FTSE Global Markets by FTSE Global Markets

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) NEW MEDIA MANAGER: Andrew Neil T: +44 [0]20 680 5151 | E: andrew.neil@berlinguer.com HEAD OF NEW MEDIA: Alex Santos T: +44 [0]20 680 5161 | E: alex.santos@berlinguer.com PRODUCTION MANAGER: Lee Dove – Alphaprint 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: James Cooper T: +44 [0]20 7680 5156 | E: james.cooper@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) EVENTS MANAGER: Lee Michael White T: +44 [0]20 7680 5153 | E: lee.white@berlinguer.com FINANCE MANAGER: Tessa Lewis T: +44 [0]20 7680 5159 | E: tessa.lewis@berlinguer.com RESEARCH: Lydia Koh: Lydia.Koh@berlinguer.com | T: +44 [0]20 7680 5154 Oliver Worsley Gorter: OliverWG@berlinguer.com | Tel: +44 (0) 207 680 5157 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 • OCTOBER 2012

HIS FINAL QUARTER will determine the complexion of 2013. As our cover story suggests, if the ECB’s OMT programme (read last roll of the dice) fails to contain the growing unease over Spain, then all bets are off and we will all be caught in yet another rollercoaster year. Ratings agency Standard & Poors’ did all it could to raise hackles early October by demoting Spain to one point above junk status. Thankfully the markets did not go into overdrive. September showed promising signs of hope.“As the OMT programme gave yield-hungry investors the confidence to plough money back into riskier assets and issuers seized the opportunity to lock into cheap debt, investment-grade issuance in Europe in September had passed €35bn with a week to go, while the third week of the month saw flows into high-yield exceed €2bn for the first time. Even corporate issuers from Spain and Italy—including Repsol, Iberdrola, and Telecom Italia—were able to join the party,”writes Andrew Cavenagh. The general feeling is, that if the ECB can keep a lid on things over this last quarter the rest of the market might just take a positive step; though that might just be wishful thinking trumping reality. A two-way bet: it is clear that we are on the cusp of change. Either we continue to descend into a global funk; or we grab every opportunity to look hard at what we do and make a positive change for the better. Everywhere you look people are talking about change in a positive light. Among our trading coverage this month is a small piece on plans to change the settlement cycle from T+3 to first T+2 and at some point in the future T+1; which actually has big implications. We will look at the debate around settlement in greater depth in the next edition; however we provide a taster with a first look at the result of a new survey from the Boston Consulting Group, commissioned by the US Depositary Trust and Clearing Corporation (DTCC), which has polled both the sell side and buy side and finds that most respondents think that the proposed change is a good thing. We will keep you posted on developments. Elsewhere, we are now on the third leg of our own quarterly survey of asset managers in the Middle East and North Africa (MENA) through 2012, which is undertaken in conjunction with the Qatar Financial Centre. The results of this third survey bring into vivid relief the adverse impact that civil unrest in Syria is having on investor approaches to both Jordan and Lebanon. In contrast, investors largely continue positive about investment risk in Saudi Arabia, South America and Africa. Meantime, Bahrain and Egypt continue to feel the repercussions of the 2011 Arab Spring, with Dubai the immediate beneficiary investors as corporations have uprooted and moved to the UAE. The survey also throws up interesting news for international providers of securities services in the MENA region. HSBC emerges as a clear regional front-runner among the 83 investors polled. The survey shows that investors in the MENA are looking increasingly to the region itself for investment returns. While Asia looks to be growing in popularity, there is no escaping the concentration of attention on local/regional investment opportunities. The results are consistent with the findings of the April survey, which also registered growing investor interest in both Asia and Africa. In stark contrast, Europe, Jordan, and Lebanon remain the poor relations in terms of investor sentiment.

Francesca Carnevale, Editor, October 2012 Spanish prime minister Mariano Rajoy speaks at the press-conference with Angela Merkel during her working visit at the Moncloa Palace, Madrid. The Spanish prime minister Mariano Rajoy and the German Chancellor Angela Merkel give a press-conference at Moncloa Palace after the working visit of Angela Merkel in Madrid explaining common plans to re-enforce the eurozone. Photograph by Matthias Oesterle for Demotix. Photograph supplied by PressAssociationimages, September 2012.

COntents COVER STORY

SPAIN THREATENS TO UP-END ECB’S OMT

..........................................................Page 6 Intervention by the European Central Bank and the US Federal Reserve in early September gave bond markets on both sides of the Atlantic the desired boost; bond spreads tightened and primary issuance surged. However, the crisis in Spain upended any of the good within days. Can OECD central banks produce a lasting period of normality in the markets? Andrew Cavenagh reports.

DEPARTMENTS

MARKET LEADER

TESTING THE BAR FOR CAPITAL REFORM OF THE TRADING BOOK ..Page 12 Can the capital regime for the Trading Book be re-written?

DO NEW CCP ENTRANTS COMPLICATE MARKET STRUCTURES ..Page 16 The benefits, or otherwise, of tri-party collateral management structures.

IN THE MARKETS

TOWARDS EFFECTIVE MIDDLE MARKET TRADING STRATEGIES ..Page 17 Why mid cap stocks are sensitive to institutional-sized orders.

THE IMPLICATIONS OF DODD FRANK FOR HEDGE FUNDS ............Page 23 Will hedge funds find compliance too difficult?

SPOTLIGHT

VANGUARD AGREES INDEX MANDATE WITH FTSE GROUP .........Page 22

THE BEAR VIEW

LOOKING FOR EVIDENCE TO CARRY ON ...................................................Page 24

INDEX REVIEW

LATEST CHANGES TO FTSE’S COUNTRY CLASSIFICATION

TRADING POST

IT IS CREDIT RISK; BUT NOT AS WE KNOW IT .........................................Page 26

FX VIEW

THREE WAYS INTO RMB .........................................................................................Page 27

DERIVATIVES

LOW INTEREST RATES IMPACT PENSION FUND HEDGING STRATEGIES ..Page 29

DEBT REPORT 2

FTSE Group becomes index provider for six Vanguard international equity funds.

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

.............Page 25 Argentina and Mongolia mark the changes in FTSE’s country classification review.

Bill Hodgson asks whether central clearing mitigates credit risk in all circumstances.

Why it is time to plunge into the Chinese currency.

Complexity and costs can limit a fund’s options writes Dan Barnes.

SHOULD YOU BE IN OR OUT OF MTNS? .....................................................Page 32 Neil O Hara explains why the euro crisis will change the MTN market forever.

OCTOBER 2012 • FTSE GLOBAL MARKETS

If you’re ahead of the game,

you’ll know all about Brazil.

If you know about Brazil, you’ll choose

the bank that’s always out in front.

COntents LOW INTEREST RATES IMPACT PENSION FUND HEDGING STRATEGIES ..Page 29 Complexity and costs can limit a fund’s options writes Dan Barnes.

ARE YOU IN OR OUT OF MTNS?

............................................................................Page 32 The eurozone crisis has changed the MTN market forever: so should investors buy?

T2S – EUROPE’S GAME CHANGER

SIBOS REPORT

......................................................................Page 36 Mark Gem, Clearstream board member, outlines the key issues.

FACE TO FACE WITH SATVINDER SINGH, DEUTSCHE BANK

..........Page 40 Transaction banking is in flux: who wins, who loses in the new world order?

TOWARDS A GLOBAL VIEW OF COLLATERAL MANAGEMENT

..Page 43

eSecLending’s Matt Gagne outlines the issues facing beneficial owners.

CUTOVER TO NEW UK REGULATIONS

..............................................................Page 46 Law firm Stephenson Harwood ticks the boxes on new incoming market rules.

FEATURES

IN CONVERSATION WITH

....................................................................................Page 48 Laurence Bailey, chief executive officer, Asia-Pacific, JPMorgan WSS discusses Asia’s new business trends and argues for a more holistic approach to asset servicing in the region. Clients are demanding more than custody services right now, and looking for custodians to provide them with help in reducing risk, increasing revenue and enhancing operational efficiency

ARE IFAS UNDER THREAT?

................................................................................Page 52 New regulation in Europe looks to review commissions. What does it mean for investment funds advisors? Lynn Strongin Dodds reports on a community that increasingly feels itself under threat.

MENA ASSET MANAGEMENT SURVEY ........................................................Page 53 The third round of this year’s ongoing survey of asset managers in the MENA region finds growing bifurcation in investment approaches. Political unrest continues to impact selected markets, with Lebanon, Jordan, even Kuwait feeling the investor pinch. Bahrain and Egypt too continue to feel the repercussions of the Arab Spring. In contrast, investors are more optimistic about Saudi Arabia, Qatar and the UAE as well as South America and Africa. What are the drivers of change?

IS IT TIME FOR A NEW US SETTLEMENT CYCLE ......................................Page 60 The DTCC recently commissioned a study from the Boston Consulting Group. It polled and interviewed hundreds of investors, traders and brokers to find out what they thought about potential changes in the post trade settlement cycle; lowering it from its traditional hook of T+3. The study suggests it’s time for a change.

SECURITIES LENDING ..............................................................................................Page 62 Lenders of securities remain a highly risk averse bunch. Accordingly providers of securities lending services must now bring to the table a fair amount of dexterity in order to keep beneficial owners in the loop and feeling confident about the service. David Simons reports.

TRANSACTION COST ANALYSIS ........................................................................Page 66 Classic comparisons of trades against benchmarks are being expanded; thanks to technology. Even the reasons for the buy side to utilise TCA have changed. That’s because in difficult markets, traders and portfolio managers are looking for any margin they can squeeze out of their performance. Ruth Hughes Liley reports on the trends.

PRIME SERVICES ........................................................................................................Page 70 Capital and liquidity remain focal points for prime brokers and clients. However, reduced volume and perpetually thin margins weigh heavily on primes. Dave Simons reports.

DATA PAGES 4

DTCC Credit Default Swaps analysis ..............................................................................................Page 73 Market Reports by FTSE Research................................................................................................................Page 74

OCTOBER 2012 • FTSE GLOBAL MARKETS

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

Cover story

ECB INTERVENTION: PALLIATIVE OR BETTER? President of the European Central Bank (ECB) Mario Draghi, centre, is guided by the president of the Umbrella Association of German Industry, BDI, Hans-Peter Keitel, right, to attend the annual meeting of the BDI in Berlin, Germany, Tuesday, September 25th 2012. Photograph by Michael Sohn for Associated Press. Photograph supplied by PressAssociationImages, September 2012.

Spain will test investor I hope in ECB’s debt purchase commitments The most spectacular market intervention yet by the European Central Bank and the US Federal Reserve in early September gave bond markets on both sides of the Atlantic the predictable—and desired—boost. In the immediate wake of the two central banks’ respective announcements, spreads tightened and primary issuance surged. Will these latest initiatives really produce a more lasting period of normality in the markets? Or, are they a temporary palliative in the ECB’s efforts to restore order? Andrew Cavenagh reports.

T IS CLEAR that the scale of the market response to the ECB’s conditional commitment to buy “unlimited”amounts of the short-dated (one- to three-year) sovereign debt of beleaguered eurozone countries though a programme of Outright Monetary Transactions (OMT) and the US Federal Reserve Bank’s (the Fed’s) third round of quantitative easing (QE), which will inject further liquidity into the system by buying $40bn of mortgage-backed securities a month for an unlimited period, has given market optimists grounds for hope. The OMT programme has given yield-hungry investors the confidence to plough money back into riskier assets. Issuers too have seized the opportunity to lock into cheap debt.

OCTOBER 2012 • FTSE GLOBAL MARKETS

Investment-grade issuance in Europe in September had passed €35bn with a week to go, while the third week of the month saw flows into high-yield exceed €2bn for the first time. Even corporate issuers from Spain and Italy—including Repsol, Iberdrola, and Telecom Italia— were able to join the party. There may have been an element of striking while the iron is hot to all the European activity, however, as the true efficacy of the ECB’s initiative may well be put to the test quite soon. For there is a good chance that the ECB will need to start making purchases under the OMT well before the end of October to avert a funding crisis in Spain. If investor worries start to escalate again through the fall, it would rapidly take anxiety over the future of the single currency to levels not yet seen. It became clear by late September that Spain has once more become the main focus of eurozone concerns. The Spanish government will have to refinance €20bn of maturing debt in the second half of October (and €180bn over the next year). There is considerable doubt that it will be able to do so at an affordable price without the backing of the OMT. Despite ECB protestations to the contrary, there is the possibility that the sheer scale of support required will put the OMT to a very severe test of ECB nerve. For a key condition of the ECB buying sovereign bonds under the programme (whether Spanish debt or that of any other eurozone country) is that the government concerned first applies for a formal EU bail-out from the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM), which is due to replace the EFSF at the end of October. Without this crucial stipulation, the ECB would never have secured the essential backing of the German Bundesbank for the initiative. In all previous instances where the EU has provided such support (to Greece, Portugal, and Ireland), however, the aid has been accompanied by rigorous demands (and targets) for fiscal-deficit reductions and the

FTSE GLOBAL MARKETS • OCTOBER 2012

implementation of attendant structural economic reforms. This of course, is invariably backed up with an unstated threat that aid will be withheld if any countries fail to meet these conditions. Actually, any such conditions will, in practice, be politically impossible for the government of premier Mariano Rajoy Brey to accept, particularly given the truly parlous state of the Spanish economy. With unemployment around 25%, the country’s banking system in need of recapitalisation to the tune of at least €100bn, and the imminent prospect of ratings agency Moody’s downgrading the country’s sovereign rating to junk, no government could countenance the imposition of further austerity measures on the country’s suffering—and increasingly volatile—population.

Prolonged depression It is hard to see how additional cuts in state spending and/or tax increases could fail to push the country into a prolonged depression. Moreover, if by popular demand the government is pushed out of office. “Anything that would create even more unemployment would go down like a lead balloon,”confirms Marc Ostwald, bond strategist at Monument Securities. The lead going down might well not just be figurative, either. Social unrest and internal division in Spain has already reached alarming levels, with the regional government of Catalonia threatening to attempt secession from the kingdom. The threat of disestablishment of the state has led most economists to conclude that Rajoy Brey’s government will not realistically be able to meet existing commitments on deficit reductions in the near term. These reductions are supposed to see the annual shortfall come down to 6.3% of GDP this year, 4.5% in 2013, and 2.8% in 2014. So although the widespread belief is that Spain will endeavour to agree terms for an EFSF/ESM rescue package at the meeting of EU leaders on October 18th and 19th (if not before) its ability to do so will depend on

Germany consenting to much more relaxed and flexible bail-out terms than those on which it has insisted up to this point. Spain would have to be allowed to run considerably larger budget deficits in the medium term to buy the necessary time for (long overdue) reforms to work and ultimately enable the country’s economy to grow its way out of trouble. While there have been some signs in the past few weeks that German Chancellor Angela Merkel and the Bundesbank are starting to place more emphasis on reforms than meeting annual deficit-reduction targets, whether they are prepared to go far enough on this score to meet Spain’s needs remains to be seen. If they are not, however, the“eurozone risk”in the markets will be “back on” to a much greater extent than before. “Until they have decided that they will tolerate larger deficits, the risk of Spain leaving the union is real and the sovereign crisis will persist,”concluded the bond markets team at the international research firm CreditSights in a recent note. Unless the terms of a bail-out allow Spain to run larger—and crucially— flexible deficits, the markets could have no confidence that the OMT support would not be withdrawn the moment the country failed to meet any of the prescribed terms or deadlines. If bond investors do not receive the assurance they need on that score, they will simply use the ECB programme to offload any current holdings of Spanish debt they still possess. At a stroke, the objective of the programme—to enable Spain and other eurozone countries in difficulty to continue accessing the capital markets at a sustainable cost—would be undone. Ostwald at Monument says these cross-border political considerations are the second aspect of the OMT programme that “differentiated it very substantially” from the quantitativeeasing initiatives taken by the US Fed, the Bank of England, and the Bank of Japan; the first being the fact that it was a ‘fully sterilised’ initiative that

Sponsored statement

Expansion and Divergence of the Transition Management Offering Author: Nell Axelrod, J.P. Morgan Transition Management Team

HE INVESTMENT INDUSTRY has witnessed the transition management service change from one focused on project management and crossing to a sophisticated offering that emphasises minimising the overall financial impact to client portfolios. This approach to managing risks is now the norm, as outlined in the T-Charter1, and one that all transition management providers are expected to follow. In recent years however, transition management has undergone a second, quieter evolution where some providers have leveraged their risk management and trade execution skills to offer additional services beyond single transactional portfolio restructures. We now see a divergence among transition managers, with some providing the core portfolio restructure services, and others providing a more complete range of related services. We’ve outlined below a number of these enhanced transition management services.

Risk measurement & management services Significant investment decisions are made on a regular basis through formalised asset liability

studies and manager reviews. These rigorous studies can often result in the major portfolio restructures that transition managers are asked to undertake. A subset of transition managers now offers interim risk management services that help bridge the gap between these studies. When an asset manager is terminated, transition managers can neutralise an active portfolio so passive exposure is provided with minimal market trading. On a macro level, by using futures, ETFs and other instruments to realign portfolios, clients can reduce policy drift and more closely align portfolios to their investment objectives and strategic asset allocation. These services generally all follow the same process. The transition manager reviews the client’s portfolio through their multi-asset class platform, which captures overall risk and exposure. The transition manager can then evaluate this exposure versus the intended exposure within the client’s policy statement and the manager implements the appropriate measures to realign the portfolio. Rebalance frequency, data sources, permissible securities and duration of the service are all determined in advance.

Specific examples of this service include:

Cash securitisation Cash securitisation can be implemented over a single portfolio, providing passive benchmark exposure for a prescribed period of time. This is useful when an institution has decided to make an asset allocation shift but is not yet ready to appoint portfolio managers for the new investment. A portion of the securities can be transitioned to the strategic allocation with the use of futures, swaps or exchange traded products. This example addresses individual portfolio changes, however cash positions across multiple portfolios within a single client can also be securitised. These balances, while small in any single portfolio, on aggregate create a drag on investment performance. As illustrated in Diagram 1, transition managers combine the balances of applicable portfolios and securitise this value in accordance with the client’s investment policy statement and asset allocation policy, using listed Index Futures and/or ETFs. Armed with holistic portfolio information, decisions can also be made to hedge specific exposures.

Diagram 1: Cash Securitisation

1 T he T C harter is a voluntar y code of best practise for transition managers, meant to encourage disclosure and transparency. Firms stating they comply with the T-C harter must comply with it in its entirety.

OCTOBER 2012 • FTSE GLOBAL MARKETS

measurement and management that allows clients to protect their assets on a strategic basis or take tactical measures.

Diagram 2: Client’s Investment Policy Statement

Execution services

Allocation

Current Exposure

Deviation

Global Passive Equity

Asset Class

40%

43%

Global Active Equity

15%

17%

Total Equity

60%

69%

Global Government Bonds

25%

22%

-3%

High Grade Credits

10%

-4%

-2%

40%

31%

-9%

Emerging Market Equity

High Yield Bonds Total Fixed Income

Asset allocation adjustment The investment policy statement and asset allocation model prescribe the optimal asset mix, and are widely held as the single largest determinant of long term portfolio return. However, market movements skew actual allocations away from policy and create risk. Therefore, overlay services have been developed, which utilise listed index futures and ETFs to create marginal long and short exposures, bringing actual exposures back to policy weightings.

Style management Passive securities can be used to influence portfolio style in the same way they are used to adjust asset allocation. Portfolios are evaluated versus value and or growth indices, and adjustments can

be made, in line with predetermined rules, to achieve the desired style exposure. The overlay services essentially utilise the same multi-asset class global platform for risk management and execution to deploy a continual “transition like” service that sits atop the client’s assets. Beyond simply managing deviations from strategic targets, there is an incidental and incremental benefit to the client as well. In order to manage this risk, there must be a process in place to regularly measure the exposure drift, thus allowing for the possibility of more timely recognition of these exposures. This monitoring process also allows asset owners to make tactical decisions should markets or specific asset classes move sharply or potentially dislocate from standard norms. It is this process of regular

Transition management delivers pre- and posttrade analysis alongside an optimised execution strategy—a service that is desirable to block traders and to institutions implementing significant portfolio changes alike. To this end, some asset managers have started to outsource a portion of their trading requirements to transition managers. The level of required service ranges from specific portfolio restructures, similar to traditional transitions, to the outsourcing of an entire dealing desk. Examples of specific restructures include regular fund manager changes to multi-manager funds, onboarding of new clients as in-specie subscription, and fund mergers and consolidations. On a grander scale, some smaller asset managers have started to shift their dealing requirements, with transition managers handling all of the manager’s execution requirements. Fund managers send the required trades to the transition manager, normally electronically via the FIX protocol, and they receive filled orders in the same way. The transition manager designs and implements an optimised trading strategy and handles all post trade middle office and settlement functions. The fund managers benefit by accessing a robust transition management platform, trade strategy design and execution capabilities, while receiving comprehensive reporting detailing trade performance. This extension of the transition services also provides asset managers with the transparency and accountability they require.

Summary Transition management started life as a client’s trusted partner delivering a basic transactional service. Over time, the industry has expanded, building on that close relationship, and making available additional analytic and execution services required by clients. Today, we remain trusted partners, although we see a divergence of transition management providers; some focus on the core transactional service, while others, with the infrastructure and skills, offer the basic service as well as the enhanced tailor-made services for both asset owners and asset managers. I

The main aim of this article is to provide information on various topics relating to transition management services. We have not set out to recommend any specific actions that arise from the topics covered. This article is designed to make you aware of our views on changes within the transition management market. It is not intended as a substitute for your own due diligence as to what action should be taken as a result of the views described herein. J.P. Morgan has taken reasonable care in forming its views; however, it cannot be responsible for inaccuracies or misrepresentations in the information furnished hereby. This article has been issued by the Worldwide Securities Services business of J.P. Morgan Chase Bank N.A., which is authorised and regulated in the United Kingdom by the Financial Services Authority.

FTSE GLOBAL MARKETS • OCTOBER 2012

IN tHe markets

MIDDLE MARKET STOCKS: TRADING STRATEGIES IN A BEAR MARKET

Their preference is to find a natural match on the other side, so they often look first at the block crossing networks open only to institutional investors: Liquidnet or POSIT, for example. Usually, they won’t find a match— block volume (wherever traded) now represents only 4% of the market, down from 23% before the advent of electronic trading. Absent a match, the trader has to find liquidity without tipping his hand to other market participants. Much depends on the time of day and the order instructions—is the portfolio manager in a hurry or willing to wait? Can the trader start with a block and pick up the rest over the next week or so? The best strategy may involve multiple venues and execution methods: a block crossing network, one or more dark pools, a suitable algorithm and perhaps a conventional execution in the public markets to finish the trade. “Traders have to make a choice between exposing the order to more places and not appearing too large because the order is in so many places,” says Mizen.“The buy side is playing an unwelcome game of hide and seek; trying to disguise its intentions while still tapping liquidity.” Sometimes the human touch can be the right answer for the whole order. US regional brokers thrive on their expertise in trading local companies, many of which they took public. They may have access to a different client base, or know better than anyone else who owns the stock and what their intentions are. If the buy side player has a relationship with a broker that has the axe in a particular stock, a sales trader at that firm may be its best call. If the investor doesn’t have a direct relationship, it may be able to pay through a commission sharing arrangement—only the largest asset managers are likely to have relationships with all the brokers they may need. “It comes down to trust,”says Mizen. “Shopping orders is dangerous. How

Miranda Mizen, a principal at TABB Group. Mizen says most buy side traders start by looking at where a stock has traded and who is active in the name, information just as valuable today as it has always been. Photograph kindly supplied by TABB Group, September 2012.

well does the buy side desk know the sales trader?” Although sales traders handle a much smaller proportion of trades than they used to, they can still add value to the buy side because they have a different perspective. They see what other institutions are doing and may be able to find liquidity not available through electronic trading platforms. Indeed, in a fast market the buy side tends to gravitate back to humans and the lit venues. “If there is high volume and high volatility, people are worried they will miss out,” says Mizen.“They trend back toward the public market.” If the buy side has indicated interest to a broker who finds a natural block on the other side, the trader must decide how much to trade. Should he accelerate execution to take advantage of the opportunity, or do a modest

amount and risk getting a worse price later when the block isn’t there? Those are the judgments traders get paid to make and for which they are held to account through transaction cost analysis. No matter how skilled the trader is, execution costs will be higher for less liquid stocks, so investors in smaller companies expect to be compensated for the incremental risk of market impact when they buy or sell. Their goal is to find small companies that will grow into large ones—and of course the smaller the revenue base the easier it is to generate fast growth. It’s a stock picker’s game, which works best in times of low market volatility rather than the risk on/risk off environment that prevailed in 2008 and more recently during the eurozone crisis.

