FTSE Global Markets by FTSE Global Markets

EXPERT PANEL: THE CHALLENGES OF ADHERING TO REGULATION

ISSUE 59 • MARCH 2012

Demand grows for illiquid hedge fund strategies What’s in a domain name? Applications around trade flow gain in stature LTRO: does it really work?

LEI

How far can the FSB and other agencies take a global ID standard? ROUNDTABLE: IS ASIA A FIELD OF (BROKEN) DREAMS?

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OutlOOk EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152 email: francesca@berlinguer.com SENIOR EDITORS: Ruth Hughes Liley (Trading); David Simons (US) Neil A O’Hara (US) EDITORS AT LARGE: Art Detman; Lynn Strongin Dodds CORRESPONDENTS: Rodrigo Amaral (Iberia/Emerging Markets); Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Ian Williams (Supranationals/Emerging Markets) PRODUCTION MANAGER: Luke W Cleary, tel: +44 [0]20 7680 5161 email: luke.cleary@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) Luke McGreevy (Middle East) +971 (0)4 391 4398 email: luke.mcgreevy@dubaimediacity.com 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. Multiple company subscriptions are also available FTSE Global Markets is now published ten times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2012. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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

FTSE GLOBAL MARKETS • MARCH 2012

ARLY IN FEBRUARY, the European parliament and Council agreed new rules to regulate financial derivatives under the European Market Infrastructure Regulation (EMIR). European Commissioner Michel Barnier stated on the news,“The regulation ensures that information on all European derivatives transactions will be reported to trade repositories and be accessible to supervisory authorities, including the European Securities and Markets Authority (ESMA) to give policy makers and supervisors a clear overview of what is going on in the markets. The era of opacity and shady deals is over.” This is a theme that is returned to again and again through this edition. Our cover story this month focuses on the impending introduction of Legal Entity Identifiers (LEI), which together with initiatives such as EMIR will build transparency across markets and product. LEI is expected to be brought into greater focus at the planned G20 meeting in Los Cabos, Baja California Sur in mid June. The intentions behind much of the incoming regulation are laudable and many initiatives will bring increased visibility and tighter security measures to the global financial markets in general and to the OTC derivatives market in particular. However, as our cover story suggests, behind much of the legislation lies a great deal of complexity, in which LEI will play an important role. It should come as no surprise them that ESMA now has until the end of September to finalise the technical standards that will underpin EMIR and LEI will become a key element in that delineation. Among the issues that ESMA will address include establishing what types of derivatives will be eligible for centralised clearing. The regulator will also have to set clear organisational standards for clearing houses and data repositories and establish exhaustive reporting, cross-checking and netting standards. Moreover, ESMA now has to set a benchmark or threshold for trade activity (or volumes) at which nonfinancial firms will come under the umbrella of the legislation. In this regard, EMIR may ultimately suffer the same fate as MiFID II and fall onto the delayed pile as market participants rush to seek clarification and modifications. The stark truth is that questions must now be asked as to whether those agencies established by politicians in the wake of the financial crisis to supervise the flood of new regulation are large enough or well prepared enough (or both) to handle the increasingly complex workload thrust upon them. In an open letter to the European Commission last month, seven European trade bodies including the Futures and Options Association and the Association for Financial Markets in Europe, suggested ESMA should be given at least a year to draft appropriate standards, rather than the somewhat measly seven months allotted to it. In the UK, similar concerns are being voiced by the restructuring of the Financial Services Authority (FSA). The UK’s tripartite system of regulation, shared between the Bank of England, the FSA and the Treasury is now being replaced by a new tripartite system of committees, one sitting in the Bank of England, one sitting outside it, but under its control and another agency called the Financial Conduct Authority (FCA) that will inherit much of the current FSAs’remit. Charlotte Hill, who heads up the financial services and regulation practice at law firm Stephenson Harwood, explains the limitations of the new structure and its impact on the compliance and reporting requirements on UK financial firms. With so much in flux it is vital that market participants remain well informed as to the implications of change and regulation. Over the next four months we will provide a regional roundup of the key rules and regulations coming on stream and discuss their implications. Our Expert Panel discussion provides but a small taste of things to come!

Francesca Carnevale, Editor, March 2012 Cover photo: Central Bank of Canada governer, Mark Carney, who is also the chairman of the Financial Stability Board (FSB), charged with co-ordinating the global roll out of LEI. Archive photo by Lefteris Pitakaris and supplied by Press Associtaion Images, February 2012

COntents COVER STORY

BAGGED & TAGGED: THE LEI PROJECT

....................................................................Page 6 In the effort to make investing a risk-free zone and give regulators a 360 degree map of the risk exposure of trading counterparties, the creation of a universal legal entity identifier (LEI) standard for financial markets is now underway. How will it change business life as we now know it? Francesca Carnevale spoke to some of the agencies involved and posits a world where regulators effectively map risk exposure.

DEPARTMENTS

MARKET LEADER

HAS LTRO GIVEN A BOOST TO EUROPE’S BOND MARKETS?

.........Page 14

Can the ECB’s support for eurozone banks work over the long run?

WHO REALLY BENEFITS IN MERGERS OR AQUISITIONS? ..............Page 18 Ian Williams wonders whether shareholders get the best deal.

IN THE MARKETS

BAHRAIN’S CENTRAL BANK UPS THE ANTE

............................................Page 21 Growing competition in the Middle East insurance market.

GUEST COLUMN

..................................................................................................................Page 23 Stuart Z Goldstein asks for tougher capital requirements for derivatives trades.

FACE TO FACE

WITH BILL SMITH, MD, SECURITIES LENDING, JP MORGAN WSS ....Page 24

COUNTRY REPORT

HIGH GROWTH BUT VIETNAM NEEDS REFORMS ................................Page 26

BANK REPORT

AFRICAN BANKS ON THE BRINK OF HIGH GROWTH? ....................Page 28

What’s cookin’ in the US securities lending market?

David Simons explains where service providers see new business opportunities.

Much is promised, but little ever delivered. Can Africa’s banks change tack?

THE PARADIGM SHIFT IN ASSET ALLOCATION

COMMODITIES REPORT

COMPANY PROFILE INDEX REVIEW

DERIVATIVES 2

......................................Page 32

How much can commodities really deliver?

BUNKING THE MYTH OF OIL PRICE SPECULATION

............................Page 34 Academia sheds new light on supply and demand dynamics in the energy sector.

WHAT’S IN A (DOMAIN) NAME?

........................................................................Page 35 How and why ICANN is extending the frontiers of the Internet.

THE EURO CRISIS, CENTRE VERSUS PERIPHERY

....................................Page 38 Simon Denham, managing director of Capital Spreads, applies Ricardian economics.

DEMAND FOR ILLIQUID HEDGE FUND STRATEGIES RISES

................Page 39 Flush with cash and looking for action: what’s an alternative investor to do?

MARCH 2012 • FTSE GLOBAL MARKETS

COntents FEATURES TRADING REPORT:

DERIVATIVES: CLEARING COMES FIRST ........................................................Page 41 Clearinghouses stand ready to clear swaps—some already do for the dealer community—but nobody knows yet which swaps will have to be cleared when the rules take effect. Numerous entities want to be SEFs, but the regulators haven’t even decided what constitutes a SEF, let alone how a SEF should operate. Neil A O’Hara reports.

APPLICATIONS AROUND TRADE FLOW GAIN IN STATURE................Page 45 Although speed is often critical to the investment strategy of just a handful of high frequency traders and hedge funds (and those brokers that service them) traditional long only asset managers also increasingly rely on fast and faster data speeds. Data-intensive functions, such as risk management and transaction cost analysis (TCA) once relegated to the back office for processing long after trades were executed can now be performed fast enough for traders to use the results in real time. Neil A O’Hara looks at the consequences.

REAL STEEL: THE NEW TRADING BREED ..........................................................Page 48 US electronic trading mavens once used to a cornucopia of fee income, trading fees and a broad spectrum of technological tools with which to tempt the buy side trader are now dealing in darker times. Volumes remain constrained; fee income is down and the rationale to spend, spend, spend on technology is giving way to a more intelligent use of resources. In this pared down environment, only the very best will survive. Francesca Carnevale reports.

ASSET MANAGEMENT AND SECURITIES SERVICES:

ROUNDTABLE: IS ASIA A FIELD OF (BROKEN) DREAMS? ....................Page 53 Asia isn’t all that it is cracked up to be. That’s the view of the expert panel discussing the strengths, weaknesses, opportunities and challenges in the highly diversified continent. So, what does it take to succeed in Asia? Money? The panel discuss the changing needs of the region and ask (out loud) whether Western institutions always have the right answers to uniquely Asian questions.

REGULATION:

CAN FINANCIAL FIRMS COPE WITH REGULATORY DEMANDS? ....Page 61 On January 31st the US SEC held an all-day conference to deliver a clear message: chief executive officers and senior management will be held responsible for creating, managing, and maintaining an effective control environment. The SEC called for business and control functions to work together and to interact effectively. Deborah Prutzman, CEO of The Regulatory Fundamentals Group explains the need for senior management to build a robust governance programme that addresses all the risks within their organisation in a repeatable manner.

TWIN PEAKS: THE FIRE WALK OF UK MARKET REGULATION ........Page 64 Charlotte Hill, partner and head of financial services at UK law firm Stephenson Harwood, gives a sprightly, sometimes humorous, analysis of the impending changes to the structure of financial market supervision in the UK. Current FSA chief executive, Hector Sands, used the analogy of Twin Peaks to explain distinctions in the application of regulation. Hill wonders whether he unintentionally meant something else.

THE EXPERT PANEL: THE IMPACT OF MARKET REFORM........................Page 66 The trend towards enhanced supervision and prudential requirements looks onerous at first glance; particularly as the tide of incoming regulation appears to stretch both across product areas, business segments and geographic regions. Various legislative efforts are either in the statutes or still in the proposal stage; either way new rules that will change the structure, supervision and governance of financial services will now be part and parcel of our daily lives and more legislation is in the pipeline.

DATA PAGES 4

DTCC Credit Default Swaps analysis ..............................................................................................Page 73 Fidessa Fragmentation Index ........................................................................................................................Page 74 Market Reports by FTSE Research................................................................................................................Page 76 Index Calendar ....................................................................................................................................................Page 80

MARCH 2012 • FTSE GLOBAL MARKETS

cover story

LEGAL ENTITY IDENTIFIERS: A TOOL TO MAP SYSTEMIC RISK

A range of regulatory initiatives are driving the establishment of a number of systemic risk boards and improved market data collection. Among the crop is the creation of a universal legal entity identifier (LEI) standard for financial markets. A number of organisations are laying the groundwork for LEI right now, including the Financial Stability Board (FSB), SIFMA, ASIFMA, AFME, IOSCO, the Office of Financial Research (OFR) and the Commodities and Futures Trade Commission (CFTC). Work on LEI has been gathering momentum since the last G20 meeting and in particular the passing of Dodd-Frank legislation. The next G20 summit in Mexico is expected to give even more importance to creating standardised reporting monikers. Francesca Carnevale discusses the implications of the initiative. Will life ultimately be easier and safer if regulators can effectively map financial markets risk?

SNAGGED, BAGGED AND TAGGED: The LEI imperative HE LACK OF a standard identification system for financial counterparties makes it difficult for financial firms (or regulators for that matter) to develop a consistent and integrated view of their exposures. In the seemingly relentless search to eliminate any and all risk in the global financial markets, the latest regulatory wheeze is to eliminate the current fragmented identification system and replace it with an internationally recognised system of common company identifiers. Once introduced, an LEI should help improve, goes the theory, the measuring and monitoring of systemic risk and help support more cost-effective compliance with regulatory reporting requirements. LEI is a unique ID associated with a single entity. Essentially it is a reference data tool that will standardise how counterparties are identified in financial transactions. LEI will allow regulators to conduct more accurate analysis of the risks in financially important institutions and keep a check of their transactions with all their counterparties across markets, products and regions. Regulators will ultimately be able to identify any concentrations of systemic risk in these institutions and across market segments. The move towards LEI goes back a few years and essentially hangs

Photograph © Sur / Dreamstime.com, supplied February 2012.

around the concept of data gaps in the capital markets that have resulted from the almost constant development of new financial and investment products as markets have globalised. To bridge these information gaps and complement the policy efforts underway to address market risks, the G-20 finance ministers and central bank governors asked the Financial Stability Board (FSB) in November 2009 to improve data collection and sharing in this area, in close consultation with the IMF. Around the same time, in the United States, the Dodd-Frank Act created the Financial Stability

Oversight Council (FSOC) and its data and research arm, the Office of Financial Research (OFR). OFR, in parallel with the FSB, took up cudgels for a universal standard that could be implemented on a consensual basis. They are not alone. Across the globe other institutions are also in the mix, sometimes on the same path, sometimes on a parallel one. Recent steps by the FSB, for example, and by diverse national regulators, such as the Commodity Futures Trading Commission (CFTC), the Federal Reserve Bank of New York (FRBNY) and the Bank of England (BoE), in the area of data gaps and shadow banking, have focused on mapping the financial system and are motivated by the need to understand the linkages between different sectors of financial markets. According to an FSB whitepaper published in early October last year, the move towards common reporting standards and tags is timely, noting that “the lack of timely, accurate information has proved very costly. The current data architecture lags well behind the forces driving increased complexity and globalisation of financial systems, institutions and markets”. While data initiatives should and cannot be substitutes for effective policy design and judgement, the recent financial crisis and the brouhaha surrounding well-known market

MARCH 2012 • FTSE GLOBAL MARKETS

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cover story

LEGAL ENTITY IDENTIFIERS: A TOOL TO MAP SYSTEMIC RISK

anomalies such as Madoff and MF Global show that market opacity can prove very costly indeed. Robin Doyle, co-chair of the LEI Trade Association Group, acknowledges that there are major gaps in entity identification information that is used by global financial institutions and regulators that play a key role in the international financial system. “There is little consistent entity information on the major bilateral linkages between institutions, as well as on their interactions with other transactors in the markets across the world. As a consequence, there is a poor understanding of the global financial network which continues to hamper policy responses,” she explains. In early May last year, SIFMA and 12 other trade associations released their thoughts in Requirements for a Global Legal Entity Identifier (LEI) Solution, a PDF outlining an industry consensus perspective on how the LEI system might work and the essential requirements for any potential LEI provider. To help identify providers who could deliver this new LEI infrastructure, the

LEI Trade Associations Group, which included SIFMA and other global trade associations and firms, launched a Solicitation of Interest (SOI) process some days later, setting out a specific set of questions and prerequisites for potential providers, based on LEI requirements documents and other policy statements from regulators and industry participants. The LEI Trade Association Group reported its recommendations, which it said: “represents a powerful foundation upon which the remaining aspects of an LEI system, such as governance, can be built”. The LEI Trade Association Group suggested any provider should use the International Organisation for Standardisation’s (ISO’s) Draft standard ISO17442 as an authoritative legal entity identification benchmark. It also recommended that the Depository Trust & Clearing Corporation (DTCC), its subsidiary AVOX Ltd and SWIFT were key partners to operate any LEI utility (that is, a central data collection point that could also provide data maintenance, LEI assignment and quality assurance). The association also

suggested that the Association of National Numbering Agencies (ANNA) via its agency network was also an important participant in any solution that involved registering, validating and maintaining LEIs for issuers, obligors, and other relevant parties in their home markets. Since then, the DTCC, SWIFT, ISO and ANNA, have put flesh to the bones of the proposals and in conjunction with the LEI Trade Association Group issued a whitepaper Legal Entity Identifier (LEI), Project Scope and Preliminary Implementation Plan at the end of January. “Our early interest,” acknowledges William Hodash, managing director of business development at the DTCC, “stemmed from looking at the landscape of regulation and the gradual establishment of various systemic risk boards and data collection systems. While the CFTC is on top of those issues in the OTC space, it was clear that the Dodd Frank legislation and other emerging legislation and regulation around the world would take a much broader sweep. There were a number of smart people in the industry

The expected roll out and attributes of LEI

arket participants today use many codes to identify counterparties and issuers. these include marketplace identifiers, such as exchange company codes), company registration numbers, tax reference ids, vendor codes and the internal numbering systems of individual firms. Lei is not meant to be a substitute for these codes and will not necessarily replace them. the intention is that Lei will instead be an authoritative identifier for regulators and will be mapped by those firms that have reporting responsibilities or obligations. Lei will ultimately need to be mapped to a wide range of identifiers in and within many different databases, including internal legacy systems and vendor data feeds. Firms are now being asked by entities such as the

dtcc to consider whether any implementation of Lei is an opportunity to refine and improve these complex mapping systems. Global Lei is expected to be rolled out in three main phases. the first phase is designated between January and the end of June this year. in this first phase some 50,000 records are likely to be established related to transactions in the cds and interest rate derivatives asset classes. the second phase is described up to the end of 2012, by which time more than 400,000 records are expected to go live across the derivatives trading segment, with counterparties in some non-derivatives transactions being included in the records. derivatives feature heavily in these first two phases as the cFtc was the first regulator to mandate the use of

Lei in regulatory reporting. specifically, cFtc rule 17 cFr part 45 – swap data recordkeeping and reporting requirements, will come into force at the end of June 2012 and will require dealers executing otc derivatives transactions with their global counterparties to report those trades subject to cFtc oversight to trade repositories (such as the dtcc), identifying themselves and their counterparties and the reference entities of the contracts with Leis. the initial data model will likely include the Lei itself, the exact legal name of the entity, its address, country of formation and legal form that will be captured in a free form text field, metadata such as the date the Lei was issued and the ultimate parent of the entity. I

MARCH 2012 • FTSE GLOBAL MARKETS

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cover story

LEGAL ENTITY IDENTIFIERS: A TOOL TO MAP SYSTEMIC RISK

Robin Doyle, co-chair of the LEI Trade Association Group. Doyle acknowledges that there are major gaps in entity identification information that is used by the global financial institutions and regulators that play a key role in the international financial system. “There is little consistent entity information on the major bilateral linkages between institutions, as well as on their interactions with other transactors in the markets across the world. As a consequence, there is a poor understanding of the global financial network which continues to hamper policy responses,” she explains. Photograph kindly supplied by the DTCC, February 2012.

who helped our organisation clearly see the growing importance of reference data in the markets. LEI is one manifestation of that thinking.” The LEI Trade Association Group and the more than 40 global financial institutions that are part of it have been meeting since the third quarter of 2011 to focus on four LEI segments including data quality, technical requirements, unique identifier issues related to various types of investment funds and the overall LEI operating model, explains Hodash. These working groups have been instrumental in defining a phased implementation plan and to determine specific functions for the initial phase, “to meet, in the first instance, reporting requirements for

OTC derivatives regulatory reporting,” he states. This initial phase relies on the code structure and accompanying core data record called for by the Draft ISO standard. Right now global financial institutions such as JP Morgan Chase and Citi all have their own individual identifiers for transaction counterparties, issuers and borrowers for instance, that more often than not do not coincide. “As regulators seek to map financial market activity, having multiple identifiers reported to them for the same firm causes obvious difficulties,”says Hodash. Future phases will require a new “utility strength global infrastructure, which will have similar robustness and reliability as other financial market structures, such as securities settlement systems and/or trade repositories,” he explains. According to the January 31st whitepaper issued by the DTCC and others, the recommended solution providers have already begun to define how an LEI utility should be delivered, which will involve (among other elements) processes for self and third party registration, validation against publicly available information, records that provide full transparency as to its source(s) and the timeliness of information. This initial process will also include local jurisdictional inputs and support from national numbering agencies to provide up to the minute information on reporting entities. As an interim step, the DTCC and SWIFT are planning how the LEI Utility might be formed how it would contract LEI services, and are working with the industry and regulators to determine an appropriate interim governance model that will cover this first initial phase, prior to any formal governance and oversight provided by the FSB to the G-20. The LEI database will be available free to all users, including commercial data vendors, without licence or usage restrictions. While the funding model will ultimately be agreed through the FSB

“There is little consistent entity information on the major bilateral linkages between institutions, as well as on their interactions with other transactors in the markets across the world. As a consequence, there is a poor understanding of the global financial network which continues to hamper policy responses,” says Doyle. process, the industry (via the DTCC) has been funding the initial work on the solution. As part of this funding model, a small registration charge ($200 initial per entity and $100 annual maintenance costs) will be charged to registered entities to help recover start up costs. Once an official structure is in place, new pricing systems will likely be set. Meantime, over in Europe, the FSB is working to complete consensus building around key topics such as governance and oversight for the global LEI project, ensuring that any global LEI initiative meets the need of regulators, reporting entities and the public interest. It is also responsible for elucidating privacy and access issues related to the cross-border transfer or publication of data. The FSB is chaired by Mark Carney, governor of the Bank of Canada. Its Secretariat is located in Basel, Switzerland, and hosted by the Bank for International Settlements (BIS). In its July 2011 implementation progress report on The Financial Crisis and Information Gaps, prepared by the FSB and the IMF, it stated: “Since the last progress report a year ago, consultations with national authorities revealed broad agreement with, and a positive view of, the G-20 Data Gaps Initiative, with better identification of the build-up of risks in the financial sector and financial interconnectedness (domestic and cross-border) being among the highest priorities.”

MARCH 2012 • FTSE GLOBAL MARKETS

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cover story

LEGAL ENTITY IDENTIFIERS: A TOOL TO MAP SYSTEMIC RISK

“There were a number of smart people in the industry who helped our organisation clearly see the grow-ing importance of reference data in the markets. LEI is one manifestation of that thinking,” says Hodash. The FSB was approached a number of times for information as to the progress of the agency’s work in this area. Ultimately a spokesperson said the agency had yet to formulate its policy on speaking to the press on this topic and when it did someone from the agency would revert, if they felt it was necessary. No-one did. It may be that the special LEI Expert Group convened by the FSB, which involves the agency’s ‘key stakeholders’ (that is members nominated by national regulators) is still formulating important policy elements. Irrespective, the FSB must deliver its recommendations to an FSB Plenary meeting in April and then to the June G20 meeting, by which time (in the US) the first phase of the project will already be in place. Even so, the FSB has been designated a rather key role in the development of global LEI. All long term decisions regarding funding for the initiative, the LEI revenue generating model, its governance and oversight have to be finalised in conjunction with the FSB’s Expert Group.

Towards a common standard The LEI is a unique 20 character alphanumeric code that will be assigned to all entities that are counterparties to financial transactions through a newly developed International Standards Organisation (ISO) Draft standard, namely ISO17442. “If all those firms use the same 20 character number to identify say hedge fund XYZ in the Cayman Islands, a regulator can begin to effectively map what is going on,” explains Doyle. The LEI itself will be neutral, she explains.

This means that there will be no embedded intelligence or country codes included in the code, which could create “unnecessary complexity for users,” she adds. Essentially the LEI Utility will maintain a public database, accessible by any record keeper, for each entity, which will include the 20 character LEI, the name of the entity, its legal address, the location of incorporation and status code. This will be the extent of the public information on market participating entities, explains Doyle. “It is not a collection of private information on companies, stresses the DTCC’s Hodash, “the important element in the Draft ISO standard is keeping the number pure and unique; though equally important are the data elements added to it. Moreover, the approach is consensual, rather than prescriptive. Everyone understands that the entity is the best repository of information on itself. So the entity has to register itself and make sure its information is updated.” Equally, explains Hodash, the database maintained by the LEI Utility will not contain trade information. This will rest entirely with the trade repositories and trading parties, with only regulators seeing confidential trading information. Any legal entity that enters into a financial transaction will be eligible for LEI, including traders, issuers, reporting entities and parent firms or holding companies. Other participants in financial transactions, such as exchanges, utilities, registrars, regulators and perhaps specialist industry organisations, are excluded from LEI’s scope initially, but may be added later. A key component of the initiative is one that Hodash and Doyle return to repeatedly: namely that there is growing global co-ordination between regulators so that all will endorse the same LEI standard for regulatory reporting. “We have been very responsive to the global regulatory community,” explains Doyle.

William Hodash, managing director of business development at the DTCC. “Our early interest,” acknowledges Hodash, “stemmed from looking at the landscape of regulation and the gradual establishment of various systemic risk boards and data collection systems. While the CFTC is on top of those issues in the OTC space, it was clear that the Dodd Frank legislation and other emerging legislation and regulation around the world would take a much broader sweep.” Photograph kindly supplied by the DTCC, February 2012.

Support for the initiative is rapidly gaining global ground. “What we’ve proposed,” explains Doyle, “will serve the global market and even the OFR has voiced strong opinions that the LEI initiative must be part of a global solution, rather than a national one; and we see that happening. The US is leading only in that some of its regulators are already out of the block. In the derivatives space for instance, the CFTC has refined its own regulatory requirements in this field, which will come into force in July this year. The Hong Kong Monetary Authority’s (HKMA’s) rules will come out sometime in early 2013, with the Canadian Securities Administrator’s (CSA’s) rules close behind. Europe is beginning work on it and also, Mexico is beginning to get its rulemaking in place.” I

MARCH 2012 • FTSE GLOBAL MARKETS

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MuCH wAS ExPECTED FROM LTRO: HAS IT DELIvERED?

Has LTRO given a boost to Europe’s bond markets? As the European Central Bank (ECB) prepared to inject another huge tranche of money into the EU banking system at the end of February––little more than two months after it pumped in €489bn under its expanded long-term refinancing operations (LTRO) in December, it seems as if the massive boost to bank liquidity has given a much-needed tonic to Europe’s bond markets. Even so, how meaningful a recovery can the ECB’s unprecedented support for the eurozone banks really deliver on its own? Andrew Cavenagh reports. HE MASSIVE EXPANSION of the LTRO programme late last year has certainly had the rapid headline impact in the sovereign arena for which the EU’s political leaders and senior officials would have been praying for. As the banks that took part in the December hand-out have looked to park the three-year money they borrowed at an interest rate of 1% in higher-yielding and shorter-dated assets, the yields on short-term Spanish and Italian sovereign debt have dropped spectacularly. By mid-February sixmonth Italian Treasury bills were yielding just 1.59%––a fall of 360 basis points (bps) on their level in December. This was a welcome development. Towards the end of 2011 the yields on the two countries’ short-term paper were moving into unsustainable territory, threaten a debt crisis well beyond even the capacity of the EU to resolve. The imperative for banks to put their LTRO funding to work somewhere where it could generate income (rather than actually lose money on deposit at near-zero interest rates) also gave a fillip—partly indirect—to both the financial and non-financial corporate bond markets. As the sovereign yields declined, non-bank investors increased allocations to non-government bonds, and the consequent pick-up enabled

some European banks, including two of the stronger Spanish and Italian names, to access the market on their own account once more. Although covered bonds have dominated issuance from the financial sector so far this year (particularly from institutions in the weaker eurozone countries) with €32.5bn of the instruments placed in January, there were also two notable issues in the senior unsecured market from Italy’s Banca Intesa. The bank initially managed to place a €1.5bn bond with an 18-month maturity at the end of January, pricing the deal to yield 295bps over the mid-swaps benchmark (although by midFebruary it has come in to 230bps in secondary-market trading). It then followed this up with a €1bn, fiveyear deal on February 20th which priced at 355bps over mid-swaps to give investors a new issue premium of around 30bps. Suki Mann, head of cross-asset research at SG Corporate and Investment Banking, says the tenor of the second deal was particularly significant, as it might well give other large banks in the European periphery the confidence to “chance their arm” in the senior unsecured market. “It could also be seen as a sign that we are

Greek finance minister Evangelos Venizelos (left) speaks with European Central Bank president Mario Draghi (right) during a meeting of eurozone finance ministers in Brussels on Monday, February 20th 2012. Photograph by Yves Logghe for Associated Press. Photograph supplied by PressAssociationImages, February 2012.

starting to see an unclogging of the funding transmission mechanism for banks of this nature,” he concludes. There were issues with even longer maturities from the non-financial sector in southern Europe. Two of the leading energy companies in Spain and Italy, Repsol and ENI, came to the market with seven-year and eight-year bonds respectively in January, shortly after their governments had successfully completed debt auctions in each case. Repsol was the first company from one of the peripheral European countries to test the market in 2012, and it priced a €750m, seven-year bond on January 12th at 292bps over mid-swaps for a yield of 4.89%. ENI priced its €1bn eight-year bond towards end of January at 220bps (which still gave investors a 30bps new issue premium). As neither company had any urgent need for refinancing, the deals were clear evidence that both considered the time was right to put long-term funding in place on advantageous terms. The recovery in the corporate bond market has been reflected in its performance over January and February. According to the research team at SGCIB, investment-grade credit had delivered year-to-date

MARCH 2012 • FTSE GLOBAL MARKETS

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MuCH wAS ExPECTED FROM LTRO: HAS IT DELIvERED?

returns of 3.4% by mid-February while the high-yield sector had achieved 8%. Although the bank’s research team said it did not expect total returns to increase at this pace throughout the rest of the year, it maintained they were likely to remain positive as the sector continued to offer “the most attractive risk-reward profile among the major asset classes”. EU political leaders and bureaucrats have acclaimed the near-term improvement across the bond markets as a vindication of their and the ECB’s strategy. However, the true impact of the central bank’s expanded LTRO programme on the capital markets has probably been a lot more limited than the politicians would like everyone to believe. For the vast majority of the bond purchases that the LTRO beneficiaries have made are essentially “defensive”. That is, where banks are simply trying to place the money to best possible advantage until they need it to meet their refinancing requirements rather than “aggressive” carry-trade investments. “The LTRO funding hasn’t been used so far for the expansion of bank balance sheets,” explains Justin Knight, head of European rates strategy at UBS in London.“In general, we don’t expect to see them doing that.” Knight says this had focused the banks’ bond purchases on short-dated assets that would mature before they needed the funds to refinance their own maturing debt––to ensure they would not run the risk of having to sell the investments at a loss. “They would rather buy six-month bills than threeyear bonds with larger yields,” he explains. This has inevitably limited most of the pick-up in sovereign-market yields to the shorter end of the curve. While the yields on ten year Spanish and Italian sovereigns have come down from their highs at the end of 2011, the drop has been markedly less than that on their short-dated securities. By February 20th, Spain’s and Italy’s ten year bonds were yielding 5.17% and 5.49% respectively having breached the 7% level in early December.

