FTSE Global Markets

GM Cover Issue 67 Impo_. 20/12/2012 17:34 Page FC1

NEGATIVE YIELDS ON GOVERNMENT DEBT LIKELY IN 2013 SAYS RLAM

ISSUE 67 • DECEMBER 2012/JANUARY 2013

FTSE GLOBAL MARKETS

The 20-20 Review The rising cost of collateral New asset servicing models Gulf Bank sets a new pace ECB takes the euro lead The return of Barclays Moscow exchange reaches out

ISSUE SIXTY SEVEN • DECEMBER 2012/JANUARY 2013

Can Bersani solve Italy’s €430bn debt conundrum?

INVESTORS FLOCK TO LOW VOLATILITY STRATEGIES

GM Cover Issue 67 Impo_. 20/12/2012 17:34 Page FC2

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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 5158 | E: peter.keith@berlinguer.com HEAD OF SALES, EUROPE: Melissa Guler T: +44 [0]20 7680 5153 | E: melissa.guler@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) 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.

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EWS BROKE IN late December that the NYSE Euronext Group would be subsumed by the IntercontinentalExchange, the electronic commodities trading platform. If the transaction goes ahead, the company will become the world’s largest exchange grouping. The gen is that ICE’s real target is Liffe, as a vehicle to enter the potentially lucrative and growing European derivatives market. This is the second attempt at Liffe by ICE, which made a bid for the group (in conjunction with NASDAQ) back in 2011 and which made a failed bid for the London Metal Exchange in the summer of 2012.

The question is what ICE will do with the equity trading operations of NYSE Euronext, which like all trading venues have been hurt by lower trading volumes. Current thinking is that either or both exchanges will be sold off either separately or together, which could spark another exchange consolidation round in Europe. Equities continue torrid and national exchanges perforce must pursue business diversification plans to maintain revenue. Consolidation in the exchange segment has come in fits and starts over the last few years with little to show for it as alternative trading venues have captured liquidity and successfully fragmented the market.

However, to the outsider, what has all this hullaballoo about redrawing the exchange landscape to best serve the needs of the buy side come to? By and large the buy side looks to be avoiding the equities markets altogether.

Is this a temporary lull; or have the markets become too difficult for the buy side? Has all this market change happened only to serve a high frequency trading (HFT) community whose business model has also been severely tested in the moribund markets of 2012? Is HFT the unintended consequence of achieving cheaper front end trading fees?

It is clear that seminal changes continue to run through the capital markets and that the ultimate structure of the global investment markets has yet to be defined. Banks and asset gatherers are being redesigned; both for retail and institutional clients; new investment products are emerging; market infrastructure is being redrawn to suit changing asset allocation preferences that look to be systemic rather than cyclical and the current crop of political masters appear keen to impose stricter market controls. Ultimately how new technology, new consumer demands, new politics and new growth markets will impact on the flow of investment dollars is still in an undiscovered country. It should be fun beginning to explore it over the next twelve months.

This edition is fairly dedicated to some of those key trends and market makers that will feature largely in this new world order. The move to the future will inevitably be stop-start; particularly as this period of change comes at a time when markets continue under duress. However as we all know, you can’t stop the engine of history (no matter what Francis Fukuyama thinks) and we will all be living with the consequences of these sweeping changes for the next few decades, at least. This year’s 20-20 has been stretched to cover more market trends than people, and some of themes (such as collateral and high growth markets) are looked at from different angles. In times of immense change, nuance is everything.

We hope you enjoy the selection: as always with FTSE Global Markets there’s an element of whimsy to be found amid the deadly serious stuff. We also take this opportunity to wish our readers a very happy and successful new year.

N

Italy’s centre-left leader Pier Luigi Bersani, the front-runner for next year’s parliamentary elections attends a news conference at the foreign press association in Rome, Italy on December 13th 2012. He says he wants outgoing premier Mario Monti to remain in public service after the vote. Photograph by Eric Vandeville for ABACAPRESS.COM. Photograph supplied by PressAssociationImages/December 2012.

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

1

CONTENTS COVER STORY

CAN BERSANI SAVE ITALY AND PAY BACK ALL ITS DEBTS?

................Page 6 Italy has scheduled emergency elections in February. The results will be important, as any incoming administration will have to work overtime to reduce the country’s overweening debt, implement structural reforms and all in quick time. There’s € 420bn in to raise to refinance some debts and lay off others. Can it be done?

DEPARTMENTS

MARKET LEADER

INVESTORS FLOCK TO LOW VOLATILITY STRATEGIES................................Page 10

VOX POP

ARE REGULATIONS GETTING IN THE WAY OF PRINCIPLES? .........Page 13

Lynn Strongin Dodds outlines the value of low volatility strategies in unsettled times.

Michelle Carroll, partner BDO says the regulatory wood is too dense.

WHAT HAPPENS WHEN OTC TRANSACTIONS GO AWRY ................Page 15

IN THE MARKETS

Can you really avoid meltdown in the OTC derivatives market?

FILLING THE COLLATERAL GAP ......................................................................................Page 18 Dan Barnes questions whether the collateral gap really exists.

TRADING POST

WHY YOU SHOULD GET REAL FRIENDLY WITH REPO .....................Page 21

DEBT REPORT

US HIGH GRADE DEBT ON AN ALL TIME HIGH

Bill Hogdson looks at the growing popularity of the repo market. ...................................Page 22

David Simon reports on record breaking issuance volumes.

THE BEAR VIEW

YEAR END OUTLOOKS RESTS ON A FISCAL CLIFF ...............................Page 25

FACE TO FACE

JONATHAN PLATT, HEAD OF FIXED INTEREST, RLAM .......................Page 26

20-20 PREVIEW

INTRODUCTION .............................................................................................................Page 28

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

Why credit spreads in investment grade bonds are still too high.

Regulators and collateral managers: the new market princes.

THE FIGHT TO DELIVER PERFORMANCE EDGE

.....................................Page 29 Rob Lane, European business manager, Interactive Data reports on key trading trends.

REDEFINING MARKET STANDARDS.................................................................Page 30 Stuart Adams, EMEA regional director, FIX Protocol, updates the messaging landscape.

THE REGULATION OVERHANG ...........................................................................Page 32 Ruth Hughes Liley looks at increasingly nuanced trading solutions.

TRADING

THE REGULATION OVERHANG ...........................................................................Page 32 Ruth Hughes Liley looks at increasingly nuanced trading solutions.

BATS TRADING UPGRADES BANK ON MARKET CHANGES ..........Page 38 Ruth Hughes Liley spoke to CEO Mark Hemsley about market change

INSTINET: A NEW AGENCY BROKING MARKET MODEL ................Page 39 Can Instinet lead a new charge in the agency broking space?

THE 2013 IPO CALENDAR. ..................................................................................Page 41 Will tech stocks and Twitter lead an IPO revival

2

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

CONTENTS TOWARDS EFFECTIVE COLLATERAL MANAGEMENT ........................Page 42 Nadine Chakar, global business head, 360 Derivatives at BNY Mellon talks tactics

THINKING LATERAL ON COLLATERAL ........................................................Page 44

COLLATERAL

Dan Barnes compares principle and practice in collateral management

2013: THE YEAR CLIENT CLEARING BECOMES REALITY ................ Page 45 Lee McCormack, client clearing business manager, Nomura rings in the changes

BEYOND COLLATERAL: THE COST EQUATION .................................... Page 47 The true costs of collateral management

NEW INVESTORS RESHAPE PROPERTY FUND STRATEGIES ............Page 48

REAL ESTATE

Mark Faithfull follows the smart money

LOGISTICS ON THE MOVE ..................................................................................Page 50 Mark Faithfull outlines the changes in logistics strategies in the computer age

CAN THE GREENBACK STAGE A COMEBACK?..................................... Page 52

FX

David Simons on the outlook for the US dollar

RMB IN THE SPOTLIGHT .................................................................................... Page 53 When will the Chinese currency achieve reserve currency status?

SEC SERVICES

THE ASSET SERVICING JIGSAW TAKES SHAPE ...................................... Page 55 David Simons reviews the new look custody and fund administration service set

CAN SPAIN STILL UPEND THE EURO?......................................................... Page 58 Andrew Cavenagh looks at the potential pressure points in 2013

UK STAYS ON THE SIDELINES IN EUROPEAN BANKING ................ Page 59

EUROPE

How long can the UK define a separate banking rulebook?

THE TEST CASE: IBERDROLA RE-RISKS....................................................... Page 61 Andrew Cavenagh questions how far the firm’s de-risking can go

BARCLAYS CAPITAL MAKES A COMEBACK

.......................................... Page 62 The bank’s had a good year in the capital markets: can it last?

CAN EM MARKETS MAKE A COMEBACK IN 2013? .......................... Page 63 Neil O’Hara looks at the prospects for high performance BRICS

CAN EM BONDS KEEP THEIR SHINE?

........................................................ Page 65 Andrew Cavenagh thinks not: have they done too much in 2012?

MENA ASSET MANAGEMENT: A STRONG REGIONAL FOCUS .... Page 66 Yosuf Al Jaida, director, banking & asset management, QFCA, outlines the trends

HIGH GROWTH MARKETS

GULF BANK AT A POSITIVE TIPPING POINT .......................................... Page 67 Michel Accad, Gulf Bank’s CEO is on a roll with a new banking vision

BANKING IN THE CRUCIBLE ............................................................................ Page 68 Hisham Ezz al Arab, CIB’s CEO on the challenges of the new Egypt

LOOKING TO THE MIDDLE EAST’S LONG TERM PROMISE .......... Page 70 Samir Hanna, Group CEO Bank Audi, explains the bank’s long term strategy

GCC BANKS FIND THEIR MARK...................................................................... Page 72 Why banks in the Gulf are beating performance marks

ZENITH BANK REACHES OUT .......................................................................... Page 73 CEO Godwin Emefiele talks through the bank’s strategy, culture and upcoming GDR

SHALES UPEND OIL GEOPOLITICS ................................................................ Page 74

ENERGY

Vanja Dragomanovich on the new challenges facing the global oil industry

SHALE OIL CHANGES THE GLOBAL SUPPLY LANDSCAPE .............. Page 75 Vanja Dragomanovich and Henry Blanchard report on a rising industry

DATA PAGES 4

Market Reports by FTSE Research................................................................................................................Page 77 Entrances & Exits................................................................................................................................................Page 80

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

COVER STORY

ITALY: WILL MONTI SECURE ITALY’S SOFT LANDING?

Contrary to expectations, Italy easily sold €6.5bn ($8.45bn) in 12-month bonds at lower interest rates despite uncertainty about its future in mid December. The Italian Treasury announced that the yield, or interest rate, on the bonds was 1.46%, down from the 1.76% paid in November. Moreover, demand was 1.94 times the amount on offer. The bond auction was the first since premier Monti’s resignation, precipitating general elections in February, several weeks ahead of schedule.

Can the incoming government keep to a soft landing?

Italy’s €420bn borrowing conundrum HEN ECONOMIST MARIO Monti was nominated to replace Sylvio Berlusconi in November 2011, comparisons with Lucius Cornelius Sulla Felix (138-78BC) abounded. Like Sulla, Monti was brought in to stem the chaos of a decadent and disarrayed administration and bring Rome (read also Italy) back to fiscal probity and good government. In just under two years of dictatorship (circa 80BC) Sulla reformed the Roman constitution, restored the balance of power between the Senate and tribunes, put the empire’s finances in order, resigned the dictatorship and retired to private life. Monti has fared less well.

Premier Monti’s departure is pending parliament’s rubber stamp on his budget proposals. Monti was coerced into resigning following the withdrawal of ex-premier Sylvio Berlusconi’s People of Liberty party (the biggest single group in the Italian parliament) from his technocratic coalition, which he interpreted as a vote of no confidence.

While Monti managed to raise the country’s standing in the global financial markets as he introduced biting austerity measures, arguably some of those measures have fallen short.

Italy still has to tackle its creaking and over-committed pension system, uncompetitive industries and labour market reform.

Berlusconi’s grandstanding may come to nothing. Recent opinion polls

W

6

give the 76-year-old billionaire small chance of electoral success, with the centre-left Democratic Party (PD) under Pier Luigi Bersani currently holding a strong lead. But six weeks is a long time in Italian politics and the polemic leading up to elections now tabled for February next year could be brutal and renew uncertainty about Italy’s commitment to reform.

The timing of Monti’s statement could also undermine the good work achieved by his administration in bringing sovereign borrowing costs to a two year low by the end of November this year. By Monday 10th December (two days after Monti’s announcement) the spread between Italian BTPs and German bunds widened to 349 basis points (bps), while BTP futures shed more than a point. The main barometer of investor confidence, the yield on the 10-year Italian government bond, spike up to 4.74% although that is way below the 7.3% peak hit last year when the spread with German Bunds hit 550bps.

In a show of what might happen if the markets decide the election outcome is not their preferred one, Italy’s equity markets tanked in the immediate aftermath of Monti’s resignation. Inevitably, German bund futures were pushed 28 ticks higher, pushing ten year yields a couple of basis points (bps) lower to 1.27%.

In the event, the country’s last big borrowing push before year end was a

Italy’s premier Mario Monti leaves the European People’s Party summit, ahead of the EU summit in Brussels on Thursday, December 13th 2012. In one whirlwind morning, the European Union nations agreed on the foundation of a fully-fledged banking union and Greece’s euro partners approved billions of euros in bailout loans that will prevent the nation from going bankrupt.

Photograph by Yves Logghe for Associated Press. Photograph provided by PressAssociationImages, December 2012.

reassuring squib; with none of the expected drama. Equally, in the run up to year end Italy looked to be running towards a soft landing, though not everyone is convinced. In November, the Bank of Italy published its latest bi-annual report, confidently stating: “Political uncertainty in Italy poses a risk to sovereign borrowing costs, but otherwise Italy is steadily correcting imbalances.”

However, not everyone is confident about Italian growth in 2013. “Italian austerity has favoured tax rises over expenditure restraint. Yes, the present government has introduced some structural reforms but it is difficult to see a sustained improvement in economic conditions—particularly as exports will remain pressurised by weak global growth,” says Jonathan Platt, head of fixed interest at Royal London Asset Management (RLAM).

“While it would be a massive step backwards, should we for any reason (political or economic) return to a situation where there is the possibility of a rescue of Italy being required (akin to that in Greece), the impact on the wider markets, not least the credit market, would be large.

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

COVER STORY

ITALY: WILL MONTI SECURE ITALY’S SOFT LANDING?

Others acknowledge that the Italian treasury is within reach of its funding requirements for this year, but say it will still have to borrow €420bn in the coming year. The bulk of the debt burden is held internally by the country’s domestic banks, which reportedly hold some €351bn worth, according to the latest central bank figures, a figure that has increased by a massive 45% since 2011. In the same period, foreign private investors have withdrawn some €200bn, with the bulk of that being divestment from government paper. This has left the country in the precarious position whereby a mere 28% of its debt is held in foreign hands, which increasingly limits the country’s manoeuvrability.

Equally, “Italian banks are saddled with far too much domestic debt,”holds Dr. Nicholas Spiro, managing director of Spiro Sovereign Strategy.“They have been holding the fort at government debt auctions in the absence of foreign investors. The run on the bond markets of Spain and Italy continues and domestic banks have been left to pick up the slack. The question is how much longer they will be able to plug the gap if foreign investors continue to steer clear of Spanish and Italian debt.”

Direct investment into Italian industry is also thin on the ground. Recently Monti undertook a tour of the Middle East in an attempt to sign up foreign investors. The “Italian brand” has been popular over many decades, from Fiat to Ferrari, lifestyle to luxury. The only result of the recent tour though was a paltry €150m from Qatar, which had to be matched by the Italian government via its Strategic Fund. Even this meagre sum was solely for investments in luxury goods, fashion and tourism—sectors which have thrived even in the downturn; hardly a glowing endorsement of the potential for an industry-wide, manufacturing-led recovery.

However, in light of unappealing yield returns from the more stable European economies, investors could be tempted back to invest in periphery debt, especially if it is backed by the

8

eurozone’s third largest economy.

According to Erik Nielsen, chief economist at UniCredit, “We are selling Italian bonds again to foreign investors and at a nice clip. Just wait until people get tired of holding German bunds, which pay nothing at all.”

Spiro continues, “Psychological factors are important. The ECB backstop has been key, and I don’t see the bond market collapsing. A big theme is differentiation. Months ago Italy would follow where Spain trod, but that is now not so. The fundamentals are a lot less bleak in Italy compared to Spain, and there is greater awareness of that in the market now.”

The ECB backstop unveiled by Mario Draghi has driven down bond yields and led to the restoration of at least some investor confidence. However, the efforts of the Monti administration to pursue reform looks to have had the greatest effect. Whichever party comes to power in February, it will make little difference as they will, in all probability, have to follow the road already mapped out by Monti’s administration. In fact, Bersani has stated, should his party win the right to lead a coalition government says he wants Monti on board.