OCTOBER 2012 • FTSE GLOBAL MARKETS

Smaller companies typically need capital to finance their growth, but it has become harder for them to tap the public markets in recent years. Some observers blame the switch to penny pricing, which removed the incentive for brokers to take small companies public in the expectation of a continuing revenue stream from making a market in the stock. The average size of IPOs has increased and with it the time it takes companies to grow large enough to make the grade. In the United States the average period for venture capital startups to go public has extended from 4.5 to ten years since the turn of the century. In the United Kingdom, the latest small and mid-cap sentiment survey by consulting firm BDO and the Quoted Companies Alliance found that while almost half the companies were interested in raising money from the public equity markets in the next 12 months; 58% of respondents considered their listing to be a hindrance to development, of which 62% cited lack of liquidity as the reason— that trading volume was too low to attract large investors.

FTSE GLOBAL MARKETS • OCTOBER 2012

While some asset managers specialise in small-to-mid-cap names, others ignore them altogether—the largest investors simply can’t put enough money to work in smaller names. If a successful investment won’t move the performance needle, why devote the resources required to research, trade and monitor the position? As a result, smaller public companies don’t have access to the entire investment pool—they are trapped like non-swimmers who want to play with whales that dare not venture into the shallows to give them a ride. The JOBS Act which was signed into law this spring is intended to provide some relief to smaller US companies by permitting them to go public with reduced disclosure and to tap small private investors through so-called crowd funding. The SEC has yet to finalise detailed rules for crowd funding but a handful of companies have already gone public using the new disclosure standards for emerging growth companies (EGCs). To qualify, a company must have revenues of no more than $1bn in its most recent fiscal year, and will continue to qualify for

reduced disclosure once it has gone public until the first fiscal year after revenues breach the $1bn barrier. In its offering prospectus, an EGC may elect to present two years (versus three) of audited financial statements, two years (versus five) of selected financial data and two years (versus three) of management discussion and analysis. The company must declare its status as an EGC on the prospectus cover, and so far most companies that have floated as EGCs have included a risk factor describing the potential impact reduced disclosure could have on trading in their shares. Critics of the JOBS Act claim that reduced disclosure (including a pass on auditor attestation under Section 404 of Sarbanes-Oxley Act and less detail about executive compensation) opens the door to fraud, crowd funding poses risks and a lack of transparency undermines investor protection. Resistance to any relaxation of disclosure for smaller companies won’t solve the problem, however. If the existing rules inhibit capital raising, any solution must ease the rules and let investors take responsibility for doing their homework. I

spotlIgHt

FTSE WINS VANGUARD INDEX PROVIDER MANDATE

FTSE to provide index benchmarks for six Vanguard funds FTSE becomes third-largest equity ETF index benchmark provider globally N THE LARGEST ever international index provider benchmark switch FTSE Group has been selected by Vanguard, one of the top three US asset management firms, as the index benchmark provider for six international equity index funds with aggregate assets of $170bn (as of August 31st this year). The funds will transition to benchmarks in the FTSE Global Equity Index Series, replacing MSCI. The transaction represents the largest international index provider benchmark switch ever and includes the world’s largest emerging markets fund, the $67bn Vanguard Emerging Markets Stock Index Fund and its exchange-traded fund (ETF). The funds will move to the FTSE Emerging Index. The success of the index provider in winning the mandate reinforces FTSE’s growing US presence, and establishes the firm’s top three position globally.

“Today’s agreement with Vanguard underlines FTSE’s continuing growth as a global brand,” explains Mark Makepeace, chief executive of the FTSE Group.“With the switch, FTSE will become the third-largest equity exchange traded product index benchmark provider globally, with more than $124 billion in ETF assets benchmarked to FTSE indices.” The agreement “represents another significant step forward in making the FTSE name as prominent in the United States as it is elsewhere in the world,” adds Jonathan Horton, president, FTSE North America.“FTSE is committed to building long-term, sustainable relationships with clients in the US and around the world to bring real value to investors.” Vanguard conducted a rigorous selection process, which evaluated the quality and suitability of the respective indices.“The FTSE indexes

[sic] are well constructed, offer comprehensive coverage of their respective markets, and meet Vanguard’s ‘best practice’ standards for market benchmarks,” said Vanguard chief investment officer Gus Sauter.“The benchmarks offer comprehensive and diversified coverage of the international developed and emerging markets.” The long-term licensing agreement expands an already deep relationship between FTSE and Vanguard. The investment firm already employs FTSE benchmarks for more than 20 index portfolios around the world, representing $26bn in aggregate assets, including nine ETFs benchmarked with a total AUM of $13.4bn listed in the US, UK and Australia. FTSE will also be a partner in Vanguard’s international growth strategy going forward, with products already announced in the UK and Canada.

FTSE350 pension schemes funding levels hit 2012 high Pension scheme accounting deficits were £42bn at end September; a funding ratio of assets over liabilities of 92%. ERCER’S PENSIONS RISK Survey data shows the accounting deficit of defined benefit (DB) pension schemes in the UK reduced significantly in September. The latest estimated aggregate IAS19 deficit for the DB schemes of FTSE350 companies is £42bn (equivalent to a funding ratio of 92%) at the end of the month, compared with a deficit figure of £63bn at the end of August. The improvement is due in part to an increase in yield on high quality corporate bonds and a reduction in implied long term inflation (based on the differ-

ence between fixed and index linked gilt yields). “This is good news for companies sponsoring DB pension schemes .... The two key factors which drive the calculation of liabilities have both moved in a favourable direction. The yield on corporate bonds increased marginally, albeit still remaining low compared to historic standards. The outlook for long-term RPI inflation has also reduced ... It is far too early to speculate whether the reduction in the outlook for RPI is due to the announced consultation or the many other factors in the UK and global economy which impact

on this,” says Ali Tayyebi, head of DB Risk in the UK. “September has been the stand out positive month this year so far, but experience shows that the factors causing the improvement could reverse just as easily. Many pension scheme trustees and their sponsoring employers are all too aware of this. Those who have trigger mechanisms in place for de-risking actions may well have moved closer to some of those triggers over the month and some “locking-in” of improved conditions may be taking place,” he adds. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

As the Dodd-Frank Act continues to be implemented in the US, financial services organisations around the world are analysing what it will mean for them. Henry Raschen, Head of Regulatory & Industry Affairs, Europe at HSBC Securities Services outlines the consequences for US and non-US hedge fund managers. HE DODD-FRANK Wall Street Reform and Consumer Protection Act of 2010 (DFA) is the greatest set of financial reforms since the 1930s. US Treasury Secretary Timothy Geithner told a Senate committee in July that all the key elements of the law will largely be in place by the end of the year. At HSBC Securities Services we continue to analyse the implications for hedge fund and private equity fund managers. Three key impacts are the movement of standardised OTC derivatives transactions on to exchanges and trading platforms, the Volcker Rule, and the requirement for hedge fund managers to register with the SEC. Following the G20’s mandate of 2009, DFA requires certain standardised OTC derivatives trades to be moved onto exchanges or electronic trading platforms, to be cleared through central counterparties (CCPs) and to be reported to trade repositories. Trades that remain off exchange and are not centrally cleared must also be reported to trade repositories, and be subject to higher capital requirements and stricter eligible collateral rules. Hedge fund managers therefore need brokers and CCP clearing members who can provide access, margining and reporting. The higher margin requirements for non-centrally cleared contracts means that collateral must be even more efficiently managed to mitigate the additional costs. Aspects of the Volcker Rule are still being finalised, but it is likely to pro-

FTSE GLOBAL MARKETS • OCTOBER 2012

hibit banks from engaging in proprietary trading, and to set limits on how much they can invest in hedge funds. Hedge fund managers within banks will need to restructure. Even independent hedge fund managers may find that the ban on bank proprietary trading creates a less efficient market place and drives up investor costs, so they will need to review their systems and portfolios to reduce operating costs and minimise any threat to returns. There are immediate implications of the requirement for investment advisers to private funds (such as hedge and private equity funds)—“private advisers”—to register with the Securities and Exchange Commission (SEC). The registration process applies to US private advisers and non-US private advisers to US-domiciled funds. However, there are limited exemptions for US and nonUS advisers, including advisers to funds with less than $150 million, and to venture capital funds. Registration puts private advisers in a similar situation to traditional investment advisers, who have long had to register with the SEC under the Investment Adviser Act 1940—although many of the largest private advisers voluntarily registered before registration became mandatory. Although the deadline for new registrants was March 30th 2012, many smaller non-US domiciled private advisers may have failed to register correctly because Dodd-Frank has simply not appeared on their regulatory radar as a relevant issue.

DODD-FRANK: IMPLICATIONS FOR HEDGE FUNDS

The Dodd-Frank Act: its implications for hedge fund managers

Henry Raschen, Head of Regulatory & Industry Affairs, Europe at HSBC Securities Services. Photograph kindly supplied by HSBC.

Compliance with any requirement to register is essential, even though late registration may involve penalties. The message for non-US private advisers is clear: if you have US investors, you must determine whether you need to register. Registration carries with it strict reporting requirements. All registered private advisers with at least $150 million in private fund assets under management must periodically file a new reporting form, Form PF. The information on this form will be used by the Financial Stability Oversight Council to monitor and mitigate systemic risk. The sort of information required depends on the type and size of private adviser. However, all private advisers have to provide basic information including details about themselves and the assets they manage, investment concentration, borrowing, liquidity and performance. Large private advisers must provide more detailed reports. These registration and reporting requirements will create a significant compliance burden, cost and risk for private advisers. Failure to comply is likely to result in penalties and reputational damage. Fund administrators, custodians and prime brokers hold a great deal of the information that private advisers need to complete Form PF. Collating this data is not straightforward. For example, derivatives contracts may be classified differently by the fund administrator, the prime broker and the adviser, so a way of standardising such classifications has to be found. US and non-US hedge fund managers alike may find it difficult to comply with the new requirements on OTC derivatives trades, the Volcker Rule and SEC registration. Furthermore, they may not be aware of the wider consequences. In either case, they should seek external assistance. I

tHe bear vIew

EURO-DEBT CONTINUES TO UNDERMINE MARKET RECOVERY

On the one hand growth is grinding to a halt and companies seem to be making a stream of negative forecasts. On the other, interest rates are slowly coalescing towards zero making any equity return at all look attractive. Add to this the seemingly never ending river of state liquidity and we can begin to understand why markets are unable to decide whether we are on or near the end of the world, or about to launch into slow but steady recovery.

approached from the other extreme of forever getting a dwindling number of high earners to pay ever more for the millions who rely on the state. A

LOOKING FOR EVIDENCE TO CARRY ON

better example of an ever decreasing circle it would be hard to imagine. The majority of our clients have, once again this year, been proved right in disbelieving the likelihood of any break out and we saw massive selling as soon as the markets pushed above 5880. This has definitely been a year of sitting on losses and taking any profits quickly. With markets failing to cover new ground and simply ploughing the same old field over and over again, bad trading practices have paid off handsomely. We have seen any number of “doubling up” of loss making positions turning out to be the wise move. With interest rates so low the cost of running a bet for quite a significant period of time is very small and so we have seen clients sit on long and short positions for months and months waiting for the markets to come back to them. It has definitely been a year to sit on your losses and take your profits quickly. With markets failing to cover new ground and just ploughing the same old field over and over again, bad trading practices have paid off handsomely and we have seen any number of “doubling up” of loss making positions turning out to be the wise move. With interest rates so low the cost of running a bet for quite a significant period of time is very small and so we have seen clients sit on long and short positions for months and months waiting for the markets to come back to them. A few months ago the outlook seemed a little brighter but the clouds appear to be gathering once more. As ever ladies and gentlemen, place your bets. I

HE PROBLEM FOR many of us is in trying to estimate what the situation would be like if the printing presses were turned off is that we have no evidence to go on and only the word of the economists that ‘it would be worse’. Once again, in the face of the failure of the last stimulus package, the US Federal Reserve Bank has announced that they will just add liquidity, over an unlimited time period, until the economy shows sign of picking up. This sounds great until you realise that any such recovery will, by then, be dragging along the cost of creating it. The risks are immense: either it triggers an inflationary spiral, or the burden of the national debt pile pulls us into a deflationary pit from which it will be almost impossible to emerge (that is, Japan). So we now sit at the classic crossroad between fear and greed. The fear is that any green shoots will eventually turn out to be weeds. The greed is that we are at the start of a huge bull run that will rerate equity returns in line with the massive bond market rally. Remember that the Nikkei had a similar problem since its peak back in 1989. Indeed, if we ignore the ridiculous bubble of 1989, the OECD equity markets have shown a disturbing matching pattern with Japan, only dislocated by ten years. For investors this possibility is a sobering. Despite the desperate sov-

ereign stimulus packages launched over the last few years, the real driver of growth is, and always has been, corporate spending (small, medium and large) and unfortunately share capital is a critical underpinning of such expenditure. Of course financial markets are not the prime mover for politicians. They are well aware the average voter has absolutely no comprehension of the link between the value of capital and their standard of living. Hence, the fear of a gently drifting market for the foreseeable future sits well down the list of their political worries. It also means their addiction to printing money will continue. Central banks too look happy to go along with a policy they know is flawed, simply because their lords and masters refuse to take the hard decisions necessary to put the whole framework on a stable footing. It has always been a small flaw of democracy that people with absolutely no input to the economy have the exact same vote as those who have worked for their entire lives. This did not matter in the past but the social support levels and the vast numbers of those who now rely on them has tipped the balance. Any politician in Europe recommending a harsher lifestyle for the non-contributors (to re-adjust sovereign expenditure versus income) will just not win an election. In the UK the problem is

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

OCTOBER 2012 • FTSE GLOBAL MARKETS

INdex revIew

COUNTRY CLASSIFICATION CHANGES

Each September FTSE conducts an annual review of the market status of all countries contained in its global benchmarks and assigns countries to one of Developed, Advanced Emerging, Secondary Emerging or Frontier categories. This year, FTSE’s Policy Group has not reclassified any countries but has added two further countries to the current Watch List of seven countries being considered for promotion or demotion between FTSE’s market classifications.

Argentina listed for possible demotion in new country classification review RGENTINA IS LISTED for possible demotion from Frontier due to continuing stringent capital controls imposed on international investors and the perceived lack of an independent regulatory authority to protect the rights of shareholders. Argentina was demoted from Secondary Emerging to Frontier in 2010 and now looks to be in danger of falling out of the classification system altogether. In mid-April Argentina seized control of 51% of YPF, the country’s largest oil group, by taking over the holdings of its biggest shareholder (Spanish oil company Repsol) in a move that stunned foreign investors and provoked the EU trade commissioner to seek settlement at the World Trade Organisation (please refer to FTSE Global Markets, May 2012 edition). Argentina has had stringent capital controls for the last ten years, requiring all currency transactions to be authorized by the tax agency on a discretionary basis. In July, President Cristina Fernandez stepped up a gear and banned the buying of dollars altogether in a bid to halt capital flight. In a separate development, Mongolia will join the Watch List for possible inclusion as a Frontier market based on its progress in developing a market infrastructure that is attractive to foreign investors through improvements to its trading, settlement and custody arrangements. According to Chris Woods, managing director, governance and policy at FTSE Group, Mongolia has been receiving help from the London Stock Exchange to help upgrade its internal trading infrastructure.“There is

FTSE GLOBAL MARKETS • OCTOBER 2012

a discernible improvement in the country’s settlement and custody landscape,” he explains. The FTSE Country Classification Annual Review, carried out every September, evaluates countries against a set of 21 ‘Quality of Markets’ criteria developed by the index provider, together with the institutional investor community and domestic market authorities. The criteria are divided into four main segments, including the prevailing market and regulatory environment; the existence of a robust custody and settlement regime; a comprehensive dealing landscape that ensures (for example) there is sufficient competition in the market to ensure high quality broker services and sufficient broad market liquidity; and the existence of a developed derivatives market. “We refine the criteria for each category,” states Woods,“to ensure the relevance of the process. We also undertake the review process in the most transparent and objective way possible.”To achieve Developed Market

designation all 21 market quality criteria have to be met, he adds. Markets join the Watch List if, at review, the index provider’s Policy Group agrees that a sufficient number of scores against the review criteria have been modified to warrant potential promotion or demotion. The index provider also calculates and maintains the FTSE Watch List Index Series. These indices are calculated as an indicator of what current market performance would look like if certain key Watch List events had already taken place. They are designed to help investors assess the influence on turnover, investment flows and weightings that any reclassification of those markets on the Watch List would have on portfolios. The current FTSE All-World Index Series includes 47 countries: 25 Developed, 10 Advanced Emerging and 12 Secondary Emerging countries. A further 26 countries are classified as Frontier markets and make up the eligible universe for the FTSE Frontier 50 Index. I

CURRENT COUNTRIES ON WATCH LIST: Argentina – Possible demotion from Frontier China “A” Share – Possible inclusion as Secondary Emerging Greece – Possible demotion to Advance Emerging Kazakhstan – Possible inclusion in Frontier Kuwait – Possible inclusion as Secondary Emerging Mongolia – Possible inclusion in Frontier Poland – Possible promotion from Advanced Emerging to Developed Taiwan – Possible promotion from Advanced Emerging to Developed Ukraine – Possible inclusion in Frontier

tradINg post

CAN CCPS REALLY REDUCE CREDIT RISK?

One of the claims for central clearing is that it reduces or eliminates the usual credit risks associated with using OTC products. Given the complexity of the client clearing model via intermediaries such as Futures Commission Merchants (FCMs) in the US or Clearing Brokers (CB) outside the US, can a credit risk officer rely on central clearing to minimise credit risk under all circumstances? By Bill Hodgson.

It is credit risk: but not as we know it T HE BEST OUTCOME is one where all trades intended for clearing have been accepted and registered by a central counterparty (CCP), all items of collateral have been delivered to the CCP via an intermediary, and no excess collateral has been lodged for any reason. In this situation, the client is fully protected should their intermediary default, as they would expect the resolution mechanisms of the CCP to port their trade portfolio to a new intermediary along with their collateral assets. This situation does however assume that portability is successfully achieved; something which under the current European model is not guaranteed. Portability relies on each client having appointed one or more back-up clearing brokers, who accept the client’s portfolio and provide a new route into the CCP. However, each clearing broker has to measure and manage their capacity to provide client clearing in terms of capital and liquidity, and cannot guarantee to accept new portfolios. In the US in the event of the failure of an FCM, the CFTC can make immediate operational decisions as to where to place client portfolios at other FCMs to avoid failure of portability. How this works in practice is unknown. Where porting fails, a client stands to lose money (relative to long term gains) as their portfolio will be liquidated by the CCP at prevailing market prices. The circumstances of the failure

of an FCM or CB, and the prevailing market conditions will have a big influence on the success of portability. If the failure is a result of bad market conditions, other intermediaries may refuse to take on new client portfolios to protect their own stability. Another source of risk is the transfer of securities as collateral between the client and the CCP. Each time a security is nominated to cover a liability at a CCP, it has to make its way via your intermediary to the CCP through a series of depository movements. The possibility of an intermediary defaulting with assets in transit to the CCP is low. The LSOC model mandated by the CFTC, should ensure that collateral is held in an account segregated from other customers, and can be recovered, reducing credit risk. Another possible situation is that of ‘excess’ collateral, which can occur for reasons such as an increase in the value of margin assets; a decrease in the margin required by the CCP for a portfolio; or additional funds provided to an intermediary to cover intraday margin calls. The LSOC model does not protect excess collateral. In the default of an intermediary, excess should be regarded as an amount ‘at risk’ to be minimised, or protected through a bilateral agreement with an intermediary equivalent to LSOC. The final area of greatest complexity for the industry is in the execution space. Intermediaries like FCMs and

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

CBs have the obligation to take over the portfolio of a defaulted client, and must consider carefully the characteristics of the client trades as they arrive from an execution platform such as a SEF. This checking process will include a credit limit. This can be complicated in that clients can execute at multiple venues, and clear at multiple CCPs, so how can they manage their credit limits across these platforms without becoming constrained? Three models have been proposed: Push, Ping or Hub. Push has each FCM/CB allocate a portion of a credit limit to each execution platform utilised; Ping relies upon messages requesting credit between the SEFs, FCMs and CCPs; and Hub requires a central utility to record and manage each credit limit. The Hub model is the most flexible; the Push model the least flexible, but is the simplest to implement, and Ping requires the industry to adopt a common messaging protocol with time criticality for the solution to work. Concluding, central clearing does in a stable state transform credit risk by way of variation margin, initial margin and default fund contributions, but the process to achieve clearing, and the default scenarios introduce new issues in managing exposures. With the market infrastructure for managing credit limits incomplete, now is the time for firms to join the debate and make your views known. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

fx vIew

THREE WAYS INTO RMB Despite rapid growth in the offshore renminbi (RMB) since its inception in 2010, many corporations have preferred to wait and see before opting to settle their Chinese trade in the currency. Michael Vrontamitis, head of product management, East, Transaction Banking, Standard Chartered thinks that now is the time to come off the fence. He outlines at least three good reasons why corporations should consider taking the plunge into RMB. ETTLING IN RMB would net most international corporations cost savings and an increased control over foreign exchange and interest rate risks. Many companies are wary of invoicing or receiving payment in RMB due to concerns over cost control and foreign exchange risk.

FTSE GLOBAL MARKETS • OCTOBER 2012

However, Chinese firms typically price into their contracts the cost of conversion between US dollars and RMB. This conversion premium has been growing since the widening of the RMB trading band last April, which made the currency risk more expensive to manage onshore in China.

RENMINBI: WHY IT IS TIME TO TAKE THE PLUNGE

Photograph © zoom-zoom/Dreamstime.com, supplied September 2012.

When transactions are settled in RMB, however—with the non-Chinese counterpart taking on the foreign exchange risk—the premium is eliminated and the underlying price of the goods becomes transparent, ultimately paving the way for negotiating cheaper contracts. We believe that most corporations would gain cost savings in the order of 2% to 3%. Added to this, would be the competitive advantage of gaining access to a wider range of Chinese customers and suppliers. Moreover, the RMB will continue to rise in importance as a trade currency. In the last two years, the speed of growth in the offshore market has exceeded all expectations, as has the rate at which China has liberalised the currency. Currently, around 10% of China’s trade with the world is settled in RMB. In the past six to nine months growth has paused, but we believe this is temporary, and remain confident in our prediction that as much as 20 per cent of China’s cross-border trade will be denominated in RMB by 2015. Driving this will be strong underlying growth in China’s trade with the world, supported by continued liberalisation. Recently, the Hong Kong Monetary Authority (HKMA) launched a pilot scheme whereby banks can exercise due diligence assessment and waive documentation checking for trade by eligible firms. A similar scheme has been launched onshore, by the People’s Bank of China in Shanghai. Both should encourage corporations that may previously have been put off settling in RMB because of the large amounts of paperwork involved. Meanwhile Beijing has announced a $45bn test scheme in the Qianhai region of Shenzhen to allow the RMB to be used more freely. Dubbed ‘miniHong Kong’, this will encourage the repatriation of RMB into Qianhai and in turn create opportunities for banks to provide RMB financing to corporations and projects in the area. The scheme will also enable banks to help corporations and financial institutions to issue so-called dim sum bonds, and

fx vIew

RENMINBI: WHY IT IS TIME TO TAKE THE PLUNGE

foreign investment funds to invest in Qianhai. It demonstrates the accelerating liberalisation by China, and should be viewed as a positive by companies now considering the RMB. Third, doubts about the true nature of RMB flows should now be receding. For a while now, there has been some concern among corporations trading with China that the volumes of RMB redenomination are being exaggerated by arbitrage, as opposed to reflecting ‘real’ cross-border trade flows. However, as arbitrage opportunities have faded away, the genuine, underlying volumes of RMB trade have become apparent, and this should encourage corporations looking to make the switch. In the early stages of the RMB internationalisation, the RMB was expected to appreciate gradually against the US dollar, at very low volatility. With onshore forward exchange rate in China being much higher than offshore rates, corporations with cross-border trade flows were able to reduce their cost of funding by leveraging the difference in forward exchange rates in what could be described as a one-way bet. While the early arbitrage opportunity encouraged a number of companies to switch their invoicing to RMB, it left many others less confident in the currency, because of concern that RMB trade flows were based on arbitrage rather than genuine demand. Since then, however, circumstances have changed. The opportunity to benefit from currency appreciation has receded, while the onshore and offshore RMB exchange rates have converged, making arbitrage based on underlying trade flows non-viable. However, against the expectation of some corporations, this has not resulted in a sharp fall in the proportion of Chinese trade settled in RMB. There was an immediate drop of one basis point to 9%, but the fact that the rate has since rebounded to 11% shows that RMB settlement continues unaffected and that underlying trade flows are indeed ‘real’.

