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I S S U E S I X T Y O N E • M AY 2 0 1 2

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Savoir faire: Will Hollande salvage or sink the euro? MALTA REPORT: REDEFINING FINANCIAL SERVICES

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GM Front Issue 61_. 22/05/2012 15:43 Page 1

OUTLOOK EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152 email: francesca@berlinguer.com SENIOR EDITORS: David Simons (US) Neil A O’Hara (US) Ruth Hughes Liley (Trading) EDITORS AT LARGE: Art Detman; Lynn Strongin Dodds CORRESPONDENTS: Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Ian Williams (Supranationals/Emerging Markets) PRODUCTION MANAGER: Lee Dove at Alphaprint, tel: +44 [0]20 7680 5161 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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F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

eality bites. It is now clear 2012 is not a year of consolidation. Instead it is a reckoning. Markets and electorates remain volatile as the world looks to put in place a new order. It was never going to be easy; but perhaps no one estimated just how difficult or expansive change would be. High levels of debt and continuing regulatory and political change in Europe continues to exert pressure on the continent’s financial markets, at growing cost to its overall prospects as an investment destination. Our cover story once again addresses the festering sore that is the eurozone. Greece is a long gone saga; the only question there is when will everyone have the grace to cut short its suffering; set the country free from its euro-shackles and find a solution instead for the foreign banks that are still heavily exposed to Greek debt. Cauterisation of the boil is needed: perhaps sooner rather than later. Neil O’Hara looks at the market pressures on the euro and assesses how far the euro-club can keep what looks to be inevitable change at bay. It is clear that the impact of euro crisis is being felt across the globe. The long term cost is incalculable; and there are worrying signs for Europe at many levels. I highlight just three of them. Already global institutions look to be shifting their strategies to leverage the more encouraging outlook in still emerging, but higher growth markets. “I’m shifting the entire focus so the emerging-market business predominates,” stated Stuart Gulliver, HSBC’s group chief executive, at a recent earnings call. HSBC generated an underlying pre-tax profit of $6.7bn in the first quarter (Q1) at group level, up 25.1% compared with Q1 2011. The profit beat analysts’ estimates as the bank leveraged growth in the Asia-Pacific. Tellingly, the bank reported a loss of $997m in Europe, after it set aside $468m to cover charges arising from the misselling of payment protection insurance in the United Kingdom. Singaporean sovereign wealth fund Temasek too indicated a growing shift eastwards in the last few weeks, announcing it had bought $2.3bn worth of ICBC’s Hong Kong listed shares. It only holds a 1.3% stake in the bank; but the story of fund is that now 20% of its portfolio involves Chinese assets. This is something of a sea change for a fund which traditionally has gone long on banking assets concentrated in developed markets (and particularly in Europe). Now it has shifted to those banks with an ability to leverage emerging market growth. Elsewhere, our annual report on the boom town that is Qatar shows that European banks are also scaling back on international lending. “European banks’ share of total funding to Qatari entities has declined from 63% in 2007 to 28% in 2011,”explains George Nasra, chief executive of IBQ in Doha City, sourcing Dealogic for the data. Though because of the surplus funds in the Qatari government’s coffers, he thinks this decrease will have only a limited impact on project funding; but then again he also points to the growing presence/influence of Asian banks in the country and in the wider Gulf region. It is not all doom and gloom. The Nordic zone, writes Lynn Strongin Dodds, is doing rather nicely thank you; and across Europe there are pockets of hope and good performance. Moreover, if the euro continues to devalue it may give some of the suffering sovereigns in the region a lifeline for their stressed export industries. However, politics currently trumps entrepreneurship across the continent and that is always worrisome; particularly as it tends to mean hefty regulation of the financial sector that is supposed to support business growth. Answers to these problems anyone? On a postcard please. Francesca Carnevale, Editor, May 2012 New French President Francois Hollande gives a press conference after meeting German Chancellor Merkel for talks at the Federal Chancellery in Berlin, Germany, May 15th 2012. The visit to Berlin is the first state visit of the French socialist politician as French President. Merkel and Hollande discussed a joint solution for the Euro crisis. Photograph by Kay Nietfeld for AssociatedPressimages, supplied May 2012.

GM Front Issue 61_. 22/05/2012 15:43 Page 2

CONTENTS COVER STORY

LAST RITES FOR THE EUROCLUB?

................................................................................Page 6 Can Germany go it alone and keep the euro project afloat? Does it want to? While the ECB and the rest of the world wait for the response of the euroclub to another critical round of talks over the ins and outs of Greek eurozone membership, the markets might this time push harder for a revamp of the euroclub structure. Neil O’Hara surveys the options.

DEPARTMENTS

SPOTLIGHT

MUCH ADO ABOUT HFT & OTHER STORIES ...................................................Page 12 Market highlights in review: debunking myths around HFT.

NATIONALISE? ME? ............................................................................................................Page 14 Vanja Dragomanovich reports on the nationalisation trends sweeping Latin America.

SHADOW BANKING: BRINGING LIQUIDITY INTO THE LIGHT ....Page 19

IN THE MARKETS

Neil O’Hara looks at whether shadow banking is pussycat or polecat.

INVESTORS PILE INTO ISLAMIC BONDS ..........................................................Page 22 Two dollar denominated bond issues out of Saudi Arabia set a benchmark.

INVESCO STUDY SHOWS INVESTMENT TRENDS IN GCC SWFs ....Page 23 Subtle shifts in asset allocation evident towards local investment.

MALAYSIA MOVES TO STIMULATE SUKUK ISSUANCE ............................Page 25

COUNTRY REPORT

The jurisdiction is keen to support foreign denominated sukuk.

QATAR: BANKING ON INFRASTRUCTURE............................................................Page 26 Qatar’s financial sectors are deepening; can infrastructure investment deliver more?

COMPANY PROFILE INDEX REVIEW SECURITIES SERVICES

SEARS: THE LONG GOODBYE?

..............................................................................Page 31 Can Edward S Lampert turn around the fortunes of Sears? Art Detman reports.

THE PUSH AND PULL OF POLITICS AND WILLPOWER ......................Page 34 Simon Denham, managing director of Capital Spreads, takes the bearish view.

EUROPEAN SUB CUSTODY: THE FOCUS ON COSTS & RISK

........Page 35 David Simons explains the impact of changes in post trade settlement infrastructure.

NORDIC STATES UNDER PRESSURE FROM EUROZONE

REGIONAL REPORT

......................Page 37 Lynn Strongin Dodds on the repercussions of the euro crisis on the Nordic zone.

DIVERSITY AND COMPETITION IN NORDIC SUB CUSTODY ............Page 39 Ulf Norén, Global Head of Sub-Custody at SEB, discusses the main trends.

DEBT REPORT 2

DEBT TRADING IN FLUX: A NEW INFRASTRUCTURE EMERGES ....Page 41 Andrew Cavenagh looks at why banks might withdraw from bond trading.

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Front Issue 61_. 22/05/2012 15:44 Page 3

GM Front Issue 61_. 22/05/2012 15:44 Page 4

CONTENTS FEATURES SECURITIES SERVICES

REGULATION ADDS MORE STRESS TO SEC LENDING ..........................Page 44 While the industry broadly supports stronger transparency measures, Europe’s securities lending participants worry that the imposition of some tough new regulatory regimes could help undermine market efficiency by reducing liquidity and price discovery while widening deal spreads. Does the opportunity still exist for some modification to take place? David Simons reports.

AT THE TOP OF THE DEMAND CYCLE ..........................................................Page 47 Though asset volumes have improved, client service demands remain at an all time high. It is forcing domestic fund administrators to wring every last drop of efficiency out of their operating systems. Meanwhile, a raft of challenging new regulations on the horizon continues to fire the worry machine. How are these firms faring? David Simons went in search of some answers.

TRADING REPORT

SOLVING THE LIQUIDITY EQUATION..............................................................Page 51 With the jury still out on whether average daily trading volumes will rise, stagnate or fall through the rest of this year, the story du jour is the search for liquidity. As the buy side coalesces trading in the hands of fewer broker-dealers, the onus is on the sell side to provide liquidity on tap. How they do that is in ever smarter ways. Ruth Hughes Liley surveys the trading trends and the options open to the buy side.

MALTA REPORT

TOWARDS A NEW VISION OF FINANCIAL SERVICES ............................Page 55 The story of the financial sector in Malta over the last ten years is one of growth. Growth is evident in the number and size of organisations locating in the jurisdiction and the services that have sprung up in support of financial services. Ruth Hughes Liley headlines a detailed report of the Maltese financial services sector.

FUND PROFILE: HSBC AM – A BALANCED APPROACH

......................Page 58 Developing a diversified and balanced investment approach is de rigeur for asset managers working in Malta, to optimise returns for investors and to minimise risk. Ruth Hughes Liley profiles HSBC Global Asset Management (Malta).

A READY GUIDE TO SETTING UP PIFS ..........................................................Page 60 Over the past seven or so years of its existence, the Maltese Professional Investor Fund (PIF) regime has proven to be a success story with over 400 PIFs licensed in Malta to date. As the scramble for AIFMD friendly jurisdictions for hedge funds heats up, the PIF regime looks set to continue from strength to strength.

DEMAND FOR CUSTODY SERVICES GROWS IN MALTA ......................Page 63 In 2004 there were just eight locally-based professional investor funds (PIFs) licenced in Malta. By December 2006 this had grown to 91 funds worth €3bn. Today 700 licences have been issued for all types of collective investment schemes.

Q&A: ASSET MANAGEMENT EVOLUTION IN MALTA ..........................Page 67 The principal elements contributing to the growth of Malta’s financial services industry have been the shift in status from an offshore jurisdiction to an onshore jurisdiction, and Malta’s entry into the European Union in 2004. In a special Q&A Daniele Cop, partner and Dr Nicolé Ann Saliba, associate, at Mamo TCV Advocates explain the dynamics.

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GM Regional Review 61_. 22/05/2012 15:45 Page 18

IN THE MARKETS

INVESTORS STUNNED BY ARGENTINE AND BOLIVIAN NATIONALISATIONS

trade particularly with Brazil, infrastructure is good and it has a well educated population. But this has to be balanced out with high inflation which is close to 30%, massive wage increases and a mixed outlook on resources. This has to be reflected in the valuation of the stocks and while stocks have priced in some of that I still don’t see that valuations are reflecting that,” says Adam Kutas, who manages two Latin American funds for Fidelity Advisors. Fidelity’s Latam funds were among the ten most successful Latam funds this year, according to Morningstar. “You have to ask yourself why invest in Argentina when you have better options for instance in Colombia’s energy sector? I can for instance find great opportunities in Colombia, Chile or Brazil,” adds Kutas. He notes that a major deterrent to fund investors is the fact that money invested in Argentina has to be kept in the country for a number of years.“As a fund manager I need to have access to money, I cannot afford for it to be tied up and to have to be able to wait for a few years,”he adds. “Latin America is a pretty dynamic region and these situations create opportunities. If, for instance, you already are an investor in the country and you have dollar-funding then you can command higher returns on your investment,” explains Ernest Bachrach, managing partner at Advent International, a global private equity firm. Companies active in the country include Americas Petrogas Inc, a junior Canadian exploration company operating in Neuquén, the province in which the shale oil was discovered, and major oil services firm Schlumberger, as well as Cargill, the agriculture exporter. “Nobody says that this decision is a good thing but it is a question of returns. Emerging market investors are fairly resilient, they are used to these kinds of situation and they will stay in a country even if the red tape becomes more complicated as long as they can make good returns on their investment,” says the

head of emerging markets research in a London-based bank. What investors are trying to assess now is how long policies such as the current strict foreign-exchange controls will stay in place. Argentina’s political system is modelled on the one in the US and allows the president a maximum of two terms in power. The current government was voted in for its second term at the end of 2011 and will most likely stay in place until late 2015. However, in a move reminiscent of Putin’s manoeuvring in Russia there has been talk about changing the constitution to allow for a longer presidency. Before that happens however Argentina will likely lose Spain, and potentially Netherlands, as one of its major trade partners and face repercussions from the EU for breaching international trade regulations. China is likely to take up the space left open by European investors. What kinds of strings this will bring with it remains to be seen.

Bolivia’s investor assault In early May came the news that Bolivia’s president Evo Morales intended to seize Bolivia’s main electricity company, reinforcing the divide between free market Latin American leaders and those seeking more state control. Bolivia is nationalising the local assets of Alcobendas, Spain-based Red Eléctrica Corp., giving him control of the country’s power grid. Reminiscent of Fernandez’s reasoning, Morales says the company’s local investment was inadequate. However, Morales has been at the nationalisation game for a lot longer. He began his nationalisation drive in 2007 when he took control of the country’s largest telecommunications company and an electricity company and forced foreign oil companies into minority shareholder agreements as part of joint ventures. Then, on May 1st 2010, he nationalised four power companies, including assets from the UK’s Rurelec Plc and France’s GDF Suez SA.

Bolivia’s latest announcement is not of the magnitude of the Argentine move. The benchmark IBEX 35 index dropped 1.2% on the news; Bolivia generated €45.7m ($60m) in revenue for Red Eléctrica in 2011, less than 3% of total sales. However, the impact of the spectre of nationalisation has been felt in the debt markets. Venezuela’s dollar bonds yield 913 basis points (bps) over Treasuries while Argentina’s spread is 953bps, according to JPMorgan. The countries post the two highest yield gaps among major emerging-market countries. Colombia by comparison has a yield spread of 148bps and Brazil has a yield gap of 184bps. The latter two jurisdictions are liberalising with a bullet; with Brazil having raised $14bn earlier this year from a February auction of licenses to operate three of the country’s busiest airports in an effort to accelerate investments ahead of the 2014 World Cup (please refer to www.ftseglobalmarkets.com, for more details). The timing of the moves is clever. Spain (and in fact the EU) is in a greatly weakened position on the international stage. Look at opprobrium the UK faced in the American and Latin American press and in Latin American seaports having underscored its claim to the Falkland Islands following Fernandez’s revival of a claim on the island group at the end of last year. Now, as in 1982, the American presidency happily stood on the sidelines. It is presidential election year in America, and no one wants to upset the bloc Latino vote. Equally, Fernandez and Morales (together with Venezuela’s Chavez) have calculated that Asian investors have few qualms in substituting their investment dollars in place of disenfranchised Europeans. It’s a new power play by resource-rich nations and institutional investors will have to take note of the new political risks in play in cross border investment as this decade matures. How they respond will be telling. What is certain is that this story will run and run. I

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Regional Review 61_. 22/05/2012 15:45 Page 19

CAN REGULATORS CONTROL SHADOW BANKING?

Photograph © Loveliestdreams/Dreamstime.com, supplied May 2012.

SHADOW BANKING: PUSSYCAT OR POLECAT?

The European Commission pledged at the end of April to tighten control of shadow banking. At a pivotal time in the global financial markets, regulators have become concerned that as the remit of traditional banks is gradually redefined (and, in some cases shrunk) that the shadow banking segment (said to be worth $61trn) could step into the breach. Michel Barnier, the EU official responsible for financial regulation, is examining rule changes for what he termed the ‘complex ecosystem’ of shadow banking. Neil A O’Hara examines whether real danger lurks in the shadows or whether regulators have become too skittish.

HE 2008 FINANCIAL crisis was blamed in part on the collapse of certain entities within the shadow banking system, a parallel world of credit intermediation that takes place without access to either lenders of last resort (central banks) or public sector credit guarantees (deposit insurance). In addition to Lehman Brothers, the culprits included structured investment vehicles (SIVs), highly leveraged entities that issued shortterm asset-backed commercial paper (ABCP) to finance portfolios of collateralised debt obligations and other securities of dubious credit quality. Those SIVs have vanished, but the business model lives on in the public sector, where central banks are providing emergency liquidity secured

F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

against collateral they would once have shunned. Central banks staved off a complete collapse of confidence in the financial system, but at a cost that has yet to be tallied. Their once pristine balance sheets have become bloated with either mortgage-backed securities (the Federal Reserve Bank) or sovereign debt of questionable quality, financed by overnight deposits from banks that are no longer willing to lend directly to each other. A recent Credit Suisse report on shadow banking noted that central banks are “lending at extremely low rates at below market haircuts against practically all manner of collateral for term.” In effect, the central banks have become part of the shadow banking system—gigantic SIVs, with one critical advantage over their private

sector cousins: they can print money to cover any funding shortfall. The Long Term Refinancing Operation (LTRO) has also turned the European Central Bank (ECB) into an intermediary between German banks, stuffed full of surplus cash generated by the country’s successful exportoriented companies, and shaky banks in the peripheral eurozone countries. Barrie Wilkinson, a partner in the finance and risk practice at Oliver Wyman in London, points out that, until last year, German banks were happy to deploy their surplus cash in funding Portuguese, Irish, Italian, Greek or Spanish banks that were, among other things, financing local purchases of German cars and machinery. “Now they are doing it via the ECB,” he says.“The ECB is running a huge maturity mismatch, borrowing overnight money from German banks and lending it out for three years to banks in the peripheral countries— very poor credits.” The private sector SIVs got into trouble in 2007 when they were unable to roll over their funding after investors began to question the credit quality of their assets as the housing bubble deflated. Unable to sell purportedly liquid assets to pay off

GM Regional Review 61_. 22/05/2012 15:45 Page 20

IN THE MARKETS

CAN REGULATORS CONTROL SHADOW BANKING?

maturing ABCP, SIVs turned to their bank sponsors for emergency liquidity support. In many instances, the banks ended up taking back assets they had “sold” to the SIV on to their own books; in other cases, the sponsors funded the SIV until it could liquidate as its assets matured. The net effect was a substantial reduction—up to $5trn, according to a recent Federal Reserve Bank of New York report—in the aggregate assets of the shadow banking system, and a corresponding increase in regulated bank assets. Shadow bank assets may have shrunk ($12trn in 2011 versus $17trn in 2007) but alternative credit intermediation remains an important part of the financial system. In fact, shadow bank assets are likely to grow again relative to the regulated credit sector in coming years as Basel III and other new regulations under the Dodd-Frank Act in the United States and the European Market Infrastructure Regulation (EMIR) directive take effect. Banks will have to hold more regulatory capital, which will crimp their ability to lend. Credit demand won’t go away, however, and borrowers who cannot get it from the banks will turn to alternative sources. “If the regulators reduce the banks’ leverage, the lending has to happen somewhere else,” says Wilkinson.“The demand is still there, and politicians want it there to fund growth.”

Understanding shadow banking Hedge funds and private equity are regularly cited as examples of shadow banking. Shadow banking encompasses a host of different entities, including finance companies, ABCP conduits, SIVs, credit hedge funds, money market mutual funds, securities lenders, limited-purpose finance companies, and governmentsponsored enterprises. In one way or another, they all facilitate maturity, credit or liquidity transformation—the principal functions of regulated

banks—but do not have access to the central bank discount window or deposit insurance. As a result, they lack protection against funding shortfalls and are exposed to the risk of a run. The Financial Stability Board’s (FSB’s) definition is a “system of credit intermediation that involves entities and activities outside the regular banking segment”. Many shadow banks are instrumental in transforming illiquid assets that used to reside on bank balance sheets into tradable instruments through securitisation. They pool mortgages and convert them into mortgage-backed securities, repackage MBS into collateralised debt obligations, gather loans to less creditworthy corporations (below investment grade) into collateralised loan obligations, turn credit card receivables, student loans and auto loans into asset-backed securities. The list goes on and on. The financial engineers have a single goal: to turn stodgy loans into liquid assets. From a regulated bank’s perspective, the transformation shifts assets from the lending book, funded by sticky retail deposits, to the trading book, which relies on cheaper but fickle wholesale funding. It is a neat trick, as long as the securitised instruments remain liquid. For the shadow banks, that liquidity is crucial—they must be able to liquidate the portfolio before their liabilities mature. If they have 30-day funding but can sell everything within 10 days, they’re fine; but when their assets become illiquid, as they did in 2008, they cannot go cap in hand to the central bank for an emergency loan. “The shadow banks had trading books with very short term liabilities and assets they could not sell,” says Wilkinson. “They transform something less desirable into something more desirable that they can fund more cheaply, but there is always a snag.” In theory, the inherent instability should not matter unless a shadow

bank failure infects the rest of the financial system. Shadow banks are not subject to bank regulation precisely because they do not enjoy central bank access and deposit insurance. “The argument is that if a hedge fund or a money market fund blows up, who cares?” says Larry Tabb, founder of TABB Group, a New Yorkand London-based financial services research and consulting firm, “The government doesn’t have to bail it out, nor do taxpayers.” But what if the shadow banking system plays such an important role that in times of extreme stress the authorities have to support it anyway? When the Reserve Fund, a US regulated money market fund, reduced its net asset value to less than $1 per share in mid-September 2008 it touched off such a stampede for the exits among money market fund investors that the US Treasury had to step in with a temporary backstop to forestall a run on industry assets. Initially in place for three months, the backstop was later extended through September 2009. In effect, the government committed taxpayers to a limited guarantee of money market fund accounts even though the funds had never paid a penny in deposit insurance premiums. “Explicit guarantees are fine— investors pay for a put option,” says Tabb. “No guarantee is fine because investors are on their own. The problem is implicit guarantees that nobody pays for.” The Reserve Fund panic prompted regulators to review the rules governing US money market funds. The proposals put forward so far include requiring money market funds to have a floating net asset value, a 3% holdback of redemption proceeds for 30 days, or a requirement for money market funds to maintain a loss reserve or capital buffer. All three have raised howls of protest. A study commissioned by the Investment Company Institute, a trade association for the mutual fund industry, found

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Regional Review 61_. 22/05/2012 15:45 Page 21

that if any of these proposals came into effect, most institutional investors in money market funds would either drastically curtail or eliminate their use of these vehicles. The regulators may not care, however. If retail investors were to abandon money market funds, the $900bn (35% of industry assets) now held in those accounts would likely end up in retail deposits at the regulated banks, the stable funding that receives most favoured status under the Basel III capital regime. Institutional money market fund investors could either buy the same assets that money market funds now buy on their behalf—or put their money on deposit at a regulated bank. The wholesale deposits might still be fickle, but to the extent that money market fund assets migrated back to banks the FDIC would assess deposit insurance premiums to cover the cost of potential default, eliminating what is tantamount to a free ride for money market fund investors. “There are good reasons to regulate the money market funds, or even to dismantle part of the industry,” says Wilkinson. “They transform sticky retail deposits into hot money;” some of the hottest money around, in fact. Money market funds hold a majority of their assets in overnight or seven-day repo and other assets that mature in 30 days or less, which means they are quick to bail out when credit fears surface. Wilkinson points out those US money market funds pulled between $200bn and $300bn out of European banks last summer as the eurozone crisis intensified, money the banks were unable to replace. Those outflows contributed to the funding stresses that the ECB tried to alleviate through its LTRO facility. “The US money market funds are the first to leave,” says Wilkinson. “They all piled into Europe in the past few years because banks were paying a few extra basis points for deposits. As soon as they sniff any problem,

F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

they pull back—which causes massive systemic risk.” The shadow banks are now so intertwined with regulated banks that a serious problem in one sector will almost certainly spill over to the other. The lines between the two sectors have also blurred as regulated banks moved away from their traditional role of warehousing loans through maturity toward the originate and distribute model prevalent among shadow banks. “Insurance companies buy whole loans, money market funds buy commercial paper and auction rate securities, hedge funds buy corporate debt,” says Larry Tabb. “In a sense, the entire banking industry has become shadow banking.” Regulators do need to proceed with caution, however. The more they tighten the screws on regulated banks, the greater the risk that borrowers will seek credit elsewhere—from the shadow banking system. If the cost of bank credit rises, the economics of securitisation may improve to the point where the new risk retention rules no longer represent a significant hurdle. A reinvigorated securitisation market might boost economic growth—but it would surely drive a larger proportion of credit creation through the capital markets. “The credit risk switches from a few banks people love to hate to thousands of entities they don’t even know,” says Tabb. It’s like a game of Whac-a-Mole, in which the regulators clamp down in one area only to have the risk pop up somewhere else that may not even fall within their purview. The European Commission will propose EU-wide rules for shadow banking in 2013 after the global regulatory body, the European-based Financial Stability Board (FSB), completes work on policy recommendations by November this year. The FSB will focus on issues such as transparency, risk and defining clearly what does and does not fall into the fluid definition of shadow banking. It won’t always be easy: for instance,

Larry Tabb, founder of TABB Group, a New York- and London-based financial services research and consulting firm. “The argument is that if a hedge fund or a money market fund blows up, who cares? The government doesn’t have to bail it out, nor do taxpayers,” he says. Photograph kindly supplied by TABB Group, May 2012.

do you class German covered bonds in the same way that other asset backed structures are classified? Surely not. Moreover, any sweeping recommendations covering the shadow banking segment must encompass solutions for the traditional banking sector, which is increasingly under fire from both popular and official sources and which looks to be struggling to find a positive role for itself in the changing global financial system; and it is impossible to divorce one from the other. In fact, in a Green Paper, issued in March this year, the European Commission identified several areas of investigation: this includes banking regulation (involving a review of the consolidation and large exposure rules); asset management (and the risk posed by money market funds and exchange traded funds); securities lending and repos (looking at the leverage they fuel and pro-cyclical effects) and entities operating outside the regular banking system. I

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IN THE MARKETS

PICK UP IN NEW ISLAMIC ISSUANCE

Investors pile into Islamic bonds April and May looked to be banner months for sukuk. Two deals, one from the Saudi Electricity Company (SEC) and the other, from Banque Saudi Fransi, the Saudi lender part-owned by Credit Agricole, marked two rare but popular US dollar denominated issues which were highly prized by investors. The benchmark deals helped underscore growing investor appetite for Islamic bonds.

