recognised firm RIOR TO THE institutionalisawith a proven ability to generate Alpha tion of hedge fund investing, lends credibility to their training. It can investment decisions and alloalso lead to a shorter due diligence cations were largely made on the process as it makes it easier for investors basis of performance numbers and to check references. Investors will speak the qualitative aspects of a fund. In to previous employers and colleagues to other words: people, process and phidetermine a manager’s exact role and losophy. Today however, to successspecific contribution to performance. fully raise capital, managers must be Investors also want to know that a able to convey their value proposimanager has a proven process in place tion, the components of their perfrom idea generation, through research formance and the risks they take to and portfolio construction, to risk manachieve that performance. In conseagement. Managers must be able to quence, the due diligence process has articulate this process to show expanded to encompass both qualitainvestors that a fund’s performance is tive and quantitative aspects of a fund consistent and repeatable. and its performance.

To effectively communicate a fund’s Before selecting an investment philosophy, a manager should focus target, investors in hedge funds internally on aspects critical to their determine the investment strategy to investing process. Investors want to which they will allocate capital. understand where managers allocate Popular strategies include equity funthe majority of their time and where damental value, fundamental growth they have true expertise. These qualitaand market neutral; event-driven tive factors build a framework for a funds; global macro-oriented fund; but they are only the first of a products; and relative value stratemulti-step due diligence process. If a gies, including fixed income. Then, manager fails to meet an investor’s after generating a manager list within Photograph by Patrimonio, kindly supplied by standard on the qualitative front, then the strategy subset, the natural entry Dreamstime.com, January, 2012. it is unlikely the manager will have the point for an analysis of a fund is a opportunity to move forward in the due diligence process. qualitative look at its people, process and philosophy.

In fact, people tend to be one of the most important and That being said, qualitative analysis alone is not enough. As decisive elements of the due diligence process. Investors want Paul Platkin, chief investment officer of Arden Asset Manto know who the decision makers are at a fund and where they agement, explains: “Any manager can tell a good story, due received their training. A hedge fund manager’s experience and diligence is the process to make sure the story makes sense pedigree is important in establishing him or her as an expert. and that the numbers support it.”

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Demystifying elements of fund performance Three elements comprise the quantitative due diligence process: performance, risk and attribution analysis.

After a full review of returns and risk, an investor will take a deeper look at the numbers to understand the factors behind performance generation. The most common method, absolute attribution analysis, will answer questions regarding active versus passive investing and determine whether returns fall inside a manager’s stated strategy and where managers are risking investor capital.

Performance data provides a static snapshot of a fund’s returns and is often the first question a potential investor poses. Historical data is used by investors to predict the future returns of the fund’s strategy, but while past performance is not indicative of future results, it is one of the best tools that the investor has to evaluate the manager. Performance should be presented in a number of ways because the period in which investors are interested can vary.

Total return since inception, also called cumulative return, is used to calculate the compounded returns since the formation of the fund. Most funds will present this information visually and prominently. The 12-month rolling return reports shows how the fund has performed in the most recent year-long period. It is also a cumulative number and neatly frames more recent data for the investor to review. Finally, the average monthly return is presented. Averages are simple to understand and set a month-to-month return expectation.

Returns, however, cannot be viewed in isolation. Investors still need to understand how a fund’s total returns compare to the broader market, other managers or a passive benchmark. The last component of performance analysis is comparing a manager’s returns to the appropriate benchmarks. This enables an investor to understand if the manager’s net returns have performed better or worse than the alternatives. Simply outperforming a benchmark is not enough to command an investment as total return alone

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does not paint a complete picture of the manager. Investors will want to know how much risk the manager employed to achieve those returns; which leads to an analysis of risk, the next step in the due diligence process.

Analysing risk Understanding fund exposure is the first step to understanding risk. However, contrary to popular belief, exposure does not equal risk. Risk is only introduced through exposure to risky or volatile assets. Exposures can also vary significantly over time, so single point references often do not show the complete picture.

Investors will want to know the portfolio’s exposure over the period in which performance is being presented. While averages are useful, presenting the information in time series is preferred as it allows investors to view intra-month exposures and to check for style drift.

Exposure is traditionally presented by long/short and net/gross. For a truly complete picture, advanced analytics of delta-adjusted exposures and beta-adjusted exposures should be incorporated in the report, to give an initial view of the risk normalised to a single equity risk number and also to a relevant index for the beta comparison. A manager’s delta-adjusted exposure can be significantly greater than their notional exposure; however, any manager utilising derivatives should include this analysis to form a complete picture of exposure.

After understanding notional and delta exposures, investors will want to break down the portfolio’s composition. Composition, like exposure, is not synonymous with risk, but rather a component of risk in the portfolio. Composition details where the investor committed or “risked” capital over a time frame to achieve returns. A sophisticated investor will want to understand a time series of the portfolio’s composition by asset class, sector, country, market capitalisation and other relevant criteria.

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One of the most difficult analyses for a multi-strategy manager, and conversely one of the most valuable to an investor, is to classify and report portfolio composition by strategy as shown.

Risk represents the possibility that a portfolio will not achieve its desired results. This definition is critical because it frames risk from the perspective of the manager’s strategy as certain strategies have more implicit risk than others. Like returns, risk should not be viewed in isolation and must be benchmarked to the market and to the strategy and taken in the context of the investor’s goals in choosing a fund.

Standard deviation of returns is the most commonly used metric for risk. It is a statistical measurement of the volatility of a portfolio, and tells the investor how much variability there has been in the fund’s returns.