The strong reasons for settling in RMB notwithstanding, it is clear that making the switch comes with significant challenges. The Chinese market remains highly complex and fastchanging. For most international corporations, making the move would entail an extensive internal change process. It would involve the setting up of procurement and sales teams to renegotiate prices and mitigate the impact of adding the currency to the firm’s accounting systems, not to mention that the treasury team would have a new foreign exchange risk to contend with. It would also impact on operational processes, which would need to be adapted to meet the evolving documentation requirements from Chinese regulators. A company setting up a regional treasury centre to enable invoicing in RMB, sourcing of RMB funding, the issuance of dim sum bonds and the management of foreign exchange hedging would need to consider the potential tax impact of various jurisdictions. In addition, the company would have to keep an eye on external factors, such as changing legal requirements and movements in the different onshore and offshore prices for RMB. One of the main problems still facing the development of the offshore RMB is a lack of awareness around what can and can’t be done in China by overseas corporations. The rules in China are changing rapidly, and this is compounded by the fact that many of China’s regulations are available in Chinese only. It is no surprise that the majority of the early movers on RMB are Chinese companies with overseas subsidiaries, or foreign companies with subsidiaries in China. These companies are more capable of overcoming the language and awareness issues still surrounding the currency. Today, the firms considering whether or not to settle in RMB would typically be those without the benefit of an onthe-ground presence in China, and those that trade directly with third-

Michael Vrontamitis, head of product management, East, Transaction Banking, Standard Chartered. Many companies are wary of invoicing or receiving payment in RMB due to concerns over cost control and foreign exchange risk. However, Chinese firms typically price into their contracts the cost of conversion between US dollars and RMB, writes Vrontamitis. Photograph kindly supplied by Standard Chartered, September 2012.

party suppliers or buyers in the country. However, we believe that an increasing number of these corporations will be persuaded to make the move within the next three years. The recent UKHong Kong forum to develop London as an offshore RMB centre will support this trend, as it will generate greater awareness of the implications involved in managing the RMB globally. This in turn will encourage more companies to take the leap. While the US dollar remains by far the most commonly used currency for trade with China—and is likely to remain so for a while to come—we believe that the RMB has potential for substantial growth to develop towards a global currency. Despite the challenges, firms should not be put off by using the RMB. For most companies, the benefits of settling trade with China in RMB will far outweigh the drawbacks. As we can see, the overall theme in the market is one of support—with encouragement from regulators, domestic banks and local corporations coming together—to make invoicing in RMB to China gradually simpler than in other currencies. With complexities fast receding and RMB-denominated trade expected to grow rapidly in the next few years, now would be a good time to consider making the move. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

derIvatIves

Low interest rates impact pension fund hedging strategies Pension funds now seek out complex hedging tools as their liability discounts are punished by low interest rates. Setting aside the right amount to meet the future obligations of a pension fund is a challenging task, but when interest rates become skewed it is made more difficult. Pension schemes are heavily exposed to interest rate risk, which determines the extent of their liabilities. Getting access to the right hedging instruments is crucial, but the complexity and cost of using instruments can limit a fund’s options. Dan Barnes reports. ENSION PROVIDERS HAVE long liability cash flows, which are typically a nominal guarantee in the future (as with defined benefit retirement schemes) or inflation linked (as with US public pension plans). The assets a fund invests in determine its efficiency at generating a premium. For example, if a fund wanted to provide £1,000 in four years’ time with interest rates at 4% it would have to set aside £821.93 in cash. If it invested in corpo-

FTSE GLOBAL MARKETS • OCTOBER 2012

rate bonds providing 6% it would only need to set £747.26 aside. Equities providing a return of 7% would require the fund to set £649.93 aside. “At the moment the customer pays 25 cents and there is a promise they will be paid one euro in 40 years,” says Pieter van Foreest, head of client risk at Dutch asset manager APG.“In between that there is a lot of interest rate growth. So you need a high interest rate to catch up the difference and of

STRATEGIES TO COUNTER THE IMPACT OF LOW INTEREST RATES

Photograph © Kevin Renes/Dreamstime.com, supplied September 2012.

course there is equity risk. You need to get the equity risk premium over and above the term risk premium,”he adds. Funds get hurt by low interest rates in several ways. Primarily, a low interest rate lowers the discount rate that is applied to the fund’s liabilities, effectively increasing them. Future cash flows are discounted to account for the effect of inflation; one pound sterling will be worth less in the future than it is at present. The discount rate applied to liabilities is calculated using a yield curve and is dependent upon the length of the liability. The accounting standard IAS19 requires funds to measure, report and rectify any funding deficits they may have, based on valuations of liabilities and assets. Under these rules, current high quality bond or swap yield curves are used to calculate the discount rate for present value of pension liabilities, so if interest rates fall the discount rate follows suit. Funds typically have limited methods of dealing with a shortfall. The premium paid in by scheme members tends to be a consistent amount, so if rates fall the premium may not be high enough to cover the drop. The poor levels of economic growth associated with a period of protracted low interest rates could also suggest that the return on investments such as equities could be lower than expected. In the past the regulatory framework always said that in the long run interest rates are 4%, says van Foreest. “All the premium accounting has been based on 4% and now interest rates are low, liabilities grow very high, so there is a deficit. Even though there are a lot of assets, liabilities grow faster than the assets.”

Limited bonds A report by the Organisation for Economic Co-operation and Development (OECD), entitled The economic impact of protracted low interest rates on pension funds and life insurers released in September 2011, warned, “Pension funds offering defined-benefit promises and life insurance companies that have

derIvatIves

STRATEGIES TO COUNTER THE IMPACT OF LOW INTEREST RATES

sold products with high-return guarantees may have difficulty fulfilling these promises.” Furthermore Dr Iain Clacher and Professor Peter Moizer of Leeds University Business School noted in their September 2011 paper Accounting for Pensions that IAS19 “has resulted in schemes purchasing greater amounts of financial investments which better match the estimated present value of their pension accounting liabilities. Pension schemes have been divesting real asset investments, such as equities, and investing in financial investments, such as long?dated index linked gilts and corporate bonds, that are a better match for the estimated accounting liability. The systemic effect of this has been to exacerbate the bubble in long?dated bonds and, in particular, index linked gilts.” However straight matching of cash flows with bonds in this manner is not practical for several reasons: “The size of the Dutch pension fund business is about €800bn at the moment so it is not feasible for everyone to hedge solely with government bonds,” says Arjen Tebbenhof, member of the investment strategy team at TKP Investments. “So we see the larger funds make heavy use of derivatives, swaps and swaptions which give flexibility in exactly matching that part of the IR risk that the board wants to hedge.” James Wallin, senior vice president at asset manager AllianceBernstein adds, “The optimal portfolio of cash funds may be completely different, in terms of duration and interest rate sensitivity, compared to the optimal cash flow for the benefit plan. That is where the interest rate swap provides an invaluable mechanism for taking the income generated from that portfolio of securities and converting it through a swap agreement into a flow of income that is more closely tailored to the needs of the plan.” If low rates are sustained, the returns seen on fixed income portfolios that are reinvested will also be lower. Tying liabilities to debt valuation is driving liability driven investment strategies,

points out John Dewey, managing director within asset manager BlackRock’s multi-asset client solutions. “[Funds] either have to value their liabilities using low-risk gilt or a swap yield curve, or the sponsoring company will have to disclose the valuation of the pension scheme using accounting regulations on a regular basis with a corporate bond valuation rate that it has prescribed,” he says. “This means that the impact of interest rates as they fluctuate has a direct consequence for the liability reported, irrespective of whether you use a government bond or a swap or a corporate bond. That creates the desire to manage the performance of the assets, given the liabilities are going to depend very largely on interest rate exposure or the impact of interest rates,” he adds.

Getting to grips with the rate The starting point for pension schemes in managing their interest rate risk beyond the use of bonds is to look at their exposure, the assets they hold and how these might be better tailored to meet their liabilities. “Funds are also typically underfunded in the UK, less so in the Netherlands, and your typical bond profile might only have a duration of six to eight years where the average pension scheme liability might be 20 years or more in the UK,”notes Dewey. “Because there is only so far you can go with physical assets people often look to derivatives which, while they increase the complexity of the strategy, they give you the ability to manage that risk and give you the exposure without holding the full capital behind it. Soon you find yourself working in interest rate derivatives as a way of really getting more bang for your buck in your hedging strategy.” There is a trade-off; the requirement to centrally clear interest rate trades will mean the cost of transactions will increase. Although under the European Market Infrastructure Regulation there is an exemption for pension funds having to centrally clear over-

the-counter (OTC) derivatives, like interest rate swaps, the additional capital costs imposed on sell-side firms that do not clear OTC trades will means that real costs will increase. For many investors the expense of not using them will outweigh the additional cost of using them. “The aim of the central clearing regulation is to provide greater security and clarity around those arrangements so it is quite a desirable objective as well as increasing costs, which is less attractive,” says Dewey. The degree to which funds decide to hedge against interest rate risk will vary and that will affect their requirements for bonds or interest rate swaps. Not a lot of pension funds hedge against interest rate risk as intensely as life insurers do at 100%, notes van Foreest, who estimates the average pension fund in the Netherlands would cover about half of its liabilities. “The level covered depends on vision on interest rates, on risk appetite, and then politically on the regulatory framework there is the issue of the discount rate,” he says. Tebbenhof concurs, “There is variation in how much interest rate risk is hedged by pension funds but that is not solely dependent on the asset mix, because of the flexibility that derivatives give. There is some variation due to the size of the pension funds, typically the more complex derivatives require a lot of legal contracts to set up, so smaller pension funds have a harder time of implementing IR rate risk measures simply because of the cost of implementing the derivatives.” “What we see is those smaller pension funds often opt for hedging interest rate risk using government bonds and strips, which are government bonds solely with repayment at the end and coupon payments stripped off; these give more interest rate sensitivity without the need of additional legal documentation,” he continues. van Foreest says that many pension funds hedge that interest rate risk with swaps as this frees up capital by reduc-

OCTOBER 2012 • FTSE GLOBAL MARKETS

ing the interest rate risk from the balance sheet, which allows the fund to buy more assets. “Some of our larger clients use swaptions, options on interest rate swaps,” adds Tebbenhof. “They implemented these a few years ago in de-risking their pension fund balance sheet. They use swaptions as a solution in order to hedge nominal interest rate risk for the shorter term, but also to allow the funding ratio to increase in high inflation scenarios. A higher funding ratio makes it possible to compensate for the loss of purchasing power of pensions due to inflation. That could happen quickly when quantitative easing wears off.” However a cloud on the horizon may challenge the wisdom of holding swaps. Several European countries, including the Netherlands and Scandi-

navian countries, are pushing for the liability valuation model used by insurers under Solvency II, to be applied to pension funds, complete with a new discount curve.

Solvency II “The discount rate it is not an economic discount rate,”says van Foreest. “We may develop a new interest rate [under Solvency II rules]. While liabilities would not increase in value that much, there would then be a huge mismatch with the swaps that firms had bought earlier. The swaps are set at the market value and on the swap curve, and in the current regulatory framework liabilities are also valued on the spot curve so move in lockstep. Once you change this rule of discounting liabilities that lockstep is gone.” He warns that moving to a new dis-

count rate it effectively creating a political risk, because at any time the discount rate could change and funds would be left with swaps in their portfolio; from a regulatory perspective a pension fund with 100% interest rate hedge would be left in an obsolete position if the discount rate were changed to 4%. “What should you do? Sell the swaps and leave the economic paradigm?” asks van Foreest.“Or ignore the regulatory paradigm and see what happens with the discount rates? The challenge is to look after the economics story even though the regulator may say that things are different. It seems that all proposals aim to get a higher discount rate so liabilities reduce. Then funds may seem healthy from a regulatory perspective, but in real economic terms they may not be,” he adds. I

The Bank of Canada, the country’s central bank, says Canadian derivatives investors can now process trades through new global clearinghouses. The rule, issued in a special statement by the central bank allows Canadian banks to clear their derivative trades overseas. The statement also noted that improvements in the new trading systems are sufficient to protect financial markets.

BANK OF CANADA CHANGES RULES ON DERIVATIVES CLEARING “

ANADIAN AUTHORITIES ARE committed to clearing standardised over-the-counter derivative contracts, subject to appropriate exemptions, through central counterparties, CCPs, Canadian market participants can respect this commitment by clearing OTC derivatives using any CCP recognised by Canadian authorities, including global CCPs,” noted the Bank of Canada official statement. “Canadian authorities judge that global CCPs will provide a safe, robust and resilient environment for clearing OTC derivatives,” it adds. The central bank, along with other regulators have instigated a commitment to centrally clear derivatives trades to help improve transparency, mitigate

FTSE GLOBAL MARKETS • OCTOBER 2012

systemic risk, and protect against market abuse. Since December 2009, the Bank of Canada, the Canadian Securities Administrators (CSA), the Office of the Superintendent of Financial Institutions (OSFI), and the Canadian Department of Finance have coordinated efforts to implement reform of Canada’s OTC derivatives markets in line with the G-20 commitments, including the commitment to clear standardised OTC derivatives. The move has been anticipated for some time. However, the authorities had to decide whether it was worthwhile to create Canada’s own system, or allow the banks to use existing ones such as LCH.Clearnet (which is based in

London). Even so, the authorities have stipulated clear conditions. Canadian authorities clearly judge that global CCPs will provide, “a safe, robust and resilient environment for clearing OTC derivatives, provided that they comply with the Principles for Financial Market Infrastructure published by CPSS-IOSCO,” notes the statement. It also outlines a number of safeguards that the central bank should be in place. These include fair and open access by market participants to CCPs, cooperative oversight arrangements for CCPs between relevant authorities, resolution and recovery regimes that ensure the core functions of CCPs are maintained during times of crisis, and appropriate emergency liquidity arrangements for CCPs in currencies in which they clear.

debt report

MTNS: NEW FASHIONS IN BESPOKE FINANCING

Photograph © Skypixel/Dreamstime.com, supplied September 2012.

The medium term note (MTN) market is rather like a stealth airplane: precision-engineered, hard to detect but highly effective. The deals are typically private placements customised to meet the needs of the issuer and either a single investor or a small club. Individual amounts raised are often so modest they create barely a blip on the market radar. Bespoke finance is no more immune to the whims of fashion than Savile Row tailors, however. The 2008 financial meltdown and the ongoing eurozone crisis have altered the complexion of the MTN market in ways that will have an enduring impact on both sides of the Atlantic. Neil A O’Hara reports.

IN OR OUT OF MTNs? I N THE UNITED States the $131bn MTN market is only one third the size of its $400bn European counterpart and has a very different profile. Jerome Merveille, head of the MTN desk at Barclays Capital in New York, breaks the US market down into three segments: short-term, plain vanilla notes that carry a floating (85%) or fixed (15%) rate with a maturity from 18 months to three years ($13bn in 2011); retail notes bearing a fixed rate of interest for three to 15

years ($8bn in 2011); and structured notes maturing in three to seven years with a return tied to a market benchmark ($110bn in 2011). Bank issuers dominate the shortterm MTN segment, but Merveille says the participants have changed dramatically in the past year. Gone are the Europeans (Intesa SanPaolo, Rabobank, Dexia, BNP Paribas and ING were all active in 2011), replaced by Australians (National Australia and Commonwealth Bank of Australia) and

Canadians (CIBC, Scotiabank and Royal Bank of Canada). Sovereign and supranational agencies (SSAs) have been more active this year, too, including Kommunalbank, the stateguaranteed Norwegian municipal finance lender, and Export Development Canada, the Canadian export credit guarantee agency. American corporations dominate the retail note segment, but again the issuers have changed in recent years. Goldman Sachs, John Deere, GE and Ford were the largest issuers in 2011, but IBM, Boeing, AIG and a raft of financial companies, that were highly active before 2008, are now nowhere to be seen. Tight credit spreads for investment grade corporate issuers and low nominal rates have deterred issuers at a time when retail investors resist coupons lower than 5% on long term bonds. Structured note issuance plummeted after 2008, when a combination of illiquidity and soaring credit spreads inflicted severe mark to market losses on investors (primarily insurance companies and corporate treasurers), some of whom were forced to sell after credit ratings fell below permitted thresholds. The structured investment vehicles (SIVs), once big structured note issuers, have vanished, as have most corporate issuers. Just to mention a few: Toyota has cut back, Honda stopped altogether and GE is now very limited. This has left foreign banks as the major players: Lloyds, RBS, Barclays, HSBC, Credit Suisse, UBS and Deutsche Bank. “Investors, especially institutional buyers, now value liquidity even more than before when making investment decisions,” explains Merveille. “Structured notes, usually tailor-made for a specific need or payout, are by nature less liquid than benchmark bond issues. With the renewed focus on balance sheet capacity, many dealers have become more conservative, increasing bid-ask spreads. We are now missing a lot of institutional demand that used to be there.” Around 70% of US structured notes

OCTOBER 2012 • FTSE GLOBAL MARKETS

are equity-linked, between 7% and 10% are tied to commodities and most of the rest to interest rates. In Europe, where structured notes are not as popular, Dealogic’s latest Euro MTN Review found that interest rate-linked notes accounted for 56% of the $20.7bn issuance in the first half of 2012, equitylinked for 23%, and currency-linked for 14%; the balance of issues were tied to inflation, credit or commodities. MTNs have long played a vital role in Europe. They have been widely used by banks, SSAs (which include entities such as the World Bank, the European Investment Bank, the European Bank for Reconstruction and Development and national export credit agencies) and some corporations before the 2008 crisis. While financial institutions still account for almost half of European MTN issuance, their market share has fallen in the last 18 months as investors have shunned those banks which they have perceived to be at risk if the euro unravels. Meanwhile, pressure to meet the forthcoming Basel III capital requirements has caused many European banks to cut back lending, prompting corporate clients to seek alternative funding sources. The latest Dealogic review shows that in the first half of 2012 corporations raised $25.5bn through European MTNs, 33% more than in the prior year. While still small compared to financial institutions ($97.4bn) and SSAs ($72.7bn), growth in European corporate issuance is likely to continue; not least because investors are clamouring for paper that is perceived as a safe haven. Pooja Goenka, a director in the MTN team at Credit Suisse in London, points out that some large diversified corporations in peripheral European countries can now raise money at lower rates than either local banks or the sovereign itself. “Investors believe corporates are safer,” she says. “They have assets backing them. They are less risky than peripheral countries or banks loaded with peripheral exposure on their balance sheets.”

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In a market dominated by plain vanilla deals, financial institutions remain the most active MTN borrowers in Europe, including banks that tap the market for their own account in self-led transactions. “We sell our own paper,” says Goenka. “We do not allow other dealers to originate our deals, nor do many of the other investment banks.” In addition to shifts in issuance, recent years have brought changes in European MTN deal origination. Goenka explains that before 2008 almost half the transactions came from reverse inquiries—that is, investors expressing interest in lending at designated terms or even to specific credits. Today, reverse inquiries account for just 10% of the market. Issuer requests generate another 30%, but the dealers create about 60% of MTN financings by matching up what they know about client appetites for particular credits and maturities with issuers’ borrowing needs. In a typical transaction, Goenka identifies a potential issuer and then works with her origination team to find investors looking for a similar maturity and credit quality. The two sides don’t always agree at first, so Credit Suisse handles the negotiations—it may add a structural element (a call option, for example) to bridge the gap between what investors want and the issuer is willing to pay—and when both sides are satisfied the deal is struck.“We have no risk,” says Goenka. “It is not like being joint lead on a public bond where we have guaranteed $500m and if we cannot sell the paper we are left with it on our book.” In fact, MTNs are not underwritten at all in the normal sense. More than 95% of the deals Bank of America Merrill Lynch (BAML) handles in Europe are sold to a single investor. The MTN desk acts as an agent, smoothing the path to mutual agreement. The trade is then executed privately and the bank takes a fee. In Europe, life insurance companies are the biggest buyers of MTNs, not least because they can prescribe the exact

maturity and quantity they want. In a public bond issue, investors must take the terms that are offered, which may not be a perfect match for their liabilities, and they cannot be sure when an issue will become available or how many bonds they will buy. An investor will receive the entire allocation it seeks in a public bond deal only at the worst possible time—when sales are slow and the issue is likely to trade below the offering price. European MTN buyers also include pension funds and banks, which, like insurance companies, are always looking for ways to improve the match between the duration of their assets and liabilities. Customisation adds enough value that investors will usually accept a slightly lower yield than they could get in the secondary market for public bonds of similar maturity and credit quality. Issuers get a lower nominal cost of funding, although they must service what are typically small transactions. BAML estimates that about 40% of US MTNs fall in the $10m to $50m range, and while some single-investor European deals run as high as $100m to $200m (up to $500m for club deals) the average size for the first half of 2012 was just $27.9m.

debt report

MTNS: NEW FASHIONS IN BESPOKE FINANCING

The incremental cost of servicing MTNs may offset any saving on the interest rate, which deters some potential issuers. In addition, although financial institutions and SSAs already have the skills required to account for and value derivatives used for their own risk management, corporations may not—an obvious obstacle to issuing structured notes. Moreover, in the United States where documentation is more complex than in Europe, corporate treasurers often prefer to devote their time to a few big public bond issues rather than the multiple small transactions required to raise the same amount of money in MTNs. A treasurer who has $5bn of annual funding to arrange could do five $1bn benchmark bond issues, which would require his attention five times a year. If he were to do 50 MTNs of $100m each, he would spend every week arranging financing, although in theory he could capture a lower funding cost. In fact, the main benefit of MTNs for issuers is investor diversification rather than lower cost. In the US, MTNs are often sold to smaller banks, insurance companies, pension funds and wealth management investors who typically

do not participate in public benchmark bond issues.“Issuers talk about diversification all the time,” says Suzanne Buchta, head of the U.S. MTN team at BAML in New York. “Ever since the financial crisis, issuers don’t want to be totally exposed to one region or investor type.” The nature of the investor varies by MTN type, too. Plain vanilla fixed or floating rate paper tends to find a home at financial institutions and some municipalities, while wealth management investors take the majority of structured notes. One positive sign perhaps is that American corporate treasurers show distinctive signs of edging back into the MTN market, a funding source many abandoned after 2008. In August, Ally Financial relaunched its retail note program, a harbinger of the auto finance company’s improving financial health. Meanwhile, the shift toward greater corporate MTN issuance in Europe portends a fundamental change in a corporate finance model historically more dependent on bank credit than the United States. “European corporations traditionally met 70% of their borrowing from banks and 30% from the capital markets,” says

Oliver Johnson, head of MTNs for EMEA and Asia at BAML in London. “We are seeing a slow move toward an inverted relationship, where 70% will come through the capital markets and the rest from bank lines.” The change will not happen overnight, but when bank credit lines fall due for renewal some corporations will let them lapse and tap the capital markets instead. In time, European corporations will move closer to the established US model, albeit with a larger component of MTNs. The forthcoming Basel III regulatory capital regime is likely to spur additional MTN issuance by banks in both Europe and the US, too. The rules give banks a strong incentive to extend the average maturity of their funding and reduce their dependence on wholesale money markets.“We have recently seen Yankee banks focus on expanding the MTN buyer base, especially in maturities up to one year, away from the 2(a)(7) money market funds,” says Merveille at Barclays.“They are looking for liquidity funding from investors, which could provide beneficial treatment for net stable funding ratio purposes under Basel III.” I

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SIBOS REPORT

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T2S: BREAKING DOWN SINGLE MARKET BARRIERS

TARGET2-Securities (T2S) will have—in many ways is already having—a major impact on the shape of the European securities services landscape. The effects will be felt throughout the financial sector both in the type of business we choose to do in the future and the way that we do that business. By Mark Gem, member of the executive board of Clearstream and responsible for the company’s business strategy.

T2S: Europe’s game changer

Photograph © Rolff Images/Dreamstime.com, supplied September 2012.

HE EUROPEAN CENTRAL Bank-led (ECB-led) revolution comes at a difficult time for the industry: economic growth is negligible, the Eurozone is still volatile and many financial institutions are undertaking aggressive cost-cutting in order to ensure their survival. Financial institutions are having to find budgets to pay for the regulatory compliance—

and T2S is not the cheapest initiative: some market estimates put the total at well over €1bn. It is now confirmed that all but one of the Eurozone’s central securities depositories (CSDs) and some others from outside the Eurozone will join the project and outsource their settlement processing to the Eurosystem’s new platform. We can be confident that T2S

will finally deliver what amounts to a single settlement utility that can make European post-trade processing competitive on the world stage. It is now up to all of us to make it work. How did we get to this point?

Breaking down the barriers In the 1990s, the European Union pushed forward with its single market programme that was designed to establish the framework for the free circulation of goods, capital and services. Customs union was followed by the launch of the single currency in 1999; half the trade in the EU is now covered by legislation harmonised by the EU. However, financial services have lagged behind with integrated cross-border securities trading being difficult to achieve across the fragmented region; banks have to contend with a jigsaw puzzle of different jurisdictions and local practices. The Lamfalussy Committee, established more than a decade ago to consider how best to develop the EU financial services market, reported that creating an integrated European securities market was essential. It warned that failure to act would prevent the sector from being competitive and would adversely impact economic growth, employment and prosperity. This stark warning was reiterated by the Giovannini Group which had been working since 1996 to identify the challenges that were preventing integration. The 15 barriers to full integration that Alberto Giovannini identified could only be overcome, the Group concluded, through a combination of private and public sector action. The underlying objective they proposed was to create an efficient environment which would enable easier cross-border securities trading and processing and with reduced transaction costs. T2S sought to resolve a large part of that equation by providing the means to integrate a fragmented system of securities depositories into the Eurosystem’s newly-created payment system, TARGET2.

