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Redrawing the map of asset servicing Explaining Delta One Can repo rebound? Gaming Activision Blizzard

HIGH OR LOW? The oil price versus growth conundrum ROUNDTABLE: WINNERS & LOSERS IN US TRADING WORLD

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GM Front Issue 63_. 20/07/2012 14:41 Page 1

OUTLOOK EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152 email: francesca@berlinguer.com

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t’s a funny old financial world, marked right now by a keen dialectic. On one side regulators seek to eliminate risk from the international financial system by legislation and by tightly prescribing financial activity. Yet, even while they throw proverbial books at the problem, risk runs recklessly through the capital markets like the word Blackpool runs through English sea-side toffee. On the other side we have some bankers who also want to eliminate any and all kinds of risk from their dealings; only they want to do it by rigging markets. Some might mis-sell investments or product; others price-fix terms of trade. Yet others ask for money at zero interest rates from governments, thereby virtually eliminating their cost of funding and ensuring that any activity they undertake rakes in profits. Even with all that help, some banks still cannot make money and risk remains high in the system. [Then again, there are some really good bankers, who understand and can handle theirs and others’ money, but they look to be increasingly rare.] Either by regulating or rigging the markets, neither side appears to be succeeding in their desired goal. So where’s the synthesis? Are we on a long term slide because markets have outpaced financial institutions that were constructed to service a financial order that saw its roots form in the July 1944 Bretton Woods agreement? Are we now in a highly volatile interim phase out of which new institutions will emerge that will support new global financial themes for generations to come? Or, instead have we genuinely experienced a fundamental shift in economic philosophy since 2001, where confidence in the free and self-balancing operation of financial markets has gradually been abandoned by all and sundry? It certainly has the hallmarks of a paradigm shift: banks subsidised to a point where they cannot fail; countries subsidised to a point that they cannot exit dysfunctional currency unions; and central banks whose policies dictated to by international rather than national interests. Are we moving, as old man Marx (Karl, not Harpo) himself prophesied, into an era of benevolent dictatorships, where the notions of free market economies are subsidised and subsumed into the self-serving interests of international pressure groups? (G20 anyone?) No? Well, something’s up. Read Andrew Cavenagh’s insightful piece on the threats to Europe’s corporate bond market and (if you are that way inclined) weep. Alternately, feel the burn in David Simon’s look at the overwrought repo segment, or the challenging sweep of this edition’s US trading roundtable, where both the sell side and the buy side are working overtime to rediscover their mojo. Is the concept of free markets consigned to the scrapheap? If you are of a nervous disposition the words hell and handcart will probably spring to mind as you trawl through this edition. If though you are made of sterner material then you will embrace the limitless opportunities that change will invariably bring in its wake, and we have tried to highlight one or two of those as well. One final note, you may not yet have had a chance to look at the magazine’s improved website: www.ftseglobalmarkets.com. You are kindly urged to access the additional information, news, whitepapers and interviews that supplement the magazine’s coverage. There are also news e-alerts and social media initiatives in hand, so look out for those too. As always, if you have feedback or suggestions as to how we can improve our service, please let us know. As for providing the right synthesis of the dialectical trends outlined above, answers on a postcard please.

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Francesca Carnevale, Editor, July 2012

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

Cover photo: Minister of Oil from Kuwait Hani Abdulaziz Hussain listens to a speech during a seminar of the Organization of the Petroleum Exporting Countries, OPEC, at Vienna's Hofburg palace, Austria, on Thursday, June 14, 2012. (AP Photo/Ronald Zak).

GM Front Issue 63_. 20/07/2012 14:41 Page 2

D E

CONTENTS COVER STORY

A DELICATE BALANCE: HIGH OR LOW OIL PRICES?

..................................Page 4 Are we back to July 2008 where after a sustained climb in oil prices, benchmarks fall to ultra-low and damaging levels for key energy producing economies? Or, has the bottom of the market been touched? If so, what will it mean for east and west in the remainder of 2012?

DEPARTMENTS

MARKET LEADER

THE RENEWED APPEAL OF PENSION POOLS.....................................................Page 8 Why are pension pools popular among multinationals again? Neil O’Hara reports.

CAN REPO REBOUND?........................................................................................................Page 14 David Simons explains why regulators should try to come to terms with repo.

SLOWING MARKETS NO BARRIER TO RUSSIAN PRIVATISATION ....Page 17 Vanja Dragomanovich explains the dynamics of Russia’s state sell-off plans

IN THE MARKETS

EASTERN PROMISE AND THE LME ........................................................................Pagae 20 What does the relentless shift in capital flows mean for exchanges everywhere?

CÜREX AND A NEW RANGE OF FX-BASED INVESTIBLE INDICES ....Page 22 Next generation FX valuation and performance benchmarks

REDEFINING THE DERIVATIVES SERVICING SET ............................................Page 24 BNY Mellon’s service set for derivatives

SOVEREIGN DOWNGRADES HURT CORPORATE ISSUES ........................Page 28 The growing nervousness in the investment grade corporate bonds market

THE RISE OF ELECTRONIC TRADING IN FIXED INCOME..........................Page 32 New ways of matching orders emerge in this illiquid market

DEBT REPORT

REGULATION SUPPORTS E-TRADING OF EUROPEAN CREDIT............Page 34 Corporate credit has started to embrace electronic trading

WILL EUROPE LOSE THE LEAD IN COVERED BOND ISSUANCE? ....Page 35 Banks dominate issuance, but volumes are under pressure

HIGH ALERT ON HIGH YIELD DEBT ........................................................................Page 38 Global macro volatility keens high yield investors on their toes

INDEX REVIEW

OF MICE, MEN AND BAILOUTS ..................................................................................Page 41 Simon Denham, managing director of Capital Spreads, takes the bearish view

FACE TO FACE

STUART HENDEL REVIVES BAML’S PB FORTUNES ......................................Page 42

REAL ESTATE

US REITS: ON THE COMEBACK TRAIL? ................................................................Page 45

SECURITIES SERVICES

ASSET SERVICING ENTERS A NEW PHASE ..........................................................Page 48

COMPANY PROFILE

ACTIVISION BLIZZARD: MASTERS OF THE GAMING UNIVERSE ......Page 52

Can BAML rediscover its prime broking mojo? REITS shine despite global uncertainty. Mark Faithfull reports Cost efficient securities services Art Detman explains why the shock of the new helps the games industry

W S l

S t

ROUNDTABLE: US TRADING INFLUX ......................................................................Page 55

TRADING

The challenges and opportunities for traders in a fast changing business landscape

CAN ALGOS THINK LIKE HUMANS?........................................................................Page 63 Do algorithms need to take on human traits to successfully navigate today’s equity markets?

ASSET ALLOCATION DATA PAGES 2

INVESTMENT STRATEGIES FOR AN ALTERED WORLD ............................Page 67 Where is the smart money moving? DTCC Credit Default Swaps analysis ..............................................................................................Page 75 Market Reports by FTSE Research................................................................................................................Page 76 Index Calendar ....................................................................................................................................................Page 80

J U LY / A U G U S T 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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GM Front Issue 63_. 20/07/2012 14:42 Page 3

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GM Regional Review 63_. 20/07/2012 14:10 Page 4

COVER STORY

GROWTH AND OIL PRICES: THE UNEASY RELATIONSHIP

There’s much to conspire to push up oil prices through the rest of the summer: US Federal Reserve chairman Ben Bernanke fails to deliver any promise of immediate monetary stimulus to aid the still weak US economy, at his presentation to Congress early in July; China’s economy shows continued signs of slowing; and Europe’s debts continue to depress everyone. At the same time, international tensions rachet up in the Straits of Hormuz. Are we back to July 2008 where after a sustained climb in oil prices, benchmarks fall to ultra-low and damaging levels for key energy producing economies? Or, has the bottom of the market been touched? If so, what will it mean for east and west in the remainder of 2012?

OIL PRICE FLUCTUATIONS TESTS MARKET RESOLVE OUR OR FIVE elements current interplay to impact oil prices: growth prospects in leading emerging markets such as China (bolstering demand); economic weakness in the eurozone (which reduces demand); signs of economic recovery in the US; warm weather reducing demand in Europe and the likelihood of Israel-American action against Iran over the oil producer’s nuclear programme. Aside from particular fluctuations, such as growing tensions in the Gulf, oil prices have taken something of a pasting in the last few months as eurozone debt problems and bearish economic data emanating out of major economies have triggered concerns that demand for oil may fall. In mid July on the New York Mercantile Exchange, light, sweet crude futures for delivery in August traded at $88.95 a barrel in trading, down $0.27 in the Globex electronic session, on the same day. Meanwhile September Brent crude on London’s ICE Futures exchange fell $0.33 to $103.67 a barrel. The headline right now is that the extended economic doldrums into which the West has fallen could now start to threaten the high economic growth rates of the BRICs and other leading emerging markets. It is not simply a demand equation: particularly for those countries which are also oil producers. The price of oil has important connotations for leading emerging economies in the doldrums of the

Photograph © Auris | Dreamstime.com.

immediate post financial crisis period. In June, for instance, the Russian government revised its forecast for the price of its benchmark Urals oil. The benchmark had set a record at $122.6 per barrel back in March, an uptick of 14.3% compared to the same month in 2011. By the end of the second quarter, the bearish government suspected the benchmark would drop to $102 by the end of the year as producers such as Saudi Arabia boost output and Iraq resumes supply. Russia, like other producers is also conscious that last year’s high prices might be an aberration, largely due to perceived and real disruptions in supply from the Arab spring. Russia is particularly sensitive about the price of oil. After all, it was oil prices hike that provided a surplus for Russian budget in 2011, increasing state revenues by an estimated 50%. Remember too that Russia needs oil prices to be at a minimum $117 per barrel, fulfill its current budget obligations according to Ministry of Economic Development figures. In anticipation of a dip Russian

federal budget spending in 2013-2014 might be reduced by cutting provisionally approved expenditures by RUB830bn (about $ 25bn), Tatyana Nesterenko, deputy finance minister, announced in mid July. Under the country’s new balanced budget rule all provisionally approved expenditures for 2013 will be cut to RUB343.3bn, with more cuts planned for 2014. Nesterenko said budget revenues are calculated based on the macroeconomic price forecast for oil, with the spending ceiling for the year based on the price of oil plus 1% of GDP. Equally, higher oil prices are important for the oil producing industry itself right now, particularly as reserves of light crude are in overall decline. Higher prices provide an incentive to extract as much oil from existing reservoirs as possible. Moreover, they also encourage spending on enhanced oil recovery (EOR) techniques (such as water flooding and/or gas lift) for the production of heavy oil, particularly in mature fields. Canada and Venezuela lead a pack of countries with heavy oil reserves. The size of these heavy oil deposits is huge and will likely account for the bulk of future energy exploitation over the next twenty years. The size of investments is substantial. Nigeria, Africa’s largest oil producer, plans to spend $100bn with joint- venture partners (including Royal Dutch Shell, Exxon Mobil and Chevron) in the next five years to

J U LY / A U G U S T 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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GM Regional Review 63_. 20/07/2012 14:10 Page 6

COVER STORY

GROWTH AND OIL PRICES: THE UNEASY RELATIONSHIP

explore for crude and gas onshore and in deepwater fields as it seeks to boost output and increase reserves. Nigeria currently has 37bn barrels in crude reserves and Africa’s largest gas reserves of 187trn standard cubic feet, according to the country’s Department of Petroleum Resources. The country is the fifth-biggest source of US crude imports. The development of deepwater oil fields is well below the country’s potential and Nigeria needs to introduce better investment terms to encourage companies to explore in deep water, with higher basic oil prices a component of those incentives. The question is whether a 15%-17% rebound in both West Texas Intermediate and Brent crude suggests that the bottom in the oil price is now passed; or whether over the medium term more falls are likely. Is the rising price of oil in July 2012 more related to temporary geopolitical tensions in the Gulf rather than being indicative of a wider and more sustained trend? To all intents it looks like prices are being tugged by two trends. The first is continued weakness in economic growth across the board which will continue to exert downward pressure on demand. The other is growing tensions in the Middle East that possibly threaten supplies. World oil demand growth will slow in 2013 from the already weak 2012, OPEC reported in mid July, citing Europe’s debt worries, the faltering US

economic recovery and deceleration of growth in emerging markets. OPEC left its 2012 world oil demand growth forecast unchanged at 0.9m barrels per day (bpd) and said growth in 2013 would slow to 0.82m bpd. The group’s forecasts are close to those of the US government, which has cut its global oil demand growth estimate for 2013 by 360,000 bpd to 730,000 bpd. The west’s leading economy looks unlikely to provide succour over the near term. “Bernanke confessed that recent data on the economy had been disappointing, that jobs growth was ‘frustratingly slow’ and that both Europe’s debt crisis and the fiscal cliff mooted for early 2013 represented two huge risks for the US economy. While being prepared to act if necessary, it is clearly the Fed chairman’s preference that Washington steps in and resolves the differences over fiscal policy to ensure that the recovery does not come to a grinding halt in the first half of next year,” underscores Simon Smith, chief economist at FXPro. Following the fatal shooting of an Indian fisherman by a US navy ship in waters off Dubai in July, Iranian foreign affairs spokesmen said that US military deployment in the Gulf was“a source of insecurity”. The US navy has been building up its capacity in the Gulf amid mounting tensions with Iran over western claims that the country has an advanced nuclear development programme that could support the

construction of nuclear armaments. Moreover, the West is enforcing trade sanctions against Iran. Tehran, in turn, has warned it could close the Strait of Hormuz, in the southern Gulf, if international sanctions begin to bite, potentially disrupting shipping and world oil supplies through the strategic waterway. This escalation kept the September delivery price of Brent crude oil above $103 a barrel in London trading mid month. The consensus is that these forces will counterbalance each other to keep oil bubbling between $85 and $100 per barrel for the foreseeable future; though most analysts opted for figures either side of this range. These levels however remain too low for comfort for the investment plans for Saudi Arabia (which would like to see a minimum price of $100 per barrel) and, as noted earlier Russia (at $117). Clearly, the long hoped for upturn in economic fortunes for the West (still the world’s main economic engine) is unlikely to materialise through the remainder of 2012. Unless governments can find an effective mechanism to stimulate growth at levels higher than 1% over the coming year, it is likely that the global economy and key energy commodity prices will remain below optimum levels for producing countries some time to come, with an attendant impairment on direct investment in infrastructure. It looks like a long, slow haul out of the doldrums ahead. I

HIGHLIGHTS OF OPEC’S MID YEAR STATISTICAL BULLETIN orld crude oil production increased by less than 1% last year overall: with crude production in Canada, the US and Middle East rising and production in Western Europe and Africa falling. Meanwhile OPEC members raised production by 3%. World oil consumption last year also rose by 0.9%, but this growth was seen solely in emerging economies, primarily in Asia (in particular China), in Latin America and the Middle East. In OPEC countries, oil consumption increased by 0.2 mb/d or 2% year-on-year. The bulk of the crude oil exported by OPEC Member Countries during 2011 went to Asian and Pacific countries, with 12.5 mb/d or 54.0% of the total. North America and Europe

followed, importing 4.9 mb/d or 21.1%, and 3.7 mb/d or 16.0%, respectively. Proven crude oil reserves in OPEC countries increased slightly in 2011, almost reaching 1.2bn barrels. OPEC’s percentage share of reserves stood at 81% at year-end, largely unchanged from 2010. The cartel continued to play an important role in the natural gas market last year, with proven natural gas reserves of 95,020bn standard cubic metres, an increase of 0.8% over 2010, making a total world share of 48.4%. Refinery capacity in OPEC countries rose by 0.7% during 2011, indicating that they held 10.1% of total world refinery capacity, compared to 9.9% in 2010.

J U LY / A U G U S T 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Regional Review 63_. 20/07/2012 14:10 Page 7

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

ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

GM Regional Review 63_. 20/07/2012 14:10 Page 8

MARKET LEADER

Photograph © Andrew Chambers/Dreamstime.com, supplied July 2012.

PENSION POOLING: THIS TIME ROUND ITʼS DIFFERENT

THE RENEWED APPEAL OF PENSION POOLS

Until recently it looked like pension fund pooling had fizzled into insignificance even before it had managed to enjoy prime days. In part this was due to events beyond the immediate control of those major international firms which had spearheaded the movement, or the banks which supported them. The reasons lined up like regular extras in movies: the financial crisis, poorly defined tax incentives and high set-up costs appeared to scupper the enthusiasm of firms that were set to follow major firms such as Unilever and Nestlé along a pension pooling track. However, as Neil O’Hara finds, it did not fade away at all and pension pooling looks to have become more popular among multinationals than ever before. Neil A O’Hara reports. OR MULTINATIONAL COMPANIES, pension plans can be a nightmare. A company that has grown organically has at least one pension plan for each country in which it operates. If it has grown through acquisition, it likely has multiple plans of varying size with different qualifications and benefits in every country. With a little help from legislators, multinationals can now use more efficient pooling structures to mitigate the expense. The impetus toward pooling also derives from the increasing mobility of labour at the managerial level. John Whitworth, a partner in the insurance practice at Oliver Wyman in London, notes that more European manufacturers operate in multiple countries and managers often move

from one to the other.“It is possible to deliver a pension that looks and feels like it gives them continuity,” he says. “There may be different pools of money in different countries but behind that is a single asset pool and a single investment philosophy.” As a first step, multinationals abandoned local and regional custodians for global providers like Northern Trust and BNY Mellon that can service their plans around the world and use the economies of scale to offer more favourable pricing. They also centralised the appointment of asset managers, picking a stable of managers with global reach instead of local firms in each country. While this “virtual” pension pooling offers some savings, it does not address the inherent inefficiency of so many legal entities controlling their

own assets. If the parent company chooses PIMCO as the preferred fixed income manager, each plan still has to negotiate a separate contract—and although the fee may be lower than it would be for a standalone entity it is still higher than it would be if the plan assets were pooled. The biggest obstacle to asset pooling used to be withholding tax. In most countries, pension plans can reclaim from the local tax authority any withholding tax on dividends paid by domestic companies. Depending on the provisions of the governing double taxation treaties, plans may be able to recover withholding tax (typically 30%) on foreign dividends, too—provided they own the shares directly. If the parent company established a separate legal entity to pool

J U LY / A U G U S T 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Regional Review 63_. 20/07/2012 14:10 Page 9

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MARKET LEADER

PENSION POOLING: THIS TIME ROUND ITʼS DIFFERENT

Kerry White, head of business strategy and development at BNY Mellon Asset Servicing. Certain European countries—Ireland, Luxembourg and the Netherlands—soon to be joined by the United Kingdom have created vehicles that offer complete tax transparency for pension plans, enabling multinationals to pool assets from different countries without a tax penalty. “The numbers add up very quickly if a plan gives away 30% of its dividend income every year,” says White. Photograph kindly supplied by BNY Mellon Asset Servicing, July 2012.

its pension assets, that entity was not a qualified pension plan and could not reclaim withholding tax. The solution demanded a new legal structure. Certain European countries— Ireland, Luxembourg and the Netherlands, soon to be joined by the United Kingdom—have created vehicles that offer complete tax transparency for pension plans, enabling multinationals to pool assets from different countries without a tax penalty. “The numbers add up very quickly if a plan gives away 30% of its dividend income every year,” says Kerry White, head of business strategy and development at BNY Mellon Asset Servicing, “That is why these vehicles are so interesting.” Asset pooling allows the parent company to negotiate a single global investment management mandate for each asset class or strategy at a lower price based on the value of all covered assets. Trading costs drop, too, particularly in fixed income where small

orders are expensive to execute. For smaller plans in the pool, the structure gives them access to best in class managers who might not otherwise take them on—or even to asset classes like hedge funds or private equity for which they could not qualify on their own. The advantages to the parent company may be obvious, but the upfront cost can be significant: one large BNY Mellon client shelled out more than €1m just to get all the required tax rulings. The pooled vehicle has to apply for tax relief in every country in which it wants to invest, and in every country from which it draws assets. While some tax authorities grant the approvals within two weeks, others may take months. “If a pooled vehicle wants to invest in 80 countries and sell fund shares to participating plans in 10 countries it can take a while,” says White. The impetus for asset pooling comes from corporate headquarters, but the parent cannot force plans to participate. Local trustees, who owe a fiduciary duty to plan participants, must agree to invest in the pooled vehicle— not always an easy sell because they cede control over where the money is invested. Companies often start small and then expand coverage. One Northern Trust client that set up a common contractual fund in Ireland and started with two equity sub-funds (one for ERISA plans and one for all others) recently added a fixed income fund.“In every case, our clients have grown their pools over time,” says Gwyn Koepke, business development director at Northern Trust.“They demonstrate the efficiency gains and then bring in more investors and strategies.” In some countries, asset pooling can offer additional cost savings. For example, many European countries levy VAT on fees paid to an investment manager, while those same fees paid inside a tax efficient commingled vehicle are exempt. In Switzerland, a traditional segregated managed account has to pay stamp duty on every trade it makes—but if the assets are in

Paul Bonsor, US practice leader for international retirement and investment consulting at AON Hewitt, estimates that only 80 or so out of 140,000 have taken advantage of the ability to cross borders. He counts no more than 10 true cross-border pension vehicles set up for that purpose, including funds established by BP and Nestle, both AON Hewitt clients. Photograph kindly supplied by AON Hewitt, July 2012.

a pooled vehicle, the duty is paid only on cash flows in and out, not on trades executed by the pool.“Stamp duty can be significant for Swiss plans,” says Koepke. “Tax advisors have told our clients they have saved hundreds of thousand of francs every year.” Northern Trust began working on asset pooling ten years ago and helped a client launch its first pooled vehicle in 2005. The process has become easier as tax authorities grew familiar with the concept and law firms developed templates for the paperwork. “It is a well-travelled path for us, at least,”says Koepke.“Typically, we don’t see implementation taking more than four months.” Northern even has a dedicated team of tax experts who focus on double taxation treaties. It has a sophisticated accounting system, too, capable of handling pools that have multiple plans investing in them, multiple subfunds for different investment strategies, multiple managers for each strategy and multiple countries in which the pool invests.

J U LY / A U G U S T 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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GM Regional Review 63_. 20/07/2012 14:11 Page 12

MARKET LEADER

PENSION POOLING: THIS TIME ROUND ITʼS DIFFERENT

John Whitworth, a partner in the insurance practice at Oliver Wyman in London, notes that more European manufacturers operate in multiple countries and managers often move from one to the other. “It is possible to deliver a pension that looks and feels like it gives them continuity,” he says. “There may be different pools of money in different countries but behind that is a single asset pool and a single investment philosophy.” Photograph kindly supplied by Oliver Wyman, July 2012.

Andrew Warwick-Thompson, global defined contribution leader for international retirement and investment consulting at AON Hewitt in London, says a company that already negotiates asset management mandates on a global basis may clip five basis points (5bps) per annum off its costs, while a less streamlined organisation may recoup up to 20bps, numbers that are still meaningful for large defined benefit plans. Photograph kindly supplied by AON Hewitt, July 2012.

Gwyn Koepke, business development director at Northern Trust. One Northern Trust client that set up a common contractual fund in Ireland and started with two equity sub-funds (one for ERISA plans and one for all others) recently added a fixed income fund. “In every case, our clients have grown their pools over time,” says Koepke, “They demonstrate the efficiency gains and then bring in more investors and strategies.” Photograph kindly supplied by Northern Trust, July 2012.

For all the advantages asset pooling offers to large multinationals, it leaves the underlying plans intact, responsible for their own liabilities and administration. Within the EU, it is now possible to merge both assets and liabilities to create a truly cross-border European pension plan known as the Institution for Occupational Retirement Provision (IORP). Technically, the legislation made every EU pension plan an IORP but Paul Bonsor, US practice leader for international retirement and investment consulting at AON Hewitt, estimates that only 80 or so out of 140,000 have taken advantage of the ability to cross borders. He counts no more than 10 true crossborder pension vehicles set up for that purpose, including funds established by BP and Nestle, both AON Hewitt clients. The ability to merge liabilities may enable the sponsor to escape jurisdictions that impose unusually high funding requirements—the Nether-

lands, for example. “If a company can finance defined benefit obligations in a jurisdiction that has a lower funding requirement, it can reduce short term cash requirements, enable full payment of benefits and mitigate potential build-up of trapped surplus in the future,” says Bonsor. It’s a form of regulatory arbitrage: it affects the timing of cash flows but does not affect the ultimate pension liability. The potential savings from pooling depend on how centralised pension administration is at the outset. Andrew Warwick-Thompson, global defined contribution leader for international retirement and investment consulting at AON Hewitt in London, says a company that already negotiates asset management mandates on a global basis may clip five basis points (5bps) per annum off its costs, while a less streamlined organisation may recoup up to 20bps, numbers that are still meaningful for large defined benefit plans. For DC plans, which are priced

as retail products in many countries, the administrative savings can be much higher—200 bps or so, albeit on a much smaller asset base because these plans have a shorter history than most DB plans. The potential savings have prompted companies to rethink how they handle defined contribution plans. In many cases, multinationals outsourced these plans to insurance companies or banks, retaining little control over how the assets are managed or administered. Warwick-Thompson says companies now recognise that high costs will eat into the final benefit employees can achieve—but do not want to increase contributions.“The best option may be to restructure the plans,” he says, “We will see a move towards unraveling many of the third party DC programs because they are inherently bad value for money.” That may explain why AON Hewitt sees more interest in pension pooling among multinationals than ever before. I

J U LY / A U G U S T 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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GM Regional Review 63_. 20/07/2012 14:11 Page 14

IN THE MARKETS

REPO: CAN REPO FINALLY REBOUND?

Widely considered the cornerstone of shadow-banking vitality, the repo market has fallen on hard times post-crisis, the result of changing market conditions and increased regulatory scrutiny. Accordingly, many worry about the unintended consequences of new repo restrictions; including the potential impact on liquidity should repo-market efficiency be compromised. As part of the effort to reign in recklessness in the financial markets, regulators have increasingly turned their attention to the so-called shadow-banking system—where financial activity occurs by and large outside of regulators’ purview—as well as its chief benefactor, the repurchase, or repo, market. David Simons reports on the implications.

REPAIRING REPO: AT WHAT COST? OR YEARS, REPO has enabled dealers, banks and other institutions to secure relatively easy short-term funding through the posting of securities held as collateral. Often considered the exclusive financing arm of shadow banking, repo has proven to be a crucial funding mechanism for the markets as a whole. Even so, regulators appear steadfast in their desire to affect meaningful change. In a recent statement, the New York Federal Reserve Bank noted that structural weaknesses within repo are“unacceptable and must be eliminated.” Should such rhetoric turn into reality, the road for repo could become long and winding, and feature many of the same restrictions that have befallen other perceived culprits of the credit crisis. A 2010 estimate put the value of US repo at roughly $10 trillion; research released last month by the Federal Reserve Bank of New York suggested a market roughly half that size, at around $5.48trn. However, even Federal Reserve board governor Daniel K Tarullo cannot say for sure how big repo really is. “At present, there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions,” Tarullo recently remarked. On the other side of the Atlantic, surveys by the International Capital Markets Association appear to give the most consistent numbers of volume in Europe. In the association’s most recent published survey, a sample of respondents in Europe were asked for the value of their

79.1% of the market from 74.3% six months earlier. The market share of German collateral continued to fall, touching 20.9% of the total (from 24.9% in December 2010), as risk averse investors became more cautious about lending these safe haven securities. The share of Italian collateral also fell to 7.0% (from 10.3% in the December 2010 survey) possibly reflecting credit concerns; and these trends are likely to have continued through the first half of this year.

Photograph © Antaratma/Dreamstime.com, supplied July 2012.

A move to regulation

repo contracts still outstanding at close of business on a single day in December last year. The result of this survey (which contained 64 leading market practitioners among its respondents) set the baseline market figure at €6,204bn. Analysis of the figures for banks that participated in both the December 2010 and December 2011 surveys shows modest growth in the market of 2.6% year on year, although there was a contraction in market size of 3.3% from the June 2011 survey using a constant sample. The latest survey results reflect continued stability in the repo market despite underlying difficulties for euro sovereigns which furnish the majority of the collateral for repo activity. Heightened risk-aversion among investors was evident in changes in the collateral composition of the market. Overall, the share of government bonds within the pool of EU originated collateral rebounded in the survey to

In spite of changes already underway, the perceived opacity of the market by the general public has helped fuel calls for repo reform. In 2010 the Federal Reserve created the Tri-Party Repo Infrastructure Reform Task Force in an effort to address a number of repomarket vulnerabilities. Numerous fixes have since been implemented, including the establishment of three-way trade confirmation, shifting the daily unwind from early morning to 3:30pm, as well as posting a monthly report on collateral quality, margining practices and other relevant data. Meanwhile, regulators have consistently hammered away at what they consider to be a chief culprit of repo mischief—the use of cheap and easy intraday credit. Last year the task force called upon JPMorgan and BNY Mellon, the two banks responsible for clearing tri-party repo transactions, to establish a 10% per-transaction intraday lending limit on borrowers;

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IN THE MARKETS

REPO: CAN REPO FINALLY REBOUND?

though to date, such a threshold has yet to materialise. Although the task force has since been dissolved, JP Morgan and BNY Mellon have worked to come up with strategies for dealing with intra-day lending on their own. For its part, BNY Mellon recently announced an increase in fees on certain short-term Treasuries transactions. Separately, the bank said it will require pre-funding of maturing tri-party trades with collateral that clears through the Depository Trust & Clearing Corporation (DTCC). Too much regulation, however, could potentially threaten the livelihood of financial institutions that depend on repo for borrowing in a pinch. Given recent market volatility and the ebbs and flows of collateral inventory, borrowers have understandably enjoyed the flexibility offered by tri-party repos. However, various factors have combined to make repo borrowing more challenging than ever. Ironically, one of the main deterrents has been the steady reduction in interest rates resulting from the Federal Reserve’s ongoing quantitative easing, which in turn has put the squeeze on holders of shortterm US government securities. Also in the regulatory crosshairs are the “haircut”discounts used by lenders to safeguard against potential losses in collateral value. Citing evidence that increases in haircuts helped accelerate the unwinding of the credit markets circa 2008; regulators have proposed the establishment of a minimum mandatory haircut on all repo collateral. However, in their paper Sizing Up Repo for the Cambridge, Massachusetts-based National Bureau of Economic Research (NBER), authors Arvind Krishnamurthy, Stefan Nagel and Dmitry Orlov found no evidence of haircut increases in securities backed by Treasury/agency collateral, and only nominal increases in haircuts tied to money-market-fund-to-dealer repo. As such, repo played only a relatively minor role in the funding of privatesector assets leading up to the crisis, said the authors.