AUDI FRANSI, SAUDI Arabia’s fifth largest bank, launched $750m five-year Islamic bond mid-month at par amid strong investor demand for the issue in mid-May. The issue is the bank’s first sukuk sale under a recently-established $2bn debt programme. The sukuk came in at a spread of 185 basis points (bps) over midswaps, at the lower end of its indicated range. Initial price guidance was 200bps over midswaps. The deal was heavily oversubscribed, attracting investor orders worth $4bn, underscoring growing investor appetite for sukuk issuance. The sukuk carries a profit rate of 2.947%. Citi, Deutsche Bank and Credit Agricole were arrangers on the deal. The deal marks the second dollar denominated sukuk emanating from the Kingdom so far this year. Saudi Electricity’s $1.75bn sukuk, issued three weeks earlier, raised the bar with some $17.5bn in investor orders. The Saudi Electricity Company (SEC), which is rated A1/AA-/AA- all Stable, is the largest utility in the GCC. The issue was made up of a five year $500m tranche and a $1.25bn ten year element. The transaction was led by Deutsche Bank and HSBC marked the inaugural international sukuk issuance by SEC and the largest international debt capital markets issuance out of Saudi Arabia for some years. The issuer also wanted to achieve a long tenor

bond supported by a diversified investor base, which the arrangers helped secure after a comprehensive global road show. The dual-tranche Sukuk transaction was well received globally and generated a large order book with over 440 investors placing orders. Shortly after the issue the SEC’s chief executive Ali Al Barrak explained,“The sukuk issue is important to us for strengthening our funding mix, accessing longer-tenor financing, broadening our investor base and helping us become more in line with our global peers while supporting SEC’s capital expenditure requirements.” Saudi Arabian dollar-denominated bonds come to market relatively infrequently, and attract substantial demand when they do; illustrating that Gulf issuers are benefiting from their own economic micro-climate and are providing something of an oasis for investors starved of comprehensive corporate issuance opportunities. Investor appetite for the deals was marked and might just be a sign of a growing preference for Islamic instruments. The evidence is still thin: however Banque Saudi Fransi’s existing $650m conventional bond, which carries interest of 4.5% and matures in 2015, was bid at just over 103.97 in the second week of May, to yield about 2.8%, coming under some selling pressure ahead of the new issue.

Also in mid May Islamic Development Bank (IDB) enhanced the size of its medium term notes (NTN) programme from $1.5bn to $3.5bn, which will be issued in both London and Kuala Lumpur. The IDB’s forthcoming medium term sukuk (which is expected to range between five and seven years) will be issued under this programme sometime in June and is expected to raise between $750m and $1bn. Funds will be used to provide blended credits in support of capital goods projects in member countries. IDB, which is AAA-rated, priced a $750m five-year sukuk last May at a spread of 35bps over midswaps to yield 2.35%. According to local Saudi press reports, the sukuk will be 144a-compliant and, therefore, open to investors from the United States; though the IDB did not respond to questions about its forthcoming issue. Elsewhere, bond traders expect the first restructuring of an Islamic bond. United Arab Emirates’ Dana Gas, the Sharjah-based energy company, is expected to restructure its $920m sukuk in coming weeks as investor concerns have heightened over the ability of the utility to meet its payment commitments. Up to now no Islamic bonds have been renegotiated though there have been examples of outright defaults (in both Saudi Arabia and Kuwait). Dana has reportedly hired Blackstone, Latham Watkins and Deutsche Bank to advise on the various options for repaying the sukuk. The company is “committed to finding a consensual solution that is equitable to all stakeholders”, it said in a statement to the Dubai stock exchange. Meantime, the Central Bank of Bahrain (CBB) says its monthly issue of the short-term Islamic leasing bonds, Sukuk Al-Ijaara, has been oversubscribed by 175%. Subscriptions worth BD35mwere received for the BD20m issue, which carries a maturity of 182 days. The expected return on the issue, which matures in mid-November 2012, is 1.34%. I

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Sovereign governments and sovereign wealth funds (SWFs) are investing less internationally than they have done at any point in the last three years, according to the third annual Invesco Middle East Asset Management Study. Gulf Cooperation Council (GCC) sovereign states have deployed wealth into local economies throughout the Arab Spring and SWFs show signs of diverting away from international trophy assets and other global investments. The findings come as something of a surprise given the current penchant for some of the GCC’s most high profile SWFs to continue to invest in strategic companies abroad. However, says the study, sovereign wealth fund surpluses may reduce despite oil price rises as local investment continues.

NVESCO’S STUDY HAS analysed sovereign revenues and defined the investment behaviours of major SWFs in the GCC region. These SWFs account for 35% of global SWF flows, representing $1.6 trn, a huge market which major global economies, including the UK, rely on for investment. This is Invesco’s third asset management study of the GCC region (comprising the United Arab Emirates, Saudi Arabia, Qatar, Bahrain, Kuwait and Oman). Invesco worked with independent strategy consultants NMG to conduct an in-depth market study based on over 100 face-to-face interviews on retail and institutional investor preferences across the GCC. The study shows the international flow of

money directly from GCC sovereign governments and from SWFs has changed considerably in light of the current unrest, with large commoditylinked surpluses in these regions increasingly being put to use locally. (Please refer to Figure 1) Even so, and despite stable and high oil prices, the available surplus, or investable assets, of governments in the GCC region is forecast to reduce by 9% in 2012 (compared to 2011) and surplus forecasts have been revised downwards since the Arab Spring, says the study. This is illustrated by the fact that forecast funding rates for the recipient SWFs have declined this year. The findings of the survey look to undermine some of the latest news

Figure 1: GCC SWF funding chain and local pressures GCC SWF funding chain and local pressures Historic flow of capital from sovereign revenues via sovereign surpluses to Diversification Vehicles Flow of capital

Local pressuure 1 Government spending Sovereign expenses

Sovereign revenues

Local pressuure 2 Sovereign allocations

Other SWF profiles*

Sovereign surplus Diversification Vehicles

* Other SWF profiles; Development Agencies, Policy Supporters and Asset Managers

INVESCO PREDICTS INCREASED COMPETITION FOR SWF ASSETS

SWFs TENDING TO INVEST LOCALLY

to emerge from the mega SWFs of the GCC. The Qatar Investment Authority, one of the largest and most diversified sovereign wealth funds in the GCC for example continues to veer from the norm. The latest news from the Gulf is that the SWF is about to increase its allocation to Shell, which will add to a growing roster of western investments by the fund. The Anglo-Dutch company declined to say what the size of the QIA holding is, but stock exchange rules in the United Kingdom meant that any stake over 3% will automatically trigger a public statement. Other reports suggest that the Qataris are in the middle of negotiations to buy a stake in Italian oil major ENI. It already holds a minority stake in Total, the French energy group. The QIA has also recently bought into Xstrata, as well as Barclays Bank. Moreover, Abu Dhabi’s normally secretive SWF opened up last October with the release of an official report which showed that the sovereign wealth fund remains diversified across all major global markets. Although over a year old, according to the report, ADIA’s assets are largely allocated to developed equity investments. With an estimated $350bn in assets, the fund allocates 60% of its total portfolio to externallymanaged indexed funds. Overall, roughly 80% of the fund’s assets are invested by external fund managers. Allocations to developed equity markets constitute 35% to 45% of the fund’s portfolio. Emerging market equities make up 10% to 20%. Government bonds make up 10% to 20% of the portfolio. In terms of geographic prevalence, ADIA allocates 35% to 50% in North America, 25% to 35% in Europe, 10% to 20% in developed Asia, and 15% to 25% in emerging markets, according to the report. However, Invesco’s latest study may point to a sea change. The Invesco study did not elucidate the detailed investment strategies of individual funds.

Source: Invesco Middle East Asset Management Study, May 2012.

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IN THE MARKETS

available for SWFs, those with local objectives are expected to benefit. Invesco forecasts SWF assets invested in benchmark driven SWFs who prioritise international asset manager products or ETFs have fallen by 1% since the beginning of the ‘Arab Spring’ in 2011. At the same time sovereign wealth fund assets allocated to SWFs investing locally, in infrastructure for example, have risen by 10%7, which illustrates a major shift (see Figure 2). Nick Tolchard, head of Invesco Middle East commented: “It’s clear that sovereign states are redirecting revenues and SWF assets from international investments back into the Middle East. The most common change across the region is money into local wage inflation, with healthcare and education a real focus for Saudi Arabia and Oman. Major infrastructure is a focus for Qatar due to the World Cup, and there are significant developments taking place in Abu Dhabi as it seeks to grow and set up as a major financial centre.” Tolchard continues: “Western governments, including the UK, have approached SWFs from the Middle East to help with economic recovery, but many will fight a losing battle. There is certainly less money to invest internationally so the stakes are higher. Those courting GCC money from outside the region will only win with a deep understanding of what is driving the thinking of SWFs, and a long term commitment to building bilateral relationships which add value to their investment policy.” Last year, Invesco created the first ever framework that categorises the core objectives of SWFs and revealed the drivers behind the investment strategy and preferences of these huge investment funds. Last year, the study revealed that traditional investment SWFs (diversification vehicles and asset managers) appeared to be favouring developed markets, with around 54% of GCC SWF assets held in this region

Figure 2: Competition for sovereign assets Competition for sovereign assets* Other government entities

38%

Other SWFs

28%

None

34%

* Institutional investors screened based on their knowledge of GCC SWFs (Sample split is SWF = 7, Sovereign experts = 12) Sovereign experts – other interviews conducted as part of the study where the respondent demonstrated in-depth knowledge of the SWF segment.

with the highest exposure to North America (29%) and to Western Europe (19%). Investment in North America is now down this year at 14% and Western Europe down at 6%, as a result of the Eurozone crisis. The clear shift in terms of geographic allocation of investment money has been towards the local region. Investment in assets related to the GCC moved up from 33% to 56%, with local bonds seeing a rise from 6% of SWF investable assets to 14%. Property and infrastructure have also take a large proportion of the investable assets from these SWFs, 13% and 14% respectively. “The story this year is that it is no longer a given that large sovereign governments are going to direct their oil revenue surpluses around the globe, pumping cash into other global economies. There will be high profile, strategic investments like the proposed RBS deal, or indeed other large trophy assets, but it’s a changed market. There will be contestable assets for fund managers in core relevant markets but with more money being deployed into the local economies it is likely to be a much more competitive landscape as long as the unrest continues,” says Tolchard. I

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

Source: Invesco Middle East Asset Management Study, May 2012.

INVESCO PREDICTS INCREASED COMPETITION FOR SWF ASSETS

There are other deals in train. Most recently new banking venture NBNK has reportedly held talks with Middle Eastern SWFs to bolster its bid for 632 Lloyds branches that are up for sale, according to a recent Reuters news item; NBNK refused to comment. The venture was set up in 2010 by former Lloyd’s of London insurance head Peter Levene, aiming to bring competition to a market dominated by four lenders. It is run by former Barclays and Northern Rock executive Gary Hoffman. Separately, the UK’s Sunday Telegraph reported that NBNK had held discussions with Qatar Holdings and Abu Dhabi's Mubadala fund. One of the fund’s subsidiaries, Mubadala Healthcare (a business unit of Mubadala Development Company) and Dubai Health Authority (DHA) have signed a memorandum of understanding to discuss several key collaboration areas that will facilitate knowledge-sharing, partnership initiatives and improved access to care for patients in Dubai. The initial areas for collaboration outlined in the MOU relate specifically to three of Mubadala Healthcare’s facilities—Wooridul Spine Centre, Tawam Molecular Imaging Centre and National Reference Laboratory—and focus on the facilitation of patient and laboratory test referrals, knowledge exchange and the inclusion of these facilities in the Government of Dubai’s Enaya network. While the investment approaches of the GCC SWFs remain mixed, one thing looks certain. According to Invesco’s study, in 2011 funding rates grew at 13% compared to an increase in GCC government revenue of 25%, this year funding rates rose just 8%, despite GCC government revenue increasing by 31%. Funding for sovereign pension funds on the other hand rose from 8% growth in 2011 to 13% growth in 2012. There is an expectation that spending will continue to increase over time potentially outstripping commodity prices and shrinking surpluses further. Of the sovereign surplus that is

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COUNTRY REPORT

Malaysia is offering tax breaks to issuers in an effort to secure its global dominance of Islamic finance. It seems to be working, there appears to be a record rally in foreign-currency sukuk. Moreover, arrangers say interest is increasing among local corporate issuers; with Standard Chartered claiming a growing issuance pipeline worth $1bn, most of which will be in foreign currency denominated bonds.

ALAYSIA IS SEEKING to strengthen its lead over the Gulf Cooperation Council countries as a centre of Islamic finance. It hopes to become a capital markets issuance hub, and in an effort to secure its place in the pantheon of issuing markets has announced that it is exempting investors from capital gains taxes on non-ringgit sukuk between now and the end of 2014. It is a smart move, given that more Asian companies see sukuk denominated in currencies other than the ringgit as an effective funding strategy. Malaysia has become the world’s leading sukuk market, accounting for some 73% of the $92bn of sukuk issued globally last year; a banner year in which issuance volume rose by 68% on 2011. Malaysia is also the domicile for 68% of the $210bn total sukuk outstanding globally as at end-2011, according to recent figures issued by the Securities Commission in Malaysia. Nonetheless, there is some way to go and sales of foreign currency bonds issued out of Malaysia have topped only $358m so far this year, compared with a grand total of $2.1bn for the whole of last year. The signs are that the Malaysian authorities have discounted this year for foreign currency denominated ringgit and have introduced a raft of initiatives in the hope of capitalising on better global market conditions in 2013 and beyond. Ringgit sukuk however continue to outstrip issuance in foreign currency. Khazanah, the country’s sovereign-

F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

wealth fund alone, sold $358m of seven-year bonds convertible into shares at a negative yield in March alone. However, that was pretty much a plain vanilla deal for the issuer, which is rated A3 by Moody’s. Sukuk watchers may remember that the fund issued the first yuan-denominated Shari’a compliant notes in Hong Kong last year. Corporate sales of ringitt denominated sukuk in Malaysia climbed 8% in the first quarter (compared with Q1 2011) to MYR13.4bn, after Tanjung Bin Energy raised MYR3.3bn in March in the biggest offering so far this year. Investor demand is also buoyant. A recent issue by Pembinaan BLT, the state-owned construction company, worth MYR1.35bn was oversubscribed 2.6 times. Even so, the market infrastructure remains problematic and will likely dampen growth unless Malaysia can unlock key elements. Among them must rank a lack of secondary market liquidity; in particular the lack of secondary market trading. This is a problem of infrastructure and supply as well as a lack of formal trading mechanisms. Without an active secondary market liquidity and sustained fund manager participation in the market is not really feasible. Once the Kuala Lumpur-based International Islamic Liquidity Management Corporation (IILM) is up and running properly, the resulting intermarket dialogue should spur member states and the central bank executives that represent them in the

MALAYSIA: RECORD RALLY IN SUKUK

Malaysia offers tax breaks to secure dominance of sukuk issues corporation should help (over the longer term) should help to mitigate this lack of market liquidity. The IILM is supposed to facilitate cross-border liquidity management among institutions offering Islamic financial services by making available a variety of Shari’a-compliant instruments, including sukuk, on commercial terms, to suit the varying liquidity needs of these institutions. The IILM, of which the Saudi Arabian Monetary Agency (SAMA) is a founding member, is due to launch its debut benchmark sukuk within the next two months. Some $3bn of issuance is expected to originate out of the IILM each year. For now, Malaysia is managing to retain the initiative and remains the most developed systemic Islamic financial market and an active secondary trading market. However, it is not the largest liquidity pool in Islamic finance; that honour goes to Saudi Arabia, which is potentially the largest sukuk origination market; though again, local infrastructure limitations are apparent. Very few sukuk, for instance, are traded on the Tadawul and the market remains firmly domestic. According to the latest data of the Securities Commission Malaysia, between 2000 and 2010, the First Capital Market Masterplan period, the local Islamic capital market more than tripled in value to MYR1.05trn, growing at an annualised rate of 13.6%. The Second Capital Market Masterplan, or CMP2, which spans the ten-year period to 2020 (please refer to FTSE Global Markets, Issue 57, pages 55 to 60 for more information), expects Malaysia’s Islamic capital market to grow by an average 10.6% a year, to reach just under MYR3bn by 2020, of which sukuk segment will account for 46% of the total. I

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COUNTRY REPORT

QATAR: BANKING ON INFRASTRUCTURE

Photograph © Creator76/Dreamstime.com, supplied May 2012.

QATAR ON THE CUSP OF MAJOR CHANGE Notwithstanding the huge capital surpluses in Qatar, the scale of investments planned over the coming decade means that at some close point in time the country will have to loosen its capital borders and accept more inward investment, foreign ownership and bank and project financing. The country’s main financial institutions are looking at the world differently too. It’s a dynamic time in Qatar; however important questions remain for investors, involving both political and investment risks. Francesca Carnevale surveys the main trends.

HE GOOD TIMES have rolled in Qatar for some years; but only for the gilded few. While the overall sense and reality of prosperity look to be undiminished the reality for the country’s leadership and financial administration is that substantive change must come if the country’s dream to be a global leading light is to have any concrete meaning. Quite how it will all pan out over the coming decade, right now, is anyone’s good guess; however some realities must be faced if the country is to be a meaningful financial destination. International indexing companies have been tough on the country. Index

provider MSCI noted in a recent report, published in the opening months of this year that the country’s strict foreign ownership limits, and the limited availability of shares to foreign investors, have made shares in large companies, such as Industries Qatar, almost unobtainable for international investors. Equally, alongside other high growth emerging markets, foreign ownership in strategic industries (read gas) is a no-no. Ultimately restrictions meant that the country failed to reach emerging market status in this year’s MSCI’s country classification. Ultimately, the decision failed to register anything other than a shrug. Qatar

has time on its side and continuing appeal to specific investors. Its $5bn three-tranche eurobond (issued back in November 2011) was a clear indication of that fact, in an otherwise arid period for the capital markets. Broken into tenors of five, ten and 30 years, yielding 3.12%, 4.5% and 5.75% respectively, the bonds were heavily oversubscribed. The bond will help finance the country’s Barzan natural gas field project, a joint venture between Qatar Gas and Exxon Mobil, which is expected to process 2bn standard cubic feet of gas per day by 2015. South Korea’s Hyundai Heavy Industries was awarded the main EPC contract in January last year, with construction of wellhead platforms and pipelines in Ulsan, in South Korea and installation in Qatar. Qatar has booked a huge budget surplus in one year up to March, earning more than double the conservative estimate on which the budget for fiscal 2011-2012 was based. Qatari crude price averaged $112.84 a barrel between April 2011 and March 2012, compared with $108.6 per barrel in fiscal 2010, while the budget estimate was $55 a barrel according to QNB’s Economics, Financial Analysis & Research department; some 105% more than the conservative budget estimate. Qatar’s crude is classified as Dukhan and Marine and the average of the two decides the pricing. At the start of the fiscal 2011-2012, Qatar had expected to book a budget surplus of QAR22.3bn in this financial year. Moreover, says QNB research, full year 2011 nominal GDP grew by 36.3% to QAR632bn (around $174bn) with hydrocarbon growth (including manufacturing) up 47.8% as oil prices rose and new LNG and GTL capacity came on stream (leading to higher condensate production) and nonhydrocarbon revenue grew 17.1% led by government services (up 37.5%), which benefited from public sector salary increases and financial, business and real estate services increasing by 18.2%.

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COUNTRY REPORT

QATAR: BANKING ON INFRASTRUCTURE

QATAR BANKS: A HEALTHY SECTOR BANK

QNB CBQ QIB RAYAN DOHA KHALIJI QIIB IBQ AHLI

Shareholder equity QARm

Net profit 2010 QARm

42,635 14,230 11,200 8,504 7,081 5,401 4,900 4,147 2,513

5,702 1,635 1,273 1,211 1,054 427 559 458 412

Net profit 2011 QARm

Increase/ Decrease %

7,554 1,884 1,375 1.408 1.241 487 653 573 442

32.5 15.2 8.0 16.3 17.7 14.1 16.8 25.0 7.3

Source: IBQ research, Jan 2012.