Hopeful signs Professor Iain Begg, a research fellow at the London School of Economics’ European Institute, thinks there are hopeful signs that Monti’s policies are beginning to work.“Monti has enabled Italy to head for a soft landing—he has helped resolve not so much a fiscal crisis, but more a longstanding inability of the Berlusconi government to reform the supply side.”

It is a sentiment echoed by Fitch. In its latest published report the ratings agency praises the “comprehensive policy response,” which has improved the country’s longer-run growth potential and “put the debt on a declining path. The structural reforms adopted since mid-2011 exceed the entire improvement in the business environment over the previous decade”.

These measures can be broadly placed into three areas: liberalisation of product markets and services, administrative and bureaucratic rationalisation and improvements in the labour market.“These reforms will take time to fully enact,” continues Begg, even Monti has struggled to bring into legislation what is needed.” The fiscal position is not desperate. Monti laments the fact that ratings agencies have not given him the credit for the decisions he’s taken,” he adds.

While Italy’s supply-side legislation has been beneficial to both Italy’s standing with foreign investors, there are two politically driven risks that threaten to derail the country’s best laid plans. The first is reform fatigue and ongoing discontent.

This is amply demonstrated by the rise of the populist and anti-euro Five Star Movement, led by political satirist and blogger Beppe Grillo, which is set to contest the upcoming April 2013 elections, consistently scoring 15% and 20% in national opinion polls. “Now, there will be possible pre-election instability, and more probably instability post-election. There is complacency in the marketplace—there are scant prospects for growth and political instability will bring that to attention [sic],” says Spiro.

The second is who will come to power. If it is Sylvio Berlusconi, all bets are off. Monti has not announced his intention to run for re-election, and indeed has sought to avoid it.“Did you ask whether I would like to remain prime minister? If the word was really ‘like’, the answer is no,” he said at a recent press conference. However, he has also indicated that he would stay on to fulfil the enactment of his reforms if asked, and many politicians and commentators in Italy support this option.

Whoever comes in, their effectiveness will be measured not only by the administration’s ability to revive the moribund Italian economy and continue structural reforms, but also its ability to diversify and cut back Italy’s debt pile. It’s a big ask. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

www.banqueaudi.com

MARKET LEADER

INVESTORS FLOCK TO LOW VOLATILITY STRATEGIES

Low volatility strategies: a necessary accessory?

Photograph © Nicemonkey/Dreamstime.com, supplied December 2012.

It is no wonder that given these unsettled times, institutions have flocked to low volatility equity strategies. The eurozone crisis coupled with the spluttering economic recovery in the West has made even the most adventurous investor nervous.

A big question today though is whether this fashion statement has become too costly or is it still a must have accessory in the portfolio? Lynn Strongin Dodds reports.

LBEIT A PINPRICK in global markets terms, industry figures show that by 2011 pension funds and other institutions invested almost $10bn in low-volatility US equity strategies, up from virtually nothing in 2005. The story has been similar in continental Europe which has seen flows of $6bn.

The main problem facing investors is that there are only a limited number of safe haven stocks in the marketplace. In this moribund climate those stocks are being stretched thin as fund managers are slotting them into similar types of funds such as high income and quality approaches. The inevitable consequence is rising valuations. According to recent research from Alliance

A

10

Bernstein, the forward-earnings multiple of the highest dividend-yielding quintile of global stocks is at its loftiest level since 1989, while traditional defensive sectors such as utilities, consumer-staples and telecoms that dominate low volatility portfolios are currently trading at premiums between 9% and 22% versus their ten-year averages, based on 12-month-forward earnings estimates.

Despite this rising tide, appetite has not diminished mainly because investors are looking for alternatives to the tried and tested passive offerings.

“There have been three major corrections of equity markets: the TMT crash in early 2000/2001; the Lehman collapse in 2008; and the recent eurozone

debt crisis,” says Emmanuel Bourdeix, head of SEEYOND, an investment division dedicated to volatility strategies at Natixis. “The frequency of these shocks has made investors nervous about equities as an asset class and it is not surprising that these less volatile strategies have grown in popularity. I do not see this changing.”

Bertrand Delarue, global head of institutional product engineering at BNP Paribas equity derivatives, agrees adding, “These stocks may be more expensive because of the recent popularity of high income stocks generally, but there is not yet enough money overall going into low volatility or minimum variance strategies specifically, to push the price further up.

One of the main drivers of low volatility strategies is that investors are looking to build their equity portfolios in a more efficient way and there are questions over the traditional market cap indices. They have been the most popular over the past 50 years because they are cheap, liquid and easy to replicate. There is no free lunch and investors have to be smart about the implementation of low volatility investments. Things such as timing, turnover and concentration risk have to be carefully managed.”

Jeffrey Molitor, chief investment officer Europe at Vanguard Asset Management, also notes that “too many investors make moves on what has worked in the past or buy assets that would have been the perfect anecdote for their portfolios 12 to 18 months ago.

The most important thing for pension funds is to define their objectives clearly and stick with them.“ The main attributes of low volatility strategies is that they offer downside protection and the potential for better risk adjusted returns than their benchmark peers over a full market cycle.

These virtues are highlighted in a bountiful crop of academic studies which although using different data all reach similar conclusions thanks to what is called the volatility anomaly.

This flies in the face of the well estab-

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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MARKET LEADER

INVESTORS FLOCK TO LOW VOLATILITY STRATEGIES

lished Capital Asset Pricing Model that espouses investors need to take on additional risk in order to generate greater returns.

While this rings true in the short term, low volatility strategies dramatically underperform in bull markets— recent research in the Journal of Portfolio Management shows that investors’ patience could be rewarded. From 1968 through 2005, the least volatile stocks among a universe of the 1,000 largest issues had an annualised return that was nearly one percentage point more than group as a whole with about 25% less volatility.

In addition, results published last year in Financial Analysts Journal, which looked at statistics from 1968 through 2008, show the same pattern. While Robert Haugen, president of Haugen Custom Financial Systems, a US-based research firm and Nardin Baker, chief strategist at Global Alpha, Guggenheim Partners Asset Management, found that low volatility stocks consistently beat the market in all of the 21 developed countries they examined between 1990 and 2011.

The past though is not always a guide to the future, warns James Klempster, multi-asset portfolio manager at Momentum Global Investment Management. “Despite the attractiveness of the strategy in recent years, it may not necessarily be as successful going forward. Investors remain acutely aware of the difficult market conditions and the fact that we have had two significant bear markets over the past decade. As a result of this, appropriate low volatility strategies can be attractive because they provide a degree of diversification in a portfolio.”

As with any investment strategy, there are different variations but broadly speaking these strategies generally fall into two camps—portfolios composed of low-volatility stocks and equity portfolios with low volatility. The former are generally constructed by selecting the least volatile stocks from an eligible universe and then blending them together.

There may be fundamental or quantita-

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tive overlays and possibly some constraints in the choice of stock weighting.

Their correlations are not always taken into account during the stock selection process which means that the overall portfolio volatility may be higher than expected although still lower than a cap-weighted index.

The latter includes the quant based minimum-variance which can trace its roots back to the 1950s when Nobel prize winner Harry Markowitz espoused his modern portfolio theory that noted variance could be minimized by looking at the correlations and volatility among stocks. These approaches are thought to address portfolio risk in a more effective manner than portfolios of low volatility stocks because reducing that risk is specifically targeted.

Optimised approach “I think the cleanest and purest way to achieve low volatility is by using an optimised approach,” says Peter Gunthorp, managing director, Research Analytics at FTSE Group. “If you have black box concerns, you can get something close to minimum variance in terms of volatility reduction using low volatility screens and risk weighting stocks, but liquidity and turnover become an issue. One of the concerns with minimum variance strategies is concentration risk. We keep constraints to a minimum in our indices so it is clear what drives the index, limiting constraints to stock, industry and country constraints. We also have a diversification target that allows us to target a minimum number of stocks to address concentration issues.”

FTSE recently broadened its minimum variance range by adding eight new benchmarks to provide a wider geographical reach. The indices which cover Asia, Europe and the US follow on from the launch earlier this year of a version of the FTSE 100 index of UK-listed large-capitalisation stocks.

Another tactic generating a buzz is overwriting, which is making a comeback because it can enhance yield while

reducing risk. According to Pam Finelli, head of equity derivatives strategy at Deutsche Bank, investors write a call option, receiving a premium up-front.

This type of lower volatility strategy will benefit from a buffer in bear and sideways markets and while they will still undershoot a buoyant market, riskadjusted returns may still be superior to a long-only stock portfolio.

These strategies can also be applied with a more dynamic tilt.“Certain low volatility stocks are looking historically expensive and for that reason I would exercise a degree of caution at this time and consider active implementation of the approach,” says Lloyd Raynor, senior consultant at Russell Investments. “They have become popular and there are so many different types of strategies in this space.”

Matt Peron, head of active equity at Northern Trust, which has a quality low volatility strategy, believes,“you want to be as thoughtful as possible when constructing low volatility portfolios. The three biggest criticisms of these strategies are high tracking error to standard benchmarks, turnover and concentration risk. The first is by design, but can make it challenging for those who are benchmark sensitive. We use an optimiser but also use a proprietary quality overlay and have constraints including a limit on the relative stock positions and sector weights. This enables us to lower the overall portfolio volatility as well as increase diversification.”

Lazard also injects an alpha component into its global managed volatility strategy. According to its portfolio manager, Susanne Willumsen, the fund ranks stocks using four factors—growth, value, sentiment and quality. They each consist of a series of proprietary models that have been tested and proven for their efficiency and independence in identifying return opportunities. This means that highly attractive stocks are selected that are not exclusively low volatility. However, the result is a portfolio that over the long term is more stable than a passive approach which only focuses on one factor, volatility. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

VOX POP

Are regulations getting in the way of principles?

AN ANY READER find an article or comment in recent times where the content goes further than the question of whether the fund, fund strategy or financial instrument comply with the relevant regulation? Those of us who would argue for a debate on the appropriate balance between compliance and performance appear to have lost to those who seem intent on ensuring that regulation becomes ever tighter and compliance is the new benchmark.

Merely asking if a hedge fund complies with AIFMD requirements now appears to be the extent of the due diligence required by professional investors where only an answer in the negative prompts the need to enquire further. Regulation is important but not to the extent that it crowds other, equally fundamental, assessments of hedge fund manager ‘value’.

As we look into the prospects for the investment industry in 2013, regulation needs to be placed in the appropriate context, alongside an assessment of other risks to performance within hedge funds. This new context should be a focus, between professional investors and hedge fund managers, on thematic risk. It should also cover a broad spectrum of topics and issues which could form the basis of an infrastructure for investor assessment of funds’ processes.

Critically, while regulatory compliance is a central pillar of this infrastructure, it is

C

accorded equal importance to other, performance-related measures.

I offer the following five themes as the basis for this new infrastructure; themes which combine regulatory assessment with consideration of prospective performance characteristics.

The first is culture. Amid the analysis and re-analysis of the remuneration code and the proposed guidelines for alternative investment managers— issued by ESMA, itself driven by AIFMD and, latterly UCITS V—we are now faced with further potential regulation in the wake of the Kay Review. This was fiercely critical of annual bonus calculations and made several, wide-ranging points relating to a re-alignment of executive pay to the long term. Within this, Kay asked key questions as to how to resolve the apparent conflict between the needs of investors and fund managers. These questions rumble on and I venture that further regulation is likely.

However, when considering this point, very little of the debate has focused on the positive benefits of culture and “tone” within funds. Moreover, the current regulatory framework already has many facets which, used appropriately, could result in the desired outcome. In terms of aligning the needs of investors and managers, co-investment has been cited as a possible solution. This might go too far but, within this space, there is surely scope to look to utilise claw-back clauses for

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

ASSESSING THE IMPACT OF MARKET REGULATION

The debate on global regulation within financial services in general and professional investment and hedge funds in particular has grown into an industry in its own right. Rarely does a day go past without a new interpretation of the forthcoming tsunami of rules, bolstered by comments from august figures drawing the battle lines on both sides of the debate. Has regulation gone too far? Michelle Carroll, partner, BDO LLP argues that the ‘trees’ of the financial services regulation have now almost completely obscured the ‘wood’ of the industry.

Michelle Carroll, partner, BDO LLP argues that the ‘trees’ of the financial services regulation have now almost completely obscured the ‘wood’ of the industry.

Photograph kindly supplied by BDO, November 2012.

performance fees (specifically for hedge funds rather than private equity).

Moreover, the alignment of the needs and wants of investors and managers must not stop at remuneration.

As Kay clearly highlighted, investors should seek to embrace a stewardship role within their portfolios. While the spotlight is on the relationship between professional investors and their managers, should we not encourage the former to review the latter in light of other, non-traditional factors? In light of this, professional investors should review the culture of the hedge fund managers against, for example, gender diversity in the latter’s organisation, internal policies on treating customers fairly and wider concepts of inclusion.

It is a short leap in logic for professional investors, under Kay’s stewardship entreaty, to look to their managers’ own non-financial performance in these areas.

The second theme is caveat emptor.

There is a risk (and a growing one at that) whereby the implementation of compliance with regulations such as AIFMD supercedes the more fundamental caveat emptor approach from investors to any investment. Indeed, speaking directly to the final Level II rules within AIFMD, I fear that the required reporting may reduce the focus on key underlying problems. This is a result of the need to ensure that mandatory reporting is kept at a high level, in terms of detail, for the aggregate results to have any meaning for the regulator. A situation where the regulation is sensible but only if underlying common sense—caveat emptor—remains.

13

VOX POP

ASSESSING THE IMPACT OF MARKET REGULATION

In order that professional investors are able to analyse managers on a realistic basis, most alternative funds will need to put in place bespoke reporting.

To my mind, investors must go further than the regulations and demand the information which they require to make a considered judgement and hedge fund managers must be able to provide that information on a timely basis. Regulation such as AIFMD is not a replacement for this structure.

Recent experience suggests that UK regulators, for example, are taking this position on board and are focussing on “themed” visits to managers. Several asset management firms have had to undergo reviews of their conflict of interest policies, processes, attitudes and behaviours. The results of these reviews were indifferent at best and further investigation was required with the potential for fines clear. It is critical that the industry as a whole does not allow itself to fail on these basic measures while seeking to adhere to the more esoteric of our new regulatory framework. There should be strong AML checks, there should not be regular pricing errors, client money should be identifiable and separate to the firm. Getting the basics right is the basis of sound investment management and it is reputationally damaging for the market and the investment management community if the regulator continues to find examples of fundamental errors. This should be a base line for the industry so that, when individual firms or managers are noncompliant, this is seen as the exception.

If the industry does not maintain this basic level, then investors are entitled to move their funds elsewhere.

An obvious theme is recognising the politics in regulation. Further to my point about making sure the basics are in place, is the responsibility of the industry to recognise that it is facing a substantial trust issue and that it must seek to go further than ever to remedy this perception. To my mind, there is too much effort expended by the industry in addressing the detailed points

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raised by ever tighter regulation when, often, these points remain outside the scope of many to understand and, therefore, interpret their impact.

Better that the industry recognises that there are many components of the wider market who are seeking to atone for the errors leading up to the financial crisis. Politicians of all hues will seek to make political capital out of further regulatory “advances”. It is essential that the industry is ready and willing to show that the appropriate checks and balances are already in place and, where they are not, to embrace the change. It is better that we are all seen as working towards a common goal— greater understanding of underlying risk and the rewards it can generate— than become mired in debates over investment manager remuneration.

Focus on fundamentals To that end, investors might want to look beyond the political grandstanding of recent years and focus on the fundamentals of the individual manager and its structures. If these are fit for purpose and will ensure compliance is both achieved and seen to be achieved, goodwill can be created.

The next theme is concentration risk.

One specific example of the unintended consequences of regulation surrounds depository liability under AIFMD. The possible outcome of the expected level 2 rules is that only a small number of depositories, probably those that are part of large global banking groups, will be able to meet the liability requirements. By reducing significantly the number of depositories available to AIFMD compliant firms, there is higher concentration of counterparty risk: if one of these depositories has concerns or is impacted by a negative event in their banking arm, it is possible that assets are frozen, and a significant number of investment funds will be impacted. I can foresee a market where there are only six AIFMD compliant depositories and they have an equal share. If one of those depositories were to have

liquidity issues, then circa 15% of the regulated hedge fund market doing business in Europe will be impacted.

This concentration risk is not necessarily driven by regulation. In my experience, a hedge fund manager I know put its administration, prime brokerage and custody, middle office, leverage and share currency hedging with different entities of the one global bank group. However, when something went wrong with NAV pricing, the administrator didn’t co-operate.