Knight explains that the Spanish and Italian sovereign markets have also been supported this year by indexed asset managers (predominantly German, French and Danish funds) had become seriously which underweight in the bonds at the end of 2011 and had subsequently been obliged to rebalance their books as the yields on the instruments fell. Given the overriding concern of banks that have made use of the LTRO funding is to maintain enough liquidity to meet their own near-to-medium term liabilities, it is hardly realistic to expect them to use that precious liquidity to support auctions of long-term sovereign debt in the beleaguered southern European countries.

Greek euro exit still possible The risk of using the cheap, three-year ECB money to buy lower-rated government bonds with longer maturities would just be too great, given the uncertainty over what could happen to their value in the meantime. Banks could easily find themselves having to raise expensive funding to refinance depreciating assets, or sell them at a loss. There will be no assurance on southern European sovereign valuations as long as the medium threat of a Greek default and ejection from the euro remains (and the final EU approval on February 21st for a second €130bn bail-out for Greece has by no means removed that threat). It is just possible that positive-carry gains over the three years might more than compensate for the decline in yield on four-year, or even five-year debt when the residual risk would, in effect, be on a one-year or two-year bond. However, it is inconceivable that banks would take such a chance in the current environment on bonds with maturities of seven years or longer. The scope for the ECB’s LTROs to underpin the sovereign bond markets in the future will consequently remain limited, and it is clear that the bank’s president Mario Draghi does not consider that to be part of the programme’s purpose. Draghi has

stressed from the outset in December that the prime aim of the huge expansion of the refinancing operations was to reduce the risk that a serious liquidity crisis would arise in the euro banking system during 2012, as its banks had €230bn of maturing debt to refinance in the first quarter of the year alone. A secondary target was to lend support the“real”economy (in the hope that the banks would on-lend some of the funds they were raising). It is also clear that the ECB also does not intend to provide liquidity to the banking system on this scale for the length of time that would be necessary to provide meaningful support for the bond markets in the long term. As the central bank announced in early February that it would extend the collateral it will accept under future LTROs to include credit claims or loans (albeit with hair-cuts of 66%), Draghi firmly rejected any suggestion that the operations would continue indefinitely. “Because of their size and complexity, one would certainly not want to commit to making them a permanent feature of our monetary policy,” he said. Marc Ostwald, senior bond strategist at Monument Securities, maintains that the programme had done little more than provide a “firewall” for the European banking system in the short term. “What it doesn’t solve, of course, is long-term solvency––and it will have to be withdrawn at some stage.” Ostwald says that the massive provision of short-term liquidity would not address the timing mismatch between assets and liabilities that was still prevalent in the banking system or restore confidence in inter-bank lending (although that market had relaxed a little recently), given the extent of fears about counter-party risk. He says the expansion of the LTRO programme shared a common feature with previous EU initiatives to resolve the crisis in the eurozone, putting off the ultimate day of reckoning to some point in the future. I

MARCH 2012 • FTSE GLOBAL MARKETS

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

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

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MERGERS AND AquISITIONS; wILL 2012 bE ANOTHER DAMP SquIb?

Like pretty much everything else this year, the outlook for mergers and acquisitions (M&A) is pretty low key this year. Even so, corporations seem to be cash rich and the US corporate bond markets is highly active, with record issuance levels of both high and low rated bonds in the opening weeks of the year. The yield on junk bonds is at its lowest juncture (around 7.93% in the third week of February) since the beginning of August 2011. Corporate resizing and restructuring is underway on an epic scale in Europe and the United States. All in all it looks like a buyers’ market is developing; if only! Ian Williams reports on the implications of continuing uncertainty in 2012 and whether M&A is, in fact, the best solution to a company’s growth conundrum this year.

Where’s the real value in M&A? S CORPORATIONS ARE sitting on up to $2trn in cash reserves, and investors—let alone unions and the government— are wondering what they will do with it all. The chances of it being spent in salaries, dividends, stock buybacks or investment in new plant however are low. The developing consensus is that many companies could splurge on massive M&A exercises in the second half of this year. Even so, more than ever before, previously unchallenged executive expansionist ambition is under closer scrutiny. Evidence suggests that many M&As definitely make money for the banking advisors, probably for the senior management, and very possibly for the stockholders in the target companies, but are unlikely to benefit the acquiring corporation’s shareholders. Shareholders have other reasons to be leery. According to a recent Wells Fargo analysis S&P500 firms are paying out the lowest level of retained earnings in dividends since records started in 1871 and even share repurchases (which often camouflage management stock options) are running at a very low level. With returns on cash at their lowest levels ever, the wisdom of chief executives sitting on cash hoards like dragons on piles of gold is not enticing. Indeed, at current rates the dragon would probably be getting a better ROI! Jimmy Osman of Spin-off Report, which tracks impending demergers, expresses a robustly jaundiced view, “Whilst some companies believe in returning the cash to their investors,

Photograph © Dundanim / Dreamstime.com, supplied February 2012.

even more hold on to it for reasons that at best can be described as nontransparent. For example, Apple is currently holding more than $100bn in cash, with no possible deployment hinted in the analyst or shareholder meetings. When investors [such as] Warren Buffet hold on to cash they offer a simple premise that they can do better with the cash deployment than their investors can; and over the years, they have proven it. That cannot [however] be said for the majority, for whom cash serves as a means for empire building for management, and destroying value for the shareholders. Several studies have conclusively proven that shareholder valuemaximization happens when the cash generating businesses spin off their cash consuming parts, forcing them to stand on their feet or get taken over by more efficient enterprises.”

In fact, now that Steve Jobs has gone, Apple is reportedly beginning to look at M&A. However, surprisingly perhaps it has never paid a dividend to its shareholders. With the disastrous aftermath of mergers such as Bank of America’s takeover of Countrywide, Rio Tinto’s marriage with Alcan, and Time Warner/AOL, it does take an exceptionally amnesiac investor to buy into the M&A dogma. On the other hand the economic sense of deals that sometimes look questionable at the time sometimes comes into focus afterwards. Take, for example, Kraft’s acquisition of Cadbury, which became the keystone of the global confectionary business that Kraft now proposes hiving off to the seeming applause of investors and analysts. Professor Ben Branch, of the Isenberg School of Management recently completed a study on mergers, and counters, “Generally, spin-offs do create value if the sharper focus is better for their productivity, but I don't think you can reason that spin-offs create value; therefore mergers must destroy it. Managements have to do something with that money. Certainly some of them will just sit on it, but there’s pressure from the shareholders and the board when yields on money market instruments are essentially zero. If they increase the dividend, they lock themselves into a longer term payment strategy that they may not want. If they use the money to buy in shares, they have shrunk their company by the amount that they've used. [Therefore] some of the money

MARCH 2012 • FTSE GLOBAL MARKETS

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MERGERS AND AquISITIONS; wILL 2012 bE ANOTHER DAMP SquIb?

that they're sitting on is going to go into mergers and acquisitions.” Branch’s research concludes that, on balance, value was created in more of the mergers than was destroyed, but that most of it went to the target shareholders and management. “There's not a lot in it for the shareholders of the acquiring company in general. There may be something in it for the managers of the acquiring company because they now control a bigger entity. But the funds that own those shares don't get much,” he says. Jon Lukomnik, of the Investor Responsibility Research Center puts in some, strictly qualified, lines of defence for cash-hoarding management. “They are feeling the fallout from the global financial crisis and the credit crunch. Companies are basically becoming their own banks. Until they can trust banks again, they’re keeping liquidity on the balance sheet, where in the past perhaps they might have preferred less cash and more of a line of credit." However, he admits the danger that, “They feel like the money is burning a hole in their pocket, and they go out and they do something silly with it. There are lots of cases of that, from the purchase of Countrywide to building huge, new glistening corporate headquarters, or overpaying for naming rights on a stadium for non-consumer affairs business.” The question is whether shareholders are prepared and able to do due diligence on proposed M&A activity. Lukomnik suggests that in the real world of indices and funds, few investors sit and pick specific companies to buy the stock, and many institutions are universal owners, they have stock and bonds in both the acquiring and target companies, and indeed in their peer companies as well. In that respect, he explains, “You are somewhat more sensitive to overall market moves; to beta rather than alpha. You need to do holistic analysis and not: this is 20% more than I would have had yesterday, and therefore I'll take it.”

Apart from reading the proxies and balance sheets very carefully, he advises, investors to look at the compensation disclosure analysis, and ensure that executive compensation is geared towards actually building real economic value over time, “that the compensation and the metrics that are disclosed are truly value-creating rather than just topline growth-creating”. Wharton Professor Pavel Savor brings up the second-guessing of the market once M&A activity is augured. “Once you announce that you're trying to do a deal, you can’t reveal yourself as potentially maybe overvalued. Then however, if you don't close, it’s even worse for your shareholders, because you won’t get the benefits of a merger, one of which is maybe issuing a lot of overvalued stock!” Again though, he cautions investors, “You might think that if management, for whatever reason, does not like returning cash to shareholders, then their interests might not be fully aligned with those of shareholders.”

Hedging against tax Apart from rational motives, such as hedging against taxes and credit crunches Savor suggests that “there's some evidence that managers who are entrenched, for example, either because they've been there for a long time or because they've captured the board, seem to do worse deals as acquirers, than managers who are perhaps more restrained by their shareholders. There's also evidence on the target side that when managers receive very good treatment, for example, by being issued high stock options or being given high positions in the combined entity, their shareholders tend to do less well than they would in other circumstances.” He concludes, “If you believe that a firm is well-governed in the sense that the chief executive and his top management are fully aligned in their interest with shareholders, and the board is adequately independent and, again, taking care of shareholders,

then as long as management is competent, that M&A should create value on both sides, because why else would anybody try?” Branch also discovered that there are collateral benefits of M&A. His team examined the aftermath of M&A on peer companies, that is, those in the same industry of a size comparable to the target and to the acquirer.“We found some positive impact in the short run, and I think in the longer run, the peers of targets tended to have some benefit perhaps because it raised the possibility of their being on the block,”he says. For the benefit of duly diligent investors, Branch’s research team also suggests acquisitions with cash were much more likely, or significantly more likely, to be value-creating than those that were paid for by stock of the acquiring company. “That kind of stands to reason,” he concludes, “If you're spending your own cash you're more careful about it than if you're using value that you created by printing up more stock.” Even so, Branch reinforces Lukomnik’s point about most modern investors. “If you are an institutional investor with a very diversified portfolio, and you're wondering whether to support this transaction or not, then you will probably hold both the acquirer and the target. If it's going to create value, it's a good chance that it will benefit your portfolio; and if it's not going to create overall value, even if it does result in a premium to the share-holders of the target, then it's probably not going to benefit you.” However, while there might be different opportunities for selective and universal investors, looming is the possibility of an equity bubble if all that cash pours into competitive M&A in a short time. In the end, the rational response again is due diligence and healthy suspicion in the face of the continuing uncertainty. When you see the lemmings run, watch out for the cliff edge that is surely waiting. I

MARCH 2012 • FTSE GLOBAL MARKETS

In the markets

Opportunity in GCC insurance at a time of change lthough mired with promise, the fact remains that it has been something of a curate’s egg for the GCC’s insurance segment (good in parts. The Shari’a compliant takaful insurance segment continues to rise in popularity, though outside of Saudi Arabia its upward trajectory has been dented somewhat by rising political risks. Its strong performance in the Kingdom is related however to the continued rollout of compulsory medical insurance, rather than any extra mural factors. The GCC itself accounts for some 45% of the global Takaful premia market and while the traditionally higher margin business segment was beset by rising political risks through the first half of 2011; the growth outlook for this business segment looks bright. The insurance market in the GCC is characterised by the following: the market is overcrowded; there is a shortage of premium, and premia are marked by soft (or low) rates. Moreover, across the region, the sector is in flux, increasingly subject to a raft of incoming regulation some of which is international (such as Solvency II), some of it local, such as the UAE Insurance Authority's requirements for enterprise risk management and risk-based solvency calculations. Once they are implemented these new rules will impose significant new requirements on UAE insurers. The insurance industry globally remains under pressure, which may end in the closure or takeover of smaller

FTSE GLOBAL MARKETS • MARCH 2012

insurance companies. The same may very well hold true for those in the Gulf states. The ban on composite insurance, which is currently due to come into effect in 2012, is a case in point: composite insurers must have not only ceased one or the other of life or general business, but also achieved full legal segregation of these businesses, so that their liabilities are housed in separate entities. Putting one part of their business into run off (closing down new policy writing) and/or disposing of it could be one of a number of solutions available to them. In addition to impending changes in the Emirates, Bahrain’s central bank’s (CBB) has issued new rules for its module on the Shari’a compliant insurance segment (or Takaful). CBB has introduced new rules on client money, to enhance the regulatory framework relating to the appointed representatives and insurance brokers. The new rule is designed to strengthen the central bank’s supervision of the sector to help protect the funds of clients being used other than for purposes outlined in their insurance contracts. The move to upgrade the Bahraini insurance regime is predicated on growing competition within the GCC itself to define a properly regulated and rules based industry as the business potential for the sector remains largely positive. In this regard, the CBB’s Al Baker addressed, in his speech, the wider region as much as his domestic regulatory remit.

MIDDLE EAST INSuRANCE: THE PROMISE OF PLENTY

Bahrain’s central bank is working on its Shari’a compliant insurance, or Takaful module, to ensure that stakeholders are better protected. According to Abdul Rahman Al-Baker, director of financial institutions supervision at Bahrain’s central bank, “It is also expected that changes to the module will attract new players to the market and will foster competition for the betterment of consumers.” For yet another year, the Gulf Cooperation Council’s (GCC’s) countries insurance market stands on the cusp of take off. What should the industry look for in 2012?

Photograph © Mishkacz / Dreamstime.com, supplied February 2012.

With all these developments in mind, there is a growing sense in the GCC that this is a pivotal year in the affairs of the region. Diversification away from dep-endence on energy revenues con-tinues apace and there is a renewed focus on infrastructure. Various locally based reports suggest that combined, the GCC countries are set to invest in the region of one trillion dollars, enco-mpassing over 1,638 new capital goods projects over the next decade. Over 80% of these projects are in construction, infrastructure and energy sector projects. In new tran-sportation links (involving new roads and railway projects) GCC countries have ear-marked some $100bn in spending between 2011 and 2020. Meanwhile a number of high profile projects are coming on stream, such as the New Doha International Airport, which is set to open with a passenger capacity of 25m, rising to 50m by 2012, while Dubai’s Terminal 3 development is specifically designed to accommodate the new super-jumbo carriers. In Qatar meantime, preparations are underway for the country to host the 2022 World Cup, with the entire attendant internal infrastructure that this project will require. Within this context alone, insurance and reinsurance businesses are expected to thrive; irrespective of the opportunities still extant in the family and life insurance segments.

In the markets

MIDDLE EAST INSuRANCE: THE PROMISE OF PLENTY

Further afield, there are also major investment and developments in the reconstruction of Libya and its petrochemical sector, where there is backing from UAE and Qatari interests. Likewise in Iraq there are a number of major projects in the pipeline. Even so, the construction insurance market in the GCC area is overcrowded, with att-endant pressure on premium rates. It is harder for international companies seeking to enter the market, where onshore energy risks worth up to $1bn can be placed locally. Moreover, with demand for new construction significantly dampened in the 2009-2011 period it is hard to see, with selective demand mixed with rising competition, how premia can rise significantly over the near term. It is unlikely however that the appeal of the GCC to foreign insurers will diminish. Energy risk sums insured in the Middle East (in the GCC in particular) remain especially large, with many projects, such as the Qatari and Saudi downstream petrochemical developments running into billions of dollars. Even so, low retention continues to problematic. Consequently, energy insurance does not necessarily benefit the local markets in the same way as other insurance lines, such as life, motor or medical, for example.

Bahrain’s reformist agenda In Bahrain specifically, the central bank is essentially carrying on its reformist agenda to help establish the country as a financial centre of excellence despite haunting concerns that the Kingdom is not as liberal as once was thought. Bahrain’s central bank has always moved to the beat of its own drum; defining its role by market pragmatism rather than ideology; an unusual stance against the zeitgeist in many GCC countries, which are moving towards the definition of their inimitable brand of autocratic democracy. Political oxymorons aside, Bahrain’s central bank has had much to celebrate as over the years it has established a reputable and deep

regulatory regime that well outstrips the financial markets that it serves. From a regulatory perspective, the CBB has taken various steps to ensure that a stable insurance market continues to prosper, claims Al-Baker. A keystone of the central bank’s policy is protection of policyholders and this tenet is “clearly outlined in the CBB Law as well as through the rules that have been introduced to specifically deal with tied agents,” he noted in a keynote speech to the Middle East Insurance Forum in Bahrain in early February. “These rules require a minimum level of qualifications for those dealing with potential policyholders and recognise that the offering of insurance products must be made in a professional and ethical manner. In this regard, the CBB will also be introducing training and competency requirements for insurance licensees and their staff performing controlled functions, as well as those involved in dealing with potential customers.” Moreover, the central bank has played an important role in the founding of the Arab Forum of Insurance Regulatory Commissions (AFIRC), which brings together some 17 Middle East regulatory authorities, and aims to promote collaboration, transparency and adoption of the best international standards among regulators in the region. Al-Baker’s speech stressed the need to maintain adequate levels of solvency in line with the best regulatory standards across the globe, which “is another regulatory priority for regulators in the Middle East insurance industry”. Adequate solvency requirements basically enhance the confidence in the financial stability of the insurance industry and further improve the financial standing of insurance firms. “Such solvency requirements should be helpful to provide early warning to regulators so that they could take the necessary measures should the capital of insurance firm falls below the required level,” he adds.

With the GCC’s insurance industry set fair for growth over the coming years, regulators will have to act locally, and internationally. Locally by working closely with insurance companies, service providers and other industry stakeholders to ensure a close oversight of their activities yet provide enough room for them to grow. And internationally by coordinating and cooperating with standard-setting bodies such as the IAIS to build on existing regulatory and supervisory standards. In the meantime though, Bahrain’s central bank is working on a parallel road alongside the Qatar Financial Centre Authority (QFCA), which is also trying to establish the jurisdiction as a natural hub for insurance, captive reinsurance and reinsurance. According to a recent report by Alpen Capital, “The country’s liberal policies, such as special tax concessions for reinsurers and 100% foreign ownership, offer distinct advantages. Taking cue, a number of global reinsurance companies are expected to establish a presence in Qatar. Other global players also see the present as offering them more opportunities than at any time in the past.” The QFC Authority adopted a new strategic focus in 2010, which directed its efforts in building three hub strategies (involving asset management, reinsurance and captive reinsurance). It issued two consultation papers in May last year to help it develop captive insurance in the region; including a rulebook for captive insurers and another for managers and insurance intermediaries. The Regulatory Authority deputy CEO, Michael Ryan, explained at the time that: “Qatar’s insurance market is expected to see substantial growth over the coming years and the authority’s proposed rules are des-igned to ensure that the appropriate structure is in place to support the growth of a worldclass sector. I

MARCH 2012 • FTSE GLOBAL MARKETS

guest column

THE NExT CRISIS: wHAT IF A STOCK ExCHANGE FAILED?

Stuart Z Goldstein is a communications consultant in the financial services executive. He is co-author of two books, The Guide to Clearance and Settlement (2009) and The Lifecycle of a Security (2010) that explain (in plain English) how US capital markets settle securities transactions.

In the wake of the financial crisis triggered, in part, by the fall of Lehman Brothers and AIG, the consensus among policy makers in the United States and Europe has been to require that derivative instruments, such as credit default swaps (CDSs), be traded and cleared on public exchanges. The process of clearing trades would require exchanges to both guarantee that trades will be completed and the collection of collateral from individual firms to mitigate risk and exposure from these trading activities. However, the unintended consequences of these planned reforms may well set the stage for the next major crisis, which is the collapse of a major stock exchange. Such an event would paralyse financial markets worldwide and have a catastrophic impact on the global economy. By Stuart Z Goldstein.

Are tougher risk capital requirements needed for derivatives trades? HE MOVE TO have exchanges guarantee derivative trades has not been fully vetted by financial experts and academia. Policy makers have seized on the model of clearing and settlement used in the cash markets for equities and bonds. However, derivative instruments are very different from the cash markets, both in complexity and value. The total value of all equity trading in the United States could reach $2.2trn on a peak day, around half of what’s traded worldwide. In contrast, the current value of credit derivatives traded globally is over $26trn. This exposure exceeds the total GDP of more than 150 countries combined. Automated clearing was implemented in the US equity markets in the late 1970s. The goal was to solve the paperwork crisis that threatened trading markets, when the NYSE handled an average 15m trades per day. Today, because of automation, more than 1.3bn shares of stock are traded seamlessly across all US stock exchanges and electronic venues. Aside from creating efficiency, clearing promotes the anonymity of trading parties. Once an exchange’s central clearing corporation receives the trade, it assumes the risk of completing the transaction. No one needs to worry about counterparty exposure. If a firm goes out of business, the exchange’s clearing corporation will sell their securities or provide payment to counterparties to satisfy obligations.

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In the derivatives market, however, anonymity of trading counterparties is a major part of the problem. The market for credit default swaps is so opaque that regulators are unable to see the concentration of trading risk by individual firms or their counterparties. Centralised clearing by one exchange will not shed light for regulators on the trading of derivatives that may be going on in other parts of the world. Credit default swaps are essentially insurance contracts that help financial firms mitigate risk. Once the contract is completed, pieces of the contract are sold off to multiple counterparties, so risk can be further reduced. Since the trading of these instruments is going on globally, a single exchange will never have a complete snapshot of a firm’s risk profile for purposes of assessing their financial strength or collecting adequate collateral. Exchanges are welcoming the idea of clearing derivative trades, because it provides them with a new source of revenue, but this does not mean they have the risk management expertise to manage complex derivative instruments. What happens if an exchange has not collected adequate collateral to cover the exposure of trading parties? In such a crisis, the credit ratings of an exchange would have a direct bearing on their access to credit lines and liquidity. Two years ago, one of the major

exchanges had a credit rating of BBB-. The point is that as market conditions change, the exposure from derivatives may inhibit the ability of exchanges to get sufficient liquidity to withstand financial shocks. As with Lehman Brothers, even the perception that credit is inadequate or access to liquidity is drying up that could cause irreparable harm. At that point, would central banks now become the backstop for publicly listed exchanges? Would taxpayers, once again, bear the burden? In the world of immunology, doctors try to isolate and contain a contagion. They do no bring the infected party to the public market (or population centers), since they understand the risk inherent in doing so. Instead of concentrating the risk of credit default swaps on listed exchanges, policy makers should pursue better alternatives. Let financial firms trade derivatives directly, but impose tougher risk based capital requirements corresponding to a firm’s changing risk profile. Support regulators in their efforts to have banks adopt living wills, which will details how they plan for the unthinkable. Lastly, policy makers need to embrace the critical role of a centralized global trade repository, where transactions details for all derivative trades are reported. Only a trade repository can ensure regulators see the risk of a single firm across the global marketplace, so they can stop a contagion. I

face to face

bILL SMITH, MANAGING DIRECTOR, SECuRITIES LENDING, JP MORGAN wSS

Bill Smith, managing director, Securities Lending for JP Morgan’s Worldwide Securities Services. Photograph © Berlinguer, February 2012.

Securities lending markets were something of a hotchpotch through 2011: with some brighter lights at the end of the year, particularly in the United States. With the vast amount of market volatility in the last quarter of the year, US special activity picked up. Meantime, collateral preferences ebbed and flowed over the last twelvemonth, with interest in non-cash collateral rising. It is still too early to tell how this year will span: as always in difficult times, the indications are often contradictory. Bill Smith, managing director, Securities Lending for JP Morgan’s Worldwide Securities Services business explains the US market’s current dynamics.

New securities lending trends for new times N SECURITIES LENDING, a key component of risk mitigation is collateral management. This might, for instance, involve a well defined haircut, daily mark to market calculations of loans and collateral, as well as ensuring good counterparty quality and an effective collateral mix. First off: how diversified is the collateral mix right now? Or does cash still dominate and if so, why? BILL SMITH: Moving into 2012 the mix of collateral supporting securities lending transactions continues to diversify. The expectation of historically low interest rates in the US and many foreign markets, when coupled with ‘risk off’ cash collateral investment view from beneficial

owners, have driven returns from cash collateral investment to low levels. This has created a greater interest in non-cash collateral. The resulting increased use of non-cash collateral, and the willingness of both borrowers and lenders to explore a broadening array of non-cash collateral, is being further complemented by regulatory changes that will expand the universe of transactions that require collateral. All of these factors are driving securities lenders and borrowers, and all global capital market participants toward a need to focus on the acceptable types, available supply, operating models, and oversight and control of collateral (including cash) within their organisations.

Is it better for beneficial owners to accept a broad range of collateral types; or to favour cash? BILL SMITH: Accepting a broad range of cash and non-cash collateral types will increase any beneficial owner’s opportunity to generate securities lending revenue. The opportunities generated by this flexibility are available because a flexible position better meets the needs of the borrowers. Borrowers offered this flexibility will have a greater opportunity to reduce their cost of borrowing. In the case of cash collateral, borrowers have developed a cost aversion to providing cross-currency collateral. Borrowers increasingly desire to provide collateral in the currency of their short (borrow) to avoid the FX cost involved in providing cross-currency collateral. In the case of non-cash collateral, which is the dominant collateral utilised in Europe, flexibility creates similar revenue opportunities for beneficial owners because borrowers can utilise their ‘long’ inventory as collateral which is cost effective for them. By moving away from cross currency cash collateral, FX swings, and the risks that they can create are eliminated from the loan versus collateral equation. Also by broadening non-cash collateral flexibility the opportunity exists to reduce market risk by pairing loans and collateral in both the same currency and the same security type (that is, loans of equity securities collateralised by equities issued in the same currency). Have you noted an increased demand for customised collateral schedules? Which beneficial owner segment favours this and why? BILL SMITH: As a major provider of triparty collateral services, JP Morgan works with our customers to ensure that the collateral that they take meets their requirements. We have experienced an ongoing desire in many segments of the beneficial owner community for more customized collateral schedules. This is consistent with the industry-wide moves toward greater transparency and increased risk oversight as well as the broader capital markets moves where ongoing regulatory change is focusing

MARCH 2012 • FTSE GLOBAL MARKETS

heavily on collateralisation of financial transactions and derivatives. In the future all markets participants will focus on the increased rigor necessary to create efficient collateral management disciplines in all of their transactions. Why are tri-party collateral agents so in demand? BILL SMITH: The regulatory environment is driving the need to collateralise obligations with third party providers. Dodd Frank, US Fed Tri-Party Reform and additional global banking changes are driving our clients, their counterparties, and other market participants to collateralise obligations efficiently and in a segregated manner, fund their activities more efficiently over longer terms and to preserve capital. As a result of these changes our clients require the services of a tri-party custodian to mitigate risk, increase operational efficiency and maximize funding capabilities. How important these days is indemnification against counterparty default, particularly in repo? BILL SMITH:The value of indemnification in both securities lending and repo arrangements should be appreciated highly by clients utilising these services. A detailed understanding of the terms of any indemnity, and the ability (financial strength) of the institution offering it are mandatory in order to gain comfort in the mitigation of risk that it is intended to provide. The value of meaningful risk mitigation, against the backdrop of the volatility in current global markets, is very significant. On a completely different topic: how do you help clients leverage or maximize incremental revenue opportunities and still execute on their share voting (proxy or otherwise) responsibilities? Is it possible? BILL SMITH: We work with our securities lending clients in a number of ways to allow them the opportunity to take advantage of the return enhancement from securities lending while also executing their proxy voting rights. We coordinate strategies with clients and externally provided proxy data services to allow clients to determine which proxy votes are “material”, as well as working

FTSE GLOBAL MARKETS • MARCH 2012

with clients and their portfolio managers in order to recall from loan those issues where they have identified the desire to vote. By utilising these available efficiency tools and procedures, JP Morgan’s clients have the ability to balance their goals of generating securities lending revenues with appropriate levels of proxy voting. A new survey by Finadium of 96 US public funds and private pension plans found a fall off in the number of funds using a securities lending provider who was not their custodian. Have you noted similar? If so, why do you think this is happening? BILL SMITH: The decision to use a single entity as both custodian and securities lending agent, or to choose one or more securities lending agents away from the custodian, has historically been based on two major factors. One is whether the beneficial owner viewed the bundling of the costs for the custodial and securities lending services to their advantage; the other being whether beneficial owners perceive securities lending ‘performance’ enhancement from engaging a separate securities lending agent(s). Recently we have been involved in cases where clients both ‘re-bundled’ custody and securities lending and also ‘un-bundled’ the two services. While Finadium may identify this as a trend among surveyed US public funds and private pension funds, this finding may not be representative of the broader global universe of pension plans and beneficial owners. Again, in similar vein, is this trend more prevalent among those funds in which cost is more of a focus than, say performance, or other factors? Or is it across the board? BILL SMITH: This is really not an either/ or case. Once a beneficial owner has gained access to transparent, detailed pricing for the custodial and securities lending services, then the direction that their decision making takes can incorporate the values available from both of the services. This is more the case of seeking to optimise the service values and costs for each of the services and only then making the pricing decision.