If enacted therefore, such a requirement could be potentially destructive to repo, suggests Richard Comotto of the ICMA Centre at the UK’s University of Reading. For a mandatory haircut or call margin to effectively offset a fall in collateral value, says Comotto, the increase would have to be substantial; a 20% minimum, however, would likely remove an estimated €4trn worth of liquidity from the repo markets, he adds, or roughly four times that of the European Central Bank’s three-year Long Term Refinancing Operation (LTRO).

CCP solution In a recent speech before the European Commission Conference, Portuguese economist Vítor Constâncio, who is also vice-president of the European Commission Bank, underscored the role of repo in helping to maintain the financial-world order. Repo, said Constâncio, has served as a key source of financing for both traditional and shadow-banking sectors, and secured financing has demonstrated real benefits over unsecured lending, particularly during periods of market turbulence. Still, the tendency for secured financing to act as a conduit through which systemic shocks can travel highlights the need for practical oversight. Says Constâncio,“A system in which financial institutions rely substantially on secured lending tends to be more procyclical than otherwise.” Using central clearing counterparties (CCPs) as a repo-market intermediary may be one such solution, suggests Constâncio. At the height of the credit meltdown, the decline in volume for many CCP-cleared repos was significantly lower than in other segments of the market, he adds.“Some CCPs actually saw an increase in their business at a time when counterparty-risk adverse market participants turned to safer avenues,” explains Constâncio. Given their ability to serve as a risk firewall while improving transparency and boosting liquidity, moving repo into the realm of the CCP appears to be “an appropriate solution,”he says, and one

Federal Reserve board governor Daniel K Tarullo cannot say for sure how big repo really is. “At present, there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions,” Tarullo recently remarked. Photograph kindly supplied by New York Federal Reserve Bank, July 2012.

that has already gained significant traction in Europe, where market users increasingly make use of CCPs to settle their repos in a low-risk environment. The imposition of such a third party in the US could help avert a tri-party doomsday scenario involving clearing banks JP Morgan and BNY Mellon, argue CCP proponents.“The benefits of central clearing are directly applicable to the repo market, and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike,”says Jeff Penney, senior advisor to global consulting group McKinsey & Company and author of Out of the Shadows: Central Clearing of Repo. “Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.” In addition to providing capital efficiency and a more stable source of funding for banks and broker-dealers, a CCP for repo could potentially evolve into a hub of funding activity for other forms of liquid collateral, adds Penney—and, in the process, “bring the majority of the shadow-banking system into full view.” I

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SLOWING MARKETS NO BARRIER TO RUSSIA'S PRIVATISATION PLANS

Russian President Vladimir Putin heads a meeting in Moscow’s Kremlin on Tuesday, July 10th 2012, on oil and natural gas industry issues and ecological security. Photograph by Mikhail Klimentyev of the Presidential Press Service/AP Photo/Press Association Images, supplied July 2012.

Will Russia keep up with its ambitious privatisation programme? As dust settles on Russia’s latest elections and on the political frictions that accompanied Vladimir Putin’s return to the presidential seat, the country’s focus is shifting back to economic issues and making good on the promises made during the election campaign. In early June the newly formed cabinet spelled out Russia’s targets for privatisation, saying the government aimed to raise about $10bn from state asset sales this year and roughly the same amount next year. In total, Russia aims to place an ambitious $100bn of primary and secondary shares into the markets and relinquish control over most companies that are not either natural resources monopolies or part of the defence sector. By Vanya Dragomanovich.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

HRIS WEAFER, CHIEF strategist at Troika Dialog in Moscow, says that privatisation will proceed on a twin-track, with the energy sector likely to go through a stage of further state consolidation before parts of the companies are sold off.“The priority over the next 12 to 18 months will be to sell “surplus” equity in already listed non-energy sector stocks,”he says. In some juicier assets, such as Russia’s biggest lender Sberbank, the government will still keep control of a 50% stake plus one share. In contrast, its second biggest lender VTB bank will

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IN THE MARKETS

SLOWING MARKETS NO BARRIER TO RUSSIA'S PRIVATISATION PLANS

likely be sold off completely by 2016. The stake in Sberbank and at least an initial batch of VTB shares are earmarked to come on the market either this year or in 2013, as are Rusnano, the country’s $10bn technology fund that invests in hi-tech and innovative technologies; diamond producer Alrosa, the only serious competitor to De Beers; Sovcomflot, which owns the world’s largest fleet of Arctic and ice-class LNG tankers, and state grain trader United Grain Company. Companies on the long-term sales list are Federal Grid, Aeroflot, oil producer Rosneft, state power company InterRao and Russian Railway. Even a cursory glance at the performance of the local market—Moscow’s MICEX index is down nearly 7% year to date and the RTS is down 10%—and the continued outflows of capital from emerging market funds suggest that now is not the best time to sell Russian equity stakes. For instance, Russia’s central bank, which is the main owner of Sberbank, initially planned to place a 7.6% stake on the market last September but held back because share prices started to slide. Government sources indicated that Moscow was looking for a price of at least RUB100 per share, a level achieved this spring before it dropped to the current RUB80. In the short term the government is likely to find itself behind schedule given the fragility of the global equity markets and the drop in foreign investor appetite for emerging markets. In the long term, however, it is more likely than not to succeed in attracting foreign investors as most of the companies’ valuations are at a fairly low level. The inflow of new shares will add a substantial amount of liquidity to Russian stocks and will make the domestic market more interesting to both local and foreign investors. The timing of the actual placements will depend on the interplay between wanting to keep momentum in the process and the markets recovering. There is a split in the government between a faction that wants to move faster on privatisation and one that

thinks the process should be delayed until the markets recover, says Troika’s Weafer. “One group under the lead of (first deputy prime minister) Shuvalov is taking the view that they need to push on with the privatisation programme,” says Weafer. This will mean that the government may compromise on slightly lower prices than it would like in order to keep the privatisation momentum going, he adds. Financially there is only mild pressure to go ahead with the sales. The budget is currently balanced and the country’s macroeconomic figures are relatively strong. However, the drop in the oil price is beginning to be felt: Russia has revised its growth expectations for next year to 3.4% from 3.7%. “Given the current climate the focus of international investors will be on top quality, top tier shares,” says Jacob Grappengiesser, partner at Swedish investment firm East Capital. Lesser known companies such as diamond producer Alrosa will likely struggle to IPO.“Although a company like Alrosa is looking quite good and it had good financial results, investors will be hesitant to go for it,” says Grapengiesser. Sberbank is attractively valued, says Edward Conroy, co-manager of the HSBC Russia Fund. “What will also appeal to investors is the strength of the franchise and the fact that it holds the dominant share of the market,”adds Conroy. If Sberbank’s shares are priced at RUB100 they alone could raise close to $6bn or the bulk of the target income for this year. The necessary footwork has already been performed late last year, with road shows in London, and if the markets turned after the summer the stock could make it onto the market within weeks. Given the current state of world markets the government in Russia is likely to take the most pragmatic approach in terms of where to list its companies, says HSBC’s Conroy. Although the preference will be for Moscow, especially now that two of the country’s main bourses, MICEX and RTS, have merged, there is likely to be

a mix of placements which would involve both London and Hong Kong. “It will depend on what kind of investors the government will want to attract,” adds Conroy. Some foreign investors remain fairly bitter about the Russian market, noting that the performance of Russian shares has been the weakest of all BRIC countries. Also, the fact that the there is barely any domestic pension fund investment presence means that the market is more thinly traded than it could be. Although there have been discussions about changing Russia’s approach to pensions a major overhaul of the current system does not seem likely in the near future. “The overall pension investment in Russia is 5% of GDP, which is fairly low. Of that, only 4%-5% is in equities compared with 40% in equities globally. There is clearly a lot of room for growth here,” he says. In defence of the local markets, the outflow of fund money from Russia has been far less than from other emerging markets, and while steady, the exodus has been more a trickle than a flood. Also, the cautious investor approach will change as markets recover, says Matthias Westman, founding partner at Prosperity Capital Management, one of the largest hedge funds invested in Russia. He believes that in the long term some of the smaller and medium sized companies will prove the best investment.“On the whole, companies which remain only part privatised, that is, with the government holding a 50% plus one share, will be less interesting for foreign investors,” who will more likely opt for companies like Rosneft which will be fully privatised. Nobody can accuse the Russian market of being an easy one to play, but although foreign investors have burnt their fingers in the past, fortunes have also been made. A shining example is East Capital’s Russia fund, which though down 1.35% year to date is still up 1,000% since inception. Current low valuations and the absence of a large number of investors suggest that now is the time to enter the market. I

J U LY / A U G U S T 2 0 1 2 • F T S E G L O B A L M A R K E T S

Sponsored statement

Adding Transparency to Exchange-Traded Funds Exchange-traded funds (ETFs) continue to receive an enormous amount of attention from investors, asset managers and media outlets, due to the overwhelming amount of asset growth that the innovative product structure continues to generate. Regulators too are turning their focus on ETFs, with a determination to ensure that the product innovation will not become the impetus of another global financial crisis.

INCE THEIR INTRODUCTION in 1993, exchange-traded products (ETPs) have been growing rapidly, crossing $1 trillion in U.S. assets at the end of 2010, a feat which took the U.S. mutual fund industry more than 60 years to accomplish.1 Global assets exceed $1.6 trillion as of January 2012,2 and are expected to grow by as much as 30 percent annually during the next few years. An often-heralded aspect of ETFs is the inherent transparency of the structure. Investors can easily assess their exposure to an ETF’s underlying holdings on a daily basis, while it might take 30-90 days for investors to assess their exposure in an open-ended mutual fund.This transparency is especially valued during times of market crisis: A point amply illustrated during the credit crisis of 2008, when investors were anxiously trying to gauge their exposure to Lehman and other stocks, investors in ETFs had the benefit of viewing their exposure in real-time.

REGULATORY SCRUTINY One conclusion in the U.S. Senate’s Permanent Subcommittee on Investigations report on the 2008-2009 credit crisis was that regulators failed to act on elements of systemic risk, thereby exacerbating the situation.3 Thus, the rapid growth of ETFs, and some of their unique product attributes cited below, have thrust ETFs into the regulatory spotlight. l Leverage/Margin: Since ETFs are held in traditional brokerage accounts, investors can utilize their margin accounts to add leverage to their purchasing power. Incorporating leverage into investment processes adds risk to investors’ portfolios, and could result in large swings in returns or mismatches.

(subscribe) and redeem shares directly with the issuer (instead of an ETF Authorized Participant), similar to a mutual fund.

REGULATORS TAKING ACTION

Brian Reilly, Vice President, Global Exchange-Traded Fund Services, Brown Brothers Harriman. Photograph kindly supplied by BBH, June 2012. l Synthetic

ETFs: The use of swaps or futures, instead of physical securities, alarms regulators due to perceived risks associated with the use of swap contracts instead of physical securities. The concern is that the investor may be unknowingly exposed to the risk profile of the underwriter, which may – or may not – be an affiliate of the ETF sponsor. l Securities Lending: It is argued that securities lending assists in creating efficient markets by facilitating the short side of the market. However, regulators are concerned about the amount of short interest in ETF shares, and the ability to recall shares, should the ETF experience large redemptions. l Liquidity: Regulators are considering whether investors should be given the ability to create

ETPs possess a unique spectrum of product types, each with its own benefits and risks. Regulators in the U.S. are questioning if the industry should create better labeling of ETPs, and provide adequate disclosures in legal documentation. In Europe, concerns regarding the lack of investor protection, and associated risk, have been expressed by a host of regulatory entities, including the European Commission, the European Securities and Markets Authority, the Financial Services Authority, the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements.

LOOKING AHEAD Global regulatory attention will most likely result in policy changes that will affect ETPs, translating into investors making more informed decisions when they include ETFs in their portfolios. n Sources: 1 Investment Company Institute. 2 BlackRock ETF Landscape. 3 http://www.hsgac.senate.gov//imo/media/doc/Financial_

Crisis/FinancialCrisisReport.pdf?attempt=2, pages 4-5.

For additional information about Brown Brothers Harriman’s Exchange-Traded Fund Services, please contact Brian Reilly at brian.reilly@bbh.com.

Investing in ETFs involves substantial risk, including loss of principal. These risks may pose different from, or greater than, those associated with a direct investment in the securities underlying the funds’ benchmarks, can cause volatility, and may dramatically decrease performance. There is no guarantee that any ETF will achieve its investment objective. ETFs may not be suitable for all investors. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. The views expressed are as of July 2012 and are a general guide to the views of Brown Brothers Harriman (“BBH”). Commentary is at a macro or strategy level and this document does not replace portfolio and fund-specific materials. This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients and Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited.This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Services Authority. BBH, is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2012. All rights reserved. 07/2012.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

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IN THE MARKETS

THE IMPLICATIONS OF THE LME SALE

In the latest manifestation of China’s rising economic power, Hong Kong Exchanges & Clearing (HKEX) has agreed to buy LME Holdings, the parent company of the London Metal Exchange, for £1.388bn, an eye-popping 58.3x net profits for 2011 even adjusting for a higher fee schedule implemented only on July 2nd this year. It is a trophy price for a trophy property: the largest base metals futures and options exchange in the world, with an estimated 80% market share. If the transaction receives shareholder and regulatory approval—not a racing certainty, given the unusual voting rights of LME shareholders—the new owners of a traditionally western capitalist bastion reflects the relentless eastward shift in capital flows, driven by China’s rapid economic growth.

Hong Kong Exchanges and Clearing's officials, from left, Chief Executive Charles Li, Market Development chief Romnesh Lamba and Chief Operating Officer Gerald Greiner attend a news conference in Hong Kong Friday, June 15, 2012. Hong Kong's stock exchange operator said Friday it has agreed to buy the 135-year-old London Metal Exchange for 1.4 billion pounds (US$2.2 billion) as it shifts into commodities to capitalize on Chinese demand. (AP Photo/Kin Cheung).

LME goes east HE IMPERATIVE TO secure ownership of the LME by Chinese entities will come as no surprise. The Middle Kingdom now accounts for 42% of global metals consumption; Chinese companies already trade on the LME through member firms; and several LME members have opened offices in Hong Kong. Newedge, whose 15% to 18% market

share by volume makes it the largest LME ring-dealing member, even has a joint venture with Citic, the Chinese financial conglomerate, through which qualified customers can trade on the Shanghai Metals Exchange, the regional market for the same metals that dominate trading on the LME: aluminium, copper, zinc and lead.

Shanghai still takes its opening cue from LME closing prices, but the relationship between the two exchanges has evolved into a two-way street— traders now track closing prices and trends in Shanghai before they set opening prices in London the next day. If the Shanghai market were to open up to foreign participants, John Fay, global head of fixed income, currencies and commodities at Newedge, expects overall trading volume would grow but does not see business migrating from London to Shanghai.“Liquidity moves to where the capital is created,”he says. “The markets in China will continue to grow, but it will be complementary to growth on the LME. It will be additional volume.” Unlike other futures exchanges, LME operates three trading systems that work in parallel: a continuous electronic trading platform open 24/7, ring dealing sessions on the exchange floor, and OTC trades negotiated off the floor. No matter where trades take place, they are centrally cleared by LCH.Clearnet, at least for now. The LME plans to set up its own clearing house by 2014, an initiative HKEX supports and to which it can bring its own expertise in clearing (albeit not in commodities). Self-clearing will give the LME greater flexibility to launch new products and may enable the exchange to take as eligible collateral assets not acceptable to LCH.Clearnet for initial and/or variation margin. The LME also offers a wider range of delivery dates than other futures exchanges: daily “prompt dates” out to three months, weekly out to six months, and thereafter monthly to 15, 27, 63 or 123 months forward depending on the metal. HKEX has committed to retain this structure at least until 2015, but Fay is keen to see it preserved in perpetuity. “It is the model our customers want because it is built for size or speed,” he says.“They want to go to the floor for price discovery and liquidity, to be able to trade electronically or over the counter (OTC), and they want it all cleared.”

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GM Regional Review 63_. 20/07/2012 14:11 Page 21

Michael Overlander, chief executive of Sucden. Photograph kindly supplied by Sucden, July 2012.

The LME model is unique, but may not remain so. In fact, it offers a viable template for trading financial OTC derivatives on an exchange: the prompt date flexibility eliminates the mismatch between quarterly contract expiration dates and the dates to which commercial participants need to hedge. “The LME model is an answer to Dodd Frank,” says Fay. HKEX intends to help the LME expand in Asia through a combination of enhanced data distribution, the introduction of futures contracts denominated in renminbi (RMB) and additional warehouses. LME operates a network of more than 600 licensed warehouses around the globe in which market participants can deposit deliverable material in exchange for a bearer warrant for the number of contract lots the metal represents at that location. None of the existing warehouses are in mainland China, however; Chinese companies typically deliver to warehouses in South Korea if need be, which is typically in times of tight supply. Michael Overlander, chief executive of Sucden, a ring-dealing LME member that accounts for between 10% and 15% of trading volume, says past efforts to license warehouses in China have foundered on doubts about the rule of law in the country. If someone presented a bearer warrant to the warehouse at an inopportune moment, would the operator honour the obligation? “In countries where the LME does have warehouses the warrant would never be questioned,” says Overlan-

der.“I think fear of the unknown legalities has prevented the LME from putting warehouses on the ground in China.” Local warehouses would no doubt improve liquidity and attract more Chinese participants to the LME, but while HKEX can help the LME cut through bureaucratic red tape it may not be able to resolve the legal difficulty. HKEX wants to leverage its existing renminbi-based trading and settlement infrastructure in Hong Kong to support new LME futures contracts denominated in the Chinese currency. Although these products would be another step toward the internationalisation of the renminbi, Overlander does not see them as an immediate precursor to free convertibility. “The Chinese government has shown a great reluctance to take the handcuffs off the RMB,”he says.“It will first have to relax the controls to get people excited about a currency with limited uses.” Both Sucden and Newedge own shares in the LME but, at just under 3%, their holdings are far smaller than their market shares of exchange business. Maintaining the business model should be more important to both firms than the price at which they can sell LME shares, but few people are altogether immune to the lure of money. “I would be lying if I said the equity isn’t important,” says Overlander.“It would be hard to see the value of our shares topped in the foreseeable future. It was a relatively easy decision for us to support the transaction: we were satisfied with the buyer and the price.” The losing bidders—Intercontinental Exchange and CME Group—must now explore alternatives if they wish to expand in base metals. For ICE, it would be a new business line, while CME has a copper contract traded on the Comex that competes directly with the LME. Apart from copper, CME has historically focused on precious metals—gold, silver, platinum and palladium—that do not overlap with LME products.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

John Fay, global head of fixed income, currencies and commodities at Newedge. Photograph kindly supplied by Newedge, July 2012.

The LME’s dominant position represents a significant barrier to entry, however. Market participants have great confidence in price discovery on the LME, so much so that prices for physical contracts (which are not traded on the LME) are usually based on LME prices. The LME warehouse infrastructure would be hard to replicate too. “Virtually anywhere in the world, metal can be stored in exchange for a negotiable LME warrant. Warrant holders can have almost instant access to material on whatever day they want,” says Overlander. “The warehouse network is just one example. It would be tough to knock the LME off its pedestal.” The reaction in some quarters to the LME sale—another British champion passes into foreign hands—may be more Sinophobic than xenophobic. Nobody claimed that American interests would interfere with price discovery in London when ICE bought the International Petroleum Exchange or NYSE Euronext took control of LIFFE. Chinese influence in London is likely to grow if Chinese companies do more business on the LME but Overland insists Chinese ownership will not affect market operations. “Whatever the rationale for buying the LME, it was not to manipulate prices in favour of Chinese buyers,” he says. “The LME will still have to comply with FSA rules that govern regulated investment exchanges, which are designed to make sure the market has the confidence of users.” I

GM Regional Review 63_. 20/07/2012 14:11 Page 22

IN THE MARKETS

INDEX INVESTING: CUREX AND FX-BASED INVESTIBLE INDICES

FTSE launches FX-based indices The FTSE Cürex FX Index Series provides the next generation of FX valuation and performance benchmarking for global capital markets. By establishing real-time Bid and Offer spot FX indices on 192 currency pairs (FTSE Cürex FIX), from multiple independent contributors and at multiple depths of liquidity, global capital markets benefit from improved clarity when viewing previously opaque foreign exchange pricing. Mark Makepeace, chief executive of FTSE Group, explains that, “FX is the world’s largest capital market and currency exposure affects investors in all asset classes. This new series of FX indices will be used by our clients world-wide as a better benchmark for managing currency risk and performance, and will support a wide range of passively managed FX currency funds and strategies.” FTSE Global Markets spoke to Jonathan Horton, president, FTSE North America and Bill Dale, chairman & chief executive officer of New York-based Cürex Group about the salient features of the initiative. FTSE GM: What is the value of the FTSE Cürex FX Index Series? Why is the index series innovative? JONATHAN HORTON, PRESIDENT, FTSE NORTH AMERICA: The indices include a number of features which, in combination, offer a highly differentiated value proposition: Price discovery for the indices occurs in the institutional FX markets using multi-contributor price inputs from many of the world’s largest FX liquidity providers. By linking institutional FX liquidity directly to our independent indices, we enable execution at a benchmark rate, where every trade is a time-stamped print on the index— effectively a 24/5 real-time FIX. As is standard practice for FTSE, the indices are calculated and managed according to a transparent and publically available rule set, and audited electronically to ensure data quality—this is in contrast to many other FX benchmarks in the market. In turn, this transparency, independence and executability creates unprecedented opportunities for both the buy and sells sides, who

seek to grow FX as an asset class, expand investor access and develop the next generation of currency investment products. FTSE GM: What are the main indices in the index series and what products might be created from them? BILL DALE, CHAIRMAN & CEO, CÜREX GROUP: We are calculating and publishing executable bid and offer indices for 192 currency pairs (FTSE Cürex FIX) and 8 benchmark baskets on a real-time basis, 24 hours a day, 5 days a week. Additionally, every 15 minutes a ‘snap’ index is published to provide a time-stamped valuation metric for NAV calculations, product valuation and client reporting. Once a day we also publish DANI—Daily Accrued Net Interest—which is equivalent to an overnight rate. We look at the benchmark pairs as building blocks for the creation of a wide range of OTC and on-exchange products and we are actively in conversation with a number of providers who wish to create new products which will enable investors

to gain exposure, or manage currency risk in new and improved ways. Importantly, whatever the structure, FTSE Cürex FX Indexes are designed to be flexible and inclusive, providing an independent, rules based and consistent valuation input to calculate NAV, or benchmark performance in a wide range of products. FTSE GM: Who is FTSE Cürex FX Index Series designed for? BILL DALE: The index series is designed to be an inclusive platform, accommodating a broad array of institutional foreign exchange requirements. The index series can be used by asset owners and plan sponsors who seek to gain efficient exposure to global currency markets and new sources of uncorrelated beta. The indices can also be used for benchmarking the performance of active currency strategies and as an independent auditable, pricing input for analytics and risk management. Asset managers can use the indices as an independent currency price input for purposes of NAV calculation, client reporting, risk management and analytics. Additionally, managers can leverage the FTSE Cürex Benchmark FX Pairs as fuel for the creation of new currency investment and overlay products. Meantime, sell side organisations and product issuers seeking to grow FX as an asset class can use the indices as an independent price input for the creation and valuation of the next generation of innovative FX investment, hedging, risk management and currency overlay products, and as an input for client reporting and best execution analysis. FTSE GM: How can investors use it to enhance their approaches to FX risk management and FX overlay products? BILL DALE: Using the currency pairs as building blocks, we are now able to offer the market executable FX indices linked to the FX exposure in third-party products which enables that risk to be monitored and managed dynamically—so for example, we can create

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GM Regional Review 63_. 20/07/2012 14:11 Page 23

an index which exactly mirrors the FX exposure of the FTSE All-World Index so that that currency exposure can be separated from the equity exposure. That risk can then be separately managed in accordance with the specific goals of the investor. FTSE GM: Which currencies are included? JONATHAN HORTON: At launch we are providing executable benchmarks for 192 different currency pairs based on 24 developed and emerging market currencies (AUD, CAD, CHF, CNH, CZK, DKK, EUR, GBP, HKD, HUF, ILS, JPY, MXN, NOK, NZD, PLN, RON, RUB, SEK, SGD, THB, TRY, USD, ZAR). We will be expanding coverage to other currencies over time. For each currency we publish a spot, spot-next, tom-next and total return index. FTSE GM: Can you please explain the operation of the Benchmark Basket Index Series? Which currency baskets are included and how are baskets weighted? BILL DALE: We have launched with eight initial currency baskets which are designed to measure the value of the USD against different combinations of currencies—G7, G8, G20 and Emerging Markets. The baskets are equally weighted and rebalanced on a weekly basis to ensure a consistent exposure. The flagship USD/G8 basket tracks the value of the dollar against currencies key to global finance, trade and commodity production, and also the Chinese renminbi (RMB), Asia’s most important emerging reserve currency. This unique combination provides differentiated information for investors seeking to express ‘risk on, risk off’ trades and also provides a representative benchmark for active currency strategies. JONATHAN HORTON: To add to Bill’s point, the index series is designed to be flexible and to evolve. Leveraging FTSE’s successful custom index services, investors can create custom currency baskets using any combination of pairs to suit their individual investment.

FTSE GM: Why does the world need a new USD Index? JONATHAN HORTON: There is a need for a new USD index as China begins to emerge as a significant global trading counterparty and the RMB becomes more prominent in global commerce. Currently there are no major USD indices which incorporate this important currency and the FTSE Cürex USD G8 Index provides a more even measure to capture and assess the movement of the USD relative to the rest of the world. Through the inclusion of RMB, the index captures over 90% of the USA’s international trading relationships, creating a more representative benchmark for the valuation of the US Dollar. Established dollar benchmarks were created long ago for very different purposes than they way they are used today and are commonly overweight certain currencies, underweight commodity-centric currencies and have not kept pace with changing FX markets as developed countries with high debt levels devalue their currencies. FTSE GM: Why was the index series launched at this time? JONATHAN HORTON: Traditionally, currency has been viewed by investors as a risk that they are exposed to as a result of global allocations to other asset classes like equities. With heightened consciousness of the impact of currency risk on portfolios, there was a clear demand for services which enabled that residual risk to be managed in a smarter, more efficient and more transparent way. Secondly, as main asset classes become increasingly correlated, many organisations are looking at how currency allocations can diversify their portfolio and augment performance—we wanted to provide solutions for these groups which enable them to gain exposure and access these benefits more easily via transparent, rules-based an independently calculated products. FTSE GM: Why did Cürex and FTSE Group start working together? BILL DALE: FTSE was a natural choice

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

Jonathan Horton, president, FTSE North America. Photograph kindly supplied by FTSE Group, July 2012.

for us to partner with in the creation of these new currency indices—they have tremendous brand with investors around the world and are well known for providing both high-quality robust solutions and leadership in the development of new concepts and approaches to indexation. JONATHAN HORTON: The partnership is a strong combination of complementary skill sets and expertise—Cürex has tremendous experience in FX—their senior team comprises former chief dealers, ECN technology specialists, fiduciaries and former governmental advisors, so they are in an excellent position to understand the challenges facing FX market participants and provide smart solutions. FTSE’s deep expertise in index creation, distribution and governance, coupled with our relationships with asset owners and asset managers gives us insight into the needs of buy-side which have enabled us to develop an index series which meets their requirements, whilst being flexible enough to evolve with the market. I

GM Regional Review 63_. 20/07/2012 16:53 Page 24

IN THE MARKETS

DERIVATIVES: 360 DEGREE COVERAGE

Odds are (whatever your investment strategy) that derivatives form an integral element of investors’ risk management and ROI augmentation strategies. It is natural then that securities services providers are now widening their service set to cope with both market change and complexity in investor strategies. Since the beginning of this year, Nadine Chakar’s task is to describe and round-out the service further to provide succour and support for the buy side, bringing the business, she says, into the bank’s “natural territory”. Francesca Carnevale spoke to Chakar about the scope and potential of the task in hand.

Defining the derivatives services set

Photograph © KTS/Dreamstime.com, supplied July 2012.

NY MELLON INTRODUCED Derivatives360, an integrated investment servicing lifecycle solution to help clients execute and manage derivatives transactions, in late 2009. From the outset, the service’s modular design allowed the bank to expand the overall product set and help clients structure a customised composite of service elements offered by the platform to introduce holistic and standalone solutions. The expansion of securities services for derivatives has grown as “Investors look to outsource derivative functions historically

handled in-house for a number of reasons, including credit considerations, product complexity, the high investment costs associated with specialist systems, a shortage of high-calibre staff, stronger regulation and the wider industry drive towards standardisation,” explains Nadine Chakar, head of Derivatives 360 at the bank. A long time securities services specialist at the bank, Chakar recently made the move into the Derivatives 360 area with a brief to establish the bank as a service leader. The bank has

upgraded its overall derivatives business and has variously reshuffled executives to reinforce particular business pressure points in the bank, such as collateral management. Reporting to Kurt Woetze, vice chairman and chief executive officer of BNY Mellon’s Global Collateral Services division, and head of global operations and technology, Chakar came into the role as Patrick Tadie moved across to the bank’s alternative and broker-dealer services operations, and she admits that the new role is outside her historical comfort zone. Nonetheless, she says, it is where she wants to be as “the business gradually enters mainstream investing.” The Derivatives360 business was a natural development as over recent years exchange traded derivative instruments had been employed as core holdings in institutional investor portfolios. Over-the-counter (OTC) traded derivative instruments too began to be a common feature within the portfolios of institutional investors. One such firm is BBVA Asset Management, which manages global funds worth €23bn. The firm asked BNY Mellon in April this year to provide access to a range of tailored, middle office services including OTC trade affirmation and confirmation, independent (third-party) valuation, lifecycle event management, portfolio reconciliation, and collateral management and custody. Customisation appears to be a vital element in the service; “it is all about moulding the service to help the client mould their exposure and risk,” says Chakar. Given the high element of customisation, innovation and fast evolving markets, Chakar explains that the service set itself is in constant flux. “This sense of change reflects the bank’s commitment to expanding the overall investment servicing set to cope with increased market complexity and incoming regulation. It’s a game changer,”she concedes.“Not all the buy side is in a state of readiness for regulatory change or for new investment

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GM Regional Review 63_. 20/07/2012 14:11 Page 25

How the world advances

Volume

10,000

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18,000

9,000

16,000

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2,000 6/4/12

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1,000 3/28/11

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12,000

6,000

Open Interest

14,000

7,000

GM Regional Review 63_. 20/07/2012 16:53 Page 26

IN THE MARKETS

DERIVATIVES: 360 DEGREE COVERAGE

Fundamental reforms of over-the-counter (OTC) derivatives markets around the world are having a profound impact on how derivatives are used, raising particularly challenging questions for sovereign institutions, according to a BNY Mellon report. In the report titled Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts, the bank explores inherent inconsistencies in the application of key OTC reform provisions and the potential impact on sovereign institutions, a base of increasingly influential global investors that use capital markets and OTC derivatives for implementing their investment strategies and hedging exposure.