The law of unintended consequences also comes into play through the regulatory-inspired risk of concentration. It has been argued—correctly in my view—that the cost of regulatory compliance will be prohibitive for boutique hedge fund managers. This will lead to mergers or liquidations. Small, entrepreneurial managers may find themselves with the only option of joining or becoming an institutionalised business. AIFMD, Dodd-Frank and Volcker are all contributing to the institutionalisation of the industry, both in terms of operational processes and investor base. This is likely to continue (restrictions on short selling and OTCs) and bring the industry further into the mainstream, which is not a bad thing as it helps attract pension money but may also mean we lose some of the individualism and, with it, lose opportunity to invest in creative areas.

At the risk of protesting too much, professional investors should consider reducing their attractions to brands within the choice of counterparty. It must be best practice that certain engagements, such as fund directors, auditors or administrators, are examined on a wider set of factors than cost.

In fund management, as in life, the cheapest is not necessarily the most efficient while the most expensive is no longer a guarantee of quality. Like the regulators, professional investors should think differently. Unlike the regulators, professional investors should go back to the basic fundamentals of manager selection and look to culture, tone and experience. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

IN THE MARKETS

A patchwork of national and regional regulations is rolling out around the globe, each patch reflecting an interpretation of the G20 countries’ commitments to address the “systemic risk” posed by the derivatives market. In principle, if a big broker were to default under the regulations currently being enacted globally, its counterparties ought to be protected against significant loss and its clients should have their assets safely segregated from the firm’s own reserves. However the rules are not yet in place. Have regulators correctly identified the systemic weaknesses in the derivatives market?

Dan Barnes reports.

HOW TO BEST REDUCE SYSTEMIC RISK IN OTC TRADING “

T THE MOMENT things are changing,” says Jane Lowe, director, markets, at buy-side industry body the Investment Management Association (IMA). “Central clearing is changing; you could go and clear through LCH.Clearnet but you would have a limited number of options because they haven’t finalised their full suite yet. Even if you cleared through them and were satisfied with the option you took it wouldn’t be under European Market Infrastructure Regulation (EMIR). Although technically it is in effect, the clearinghouses are not regis-

A

tered with the European Securities and Markets Authority (ESMA), and their products are not yet registered for mandatory clearing. Although we have a resolution regime in the UK it is untested. If you are a regulator you might look at this and think more has been achieved than really has.”

The G20 mandate covered electronic trading, central clearing and trade reporting to the over-the-counter (OTC) derivatives market. Capital buffers were erected, to be used in the event of a counterparty defaulting, to make sure transactions were honoured.

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

WHAT HAPPENS WHEN OTC TRADES GO WRONG

Photograph © Kovacs Ferenc/ Dreamstime.com, supplied December 2012.

The thinking was straightforward enough; large financial services companies had been found to have exposures large enough to sink them if market sentiment became negative and these bankruptcies could trigger a domino effect that could destroy the financial system. There was no standardised or centralised model of recordkeeping so when problems occurred their size was a complete unknown until the administration had been unpicked. Without centralised marketplaces and standardised contracts liquidity was in an as-and-when basis and pricing was adhoc while the assessment of exposures and positions was more challenging.

Even if governments funded banks through a period of uncertainty following a default, the subsequent lack of faith in counterparties would still prevent the banks from trading with other firms and firms trusting their banks, destroying liquidity. The lack of market transparency or decent record keeping meant that no firm’s position could be easily established to engender trust. Central counterparties (CCP) were envisioned by the G20 as safe middlemen to contain the risk that the derivatives markets generate. Will Rhode, senior analyst at research firm TABB Group says,“Risk is like energy, at least in today’s financial markets. It is not being destroyed, simply transferred.”

Repairing the markets In Europe and the US, where the G20 rules are being delivered via the EMIR and the Dodd-Frank Act respectively, CCPs require enough collateral to be posted with them that they can withstand the default of two large clearing members and unwind their positions in a matter of days. The value of the collateral should exceed the cost from losses which occur through adverse price movements.

That level of buffer should mean CCPs mitigate counterparty risk to such an extent that the firms do not have to freeze liquidity following a bankruptcy.

15

IN THE MARKETS

WHAT HAPPENS WHEN OTC TRADES GO WRONG

Anglo-French CCP LCH.Clearnet handled the unwinding of clearing member Lehman Brothers’ positions in 2008 successfully. For the most part these rules will deliver positive change says Lowe.

“Some of this new legislation will enforce the issues that needed fixing before the crisis; it may happen ahead of time but it will definitely happen by the time the legislation comes in,” she asserts.“Unequivocally it will be an improvement, as regulators gain insight into the market they can see who is exposed to who and if there is a failure they can work out what that means for other participants and work out contingency or provide reassurance which they were not in a position to do in 2008.”

However, there are still weaknesses in the system. Client money rules did not offer sufficient protection for Lehman Brothers’ clients, according to Richard Sutcliffe, head of Client Assets Unit (CASS), at UK regulator the Financial Services Authority (FSA). On November 20th 2012, he noted in a speech to the CASS and Markets Conference, “The stark reality is that clients have not still received any client money back from the administration four years after the firm’s failure. This was the client assets world’s watershed moment. It was clear that change was needed in both the industry and the regulator.”

Joining the dots Two further broker defaults, that of MF Global in late October 2011 and that of Peregrine Financial Group in July 2012, have since demonstrated that weaknesses in client money protection rules persisted after Lehman. In the US these issues are being addressed with the introduction of client money segregation and increased monitoring observes Marc Katz, head of OTC strategy at futures commission merchant (FCM) Newedge.

“Firstly I think the self-regulatory organisations and the CFTC are very serious about stepping up the ability on a real time basis to ensure adequacy of FCM’s controls relating to client funds,”

16

he says. “Clearly that was a failure in the case of Peregrine. Secondly FCMs are redoubling their efforts to demonstrate the sanctity of client funds. The third point is that clients are increasing their own degree of due diligence with regard to these markets which is a very good development.”

Likewise European regulators are demanding client assets be segregated, however as these laws are national and there is no international coordination of them.

“A lot of these events are determined by how insolvency rolls out in each jurisdiction,” says Lowe. The global nature of the derivatives markets also means that even though the G20based regulations are being coordinated internationally, as they are transposed into national rules they can become markedly different.

Global standards “It has always been said that we need a global standard for regulation,” says Markus Zickwolff, chair of the European Association of Clearing Houses.

“If there is a regulatory environment that is less strict this may on one hand attract liquidity and innovation that would on the other hand be dangerous due to greater risk appetite in the less regulated environments. We fear that differences in regulation between the US and the EU may lead to regulatory arbitrage, however no-one can assess currently whether these differences will be big enough to result in arbitrage just yet.”

For example, in the US only ‘systemically important’ CCPs have to assess their ability default for the two largest clearing members, which applies to all CCPs in Europe. The liquidation period a CCP has to consider for exchangetraded derivatives is two days for liquidation in Europe and one day in the US, which could lead to arbitrage if a US clearing house and a European clearing house were competing for the trading of the same derivative.

Questions have also been asked about the risk that a firm faces if liq-

uidity dries up for the assets that are required to be posted as margin. “The initial margin requirement which is like the ante at a casino table,” says Rhode.“We all know that once we start betting it’s not the ante that kills us, that’s just skin in the game, it’s the variation, and how the game evolves that kills us.”

He notes that new client money segregation rules remove a lot of the flexibility that previously existed just at a time when variation margin calls are moved to a daily basis in line with CCP policies, away from the more relaxed bilateral model which often saw margin calls on a quarterly basis. There is a risk that second-tier firms will either have to prefund calls or if they cannot, pull out of hedging.

One potential problem foreseen currently are a liquidity crisis that could threaten the ability of firms to find the collateral needed to participate in hedging, although Zickwolff notes that this should be preventable.

“What we currently see is a phased introduction of regulation; I would expect this issue to be raised if we see an increased demand for collateral after the first phase of regulation; members will ask for exemptions from or changes to the regulation which has been put in place because of that lack of collateral, but I don’t expect an immediate shortfall on collateral due to the phased nature of regulation,” he says.

Nevertheless concerns remain that backward-looking precautions will not be sufficient.

“We know that tomorrow’s crisis will be seismically worse than anything we’ve seen today. It will be something unimaginable, that is the nature of black swan events,” says Rhode. “The CCPs who are buffered up to the hilt, with an implicit government guarantee behind them, are in a difficult position because they are the fulcrum of risk for the whole system and have to have a risk management process in place to contingency plan for an event that they can’t even imagine. So risk has only been transferred.” I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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

IN THE MARKETS

PUTTING THE COLLATERAL GAP INTO PROPER PERSPECTIVE

Photograph © Fabian Schmidt/Dreamstime.com, supplied December 2012.

What’s in a number?

Minding the collateral gap The International Swaps and Derivatives Association (ISDA) claims up to $10.2trn in assets may be needed to support the risk mitigation measures demanded by new rules including Dodd-Frank regulation and the European and Markets Infrastructure Regulation. Where will the trillions of dollars of capital needed to margin derivatives trades come from? Dan Barnes reports.

HE SCALE OF the demand, needed to cover initial margin on non-cleared derivatives trades, would threaten a severe liquidity drain once new regulations are enforced.

Based upon the data that was submitted by member firms to the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) joint Working Group on Margining Requirements (WGMR), ISDA’s analysis is that the pressure on collateral would reach dangerous levels at times of market stress. Determining the operational effect that such a large strain for collateral demand would have on the markets is hard to assess, and the challenge is compounded by the multitude of different figures that are given to represent the expected demand.

“Depending on who you speak to, you see figures from hundreds of billions to a few trillion dollars shortfall predicted in the cleared market and then ISDA’s study is claiming that anywhere between $1trn and $10trn is needed for the uncleared market,” says Jonathan Philp, OTC specialist,

T

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Rule Financial.“The $10trn isn’t real. If you are a bank and accredited you have the choice of using two models to calculate your collateral requirements; one is based on your internal model and that would deliver $1trn to $3trn, the other is based on using the naïve lookup tables provided by the regulator with standard amounts posted for contracts individually and that will give you $10trn, but it’s not real.”

The increase in collateral requirements stems from an agreement by the G20 countries, made at the Pittsburgh summit in 2009, that all standardised OTC derivative contracts “should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements.”

The G20 was motivated to impose a framework upon the OTC derivatives market following the bankruptcy of Lehman Brothers in 2008. The knockon effect of the broker’s default was

felt by the bank’s many counterparties who had collateral held by Lehman Brothers frozen during the bankruptcy proceedings. Underwriters of credit default swaps (CDSs), such as insurance giant AIG, were also under threat both from the Lehman credit event and the collapse of mortgage-backed securities (MBS) market. Goldman Sachs, and later other brokers, marked down the value of MBS assets when mortgage defaults became a concern.

In Goldman Sachs’ case this forced AIG to give it ever larger sums of collateral, leading it to require a government bailout.

The lack of good post-trade processing of derivatives trades had first been raised as an issue by the Federal Reserve in 2005, leading major brokers to write a letter of intent that detailed where work was being done to improve the efficiency of the derivatives trade processing. This was the first in a series of documents that came to be known as ‘The Fed Letters’, however three years later the investment necessary to unwind trades efficiently had still not been made. The complexity of unwinding Lehman Brothers’ positions and the uncertainty this caused in the market, led the G20 to act.

The cost of making the financial infrastructure more secure is borne by market participants. Using a CCP involves a more rigorous method of margining against risks. CCPs require initial margin to be posted which is a lump sum to be weighed against the initial value of the contract traded. They also require daily calculation of variation margin, which in turn accounts for movement in the value of the contract.

Uncleared bilateral trades were typically only required variation margin and that was often only checked once a quarter. “Given the way the deals were structured often brokers would not require collateral, they would use portfolio margining for the entire scheme of what they are covering and there was no initial margin required and the variation margin was a threshold variation margin so if the product a

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

IN THE MARKETS

PUTTING THE COLLATERAL GAP INTO PROPER PERSPECTIVE

client traded stayed within X and Y range no margin was required,” explains Alex Tabb at analyst firm TABB Group. “Everything was done in cash.

Now, that’s gone.”

The amount of collateral needed is of particular concern because only assets that are highly liquid and low risk are accepted by CCPs; for initial margin, high quality government bonds are typically used, while cash is required for variation margin. Many buy-side firms do not hold these instruments as a matter of course and sourcing them could prove a challenge. If a firm is unable to provide the initial margin it will be unable to trade; if it cannot pay variation margin its position may be closed out.

Sell-side firms are offering to alleviate the risk of a collateral shortfall for their clients through collateral transformation services which allow them to exchange assets that they are mandated to use, such as equities, for usable collateral such as government bonds.

“Collateral to secure derivative exposure was once thought of from only an operational standpoint—a simple bilateral transaction between broker-dealers and their clients and counterparties,” says Nadine Chakar, global head of business, 360 Derivatives at BNY Mellon, which offers a transformation service. “Viewed as operational, front office investment professionals rarely took notice of it. All of that changed at the start of the financial crisis in 2008.

The use of collateral has since been on the rise. Consider ISDA’s 2012 Margin Survey which shows a sharp increase with collateral in circulation rising 24%, from $2.9trn to $3.6trn, over the course of 2011 alone. That was primarily as a result of the Eurozone debt crisis, downgrades of financial firms and declining interest rates.”

With the Dodd-Frank Act still being transposed into market rules by the US regulators the Securities and Exchange Commission (SEC) and Commodities and Futures Trading Commission (CFTC) and EMIR still being debated

by Europe’s legislative bodies there is

20

an understandable level of uncertainty over the effect that increased collateral demand will have on the business.

Research firm Celent expects between 40% and 50% of OTC contracts to be cleared by year end 2013, which will create an additional collateral requirement of $2trn to $2.5trn with an estimated 80% of OTC contracts being cleared by CCPs inside of the next four years, creating an additional collateral requirement of $6trn. In their research paper Cracking the trillion dollar collateral optimisation question authors Medy Agami and Cubillas Ding noted that there is a very real possibility that margin compression surges will lead quality collateral to become “a new kind of scarce currency”.

TABB Group shows a potential collateral shortfall in the range of $1.6trn which it updated this summer to $2.5trn as a worst case scenario. Alex Tabb notes that when analysts put the figures together they have to take into account all of the cross margining that is going to occur in the new CCP environment.“We think there is going to be a significant reduction in the overall level of collateral required because of that but it will still be significant level of collateral,” he says.

Ted Leveroni, executive director of derivatives strategy at derivatives processing technology supplier Omgeo, says that the dollar numbers being bandied about may prove to be irrelevant in the long run, “I’ve seen estimates of $0.5trn, $4trn and $6trn.

When you are looking at it in a macro sense it’s very difficult to estimate how the regulations will impact market behaviour. Will clients stop trading derivatives? Will they move towards exchange-traded derivatives that have different margin requirements to OTC derivatives? You can’t predict the behaviour and you need to know that in order to come up with the final figure.”

Of more fundamental importance is the degree to which the use of CCPs will mitigate risk for the industry. Not

Jonathan Philp, specialist in OTC derivatives, Rule Financial. “Depending on who you speak to, you see figures from hundreds of billions to a few trillion dollars shortfall predicted in the cleared market and then ISDA’s study is claiming that anywhere between $1trn and $10trn is needed for the uncleared market,” says Philp. Photograph kindly supplied by Rule Financial/Hotwire PR, December 2012.

everyone is convinced that the new system is solving the real problems that sunk firms in 2008.

The Committee on Capital Markets Regulation, an independent research organisation made up of industry and academic participants, dedicated to improving the regulation of US capital markets, released a paper ‘Interconnectedness and contagion’ on November 20th 2012 which challenges some of the assumptions made about the role of derivatives in triggering the crisis. It concludes that asset interconnectedness was not to blame for the collapse of several institutions so much as a loss of confidence in them.“Contagion can threaten the financial system in a fundamentally different way than asset interconnectedness or liability interconnectedness because run-like behaviour can indiscriminately spread to solvent institutions,”writes Hal Scott, director of the Committee on Capital Markets Regulation.“A solvent financial institution displaying no characteristic warning signs of distress can be put at risk or even fail if the short-term funding market is impaired.”

“The contagion was in the inability of banks to fund themselves; lending became tight because there was a breakdown in trust,”Philp says.“Part of the idea of the CCP in a derivatives transaction is to reduce that but if all you do is require massive amounts of collateral trust that is pressure on the funding process.” I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

TRADING POST

The repo desk, your new best friend forever OLLATERAL MANAGEMENT FOR OTC trades has often been aligned around the OTC operations department, as the margin agreements (credit support annexes) belong close to the OTC confirmations function, and the OTC settlement function. In addition to OTC margining, is repo margining, stock loan and futures, which don’t all naturally lie together and can be aligned around their respective business units, leading to duplicated effort to solve more or less the same margining problem. With the move to centrally clear the majority of OTC products, the demand to fund margin requirements will obviously go up, as will the appetite for CCPs to accept a wider range of products into clearing, such as the recent launch by Eurex of clearing for stock loans.

