FTSE Global Markets by FTSE Global Markets

THE 2012 MIDDLE EAST ASSET MANAGEMENT SURVEY

ISSUE 60 • APRIL 2012

Leveraging Kuwait’s new FDI law Face to face with South Korea’s FSC

The hits and misses of Islamic real estate The slow and steady return of repo

Springsteen may be the Boss, but music still needs a leader ROUNDTABLE: US SEC LENDING WAITS OUT THE NEW NORMAL

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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.

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FTSE GLOBAL MARKETS • APRIL 2012

mid the growing angst that April will bring something rather heavier than spring showers, comes this month’s edition. To lighten the financial load that might just as easily blight the rest of 2012, as it did the second half of 2011, we provide a bit of lighter-hearted diversion in our cover story. If you cannot find consolation in the financial markets this month, you might find some solace in music. That is, if you know how to access what you are looking for. It is getting hard for aficionados to source some decent music outside the ubiquitous pop pap that is so readily available and the holier than thou musical press that often favours the avant-garde that rarely makes it beyond a debut album. David Simons reviews what’s on offer and where you can find new sourcing ideas and what it all means for a still largely rudderless music industry. Elsewhere, satisfying any wanderlust you might be feeling to escape these still droopy markets, Art Detman offers high-velocity getaways in California, as long as you can persuade local politicos to adopt high speed trains. It has to come if Americans are to get out of their gas guzzling cars and planes to gad about towns and join the rest of humanity in trying to conserve carbon resources. Art explains the comings and goings; arguing both sides of a growing debate over the future of long distance travel (even intra-state). We are branching into new territory in this edition by launching the top line results of the first of our quarterly surveys: in this instance on asset management in the Middle East region. A number of important trends are emerging; not least growing agreement across the rejion that stronger capital markets and investment infrastructure is now a necessity, if further growth in the financial services and investment markets is to occur. Most of the Gulf state capitals are keen to tout their financial credentials and to set themselves up as viable international financing hubs. These are laudable goals: but if they are to be achieved then they must begin in earnest to build their regulatory, social, legislative and operational infrastructure to facilitate these goals. For too long the rich Gulf States have been stalking grounds for consultants and ex-politicians to make money making sweeping recommendations for change. Demand for market liberalisation; transparency, appropriate regulation and legislation is happening right now at the grass roots; by firms which are at the heart of the business community, and who have real, hands on experience of what is and what is not important. Much has been achieved and few governments have not acknowledged that it is a long haul process. However, the cry for improved financial infrastructure is a clear clarion call for the region’s governments to take up the cudgels of appropriate market reform as soon as is feasible. We hope you find the myriad trends thrown up by the inaugural survey to be of real interest. In spite of all the hope that 2012 inspires, there remains a gnawing doubt in investors’ minds over the efficacy of the eurozone’s government to have an effective strategy to manage the risks inherent in a large currency union. While speculation and predatory behaviour is often to be found in the capital markets (and is celebrated by some institutions); and some market practitioners think that if an economic system cannot sustain attack it should not be allowed to live, we would argue caution before attacking a still-juvenile structure that might provide a strong counter-punch to the emergence of a multi-polar world. So, before firms start to try to dismantle the euro once again, it might be time to think about what the alternative might be.

Francesca Carnevale, Editor, April 2012

Cover photo: Bruce Springsteen performs with the E Street Band during his "Wrecking Ball" concert tour premiere Sunday, March 18, 2012, in Atlanta. (AP Photo/David Goldman). Supplied by Press Associtaion Images, February 2012

COntents COVER STORY

MUSIC REDISCOVERS ITS MOJO

......................................................................................Page 6 Is the long suffering music industry about to find its feet once more now that hand held technology is dovetailing with online retail models? David Simons reviews the new business strategies employed and the firms that are leading the charge into new money making ventures.

DEPARTMENTS

SPOTLIGHT

WHAT NOW FOR THE VOLCKER RULE? .............................................................Page 12 David Simons highlights the possible modifications to the much disputed Volcker Rule.

CAN REPO FINALLY LOOKS TO A REBOUND? ..........................................Page 14

MARKET LEADER IN THE MARKETS

Lynn Strongin Dodds on the continuing challenges and opportunities in the short term refinancing sector.

IMPLICATIONS OF THE LAST GREEK DEBT SETTLEMENT ..............Page 18 As Spain’s debt problems mount, we assess the impact of Greece’s debt deal.

WITH SANGCHE LEE, OF SOUTH KOREA’S FSC................................................Page 20

FACE TO FACE

Ian Williams meets with the former member of the Korean Institute for Finance and now head of the FSC aand talks bout market reforms and regulations.

WITH SHEIKH MESHAAL, JABER AL AHMAD AL SABAH ......................Page 24 How Kuwait’s Foreign Investment Bureau is encouraging a new Foreign Direct Investment law.

KUWAIT’S BANKS AT THE CROSSROADS ............................................................Page 28

COUNTRY REPORT

Can the country and its banks rise about their sometimes restrictive moulds to take advantage of the opportunities that lie ahead?

SBERBANK FIRST SALVO IN A NEW ROUND OF STATE SALES?..........Page 33 A slug of Sberbank shares are on offer: what does it mean for the Russian privatisation programme and Russia itself?

GUEST COLUMN

REAL ESTATE

THE SOCIAL PARADIGM OF ISLAMIC FINANCE ......................................Page 35 Natalie Elphicke of law firm Stephenson Harwood talks through the key issues with respect to Shari’a law.

KEEPING THE FAITH ..........................................................................................................Page 36 Mark Faithfull looks at the gradual return of Shari’a compliant finance in real estate.

APRIL 2012 • FTSE GLOBAL MARKETS

COntents

PRIMARY ISSUES SOAR IN EUROPEAN INVESTMENT BONDS

DEBT REPORT

......Page 40

Andrew Cavenagh reports on the impact of a dramatic compression in spreads.

DOES EUROPE’S DISTRESSED DEBT OFFER RICH PICKINGS?

..........Page 43

Lynn Strongin Dodds looks at the potential opportunities for investors.

INDEX REVIEW

THE SPECTRE OF SPAIN DAMPENS MARKET SENTIMENT ............Page 46 Simon Denham, managing director of Capital Spreads takes the bearish view.

FEATURES

SECTOR REPORT:

TRAIN TO TOMORROW, OR NOWHERE ......................................................Page 47 California’s vision for high-speed passenger rail was hailed as the answer to congested freeways and crowded airports as well as a blueprint for other US states to follow. However, according to writer Art Detman, the $100bn project looks to be in disarray and beset by criticism on all sides. Is there an end in sight and will California finally get the high speed rail system it deserves?

FUND ADMINISTRATION:

ALTERNATIVE FUND ADMIN WORKS TO A NEW BEAT ......................Page 51 While economic conditions have been trending favourably, alternative fund administration must still contend with a host of challenges. As many providers are finding out, delivering a broader and more costly range of services to keep everyone in line with an avalanche of new legislative bureaucracy is a growing headache. David Simons reports on the key trends.

SURVEY: MIDDLE EAST ASSET MANAGEMENT

NEW BEGINNINGS, NEW VISTAS ......................................................................Page 55 We launch our inaugural survey of the status of the asset management industry in the Middle East, which will be updated quarterly. The most salient finding of this first survey is that investors are keen for local regulators to pursue further market liberalisation and for private sector providers to introduce more risk management services.

DATA PAGES

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

APRIL 2012 • FTSE GLOBAL MARKETS

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COVER STORY

THE RESHAPING OF THE MUSIC INDUSTRY

Coldplay perform on stage during the 2012 Brit awards at The O2 Arena in London. Photograph by Yui Mok, supplied by PressAssociationImages, March 2012.

The rapid deployment of handheld devices such as tablets and smartphones, combined with the steady growth in emerging online retail models, have helped breath life into a music business hobbled by years of sagging revenues. Has the long-suffering industry finally found its feet as a result of this technological convergence? And if the turnaround is at hand, where do investors go to rock and roll? Dave Simons reports from Boston.

DOWNLOAD UPSWING N PAPER, THE ultra-exclusionary business model championed by Apple Inc— keeping competitors at arm’s length while pumping up its vast inventory of proprietary apps—should have given investors and consumers cause to reassess the way they buy music. However, on the day it launched its latest technological marvel, the new iPad third-generation tablet, shares of the Cupertino, California-based company were trading in the vicinity of $600, roughly double last summer’s stock price. Numerous market watchers maintained a solid ‘buy’ rating, some even calling the stock ‘underpriced’ at current

levels. Apple could move more than 65m iPads this year alone, according to some analysts. In fact, the rapid deployment of handheld devices such as the iPad, combined with the steady growth of emerging digital-music models, have helped breathe life into a record industry hobbled by years of sagging revenues. While Apple and its league-leading iTunes Music Store continues to dominate (holding down an estimated 70% of digital music sales), “all-you-caneat” subscription services such as UK-based Spotify and France’s Deezer themselves attracted some 13m paying customers last year. This is a 60% increase over 2010, according to UK’s

International Federation of the Phonographic Industry (IFPI). Music downloading has also been helped in no small part by ‘in-thecloud’ services; those that use a central network infrastructure, rather than a home-computer application, among them Amazon’s Cloud Drive and Apple’s newly launched iTunes Match. All told, digital-music revenues rose 8% in 2011, according to IFPI, the first year-over-year growth increase since 2004. Providing music to users wherever and whenever they want appears to be the lynchpin going forward. By 2016, an estimated 161m subscribers worldwide are expected to access music from a mobile device, up from less than 6m in

APRIL 2012 • FTSE GLOBAL MARKETS

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COVER STORY

THE RESHAPING OF THE MUSIC INDUSTRY

2011. Frances Moore, chief executive for UK-based International Federation of the Phonographic Industry (IFPI), agrees that consumer choice“has been revolutionised…as new models for consuming and accessing music are rolled out in new and existing markets.” Has the long-suffering music industry finally found its feet as a result of this technological convergence? And if the turnaround is at hand, where do investors go to rock and roll?

Hear today—gone tomorrow Back in 1999 the record industry was sitting pretty—that year, 847m CDs were sold, according to the Record Industry Association of America (RIAA). By that time, intense consolidation from the Telecommunications Act of 1996—which enabled a handful of conglomerates to secure majority stakes in numerous media markets—had turned the airwaves into an increasingly exclusive club. Eventually, listeners began seeking alternative sources online—some of them legit, many of them not. As faster connection speeds accelerated the trend toward peer-to-peer file sharing, recording artists began flocking to upstart venues such as MySpace, YouTube and Facebook (and, more recently, Bandcamp and Soundcloud), bypassing traditional distribution channels in the process. As the online phenomenon reached new heights, sales of physical media were suddenly in free fall; by last year, CDs hit an all-time low of 223.5m units sold. Of course it is hardly the first time the music establishment has been forced to re-group in response to a major cultural backlash. But despite the potential to attract millions of newcomers, for years record executives have bristled at the idea of unfettered digital access, and have leaned on companies to push premium-pricing plans in an effort to optimize revenue. However, after years of waging war over no-charge music streaming,

record companies are now beginning to see the benefits of ‘freemium’ services—which, say analysts, are used by providers mainly as an acquisition strategy, roughly 15% of Spotify’s paid subscribers for instance consist of former ‘freemium’ users drawn to premium-level benefits such as higherquality downloads and no intrusive banner advertising. Spotify chief executive officer Daniel Ek argues that his service has helped the music business enter a "golden age," as people who share music online are more likely to buy more tracks and albums. “Even though labels worried about the impact of free Internet radio, music social networks, and other streaming services like Pandora and Spotify, it looks as if those services are having the same effect that radio did back during the height of its viability,” notes Anthony John Agnello in financial news site InvestorPlace.com. “Free Internet music broadcasts appear to be encouraging digital music sales,” he says.

Looking for a leader The speed with which the digitaldownload business has evolved has turned more than a few would-be sure-shots into eventual also-rans. One notable casualty was (former) digital-music provider Napster, which went head-to-head with Apple back in 2005 on the assumption that its Napster To Go portable subscription service—which gave customers access to over a million songs for a mere $15 a month—would help revolutionise the music-listening experience. In 2008, however, a floundering Napster was acquired by retailer Best Buy on the cheap, and last year its remaining assets were sold to rival subscription service Rhapsody. By then, Rhapsody itself was feeling the heat from new arrivals such as Pandora.“There are a lot of bodies on the road leading to success with a digital music service,” muses Tim Schaaff, chief executive officer of Sony Network Entertainment.

As such, betting on who will be tomorrow’s music-delivery heroes is no easy task. While up-and-comers such as Spotify are certainly attractive at the moment, it’s tough to argue with the proven track records and 25% profit margins of behemoths Apple and Google. Despite the lure of all-you-can-eat plans such as Rhapsody, Apple’s iTunes ownership model shows no signs of weakening. During the final quarter of 2011, iTunes users downloaded estimated 16bn songs, good for approximately $1.5bn in revenue. Not to be outdone by the cloud crowd, Apple now offers its ITunes Match, a service that wirelessly syncs users’ iTunes music library between Apple devices using a cloudbased personal storage locker. The fact that Apple has managed to maintain download supremacy through the creation of must-have proprietary devices (such as the iPad, iPhone and iPod) is obviously not lost on rival Google, which has already announced its intentions to move into the hardware market. Earlier this year, Google got the green light to acquire Motorola Mobility––part of its ongoing effort to boost production of Android-based smartphones. Currently 40% of smartphones utilise the Android operating system, the Linux-based, Google-owned rival to Apple’s iOS 5 mobile OS. Additionally, the Mountain View, California-based company is said to be developing a proprietary wireless music-streaming system for the home that can be operated from an Android-based handheld device.

In with the in-cloud While not nearly as competitive on an earnings-per-share basis as Apple or Google, Amazon’s standing as the industry’s overall download sales king makes it a strong contender going forward. Last year, the Seattle-based online retailing giant announced the premier of its Cloud Drive, a musicbackup service that allows Amazon customers to store music in the cloud,

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COVER STORY

THE RESHAPING OF THE MUSIC INDUSTRY

using a “digital locker” hosted on the company’s servers, with the ability to access personal libraries from any location and on any computer. Providing a more practical means of accessing users’ personal media libraries appears to be at the heart of Amazon’s cloud-based model, notes Frank Gillett, vice president and principal analyst for Forrester Research, called the move a“first salvo in a series of steps that will lead Amazon to compete directly for the primary computing platform for individuals, as an online platform, as a device operating system, and as a maker of branded tablets,” says Gillett. In-the-cloud music plans, which typically offer users the choice of a free, advertising-supported plan, or a premium paid-for option, are fast becoming the medium of choice on the increasingly crowded digitalmusic frontlines. Compared to portable subscription plans of the past that only worked with a limited number of devices, emerging cloud providers have addressed compatibility issues by allowing users to access music through apps on smartphones and other connected devices. “This has vastly improved the quality and level of the consumer experience,” notes IFPI.

Live streaming music One of the more visible cloud-based proponents of late has been Spotify, which allows users to live-stream music from the vast libraries of companies such as Sony, EMI and Universal. Like rival Rhapsody, Spotify users rent their music on a monthly basis by accessing tracks through an internet connection; premium members may also listen offline by downloading and storing music to a smart phone or similar portable device. Where iTunes currently charges $1.29 to own a single track, Spotify users who don’t mind viewing the occasional banner ad may stream tracks free of charge (or pay $15 a month for music without any advertising).

Debuting in the states last summer, Spotify has since signed up some 2m US users, more than a quarter of which are paid subscribers. Spotify also became the first subscription service that enabled users to share personal playlists through a Facebook link, thereby turning conventional music streaming into a social experience. “Spotify has always had a keen sense of how to coexist in the broader ecosystem, rather than try to do everything itself,” says digital-media analyst Mark Mulligan. By integrating with Facebook, Spotify has found a way to simply the learning curve for its new users, suggests Mulligan. Also joining the ranks of the cloud crowd is Sony Corp and its Music Unlimited Powered by Qriocity service, which links content across Sony-manufactured devices such as its Playstation 3 as well as Androidequipped smartphones. Google too has unveiled its own Google Music streaming/storage service that will allow users to access online music from a variety of devices, and share music through a social network (Google’s own Google+). Equally important in the resurgence of the music trade has been the rampup in smartphone and tablet sales. In areas with higher-than-normal handheld uptake, subscription plans have fared unusually well. In Spotify’s native country, Sweden, for instance, subscription services accounted for some 84% of digital revenues through the end of last year. Manufacturers of connected devices will continue to expand their reach, say experts, with sales of tablet computers expected to set the pace over the next several years. Research firm Gartner estimates that tablet revenue could reach $326m by 2015, led by Apple, which has shipped an estimated 55m iPads since the product’s debut two years ago. Meanwhile, sales of smartphones grew by 47% during Q4 of last year, reaching 149m units sold, according to Gartner. Apple’s

iPhone accounts for nearly one-fourth of global smartphone sales, says Gartner, which expects smartphones to eclipse desktop computer sales over the neat term.

Own or access, or both? As downloads continue to displace tangible media such as CDs and vinyl albums, for many the term digital has become synonymous with “disposable”—and for those users, subscription services that allow access rather than ownership remains the most logical choice. For that matter, it is the model that would appear to give iTunes a real run for its money. Rather than battle for digital supremacy, however, subscription and ownership plans have managed to achieve profitability independent of one another. “The fact that these two models of consumption can coexist speaks volumes about the future,” says Rob Wells, president, global digital business, Universal Music Group. “In fact, we have really only scratched the surface of digital music in the last decade—now we are starting the real mining, and on a global scale,” he says. The bottom line: analysts and music executives alike believe that the current uptick in digital music sales is sustainable, and that the recent numbers reveal an industry on the cusp of a rebound. “We are still seeing healthy growth in the market for digital-music downloads,” observes Russ Crupnick, senior vice president of industry analysis at NPD Group. Adds Stephen Bryan, executive vice president, digital strategy and business development, Warner Music Group, “There’s a race among the services to go global and plant the flag in new territories, and we’re seeing services that are generating revenues and growth. There is high engagement with these services. Consumers love them and spend hours using them.” I

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SPOTLIGHT

VOLCKER REVOLT

Volcker Rule likely delayed until after US presidential elections As mandated by the Dodd-Frank Act, the Volcker Rule—named for its author, former Federal Reserve Chairman Paul Volcker—prohibits commercial banks from using their own capital to invest in hedge funds and private equity funds, unless such activity is deemed “systemically important” (that is, is related to market making, securitisation, hedging, and/or risk management) and is limited to a three-percent ownership stake. With nary a fan on either side of the pond, the much-maligned Volcker Rule could be ripe for modification— though any change is more likely to happen later than sooner. David Simons reports. EGULATORS HAD HOPED to have the Volcker Rule finalised by mid-July. However, ironing out the increasingly complex proposal—which includes newly added exemptions needed to placate the bill’s many opponents—will likely take much longer. Retiring Massachusetts congressman Barney Frank, head of the House Financial Services Committee and co-author of the 2010 Dodd-Frank Act, has suggested something of a compromise; that regulators work towards completing a simplified version of the law by early September. "The agencies [have] tried to accommodate a variety of views on the implementation,” says Frank, “but the results reflected in the proposed rule are far too complex, and the final rules should be simplified significantly.” Financial institutions may be struggling to regain public trust in the wake of the 2008 credit meltdown; however that has not stopped officials from taking aim at the proposed Volcker legislation during the SEC’s comment period which closed on February 13th. Speaking on behalf of the Securities Industry and Financial Markets Association (SIFMA), Tim Ryan, SIFMA’s president and chief executive officer called the proposed regulations “unworkable” and “not faithful to Congressional intent”. Moreover, Ryan says they will have negative consequences for US financial markets and the economy. Echoing a common theme among Volcker critics, Ryan contends that the new law could result in drastically reduced market liquidity for investors, and make it more difficult for companies

to raise capital. SIFMA’s five-part comment letter includes proposed modifications to proprietary trading restrictions and hedge fund/privateequity fund investment activity under Volcker, and expresses concern over Volcker’s impact on municipal securities and global securitisation. Like almost everything else drafted by the Obama White House, the Volcker Rule has virtually no support in the GOP, and includes among its detractors Daniel Gallagher and Troy Paredes, the two Republican members of the Securities and Exchange Commission (SEC). Speaking at an Institute of International Bankers conference held in Washington last month, Gallagher suggested that regulators re-examine their initial efforts and, if necessary,“go back to the drawing board to make sure we regulate wisely, rather than just quickly.” Not that all of the criticisms have had political overtones. An exception to the rule allowing US banks to continue trading treasuries and municipal bonds has drawn fire from state and local government agencies, which have demanded that they receive the same exemption. The Municipal Securities Rulemaking Board (MSRB), the US-based firm charged with protecting investor interest in the municipal-securities space, has urged regulators to expand the rule’s proprietary trading exemptions to include municipal-bond brokers. It’s an effort to avoid “bifurcation” within the municipal securities market, says MSRB, warning current exemptions“are not useful in the municipal securities market,” and unless

modified will “prevent a free and open market from prevailing.” Nor has Volcker venting been limited to the US. In a comment letter issued in February, the European Fund and Asset Management Association (EFAMA), the representative association for Europe’s investment-management community, argued that exemptions favouring US institutions pose a serious threat to European funds due to the potential shift in the balance of power. Accordingly, regulators should take the necessary steps to prevent any negative impact on liquidity and operational efficiency abroad, said the group. Meanwhile, Oregon’s Democratic Senator Jeff Merkley, who along with Senator Carl Levin of Michigan helped draft some of the Volcker provisions, bristled at suggestions that substantial modifications would be required. If anything, said Merkley, the rule needs to be tougher, though not “as vague or complex as regulators are making it.” Also in favour of a stronger Volcker is former Citigroup chief executive officer John S Reed, who has argued that in its present form the rule “does not offer bright enough lines or provide strong enough penalties for violation." Having made regulatory reform one of its chief priorities, the Obama administration is unlikely to cede any ground in the months leading up to the US presidential elections in November. Hence, even the most vocal of Volcker opponents admit that change is unlikely to happen until after the new Congress convenes in January of next year. I

APRIL 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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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

maRkET LEadER

IMPROVED OUTLOOK FOR EUROPE’S REPO MARKET

The European repo markets, which provide banks with short-term funding, have rebounded from last year’s trough thanks to the European Central Bank’s Long Term Refinancing Operation (LTRO). Predictions for 2012 though are tempered. Nervousness over the eurozone’s long term prospects coupled with the prospect of more stringent rules continues to cast a cloud over the segment. As a result, the quality of collateral remains paramount. Lynn Strongin Dodds reports.

The slow but steady rebound of repo EPO TRADES REQUIRE borrowers to offer collateral as security against a cash loan. The borrower sells the security to the lender and agrees to repurchase it at an agreed time in the future for an agreed price. Activity rebounded in 2010 after the nadir of 2008 and 2009 and market participants were optimistic going into 2011. However, the resulting market panic as the euro crisis unfolded, promptly sucking energy out of the repo market, liquidity came to a virtual standstill and yields rose sharply. The repo markets shrunk considerably in the last six months of 2011 as cautious investors pared back trading. The International Capital Market Association’s (ICMA’s) semi-annual industry report card shows volumes contracted by 3.3% in the second half to €5.92trn from €6.12trn in June 2011 and the record €6.98trn in June 2010.Banks had been seeking longer term funding to cope with regulatory pressures and buffer against concerns over market liquidity; explaining perhaps why transactions of over one year climbed to 12.7% of the total from 8.7% in June. Central bankers were forced to step in. The Bank of England introduced the Extended Collateral Term Repo (ECTR) Facility as a temporary measure designed to mitigate risks to financial stability arising from a market-wide shortage of short-term sterling liquidity. The ECB, on the other hand, launched the LTRO, essentially unlimited three-year loans to banks that were facing an imminent credit crunch. The ECB’s most recent infusion of liquidity at €530bn followed on from the first injection of €489bn late last

Photograph (c) Jaroslav Viner /Dreamstime.com, supplied March 2012

year. The impact was immediate, particularly for Spain and Italy, who having flirted with yields of 7% and 8% in mid-December 2011, saw them drop to between just over 2.5% and above 3.5%, respectively, by the end of January. Greg Markouizos, global head of fixed income finance at Citi, says, “The LTRO has changed the dynamics. There is so much support from the ECB that it is quite difficult for the markets to blow up and there is a great deal of excess liquidity looking for a home.” The repo market is not out of the woods however and Markouizos sounds a still cautious note:“It is almost like a normal market but one of the big questions in the future is: how will it be able to exit delicately?” ICMA’s survey, which canvassed 64 financial institutions in Europe (including the UK), has revealed heightened aversion to risk and changes in the collateral composition

of the market. Government bonds were a preferred option through 2011, accounting for 79.1% of collateral originating from Europe in the second half of last year, up from 74.3% in June. There was however a premium on high quality collateral as investors held tightly onto German as well as UK and Japanese bonds, which were considered safe havens. The use of Spanish collateral was stable, partly because investors had more confidence in the country than some of its Southern neighbours such as Italy which saw volumes drop to 7% from 10.3% during the same time period. “There is no doubt that the escalation in the sovereign debt crisis in Q4 had a significant impact on repo markets, resulting in a drop in volumes across the board,”explains Don Smith, economist at the London interdealerbroker ICAP. “We are moving back towards normality and although there is still evidence of collateral tightness because of elevated levels of risk aversion, things have definitely improved.” Richard Comotto, senior visiting fellow at the ICMA Centre, University of Reading, underscores the exceptional nature of the European repo market right now. “[It] is being dramatically impacted by the LTRO [and] has recovered from its weak state last year. However, there is still a degree of uncertainty and the big unknown today is regulation, especially with [regard to] Financial Stability Board (FSB) discussions.” The FSB which brings together G-20 regulators, central bankers and finance ministry officials is casting its eye over the so-called shadow banking sector which many believe played a part in

APRIL 2012 • FTSE GLOBAL MARKETS

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maRkET LEadER

IMPROVED OUTLOOK FOR EUROPE’S REPO MARKET

the collapse of the financial system in 2008. This roughly $61trn industry typically includes hedge funds and private equity firms but the term can also include asset management, securities lending, repos and securitisation. Lord Turner, chairman of the UK’s Financial Services Authority as well as the FSB’s standing committee on supervisory and regulatory co-operation, is tasked with helping to develop the FSB's regulatory reform proposals by the end of the year. The group may propose minimum haircuts and margins for repo and other secured lending to minimise their pro-cyclical effect in falling markets. During 2007 and 2008, decreasing prices led lenders to increased margin requirements, forcing borrowers to sell assets to post collateral which, in turn, drove assets down further. There are also efforts on the regional front with the European Commission’s recently launched Green Paper looking at whether to enlarge existing EU banking legislation beyond deposit-taking institutions that provide credit. This includes tougher collateral requirements and oversight on the repo market. While it is too early to predict the outcome, market participants are lobbying to have repos removed from the shadow banking classification. “There are a series of regulations out there that touch upon the repo market,” says John Burke, executive director and head of fixed income at LCH Clearnet. “Policymakers though should consider the wider ramifications before passing any laws. The repo market is the oxygen in the system. It provides liquidity to the bond markets and if that is reduced then it can have unintended consequences.” Comotto who recently authored a paper on the subject for ICMA’s European Repo Council (ERC), agrees, noting that repo has been widely used by banks in Europe for several years and has helped many to ride out the financial crisis by giving them continued access to a source of term funding when unsecured term markets have

been closed.“Regulatory change needs to be careful not to undermine the efficiency of this important funding market or it risks restricting the flow of funding ultimately into the real economy,” he adds. The paper also refutes regulators’ claims that collateralised instruments such as repo facilitate or even encourage excessive leverage—a major factor in the recent credit crunch. Comotto notes that in practice markets will not allow banks to keep borrowing, even against good collateral.“The role of collateral is often misunderstood,”he says. “Lenders are not indifferent to counterparty risk because of collateral; the repo market tends not to lend to riskier counterparties, even if they can offer the best collateral.” Comotto also points out that the use of collateral does not make borrowing riskfree and if employed prudently it can be a source of stability for individual institutions and markets. There is a danger that the current discussion about collateralised lending paints collateral in a negative light. However, “collateralised lending is always preferable to unsecured funding. Regulators should therefore avoid action on repo that distorts the relative pricing advantage of secured over unsecured funding,”he adds. Looking ahead, regulation, risk management and the increased use of central clearinghouses will continue to be main themes running through the market segment. The ICMA semiannual survey shows that the share of CCP-cleared repos jumped to 32% of the survey business, from 30.5% in June 2011. That trend can only continue in current market conditions. The quality of collateral will also be high on everyone’s priority list and participants are taking a wider view due to continuing shortages, particularly in German government bonds. Burke says, “There is only so much collateral out there and we are seeing clients look at a broader range of collateral such as quasi-government and corporate bonds to allow them to manage the efficiency of their inventory. As an

Richard Comotto, senior visiting fellow at the ICMA Centre, University of Reading. Comotto underscores the exceptional nature of the European repo market right now. “[It] is being dramatically impacted by the LTRO [and] has recovered from its weak state last year. However, there is still a degree of uncertainty and the big unknown today is regulation, especially with [regard to] Financial Stability Board (FSB) discussions.” Photograph kindly supplied by ICMA, March 2012.

organisation LCH.Clearnet recognises the importance of collateral management and is working with clients to increase the range of eligible collateral where possible.” Drew Demko, head of broker-dealer services EMEA for BNY Mellon, adds,“I expect to see the trend continue for collateral optimisation and mobilisation. There is an increasing pressure on institutions to diversify their counterparties, manage margin across all asset classes and expand their pools of collateral.” As for activity, it is harder to predict. Volumes may have recovered but as Smith points out,“To a large extent, the outlook for repo markets is dependent on how the eurozone crisis pans out and its impact on risk aversion. The big question is whether the Greek restructuring has been enough to avoid a doomsday scenario. If that is the case then we will see a continued improvement throughout the year. I

APRIL 2012 • FTSE GLOBAL MARKETS

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In THE maRkETS

THE COST OF PAYMENT PROTECTION ON GREEK DEBT

Payment protection on Greek sovereign debt will cost its sellers around €2.5bn, following the auction that took place under the aegis of the International Swaps and Derivatives Association (ISDA) on March 19th to determine the level of compensation that should be due under credit default swaps. The auction became obligatory once an ISDA committee had ruled on March 9th that Greece’s agreement to restructure its debt earlier in the month constituted a ‘credit event’ that would trigger payouts under credit default swaps (CDS) contracts, because the Hellenic Republic had invoked legal measures to coerce private investors to accept the restructuring plan. Andrew Cavanagh reports on the fallout.

