FTSE Global Markets

EUROPEAN ASSET MANAGEMENT AND ASSET SERVICING ROUNDTABLE

ISSUE 64 • SEPTEMBER 2012

Will regulation help or hinder Canadian sec-lending?

Sorting out the processes in OTC derivatives clearing Structured finance held hostage by cheap money Is Delta One risk-free investing?

US election brings regulation into focus MANAGING RISK AND LIQUIDITY IN TRANSITION MANAGEMENT

Gold market intelligence Responsible investment decisions require a solid understanding of assets and markets.

The World Gold Council offers investment professionals a unique resource through our investment research and marketing programme. We use a variety of media to provide the in-depth information and independent analysis that are needed to support gold investment. We are the world’s leading organisation for investor education on gold. www.gold.org/investment

The World Gold Council is the market development organisation for the gold industry. Working within the investment, jewellery and technology sectors, as well as engaging in government affairs, our purpose is to provide industry leadership, whilst stimulating and sustaining demand for gold.

We provide insights into the international gold markets, helping people to better understand the wealth preservation qualities of gold and its role in meeting the social and environmental needs of society.

World Gold Council 10 Old Bailey, London EC4M 7NG, United Kingdom T +44 (0)20 7826 4700 W www.gold.org

F +44 (0)20 7826 4799

E info@gold.org

OUTLOOK EDITORIAL DIRECTOR: Francesca Carnevale T: +44 [0]20 7680 5152 | E: francesca@berlinguer.com SENIOR EDITORS: David Simons (US); Neil A O’Hara (US); Ruth Hughes Liley (Trading) EDITORS AT LARGE: Art Detman; Lynn Strongin Dodds CORRESPONDENTS: Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Ian Williams (Supranationals/Emerging Markets); Dan Barnes (Derivatives/FX) PRODUCTION MANAGER: Mariangel Gonzalez T: +44 [0]20 7680 5161 | E: production@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Paul Hoff; Jerry Moskowitz; Andy Harvill HEAD OF SALES: Peter Keith T: +44 [0]20 7680 5153 | E: peter.keith@berlinguer.com SALES MANAGER: Alex Dale T: +44 [0]20 7680 5156 | E: alex.dale@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) EVENTS MANAGER: Lee Michael White T: +44 [0]20 7680 5153 | E: lee.white@berlinguer.com EVENTS: Oliver Worsley Gorter, T: +44 [0]20 7680 5154 FINANCE MANAGER: Tessa Lewis T: +44 [0]20 7680 5159 | E: tessa.lewis@berlinguer.com HEAD OF RESEARCH: Henry Blanchard T: +44 [0]20 7680 5157 | E: henry.blanchard@berlinguer.com RESEARCH: Rebecca O’Brien, T: +44 [0]20 7680 5160 Lydia Koh, T: +44 [0]20 7680 5151 PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION: Register online at www.ftseglobalmarkets.com Single subscriptions cost £497/year for 10 issues.

Multiple company subscriptions are also available FTSE Global Markets is now published ten times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2012. All rights reserved.]

FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence.

FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors.

All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication.

All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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

Total average circulation per issue, July 2011 - June 2012: 20,525

FTSE GLOBAL MARKETS • SEPTEMBER 2012

HE QUESTION IN most investors’ minds must now be: how do we rediscover our market mojo while all around us the rest of the world continues in a recessionary funk? There are no quick fix solutions in sight and only the occasional glimmer of the promise of tomorrow.

While London basked in the Olympics, the City remained anxious and quiet. That was pretty much the mood everywhere in what turned out to be, for most of Europe, a rather arid summer. The pall is understandable. The global economy continues to register anaemic growth, and as September opens it looks to be faltering as consumer spending (even in burgeoning China) has lost most of its steam. With the eurozone teetering once more on the brink of recession we now look to both political and business leaders to help reignite market confidence. This will not be easy, as deleveraging remains the prime focus of Europe’s political classes.

The present, seemingly unlimited availability of cheap funding from the European Central Bank (ECB) seems certain to cast a shadow over the debt markets, particularly the securitised debt market, for many more months yet. The €1trn of three-year money (with an interest rate of 1%) that the ECB injected into the eurozone banking system through its two Long-Term Refinancing Operations (LTROs) in December and February will give banks little incentive to attempt securitising assets until 2014 (when they will need to think about refinancing the LTRO funds). The cost of funding themselves in the market in the meantime would be considerably higher than using the ECB-offered liquidity. It is also quite possible that the ECB will conduct further LTROs, particularly if political developments in the eurozone—such as a sovereign default by Greece and/or the country’s exit from the single currency—threaten to destablise the European banking system once more.

Andrew Cavenagh looks at the long term consequences.

Across the pond come November conditions look to favour a second Obama term and the possibility that the Republican Party will gain control of the Senate.

That invariably means the US economy and political will remain in gridlock for some more years, unless someone finds a new way to communicate across the political divide. As David Simons points out in this month’s cover story, even with a GOP Senate majority, Democrats will likely retain enough seats to prevent the passage of major legislation should they wish to, and they just might, given the rather wide philosophical differences between the two parties right now. Great chasms have never been crossed with tiny steps, but it is questionable whether anyone has the political vision right now to develop much needed cross-party consensus to meet today’s market challenges.

The disconnection between politicians and regulators and the investment community is clearly highlighted in this month’s roundtable. In an often trenchant discussion, the roundtable highlights some of the frustrations felt by the buy side in today’s regulation-happy climate. As Alan Miller, founding partner and chief investment officer, of wealth manager SCM Private notes,“In terms of market change, we don’t want more regulation; we simply want more effective regulation. If you have a system which nobody inside the industry can ever begin to understand then I say it is almost impossible for that regulation to be effective. It rather like a business contract: if it is a short contract, it is probably going to be honoured by both sides.”

T

Francesca Carnevale, Editor, September 2012 Cover photo: SEC Chair Mary Schapiro testifies on Capitol Hill in Washington, before the Senate Banking Committee hearing on the implementation of the Wall Street reform act. Photograph supplied by Evan Vucci/AP/Press Association Images, August 2012.

1

CONTENTS COVER STORY

WILL THE US ELECTION SHAKE OUT REGULATION?

....................................Page 4 After three and a half years, Mary Schapiro, chairman of the US Securities and Exchange Commission (SEC), has sought to make a far more vigorous and aggressive organisation. Does the outcome of the elections alter the current regulatory dynamic? A lot will depend on what happens after November 6th.

DEPARTMENTS

MARKET LEADER

FX TRADING: THE ALGOS ARE COMING! ...........................................................Page 10 New trading venues re-write FX trading. Neil A O’Hara reports.

PRIVATE EQUITY FLIES IN CEE STATES ..................................................................Page 16

IN THE MARKETS

Why European private equity is looking eastwards.

TECHNOLOGY TAKES THE STRAIN OF LOW TRADING VOLUMES ........Page 20 Big spend on technology as regulation reform approaches.

FACE TO FACE

HOW ESECLENDING RESPONDS TO MARKET CHANGE ........................Page 26

TRADING POST

SAFETY FIRST FOR MARGIN ASSETS ......................................................................Page 28

Francesca Carnevale speaks with Karen L O’Connor, co-CEO of eSecLending.

Bill Hodgson, consultant, The OTC Space, on margin calls and asset management.

RUSSIAN TRADING UPS THE ANTE ..........................................................................Page 29 Russian brokers gear up for new business.

COUNTRY REPORT

THE MOSCOW EXCHANGE’S DASH FOR GROWTH ..................................Page 34 The Moscow Exchange: A cornerstone of market renewal.

TURKEY WIDENS DEBT MARKET ..............................................................................Page 37 The range of securities and maturities continues to grow.

DERIVATIVES

LOW RISK BY NAME, BUT IS DELTA ONE RISK FREE? ..............................Page 40 Neil A O’Hara finds that Delta One hasn’t always lived up to its low-risk name.

INSTITUTIONS AND CORPORATIONS LOOK ANEW AT SUKUK ........Page 42

DEBT REPORT

Is this a new beginning for sukuk? Andrew Cavenagh reports.

STRUCTURED FINANCE HELD HOSTAGE BY CHEAP MONEY ............Page 46 The recovery in primary issuance over the last three years drawn to a halt.

THE BEAR VIEW

A SMALL STEP FOR EQUITIES BUT TOO LARGE FOR BAILOUTS? ..Page 50

TRADING VENUES

MARKET FRAGMENTATION WORK IN LOW VOLUME TRADING ..Page 52

EXPERT PANEL

TRANSITION MANAGEMENT: MANAGING RISK & LIQUIDITY ..........Page 57

SEC LENDING

WILL REGULATION END OR BOLSTER CANADIAN SEC LENDING? ....Page 63

CLEARING & SETTLEMENT

DERIVATIVES CLEARING: DOWN TO THE NITTY-GRITTY ..........................Page 66

ROUNDTABLE

BALANCING MARKET OPPORTUNITY AND RISK ............................................Page 69

DATA PAGES 2

Simon Denham, managing director of Capital Spreads, takes the bearish view.

Brokers-dealers must work harder to secure best pricing. Ruth Hughes Liley reports.

How can transition managers handle this demanding business set?

The sector braces itself for the possible impact of regulation at home and abroad.

The deadline for clearing OTC derivatives is near. Can the industry sort it out on time?

European asset servicing: buy side and sell side responses to market change.

DTCC Credit Default Swaps analysis ..............................................................................................Page 79 Market Reports by FTSE Research................................................................................................................Page 80 Index Calendar ....................................................................................................................................................Page 84

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Business solutions made for you We value partnership Are you ready to meet tomorrow’s challenges? We are working with top quality partners to create opportunities in a turbulent world.

Clearstream. Your partner. clearstream.com

COVER STORY

US ELECTION: IMPACT ON REGULATION Photograph © Benjamin Haas / Dreamstime.com, August 2012.

Will the US election shake out regulation?

During her three-and-a-half years on the job, chairman Mary Schapiro has sought to make the US Securities and Exchange Commission (SEC) a far more vigorous and aggressive organisation than in the past. Does the outcome of the US elections alter the current regulatory dynamic? A lot depends on how much (if any) change occurs come November 6th. From Boston, Dave Simons reports.

PPOINTED BY PRESIDENT Barack Obama just days after the 2009 inaugural, SEC chairman Mary Schapiro took the reins at one of the most cataclysmic intersections in global financial history. In the rearview mirror was Lehman and Madoff; weeks later, the markets plunged 2000 points, the culmination of a historic sell-off that began during the dying days of the Bush administration. Schapiro’s predecessor, former SEC chairman Christopher Cox, had worked earnestly to hold financial

A

4

institutions’ feet to the fire, yet in the credit crisis had failed to nip the big one in the bud. In defense of the SEC, the outgoing Cox argued that the agency’s limited powers were at least partially to blame for the oversight gaps that were exploited by the likes of Lehman and Bear Stearns; the SEC had also lacked the wherewithal to bring clarity to the hopelessly opaque swaps market.

What Cox needed—but never got, until it was too late—was a brand new set of regulatory tools that were capable of addressing the multitude of loop-

holes, conflicts of interests and other abuses that had led to the systemic unraveling of the markets.

Schapiro has had a much better run of it on many fronts. After bottoming out in March 2009 the Dow has tacked on 7000 points, corporate balance sheets have strengthened and the nation’s economy is inching forward, albeit in fits and starts. Under Schapiro, the SEC has worked to improve the efficacy of its enforcement division, and has sought to bring greater transparency and fairness to the world of finance through the mother of all regulatory initiatives, the Dodd Frank Wall Street Reform and Consumer Protection Act. More importantly, Schapiro’s efforts to bring about bona fide financial reform have been bolstered by a select group of regulation hawks in Congress who have shown a willingness to give the SEC greater authority to hold non-compliant firms accountable. (Legislation recently introduced by Democratic Senator Jack Reed and Republican Senator Chuck Grassley, for example, would allow the SEC to raise the maximum penalty from $725,000 to $10m for violating financial institutions.)

Despite some suggestions that increased regulation under the current SEC regime has led to greater inefficiency and the potential for market dislocations, the improvements in transparency have allowed investors to breathe a bit easier, asserts Brian Kinney, who oversees fixed-income portfolios as managing director for State Street Global Advisors.“Say what you want about regulation—the fact of the matter is investors have been able to look at corporate balance sheets and have had a much better understanding of what’s actually behind them,” offers 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.”

Nicholas Colas, chief market strategist for New York-based ConvergEx

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

COVER STORY

US ELECTION: IMPACT ON REGULATION

Group, says there is no doubt that today’s SEC is a much more vigorous organisation than it has been in the past. “In terms of overall investigative powers as well as its profile on the street, the SEC under chairman Schapiro has gained considerably strength, not just compared to the administration of Christopher Cox, but those before him as well.”

One could argue that the radically revamped political and financial landscape post-2008 helped make this metamorphosis almost inevitable. “In chairman Schapiro’s case, it certainly was a case of the person being shaped by the times,” says Colas.“In the aftermath of the financial crisis investors wanted a regulatory agency that would be far more aggressive, and I believe that by and large the SEC has fit that bill. Had things not blown up quite the way they did in 2007-2008 we might not have seen this kind of profile.”

Even so, the road ahead is likely to be a rocky one for Schapiro, should she stay on as SEC head. While contending with those who consider the agency’s policies inordinately restrictive, Schapiro will have to continue to endure an unprecedented ideological divide that has forced the Obama administration— and Schapiro herself—to attempt to pass meaningful legislation with little to no GOP support.

Finding bipartisan consensus on money market reform, for example, proved to be much too tall an order for Schapiro’s SEC. Earlier, Schapiro had proposed a two-tiered plan to re-structure money funds, one part featuring a capital buffer requirement with a 30day hold-back on investor redemption requests, the other involving a moving net asset value (NAV) to discourage complacency and accurately reflect fund holdings. Speaking at an Investment Company Institute (ICI) conference last spring, Schapiro said that these reforms would be necessary in order to address “legitimate concerns about the risks posed by the stable NAV and the potential to cause runs,”adding,“we all know what happened in 2008,”a refer-

6

Mary Schapiro, chairman of the US Securities and Exchange Commission (SEC). Photograph kindly supplied by the SEC, August 2012.

ence to the collapse of the Reserve Primary Fund during the height of the crisis that fall. However, in August the plan was rejected by the SEC’s two Republican members, Daniel Gallagher and Troy Paredes, along with Democratic commissioner Luis Aguilar, leaving it to the Timothy Geithner-led Financial Stability Oversight Council (FSOC) to take up the cause.

Election scenarios Do the upcoming US elections impact the regulatory dynamic under Schapiro’s regime? A lot depends on how much (and if any) change occurs come November 6th. Incumbency offers tremendous advantages; since World War I, only three sitting presidents elected to office have gone down to defeat. Given those odds, soothsayers such as Mike Ryan and Kurt Reiman of Wealth Management Research-Americas division, UBS, say that conditions favour a second Obama term, but also the possibility of Republicans narrowly gaining control of the Senate, with 21 of 33 seats up for grabs held by Democrats. Under that scenario gridlock is likely to prevail for at least another two years, given the degree of Congressional bipartisanship that has marked the current term. Even with a GOP Senate majority,“Democrats will likely retain enough seats to prevent the passage of major legislation,” note the UBS strategists, “and with broad philosophical issues about

the size and role of government, compromise seems unlikely.”

Colas agrees that a re-elected Obama, coupled with the same congressional balance of power, equals status quo—which, since the GOP power shift of 2010, has meant little in the way of real change. “Against this backdrop, we’re likely to see a continuation of the same kind of regulatory environment,” remarks Colas. Even a “best-case” scenario in which Senate Democrats maintain their miniscule majority and Barack Obama keeps his 1600 Pennsylvania Avenue mailing address doesn’t favour a swift acceleration of Dodd Frank implementation.

“To investors who prefer the status quo because it’s predictable, this scenario represents the most positive outcome,” says Colas. To others, however, it means that Dodd Frank likely becomes the next Sarbanes-Oxley, says Colas, referring to the financial-accounting legislation enacted in the wake of the Enron scandal.

“To date Dodd Frank has essentially been deprived of oxygen,” says Colas.

“Talk to Gary Gensler [chairman of the Commodity Futures Trading Commission] or anyone else in that position and they’ll tell you that there simply haven’t been enough resources to keep this thing moving forward. Status quo means that situation stays the same— a slow, grinding, difficult road to implementation, marked by a lot of back and forth and more arguing and wrangling in between.”

Things could get interesting (or ugly, depending on one’s perspective) should GOP contender Mitt Romney prevail. On the campaign trail the former Massachusetts governor has vowed to dismantle Dodd Frank lock stock and barrel (ditto for SarbanesOxley and Obamacare), saying he would institute alternative measures that include offsetting the cost of new regulations by eliminating others, while asking Congress to vote on any new regulation with an economic impact in excess of $100m. According to Romney spokeswoman Andrea Saul, as presi-

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

COVER STORY

US ELECTION: IMPACT ON REGULATION

dent Romney would “push for common-sense regulation that gives regulators tools to do their jobs, and that gives investors more clarity.”

Additionally, naming Wisconsin Republican Paul Ryan as veep was a concerted effort by Romney and the GOP to bring the near-term role of government into sharper focus. While taxation is a key part of this theme, equally important is the manner in which regulatory matters are handled.

Moreover, with a Republican administration, it’s likely that a re-shaping of governmental responsibility would include an overhaul of the financial system’s regulatory framework, currently in progress.“One would have to assume that, at least at the margin, things would be considerably more lenient under Romney-Ryan,” remarks Colas.

Lenient? Maybe. A fully-fledged repeal of Dodd Frank? Not likely. Even staunch critics of Dodd Frank have expressed scepticism over Romney’s repeal rhetoric. In reality, many in Washington and on Wall Street have already factored in Dodd Frank; as Wisconsin’s freshman GOP congressman Sean Duffy notes,“There’s not a movement to repeal and replace Dodd Frank—there’s a movement to fix it.”Attempts to completely gut Dodd Frank could have dire consequences for the financial industry as a whole, say some observers, and that such efforts would only delay the inevitable legislation that has yet to be implemented.

“Yes, repeal makes a good talking point,” says Colas, “but one has to wonder how something of that nature would actually be executed.” For one thing, it calls into question whether large money-center banks would actually want to re-engage on things such as proprietary trading, even if they’re given the opportunity to do so via a deconstruction of Dodd Frank.

“This hasn’t been that great a year for hedge-fund returns,”says Colas,“therefore, do you really want to go and replicate a hedge-fund model inside your firm when it might not matter that much for your return on equity? In

8

Troy Paredes, commissioner, US Securities and Exchange Commission (SEC). Photograph kindly supplied by the SEC, August 2012.

terms of valuation, the main challenge facing banks right now is that no one believes they can make a return sufficient enough to cover their capital costs, which is why many of them are currently trading below book value. So does the ability to suddenly bring back prop trading really help you all that much? I think not.”

Regulatory matters Any discussion of pending regulatory matters wouldn’t be complete without contemplating the near-term fortunes of the economy, not to mention the post-election direction of the financial markets. Some suggest that a change in the White House could trigger a rally in equities as the markets suddenly discount pre-existing assumptions about regulatory costs under a Democratic administration.

However, in the current environment, it is extremely difficult to fathom large banks suddenly reveling in the death of Dodd Frank by plowing funds once earmarked for capital adequacy into a resurrected prop fund. “If anything, that could create even more anger among institutional investors,” observes Colas. Nevertheless, reversing elements of Dodd Frank remains at the top of the GOP agenda; for better or for worse. Speaking in July to the Society of Corporate Secretaries & Governance Professionals, SEC commissioner Troy Paredes argued that Dodd Frank was “a historic expansion

of the federal government’s power over the economy” and that the measure “goes too far.”

For whatever reason, lawmakers such as Paredes have had a habit of not paying enough mind to opinion polls, such as the one from Lake Research Partners issued in July that found 75% of voters strongly favouring the Dodd Frank reforms. “Regulation of financial institutions following the crisis is a force influencing global markets, regulators and economies,” acknowledges Société Générale in a recent Cross Asset Research report.“Voter sentiment against financial institutions is too strong at the moment.”

Sustained public discontent, fueled by periodic disturbances such as Knight, Pipeline, MF Global et al, could play a key role this election season, as it did during the last election season. Just prior to the collapse of Lehman four years ago, then-candidate Obama was running neck-and-neck in the polls with GOP rival John McCain. By the time the dust had settled weeks later, Obama—who’d humbled his opponent during a memorable White House exchange the week of the crisis—had opened up an insurmountable lead.

“People question whether they’re getting accurate and honest information,” remarked Chairman Schapiro during a recent House Oversight subcommittee hearing,“and whether or not the market structure itself is tilted against the individual investor and in favor of the institutional investor. Those are things we worry about all the time. Because at the end of the day, investor confidence is the oxygen markets survive on—and if we lose it, it is extraordinarily hard to regain it.”

No matter what happens on November 6th, once thing is certain: the electorate will gain some real clarity into the future course of government, including the degree to which government chooses to enforce investment matters.

The smart money would seem to favor those with a willingness to commit to workable reform; time will tell if those bets turn out to be correct.I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Team with the experts who make your business needs their own.

Who’s helping you?

Risk mitigation, operational efficiency, new assets and new regulations. Meet the challenges of today’s markets head on with your team at BNY Mellon. We offer an unmatched range of global product solutions backed by experts to help you along every step of the investment continuum. Our strength and scope keep us at the forefront of the changing marketplace. But we remain dedicated to putting your objectives at the core of everything we do.

For more information, please contact: US: Bill Salus +1 302 791 2000 Canada: Barbara Barrow +1 416 643 6361 UK: Dean Handley +44 20 7163 5458 Continental Europe: Sid Newby +44 20 7163 3429 Asia-Pacific: Michael Chan +65 6372 6931 bnymellon.com/assetservicing Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. ©2012 The Bank of New York Mellon Corporation. All rights reserved.

MARKET LEADER

NEW TRADING VENUES RE-WRITE FX TRADING

The banks embraced electronic trading among themselves in the early 1990s through platforms such as Reuters and EBS, which initially denied access to other market participants. The bank-only platforms later opened up to a wider audience, attracting among others high frequency trading firms whose liquidity some banks consider toxic. The banks began to pine for a trading venue for their exclusive use, or at least where they were protected against scalpers—the origin of the forthcoming TraFXpure platform. Neil A O’Hara reports on the implications of its introduction.

FX trading: the algos are coming!

HE DRIVER FOR TraFXpure was to address the needs of those who participate in the wholesale foreign exchange market,” explains Campbell Adams, managing director of TraFXpure. “That means transparency, openness, the same fees for all, no special deals. The overarching principle was that no one could buy a trading advantage.”

Adams, who founded FX Pure, the consulting firm that conceived the new platform, secured an agreement with inter-dealer broker Tradition in May to bring the system to market; the target launch date is January 2013. He has been working with Tradition since June.

Although TraFXpure will be open to all market participants—the only requirement is the ability to clear trades through CLS—the design discourages predatory tactics. Market data will be available to all participants on an equal basis—unlike some competing platforms, traders cannot obtain enhanced data or faster delivery for a premium price. Execution charges will be the sole revenue source for TraFXpure. “We are open to high frequency trading, a much-maligned term,” says Adams. “We will promote positive trading behaviour at all times. We aim to exclude bad behaviour rather than specific types of participant.” The system architecture will ensure that low latency connections per se will not give users an edge.

Upon launch, the platform will facilitate trades in the 17 currencies CLS clears as well as certain popular currency pairs like sterling-yen, sterling-Swiss franc and euro-yen—

T

“

10

Photograph © Frenchtoast / Dreamstime.com, August 2012.

some 25 line items in all. The goal is not so much the tightest bid-offer spread as reliable depth at the quoted price.

“Wholesale participants wanted a market where they have confidence in size rather than trying to lay off risk in an environment cluttered with unnecessary noise,” says Adams. “I suspect we won’t be the narrowest spread, but we will have firmer liquidity at each price point.”

Several major banks have agreed to provide seed liquidity on TraFXpure, including Barclays, BNP Paribas, Deutsche Bank, Royal Bank of Canada and UBS. While TraFXpure focuses on

wholesale traders, another new platform, FastMatch FX, tries to offer a solution for every participant, from banks, hedge funds and high frequency trading shops to asset managers, commercial users and retail investors. Chief executive officer Dmitri Galinov identified four flaws with the existing electronic trading platforms: old, and therefore slow, technology; server locations remote from most customers; lack of transparency; and undifferentiated liquidity pools.

FastMatch FX tackles them all. The matching engine is fast—average round trip response time is just 99

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Transition Management Seamless change. Extraordinary results.

Changing asset allocation and hedging exposures is not a decision investors take lightly.

Neither do we. By combining the execution capabilities of a leading investment bank with the operational skills of a global custodian, our dedicated transition management experts help reduce both cost and risk for our clients.

As markets evolve, we can help you manage the complexity of structural change seamlessly and efficiently, reshaping your investment portfolio and managing your risk to achieve the results you need.

Transition Manager of the Year Global Pensions, Annual Awards, 2011 Transition Management Provider of the Year ICFA Magazine, European Awards, 2011, 2010 Americas PSA Awards, 2011 Best Transition Management Firm of the Year European Pensions Awards, 2011 Transition Manager of the Year Global Investor, Middle East Awards, 2011, 2010 Transition Manager of the Year Asia Asset Management, Best of the Best Regional Awards, 2011 Best in Transition Management Best Transition Management Mandate The Asset, Triple A Awards (Asia), 2012

To find out more about our transition management solutions, visit www.jpmorgan.com/transitionmanagement or contact: Robert Calder, robert.a.calder@jpmorgan.com or +44-20-7742-0257 Patrick Fanning, patrick.s.fanning@jpmorgan.com or +61-2-9003-7810 Michael Young, michael.j.young@jpmorgan.com or +1-212-552-9320

The products and services featured above are offered by JPMorgan Chase Bank, N.A., a subsidiary of JPMorgan Chase & Co. and its affiliates.

JPMorgan Chase Bank, N.A. is registered by the FSA for investment business in the U.K. J.P. Morgan is a marketing name for Worldwide Securities Services businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. Š2012 JPMorgan Chase & Co. All rights reserved.

MARKET LEADER

NEW TRADING VENUES RE-WRITE FX TRADING

microseconds, up to 10 times faster than the competition. The servers live in the Equinix NY4 facility in Secaucus, New Jersey, where most customers already have servers, eliminating the need for expensive dedicated connections or colocation charges. A real time tape delivers quotes as well as price and size for every trade. Finally, liquidity is divided into four virtual ‘rooms’ so that participants can choose the nature of the liquidity with which they interact.

The retail room targets small investors, but for the first time it allows them to interact with institutional flow, not just the banks. A second room serves ‘GUI clickers,’ people who like to see multiple quotes on a screen and click to enter their orders. Speed is not essential for these players; in fact, quotes are held open for at least 200ms so that participants have time to react. Next is the general room designed for banks, high frequency trading shops and other entities interested in fast execution—a place where machines trade with each other.

The fourth room is reserved for banks, where they can trade in size without fear of high frequency parasites feeding on their order flow.

Prices and spreads can vary between rooms—and do. “The retail and GUI clicker flow is less toxic,” says Galinov.

“People make tighter prices and offer greater depth in those rooms than in the general room.”

FastMatch FX went live at the beginning of July. It’s early days, but so far the retail and general rooms have seen most activity, although Galinov expects that to change as more banks come on stream. One financial backer, FXCM, is directing its retail flow through FastMatch FX, while high frequency traders have been quick to set up connections to a room tailor made for their trading style. “By the end of the year, we will have most of the top banks connected,” says Galinov.“When that happens, we expect the bank to bank room will have much bigger volume than the general room.”The acid test will be how much liquidity the venue attracts in the next

12

Currency top and bottom performers August 2012.

1.20 USD CHF USD CZK USD HUF USD ILS USD MXN

1.15 1.10

USD PLN USD RON USD SGD USD TRY USD ZAR

1.05 1.00 0.95 0.90 0.85 0.80 02 Jan

16 Jan

30 Jan

13 Feb

27 Feb

12 Mar

26 Mar

09 Apr

23 07 21 Apr May May 2012

04 Jun

18 Jun

02 Jul

16 Jul

30 Jul

13 Aug

10 most volatile currencies relative to the USD 1 January - 31 July 2012. Volatility % per annum 17.6% 16.5% 14.3%

14% 12.3% 12.2%

11.5%

10.5%

10.3% 8.9%

Hungarian Forint

Polish South African Czech Zloty Rand Koruna

Mexican Peso

Russian Rouble

Romanian Norwegian Swedish Leu Krona Krona

Swiss Franc

Source: FTSE Group supplied August 2012. All data based on end of day prices for spot currency pairs (FTSE Cürex FIX). Index data on charts rebased for ease of comparison. FTSE Cürex FX Index Series provides 24/5 streaming executable FX benchmarks for 192 currency pairs and 8 benchmark currency baskets. www.ftse.com/fx

twelve to 18 months, but the initial indications are encouraging.

The FastMatch FX structure embraces the diversity of market participants and attempts to satisfy their different needs in a single partitioned venue. Other platforms, including TraFXpure, concentrate on one segment of the market. Cliff Lewis, executive vice president and head of electronic exchanges at State Street Global Markets, attributes the prolifer-

ation of foreign exchange execution platforms to the varied requirements of a global customer base. The banks still have a major role, however, and always will in the cash market. Corporations and asset managers trade foreign exchange as part of their normal operations to settle real money flows, which means they must deal with the banks. “If you need settlement in foreign exchange, you have to go through a bank. There is no other

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Daiwa Capital Markets Centred on Asia. Serving the world.

Daiwa Capital Markets is an award winning investment bank that is passionate about Asia.

Our experienced professionals provide clients with insight across asset classes, backed by comprehensive investment banking services linking Asia and other global markets.

Most Improved Bank for Supranational and Agency Borrowers May 2012

Yen Bond House of the Year

Best Investment Bank Japan 2012 February 2012

January 2012

www.daiwacm.com

Daiwa Capital Markets is the global brand name of Daiwa Securities Group Inc.'s investment banking arm. Its global subsidiaries are authorised to do business within their respective jurisdictions. These include: Daiwa Capital Markets Hong Kong Ltd. (Hong Kong), regulated by the Hong Kong Securities and Futures Commission, Daiwa Capital Markets Europe Limited (London), authorised and regulated by the Financial Services Authority and a member of the London Stock Exchange, and Daiwa Capital Markets America Inc. (New York), a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, a futures commission merchant regulated by the U.S. Commodity Futures Trading Commission, and a primary dealer in U.S. government securities. Daiwa Capital Markets America Inc. is a member of the Securities Investor Protection Corporation (SIPC).

MARKET LEADER

NEW TRADING VENUES RE-WRITE FX TRADING

option,”says Lewis.“A larger volume is traded by participants who are not looking for settlement for a variety of reasons, including price discovery. The market has to accommodate both types of user.”

The banks’ role in settlement guarantees them a substantial market share.

Indeed, Lewis says the largest electronic trading volumes in foreign exchange occur on single bank platforms, some of which transact almost as much business as EBS or Reuters, their better-known multibank competitors. State Street itself has several foreign exchange trading products, including FX Connect, the leading platform for traditional asset managers to handle FX for their international investments. Its success rests on the ability to facilitate back office work flow for asset managers who have to allocate foreign exchange trades among hundreds or even thousands of accounts. “FX Connect nets and bundles the trades, sends them to a bank and then automates the allocation,” says Lewis.“The model works well for us and both the buy and sell side seem to like it.”

Another arrow in the State Street quiver is Currenex, which provides foreign exchange execution software on a white label basis to banks, brokers and hedge funds of every size worldwide. Currenex also operates a central limit order book, FX Trade, the first platform designed to permit computerised trading instead of displaying multiple quotes on a screen from which a human could trade.“Currenex was the first to market with an API [application programming interface],” says Lewis.