OTC DERIVATIVE MARKET REFORMS RAISE CHALLENGING QUESTIONS FOR SOVEREIGN INSTITUTIONS, SAYS BNY MELLON REPORT he core objectives of the proposed reforms, which include The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), the European Market Infrastructure Regulation (EMIR), and similar measures throughout Asia-Pacific, are to centralise and manage counterparty credit risk and increase transparency. The evolving and inconsistent regulatory framework raises important issues for sovereigns regarding their obligations and the potential cost of compliance. “Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral,” says Jai Arya, head of the bank’s Sovereign Institutions group. “With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky. The classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage. In addition, the cost of compliance to the new rules could potentially hit sovereigns—and those servicing sovereign counterparties—very hard.” The report notes that the continuing debate over ‘extraterritoriality’, defined as the applicability of a set of rules outside the direct jurisdiction of the overseeing regulator, adds further complexity. European sovereigns have generally expressed concern over the potential impact on counterparty selection as a result of the proposed Dodd-Frank Act’s extraterritorial scope, for example. The de facto exclusion of US financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management. “We expect that a common approach will be reached between the major strands of regulatory reform to avoid market distortions and regulatory arbitrage, but inconsistency and conflict between national and supranational rules persists,” says Nadine Chakar, head of Derivatives360SM, at BNY Mellon. “Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, sovereigns may find that their OTC derivatives activities become subject to mandatory clearing,” she adds.

strategies. Hedge fund and insurance companies, for instance, clearly understand strategies such as Delta One trading, and associated collateral and clearing requirements. Pension plans on other hand are somewhere in limbo. It is the growing complexity in the process that worries investors, though there is a fair amount we can do to simplify their strategies. In this regard, it is about providing tools and facts.” Most recently, in May, the bank augmented its collateral management platform, introducing online central messaging, enabling clients to transmit margin calls, substitutions instructions and interest statements electronically in real time.“It fits in with risk, regulatory and compliance requirements, by producing detailed audit trails of transactions, reducing inefficiencies and operational risk, as well as increasing transparency,” explains Chakar. Whether clients are using derivatives as a hedging tool or as a separate investment strategy, the service set covers the execution and processing of derivatives, including trading and execution, middle- and back-office outsourcing, collateral management, accounting and recordkeeping. “It has to be comprehensive,” holds Chakar, “because of the detailed work we are doing with individual clients to help them adapt to change. Pension plans, for instance, have perhaps never had to deal with the trading of derivatives, or understand detailed processes around collateral management. Moreover, as new regulations kick in, we have clients asking us to help them standardise contracts; and to the extent that clearing is involved, it might range between explaining how margin is posted or collateral is optimised.” In April the bank began allowing futures commission merchants (FCMs) to post a wide range of collateral, including corporate bonds, for futures and cleared swaps margins at CME Clearing, via the CME IEF4 program. “As demand for non-traditional collateral grows at clearinghouses in the

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wake of regulatory reforms, it is critical that market participants post and track their collateral efficiently,” says Chakar, who explains that the bank has provided tri-party collateral management for traditional repo transactions for decades and has expanded the model to meet new centralised clearing requirements. Derivatives360 also offers a broad array of offerings for issuers involving the execution and processing of derivatives. These include trading and execution, derivatives middle office outsourcing services and back-office recordkeeping services. “We do not structure derivatives,”says Chakar.“But should the client require it, we will trade simple derivatives.”In this regard, services are designed to help not only the buy side, but also the sell side.“It is about helping the sell side manage overall demand for derivatives and on our side it helps us as it allows us to structure an end to end process that helps everyone.” Considering the range and complexity of services, Chakar acknowledges that there is no custody style pricing involved. “It’s not a mass market product, but it’s big, it’s complex, it’s risky, and this bank like others offering these services will want a real return given the work, infrastructure and expertise involved.” Even so, much of the business rests on the laurels earned by the bank’s custodial service providers. In that context, the service set around Derivatives360 is viewed as a “premium priced add-on to our custody relationships.” A key challenge for investors and the sell side alike thinks Chakar will centre on collateral.“Derivatives360 is essentially about effectively managing the collateral that investors put in play. Going forward, this will be the battleground and where you will find out where your real business partners lie. Some estimate the collateral shortfall to be $2trn going forward,” says Chakar. “Solving the coverage problem on that magnitude is not going to be easy.” The ability to be more efficient in the

A joint Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) rule that defines what is a swap and security based swap for regulatory purposes was issued in early July. Once the rule comes into effect, market participants will be required to register as dealers or major participants. The definitions will also have a broad affect on the marketplace, not least by triggering other rules.

CFTC AND SEC ISSUE JOINT FINAL RULES ON SWAP-RELATED DEFINITIONS ll of the derivatives-related rule makings being issues by the CFTC and SEC are fundamentally dependent on what these agencies determine what will be a swap, security based swap and mixed swap. Now, with product definitions finalised, although still subject to interpretation, a number of major CFTC rules will go into effect, including swap dealer and major swap participant registration, external business conduct requirements, transaction reporting requirements, and position limits, to name a few,” said Tim Ryan, president and chief executive officer of SIFMA, shortly after the CFTC-SEC rule release. On May 23, the Commodity Futures Trading Commission (CFTC) and the SEC published final rules and interpretive guidance under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) defining the terms swap dealer, security-based swap dealer, major swap participant, and major security-based swap participant. The Dodd-Frank Act divided the regulation of swaps between “swaps” overseen by the CFTC and “security-based swaps” overseen by the SEC. Unless exempt under the new rules, market participants covered by the definitions will be required to register as dealers or major participants and will be subject to requirements governing margin, minimum capital, and business conduct. In some cases, the final rules modify the rules and guidance which had been proposed by the agencies back in December 2010. In consequence, these final rules cover a smaller number of market participants than originally thought. The CFTC estimates that approximately 125 market participants will be covered by the definitions of swap dealer and major swap participants, while the SEC estimates that 50 or fewer market participants will be classified as security-based swap dealers and that only up to five market participants will be classified as major security-based swap participants.

“

way that collateral is utilised is part of it, but the effectiveness of investor efforts to utilise collateral to best effect will in part be determined by local regulatory conditions. “In Europe, for instance,” says Chakar, “you can do some crossmargining. This is not always the case elsewhere. You have to look across the board as to what chips you can play.” Chakar holds that this is the bank’s sweet spot: “this environment is

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perfect for us, and we are well placed to manage this demand.“ Equally, she believes the bank has a role in dumbing down the jargon, the parlance and the mystique around derivatives. “It is about eliminating the complexity for clients, so that they focus on investment strategies. When we get there, and this business is part of the mainstream, we will have succeeded.” I

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RATINGS CUTS THREATEN EUROPEAN INVESTMENT GRADE ISSUERS

After its runaway start to the year in the first quarter, the European market for investment grade corporate bonds grew more nervous though May and June. The skittishness was natural: investors took serious fright over the eurozone’s worsening prospects for economic growth and further downgrading of sovereign debt. In the event, the EU June summit took much of the sting out of the early July markets. However, as Andrew Cavenagh reports, the rollercoaster is so not over.

Sovereign downgrades hurt non-financial corporate bond spreads T IS CLEAR that Spain remains the most serious focus of eurozone worries to date. In consequence, the widespread expectation that the Moody’s rating agency will cut the country’s sovereign rating to junk status before the end of the summer (having slashed it by three notches to Baa3 in early June) looks to have had an increasingly detrimental impact on the spreads of Spanish (and to a lesser extent) Italian non-financial corporate bonds in June.“This is affecting corporates that are otherwise in good health but have seen spreads widening by anywhere from 80 to 200 basis points (bps) or more in the past few weeks,” explains Suki Mann, head of crossasset research at SG Corporate and Investment Banking. In the last week of June, the spread on the bonds of the Spanish power grid operator Red Electrica, widened by as much as 70 basis points at one stage. It was notable as Standard & Poor’s rates its debt one notch higher than the Spanish government (at the A- level).

Meanwhile the credit default swap (CDS) on the five-year-debt of telecoms group Telefónica moved out by the same margin to 570bps. This was 150bps wider than that of the junkrated French construction group Lafarge. To put this is perspective, Telefonica, which carries a Baa2/BBB/BBB+ rating, is also Spain’s biggest non-financial issuer with €16.57bn of bonds outstanding. Only Italian oil major ENI (which carries A2 and A ratings from Moody’s and Standard & Poor’s respectively) and Telecom Italia (BBB/Baa2) from the peripheral eurozone countries came to market with deals in the second quarter this year. ENI’s €750m seven-year offering was the later of the two, and it priced on June 20th at 215bp over the mid-swaps benchmark to offer a newissue premium of 22bps. Initiatives agreed at the EU Summit at the end of June appear to offer some hope of finally breaking the “loop of death” between sovereigns and the banks have seen pressure on Spanish

and other peripheral eurozone investment-grade spreads ease back slightly. However, this respite may well prove short-lived. As the old English chestnut has it: there’s many a slip twixt cup and lip. It may be well to remember then that the measures pushed through in the June EU summit are a long way from being implemented and much will depend on investor patience with the process. Equally, as the short-to-medium term outlook for the Spanish economy remains grim (with unemployment at just under 25%), the risk remains that S&P and Fitch could well follow Moody’s lead before the autumn and also consign Spain’s sovereign rating to junk. If this happens it will likely send shock waves through the European corporate-bond markets. Certainly, it will send close to €50bn of investment-grade debt crashing into the high-yield arena. Not only would this threaten to overwhelm the European high-yield market (which remains a fraction of

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Photograph © Kheng Ho Toh/Dreamstime.com, supplied July 2012.

DEBT REPORT

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Bond market returns Q2 – An increase in anxiety over the peripheral eurozone saw Italian bonds deliver negative (-3.5%) returns. By contrast, the (safe haven) US, UK and German bonds continued to post positive returns. While total 7-10 yr UK and euro corporate bond returns were positive, the euro BBB returns were negative. FTSE government bonds (TR, Local) US (7-10 y)

1M%

YTD%

-0.4

UK (7-10 y) Germany (7-10 y)

QTD% 3.1

-1.1

15.2

3.4

-2.5

16.4

2.7

Japan (7-10 y)

0.2

14.2 4.3

2.2

-2.4

France (7-10 y)

10.5

6.0 1.6

Italy (7-10 y) FTSE corporate bonds (TR, Local) UK (7-10 y)

-0.6

Euro (7-10 y)

-0.4

UK BBB

-0.4

FTSE inflation-linked bonds (TR, Local) UK (7-10 y) -3

4.2

4.5 10.0

4.2

-1.8 -2

7.6

3.4

-1.0

Euro Non Financial

8.5

10.0 3.1

-0.3

UK Non Financial

10.9

5.0

-0.8

Euro BBB

-0.3

9.7

6.5

12.8

1.6 -1

-3

Source: FTSE Analytics. Supplied July 2012.

the size of its US counterpart) but also it would precipitate a massive enforced sell-off by investment-grade index investors with all the losses and knockon effects that will entail. While Telefonica, Red Electrica, the gas-grid operator Enagas and the energy utility Iberdrola have shown it is possible for large and diverse corporates to break through their sovereign rating ceilings, however irrespective of their own business outlook, it is most unlikely that these companies will be able to retain investment-grade ratings for long if the agencies all drop Spanish sovereign debt below this level. S&P and Moody’s only allow corporates to achieve a one-notch higher rating than their underlying sovereign. Therefore, a transition for these firms to junk is inevitable should the agencies to cut their ratings on Spain by two notches

or more below the investment-grade minimum. Right now, this is a real risk. “If Spain goes into mid-double B territory, Telefonica goes into high yield,” confirms one investor.

Ratings test Even if the rating agencies’ action is not that drastic and just tips Spain into the junk arena, most investors doubt that corporates can sustain higher ratings than their host sovereigns in the long term. For there will always be limits to their ability to de-link, even for companies that generate a significant proportion of their revenues from overseas, such as Spain’s Repsol and Italy’s ENI. There will inevitably be some impact on their bottom line from worsening economic deterioration at home, and in such circumstances they would become

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more vulnerable to the threat of windfall taxes or other similar measures as their financially strapped governments looked to raise money from every available source. “It is very difficult for companies to have higher ratings than sovereigns anyway,” said Chris Bowie, head of credit at Ignis Asset Management in Glasgow. “And they will certainly struggle to do so for any length of time.” Meanwhile John Stopford, head of global fixed income at Investec Asset Management in London, says. “Given the dynamic of what’s happening at the sovereign level, we’re certainly cautious of the ability of these companies to de-couple themselves completely from what happens to their sovereign debt,” he said. It is probably not just the threat of a downgrade to junk status has led

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DEBT REPORT

RATINGS CUTS THREATEN EUROPEAN INVESTMENT GRADE ISSUERS

investors to shun Spanish investmentgrade corporate debt over the past two months, but the much worse possibility lurking in the background that the country could yet leave the euro. While the conciliatory noises from the latest EU summit (including the approval of €100bn of rescue fund money to recapitalise Spain’s banking system) may have alleviated fears on this score for the time being, it is still possible that Spanish electors will decide at some point that such a course is preferable to a “lost decade” of economic stagnation and high unemployment, which appears at present to be the price of remaining in the euro. Although the market currently views this as a relatively small risk (less than 10%) the consequences for debt investors would be ruinous. The value of euro-denominated Spanish holdings could easily halve overnight, as the country would instantly devalue the replacement currency. “The loss for anybody with investments in Spain if it did leave the euro would be

really severe,” confirms Bowie at Ignis. “They’d lose their shirt.” The present direction of the markets for Spanish and Italian corporate debt must be causing considerable anxiety among treasurers at the blue-chip companies in both countries. As Mann at SGCIB points out, they have “massive ongoing funding requirements”, and the prospective cost of issuing over the next 12 months is fast becoming unsustainable. A company such as Snam, the holding vehicle for four regulated gas transmission businesses in Italy, is a good case in point, as it will be looking to raise €6bn from the bond markets over the next two years. This requirement will arise from its parent ENI selling down its 52.3% stake in Snam to comply with the EU directive on “unbundling” in the energy-utility sector. ENI announced at the end of May that it had agreed to sell a 30% interest less one share in Snam to the state bank Cassa Deposit e Prestiti, but on completion of the deal Snam will have to repay ENI €11bn of inter-company loans. Although it has

Roger Sadewsky, investment director for corporate bond and absolute return funds at Standard Life Investments. For the all-in yields on the investment-grade bonds that corporates in the core countries are currently able to issue are at (or close to) record lows (given the levels of the benchmarks in the present interest-rate environment), and this leaves their investors potentially exposed to significant hikes in inflation over the next two years. “Materially yields can’t go much lower from here, so there could be a risk of principal loss in that case,” acknowledges Sadewsky. Photograph kindly supplied by Standard Life Investments, July 2012.

the necessary commitments from banks to meet this obligation in the short term, it is planning to refinance €6bn of the facilities in the capital markets by mid-2014. To some extent, the virtual absence of new issuance out of Spain and Italy in the second quarter has redounded to the benefit of investment-grade corporate issuers in the core European countries, as money continues to flow into credit funds. According to the team at SGCIB, there was just over €30bn of new issuance over the three months to bring the total for the first half to €84.1bn, not far short of the €90.1bn for the whole of 2011. The last deal before end of June saw the BBB-rated Danish brewer Carlsberg issue a €500m, seven-year deal at a spread of 112bps over the mid-swaps benchmark (offering a new issue premium of just 2bps). Mann at SGCIB says notwithstanding the glimmer of hope from the EU Summit, the strategy for core bondholders has to be more of the same as far as positioning portfolios was concerned and stick to non-financial, investment-grade debt in the core European countries. Even within those broad parameters, most investors seem focused on minimizing risk at present. “We tend to prefer the defensive sectors, such as telecoms, media and utilities, at the moment,” adds Stopford at Investec. “There is still too much uncertainty as to how this cycle will play out,”he adds. Such highly defensive strategies are not without risks of their own however, in the uncertain macro-environment that prevails. For the all-in yields on the investment-grade bonds that corporates in the core countries are currently able to issue are at (or close to) record lows (given the levels of the benchmarks in the present interestrate environment), and this leaves their investors potentially exposed to significant hikes in inflation over the next two years. “Materially yields can’t go much lower from here, so there could be a risk of principal loss in that case,” acknowledged Roger Sadewsky, invest-

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ment director for corporate bond and absolute return funds at Standard Life Investments in Edinburgh. The risk of such a sharp rise in inflation at some point in the medium term has to be high. Particularly as the grim growth projections for the entire eurozone will force the EU authorities to turn to some form of economic stimulus to convince the markets that they really have a credible solution for the problems of the single-currency. The trouble is, that it has become evident that simply imposing financial austerity measures will be neither economically nor politically sustainable. The only mechanism that can probably now save the single currency in its current form will be for European Central Bank (ECB) to become a true lender of last resort, which will be able to buy the sovereign debt of member states and provide liquidity to the banking system without restriction. Though to some extent it has already begun to do through the LTROs and the widening of the collateral it will accept under the programme. The truth is out there: it will just not be possible to secure the necessary political agreements in time for the

Chris Bowie, head of credit at Ignis Asset Management in Glasgow. Most investors doubt that corporates can sustain higher ratings than their host sovereigns in the long term. For there will always be limits to their ability to de-link, even for companies that generate a significant proportion of their revenues from overseas. “It is very difficult for companies to have higher ratings than a sovereign anyway,” says Bowie, “And they will certainly struggle to do so for any length of time.” Photograph kindly supplied by Ignis Asset Management, July 2012.

other measures that might persuade the markets that the European Union is serious about resolving the crisis. All of these proposals will take the eurozone down the road to some form of fiscal/transfer union and given the explicit surrender of national sovereignty they will require, most consider it will take between five and ten years (at the very least) to persuade member states to sign up to them, let alone implement them. Spain, Italy, Portugal, Ireland and Greece will not be able to survive within the euro for a fraction of that time without a credible stop-gap solution. Therefore, as the focus of EU politicians shifts from austerity to growth, the ECB will need to embark on a massive further exercise in quantitative easing to ensure that all member states and surviving banks have access to the funding they need at a sustainable cost, and this cannot fail to feed through into higher inflation at some point over the next two or three years. Bowie at Ignis points out that those who had bought bonds at the present yield levels will then become highly exposed.“I’m very worried about the growth problem and the likely response to it,” he says. I

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DEBT REPORT

THE RISE OF ELECTRONIC TRADING IN FIXED INCOME

FIXED INCOME: Electronic trading in an illiquid market Photograph © Kheng Ho To/Dreamstime.com, supplied July 2012.

While electronic trading has made some inroads among retail fixed income investors, most buy side institutions continue to place their orders in the traditional way: by voice, through dealers who hold sizable inventories of fixed income securities and will commit capital to facilitate customer trades. The dealers are beginning to balk, however. Higher regulatory capital requirements have forced them to pare securities inventories and reduce facilitation. If a customer calls with an order to sell $20m face amount of bonds, the dealer will no longer take on the whole position; instead, it may take $2m into inventory and execute the balance of the order only when it finds other customers willing to buy the bonds at the seller’s price. Frustrated institutions are looking for new ways to find a match for their orders, opening the door to electronic solutions. Neil A. O’Hara reports on a rising trend. XPERIENCE SHOWS THAT electronic trading works best in liquid markets like equities, in which millions of shareholders pursuing different investment strategies and objectives trade a few thousand issues in significant volume every day. The fixed income world reverses these characteristics: it comprises millions of issues, most of which trade infrequently. Investment institutions—banks, insurance companies and asset managers—own the vast majority of bonds, which means the average ticket size when bonds do trade is much higher than for equities: millions of dollars, not thousands.

Electronic platforms can accommodate less liquid instruments such as fixed income but the central limit order book used for equities will not work— bonds need a different matching mechanism. For example, GFI, a leading interdealer broker, trades bonds on its flagship CreditMatch platform using what Francesco Cicero, head of electronic trading, calls “micro-auctions.” Instead of asking dealers to post bids and offers that would reveal which way they want to trade, GFI sets a price between the best bid and offer and invites dealers to post buy and sell orders at that price within a limited

time period. To the extent the orders match, the trade executes. Neither side has to cross a spread. GFI meanwhile acts as a matched principal to both parties so the dealers never know which competitors took the opposite side. “We say a bond is 88.25, does anyone care?” says Cicero.“It becomes a gravitational pull toward that price. There is no negotiation, but it gets everyone’s attention.” GFI has operated an electronic platform for financial and corporate bonds in Europe for many years but launched its North American platform only in March 2012. Dealer reaction was enthusiastic—within a week, GFI went from all voice to trading one third of its US volume electronically. “When liquidity is hard to come by, we provide an extra service relative to a limit order book by indicating a level at which dealers can trade anonymously,” says Cicero. “It has massive value-added.” Another GFI system used in Europe operates more like a limit order book. It requires two parties to agree a price at which they will trade, but GFI then advertises the trade to the market for a brief period. More often that not, other participants join in and the trade goes through in larger size than the amount agreed between the two original parties. “Some people are happy to make markets and others to take those prices,” says Cicero. “A third group is more opportunistic: people who want to see a trade happening and will then go along.” Dealers are not the only participants worried about tipping their hand, of course. If anything, the buy side is even more paranoid about information leakage. That’s why when Vega-Chi, a London-based start-up, launched buy side-only electronic platforms for trading high yield and convertible bonds in Europe in 2010 it designed them to preserve anonymity all the way through settlement. The firm will apply the same model in the US when it launches a platform to trade high yield bonds in September this year. Constantinos Antoniades,

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Josephine de Chazournes, a senior analyst at Celent. Several other electronic platforms serving institutional investors have gained ground in Europe in recent years, according to de Chazournes. Photograph kindly supplied by Celent, July 2012.

chief executive officer of Vega-Chi, wants to disintermediate dealers and enable buy side institutions, which own 99% of high yield bonds outstanding, to trade directly with each other. “The average bid-offer spread in high yield bonds is ¾ point to a point, whereas we charge between three and 6.25 cents on each side,” he says.“Why pay a bank to act as a glorified risk-free broker when you can trade with your peers for a fraction of the cost on an electronic platform?” Electronic trading was slow to take off in fixed income in part because the entities best equipped to implement it had no interest in doing so. Every time a product switches to electronic trading, bid-offer spreads collapse and eviscerate the dealers’ profit margins. The banks that could have led the way preferred to keep their legacy golden goose business model alive—and the interdealer brokers could not afford to upset the banks, which are their clients. Now, the availability of cheap technology has tipped the balance.“Given that institutional investors rather than dealers own almost all the high yield bonds, it makes perfect sense to create a market structure that puts them in the driving seat,” says Antoniades.

The Vega-Chi platform requires buy side participants to post firm bids and offers; it operates like an exchange rather than the traditional request for quote process commonly used in client-oriented fixed income trading. Single dealer platforms do allow the buy side to interact with firm prices, but only on a take-it-or-leave-it basis. Vega-Chi alone gives the buy side control over what prices they post and when to change them, complete anonymity and no risk of information leakage to a dealer. Several other electronic platforms serving institutional investors have gained ground in Europe in recent years, according to Josephine de Chazournes, a senior analyst at Celent, a research and consulting firm. Tradeweb, a multilateral trading facility owned by a consortium including many of the big dealers, handles primarily government bonds, although it also trades US agencies, corporate bonds, mortgage-backed securities and covered bonds. Market Axess, also an MTF, specialises in corporate bonds and other credit-related instruments. BondVision is a regulated exchange for government bonds; it is owned by MTS, the leading interdealer electronic trading platform in Europe. Bloomberg provides a matching service for all kinds of bonds, and while it is neither an MTF nor an exchange it is widely used by dealers and other market participants. Dealers’ support is critical to the success of any platform open to them—and capital pressures have eroded their once fierce resistance to electronic trading of bonds. Goldman Sachs has even developed its own electronic trading platform, GSessions, on which clients can trade corporate bonds, an obvious attempt to keep as much business as possible in house notwithstanding the lower margin. Capital constraints have reduced liquidity in the primary market as well. Dealers used to take entire issues on their own book but are now more inclined to share the risk with others.

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Francesco Cicero, head of electronic trading at GFI. Electronic platforms can accommodate less liquid instruments such as fixed income but the central limit order book used for equities will not work. Photograph kindly supplied by GFI, July 2012.

Buy side institutions find it harder to amass sizable positions in new issues; instead of leaning on one dealer for a large allocation, they have to work with three or four, each of which has its own favoured clients.“Corporate bonds are where the yields can be found for asset managers,” says de Chazournes. “The liquid issues are all oversubscribed. Every large asset manager wants 80m of a 500m issue; they cannot get it. The buy side needs to get closer to the new issue process.” One possible model is BlackRock’s Aladdin trading platform, which the firm has announced will be extended to trade bonds. It will be open only to clients of BlackRock Solutions however, a list that does not include some of the largest asset managers. De Chazournes says market participants in Europe are even talking about creating an MTF that would be open to both dealers and clients on an almost equal footing, similar to the direct market access institutions already enjoy in European equity markets. “Everyone is trying to find a solution,”she says.“The liquidity is not there and the buy side is not able to do business as they did—but no one seems to have come up with the best solution yet.” I

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DEBT REPORT

REGULATION SUPPORTS E-TRADING OF EUROPEAN CREDIT

Corporate credit embraces electronic trading Recent years have witnessed unprecedented growth in the electronic trading of European credit instruments. Designed to improve transparency and minimise counterparty risk in the derivatives markets, the direction of new regulation is an important factor behind e-trading of European credit. The rules that will govern trade execution, clearing and reporting have yet to be finalised, but it is clear that reform is likely to push trading further towards electronic markets, where there is enhanced price transparency, workflow efficiency and regulatory oversight. Rupert Warmington, director of European credit markets at Tradeweb, discusses why he expects this trend will continue. O IMPROVE PORTFOLIO yields in a climate where other fixed income instruments are showing historically low yields, many investors have turned to European corporate bond markets in recent years. Meanwhile, corporate issuers in Europe are increasingly looking to access capital markets as a result of balance sheet constraints in the bank loan market, which they have traditionally relied upon for a large part of their financing needs. Upcoming regulatory changes and a desire for greater operational efficiencies within asset managers have combined to form an ongoing and significant increase in the electronic trading of European credit instruments. The shift towards e-trading in European credit bonds corresponds with widespread change in the investment patterns and workflows of “realmoney” institutions. European dealers are increasingly looking to electronic platforms to service clients’ flow business in vanilla products—precisely where there is greatest liquidity. Growth in electronic trading of investors’ flow business has boosted e-trading volumes overall—estimated now to represent well over 35% of the European credit market, up from less than 20% just a couple of years ago. Access to liquidity lies at the heart of successful e-trading platforms. There has been a sizeable increase in the number of market makers providing

prices in European credit over electronic marketplaces such as Tradeweb. Sell-side participants’ desire to win volume through e-platforms has led to significant improvements in the quality of electronic liquidity compared to that offered by phone. This is especially evident in recent months, and has not necessarily reflected conditions in the market overall. There is indeed an increasing buy-side perception that a growing proportion of overall sell-side liquidity is now being offered electronically as opposed to voice trading. Yet, for institutional investors, operational efficiency is almost as important as liquidity. Throughout the entire trading cycle of price discovery, execution and post-trade processing, electronic trading platforms provide ready access to trade information, analytics, and price transparency. And both buy- and sell-side institutions can fully integrate electronic trading platforms into their existing workflow systems. This automation must not come at the cost of flexibility. Buy-side traders can tailor tickets to their precise requirements on electronic platforms and request prices from specific dealers (the “request-for-quote” or RFQ model). This auction-like process gives buy-side traders fast and transparent price discovery, simultaneously putting dealers into competition. Increased competition optimises

pricing efficiency and helps the buyside demonstrate best execution. More sophisticated electronic trading platforms are also flexible enough to allow buy-side investors to execute multiple trades concurrently from a single list of orders across multiple asset classes. The time saved allows asset managers to invest resources more efficiently to boost overall productivity and performance. The need for flexibility in trading these instruments has become increasingly important as both regulatory and macroeconomic factors coalesce, reducing overall market liquidity. This has led various market participants recently to explore new price discovery and execution models which, if successful, could increasingly challenge the way business is done and even the current market structure. However, the common thread running through the fundamental changes underway in the marketplace is the greater use of electronic trading. Whilst the main driver stimulating the willingness to look at new ways to execute trades may be regulatory and macroeconomic change, the need for more efficient and cost-effective trade execution is also at the core of these moves. In other words, the evolution happening today is underpinned by some of the same drivers that have been central toward the increased use of electronic trading across fixed income markets for more than ten years. It is clear that the fixed income markets are becoming an increasingly dynamic and exciting place in which to operate, especially in the burgeoning electronic marketplace for European credit. This presents us with challenges, but also many opportunities to contribute to the accelerating evolution of the market. As electronic trading continues to meet the needs of financial institutions seeking better liquidity, increased efficiency and improved performance, marketplaces like Tradeweb will continue to partner with the buy- and sell-side to drive innovation in the new regulatory and economic environment.I

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Will Europe lose the lead in covered bond issues this year? European banks have issued just over half the volume of covered bonds so far this year that they did up to the same point in 2011, as a direct consequence of the worsening sovereign debt crisis in the eurozone and one of the main initiatives that has been taken (unsuccessfully) to address it. Total issuance by the end of June amounted to the equivalent of just under €75bn (which includes £10bn in sterling from UK issuers) compared with the €130bn that had come to market by this stage last year. Much of that was down to the fact that further rating downgrades of governments and banks closed the primary market for issuers in the beleaguered southern European countries pretty much from the end of February. Andrew Cavenagh reports. S A RESULT of the negative rating actions and heightened fears over the eurozone’s future, quoted spread differentials between the covered bonds of Spanish and Italian banks (let alone Portuguese and Greek institutions) and their counterparts in the core northern European and Nordic have reached record levels. Although most doubt that much, if any, actual trading is taking place given the size of the discounts in the pricing. By late June, for example, the

spreads on the five-year bonds of Spain’s two strongest banks, BBVA and Santander, were around 400 basis points (bps) over the mid-swaps benchmark, against a range of 10bps to 20bps for most of the German pfandbrief issuers. At the same time, the €1trn of three-year liquidity at an interest rate of 1% that the European Central Bank provided for the eurozone banking system through its two Long Term Refinancing Operations (LTROs) in December and February has removed any incentive

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

EUROPEAN COVERED BONDS: BANKS DOMINATE ISSUANCE

Photograph © Atanasbozhikov / Dreamstime.com, supplied July 2012.

for banks to fund themselves with covered bonds over this time frame. “There is not a single country where covered bonds can compete with that level of pricing,” said Heiko Langer, senior covered bond analyst in the credit research team at BNP Paribas in London.“The LTROs and the continuing sovereign concerns have been the drivers that have contributed to such a very low supply of primary issuance.” As a consequence, the second purchase programme for covered bonds that the ECB launched in November has had a negligible impact on the market. The central bank had managed to spend only €13bn of the €40bn it allocated to the programme by the end of June—despite increasing the maturity limit on the bonds it is prepared to buy from seven years to 10.5 years. The second programme has also failed so far in its goal to increase the proportion of purchases it makes in the primary market from the level of almost 75% that its initial €60bn covered-bond purchasing programme achieved in 2009/2010. To date, around 65% of the second programme’s purchases have been in the secondary market. This probably reflects that the aim of the second programme was to help issuers in Spain, Italy and elsewhere, who could no longer sell their bonds into the market at viable cost. However, once the worsening situation in the eurozone had obliged the bank to intervene on a far larger scale with the first LTRO just one month later, there was little need to support the peripheral covered-bond market in the short to medium term. “The purchase programme got overtaken by the LTROs, and in addition the central bank has not been marketing it very aggressively,” says one close observer.