Standard deviation is also a historical measure that can provide insight into probable results. As shown in the graphic Daily Volatility of Returns (above), the fund and the benchmark have the same average return, but the greater variation in the benchmark’s return, as represented by the larger tails, results in a higher standard deviation and therefore greater risk. The higher the standard deviation, the greater the probability of the expected periodic returns deviating, in either direction, from the average or mean return. While the standard deviation does not imply direction, a higher standard deviation translates into greater potential for gains, losses and risk.

Once the standard deviation of risk is calculated and graphed, the investor will want to directly compare the portfolio’s returns and volatility using Sharpe and Sortino ratios. These industry-standard formulae are used to determine the risk-adjusted performance of a portfolio.

Sharpe and Sortino measure the amount of return that was generated per unit of risk, making it useful in comparing funds of different strategies. The ratios show whether a

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portfolio’s return is due to good investment decisions or the result of excessive risk taking.

Since large positive returns will also cause an inflated standard deviation, the Sortino Ratio differentiates between good and bad volatility, providing a risk-adjusted measure of a fund’s performance. It does this without penalising the fund for positive performance.

Simply stated, the higher the value of either ratio, the more return is generated per unit of risk. Therefore, a higher absolute return over the risk-free rate or a lower standard or downside deviation, will lead to a higher ratio.

The ratios will show exactly what types of risks––good or bad––were taken to achieve that performance. By calculating these ratios, one might learn that a fund did not properly compensate the investor for risk or, worse, that the fund was simply levering market returns.

Drawdown analysis is another way of assessing risk by measuring the valley between peaks of monthly performance.

As with averages, drawdown analysis is simple to under–stand and compare across peers, and provides investors with a feel for risk over the life of the fund. Investors will want to know both the number of months down and months up since inception, the best month, the worst month and most importantly, the Max Drawdown (MDD).

The Max Drawdown is the greatest observed amount of loss from equity high until a new equity high is reached.

How much was the drawdown and what was the length of time to recovery? Drawdown analysis is useful for investors to understand how long they might need to wait for their capital to recover in the event of loss.

Many investors will also be interested in up and down capture ratios. These are a fund’s cumulative return divided by the relevant index’s cumulative return for up and down markets respectively. During up markets, the greater the value the better, whereas during down markets, the smaller the value the better. In an up market, a value over 100

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would indicate that a manager has outperformed that index during the period. Simply stated, attractive managers perform better than the market when it is up and hold up better than the market when it is down. This metric is a simpler version of what we statistically analyse later in the regression analysis section.

Regression analysis Regression analysis statistically compares the portfolio to a benchmark and yields metrics which help the investor better understand the manager’s returns. Specifically, the regression model tells the investor how the portfolio will perform given a known market return. This allows the investor to verify that the fund has correctly categorised itself as part of a certain index or strategy and also understand if the fund fits within its overall investment objectives. The main components of regression analysis are beta, alpha, R-squared and correlation. All the concepts work together to give the investor a perspective on the fund relative to the benchmark.

Beta is used to predict what the portfolio return will be, given a known return in the benchmark. The steeper the line gets, the more the portfolio is predicted to move when the index moves. The line is therefore describing the portfolio’s volatility. A beta of 1 suggests a portfolio that equals fund/market volatility.

Alpha is commonly thought of as return over the benchmark. This, however, is incorrect as it ignores the beta or relative volatility to the market benchmark. Alpha predicts what the portfolio will do if the index return is 0, meaning the amount of return not explained by market risk (beta). A positive regression alpha means the fund has outperformed compared to the benchmark, whereas a negative-regression alpha means it has underperformed. In other words, alpha measures the value a manager adds to or subtracts from a fund’s performance relative to the market.

Attribution analysis The due diligence process starts by giving investors a snapshot of a fund’s performance, while the second step is to analyse risk. The third is to show investors exactly from where managers are producing their returns. This leads us to a discussion about attribution. To have a complete picture it is necessary to conduct both absolute and relative attribution analysis.

Absolute attribution disaggregates the returns into their respective components. The traditional categories stop with attribution by long and short, but sophisticated investors may require the following categories: • Attribution by sector • Attribution by analyst or manager • Attribution from stock selection • Attribution by market capitalisation • Attribution by liquidity Relative attribution is an industry-recognised method of analysis which helps a manager separate returns into two categories: those created by the market compared to those

FTSE GLOBAL MARKETS • FEBRUARY 2012

Patrick J McCurdy, partner and head of capital developement at New York-based Merlin Securities. Photograph kindly supplied by Merlin Securities, January, 2012.

resulting from active management. Investors want to see that it was the manager’s decisions, as opposed to luck or leverage, which generated alpha.

In a popular attribution model, such as a Brinson-based model, total return is broken down into performance of the portfolio versus performance of the benchmark. It explains how the manager’s asset allocation and stock selection decisions contributed to the excess performance or underperformance relative to the benchmark.

Absolute and relative attribution provides the final overlay of the due diligence process and shows how the manager is adding value. While this article has outlined a few of the more popular attribution techniques there are countless additional methods that we simply did not have the space to cover: outperformance adjusted by exposure, long/short spread, attribution by largest winners and losers, and so forth. The focus of this piece is not to write an exhaustive statistical analysis but instead to review the most widely-used due diligence techniques.

The final step for investors will be to determine if, based upon their findings, an investment is warranted. Investors will look at the risk-adjusted return figures and run a correlation between the manager and the investor’s existing portfolio. There are a whole host of good managers who do not receive allocations because they do not beat out the great managers already in the investor’s portfolio. Today, it is not good enough to simply have positive performance: to be successful raising capital you must create a truly differentiated fund that consistently adds value. I

87

MANDATES

DATE

January 18th 2012

January 17th 2012

MANDATE/ VALUE

WINNING FIRM/ CONTACTS

CLIENT/ CONTACTS

COMMENTS

Structured products portfolio pricing solution/no value given.