Is the decision-making around custody and securities lending generally a separate process; or one which is increasingly made together? BILL SMITH: It has definitely become more common for pension plans and other beneficial owners conducting searches and RFPs to ask for ‘transparent pricing’ so that they can understand the cost of each service offering clearly through the ‘un-bundled’ lens. What do you think will be the key characteristics of the securities lending market in 2012, in terms of borrower demand? BILL SMITH: The securities lending industry faced significant headwinds in 2011. The industry was challenged by near zero interest rates, uncertainty over many details in pending market regulation (for example, Dodd Frank and Basel III), the European debt crisis, short selling bans in several European countries, low borrowing demand from hedge funds, constrained IPO and M&A activity, and continued low returns from the lending of G-8 debt securities. In 2012, we do not expect market conditions to differ significantly from 2011, as the macro issues that caused volatility and uncertainty in 2011 will continue into 2012. Corporate activity and capital markets are subdued in many markets due to the current market uncertainty. These are conditions which are not good for the lending business. In a number of European countries “tax harmonisation” will continue in 2012. These changes will have a reducing effect on the seasonal revenue generated for holders of securities in these markets. However, there is pent up demand among companies to do deals once the environment changes. Hedge funds are looking for opportunities amidst the market uncertainty and this may drive increased demand and wider spreads. The potential for improvement on a broad based scale is dependent on the resolution of the European debt crisis, improved economic conditions in Europe, an increase in short term interest rates, and increased global IPO and M&A activity. I

country report

vIETNAM’S SLOw buRN TO RECOvERY

Vietnamese foreign minister Pham Binh Minh, left, walks with his Malaysian counterpart Anifah Aman as he arrives for a bilateral meeting in Putrajaya, Malaysia, February 8th 2012. Minh was on a two-day official visit in Malaysia. Photograph by Lai Seng Sin and kindly provided by Associated Press Images, February 2012.

Vietnam’s high growth rates belie the need for widespread infrastructural reform As financial reform gathers slow pace in Vietnam, the markets look to remain cautiously optimistic on both the currency and macroeconomic stability, although external factors may thwart even the country’s best laid plans for change. Much needed reform to restructure the banking sector will likely hold back the corporate bond market short-term and the narrow and thin investor base will continue to impede both market liquidity and growth over the same period. However the longer term prospects look decidedly brighter, as long as the government stays the course on economic reform. Dan Svensson, portfolio manager at Dragon Capital in Ho Chi Minh City reports on the country’s economic and capital markets outlook for the rest of this year. IETNAM REMAINS ON track for between 6% and 6.5% GDP growth this year, even though the economy is still restrained by both internal and external challenges. Financial reform, new regulations and restructuring in the banking sector are key themes for 2012. Even so, the limited nature of the investor base in Vietnam will continue to hold back the expansion of the corporate bond market for much of this year though there will be solid demand for government bonds caused by large redemptions and also a more positive outlook on macroeconomic stability. The value of Vietnam’s bond market is relatively light compared to its Southeast Asian neighbours, representing some 16% of GDP (compared to say 74% in

Singapore and 82% in Malaysia). In the last quarter of 2011, the market was worried that USD loan redemptions and the traditionally high demand for USD before the Vietnamese New Year (Tet) would put pressure on the dong (VND) to depreciate. Instead the VND has strengthened since November last year thanks to decelerating inflation, a falling trade deficit and solid US dollar inflows. In terms of trading, the overall trend is one of improvement: Vietnam’s General Statistics Office estimates exports in January at $6.5bn, or -11.1% year on year, and imports at $6.6bn, or -18.7% year on year, implying a much reduced trade deficit compared to 2011 when it maxed out at $880m. The 12 month rolling core trade deficit (ex oil and gold) came down to $8.5bn, the lowest in two years.

However Tet has fallen much earlier than in previous years and it is likely export growth will bounce back over the coming quarter. Improvement will be gradual and we will likely see the first signs of this in 2012 assuming that macro economic conditions stabilise. In this regard, I think we should be cautiously positive on the development of external balances and the government’s determination to control fiscal spending. Meanwhile gold flow and market sentiment are harder to predict, though right now it looks like the sentiment on gold and the US dollar is much less bullish compared to last year. With that in mind, it is likely that any dong depreciation will be very modest (between 2% and 3% perhaps) this year.

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Monetary conditions are now very tight which may lead inflation towards 10% (or just slightly less) by the second or third quarter of this year. Even so, while the real economy will need time to pick up speed lighter monetary conditions during the second half of the year should allow for lower government yields and also lending rates, which will give some support to asset prices.

Restructuring the banks The government is firmly adhered to a policy of restructuring of the banking system to enhance its efficiency and lower lending rates by the second quarter of this year. There are three elements to the government’s approach to banks. The first is the creation of local market liquidity through bank lending, while keeping interest rates and inflation in check. The central bank is trying to control credit growth to between 15% and 17% to help control inflation to a level below 10% and secure the government’s growth target. Equally the central bank is keen to control/reduce interest rates to rest around 10% by year end. High inflation and new measures introduced by the State Bank of Vietnam have driven many larger banks to offer interest rates of 14% per year to attract deposits, while some smaller banks are forced to offer even higher rates––up to 16-17%. In contrast government bonds have typically paid around 12%. To address the weak link between the different market rates, the State Bank of Vietnam enforced a number of restrictions in 2011, including a cap on deposit rates. Macro economic conditions have, since then, stabilised. Moreover, the currency has held up and government yields are now down a notch to around 12% after peaking at 13.2% in May-June last year. The development of the country’s agricultural sector (including farming, fishing and forestry production) is a top priority of the government, which is

FTSE GLOBAL MARKETS • MARCH 2012

anxious to encourage banks to lend to these segments. A secondary priority is export and downstream industry. The central bank is encouraging lending to small and medium sized enterprises for capital investment. Perhaps most important element however is the overhaul of the country’s banking infrastructure, which may take some years to complete. A number of the country’s banks remain weak and lack exhaustive internal controls. The overhaul should improve the security and effectiveness of the sector. The establishment of two Vietnamese banks that can compete at a regional, if not the broader international level, is a key goal of the government’s consolidation plans for the sector. It also hopes to ensure the country has up to 15 healthy domestically focused banks to serve the country’s growing consumer and entrepreneurial business segments. In addition, the central bank is looking at setting up micro-finance companies to ensure as many people as possible have access to banking services. Speculation surrounding a possible merger between Sacombank, Eximbank and Asia Commercial Bank has impacted banking stocks over the opening days of February. However, buy orders have mainly come from domestic investors tempted perhaps by Sacombank’s reported uptick in Q42011 profits and merger rumours. Foreign investors have largely stayed away since the 2008 crisis impacted the country and local financial website vietstock.com reports that foreign investor redemptions of Sacombank shares amounted to $1.1m in the first two weeks of February alone.

Capital markets boost To help boost the bond market, the government issued Decree No 90/2011 in mid October last year which introduces two prescriptions governing bond issues. First, if bonds are issued to finance programmes or projects, the issuer must maintain a minimum equity ratio of 20% of the total investment capital of the programme or

project. The audited financial statements of the issuer must then be independently audited and granted an unqualified opinion in order to proceed with the issuance, a strict requirement that could bar up to a quarter of potential issuers which might struggle to comply. Second, issuers of international bonds must now satisfy current international market requirements with regards to credit ratings. State run enterprises must also ensure that their rating is on par with the sovereign. This may be problematic: the only professional credit rating apparatus in the country is via the Credit Information Centre, which is attached to the central bank. Any ratings by this agency tend to be issued on a temporary basis and the rating criteria sometimes fall short of global standards. Certainly, when they come into force later this year, the rules will help ensure that enterprises are suitably creditworthy before they issue bonds. Moreover, bonds will have to be treated differently by banks, which will have to treat them as loans. That will have a knock-on effect on capital adequacy requirements for the country’s banks and make it more expensive for issuer to borrow. While no doubt detrimental in the short term, over the longer term, the market should have more confidence both in the underlying borrower and the improved risk pricing of Vietnamese corporate debt. These developments are to be welcomed, as international investors will not return to the market in force without significant moves to improve the country’s credit and financial infrastructure. In the meantime the government and Vietnamese Bond Market Association (VBMA) have initiated a number of projects to develop the domestic debt capital market. Specialist investors in the Vietnamese market acknowledge however that any improvements will be gradual and we will see the first signs of this in 2012 assuming that macro economic conditions stabilise. I

bank report

INvESTMENT TRADE wINDS COME IN FROM THE EAST

Could banking in Africa be poised for lambent times? A fast-rising middle class; many economies buoyed by consumer spending and real estate investment, as well as those ubiquitous mines and minerals have combined to bring the continent to the attention of investors once more. We’ve been here before: most notably in the 1970s which promised much but delivered very little. Have things really changed for the better? Lynn Strongin Dodds went in search of some answers.

Photograph © MinervaStudio / Dreamstime.com, supplied February 2012.

Are Africa’s banks well placed enough to leverage new business? N THE SPRING 2011 survey of foreign investors in Africa by Ernst & Young participants claimed to see huge long term growth potential on the continent. Some 42% of businesses surveyed considered investing further in Africa with 19% of executives confirming they will maintain their operations on the continent. Those companies that have invested and already integrated Africa into their overall investment strategy were particularly positive. Although slightly dated, the survey points to an important and still current trend. Much of the interest in the continent is coming from investors based in emerging markets. In fact, emerging markets investment flow comprises 38% of the total into Africa (up from 30% in 2003), with 74% of emerging market investors surveyed acknowledging Africa had become a significant attractive investment destination over the last three years. Moreover, they were increasingly positive about the continents longterm investment potential. Developed regions such as Europe and North America remain

ambivalent, with many developed market investors holding that Africa’s progress has stalled over the last few years; though Ernst & Young noted that North American respondents were marginally more optimistic about Africa’s long term investment potential than Europeans. At the time of the survey’s release Ajen Sita, managing partner, Africa at Ernst & Young noted: “FDI has a particularly important role to play as a future source of longer term capital for reinvestment in infrastructure initiatives and as an accelerator of sustainable growth across Africa. And there is far more to come. Although the African share of global FDI has grown over the past decade, we believe that it does not reflect the increasing attractiveness of a region that has one of the fastest economic growth rates and highest returns on investment in the world.” Mark Otty, area managing partner Ernst & Young Europe, Middle East, India and Africa says, “There has been a fundamental shift in the global economy over the past few years, with emerging markets not only

dominating investor attention and capital flows, but also playing an increasingly strategic role in defining the global economic agenda.” African markets must position themselves appropriately in this shifting landscape to accelerate growth and development and avoid getting left behind by other emerging markets and regions. The point of all this being that while the risks of investing in Africa remain high, profits from those investments (when they work) are high as well, with competition in some sectors comparatively low. This investment window may not remain open for long, but it suggests that Africa could now be relatively well positioned for an uptick in inward investment inflows, both direct and indirect. There are, of course, parts of the continent where there are real and perceived barriers to investment. In large part, this is due to political instability and corruption. Even so, while the region’s extractive industries continue to be a major area of investment, a more diverse range of sectors is now beginning to emerge as

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attractive investment options. Sectors such as tourism, consumer products, construction, telecommunications and financial services featuring strongly as offering high growth potential. Moreover, Africa’s growth story (except those economic and political basket cases, such as Sudan, Zimbabwe, and the Ivory Coast) is underpinned by a longer-term process of economic and regulatory reform that continues to roll across much of the continent. By and large inflation has been brought under control, foreign debt and budget deficits reduced, state-owned enterprises privatised, regulatory and legal systems strengthened, and many African economies opened up to international trade and investment. Among them, South Africa, Egypt, Morocco, Algeria, Tunisia, Nigeria, Angola, Kenya, Libya, Ghana continue as the main recipients of substantial investment inflows. Against the degrading background of economic uncertainty in their home markets, a number of European and US banks now look to either solidify their presence in Africa or mine new business prospects. As in Asia, unlocking Africa’s potential will be difficult. There are 54 different countries each with differing rules, regulations and growth prospects. Choosing the right strategy can be tricky and competition is growing not only from existing and new domestic entities, in line with Ernst & Young’s research in the FDI space, Chinese banks are hoping to make their international mark in the continent. It is easy to see why Africa is on radar screens. By and large the continent has escaped the global financial crisis relatively unscathed with most national economies in robust health, according to Fitch analysts Frederick Fouche and Eric Dupont. It benefits not only from a period of strong pre-crisis growth but also growth in public investment, strong demographics and rising consumer spending.

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Cross-continental growth in 2011 came in at around 5.2% and this year the International Monetary Fund (IMF) projects it could rise to about 5.8%. Urbanisation is another driving force with industry estimates showing that the number of Africans currently live in the cities has jumped to 40% from 28% in 1980. This figure could hit 56% by 2030. The trend has given birth to a growing middle class (currently 350m) who are steadily increasing their consumer spending. Add all these factors together and it is no wonder a recent report by the Economist Intelligence Unit shows a banking industry on the precipice of change. It predicts a doubling of banking assets and deposits, a proliferation of outlets and the extension of products and services to swathes of the continent’s one billion unbanked majority over the next decade. Opportunities of course will vary depending on the country. However, some projections suggest financial assets in 16 key countries in the subSahara could skyrocket 248% to $1.37trn by 2020. Angola is expected to be one of the main beneficiaries with a nearly fivefold hike in assets thanks to surging petroleum production and industrial development which had been hampered by civil war and economic malaise. Ghana, Tanzania and Uganda are next line with an expected tripling of assets over the next eight years. Fouceh and Dupont predict that retail banking will be one of the fastest growing areas followed eventually by asset finance and other types of unsecured retail products. Excluding the more mature South African market, credit risk is predominantly based on small to medium enterprises while retail lending is at the nascent stage. Although international banks may be salivating at the prospects, cracking the retail market may prove challenging and the continent is years away from the margin

producing higher end products. Plain vanilla banking is still the order of the day. "There is a fair degree of competition between local, regional and sub-regional banks but there are currently not that many foreign players in Africa,” says Arnold Ekpe, group chief executive of pan African banking group, Ecobank. “They are mainly present in the wholesale market, as opposed to retail, and I expect this to continue.”

Brand recognition Denzil De Bie, director, financial institutions at Fitch Ratings, agrees, adding, “Brand recognition is very important in the region. People want familiar names that are trusted institutions. The winning strategies tend to have been based in the region for a number of years. However, banking can be a canny sector. Local banks are happy for the skills of the international banks to be transferred and any assistance with businesses such as trade finance are also welcome. The main players have made a dent in the wholesale market but I think it will be difficult for new entrants to develop a branch network.” At the moment, the most active international banks are those with ‘colonial ties’; an apt but now heavily coloured expression. For example, Société Générale has a marked presence in French-speaking West Africa while Barclays and Standard operate in English-speaking countries. Portuguese banks such as BES, Banco BPI and Banco Millennium BCP work in Angola and Mozambique. Until recently, they mainly operated in these tied-markets but over the past year, many have ramped up their activities to tap into the burgeoning prosperity across the region. This is particularly true of Standard Chartered and Barclays, perhaps two of the region’s most established banks. The latter had come under fire for not leveraging the 56% stake it bought in Absa, the

bank report

INvESTMENT TRADE wINDS COME IN FROM THE EAST

Downtown Pretoria. Urbanisation is another driving force with industry estimates showing that the number of Africans currently live in the cities has jumped to 40% from 28% in 1980. This figure could hit 56% by 2030. The trend has given birth to a growing middle class (currently 350m) who are steadily increasing their consumer spending. Photograph © Obie1 / Dreamstime.com, supplied February 2012.

largest retail bank by customers in 2005. The original aim was to join forces to become the pre-eminent pan African banking group but instead the two banks kept their operations separate until last year when the UK bank moved its African headquarters from Dubai to Johannesburg. They recently launched their ‘One Africa’ strategy which is designed to consolidate their respective significant African continental resources in order to take advantage of the present boom in commodities and attract foreign investment. It also creates a new geographical and global product platform to leverage new opportunities and better serve clients across their 12 country network. One of the first initiatives has been to sell insurance products in Botswana and the group is now applying for insurance licences in Mozambique and Zambia Meanwhile, Standard Chartered which has weathered the financial storms better than most of its competitors has embarked on its own

expansion programme. The bank plans to double its Nigerian network to 75 branches by the end of the year and make additional hires in Kenya, South Africa, Botswana and Ghana. The bank is also applying for a full banking license in Angola and it recently appointed Ralph Watonga who successfully led the bank’s growth in Zambia, to head its Zimbabwean operations. Other UK and European banks are also trying to making inroads; JPMorgan recently started offering rand clearing services in South Africa for the first time. It is also planning to apply for regulatory approval to open a local currency subsidiary in Nigeria and to establish representative offices in Kenya and Ghana. Credit Suisse, on the other hand, set up a wholly owned subsidiary in South Africa last January after ending its brokerage joint venture with Standard Bank after only four years. The Swiss bank is hoping to bolster its investment and probate banking business across the continent. It has already advised on several deals in

South Africa including the HSBC’s unsuccessful bid for Nedbank as well as the $326m takeover of South African-based Defy Appliance by Arcelik Group, a Turkish based white goods company. It has also been involved in initial public offerings in South Africa and Tanzania. European, UK and US banks are not alone in their ambitions and could face stiff competition from banks such as Industrial and Commercial Bank of China, which is an early mover in the continent, having bought a 20% share in Standard Bank (South Africa’s largest commercial bank) in 2007. It also opened its first representative office on the continent in Cape Town last November. Bank of China, the country’s most international group, enter into a pact with Toga based Ecobank, which operates in 32 African countries. One of the main drivers is to s to help ease the flow of Chinese loans for African infrastructure projects. China is one of the biggest investors in infrastructure projects across the continent. The largest deal to date has been a $13bn loan facility agreement struck with Ghana to fund energy, agriculture and transport projects. It has also signed respective $9bn and $7bn miningfor-infrastructure contracts in the DR Congo and Guinea plus $4bn worth of projects building roads, hydroelectric dams and an expansion of state-owned mobile telephone networks in Ethiopia. The continent’s needs are vast. A report by the World Bank, Building Bridges: China’s Growing Role as Infrastructure Financier for Sub-Saharan Africa, reveals that only about 30% of Africans have access to adequate roads and energy. In addition, an unreliable power supply has led to losses in industrial production and higher costs for transporting goods. “We are seeing Chinese banks and companies compete for business,”says Ekpe.“They are investing heavily in infrastructure

MARCH 2012 • FTSE GLOBAL MARKETS

projects across the region and this is having a positive impact on economies. For example, companies now have access to roads which helps boost trade and creates jobs”. The fact is, “China offers short term loans to African governments and also invests in projects ranging from bridges, roads, government buildings and power stations,” explains Jamie Allsopp, portfolio manager for Insparo Asset Management, which specialises in Africa. “This is in exchange for the security of supply of natural resources to fuel its own economic growth." Despite the foreign banks increasingly encroaching on their territory, indigenous banks are also strengthening their positions on their home as well as regional front. The trend is ubiquitous across Africa. "I think what is clearly happening is the emergence of non-South African players,” says Ekpe. He explains that this is particularly true in Nigeria, which has recently undergone a period of consolidation, as well as Kenya, which has focused on the growing markets of East and Southern Africa. Nigeria’s banking sector underwent a major overhaul following a recapitalisation directive which shrunk the sector radically to 24 banks from 89. However, the improvement in its fortunes was short-lived as yet another banking crisis swept through the country two years later. Lamido Sanusi, the central-bank governor initiated an emergency audit of Nigeria’s lenders and found that nine medium-sized banks, with at least 40% of the country’s deposits, were near to collapse. Capital worth $3.9bn was injected into the banks and the sector has finally regained its equilibrium. According to the Investec Frontier Advisory Team, the outlook looks more promising. The Nigerian banking sector is still in its infancy in terms of penetration and reach with banks operating in an economic environment that should support rapid growth. This is further underpinned by the

FTSE GLOBAL MARKETS • MARCH 2012

demographics - a country with about 155m people with around 50% below the age of 30 years––as well as expectations of significant infrastructure development within the country. Dominant players according to analysts will be the newly combined entity of the country’s two largest lenders––Access Bank and Intercontinental, which was one of the banks bailed out by the government two years ago. Together they could produce one of Africa’s top 10 banks by assets. Meanwhile the recently merged Ecobank Nigeria and Oceanic Bank has created the fourth largest bank in the country. South African banks, which have long been the envy of the region, are also looking to carve out greater market shares across the region. As Nondas Nicolaides, vice president and senior analyst at Moody’s says, “The big four South African banks have taken the strategic decision to grow their African operations, in light of slower growth potential at home: Standard Bank and Absa/Barclays are leading, but FirstRand and Nedbank have also expressed their intention to grow rapidly in the rest of Africa.” While they are each developing their own strategy, the burgeoning retail sector is a main thrust. For example, Standard Bank, which has 500 branches and operates in 16 countries outside its home market, recently entered the fast growing Angolan market and hopes to have 11 branches by year-end “The bank is making much more of a retail push than in the past,” says De Bie. “As a result, they have targeted branch expansion and innovative products for the consumer such as car loans. These types of loans have historically been impossible to get in many markets outside of South Africa.” Looking ahead, “one of the biggest challenges banks face, according to De Bie is, “that there is a high percentage of people in

Arnold Ekpe, group chief executive of pan African banking group Ecobank. "There is a fair degree of competition between local, regional and sub-regional banks but there are currently not that many foreign players in Africa,” says Ekpe. “They are mainly present in the wholesale market, as opposed to retail, and I expect this to continue,” He says. Photograph kindly supplied by Ecobank, February 2012.

countries such as Kenya and Nigeria who are excluded from the banking sector. The first step will be to get them on the financial services ladder because it is a relatively new concept for many.” This is even true in South Africa, which is considered to be the continent’s most developed economy. Only about one-half of households use formal financial services, according to industry figures, but this is not the norm. In many other African countries, this figure is less than 10%. Mobile banking which has been pioneered by Safari.com M-Pesa in Kenya is seen as a way forward. However, some analysts question whether the network agnostic model can translate into other parts of Africa which have an altogether more competitive landscape. I

commodItIes

ASSET ALLOCATION: STILL SITTING ON THE SIDELINES?

Portfolios continue to maintain historically high levels of cash, as managers seek extra protection in the face of ongoing global economic uncertainty. That has not stopped profit-hungry investors from considering plausible alternatives to equities, and to date many continue to mine potential opportunities in the vast commodities arena. From Boston, Dave Simons reports.

Is asset allocation undergoing a paradigm shift? t has been over three years since the onset of the credit crisis, yet the combination of market volatility and economic weakness continues to keep global investors guessing. Will there be a soft landing or another freefall? Can the global economy find workable solutions, or is sovereign-debt default just around the corner? These and other macro questions have done little to reassure participants; it no surprise, then, that many investors and corporate managers remain historically underexposed to equities. What are the alternatives though? Cash, typically little more than a shortterm respite during bouts of extreme volatility, remains a zero-sum game (or even less than zero, once inflation is factored in). Similarly, paltry yields continue to offer income seekers little in the way of comfort, while a sudden economic rebound could spark a jump in interest rates and, in turn, a reduction in bond prices. Given the circumstances, a reallocation into certain commodities assets appears to be a viable route. However, questions remain. How hazardous is the downside risk for commodities prices at this stage of the game? Will the uncertainty that has informed the markets fuel the trend toward commodities and other plausible alternatives, or, as recent movements within the US markets seem to suggest, will investors make a much stronger commitment to equities? Is there a case to be made for maintaining a much more balanced mix of assets within a portfolio at any given time? A year-end poll by Reuters appeared to substantiate the notion that cash is

still king. The survey of more than 50 global asset-management facilities found that portfolios were comprised of 6.6% cash on average—the highest such level in at least a year, according to the poll—as managers sought extra protection in the face of economic uncertainty stemming from the EU debt crisis and other macro concerns. Meanwhile, corporations continued to raise cash largely for the purpose of funding M&A activity as well as buying back shares. Barring an unexpected economic tailwind, Christopher J Wolfe, managing director and chief investment officer for Merrill Lynch Wealth Management Private Banking and Investment Group, sees a continuation of this scenario, with businesses keeping costs in check while (at the same time) “accumulating cash and waiting for better days.” The mountain of cash that’s been sitting on the sidelines has been growing for the better part of a decade, remarks Nicholas Colas, chief market strategist for New York-based ConvergEx Group. “CFOs and boards of directors are well aware of the fragility of the financial system, and particularly since the start of the crisis there is this notion that as a large company you have to do everything you can to be your own bank. Unlike investors who can diversify portfolio risk and aren’t really concerned about the welfare of any single company, CFOs have their reputations at stake—and in an effort to protect the franchise during times of uncertainty, they tend to hold higher levels of cash.” In the US, the situation has been exacerbated by years of low productivity

and feeble economic growth. Accordingly, the ability for companies to invest capital has itself declined, says Colas. “Compared to the 1970s, 1980s and even the tech-boom1990s, we just haven’t seen the kind of incremental wealth creation that paves the way for bigger markets.” US-based chief financial officers have tended to look overseas for growth explains Colas, “or just haven’t made any moves at all.” Andreas Utermann, global chief investment officer for global assetmanagement firm RCM, agrees that the precariousness of the European debt situation and the possible impact on the global financial system calls for a more defensive posture. Accordingly, RCM continues to underweight financials, but will be prepared to make adjustments, says Utermann, “should conditions improve and/or bond spreads in the EMU periphery decrease.”

Commodities alternative Continuing market uncertainty hasn’t stopped profit-hungry investors from seeking plausible alternatives to equities, and to date many continue to look for opportunities within the vast reaches of the commodities sector. With good reason: relative to equities, commodities have generally offered historically competitive returns, while serving as an inflationary hedge as well. Federal Reserve Bank chairman Ben Bernanke’s pledge to leave interest rates alone for the better part of two years was music to the ears of gold mavens, who have watched gold prices recently rebound as real rates remained in negative territory. Gold

MARCH 2012 • FTSE GLOBAL MARKETS

Colin O'Shea, head of commodities for London-based Hermes Fund Managers. “Another consideration is the historically low correlation between commodities and bonds as well as other fixed-income assets,” says O’Shea. Photograph kindly supplied by Hermes Fund Managers, February 2012.

has been the commodity of choice for the likes of Goldman Sachs and Morgan Stanley, while UBS analyst Edel Tully called for a price target of $2,500/oz before year’s end. “Commodities continue to be attractive proposition for those seeking a properly diversified portfolio mix,” offers Colin O'Shea, head of commodities for London-based Hermes Fund Managers. “Another consideration is the historically low correlation between commodities and bonds as well as other fixed-income assets.” Particularly over the last several years, commodities have yielded a positive risk premium over equities, and have also exceeded the risk premiums of many pension-plan liabilities during the same period, says O’Shea. Though it maintains reduced materials exposures, RCM is currently overweight energy commodities. “Longer-term, we remain positively orientated on commodities, given the significant pentup demand in developing nations, supply constraints and the negative real interest environment created by many central banks globally,”says Utermann. Perhaps more importantly, commodities serve as a safeguard against event risk, proving invaluable to investors particularly in the perpetually

FTSE GLOBAL MARKETS • MARCH 2012

volatile energy sector. At present, conditions in the Middle East and other regions are such that, even in the face of relatively soft demand, a significant spike in the price of oil remains a very real possibility. “A major oil-price shock resulting from these geopolitical elements would not bode well for equities,” concurs O’Shea. “Given this scenario, it certainly makes a lot of sense for investors to look for viable opportunities to achieve adequate portfolio protection.” The downside is that the perceived supply risk is overblown, prices begin to fall and, with risk premia lowered, investors suddenly go on an extended equities shopping spree. “The floor is likely no lower than $90,” says O’Shea, “which is largely due to these regions having to re-set their minimum pricing requirements based on the political events of the past year.” Even if the current cash stash winds up being re-directed into equities, commodities will likely be none the worse for wear, says O’Shea. “There may be some short-term impact in response to equity investment flows, should that occur,” he says. “However, the underlying supply-demand drivers are what ultimately dictate price, and they remain solid. So yes, I think volume would fluctuate and we could see some price movement as well, but a correction would likely be limited to readjusted market fundamentals.” Because of their historically low correlation to financials, commodities have been attractive to asset owners. However, within the last year or so non-correlative strategies have been harder to come by, notes Colas, commodities included. “Over a three, five, and ten year perspective, those low correlations are still intact,” says Colas, “but as more people use commodities as an asset class that has begun to change.” Even gold, which typically moves at opposing angles from any financial asset, has recently shown monthly correlations in the 50% to 60% range versus US stock. So while commodities

Nicholas Colas, chief market strategist for New York-based ConvergEx Group. The mountain of cash that’s been sitting on the sidelines has been growing for the better part of a decade, says Colas. Photograph kindly supplied by ConvergEx, February 2012.

will likely continue to gain traction, some of their inherent appeal has been diminished as correlations increase. “Lack of correlation really has been the raison d'etre for keeping commodities in one’s portfolio,” says Colas. “I mean, why else would you want to own a warehouse full of copper?” Having said that, there are lessobvious reasons for maintaining one’s commodities connection. “While it is somewhat more nuanced, the fact that commodities cannot be manufactured by a central bank is in and of itself a compelling enough argument for some investors,”explains Colas. In a complex world where most other investments are inexorably linked to central bank policymaking, theo-retically a warehouse full of copper should appreciate at or beyond the going inflation rate. “For all the things the Fed can control, the fact is they can’t produce an ounce of copper. It’s like an old master painting—it doesn’t matter how much money the Fed pumps into the financial system, there are still a fixed number of old masters. In reality, there is an increasingly vocal branch of the investment world that thinks you should just be long anything the central banks can’t make.”I

commodItIes report

OIL PRICE SPIKES: wHAT IS DRIvING THEM?