In that regard, “Qatar remains a very attractive place to do business and invest in,”explains George Nasra, managing director of the International Bank of Qatar (IBQ):“It has the highest GDP growth rate in the GCC and is expected to continue to grow at relatively high rates; there is no high unemployment or poverty issues and therefore there is a very limited impact of the Arab Spring; it has the highest credit rating (Moody’s Aa2 and S&P’s AA rating) and the 2022 World Cup will act as a further catalyst for change and continued growth in the economy. Plus there is very limited impact on Qatar from the eurozone crisis.” Spending is a big theme in the country right now. The government’s total infrastructure spending over the coming five years is estimated at $150bn, and this investment will deepen and diversify economic growth over a much longer term. Even with

an expansive spending programme, the government is, according to Nasra, expected “to generate a budget surplus of around $75bn in the next five years. More importantly, the breakeven price of oil for a balanced budget in Qatar is around $35 per barrel.” In January finance minister Mohammend Al-Sada confirmed the country planned to more than double its annual petrochemical production capacity from 9.2m tonnes now to 23m tonnes by 2020, spending $25bn in the process. Already the world’s largest Liquefied Natural Gas (LNG) exporter, Qatar has imposed a moratorium on further export development of its huge North Field until 2014; in the meantime, the state is pumping money into other projects such as a $6.4bn petrochemicals complex at Ras Laffan industrial city, with Royal Dutch Shell. Moreover, a recent study by Standard Chartered shows that the outstanding

QATAR BANKS OUTPACE OTHER GCC COUNTRIES IN TERMS OF ASSET GROWTH COUNTRY

UAE Saudi Arabia Kuwait Qatar Bahrain* Oman

Total banking assets $bn Q3 2011 456 403 155 177 66 45

Growth 2007-Q3 2011 % 9 9 5 23 8 15

Source: IBQ research, Jan 2012 * excludes all offshore banking assets.

value of projects to be awarded in the rest of this year stands at around $26bn, an increase of 153% over 2011. Over the coming weeks Qatar plans to award three tenders for its upcoming $7.4bn port project; plus any projects outlined in its Qatar Vision 2030 development roadmap (outlined in FTSE Global Markets passim). It all adds up to a 12% a year growth rate in the country’s internal construction industry. Investment on this scale requires shedloads of cash: while Qatar has abundant funds, the scale of infrastructure spending means that there must be an opening for foreign institutions to enjoy lending and new business opportunities in the country. According to Shahzad Shahbaz, chief executive officer of QInvest, “the net capital in the country, even with surpluses is not enough to finance wholesale the infrastructural investment planned. Initially, you will see more Asian banks becoming more active here: and in time, institutional investors. It will not happen immediately: there is still resonance from the Arab Spring elsewhere in the Gulf region; moreover, external macro factors will exert their influence on the market.” However, according to Nasra, the participation of European banks in project finance in Qatar has already significantly declined and may fall further.“European banks were given a deadline of up to June 30th 2012 to satisfy new capital requirements of 9% CAR. Banks usually sell new shares to investors to improve their capital ratio, but the share prices of European banks are at very depressed levels, so most of them are selling assets to boost their capital,”he says, adding that European banks are also scaling back on international lending.“European bank’s share of total funding to Qatari entities has declined from 63% in 2007 to 28% in 2011,” he says, sourcing Dealogic for the data. Though because of the surplus funds in government coffers, he thinks this decrease will have only a limited impact on project funding.

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QATAR: TOTAL GOVERNMENT REVENUES VERSUS SPENDING 2010-2015 YEAR Spending $bn Revenue $bn

2010

2011

39 43

51 72

2012

2013

2014

2015

57 72

63 76

70 80

52 70

Source: EIU/IBQ presentation Feb 2012. Figures for 2012-2015 are estimates.

It also signifies a sea change in the make-up of the country’s revenue: up to now Qatar’s rich growth have been driven in large part by rising gas production. With production now close to capacity, the non-oil sector will be expected to pick up slack and play a more important and visible role in the overall economy. Equally, there is a directional change in export flows with more energy related output being sold in long term offtake contracts to high growth markets in Australasia.

Banking on growth Set against this backdrop the country’s banking sector is poised to leverage growth at home and abroad. The outlook on Qatar’s banking system is stable, reflecting Qatar's strong macro environment and high public spending levels that will continue to sustain growth and bank lending activity over the 12-18 month outlook period, says Moody’s Investors Service in a recent Banking System Outlook. Moody’s says that the stable outlook captures the banks’ limited asset-quality pressures

and healthy capitalisation levels; a stable deposit base and significant liquidity buffers; and strong earnings potential. The report also notes that these supportive factors are counterbalanced by high levels of concentrations on both sides of the balance sheet; the banks’ dependence on the domestic economy, which is undiversified and heavily reliant on the oil and gas sector; and the credit risks relating to exposures to the construction and real-estate sector. Moody’s estimates that Qatar’s real GDP will expand by six per cent in 2012, driven by high oil prices, strong liquefied natural gas export volumes and accelerated public spending, which will stimulate the non-oil economy. This, in turn, will support banks’ asset quality, drive credit growth—likely to be between 20% to 25% during 2012 and increase bank revenues. In this regard, Qatari banks are both sitting pretty and stymied by limited possibilities in their home market, albeit tempered over the coming decade with a project bonanza that

THE PIPELINE OF MAIN PROJECTS IN QATAR IN 2012 Project New Doha International Airport Barzan Oil Field New Doha Port QF – Education City Musheireb (real estate) Qatar transmission Phase VIII Ras Laffan Olefins Complex Ras Laffan IWPP expansion The Doha Metro 2022 World Cup stadiums Qatar Foundation Aerospace City Inner Doha Re-sewerage project

Value $bn 11.1 10.3 7.0 7.0 5.5 2.8 6.4 3.0 41.0 4.0 3.3 2.0/3.0

Status Execution Execution Execution Execution Execution Execution Study Study Tenders Design Design Design

Target completion date 2013 2013 2014 2014 2016 2012 2017 2014 2020 2019 2017 2019

Source: IBQ Feb 2012 presentation/MEED/Internet research

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will offer them substantial lending and advisory work. Even so, the temptation to move overseas and to acquire market share is tempting. Already QInvest has reportedly reached agreement with EFG Hermes to establish a joint investment bank with operations across the Middle East, Africa, Turkey and Asia. QInvest reportedly will hold a 60% stake in the new bank, which will carry the moniker EFG Hermes Qatar and will start off with capital in excess of $250m. The transaction is one of the larger M&A deals in the Gulf region this year. The joint bank includes EFG Hermes’ brokerage, research, asset management, investment banking and infrastructure funds operations. EFG Hermes’ equity unit and its Lebanese subsidiary are not part of the deal. The new bank will be headed jointly by Karim Awad, currently EFG Hermes’ head of investment banking and Kashif Siddiqui, who was head of EFG Hermes’s asset management business. QInvest was advised by international law firm Hogan Lovells on the deal. Also at the end of April, quasinational Qatar National Bank (QNB) the country’s largest bank, in which the government owns a 50% stake, announced it had bought a 49% share in Libya’s Bank of Commerce and Development, which has assets of $2bn. It is also reportedly circling around Denizbank, the Turkish unit of Franco-Belgian Dexia SA. QNB’s acquisition trail began earlier this year in Morocco, where it bought a majority stake in Union Marocaine des Banques. Meanwhile Qatar Islamic Bank has indicated that not only does it want to acquire other Islamic units in the country, but also an Islamic financial institution in Turkey. International expansion is an obvious move for a phalanx of well capitalised banks with defined opportunities for business growth in the country; not that any are complaining, with some £250bn of capital goods projects in the pipeline, there is enough residual business opportunities to ensure a rosy future.

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COUNTRY REPORT

QATAR: BANKING ON INFRASTRUCTURE

QAMC & BRNI FORM PE PARTNERSHIP

HE QATAR ASSET Management Company (QAMC), a special collaboration between the Qatar Financial Centre Authority (QFCA) and the sovereign wealth fund, the Qatar Investment Authority (QIA), have agreed with Barclays Natural Resource Investments (BRNI), a private equity division of Barclays Bank, to establish a strategic partnership that will co-invest $250m in BRNI’s current and future portfolio of private equity investments in companies working in natural resources sectors. BRNI will continue to source, execute, manage and exit private equity transactions in the natural resources sector (on a global basis) and co-investors will be invited to participate immediately upon completion of each transaction. The deal has two-fold value to Qatar. According to Abdulrahman Ahmad Al-Shaibi, managing director of the QFCA, it is a milestone in the country’s strategy of “developing an asset management hub and promoting the expansion of Qatar’s financial services industry.” Shashank Srivastava, chief executive officer of the QFCA expands the theme. “An important component of this strategy is a seeding programme to incetivise firms to think of Qatar as the platform to capitalise on the regional opportunity and this transaction marks the launch of that seeding programme. The QFCA is in talks with a number of international investment firms which have quite different investment styles and we will be working on a number of initiatives in the coming months to help deepen Qatar’s asset management segment.” The transaction also continues to diversify QIA’s investment portfolio and is a natural extension of the country’s overall expertise in the natural resources segment. The advantages of the deal are clear, according to Mark Brown managing director and head of BRNI. He explains that: “the demand for natural resources continues to grow as the global economy expands, but their supply is limited. This means our focus investment area of global natural resources is set to continue to generate attractive investment opportunities.” BRNI specialises in investments in upstream oil and gas and currently has in the region of $2.1bn committed in 22 portfolio companies. The firm typically commits between $50m and $200m to each management team to help execute their business plans. “The upstream segment tends not to have capital constraints,” explains Brown, “so we look for quality teams, with quality ideas to back. One of the reasons for this partnership is the removal of any constraints at the top end and allows us to continue to take off-market opportunities. We are bored of the traditional private equity model, which is based on a blind payment and management fee. We have a co-investment model, where all parties to the deal fund the transaction alongside each other; that means all

parties focus on the long term growth and we think that the only constraint to growth is the availability of welltrained management teams that we can work with. I stress that this is not an AUM-based business.” According to Vitalo, “this is the crux that makes BRNI unique; we turn the traditional private equity model on its head, first we look for exceptional management teams and look for the right assets; we are not about betting on the price of commodities. Instead we look to see whether good returns are possible based on the lowest projection of commodity prices in today’s terms; so if we make an investment and the price of commodities stays at prevailing prices, we make money; if on the other hand the price of the commodity rises, we make a lot of money. It is about providing downside protection.” Moreover, on the surface, the deal appears to cement the relationship Barclays has with the QIA, which is one of the top three shareholders in the British bank as at the end of last year; it has a 6.8% stake. It is also a natural extension of the holding company brand in the country. Barclays already has a presence in the Qatar Financial Centre as a licenced entity, adds John Vitalo, chief executive officer for the Middle East and North Africa (MENA) for the bank. However, stresses Srivastava, this is unrelated to the relationship between the QIA and Barclays, “BRNI was first off the block in the seeding programme, though it is a important strategic relationship for us. However, we want to be clear that we are looking for investment activity to happen on the ground in Qatar.” The Qatar Financial Centre provides a platform for financial services, focusing on reinsurance, captives and asset management. According to Srivastava, the QFCA has set itself a very ambitious target in terms of assets under management (AUM) in the country. “If we can achieve it, we will be the largest asset management hub in the Gulf region.” In pursuit of this, explains Srivastava, “Strategically we have no bias towards the alternative space. We would like to see many different investment models and strategies in Doha; as we think a deep multi-asset based asset management segment is an essential component of the ecosystem that we are trying to create in Qatar. However, I stress it is important to have investment professionals on the ground.” For its part, the QIA has been the most active of the region’s sovereign wealth funds in recent years, deploying the Gulf nation’s plentiful natural gas riches in assets ranging from German sports car maker Porsche to British bank Barclays. The fund has also been slowly buying into London-listed miner Xstrata recently. Its current holding in Xstrata, which is planning to merge with commodities trader Glencore, is about 7.2%. I

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CORPORATE PROFILE

SEARS AND THE FUTURE OF RETAIL

When hedge fund whiz Edward S Lambert merged Sears and Kmart in 2005, it was seen as a brilliant move that would save these storied but troubled companies. But in the past five years, the decline of Sears and Kmart has only accelerated. Now it appears to be just a matter of time before both disappear. However, three strong brands created by Sears will likely survive. Art Detman, who started shopping at Sears before Eddie Lampert was born, reports. Archive photo of Kmart chairman Edward Lampert listens during a news conference to announce the merger of Kmart and Sears in New York. Kmart Holding Corporation shareholders had just approved the acquisition of Sears, Roebuck and Co on Thursday, March 24th 2005, in an $11bn deal executives hoped would create a retail powerhouse while helping to reverse years of lagging sales. Photograph by Gregory Bull, for Associated Press. Photograph kindly supplied by Associatedpressimages, May 2012.

Can Edward Lambert turn around Sears Holdings?

OR A CENTURY Sears was where America shopped, either at its modern stores or from its fabled catalog, the “wish book” of generations. Sears was once the world’s largest retailer, ringing up greater sales than its five closest competitors combined, enough to account for more than 1% of the country’s gross domestic product. Flush with success, the company built and in 1973 moved into the 110-story Sears Tower in Chicago, then the world’s tallest building. Even as Kmart—a remarkable success story itself—was pioneering modern discounting, Sears remained America’s number one retailer. Are those glory days a thing of the past? Paul Swinand at Morningstar gives the firm its lowest rating and estimates that the stock’s fair value is no more than $37 per share, compared with the low 60s it traded at in early May. “I think that they will survive [sic],” he says cautiously. “But during the next two or three years they will have to go through a deeper restructuring and close more stores.” Matt McGinley at International Strategy & Investment Group (ISI)

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offers three outcomes. In the best case, its shares are worth $50. His base case calls for a $25 value, and the bear case —in which vendors worry about being paid and Sears continues to sell assets in an unsustainable attempt to remain afloat—the shares are worth $10. At Imperial Capital, managing director Mary Ross Gilbert believes Sears Holdings is worth more dead than alive. If it undertakes an orderly liquidation soon, its shares may be worth as much as $35 each; but as a going concern, its value is $7 per share. “We’re basically saying, don’t go near this stock.” This is a far cry from the summer of 2005. Investors—certain that Lampert would create value by either reviving the Sears and Kmart retail operations or, more likely, by converting its vast real estate holdings into cash—bid up the stock to $163.50. Sears Holdings (SHDL) was created earlier that year when Kmart—fresh out of bankruptcy and controlled by Lampert and his ESL Investments hedge fund—surprised Wall Street by acquiring the much larger Sears. At first, the merger seemed inspired. More than 350 new stores were opened the follow-

ing year; sales rose 8%, to $53bn; and profits doubled, to $1.4bn, some $9 per share. Since then, sales have declined for five consecutive years, to $41.6bn for the 2011 financial year, ended January 28th. Adjusted for inflation, 2011 revenues were lower than what Sears alone reported for 1997. Today, Sears and Kmart together rank only fourth among full-line retailers, behind Wal-Mart Stores ($448bn), Costco Wholesale ($90bn) and Target ($70bn). They also trail big-box specialty retailers Best Buy ($51.5bn), Home Depot ($70bn) and Lowe’s ($50bn). Even though revenues have fallen by 20% since 2006, the number of stores at the end of 2011 had increased by 6.5%, to 4,038 in the US and Canada; while sales per square foot plummeted. Sears and Kmart weren’t the only retailers to suffer last year, but among the big chains, Sears’ and Kmart’s 2011 numbers were the worst. Sears’ operating profit margin was a negative 2.5%, and Kmart’s a mere 0.6%. When 2011 ended, it had recorded 18 straight quarters of declining sales. During the crucial eight weeks before Christmas, sales declined 5.2% year

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CORPORATE PROFILE

SEARS AND THE FUTURE OF RETAIL

over year, hurt especially by weak demand for electronics, appliances and cold weather outerwear (it was a warm winter). Sales at stores open more than a year slid 4.4% at Kmart and 6% at Sears. For the year—“a disaster,” according to ISI—Sears Holdings reported a loss of $3.1bn, or $29.54 per share. Net of one-time charges of $2.6bn, losses from continuing operations were $539m, or $5.05 per share. Three days before Christmas Fitch Ratings cut its credit rating on Sears Holdings bonds to CCC—junk status —and five days later the company announced it would close 100 to 120 stores, a move expected to generate between $140m and $170m in cash as inventory is liquidated and properties sold or subleased. As usual, Lampert confined his explanations to his annual chairman’s letter, which have become increasingly defensive and belligerent. Last years’ poor results “underscore the need to accelerate the transformation of Sears Holdings,” he wrote. But they also were “an anomaly after three years of relatively stable earnings before interest, taxes, depreciation and amortisation (EBITDA) performance.” In January, CIT Group stopped making loans collateralised by shipments to Sears and Kmart. Sears Holding said that the suppliers involved were responsible for only 5% of the company’s inventory, but more important was the fact that a major commercial lender now questioned its ability to pay its bills. This could prompt vendors to demand cash-on-delivery or bank letters of credit, which would drain cash and impair SHLD’s ability to survive. About the same time Lampert spent $130m of his own money to buy SHLD shares, not on the open market but from ESL (named after Lampert’s initials). He gave no explanation, but it was speculated that he did this to meet redemptions. Presumably, the purchase wasn’t a financial hardship. Last year his wealth was estimated at $3.6bn by Forbes. In February, breaking from custom, the company held a conference call

with analysts, hosted by President Lou D’Ambrosio, head of SHLD since February 2011 (and the fourth chief executive in six years) to emphasise Sears Holdings’ ability to pay its vendors. “Our results for the quarter were an earnings issue, not an asset or liquidity problem.”But at the same time he announced two moves clearly designed to increase liquidity. First, the company expects to raise $400m to $500m through a vaguely described rights offering for its Sears Hometown and Outlet businesses and certain Sears Hardware Stores. The offering will be open to all shareholders, which means that Lampert, ESL, and another hedge fund, Fairholme—which together control 77% of the outstanding stock—would be able to buy what they already own. (Gilbert thinks the deal would be attractive to buyers but not to Sears Holdings.) In addition, Sears Holdings would sell 11 properties for $270m to General Growth Properties (GGP), America’s second-largest mall operator (the deal closed in April). Altogether then, D’Ambrosio outlined plans to raise at least $670m through the rights offering and sale of 11 properties, and an additional $350m by reducing the inventory at its stores. But sceptics weren’t won over. ISI analysts said the sale of 11 stores to GGP was “the equivalent of selling one crown jewel and ten lumps of coal.” Fully 80% of the purchase price was accounted for by the Sears store at the Ala Moana mall in Honolulu, one of the most profitable retail locations in the US. This store sold for $690 per square foot; the remaining nine sold for an average of $36 per square foot.

From frontrunner to also ran Edward Brennan took over as Sears chairman in 1986 and in 1992 moved headquarters into an office park in nearby Hoffman Estates. Arthur Martinez, who built his reputation at Saks Fifth Avenue, became head of the merchandise group, the first outsider to hold that job. He closed the historic general merchandise catalog and

turned around the stores. In 1995 he became chief executive and announced he would transform the company by focusing on its proprietary brands, Craftsman, Kenmore and DieHard. He wasn’t able to stem the loss of market share to the discounters and category-killers, but when he retired in 2000 Sears was again financially sound and profitable. Meanwhile, Kmart had allowed its stores to become shabby and—unlike Wal-Mart and Target—failed to invest in computer technology to manage its supply chain. It maintained a generous dividend and diversified into non-core businesses. Overwhelmed by red ink, in 2002 it declared bankruptcy. Lampert, who had prospered by investing in other retailers, bought enough of Kmart’s debt to gain control of the company and accelerate its exit from bankruptcy in 2003. Lampert closed underperforming stores, reduced inventory, and cut other costs. In 2004 he sold 100 stores to Sears and Home Depot for nearly $100bn, nearly as much as he paid for the entire 1,400store Kmart chain a year earlier. The cash enabled him to buy Sears just a year later and caused some to call him “the next Warren Buffett.” But even Buffett questioned whether Lampert could save the company. “Eddie is a very smart guy,” he told University of Kansas students in May 2005. “But putting Kmart and Sears together is a tough hand.”The longer a retailer lags behind its competitors, he observed, the harder it is to turn it around. History bears him out. By the time Lampert combined the chains; many other once major retailers had closed their doors for good. In addition to Woolworth were EJ Korvette, WT Grant, Gimbels and Montgomery Ward. Soon, Borders, Circuit City, Linens n’ Things and Tower Records joined the list.

A strategy to extract value Lampert had achieved success with AutoZone, a retailer of automotive replacement parts. His strategy was

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simple: raise prices, minimize reinvestment, and buy back stock. It worked, and Lampert applied this model first to Kmart and then, after the merger, to Sears. However, neither the Sears nor the Kmart customer is the same as the AutoZone customer. The latter is almost always a man seeking a specific part—a head gasket, fan belt, fuel pump, for instance—and is less concerned with price than availability. As for the store experience, the typical backyard mechanic is almost oblivious to it. Not so with department store shoppers. Yet from the beginning Lampert made it clear that he intended to reduce capital expenditures, even though under investment at Kmart was a prime cause of its failure. As years passed and profits dwindled, he became increasingly insistent that the path to prosperity did not entail costly store renovations. Before the merger, Sears spent more than $700k per year on each of its stores. That dropped immediately to $250k or so. Today, Sears Holdings spends $1.50-$2 per square foot on each of its stores annually compared with $6-$8 at Wal-Mart. “The fact is that retail stores wear out,” says Mark Cohen, who headed the profitable Sears Canada subsidiary and left before the merger to become a professor of marketing at the Columbia Business School.“The paint fades, the lights dim, the carpet becomes threadbare; the stores become dirty and outmoded, and competitively speaking less and less attractive.” Meanwhile, prices were hiked at both Kmart and Sears. A Goldman Sachs report in 2008 said that prices on nationally branded products at both chains averaged 18% higher than at Wal-Mart.“The prices are totally out of whack,” an analyst told The New York Times. So were the prices that Lampert paid to buy back stock. Through October 2011, Sears Holdings had purchased 59m shares at an average price of $103.58, yet SHLD traded earlier this

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year under $30. The buy-back cost $6.1bn, compared with $3.2bn for capital expenditures and a depreciation charge of $6.6bn. Lampert’s strategy worked at AutoZone because it had a stable double-digit market share and a stock price that remained low for years after Lampert gained control. In contrast, Sears Holdings’ market share continued to decline—it’s less than 6% now —but its stock price has been volatile. Each initiative announced by the company spurred hope, which faded as profits continued to dwindle. The volatility attracted short sellers, most of whom probably lost money. “ESL likes to chase people out of short positions,” notes Swinand. As for the supposed treasure of unrecognised real estate value on Sears Holdings’ balance sheet, that idea was undermined by the financial crisis of 2008 and the ensuing Great Recession that popped the real estate bubble. It’s now apparent that America has too much retail space, especially for mass merchandisers like Kmart and moderately priced department stores like Sears. “At the high end of the market, there actually isn’t that much supply of space,” says Cedric Lachance, managing director of retail research at Green Street Advisors.“Where you find too much is at the lower end of the business. So over the next decade we expect 10% of the mall space in the country will be taken out of retail.”