“We have always been a latency leader, which is important—and not just for high frequency traders.”

Prospective regulatory changes following the financial crisis have already curbed the banks’ appetite for making markets in foreign exchange. Michael Cairns, chief executive officer of FX Solutions, a foreign exchange broker and part of City Index Group, says banks and ECNs often show a tight spread but in small size, perhaps $1m

14

Dmitri Galinov, chief executive officer, FastMatch FX. Photograph kindly supplied

by FastMatch FX, August 2012.

Cliff Lewis, executive vice president and head of electronic exchanges, State Street Global Markets. Photograph kindly supplied by State Street Global Markets, August 2012.

or $5m.“The banks have become more risk averse in the past four years due to the economy as well as increased public and government scrutiny of their industry,” he says. “They don’t offer as much liquidity as they used to relative to their order flow.”

A bank today will no longer write a $50m or $100m ticket for its own

account; instead it will offer a partial fill and work the rest to match against customer flow. It’s a tectonic shift that is turning high frequency traders into the default liquidity providers, a role they already fulfill in equity markets.

Participants concerned about best execution—an obligation under Europe’s MIFID II directive—cannot justify paying the bid-offer spread to a bank acting as a riskless principal if they can trade directly at a better price.“The man in the street now has real-time access to the same prices as the banks,” says Cairns.“The playing field has been leveled.”

The new paradigm opens the door to increased algorithmic trading in FX. In the past, liquidity was so extensive in the major currency pairs nobody needed to use an algorithm to prevent information leakage. State Street’s Lewis points out that 60% of the $4trn daily foreign exchange volume is in euro-US dollar, dwarfing liquidity in even the largest equities. Currencies trade as a single instrument rather than in baskets, too. “Equity traders who want volume weighted average price for a basket need to slice up their orders to avoid moving the market,” says Lewis.“In the FX market there is significantly greater liquidity and prices typically don’t move as much.”

Another obstacle to algorithmic trading in foreign exchange is the tendency for providers to port algorithms from the equity markets rather than develop bespoke routines for FX. Most institutions now use algorithms for a small portion of their foreign exchange flow, just to check execution quality on other channels. The lion-share of orders—either executed electronically or not—still go through on a single ticket.

“Algorithmic trading will grow,” says Lewis, “but only as algorithms are designed for foreign exchange users.” With the banks providing so much less liquidity, the institutions will soon be clamoring for developers to help them bullet-proof orders against the new liquidity source: high frequency traders.I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Transition management continues to be a key consideration for all pension funds as they seek to maximise returns for their members by adopting new asset allocation/investment strategies. The FTSE GLOBAL MARKETS Transition Management 2013 is taking place on October 11th 2012 at Gibson Hall in the City of London. This four hour, tightly focused, afternoon seminar brings together municipal pension funds, county council pension funds, private pension funds and asset managers to learn about the latest developments and innovations in transition management, particularly the transitioning of fixed asset portfolios, direct benefit compared with direct contribution transitions and insights into securing best execution/performance of portfolio transitions.

The seminar offers an exceptional opportunity to share insights and experience in managing changes to asset allocation; learn the lessons of recent portfolio transitions, understand continuing changes in the pension fund market and their impact on managing and changing portfolio strategies. The seminar will give attendees the chance to network with key providers and advisors as well as other beneficial owners and pension funds. It will be an important opportunity to gain valuable insights into market developments and find ways to optimise ways that beneficial owners treat with transition managers.

Beneficial owners, pension funds, insurance companies and asset managers will benefit from high quality analysis and insights into key market trends

Who should attend?

Pension fund trustees Pension fund treasurers G Pension fund chief accountants

Chief investment officers Portfolio managers G Consultants

G

G

G

G

ust t m The even nd e who e t t s a ll tho sition a r fo tran ent e s u m age n a m

SCAN QR CODE WITH YOUR SMARTPHONE TO REGISTER

BOOK NOW TO SECURE YOUR COMPLIMENTARY PLACE at www.ftseglobalmarkets.com or call Lee White at +44 (0)20 7680 5153 Some of our keynote speakers

Chris Adolph

Robert Brown

Mark Dwyer

Michael Gardner

Ben Gunnee

John Minderides

Jonathan Platt

Head of TM, EMEA Russell Implementation Services

Chairman of Towers Watson Global Investment Committee

MD & Head of EMEA, BNY Mellon Beta & TM, BNY Mellon

CFA, Managing Director, Global Head of TM, J.P. Morgan

European Director Mercer Sentinel Group

Head of EMEA Portfolio Solutions Business, State Street

Head of Fixed Interest, Royal London Asset Management

IN THE MARKETS

LIMITED PARTNERS LOOK FOR OPPORTUNITY IN CEE

Private equity rises in CEE states as eurozone continues to flounder The private equity industry in Central and Eastern Europe is undergoing something of a recovery in investor optimism with a number of investors looking to channel capital into the region. In terms of emerging market private equity investment destinations Asia still predominates, however CEE states are featuring in around a quarter of investment transactions. The outlook looks good in the run up to 2013 as continuing debtcrisis woes in the eurozone increasingly focus investor attention on Europe’s peripheral, but growing markets.

RIVATE EQUITY FUNDS based in the Central and Eastern European (CEE) region have already picked up almost 50% more funds in the first half of this year ($2.6bn) that they did over the whole of 2011, according to the Emerging Markets Private Equity Association (EMPEA). The trend underscores the latest findings by the European Private Equity and Venture Capital Association (EVCA), which reports that private equity and venture capital funds focused on the CEE states attracted €941m of new funds last year, up however 48% on 2010 and 135% more than in 2009. Clearly a rising trend is visible.

The increase this year says the EVCA is largely driven by buyout funds and is particularly meaningful, given that €1.2bn or so was invested in the region last year, a slight decrease (-4.6%) on 2010. The CEE has also enjoyed the highest boost of private equity fundraising since the onset of the global financial crisis in 2007-2008 and investor confidence looks to be on the rise.

Nonetheless, concedes EMPEA, limited partners are becoming more demanding when choosing the right private equity fund managers looking for investment opportunities in the CEE states and with good reason. Competition is fierce for

P

16

available assets and traditional sources of debt financing are under strain. Understanding underlying is also vital as investors seek to find sustainable investment opportunities in various business sectors, such as healthcare, consumer goods and retail.

As with the EVCA survey, the figures from EMPEA generally reflect the region’s steady recovery and integration into the wider European economy.

Dörte Höppner, the EVCA’s secretarygeneral, explains that:“The Central and Eastern Europe region’s 2011 positive dynamics demonstrates how private equity and venture capital can be a major provider of finance, and a reliable one, stable throughout the toughest economic conditions, driving Europe’s economic recovery.”

In a wider emerging market context, the region is also performing well.

Turkey and Poland have been leading from the front as fund raising volumes have varied widely across emerging markets. Emerging Europe has around a 15% share of capital raised in frontier markets for private equity investments, says EMPEA. Deal flow is also healthy, accounting for 8% of emerging market private equity deal flow. (Asia still represents nearly two-thirds of both total invested capital and number of deals).

A number of transactions coming to market in August typify the main trends. Central Europe-focused private equity firm Penta Investments purchased a 100% stake in Estate Consult, the owner of Slovak hospital chain Svet zdraví, for a modest €3m. Svet zdraví operates ten hospitals throughout Slovakia and plans to use the funding to modernize the hospitals. Meanwhile Hungarian venture capital firm Primus Capital Management has invested HUF400m in Hungarian firm HYD, a biotechnology company. HYD specialises in developing products for the prevention and treatment of tumours.

The investment was made through the Primus Capital III fund.

Most recently Lux Med, the Polish medical services business based by CEEfocused private equity firm Mid Europa Partners is reported to be in acquisition talks with Polish insurance giant PZU. The insurance major is keen to have a stake in the private medical services provider, which is said to be worth around PLN1bn (around $300m). Mid Europa Partners bought into the business back in 2007.

In Turkey investment management company NBK Capital, an affiliate of the National Bank of Kuwait (NBK), acquired a 50% stake in Turkish animal pharmaceuticals distributor Bavet. The investment was made through NBK Capital Equity Partners Fund I. Mid Europa Partners has also entered into an agreement with the founders of Walmark and will take a 50% stake in the company, in a transaction which is expected to complete sometime in the last quarter of this year. With revenues approaching €100m, the firm is the leading independent vitamins, minerals and dietary supplements manufacturer in the CEE. Matthew Strassberg, a Mid Europa Partners private equity partner responsible for healthcare investments by the firm, explains that the sector is: “driven by rising disposable incomes, increasing awareness of the benefits of preventative medicine and supporting regulatory shifts favouring OTC medicines.”

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

IN THE MARKETS

LIMITED PARTNERS LOOK FOR OPPORTUNITY IN CEE

Elsewhere Turkish venture capital firm 212 Capital Partners announced a second round of funding for Turkish online rental service Hemenkiralik.com, which provides an online marketplace where people can list and book shortterm rentals in Turkey and the surrounding region. 212 Capital Partners invested alongside two individual investors who have not been named.

In the financial services sector, Netherlands-based investment and finance group PPF Group sold its stake in Russia’s NOMOS Bank to Russian banking group Otkritie Financial Group in a share swap deal. In exchange, PPF Group received shares in Russian fertiliser company Uralkali, plus an additional equity investment.

As these transactions suggest, investment activity is concentrated in the region’s larger countries, with Poland taking the largest share, with 55% of the total investment inflow. Poland attracted more than $1.6bn of private equity investment in 2011, double the figure recorded in 2010. Roland Berger Strategy Consultants classifies Poland as a separate market against other CEE countries in the firm’s recent European Private Equity Outlook 2012. According to the research, private equity investor focus showed Poland as a top performer, attracting some 7% of all private equity inflow into Europe (the UK share is 4%, that of France 5% and that of Greece 1%).

Moreover, competition for Polish assets looks to be heating up. Poland is attractive to investors in that its economic performance continues to outstrip its near neighbours; its banking system is regarded as diversified and relatively healthy and the market still offers comparatively cheap labour costs. UK-based private equity majors Cinven and Permira are reportedly in competition

with UPC Holding, the Polish corporate arm of cable company Liberty Global in a second round shortlist of bidders for Multimedia Polska, Poland’s third largest cable company. Bids are said to be in the region of $800m. The transaction markets the growing popularity of private equity and private sales as a corporate strategy. The company was delisted from the Warsaw Stock Exchange last November, hiring JP Morgan the investment bank to arrange a trade sale.

It is not all plain sailing. Mid Europa Partners missed out on the chance to buy Polish supermarket chain Stokrotka earlier this year, which is said to be worth upwards of $260m. Its main stakeholder, Emperia pulled the planned sale. While Emperia would not confirm why it had pulled the deal, a spokesman said he thought the firm would come to market again sometime in 2013.

One problem for investors hoping to leverage the CEE growth story through limited partnership participations is that investment times tend to be longer in emerging markets. Moreover, many transactions are low value, which means that private equity firms active in the region have to make a large number of correct investment bets. For instance, GimV, a European private investment firm invested a modest €4m in GOVECS, in early September. Although technically it is a German headquartered firm, all of GOVECS production facilities and revenue generation is based out of Warsaw. GimV’s investment is part of a €10m financing round in which also KfW and BayBG have also invested.

Venture capital investments in the CEE have also grown in the last year and are up by 57% says the EVCA. The good news is that the figures are driven by an 85% increase in new business start-ups, although admittedly from a

low base. Importantly for private equity investors tool divestment activity through last year also showed a significant increase to reach an all-time high in the CEE of €1.383n (measured at investment cost). There’s even more potential in the region, claims the association. It analyses total investments as a percentage of GDP, which it says remained relatively constant for both the CEE and the wider European zone.

The CEE recorded an investment/GDP ratio of 0.105%, compared with 0.325% which says the association indicates significant untapped potential.

Total investments as a percentage of GDP remained relatively constant for both the CEE region and for Europe as a whole in 2011, with the CEE region recording 0.105% compared to the Europe-wide average of 0.326%. This indicates the untapped potential of the CEE region for development of private equity. The return of private equity dealmaking in 2010/11 has persuaded many funds that their traditional models still hold true. A smaller amount of leverage is available than during the 2005–2007 boom, which has encouraged the use of more conservative and sustainable financing structures. The main change however exemplified by the CEE is that private equity funds are increasingly looking to invest in growth markets outside their home geographies.

A recent private equity survey by consulting firm PwC found that while almost 40% of private equity funds polled in their survey found Asia the most attractive investment region, both Latin America and Central and Eastern Europe polled a respectable 25% of positive responses. Within the CEE, PwC’s survey found Turkey and Poland the most popular investment destinations, somewhat similar to the findings of the EVCA. I

AMENDMENTS TO FTSE INDEX REVIEW DATA PROVIDED ON PAGE 84: DATE 04 – Sep 12 – Sep 12 – Sep 13 – Sep

18

INDEX SERIES FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Multinational FTSE EPRA/NAREIT Global Real Estate Index Series

REVIEW FREQUENCY/TYPE

EFFECTIVE (COB)

DATA CUT-OFF

AMENDMENT

Annual review / Japan

21-Sep

29-Jun

Deferred until March.

Annual review / Developed Europe Annual Review

21-Sep 21-Sep

29-Jun 29-Jun

Deferred until March.

Quarterly review.

Annual review

21-Sep

31-Aug

Quarterly review.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

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

dŽ ŐĞƚ Ă ďĞƩ Ğƌ ŚĂŶĚůĞ ŽŶ ƌŝƐŬ͕ ĐŽŶƚĂĐƚ͗ ǁǁǁ͘ĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ +44 20 7125 0492 ƐĂůĞƐΛĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ

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

IN THE MARKETS

TRADING TECHNOLOGY: THE SHOCK OF THE NEW

Technology takes the strain of reduced trading volume Spending on technology in preparation for credit crisis-linked regulatory reforms, including MIFID, Basel I and II lies somewhere between $0.8bn and $1.5bn, estimates Oliver Wyman research firm in a joint report with Morgan Stanley. Such eye-watering sums are eating up as much as 80% of discretionary technology budget, estimates David Little, director of Strategy at technology firm, Calypso, “either directly, complying with regulation or a mix of regulation and related business cases. IT systems evolved when budgets were bigger. There are a lot of legacy systems around and now the cost of IT is disproportionate and firms can only bring it down by bringing down the number of their systems.” Ruth Hughes Liley looks at the implications.

S REGULATION IN Europe moves the financial industry towards greater transparency including central clearing of over-thecounter (OTC), a much larger market than equities, the impact on costs and technology should not to be underestimated, according to Brian Schwieger, head of EMEA Execution Services Sales at Bank of America Merrill Lynch, who says the changes will be ”significant” and will require careful planning. “In terms of spend, everybody—brokers, venues, the buyside—is increasing their budgets so they are adequately prepared,” he says.

Regulations such as Dodd Frank in the United States and EMIR in Europe are driving increased transparency and derivatives trading to become increasingly electronic. Even the much delayed second iteration of the EU’s Markets in Instruments Directive, (MIFID 2), which is currently expected in 2015 (say UK Financial Services Authority (FSA) estimates) has not prevented both buy side and sell side trading desks to continue to upgrade their trading technology specifications and spend.

Mark Goodman, head of quantitative electronic services at Société Générale says: “With the amount of regulatory change and with exchanges upgrading their technology, you don’t have any choice. It is the cost of doing business.

If you don’t invest you are not in business. However we would also include

A

20

Photograph © Krishnacreations / Dreamstime.com, August 2012.

the on-going optimisation of algorithms in this category; you can’t offer clients algorithms designed for yesterday’s market.”

There are various trends and subtrends running through the markets, some of which have been in play for some years. Before the credit crisis, for instance, the name of the game was speed and spending was directed

towards lowest latency trading. With many exchanges now reaching below 100 microseconds for a round trip trade, Jerry Avenell, Bats Chi-X Europe’s co-head of sales, believes the debate is fast evolving. “I think the whole latency and capacity debate has become a zero sum game in the exchange space and the focus has shifted as brokers continue to look to

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

- %(!; 5* ; 6* %, #

$ 7* ( 2812 ** $ $

%"" * ( " # $ # $* ) +$ ( $ ( ) $ "/ (& % +)9 $ $ " $)* *+* %$) -%(! $ - * %"" * ( " $ *% ( )&%$ *% * ( +" *%(/ ( # ) * * ) $ " +$ # $* " $ *% * - / *( ) ( . +* 9 $ /-* * +/=) $ ) ""=) "! &* *% $ ) - "" * &(% * " */ % * %"" * ( " %( * $)* *+* %$9 ) , $* - "" "& $ $ " $)* *+* %$) *% +$ ()* $ - * * $ - " )" * %$ # $) %( %"" * ( " # $ # $* $ %- *% # $ * " '+ */ )'+ 0 - ")* ) #+"* $ %+)"/ ,$ %"" * ( " %&* # 0 * %$9 )

.& (* &

! (

1 , *,, ' "% " % (= *,# ) . )'!3

"" $

"

%+ %:

) !,-. ) * #& * % % ( $! $ ) " %$ %"" * ( " # $ # $* --!-- * #& * % ) $ * ( &%* $* " ( )! .,/ ./,! $ # $ $ $* ( * %"" * ( " *( $ &&(% +.%(%4! * +) % %"" * ( " )) *) !0!'*+ $ $* # ( $ $ ( # +$ ( % ( $!

0!, *(! ( = /&%* * %$ "" $ ) - * * $ ( ) " '+ */ )'+ 0 ) '34! * $ *) % #%, *%- ( ) )* $ ( 0 ) '%#) %"" * ( " # $ # $* &( * ) - * ( )! # * * %$ --!-- * *) % * * )!= %( %$ * *( =& (*/ )&

A A A A A A A A A

$ ": (*/

&%< %"" * ( " &* # 0 * %$

!.! (+ !'' ()* ( ) $*; %"" * ( " $ %# & ( * %$) ( %) ) % ' ,*/+ ' ,& $*(+-*) ( *%(; +) $ )) ( ,! %. /%--!

$

$ %( &% ( & * &

,3 3 $ $

(

!+*,! $ $ ( *%(; "% $ %"" * ( " !/.- $! )&

% ) ,!-.*) &+*/ $ ( " %+$) " ! /,%.%!- --* % .%*)

,%

* *+(

. ) - *, )*0 $ $ ( *%(; ( , * , ) (; $, )*# $*) $! / , % ) %"! )-/, ) ! *(+ )3 *" (!,%

&

, * !.. " ( *%(; (! * $ * * , ) )& *" )

)

%$* *:

"

)* (

( ;

) !, * -% $ %( $ $ " (; %"" * ( " ( )+(/ & ( * %$) $! *,' )& * /( ) $ ))% * (% ))%( % !1 *,& 1 $**'

(! * $

$

# $*;

-

,&

43 $!, ( ) $*; $* (&( ) --!. ) #!(!).

- * $ $ " %$ (# * %$

* %$ &%$)%(:

$ %(

0%-*,-

(, *, )

(!''%) $ %( ( ) $* ''% ) ! !,)-.!%)

.

!.!, /,!)%$)+"* $* * &1!'' %-&

*$) (- 3 &+*/ ( *%(; , ) %$ % ( $ $ (! *) ! /,%.%!- ) 2 $ )#! *((%--%*)

!))%- $%& , $ $ ( *%(; % '+ */ $ $ ( $ ; %(* # ( .%2%- ! /,%.%!- (!,% -

%+$* (& (*/

)

%

)!

,&

( $ %(# * %$; &"

"

/ % $ ( *%(

$ /, $ ) ! (*$ ( !1 & *'/.%*)-

0% '*3 .= "% " % %"" * ( " $ ( $ $ # $* ,! %. /%--!

# $*; .

) ,!1 /-' ) !, % )! $ # $* . 6 --!. ) #!(!).

!, % %"" * ( " $ )!; # ( ) * %5.5 5)5, '!

'

*$) , .' ) $ %( %" / , )%(; $ $ " (! *) (%+& ! !, ' !-!,0! )& *" $% #*

(!, / ,% "% " % %"" * ( " " )& *" (!,% !,,%'' 3) $

%( +(*

) ( # ( %$ ( $

$

)!

$ " &%$)%(:

(;

>

": @1 312 548 3888 .*9 6625; # ":

$

# $*

(*$ (:

"

?# ( +) , $) 9 %#

IN THE MARKETS

TRADING TECHNOLOGY: THE SHOCK OF THE NEW

differentiate on a range of criteria: relationships with their clients, performance of their systems, price, service and innovation in very difficult market conditions.”

London Stock Exchange Group (LSEG) set something of a pace in this respect when it bought Millennium IT, the company behind the high-speed Millennium Exchange platform. LSEG COO, Antoine Shagoury, says: “Once you get to the crest of the wave, the challenge is to stay there. Many of us are in such a tight range of latency we are all riding that crest. We are all hovering between 50 and 100 microseconds.

What is there to differentiate us? Now, it is about new products and getting back to our core goal which is providing access to capital, innovation and relationships. If a client wants to follow our model we will help them or we are happy to customise.”

In line with developments in exchanges, sell side broker dealers are also under pressure to raise their technology game; and it is not always easy to get it right. The unfortunate experience of Knight Capital, for instance, in July this year, when its software upgrade suffered a serious glitch, sending millions of orders to the New York Stock Exchange at the open, losing the company around $400m, shows the hair-fine triggers that can be set off by a technology snafu.

Natural questions emerge, such as is technology becoming too sophisticated or complex to handle? Is it out-riding or surpassing the abilities of sell side firms?

Goodman at Société Générale thinks not: “I don’t think it has to get complex but you have to approach it very cautiously despite having better tools to manage the speed. We want to see more market-wide initiatives to safeguard against errors that have the potential to disrupt the market. We’re extremely cautious when we make changes. There are multiple levels of sign-off and it is in no one’s interest to have incidents which damage investor confidence.”

The robustness of systems is also being tested in other ways too. At Linedata, Dave Hagen, director of strategic

22

Paul Squires, Head of Trading, AXA Investment Managers. “Order management systems can have quirks and although vendors argue that clients want flexibility, you have to ensure your traders know what to look out for.

You can’t foolproof order management systems completely,”he says. Photograph kindly supplied

by AXA Investment Managers, August 2012.

Dave Hagen, director of strategic accounts and trading, Linedata, says: “Electronic risk management systems certainly should be robust, but they are not going to do away with the compliance officer.” Photograph kindly supplied by Linedata, August 2012.

accounts and trading, says: “Electronic risk management systems certainly should be robust, but they are not going to do away with the compliance officer. One of the things we emphasise is the importance of being able to see good, real-time data. If you are a busy desk with a thousand orders on your blotter, it’s hard to keep track of that. It’s all about getting the edge. The vendor community is getting close to this and I really believe that the future buyside trading desk will look like an air traffic control centre. They have assets, like flights, coming in and going out. That’s where data visualisation helps – it gives traders an easy throttle control.”

In other words, trading technology continues to be a game-changer. Chris Hollands, head of European sales at TradingScreen explains the dynamics.

He believes that the bar has been raised all round, not least “functionality-wise from what the buy side expects from its systems. Now it is more about compliance, risk and real-time position keeping; but is it also because the decision-making has shifted from the trading desk. In the last 18 months, it has been compliance managers deciding on a solution and what they are most interested in is whether it connects up to their existing systems and whether it fits into their current workflow in order to avoid breaks in the order life-cycle.

Little at Calypso thinks also that silos are being broken down between the front and back offices as multi-lateral trading comes in:“The front office used to be able to trade on price, but now you need to know all sorts of other things: what will be the margin cost of the trade, will it be cleared or bi-lateral, will I be able to offset the margin against others? Firms are spending money on capability, customisation and adaptability to change. This is very important. No-one knows what the new world is going to look like. When it settles down, no-one knows where the liquidity will be. So systems must be able to adapt to the rate of change.”

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

FTSE All-World Index Review

2,800 Stocks

50

Countries

Equity Insight Essential monthly performance analysis and fundamentals across Developed & Emerging Markets, Industry Sectors, and Individual Securities.

Professional investors can register online and download today at www.ftseall-world.com

95%

of the worldâ&#x20AC;&#x2122;s equity market capitalization

IN THE MARKETS

TRADING TECHNOLOGY: THE SHOCK OF THE NEW

Risk management is one of the growing areas demanded of technology firms and brokers, and order management systems (OMS) are being expected to be multi-function: as a trading platform, a fund management tool and compliance solutions. ConvergEx’s Eze OMS was recently upgraded to include new portfolio risk management tools. It includes tools to value and analyse listed equities, options futures and indexes under different scenarios in real-time seeing how their holdings respond to significant market events designed to ‘shock’.

Cost control in this changing environment remains a constant concern.

“Without question cost is bearing down on the sell side, but equally on the buy side, where they want to gain system efficiencies, if you can have one platform that does fully fledged order and portfolio management in addition to execution management, clearly you are deriving economies of scale,” adds Hollands. A viewpoint reflected by Brian Schwieger at Bank of America Merrill Lynch, who says that: “If you want to be a serious participant in electronic trading these days, you have to have economies of scale. We have been going through a pretty intensive programme of platform upgrades, constantly testing connections, coding, hardware and internal code. It’s a constant evolution and takes a lot of time and resources.”

One of the issues is that everything is working towards real-time delivery; in particular, real-time data feeds Bloomberg’s event-driven trading data feeds, for example, are optimised for computer algorithms, turning text news into machine-readable data, tagging securities, news topics and individuals.

Of course, this then means that effective management of this data is vital.

Equally, OMS systems are being tested as never before. As AXA Investment Managers’ Head of Trading, Paul Squires, points out: “Order management systems can have quirks and although vendors argue that clients want flexibility, you have to ensure your traders know what to look out for. You

24

Antoine Shagoury, LSEG COO. “Once you get to the crest of the wave, the challenge is to stay there. Many of us are in such a tight range of latency we are all riding that crest.

We are all hovering between 50 and 100 microseconds,” he says. Photograph kindly supplied by LSEG, August 2012.

Chris Hollands, head of European sales, TradingScreen. “If you can have one platform that does fully fledged order and portfolio management in addition to execution management, clearly you are deriving economies of scale,” he says. Photograph kindly supplied by LSEG, August 2012.

can’t foolproof order management systems completely.” Added to that, multi-asset trading technology is also essential, says Jeff Gavin, ConvergEx Group’s director of global product management for its order management system, the Eze OMS. “Our clients trade virtually every asset class, so they want one order management system to do it all and providing multi-asset trading technology is one of our top strategies. On separate platforms it is tough to tell how exposed you are.”

At AXA-IM, Squires is responsible for three asset classes: foreign exchange, fixed income and cash equities. He says he is “fully invested” in an order management system which is outsourced. All equity trading is on an execution management system (EMS) and by the end of 2012; the foreign exchange platform will be on it as well.

“Putting foreign exchange into the EMS gives us two things: more TCA insight and we can also start to use algos. When that is done we want to have access from the OMS into the fixed income order book. We’ve already completed the suite of TCA across three asset classes. I’m quite proud of that,” says Squires.

As day-to-day management systems are outsourced, traders have more capac-

ity to develop other internal projects and post-trade services is another area ripe for technology firms, vendors and brokers to sell to the buyside, as the subject moves further into the regulators’ spotlight. New firms providing these services are springing up and in March 2011, ICAP set up EUCLID Opportunities, a venture capital fund to support young firms aiming to benefit from outsourcing from brokers and the buyside.

One of their investments is in OpenGamma, creators of open-source analytics and risk management platform. With a recent injection of $15m funding, it plans to drive innovation and expand geographically. Open source software is gaining ground as firms realise they can do more for less and the demand for advanced risk management and analytics systems has also increased dramatically as regulation and growing data volumes push hedge funds and investment banks to explore flexible open source alternatives to traditional, proprietary and costly risk analytics tools.

One advantage to outsourcing IT support for a fixed cost is that it helps clients with budgeting and allows them to focus on their core business. Eze partners with several IT hosting firms and has a dedicated consulting team

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

David Little, director of Strategy, Calypso.

“The front office used to be able to trade on price, but now you need to know all sorts of other things. Firms are spending money on capability, customisation and adaptability to change,” he says. Photograph kindly supplied

by Calypso, August 2012.

Jeff Gavin, ConvergEx Group’s director of global product management for its order management system, the Eze OMS. “The OMS is designed to be highly extensible and customisable,” he says. Photograph kindly supplied by ConvergEx Group, August 2012.

that focuses on the day-to-day support for the client. Consulting is included with the OMS licence fee. Gavin says: “Each consulting team has an in-depth knowledge of the client’s workflows and strategies. The OMS is designed to be highly extensible and customisable. The consulting teams work closely with the client to customise the OMS to achieve their business needs.”

tomers to locate their servers as close as possible to the exchange. Michael Krogmann, executive vice-president, Institutional Equity at Deutsche Börse, says:“We need to treat all our customers equally so everybody is free to use our co-location services and we are seeing all kinds of business models using it – retail, small and large institutions.”

On the other hand, LSEG does very little outsourcing with 80% of its activity internally sourced. Shagoury says: “It’s banks and brokerages that do business with LSEG and they need connectivity and physical hosting: so we run the technology as though we are their hands.”

Through its proprietary technology company, Millennium IT, LSEG has started offering software as a service (SAAS). “If you are a small growing brokerage, don’t have much capital or don’t want to develop market tools, we can provide them and run it for you.

You can rent from us or buy it and we’ll house it,” says Shagoury.

Outsourcing to cloud technology “has definitely become mainstream,” says Dave Hagen of Linedata, which has 120 clients using its hosted environment. “Its biggest benefit is that it allows users to have all the current versions of software all the time – some

Customer relations Customer relations go hand in hand with provision of technology.

Goodman says his bank has moved away from selling algorithms to selling performance and servicing relationships: “Clients are tired of new algorithms so we focus new products on creating individual solutions. An algo is a means to an end and we see ourselves as trying to provide a solution to the client—our first conversation with them will be ‘what are you trying to achieve?’ As clients start to use it they learn new things about their trading, so it’s a continual process. You have to keep going back to see whether the client has the optimal solutions.”

Exchanges are also focusing on customers as they outsource: Deutsche Börse outsourced its co-location facility to Equinix 18 months ago, enabling cus-

FTSE GLOBAL MARKETS • SEPTEMBER 2012

clients are on five-year-old vendor software because it is very expensive to upgrade in big companies.”

Over the past 10 years, it has become more of a ‘self-serve’ environment for trading, according to Jeff Gavin.“A lot of tools have moved to the buyside trader, algos, DMA, EMS etc, where traders can directly access the market place. The buyside still believes that customisation is important and the investment banks and vendor firms and even exchanges are fighting for the business.”

Another key question is: who is winning in the stakes to provide all this technology? The sell side have traditionally been providers to the buyside, but with new technology start-ups (The Daily Telegraph has a Top 100 technology start-up listing, dominated by finance and data firms) and exchanges moving into the area (NYSE Technologies, for example) the edges are blurring across all providers.

Hollands says Trading Screen deploys algorithms created by the investment banks, which have spent tens of millions of dollars developing them, originally for their internal use, but then to provide to clients.“Smaller brokers, or those late to the game have taken, say, a Credit Suisse or a Morgan Stanley algorithm and white-labelled it as their own,” he says.

“There is exchange and broker overlap,” adds Shagoury. “We have some similar goals and similar solutions so it’s a natural transition to move into these areas. It’s ‘facility brokerage’, but it comes down to the type of services a firm wants to employ. Firms want their technology and service providers to provide similar tools, such as execution services and matching facilities.