The question of whether speculators are responsible for the recent spikes in the price of oil has been one of the most hotly debated topics in the oil market in the last few years. Most recently it has prompted US regulators to put limits on some speculative positions and re-define what they consider to be speculative positions. Vanja Dragomanovich met up with Rita D'Eclessia, professor at the Department of Economic Theory and Quantitative Methods for Political Choices at the University of Rome and a visiting lecturer at Birkbeck University in London, who has run these theories through a set of mathematical tests and has produced some slightly surprising results.

Bunking the myth of oil price hikes and speculation VANJA DRAGOMANOVICH (VD): Why has the issue of oil prices attracted so much attention outside the actual oil market? Rita D'Eclessia (RD’A): Analysis and empirical evidence shows that four out of the last five global recessions were preceded by oil shocks. In the case of the 2007-2008 crisis oil prices cannot be ignored as a culprit of what happened: the oil price increased over 300% and this caused the annual fuel bill of OECD countries to increase dramatically. Exceptional oil price volatility affects many economic variables and their related markets. Oil price fluctuations affect consumers, producers and marketers, especially in terms of costs, incentives to invest in technology and trading strategies. The importance of oil prices is further increased by the fact that other forms of energy such as coal, gas, and, to a lesser extent, electricity are sometimes priced in order to compete with oil, so that oil price fluctuations become reflected in broader energy price changes. V D: As part of your research you looked into the link between the v olatility in oil prices and the involvement of speculators in the market. Can you talk us through your findings? RD’A: Economists and financial experts are divided over who they think was responsible for driving crude oil prices to their peaks in the first half of 2008. Basically trend-following speculation

and institutional commodity indexbuying have reinforced the output pressure on prices. In my research I tried to identify which economic and financial variables provide insights into understanding oil price dynamics. Our proposition was that the changes in the oil price are an example of an economic variable which is largely unpredictable. In such a context the role of futures markets, considered as a measure of the speculative component in the market, is also investigated. However, our conclusion was that using the data we had, we could not find any evidence that the oil price depends on speculative activity in the market. VD: What data did you base your research on? For instance, how did you define speculators and how did you distinguish between speculative and non-speculative activity? Was your research based on information from several commodity exchanges? RD’A: I set up an econometric model to capture possible long run equilibrium between some macroeconomic variables and some financial variables. The data used to measure speculation is the number of the benchmark US futures oil contracts, the West Texas Intermediate (WTI) spot crude oil held by speculators; this is data published by the US Commodities Futures Trading Commission (CFTC). I used monthly West Texas Intermediate spot oil prices between 1993 and 2011 and assumed that speculators are participants who trade

oil as an investment and not to hedge. VD: Once you established that the link between speculative activity and oil price volatility was weak which other factors proved most influential in the oil market? RD’A: Surprisingly, by far the strongest influence is the price of gold, followed by the strength of the euro against the dollar. For instance we found that for any one basis point move in the euro/dollar exchange rate the oil price moved by $2.8 dollars. Given that the euro was only introduced in 2000 we ran the analysis using the Deutschmark from 1993 till the introduction of the euro. In all, we tried six different variables to try and find some meaningful correlation. We tried open interest, US interest rates, imports of WTI and WTI oil futures, all of which proved not to have a strong impact on the oil market. VD: Your analysis was primarily statistical. However, in that period of time oil would have also moved for other reasons such as geopolitical crises, conflicts in the Middle East, economic crises, and political changes in Europe. How do those factors feature in your analysis? RD’A: That is correct, but we can infer the influence of political events through the fluctuations of the dollar exchange rate and the price of gold. In any case the debate continues; oil price changes certainly cannot be explained solely by looking at the supply and demand dynamics. I

MARCH 2012 • FTSE GLOBAL MARKETS

company profIle

ICANN: THE INTERNET NAME GAMER

Small and not as well known as it should be perhaps, the Internet Corporation for Assigned Names and Numbers (ICANN) is one of the most pervasive and influential companies in the world right now. As the firm that manages and coordinates the framework of addresses we all use to navigate the web, by overseeing the distribution of unique IP addresses and domain names. It also ensures that each domain maps to the correct IP address. ICANN has just announced a major step forward for business and globalisation with its new ‘Top Level Domain Names’ (The right-most label in a domain name is referred to as its ‘top-level domain’ or TLD). Ian Williams reports on the implications. Rod Beckstrom, the chief executive officer and president of ICANN explains that: “Just the declining cost of technology and network bandwidth along with the physics of electronics are leading to a complete perfusion of intelligent devices that want to communicate; whether it's sensors in a light bulb, or sensors to measure the pressure of a tyre, or a sensor in a toaster to tablet computers. Even cameras are now becoming IP-enabled and connected. You know, that protocol’s going everywhere.” Photograph kindly supplied by ICANN, February 2012.

ICANN purveys it’s new top level internet domains O NE OF THE BIGGEST changes in the evolution of the Internet took place at one minute past midnight on January 12th. That’s when ICANN began accepting applications for new generic TLDs, to include almost any word or name. The first application window for new generic TLDs will close on April 12th, and soon afterwards ICANN will post on its website what domain names have been applied for and by whom. Up to 2000 applications will likely be made to own or control new fronts of internet real estate. The intention behind the new generic TLDs is that new internet communities will arise, corporations will be able to strengthen ties with customers and users of the internet will enjoy more innovation.

FTSE GLOBAL MARKETS • MARCH 2012

The biggest winners of the change will be large brand owners which will likely utilise the opening up of the Internet’s naming frontier to boost their online visibility or protect their brand. Whatever, it is a frontier that right now only larger corporations will be able to benefit from. Running at $185k per application and annual running costs of some $100k, the exercise will likely be dominated by cities, financial services firms and consumer goods companies. Canon, Deloitte and Hitachi are just some of the companies that have signalled their intent to establish and expand their brand domains. Prosperous social communities and pressure groups are also likely to want to establish their own internet space (with obvious monikers such as .eco, or .gay likely to come into play).

As the price of applying to join the new band of own-name domains might suggest, the application process is not automatic or that easy. Each applicant must also complete a long and detailed application form, which itself is generating business for specialist consultancies in the internet space. If successful however, applicants will be protected by the full force of copyright and trademark law, The internet is a collateral benefit of the Cold War. Beginning as Arpanet, the internet was designed to ensure that a few (mostly American) behemoth mainframes could continue to exchange information in the wake of a nuclear attack. Up to now it has mainly focused on Roman alphabetic forms; though going forward it will recognise dozens of different scripts,

company profIle

ICANN: THE INTERNET NAME GAMER

including Arabic, Cyrillic, Mandarin and Hindi, and allow countries to use their own equivalents of dot-com or dot-net. The internet has mutated as the world has moved from mainframes to PCs to handheld devices and nanobots, which chat to each other incessantly. When the internet outgrew the US, hard decisions were called for. The rest of the world was not going to accept leaving the internet under the control of Washington and in Congress neither the right nor the left favoured handing the responsibility over to a multinational/UN body such as the International Telecommunications Union or the Universal Postal Union where authoritarian regimes could try to police the web. ICANN is the resulting compromise, and has proven remarkably efficient and receptive to global input. It is a not-forprofit California corporation but its advisory boards and regional branches have continued spinning the web during an era of feverish expansion with what is (under the circumstances) remarkably little contumely from various parties, which include no less than 111 governments. Rod Beckstrom, the chief executive officer and president of ICANN explains that: “Just the declining cost of technology and network bandwidth along with the physics of electronics are leading to a complete perfusion of intelligent devices that want to communicate; whether it's sensors in a light bulb, or sensors to measure the pressure of a tyre, or a sensor in a toaster to tablet computers. Even cameras are now becoming IP-enabled and connected. You know, that protocol’s going everywhere.” Internet Protocol 4 was developed and was designed to have just over 4bn addresses, and Beckstrom recalls“People said,‘Well, they'll last forever.’ In fact, we ran out. Last February, I handed out the last five virgin blocks of IPV-4 addresses in the world and so, now we go to IBV6, which has more than thirty trillion, trillion, trillion addresses, and we all think of that as an inestimably huge addressing space. Yet, quite a few of us actually expect there could very well be

“Just the declining cost of technology and network bandwidth along with the physics of electronics are leading to a complete perfusion of intelligent devices that want to communicate; whether it's sensors in a light bulb, or sensors to measure the pressure of a tyre, or a sensor in a toaster to tablet computers. Even cameras are now becoming IP-enabled and connected.” says beckstrom. trillions of devices connected to the internet in the next few decades.” Beckstrom became the corporation’s chief executive, in 2009 with a background in public and private enterprise that made him uniquely qualified for such an anomalous company, not to mention an affable and approachable demeanour. His three year contract expires this year and he has “decided not to renew. I'm very much looking forward to moving on. This has been a fantastic experience, and I think it's just a great staff and fantastic executive team, but I'm ready to go on to the next challenge,”he says. A successful entrepreneur, involved in several business tech start ups, such as Mergent Systems and Privada Inc, and a pioneer of the concept of“value at risk,”he recalls, Beckstrom shows all the hallmarks of an over-achiever. He founded his first company at 24 years of age, when he was studying at Stamford Graduate School. He later took that software company public on NASDAQ. He was also involved in starting more than 15 other high-tech companies but has also been a stalwart of the nonprofit sector. He has, for instance, sat on the board of Environmental Defense Fund, a $100m/year environmental policy shop for 18 years and in 2008 he became a director of the National Cybersecurity Center (NCSC) at the US Department of Homeland Security giving some insider experience of dealing with government. He

has also written a book on business leadership The Starfish and the Spider: the unstoppable power of leaderless organisations. Beckstrom has been allowed to test his leadership theories when he became an arachnid at the heart of the world-wide web. “I think this has to be one of the most exciting and challenging geopolitical assignments on the planet earth today. ICANN is a fascinating hybrid organisation. It is very starfishy [sic] in the huge number of its decentralised components. On the other hand, it is centralised in some areas such as the fact that we have to run compliance and make sure that parties are meeting their contractual obligations in how they get their business and affairs on the internet in a domain space.” As well as the ICANN board, Beckstrom explains that there is a phalanx of supporting organizations and advisory committees,“who all feel they have a role in advising the chief executive directly. While you might get lobbied by special interests from individual stakeholder groups, you have to remember, every single day that this job is about the global public interest, not simply placating any individual special interest group,”he avers. “For a chief executive,” he muses, “the hardest thing is that the policy development processes are very, very open and loosely coupled. It's like a perpetual debating society, because the losing party never gives up; they just keep trying to come in through a different policy door or an open process door and lobby for changes. Moreover, because the board members are elected by those parties, they often bring return to these very issues. Even when you think an issue is settled, it gets brought right back up.” Beckstrom provides an example. ICANN decided last year when adopting the new top level domain name structure that it would not permit single characters, such as .a or .b. Even so, he says, “I was pressured three times subsequently by board members and others to open the program up to single-character TLDs, and I simply said,‘I can’t do that unless we move all the timeframes’”.

MARCH 2012 • FTSE GLOBAL MARKETS

“Going from a just a concept in 1998 to one of the richest, most complex and productive multi-stakeholder groups in the world, I would measure productivity by the expansion of the technical operation, a huge output of detailed policies to allow the continued growth of the internet, including internationalized domain names into the internet. We are tiny compared to our impact,” explains Beckstrom. Photograph kindly supplied by ICANN, February 2012.

“When I joined, the organisation didn’t have a particularly strong execution track record. It wasn’t known for meeting dates and the timeframes it committed to. As a CEO you have to enforce discipline, to say, ‘We've made that decision; we're not revisiting it because we're now in implementation mode. If we revisit it, we're going to mess up all the timeframes.’” He takes great pride that“the executive team and staff have worked together very hard to bring that discipline in over the last few years, and we're now regarded as being trustworthy in establishing and meeting dates; but that's a very difficult thing to do in a bottom-up community-based consensus organisation. It means the CEO has to be willing to be very unpopular at times, and clearly state: ‘No, this is not going to be revisited.’”

FTSE GLOBAL MARKETS • MARCH 2012

Even so, lawyers are part and parcel of ICANN’s territory.“We are often subject to lawsuits, simply because people become unhappy when they don't get what they want. We have faced over 60 different lawsuits in our short history as an organisation,”he states. Although ICANN has not lost a suit up to now, a third of the $185,000 application fee for the new top level names introduced this January is earmarked for potential litigation. Beckstrom acknowledges his task list is defined by the global public interest; a rubric that expediently also helps fend off demand from countries Russia and China to internationalise the domain name initialisation process. Even so, part of his remit is to help expand internet usage globally. That means applications from developing countries are charged at much lower rates. As well, Beckstrom has been working closely with the World Intellectual Property Organisation (WIPO) and similar intergovernmental bodies to prevent cybersquatting with the new names to ensure respect for trademarks. Nigerian email scammers will not, he assures, be able to run off with .imf or .worldbank domains but the process of ensuring that fact will not be easy. For example, the Australian Football League wants to take .afl. But what would the American Federation of Labor say if they wanted it? Beckstrom is confident that the processes ICANN has set up can cope, not least since much of the conflict resolution has been outsourced. Such diplomatic tightrope walking apart, unlike most chief executives he does not have to worry unduly about the bottom line. “This is the easy bit about this job compared to other chief executive jobs in the private sector, since the revenue model is very predictable. More than 90% of our support from domain name registrations in the generic name space. Every time someone reserves a .com or registers a .com name or a .net name, or a .org name, we receive a payment on the generics, typically in the range between 40 cents and $2.00 per name. That, in turn, gives us the financial support to run our global nonprofit operations, and to run the

“when I joined, the organisation didn’t have a particularly strong execution track record. It wasn’t known for meeting dates and the timeframes it committed to. As a CEO you have to enforce discipline, to say, ‘we've made that decision; we're not revisiting it because we're now in implementation mode. If we revisit it, we're going to mess up all the timeframes,” says beckstrom. policy process, to run global events.” So how would he summarise his end of term report? “Going from a just a concept in 1998 to one of the richest, most complex and productive multistakeholder groups in the world, I would measure productivity by the expansion of the technical operation, a huge output of detailed policies to allow the continued growth of the internet, including internationalized domain names into the internet. We are tiny compared to our impact. We are, for instance, caught up almost constantly between any numbers of highly complex international issues. Even so our processes are efficient. If you take that whole ecosystem into account, then the entire financial footprint of the key bodies that are helping to support the internet costs less than $300m a year, and that's supporting something which is used for trillions of dollars in ecommerce alone, and trillions of dollars of communications a year.” Beckstrom remains coy about his future plans. Even so, he firmly believes his current work is a paradigm in the making. “ICANN and the multistakeholder model of the internet is the model for the future that we should use in other areas of society. We are a hybrid, and that's why I think we're certainly the most complex organization in the world I've ever seen, and we have only 130 employees,”he says. I

Index revIew

EuROPE’S PROSPERITY MAP HAS DISTINCTLY RICARDIAN uNDERTONES

The euro crisis – centre versus periphery Southern Europe may have a rescue package, but its recipients will probably need a generation to recover from it. It will, crucially though, keep them in the euro and (even more importantly, if it works) not cost the northern states a penny in the long run. Last month’s missive was cautiously optimistic as the forecast “end of the world” continued to miss its prompts. This one is no different. So what’s the new buzz? Simon Denham, managing director of spread betting firm Capital Spreads takes a slightly less than bearish view. ERMANY HAS DONE rather well out of the euro project. They are the second biggest exporter on the planet, after China, and yet their currency fails to rise at all as the value is continuously eroded by their weaker partners, for whom they have had (until now) no liability. The US aims its heavy artillery at China for uncompetitive exchange rates but at least their currency does appreciate, albeit at a slow rate. Since the start of 2005 the renminbi has risen some 24% but the euro has actually fallen marginally from 1.35 to 1.32. From the German viewpoint this is something of an advantage to put it mildly. 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

Bank of England 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. 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

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

dividend yield when other investment assets in bonds or cash were giving much better returns of 4% to 5%. 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 quarter 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 loosening of the straitjacket that is this mis-timed 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

MARCH 2012 • FTSE GLOBAL MARKETS

derIvatIves

ExOTIC ALTERNATIvES: FROM FENDERS TO FOREx

Flush with cash and looking for action—what’s an alternative investor to do? With many assets continuing to move in lock-step, those looking to balance risk or hedge inflation through noncorrelative issues such as commodities have often found their portfolio picks wanting. Moreover, as regulators work around the clock to eliminate opacity, those same esoteric strategies that bore much of the blame for the global-market unraveling have been forced out into the light, leading many to shun such exotic plays altogether. Still, those seeking a respite from the mainstream have a number of creative alternatives at their disposal, provided they also exhibit a willingness to roll the dice and think outside the box. David Simons reports.

Deal-flow demand for illiquid hedge fund strategies rises OR SOME, CASH is definitely not king—or at least that would appear to be the case for investors who have increasingly piled into the illiquid secondary hedge fund market. Having picked up steam particularly during the second half of 2011 (thanks mainly to weakness in opposing asset classes), secondary hedge-fund opportunities are now going head-to-head with those of other asset classes, notes London-based broking intermediary Tullett Prebon, as multi-asset class investors size up risk/reward ratios of illiquid hedge funds and their equities/bonds counterparts. Lars Lindqvist, founder of Londonbased alternatives secondaries broker Cattegatt Capital, agrees that deal-flow demand for illiquid hedge-fund strategies has risen of late. Investors have been seeking value in such strategies as ABL funds and structured credit, says Lindqvist, who also credits the growing appetite for secondaries in part to increased risk in a majority of asset classes. Secondary hedge-fund pricing has also benefited from “previously discounted margins of error that these assets trade at,”says Lindqvist. Foreign-exchange investors have benefited from a relatively laid-back US Treasury, which, at least for the time being, has exempted forex swaps and forwards from on-exchange clearing. Unlike derivatives payment obligations that can fluctuate as market conditions evolve, FX swaps require participants to make fixed payments up front, thereby

FTSE GLOBAL MARKETS • MARCH 2012

Photograph © Ksaady / Dreamstime.com, supplied February 2012.

minimizing risk exposures. Regulation hawks, however, believe these exemptions allow swaps to be reengineered in order to cloak shady deal making, and have called for tougher standards in an effort to discourage such activity. Recent comments by US deputy secretary of the Treasury Neal Wolin suggest the powers that be may be changing their tune; while spot forex would likely remain untouched, Wolin intimated that moving FX swaps and forwards trades onexchange was open to debate. Meanwhile, proposals to beef up margin requirements and curb rampant

speculation on certain OTC products have sent many alternative investors running for cover. According to the TABB Group report Initial Margins for OTC Derivatives: The Burden of Opportunity Costs, if enacted new margin requirements for OTC interestrate derivatives could render such trade structures “extinct,” while triggering an estimated $1.4trn in capital allocations for rates swaps worldwide over the next five years. Cross-margining and other offsets would be necessary to ease the potential burden of the opportunity costs, says E Paul Rowady Jr, TABB senior analyst and report author. “Although dealers have readily adopted clearing for the most vanilla segment of their OTC derivative portfolios, these exposures require comparatively little initial margin since they represent the cream of the proverbial crop,” says Rowady. For exotic OTC derivatives and boutique portfolios managers, the initial margin requirements could range from “painful” to the “outright extinction of some types of trades,” says Rowady. TABB expects the requirements may help determine which derivative trade structures remain popular and which are ultimately abandoned. “Initial margin levels for even the most vanilla trades will continue to be a huge drag on capital,” says Rowady, “given that they’re starting from zero today. Even small margin requirements attached to huge notional values outstanding

derIvatIves

ExOTIC ALTERNATIvES: FROM FENDERS TO FOREx

have the potential to wreak havoc on product selection.” Clearing proposals for other esoteric products remains a source of concern. Speaking to FTSE Global Markets’ Ruth Hughes Liley, Joe Kohanik, vicepresident, fixed income and derivatives for technology services provider Linedata, said that the “shoehorning” onto platforms of various exotic instruments may be doing more harm than good. Rather than curb speculation, the sudden spike in margin requirements on silver commodities trading, for example, has merely“raised the cost for a normal asset manager who just needs to hedge his position,”says Kohanik.

No strings attached As more wealth is created globally— and as investors continue to look beyond the major markets for opportunities—demand for more tangible alternative investments, including luxury automobiles, fine art, wine, even musical instruments, has grown exponentially. Not only are the likes of old Ferraris or rare Picassos often less vulnerable to the movements of the major markets, many are viewed as a play on global wealth, says

Nicholas Colas, chief market strategist for New York-based ConvergEx Group. “Someone who was really tuned in about ten or 15 years ago would have stocked up on all the Chinese art they could have gotten their hands on,” says Colas. During the last decade, China moved past the US and UK to become the world’s foremost auctioneer of fine art, and with the spread of global wealth into other emerging areas, fine art has found an enthusiastic investor base in countries like India and Russia as well.“As nations such as China move beyond the traditional breakpoint of $4000-per head GDP and become more middle-class oriented,” says Colas, “the super wealthy within that group typically want to repatriate their country’s art objects in order to gain a connection to the past.” The same is true for wine, notes Colas: in China, per-case values have doubled over the last several years, as the country’s middle class seeks the same symbols of sophistication as their wealthiest peers. Investors have historically benefited from prudent investments in wine (with select Bordeaux vintages frequently outperforming traditional asset classes).

Investor interest has even created opportunities to capitalise on the appreciation of certain vintage instruments. Introduced in the early 1990s, the Vintage Guitar Market 42 Index—which includes among its core holdings a 1958 blonde Fender Telecaster electric and a pre-WWII Martin D-28 acoustic—shows vintage instruments outperforming the major stock indices over a 20-year period, rising some 20% annually on average. Though not completely immune from financial-market gyrations, on balance vintage-instrument values have tended to flatten rather than freefall during periods of market volatility, and have regained their upward momentum faster as well. Londonbased Anchorage Capital Investment Management has even gone so far as to launch the Guitar Fund, a closedend fund offering designed to capitalise on vintage-guitar gains over a ten year window. Colas sums up the appeal of these unique alternatives: “There is an increasingly vocal branch of the investment world that thinks you should just be long [just about] anything the central banks can’t make.”I

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MARCH 2012 • FTSE GLOBAL MARKETS

DERIVATIVES

In 2010, legislators on Capitol Hill sent down two commandments etched in stone: “Thou shalt centrally clear most OTC derivative trades” and “Thou shalt trade most OTC derivatives upon a swaps execution facility (SEF).” Two years later, market participants and regulators have still not figured out how to obey. Clearinghouses stand ready to clear swaps—some already do for the dealer community—but nobody knows yet which swaps will have to be cleared when the rules take effect. Numerous entities want to be SEFs, but the regulators haven’t even decided what constitutes a SEF, let alone how a SEF should operate. Time is running out; the new regime is supposed to be in place by year-end, which means the regulators must resolve key issues soon. Amid all the confusion, the one sure bet is that clearing will come first. Neil A O'Hara reports.

In the OTC regulatory bruhaha clearing comes first CCP. The new regulations also S THE DODD FRANK Act and impose collateral and real time similar measures under reporting requirements designed to European Market Infrastructure reduce counterparty credit risk and Regulation (EMIR) and Markets in bolster market transparency. Financial Instruments Directive (MiFID) Up to now OTC or "privately negoare adopted, a large swathe of derivitive tiated", derivatives have tended to be contracts currently traded over the traded on the telephone and increascounter (OTC) directly between two ingly on electronic markets. There are parties will migrate to multi-party electwo sectors of the market: institutronic trading platforms. These SEFs are tional dealer-to-client (D2C) and expected to create greater price transinter-dealer (D2D). These markets are parency and increased liquidity as more approximately the same size in terms participants enter the market. of trading volumes, but there are As this article went to press, State many more participants in the D2C Street Corporation had announced its marketplace than D2D. According to intention to launch its own SEF named Tradeweb, D2C electronic trading is SwapEx and was planning to submit more than 10% of the overall marketits registration with the United States Photograph © Tbe / Dreamstime.com, supplied place, and is growing fast. Commission Futures Trading Commis- February 2012. Nobody knows what proportion of sion (CFTC) when the application window opens later this year. In preparation for the launch, the OTC derivatives business ultimately will migrate to central State Street has entered into an agreement with National Futures clearing and/or trading on a SEF. Estimates range from 50% to 80%, but the number may very likely vary by asset class. Association (NFA) to perform regulatory services for it’s SEF. Eric Litvack, chief operating officer in global equity flow for “The derivatives market is in the midst of significant change as it moves away from a bilateral trading model to a centrally Societe Generale, expects the highest percentage in interest traded and cleared environment that offers greater price trans- rate swaps and credit default swaps where clearing is already parency, liquidity and enhanced risk management,” explains well established in the dealer-to-dealer market. “It will be Clifford Lewis, executive vice president and head of the lower for OTC equity and commodity derivatives, which are eExchange business at State Street.“State Street’s core compe- much smaller markets and tend to be more bespoke,”he says. tencies as a custodian combined with the advanced technol- “A market for listed and cleared equity derivatives already ogy of our eExchange platforms, including SwapEx, make the exists. Arguably, the transition to clearing of standardised expansion of our derivatives solution to include a swap products in equities has already occurred.” Central clearing of derivatives is supposed to help reduce execution facility a natural extension of our business,”he adds. State Street added to its end-to-end derivatives solution counterparty risk and assist with position segregation and last year, expanding its futures commission merchant portability in the event of a default. It also improves transservices to cover swap clearing capabilities, as these parency for regulatory requirements, and benefits the central products will move into a centrally cleared environment management of trade lifecycle events, such as cash settlement through established central clearing counterparties (CCPs). with central counterparties and credit events in the credit Parties to trades will be required to work through a clearing default swap (CDS) market. Despite the uproar about certain broker that acts as intermediary between its clients and the aspects of the proposed regulations, clearing itself is not a

FTSE GLOBAL MARKETS • MARCH 2012

DERIVATIVES

foreign concept to the swaps market. SwapClear, a unit of LCH.Clearnet, has been clearing dealer to dealer interest rate swaps for more than ten years, while a division of CME Group clears interest rate swaps for D2C transactions. CME clears some credit default swaps, too, but most market participants have gravitated to ICE Clear Credit, which clears the vast majority of credit default swaps for both dealer-todealer and dealer-to-client trades in North America. ICE rules the roost in Europe, too, through its affiliate, ICE Trust. The competing service offered by Eurex has failed to attract dealerto-dealer flow although it could draw dealer-to-client business. The proposed regulatory regime has brought in one new entrant: International Derivatives Clearing House, an affiliate of NASDAQ OMX, which plans to clear interest rate swaps for both dealers and clients. Eurex too has broadened its OTC derivatives clearing services to cover interest rate swaps and equity swaps—and will offer cross margining between listed products and OTC derivatives. Customers who already use Eurex on the listed side may be able to improve collateral utilisation if they clear OTC derivatives there, too—a potentially powerful lure for participants who face capital constraints. The incumbent clearinghouses enjoy a natural advantage, but the massive extension of clearing to customer transactions may enable new entrants to grab market share. CME has already made some inroads in clearing dealer to client swap trades—and if it is able to offer cross-margin capability against its enormous Eurodollar futures business it could bootstrap the swaps clearing into serious contention. Dealers are accustomed to clearing swaps—and so are the interdealer brokers (IDBs), the middlemen who put together trades between dealers who wish to remain anonymous. “The North American energy markets have been largely cleared since 2001,”says Michael Cosgrove, a managing director at GFI, a leading IDB. “We know precisely what to expect. It is very simple and something we are comfortable with,” he adds. GFI and its fellow IDBs will all have to register as SEFs when the trading mandate takes effect. Wannabe SEFs that do not handle cleared transactions today should not have too much trouble connecting up to the clearing houses. James Rucker, credit and risk officer at MarketAxess, which runs electronic trading platforms for corporate bonds and credit default swaps, explains that his firm already has links to the two major clearing houses active in credit derivatives. MarketAxess plans to become a SEF and will link to whatever additional clearing houses its clients want to use.“It would not be too onerous if we end up with four clearing houses for credit default swaps instead of two,”he says.“It is work, but not a huge amount.”The need to post margin at each clearing house will keep a lid on how many the market will support—perhaps fewer than half a dozen for the entire OTC derivatives market. Market participants are still debating how to ensure counterparties know at the time they agree terms that a trade will be accepted by a clearinghouse. A SEF will have to contact the futures commission merchant (FCM) for each customer to check that the trade will not breach its credit limit—and that the FCM has available credit at the appropriate clearing house.

Jon Williams, head of US markets at Tradeweb, which operates dealer to customer trading platforms for interest rate and credit default swaps in the United States and Europe. Williams says that clearing brokers could provide a certain level of credit exposure at the beginning of every day. Photograph kindly supplied by Tradeweb, February 2012.