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T2S: BREAKING DOWN SINGLE MARKET BARRIERS

Mark Gem, member of the executive board of Clearstream. Photograph kindly supplied by Clearstream, September 2012.

Regulation soup For many of our banks, the challenge of reducing cross-border transactional costs is dwarfed by the challenges posed by the financial crisis and the Eurozone sovereign debt crisis that has followed it. The focus is now on safety and risk management. Market participants must figure out how to manage ever scarcer capital resources effectively, how to bring down their liquidity costs while digesting the heaviest regulatory agenda in living memory. On the face of it, the market participants whom T2S is designed to serve have better uses for their time and budgets than chasing the quixotic goal of reducing the marginal costs of cross-border transactions in Europe’s cash markets. At Clearstream, we have been told by a number of customers that they are currently spending around 70% of their development budgets on regulatory compliance. Yet despite this, T2S continues to enjoy widespread support across the financial community. CSDs have elected to sign the Framework Agreement committing themselves to both heavy investments and uncertain futures. Their customers, especially in the Eurozone, have supported them in doing so. In the light of the fires that are burning across the sector,

quite why T2S continues to command such widespread support demands an explanation.

In for the long haul In response to this question, some Anglo-Saxon bankers have been heard to observe that it is hardly surprising that banks depending on ECB liquidity support T2S if that is what their central banks want them to do. But there are also more cogent explanations. First, the market knows that T2S is a long-term project whose benefits will be felt long after the current crisis and the regulatory pressures associated with it have become memories. Second, T2S and the CSDs which will act as its distributors can help the European banking sector to husband scarce capital and liquidity resources much more effectively than in today’s fragmented world. T2S is a project for the long haul. Between, the publication of the first Lamfalussy report and the full migration of European CSDs to T2S, nearly 30 years will have passed. As a project, T2S dates from 2006 but much earlier the market had begun to invest considerable resources in attempts to untie the knots of European post-trade. The European central securities depository association proposed its “spaghetti

model” in the mid-1990s, followed by Cedel’s European Clearing House and Euroclear’s “domestic market for Europe” initiative in which considerable sums were invested. Each of these initiatives floundered on two fundamental issues; the successful provider of a single settlement utility could expect to reap significant rewards. So the question of the provider’s neutrality became an issue which led the formation of Fair and Clear in 2002, a pressure group of custodian banks challenging Euroclear’s plans to deliver its single settlement engine. The second problem was that any solution had to unify not only securities processing but also the interaction of the settlement system with the payment system. No initiative could succeed without the support of the Eurosystem who, for its part, faced deciding whether to adopt either the French model or the German model to achieve this. The decision to develop and operate T2S resolved both of these difficulties. Given this history, market participants recognise that the effort to invest in the infrastructure of an efficient market is something that the Eurosystem is best placed to deliver and that T2S therefore merits their support. After all, the crisis will one day be over.

Reaping the rewards At Clearstream, we believe that T2S will fulfil its original stated purpose which was to break down some of the Giovannini barriers and foster an integrated European securities market. But it will also address the current preoccupations with risk and clarity by reforming today’s incoherent and inconsistent payment system in the Eurozone. At the moment, the TARGET2 payment system has to connect to a fragmented network of 31 settlement systems throughout the Eurozone. T2S, by contrast, has a Eurosystem-operated central platform which insources the securities leg of a DVP settlement from Europe’s CSDs to create a single pan-European

OCTOBER 2012 • FTSE GLOBAL MARKETS

settlement system for transaction settlement in central bank money. What is more, by having the CSDs distribute that service, Europe will in principle enjoy the benefits of both scale and competition. The standardisation and harmonisation necessary will create a far more efficient and streamlined environment which will have the effect of reducing risks and so reducing costs. These efficiencies will leave the European securities industry stronger, more stable and more competitive in the global marketplace and will, importantly, facilitate more effective collateral management.

Show me the collateral The crisis introduced a safety agenda that was arguably missing pre-crisis and this has forced firms to think much more fundamentally about how they are going to manage their limited capital resources. In April 2012, The Quantitative Impact Study of the Basel Committee on Banking Supervision said that, in Europe alone, banks faced an aggregate shortfall of stable funding of €2.78trn in fulfilling the additional liquidity requirements of Basel III. The global industry is now facing an unprecedented need for collateral and it is not surprising that many banks are already concerned about how they can overcome this challenge. It is our experience at Clearstream that many players in the market still do not appear to have grasped just how much there is to gain from efficient collateral management. For example, some institutions have been exercising great effort in shaving fractions of basis points from custody fees—any cost reduction is clearly welcomed by them—but, at the same time, they are neglecting to undertake efficient collateral management which has a far greater potential for cost savings. In fact, optimising collateral can enable a bank to reduce its treasury costs by as much as half—say, from around 30 to 15 basis points—on what are usually considerable sums. In a market where

FTSE GLOBAL MARKETS • OCTOBER 2012

collateral has taken on such an important role, the savings available from maximising the use and holdings of a client’s collateral are a far more compelling prospect. Last year, a study undertaken by Clearstream with Accenture explored how banks managed their exposures and found that the majority did not have sufficient capability to optimise their collateral management. This was reinforced by a survey carried out by Finadium in May 2012 which found that only 13% of the 17 CSDs from around the world that they studied were able to deliver collateral optimisation services. The fragmentation at market level and the lack of coherence and cooperation within the banks themselves mean that between 10 and 15% of all available collateral is currently left unused. Accenture estimated that this inefficiency in collateral management has an annual cost to the global banking industry of more than EUR 4 billion. And these costs are set to increase substantially when the full impact of the new regulations is felt. One of the most significant findings in the Accenture study was that most institutions did not have a single overview of their available collateral globally and, in consequence, had no single point of control over their collateral management activities. T2S will go some of the way to easing this situation because the consolidation of settlement on the T2S platform will lead to a greater concentration of asset volumes in fewer locations which will enable a much greater efficiency in collateral optimisation. Choosing the right custodian is therefore key as it will determine the level of collateral management services available. At Clearstream, we are fortunate that we will be able to offer our T2S customers with a very high level of collateral management capability that gives them access to all their counterparties, both in the T2S and in the ICSD environment, all from a single account. T2S therefore will help

solve the fragmentation that has been costing the industry so dear.

It’s crunch time For some years now, the T2S initiative has been beset with uncertainty. The hesitancy of the financial sector and the sheer scope of the project left many with the impression that it might never get off the ground. After all, the ECB had postponed the T2S launch date from 2013 to 2014 and, last October, to 2015. It was only this year that that uncertainty was assuaged when the first CSDs put pen to paper in April and committed to join. The moment was significant for Clearstream: we were one of the first to sign and as the German CSD, we will account for 42% of all settlements on the T2S platform based on today’s volumes. LuxCSD, the CSD for Luxembourg which Clearstream has launched jointly with the Banque centrale du Luxembourg, was also in the first wave of signatories. Our strategy going forward fully encompasses everything we need to do so that our customers will be prepared not only for T2S but for the additional advantages it will deliver. For the participating CSDs, then, the way is now clear: we have to be ready to guide our customers into T2S through testing, migration and then the go-live, which is scheduled to be phased in from mid2015. Clearstream’s CSDs for Germany and Luxembourg are expected to join T2S in 2016. Some banks have already expressed their nervousness at going into T2S from the outset and are planning to hold back their system adaptations for a few years with a view to joining later. If they do, they face the risk of losing out on what for many market participants could prove a compelling business case, particularly in the area of collateral management, a growing priority for the global market. There is plenty to support the argument for undergoing the short-term pain of adaptation in order to reap the longterm gain set to result from the post-T2S world. I

sIbos report

FACE TO FACE: SATVINDER SINGH

Global transaction banking is an industry in transition. Deutsche Bank’s Satvinder Singh, global head of trust and securities services and cash management for financial institutions, outlines the developments, challenges and trends facing the future of the sector.

The evolution of transaction banking TSE GM: What are the elements of the transaction banking business which make it important to Deutsche Bank? SATVINDER SINGH: While macro economic conditions are still very challenging (with some experts now declaring that we are in the middle of a ‘lost decade’), the outlook for transaction banking is considerably rosier. Far from being in the middle of a ‘lost decade’, we would argue that transaction banking is in the middle of a decade of growth, a decade of being in the spotlight for exactly the right reasons. As all banks look to focus on business lines that can deliver stable growth, transaction banking offers not just the promise of a growing business that isn’t capital or risk-weighted asset-intensive but one that is fundamental to powering economic recovery, to strengthening international trade and to building new commercial connections. Transaction banking has always been core to the Deutsche Bank franchise and it has now been positioned as one of the four pillars of our business. Since we share clients with colleagues from other business units and serve those clients best by building solutions for them from across the Deutsche Bank franchise, transaction banking often acts as a glue and as the connectivity that helps brings the whole bank together for a client. FTSE GM: What are the unique selling points of the bank’s offering? SATVINDER SINGH: To me it boils down to one thing: we are singularly focused on delivering the best client service in the industry. There are four elements to that: being committed to transaction banking, acting as a partner not a supplier, deploying our expertise wherever our clients need it, and —

Deutsche Bank’s Satvinder Singh, global head of trust and securities services and cash management for financial institutions

perhaps most importantly—constantly innovating. Deutsche Bank’s commitment to transaction banking is a given. The business has been core to our offering for over a hundred years. That commitment involves expertise, sophisticated technology and robust global operations; and we continually invest in these three elements to ensure we are the safest, most credible provider. Moreover, we act as partners, not just suppliers. We spend time to fully understand the intricacies and nuances of our clients’ businesses and offer the right solutions to their problems, employing the entire Deutsche Bank network if we are required to do so. Equally, we take up cudgels on behalf of our clients driving, where appropriate, industry dialogue to ensure their views are best represented—a vital service in a time of extensive market change.

We also employ our global reach to ensure that, wherever our clients need it, we have the expertise to help them. We have people on the ground in most countries, with deep, local expertise and who are well connected with the local regulatory and business infrastructure, and who are able to deploy best practice between locations and products. Finally, perhaps dearest to our hearts at Deutsche Bank: innovation. In practice, it means we are constantly looking for better ways to deliver more value to our clients. Our Autobahn App Market, for instance, is just the latest example of the ways we harness the bank’s technology platforms to build client solutions that are simple, reliable and scalable. FTSE GM: What are the key influences on the evolution of the transaction banking service set? SATVINDER SINGH: Significant changes are blowing through the markets, with consequences for the transaction banking segment. There’s a sea change in the way that clients interact with banks for example. In some part, and we have to be frank about this, it is because of the loss of some degree of trust in the banking industry as a whole. Equally though, more than ever clients are making buying decisions based on the quality of service they believe they will receive from a provider. In that regard, they are looking not only for a provider of solutions, but a true strategic partner. Other reasons for this change result from impending regulation: some of it global, such as Basel III, some of it regional, such as Target2Securities. Clients rely on Deutsche Bank to better understand the exact impact of this regulation on their particular business and help them through the nuances of these rules, such as the different

OCTOBER 2012 • FTSE GLOBAL MARKETS

Deutsche Bank Global Transaction Banking

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sIbos report

FACE TO FACE: SATVINDER SINGH

requirements of doing business in each market in which they operate. Clients also rely on us to help them achieve greater operational efficiencies. All these developments are set against a business climate in which we’re seeing consolidation taking place. It is an interesting challenge to bring together all these strands and provide our clients with appropriate and robust platforms that can support the sometimes sophisticated solutions to the issues and problems outlined above. FTSE GM: Where do you see growth opportunities? SATVINDER SINGH: Our strategy is governed by our clients. At a group level, Deutsche Bank’s vision is to be the leading client-centric global universal bank. We believe we serve shareholders best by putting clients first and by building a global network of balanced businesses underpinned by strong capital and liquidity. What this translates to in transaction banking is that the effectiveness of our strategy depends on our ability to address the changing needs of our clients and help them benefit in this uncertain economic environment. External pressures aside, the greatest influences on our business strategy are our clients’ concerns and requirements. Services such as custody and clearing, cash management, and alternative fund and escrow services—where we can both respond to and in many cases pre-empt our clients’ needs—are important pillars in the implementation of this strategy. FTSE GM: Cash management is evolving rapidly. How do you work with your clients to augment their cash management operations and processes in an era where regulation and heightened reporting requirements are impacting on the business? SATVINDER SINGH: Cross-border trade remains dominated by two currencies: the euro and the US dollar. Deutsche Bank is the number one clearer of the euro and a dominant clearer of the dollar. Those straightfor-

ward facts make us a natural global cash management partner for local and regional banks. Moreover, Deutsche Bank continues to make significant headway in this business segment in the emerging markets, in currencies such as the renminbi. Of course, regulation continues to exert pressure on cash management operations, particularly in banks. In many cases, compliance has resulted in increased costs and depleted revenue streams for our clients and it is a nigh-on impossible dilemma for them. Increased reporting requirements add to this burden, and some institutions now worry that cash management might become an unprofitable business line for them. We can help. Our capacity, capabilities and global network means we can alleviate some of these strains for our partners and clients: we can do the heavy lifting, so to speak and act as their international bank network. It saves them time and cost and our clients appreciate the consistency and reliability of both our services and our commitment to provide them with solutions. FTSE GM: Trust and securities services are also undergoing change: with a raft of regulation ranging from AIFMD through to FATCA requirements. How is the bank helping them meet heightened standards of governance, investment and reporting? SATVINDER SINGH: Clients can best prepare by being informed. The challenge is not about knowing what the regulations are, but rather understanding what the regulations actually mean for them and their impact on their business models. Of course, this is easier said than done. Regulation has to be assessed on three levels: global, regional and country-specific. There is plenty of change at the global level and more and more our clients are asking us for detailed impact assessments to help them understand and gauge those rules which will apply to their own business models. They want us to help them take these regulations into account as they

shape their business strategies. The same logic applies at the business level. Our customers want to know how regulation will affect the pricing of products and services and, crucially, how it will affect their ability to win new business. It’s our job to provide understanding and guidance and we can provide this internationally, regionally and at country level. We can also assess the interplay of each of these levels of regulation and where contradictions and anomalies occur, we work with both clients and regulators to find a practical and workable solution. FTSE GM: With so much in transition, an overhaul of service sets and appropriate charges are in the pipeline for many institutions. What added value is the bank providing to its clients? SATVINDER SINGH: With so much in flux, we continue to focus on providing a consistently high level of client service, which is the foundation upon which our business is built. We understand that success in the trust and securities business, which is an area of finance in which trust and attention to detail are paramount, depends not only on sector experience and expertise, but also local market knowledge. We have skilled staff on the ground around the world that know the business, regional and local markets and regulators. This knowledge and reach, added to our products and platforms, plus our ability to leverage the bank’s expertise across any number of business lines, gives us the opportunity to package solutions that are designed specifically for each client. It is a powerful business tool. Deutsche Bank is doing some exciting things in terms of innovation in technology. An example that springs to mind is our Autobahn App Market. This is a first in the industry; an app-based electronic client offering that breaks down the complexity of corporate banking, retains richness of content and provides a highly intuitive and easy to use interface. It’s a great illustration of where Deutsche Bank is aiming its innovation: simplicity for the client. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

Towards a holistic view of collateral management Collateral optimisation is the name of the game right now: a way of ensuring that safe assets are deployed as efficiently as possible. This entails posting the right securities up as collateral against trades and means clearing trades in ways that lessen overall collateral requirements. Securities lending providers are now upping their game in terms of helping clients manage margin requirements and eligible collateral. However, collateral optimisation and its close partner, collateral transformation, carry risks. Firms that lend out securities need to apply rigorous haircuts on collateral they accept to ensure they have ample security. eSecLending’s Mat Gagne, managing director, product development outlines some considerations for beneficial owners. TSE GLOBAL MARKETS: How can firms make better use of their collateral assets? MAG GAGNE, MANAGING DIRECTOR, PRODUCTION DEVELOPMENT, ESEC LENDING: For firms where collateral has been managed within designated ‘silos’ of activity; for example, treasury/funding, trading and hedging, there is great potential for increased efficiency, improved risk management and decreased cost. By taking a more holis-

FTSE GLOBAL MARKETS • OCTOBER 2012

tic view of collateral and allowing cross-silo management to satisfy both internal and external constraints, requirements, supply and demand as they relate to cost, firms can proactively allocate and optimise collateral. FTSE GM: How complex is collateral management for most firms? Is it more or less complex now than say two years ago? If so, why has it become more complex? Is this complexity a good or bad thing? MAG GAGNE: With new and

COLLATERAL OPTIMISATION IN SECURITIES LENDING

Photograph © Rolfimages/Dreamstime.com, supplied September 2012.

changing regulation that calls for increased margins, collateralisation of previously unsecured trades, movement to centrally cleared settlement, and the call for higher quality assets, demand conditions have put added stress on supply. That stress is manifested in the granularity with which collateral assets are now being viewed and segmented. This makes the allocation decision far more complex than pre-Dodd Frank and Basel III environments. With complexity comes either opportunity or the possibility of being in a reactive and potentially less competitive position. FTSE GM: What are clients looking for in terms of collateral reporting? How do they make use of this analysis? What should they be looking out for? MAG GAGNE: Our clients have traditionally looked for verification of marks to market, compliance with margin requirements and intra-company securities financing P&L. In recent years there has been an increase in stress testing the adequacy of collateral and its margins against the underlying trade assets given default through the use of Value at Risk (VaR) measurement techniques. Additional emphasis is now placed on providing liquidity assessments of collateral under multidefault scenarios within bi-lateral, tri-party, an CCP trading. In short, what started as nominal exposure coverage, expanded to include measurement of potential losses and now addresses collateral and systemic liquidity analyses. FTSE GM: How does technology actually help firms optimise their use of collateral? MAG GAGNE: Software firms are investing heavily in their existing trading and back office systems to extend their collateral features. These include enhanced inventory management functions, expanded cost and prioritisation characteristics, segregated pools among legal entities, and integrated rules-based conditions derived from legal agreements, counterparty

sIbos report

COLLATERAL OPTIMISATION IN SECURITIES LENDING

limits, and regulatory requirements. With an increased level of granularity, technology providers can overlay workflow management tools and optimisation engines to present the most cost effective allocations and provide STP processing to increase efficient collateral movements. FTSE GM: Beneficial owners and banks are improving their crossproduct, firm-wide risk management of collateral of all types, and optimise returns from collateral trading in order to help them remain competitive. How is eSecLending working with clients to help them achieve collateral optimisation? MAG GAGNE: eSecLending’s holistic approach to securities lending extends naturally to collateral management. As an independent agent, we see value in managing enterprise-wide securities lending programs through the use of multiple providers and routes to market to achieve the optimal risk adjusted returns. Likewise, we are currently supporting clients by analysing the risk of their sources and uses of certain collateral on a firm-wide basis, optimising for cost and returns by trading that collateral and efficiently administering the workflow process. Against the backdrop of intensified competition and increasing regulations, more complex requirements from beneficial owners and banks are driving collateral management providers to expand their service and technology offerings. FTSE GM: How can clients optimise their collateral? Is it really possible? Or does it mean in practice, better processing of margin calls and returns? MAG GAGNE: While processing margin calls and returns can benefit from increased operational efficiency, collateral can be further optimised through active collateral management. The ability to release value by posting assets that reduce capital charges, substituting to capitalise on specials in the collateral pool, taking advantage of potential netting effects at CCPs and collateral transformation

Mat Gagne, managing director, product development, eSecLending.

trades all have the prospect of meaningful optimisation. The extent to which this is possible is dependent upon many factors including client guidelines, evolving regulations and ever-changing market factors. FTSE GM: Do you think that clients regard risk mitigation as the main driver of their collateral management efforts? Or have clients moved into more sophisticated or diverse approaches to collateral management? MAG GAGNE: Inquiries about collateral management, while traditionally driven with a view toward counterparty risk, have shifted focus toward optimisation as an expression of profitability of risk management. Traditionally, firms assessed the creditworthiness of a counterparty to determine the correct amount and quality of collateral to cover that credit exposure. Now, companies are looking across collateral silos toward enterprise-wide inventory management and are considering additional factors such as capital charges liquidity and opportunity costs of funding for their collateral assets. What was once a function relegated to back-office processing may now be becoming a more active component of overall asset, risk, and expense management. FTSE GM: Products that require collateral management are often handled in silos within organisations by product and/or by geographical divisions among derivatives (OTC and listed), equities, fixed income, and foreign exchange

and money markets. Are you seeing a drive to consolidate these silos? MAG GAGNE: The initial drive we are seeing is interest in examining what, if any, optimisation can be derived from establishing an enterprise-wide, holistic collateral management function. Should the analysis substantiate significant benefits, firms will then need to determine if it is practical to “consolidate” silos within their firm, for example, by creating a single collateral pool, allowing cross-silo collateral movement, or establishing a centralised distribution mechanism to exchange collateral intra-firm. FTSE GM: It is often stated in the marketing blurb of securities lending providers that: collateral is a vital tool for mitigating credit risk? How is that? MAG GAGNE: Collateral reduces exposure because a lender can seize collateral in an event of default. It follows that the more collateral one has and the higher the quality of the collateral, the lower are the expected losses associated with a default. FTSE GM: Equally, the marketing blurb often states effective collateral management helps “maximise potential returns”. How does that work? MAG GAGNE: Allowing for multiple collateral alternatives provides another lever for the securities lending provider and therefore the asset manager to impact returns. By adding flexibility to collateral guidelines, more stringent controls and active management, lenders can allow borrowers to deliver lesser quality collateral with higher margins. Since this is more costeffective for borrowers, lenders should reap the benefits of higher intrinsic returns. When accepting a relatively diverse collateral mix, lenders exploit another revenue driver as they expand their universe of counterparties and increase distribution channels. In addition, cash collateral can be reinvested to capture interest income which can also maximise returns within a securities lending transaction. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

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sIbos report

UK FINANCIAL MARKETS REGULATIONS: A READY CHECKLIST

Next year marks yet another momentous period in terms of incoming regulation and red tape, and already over-burdened securities firms must be prepared. Since the financial world first showed signs of ailing five years ago, the world’s regulators have been gradually fighting back and tightening their control over firms with ever more intrusive and restrictive regulation, in Europe and the United States especially. The next 12 months is a bumper year for regulation in the United Kingdom. Charlotte Hill and William Maycock, partners at law firm Stephenson Harwood, look at the few of the more significant regulatory developments that will affect securities firms.

Cutover to new UK regulations HILE INCOMING REGULATION will affect the financial services sector in its entirety, it is naturally a serious consideration for securities firms. Under the UK coalition government’s proposals, the Financial Services Authority (FSA) will cease to exist in 2013 will be replaced by three new regulators: the Financial Policy Committee (FPC) which will sit within the Bank of England and be responsible for macro-economic issues and financial stability; the Prudential Regulation Authority (PRA) which will be a subsidiary of the Bank of England and have responsibility for microprudential regulation; and the Financial Conduct Authority (FCA) which will be a company limited by guarantee and take on conduct of business regulation and the majority of the FSA’s current responsibilities. Lord Turner has expressed the view that the new regime will begin operating in April; a regime whose changeover date has been named “legal cutover” by the FSA. The UK Financial Services Bill, which provides the legal framework for the new regime, is currently going through the final stages of the legislative process in the House of Lords and is expected to receive Royal Assent before the end of this year. Any legislative changes arising from the review of the London Interbank Borrowing Rate (LIBOR), headed by Martin Wheatley, the chief executive officer designate of the FCA, will also be included in the Bill once they are published this autumn.

Photograph ©Eltoro69/Dreamstime.com, supplied September 2012.

In addition, the FSA is currently consulting on the framework for new rules and guidance to replace the current FSA Handbook as required by the new regulators. Both the PRA and the FCA will end up with their own rule books once they gain their legal powers. The interrelationship between both regulators and the make up of their rule books is of particular importance to securities firms, since a select number may find themselves dual regulated when legal cutover takes place. All of this will become much clearer in the next few months.