Pricing Partners

CITIC Bank

Eric Benhamou, chief executive officer.

Dominic Tsui, head of market risk

CITIC is Hong Kong based and the agreement was signed through its regional partner Belatos.

Deutsche Bank

BG Group an LNG exploration and production company.

Depositary bank for Level I American depositary receipts.

Akbar Poonawala, head of global equity services.

The mandate was reportly transferred from JP Morgan.

not available January 12th 2012

January 12th 2012

January 12th 2012

January 9th 2012

January 5th 2012

29th December 2011

88

Depositary Bank for the sponsored Level I American depositary receipt programme.

Deutsche Bank

Casino Guichard Paerra

Akbar Poonawala, head of global equity services.

not available

Citi GTS Treasury and Trade solutions

Sinopec (China's largest oil refiner)

Anthony Nappi, region head, AsiaPac, GTS. As of Q3 2011 Citi held on average $365bn in liability balances and $12.5trn under custody.

Guangsheng Wang, deputy director general, finance department.

Fund administration and custody services for Dorchester Capital Advisors' two accounts, totalling $206m.

Citi

Dorchester Capital Advisors

Administration services for the client's stock plan and agent bank and settlement provier for its Employee stock plan.

SGSS/ not available

Strategic global treasury management agreement

Exchange traded funds (ETFs) services, fund accounting and fund administration for two funds: Direxion Large Cap Insider Sentiment Shares (INSD) and Direxion All Cap Insider Sentiment Direxion All Cap Insider Sentiment Shares (KNOW).

Custody and related services, including investment risk and analytics services/$1.8bn

Bob Wallace, head of North America for Securities and Fund Services

SGSS began in May 2011 to provide global administration services and then in Octoberit was hired to provide agency and settlement it was hired to provide agency and settlement services for the firm.

Craig Carlson, chief financial officer.

Repsol, the global energy company not available

BNY Mellon

Direxion

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

Daniel O'Neill, president and chief investment officer Founded in 1997 the company has approx $7.5bn in assets under management as of Q3 2011.

This mandate extends BNY Mellon's relationship with Direxion to include 52 ETFs.

Northern Trust Laurie Neu, group head for public entities and institutions. NT has assets under custody of $4.2trn as of Q3 2011.

St Joseph Health System (SJHS)

Casino is a leading food retailer, with outlets such as Spar, Vival etc in Spain and also Latin America.

Services include host-to-host connection streamlining cross-border cash pooling, agency and trust services.

Dorchester Capital Advisors is a California-based hedge fund advisory firm; specialising in building and managing hedge fund portfolios.

The mandate, says SGSS, reflects the bank's experience of managing international employee plans, and its technology.

Direxion Funds & Directions Shares are managed by Rafferty Asset Management.

Direxion Funds & Directions Shares are covering leveraged index funds, ETFs and alternative class fund products.

SJHS provides health care services throughout California, Texas and New Mexico.

Lisa M Laird, vice president of investments and cash management.

FEBRUARY 2012 • FTSE GLOBAL MARKETS

(Week ending 13 January 2012) Reference Entity

Federative Republic of Brazil Republic of Italy United Mexican States Republic of Turkey Bank of America Corporation Russian Federation JPMorgan Chase & Co. MBIA Insurance Corporation Republic of Korea 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 Government Government

Sov Sov Sov Sov Corp Sov Corp Corp Sov Sov

18,136,296,871 21,441,977,626 8,384,790,866 5,208,033,892 5,651,930,251 4,061,401,324 5,548,673,866 3,386,442,116 4,937,591,613 14,413,827,189

176,964,139,502 308,559,501,586 129,691,594,634 141,662,721,398 76,144,493,379 110,172,206,190 83,154,479,342 77,117,992,704 67,480,738,466 172,830,849,652

11,574 9,846 9,453 9,124 8,723 8,511 7,865 7,850 7,753 7,464

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

21,737,737,868 21,441,977,626 18,908,209,562 18,136,296,871 14,413,827,189 12,232,531,973 10,549,366,603 9178,369839 8,970,149,623 8,384,790,866

141,344,260,148 308,559,501,586 121,585,533,423 176,964,139,502 172,830,849,652 72,690,711,125 92,867,886,754 64,384,966,471 67,803,802,576 129,691,594,634

7,311 9,846 4,814 11,574 7,464 4,964 7,243 7,444 6,787 9,453

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

Top 10 net notional amounts (Week ending 18 November 2011) Reference Entity

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 13 January 2012)

(Week ending 13 January 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,160,841,048,920