“That involves much more connectivity,” says Rucker. “We either have to have the limits for every customer of every FCM on our platform, or we have to message every time to confirm credit is available,”he adds. Who will monitor credit availability has yet to be decided. SEFs claim they should do it in order to eliminate latency if they have to ping the FCM and the clearinghouse before every trade. Jon Williams, head of US markets at Tradeweb, which operates dealer to customer trading platforms for interest rate and credit default swaps in the United States and Europe, points out that the delay could expose customers to market risk. He also argues that locating the credit approval process within a SEF offers both flexibility and confidentiality for the participants in the trade. “Clearing brokers could provide a certain level of credit exposure at the beginning of every day,” says Williams.“We could draw on that during the day. If we reached a tolerance threshold just below the credit limit for a particular customer, we could message the broker, which could decide whether to extend additional credit,” he says. Other participants point out that SEFs can’t see the whole credit picture because they don’t know what customers are doing on other SEFs. The FCMs have the same problem: they know only what each customer trades through them. That works for customers who deal with only one FCM, but not the major players who have multiple FCM relationships. An industry committee has recommended that clearing houses should make the credit decision. If there were only one clearinghouse, as in certain other markets, this might be the ideal solution. The regulators want to foster competition, however, so the swaps market will have multiple clearing houses who won’t know what clearing members and their customers are doing with competing clearing houses.“It is the elephant in the room,”says Ed Brown, executive vice president of business development and research at ICAP, an interdealer broker. He points out that:“Credit approval was co-

MARCH 2012 • FTSE GLOBAL MARKETS

DERIVATIVES

Jeffrey Maron, managing director at MarkitSERV. “Connectivity is what we do. We have about 2,500 buy side institutions and all the major dealers connected to MarkitSERV,” he says. MarkitSERV is a joint venture between Markit and DTCC. Photograph kindly supplied by MarkitSERV, February 2012.

Ed Brown, executive vice president of business development and research at ICAP, an interdealer broker. “Credit approval was coalescing around the central counterparty, but the missing customer funds at MF Global have added to the uncertainty,” he notes. Photograph kindly supplied by ICAP, February 2012.

alescing around the central counterparty, but the missing customer funds at MF Global have added to the uncertainty.” Another contender for the credit approval function is MarkitSERV, the joint venture between Markit and DTCC that brought together the former SwapsWire/MarkitWire and DerivSERV businesses under a single umbrella. In essence, it is a communications hub that facilitates post-trade processing of OTC derivatives contracts, whether cleared or bilateral, arranged by the principals or through a broker, and open to market participants of every size. “Connectivity is what we do,” explains Jeffrey Maron, a managing director.“We have about 2,500 buy side institutions and all the major dealers connected to MarkitSERV.” A single point of credit approval across the entire OTC derivatives market would prevent the fragmentation of liquidity that will occur if clearing houses and FCMs have to allocate credit lines across multiple SEFs. For example, a customer may exhaust its credit line at one venue but be unable to tap unused credit capacity at other SEFs to complete a trade on the original venue. If an entity like MarkitSERV acts as a repository of credit information, SEFs could confirm a customer’s credit with a single ping. “A central mechanism or hub to manage credit is a classic opportunity for a middleware provider because it has to be connected to everybody. If an FCM wants to provide more credit to a customer—or cut it off—the FCM tells us and we let everyone else know,”says Maron. MarkitSERV will use its connectivity to smooth the transition to clearing in other ways, too. For example, in a bilateral market the counterparties know each other and can determine who has the obligation to report a trade. With a central counterparty, the market becomes anonymous; someone has to report the trade but the parties won’t always know whether they are transacting with a swap dealer, a major swaps participant or an ordinary customer. “We will have all that data by asset class,”says Maron.“If a SEF routes a trade to us, we can look up the legal entity identification for each side and let them know who has to report.” Without MarkitSERV, each SEF

would have to maintain its own database of the same information—a wasteful duplication of effort. Details like these bedevil the practical implementation of a simple concept that may contain traps for the unwary. The CFTC has proposed that trading on SEFs must be electronic even though the DoddFrank Act permits SEFs to use “any means of interstate commerce”, which would include voice broking. Screens work best in markets that have continuous trading in relatively small size, like equities. By contrast, OTC derivatives trade infrequently in large notional amounts: the average daily volume in credit default swaps amounts to just 7,000 trades per day. A ban on voice execution could have a deleterious effect on liquidity in the derivatives market. Cosgrove at GFI, a member of the CFTC’s Technology Advisory Committee, points out that the most liquid energy swap, the Henry Hub natural gas contract, trades 59% of its volume on the ICE exchange—which means 41% is voice transactions given up to ICE for clearing. In the PJM West electric power contract, the next most liquid energy swap, only 22% of the volume trades electronically.“If a market with episodic liquidity goes on a screen, the traders see a wide bid-offer spread and a handful of trades,” says Cosgrove.“They watch it for a day or two, decide it is not worth their time and turn it off.”In order to preserve liquidity, he argues that the standard for a swap “made available to trade (that is, one that has to trade on a SEF) must be set high if voice broking is prohibited. If the phone is allowed, the bar could be much lower without adverse effect. With so many crucial regulations still to be finalised, the end of year target date may be ambitious, at least for the SEF trading mandate.“It is one thing to figure it all out in theory and put the systems in place,” says Brown at ICAP, “ but what happens when you flip the switch and go live? That could be the hard part.”A phased implementation beginning with the most liquid swaps contracts will ease the transition from bilateral trading to central clearing—and the requirement to execute on SEFs that will follow shortly afterward. I

MARCH 2012 • FTSE GLOBAL MARKETS

TRADING TECHNOLOGY Photograph © Kentoh / Dreamstime.com, supplied February 2012.

Although speed per se is critical to the investment strategy of just a handful of high frequency traders and hedge funds—and those brokers that service them—traditional asset managers rely on fast data feeds for their own purposes too. Data-intensive functions such as risk management and transaction cost analysis (TCA) once relegated to the back office for processing long after trades were executed can now be performed fast enough for traders to use the results in real time. Neil O’ Hara reports.

Why applications around trade flow have become more important LTHOUGH SPEED per se is critical to the investment strategy of just a handful of high frequency traders and hedge funds—and those brokers that service them—traditional asset managers rely on fast data feeds for their own purposes too. Data-intensive functions such as risk management and transaction cost analysis (TCA) once relegated to the back office for processing long after trades were executed can now be performed fast enough for traders to use the results in real time. “The applications around trade flow have become much more important,” says Mark Palmer, chief executive officer of StreamBase.“Five years ago, most risk management was done in batch at the end of the day, but in the past two years more risk controls are taking place before the trade, driven by regulation and a desire to minimize risk exposure.” StreamBase supplies a software platform that enables brokers, exchanges and other market participants to build their own trading systems. To Palmer, the buy-side embrace indicates that the pursuit of low latency has reached full maturity. At first, speed alone was a differentiating factor—people willing to spend the money to build a faster mousetrap had a competitive edge. Soon the tools became commoditised and widely available, which allowed anyone so minded to create a state of the art

FTSE GLOBAL MARKETS • MARCH 2012

system using standard building blocks. At that point the market split between the few who depended on speed and had the resources to invest in the further pursuit of it, and the majority who either didn’t need it or couldn’t afford to keep up. These latter participants have substituted brains for brawn to make the most intelligent use of the speed to which they do have access.“The early stage is like the Wild West,” says Palmer,“We are way past that in equities, about half way through in foreign exchange and just at the beginning in fixed income.” It took about ten years for electronic trading in equities to reach the point where further advances in speed may depend on hardware rather than software enhancements. The nature of hardware used has already changed: even at the millisecond level the time to access data became a constraint. “We had to take hard discs out of the equation. Instead of waiting to store information in a database on a hard disc, analysing it and deciding how to trade, we use in-memory streaming technology so that traders can take advantage of opportunities in real time,” says Palmer. The pure speed demons are now investigating the potential of customisable computer chips called field programmable gate arrays (FPGAs). The acceleration of specialised applications through hard wiring is not new—

TRADING TECHNOLOGY

the dedicated graphics cards in personal computers use the technique—but it has never been applied to the financial markets. Instead of writing algorithmic software stored in RAM that interacts with a central computer chip through the operating system software, the algorithm is baked into circuits on a customised chip, shaving precious microseconds off the processing time. However elegant the concept is, the technology is not without its drawbacks. The lead-time from algorithm design to market rollout is far greater than for software. Moreover, FPGA chips do not come cheap. “People forget about cost when they talk about pico-second trading,”explains Palmer, “If you are not one of the top ten players, the cost of getting to that level of latency far outstrips the benefit, especially in equities where spreads are so thin.” FPGA chip developers also face the risk that in everchanging markets a hard-wired algorithm may soon outlive its shelf life. Custom chips cannot be reprogrammed easily, if at all. Richard Bentley, industry vice president, banking and capital markets at Progress Software, a provider of software tools to the financial services industry (among others), notes that each unit reduction in latency comes at exponentially higher cost, too.“A firm could spend millions embedding an algorithm with hardware acceleration on a fancy chip”he says,“but if in three months the algorithm no longer works in the market all they have is an inflexible routine that is hard to change.” Other developments will soon jazz up communications links anyway. Richard Ahrens, managing director, electronic trading technology at Bank of America Merrill Lynch, says the rollout of remote direct memory access (RDMA) technology combined with increasingly sophisticated parallel processing could achieve performance superior to FPGA chips at a fraction of the cost.“There are real concerns about FGPA technology from the standpoint of flexibility and time to market,” he says. “It remains to be seen whether it will take off in this area.” Latency sensitive market participants will always pay up for hardware if it provides a sustainable competitive advantage. For example, in August 2010, Spread Networks launched a service that offers customers a dedicated fiber optic connection between New York and Chicago along the most direct land route. The firm guarantees a round-trip time of 13.33 milliseconds or less, faster than any existing alternative. The telecommunications carriers, which try to capture as much traffic as they can, do not take the most direct route and use shared lines that add latency. Spread Networks offers dedicated lines for Wall Street and charges a premium price for it. While it is still a narrow market, it delivers a measurable edge.” A fast link unobstructed by third party traffic is of obvious benefit to arbitrageurs juggling financial products traded in New York against those traded in Chicago—Standard & Poor’s 500 Index futures versus cash equities, for example. Traders cannot co-locate at both ends. The brain that controls the strategy has to be at one end or the other.“A segment of the business will always lower the latency until execution ap-

Richard Bentley, industry vice president, banking and capital markets at Progress Software, a provider of software tools to the financial services industry (among others). Bentley notes that each unit reduction in latency comes at exponentially higher cost. “A firm could spend millions embedding an algorithm with hardware acceleration on a fancy chip” he says, “but if in three months the algorithm no longer works in the market all they have is an inflexible routine that is hard to change,” he says. Photograph kindly supplied by Progress Software, February 2012.

proaches the speed of light,” explains Robert Iati, a partner and global head of consulting at TABB Group, a New Yorkand London-based financial services research and consulting firm. “There will always be a hedge fund, a high frequency trading shop or a broker-dealer trading desk that will recognise the advantage in trading first.” The network connections are not the only factor creating latency—and by no means the biggest obstacle today. Bentley at Progress estimates that infrastructure accounts for no more than 10% of total latency, which puts a premium on streamlining the rest of the system. Traders need to accelerate the transition between idea generation and market action, perhaps through slick code in algorithms to make them spit out trading signals faster, or by reducing the time it takes to roll out a new or modified algorithm—the sweet spot for Progress and its ilk. Faster execution ramps up the need for adequate controls, too. Bentley says the May 2010 flash crash was traced to an errant algorithm that created its own feedback loop in which each trade it executed generated another signal to do more of the same. In effect, an algorithm engaged in electronic onanism created havoc in markets around the globe. “Ever lower latency puts enormous pressure on the trading infrastructure and connectivity,” says Bentley,“but it has a knock-on effect on risk controls, the back office, clearing and settlement.” Developers are striving to make algorithms smarter as well as faster. The early volume weighted average price

MARCH 2012 • FTSE GLOBAL MARKETS

Dan Nachtman, director, global execution services, Bank of America Merrill Lynch (BAML). “The ability of an algorithm to adapt is a vibrant development area now,” says Nachtman. “Quantitative signal generation and integration into how the algorithm responds is at the heart of current algo development,” he adds. Photograph kindly supplied by BAML, February 2012.

Robert Iati, a partner and global head of consulting at TABB Group, a New York- and London-based financial services research and consulting firm. “There will always be a hedge fund, a high frequency trading shop or a broker-dealer trading desk that will recognise the advantage in trading first.” Photograph kindly supplied by TABB Group, February 2012.

routines, which traded a prescribed percentage of average daily volume every few minutes, have given way to a new generation that adapts to changes in market conditions in real time. If volume picks up, the algorithm will accelerate its execution; if activity slows, the algorithm will back off, too. “The ability of an algorithm to adapt is a vibrant development area now,” says Dan Nachtman, director, global execution services at Bank of America Merrill Lynch (BAML). “Quantitative signal generation and integration into how the algorithm responds is at the heart of current algo development.” While the underlying logic has become more sophisticated, developers have responded to client demands to simplify the user interface. In an effort to differentiate products that performed a similar function, firms added so many bells and whistles that clients began to throw up their hands. Nachtman says large asset managers may have access to 100 different algorithms, each with a different order entry screen and dozens of parameters a trader can set.“The breadth of choices overwhelmed many of our clients,” says Nachtman. “We have taken our best algorithm, Instinct, and made order entry very straightforward on the front end and engineered the algo to support multiple trading objectives.” The new version requires the trader to specify only the urgency of order execution; the algorithm determines where and how to execute depending on that choice. To assure customers that orders will meet best execution standards based on a single parameter Nachtman and his team explain the embedded logic in minute detail. The design fends off requests for tweaks, too.“Customers have asked for very few

customisations in the year or so since we rolled the algorithm out,” says Nachtman, “We put the complexity on the back end in order to keep the front end simple.” The demand for ease of use represents a significant shift in manager attitudes over the past three years, according to Iati. In past surveys, managers told TABB they wanted better performance and more customisation, but high performance is now taken for granted and traders can set as many parameters as they need—or more. Algorithms have advanced to the point where most traders aren’t even sure what they want from the next generation.“The buy side feels we may be approaching the point where it is hard to come up with anything truly different in algorithms,” says Iati. The widespread adoption of algorithms that derive trading signals from electronic news feeds may be a harbinger of the future, however. StreamBase has worked with Recorded Future, which scours more than 70,000 sources—traditional news, blogs, social media, government filings, and niche publications—for references and sentiment indicators used to generate trading signals. It takes trading technology one step closer to artificial intelligence, an oxymoron that gives one traditional money manager pause.“The model is still based on historical data,” he says.“If people know how it works, it is easy to influence what the future looks like and game the algorithm.” The goal is—or should be—to generate trading signals that are smart, not just fast, a distinction that becomes more important with every reduction in latency. Trading technology will surely open up new horizons in the years to come, but developers must never forget the lesson of the flash crash: fast and dumb can be dangerous. I

FTSE GLOBAL MARKETS • MARCH 2012

ELECTRONIC TRADING uSA

Prick an electronic trading expert in New York and the honest ones will tell you that life has changed, perhaps irrevocably. Business is often referred to as ‘the new normal’ and many sell side traders acknowledge that trading volumes are not coming back anytime soon. Opportunities these days are to be found in leveraging internalised flow; on marginal increases in market share as smaller firms fold and/or merge; and a greater commitment to upgrading existing services, rather than redefining new ones. While some technology companies serving the electronic trading market are working in the ‘cloud’; leading sell side trading operations have their feet firmly on the ground and in the economic here and now. Francesca Carnevale reviews the trends and outlines what it will take for some firms to continue to lead a slowly diminishing pack.

Real steel: US electronic trading meets its financial mettle improving market conditions T IS A fact of life that most and hopes of economic growth. US trading houses have At least that’s what Bank of come to terms with: the America Merrill Lynch’s share of equity trading (BAML’s) February survey of 277 volume executed through fund managers (with a electronic platforms fell off combined $783bn of assets last year in the United States. under management) says. AlloAs trading volumes fell, cations towards equities made changing investor demand the largest one-month leap for research and other since the beginning of last year, essential sell-side advisory while 26% of asset allocators are services prompted some sell overweight equities, up from side firms to revert to tradi12% last month. tional, full-service trades. It Meanwhile, appetite for also helped generate sufficyclical stocks, including induscient commissions to comtrials and materials sectors, has pensate for an attendant fallpicked up, says the survey. off in research income. Equally, allocations towards Continual change is Photograph © Rolffimages / Dreamstime.com, defensive stocks, including now a given. As Laurie supplied February 2012. pharmaceuticals and telecoms, Berke, principal at TABB Group, notes in her Execution Consulting: The Next Gener- have fallen. Investors have also reduced cash levels. A net ation in Sales Trading report, “By 2013, the way in which 13% of asset allocators are overweight cash, down from a net the sell-side services its clients will look substantially 27% in January. A majority of the fund panel behind the survey now sees the different from today. Buy-side traders are demanding innovation, new tools and new technology solutions. More world economy improving. A net 11% says the economy will importantly, traders are beginning to seek out value- strengthen in the coming 12 months. That is something of a added insight from their electronic trading providers to turnaround; particularly given that in December 2011 a net provide data, analysis, insight and guidance that will 27% predicted a worsening economic outlook. Investors also result in quantifiable reductions in trading costs and say that liquidity conditions and the ease of trading have bounced back. Some 32% of the panel assessed liquidity as positive performance.” Numbers also write the story large. According to recent ‘positive,’compared with a net 7% saying‘negative’in January. reports, the share of institutional US equity trading volume It remains the largest one-month improvement since the executed through single-stock electronic trades topped 38% survey first asked the question in October 2007.“The strongest during 2009 and 2010. However, through 2010 and 2011 that indication of risk appetite is investors’ definitive move into share contracted to just 34%; while high touch trades rose cyclicals from defensive stocks and the closing of underweight positions in banks, especially in Europe,” says Gary Baker, from 55% to 60% of the total. Whether 2012 will be a bellwether of an improvement in head of European Equities strategy at BAML Global Research. It might all presage better days; just as easily it might not. fortunes is still moot. Certainly, some investors hint of a cautious renewal of confidence in global equities amid slowly “Hard economic data has to continue improving to sustain a

FTSE GLOBAL MARKETS • MARCH 2012

ELECTRONIC TRADING uSA

Ray Tierney, chief executive officer and president, Bloomberg Tradebook. “An organisation either optimises its client structure, the product suite or the firm’s skill set; or even all three. Until the street reconciles all those verticals, there will be too many verticals in play while volumes continue to decline,” says Tierney. Photograph kindly supplied by Bloomberg Tradebook, February 2012.

Lee Morakis, head of Americas Execution Services, BAML. Morakis questions; “These days it is about rationalisation, or simplification; concentrating on those elements or services that we do really well and then letting the user decide how they want to act in the market. Do you need a vast array of algorithms? Or do you need a few really good ones?” Photograph kindly supplied by BAML, February 2012.

recovery,” is the obvious concession from Michael Hartnett, chief Global Equity strategist at BAML’s Global Research. Either way, the electronic trading market is still living with the hangover of a protracted soft market over the last three years. Even if volumes improve over the first half of the year increasingly it is a pastime that only the largest and best players can continue to compete in. Trading is increasingly a big man’s game. Small, specialised firms must now either give their business up to the zeitgeist or make bold moves on other firms to beef up their strength and diversify revenue streams. Cowen Group is a recent case in point, having purchased Algorithmic Trading Management (ATM), a Jersey Citybased developer of multi-asset algorithmic trading strategies earlier this year. For Cowen, a research-centric firm that mainly focused on high-touch trading capabilities, ATM was acquired to fill a void in its electronic service set. The buy gives Cowen access to an algorithmic trading capability which it can offer to buy side clients to add to its existing financial technology business which it plans to keep separate and growing. The firm intends to deploy ATM’s algorithms first in equities, and later in other asset classes, including futures, options and FX. The transaction is expected to be finalised by the end of the first quarter this year.

pace of change. Even so, even the top ten broker-dealers have to do more, with less resource. Clients are provided with (nay, demand) an increasingly diverse set of data and analysis. At the same time, broker dealers now access more markets and asset classes than ever before. In the electronic trading segment, more processes are being automated. It adds up to systemic change and is creating particular challenges for large brokerdealers to generate new revenue without incurring extra costs, confirms Lee Morakis, head of Americas Execution Services at BAML.“It’s the new normal,” he confirms. Despite still-straightened times, Morakis holds continual investment in technology and closeness to market centres as vital service components.“Technology has to adapt to new market conditions and infrastructure to lower venue latencies and increase overall speed is paramount,”he notes. Even so, there is, he adds, greater rigour being applied to the way that technology is employed.“These days it is about rationalisation, or simplification; concentrating on those elements or services that we do really well and then letting the user decide how they want to act in the market. Do you need a vast array of algorithms? Or do you need a few really good ones? That’s a key question these days, for both the buy side and the sell side. The crux of what makes them work well is the underlying; if you have one good algorithm, such as INSTINCT, it works well in New York, London, in fact everywhere.” “Are all algorithms the same?” questions Charles Susi, managing director and co-head of direct execution at UBS in New York. “It’s a tight pack. In performance, every basis point matters, so in that sense technology matters. However, as everyone will tell you, nowadays the service is about more than just delivering algorithms. It is about delivering the right service when the client needs it, and the overall

Automation everything Regulatory changes and advances in technology continue to re-write the trading landscape. It is not just about the explosion of new trading venues and the technological means to connect to them in ever faster ways. Change is impacting business models and trading strategies. Given that all these development have been condensed into the last few years only those firms with deep pockets and experienced trading capabilities have been able to keep up with the

MARCH 2012 • FTSE GLOBAL MARKETS

quality of that service. Did we respond more than adequately when our client had a problem, for instance?” The drive toward rationalisation is logical; particularly as investment in technology by broker dealers is increasingly focused on greater automation of order management and trading processes. Everyone might be living in a more streamlined world; but it also helps drive down costs as brokerage commissions continue under pressure. In this context optimising internal flow takes on added piquancy; particularly as it helps“manage the bottom line more effectively,” explains Ray Tierney, chief executive officer and president at Bloomberg Tradebook. Reorganisation is the theme du jour, agrees Tierney.“An organisation either optimises its client structure, the product suite or the firm’s skill set; or even all three. Until the street reconciles all those verticals, there will be too many verticals in play while volumes continue to decline,” he says. Bloomberg Tradebook under Tierney has undergone a revolution. Historically, a product focused organisation albeit highly service driven, Tierney brought a tightly focused, entrepreneurial focus into the firm. In this regard, Tradebook’s particular positioning now focuses on providing high level

execution consulting, independent research, and helping clients achieve commission management efficiencies; a product suite that Tierney believes is finely tuned to today’s buy side trading requirements. It is not just a buy side story. Like other broker-dealers, Tradebook has ramped up its broker-to-broker businesses, particularly to those brokers lacking sophisticated algorithms, direct market access, analytics and connectivity to dark pools. Tierney is driven by the help it can provide smaller broker-dealers by providing advanced execution capabilities they need to solicit business. “With multi-assetclass execution capabilities, Bloomberg can help these firms develop an all-encompassing trading solution," Tierney holds. “This includes providing low-latency market access, algos with cross-asset pairs strategies and global portfolio trading capabilities.” He does however find confluence in both buy side and sell side requirements: "They need something on the edge that differentiates them, in terms of their execution performance," he continues. "We can provide that help despite the complexities in today's marketplace." Not that the service set is ultimately different for smaller, mid-tier or larger buy side

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FTSE GLOBAL MARKETS • MARCH 2012

ELECTRONIC TRADING uSA

desks. Fundamentally, explains Susi, “this is not a business of haves and have-nots. Rather it is a bifurcation in the business set. We actually remain one of the brokers that are delivering across the board. Some of our clients have spent their time understanding what they want; others do not have the bandwidth and so they lean on us.” BAML, UBS and Bloomberg are all in a high-roller play. Only those secure in their place in the trading firmament can and will tell you: they are no longer all things to all men. In part, it makes economic sense to focus on those clients which actually generate money for the sell side firm. But in large part, it is ultimately about service evolution and not all clients can benefit from that step up.“Execution consulting takes the high touch provider into the next phase of evolution in the new world order,” agrees Tierney.“It is part of a structural change in market dynamics. These days stories about single stocks are no longer important. These days it is all about macro factors, such as the euro crisis, that impact on trading strategies. In that context, nowadays it is all about liquidity. Too many clients tend to embrace an organisation’s algorithm because they might understand it. However, if you have a co-pilot, who understands your benchmarks and your metrics, you can make better use of it and your copilot becomes a trusted advisor; but it takes time.” Moreover, Morakis explains, the execution consulting service set is deep; going down to individual portfolio managers. In that respect, electronic trading is now expected to add to the portfolio manager’s ongoing search for alpha, rather than being a sidebar to an investment strategy. “It is not so much about finding particular stocks for particular managers; it is knowing and advising when it is the right time to buy or the right time to sell assets,” he says. At the same time, Susi at UBS stresses that there is convergence between the electronic desk and high touch service providers.“Pre and post trade execution consultancy or TCA are something of a misnomer for us right now. Clients are demanding real time feedback and making adjustments to their trading strategies accordingly. In fact, there is no such thing as low touch anymore—it is all just a different touch.” Susi welcomes the new world order. “This new model of mixing electronic trading with high touch is a much more efficient way of working than the definition of an electronic service desk historically implied. We have economies of scale and have a decade of investment into the system. An element such as co-location, which is important, is ultimately incremental cost. There is a lot more consolidation with different trading desks and there is more cross-fertilisation of expertise as we deal with clients in an increasingly holistic way,” he says. To remain competitive, the largest sell-side firms now also need to offer a broad, global network of exchange connectivity that includes emerging markets, as well as provide direct market access and services around different asset classes. “Exchange competition has been good for the market,” explains Susi, “Any venue that is slow disappears very quickly, however there are 13 exchanges in the United States right now. Clearly they are profitable.”

Charles Susi, managing director and co-head of direct execution, UBS, New York. “It’s a tight pack. In performance, every basis point matters, so in that sense technology matters. However, as everyone will tell you, nowadays the service is about more than just delivering algorithms,” he says. Photograph kindly supplied by UBS, February 2012.

According to BAML’s fund manager research, as risk appetite has risen, investors have bolstered allocations to emerging market equities. A net 44% of asset allocators are overweight emerging market equities this month, up from a net 20%in January. Demand for commodities has also risen. A net 10% of global asset allocators are overweight the asset class, up from a net 5% one month ago. A growing majority (86%) believes the Chinese economy is heading for a soft rather than hard landing. Only 2% of investors in Asia and emerging markets now believe China’s economy will weaken in the next 12 months, a significant improvement from a net 23% in January. Looking ahead, a net 36% of the global panel says that they would like to overweight emerging markets more than any other region. Not only is this an increase on January’s reading, but investors have expressed that they would like to underweight all other regions, including the US. The trend towards international exposure is nothing new for the major broker-dealers. BAML for instance, has adapted its algorithmic trading suite for use in more than 30 countries. The group has made more than 50 specific enhancements to its core algorithmic offering, yielding improved performance for clients, notes Morakis. "We are well-versed in customising our offering for new markets, and relied heavily on local trader feedback when fine-tuning our algos for the Bovespa for example," he says, "Our clients now have a robust new channel for accessing Brazil's equity markets, that complements our service set in Sâo Paulo." Equally, equity broker dealers are now required to think outside their service set and look at client relationships across their entire organisation. As UBS’s Susi notes,“Clients expect us to understand exactly how they trade across the board with other parts of the bank. It is the same internally too. If their business is important to the fixed income team; it sure is important to me too.” I

MARCH 2012 • FTSE GLOBAL MARKETS

THE 2012 ASSET MANAGEMENT AND ASSET SERVICING ROuNDTABLE

ASIA: LAND OF PROMISE, OR FIELD OF (BROKEN) DREAMS?

Expert speakers:

Supported by: (From left to right) UK: Dean Handley +44 20 7163 5458 Dean Chisholm, regional head of operations, Invesco Continental Europe: Sid Newby +44 20 7163 3429 Asia Pacific: Michael Chan +65 6372 6931 Michael Chan, managing director of business development, BNY Mellon US: Bill Salus +1 302 791 2000 Canada: Barbara Barrow +1 416 643 6361 Eleanor Wan, chief executive, BEA Union Investment bnymellon.com/assetservicing Naomi Denning, managing director, investment services, Asia Pacific, Towers Watson Douglas Eu, regional chief executive, Allianz GlobalBNYInvestors Mellon is the corporate brand of The Bank of New York Mellon Corporation. Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within Alastair Murray, regional head of asset managers each and insurance sector, sales and jurisdiction. Products and services may be provided under variousbusiness brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. Statistics pertaining to assets under custody worldwide are as of February 2011 by globalcustody.net. development, HSBC Securities Services ©2012 The Bank of New York Mellon Corporation. All rights reserved.