MiFID II The legislative proposals for the European Commission’s review of the Markets in Financial Instruments Directive (MiFID) were published in late October of last year. This is a hugely complex piece of European legislation which will take the form of both a directive (MiFID II) and a regulation (MiFIR) and will affect securities firms enormously. While it is not due to come into force in member states

until 2015, 2013 will see the terms of its mandate finalised. Some of the key proposals include the creation of a new type of regulated trading venue, the organised trading facility (OTF), which will catch all forms of organised trading that do not match existing categories; new safeguards for algorithmic and high frequency trading; and an extension of the directive’s scope to include types of financial product currently outside MiFID, such as structured deposits. Moreover, proposals include a comprehensive ‘one size fits all’ transparency regime for both equity and non-equity markets, such as bonds, derivatives and structured finance products; extending the scope of transaction reporting requirements to all financial instruments to ensure alignment with the Market Abuse Directive (MAD); the ability for regulators to ban specific products or services if these threaten investors or financial stability; and the introduction of a harmonised third country equivalence regime for access to the EU. Another key proposal involves new rules on corporate governance for all MiFID firms, especially in relation to executive and non-executive directors. Many of these proposals present seismic changes to the regulatory landscape for securities firms and it remains to be seen how many will make it into the final draft early next year. A number of bodies including the Treasury and FSA in the UK have voiced concerns about some of the proposals including the creation of OTFs,

OCTOBER 2012 • FTSE GLOBAL MARKETS

William Maycock, partner, Stephenson Harwood. Some of the key proposals in MiFID II include the creation of a new type of regulated trading venue, the organised trading facility (OTF), which will catch all forms of organised trading that do not match existing categories; and new safeguards for algorithmic and high frequency trading, writes Maycock. Photograph kindly supplied by Stephenson Harwood, September 2012.

the third country access regime and transparency. Further, the House of Lords EU Select Committee stated in July 2012 that the new proposals are too rushed and risk creating confusion rather than clarity. It has suggested the government should liaise with the European Parliament to make its objections known. It is by no means yet set in stone, so watch this space.

MAD II The European Commission is also currently overhauling the Market Abuse Directive (MAD), which was adopted in Europe in 2003, and it put forward legislative proposals to this effect in October of last year. The aim of the overhaul is to strengthen and update the EUâ&#x20AC;&#x2122;s defences against market abuse by replacing the old directive with both a regulation on insider dealing and market manipulation and a directive on the available criminal sanctions in relation to both activities. By electing to use a regulation the European Commission aims to create a single, directly applicable, EU-wide rulebook on market abuse for the first time. It is an attempt to remove the inconsistencies that currently exist between regimes in different member states. The regulation is broader in scope than the original directive and shall extend the market abuse framework to cover not only financial instruments admitted to trading on an EU regu-

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2012

lated market, but also those traded on multilateral trading facilities and OTFs, as well as any related OTC financial instruments. A number of high frequency trading strategies will also fall foul of the new regulation. In addition, the definition of market abuse is to be widened to include certain information outside the public domain, which would significantly affect the price of relevant financial instruments if it were made public. Suspicious transaction reporting obligations are to be extended to capture suspicious orders as well. The regulation also builds in numerous new enforcement and supervisory powers for regulators and gives them access to more information so as to better detect possible abuse. The new directive proposes a set of minimum rules on the types of behaviours which will constitute a criminal offence. Intentional insider dealing and market manipulation shall constitute offences, as will inciting, aiding and abetting market abuse. However, the UK has decided not to opt into the new directive at this time, but shall reconsider once the regulation and the new MiFID II proposals are more concrete. The texts for both the regulation and new directive have been passed to the European Parliament which is to review them in plenary session in January. Given the delays and the amount still to resolve, it is now not likely that either will come into force before 2015. At present, it is also very difficult to assess accurately how MAD II will affect the UK, since the government has exercised its opt out from the new directive element of it. Despite this, next year will be critical in determining what sort of beast MAD II will be and how it will affect the UK.

CRD IV Proposed amendments to another European directive, the Capital Requirements Directive (known as CRD IV), are set to provide securities firms with yet more regulatory food for

Charlotte Hill, partner, Stephenson Harwood. Any legislative changes arising from the review of the London Interbank Borrowing Rate (LIBOR), headed by Martin Wheatley, the chief executive officer designate of the FCA, will also be included in the Bill once they are published this autumn, writes Hill. Photograph kindly supplied by Stephenson Harwood, September 2012.

thought during this period. The European Commission wishes to replace the two current directives with a directive and a regulation. The main purpose of CRD IV is to implement the changes agreed in the Basel III reforms in December 2010, which are designed to strengthen the prudential requirements for credit institutions and investment firms following the financial crisis. The deadline for EU member states to implement CRD IV and for it to come into force is January 1st 2013, but the text has not yet been finalised at a European level and a number of member states are questioning its usefulness. The FSA does not currently believe that it is therefore feasible to implement CRD IV by the start of next year and has put back the date of its consultation on implementation until further notice. However, it expects firms affected by the proposals to prepare as much as possible for a January 1st implementation date. The key proposals in the directive include strengthening the criteria for what may make up regulatory capital, especially the definition of common equity; increasing the minimum ratios for common equity and Tier 1 capital; new types of capital buffer; encouraging the use of central counterparties for clearing OTC derivatives trades; and new liquidity and leverage ratios. CRD IV also proposes to introduce a stricter, single set of harmonised prudential rules for all firms caught by the CRD. I

Q&A: LAURENCE BAILEY, CEO ASIAPAC, JP MORGAN

It is a period of immense change in the Asia-Pacific securities services market. While obvious requirements, such as an onshore presence in the various markets and the integration of investment products and services is becoming more important, in recent years providers have had to overhaul and redraw the boundaries of the servicing set; often involving high value services such as risk analytics, collateral management and so forth. Francesca Carnevale spoke to Laurence Bailey, chief executive officer for Asia Pacific at JP Morgan Worldwide Securities Services (WSS) about the changes in train. Bailey says Asia is evolving quickly. Risk analytics, compliance monitoring, performance measurement, increased support on class actions and proxy service are becoming an important component of the securities service set. “There’s significantly more change occurring than ever before. Shifting economic priorities in domestic markets, evolving regulatory frameworks and an increasing pool of assets are key drivers of this change. However, the one constant that we see in Asia is the growing sophistication of clients and their sharper focus on leveraging new crossborder investment channels and entering new asset classes.”

Towards an Holistic Approach to as much as $7trn or even $8trn over RANCESCA CARNEVALE the next three or four years. These (FC): Asia’s continued growth growing international flows mean that and development despite as an asset servicing industry, we are some current hiccups, looks a given; evolving rather quickly in the way we how are you feeling about Asia’s are servicing clients and the way that prospects within a global context we conduct and prioritise our own right now? business development to meet LAURENCE BAILEY (LB), CHIEF these growing asset pools. On the EXECUTIVE OFFICER, ASIA back of Asia’s continued growth, we PACIFIC, JP MORGAN would also expect to see an ongoing WORLDWIDE SECURITIES diversification of assets and financial SERVICES: Since first arriving in Asia Photograph © Simon Child/ Dreamstime.com, instruments that are invested into, as around 20 years ago, I’ve seen the supplied September 2012. well as client needs and client industry grow and evolve through a solutions. Risk management will number of different lenses. It has been exciting and rewarding, but also tremendously challenging. remain a crucially important consideration. In terms of Driven by deepening asset pools and rising consumer wealth themes, the conversation around a potentially UCITS-styled across the region’s 18 markets, I feel good about Asia’s Asian passport system will continue to spark interest, as of course will the evolving relationship between global and short-, medium- and long-term prospects. FC: What are the big themes that you’re seeing today, sub-custodians—we’re are already seeing a blurring of the lines between global and local custodians and that you’d expect to see over the next few years? LB: Looking at how the region has changed, one of the presenting something of a convergence of custody and this most fundamental trends over the years has been the surge will accelerate. in cross-border flows, with markets such as Japan, Australia FC: There are some interesting issues there that we can and Taiwan—as well as some of the more developed ASEAN explore. Let’s start however with the fact that an onshore markets—really leading the way, with Korea and China fast presence in the various markets and the integration of catching up. A few years ago, these international flows investment products and services is becoming more probably came to around $2trn or $3trn and while the important as the Asian securities services continues to available industry data is not entirely definitive, I would evolve. What are the key client requirements in this agree with some of the estimates I’ve seen that place the climate of change and how is JP Morgan responding in current cross border asset flows at around $5trn, increasing terms of new platforms and new services?

OCTOBER 2012 • FTSE GLOBAL MARKETS

LB: As institutions increase investment and exposure to cross border assets, more and more often they are also looking for a more complete local service and not just a mailbox for a remote global operation. As opposed to simply receiving an enquiry and waiting for their global teams to respond, clients want someone who can speak the local language, who understands their needs and has the ability to interrogate system data locally and effect changes if required within the same time zone. From our perspective, we’re taken this new client landscape to heart. We’ve invested considerably to build new client tools that allow them to self-review data and enquiries so that they can achieve an even faster response locally, before passing to our team to leverage our distributed operating model and take advantage of time zones without being beholden to global hubs. FC: In recent years, the trend has been for custodian providers to offer a more holistic approach in terms of service solutions. All this must involve substantial investment costs; but Asia is notorious for wanting added value at no extra charge. How are you approaching this with clients? LB: It’s all about understanding what the client needs and the problems that they’re trying to solve, and making sure that the solution fits. As a client, it is easy to get excited by a Ferrari’s sleek lines and the engine under the hood, but if you only need to drive 30 km/h, you need to ask yourself whether you really need or are willing to pay for one of the fastest cars in the world. In the past, service providers have tried to keep their clients happy, showcasing products and solutions to clients that may not be required at that stage or are not needed to solve the client’s needs, resulting in higher fees for a range of solutions and a lack of flexibility in future fee schedules. However, with asset pools in Asia growing rapidly, there is increasing recognition of tiered pricing structures that match the client’s growth trajectory. This is the challenge. FC: Shifting economic priorities in domestic markets, evolving regulatory frameworks and an increasing pool of assets are key drivers of financial change in Asia. However, the knock-on effects of sustained recession in the West now look to have started to squeeze Asian GDPs. What is the general business outlook for the rest of 2012 and the first half of 2013? Where are the pressure points and where are the opportunities? LB: The correlation between domestic GDP growth and the size of cross border investments is not a simple one. Strong local GDP, which can result in strong local stock markets, can effectively result in a slowdown of cross border flows. The reasoning is obvious: why move into offshore investments, into markets facing headwinds, when the returns at home are perfectly adequate and in fact superior? It is when GDP in a home market begins to slow, that institutions will look offshore to diversify their holdings and find a better yield relative to their risk appetite. Of course, you have to strike the balance and investors should always ask: does the investment destination give me what I need at the right price? In

FTSE GLOBAL MARKETS • OCTOBER 2012

Laurence Bailey, chief executive officer for Asia Pacific at JP Morgan Worldwide Securities Services (WSS). Photographs kindly supplied by JP Morgan, September 2012.

terms of cross-border flows, we have seen a mild slowdown in Asia as a result of challenges in Europe and the United States. However, even as Asia has cooled slightly, it’s also making those markets look more attractive again—at least for now—so we’re again seeing a slight pickup to those global markets. FC: What is the appetite of Asian investors for new asset classes and alternative investment approaches? How is this changing the definition and provision of securities services in the region? LB: There’s a wider focus now on different asset classes and instruments, and institutions are moving away from the traditional fixed income markets, and into global equities and alternatives. From an asset servicing perspective, it means we’ve got to be better at looking after our clients, provide broader solutions and deliver value across a wider range of asset classes and instruments. The full service value play is key here. FC: If full service provision is key, that means clients are still asking for end to end solutions from individual providers? Or, are they beginning to spread their business across two or three providers to share out risks? LB: That’s a great question with a simple answer: absolutely, though the scope of business typically varies depending on the client’s needs. In some markets—take Australia for example—you have legislation in place which essentially dictates the use of a single custodian. When you move out

Q&A: LAURENCE BAILEY, CEO ASIAPAC, JP MORGAN

of Australia, there is a more defined mix between providers handling either domestic or international holdings, so that’s at least two. We’re also seeing a split sometimes between in-house managed funds and externally managed funds, along with different custodians handling fixed income, equities and alternatives. As an asset servicing provider, the more strings you have to your bow, the more widely you can engage with your current and potential clients to talk about a holistic solution. It doesn’t mean you’re necessarily going to capture all the business every time, as a client’s diversification strategy is important. However, it does mean you’re at least part of the conversation and more importantly the solution. FC: JP Morgan executives have always stated that the bank takes a ‘client-first’ approach. This suggests a large degree of product and service customisation. How feasible is this policy in straightened times? Or does technology now allow the bank to do more with less? LB: Clearly we need to have systems in place that are highly efficient in providing our core servicing capabilities, coupled with the ability to customise services for our clients’ specific needs. Interestingly, in the past, the industry felt that client first was always saying “yes”, rather than fully understanding what the client needed or more importantly what the client was trying to achieve. So we’ve listened, responded and deepened what we offer—not only do we customise for our clients, but we have flexible client reporting tools that put the power of customisation into the hands of our clients. Best practice asset servicing is about building an information superhighway and then giving the clients the fuel to hit top gear themselves. FC: You mentioned at the start of the interview, a convergence of custody. What is the state of play in the relationship between custodians and sub-custodians in the Asia-Pacific region? LB: We are seeing a convergence of custody between the global and sub-custodian segments, but the motivation for each is complex and different. Speaking primarily as a global custodian, we see our role as supporting the cross border investment needs of our institutional investors, which are increasingly looking to invest directly in certain markets where they feel they have the size and scale, and will benefit from a direct relationship into the market. So we’ve responded to this by bringing back in-house direct custody and clearing where we already have size and scale ourselves, and where the strength of our balance sheet gives clients security around solvency risk and the availability of liquidity. Our clients are asking for this support. FC: Are sub-custodians looking themselves to expand the service offering to their clients? What might this mean for the custodian/sub-custodian relationship going forward? LB: Local custodians on the other hand are recognising that some of their larger global custodian clients are starting to insource direct custody operations and so are leveraging their distribution capabilities to support the growing local market, particularly around mutual fund support.

FC: How much of your business in Asia is domestically sources, among local asset gatherers and pension funds and how much is following Western firms that have established operations in the region? What does this business mix mean for the definition and evolution of client sales in the region? LB: The majority of our business in Asia is sourced from Asian institutional investors, investing outside of their home markets, although a significant component of our business is also supporting the global investment managers who not only invest into the region and have set up research and trading desks, but are also setting up mutual funds—either distribution centres for their UCITS funds or local mutual funds. In terms of what JP Morgan handles, over $1.5trn of assets are originated and safe kept on behalf of Asia clients investing overseas. FC: Is there still a lot of investment in offshore funds domiciled in Europe? Or are clients now looking at domiciles within Asia, while still utilising UCITS structures? LB: Luxembourg and Dublin UCITS funds are established vehicles that have a proven track record, transparency and geographic independence. So yes, they are still very much a central part of the investment destination mix. One of the current hot topics is around a potential Asia passport system, but a final resolution could be some way off. Setting up a locally-domiciled UCITS platform would be expensive, and there would be a lot of intra-regional considerations to take into account. FC: What are the implications of this trend over the long term? LB: It may well happen that down the track we see something like a Greater China hub, or an ASEAN hub, or even a single market offering, perhaps in Australia, for example. FC: Services to the cash-rich central banks of the Asian region must be a strong pillar in your overall business strategy. How much more can you expect from this business segment? LB: Central banks and sovereign wealth funds are a key foundation for any country’s cross border investments, and so it is an important client segment for us. We see the foreign reserves of Asian central banks continuing to grow and continuing to direct their investments out of traditional US treasuries and Eurobonds and into more diverse investments—and even more so for sovereign wealth funds. Central banks and sovereigns are investing, getting bigger and spreading their focus to new markets, asset classes and instruments. From our perspective, we have to maintain security of assets, accuracy and timeliness of reporting and confidentially. It’s as simple as that. FC: Back in 2012, we saw massive investment by JP Morgan in terms of Asia-Pacific headcount. What is the growth strategy of the bank’s WSS business over the coming three years? LB: As a firm we are continuing to invest strongly in our Worldwide Securities Services business across the region, and we’re going to continue to do so. Investing for our

OCTOBER 2012 • FTSE GLOBAL MARKETS

“Clients are demanding much more than global custody services these days,” says Bailey. “Clients in Asia, like clients around the world, are looking to provide help on three key pillars: reduced risk, increased revenue and enhanced efficiency,” he says. Photographs kindly supplied by JP Morgan, September 2012.

clients—even in challenging market conditions—is an important part of our long-term business strategy, and it is vital that we continue to focus on helping our clients succeed with new products, new platforms and new market capabilities. Specifically, we’ve been spending on our technology and infrastructure platforms; we’re deepening our focus on direct custody & clearing in India, Australia, Taiwan and soon-to-be Hong Kong, and in collateral management, we’ve hired specialists that can drive solutions for our clients. We are viewing the Asia Pacific region as having a much higher stake in the investment initiatives for our core underlying platforms and people resources. It’s about making sure that as a region, we have the right builds in place for our clients. We’re also seeing opportunities to link in with our investment banking and asset management franchises to incorporate elements such as passive currency overlay, futures and options clearing, derivatives pricing. FC: How much further expansion do you envisage? Or is this not the right time to talk about this? LB: Actually, it’s fine. Clients are demanding much more than global custody services these days. Clients in Asia, like clients around the world, are looking for custodians to provide help on three key pillars—reduced risk, increased revenue and enhanced efficiency. Being linked to a world-class investment bank, which allows us to offer services around FX, collateral management, currency overlay, futures and options clearing, is very much a benefit in this regard. It means that we can bundle solutions that allow our clients to benefit from a seamless service from one provider; we think this is a very significant advantage going forward. FC: Let’s look at some other trends please. Regulation and re-regulation is a key theme in many markets right now.

FTSE GLOBAL MARKETS • OCTOBER 2012

How much is the Asia-Pacific striving to be in line with regulation, governance and best practice in the West? LB: Regulatory reform is happening everywhere—not just in the United States and Europe. As a US firm, we are very conscious that we have to adhere not only to the rules and regulations in the US, but also all the other countries around the world where we do business. Given that we’re increasingly making decisions looking through each lens, we have an extremely comprehensive legal and compliance support structure to ensure we’re doing it right. When we want to offshore a particular service from one location to another, or when we’re introducing a new solution, we need to closely engage with local regulators. Our relationship with local regulators is becoming even more comprehensive, transparent and collaborative, which I think ultimately, will be an important relationship in terms of the industry’s future development. FC: Outside of Hong Kong, how much cross-border investment is taking place in Asia? Where do you see growth? LB: As I mentioned earlier, we think the amount of crossborder flows currently stand at around $5trn, and this is growing on multiple fronts. The public sector is leading the charge with stated objectives by many governments to increase their cross border allocation, while pension funds in Korea, Malaysia and Thailand are also increasing their exposure. In general, Asia is now one of the largest contributors to inflows into UCITS funds, specifically, Japan, Taiwan, Hong Kong and Singapore. Local insurance companies are also expanding internationally. Looking forward, we feel much of the growth will be driven by Australian superannuation funds, emerging Asia public sector funds and local insurance companies. I

FUNDS REGULATION

Regulation was not surprisingly the dominant theme at the recent Association of the Luxembourg Funds Industry (ALFI) global distribution conference but the MiFID proposals on inducements did generate quite a buzz. Although the final version is still being debated, there are concerns that a ban on commissions could dramatically diminish the independent financial adviser (IFA) community. Lynn Strongin Dodds reports.

ARE IFAs UNDER THREAT? investors will adopt a do-it-yourself T THE END of September approach to investing and turn the European Parliament’s to the internet to canvass Committee on Economic suitable products. and Monetary Affairs (ECON) voted His views were shared by fellow to restrict the commissions brokers speaker Diana Mackay, head of can accept for selling financial research consultancy Mackay products. It said that such inWilliams, who noted that, “the ducements posed a conflict of whole area of distribution is interest and wants to follow the lead standing at a crossroads, and a of the UK’s Retail Distribution heavy hand of regulation that is a Review, which becomes effective in one-hit ban on inducements will January 2013. potentially destroy those people we The Netherlands and Denmark need to develop a healthy financial are also on the same track but the system: the IFAs.” ruling is expected to be challenged According to Mackay, distribufrom several European countries tors are “looking at how they can including France, Luxembourg and secure their business propositions Germany, where commissions are a Photograph © Vladgrin/Dreamstime.com, for the future, and all this will place key revenue stream for their banks supplied September 2012. extra demands on cross border and brokerages In fact a recent study conducted by Cerulli Associates and groups at a time when business volumes are scarce and Phoenix Marketing International, which canvassed 5,000 profit margins are being squeezed. The solution must be to high net worth individuals, showed that only 28% of French try and engage and develop an independent advisory and 36.8% of German investors would be willing to pay for structure in continental Europe, because these are the people who will educate the end investor.” financial advice. Mackay advocates a lighter touch such as rules that In both countries, almost half preferred their adviser to be remunerated via commission than by either a fixed fee based promote increased transparency of information on product on their assets or an hourly rate. Luxembourg has been es- structures, fees and charges and other issues that enable pecially opposed to any ban due to the size of its banking investors, and their advisers to be properly informed. In industry and its reliance on this model and has argued addition, she believes that best practice should be embraced against laws that would require banks to disclose to clients among all levels of advisers and that the conflicts of interest and incentives that potentially encourage the sale of inapthat they are compensated for certain product sales. The main concern ling is that without inducements the propriate products to investors be eradicated.“There should financial industry could lose huge numbers of customers. be industry and government support to build the regulated They also claim their IFA structures cut the cost to clients for independent advice sector and all of the above should be financial advice as they do not have to pay directly for the in- product agnostic,” he says. Market participants also believe that more attention vestment product. Negotiations on the Parliament’s version of the rules will begin once the 27 member states agree on should be given to the quality of advice. The Cerulli a common approach, which is expected in November. The Associates and Phoenix Marketing International found that satisfaction levels were only 50% in France, where directive is slated to become law around 2015. Eddy Wymeersch, professor at the University of Ghent, investors rely more on private banks, Italy which depends told the conference if the ban is passed, “the integrated on retail banks and Spain which also has a bank distribution model will continue to thrive but independent dominated advisory culture. Ironically, the UK where advisers will be under heavy pressure and this could IFAs have a lock on the business, accounting for about drive them out.”The result, according to the former chair of 80% of fund sales scored the lowest among the five the Committee of European Securities Regulators, is that countries surveyed. I

OCTOBER 2012 • FTSE GLOBAL MARKETS

Q3 2012 MENA ASSET MANAGEMENT SURVEY

The third iteration of the Middle East Asset Management survey, which we undertake under the auspices of the Qatar Financial Centre Authority (QFCA), brings into vivid relief a number of important trends. Bifurcation in investment approaches has become stronger over the last two quarters: domestic investors are investing more domestically and international investors are increasing their cross-border allocations. Two, civil and political unrest continues to impact selected markets, with Lebanon, Jordan, even Kuwait feeling an investor pinch as local asset managers upscale their risk assessments on these countries. Bahrain and Egypt too continue to feel the repercussions of the Arab Spring; however a move towards more positive investor sentiments is apparent. In contrast, investors continue to be optimistic about Saudi Arabia, Qatar and Oman in the region; and about South America and Africa outside it. Dubai too has benefitted as investors and corporations have uprooted and moved in many instances to the UAE. The survey also throws up interesting news for international providers of securities services in the MENA region. HSBC emerges as a clear regional front-runner among the 83 investors polled. Among the key trends to watch are growing investor frustration with constrained liquidity and inadequate regulation covering the region’s capital markets, which they say, will have long term effects on the efforts by individual markets to develop as regional financial hubs. Research by Henry Blanchard, Lydia Koh and Rebecca O’Brien.

Middle East investors grapple with political risk & constrained liquidity HIS IS NOW the third iteration of our commitment to map quarterly changes in the MENA asset management industry which, after a summer lull, appears to have regained in ground and depth. The survey strives to describe the current investment outlook of a diverse range of asset management firms in the Middle East region; to assess the perception of political/economic risk within the region and to outline current thinking among the asset management industry as to what infrastructure is important to the proper functioning of their business. The survey polled a wide variety of asset management firms: including mutual funds, sovereign wealth funds, dedicated country funds, a smattering of hedge funds and the asset management arms of leading banks in the wider region. From these returns we have extrapolated the analysis from the responses of these asset managers, which handle (on the basis of numbers provided to us by them) some $74,883m worth of assets under management (AUM).