Drop in primary market issuance The primary market in Europe has declined progressively over the first six months of the year, as issuance dropped sharply over the first quarter

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DEBT REPORT

EUROPEAN COVERED BONDS: BANKS DOMINATE ISSUANCE

Altered states: Australian bond issues 2011/2012

$m 17,500 15,000 12,500 10,000 7,500 5,000 2,500 0 Jan

Mar

May

Jul

Sep

Nov

Jan

2011 Senior unsecured

Govt. guaranteed

Mar

May

2012 Covered bonds

Suncorp covered Source: NAB Credit Research

from €26.6bn in January to €16.7bn in February (two months in which the two big Spanish banks were able to raise €7bn before the market closed on them once more) and to €10.4bn in March. Since then, there has been little more than a trickle of deals out of Germany, Norway, Finland and the UK, as the French market has gone quiet pending a final resolution of the uncertainties surrounding two of its big historical issuers, Dexma and CIF Europe. The market is still awaiting finalisation of the change in ownership at Dexma, under which 65% of its equity will transfer to CDC (35%), the French state (25%) and La Poste (5%) with the balance remaining with its current parent Dexia. Meanwhile 3CIF, which owns CIF Europe, is still looking for a buyer that will be able to ensure it has access to private-sector funding in future. The low level of activity has prompted some market commentators to forecast that covered-bond issuance from non-European countries is likely to exceed the total from Europe for the

first time this year. Given the influence that the UK and two Nordic issuers have had on the European total so far, it would certainly seem a fair bet to assume that issuance from outside the eurozone will be greater from that within it. “That looks like a distinct possibility,” says Tim Skeet, managing director in the financial institutions group within the debt capital markets division at Royal Bank of Scotland.“Even within Europe, the non-eurozone issuers appear to be doing a lot more than the euro countries.” Some covered-bond markets outside Europe are also certainly booming, with Australia perhaps the leading case in point. Since the Australian parliament passed legislation to allow its banks to issue the instruments on 13th October in 2011, the country’s four leading banks—ANZ Banking Group, Commonwealth Bank of Australia, Westpac, and National Australia Bank—have successfully issued more than $30bn [see table] in five different currencies, predominantly Australian dollars, US dollars, and euros. Smaller

Australian banks are expected to follow their example in the near future. Wayne Swan, the Australian Government’s Treasurer, told a conference in Sydney on June 14th that covered bonds had enabled Australia’s banks to extend the maturity of their debt and reduce dependence on short-term borrowing, a development he says has been “critical in helping out financial institutions weather heavy market turbulence”. Swan add that covered bonds had provided the banks with cheaper funding than they would have been able to access in the senior unsecured market and that spreads on the instruments had continued to tighten. Two days earlier, National Australia Bank sold $1.25bn of five-year bonds paying a coupon of 2%, compared with coupons ranging from 2.25% to 2.45% range on its three previous issues, all of which had the same fiveyear maturity. The Canadian market has also grown progressively since 2007 and is now more than twice the size of Australia’s with C$63bn of covered

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bonds currently outstanding. While there has been a marked pick-up in issuance since the beginning of last year, however, this seems certain to tail off—if only in the short term—once the Ottawa Parliament passes a new legislative framework for the instruments by the end of the third quarter of 2012 that will govern all future issuance from that point on. Not only will the issuing Canadian banks have to set up and register programmes that comply with the legislation for their future issues, but there will also be a fundamental change in the underlying credit characteristic of all bonds issued under the new regime. This is because the new law will not allow mortgages that are insured by either the public Canadian Mortgage and Housing Corporation or private insurers to be included anymore in covered-bond collateral pools. Such insured mortgages currently account for about 85% of the collateral supporting Canadian covered bonds— the notable exception being those that Royal Bank of Canada issues under its global contractual framework—and a government guarantee of payment covers 100% of loans backed by the CMHC and 90% of those that have private insurance. This has led the US investors who have bought most of the Canadian issues over the past five years on the American 144a market to view the assets as a quasi-sovereign risk that offers a valuable pick-up in yield over government debt of the same maturity. “In effect, you have had sovereign risk, as the collateral was insured by the Canadian state,” explains Skeet at RBS. “Now they will all become much more of a credit-driven product than a rates-driven product, and while the banks will still be able to issue, we don’t how the market will respond to this change in their underlying characteristics.” It seems inevitable that there will be a hiatus of at least a few months,

while investors get to grips with the different nature of the risk involved. “It’s going to be a different game, and there’s going to be a good degree of further assessment of them as an asset class,” confirms Langer at BNP Paribas. There is also bound to be an impact on pricing as a result of the heightened credit risk. Most analysts believe this will be in the range of 10bps to 20bps given the conservative lending criteria that govern Canadian mortgages. Meanwhile traders seem to think it may be more than that. One suggests that Canadian covered bonds in future were likely to trade closer to the senior unsecured debt of their issuers rather than 50bps to 60bps inside that level as they do at present. How the issuers respond to the change in their market remains to be seen. One option will be to follow the recent example of Royal Bank of Canada (RBC) and seek public registration with the US Securities and Exchange Commission (SEC) for their programmes. This would open up their offerings to a wider pool of US investors, as the bonds would become eligible for inclusion in indices such as the Barclays US Aggregate Bond Index. In its registration statement, RBC indicated it might issue $12bn of public registered bonds over the next three years. However, it may prove difficult for some of the Canadian banks with weaker balance sheets to meet the disclosure requirements of registration. What happens to the European market over the second half of the year, meanwhile, will obviously depend on the sovereign developments in the eurozone. Even if the EU politicians devise (and begin to implement) a solution that instills confidence in the bond markets, however, it is difficult to see how any of the banks in the peripheral countries will be able to resume issuance before well into 2013,

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

Tim Skeet, managing director in the financial institutions group within the debt capital markets division at Royal Bank of Scotland.

unless it involves selling bonds directly to the ECB. Assuming the sovereign situation does not deteriorate further, Langer at BNP Paribas nevertheless believes that the primary market could still hit €120bn for the year. This is because issuers in the core countries— Germany, the Nordics, the UK, the Netherlands and possibly France— will look to put longer-term funding in place as part of the LTRO money approaches a two-year horizon. It is unlikely that issuance outside of Europe will exceed that figure, given the inevitable curb that is going to apply to the Canadian market. However, a continued failure on the part of the EU’s politicians to come up with a credible fix for the sovereign woes in the eurozone could yet see the traditional markets for covered bonds issue less than their much more recent rivals for the first time in history. I

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DEBT REPORT

HIGH ALERT ON HIGH YIELD DEBT

HIGH YIELD MARKET: FINDING FIXED-INCOME FIREPOWER With Fed liquidity helping to drive rates in competing asset classes lower, fixed-income mavens have been understandably buoyed by the comparatively attractive risk-adjusted returns of high-yield corporate bonds. Despite consistently strong credit fundamentals, however, the persistence of worrisome global-macro volatility will likely keep high-yield investors on alert throughout the second half of the year. From Boston, Dave Simons reports. HILE MANY SEGMENTS of the bond market have struggled in the face of plummeting interest rates, one area that has been increasingly attractive to income investors has been high yield. Unlike 2011 which saw long-term treasuries outperform US corporate high yield by a six-to-one margin (according to figures from Barclays Capital), the global high-yield market began the current year in top form, with portions of the sector topping 8% as of late May. With corporations de-leveraging and balance sheets improving, high-yield fundamentals appear to be sound (and include a record low default rate), while new issuance has been largely limited to extending maturities and boosting liquidity. Though price action is typically impacted by global-macro volatility concerns (particularly with respect to the situation in Europe), the sector’s aggregate yield has advanced approximately 100 basis points since the start of the year, which could help attract even more investors going forward. Accordingly, many observers remain unusually bullish toward high yield corporate bonds and their attractive risk-adjusted returns, and believe these investments will be aided by the central-banking pro-growth monetary policy of the US and EU.

Credit fundamentals remain reasonably healthy across most sectors, particularly within the US and developed areas, affirms David Leduc, chief investment officer of Standish Mellon Asset Management’s active fixed income division. “We have been a bit lighter on energy given the recent fluctuation in oil prices and other concerns,” says Leduc, “however on balance we’ve liked what we’ve seen.” Earnings have been strong, says Leduc, and the vast majority of companies have been able to secure financing at historically favorable terms, giving them greater flexibility. As one would expect, the top end of the yield curve has been shaped for the most part by lower-rated issues, with some CCC-rated products approaching the 10% mark. Emerging-markets high yield has garnered significant interest, while European high yield continues to lead the pack on a global basis.“Euro spreads have been consistently higher,” says Leduc, “which helped the sector outperform during the first part of the year.” Navigating the financial space has been tricky, though, says Leduc. “There have been a lot of fallen angels particularly around European bank sub-debt, and we’ve tended to steer clear as a result.”Attractive opportunities in the US include various issues in the lease-finance sector; communica-

tions has had its share of good performers, and Standish Mellon has also benefited from positions in the US auto sector, particularly in light of recent upgrades. Even those with a reduced appetite for risk have seen returns in the vicinity of 4% or higher from certain higher-rated (BB and B) issues. “Some of the smaller names in Latin America and Asia have paid upwards of 60 basis points (bps) higher than their US counterparts, simply because they may have better credit metrics including lower leverage and higher interest coverage,” says Leduc. “While it might not sound like that big a deal, when you have 10year treasury bonds yielding less than two percent, it does mean something.” The perception that the Fed will keep rates at low, combined with the positive direction of corporate balance sheets, has helped boost comfort levels, says Brian Kinney, managing director at State Street Global Advisors (SSgA). As such, investors are increasingly viewing high yield as a plausible mechanism with which to diversify away from lower-paying government bonds, or to use high yield in part as a hedge against inflation. “Not only are clients moving into these types of asset classes in greater numbers, they are doing so in a way that they feel will provide them with the most liquidity,” says Kinney. Given the illiquidity licking that many an investor suffered pre-crisis, it’s not that surprising that the vehicle of choice for high-yield entry has often been exchange-traded funds. During the first quarter alone, roughly 25% to 30% of total high-yield inflows arrived via ETFs, with the majority directed toward State Street’s SPDR Barclays Capital High Yield Bond ETF as well as iShares’ iBoxx $ High Yield Corporate Bond ETF (the two funds currently account for an estimated $25bn combined). Because high-yield ETFs tend to invest in a smaller number of larger, more liquid issuers, there is a bit of a trade-off between liquidity and broad exposure when compared to institu-

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David Leduc, chief investment officer of Standish Mellon Asset Management’s active fixed income division. “We have been a bit lighter on energy given the recent fluctuation in oil prices and other concerns,” says Leduc, “however on balance we’ve liked what we’ve seen.” Photograph kindly supplied by Standish Mellon Asset Management, July 2012.

tional fixed-income high-yield benchmarks. It’s a sacrifice that many clients have been willing to make, says Kinney. “If you look at the performance of high-yield managers versus the index, on balance the returns haven’t been all that different,” says Kinney. “Particularly when you consider the importance of liquidity to investors nowadays, you can see why ETFs have become a legitimate choice for clients in support of high yield.” Despite the upward trend, managers have been loath to keep the pedal to the medal, given the perpetual ebbs and flows of economic developments both at home and abroad. In contrast to the buoyant first quarter that saw major fund flows into high yield, the economic realities of Q2 subsequently sucked some of the joy back out of the

markets; though still north of 5% on an aggregate basis (as of June 30th), corporate high-yield indices have since retraced much of the gains tacked on earlier in the year. “There could still be a fair amount of volatility into the foreseeable future,” says Leduc,“which is important to keep in mind, particularly when using high yield in accounts that may not be totally dedicated to that asset class. Things have clearly gotten a bit softer in the US during the second quarter, which isn’t all that surprising given the higher-than-average performance we saw during the previous quarter, nevertheless it does bear watching. But there are other things to look out for as well—China’s growth has been slower than the markets had previously expected, and of course Europe continues to struggle with the sovereign-debt problem. So global-growth concerns do remain at the forefront, and even though it’s not our view, should there be a more meaningful pullback in the US economy, that would certainly not be constructive for high yield. While we’re not necessarily building those expectations into our high-yield strategy, it is something we need to be cognisant of as we move forward.” Still, experts such as Kinney prefer to look at the bigger picture.“The fundamentals story, which is about corporations’ balance sheets, cash on hand, and access to the capital markets is still quite positive,” says Kinney. “If you forget about the spreads and just focus on the absolute yields, you see that corporations are in better shape than they’ve been in years. You also have a very strong technical story in the sense that there is a lot of liquidity in the system right now—and the indirect result of the Fed putting all of this money into the system is that absolute yields in other asset classes have been driven very low. So as a relative-value proposition high yield looks very attractive, particularly in a market that is awash in liquidity and other yields are at their historical lows.” Despite some suggestions that gov-

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

Brian Kinney, managing director at State Street Global Advisors (SSgA). Treasury bonds yielding less than 2%; it does mean something,” he says. The perception that the Fed will keep rates at low, combined with the positive direction of corporate balance sheets, has helped boost comfort levels, he adds. Photograph kindly supplied by SSgA, July 2012.

ernment regulation has lead to greater inefficiency and the potential for market dislocations, the improved transparency has allowed investors to breathe a bit easier whilst on the highyield hunt. “Say what you want about regulation—the fact of the matter is that investors have been able to look at corporate balance sheets and have a much better understanding of what’s actually behind them,” says Kinney. “The ability to analyse and subsequently invest in corporations is probably better than it’s ever been, and that is certainly one of the more positive aspects of the increased disclosure around what corporations are doing with their money. And the high-yield market has really been one of the key beneficiaries of that trend.” I

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DEBT REPORT

BONDS VERSUS EQUITY RETURNS

Comparing Bond and Equity total returns UK Bond vs. Equity returns (12M) – Equities have returned –2.6%, while bonds have returned +10.5%

1 Month (%)

3 Months (%)

115 110 4.9

FTSE UK Index

105 100

-2.4

95 90 85 80 Jun-2011

FTSE USA Index Aug-2011

Oct-2011

Dec-2011

FTSE UK

UK Bond

Feb-2012

Apr-2012

4.0

-2.8

Jun-2012

US Bond vs. Equity returns (12M) – Equities have returned 5.3%, while bonds have returned +9.6% FTSE -0.7 UK Bond

115

2.0

110 105 100 95 FTSE USA Bond

-0.3

2.5

85 80 Jun-2011

Aug-2011

Oct-2011

Dec-2011

FTSE US

US Bond

Feb-2012

Apr-2012

-1

Jun-2012

UK Bond vs. Equity returns (5Yr) – Bonds have returned 54.7%, while equities have returned 2.0%

-4 -3 -2 -1

12 Months (%)

5 Years (%)

170 150 FTSE UK Index

130

-2.6

2.0

110 90 70 50 Jun-2007

FTSE USA Index Jun-2008

Jun-2009 FTSE UK

Jun-2010

Jun-2011

5.3

2.2

Jun-2012

UK Bond

US Bond vs. Equity returns (5Yr) – Bonds have delivered 50.6%, compared with 2.2% from equities

10.5

FTSE UK Bond

160

54.7

140 120 100 FTSE USA Bond

9.6

50.6

60 40 Jun-2007

-5 Jun-2008

Jun-2009 FTSE US

Jun-2010

Jun-2011

Jun-2012

US Bond

Source: FTSE Analytics

J U LY / A U G U S T 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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INDEX REVIEW

MARKET RALLIES ON ECB LTRO EXTENSION

Of mice and men and bailouts With the sovereign debt crisis still in full swing it is becoming a moot point as to where you should place your money. Popular reflection throws up the usual suspects, gold, bunds, gilts, US T-bonds and so on, but one does begin to wonder whether this accepted order of security is actually right. We have seen haircuts taken on quite a bit of sovereign debt. However, were not for central banks still accepting such debt as collateral, the yields on certain national issuance would be considerably higher than they are at right now. Simon Denham, managing director of spread betting firm, Capital Spreads gives the bearish view. E HAVE THE curious situation of New Spanish issuance being bought by Spanish banks then repoed at favorable rates back into the ECB as collateral against debt taken out for this very purpose. The politicians have now agreed bailouts for the banks (but not for Spain itself) in the full knowledge that most of such bailout monies will be used for exactly the purposes described above. The question must be: how much more will northern Europe tolerate? As times get tougher in Greece, Spain and Italy more of the little business still being done is actually flowing into the black market, exacerbating already critical deficit problems. Forcing through stern excise adherence needs to be done when times are good not when many businesses are struggling for survival. This actually is the knub of the problem of the eurozone since its inception; Southern States previously accepted a generally deteriorating currency in exchange for a certain laxness in fiscal responsibility. Other the other hand, the much bigger North (economically) certainly did not. When the good times rolled all the politicians basked in the supposed genius of the new bloc studiously ignoring all of the ever more strident warnings of productivity dislocation

and failing dismally to impose any form of regional spending controls. The saying ‘your sins will find you out’ could hardly be more apposite in this situation as Germany and France (who were amongst the first to break the piously agreed deficit limitations back in 2003) are now requiring just such a response from the weaker members. Where then, does this leave equities? Well, oddly enough there is an argument to say that corporate assets might well become the safe haven investment of the future. The ability to move companies from one jurisdiction to another if the regulatory/tax burdens becomes too extreme, the general fiscal responsibility of the vast majority of executive boards, their generally low debt position and the high profit margins lead one to consider that equities and corporate bonds are a rather safer home than sovereign debt (of whichever nation). The major advantage of a sovereign nation has always been the accepted lore of their ability to raise taxes no matter what the economic situation. Even so, as we see from Spain and Italy’s recent tax receipt numbers—and even the UK over the past few months—this accepted truism may be starting to wear thin. People in general continue to lose any respect for their government’s ability to spend wisely. If then the average German, Finn or Dutchman decides

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

that bailing out Southern Europe is not his responsibility and we effectively move towards a Greek position on paying tax, or voting for parties that espouse a more isolationist policy, the general deficit situation may well deteriorate exponentially. All the while, returns on equities look to be attractive in the current interest rate environment. The FTSE 100 yield is over 4% as is the Stoxx 50 and the dividend adjusted price versus the cost of acquisition is now at historically high levels. Obviously, dividends might well be lowered over the coming years as growth looks more remote, but interest rates are likely to remain sub 1% as well, so even a reduction in payments might not be accompanied by a fall in price. Returns on stocks have remained remarkably stable despite the current political brouhaha. However, this might be the time that this ‘value’ was reappraised upwards to reflect falling returns elsewhere. For all of the truly awful news of the last six to twelve months the FTSE is still pretty much where it was this time last year. It might not take much in the way of good news to send us higher. Of course, this said, we do still need the politicians to make at least a couple of good choices! As ever ladies and gentlemen, place your bets! I

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FACE TO FACE

STUART HENDEL, GLOBAL HEAD, BAML, PRIME SERVICES

Stuart Hendel’s lugubrious humour belies a driven mind that built substantive prime broking franchises at both Morgan Stanley and UBS. Having last year joined Bank of America Merrill Lynch’s still-promising prime broking (PB) operations Hendel faced up to the dual task of sustaining the bank’s PB business in various press league tables and finding new service solutions for a business landscape in serious flux. It is not a simple task. The industry is still dominated by two US banking stalwarts but the sands are shifting and if the latest BAML win is anything to go by, the new team is on the right track. Does he have the right answers for today’s new investment dynamics? Lynn Strongin Dodds reports.

BAML prime services: great expectations AVING TAKEN OVER the helm of Bank of Americas global prime brokerage group a year ago, Stuart Hendel is peachy keen to win a seat at the top table. It won’t be easy. EuroHedge’s recent poll, shows Goldman Sachs and Morgan Stanley continued lock on the business in terms of mandates; 288 and 277 respectively. Meanwhile Credit Suisse (at 227) remains front runner on assets under management (AUM), extending the lead it has held onto since 2009 with its European client prime brokerage assets jumping from $67bn in 2010 to over $84bn last year. In contrast, Morgan Stanley saw the biggest drop in AUM last year, with its total European prime brokerage assets dropping from over $54bn to just under $44bn, due in large part to unpopularity of equity strategies (a mainstay of its business). Rival Goldman Sachs fared slightly better, suffering a slight fall in assets from $52bn to $48bn—because it caters to a more varied group of strategies. The same applies to JPMorgan, Barclays Capital and Newedge all of whom benefit from strength in depth in global macro, fixed income and futures hedge fund approaches. Bank of America Merrill Lynch (BAML) on the other hand is trailing this pack; with 84 mandates and $15.4bn in client assets; but it has prospects, evinced by the recent appointment as Paris-based hedge

Stuart Hendel, global head of BAML’s prime brokerage unit.

fund manager Bernheim, Dreyfus & Co’s second prime broker alongside Newedge. “Our goal is to be viewed as a top prime broker,” explains Stu Hendel, global head of BAML’s prime brokerage unit. “If that results in a doubling or tripling of market share, that will be an indirect benefit; but when hedge funds are looking for a prime broker we want to be included in that conversation and be seen as part of the solution.” Even so, Hendel is realistic about the time it might take the unit to reach that goal, but claims that so far, he is happy with the firm’s progress. The group has clinched a number of awards over the past year including being named as the most innovative investment bank for prime brokerage in the Banker 2011 poll as well as taking the number one

spot for capital introductions and in Europe in Global Custodian’s 2011 Prime Brokerage Survey. “It is not easy out there and we have a ways to go to catch up to our competitors,” he adds. “However, our aspirations are high and we are definitely moving in the right direction.” The first step involved new hires to bolster the team. Hendel made roughly 30 new strategic hires, which included two of Hendel’s former colleagues at UBS, namely Charlotte Burkeman, who was appointed co-head of EMEA prime brokerage and Jonathan Yalmokas who joined as head of US prime brokerage. Other recruits include Michael Terry who was brought in as global head of capital introduction, Daniel Katz, head of stock loan and structured marketing for EMEA, Ross McDougall, head of EMEA stock loan trading, Martin Donnelly, head of hedge fund consulting in Europe, and Simon Key, director in the synthetic equity sales team. The other change was a shift in client emphasis. Historically, the group focused on the long-only fund management community but Hendel decided to reach out to other hedge fund groups. This not only meant covering existing managers but also the fledgling ones hoping to make their mark. For bigger banks such as BAML, the relationship can prove to be a springboard to other services such as financing, trading as well as banking, a

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FACE TO FACE

STUART HENDEL, GLOBAL HEAD, BAML, PRIME SERVICES

keystone of Hendel’s strategy. In addition, BAML is keen to form a bond with emerging hedge fund managers and allow them to build loyalty as funds develop and mature. Hendel notes, “Our equity financing business was substantial prior to my joining but we decided to place more focus on hedge fund clients because we have a lot to add. We are a big trading and clearing firm and we were punching below our weight in the hedge fund space especially with new start-ups. Now [we] have a dedicated platform. We have a good team in place who have the right experience and have built the culture where we can develop the hedge fund business.” There’s a personal touch as well. The biggest challenge for prime brokers is supporting clients at a time when average hedge fund performance is down on the year and clients may not be making money for the next few quarters. “That’s just a really difficult environment and being a good prime breaker means being a good partner in that environment,” says Hendel. In general though, top of a hedge fund’s agenda when selecting a prime broker are the quality of operations as well as the price and availability of capital but they are also increasingly looking for value added services such research, consulting and capital introductions. Ironically, although the industry suffered in the wake of the financial crisis, the tougher impending regulatory climate has given birth to a new generation of hedge fund managers. The Dodd Frank Act and Volcker Rule precipitated a mass exodus from prop trading desks, while incumbent managers are also leaving their nests in search for greener pastures. The trend started to gather pace in 2010 when 1,184 funds made their debut, a hefty 51% hike from 2009 while 2011 showed robust activity although slightly down to 1,100 due to the eurozone crisis last summer, according to figures from the Hedge Fund Review. Numbers have since sharply rebounded in the first quarter of 2012 with launches

reaching heights not seen in the past five years. The total global tally was 304 in the first three months, narrowly eclipsing the 298 in the first quarter of last year for the highest quarterly total since the fourth quarter of 2007. In addition, the hedge fund industry overall enjoyed a bumper first quarter with investors allocating $16 bn on the back of the best performance start to a year since 2006, according to HFR. It is on target to beat 2011’s net $70bn of new capital, which was up from $55bn in 2010, and a reversal of the $286bn that flowed out from funds in the preceding two years. Despite the optimism, prime brokerage balances have become sticky again and it is not that easy to pry business away. This was not the case in the initial aftermath of the financial crisis when hedge funds turned away from the single provider and embraced the multi prime model. Today, they are reassessing that decision and are scaling back the numbers they use. According to TABB Group, in 2009, hedge funds with over $3bn in assets had an average of 4.8 prime brokers but that slipped to 3.9 in 2010 and to 2.9 brokers in 2011.“After the crisis, people took it to extremes and had several prime brokers but they are much more rationale today,” says Hendel. “The typical hedge fund will have around two to three prime brokers and the exceptions are those that have eight or nine. The single prime brokerage model is gone for good.” Winning new and retaining existing business is only one of the many challenges that BAML and its colleagues face. Low interest rates, reduced use of leverage and less hedge fund activity are squeezing revenues while new capital regulations are raising costs. In fact, some believe that Basel III with its new capital requirements on liquidity and leverage could be a game changer. It could put pressure on balance sheets, leaving less spare capital for banks to finance businesses. While there is talk of the major players passing down the higher costs to their hedge fund clients there is nothing concrete being done at

the moment. The smaller players though are feeling the heat and are questioning the value proposition of the prime brokerage model. Nomura, for example, retreated from the European arena earlier this year and others are expected to follow. Hendel says,“Things have changed dramatically since 2008. The funding of a prime broker’s balance sheet is much more front and centre. Every prime broker is now being asked about how they are going to finance collateral. As for regulation in the prime brokerage space, it has been argued that it is a positive factor because of the risks associated with the industry.” BAML may also be a beneficiary because it is rich in bank deposits and is one of the world’s largest capitalised banks. It not only has a strong balance sheet but also funding capacity. It is also ready for the challenge and has been developing a slew of higher margin products including research, White Papers, articles and webcasts that keep its clients up to date with the latest technical and regulatory developments. For example, in May the unit published a White Paper detailing the impact the changes of the Dodd-Frank Act will have on the private fund industry. The US Securities and Exchange Commission is creating a new regulatory filing for SEC registered investment advisors to hedge funds and other private funds: Form PF. The aim is to more actively monitor and track systemic risk across the private fund industry and BAML offers a detailed analysis of the changes. “Prime brokerage is a scale business and you need to put as much volume as you can through your pipes,” says Hendel. “If you don’t, your business will be short-lived. Although it is hard to differentiate in many areas because the business is arguably commoditised, we are focused on building a better mousetrap in terms of our value added services. Clients not only expect prime brokerage service but also access to the rest of the bank’s products and services.” I

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REAL ESTATE

US REITs SHINE DESPITE GLOBAL UNCERTAINTY

When the lights failed in the midst of NAREIT's annual Investor Forum at the New York Hilton in June the temptation to draw allusions with making property investments in the dark were inevitable. Even so, the power cut out could not disguise the fact that real estate investment trusts (REITs) have been a shining light in the US investment sector so far this year, with strong performance driven by growing optimism about the prospects for commercial real estate in the US in the second half of 2012. Mark Faithfull looks at the drivers of change. Photograph © Maxim Samasiuk /Dreamstime.com

US REITs look to a brighter future N SPITE OF lingering and persistent economic uncertainty in the US, which has recently translated into a worrying dip in domestic retail sales, REIT industry analysts and investors emerged from the industry’s annual REIT Week gathering in New York this summer with marked optimism about the outlook for commercial real estate in the second half of the year. The US REIT sector has raised $25.6bn in the year to date, with the most active sector retail having raised $6.9bn, followed by healthcare with $5bn. Key sectors including retail, multi-family residential, industrial and even CBD offices have shown encouraging signs of recovery and at the halfway point of the year, the FTSE NAREIT All REIT Total Returns Index was up 10.88%, after a blip in May when it hit its highest year level.

Meanwhile, a survey conducted by consulting specialist PwC and the not-for-profit research facility Urban Land Institute confirmed growing optimism, with survey participants forecasting “good-to-excellent” profits for 2012 up from 42% at the beginning of the year to 48% in the most recent report. Actually, the survey builds on a very positive 2011, when the total returns of listed US equity REITs—which is far larger than the relatively minor unlisted REIT sector—were approximately four times those of the broader stock market. The total return of the FTSE NAREIT All Equity REITs Index was up 8.28% for the year and the FTSE NAREIT All REITs Index, which includes both equity and mortgage REITs, was up 7.28%, compared with a 2.11% gain for the S&P 500.