433,960

Republic of Italy

6,777,941,212

285

Sovereign / State Bodies

2,896,312,831,793

219,335

Kingdom of Spain

5,124,272,958

390

Corporate: Consumer Services

1,964,328,769,063

338,111

Federal Republic of Germany

2,828,482,086

144

Corporate: Consumer Goods

1,537,417,690,779

256,993

Republic of Turkey

2,245,849,344

214

Corporate: Industrials

1,211,866,740,922

214,790

French Republic

2,190,334,727

159

Corporate: Technology / Telecom

1,160,929,127,700

188,226

MBIA Insurance Corporation

2,059,820,000

206

Corporate: Basic Materials

928,575,010,494

156,368

Republic of Ireland

1,808,200,000

168

Corporate: Utilities

705,689,723,594

115,416

UK and Northern Ireland

1,782,650,000

93

Corporate: Oil & Gas

461,072,404,603

83,847

Russian Federation

1,748,968,800

198

Corporate: Health Care

332,720,121,477

58,907

Corporate: Other

147,514,231,927

16,211

Federal Republic of Brazil

1,629,613,000

154

CDS on Loans

59,921,491,924

15,898

Residential Mortgage Backed Securities

55,499,552,482

10,887

Residential Mortgage Backed Securities* 14,173,794,078

1050

Commercial Mortgage Backed Securities 13,814,441,844

1421

CDS on Loans European

4,258,409,687

629

Muni:Government

1,221,700,000

125

Other

1,092,935,456

118

Commercial Mortgage Backed Securities*

794,753,966

75

CDS Swaptions

101,399,250

1

Muni:Other

50,000,000

1

Muni:Utilities

36,600,000

11

*European

FTSE GLOBAL MARKETS • FEBRUARY 2012

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

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

89

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator® 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 13th January 2012 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.51

2.22

2.02

2.06

2.09

6.92%

2.89% 4.76%

3.57% 0.02%

4.40%

4.64%

31.93%

25.97%

4.61% 21.60%

25.61%

0.06%

1.53%

Europe

Amsterdam 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 Xetd Xetc

53.25% 0.14% 0.08% 0.02%

0.12%

0.04%

58.35% 63.83% 65.78% 0.10% 6.27% 0.00% 0.00%

7.72%

VENUES

5.34%

INDICES

3.57%

5.31%

VENUES

INDICES

INDICES

DOW JONES

S&P 500

INDICES

S&P TSX Composite

FFI

FFI

2.04

2.08

18.10% 11.43% 2.29% 1.85% 1.97% 64.36%

16.72% 12.81% 2.44% 2.10% 1.73% 64.19%

US

5.15

4.74

BATS

12.70%

12.23%

BATS Y

4.16%

3.75%

CBOE

0.16%

0.12%

Chicago Stock Exchange

0.71%

0.60%

EDGA

5.49%

4.56%

EDGX

10.62%

9.60%

NASDAQ

21.51%

25.16%

NASDAQ BX

6.03%

3.98%

NQPX

2.25%

1.84%

NSX

0.37%

0.41%

NYSE

19.42%

22.60%

NYSE Amex

0.05%

0.16%

NYSE Arca

16.55%

14.94%

VENUES

S&P ASX 201

FFI

1.02 Australia Chi-X Australia

Canada*

99.12% 0.88%

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/.

Alpha ATS Chi-X Canada TMX Select Omega ATS Pure Trading TSX VENUES

INDEX

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

1.42 2.86% 0.00% 0.00% 0.00% 3.88% 83.54% 9.69% 0.02%

VENUES

INDEX

FFI

Japan

S&P TSX 60

NIKKEI 225

INDICES

INDICES

INDICES

Australia

90

24.60% 65.47% 0.02% 0.00% 0.78% 0.05% 0.01%

INDICES

HANG SENG

FFI

1.00

Asia

Hong Kong

100.00%

FEBRUARY 2012 • FTSE GLOBAL MARKETS

COMMENTARY

By Steve Grob, Director of Group Strategy, Fidessa

A

t the time of writing it seems almost certain that the most talked about merger in the exchange space, between NYSE Euronext and Deutsche Börse, will not go ahead. Joaquín Almunia, the EC's Commissioner responsible for competition, has made the initial recommendation to block the deal. His decision is based on concerns that the merged company would have a share of Europe’s listed derivatives market in excess of 90% and that “competition between exchanges is needed”. This recommendation has also been endorsed by national competition regulators in the European Union, with the European Commission having its final say at the start of February. It is ironic, then, that the industrial logic behind the proposed NYSE Euronext/Deutsche Börse merger – namely the concentration of derivatives trading - has now become the primary reason for its failure to obtain regulatory approval.

Joaquín Almunia, the EC's Commissioner responsible for competition, has made the initial recommendation to block the deal. His decision is based on concerns that the merged company would have a share of Europe’s listed derivatives market in excess of 90% and that “competition between exchanges is needed”.

What this decision has done, however, is to shine a bright light on competition (or rather the lack of it) in the derivatives markets and to set in play a process that looks certain to change these markets significantly. This process has been given additional momentum by an equally strong desire on the part of the regulators to move as much as possible of the OTC derivatives market onto exchange traded, or at least centrally cleared, platforms. Whilst this secondary initiative is driven by fears over market safety and systemic risk, the effect will be the same, namely to spark enthusiasm amongst equity venues to participate more actively in derivatives markets. Pretty much every equities venue in Europe has already launched derivatives contracts (including the London Stock Exchange Group’s Turquoise), or announced plans to do so (Bats/Chi-X, for example).

One of the key benefits resulting from these new initiatives is the ability for a venue to offer risk or margin offsets between different products or related asset classes.

This, in turn, provides its trading members with a more efficient use of capital. The current economic climate, together with other regulator-inspired initiatives such as Basel III, means that capital is an incredibly valuable commodity and so anything that makes its application more efficient should be welcomed. It’s not quite that simple, however. In contrast with equity markets, the lack of fungibility in derivatives trading means that contracts cannot

Steve Grob, Director of Group Strategy, Fidessa. “Whilst this secondary initiative is driven by fears over market safety and systemic risk, the effect will be the same.” Photograph kindly supplied by Fidessa, January 2012. be bought on one venue and sold on another. For this reason it is much harder for derivatives liquidity to move between venues than has been the case with equity markets.

Whilst this secondary initiative is driven by fears over market safety and systemic risk, the effect will be the same, namely to spark enthusiasm amongst equity venues to participate more actively in derivatives markets. Pretty much every equities venue in Europe has already launched derivatives contracts (including the London Stock Exchange Group’s Turquoise), or announced plans to do so (Bats/Chi-X, for example).