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MAPPING MARKET CHANGE: MAIN SURVEY FINDINGS I

Investors remain positive about Saudi Arabia, Qatar and Oman; and Dubai enjoys a comeback Investors remain bearish on Europe, but very positive on South America and Africa Investors keen to see coordinated efforts between countries to improve the regulatory environment and achieve more efficient capital markets HSBC is the clear front-runner as a provider of custodian services to the region’s investors Investors keen to achieve passportable investment product Investors frustrated by constrained liquidity across the region Investors keen to see more sophisticated products introduced (including derivatives, but under proper regulation) Investors worry about Lebanon and Jordan, and to a lesser extent Kuwait, as political unrest waxes and wanes across the region

Clearly, 2012 has been a testing year for investors; no less so than in the Middle East and North Africa (MENA) region. This third survey provides a clear touchstone across a number of trends and segments that will likely govern the investment outlook and business approaches of an increasingly confidence asset management industry for at least the next twelve months. The survey was conducted between July 25th and September 20th this year. Some 393 firms were approached for information of which 83 responded, either by phone, fax or email. The first iteration of this quarterly survey (please see FTSE Global Markets, April 2012) clearly set out the goals of the survey: to describe the current investment outlook of a diverse range of asset management firms in the Middle East; to asset the perception of political risk within and without the region and to outline current thinking among the asset management industry regarding the emerging infrastructure that supports

Q3 2012 MENA ASSET MANAGEMENT SURVEY

investment and the emergence of investible product in the wider region. Each past iteration has emerged with its own findings and character. The first concentrated on the main asset allocation strategies utilised by the 79 respondents. The initial survey clearly showed that private equity, equities, bonds and real estate dominate the asset allocation mix political risk remains a constant backdrop. This time around we have attempted to provide a more detailed analysis of the nuances in approaches to asset allocation. If respondents were exposed to three or more asset classes, then they were deemed to have a mixed or diversified strategy; and we distinguished these from a dual asset class or single asset class investment strategy. With the international investment markets continuing in flux; it is no surprise that this third survey shows that access to liquidity is the prime concern of survey respondents. This latest update also highlights the continuing impact of socio-political unrest, which continues to resonate across the region; with the Levant and Jordan materially impacted. Global custodian providers must also pause for thought as the region shows a marked preference for local providers; though HSBC has emerged a clear favourite among the ranks of global custodians.

Chart 1: Domicile of Survey Respondents Levant 11% North Africa 11%

Region

GCC North Africa Levant

Number

78 11 11

trend to invest more funds abroad, though the definition of abroad is often described by other countries in the wider MENA region. Like the Q1 survey, we found a tendency towards a bifurcated approach to the geography of asset allocation; with varying amounts of assets allocated to international investment. Please refer to Charts 2, 3 and 4 for a more detailed look at the changing spread. Although the overall trend is towards more internationally focused investments, in those firms with more than 80% of assets retained in domestic investments there is an equal preference to place more assets in the domestic market. Please see Chart 4. Although quarter on quarter trends in asset allocation can obscure longer term structural changes in geographic preferences of investment firms, because the MENA region has been subject to socio-political disruption through 2011-2012, we would expect more dynamism among investors in terms of geographic asset allocation. Moreover, we would expect this to be illustrated in shifting investment preferences towards international (global) rather than domestically (regional) focused investment. Two things are apparent from this survey. FIrst, the impact is measured rather than extreme. It shows, however, some sign of either increased use of risk management tools among the investment community or growing confidence in the ability of the investment managers to generate returns from their existing investments. These are trends are also mentioned informally in the phone interviews (and are themes we intend to pursue in more depth in the final quarter survey).

Chart 2: Domestic v International Investment Q3 2012 GCC 78% 16

Number of firms

14 12 10 8 6 4 2

Ratio Domestic: International

rn No ation An al sw er

10 :90 10 0%

Int e

20 :80

30 :70

40 :60

50 :50

60 :40

70 :30

80 :20

90 :10

me sti c

10 0%

Chart 1 shows the general breakdown of the location of respondents. Dubai made up the largest contingent in the GCC grouping, providing 29% of all responses. Kuwaiti investors were also keen survey respondents, accounting for 21% of all responses; Bahrain 13% and Saudi Arabia 11%. As with this yearâ&#x20AC;&#x2122;s first quarter survey, Lebanon (which accounted for 8% of the total responses) was the single biggest provider of responses outside of the GCC. Egypt followed closely on with 6%. The overlap of respondees with the first quarter survey was 92%, thereby providing some resonance to any synergies between the two sets of results. This latest iteration of the survey series has delved more deeply into the survey sample with the result that discernible shifts in approaches to asset allocation are visible. While the April survey results showed a diverse mix in the ratio of assets invested at home and abroad; this third quarter survey looks to show a small yet measured

Moreover, the definition of international is increasingly described by the MENA region. It is not surprising then, that the variance analysis (Chart 4) shows both a modest movement towards international investment and a markedly renewed focus on domestic investments among those firms with a concentration (80% of assets and above) in local markets. While there are national differences in the way that

OCTOBER 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

Chart 3: Domestic v International Investment: Q1 2012 versus Q3 2012 18 16

Number of firms

14 12 10 8 6 4 2

No 0:1 An 00 sw er

10 :9 0

20 :8 0

30 :7 0

40 :6 0

50 :5 0

60 :4 0

70 :3 0

80 :2 0

10 0:0

90 :1 0

Domestic vs. International Investments

Chart 6: Concentration of Investments in the GCC among respondents Not Declared 14%

4 3 2 1 0 -1 -2 -3 -4 -5

Region

Levant 5%

:90

GCC 73%

0 :1 00

:80

:70

:60

:50 50

:40 60

:30 70

:20

:10 90

Value of Assets held, US$m

GCC 29,076.036 North Africa 3,051.645 Levant 1,995.694 Not Declared 5,388.625

North Africa 8%

0:0

Variance between results Apr 2012 v September 2012

Chart 4: Variance Analysis: Domestic v International Investment: Q1 2012 v Q3 2012 â&#x20AC;&#x201C; A marked tendency towards more international investment?

Of those respondents whose funds are invested either wholly or in part in MENA the bulk are directed towards the GCC. The Levant (which for this survey includes Lebanon and Jordan) was attractive to only 5% of respondents, while North Africa (for this read in large part Egypt) was attractive to 8% of respondents. There is notably lesser interest in Morocco and Tunisia and none in Algeria and Libya. While it is clear that money attracts money; it also appears that the concentration of invested assets in the GCC is also indicative of the heightened risk profile of many countries on the periphery of the Mediterranean. In this regard, as with the first quarter survey, the responses show that international macro-factors continue to exert a strong influence on investment decisions both at home and abroad among respondents. These trends are clearly exhibited in Charts 6 & 7.

Ratio of domestic focused to international focused investment Variance Linear (Variance)

investors approach investment to the MENA region, there is a clear disposition among survey respondents to invest locally. Over one third of respondents have all their assets invested in the Middle East and North Africa. Only a handful claimed to have none invested in MENA. As Chart 4 illustrates there is more dynamism in asset allocation among those funds with approximately 80% of their portfolio in the domestic market: a marked willingness then to shift capital when necessary.

No Answer

ria

None

Less than 20%

Ira q

20-49%

pt Jo rd an

50-69%

Eg y

70-99%

UA E Ku wa it Le ba no n

1 100%

tar

Om an

Sa ud i

100% 70-79% 50-69% 20-49% Less than 20% None No Answer

7 6 5 4 3 2 1 0 -1 -2 -3 -4

Ba hr ain

Number of firms investing/divesting

Chart 7: Where MENA Investors will put their money in 2013

Chart 5: Percentage of Assets Under Management Invested in MENA 40 35 30 25 20 15 10 5 0

The concentration of investment within the MENA region by the respondents is visible from Chart 6: Placement of investments in the MENA region. Moreover, International investment still has strong intra-regional, rather than global connotations. Chart 7 outlines the vagaries of cross-border investment flows. Compared with the April survey, investor positions on Iraq are more muted. Egypt, Jordan and Lebanon look to be negatively impacted by continuing socio-political tensions. Even so, one investor (from the UAE) continues

Number of responses

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2012

Q3 2012 MENA ASSET MANAGEMENT SURVEY

to believe that Syria offers investment returns: he is however in a single minority. However, on balance, with the exception of Jordan, any negative investment flows look to be balanced by an equal and opposite reaction among investors. Kuwait is the wild card and continues a theme noted in all three quarter surveys that investors are increasingly cautious of the risks involved in investing in the country. In the Q1 survey Saudi and Qatar were the most popular single choices for 2012. The Qatari and Saudi Arabian economies have benefited from a very supportive operating environment characterised by robust economic growth over the past few years, fuelled by expansion of the hydrocarbon sector. Even so, although these are macro and long term indicators, it is clear from the general conversations with respondents to the survey that short term considerations can determine rapid changes in country strategies. The performance of the underlying markets themselves over the intermediate quarters has likely contributed to the churn. During Q3 2012, for instance, Egypt has emerged as one of the best-performing equity markets globally with a notable increase in trading activity. The GCC, on the other hand, underperformed both emerging and developed markets during this period. However, most GCC stock markets still witnessed growth in conjunction with increased trading activity. Based too on relative valuation metrics, a number of equity analysts based in Kuwait also suggest that Bahrain remains attractive on several counts, while Kuwait and the UAE appear attractive on market cap-to-GDP and trailing price-to-earnings ratios, respectively. On the other hand, Egypt appears relatively expensive on price-to-earning and price earning-to-growth ratios. Respondents to this latest survey also think that future investments in Egypt will be dependent on coming to terms with the IMF. As an investor in Saudi Arabia says,“It is all about sentiment and hope.” By the third quarter survey investors appears to have remained favoured towards Saudi Arabia, though improving fortunes of the UAE states have now brought the emirates on par with Qatar in terms of overall investor

sentiment. Qatar had been the second most popular investment destination in the first quarter. Even so, as Chart 8 amply illustrates, there remains a concentration of investment activity within MENA among the region’s investors. While Asia looks to be growing in popularity, there is no escaping the concentration of attention on local/regional investment opportunities. The results are consistent with the findings of the April survey, which also registered increasing interest in both Asia and Africa. In stark contrast, Europe, Jordan, and Lebanon remain the poor relations in terms of investor sentiment. Again, reflecting trends outlined in the April survey, North America did surprisingly well out of the Q3 questionnaire. However, in the first quarter survey the respondents viewed North America much more positively than South America. This time the numbers reversed. Asia and Africa also received rather respectable scores, with Africa outshining Asia for the first time. While in the Middle East, Saudi Arabia, Qatar and the UAE scored particularly highly as low risk investment regimes. Interestingly perhaps, Bahrain scored relatively positively in the first quarter survey, even though at the time of going to press, social unrest was still bubbling in the country. Investor nervousness is more noted this time round. Syria, of course, remains a worry, both to investors and the international community which cannot seem to find any workable short term solution to its problems. No surprise then that the countries on its hinterland would be adversely impacted in terms of investor sentiment. The natural question following on from these trends was how investors intended to invest their money in 2013. We also looked to see whether there was any change in investor sentiment towards countries in the MENA region depending on whether investors were located in the Gulf Cooperation Council (GCC) states or not. We were surprised the general synergy between the two, excepting perhaps on Iraq. Not surprisingly GCC investors were more skittish on their near neighbour. As one investor in Abu Dhabi noted: “We live in a bad neighbourhood.” See Chart 9

Chart 8: Investing sentiment towards key MENA countries v the rest of the world

Chart 9: Investing Sentiment: GCC v non-GCC Investors

ria As i Eu a N rope Am e S A rica me ri Ro ca Af ric a

Ira q

–

0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 Sy

Ira Ba q hr a Ku in wa Jo it rd a Eu n rop Le e ba no n Sy ria

UA Am E eri ca Qa tar Eg yp t Om an N

S S A aud me i ric a Ro Af ric a As ia

–

+ 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8

Ba hr ain Sa ud i Qa tar Om an UA E Ku w Le ait ba no n Eg yp Jo t rd an

OCTOBER 2012 • FTSE GLOBAL MARKETS

The overall positive sentiment to the majority of countries in the asset management survey looks to have a market impact on planned investments over the coming 12 months. While most respondents saw no need for change, Chart 10 illustrates the investment focus this year and next on opportunities in the local market. Investments can often rest on specific developments. As an investor in the UAE notes,“We intend to invest in unlisted power and infrastructure projects in Bahrain and Oman. The UAE will continue to flourish based on high oil prices and low population numbers. We would not even look at a proposal from Syria; though in all honesty we do not know whether the situation will worsen or improve in 2013.” MENA and Asia look to be the beneficiaries of investor focus in 2013, reflecting growing ties between the Middle East and the Asian markets. Sovereign wealth funds (SWFs) in the GCC have led the way in this regard, with substantial investments by SWFs in agriculture and land development in Southeast Asia and India. The survey results are generally skewed towards GCC investors and this became clear when we asked each respondent which countries they were invested in. Lebanon and Egypt dominated non-GCC; while GCC investors were more evenly spread, though there is again this concentration among the GCC home markets. However, as one investor in Dubai says: “All GCC markets, with the possible exception of Saudi Arabia, are small and suffer

Number of firms planning to change their regional allocation

Chart 10: Investing sentiment towards key MENA countries v the Rest of the World: 2013 investment intentions 50 40 30 20 10 0 MENA

Asia

N. America

S. America

RoAfrica

Number of firms (GCC and non-GCC domiciled)

Chart 11: Investing Sentiment: Asset allocation strategies by country 60 50 40 30 20 10 0

Bahrain Saudi

Qatar Oman

UAE Kuwait Lebanon Egypt Jordan

FTSE GLOBAL MARKETS • OCTOBER 2012

Iraq

Syria

liquidity constraints; we have to work with what we have available to us.” Generally investors responding to the survey remain positive in their outlook. One investor in Saudi Arabia sums up the overall mood.“Oman has as good an outlook as the GCC. Egypt looks to be improving politically and Oman and Qatar continue to spend on capital projects. The governments in the region have learnt the lessons of the Arab Spring and are intent on keeping their populations happy. If the price of oil stays high, it will keep Qatar, Oman and Saudi positive.”

ASSET ALLOCATION It was clear from the initial survey results that investments in the MENA region are concentrated in four segments: equities, bonds, real estate and private equity. Although a significant number of firms failed to signal any change in their asset allocation programme for the next 12 months, the general level of consistency in asset allocation approaches is well illustrated. This suggests a degree of significant comfort in the firms’ overall investment strategy and is an indication of stability in the sector. However, it was clear from the Q3 survey that investment strategies were by and large multi-focused. Please refer to Chart 11. Equities have of course taken a hammering in almost every region this year; with volumes down on 2007 by approximately 60% overall; though some markets in the region, such as Egypt have performed well. The Italian proverb says that a door closes and a window opens. 2012 has been the year when asset managers have either timidly sat on their cash; or been willing to assume a more diversified approach to risk. Bonds and fixed income investment has matured and asset managers of all persuasions have shown more willing to adopt derivatives and other means of gaining exposure to local markets, through ETFs for example. “In this way,” says an investor in the UAE, “the size of the local capital markets is no longer a concern.” Equally, another investor in Dubai states: “There is a desperate need for derivatives, but it is difficult to implement as an investment strategy. Many parties are in talks with NASDAQ Dubai, but progress is slow. A lack of proper regulation in the underdeveloped markets makes things hard.” An investor in Egypt shares the general sense of frustration, “We can’t short in the GCC and sophisticated investment products are not available to us. It seems ridiculous to be moving towards globalisation and yet some regions are not able to participate in transactions types.” However, an equal number of investors remain cautious of entering the derivatives market or of investing in ways that are not plain vanilla. One investment firm in Bahrain notes,“The Middle East is a very speculative culture. Derivatives open the door to even more speculation. While they can add value, some investors in the Middle East can be unsophisticated. There needs to be much more education and awareness of market behaviour and risk. There have been a

Q3 2012 MENA ASSET MANAGEMENT SURVEY

lot of losses by uninformed investors; derivatives can make the situation worse.” This latest survey has thrown up some interesting results. Equal numbers of firms plan to decrease their allocations to bonds and real estate in 2012; while even more firms look to increase their allocation to equities, despite a generally indifferent year in terms of returns. An investor in Lebanon illustrates the thinking, “We are rebalancing our portfolio from 80/20 bonds/equities to 50/50. We are catering to placement agents’ demands as an appetite for equities returns. Fixed income has been a safe haven of late; but investors are hungry for more and want access to the returns that equities can offer.”

Number of firms

Chart 12: Planned changes in asset allocation

Chart 14: Most favoured asset classes by investment firms

7 6 5 4 3 2 1 0 -1 -2 -3 -4

Islamic Structures Commodities Private Equity Equities Sovereign Issues Bonds Real Estate

Real Estate

Bonds

Equities

Private Equity

20 30 40 50 Number of firms investing in that asset class

Please refer to Chart 12, which illustrates investor intentions; though the majority of respondents envisage no overall change in 2013 in asset allocation. Any meaningful analysis of long term investment trends will only be pulled out in subsequent annual updates, where we can compare and contrast annual asset allocation preferences and cross reference this with deeper analysis of the types of investment strategies employed (Quant, Qualitative, Value, Fundamental etc). We hope to build on this aspect in subsequent updates. With these results in mind, we began to look at the way that assets were allocated among the investment community. As with previous surveys, there appears to be a preponderance of an equity/private equity investment mix. While equities dominate overall investments (buy and hold being the most prevalent stated strategy in this regard);

In Chart 15 we see the current usage of investment services infrastructure among the respondees. While most of the large global custodian houses are now present in the GCC and Middle East markets, it is clear from the survey responses that investment firms have coalesced their business along either domestic lines, or towards those firms with a long history of local service. HSBC is a clear leader, according to the survey results and has been in the Middle East in various guises for more than a century. This long term investment has paid off. Standard Chartered too has made inroads. No surprise that leading local brands such as Emirates NBD and Arab National Bank have cemented their local custody operations.

Chart 13: Asset Allocation: Current value of investments in different asset classes

Chart 15: Investment Infrastructure: provision of asset services: most popular custodians

Islamic Structures

HSBC Standard Chartered Emirates NBD ARAB National Bank AHLI United Bank Kuwait Clearing Company Citi Deutsche Bank

Commodities Private Equity Equities Sovereign Issues Bonds Real Estate 0

there continues a clear diversification strategy in routes to market. Chart 13 shows the preponderance of investments in equities, with private equity a close second; reinforcing the popularity of these assets. Moreover, this diversity is also reflected among the endinvestor; though this is largely anecdotal and again will be followed up in future surveys. As one investor in the UAE notes,“Our investors increasingly like mutual funds as they are very liquid compared to some investments in the MENA region, such as real estate, which can tie up your money for some time.” The survey results show a continued commitment to varied investments; though commodities have been less favoured in this survey than they were in the Q1 survey.

10 15 20 Value of assets, US$ billions

CUSTODY PROVISION

Number of firms using bank as main custodian

OCTOBER 2012 • FTSE GLOBAL MARKETS

Citi and Deutsche Bank also have some visibility: with some of that related to the fact that both banks have been active in financing trade. Other banks were utilised more sparingly, with banks including Société Générale, JP Morgan and BNP Paribas garnering one mention each. The results can be interpreted one of two ways: one that local asset management firms tend towards brands they know well (a view supported by anecdotal evidence). Two, that the market is very hard for global custodians to break into because of long standing relationships; and in the Middle East these are hard ties to break.

Chart 17: What do you think are your greatest strengths? North Africa

GCC

Levant

Quality of staff

Transparent&verifiable

Consistent returns

Chart 18: What does the MENA region need to help deepen the investment markets? GCC

North Africa

Levant Liquidity

Liquidity

INFRASTRUCTURE AND BRAND BUILDING

Lower political risk

Regulation is a patent concern among survey respondents. In the GCC, North Africa and Levant all respondents rank local regulations as the most important consideration in determining whether to domicile in one country or another. Respondents were asked about their top priorities when setting up operations: with a lot of synergy among them across the broad region. Then firms were questioned about brand building and what strengths they felt they brought to the market. In all cases there was a strong similarity in replies. Local regulation, ease of doing business in individual countries and the quality of local staff were the leading considerations. These values and more were reflected in the answers provided to the second element of this line of questioning. Quality of staff and the provision of transparent, verifiable returns (a function always of the strength of the local regulatory environment). The third element of questioning focused on those issues which investors felt needed to be addressed if the local capital and investment markets were to deepen. Lower political risk and the provision of liquidity remain constant priorities. However a number of respondents were keen that we telegraph their desire for a unified approach to market regulation/liberalisation, particularly across the GCC states. “The Middle East is not for the fainthearted,” exclaims one, who adds “GCC-wide products are now required. Individual markets such as Bahrain and Qatar are too small by themselves. It is unfortunate but an EU crossborder model won’t happen here.” No surprise then that market liberalisation and portable investment product figured highly in the list of investor wants.

liberalisation

Portable product

Liberalisation

Risk management

Clearing & settlement

Chart 16: Top priorities for setting up operations/investments in a country: GCC

North Africa

Levant

Local Regulatory

Ease of doing business

Ease of setting up

Quality of local staff

Ease of doing business

Ease of setting up

Quality of local staff

Ease of setting up

Size of local cap markets

Access to distributors

Size of local cap markets

FTSE GLOBAL MARKETS • OCTOBER 2012

The most significant part of the survey results are perhaps to be found in these charts. This shows the level of investor concern over the state of the investment infrastructure within their relevant jurisdictions. Continuing market uncertainties and the still bubbling brook of popular discontent in some countries in the region, meaningful moves towards market change might just as easily be cut down by the vagaries of socio-political fortune (which vary so widely across the region). This iteration of our continuing survey of Middle East investment and investment patters more than any to date illustrates the vulnerability of the market and long standing failures to address the requirements of a fully functioning capital markets, in spite of growing riches. As one frustrated Saudi investor notes: “there continues to be a lack of IPOs in the MENA region. It is indicative of continuing limits in MENA markets. Even in these difficult times for the world, the opportunities in the region are very real: so why do we see so few opportunities for IPOs?” Another points to the piecemeal nature of much of the efforts by governments to introduce change. “Random pieces of legislation are useless. We need a unified approach,”cries another Saudi investor.Yet another in Oman concedes: “We accept that the local regulatory environment is not up to par; but we deal with it and factor it into our calculations. The GCC market is retail driven: for this reason alone, we need better regulation.” If anything this round of results underscores early findings that despite the still challenging macro-economic environment, asset management is gradually gaining in importance and momentum in the Middle East. The question is now whether the region’s governments recognise the role of asset management and asset servicing as a cornerstone of sustainable economic growth and the deepening of the region’s capital markets and whether they have plans to help or hinder the sector. I The survey is sponsored by the Qatar Financial Centre Authority (QFCA).

CLEARING & SETTLEMENT

A recent study completed by the Boston Consulting Group (BCG) reports that shortening the time period between trade execution and settling payment for US cash securities transactions could reduce the industry’s costs and risk exposure by several hundred million dollars annually. Commissioned by The Depository Trust & Clearing Corporation (DTCC), with the guidance of the Securities Industry and Financial Markets Association (SIFMA), BCG completed an 18-week business case analysis of the impacts of shortening the trade settlement cycle in the US financial markets for equities, corporate and municipal bonds and unit investment trust (UIT) trades.