Store closures Lampert’s recent moves appear to recognise this. The number of stores to be closed this year has been increased to 173. Orchard Supply Hardware, a California chain acquired in 1996, was spun off to shareholders late last year. Meanwhile, Lampert has advanced Martinez’s idea of exploiting the value of Sears’ private labels. He put Craftsman, Kenmore and DieHard into a separate business unit a few years ago—which should ensure their survival even if Sears and Kmart disappear—and has engaged a firm to

find new distribution channels. Already some Craftsman tools are sold at Costco, Ace Hardware, and other retailers. Lands’ End, an apparel brand Sears bought in 1992 for $2bn in a failed attempt to duplicate Target’s success with pricier clothing, is said to be up for sale. “I don’t know of another retailer that is in this position, where the private brands are beginning to have more equity than the corporate brand,” says Carol Spieckerman, president of Newmarketbuilders.“But this is the situation at Sears.” The company also has gained traction in online retailing. “Online sales have been strong over the past year or two, and I would expect that to continue,” says ISI’s McGinley. “But that doesn’t offset the very bad position that the stores are in.” “They don’t have a clear-cut merchandising strategy,” adds Richard Seesel, of Retailing in Focus. “The essence of being a retailer—creating a store experience that will make the customer want to come back—is where they haven’t been successful.”Timothy O’Connor at RetailNet Group agrees. “Their competition has been skunking them regarding better store locations, superior execution of their stores, and in general focusing on being relevant to today’s consumer. Basically, Sears has just been sitting there.” Sitting still in the dynamic US marketplace means, of course, falling behind. McGinley expects SHLD’s revenues to fall to $37.3bn this year and decline further in following years. This bleak outlook vindicates Lampert’s critics, who said his strategy of higher prices and a degraded shopping experience was unsustainable. They said that being a great stock picker doesn’t qualify one to run a retail operation; now it appears it might be too late to save either Sears or Kmart. To a generation of Americans who once turned first to Sears for their shopping needs, this is a dispiriting vision, but for a larger and growing segment of the population, Sears and Kmart will hardly be missed. I

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INDEX REVIEW

THE PUSH AND PULL OF POLITICS AND WILLPOWER

THE PUSH AND PULL OF WILLPOWER AND POLITICS June will be a battle between political will and economics. While European leaders continue to insist that they want Greece to remain in the eurozone, they are continually being reminded of the economic reality that a break-up of the single currency is almost certain. What is becoming more apparent day by day is that the markets will simply not allow the likes of Greece to have their cake and eat it without paying for it too. Whether Europe’s politicians will listen to those market siren calls for change has yet to be determined.

F THE GERMANS and French remain reluctant to put their money in the pockets by either using the ECB’s potential firepower or create a special eurobond then they could themselves become the very nemesis of the single currency that they tell us they are so desperate to keep. Even so, risk aversion continues to whittle down the markets; at the time of writing the index is at 5380, down some 25 points. Traders are watching term support trends at 5335, 5300 and 5275; hopeful bulls out there will be looking for resistance at 5490, 5615/45. This near term downward trend sees the index capped by a downward trend line that also puts some resistance at 5450. Over the longer term now that the index has broken below its 200 day moving average and its upward trend line a close below 5400 could been seen as very negative and we’re now in the territory of people not wanting to catch a falling knife. While immediate market focus will remain on Europe and its affect on the macro picture, there are a couple of important pieces of data that UK investors should note. First, following a surprising improvement in April, unem-

ployment numbers are likely to show a weakening labour market. There’s little in the way of encouraging data from the UK at the moment, but last month’s data was the first indication that unemployment is starting to peak. Job creation has come largely from part time rather than permanent work and the tick downwards to 8.3% in the rate of unemployment is expected to rise back to 8.4%. Second, it will be interesting to see whether the upcoming Bank of England’s inflation report will encourage the central bank to stick to their hawkish guns or whether the confirmation of the double dip recession and a further downgrading of growth projections will result in a more dove-ish tone. Other European indicators are not great either: Italian ten year yields have crossed back above 6% and for Spain back above 6.5%, meanwhile risk adverse investors piled into German bunds driving their cost of borrowing even lower. This is classic fear gripping the markets once again as the vicissitudes of 2012 look to be playing out in a very similar fashion to 2011. Financial markets detest uncertainty and at the moment they

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

are riddled with them since Greece has been unable to form a government and has had to call for a new round of elections on 17th June. Up until that point we can expect volatility to remain high and continued pressure to the downside. The euro made a low of $1.2720 as the situation in Greece continues to deteriorate. Bears sold the single currency heavily after socialist leader Evangelos Venizelos announced that talks to form a coalition government had failed and that the public would have to go back to the polls next month. Gold continued to fall as traders dumped risky assets and piled into the safety of the US dollar. Spot gold traded as low as $1541 an ounce. With little technical support seen until $1531 and no turn around in Greece on the horizon, the down trend looks set to stay firmly in place. On top of all the European woes there’s also the growing concern that China is slowing down quicker than was previously thought. Add any downturn to the euro crisis and it has negative connotations for global growth. As ever, ladies and gentlemen, place your bets... I

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SECURITIES SERVICES

To date, global custodians have typically maintained relationships with several different sub-custodians, including those that they feel offer a unique level of regional service. Will the trend continue? Or will economic factors increasingly favour global players over those with significant regional networks? Dave Simons reports.

ISK MITIGATION CONTINUES to dominate the conversation in the asset-servicing sector, affecting the custody business in particular. After all, asset owners view custodians as the ultimate gatekeepers, and this has caused a fair amount of soul-searching among custodians who have been forced to stress test nearly every aspect of their business processes in an effort to give clients the peace of mind they crave. Perhaps not surprisingly, a portion of this extra attention has spilled over onto the sub-custody side. A chain is only as strong as its weakest link, and with many sub-custody networks covering well over 50 different markets, the need for strong network-management skills has become compulsory. This has led many custodians to maintain both primary and secondary businesses in certain markets, thereby allowing assets to be quickly shuttled from one to the other should problems arise. In contrast to the resilience of emerging regions such as Africa, Asia, Latin America and the Middle East, in Europe the decades-old consolidation trend continues to whittle away at the ranks of local players, while leaving a limited number of regional and/or global providers. EU banks, already under considerable strain as a result of the ongoing Euro crisis, face much tougher capital-adequacy requirements, leaving some to wonder if CEOs might consider abandoning sub-custody providers altogether in order to avoid increased exposure to legal action. What does all this mean for sub-custodians

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trying to cope with the perpetual increase in costs, rising transparency demands and unbundling of services? According to European Central Bank (ECB) figures issued late last year, costs associated with EU cross-border transactions could be as much as ten times higher than those borne by US equity traders. This persistence of post-trade EU market fragmentation has led regulators to place even greater emphasis on harmonisation initiatives, most notably TARGET 2 Securities (T2S). Such streamlining could prove quite costly to those in sub-custody, however. To date, the vast majority of custodians have relied on subcustody providers to navigate the fragmented European markets. By providing direct access to eurozone CSDs, however, sub-custody disintermediation on a larger scale seems increasingly likely, particularly in regions where custodians are able to handle tax claims, corporate announcements and other functions that fall under a sub-custodian’s purview. “T2S’s impact on market participants would be huge,” affirms global service provider Cognizant in its recent survey TARGET2-Securities Platform: Implications for the Post-Trade Arena. While the platform would certainly lead some players to retool their business models, T2S could have a particularly profound impact on subcustody, as increased competition puts added pressure on transactional revenues and forces participants to beef up their menu of services in order to maintain regional distinction.

EUROPEAN SUB-CUSTODY: RISK MITIGATION DOMINATES

THE GROWING DOMINANCE OF GLOBAL PLAYERS

Makeovers of this magnitude, however, could be extraordinarily costprohibitive for the smallest participants, leading to further consolidation as local custodians join forces in order to remain viable. Should the settlement business decline further still, notes Cognizant, these entities may start transforming their business models to operate more like a utility that provides a bouquet of services to custodians such as asset optimisation, tax-related services and income collection. “T2S is still very much a hot topic in Europe,” concurs Alan Cameron, head of client segment, broker dealer and investment banks, BNP Paribas Securities Services. “However, at this point I think people have a much better idea of what T2S is about, and have begun to plan accordingly.” From a sub-custody perspective, T2S will lead to an even greater emphasis on asset servicing. Or, to put it mildly, says Cameron,“it is where we will really be asked to show our mettle.” Despite an increase in capital adequacy requirements, EU bank chief executives are keen to keep their existing network for their own operations as well as those of their customers’ in order to avoid taking a risk on third party sub-custodians, contends Etienne Deniau, head of custody and trustee services for Société Générale Securities Services. Besides, says Deniau, custody is not a big consumer of capital, and it also provides recurring fees. “Regional custodians have traditionally been used by those who want to simplify their network management,” says Deniau.“These players likely only have a single relationship covering a small number of markets where they have less activity. This ‘pooling’ of markets will likely continue, so long as there is a cost to maintaining a specific relationship.” Because they typically prefer receiving ‘raw’ information in real time, arbitrage players and brokers/dealers tend to favor direct access over utilising a sub-custodian, adds Deniau. “Investors are less interested in

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EUROPEAN SUB-CUSTODY: RISK MITIGATION DOMINATES

Etienne Deniau, head of custody and trustee services for Société Générale Securities Services (SGSS). “Regional custodians have traditionally been used by those who want to simplify their network management,” says Deniau. Photograph kindly supplied by SSGS, May 2012.

rumors—they want accurate and definitive information delivered in a smooth format that can be adapted to meet their needs.”Meanwhile, larger players will need to maintain multiple providers in markets where there is significant risk exposure in order to bring proper diversification to the supplier chain. While some may rely on dormant back-up providers, having a live back-up offers the only real protection, says Deniau. The sub-custodian’s trump card has long been its ability to offer keen insight into the local regulatory environment. Within certain regions, such attributes may be enough to give pause to global players who might otherwise consider doing without a sub-custody network. Indeed, providing expert advice about Europe in maturing regions such as Asia remains one of BNP Paribas’ leading attributes, asserts Cameron.“To maintain these standards, we have to ensure that our staff is continually up to date and is able relay information as clearly as possible. So that remains a major challenge.” With EU sub-custody restricted, BNP Paribas, like others, has turned its attention to the considerable growth prospects within regions such as Asia, and countries such as Brazil, and other developing centres. Strong investor demand continues to fuel such explorations, says Cameron. “Acquisitions have accounted for a portion of this growth—for instance; the

company may purchase a regional bank, and in the process inherit its preexisting custody business. Still, the most important driver all along has been the expectations of our clients, whose purview has become increasingly global.” Helping fund managers boost inflows through its cross-border distribution remains a critical part of BNP Paribas’ sub-custody offering. Last month, the Securities Services division added Hong Kong to the list of markets that comprise the company’s crossborder fund distribution network. The move will allow global asset managers easier regional access, while facilitating more efficient interaction with local institutional investor clients. Meanwhile, HSBC Securities Services (HSS) recently announced the debut of its own Germany-based subcustody and clearing offering through the integration of the parent bank’s domestic custody provider HSBC Trinkaus into the division’s global network. The new offering seeks to make available existing services within Germany to cross-border banks and broker dealers that use HSBC as a local sub-custody/clearing provider. According to Colin Brooks, global head of sub-custody and clearing, HSBC, in the aftermath of the financial crisis many global custodians have reviewed their custody arrangements, with some re-adjusting their portfolios to help manage the risk profile of their sub-custodians. “In light of pending regulatory changes,” says Brooks, “looking ahead there are clearly benefits in holding assets with a wellcapitalised custodian, which are typically the regional or global subcustodians such as HSBC. While I do see this trend continuing, large global custodians in particular will likely maintain more than one provider for a number of reasons—first, no subcustodian has full global coverage and therefore use of more than one provider is necessary; secondly, global custodians’ risk committees will need to ensure that concentration risk is

Colin Brooks, global head of sub-custody and clearing, HSBC. According to Brooks in the aftermath of the financial crisis many global custodians have reviewed their custody arrangements, with some re-adjusting their portfolios to help manage the risk profile of their sub-custodians. Photograph kindly supplied by HSBC, May 2012.

managed; and finally, clients like to be able to compare sub-custodians in terms of products and services.” Even if bank CEOs do not jettison their sub-custody businesses to avoid a possible increase in legal action and/or compensation, Brooks expects that the number of sub-custodians will nevertheless continue to fall, as the knock-on cost of adhering to regulations aimed at global custodians and fund managers have an impact on the industry at large. “This is the continuation of a trend that has been in play for many years, where only the strongest subcustodians have the financial wherewithal to continue investing in their businesses,”says Brooks.“It is possible, though, that global custodian activity may be reviewed in light of new regulatory responsibilities.” In the meantime, says Brooks, asset owners need to be vigilant and continually press global custodians for information to ensure that their sub-custody network is in good working order. “Asset owners should ask about the criteria for selecting a sub-custody provider, and should be looking for assurance that their sub-custodian has a strong balance sheet, a comprehensive product set, and can provide an adequate level of service quality,” says Brooks.“If they can receive verification of these qualities, it will go a long way towards boosting confidence.” I

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REGIONAL REPORT

Photograph © Drizzd/Dreamstime.com, supplied May 2012.

As the eurozone lurches from one crisis to the next, the Nordic region has become the poster child for the continent. Characterised by relatively low public debt, unemployment and strong structural growth, Sweden, Norway, Finland and Denmark have been successful in weathering the worst of the storm. They have not been immune though to the aftershocks of the eurozone crisis and the challenge will be to see whether they can continue to set an example if the 17 member bloc unravels by the end of this year. Lynn Strongin Dodds reports. “

OST OF THE region went through some kind of financial crisis in the early 1990s and they all had painful experiences,” says Nick Davey, analyst at UBS. “They learnt their lessons and this has filtered through in the way they handled the crisis which has held them in good stead.” Øyvind Fjellm portfolio manager at Delphi Norden, agrees, adding that they all pursed sensible fiscal policies which have translated into the region being a net creditor. All four countries boast low levels of national debt in relation to their developed peers plus they stand out of a total of 13 who are proud owners of a triple-A rating from the credit rating agencies. Sweden’s finance minister Anders

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Borg in particular has been singled out for his adept handling of the global financial debacle. He may cut an unconventional figure with his ponytail and earring but in fact he has shaken Sweden to its core by tightening the eligibility for welfare, reducing taxes for those in work and rigorously pruning the budget deficit. These reforms made Sweden the envy of its European peers in 2010 with growth rates of 5.5%, which was the highest figure since the record year of 1970, when it climbed to 6.5%. The country though has been unable to keep up the pace with the government recently lowering its gross domestic product (GDP) forecast to 0.4% this year, down from its previous estimate of 1.3 %. The main problem is

NORDIC ZONE OUTSHINES EUROZONE

An oasis in a barren sea?

its heavy reliance on exports to Europe —they account for half of the economy and 70% is directed towards the continent. Efforts are underway to shift the trade to the faster growing emerging markets and to boost jobs in other sectors which analysts hope will improve the GDP figures in 2013 to 3.3%. Although acknowledging the difficult operating environment, market participants are not unduly concerned about Sweden. “Everyone accepts that there is a slowdown, but in relative terms the country is doing well in a European context and we are not worried,” says Cecilia Auvray, chief portfolio manager, Nordic equities at Handelsbanken. “The problem is with the global economy and the eurozone in particular. We still see Sweden as a safe haven in relative terms and have confidence in the government.” Peter Andersson, director of business development at Legg Mason, adds, “Sweden is the biggest economy in the region and the government responded early to the financial crisis. There is a good blueprint for growth and the finance minister is making all the right calls.” Analysts are particularly bullish on the country’s banking sector particularly the pure plays such as Swedbank, SEB and Svenska Handelsbanken. According to Davey, the banks should deliver more resilient revenue growth of 2% versus –12% last year with lower loan losses (6 basis points compared to 53bps) which will translate into higher return on equity (12.2% against 5.9%). The main drivers are a more disciplined pricing environment in the Swedish mortgage system year to date as well as an encouraging wholesale banking backdrop which is a key support for Swedbank, SEB and SHB earnings. “There are a couple of differentiating factors,” says Davey. “The domestic economy is strong and the banks have held up well during the crisis. SEB and Swedbank may have had exposures to the Baltics but they have aggressively

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REGIONAL REPORT

NORDIC ZONE OUTSHINES EUROZONE

cleaned up their balance sheets and unlike Southern Europe did not look to spread those losses over many years. Pre-crisis, they lent money but at a slower pace and they have been on a much stricter regulatory model than for example, the Danish,” he adds. Denmark has been the weakest link in the region with its banks suffering the most due to the bursting of the country’s property bubble in 2007 coupled with a downturn in the agricultural arena and beleaguered SMEs. “There are two to three major challenges in the country, says Jens Hallén, analyst with Fitch Ratings.“Real estate prices have fallen by about 25% since the peak and our expectation is that they will fall slightly further this year. The agricultural sector remains difficult while SMEs which are a large section of the economy are facing problems due to the slowdown in exports. However, while Denmark is underperforming in a Nordic context, it is still relatively strong compared to other European markets.” About 12 Danish banks have failed since 2008 including Amagerbanken, the country’s eighth biggest bank in terms of lending last year. The government has launched five bank rescue packages in the past four years but as those measures have faltered the Finanstilsynet (Danish FSA) has introduced a tougher regime. It not only clamped down on lenders with stricter impairment rules, but also conducted surprise audits and stricter governance. For example, half of Denmark’s 20 biggest banks do not have a board member with bank industry management experience which means they are not fulfilling the basic regulatory requirements designed to ensure banks are properly run. There are hopes that the latest reforms, which will compensate stronger banks for acquiring their struggling brethren, will trigger the much needed consolidation in this 120 overbanked market. Søren Brinkmann, partner at Danish based Lett law firm, says,“The problem is that there are too

many small banks and the two to three large ones are too big to fail. The FSA has been aggressive towards the smaller banks and has introduced stricter solvency requirements while the government has allowed the banks to go bankrupt, which was a radical approach compared to the rest of the Europe. Also, despite the banking problems, the Danish economy is doing relatively well. There is little foreign debt, unemployment has increased from 5% to 6% but that is not an alarming figure and it is still running a positive trade balance.” As for the other countries, Finland’s paper and pulp companies have reaped the benefits of China, Russia and other emerging markets while its industrial and shipping sectors have been more exposed to the downturn in the developed world. The country which is the only Nordic to belong to the eurozone club has kept a tight rein on fiscal policy and is a strong advocate of the EU’s new treaty on stability, coordination and governance treaty which will require EU member states to limit their budget deficits to 3% and structural deficits to 0.5% of GDP.

Norway: a star performer The star performer in the region is Norway thanks to its vast oil and gas reserves which produced a $19bn budget surplus at the end of 2011. The country, which is not a member of the EU, enjoys strong income growth, low interest and unemployment rates and a buoyant housing market. Analysts at Handelsbaken forecast GDP hitting the 2.9% mark this year, up from 2.6% in 2011 and increasing to 3.5% at the end of 2014 due to an upswing in the global economy and an increase in petroleum investments. While on the surface the prospects are bright, the country is still subject to the vagaries of the global economy plus there are warning signs of a possible housing bubble brewing underneath, according to Davey of UBS. He points to Norwegian household debt-todisposable income metrics trending

towards 220%, house prices rising by 20% plus the loan to value profile of its mortgage system is materially worse than in pre-crisis Denmark. There are concerns that the recent unexpected rate cut from Norges Bank from 1.75% to 1.50% may only exacerbate the situation and some analysts are calling for the county to follow Sweden’s example in requiring banks to set aside more capital to cover the risk of mortgage losses. Sweden has not only towed a more stringent line domestically but also globally. The details are still being decided but the country’s central bank has already stated that its largest banks will have to follow a more rigorous regime than the one imposed by Basel III whereby banks will have to hold common equity of 7%, comprising a 4.5% minimum requirement and a 2.5% capital conservation buffer. “Finland, Sweden, Norway and Denmark all tend to follow European Union regulations to the letter,” says Helge S Arnesen, Nordic chief investment officer at Alfred Berg.“I do think though that the three other countries could follow Sweden’s lead and impose stricter requirements to ensure a solid banking industry at all times. As for Solvency II, it could also have an impact for occupational pensions in Norway, but we are waiting to see what the final details will be in the new regulations for the industry.” The one thing that is unlikely to change is the lock that the national players have on their home markets. Global firms are welcome but breaking into the Nordics is not easy. As Katrin Boström, head of Nordic sales at AXA Investment Managers, explains:“private individuals and small institutions often use domestic providers while the larger international players tend to focus on the bigger firms. However, they are often not looking to compete but provide a service that is not offered by the locals and where they have an edge. For example, this could be structured finance, global and European high yield or short duration products.” I

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REGIONAL REPORT

NEW OUTLOOK FOR NORDIC SUB CUSTODY Small and open economies like those of the Nordic zone are heavily affected by the problems haunting the euro. Relatively good state finances and strong external balances give the Nordic states some power of resistance but cannot stop growth sliding behind trend. With the exception of Norway (which is expected to grow by more than 2% this year) the Nordic countries will likely see GDP growth levels of about 0.5% this year. Even so, good fundamental factors mean that the Nordic markets have become more attractive investments, manifested by low interest rates on sovereign bonds. Ulf Norén, global head of sub-custody at SEB considers the key macro trends impacting on business.

HENEVER DISCUSSING THE Nordic region, it is important to remember that the four markets are small and very dependent on global—particularly European—growth and development. The Nordic Region, as an entity, has managed to navigate well in the choppy waters of today’s financial markets. Even so, despite the somewhat brighter prospects for the region; issues in surrounding markets continue to dampen the overall business environment, even with massive intervention by the European Central Bank (ECB), signs of increased coordination of economic policy among eurozone members and the emergence of a more balanced financial discussion about tackling global recession. Many of the Nordic markets have performed stronger than broad exchange indices in the US and the eurozone. For the next year, many factors speak in favour of the Nordic markets performing better than Western Europe in general. That is for three reasons: Nordic economies will

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avoid falls in GDP output in 2012; given the more stable environment in the region, the many listed companies with cyclical exposure will enjoy competitive advantage; and finally, any negative effects that limited liquidity imposes on smaller markets will be considerably reduced In terms of the outlook for subcustody: this too is subject to a myriad of external influences; many of which are related to developments in the wider European market. The overall business environment is in flux, and subject to changes in scale. In part this is due to the emergence of new regulations and rule books. In part it is due to increased competition for business as foreign firms try to access the growth story in the region. As well, local subcustody providers are finding that it is a buyers’ market and that customers have stepped up their service requirements and exhibit very little patience for the time needed by sub-custodians to adopt new rule books. We have counted approximately 40 separate initiatives that will have a direct

NORDIC ZONE: SEAWORTHY MARKETS BUT NO PLAIN SAILING

Photograph © Philcold/Dreamstime.com, supplied May 2012.

or indirect impact on the provision of sub-custody. The majority of these initiatives are European (including EMIR, AIFMD, MiFID II, UCITS V, SLD and CSD Reg); though others such as the American Dodd Frank Act and FATCA directives are also impacting on the business. While some of these initiatives have been delayed and the impact of others diluted in recent months, it would be naïve to think that this magnitude of regulation will not drive and forever re-shape the European scene. The biggest catalyst for change will however be Target2Securities (T2S). In the Nordics, only Finland has expressed a clear intend to adopt the initiative; while other markets have preferred to take a wait and see approach. At the end of the day, the impact of T2S effects will diffuse through the market, irrespective of whether it is formally adopted by individual markets or not. The driver will be our clients as T2S broadens the way in which they will be able to treat cross-border trade flow. Equally the benefits of T2S will ultimately flow towards those markets outside of it and will likely encourage them to join eventually. Either way, it is imperative that as an organisation we prepare our service model for T2S as if it will be introduced in all markets. Over the past seven or eight years we have seen a sea change in the way that clients treat with sub-custodians. In our region, we now see fewer than five major names using more than two providers in the region. Other than for reasons related to existing strategic relationships, or for reciprocity, clients have tended to opt either for SEB or Nordea. We expect this concentration of business to continue for the following reasons: increased competitive pressure on fees; regional providers are a better fit for cross border clients in almost all dimensions; and regional’s have a superior ability to run a client’s change agenda over multiple country borders. Sub-custodians have for decades been involved in risk management processes and these processes have stood up extremely well during the

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NORDIC ZONE: SEAWORTHY MARKETS BUT NO PLAIN SAILING

Ulf Norén, global head of sub-custody at SEB. Many of the Nordic markets have performed stronger than broad exchange indices in the US and the eurozone. For the next year, many factors speak in favour of the Nordic markets performing better than Western Europe in general, writes Norén. Photograph kindly supplied by SEB, May 2012.

financial crisis. Among the key mandates for sub-custody providers over the near term will be to continue to ensure that their client assets are safe and well protected. This requirement is clearly spelled out in regulations, such as AIFM and initiatives such as UCITS 5. It will involve sub-custodians and clients working closely together to ensure the appropriate distribution of responsibilities in the new rule books and involve renegotiation of both service contracts and procedures. As a result, sub custodians must further encourage active due diligence among their clients and adopt clear and exhaustive risk measurement and management processes, and start demanding the same of the internal infrastructures we provide, refining and enhancing our internal processes at all levels. As a sub-custodian, you must be able to visualise the risk management tasks you perform, what risks you are absorbing and enter into a realistic dialogue around appropriate compensation based on this analysis. A lot of this renewed focus on risk is imposed politically. In my opinion, some of the solutions proposed contain some elements of over-simplification of the understanding of the processes involved. Inevitably, in any proposals that emanate from political rather than market sources, volume producers are often hit hardest and proposed restrictions on trading behaviour might ultimately damage business models.