We have also expanded into other areas, such as reconciliation and back office.“If I had a crystal ball, I think we are going to continue to progress towards trading globalisation. Physical boundaries will start to blur and the regulatory pressure on risk management and collateral management cross-border intermediating will continue,” he says. I

25

FACE TO FACE

KAREN L O’CONNOR, CO-CEO, ESECLENDING

The global securities lending market is in flux. Clients exhibit a greater understanding of risk and now carefully scrutinise the risks and rewards of their lending programs. Moreover, firms want more reporting on their lending or repo programmes and clearer views of data relating to what they are lending out as well as detailed analysis of their collateral allocations (both in terms of eligibility and concentration) and what their returns are. Even so, volumes remain healthy though, the market has become more complex even as the business set now enjoys greater transparency. Karen L O’Connor, co-chief executive officer of eSecLending talks to Francesca Carnevale about the main trends.

Regulation favours the discrete service provider: How eSecLending has responded to market change RANCESCA CARNEVALE (FC): Given continuing financial turmoil how have beneficial owners changed the way that they approach securities lending and the goals that they have set from a securities lending program?

KAREN L O’CONNOR, CO-CHIEF EXECUTIVE OFFICER OF ESECLENDING: Beneficial owners are taking a more cautious approach to managing their securities lending program in today’s market environment.

Fortunately, the lessons learned in 2008 have better prepared all participants in terms of instituting risk adjusted goals and objectives. We are seeing some clients impose restrictions credit limits, borrower restrictions and profitability targets. While generating incremental returns remains one of the priorities for beneficial owners, regulation and counterparty risk are areas that continue to take centre stage in this environment. As a result, we are seeing beneficial owners seeking more information about the market and their program, at greater speeds and granularity than ever before.

Risk analytics, performance attribution and benchmarking are all required and many institutions are taking a committee based approach to evaluating and monitoring their lending program.

FC: The markets revolving around the securities lending function have become more volatile and, at the same time, more complex and sophisticated. How does the eSecLending service set shine in this context?

F

26

Karen L O’Connor, PhD, co-chief executive officer of eSecLending. Photograph kindly supplied by eSecLending, August 2012.

KAREN L O’CONNOR: Despite the current volatility in the market, the industry remains poised for growth over the next several years. The core securities lending industry has stabilised over the past 18 months and the intrinsic value of securities on loan has steadily increased since 2011. Securities lending remains a strong global business with healthy margins. While the industry as a whole must go through this period of consolidation and contraction, it will likely emerge much healthier and provide significant value to its participants for years to come. eSecLending is first and foremost committed to service excellence in all market environments. Our independence and focus on innovation with a high touch service model employing frequent communication, accessibility

and customised solutions are resonating well in this market. The key regulatory developments to date favour a smaller niche player. In addition, in an environment where every basis point of incremental return is important, our unique ability to extract the best price for our clients’ assets differentiates us from more traditional custody bank “pooled” lending programs.

FC: One of the interesting points to come out of the crisis is the change in the way clients approach indemnifications. What is your experience and what is the potential impact of market regulation?

KAREN L O’CONNOR: Our approach to indemnification has always been unique in the market so our position and experience on this is likely to be different from that of our other agents. As a benefit to our clients, we diversify their potential exposure in securities lending by providing borrower default indemnification backed by an insurance policy from three independent insurance companies. Other agents use their balance sheets to self-insure. We believe there is a diversification and non-correlated risk advantage to using an independent indemnity. Our insurance firms’ businesses are less interconnected to the underlying borrowers in our program, and we already have a built in cost for this protection. The current regulatory discussion will likely be changing indemnification in the marketplace for the bank agents that use their own balance sheets to provide insurance.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

With regard to Basel III, most of the provisions relate to the capital adequacy of banking institutions and suggest that they must not only increase the amount of capital that they hold on their balance sheet but also increase the quality of that capital. As it relates to borrower indemnification, it remains unclear as to how much of the coverage would be included as a liability on a bank’s balance sheet and exactly how much of a capital charge would be assessed for banks providing this “insurance” to their clients.

Depending on how this is ultimately defined, indemnification could become cost prohibitive for certain banking institutions as this service would weigh heavily on their regulatory imposed leverage ratios.

FC: Are you still seeing borrowers wanting exclusive access and supply of quality assets and quality portfolios?

KAREN L O’CONNOR: Borrowers continue to have demand for captive supply of quality assets as evidenced in our auctions over the last few years which have achieved material year over year increases when valuable assets were auctioned. This shows a deep core market for shorting and lending activity in the US and Asian markets, and a solid arbitrage market in Europe. The auction results also continue to demonstrate the benefits of our model with significant premiums for exclusives achieved over widely accepted industry benchmarks.

FC: Does fixed income lending have more value these days, particularly given the drift of regulation and the continued limits on liquidity in the wider markets?

KAREN L O’CONNOR: Fixed income lending remains an important part of the lending markets. Today, the highest value is coming from corporate bonds, especially the high yield bond sector. We have seen record results in our auctions of high yield bonds over the last 12 months, as issuance in the corporate market is at an all-time high and arbitrage opportunities and specific corporate events are driving demand

FTSE GLOBAL MARKETS • SEPTEMBER 2012

levels higher. The demand is concentrated but this is an asset class with significant lending value. In the treasury and agency space, the intrinsic spread is small and opportunistic.

FC: Are clients refocusing once more on customised securities lending approaches?

KAREN L O’CONNOR: Yes. Every client’s approach to managing their program will vary and their agent’s ability to respond efficiently is essential.

Although client profiles may differ, there are some trends currently present in the market such as customised credit limits, diversification rules, proxy voting policies, minimum spread thresholds and customised collateral schedules.

Beneficial owners should expect to receive a focused, highly customised program tailored to their unique needs.

FC: Further to the last question, do these customised solutions extend to say working with agent lenders with some portfolios and eSecLending with others? Where does the eSecLending product add value in this regard?

KAREN L O’CONNOR: Many of our clients employ a multi-agent model when it comes to their securities lending strategy. Utilising multiple agents delivers benefits such as competitive tension, provider diversification and effective benchmarking. Our auction model is best suited and utilised for the most attractive asset classes (that is, small cap equities, international equities, high yield bonds, etc) as this is where we see the greatest premiums achieved. We are also seeing greater demand from institutional investors seeking ways to optimise the performance of their multi-agent program on a pre-trade basis. For these clients we apply our enhanced auction optimisation process to compare guaranteed, exclusive bids to other agent estimates to deliver best execution.

FC: What, may I ask, are your firm’s ambitions for remainder of 2012 and 2013? Where do you see opportunity and where threats in the market?

KAREN L O’CONNOR: Although the industry is poised for growth, there are

short term threats that participants are navigating such as unintended consequences of new regulation, continued tax harmonisation, canceled dividends and financial transaction taxes. Some European companies specifically in Belgium and Switzerland declared their dividends to be returns on capital eliminating a tax differential and eliminating 2012 dividend yield enhancement for their distributions. In addition, knee-jerk reactions from global regulators instituting temporary, short selling bans—such as Italy and Spain—has negatively impacted industry volumes. European credit and political volatility continues to have a negative effect on short selling across the overall European marketplace due to extreme volatility overshadowing fundamental conviction.

With threats, come opportunities as the volatility in the market also drives borrowing demand for specific US treasury issuances, increases the negative sentiment of European debt and increases directional shorting activity on several sectors such as energy, retail, consumer durables, automobile and components and defense.

In short, the industry is rapidly evolving and our ability to be nimble, risk averse and thoughtful in our solutions to clients remains our primary goal. We are continuously seeking opportunities to extract risk managed value and enhance our offering.

Recent examples include our work in the collateral optimisation space, emerging markets and through valueadded services such as ProxyValue™ and ShortValue reporting.

In addition, we continue to invest in our future by expanding the expertise and depth of our executive management team with the hiring of Peter Economou, for a newly established Chief Risk Officer role. With twenty years senior securities lending experience, he will bring a dedicated focus to risk management for our company and our clients. We have also expanded our legal team to ensure we have dedicated staff focused on monitoring regulatory developments. I

27

TRADING POST

MARGIN CALLS: EFFECTIVE MANAGEMENT OF ASSETS

Independent consultant Bill Hodgson of The OTC Space, kicks off his new (regular) column looking at the key issues of the day in the post-trade segment. In this inaugural commentary, he explains why clients must now exert greater control of assets delivered against margin calls. The omnibus model used in the futures markets has in practice shown weaknesses that users of OTC (ISDA) products will want to avoid.

Safety first for margin assets HE OMNIBUS MODEL gives intermediary brokers the ability to register client trades in a single account at an exchange, and be called for the margin on the net risk across those client trades, and call the clients for the gross risk on their individual trade portfolios. In most cases the net risk is lower than the gross risk, enabling the intermediary to build a pool of ‘excess’ margin assets held in its own accounts, which it then invests to make a return.

MF Global has shown the risk of uncertain control over client assets; they can move between broker accounts, and between group legal entities, without the client knowing. They can also be lost in trading activity through market risk and poor investment decisions and frankly, most clients have no knowledge of the investment activity of their intermediary.

US regulator CFTC has had strong feedback that the omnibus model is unwelcome in the new world of clearing OTC products and has consequently embraced a new model entitled Legally Segregated Operationally Comingled (LSOC) that must be implemented by November 8th.

Legal segregation requires CCPs and an intermediary to keep precise records of each client’s trades and their related margin assets. It also means an end to combining multiple client portfolios within a CCP’s margin calculations as each client account is calculated separately for margin purposes. LSOC encourages the CCP or intermediary to hold cash

T

28

or securities in as few custody accounts as they can, in theory saving cost of maintaining individual accounts for every client.

For an intermediary, this is a simpler but less profitable business opportunity. For each margin call from the CCP, they must pass a similar call to the client for not less than the CCP margin amount, and then pass on to the CCP the collateral provided. The client might be asked to post additional collateral to prevent intraday margin calls, but this amount is unlikely to be as large as in the omnibus model.

A key protection offered by LSOC comes in the event of a default by a fellow client of your intermediary, in the US a futures commission merchant (FCM); or the default of the FCM itself. If a fellow customer defaults, LSOC prevents the FCM or CCP from using client assets in any way to cover losses by their fellow customer. In the event that the FCM defaults, LSOC enables the CCP to provide portability of client positions and assets to another FCM, and prevents the bankruptcy of the FCM from utilising client assets.

However, LSOC doesn’t prohibit an FCM from investing client assets. Any excess collateral clients post can still be moved within the FCM group organisation, and invested into the markets where the FCM may make a profit, or worse make a loss, on their trading strategy. Moreover, it is going to be hard for clients to tell whether an FCM is actually meeting the letter of the LSOC rules for segregation,

Bill Hodgson, independent consultant, The OTC Space. Photograph kindly supplied by The OTC Space.

even with daily delivery of account statements. The failure at Peregrine remained undiscovered due to the CEO allegedly providing falsified account statements. CFTC Commissioner Scott O’Malia has stated his concerns over LSOC, including the fact that the new regulations do not protect any excess collateral held at an FCM only that posted to the CCP. Intermediaries such as FCMs will have to adopt a new business model (for OTC products) to remain profitable. Clients should now look out for revised fee schedules to shift the cost towards a per-transaction model or similar.

On the plus side: new ideas are emerging to improve the safety of margin assets. Eurex wants to go beyond LSOC and offer full segregation of client assets, with no mingling at any point; though its legal framework will need careful analysis to isolate any residual risks, such as the transit process from the client via the clearing broker, to the CCP. Equally, custodians now want to partner with CCPs to provide an integrated service; a client, an intermediary and a CCP can all hold asset accounts with the custodian, which as a third party can provide operational safety and additional legal protection to the client assets, and also provide speed of transfer via book-entry.

Clients need to consider these risks and look for firms to offer solutions which go beyond LSOC to minimize the possibility of another MF Global.I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

COUNTRY REPORT

In next month’s FTSE Global Markets we will be running a major report on the implications for market change on the Russian broking community. As work started on the project, news emerged of Okritie Financial Corporation’s move on Nomos Bank.

While the merger looks to be part of a wider and long term move to create a more streamlined and efficient banking segment; in reality the acquisition has stimulated more questions than answers. Key to the successful integration of the Russian market into the international financial community is transparency and a more open market for foreign investors. Will current moves to upgrade and expand the Russian markets be defined by only local interests: or can Russia look to a wider horizon?

N RUSSIA’S OPAQUE banking system, anything can happen. As the market gears up for upgrades to it capital markets infrastructure, Russia’s brokerages and banks are beginning to set out their stalls to meet the opportunities of the changing market head on. In late August Otkritie Financial Corporation announced that it was planning to raise more capital and broaden its shareholder base to help fund a London-traded Nomos Bank and create the country’s second biggest privately owned banking group in a deal said to be worth $2bn. The acquisition propels Otkritie from a mid-ranking player into one of the country’s top ten banks. Any merger between the two would establish the entity as the country’s second largest private bank (after Alfa Bank).

The transaction is regarded as a sign that the long expected consolidation of the Russian banking and broking sectors is underway. Otkritie is currently the country's 35th-largest bank by asset size, though the combined entity of NomosBank and Otkritie will have assets of over RUB1trn (around $32.3 bn).

Okritie is part owned by state run banking major VTB, which owns 20%

I

FTSE GLOBAL MARKETS • SEPTEMBER 2012

of Okritie shares. The likelihood is that Okritie will eventually own all of Nomos’ shares, a fact confirmed in an official statement by the company.

VTB’s role in the acquisition is also obscure right now. Certainly it appears to be a key player in Okritie’s efforts to raise $1bn in financing to help fund Okritie’s purchase of Nomos; leading to speculation in some quarters as to whether Okritie is a player or a pawn in this particular move.

Certainly, the shareholding of the parties in the deal is at best Byzantine in its complexity. In early August Czech private equity firm PPF Group gave 19.9% of its 26.5% stake in Nomos to Okritie in exchange for a slice of a potash producer Uralkali. Separately, Russian billionaire Alexander Nesis, who controls over 50% of Nomos shares via a special investment vehicle (ICT), provided the Uralkali equity. The remainder of the 26.5% stake held by PPF was then acquired by Alexander Mamut, a business partner of Nesis, and another investor called Oleg Malis.

The exact financial details of these transactions have not been disclosed.

Otkritie is now said to have agreed with the shareholders of Nomos a price

WILL RUSSIA REALLY OPEN UP ITS FINANCIAL MARKETS

Can Russian bankers step up to best leverage market changes?

for their equity in the bank. In a less than clear statement, Okritie announced in August that: "Upon completion of the consolidation of Nomos-Bank shares by Otkritie Financial Corporation, the distribution of shares among major shareholders will be as follows: Otkritie chief executive Vadim Belyaev and the Otkritie management team will control up to 25% of shares; stakes of up to 10% will be owned by companies affiliated with ICT Group shareholders, by VTB Group, by Otkritie chairman Boris Mints and by Alexander Mamut," VTB remains a power player in the Moscow banking market and last year acquired Bank of Moscow and OAO TransCreditbank as part of an expansion into consumer and corporate lending. Meanwhile, rival state banking major Sberbank, which has almost 50% of Russia’s deposits, bought Moscow brokerage Troika Dialog in January to compete with VTB’s investment banking assets.

Similarly, Russia’s brokerage market has also been hotting up over the summer as market reforms take hold and demand for access to the Russian market by European buy side trading desks steadily rises. For instance, brokerage Okritie Securities in London saw five of its staff left to join rival Russian broker BrokerCreditServices (BCS), including Tim Bevan, a director of its electronic trading business, is now heads up BCS’s prime Russian broker BCS has opened a unit in London. Bevan, who has also had a stint with RenCap, started his career with a job at the London Stock Exchange, and was later in charge of Russian derivatives at Turquoise Derivatives (later EDX). “The appointment of key individuals, along with other recent hires in Moscow in technology, operations, trading and sales, emphasises BCS’s commitment to become a leading force in Russia’s capital markets,” BCS chief executive Oleg Mikhasenko says.

These are well documented examples of some of the changes running

29

COUNTRY REPORT

WILL RUSSIA REALLY OPEN UP ITS FINANCIAL MARKETS

through the Russian financial markets: consolidation of the power and influence of key oligarchs and the management of the two state giants Sberbank and VTB on the one hand and the efforts of investment banks and broker-dealers to upgrade their service offering to leverage the very real market opportunities that are opening up in Russia. The question now is whether developments at the macro level will help or suffocate the more liberal operations of the specialist broking and investment banking communities. More about that next month.

Some of the immediate signs look hopeful. The government appears to have adopted a cautious liberalism in its outlook. It has clearly voiced its intentions to develop Moscow as an international financial centre and appears to acknowledge what is necessary to create a well spring of inward

investment, which is crucial to the success of that particular project.

Small, but meaningful initiatives are clearly underway, such as the RDIF initiative (see box).

As well, the continued integration of Russia’s two exchanges MICEX and RTS, which is now close to full integration into the Moscow Exchange will again feed into this understanding that the country needs higher levels of foreign investment. Similarly, the further deepening of the country’s investor base will be stimulated by impending changes to the country’s clearing house, which are scheduled for the first half of 2013. These reforms will ultimately enable a move to T+3 settlement (from T+0 currently) and revisions to tax laws.

While these changes are a step forward for the Russian markets, it is imperative that the government bring

some order to the efforts by local businesses and institutions to consolidate their market positions. While it is natural that Russian entrepreneurs and financial institutions want to safeguard their interests, it is vital that they understand and actively work to open up the country to foreign firms and give them the freedom and room to bring new ideas, business and investment money into Russia for the benefit of all.

If this does not happen, it is likely that for the short term at least, Russian brokerages and financial institutions will continue to dominate the local trading and banking market as global banks stay away. It is understandable to want to be a big fish in a small pond; but it might be more valuable for everyone if Russia’s big fish allow foreign firms and investors increase the size of that pond.I

RDIF MAKES ITS MARK T HAS BEEN a busy summer for the Russian Direct Investment Fund (RDIF) as it begins to make its mark in the emerging Russian private equity market. The private equity focused sovereign wealth fund was established by the Russian government last year, with some $10bn in start-up capital. It’s subsidiary Russia-China Investment Fund (RCIF), says it has reached a preliminary agreement to become a shareholder of Russia Forest Products (RFP), Russia’s second-largest forestry company. RDIF is mandated to secure co-investment that as a minimum matches its commitment, and tries to act as a catalyst for direct investment into the Russian economy.

RCIF is likely to invest over $200m in RFP and become the firm’s largest shareholder. “We expect it to generate strong returns as well as to advance bilateral economic cooperation between Russia and China,” explains Kirill Dmitriev, RDIF’s chief executive officer. “The investment will lead to the

I

30

creation of new jobs throughout Russia’s Far East and the implementation of modern technologies in the Russian forestry sector,” he adds.

The transaction is a new departure for the fund and illustrates the growing range of investments the state run private equity fund will make. In July, RDIF partnered with Cartesian Capital Group to acquire stakes in the new Moscow Exchange, with the purchase of shares from ZAO UniCreditBank. RDIF now owns approximately 2.7% of the exchange, while Cartesian will own approximately 2.5% of the merged exchange. UniCredit Bank will reduce its stake in the exchange to 6.2%.

That investment is part of a long-term strategy to promote the development of Russian capital markets and broaden the regional and international appeal of the Moscow Exchange. This transaction follows an investment earlier this year in the exchange by the RDIF and the

European Bank for Reconstruction and Development (EBRD). Dmitriev says: “This is our second investment in the Moscow Exchange, and together with Cartesian and the EBRD we look forward to supporting the exchange as it continues to grow and develop."

Russia is potentially an attractive host economy for foreign direct investment (FDI), mainly due to its large market and rich natural resources. However, up to now the government has been unable to make some of the radical changes required in the country’s investment culture to continue to attract FDI on a large scale. RDIF is one response by the government to begin to instigate meaningful change.

The establishment of RDIF is timely, as the country’s infrastructure is still in need of massive investment.

International foreign direct investment inflows have risen slowly but steadily, reaching $43bn in 2010 and $53bn last year.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

COUNTRY REPORT

RUSSIA: STATOIL HIGHLIGHTS INVESTOR RISK

STATOIL GETS COLD FEET IN THE ARCTIC Statoil has left a major Russian natural gas production project on the Arctic shelf. The Norwegian investor’s four year history of involvement in the Russian special purpose vehicle, Shtokman Development AG, has ended rather dramatically. A shareholders’ meeting of Shtokman Development has been scheduled for August 30th. One of the issues on the agenda will be the return of the shares by the French partner. Pavel Gargarin, chairman of the board of Gradient Alpha Investments Group, explains his take on the venture.

HTOKMAN DEVELOPMENT AG was set up to prepare the exploration of the giant Shtokman gas field in the Russian Arctic shelf. All rights for its development belong to the Russian gas monopoly Gazprom. After a competitive selection, two foreign companies were invited to join the project and were allocated 49% of the company (Statoil 24%, Total 25%). The Russian company retained a 51% share.

Foreign companies were invited to participate in the project in order to secure the most advanced technologies and solutions for the very difficult field development project and to finance the expensive initial phase.

According to the shareholders’ agreement, if its terms were not met, the foreign partners would have to return their shares to Gazprom without recompense. Statoil has already accounted for a $340m write-off for its participation in the project.

The conditions for foreign investors were clearly not on equal terms with the Russian company, but, given the enormous scope of the project (the initial development costs were estimated at $20bn), if successful, foreign participants could count on no less enormous dividends. Perhaps the scale and cost of the project is an obstacle to its successful implementation. Gazprom seems to be in no hurry to develop the new field, instead concentrating on its other operational projects.

After four years, the shareholders could not reach agreements on either the technical aspects or the financial side of the project. In addition, the expected capital expenditures

S

32

Pavel Gargarin, chairman of the board of Gradient Alpha Investments Group.

Photograph kindly supplied by Gradient Alpha Investments Group, August 2012. increased by 50% to $30bn with increasingly hazy prospects of recouping the investment; due in large part to uncertainty about the level of demand for future supplies, as well as the price of gas. In recent years, the demand for gas in Europe has been decreasing, and the expected recession in the economy gives no hope for the revival of demand in the foreseeable future.

At the same time, competition in the European gas market has increased, and consumers have begun to demand that Gazprom offers a price reduction on previously agreed contracts. There are increased gas supplies from Africa and there is a lot of potential production in the Middle East. Even Turkmenistan is trying to sell gas directly to consumers.

The shale revolution in the US will also bring large volumes of gas to the world market in future.

Can we say that the project, with gas reserves estimated at 3.9trn cubic meters, will fail? Certainly not! The configuration of the project will change, terms will change, there will be new partners, but the project will go on. The original plan was for pipeline gas

supplies to start in 2013 and liquefied natural gas (LNG) supplies in 2014.

Commissioning of the field is now unlikely to happen before 2018.

On the political side, the Russian government is bound to support the project. Putin has already indicated that Gazprom can expect to get significant tax breaks and other preferences that will be needed to make the project attractive to foreign investors.

That is why both Statoil and Total have expressed a desire to continue with their participation in the project, despite no longer being shareholders. They have already spent hundreds of millions of Euros in Russia and are unwilling to give up the opportunity of making a significant return on their investment.

Investors are continuing negotiations with Gazprom for the commercialisation of the Shtokman project and hope to come out with a sound commercial plan that would justify future large investments.

A certain intrigue in the present situation is created by the shareholder’s desire to involve another participant in the project. Anglo-Dutch Shell, with its experience in exploiting similar difficult fields, has the best chance of joining the project. Besides, Shell has long been cooperating with Gazprom on other projects and participates in another Russian gas project on Sakhalin Island in the Far East. The final decision on the fate of the project and its participants rests entirely with Gazprom. Foreign investors will have to wait until they are chosen to become a member of one of the world’s largest projects. The payback from winning the bet could be billions.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

WWW.DMADIRECT.SE

EMERGING MARKETS PROVIDE UNIQUE INVESTMENT OPPORTUNITIES â&#x20AC;&#x201C; WE MAKE THEM EASILY ACCESSIBLE We target growth markets and provide the required local know-how and COMPETITIVE MARKET ACCESS FOR EASY SECURE AND COST EFk CIENT ORDER EXECUTION DMA Direct is an agency broker and custodian covering emerging markets and specializing in CAPITAL DERIVATIVES AND FOREIGN EXCHANGE TRADING

PHOTO: ROB ATKINS / GETTY IMAGES

CONTACT US sales @ dmadirect.se +46 (0)8 402 29 73 www.dmadirect.se

COUNTRY REPORT

THE MOSCOW EXCHANGE: A CORNERSTONE OF MARKET RENEWAL

On August 9th, the Moscow Exchange board of directors held a meeting to consider a planned IPO for the exchange. An extraordinary general meeting of the exchange’s shareholders will be held on September 21st to decide whether to increase the share capital of the exchange through the private offering of additional 200m shares. The move consolidates the exchange’s efforts to become a commercial hub and powerhouse in Russia.

To achieve this, exchange has embarked on a hefty work program which involves the modernisation of the country’s capital markets infrastructure, deepening the exchange’s derivatives offering, encouraging the growth in Russia’s domestic investor base, improving primary market product quality, attractive long term foreign indirect investment and promoting the country’s domestic privatisation program. Can it all be done?

FTSE Global Markets spoke to Sergei Sinkevich, Primary Market Department and Globalisation Managing Director of the Moscow Exchange to find out how.

The Moscow Exchange’s dash for growth TSE GLOBAL MARKETS: The merger of Russia’s two largest stock exchanges, MICEX and RTS, in December 2011 has provided a one-stop-shop for trading equities, bonds, derivatives, and currencies.

How does the merger of the exchanges dovetail with the government’s plan to establish Moscow as an international financial centre?

What in your view are the challenges and opportunities of this plan?

SERGEI SINKEVICH: The creation of the International Financial Centre in Moscow is an ambitious and extremely important project. It directly impacts the future of Russia’s stock market. The project has encouraged the evaluation of Russia’s current potential and prioritised a wide range of initiatives—including the introduction of new regulation and infrastructure— that will ultimately re-shape the market significantly.

The merger of the two major Russian exchanges, MICEX and RTS, has had a positive impact on international ratings of the Russian market, and has raised

F

34

the overall assessment of those parameters that contribute to these ratings.

These achievements have been possible because of the actions of the exchange, such as its active involvement in the development and deepening of the country’s financial markets’ infrastructure; its efforts to improve corporate governance; and improvements in corporate law enforcement, including protection of investors’ rights and the upgrading of the general business environment.

FTSE GLOBAL MARKETS: Can you briefly explain the structure of the exchange and its main business areas?

S.S.: Moscow Exchange is a vertically integrated operator in as rapidly growing economy (real GDP growth in Russia last year reached 4.3%). It is a leading platform for multi-asset trading of Russian instruments: stocks, bonds, repos, FX and derivatives. Our group has its own clearing, settlement and depository infrastructure. Moscow Exchange is in already in the top five exchanges in fixed income, and top ten in terms of cash equities trading turnover in Europe,

Sergei Sinkevich, Primary Market Department and Globalisation Managing Director of the Moscow Exchange. Photograph kindly supplied by the Moscow Exchange, August 2012.

and yet has an unprecedented potential for both share and volume acquisition.

FTSE GLOBAL MARKETS: What are the top three strategic goals of the merged exchange?

S.S.: We actually have six, but, I will mention the three most important to us in 2012-2015 period: winning IPOs/ SPOs and secondary liquidity back to Russia by focusing on development of domestic investor base and by attracting foreign investors; to grow and develop the local derivatives market and to develop a competitive settlement and depositary product offering.

FTSE GLOBAL MARKETS: Compared with the volumes in the Russian bond market, trading in equities remains a small percentage of the overall capital markets in Russia. How do you plan to increase the role of equities trading over the coming years? What additional developments, such as freeing mutual and pension funds asset allocation limits to equities, do you think need to be in place to help you achieve the deepening of the equities trading market?

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

S.S.: Russia’s most needed resource is long-term investment. It exists, but we just need to put it to work. There has been a strong movement within the business community to re-visit the current regulation framework, which governs pension fund investment guidelines. Besides that there are plans to attract funds from the local insurance industry and Russian sovereign wealth funds to the local equities market.

It has been recently announced that privatisation will take place in Russia with further listing at Moscow Exchange. Privatisation is a strong catalyst to reset any market, especially the Russian one. It is important to have this communication ahead of time. Most investors into GDRs, ADRs and shares, whether local or abroad need to complete internal procedures to increase exposure on Russia’s local stock.

FTSE GLOBAL MARKETS: How much of the trading on the exchange is originated by foreign investment firms? How do you plan to increase this share?

S.S.: Currently we are witnessing 29% of trading on the exchange conducted by foreign investors. That indeed is an area of improvement for Moscow Exchange. Our competitors have managed bigger volumes. Our key goal

is to increase the share of nonresidents on the Russian market to 40% within a few years. Our focus is to have share and volume of foreign investors grow to develop Russia’s cash equities market.

FTSE GLOBAL MARKETS: How is the exchange working with regulators to liberalise the issuance of securities and improve the market for companies to launch IPOs in Russia and bring procedures in line with international best practice?

S.S.: Moscow Exchange actively cooperates with the Regulator to improve Russia’s securities market regulatory framework. At the moment two drafts initiatives that will modernize the country’s listing procedures have been submitted to the Federal Service for Financial Market of Russia, the market regulator, for review. These initiatives will simplify the current listing system and bring it in line with the practices applied globally. Re-shaping of the listing system involves enhancing the requirements for issuers, their securities and corporate governance. Moscow Exchange plans to re-set the relationship between the exchange’s indices and its listing requirements. Moreover, we will continually strive to create an effective system of qualitative selection of issuers in whom investors can trust.

FTSE GLOBAL MARKETS: Is the exchange considering issuing its own set of rules that companies who want to list on the exchange can adopt voluntarily in addition to any others required by law?

S.S.: Yes, we are working on it. Beginning in the second quarter of this year, Moscow Exchange launched a project involving the development of criteria for the premium listing segment Novy Rynok. Joining the premium segment involves the voluntary acceptance by issuers of the need for enhanced commitments in reporting, corporate governance and transparency. The segment will provide comfort to foreign and local investors by introducing additional mechanisms that protect their rights and increase the level of information disclosure.

We are introducing this segment for two reasons: on the one hand we are planning to attract long-term investors who are ready to invest in“high-quality’’ issuers. On the other, we want to attract issuers that want to establish reputational capital and who expect to enjoy market premia, added to the price of their shares, which clearly demonstrate their exemplary practice of corporate governance and transparency. The project is set to be launched in 2013.

DRAWN A BLANK? If you need reprints for your marketing needs Simply call or email

Contact: Peter Keith Tel: 44 [0] 20 7680 5158 Email: peter.keith@berlinguer.com

We will be pleased to tailor our reprints to your specific requirements.

FTSE GLOBAL MARKETS • SEPTEMBER 2012

35

COUNTRY REPORT

THE MOSCOW EXCHANGE: A CORNERSTONE OF MARKET RENEWAL

FTSE GLOBAL MARKETS: What types of companies would you like to attract to list on the exchange and why?

S.S.: At the moment the Moscow Exchange is focusing its attention on several key types of issuers. The first type includes non-public Russian companies, such as those on the country’s privatisation list. Our biggest challenge, and one on which we are fully focused, is to have all Russian companies list their shares domestically, on Moscow Exchange. This is the key factor to help secure and protect the sovereignty of Russia’s public equity capital market.

The second type is small caps. We offer a special capital raising facility, the Innovation and Investment Market (IIM), which is Russia’s equivalent to NASDAQ. One of the missions of this section is to help small businesses to raise equity via public market sources.

The third group includes depository receipts and the shares of Russian companies registered in foreign jurisdictions and listed only on foreign exchanges.

Moving back home will provide them with a domestic investor base, which we believe is necessary to stabilise their market capitalisation. We are talking to all of them and have a few deals on the table to come to the market soon. Many of them that did not list their shares in Russia have suffered during the recent crisis as foreign investors exited their stocks. In contrast, those firms that have a domestic listing have experienced better price recovery due to the support of domestic investors.

The next group involves multinationals whose footprint is significant in Russia. Admitting the shares of these companies to trade should greatly contribute to a number of unique instruments in Russia’s public equity sector.