Greece CDS holders paid off in line with unprotected bondholders HILE THE TOTAL or ‘gross’ amount of CDS contracts written on Greek sovereign debt amounted on March 2nd to €69bn, the ‘net’ figure (after offsetting trades and mark-to-market adjustments) per the US Depository Trust & Clearing Corporation (DTCC) was a fraction of this figure at €3.2bn. The level of payout under CDS once a credit event has been called are decided by ISDA-organised auctions, in which dealers bid for the qualifying debt securities (of the defaulting entity) and an independent auction administrator determines a final price based on those bids. The protection sellers then pay the CDS holders the face value of their bonds—100 cents in the dollar—less the recovery value that the administrator has placed on the bonds. While investors will usually put forward the ‘cheapest to deliver’ bonds (those trading at the largest discount to their par value) that they own in such auctions, which then tend to set the price that the CDS sellers have to pay. It is not uncommon though to have a diverse mix of securities put forward to meet differing investor strategies and requirements. In the case of the Greek sovereign debt, the ISDA committee allowed the new bonds that the government had issued under it debt restructuring plan to be put forward for the auction as well as the retired bonds (which under the plan had to be offered for exchange no later than March 23rd).

Photograph (c) RonfromYork /Dreamstime.com, supplied March 2012

The mix of debt did not make much difference to the end result, however. At the end of the two-stage auction process the final price for eligible Greek debt was set at 21.5 cents on the euro. This price was close to the level at which the longest maturity (30-year) new bonds that the Republic has issued were trading at that point (22 cents on the euro). That obliged the protection sellers to pay the CDS holders 78.5% of the par value of their holdings. The outcome means that the CDS holders have been paid off broadly in line with the losses that unprotected bondholders have suffered under the Greek debt restructuring. For the latter received €15 of high-quality bonds out of the eurozone rescue fund and €31.5 of assorted new Greek bonds for every €100 of the old Greek debt that they

held. As the new Greek debt is trading at around 25% of par (€8) however, their loss in present value terms is 77 cents on the euro. The payouts on CDS contracts in respect of Greek sovereign debt are not expected to cause significant problems in the eurozone banking system. Not only is the aggregate amount small in systemic terms, but only one bank— Austria’s KA Finanz—has so far indicated that it has a substantial exposure to Greek CDS or ‘CDS-type’ risk. Actually KA Finanz is reportedly facing losses of up to €523m, but it should be able to manage these with shareholder support. Virtually all other exposures will long since have been marked to market, and most of the money that will need to change hands as a result of the Greek CDS event will have already done so. “With this event so well telegraphed, we would expect the vast majority of counterparties to have already provisioned/prepared for this event,” says Arup Ghosh, vice-president for credit strategy at Barclays Capital in London. The CDS on the debt of other peripheral eurozone countries is equally unlikely to create a systemic banking risk, given that the outstanding CDS volumes on their debt are also much smaller than those for their cash bonds. The latter would also have to under-perform and incur significant mark-to-market writedowns long before a CDS trigger event arose. I

APRIL 2012 • FTSE GLOBAL MARKETS

faCE TO faCE

SANGCHE LEE, STANDING COMMISSIONER, FSC, SOUTH KOREA

Photograph © Xyzproject/Dreamstime.com, supplied March 2012.

South Korea’s Financial Services Commission FSC was established in 2008 to serve as a consolidated policy making body for all matters related to supervising the country’s financial industry. At the end of March Ian Williams interviewed Dr Sangche Lee, FSC standing commissioner in Seoul. A Columbia University PhD, he had served for many years with the Korean Institute for Finance, the influential think tank that has dissected the country’s finance sector and prescribed its relations with the rest of the world. He then joined the FSC, charged with implementing policies, often devised by his former Institute. The FSC is also charged with implementing the G20 Summit agreements and overhauling the Basel III-related reforms. Lee explains the challenges facing the Commission at home and abroad and how it is facing up to them.

South Korea’s FSC legislates for a better future for investors OUTH KOREA, AS the alleged Confucian curse has it, lives in interesting times. As befits many emerging economies, it bestrides the developed and the frontier markets. On the one hand it has just ratified a Free Trade Agreement (FTA) with the US; on the other it continues to treat (unsuccessfully) with its somewhat insane neighbour to the North, which continues to threaten it with Armageddon. At home South Korea has more prosaic concerns. Impending and hotly contested elections mean that

competing political parties make populist promises about welfare payments, employment and small businesses, and also threaten regulatory legislation dear to the heart of the FSC. If parliament does not vote on financial reforms before the election, the incoming government will have to take up the cudgels of reform. Dr Sangche Lee, the FSC’s standing commissioner explains the underlying dynamics: “The FSC has three priorities this year. The first is to mitigate the risks of a global crisis; the second is to help grow the real

economy and protect SMEs and low income firms, since they are vulnerable sectors. Our third priority is investor and consumer protection. New legislation is before parliament, as are new proposed rules on financial companies’ governance and ownership. If [these bills are] not endorsed by May we will have to start again.” Even though South Korea survived the financial crisis relatively unscathed (by US and European standards at least) the tumult still had its effects. Asked about uncertainty, Lee refers with a reserved smile to the “IMF’s

APRIL 2012 • FTSE GLOBAL MARKETS

World Economic Outlook. They categorise Korea as an advanced economy, not an emerging market. However, World Bank data always categorises us as an emerging market, while according to the market indices of the S&P, Dow Jones, and FTSE, Korea is a developed economy. Only MSCI gives Korea as emerging status.” Lee smiles diffidently too at any suggestion that Korea and Taiwan (its twin soul in uncertainty) might be too big to drop from MSCI emerging markets indices since they represent such a large proportion of their value. “According to its Global Market Accessibility Review, MSCI has some concerns on market accessibility for foreign investors; disclosure in English; those types of things. We are working very hard to improve on these issues. I heard that they will re-evaluate our country status this coming April, and they'll announce their decision in June,” he states. The FSC only has regulatory jurisdiction only over some aspects of MSCI’s worries. Others are beyond its regulatory scope. “For example, their concern over foreign ownership limits in the media, aviation, telecommunication and utilities; these are tied to national policy, which is a product of the country’s geopolitical location, facing North Korea. Government officials have some reservations in opening up these industries, and it will take some time to lose these limits,” explains Lee. He is perhaps too kind to point to similar restrictions in the US, which would technically demote the world’s biggest economy; but that is for another article. Within the FSC’s domain however are investor registration accounts. “We are working hard right now to improve foreign investor concerns in this regard,” he says. “We are having a roundtable conference with foreign investors to discuss their issues around market accessibility; and we're going to have a roadshow in San Francisco, Boston, London, and Hong Kong to explain in

FTSE GLOBAL MARKETS • APRIL 2012

detail MSCI’s accessibility issues. We have already improved issues around disclosure in English and clearing and settlement. Depending on the results of the MSCI decision in June, of course we’ll do our best to address any other issues that might emerge.”

Residual complaints There are also residual complaints to contend with, which never quite reach official denunciation. Among them is the alleged manipulation of the won. Lee defers the point: “Foreign exchange market equalisation is the job of the Treasury and they think that the international valuation of the won is a national agenda item. It has a very diverse impact on the entire economy, so they have to consider it as a macroeconomic policy variable, related to the [overarching] national economic policy, not just from a capital market or financial industry perspective.” However, he loyally rebuts the prevalent foreign accusation of currency manipulation.“Treasury determination of the won rate depends on the market. When the balance of payments is positive it rises. During international financial difficulties foreign investors devalued the won but over the last three years it has been strong.”He maintains that“the Treasury always tries to defend the principle of a high-value won, set against a macroeconomic background. Any undervaluation is not the result of manipulation,” he avers.

Opportunity knocks, for some In downtown Seoul restaurants offer live octopus, chewed up tentacle by writhing tentacle. To the country’s critics, internal and external, anyone doing business in or with Korea is a menu item for the ten or so Chaebol, whose reach appears to extend into all aspects of business. Lee admits there are issues, but he says,“The Fair Trade Commission is in charge of Chaebol governance and ownership and regulations [affecting them. Each year], the Commission announces which of the Chaebols are under

[scrutiny], and we have separate laws and regulations regarding them [sic].” From an investor’s point of view, the Chaebol’s interlocking network of shareholdings considerably diminish the point of the country’s equity capital markets, although Lee is reassuring: “The transactions inside the Chaebols are closely monitored by the Fair Trade Commission, and they have to declare all their transactions. It is very transparent and closely monitored. If there is anything fishy, the FTC will investigate.” From the FSC’s side, “We are trying to encourage the Chaebols to set up holding company structures. The Fair Trade Commission has presented [appropriate] legislation to parliament that will clarify things.” The incentive for the Chaebol, whose power is comparable with the business lobbies in Washington but more concentrated, is that “a holding company could have financial companies under its umbrella. Right now, however, it is illegal. Once legislation is implemented, any concern about interlocking holdings disappears,” adds Lee. Up to now only LG (under international shareholder pressure) has split its businesses and put them under a holding company. Lee explains the rationale, “If you look at certain financial companies, their business segments are all separate, but all their managements are the same! If the legislation is successful they’ll have to re-organise and separate.” The proposed legislation, he says, also focuses on financial companies “Under the Banking Act of Korea, nonfinancial companies cannot hold more than up to 9% of a bank's shares. There will be no change there, but we are trying to improve outside directorships. The banks don’t have major shareholders so outside directors are very powerful and it’s very important to organise things so they can maintain their independence.” However, he points out those non-financial companies are often“owned by Chaebols with huge influence, so we tried to protect

faCE TO faCE

SANGCHE LEE, STANDING COMMISSIONER, FSC, SOUTH KOREA

the independent directors, but we meet some resistance,” he concedes. Of course, size is an issue. Lee points to Samsung and asks semi-rhetorically “Is Samsung a Korean company? In terms of sales, facilities, employment and so on its activities are mostly offshore. Even its stock is 70% foreign held. The only thing we can say is its HQ is Seoul and it represents some 20% of the Korea benchmark index (KOSPI).”He adds philosophically“It’s too big for the Korean stock market, but what can we do? We have to develop the Korea Exchange (KRX) to make it more global.” However, the KRX has structural problems that reflect the country’s corporate map. There is not much of a medium or small cap sector when compared with the Chaebol, and despite the global footprint of Korean industry only a dozen or so companies are listed abroad. The management holdings and the national pension fund holdings freeze a lot of the market cap leaving a relatively shallow free float, all the more vulnerable to volatility from flows of capital. Up to now about a third of shares on the KRX are held by foreigners. Lee explains that the Chaebols (such as Samsung) are so big that their stock is “very hard to manipulate, while the National Pension Fund has allocation ceilings for each sector. In contrast, some smaller stocks used to be so thinly traded that they could be manipulated. However, the FSC has stepped in and the KRX itself has a special operation that investigates any unusual trading patterns. We strictly enforce rules and penalise any organisation that violates those rules. It is not like it used to be. The market is much clearer”. Nonetheless, some finance companies think the regulators are not welcoming enough and budding hedge fund operators in particular express concern about tough capital requirements.“Regulations are different depending on whether they are asset managers, investment advisors, or security companies—whose equity capital should be KRW1trn,”adds Lee.

There are rules on head counts too. “They should have at least three qualified asset managers. But there are concerns that hedge funds may increase market volatility. That's why we're working to develop a hedge fund industry that prevents such systemic risks. We closely monitor the hedge fund sector for excessive risks that might occur in the early stages. Some argue that it’s too harsh, but these are early days, and the trend is towards some liberalisation.” In fact, he ruminates,“Developed economies had light regulation but are getting heavier, while we started heavier and are getting lighter so we will probably meet in the middle!” says Lee. In particular, he points out that even during the financial crisis,“There were no restrictions on portfolio investment. As in all emerging markets the problem is always foreign currency liquidity, so it’s always hard to borrow dollars, to pay back any foreign currency debts. If you look at 2008, there was a huge outflow of portfolio investment, but South Korea also has large portfolio investments abroad so it almost compensated, and the balance was near zero.” Additionally, he points out that,“we abolished the exemption for withholding tax for foreign investors. It had always applied to domestic investors, but not to the many foreign share and bond holders. It doesn’t impact the fundamentals of the investments, just puts some sand in the bearings to slow it down”. In contrast, with the accumulated experience of the Asian currency crisis running into the Lehman crash they decided, “Commercial bank borrowing was an issue and the banks had a hard time rolling over loans, so we concentrated on that, and most of the regulations were aimed at the soundness of foreign risk management. We introduced a ‘macro-prudential levy’ of 20 basis points (bps) if the loan was for less than six months, 10 bps for less than a year, then down to five basis points for two, and for three

Dr Sangche Lee, standing commissioner of South Korea’s Financial Services Commission (FSC). Photograph kindly supplied by the FSC, March 2012.

years 2.5bps, to control short term flows. So we tried to restructure the foreign currency loans to lengthen them, to incentivise the longer term.” After the initial calls on liquidity, Asian Tigers (like BRICs) became a safe haven but suffered from an inrush of foreign liquidity forcing some to introduce measures to control flows. Lee assesses that “We focused on certain foreign borrowing, but they are more inclusive, putting hurdles at the door for foreign investment. I think it is 6% of total money, and thus raises the cost of investment. We are studying whether our more focused measures have the required impact, and the IMF is also looking with interest at what we are doing.” The overall impression is that, while the problems for investors in Korea are different from those in many other countries, they are far from being significantly greater, and what is more reassuring, both the regulators and the government are aware of the issues and are, when not distracted by bombs and ballots, making a sincere effort to address them. Korean growth rates seem assured, along with investor returns. I

APRIL 2012 • FTSE GLOBAL MARKETS

faCE TO faCE

FACE TO FACE WITH SHEIKH MESHAAL JABER AL AHMAD AL SABAH

Sheik Meshaal Jaber Al Ahmad Al Sabah, chief executive officer of the Kuwait Foreign Investment Bureau. Photograph kindly supplied by KFIB, March 2012.

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

Leveraging Kuwait’s new FDI law Kuwait is keen to become a financial and investment hub and encouraging foreign direct investment is a keystone of this strategy. In consequence the government has established incentives to foreign investors that include a reduction in its tax rate from 55% to 15%, has begun to offer tax breaks of up to ten years, now requires zero custom charges for products relating to FDI projects and has instituted a liberalised employment regime related to FDI projects, irrespective of whether they employ foreign or Kuwaiti nationals. Francesca Carnevale spoke to Sheikh Meshaal Jaber Al Ahmad Al Sabah, chief executive officer of the Kuwait Foreign Investment Bureau about his vision for Brand Kuwait. Francesca Carnevale (FC): The 2035 vision for Kuwait, articulated by the government is clear in establishing a ground plan for the country to become a commercial and financial hub, embracing private sector finance and initiatives. What are the main obstacles to achieving these objectives? Sheikh Meshaal Jaber Al Ahmad Al Sabah: There are no obstacles that would seriously prevent or impede the achievement of this vision, which has been articulated in a manner that genuinely reflects the resolve of our leaders and our own national aspirations. It is based on actual attributes that Kuwait enjoys or is either able to acquire or develop easily. I will say however that

any apparent problems lie in the sometimes slow pace of achieving this vision, due to some technicalities or bureaucratic procedures. FC: How do you intend to overcome these glitches? Sheikh Meshaal Jaber Al Ahmad Al Sabah: I can see that serious steps are being taken to streamline the business environment and reduce the lengthy procedures, as well as adopting accommodating strategies with defined KPIs that are tied to core strategies and mandates. Better synergies are expected to facilitate this task. Thus we will end up creating efficient and transparent government processes that will enhance the overall institutional performance, lead to an

improved business environment, and help us conclude viable public private partnerships. FC: How competitive is the GCC market and by extension Kuwait? Many other countries in the immed iate region have articu lated similar strategies. How do you differ from them? Sheikh Meshaal Jaber Al Ahmad Al Sabah: Changing FDI dynamics based on international sources such as UNCTAD show that increasingly the GCC countries are being sought as favoured investment locations, much like other emerging economies. Naturally, this is because of the security and abundance of investment opportunities in the region, which are estimated

APRIL 2012 • FTSE GLOBAL MARKETS

in the hundreds of billions of dollars and are exemplified in the mega infrastructural projects, energy, electricity, transport, renewable sources, etc that abound in the GCC. The region is becoming more like one extended market, with a vibrant population of more than 40m, enjoying one of the highest per capita incomes in the world with strong purchasing power. Kuwait differentiates itself by its strategic location, its history of having an open economy that embraces the free trade activities of its merchant class. The country is rich oil resources, offers a low tax rate, competitive business costs, high literacy rates, well educated people, a genuinely welcoming attitude to foreigners, an entrepreneurial mindset, it provides mature banking & financial sectors, and low political risk and an enviable investor grade sovereign rating. FC: Conversely, what are the unique advantages for direct investors wanting to establish operations in the country? Sheikh Meshaal Jaber Al Ahmad Al Sabah: It is very much a combination of concrete attributes that I have mentioned above. FC: Can investments be standalone, without the involvement of a Kuwaiti partner? Sheikh Meshaal Jaber Al Ahmad Al Sabah: Yes they can. Law No 8/2001 allows foreign direct investors to own up to a 100% equity share in closed shareholding companies only. They can also freely select viable business opportunities in thirteen open sectors; can enjoy several incentives and guarantees, including allowing them an exemption of ten years for corporate income tax and import taxes. FC: What are the key elements required of foreign firms that want to invest in the country? Sheikh Meshaal Jaber Al Ahmad Al Sabah: If foreign investors apply to our Bureau (KFIB) for an investment license under FDI Law 8/2001, any projects proposed must be in one of those thirteen sectors. The investment must also bring about added value to the local economy

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2012

through the transfer of technology, advanced administrative systems or other forms of knowhow. There are also considerations such as the number and quality of jobs created for Kuwaiti nationals, links to the local SMEs, and the impact on Kuwaiti exports. Equally, relevant government entities must also give their approval to the investment (without objection), and these entities often look at issues such as the environment, public safety and also national security considerations. FC: There is a new foreign investment law ready for discussion by the parliament. What law does this replace? Sheikh Meshaal Jaber Al Ahmad Al Sabah: The new draft FDI law will replace current FDI Law No. 8/2001. This law was approved and came into force more than a decade ago and established KFIB as a division within

the Ministry of Commerce and Industry. Right now there is an obvious need to cater to changing global circumstances, and to benefit from recent developments in similar FDI legislation in other countries. Thus a more modern and accommodating draft FDI law was articulated (it took over two years), in a collaborative effort engaging various stakeholders, including the private sector and the civil society. FC: What are the main elements of the new law that will be attractive to foreign investors in Kuwait? Sheikh Meshaal Jaber Al Ahmad Al Sabah: It includes several additions to current law. Importantly, the new law will establish an independent investment promotion agency in charge of attracting and servicing investors. It will also reduce the duration of the time needed to issue investment licenses; in

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faCE TO faCE

FACE TO FACE WITH SHEIKH MESHAAL JABER AL AHMAD AL SABAH

essence it will become a one stop shop for investors. Another added value element is that the government will introduce a special incentive package to encourage implementation of priority or mega projects. There are other benefits to the new draft FDI law: it establishes a clear investment dispute resolving mechanism either through arbitration or through a formal Alternative Dispute Resolution. Moreover, under the new law, several incentives are provided for, such as 10 year tax exemptions and either full or partial exemptions from customs duties, in appropriate circumstances. The law distinguishes between applications for licences and those for incentives, particularly with respect to any privileges and exemptions granted. FC: The approval process for foreign investment in Kuwait up to now has been exhaustive and perhaps overly rigorous. How will the new law modify these processes? Sheikh Meshaal Jaber Al Ahmad Al Sabah: The new law will shorten the duration substantially from the current four months to 30 days. Extension will be allowed upon justified reasoning for delays only. Practical arrangements will be made with concerned government entities to facilitate the establishment and operations of a one stop shop that will combine around 16-18 entities in one place. FC: How will the role of the KFIB change once the law comes into force? Sheikh Meshaal Jaber Al Ahmad Al Sabah: KFIB will become an independent agency, with independent financial and administrative resources. This will allow it to extend outreach to open branches outside Kuwait in targeted countries which, in turn, will mean more effective positioning in global markets. The agency will have a stronger clout and independence in launching promotional campaigns, adopting the needed agile strategies, appointing qualified teams, and engaging needed technical support. The new independent agency will be more equipped to achieve the country’s FDI

goals and which will directly benefit Kuwait’s economy in areas such as technology transfer, the creation of more quality jobs and training opportunities for Kuwaitis, support for domestic exports and improved links to local SMEs. FC: How will investors benefit from this change? Sheikh Meshaal Jaber Al Ahmad Al Sabah: Definitely they will benefit from a better service and aftercare, as well as full engagement of the agency in helping them directly in obtaining approvals for investment licences, the shortening of the application period, and the establishment of a one stop shop centre. We also hope to generate more trust and confidence in the investment process through the establishment of a special arbitration centre in case of disputes with other investors. FC: What kinds of inward investment would you like to see coming into Kuwait? Sheikh Meshaal Jaber Al Ahmad Al Sabah: We would like to see more ‘asset augmented’ FDI rather than ‘resource seeking’ FDI, meaning FDI that brings added value, with technology and productivity gains, that will be conducive to diversify the productive base of the domestic economy, create linkages with local suppliers and service providers, enhance SMEs, and create thriving competitive clusters that make Brand Kuwait a reality. FC: Are there any particular business segments (industry, finance, manufacturing, for instance) that you would like to encourage to invest in the country? Sheikh Meshaal Jaber Al Ahmad Al Sabah:There are currently 13 open economic sectors under the new law. We do not target any specific or preferred sector. Each FDI project (in any of these sectors) is assessed on its own merit. We evaluate the expected economic impact of the project, based on current criteria such as technology transfer, job creation, training opportunities, the strengthening of the role of the private sector and export growth. Our objective is to

increase both the volume and value of inflow of FDI investments, supported by lucrative investment opportunities provided by the Kuwait (five year) development plan. There is no upper or lower limit on investments and we welcome all investments that prove viable for Kuwait. FC: How important is technology in this thinking? Sheikh Meshaal Jaber Al Ahmad Al Sabah: Technology and knowhow transfer is a primary goal for attracting FDI into Kuwait and it plays an important component in the overall assessment of investment licensing applications, and incentives granted. Kuwait is seeking various forms of technology including administrative systems, management techniques, supplier/vendor development, enhancing R&D and innovation capabilities, among others. FC: Are there any key points you would like to raise that you have not had the opportunity to outline? Sheikh Meshaal Jaber Al Ahmad Al Sabah: We have tried to be more responsive to investors’ needs, existing and potential, international and domestic, through a better understanding of the investment pipeline. We continue to work to resolve issues such as the availability of land through the establishment and development of three economic zones; we continue to improve links to other government entities via a special egovernment initiative. We have also opened a branch at the airport to encourage investors to find out more about what we do and we will soon develop a formal Kuwait Investment Map. We work with several international experts in investment promotion and specialist media, like you, to portray a revitalised image of Brand Kuwait, emphasising that we are open and ready for business. KFIB works in coordination with all relevant government entities and stakeholders to maintain a favourable investment climate and deliver results that will reassure investors and enhance the country’s credibility as an investment destination. I

APRIL 2012 • FTSE GLOBAL MARKETS

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COunTRY REPORT

KUWAIT: OIL REVENUES HELP BUOY ECONOMY

Kuwaiti Members of Parliament argue during a heated debate over the situation in Syria at the Kuwait's National Assembly's session on Wednesday, Feb. 29, 2012. Photograph © the Press Association, March 2012.

Kuwait banks at the crossroads Kuwait’s banks are caught between opposing forces: some economic, some political which continue to test the efficacy of their business strategies. After a torrid few years, most of the country’s banks, having undertaken substantial restructuring and recapitalisation programmes, looked set fair to rebuild their franchises up and out this year. However, the immediate threat is that 2012 delivers more of the same challenges that presented themselves in 2010/2011. Can the country and the banks break out of their restrictive moulds? The omens are set at fair, but the question is: can everyone deliver on the promise? Francesca Carnevale reports. UWAIT'S BANKS HAVE been through the crucible of late and look to have emerged a bit battered perhaps, but certainly stronger for the experience and not out. The reasons are manifold and (perhaps too) well worn. The eurozone crisis, for instance, has stretched its icy fingers across the Gulf Cooperation Council (GCC) region, and sprinkled its own little bit of frosting across Kuwait to boot. The risk is not one of direct business disruption or a downturn in exports; rather the prospect of any further deterioration in the eurozone that might upset the GCC's capital markets and thereby

impair the ability of the region’s banks to fund themselves at appropriate cost, remains a nagging concern. Equally, Kuwait is naturally nervous about its politically restive contiguous neighbours (Iran and Iraq), which continue on and off to ratchet up their own brand of regional tensions and political risk. The impact on business of the socalled Arab Spring has not helped either: though of all the countries in the MENA region, Kuwaiti politics are the most democratic (in a Western sense, if you will), even if they do remain rather fractious. Arguably though it has had least to fear from the impending change the social revolution has brought about.