FTSE GLOBAL MARKETS • MARCH 2012

ROuNDTABLE

Overview: For better, for worse, richer or ... DOUGLAS EU, REGIONAL CHIEF EXECUTIVE, ALLIANZ GLOBAL INVESTORS: I have been involved in this industry since 1987 and I find that we are in a difficult period almost every year. Frankly, it is the norm. I agree things look difficult, although when we talk about the outlook across the world (in general) my colleagues feel that in Asia we have it better than the rest of the world. There are obviously bigger problems in Europe right now at the macro level. Moreover, there is uncertainty around some asset classes. Some commentators, for instance, have suggested that we are at the tail end of a long bull market in fixed income, but clearly people are still interested in buying the asset class. We are also looking at potential shifts in asset classes that people will buy and we are trying to prepare for that. ELEANOR WAN, CHIEF EXECUTIVE, BEA UNION INVESTMENT: We are a young organisation with only a four year track record. It is a joint venture between the Bank of East Asia in Hong Kong and Union Investment of Germany. Right now, I am pretty relaxed about the market slowdown as it gives me time to refine our infrastructure setup, and build a solid base for the business growth after the market recovers. Traditionally, Hong Kong investors are risk takers and prefer equities. However, in the last two to three years, fixed income has been getting more attention. Then again, fixed income in Asia is preferred rather than global fixed income as they offer higher yields. Investors in Asia are very different to those in the United States and Europe. They are very short term and think that one year is very long-term; nonetheless they are solid state, astute investors, who take factors such as currency into account. Product providers like us have to follow the game and right now, the investment appetite is all about renminbi. ALASTAIR M URRAY, REGIONAL HEAD OF ASSET MANAGERS & INSURANCE SECTOR, SALES AND B USI NE SS D EV E LOPM ENT, HS BC SEC UR IT IE S SERV ICES: There’s uncertainty as to how economies around the world will perform this year. I would expect that Asia is somewhat in a better position than Europe and the States, but it remains to be seen. Irrespective, it is going to be a tough year. Nonetheless, we are in the process of a big investment in our services and that will continue throughout 2012. Our focus is to provide services in all the main markets in Asia for fund managers, for global and regional fund managers. As we expect more attention to devolve into Asia, and more international managers to come to Asia, we continue to invest in order to provide our clients with a full range of services across the back and middle office. DEAN CHISHOLM, REGIONAL HEAD OF OPERATIONS, INVESCO: It is probably going to be a year in which we have to react rapidly across multiple asset management strategies. It is the continual challenge of building a platform which can deliver multiple asset management strategies into the Asian market for a very differing range of clients; from the less sophisticated bank distributors through to the more sophisticated sovereign wealth funds. It is actually this lack of uniformity in the client base that preoccupies us. Even so, although a few people around the table may not think these are good times, opportunities are still to be found out there and

Invesco has had the opportunity to apply a strategy of buying companies. In this regard, bad times are often a better time to buy a company and build out the business. You have to remain optimistic, especially in Asia. MICHAEL CHAN, MANAGING DIRECTOR OF BUSINESS DEVELOPMENT, BNY MELLON: I would suggest we may be at the tail end of changes resulting from the global financial crisis. The industry is increasingly at the mercy of a slew of regulatory changes around the world. Inevitably, in the context of our relationships with our clients, such a level of impending market transformation means that we are doing more for less: whether it is dated aggregation, additional reporting, clearing, or CCP for instance. Global custodians such as BNY Mellon are the natural place global clients come to. Another trend, of course, is UCITS distributions into the region. Global managers are looking for more ways to distribute their products further afield. In that regard, there are more firms moving from west to east and we are helping their distribution strategy. Historically, this work has been done by the likes of regional players such as HSBC and Standard Chartered in return for distribution channels, but increasingly over the last 12 to 18 months, global asset managers are asking us (as their global custodian) to do it as we have a larger worldwide relationships. Another change, interestingly enough, is that when I participated at this roundtable about two and a half years ago, the big talk in the region was the QDII initiative; that is money coming out of China. Now it is the other way around; it’s about RQFII, that is, money going back into China. NAOMI DENNING, MANAGING DIRECTOR, INV ESTMENT SERV ICES, ASIA PACIFIC, TOW ERS WATSON: There is less and less distinction between institutional and retail, with the defined contribution pension market increasingly looking more and more retail-like and obviously MPF in HK is no exception. This year we have the potential onset of the Employee Choice Arrangement (ECA) where individuals will be able to move part of their balance to different providers in the marketplace once a year. We also work with the wealth management market in helping them to manage and develop their product line-up. The challenges our clients are facing are continued volatility in the market and how they manage the risk on behalf of their members. It is not an easy time in this regard. Our view as a house is that the market environment is going to continue to be very volatile. Our central macro view is a bumpy road to recovery over a number of years. It’s a very difficult time for investors to manage their strategy and manage their risk which they’re obviously acutely aware of. So, our work is a lot more focussed on helping funds look at strategy and downside risk to understand what can happen in the worst case, given the significant volatility. Additionally, there continues to be a lot of interest in diversity of asset classes and particularly the continued focus on alternative investments as a means of diversification away from traditional equities and bonds. Much of our work is focussed on that and we expect that to continue through this year. Finally, people are concerned about what’s going on in Europe, and the impact that will have on their portfolios.

MARCH 2012 • FTSE GLOBAL MARKETS

Rules, rights and regulation: MICHAEL CHAN: I will just pick one that seems to be at the forefront of thinking: the Dodd-Frank Act. US regulation, like that in Europe (via EMIR) is pushing for centrally cleared OTC trades. However, this will not happen in Asia soon. I don’t think that regulators in Hong Kong, Korea, China and Japan are sitting down together right now to think central clearing. Equally, with what’s happening in the EU, Asian countries are not interested in creating a similar economic zone in the near future. How does something like a CCP affect us? Well, in one way, it has a large impact on the collateral management process. In an ideal world, there would be one central clearing operation. Everybody trades through one book and all collateral will be calculated on a daily basis. Certainly, the days of leaving big bundles of margin with multiple counterparties are over. Whether it is because of the collapse of Lehman Brothers or the euro crisis, our clients are coming to us (both asset owners and asset managers) and asking: "I want to know what I have out as my collateral on a daily basis. Am I leaving too much? What’s my counterparty risk? What currency is it in? Legally, which entity, is it in?" It would be really easy if there was only one central clearing house. In Asia, however, the likelihood is they’re going to continue to have a fragmented clearing system. I think SGX is the only clearing centre (up to now) that clears OTCs. FRANCESCA CARNEVALE: Just to clarify what you are saying: the lack of movement towards a central clearing system, is putting the onus on you to provide it, given that there is a paucity of supporting regulation in Asia. MICHAEL CHAN: Correct; in the context of clients demanding the global custodians to do more in areas such as collateral management, for example. DOUGLAS EU: I probably take a slightly different view of regulation. We are obviously in a period where we expect significantly more change. Here in Asia you have multiple different monopoly games that you’re trying to play and whoever’s in the background, whoever organised the monopoly, is changing these rules constantly. The impact is invariably increased cost in a lot of cases; it also multiplies bureaucracy—all the side things that we have to do and the things we have to report. It's all part of the game. Everybody has to deal with these problems, depending on the size of our footprint. We are fortunate. I can shove it down the table at somebody else, if at all possible. Equally, there is a limit to how much you’re willing to push down because you need to understand a lot of this stuff internally as well. To the extent that we can, we’re just shoving over to the service providers. DEAN CHISHOLM: In terms of external regulation coming to Asia, certainly a lot of the European stuff in the alternative space is forcing up the cost base and barriers to entry. Right now however, what Asia hasn’t really got its mind around is FATCA and when that comes through, it is the one which is going to be the shocker to the system because it affects distribution quite heavily and the information you have to collect on distribution. Moreover, if you combine that with local regulators pushing to ensure product suitability for instance, it will put a significant burden on distribution. Distributors will have

FTSE GLOBAL MARKETS • MARCH 2012

Douglas Eu, regional chief executive, Allianz Global Investors. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

to collect a lot of information and do more upfront and it will drive more margins in the wholesale area of distribution rather than the front end direct sales, just to get their cost model right. ELEANOR WAN: Another area that will impact the market quite significantly is fee-based advisory services; an element which is already incorporated in Australia, and will be in the UK at a later date. There is the potential for it to roll out globally. In Asia, as banks are the major distribution channel for investment products, fee-based advisory services may not be easy to implement. The other area is client suitability for those products that invest in derivatives. In Hong Kong for example, the new regulation on investor characterisation requires distributors, as part of their client profiling, to match the level of knowledge of investors of derivatives instruments to the kinds of investment products offered to them. Manufacturers also now need to assess the risk profile of each product according to its exposure in derivatives and distributors need to map the knowledge of their clients’in derivatives to the level of complexity of each fund in which they invest. Out of the 2,000 registered funds in Hong Kong, the majority of them are UCITS funds with derivative components. Global managers offer these UCITS products on a global basis, including Hong Kong. You can imagine then the costs now involved for this particular requirement. Moreover, we all understand that investing in derivatives does not necessarily mean higher risk and also that derivatives is a wide topic area which is not easy to explain to each investor. DEAN CHISHOLM: What we’ve seen a few times this last two or three years, is that when you want to get a product to market relatively quickly to capture an opportunity, you don’t use the UCITS vehicle. You use the UCITS vehicle for the second wave of sophistication in an area, simply because the time to market is very long. Typically, funds would roll out Caymans products, keep them unregulated, and that stirs an initial wave of interest. Then, you go for the more regulated, authorised in different jurisdictions second wave product. Actually, people are going to have to continue to be innovative to capture the front end of the money, especially in a period where there’s not a clear trend in play. In these markets it is not about mature products on a straight upward cycle. However, in some areas you can’t do that. However, we’ve seen that trend repeat itself again and again in Hong Kong and Singapore in the high net worth private banking segment where you can collect a reasonable amount of money with not too many end investors in it.

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ALASTAIR MURRAY: Asia is diverse. Each market is at a different stage of evolution and in each market regulators have different areas of focus. There are two main types of regulation in play over here: market–focused regulation and investor-focused regulation. Market-focused regulation is about liberalising the market, allowing a more complex state of products and encouraging investment into funds. Investorfocused regulation on the other hand, looks at investor protection and has more to do with disclosure and controlling the distributor. This requires more reporting to the regulator, which adds cost. In Asia clearly there was a lot of market-focused regulation leading up to 2008, which has since slowed down. Around the region there’s very little new product that has been encouraged by change in regulation; possibly with the exception of pension funds. Many emerging markets are focused on pension funds to encourage individuals to save for retirement. There were a lot of plans to liberalise the market and add more complex investible instruments or encourage the launch of hedge funds. In reality, with the exception of Korea, and in terms of investor-focused regulation, this hasn’t been over-reactive. However, there has been a growing focus on investor protection and a lot more focus on distributors and disclosure. The time taken to get products approved and come to market has definitely increased, but there’s nothing that has been terribly draconian—certainly nothing on the scale of what has happened in the United States and in Europe. Dean mentioned FATCA and it will require a significant amount of investment in systems for all of us. Elsewhere, hedge funds are generally not regulated in Asia. The managers themselves are regulated in most parts, s, so in that regard we will not see a replica of the regulation working throughis in force in Europe coming out here. The exception to this perhaps is where European and American investors want to have that same level of compliance, of control, of governance. Up to now however that’s been pretty much on a voluntary basis.

Recasting the service set for tomorrow’s world ELEANOR WAN: Risk management processes are a hot topic right now. Even when you make appropriate disclosures and outsource the monitoring function to a service provider, the responsibility still rests on us as the product owner to manage risk. Also, to cope with evolving regulation, our operational costs keep rising. In the retail space, we are squeezed by distributors who now take a big portion of the management fee. Together with other activities, such as marketing and client services, for example, our profit margin is getting thinner and thinner. These are important considerations for this industry right now. DOUGLAS EU: There is no doubt that regulations are increasing and introducing complex into the business. There are two competing problems. Everybody thinks Asia’s better than everywhere else, but if you actually look at the market’s size over the last four or five years, it hasn’t grown. In fact, in many countries markets have shrunk. So, you’re selling less and there’s a smaller pool of fees. As well, there is increasing competition and then you’re ladling additional cost on top. Margins are becoming more and more difficult for people to achieve

Eleanor Wan, chief executive, BEA Union Investment. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

and interestingly, these days few firms have scale and while those firms continue (probably) to earn decent profits I see fewer and fewer names joining those firms on a daily basis. Gone are the days when five new firms started up and each of them were going to be very competitive with you. The reality is that there are very high basic costs for those who want play in this space. DEAN CHISHOLM: Douglas’s words are a wise caution for some European and North American fund manager hoping to step into Asia with a two-man shop. It won’t work anymore. It’s not a strategy. If you’re going to come into Asia, you have to put serious money down on the table. You have to show, and Asians will often meantion this, commitment to the market; but it means you have to spend a lot on getting your product passed by product gatekeepers in the big asset houses. If you can’t get your product passed at Citibank in Singapore you’re not going to get into anybody’s platform, virtually or otherwise. I was in India last month and I saw that even Indian retail asset managers had to get through Citi’s gatekeeper to get on Citi’s distribution network in India. Moreover, these days even local fund managers have to play at the international level if they want sizeable distribution. That trend will not go away anytime soon. Collateral, producing pieces of paper, is a major industry for asset management these days. There are two outsourcers, both out of Europe, who are making a fortune out of this exercise: KIIs, prospectuses, multiple languages, slightly different for each country because each country is different and they will not harmonise themselves. If you’re in Europe, yes, you’ve got to produce collatoral in different languages but it’s basically the same document and you can run it through some conversion software. Not here. ELEANOR WAN: Then there is Korea. DEAN CHISHOLM: Korea, yes. We don’t do much in Korea. Compare this to Europe, where the number of countries, you can actually access, apart from a few tax issues, by playing with UCITS III and IV, is vast. You can find a whole range of funds in all territories, including multi-currency funds, with one service provider doing the whole lot. Come to Asia, forget it. You’ve got a much higher cost threshold to get over just to service those investment themes you want to get up to market. ELEANOR WAN: Not only are regulatory developments an important consideration, even language is an important element. Chinese, say, for example, is not a straightforward element. The use of Chinese is quite different in Hong Kong, Taiwan or mainland China. In written form, there is simplified

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Alastair Murray, regional head of asset managers and insurance sector, sales and business development, HSBC Securities Services. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

Chinese used in mainland China, but only traditional Chinese in Taiwan. The sentence structure and use of terms are different as well. For an example, the term“Inflation”is used differently in each place. All this results in costs; it is not just about very tedious client service requirements or regulation. Something as simple as marketing is already a major business cost. ALASTAIR MURRAY: There is another dimension to this beyond regulation. All the markets are starting at different points. In my view you need to be local if you’re going to service these markets. You need to be very familiar with what changes are coming and hopefully you can influence those changes. HSBC has tended to do that in many of the emerging markets. Actually, there’s another dynamic beyond regulation and that is best practice and governance, compliance and internal controls. I’m sure it’s not just at HSBC where these have veincreased enormously since 2008. In consequence, we have a far more intimate relationship now with fund managers than perhaps we used to. In fact, we have an interesting relationship with fund managers, as they appoint us to act as custodian and trustee for their products and in some cases, they may also be appointed as a fund manager for institutional mandates by another part of the group. In turn, those same fund managers are also doing significantly more due diligence on us to make sure that we have best practice and controls in place. Equally, we’re also doing a lot more due diligence on the fund manager, so, we see each other a lot more often and all this does add cost. NAOMI DENNING: Obviously another question comes up: whether any of the costs get passed on to the funds in the marketplace and that’s an ongoing issue as, Alastair, you’ve alluded to. The funds want to be sure they are getting value for money and there continues to be a lot of pressure on fees. However, we are not advising the service providers on compliance with regulations, we are advising the funds. Much of the regulation that service providers talk about is more about running their business rather than helping funds. The sort of regulations that the pension funds are dealing with are more about either the liberalising of the markets to broaden the opportunity-set for the funds to invest in or pension regulations that are gradually evolving to encourage higher contributions and more investment. I would say that is pretty unilateral across the region. While countries may be at different stages in this process, Asia, much like many other regions, is very keen to encourage additional saving to look after the aged as it populations is aging rapidly. In some countries it is about appropriate tax incentives, just to encourage people to put money aside. Korea’s

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one example where they’ve moved away from the old severance arrangement and put in place more tax incentives for corporations to actually fund the pensions which is about protecting the investors. Hong Kong is one of the markets that requires mandatory investment and, of course, we see more rapid growth in a mandatory environment than an environment where companies are only gradually incentivised. ALASTAIR MURRAY: In Europe the new UCITS regulations are putting more responsibility on custodians. The point I’d like to make about Asia is that I believe we are somewhat ahead of Europe in this point. If you look at the various markets in Asia, such as Hong Kong, Singapore, and Malaysia, they are trust environments and custodians act as trustees. They already have a responsibility to oversee the fund manager. In noncommon law jurisdictions, such as Korea, Thailand, Indonesia, and Vietnam, the custodian also has the responsibility to oversee what the fund managers are doing with heavy penalties for a custodian that fails to do that. Those responsibilities include checking investment restrictions, checking NAV’s etc. So, we’re somewhat ahead of where I believe this is moving to in Europe.

China: the elephant in the Asian room MICHAEL CHAN: I’ll focus on a couple of areas. From a global custodian perspective, we traditionally don’t do the domestic piece. Back in September 2007, the first QDII was China Southern (as the Chinese asset manager). It was about $4bn of global assets that came out in the form of an open ended mutual fund structure. BNY Mellon was fortunate enough to be the world’s first global custodian for this kind of a product from China. I remember the two, three months leading up to the final approval from the Chinese regulators in 2007, BNY Mellon was going into China almost weekly working with all the parties to launch the products, working at a very detailed level; right down to how many decimal places were required for NAV reporting and the treatment of currency exchange for foreign securities. That was only a few years ago, right? Since then, the most recent QDII launched raised only about $100m; volume dropped off the proverbial cliff. From a global custodian service provider perspective, BNY Mellon has invested a lot of time with Chinese regulators laying the groundwork, setting it up for the future pot of gold at the end of the rainbow, so to speak. But that just hasn’t happened for the industry yet. Now, the next big thing is the RQFII’s flows back into China. This time round, the local banks in China will have a bigger piece of the action here than the foreign players. ALASTAIR MURRAY:Yes, everybody’s looking at China and all the opportunities that are there. It’s the second largest funds market in Asia, after Japan and as such it’s a tremendous growth story. Opportunities are both local and overseas. Currently, we do act as a sub-custodian for QDII funds when they are investing offshore, and the fund administration is currently being serviced out of Hong Kong, for which we have obtained regulatory approval. Now, internally we are not able to provide custody and fund administration services to domestic funds there but we continue to work with regulators to discuss the possibility of this development. It is only a

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matter of time before, I believe, we’ll be allowed to offer fund administration and custody for domestic funds investing domestically. This is a huge focus and a huge amount of attention therefore for us, not surprisingly, as we want to be the first in every aspect of that market. As for the offshore business and a global custody perspective it’s very much a growth market and is receiving a lot of attention from service providers. I’m sure you’re right, it’ll go through waves but you can’t ignore China. Everybody is looking at that space. ELEANOR WAN: Almost all asset managers want to have a presence in China, but unfortunately the current regulations only allow joint ventures with local players. BEA Union also has a small shareholding in a Chinese fund manager. Of course, it has been a disappointing development for a lot of global managers because the asset hasn't really grown yet, even though it has been in the industry for ten years. However, I do not see interest in the asset class dying off anytime soon. However, you definitely need to know how to integrate that investment into your business strategy. The other challenge is managing the relationship with your joint venture partner(s). You will obviously want to influence them given your international experience on corporate governance, risk and compliance management, for example. I can only say it is challenging and a good learning curve for all of us! DEAN CHISHOLM: We’ve been in China since 2003 in terms of having a joint venture there and I was walking around China giving advice back in the late 1990s. China’s not an easy gig, particularly for foreigners coming from overseas. You have to spend the time on relationships, you have to spend the time knowing the marketplace and you’d actually be surprised about the breadth of product sophistication there is. At the same time there is sometimes a surprising breadth of naivety around product.You really have to do your research and you have to be prepared to go in to the country in multiple ways and what I mean by that is different strategies.You may require a range of different vehicles to go into China whereas in a lot of markets you could put them under one umbrella. Yes, the locals are struggling with overseas investment in terms of the infrastructure and how they make it work, but if you go back three years ago, there were virtually no Chinese fund managers in Hong Kong and there’s now something like 13 or 14 of them in Hong Kong alone. In that context, China's liberalisation is happening quite rapidly and the market is developing into a major centre much faster than we give it credit for sometimes. Even now, it’s a solid market with a solid middle class. However, I share some of Naomi’s comments about pension schemes. It’s one market where we’d love to have done more over the years and help develop a mandatory pension scheme because there is a real need there and it’s a significant opportunity; but they are very difficult to implement in the short-term. NAOMI DENNING: Actually, we took a group of investors up to China just three months ago, prompted by Australian funds that wanted to understand China better. We met with the regulators, some of the asset managers, and showed these investors some of the companies on the mainland, to help deepen their understanding and they were quite enlightened by it. They didn’t necessarily come away saying: "We must

Dean Chisholm, regional head of operations, Invesco. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

invest!" Instead, their goal was to try and educate themselves so that when they do get to the point that they’re comfortable, they can be ahead of the game. Actually, what they’re thinking about right now is market capitalisation. If you invest according to market capitalisation weightings, you are not investing in tomorrow’s winners; you are investing in yesterday’s winners. So, if you want to get ahead of the game and you believe that China is going to deliver strong returns, you may need to take a strategic stance and that’s why the investors are looking and doing their homework. We did help them look across a wide range of asset classes, from the more traditional equities and bonds to private equity and real estate. One observation I’d make about the private markets is that there are a lot of funds developing in China. Many of them are quite short-lived at the moment and if someone earns a good reputation, they may move on and set up their own fund. Achieving the sort of longevity that global investors look for to be comfortable investing is not necessarily there yet. We also found that a lot of the Chinese asset managers aren’t necessarily interested in the foreign investors because there’s so much potential and actual demand emanating from the domestic market. Having to deal with the added burden of foreign investors, the language and the legalities is too cumbersome. Then there is government policy. I would characterise China by the focus they have on control and stability. That’s one of the reasons they’re opening up so slowly. They don’t want floods of cash, in or out. In their next five-year plan they are really focusing on shifting from being the outsource manufacturer to the domestic consumer. It shows they do want to develop all of their industries, including the financial industry. DOUGLAS EU: I started my career as a fund manager looking at China in 1992. It was a big thing for us 20 years ago as a firm when we launched funds around the world and the truth is that the potential for China is undemonstrated. It dominates our agenda because nobody wants to be the person in the room who doesn’t have a China strategy and that’s whether you’re sitting in the US or you’re sitting out here in Asia. However, the Chinese make it very difficult for us to have a strategy. Most of us have multiple strategies that we have to go in through and regulations make it quite complicated. They force everybody in our industry into a joint venture, whether you’re domestic or local. I wouldn’t ever suggest that it’s intentional but the regulations that are in place are easier to comply with if you’re a local than if you are not. I wouldn’t

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Michael Chan, managing director of business development, BNY Mellon. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

want to say that’s necessarily intentional but the local firms have an easier time with the regulations than the foreign firms. Michael pointed out the big problem, which has been the same problem for everybody for the last 20 years looking at China, which is that we all see this thing and it looks big. However, if I take a side bar there, we have a mutual fund in the United States that’s roughly the same size as the whole China mutual fund market. So, how big is it, right? There are a limited number of distributors and these days we talk about funnel distribution. We are talking about two players on the retail side and maybe no more than half a dozen serious size institutional clients that you can go to. We have all invested a significant amount of money into getting ready for QFII, and I’m not sure that many of us on a net basis across all of our businesses have made a ton of money out of China. A lot of it is in the 'quote unquote' investment phase and we have been in this phase for a long time. I’d love to be able to say that this will be a huge market for us but if we were honest in our industry I doubt whether China is the biggest profit contributor to very many firms in this region, or for any international players. It’s not the biggest contributor for our profitability in this region and I don’t anticipate it being so for quite a long time. There many businesses that we all have outside of China that are, frankly, more profitable for us.

So what’s in store? DEAN CHISHOLM: Shall I put something down? It’s a starter for the rest of the people. What you’ve got with China is probably three cities or three conurbations and one has to think about one strategy in relation to and how you do it. If we go back to 1997, even pre 1997, everybody thought Singapore was going to become the Asian hub. Well, the reality is the last ten/15 years has made Hong Kong the Asian hub, and quite strongly too, because it’s in close flying distance to Beijing. You can do a day trip to Beijing, which is very important because it’s the seat of government; it’s the seat of the country's major distributors, insurance companies as well as the banks. Then you’ve got Shanghai which has got a lot of domestic securities industry in it as well as a lot of the asset managers and then Hong Kong as the outside gateway to the world for China. China’s using Hong Kong as the outside gateway very much now with the various RMB treats it’s being given in various shapes and sizes. There will be this long-term theme but most of the members around the table will be retired by then, when you do actually get to a level playing field.

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NAOMI DENNING: Speak for yourself. I’m only 30! DEAN CHISHOLM: I’m taking the long view! However, anyone coming into Asia has got to realise China is at least a two-dog game. You have to play Hong Kong as well as Beijing and maybe you want to be in Shanghai, depending on relationships and so forth. It is not a simple equation though and you have to work it out for individual organisations. Moreover, depending on what you are, how you’re doing it (and we’ve all got different combinations of staffing around China) it’s not a simple territory. It would be easier to write a market entry for the US than it would be for China at the current position. MICHAEL CHAN: I have heard it said that to some uninitiated newcomers looking to do business in China-Hong Kong can be the ultimate China Jedi mind trick. In that Hong Kong is what China wants foreigners to see when they come into the region. New players visit Hong Kong for a week or two and say: "Hey, so this is China and it doesn’t look that foreign. I think we can do business here, walk the street, signs are in English and so forth". They are wrong. Hong Kong is part of China but it isn’t China. Doing business here in Hong Kong is different than doing business on the mainland. I visit China once every couple of months or so. After more than a decade, each time I am there I realise that there’s more I can learn. Some say the Chinese are really sophisticated when it comes to investing. I disagree. Chinese investors can certainly be considered as very sophisticated and pragmatic: but if something is not making money, they are going to get out of it without taking a long term view of the investment. One reason for that is there isn’t any requirement, like a mandatory pension scheme, that forces the Chinese to put their money into long-term savings.They need to have regulations that are going to encourage locals to save for the longer term. In China, they have the recipe for that: government power to enforce such a scheme coupled with a high personal tax rate. In places such as Hong Kong and Singapore, a low tax rate is no real incentive for anybody on a voluntary basis to put more money into their MPF or CPF. What can you save, 10%, 12%, maybe 15%? Even with that, there’s no big interest. Now in China the personal tax rate is 30% to 40%. If the government comes out with a mandatory plan that reduces taxes with contributions, by deferring that for 20, 30, or 40 years until retirement age, that would certainly encourage more people to keep their money in for a longer term; akin to the environment in say, Australia, the UK and Canada. ALASTAIR MURRAY: We expect to see a long term return on our investment in China. While it definitely has benefited from China, Hong Kong stands on its own and is successful on its own. Companies are making a lot of money in Hong Kong; it is a good place to do business and it’s very much our home ground and remains the centre of our successful regional operations.

The year of the dragon: but is it good for business? DOUGLAS EU: A really good year. For us individually this will be a good year but I’d say despite the external environment, not because of it. I’d say that it will be a better year if the external environment improved. Obviously the fourth quarter of last year was hard on all of us. Markets are down and in our industry that’s basically revenue. So, revenue is lower. We’d like to believe in the

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optimism that the rest of the world has, that our markets are the best. We like to believe that and we probably each have different degrees of belief in that and if that happens, that will make the world a little bit better for us. If I look at what we’re counting on, in the asset management business a lot of us are competing in the same area, which is domestic fixed income, Asian fixed income. A number of firms in this region, all the biggest ones, as far as I can work out, have put significant investments into teams there. That is where we are, always in assets right now and we need to see some of that continue for a little bit. At some stage we’re all hoping that that shifts a little bit to the equity side. DEAN CHISHOLM: One of the challenges for us all, after being in Asia for a number of years, is that we have to learn how to run our businesses without predicting where the market’s going to be. That may sound hard to people outside their region but it is about being ready for the different bits of the cycle, being with the distributors, being with the clients, doing all the basics correctly so that when the opportunities come along, you can actually optimise those opportunities. If you try to predict markets, you are in difficult territory. DOUGLAS EU: Adding to that, probably the reason why I struggle with that answer is exactly what Dean said.You almost don’t care. You’re running the business regardless. You just expect it to be tough.You build it into your expectations and if the outcome is better than you thought, that’s the icing. MICHAEL CHAN: There will be elections in the US this year. I doubt Obama is going to push harsh regulatory changes in the coming months, whether it’s FATCA or Dodd-Frank in its original form. He’s got to try hard to bring the market up somehow and hopefully, any such buoyancy in the US should certainly help the markets in this part of the world. Personally speaking, I really can’t see how it could get a lot worse in the next nine to ten months. NAOMI DENNING: We’re hiring and we’ve been hiring people with alternative investment experience; that’s where we see ourselves trying to help our clients progress their strategies across the region. Also, we’ve hired someone to help the wealth management industry which continues to develop. Another focus for us for 2012 is here in Hong Kong getting ready for ECA. We’re taking on a bit of a social mission to try and provide consistent information about MPF providers to the individuals who are suddenly going to face this barrage of salesmen and a broad spectrum of products to choose from and we are working on tools to help them do that. ALASTAIR MURRAY: We have a very strong business in Hong Kong and in Singapore, and the focus for 2012 is going to be to retain that market share in the face of increasing competition from global players who are coming into this market space and to leverage off the technology which we’ve been investing in Europe. The other priority is in emerging markets where we face more competition from local banks, we are focusing on both domestic and international fund managers who are also looking into those markets. There’s been a trend in international managers looking at emerging markets but whether it will happen this year, whether the global uncertainty will help to focus international managers into these emerging markets or whether they will be held

Naomi Denning, managing director, investment services, Asia Pacific, Towers Watson. Photograph by Danny Ng, © Berlinguer Ltd., February 2012.

back is a difficult one to call, but we continue to focus on growing our market share in emerging markets. FRANCESCA CARNEVALE: As a custodian are you a-feared by the news last year that Bank of China is looking to establish credentials as a global custodian? ALASTAIR MURRAY: It is not surprising that they are looking at that space. It’s an interesting time to go into it. There’s increasing competition in global custody. We talked about increasing regulations adding on costs for global custody, a market that the margins are getting squeezed all the time. Getting the right technology could be time consuming because the demands are increasing all the time. MICHAEL CHAN: I recall that back several years ago one of the large Chinese banks was announcing the same thing. That’s what I love about the Chinese banks as they are open about their strategy and asking for guidance on how things are done. BNY Mellon has provided training sessions and workshops with many of those banks—of course, the learning is both ways. We shared with them the knowledge that they will need a lot of technology and upfront investment to do get involved in this business and to be selective. BNY Mellon succeeded in being the world’s largest global custodian; by focusing only on curtain functions that we are good at, as you cannot be all things to everybody. Nevertheless, it looks like some of those Chinese banks are heading in that direction despite many of the universal banks exiting the custody space. I think they've taken the intelligence to heart, but who knows, only time will tell. ELEANOR WAN: The one word to describe 2012 is the word “tough”. It will be tough on how you apply your business strategy and how you grow your business. For me, it a start-up approach; I have laid down the plan to build a solid foundation for future growth. We are also focusing on enhancing efficiency, upgrading client services, grooming our talents. This basically involves upgrading both hardware (systems) and software (people). The challenge for me and all of us in the industry is how the market will evolve. Looking back in November/December last year, it was very difficult, with only bad news in the market. However, there has been a little bit of a rebound since the start of this year. Market volatility is the worst enemy for portfolio management. NAOMI DENNING: We’re all seeing that headcount is being cut, but it does tend to lead to a bit more stability and one of the features of Asian markets is people constantly moving for one extra dollar. So, maybe, the silver lining of the difficult time is possibly a bit more building of talent if people stay put for a while. I

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REGuLATIONS Photograph © Archmen / Dreamstime.com, supplied February 2012.