It will also help them in their localisation strategies when it comes to local public capital markets, such as debt financing; or the local administration of an options program; or the establishment of a new investment base, to give you a few examples.

The last group involves companies from the CIS states. Moscow Exchange

36

is the leading trading floor in Eastern and Central Europe. Some 70% of the liquidity in this region is concentrated on the exchange. Knowing that the capacity of local markets is often insufficient, these companies opt to list on foreign exchanges. We can offer them win-win solutions that involve a domestic listing and Moscow’s deep liquidity pool. Russia’s investors are interested in CIS issuers and understand their risk profile well. Currently, all foreign investors that invest into those companies in London are all operating in Russia’s local market. We are determined to gain back Moscow’s positioning as a financial hub it has enjoyed in the past.

FTSE GLOBAL MARKETS: What will membership of the World Trade Organisation (WTO) do for the exchange?

S.S.: Russia’s acceptance to the WTO is an important step towards accelerating the growth of Russia’s economy; it will enhance its competitiveness, and contribute towards the modernisation and productivity of the country. In accordance with the WTO requirements, the regulatory framework is going to be changed and many restraints lifted.

These elements will also garner improvements in the business environment in Russia and help to bring foreign investors to the Russian market. This is what we are interested in.

FTSE GLOBAL MARKETS: Among the tasks of the new Moscow Exchange is to encourage more Russian companies to list on the main board. Might I please ask how you plan to do that and what changes need to take place to help you achieve this target?

S.S.: In order to win this business back we must become a liquidity and price discovery centre. We clearly need to stimulate significant growth in local liquidity in both the primary and secondary public equity markets; and we must change the mindset of issuers and investors.

The merger of MICEX and RTS has allowed us to re-allocate resources so

that we can enhance competition and create Russia’s cash equities powerhouse. We are working in four main areas: infrastructure modernisation, growth in the domestic investor base, primary market product quality, and domestic privatisation.

FTSE GLOBAL MARKETS: Trading on the exchange has to be done through local brokerages.

Might the day come when foreign brokers can compete as equals on the exchange?

S.S.: At the moment trading could be done through local brokers only and this position is not likely to change in the nearby future. Currently brokers who are actively working with international clients offer a competitive product. We also see growing emergence of major global players domestically.

FTSE GLOBAL MARKETS: T+0 trading regimes bring opportunities and challenges: will you move to T+3? How soon might this occur?

What are the obstacles to change?

S.S.: I believe it is safe to say that T+0 will soon become a thing of the past for Moscow Exchange. We are fully committed to switching our settlement to T+n and we are certain that it will change the entire landscape of the Russian stock market. There is one very good reason why the transition of our market to T+n is imminent. It is a world standard, which is acknowledged by the international investment community and it is one of prerequisite conditions for foreign investors to enter the local market. Currently the project is moving ahead at a very good pace and we are optimistic about its impact on market participants. Obviously there are challenges when it comes to preparing for the changeover in the areas of operations, risk management, collateral requirements, and FX risks.

There is a lot of preparatory work to be done, but we have a clear strategy of T+n implementation, which we are committed to. We expect the final implementation of T+n settlement to happen in the first half of 2013. I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

TURKISH BANKS STRETCH TENORS AND DEBT ISSUES

Photograph © Ig0rzh / Dreamstime.com, supplied August 2012.

Turkish banks extend borrowing maturities and cut the cost of funding The capital and funding structure of Turkey’s banking segment is in flux. Both tenors and the range of securities employed is widening. Moreover, investors in Turkish bank paper are gradually changing as well. European banks are being replaced by local or alternative foreign investors. Although underlying loan growth by Turkish lenders is slowing, it is still expected to expand by around 15% this year, according to bank analysts, which should provide the country’s banks with reason to keep on tapping the Eurobond markets. While cash and capital cushions look largely sufficient for the near term borrowing is expected to remain steady.

URKEY’S HALKBANK CAME to the Eurobond market in mid July with a $750m offering at an issue price of 99.53, yielding 5% with a coupon of 4.875% in a deal arranged by Bank of America Merrill Lynch, Citi and Deutsche Bank. Interestingly the bond matures in 2017, a signal indication of the stretch that Turkish banks have achieved of late in terms of tenors. It is also a sign of the growing maturity of Turkish issues in the Eurobond markets.

The sector's funding costs reduced in second quarter of this year, with an attendant compression of credit spreads. Deposit rates and repo costs also reduced. The average funding cost

T

FTSE GLOBAL MARKETS • SEPTEMBER 2012

went down marginally to 5.7% for the banking sector from 5.8% in the first quarter of the year, although the pricing of the bonds is still above 2011 levels when the average funding rate was around 5%. Turkish banks have also increased their reliance on bonds, bills and sub debt on their funding side as opposed to syndicated loans, indicating a broadening in the use of debt instruments. Sekerbank has also tapped the securitised debt market in recent years (see FTSE GM passim).

Several banks have successfully tapped the Eurobond market so far this year with good demand from investors and with most issues over-subscribed.

Local private banking majors Akbank and Isbank, as well as Yapi Kredi Bank are expected to lead the issuance calendar in the second half of the year with a number of benchmark issues in the Eurobond markets.

Their issue prices are expected to put further downward pressure on prices for Turkish bank paper. Akbank was an early issuer and came to market in mid-August with a one year syndicated loan worth up to $1.5bn. The dual tranche refinancing facility was divided into a $450m tranche and one for €875m, and was marked by the bank’s success in bringing down all-in pricing to 135 basis points, setting a new, low pricing benchmark for a Turkish banking issuer.

Isbank will come to the domestic market in September with a short term TYR300m issue with a 173 day maturities and a further TYR100m in discount bonds with a maturity of one year, though the bank may increase the amount it borrows to TYR700m if there is sufficient investor demand for the paper. Turkey’s banking major is also reportedly ready to come to market with a ten year Eurobond in a statement sent

37

COUNTRY REPORT

TURKISH BANKS STRETCH TENORS AND DEBT ISSUES

to the Istanbul Stock Exchange in late August, though the bank would not comment further on these plans.

Yapi Kredi Bank is also set to tap the Eurobond market in September with an issue said to be worth $1.32bn, with varying maturities. The bank last tapped the market back in February this year with an issue of $500m worth of five-year fixed rate notes lead managed by JP Morgan Securities, Standard Chartered Bank and UniCredit. That deal marked the first senior unsecured bond offering from a private Turkish bank since May 2011.

The bond, which matures in February 2017, was approximately 2.8x subscribed with the participation of 145 accounts from 22 countries, allowing it to be priced at the tight end of price guidance, with a coupon rate of 6.750%. The interest on the notes will be paid semi-annually with the principal payment due at maturity. The deal also showed that Turkish banks have moved away from their dependence on European banks as purchasers of their paper and have broadened their investor base considerably. While the Middle East features in the investor profiles, Asian financial institutions have yet to make a mark as investors in Turkish banking issuance, though Taiwanese and Korean investors have bought Turkish paper in the past.

Overall however, internal market developments might impact on the volume of loans coming to market. The bank’s own loan growth looks to be slowing down and the year-on-year loan rate as of end-June was the lowest in more than two years, according to local banking reports. Consumer loans were up 17.2% year on year to the end of June, but this compares to an uptick

of 30% year on year in the first half of 2011. The medium term impact of the slowdown on borrowing by Turkish issuers has yet to be determined.

The signs generally remain positive even while the real economy in Turkey is facing difficulties, not only because of knock on effects of the continuing dampening of export demand, but also due to low demand in the domestic market. One reason is the tight monetary policy employed by Turkey’s central bank in its efforts to reduce the country’s current account deficit.

However, Turkey’s export sector is nothing if not resilient and despite visible dampening of demand from traditional markets in Europe, Turkish exporters have enjoyed notable success in sustaining export performance by gaining market share across those EU markets where demand for cheaper quality products has increased.

Another reason is its increasing penetration in MENA countries on the back of strengthening political and economic ties. Highly dependent upon imports of energy and raw materials, the Turkish economy has also benefited from easing oil and commodity prices.

After posting strong GDP growth rates of 9% in 2010 and 8.5% in 2011, Turkey’s growth rate is expected to moderate to 3.6% in 2012, according to the latest survey of consensus expectations released by the Central Bank of Turkey (CBT).

Even so, Ercan Güner, manager of the $172m HSBC GIF Turkey Equity fund, managed from Istanbul, says “Although the large current account deficit constitutes one of the main risks for the Turkish economy, we remain encouraged by the government’s recently-introduced incentive

scheme to tackle the structural and long standing current account deficit problem over the long term and also

by CBT’s flexible monetary policy over the short-term.”

The Turkish equity market meantime has been one of the world’s best performing equity markets with a year-to-date return of more than 30% in dollar terms. Although there may be a short-term correction as the global stock market rally pauses for breath, optimism remains in the medium to long term as the country continues to emerge as a regional economic power, according to HSBC Global Asset Management.

Güner says the Turkish economy has remained resilient to the global economic downturns witnessed in recent years, benefiting from low levels of public and household debt, favourable demographics and a solid and profitable banking industry. He says that after posting strong GDP growth rates of 9% in 2010 and 8.5% in 2011, Turkey’s growth rate is expected to moderate to 3.6% in 2012, according to the latest survey of consensus expectations released by the CBT. This would represent a soft landing rather than a return to the “boom and bust” periods that the Turkish economy typically experienced in the 1990s.

Against that background, the total loan book among Turkish banks has grown by around 7% in the first half of this year, and by 9% to the end of July. Turkish banks have been focused on high-value generating segments, such as credit card loans, general purpose loans and Turkish liradenominated corporate loans.

Deposits grew 4% in H1 2012 and 6% between January and July according to central bank figures.I

CLARIFICATIONS Securities lending specialist Roy Zimmerhansl and Consultant Andrew Howieson want us to clarify that a substantial quote in the article: Securities Lending: To clear or not to clear by Neil O’Hara in the June edition of FTSE Global Markets was attributed to “a recent TABB study”, was in fact a quote from the Executive Summary of a previous white paper Good, Bad or Inevitable? The Introduction of CCPs in Securities Lending by them. TABB Group chose to carry this publication on their website, but have no other involvement in the paper. We are happy to clarify this point.

In the July/August edition we carried a story on Activision Blizzard, Fighting on All Fronts, by Art Detman. We referred to its chief executive Robert A Kotick as Billy Kotick. He would like us to explain that he does not use the moniker Billy. We apologise for this error.

38

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

DERIVATIVES

DELTA ONE DOES NOT MEAN RISK FREE

Low risk by name, but is Delta One risk free?

Prospective implementation of the Volcker rule and higher regulatory capital requirements have already curbed proprietary trading at the big banks, ratcheting up the pressure to snag as much customer order flow as possible. Combining their formidable trading expertise with high-powered information technology, banks seek every opportunity to meet the needs of customers around the globe. They mine flow not only to pair off trades in identical assets but also to facilitate and hedge customer requests for synthetic exposure through their Delta One trading desks. Although Delta One books are supposed to be fully hedged at all times, they haven’t always lived up to their low-risk name. Neil A O’Hara reports.

T MAY BE coincidence that Jerome Kerviel at Société Générale and Kweku Adoboli at UBS racked up multi-billion dollar trading losses even though both were Delta One traders.

Fraud is notoriously hard to detect in trading; indeed, perpetrators have come to light in instruments as varied as government bonds (Joseph Jett at Kidder Peabody), index arbitrage (Nick Leeson at Barings), copper (Yasuo Hamanaka at Sumitomo) and foreign currency (John Rusnak at Allfirst).

Managing risk on Delta One desks is nevertheless a challenge because trades often involve multiple instruments in one or more countries. In addition, the focus on synthetic products means most trades involve swaps or other bilateral derivatives traded over the phone. Manual execution relies on humans to document the trade, a process far more susceptible to abuse than electronic trading, which automatically creates an audit trail from order entry all the way to settlement.

At heart, Delta One traders are market makers who would prefer to match customer orders on opposite sides of each trade and take a spread in the middle, just like market makers in listed securities. In practice, orders in synthetic products don’t usually match in size,

I

40

specification or duration—or because customers are all on one side chasing the same opportunity.“In derivatives and Delta One products, the broker is generally warehousing something for a period when it deals with a customer,”explains Anthony Hayden, head of the newly established Delta One desk at Nomura Securities in New York.

Warehoused securities have to be financed, and brokers leave no stone unturned to find the most efficient funding. If a customer wants a bespoke stock basket—the Standard & Poor’s 500 excluding financials, a classic Delta One product—the desk will write a swap, leaving the broker short. To acquire offsetting long exposure, the trader could just buy the non-financial components of the index, but that ties up significant capital. It may be cheaper to buy futures on the Standard & Poor’s 500 or the ETF index tracker and sell short the financial components, either directly or through an ETF that tracks the Standard & Poor’s Financials. The trader could also set up a reverse conversion using Standard & Poor’s 500 options and short the financials, or enter into a matching equity swap.

Delta One desks don’t just set the hedge and forget it, either. “We constantly look at the relationship between

the products we use to hedge,” says Hayden. “To the extent that one is out of line with another it may be more efficient to switch the hedge.” Differences in pricing among economically identical positions arise for both fundamental and technical reasons, including distortions around contract expiration or quarter-end dates.

In August 2011, for example, the Standard & Poor’s 500 futures began to trade below theoretical fair value at the same time the ETF that tracks the index became hard to borrow, forestalling arbitrage that would have eliminated the pricing anomaly. Institutions naturally long the Standard & Poor’s 500 could capitalise by lending their stock through a Delta One desk in an equity repo and buying futures to maintain their exposure, picking up a few extra basis points.

“Some customers care about short-term variations in how the Standard & Poor’s 500 trades relative to the futures, while others have a time horizon of eternity,” says Hayden. “Knowing which customers have what interest, the broker can provide added value.”

Delta One desks have expanded in recent years as institutions have come to prefer synthetic financial products for certain purposes. Even mainstream investments have gone synthetic. In Europe, almost half the ETF market comprises vehicles that do not own the market value weighted components of the indices they purport to track.

Instead, synthetic ETFs own swaps that deliver the return on the index, outsourcing tracking error to the swap counterparties. Leveraged ETFs in both Europe and the US also use synthetics, as do many hedge funds.

Only the largest banks and securities houses have the order flow needed to support Delta One trading and can afford the necessary investment in technology.“A firm cannot start a Delta One desk from scratch without the ability to match order flow,” says Andy Nybo, principal and head of the derivatives practice at Tabb Group, a New York and London-based financial services research and consulting firm.“The

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

desks are built on scale and the capabilities of an international bank to accommodate a client’s needs.”

In addition to synthetic basket trades, investors may use Delta One products for market access. A pension fund that wants exposure to the emerging markets may prefer to enter into a swap rather than buy the stocks directly, even if it could. In countries that limit foreign participation in their capital markets a swap with a bank that has a local presence may be the only way to get the desired exposure.

Synthetic structures can provide leverage and tax efficiency. If a hedge fund wants $100m exposure to the MSCI EAFE, it could either invest $100m in the individual components, or it could enter into an index swap and put up $25m of capital (subject to daily variation margin), leaving the swap counterparty to finance the other $75m through its prime broker and embed the cost in the swap price. On the tax side, in countries that do not allow foreigners to reclaim dividend withholding tax, or that levy a financial transaction tax like UK stamp duty, synthetic exposure may enable nonresident investors to sidestep the taxes.

“It is all about providing the best price, service and capabilities,”says Nybo.“The broker that can facilitate the trade and offer price improvement through its ability to match flow or structure products will win more business.”

The broker that creates a synthetic product charges a fee plus its funding cost, while the investor receives a payment stream equal to the return on whatever benchmark it wants to track.

The investor eliminates tracking error associated with physical replication (bid-offer spreads, commissions and market impact) although in exchange it has to accept counterparty credit risk.

The Delta One desk works hand in glove with the prime broker division to tap the cheapest financing source for its inventory. For example, a broker dealer that relies on wholesale funding may find it advantageous to set up an equity swap with a commercial bank

FTSE GLOBAL MARKETS • SEPTEMBER 2012

Anthony Hayden, head of Delta One desk at Nomura Securities in New York.

Photograph kindly supplied by Nomura Securities, August 2012.

that has cheap retail deposits. Both sides benefit: the cash-rich bank adds to its interest bearing assets, while the broker secures a lower funding cost.

In an effort to capitalise on a fastgrowing business, ICAP, the inter-dealer broker, set up an electronic trading platform in March dedicated to Delta One trading. Alex Lynch, head of the new desk, says the firm will act either as a riskless principal—a dealer may ask ICAP to buy an equity basket it needs to hedge a client’s synthetic position, for example—or as agent in bringing two counterparties together to trade.

“We are matching buyers and sellers in the Delta One space,” he says. “It’s either the facilitation of customer business or managing the internal balance sheet, the stock and funding requirements of the prime broker business within a broker dealer or bank.”

The Delta One hedges do not expose the desk to significant market risk, at least under normal conditions. In times of stress, a futures or options hedge could introduce temporary tracking error but any distortion would dissipate by contract expiration date, if not before.

If the hedge has a short duration— less than one year—the risk of a persistent price anomaly is low and the firm could likely carry the position through maturity. Delta One desks may also hold longer dated positions—out to ten years or more—for which bad marks can endure for months or even years, raising the possibility that the firm may not be able to sustain its position until the prices converge.

The possibility of permanent tracking error does arise with index replication techniques that do not track every single component. For an index with a large number of components—the Russell 2000, for example—trackers typically use “optimised sampling” of only the largest, most liquid components, a strategy that tolerates greater tracking error in exchange for lower trading costs. A Delta One desk using this technique may find delta does not equal one on these hedges during major market dislocations.

Delta One traders typically don’t have authority to take unhedged risk, however. If a bank wants to trade risk around the edges of its Delta One book, it will give that mandate to a separate unit with specific trading limits.“A volatility trader may trade against a synthetic option, which is a Delta One product,” says Lynch. “He may trade around the hedge, but he will have full authority to do that.”

While Delta One desks should not expose the banks to major market risk, the focus on derivatives does introduce counterparty credit risk. The move toward central clearing of derivatives may mitigate the risk if equity swaps qualify for clearing, which is by no means certain. While clearinghouses may be willing to handle simple index and single stock swaps, more exotic customised baskets may not qualify.

Hayden at Nomura says banks and brokers have tightened up risk management procedures in the wake of the financial crisis and the trading losses at Société Générale and UBS anyway. The trading desks, credit group, middle office and technology department work together more and the quality of personnel in support functions has improved. People recognise that they may not have the whole picture, too.

“One particular trading desk can’t see the entire firm’s counterparty credit obligations across currencies, commodities, fixed income and equities.

The front office has to work closely with the credit department to manage these exposures,” says Hayden. I

41

DEBT REPORT

SUKUK ON THE RISE: A NEW BEGINNING?

Photograph © Lavitreiu / Dreamstime.com, supplied August 2012.

Institutions and corporations look anew at sukuk Islamic finance is experiencing unprecedented growth, driven by the booming demand for financial services in Asia and the Middle East and the need to fund it. As mounting capital constraints have forced Western banks to cut back on their overseas exposures, governments in the Middle East and Asia are looking more to local investors to meet the financing needs of their economies. Issuance of sukuks—the bonds structured to pay investors a “rent” rather than interest to comply with the requirements of Shari’a law—is consequently certain to rise yearon-year for most of the next decade. Andrew Cavenagh reports.

RECENT REPORT FROM Ernst &Young suggests that the overall Islamic debt market—of which sukuks account around 10% to 12%— could be worth $1.1trn by the end of this year, compared with $826bn in 2010.

A 42

Looking further ahead, the Islamic Financial Services Board (IFSB) based in Kuala Lumpur in Malaysia (the country that has dominated sukuk issuance historically) forecasts that the market will grow to $2.8 trn by 2015.

Jaseem Ahmed, the IFSB’s Secretary General, said recently these projections reflected a fundamental shift in fund sourcing: “There is decreasing reliance on the transatlantic economies for direct and indirect financing of Asia’s non-financial private sector and greater reliance on financing from within the region.” There are other changes in place too. Whereas companies were mostly responsible for the relatively small number of sukuks issued between 1996 and the financial crisis in 2008, from that point onwards it has been governments and governmentrelated entities (GREs) that have dominated the market.

For now, Malaysia, Indonesia, and the countries of the Gulf Co-operation Council (GCC) remain the driving force in the sector (Malaysia alone issued 70% of the $85bn of sukuks that came to the market in 2011), but several other countries with significant Muslim populations (including Turkey, Iran, Pakistan, Nigeria and South Africa) are now also looking to issue Shari’a compliant of debt.

The volume of activity so far this year certainly supports the growth projections. According to the IFSB, at least $68bn worth of the instruments was issued in the first half of 2012 and the organisation predicts that the total for the year will exceed $100bn. That would comfortably surpass the record $85bn seen in 2011 (which represents a 64.5% increase on the previous year).

While the focus of the market is still mainly domestic, with most issuers selling to their home investor base— international issues are also on the increase. The $4bn jumbo offering from the Government of Qatar in July pushed international issuance for the year to over $12.5bn, well above the $10.6bn total for the whole of 2011 (again an annual record up to that point).

The Qatari deal also sent an important message to the markets. Not only was it the largest international sukuk issue to date, but it was the first that Qatar—a highly rated country that has ready access to virtually any form of

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Sukuk issuance by country and by total value (1996-2011) ($bn) Bahrain

Indonesia

Malaysia

Saudi Arabia

UAE

Others

1996

0

0

0.7711

0

0

0

1997

0

0

1.09

0

0

0

1998

0

0

0

0

0

0

1999

0

0

0.2271

0

0

0

2000

0

0

1.0371

0

0

0

2001

0.275

0

2.451

0

0

0

2002

0.5

0.0193

3.4591

0

0

0

2003

0.855

0.0622

3.5543

0.4

0

0.7

2004

0.7292

0.0918

3.2203

0.0261

1.165

0.129

2005

1.3171

0.0716

7.8734

0.5

0.95

1.0483

2006

0.828

0.022

10.7467

0.8179

8.755

2.121

2007

1.0652

0.135

18.4112

5.7163

10.8075

2.0726

2008

0.7004

0.6955

9.8626

1.8734

5.3002

1.1408

2009

1.5644

1.7653

22.1242

3.1099

3.3306

1.5395

2010

0.6996

3.0811

39.8134

3.0033

1.0754

3.6123

2011

2.551

3.7328

58.0621

2.7633

4.0845

13.2623

Source: Zawya Sukuk Monitor Database and Standard & Poor’s., supplied August 2012.

debt it chooses—had issued since 2003. It was a clear sign that one of the region’s richest countries is committed to supporting the growth of the Islamic bond market.

Furthermore, the Qatari issue revealed the extent to which demand for sukuks has now spread beyond the traditional domestic investor base in Asia and the Middle East. European investors bought 38% of the issue, as orders for the five-year and 10-year bonds on offer surpassed $25bn; reportedly the highest level of oversubscription yet seen for a sukuk.

The growing demand from European investors owes much to the fact that the big sukuk issuers are relatively insulated from the problems in the eurozone. As the performance of most European government bonds has become highly vulnerable to overnight shifts in market sentiment (with each fresh scare on the future of the eurozone), sukuks are now offering a more stable exposure to sovereign risk in many cases.

“Sukuks have proved to be one asset that hasn’t suffered a lot from the crisis,”

FTSE GLOBAL MARKETS • SEPTEMBER 2012

explains Souhail Mahjour, a syndication banker at HSBC. “London-based investors (particularly hedge funds but also some real-money accounts) are starting to look at them more often, with an increasing level of participation. They are realising that sukuks have performed strongly in the recent past and that their liquidity is improving.”

In the longer term, there could also be more interest from the US, where only a handful of 144a-compliant sukuks have been issued so far. Sukuk issuers have had no great need to tap the US market up to now. That’s because domestic demand has remained strong. Moreover, the instruments remain tightly priced. Added to this is a general lack of knowledge about the sukuk market in the US. In consequence, those sophisticated US investors that do know about them have tended to avoid them.

Even so, tentative initiatives are underway to establish more of a presence on the other side of the Atlantic.

The recent $850m issue from the influential Saudi-based Islamic Development

Bank, for instance, was structured to meet the 144a listing requirements.

In the medium term at least, it will continue to be the core sukuk-issuing countries that drive most of the growth in the market. Malaysia will remain the dominant issuer in the near term, as its government continues to tap the country’s well-established Islamic capital market to finance huge infrastructure investments.

About 80% of the $58bn worth of sukuks that Malaysian entities issued last year came from either the government or GREs for this purpose and Projeck Leburhaya Ushasham issued the largest global sukuk to date: a MYR30.6bn (about S$10bn) offering in January to finance the takeover of a toll-road company.

The GCC countries may well match Malaysia’s level of issuance in the medium-to-longer term, however, as it is unlikely that oil revenues alone will be able to finance the huge planned infrastructure investments in the region, particularly in Saudi Arabia.

While the Saudis have yet to launch a sovereign sukuk, the General Authority for Civil Aviation issued a SAR15bn ($4bn), 10-year Islamic bond in January that may well pave the way for further quasi-sovereign, and possibly sovereign, issuance in the near future.

Meanwhile, issues out of new jurisdictions will gradually augment the increased levels from the established issuers. Many sector analysts think that the overall market will tend to grow at an annual rate of around 20% over the next five years at least. New issuers are coming into play all the time, adding depth to the issuance calendar.

Development Bank of Kazakhstan, for instance, issued the country’s first ringgit-denominated bond in August —an MYR 240m ($76.7m) five-year murabaha Islamic note—swapping the proceeds into US dollars under a fiveyear agreement with Royal Bank of Scotland (RBS). Elsewhere, Oman and Hong Kong are in the process of drafting legislation to enable them to issue sukuks, while South Africa has report-

43

DEBT REPORT

SUKUK ON THE RISE: A NEW BEGINNING?

edly mandated banks to arrange an inaugural sovereign issue.

The scope of the instruments is also expanding. The Satorp joint venture between Saudi Aramco and the French oil major Total, for example, launched the world’s first project sukuk in August as part of the complex financing package that it has put together for the $14bn oil refinery it is building in Saudi Arabia’s north-eastern city of Jubail.

The SAR3.75bn ($1bn) offering had a 14-year tenor, almost three times the five-year norm for sukuks, but nevertheless managed to price at the tight end of the offered guidance: between 95 basis points (bps) and 100 bps over the six-month Saibor benchmark.

The pricing no doubt owed much to that fact that Saudi Aramco is providing a guarantee for the debt for the duration of the refinery’s construction phase and that lead managers Bank Saudi Fransi, Deutsche and Samba Capital marketed the bonds exclusively to domestic investors (who would need little convincing about the strength of Saudi Aramco’s credit).

However, while it is obviously open to question how easily a less-strong project sponsor would be able to replicate the transaction, the issue still represented a notable extension of sukuk financing.

Satorp could almost certainly have raised the $1bn of debt more rapidly through a conventional 144a offering in the US, and its decision to go down the sukuk route was further evidence of the regional desire to develop the capability of local capital markets.

Despite the impressive medium and long-term growth outlook for the sukuk market, however, it still has a long way to go before becoming a mainstream asset class in the global capital markets (although it should account for more than the 1% of the overall bond market that it does at present). One of the main obstacles to the Islamic instruments achieving such standing is the wide range of different structures that the various issuers adopt—many of which offer inconsistent interpretations of what does or does not comply with Shari’a

44

“For sukuk to transform into a truly global offering, there would have to be globally accepted standards,” says Paul-Henri Pruvost, an associate at Standard & Poor’s. Photograph kindly supplied by Pruvost, August 2012.

law. Ratings agency Standard & Poor’s (S&P) recently highlighted this lack of standardisation as a deterrent for many global investors that was likely to limit the extent to which sukuks could appeal to investors beyond their home markets.

“That has been one of the original weaknesses of the sector from its infancy,” explains Paul-Henri Pruvost, an associate at S&P. “For it to transform into a truly global offering, there would have to be globally accepted standards.”

Pruvost adds, however, that there had been some improvement on this score over the last five years and there was now a handful of structures that had achieve wide acceptance.“There is a growing consensus for sure.”

Another problem for investors is uncertainty over the procedures for resolving defaults and restructuring the debt. Given that sukuks have to be asset-based (as opposed to assetbacked) to be Shari’a compliant, there is still some doubt over the likely direction of legal rulings on ownership in instances of default, despite the basis of the instruments in international (English) law. Will courts really favour the claims of foreign investors over indigenous companies?

To some extent, developments in Dubai and elsewhere in the Middle East are allaying these concerns, as it is clear that issuers are keen to protect the market’s reputation. Worries earlier this year that DIFC Investments, a subsidiary of the company that runs Dubai’s financial free zone,

would default on $1.25bn of debt that was due to mature in June were laid to rest when the company took out a $1.04bn five-year loan to enable it to repay the bond. Abdullah Mohammed Saleh, chairman of DIFC Investments (and governor of the Dubai International Financial Centre) noted that the move “reaffirms our commitment to meet our obligations”.

In the United Arab Emirates, meanwhile, Dana Gas is expected to restructure its $920m sukuk in the coming weeks as investors have become increasingly concerned over the company’s ability to meet its payment commitments. The company has hired Blackstone, Latham Watkins and Deutsche Bank to advise on it options for repaying the sukuk and stressed that it was “committed to finding a consensual solution that is equitable to all stakeholders”.

Nevertheless, non-traditional sukuk investors will almost certainly want to see a longer history of successful resolutions before they feel completely confident in the process. “You need a longer track record than that to encourage investors to make that leap of faith,” agrees Provust at S&P. Possibly the biggest impediment to the adoption of sukuks as mainstream capital-market assets, however, will be restrictions that Shari’a law imposes on the use of their proceeds. Apart from investments in banned industries, such as arms, alcohol, and pornography, it is also forbidden to use the proceeds for any form of conventional financing activity that involves payment of interest. And while it would be next to impossible to ascertain the specific use to which a bank, for instance, was using the money it raised from a sukuk, any doubt on this score could well lead traditional investors to spurn the issue.

“The main concern that Islamic investors have is over the use of the proceeds,”confirms Mahjour at HSBC. “And if you don’t target them, it is difficult to benefit from what the sukuk has to offer in terms of liquidity and price tension.” I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Streaming index values.

Real time index values & custom alerts.

Download today from the app store.

Real time values for over 60 indices at your fingertips.

% Change.

See the latest gainers and losers at a glance.

Alerts.

Customizable alerts instantly notify you of major market movements.

Favorites.

Customize the indices you follow at the touch of a button.

Graphing.

View index performance over a selection of time periods, from 1 day to 2 years.

Ticker scroll.

Snapshot of the latest pricing on over 60 global markets.

Apple, the Apple logo and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc,.

DEBT REPORT

STRUCTURED FINANCE: A HALT IN PRIME ISSUANCE

Structured finance held hostage by cheap money and hostile regulation The market for European structured finance has taken a step backwards in 2012. The double whammy of huge volumes of cheap central-bank funding and the impending threat of hostile EU regulation—against the background of weakening economies—have brought the gradual, if selective, recovery in primary issuance over the previous three years to a halt.

Andrew Cavenagh reports.

HE LEVEL OF genuine securitisations (those sold to third parties rather than hastily structured deals that banks retain for use as collateral in the repo markets or for longer-term central bank funding) over the first seven months of this year fell 10% to €44bn against the comparable period of 2011. This is the first decline in issuance for three years. It is a blow to a market segment that had looked promising. From a low base of just €25bn in 2009, the primary market had increased dramatically to €97bn in 2010 before growing again to €120bn last year.

The reversal in fortune over the first half of 2012 has led banks and others to slash their forecasts for the year. Some structured-finance bankers have cut their estimates for total (placed) issuance by as much as 40%, while Fitch Ratings expects that the publicly/privately placed market in 2012 will now be worth somewhere between €75m and €100m rather than in the €100m-€150m range that it forecast in January.