Each business line (OTC, repo, futures, stock loan) are all engaged in receiving and servicing margin calls, either from CCPs or under bilateral agreements, and service those agreements under tight controls to achieve the full credit protection they are supposed to deliver. In common is the need to receive position data from external parties including CCPs, brokers or agents, and reconcile it with their multiple internal trading and risk systems.

Also in common is the need to receive margin calls and process them in a timely manner, and for control purposes to validate the margin calculations.

In the past some of these functions could be achieved manually, using Excel to reconcile trades, and track the margin calls. What Excel can’t easily do is track the successful processing of a margin call, and importantly track any delays

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to the process with escalation where needed, or disputes. Many firms are now looking at these business lines and the similar margining business processes and deciding to invest in automation, which is where the story returns to the repo desk. Once a firm has a collateral management system, the next connectivity challenge is with the repo systems (and people), to fund margin calls. After all, while processing a margin call is relatively straightforward, the costs of margin are not, an opportunity exists to carefully decide what assets to deliver to meet a firm’s liabilities.

The costs of funding margin calls are more easily managed in a central place, with a team close to or within the treasury, which is often the repo desk. The repo desk is close to the heart of funding a firms short term needs, filling the forecast cash settlement requirements, re-using bond inventory as collateral.

The decision on how to fund a margin call is now migrating to the repo desk, as it is best placed to understand cost implications, and can also decide what parts of a bond inventory can be delivered as collateral. This makes the collateral decision process much more tightly integrated with the repo desk; and means the repo and collateral systems must work together efficiently.

This movement is seen in the software offerings from some companies, where they can support both the repo/ stock lend desks for trade processing, and also the collateral management function for any of the external margin agreements. As margin calls arrive, the collateral team need to make quick decisions on how to fund the liabilities.

This involves a many-to-many decision

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

REPO IN THE SPOTLIGHT

The importance of the Repo desk has moved up a gear, due to the regulators enthusiasm for margining, likewise a typical collateral management team may well find itself pushed towards or merged into that business line.

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

matrix, combining the available assets, with the eligibility rules in each margin agreement, with concentration rules, liquidity rules and capital calculations.

It is no surprise that collateral “optimisation” has become a buzz word on the conference circuit and in product literature, as the complexity of managing margin is being pushed to a new level by Dodd Frank and EMIR. An ideal software platform will combine the trading activity of a repo desk with the collateral management functions, alongside support for reconciliations, workflow, automated tracking, escalation and integrated communications with external parties—a tall order.

In some firms the collateral team now reports into the repo desk, as their functions are so closely aligned. Collateral Management has always had an uncertain alignment within firms, as it isn’t always clear whether their role is to simply meet incoming margin calls, proactively manage credit risk, or strategically analyse margin requirements via CCP risk models. Putting collateral within the repo desk at least removes a significant friction surface, and means the processing of margin calls meets tight deadlines without excessive cost.

Once these two teams are working closely, the systems must follow, and the more integrated the better.

In the longer term further challenges await, including the ability to independently calculate and verify CCP margin calls, support electronic margin call messaging from firms such as Acadiasoft or SWIFT, and support the proposed clearing connectivity standard (CCS) sponsored by large buy-side firms and ISDA. I

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DEBT REPORT

RECORD ISSUANCE IN US HIGH GRADE CORPORATE BONDS

Photograph © Marek Redesuik/Dreamstime.com, supplied December 2012.

HIGH TIMES FOR HIGH-GRADE CORPORATES As 2012 drew to a close, high-grade corporate bonds look poised to set a single-year record for new issuance. With government debt remaining at rock-bottom levels and corporations still flush with cash, what’s to stop the bond bonanza from suddenly going belly up? Dave Simons reports.

YPICALLY SOME OF the fattest returns in the bond business belong to the shakiest of propositions. However, with ten-year US Treasury yields struggling to stay above 1.5% (after breaking below 1.4% last July for a new all-time bottom), even higher-grade corporate issues have looked downright appealing by comparison. Take Intel’s A-rated 20-year bond, issued as part of the chipmaker’s $6bn December offering, which sported a ripe 4.065%—a 130 basispoints (bps) premium over an equivalent-duration Treasury yield.

Monetary easing continues to make it that much easier for investors to transition from lower-paying government-debt into more attractive corporate issues. Meanwhile, companies such as Intel have been more than happy to meet the enormous demand.

As of early December, high-grade new issuance stood just north of $1trn, according to Dealogic, making 2012 an odds-on favorite to surpass 2009’s record-setting $1.024tn.

Much of the bond boom has been built on the back of strengthening corporate balance sheets and more fiscally

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sound management policies, including lower use of leverage. One question is whether the trend can continue through 2013. More importantly, can bond spreads remain within the “comfortable” zone in the months ahead?

Despite the sluggish recovery, during 2012 impressive productivity gains, combined with uncertainty over regulatory matters and fiscal policy making, helped raise liquidity to record levels, as companies continued to horde their cash until the coast is clear.“At this stage corporations’ balance sheets appear very healthy, and that obviously has been a key focal point for investors,” says Chris Probyn, chief economist at State Street Global Advisors.

During the third quarter, data from Prudential Fixed Income showed US corporate bonds in heady territory, reaching 3.83% for a YTD return to 8.66%, more than 600 bps higher than Treasury returns through the same period. Third quarter (Q3) new issuance jumped 65% year-over-year, and with the Fed pledging to keep rates in check through 2015, corporations are likely to have conditions working in their favour for quite some time. Sup-

portive monetary policy on a global basis has provided the markets with a “tailwind of support,” says Prudential, and despite slower earnings US corporate issuers appear to be in very good shape, with both cash flow and debt coverage at high levels. In Europe, certain USD-denominated issues also look attractive, however the persistence of recessionary concerns in the EU make domestic bonds a somewhat better bet.

For 2013, the combination of balance-sheet strength and more prudent management practices should allow US companies to hold their own until GDP truly takes off, notes Prudential. While volume levels may recede somewhat during the first part of the year, particularly as companies that have stocked up in advance of the fiscal cliff (and perhaps in anticipation of a possible increase in the dividend tax rate) take a breather, corporate balance sheets are expected to remain robust, helping to keep bond spreads in check going forward.

Accordingly, post-fiscal cliff Probyn sees even smoother sailing. “Looking beyond the start of the year, I’m quite confident that spreads will remain tight, as companies continue to benefit from a much stronger economic environment,” he adds. “Consumer spending is on the rise, there are signs that housing is coming back, and if the pace of investment picks up as well, we could end up seeing very decent growth before the year is out,” says Probyn.

This in turn could lead to further upside for high-grade corporations, says Probyn, particularly with very little in the way of potential seismic disturbances in the year ahead.“There is the remote possibility of a Chinese hardlanding, or even a sudden Greek exit, but even these occurrences probably wouldn’t change the story in a meaningful way,” says Probyn. “So from our perspective, there really isn’t much on the radar that could seriously threaten the health of these markets.”

Clearly, issuer opportunism has played (at the very least) a small role in

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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DEBT REPORT

RECORD ISSUANCE IN US HIGH GRADE CORPORATE BONDS

the record run-up. With borrowing costs lower than they’ve ever been, even corporations with no real need to issue have come to market. At year’s end, domestic energy giant ConocoPhillips floated a $2bn issuance following a four-year absence, while in November, cash-rich Amazon made its first foray into the borrowing biz since the dot-com late 1990s with its own $3bn offering.

While large-cap growth players have typically relied on traditional financing arrangements or simply dipped into their cash reserves to fund expansion plans, the ability to borrow at the absolute bottom of the yield curve has been awfully tough to pass up (not to mention that dividend yields for many issuing companies are higher than the after-tax cost of issuing debt). Furthermore, by using new bond issuance instead of cash, companies are able to avoid being taxed on reserves that are held in overseas accounts.

Still, the most compelling factor for issuing companies continues to be investors’ insatiable appetite for new product. “Insurance companies have been big buyers of high-grade corporate bonds,” observes Jake Gaul, CFA, portfolio manager at Boston-based fixed-income specialist Standish.

Corporations represent a quality, fixedincome alternative for high-grade institutional investors and those with multi-sector bond portfolios. “The crowding-out effect of the Fed buying $45bn worth of mortgages per month, combined with the ongoing need for yield, certainly helps explain the current supply-demand dynamic.”

Naturally one cannot completely rule out an unforeseen US economic downturn linked to unresolved fiscal matters, which could send investors scrambling for the exits and causing a widening of corporate spreads in the process.

However, assuming that lawmakers will ultimately find some form of consensus makes this scenario only a remote possibility. For that matter, not even a possible jump in the dividend and/or capital-gains tax structure

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would likely pose a major threat to corporate-bond activity. “The fact of the matter is that investors are still going to be seeking return—they just may have to pay a little more for it,” shrugs Probyn. Short of a special tax rule singling out a particular asset class, says Probyn, “I can’t see there being any significant impact on the asset allocation decision-making process,”he adds.

Bubble ahead?

With gross issuance in record territory, rumblings of an eventual corporatebond bubble have once again surfaced.

Despite the enormous amount of supply currently on the books, however, supporters remain sanguine.

“When we look at supply, we consider the actual figures versus the estimates,” says Gaul.“And the fact is the majority of ‘actuals’ have typically outpaced the projected numbers.”

Current valuations offer little indication of a reversal on the horizon.

“Particularly when you look at valuations, you really don’t get the sense that we are anywhere near correction territory,” says Gaul. “While upsets are often things that you couldn’t anticipate, at this juncture we certainly don’t see the same kinds of excesses that occurred, say, during the dot-com bubble, or that preceded the collapse of late 2008. I think that’s really been important, as it has allowed us to be overweight corporations during certain periods, and still be able to sleep at night.”

Meanwhile, spreads continued to tighten during 2012, led by the US financial sector, which saw a spread increase of approximately 174 bps, or nearly twice that of industrials, according to figures from Standish.

Higher capital ratios and lower debt/leverage have kept financials in general (and money centre banks in particular) well ahead of the pack, notes Gaul.

“The financials have really been the driver, their fundamentals have been consistently strong all year,”Gaul says.

“For a lot of people, it was hard to

Jake Gaul, CFA, portfolio manager at Bostonbased fixed-income specialist Standish.

Corporations represent a quality, fixed-income alternative for high-grade institutional investors and those with multi-sector bond portfolios. “The crowding-out effect of the Fed buying $45bn worth of mortgages per month, combined with the ongoing need for yield, certainly helps explain the current supplydemand dynamic,” says Gaul. Photograph kindly supplied by Standish, December 2012.

fathom this kind of outperformance, particularly when the year began.” Of course, strong balance sheets didn’t prevent 2011 from turning into a bear of a year, as global systemic factors completely overwhelmed the fundamentals. So what’s to stop that from happening again in 2013?

If there is a tangible risk exposure for high-grade corporations, it is the ongoing situation in Europe. “At this point there still hasn’t been nearly enough progress made in terms of solving the sovereign debt crisis,” concurs Gaul. “The fact of the matter is that a lot of the credit-spread pricing that has been factored into the market is based on a path to a eurozone solution that is very straight and has only marginal volatility. And perhaps that’s being a bit too optimistic at this point.” I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

THE BEAR VIEW

Will equities finally outperform in 2013 F COURSE, OVERALL, we are merely back (almost exactly) to the starting point of 2011 and have endured substantial pain in the meantime (may I remind you of August 2011 and May 2012).

We have also endured the relative underperformance of UK stocks versus those who we would consider our peers (Germany and the US) and this with a substantially weaker currency then was the case five years ago.

Strange then, when you consider that the component parts of the senior UK index are in reality massively weighted towards companies that actually have nothing to do with Great Britain at all. Moreover, their currency of business (mainly the US dollar) has moved in their favour, implying that their cost base (GBP) should have shrunk versus the revenue side (USD/EUR). It is hard not to draw the conclusion that the global corporate giants quoted on the UK stock exchanges have derived no benefit at all from the weak pound and that it has merely served to obscure poor overall performance.

Is this enough though to cause the malaise that seems to be affecting the City right now? Investment activity remains in free fall with traded equity volumes hitting fresh lows on an almost monthly basis. Meanwhile FX business flow is now back to a multiyear trough and M&A/IPO activity should best be described as virtually non-existent.

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As the central banks of the world continue to suck liquidity away in the bond markets returns on interest related assets have plummeted and new corporate and mortgage lending remains extremely weak as companies continue to hoard cash against a perceived problematic future.

Coupled with this is the continued attack on bank capital from both Basel and the UK regulators.

As is normal every time an EU/International regulation is agreed, the UK proceeds to gold plate the rules while the rest of the world looks for loopholes. Even now the French and Germans are looking for delays on the Basel III capital requirements (quite rightly in the current economic environment) as they are aware that implementation would seriously impact the potential for growth.

In the UK banker bashing is still a national sport and the political and regulatory establishment seems unable to break free from the threat of another economic downturn. This adds up to lower quality demand for lending and a squeeze on the ability of banks to lend anyway especially in the area of treasury functions.

What was not foreseen was how the removal of the liquidity provided by these market makers has impacted equity valuations (especially at the lower end of the value curve). Trading volumes in the AIM markets is now so low that most funds just will not invest in the sector for fear of being

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

THE OUTLOOK: SHORT TERM BAD, LONG TERM BETTER

The FTSE100 performance for 2012 looks pretty good, especially when you combine the near 400 point (9%) rally with the 4.3% average yield. At the start of the year most investors would have taken this, snuggled down on their sofas, and pondered about how good life was. So why is everyone so miserable? Simon Denham, managing director of capital spreads betting firm Capital Spreads gives the bearish view.

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

stuck with no exit and the AIM all share index is now over 25% down over the last two years having lost hundreds of companies that have either chosen to exit, gone bust or been acquired.

Very few have been floated as fund managers have increasingly focused on the plus ÂŁ250m valuation levels. For those who promote the trickle-down economic theory effect this is a classic example of its negative correlation.

Does this matter? The UK seems to be stuck somewhere between the US model, where the appetite for small company IPO risk continues to abound, and the European version where the equivalent of the German mittelstand company fills the roll. Over the decades the German and French banks have tended to support mid tier companies with favorable financing whereas in the UK it is almost always been the exact opposite. With IPOs largely closed, and banks staying on the sidelines, it is the small and mid range companies that are suffering.

Of course the FTSE350 constituents can, in the main, ignore all of these problems as they have either no problem over funding (issuing bonds is becoming popular again and banks will always beat a path to their door) or are sitting on a mountain of cash themselves. It would appear to this scribe that the senior UK equity indices are lagging the peers for no particularly good reason and that 2013 might well see an outperformance. I

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REGIONAL FACE TO FACE REVIEW

JONATHAN PLATT, HEAD OF FIXED INTEREST, RLAM

Royal London Asset Management (RLAM) has $45bn in assets under management, and serves a wide range of institutional and wholesale clients. RLAM’s head of fixed interest, Jonathan Platt, gives us his views on the year ahead.

Negative returns on government bonds in 2013 says RLAM TSE GLOBAL MARKETS: Shrinking spreads, increased regulatory scrutiny and dwindling margins pose considerable barriers to delivering the types of returns seen before 2008. Why should investors look at the fixed income segment in 2013? Where should they be putting their money and why?

JONATHAN PLATT: Let’s be clear here: going forward investors will not achieve the same levels of returns they have enjoyed from fixed interest investments over the last few years. Indeed, although we had a credit crisis in 20072009, and further credit market volatility in 2011-2012 in relation to eurozone problems, credit bonds have delivered healthy returns due to the fall in safe haven government bond yields, such as those of gilts. RLAM’s strategy is to favour higher yielding investment grade bonds, sub-investment grade debt and short duration strategies (including zero duration credit strategies) for a number of reasons. Government bond yields will rise in the medium term; in effect real yields are too low. Moreover, credit spreads are still too high in investment grade and sub-investment grade bonds.

Yes, spreads have narrowed a lot in 2012 but they still significantly over-compensate for default risk. Additionally, credit markets undervalue security; our focus is on achieving attractive yields from diversified portfolios and on achieving this through a greater emphasis on secured debt than our peer group.

Putting this all together we see negative returns from government bonds in 2013 and, at best, only small positive returns from investment grade debt.

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Jonathan Platt, RLAM’s head of fixed interest.

Photograph provided by the Berlinguer Photo Archive, December 2012.

High yield will be more volatile but offers the prospect of superior returns.

FTSE GLOBAL MARKETS: It is clear that growth will remain constrained in the developed markets over the near term (over a one to three year outlook). Can emerging high growth markets continue to offer investors returns over this period? Which markets should investors look at?