Other elements however are much closer to home. Ever since 2008, some of the country's leading investment companies, for instance, which had operated with high levels of leverage, experienced difficulties as their real estate and capital markets investments went south and weaknesses in their funding structures were exposed. Those Kuwaiti banks with credit exposures to these entities were sorely tested as the quality of their assets deteriorated. Even so, throughout 2010 and 2011 Kuwaiti banks, such as Gulf Bank, worked hard to increase their capital levels, work out and through their non-performing loan

APRIL 2012 • FTSE GLOBAL MARKETS

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COunTRY REPORT

KUWAIT: OIL REVENUES HELP BUOY ECONOMY

(NPL) book and develop new business strategies to cope with a changed business outlook. Gulf Bank, which was rescued by Kuwait's central bank in 2008 after suffering big losses related to derivatives trading, made a KD30.6m ($110m) profit last year, compared to $19.1m in the previous year, thereby underscoring the bank’s steady turnaround in fortune. “We brought in an entire newly management team in the second half of 2009, to help us rebuild trust and profitability. We had to take huge reserves and provisions,” explains Gulf Bank’s chief executive Michel Accad. Kuwaiti banking major NBK meantime, “continued to maintain exceptionally strong asset quality indicators with NPLs/gross loans ratio dropping to 1.55% as of year-end 2011 compared to 1.65% in 2010 and coverage ratio mounting to 243% in 2011 up from 209% in 2010,” according to Randa Azar, NBK’s Group head of strategy and research. However, Azar strikes a note of caution in over-blowing any capital adequacy or liquidity problems in the sector. “The starting point for many banks in the Gulf is pretty strong right now; capital adequacy and liquidity is not really a problem in the region. At the same time, regional banks continue to step back from risk and speculation, with or without prodding from their central banks, particularly where the private sector has slowed,” she explains. “A good number of banks are already compliant with both Basel II and Basel III, at least on the capital ratio side.” Even so, she concedes that the country’s banking segment remains cautious and big ticket lending has been pulled back. Equally home grown is the fall off in corporate lending which has stymied bank results for the last couple of years. Credit growth overall remained stagnant all through 2011, with growth overall registering only 1.6% last year, with the bulk of activity in the retail rather than corporate space. As well,

according to a recent EFG Hermes research note, lending to financial institutions in Kuwait was down by over 16% over the last year, as banks reduced their lending to the investment company segment. In contrast, “Consumer/household lending continued to lead credit growth and personal facilities, excluding loans given for the purchase of securities, were up over 8% year on year,” explains Daniel Kaye, senior economist at National Bank of Kuwait (NBK). Gulf Bank’s Accad explains some of the underlying dynamics.“While economic growth touched 4.7% last year and will top 5% this year, there is a distortion in the figures because of the price of oil. Moreover, the Emiri grants this year topped $2bn, with which many people have spent on high end consumer goods; that money was not invested productively. So overall, the banking sector has not done that well. Loan growth is up only 1.1% across the board.” "In 2011 consumer and household lending recovered further and grew almost 10%. Growth in corporate lending was more subdued, held back by investment companies paying down debt. We expect the corporate sector to improve gradually ahead, but only really get a significant boost once the projects and PPP companies of the five-year plan are in full gear," adds Elias Bikhazi, head of economic research at NBK. Third, Kuwait has seen its prestige in the region increasingly overshadowed by countries such as the United Arab Emirates and Qatar as they continue to steam ahead with financial reforms and mega investments in urbanisation, telecommunications and infrastructure, with modern transportation facilities and sleek airline fleets. That slippage has cost the country dear, with the Kuwait Stock Exchange, the local bellwether of prosperity languishing at an eight year low. It adds up to a serious strategic challenge for the country’s leading banks

“We brought in an entire newly management team in the second half of 2009, to help us rebuild trust and profitability. We had to take huge reserves and provisions,” explains Gulf Bank’s chief executive Michel Accad. which perforce must re-hone their business strategy.The result is a broad brush of approaches. Some banks, such as NBK, Burgan and Kuwait Finance House have international business remits, which have enabled them to leverage growth both in the GCC and the wider MENA region (and sometimes even beyond that). Even then, some redirection is also taking place. NBK remains the largest bank in Kuwait and has a strong position in all segments of the non-Islamic banking market. With a stake in the Islamic vehicle Boubyan Bank and the widening range of products offered by its investment banking arm NBK Capital, the diversified group has been able to compensate for the limited growth opportunities in the market. International expansion has also provided fresh avenues for potential growth. However, following social turmoil in some of its key markets (such as Egypt) in the aftermath of the Arab Spring, NBK explains Azar is looking for growth closer to home, in the GCC region. NBK’s Qatari business (for instance), channelled in large part by its stake in IBQ, led by NBK group stalwart George Nasra, has continued to “deliver fantastic growth, around 25%,” explains Azar. “Even in Iraq, with the country’s political risk, disorder and general chaos, the bank is still delivering good growth. We should build on these developments.” Gulf Bank in contrast is focusing entirely on the potential of Kuwait itself. “We have aspirational growth

APRIL 2012 • FTSE GLOBAL MARKETS

plans,” explains Accad, “and we have decided to continue with a clear focus on domestic retail and commercial banking. We have no presence or ambitions abroad. Our strategy has its pluses and minuses: on the plus side we have extreme clarity of purpose. It enables us to ratchet up our client services offering such as upgrading our internal credit scoring system so that we can make ultra-fast decisions on credit facilities, within the same day for consumers; it takes a little longer for corporations. On the minus side: the size of the pie is somewhat restrictive.” Even so, the bank’s new business focus is already working, says Accad. “Our volumes on the consumer side are up 50% and we are booking KD1million in new consumer loans per day, leading all other banks in the country.” Gulf Bank reported a 60% jump in full-year net profit in 2011, despite a significant decline in fourthquarter earnings compared to the same period in 2010. Meanwhile, Burgan Bank’s Bashir Jaber, Burgan Bank’s assistant general manager, corporate communications explains that“2011 marked a period of turnaround for the group. It has been a challenging year in terms of the European debt crisis, affecting credit demand and political unrest in sections of the Middle East. Despite the less favourable economic and business environment, Burgan Bank Group delivered a solid performance in terms of strengthening top line behaviour [sic], significantly improving margins, controlling costs and delivering impressive returns while maintaining its prudent risk management approach..” Adds Jaber, "In addition to maintaining 2011 strategic objectives our 2012 focus will be in growing our local market share, in repositioning our Kuwait retail bank, expanding the bank's footprint and achieving scale through strategic acquisitions." This is backed, says Jaber, by the announcement in March that the brand was

FTSE GLOBAL MARKETS • APRIL 2012

rated AA with a positive outlook, placing the bank second among the most valuable banking brands in Kuwait. (NBK again won top slot).“In modern business conditions, the brand is essential for our business strategy success. Therefore, strategic brand management is a vital component of Burgan Bank’s corporate strategy,” he adds. Meantime, Islamic specialist bank Kuwait Finance House refused to participate in a formal interview, but issued a statement that it had just launched a new five-year strategy and a transformation programme, “based on three pillars to improve the bank’s performance and overcome challenges, which will allow KFH to maximize profits and reinforce its leading status in the Islamic financial field,” according to the bank’s chairman Samir Al-Nafisi. The bank’s new strategy, he explained in the statement, is based on developing the banking performance in Kuwait and the investment portfolio of the group, in addition to increasing the coordination among KFH and its subsidiary banks. In particular, Al-Nafisi says the KFH Group is gaining more ground worldwide, and its subsidiaries in Turkey, Malaysia, and Bahrain are playing a larger role in cementing trading and economic relationships among the countries in which they operate in, “with both Kuwait, and the GCC”. With the banking sector having put its strategic ducks in a neat and manageable row, much now depends on the country’s willingness to undergo and sustain substantial reform and enthusiastically implement a long awaited economic expansion plan. The expansive investment plan, first articulated back in 2009, is designed to lessen the country’s dependence on oil while at the same time increasing oil and natural gas production capacity. After a promising start in 2010, virtually alongside the passage of a much delayed privatisation bill, the Kuwaiti parliament approved a

Burgan Bank’s Bashir Jaber, explains that “2011 marked a period of turnaround for the group. It has been a challenging year in terms of the European debt crisis, affecting credit demand and political unrest in sections of the Middle East. Despite the less favourable economic and business environment, Burgan Bank Group delivered a solid performance in terms of strengthening top line behaviour 2010/2014 plan to help revive the Kuwaiti economy which had been languishing since September 2008. The plan includes some 1,100 projects in both the oil and non-oil sectors (among them a smattering of megaprojects), with an estimated minimum cost of KD37bn (around $130bn). Banks expected some KD16bn (around $55bn) of project spend in 2010/2011 alone. Like any self-respecting rich high growth market, Kuwait has ambitions to shed its conservative coil, become a regional trade and financial hub, find ways to sustain economic development and diversification (through direct and indirect inward investment) and buoy GDP growth. Specific projects to be implemented under the plan include: a new business hub (Silk City) at an estimated cost of $77bn; a major container port/harbour and a 25km causeway; railway and metro systems; additional spending on new cities, infrastructure and services (in particular health and education); and some KD25bn worth oil sector investments to raise energy production capacity. Private sector involvement in the plan is envisaged through 20-year Build-Operate-Transfer (BOT) project financing schemes, which share risk between contractors, project sponsors

COunTRY REPORT

KUWAIT: OIL REVENUES HELP BUOY ECONOMY

and project operators and which have a tightly drawn funding structure that (in turn) appeal to banks. In this regard, Kuwait’s banks were expecting a lending bonanza, in a corporate lending market which is still dominated by domestic rather than international banks. It is not a question of money; most of the plan was costed with oil at $43/barrel, while Europe’s benchmark Brent crude is expected to run somewhere around $117/barrel for most of this year; albeit Gulf crude trades at a slight discount to Brent. Moreover, Kuwait is not shy of spending money to achieve international approbation of its plans; having famously paid ex UK premier Tony Blair, £7m for an FDI strategy outline; and will pay any number of consultants going forward similar amounts to articulate appropriate infrastructure for its development plans to be achieved. Spending so far on the plan has been piecemeal and the overarching application of its vision is still mired in political debate and controversy. Ironically perhaps, it is Kuwait’s democracy in action that looks to be scuppering the countries best laid plans for long term success. The latest parliamentary elections, the fourth in six years, have resulted in Islamists winning 34 of the country’s 50 parliamentary seats; which say bankers is likely a backlash against years of dysfunction in the political system and a failure of the country to tackle corruption and bring about workable reforms. Liberal secular parties who came to power in the last elections were routed at the polls. The Islamist victory took the world by surprise, as Kuwait has a cradle to grave welfare system and boasts the only elected parliament in the Gulf; but reflects a growing trend in the wider MENA region to associate lslamic political parties with personal probity. However, it will not be plain sailing for the political newbies, which will have to contend with a Western

leaning populace that is keen to see a constitutional monarchy and political reforms. The interesting question is whether the incoming Islamists will push through the country’s all-important development plan. The outcome might turn on a sixpence; as some commentators say they will (as they might have something to prove that the economy is safe in their hands); others that they won’t.

Stabilisation of asset quality

Kuwait is not shy of spending money to achieve international approbation of its plans; and will pay any number of consultants going forward similar amounts to articulate appropriate infrastructure for its development plans to be achieved.

With all these cross trends blowing through the markets the name of the game over the last 12 months has been stabilisation of asset quality; particularly as credit growth was largely constrained through 2011 and the outlook for 2012 remains pretty much the same. While there is no silver bullet that will kill off the global recessionary gloop-monster that has mired the developed economies and capped growth levels in normally highgrowth or (to use an old fashioned term) emerging markets, in Kuwait's particular case, sustained revitalisation of the banking sector in its home market remains dependent on a number of elements. “We will continue to see improvement in the liquidity situation, and we hope that this will translate into a higher credit situation extended to the private sector, which will help the GCC economies grow in 2012,” says NBK’s Azar. Moreover, NBK research reports suggest that construction and business services will continue to improve this year, as may real estate (where sales role by 35% in 2011) but any continuation of these upticks may ultimately swing on the old sixpence that is the government’s five-year development plan. On a positive note, a new FDI law is in train and the government is said to be considering liberalising its property laws, which have long been a stumbling block to corporate FDI. Foreign Investment Law (No. 8/2001), which is still extant, regulates foreign invest-

ments in Kuwait. The new proposed law will allow foreign investors to own up to 100% equity in Kuwaiti companies or ventures for special projects as determined by the Council of Ministers. It is expected that, this significant change proposed by the government will throw open the Kuwaiti markets to multinational corporations giving them a free hand in doing business in Kuwait. Until recently, foreign investors were subject to a ceiling of 49% (maximum) stipulated under the Law of Commerce No. 68 (1980) and the Commercial Companies Law No. 15 (1960). It is not a panacea, but it is an important step and it shows meaningful intent at the top of government to update Brand Kuwait. Unless change continues at a clip however, Kuwait’s now stronger banks and its newbie parliament will undoubtedly face the same set of challenges that have stymied the country for years: a lack of meaningful economic diversity (the non oil sector grew only 2.9% last year, the second lowest in the GCC), stalled development and a fractious political environment that does not brook meaningful change. Right now many of these issues are masked by an oil sector that has delivered growth in excess of 7% in 2011 and a similar figure in 2012 (as export problems in Libya and Iran help keep oil prices high); thereby potentially kicking the country’s much needed development plans into the long grass—yet again. I

APRIL 2012 • FTSE GLOBAL MARKETS

COunTRY REPORT

RUSSIA: GOVERNMENT TO SELL DOWN BANK HOLDINGS

Chairman of the board Volksbank International Friedhelm Boschert (left) and Libor Holub (middle) chairman of the board Volksbank CZ and Sergei Gorkow, vice-chairman of board in Sberbank for international business speaks speak during a press conference about selling the division Volksbank International to the Russian Sberbank and plans for the future in Prague, Czech Republic on March 28th, 2012. Photograph by Michal Kamaryt for CTK via AP Images. Image provided by PressAssociationImages, March 2012.

Having postponed its partial privatisation in September 2011 because of a global weakening in investor sentiment, the sale of a $6bn government stake in Sberbank is now being revisited. If successful, it will spur a new round of market liberalisation in Russia and support the coming partial privatisation programme of Russia’s banks. However, warns a leading credit rating agency, there may be a sting the tail of these latest plans. According to a recent report by Fitch Ratings, “further privatisation of Russia's banks could reduce the potential for state support, resulting in moderately lower Support Rating Floors (SRFs).” The roadshow for the sell-off of Sberbank shares is reported to start on April 14th.Should investors approach with caution? Or, should they embrace the slow but steady opening of the Russian market once more?

Sberbank sale first salvo in new state sell off T COULD TURN out to be a watershed year for Russia. There’s membership of the World Trade Organisation (WTO—due for ratification in the summer) to look forward to; giving Russian exporters improved and cheaper market access. Moreover, Russian firms that have been subject to anti-dumping actions in export markets, such as Russian steel producers, nonferrous metal producers and chemical exporters, will have increased legal rights to protect their commercial interests in anti-dumping cases. The energy exporter has been supported over the near term by a continuing surge in oil prices that could that does not look likely to abate any time soon. The economy is expected to rise by a healthy 4% this

FTSE GLOBAL MARKETS • APRIL 2012

year, with WTO membership likely to crank that up in 2013/2014. Russian industry is primarily split between globally-competitive commodity producers and other less competitive heavy industries that remain dependent on the Russian domestic market. The reliance on commodity exports makes Russia vulnerable to commodity-led boom and bust cycles. Since 2007 Russia has embarked on an ambitious program to reduce this dependency and build up the country's high technology sectors, but with few results up to now. Moreover, the economy was one of the hardest hit by the 2008-2009 global economic crisis as oil prices plummeted and the foreign credits that Russian banks and firms relied on dried up. In 2008 the central bank spent $200bn to slow deval-

uation of the ruble, and a further $200bn to increase liquidity in the banking sector and help Russian firms roll over large foreign debts. Although the economy began to grow again in the first quarter of 2010; a drought in central Russia reduced agricultural output, prompting a ban on grain exports for part of the year. Growth also slowed in manufacturing and retail. As well, Russia faces other problems: a shrinking workforce, corruption, hardto-find capital for smaller, non-energy companies, and continuing low levels of investment in infrastructure. However, the country is also set on a path to develop Moscow as an international financial centre. For that to happen, incoming president Putin has to achieve a number of market reforms;

REGIOnaL REVIEw

RUSSIA: GOVERNMENT TO SELL DOWN BANK HOLDINGS

only a few are outlined here. One, already in the bag, is the concentration of market power into a central exchange (which it has done by encouraging the merger between MICEX and RTS). Two, he has to improve Russia’s business climate (which is riven by factionalism, monopolies and corruption). It is a big ask. The country remains among the lower-ranked countries for doing business: at number 120 out of 183 countries (according to a World Bank survey). Three, the legislative book that governs business and the economy still needs an overhaul; up to now various governments have and continue to tackle reform in piecemeal fashion. Fourth (and this is hard, as banks are a key tool of government economic policy enforcement) Russia’s banks need to be eased out of state control. The state directly or by a contortion or two controls the country's key banks. VTB and Russian Agriculture Bank are directly state controlled. Some others are controlled by the state-owned Vnesheconombank; while Sberbank, Russia's biggest bank, is still controlled by the central bank. Outgoing president Medvedev has instigated measures reduce public stake in VTB Bank and Sberbank to below 50%.

State holdings reduced Over this year and next, the government has planned to reduce its holding in VTB (currently 65.5%) by a further 25% (minus one share). It divested a 10 percentage point share in the bank in 2011. Russian Agriculture Bank (Rosselkhozbank) is wholly owned by the state, which aims to sell off a quarter of its stake in the bank by 2015 and the balance by 2017. The government had hoped to sell off the 7.6% stake in Sberbank last September; though its plans were thwarted by the growing weakness in investment sentiment through the third and fourth quarters of 2011. It seems to think that now is a good time; based on the country’s improving finances.

Sberbank has an equity market value of around $76bn, second in Europe behind HSBC, giving the stake offered for sale a market value of $5.8bn, not an insignificant chunk of change in a still skittish investment market. It is also a pivotal bank in the country’s affairs. Sberbank accounts for around a third of overall lending in Russia and is a home for half of the country’s household deposits, which along with state backing gives it access to cheap funding. The Russians are taking a bet that the time is ripe for the issue, particularly given the market’s fair prospects. Given that the Russian economy is expected to grow somewhere in the region of 4% this year, chances are that the brooding giant atop Europe could be the surprise market du jour of this year; and it looks rather like the reawakened sale of Sberbank shares will undoubtedly be viewed as a proxy for the attractiveness of the Russian economy in 2012. If the stock sale is successful, it will also mark a milestone in chief executive German Gref's drive to transform the former Soviet state savings bank into an efficient and profitable universal bank with international pretentions. The bank launched a cautious acquisition in 2011, buying Moscow brokerage Troika Dialog last year for $1bn. It also acquired the European arm of Austria's Volksbank in March for $660m, and plans to earn at least 5% of its profit abroad by 2014. The lender posted a record RUB322bn ($10.9bn) in net profits for 2011 under Russian Accounting Standards (RAS), up 75% on 2010. Its return on equity (RoE) also topped 27% under RAS. Sberbank posted RUB97.4bn ($3.3bn) in net profit in the first quarter under RAS, up 16% year-on-year, based on strong net interest income (up 26.9%) from increased lending to corporate and retail customers. The bank also says its assets were up 5.5% to over RUB11trn over the first quarter, while its nonperforming loan ratio stood at 3.34% as of April 1st, marginally up from the

year-start level of 3.36%. However, the bank also registered RUB12bn in provisions, as lending rises. Sberbank itself is already a well known brand to international investments, having launched depositary receipts on the London Stock Exchange. It is likely the sale will price the shares at a discount of around 6% to its emerging market peers, though it should prove popular among investors.

Some concerns The move has somewhat unnerved Fitch however: “If government ownership falls below 50%, it would be moderately negative for the level of potential support we factor into the banks' ratings. Combined with the broader global trend for governments to reduce their implicit support for banks, this would probably lead to a moderate reduction in the banks' 'BBB' SRFs,” says its latest paper on Russian banking. Moreover, it adds:“We think it is unlikely the state will relinquish control of the banks in the next two to three years. However, if hypothetically the stakes in Bank VTB and Sberbank were to fall below 50% tomorrow, with the government retaining large minority stakes, downgrades of SRFs would probably be moderate and could be limited to one notch, to 'BBB-'. Currently, any downgrade of the SRF would result in a corresponding downgrade of the Long-Term IDR of Bank VTB as this is driven by its SRF. Sberbank's IDR is underpinned by its 'bib' Viability Rating and would therefore currently not be affected by a downgrade of the SRF.” However, the ratings agency concedes: “This would in turn also benefit the health of the Russian banking system as a whole. Russian Agricultural Bank ('BBB'/Stable) is less likely to be privatised in the medium term, in Fitch's view, because its more explicit policy role would make it harder to attract investors. Vnesheconombank ('BBB'/Stable) as a development bank is not expected to be included in any privatisation programme.” I

APRIL 2012 • FTSE GLOBAL MARKETS

GuEST COLumn

SOCIAL AND ETHICAL ASPECTS OF ISLAMIC FINANCE

ISLAMIC FINANCE – THE SOCIAL PARADIGM The genie out of a modern day bottle is the first home purchase plan approved by the Financial Services Authority (FSA) for the mainstream UK market, rather than a specialised market. It demonstrates that the religious principles underlying Islamic products are relevant in the ethical and social finance marketplace; that Islamic principles can inspire and enhance the finance products being developed to meet these challenging times in the residential domestic market. Natalie Elphicke, head of structured housing finance, partner, international law firm Stephenson Harwood gives her take on the application of Shari’a principles to ethically-charged social housing and the investment opportunities that arise from it. ISK SHARING, NOT profiting unjustly or unfairly, not charging excessive charges; in a residential purchase context, allowing part rent, part purchase, sharing equity upside, sharing downside property risks. These characteristics apply equally to an approved Islamic home finance plan as they do to a new conventional purchase plan designed for a housing association in the north east of England. What does this matter? For many years it has been felt that Western finance constructs have been squeezed and shaped to meet the requirements of the fatwa (approval) for Islamic finance. One result of this has been an understandable reluctance to provide an Islamic checklist to those structured financiers who specialise in dressing a product to fit a market, rather than perhaps understanding and applying the underlying intentions and principles. The desire to conform to those Islamic standards is being driven by a desire to access a rich seam of devout consumers prepared to pay a premium for compliance, and to harness rich Islamic investment funds, rather than shape and deliver products or investments which enhance and develop the lives of Muslims within their beliefs and philosophy. The tide is turning. In ethical and social investment arenas there is significant interest in three areas of Islamic finance:

FTSE GLOBAL MARKETS • APRIL 2012

Ijara, Musharaka and Mudaraba. Musharaka is the basis for property transactions which allow shared equity participation within a trust holding, providing much more flexibility to manage changes in lifestyle and more fairly share market rises and falls in residential property over a longer period of time. This can provide a much more transparent and fairer approach than Western style 100% mortgage finance or the more limited traditional shared ownership structures. There are similarities between partnership finance structures of Mudaraba, and ljara leases. In the former, some people provide labour and others money, in a plethora of 'Big Society' style co-operatives and social enterprises, bringing together those who work, and give their 'sweat equity'. Then there are those who provide funding and those who share in a financial loss/gain Ijara- based lease-purchase contracts, which can offer a fairer sort of hire-and hire-purchase arrangement of equipment, such as washing machines and other household appliances. If there is an interest from ethical and social residential property to engage with and be inspired by Islamic based principles, how interested are Islamic funds in residential property, especially student, affordable or social housing? The evidence is mixed. There is also anecdotal evidence of a tightening of conditions for investment funding to

Natalie Elphicke, head of structured housing finance, Stephenson Harwood. Photograph kindly supplied by Stephenson Harwood, March 2012.

reflect wider, purposive beliefs of Islamic funds. One such interesting example is the financing of student halls of residence. The usual student bar and pool table on the ground floor is being replaced by a coffee bar, with a restrictive covenant on the space becoming licensed, as a condition to access to that investment funding. Housing associations have started dialogues with Islamic funds which have financed other UK core infrastructure and utilities, such as ports and airports, water and electricity. Social housing can offer a solid investment yield. Not racy but solid and responsible, reflecting the core values of a mature residential regulated housing industry worth around £100bn. Islamic finance techniques offer new ideas and new ways of financing. This financing is perhaps more in line with the spirit of our times. There is a greater sense of partnership and risk sharing; and an aversion to excessive rates of return. Islamic finance principles offer useful ideas to the increasingly social and ethical spirit of our post banking crisis.Yet even so, ethical and social structures still have to provide a return and perform at an acceptable yield or investors will be thin on the ground. The real plus is that Islamic finance offers different ways to raise finance and widens to base of potential funders.I

REaL ESTaTE

ISLAMIC FINANCE: DOES IT STIFLE REAL ESTATE INVESTMENT?

With an estimated value of around $1.1trn in global assets, Islamic finance has maintained continuous growth against the backdrop of global economic turmoil across many of the conventional world markets. Yet while their inherent conservatism and overweight exposure to low risk investment has proven a strong point for Islamic-compliant financing of real estate, as safer investments have generally out-performed the market, the ongoing lag in Shari’a rules harmonisation is threatening to stifle their full potential in the Middle East and Islamic Asia, reflects Mark Faithfull.