The present, seemingly unlimited availability of cheap funding from the European Central Bank (ECB) seems certain to cast a shadow over securitisation for many more months yet. The €1trn of three-year money (with an interest rate of 1%) that the ECB injected into the eurozone banking system through its two Long-Term Refinancing Operations (LTROs) in December and February will give banks little incentive to attempt securitising assets until 2014 (when they will need to think about refi-

T

46

nancing the LTRO funds). The cost of funding themselves in the market in the meantime would be considerably higher than using the ECB-offered liquidity.

It is also quite possible that the ECB will conduct further LTROs, particularly if political developments in the eurozone—such as a sovereign default

by Greece and/or the country’s exit from the single currency—threaten to destablise the European banking system once more.

Meanwhile, the Funding for Lending Scheme (FLS) that the Bank of England introduced at the beginning of August promises to have much the same impact on the sterling securitisation market in the UK. For under the scheme, banks will be able to finance lending to individuals and companies at between 25 and 150 basis points (bps) over the repo rate on Treasury Bills (currently 0.5%). Even after the obligatory hair-cuts, the lower end of this pricing scale will deliver funding at far cheaper cost than British banks could currently access in the asset-backed market.

If cheap central-bank funding has removed the incentive for banks to issue asset-backed bonds in the shortto-medium term, the present EU proposals for tighter regulation of the banking and insurance sectors (which between them have historically constituted two thirds of the investor base for European structured finance) will certainly discourage both from investing in asset-backed securities in future.

The fourth revision of the Capital

Requirements Directive (CRD 1V) and the Solvency II Directive, which will start to take effect from next year and 2014 respectively, both penalise structured finance heavily in terms of the capital charges they apply to such assets. Insolvency II, for example, will impose a capital charge of close to 100% for all mezzanine (under triple-A rated) asset-backed debt that insurance companies hold and also increases the charge with the length of the securities’ tenor. This will mean that in most cases it will be more capital-intensive for insurers to hold triple-A asset-backed bonds than corporate debt that is rated up to three notches lower.

The Association for Financial Markets in Europe (AFME) and other industry bodies continue to argue that there is no logic to this discrimination against securitisation and that the Brussels’proposals represent a knee-jerk reaction against an asset class that some leading politicians consider—wrongly in their view—to have been the root cause of the financial crisis in 2008.

The critics point out that Solvency II’s risk weightings for ABS simply do not reflect the true credit risk, and the latest transition report on European structured finance from Standard & Poor’s certainly supports their case.

According to Standard & Poors (S&P), only 1.1% of all European structured-finance bonds have actually defaulted since mid-2007, in sharp contrast to the US market where default rates reached a high of 9.5%.

In the case of the consumer-related deals (the bonds backed by granular assets such as residential mortgages, auto loans, and credit-card receivables that account for the bulk of the market) the default rate has been just 0.3%, against 3.59% for transactions backed by corporate debt.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

FPL Americas Trading Conference 2012

© mtsrs

Cr Created eated b byy TThe he American American TTrading rading Community, Community, for for The The American American TTrading rading Community Community

TTuesday uesday 23rd 23rd October October | Metropolitan Metropolitan Pavilion Pavilion | New New York Yor Y ork City City Sponsorship Sponsorship Opportunities Opportunities Now Now Available Available The 2 2012 012 FFPL PL Am Americas ericas Trading Trading Conference Conference will will bring bring together together more more than than 500 500 senior senior market market representatives representatives from from across across the the ƌƌĞŐŝŽŶ͛Ɛ ďƵLJ ĂŶĚ ƐĞůů-sides, ĞŐŝŽŶ͛Ɛ ďƵLJ ĂŶĚ ƐĞůů-sides, trading trading venues venues and ve vendor ndor ccommunities ommunities to to debate debate the the changing changing climate climate of of the the global global electronic electronic ttrading rading eenvironment. nvironment. Join Join FPL FPL in Ne New w York York and and bene benefit fit from from an event event that that will will offer: offer: Separate ate b business usiness and and ttechnical echnical sstreams treams spanning spanning a w wealth ealth o off contemporary contemporary interests interests An agenda created exclusively by by senior senior representatives representatives from from the the American American trading trading enda cre ated exclusively community comm unity impartially about about the the critical critical isisdiscussion by highly regarded regarded panelists panelists speaking speaking impartially Lively discussion by highly beyond challenges trading globally globally in 2012 and and beyond ssues, ues, ch allenges and and opportunities opportunities impacting impacting firms firms trading and the the The opportunity network decision during extended extended breaks breaks and on etwork with kkey ey d ecision makers makers during pportunity tto reception eevening vening cocktail cocktail reception

Topics Topics ffor or di discussion scussion will in include: clude: bal regulation regulation urning point point in mark et evolution evolution in the the face of of glo The turning market global he buy-side buy -side community community ng the the automated automated trading trading needs needs of of tthe Meeting Transaction cost analysis execution quality measurement changes alysis and and exe cution q uality me action co st an asurement in the the face of of regulatory regulatory changes Fs bal ffinancial inancial cris is and and the the changing changing landscape The fallout off tthe global crisis SEFs nd SE allout o he glo landscape of of SDRs SDRs aand The benefits, trading and controversies controversies caused caused by by high high frequency frequency and and low low latency latency trading enefits, challenges challenges and The business challenges off trading across multiple multiple asset asset classes classes usiness aand nd ttechnical echnical ch allenges o trading across

FREE FREE Passes Passes Available Available ffor or FP FPL LM Member ember Fi Firms, rms, B Buy±Side uy±Side A Attendees ttendees and R Regulators! egulators!

Fo Forr more iinformation nformation a and nd to register ttoday, oday, vi visit: isit: www.fixprotocol.org/americas2012 w ww.fixprotocol.org//amer am icas2012

DEBT REPORT

STRUCTURED FINANCE: A HALT IN PRIME ISSUANCE

The market has also been remarkably resilient to the deterioration in the economic environment across most of Europe since the end of 2011, which saw unemployment for the region overall reach a 15-year record level of 10.4% in June. S&P reported that the rolling 12-month average default for European securitisations had edged up only marginally to 0.5% over the period, although agency analyst Arnaud Checconi did caution that the increasing likelihood of a double-dip recession in Europe “could further weaken collateral and ultimately transaction performance”.

It is certainly ironic that European regulators are proposing to treat securitisation so much more severely in future than their counterparts in the US, where some of the excesses in the sub-prime mortgage market might have understandably given rise to such a draconian approach. In contrast to the situation in Europe, securitisation in the US has now come back as a normally functioning market for most asset classes, with over $130bn of fresh issuance in the first seven months of 2012. The exception remains the market for residential mortgagebacked securities (RMBS), where there has been virtually no private issuance since 2007 as government-backed entities have continued to dominate housing finance since then.

The AFME and its supporters still hope to persuade the EU authorities to amend the legislation before it comes into force. They point out that it is in everyone’s interest to have a functioning securitisation market as an alternative source of funding and that banks’ increasing reliance on the ECB for finance is not without systemic risks of its own—it was dependence on a single source of funding (the wholesale market) that proved Northern Rock’s undoing in late 2007.

“To get a functioning new issue securitisation market up and running in Europe, that source of funding will have to become significantly less attractive than it is now,” says Greg

48

“To get a functioning new issue securitisation market up and running in Europe, that source of funding will have to become significantly less attractive than it is now,” says Greg Branch, partner at specialist ABS fund manager SCIO Capital. Photograph kindly supplied by SCIO Capital, August 2012.

Branch, partner at specialist ABS fund manager SCIO Capital.

To encourage the authorities in Brussels to reconsider the Directives before they come into force, the AFME launched a Prime Collateralised Securities (PCS) initiative in June that is designed to identify securitisations that are high quality in terms of their simplicity, standardisation and above all transparency—and could be exempt from the more stringent provisions of the regulations. Whether it cuts any ice with the politicians and bureaucrats remains to be seen, but time is running out.

In the secondary market, meanwhile, European asset-backed securities have continued to trade at heavy discounts to par values (over 50% in the case of triple-B bonds) and up to 500 basis points wide of comparable US instruments (although in recent weeks spreads have come in). While maturing issues over the past five years have drastically reduced the overhang of ABS on bank balance sheets (S&P estimates that 58% of the European asset-backed bonds outstanding in mid-2007 have

now been fully redeemed) pressure on banks to sell residual holdings to meet the European Banking Authority’s 9% target for Tier 1 capital by June maintained a big imbalance between supply and demand until recently.

The market was also not immune from the general risk sell-off this year as the macro economic situation in the eurozone has deteriorated, heightening fears over the future of the single currency. While spreads on mezzanine debt predictably widened earlier this summer, however, those on the senior tranches of prime RMBS remained broadly constant, and Branch at SCIO Capital said there were now good reasons to believe that pricing should firm up on a more permanent basis over the next 12 months.

Branch explains that not only had the selling pressure on the banks eased with the passing of the EBA’s core capital target date of June 2012 and the improved prospect of regulatory relief, but the tender announced in June for the subordinate ABS in the securitisation vehicles of nationalised UK banks Northern Rock and Bradford & Bingley (Granite, Whinstone and Aire Valley) should establish new pricing benchmarks.

ABS investors have historically used Northern Rock’s Granite programme as a risk-pricing proxy for RMBS, and spreads on its triple-B bonds have already come in several hundred basis points from their highs. “We’ve witnessed a significant contraction in spreads over the last few months,” Branch confirms.

The pricing differential with American ABS has also begun to attract US multi-strategy funds to the European market—as it now offers them returns that they can only achieve at home with significantly increased leverage— and this is further correcting the demand-supply imbalance. The first fund that SCIO Capital set up illustrates the potential returns on heavily discounted ABS investments. From December 2009 to June this year, it had achieved a return of 60%. I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Osaka 29 Oct - 1 Nov 2012

Because a lot can happen in a w we eek Each year, Sibos, the annual business conference a nd exhibition of the SWIFT community, brings together s ome 7,000 thought-leaders, decision-makers and t echnology experts from across the globe.

For one week, key representatives of the worldâ&#x20AC;&#x2122;s l eading EDQNV oQDQFLDO LQVWLWXWLRQV DQG FRUSRUDWHV PHHW ZLWK JOREDO H[SHUWV LQ WHFKQRORJ\ DQG oQDQFLDO VHUYLFHV 7KH\ debate common challenges facing the industry, share insights and collaborate on building solutions that help reduce complexity, cost and risk.

Hosted by SWIFT, the event has become the worldâ&#x20AC;&#x2122;s premier oQDQFLDO VHUYLFHV DQG PDUNHW LQIUDVWUXFWXUH HYHQW

Sibos S ibos Os Osaka a a ak 29 2 9 Oct --11No No Nov v2 2012 02 01 Join us this year year in Os Osaka aka tto o sha share hare ttodayâ&#x20AC;&#x2122;s odayâ&#x20AC;&#x2122;s challenge challengess o build the ssolutions olutions ffor or ttomorrow. omorrow. â&#x20AC;&#x201D; and tto Register now: www.sibos.com R egister no w: www w.sibo sibos.com o

Sibos, Sibos, powered powered by by the SWIFT SWIFT community community www.swift.com www .swift.com

THE BEAR VIEW

A SLOW GRIND RISE, DESPITE POOR PERFORMANCE NUMBERS

With market makers holding historically low levels of stock, flow of any kind is managing to move the market. Of course, the problem with this is that low volumes are usually synonymous with falling markets as the natural state of investors is to be long and for whom “a bear outlook” is merely reflected by an absence of buying rather than outright selling. This slow grind higher is even more remarkable when you remember that the economic numbers from virtually everywhere are almost universally bad.

Simon Denham, managing director of spread betting firm Capital Spreads, gives the bearish view.

A small step for equities.

Too large a step for bailouts?

INCE MY LAST missive the markets have duly traded from the bottom of the current range up to the top (or near enough) as investors, desperate for any kind of return, have turned to equities. This said, the volumes on the global stock markets have fallen to unheard of levels, such that trading at both ends of the time curve from the number of IPOs to long terms members of the FTSE is grinding to a halt.

In the UK and Europe creditor nations have followed a policy of nothing very much other than allowing the Bank of England and ECB to print billions of pounds/euros in the quaintly named Quantitative Easing (QE) strategy. Even though Japan has been unsuccessfully following this stimulus project for the last twenty years or so (and the US and UK, equally unsuccessfully, for the last three/four) the strategy continues to flow unchallenged into central bank folklore.

Unfortunately, no-one really knows if it is working or not. Proponents say: if we had not done it we would be in a far worse situation. This, of course, is rather difficult to challenge as we simply do not know whether it is true or not. It leaves those who instinctively shy away from massive monetary stimulus, with the quandary of trying to prove the absence of something. Many economists believe that we are building up

S

50

a problem of tsunami proportions but, until the wave breaks, the markets seem remarkably calm.

Assuming the Mayans are wrong and the world does not come to an end in the next few months things are, oddly enough, looking reasonably favourable for the equities. The consensus view has it that almost all other asset classes are overvalued and that even in the swamp of bad economic news equities still manage to maintain a mildly positive bias. This then might be enough to give battered investors enough incentive to allocate more capital to stocks.

Additionally, the VIX index has fallen to multi year lows. While it is essentially a backward looking calculation (and has a definite forward looking fear/greed component) this is possibly a counter-intuitively optimistic signal. Oddly enough—and contrary to popular perception—a low VIX calculation has not historically meant an unmoving market. Over the past twenty years or so any consistent VIX reading below 16% to 20% has been associated with a rising market.

There is a nasty little saying that I tend to bring out at times like this which goes along the lines of : the markets generally move in the direction which causes the greatest amount of pain to the greatest number of people. In other words, the powers that be in Europe will, probably, just

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

roll over and agree to bail out Greece and (in time) Spain and Italy as well.

The political capital tied up in the euro project is just too vast to give up now and, while this may well leave the euro zone with virtually zero growth for years to come, this is better in a politician’s eyes than taking the seriously hard choices right now.

This means years of stimulus packages (of varying degrees of desperation) until either it does work and growth builds its own impetus or creditor nations finally lose patience.

In the meantime, with most major European companies operating globally, but based in slowly devaluing currencies, there is a reasonable chance that the indices will, in purely numeric terms, rise whilst remaining static on a global basket of currencies valuation.

Of course there is always a ‘but’.

Recent corporate and sovereign data releases make depressing reading.

Equally, recent economic news out of China and continuing social upheaval in the Middle-East continue to provide alarming news. The West thinks it will be bailed out by the oil producers of Arabia and the ‘trade surplus’ of the Far East. But, fearful of low returns in Europe, those investors are now casting for alternative places to invest their money. The consequences of that don’t bear thinking about.

As ever ladies and gentlemen: Place your bets!I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

TRADING VENUES

Photograph © Macrocozm / Dreamstime.com, August 2012.

DOES MARKET FRAGMENTATION WORK IN A LOW VOLUME TRADING ENVIRONMENT? Trading venues are at a tipping point. While the merger of BATS and Chi-X Europe confirmed the pan-European trading platform as the largest single venue in terms of turnover, a succession of high profile exchange takeover talks failed last year. Other mergers are still taking place: for instance, in August the Hong Kong Stock Exchange bought the London Metal Exchange for $1.4bn. The ebb and flow of mergers and acquisitions is set against a backdrop of record low equity volumes. Is it all worth it? Is there is a meaningful direction in which current competition and market fragmentation is headed? What is clear, broker-dealers must now work harder to secure liquidity and best pricing. Ruth Hughes Liley reports.

HE MARKET IN Financial Instruments Directive (MiFID) opened a door to competition to establish new trading venues. However, notes Brian Schwieger, head of EMEA execution services sales at Bank of America Merrill Lynch, in carefully understated analysis:“Within that competition, venues have realised that there are different market segments in terms of potential client base. In the US, which has gone further down the fragmentation route, there are ‘sub-venues’ or venues with multiple order books with different pricing structures to capture different participants.

It can be confusing and the cost of connecting to all these venues is not cheap.”

The interplay between pricing, technology and matching rules on individual venues determines the type of liquidity on each venue, explains Mark Goodman, Société Générale’s head of quantitative electronic services. “Venues can adjust their pricing through rebates and charges to attract more passive or aggressive flow. They can invest in fast technology and that will attract the faster players and they can adjust their matching rules offsetting price and time or price and size to determine who has priority in an order.”

In fact, what it adds up to is that market fragmentation is bigger than it first appears from the angle of a simple venue count. Venues themselves are changing and increasing the

T

52

number of order types in order to maintain depth and quality in their order books. When BATS and Chi-X Europe merged they kept two lit and two dark books under ownership and, from April 2012, one technology system. Similarly the LSE and Turquoise, the MTF it acquired in February 2010, are able to offer one connection point and common interfaces to brokers but different tariff models and different order types.

Adrian Farnham, CEO Turquoise, explains this is because the two markets serve different purposes. “We now see ourselves as a credible marketplace; but the LSE is the primary market, has opening and closing auctions and is still the reference price market.”

In April this year, Turquoise began offering a size/time matching logic which enables larger orders to be matched first. It has continuous matching in its dark pool order book, but also has timed auctions at random frequency to attract a more traditional flow in the same dark pool order book.

The two matching mechanisms may attract different players to the two different order books as Farnham explains: “The sophisticated customer, depending on their execution requirements for each, will trade each matching mechanism as a discrete book and decide which to go to.”

Elsewhere, UBS MTF now offers peg-to-bid and offer price points in addition to the original mid-point match. Deutsche

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Börse meanwhile has introduced the ‘trailing stop order’, a retail-oriented order type where the limit moves in line with the share price, keeping a predefined percentage below or above the current market price.“Extending your product order types brings more flow to the book and more participants coming to the platform,” says Michael Krogmann, executive vice-president, institutional equity, Deutsche Börse.“It is very important to have a healthy mixture of flow including retail, institutional and market makers, to facilitate price discovery and for the quality of the order book.”

Encouraging retail flow A sign of the times perhaps, but it now seems that exchanges are attempting to improve liquidity by encouraging retail flow. In the US, NYSE Euronext has introduced a Retail Liquidity Program to draw retail flow by offering improved prices, NASDAQ OMX has announced plans to do the same and, not to be outdone, on August 14th BATS Global Markets also announced a similar scheme. Onlookers believe all exchanges will have to move to this strategy.

While the move is expected to fragment prices even further, it might eventually cut venue fragmentation.

In fact, important questions are now being raised about the viability of the number of venues over the long term. In the US an estimated 93% of exchange volume is controlled by only four entities: NYSE, NASDAQ, DirectEdge and BATS; the natural reservation being: is there enough volume to support the rest?

Goodman doubts it: “There is just not the volume; although we may see further fragmentation at the order book level.” However, he does not think success in attracting new liquidity through the introduction of different order types is guaranteed:“While these initiatives are more attractive than simply introducing a new venue, a large number of brokers don’t have the flexibility in their smart order routers (SOR) to interact intelligently with these new order types. The broader market is using a fairly uniform approach to accessing venues,” he explains.

In fact, distinguishing between around 50 European venues including lit, dark and broker crossing networks has become full-time work for traders, who are constantly honing their skills to judge the efficacy of individual venues. Turquoise’s Farnham, for instance, speaks of the ‘credibility’ of a venue: “This is a venue where the execution likelihood is sufficiently high to include it in your liquidity search. There is a genuine cost of connecting to venues and brokers have to ask: is it a sensible opportunity cost to search that venue for liquidity?”

Schwieger explains that Bank of America Merrill Lynch bases its SOR logic on probability of fill. “Most brokers are more or less connected to the same venues. We build heat maps of the dark pools as well as looking at what is happening in the lit venues. It’s important to identify where the best liquidity is at the best possible price and consider the amount of time you are sitting on an order book before you become ‘top of book’. Venue A might have a shorter queue than venue B, but venue B may have a faster turnover, so you might get a fill more quickly there.”

FTSE GLOBAL MARKETS • SEPTEMBER 2012

Adrian Farnham, CEO Turquoise. “We now see ourselves as a credible marketplace; but the LSE is the primary market, has opening and closing auctions and is still the reference price market,”he says.

Photograph kindly supplied by Turquoise, August 2012.

Moreover, he says, his clients are asking for greater granularity in post-trade reports. “We’ve seen more interest in tagging of fills so that information about where we are trading and where their fills are executed can be followed.”

The buy side isn’t entirely dependent on the sell side for market intelligence. AXA Investment Managers (AXA-IM), for instance, conducts its own analysis into venues and also does transaction cost analysis and then cross-references the two, explains Paul Squires, head of trading at AXA-IM:“Our overriding approach is to gauge, using the statistics, whether we feel certain venues have signalled information that may be detrimental to our performance. This supplements the trader’s own intuition and is used in conjunction with TCA to compare different algos from different providers.”

Key trends One of the main complaints about knowing where to trade is deciphering the huge amount of data. In its latest Navigating Liquidity report, CA Cheuvreux sets out how, as processor capacity improved, messages ballooned from 0.64m instructions per second (MIPS) in the 1970s to 147,600m in 2010. In 2011 the figure rose to 177,700 MIPS, despite overall declining volumes. Under the impending directive MiFID II, a proposal for a consolidated tape of European prices could help the process.

Société Generale’s Goodman says: “If this is introduced then the negative impacts of fragmentation would be reduced as the buy-side would have an easily accessible, transparent view of the market with trades being reported according to a standard set of rules.”

53

TRADING VENUES

Krogmann at Deutsche Börse points out that a consolidated tape is only as good as the data it contains. “Fragmentation isn’t the issue per se. You just need to have the right information and transparency and a level playing field among venues.

It is important to consolidate high quality market data from all the venues and that needs to be trusted and credible.

There’s still a lot of trading going on outside of regulated transparent venues, which does not deliver an adequate quality.

Until this is sorted out, no-one has the full picture.”

There are important medium term trends in play however which will ultimately decide the structure of the visible traded equity market: two have been impacting the market for some years. One, some 47.8% of equity trading was conducted offexchange in Europe in July at €483bn, according to Thomson Reuters, down from a spike in May of €1,080bn. If that continues, tough questions have to be asked about the current exchange business model. Equally, overall equity trading volumes continue to shrink; and it is a dramatic trend. The total order book is down by €524bn in the past 12 months from a high in August 2011 of €1,227bn to €702bn in July 2012, €30bn down from June. Furthermore in a 2012 buy side survey

by Create Research, one respondent claimed equities as an

Mark Goodman, head of quantitative electronic services, Société Générale. “Venues can adjust their pricing through rebates and charges to attract more passive or aggressive flow,” he says. Photograph kindly supplied by Société Générale, August 2012.

WILL MiFID II ADD OR SUBTRACT TO EUROPEAN MARKET FRAGMENTATION? ROPOSALS UNDER THE EU’s revised Markets in Financial Instruments Directive (MiFID II), and the Markets in Financial Instruments Regulation (MiFIR), could see as many as 30 more multi-lateral trading platforms (MTFs) come into existence, believe some, adding to the complication of fragmentation among trading venues.

Europe has 17 dark pools, several internal broker crossing networks (BCNs), some of which are registered Systematic Internalisers, as well as the primary exchanges, largely owned by NASDAQ OMX, NYSE Euronext, Deutsche Börse and London Stock Exchange Group.

One of the aims of MiFID II is to separate agency, prop and principal flow into different venues, explains Mark Goodman, head of quantitative electronic services, Société Generale: “It may mean that to do the same business as we do today we will have to operate two or three instead of one

P

54

dark pool. This means MiFID II could contribute to more fragmentation.”

The industry is already gearing up for new regulation. In April, CA Cheuvreux launched Blink, its own dark MTF, which it claims is free of proprietary and high frequency flow. “Blink is designed with a dual order-book structure: a mid-point cross and a primary best bid and offer cross aimed at giving clients optimised crossing opportunities with the firm’s retail and institutional flows,” says Ian Peacock, global head of execution services at CA Cheuvreux.

Proposed changes to the criteria for defining a dark book are adding to the complexity. Currently a venue can be ‘dark’ or non-displayed, if the reference price used for matching executions in the pool is taken from a third party venue, usually the primary exchange, or if the trade is ‘large-in-scale’ (LIS)— based on five thresholds and roughly up to 10% of average daily turnover.

Proposals could see the disappearance of the reference price waiver and lower

thresholds for the LIS. Additionally under MiFID II, a new type of transparent trading platform, an Organised Trading Facility (OTF) was originally going to be applied to equities, but may now only apply to over-the-counter derivatives. If this is the case, broker crossing networks (BCNs) will have to become Systematic Internalisers or MTFs. Jerry Avenell, co-head of sales, BATS Chi-X Europe, says: “Do we want another 20 or 30 MTFs? There is a danger you could end up with a huge number and if the reference price waiver goes it would leave no options because it would mandate almost all business to a regulated market; but the reality is that that is not the way markets operate.”

Robert Barnes, chief executive officer of UBS MTF, a dark MTF, says the reference price waiver has crucial benefits: “When the regulators implemented MiFID, they empowered investors with choice and a harmonised

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Brian Schwieger, head of EMEA execution services sales at Bank of America Merrill Lynch (BofAML). “We build heat maps of the dark pools as well as looking at what is happening in the lit venues,” he says.

Photograph kindly supplied by BofAML, August 2012.

transparency framework. Today's reference price waiver exists in a framework where post-trade transparency is pre-trade transparency for the next trade. Investors are empowered with choice to set minimum acceptable quantities to control the size (large and small) with which they interact on their choice of venues. Together these contribute to more informed decision-making.”

It is understood that the proposals could remove a large percentage of flow from BCNs as Paul Squires, head of trading, AXA Investment Managers, explains: “Brokers are worried. A lot of our trades are partially executed in broker crossing networks (BCNs) before they move on to another venue.

If the reference price waiver for BCNs is removed then a lot of flow will drop out of the BCN. There may also be a reduction in the LIS threshold but that is likely to remain too high for most flow currently in a BCN.” Avenell adds: “If a trader wants to sell 10m shares, he might do five million on an exchange, four million on BATS and a million on another MTF. However, with execution sizes coming down as they have been, the threshold

FTSE GLOBAL MARKETS • SEPTEMBER 2012

asset class had fallen as a proportion of his clients’ portfolio allocation from 60% to 18%.

“Globally volumes are down around 20% and at these kinds of volumes a lot of businesses in the trading venue arena aren’t profitable any more. I wouldn’t be surprised to see some of the trading venues cease to exist,”predicts Krogmann.

For exchanges with a diversified multi-asset offering, the current business trends play to their strengths. In recognition perhaps of the medium term impact of lower equity trading volumes, last year, Deutsche Börse bought its jointly-owned derivatives platform, Eurex, outright from SIX, the Swiss exchange. In its last set of figures for Q2 2012, Eurex was shown to contribute almost half of Deutsche Börse group net revenues, its only segment to grow over the quarter. No wonder then that it is the focus of new investment; Eurex is to introduce a new trading system in Q4 2012. Meanwhile, its Xetra trading system is already being used by several other stock exchanges including the Irish Stock Exchange, the Vienna Stock Exchange and since July, the Malta Stock Exchange.

Nonetheless, Krogmann sees exchanges finding value in a continued focus on their traditional role as listing venues.

“As an exchange, our business model is different from MTFs

Robert Barnes, chief executive officer of UBS MTF. Photograph kindly supplied by UBS, August 2012. might not be reached and brokers won’t be able to do the business.”

Liquidnet’s head of EMEA corporate strategy, Per Loven, points out that one proposal would see the untraded part of an order, a ‘stub’ order, re-measured

after every execution. If the stub falls below the large-in-trade threshold, it would then be subject to pre-trade transparency requirements. “This makes little sense to us. It contradicts the reason for the large in size pretrade transparency waiver, which is to safeguard institutional investors' ability to efficiently implement substantial investment decisions,” he says.

With around 2,000 amendments to the original MiFID II proposal published in October 2011, discussion over the fine detail of the directive is now taking place at the European Parliament and the European Council.

While everyone chats about the final version, the result is that a final agreement between the legislative bodies on the Level I proposals has been delayed and is now expected by the end of 2012. That means that implementation of the directive is not expected until at least 2015. The first iteration of MiFID did not stop the market introducing its proposals well before the directive was finalised. It might be that much of the final form of MiFID II and MiFIR will be executed in the wider market well beyond that expected 2015 deadline.

55

TRADING VENUES

because we are servicing the real economy, providing companies with capital,”he says. However, he concedes this element remains slim pickings in a period of extended economic downturn. Nonetheless, he maintains the role of a formal exchange as integral to the efforts of corporations (large and small) to raise new capital.

Other exchanges seem to have the same view. In July, an independent committee set up by NYSE Euronext proposed the creation of an Entrepreneurial Exchange to support smaller businesses to raise capital through, for example, the issue of bonds and equity. If agreed, in September after a consultation period, Euronext’s segment B (mid caps) and segment C (small caps) would transfer and the small companies listed on NYSE Alternext would automatically join the new exchange – in all, around 859 names with a market cap of less than €1bn. Pan-European, it would operate on all four NYSE Euronext markets of Paris, Amsterdam, Brussels and Lisbon.

Dark pool orders on the rise Even as equities trading volumes have shrunk, the dark pool order book has grown by €2.4bn to €28.7bn, up €10bn in two years, according to Thomson Reuters. Robert Barnes, chief executive officer of UBS MTF, says that bearing in mind dark trading is less than 5% of European trading, lit and dark trading complement one another. “The lit book gives you the certainty of the price you can see, but can suffer market impact from pre-trade signalling. In a dark pool, you don’t have this certainty pre-trade, but you have the benefit of confidentiality. The role of the dark book complements the lit book as it may encourage liquidity which otherwise might not be on the lit book and together they allow clients to meet liquidity in a controlled way.”

With the primary exchanges providing price formation for the MTFs, the two are dependent on one another.

LiquidMetrix, a financial intelligence service, has analysed the effect on different venues when the computer system on one breaks down. The results bear consideration.

Mark Ford, principle consultant, elucidates: “During the London ‘outage’, although reasonable spreads and liquidity were provided by market markers, few buy side institutional participants chose to trade and most retail brokers suspended trading for their clients while the LSE was down.

But outside London, for example on Paris, Brussels, Milan and Swiss exchanges, when the primary venue was down, liquidity was very thin, spreads were wide and virtually no trading occurred. Interestingly, when Chi-X was down, though it represents up to a third of the various national markets, the impact on trading was minimal. Trading simply routed to other unaffected venues.”

One development which has benefited liquidity took place in July 2011, when regulators reviewed central counterparty (CCP) clearing and gave the go-ahead for interoperability, in which trades can be conducted cross-border and settled through a client’s preferred clearing house, removing the need to fund cross-margin arrangements across different CCPs. BATS Chi-X Europe and Turquoise both now offer four-way

56

Michael Krogmann, executive vice-president, institutional equity, Deutsche Börse. “It is very important to have a healthy mixture of flow including retail, institutional and market makers, to facilitate price discovery and for the quality of the order book,” he says. Photograph kindly supplied by Deutsche Börse, August 2012.

clearing. UBS MTF was the first venue to offer fully interoperable clearing in July 2011, when it went live with SIX xClear and EuroCCP. Interoperability has helped propel UBS MTF through the ranks of the dark venue market share from ninth out of 15 at its launch in November 2010. In June 2012, out of 17 venues listed by Thomson Reuters, it reached the number one spot ahead of the Chi-X dark book with 24.5% market share. Depositary receipts are a fast-growing segment and the venue has recorded matching in 48 DRs spanning underlyings from more than 12 countries with six Russian names the main activity.

Barnes explains: “After we went live with CCP interoperability independent statistics recorded increases to our ranking. With multiple CCPs, a member can consolidate its clearing into the CCP of choice for economies of scale without imposing switching costs on those members that wish to stay with the incumbent CCP. Interoperability contributes to safety and business continuity in the unlikely event of CCP outage, since those members with access to the alternate CCP can continue to trade. Commercial and structural benefits of interoperability attracted onboarding of members to our venue and are consistent with the vision of a single European market.”