JONATHAN PLATT: This question has several components that I would like to take in turn: Will developed market growth be constrained in the near term? I would say yes because the austerity programmes already being implemented in Europe will soon be followed by a policy shift in the US. However, I would go further and argue that we are beginning to see a more structural shift in medium term growth expectations that will have implications for all financial and real assets. I believe that we will have to get used to slower growth on a global basis for two main reasons: a changing demographic profile in developed economies (but also China) and lower long term productivity growth

as the impact of technological progress becomes more muted.

So will emerging markets help out?

The answer is yes, but perhaps by not as much as is presently assumed (or discounted). In the long term I am optimistic that China will be a strong force for economic growth. This reflects one of China’s great advantages: a growing educated workforce. I think a similar point can be made for several emerging economies, including India. However, in the short term China faces several pressures: rising labour costs, overinvestment in unproductive assets and indeed, dealing with the issues raised by internal migration.

As for the best areas, I still think that high yield opportunities will give the best long term returns. Emerging market credit, as a sub-set of global high yield, offers better opportunities than emerging market government debt.

FTSE GLOBAL MARKETS: FX risk will likely impact on returns over the near term, with continued downward pressure on the US dollar and the euro. What will be the impact on the credit markets?

JONATHAN PLATT: Whereas the euro typically acts as the safety valve for pressure on the US dollar, to suggest downward pressure on both the US dollar and euro suggests upward pressure on EM currencies. This realignment of currencies is an essential part of the rebalancing need between surplus and deficit economies (emerging and developed). Should this happen, it would be a positive for credit markets, helping to underpin a more balanced and sustainable period of global growth. Unfortunately, the pace

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

at which currency realignment is taking place is still quite slow, owing to the fact that many of these currencies, and especially the Chinese yuan, are managed rather than free floating.

FTSE GLOBAL MARKETS: Is an end to the global gloop in sight? If not, how should investors’ best position themselves to take a low growth environment in their stride?

JONATHAN PLATT: I think we are in for a generation of low growth. Or more properly, I think the post WW2 period will be regarded as the aberration; we have basically borrowed growth from future years. In portfolio terms I think it means that we have to get used to lower real returns. To some extent investors have already made an adjustment by looking for a greater variety of investment themes.

However, like the Elizabethan alchemists, it will be eventually realised that you cannot conjure super returns from assets whose long term return potential has been exaggerated.

I would advocate a diversified portfolio strategy—looking for a wide range of assets where correlations are lower.

Unfortunately, from a bond manager’s perspective, the role I see for government bonds is one of portfolio insurance.

FTSE GLOBAL MARKETS: The US fiscal cliff is looming. Moreover, you have stated repeatedly in commentary that you believe that the US political economy going forward is a story of two halves.

What will be the impact should democrats and republicans achieve agreement on budgetary management through 2013?

JONATHAN PLATT: The fiscal cliff is a bit of a misleading title—it implies that unless an agreement is reached between Republicans and Democrats there will be catastrophe and, by implication, if there is an agreement everything will be OK. Unfortunately it is not that simple. If there is no deal by January 1st 2013 I think there will be a sell-off in all risk assets and there may be a temporary impact on Treasury yields. Under this scenario the loss of

confidence in financial markets may give rise to second round economic effects leading to a recession in the US. In terms of the impact of any outcome of the US situation on the rest of the world, notwithstanding a more significant positive contribution from emerging markets, and particularly China, weakness in the US will be felt globally.

If there is a Grand Bargain (GB) everything will be OK right? Yes, in the short term; however, what we must not forget is that any GB will involve higher taxes and spending restraint. While the short term tonic effect will help markets, the fiscal headwinds will be powerful. So it becomes a question of whether entrepreneurial spirits will trump fiscal arithmetic. I just don’t see the global picture being strong enough to support a sustainable positive impact on growth.

FTSE GLOBAL MARKETS: It is clear that the UK government has under-estimated the ability of the economy to handle a protracted business downturn. Government receipts are now falling. What does the UK chancellor need to do to help re-fire the UK economy?

JONATHAN PLATT: The Office of Budget Responsibility (OBR) helped the government out by ascribing the shortfall in growth in 2012 to the net trade position, that is, the European mess. Actually, this is pretty much the case. The historical precedent that is often cited for austerity is the 1981 Geoffrey Howe Budget when an austerity package was seen to lay the foundations of future growth. Unfortunately, the situation now is different. In 1981 the UK benefitted from a recovery in the global economy and I can see no such parallel now.

So does this make present policy wrong? In short, no. Sing a 1980s phrase: “There Is No Alternative” (TINA). Indeed, the policies proposed by the opposition parties are not significantly different. The key points are that we have spent too much in previous years and we need to constrain the rate

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

of growth of debt. Also, we live in a global economy—actions taken elsewhere will determine global growth and the UK is not big enough to impact this. The Chancellor must keep the confidence of financial markets and this is not the same as keeping an AAA rating.

This is not to say that there have been no policy mistakes. I think that there has been a contradictory attitude to banks—wanting them to increase lending and improve capital ratios (if equity holders won’t stump up the cash then leveraging will be the response).

In addition, the Chancellor cannot resist tinkering. What we need is clear policy within a framework of debt restraint. The autumn statement saw a new set of forecasts from the OBR which were endorsed by the Chancellor. I think they are still too optimistic.

FTSE GLOBAL MARKETS: The eurozone appears to have been given some breathing space by the markets; as the news of recent sovereign downgrades has not precipitated another panic. How long can this last?

JONATHAN PLATT: The economic outlook for Europe remains grim. Yes, Spanish and Italian bond yields have fallen sharply from the elevated levels of earlier in the year but problems remain. These are basically economic and political. The first point is that European growth is just not strong enough and this is unlikely to change in the medium term. Instead of the depreciation in the currency that weaker euro members have relied upon in the past, these economies have to implement internal devaluation through cuts in real wages. The political problems are twofold: the reluctance of the German government to realise the logic of the euro i.e. near perpetual subsidies for the southern economies nations and the question of whether the electorates in Spain, Greece, Italy and others will stomach the actual and implied austerity.

What this means is that we are in a phoney war stage and that I don’t think we are near a solution. I

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2013 OUTLOOK: THE SEARCH FOR GROWTH

Global markets continue to evolve at an accelerating rate. The annual 20-20 review has been expanded this year to include business trends as well as markets and market makers. We bring together varied strands in the market and project some of the implications of change through 2013. We reckon it is a richer cocktail of prediction and hope, interspersed with profiles of outperformance or new trend setters.

EGULATION WILL CONTINUE front and centre of any discussion of material transformation in the global markets over the coming years. In the weave of this annual preview we include trading, asset servicing, asset gatherers and today’s new business princes: those involved in collateral and risk management and risk optimisation; clearing and settlement; and corporate identifiers. Also interweaved are profiles of market professionals that have overcontributed to their specialist segment.

Market transparency (knowing your client/knowing your supplier/knowing your counterparty) looks to be the basic building block of business communication in the coming decade. That dynamic has been forced by regulators, which claim to want to have workable high level snapshots of where true market risk resides. An important question is therefore: what will they do with that knowledge, once they have it?

The BRICs seemed to take a back seat in 2012, in an investment world that crazed over chronic ructions in the US senate between republicans and democrats and (until the second coming of Mario Draghi as architect of the eurozone’s bond buying programme) the inability of European leaders to save the euro project in practice as well as principle.

Contagion was no longer just a B-movie. The fallout from the euro-crisis and political paralysis in the US spread as far as Beijing and Brasilia. Moreover, worries about dampening of foreign trade demand and growing foreign capital inflows led to some high growth markets introducing capital controls (either through taxes or firm quotas). It will be interesting to see whether those same countries will continue on the same path through 2013: the likelihood is yes, with countries such as Brazil keeping foreign investments on guard for the foreseeable future.

Will next year be completely different, and BRICs come to the fore as an immutable force once again? The signs are

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mixed. M&A and continuing market reform and restructuring will keep Russia at the forefront of change, with an attendant uptick in foreign investor interest. Turkey continues to excite interest, and China too, will resurge, based on an incoming administration keen to reap the benefits of growing wealth. Others might struggle to deliver high growth rates.

FX looks to continue its inexorable rise as world trade picks up steam once more and the BRICS currencies come increasingly into regional plays. Deutsche Bank sees the RMB appreciating some 2%-3% against the dollar, supported by an estimated 30% rise in RMB cross-border trade settlement.

Continuing market liberalisation will help the RMB solidify its standing within the global currency markets, suggests Linan Liu, Greater China rates strategist for the bank.

As our cover story suggests, the generally moderated response to impending elections in Italy shows that the markets are factoring in continued uncertainty in the eurozone. However, Spain, Portugal, Ireland and Greece still remain wildcards. While the ECB has taken much of the sting out of Europe’ spiny debt tail, if two or more countries struggle with repayments at the same time, the delicate pillars holding up the euro-project might be toppled.

Next year will be interesting in terms of asset allocations.

The UK press widely reported that for the first time in 50 years UK pension funds were holding more bonds than equities. Any numbers of broker/dealers has factored in the belief that this is a systemic rather than seasonal change and have designed their business plans accordingly.

Nonetheless, 2012 turned out not too bad for equities in performance terms. The FTSE100 is up only 3.9% on the year, but UK smaller companies funds have registered a heady 20.1% uptick and UK All Companies is up 14.2%. However, given that this remains a difficult climate for companies, it is moot whether these performances can be repeated in 2013. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

Photograph © Demango 23/Dreamstime.com, supplied December 2012.

20-20: INTRODUCTION

20-20: ELECTRONIC TRADING TRENDS

Regulatory compliance, enhancing client service, cost control and the demand for generating returns coupled to ongoing economic uncertainty will see a number of trends that have emerged in recent years continue to gain momentum over the next 12 months. With IT budgets facing immense constraints and firms under increasing pressure to identify new investment opportunities, the challenge is how to deliver these strategies in such a cost conscious environment. This is driving firms to examine technology to deliver a performance edge and looking for the most cost-effective approach to trade new asset types and within new markets. Rob Lane, European business manager—trading solutions, Interactive Data, sets the scene for this trading section and outlines what he thinks are the key macro-trends in electronic trading.

Rob Lane, European business manager —trading solutions, Interactive Data.

Photograph kindly supplied by Interactive Data, December 2012.

The fight to deliver performance edge RADERS IN THE US and European markets are dealing with significant challenges associated with a mature competitive landscape. Shrinking spreads, increased regulatory scrutiny and dwindling margins pose considerable barriers to delivering the types of returns seen before 2008. Firms have two growth options available; they can either diversify into other asset classes or look to new regions and markets.

The Asia-Pacific region is attractive because of its diversified range of markets combined with stable liquidity, tradingfriendly regulation and greenfield opportunities for generating returns. There has been a sustained period of investment.

Venues continue to launch new technology (including trading system upgrades to boost capacity and speed), and adopt standard technology offerings from NYSE Technologies and NASDAQ. Venues such as Singapore (SGX) and Australia (ASX) have also introduced direct market access (DMA) and modern co-location facilities. Meanwhile new venues, such as Chi-X Japan and SBI Japannext, have emerged to challenge the incumbent exchanges.

Regulatory evolution has also led more firms to look at multi-asset strategies in over the counter (OTC) instruments. The establishment of Swap Execution Facilities (SEFs) in the US and the proposed Organised Trading Facilities (OTFs) in Europe means OTC derivatives can be traded electronically and multilaterally. As a result, firms will be examining the prices and liquidity within each facility and looking to execute strategies across one or more of them.

However they must consider how to balance venue-driven trading via these SEFs/OTFs with the evident shift to off exchange dark pools for some types OTC instruments.

Accessing multiple markets to diversify a trading strategy can offer a means to generate returns, however it has the potential to also create a large operational overhead, both in terms of the internal resources required and the entry costs to these markets.

This is driving demand for outsourced managed solutions that can provide a combination of DMA, co-location and proximity to multiple markets alongside traditional consolidated data feeds offering access to normalised global content.

Firms now access specific markets in the most cost-effective

T

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

way to execute their trading strategies. With new routes scheduled to open and continuing technological advances, firms that choose to outsource don’t have to worry about investing in the fastest lines between markets, or ensuring they have the latest switching and routing hardware. All these elements can be managed on their behalf at a lower total cost, leaving them to concentrate on strategy and client service.

Firms also spend millions on data feeds to power their various applications and are looking at those providers which offer the most complete service for their needs.

Latency and data quality are key considerations as they gauge providers, so are the number of sources available as they look to access new venues and trade different asset classes. As regulation continues to fragment liquidity, firms need to understand precisely what value their market data feed can offer and whether their provider is able to meet the asset coverage they require.

To remain competitive, firms can either diversify as above or they can try to get to market faster, or both. Executing an order in the fastest possible manner is driving some interesting market-changing technology developments. Perhaps the most interesting infrastructure development is the use of microwave transmission. Initially used in the US to deliver data between Chicago and New York, it shaves critical milliseconds off roundtrip times and is now developing in Europe, across London and the critical path between London and Frankfurt. With the technology improving, the cost of using microwave is steadily falling.

However some concerns remain about the quality of the path and error rates as well as the barriers to new entrants offering microwave-based services. When transmitting across large distances a longer wavelength is needed which results in a lower bandwidth and consequently less data can be carried. Current leased links between Chicago and New York are in slices of 150MB, which is too small to send large volumes of data. While the current quantity of data being transmitted by microwave is a tiny proportion of the daily market data volume, the market’s interest suggests that this will be a major technology development that shapes low latency trading over the next 12 months. I

29

20-20: TRADE MESSAGING

Since its inception in 1992 as a bilateral communications framework for equity trading between Fidelity Investments and Salomon Brothers, FIX has become the messaging standard for pre-trade and trade communication globally within the equity markets, and is now experiencing rapid expansion into the post-trade space. The protocol continues to gather momentum as it now expands across the foreign exchange, fixed income and derivative markets. FTSE Global Markets spoke with Stuart Adams, EMEA regional director, FIX Protocol about the latest trends.

DEFINING MARKET STANDARDS TSE GM: A new reality has been mandated by the G-20, and is being enshrined in various pieces of legislation on OTC derivatives, central counterparties and trade repositories. How is FIX Protocol helping its clients prepare for change and what messaging processes are in place to facilitate change?

STUART ADAMS: The OTC derivatives space is currently undergoing significant change, many of these developments are impacting FPL’s member firms, a significant number of which currently trade OTC derivatives using FIX and are keen to leverage their investment and use FIX for reporting purposes as well FPL is currently working with the membership to ensure that the protocol is able to meet new and emerging requirements as effectively as possible.

FIX supports OTC derivatives trading through to allocations and clearing, however we are currently in the process of including additional functionality to support recent regulatory developments. Examples of this include enhancements we are now adding to enable firms to meet the CFTC’s swaps data repository reporting, end of day positions and margining regulatory reporting requirements. These are in addition to functionality added last year to support the CFTC’s commodities large trader reporting legislation. These are just some of the many enhancements currently underway. We are keen to ensure the protocol meets industry needs in this evolving space and as the environment changes we are continuously working to update the protocol to ensure it supports global trading practices.

FTSE GM: What are the implications of the LEI initiative in terms of transaction messaging, reporting and ultimately back office clearing and settlement?

STUART ADAMS: LEI is positioned to become a global regulatory requirement, impacting the business processes of many of the 260+ firms, from across the industry, that make up the FPL membership. FPL is committed to supporting its members in addressing the business challenges impacting the trading community, and the LEI is a primary example of how the use of standards, and standardised business processes could aid easier implementations. Not only is this technically efficient, it is financially efficient too as it enables firms to leverage their existing FIX investment to support this development.

FIX has been enhanced to support LEI requirements, as well as the counterparty relationships and hierarchies information which will accompany it. One of the key concerns, we are hearing, is the speed at which the LEI is moving.

F

30

However, now the regulators have said it is going to happen, firms are able to allocate resource to ensure it can be delivered and although the time-frame is quite tight, the availability of well-adopted, non-proprietary, free and open standards makes the deadline more achievable.

FTSE GM: What is the status of MiFID II? STUART ADAMS: MiFID II has identified a plethora of different trading situations where the increased use of standards would prove highly beneficial and there is still much work to do. There are a number of regulatory technical standards that need to be defined to address different regulatory requirements and business changes, and as an industry we have a choice—either we get together and drive their development, and demonstrate to the regulators and investors that we are engaged and taking things seriously or we let the regulators develop standards for the industry.

As an organisation we see driving the development of these standards and playing a key role in shaping the future trading environment as highly advantageous. FPL is keen to bring the trading community together to help develop these standards, enabling the industry to play a fundamental role in ensuring that the new standards implemented can be imbedded into our industry’s infrastructure in a cost-efficient and effective manner. In the end, it is the end-investor, you and I in our pensions and savings plans who will also benefit from these efficiencies.

FTSE GM: Once it comes into force, will MiFID II be a force for good?