Keeping faith in real estate NCE AGAIN RISING to prominence at a time when the dominance of conventional financial markets has been shaken by the global economic crisis, developments over the past few years have allowed Islamic finance to blossom into a recognised alternative market for property investments. The financial meltdown has served as a useful reminder of the attractiveness of what should be a safer, more stable alternative to conventional financial models, because issues such as excessive leverage are not allowed to play any part in a Shari’a-compliant product. Although the biggest opportunities lie within the oil and gas rich nations of the Gulf region, Malaysia has made much of the early running in developing investment-grade Islamic products, including Islamic real estate investment trusts (REITs) in the country. According to DH Flinders, an AsiaPacific corporate advisory practice that focuses on real estate, financial services, and small capital sectors, Malaysia’s early actions have proved vital to its current status. Executive director of the group, Stephen Hawkins, says that there is already a foundation in place with Shari’a law and an awareness of Islamic REITs. “Malaysia has Shari’a guidelines and Shari’a REIT guidelines, so there’s already a formal structure that provides fund managers and operators a structured environment to work within,” Hawkins says of the country’s structure.“It also provides the regulators with an

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

environment to regulate and investors will be able to see clearly how things will be structured and run in this market,” he adds. Guidelines for Islamic REITs were laid down by the Malaysian government as long ago as November 2005 through the Securities Commission (SC), which made Malaysia the first jurisdiction to introduce such measures. There are now two Islamic REITs in a total market of 13 REITs in the country. “Malaysia has an advantage over the rest of the region because it has taken the time to put those guidelines in place,” says Hawkins. Yet on a global level, he believes that there is still a large, untapped market for Islamic REITs which is yet to be

exploited, especially given the first signs of property recovery in some of the worst-hit Middle Eastern markets. “From an international perspective, there are lots of Shari’a investors in the Middle East that look to countries like Malaysia that have established guidelines. There’s an opportunity to provide more investment products to those investors to give them choice,” he reflects. A key factor driving the expansion of Islamic product offerings in Malaysia has been the country’s ability to drive down the cost of structuring such products without having to sacrifice on returns. One of the active players, Deutsche Bank in Malaysia expects more products to introduce a volatility target overlay to avoid excessive risk-taking, such as by using monthly rebalancing to ensure the target volatility is maintained. Islamic credit-linked notes are also expected to play a bigger role in the overall portfolio management industry in the near future. Singapore too has made no secret of its desire to be the principle Shari’a hub in Asia and Monetary Authority Singapore (MAS) has over the last few years facilitated the development of Islamic finance in Singapore’s financial markets. Several sizeable cross-border transactions have been achieved, including the world’s first Shari’a-compliant data centre fund (Securus Data Property Fund); the listing of the world’s largest Islamic REIT (Sabana Shari’a-Compliant REIT) on the Singapore Exchange, as well as Khazanah Nasional’s SGD1.5bn sukuk — the

APRIL 2012 • FTSE GLOBAL MARKETS

largest Singapore dollar sukuk to date. The spread of Islamic finance in South-East Asia is likely to gather momentum, especially in countries such as Indonesia and Brunei, where banks are seeing increasing investor interest in Shari’a-compliant alternatives to conventional financing. There is a big prize on offer, even given the current constraints on the market. According to consultancy Ernst & Young, global Islamic finance will hit $1.1trn in value this year, a significant jump up from $826bn in 2011. However, a closer look at recent developments reveals a mixed picture. While the Middle East's oldest Shari’a-institution Dubai Islamic Bank (DIB) achieved a 2011 net profit of $272.7m, an increase of 27.8% on the previous year, rival Emirates Islamic Bank (EIB) lost $122m dollars in 2011, after a profit of $16.2m a year earlier. Moreover, Kuwait Finance House, which specialises in real estate financing, at home and abroad, surprised the

market in late March reportedly announcing that it was divesting nonprofit making operations. Elsewhere, in October last year Dubai Bank, another Islamic lender, was taken over by the United Arab Emirates (UAE)'s largest bank, Emirates NBD, upon the orders of the Dubai government. Dubai Bank posted a net loss of $79m in 2009 and since then it has not reported figures. The stories go on and on. Bahrainbased private equity investor Arcapita Bank, which has a range of real estate investments in Bahrain and Dubai, is working with advisers ahead of imminent debt repayments totalling $1.1bn for the Manama-based group. The Shari’a-compliant group, which has many wealthy Gulf nationals as shareholders, is in talks with a coordinating committee of lenders, including Royal Bank of Scotland (RBS), plus advisers, including accounting and consulting group PwC and law firm Clifford Chance.

MAF TARGETS LOCAL FINANCE FOR CAIRO MALL

ubai-based developer Majid al Futtaim (MAF) has picked two Egyptian banks to arrange a loan worth around $500m, to continue to fund construction of its Mall of Egypt project. The project is a high density mixed use retail development, and the is expected to be opened in mid-2014. The Mall will be raised on a 160,000 square metre site in the Egyptian capital Cairo, and when completed will be one of the largest shopping centres in North Africa. Project sponsor MAF, which is the sole franchisee of Carrefour in the Gulf region, has reportedly had to instigate a number of accounting

FTSE GLOBAL MARKETS • APRIL 2012

write-downs of it’s assets in both Egypt and Bahrain last year. Nonetheless, it does not appear to have had any problems in its recent efforts to raise funds. MAF already has three malls, two hypermarkets and various supermarkets in Egypt. While MAF has suffered from the fallout from social unrest during the Arab Spring, the company’s assets remain buoyed overall. That’s because of the rising value of some of it’s holdings in the United Arab Emirates, making the firm a still-bankable prospect. Banque Misr and National Bank of Egypt will be lead arrangers for the deal. Interest in the deal is among syndicate members is likely to be restricted to local and regional banks as many international financiers now have restrictions on lending into Egypt following the political unrest which has dominated the country and many other parts of the Middle East. I

“From an international perspective, there are lots of Shari’a investors in the Middle East that look to countries like Malaysia that have established guidelines. There’s an opportunity to provide more investment products to those investors to give them choice,” says Stephen Hawkins, exectutive director of DH Flinders. Analysts are particularly concerned about the health of a number of Bahrain-based financial institutions’ health, given the rising cost of borrowing after the pro-democracy uprising damaged confidence in the economy and political stability. Elsewhere, while Islamic financing may be finding greater acceptance it has failed to make the deep inroads in the Muslim world that were originally anticipated, thanks in part to complications around Shari’a definitions and also because of the difficult investment market. While Ernst and Young expects Islamic finance to keep growing at a per annum rate of circa 15%, many Islamic retail investors enjoy much smaller growth rates on their Shari’a-compliant portfolios than they had expected or had been used to in the past. Indeed, although the breadth and cost-efficiency of Shari’a-compliant structured products have greatly improved, they are sorely missing a standardised platform and as a result a fragmented and relatively young market has been burdened by the problem that compliance rules often differ from region to region. This confusion is hampering market development and restricting the range of Shari’a-compliant platforms that can be used to create structured products. One of the major challenges the Islamic industry faces is a lack of con-

REaL ESTaTE

ISLAMIC FINANCE: DOES IT STIFLE REAL ESTATE INVESTMENT?

sensus regarding the interpretation and application of Shari’a principles, as well as market participants' ongoing preference for bespoke contracts over standardised versions. The lack of a ‘doctrine of precedent’ with regard to scholarly decisions has also led to regular inconsistencies in interpretation, and subsequent delays have been caused by ensuring Shari’a consistency and approvals. In Malaysia, one of the least restrictive Islamic markets, the bai’ ’inah concept allows investors to buy and sell the same asset and create products which would be considered interest-bearing in the Middle East, where interpretation of the compliance strictures is far more rigorous. However, despite its proactive stance, Malaysia remains predominantly a domestic market which is denominated in ringgit, limiting the interest from outside investors, while Middle East products are more usually US dollar denominated and offer the potential for broader appeal. Simon Gray, director for supervision at the Dubai Financial Services Authority in Dubai, reflects: "The scope for growth is tremendous, but much will depend on how Islamic finance copes with its own infrastructure. One hoped that Islamic finance would come into its own after the global financial crisis, but it has yet to make a massive impact." A more integrated infrastructure between Islamic and conventional

markets is developing elsewhere in Asia, with countries such as Singapore paving the way for an Islamic finance sector based on a single licensing and supervisory framework for both conventional and Islamic finance. A spokesperson for MAS explains: "The Singapore Islamic finance sector has achieved several milestones in recent years as a result of the authorities working closely with the industry. These include the launch of the FTSE SGX Asia 100 Shari’a Index, the FTSE Japan Shari’a Exchange Traded Fund on the Singapore Exchange and the listing of the world's first Shari’a-compliant Industrial real estate investment trust. The prospects for the industry are good as more institutions consider Shari’a-compliant structures." There are also signs that other corporates are becoming more interested in Islamic-backed real estate vehicles across the MENA region. In March of this year, Tecom Investments, a diversified conglomerate and a member of Dubai Holding, paid AED170m for a 25% stake in Emirates Real Estate Investment Trust “in addition to liquidity for pursuing new development opportunities," it said in a statement. Emirates REIT—the first REIT to be established in the UAE—was created in November 2010 with Dubai Islamic Bank and Eiffel Management and is a Shari’a-compliant real estate investment vehicle. Tecom CEO Abdul Latif Al

SHARI’A COMPLIANCE SPREADS SOUTH IN AFRICA

n March of this year Kenya licensed the country’s first ethical fund, an Islamic fund issued by First Community Bank Capital, a subsidiary of First Community Bank (FCB), one of the two Shari’acompliant banks in Kenya. The fund is the first to offer a collective investment scheme geared towards ethical investing within Islamic capital markets and will include real estate as one of its key targets.

“Kenya has ambitions of becoming the Islamic finance hub of East Africa as part of our wider aspiration to become an international financial centre,” says Stella Kilonzo, Capital Markets Authority’s (CMA) chief executive officer. Kilonzo says that the CMA will continue to encourage stakeholders in Islamic finance to explore opportunities available for structuring, issuance and investment Shari’a-compliant products, such as REITs and bonds. I

Simon Gray, director for supervision at the Dubai Financial Services Authority in Dubai, reflects: "The scope for growth is tremendous, but much will depend on how Islamic finance copes with its own infrastructure. One hoped that Islamic finance would come into its own after the global financial crisis, but it has yet to make a massive impact." Mulla says of the deal: "While we will benefit from the liquidity and exposure to increasing values in a resurgent local property market, we will also help Emirates REIT take a step forward in its vision of launching an IPO. It is essential that developers come forward to form strategic partnerships with Emirates REIT to lay the foundation for a professionally managed real estate market in the UAE." Hawkins stresses the need for a global market where real assets have regained popularity:“One of the underlying principles of Islamic finance is the need for an underlying asset, something real and tangible as opposed to bundled complex derivatives and other such instruments, the misuse of which caused the global financial crisis in the first place. Therefore, more tangible physical real estate, such as a building, has become more attractive to investors.” Yet to exploit that change in priorities fully, Islamic financing needs to create a more transparent assessment methodology and agree to a more uniform scholarly approach, which will allow products to be delivered to market more quickly. Despite the political turbulence of the Arab Spring and the deep fall in valuations across some of MENA’s most over-inflated nations, there is a sense that the region is in a comeback cycle. If Islamic financing wants to be the dominant player in any resurgence those holding the reins need to act quickly. I

APRIL 2012 • FTSE GLOBAL MARKETS

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dEbT REPORT

REVIVAL IN INVESTMENT GRADE EUROPEAN BONDS

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

The market for European investment-grade corporate bonds has witnessed a remarkable revival in the first quarter of this year, as fears of an imminent meltdown in the eurozone have abated (at least for now). Primary issuance has soared over the first three months of 2012, as investors have looked to put large holdings of cash to more profitable use and issuers have sought to take advantage of a dramatic compression in spreads. Andrew Cavenagh reports.

Primary issues soar in Europes investment grade bond market HE CATALYST FOR the recovery was the European Central Bank’s (ECB’s) injection of more than €1trn worth of liquidity into the banking system, through its two massive Long Term Refinancing Operations (LTROs) in December and February. Although the beneficiary banks may have invested relatively little of the proceeds in the bond markets directly, the LTROs did provide crucial reassurance that a big bank failure in the eurozone—with all the mayhem that would entail — was no longer a near-term risk. Suki Mann, head of cross-asset research at SG Corporate and Investment Banking, says the intervention of the central bank had been pivotal to the resurgence in the corporate bond market. “It was all about sentiment and giving investors the confidence that the ECB facility had

alleviated the risk of a systemic crisis.” Once the ECB’s first €487bn LTRO had allayed this fear, investors clearly regained the confidence to plough the large cash surpluses they had accumulated into investment-grade debt that by then were offering highly attractive spreads. “I think the penny dropped towards the end of January, and investors began coming back into the market,” says Roger Sadewsky, investment director for corporate bond and absolute return funds at Standard Life Investments in Edinburgh.“There was a fear at the end of last year that we might see banks liquidating assets at any price, and the markets were pricing in a huge amount of risk.” Spreads have since come in rapidly as a consequence. The iBoxx corporate cash index tightened by 53 basis points (bps) in January, then by

another 39bps in February, and a further 25bps by the middle of March, while the spread tightening on some large individual corporate credits has been considerably more pronounced. Telecom Italia, for example, saw its notional cost of borrowing more than halve from a spread of 720bps over German bunds in January to 350bps in March. “For them, it will now be a fantastic trade whenever they decide to do a deal,” observes Mann. Meanwhile, Eastern Power Networks (EPN), one of the monopoly electricity distribution network operators in the United Kingdom, owned by UK Power Networks and rated Baa1/BBB+/BBB+, mandated Lloyds, Mizuho and RBC Capital Markets to lead manage a £150m tap on its £250m 4.75% issue due September 30th 2021. EPN was last in the market in September 2011 when it issued a

APRIL 2012 • FTSE GLOBAL MARKETS

“I think the market for highgrade corporates will remain robust, while the subinvestment grade sector is certainly going to alternate more between risk-on, riskoff. High-grade corporates are probably among the best bets there are in the fixed-income market right now,” says Eden Richie ten-year £250m deal led by Barclay’s, BNP Paribas and Lloyds. There has been a proliferation of new issues over the first three months of 2012 as companies have looked to tap the improving market to fix into long-term debt on advantageous terms (before the window closes and/or interest rates rise). Issuance of non-financial, European investmentgrade corporate bonds in the 11 weeks up to mid-March totalled €42.2bn; compared with a figure of €90.1bn for the whole of 2011. The average maturity for eurodenominated investment-grade corporate bonds issued in the first two months of this year is around four and a half years; though the average maturity during the last week of February and the first week of March, according to London based news group BreakingViews, fell just short of seven years. In this environment, high-beta names and crossover credits will be able to tap the markets; moreover, according to some commentators we may also begin to see longer dated paper (as far out as 20 years could be possible). At the same time, demand for the paper has become so strong that by the beginning of March, the Dutch brewing group Heineken was able to price €1.35bn of debt, split between seven-year and 12-year bonds, at a discount to secondary-market pricing levels (although some investor resistance to this trend of pricing through

FTSE GLOBAL MARKETS • APRIL 2012

the secondary curve was starting to surface by the middle of the month). All 33 of the new issues up to that point were also trading comfortably inside their launch spreads, most of them by a considerable margin. The most extreme case was the two-year, triple-B rated bond with a 6% coupon that the French car maker Peugeot launched in January, which by midMarch had come in by 281bps. There was a similar surge in the market for European investmentgrade credit in the first quarter of 2011, of course, which fell away sharply as concerns about the sovereign crisis in the eurozone escalated from the second quarter of the year onwards. Most expect the revival to be more enduring this year, however, given that the immense liquidity that the ECB has provided through the LTROs should underpin confidence in the financial markets for considerably longer than the various abortive measures that the EU authorities tried to introduce last year. Eden Riche, the head of debt capital market origination at Investec, pointed out that the relative credit strength of investment-grade corporate debt (excluding financials) against other types of fixed-income investment should provide further support for the market––and sustain current spread levels––throughout the rest of 2012. “I think the market for high-grade corporates will remain robust, while the sub-investment grade sector is certainly going to alternate more between risk-on, risk-off,” Riche says. “High-grade corporates are probably among the best bets there are in the fixed-income market right now.” Despite these encouraging factors, however, there are still grounds for a measure of caution. For a number of potential political and economic developments in the eurozone this year could rapidly disrupt all bond markets once more and swiftly reverse the gains that investment-grade corporates have made in the first quarter.

Chris Bowie, head of credit at Ignis Asset Management. “I cannot see the eurozone sustaining itself without some kind of fiscal-transfer mechanism, which at the end of the day will involve German taxpayers supporting the weaker economies for a decade or more,” notes Bowie. Photograph kindly supplied by Ignis Asset Management, March 2012.

The outcome of the French presidential election on April 22nd (with a further poll on May 6th if a run-off proves necessary) is a case in point. A triumph for the Socialist candidate François Hollande, whose policies include a plan to impose a 75% tax on all French households with an income of more than €1m a year and a commitment to renegotiate the EU’s fiscal compact, would certainly see the market retrench on the uncertainty (whether or not Hollande moderated these policies on actually assuming the presidency). The sovereign-debt crisis could also instigate further alarm across the markets before the end of 2012, as the deteriorating situation in Portugal (sovereign spreads remaining at an unsustainable 12.5% and GDP forecast to decline by 3% this year) threatens to undermine the assertion of the EU’s leading politicians and bureaucrats that Greece was a one-off special case.

dEbT REPORT

REVIVAL IN INVESTMENT GRADE EUROPEAN BONDS

Roger Sadewsky, investment director for corporate bond and absolute return funds, Standard Life Investments. “I think the penny dropped towards the end of January, and investors began coming back into the market,” says Sadewsky. “There was a fear at the end of last year that we might see banks liquidating assets at any price.” Photograph kindly supplied by Standard Life Investments, March 2012.

There is a growing belief in the markets that Portugal will have no option but to follow the Greek example and seek a second EU bailout. The country will probably need to restructure its debt as well. Either event would surely see confidence across the bond markets evaporate. The fresh bout of contagion (and speculation as to which country would be next) would severely impair the ability of both sovereign debt markets and the banking sectors in the weaker European countries to function. It might, thinking of the words straw, camel and back, probably initiate a break-up of the eurozone (at least in its current form). Some investors already believe this will be inevitable; unless, of course, the EU rapidly adopts a meaningful stance on fiscal union. “I cannot see the eurozone sustaining itself without some kind of fiscal-transfer mechanism, which at

the end of the day will involve German taxpayers supporting the weaker economies for a decade or more,” notes Chris Bowie, head of credit at Ignis Asset Management. “If the Greek situation does happen again [in Portugal], where does it end?” he continues.“For me, these key questions have not been resolved. The LTROs may have solved the shortterm liquidity concerns, but they have not addressed the fundamental solvency problem.” For this reason, Bowie said Ignis was continuing to shun the senior debt of European banks, which has followed the same trends as that of non-financial corporates over the first quarter (a tightening of spreads generally and notably for new issues post-launch). Despite the improvement in banks’ borrowing costs in the senior unsecured market, he pointed out that they were still not able to raise subordinated debt. “We have not liked banks since 2010,” he adds. Even the non-financial, European investment-grade credits that most investors currently view as relatively insulated from the eurozone’s woes, such as large utility groups with interests outside the EU and international manufacturers (such as car makers BMW and Volkswagen) with plenty of exposure to the high growth markets in the developing regions of the world, could suffer if Portugal precipitates a further crisis in the peripheral countries.“If they’re domiciled in Italy or Spain, they could be vulnerable to windfall taxes,” says Bowie. The ultimate solution to the broader solvency problem (for both sovereigns and the banking system), of course, will be sustained economic growth in the peripheral countries. There seems to be little prospect of that in the medium term, however, as their economies face a continuing squeeze from EUimposed austerity measures and an uphill struggle to improve their international competitiveness within the constraints of the single currency.

According to a recent assessment from Moody’s Analytics, the entire eurozone economy shrank in the final quarter of 2011 for the first time since 2009. The report said the 0.3% decline in GDP against the preceding three months would also have been “substantially worse” had it not been for a 1.2% decline in imports and warned that the outlook was still highly uncertain in the absence of a final solution to the debt crisis.“The upside to growth will be limited by governments imposing fiscal austerity measures across the region,” it concluded.“Even core economies such as France and Italy have had to introduce measures to rein in their ballooning budget shortfalls.” Sadewsky at Standard Life points out that two other reasons for bond investors to exercise caution at present were the outlook for interest rates and the ongoing reduction in market liquidity. He says investors were undoubtedly “getting nervous” about the prospect of interest-rate hikes at some point over the next two years, while the scaling-back of market-making operations at large investment banks (which seems certain to be a permanent change as the tougher regulatory capital rules of Basel III come into effect) meant liquidity was now a lot more challenging and exacerbated by swings in investor sentiment. “What that means for us is that liquidity, while poor anyway, rapidly deteriorates when the market takes a downturn,” he explains. “Markets seem to be either very cheap or very expensive for us, but they tend not to stay in either position for long.” As a consequence, he says Standard Life’s investment decisions now required rigorous work on both the macro environment and its underlying constituents. “Spreads have compressed very suddenly, and it comes down to individual issuers, individual structures and even individual bonds. I think you’ve got to tread carefully.”I

APRIL 2012 • FTSE GLOBAL MARKETS

dEbT REPORT

INVESTMENT OPPORTUNITIES IN EUROPEAN DISTRESSED DEBT

Slow but steady deleveraging in European banks and the existence of a large slug of debt that requires refinancing is opening up new investment opportunities for private equity and hedge fund investors. With a dearth of opportunities in the distressed debt space in the United States, American alternative asset managers are now very interested in what Europe can offer. A raft of regulations and European directives are urging on European banks to recapitalise, but up to now banks have been reluctant to sell off distressed assets at deep discounts because they are still unable to absorb large capital losses. Even so, investment managers look to be prepping for a period of sustained deleveraging across Europe and the opportunity to provide alternative sources of capital as banks continue to lend less. However, recent market interventions by the European Central Bank (ECB) look to have given banks more time to restructure their balance sheets. Lynn Strongin Dodds reviews the implications.

Will Europe’s distressed debt offer rich pickings for investors? OR SOME TIME now, a virtual cavalry of US hedge fund and private equity managers have ridden into Europe in search of distressed opportunities. A combination of regulation, structural changes, austerity cuts, the ongoing eurozone crisis and sluggish economies set the scene but so far the landscape has not radically altered. Investors are waiting with bated breath but recent actions by the European Central Bank (ECB) may have put a chink in their plans. Late last year, the ECB launched its three year Long Term Refinancing Operation (LTRO) in the hope of staving off a second credit crunch. The first tranche of €489bn was fired into the market last December and used by 523 banks. This was followed in March by €530bn being pumped in and tapped by 800 banks. The prevailing view is that this extra boost of liquidity has given banks a new lease of life, enabling them to restore their cash reserves, generate capital through operations and avoid any immediate asset fire sales (please refer to FTSE Global Markets, Issue 59, page 14 for more analysis). Robert Marquardt, founder, chairman and co-head of investment at Signet Group, the fixed income hedge fund specialist firm, explains the context,“We all know what the opportunity should be in terms of banks restructuring and deleveraging, but some of the pressure is

FTSE GLOBAL MARKETS • APRIL 2012

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

off thanks to the LTRO. It gives banks time to convalesce and rebuild their balance sheets. We are in a better environment and the loans can be swapped out in the bond market and refinanced.” The LTRO has also helped oil the wheels of the credit markets especially high yield which had virtually shut down last summer when Greek’s problems appeared to be spiralling widely out of control. The Merrill Lynch Euro high yield index dropped 14% from its 2011 peak in May to its October trough as worries over Europe's deepening debt crisis pushed investors to cut their bets and shun risk. The index has since rebounded to around its May levels,

fuelled by recent statements from the ECB president Mario Draghi that the worst of the eurozone crisis may be over. “Distressed managers came expecting opportunities but I do not think anyone foresaw the high yield market to open as it has,”says Solomon Noh, partner at in the bankruptcy and reorganisation group at international law firm Shearman & Sterling. “This has allowed companies to refinance their debt and we are seeing the continuation of the extend and amend agreements in the hopes that the economy and companies’ finances will improve.” As with any investments, it is a question of timing, according to Damien Miller, portfolio manager at credit investment boutique Alcentra. “When you talk to investors, everyone is waiting for the Lehman Brothers moment and for the market to explode. I think there will be opportunities much choppier because of central bank intervention,” he says. Jon Macintosh, manager, Acencia Debt Strategies adds,“You would have thought that when the capital markets froze in 2008, there would have been a feeding frenzy for distressed debt in Europe but that was not the case. Only a few deals have happened. Investors have been consistently disappointed - maybe at some point the floodgates will open but I think instead we are likely to see a steady slow stream of transactions.”

dEbT REPORT

INVESTMENT OPPORTUNITIES IN EUROPEAN DISTRESSED DEBT

“Distressed managers came expecting opportunities, but I do not think anyone foresaw the high yield market to open as it has,” says Solomon Noh, partner at in the bankruptcy and reorganisation group at international law firm Shearman & Sterling.” Photograph kindly supplied by Shearman & Sterling, March 2012.

Hope though springs eternal and this has not stopped US fund managers from casting their nets across the pond. Currently, nine private equity firms, including Warburg Pincus, the Blackstone Group and Apax Partners, are seeking to raise a combined $184bn for funds targeted at Europe, according to the data provider Preqin. That compares with the $62.1bn that was raised last year for Europefocused funds. They join their hedge fund compatriots who have already been busy canvassing interest. The list includes Strategic Value Partners which raised $918m for its Strategic Value special situations fund II, more than double its original target of $600m as well as Oaktree Capital Management which activated a $2.6bn distressed debt fund. Other notable mentions are Columbus Hill Capital Management, Marathon Asset Management and Avenue Capital Group. European managers such as GLG, Sothic Capital Management and Fortelus Capital Management have also thrown their hat into the ring. Recent

entrants also include Northill Capital, which is seeding Goldbridge Capital Partners, a new credit boutique focused on the distressed debt and high-yield markets as well as hedge fund manager CQS which recently launched the CQS European Distressed Debt Fund. One reason for the influx of Americans is that there is dearth of distressed opportunities in the US, according to Noh. Corporate America started the de-leveraging process in the wake of the dotcom debacle in 2003 and the momentum only gathered pace after Lehman Brothers collapsed. Industries ranging from auto manufacturers to airlines, financial institutions, and retailers have already undertaken painful restructuring measures. Europe has lagged behind with banks being reluctant to purge assets at the steep discounts that were on offer while companies have been slow to streamline their operations and restore their balance sheets. The much discussed "wall of maturities", ready to be unleashed in a wave of restructurings did not materialise and instead there has been a trickle of companies who have been forced to reorganise their operations. This includes. the travel giant Thomas Cook, hotel group Travel Lodge, food producer, Premier Foods and lingerie chain La Senza as well as Italian yellow pages Seat Pagine Gialle and Eksportfinans, Norway’s export credit agency, which is being wound down. More recently Fitness First is reportedly close to accepting a lifeline by the Oak Tree Capital fund which wants to swap its debt [it owns more than a third] for an equity stake. Owners BC Partners, which paid €1.2bn for of the UK’s third largest fitness operator by membership in 2005, have signalled it may not be able to meet an £18m interest payment due to debt holders in March. It is no surprise though that these sectors have come under scrutiny as they are among the most vulnerable to an economic downturn. “If you look at the deals that have been done there has been a mini-glut in the retail and leisure business and I think this will continue,”says Iain Burnett, head of distressed debt at

Damien Miller, portfolio manager at credit investment boutique Alcentra. “When you talk to investors, everyone is waiting for the Lehman Brothers moment and for the market to explode. I think there will be opportunities much choppier because of central bank intervention,” says Miller. Photograph kindly supplied by Alcentra, March 2012.