If regulators really are serious about increasing competition in derivatives markets then they will need to break the clearing monopolies that currently exist or introduce fungibility in some other way. The final irony in all this is that, were this to happen, then their primary objection to the NYSE Euronext/Deutsche Börse merger would fall away anyway.

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 • FEBRUARY 2012

91

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

Global Equity View 5-year Performance Graph (USD Total Return) 180 Index level rebased (31 January 2007 = 100) 160 FTSE All-World Index FTSE Developed Index FTSE Emerging Index 140 Global Equity View 5-year Performance Graph (USD Total Return) 180 Index level rebased (31 January 2007 = 100) 120 160 FTSE All-World Index FTSE Developed Index FTSE Emerging Index 100 140 180

GLOBAL MARKET INDICES

FTSE Frontier 50 Index

FTSE Frontier 50 Index

80 120 160 60 100 140

2

1

Ja n1

1

1

Oc t1

Ju l1

Ap r1 Ap r1 Ap r1

0

Ja n11 Ja n11

Oc t1 Oc t1 Oc t1

Ja n11

Ju l10 Ju l10 Ju l10

10

Ap r10 Ap r10

Ap r0 Ap r0

9

Ja n09 Ja n09

Ja n-

Oc t08 Oc t08

Oc t0

Ju l08 Ju l08

Oc t0

Ap r08 Ap r08

9

Ja n08 Ja n08

Ju l09

Oc t07 Oc t07

Ju l09

Ju l07 Ju l07

07

Ap r07

Ja n-

60 100

Ap r07

40 80 120

2

1

Ja n1

1

Oc t1

1

0

9

9

10

Ju l1

60

Ja n-

Ja n-

07

40 80

2

1

Ja n1

1

1

Oc t1

FTSE DBI Developed Index

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return)

Ju l1

FTSE EDHEC-Risk Efficient Developed Index

0

10 Ja n-

Ap r10

9 Oc t0

9

Ju l09

FTSE Developed ActiveBeta MVI Index

Ap r0

Ja n09

Oc t08

Ju l08

FTSE RAFI Developed 1000 Index

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

07

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) 40 Index level rebased (31 January 2007 = 100) Ja n-

MARKET DATA BY FTSE RESEARCH

FTSE All-World Index

FTSE All-World Index

140 Index level rebased (31 January 2007 = 100) FTSE RAFI Developed

120

FTSE Developed

FTSE EDHEC-Risk

1000 Index MVI Index Efficient Index Global Alternative/Strategy ViewActiveBeta 5-year Performance Graph (USDDeveloped Total Return)

FTSE DBI Developed Index

FTSE All-World Index

FTSE DBI Developed Index

FTSE All-World Index

140 Index level rebased (31 January 2007 = 100) 100 120 80 140

FTSE RAFI Developed 1000 Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE Developed ActiveBeta MVI Index

100 60 120

2

1

Ja n1

Oc t1

1

Ap r1

Ju l1

Ap r1 Ap r1

Ja n11

1

Ja n11

Oc t1 Oc t1 Oc t1

Ja n11

Ju l10 Ju l10 Ju l10

0

Ap r10 Ap r10

Ap r0 Ap r0

10

Ja n09 Ja n09

Ja n-

Oc t08 Oc t08

9

Ju l08 Ju l08

Oc t0

Ap r08 Ap r08

Oc t0

Ja n08 Ja n08

Ju l09

Oc t07 Oc t07

Ju l09

Ju l07 Ju l07

9

Ap r07 Ap r07

Ja n-

60

07

80 40 100

80

2 Ja n1

1 Oc t1

1 Ju l1

1

0

9

10 Ja n-

Ja n-

07

60

9

40

2 Ja n1

1 Oc t1

1

1 Ju l1

0

10

Ap r10

FTSE Global Infrastructure

Ja n-

9 Oc t0

Ju l09

9 Ap r0

Ju l08

FTSE Global Government

Ja n09

FTSE EPRA/NAREIT Global Index

Ap r08

Ja n08

Oc t07

Ju l07

-0 7

Ap r

Ja n

-0 7

Index level rebased (31 January 2007 = 100)

Oc t08

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) 40

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

FTSE EPRA/NAREIT FTSE Global FTSE StableRisk FTSE Global Government Composite Infrastructure 200 Global - Global AcrossIndex the Asset Classes 5-year Performance Graph (USD Total Return)Index Index Index level rebased (31 January 2007 Bond = 100)Index 250 150 FTSE EPRA/NAREIT FTSE Global FTSE StableRisk FTSE Global Global Index Government Composite Index Infrastructure 200 Bond Index Index 100

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

Global - Across the Asset ClassesBond 5-year Performance IndexGraph (USD Total Return) Index Index level rebased (31 January 2007 = 100) 250

250 150 50

2 Ja n1

1

1

Oc t1

Ju l1

1

2 Ja n1

1

1

Oc t1

Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

10

Ap r10

Ja n-

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

12

11

11

11

11

10

10

10

09

09

09

09

08

08

08

08

07

07

07

10

FEBRUARY 2012 • FTSE GLOBAL MARKETS

0 07

92

-0 7

Ja n

50

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

Ap r

-0 7

100 0

Ap r1

Ja n11

0 Oc t1

Ju l10

10

Ap r10

Ja n-

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r

Ja n

-0 7

150 50

-0 7

200 100 0

USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE USA Index

FTSE All-World ex USA Index

USA 140 Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100)

USA MARKET INDICES FTSE USA Index

120

FTSE All-World ex USA Index

USA 140 Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) 100 FTSE USA Index