Striving to comply with the new regulatory structure On January 31st this year the US Securities and Exchange Commission (SEC) held an all-day conference to deliver a clear message: chief executive officers and senior management will be held responsible for creating, managing, and maintaining an effective control environment. The SEC called for business and control functions to work together and to interact effectively. Collaboration was a central theme. Deborah Prutzman, chief executive officer of The Regulatory Fundamentals Group explains the need for senior management to build a robust governance program that addresses all the risks within their organisation in a repeatable manner. This is consistent with the changing expectations of regulators worldwide. N A RECENT Cayman Islands’ development, the liquidators of a fund brought a case against the fund’s independent directors for willful neglect of their duties. It was the first time a Cayman Islands court held directors personally liable for the losses of a fund. In similar vein, the UK’s Financial Services Authority (FSA) recently fined a senior manager at UBS AG for failing to prevent unauthorised trading at the bank’s wealth management unit in London. In court filings, the FSA alleged the manager failed “to carry out an adequate initial assessment,” and to monitor business processes. Had he done so he “would have identified serious flaws in the design and operational effectiveness” of the firm’s governance and risk management framework. These actions send an unambiguous message. As a manager, you must focus your team on doing the right thing both for the firm and for your clients. You can demonstrate the importance of enterprise risk management by honestly assessing the risks facing your firm and evaluating whether its business processes are sufficiently robust to protect you, your firm, and your investors.

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You may believe it is more difficult to evaluate the effectiveness of your firm’s compliance and other risk management initiatives. After all, laws and regulations can be technical, complex, and dense. Making matters worse, what if you do not have direct expertise on these fronts? A short set of questions that can help you make this assessment can be found on page 63. The questions will clearly highlight those areas that warrant additional emphasis on compliance, risk, and governance. This exercise is important because the regulatory landscape continues to change and you need to know if you have done enough to ensure that your compliance program is effective. Even before the SEC held its conference, the regulatory landscape was tipping towards holding senior management accountable for business governance and compliance oversights. In the United States, the level of regulatory activity is partially motivated by the immense public pressure the SEC received in response to the Madoff scheme and the so-called Flash Crash of 2010. Moreover, the US Commodities Futures Trading Commission (CFTC) has also faced major scrutiny during Congressional

REGuLATIONS

hearings on the collapse of MF Global and its missing customer funds. The court of public opinion and the US Congress continue to put an unprecedented level of pressure on regulators. Senior management should be aware that these days they are dealing with a much more robust SEC. In 2010, the SEC's enforcement division created five new units dedicated to asset management and mutual funds, illegal trading and other market abuses, structured and new products, foreign corrupt practices, and municipal securities and public pensions. These units provided the staff with much needed specialised knowledge and expertise. In consequence, you really do not want their attention directed at you in any shape or form. Moreover, a substantial portion of the SEC's January compliance outreach programme was dedicated to the need for trading and operations staff to fully understand legal requirements and to internalise their obligations to the law. Equally, these days there is a particular focus on investment advisers. A former assistant director of the SEC’s asset management unit recently warned that the “world is about to change for investment advisers.” Last year, the SEC filed a single-year record of 146 enforcement actions against investment advisers and investment companies; a 30% increase on 2010. In some of these cases, the SEC ordered the dissolution of the firms for blatantly failing to remedy compliance deficiencies that examiners had previously warned about. During the January programme, the SEC mentioned three specific cases: one involving a Ponzi scheme, one focused on valuations, and the third involving the failure of a firm's escalation process. In the third case, the firm's business unit was so forceful and influential that it prevented the firm from appropriately addressing a problem with a trading algorithm. Admittedly, these fact patterns are extreme, but do not let that lull you into a false sense of security. Regulators frequently start with egregious situations and move to less obvious ones. Last year’s activities are a clear indication that the SEC is serious about examinations and the remediation of compliance deficiencies. It is also important to remember that these days penalties may become much more onerous. Mary Schapiro, the SEC’s chairman, has proposed legislation to increase the penalties for violations of the securities laws, noting that the Commission’s statutory authority to obtain civil money penalties “with appropriate deterrent effect” is limited in many circumstances. She would increase the statutory limits on civil money penalties; more closely link the size of the penalties to the harm faced by investors, and substantially raise the stakes for recidivists. Specifically she proposed increasing the penalties for the most egregious conduct to $1m per violation for an individual and $10m per violation for an entity, and allowing penalties equal to three times the amount of pecuniary gain in certain instances. There is precedent for this in the US. In 1989, following the failure of savings banks throughout the US Congress

passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). This granted the FDIC the power to charge bank board members, employees, and consultants with civil money penalties ranging up to one million per day for reckless or willful violations of the law. Additionally, the ability of such individuals to benefit from coverage under indemnification and insurance policies was limited in certain situations. It is not clear whether Congress will choose to go down this path, but it cannot be ruled out, especially if more incidents such as MF Global should occur. While the SEC does not currently possess the same draconian powers that the bank regulators have under FIRREA, it does have the authority to bring actions against management for failures to supervise under Rule 204A of the Investment Advisers Act of 1940. Any officer can be the target of an enforcement action. Last year, the SEC charged more than eighty individuals and entities—nearly half of whom were CEOs, CFOs, and other senior management— with wrongdoing in the financial crisis.

Culture of compliance Every firm has a different approach to compliance. As every compliance officer knows, a firm's culture can support compliance efforts, or, at its worst, can render compliance efforts virtually meaningless. The SEC has emphasised the importance of a culture of compliance repeatedly during its January outreach program. Staff and other programme speakers noted several times that the true test of a culture of compliance is not with the support staff—it is whether there is meaningful buy-in from profit centres and investment personnel. For this to occur, business personnel must understand that doing the right thing is important to senior management. They must respect the compliance personnel, and the compliance personnel must feel empowered to speak up, even when profits are at stake.

Organisational structure An appropriate organisational structure provides for proper processes to address compliance deficiencies. While not every regulatory regime requires the chief compliance officer to have direct access to the governing body, it is specifically required in the US Federal Sentencing Guidelines. Likewise, an organisation needs to make an effort to determine which laws apply to it. Without such an effort, an adviser cannot know whether it is operating in compliance with legal requirements. Conducting a risk assessment initially and updating it periodically allows the firm to develop procedures tailored to its organisation. Once the firm has implemented a system for complying, it must have a method for keeping up-to-date on new or changing rules and regulations so that senior management can consider the implications for the organisation. Lastly, an effective framework must be established to coordinate the work throughout the firm, reinforce the message and facilitate escalation of issues—particularly in those instances where business and control groups may have differing viewpoints.

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Compliance manual Sometimes managers think that it is enough if their firm has a compliance manual. Many times these manuals, if for a USbased adviser, focus only on Advisers Act rules and regulations, without trying to provide a broader viewpoint on the key risks facing the firm. Simply having a compliance manual is not the ‘be all, end all’. Many firms have compliance manuals, but they are esoteric, outdated, and ignored. Furthermore, an off-theshelf compliance manual that is not customised to the business is insufficient. When examining the effectiveness of the firm’s compliance manual, it is important to check whether it is meaningful to the business and actually followed by staff. It is a key building block to an overall enterprise-wide governance program. In short, an effective compliance program can be an effective shield. It can help avoid reputational damage at a time when investors have become increasingly critical. Institutional investors and their consultants expect, value, and embrace

the protections such a program offers. Moreover, as noted above, the existence of a robust compliance program can help a firm avoid prosecution. Or, if the worst should occur, it can mitigate the seriousness of fines and penalties imposed. A criminal charge could easily end a manager’s career. However, even at a more pragmatic level, insurance policies and indemnification provisions may have limits or exclusions that are triggered by legal and regulatory missteps. It is crucial to understand that regulators and investors are looking for an appreciation of the key risks, an awareness of the law and a willingness to comply with legal requirements. This is most easily demonstrated by implementing and testing robust, repeatable, and documented processes within your organization. While this is a challenging endeavour, building a governance infrastructure now will serve your firm well by providing confidence to investors, enhancing regulatory relations, and creating a foundation for future growth. I

Is your compliance program adequate to the task? IN THE fACE of a changing regulatory environment it is important for you to determine that your compliance program is adequate to protect you and your firm. The following questions are designed to identify factors that are important to an effective and robust compliance program. Honestly answering the following questions is the first step in making this assessment.

Process Culture of Compliance

Key questions 1. Does the management team, as well as the investment personnel, believe that governance processes are important and understand the legal and regulatory requirements impacting their roles? 2. Does your chief compliance officer have respect and influence in your organisation? 3. Do risk and compliance personnel raise issues to you (or your senior management team) for consideration, even when the issues concern a major profit centre?

If you answered “No” to any of these questions, you are at risk of not realising that something has gone awry until it is too late. You must manage regulatory and legal issues just as closely as you would manage financial challenges Organisational Structure

1. Does your chief compliance officer have direct access to your governing board or executive committee? 2. Have you (i) identified the laws that apply to your company, your investment vehicles, and your investments, and (ii) have you incorporated these requirements into operational processes? 3. Is there a process for keeping the information gathered in #2 up-to-date reflecting both changes to laws, changes to the market place, and new activities?

If the answer is “No” to any of these questions, you need to build these processes now.

Compliance Manual

1. Is your compliance manual tailored to your business? 2. Is it meaningful to you and your staff so that you use it to obtain guidance in unusual or tricky situations? 3. Do the investment personnel appreciate the importance of the policies and procedures that apply to them?

If you answered “No” to more than one of these, you probably do not have satisfactory compliance manual in place.

Source: The Regulatory Fundamentals Group, supplied February 2012.

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uk REGuLATION

Those who were keen followers of the 1990s cult television series Twin Peaks and its prequel film, Twin Peaks: Fire Walk With Me may have experienced some concern at hearing recently in a speech by the Financial Services Authority's (FSA’s) chief executive officer, Hector Sants, that the regulator would very shortly start adopting a ‘Twin Peaks’ model of regulation. However, rather than a drama concerning the murder of a teenage girl, which explored the gulf between the veneer of small-town respectability and the seedier layers of life lurking beneath it, this is the continuing drama of the progress of the UK’s regulatory reform programme, though it is also laced with some underlying seediness, mystery and double-think, all thrown in for good measure. Charlotte Hill, partner and head of the financial services and regulation practice at law firm Stephenson Harwood, gives a sprightly, sometimes humorous run through the implications of change, positing that it might all be too complicated for it’s own good.

Twin peaks: the fire walk of UK market regulation? dual-regulated, authorised and HE FINANCIAL CRISIS subject to prudential regulation by and recession caused the the PRA. FSA, the United KingIn two speeches on February dom’s financial markets reg6th and 7th this year, Hector Sants ulator, to be criticised for being announced what he termed a too costly and ineffective in its "major milestone" in the progress approach to regulation, resulting of the regulatory reform in a complete reform of the UK's programme, namely, the introregulatory structure. duction of a "Twin Peaks" model Right now the UK financial of regulation, which would be markets are governed by a triparoperating within the FSA from tite system of regulation, with April 2nd 2012. From this date, regulatory responsibility being two regulatory models (the Twin shared between the Bank of Peaks) will operate within the FSA England (BoE), the FSA and HM in preparation for those models Treasury. However it looks as if becoming separate regulatory this system has now had its day entities early in 2013. One peak is and change is afoot. There is earmarked for prudential regulamuch optimism that this time tion and the other for conduct around, all will be well and the Hector Sants, chief executive of the Financial Services Authority regulation. So, banks, building shortcomings of the previous (FSA) arrives for a meeting with protesters from the Occupy system will be addressed and a London movement at St Ethelburga's centre for reconciliation and societies, insurers and major investment firms will have two new dawn is breaking. peace in the City of London. Picture dated Wednesday December separate groups of supervisors: The old structures will be 7th, 2011. Photograph by Sean Dempsey/PA Wire. Photograph one focussing on prudential issues replaced with an all-new, all- supplied by PressAssociation Images, February 2012. and the other on conduct. improved, shiny new system, Whilst the FSA could not completely replicate the new where responsibility for regulation will be shared between, em ... three new regulatory bodies! These are the Financial Policy approach envisaged by the Financial Services Bill at this stage, Committee (FPC), which will sit in the BoE and take responsi- the Twin Peaks model will ensure that the transition to the new bility for the macro-prudential regulation of the UK financial regulatory structure early in 2013 (termed, in true superb FSAsystem; the Prudential Regulation Authority (PRA), which will sit speak, the "cutover") would be "seamless". Not only are there the two independent groups of supervias an independent subsidiary of the BoE and take responsibility for the micro-prudential regulation of financial institutions of sors for banks, insurers and major investment firm but also, all systemic importance, such as banks and building societies; and other firms (that is, those which are not dual-regulated) will be the Financial Conduct Authority (FCA), which will inherit the supervised entirely by the conduct supervisors. These separate majority of the FSA’s current regulatory functions and be respon- groups of supervisors will make their own separate judgesible for the conduct of business regulation of all firms currently ments, and against different objectives. This is an important regulated by the FSA. This will include those firms that will be distinction, as we are told that they will be "pursing different

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goals". Up to now, there has been little clarity on what all this means, but the approach is summarised in another piece of fluent FSA-speak: "independent but coordinated decision making"––an approach that will be "stressed to staff". The thrust of this appears to be a policy of sometimes working together, but sometimes not, whilst somehow managing to share all data collected from companies. Although no detail is given, "greater clarity" apparently has been given to the objectives of the two supervisory groups. No information is given on what this "clarity" entails. Those still reeling from the spectre of two separate sets of supervisors will exit screaming at the intelligence that the existing ARROW risk mitigation programme will be split between the Twin Peaks. The Financial Services Authority (FSA) is a riskbased regulator and ARROW is the framework it uses to make risk-based regulation operational. ARROW stands for the Advanced, Risk-Responsive Operating Framework and covers firm specific (vertical supervision), thematic (those involving several firms or relating to the market as a whole; the FSA terms this ‘horizontal’ work) and internal risks (these are operational risks that might impact the FSA). ARROW will be split between those actions which are relevant to the conduct supervisory group's objectives and those that relate to the objectives of the prudential group. What is worse is that this is only just around the corner. From April 2nd 2012 onwards, the two separate supervisory units will run their own risk mitigation programmes and firms will have "two separate sets of mitigating actions to address". The two supervisory teams will assess risk separately, against their own separate objectives (and of course, firms do not as yet know what these are). Any firm currently preparing for an ARROW visit, or anticipating one later in the year will not be delighted by the knowledge that each group may well ask apparently similar questions, but that the purpose will be different. Conclusions drawn from the ARROW process will be coordinated with "a single pack of documentation" being presented to the firm's board––but this will have "two separate sections". However, there will not be a consolidated list of required actions arising from the ARROW visit.

Doubling up on visits The meaning seems to be that you will still have an ARROW visit (at least, for the lifetime of the current FSA), but this will in fact be two visits. When the visit is over, the FSA will provide one, consolidated pack of documentation summarising the conclusions of the assessment. However this will be divided into two, with two separate sets of actions, to each of which firms are required to give "equal focus". So, you are indeed seeing double––your one ARROW visit has suddenly become two. Anyone who has been through the current ARROW process well knows the enormous amount of preparatory work that is necessary and the stress of the increasingly demanding interviews, so it is hardly welcome news that the amount of work involved is about to be doubled. Firms will be required to make "behavioural changes", so that the new approach works "to the benefit of society" as

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Charlotte Hill, partner and head of the financial services and regulation practice at law firm Stephenson Harwood. Photograph kindly provided by Stephenson Harwood, February 2012.

a whole. In line with this, firms must comply with supervisory judgements "willingly" and "proactively"; in other words, not challenge FSA judgements, but take it like lambs. Firms must align their goals with those of their supervisors and (again) "with society as a whole". So, now companies have "the best interests of society" to contend with, along with everything else. Unsurprisingly, no steer is given as to what these might be, or which society the regulator may have in mind. Rather puzzlingly, a further feature of this new world is that firms must "recognise that there are times when both firms and the regulator will make judgements which in hindsight are found to be wrong". Sounds sinister! What does this mean exactly? Perhaps the killer punch comes in an apparently throwaway line that is not elaborated further that firms must "recognise that this new approach will require greater resources and expertise and thus costs more than the old reactive model". Double the trouble, it seems, means double the cost. More fees and a greater cost of regulation at a time when companies are feeling the pinch of uncertain markets and falling revenues and buckling under the weight of around thirty-five (at last count) separate new legislative measures from Europe. There is much still to be done and in his speeches, Sants provided a shopping list of the issues still to be addressed within the next twelve months, any one of which would be enough to keep an army of regulators busy for a good deal longer than this. They include amendments to the threshold conditions; the designing of a new "operating platform" for the FCA and the PRA; designing a new supervisory framework to replace ARROW; finalising the new Memorandum of Understanding detailing how the FCA and the PRA will coordinate their activities; splitting the Rulebook between the PRA and the FCA; and training (and presumably, recruiting) staff. The next twelve months are likely to be extremely lively, as the FSA wrestles with operating within the Twin Peaks framework and labours with the complexity and volume of the issues still to be addressed. Firms once again will be obliged to wrestle with major operational changes due to regulatory upheaval. Twin Peaks looks like being only the beginning of the fire walk. I

THE ExpERT pANEL

The trend towards enhanced supervision and prudential requirements looks onerous at first glance; particularly as the tide of incoming regulation appears to stretch both across product areas, business segments and geographic regions. Various legislative efforts are either in the statutes or still in the proposal stage; either way new rules that will change the structure, supervision and governance of financial services will now be part and parcel of our daily lives and more legislation is in the pipeline. This ticket looks to have no immediate expiry date. Regulatory change remains on the G20 agenda and will likely continue so for some more years. Even when regulation is well researched, clear and well thought out, the ripple of change instigated by new, sometimes exhaustive rules, often results in unintended consequences. MiFID II, AIFM, FATCA, UCITS IV Basel III, and Securities Law Directive are just some of the directives and rules in the immediate pipeline. We assembled a team of experts across the financial spectrum to think about answers to some of the key questions rolling around the markets; some of which might affect you.

FINANCIAL MARKET REFORM: REDRAWING THE PRODUCT SUITE implications). Service providers, FTSE GLOBAL MARKETS: What role Photograph © Pixelgallery / such as RFG, can help their clients can securities services providers Dreamstime.com, supplied answer the questions: does it play in helping clients keep abreast February 2012. impact me? And, what do I need to of new rules and regulations across do about it? They can provide a swathe of investment activity? DEBORAH PRUTZMAN, CHIEF solutions to make the actions EX ECUT IV E OFFICER, T HE easier to understand and accomREGULATORY FUNDAM ENplish. That’s where service proTALS GROUP: One of the chalviders need to focus these days. JEA N-ROBERT WILKIN, T HE lenges everyone faces today is an EXECUTIVE DIRECTOR, HEAD overload of information that hits OF PRODUCT MA NAGEall levels of an organisation. Rarely M ENT, GLOBAL SECURIT IES does a new rule or regulation fail to FINANCING, CLEARSTREA M receive substantial play in the press BA NKING: and on the web. You hear about it Customers are multiple times, and this relentless looking for information but they repetition runs the risk of distractare also seeking solutions to the ing the business from what really changes that are coming; especially matters. Service providers need to now as the clock is ticking. move from simply alerting that Certainly, at Clearstream, we have The Expert Panel something new has happened and been proactive in developing some Kara l Cauter, director, FS Regulatory Centre of offer a deeper more meaningful new state-of-the-art processes and Excellence, KPMG Rebecca Healey, senior analyst, TABB Group analysis for their clients. services which help customers Ian Morton, head of Prudential Risk and Quantitative The key question every client has make the most of the new enviAnalysis Internal Audit at Santander is: does this impact me? In order to ronment. In particular, our priority Deborah Prutzman, chief executive officer, The answer the question, someone has been to create solutions which Regulatory Fundamentals Group needs to digest the news, undersimplify operations and promote Jean-Robert Wilkin, executive director, head of stand the types of entities it an efficient and cost-effective product management, global securities financing, impacts and, within those entities, management of liquidity. Along Clearstream Banking which functions are impacted. with the rest of the global financial Once that effort is undertaken, the challenge is to answer community—and non-financial institutions too—collatthe question: what do I need to do about it? This answer eral management is now a global priority. has both a strategic component and a more technical Fortunately, Clearstream is in a good position now action-oriented aspect. For example, in the United States, because we took the decision some years ago to invest sigmany SEC registered advisers will need to file a Form PF nificantly in developing our Global Liquidity Hub and (this is the action); however the regulators will be creating a flexible, risk management environment. The reviewing the information provided (and this has strategic Hub continues to evolve but it already has a global reach

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across markets, time zones and asset classes enabling customers to gain the cost benefit of consolidating their collateral into a single, usable pool. Already, equities, bonds, mutual funds and gold can be used as collateral in the Global Liquidity Hub while we continue to develop a solution for OTC derivatives. FTSE GLOBAL MARKETS: Will the provision of services as a result of regulation lead to increased pricing for securities services providers? KA RA L CAUT ER, DIRECTOR, FS REGULATORY CENTRE OF EXCELLENCE, KPMG: Possibly, but given the multiple price pressures facing their key customers, there may be a limit on the extent to which price rises are excepted by the market. That said, securities service providers are likely to incur additional costs of their own as they respond to the evolving regulatory requirements. FTSE GLOBAL MARKETS: How will incoming regulation impact on the costs and/or product range offered by securities services going forward? IAN MORTON, HEAD OF PRUDENTIAL RISK AND QUANTITATIV E ANALYSIS INTERNAL AUDIT AT SANTANDER: The obvious answer is that it will increase costs as more funds will have to be tied up in low return investments, greater resources, increased regulatory reporting requirements resulting in a greater proportion of staff and systems supporting income-earning areas and a smaller or more focused product range which may tend back towards the bank’s core business. JEAN-ROBERT WILKIN: Customers need solutions and it is those suppliers who move up the value chain which are most likely to service in this environment. At Clearstream, for example, our bread-and-butter services were always settlement and custody but now we see ourselves more and more as a risk management company. Whereas collateral management used to be a nice-tohave extra now it has become a major driver in service buying decisions. CSDs and other infrastructures may have problems if they are unable to deliver sophisticated collateral management to their clients. This is why Liquidity Hub Go has sparked so much interest in the markets around the world. The upcoming regulations are not restricted to the banking industry—corporates will also be impacted by EMIR, Dodd Frank, MiFID and other regulations. Until now, Clearstream has always been primarily a supplier to financial institutions but, together with our Deutsche Börse sister company Eurex Repo, we are developing an extension of our successful GC Pooling product to corporates, insurance companies, asset managers and some other sectors which will act as cash providers. The service is expected to roll out in Germany in Q4 2012 with some selected banks and, as with GC Pooling, it will then expand into other markets. DEBORAH PRUTZMAN: Securities services providers will need to find ways to be more efficient, otherwise compliance and regulatory costs could increase substan-

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tially—driving up price. Most will also need to be more tailored and not engage as readily in “one-off” service offerings that add complexity and expense. REBECCA HEALEY, SENIOR A NA LY ST, TA BB GROUP: Whilst cost is becoming an increasing factor for all divisions of financial services firms, these organisations are also becoming increasingly focused on cost efficiency. There is an argument for investigating opportunities to spread the necessary spend on regulation into new areas that could potentially offer cost efficiency savings and improve the overall bottom line. However, as usual further clarity is required as to what exactly the regulation will entail before the impact on costs and products offered can be clarified. One example would be the continuing confusion regarding off-exchange block trades, whether they are required to be printed ahead of the brokers ability to unwind their risk position; this would inevitably have to be reflected in the risk price offered and subsequently increase the cost of trading for large pension fund orders, once again impacting the man on the street’s pension fund. Until all the rules and regulations have been clarified, the impact on the costs and products offered remains nebulous in the extreme. FTSE GLOBAL MARKETS: How much work is being done by service providers to assess the impact of regulation on costs; risk analysis and reporting; transparency and compliance, as well as the dangers of not complying with regulation and rulings in a timely manner? JEAN-ROBERT WILKIN: The increasing importance of collateral in the global marketplace prompted Clearstream to commission a study from Accenture in 2011 to assess the state of the banking sector’s collateral management. The results are very revealing in that most institutions acknowledge their current collateral management capabilities are insufficient to cope with today’s complex business architecture. The global banking industry pays a heavy price for this inefficiency: Accenture estimates it at more than €4billion a year. They found that around 10%-15% of available collateral is left unused because banks cannot consolidate their pockets of available collateral into more efficient pools. Not managing collateral centrally means banks are unable to ensure they deliver the cheapest possible collateral to each liquidity or funding point where it is needed. The report concludes that this fragmentation results from a lack of overview of the available collateral and the majority of banks just do not have a sufficiently sophisticated collateral management system to undertake the task. Bear in mind that Accenture’s estimation is fairly conservative because it reflects the current situation that is before the industry is hit by the impact of Basel III measures in the Capital Requirements Directive (CRD) IV and the (EMIR) which demand even greater commitment of capital to secure transactions. Our experience is that many companies have been hesitant to tackle the problem of collateral management but the regulatory changes mean it’s time to wake up now and take action.