BlueBay Asset Management. “However, the underlying problems are huge due to the debt overhang in the corporate world and they will have to be addressed. You can’t keep sticking a plaster on the problem and we are looking at a decade of debt being unwound.” In fact, there is an unprecedented amount of debt due to mature over the next three years that is likely to overshadow the availability of credit. Industry estimates show that around €140bn ($198.6bn) of leveraged loans alone will need refinancing, starting this year.“The structural problem has to be addressed," says Mark Unferth, head of distressed strategies at CQS. "In many cases Europe has resisted any form of restructuring or deleveraging and we think you will see a variety of assets put to the market for sale because of the need for Europe-wide deleveraging. The capital markets in Europe may not be open to highly leveraged corporates any more." Analysts believe that corporate defaults rates albeit low today could start

APRIL 2012 • FTSE GLOBAL MARKETS

to creep up by the end of the year. "We are in a better situation now than last year thanks to central bank liquidity and because we did not enter a deep recession,”says Alberto Gallo, European credit chief at Royal Bank of Scotland. “Moody’s high yield default rates climbed to 3% in the November to December period last year from 2.5% in October but they are now back to 2.7%. We are forecasting high yield defaults to rise to 4% by the end of the year and I expect the companies that will be most affected and offer the most opportunities for distressed funds will be small firms. Patrick Flynn, a co-manager of the Neuberger Berman distressed debt fund also believes that investors should be looking at the smaller end of the corporate sector.“I think the larger companies will be tapping the high yield and institutional leveraged loan market for financing but smaller companies are having a hard time accessing the capital markets. I also believe that there will be increased pressure for banks to address their non-performing loans.” In fact, the European Union will be the first to implement the Basel III global rule book via the Capital Requirements Directive IV, a set of amendments to the existing capital requirements directive that sets out

Mark Unferth, head of distressed strategies at CQS, the global multi-strategy asset management firm. "In many cases Europe has resisted... deleveraging and we think you will see a variety of assets put to the market for sale because of the need for Europe-wide deleveraging,” says Unferth. Photograph kindly supplied by CQS, March 2012.

regulations for bank capital. According to research from Morgan Stanley, European banks will have to downsize their balance-sheets by €1.5trn to 2.5trn ($2tn-$3.4trn) over the next 18 months,

which represents shrinkage of some 3.5% of total European banking assets. The bailed out or partially nationalised banks in Ireland and the UK which have already have taken several hits may offer the most opportunities in the short term. Lloyds’ sale of a pool of £500m of largely UK leveraged loans to Sankaty, a Boston based debt investment arm of Bain Capital, is the most recent example of a bank in the United Kingdom de-leveraging its balance sheet. Continental banks, by contrast, have not written down the value of their loan portfolios as much and they may be able to shield under the LTRO umbrella for a longer period. However, investors keen to leverage Europe’s distressed debt market may be heartened by the fact that European banks must meet increased capital ratio requirements set by the European Banking Authority (EBA) following last year's stress tests by the end of June this year. The EBA says banks need to raise some €115bn euro in new capital. Additionally, according to recent data from Thomson Reuters some €264.5bn in European sponsored loans are due to be refinanced by the end of 2014; a fact which should present the alternative funding segment with some interesting opportunities as access to traditional sources of capital is expected to remain constrained through the duration. I

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IndEx REVIEw

THE OUTLOOK FOR THE SECOND QUARTER – MIXED SIGNALS

Will Europe once again dampen market optimism Equity markets ended the first quarter well and recorded some of the best gains for Q1 for many years. April has not fared so well, markets look to be spinning once again. However the overriding fear remains that we see a repeat of a year ago. Early on in 2011 expectations were that an economic recovery was gaining traction, only for the European sovereign debt crisis to blow up later in the year. Simon Denham, managing director of spread betting firm Capital Spreads, as always takes the bearish view. HEN WE LOOK back on the first quarter of 2012 we will remember it for a decent rally in stock markets at a time when Greece defaulted on its debt but still managed to remain in the eurozone. For those wishing to hear an end to the European saga unfortunately this one is going to drag on and on. First up in second quarter after the Easter break is the French general election. This will be an interesting one to watch as the polls currently point to a new socialist leader gaining popularity via his banker bashing stance, and plans to reverse much of the reforms made by the incumbent President. The policies touted around are not the most fiscally prudent so we’ll be keeping an eye on the French bond market, which might give an indication of just how investors feel about any change in office. Businesses look to have become slightly more optimistic about the future and are starting to recruit a few more people in expectation of improving growth. However, they continue to hold back from really ramping up investment as they don’t want to have their fingers burnt again; just as they did this time last year. There’s a high probability that another European nation might become embroiled in the still bubbling euro crisis—either Portugal needing

another bailout, or the possibility that Spain and Italy (far bigger economies that those bailed out so far) suddenly fall off their tightrope. The eurozone focus at the end of March has really shifted onto Spain which has just entered another technical recession. The markets have, up to now, been rather sanguine about the growing unrest in the country and have been calmed by the news in late March that European leaders (sorry, I meant Germany) have agreed to increase the bailout facility with a few extra hundred billion euros. The fact that confidence surveys have not yet fallen off a cliff gives some degree of comfort. However, this is no reason to be complacent. Higher borrowing costs in peripheral Europe are pretty much a given through the second and third quarters this year. A banking sector still living on life support will continue to add its own strains into the system. Businesses may be a little more confident but other indicators of investment intentions such as industrial confidence have been less sanguine. Moreover, the impact of the weak financial sector is not just limited to investment and the corporate sector: it also has an impact on the consumer sector. As the eurozone continues to skate on thin ice one of the big questions for Q2 will be whether the UK will follow

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

Spain into recession and this is certainly the view of the OECD for the last quarter. They are in the minority at the moment with most people expecting the UK to narrowly avoid a double dip, but it’s going to be a close call. In the UK too, there are problems of another sort to contend with, which could continue to scupper the coalition’s best laid plans. Already upset with the escalating price of oil, motorists were panicked into bulk buying of petrol as the government attempted to head off the prospect of an Easter weekend strike by tanker drivers. The result: the Easter holiday period began at a time when the expected uptick in consumer spending is not happening and when your central bank is hoping on a consumerled recovery. Any poor retail data coming up in the next few months will not be welcome news at all. But then, if you look to Europe, your wallet may begin to feel as if it’s going to shrink. The second quarter has got off to a market correction. However, if you continue to see the main engines of global growth, such as China and the US, releasing economic data that consistently beats expectations then no one will want to get in the way of a raging bull. As ever, ladies and gentlemen: place your bets! I

APRIL 2012 • FTSE GLOBAL MARKETS

CALIFORNIA RAIL Mock up photo of the proposed high speed rail link in California. Photo kindly supplied by HSR, March 2012.

California’s vision for high-speed passenger rail was hailed as the answer to congested freeways and crowded airports as well as a blueprint for other states to follow. Now, the $100bn project is in disarray, beset by criticism on all sides and with no long-term financing in hand. Governor Jerry Brown has appointed a new board chairman and is putting his weight behind the project. Is this change a fresh beginning or the beginning of the end? Art Detman reports from Los Angeles.

Train to tomorrow — or to nowhere? F CALIFORNIA IS where the future comes from, then advocates of high-speed rail service in America must be despondent. Just a couple years ago plans of the California High-Speed Rail Authority called for spending $45bn to build an 800-mile system by 2020, America’s first high-speed rail system. Bullet trains zooming at speeds up to 220mph would link San Diego in the south to San Francisco and Sacramento in the north. Service would be so frequent — every four or five minutes at peak hours — and so affordable ($105 between LA and Frisco) that 54m passengers would board each year. There were sceptics, of course, and some fierce opposition. Californians though had back in 2008 passed Proposition 1A, which authorised selling $9.95bn in bonds to finance the first step in what would be America’s single most expensive public works programme. Hollywood and Silicon Valley would be just two hours and 40 minutes apart by bullet train, LA and Sacramento just two hours and 17 minutes apart. This all changed in November, when the Rail Authority released a revised business plan. The cost had climbed to $65.4bn and the completion date was pushed out to 2034. While the one-way fare had dropped to $81, expected ridership was now no more than 44m, perhaps only 27m. As for the initial construction segment, it would cost $6.2bn, to be paid for with a $3.5bn federal grant and $2.7bn from the sale of Prop 1A bonds. For this, the

FTSE GLOBAL MARKETS • APRIL 2012

Authority would get 130 miles of track in the Central Valley, beginning just north of Bakersfield (population 348,000) and ending just south of Merced (population 79,000). Electrification, signals, and the actual trains would be extra. Moreover, the plan — an evasive document of misdirection and optimistic assumptions — assumed that both the federal government and private investors would provide additional money to continue building out the system. With a 3% annual inflation adjustment factored in, the total cost would be $98.5bn. Critics howled. High-speed rail (HSR) in California would be an economic disaster; a train to nowhere. Even many HSR supporters expressed grave concern, among them Richard Tolmach, president of the California Rail Foundation, organised in 1987 to promote HSR. “It’s hard to justify anything that’s a $98bn proposal and for which there’s no long-term state funding,” he says. Republicans like Congressman Kevin McCarthy of Bakersfield, who is majority whip in the House of Representatives, moved to delay or kill HSR in California. (Although the Authority was formed under Republican Governor Pete Wilson in 1996 and Prop 1A passed with the backing of another Republican governor, Arnold Schwarzenegger, today virtually only Democratic elected officials favour California HSR.) In early January the Peer Review Group, established to provide arm’s length analysis of the Authority’s actions,

CALIFORNIA RAIL

issued a blistering report. Construction should not begin, it said, because no source of long-term financing has been identified, the projected ridership figures are suspect, and the Authority’s supervision of its contractors is woefully inadequate. In short, the plan represents “an immense financial risk” for the state. The Authority disputed the Peer Review Group’s report, stating it was“deeply flawed, in some areas misleading and its conclusions are unfounded.”Even so, criticism continued to mount. The Legislative Analyst’s Office, a nonpartisan advisor to the state Senate and Assembly, and the state auditor both took strong positions against the project as proposed. Opinion polls showed that Californians had turned against HSR by nearly a two to one ratio. On a single day in mid-January, both the Authority’s board chairman and its chief executive officer unexpectedly resigned. The chairman, Southern California attorney Thomas Umberg, remains on the board but was replaced by Dan Richard, a Northern Californian attorney and a longtime ally of Governor Brown who has 12 years’ experience on the board of BART, the Bay Area Rapid Transit Authority, a rail system that connects San Francisco with Oakland and inland cities. The chief executive officer, Roelof van Ark, a South African-educated electrical engineer with extensive HSR experience in Europe, stayed on until March to allow time for the Authority to recruit a replacement (American experts in HSR construction are rare, and van Ark’s position was unfilled when he departed). Van Ark was hailed for his extensive high-speed rail experience when he was named chief executive officer in 2010. However, while legislators admired his technical expertise, apparently they lost confidence in his political skills after the release of the revised business plan.

Economics, or social engineering? There is more going on in the struggle over California highspeed rail than mere economics. To political conservatives, the entire concept smacks of left-wing social engineering. Once built, high speed rail wouldn’t be simply another choice for travelers wishing to get from one place to another. Instead, it would enable the government to force people out of their cars and suburban single-family houses and into trains and high-rise downtown apartment buildings. In this respect, the fight over HSR recalls the battles fought over the introduction of social security, fluoridated tap water and Medicare. The issue is resistance to a growing and ever more intrusive big government, rather than cost alone. Although controversial, HSR isn’t a new idea in California. During his first stint as governor (1975-83), Brown signed legislation to study the idea. By then Japan’s Shinkansen bullet train had proved itself in a decade of service and the French were developing the TGV. In the event, nothing came of HSR in California as Brown was distracted by other ambitions, namely two runs for the US presidency and one for the US senate (all in vain). Although home to 37m people, California has fewer people than countries such as Spain or France, both of which

The proposed high speed rail hub in Anaheim, California. Photograph kindly supplied by HSR, March 2012.

have vigorous HSR systems. Moreover, compared with Japan, where the bullet train originated, California is thinly populated. “The population density in California is 241 persons per square mile,” says Robert Kleinhenz, chief economist for the Los Angeles County Economic Development Corporation, which has not taken a position on HSR. “Japan’s population density is 836 persons per square mile.” True enough, but many of California’s largest cities (San Diego, Anaheim, Los Angeles, Bakersfield, Fresno, San Jose, San Francisco and Sacramento) are mostly too far apart for easy driving and too close for economic air travel. The 400mile LA-San Francisco trip is America’s busiest short-haul air corridor, and runway delays are common. Air travel to Central Valley cities, on the proposed route of the bullet train, is pricey. On a recent morning, a round-trip fare between LA and San Francisco was $158; between LA and Fresno — 219 miles apart — it was $224; the fare between Bakersfield, 112 miles from LA, was even higher. As for driving, peak hour traffic is stop-and-go between San Jose and San Francisco and Los Angeles and Anaheim. All this is an argument for HSR, but then again California’s spectacular scenery is an argument against it. The state is embraced by mountain ranges, dotted with national and state parks, and in the San Francisco Bay area awash with rivers and wetlands. The Coast Range hugs the Pacific shoreline and forms the western flank of the bountiful Central Valley. On the eastern flank rise the towering Sierra Madre (fortunately too far east to affect any currently proposed HSR route). In the south, a mountain range bisects Los Angeles, where the elevation within the city limits soars from sea level to 5,081 feet. The summit for Interstate 5 between LA and the Central Valley is a mile high and sometimes closed by snow. This daunting topography, combined with the need to eliminate grade crossings, means that 43% of the proposed HSR route comprises tunnels or viaducts. At one time, the Authority considered building its line from LA to San Jose following for the most part Interstate 5, which runs arrow-straight along the Valley’s sparsely populated western side. Now, plans are to lay tracks

APRIL 2012 • FTSE GLOBAL MARKETS

through the Antelope Valley (where, yes, antelope were once abundant) and follow state highway 99 on the Central Valley’s eastern side. Stations will be built at Palmdale, Bakersfield, Hanford and Fresno, at which point the line will turn west to Gilroy, then north to San Jose and onward through Silicon Valley to San Francisco. Later, the line would be extended from Fresno north through the inland cities of Merced, Modesto, Stockton and Sacramento. The Route 99 choice was contentious. “If we were to have an efficient, high-speed rail line in California, you’d build it right next to I-5 and link the Bay area with Los Angeles,” says Tolmach, who believes the route serving inland cities was chosen to reward politically connected land owners. But most experts favor the Antelope Valley path. “This is the correct route,” says Mark Pisano, West Coast director of America 2050, a national planning group, and a professor at the University of Southern California. “This route solves several transportation problems at once. It eliminates huge deficiencies in service to inland cities like Bakersfield and Fresno. Then over time, as you make these investments, you will be able to link San Francisco and Los Angeles.” Then, too, goes the argument, the Antelope Valley route will encourage population growth where growth is already taking place. Fresno, for example, now has a metro area population of 1.1m. Bakersfield has more than tripled in size in the past 30 years, while Stockton’s population has doubled. As we’ve seen, these are orphan cities as far as the airlines are concerned. That would change with HSR. As Tom Umberg likes to note, Angelenos could zip over to Bakersfield for a morning meeting and be back in LA for lunch. Furthermore, HSR proponents believe that connecting the string of inland cities—from Palmdale in the south to Sacramento in the north—will not only improve access to these communities but also revitalise their economies. Sacramento, the state capital, is relatively prosperous. Inland cities to the south however have some of the highest poverty, unemployment and crime rates in America. For example, on a per capita basis, Stockton — a city of 300,000 — is near or at the top in both home foreclosures and homicides. Martin Wachs, a transportation expert at the RAND Corporation, takes a view that conservatives would cite as evidence of the social-engineering goals of HSR.“There is an opportunity to use high-speed rail to save the future of the state physically,” he says. “An opportunity to preserve the Central Valley as prime agricultural land by concentrating development at station-side, to encourage the growth of these inland cities at their core rather than at their edges. If properly articulated with land-use policies, highspeed rail could be an important element of planning California’s future.” Equally contentious is where to start laying tracks. Should work begin in the Central Valley, the “backbone” of the system? Or in the urban centers of San Francisco-San

FTSE GLOBAL MARKETS • APRIL 2012

A view of the interior of the proposed high speed rail station at San Jose, California. Photograph kindly supplied by HSR, March 2012.

Jose and Los Angeles-Anaheim, the “bookends”? Some experts, including Pisano of America 2050 and Louis S. Thompson, a transportation consultant and member of the Peer Review Group, favor the bookends. They argue that work should begin where the most passengers are, where improvements would be achieved soonest, and where revenues would be generated quickest. This widely held view is hotly disputed by van Ark. “The decision to start building in the Central Valley is 100% correct,” he says.“If you put $6bn in the bookends, you would achieve nothing that equates to a high-speed rail infrastructure at all because in the bookends you would never operate at high speed. High-speed rail won’t make much difference to someone traveling from Los Angeles to Anaheim because the train can travel at only 60 to 80 miles an hour. That’s not high-speed rail. That’s fast commuter rail or regional rail. Our job is to build out a real high-speed rail system that will connect Northern and Southern California, and the only way to do that is by first building the backbone between Northern and Southern California. You do not do that by first putting money into the bookends because that means that you will never get to build the backbone.” In truth, the Authority doesn’t have much choice. The federal grant of $3.5bn is contingent upon its being used only to fund the Central Valley line. What’s more, it appears that work must be started this year in order to qualify for the money. Chairman Richard is trying to achieve a truce between the backbone and bookend views. He wants construction of the backbone to begin first, in September, but he’s working with local governments to obtain their cooperation in upgrading the bookends to first handle faster trains and then provide the overhead catenaries that the electric bullet train will need. He may be able to offer a sweetener in the form of $3bn from a second round of Prop 1A bond sales. He also won over some critics in April by proposing to use existing track in some areas, to achieve a “blended” system that would save $30bn and reduce the projected cost to $68.4bn.

CALIFORNIA RAIL

Building HSR and a legacy With the surprise shakeup at the top, the entire plan for high-speed passenger rail service in California appeared to be in disarray. But as the dust settled it became clear that Governor Brown had taken ownership of the high-speed rail plan. Brown is a Democrat whose father, Pat Brown, also a Democrat, as governor in 1959-67 presided over the creation of California’s university system, freeway network and state water project (each an example of social engineering). “From here on out, Jerry Brown has full responsibility for high-speed rail in California,” says Thompson of the Peer Review Group. “It may seem from the outside that things are in disarray,” concedes van Ark.“But I think you must look at something that is very positive, and that is that the governor is standing strongly behind the project. Projects of this nature can be a success only if you have a champion.” That’s true. What’s more, California’s HSR program is in better shape than it might appear. For one thing, Richard is serving full-time as executive chairman, even though the law calls for only a part-timer, as Umberg was. (The pay, $500 a month, remains the same.) The Authority has been placed within the powerful California Transportation Department (Caltrans), and it is adding more managers to supervise the work of consultants. Two state electoral reforms — redistricting by an independent commission and the open primary — may end the Republicans’ ability to block all tax increases. The California economy, eighth largest in the world, is expected to top $2trn this year, 20 times the total projected cost of the HSR programme over the next 22 years. Moreover, Brown believes the project can be done for much less than the current $98.5bn price tag; and while the state’s economy is steadily recovering from the Great Recession, bids on public works programmes remain 10% to 30% lower than in 2005 and 2006. Low construction prices mean little without adequate funding however. As Thompson, a staunch advocate of HSR, points out, there is no federal program in place to finance high-speed rail anywhere in America, and there is no state program to finance it in California. On the federal level, President Barack Obama is a strong supporter of HSR and has proposed spending $13bn over the next five years on high-speed rail. Even though Congressional Republicans remain largely opposed to HSR, Richard is optimistic. “We will need a significant amount of federal

“It may seem from the outside that things are in disarray, but I think you must look at something that is very positive, and that is that the governor is standing strongly behind the project. Projects of this nature can be a success only if you have a champion.” say’s Roelof van Ark, former CEO of BART.

The proposed high speed rail station in Sacramento, California. Photograph kindly supplied by HSR, March 2012.

funding, and we think that over time it will be there. The current political environment doesn’t allow for it, and that’s okay. We didn’t assume any federal funding for the next three years.” Richard also is confident that, once an initial operating segment is built — from Bakersfield north to the Bay area or from Fresno south to LA — private investors will be interested in providing the rolling stock and operating the trains in return for all the fare revenues. “All of our numbers show that we will have revenues far in excess of the operating costs,” he says. The high cost of gasoline and air travel also favours HSR. Expensive petrol in California appears here to stay. Meanwhile, the airlines have made it clear that they intend to avoid returning to the days of overcapacity and low fares. A favorite place to cut service is to cities like those in the Central Valley. But perhaps the most important factor favoring California HSR is Jerry Brown’s burning desire to leave a lasting legacy. In his State of the State speech to legislators, Brown recalled opposition to the Central Valley water project, the national interstate highway system, and BART. “The critics were wrong then, and they’re wrong now,”he said, imploring his audience to approve necessary funding “without any hesitation.” Almost certainly he’s right. The question isn’t if California should build high-speed rail but how. The state’s population continues to grow—by one estimate it will reach 60m by 2050—and it is wishful thinking to believe that air service and highways can be expanded sufficiently to accommodate that growth. The state needs more rail service, both high-speed and conventional. As for the concern about social engineering, that’s fanciful. All government policies affect people’s behavior, but HSR will not turn Californians into collectivists, mindlessly riding their bicycles from their communal apartments to the train depot. Instead, HSR will open the Central Valley to more business investment and give Californians greatly increased mobility (and more iPad time). No country that has built a high-speed rail system has regretted it, and if California does it correctly, it won’t either. I

APRIL 2012 • FTSE GLOBAL MARKETS

FUND ADMINISTRATION

While economic conditions have been trending favourably, alternative fund administrators must still contend with a host of challenges, from tricky new regulations such as Form PF, to incessant investor demand for air-tight due-diligence practices. As many are finding out, delivering the data, risk management and compliance functionality that fund clients sorely need is a job for only the heartiest of providers. Dave Simons reports from Boston.

Alternative fund admin works to a new beat initial deadline to file will be HE START OF 2012 the close of the first fiscal was particularly good quarter or fiscal year after for the alternatives December 15th this year. trade, with data suggesting a Funds with AUM exceeding significant rise in hedge-fund $5bn, however, only have assets under management until the close of the first fiscal (AUM). Welcome news for quarter/fiscal year after June alternative fund administra15th to comply. tors, who have struggled “We are watching the with rising costs and lower proposed changes quite growth these past few years. carefully,” confirms Brian However, while the Ruane, chief executive officer economic winds appear to be of BNY Mellon’s Alternative blowing in their favour, adand Broker-Dealer Services ministrators still face a host division. “In the US we are of challenges. Fueled by peralready hearing from some sistent investor demand, an of the larger firms that have even greater number of hedge funds now require Photograph © Maks7636 / Dreamstime.com, supplied February 2012. begun to complete their own Form PFs. Whether they are third-party accounting oversight, and this extra responsibility—and the costs going it alone or using an audit firm, additional work will therein—continues to weigh on the administration business. be required on behalf of the fund administrator.” Like their counterparts at State Street, Northern Trust, With good reason: as the number of institutions diversifying their portfolios through hedge-fund investments GlobeOp and elsewhere, BNY Mellon is working on estabincreases, many have elected to go direct, rather than chan- lishing reporting services that are specifically tailored to the neling their investments through fund-of-funds (FoFs) as needs of those required to file Form PF.“This is the first year often happened in years past. This shift in investment that we have performed this kind of service, and while it is strategy has had a profound impact on due diligence and labor intensive to some degree, it nevertheless represents transparency demands, says Ron Tannenbaum, managing an excellent opportunity for the company,” says Ruane. Yet another potent piece of legislation to emerge from the director, GlobeOp Financial Services. “Institutions are pushing hedge funds for the same industrial-strength infra- pro-transparency, post-Lehman era is the Foreign Account structure, governance, transparency and reporting they Tax Compliance Act (FATCA), which seeks to address persistent loopholes that have allowed US investors to avoid receive from more mature investment sectors.” Last fall, the US Securities and Exchange Commission taxation through the use of offshore accounts, primarily (SEC) announced a new initiative aimed at boosting the held through foreign financial institutions (FFIs). FATCA quality and frequency of data reported by private funds that will require that financial companies place even greater are managed by registered advisors, among them hedge emphasis on due-diligence practices, and, for the first time, funds, private equity funds and liquidity funds. Using Form force non-US investment managers/fund companies to PF, fund advisors with at least $150m AUM will be required comply with US-based tax laws. Banks, traditional and alterfor the first time to provide regulators with operational infor- native investment funds and trusts as well as affiliated mation that includes fund AUM, monthly performance sta- managers, brokers and dealers operating outside of the U.S. tistics, investment strategies, trading/clearing mechanisms, would fall under the purview of FATCA, which is set to take cash on hand, monthly VaR, and more. For most firms, the effect on January 1st of next year.

FTSE GLOBAL MARKETS • APRIL 2012

FUND ADMINISTRATION

Not surprisingly, FATCA preparedness remains at the top of administrators’ checklists. “We have been working with clients on this measure for the better part of two years,”says Ruane, “and we feel that puts us at an advantage in terms being able to do help clients achieve compliance and perform more of this kind of reporting on their behalf. While there is a cost, fund institutions like ours stand to benefit from the emphasis placed on FATCA readiness.” Administrators that can process data in the most efficient manner possible will be best positioned to take on the added responsibility arising from the likes of Form PF, FATCA and similar regulations, says Peter Sanchez, chief executive officer of Northern Trust Hedge Fund Services. “These new initiatives call for tools that allow both administrator and manager to simultaneously view information covering trade and NAV lifecycles, valuation and other middle-office services, while also factoring in regulatory requirements,” says Sanchez. “Obviously the more robust the services provided, the greater the opportunity for managers to focus on investment strategies and alpha, as opposed to worrying about infrastructure and trade flow.” While complete operational transparency remains paramount, managers and administrators alike must be on their toes when disclosing information through new regulatory measures such as Form PF, says Stephanie Miller, global head of alternative investment services for JP Morgan Worldwide Securities Services. JP Morgan’s secure environment and knowledge of disclosure practices is such that“we can partner effectively with clients, thereby allowing them to focus on putting customer assets to work,”says Miller. Mike Sleightholme, global head of hedge fund services, Citi, agrees that regulation is quickly coming into focus for an even greater number of hedge fund managers, says. “Particularly as the realities of Form PF, AIFMD and DoddFrank draw even closer, we have seen a lot more planning taking place. The impact of central clearing has also been very topical. I think the general feeling is that the rubber is really starting to hit the road right now [sic].” As such, managers are looking to attract more institutional money in order to achieve “a longer term and more sticky” client base, offers Sleightholme. Pre-crisis, some managers found themselves overly exposed to shorter term money that left very quickly once the crisis erupted. “So what we have seen, particularly in Europe, is managers actively seeking to rebalance their investor base by adding institutional money where they can,” he adds. “This in turn requires those managers to have a more institutional infrastructure and approach to their clients.” All of this is leading alternative investment managers to reevaluate their risk and compliance infrastructure as they seek greater transparency and more comprehensive risk reporting functionality. “Obviously this had an enormous impact on the administration business as a whole, and continues to drive a lot of the initiatives that we have undertaken on behalf of clients,” says Sleightholme. Key to servicing the alternatives space has been the ability for administrators such as Citi to offer web-enabled technology

“These new initiatives call for tools that allow both administrator and manager to simultaneously view information covering trade and NAV lifecycles, valuation and other middle-office services, while also factoring in regulatory requirements,” says Sanchez. “Obviously the more robust the services provided, the greater the opportunity for managers to focus on investment strategies and alpha, as opposed to worrying about infrastructure and trade flow.” services to clients, which, says Sleightholme,“allows managers to effectively peer into everything that we do on a regular basis. One of the impediments to outsourcing in the past has been this great fear of everything disappearing into this big black box— the information may be there at the end of the month, but you're not always sure what is happening in between.” With the right kind of technology, however, managers are able to view data in real-time and on an intraday basis, says Sleightholme, including P&L, NAV, trade processing, and the like. In this way, says Sleightholme, asset-manager clients “have the same degree of control that they would under normal in-house circumstances, when you can just yell across the floor at someone—and yet with all of the benefits that typically come with an outsourced offering.”

M&A Up According to BNY’s Ruane, two favourable trends in particular that have emerged over the past half year include a noticeable jump in M&A activity, along with a greaterthan-expected move toward outsourcing among larger hedge funds. “Consolidation has been unusually strong within the alternatives space of late,” says Ruane, “we’ve seen numerous fund managers in the $500m range joining forces, and there have been several instances of those in the $500m-$1bn range being acquired by insurance firms.” Meanwhile, large financial institutions in need of thirdparty accounting services have become an even bigger prospect than previously anticipated. “While these firms obviously have the ability to successfully calculate NAV inhouse, these days it all comes down to independence— which is why we've seen so many reputable firms seeking the same kind of guidance as smaller or mid-sized funds. Having the wherewithal is besides the point—the compelling factor is investors and regulators wanting this aspect of the business to remain separate.” From his vantage point, Northern Trust’s Sanchez has witnessed a marked increase in the number of managers with multiple fund structures, which in turn has placed increased demands on administrator functionality.“In the process, we’ve seen a widening of the capability gap separating larger administrators and niche players,” says Sanchez, and this will likely lead to further attrition within

APRIL 2012 • FTSE GLOBAL MARKETS

TO OPPORTUNITY IN THE GLOBAL MARKETS

HE WORLD’S HIGH growth markets are an increasingly important focus for businesses and investors seeking profits and returns. A recently upgraded FTSE Global Markets now offers unrivalled coverage of the globe’s new financial hotspots: providing accurate and reliable market intelligence and coverage of leading markets, key investible products and the month’s benchmark transactions in the capital markets. Published ten times a year FTSE Global Markets, offers the best in objective comment and analysis, allowing readers to track key markets and trends. It provides the reader with straightforward, ready synthesis of important developments, key transactions and trends in equity, debt and Islamic finance, sovereign loans, foreign exchange, trade and project finance, private equity, fund management and administration, asset services, mergers and acquisitions and depositary receipts. For only £497.00 FTSE Global Markets is a trusted and valued source of market intelligence and analysis by local and international organisations, commercial and investment banks, asset management firms, pension plan sponors, mutual funds, insurance companies, government agencies, nongovernmental agencies, trading firms, consultancy and accounting firms, legal practises and regulators in over 120 countries.