STUART ADAMS: As an independent and neutral industry organisation, FPL is less concerned about whether a particular regulation is seen as good or bad, and is more focused on ensuring that the business issues raised by the emerging regulation can be effectively addressed by the trading community. There are many industry associations that perform an advocacy role for their member’s interests related to specific trading trends or developments, and a number of those are also associate members of FPL, however FPL is more focused on ensuring that it can support market participants as they seek to implement regulatory requirements and do so in a timely fashion to minimize impact.

FTSE GM: FPL has just published recommended standards for the consolidation of trade reports and market data. What are the main considerations around the publications of the recommended standards? When do you hope to see a standard in place.

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

the central tenets of transparency and conSTUART ADAMS: The MiFID review idensistency of information. tified the need for market participants to FTSE GM: Going forward what do you gain a complete view of European equity hope for the FPL organisation? What market activity, through the consolidation of more can you provide to the industry? post-trade data feeds, however the lack of common standards and guidelines was STUART ADAMS: Two of FPL’s greatest limiting progress. In response to requests strengths are its independence and received from different industry sectors of neutrality; factors that have proven pivotal the FPL membership to address this to the organisation’s continued success. challenge, FPL formed a group to explore These values ensure that when FPL looks at how standards could be applied to meet the a specific business challenge, the market can be certain that the solution developed challenges facing post-trade equity and has been achieved clear of commercial equity-like data. conflict, enabling the industry to profit In developing the recommended Stuart Adams, EMEA regional from a wealth of benefits including standards, the group built on CESR’s earlier director, FIX Protocol. FIX supports work to define trade reporting and market OTC Derivatives trading through to increased transparency, reduced costs, data publication standards, and they also allocations and clearing, however we enhanced efficiencies and an environment within which innovation can flourish. I considered the MiFID review’s new require- are currently in the process of ments and recent changes to European including additional functionality to often joke that it is about checking your commercial interests and ego at the door market structure—our recent announce- support recent regulatory when you come to an FPL meeting and ments on this have been well received developments, says Adams. that has in many ways resulted in us being across the industry. FPL does not have any Photograph kindly supplied by FIX able to address some challenges which commercial interest in this regard; it is all Protocol, December 2012. otherwise would have got caught up in about the standards and governance of self-interest—we are quite unique in that. standards for the benefit of the industry as a whole.

FPL is shaping the future of the trading environment, the Standards only become standards once they are well adopted. What FPL aims to achieve is to continue to bring organisation has proven fundamental in facilitating many of together market participants to develop standards that the electronic trading trends that have emerged over the past address business challenges and recommend best practices decade and is well positioned to continue to do so as new for their implementation to ease adoption. Much of the opportunities and challenges emerge. I would like to future work of this group will focus on promoting awareness encourage even greater engagement from firms across the of the new standards and providing educational opportuni- trading community, as it is through the strength of its ties to communicate their associated benefits and how they membership and the breadth of different perspectives shared, that FPL can continue to build on the great work can be implemented.

FTSE GM: The plethora of regulatory requirements achieved to date. continues to impact the trading community, what do FTSE GM: High frequency trading has been under the you think are the main requirements for the European cosh this year: both in terms of regulation; but also the trading segment to help it grow and deepen in 2013; will business model looks to be somewhat frayed. What do you think are the main challenges facing this segment of regulation smooth or dog this path?

STUART ADAMS: To enable trading in Europe to grow we the market going forward? need to continue to evolve market structure in-line with STUART ADAMS: High frequency trading, what it means industry needs, with further focus on achieving increased for the industry and its impact on market participants transparency and consistency of information. These factors, continues to be an ongoing debate. The FPL membership I believe will prove fundamental to longer-term success. includes buy and sell-side firms, trading venues, regulators, Regulation is a key driver in achieving these goals, as once vendors and other associations. Each of these industry something becomes a regulatory requirement, budgets are sectors has a differing HFT experience and this factor, along released and firms are able to allocate the necessary with the organisation’s independence and neutrality, resources. The real question is whether without the use of means that it does not sit on a particular side of the ‘is standards, it is realistic that change can be delivered in HFT good of bad?’ fence. However, what is clear is the desire the time-frames required? Our industry is great at innova- for a deeper understanding of the sector, its impact across tion and what we are seeing is the need to find some the board and the role technology could play in enabling common ground which represents the desires of greater transparency.

G20/ FSB/IOSCO and the regulatory community, as well as Technology will always be a differentiator in this space and not losing sight of what it means for the end investor— what is important, is that we achieve increased transparency research has shown that standards enable innovation to through the use of greater standardisation and explore how happen and I am sure that as the economic climate technology can be best applied by market participants to improves, we will see much more innovation, that embraces take advantage of investment opportunities. I

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

31

20-20: ELECTRONIC TRADING

It is clear that the equity trading markets find themselves at a pivotal time as regulation and buy side requirements increasingly demand appropriate and nuanced business and trading solutions from the sell side. Ruth Hughes Liley reports.

Electronic trading now at the crossroads linked up to users of trading P TO 70% OF and analytics platform trading in the US provider Fidessa’s order and around 30% of management system. trading in Europe is From the end of Q1 2013 conducted electronically, when Squawker goes live, although there are signs that users of the Fidessa this has levelled off during European Trading Platform 2012. Elsewhere, computerwill be able to route orders, driven trading accounts for indications of interest (IOIs) just under half of all trading and advertised trades autoin Singapore, Hong Kong, matically to Squawker direct Japan, Australia and India, through FIX connectivity up from an average of 11% the instant they receive a in 2008, and is expected to block order on to their hit 58% next year, according OMS blotter. to Celent. A survey Squawker is currently by computing software in discussions with the sell developer MathWorks Photograph © Rolffimages/Dreamstime.com, supplied December 2012. side from investment banks conducted during the summer found that although 67% of sell side respondents and market makers to agency brokers, proprietary and were looking to increase levels of automated trading, only principal trading firms.

Electronic trading is also expanding to include fixed 46% of buy side respondents were planning to do so.

Moreover, one third of buy side firms were looking to move income. Banks and others predict an increase in electronic towards alternative trading models, believing that automated fixed-income trading next year as investors look beyond traditional phone-based trading with dealers, according to trading models have ‘had their day’.

Change is clearly afoot in electronic trading and the tug new research by TABB Group. TABB spoke to 24 US dealer and push of change highlights a number of cross trends. The banks and brokers who said they expected a minimum 10% adoption of electronic trading has rested on considerations uptick in 2013 in the value of fixed income trades and up to of speed and efficiency. Moreover, it is relatively cheap. High 4% in deal volume. MarketAxess which operates the largest levels of technology spend have also fed the trend; with electronic network for corporate bond trading by institutions national exchanges complicit in the run towards electrifica- in the United States says it is preparing the launch of a new tion of trading through co-location initiatives and working trading platform for corporate bonds, though was vague as with banks to allow clients to trade baskets of stocks across to any launch date.

As electronic trading adoption continues its global march, multiple exchanges. The trend for high frequency trading (HFT) firms to co-locate near exchanges shows no sign of local regulators are also keen to minimize ensuing risks. In abating. Sungard for example has 3,000 businesses which September last year, Germany advanced legislation that use some of its five million square feet of data centre and would, among other things, force high-speed trading firms operations space. However, with volatility down and to register with the government and limit their ability to volumes low, it has been difficult for arbitrage models to rapidly place and cancel orders, one of the central strategies used by the firms to take advantage of small changes in the make a profit.

Perhaps as a consequence, electronic trading is moving price of stocks. Almost immediately, a European Union into areas where it has not traditionally been. Squawker, a committee agreed on similar but broader rules, though these new negotiation venue for sell-side block trading, is now require broad adoption by EU members.

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32

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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20-20: ELECTRONIC TRADING

Brian Schwieger, head of EMEA Execution Services Sales at Bank of America Merrill Lynch (BAML) believes algorithms will continue to become more intelligent: “Intelligence is to algo traders as speed is to high frequency traders. Algorithm development is in adaptive algorithms where you can have the same algo which uses different tactics in different market circumstances.” Photograph kindly supplied by BAML, December 2012.

In Australia, as well, the top securities regulator recently stated its intention of bringing computer-driven trading firms under stricter supervision and forcing them to conduct stress testing, to protect the country’s markets “against the type of disruption we have seen recently in other markets.”

The broadest and fastest reforms however have come out of Canada, where in early 2012 regulators began increasing fees charged to firms that flood the market with orders. Most recently in early December 2012, the Investment Industry Regulatory Organisation of Canada (IIROC), the national self regulatory organisation which oversees all investment dealers and trading operations, announced that it had adopted rule amendments, approved by the Canadian Securities Administrators (CSA), designed to ensure the effective management of risks associated with electronic trading. The changes establish another tier in a comprehensive system of controls which include single-stock and market-wide circuit breakers. The rules come into force on March 1st 2013, though because of the technology enhancements required by the ruling, broker dealers have until the beginning of May to fully test and implement the controls.

IIROC’s latest amendments expand on existing obligations under the Universal Market Integrity Rules (UMIR) by assigning regulated dealers clear supervisory and gatekeeper responsibilities to protect against errors related to electronic

34

trading. The changes will ensure that market participants have appropriate automated filters, testing of algorithms, and other risk management tools in place for handling orders before those orders enter the marketplace.“The revised rules will help to bolster market integrity by ensuring that electronic trading risks are mitigated through appropriate controls for all trading activity, regardless of source,” says Susan Wolburgh Jenah, IIROC’s president and chief executive officer.

However, so far, the United States remains cautious about clipping the wings of the electronic trading segment even though US markets have witnessed the most high profile market disruptions (remember the Flash Crash in May 2010 and Knight Capital’s $440m runaway trade?). The US Securities and Exchange Commission (SEC) began real time surveillance of market transaction through its Midas program. Midas built on the regulator’s decision in July 2011 to introduce a large trader rule, requiring firms that have high volume traffic (including HFT firms) to offer more information about their trades. Even so, Midas is limited: it does not have information on trades executed in dark pools, for instance.

Something that might tip the scales towards more aggressive regulation appeared in early December. Commodity Futures Trading Commission (CFTC) economist Andrei Kirilenko, concluded in a new study that high-speed trading firms are taking significant profits from traditional investors.

Kirilenko, the chief economist at the CFTC reported that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts.

The study focused contracts settled based on the future value of the S&P500. Using previously private data, Kirilenko found that between August 2010 to August 2012, more aggressive HFT firms accounted for the largest share of trading volume and made the biggest profits. The most aggressive scored an average profit of $1.92 for every futures contract they traded with big institutional investors, and made an average $3.49 with a smaller, retail investor. Passive traders, on the other hand, saw a small loss on each contract traded with institutional investors, but they made a bigger profit against retail investors, of $5.05 a contract.

The study came as the Financial Stability Oversight Council (FSOC), an organisation of the nation’s top financial regulators, is showing increasing concern that the accelerating automation and speed of the financial markets may represent a threat to the stability of the financial system.

However, at the time we went to press the CFTC still had not commented on Kirilenko’s findings.

Regulation continues to bear down on the electronic trading market even as exchanges and traders continue to feel the obvious financial pinch resulting from the fall off in trading volumes since 2007. In that light, an obvious question is whether continued investment in technology for electronic trading can keep pace as inevitably sell side desks shrink and those traders that remain are required to do more. A new study by technology firm IPC suggests that it

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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20-20: ELECTRONIC TRADING

36

Tim Wildenberg, head of electronic execution, EMEA, Citi. “We are planning to build with the same intensity in 2013 in a market where most people are spending less or postponing plans for improvement.

There are some asset managers who are significant investors in trading technology and they have significant budgets, but theirs is a simpler task. The sell side task is more difficult. We have a global business and are trying to service clients all over the world trading in markets all over the world. It is the broker’s role to match the client interface— that’s every client that comes up with their own solution.” Photograph kindly supplied by Citi, December 2012.

Mark Goodman, head of European electronic trading, Société Générale, admits it is challenging. “Some investment is regulatory driven and is non-discretionary. So you either spend money or get out of the business.

Having said that, it is not as expensive as when equities technology was first going electronic. By integrating multiple products you do not have to maintain separate systems for different asset classes. The technology for equities can be used for other asset classes and the cost of doing that is lower than ever.” Photograph kindly supplied by Société Générale, December 2012.

will. IPC’s study suggests that technology spend is driven as much by the need to cut costs as it is to help firms comply with new regulations. Three quarters of respondents to the study said their firms would increase spending in 2013.

However, while half said their investment would support electronic trading, only 12% said it was their top priority, on a par with high frequency trading (12%) and algorithmic trading (11%).

Mark Goodman, head of European electronic trading, Société Générale, admits it is challenging. “Some investment is regulatory driven and is non-discretionary. So you either spend money or get out of the business. Having said that, it is not as expensive as when equities technology was first going electronic. By integrating multiple products you do not have to maintain separate systems for different asset classes. The technology for equities can be used for other asset classes and the cost of doing that is lower than ever.”

“Investment remains as significant as it always was,”says Tim Wildenberg, head of electronic execution, EMEA, Citi.

“We are planning to build with the same intensity in 2013 in a market where most people are spending less or postponing plans for improvement. There are some asset managers

who are significant investors in trading technology and they have significant budgets, but theirs is a simpler task. The sell side task is more difficult. We have a global business and are trying to service clients all over the world trading in markets all over the world. It is the broker’s role to match the client interface—that’s every client that comes up with their own solution.”

As Wildenberg suggests, the move to electronic is immutable. Andrew Crane, head of European equity flow trading at HSBC carries the theme. “Those institutions which have embraced algorithms in a big way are moving back from using them as much, because when they look at the impact on executing business, they are finding it hard to find liquidity. When they go to the sales trader they are getting better execution because they can find the buyer or seller on the other side. I think in the short term we will see a move towards more high touch execution by some institutions. However in the long term, the trend is towards more automation.”

Wildenberg takes up the theme and talks of ‘channel merge’. He says clients now want their high touch sales trader to be able to view the order flow they are self-trading down electronic pipes.“Channel merge should not be driven

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

by profitability concerns of the broker but offered as a way of improving the execution service for the client, where the client wants it. We are driven by our clients. Some clients fear letting the high touch sales trader see the order out of concern about lack of anonymity. Whereas others see it as completely logical that their high touch sales trader can see what they are doing electronically. But even down the low touch route clients are always looking for guidance on how they can improve their execution performance. It is advice on how to use the tools and algorithms rather than ringing clients up offering them blocks of stock.”

These developments, Wildenberg holds, are a strong indication that the buy side has become much more comfortable with electronic trading. “Clients have become increasingly confident about self-trading and how they use the machines, many of them have some very specific expectations about how an algorithm should behave,” he says.

With 88% of the buy side now using broker-developed algorithms, according to a December report from CA Cheuvreux, it is perhaps surprising that they report only 47% using customised algorithms. Wildenberg is not surprised: “There’s a mix of clients. Some want to lift the bonnet and tune and tweak algorithms themselves, some want changes made every week, some every six months and some clients take it straight out of the box. As time passes, a standard algorithmic platform improves in quality.

What was developed with one client in mind can be used to solve a similar problem for another client.”

Creativity in implementing a client’s objectives then looks to be become much more important, especially in trading across multiple asset classes, according to Goodman at Société Générale.“Clients’ objectives don’t change, so the list of algorithms doesn’t need to change; but how you get creative is to access a wider range of assets with the same algorithm. I don’t see us building ten new algorithms in

2013, but I do see it as an opportunity to use our algorithms more creatively. We already trade equities versus futures and we want to be able to trade equities versus bonds. With the way we built our platform, it’s easier and cheaper for us to customise.”

From an electronic trading point of view, as people start trading more assets, the links between assets increase.

Goodman gives the example of a company’s listed stock and the same company’s bond.“If they are both being traded on an electronic exchange you start to see more short-term correlation between the asset classes. We are looking at these cross-asset signals more and more.”

Wildenberg sees synergies between equities and equity related futures and how technology can be shared and reused in other asset classes where appropriate, but he says: “Many clients might touch multiple assets but they don’t always trade these across the same desk. There is always a need for a specialist.”

Brian Schwieger, head of EMEA Execution Services Sales at Bank of America Merrill Lynch (BAML) believes algorithms will continue to become more intelligent:“Intelligence is to algo traders as speed is to high frequency traders.

Algorithm development is in adaptive algorithms where you can have the same algo which uses different tactics in different market circumstances.”

His bank’s most popular algorithm is their adaptive algorithm, Instinct, which Schwieger says was developed to trade like a human. The bank’s speed algorithm is Ambush, which is more aggressive and liquidity seeking.“Ambush is more reactive to what is on the order book here and now,” he says. Nonetheless Schwieger acknowledges that “Speed is still critical in certain models—short duration statistical arbitrage trades, for example—but for longer-term strategies, speed is important, but not critical, particularly if you are supplying liquidity and you have time to wait. ” I

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37

20-20: PROFILE: BATS CHI-X

BATS Chi-X Europe has become one of the largest pan-European equities market operators, taking on traditional national exchanges at every turn and often winning. If there is a cloud on the operator’s horizon, it is that equities remain out of season for today’s multi-asset focused investors; though more optimistic market watchers predict something of a comeback in 2013. It’s a moot point though (to stretch Shakespeare) it is a consummation devoutly to be wished. Mark Hemsley, chief executive officer of BATS Chi-X Europe, thinks that one potential spur will be an improvement in Europe’s economic outlook next year.