The gain for equity REITs in 2011 came on top of a 27.95% jump in 2010 and a 27.99% increase in 2009—years in which the S&P 500 gained 15.06% and 26.46%, respectively. Much of REITs’ performance advantage has come from the stocks’ dividend payouts, since almost all of a REIT’s taxable income is paid to shareholders as dividends. The FTSE NAREIT All Equity REITs Index’s 8.28% total return in 2011 included a share price return of 4.32%, and the FTSE NAREIT All REITs Index’s 7.28% total return included a share-price return of 2.37%.“The strong, continuing income stream from REITs is an important component of the appeal of REIT shares for investors,” says NAREIT president and chief executive officer Steven Wechsler. “REIT dividends boost an investment portfolio’s per-

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US REITs SHINE DESPITE GLOBAL UNCERTAINTY

formance in good times and help insulate it from downside shocks in turbulent market conditions.” In all, REITs raised $51.3bn in public equity and debt in 2011, beating the previous 2006 record of $49bn. REITs have used the equity raised to manage their leverage and at December 31st last year, the listed US REIT industry’s ratio of debt divided by total market capitalisation stood at 38.6%, a little below its historical average and a relief to those concerned at leverage rates during the trough of the downturn. Indeed, the Americas region was the only segment of the global listed property market to deliver positive returns last year. On a dollar basis, the Americas sector of the FTSE EPRA/NAREIT Global Real Estate Index delivered a 3.99% total return for 2011, compared with negative total returns of 13.38% for Europe; 18.20% for the Middle East/Africa and 19.74% for Asia/Pacific.

Improved fundamentals Ratings agency Fitch Ratings believes that US equity REITs are likely to see improved fixed charge coverage and property fundamentals, while maintaining strong capital market access. It highlights opportunities for multifamily REITs, in particular, for the remainder of the year. Conversely, it believes that suburban office REITs will continue to face challenges. With continuing macro-economic uncertainty, it is no surprise that valueadded opportunities, new leasing strategies and the strategic disposal of non-core assets were the major themes discussed by the nation’s biggest real estate investment trusts at the National Association of Real Estate Investment Trust’s (NAREIT’s) annual investor forum. There is also an inevitable (and global) shift towards premium product and those with prime assets undoubtedly sit prettiest; the flight towards quality combined with a low level of supply, looks to be boding well for Class-A real estate holders. In order to sweat such assets, Chicago-based retail giant General

Retail REITs have attracted the most investment so far in 2012, according to NAREIT. Photograph kindly supplied by Macy’s, July 2012.

Growth Properties (GGP) is to focus on raising occupancy above the current 94.7% rate, while it plans to drop its US mall count from 135 to 125, while growing its Brazilian mall portfolio from 15 to 19 properties.“Our focus is about leasing, leasing, leasing,” says chief executive officer Sandeep Mathrani. GGP has revamped its senior management team and shed more than 1,000 employees since emerging from bankruptcy in 2010. It derives about 80% of its income from its 85 Class A malls.“We are trying to sell off our lower productive malls, which generally range in the $330 to $340 per sq ft sales range,”says Mathrani. Average sales for the trust’s portfolio are at $530 per sq ft. However, he also believes there is still scope for profit development with retail properties away from prime. “Someone asked me what I would do if I had $1bn to invest, and I said, it depends on the desired horizon,” he recalls.“If I’m looking at five years to pull out profit, I’d put it all in Class B malls which have a shorter return time, if it was longer term I’d go with core malls.” Meanwhile, Ohio-based DDR Corp, which owns 481 value-oriented shopping centres across 39 states was also upbeat about the state of retail, and claims that 90% of the portfolio is performing at Class A levels, with 94% average occupancy overall. The REIT is focusing on leasing its core properties while also disposing of non-core assets, such as the recent sale of an office portfolio in Maryland for $31.1m.“We have

been trying to sell the stuff that doesn’t belong,” says Dan Hurwitz, president and chief executive officer. “With that sale we are almost purely a shopping centre REIT, and we are going to move to sell more to become a purely prime centre REIT.” He feels the biggest issue for retail is that there is insufficient development to keep up with tenant growth desires and that such development is being held back by the gap between landlords’ rental expectations and how much retail tenants are prepared to pay. Because of this, he believes that owners will focus on investing in their existing real estate holdings, rather than constructing new centres. “It’s much wiser for a developer or owner to take capital and invest into existing assets and maximize the value of what you have,” he says. However, all is not well in the US retail sector. Retail sales in the US unexpectedly fell in May for a second consecutive month, prompting economists and analysts to cut their forecasts for economic growth as lukewarm job and income gains kept consumer confidence low. The 0.2% decrease matched April’s drop, Commerce Department figures from Washington reveal. Sales excluding car dealerships slumped by the largest margin for two years. Commentators have put the poor sales data down to the most subdued wage gains for a year and an unemployment rate running at a little above 8%, both of which, along with uncer-

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The Grand Canal Shoppes at Las Vegas are an iconic flagship for General Growth Properties (GGP), currently focusing on lifting occupancy rates. Photograph kindly supplied by GGP, July 2012.

tainty over the global economy, are taking their toll on consumer confidence. Federal Reserve policy makers are gathering this week to determine whether further stimulus is needed for the US economy to help fuel the threeyear expansion programme. The two month drop comes in sharp contrast to the preceding months when retail sales rose an average of 0.5% a month from September through to March. The latest data for chain-store sales in June is less hopeful. The Johnson Redbook index of weekly retail sales rose at just a 2.0% rate in the most recent figures for the week ended June 9th, down from a 3.3% rise the week before. This was the smallest gain in more than 14 months and monthto-date sales rose 2.5% over the last year and 0.6% relative to May. In the office sector, SL Green Realty Corp, New York City’s largest office landlord, says it is re-entering Manhattan’s Midtown South after selling off assets in the Manhattan sub-market in 2006 and 2007. Marking its return to the area, the REIT recently purchased 304 Park Avenue South for $135m and SL Green president Andrew Mathias says the company is planning more acquisitions in the Flatiron District and Gramercy Park: “We are actively looking for other opportunities. There is a very broad base of tenants looking for that Downtown/Midtown Southtype lifestyle.” The REIT has determined to focus away from buying projects at the circa $1,000 per square foot rate but instead

buildings in the $400 to $500 range, providing value-added opportunities for asset management.“The key is to buy in a location where you have a desirability advantage and then maximize your premium. There are lots of options out there and the key is just to make it so attractive to tenants,”he says. Douglas Linde, president of Bostonbased REIT Boston Properties, which owns and operates class A properties in five markets, including New York, Boston, Princeton, San Francisco and Washington DC, adds of demand: “There are tenants out looking for 100,000 sq ft blocks of space that need to make a decision by early 2013 or 2014.”

Industrial and multi-family One of the highlights among REITs has been the performance of the industrial sector.Year-to-date total returns for the sector were 13.63% and the multifamily sector has also witnessed a significant boost from the housing crisis, up 8.2% in 2012 alone. Ric Campo, chairman and chief executive officer of Camden Property Trust, says that his company is ramping up its development pipeline and maintains that he still sees room for growth. “The fundamentals in our business right now are incredible,” he says. “They’re about as good as they get right now. The position from a supply-and-demand perspective is really good.” William Bayless Jr, president and chief executive officer of Austin-based

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American Campus Communities, a student accommodation REIT worth $4.8bn, says privatisation of on-campus student housing is becoming more popular in the industry, even among major public institutions and the Ivy League. “It has become mainstream,” he insists.“Historically, the Ivy League and premier flagship institutions were very proud of their own internal abilities in terms of delivering real estate and capital assets. And that has evolved, given financing limitations. Even the wealthiest institutions have said, if there are companies that have a core competency that can help us deliver better market-based products more cost-effectively and more efficiently, then we should not waste our own precious dollars,” he adds. Virginia-based AvalonBay Communities, an equity REIT with 199 apartment communities containing nearly 60,000 units in nine states and Washington DC, says the REIT saw growth exceeding 10% for the second consecutive quarter in Q1 and is expecting $2bn in this cycle. Timothy Naughton, president and chief executive officer of AvalonBay, says the company will continue to focus on coastal markets as supply becomes limited and pricing increases. “We do believe there is a significant amount of pent-up demand,” he says. “There are about four million young adults living at home, just given long-term trends, and they will all form households.” However, for all the positive noises, the two major concerns affecting the outlook for commercial real estate continue to be the financial crisis in Europe and weak new jobs growth domestically. US REITs have bucked the bad news over the past 18 months and all the indications are that commercial real estate could enjoy a very positive 2012 when the final numbers are rolled. But there are enough known unknowns to send the jitters through even a resurgently confident market and the ongoing lurches across the eurozone especially could yet dent a very American comeback. I

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SECURITIES SERVICES

Growing complexity within the global financial markets continues to shape the securities services industry, as providers wrestle with an increasingly diversified field of portfolio-investment strategies ranging from long only, cash holdings to derivatives and other alternative approaches. All of this has greatly affected providers’ pricing matrix; today custody, for instance, is no longer the bargain-basement offering it once was. What does all this change mean for providers and clients? Who will bear the costs associated with new regulation, not to mention the system upgrades needed to ensure compliance? From Boston, Dave Simons reports.

CONVERTING SECURITIES SERVICES FOR NEW MARKET STRUCTURES A MAN WHO SELDOM minces words, Tim Keaney, vice chairman and chief executive officer, asset servicing, BNY Mellon, is particularly effusive when talk turns to regulatory compliance. Speaking at a panel discussion at the annual SIBOS conference in Toronto last fall, Keaney told the audience that providers such as BNY Mellon face a double-edge sword: having to cover the massive costs associated with compliance-based technology, while still being expected to outfit clients with all of the trappings of increased transparency. “Obviously I’m concerned about some of these regulatory initiatives,” notes Keaney,“only because I’m not totally sure that every one of them will ultimately benefit investors. There are some instances in which we have several different global agencies checking on the exact same process—which, in turn, can create a lot of additional work for custodians. Naturally, one has to wonder where the ultimate benefit lies in some areas.”

Dealing with the enormous array of challenges hasn’t gotten any easier in recent times, remarks Keaney.“There are myriad regulatory changes, which have taken up a tremendous amount of resources,” says Keaney. “Then you have clients which are struggling to pull in revenue, [and which, in turn] have been stretching boundaries through investments in alternative asset classes. Meanwhile, the industry as a whole has been profit-challenged in part due to the reduced performance in sectors such as FX and securities lending. The single biggest issue is the intersection of all of these different challenges—which helps explain why there isn’t a single asset servicer today that has profits moving in a positive trend compared to where they stood back in 20072008, ourselves included. It is really a market in which there is virtually zero tolerance for defects of any kind.” Furthermore says Keaney, industry providers “have been guilty of not really passing along enough of these new costs to investors on a regular basis. Ideally the imposition of

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Jack Klinck, executive vice president and global head of State Street’s Corporate Development & Global Relationship Management groups. “Hedge funds, managed accounts and private equity are all businesses that we had committed to very early on through the building out of very specific processing platforms,” he says. Photograph kindly supplied by State Street, July 2012.

Paul d’Ouville, global head of product management, Chicago-based Northern Trust, agrees that the confluence and level of intensity that has marked the post-Lehman cycle is unprecedented. “We’ve experienced a rapid shift in asset classes and investment strategies, and along with it the need to keep up with the increased speed of the markets,” says d’Ouville. Photograph kindly supplied by Northern Trust, July 2012.

these regulatory measures is to improve the resiliency of the network and restore investors’ faith in the markets—but that doesn’t mean that BNY Mellon shareholders as well as those of our peers should have to bear the costs for that improvement exclusively; which is why we are now really focused on sharing some of these costs.” To this end, BNY Mellon has begun re-negotiating certain client contracts to help absorb some of the financial impact of regulations as they affect client constituencies. “We are actively engaged in discussions with our clients so that they understand why we are passing these costs through,” says Keaney.“Of course right now we are still in the ‘spend mode’ and may take some time for us to get better at sharing the cost responsibility as it were, possibly upwards of three years as all of the different client contracts come up for renewal. But it is something we are fully committed to carrying out.”

one provider of alternative assets worldwide, seems to have seen it coming all along. It was a decade ago that the Bostonbased financial-services giant scooped up International Fund Services (IFS), a provider of alternative fund accounting and administration; State Street’s 2007 purchase of hedge-fund administrator Investors Financial Services Corp (IFIN), as well as its subsequent acquisition of Palmeri Fund Administrators (PFA), a New Jersey-based provider of fund administration services to the private equity industry, continues to work to the company’s advantage. “Hedge funds, managed accounts and private equity are all businesses that we had committed to very early on through the building out of very specific processing platforms,” says Jack Klinck, executive vice president and global head of State Street’s Corporate Development & Global Relationship Management groups,“mainly because we were quick to recognise those asset classes were quite different from the long-only, exchange-traded type of product. And we’re continuing to make major investments in that space on a global basis.” This investment has taken place, despite the fact that the economics aren’t nearly what they were back when State Street went on its initial buying spree.“Like everyone else, we’re seeing pressure on revenues as the markets continue to move sideways and interest rates remain low,” explains Klinck. To reap the benefits of these scale businesses, State Street has worked to streamline its back and middle offices and systems, and has plowed the savings into newer business opportunities such as derivatives clearing, as well as helping hedge-fund clients gather data required under the newly issued Form PF.“It is an ongoing process,” adds Klinck, “you cut where you can, then you quickly reinvest.” The potential for significant revenue to emerge from these new sources means that it’s not all doom and gloom out there, adds Klinck. Christopher McChesney, senior vice president, Brown

Reasons to be cheerful With many defined-benefits plans looking to close liability gaps—and with enthusiasm for equities still relatively muted—it is no surprise that investors continue to plunder opportunities in a wide range of alternative options, from real estate and private equity to hedge funds, commodities and more. The ongoing reliance on these strategies has been a major source of optimism for the likes of Keaney and his cohorts. “The commodities sector has traditionally been a strong area for us, and we’ve seen a very significant flow into commodities-based exchange-traded funds of late,” says Keaney. “Because they are backed by the physical assets, we feel that the ETF model serves as an excellent gateway to this market.”Having launched the first long-short, active and commodities-based ETFs, BNY Mellon is able to navigate this potentially complex market carefully and with authority, says Keaney. If the strength of the alternative-reallocation trend has taken some by surprise, State Street, currently the number

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SECURITIES SERVICES

Tim Keaney, vice chairman and chief executive officer, asset servicing, BNY Mellon. “Obviously I’m concerned about some of these regulatory initiatives,” notes Keaney, “only because I’m not totally sure that every one of them will ultimately benefit investors. Photograph kindly supplied by BNY Mellon, July 2012.

Nick Rudenstine, global head of investor services for JP Morgan’s Worldwide Securities Services division (WSS). “Though capital is harder to come by in times like these, we’re fortunate in that we’ve been able to continue to invest through the cycle,” says Rudenstine. Photograph kindly supplied by JP Morgan, July 2012.

Brothers Harriman, sees an ongoing convergence between traditional and alternative managers, funds, and investment strategies. Investor demand and new regulations continue to reshape the markets, and the result has been an influx of newer alternative mutual funds and private-equity products with high concentrations in fixed income and listed equities. “For many of the largest global asset gatherers and their service providers, these hybrid products represent an increasingly strategic area of focus,” says McChesney, “one that requires specialisation and investment in technology and processes that support the complex operations of private and public alternative funds.”

Securities Services division (WSS). “Though capital is harder to come by in times like these, we’re fortunate in that we’ve been able to continue to invest through the cycle,” says Rudenstine. “It’s our expectation that these programs will pay significant dividends in terms of what we are able to deliver to our clients, and hopefully help us stay a step ahead of the markets.” The derivatives landscape has been rapidly evolving as a result of Dodd-Frank and similar measures, and is likely to lead to a much stronger reliance on collateral-management services.“Through the combination of WSS and a full-service global investment bank, derivatives is certainly one area where we feel we are uniquely positioned to serve clients in terms of OTC derivatives structuring, execution, clearing, settlement, life-cycle management and more,”says Rudenstine. “No one else can provide that kind of integrated offering.” Paul d’Ouville, global head of product management, Chicago-based Northern Trust, agrees that the confluence and level of intensity that has marked the post-Lehman cycle is unprecedented. “We’ve experienced a rapid shift in asset classes and investment strategies, and along with it the need to keep up with the increased speed of the markets,” says d’Ouville.“Clients require support in all of these areas— so as a provider, the challenge is to manage all of this complexity and change occurring along a number of different dimensions, and all at the same time.” Like others, Northern Trust has worked to reduce the cost of delivering services in part through the standardisation of industry utilities. Decision support for clients has also risen to the fore, as have services around risk management and governance, as well as accounting and tax solutions. In short, it’s no longer all about the provision of safekeeping and transaction-processing services that have historically been

Technology remains tops Even with the downward pressure on revenues, asset servicers have still set aside a generous amount of technology based investment capital in order to keep up with client demand. “Clients have had an insatiable appetite for new asset classes, and are looking to us to provide them with an integrated set of services that can match the sophistication of these products,”says Keaney. BNY Mellon devotes an estimated $1.4bn on technology spend, with more than half going to Keaney’s division.“From regulatory compliance to lowering fixed costs through core-process re-engineering—all of it requires massive infusions of technology capital,” he says. The silver lining? By addressing these issues through technology,“we substantial lower our risk at the same time. So it’s not all bad news,” he adds. Regulatory complexity, along with a more elaborate assetclass menu, has led to greater emphasis on automated platforms and capabilities, adds Nick Rudenstine, global head of investor services for JP Morgan’s Worldwide

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the bread-and-butter of the custody business. “Not only is the cost structure associated with all of these new services higher than before, clients’ informational needs have also risen at the same time,” says d’Ouville. As a leading global custodian, Northern Trust has been able to leverage its unique position within the information food chain in order to more effectively meet the informational needs of its clients. For instance, Northern Trust has been able to provide insurance clients with guidance around Solvency II, particularly when the relevant information isn’t as readily available.“With respect to the asset-portfolio side, we can supply things like risk analytics and other services that insurers need to get up to speed with that part of the legislation,” says d’Ouville. From his standpoint, Klinck sees the opportunities outweighing the challenges.“One area that we have really been focused on is enhancing functions and compliance needs that are derived from data gathering,” says Klinck. “For instance, when you look at Form PF it’s really about how to answer all of these different questions, using pieces of information that we already have on hand by virtue of the accounting and custody work we perform on behalf of our clients.” The fact of the matter is that a lot of regulatory requests are data-oriented—regulators are trying to determine what might cause systemic risk, the events that can lead to toobig-to-fail scenarios, and other undesirable outcomes. “It’s the kind of information that we can easily provide,” says Klinck, “simply because of our position as a custodian and fund administrator. So what it really comes down to is how we can fully leverage our skills as a data aggregator, using software and tools to help our clients get in line with all of these regulatory and compliance burdens, all the while transforming our back office using the cloud and automation to create a far more efficient business model, rather than actually reducing the size of the business model.”

The waiting game This month, Dodd-Frank—initially considered the touchstone for the regulatory reform movement—marks its second anniversary, yet by some estimates barely one-fourth of its initiatives have been implemented to date. Klinck views these kinds of extended rulemaking timelines as one of the key challenges for providers going forward. “You think of the amount of time, energy and resources that have been devoted to these projects—not just DoddFrank and Volcker but foreign-based measures [such as] AIMFD and FATCA—and you suddenly realise that this has become a real marathon,” says Klinck. Not only is the list of pending regulations a mile long, but often the uncertainty regarding the shape and direction of these incoming rules means that in many instances asset servicing providers are having to take either best guess positions over likely outcomes, or in extreme cases sit back and wait. Providers acknowledge, it is a testing period. As Klinck explains:“ It’s not like we can go to our programmers right now with a map of Volcker and have them build us a

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Christopher McChesney, senior vice president, Brown Brothers Harriman. McChesney thinks there is noticeable convergence between traditional and alternative managers, funds, and investment strategies. “For many of the largest global asset gatherers and their service providers, these hybrid products represent an increasingly strategic area of focus,” says McChesney. Photograph kindly supplied by Brown Brothers Harriman, July 2012.

system to match—because the fact of the matter is we don’t really know what it is going to look like. Although we wholeheartedly endorse many of these rules and consider them necessary to bring stability to the industry, it really hasn’t helped to have this cloud of uncertainty hanging over our heads; which is why we’re really hoping for a speedy resolution to some of these initiatives.” “If what ultimately appears is radically different from what we’ve anticipated and forces providers to revamp systems within a short period, I suppose that could be problematic for the industry,”acknowledges JP Morgan’s Rudenstine.“But frankly, I don’t believe we’ll find ourselves in that kind of situation, because in many instances regulators already have a good understanding of what can be accomplished within a reasonable timeframe, and if not they’ve been working with the industry so they can get a clearer picture. Sure, we would like to have these things clarified as quickly as possible, and I think that regulators would as well—but in the meantime, it’s not like it’s been causing us any real problems.” Although the list of demands coming from both investors and regulators may have escalated with the global push for operational transparency, the bottom line is that clients ultimately want their providers to remain profitable. “Our ability to re-invest in the business ultimately affects the well-being of our client base,” says d’Ouville. “While there may be clients who may want to consider handling certain services themselves, by and large the more sophisticated investors understand that having a dedicated partner is more efficient and cost-effective in the long run. So it has made for an interesting dynamic, to say the least.” I

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COMPANY PROFILE: ACTIVISION BLIZZARD

When Billy Kotick merged Activision with Vivendi Games in a deal valued at nearly $19bn, he created what would soon become the world’s largest and most profitable independent publisher of video games, with studios and customers in the US, Europe and Asia. One of its titles generated sales of $1bn in just 16 days, another has more than 10m paid subscribers worldwide, and a third sold 6.3m copies in its first week. This and more was achieved without a dollar of long-term debt and while buying back stock and paying cash dividends. But, reports Art Detman from California, the powerhouse that Billy built takes nothing for granted.

FIGHTING ON ALL FRONTS OBERT A KOTICK is no stranger to hard times. In 1991, when he was 27, he joined Activision as chief executive, rescued it from bankruptcy, and steadily built it into the industry’s leader. When Vivendi, the French media giant with a major gaming operation, came knocking in 2008, he accepted an offer that gave it 52% of the combined company, which included Vivendi’s Blizzard Entertainment studio. The combination seemed perfect. Activision, based in the Los Angeles seaside suburb of Santa Monica, was a major force in games sold on DVDs in stores and played on consoles (Sony’s PlayStation, for example) or on personal computers. Blizzard, based not far away in Orange County,

was the leader in massively multiplayer online role-playing games—MMOs for short—that were downloaded from the Internet and paid for through monthly subscriptions. Alas, the July 2008 timing could hardly have been worse. In September, at the onset of the holiday season when video game sales peak, Lehman Brothers went bust; the ensuing financial crisis brought on the New Great Recession. For 2008, the new Activision Blizzard (ATVI) had sales of only $3bn, an anaemic operating margin of 8.1%, and a net loss of $107m. Kotick reduced headcount and dropped slow-selling titles, but he kept the company’s core capabilities intact, and results improved steadily. Last year, earnings were more than $1bn on sales of $4.75bn. The operating margin was 31%.

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“We have the highest operating margins in the games business,” says Dennis Durkin, who joined ATVI as chief financial officer in March after many years in Microsoft’s interactive entertainment operation. This profitability reflects Activision’s business model, which is to spend heavily to create and market high-content games in hopes of selling millions of units at premium prices. The company’s two biggest franchises are Call of Duty and World of Warcraft, both of which appeal mainly to men who seek a wonderful-world-of-war experience on computer screens. Call of Duty, a first-person shooter game, was developed in 2003 by an independent studio, which Activision acquired later that year. [Major gaming companies develop some titles internally, commission others from independent studios, and buy existing titles from one another.] According to consultant Jeremy Miller, head of JMG Inc, Call of Duty was created by the same team that developed the highly successful Medal of Honor game for Electronic Arts, another major games publisher. “That game was all about you, a lone soldier fighting the war. What Call of Duty did is have this new tagline: No Man Fights Alone. It was more of a Band of Brothers experience,”Miller explains, referring to the very successful television series about World War Two. Call of Duty’s customer base so resonated to the relationship that Activision used actors from the Band of Brothers to voice some of the characters in the sequel, released in 2005. Its success prompted Activision to release annual editions, much like sports games (Madden NFL and FIFA, for example, from Electronic Arts). It also inspired a new tagline: There’s a Soldier in All of Us. When Call of Duty 4 was launched, Activision gave each player an online identity. Players logged in, earned points, moved up level to level, and posted their gains on a message board—a form of boasting, really. It was, Miller observes, brilliant exploitation of the male ego. Highly effective TV ads supported the annual editions. Celebrities such as basketball star Kobe Bryant and movie actor Sam Worthington appeared in spots not as endorsers but as game players.“Now, there was a brand value associated with Call of Duty, and that was swagger,” Miller says. By the end of last year, Activision had grown the Call of Duty franchise every year for eight years running. Call of Duty: Modern Warfare 3 was the best-selling game in the US in 2011, selling 20m units. It reached the billion-dollar mark in just 16 days, surpassing the strong results of both the 2010 and 2009 editions.“Call of Duty had the largest entertainment launch in history,”says Durkin. He doesn’t mean the largest video game launch. He means the largest of any entertainment product, including the Harry Potter movies. Since 2003, Call of Duty has sold 120m units. The current retail price is about $60, but many gamers also download an upgrade for $50 a year.“About 30m to 40m people play Call of Duty every month across the various products that we have released over the past three or four years,”says Durkin. Whereas Call of Duty is an Activision Publishing product, World of Warcraft is a Blizzard Entertainment creation.“World of Warcraft is the most successful MMO of all time by a factor of more than two,”explains Michael Pachter, an analyst

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with Wedbush Securities, the privately held research and investment firm. Each month more than 10m gamers throughout the world go online to play. Their average subscription rate is $10, although in the US it is nearer $15. Last year, in time for Christmas, Activision released Skylanders Spyro’s Adventures, a children’s title that uses toys that are interactive with the game. “We develop and design the toys ourselves, do all of the supply chain work, and outsource the manufacturing,” Durkin says. In six months Spyro’s Adventures’ sales reached $300m, and Durkin says the company hopes the title will be its next billion-dollar franchise. Just a few months ago Activision followed up with Skylanders Car Patrol, which can be played on mobile devices. In May Activision launched Diablo III, a Blizzard franchise. “It was the biggest PC launch of all time,”Durkin says,“and sold 6.3m units in just the first week.” Not every title is a hit, of course, and even some that are fade after time. For example, Guitar Hero was a big seller for Activision but has been retired, at least temporarily. Activision does its share of games tied to movies, such as Transformers and The Amazing Spider-Man, but success at the box office doesn’t always carry over into the game market. “It used to be that if you had just a great brand, people would buy it,” Durkin says.“But now brand alone is not enough to bring consumers to the table.You really have to create unique game-playing experiences.”

Rough patch The fact is that, despite its record-setting results with the latest Call of Duty and Diablo title, Activision Blizzard, like the rest of the video gaming industry, has hit a rough patch in the road. Sales have softened, and in February 600 employees got pink slips (the company still has 7,000 on the payroll). It appears that ATVI revenues for 2012 will be around $4.6bn, down around 3%. One reason is the weak economy, both in America and Europe [nearly half of Activision’s sales are outside the US]. Another and probably more important reason is that all of the major consoles are nearing the end of their life cycles and will soon be replaced by new models. Many gamers appear willing to wait for titles created specifically for the new consoles. Activision has unique challenges as well. Just two franchises—Call of Duty and World of Warcraft—account for around 60% of its revenues and, believes Wedbush’s Pachter, perhaps all of the profits. These two properties are virtually unmatched in their popularity and longevity, and provide a sharp contrast to the company’s many second-tier titles that have struggled in the marketplace. If Skylanders Spyro’s Adventures and Diablo III prove to be the next blockbusters, it will be welcome news. Meanwhile, Blizzard is readying a new major MMO game, although Durkin isn’t willing to commit to a launch date. There are other clouds on the horizon.“The foremost is the rise of mobile, social and free-to-play gaming,” says Scott Steinberg, head of the consulting firm TechSavvy Global.

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COMPANY PROFILE: ACTIVISION BLIZZARD

“Consoles and $60 retail games are suddenly competing with games that are available free or at very little cost on smartphones, tablets, and web browsers. So Activision is not competing simply on price, value and quality. They are competing for the end-user’s time. “Blizzard has made its money on the subscription model,” Steinberg continues. “And many of its competitors, from Sony Online to Turbine, have largely switched to free-to-play models. Instead of charging, say, $13 a month for a subscription, they actually make more money by letting millions of people play for free and monetising roughly 2% or 3% of those players, many of whom will pay quite a bit more in any given year than they would for a boxed retail product or a monthly subscription.”The money comes from micro transactions—online upgrades that go for a dollar or two, maybe three. A small number of players will purchase many of these upgrades over time. The mobile market has its own challenges. Small screens don’t lend themselves well to the epic stories played in Call of Duty or World of Warcraft, and on a tablet or smartphone even $9.99 may be too high a price for a game (let alone the $60 that Activision’s biggest titles command). But Activision is moving ahead in this market in partnership with Flurry Analytics.“They’re very smart about doing their homework,” Steinberg says. Another area where Activision is weak is social games, which can be defined as games that involve building something instead of destroying it. CityVille from Zynga, which has 40m monthly players, is one example. Does the rise of mobile, social and free-to-play games threaten Activision’s long-term prospects? After all, the company’s success has depended on creating ever-morecomplex games that require a major commitment from players in terms of time and money. They also entail major development costs. Edward Woo, an analyst with Ascendiant Capital Markets, estimates it would take $50m to replicate Call of Duty today, and at least $100m to bring another World of Warcraft to market. But mobile, social and free-to-play games aren’t likely to support that kind of investment. “There hasn’t been a lot of money in those games,” notes Durkin. He’s right. Zynga, for example, last year lost $404m on sales of $1.14bn, and in recent months its stock price has fallen by half. Even so, holding fast to even a proven business model has its own hazards. Leading-edge online companies like AOL, MySpace and Yahoo! are now laggards. Look back farther and you see that MGM was once Hollywood’s mightiest studio, and RCA Victor and Columbia dominated recorded music. “There’s a ton of change in our markets,”Durkin concedes. “People are changing their patterns in terms of mobile and how they spend time on line and how they consume media. There are going to be winners and losers, and I believe that the companies that have the most innovation and the biggest franchises will have the biggest opportunity for success in this new world.” He means, of course, that Activision will prevail, prosper and grow. After all, it has $3bn in working capital and

BLIZZARD ENTERTAINMENT HIGHLIGHTS FOR 2012 Diablo III Game was launched in May 15th, with more than 8,000 retailers hosting midnight openings. Over 2m players participated in the beta, with worldwide record preorders, including 1.2m World of Warcraft Annual Pass* subscribers. World of Warcraft: Mists of Pandaria 1.2m players signed up for World of Warcraft Annual Pass (as of May 1st 2012). Beta test feedback has been positive. StarCraft II: Heart of the Swarm Testing Arcade update and collaborating with map creators in the community to incorporate new functionality. Planning to launch the new Arcade in coming months. eSports The firm announced a StarCraft II: Heart of the Swarm beta sneak peek at Major League Gaming’s Spring Championship at the Anaheim Convention Center, June 8th to June 10th. Korea eSports Association and Ongamenet, a cable TV station, will create new StarCraft II leagues in Korea. Games Pipeline Multiple title launches expected in 2012; work continues on the unannounced MMORPG. Source: Q1202

arguably the industry’s most talented game designers, a combination of resources that should enable the company to create the next Call of Duty or World of Warcraft. The question is, of course, how much longer will there be a big market for these super games? By the time that question is answered, Vivendi may be out of the picture. The company is said to be seeking a buyer for its controlling interest. “Vivendi would love to keep Activision,” says Ed Woo. “But they believe that Activision’s stock price is significantly below what Vivendi believes it should be that it does not reflect the true value of the business.” A movie studio like Disney, Fox or Warner Bros. might be the logical new owner. “Activision has some of the most successful gaming properties in the business,” says Scott Steinberg. “It has a back catalog, but what it doesn’t have is a content library that it can exploit.” The movie studios do. Whereas Vivendi has been a hands-off owner, a Hollywood studio will likely be very involved. For Billy Kotick—master of the video game universe—it would be his latest and perhaps greatest challenge. I

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US TRADING ROUNDTABLE

LESSONS FROM MARKET CHANGE:

WHO WINS, WHO LOSES IN THE NEW TRADING PARADIGM?