Equally there is a strand of political opinion that all risk can and should be mitigated by the use of collateral. There are pros and cons to that stance and all that can be said at this point is that it will create both challenges and opportunities for the sub-custodian segment.

What kind of provider map will we then see in the future? It is not easy to predict the outcome of the many strands at play in the market right now. I do however think that subcustodians will continue to play a considerable role in defining the infrastructure of the financial markets. I also believe that sub-custody will actually increase its contribution to the value chain as a whole. However, the industry will consist of fewer players with a wider geographical reach. In an environment of growing complexity, I believe that we will see providers that develop in fashion that is coloured by: a new focus and understanding of the changing requirements and behaviour of clients; the emergence of new client segments; and increased and deeper dialogue with clients, vendors and competitors in the establishment of a new service infrastructure. This will mean that sub-custodians must allocate resources to spend much more time on these broad yet individual relationships. Looking at the political/ regulatory agenda, I firmly believe that optimising the use and management of collateral and margining areas will be vital to the effective operation of this new infrastructure. I also think that those sub-custodians that remain in the business segment must take control over all bank to bank business; this should kick off in the area of cash management so that the sub-custodian becomes a holistic partner to their business clients. In this regard, long term, solution-oriented providers will win out over those firms whose strategy is based on short-term/profit maximising/individual product focused providers. Within this changed business environment the emergence of realistic

compensation models will be crucial. We see a number of models coming into play. While it is true that existing compensation models will remain for some relationships (depending on the nature, width and depth of the client business); effective compensation must come into play. Other considerations will also come into play, including support for various levels of self-servicing models, primarily focused towards maybe ten to 15 larger relationships. As well it is incumbent on sub-custodians to create efficient, service minded and error free operational areas to benefit from economies of scale advantages. Over the next five years, I am comfortable with the current markets coverage we offer, which ranges over nine markets. I am doubtful that we will see the emergence of the ‘global sub custodian’ or even true European sub-custodians within that time frame. It is unlikely that I will see this (even with service providers with global ambitions) within my working lifetime (and I am not scheduled for retirement before the 2021/2022 season). For the time being however, we still have a host of macro issues to content with, not least the continuing eurocrisis and the contraction of growth in many European economies. The spectre of Portugal and Greece having to leave the eurozone will continue to haunt the markets for some months to come; and the risk of Spain requiring a massive European funded bailout will likely consume much of this summer. Until a new institutional framework that supports the euro is clearly in place I see no end to these problems or any reduction in political instability in some countries. The situation is testing as simultaneously, both Europe and the world at large is trying hard to tackle serious imbalances in competition and trade. While not surmountable at this time, all these issues will at some point be tackled, but not before the financial markets and those that support them, such as sub-custodians have to instigate massive changes themselves. I

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DEBT REPORT

DEBT TRADING IN FLUX: A NEW INFRASTRUCTURE EMERGES

Caretaker Prime Minister Mark Rutte, right, and deputy prime minister Maxime Verhagen, centre, listen to anti-EU lawmaker Geert Wilders, left, as he addresses parliament in The Hague, Netherlands, Tuesday April 24th, 2012. Rutte appealed to a polarised Dutch Parliament the same day to help him get the economy back on track rather than let the country drift in political limbo until new elections. Speaking publicly for the first time since he tendered his resignation on April 23rd, Rutte said the nation, long considered one of Europe's most fiscally responsible, has no time to waste in tackling its economic woes. Photograph by Peter Dejong for Associated Press. Photograph supplied by PressAssociationImages, April 2012.

DEBT TRADING BRACES FOR CHANGE There is a growing sense that over the near term the markets will witness a significant withdrawal of banks from bond trading, as chronic uncertainty in the eurozone and incoming regulation make it harder for bond trading desks to make ends meet. It is leading some buy side houses to find their own responses to the challenges being thrown up by market change. The planned BlackRock trading system is designed to mitigate the widening of spreads by allowing its clients to trading with each other. Given the pressure that is mounting on banks’ debt trading operations, it seems increasingly likely that non-banks are going to play a much more significant role in bond trading in the future. Andrew Cavenagh reports on the key trends playing through the bond markets and the impact of change.

EBT-TRADING OPERATIONS at European investment banks face a difficult year. Not only will they have to deal with considerable uncertainty across the bond markets as a result of further political upheaval in the eurozone, but also they must now adjust their businesses and adapt to a significantly different regulatory regime. Although

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the first-quarter financial results from Credit Suisse, Barclays Capital and Deutsche Bank showed a clear improvement in trading income at all three banks over the second half of 2011 for two reasons. One, the trend largely reflected seasonal factors; first-quarter (Q1) sales are historically higher than over the rest of the year. Two, bond trading received a

short-term fillip as market confidence as the European Central Bank’s provided €1trn of additional liquidity to the banking system in December and February. On a different slant (and more pertinent perhaps) was the fact that trading revenues at both Credit Suisse and Deutsche Bank were down on the first quarter of last year. In contrast Barclays

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DEBT REPORT

DEBT TRADING IN FLUX: A NEW INFRASTRUCTURE EMERGES

Capital managed to buck this trend with a marginal increase in revenue on Q1 of 2011. The figures that Deutsche published in the final week of April, for instance, show that the bank’s revenues of €3.4bn from debt trading over the first three months of 2012 year represented a drop of €301m (or 8%) on the same quarter of last year (although the decline compared favourably with the 23% deterioration in the bank’s revenues from equity sales and trading). Dr Josef Ackermann, chairman of Deutsche Bank’s management board, pointed out that the results should be seen “against the backdrop of a far less favourable environment” than that prevailing in the comparable period of 2011, as the bank was confronted with lower levels of client activity at the same time it was imposing stricter risk discipline. It is no secret that since the end of the first quarter, the trading climate has deteriorated markedly as political developments in the eurozone have yet again increased anxiety throughout the sovereign debt markets, by far the largest in both overall size and volume of trades. Towards the end of March, renewed fears that Spain would not be able to bring its public finances under control saw the yields on 10-year Spanish government bonds climb towards 6% and break through that level early in April. Naturally, alarm bells started to ring afresh in the markets. If that was not enough; market fears were then heightened by the success of the socialist candidate François Hollande in the first round of the French presidential elections on April 22nd. The worry about Hollande’s almost certain election is that he has promised to renegotiate the terms of December’s EU pact on deficit reduction. The situation was further exacerbated by the resignation of the Dutch Prime Minister Mark Rutte on April 23rd, after the coalition government he was heading failed to secure parliamentary

backing for a programme of EUimposed austerity measures. Much of the fear and uncertainty that paralysed markets towards the end of 2011 seemed to return in big packets. The resulting market churn has subsequently lent support to those who had argued that the ECB’s unprecedented intervention earlier this year would prove no more than a short-term palliative; with a predictable impact on secondary-market activity. “While a degree of volatility is generally good for trading, when that becomes too extreme and investors have a lower degree of certainty then it tends to have a negative impact,” comments Roger Barton, a regulatory expert at MTS, which operates by far the largest electronic trading platform in Europe for dealer-to-dealer sovereign debt trades.

Extreme conditions Barton adds that such extreme conditions tended to have an even more pronounced impact on electronic trading, because in such turbulent circumstances investors and dealers may prefer to talk to somebody before making any decisions. Exactly what this will mean for banks’ debt-trading revenues in the second quarter and over the remainder of the year remains to be seen, but sector analysts are not optimistic. “It is a guessing game to know how much revenues will drop in the rest of the year, but the outlook does not look positive given the re-emergence of sovereign risk concerns and continuing economic weakness,” says Simon Adamson at the international research firm CreditSights. While the increased market uncertainty may have put more of a brake on electronic trading than voice-activated deals, however, the regulations that the EU (in line with the other main financial jurisdictions) will introduce to ensure there is more transparency in the bond markets—and less scope for shocks—will drive the business inexorably towards greater use

of electronic platforms such as those that MTS provides. The shift is being driven in part by the recent European Market Infrastructure Regulation (EMIR); upcoming market surveillance initiatives driven by ESMA, the European financial markets regulator and, of course, the second iteration of the Market in Financial Instruments Directive (MiFID II). While the exact requirements of the amended directive may not be finalised for some months, with various points of the measure still under discussion in the European Parliament and European Council, the new regime (in conjunction with other related initiatives) is certain to impose stricter demands on both pre-trade and post-trade transparency. As currently proposed, MiFID II will extend transparency and transaction reporting requirements to additional asset classes such as bonds, structuredfinance products, derivatives and emissions allowances. It will also extend this regulation to all venues that trade on a “systemic basis”, such as organised trading facilities (OTFs), which it defines as “any system or facility, which is not a regulated market or MTF, operated by an investment firm or a market operator, in which multiple third-party buying and selling interests in financial instruments are able to interact in the system”. It is difficult to see how the EU authorities can achieve these goals without significantly more use of advanced (electronic) technology for trading.“Over the past couple of years, in particular, there has been a great deal of focus on these regulatory changes,” says Barton.“And the effect of the [new] regulation will inevitably be to move more business to electronic platforms, although of course some business will continue to be conducted by voice.” In a sense, this development will simply advance a process that has been underway for several years, as MTS and others have developed such platforms and growing numbers of market participants have begun to use them

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(about 50% of dealer-to-dealer transactions in the sovereign debt market in Europe are currently conducted in this way). However, the new regulatory requirements are likely to precipitate a step change in the percentage of trading that is conducted through electronic platforms. For the trading operations at large banks, one consequence of this greater reliance on increasingly sophisticated technology will inevitably be further pressure on profit margins. As the bond-trading business becomes more commoditised, bid-ask spreads will become narrower and continue to squeeze the profitability of individual trades. Banks will then need either to look for higher volumes of business to maintain the profitability of their debt-trading divisions, or reduce their commitment and deploy the capital more profitably elsewhere. There was some evidence that most of the leading US banks achieved higher business volumes over the first quarter of 2012; but it was not always the case in Europe. US financial institutions have been subject to much the same pressures as their European counterparts. This has involved enforced reduction in risk taking and adjusting to new regulation; although the initiatives to improve market transparency in the US have focused more on swaps and derivatives than the cash bond markets. Most big American banks—with the notable exception of the market leader Goldman Sachs—saw a significant improvement in debt-trading revenues and profits over the three months. According to Credit Suisse, the five largest US banks amassed combined revenues of $20bn from their fixedincome, currency and commodities (FICC) divisions, the highest aggregate figure they have achieved since the opening quarter of 2010. Citigroup, Morgan Stanley, and Bank of America recorded the largest increases. At Morgan Stanley, for example, underlying FICC revenues (before taking account of debt value adjust-

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ments to represent the change in the fair value of the bank’s borrowings as a result of changes in credit spreads) increased by nearly 34% over the first quarter of 2011 to just under $2.6bn. Morgan Stanley’s chief financial officer Ruth Porat attributes the improvement to higher levels of low-margin business or “flow”. However, the bank is likely to see revenues from fixedincome derivatives drop sharply over the rest of the year if Moody’s goes ahead with a threatened three-notch downgrade from A2 to Baa2. Bruce Thompson, Porat’s counterpart at Bank of America, observes that US banks are “making significantly more amounts of money with less risk” on the back of strong client flows as Value at Risk (VaR) levels—which measure how much a bank believes it could lose in a day of trading—had dropped appreciably. (At Goldman Sachs, the VaR came down to $95m over the quarter against $135m during the final three months of 2011.) This trend however might just prove a temporary respite. Most banking analysts expect the figures at US banks to tail off in the second quarter as the impact of the latest outbreak of panic in the eurozone feeds through into lower levels of activity. It might also mean that they will cut back on trading in the longer term as they adjust to higher capital requirements and a more restrictive trading regime under the Volcker Rule. In anticipation of this expected retreat by banks, other large investment institutions are looking to set up trading systems of their own that will cut banks out of the process. BlackRock, the world’s leading money manager with $3.7trn of assets under management, is planning to launch a system this year that will be able to match clients’ orders without recourse to either banks or other electronic trading platforms. While BlackRock has yet to release details of how the scheme will work the firm says in a statement that the initiative would be an extension of its

Roger Barton, a regulatory expert at MTS, the electronic fixed-income trading platform owned by the London Stock Exchange. “While a degree of volatility is generally good for trading, when that becomes too extreme and investors have a lower degree of certainty then it tends to have a negative impact,” comments Barton. Photograph kindly supplied by MTS, April 2012.

“broader efforts to streamline trading and access liquidity across various means”. It follows the Aladdin programme that BlackRock introduced in 2010 to enable its clients to acquire bond tranches directly from issuers (and trade them among themselves) through its own capital-markets unit (which generated $123m of revenue for the firm in the first quarter). In a recent conference call with analysts on the company’s first-quarter results, BlackRock chief executive Laurence Fink insisted that the trading system was not designed to compete with the fixed-income brokers on Wall Street (and transform the nature of BlackRock’s operation) but to fill a gap that was likely to develop if the banks reduced their involvement in trading as most expect. “We are responding to the regulatory regime that is transforming the future ways of the business,” Fink maintained. The fear is that a significant withdrawal of banks from bond trading will see a widening in bid-ask spreads, which the BlackRock trading system (and any others like it) would mitigate for clients trading with each other. Given the pressure that is mounting on banks’ debt trading operations, it seems probable—despite Fink’s protestations—that other types of institution are going to play a much more significant role in the business in future. I

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SECURITIES LENDING

REGULATION ADDS MORE STRESS TO SEC LENDING While the industry broadly supports stronger transparency measures, Europe’s securities-lending participants worry that the imposition of some tough new regulatory regimes could help undermine market efficiency by reducing liquidity and price discovery while widening deal spreads. Does the opportunity still exist for some modification to take place? Dave Simons reports.

N RECENT REMARKS, Lord Turner, head of the United Kingdom’s Financial Services Authority (FSA), suggested that the $60bn shadow banking sector, of which securities lending is a part, was in need of greater attention. However, it has been left to the Financial Stability Board (FSB) regulatory task force to draft tougher new laws by year’s end. While hardly earth-shattering news, the fact that the FSA considered securities lending to be a key component in this potential quagmire has raised concerns over the nature of forthcoming legislation. Already a sector under siege due to the backlog of current legislation in various markets around the globe, in Europe securities lending supply and demand is likely to be affected by fresh restrictions within Basel III, the sec-lend/shortselling proposals issued by the European Securities and Markets Authority (ESMA), as well as the imposition of the Financial Transaction Tax. Though it is too early to tell which of these pieces of legislation could have the greatest impact, any kind of transaction tax would be bad news for seclending, given the relatively low levels of income derived from very large deal sizes. With demand for standardisation in sec-lending continuing to mount, the effective quantification and accurate monitoring of counterparty positions, along with the ability to extract and report on any relevant position at any given time, has become far more important from a risk perspective. Faced with mounting regulatory pressure, France has already intimated it could cease sec-lending activity, even if others in Europe may not necessarily follow suit. Meanwhile, collateral is likely to play a much greater role in Basel III, in the process raising the cost for custodians needing to indemnify lending schemes. Although the industry broadly supports measures aimed at introducing a more rigorous and transparent market regime, Europe’s securities-lending specialist worry that incoming regulation could undermine market efficiency by reducing liquidity and price discovery while widening deal spreads. What might be the impact of upcoming legislation? Does the opportunity still exist for those in the industry to help modify these new rules? At the behest of the European Central Bank (ECB), ESMA is attempting to rush release a restrictive new set of shortselling regulations that could re-shape the map for the securities lending industry as a whole. With a November 1st

2012 compliance deadline looming but nothing yet set in stone, industry participants are in the rather unenviable position of trying to prepare for what may happen, without knowing if in fact it actually will.“Given that many of these roads are still under construction, it’s still too early to gauge the possible impact on the lending business,” says James Slater, global head of securities lending, BNY Mellon.“This naturally makes it quite challenging to formulate a proper working plan.” In terms of quantifiable change, the imposition of new capital rules calling for better ratios covering leverage and stable funding have had the greatest impact on the securities lending markets to date. “In response, there has been a much wider use of securities as collateral on a global basis, and I believe we will see a continuation of that trend,” underscores Slater. However, most agree that ESMA seems bent on drafting some form of legislation that, while ostensibly aimed at de-railing naked-short selling, could have even fartherreaching consequences.

Separating liquid from illiquid “ESMA is looking to separate liquid from illiquid instruments,” explains Brian Lamb, chief executive officer of EquiLend, a global provider of trading and operations services for the securities-finance industry, “and for those that fall into the latter category there could likely be some kind of locate as well as hold requirement, though again it is hard to say for sure.” Most troubling, says Lamb, is regulators’ efforts to use the Markets in Financial Instruments Directive (MiFID) as the rubric by which “illiquidity” is defined. Though it may sound like a reasonable approach to some,“you’re talking about two very distinct markets—that is, the cash market on the one hand, and the financing market on the other,” notes Lamb.“While there is certainly some common ground, there are very substantial differences as well." This has the potential to wreak havoc—or at the very least, create a lot of extra work—for those attempting to short stock that happens to wind up on the illiquid hit list. “First you’ll have to locate that stock, but then you would also be required to hold the stock, thereby introducing a dynamic that doesn’t currently exist within the market,” says Lamb. This, in turn, raises a whole new set of questions,

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

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SECURITIES LENDING

including who is paying to keep the stock on hold, the ability for participants to view “held” stock; not to mention how all of this might impact the economics of the transaction. Unfortunately, at this point concrete answers are hard to come by, says Lamb. Also part of the effort to keep lenders on a tighter leash is ESMA’s suggestion that income arising from certain seclending arrangements be returned to a fund in its entirety “as a general rule,”rather than having a portion of the proceeds distributed to the fund manager. In the event that any sharing of fees takes place, such arrangements should be fully disclosed by the fund, contends ESMA. As expected, the proposal has had lending leaders from all corners up in arms, among them the International Securities Lending Association (ISLA) as well as the European Fund and Asset Management Association (EFAMA). Fee-sharing revenue allows managers to offset some of the costs associated with offering lending services, say proponents, and, if prohibited, could affect the livelihood of lending providers. Calling securities lending a “costly activity” requiring “significant investment in research and technology”in order to generate incremental returns, ETF leader BlackRock claimed the ruling would present the industry with considerable operational challenges. Particularly in opaque sectors such as OTC derivatives, the application of research and analytics can have a direct impact on the investor base, suggested BlackRock. Furthermore, risk-management capabilities call for a steady stream of capital in order to properly monitor counterparties and collateral parameters. “Since it may be difficult to assign costs, such as risk oversight and trading tools to a specific fund, in our view a transparent revenue sharing agreement is the most appropriate way of ensuring a UCITS can benefit from securities lending,” says the fund. Other proposed rule changes have raised similarly strong objections. While agreeing that liquidity risk may rise in the absence of lending limits, the non-profit CFA Institute nevertheless argued against using a “bright-line rule” for all lending situations, suggesting instead a solution based on a combination of outstanding short volume and the total market float for each specific security. Such an approach said the group“would take into consideration the ability of share borrowers to unwind short positions.”

Understanding lending Though the sec-lending business has been a ripe target since the start of the financial crisis, if anything election season appears to have made the bull’s eye that much bigger. Says Lamb: “It’s a shame that these things have to become so overly politicised. It seems that somebody’s always looking for a scapegoat, when instead they should just be looking out for the better interests of the public.” Slater agrees that there are a number of forces helping to shape the discussion around Europe’s securities-lending markets at present, “and not all of it is about regulation— there are geopolitical and geo-economic concerns as well.” Despite concerns over the unintended consequences of ini-

James Slater, global head of securities lending, BNY Mellon. “It’s still too early to gauge the possible impact on the lending business,” says Slater, “Which naturally makes it quite challenging to formulate a proper working plan.” Photograph kindly supplied by BNY Mellon, May 2012.

tiatives in the making, the belief that EU regulators understand the connection between the vitality of securities lending and the smooth functioning of the financial markets will ultimately enter into the conversation, says Slater. “Generally speaking, regulators seem satisfied with the level of transparency currently on offer from agent lenders,” says Slater. If there is room for improvement, he adds, it is within the reinvestment segment. “There is still not enough information that is publicly available or easily accessible by regulators,”he adds, explaining that it“helps explain the increased regulatory focus on shadow banking, as well as the FSB’s and Bank of England’s recent work stream on raising transparency.” In an effort to engage regulators more broadly, participants such as BNY Mellon have considered the possibility of creating a central transaction depository whereby information could be stored and subsequently accessed by regulators. “Just so that everyone can understand the facts,” says Slater, “and decisions are not made that could lead to unintended consequences.” Just back from a round of sec-lend policy briefings in London, Lamb attempts to put a good spin on a potentially volatile situation. “Securities lending is a complex market, one that compels people to take the time to really think things through, lest they wind up with the wrong kind of legislation on their hands,” he says, adding that this is why it is so important to take the time to be thoughtful about any changes that need to be made, to understand the consequences and not just throw the baby out with the bathwater, so to speak. Obviously there is a lot of good that can be derived from these markets. I think that EU regulators by and large understand this—and although they are committed to making substantial modifications in areas like repo and re-investment, I hope they will know where to draw the line”. I

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GM Editorial 61_. 22/05/2012 15:48 Page 47

FUND ADMINISTRATION

At the top of the demand cycle Though asset volumes have improved, client service demands remain at an all-time high. It is forcing domestic fund administrators to wring every last drop of efficiency out of their operating systems. Meanwhile, a raft of challenging new regulations on the horizon continues to fire the worry machine. How are these firms faring? From Boston, Dave Simons reports.