THE ExpERT pANEL

FTSE GLOBAL MARKETS: How much time is spent by you on educating clients on the range of regulation now coming into the market? REBECCA HEA LEY: Increasingly both brokers and vendors alike are focusing on the need to educate their client base with regard to the ensuing proliferation of regulation. The underlying confusion as to what applies to who, when and where becomes truly mind blogging when you take into consideration the global cross asset view regulators are taking in line with the G20 mandate. Both greater clarity and education can only be positive for the industry as a whole in the long term. JEAN-ROBERT WILKIN: This is an ongoing task for our client-facing staff such as relationship managers. Additionally, our senior staff take part in many events and conferences each year and Clearstream hosts a number of key events including the Clearstream Summit for Central and Eastern Europe, The Funds Summit, Global Securities Financing (GSF) conferences in Asia and the GSF Summit in Luxembourg, which this year attracted more than 800 participants. As a company, Clearstream is committed to adding value for our clients by facilitating these opportunities to discuss and debate issues in the industry but not all our efforts are on such a big scale. In 2011, Clearstream undertook a series of client workshops across Europe where experts explained the changing post-trade landscape. A key focus for these roadshows was the challenges arising from TARGET2-Securities (T2S) plus, of course, EMIR, CRD IV, the CSD regulation, and MiFID/MiFIR. There has been plenty to discuss. We also held a FATCA seminar for customers. DEBORAH PRUTZMAN: This is a time of extraordinary change on the legal and regulatory front, worldwide. Many of our clients tell us they are spending substantial amounts of time digesting all these changes. Our goal is to understand their questions, to do the analysis once in a thoughtful and comprehensive way that can be shared by many and to help them focus on running their business. One of the key areas we find we need to focus on is helping clients understand that financial regulators are looking for process. We understand and are comfortable with this process orientation and can help clients focus on building that into their firms. We focus on the process rather than trying to train staff on the ins and outs of all the regulations that apply. FTSE GLOBAL MARKETS: Is it worth trying to pre-empt regulation or is it better to wait for the final version? How can you pre-empt in a cost-effective manner? IAN MORTON: This would depend upon the type of legislation being passed. With some, it is obvious that the regulators are intent on enforcing their proposals and little comment will come from the industry. In these instances it could be sensible to pre-empt. However, where pending legislation is controversial, businesses can’t afford to allocated resources to what could be a dead-end. JEAN-ROBERT WILKIN: One concrete example of how we have pre-empted a regulation is the joint venture trade

Rebecca Healey, Senior Analyst, TABB Group. “In terms of systemic risk, there is still much more to be done. The danger within certain pieces of legislation would appear to be the fixation on one area of trading only, such as in the case of MiFID II with HFT and algorithmic trading.” Photograph kindly provided by TABB Group, February 2012.

repository REGIS-TR, launched by Clearstream and Iberclear. This new company, which is already operational, provides a regulatory reporting solution in the OTC derivatives space, enabling customers to be compliant with international regulations, namely EMIR. Specifically, EMIR calls for OTC derivative contracts to be reported to a trade repository directly or post-clearing by both trade counterparties, be they financial or non-financial institutions. The regulation also requires all existing trades to be ‘back-loaded’ into the trade repository database before the regulation becomes active – this is a detail which many in the market appear to have missed so far. Time is of the essence with regard to this regulation and our priority is to make sure we can help our customers to comply. We are making it easier for them by aiming to accept any and all types of OTC derivatives. Covering as many types as possible—including foreign exchange swaps, exchange rate derivatives, credit default swaps, commodities and equity derivatives will allow our customers to streamline their processes by dealing with just one trade repository. While compliance is the biggest thing on everyone’s mind now, REGIS-TR is looking beyond this stage and will be offering added-value services such as exposure management services in due course. There is certainly no point in waiting until regulation is upon you––we have to make sure our customers have a system they can use from day 1, a system that allows them to prepare for the regulation well in advance of that day 1 actually––and REGIS-TR can cater for this need. REBECCA HEALEY: By getting involved. The more input you can have in the implementation process the better, not only from an effective implementation process but also to ensure that the procedures and regulations involve offer a workable and viable solution. It is in all our interests to have legislation that is deemed to be effective. DEBORAH PRUT ZMAN: This is a bit of an art. It is always worth understanding what the regulators are trying

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Jean-Robert Wilkin, executive director, head of product management, global securities financing, Clearstream Banking. “We took a strategic decision some years ago to invest substantially in our collateral management and securities lending services and we will continue to do so.” Photograph kindly provided by Clearstream Banking, February 2012.

to achieve and to build a platform that can accommodate the likely next steps—both from the regulators and as you grow the business. Growth frequently triggers new and different regulations. So what you want to do is find the likely high water marks and build a process that is as simple as possible to accommodate them. That, of course, is not always possible. This is especially the case when so much of the regulatory landscape is being crafted for the first time. Sometimes in this situation it’s better to wait and see what is actually adopted, rather than to jump the gun and build something that is not required. I’ll end where I began; it is a bit of an art. FTSE GLOBAL MARKETS: A large element of forthcoming regulation relates to transparency. How easy it to comply in this area of legislation? KARA L CAUT ER: There are a number of key challenges––though the basic principal of transparency in some key and previously opaque markets such as OTC derivatives should add value, particularly on an aggregate basis to help highlight potential areas of risk. However, many data requirements individually may be challenging to capture reliably or within the timing intended, and the value of some data elements and metrics is not always proven, nor is it always clear how supervisory bodies might make best use of this information. Transparency in the area of customer protection needs greater focus on clarity rather than volume, similarly initiatives around financial reporting. FTSE GLOBAL MARKETS: Does full transparency really equate with improved risk management? DEBORAH PRUT ZMAN: Showing others what you are doing, and realising that they will have reactions including possibly asking “why?” does cause one to view a situation from another point of view. That frequently enhances risk management. However, there is so much more to risk

FTSE GLOBAL MARKETS • MARCH 2012

management than just that. In a study of 100 hedge fund failures, Capco determined that 50% failed due to mismanaged operational risk, not bad investment decisions. Therefore, a focus on sharing information on internal processes and controls, increased awareness about internal and external risks, and building these to withstand external scrutiny (and to accept constructive suggestions), should encourage and improve risk management. KARA L CAUTER: Not necessarily, an over abundance of data or data delivered to the wrong recipients could result in key messages being lost. Quantity over quality also risks undermining the quality of the data due to inherent limits on capability within reporting functions and control frameworks designed to assess their outputs. More focus is vital. REBECCA HEALEY: The investment process is multifaceted and no two methods just the same as no two orders can be treated the same. The idea that full transparency automatically equates to improved risk management is nonsensical. For example the claim for greater transparency in dark pools defeats the purpose of trading in the dark; greater clarity around the rules of individual dark pools, yes that would offer improved risk management as then the client could chose as to whether they wanted to participate or not depending on the individual order, and therefore the risk implications involved in the particular trade. Full transparency in the dark period? No, I cannot see how that automatically ensures improved risk management. FTSE GLOBAL MARKETS:Which single regulation will have most impact on your business and what will be the principal changes resulting from it? IAN MORTON: In the short, medium and long-term, it appears that Basel III should have the greatest impact as it affects the capital structure, funding, leverage, cost of funding and shareholders’ returns. JEAN-ROBERT WILKIN: As I have mentioned, we took a strategic decision some years ago to invest substantially in our collateral management and securities lending services and we will continue to do so. Certainly collateral management is going to be a major focus in our corporate strategy in 2012 and some years to come. And the new environment – with its increasing demands for collateralisation – means it will be a major focus for many in the industry. This new landscape prompted us to launch the pioneering outsourced collateral management service, Liquidity Hub GO, which has already gained a great deal of interest in the market. Most banks do not have sophisticated collateral management systems to manage their collateral pools effectively and it is costly and time-consuming for an infrastructure to develop its own. We launched Liquidity Hub GO with the Brazilian CSD Cetip in July 2011 after just over a year in development––it was a quick and cost-effective solution for our partner. Cetip is able to connect directly with Clearstream’s collateral management engine which does all the calculations but all the underlying assets remain in

THE ExpERT pANEL

Brazil as required under Brazilian law. This is a unique feature and the reason why we have been approached by a number of infrastructures and central banks around the world. Liquidity Hub GO will be a practical solution for those infrastructures seeking to deliver much-needed collateral management to their clients and we are now developing GO with the Australian Securities Exchange and are exploring ways of going forward with Strate, the South African CSD. FTSE GLOBAL MARKETS: Where are the key stress points or risks in the business resulting from incoming regulation? DEBORAH PRUTZMAN: Missing something significant on the business front as one focuses on regulatory changes is always a risk. People can only focus on so much change at any one time. FTSE GLOBAL MARKETS: How can you/will you minimize the business impact of the upcoming regulation? DEBORAH PRUTZMAN: RFG has built a comprehensive, web-based knowledge management platform, called RFG Pathfinder™, which turns legal and regulatory requirements into actionable firm governance, business risk management and regulatory compliance processes. It translates ‘legalese’ into business process workflows, and shows how they apply at the level of the manager, the investment vehicle and the investment level. By simplifying issue identification early on, we are increasing productivity and reducing time spent on high-level issue identification. We also ‘push out’ targeted, actionable updates with messages that are tailored to specific roles in an organisation. This can be the governing body of a fund, legal and compliance teams, marketing teams, human resources and the investment professionals themselves. Service providers, who need to understand the same information, also find this very helpful—whether they are accountants, fund administrators, due diligence teams, lawyers or prime brokers. FTSE GLOBAL MARKETS: Will incoming regulation result in clarity, consistency and sustainability for the financial services industry over the medium term? REBECCA HEALEY: This again depends on the regulation being implemented. The sooner the regulators are able to produce a clear set of guidelines that the financial services industry understand and are able to implement the better. The problem is the drip-feed mentality of potential on-going regulation which is adding to the confusion and potential lethargy in understanding the complex myriad of proposals on the table. In TABB Group’s European Equity Trading study 2011/2012, 51% of buy-side traders we spoke to told us the impact of further regulation will make it harder to source liquidity. UK buy side traders in particular value the role that broker crossing networks play in limiting information leakage and thereby improving execution quality; 58% see the potential restriction under MiFID as limiting

Deborah Prutzman, chief executive officer, The Regulatory Fundamentals Group. “They will need to find ways to be more efficient, otherwise compliance and regulatory costs could increase substantially—driving up price. Most will also need to be more tailored and not engage as readily in “one-off” service offerings that add complexity and expense.” Photograph kindly provided by The Regulatory Fundamentals Group, February 2012.

available liquidity and impacting execution performance. If broker-operated dark pools are forced to become Systematic Internalisers (SI’s) or MTF’s, this may well negatively impact the brokers’ ability to facilitate client flow at a time of dissipating volumes in volatile markets. That seems contrary to the desired effective of consistency and sustainability for the financial markets over the medium term. Ideally we should look at what different investors require for different orders in different products and be able to offer a variety of responses, rather than the continual blanket of ‘one size fits all’ regulation. DEBORAH PRUTZMAN: We have a long way to go to get there, but certainly that is the hope. One of the lasting legacies of the financial crisis is an increased focus on how financial services companies manage risk, with all signs pointing to closer scrutiny of board responsibility for managing risk. If done right, this should result in greater clarity, consistency and sustainability. In England, the government-commissioned Walker Report found that “governance failures contributed materially to excessive risk taking in the lead up to the financial crisis”. Moody’s Investor Service has said the effectiveness of a financial firm’s management will be an important rating consideration. The SEC has proposed more disclosure concerning the role of the board in this area. The US Federal Reserve Board, meantime, in its December 20th, 2011 release on prudential standards for systemically significant companies, requires a board level risk committee. Clearly regulators are encouraging boards and senior management to take the time, during a period of great uncertainty and change with many day-to-day pressures, to really engage in a dialogue about risk. Despite the time challenges, management needs to put in place appropriate processes to identify, review

MARCH 2012 • FTSE GLOBAL MARKETS

and understand the risks their organisation faces. This can even be a marketing plus, that helps a firm retain existing clients and grow its business. What is clear is that risk identification cannot be a boilerplate effort, and cannot be examined in a boilerplate way. For this reason, regulators and legislators need to resist the understandable reflex to provide prescriptive ‘thou shall’ type rules. Personally, I would like to see regulators conduct a systematic review of existing requirements (after soliciting industry input) to remove some requirements so that valuable board time is spent only on matters that impact the safety and soundness of a regulated entity. Of course, a worse situation would be for detailed requirements to be piled on in the risk management area without leaving room for qualitative discussion. IAN M ORTON: Much of the regulation is accenting greater transparency and if applied evenly across the globe, should improve consistency. It may help institutions become more sustainable, but increased requirements such as Leverage ratios could restrict their ability to expand or even maintain their present size. FTSE GLOBAL MARKETS: How well prepared are clients for changes in the market resulting from impending regulation such as MiFID II, FATCA, UCITS IV Basel III, and the Securities Law Directive? KARA L CAUTER, DIRECTOR, FS REGULATORY CENTRE OF EXCELLENCE, KPMG: Preparedness is very different depending on the policy. MiFID II is still at a very early stage of legislative development, and significant changes are expected. FATCA has been subject to significant impact assessment as well as initial assessment of data and gap analysis with existing data and processes to identify what change is necessary to meet current proposals, but again current thinking is that moderation of the requirements is likely to ease the burden to something which is more proportionate. Basel III has been the subject of detailed impact assessment, and many firms are well progressed in assessing the impact on particular business lines and interactions with particular counterparties and some broad decisions have been taken to close or build particular desks or relationships. Efforts to build capital levels are already well under way, spurred on in continental Europe by the EBA’s 9% requirements. IAN MORTON: With respect to Basel III, institutions are still evaluating the potential impact on markets and despite the relatively long run-in to implementation, a number of feasibility studies and scenarios are being run, particularly around funding costs and feasibility of retaining some of their high-risk low-return portfolios. FTSE GLOBAL MARKETS: What are the risks raised by regulations which will encourage the movement from OTC to OTC-cleared contracts, given the huge initial margin requirements involved? IAN M ORTON: The historic risks of OTC contracts include the inconsistency of terms of the contracts, which have a direct impact on the ability to clear efficiently. This

FTSE GLOBAL MARKETS • MARCH 2012

became very apparent with the collapse over the last few years of major counterparties. Possibly the fear of further collapses of major OTC market players justifies raising additional margin with the clearer. FTSE GLOBAL MARKETS: Can CCPs handle the huge volume of centrally cleared derivatives that will be generated by regulation? KARA L CAUTER: Though systems enhancements have in many cases been made, concerns remain over the accompanying risk management and governance standards, and the ability to provide necessary reporting and valuations. Questions over business model given likely restrictions over rehypothecation of collateral and default fund assets could also add to pricing pressures for other participants. FTSE GLOBAL MARKETS: How easy will it be to create these pools of collateral required by incoming regulation? KARA L CAUTER: Extremely difficult without a widening of the definition of acceptable collateral both for liquidity purposes and for trading purposes, including positions with CCPs, non financial counterparties and intra group in some jurisdictions. Managing pools of collateral and efficient allocation across different counterparties will be a key source of competitive advantage for some institutions, and is an area where significant investment is already in train. FTSE GLOBAL MARKETS: Do you think that perhaps the efforts by regulators to reduce systemic risk might be impossible at a time of extended market uncertainty? KARA L CAUT ER: The most significant conflict is the scale of additional capital and liquidity buffers impacting incentives to lend in to the wider economy and support economic growth. Despite long Basel phase in periods, the market (and many supervisors in practice, including the EBA) is accelerating compliance. Costs of compliance will also consume available capital and earnings, and there is an inherent conflict between political desire to have affordable, available credit and the loose, cheap credit policies which in and of themselves were a key driver of the financial crisis. REBECCA HEALEY: In terms of systemic risk, there is still much more to be done. The danger within certain pieces of legislation would appear to be the fixation on one area of trading only, such as in the case of MiFID II with HFT and algorithmic trading. Whilst there are risks, responsible brokers have limit checkers and other pre-trade risk controls in place to mitigate disorderly trading and prevent onerous trades. Penalising those who do not abide by the rules more heavily would act as a greater deterrent for those brokers who choose to cut corners rather than demonising one industry segment in its entirety. IA N M OR T ON: Containing systemic risk is much easier before it occurs. If it already exists, the regula-

THE ExpERT pANEL

tors have to contain it and prevent it from worsening. Possibly the current efforts by the Regulators are aimed at reduction of systemic risk before it reached current levels and their efforts may not be that successful. FTSE GLOBAL MARKETS: Who really benefits from this incoming raft of regulation? R EBEC CA HEA LE Y: The intention is obviously the man in the street, the underlying financial investor, however, whilst regulation undoubtedly has an important role to play, how much the legislation will actually benefit those the regulators propose to protect is another matter. Regulators unfortunately have the unenviable task of establishing all the possible unintended consequences ahead of implementing legislation; however this is critical in ensuring the financial services industry is serviced by efficient and viable regulation. A case in point would be the financial transaction tax (FTT). Much has been written on the topic but the danger remains that the French government rather than creating a viable tax with a strong revenue stream will in fact hurt their domestic banking industry at the very time it can least afford it as well as push the investor to switch to other asset classes to avoid the tax, in particular CFD’s. Whatever the eventual outcome, one conclusion would appear guaranteed. The more the financial industry is penalised, the more risk averse it will become, ensuring continued automation of order flow in minimal order sizes rather than risk the potential market impact of a block trade. FTSE GLOBAL MARKETS: Do you think that regulators (particularly in the US and Europe) have properly coordinated incoming regulation; and might this flood of regulation create new systemic risks? KA RA L CAUTER: There are significant efforts to coordinate, and the major principles are likely to be consistent across key markets. However, detailed implementation is likely to see some differences, which will spur detailed assessments by financial institutions to determine the best location for conducting certain types of business with certain types of counterparty – particularly where the extent of extraterritorial reach of home and host regulation is unclear, sadly an issue which is likely to remain uncertain for some significant time. DEBORA H PRUT ZMA N: A flood of new regulations that are detailed and unwieldy can distract managements from taking the time to understand underlying and critical business issues. Effective risk management involves the board and senior management ensuring that a process is in place to assess, weigh and mitigate (or accept) known risks. This is a challenge, as it frequently requires a look across technical and complex lines and staff areas. And it is a never-ending process that must include changes in the environment. It is hard to do this right, but particularly hard to do it when new “rules of the road” are being adopted, implemented

Ian Morton, Head of Prudential Risk and Quantitative Analysis Internal Audit, Santander. “Much of the regulation is accenting greater transparency and if applied evenly across the globe, should improve consistency. It may help institutions become more sustainable, but increased requirements such as leverage ratios could restrict their ability to expand or even maintain their present size.” Photograph kindly provided by Santander, February 2012. and enforced at an alarming rate. When this happens, the board needs to stop and understand the new rules. This can distract them from expending effort on unexpected and unanticipated forward-looking risks. A pressured and down-sized in-house staff may not have the time or talent to look for the unexpected, especially during times of stress when daily developments require immediate and nearly full-time attention. Instead of focusing on new prescriptive regulation, regulators might ask the senior team to document its answers to these three questions: How does our existing organisation view risk? This includes a review of existing processes, including contingency planning, regulatory and legal updates, and new product development, with an emphasis on how members of staff functions view their roles in these situations. What external changes could impact key product lines, major customers and other stakes holders and significant assumptions about risk? This includes consideration of legal, accounting, regulatory trends and a thorough understanding of the processes they will impact. Finally, what kinds of red flags should we be following closely? This final ‘prong’ involves a discussion of the kinds of events that should trigger a new review of a product, service, underlying risk assumptions or the company generally. Let’s give senior management the time to consider these issues in a meaningful way. That, in and of itself, will be a tough job. I

MARCH 2012 • FTSE GLOBAL MARKETS

(Week ending 3 February 2012) Reference Entity

Federative Republic of Brazil Republic of Turkey Republic of Italy Bank of America Corporation United Mexican States Russian Federation JPMorgan Chase & Co. MBIA Insurance Corporation Republic of Korea Peoples Republic of China

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Financials Government Government Financials Financials Government Government

Sov Sov Sov Corp Sov Sov Corp Corp Sov Sov

18,073,233,898 5,440,688,660 22,517,673,426 5,783,681,029 8,381,458,005 4,171,520,218 5,280,873,275 3,314,509,429 5,116,475,973 9,091,715,580

168,620,345,067 144,263,410,325 309,960,609,550 79,444,435,370 124,875,642,710 113,259,615,782 79,196,446,053 85,462,969,938 69,408,298,785 66,495,879,603

11,404 9,413 9,154 9,136 8,862 8,832 8,039 8,196 7,972 7,605

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

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

22,265,053,482 22,517,673,426 19,348,329,987 18,073,233,898 14,245,699,671 12,013,199,218 10,789,788,267 9,091,715,580 8,940,869,725 8,381,458,005

122,766,300,595 309,960,609,550 111,362,594,635 168,620,345,067 155,448,657,995 62,968,812,426 93,697,754,408 66,495,879,603 71,332,908,361 124,875,642,710

5,980 9,154 4,147 11,404 6,255 4,197 7,230 7,605 7,101 8,862

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

Top 10 net notional amounts (Week ending 3 February 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 3 February 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,284,873,231,269

447,105

Republic of Italy

17,377,061,102

682

Sovereign / State Bodies

2,820,602,296,517

213,581

Kingdom of Spain

2,257,466,752

162

Corporate: Consumer Services

1,987,746,395,317

339,072

Federal Republic of Germany

4,665,924,852

169

Corporate: Consumer Goods

1,537,779,283,296

252,907

Republic of Turkey

1,540,185,000

110

Corporate: Industrials

1,247,318,780,486

218,177

French Republic

4,468,510,215

286

Corporate: Technology / Telecom

1,197,359,557,978

191,097

Volkswagen Aktiengesellsghaft

1,369,405,645

Corporate: Basic Materials

936,528,553,315

154,941

Bank of America Corporation

1,203,009,929

156

Corporate: Utilities

730,052,340,741

117,148

Japan

1,046,546,000

Corporate: Oil & Gas

474,154,768,001

86,184

Russian Federation

1,693,915,000

159

Corporate: Health Care

336,571,199,535

59,352

Corporate: Other

180,224,080,197

21,255

Federal Republic of Brazil

12,439,659,536

1444

CDS on Loans

59,278,140,359

15,714

Residential Mortgage Backed Securities

50,395,299,258

9,775

Residential Mortgage Backed Securities*

9,404,763,933

679

Commercial Mortgage Backed Securities 13,443,293,806

1,394

CDS on Loans European

4,297,181,074

Muni:Government

1,206,700,000

122

Other

2,289,743,043

129

633

Commercial Mortgage Backed Securities*

807,448,784

CDS Swaptions

101,399,250

Muni:Other

50,000,000

Muni:Utilities

36,600,000

*European

FTSE GLOBAL MARKETS • MARCH 2012

DTCC CreDiT DefaulT swaps analysis

Top 10 number of contracts

All data © 201 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

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 17th February 2012 INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.45

2.14

1.91

2.04

1.65

6.56%

2.89% 4.12%

3.21% 0.02%

4.39%

3.07%

30.15%

23.99%

5.06% 20.04%

16.55%

0.10%

2.02%

0.12%

0.67%

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

55.34% 0.17% 0.10% 0.01%

0.13% 60.57%

76.06% 66.64% 0.05% 6.19% 0.00% 0.00%

7.72%

VENUES

4.59%

INDICES

3.75%

3.65%

VENUES

INDICES

DOW JONES

S&P 500

INDICES

S&P TSX Composite

FFI

2.02

2.05

17.88% 11.07% 1.82% 1.72% 2.13% 65.41%

17.70% 11.84% 2.01% 1.84% 1.80% 64.89%

5.05

4.67

BATS

11.00%

11.58%

BATS Y

4.09%

3.75%

CBOE

0.14%

0.08%

Chicago Stock Exchange

0.70%

0.55%

EDGA

5.49%

4.46%

EDGX

10.79%

9.44%

NASDAQ

24.24%

27.22%

NASDAQ BX

5.73%

4.07%

NQPX

2.32%

1.90%

NSX

0.42%

0.39%

NYSE

20.98%

22.09%

NYSE Amex

0.14%

0.16%

NYSE Arca

13.96%

14.31%

VENUES

S&P ASX 201

FFI

1.01 Australia Chi-X Australia

Canada*

99.46% 0.54%

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

1.32 2.39% 0.00% 0.00% 0.00% 2.88% 86.58% 8.15% 0.00%

VENUES

INDEX

FFI

Japan

S&P TSX 60

NIKKEI 225

INDICES

Australia

22.65% 68.45% 0.03% 0.01% 0.81% 0.06% 0.01%

INDICES

HANG SENG

FFI

1.00

Asia

Hong Kong

100.00%

MARCH 2012 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

LEARING HAS PROVED to be one of the key determinants of the level of integration between trading venues across the world and, again, Europe provides its own particular spin on this issue. This is due to the fact that, historically, exchanges operated in vertical silos constrained by geography and so a panoply of different Central Counterparty Clearing Houses (CCPs) emerged with each supporting specific venues. This led to a strange scenario of there being multiple clearers yet still low levels of competition between them. With the advent of MiFID these geographic silos were broken up and equities trading was, instead, set on a horizontal pan-European basis. One of the early winners of this was the European Multilateral Clearing Facility (EMCF) created specifically to offer pan-European clearing for the new alternative venues that were being set up, such as Chi-X and BATS Europe. In other geographies a single clearer is nominated for all securities transactions. In the US, Canada and Japan this is mandated by law, whilst in Australia it is the result of the market having been dominated until recently by a single execution venue, the Australian Securities Exchange (ASX), with its own clearing facility. The situation in Europe is starting to change, however, thanks to the initiatives of some venues that have put in place agreements with multiple clearing providers. These so-called 'interoperability programs' allow market participants to choose which provider(s) they use to clear their trades. The advantage of clearing interoperability for market participants is significant: they can benefit from lower clearing fees as a consequence of the increased competition between providers and reduce their margins due to the netting between the different positions. But market participants are not alone in benefitting from these initiatives as interoperability also allows newer venues to challenge the established players too. Take as an example UBS MTF which was launched in August 2010 and implemented a two-way interoperability program at

the end of July 2011. Following this, the venue experienced an exponential increase in turnover and number of trades, gaining second place in terms of dark pool market share behind Chi-X in just one month (see chart). At the same time the brokerowned venue expanded its stock universe to include Italian blue-chips and made available pegged orders for bid and offer prices, in addition to those for midpoint. Whilst it's difficult to quantify the effect of each of these initiatives, there's little doubt that clearing interoperability played a significant part in its competitive appeal to market participants. Not everybody is swimming in the same direction, though. Some venues, such as Deutsche Börse for example, continue to rely on the vertical integration of clearing services against the interoperability tide. This may well be a sensible strategy, particularly in light of drastically reduced trading fees. On the other hand, its reluctance to open up this same clearing arm to other derivatives venues was one of the key reasons the EU Commission blocked Deutsche Börse's proposed merger with NYSE Euronext. It seems that Australia's ASX has learnt from the experience of other regions and, aware of the benefits, is now trying to maintain its place as the single central clearing provider too. Despite recognising that interoperability may be the way toward a truly pan-European trading landscape, the regulators - presumably concerned about systemic risk - are causing further delays in its widespread adoption. There are currently just three interoperability programs fully underway in Europe, namely the agreement between SIX Swiss Exchange and the London Stock Exchange and their respective clearers (SIX x-clear and LCH.Clearnet), the four- way program introduced by the newly merged BATS Chi-X Europe, and the two-way program operated by UBS MTF. It will be interesting to see just how much of an impact these will have on liquidity fragmentation and how long it will be before we have a truly pan-European clearing landscape. I

UBS MTF trading ac vity Value (le ), 4 week Mov. Avg 140

1,200

120

1,000

100

800

600

400

200

‘1 2 Ja n

No v‘ 11 De c‘ 11

‘1 1

Oc t‘ 11

Se p

‘1 1

Au g

Ju l

‘1 1

M ay ‘1 1 Ju n ‘1 1

Ap r

‘1 1 M ar ‘1 1

Fe b

Ja n

‘1 1

0 No v‘ 10 De c‘ 10

Oc t‘ 10

Thousands

Million Euro

Number of trades (right), 4 week Mov. Avg 1,400

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 • MARCH 2012

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

Ja n1

Oc t1

Ju l1

Ap r1

Ja n11

Oc t1

Ju l10

Ap r10

Ja n-

Oc t0

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

40 Ja n-

MarkeT DaTa by fTse researCh

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE RAFI Developed 1000 Index

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

140

120

100

Ja n1

Oc t1

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

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE EPRA/NAREIT Global Index

FTSE Global Government Bond Index

FTSE Global Infrastructure Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

250 200 150 100 50

2 Ja n1

Oc t1

Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

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

-0 7 Ap r

Ja n

-0 7

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

MARCH 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES 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

140

120

100

Ja n1

Oc t1

Ju l1

Ap r1

Ja n11

Oc t1

Ju l10

Ap r10

Ja n-

Oc t0

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

07 Ja n-

Ap r07

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE RAFI US 1000 Index

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

140 120 100 80 60

-1 2 JA N

Oc t1

Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

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 r07

Ja n-

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE Americas Government Bond Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance US IPO Index

FTSE FRB10 USD Index

160 140 120 100 80 60 40

-1 2 JA N

1 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

Ju l07

-0 7 Ap r

Ja n

-0 7

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

FTSE GLOBAL MARKETS • MARCH 2012

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (31 January 2007 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140 120 100 80 60 40

Ja n1

Oc t1

Ju l1

Ap r1

Ja n11

Oc t1

Ju l10

Ap r10

Ja n-

Oc t0

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

20 Ja n-

MarkeT DaTa by fTse researCh

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (31 January 2007 = 100) FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

120

100

Ja n1

Oc t1

Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

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 r07

Ja n-

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (30 January 2009 = 100) FTSE JSE Top 40 Index (ZAR)

FTSE CSE Morocco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

240 220 200 180 160 140 120 100

Ja n12

1 Oc t1

1 Ju l1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

Ap r10

-1 0 Ja n

09 Oc t-

Ju l09

9 Ap r0

Ja n

-0 9

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

MARCH 2012 • FTSE GLOBAL MARKETS

ASIA-PACIFIC MARKET INDICES Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE Asia Pacific Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

200 180 160 140 120 100 80 60

Ja n1

Oc t1

Ju l1

Ap r1

Ja n11

Oc t1

Ju l10

Ap r10

10 Ja n-

Oc t0

Ju l09

Ap r0

Ja n09

Oc t08

Ju l08

Ap r08

Ja n08

Oc t07

Ju l07

Ap r07

Ja n-

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 January 2007 = 100) FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

250 200 150 100 50

Ja n1

1 Ju l1

Oc t1

1 Ap r1

Ja n11

0 Oc t1

Ju l10

Ap r10

10 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 r07

Ja n-

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (30 July 2010 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

180

160

140

120

100

12 Ja n-

-1 1 De c

ov -

1 N

Oc t1

11 Se p-

11 Au g-

l11 Ju

1 Ju n1

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 Au g

Ju l10

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

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH 2012

inDex CalenDar

Index Reviews March - April 2012 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

Early Mar

ATX

Semi-annual review / number of shares

30-Mar

29-Feb

02-Mar

CAC 40

Quarterly review

16-Mar

29-Feb

02-Mar

S&P / ASX Indices

Annual / Quarterly review

16-Mar

24-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

07-Mar

NZX 50

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE RAFI Index Series

Annual review

16-Mar

31-Jan

07-Mar

FTSE JSE All-Africa Index Series

Quarterly review

16-Mar

17-Feb

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 ECPI Index Series

Quarterly review

16-Mar

29-Feb

07-Mar

FTSE JSE Index Series

Quarterly review

16-Mar

29-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

TOPIX

Monthly review - additions & free float adjustment

29-Mar

29-Feb

Quarterly review

15-Mar

29-Feb

08-Mar

Dow Jones Global Indexes

08-Mar

FTSE EPRA/NARIET Index Series

Quarterly review

16-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

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

09-Mar

S&P Asia 50

Quarterly review

16-Mar

02-Mar

09-Mar

S&P Europe 350 / S&P Euro

Quarterly review

16-Mar

02-Mar

09-Mar

S&P Topix 150

Quarterly review

16-Mar

02-Mar

09-Mar

S&P Global 1200

Quarterly review

16-Mar

02-Mar

09-Mar

S&P 500 - US

Quarterly review

16-Mar

02-Mar

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 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 27-Apr

30-Mar

float adjustment

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

MARCH 2012 • FTSE GLOBAL MARKETS