Photograph © FTSE Global Markets, supplied July 2012.

Attendees

Supported by:

(From left to right) CURT ENGLER, quant and automated trading, JPMorgan Asset Management JOSE MARQUES, global head of electronic equity trading, Deutsche Bank ROB KAROFSKY, global head of trading at Alliance Bernstein MIRANDA MIZEN, head of equities research, TABB group FRANCESCA CARNEVALE, director, FTSE Global Markets

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TRADING ROUNDTABLE

WORKING IN A NEW PARADIGM & HOW BEST TO FIND LIQUIDITY JOSE MARQUES, GLOBAL HEAD OF ELECTRONIC EQUITY TRADING, DEUTSCHE BANK: The markets today are as challenging as I’ve ever seen in my career, not just from a pure execution and quality of execution perspective, but in really understanding the liquidity landscape and how to navigate it in a way that allows my clients to really exploit the limited liquidity resources that are out there, and how as a broker we can create value for them in that process. CURT ENGLER, HEAD OF QUANTITATIVE AND AUTOMATED TRADING, JPMORGAN ASSET MANAGEMENT: We are focused on optimising the trading process. That includes understanding the portfolio manager’s process and researching the trade data which allows us to automate a significant amount of our flow. That also means we have to monitor both the macro and micro segments of the market, to better understand what is going on with volume and volatility. Many of our automated strategies are in house algorithms that we can tune to specific portfolio managers as well as market conditions. For us business is now about having to be on top of the portfolio manager’s process, the characteristics of the orders, and the market conditions. ROB KAROFSKY, GLOBAL HEAD OF TRADING AT ALLIANCE BERNSTEIN: There is also another element in play: that is, the trader is getting closer to the investment decision-making process in a world where liquidity has become a scarce resource. The ability to react quickly is dependent upon understanding which way your portfolio manager is going to zig and which they’re going to zag. It is about taking the trading and execution business directly into the investment process; and this trend is relevant and essential because of the difficulty of finding liquidity. In a highly volatile and highly correlated environment there’s a tremendous amount of alpha that can be extracted through the trading desk. We are in a new paradigm and I don’t think that it is necessarily cyclical. Certainly, it is unlikely that we will revert back to the 9bn shares a day that we used to trade in the United States. In part, this is because everything we’re living through now is a by-product of the two crises that have occurred during the last three or four years. In part, it is a function of a trend where equities as an investible asset class are out of favour. Year to date, we have seen in excess of $70bn in outflows and it is a continuing theme and this money is moving into fixed income. When you have global monetary authorities telling you that rates will be low through 2014, it’s an issue that will keep us out of equilibrium for some period of time, whether it’s artificial or not. Moreover, it is destructive to the liquidity in the equity markets. For that reason, I don’t believe that liquidity in the marketplace (and hence volumes) will pick up until money begins to flow back into the equity asset class. That will only happen when rates, particularly short rates, begin to rise and force people out of fixed income and into equities.

MIRANDA MIZEN, HEAD OF EQUITIES RESEARCH, TABB GROUP: Our role is to look across the industry as objective observers. We spend an enormous amount of time talking to the market practitioners that make up the marketplace. We see a huge amount of changes are both currently visible and some that may happen that will change the makeup of the market and liquidity patterns. Regulation and technology have both become equally challengers and facilitators in the market and are both developing at a very fast pace but the hunt for liquidity is not getting any easier. ROB KAROFSKY: One more thing: if you look over the last several years, the absence of retail in equity trading has significantly exacerbated the situation. If the retail component is gone and if you’re talking about liquidity between one large asset manager selling and another buying, it is like ships passing in the night. You then are dependent upon finding that other large institutional holder on the other side of the trade if you will; it makes the problem of sourcing liquidity that much more complicated. So once again I say, we are living in a new paradigm and this paradigm will remain for the next couple of years, at least. JOSE MARQUES: There has been a lot of press over the last couple of years about the role of liquidity providers in the market. There used to be specialists who were clearly identifiable. You could walk down to the exchange and if you didn’t like the other side of a transaction, you could challenge the person directly. Nowadays, liquidity has become much more anonymous. When we talk about liquidity, it really is about the ability to convert cash into securities and securities back into cash and how quickly and how fungible that process is. In that regard, the role of the liquidity provider is greatly misunderstood in today’s marketplace. When you look closely at the dynamics of what’s going on, a buy side to buy side natural match happens with such small frequency that it’s almost de minimus. If there really was a buy side to buy side relationship then platforms such as Liquidnet would have huge market share. In reality though, this does not happen, simply because if one buy side institution wants to sell, it doesn’t automatically mean that there is a buy side institution that is willing to buy. Instead there is an entire ecosystem of liquidity providers that have evolved in the marketplace and they collect a toll for their services. Having continuous liquidity has never been free and it is certainly not free today. What you see on the shortest horizons are the high frequency market makers, and they are intermediating those trades a couple hundred shares at a time and taking a tiny slice out of those trades. Next on the horizon are the statistical arbitrage traders, who are in fact intermediating the high frequency guys and they’ll take inventory and keep it in mid-air for anywhere between a few minutes to a few days. Then there are the slightly longer horizon players, which include the hedge fund community, which in turn will keep inventory in suspended animation until a long-term player on the other side shows up who perhaps wants to do the whole process in reverse. It is this ecosystem that provides the liquidity and ultimately intermediates a long-term buyer and a long-term seller, which can show up hours, days, weeks, even months

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Jose Marques, global head of electronic equity trading, Deutsche Bank. Photograph © FTSE Global Markets, supplied July 2012.

apart in time. Certainly, from a regulatory market structure perspective, we need to understand how this works. We need to know what the cost of this liquidity really is and what structures ultimately make the markets more efficient and maximise the amount of instantaneous liquidity available for everyone. One interesting point is that the very richness of equities as an asset class that drives the diversity the ecosystem which in turn delivers the tremendous amount of continuous liquidity we see. CURT ENGLER: We have had such an interesting period of a rather volatile macro environment; when volatility comes down, liquidity is going to come down. At the same time, we have had such deleveraging out of a lot of strategies that were called more intermediate term—as Jose explained— that everyone used to be leveraged a lot higher than they are, particularly as banks are also lowering their leverage ratios. Whether this really is or is not a new paradigm, I cannot say. I don’t know what the headlines are going to be tomorrow that might completely change this set up. ROB KAROFSKY: This is an interesting point, that volume and volatility are linked. Volatility goes up, and volumes obviously increase and as we have seen, a larger percentage of that increase is going into ETFs and not individual stocks. When (and if) we do get into a better paradigm where volumes pick up, we need to see that link between volumes and volatility break. Would you agree? We need to achieve healthy volumes without market volatility. CURT ENGLER: You would have a lot of happier people in the industry rather than the other way around. It is certainly better than the alternative where volatility spikes and volumes remain low; that’s a double whammy. ROB KAROFSKY: Actually, we do have that. CURT ENGLER: Liquidity can still be fleeting in the shortterm if you are too much of a liquidity demander and that’s going to lead to higher costs. If all else is equal, volumes stay the same and volatility goes up, leading to higher costs. So, if we could ever get that sweet spot where volatility stays relatively constant and volumes start picking up, then correspondingly trading costs should come down all else being equal and I would welcome that. The question of course hangs around how we make that happen. ROB KAROFSKY: As I look at the world, I see would look for the signal that assets (or money) are flowing into equity assets and equity risk premiums are coming down, which correlates with your comment about volatility. People will have to feel much more comfortable in the equity space and once that happens you can have volumes without the volatility. We would, in that instance, turn the corner. JOSE MARQUES: Another way of looking at this is correlation. In the current high correlation environment you’re seeing

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people coming into the market demanding macro equity exposure. But they come in one day and they leave the next day and, at the same time, you’re seeing a lot less of a stock selection process happening. So you get exactly what you see. MIRANDA MIZEN: Last year the combination of higher volatility and the higher volume also resulted in a higher percentage of high frequency trading. If we have lower level of volatility and if we see assets coming back into the market, we should see the participation rates of some of the participants in the market change proportionally. ROB KAROFSKY: Well, it increases the odds in a lower volatility environment of two ships hitting each other when they pass through at night. JOSE MARQUES: The data there is pretty straightforward. About 30% of liquidity is found within broker pools in general or dark venues overall.You see that in the TRF volumes for the US. The rest is found in the broad markets. The underlying question there seems to be: do we need 48 different dark pools and 17-plus lit venues? Clearly not. On the other hand, the technology has gotten cheap enough and robust enough that connectivity between venues is not the hurdle that it used to be and in some sense, it has gotten cheaper. One of the underlying benefits of our highly decentralised marketplace is a tremendous amount of robustness in our markets. It used to be front page news whenever NYSE had a system outage and stocks could not trade for a whole afternoon. When was the last time you saw a headline like that, aside from May 6th 2010? There have been real benefits to the fragmented structure, but like anything you can overdo it and there is a selection process underway. Even so, the costs are not outrageous; at least not for most participants.

MARKET EVOLUTION: HOW FAST & DEEP IS THE RATE OF CHANGE? FRANCESCA CARNEVALE: Miranda, has TABB Group undertaken any research that looks at how the overall market structure will look in a few years time? As Rob highlights there is a paradigm shift in play. Surely, that must test existing structures and institutions and firms to the limit. How might it play out over the long term? MIRANDA MIZEN: We have undertaken a number of big studies around this theme, talking to long only asset managers and hedge funds, both here and in Europe. In January this year, we talked to 51 hedge funds and found a perhaps surprising level of optimism in the market. Many were thankful last year was over as they had found that volatility around volumes was extremely testing. There was a certain relief they had managed to survive a brutal trading environment and ventured that (overall) this year would be better, that early election fever would reinvigorate the market and that commission wallets would increase. However, that was early in the year and as the months have passed, that optimism has not played out. There are a number of trends coming in play as a function of lower trading volume. Low commission wallets mean there is not always enough to go round and broker lists are

TRADING ROUNDTABLE

being scrutinized, especially as you look down the length of the tail. There is not a major change in commission concentration levels at the top. But brokers who are sitting on lists and haven’t seen order flow from their client for a year are very vulnerable and in some cases tails are being chopped quite aggressively. Asset managers are also re-examining some of the tools they’re using and how they want to access the market. If it’s obvious where liquidity is concentrating, the decision is how to interact with that liquidity. But especially in the dark, liquidity may be so scattered it’s hard to know if there’s another ship out there, let alone if it’s passing you in the dark. So there’s a constant demand for better tools such as those that combine block trading with algorithms and that can interact with the different types of liquidity, and duck and dive electronically in the market like the traders do. But tools aside, low volume markets and shifting liquidity patterns due to both trading styles and investment decisions require a re-think with regard to how to approach the market. We have this paradigm shift and although we all hope volumes will rise again, it doesn’t look likely in the short term, particularly in Europe where the outlook remains poor and the regulatory environment is undergoing a major upheaval. FRANCESCA CARNEVALE: Jose what is the role of the sell side in easing everyone’s pain? JOSE MARQUES: In today’s environment, the role between a broker and the buy side has turned back to the fundamental value propositions brokers traditionally have offered. In other words, if you ask: what is the role of the broker in the marketplace? It is to source and aggregate liquidity for the buy side and provide it to them in a cost effective way. By cost effective, I am not talking about commission rates; that’s really the total impact of trading. A good broker is going to deliver execution, and not leak information; a good broker is going to be able to provide you liquidity in whatever it is you’re looking for in the cheapest way possible. Then if he does it well, you’re going to reward him. Over the last couple of years, there’s been a lot of angst around the new electronic market structure and the problems this structure has created for participants that haven’t yet invested in the latest and fastest technology, whether that be co-location, or the whole techno-parlance of the new world. Ultimately, we have a pretty simple message to these folks, which is: if you don’t like your executions, get another broker. At the end of the day, the broker’s role is to provide technology and smart, intelligent execution, to control information and give clients a buffer on those hard to trade trades. If your broker is not effective, you must find someone who will move your business accordingly. CURT ENGLER: There’s a lot in this conversation to synthesise. I guess I’ll start by piggy-backing on two of the comments Jose made about the broker’s role and (as well) the trader’s job to understand the investment process better. Both those comments were spot on. Certainly, as markets evolve the buy side trader will increasingly be tasked with being more strategic in the whole investment process. In any case, it is incumbent on the buy side trader to better under-

Curt Engler, quant and automated trading, JPMorgan Asset Management. Photograph © FTSE Global Markets, supplied July 2012.

stand the importance of the overall investment strategy that determines his trades as well as to be more proactive with regard to sourcing liquidity so that, if one of those ships does show up, the buy side trade should to be able to filter that trade in a way that is better for the portfolio manager. On the electronic side, given that we make the effort to better understand the portfolio manager’s process—whether it is what factors they use for stock selection, or their portfolio construction criteria—and understanding that process to the point where the broker’s role is going to evolve further. I actually think the broker’s role will become more difficult and complex in future; particularly as technology is now one more level of disintermediation of the sell side to the point where we can now make all of our own order placements, rather than just placing it one scheduled algorithm and work on the basis of the anticipated outcome of that.

MARKET FRAGMENTATION: GET OVER IT OR UNDER IT? JOSE MARQUES: Execution and portfolio implementation costs have come down over the last ten years. Over the last six months, they’ve probably bottomed out and maybe ticked up a little bit because of t`he dramatic fall off in overall market volumes and liquidity. However, market structure changes have driven a great deal of that drop in terms of real trade implementation costs with tangible benefits to investors. FRANCESCA CARNEVALE: Hasn’t there been an attendant cost in terms of connectivity, technology, investment in new processes and linkages with brokers and trading venues? JOSE MARQUES: Collectively the sell side spends hundreds of millions of dollars to develop and maintain its technology, for sure. ROB KAROFSKY: As the world has become far more reliant and dependent on technology, both sides (and it is a relative spend) have had to spend on technology and become aware of measured tools and things like that. So that the explicit costs that Jose mentioned have been coming down and perhaps bottoming is true. Also, the costs of being able to navigate the 40-plus dark venues and 17 or so lit exchanges has also been an offsetting cost. JOSE MARQUES: Yes, costs elsewhere in the system have also emerged. TV cameras used to pan around the heavily populated floor of the New York Stock Exchange, where in the mid-1990s you could barely walk through the crowd. It’s a very different picture today and that is the very real impact technology has had. Of course, this has occurred at all levels through the markets and in the trading process. We used to

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have tens of thousands of people to clear trades. As an industry, those numbers have come down. There are efficiencies that have been extracted, even though the technology costs and people resourcing around technology have gone up considerably.

WHERE DO YOU FIND ADDED VALUE AS MARKETS CHANGE? MIRANDA MIZEN: A major area of differentiation that is being highlighted over the last six to twelve months is coverage. Take algorithms, the most commoditised area of trading.You often hear the buy side grumble there’s little real difference between many of them. In fact there is, both in terms of the algorithmic environment and liquidity accessed as well as in the surrounding services. It isn’t necessarily someone coming with a new algorithm that’s really going to make the difference; it may be the coverage person stopping by, taking off his jacket, sitting down with the client and talking about how they access the markets and talking through how they trade their orders, the kinds of algorithms they need and are comfortable using, how individual algorithms work with certain market conditions. Increasingly, coverage combines both elements of high touch and low touch services. A major factor is trust, because there’s no way in a highly volatile, fast-moving market that someone is going to use an algorithm if he doesn’t know how it performs and exactly what to expect. Partly this is a function of understanding both the market dynamics and the technology and having transaction cost analysis tools, but equally, there is also a level of human interaction, in terms of providing the knowledge to use those tools very efficiently. It’s the same on the high touch side; you have to be able to trust the person at the other end of the telephone if you’re doing a trade. The buy side is demanding greater insight into how the algorithms are working. Not everybody wants to look under the hood and know where the fan belt is, but in terms of order placement logic that Rob mentioned earlier, if the order is being exposed in the dark, where is it being exposed and to whom? In other words, I want to know where it traded, but I also want to know where it is going and what level of exposure goes with it. Who am I trading with and what is the quality of liquidity at the other end of the order that may help or not help my order flow? This transparency is partly coverage, partly product. Ultimately though, they are two halves of the same whole. CURT ENGLER: If the buy side is going to make the effort to understand what the portfolio manager’s process is (and that the technology is available) we are doing our fiduciary role to own the order execution process as well. We’re the ones putting the fixed tags in place, because we want this many shares placed at this location for this amount of time, for example. In this regard, the buy side has been the biggest winner on the transparency front to actually understand that logic as well as then mine any resulting analytical data for relevant analysis of orders. People may or may not want

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to get into that minutia, but once you do, you learn from how orders are placed at various venues, and where the margins are made; understanding that entire process is now integral to doing our job well. FRANCESCA CARNEVALE: Is that typical though of all buy side trading desks? Or, is that typical of large buy side trading desks of the magnitude of your firm, and that of Rob’s trading desk? It is easy for you, you have resources, and you are huge asset gatherers, are you not? CURT ENGLER: You are right, scale certainly plays into it. We traded $250bn last year and a basis point matters on that volume. If you’re a smaller asset manager there are likely different investment strategies and other business considerations involved. In that instance, the effort required may be too onerous or high a hurdle. Even so, technology is almost ubiquitous enough now and in that sense there is a really low entry level that will allow you to do some of these things quite easily. FRANCESCA CARNEVALE: Jose, in this environment and with that minute detail required, knowing your client very well indeed is vital to a successful business strategy, isn’t it? JOSE MARQUES: Absolutely, knowing your client as well as every detail of their trading processes and trading technology is essential. As Curt acknowledged, access to modern trading technology is very democratic, even for small buy side firms or even retail participants, due to the massive investments made by the sell side. The key is helping clients apply the appropriate technologies to their specific trading problems. It’s not all about speed either. Some of the most important technologies are all about quantitative processes, down to the microstructure level, involving how you place trades, how you read that order book, which venues you go to and when, and understanding the intention behind that order when it was sent. Moving up the value chain, one of the things that both Curt’s and Rob’s firms do extremely well is understand the alpha of the portfolio manager and how to modulate trading to maximize alpha capture. These are things that the sell side can absolutely provide for all clients and do so by modulating the behaviour of algorithms based on who’s trading on the other side and the portfolio manager’s intentions. This is becoming a very important part of the business because capturing a few extra mills here and there adds up to percentage points of incremental returns. FRANCESCA CARNEVALE: Rob, there’s probably not much any sell side trader can teach you. So where do you look for value-add from your sell side provider? ROB KAROFSKY: Actually, it is complicated navigating the marketplace. Both Curt and Jose mentioned basis point matters on a lot of notional trade and that’s absolutely true. It is how you capture that basis point. Plus, to me that’s the interesting part. It is not just being a liquidity provider versus taking liquidity when you’re executing electronically. Where the sell side truly helps us is in understanding when to trade with more urgency and understanding when to trade more slowly. It is taking advantage of liquidity when it comes to your doorstep and trying to understand where the alpha

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is embedded in your order flow if by definition if it is a value order and in that instance you should trade more slowly. It is about helping us understand the subtleties and complexion of the market. FRANCESCA CARNEVALE: Is that a conversation that happens before the trade or in real time? ROB KAROFSKY: It happens in real time and it is ongoing and it speaks directly to an initiative that many firms on the sell side are taking where they’re trying to combine both the electronic and high touch points and deliver something to clients that hasn’t necessarily been delivered up to this point. Now, you could argue that this has happened through daily dialogue in the past. However, there has been a sea-change; there is now a more concerted effort by the sell side to be part and parcel of the process. I am working slowly, trying to have minimal impact in a particular situation, but if something larger comes along, I am interested. It is about effectively combining those different approaches that people are attempting to achieve now. FRANCESCA CARNEVALE: Can you measure the efficacy of this approach in numerical terms? ROB KAROFSKY: It is difficult to capture 100% of the dialogue, the relationship that you have on a daily basis, but it shows up in your performance and we’re constantly evaluating how we’re doing. We evaluate it every day. And we can directly attribute it to brokers that help us achieve the numbers, whether it is through their trading pipes or whether it is through a piece of liquidity that comes through their high touch area. JOSE MARQUES: At the end of the day, realised portfolio performance matters. From the moment that a portfolio manager decides he wants to buy or sell a security, at that instant prevailing market prices are the most relevant benchmark. Often arrival price, the prevailing market price when the order is received by the sell side desk is used as a proxy. When you look at the newest and most creative ideas we have implemented, they are around creating opportunistic liquidity-seeking algorithms that really go after alpha directly and minimizing slippage to arrival price. When the liquidity is there at an excellent price, clients take all they can, and when it is not there, they fade the trade and become patient. Doing that effectively is important. Now that’s what we do at the end of the value chain, but there is also an important piece in the middle of the value chain - between the portfolio manager and the sell side - and that’s the role of the buy side trader to finesse. We don’t have complete transparency as to the alpha of an individual portfolio manager. We have some if it is provided to us, but we can’t pick up the phone and call the portfolio manager and ask him: do you want me to be more urgent with this order? That’s the role of the buy side trader who is to understand his portfolio managers and what their liquidity needs really are. I would say it is when all three parties are working together on this value chain that delivers the best outcome. A portfolio manager has to be sensitive to his own process and know when he should be aggressive and communicate

that to his desk, and then the buy side desk can give the appropriate signalling to their sell side counterparts. The process works in reverse too. If you look at a portfolio optimisation process, there are some implicit costs that go into doing the optimisation. If all of the sudden I can offer a big chunk of liquidity at a very cheap cost, the portfolio manager might look at that and say: yes, that’s attractive if I can get it on the cheap. Otherwise, he might not have done that marginal trade. So, pushing that information back is very important too. That speaks to the hybrid model Rob was talking about, where we combine the smarts of the electronic world with the sensitivity of the high touch world where we really know the client; then we will be able to push that alpha back the other way.

BROADENING THE SKILL SET: ASSETS OTHER THAN EQUITIES FRANCESCA CARNEVALE: All this understanding is well and good. However, there are big macro forces in play right now. As buy side trading desks, you’re at the forefront really of the movement out of equities and into fixed income. How, in turn, are these changes in asset allocation changing the way that the buy side trading desk operates? CURT ENGLER: Our desk definitely has a broader skill set now than before. Historically I guess everybody would’ve had experience on the single stock side, whereas now we have two quantitative analysts that are on the desk full-time now that are the ones who are helping craft the trading strategies and fine tuning the strategy given the market dynamics. Along the lines of having people who can speak the language of the portfolio manager, we have three (CFAs) involved too, all the while still having very experienced traders we have hired either from buy side or the sell side on the desk. However, I would say we have broadened the skill sets on the desk considerably in response to the market rather than any sort of shift in what asset class is in favour or not So having that mix of those different and differentiated skill sets has been the direction we have taken. ROB KAROFSKY: I’d say two things. One based on what I initially said about being in a new paradigm, there’s been a shift, from the sell side to the buy side in terms of understanding how to price assets better and how to source liquidity. We’re definitely seeing that shift. It is a scarce good, if you will, and the onus is on us to develop expertise in that area. So, we have certainly moved in that direction and what that means is staffing the desk appropriately with people that have that type of experience. The second thing in terms of dealing with the overall environment as far as asset flows, that we absolute need to scale our desks appropriately given the global volumes that we have experienced and that we probably will experience. That’s a similar exercise that’s happening on the sell side as well. We have seen a lot of capacity come out and my guess is we’ll continue to see more capacity come out. As far as expertise across asset classes toes, the worlds are correlated, more so than they’ve ever been. If you’re trading

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Rob Karofsky, global head of trading at Alliance Bernstein. Photograph © FTSE Global Markets, supplied July 2012.

equities and you don’t have that vital understanding of how credit markets will impact equities, you’re missing an important step. Therefore, if the world is going to be more correlated, you need to have an understanding of how commodities and credit and things of that nature are going to impact idiosyncratic moves in stocks. One of the things that we have done is we have moved all of our trading capabilities onto one floor to help enhance that connectivity. It is important than having one person trade multiple thing. Given our size, it is not realistic. With smaller hedge funds or smaller asset managers, it is more that they aren’t dealing with as many transactions so perhaps it is more achievable, but I still think, at the larger institutions, that you need a certain amount of specialisation in order to effectively executive and more importantly become embedded in the investment process. FRANCESCA CARNEVALE: How much analytical work, Miranda, is being or has been done on the long-term impact of these changes in the way that buy side trading operations are structured and the increased skill sets that are being imported into the buy side? What ultimately might this mean for the definition of sell side services? MIRANDA MIZEN: As an average over the last couple of years on the buy side, and taking in the biggest and the smallest firms into account, we haven’t seen a huge amount of change in terms of sheer numbers of people per desk. But obviously the markets are a lot more complex so each person is doing a lot more. The point Rob made about having to worry about credit risk as well as credit markets is true. There is a far greater need for and awareness of the influence of other asset classes on equity trading or geographical influences. May the 6th Flash Crash was a classic example: one minute the events in Greece were being played out on the television, the next minute they were unravelling on our own trading doorstep. To stay on top of so many different things going on has led to investment in seamless toolsets on the desktop, reducing any manual handoffs in the execution chain and expanding and improving the capabilities of execution management systems on the desk. There will never be a one size fits all solution going forward, that’s for sure. There needs to be flexibility and there are very few systems that do absolutely everything extremely well that everyone needs. Nonetheless, there is a very high attention being paid to how the tools interact, both from the execution and into the order management systems and back into all the way back up to portfolio managers. Some of that is being driven by regulation and the need to have new compliance procedures, reduce risk, add new reporting standards and make sure that there aren’t manual processes and file transfers that introduce risk because it’s a break in the chain.

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While the trading desk size hasn’t changed significantly, the scope of what some buy side firms trade has. A small hedge fund for example may have a trading desk of two people; trading the US markets is one thing, but it is a different story when branching out to trade markets on the other side of the world in search of alpha. While larger houses have local offices and have the choice of building their own technology, most rely on their brokers for the combination of access, information and execution tools. JOSE MARQUES: A few years ago there was a lot of talk about multi asset class convergence - where in the future you’d stack every asset known to mankind, working with geniuses who would be able to trade everything all the time and never sleep. That’s simply not realistic in the real world. The role of the specialist in asset classes isn’t going away. There are a lot of idiosyncrasies, market microstructure issues, regulatory issues that vary dramatically across the asset classes. So what we’re doing and what you’ll see broadly is that the specialisation function, both on the buy side and the sell side, will remain and what is happening is a convergence of tools and trading techniques across different asset classes even as regulators drive for uniformity of market structures. For instance, now algorithms are applied to FX trades. Liquidity seeking algorithms that have been developed in equities are certainly directly applicable to other asset classes that are traded on exchanges or exchange-like structures. Moreover, it allows them also to find that liquidity or assess its relative value and then decide whether they take it or not. In that regard, you’re seeing a lot more sharing of tools and techniques and understanding. We also able to link together some of the more esoteric bits of what happens in other markets and how they affect equities and vice versa. Therefore, I would say that there is definitely convergence of understanding underway; but, at the end of the day, there still has to be specialisation, which will remain for quite some time.