N THE ONE hand, the stateside fund administration business has been in relatively good form through the first portion of 2012. That’s because institutions continue to allocate capital to hedge funds and other alternative strategies and asset managers seek to offload a greater portion of non-essential duties in response. Concurrently, a ramp-up in disclosure demands, fueled by a flotilla of explosive regulatory measures (FATCA, Volcker, et al) has helped keep the heat on administrators. The challenging conditions have played a hand in at least one administrator relocating its domestic base of operations. In February, HSBC announced it would move HSBC Holdings, the firm’s US administration division of its securities services unit, from New York to Dublin in what is viewed as part of the company’s ongoing cost-containment program. Like others of its ilk, HSBC will stand to benefit from the Emerald Isle’s lower corporate tax structure and ready access to mainland Europe, say observers. As firms re-evaluate existing models and place greater emphasis on core business lines, further closures are not out of the question, particularly if the principal business is not US-focused. Still, observers such as Noreen Crowe, product

F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

manager for Linedata, a global provider of financial information technology solutions, does not expect to see a major widening of this trend.“The current regulatory environment will not cause a significant exodus from the US, particularly since financial firms can expect to face increased regulatory scrutiny for the foreseeable future—irrespective of where they base their operations.” Regulatory rule changes continue to rank high among administrators’ most pressing concerns, according to research firm Deloitte’s recently published Performing under Pressure fund-administration survey. Cost controls, pressures on fees and the ability to keep up with IT demands round out the worry list. Though asset volumes have shown improvement, client-service demands remain are at a peak. The sheer volume of requirements requires administrators to develop far more efficient methods of operating, even while the overall market is still challenging. In that context, administrators have now to do more with less: or in administrator parlance ‘drawing upon a relatively lower budgetary supply’. “The services that clients request from administrators are also changing with the new investor model,”reports Deloitte. “Today’s clients demand middle-office services, risk

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FUND ADMINISTRATION

Brenda Lyons, executive vice president for fund administration at Boston-based State Street, continues to see a ramp-up in hybrid products such as registered funds of hedge funds, as well as businessdevelopment companies with complex investment strategies that have all the regulatory requirements of registered funds. Photograph kindly supplied by State Street, May 2012.

Noreen Crowe, product manager for Linedata, a global provider of financial information technology solutions. “The current regulatory environment will not cause a significant exodus from the US, particularly since financial firms can expect to face increased regulatory scrutiny for the foreseeable future—irrespective of where they base their operations, ” says Crowe. Photograph kindly supplied by Linedata, May 2012.

reporting, and an increased level of transparency.” In time these will become core services, says Deloitte, requiring that administrators become more innovative “in order to maintain their client levels.”

from real estate and hedge funds to private equity and more. “The key issue here is consistency of information reporting and, in particular, the ability to dig down and retrieve security or investment level data, performance and risk metrics covering the underlying assets,” says Pandiri. Given the nuances that distinguish many of these strategies, harmonisation of reporting and valuation data can be exceedingly difficult.“Again, this requires administrators to make strategic investments in cutting-edge tools in order to keep pace with both regulatory rule changes, as well as investor appetite,” says Pandiri. Investors’ ever-expanding list of global investment targets will only fuel this complexity, says Pandiri.“So in addition to covering numerous asset classes, administrators need the management capabilities to sufficiently monitor the different locales that have piqued investor interest,”says Pandiri.“This again speaks to the level of scale that is required to successfully manoeuvre through these various jurisdictions.” The bottom line, says Pandiri, is that clients need a way to focus on their core mission of managing assets, rather than being sidetracked by administrative or operational duties. “Offloading middle- and back-office functions is a tremendous benefit that we can deliver on behalf of our customers,” maintains Pandiri. Brenda Lyons, executive vice president for fund administration at Boston-based State Street, continues to see a ramp-up in hybrid products such as registered funds of hedge funds, as well as business-development companies

Administration attributes Fund administrator guidance has been undeniably essential for clients attempting to weigh the costs of complying with new or revamped regulatory rule structures, remarks Samir Pandiri, executive vice president and head of Asset Servicing, Americas, BNY Mellon.“Our ability to stay in step with both current and pending regulatory measures, using our affiliations with trade associations and other key participants, allows us to articulate the message to our clients so that they can understand exactly what the pipeline looks like going forward, and, most of all, how to properly respond.” Recent regulatory reforms affecting money market funds, for instance, require that providers not only have greater insight into all of their counterparties and how their collateral is managed, but also have the wherewithal to present the information in a timely manner. “Keeping tabs on the fluctuating NAVs of these types of funds has also become integral,” says Pandiri. “It is yet another reason why as a fund administrator you have to continually invest in your infrastructure in order to keep up with the increasingly intricate regulatory environment.” For administrators, the dominant theme remains investor diversification into multi-asset classes, running the gamut

M AY 2 0 1 2 • F T S E G L O B A L M A R K E T S

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FUND ADMINISTRATION

Samir Pandiri, executive vice president and head of Asset Servicing, Americas, BNY Mellon. “Our ability to stay in step with both current and pending regulatory measures … allows us to articulate the message to our clients so that they can understand exactly what the pipeline looks like going forward, and, most of all, how to properly respond.” Photograph kindly supplied by BNY Mellon, May 2012.

with complex investment strategies that have all the regulatory requirements of registered funds. State Street has been able to tailor servicing solutions for these products, says Lyons, “by combining top-tier technology with a high level of technical expertise, regardless of traditional reporting lines or product responsibilities.” According to Lyons, State Street regularly monitors changes to both local and worldwide regulatory structures (including the likes of FATCA, CFTC Rule 4.5 and possible new Rule 2a-7 reform) to ensure that its technology, work processes and control environment are properly updated, thereby enabling clients to remain compliant. “As product complexity and regulatory requirements increase, the cost of developing and maintaining technology and human resources to service products itself rises,” says Lyons. Hence, State Street is continuously evaluating its global capabilities in order to deliver the most comprehensive and cost-effective solutions possible on behalf of its clients, says Lyons. Over the near term, she adds,“we expect to see a continuation of outsourcing by investment advisors who do not have the scale needed to support the investment required to keep pace with regulatory changes. This may hold true for smaller-sized fund administrators as well.”

Complexity and coverage Since the onset of the global financial crisis, institutional investors seeking to fine-tune control of their assets have continued to gravitate towards the use of separately managed accounts. “These investors are attracted by the operational and risk rigor involved, including good process safeguards related to valuation, reconciliations, daily P&L

reports and risk analytics,” suggests Ron Tannenbaum, managing director, GlobeOp Financial Services. Due to their complexity, however, managed-account relationships require significant additional infrastructure and coordination by managers, investors and administrators. As a result, investors are increasingly calling upon independent administrators to provide checks and balances on managers, including asset and portfolio valuation, daily position and risk reporting, and other services. This added layer of managed-account protection“can offer investors comfort, yet another reason why these vehicles continue to be attractive,” says Tannenbaum. Through its proprietary GoMAP managed-account service platform, GlobeOp has been able to simplify the process for both fund-manager and investor clients by offering independent middle and back office services, integrated risk analytics and daily, in-depth data and reporting tools. In this way, clients are able to more clearly monitor individual and aggregated fund performance, operational controls and risk reporting, says Tannenbaum. As managers move into different asset classes and product sets, they will increasingly benefit from an administrator that can handle as broad a coverage area as possible, including, among other things, multiple strategies along with the ability to create NAVs at the strategy level. Having these capabilities at arm’s length make it that much easier for managers to focus on the well-being of the investment portfolio, remarks Peter Sanchez, chief executive officer of Northern Trust Hedge Fund Services. “The more that the manager can engage in the data and respond to possible breaks and exceptions that may occur, the more efficient and controllable the entire process becomes,”says Sanchez. Hence,“providing the right kind of tools for interfacing with this data ultimately results in less pain for the manager,” he adds. Though regulations have had the greatest impact on the administration of alternatives such as derivatives and swaps, the scope of new reporting requirements has affected the manner in which all data is stored and categorised, says Linedata’s Crowe.“In most instances, multiple systems will need to be analysed, as the data needed to satisfy regulatory reports such as Form PF, for example, are housed across multiple administrator platforms,” says Crowe. “Other regulations, such as FATCA, are causing administrators to overhaul existing processes, and significant system changes will be necessary in order to provide proper support.” While providing additional services for the same or often reduced fees, administrators must also deal with increased reporting demands from institutional investors seeking greater transparency. In an effort to contain costs and boost margins, many firms have moved beyond the standard administration business into new areas such as middle-office or compliance services, says Crowe. “In addition, cost savings and operational efficiencies are being achieved though straight though processing, process automation and the removal of time consuming and risky spreadsheet workarounds.”I

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GM Editorial 61_. 22/05/2012 15:48 Page 51

SOLVING THE LIQUIDITY EQUATION

EUROPEAN EQUITY TRADING – LIQUIDITY

With the jury still out on whether average daily trading volumes will rise, stagnate or fall through the rest of this year, the story du jour is the search for liquidity. As the buy side coalesces trading in the hands of fewer broker-dealers the onus is on the sell side to provide liquidity on tap. How they do that is in ever smarter ways. Ruth Hughes Liley surveys the trading trends and the new options open to the buy side in finding the other side of their trades.

N LATE APRIL Société Générale (SG) launched its cash equities crossing network called Alpha Y. The platform has the potential to allow access to a vast amount of liquidity, as it will not only draw on cash equities client flow, but also on the firm’s structured product flow—its Delta One and broader derivatives and proprietary teams—which all have the ability to post blocks directly into the pool. As SG has the largest derivatives desk in Europe, the move is significant. Alpha Y executes trades at the mid as well as the ‘near and far’ touch. Price points are taken from the SG-derived European best bid and offer, based on lit venues including three MTFs, BATS Chi-X, Turquoise and Burgundy. Also in April, CA Cheuvreux took a different route and launched a pan-European MTF called Blink. A dark pool, Blink started trading in 1700 stocks across 14 European markets and claims to have no proprietary or high frequency trading flow. It has a dual order-book structure, a mid-point cross and a primary best bid and offer cross, which aims to optimise clients’ crossing opportunities. Ian Peacock, global head of execution services, says:“We felt it was important to register Blink as an MTF to provide our clients and the market with maximum transparency.” The moves are part of a chain of initiatives by the sell side to conquer the liquidity equation.“Liquidity attracts liquidity,” explains Jeremy Ellis, head of European Equity Trading, T Rowe Price.“You may see a trader making a loss leading price on a particular stock, for example. But once they attract the flow they can trade successfully on the back of those orders.”

F T S E G L O B A L M A R K E T S • M AY 2 0 1 2

T Rowe Price trades around 50% through low touch channels and Ellis says:“If you think back a decade ago and picked up the phone to a sales trader to see if there was any business and engaged with him in a risk trade or wanted to participate with volume, it would seem a little naïve today. I think MiFID has made it an absolute necessity to search out orders so we are engaging more in how our sales are traded,” he adds. The increasing onus on the buy side to find the right liquidity and the sell side to provide is an unintended consequence of MiFID, which brought competition to the exchange space in Europe by allowing the creation of panEuropean platforms. The resulting multi-lateral trading facilities (MTFs) have competed for the share of flow with the previously national exchanges. Where trades would once be conducted on one exchange, most of the liquid blue chips are now traded on more than one venue. To illustrate the state of play, Fidessa’s Fragmentation Index, which gauges the level of fragmentation in stocks, shows that at the end of April, for example, traders in BHP Billiton had to seek out stock on 2.79 venues before being able to achieve best execution. In comparison, trading in FTSE 100 stocks hover around the 2.5 mark. Paul O’Donnell, chief operating officer of MTF, BATS Chi-X Europe, explains that while Europe has always been a fragmented market—with different national stocks on different national exchanges—the future lies in all stocks being traded on pan-European exchanges. “Fragmentation

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EUROPEAN EQUITY TRADING – LIQUIDITY

Martin Porter, head of business development at b-next, a market surveillance technology firm. “We provide a solution to an MTF to monitor gaming and every single day a compliance officer will get online reports of any possible suspicious trading activity and act on this accordingly.” Photograph kindly supplied by b-next, April 2012.

Jeremy Ellis, head of European Equity Trading, T Rowe Price. “You may see a trader making a loss leading price on a particular stock, for example. But once they attract the flow they can trade successfully on the back of those orders,” says Ellis. Photograph kindly supplied by T Rowe Price, April 2012.

is just another way of describing competition,” he says. He acknowledges that “it does bring complexity, so piecing it together with a consolidated tape would be good.” However, there are also other forces in play. Volumes on the UK equities order book of the London Stock Exchange rose 6% in March and 10% in February by value. Compared with a year ago though, the figures are still poor: down 21% between March 2011 and March 2012. The story is the same with equities on the Italian order book, where the average daily value traded was down 31% over the same period. Matt Cousens, co-head AES sales in Europe, Credit Suisse, says: “If current levels of trading remain in the cash equity markets, the brokerage industry will remain a challenging environment to work in. Every single broker is examining their offering, and we’ve already seen RBS step out of the equity space.” Other recent moves out of equities or mergers with other firms have included Unicredit, Icap Equities and Evolution Securities (which merged with Investec). What flow there is, is increasingly concentrated among a handful of bulge bracket houses. Credit Suisse and UBS have 12.1% and 11.1% share of buy side vote respectively, according to recent Greenwich Associates figures. Add in Bank of America Merrill Lynch, Morgan Stanley and Deutsche Bank and the five firms represent 49% of the vote, calculated from the amount of business conducted with each respondent and the commission spent with sell side firms. Another trend the sell side has to satisfy is the search for larger stock sizes. Indeed, finding a block trade is becoming the nirvana for many on the buy side and there are a growing number of firms using technology to create smart block trading platforms. The investment looks to have paid off for some. Credit Suisse’s offering in this regard is Blockfinder. In various stages of global deployment, it allows clients to dictate a minimum size of trade they wish to interact with. Blockfinder will then search multiple dark venues for an appropriate ‘block’. It has been enabled by the growth of Credit

Suisse’s internal crossing network, Crossfinder, which between Q1 2011 and Q1 2012 saw a 45% increase in notional traded volume at a time when the overall market was down 25%, according to Cousens. Equally, on Liquidnet’s buy side to buy side crossing network, says John Barker, head of international at the firm, volumes on the platform have brightened this year with average daily volume traded in Europe up from a low of $10.5bn a day in December, to $14.7bn by the close of Q1 2012.“Couple this with a reduction in volatility,” he adds, “and we and the market are much more positive. It has led to the buy side being much more comfortable trading blocks than last year.” For the first time in 18 months, Barker has seen more buyers than sellers on the platform. O’Donnell explains that:“Block crossing networks are not new and there will always be a niche for someone who wants to get a block done in one day but trying to get a block match is a bit like ships passing in the night. These are not going to provide sustainable liquidity that we want to see.” He believes that the best liquidity in a market, either an exchange or an MTF, is diverse liquidity: “No matter where you are on the scale, whether you are a customer SOR or an internaliser, you need to go where someone else is too, where a lot of different trading objectives meet together— that’s what makes a market. You need diversity of participants and liquidity.” To some on the buy-side the definition of diverse liquidity can mean the inclusion of ‘bad’ liquidity in the pool as Ellis explains:“The challenge if we are trading in an internal pool like a broker crossing network is always working with the provider to find who else is in the pool. The fear is that signalling an order to some form of external market maker might be detrimental. We would be healthily aware of the high frequency trading strategies where a trader starts a day with zero on his book and ends the day with zero.” One fear is that an order will be ‘gamed’, in which a small amount of a stock is placed in the market at a very attractive price to tease out more liquidity which is then bought or sold

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Matt Cousens, co-head AES sales in Europe, Credit Suisse, says: “If current levels of trading remain in the cash equity markets, the brokerage industry will remain a challenging environment to work in. Every single broker is examining their offering, and we’ve already seen RBS step out of the equity space.” Photograph kindly supplied by Credit Suisse, April 2012.

Paul O’Donnell, chief operating officer of MTF, BATS Chi-X Europe. O’Donnell explains that while Europe has always been a fragmented market—with different national stocks on different national exchanges— the future lies in all stocks being traded on pan-European exchanges. Photograph kindly supplied by BATS Chi-X Europe, April 2011.

more advantageously by the gamer. Another example is washing, where two parties trade both sides of exactly the same size of trade,‘washing’ the slate clean and not allowing anyone else into that liquidity—so although it shows up on the books, it is not available to trade with. Martin Porter, head of business development at b-next, a market surveillance technology firm, explains that the buy side fear of ‘bad’ liquidity is justified: “You know it is being done because trading firms are full of bright people and top computer systems. We provide a solution to an MTF to monitor gaming and every single day a compliance officer will get online reports of any possible suspicious trading activity and act on this accordingly.” The Financial Services Authority has issued guidelines to firms regarding market abuse surveillance and regulators are being given more power to penalise firms and venues that allow market manipulation to go on. Moreover, Europe’s ESMA is currently considering further regulation covering market transparency and surveillance. However these elements will more likely muddy than clear the waters. Ultimately, it is the buy side firms who have the power to shift liquidity from one venue to another, says Porter. “If a venue doesn’t perform surveillance and is open to abusive trading activity, it will be self-regulating because the buyer will expect certain levels of reporting and will not go back to that venue if it doesn’t exist there. The buy-side has a right to expect a ‘fair and orderly market’. So the poor old sell-side has to make a further level of investment. It’s an ever-evolving market and things are getting cleverer and cleverer, so surveillance systems have to be up to date and adaptable to meet and deal with the latest new algo or HFT programme.” Markets too are becoming more aware of the need to keep an eye on their platforms to ensure they retain liquidity. BATS Chi-X Europe uses a third party provider to check for market abuse on its own exchange as well as checking real-time data feeds from other exchanges. “In a crossmarket environment abusive behaviour that has become automated has become a little more complex to detect

but we have highly automated systems in place and monitor for abuse across our platform and other platforms and reporting to the regulator when we see anything suspicious,” adds O’Donnell.

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Too much ado about HFT? Credit Suisse’s Cousens believes paranoia about high frequency flow was not helped by an issue of the Sixty Minutes television programme in the US in October 2010, six months after the Flash Crash, which painted all high frequency trading as eager to take advantage of the average person’s pension fund. “We were inundated with calls the next morning after portfolio managers had phoned their trading desks and trading desks called us wanting to know what we were doing to protect their flow.” Out of this, launched at the beginning of 2011, Credit Suisse produced their Alpha Scorecard, which categorises all participants in their Crossfinder internal broker crossing network as ‘contributory’,‘neutral’ or ‘opportunistic’. “Participants have a choice,” explains Cousens. “If someone is extracting short-term alpha, then we will see that and ensure that they can only interact with participants that are happy to have them. Alpha Scorecard builds a profile of the client over time, not just on a trade-by-trade basis. This has given clients a lot more confidence and it is proving very successful at allowing us to police participants in the pool.” Actually, it is harder to police flow on an exchange, believes Cousens.“Exchanges and MTFs have a huge mixture of flow because they have to let everyone in who is a member. Exchanges have been under tremendous pressure to generate revenues and have thus courted high frequency flow as a result. At Credit Suisse, we get paid on commission and that comes from the quality of our execution.” Other brokers are adopting similar analytical tools. Morgan Stanley has said it is to track behaviour of users of its dark pool, MS Pool. It also blocks Immediate or Cancel orders and doesn’t send them, and mandates a minimum order resting time in the pool.

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EUROPEAN EQUITY TRADING – LIQUIDITY

John Barker, head of international at Liquidnet, volumes on the platform have brightened this year with average daily volume traded in Europe up from a low of $10.5bn a day in December, to $14.7bn by the close of Q1 2012. Photograph kindly supplied by Liquidnet, April 2012.

Tony MacKay, founding CEO of Chi-X and who is currently building a new exchange to facilitate block trading, explains: “Regulators extending trading hours is not the solution to finding liquidity. Photograph kindly supplied by Tony MacKay, April 2012.

Liquidnet, which automatically sweeps the blotters of 300 asset managers in Europe and 700 globally, streams out the high frequency flow by setting a minimum participation size based on the venue, so on a venue with an average execution size of €7,000, Liquidnet might set a minimum size of €20,000 “to stream out the noise” says Barker. Participating with sell-side flow was initially controversial for Liquidnet but Barker points out: “In the past year, as we have seen the pool of liquidity from brokers building up, more and more of the buy side are interacting with it as they see we are giving them an advantage and a safe way to execute.” The firm has also launched Liquidnet Dark, an algorithm which allows buy side firms to specify minimum size of trade on most of the external dark pools in Europe. Dark is currently executing block trades averaging around €100,000 each, but Barker is confident this will grow:“At the moment, our dark algo is trading $40m a day in Europe, so it’s still a relatively small part of the business but it has grown 150% between Q4 2011 and Q1 2012.”

many places and are now going through it in the Spanish market and starting to see more people coming to us there.” Week ending April 20th this year, BATS Chi-X Europe’s market share of Spain’s IBEX 35 was more than 6%. Separately, the legacy Chi-X platform migrated to the faster BATS platform during the last weekend of April and O’Donnell says participants will notice better performance of the platform, one set of protocols and one order router, although two order books will still remain for each. Simplicity of documentation can help draw liquidity, O’Donnell says: “Our rule-book is relatively short and our protocols document runs to tens of pages instead of hundreds. How long that document is, is a proxy for complexity. The larger the document the more difficult [it is] for someone to deal with the platform. We try to make it as simple and straightforward as possible for people to understand and connect.” When flow returns, the type of broker who will benefit will depend on the type of flow returning, says Matt Cousens.“If it’s institutional flow, then houses with research and full service provision will remain the most important partners. If hedge funds come back, then houses with strong prime brokerage services will also benefit. There are two key questions: who are the firms with the best products that add value to the trading process and who has the most relevant liquidity. Those products will remain a major component of the buy side’s decision.” Then again, some simple solutions may also present themselves. Shorter trading hours could perhaps be one solution for finding liquidity in less liquid stocks, as Tony MacKay, founding CEO of Chi-X and who is currently building a new exchange to facilitate block trading, explains: “Regulators extending trading hours is not the solution to finding liquidity. In Europe liquidity is fragmented because exchanges don’t interact with one another like they do in America. Fragmentation is increased because broker crossing networks also don’t interact with each other. Long-term investors are reluctant to go into the market with big orders because everyone is analysing order flow. I

Helping the small and mid cap space “Liquidity in the mid and small cap European equities space including quote-driven stocks has been falling in Europe as trading fees have risen significantly relative to the more frequently traded large caps,” says Kee-Meng Tan, head of Knight’s Electronic Trading Group in Europe. Launching an expansion of the firm’s market-making business in London in March, to include small and mid cap European equities with an initial focus on the UK AIM market, Tan says: “We believe that Knight’s offering will fill a significant gap in the marketplace.” In the small and mid cap space, BATS Chi-X Europe’s market share has reach around 25% in the FTSE 250, 27% of the CAC 40 and more than 20% on the OMX S30. O’Donnell believes that 5% market share is a threshold point. “Once you get to 5% market share it is difficult for a smart order router to ignore you as a venue and you get a real growth in diversity. We have been through that cusp in

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MALTA REPORT

The story of the financial sector in Malta in the last ten years has been one of growth. Growth is evident in the number and size of organisations locating there, growth in the type of support services which have sprung up, and growth in the numbers of people working in financial and related firms. Ruth Hughes Liley reports.