120

FTSE All-World ex USA Index

80 140 100 60 120 80

1

-1 2 JA N

1

Oc t1

1

Ju l1

Ap r1

0

Ja n11

Oc t1

Ju l10

10

Ap r10

9

Ja n-

Oc t0

Ap r0

Ju l09

9

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ja n-

60

Ap r07

07

40 100

80

-1 2

Oc t1

1

Oc t1

1 Ju l1

1

Ap r1 Ap r1

JA N

Ja n11 Ja n11

1

Oc t1 0 Oc t1

0

Ju l10 Ju l10

10 Ja n-

Ap r10

9 Oc t0

Ap r0

Ju l09

9

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ja n-

Ap r07

07

40 60

-1 2

1

JA N

Ju l1

FTSE US ActiveBeta MVI Index

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return)

1

10 Ja n-

FTSE EDHEC-Risk Efficient USA Index

Ap r10

9 Oc t0

9

Ju l09

FTSE DBI Developed Index

Ap r0

Oc t08

Ju l08

Ap r08

FTSE RAFI US 1000 Index

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

07

Index level rebased (31 January 2007 = 100)

Ja n09

USA 40 Alternative/Strategy View 5-year Performance Graph (USD Total Return) FTSE All-World Index

140 level rebased (31 January 2007 = 100) Index

FTSE All-World Index

JA N

Oc t1

Ju l1

Ap r1

Ap r10

10 Ja n-

9 Oc t0

9

Ju l09

Ap r0

-1 2

FTSE US ActiveBeta MVI Index

1

FTSE EDHEC-Risk Efficient USA Index

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

07

140 level rebased (31 January 2007 = 100) Index 100 FTSE RAFI US FTSE DBI 120 1000 Index Developed Index 80 140 100 60 120 80 40 100 60

1

FTSE All-World Index

1

FTSE US ActiveBeta MVI Index

Ja n11

FTSE EDHEC-Risk Efficient USA Index

0

FTSE DBI Developed Index

Oc t1

FTSE RAFI US 1000 Index

Ju l10

120

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return)

1

-1 2 JA N

Oc t1

1 Ju l1

1

Ja n11 Ja n11

Ap r1

Oc t1 0 Oc t1

0

Ju l10 Ju l10

Ap r10

10 Ja n-

9 Oc t0

9

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

60

07

80 40

FTSE Renaissance US IPO Index

FTSE FRB10 USD Index

FTSE EPRA/NAREIT

FTSE Renaissance

FTSE FRB10 USD Index

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return)

-1 2

1 Oc t1

1 Ju l1

1 Ap r1

Ap r10

10 Ja n-

9 Oc t0

9

Ju l09

Ap r0

-0 9

FTSE EPRA/NAREIT North America Index

JA N

FTSE Americas Government Bond Index

Ja n

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

-0 7

Ap r

Ja n

-0 7

Index level rebased (31 January 2007 = 100)

Oc t08

USA 40 - Across the Asset Classes 5-year Performance Graph (USD Total Return)

Index 160 level rebased (31 January 2007 = 100) 140

FTSE Americas Government

Bond the Index North America Index(USD TotalUS IPO Index USA - Across Asset Classes 5-year Performance Graph Return) 120 Index 160 level rebased (31 January 2007 = 100)

1

-1 2 JA N

Oc t1

1 Ju l1

1 Ap r1

Ja n11

Oc t1

0

FTSE FRB10 USD Index

Ju l10

Ap r10

10 Ja n-

Oc t0

9

FTSE Renaissance US IPO Index

Ju l09

9 Ap r0

-0 9 Ja n

Oc t08

FTSE EPRA/NAREIT North America Index

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

40 80

FTSE Americas Government Bond Index

-0 7

Ja n

-0 7

80 120 160 60 100 140 40 80 120 20 60 100

Ap r

100 140

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

1

-1 2 JA N

Oc t1

1 Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

Ap r10

10 Ja n-

9 Oc t0

Ju l09

9 Ap r0

-0 9 Ja n

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

-0 7

Ju l07

40

Ap r

Ja n

-0 7

20 60

93

FTSE GLOBAL MARKETS • FEBRUARY 2012 12

11

1

11

11

10

0

10

10

09

9

09

09

08

8

08

08

07

7

07

07

20

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (31 January 2007 = 100) FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) 140 Index level rebased (31 January 2007 = 100)

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES 120

FTSE 100 Index

FTSEurofirst 80 Index

FTSE Nordic 30 Index

FTSE MIB Index

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) 140

Index level rebased (31 January 2007 = 100) 100 120

FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

80 140 100 60 120 80 2

1

Ja n1

1

1

Oc t1

Ju l1

Ap r1

0

Ja n11

Oc t1

Ju l10

10

Ap r10

9

Ja n-

Oc t0

9

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

07

Ja n-

60

Ap r07

40 100

80

2

1

Ja n1

1

Oc t1

Ap r1 Ap r1

Ju l1

Ja n11 Ja n11

1

Oc t1 0 Oc t1

0

Ju l10 Ju l10

10

Ap r10

Ja n-

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

07

Ja n-

Ap r07

40 60

FTSE All-World Index

FTSE EPRA/NAREIT

FTSE All-World Index

2

1

1

Oc t1

Ju l1

1

10

Ap r10

FTSE EPRA/NAREIT Developed Europe Index

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return)

Ja n1

FTSE EDHEC-Risk Efficient Developed Europe Index

Ja n-

9 Oc t0

Ju l09

9 Ap r0

Ju l08

Ap r08

FTSE4Good Europe Index

Ja n09

FTSE RAFI Europe Index

Ja n08

Oc t07

Ju l07

Ap r07

07

Index level rebased (31 January 2007 = 100)