SERVICE UPGRADES BANK ON GROWING MARKET SHARE M ARK HEMSLEY, CHIEF executive of BATS Chi-X Europe, is nothing if not upbeat. Undeterred by the sloth that has stalked Europe’s equity markets since November 2007, Hemsley’s development team continues to push through service improvements. A new price structure kicks off from January 1st that intends to coalesce liquidity differently between its four order books.

The firm also wants to build market share in European retail flow; and is exploring ways to trade new asset classes. In December the firm also launched a suite of free pre-trade risk protection tools to all its clients as a supplement to their internal risk controls, including a ‘kill switch’ which customers can use to cancel open orders and block new ones, by directly controlling their exchange interface.

Previously these tools were only available for participants that provided sponsored access to their clients.

Users can set critical parameters for orders to prevent unwanted executions without incurring additional latency on inbound orders to the BXE and CXE order books. “The ability to manage risk effectively at multiple layers of the trading cycle has become increasingly essential, with pretrade risk checks at the exchange level as well as the participant level. Our risk management tools provide our trading participants with an additional layer of risk controls in relation to their obligations under the ESMA guidelines on systems and controls in an automated environment,” explains Hemsley.

“Risk management tools will continue to be far more in focus,” he continues. “We always thought they were important, but it is how the industry implements them which is key. When you look at the US Flash Crash in May 2011, it was a failure of the electronic market structure.

In Europe, every market centre does their own thing— markets have their own individual circuit breakers and there is no one Europe-wide solution. A consolidated tape is [vital] to providing control to pan-European market flow: a consistent reference point from which to co-ordinate price volatility market halts.”

Recent modifications and service upticks come on top of other changes in 2012, including the launch of interoperability and the introduction of market data charges at a level that Hemsley believes is a “commercially reasonable price to

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encourage the overall reduction of the cost of data in Europe.”

Market transparency is a big theme for Hemsley, who also favours the introduction of a European consolidated tape of pre- and post-trade price information as proposed under MiFID II. “While it’s good for investors and transparency, it is also a valuable tool that enables us to monitor trading patterns on a pan-European level and spot Mark Hemsley, chief executive irregular behaviour. If we can officer of BATS Chi-X Europe. monitor cross-market, then reg- Photograph kindly supplied by ulators can do it. You can make a BATS Chi-X Europe, considerable leap forward in December 2012. market surveillance if there is a consolidated tape.”

BATS famously entered the European markets in 2008 with an aggressive loss-making pricing policy. In October 2012, it began charging for European market data. Hemsley believes that forcing down the prices incumbent exchanges charge will only come about by regulation in pricing given the lack of voluntary industry progress towards a consolidated tape: “Exchanges still produce the data that trading and investment companies realistically have to purchase as part of their business function and thus the incumbent exchanges make tens of millions of euros out of market data. You have to take on the difficult problem that market data is priced based upon an established legacy monopolistic environment.”

Index calculations, such as that for the FTSE100 or FTSE250 are currently done by taking data from the primary exchange.

With BATS now topping 25% market share in Europe and with a fifth consecutive month above 12% market share in the US, Hemsley asks: “Whose data is being taken to create that calculation? Without BATS data, European intra-day indices are missing 25%-30% of the volume.”

BATS Chi-X Europe has created its own suite of indices in partnership with Russell, the CHERI series, launched in October 2011 partly with an eye on moving into derivatives.

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

20-20: INSTINET: ADAM TOMS

Hemsley is in further discussions with Russell to develop use of the CHERI index in Europe during 2013.“It’s a more efficient delivery of the Eurostoxx index. We are continually looking at other asset classes,” he states.

Indeed, BATS is exploring moves into the Brazilian and Canadian equities markets and into foreign exchange, but retail flow is also high on its priority list. It has applied for recognised investment exchange (RIE) status which would put it head to head with the London Stock Exchange and other European exchanges. Hemsley says:“The key reason we are looking at this is to attract retail brokers, many of whom do not yet trade on MTFs and are obliged to trade on an RIE. In any market, attracting as diverse a range of flow as possible is important because it enhances liquidity and creates a healthy ecosystem essential to running a balanced market. Our current customer base represents a wide range of investment firms, with retail largely underrepresented. Furthermore, retail investors haven’t yet seen the benefits of competition brought about by MiFID and we aim to change that.”

In preparation, BATS has adjusted its pricing on its four order books: two lit and two dark, and introduced sweeping order types across all four books, which Hemsley believes are interesting to retail brokers. In 2013 new order types will allow more flexible trading. “Sweeping order types are a very effective way for a smaller broker to get a low-cost fill.

It provides simple access to additional levels of order sophistication for smaller clients.”

At the other end of the scale, Hemsley has seen the proportion of HFT flow drop off during the year: “Market makers typically provide around 30 to 35% of trading and they have always provided liquidity. However, as more customers come on board across Europe, so the proportion of HFT flow on BATS Chi-X Europe is down. You have to have a certain level of speed to be in the game and exchange competition in that has definitely levelled off.

Brokers have got better at using algorithms that take into account how market makers work—phased execution across different venues, for example. Speed as a competitive advantage has been eaten away, so business models have changed. It is not ‘game over’ but it reflects the development in the market.”

As the main pan-European MTF, onlookers could be forgiven for assuming BATS Chi-X Europe would continue to take market share from other exchanges.

However in the 12 months to November 2012, market share fell in several European countries as it rose in some regional markets such as the Nordics. Overall it was down from 25.7% to 25.3%.

Hemsley admits:“We and our customers were focused on a number of significant initiatives and while market share is always an important consideration, we are very pleased to have accomplished so much this year without experiencing significant market share attrition. We are still a relative newcomer and there is still a lot of work to do to build up the number of customers across Europe and within equities. Equities is still a really good business.” I

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

Nomura transferred all its equity execution functions outside of Japan, including cash equities, electronic and program trading, into its Instinet agency brokerage subsidiary in September. The Japanese investment bank, which embarked on the strategy as part of a larger $1bn cost-saving initiative, believes that a modified agency broking model will set the gold standard in a tight but still dynamic equity trading segment.

Can Instinet beat the current trading lull, increase profitability and successfully evolve its global agency broking franchise?

Francesca Carnevale spoke to Adam Toms, chief executive officer at Instinet Europe, about the evolution of the firm’s brand, its ambitions and the market influences that will shape its future.

AN AGENCY BROKER FOR ALL SEASONS E

QUITY MARKETS ARE being dramatically reshaped as a result of the current environment and in that light, the accompanying demand is for transparent, agency-driven execution. As such, Nomura Management announced that the bank would transfer its non-Japanese equity operations lock, stock and smoking barrel into its agency broking business Instinet. The mid-September 2012 announcement noted that Nomura Holdings was reorganising its global equities franchises along three primary business lines—research, corporate and investor solutions and Instinet—with “the best of our superior technology platforms being consolidated under Instinet to provide our clients with a truly independent, agency-only execution offering.”

The announcement also ended questions around Instinet’s future, as many in the market had speculated that it would be folded into Nomura’s brokerage operations. Close observers would have gotten a clue of what was to come in June, however, when the bank moved Adam Toms from its electronic business into the chief executive role at Instinet Europe.

Nomura had bought the agency broker from Silver Lake, the private equity firm, in 2007 for some $1.2bn to increase its trading presence outside Japan. It wasn’t

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until 2008 that Nomura’s takeover of the European and Asia-Pacific businesses of Lehman Brothers transformed it into a full-fledged equities player globally. However, its ambitions left it operating two separate and often competitive businesses.

Given Toms’s pragmatic nature and entrepreneurial eye, he would never have transferred into the agency business without some major moves by the bank to underpin the Instinet brand. Equally, since his arrival, Instinet has continued to bolster its product set, particularly its EMS and commission management platforms.

The new agency model that combines the best of Nomura’s ex-inhouse team and that of Instinet speaks to the zeitgeist, says Toms. He acknowledges there’s a host of investor trends, regulations, sell side developments and technology elements which continue to coalesce in the equity trading segment as a whole, which Instinet’s agency model will be best able to leverage.

Take just one. Trading volume is still off considerably from its 2008 peak, with 2012 having been another down year. “Clearly, this picture is challenged. We have come to realise that it is a secular, rather than cyclical development.

In that changing arc it is imperative that we define a new and effective business model,”explains Toms. It’s not an easy ask. Instinet Europe Ltd., the European arm of the global Instinet Incorporated, reported a pre-tax, break-even position for the 15 months ended March 31st, 2012.

Overall, Instinet Europe reported revenues of £69.1min the period, 74% of which were generated in Europe and 25% in North America. The figure was 16% higher than 2010 because of its longer accounting period (the company’s financial year-end was changed from December to March to bring the company in line with Nomura reporting cycles).

On a year on year basis, however, business was down 7% on 2011. While disappointing, the firm at least held its own, particularly compared to other agency brokers, even as trading conditions remain tough across the board. Looking ahead, Toms does not decry the challenge.“The market was challenging in 2012 and is expected to be challenging in 2013, but we are positioned to withstand the current market uncertainties and will continue to seek to expand operations where it makes sense.”

In many respects, Instinet puts Nomura in a stronger position than the other bulge brackets trying to work out how they can shrink their unprofitable equities execution franchises and still operate a credible equity capital markets business. The merger of two trading operations, though challenging, offers the opportunity to effectively create a highly cost effective and efficient operation through economies of scale. It also offers the chance to revitalise the agency broking model at a time when the market is increasingly demanding transparency and unconflicted trading models.

Toms he believes he offers a strong hand: “With no risk capital, our offering must stand on its own merit, and that’s the way it should be. It is also a technology-leveraged, agency-only model that is compelling and fitting given

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Adam Toms, chief executive officer at Instinet. Photograph kindly supplied by Instinet, December 2012.

recent market trends. It is not a gamble, thinks Toms. He is banking that the outrageous fortune that Instinet seeks can be found in a host of unique selling points (USPs) it can lay before its customers.

The first element is advanced technology. Following its acquisition of Lehman Brothers’ European and Asian assets, Nomura spent heavily on technology and personnel to expand its electronic equities capabilities globally.

Instinet, which brings its own robust platform (the Chi-X businesses Instinet launched ran on it, after all) that will serve as the foundation for the combined offering, can reassess the services it offers to clients and keep only the best of breed components.“We are looking at all the technology across both entities,” says Toms. “It gives us a chance to revisit our execution services products and think strategically about what clients need for tomorrow’s markets and beyond.”

Instinet management has a substantial technology suite to pick and mix from. As part of the Lehman Brothers’ acquisition, Nomura inherited the former US bank’s lowlatency execution infrastructure as well as well as a sophisticated analytics suite, TradeSpex, developed by Nomura. Instinet, meanwhile, offers the Execution Experts algorithmic suite, award-winning Newport execution management system, a commission management platform known as Plazma and a number of execution venues, including the BlockMatch dark multilateral trading facility in Europe and the CBX, BLX and VWAP Cross dark pools globally).

The second differentiating factor is the access it offers to quality content, which remains critical to any serious provider of equities execution. Fundamental research will remain with Nomura and have an east-to-west flavour,

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

20-20: IPO

with Instinet becoming the preferred payment channel for the research. In addition, Instinet will offer a mix of value-added content focused on quantitative strategy, global index strategy and a variety of sectors. It will also continue with its CSA platform that pays over 900 research service providers globally on behalf of its clients.

Through this new model, Instinet’s gains access to a larger chunk of the fee pool, which historically has been the biggest challenge faced by agency-only firms, particularly in low-volume markets. Instinet in turn ensures buy-side clients have full visibility on the specific services they pay for, allaying fears over potential conflicts of interest.“The preferred mechanism is for clients to pay for Nomura research and other services via Instinet are on an unbundled basis,” explains Toms.

Additionally, Toms is committed to continual enhancement of the overall business service set. Most recently, Instinet has added multi-strategy functionality to its commission management platform, which enables users to view budgets and balances on a sub-account level and is particularly useful for buy-side firms that allocate vendor charges across multiple funds or make CSA payments on a fund-level basis. Sub-account information can also accessed with designations that are customisable and may be set by fund name, portfolio manager, analyst, account, sector, as an example. As Toms’ US counterpart, Jonathan Kellner, notes,“The challenges associated with compressed commission pools continue to add pressure to the soft dollar budgeting and administration process.

Since Plazma is at its core a broker-neutral workflow management solution, we worked with our clients to improve efficiency by adding the ability to track and manage payments on a sub-account level.”

The firm is also using classical add-on value tactics to create customer stickiness. In November, for instance, the firm announced it would be distributing a market research facility, Truth On Call, and provide access to the NPD DisplaySearch syndicated research portfolio and global analyst team via the Instinet Access platform in the US, which its clients use for marketing support, account coverage, and payments.

Because Instinet is an agency broker, products that require capital commitment (including flow and structured derivatives for instance) and syndication continue to be offered by Nomura’s Investor and Corporate Solutions. An interesting move, however, is that Instinet will play a role in primary business going forward, effectively acting as order taker for Nomura’s syndicated deals, given Instinet’s substantial distribution capacity.

Toms is clear that buy side clients can only benefit from the new Instinet.“On a global basis, we are a force to be reckoned with,” he states,“and over time the value proposition can only get better. Equally important is the ability of people to utilise research products from Nomura and compensate the firm through Instinet.

Instinet, and its agency-only model, is here to stay,” concludes Toms. I

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

Facebook’s $16bn initial public offering (IPO) hogged the headlines for many wrong reasons, and ultimately was a squib. All the better it was then for palm-oil major Felda Global Ventures Holdings’ lucrative $3.13bn IPO (the secondlargest of 2012), which came to market midsummer. Felda Global priced the institutional portion of the offering at MYR4.55 ($1.43) a share, near the top end of its indicated range.

They defied a market downturn that has led to the delay of other offerings in Asia.

US TECH STOCKS LINE UP IN 2013 HE VOLUME AND value of US IPOs outstripped 2011, according to recent figures issued by global consultancy PwC. Some 138 companies raised proceeds of $40.7bn, compared with 134 companies that had completed their IPOs for all of 2011 raising $35.5bn, according to the survey; but those figures include Facebook’s $16bn offering. Take that out and volume drops by 30% year on year. PwC points out that most US IPOs took place either in March or October, while the average value of individual issues fell by almost 30% to $180m. “Following a very strong October, companies began to take a more cautious approach given the presidential election, uncertainty of the Congressional budget negotiations and the fiscal cliff,” says Henri Leveque, who heads up of PwC’s US Capital Markets and Accounting Advisory Services.

Outside the US, the positive trends in European IPO activity seen at the end of the Q3 this year continued into Q4, which is set to be the strongest of the year with two IPOs in London and one IPO in Germany raising in excess of €1bn each. PwC says “while economic and political conditions remain challenging across Europe, the outlook for IPOs is as positive as we have seen for some time”.

In Asia, IPO activities regained pace. Interest in listing in Asia is expected to resume gradually with market sentiments and fund flow liquidity continuing to pick up well into 2013 and a strong pipeline of potential listings that companies have postponed from 2012.

Activity in China has tailed off sales of large state owned enterprises. The after-market in mainland markets has been depressed and across Asia investment confidence remains.

Deals to watch out for in 2013 include social networker Twitter. If it does come to market expect it to be the year’s biggest offering. Tech stocks will dominate the US market, with some big names expected to debut, including online file storage firm Dropbox, internet portal Gilt Groupe, helpdesk provider Zendesk and cloud computing firm Box. I

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Photograph © Keng Ho To/Dreamstime.com, supplied December 2012.

20-20: COLLATERAL MANAGEMENT

Nadine Chakar, global business head, Derivatives 360 at BNY Mellon, talks to FTSE Global Markets about the latest trends in collateral optimisation.

Towards effective collateral management TSE GM: Where do you think there are still untapped opportunities in the collateral management sector?

NADINE CHAKAR: We believe there are opportunities to create mechanisms to source collateral in ways that are more robust than through agent relationships, but still less expensive than through principal relationships. We believe there are opportunities to deploy algorithms to optimise collateral. And in many cases, to source collateral externally, particularly for reasonably straight forward needs. There are opportunities to improve straight through processing as referenced above as an area that SWIFT is developing. There are opportunities to protect collateral from counterparty risk in the cleared markets, particularly in the United States under LSOC and Interpretation 10.