A NEW VISION OF FINANCIAL SERVICES

“

E HAVE SEEN the financial services sector grow positioned as a financial region, but the MFSA did a very from very humble beginnings,” says Kenneth good job of preparing us for EU membership. We shed our Farrugia, chairman of FinanceMalta, a non-profit offshore status to become onshore in the 1990s and public-private partnership tasked with promoting Malta to aligned our laws with Europe so by the time we joined the world’s financial community. Indeed the sector is starting the EU in 2004, we didn’t have to overhaul our systems to play a vital role in the Maltese economy. The independ- because we had been using them for nearly ten years ent National Statistical Office of Malta estimates that its already. It was a seamless transition.” FinanceMalta organises its prodirect and indirect contribution motional activities across five to the economy in 2001 was sectors: funds, insurance, trusts, over €1bn, representing over 12% banking and wealth manageof total GDP. ment, which was added last year, Still short of the 25% contriand has produced in-depth bution spelt out in the Maltese guides to each sector. In May it government’s Vision 2015, it has will hold its fifth annual confersome way to go. The ten-year ence, providing a forum for those plan named financial services as in Malta and internationally to one of seven through which the discuss regulatory and economic government wanted to develop issues and industry trends. the country. In a sense, promotion of Malta With this in mind, the governas an EU base is not difficult. On ment set up FinanceMalta in 2007 an island no bigger than 30 miles to drive forward development of by 10 miles including the satellite the financial services sector once island of Gozo, access to high it became clear that Malta Financial Services Authority Kenneth Farrugia, chairman of FinanceMalta, a non-profit speed broadband and ICT infra(MFSA), the investment market public private partnership that promotes Malta to the structure is a given, English is an regulator, could not both promote internatiuonal financial and investment community. official language, and it has a highly educated workforce, low and regulate at the same time. Photograph kindly supplied by FinanceMalta May 2012. cost of living (salaries are 25% Funded partly by the state and partly through subscriptions and sponsorships, its eight- to 30% lower than in Luxembourg), an efficient tax strong board includes representatives from across the framework and an enviable climate. On top of this, office financial sector including the head of the Malta Financial space is one third to half the cost of other European Services Authority, Joe Bannister, a government representa- jurisdictions, according to the latest Ernst & Young Malta tive, Alan Caruana and chief executive officer of HSBC Malta Attractiveness Survey. Farrugia is also tasked with looking beyond the financial Bank, Mark Watkinson. Bruno L’ecuyer, head of business development at Finance sector.“We don’t want to be dependent on one sector and we Malta, sees the promotion agency as a bridge between the need to induce firms and institutions to encourage people to government and industry and points out: “Because we come here to work,” he says. Large organisations are beginning to set up shop in the are small it helps. We have more governors than staff and the board is very active and involved in opening doors for country. Toy manufacturer Playmobil makes all its toy figurines in Malta and pharmaceutical specialist Baxter is the industry.” It is a vital role in a country where the financial services moving its global research and development to Malta later sector seeks to become a significant employer: out of Malta’s this year. The usual quota of global brands is also visible in active labour force of 170,000, around 7,000 people are the economy; accountancy firm PwC employs 400 people employed directly in the sector with a further 1,900 as and HSBC, one of the larger financial groups operating in the lawyers, accountants and other supporting personnel. In country employs more than 500. One of the concerns for the financial industry is that not total, it accounts for 5% of the workforce. There is still some way to go. Farrugia understands that enough adequately qualified people are available. The jobs it is a slow process and explains that: “Malta was never page of the FinanceMalta website has around 46 vacancies.

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MALTA REPORT

To try to attract the more senior and experienced employees, the government has created inducements including the ‘highly qualified persons’ rule, which offers a tax rate of 15% on income for anyone living in Malta and working for a qualifying institution at senior level. That said, Erik Nelson, a hedge fund director who resides in Malta says:“There’s an oversupply of accountants coming out of university and there’s definitely a lack of more senior level risk management and portfolio management personnel. However, you do see Maltese leave, go to London and get their experience and then come back. People are waiting for good opportunities to arise [in the jurisdiction] and get the equivalent salary [for their experience]. Now that is becoming a reality.” Farrugia agrees:“You don’t have employees with 20 years’ experience in, say, investment analysis. We need to ensure we have a good supply of workers to service the industry.” Nonetheless, he explains that Malta invests heavily in the country’s educational system (around €250m a year) and that this will pay dividends going forward. While its business networking activities are a given, FinanceMalta also aims to dig deeper promoting business where it will aid the development of the financial industry. To this end it also works closely with Malta Enterprise, the economic development agency tasked with promoting business. In April, for example, Malta Enterprise organised a business delegation to the Middle East, which FinanceMalta helped to promote. In March, they collaborated with the Malta High Commission in the UK and government agencies in ‘Malta Month’ in the Harrods department store in London showcasing key sectors within the Vision 2015 economic programme. Another sign of the country’s growing confidence in the financial sector is the news in February that for the first time in Malta’s shipping history, Malta has surpassed Greece and Cyprus as keeper of the largest ship register in Europe at 45.6m tonnes, according to figures from law firm Ganado & Associates. Promoting Malta overseas is one of the key planks of FinanceMalta’s strategic vision, staying focused on Europe in 2012 with a gradual expansion around the world over the next two to three years. L’ecuyer says: “Malta’s Minister of finance, the economy and investment has a vision for a diversified financial sector so we are starting to look beyond Europe and to promote to the Middle East, Africa, Asia, North America and South America in the next two years. Our core focus is Europe, but we follow the double tax agreements in place, which are modelled on the OECD.” Malta has in place 59 double tax agreements with other countries. A further eight are signed but not yet ratified and another ten are up for further negotiation. Around 30 memoranda of understanding (MOUs), including ones with China and South Africa in 2009, cover different aspects of financial services and provide clearer channels for co-operation, exchange of regulatory and technical information and investigative assistance between the financial services regulators.

Bruno L’ecuyer, head of business development at FinanceMalta. He sees the agency as a bridge between government and industry. Photograph kindly supplied by FinanceMalta, May 2012.

As Malta becomes a more viable alternative to Luxembourg or Dublin, FinanceMalta’s role will not recede, says L’ecuyer: “We will still be needed to push the boundaries. We established a good reputation in Europe and are happy with the flows of business and need to further that and go to new markets where our members have not classically been going to.” One of Malta’s selling points is its banking system—the 12th soundest in the world, according to the latest World Economic Forum’s Global Competitiveness Report 20112012. Indeed, Malta contributed €30m to the European bailout fund, the European Financial Stability Fund during the sovereign debt crisis. A founding organisation of FinanceMalta was the Malta Bankers’ Association and Farrugia says: “In the crisis, banks in Malta proved to be very resilient because actually, they are ‘boring’ banks. So you do not find collateralised loan obligations, for example and banks have always adopted prudent policies. They fared relatively well under the EU stress tests. Also, government debt is 70% domestically funded and that has kept us afloat as a country.” Nonetheless, one of the challenges it has had to overcome is that of the legacy of the 1980s when Malta was seen as an offshore tax-saving jurisdiction with easy tax laws, although Farrugia dismisses this: “I don’t think that any serious institution seeking to move to any domicile is driven solely by tax. You look at the regulatory regime; you look at the regulatory body and how it issues licences and supervises the sector; you look at the other structures and supporting institutions.” Farrugia believes it is important to convey Malta as a domicile with a good reputation: “Trust has become a very important word in the vocabulary of financial services. Investors have become more sensitive to the products that are being provided. There’s a lot of emphasis placed on due diligence and Know Your Domicile! I don’t believe there should be an offshore/onshore interplay because they address different needs. I

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Committed to excellence

MamoTCV Advocates is a tier-one law firm in Malta with a strong international practice and actively involved in all areas of commercial law, with a particular focus on financial services. The Financial Services Department within the firm is committed to providing bespoke legal solutions to credit and financial institutions, investment firms, family offices and other stakeholders in the financial services industry. Our mission is to deliver high-quality services in structuring and implementing investment proposals, operations and products in a pro-active, efficient and timely fashion. To this end, we continue to foster and develop our local and international network with a view to offering comprehensive and integrated services to clients.

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MALTA – FUND PROFILE

Aiming for a balanced approach to investing HSBC Global Asset Management (Malta) manages several retail funds and twelve discretionary mandates, and distributes over 40 HSBC funds managed internationally. Managing director of HSBC Global Asset Management Malta, Reuben Fenech, took up his role in October 2009, and restructured the business. The exercise resulted in changes to the fund management team and a new business strategy. The transition was to a balanced approach between manufacturing and distribution and between retail and discretionary. Ruth Hughes Liley reports.

EUBEN FENECH, MANAGING director of HSBC Global Asset Management Malta, explains that over the last two years “we have gone through a consolidation of the product range to focus on funds managed here. We now have a smaller range which allows us to have more focus and add value for our investors, but it’s wide enough to satisfy the main needs of our client base.” The firm’s locally managed retail funds are at least partially invested in local assets and securities. Among them and one of the oldest funds, the €100m Malta Government Bond Fund holds 85% Maltese bonds and 15% global bonds. Others such as the €50m Maltese Assets Fund invests mainly in the local stock exchange. In the alternative space, the HSBC Property Investment Fund is a fund of property funds invested largely outside Malta, while the Maltese Money Market Fund is in liquidity, government Treasury bills and deposits. Maltese law distinguishes between prescribed and non-prescribed funds; with prescribed funds having to have at least 85% of assets invested in Malta. These funds “can benefit from better tax treatment,” says Fenech. “The non-prescribed funds have between 10% and 20% invested in Malta by choice. We vary it according to the local market demand and the opportunities in the local equity and bond market.” The firm divides into three business lines: retail, discretionary and advisory. The retail business represents around half of the business and holds over $540m. The discretionary business for institutions and family offices holds $500m, while the advisory business which relates to mainly internal services to HSBC’s wealth management and insurance business covers over $250m. Nonetheless, it is the firm’s discretionary portfolio management business that Fenech believes is set to grow. The number of mandates under the discretionary business has grown from four to 12 in the past two years and Fenech is expecting more still, with insurance companies, trusts, family offices, and small private institutions with portfolios of more than $5m which are the main client base. In particular, Fenech has seen a change in the strategy of his discretionary clients: “Insurance companies have become more conservative in their approach to investing due to heightened

volatility in equity and credit markets and as a result on the significant changes in regulatory capital requirements lying ahead. While various insurance companies used to run investments in house, I think the game has become more sophisticated as they evaluate the combination of investments that will attract the least requirement for capital.” “The challenge for them is to have an investment strategy that minimizes the potential for loss based on the volatility exhibited by those assets in the past. So there is a whole process to go through in identifying the portfolio with best risk-return trade-off for any given level of risk stipulated by the investor. It has become a more sophisticated exercise and many companies are outsourcing this,” he says. According to Fenech, “We are working to grow while keeping up with the changing investors’ preference to diversify their portfolios outside Malta and out of the limited local markets.”One example is in the performance of two new global locally-managed funds. The International Bond Fund which invests in corporate, high yield and sovereign bonds has grown from €16m to €27m over 12 months. Similarly the Equity Growth Fund, a global equity fund, has increased from €8m to €23m in the same period after amalgamating with a separate all-European equities fund in 2010. Nonetheless, Fenech believes that the 2008/2009 crisis left a lasting impression on investors and forced many not only to diversify globally, but also to switch into fixed income and away from the more volatile equities. “The local market has been paying high dividends for a few years and the correlation with local markets and foreign markets has been low, so this has been a nice cushion in volatile times. People feel more secure when they are tied into assets they can touch and see. It gives them a sense of comfort when the companies they are investing in are familiar names,”he explains. Meantime the firm is dealing with increasing competition in the funds industry, not least from the emergence of exchange traded funds (ETFs): “Passive strategies provided by ETFs have gained support because of their flexibility and their costs and fees are considerably lower than that for actively managed funds. ETFs also became more popular as investors at times felt that active fund managers are not always worth their fees,” he says. I

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INVESTMENT FUNDS SECURITIES LAW TRUSTS CAPTIVE RE-INSURERS PENSIONS & QROPS INTERNATIONAL BANKING CORPORATE FINANCE MERGERS & ACQUISITIONS JOINT VENTURES PRIVATISATION TAXATION EU PASSPORTING SHIPPING AVIATION CORPORATE SERVICES LITIGATION & ARBITRATION EMPLOYMENT INDUSTRIAL & LABOUR TELECOMS, MEDIA & TECHNOLOGY INTELLECTUAL PROPERTY COMPETITION PUBLIC PROCUREMENT ENVIRONMENTAL LAW RESIDENCY PROPERTY CONVEYANCING MEDICAL & HEALTH ENERGY & RENEWABLES

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MALTA – SETTING UP A FUND

Over the past seven or so years of its existence, the Maltese Professional Investor Fund (PIF) regime has proven to be a success story with over 400 PIFs licensed in Malta to date. As the scramble for AIFMD friendly jurisdictions for hedge funds heats up, the PIF regime looks set to continue from strength to strength. In this brief guide, Ganado & Associates outlines some of the salient features of the PIF regime in Malta.

A ready guide to establishing a Maltese Professional Investor Fund

Qualifying Investors include individuals, N TERMS OF the Investment Services trusts, associations or corporate entities Act (ISA), no collective investment whose net assets exceed €750,000, with scheme (CIS) is permitted to issue, or reasonable experience of PIFs and investcreate, any units, or carry on any activity, in ments. They might be employees and or from within Malta unless it is licensed directors of service providers to the PIF, or by the Malta Financial Services Authority relations and close friends of the promoters (MFSA). In terms of the Act, an invest(limited to a total of 10 persons per PIF). ment fund is bound to satisfy the following The minimum investment is €75,000 or criteria to qualify as a CIS. It must, for $75,000 or equivalent. instance, have the objective, or one of its Extraordinary Investors are the highest objectives must be, the collective investqualifying individuals or entities, defined by ment of capital acquired through an offer a net worth of over €7.5m or $7.5m. The of units for subscription, sale or exchange and operate according to the principle of Photograph © Paul Fleet/ Dreamstime.com, minimum initial investment in this case is of €750,000 or equivalent. PIFs available to risk spreading. It also has to involve the supplied May 2012. Qualifying or Extraordinary Investors are pooling of investments; or that unitholders are able to request the fund for redemption of their not subject to any restrictions on their investment or units; or that units will be issued continuously or in blocks borrowing powers except for those imposed by the PIF’s own marketing and offering documentation. Restrictions remain at short intervals. CIS can be established as companies (so called SICAVs or only in the case of Experienced Investor Funds wherein INVCOs), unit trusts, limited partnerships or in contractual gearing or leverage is limitedly allowed and the PIF is subject form (mutual funds). CIS can be open-ended or closed- to certain investment limits. ended. By far the most popular choice, the investment company with variable share capital (or SICAV) may be Service providers established as a single fund with multiple shares classes Another advantage of Malta’s PIF regime is that none of the (multi-class), an umbrella fund with or without legal segre- PIF’s service providers (such as its manager, investment gation between sub-funds (multi-fund), an incorporated advisor, prime broker, administrator or custodian) have to be cell company (ICC) with incorporated cells and now as a based or licensed in Malta as long as they are based in recognised incorporated cell company (RICC). recognised countries which are subject to a standard of regCIS licenses in Malta come in three main types: Retail ulation equivalent to Malta’s regulatory regime. CIS (including Maltese UCITS), Non-Retail CIS (the PIF The MFSA would carry out limited due diligence on Regime) and Private CIS, the latter being subject to a service providers licensed in recognised countries or in recognition requirement rather than a formal licence or countries that are full signatories to IOSCO’s multi-lateral authorisation. This represents the first major choice for a fund memorandum of understanding on regulatory cooperation. promoter looking to establish a CIS in Malta which will be If a particular PIF has no physical presence in Malta, it is decided according to the type of investor being targeted, expected to appoint a local representative who will accept investment strategy proposed to be pursued and distribution directions from the MFSA and provide it with any methods envisaged. There are also three categories of PIFs, information requested. Local representation, which can be those targeting Experienced Investors, those for Qualifying law firms, audit firms or investment services providers, is Investors and those for Extraordinary Investors. required to comply with certain record-keeping requireExperienced Investors have the expertise and knowledge ments for possible inspection by the regulator. to make their own investment decisions and understand A PIF which is made available to Qualifying or the risks involved. The minimum investment threshold Extraordinary Investors is not required to appoint a custodian is €10,000, $10,000 or equivalent and may not fall below or a prime broker although the PIF directors have to inform this threshold unless this is due to a fall in the NAV of the PIF. the MFSA of the alternative arrangements for the safe-

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MALTA – SETTING UP A FUND

keeping of assets. Promoters with one eye on AIFMD may wish to identify a custodian willing to act as custodian for the whole PIF in line with the AIFMD’s single depositary requirement. In this regard, since Malta intends exercising its derogation under AIFMD until 2017, a custodian in Malta or any other EU member state may be selected.

Self-Managed PIFs PIF Rules permit structures where discretion on the PIF’s investments is retained solely and directly by the PIF Board of Directors rather than delegated to an external discretionary investment manager. These are Self-Managed PIFs. Typically, a Self-Managed PIF would set up an investment committee of the board of directors, with one or more portfolio managers, whether appointed from within the board of directors or consisting of such other competent persons approved by the MFSA for that role. However, as part of the application process, there are additional requirements to be fulfilled, such as an initial capitalisation of €125,000 and an Investment Committee that is composed of individuals who satisfy the MFSA’s competence assessment in addition to being “fit and proper”.

The Application While the MFSA is flexible and ready to discuss issues arising in the application process, promoters should not expect an offshore regulatory approach. The MFSA applies thorough due diligence on the PIF’s directors, promoters and service providers before issuing a licence. The MFSA ordinarily requires a number of supporting documents depending on the structure of the PIF and the service providers involved. Documentation is normally submitted in draft form and, once feedback is provided by MFSA, these are finalised. A typical application pack includes: an application form; a non-refundable application fee consisting of €1,500 for the scheme and €1,000 per sub-fund (if any). A supervisory fee of €1,000 per scheme and €500 per sub-fund (if any) is subsequently due and first payable in advance on the day of issuance of the license and on each subsequent anniversary thereafter; the Offering Documentation or Prospectus; a copy of the minutes of the first meeting of the PIF’s Board of Directors; the PIF Memorandum and Articles of Association; the MFSA Personal Questionnaires of each proposed director and qualifying shareholder holding more than 10% of the PIF’s voting shares, whether such are corporate entities or individuals; other information required by the MFSA, proposed local representation (if applicable); and the PIF’s Compliance Officer & MLRO (where applicable).

Licensing and Post-Licensing Supervision The MFSA will reply to licence applications within seven working days after the submission of a full set of complete and final documentation and the process typically takes eight to ten weeks from first submission to issuance. Documents are thoroughly reviewed by the MFSA’s Authorisations Unit and a two-way dialogue

commences. Once the MFSA is satisfied, its Supervisory Council issues an approval letter setting out any prelicensing, post-licensing and post-commencement of business stage conditions. Pre-licensing conditions typically include submission of signed application documentation and incorporation of the legal entity. Once the PIF has been licensed and has commenced operations, it is vital that the appointed Compliance Officer maintains accurate records and scrutiny of the PIF’s ongoing obligations. PIFs set up as investment companies are also required to submit an annual return to the Registry of Companies in Malta indicating the PIF’s Directors and shares in issue and file the annual audited accounts and financial statements to both the Registry of Companies and the MFSA. Changes to the Offering Documentation and the PIF’s constitutional documents have to be approved by the MFSA in advance. Advance notice must also be given to MFSA before changing the PIF’s Investment Manager or any other service provider.

Taxation of PIFs The tax treatment of the income derived by a CIS and any income derived by individual investors in the form of capital gains or dividend depends on whether the CIS qualifies as a ‘prescribed’ or ‘non-prescribed’ fund. Essentially, a CIS is classified as a prescribed fund if it satisfies two conditions cumulatively, namely, that the fund is resident and based in Malta and that the value of the assets situated in Malta amount to at least 85% of the fund’s total assets. By default, other funds are classified as non-prescribed fund and as a general rule; non-prescribed funds are exempt from payment of tax in Malta on any income received or gains made. As soon as a fund is licensed by the MFSA, it is subject to tax but then exempt from tax if it qualifies as a nonprescribed fund irrespective of legal form. On the other hand, prescribed funds are tax-exempt in Malta on their income and capital gains except from a 15% final withholding tax on bank interest payable by banks licensed under the Maltese Banking Act and a 10% final withholding tax on other investment income (interest, discounts or premiums). Subject to certain filings with local tax authorities, no stamp duty is payable by investors in a Maltese PIF on a transfer of their shareholding or participation. Maltese funds can also benefit from Malta’s extensive double taxation treaty network; however, this needs to be determined by the tax authorities of countries where the Maltese fund has its assets and where such fund is invoking double taxation treaty benefits.

Listing of PIFs CIS licensed in Malta can seek a listing on the Malta Stock Exchange. A CIS (including PIFs) which is licensed in Malta is also permitted to list on an investment exchange overseas. The promoters of the fund would have to go through a listing application process with the MFSA (also the Listing Authority) which process is typically neither extensive nor costly. I

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MALTA – FUND INDUSTRY

Demand for custody services grows in Malta In 2004 there were just eight locally-based professional investor funds (PIFs) licenced in Malta. By December 2006 this had grown to 91 funds worth €3bn. Today 700 licences have been issued for all types of collective investment schemes, of which 566 funds, including sub-funds, are actively operating, with a net asset value of €8.3bn. Three-quarters of these are professional investor funds, although there are a small number of UCITS funds (59 as of December 2011). Ruth Hughes Liley looks at the emergence of the Maltese fund industry and the opportunity as well as the current limitations therein.