CHANGING ECONOMICS in THE BUY SIDE/SELL SIDE RELATIONSHIP FRANCESCA CARNEVALE: Is there a new understanding of the need to pay for consumption and resources in such a complex and changing trading environment? ROB KAROFSKY: Yes, absolutely and speaking for our firm, more so than ever. As liquidity is scarce, so are some sell side resources. I truly believe that we all make money together in this industry and we all lose money together in this industry, meaning that obviously there are divergences. In general though we’re all going through a difficult time and the sell side will have to do some hard facing of facts in its efforts to try to figure out an effective business model and, at the same time, how to scale their operations to provide and service varying levels of volume and volatility which are key drivers of revenues. Moreover, as we are about to deal with massive regulatory change which could at some point also cut off some key drivers of revenues for the sell side, I wouldn’t be surprised if we get to a model where the sell side

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are demanding some sort of operating margin with their buy side clients, which is something that we may have to deal with at some point soon in the future. The days of subsidising one business for another business are, given current circumstances, going to be far and few between. We are very well aware that there’s no free business anymore. We have bills to pay and we need to make sure that we’re paying the people. We are very focused on it right now and our list has shrunk, which if everyone is working in this way, ultimately has important consequences for the market. I think it is inevitable that people at the top of the food chain will, overall, take more business because of these changes. That being said, we need to be relevant to people that we believe add value to us and deliver resources that help us make money, period. Miranda was talking about broker lists and things like that. Yes, we are becoming very aware about whom we’re doing business with and why we’re doing business with them and how we are paying those people. It is an important initiative that’s going on at our firm and I would imagine right now that it is an important initiative going on at every firm. MIRANDA MIZEN: It is absolutely true that the buy side needs to know who they’re paying and why they’re paying them. We have already seen broker lists being curtailed, and similarly brokers have to make decisions about the client segments they want to service. This looks set to continue in the current environment, and some of those consequences will be positive. Do we need, for instance, so many dark pools? Well, if we don’t and liquidity continues to form in only some of them, then others might naturally fall by the wayside. Natural competition might solve some issues of fragmentation and cost. So many people are electronically connected. Those connections cost money even if it is not in a pure payment form. Even so, they still accrue maintenance costs. Inevitably then, there is a lot of attention being paid to those hidden costs of doing business, of just having these connections and how you deploy your resources within the company, which then dictates what you’ve got left for some of those more innovative and discretionary and interesting projects, other than just trying to meet the next regulatory deadline. So much more is now visible in a way that it wasn’t five or six years ago in terms of explicit and implicit costs, in terms of bundling and unbundling, in terms of the way things are allocated, who they’re allocated to, why they’re allocated. CURT ENGLER: Obviously, there are implicit and explicit costs. Tackling implicit costs will always be a battle. As for explicit costs, clearly the sell side is under some considerable pressures, given the backdrop of the market. That said it is not sustainable to have 100% loss ratios or have the sell side not earning a return. With that in mind, what’s in store for the future? It could range anywhere from a cost plus type model where if we have fixed tags that we know exactly the cost implication if we’re adding or taking liquidity. That’s a significant swing in the profitability of execution on the explicit side. Then again there is the whole range of services that the sell side provides. It is just determining, accurately, what is that actually worth? If in practice it was easy to just

Miranda Mizen, head of equities research, TABB group. Photograph © FTSE Global Markets, supplied July 2012.

come up with a ledger of the costs involved and the revenue needed to cover those costs, it would all be simple. Life unfortunately isn’t that simple. Now there could be a whole host of other unintended consequences from applying a cost plus model, but to me it makes sense. What’s happening in the trading world and in financial services in general, in this post 2008 period, is really not all that different from what’s happening in just about every other industry in our economy; whether it is automobile manufacturing or airline seats. Technology has been a highly disruptive influence, margins have collapsed for a lot of reasons and there is a fundamental restructuring going on in the marketplace, and it is happening both on the buy side and sell side. Buy side desks are much smaller and more efficient than they’ve ever been and the sell side is working aggressively to become more efficient as well. This is part of the natural evolution of things and trading desks have to face this issue and deal with it. ROB KAROFSKY: The sell side equity business model has always been inefficient and that’s why they talk about specialisation. The sell side has layers and layers of specialisation. If you look at touch points, it is electronic, it is programme, it is cash, it is derivatives, it is research sales, it is speciality sales; it is just on and on and on and on. And this in a business that is 100% about picking up pennies and you need to do everything to pick up that penny! As Jose mentioned, this environment could provide the catalyst to finally change the business model and help evolve it and move it on to the next level. There’s always been a concern and I’m guilty as well, of moving ahead of your clients, the people that are paying you. It has always been a concern. We may be at a point now where you have to take that risk of changing your approach and business model in order to preserve or drive profitability over the longer term. Change is coming firms that are facing up to that change and respond to it as Jose describes, will be the winners. JOSE MARQUES: These changes are gut-wrenching whenever they happen. As Rob says, there will be clear winners and losers. But the story is the same in other industries. They have had to make wholesale changes and they are now benefitting from those changes. In the 1980s you could hardly get me to rent an American car, let alone own one. Now American cars are fantastic; cars coming out of Detroit are now on par with anything being produced anywhere in the world. Similarly in our industry, we are now forced to look hard at what we do and why we do it. What you’ll ultimately see is a much, much more efficient, better and more transparent trading environment. Though it may be a few more years for this play out fully, change is a reality. I

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ALGORITHMIC TRADING

Photograph © Donald Swartz/Dreamstime.com, supplied July 2012.

New generation trading algorithms are taking on fewer characteristics of machines and more characteristics of humans. In today’s low liquidity environment being unpredictable is essential and this consideration is driving innovation and change in the way that algorithms intuit market nuances and work. However, given the increased ‘awareness’ of new algorithms in distinguishing between rational and irrational markets, new types of controls are also required. Can innovators and the sell side meet the challenge? And what’s in it for the buy side? Ruth Hughes Liley went in search of answers.

Can algos really think like humans? LGORITHMIC TRADING IS advancing at a clip and changing rapidly in its capacity to adopt more ‘human’ approaches to trading. In other words, algorithmic trading is adopting still logical, but more unpredictable behaviour patterns. Owain Self, UBS’s global head of algorithmic trading, explains the dynamics.“There’s more and more discussion given to taking the intuitive logic of the human being in their ability to tell the difference between an irrational market situation and a rational one, and embedding this inside an algo. [However] at the end of the day, in implementing these controls we know we can never make the perfect decision every time so need to find the balance between controls and allowing clients to achieve their objective,” he says. The difficulty is highlighted by the nuances inherent in day to day trading. “In situations where a client wants to sell stock down 3% because they have a strong view, should we prevent them from doing that? In the past when a human

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has manually executed the order, there is an assumed constant evaluation on whether they are still happy to sell the stock at lower levels. But with limited ability to second guess its operator, an algorithm is under the assumption that its parameters have been set correctly and not that the user has made a mistake. So we have to find the balance allowing clients to trade in a legitimate but aggressive mode,” he adds. By and large, says Self, the sell side is achieving its aims in this regard: “Over time we have enhanced those controls and become more sophisticated about learning what is normal and what is abnormal, especially in these volatile markets.You do not want to prevent clients doing something in a fast market.” A year ago the buzz-word in the algorithmic trading space was customisation and TABB Group figures found 63% of buy side traders considered it an important feature of their use of trading algos. However, today it is less about

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customising a ready-built algorithm for a particular client and more about custom building an entirely new algorithm for a particular client. In April, for example, UBS launched its ‘quant-on-demand’ studio, an algorithmic design tool delivered via an iPad app and aimed at the traditional buy side space. Self explains that the service is essentially “a rapid algodevelopment framework. We can build a solution in the room with the client, generating code that is uploaded into our systems. We basically build it there and then with the client and can get it tested and live in days, potentially hours. It is popular because where traders want to give the algos they use more ‘discretion’, this [service] allows them to specifically dictate where and how much.” This element of custom building inevitably requires continuous investment in technology and therefore it is no surprise that the larger broker-dealers dominate the space. Specialist research house Aïte Group has estimated $51bn will be spent in 2013 alone as brokers try to stay ahead or at least abreast of the competition. As Mark Goodman, head of Quantitative Electronic Services, Société Generale, points out:“If you use yesterday’s algos you are trading yesterday’s market. If firms don’t continually invest, they will fall behind. Having said that, it is not about continually inventing new algorithms but ensuring your existing product suite is optimised and able to adapt to the current market.” Société Générale has opted for a different solution. In April this year it gave cash equity traders access to the firm’s vast derivative flow through its Eclipse algorithm. “Most investment banks are active in derivatives,” says Goodman. “It’s just a question of how much. When I’m talking to clients, I am one of many brokers; but when I talk about the type of liquidity we can offer, they listen. Most broker pool liquidity is pulled from agency client flow and when everybody’s selling, everybody’s selling, and that’s exactly the time that you need this type of hedging flow. When you are hedging you tend to go in the other direction away from the market, so we can find the other side of the trade even when the market is moving away.” Eclipse, which accesses the firm’s Alpha Y liquidity platform, makes a distinction between volume and liquidity, says Goodman. “Volume, with a finite number of shares, is the speed at which the shares change hands. Liquidity is someone wanting to buy or sell a stock. It is important that the algorithm understands the difference between where the liquidity is and where the volume is. Volume is often associated with a high frequency style of trading; if you are a client trying to source liquidity, that’s your core objective.” Embedding logic in an algorithm is applied somewhat differently according to where you are in the world as trading conditions and considerations vary from region to region. To what extent is clearly highlighted in CA Cheuvreux’s its sixth Navigating Liquidity publication [dated January 2012]. The firm explains that the US, where high frequency traders are“almost everywhere”, stealth trading is the main point of focus. In Asia on the other hand, it is crucial to take local market differences into account. Then again in Europe, the

Owain Self, UBS’s global head of algorithmic trading, explains the dynamics. “There’s more and more discussion given to taking the intuitive logic of the human being in their ability to tell the difference between an irrational market situation and a rational one, and embedding this inside an algo.” Photograph kindly supplied by UBS, July 2012.

need is to avoid detection by HF traders and (understanding the efficiency of interacting with a set of order books) to adjust order routing policies as fast as possible. The publication’s co-author Charles Albert-Lehalle, global head of Quant Research, writes: “In terms of benchmarks, this implies that on paper, European investors should target implementation shortfall, Asian ones Volume Weighted Average Price (VWAP) or Percentage of Volume (PoV) and US ones liquidity seekers. Of course, the sizes of the order and market condition have to be taken into account to adjust these drastic rules: liquidity seekers are more suitable to trading orders without minimum participation rate constraints, IS are for small ones, VWAP for larger ones and PoV for very large ones.” Lehalle points out that benchmarks can be combined, matching sophisticated benchmarks with a VWAP or TWAP backbone, although if the desired features of different benchmarks are combined in a ‘trading envelope’ a better result is obtained if the trading logic itself is based on the trading envelope. “Inside a trading envelope, any combination of liquidity capturing tactics can be plugged in without harming the optimality of the risk control layer. The next generation of trading algorithms is made up of trading envelopes, execution constraints and liquidity-seeking tactics.”

Changing tempo Many brokers have invested in development of algorithms that alter their tempo between fast and aggressive to capture liquidity when it appears to much slower and passive, when markets are slower. In the area of low-liquidity, or hard-totrade stocks, UBS Swoop is an example of the new type of algorithm that enables clients to capture unpredictable liquidity, waiting and pouncing when it appears. Launched

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globally in April it has different versions to take account of differences in market structure around the world. UBS’s Self says: “Traditional algorithms were built to trade on a schedule or consistent profile of liquidity, which means they were not suited to appropriately capture unanticipated bursts of liquidity.” As volumes have only partially recovered from the deep lows of 2011, many traders believe they are in a ‘new normal’ of lower volumes and patchy liquidity and firms are adjusting their algorithms accordingly. It is not necessarily however a reason for pessimism holds Robert Hegarty, global head of Market Structure, Thomson Reuters. He believes this state of affairs carries benefits: “This prolonged period of trading volatility, particularly in illiquid markets, is a challenge, but in the long-run it is actually healthy for the market overall. With fragmentation and the focus on breaking down the large liquid stocks, the illiquid part of the markets such as small cap stocks have been neglected as far as algorithms go. Now that algos have become proficient at traversing venues for the harder trades, when volumes do return, traders will be better equipped.” “With lower volumes, algorithms are more critical because we have to use all the tools we can to trade in illiquid conditions. It has forced everyone to get a better understanding of illiquidity and it is going to accelerate algo trading expansion into other areas such as derivatives and overthe-counter, which will largely be illiquid when they move to exchange or SEF trading.” Indeed, Aïte Group is already expecting foreign exchange (FX) algorithms to account for more than 25% of FX trade volume by the end of 2014 and to keep growing over the next five years as buy-side traders continue to demand them. The report states: “Client interest has increased in recent years, driven in large part by traders’ desire to create greater transparency and execution performance measurement. Clients used to algorithms in equities and futures markets, too, have pushed for the development of algorithms in the FX market.” Indeed, Hegarty believes that as regulators look at the over-the-counter (OTC) market, the development of algos to date has just been a warm-up. “OTC trading is going to appear pretty illiquid as trading of standardised derivatives moves on to exchanges. The listed market will grow as well as the OTC market, so we will need algos for harder trades.”

Algorithms for dark liquidity One area which has grown for trading larger amounts of more difficult stocks has been the non-display markets and William Capuzzi, president of ConvergEx’s global execution business, sees three types of liquidity dominating the trading landscape for the foreseeable future: exchange lit liquidity, MTF lit liquidity and dark liquidity. He says: “Over the next 12-18 months disparate dark pools will start to connect to each other. My bet is that MiFID II and market forces will drive this connection as the buy side needs access to the darkest liquidity.” ConvergEx, however, has agreements with all the major

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Robert Hegarty, global head of Market Structure, Thomson Reuters. Hegarty believes this state of affairs carries benefits: “This prolonged period of trading volatility, particularly in illiquid markets, is a challenge, but in the long-run it is actually healthy for the market overall. With fragmentation and the focus on breaking down the large liquid stocks, the illiquid part of the markets such as small cap stocks have been neglected as far as algorithms go.” Photograph kindly supplied by Thomson Reuters, July 2012.

broker crossing networks and dark MTFs and its newest algo Global Darkest connects directly to these pools and constantly readjusts where orders are being sent in real time, thus creating a one-stop-shop for access to dark European liquidity. “Clients have to look at all forms of ways to find liquidity and the dark market becomes more relevant. It’s difficult to get an order done in significant size in a low volume environment,” says Capuzzi, who points out that the lit market still represents around 70% to 80% of the market. “If a dark-only strategy only works in a passive way [it] will involve opportunity cost of missed liquidity. You also need algorithms that can be more aggressive in the dark and also trade in the lit market as well.” Convergex’s Abraxas, explains Capuzzi balances orders among market venues to access numerous sources of displayed and dark liquidity. In the US market, where liquidity is dispersed between growing numbers of venues, volumes in dark pools have grown to record levels, driven by connectivity between pools. The firm’s Global Darkest monitors liquidity conditions and adjusts to take liquidity as it is available. Regulation, as a driver of how algorithms are built, will also influence the amount of algo trading in Europe, says Capuzzi. “Creating a true consolidated tape of prices is necessary to really improve things for the buy side and the sell side by improving transparency of prices and getting their arms around dark liquidity in Europe—how do you regulate broker crossing networks that don’t have to report trades?”

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William Capuzzi, president of ConvergEx’s global execution business, sees three types of liquidity: exchange lit liquidity, MTF lit liquidity and dark liquidity. He says: “Over the next 12-18 months disparate dark pools will start to connect to each other. My bet is that MiFID II and market forces will drive this connection as the buy side needs access to the darkest liquidity.” Photograph kindly supplied by ConvergEx, July 2012.

Mark Goodman, head of Quantitative Electronic Services, Société Générale Investment Bank (SGIB). Goodman points out: “If you use yesterday’s algos you are trading yesterday’s market. If firms don’t continually invest, they will fall behind. Having said that, it is not about continually inventing new algorithms but ensuring your existing product suite is optimised and able to adapt to the current market.” Photograph kindly supplied by SGIB, July 2012.

He adds: “MiFID gave rise to HFT flow and that can be both a blessing and a curse. If the right anti-gaming tools are used and the HFT flow is managed properly, it can be a very valuable source of liquidity.” Another source of liquidity is understanding and identifying who holds a stock, believes Hegarty. “The biggest problem has been fragmentation—if we only went to two or three venues it would be easy. But this is not the case and not only is a stock illiquid, but when it is liquid, who knows where it’s going to trade? There’s a difference between a position and a holding. A lot of algos today are focused on positions, but what is necessary is to find people who hold a stock.” There are also other issues to deal with. “With 60 Alternative Trading Systems in the US, 20 multilateral trading facilities in Europe, the hard part is accessing people who don’t know they want to trade. As a comparison if you are holding on to some sort of antique, but you don’t know it is of high value, then someone lets you know it is high value, you will trade. It’s the same thing with securities; because some are so illiquid, you are not sure there is a market and you think the price will go down when you show your hand,” adds Hegarty. With that in mind, algorithms will inevitably become more tailored to suit particular trading requirements or conditions. With every money management firm in the US required to register holdings with the regulator, the Securities and Exchange Commission (SEC), for instance, Hegarty foresees that some algorithms will begin to take a step back from looking for liquidity and look for holdings. As traders look to algorithms to do more of the decisionmaking, inevitably the data which feeds the algorithms

becomes more important and event-driven algorithms have grown in popularity over the past year. Thomson Reuters ‘machine-readable news feed’ looks for terms such as ‘buy’, ‘earnings’, or ‘position’ from 50,000 news sites and four million social media sites to enhance trading strategies. It is used by traditional traders as well as high frequency traders and is more mainstream than people might think, says Hegarty. Aïte Group estimates 35% of quantitative firms use some kind of machine-readable newsfeed. Going forward anything is on the cards. US broker Wedbush Securities, for instance, announced in June that it was allowing social media to be used for business within the firm, using Twitter, LinkedIn and Facebook. Thomson Reuters announced in March that it would include a ‘sentiment’ scoring service for its social media data. It will mine social media and blog content to deliver digestible analytics on selected companies or market segments. In other words, the use of algorithms will become more embedded in the overall trading process as they become men for all seasons. In turn, as algorithms read news and respond to events, Self sees firms relaxing about how algorithms operate.“I don’t think we will get back to those past higher volume levels and we have to prepare ourselves for the new normality. As people have got more comfortable with algorithms they are willing for them to be more like a human, being more unpredictable, and that is a significant change in the last couple of years.” However varied their development and usage however, ultimately it will all boil down to money. As Self points out, while people have had to embrace change:“They can’t afford to micromanage algorithms and miss opportunities.” I

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ASSET ALLOCATION ROUNDTABLE

Photograph ÂŠ Level II/ Dreamstime.com, supplied July 2012.

TOWARDS 2020: A NEW FINANCIAL MARKETS STRUCTURE Profound changes are underway in the global financial markets. A tidal wave of regulation will force a substantial overhaul and review of current business and investment practices, and bring in new business models and processes that will underpin a new era of financial and investment flows. Moreover, the stresses and financial constraints experienced by traditional banking and investment institutions in the west are now encouraging extensive reviews of the current financial market superstructure: new institutions will enter the market driving forward new ideas and continued change. We asked a discrete panel of experts to give their view on some of the questions and trends that continue to reverberate through the capital, financial and investment markets. This discussion offers no firm and fast predictions about the future; but it highlights importance developments and financial movements which investors can keep in mind when formulating their new portfolio strategies.

Participants:

Supported by:

JUAN CARLOS ARTIGAS, global head of investment research, World Gold Council DAN BRIGGS, chief investment officer, Fleming Family & Partners Asset Management JOHN VEALE, chief investment officer, Stonehage Investment Partners (SIP) PAUL WHARTON, UK chief investment strategist, Deutsche Bank Private Wealth Management

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HISTORICAL DRIVERS: ECONOMIES AND DEMOGRAPHICS Q: Much has been written about the shift in global production from developed to emerging/high growth markets. How sustainable is this shift? How mobile is production? What drives this shift? JOHN VEALE, CIO, STONEHAGE INVESTMENT PARTNERS (SIP): After the Uruguay Round negotiations and the establishment of the World Trade Organisation in 1995 there has been a concerted effort to break down trade barriers globally. The shift of global production predominantly to Asia was, however, already a major trend as a significantly cheaper labour force drew in production work. Today there are definitely signs that this trend has run much of its course. The cost of production advantage has been eroded quite significantly as a substantial portion of the post 1997 currency weakness in Asia has returned and as local wages have increased ahead of local inflation. Asian regions are still generally on a lower base and do have scope for faster productivity gains than developed markets. This, together with the scope for an ongoing regional shift of work to local areas with lower cost labour, presents ongoing attractions for production. There will, however, be more competition from the developed regions where currencies have fallen back, labour costs have remained static or fallen in real terms. There has also been more recent realisation of the risks and costs of relying on remote supplies which has led to some shift of production capacity back to areas of consumption. This has been helped by developments in production methods including the use of robotics and 3D printing technology. PAUL WHARTON, UK CHIEF INVESTMENT STRATEGIST, DEUTSCHE BANK PRIVATE WEALTH MANAGEMENT: We have had some interesting conversations with manufacturers in respect of this phenomenon. Clearly, the principal driver is cost and until recently the principal comparative advantage in much of the developing world including China has been in very low labour costs relative to the West. This cost advantage has been sufficiently strong to offset the management and logistical problems associated with extended supply chains crossing oceans and continents. There is some evidence from some manufacturers that the combination of wage inflation and currency realignments is beginning to erode the benefits of those cost advantages. At the same time quality control issues lead to much extended delivery times as and when things go wrong. Consequently, we see some production being withdrawn from EM economies as the advantages of cost competitiveness erode relative to shorter logistics timeframes, access to pools of skilled labour and narrower price differentials. Onshoring is, of course, consistent with a change in the dynamics of emerging market development as reduced cost competiveness forces production up the value added chain supporting rising wages and increased domestic consumption. One positive aspect of this would be a much more balanced global trading regime supporting growth in world incomes.

Q: In the last 100 years the trend has been towards the concentration of financial activity in a handful of global financial centres. How might this change over the next decade? Will more regional financial hubs emerge? What will this mean for traditional global financial centres: will they be weakened or strengthened by this trend? JUAN CARLOS ARTIGAS, GLOBAL HEAD OF INVESTMENT RESEARCH, WORLD GOLD COUNCIL: We have witnessed many shifts in national and regional concentrations of financial activity over the last century, particularly as shaped by the post-war decades and the boom in financial services and products of the latter end of the twentieth century. But, in recent years, there have been very strong indications of a substantial global realignment in wealth generation and trade flows. While it has been over a decade since Jim O’Neill defined the BRIC countries, and they may still only be responsible for a minority of global trade, it is worth noting that between 2007 and 2010 they represented around half of global growth. Furthermore, we are now seeing the next wave of growth coming from an even more diverse set of countries. And, as commerce between them rises, they are increasingly starting to denominate trade contracts in currencies other than dollars. Of course, China and India are already playing a more pronounced role in the global economy; although not immune to contractions elsewhere, their economies are developing rapidly, and they have large populations, with expanding middle classes and high levels of savings. From the World Gold Council’s perspective, both countries, having strong and enduring cultural affinities for gold, represent significant markets with considerable growth potential. An interesting phenomenon occurring in tandem with the shifts in global wealth and financial activity is that gold also continues to evolve as a truly global asset, playing an increasingly relevant role in both developed and developing economies. Q: Which will be the next tier of emerging markets over the coming decade? JOHN VEALE: With Asia and Latin America already well represented in the emerging market indices the majority of markets that will join the “emerging” ranks will be from the EMEA region. Countries like Pakistan, Bangladesh and Vietnam with populations of approximately 180m, 150m and 90m each obviously have significant potential to develop further. Some of the energy producing countries in the Middle East also have the potential to grow their local markets as more of this revenue is shared with their growing populations. The countries that are on our radar today, however, are those in Africa. While historic interest has predominantly been led by plays on the commodities these countries produce, there is potential for more sustainable growth from the growth of local consumer markets in this region. Investors may be surprised to find that there are already a number of long established income-producing companies and some well known western brands listed on the 29 local stock markets on the continent.

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Q: Will the model of western markets be reproduced in emerging or high growth markets: or does evidence show that new models will emerge? PAUL WHARTON: There is no such thing as historical inevitability and even within recent memory there have been a variety of different capitalist models. One thinks of the Nordic Social Market forms; the Thatcher/Reaganite ‘deregulated model,’ the European model of ‘managed capitalism’ and the Japanese ‘market share’ and permanent employment model of the 1970s and 1980s. Following the recent collapse of the ‘Anglo-Saxon credit’ model it seems likely that modern Western capitalism is likely to undergo significant change and rapid evolution itself. So, it seems highly likely that emerging or growth markets will develop their own norms and models of economic distribution within their respective economies and whilst recent Western experience will doubtless be a part of that process, equally, the obvious weaknesses of the Western system will also place a brake on these developments. Q: What kind of firms will benefit from the rise of the new middle class in high growth markets? How are financial institutions across the world preparing for this change: both banks and manufacturers of investment product? DAN BRIGGS, CHIEF INVESTMENT OFFICER, FLEMING FAMILY & PARTNERS ASSET MANAGEMENT: Middle classes everywhere aspire to comfortable lifestyles, status and ample disposable income for housing, education, leisure, savings and pensions. Key beneficiaries have been multinational consumer staple companies (for example, Unilever and Nestle), and branded consumer cyclicals (for example, BMW), but a new generation of local entrepreneurs and innovators now provide indigenous services and brands. The response of financial institutions such as Citigroup and Standard Chartered and new local providers such as ICICI bank has been to offer credit cards, mortgages, savings and pension products, which with the increasing shift from manufacturing to consumption are growing faster than legacy trade finance and business lending. Q: Given recent experience, how credible is a coordinated euro currency? Will it still exist in 2020? PAUL WHARTON: The recent experience in Europe suggests that conditions required for an “optimal currency area”are sufficiently intractable to offset the sincere desire to bind Europe together as a prosperous but more importantly “peaceful” economic area. The more pertinent question is whether the currency union will still exist in 2013. It is interesting that the popular will to retain the single currency remains very strong even in Greece despite the very severe economic hardship endured by the Greek people. In a recent poll some 72% of respondents in Greece wanted their leadership to do everything necessary to retain the currency unit. Nevertheless, it remains striking that the gap between the time it will take to engineer structural reforms south of Germany and the short-term nature of the technical monetary assistance offered by the European Central Bank and other European institutions remains all but unbridge-

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Juan Carlos Artigas, global head of investment research, World Gold Council. Photograph kindly supplied by the World Gold Council, July 2012.

able. Deutsche Bank economists posit the idea of a G-Euro in Greece in order to facilitate a devaluation in Greece within the euro. Short of the willingness of Germany to fund transfer payments across the zone, it seems very unlikely that the euro can continue in its current form. DAN BRIGGS: Enormous political capital has been invested in the euro as a means of fostering European trade and security, but politicians have baulked at introducing fiscal, legislative and regional support structures necessary to support a successful and unified currency union. Differences in wealth, GDP, pensions and tax laws, not to mention attitudes to work and thrift were glossed over at inception, but a decade on (after weaker countries have sated on cheap, freely available debt) unsurprisingly the euro faces a crisis. ’Core’countries are at last addressing the issues and likely a slimmed down euro-bloc and euro will emerge by the end of 2012.

INVESTMENT INSTITTUTIONS AND APPROACHES TO INVESTMENT Q: How might investment horizons be defined in coming years? Will investments be increasingly short term in nature? If so why? If not, why not? JOHN VEALE: Capital markets have developed investment mechanisms to allow investors to provide capital to businesses with a wide range of risk and liquidity levels. Prior to the credit crisis some investors paid little attention to their liquidity requirements and did not retain enough of their capital in investments that would provide the liquidity they might need. Some suffered significantly as liquidity dried up and this led to a wave of aversion of illiquidity amongst investors. Long-term projects and businesses will, however, always require longer term financing and there are investors who have long term liabilities that should be able to provide capital. This aversion for illiquidity is today, in fact, offering an opportunity for investors who are willing to invest in longer term investments. We have been recommending that investors do make allocations to areas such as mezzanine finance where we believe they are being offered a significant additional illiquidity premium on top of the credit risk being taken. As these investments are typically made through pooled investments, a key issue for us is ensuring that the structure used for investing matches the liquidity of the underlying investments and that all investors are tied in with the same liquidity terms. DAN BRIGGS: The generally more volatile and macrodriven nature of markets have certainly led to a higher degree

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of short-termist thinking when evaluating investment opportunities; this can manifest itself in two ways. The first is that investors increasingly ascribe premiums to those investments that offer higher visibility and certainty of return streams as forecasting becomes more difficult further out. This favours those investments with significant high and sustainable income or cash flow returns over those that rely more on capital appreciation. These investments now form the core of investor portfolios and, barring a significant change in their fundamentals, will continue to be held for a long time period. The second manifestation is in the more opportunistic section of portfolios, where the increasing significance of news flow on market returns has led to a shift away from longer-term fundamental based opportunities towards shorter-term tactical allocation shifts and taking advantage of short term mispricing and momentum characteristics of investments that occur at different times. The final factor to consider is that stresses in the economy have led to more uncertainty and demands from investors for greater liquidity, which impacts the perceived merits of longer term investment decisions and has led to a shortening of investment horizons. In aggregate, it would be safe to say that investments are now being considered more in extreme black and white terms as either long or short term, with the focus between the two dependent on the investor’s individual characteristics and liquidity. PAUL WHARTON: One of the interesting consequences of the “money manager capitalism” that has characterised recent Western European capitalism and which Hyman Minsky talked about at length has been the growth of the financial economy as a percentage of total economic activity. This has been a function of the amount of leverage that built up over the last couple of decades culminating in the credit problems of 2008.The combination of leverage and the proliferation of “financial capitalism” has indeed, shortened investor time horizons. One of the consequences of a shrinking financial sector may be to refocus on the “real economy” as opposed to the financial economy. To that extent investor time horizons may begin to extend again as they have in the past in the recognition that successful businesses are built in years not months. Q: In the current precarious financial climate are investors blinded by uncertainty and therefore in danger of clinging to what they know and are therefore finding refuge in short termism? Or is this a longer term trend? Does this fear rest only on the future of the euro? Or are there other forces in play? PAUL WHARTON: Investors are blinded by uncertainty but perhaps quite rationally. We should not forget that in the 20th century savings were destroyed by waves of deflation and inflation. In a period where growth is hard to find and central banking authorities are manipulating both the value and quantity of money which is, after all, fiat money. That is say money which backed by nothing other than collective confidence in it then investors are rightly concerned. When the world beneath your feet is shaking, where can you be safe? Yields on major sovereigns reflect deep anxiety and, of course, are a strong indicator of the lack of confidence that

is hampering reflation and growth. Shiller’s animal spirits are weak indeed. But, what would you rather own? A financial claim—which may or may not hold value—or the factors of production, which includes land and capital (human and technological) which have intrinsic values and hedge all kinds of economic transformations including foreign exchange, fluctuating international capital flows , differential GDP growth rates. In other words the large cap multi-nationals that are cash rich probably offer a stronger hedge of the plausible medium-term outcomes following on from the resolution of current difficulties. Risk-free bonds (on the other hand) probably lock-in a real loss given that inflation rates are currently higher than yields and even the IMF is calling for a higher global inflation rate to help ameliorate excessive global indebtedness. JUAN CARLOS ARTIGAS: An unfortunate response to the current economic and financial environment has been that investors have adopted a far more“short-term”perspective as they struggle to see beyond the current fog of uncertainty. This approach is far from optimal for ensuring capital preservation as it will lead to“tactical”decisions lacking any cohesive strategic foundation. The key point is that investors ought to look more closely at longer-term portfolio risk management and consider better cross-cyclical strategies. We believe gold has a significant role to play here. In impending research from the World Gold Council entitled “Gold as a strategic asset for UK investors: Portfolio risk management and capital preservation”, we analyse the role gold can play in a more balanced and long-term investment strategy. We found that, by adding a modest strategic allocation to gold of approximately 2 to 10%, investors can consistently improve risk-adjusted returns while reducing potential losses. Q: While some institutions continue to accrete capital, there is a distinct capital shortage in many financial markets. Western investors are sitting on cash. How long will this last? And what are the long term implications of this trend? DAN BRIGGS: Governments want to protect banking institutions, so have artificially kept funding rates low to subsidise the rebuilding of their balance sheets. Banks are no longer able to fund themselves through the ”real money” markets, so the government have intervened by providing funding lines for them. Banks need to rebuild their balance sheets so are exploiting the low cost of financing, by limiting lending to low risk borrowers that enhance their returns. Governments realise that this is the case, but are conflicted as they must protect depositors and are now owners of bank equity. This serves to restrict “higher risk” borrowers from traditional sources of financing. However, to say there is a lack of capital in many capital markets is a fallacy. There is capital, but at a higher price from non-standard sources; but for as long as borrowers do not re-adjust to the higher postcrisis real-money funding rates, there will be a lack of capital at attractive government funded levels. The longer term implications will be that governments will be forced to readjust the base rates and open banks to real funding (taking