TIME FOR A NEW US SETTLEMENT CYCLE? HE 2008 FINANCIAL crisis and its after-effects, coupled with more recent industry problems, have brought into greater focus the risks and inefficiencies in post-trade processes, a portion of which may relate to the length of the settlement cycle, says a BCG study. Since 1995, the settlement cycle has remained at trade date plus three business days (T+3) for US equities, corporate bonds and municipal bonds, despite significant improvements in post-trade processes and underlying technology over the same period. The idea behind the BCG survey was to examine three of the financial industry’s critical areas of concern: reducing risk, optimising capital and reducing costs. The results will be used to help the industry determine whether it should accelerate settlement or stay at T+3. The DTCC says it is not predisposed to a specific outcome but will drive discussions with the industry to determine if the significant benefits of a shortened settlement cycle (SSC) outweigh interim challenges that any change might present to market participants.“With a strong focus on risk reduction and capital optimisation, DTCC, along with the financial services industry, believes it’s an opportune time to examine the potential benefits of an accelerated trade settlement cycle,” says Michael Bodson, DTCC’s president and chief executive officer. “Over the coming months, DTCC will spearhead further outreach with all industry constituents to enlist feedback on the various scenarios the report outlines to determine next steps, if any, to be taken.” BCG interviewed or surveyed market participants— including institutional and retail broker-dealers; buy side firms (asset managers, hedge funds and pension funds); registered investment advisors, custodian banks, transfer agents, service bureaus, exchanges and market utilities,at firms of various sizes across the financial services industry. Initial industry outreach to over 300 firms by the consultant found that the majority of participants within different segments of the trading market are in favour of a shorter settlement cycle (SSC) with 68% of all participants supporting a move. Some 27% of participants considered a SSC a high priority prior to consideration of an industry-wide cost-

benefit analysis. Furthermore, there appears broad consensus on the risk reduction benefits of a shorter cycle, with 55-60% of firms indicating risk reduction to their firms (and 70-75% of firms indicating risk reduction to the industry) from shortening the cycle by one day. Beyond risk reduction, constituent groups have indicated different benefits and challenges from transitioning to a shorter settlement cycle, says BCG. However, the nature of the benefits and challenges of any move to SSC vary by the constituent segment. For example, institutional brokerdealers, and to a lesser extent retail broker-dealers, cite the benefits from process efficiency and risk reduction. On the other hand, buy side firms and custodians with a significant amount of cross-border activity, mentioned the benefits of improved international harmonisation with T+2. Buy side firms mention reductions in loss exposure on inprocess trades and faster issue resolution as the primary benefits, significantly higher than any operational cost savings. On the other hand, custodian banks mentioned increased operational efficiency as a primary benefit, especially from process improvements at buy side firms. Finally, correspondent clearers and service bureaus cited risk reduction and improvements in process efficiency as important benefits of any change. However, constituents broadly stated that competing priorities and other regulatory initiatives represent a potential challenge to shortening the settlement cycle right now. Assuming a decision to shorten the settlement cycle is made, these competing priorities, say some respondents, would limit how soon a transition might occur. Several institutional and retail broker-dealers also state that settlement of physical securities could present another potential challenge were the cycle to be shortened. A subset of broker-dealers, buy side firms and custodian banks pointed out potential issues with securities lending and the timing of foreign exchange (F/X) transactions to support cross-border trades particularly in a T+1 environment. T+0 was ruled out as infeasible for the industry to accomplish at this time, given the exceptional changes required to achieve it and weak support across the industry. This should

OCTOBER 2012 • FTSE GLOBAL MARKETS

come as no surprise. Russia, which is building out its trading infrastructure and has been characterised by a T+0 regime is looking at the ways in which it might extend settlement cycles so that it conforms to international conventions. One of the issues in T+0 is that as settlement is instantaneous, collateral against future trades has to be posted in advance so that straight through processing can occur. In a T+0 environment, the relationship between broker and client also changes, as the brokerage often makes additional revenue from lending to clients to enable trades to be settled. A summary of the results of the costs and benefits of moving to T+2 or T+1 are as follows: T+2

T+1

Required investments

($550m)

($1,770m)

Annual operational cost savings

$170m

$175m

$25m

$35m

Annual value of Clearing Fund reductions

Reduction in risk exposure on unguaranteed buy-side trades Up to $200m Up to $410m Source: Boston Consulting Group

The survey found that industry participants were keenly aware that T+2 could be accomplished through mere compression of timeframes and corresponding rule changes but that doing so would limit the amount of savings across the industry. “Alternatively, implementing T+2 with certain building blocks/enablers would be more effective considering the fact that different changes have various levels of impact for different constituent groups. These enablers include trade data matching, match to settle, a cross-industry settlement instruction (SI) solution, dematerialisation of physicals, access equals delivery for all products, and increased penalties for fails. T+1 could be built on the foregoing but would also require infrastructure for near-real time processing, transforming securities lending and foreign buyer processes, and accelerated retail funding,” noted the report. The consultant also undertook cost-benefit analysis of a reduction in settlement times, the results showed material differences between the investments required for each model as well as across constituent groups. Moving to a T+2 environment, for instance, would require approximately $550m in incremental investments, whereas upgrading systems and processes across the market to support T+1 would require approximately $1.8bn. Although these values are large in aggregate, suggests BCG, the required investments are small on a per-firm basis. For example, large institutional brokerdealers would need to invest, on average, $4.5m for T+2 and about $20m for T+1, driven by various degrees of systems/platform enhancements and end-to-end testing and analysis.“Similarly, large retail broker-dealers would need to invest, on average, $4m for T+2 and $15m for T+1 for a comparable set of changes. Custodian investments would involve enhancements to interfaces to increase automation and standardization of data formats, with average investments for large firms of $4m for T+2 and $16.5m for T+1. Average investments for large buy-side firms would be $1m for T+2 and $2m for T+1, driven primarily by automation and standardisation to enhance interfaces with broker-dealers and custodians and enable compressed timeframes,” says the report.

FTSE GLOBAL MARKETS • OCTOBER 2012

“Our findings show that while shortening the settlement cycle will involve upfront investments, our assessment indicates that the calculated payback period—across the industry based on operational cost savings—is approximately three years for the T+2 model and approximately ten years for the T+1 model,”explains Chandy Chandrashekhar, a BCG partner and managing director.“Our initial industry outreach, prior to the results of the cost benefit analysis, also shows that 68% of participants favour a shorter cycle and 27% of participants consider such a move a high priority for bringing greater efficiency and risk mitigation to the US financial markets. Other constituents stated that competing priorities and regulatory initiatives represent a potential challenge to shortening the settlement cycle at this time.” For the whole industry, BCG says that the implied payback period based on operational cost savings is more or less years for the T+2 model and approximately 10 years for the T+1 model5. The significantly longer payback period for T+1 reflects scepticism among participants that the industry would broadly change behaviour and “adhere to a ‘trade date’ environment to unlock a significant portion of the value of T+1. If, by contrast, significant behaviour changes do accompany a move to T+1, reduction in manual processing across exceptions management, client data management, and institutional trade processing would lead to enhance interfaces with broker-dealers and custodians and enable compressed timeframes,” says the report.

Cost Reductions BCG also says that an additional $195m of operational cost reductions (corresponding to a five year payback). Beyond the operational cost and clearing fund impacts considered in the calculation of payback periods, a material reduction in buy side risk was estimated at $200m for T+2 and $410m for T+1. The inclusion of these benefits would lead to a faster payback across the industry, but they were not included in the initially stated payback periods due to various values ascribed to risk reduction by different constituents. The next step is to have the industry decide the most appropriate path forward regarding a potential shortening of the settlement cycle; and that would inevitably have to lead agreement on a timetable and interim procedures. Regulation will have to be overhauled and regulators brought into the process to help initiate change. This preliminary research by BCG suggests that the industry could transition to T+2 within approximately three years when and if a clear direction for the industry is set. T+1 would be ‘aspirationally’ achievable within four to six years following a move to T+2. According to the BCG study, “enablers to implementing T+2 include trade date matching, match to settle, a cross-industry settlement instruction solution, dematerialisation of physicals, ‘access equals delivery’ for all products, and increased penalties for fails. T+1 can then be built on the foregoing but will also require building an infrastructure for near-real time processing, transforming securities lending and foreign buyer processes, and accelerating retail funding.” I

SECURITIES LENDING Photograph © Kheng Ho To/Dreamstime.com, supplied September 2012.

Although there have been few defections during the post-crisis period, securities-lending clients nevertheless remain a highly risk-averse bunch, requiring hard evidence that everything is as it should be. Accordingly, providers must now bring to the table a fair amount of dexterity in order to keep beneficial owners in the loop and feeling confident about the service. Dave Simons reports.

Is Securities Lending finally on the right foot? ESPITE CONTINUED GLOBAL economic volatility, stronger cash balances, along with generally positive expectations for both traditional and alternative sectors, have domestic securities lenders feeling optimistic going forward. Though volumes remain muted, the intrinsic value of securities on loan has continued to rise, allowing the core industry to achieve some measure of stabilisation over the past 18 months. This is not to say however that leading lenders are about to let down their guard any time soon; particularly given the spate of new regulatory measures on the horizon, not to mention an expected period of consolidation and contraction. As the lending market has evolved, so have the needs of beneficial owners, with the likes of customisation and counterparty risk management rising to the fore. Of course transparency has also been a priority item, says Paul Wilson, managing director, global head of client management and sales, JP Morgan. “For a long time now we have offered very detailed performance and program analysis for clients who want that level of insight. Whenever there have been significant market events for instance, we

have been very proactive about discussing the impact with our clients on an individual basis, which I feel has been a real differentiator for us.” Post-crisis, Wilson admits that it has been difficult at times to demonstrate to clients that the industry is in fact on the right footing, particularly if one chooses to focus exclusively on metrics like volume and fee revenue. However, there is evidence that things has moved on. “At the time of the 2007/2008 crisis, approx 15% of the client base either temporarily suspended or exited lending altogether”says Wilson. “The vast majority of these clients are back and fully active again, albeit most have made modifications to some degree to their lending parameters. When you contrast this to the events from August 2011, which included the US debtceiling crisis, the start of eurozone crisis, the US debt downgrade and MF Global to name but a few, we have seen very few changes made and all clients have stayed active in lending. I like to think that the difference in this response compared to 2007/2008 speaks well for the strides that the industry has made to improve customisation, transparency and improve client confidence.”

OCTOBER 2012 • FTSE GLOBAL MARKETS

Although returns are well off their highs of 2007, from a very simplistic risk-return standpoint—revenues versus onloan balances—the overall return looks fairly positive, says Wilson. “Sure, lenders are probably not making as much money, but on the other hand they don’t have as much on loan, so risk adjusted, the position looks positive given the lower risk due to lower loan levels.”It is a particularly cogent selling point for institutions and beneficial owners who are thinking about engaging for the very first time. “There is a myth from many potential first time lenders that large proportions of their portfolio will be out on loan,” says Wilson. “So they are often pleasantly surprised to learn that the dynamic has shifted and so I think that it’s a real change for the better for the market as a whole, going forward.”

Consultation criteria To help bolster client confidence, lending agents now work with multiple stakeholders within a clients’ organisation to ensure that clients fully understand the impact of securities lending on their business, notes Julie Hubbard, head of relationship management, Americas, Securities Lending at

Boston-based Brown Brothers Harriman (BBH).“Scheduling tax and regulatory updates in addition to performance reviews has become [part of the] mainstream and meeting with multiple groups within the beneficial-owner’s organisation is now standard practice,”says Hubbard.“Additionally, beneficial owners have placed greater focus on mitigating securities-lending risk since the credit crisis, so agents are also working with clients to better understand their tolerance levels and are customising programs that fit within their profiles while still achieving meaningful returns.” Finding the right level of interaction with beneficial owners has become something of an art form for providers, suggests George Trapp, head of North American client relations for securities lending, Northern Trust.“Most providers have the data that clients need, however it should be up to the client to dictate how that data should be disseminated and in what form,”says Trapp.“For instance, there are certain owners who really want to talk to someone on a regular basis, so for those clients we’ll set up a quarterly call in order to discuss the status of their portfolio.” Others are content to download and analyse information

Securities Lending Mapping strategies to get our clients where they want to be. For more than 25 years, J.P. Morgan has been guiding clients with lending programs that meet their unique profile. We believe that clients should have choices with respect to program design, parameters, collateral, loan distribution and oversight. Our clients benefit from customized and comprehensive lending options and one-stop access to a range of solutions, supported by the world-class expertise and execution of our entire firm. jpmorgan.com/securitieslending

The announcements above appear as a matter of record only. J.P. Morgan is the marketing name for JPMorgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities LLC is a member of NYSE and SIPC. ©2012 JPMorgan Chase & Co. All rights reserved.

FTSE GLOBAL MARKETS • OCTOBER 2012

SECURITIES LENDING

on their own using the securities-lending block found on Passport, the company’s online portal. Here, clients are afforded a snapshot overview of their lending programs without the need to run reports.“Clients can obtain information around collateralisation, who has been borrowing their securities, as well as more detailed and customised data around their specific program, if they so choose,”says Trapp. Still others may want“push”notifications that combine both written analysis along with key data points.“This interaction with clients is still evolving and as a result, we spend a good deal of time trying to perfect the formula,” he adds. When it comes to offering guidance, the divergence in risk that separates one client from the next requires that providers maintain a considerable amount of dexterity and foresight.“At one end of the spectrum you have more conservative owners who may only want to accept US Treasuries as collateral,” says Trapp. “Then there are those who are willing to achieve higher returns with their cash collateral. Our program is designed to accept all of these levels of tolerance, so that clients have the flexibility to set their investment guidelines and other program parameters the way they want. Naturally we may be inclined to offer our own thoughts about some of these guidelines and parameters as part of our consultative approach with clients—still, if the client is comfortable with the program's risk and return profile, then we need to be able to switch gears and support the clients reporting and information needs.” Nick Bonn, head of the Securities Finance division, State Street, agrees that conditions remain choppy, yet was pleased by what he saw during the first half of the year. “Our US equities business outperformed, demand for dividend borrowing was strong, even LIBOR exceeded our expectations.” Even so, the background noise emanating from the eurozone and elsewhere cannot be ignored.“Many of these sovereign countries issue debt that State Street invests in, and there may also be concerns about some of the banks that issue commercial paper and short-term instruments that we buy,” says Bonn. “This uncertainty affects the risk tolerance of our clients, which in turn has a direct impact on the securities-lending business as a whole.” While there have been few if any defections during the post-crisis period, State Street’s lending clients remain a highly risk-averse bunch that require hard evidence that everything is as it should be.“You can’t just tell everyone: Hey, no problem, we’re running a really tight ship.You have to get out there and demonstrate it. [This] means we now get into a lot more depth as to how we’re managing risk, including much more detailed risk reporting, as well as ongoing risk discussions with our clients. Our clients trust us—they’ve fared quite well during these turbulent times—and yet maintaining that trust requires continuous verification.” Like others, the frequency of State Street’s consultations can vary depending on the nature of the client. “There are some sophisticated clients who we may speak with on a biweekly basis,” says Bonn, “while others will confer with us quarterly. It really runs the gamut. Bottom line, though, everyone requires some kind of regular update.”

Paul Wilson, managing director, global head of client management and sales, JP Morgan. “For a long time now we have offered very detailed performance and program analysis for clients who want that level of insight. Whenever there have been significant market events for instance, we have been very proactive about discussing the impact with our clients on an individual basis, which I feel has been a real differentiator for us,” he says. Photograph kindly supplied by JP Morgan, September 2012.

Room for innovation To stay competitive, agent lenders must be able to demonstrate significant expertise in various disciplines. Technology can help lenders in this regard, says Hubbard, and, accordingly, is another area where there has been great investment. “Having a flexible platform to provide robust reporting that facilitates program oversight on the part of the beneficial owners is a necessity. It is also a requirement to have experienced traders who understand the demand behind each name to ensure they are extracting a premium for each loan, especially since the majority of the industry has shifted toward intrinsic value lending.” In contrast to the standardisation that is now commonplace throughout much of the financial world, the role of the securities lender has become increasingly complex.“The core services provided go much deeper than execution and operational oversight,”offers Hubbard.“Agent lenders must now have dedicated legal tax and regulatory expertise to ensure they stay abreast of the myriad regulatory changes on the horizon with respect to the impact on clients’ securities lending programs.”With customisation on the rise, beneficial owners are now setting their own risk parameters around borrower credit limits, minimum spreads, utilisation limits, buffers, and other lending functions.“Reporting has become more customised as well,” adds Hubbard. Accordingly, daily transparency is now required to ensure that the program is operating within the confines of the limitations set. While providers are generally in favour of giving clients more choice over lending models and approaches, many remain skeptical over the introduction of CCPs within the lending space.“I think there are certain kinds of transactions, such as principal to principal trades for instance, that potentially fit better into a CCP model,” says Wilson. However, when the business model consists of a beneficial owner using an agent to lend to a prime broker who in turn lends to a hedge fund—like the one generally used by beneficial owners in the lending industry today—a CCP may actually be a backward step.

OCTOBER 2012 • FTSE GLOBAL MARKETS

Nick Bonn, head of the Securities Finance division, State Street. Bonn agrees that conditions remain choppy, yet has been pleased by what he has seen during the first half of the year. “Our US equities business outperformed, demand for dividend borrowing was strong, even LIBOR exceeded our expectations.” Photograph kindly supplied by State Street, September 2012.

“Currently, it is likely that most beneficial-owner clients have loans distributed across as many as 25 different borrowers, giving them diversification to borrowers and collateral, as well as getting an indemnification from their agent against borrower default,” says Wilson. Using the centralcounterparty model, however, for the beneficial owner the risk would be concentrated not just with the CCP itself, but with the clearing member of the CCP, used by the beneficial owner.“In other words, you’re moving from a scenario today in which the risk is well diversified, to one in which the risk is rather more concentrated,” says Wilson. “Furthermore, I don’t think there will be many, if any, agents willing to provide indemnification to a beneficial owner over a CCP. So when you consider the type of business beneficial owners want to undertake, along with the risk model they already have in place, I just don’t see a CCP as an attractive or viable opportunity. That being said, choice is a good thing for beneficial owners and if a CCP can work for some, it would be another option, and that is a good thing.” Despite the relative maturity of the securities-lending market, looking ahead State Street’s Bonn sees continued room for innovation. "For instance, in the value end of the cycle where there is the most money to be made, automation still does not exist,” says Bonn.“I believe that is something that needs to be addressed. Disintermediation remains a significant concern, but to date nothing has really forced automation into the picture. However, I think that agent for change could be coming—in the form of regulation."

Regulatory uncertainty Uncertainty over securities-lending regulation in the making continues to be a source of angst for providers and clients alike. For example, Bonn cites Section 165 of the Dodd Frank Wall Street Reform and Consumer Protection Act, which requires that large banks maintain a maximum debt-equity ratio of 15:1, or roughly half that of pre-crisis 2007. It also restricts single-counterparty exposures to 25% of the capital of the lender, and as little as 10% for the largest, systemically important counterparties. Such curbs could have a negative

FTSE GLOBAL MARKETS • OCTOBER 2012

impact on investment-bank borrowers as well as custodial lending agents, argue critics. “There is widespread belief that these measures won’t be in force a year from now,”says Bonn. “Yet there is no saying that there will actually be a delay. As these measures could have a meaningful impact on lending, the uncertainty over when, how, and to what extent they will take hold is something we all must contend with.” Hubbard agrees that ongoing regulatory uncertainty remains a key talking point among the client base. “The outcome of certain aspects of Dodd Frank and Basel III could have a major impact on how we as market participants adapt our business models,” says Hubbard. “It is at the forefront of discussion in nearly every client meeting.” Given the ongoing ideological divide in the United States, advancing the domestic regulatory agenda has been suitably challenging for providers. But with some countries abroad setting the bar higher than others, global consensus may not come any easier, surmises Brian Lamb, chief executive officer of New York-based EquiLend, a provider of trading and operations services for the securities-finance industry. “It is like a dragon with five heads,” says Lamb, “you have all of these countries trying very hard to move transparency forward, yet because of some very pronounced differences in regulatory policy, in many ways they’ve just been pulling at each other.” While acknowledging “an unprecedented amount of collaboration” between the US Federal Reserve Bank and the Bank of England to forge a more transparent global monetary framework, Lamb, like many of his peers, takes issue with some of the regulatory strategies being bandied about on both sides of the pond. “The whole notion of casting securities lending under the ‘shadow-banking’ umbrella, for instance, is a bit misguided,” says Lamb. This underscores the need for policy makers to be educated about the subtleties of the lending business—and for regulators to affect whatever changes they see fit using a scalpel rather than a switchblade. Says Lamb:“A big part of the problem is that legislators tend to regard with suspicion anything in the financial world that isn’t a run-of-the-mill, brick-and-mortar type of operation.” By all accounts, the uncertainty that seems to have spread throughout the entire investment universe will remain in force at least until after the first Tuesday in November. “My wife and I have been looking to purchase a home in the area, but over the last month or so there hasn’t been a lot of activity on the market, because, according to our realtor, everyone is waiting to see what happens with the election,” says Lamb. “Oddly enough, when I meet with all of these financial regulators in London, Tokyo and Hong Kong, I hear the exact same thing! The point is nobody is really sure how to proceed until they get some indication as to what is going to happen in the US over the next year or so, based on the political outcome next month. Obviously this uncertainty has been a real drag on the business. Once you know what the rules are, you can play the game—but until that happens you are stuck at the starting position without knowing which path to take. That is where we are at right now.” I

TRANSACTION COST ANALYSIS

Photograph © Andreus/Dreamstime.com, supplied September 2012.

Transaction cost analysis (TCA) sounds like heaven for accountants, but it has come a long way since its past life as a tool to check compliance for best execution. Classic comparisons of trades against benchmarks are now being expanded thanks to technology. Moreover, these are used to garner comparisons not just of trades, but of brokers, venues and even individual traders, and the new buzz-words are decision-support tools. Ruth Hughes Liley writes about the new and expanding ways that TCA is utilised.

The next generation of TCA HE REASONS FOR using TCA have evolved in the five years since MIFID, holds Michael Sparkes, ITG’s head of consulting. “Market fragmentation has led to far greater complexity. Without a consolidated tape in Europe, we have had to work hard to mitigate the problem of reduced transparency. In difficult markets, traders and portfolio managers are looking for any margin they can squeeze out of their performance,” he says. Trade analysis is usually against three benchmarks: volume weighted average price (VWAP), implementation shortfall (IS) or reversion, where market impact is measured. With algorithmic trading up from around 2% five years ago to up to 50% and more today, the buyside wants to know which algorithm works best for which type of trade and in which conditions. Sparkes says: “With three

types of algorithm—maybe VWAP IS and liquidity seeking—they might want to know which does the best job in certain circumstances. Five years ago no-one was analysing that.” Andrew Allwright, Thomson Reuters EMEA head of market structure, points out a simple pitfall when working to specific benchmarks.“You will execute in a way that is as flattering as possible against the benchmark. If it is against Implementation Shortfall, you will make a judgement about whether the market is trading up or down and trade more quickly or slowly.” Dealing with market impact on trade performance takes the largest chunk of time and successful TCA can have dramatic results according to Scott Daspin, a managing director in the Global Electronic Execution unit, ConvergEx

OCTOBER 2012 • FTSE GLOBAL MARKETS

Andrew Allwright, Thomson Reuters EMEA head of market structure. Allwright points out a simple pitfall when working to specific benchmarks. “You will execute in a way that is as flattering as possible against the benchmark. Photograph kindly supplied by Thomson Reuters, September 2012.

Jon Fatica, head of analytics at technology firm, TradingScreen, agrees: “It’s important to use a combination of quarterly reporting and more frequent insights. Real-time TCA is evolving into a set of decisionsupport tools for traders at the point of execution,” says Fatica. Photograph kindly supplied by TradingScreen, September 2012.

Group, who says costs came down from 25bp to 5bp for one client. “We have identified trading too soon or too aggressively. In that scenario we trade as slowly as possible and even turn off liquidity seeking algos. Each client is different and so we bring in our sales consultants from our execution consulting team, looking at data and coming up with metrics to help them trade.” With full-blown execution consulting at one end of the spectrum, the technical metrics of TCA are at the other with reports given pre-trade, post-trade, intra-day and end-ofday all playing their part. Andrew Morgan, co-head equity trading EMEA, Deutsche Bank says:“Our focus recently has been on delivering clients Trade Insight, our real time analytics product, offering full transparency on performance, spread capture and venue selection. End-of-day reports are less useful for clients. There’s rarely enough information to establish a meaningful conclusion. Few clients ask for them. If you are not looking at a month’s or three months’ worth of data, it’s difficult to get an idea of anything material. Post-trade of this type can be enormously valuable, but it’s an acquired taste. You sit down with clients and can apply the feedback but very few people get the most out of it.” Jon Fatica, head of analytics at technology firm, TradingScreen, agrees: “It’s important to use a combination of quarterly reporting and more frequent insights. Realtime TCA is evolving into a set of decision-support tools for traders at the point of execution: how a trader did in a particular name in the past, what brokers did he use, what algo did he use, what were the conditions then and are they different today? In a program trade, 1% difference in a portfolio value could be huge.”

Indeed, real-time TCA is developing fast as the major TCA houses invest in the technology to provide it. Abel Noser Solutions, a provider of execution consulting, plans to roll out a real-time TCA tool early in 2013, which will update post-trade analysis in real-time and show how much of an order is left and the likely costs for trading the rest of that order. “It is still early days for real-time TCA,” cautions president, James Noser. “Eventually we will see people closing the loop: so that post-trade will inform the pretrade and pre-trade will inform real-time applications, but real-time TCA is not there yet for most traders. They are probably aware of how they are doing but not necessarily using it to inform. That will change over time. It is a ripe field for innovation.” Abel Noser’s chief executive officer, William Conlin, notes: “Real-time TCA is like driving a car on a winding road that you have never gone on before. You don’t know what is coming next. But if you can link what you know about a manager’s way of investing with what you know about the stock, you can improve your trading.” The firm has used the metric, Manager Styles, for two years and Conlin says: “We might look at 15 managers in a big asset management shop and they all have a different way of investing; but in terms of implementation, the majority of traders do the same thing because they are driven by what the stock is doing. If we can obverse that the manager’s timing is very consistent we can begin to improve their trading.” As trading venues have proliferated in Europe, dark pool activity on multi-lateral trading facilities (MTFs) and broker crossing networks rose from 4.56% to 8.29% of total order book activity in the year to August, says Thomson Reuters,

FTSE GLOBAL MARKETS • OCTOBER 2012

TRANSACTION COST ANALYSIS

Stephane Loiseau, head of equity execution at Société Générale, says: “We measure the quality of the venue and derive a toxicity level and we do that for every single print. So you are continuously adjusting your strategy at a macro – the venue – and a micro – the stock strategy – levels.”Photograph kindly supplied by Société Générale, September 2012.