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FUND ADMINISTRATION

the administration business.“We have already experienced an uptick in consolidation, as smaller players find they lack the scale and system capabilities needed to effectively handle data management, which is increasingly driving industry functionality. Smaller firms are also challenged to provide the level of transparency required by both investors and regulators.” Looking abroad, demand for prime custody in Europe, a byproduct of ongoing regulatory changes, remains one of BNY’s fastest growing cross-sell solutions to hedge fund clients, notes Ruane. Meanwhile in Asia, BNY, like many of its peers in the West, continues to sow the seeds for future growth. “There are significant opportunities in the making, particularly in China,” says Ruane, “and therefore we are steadily visiting the market in order to build relationships there.” The ability to sift through the disparate regulatory structures that exist within various foreign jurisdictions remains an essential part of the global provider's skill set. “In many non-US nations, for instance, tax reporting has become compulsory,” observes Sanchez. “In short, providers must have capabilities that are much broader than those used for a traditional domestic master-feeder—if you're going to handle a UCITS or a registered fund, you need to have daily risk reporting/daily dealing, the ability to examine the portfolio for concentration risk, track commissions tied to capital distributions, and so forth. Without these capabilities, it is going to be very difficult to service the multiproduct or multi-strategy asset manager. Furthermore, you need people who not only are familiar with the indigenous regulatory requirements that exist from country to country, but also have a thorough understanding of the system and how it can solve the problems that are unique to a particular region.” As investor due diligence becomes more frequent and sophisticated in nature, administrators have been increasingly drawn into the process, notes Glenn Kennedy, head of sales and relationship management, alternatives, HSBC Securities Services. Accordingly, investors “want a name that can instill confidence, offer quality processes and systems and comes with a proven record of service.”Administrators that can offer a full range of side services including custody, collateral management, enhanced transparency reporting, prime services, and FX are in top demand; those that cannot deliver on these counts may not have the capacity to help clients grow their asset base, contends Kennedy. JP Morgan’s Miller maintains that the presence of a premier service provider brings an added layer of comfort to investors within the alternatives space. “JP Morgan’s control process ensures that manager prospects undergo careful review prior to becoming fund administration clients,” says Miller. “The stability of the firm and depth of our resources has been key to maintaining the commitment to our clients.” As its fund administration business sits within the larger franchise, the company is able to assist clients on multiple fronts, including prime services and investment banking, should clients’ needs evolve, adds Miller.

Brian Ruane, chief executive officer of BNY Mellon’s Alternative and Broker-Dealer Services division. “We are watching [Form PF] … quite carefully,” confirms Ruane, “In the US we are already hearing from some of the larger firms that have begun to complete their own Form PFs. Whether they are going it alone or using an audit firm, additional work will be required on behalf of the fund administrator.” Photograph kindly supplied by BNY Mellon, March 2012.

At the behest of their investors, funds of all types are increasingly seeking the capabilities, capacity and technology of a Tier 1 administrator, concurs GlobeOp’s Tannenbaum.“Experienced managers spinning out of investment bank prop desks offer investors new funds and lower asset commitments in return for potential nimbleness and innovation. These entrepreneurs require a robust operational infrastructure to compete for assets with established funds with well-known brands and successful track records.” Hence, the pressure on fund administrators continues to intensify, says Tannenbaum, “as the bar for independent valuations, integrated risk analytics, greater data transparency and timeliness moves higher and higher.” Along the way, funds both large and small will increasingly outsource administration, says Tannenbaum, as it offers operational credibility, meets due diligence requirements, improves operating costs and responds nimbly to continuing market evolution. Looking ahead, Tier 1-level administrators will be key to delivering the data, risk management and compliance functionality that funds sorely need, insists Tannenbaum. “Operational quality and strength are a hallmark of an institutional-quality fund. Continuous administrator investment in good governance, cutting-edge technology and in acquiring new domain expertise will no longer be an option— investors will increasingly insist on it as a due diligence requirement, and recognise it as a primary source of competitive advantage for funds and administrators alike.”I

APRIL 2012 • FTSE GLOBAL MARKETS

KEY TRENDS AND ANALYSIS OF A SECTOR IN CHANGE

2012 MIDDLE EAST ASSET MANAGEMENT SURVEY Photograph ÂŠ Lavitreiu / Dreamstime.com, supplied February 2012.

Domestic versus international investment trends The risk outlook for the Middle East The importance of investment infractructure

Supported by

SUPPORTED BY THE QATAR FINANCIAL CENTRE AUTHORITY

MIDDLE EAST ASSET MANAGEMENT SURVEY

At a time of huge change in the international investment markets, and the continuing challenge of a global economy still mired in the aftershocks of the 2008-2009 financial crises, the asset management sector in the Middle East is on the brink of a new era. That epoch will hopefully involve a deepening of the asset management segment. However, given continuing market uncertainties and the still bubbling brook of popular discontent in some countries in the region, meaningful moves towards market change might just as easily be cut down by the vagaries of socio-political fortune (which vary so widely across the region). Whatever the outcome (and it will be different in each country), if any nation wants to develop a top ranking financial centre in this century, then a significant strengthening of the asset servicing and asset management industry must form part of any meaningful strategy. This survey goes part way to underscoring the importance of this fact.

New beginnings, new vistas Preliminary results of the 2012 Middle East asset management survey espite the still challenging macro-economic environment, asset management is gradually gaining in importance and momentum once more in the Middle East. Luckily for the sector, the region’s governments increasingly recognise the role of asset management and asset servicing as a cornerstone of both sustainable economic growth and the deepening of the region’s capital markets. This is the first survey of the asset management industry in the Middle East, which we hope will gain in ground and depth as subsequent surveys takes place; in addition each quarter it will be augmented by quarterly reviews that will provide an indication of asset management sentiment. This inaugural survey throws up some important trends which ultimately stress the need for local policy makers to formulate new rules and regulation—or at least begin to think about what is the most appropriate infrastructure for a fully functioning and diverse asset management industry. If the states comprising the GCC region are to keep good their promise of turning their capitals into financial services hubs, this is the very least they can do.

Setting the ground rules This survey has three aims: to describe the current investment outlook of a diverse range of asset management firms in the Middle East region; to assess the perception of political/economic risk within the region and to outline current thinking among the asset management industry as to what infrastructure is important to the proper functioning of their businesses. The survey was conducted between January 19th and March 23rd 2012. Some 375 firms were approached for information of which 82 responded, either by phone or fax. Three of the faxed returns were unusable, leaving 79 either completed or partially-completed returns. From these

returns we have extrapolated the analysis in the survey. This presentation is a précised overview of the full survey, which will be made available from the middle of May this year online and in hard copy. The survey focuses on a diverse universe of asset gatherers/managers, to achieve the widest possible response from a broad brush of market participants. This was thought to be particularly useful as all segments of the asset management business are represented, and which we hope provides a suitably broad cross-section of opinion. The survey involves sovereign wealth funds, mutual funds, dedicated funds, and private equity and real estate funds. The ownership of the funds is also highly diversified, though at least a quarter of the funds polled, while operating largely independently, remain supported by or are part of larger commercial bank holding groups. In the past, the link with banking often propelled asset managers into dedicated single-strategy funds, with for example a strong emphasis on private equity or real estate investments. It is clear however that while some of these entities remain specialised; others have diversified significantly. While future surveys may take into account dedicated funds investing in the Middle East domiciled in other jurisdictions, this survey is entirely focused on funds domiciled in the countries surveyed. We do acknowledge however that many funds that service the region are domiciled outside the region in jurisdictions such as Guernsey, Luxembourg, Bermuda, the British Virgin Islands, the Cayman Islands, the United Kingdom and the United States. Moreover, there are signs that dedicated Middle East funds are rising in number in jurisdictions such as South Korea, Singapore and Hong Kong. How these funds might be incorporated into future surveys has yet to be determined; and will likely provide a sub-set of ongoing analysis.

APRIL 2012 • FTSE GLOBAL MARKETS

Chart 1: Domicile of respondees to the survey

Chart 2: Asset Mix: international versus domestic focus

ABU DHABI; 5% QATAR;ABU 1%DHABI; 5% QATAR; 1% LEBANON; 16% LEBANON; 16% KUWAIT; 8% KUWAIT; 8% SAUDI SAUDI ARABIA; 8% ARABIA; 8%

NO ANSWER; NO ANSWER; 17% 17%

BAHRAIN; 14% BAHRAIN; 14%

DOMESTIC DOMESTIC ONLY; 14% ONLY; 14%

MIXED; 54% MIXED; 54%

INTERNATIONAL INTERNATIONAL ONLY; 15% ONLY; 15%

DUBAI; 37% DUBAI; 37%

EGYPT; 11% EGYPT; 11%

Although responses were sought from investment firms and funds throughout the Middle East only firms in eight countries responded: the percentage of responses from each country is illustrated in this chart. Please note that the largest bulk of responses came from Dubai (with 29); as far as possible through the survey we have tried to smooth out any skewing of the data by this fact.

We simply asked whether the firm had an international or domestic investment focus. While the largest bulk of responses show either a mixed/international focus; ultimately the definition of international is largely prescribed by the larger MENA region. Outside of the countries represented in this survey, Tunisia, Morocco and Turkey figure as either actual or potential investment destinations.

Chart 3: Asset mix - breakdown in percentage terms of the international V domestic asset mix Internationally Focused

Number of respondents

Ab no

Top Quartile (30/70) 25 31.65

Domestically Focused

34.18

32 40.51

Top Quartile (70/30) 28 35.44

10 8 6 4 2 0

0/100 5/95 10/90 15/85 20/80 25/75 30/70 35/65 40/40 45/55 50/50 55/45 60/40 65/35 70/30 75/25 80/20 85/15 90/10 95/5 100/0

No answer

Ratio of international versus domestic investments The chart shows the concentration of investments at both the top ends of the international and domestic investment spectrum. Unfortunately, this particular chart is skewed by the extreme right hand column, which shows the number of respondents which failed to answer this question. We hope to provide more clarity in subsequent updates.

Number of respondents

The asset management segment, as defined by the remit of this survey encompasses firms with a minimum 35 $25m under 35 management, with no upper limit. The end results show a wide variance in the value of funds under management in different 30 firms; and this was equally applicable whether the firms invested in multiple assets or in particular asset classes, such 25 as private equity or real estate. While in subsequent surveys we may refine the value of 19 assets under management (AUM) 20 that qualify a fund for inclusion in the survey, we felt at this 15 stage 15 it would be more useful to be as inclusive as possible. 13

10 5

20 1 2 FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2 0

While the geographical remit of the survey originally encompassed North Africa and the Middle East, investment firms from a number of countries declined to participate, leaving the survey concentrated on eight countries: Abu Dhabi, Dubai, Bahrain, Saudi Arabia and Kuwait in the GCC and Egypt in North Africa and Lebanon in the Levant. Any limitations on the applicability of this survey keep this fact in mind. In terms of outlook, the responses to the survey fell almost neatly into two halves. Some 17 firms refused to answer 15international 15 or domestic investment questions about their

5 2

MIDDLE EAST ASSET MANAGEMENT SURVEY

focus, the remaining firms tended to concentrate in either focusing on their domestic market for investment returns and those with a more international vista. Variable responses to the survey obviously curtail the effectiveness of the overall results. With that in mind and with an emphasis on transparency at all time, all data presentations are either in actual numbers or if presented as ratios or percentages, the calculated are precisely shown, so as to highlight the relevance of the data. Some of the data, such as that collected in Dubai (with 29 responses and in most instances, full responses) is regarded as a key template from which to extrapolate analysis. Of notable interest are the key variations between countries, particularly in terms of the way that investors perceive political, economic and investment risk (both in the region and outside) which are highlighted in the both the political risk and asset management infrastructure sections. However the analysis of these differences is kept to the main survey. While no discrimination was imposed on whether firms were domestically or internationally focused, what has become apparent from the responses is a keen sense that international macro-factors continue to exert a strong influence on investment decisions both at home and abroad among respondents. Equally, there is a growing sense that regional and international investment expertise is becoming increasingly important as both a keystone of each firm’s own understanding of its own strengths and brand identity; as well as an acknowledgement that the Middle East asset management industry is increasingly confident about its ability to invest cross-border across a variety of investment vehicles and utilising a broader range of securities.

Investment preferences It was clear from the survey results that investments were concentrated in four segments: equities, bonds, real estate and private equity. Although a significant number of firms failed to signal any change in their asset allocation programme for the next 12 months, the general level of consistency in asset allocation approaches is well illustrated. This suggests a degree of significant comfort in the firms’ overall investment strategy and is an indication of stability in the sector. Across the region four firms were directly focused on private equity; while 11 firms invested across multiple assets in which private equity was a key component. Of these five intended to make no change to their asset allocation to private equity in 2012; one intended to marginally increase its allocation to the asset class, and one to decrease it and one intended to exit from the class altogether. The response from one of the largest funds among the respondents made clear however that its reduction in allocation to private equity stemmed more from a lack of opportunity, than any worries about the asset class itself. One quarter of the respondents invest in bonds, with a wide variation in allocations. Only one fund is a dedicated bond fund and it does not intend to change its

Chart 4: Asset alloctaion - the consistency of investing in equities Value of fund Invest now Next 12 months (US$m) % of portfolio % of portfolio

% change

Country of fund domicile

520

n.a.

Abu Dhabi

500

100

Abu Dhabi

550

100

Bahrain

n.a.

47.3

Bahrain

600

n.a.

Bahrain

4500

-16.66

Bahrain

nbd

n.a.

Dubai

464

n.a.

Dubai

250

100

Dubai

440

-16.66

Dubai

104

n.a.

Dubai

n.a.

Dubai

n.a.

100

Dubai

500

28.57

Dubai

2000

n.a.

Dubai

500

33.33

Dubai

3100

43.4

n.a.

Egypt

100

Egypt

116

100

Egypt

500

100

Kuwait Lebanon

n.a.

100

450

n.a.

Lebanon

100

Saudi Arabia

1700

n.a.

Saudi Arabia

The interesting thing in the four asset allocation charts is the consistency in approaches in 2011 and 2012 in terms of asset allocation to either bonds, equities, real estate and private equity. However when a change is intended, it is quite substantial in terms of funds allocated to the asset class.

Chart 5: Asset allocation - private equity, a stable asset class Value of fund Invest now Next 12 months % (US$m) % of portfolio % of portfolio change

Country of fund domicile

100

n.a.

Bahrain

500

Bahrain

n.a.

Dubai

100

n.a.

Dubai

6000

-5.5

Dubai

n.a.

100

Dubai

120

100

Dubai

100

Dubai

n.a.

100

Dubai

500

-15

Dubai

n.a.

Lebanon

APRIL 2012 • FTSE GLOBAL MARKETS

Chart 6: Asset allocation - bonds, a reluctance for respondees to commit to answers

Chart 7: Asset allocation - Real estate, a discrete, mature investment segment

Value of fund Invest now Next 12 months (US$m) % of portfolio % of portfolio

Value of fund Invest now % Next 12 months (US$m) of portfolio % of portfolio

% change

Country of fund domicile

% change

Country of FUND OFFICE domicile

520

n.a.

Abu Dhabi

1400

n.a.

Abu Dhabi

n.a.

Abu Dhabi

100

n.a.

Bahrain

104

n.a.

Abu Dhabi

500

-2

Bahrain

n.a.

Bahrain

4500

+6%

Bahrain

n.a.

Bahrain

n.a.

5.5

+10

Bahrain

600

n.a.

Bahrain n.a.

n.a.

Dubai

4500

20%

Bahrain

n.a.

Dubai

100

Dubai

464

n.a.

Dubai

n.a.

+50%

Dubai

440

25%

Dubai

500

Dubai

500

100

Dubai

500

Dubai

n.a.

Dubai

n.a.

Dubai

500

Dubai

150

+20%

Egypt

2000

n.a.

Dubai

100

n.a.

Kuwait

6000

n.a.

Kuwait

3000

n.a.

Lebanon

n.a.

Lebanon

n.a.

Lebanon

1700

n.a.

Saudi Arabia

500

Dubai

3100

56.6

n.a.

Egypt

4000

n.a.

Egypt

3000

n.a.

Lebanon

n.a.

-33.30%

n.a.

Number of respondents

asset allocation policy over the next twelve months. tion; with the balance keeping their allocation stable for 18 However, respondents were most reticent in this segment another year. 16 In terms of exposure to real estate only one firm that than any other about their investment intentions in 2012 14 and so it is difficult to make any assumptions about ap- responded to the survey is entirely specialised in the 12 proaches to the bond segment across the region from this segment. Three respondents have a majority focus on the 10 sector, while the remainder have a fairly standardised survey’s data. The largest8segment of responses came from those firms range of between 20% and 30%. At the lowest end of the which invest 6in equities. Seven of the firms are dedicated spectrum two firms have less than 5% of their overall 4 equity firms and will not change their strategy in 2012; of portfolio in real estate. Consistency in investment ap2 respondents eight refused to signal any proaches is again evident, with no significant alteration in the remaining 0 exposure anticipated in 2012. change in their allocation to the segment, with three of 0/100 5/95 10/90 15/85 20/80 25/75 30/70 35/65 40/40 45/55 50/50 55/45 60/40 65/35 70/30 75/25 80/20 85/15 90/10 95/5 100/0 No answer The extent of the growing diversification of routes to these respondents saying their approach was flexible. Two Ratio of international versus domestic investments firms thought they would reduce their allocation this year, market in the region is exemplified by Chart Eight, which ilwith another four saying they would increase their alloca- lustrates our respondents’ preferred investment route to

Chart 8: Asset allocation - the products respondents like to invest in - 2012 35

Number of respondents

30 25 19

20 15

2 ic Fu nd s M ar ke tF un ds M ut ua lF un d Pr iva te Eq ui ty Re al Es ta te So ve re ig n Bo nd St s ru ct ur ed No te s

Fu nd s

M on ey

Is la m

Fu nd s

ru ct ur e

dg e

In fra st

Fo re ig n

ex ch

an ge

In co m

Fi xe d

Eq ui tie

De riv at Di ive sc s re tio na ry Fu nd s

od iti es io na lF un ds ry /R eg

Co un t

Co m

Bo nd s

Asset class/investment vehicle

50.00

40.00 35.00

ents

45.00 FTSE GLOBA L MAR 43K E T S • A P R I L 2 0 1 2

MIDDLE EAST ASSET MANAGEMENT SURVEY

Chart 9: Asset mix - Concentration of investments in the MENA region as a percentage of total portfolio 50.00

35.00 30.00 25.00 20.00

st Le s

an sw er

0 10

ha n

1 25

1 30

1 40

10 0

0.00

5.00

10.00

No ne

15.00

% respondees

40.00

Number of respondents

45.00

Asset Investment in the MENA region as a percentage of all investments vehicle

market. While nine respondents failed to provide information in this segment, respondents nominated 17 different investment routes, be they asset classes, or other specialised funds provided by third parties. Again, the data shows that private equity and real estate remain the preserve of the few; while 35 (or 44%) of respondents opt for equities as their preferred investment route. Hedge funds (according to this representative survey at least) constitute only a meagre 2.5% of respondent’s preferences as an investment vehicle. Bonds and fixed income instruments remain almost equally preferred as allocations to money market funds, private equity, mutual funds and fixed income. We think that among those funds with a multi-asset investment strategy, it reflects a trend towards a mature and diversified portfolio.

INTERNATIONALISATON OF A DIVERSIFED INVESTMENT BOOK The survey results clearly illustrate the somewhat tight definition of ‘international’ by investors in the Middle East. In terms of regional investment preferences, there is a concentration of responses and investments in the MENA region (though because of the make-up of responses, most of these refer to investments in the GCC region). If you drill down further into the data, respondents from Dubai show the greatest propensity to diversify their holdings across the MENA region, with Morocco and Tunisia featuring in a broad range of investment destinations outside the tight prescription of the Gulf States. However, as an aggregate, domestically focused investments still dominate, with the dominant quartile of responses (35.44%) from domestically focused firms. The top quartile of respondees with an international focused portfolio (with at least 70% nondomestic investments) runs a close second at 31.66% (Please refer to Chart Three: Asset Mix—Domestic v International— % Breakdown); though eight of respondents with a domestic investment said they expected to increase their international allocation at some point in the future. It is with these statements in mind that we suggest that the internationalisation

of asset allocation will continue apace over the near term. For most respondents though, this means the MENA region; only a handful mentioned investing further afield and these responses were by and large confined to the largest funds among the respondees. The survey clearly indicates that aside from the largest asset management firms, local investment firms remain, by and large, domestically focused. Nonetheless, and this is an important caveat, more of those firms suggest that they might start to look outside their national boundaries for investment opportunities. Equally, the concentration of investment within the MENA region by the respondents is clearly visible from Chart Nine: Concentration of investments in the MENA region as a percentage of the total portfolio. This graph shows the concentration of investments in the MENA region as a percentage of total portfolio holdings. You can clearly see the grouping on the far left of the table as a reflection of the continuing strength of the trend. International investment still has strong intra-regional, rather than global connotations.

RISK OUTLOOK FOR 2012 After a torrid 12 months in which the Middle East and North African region has been shaken to the core by frequent uprisings, we thought it useful to determine a picture of the investment outlook of the respondees. We asked respondents two sets of questions around the risk outlook for the MENA region over the next twelve months. The first was a direct question as to whether they invested in a particular country in 2011 and whether they were investing in that country for the first time in 2012. We had 18 firms (22.7%) decline to participate in this section. Of the remaining 77.3%, over half said they were considering expanding their investments into another country. Chart Eleven shows that Bahrain, Lebanon and Qatar were the most popular single choices for 2012; the UAE and Saudi were the least nominated. Of the countries already invested in (and remembering that 36% of respondents came out of Dubai), Qatar and Saudi Arabia remained the most popular

APRIL 2012 • FTSE GLOBAL MARKETS

investment destinations, following by UAE, Kuwait and Egypt. Of all computations, Qatar remains the second most popular investment destination and the joint second most popular consideration of choice by respondees as a potential investment destination. We then asked respondents how they viewed the overall political and economic risks of doing business in the various countries of the Middle East. The overall results can be found in Chart Ten: Risk Outlook for the Middle East in 2012. No surprise perhaps that Syria scored a resounding negative, with a rough negative sentiment score of -53. Bahrain, Lebanon, Jordan and Europe are in a second grouping which ranged from -9 for Bahrain to -16 for Europe. North America did surprisingly well out of the survey, which the respondents viewed much more positively than South America. Asia and Africa also received rather respectable scored, while in the Middle East, Saudi Arabia and the UAE scored particularly highly as low risk investment regimes. This will be an area that we will return to again and again in the updates, and we hope to deepen the analysis in forthcoming editions to more clearly illustrate any direct correlations between market performance and local investor risk perceptions in the intervening period. Interestingly perhaps, Bahrain scored relatively positively, even though at the time of going to press, social unrest was still bubbling in the country. Syria remains a worry, both to investors and the international community which cannot seem to find any workable short term solution to its problems.

INFRASTRUCTURE PROVISION AND REQUIREMENTS 2012 AND BEYOND In Chart Twelve we see the current provision of investment services infrastructure among the respondees. It is clear from the chart that a growing number of employees in the sector are beginning to establish a substantive infrastructure supporting the industry. This is just one element in a mix of infrastructure that is as much determined by local jurisdictional characteristics as it is within each individual firm’s ability or commitment to establishing a strong infrastructure to support its business objectives. Some firms, quite frankly are still too small to warrant a massive investment in internal infrastructure and the difficulty of extrapolating too much meaning from this segment is limited. The results are somewhat skewed by the fact that a few ultra large asset management firms have substantial employee numbers. Nonetheless, it is clear that research accounts for 16.5% of employees in respondents’ firms, the largest slug of employees after the massive 41% of employees taken up by head office operations (though over 90% of those are concentrated in less than 6 firms. Sales, marketing and customer relationship management (8.5%) is pipped into third place by back office staff with just over 11.5% of employees. Though middle office services account for only 2.6%. Interestingly too, sales and marketing look to be just about keep pace with the number of investment personnel.

FTSE GLOBAL MARKETS • APRIL 2012

Chart 10: Risk outlook: investors view on Middle East in 2012 Improving investment risk

Neutral risk - no change

Worsening investment risk

No answers

BAHRAIN

-9

EGYPT

+11

IRAQ

JORDAN

-13

KUWAIT

LEBANON

-14

OMAN

+13

QATAR

+29

SAUDI A.

+43

SYRIA

-53

UAE

+41

AFRICA

+36

ASIA

+40

EUROPE

-16

N. AMERICA

+45

S. AMERICA

+17

COUNTRY

Rough sentiment score +/-

It is difficult to give a clear formula that would be a true reflection of investor sentiment in the region. With that in mind, it was felt that it was best to present the results as clearly as possible. In the event, we decided to give a rough sentiment number by simply subtracting the number of responses that suggested risk would increase in 2012 from those that suggested risks would improve. It's as good an indication of investor sentiment as any complex equation might provide.

Chart 11: Diversifying investors risk exposure in the Middle East in 2012 2011

2012

BAHRAIN

EGYPT

IRAQ

JORDAN

KUWAIT

LEBANON

OMAN

QATAR

SAUDI ARABIA

SYRIA

UAE

OTHER

This chart is a clear indication of investor sentiment and is a natural accompaniment to Chart Ten. It seems that despite inherent and continuing political risks, investors are still willing to consider all the countries in the sample group as potential investment destinations in 2012 (to varying degrees of course).

MIDDLE EAST ASSET MANAGEMENT SURVEY

Chart 12: Internal infrastructure/client services - a signal of investor commitment to change & investor protection?