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Dan Briggs, chief investment officer, Fleming Family & Partners, the international wealth manager. Photograph kindly supplied by Fleming Family & Partners, July 2012.

the pain of realising the losses on their balance sheets), or else accept the consequences of “lack of capital” for longer until banks’ balance sheets are stabilised. In either case, a “shadow lending” community is likely to grow in the medium term. Q: Are risk free assets in developed countries suffering from investor reticence? How might investors be persuaded back into these assets? Is the investment model currently driving investment strategies up to the job? How do investment professionals and corporate managers incorporate these changes into their investment strategies? JUAN CARLOS ARTIGAS: The global recession has brought new meaning to the term“risk-free”asset. In reality, there are no assets that are completely risk-free, but the credibility of assets previously used as risk-free proxies and benchmarks in portfolios has now been severely eroded, leading investment strategists to ponder the validity of their allocation models. On a more practical level, investors must concentrate on finding strategies that help them manage a range of risks more effectively. An asset such as gold that provides diversification, liquidity and capital preservation can be used to enhance current investment strategies and optimise asset allocation models. Of course, it is not a matter of choosing one asset class over another, but how asset classes interact and how to define allocations that promise to match investors’ financial goals over the length of their investment horizon. While many commentators have been suggesting over the last few years that globalisation and the convergent state of the postcrises markets have undermined portfolio diversification as a practical solution, we were heartened recently when polling an audience of leading wealth managers to note that a majority still believe that diversification is key in securing stable portfolio returns. Q: Commodities and their growing scarcity will become a key source of tension as countries compete for resources and access to them: what are the implications of growing competition for resources? Which countries will win out in this regard? DAN BRIGGS: Prices will inexorably rise and protectionist forces doubtless intensify as countries compete to secure supply of limited global energy, hard and soft commodities. While western consumption will remain flat for structural reasons, urbanisation, infrastructure, rising car

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ownership and changing diets will, amongst other factors, fuel explosive demand in developing markets. The US, Russia, Latin America and some central African countries have an edge in agricultural production and exports, while on-going scarcity of water will hinder Australian production. In energy the US is building a strong position from shale gas and oil and may be a major net exporter of gas in the near future. Q: Is gold a stabilising factor in an investment strategy? DAN BRIGGS: Over the past year gold has proved anything but a stabilising factor in portfolios. This has been because it’s been both the beneficiary and the victim of extraordinary liquidity measures to prop up economies and the financial system. Historically gold has represented an asset offering independent valuation and return properties from other assets, important when government money or bonds have been in question. But recently it has been liquidity measures rather than flight to quality arguments that have sustained it. We believe the latter arguments will re-assert themselves in the future and as such Gold does represent a long term stabiliser in portfolios. JUAN CARLOS ARTIGAS: We believe it is. The best way to understand gold is not in isolation, but in the role it plays in a portfolio. Gold acts as a diversifier in good times as well as bad and it also provides long-term capital preservation (against inflation and currency debasements). Gold does not have to be the largest share of a portfolio to perform these functions for investors. In fact, a modest allocation between 2% and 10% can typically increase risk-adjusted returns while reducing potential losses in times of turmoil. The primary reason why gold acts as a diversifier is its many sources of demand (jewellery, investment, technology, and central banks), spread across many countries, each with a diverse set of socio-economic and cultural drivers. India and China collectively account for approximately 50% of gold demand, but European investment demand should also not be under-estimated. Q: How does the destabilised risk free pension portfolio model move forward when government bonds (once a benchmark of low risk) are no longer risk free? JUAN CARLOS ARTIGAS: Given the erosion in confidence in instruments previously used as benchmarks for defining minimal risk levels, investors will have to adopt a more holistic approach to managing portfolio risk. Instead of concentrating on the importance of holding“risk-free”assets, investors will benefit more from understanding how their assets interact and construct portfolios that allow them to take risk while managing it appropriately by utilising assets offering some cross-cyclical stability. Gold can play an important part in this discussion, which is one of the reasons we often refer to it as a ’foundation asset’. Our research has consistently shown that, in the long run, having a modest allocation to gold improves risk adjusted returns while reducing potential losses. PAUL WHARTON: In this respect there have been some interesting developments recently. The Nordic economies of Sweden and Denmark have recognised the damaging impact on“pension deficits”of financial repression. Pension

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fund deficits have been rising in a perfect storm of falling asset values and lower discount rates. The Nordics have recently taken steps to break this rather vicious circle by permitting pension funds to use higher discount rates than offered in the underlying bond markets. Very interestingly on the day these decisions were implemented bonds fell and equities rose. This approach has stemmed the necessity to be a forced seller of assets for the technical reason of declining discount rates. This bodes well. It means that a proper investment appraisal of the benefits of longer term investment in ‘riskier’ assets can take place in a period of financial repression and depressed asset prices. It frees managers to make investment decisions for fundamental reasons and has sensibly removed an artificial restriction that has been acting to depress prices further.

FINANCIAL INSTITUTIONS Q: Will western banks follow Standard Chartered and HSBC’s example and begin to concentrate on high growth markets to (perhaps) the detriment of their business in developed markets? JOHN VEALE: Post the Asian crisis the build up of savings in the growing Asian markets sought a home in the developed western markets. Ironically a region with solid long-term growth dynamics which should be absorbing capital expenditure was sending its savings to regions which have ageing populations and should have been saving and investing to cover the long term liabilities building in their countries. Many of the so called western banks are already global banks; ultimately it does not matter whether it is western, eastern or global banks doing each component, but there should be a continued shift of savings being collected in ageing economies and then invested in regions with demand for long-term growth investments. Unfortunately in some developed regions, especially in Europe, the levels of sovereign funding requirements are likely to see increasing pressure on local banks to support these, thus constraining their ability to participate in this process. Q: Will the financial banking markets in the west return to the 1970s when banking activity was heavily prescribed and a host of discrete investment banking institutions began to rise and bring corporate and investment banking expertise to the markets? Or will another model emerge? PAUL WHARTON: One of the characteristic strengths of Western capitalism has been its capacity to evolve and reinvent itself in different periods and in different circumstances. No-one can seriously argue that any other form of social or economic model has raised living standards for so many, so quickly at other place or time in history. It is highly likely that new models will emerge; peer to peer lending, to take one current example. This is likely to put regulators under constant pressure, but the boundless opportunities of globalisation are likely to create rather than destroy opportunity and innovation.

Paul Wharton, chief investment strategist for Deutsche Bank Wealth Management UK. Photograph kindly supplied by Deutsche Bank Wealth Management UK, July 2012.

There is one word of warning however. Robert Shiller the Harvard economist regards finance as a “technology—a powerful tool for innovation,”Paul Volcker on the other hand regards the ATM as the only useful innovation to emerge out of the banking sector in decades. The banking sector exists to mediate capital flows from where there is an excess to where there is a need. In other words the financial system is the servant of the economy rather than its master. It is a paradox in modern life that arguably innovation is the enemy of good banking. Q: Banking stocks in western markets remain depressed: are they a good buy/bet for the long term? PAUL WHARTON: JK Galbraith acidly observed that “leverage operates in both directions.” Bank valuations were predicated on unprecedented levels of leverage and in a future that contains Basel II and III, maybe the Volcker rule and certainly tighter regulation, both profits and the capacity to leverage those profits are likely to be curtailed for a generation. On that basis, it is highly unlikely that we will see a return to high valuations for some time and therefore bank stocks are likely to be more utility-like in the future. When bubbles burst, history suggests that they rarely reflate. Q: Much is talked about shadow banking: can it really replace traditional banks? Or, will shadow banking continue to work alongside some of the stronger and more capitalised banks? DAN BRIGGS: It is unlikely that the shadow banking system can entirely replace traditional banks as it faces increased regulatory scrutiny and has seen a significant decline in assets since 2008, both in absolute terms and relative to the size of the traditional banking sector. After a small rebound in assets in 2009 it has continued to decline (according to the Deloitte Shadow Banking Index) following concern from investors and regulatory action such as the Dodd-Frank Act. If the trend were to reverse, any increase in assets relative to the size of the traditional banking sector would surely be met with even more stringent regulation. In November 2011, the chair of the Financial Stability Board, Mark Carney, stated that the enhanced supervision and regulation of shadow banking will be one of the top priorities for the FSB in the coming months. The EU has also already adopted measures to regulate shadow banking entities and activities directly. In coordination with the FSB, the EC is currently examining existing measures to propose an appropriate approach to ensure comprehensive supervision of the shadow banking system, coupled with an adequate regula-

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tory framework. However, despite these best efforts, and given that the growth of shadow banking has historically been fuelled by financial innovation, it is not unforeseeable that new activity not previously created could be categorised as shadow banking and enter the system below the radar of regulation. It is less foreseeable however that any new form of shadow banking to be introduced could replace traditional banks before attracting attention, scrutiny and corresponding action from regulatory authorities.

MACRO AND SECTORAL TRENDS Q : The FX markets will most likely receive a huge fillip over the changes in the global economy over the coming decade; the most prominent issue being the RMB. To all intents and purposes it is a part and parcel of trade and investment flows right now. How soon will the RMB become fully convertible? What will the implications of this once it is convertible? DAN BRIGGS: Tied to an economy growing at over 8% per annum, running fiscal and current account surpluses, fundamentally, the RMB looks an attractive potential reserve currency. But the RMB will not become freely convertible for some years to come. China cannot afford to liberalise capital market for fear of a widespread flight of savings out of China. It is also likely that China, for political and social reasons, will reduce mercantilist policies that produce large trade surpluses. It is re-balancing growth away from manufacturing and exports to domestic consumption. As part of this it may step up money printing to spur domestic growth. Currency fundamentals will therefore likely weaken. Q: What will be the implications for its members if the eurozone were to collapse? JUAN CARLOS ARTIGAS: An insight we recently gained when debating investment strategies with key leading commentators and wealth advisors was that there appears to be a broad consensus on how extremely fragile the situation in the euro area is. The majority of the audience expected the imminent departure of Greece from the union. Moreover, the vulnerability of the Spanish economy suggests the burdened euro may face even greater threats. Among many potential consequences of the uncertainty surrounding the euro, are the questions it raises about the effect that monetary and fiscal policies of individual countries can have on the universe of fiat currencies, particularly those that are widely used in global reserve asset management. In turn, this will increase debate on whether having a (de facto) single global reserve currency should the Euro cease to exist, namely the US dollar, is a viable solution in the future or if a more balanced approach with multiple currencies can help balance some of these global risks. With this backdrop, many central bank officials have recently raised the issue of whether gold, while not an official currency, can also play an increasingly important role in the monetary system. Central banks themselves have become net purchasers of gold since late 2009, itself a structural shift that indicates gold’s appeal as a reserve asset. Should the Euro cease to exist,

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

the pool of assets that central banks are allowed to own will shrink, potentially creating a larger role for gold. PAUL WHARTON: The fallout from a euro collapse might not be a great as feared. The world economy has dealt with a previous European Monetary Union collapse ironically also sparked by the Greek economy back in the 1920s and survived. There have been numerous devaluations and defaults around the world and recovery has frequently been speedy. Clearly, Germany would lose its currency advantage as the new DM would probably soar in value but, of course, the weaker states of the South would gain competitiveness and would become extremely cheap destinations for both tourism and capital. Q: Do the current stresses in the global economy call for new approaches to crisis/debt management? Where might leadership for initiatives such as this come from? PAUL WHARTON: One of the lessons that Alan Greenspan took from the recent crisis was that firms acting in“self-interest”was insufficient protection for the economy as a whole. In aggregate firms made decisions that undermined the stability of the whole system. It is also clear that the pace of financial innovation outpaced the capacity of regulators to understand what they were regulating and finally, it became clear that financial institutions themselves were often poorly understood by senior management. All these were clear and present warning signals. So too, was the build-up of major financial imbalances both within individual economies and between economies. Current account deficits have long been a red light for example. But regulators allowed bank assets to outstrip GDP in many cases and permitted loose lending practices that depended on“always open”wholesale money markets. In other words new approaches to debt management are not needed. There probably were sufficient signals to provide disinterested observers with a warning that credit was becoming overheated and there are certainly sufficient examples from history of the severe and lasting impact of credit induced banking crises. But, if you’re not looking you won’t see and while the prevailing culture as exemplified by Chuck Prince was one of “ while the music is playing you have to get up and dance,”it’s not difficult to see why the crisis unfolded. What is clear is that central bankers failed in their own terms, they failed“to take away the punch bowl as the party got going,” in fact they nipped round to the all night offlicence to bring a little bit more! JUAN CARLOS ARTIGAS: In my view, not only at the national level, but also at the commercial bank level, having strong liquidity buffers can help alleviate the unintended consequences of high concentrations of so-called “safeassets” such as sovereign debt as capital requirements. As these assets come under more careful scrutiny, gold has increasingly been playing a role as a high quality source of collateral and more frequently considered for inclusion in regulatory requirements on liquidity. Additionally, central banks, particularly the emerging market central banks, continue to add gold to their reserves, in part to diversify away from the US dollar and euro denominated sovereign debt.

ASSET ALLOCATION ROUNDTABLE

Q: What will be the key commodities in demand over the coming decade? What will be the implications of rising demand and competition for these commodities on the global economy and the global balance of power? JOHN VEALE: Even should Chinese growth shift to a lower gear in the coming decade, it, along with other developing economies, will continue to place pressure on world resources. Oil markets will remain in focus as weaker demand for Hydrocarbons from OECD nations appears all but certain to be more than offset by continued expansion in non-OECD energy consumption. Despite innovations in accessing unconventional resources, the cost basis of finding and delivering new barrels of oil is likely to rise further, placing a higher natural floor under long term prices. Agricultural commodities may also face a tightening supply/demand picture in the coming decade. Demand for each of this sector’s three primary uses – food, feed and fuel is increasing due to population growth, changing diets in emerging markets and the implementation of biofuel policies. Concurrently, supply of high quality arable land is in decline due to urbanisation, land degradation and climate change. Compounding the tightness in supply will be declining productivity gains due to water scarcity and reluctance to adopt genetically modified crops. These dynamics will almost certainly see resource-rich and energy efficient countries benefit as terms of trade continue to move in their favour. Poor countries with few resources of their own and low levels of efficiency are likely to suffer as more of their income is consumed by resource purchases. DAN BRIGGS: Energy is clearly front and centre here. Oil, gas, coal and uranium will all be in strong demand over the coming decade as developing markets expand and look to power their economies. The dynamics of oil and gas could be significantly impacted by shale technology developments in China and the US has a strong possibility of being a net exporter of energy (most likely gas) in the mid-term. Uranium, still largely out of favour, will see a resurgence as nuclear power is increasingly used in developing markets. Agricultural commodities will also be an issue. Increasing soil degradation, pollution, changing weather patterns, higher grain usage and falling water tables are all combining to place pressure on food supply. Fertilisers and GM technologies can compensate to an extent but this is likely to be a major issue in the future. Offsetting this is the fact that there are still vast areas that are underutilised in terms of agriculture (for example, DRC). We are likely to see an emergence of new regions such as this as agricultural superpowers. We hear Abu Dhabi has $150bn set aside for food security. These sums are likely to have a marked impact on the global economy. In the metals market demand is much more heterogeneous. Copper should remain in strong demand due to its widespread use while others such as nickel will need to work through a surplus – (recent changes in Indonesia’s mining laws which prevent raw exports are likely to help this). Lead is in short supply and should see on-going demand as battery use (primarily in transport/cars) grows. In terms of the global balance of power, resource rich

John Veale, chief investment officer, Stonehage Investment Partners (SIP). Photograph kindly supplied by SIP, July 2012.

countries will clearly have the ability to be price setters, however the impact of royalties/taxes and available labour etc will need to be closely monitored as this could stall projects and cut the very production these countries are looking to capitalise on. JUAN CARLOS ARTIGAS: As the populations in developing economies expand and their income grows, gold will continue to be a natural vehicle for long-term savings as well as a form of wealth. This trend is built on well-established foundations. India has a uniquely deep cultural and religious affinity to gold and, similarly, gold is well rooted in the national psyche, although the gold investment market there is still a fairly new one, albeit already one of the world’s largest. The rapid and sustained accumulation of gold by these two countries, along with other countries in the Far East, is indicative of a shift eastwards in wealth, while, concurrently, developed economies struggle to cope with unsustainable debt loads. For Western investors, the emergence of multiple significant sources of demand for gold is a net positive as the broadening base reduces geographic and other idiosyncratic risks in the gold market. And, with no one country producing more than 15% of the world’s gold supply, and many more countries producing gold than was the case in previous decades, we see a balanced picture on both sides of the demand supply equation. Q: Long term off-take agreements in the commodities segment are becoming the norm, and China is seeking to develop a series of close trading ties based around investments in strategies commodities: what are the implications over the long term of these changes in politicaleconomic relationships? DAN BRIGGS: The west is losing out to China in Africa; while we (the west) worry about sanctions and the moral issues of doing business with certain governments, China is in there signing contracts. While many Africa governments (or more specifically, their populations) resent the level of Chinese involvement in their economies they are essentially forced to deal with them as the west is unwilling to step up. For example in Niger the Chinese have built a refinery which services the local population but they also have rights to off take from the plant. Who else is going to provide the cash to build this infrastructure? In providing infrastructure and unlocking mineral wealth, China is also creating a vast consumer market to which it can export its goods. Overall the unlocking of Africa’s mineral wealth by (primarily) the Chinese is a positive as it is resulting in rising wealth which we see manifesting in greater demand for higher energy content foodstuffs (eg meat), housing and services such as telecommunications. I

J U LY / A U G U S T 2 0 1 2 • F T S E G L O B A L M A R K E T S

GM Data pages 63_. 20/07/2012 10:14 Page 75

(Week ending 29 June 2012) Reference Entity

Federative Republic of Brazil Bank of America Corporation Republic of Italy Republic of Turkey Russian Federation United Mexican States Morgan Stanley JP Morgan Chase & Co. Republic of Korea Japan

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Financials Government Government Government Government Financials Financials Government Government

Sov Corp Sov Sov Sov Sov Corp Corp Sov Sov

167,960,587,771 85,957,246,650 321,937,584,277 142,197,022,593 114,849,463,877 123,757,107,456 82,842,947,054 83,062,778,050 74,409,550,852 86,731,377,460

18,303,088,797 4,927,351,837 20,707,285,933 5,945,048,529 4,272,193,464 8,679,222,507 4,553,692,283 4,269,050,551 6,579,138,638 10,957,747,103

10,609 10,126 9,652 9,643 9,292 9,066 8,671 8,640 8,424 8,292

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

Top 10 net notional amounts (Week ending 29 June 2012) Reference Entity

French Republic Federal Republic of Germany Republic of Italy Federative Republic of Brazil Kingdom of Spain UK and Northern Ireland Japan General Electric Capital Corporation People’s Republic of China United Mexican States

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Government Financials Government Government

Sov Sov Sov Sov Sov Sov Sov Corp Sov Sov

143,815,976,192 118,408,004,776 321,937,584,277 167,960,587,771 166,758,416,350 62,944,301,971 86,731,377,460 86,083,986,880 66,849,737,966 123,757,107,456

23,457,870,370 21,144,203,012 20,707,285,933 18,303,088,797 13,939,516,307 11,098,380,953 10,957,747,103 10,165,189,821 8,731,924,075 8,679,222,507

6,196 4,396 9,652 10,609 7,153 4,073 8,292 6,944 7,485 9,066

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 29 June 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Corporate: Financials

3,238,705,951,301

457,250

Federative Republic of Brazil

5,479,707,400

406

Sovereign / State Bodies

2,806,665,266,584

212,184

French Republic

5,465,390,525

352

Corporate: Consumer Services

1,763,814,002,512

309,195

Kingdom of Spain

5,025,839,782

445

Corporate: Consumer Goods

1,717,075,987,137

290,033

Republic of Italy

4,925,791,473

286

Corporate: Industrials

1,121,759,824,053

200,707

Japan

2,272,600,976

258

Corporate: Basic Materials

Gross Notional (USD EQ)

Contracts

894,592,637,185

152,154

United Mexican States

1,701,995,400

159

Corporate: Telecommunications Services 829,329,955,130

134,361

Federal Republic of Germany

1,560,156,984

108

Corporate: Utilities

691,161,422,243

117,655

Republic of Turkey

1,476,905,000

128

Corporate: Energy

504,924,802,923

93,476

Volkswagen Aktiengesellschaft

1,459,166,824

156

Corporate: Technology

357,765,910,886

65,259

Russian Federation

1,376,400,000

166

Corporate: Health Care

328,821,128,266

59,706

Corporate: Other

140,621,770,382

16,160

Residential Mortgage Backed Securities

42,792,736,297

8,105

CDS on Loans

39,490,039,947

10,446

Commercial Mortgage Backed Securities 12,852,676,234

1,363

Residential Mortgage Backed Securities*

7,832,844,012

495

CDS on Loans European

3,175,487,331

535

Muni: Government

1,201,700,000

118

Other

787,671,524

Commercial Mortgage Backed Securities*

573,698,100

Muni: Utilities

11,400,000

*European

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 2

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data © 2012 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

GM Data pages 63_. 20/07/2012 10:14 Page 76

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

140

120

100

1 Ju

-1

ar M

De c-

11 n-

Se p11

0 Ju

-1

10 M

De c-

10 n-

Se p-

0 Ju

-1

09 M

De c-

Se p-

9 Ju

-0

M ar

De c-

08 n-

Se p-

8 Ju

-0

07 M

De c-

Se p-

40 Ju

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE RAFI Developed 1000 Index

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

120

100

-1 Ju n

2 ar -1

11 c-

pSe

Ju n

-1

1 ar -1

10 c-

10 pSe

n10

0 ar -1

09 c-

pSe

Ju n

-0

09 ar -

8 -0

Ju n

ar -

07 De

pSe

7 -0 Ju n

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE EPRA/NAREIT Global Index

FTSE Global Government Bond Index

FTSE Global Infrastructure Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

250 200 150 100 50

12 nJu

-1 2 M

11 cDe

p11 Se

1 -1 M ar

10 cDe

pSe

nJu

-1 0 ar

09 M

cDe

09 p-

09 nJu

9 -0 M ar

08 cDe

08 pSe

08 ar M

07 cDe

07 pSe

Source: FTSE Group, data as at 29 June 2012

J U LY / A U G U S T 2 0 1 2 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

GM Data pages 63_. 20/07/2012 10:14 Page 77

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE US TM Index

FTSE USA Index

FTSE All-World ex USA Index

120

100

-1 ar M

11 cDe

Se p11

1 Ju

-1

10 M

10 n-

Se p-

0 Ju

-1

De c-

09 n-

Se p-

9 Ju

-0

08 M

De c-

pSe

8 -0 ar

07 M

De c-

pSe

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE RAFI US 1000 Index

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

120

100

Ju n

-1

2 M

ar -1

11 cDe

p11 Se

-1 Ju n

11 M

ar -

cDe

0 Ju n

-1

10 ar -

cDe

-0

9 Se

Ju n

09 ar -

cDe

-0

8 Se

Ju n

08 M

ar -

07 cDe

pSe

Ju n

-0

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE Americas Government Bond Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance US IPO Index

160 140 120 100 80 60 40

12 ar M

11 cDe

11 p-

11 nJu

11 ar M

10 cDe

10 pSe

n10 Ju

10 ar M

09 cDe

09 pSe

9 ar -0 M

08 cDe

08 p-

08 nJu

08 ar M

07 cDe

07 pSe

Source: FTSE Group, data as at 29 June 2012

F T S E G L O B A L M A R K E T S â&#x20AC;˘ J U LY / A U G U S T 2 0 1 2

GM Data pages 63_. 20/07/2012 10:14 Page 78

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (29 June 2007 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

120

100

1 Ju

-1

De c-

0 Ju

-1

0 Se

-1

-1 ar M

De c-

9 M

-0

De c-

8 Ju

-0

07 M

7 p0

De c-

20 n-

MARKET DATA BY FTSE RESEARCH

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (29 June 2007 = 100) FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

120

100

11 ar M

1 p-

-1

1 -1 Ju n

10 M

ar -

0 -1 p-

-1

0 Se

Ju n

10 ar M

9 -0 pSe

09 ar M

8 -0 pSe

08 M

ar -

7 c0 De

07 pSe

Middle East and Africa View 5-year Performance Graph (Total Return) Index level rebased (29 June 2007 = 100) FTSE JSE Top 40 Index (ZAR)

FTSE CSE Morocco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

160 140 120 100 80 60 40

11 ar M

1 -1 pSe

10 ar -

10 cDe

0 -1 pSe

n10 Ju

10 ar M

9 -0 pSe

09 ar M

8 Se

-0

08 nJu

ar -0 8 M

cDe

07 pSe

Source: FTSE Group, data as at 29 June 2012

J U LY / A U G U S T 2 0 1 2 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

GM Data pages 63_. 20/07/2012 10:14 Page 79

ASIA-PACIFIC MARKET INDICES Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (29 June 2007 = 100) FTSE Asia Pacific Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

FTSE RAFI Developed Asia Pacific ex Japan Index

160 140 120 100 80 60

1 ar M

-1

1 De

pSe

-1

0 M

Ju n-

-1

De c-

p-1

nJu

ar M

-1

9 De

-0

ar M

8 -0 p-

nJu

De c-

8 -0

07 M

De c-

pSe

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (29 June = 100) FTSE China A50 Index

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

180 160 140 120 100 80 60

Ju n

-1

1 ar -1

11 cDe

1 Se

-1

0 M

ar -1

0 p-1 Se

0 ar -1 M

9 -0 pSe

09 M

cDe

ar -

8 p-

-0 Ju n

-0

08 ar -

07 cDe

pSe

Ju n

-0

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

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

130

120

110

100

2 -1 ay M

r12 Ap

-1 2 ar M

-1 2 Fe b

12 nJa

11 ov N

11 tOc

11 pSe

g11 Au

11 lJu

1 -1 M ay

11 ar M

-1 1 Fe b

11 nJa

Source: FTSE Group, data as at 29 June 2012

F T S E G L O B A L M A R K E T S â&#x20AC;˘ J U LY / A U G U S T 2 0 1 2

GM Data pages 63_. 20/07/2012 10:14 Page 80

INDEX CALENDAR

Index Reviews Aug-Sep 2012 Date

Index Series

Review Frequency/Type

07-Aug 10-Aug 15-Aug 15-Aug 28-Aug Early Sep 04-Sep

Monthly review – additions & free float adjustment Quarterly review Quarterly review Annual review Quarterly review Semi-annual review / number of shares

30-Aug 07-Sep 03-Sep 17-Sep 21-Sep 28-Sep

31-Jul 30-Jun 31-Jul 31-Jul 31-Jul 31-Aug

04-Sep 07-Sep 07-Sep 07-Sep 07-Sep

TOPIX Hang Seng MSCI Standard Index Series SMI Family Index DJ STOXX ATX FTSE Global Equity Index Series (incl. FTSE All-World)_ FTSE China Index Series AEX BEL 20 PSI 20 S&P / ASX Indices

21-Sep 21-Sep 21-Sep 21-Sep 21-Sep

29-Jun 20-Aug 31-Jul 31-Jul 31-Jul

07-Sep 07-Sep 07-Sep 07-Sep 07-Sep

CAC 40 DAX FTSE Vietnam Index Series S&P US Indices TOPIX

21-Sep 16-Sep 21-Sep 21-Sep 21-Sep

26-Aug 31-Aug 31-Aug 31-Aug 31-Aug

11-Sep 12-Sep

FTSE MIB Index FTSE Global Equity Index Series (incl. FTSE All-World)_ FTSE Multinational FTSE JSE All-Africa Index Series FTSE JSE Index Series FTSE AIM Index Series FTSE ASFA Australia Index Series FTSE ECPI Index Series FTSE European Index Series FTSE Italia Index Series FTSE Nordic Series NZX 50 FTSE UK Index Series Dow Jones Global Indexes DJ Global Titans 50

Annual review / Japan Quarterly review Periodic review Quarterly review Quarterly review Quarterly review – shares, S&P / ASX 300 consituents Annual review of free float & Quarterly Review Quarterly review/ Ordinary adjustment Quarterly review Quarterly review – shares & IWF Monthly review – additions & free float adjustment Quarterly review

27-Sep 21-Sep

31-Aug 31-Aug

Annual review / Developed Europe Annual review Quarterly review Quarterly review Quarterly review Semi-annual review Quarterly review Quarterly review Quarterly review Semi-annual review Quarterly review Quarterly review Quarterly review Quarterly review – no composition changes only rebalance/shares/float changes

21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep

29-Jun 29-Jun 17-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 11-Sep 31-Aug

21-Sep

31-Aug

Annual review Semi-annual review

21-Sep 21-Sep

31-Aug 31-Aug

Semi-annual review Quarterly review

21-Sep 21-Sep

31-Aug 31-Aug

Quarterly review Quarterly review – shares & IWF Quarterly review – shares & IWF Quarterly review – shares & IWF Quarterly review Quarterly review – shares & IWF Quarterly review – shares & IWF Semi-annual review Quarterly review – IPO additions Quarterly review – IPO additions

21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 28-Sep 28-Sep

31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug

12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 13-Sep 13-Sep 13-Sep 13-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep 14-Sep

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE ST Index Series FTSE IDFC India Infrastructure Index Series FTSE TWSE Taiwan Index Series FTSE Shariah Global Equity Index Series S&P Asia 50 S&P Europe 350 / S&P Euro S&P Topix 150 S&P Latin 40 S&P Global 1200 S&P Global 100 FTSE4Good Index Series Russell Global Indices Russell US Indices

Effective Data Cut-off (Close of business)

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

J U LY / A U G U S T 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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