Oc t08

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) 40 Ja n-

MARKET DATA BY FTSE RESEARCH

FTSE 100 Index

120 Index level rebased (31 January 2007 = 100) 100

FTSE RAFI

FTSE4Good

FTSE EDHEC-Risk Efficient

Europe Index Europe DevelopedGraph Europe(EUR Index Total Return) Developed Europe Index Europe Alternative/Strategy ViewIndex 5-year Performance 120 level rebased (31 January 2007 = 100) Index 80 FTSE4Good FTSE RAFI 100 Europe Index Europe Index 60 120

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

80 40 100

2

1

Ja n1

1

Oc t1

Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

10 Ja n-

Ap r10

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ja n-

40

Ap r07

07

60 20 80

60

2

1

Ja n1

1

Ja n1

1

Oc t1

Ap r1 Ap r1

Ju l1

Ja n11 Ja n11

1

Oc t1 0 Oc t1

0

Ju l10 Ju l10

10

Ap r10

Ja n-

Ap r10

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

07

Ja n-

Ap r07

20 40

FTSE JSE Top 40 Index (ZAR)

FTSE CSE Morocco All-Liquid Index (MAD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

FTSE Middle East

FTSE NASDAQ Dubai UAE 20 Index (USD)

2

1

Oc t1

Ju l1

Ja n-

FTSE Middle East & Africa Index (USD)

Middle East and Africa View 3-year Performance Graph (Total Return)

1

10

9 Oc t0

Ju l09

9 Ap r0

Ja n09

Ju l08

Ap r08

Ja n08

Oc t07

-0 7

Ju l07

Ap r

Ja n

-0 7

Index level rebased (31 January 2009 = 100)

Oc t08

20 Middle East and Africa View 3-year Performance Graph (Total Return)

180 Index level rebased (31 January 2009 = 100)

Ja n12

1 Oc t1

Ju l1

1

FTSE NASDAQ Dubai UAE 20 Index (USD)

1

0 Oc t1

Ju l10

Ap r10

FTSE Middle East & Africa Index (USD)

Ja n12

1 Oc t1

1 Ju l1

1 Ap r1

0 Oc t1

Ju l10

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

Ap r10

-1 0

-1 0

Ja n

Ja n

09

Oc t-

09 Oc t-

Ju l09

Ju l09

9

Ap r0

Ap r09

40

FEBRUARY 2012 • FTSE GLOBAL MARKETS

2

1

1

1

1

0

0

0

0

9

9

9

20 9

94

Ja n

-0 9

Ja n

-0 9

Index 180 level rebased (31 January 2009 = 100) 120 160 FTSE JSE Top 40 FTSE CSE Morocco 100 Index (ZAR) All-Liquid Index (MAD) 140 80 180 120 60 160 100 40 140 80 20 120 60 100 40 80 20 60

Ap r1

FTSE CSE Morocco

Ja n11

FTSE JSE Top 40

Index (ZAR) All-Liquid Index (MAD)Graph (Total & Africa Index (USD) Middle East and Africa View 3-year Performance Return) 140

Ja n11

160

Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE Asia

FTSE EDHEC-Risk Efficient All-World

FTSE RAFI Developed Asia Pacific

Pacific Index Equities Asia Pacific Index ex Japan Index Asia Pacific Regional View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph 200 Total Return) Index level rebased (31 January 2007 = 100) (USD

ASIA-PACIFIC MARKET INDICES 180 FTSE Asia Pacific Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

FTSE Asia Pacific Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

2 2

Ja n1

1 1

Ja n1

Oc t1

1 1 Ju l1

Oc t1

1

Ju l1

Ap r1 1 Ap r1 Ap r1

0

Ja n11 Ja n11 Ja n11

Oc t1 0 Oc t1

Ju l10 Ju l10

Ju l10

Ap r10 Ap r10

10 Ja n-

Ap r10

10

9

Ja n-

Oc t0 9 Oc t0

9

Ju l09 Ju l09

Ap r0 9 Ap r0

Ja n09 Ja n09

Oc t08 Oc t08

Ju l08 Ju l08

Ap r08 Ap r08

Ja n08 Ja n08

Oc t07 Oc t07

Ju l07 Ju l07

60

Ap r07

Ja n-

07

Ja n-

07

140 180 120 160 200 100 140 180 80 120 160 60 100 140 40 80 120 60 100 40 80

Ap r07

160 Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph Asia 200 (USD Total Return) Index level rebased (31 January 2007 = 100)

2

1

1 Ju l1

Oc t1

1

0

FTSE Renaissance Hong Kong/China

Ja n1

FTSE China 25

Oc t1

10

9 Oc t0

Ju l09

9 Ap r0

Oc t08

Ju l08

Ap r08

FTSE Greater

Ja n-

FTSE China

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

07

Index level rebased (31 January 2007 = 100)

Ja n09

Greater China Equities View 5-year Performance Graph (USD Total Return) 40

Index Index Top IPO Index Greater A50 China Equities ViewChina 5-year PerformanceIndex Graph (USD Total Return) 450 level rebased (31 January 2007 = 100) Index 400

FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

350 Greater China Equities View 5-year Performance Graph (USD Total Return)

2

1

Ja n1

1 Ju l1

Oc t1

Ap r1 Ap r1 Ap r1

1

Ja n11 Ja n11 Ja n11

0

Ju l10 Ju l10 Ju l10

Oc t1

Ap r10 Ap r10 Ap r10

10

Oc t0 Oc t0

Ja n-

Ju l09

Ap r0 Ap r0

Ju l09

Ja n09 Ja n09

9

Oc t08 Oc t08

Ap r08 Ap r08

Ju l08

Ja n08 Ja n08

Ju l08

Oc t07 Oc t07

FTSE Greater China Index

Ju l07

200 50

FTSE China A50 Index

Ju l07

Ja n-

07

350 200 450 300 150 400 250 100 350 200 50 300 150 0 250 100

Ap r07

400 250

9

450 level rebased (31 January 2007 = 100) Index 300

2

1

Ja n1

1 Ju l1

Oc t1

1

0

9

9

10

Oc t1

50

Ja n-

Ja n-

07

100

Ap r07

150 0

FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

2

1

Ja n1

1 Ju l1

Oc t1

1

0 Oc t1

10 Ja n-

9 Oc t0

Ju l09

9 Ap r0

-0 9 Ja n

Oc t08

Ap r08

Ja n08

Oc t07

Ju l07

-0 7

Ap r

Ja n

-0 7

Index level rebased (31 July 2010 = 100)

Ju l08

ASEAN Equities View 18-month Performance Graph (USD Total Return) 0

FTSE SET Large Cap Index

ASEAN Equities View 18-month Performance Graph (USD Total Return) 180 Index level rebased (31 July 2010 = 100) 160

FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

ASEAN Equities View 18-month Performance Graph (USD Total Return) 180 Index level rebased (31 July 2010 = 100) 140 160

FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

120 180 140 100 160 120

80

12 Ja n-

-1 1 De c

11 N

ov -

1

12 Ja n-

-1 1 De c

11 N

ov -

1 Oc t1

11 Se p-

11 Au g-

l11 Ju

1 Ju n1

1

1

M ay -1

Ap r1

1 ar -1 M

Fe b11

-1 1 Ja n

De c10

ov -1 0 N

Oc t10

Se p10

-1 0

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

Au g

Ju l10

100

Oc t1

11 Se p-

11 Au g-

l11 Ju

1 Ju n1

1

1

M ay -1

Ap r1

1 ar -1 M

Fe b11

-1 1 Ja n

De c10

ov -1 0 N

Oc t10

Se p10

120

Au g

Ju l10

100

-1 0

80 140

95

FTSE GLOBAL MARKETS • FEBRUARY 2012 2

11

11

1

11

11

1

1

11

1

11

11

1

10

10

0

10

10

0

80

INDEX CALENDAR

Index Reviews January 2012 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

10 Jan

TOPIX

Monthly review - additions & free float adjustment

30-Jan

30-Nov

31 Jan

AEX

Annual review

01-Mar

30-Dec

31 Jan

BEL 20

Annual review

01-Mar

30-Dec

16-Mar

30-Dec

31 Jan

PSI 20

Annual review

07-Feb

TOPIX

Monthly review - additions & free float adjustment

28-Feb

31-Jan

10-Feb

Hang Seng

Quarterly review

02-Mar

31-Dec

10-Feb

Russell/Nomura Indices

Quarterly review - IPO addtions

29-Feb

31-Jan

21-Feb

MSCI Standard Index Series

Quarterly review

29-Feb

31-Jan

22-Feb

DJ Stoxx

Quarterly review

16-Mar

31-Jan

Early Mar

ATX

Semi-annual review / number of shares

30-Mar

29-Feb

02-Mar

CAC 40

Quarterly review

16-Mar

29-Feb

06-Mar

FTSE All-World and FTSE Global Small Cap Asia Pacific ex Japan

Annual review

16-Mar

30-Dec

06-Mar

FTSE MIB Index

Annual review

16-Mar

29-Feb

06-Mar

FTSE China Index Series

Quarterly review

16-Mar

30-Dec

06-Mar

DAX

Quarterly review

16-Mar

29-Feb

08-Mar

Dow Jones Global Indexes

Quarterly review

15-Mar

29-Feb

07-Mar

FTSE RAFI Index Series

Annual review

16-Mar

31-Jan

07-Mar

FTSE AIM Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE European Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSEurofirst Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE Italia Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE JSE Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE JSE All-Africa Index Series

Quarterly review

16-Mar

17-Feb

07-Mar

FTSE ASFA Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE/ASEAN 40 Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE UK Index Series

Quarterly review

16-Mar

06-Mar

07-Mar

TOPIX

Monthly review - additions & free float adjustment

29-Mar

29-Feb

08-Mar

FTSE Vietnam Index Series

Quarterly review

16-Mar

24-Feb

08-Mar

FTSE ST Index Series

Quarterly review

16-Mar

29-Feb

08-Mar

FTSE EPRA/NARIET Index Series

Quarterly review

16-Mar

29-Feb

09-Mar

FTSE Shariah Index Series

Quarterly review

16-Mar

29-Feb

09-Mar

FTSE Taiwan Index Series

Quarterly review

16-Mar

29-Feb

09-Mar

FTSE4Good Index Series

Semi-annual review

16-Mar

29-Feb

12-Mar

FTSE Renaissance Index Series

Quarterly review

16-Mar

29-Feb

12-Mar

FTSE EDHEC Index Series

Quarterly review

16-Mar

29-Feb

13-Mar

FTSE GWA Index Series

Quarterly review

16-Mar

29-Feb

15-Mar

Russell Global Indices

Quarterly review - IPO additions

30-Mar

29-Feb

15-Mar

Russell US Indices

Quarterly review - IPO additions

30-Mar

29-Feb

06-Apr

TOPIX

Monthly review - additions & free float adjustment

27-Apr

30-Mar

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

96

FEBRUARY 2012 • FTSE GLOBAL MARKETS