However, it is not always a numbers game. Trading desk staff levels are at just under 1.5%, for instance, signifying the both the still nascent nature of trading in the Middle East. It is equally indicative of the highly specialised nature of the job. Many of the firm’s polled have employees servicing a number of functions in the business; a reflection of the discrete nature of many investment houses in the Middle East. The most significant part of the survey results are perhaps to be found in Chart Thirteen. This shows the level of investor concern over the state of the investment infrastructure within their relevant jurisdictions. Respondents were asked to score their concern, with 1 being the most urgent and 5 showing a low level of concern. We then totalled up the scores and then divided the result by the number of respondents: this gave a rough average from which we could extrapolate some analysis. We thought that any score 2 or lower, signified meaningful concern over the lack of a sufficient infrastructure supporting their business. Liquidity levels in the local stock exchange in some jurisdictions appears to be a key worry; as is the need for increased market liberalisation (pretty much across the board) and an improvement in the level of local provision of investment services (such as risk management). While there appeared to be a notable degree of consistency across the spectrum of respondents, approaches to political risks concerns varied widely. frastructure that is as much determined by local jurisdictional characteristics as it is within each individual firm’s ability or commitment to establishing a strong infrastructure to support its business objectives. Some firms, quite frankly are still too small to warrant a massive investment in internal infrastructure and the difficulty of extrapolating too much meaning from this segment is limited. The results are somewhat skewed by the fact that a few ultra large asset management firms have substantial employee

Yes

Number employed

RESEARCH

100

397

SALES/MARKETING/CRM

206

INVESTMENT EXPERTISE

100

178

BACK OFFICE SERVICES

100

281

MIDDLE OFFICE SERVICES

66.6

COMPLIANCE

83.3

68.5

HEAD OFFICE

4.3

1000

CUSTODIAN

83.3

FUND ADMINISTRATION

83.3

TRADING DESK

66.6

127

OTHER SERVICES

numbers. Nonetheless, it is clear that research accounts for 16.5% of employees in respondents’ firms, the largest slug of employees after the massive 41% of employees taken up by head office operations (though over 90% of those are concentrated in less than 6 firms. Sales, marketing and customer relationship management (8.5%) is pipped into third place by back office staff with just over 11.5% of employees. Though middle office services account for only 2.6%. Interestingly too, sales and marketing look to be just about keep pace with the number of investment personnel. However, it is not always a numbers game. Trading desk staff levels are at just under 1.5%, for instance, signifying the both the still nascent nature of trading in the Middle East. It is equally indicative of the highly specialised nature of the job. Many of the firm’s polled have employees servicing a number of functions in the business; a reflection of the discrete nature of many investment houses in the Middle East. I

Chart 13: All respondees: average ranking of infrastructure requirements to support asset management TYPE OF INFRASTRUCTURE

Rankings denoted by country

Key stress areas highlighted in red

KUWAIT

QATAR

SAUDI

BAHRAIN

EGYPT

ABU

LEBANON

DUBAI

Greater choice of custody provision

2.8

2.0

4.0

2.2

3.3

2.2

3.2

Evolution and provision of fund admin

2.8

3.0

3.8

2.1

3.0

2.1

3.1

Stronger local clearing and settlement

3.0

1.0

3.5

More liquidity in local stock exchanges

1.6

1.0

2.0

1.3

2.0

A lowering of political risks

1.4

4.0

2.3

0.9

2.0

1.3

2.1

Portable cross border investible product

3.0

4.2

1.7

2.5

2.3

2.2

Greater availability of derivatives

2.6

4.0

5.2

2.7

2.3

2.8

2.4

Improved local risk management services

2.0

3.2

1.7

3.0

1.7

Increased market liberalisation

1.6

3.0

2.3

1.6

1.3

1.7

1.3

1.7

Responses in each country

Respondees were asked to score each of the infrastructure sections by order of importance, with 1 being the most important and 5 being the least. The totals were added up and then divided by the number of respondents in each country. Any weighted scores 2 or below are regarded as key stress points by investors that require more supportive infrastructure.

APRIL 2012 • FTSE GLOBAL MARKETS

US SECURITIES LENDING ROUNDTABLE 2012

SECTION NAME

US SECURITIES LENDING: WAITING OUT THE NEW NORMAL, OR WAITING FOR GODOT? Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

Expert speakers:

Supported by:

(From left to right) Jeff Kearny, managing director, consulting, Kearny & Associates Chris Poikonen, Eseclending Debra McGinty-Poteet, director of mutual funds and sub advisory business for Brandes Investment Partners & president/chairman/inside trustee of Brandes Mutual Funds (now left this firm) Bill Smith, managing director, business development and sales, securities lending (Americas) JP Morgan Josh Galper, managing principal, Finadium Owen Nichols, securities finance group, Statestreet

FTSE GLOBAL MARKETS • APRIL 2012

ROUNDTABLE

No surprise perhaps that, like other segments of the global investment markets, the securities lending segment continues to remain hesitant and risk (or better, risk mitigation) remains the primary focus for all participants. Collateral, counterparty and country risk remain priority areas of business. However, it is clear that securities lending service providers are, by all accounts setting in place new infrastructure or at least new service models that allow for more measured investor returns in a much more managed and lower risk environment. So far so good perhaps; but while our securities lending expert panelists generally applaud incoming market changes spurred by regulation (some necessary perhaps, others just plain ornery), and the different opportunities they present, there is a palpable sense that the business is still caught in a waiting room and all are anxious to move to the next, more dynamic phase.

PLAYING SAFER/PLAYING SMARTER – OR SITTING OUT A HAND? OWEN NICHOLS, SECURITIES FINANCE GROUP, STATE STREET: I lead a team of relationship managers that specifically service US mutual fund and insurance company lenders. Within those segments we service clients with very different approaches to lending. The number of individuals involved, their backgrounds, the amount of lending information they require, and the frequency with which they would like to interact with us, varies significantly among our client base. Our challenge is to develop a customized servicing model that is a fit for a wide range of clients. Invariably this involves showing clients that it is worth the effort to be in securities lending and that the agent they pick is prudently managing the risks associated with lending, minimizing any operational issues and demonstrating consistent out-performance pricing their loans. These dialogues with the client might involve helping them understand the factors impacting demand for their positions or alternative ways the client’s programme could be structured. Or it might involve specific elements in the business, such as what is unique about lending in specific markets or helping a client understand the risk inherent both to the collateral reinvestment or counterparty exposures. Performance measurement is also an important consideration. For those clients that are minimum spread clients, I think data aggregators add a lot of value, particularly for security level analysis. However, we often encounter data quality issues and it can often be a lot of work for our team to manage the data and to demonstrate that the agents are performing well. In summary, discussions are concentrated around a risk-adjusted view of return, questions as to whether lending is materially worth the bother, and whether the client has picked the right provider to do it for them. JEFF KEARNY, MANAGING DIRECTOR, CONSULTING, KORT E & ASSOCIAT ES CONSULT ING, LLC: Similarly, we also now work more closely with clients to help them think critically about why they lend; or, why they started lending in the first place, and whether that reason is as valid now as it used to be. We have all seen programs chase after revenue in the past; but nowadays some clients think securities lending may not be about revenue enhancement after all. Perhaps it is just a fee offset instead. Some

investors originally got into lending with that in mind, and drifted, or their lending agents drifted—with and, in some cases, without the explicit permission or knowledge of the acting trustees. There were a lot of plans set up, sometimes decades ago, and no one really touched them. However, when things took a turn for the worse and the turmoil started, their reaction was to pull out of lending, take a hard look at everything, and reassess their approaches to the business. Now some of those clients have stopped lending altogether; others have simply changed their approach. As economies begin to stabilise a little many clients are looking at the business anew. Even so, we still need good answers to the question: why do we do this? Once we really understand a client’s rationale, only then can we put in place an appropriate programme that matches their goals. DEBRA MCGINT Y -POT EET: DIRECT OR OF MUTUAL FUNDS AND SUB ADVISORY BUSINESS FOR BRA NDES INV ESTM ENT PA RT NERS & PRESIDENT / CHA IRM A N/ INSIDE T RUST EE OF BRANDES MUTUAL FUNDS: The volatility that we’ve all experienced in the last couple of years, has contributed significantly to continuing investor fears, whether those investors are retail side, through platforms, or plan sponsors, or endowments or foundations. Although we are not changing the way that we manage money (we are a value manager) what we are trying to do is continue to reach out and calm the fears of our clients. Many people in my position are inevitably asking: how do we get all these investors to quit bailing out of equity products, and basically piling money into mattresses, with regard to where they’re parking it. It is the same with institutional clients. They really don’t want any risk to their principle. They want yield, they want total return, and they don’t want a lot of volatility. At the same time, you also want to make sure that you service those investors who realise that when the majority of investors are this scared, there’s opportunity. As an active manager we are keen to reach out to those investors. In fact, we’re a deep value manager, so obviously you’re looking for longer term managers and usually people really get deep value investing, they’re looking for managers like us who are different from the herd. That’s one side of the equation. The other is oversight. I have a very independent board, the SEC and offshoot organisations

APRIL 2012 • FTSE GLOBAL MARKETS

that are basically prodding and poking the business and telling trustees they have to be more involved in what’s going on in their businesses; how funds are managed (including securities lending programmes). As the sophistication of boards increases, because of the new generation of trustees coming into the business from industry etc they are really looking very closely at what securities lending programmes are doing. CHRIS POIKONEN, ESECLENDING: Understanding new and/or proposed regulations is the key issue for us right now. We spend a significant amount of time trying to best understand how this uncertain regulatory environment is going to affect our clients, borrowers, competitors and us, as well as what will be required for each to comply. There has already been a profound impact to the demand side of this business, including the banking /broker-dealer, and the hedge fund community. Their borrowing behaviour has changed dramatically post crisis and should continue to be subdued on a relative basis until such time regulatory clarity is reached. As a result, the supply side is experiencing reduced balances and fewer spread opportunities. The beneficial owners are much more focused on risk management, counterparty exposure, and credit ratings than ever before. The net effect from regulatory influence has been lower overall returns for securities lending market participants and changed behaviours with respect to how firms structure their overall programs; including what assets they borrow or lend, to whom, and under what conditions. BILL SMITH, M ANAGING DIRECTOR, BUSINESS DEV ELOPMENT A ND SA LES, SECURIT IES LENDING, (AMERICAS) JP MORGAN: This has been a business which, for almost 20 years, up to 2008 certainly, was growing at a steady clip. More and more people were flooding in, and it all looked like it was very easy money. Now, as Debra suggests, real decisions have to be made from every one of the participants in securities lending; between the supply side, the beneficial owners, the distribution side, and the broker dealers. As an agent bank we sit between these parties and we have to understand what level of value we can provide, and at what price, to keep this business at a fair level. We are not a not-for-profit operation either. Lending agents need to be compensated, whether it is for capital, or just the expense that we generate to run these businesses. We are all going to go through this evolving phase until regulations become clear. Until then, it is hard to determine which clients are still ideal institutions to participate in this business. It may not be that everyone who used to be a good client will be in the future. It is highly likely that the relationships between the entities that make up the supply side of the securities lending business will go through a period of change that is simultaneous with the changes taking place on the demand / borrower side of the business. As a securities lending service provider, we need to demonstrate value for clients; that’s a healthy development.

FTSE GLOBAL MARKETS • APRIL 2012

Jeff Kearny, managing director, consulting, Kearny & Associates. “Until we actually see what the regulations are going to be in Europe and the impact of say Basel III, it’s going to be challenging,” says Kearny. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

I work for an institution where much of our securities lending business is still bundled with custody and other services. It is also healthy that clients now ask banks like ours to bid for these products and services on an al a carte basis; or at least to do it transparently. That’s been a buzz word for the last two years hasn’t it? This is a good development, because we want to serve a client base that understands value in this business and who is also willing to pay us for the value we believe we’re bringing to the table. If our clients evolve in that direction, then we will all be able to sustain this business at a level which may be different than what we’re used to, but that is quite successful for all entities involved. However, I think we all agree this is an industry which is very necessary in the global capital markets. It may just be that the roles that we all play need to slightly change, and really the drivers of that will ultimately be the customers; the beneficial owners or institutional asset holders. JOSH GA LPER, M A NAGING PRINCIPA L, FINADIUM: Finadium is a research and consulting firm with expertise in securities finance, collateral management and custody. As far as the challenges we see in the market, I would echo the comments of my colleagues here including encouraging strong oversight and encouraging an understanding of why the fund is in securities lending to begin with. We also see a bifurcation between US mutual funds and some plan sponsors. We think that the largest plan sponsors are well equipped to manage their securities lending programmes, but there is a big group of second and third tier funds that really don’t have the full resources to do so. Especially in a period of low revenues, they might look to securities lending again as a free lunch. This is a great concern, particularly as this is the kind of attitude that produced trouble in 2007 and 2008 as plan sponsors and other beneficial owners may not have been as attentive to collateral pools as the times may have warranted.

ROUNDTABLE

On a positive note, I would also note the interest in this market from new players. We’ve seen a lot of interest from hedge funds and family offices in our work. We also see interest from larger technology vendors that had not previously been interested in securities finance activities. Regulations drive new winners and losers in the market, and our observation is that new kinds of financial market participants are aware that they may have something to gain or lose. As Dodd-Frank or Basel III push markets in one direction, we see smaller firms springing up to offer new kinds of solutions that for us are very interesting, and we think that over time, may take on an increased importance in the securities finance market.

IS ITS TIME FOR NEW RULES FOR A NEW GAME? CHRIS POIKONEN: New regulation, whether defined or proposed, impacts all market participants in a variety of ways. Many of the provisions suggested in Dodd Frank, for example, will materially alter the way in which firms conduct their securities lending businesses. That said there are some changes happening already that are being viewed positively from the beneficial owner community. For example, banks are required to significantly recapitalise themselves with higher quality assets (Basel III). The regulators want the banks to reposition themselves such that they will be able to not only withstand another financial crisis, but actually continue to operate seamlessly through it. Disclosure requirements are also being reviewed closely and will likely be better defined. Market participants will need to increase their level of transparency and offer more detailed information with respect to their firm wide exposures. Risk controls could also be implemented prohibiting firms from having too much exposure to any one counterpart across all of their activities. The end result should ultimately provide market participants with much stronger and safer counterparts. All said, what the industry would really like to see is regulatory clarity. Both the supply and demand sides of the industry want to understand the rules, ensure compliance, and then build their businesses accordingly. While there will always be spread opportunities it will continue to be a very challenging time for all players until the new regulations are set. BILL SMITH: The initial phase of this raft of legislative changes and regulatory changes will certainly be a hindrance, to an extent, because it causes institutions like our own to have to spend time and resources to understand how to comply with it. Then there is the impact on the current business model that we offer to most of our clients. It also requires, in sort of a secondary way, that we understand the regulation visa vie, our clients, so that we can understand how they must comply with regulations, which may or may not affect us directly, or may or may not hinder their participation in a programme like ours. Certainly, once there’s some clarity around most of this regulation, then there is the

Chris Poikonen, Eseclending. “Let’s look at the positive. Securities lending is still a very good global business; margins remain healthy; and many bright and innovative people and products are being introduced into this space and helping evolve what was once viewed as a back office solution,” says Poikonen. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

opportunity to identify, gainers and losers, because the business will have changed materially, once this is all done. We’ve seen that in these fits and starts of short selling regulations or bands and, especially with this proposed French financial transaction tax, there are real material changes taking place. However, this business has been quite adaptive in the past and will be again. In the States we certainly see a dramatic difference in the amount of resource available to institutions such as asset managers and mutual fund companies, relative to say public pension funds. The public pension plans and their in-house budgets, that would or wouldn’t allow them to do the work required to understand all these regulations have been heavily challenged, and their staff in general have been reduced, at a time where their participation and understanding in all this may actually be on the upside. That in itself is going to be a challenge for portions of the client base, which may change the way that we look at clients and/or prospects further, to see how we focus on which segment. JEFF KEARNY: Until we actually see what the regulations are going to be in Europe and the impact of Basel III, it’s going to be challenging, and until then everyone is really just sitting on the sidelines. Our challenge, as consultants, is that our clients are relying on us to help them understand the impact of these changes. We’re in close contact with lending agents and other market participants, trying to get everyone’s opinions and then really figure out what direction we think things are going to go in, and how are our clients’ programmes going to be affected. Actually there’s potential for some really negative, maybe unintended consequences to come out of some of this. Some of the short selling bans for instance. Even defining what constitutes a short sale. The ability to short sell is

APRIL 2012 • FTSE GLOBAL MARKETS

paramount to any well-functioning market. However, there’s so much public opinion, both in the US and abroad, that securities lending ‘feeds the shorts’, and that’s a bad thing. There is a fundamental lack of education with public policy makers, most of whom don’t fundamentally understand how trading works, how this industry works, and what the beneficial role of securities lending can be. DEBRA MCGINTY -POTEET: At the end of the day, I go back to what do we do this for? We do this to enhance some of the returns, or reduce the expense ratio that our clients experience without taking on any undue risk. We’ve migrated the oversight of our securities lending business farm-wide to portfolio managers, who’ve had to be brought up the learning curve, and so in addition to the other things they are doing, they are having to learn about and now figure out how to monitor this stuff. So then you have that layer of expanse of oversight you add on to it, and while the shareholder in the mutual fund isn’t experiencing that particular expense, when you do the annual profitability analysis, you’re looking at that additional cost that that more expensive oversight is costing you. So, how are we changing that? Just as the securities lending agents have to experience increased costs, with the cost of indemnification, what’s going on with the new regulatory stuff, we as the advisor who are renting fund complexes are now adding into real high dollars in terms of the cost of monitoring these programmes and training people to recognise what’s there. You get to a point, back to the beginning of this, is it worth it? JOSH GALPER: We spend about 75% of our time preparing clients for regulatory change in conversation and our research reports. Unfortunately, a number of these regulatory issues are complex; they are not the kinds of things that can be expressed in two paragraphs and be done. As an example, Dodd-Frank’s Order of Liquidation Authority gets into some real detail about the ways and means in which the FDIC could take over a failing significant financial institution. This isn’t a straightforward check box kind of thing, this is a, if A, then B, if B, then C.You’ve really got to work through the maze of how this could affect securities lending participants. Ultimately, new regulations actually help the Finadium business, because again, of the entry of new players. When hedge funds start to pay attention to repo, when family officers recognise that collateral is an important part of their business, and where is that collateral held, and how is it managed, and what are all the different underlying managers doing around collateral pools, they look for assistance. While that doesn’t speak wonderful things for the securities lending industry per se, but as a consulting firm, we think that this client need will be around for a while. OWEN NICHOLS: I will just echo a couple of these points, as well as pose a question to the group. I agree with a lot of what Chris said, in the sense that the SEC held the Round Table around securities lending in 2009 and a lot of

FTSE GLOBAL MARKETS • APRIL 2012

Debra McGinty-Poteet: Director of mutual funds and sub advisory business for Brandes Investment Partners & president/chairman/inside trustee of Brandes Mutual Funds (now left the firm). “The volatility that we’ve all experienced in the last couple of years, has contributed significantly to continuing investor fears, whether those investors are retail side, through platforms, or plan sponsors, or endowments or foundations,” says McGinty-Poteet. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

good discussion took place. For example, is it appropriate to transact at a dollar? What are appropriate forms of non-cash collateral? What should be the requirements related to investor disclosures? Many important topics were discussed, but yet we’re still waiting for clarity. We talk about Dodd-Frank and the transparency part and how it’s going to be spelled out in section 984. Still, you get any number of opinions on where that will lead us. The biggest potential impact for our business is what we think these regulatory changes could mean to hedge funds. If, for example, the locate requirements become very burdensome for prime brokers or disclosure requirements for net short positions are set very low: will hedge funds borrow a lot less? That gives us pause. I’m trying to think of anything positive to shake out the regulations, I’m struggling a bit, but Jeff touched on the idea that the industry needs to better educate the regulators and address those that simply believe that securities lending is evil. Perhaps this engagement is a positive. So the question I pose to the group is this: do you think that the impact of the two short selling bans, both in the US in 2008 and then in Europe in 2011, with the follow on effect that financials continued to get pounded despite the ban, has helped show that lending serves an important purpose—adding a considerable amount of liquidity to the markets and improving price discovery? JOSH GALPER: Very strong academic research has shown regulators and the market that short selling bans have not helped prevent stock price declines. You get this information fed back from domestic regulators, as well as from the International Organisation of Securities Commissions (IOSCO). At the same time, I think that securities lending remains poorly understood by regulators in

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general. Finadium organised a group of seven agent lenders in 2011 to produce a white paper directed towards lenders about securities lending. It wasn’t a promotional piece, it was simply, these are the facts of how securities lending plays into US financial markets. Evidence of the success or failure of short selling bans was part of that report. I agree with Jeff that the securities lending industry has not done as much as it possibly could to influence regulators, but the overwhelming evidence of the failure of government intervention to support different parts of the market by banning securities lending means there may be change. Regulators may be starting to see, at least in the US, that securities lending is actually quite important. OWEN NICHOLS: If I read the regulations right, it’s discouraging that the national authorities retained the right to jump in at any point. JOSH GALPER: Yes, they did, and there’s definitely differences between the US and Europe on that point. In the US, I feel comfortable that we will not see short selling bans, or at least not any kind of widespread bans. The same cannot be said of Europe. It’s very interesting to me that European regulators talk about themselves being interventionist. I’ve never considered that to be a very good thing, but I heard a presentation from a French regulator the other day saying they intend to pursue an interventionist policy in financial markets. DEBRA MCGINT Y-POTEET: With all due respect to all the research that’s been done, coming from the investment advisor’s side, we still have a traumatised investment advisory committee, that going over 2008, and looking at what happened, with all the bank stocks that we held. People are still convinced that there was a lot of manipulation of the market by hedge fund managers, and that what we saw going on there was the impact of that. I deal with this bias now that somehow, if you get involved in directional trading at all, you are potentially shooting yourself in the foot. So, the way we’re involved in securities lending is strictly dividend arbitrage; that’s all we’re doing on our international portfolios. We’re not involved domestically, and in fact, our UCITS funds completely pulled out, because the business manager over there and the Board were not convinced there was any value added. CHRIS POIKONEN: Asset managers and investors expect to have an efficient and orderly capital markets system and have the freedom to buy or sell, go long or go short. If you take that freedom away, or materially restrict it, you potentially risk disrupting the markets and actually increasing volatility. There are many ways to apply pressure on a stock price in addition to short selling. For example you can marry puts, utilize derivatives, or invest in levered directional ETFs. We are mindful that the markets have more sophisticated players and complex systems today than were in place even 5 years ago. The speed at which

firms can transact in volume is now a fraction of a second. The various short selling bans that have been implemented really haven’t addressed all of the issues and suggest that the situation was likely not fully understood.

PLACE YOUR BETS- BUT ONLY IF YOU HAVE THE COLLATERAL OWEN NICHOLS: Only a limited number of clients, in this environment, are prepared to take any meaningful amount of collateral investment risk, whether it’s assetbacked investing or longer durations. I find it interesting, that in the last two or three years, the discussions we have with clients about collateral re-investment sometimes focused on leaving cash in a demand-deposit account (DDA account) and just extracting returns from a minimum spread. Or, it’s looking over different government money funds and discussing the variations among them. It is a limited subset of clients, which typically comprises pension plans, which are going to invest money in an enhanced cash type product. That said there is considerable reinvestment opportunity for those investors comfortable with durations of one and a half to two years. However, while we are consistently discussing the collateral re-investment, increasingly clients are focused on whether general collateral loans are a trade that clients still want to be involved in. Pre-crisis, a general collateral trade was typically 15 basis points of funding spread, and that’s since compressed. If a client with equities can get 70%, 80% of their return from a handful of specials, with an invested collateral balance, that is a fraction of the size they would see from a lending program that includes general collateral balances. They need to constantly consider whether general collateral trades warrant the reinvestment risk. Again, there is a place for enhanced cash type products. However, that then puts a lot of effort and resources on that client to properly oversee the program. Often times, some of these pension plans are working with limited staff, and aren’t equipped to do this level of supervision on their own. CHRIS POIKONEN: Looking at the various sources and uses of collateral and determining how best to optimise these assets is becoming a much higher priority for market participants. The industry is evolving rapidly in the collateral management space and given the benign interest rate environment that is likely to exist for an extended period of time, there will be new opportunities available for firms looking to best utilize non cash assets. DEBRA M CGINTY -POT EET: In 1994 I oversaw one of the largest money market fund complexes, on the bank side. I learned a very profound lesson. I saw what happened with short term investment funds (or STIFs), and what can happen, leaving portfolio managers to their own devices and letting them talk with very clever sales people from big wire houses who were selling various

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types of derivatives. In the event, we had to make the largest contribution to our money market funds to keep everybody whole. Having learned that lesson I have to ask: why did people not learn the lessons of 1994? Why didn’t people take it into consideration? It was clear the same kind of stupid stuff was going to happen again. I’m sorry, it’s about greed. It’s thinking that you don’t need any sort of intelligence to do some of this stuff, or failing to understand the investment class. If you lived through 1994 there were some very critical lessons to be learned. One, you need to understand the nature of any sort of derivative that’s put on an instrument. Two, you need to understand what a rating means. Back in 1994 I went out and paid $10,000 to get a money market fund rating, it was one of the first money market funds to get a rating. Then, when we had the issues, in 1994, of 2A7 and inverse floaters, we were still an AAA rated fund. I took that lesson on board and fast forward, knew that ratings are only as valuable as the person doing the rating and the reason that they’re doing it. Mark my words, as we go forward with alternatives and time and space separate us from 2008, there will be another unravelling. It was 14 years between 1994 and 2008. So, in around ten years from now, there will be some other stupid thing that will cause another unravelling. BILL SMIT H: Those who don’t learn from history are driven to repeat it, right? The only other point I would make, and it harks back somewhat to what Chris said: let’s remember that this was not simply a securities lending problem, it was a short term cash investment problem driven by cash and liquidity crises. As Debra intimated, the demand for yield at times drives bad decisions, and securities lending, as an industry, owns some of those bad decisions. The money market fund industry owned a huge amount of those decisions, but the thing we need to do is learn from that. Now as we look at collateral and think about how it will evolve going forward, it is clear it will become a very sophisticated game. That is because collateral isn’t just tied to securities lending; because of regulation we have the whole OTC derivatives element to consider and collateralise. There will suddenly be a demand for collateral like we’ve never seen before, and the people, and the institutions who can truly optimise the use of collateral or the supply of collateral for clients, will be the winners in this new world. That is because people will actually pay a lot, if they can save a lot, by optimising the way they use collateral. DEBRA MCGINTY -POTEET: The thing that’s different this time is that after 1994 securities lending and related activities got pushed back to the back office. But now different considerations are in play. Portfolio managers should be looking at securities lending. It is not an operations function, it is a portfolio optimisation tool, and it should have ongoing analysis and oversight by people who understand that fact. If you’re not going to have

FTSE GLOBAL MARKETS • APRIL 2012

Bill Smith, managing director, business development and sales, securities lending (Americas) JP Morgan. “This has been a business which, for almost 20 years, up to 2008 certainly, was growing at a steady clip. More and more people were flooding in, and it all looked like it was very easy money,” says Smith. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

another repeat in another few years of chaos, it will be because it’s portfolio managers looking at securities lending, not an operating or process person, who does not have any experience or understanding of what the real risks are. JEFF KEARNY: With respect to collateral management, everyone talks about the increased cost of using a separately managed account. But for most of very large players in this business—the big fund complexes, the largest of the large pension plans—it’s not really more expensive, especially if management can be done in-house. It’s incrementally not that big a deal to pay a little more for a separate account. If you want more control, then it’s certainly worth doing it. Where you have issues is with the smaller lenders, either small mutual fund complexes, or smaller pension plans. Some are barely big enough to get into a lending programme, let alone having their own separate account. Some of those types of programmes need to look a little bit more carefully at collateral and ask: Do we really understand what we are investing in? If we’re going into a pooled product, who else invests in that pooled product, and is fund only used for lending, or is it used for other purposes as well? Many providers that manage collective trusts or other pooled collateral reinvestment funds, have argued that their funds are used exclusively as securities lending pools, and are customised for the needs of a lending program. But when everyone started running to the gate, and the gate was closed due to liquidity constraints, many lenders realised that maybe they don’t want to be invested only in a securities lending specific fund. Maybe you want to be in something with a broader base of investors, so that when there is a problem, everyone’s not reacting the same way at the same time. So we’re seeing a little more thought being given to that by some of the beneficial owners.