In spite of today’s low volumes, optimism exists. Create Research’s global buyside survey that found equities so low on clients’ priorities also states:“equities will return from the wilderness” as 58% of pension fund managers put global equities top of their list for medium term asset allocation.

Turquoise’s Farnham concludes: “We have grown our business and we still have ideas for further evolution in dark trading. I think the industry will end up with more regulated trading venues driven by MiFID II because BCNs will be regulated. We see diversity of execution venue and choice as a healthy thing.”I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

TRANSITION MANAGEMENT EXPERT PANEL

As beneficial owners have dedicated a greater proportion of their assets to more complex and bespoke mandates, the transition management (TM) industry has evolved to meet the dual challenges of multi-asset implementation and exposure management. This increased complexity has run alongside a backdrop of heightened market volatility and constrained liquidity. Transition managers are required to find liquidity in difficult markets, and manage risk while market sentiment ebbs and flows at a rapid rate. Moreover, transition managers are asked to do more, with less. As investment banking budgets remain tight, clients are demanding uplift in the service set and improved transparency throughout the entire process of portfolio transitions. How can transition managers handle this increasingly demanding business set? We asked our panel of experts to explain the main trends and how they have responded to them.

TRANSITION MANAGEMENT: Managing risk & constrained liquidity FTSE GLOBAL MARKETS: It has MARK DWYER, MANAGING been a challenging year for transiDIRECTOR AND HEAD OF tion management. Asset allocation EMEA, BNY MELLON BETA AND strategies are in flux and continued TRANSITION MANAGEMENT: market volatility has not been Starting in August we saw a significant making transitions easy. Traditionuptick in business with investors imally, the last four months of the plementing a number of asset allocayear provides uplift in transition tion trades, as well as investors raising mandates. What type of transitions money to invest in global equities and is expected to dominate? Where emerging market equities. We would will the business come from and expect this trend to continue for the what is driving it? next several quarters. The one thing I Photograph © Kirsty Pargeter / emphasise most to clients when conMICHAEL GARDNER, MANAGING Dreamstime.com, August 2012. sidering fourth quarter transitions is: DIRECTOR, GLOBAL HEAD, JP plan early, and plan thoroughly. Don’t MORGAN TRANSITION MANAGEEXPERT PANEL wait for the last minute.

MENT: Accurately predicting transiFTSE GLOBAL MARKETS: Extreme tion flows is something all transition I CHRIS ADOLPH, head of transition market volatility and low liquidity managers would like to be able to do— management EMEA, Russell have been two over-riding characbut it’s not easy in reality. The fourth Implementation Services Ltd teristics of the equity markets this quarter is a traditionally busy period as I MICHAEL GARDNER, managing year. How has this impacted on traninvestors plan to implement changes director, global head, JP Morgan sition costs for the client? Equally, before the New Year and the seasonal Transition Management, decrease in market liquidity in what methods do you employ (such JP Morgan December; however the outlook for as electronic execution, fiduciary I MARK DWYER, managing director this year remains uncertain. services) to help clients minimize and head of EMEA, BNY Mellon We have not seen the same volume cost and risk?

Beta and Transition Management of asset allocation shifts as in CHRIS ADOLPH, HEAD OF previous years and we do not know TRANSITION MANAGEMENT whether this will change in the latter part of 2012. We do, EMEA, RUSSELL IMPLEMENTATION SERVICES however, expect to see a continual flow of transitions LTD: The market has continued to be subject to heightened within asset class for both fixed income and equity. volatility in bond prices and spreads, perhaps less easily obDrivers of this business commonly revolve around fund servable is that this has also reduced liquidity. Against a manager performance issues and the desire to increase backdrop of heightened volatility and constrained liquidity yield or remove specific exposures in fixed income alloca- the result for clients, especially in asset classes such as credit, tions. The bigger European pension markets, fiduciary has been a higher mean estimate of controllable costs. Admanagers, multi managers and large institutional ditionally tracking errors are often higher and trading trajecinvestors with a long term liability horizon will continue tories may be longer so in many cases the range of outcomes to influence these events. can be wider.

FTSE GLOBAL MARKETS • SEPTEMBER 2012

57

TRANSITION MANAGEMENT EXPERT PANEL

In volatile markets the risk management strategy is critical.

Once we have a full picture of what factors are driving the risks between the legacy and target we can then identify how this can be mitigated. There are several things a transition manager can do to minimise risk for example, implementing a hedging strategy involving exchange traded futures to control country or curve risk or optimising the trading, executing the positions with the largest contributions to risk as early as prudently possible.

Alongside these risk mitigation strategies it is more critical than ever to monitor the economic reporting calendar. The market is extremely sensitive to news-flow so leading into a transition we will try and incorporate any known unknowns into the transition timeline and strategy. We will adapt the strategy, if necessary, for days when there is significant market news flow in the countries which will be traded.

Russell’s business model and our approach to trading will naturally seek to minimize both explicit and implicit costs on behalf of our clients. We act as a pure agent and access a large array of execution venues which helps to control the implicit costs incurred by our clients. The philosophy behind this is that no single source of liquidity can be relied upon for trading every security, on every day. We have no incentive to execute with any one given venue and our independence allows us to source liquidity wherever it may present itself.

We execute all trades as a pure agent with a clear mandate to pass through best execution to the client.

MARK DWYER: Increased volatility and poor liquidity typically will almost always result in higher transaction costs for investors. Despite the volatility, we’ve seen most transitions continue to be in line with our pre-transition estimates.

Actually dealing with low liquidity is an altogether different issue. We feel the solution to this is threefold: having access to multiple avenues of liquidity, having the technology to access this liquidity in an optimal way, and knowing the advantages and constraints of each venue. Equity trading volumes continue to move away from traditional exchanges and toward alternative liquidity venues. Some of these are ‘buy side only’ and the size of bids and offers are confidential. Some transition managers may not consider seeking liquidity outside their own proprietary dark pool. There’s a real advantage when trading is not tied to just one proprietary pool, but rather access is available to several. An execution management system that can sweep liquidity venues, locating the best available price, can substantially minimize cost. To be able to help clients minimize risk well, that comes from experience; understanding the pros and cons of each venue, and making active decisions in order to maximize each venue’s benefits.

Another way we’ve dealt with volatility is focusing on the quality of pre-transition model estimates. One of the most important lessons we’ve learned is that in periods of greater volatility, more weight should be accorded to models that recalibrate regularly. Models have different base case assumptions and use different data inputs. In this environment, on a transition by transition basis, you have to look at the specific model inputs and make cost and risk estimates as well as trade strategy decisions based on experience with the

58

models used. The better both cost and risk can be estimated, the better it can be managed.

When it comes down to it, experience with the nuances of the many execution venues from which one may choose, and the trade routing technology to access them efficiently, are increasingly critical to effective transition management of equity portfolios, and therefore critical to helping clients minimise cost and risk.

FTSE GLOBAL MARKETS: The T-Charter has been around now for some years. Is it fit for purpose?

CHRIS ADOLPH: The T Charter is fairly unique in the investment industry as it was the result of co-operation between investment banks, custodial banks and investment managers, all with different transition business models. It was recognised by industry participants that working together to standardise the provision of some aspects of transition services, they could not only make transition management more transparent to their clients, but also appeal to a broader audience. The collaboration resulted in an agreed code of best practice, which arms potential users of transition management services with the means to compare different providers and provides guidelines on what they should expect when employing a transition manager. On this basis the T-Charter has been a significant success, with materially greater transparency into how transitions are priced and what clients should expect from their transition manager.

However, as with any voluntary code of conduct, it is subject to the interpretations of the individual providers.

There may be variations in application between providers, particularly across different business models with some models being more transparent than others.

The T-Charter brought together very different investment organisations and created a common code, but does this code go far enough? Some would argue that there needs to be a stronger compliance function surrounding transition management and that a code of conduct is no longer sufficient. Clients assume that in adhering to the code outlined in the T-Charter the manager is acting in the best interests of the client, whereas this may not always be the case. This has led the transition management industry to review the core purpose of the T-Charter. These discussions are on-going and at the heart of what the T-Charter will stand for going forward.

The T-Charter was not designed to specifically protect clients but to provide potential users of transition management services with the means to compare different providers and provide guidelines on what they should expect when employing a transition manager.

The role of protector should be provided by the regulator.

There are some providers of transition management services, including Russell, that believe a tighter compliance regime would give clients more protection and this is currently one of the core discussions with the T-Charter group.

MARK DWYER: I have always felt that the T-Charter does not go far enough in protecting clients, and until there is a mechanism in place to hold signatories accountability to upholding its standards, it is more likely to give clients a false sense of security than actual protection.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

MICHAEL GARDNER: The T-Charter was the result of an initiative by industry participants to encourage good market practice. It was designed as a voluntary code, with no regulatory or contractual support and as such, it does not offer hard protection against those who breach it. It was expected that each firm’s compliance department would play a strong role in monitoring adherence to the code, with the main deterrent to non-compliance being the serious reputational damage that would result.

The T-Charter has been extremely effective in raising client awareness of issues relevant to transition management such as managing conflicts of interest. We feel, however, that it does not go far enough in providing meaningful transparency with respect to outsourced elements of a transition event which are passed on from the contractual transition provider to third party vendors, and any form of remuneration earned by those vendors. It is our hope that future endeavours of the group result in an agreement regarding further standardisation within the industry, such as a common measurement of transition activity and formal guidance for providers in communicating performance track records.

FTSE GLOBAL MARKETS: Does it solve the problems of misuse of track records?

CHRIS ADOLPH: The provision of track records is not included within the T-Charter. There are many providers within the transition industry that believe it is too hard to compare one transition with another to make track records meaningful.

Russell Investments is alone in the transition industry in making available to clients and consultants a five year rolling track record. It is possible to misuse track records, but a more stringent compliance function would certainly help eradicate this problem.

FTSE GLOBAL MARKETS: What needs to be added to the T-Charter to make it really effective?

MICHAEL GARDNER: How to give the T-Charter“teeth” has been an ongoing discussion since its inception, without resolution. In light of recent events, the question has become even more topical. Considering the broad drafting of the Charter and the wide disparity of legal and compliance structures of member organisations, any solution that is too prescriptive would not be beneficial to clients. The issue is a complex one and JP Morgan is actively working with other transition management providers to seek a viable solution.

CHRIS ADOLPH: The T-Charter is currently undergoing a thorough review and the hope is that under the guidance of the chairman, Martin Mannion, it will become more transparent and client-centric. This review with the involvement of both managers and consultants alike is essential in ensuring the T-Charter moves forward and remains relevant.

Many believe that central to this will be tighter compliance functionality and greater transparency on the total remuneration a firm, including its affiliates, receives when managing transitions for a client.

FTSE GLOBAL MARKETS: It is generally accepted that these days there are various measures of best execution and best performance in transition management. Implementation shortfall is one among many measures. Moreover,

FTSE GLOBAL MARKETS • SEPTEMBER 2012

Chris Adolph, head of transition management EMEA, Russell Implementation Services Ltd. Photograph kindly supplied by Russell Investments, August 2012.

issues regularly arise around implicit costs. How do you work with your clients to best measure the performance of a transition? What assurances are clients looking for and how do you deliver on them?

MICHAEL GARDNER: We are 100% supportive of Implementation Shortfall, as defined by the T-Charter, as a measure of total transition cost and report it for all events that we manage versus our pre-transition estimate.

However, clients are becoming increasingly focused on gaining a more detailed understanding of the costs of execution within the transition process. Areas of interest include how the transition manager pays for execution, and whether this is incorporated into the transition manager’s fees. For transition managers that execute through an internal infrastructure, clients require assurance that the transition fee is the only source of remuneration for the service provider. If the provider utilises external execution, then clients want to understand how the cost of external execution is paid. For example, is the external execution cost paid as a share of the TM commission charged whereby the TM provider is absorbing the cost of execution by splitting the total commission with the executing dealer? If not, is the cost of execution paid through the fee implicitly applied to the trade price by the dealing entity, outside of the TM provider and in addition to the TM commission?

Our approach is to ensure that clients understand our execution process and to provide reporting that enables customers to measure our performance. Additionally, we supplement our post event reporting with execution performance benchmarking, as agreed with clients prior to implementation, so they know how the event will be measured.

Examples of execution benchmarks include equity execution versus previous close, open or Volume Weighted Average Prices (VWAP), fixed income executions versus highs and lows or provision of cover prices and foreign exchange versus a pre-determined benchmark such as the WMR bid or offer.

CHRIS ADOLPH: Performance and attribution are so important; Russell strives to be as transparent as possible,

59

TRANSITION MANAGEMENT EXPERT PANEL

before, during and after the transition. In the end, the client should have a full understanding of the true costs (ie performance impact) of a transition event. In the absence of a transition manager, clients generally do not have knowledge of the performance impact and therefore no gauge for the success or failure of an event. Russell always provides timeweighted investment performance, not just during the implementation period, but also in the pre- and post implementation phase. This is what clients expect from their ongoing investment manager and Russell believes it should be no different for a transition manager.

At Russell we calculate the risk-adjusted investment performance of each transition using the T Standard. We will report T Standard implementation shortfall for the majority of transition events, however in a small number of instances this may not be the most appropriate measure, for example an event which is primarily comprised of pooled fund coordination. In such instances Russell will work with the client to ensure their reporting requirements are met and there is full transparency into the costs associated with their event.

In recent years we have observed an increased emphasis placed on transparency by both clients and consultants and we ensure that this is reflected in our reporting. Russell has long been a champion of transparency and disclosure in the transition management industry and as a signatory of the T-Charter and a member of its working committee, we review our processes, procedures and reporting to assure that we are acting in compliance with the T-Charter.

FTSE GLOBAL MARKETS: Equally thereâ&#x20AC;&#x2122;s been a lot of press around transition management about the need for transparency around fees and pricing. This is particularly important as the service set in transition management is sometimes no longer clear cut, as more and more elements are being provided for clients. Again, how are you working with clients to provide them with full transparency around transitions?

MARK DWYER: We are willing to attest to both the total expected amount of revenue and the actual revenue earned in a transition. In our post-trade reports, we clearly compare pre-trade estimates against results, and we think clients appreciate this type of transparency. And even though services are getting more complex, we keep our fee structure simple, making it easier for clients to understand and monitor.

MICHAEL GARDNER: First, we make the execution process fully transparent to clients, explaining how we will trade (eg agency or principal), and the benchmark that will be used for execution. We then agree how we will be remunerated, we estimate the revenue that we will earn from each transaction and we make the amount and source clear to clients at the bid stage. Pricing is agreed with each customer on a case by case basis and documented in our Transition Management Agreement. After the event, we confirm the revenue earned. We expect it to become a market standard for transition managers disclose at the post trade stage the total amount and source of revenue earned on a transition event.

On occasion, customers may require a third party to undertake an independent review of our transition perform-

60

ance. We support these reviews by supplying all the data, as well as an overview of the transition event and strategy.

CHRIS ADOLPH: We provide transparency to our clients in a number of different ways, but perhaps the strongest of all is in the way we contract with them. By contracting as an asset manager and signing an Investment Management Agreement with our clients we assume a strong fiduciary responsibility.

The legal framework that outlines the relationship between the manager and the client is crucial for ensuring that the client gets the strongest fiduciary protection possible. It is essential that clients understand what their managers can and cannot do within the legal framework agreed.

More explicitly we discuss with all clients the total remuneration that as a firm we will derive from the transition, this is made explicit in the pre-transition report and critically it covers all services provided. A summary of the actual fees charged is then given in the post transition analysis, with a comparison drawn between the pre transition figures. We also provide time-stamps on executions to verify our executions and the revenue earned.

It is important for clients to understand where their transition manager (including any affiliated companies) can derive any financial remuneration, be it directly in the form of commissions or spreads, or indirectly in the form of any commissions earned from related businesses, for example, commission on sales trading. We would urge all transition clients to better understand the ways in which their chosen transition manager can generate revenue from their transitions, either by working directly with their advisors or other transition specialists. With this knowledge they would then be well placed to fully quantify the revenue their counterparty is making.

FTSE GLOBAL MARKETS: You hear more about multiasset transitions these days. How common are they?

What are the peculiar challenges of transiting a multiasset portfolio?

MARK DWYER: A clear majority of our events are multiasset class. We believe complexity in portfolio change offers the greatest potential to add value to our clients.

Transition risk is likely to be significant, and developing appropriate hedges in light of volatility, liquidity and exposures (et al) takes considerable expertise. In our experience, multi asset class transitions typically require some type of futures overlay to hedge out asset class risk. The varying degrees of relative liquidity in different sectors or asset classes can also play a huge role in the execution of a multi asset class transition. Specialised analytical software is needed to accomplish real-time trade and risk analysis.

Equally important, the pre-transition planning around funding constraints, market requirements, and similar operational concerns is exponentially more complex for multi-asset class transitions, and critical for success. Its takes a significant investment in systems to handle multi-asset transitions, and a refined set of checks and balances to manage all of the moving parts. Managers and custodians must be provided with clear communication tools to coordinate timing and funding details, and prevent undesirable surprises. If derivatives are being used, either by the legacy or target managers or to manage

SEPTEMBER 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

Michael Gardner, managing director, global head, JP Morgan Transition Management, JP Morgan. © FTSE Global Markets, August 2012.

transition risk, there are added elements of documentation and contracting, all of which must be done in a relatively short amount of time. Lending arrangements have to be closed out prior to transferring assets, and corporate actions and proxy votes managed during the transition period. For global events, you have to thoroughly review the applicable markets to ensure that the accounts are set-up for trading. Transferability and potential re-registration costs must also be assessed.

Each of these factors can play a role in contributing to the overall risk of a multi-asset class transition, and it can be very challenging to develop a cohesive strategy that integrates each element and manages the overall process.

FTSE GLOBAL MARKETS: Fixed income transitions now look to be a staple of the transition management business. Is this going to be a permanent fixture of the business going forward, or do you expect, at some point, equities to dominate once more?

MARK DWYER: Fixed income transitions have always been a significant part of our business, but I would expect that equities will always be the predominant asset class transitioned given the higher relative volatility of equities to fixed income. The higher levels of volatility increase the odds of a larger dispersion of returns among managers, which is often a leading indicator of transition activity.

FTSE GLOBAL MARKETS: Where are you sourcing fixed income transitions from? Is the business mainly transitioning into fixed income from say equities? What are the key characteristics of this business?

CHRIS ADOLPH: While five to ten years ago transitions were mainly prevalent in the equity space, latterly fixed income transitions have become much more commonplace; generally as clients have dedicated a greater proportion of their assets to fixed income and liability matching strategies.

A fixed income transition requires the same detailed planning as any other transition, however this asset class and the opaque nature of the market place does present some unique challenges and requires a transition manager with specialist knowledge, operating and risk systems.

It is important to engage with a transition manager who has clear and un-conflicted channel between the fixed income traders and transition portfolio managers. This allows the trading desk to be engaged at an early stage in the

FTSE GLOBAL MARKETS • SEPTEMBER 2012

planning, without risk of information leakage or abuse. The end product for a client is a far more detailed overview of the trading required; the liquidity and costs involved.

We always adopt a pro-active approach to risk management, not simply passing a basket of names over to the trading desk to be executed but maintaining constant contact, understanding how liquidity and spread conditions are evolving and adapting the strategy as necessary. Critically Russell also provides evidence of best execution, for example, comparing competing quotes. At the end of every transition it is important to us that our client understands what pricing they received for each trade and how that compared to the broader market.

MICHAEL GARDNER: We believe that the level of total transition activity in the market has declined in 2012; however, we have seen a notable increase in fixed income transitions. The source of these fixed income events has primarily been European pension funds.

The drivers for the increase in fixed income activity include poor fund manager performance (primarily in credit), the search for yield - by moving out of low yielding government debt to emerging market debt and high yield—and a reduction in exposure to a particular region such as the Eurozone. In our experience, the majority of fixed income activity has been within the asset class; we have not seen significant shifts into or out of fixed income to date in 2012.

Key characteristics of these events include a reasonably high number of holdings per portfolio and a low level of commonality between legacy and target portfolios which leads to a proportionately higher level of trading. Liquidity has generally been good, although less so as you move down the quality of corporate bonds. International bond mandates are commonly hedged to base currency, which the transition manager is often expected to maintain throughout the event.

FTSE GLOBAL MARKETS: ETFs have been well used by transition managers to gain exposure to particular asset classes for clients when constructing destination or target portfolios. Are they as easy to dispense with when moving assets out of a legacy portfolio?

MICHAEL GARDNER: ETFs have become a core part of the transition manager toolkit; they are commonly used to provide interim exposure prior to funding a new manager, to hedge cash exposure during a transition and to manage target portfolio exposure differentials (versus the transition portfolio) during a transition. There is a wide product offering, allowing exposure to broad indicies and sectors as well as non-equity asset classes such as foreign exchange, commodities and fixed income.

ETFs are typically easy to buy and sell but usage should consider whether there are more efficient alternatives, such as obtaining exposure via exchange traded futures. If the size of a purchase is large, liquidity may be limited and units may need to be created through purchasing the underlying shares in the market. This process can create a purchase price that it different from the ‘screen’ price of the ETF units themselves.

The duration of the required exposure should also be considered. Initial ETF trading costs include market spreads, market impact, market taxes and commissions and cumula-

61

TRANSITION MANAGEMENT EXPERT PANEL

tive costs including management or administration fees and contract roll costs. The transition manager should assess the total costs of obtaining the exposure for the required duration using both the ETF and futures route.

FTSE GLOBAL MARKETS: A couple of years ago, the transition from direct benefit (DB) to direct contribution (DC) pension structures drove a lot of transition management business. Is this still the case? How much more work is there to be done in Europe in this segment?

CHRIS ADOLPH: Transitions in DB space still dominate the transition landscape at the moment but as DC plans continue to grow in size and complexity the need and demand for efficient implementation management within these structures will also continue to grow.

DC transitions come with an additional set of considerations and challenges for transition managers. For example, the timing of a transition for a DC scheme often needs to be carefully coordinated with a blackout period for contributions and redemptions and notification periods for plan members.

This typically means the timing is much more rigid than in DB transitions. These events also tend have specific account structure and reporting requirements and coordination with a third party administrator is typically needed.

Undertaking DC transitions bears a large number of similarities to undertaking transition management within a fund of funds. Russell’s heritage as a manager of managers has enabled us to develop an implementation platform that translates well to DC schemes; however the use of transition management within DC structures is still evolving. In some cases the DC market has become more like the DB market, with increased use of separate accounts and a focus on the explicit and implicit costs associated with making changes in the plan. This evolution within DC plans has created the need for the type of risk and cost management that transition specialists provide.

It is inevitable that DC schemes will continue to address more closely the need for efficient implementation management and explore how this can be effectively incorporated within their structures. As the demand for transitions in this space becomes more prevalent we would expect to see transition managers’ working to further adapt to the unique challenges this structure presents.

MARK DWYER: We have also observed this ebb in the conversion of DB plans to DC, but that doesn’t mean less work to be done in the space– just the opposite. DC assets are constantly growing, and plans are constantly re-evaluating their investment elections and scheme structures. One of the key areas of focus in DC is cost control, and transition management originally stemmed from efforts to control costs when large amounts of assets need to be traded. As DC assets continue to grow, plans consolidate, glidepaths adjusted, managers replaced and new plans born, there will be a continuing need for a centralized manager to coordinate the additional stakeholders and additional complexity that is characteristic of DC transitions. I’d go so far as to say that in the future, it will be best practice for DC plans to work with a transition manager to mitigate trading risk, and minimize the

62

Mark Dwyer, managing director and head of EMEA, BNY Mellon Beta and Transition Management, BNY Mellon. © FTSE Global Markets, August 2012.

operational impact of implementing plan decisions. We anticipate there will only be more work for transition managers.

FTSE GLOBAL MARKETS: How far has transition management now strayed from the original service?

Are transition managers trying too hard to be all things to all men? Or, is this a natural evolution of the service in an increasing complex investment market?

MICHAEL GARDNER: When firms started offering transition management services in the mid 90’s, most activity was confined to equities. Fixed income events started to become more common around 2000 and the use of exchange traded derivatives became common for managing risk during implementation. In 2012, transition managers handle events across most asset classes and also provide stand alone overlay and hedging services, interim management and ad hoc trade execution.

Transition managers’ involvement in these newer services is a direct response to demand from institutional investors looking to reduce risk in their investment programme. Many of these newer services have synergies with core transition management activity. Cash equitisation and asset allocation overlays can be restructured into the cash markets when investors are ready to do so; using one provider to manage the equitisation/overlay and the transition is therefore a natural fit. Another source of new business is from investors with a limited execution infrastructure, and looking for firms to execute their multi-asset class orders. A core competency of transition managers is the efficient execution of trades across asset classes, so transition managers are well placed to manage client order flow.

These services exist as a result of client demand, although it is in the transition manager’s interest to sell these services since they often lead to an ongoing and long term relationship with an investor and thus provide an annuity revenue stream. Implementation of asset restructures will remain the core business of transition managers but transition managers will need to continually develop services to differentiate themselves and build long term relationships. The effectiveness of providers will depend upon their flexibility to adapt to new client needs and their success in demonstrating an increasing skill-set within their teams. I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

SECURITIES LENDING

Photograph © DrHitch / Fotolia.com, August 2012.

A longstanding emphasis on transparency and de-emphasis on cash collateral has helped Canada’s securities lending business regain its footing faster than many of its major-market counterparts post crisis. While holding out for a long-awaited spike in volume, the sector braces itself for the possible impact of new regulatory measures from both at home and abroad.

Dave Simons reports.

WILL REGULATION UP-END OR BOLSTER CANADIAN SEC-LENDING? ESPITE ONGOING GLOBAL economic uncertainty, a strong banking sector and resilient domestic growth suggest that Canada is well-poised to endure potential pitfalls that may lie ahead. Even with relatively lower volumes, the country’s securities lending market remains a bright spot, particularly as hedge-fund activity continues to rise and the market for ETFs begins to have a positive impact.

On balance Canadian asset owners have held their ground, which has helped keep supply relatively stable.

Although Canada has historically been a non-cash-collateral market with a particular focus on fixed income or sovereign debt, the Canadian Securities Lending Association (CASLA) is currently looking at broadening the definition of qualified securities, which could pave the way for a number of different asset classes to be deemed acceptable collateral. Meanwhile on the technology front, Canadian participants continue to move towards greater automation, utilising the likes of auto-borrow facilities as well as third-party collateral managers.

D

FTSE GLOBAL MARKETS • SEPTEMBER 2012

Rather than being shaped by market dynamics, Canada’s securities lending industry is more likely to feel the affects of regulatory changes from both at home and abroad. Portions of new regulations recently drafted by the Investment Industry Regulatory Organisation of Canada (IIROC) mirror aspects of the US market, including the imposition of preborrow requirements on certain short sales, as well as the repeal of the tick test. Meanwhile, concerns continue to mount over the potential impact of US-based initiatives in the making including Dodd Frank and the Foreign Account Tax Compliance Act (FATCA). At the same time, participants remain somewhat sceptical about the prospects of a centrally cleared securities lending sector, even as regulators continue to push for greater CCP adoption. Accordingly, CASLA continues to work with domestic regulators to ensure that these changes do not cause undue damage, or slow the pace of the country’s lending facilities.

Figures compiled by global research group Data Explorers finds Canada holding down roughly one-tenth of North

63

SECURITIES LENDING

American securities lending revenue (compared to just under 90% for the US), unchanged from a year ago. Energy currently accounts for the lion’s share of revenues, fees and balances, with banks and consumer services ranking second in balances and fees respectively.

Revenue from Canadian equities reinvestment, which stood at 14% during pre-Lehman 2008 (compared to 22% for the US), held steady at 4% throughout 2010-11, leaving fee-based revenue (96%) to make up the difference. The tendency for Canadian lenders to steer clear of cash relative to other markets has, at the very least, given its participants a psychological leg up on the competition in the aftermath of the financial crisis.“As we’ve often told clients, going into cash isn’t always about increasing the potential yield,” explains Rob Baillie, president and chief executive officer for Northern Trust Canada. “Rather, it’s an alternative form of collateral that we can accept and then perhaps subsequently increase utilization. The fact is there is a risk-reward premium involved that some investors did not fully understand, and, consequently, suffered some losses as a result.”

However, like their peers in the US and elsewhere, Canada’s securities lending participants continue to hold out for a long-awaited spike in volume. Demand remains weak relative to supply on a global basis. Furthermore, levels of both supply and demand have retreated since reaching a post-crisis peak in May of last year.

In a second quarter market summary, Mary Jane Schuessler, desk head, North American trading for RBC Investor Services in Toronto, did note a moderate increase in Canadian fixed-income loan balances from the prior quarter, paced by improved demand for debt securities and utilisation levels in the 60% to 70% range.“Fixed income collateralupgrade trades were also executed during the second quarter, with equities proving the most popular form of collateral,” noted Schuessler.

There have been other bright spots. Equilend, a provider of trading and operations services for the securities-finance industry, has seen a continued expansion of its global platform, including a nearly 100% increase in the firm’s monthly trade count year-to-year. Along with strong domestic interaction, Alexa Lemstra, vice-president, CRM and sales for the company’s Toronto-based division, EquiLend Canada, reports robust cross-border activity as well, “which has been due in large part to the participation of longtime clients such as State Street, Northern Trust, BNY Mellon and others.”

Seeking improvements through process innovation continues to inform the country’s securities lending environment, says Lemstra. “The Canadian market has been steadfast in its efforts to leverage tools that can lead to greater efficiency and bring additional value to the entire process,” affirms Lemstra.

“From our viewpoint, investments in technology have helped fuel much of the demand that we’ve seen of late.”

Interest in contract-comparison solutions remains strong, says Lemstra, as have post-trade services such as dividendand billing comparison, particularly for clients seeking to

64

Alexa Lemstra, vice-president, CRM and sales for the company’s Toronto-based division, EquiLend Canada, reports robust cross-border activity as well, “which has been due in large part to the participation of longtime clients such as State Street, Northern Trust, BNY Mellon and others.” Photograph kindly supplied by Equilend Canada, August 2012.

control risk on the fixed-income side. Another highlight has been a new Canada-specific version of EquiLend’s tradingoptimisation program, which allows clients to pool long and short assets and includes limits based on existing bilateral relationships.

Rob Ferguson, senior vice president of capital markets, CIBC Mellon, says there is ample room for Canadian securities lending market participants to continue to innovate, and sees collateral flexibility as the main avenue of choice.

“Borrowers are looking to expand their ability to diversify collateral, and so I think expanded collateral acceptability is going to be one of the main drivers of innovation and opportunity here in Canada,” says Ferguson.

Earlier this year the IIROC announced its intentions to strengthen rules governing short sales and failed trades, including, among other things, the imposition of preborrowing requirements for certain short sales, as well as the requirement that shorts are labeled accordingly. The rule, which takes effect October 15th, will carry with it a locate requirement which could mandate the imposition of a cover, based on a client’s history. Though intended to discourage rampant short activity, the rule could have farther-reaching consequences, remarks Robert Young, chief executive officer, Liquidnet Canada, a provider of block liquidity to the buyside.

“Obviously there have been discussions among brokers regarding how to make this work from a process point of view,” says Young.“In a perfect world this is something that could be easily handled through technology, but of course we don’t live in a perfect world. For a smaller broker there is now an additional piece of functionality to build or buy.

One of the problems with this kind of regulation is that it creates the need for a look-aside process, which in turn requires resources.”But with volumes still muted, it becomes exceedingly difficult to make a strong case for increased technologies spend, says Young.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Rob Ferguson, senior vice-president of capital markets, CIBC Mellon.

“Borrowers are looking to expand their ability to diversify collateral, and so I think expanded collateral acceptability is going to be one of the main drivers of innovation and opportunity here in Canada,” says Ferguson. Photograph kindly supplied by CIBC Mellon, August 2012.