Scott Daspin, a managing director in the Global Electronic Execution unit, ConvergEx Group. Daspin says costs came down from 25bp to 5bp for one client. “We have identified trading too soon or too aggressively. In that scenario we trade as slowly as possible and even turn off liquidity seeking algos,” says Daspin. Photograph kindly supplied by ConvergEx Group, September 2012.

even while volumes almost halved to €1.2bn. In this context, traders have to justify their choice of venue and so venue data analysis is a growth area. According to TABB Group figures, venue-specific trade analysis of dark execution is a key tool for 51% of traders. Some order management systems now incorporate FIX Tag 30, showing where a trade was last executed and ConvergEx’s updated PerformEx system, released in August, allows traders to see a pie chart of where an order is being filled in real-time. “Transparency is important because it give the buyside trader information on where the contra-side of their trade lies. It also speaks volumes about how brokers are routing orders,”says ConvergEx Group’s Daspin.“And for us, the sell side, as the market becomes more fragmented we need to use this information to analyze fills rates, market impact and reversion so that we can continually optimise our order routing.” At Société Générale, dynamic real-time monitoring includes a quality of venue measurement (QVM). Stephane Loiseau, head of equity execution, says: “We measure the quality of the venue and derive a toxicity level and we do that for every single print. So you are continuously adjusting your strategy at a macro (the venue) and a micro (the stock strategy) levels.”However, monitoring a venue or a stock in real-time is no use unless the trader can act on the information and make use of it at the time they are trading. Loiseau says:“You need to have some alerts; some form of trigger that alert the trader to change his strategy and these triggers will change according to your strategy. One month it might be volatility, another month it might be something else. You

have to use triggers that help you change your strategy and improve your performance.” Loiseau believes the buy side needs to embrace microstructure data. “Understanding in more details all the microstructure data—where the liquidity is coming from, the speed at which the platforms work, the pricing structure— these are all points of data you can use in your trading strategy leading to better results for your end client.” Data, including prices, time, stock, market conditions, currency, events, is the root of transaction cost analysis. Fatica, at TradingScreen, explains that:“The number of transactions that have information associated with them has risen hugely as orders are fragmented into individual fills across different venues. It has become an information nightmare and traders need a way to compare information of where their order needs to go and where it has gone.” The quality of data is hotly debated. With new legislation requiring the reporting of over the counter (OTC) derivatives, a whole new raft of data from derivatives traded globally could potentially be used, predicts Allwright.“Testing it and seeing if it’s good enough will determine how good it is. It’s not good enough yet, but if classification of trades gets adopted under MIFID 2, EMIR and Dodd-Frank, we may see TCA using data from trade data repositories.” Abel Noser’s customers have already demanded the use of data from Boat, the largest OTC reporting venue in Europe, and Noser says:“There are concerns about the reliability of OTC data, but our customers have decided they are better off including it than excluding it.”Most buy side firms use between two and five TCA providers, according to Aïte Group. Bulge bracket broker-dealers provide TCA free as part

OCTOBER 2012 • FTSE GLOBAL MARKETS

James Noser, president, Abel Noser Solutions. The firm is a provider of execution consulting, and plans to roll out a real-time TCA tool early in 2013, which will update post-trade analysis in real-time and show how much of an order is left and the likely costs for trading the rest of that order. Photograph kindly supplied by Abel Noser Solutions, September 2012.

Michael Sparkes, ITG’s head of consulting. “The reasons for using TCA have evolved in the five years since MiFID,” he says, “Market fragmentation has led to far greater complexity.” Photograph kindly supplied by ITG, September 2012.

of a bundle of services, but the buyside continues to pay independent providers for their TCA as it allows them to compare broker data freely and they remain reluctant to share their information from one broker with another. ITG’s Sparkes says: “Being independent, TCA specialist providers can provide better systems, processes and benchmarks because they have invested and also because it can provide the client with a comparison against their peers: you can look at your data compared with other asset managers, you can look at brokers against the universe of brokers and potentially one venue against another.” In spite of bias existing—and many believe brokers use particular analytics to flatter their own styles—still, some 70% of firms believe TCA is important to their daily trading activities (says Aïte), a figure which ties in with a Greenwich Associates study from August 2011, which found that 68% of investment managers use TCA as part of their investment process. The figure rises to 77% for firms with more than $20bn under management. With such high significance for traders, it is no surprise that TCA is fast moving into the foreign exchange space, especially as year saw an explosion of foreign exchange trading conducted electronically; more than 60% of FX volumes in 2011, according to Portware. More than half of the buy side is estimated to be using some form of TCA for FX analysis. The sell side has responded and this year has seen a raft of FX analysis products including Portware in June and ITG in April. Abel Noser also announced an FX TCA tool in April and the firm is expecting to see a drop in FX trading costs as clients begin to measure them more closely.

ITG’s Sparkes says:“In a decentralised market such as FX, with no exchange, you go to a number of banks to get competing quotes. It’s effectively OTC and historically, people weren’t really able to do a good job of measuring transaction costs in the same way as for equities. Now we have a whole range of data vendors and market participants enabling us to get prices and sizes traded; banks have also signed up to give us their own traded volumes and prices.” One of the criticisms of TCA is that its language and methodology is used differently by different firms, making comparisons hard. This looks set to change as in June 2012, FIX Protocol formed a TCA working group to try to standardise the process with more than 55 firms are taking part, aiming to create a glossary of standard terms, first for equities and then possibly for other asset classes. Fatica of TradingScreen, part of another movement, Open TCA, also aims to publish a document by the end of the year. He says:“We are talking about 25 years of people using different kinds of terminology. As with any language, there are different dialects that can be used to express the same thing.” Meanwhile, Allwright believes a more standard approach will come within 12 months but concludes: “There is the old adage ‘if you can’t measure it, you can’t manage it’ so TCA provides a tool to measure trading by, but in and of itself it is not the golden solution. Ultimately if everyone measured themselves against one benchmark, you would get very good in that field, but is that benchmark appropriate for everything that you do? You have to think about and apply the additional data with intelligence for it to be of any use. That process is quite hard for some firms. It’s not the miracle cure.” I

FTSE GLOBAL MARKETS • OCTOBER 2012

PRIME SERVICES

Capital and liquidity remain key focal points for prime brokers and their clients, as does counterparty strength and funding capability. Still, reduced volume—and perpetually thin margins—continue to weigh on stalwart primes. Will those with the biggest balance sheets ultimately win out? Or do start-ups still stand a chance in the current environment? From Boston, Dave Simons reports.

PRIME SERVICES: Doing more with less about leveraging the prime Y NOW IT’S a familiar broker’s infrastructure,” says story: lower leverage— Hendel.“Then came the advent along with lower of introducing prospective balances—continue to weigh capital. From there it evolved heavily on prime-broking into a counterparty safety issue, margins. Seasonal volatility and today it is strength of and the resulting uptick in balance sheet and funding catrade volume aside, the pability. The one attribute that outgoing year looks much like has been a constant over the the previous one, with EU years is providing a satisfactory sovereign debt and continued client experience.” consternation over short From a regulatory standpoint selling, among other things, capital and liquidity remain key compelling asset managers to focal points for brokers and seek opportunities in regions their clients, particularly as the such as the Middle East and rules governing each become Asia. The longer this climate more stringent for financial inpersists, the greater the likelistitutions. “As they move hood of assets moving permaPhotograph © Kheng Ho Toh/Dreamstime.com, forward, hedge funds need to nently towards the biggest and supplied September 2012. know that their counterparties most-qualified managers who have the wherewithal to tap into even the most remote will have the means to maintain their balance-sheet strength, in good times and in bad,” says Teresa Heitsenglobal prospects. Accordingly, the more prime brokers can leverage off rether, global head of prime brokerage for JP Morgan.“Thus, existing institutional relationships (that is, private banking, it has become almost compulsory for fund managers to be asset management, et al) for the benefit of managers, the able to demonstrate that they are sufficiently diversified and better the chances for alpha generation for all. Expanding are dealing with credit-worthy counterparties. It is unlikely one’s service offering is also paramount; for instance, hedge- that these conditions will change any time soon.” Because the system remains significantly de-levered fund managers are increasingly seeking greater exposure to less-accessible securities in emerging areas, giving rise to relative to post-crisis metrics, hedge funds are increasingly synthetic-equities solutions, particularly in the Asian looking to prime brokers to serve in a strategic-partnership markets. Hence, it would appear that well-oiled PB’s must capacity. Says Heitsenrether, “With leverage down hedge be able to deliver a seamless blend of synthetic and cash funds have been more careful in allocating their wallet with prime offerings, not to mention pre- and post-trade key strategic partners [sic]. Prime brokers need to be able to execution, securities lending and other value-add services, all look at the relationship holistically so they can better understand how to provide value for their clients.” at competitive prices. Increased interest in attracting capital, particularly among The attributes of a successful prime broker have certainly changed over time, remarks Stu Hendel, head of Global pension funds making direct investments in the alternaPrime Brokerage at Bank of America Merrill Lynch. tives space, has led to an expansion of prime-brokers’ value“Fifteen years ago, a hedge fund was largely concerned add capabilities, including, among other things, greater use

OCTOBER 2012 • FTSE GLOBAL MARKETS

Thomas Kalafatis, head of CIBC’s Prime Services Group. “Different clients value different types of services,” says Kalafatis. “What we are seeing among all clients is a desire to have services that can handle a multitude of functions. Photograph kindly supplied by CIBC, September 2012.

Teresa Heitsenrether, global head of prime brokerage for JP Morgan. “As they move forward, hedge funds need to know that their counterparties will have the means to maintain their balance-sheet strength, in good times and in bad,” says Heitsenrether. Photograph kindly supplied by JP Morgan, September 2012.

of capital-introduction services. Being able to put investors in touch with the right sources of capital has become more important to the industry. Consultative services have also gained favour, says Heitsenrether, particularly as clients attempt to stay in step with current and impending regulatory initiatives.“Helping clients understand the impact of these changes has become very important, as funds rely on their prime brokers for help in navigating and adapting to the rapidly evolving regulatory landscape.” In the current market environment, the top priority for all alternative managers is the strength of their counterparties, remarks Aaron Steinberg, director at Pershing Prime Services. “Aside from the long-term viability of the institution, counterparty strength for a prime broker manifests itself in two ways: the ability for a prime broker to provide cost-efficient funding while acting as a stable source for securities-lending firms,” says Steinberg. “The firms with the most stable balance sheets and low leverage will have more capacity to provide stable financing. Key to an alternative manager’s business is the ability to short securities, borrow money or trade derivatives. While it has been hard in the past for a prime broker to differentiate itself in some of these spaces, with cost of funds increasing for many banks these services are now becoming more differentiated.” Having a strong solution for moving collateral between the prime broker and custodian is a major priority for hedge

fund managers as well, adds Steinberg. “As alternative managers are looking to reduce their exposures to prime brokers, the ability to move unencumbered assets to a custodian is an important service to offer a manager,” says Steinberg. “Those who can execute their strategies whilst minimizing their exposure to a prime broker—and also keep operational headaches to a minimum—hold a significant advantage.” Counterparty strength, cross-margining design, capital introduction, as well as corporate and execution access rank among the most-sought-after value-add services at Torontobased CIBC, notes Thomas Kalafatis, head of the firm’s Prime Services Group.“Different clients value different types of services,” says Kalafatis. “What we are seeing among all clients is a desire to have services that can handle a multitude of functions. A client’s needs typically change from time to time—there may be a period where capital introduction or consultative services are priority items, but should the client begin adding new strategies they may find a greater need for margining. Because these needs are constantly evolving, we’ve strived to deepen our product offering in an effort to serve clients throughout the lifecycle.” Providing services that can help attract and foster partnerships with emerging managers has been key to CIBC’s run of success.“It’s something we recognized early on when we were initially designing our business,” says Kalafatis. “As such, we specifically organised the Prime Services Group

FTSE GLOBAL MARKETS • OCTOBER 2012

PRIME SERVICES

around the idea that a broad-based services menu is key to strengthening these client relationships.” Like other leading firms, CIBC has found it useful to leverage existing resources for the benefit of its primeservices customers.“In addition to dedicated services such as capital introduction and consultation, over the years we’ve done things like integrating our stock-loan group into the business, and have continued to invest in our tradeexecution technologies as well. So it really is a team effort.”

Pension pinching The persistence of macro turbulence, exacerbated by ongoing regulatory uncertainty on both sides of the pond, has made it unusually difficult for managers to navigate the markets, and in turn has helped keep many investors parked on the sidelines. There are indications that things could be changing, helped in part by the Fed’s QE3 long-term rate commitment—as well as the realisation among many institutions that measly yields will be here for quite some time. “Pension funds are challenged given the low interest rate environment, and it is prompting some of them to take a closer look at alternative investment strategies,”notes Heitsenrether. Where institutions once favored fund-of-hedge funds (FoFs), the trend has shifted towards the use of consultants and a direct-investment approach.“This reflects an investor base that is increasingly self-directed and willing to handle due-diligence duties themselves.” As traditional clients continue to stream into private equity, hedge funds, real estate and the like, the more alternative managers are compelled to act like traditional funds, demonstrating that all necessary controls are in place so they can meet the rigorous demands of these institutional organisations.“The due-diligence periods have become longer and more intense, and they’re also ongoing,” says Heitsenrether.“It is not a once-and-done type of exercise.” Is it worth all the extra effort? Absolutely, say fund managers.“These are the type of stable investors that funds want to attract,”observes Heitsenrether.“As a result, they have been happy to invest the time to foster these partnerships.” Though hedge funds have been seemingly chasing the market since it began to trend upward, without the requisite conviction returns have continued to lag. “Long short managers, who have experienced net redemptions overall for the past three years, have generally seen performance languish,” says Hendel. With the upcoming elections, pending regulation, and general unease with the global economy, QE3, though possibly resulting in more positive momentum for the market, could exacerbate underperformance in the hedge fund space.” On the bright side, the notion of major pension funds needing to address liability gaps, combined with the longterm yield insight courtesy of QE3, ostensibly points to better days ahead for alternatives, and, by way of association, the prime-broking industry as a whole.“Even after the macro shocks we experienced during the crisis, the alternatives space has proven very resilient,” says Heitsenrether. “Capital is still coming in, albeit at a slower pace than in

Stu Hendel, head of Global Prime Brokerage at Bank of America Merrill Lynch (BAML). “Fifteen years ago, a hedge fund was largely concerned about leveraging the prime broker’s infrastructure,” says Hendel. “Then came the advent of introducing prospective capital. From there it evolved into a counterparty safety issue, and today it is strength of balance sheet and funding capability. Photograph kindly supplied by BAML, September 2012.

years past, but perhaps more importantly, the flows have been quite consistent. By and large, institutional investors entering the alternative space have done their homework and are taking a longer term view. I think that’s very encouraging, and bodes well for more investment and growth in this area.” Going forward, Bank of America Merrill Lynch believes that larger and more deposit-driven sell side firms will be able to provide the best custody and financing options for hedge funds. “Not being at the whim of the wholesale or public market is a huge advantage for Bank of America Merrill Lynch,” suggests Hendel. “This is not to imply that non bank competitors are not relevant prime brokers, but their historical advantage is dissipating.” To achieve success over the long term, a prime broker will need to maintain a solid balance sheet, and have an efficient way to fund their book of business, says Steinberg.“Stronger capital requirements around Basel III, along with other bank regulations, will place increased emphasis on the use of balance sheets. Securities lending, margin financing and derivatives transactions will all be affected by this, and any new entrant to the market will also have to account for the effect of a prime-broker business on their balance sheet, their cost of funding, and whether or not they have the risk appetite to support the business.” I

OCTOBER 2012 • FTSE GLOBAL MARKETS

(Week ending 14 September 2012) Reference Entity

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

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Financials Government Government Government Financials Financials

Sov Sov Sov Sov Corp Sov Sov Sov Corp Corp

357,378,488,615 162,660,077,670 140,745,862,573 112,805,416,321 78,955,635,631 119,611,008,194 79,295,501,612 188,470,992,571 79,995,867,757 78,789,213,385

21,082,473,367 18,576,815,839 6,907,426,087 4,187,586,315 4,896,348,936 9,055,586,599 6,993,721,339 13,248,714,031 4,621,778,003 4,258,469,088

11,347 10,331 9,426 9,241 9,038 8,955 8,703 8,582 8,224 8,107

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

Top 10 net notional amounts (Week ending 14 September 2012) Reference Entity

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

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Government Financials Government Government

Sov Sov Sov Sov Sov Sov Sov Corp Sov Sov

158,673,318,843 357,378,488,615 138,423,962,293 162,660,077,670 188,470,992,571 77,878,785,056 66,664,991,461 85,546,424,633 72,693,488,389 119,611,008,194

21,348,128,244 21,082,473,367 19,164,367,607 18,576,815,839 13,248,714,031 11,563,438,971 10,584,964,595 10,218,895,153 10,020,247,692 9,055,586,599

7,103 11,347 5,547 10,331 8,582 7,662 4,383 6,782 7,891 8,955

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 14 September 2012)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,323,090,305,071

464,347

Republic of Italy

7,634,959,972

476

Sovereign / State Bodies

2,910,130,176,689

218,431

Kingdom of Spain

5,168,825,424

411

Corporate: Consumer Services

1,827,102,630,563

320,215

Federative Republic of Brazil

4,232,493,304

329 148

Corporate: Consumer Goods

1,737,811,385,963

291,610

French Republic

3,273,412,167

Corporate: Industrials

1,140,663,736,926

201,846

Federal Republic of Germany

3,179,118,268

404

899,090,441,918

149,928

People’s Republic of China

2,840,366,700

210

Corporate: Telecommunications Services 841,113,236,639

133,137

Japan

2,735,009,000

338 182

Corporate: Basic Materials Corporate: Utilities

712,835,962,284

119,405

Commonwealth of Australia

2,514,476,000

Corporate: Energy

516,530,954,339

94,469

Republic of Turkey

2,462,281,792

169

Corporate: Technology

364,431,801,365

66,125

Republic of Korea

2,449,107,700

274

Corporate: Healthcare

330,216,967,409

59,487

Corporate: Other

142,294,389,976

16,482

Residential Mortgage Backed Securities

37,146,102,509

7,039

CDS on Loans

34,586,463,342

9,559

Commercial Mortgage Backed Securities 12,284,055,809

1,319

Residential Mortgage Backed Securities*

7,779,617,302

467

Muni: Government

3,422,427,667

269

CDS on Loans European

3,185,934,556

525

Other

1,050,684,729

Commercial Mortgage Backed Securities*

531,282,580

Muni: Utilities

11,400,000

*European

FTSE GLOBAL MARKETS • OCTOBER 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

MARKET DATA BY FTSE RESEARCH

ASSET CLASS RETURNS 1M% EQUITIES (FTSE) (TR, Local) FTSE All-World USA Japan UK Asia Pacific ex Japan Europe ex UK Emerging

12M%

1.8 2.3

10.9 17.9

-0.5

-3.1 2.1

10.3

0.4

2.7 2.6

11.4

-0.1

3.6

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

6.4

0.2

4.3

-7.3

0.7

-17.8 5.1

GOVERNMENT BONDS (FTSE) (TR, Local) US (7-10 y) UK (7-10 y) Germany (7-10 y)

-5.2

-0.5

7.3 0.0

11.9 9.3

-0.3

CORPORATE BONDS (FTSE) (TR, Local) UK BBB Euro BBB

0.6

11.0 8.3

1.4

FX - TRADE WEIGHTED USD GBP EUR

-1.2

5.8 6.7

0.2 1.3

-2 -1

-8.6

-20 -15 -10

-5

EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 1M local ccy (TR)

Regions 12M local ccy (TR)

2.6 2.3 2.1 2.0 1.8

Europe ex UK USA UK Developed FTSE All-World Asia Pacific ex Japan Emerging Japan BRIC

0.4 -0.1 -0.5 -1.4

-2

-1

-5

Developed 1M local ccy (TR) Spain Italy France Finland Belgium/Lux Norway Germany Canada USA Australia UK Developed Denmark Hong Netherlands Singapore Switzerland Korea Israel Japan Sweden

3.7 3.6 3.3 3.0 2.8 2.6 2.3 2.1 2.1 2.0 1.4 1.3 1.0 0.1 -0.1 -0.2 -0.2 -0.5 -2.2

-5

2.9 2.0 1.8 1.0 0.6 0.5 -0.1 -0.4 -2.0 -2.7 -3.3 -4.0

-4

-2

40.7 34.5

-1.4 -2.1 -3.1 -4.2 -6.1 -6.9

-20

Emerging 12M local ccy (TR) Turkey South Africa 18.6 Thailand 17.5 Malaysia 15.8 Mexico 12.4 Brazil 7.5 India 3.7 Emerging 3.6 3.6 Indonesia 0.3 Taiwan -1.7 Chile -8.2 China Russia -15.1

6.0

-6

3.6 2.7

19.9 18.7 17.9 16.2 15.7 13.5 11.9 10.3 9.7 8.1 6.9 5.4 3.2

Emerging 1M local ccy (TR) Turkey Taiwan South Africa Thailand Malaysia Russia India Emerging Brazil Chile Mexico Indonesia China

11.9 11.4 10.9 10.3

Developed 12M local ccy (TR) Denmark Belgium/Lux Germany Switzerland USA Netherlands Norway Sweden Developed UK France Singapore Korea Australia Italy Israel Hong Japan Canada Finland Spain

10.5 8.1

17.9

USA Developed Europe ex UK FTSE All-World UK Emerging Asia Pacific ex Japan BRIC -1.5 Japan -3.1

-20

-10

29.2

Source: FTSE Monthly Markets Brief. Data as at the end of August 2012.

OCTOBER 2012 â&#x20AC;˘ FTSE GLOBAL MARKETS

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World Japan BRIC

US Emerging

Global Sectors Relative to FTSE All-World Oil & Gas Health Care Financials 115

Asia Pacific ex-Japan

UK Europe ex UK

110

Basic Materials Consumer Services Technology

Consumer Goods Industrials Telecommunications Utilities

110 105

105 100

100

95 95

90 85

80 85 Aug 2011

Oct 2011

Dec 2011

Feb 2012

Apr 2012

Jun 2012

75 Aug 2011

Aug 2012

Oct 2011

Dec 2011

Feb 2012

Apr 2012

Jun 2012

Aug 2012

BOND MARKET RETURNS 1M%

12M%

FTSE GOVERNMENT BONDS (TR, Local) US (7-10 y)

-0.5

UK (7-10 y)

7.3 11.9

0.0

Ger (7-10 y)

9.3

-0.3

Japan (7-10 y)

0.0

France (7-10 y)

0.0

3.7 9.7

Italy (7-10 y)

1.2

2.7

FTSE CORPORATE BONDS (TR, Local) UK (7-10 y)

0.8

12.0

Euro (7-10 y)

15.0

1.5

UK BBB

11.0

0.6

Euro BBB

8.3

1.4

UK Non Financial

12.3

0.5

Euro Non Financial

8.9

0.9

FTSE INFLATION-LINKED BONDS (TR, Local) UK (7-10)

11.4

1.1

-1

BOND MARKET DYNAMICS – YIELDS AND SPREADS Government Bond Yields

Corporate Bond Yields

US (7-10 y)

Japan (7-10 y)

UK (7-10 y)

Ger (7-10 y)

France (7-10 y)

Italy (7-10 y)

U UK BBB

7.50

Euro BBB

8.00

6.50

7.00

5.50 4.50

6.00

3.50

5.00

2.50 4.00 1.50 0.50 Aug 2007

Aug 2008

Aug 2009

Aug 2010

Aug 2011

Aug 2012

3.00 Aug 2007

Aug 2008

Aug 2009

Aug 2010

Aug 2011

Aug 2012

Source: FTSE Monthly Markets Brief. Data as at the end of August 2012.

FTSE GLOBAL MARKETS • OCTOBER 2012

MARKET DATA BY FTSE RESEARCH

COMPARING BOND AND EQUITY TOTAL RETURNS FTSE UK Bond vs. FTSE UK 12M (TR) FTSE UK Bond

FTSE US Bond vs. FTSE US 12M (TR)

FTSE UK

FTSE US Bond

115

120

110

115

FTSE US

110 105 105 100 100 95

90 Aug 2011

90 Aug 2007

Aug 2012

May 2012

Feb 2012

Nov 2011

FTSE UK Bond vs. FTSE UK 5Y (TR) FTSE UK Bond

Aug 2010

Aug 2009

Aug 2008

Aug 2011

Aug 2012

Aug 2011

Aug 2012

FTSE US Bond vs. FTSE US 5Y (TR)

FTSE UK

FTSE US Bond

160

145

130

FTSE US

115

100 100 85 85

55 Aug 2007

Aug 2008

Aug 2009

Aug 2010

Aug 2011

1M%

FTSE USA Index

8.6

2.3

17.9

7.6

8.0

4.7

9.7

10.3

8.0

-0.1

Aug 2010

5Y%

7.8

0.0

-1

Aug 2009

12M%

2.1

FTSE USA Bond

Aug 2008

3M%

FTSE UK Index

FTSE UK Bond

40 Aug 2007

Aug 2012

52.0

4.7

45.6

Source: FTSE Monthly Markets Brief. Data as at the end of August 2012.

OCTOBER 2012 • FTSE GLOBAL MARKETS