HEN DANIEL GLADIŠ set up a hedge fund worth $7m in Malta in 2004, the year Malta joined the EU, he recalls: “We didn’t know at the time whether we were one of the first of many or whether we were doing something really stupid.” Vltava Fund, of which Gladiš is director, was only the sixth fund to be licensed in the jurisdiction as a PIF. He had considered Ireland and Luxembourg, but he heard Malta was trying to develop its hedge funds sector. Even then there were problems: Vltava was looking for a prime broker: “We visited lots but almost no-one—only two—were ready to deal with Maltese funds.” Eight years later, the fund has grown to $55m. The fund industry in Malta was designated one of seven target growth areas in a ten year strategy outlined in Vision 2015, the government official growth plan. Financial services were expected to contribute up to 25% of the country’s GDP by 2015; though it looks some way off plan right now; in real terms it makes up 12%, including supporting services. However, say local professionals, the trend is directional. Bill Scrimgeour, global head of regulatory and industry affairs, at HSBC Securities Services believes Malta

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is at a crossroads: “There are more than 500 funds with approaching €10bn assets under management. That’s small compared with the European alternative fund base of €2.1trn, but it is somewhat of a threshold to get noticed from a global industry point of view. Stephen Pandolfino, deputy head of Global Banking and Markets, HSBC Bank Malta, explains: “The growth from this sector has been exponential in the span of a few years and this has gone hand in hand with an increasing contribution to GDP. Malta has focused on foreign direct investment, so initiatives have been created around attracting and encouraging international fund managers to transfer their activities to [the island]. The country is reaching out and offering a base where regulation is firm but flexible and where the providers are focused on building relationships and service through local expertise that satisfy the administrative, accounting, legal, custody and banking needs of international clients.” Head of the Malta Financial Services Authority (MFSA) Professor Joe Bannister can take much of the credit for the development of the hedge fund industry on Malta. A former

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professor of bio-chemistry at Oxford University and then at Cranfield Institute of Technology, UK, he began to cross paths with a few of his former students who had taken jobs in the City of London and were setting up hedge funds. “Talking to them, I thought this was an area I needed to get involved in,” he recalls and later when he developed a regulatory structure for Malta at the MFSA, the hedge fund space was the first thing he looked at. The MFSA has established three classes of hedge funds with different minimum investment levels: €10,000 for funds promoted to ‘experienced investors’; €75,000 for funds promoted to ‘qualifying investors’; and €750,000 minimum investment for funds marketed to ‘extraordinary investors’. This last category is mainly used by private equity firms. Other restrictions also apply; for instance, a fund manager cannot invest more than 30% of an experienced investor fund in a single instrument. While most hedge funds operate as PIFs, a few have chosen to operate under the UCITS wrapper as Anthony Farrell of Temple Asset Management explains:“It is cheaper to set up a PIF but I personally think the investor definitions in the three forms of hedge fund allowed under the term are a little too vague for our purposes: you are relying on the client to self-certify that they are an ‘experienced’ investor and this could cause problems down the road, particularly when the fund is marketed cross border, for example. We would prefer to have retail funds, even though the compliance is more rigorous, so that these issues don’t arise.”

A boost to the funds industry The funds industry was given a boost in 2009 when the MFSA issued new guidelines to offshore funds regarding redomiciliation to Malta. It is not a free-for-all. Funds have to show that they have operated for 12 months successfully in their existing domicile before being given a licence. Any fund wishing to redomicile has to go through a strict process. This starts with an application to the MFSA for a licence, and notifying the Registrar of Companies. The MFSA conducts due diligence on the fund, vets the draft documentation and in the first instance, issues an agreement ‘in principle’. While funds registered in Malta are not required to appoint a local administrator, the funds administration business has grown substantially. The MFSA issued six new Recognised Fund Administrator licences in 2011 alone, bringing the total number of fund administrators on the island to 24. On the other hand, one of the challenges for the hedge funds industry has been a shortage of custodians and prime brokers. Deutsche Bank became only the sixth custodian on the island when it received a licence (in 2011). It has joined Bank of Valletta, HSBC, Mediterranean Bank, Sparkasse Bank Malta and Custom House as a custodian provider. Manufacturers of UCITS retail funds and PIFs targeting ‘experienced investors’ are obliged to appoint a custodian or prime broker, those funds targeting the higher-level ‘qualifying’ or ‘extraordinary’ investors are not obliged to have one, although the MFSA recommends it. FMG Funds, which

Dermot Butler, chairman, Custom House Global Fund Services, a licensed custodian in Malta. Butler believes insurance premiums could rise 20% as a result of changes needed to comply with new regulations coming out of EU and US. Photograph kindly supplied by Custom House Global Fund Services, May 2012.

has eight funds domiciled in Malta, uses Credit Suisse as its custodian/prime broker, while all local corporate banking is handled by HSBC Malta. FMG’s General Manager, Erik Nelson, says: “There is still a limited supply of custodian services in Malta. Because of the lack of competition for custody, custodial fees can be relatively costly. It’s a chicken and egg thing: it is hard for the banks to come here before the funds set up and hard for the funds to set up without the banks. [However,] because the MFSA has done such a good job, this has been improving.” In the two years Nelson has lived in Malta, he has seen the banks holding conferences and seminars and says “it is just a question of time” as to when the prime brokerage and custody sector expands. “We are definitely waiting to see banks come down here. The prime broking and custody industry is one of the last common denominators we are missing. In the next 12-18 months we will definitely see changes in one form or another.” Indeed, the MFSA is already in negotiation with two more global custodians and Bannister believes that this will help start to solve the bottleneck.“It is being driven by clients and so the issue is solving itself,” says Nelson. It is also being driven the plethora of regulation sweeping through most of the G20 economies.“New regulations, the Alternative Fund Managers’ Directive and UCITS 4, which allows funds to be marketed cross-border within the EU, have created a level playing field for fund managers wanting to distribute funds into several different countries. Malta is one of three international distribution centres. Their raison d’etre is to service funds out of other people’s markets and

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this gives Malta a wonderful opportunity to take advantage and create a third choice. It can’t catch up or compete with Luxembourg, but it can set itself a focus to win new business,” thinks HSBC’s Scrimgeour. Kenneth Farrugia, chief officer of Valletta Fund Services, a fully-owned subsidiary of Bank of Valletta, Malta’s largest banking group, says “There is clearly a cluster shaping the industry in fund administration although this is not yet the case on the custody side. Moreover, as is the case with the other EU fund service providers, keeping up with the pipeline of new regulations is taking its toll on operational costs to ensure full adherence to these new regulations; this not to mention the operational challenges that these new regulations bring about.” Dermot Butler, chairman, Custom House Global Fund Services, a licensed custodian in Malta, believes insurance premiums could rise 20% as a result of changes needed to comply with new regulations coming out of EU and US. “It is not difficult to believe that many regulators think they cannot adequately police this. The service offering from administrators will have to grow. It makes it even more difficult the smaller funds who cannot afford the whole suite of services. I think the requirement for administrators to up their game is important. All this is going to add to cost. Whereas it used to be two or three meetings a year, they are going to have to do a lot more work.” The fund industry has grown also because it is cheaper to set up a fund in Malta; up to 40% cheaper than Dublin and up to 60% cheaper than Luxembourg according to Chris Bond, head of Global Banking & Markets for HSBC Bank Malta. But other elements are also in play. Bond says: “In a very short space of time, anyone doing due diligence on Malta can meet with the regulator, who adopts an open door policy, with all major service providers and even with the government. Time to market is of critical importance.”

The opportunity presented by sub funds Farrell is planning to expand Temple Asset Management, for example, by offering sub-funds. Custom House is also using sub-fund capability in offering a ‘Nascent’ fund, a ‘Maltese umbrella’ with segregated cells that allows an aspiring fund manager to use a template structure at much less cost than it would otherwise. Butler explains the process: “The cost of setting up a fund is very expensive—around €35,000 to establish it going up to €150,000 and that is crippling for a small fund. Then operating costs mount up and are rarely less than €100,000. So we lease out a sub-fund.You manage the money and you have to use our boiler-plate structure which includes using a Maltese auditor. We charge €2,000 a month administration fees and 20bp overall organisational charge on the net asset value of the fund. If after two years you have lost money, you should probably go back to the sun, but if you have made money and have reached an appropriate size you should probably set up your own fund and you are obliged to use Custom House for the next three years. Setting up has become incredibly difficult to do and finding seed capital for

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Erik Nelson, general manager. FMG says: “There is still a limited supply of custodian services in Malta. Because of the lack of competition for custody, custodial fees can be relatively costly. It's a chicken and egg thing: it is hard for the banks to come here before the funds set up and hard for the funds to set up without the banks. [However,] because the MFSA has done such a good job, this has been improving.” Photograph kindly supplied by FMG, May 2012.

start-up investors is very difficult so we thought this was an idea for them to get their toes wet quite inexpensively.” Trading conditions are also improving the environment. Upcoming enhancements to the Malta Stock Exchange platform will also help. Furthermore, the creation of the European Wholesale Securities Market, a joint venture between the Malta and Irish stock exchanges, in which secondary listed products will be traded on Deutsche Börse’s Xetra platform, is the first time that international securities will be using the Malta Stock exchange to list products and is the first move away from a solely domestic market.

A challenging marketplace As with other jurisdictions, the impact of the cold hand of recession in Europe has also dampened Malta’s immediate prospects. Nonetheless, funds are still choosing to redomicile in Malta to ensure a European base. When FMG’s eight Maltese funds redomiciled there from Bermuda in 2008 they were domiciled both in Bermuda and Malta through a master-feeder fund structure. The main funds were kept in Bermuda due to the large number of clients invested in them, while the newly launched Malta funds were feeding into the Bermuda funds. This was the ideal set-up while the Malta fund structure was settling down. Two years later, in 2010 FMG switched the feeder fund structure around to work the other way, so the Malta funds became the main funds with Bermuda funds feeding into them.

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“A lot of different companies have had to do this,”explains Nelson,“because there has been a lot of migration of funds and getting into the EU is the gold standard. In our case we wanted to keep the clients in Bermuda, while giving new investors the ability to invest in our funds onshore, with greater regulation, transparency and liquidity.” Farrugia is confident the hedge funds market will continue to grow: “Despite the challenges still being faced by the international hedge fund industry and the state of flux of the world’s capital markets, investors’ investment appetite has improved over the past few months. Within this context, the fund industry in Malta is expected to remain highly buoyant as is evidenced by the healthy pipeline of new business.” Funds have even moved to Malta from Luxembourg and Ireland, says Nelson: “It is a popular new place to be. It’s a charming island, safe and everyone speaks English; there’s a high standard of living, a great climate and business is great. There are definitely tax benefits to being here, so it makes sense. We are expanding here in Malta. This is where we are seeing the most growth. We’re here for the long term.” I

Bill Scrimgeour, global head of regulatory and industry affairs, HSBC Securities Services. Scrimgeour believes Malta is at a crossroads: “They have put a lot of effort into getting to where they are today. There are more than 500 funds with approaching €10bn in assets under management. That’s small compared with the European alternative fund base of €2.1trn, but it is somewhat of a threshold to get noticed from a global industry point of view. Photograph kindly supplied by HSBC, May 2012.

BANK OF VALLETTA: BROADER HORIZONS

ank of Valletta Group is the most heavily traded stock on the Malta Stock Exchange with a market capitalisation of €2.5m. In line with other Maltese banks, Bank of Valetta has endured muted demand for credit and investment related business as a consequence of the continuing euro crisis. The bank has taken the opportunity to reduce the proportion of nonperforming accounts to total loans and advances, through this period of subdued demand for credit; notably in the construction, property and retail segments. “We believe that we are able to maintain an effective balance between a conservative risk appetite and innovation, which means a prudent approach on behalf of our shareholders coupled with the latest technological solutions, such as mobile banking, which we were the first to offer in Malta,” says a bank spokesman. At an end of April presentation of its first quarter numbers Bank of Valletta chairman Roderick Chalmers claimed that the bank has come in with “a decent set of numbers” for the six months to March 31st, registering a pre-tax profit of €49.1m, up 9% on the €45.2m for the same period last year. The bank had also accessed “a small amount” from the long-term refinancing operation facility (LTRO) from the European Central Bank (ECB) for three years at 1% per year. “In times of financial uncertainty, liquidity is key [sic]. We don’t need this money. We are a very liquid bank but it buys us insurance, it is part of our risk management,” noted at the presentation. However, he added that LTRO monies made available to European institutions from the ECB were “a shot of morphine, not a permanent cure”, and

fiscal and structural reforms were required, some of which would be painful. The bank’s interim net operating profit before fair value movements is flat on last year’s at €47m, noted Chalmers. The bank’s loan book rose by €87m to total €3.69bn, while the bank’s non-performing loans ratio improved to 4.1% from 5.1% in the previous quarter. Customer deposits rose €94m to €5.62bn, with “modest” growth seen in retail and institutional sectors despite high levels of government bond issues and competition for deposits in the Maltese market. Chalmers points to the oversubscription of the bank’s recent €40m medium term note programme, which carried interest of 4.25%, lengthening the duration of the bank’s liabilities in anticipation of more demanding liquidity regulations. Even so, he pointed out that liquidity at the bank remains robust at 49% while the loans-to-deposit ratio was largely unchanged at 68.7%, while core Tier I capital is at 10.8%, up from 10.5% at the end of last year. In light of current developments the bank is keen to leverage opportunities elsewhere and has not been slow to invest overseas. The bank was among the first foreign financial institutions to open a representative office in Libya in 2002 with a view to promoting business development between the two neighbouring countries. “We will clearly look into the scale and scope of our operations as the political situation stabilises,” says the spokesman. Bank of Valletta is already receiving new business requests from customers operating in the Libyan market. The bank is also in process of opening a representative office in Brussels.

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FUND SERVICES Q&A

Continued evolution in Malta’s asset management segment MamoTCV Advocates is one of Malta’s tier-one law firms with a strong international practice and is actively involved in all areas of commercial law, with a particular focus on corporate law, banking and finance and financial services. The firm has a dedicated financial services department which has been involved in the setting up of professional investor funds since 2006, and which has been earned the firm a solid reputation in the local financial services scene, not only for the structuring and setting up of funds, but also for its work in other areas, such as fund management, fund administration and custody. We spoke with two of its specialists about the steady growth of Malta’s financial services industry in recent years. FTSE GLOBAL MARKETS (FTSEGM): What are the principal advantages of the financial services regime which have buoyed its prospects over the near term? DANIELE COP, PARTNER FINANCIAL SERVICES DEPARTMENT AND DR NICOLÉ ANN SALIBA, ASSOCIATE, FINANCIAL SERVICES DEPARTMENT, MAMO TCV ADVOCATES (DC/NAS): The principal elements contributing to the growth of Malta’s financial services industry have been the shift in status from an offshore jurisdiction to an onshore jurisdiction, and Malta’s entry into the European Union in 2004. The local regulator, the Malta Financial Services Authority (MFSA) has also played a vital role in developing a robust yet flexible legal and regulatory framework. It has done this by aligning regulation with EU Law, and in designing domestic rules governing—for instance—professional investor funds, which have proved essential in attracting business to the country. While Malta has managed to earn itself a place on the map of domiciles of choice for alternative investment funds, because of the Professional Investor Fund (PIF) regime, we have, over the past years, also seen significant growth in other areas; in particular in the fund servicing industry. Furthermore, an increasing number of operators inside and outside the EEA are setting up, for example, UCITS management companies, investment firms, payment institutions and even banks in Malta, and ef-

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fectively using Malta as a base for their operations to service clients throughout the EEA, by exercising their passport rights under harmonised EU law on financial services. FTSEGM: Do you think something more has to be added to the mix? DC/NAS: Over the last three years, there have been a number of other pertinent factors which have contributed to Malta’s continued success in financial services, notwithstanding the international climate of financial distress and economic uncertainty. These mainly consist of (though are not strictly limited to): the relatively low cost of setting-up and conducting business in or from Malta; a highly beneficial tax regime applicable both for funds as well as fund services providers and other interested parties; an extensive double tax treaty network; a skilled and knowledgeable workforce; and an approachable regulator. The fact that Malta is a well-regulated jurisdiction is frequently mentioned by fund promoters as one of the key factors influencing their choice of Malta as a domicile, especially in view of investors’ demands for increased transparency and oversight. FTSEGM: Can you outline some of the immediate opportunities? DC/NAS: Seeing the number and variety of enquiries and

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FUND SERVICES Q&A

projects in the pipeline this year, we are optimistic that Malta will continue to grow and develop, not only in the funds industry but also in the area of investment services, asset management, financial services and banking. Although there is still uncertainty about the nature and consequences of the Directive on Alternative Investment Fund Managers (AIFMD) and other major regulatory changes that are imminent (not only within the EU, but also in third countries such as Switzerland) it is clear that these changes will cause a transformation in the way the alternative investment funds industry currently operates. We expect that this may present Malta with opportunities to further assert its place as a domicile for funds targeting the European market as well as for fund management companies and other service providers. At the same time, the MFSA and local practitioners continue to apply their efforts to refining the existing domestic rules, so as to tap into new potential niche markets—structured finance and private equity come to mind here. FTSEGM: How exhaustive is the financial regulatory regime: what more (in your view) needs to take place for the jurisdiction to build on its successes? DC/NAS: Malta boasts a comprehensive legal and regulatory framework for the financial services industry at large. As an EU Member State, the country is obliged to implement and apply the various pieces of EU law, regarding, e.g. credit institutions, payment institutions, investment firms, UCITS and UCITS management companies and financial collateral. The approach so far has always been to afford maximum flexibility through the exercise of available options and derogations, thus ensuring a level playing field with other EU jurisdictions such as Luxembourg and Ireland. Malta has also put in place various pieces of domestic legislation to accommodate the various segments of the financial services industry, drawing from experience in other countries; by way of example: the Securitisation Act, which creates the framework for securitisation and lays down special rules for securitisation vehicles; rules on re-domiciliation which have been successfully tried and tested as an easy, fast and effective procedure since it came into force in 2002; rules on control of assets and specific types of security interests; a dedicated framework for pension funds and pension schemes (retirement schemes established in Malta and regulated by the MFSA may be recognised by Her Majesty’s Revenue and Customs (HMRC) in the UK as Qualifying Recognised Overseas Pension Schemes (QROPS). Admittedly, there is always room for improvement, and but as local law is tried and tested over time, the MFSA regularly reviews and fine-tunes the existing rules. The MFSA is also an important driver in new initiatives to further enhance the financial regulatory regime. Since most rules applicable to local licence holders are set out in rules issued by the MFSA, which is authorised to do so under primary or subsidiary legislation, changes of a technical or regulatory nature can usually be adopted swiftly by the MFSA.

Daniele Cop, partner Financial Services Department Mamo TCV Advocates. Seeing the number and variety of enquiries and projects in the pipeline this year, we are optimistic that Malta will continue to grow and develop, not only in the funds industry but also in the area of investment services, asset management, financial services and banking. Photograph kindly supplied by Mamo TCV Advocates, April 2012.

FTSEGM: What is the outlook for the local capital markets? What role can the stock exchange play in this regard? DC/NAS: For a long time the Malta Stock Exchange ran the only regulated market in Malta. Issuers of securities listed on the Malta Stock Exchange’s official list are predominantly local companies, and the market is not particularly liquid at the moment. However, in the past years, efforts have been made to attract and accommodate foreign issuers, in particular by improving the local infrastructure; for instance, the Malta Stock Exchange is expected to start using Xetra, Deutsche Börse Group’s fully electronic trading system, in the near future. In February 2012, the Irish Stock Exchange and the Malta Stock Exchange announced a joint venture to launch the European Wholesale Securities Market (EWSM), a new regulated market in terms of MiFID, authorised and supervised by the MFSA. The eligible securities for admission to trading on the EWSM are asset backed securities, debt securities and derivative securities, with a denomination per unit of at least fifty thousand euro. The EWSM is intended to provide issuers and arrangers of such securities access to an EU regulated market with the support of a dedicated listing agency service. While the ISE acts as the market promoter providing primary market infrastructure as well as other corporate services to the EWSM, the MSE acts as the market operator providing secondary market services to the EWSM. FTSEGM: How flexible is the government in making modifications to the financial regulatory regime to leverage Malta’s interests in developing as a financial/investment markets hub? DC/NAS: Essentially, the Maltese financial regulatory regime is composed of three layers: the primary basis are the acts of law which set out the main legal framework and

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confer powers to the Minister responsible for finance to adopt subsidiary legislation in the form of regulations, and to the MFSA, to issue (among others) rules for the detailed implementation of provisions of the said acts and regulations. Since the bulk of the provisions governing the setting up and conduct of financial services business are in the form of rules issued by the MFSA, it is relatively easy to make changes to such rules when the MFSA deems this necessary—be it for the purpose of implementing EU law, or in order to clarify or modify certain rules in order to fine-tune the regime. The MFSA tends to make such amendments in consultation with local practitioners, through frequent consultation. One of the challenges with which the Maltese government is often faced is remaining up to speed with all legislative, administrative and regulatory changes being enacted at the supra-national level, in particular by the EU institutions (especially now with the avalanche of new measures being adopted and existing Directives such as MiFID being reviewed and changed). Nevertheless, Malta has an excellent track record in timely implementation of EU Directives regarding financial services—as far as possible this is done via regulations drafted and rules issued by the MFSA, in order to avoid the more cumbersome legislative process of changing acts of parliaments for this purpose. It must also be said that the MFSA is generally quite receptive for suggestions from local practitioners and their respective associations on improvements to the local regime, as long as it is satisfied that these are to promote high standards of conduct and investor protection. FTSEGM: Are there any new regulations in train which might act as a transformational engine of change in the jurisdiction? DC/NAS: As previously mentioned, there is a lot going on at EU level, but one specific piece of legislation which is expected to bring about a paradigm shift is the AIFMD. Local practitioners are eagerly awaiting the promulgation of the implementing measures for this Directive, and MFSA’s proposals for transposition (expected to be issued in the summer of this year 2012), in order to assess the full impact of the AIFMD regime on Malta as a fund domicile. Malta already regulates fund management activities and collective investment schemes, as well as the provision of custody services to collective investment schemes. Nevertheless, for the implementation of AIFMD we are expecting an overhaul of local rules, and obviously, we will need to revisit our existing fund structures and revise the offering documents and contracts in place, and probably also the fund’s constitutional documents. However, there are still a lot of loose ends and uncertainties, as we are waiting for the Level II measures to be published by the European Commission. We do not know yet which approach the MFSA intends to take for the implementation of the AIFMD, but we understand that the MFSA is currently working on a consultation document in which it will set out its views on this. Generally, Malta tends to exercise the available options

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Dr Nicolé Ann Saliba, associate, Financial Services Department, Mamo TCV Advocates. The fact that Malta is a well-regulated jurisdiction is frequently mentioned by fund promoters as one of the key factors influencing their choice of Malta as a domicile, especially in view of investors’ demands for increased transparency and oversight, writes Saliba. Photograph kindly supplied by Mamo TCV Advocates, April 2012.

and derogations when implementing EU directives on financial services, and we expect that this will also be the case for AIFMD. For instance, it is an option for Member States to allow certain funds with a five-year lock up period, typically private equity funds, venture capital funds or real estate fund, to appoint a notary, lawyer, a registrar or another entity to carry out depositary functions, subject to certain conditions—our guess is that Malta will probably allow this. Another example is that there is a transitional provision regarding the location of the depositary of alternative investment funds managed by management companies captured by AIFMD, which is optional too: in this case, the option is granted specifically to the competent authorities of home Member State of the fund, or if the fund is not regulated, the competent authorities of home Member State of the manager, and offers those Member States the possibility to allow credit institutions established in another Member State to be appointed as a depositary until July 22nd 2017 (by way of exception to the general rule, that the depositary of an EU alternative investment fund would need to be established in the home Member State of the fund). Malta will certainly exercise this option. What we are curious about is to know whether there will be a complete overhaul of the current regime, in the sense of a one-size-fits-all regime or if Malta will put in place a two-tier regime, whereby a distinction is made between funds whose managers are caught by the AIFMD and those that are not. Funds in Malta tend to be relatively small, so it is very well possible that certain managers who have alternative investment funds in Malta would not be fully subject to the directive, as long as they fall below certain thresholds. For those cases, it may be worth considering affording more flexibility, for example when it comes to the requirement to appointment a single custodian and the location of the custodian. I

GM Editorial 61_. 22/05/2012 15:49 Page 70