Because brokers serve as the intermediary in the lending arrangement, larger banks with deeper pockets and a wider coverage area have had a distinct advantage.“Roughly half of Canada’s institutional brokers are struggling to show a profit,” says Young, “therefore clients cannot afford to wake up one day and find that their intermediary has closed its doors and they can’t get their stock back.”

As a result, the industry’s longstanding emphasis on technology sharing will likely become even more pronounced, as smaller and independent entities seek lower-cost outsourced solutions in response to regulatory requirements now taking shape. “Because most businesses do not build their own systems in-house, we will see dealers increasingly attempt to mutualise their costs by tapping into third-party providers.”

The markets will also need to keep an eye out for new rules governing higher forms of collateral, adds CIBC Mellon’s Ferguson. “Of particular note for securities lenders and borrowers are emerging requirements around OTC derivatives trading and the collateralisation of derivatives, which call for higher quality collateral such as government bonds.” While this bodes well for federal/provincial bond demand, “it may prove difficult for certain investor classes that have access to lower credit quality collateral,” says Ferguson.

There are a number of possible developments in the making pertaining to mutual funds’ participation in the seclending business.“Canada currently has a rule in place—NI81-102—that restricts equities as collateral,”notes Ferguson.

“However CASLA, as well as other key stakeholders, are looking to have this amended to bring mutual fund collateral guidelines in line with other comparable regulation.”

What about the implications of cross-border regulations?

Though Dodd Frank and FATCA are on the horizon, their impact on securities lending in Canada have yet to be fully determined. However it shakes out, says Ferguson,“We see participants being squeezed from both sides—regulators

FTSE GLOBAL MARKETS • SEPTEMBER 2012

looking for more stringent controls, and borrowers pushing for greater leeway and flexibility around collateral.”

From his standpoint, Ferguson sees limited demand for the introduction of a central-clearing model for securities lending market participants. “The current system gives borrowers and lenders control when choosing a risk balance that is right for their business,” says Ferguson. “Many borrowers and lenders have also forged long-term relationships that increase both confidence and efficiency. Moving to a central counterparty for securities lending could mean reduced choice and decreased flexibility to choose counterparties.”

Given the risk-averse nature of Canada’s lending constituency, a securities lending CCP would have to address the potential for increased transactional opacity. “For example, participants will need to understand whether they would potentially be responsible for the default of a counterparty they hadn’t chosen,”says Ferguson.“Cost is a factor as well— because participants tend to view their lending programs as a stable source of risk-adjusted returns, I would expect some opposition should a CCP suddenly increase costs and subsequently drive down lending income.”

Given the country’s resiliency post-crisis, Canadian lenders continue to embrace efforts to increase transparency while working to recognize and control systemic risk, says Don D’Eramo, senior managing director, Securities Finance, EMEA, State Street Global Markets.“Canada has been at the forefront of these global themes by implementing international standards such as Basel II and subsequently the Basel III accord,” notes D’Eramo. Recent events in the financial markets have brought into greater focus issues surrounding counterparty assessment, collateral and diversification. Beneficial owners who have utilized agent lenders have been able to count on a much higher degree of risk control, says D’Eramo.“The ability for an agency lender to tailor programs with respect to collateral acceptability, counterparty approval and exposure diversification have given these owners a distinct advantage.”

Going forward, firms that are most focused on cost-containment are the ones that will be around for the long haul, maintains Liquidnet’s Young. Hence, in the current climate the notion of increased value through decreased cost has reached a whole new level.“While these firms may just be thought of as ‘survivors,’ the fact of the matter is they will have survived— and given the intensity of the markets, that’s the kind of company that investors will ultimately want to partner with.”

Despite the challenges presented by Canada’s rulemaking regime, Young stands behind regulators’ continued efforts to highlight the distinctions between un-necessary market fragmentation and necessary choice.“Canada has seen the development of a much more activist regulatory environment over the past few years, but it is one that has been driven by professional market overseers, rather than politicians,” says Young.“I think there exists a great opportunity for Canada to export this model—if we truly believe that what we are doing is correct, we need to get out in front of investors and issuers around the world and let them know that we have a market structure that’s safe; because as you know, there’s quite a lot of demand for that sort of thing right now!”I

65

CLEARING & SETTLEMENT Photograph © Dreamstine.com, supplied August 2012.

DERIVATIVES CLEARING: DOWN TO THE NITTY-GRITTY The year-end deadline for clearing OTC derivatives under the Dodd Frank Act is fast approaching but market participants are still working out the practical details. Everyone knows trades will have to be reported, but who will report what, when, and to whom? The introduction of a central clearing counterparty requires new legal documentation and alters the trade processing workflow, too.

Counterparties who never posted initial margin on bilateral trades will have to do so, creating a huge incremental demand for collateral and more frequent collateral movements to comply with daily variation margin calls. Can the industry sort it all out in time? Neil A O’Hara reports.

RADE REPORTING SOUNDS like a simple task, but nothing is ever easy when the entire market structure is changing. True, once the SEF mandate takes effect, all swaps eligible for clearing must trade on a SEF and when the regulators finalise the rules governing SEFs they will most likely require them to report trades. So far, so good, but the clearing requirement will come into force before the SEF mandate. How will those trades be reported? What about those trades that are not eligible for clearing?

The answer depends what the regulatory regime is; whether the trade is cleared and who the counterparty is.

SEFs will likely report all cleared trades, plus any trades not eligible for clearing executed on their platforms. Trades executed OTC but still cleared (ie before the SEF mandate kicks in) will be reported by the clearing broker-dealer, which will also report any customer/dealer trades executed OTC and not eligible for clearing. If both sides are dealers, or neither side is a dealer, the parties must agree who will report a non-cleared OTC trade.

Once it is clear who should report, the responsible entity needs to know what information to send and where to send it. In principle, the report goes to a swaps data repository (SDR)—but it isn’t yet clear which companies will fulfill that role. In the US, DTCC, the CME, ICE Trade Vault, Reval SDR and Global Trade Repository for Commodities have applied to become SDRs for various asset classes but none has received final approval from the regulators. The industry has to finalise report content and data format, too.“It sounds simple but the standardisation and the sheer volume of data that needs to be processed is considerable,” says a source at one of the major dealers.“There are issues around product definition and legal entity identification, too.”

T

66

The principal reporting burden will fall on the clearing brokers, who are also the major derivatives dealers. They will have to set up connections to the clearinghouses, of course, but will need a line to the SDRs as well.“It concentrates development work at the dealers, who are best placed to handle it,” says Judson Baker, product manager, derivatives and collateral services at Northern Trust. “It removes the onus on the buy side, which is what Dodd Frank intended.”

Buy side players will escape reporting requirements except on the rare occasions when their counterparty is another institution rather than a dealer. They will not get off altogether scot-free on the trade processing side, though. The dealers have to negotiate legal documentation with the clearing houses and SEFs, which will in turn require brokers to amend client agreements to reflect the new obligations, including margin calls.

The buy side will also have to change back office workflow when the SEF mandate kicks in. In the pre-SEF world, counterparties affirm to the clearing house what they believe the trade to be, either directly or through their broker; if it matches the trade is cleared and if not the clearing house kicks the transaction back to the parties to resolve the break.

On a SEF, however, trades will match at that level, just as they do on an exchange. Any trade breaks will be kicked back

by MarkitSERV or another matching service before it sends clean trade details straight through to the SDR and the clearing house, which will then notify the clearing members of their client’s obligations and the margin to be posted upon settlement.

In the post-trade phase, a cleared environment will require a new approach to trade compression, which extinguishes offsetting matched trades between the same counterparties.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

In theory, compression will become easier, at least within each clearinghouse: the central counterparty is on one side of every transaction and can readily identify offsetting trades.

“Compression is easier as we go to central clearing counterparties,”says Sanjay Kannambadi, global head of derivatives clearing services at BNY Mellon Clearing, “but CCPs may look for perfect or near perfect matches.”

Perfect matches are few in number, which is why trade compression in the bilateral world is risk-based. TriResolve and other service providers look for trades that are close but not exact matches, create a new contract that offers risk that is almost identical and invite counterparties to exchange new for old. Participants assume any mismatched risk for their own account—an exposure dealers and investors can tolerate but a clearinghouse may not. “The clearing houses will have to consider the risk,”says Kannambadi.“They work on zero risk, a matched basis.”

Perhaps the biggest challenge for the buy side will be in collateral management. Margin calls, both initial and variation, will occur daily, which means asset managers not accustomed to posting initial margin will have to put up more collateral and handle daily movements. “We see a dramatic increase in collateral velocity,”says JR Lowry, senior

vice president at State Street Global Services. “It will affect a much larger population, many of whom do not have industrial strength infrastructure in place today. Doing collateral management offline in spreadsheets and databases will no longer be an option.”The buy side must either upgrade its software or outsource collateral management to an external service provider—like State Street.

A few months ago the custodian banks and dealers were gearing up for an expected surge in collateral transformation amid fears that sufficient collateral eligible at the clearinghouses might not be available. At the time, the clearinghouses insisted they would only accept cash or high quality government securities as collateral. While dealers and hedge funds could meet that standard, it would be difficult for pension funds and insurance companies, whose portfolios typically contain minimal cash, bonds issued by corporations rather than governments, and equities. Now, however, the clearinghouses have changed their tune: CME has begun to accept selected corporate bonds, while Eurex has cast the net even wider and will take equities as well.

State Street clients continue to ask about collateral upgrade services—half the prospects include it in their requests for proposals—but Lowry isn’t sure whether the

CLEARING CONNECTIVITY STANDARD LAUNCHED FOR CENTRAL COUNTERPARTY CLEARING APIENT GLOBAL MARKETS has announced the completion of a new industry standard for cleared OTC derivatives related activity reporting for asset managers, futures commission merchants (FCMs) and custodians. The Clearing Connectivity Standard (CCS) is a standardised connectivity format that can be used by the FCM community to transmit OTC clearing related information on behalf of their asset manager clients to custodians.

As industry regulatory reform emerges, both the volume of cleared derivative trades and the number of relationships between market participants is growing. The absence of a formal standard for formatting or transmitting data between entities can create delayed onboarding and increased operational risk as well as cost of interface development and maintenance with each custodian.

Sapient Global Markets collaborated with a number of FCMs and custodians

S

FTSE GLOBAL MARKETS • SEPTEMBER 2012

to develop the CCS, which has been adopted by the original project group of participants representing more than twelve firms and hundreds of end users in the buy-side community. Overcoming the challenges faced by reading, interpreting and managing files sent in different file formats, the CCS will simplify integration with data systems and automate reconciliation in order to make clearing and communications more concise and efficient. It provides standardised connectivity and reporting initially for central counterparty-eligible interest rate and credit default swap products in the United States through LCH.Clearnet SwapClear and the CME Group, with plans to expand to include additional products, participants, and geographies over the next year and beyond.

Working with project sponsors from across the industry, Sapient Global Markets facilitated the definition of the common data format and file

definitions for account balances, margins and fees, settlements, positions and daily activity. The standard has also been discussed by the International Swaps and Derivatives Association (ISDA) and Securities Industry and Financial Markets Association (SIFMA), as well as some of its working group members. “We recognise the CCS as something that will help many participants for years to come,” says Jim Bennett, managing director at Sapient Global Markets. Future enhancements to the CCS will include a conversion of the standard to FpML on a real-time basis under the guidance of FpML Working Groups and additional product coverage. The intent is to also broaden the range of participants to include additional FCMs, custodians, asset managers and CCPs. Discussions are continuing with ISDA on ongoing governance and oversight of the clearing and communication standard.

67

CLEARING & SETTLEMENT

JR Lowry, senior vice president at State Street Global Services. Photograph kindly supplied by State Street Global Services, August 2012.

Sanjay Kannambadi, global head of derivatives clearing services at BNY Mellon Clearing. Photograph kindly supplied by BNY Mellon, August 2012.

interest will translate into real demand. “It’s a natural extension of our securities lending business,”he says.“How much of a need there will be is not clear, however.”

If collateral transformation does take off, it may have knock-on effects. In a typical transaction, the service provider takes a client’s ineligible collateral (most likely corporate bonds), lends it out through a repo and gives the client cash to post at the clearing house. How the incremental demand will affect capacity and pricing in the repo and securities lending markets remains to be seen.

The use of collateral will grow even if the upgrade opportunity fizzles, however. Pension funds and traditional asset managers, which have not posted initial margin on their OTC derivatives in the past, will have to do so when derivatives are cleared. In addition, the new rules will make bilateral trades so expensive that market participants will use cleared products whenever they can. “In both the US and Europe, real money accounts will have to post collateral, which must be segregated and cannot be rehypothecated,” says Fredrik Gentzel, head of listed derivatives and EMEA markets clearing at Deutsche Bank. “It creates a huge demand for collateral that did not exist before.”

Market participants will have an incentive to book offsetting trades through the same clearing broker and clearing house in order to minimize margin requirements. To a separate clearing house, an offsetting trade is new risk for which it will demand margin, while the counterparty will get no relief from the original clearing house, which sees no reduction in its risk. Clearing houses that handle related listed products may also offer margin offsets; for example, interest rate swaps against opposite interest rate futures positions.

Banks will face compelling pressure to optimise margin when the Basel III regulatory capital framework takes effect.

Higher capital charges will make orphaned offset positions even more expensive, but risk managers are likely to insist the banks use more than one clearing house for each product line.

Dealers need a way to check on the fly where to book a trade to their best advantage within the designated risk parameters.

68

Judson Baker, product manager, derivatives and collateral services at Northern Trust.

Photograph kindly supplied by Northern Trust, August 2012.

Margin optimisation will also affect whether participants shift legacy transactions to a clearinghouse. Suppose a hedge fund has an interest rate option hedged through an interest rate swap with the same counterparty for zero net delta. If the fund puts only the swap into a clearinghouse, it must put up margin for the swap to the clearinghouse and to the bilateral counterparty for the swaption.“If the fund were able to move the swaption and the swap into the same clearing house, it would do that,”says Gentzel.“It would cut the risk in its portfolio and hence the margin required.”

On the trading side, most buy side firms will have relationships with two or perhaps three derivatives clearing brokers but will likely execute through several others.“It will be like the futures industry, where investors trade through various brokers and give them up for clearing through just one or two,”says Baker at Northern Trust.“Indirect customers of the clearing brokers will be the norm.”

The extra link in the chain makes it harder for customers to track the securities they will have to put up as collateral.

If a client posts $1m of US Treasuries with its non-clearing broker, that firm may keep those securities and post cash or other eligible collateral to the clearing broker. If the nonclearing broker does post the client’s Treasuries, the clearing broker may either keep them and post other collateral at the clearing house or pass the Treasuries on. In the event of broker default, it can be difficult to determine where the client’s securities are. A unique identifier scheme for collateral does not yet exist.

While some large asset managers may choose to handle their own collateral management, most will hire third parties instead. The service is a natural fit for custodian banks like Northern Trust, which already offers operations outsourcing services.“Clients can focus on risk management, execution and front-office trading,” says Baker.

“We handle operations, post-trade compliance, performance and risk monitoring.” As derivatives clearing nears reality, the devil is in the details—but gold may be lurking there for asset servicers.I

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

EUROPEAN ASSET SERVICING ROUNDTABLE

SECTION NAME

BALANCING MARKET OPPORTUNITY AND RISK: Buy side and sell side responses to market change

Photograph © FTSE Global Markets, supplied July 2012.

Attendees

Supported by:

(Back row, from left to right) CHRIS SIMS, chief technology officer, Ignis Asset Management SID NEWBY, head of sales for EMEA, BNY Mellon ANDREW MAIN, managing partner, Stratton Street Capital (Front row, from left to right) MARGARET HARWOOD-JONES, head of client segments, BNP Paribas ALAN MILLER, founder and partner, SCM Private ROGER FISHWICK, director, Thomas Murray

FTSE GLOBAL MARKETS • SEPTEMBER 2012

69

EUROPEAN ASSET SERVICING ROUNDTABLE

MARKET CHANGE/COMPLEXITY AND THE COST OF REGULATION SID NEWBY, HEAD OF SALES & MARKETING, BNY MELLON: The sheer amount of change and complexity— driven by incoming regulation on our business models and our clients’ business models— is almost overwhelming right now. Our focus is on helping clients manage change. Equally, we are also reforming the underlying structure of our business to ensure we help clients effectively. We work hard to develop new service and business models that enable both us and our clients to work together efficiently and remain profitable over the long term. It involves substantial investments on both sides. Inevitably this means the traditional commercial drivers of the business are themselves being challenged.

Regulation also involves embedded costs, both direct and indirect. Our clients expect us to be on top of regulation.

Right now, they are hungry for information because many elements of the new regulatory environment remain nebulous; there are no certainties until regulation is finalised and comes into force. AIFMD is a case in point. Clients constantly ask us: what does this mean for me and how will you help me manage the process of change? Providing solutions means additional cost that has to be factored into the business model. Clients tell us that they value early engagement on these topics, even if the final shape of the regulations is still unclear. The demand for thought leadership and knowledge exchange around these events is growing and we see this as a potential area where providers can differentiate themselves.

Without doubt, regulation will reshape the fabric of the industry and inevitably some organisations will have to refocus on their core competences, while others will ask whether they are fully committed to this industry and, if not, what they need to do about it. We all have to come to terms with managing what looks to be an extremely complex business environment and there are no quick fix answers.

Solutions will have to be developed steadily and carefully.

ANDREW MAIN, MANAGING PARTNER, STRATTON STREET CAPITAL: I attended a seminar recently which noted that some 5,000 pages of financial market legislation are going through the European parliament alone. None of it is really defined yet to enable implementation and that’s a frightening thing. Also, from a business management point of view, the lead up to legislation appears to be getting shorter. In the past, there was a cooling off period, which allowed the national legislator to interpret legislation through the eyes of interested local parties. That period seems to be getting shorter and shorter.

Overall then, it is making the life of the generalist much more difficult and more expensive. People are beginning to really think about the value or contribution of marginal business within the firm. We are asking ourselves: do we become a specialist? Should we concentrate on something and try and do it very well because, as a fund manager and a provider of that information and services, we can gain a niche? These are questions that should be asked by all fund managers.

70

I think we will see a bifurcation in the market which drives out the middle tier of players and concentrates on the big ones who can afford to be generous. As Sid suggests, costs are going through the roof. The problem for specialist boutiques is that the cost of entry will continue to rise over time. This trend will also work against London (and it is still one of the great innovation centres for fund managers). The costs involved in starting a fund management firm, compared to four or five years ago, have totally changed and under the current crop of incoming regulations will become more expensive.

ROGER FISHWICK, DIRECTOR, THOMAS MURRAY: It doesn’t appear that the regulators in Europe are particularly interested in the cost of regulation. They are determined to legislate away in order to deal with perceived regulatory inadequacies. The danger for Europe is that, of course, you drive business away to other, more lightly regulated centres. In this regard Asia looks increasingly attractive to many people as an area to do business in, as it is less encumbered by regulatory change.

Regulation is becoming a threat to the developed world— the EU and the US in particular—and it is going to help to power the Asian growth story in fund management, in insurance, in custody, in banking, in all of these sectors, over the next 15 years. Similarly, many years ago the euro dollar market was created in Europe because of reforming and restrictive legislation in the US. We are in danger of strangling our particular financial services golden goose in the EU, if you can still describe it as golden.

MARGARET HARWOOD-JONES, HEAD OF CLIENT SEGMENTS, BNP PARIBAS: A point perhaps that hasn’t been emphasised (and we feel it strongly about it, as both a service provider and also as a banking institution per se), is our ability not only to help our clients understand and manage change but also how we can influence that change.

At BNP Paribas, we spend quite a lot of time trying to position ourselves so that we can lobby, and help influence events. We are not in an environment, quite clearly, where we can resist regulation; it’s happening now and we need to get ourselves into best shape to deal with it. However, there are obligations on firms like ours to find the means to actively engage in the process and wherever possible, work to shape change in both the interests of our own organisation and that of our clients.

Clearly it’s not for the fainthearted. Clearly it takes knowledge, expertise and a good deal of resourcing. Accordingly—and it is a key trend—we now work to smartly combine resource and expertise more broadly across the firm. Perhaps when we were in a less rigorous environment, perhaps when we had less complexity, different areas of the bank or different business lines, could work more in isolation. Those days are gone. Now it is vital that we work collaboratively, both for our clients and for ourselves.

If ever you wanted a reminder of why we are doing that, you only need look at the hostility of the external environment, and the need to deliver to your shareholder. Optimisation of the bank’s resources is ever more critical (on a daily basis) and that manifests itself in a number of ways. In

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Margaret HarwoodJones, head of client segments, BNP Paribas.

Photograph © FTSE Global Markets, supplied July 2012.

securities services we collaborate more and more with the investment bank; trying to see how we can bring together the best of services and do the right thing for the firm and the right thing for the customer.

There are also other elements exerting influence on market change. In that regard, the challenge for the industry is to prepare for whatever may come down the line. It also begs another important question: do we have the required stamina and adaptability to respond to continual change?

Equally, I can’t fail to comment on another important dimension in play. That is the public’s perception of the banking industry. We have a real image problem right now; and it’s a huge priority for us to think about how we begin to restore the trust of our customers and how, as an industry, we can demonstrate our commitment and responsibility towards both the economy and the wider society. Rightly so, it is a special focus for many of us.

ALAN MILLER, FOUNDING PARTNER AND CHIEF INVESTMENT OFFICER, SCM PRIVATE: I’ve been managing money since 1986 for various large companies, on behalf of individuals and institutions. We set up our business three years ago aiming to offer investors higher standards.

We think that ethics are woefully inadequate in fund management, in terms of being honest with customers about the full costs involved in building a portfolio. We think it’s shocking, to take your point Margaret, that there have been so many financial scandals and that so many have hinged on a single theme: a lack of transparency. In January this year we proposed a new True and Fair Code of Conduct, which the established investment houses have tried to break but none have managed to do so. It reveals to each customer the full and true cost of investing or saving in any single product.

This code was embodied in our True and Fair Campaign. I’m glad to say that European regulators are taking it seriously and it may well be that that code will (eventually) be introduced to all UK funds. However, and this is interesting, we are yet to hear from or have any consultation with the UK’s Financial Services Authority (FSA) about the code.

In terms of market change, we don’t want more regulation.

We simply want more effective regulation. If you have a system which nobody inside the industry can ever begin to understand then I say it is almost impossible for that regulation to be effective. It is rather like a business contract, if it is a short contract, it is probably going to be honored by both sides.

The European regulator seems to consult and do things kind after due consideration, rather than the sound-bite regulation we have in the UK, which makes it virtually impossible for any participant to know what the rules are because they change according to the latest speech. All we want as a fund management company is to have a level

FTSE GLOBAL MARKETS • SEPTEMBER 2012

playing field. That is not the case right now and that hinders any business that wants to honestly reveal to customers the full costs and fees of investing (and that is from top to bottom). This is because very few fund management companies choose to reveal this and it is completely wrong, and the FSA needs to address this urgently.

The FSA appears to spend nearly all its entire time on RDR, which is well intentioned and is the beginning of the journey to transparency. But now, by the end of the process, it seems that almost everyone in the industry recognises it won’t work or enable the industry to get to a true consumer protection destination. The full regulations, even now, six months away from RDR, aren’t even finished. Some of them regarding platforms will apply a year after the start and the original objective, which was to improve the outcome for the consumer, sadly is unlikely to be achieved.

So what we want and what we produced is a code forcing people not just to consider their own costs but all the other costs in the investment equation. Consumers can compare fairly one product with another, one type of investment with another. The problem at the moment is, if you actually reveal, which we do, the full costs, including everything, you then compete with people who don’t, and the consumer makes an erroneous decision because he/she doesn’t realise that everybody else is not actually telling him the full truth.

Recently, Lord Turner noted there has been a failure of caveat emptor. Well, it’s a failure because the FSA has not allowed caveat emptor to work as it has not forced people to properly provide all the information. We believe caveat emptor actually works. The markets are very efficient.

Consumers are very efficient. However, if the FSA seemingly ignores the basic principle of transparency then, of course, the markets will not work.

FRANCESCA CARNEVALE: Have you approached the FSA and told the regulator of your concerns?

ALAN MILLER: Yes, we invited them to both the launch and round-table event discussing transparency and our proposed True and Fair Code.

FRANCESCA CARNEVALE: No satisfaction?

ALAN MILLER: No satisfaction as they said they were unable to attend and have never responded to our requests for a meeting.

DELIVERING TRANSPARENCY IN THEORY AND IN PRACTICE FRANCESCA CARNEVALE: Chris, your firm has outsourced your back office operations. Will that help you deliver more transparency to your customer as your firm works to focus on the front office?

CHRIS SIMS, CHIEF TECHNOLOGY OFFICER, IGNIS ASSET MANAGEMENT: Yes, it will give greater transparency to the customer. Our primary customer is the life company and the deal that we’ve done with our provider is, effectively, two separate contracts: one with the investment management firm and one with the life company—which will use HSBC to centralise its operations so that they’ll have one

71

EUROPEAN ASSET SERVICING ROUNDTABLE

source of the view over all of the assets that they hold. This can only be better for the underlying customers.

We have utilised HSBC so that the bank can concentrate on adhering to the regulations in the back and middle office and streamline our processes. It resonates with everyone else’s comments on market complexity and the cost of entry for fund managers, and the ability to keep up with the regulations.

I sympathise with Andrew’s point about shortening times for legislation: just one of the myriad things I need to do, in a very short space of time is familiarise myself with the technical standards on short selling and credit default swaps (CDS) side. That only really got highlighted at the end of May, and the implementation for that is November 1st. The technical standards run to 92 pages. Not only do I have to read it, but I have to remember it. Because once you actually get into a conversation with the compliance department, a rough overview isn’t enough and these days compliance leaves no stone unturned. I have to explain, for instance, that there is no diversification and index derivative involved. So if you are using something that gives you, in theory, an advantage on the drop in an underlying security, you’ve got to calculate the exact percentage of that advantage If you’re short the FTSE250 on an index future, you have to work out the percentage and add it back in to the overall valuation.

ANDREW MAIN: What, stock by stock?

CHRIS SIMS: If you’ve got a sure position, yes. That’s the way the set of standards has been written. There’s no materiality in there, it just says an index. It doesn’t give you an opt-out on diversification, and the same with an ETF. If it is big and liquid, you don’t get any dispensation for it. If you follow the rules to the letter, you have to take every single position you’ve got, go down to the lowest level, add it all up again and then, if you move a percentage on a daily basis, you’ve got to report that in a way that’s currently unspecified by November 1st.

ALAN MILLER: I can give you one anecdote that is apt for this discussion. We wanted to provide our clients with daily transparency of all the underlying holdings. We wanted clients to be able to drill down so they could see everything from top to bottom. In the end, we couldn’t find anybody who actually provided this in customer friendly software allowing genuine 100% transparency of the holdings and updated performance of their portfolio.

We were told we were probably setting ourselves up for a fall, because the consumer would then see how volatile markets were and how volatile the funds and portfolios were and they would then object to investing with us, because they’d then be able to see exactly what’s inside it. As a last resort we had to find a company to design the software we required to provide something which you would’ve thought would be commonplace, but which isn’t. The people who provided the software thought they would get other institutions to use the same software, which we designed with them. Sadly though, I’m not sure they have managed to get a second customer to date.

I have to tell you, in practice, it has worked extremely well.

We do not have the worried phone calls when markets are going to go down because clients can see what they’ve got and they’ve actually begun to understand what they’ve got. In

72

Roger Fishwick, director, Thomas Murray.

Photograph © FTSE Global Markets, supplied July 2012.

effect the transparency had given the clients the knowledge, understanding and therefore confidence in what we do.

ANDREW MAIN: It’s a bit of an indictment of the industry at large I guess. Well done.

FRANCESCA CARNEVALE: In light of these developments Andrew, how have you changed your business approaches?

ANDREW MAIN: We made some very conscious decisions not to deal directly with the public. So that’s the first decision and having decided that it now defines the process we undertake with advisors or with institutions only. We provide transparency on a daily basis to our investors. We write daily reviews to all our clients who are invested. We do daily, weeklies, monthlies; quarterlies, semi-annuals, annuals; everything and I do know my TERs by heart, actually, by share classes. Moreover, we don’t promote or do anything with the United States. It’s just too complicated. That’s a business decision too and what we have found in the last three years is that our products have become simpler because having a simple product that performs very well seems to be what people want, rather than complicated products that say: trust me. Therefore, our products have resonance with the investor; the trustee comment coming through to us is the simpler the better.

FRANCESCA CARNEVALE: Chris, you mentioned earlier on how you’d restructured the company; I wondered what benefits you’d seen from this exercise?

CHRIS SIMS: The firm has been reorganised not because of market conditions, but to become more streamlined, so that it can focus on the front office. We can focus on our fund management, on our sales team and whomever we decide to sell to. Though, additionally, as Andrew suggests, there needs to be some sensible choices about who one sells to. Reformation is an ongoing project at the moment. We are big users of derivative products so, in our selection process for the back office, there was a lot of scrutiny around the capability of the provider in the derivative space. We were also interested in their forward strategic roadmaps and their they desire to carry on supporting products because banks are—and no offence intended— all having a degree of reengineering going on. They’re not all in the same place and a lot of it is driven by the clients that they’ve taken on or the clients they think they’re going to take on. Equally, among the big global banks, the appetite for doing insourcing changes depending on who’s at the top. Certainly from an HSBC point of view, we can see that they’ve had the tap turned off for a number of years. They don’t want the tap full open and we’re sort of riding on the waves of the current openings, to a certain extent. They’ve also taken on lots of big hedge fund clients but we’ve seen other providers that you talk to that haven’t had that sort of level of commitment to the derivatives space. They’re not all in the same place.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Sid Newby, head of sales for EMEA, BNY Mellon. Photograph © FTSE Global Markets, supplied July 2012.

AN EXPLOSION OF ASSET CLASSES AND ITS IMPACT ROGER FISHWICK: We have seen an explosion in asset classes over the last few years. This is partly been driven by the fact that the equity markets have gone nowhere since 2000. If you had put your money under a mattress, you’d have been better off than just leaving it in the FTSE100 since 2000. Asset managers are pursuing alpha and trying to find assets that are uncorrelated with the equity markets and with the bond markets for that matter, because they often seem to move together right now. Actually, if you’re invested in any of the Western European equity markets, they are very highly correlated.

The hunt for uncorrelated assets and additional return has led people into the OTC derivatives market, into hedge funds, into private equity, into property and all sorts of different spaces. We’ve also seen, particularly among the pension funds in the UK, the desire to move away from a defined benefit arrangement into defined contribution models. The desire of companies to reduce risk has driven many corporate pension funds into bond and OTC derivative type portfolios that meet the cash flow demands of their liability profile. That’s been another huge change in the investment side over the last few years.

Candidly, the custodian banks were taken by surprise when the OTC derivative market first took off. They really didn’t see it coming and there was a lot of sort of running behind the trend to catch up. To their credit, they’ve now realised the issues and are tackling them. They’ve also opened their eyes and ears looking for the changing investment trends and trying to anticipate them, whereas previously they didn’t.

They’ve certainly learned the lesson of ignoring market developments and nowadays we are seeing a lot more responsiveness from the big service providers. One thing however: they still put anything that is new on its own little web portal.

So, as a customer, when you open your web reporting portal, you find on the right hand side my equities, my bonds, my cash, my FX for example. A separate reporting portal has maybe OTC derivatives and a third one has private equity and hedge funds. As a humble customer, why do I need all these portals? Just give me one which incorporates everything in a single integrated report. We still see that kind of fragmentation in the service providers’ offering because they do tend to be in product silos and the world isn’t in product silos any more.

FRANCESCA CARNEVALE: Andrew, is your service provider is still offering a fragmented product?