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Separate accounts are terrific, but again, you still have the issue that, if the short term credit markets are melting down, just because it’s your security in your account, it doesn’t mean you’re going to be able to sell any easier than the pooled fund manager. You’ve also got to worry about maintaining enough liquidity to support changing lending volumes. We’ve seen some sophisticated lenders say they will have a separate account for the longer end of investment, but use a pooled product for the real short, liquidity management piece. Or, if they have in-house fixed income management capabilities, they might run a separate account for the bulk of the assets, and let their agent lender run the short end. We’re seeing more of that approach. JOSH GALPER: I’d like to take collateral management out of the context of securities lending for just one moment, because it is a much, much bigger issue, than just securities lending. The estimates I’ve seen put the amount of collateral outstanding globally between $8trn and $12trn. Securities lending, on the other hand, is a $2trn or so industry. So when you start to look at collateral management, more and more institutions understand that it’s really a cross product game, it’s not just about securities lending alone. Europe is much more advanced, in my opinion, than the US in this manner, where you have more cross product collateral management functionality. Clearstream for instance now offers collateral management globally in partnerships with other central securities depositories. I think that collateral management is the next big thing for pre-trade analysis. It is the next big piece of technology that’s going to be rolled out to asset managers large and small. It’s already made its way into banks, many of whom are building their own systems, but smaller banks are buying systems off the shelf. We see collateral management as following the road taken by foreign exchange some ten years ago, where it used to be that it was simply the custodian who was doing the foreign exchange trade for a mutual fund or plan sponsor. Then there was Hotspot FX, a spot trading platform, and then, prime brokerage for FX. A whole suite of pre-trade products is now available for FX at the asset management level. Collateral management seems to be following the same path including the cost of collateral management; before you even do the trade, it simply gets priced in. We put out a fairly large survey in November of last year on what are successful strategies for collateral management in the age of CCPs. While this will still take a year or two to develop in the US, in Europe it’s what they talk about all the time. FRANCESCA CARNEVALE: Why is that? JOSH GALPER: It’s been easier for US asset managers to rely on banks and bank balance sheets in order to manage all their collateral. Many trades, especially in the OTC

Josh Galper, managing principal, Finadium. “As far as the challenges we see in the market, I would echo the comments of my colleagues here at the table, encouraging strong oversight, encouraging an understanding of why the fund is in securities lending to begin with,” says Galper. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

world, have been able to be done without initial margin. That has taken the whole equation of collateral off the table. But now that standardized OTC derivatives have to move on to CCPs, a large swathe of collateral is being taken off the table and cannot be re-hypothecated. This increases cost across the board. Banks will now say to asset managers,“Here’s the cost of our commission, here’s the cost of your collateral.”The asset manager is going to reply: “Wait a minute. Really, I lose that? I lose that money or those Treasuries?” In practice collateral management becomes a much more important issue when evaluating the trade before you go in.

MAKING THE BEST OF A LOUSY HAND BILL SMITH: This is probably the new normal; but there’s still this question of the layer of very thin margin trades in an environment where it appears that (at the very least) for another few years we will have absolute interest rates near this historic low level. Inevitably you will see further erosion in these marginal spreads, and that may have an impact on volumes. In other words, it will drive a portion of those volumes down. Debra’s point is good: fixed income has one view; equities have another. Where do you put corporate and high yield bonds? They fit in between these two? DEBRA McGINT Y -POTEET: I would put it closer to equity, particularly if it’s high yield. BILL SMITH: I thought so, and actually I agree. Even so, we will see departures of segments of the client base that have come to learn that we’re not going to return to an environment where there are high quality fixed income securities that can sustain sizeable securities lending returns without taking undue risk. Once we’ve adapted and adjusted to that, then we will see increased volume from

APRIL 2012 • FTSE GLOBAL MARKETS

things such as collateral requirements and scarcity of collateral. That in turn might drive some of those high quality securities right back into demand, but on different terms. While I expect to see growth long term, in the interim we may see a dip before we see a rise, as we get some of these things straightened up. JOSH GALPER: Under the current expectation of rules, alternative repo is going to become more important, partially because banks need it in order to finance their positions, and partially because it provides a real alternative for cash investors to earn some kind of spread that they feel is more deserving of what they would like to see. In particular, equity, illiquid ABSs, corporate bond repo, these are all areas where investors can and should be focusing some attention. Certainly, there is more risk than in a traditional Treasury or agency MBS repo. We’ve also seen a huge spike in term repo, instead of overnight, and that’s something that bears watching as well in the securities lending environment going forward. BILL SMITH: That’s a good point Josh: this is a driver that’s dramatically affecting the borrower community. They are being driven by regulation, to secure more and longer term financing. At the same time our clients’ risk appetite is driving them closer and closer to overnights, and there’s a break there. Again, for those who will be willing to take advantage of that break, they will get paid for it. Those that cannot will continue to suffer at the short end of the curve, and real returns may even get lower over the next two years. If you gain stability and you’re still at this low interest rate, then it’s going to be pretty hard to get anything for your short term money, because there’s such a log jam of money, at the ultimate short end of the curve. JOSH GALPER: The same holds true for the SEC regulations, for 2A7 funds, where they are all looking for that shorter term maturity. OWEN NICHOLS: Perhaps one question to answer is: who will be participating or providing in this space going forward? We’ve already started to see a couple of fringe players exit the business. It will be interesting to see how much more is reinvested and by who, into this business over the coming years because we all agree that these levels of balances are likely to be the new normal for quite some time. So, which of the current providers will continue to invest in the business, to keep this business growing? FRANCESCA CARNEVA LE: Do you think beneficial owners will benefit or suffer from a contraction in the number of providers? JEFF KEARNY: There was such an explosion of providers entering the business when things were hot that inevitably we are going to see a something of a retrenchment in the near term. Beneficial owners will benefit from this devel-

FTSE GLOBAL MARKETS • APRIL 2012

Owen Nichols, securities finance group, Statestreet. “Our challenge is to develop a customized servicing model that is a fit for a wide range of clients. Invariably this involves showing clients that it is worth the effort to be in securities lending,” says Nichols. Photograph kindly supplied by Peter Jordan Photography, March 2012 © Berlinguer.

opment. Marginal players who cannot tough it out through hard times will go away and you will be left with players who are really flexible, creative and bright enough to handle the ups and downs of the market. As plan sponsors and beneficial owners also wise up and become savvier, they in turn can explain to agent lenders how they want their programmes run. In the past there was little thought to the way in which securities lending fits in with their overall investment process. Thankfully, there is so much more customisation, even to the point where portfolio managers are getting involved. We keep saying securities lending needs to come out of the back office and become a front office activity, and now we’re finally seeing some signs that it has. CHRIS POIKONEN: Perhaps some of the smaller beneficial owners limit their lending activity to select higher margin asset classes or exit the product altogether, given it may not make economic sense for them to continue to participate. Intermediaries may also have to closely consider the economics in providing certain services and indemnities to smaller less profitable accounts. That said, Beneficial Owners that stay the course should expect to receive a focused, highly customized program tailored to their unique needs.

WHAT’S IN THE NEXT ROOM? DEBRA MCGINTY -POTEET: Speaking from the asset management side of things, and as a boutique firm, this whole idea of bringing in folks that oversee cash is an anathema to an equity shop. Cash people and equity people don’t normally live in the same cave. So, while there may be some great opportunities to manage collateral more effectively going forward, shops like ours simply don’t want to lose clients’ money. They also don’t want some money fund desk sitting over their shops. As I watch this thing evolve, from our perspective, is, when you look

ROUNDTABLE

at these super specials, maybe when your traders are involved and you’re getting into an emerging markets security for instance, and you have the opportunity to juice your return by another 5,000 basis points, because of the demand of that particular stock, why not? Every positive basis point you can put back into the portfolio is actually meaningful. Dividend arbitrage will probably go away in the next five years, as that particular regulatory arbitrage dries up, and everybody gets wise to that. But it would seem to me that for firms like ours that don’t have wired-in fixed income—actually we do have fixed income, but it’s more of at the longer end of the curve—that we will look for those more special opportunities, and that will become more of a specialised trading and portfolio management type of activity. BILL SMIT H: We will continue to see opportunities in emerging markets and this business has learned how to take advantage of the values offered in emerging markets in a more orderly way. Each emerging market requires more effort to figure out: emerging markets produce a lot of hard work first and opportunity second. If and when we find some stability in these markets, certainly there’s a significant growth curve, right? The world needs investment right now and this is a product which has already moved towards the investment portfolio, and in a difficult market, to echo Debra’s point, we’re real alpha providers right now. It’s not because we’re that much better. It is because (quite frankly) the traditional fixed income asset management business is facing challenges over the next few years. I would say we have proven that we belong in the portfolio decision making process for this business, which means that there are lots of opportunities down the road. However, there will be—on either side—lots of work. But it’s a business which is 25 or 30 years old, if not really longer, I suppose. In the past it has found ways to remake itself, and we’re going through another one of these ‘re-calibration’ phases right now. OWEN NICHOLS: As Bill says, there are opportunities out there, and we are constantly evaluating new markets. However, I think the opportunity in our home market continues to increase. Look at the number of equities that have traded special. That number has continued to rise each year since the crisis. In 2011, between the returns linked to some of the IPOs and continued demand for ETFs and (hopefully) more deal related activity out there, there’s a lot of opportunity for beneficial owners even now. JEFF KEARNY: Actually, many programs that decided to exit lending are now having to go back in front of their trustees to explain why they’re not doing it. It will turn around. Historically there hasn’t been a lot of rigour around the decision-making process that beneficial owners have taken with respect to their lending programs. This is improving, but fiduciaries need to be careful not

only to document their decision to lend – they also need to document their decision not to participate. If you have a perfectly good lendable asset base, you are potentially leaving money on the table by not lending. There has to be good justification. FRANCESCA CARNEVALE: Is there a danger that with the inevitable flight to quality that occurs at times like this, that the main providers, will end up choosing which firms they will deal with and which firms they won’t; and that there will be a number of firms that just will be cut out of this business. JEFF KEARNY: We’ve already seen some of that; especially for some of the larger agents out there. The business used to be about gathering lendable assets. You didn’t necessarily care who your client was as long as the assets were there. However, having gone through this period of tumult, lenders now know that the worst client they could possibly have is an uninformed client. Many agent lenders found that out the hard way. There were some horror stories. Some clients literally did not know what securities lending was until problems arose. Or, if they did know, the lending agreement had been written in 1989 and had outdated indemnifications. Or that the Board of Trustees put a lending programme in place 15 years ago and no one’s reviewed it since. You don’t want clients like that. Nowadays, we see lending agents looking more closely at who their clients are and what they are committing themselves to by taking on new business. So, as you suggest Francesca, we’re already starting to see some of that selection happening. OWEN NICHOLS: In 2011, when markets were stressed over the eurozone or the US debt ceiling issue, clients did not all rush to the sidelines; but they did in 2008. What does this mean? I would say clients are now better educated and are more open to restructuring their lending programme in different ways to balance investor return. In that sense, what was going on in the market was extraneous; it didn’t matter as much. I take this as an encouraging sign. CHRIS POIKONEN: Let’s look at the positive. Securities lending is still a very good global business; margins remain healthy; and many bright and innovative people and products are being introduced into this space and helping evolve what was once viewed as a back office solution. While the industry as a whole must go through this period of consolidation and contraction, it will likely re emerge much healthier and provide significant value to its participants for years to come. JOSH GALPER: There’s a silver lining: there is a broadening level of education and understanding about securities lending throughout the financial markets. That will only serve as a positive for securities lending going forward. I

APRIL 2012 • FTSE GLOBAL MARKETS

(Week ending 16 March 2012) Reference Entity

Federative Republic of Brazil Republic of Italy Republic of Turkey Bank of America Corporation Russian Federation United Mexican States MBIA Insurance Coproration JP Morgan Chase & Co. Hellenic Republic Morgan Stanley

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Financials Government Government Financials Financials Government Financials

Sov Sov Sov Corp Sov Sov Corp Corp Sov Corp

18,965,449,928 22,124,995,261 8,409,490,952 5,688,236,251 4,230,897,652 8,409,490,952 3,235,542,261 4,865,368,097 3,056,073,359 4,767,761,730

163,434,704,675 328,774,473,845 146,444,437,234 146,444,437,234 115,539,907,212 125,898,562,538 91,208,181,005 81,235,038,151 82,454,890,234 80,291,198,058

10,312 10,023 9,791 9,519 9,173 8,962 8,856 8,193 8,082 7,632

Americas Europe Europe Americas Europe Americas Americas Americas Europe Americas

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

22,186,278,099 22,124,995,261 19,223,921,071 18,965,449,928 14,744,684,824 11,709,645,937 10,998,498,649 9,787,987,201 8,663,693,677 8,409,490,952

133,988,945,679 328,774,473,845 114,293,375,162 163,434,704,675 167,146,080,380 63,632,826,927 98,759,337,909 75,430,435,768 59,598,322,418 125,898,562,538

6,369 10,023 4,259 10,312 7,066 4,241 7,613 7,444 6,604 8,962

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

Top 10 net notional amounts (Week ending 16 March 2012) 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 Japan People’s Republic of China United Mexican States

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 16 March 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,449,615,967,463

471,202

Republic of Italy

6,555,162,026

306

Sovereign / State Bodies

2,812,686,536,771

213,016

Kingdom of Spain

5,203,186,005

381

Corporate: Consumer Services

2,129,972,375,452

360,422

French Republic

3,924,555,100

234

Corporate: Consumer Goods

1,609,530,960,586

260,506

Federal Republic of Brazil

2,615,944,000

176

Corporate: Industrials

1,320,619,935,428

230,274

Federal Republic of Germany

2,113,160,000

115

978,343,423,346

161,462

General Electric Capital Corporation 1,474,959,906

Corporate: Telecommunications Services 927,131,144,450

140,675

MBIA Insurance Corporation

1,230,750,632

122

Corporate: Utilities

776,610,155,800

124,950

Argentine Republic

1,187,879,590

102

Corporate: Energy

514,112,239,764

92,060

UK and Northern Ireland

1,088,325,000

Corporate: Health Care

361,035,026,402

63,150

Corporate: Tecnology

351,171,831,824

62,847

People’s Republic of China

1,080,025,000

184

Corporate: Other

195,621,153,576

24,561

Corporate: Basic Materials

Other

72,220,438,891

6,775

CDS on Loans

58,853,886,733

15,595

Residential Mortgage Backed Securities

48,961,293,989

9554

Commercial Mortgage Backed Securities 13,428,076,792

1385

Residential Mortgage Backed Securities* 10,456,853,754

664

CDS on Loans European

4,366,007,132

642

Muni:Government

1,181,700,000

117

Commercial Mortgage Backed Securities*

657,139,049

Muni: Utilities

64,924,880

Muni:Other

50,000,000

*European

FTSE GLOBAL MARKETS • APRIL 2012

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data © 2012 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 16th March 2012 INDICES

VENUES FTSE 100

INDICES FFI

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

CAC 40

DAX

OMX S30

SMI

2.24

1.98

1.73

2.03

1.71

5.68%

2.86% 3.83%

2.67% 0.02%

4.82%

3.37%

27.29%

21.54%

4.93% 19.81%

18.10%

0.07%

1.73%

0.05%

0.46%

60.28% 0.07% 0.01%

0.07% 64.56%

74.14% 66.97% 0.04% 5.44% 0.00% 0.00%

6.61%

VENUES

3.40%

INDICES

3.41%

3.93%

VENUES

INDICES

DOW JONES

S&P 500

INDICES

S&P TSX Composite

FFI

1.90

1.89

17.18% 9.98% 1.55% 1.32% 2.85% 67.13%

15.54% 10.52% 1.63% 1.32% 2.86% 68.14%

4.53

4.33

BATS

10.26%

10.72%

BATS Y

4.24%

3.87%

CBOE

0.26%

0.21%

Chicago Stock Exchange

0.40%

0.50%

EDGA

5.33%

4.31%

EDGX

11.08%

8.81%

NASDAQ

22.48%

25.83%

NASDAQ BX

5.15%

4.16%

NASDAQ PSX

1.60%

1.42%

NSX

0.42%

0.43%

NYSE

24.65%

25.73%

NYSE Amex

0.18%

0.09%

NYSE Arca

13.95%

13.92%

VENUES

S&P ASX 201

FFI

1.01 Australia Chi-X Australia

Canada*

99.30% 0.70%

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

1.37 2.38% 0.00% 0.00% 0.00% 2.28% 85.02% 10.31% 0.00%

VENUES

INDEX

FFI

Japan

S&P TSX 60

NIKKEI 225

INDICES

Australia

19.70% 73.44% 0.03% 0.01% 0.58% 0.06% 0.01%

INDICES

HANG SENG

FFI

1.00

Asia

Hong Kong

100.00%

APRIL 2012 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

APAN PROVIDES A particularly interesting chapter in the global fragmentation story. Whilst it was one of the first countries to allow alternative trading venues, back in 1998, levels of fragmentation in the Japanese equity markets have remained relatively low compared to other regions that have adopted a multi-market structure much more recently. Clearing restrictions, a short-selling ban and the lack of a formal best execution framework (as enshrined by the trade through rule in the US and MiFID's principles-based approach in Europe) presented Japan's alternative trading venues (known as PTSs) with some serious challenges in their efforts to wrest market share away from the Tokyo Stock Exchange (TSE). Since those early days, however, PTSs have been admitted to clearing on the Japan Securities Clearing Corporation and the short-selling ban has been lifted. The removal of these obstacles, and the fact that both of the alternative venues - Chi-X Japan and SBI Japannext - offer tick sizes one tenth that of the primary exchange (providing narrower spreads), has allowed them to succeed in attracting liquidity and building momentum. The combined share of Chi-X Japan and SBI Japannext in the Nikkei 225 is now at around 5% (chart 1). It's not all plain sailing, however. When the PTS concept was formed, the new venues were designated as OTC venues and, as such, the regulatory regime continues to present them with some ongoing challenges. In an effort to ensure transparency for corporate takeovers, the 5% TOB (Takeover Bid) rule states that any investor amassing 5% of a firm’s stock through OTC trading must then mount a full takeover bid for that firm. Furthermore, any PTS that amasses 10% market share must automatically apply for full exchange status. This impacts the potential growth of activity on the PTSs as they continue to appeal to the regulators for a more level playing field. That said, the growing legitimacy of PTSs is further underlined by the fact that the Japanese Securities Dealers Association

Average Average trade size, Nikkei 225 (Feb'12)

Minimum tick size Tokyo Tokyo

4,365 4,365

Chi-X Japan

1 JPY

852

0.1 JPY SBI Japannext

1,096

2,000

4,000

Chart 2

recently rescinded earlier restrictions that prohibited market participants from trading on these alternative venues in the event of the primary market failing. This significant new milestone was achieved shortly after the TSE outage on 2 February this year. The PTSs are already demonstrating innovation, providing the trading community with a broader range of order types (over and above the market and limit orders that the primary exchanges offer) as well as considerably lower trade sizes (chart 2). At the start of 2012 Chi-X was the first venue in Japan to introduce liquidity credits - a mechanism for rewarding liquidity providers similar to the maker-taker pricing model already popular in other regions - perhaps hoping to attract the potentially valuable high frequency trading (HFT) community. It will be interesting to see what impact this initiative has and also how the alternative venues will respond if, as seems likely, the TSE and OSE combine and the market contemplates the monopoly power of the combined Japan Exchange Group.

Lit value %, Nikkei 225

Chart 1

Chi-X Japan

SBI Japannext

8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00%

'11 O ct '11 N ov '11 D ec '11 Ja n' 12 Fe b' 12

'11

Se p

'11

Au g

Ju l

Ap r'1 1 M ay '11 Ju n' 11

ar '11

'11

Fe b

Ja n

'1 0 O ct '1 0 N ov '1 0 D ec '1 0

'1 0

Se p

Au g

Ju l

'1 0

0.00%

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 • APRIL 2012

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2007 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

Fe b12

-1 1

N ov -

Au g

M ay -1

Fe b11

N ov -

Au g-

M ay -1 0

Fe b10

N ov -

-0 9

Au g

M ay -0

Fe b09

-0 8

ov -0 8 N

Au g

M ay -0

Fe b08

ov N

-0 7 Au g

M ay -0 7

40 Fe b-

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 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

Fe b12

11 N ov -

-1 1

Au g

M ay -1

Fe b11

10 N ov -

10 Au g-

M ay -1 0

Fe b10

09 N ov -

Au g

-0 9

9 M ay -0

Fe b09

ov -0 8 N

Au g

-0 8

8 M ay -0

Fe b08

ov -0 7

-0 7

Au g

M ay -0

Fe b0

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 February 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

Fe b12

11 N ov -

-1 1 Au g

1 M ay -1

Fe b11

N ov -

10 Au g-

M ay -1 0

Fe b10

-0 9

N ov -

Au g

9 M ay -0

Fe b09

ov -0 8 N

-0 8 Au g

08 ay M

Fe b08

ov -0 7 N

-0 7 Au g

ay -0 7 M

Fe b07

Source: FTSE Group, data as at 29 February 2012

APRIL 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 2007 = 100) FTSE USA Index

FTSE All-World ex USA Index

140

120

100

Fe b12

-1 1

N ov -

Au g

M ay -1

Fe b11

N ov -

Au g-

M ay -1 0

Fe b10

N ov -

-0 9

Au g

M ay -0

Fe b09

ov -0 8 N

-0 8

Au g

M ay -0

Fe b08

-0 7

ov N

Au g

M ay -0 7

Fe b-

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 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

11 Fe b12

N ov -

Au g

-1 1

1 M ay -1

Fe b11

10 N ov -

10 Au g-

M ay -1 0

Fe b10

09 N ov -

-0 9 Au g

9 M ay -0

Fe b09

ov -0 8 N

-0 8 Au g

8 M ay -0

Fe b08

ov -0 7 N

-0 7 Au g

7 M ay -0

Fe b0

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 February 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

Fe b12

11 N ov -

-1 1 Au g

1 M ay -1

Fe b11

10 N ov -

10 Au g-

M ay -1 0

Fe b10

09 N ov -

-0 9 Au g

9 M ay -0

Fe b09

ov -0 8 N

-0 8 Au g

08 ay M

Fe b08

ov -0 7 N

-0 7 Au g

ay -0 7 M

Fe b0

Source: FTSE Group, data as at 29 February 2012

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2012

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (28 February 2007 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140 120 100 80 60 40

Fe b12

N ov -

-1 1 Au g

M ay -1

Fe b11

N ov -

Au g-

M ay -1 0

Fe b10

-0 9

N ov -

Au g

M ay -0

Fe b09

ov -0 8 N

-0 8 Au g

M ay -0

Fe b08

ov N

-0 7 Au g

M ay -0 7

20 Fe b-

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 (28 February 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

Fe b12

11 N ov -

-1 1 Au g

1 M ay -1

Fe b11

N ov -

10 Au g-

M ay -1 0

Fe b10

-0 9

N ov -

Au g

9 M ay -0

Fe b09

ov -0 8 N

-0 8 Au g

8 M ay -0

Fe b08

07 ov N

-0 7 Au g

M ay -0 7

Fe b-

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (28 February 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

Fe b12

11 N ov -

-1 1 Au g

M ay -1 1

-1 1 Fe b

10 N ov -

10 Au g-

M ay -1 0

Fe b10

N ov -0 9

g09 Au

-0 9 ay M

Fe b

-0 9

Source: FTSE Group, data as at 29 February 2012

APRIL 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 (28 February 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

Fe b12

-1 1

N ov -

Au g

M ay -1

Fe b11

N ov -

Au g-

M ay -1 0

Fe b10

N ov -

-0 9

Au g

M ay -0

Fe b09

ov -0 8

-0 8

Au g

M ay -0

07 ov -

Fe b08

-0 7

Au g

07 Fe b-

M ay -0 7

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (28 February 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

Fe b12

N ov -1 1

Au g -1 1

-1 1

1 M ay -1 11

Fe b11

N ov -1 0

10 Au g-

M ay -1 0

Fe b10

N ov -0 9

-0 9 Au g

9 M ay -0

Fe b09

ov -0 8

Au g

-0 8

8 M ay -0

Fe b08

ov -0 7 N

-0 7 Au g

M ay -0

Fe b0

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (31 August 2010 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

180

160

140

120

100

12 Fe b-

12 Ja n-

De c

ov N

Oc t1

11 Se p-

11 Au g-

Ju l11

1 Ju n1

1 M ay -1

1 Ap r1

ar -1 1 M

Fe b11

-1 1 Ja n

De c10

ov -1 0 N

Oc t10

Se p10

Au g

-1 0

Source: FTSE Group, data as at 29 February 2012

FTSE GLOBAL MARKETS â&#x20AC;˘ APRIL 2012

INDEX CALENDAR

Index Reviews May-Jun 2012 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

09 May

TOPIX

Monthly review - additions & free float adjustment

30-May

30-Apr

11 May

Hang Seng

Quarterly review

01-Jun

31-Mar

15 May

MSCI Standard Index Series

Annual review

31-May

30-Apr

22 May

DJ STOXX

Quarterly review

15-Jun

30-Apr

Semi-annual review

15-Jun

31-Jan

22 May

FTSE Goldmines Index Series

24-May

FTSE All-World and FTSE Global Small Cap Asia Pacific ex Japan

Annual review

15-Jun

31-Mar

Early Jun

IBEX 35

Semi-annual review

29-Jun

31-May

Early Jun

OBX

Semi-annual review

15-Jun

31-May

Early Jun

ATX

Quarterly review

29-Jun

31-May

01-Jun

S&P / ASX Indices

Quarterly review

15-Jun

31-May

01-Jun

CAC 40

Quarterly review

18-Jun

29-Feb

01-Jun

KOSPI 200

Annual review

08-Jun

30-Apr

05-Jun

AEX

Quarterly review

15-Jun

31-May

05-Jun

PSI 20

Quarterly review

15-Jun

31-May

05-Jun

BEL 20

Quarterly review

15-Jun

31-May

05-Jun

FTSE MIB Index

Quarterly review

15-Jun

31-May

05-Jun

FTSE China Index Series

Quarterly review

15-Jun

21-May

06-Jun

FTSE All-World and FTSE Global Small Cap Asia Pacific ex Japan

Annual review

15-Jun

30-Mar

24-May

FTSE All-World and FTSE Global Small Cap Emerging Europe Review Annual review

15-Jun

31-Mar

06-Jun

FTSE UK Index Series

Quarterly review

15-Jun

05-Jun

06-Jun

FTSE AIM Index Series

Quarterly review

15-Jun

05-Jun

06-Jun

FTSE European Index Series

Quarterly review

15-Jun

31-May

06-Jun

FTSEurofirst Index Series

Quarterly review

15-Jun

31-May

06-Jun

FTSE Italia Index Series

Quarterly review

15-Jun

31-May

06-Jun

FTSE ECPI Index Series

Quarterly review

15-Jun

31-May

06-Jun

FTSE JSE Index Series

Quarterly review

15-Jun

31-May

06-Jun

FTSE JSE All-Africa Index Series

Quarterly review

15-Jun

18-May

06-Jun

FTSE ASFA Index Series

Quarterly review

15-Jun

31-May

06-Jun

NZX 50

Quarterly review

15-Jun

31-May

06-Jun

DAX

Quarterly review

18-Jun

31-May

07-Jun

Dow Jones Global Indexes

Quarterly review

15-Jun

31-May

07-Jun

FTSE EPRA/NARIET Index Series

Quarterly review

15-Jun

31-May

07-Jun

FTSE Bursa Malaysia Index Series

Annual review

15-Jun

31-May

07-Jun

FTSE Shariah Index Series

Quarterly review

15-Jun

31-May

07-Jun

TOPIX

Monthly review - additions & free float adjustment

28-Jun

31-May

08-Jun

FTSE Taiwan Index Series

Quarterly review

15-Jun

31-May

08-Jun

FTSE Environmental Opportunities

Semi-annual review

15-Jun

31-May

08-Jun

S&P / TSX

Quarterly review

15-Jun

31-May

08-Jun

S&P Europe 350 / S&P Euro

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P Topix 150

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P Asia 50

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P Global 1200

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P Global 100

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P 500

Quarterly review - shares

15-Jun

01-Jun

08-Jun

S&P BRIC 40

Semi-annual review - constituents

15-Jun

01-Jun

10-Jun

OMX C20

Semi-annual review

22-Jun

31-May

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

APRIL 2012 • FTSE GLOBAL MARKETS