ANDREW MAIN: That’s a difficult one to answer because our investment process hasn’t changed for the last five years, the instruments that we have dealt in haven’t changed, and we use the same people all the time. Let me share my par-

FTSE GLOBAL MARKETS • SEPTEMBER 2012

ticular experience though: we’ve been running a renminbi (RMB) bond fund from London for five years, which meant that we were the pioneer in the market. There is a Hong Kong based RMB currency which is a bit like the euro dollar, and we wanted to introduce that as a class of shares into our RMB fund, which is domestic RMB. Working with our service provider, we very early on wanted to introduce it when legislation changed in Hong Kong and they were very quick to differentiate between the two different types of RMB, which a lot of other people, even today, can’t do.

I’d be struggling even now to do that exercise today with some houses and put it into their administration systems.

Now, for us, because we have that in place already, that’s a business advantage. We gave our service provider three to six months notice of the change, in other words, well in advance. We like to work on a consultative basis and we approach our service providers as partners in businesses and it’s an important part of my job to make sure that they know what we’re thinking three to six months in advance and what we’re trying to do in the market.

Everyone’s got expenses and if you’re asking people to remodel their computer systems, the longer the lead time you can give them to do it the better. The administrator as our business partner also enjoys a marginal advantage because we are supporting their market development however, I acknowledge that change costs service providers much more than we think in terms of overall service provision. In principle, though, I’ve found, working with people in general, especially these days, is nobody wants surprises. The biggest surprise at the moment is how the legislation will work out, how the FSA will interpret that legislation in due course because, even after Europe has decided, we then have to wait for particular the FSA’s view after consultation.

MARGARET HARWOOD-JONES: There are a lot of service elements to consider here. Firstly, as a service provider, you very often need to ask yourself: how best do I get the nuts and bolts right to deliver the value clients expect? Do I make sure there’s 100% integrity in the data I process and supply to the client? Do I prioritise very customer specific requirements built into the front end technology, and the reporting and the access that I give?

But what comes first? Is either of these examples more important than offering the consistent service delivery I am known for to all my clients? Finding the answer can be one big balancing act. Secondly, speed of response is important and needs the right reaction. Do I respond quickly and cope with the consequences? Or, do I again ensure the absolute completeness of the analysis and innovation I supply, and tell my client that it might take a little more time to provide.

In our experience, both approaches can be the right answer in different circumstances.

The third element picks up on Andrew’s comment. Together (client and service partner) we operate an end to end business model. This is a critical point. It’s not limited to a classic, often routine supplier/provider relationship. You are in this together with your clients, irrespective of where you sit within the service chain. Once we work out who does what, we can build

73

EUROPEAN ASSET SERVICING ROUNDTABLE

on that relationship and find solutions to most problems. If you have that can-do partnership mindset, you will get to the right answer more quickly (hopefully), not necessarily painlessly, but certainly with a greater chance of success. Generally, asset servicers are much better when we’re working on real life problems with clients. It’s terribly difficult to sit in splendid isolation and try and work through complexity on your own.

Few of us have a monopoly on right ideas.

ROGER FISHWICK: One of the things we’ve seen changing with the service providers is their willingness to accommodate putting their clients’ data onto their systems.

Up to a few years ago, none of the service providers would contemplate the idea that actually their system hosted the client’s data, as well as their own data. Chris, going through his outsourcing to HSBC, must be requiring them to accommodate a bigger range of Ignis/Phoenix data to meet your needs than they would’ve done in a conventional custodian relationship. They, hopefully, are keen and prepared to do that but it’s a big mindset change and you do get some of the banks saying: No, no, no, we’ve got our standards for how we look after data and it can only be the bank’s data. It can’t be the clients. I’m afraid those are the dinosaurs that will probably fall by the wayside. Equally, on the client side we have seen increased interest in asset safety post financial crisis, with many clients wanting to understand in much more detail how their assets are held by and through service providers and any inadequacies in the arrangements.

INVESTING IN CHANGE: COSTS AND CHARGES SID NEWBY: The pricing issue is a good place to start. When we talk about pricing, organisations have to really understand what the value proposition really is. Any discussion around pricing must be framed by what clients are trying to achieve, what they regard as a basic service and what they regard as additional value. In fairness, all sides are getting better at that dialogue. Often you find that clients will not question pricing; but they want transparency and clarity regarding what the service costs and increasingly a more detailed breakdown of those costs. When they can link the price they pay to how we help them achieve their goals and where we add value you produce a complete value proposition for your clients and a greater degree of transparency can result.

ROGER FISHWICK: One of the problems that the global custody service providers are facing is that their traditional business model, as it stands now, is broken. It relies on earnings from foreign exchange markets, from net interest income, and from securities lending to cross-subsidise the costs of the service provision, which are only partially met from the direct fees charged to clients. All of those three market based revenue sources have declined significantly in the last three years since the onset of the financial crisis, so now all the service providers are left with is direct fees and a small contribution from the three market based revenue sources, if the client still does securities lending. So there does need to be a fundamental re-evaluation of the business

74

Chris Sims, chief technology officer, Ignis Asset Management.

Photograph © FTSE Global Markets, supplied July 2012.

model and things now will have to pay for themselves, rather than relying on cross subsidies from other areas.

ANDREW MAIN: We find that even with our clients it is becoming (hopefully) a more doctor/patient relationship. If the client has a problem, we need to help them solve it. If it’s a reinsurance group and they’ve got a liability mismatch between portfolio and currency, or if it’s an institution that knows it has a liability in five years time, we are part of the solution process and we show them how we think we could help, just in very general terms. We’re not trying to be consultants. What we’re trying to do is just say: look, this is what we think, and here is how we could work the markets for you.

FRANCESCA CARNEVALE: But there has to be a cost to the client of doing that.

ANDREW MAIN: Well, eventually, as a manager we can employ the market to solve the problem.

SID NEWBY: And the client pays the cost?

ANDREW MAIN: Well, yes, the client pays...

ALAN MILLER: Pays directly? Yes. One of the things, rightly or wrongly, is that if a client pays a fund manager then that should include the costs in one number, rather than having almost a bank-style charging sheet. Therefore we set up managed accounts, with the philosophy that we would pay all the ad hoc or ongoing custody administration charges so that customers will always know the full costs involved.

The only variable costs are the direct trading costs, which are passed on at cost and the underlying fund costs which are revealed in full. To pass on dealing costs without a mark-up meant forcing our third party supplier to come up with a new system so that they could work this out for each client and pass it on with no profit or loss on each transaction.

Clients may understand the fixed annual management fee, but if you have a host of other charges, such as variable transaction costs, or even the costs of producing reports, they can never calculate the total - clients need transparency.

SID NEWBY: At the end of the day it’s about transparent pricing. Roger’s right: the service model is being challenged and it forces us to look at what we are providing, at what cost, and also the quality of service. Because over time, whether you’re a complex client, or a less sophisticated client, there’s scope-creep. We’ve been very open with our clients about the state of our relationships and about the profitability of those relationships.

We’ve been positively surprised by some of the conversations that we’ve chosen to conduct in a very open way with our clients. In some cases, we’ve agreed different pricing structures, which better reflects the service they’ve been provided. So service models do need to evolve on the basis of a different environment, lower interest rates, lower asset growth etc.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Alan Miller, founder and partner, SCM Private. Photograph © FTSE Global Markets, supplied July 2012.

The second point is around data. Outsourcing, five or ten years ago, was driven by different drivers, whether it was outsourcing a problem or reducing costs. Today, it’s very much around data, access to data, providing real time data etc. We see this as a great opportunity. It gives organisations like BNY Mellon an opportunity to move up the value chain, to be a data provider and to help manage risk in a more comprehensive way. One of the key areas, and it’s relevant to Chris’s project, is clients also do not want to feel tied so tightly to one bank that they can’t extricate themselves from relationships, even though we all understand the value of strong partnerships, which we’ve talked about.

So now clients are favouring solutions where they get the strength of the data connections and data driven solutions and the ability to access that data but also the opportunity to file for divorce at some point. No one wants to talk about that but it’s an important point of building our partnership – and one of the things we build into our outsourcing model is not only the ability to replicate and provide that data in real time, but also the ability for clients to switch more easily to another provider if they require.

CHRIS SIMS: Pricing models have evolved a long way.

From a fund manager’s point of view, the buy side is actually in the position now to agree a rate card where if there is any cross subsidisation they will look at the numbers and, if you’re trying to go down the expensive custody route, they will refuse to give the custody mandate.

You can’t have cross subsidisation anymore. So that has to be a rate card that works and it, effectively, does have to pay for itself. The engagement is complicated and, with the model of the business changing, what you have with your outsourced provider is a proper partnership where you’ll try to set off on the right foot but you don’t know how well it’s going to go. Having done this before at Gartmore, when we did outsourcing back in 2004, how you were doing things and why you were doing things was entirely different. In our case, it was setting a platform for a bank to use to move forward to use as a basis of the business. Now you’re not looking for that. You’re looking more for the outsourcers to take problems away from you and to help you on your way.

As Sid noted, you’re not necessarily going to want to tie yourself in for a very long term with an outsourced provider. You have to put conditions in there to get a balanced relationship going so that, if your business changes and this lump of business disappears and the rate card materially changes, or they don’t see certain flow, or they don’t see certain services then something’s got to change. We’re insulating ourselves from our outsourced supplier with a data repository layer that we’re taking as a hosted service from Bank of New York Mellon.

FTSE GLOBAL MARKETS • SEPTEMBER 2012

HOW PREPARED ARE YOU FOR 2015?

ROGER FISHWICK: Some of it’s going to be sooner than that. AIFMD comes in the middle of next year and we have been asking all major providers what their response to it is. The response from many is largely: well, we’re looking at it, but it is not yet 100% clear what the final form of the regulation will be. We are talking about something that is going to happen in a year’s time and involves a huge change in depository liabilities, a huge change in the nature and scale of the liabilities that the providers are required to take on, and many of the providers are still formulating their response to it and are not even able yet to articulate their approach or strategy.

ANDREW MAIN: Just in defence of service providers, part of the reason is they have the same problem. Nobody knows what the final rulebook is. The rulebook is not defined by the legislation. Legislation is still going through parliaments. It’s then got to be interpreted by national parliaments and, after the interpretation by the parliaments; and it’s got to be implemented by the middle of next year. It is a ludicrous situation for everyone.

SID NEWBY: Exactly.

ANDREW MAIN: There are two things: one is that timetabling itself has shrunk and two, I don’t think the regulators actually listened to the consultation. That’s the impression I have. If you take AIFMD, there was a consultation process. Depository liability was watered down in the second round of it and then it suddenly made a comeback in the third round. So who was listening then?

Politicians are setting the rulebook, and it is yet to be interpreted by the overarching regulators and the regulators set the level for the market. I was at a debate recently which was going on about whether or not depository banks, under the current regime suggested by the regulator, will actually have powers to influence what the investment manager can and cannot do. That’s well outside what the board of directors that have appointed the investment manager would accept, or expect that a depository bank will do. So, there’s still a lot to be decided.

FRANCESCA CARNEVALE: Who is leading the charge as a lobby group to help clarify these issues?

ALAN MILLER: If you think about our industry body the Investment Management Association (IMA), which I’m proud to say we are not members of, the record is appalling.

While they have an objective to improve the outcome for investors, as well as obviously help the industry, they’ve failed miserably to help consumers. They’ve lost sight of the fact that much of the asset management industry is meant to serve the man or woman on the street. It’s very hard then for them to actually lobby for the industry when they condone shoddy practices by many of their members.

Actually, I think it is a good thing that European regulators and the European parliament, increasingly do not, if you like, take the advice of these lobby groups with the same degree of seriousness that it might’ve done only a number of years ago. Look, if the bankers’ association lobbied for something right now, what chance would it have? I’d have

75

EUROPEAN ASSET SERVICING ROUNDTABLE

said it was quite low; and I think it is the same with the IMA. The fact is that the IMA has, for years, managed to regularly misclassify funds in which consumers have trusted the label and lost consumers huge amounts of money. This is an absolute scandal and, until those trade bodies, like the ABI, like the IMA and the BBA actually, look at the whole picture in terms of consumers, rather than their own self-interest, lobbying will have less and less power with legislators. That’s probably one of the reasons why the recent lobbying by the hedge fund industry probably seriously backfired and is likely to make it harder for other organisations going forward. Now that might be a good thing, given my comments above.

FRANCESCA CARNEVALE: Is this true? I wondered whether there were coordinated industry initiatives underway, to help enlighten legislators as to the market impact or day to day practicalities of various elements of regulation?

ALAN MILLER: I’ll give you one example. We produced research as long ago as last September about the widespread securities lending in the UK mutual fund industry and the levels of reporting and transparency, the shockingly poor level of controls within the FSA rules. We saw representatives with the Bank of England. We saw people within Europe. Earlier this year, ESMA has produced a recommendation that securities lending income should be returned to the investors in the fund and there is a MIFID amendment which would force securities lending income net of all direct costs to go to investors within the fund. Now, we’re yet to meet anyone regarding our recommendations from the FSA. So the Bank of England has taken it seriously. Europe is taking it seriously and there could be a complete overhaul, if you like, of many fund management groups which are receiving large amounts of income and, basically, lending out securities where they have no downside in terms of the risks attached. They only take a share of the upside.

CHRIS SIMS: In my experience, and certainly in my previous place, the benefits of the securities lending for the mutual funds were going to go straight back into the fund.

ALAN MILLER: No, the FSA rules are that as long as some of the income—and it doesn’t actually specify a minimum— goes back to the holders of the fund then it’s acceptable. In terms of collateral, it says simply there must be a minimum of 100%. It doesn’t give precise collateral for different types of assets. So it doesn’t state whether the counterparties have to possess a precise minimum credit rating.

CHRIS SIMS: So we’re into whatever practices individual fund managers are up to? I wasn’t aware of the level of exactly what the rules say and, if it’s open to abuse, I suspect it’s being abused.

ALAN MILLER: Exactly, and you’ll only see it normally in the annual prospectus, if it’s revealed. Many are not online so you have to request it. So most retail investors will not be aware their funds could be lent up to 100% to people they don’t know, in return for some form of unknown collateral.

SID NEWBY: I wouldn’t like people to be left with the opinion that we’re not, as an industry, trying to change things and shape regulations. We have employed several senior people in local markets engaging full time with regulators. We work

76

with and on behalf of our clients, in many instances collaborating with other service providers, or industry bodies in producing joint communiqués about these pressure points in the industry. In some cases, we’ve had successes. In others it doesn’t seem to have had the desired impact yet, but there is collaboration within the industry to try and reflect client views.

One of the challenges is that sometimes the interests of different groups within the financial markets diverge but there certainly is significant effort and costs being spent trying to influence regulators on behalf of our clients.

MARGARET HARWOOD-JONES: We have a global team that is wholly dedicated to this. Of note is that they are not based just at head office but across our European network, and in Asia and are mandated on a worldwide basis. They are business practitioners, with the knowledge and expertise and an appreciation of best market practice today, and strong understanding of the risks and the issues. We work energetically to bring that experience to bear positively on the regulators thinking, at the transnational European level and in individual countries, on behalf of the bank and on behalf of clients. A successful dialogue with regulators does involve a huge amount of work with clients to ensure we appreciate their valuable opinion in the effort we undertake For me, it’s about broad collaboration. It’s not just one lobbyist going to one party. There are so many moving pieces. It is an incredibly complex area to try and navigate successfully which is perhaps, listening to you Alan, why there are examples where it clearly isn’t working as well as it might. Equally though, there are examples where it does work and where the industry is trying to apply common sense and a little bit more consistency than would otherwise happen if it wasn’t going on. Clients absolutely expect us to do that and I guess for all of us, no matter where or who you are, you do your best: So, again, that is something that we work really hard to get right on a day to day basis.

FRANCESCA CARNEVALE: This is tricky ground isn’t it Margaret? Who does the service provider try to protect: the end investor, or your client? How do you bring your expertise to bear on the problems?

MARGARET HARWOOD-JONES: It is a question that is almost impossible to answer because it is, in a way, a client by client experience. It depends on the profile and the type of the client, particularly where their priorities and their focus may be, and then how that matches, for example, with the knowledge and expertise that we have.

ROGER FISHWICK: I’ve been to a number of the banks regulatory forums, and discussions about who they impact, why and how soon is very prevalent, particularly over the last couple of years, because so much is going on. I certainly echo Margaret’s point that the banks put a lot of energy and effort into this. Perhaps kind of harking back to your earlier point Alan, that where it may be going wrong a bit, particularly with the European level regulators, is that the banks themselves don’t act together enough as a body in Europe.

They’re all trying to influence events and lobby individually, rather than trying to do it collectively. That’s just the impression I have.

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

Andrew Main, managing partner, Stratton Street Capital.

Photograph © FTSE Global Markets, supplied July 2012.

MARGARET HARWOOD-JONES: I must interject. We talk about Europe, but let’s are clear; Europe is not a single market. Let’s be clear, Europe is not a single culture. So, in order to be successful, you have to be absolutely switched on and appreciate the nuances and the differences that you’re facing country by country.

OUT OF THE MORASS: WHERE IS NEW OPPORTUNITY? CHRIS SIMS: Obviously, I’m in operations and IT so the glass is always half full for me. From an ops and IT point of view, if you’re after work to do, it is an exciting time. It’s an interesting time. There is an enormous amount of work to do there. I complain about having ESMA stuff to change or to work out how to do but I’d rather be doing work than not be doing work. From a point of view of being in the industry, it is very difficult to actually say that fund management and investment management has done the things and treated the consumers right. If you’re actually a consumer, you say it’s far too confusing for people. That’s obviously with my personal hat on, rather than my Ignis hat on. The number of conversations I’ve been involved in over the years, where you’re actually having the conversation about will Granny in Bristol understand what she’s buying, are we selling the right things, it’s still not written down in words of one syllable that people can actually understand.

ANDREW MAIN: I’m in the exciting group. The world is changing quite dramatically. The way funds are managed, going boutique versus large group; and we’ve very much anchored our mast to the boutique model. My analogy is always that we like to be the Cosworth engine inside the body of whoever would like to distribute our products.

We do our own funds, but we advise and produce funds for other people. I’m very excited about it because there is a great role out there for us to play. As long as you’re passionate, believe in your investment process and people understand your investment process and how it works and they’re happy with it, it’s great.

MARGARET HARWOOD-JONES: To have the opportunity to shape, to participate in the huge amount of change that is right in front of us and all around us is very motivating; it is obviously a highly challenging place to be but one that’s full of opportunity. Frankly, I don’t think we have ever been busier. The amount of demands, requests coming from all over, from clients, from external market, from the organisation itself, is huge. So that gives vibrancy and sets a pace for the organisation. Without that some of the necessary urgency just wouldn’t be there. So, if you can navigate that successfully, with the best interests of your

FTSE GLOBAL MARKETS • SEPTEMBER 2012

clients, your staff and your shareholders front of mind, then it’s a privilege to have such a responsibility in such a dynamic period of time. So, yes, there’s a lot of work to do but I’m optimistic that, together, we’ll get to the right place as we go forward.

SID NEWBY: Our industry is at an inflection point which it probably only sees every generation or so and we’re all reacting to it. However, as a service provider, it gives us a superb opportunity to become part of the new world that is emerging. I’ve heard the word partnership a number of times now and we certainly feel that clients want to get closer, want to become more strategic, and we see that as a great opportunity, notwithstanding all of the challenges we’ve talked about. I also agree with Margaret, in that we have never seen so much activity from existing clients. Our pipeline has never been as diverse as it is now, and it is driven by many of the same factors that we’ve talked about today. So we’re very bullish. I think in this regard, it will eventually separate banks such as our from those that are not fully committed to the investment services industry and who no longer think it is a core focus for them.

ALAN MILLER: There is a huge opportunity in our industry, as the large fund management companies are behaving like dinosaurs. The consumer now knows, thanks to the Internet, thanks to more information, they have been ripped off. So they actually demand more. For the industry to grow, and there is huge potential growth, it needs to change fundamentally in terms of transparency, in terms of revealing in full how much it’s costing, where it’s invested and, if they do that, they will improve the reputation, earn substantially more revenues and make substantially more money. Unfortunately, the large companies will become akin to insurance companies in ‘run-off’ because a lot of the large companies are not prepared to sacrifice some of the high margins they’re currently getting and they will just decline year by year by year. They are likely to be replaced by either other large companies who are more modern and progressive or smaller boutiques who strive to be more consumer-focused and are more flexible and able to respond to customer demands.

ROGER FISHWICK: In the fund management world, the multi boutique way forward seems to be one of the trends and that’s going to give rise to a lot of product innovation, which has got to be good for the industry and for consumers. People are becoming much more financially literate than they were ten or 15 years ago and are much more wary about what they buy and explore what they buy in a lot more detail. The days of people just accepting recommendations from“experts”without critically examining them and querying them are coming to an end. The technology we see building around us—such as cloud computing and putting information on your tablet instantaneously, all of that—is certainly helping with transparency. People like Alan, pushing on transparency of costs and fees, which is something that Thomas Murray pushes for in the entire service provider reviews it assists clients with, all of these things have got to be good for consumers and for the industry. We are going to see lots and lots more innovation and it’s going to be great. I

77

(Week ending 10 August 2012) Reference Entity

Federative Republic of Brazil Republic of Italy United Mexican States Republic of Turkey Russian Federation Bank of America Corporation Republic of Korea Kingdom of Spain People’s Republic of China Morgan Stanley

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Financials Government Government Government Financials

Sov Sov Sov Sov Sov Corp Sov Sov Sov Corp

18,903,753,128 20,342,553,756 9,096,795,163 6,235,547,819 4,208,997,461 4,938,874,072 6,907,838,989 13,489,656,211 9,400,477,055 4,719,325,995

169,231,304,134 339,739,094,612 124,722,932,758 139,421,608,507 111,437,869,537 77,112,732,800 78,326,098,525 180,395,555,665 71,561,783,473 77,608,716,950

10,885 10,700 9,371 9,267 8,991 8,874 8,823 8,162 8,026 7,917

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

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

23,172,743,785 22,195,424,669 20,342,553,756 18,903,753,128 13,489,656,211 11,323,080,131 11,035,508,590 10,293,998,295 9,400,477,055 9,096,795,163

153,563,690,549 132,192,132,162 339,739,094,612 169,231,304,134 180,395,555,665 70,641,505,388 65,781,895,795 84,193,225,469 71,561,783,473 124,722,932,758

6,861 5,306 10,700 10,885 8,162 6,858 4,353 6,723 8,026 9,371

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

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

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 10 August 2012)

(Week ending 10 August 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Corporate: Financials

3,173,374,784,271

455,268

Kingdom of Spain

4,963,336,648

281

Sovereign / State Bodies

2,861,837,497,061

216,683

French Republic

3,926,854,681

259

Corporate: Consumer Services

1,757,820,773,874

313,051

Federal Republic of Germany

2,741,644,416

157 145

Gross Notional (USD EQ)

Contracts

Corporate: Consumer Goods

1,715,604,205,964

294,341

Republic of Italy

2,664,223,327

Corporate: Industrials

1,112,984,052,902

201,912

Federative Republic of Brazil

1,820,490,000

211

882,536,346,332

152,622

MGIC Investment Corporation

1,236,508,317

224

Corporate: Telecommunications Services 813,945,849,503

133,339

Radian Group Inc.

1,182,507,465

203 182

Corporate: Basic Materials Corporate: Utilities

676,006,834,850

117,042

MBIA Insurance Corporation

1,161,300,000

Corporate: Energy

508,317,448,642

94,566

Bank of America Corporation

1,115,980,000

131

Corporate: Technology

361,089,024,320

67,306

Republic of Turkey

1,100,125,000

119

Corporate: Healthcare

326,481,473,228

59,887

Corporate: Other

140,815,321,079

16,299

Residential Mortgage Backed Securities

37,920,905,841

7,190

CDS on Loans

34,667,750,887

9,578

Commercial Mortgage Backed Securities 12,433,138,026

1,335

Residential Mortgage Backed Securities*

7,356,659,387

472

CDS on Loans European

3,032,809,872

529

Muni: Government

1,186,700,000

117

Other

865,134,591

76

Commercial Mortgage Backed Securities*

538,926,806

47

Muni: Utilities

11,400,000

3

*European

FTSE GLOBAL MARKETS • SEPTEMBER 2012

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

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

79

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

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

140

120

100

80

60

2 Ju l1

12

Ap r12

Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

0

Oc t1

Ju l1

10

Ap r10

Ja n-

Oc t09

Ju l09

09

Ap r09

Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

Oc t0

7

40 Ju l07

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 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

80

60

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

7 Oc t0

Ju l07

40

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

FTSE Global Government Bond Index

FTSE Global Infrastructure Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

FTSE Physical Industrial Metals Index

250 200 150 100 50

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

Ap r08

n08 Ja

7 Oc t0

Ju l07

0

Source: FTSE, data as at 31 July 2012.

80

SEPTEMBER 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (31 July 2007 = 100) FTSE US TM Index

FTSE All-World ex USA Index

FTSE USA Index

120

100

80

60

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

0

Oc t1

Ju l1

10

Ap r10

Ja n-

Oc t09

Ju l09

09

Ap r09

Ja n-

Oc t08

Ju l08

8

Ap r08

7

Ja n0

Oc t0

Ju l07

40

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

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

140 120 100 80 60

Ju l1 Ju l1

2

Ap r12

Ja nJa n-

Ap r12

Oc t11 Oc t11

12

Ju l11 Ju l11

1

Ap r11 Ap r11

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

7 Oc t0

Ju l07

40

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

FTSE EPRA/NAREIT North America Index

FTSE Renaissance IPO Composite Index

160 140 120 100 80 60 40

2

12

1

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

n0 Ja

Oc t07

Ju l07

20

Source: FTSE, data as at 31 July 2012.

FTSE GLOBAL MARKETS • SEPTEMBER 2012

81

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

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

120

100

80

60

40

2 Ju l1

12

Ap r12

Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

0

Oc t1

Ju l1

10

Ap r10

Ja n-

Oc t09

Ju l09

09

Ap r09

Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

Oc t0

7

20 Ju l07

MARKET DATA BY FTSE RESEARCH

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (31 July 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

80

60

40

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

1

Ap r11

Ja n1

0 Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

7 Oc t0

Ju l07

20

Middle East and Africa View 5-year Performance Graph (Total Return) Index level rebased (31 July 2007 = 100) FTSE JSE Top 40 Index (ZAR)

FTSE Middle East & Africa Index (USD)

FTSE CSE Morocco All-Liquid Index (MAD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

160 140 120 100 80 60 40

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

Ap r11

1

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

n0 Ja

7 Oc t0

Ju l07

20

Source: FTSE, data as at 31 July 2012.

82

SEPTEMBER 2012 • FTSE GLOBAL MARKETS

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

2 Ju l1

12

Ap r12

Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

0

Oc t1

Ju l1

10

Ap r10

Ja n-

Oc t09

Ju l09

09

Ap r09

Ja n-

Oc t08

Ju l08

8

Ap r08

7

Ja n0

Oc t0

Ju l07

40

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

FTSE China 25 Index

FTSE Greater China Index

FTSE Renaissance Hong Kong/China Top IPO Index

160 140 120 100 80 60 40

2 Ju l1

Ap r12

12 Ja n-

Oc t11

Ju l11

1

Ap r11

0

Ja n1

Oc t1

0 Ju l1

Ap r10

10 Ja n-

Oc t09

Ju l09

Ap r09

09 Ja n-

Oc t08

Ju l08

8

Ap r08

Ja n0

7 Oc t0

Ju l07

20

ASEAN Equities View 3-year Performance Graph (USD Total Return) Index level rebased (31 July 2009 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

250

200

150

100

2 Ju l1

12 M ay -

M ar -1 2

Ja n12

11 ov N

-1 1 Se p

Ju l11

1 M ay -1

M ar -1 1

11 Ja n-

10 N ov -

Se p10

Ju l10

ay -1 0 M

ar -1 0 M

-1 0 Ja n

N ov -0 9

Se p09

Ju l09

50

Source: FTSE, data as at 31 July 2012.

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2012

83

INDEX CALENDAR

Index Reviews September 2012 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

Early Sep

ATX

04-Sep

FTSE Global Equity Index Series (incl. FTSE All-World)_

Semi-annual review / number of shares

28-Sep

31-Aug

Annual review / Japan

21-Sep

29-Jun

04-Sep 07-Sep

FTSE China Index Series

Quarterly review

21-Sep

20-Aug

AEX

Periodic review

21-Sep

07-Sep

31-Jul

BEL 20

Quarterly review

21-Sep

31-Jul

07-Sep

PSI 20

Quarterly review

21-Sep

31-Jul

07-Sep

S&P / ASX Indices

Quarterly review - shares, S&P / ASX 300 consituents

21-Sep

26-Aug

07-Sep

CAC 40

Annual review of free float & Quarterly Review 16-Sep

31-Aug

07-Sep

DAX

Quarterly review/ Ordinary adjustment

21-Sep

31-Aug

07-Sep

FTSE Vietnam Index Series

Quarterly review

21-Sep

31-Aug

07-Sep

S&P US Indices

Quarterly review - shares & IWF

21-Sep

31-Aug

07-Sep

TOPIX

Monthly review additions & free float adjustment

27-Sep

31-Aug

11-Sep

FTSE MIB Index

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE Global Equity Index Series (incl. FTSE All-World)_

Annual review / Developed Europe

21-Sep

29-Jun

12-Sep

FTSE Multinational

Annual review

21-Sep

29-Jun

12-Sep

FTSE JSE All-Africa Index Series

Quarterly review

21-Sep

17-Aug

12-Sep

FTSE JSE Index Series

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE AIM Index Series

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE ASFA Australia Index Series

Semi-annual review

21-Sep

31-Aug

12-Sep

FTSE ECPI Index Series

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE European Index Series

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE Italia Index Series

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE Nordic Series

Semi-annual review

21-Sep

31-Aug

12-Sep

NZX 50

Quarterly review

21-Sep

31-Aug

12-Sep

FTSE UK Index Series

Quarterly review

21-Sep

11-Sep

13-Sep

Dow Jones Global Indexes

Quarterly review

21-Sep

31-Aug

13-Sep

DJ Global Titans 50

Quarterly review - no composition changes only rebalance/shares/float changes

21-Sep

31-Aug

13-Sep

FTSE EPRA/NAREIT Global Real Estate Index Series

Annual review

21-Sep

31-Aug

13-Sep

FTSE ST Index Series

Semi-annual review

21-Sep

31-Aug

14-Sep

FTSE IDFC India Infrastructure Index Series

Semi-annual review

21-Sep

31-Aug

14-Sep

FTSE TWSE Taiwan Index Series

Quarterly review

21-Sep

31-Aug

14-Sep

FTSE Shariah Global Equity Index Series

Quarterly review

21-Sep

31-Aug

14-Sep

S&P Asia 50

Quarterly review - shares & IWF

21-Sep

31-Aug

14-Sep

S&P Europe 350 / S&P Euro

Quarterly review - shares & IWF

21-Sep

31-Aug

14-Sep

S&P Topix 150

Quarterly review - shares & IWF

21-Sep

31-Aug

14-Sep

S&P Latin 40

Quarterly review

21-Sep

31-Aug

14-Sep

S&P Global 1200

Quarterly review - shares & IWF

21-Sep

31-Aug

14-Sep

S&P Global 100

Quarterly review - shares & IWF

21-Sep

31-Aug

14-Sep

FTSE4Good Index Series

Semi-annual review

21-Sep

31-Aug

14-Sep

Russell Global Indices

Quarterly review - IPO additions

28-Sep

31-Aug

14-Sep

Russell US Indices

Quarterly review - IPO additions

28-Sep

31-Aug

Early Oct

S&P / TSX

Quarterly review - constiuents, shares & IWF

19-Oct

30-Sep

05-Oct

TOPIX

Monthly review - additions & free float adjustment30-Oct

28-Sep

05-Oct

TOPIX

Annual review - constiuents

31-Aug

30-Oct

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

84

SEPTEMBER 2012 • FTSE GLOBAL MARKETS