FTSE GM: How will the collateral landscape change as we move towards greater usage of CCPs? NADINE CHAKAR: As CCPs become an integral part of the collateral market, and demand for collateral increases, we see a broadening of the eligibility criteria. We also anticipate that there will be a short-term proliferation of CCPs as nations seek to protect their markets and investors. This will have the initial effect of fragmenting collateral pools and driving inefficiency in the collateral management space. However, over time we anticipate consolidation with fewer CCPs, ultimately, and a smoothing of the process into the hands of the largest, highest capitalised and best governed CCPs. FTSE GM: Various IMF papers and Singh’s work on collateral velocity have as one of their central planks that re-hypothecation creates money. How does that work in practice?

NADINE CHAKAR: Manmohan Singh’s November 2011 IMF Working Paper: Velocity of Pledged Collateral: Analysis and Implications addresses very well the money creation aspects of re-hypothecation. This makes perfect sense since one of the ways central banks inject liquidity into the markets is by buying or repo-ing assets. Banks and dealers also have the

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ability to use their assets as collateral repo-ing them to raise cash which can in turn be repo-ed again, drawing in more assets and so on. Well constructed contracts in a well understood and fully robust legal framework, such that each party has the ability to re-claim their assets, is a necessary condition for collateral substitution to even be feasible. Additionally, under Basel III, the limits on re-hypothecation are important for regulators in that they limit excess leverage and the associated risks. The Basel III mechanism that implements this is through the assets that are acceptable in the Liquidity Coverage Ratio (in other words, they cannot have been re-hypothecated).

FTSE GM: Do you provide CTD curve analysis to clients? How do you construct these curves and how do they change over time?

NADINE CHAKAR: A generic CTD curve takes into account the value of each asset that could be eligible to be posted as collateral and values it from an intrinsic (lending) value basis.

This information is available from sources such as Data Explorers a tool used in the securities lending market. The curve does change in real-time as demand for assets changes.

As an interesting side note, currently, currencies such as the Swiss franc are considered the cheapest to deliver since it has a negative yield. Normally, cash is the most expensive to deliver because it has no haircut and there is normally a credit spread to source cash when one doesn’t have any.

FTSE GM: Multi-currency credit support annexes (CSAs) of collateralised derivative trades can give counterparties a choice of eligible collateral, allowing for collateral postings of different types of securities in different currencies. These choices, which are supposed to provide flexibility to the counterparties, can sometimes increase the complexity of the derivative (and the valuation approaches needed to value them) because of the embedded optionality added by the CSA. How does BNY Mellon help clients effectively analyse the embedded optionality within CSAs?

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

NADINE CHAKAR: Interestingly, and for the reasons cited in the question which also makes novation of transactions difficult, we have heard that some key parties (for example, ISDA) may be considering cash only CSAs. If this does indeed become the case, counterparties will still need to source cash and will probably use securities they own to do it. We help our clients assess this optionality by assessing the intrinsic value of the assets. This is a key service we have long provided as part of our Securities Lending Program through which we are the largest lender of US Government Securities, for example.

For clients who also lend their assets, there is sometimes a trade-off between the value available from lending and re-investment versus pledging the asset as collateral.

FTSE GM: Do you think that the future of collateral management is centred on technology? What impact will electronic messaging have on collateral management (such as standardisation, efficiencies and interoperability)?

NADINE CHAKAR: The future of collateral is not solely dependent on technology but technology will continue to be an essential part of the mix. Collateral management success will also be a function of availability of eligible collateral and the willingness of regulators, CCPs and counterparties to agree on quality by designating a broader range of assets as eligible collateral. Overall, the future of collateral management will rely on the extent to which it can adequately protect investors and counterparties from market failures and subsequent losses.

We are pleased that SWIFT is continuing to work on collateral message types. Message standardisation will certainly bring efficiencies to the collateral market in the same way that it did to the cash, bond and equity markets.

Technology is an important component in the aggregation of collateral. That is, to have a consolidated view updated as frequently as possible throughout the day of the sources of collateral as well as the uses and eligibility parameters governing each use.

It is also vital in segregating collateral to protect it from counterparty risk. It also helps optimise collateral—or selfsourcing collateral where possible by defragmenting it and allocating it efficiently. Then again it is also basic to the transformation and financing of collateral, turning something that might be ineligible as collateral assets into something that is eligible as a collateral asset. While many of these functions can and should be automated and supported by robust standards such as SWIFT is developing, there is still an important role that many market participants want to play, particularly in optimisation and transformation and financing. Technology needs to support both algorithmic and human approaches to collateral management.

FTSE GM: What innovations is the bank bringing to the party in terms of risk calculations?

NADINE CHAKAR: One innovation that a number of market participants have begun to consider is the concept of ‘collateral at risk’. Just as it is important to risk assess the underlying derivatives transactions, so too it is important to risk assess—and importantly—stress test collateral. For example, if there was a 100 basis points increase in interest rates or a

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

Nadine Chakar, global business head, Derivatives 360 at BNY Mellon.

Photograph kindly supplied by BNY Mellon, December 2012.

ratings downgrade of posted collateral or an increase in margin requirements or a haircut, what actions would the market participant take? Where would they source collateral? If they needed to source collateral externally, would they be able to find willing counterparties? At what cost?

Clearly, these are critically important questions to answer before the market is in a crisis condition.

FTSE GM: How feasible is cross product margining (securities lending/derivatives/etc). What safeguards need to be in place in case of substitutions? How easy is it to track collateral movements of this kind?

NADINE CHAKAR: Well-constructed contractual arrangements supported by a well understood and robust legal framework are the main challenge of cross-margining, for example, the ability of a clearing member to use the margin it posts at a CCP as margin at another separate CCP. The rights and obligations of all parties involved need to be clearly established, recognising differences in risk management and loss mutualisation, differences in mechanisms to assume counterparty risk, interoperability arrangements and capabilities and fungibility rules as well as differences in bankruptcy laws especially if the CCPs are in different jurisdictions.

Examples of differences that make cross-margining challenging include claw back provisions that may be different between CCPs. Tri-party structures can be used to track collateral movements but those structures must wisely be established with well constructed procedures that implement the aforementioned contractual and regulatory provisions.

FTSE GM: How are you working with clients in the area of portfolio reconciliations? Do you provide this service or do you outsource?

NADINE CHAKAR: We provide a portfolio reconciliation service and utilise specialist operations groups that validate the reconciliations, explore differences and resolves disputes and robust vendor technology. This end-to-end service removes the burden from clients and is an important element of our overall derivative administration service.

Most clients opt to take our valuation, reconciliation and collateral management services as a bundle specifically because they are so well integrated and fit together efficiently. Reconciliation and market valuation are key administrative services that are the starting point of risk management. I

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The plan is global. The Group of 20 (G20) countries mandated in September 2009 that “all standardised over-the-counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories.” Dan Barnes looks at the implications and processes involved in transposing these principles into workable regulation. The law has been complex; it is still ongoing and that 2012 deadline has slipped.

Photograph © Froxx/Dreamstime.com, supplied December 2012.

THINKING LATERAL ON COLLATERAL CCORDING TO THE intelligence “we have had, we are unlikely to be mandated for central clearing, before the fourth quarter (Q4) 2013 to Q1 2014 and potentially as late as Q1 2014,” claims Barry Hadingham, head of derivatives and counterparty risk, at buy-side firm Aviva investors. “Clearing houses have to be reapproved under the new European EMIR framework. The European Securities and Markets Authority (ESMA) is not expected to look at that before March 2013. It will take six months to consider those applications, which takes you to September 2013. It will be difficult for ESMA to mandate central clearing before it has approved the clearing houses. As a result we are still talking with industry groups as to how some of these components are going to work in practice,” he adds.

Derivatives trading played a crucial role in exacerbating the financial crisis. When Lehman Brothers defaulted, large amounts of credit default swaps were triggered; there were no restrictions on buying the products speculatively, hoping that a firm would default. When the Lehman buyers cashed in the CDS, sellers received just over eight cents to the dollar. The scale of underwriting was estimated by the Depository Trust & Clearing Corporation (DTCC) to be $72bn,

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but uncertainty around this figure, stemming from the ability to buy CDS without owning the underlying debt, created panic in the market.

At the same time, CDS contracts that Lehman had entered into were now cancelled and any client collateral being held by the broker would be inaccessible for some time, if at all.

Finally, five years of discussion about automating the derivatives trade confirmation process had not led to the process being automated and so unwinding of counterparty’s positions was interminable.

The G20’s proposals get around these issues by keeping track of what is traded where, while placing CCPs in the middle of each trade so they bear the exposure to the participants, mitigating counterparty risk. To achieve this, CCPs demand collateral to be posted with them as a margin against adverse price movements and defaults. They are far more rigorous than bilateral counterparties: firstly, they demand initial margin to open the position, which is a proportion of the contract value up to 100%; secondly they demand that variation margin, which covers movements in contract price, is updated daily rather than once a quarter as was common with bilateral arrangements.

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

With the arrival of mandatory central clearing for ‘standardised’ OTC derivatives there will be some profound effects on the functioning of these markets. We expect trading market liquidity to be impacted initially as participants get used to the new way of processing these trades. The administration of getting client accounts opened and ready for clearing is intensive and a ‘bottleneck’ surrounding legal documentation is highly likely. Lee McCormack, client clearing business development manager, Nomura looks at some of the changes in train.

2013 – THE YEAR CLIENT CLEARING BECOMES A REALITY here are still outstanding issues regarding the ‘extra-territorial’ extent of US and European rules.

This uncertainty is not stopping the advancement of central clearing, but there is a chance that ‘de-globalisation’ of OTC trading and clearing could occur as each region pursues different timelines and market participants respond accordingly.

The ‘unbundling’ of execution and clearing services is seen as a positive impact of central clearing. Unlike the bilateral trading model, where the trade remains with the original parties for its full life (sometimes up to 50 years), with central clearing the trade is quickly given up to the central counterparty and clearing broker. Furthermore, the documentation required to execute clearable OTC trades is far less complex than the current documentation. As a result, all parties to a trade that will enter clearing will be less sensitive to the credit rating of each other. These changes will allow clients to trade with a wider number of execution counterparties than in the past, and should have a positive impact on liquidity, leading to improved trading prices.

Although some clients have already chosen their initial clearing brokers, there remains a significant number of clients who have yet to start or finalise their selection.

Clearing broker selection will therefore be highly fluid for the foreseeable future. There is an expected shift towards more trading being done in the futures markets as the impact of Basel III, central clearing and initial margin for bilateral trades starts to bite. Exchanges are already altering their

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Central clearing isn’t mandatory for all trading. It is clear that pension funds will be able to enjoy a three-year exemption to using clearing houses. However another stipulation of the G20 that, “Non-centrally cleared contracts should be subject to higher capital requirements”means the costs for non-cleared trades are higher.

“Corporate pension funds tell us: ‘We are exempt, we have a moratorium for three years,’ but when we point out the difference in pricing that is already visible on their screens, and ask what their stakeholders think about paying more money to use the higher risk, non-cleared model, they go quiet,” says Ross Whitehill, managing director, Global Collateral Services at BNY Mellon.

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

product offerings to capture this anticipated shift, and clients are looking for clearing brokers who can provide services across OTC and futures business areas that have traditionally been separate.

There is a perception from some clients that there are only five or six clearing brokers offering clearing services and this is incorrect. As the regulatory clearing mandates become reality, we are seeing more competition from between ten and fifteen clearing brokers each offering a similar service.

Client interactions have moved on from the ‘education phase’ on central clearing, with clients now concerned with the commercial terms on offer, such as credit limits and pricing, and they are now shopping around for terms which suit them. The regulations only force new trades into clearing so as cleared portfolios increase, clients may start to fill up their credit lines at their clearing brokers and look to expand from the initial one or two dealers they Lee McCormack, client clearing business have selected. development manager, Nomura.

For firms that do centrally clear, getting hold of the assets needed for posting margin will also add to their costs. The assets deemed acceptable to be used as collateral are typically highly liquid and with a low risk profile. For variation margin, cash is needed, while a range of government/ high grade corporate bonds and stocks are acceptable at CCPs, according to their individual criteria. They are not something that every buy-side firm will have the capacity to get hold of, and many funds are still not fully aware of their effect that these rules will have on their business.

“Where you have a fund that is cash rich or holding gilts or other government securities, they are going to be OK,” says Martin Higgs, senior vice president, Derivatives and

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Collateral Product Management, at custodian State Street Global Services. “Variation margin is in cash and they have a cash pool, and initial margin can be covered using the bonds. The real problem arises for the high yield bond funds and the equity funds for example which are in the majority.

The cost of transforming the assets they have into eligible assets will be quite significant. That cost is hidden and it is probably not realised by most funds.”

The amount of collateral needed will depend upon an individual firm’s investment strategy; the greater the equilibrium between bought and sold securities across any single clearing house, the more the value of exposure can be netted off, minimising the additional amount required to post as margin. For example, a pension fund may only buy interest rate swaps to hedge against changes to its discount rate leaving it with a requirement to post margin against the whole lot. By contrast, a hedge fund may be able buy and sell derivatives resulting in a smaller collateral requirement.

“There is a difference between what the overall collateral shortfall will be and where it will fall,” says Hadingham. “I don’t think it is a surprise to anyone that, as a proportion of the buy-side undertakes directional trades, the level of margin required to service those trades is very high. The activities that pensions and life companies undertake make them a likely group to feel the squeeze. That said, a life company is likely to be holding a lot of eligible assets.”

Helping hand Brokers are offering their clients the ability to transform their ineligible assets by taking the assets they do hold, with a haircut based on their perceived level of risk, and swapping them via their repo desks for eligible securities.

“Clearing brokers are at the point now where they can support clearing for the buy-side, when the buy-side is ready,” says Higgs.

There are problems with the repo model however; the new Basel III rules impose additional capital requirements upon term loans, making this an expensive way to provide collateral to support a long position.

Some clearing houses are more flexible than others in the products that they will accept as collateral than others, relieving some of the buy-side’s pain. This is not as a result of them relaxing their risk management standards, but rather a reflection of their own resources and relationships. For example, Eurex Clearing is accepting certain high-grade equities as it does for collateral to deal with its listed derivatives business. The connection that it has with the Bundesbank could allow it to swap securities for cash in a very secure manner. CME Clearing accepts corporate bonds as a proportion of margin and only up to certain ratio of the total issuance. There are also innovative new ways of holding collateral that clearing houses and custodians are offering to ensure that it is safer in case of default, primarily by segregating clients’ assets.

For example, the CME has developed a fully segregated model which it is operating with all of the major custodians.

Under this model, CME opens up an account with State

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Ross Whitehill, managing director, Global Collateral Services at BNY Mellon. “Corporate pension funds tell us: ‘We are exempt, we have a moratorium for three years,’ but when we point out the difference in pricing that is already visible on their screens, and ask what their stakeholders think about paying more money to use the higher risk, non-cleared model, they go quiet,” says Whitehill. Photograph kindly supplied by BNY Mellon, December 2012.

Street for example, which is in CME's name but references the underlying fund.

“There is a first legal charge in favour of the clearing broker and a second legal charge back to the client that offers a number of advantages,” says Higgs. “It has double bankruptcy protection, which means that if the CME goes under, then the clearing broker's charge kicks in, and if the clearing broker goes under as well the client’s charge kicks in, which means the client can then keep the assets. They don’t get lost in a default situation.”

Secondly he notes that assets are held with a client’s custodian so the client can view them on its online custodian report, even though the account is in the name of the CME. Movement of securities takes place via interbook transfer at the custodian so there is no transit risk as exists if assets are being posted externally to a clearing broker which is then passing them on to the clearing house.

“The legal documentation is a little more complex, but there are many benefits,”says Higgs. The big buy-side firms are also taking matters in hand, with some of the larger firms able to operate their own transformation services and those with the right assets to hand even seeing an upside by providing services out to the market.

“Collateral is really becoming an asset class in its own right,” says Hadingham. “Once you have that in mind you have to determine how you get the best return from that asset. At present there is a fair degree of discussion around the “futurisation” of the OTC market going forward; if we as a firm felt that moving into futures was a reasonable way to go viable route, and then we could provide those assets to the street market for people who continue to undertake OTC transactions, that could be an outcome of this. The cost of high quality collateral can only really go one way because of the increased demand we will see. People are talking about the development of a liquidity swaps market and there are a number of sources that could potentially come from.” I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

20-20: COLLATERAL COSTS

The summer of 2012 saw a rush of activity as the shape of forthcoming derivatives trading rules became slightly clearer. These new regulations are intended to make derivatives trading more secure, but inevitably more expensive, by taking capital from market participants and using it to buffer against the effect of a firm defaulting. Getting hold of collateral will increase the cost of derivatives trading for many buy-side firms, but those able to supply collateral see a boost to their income. Dan Barnes reports on the implications.

BEYOND COLLATERAL: THE COST EQUATION time to transform their entire ETTING IN SHAPE to operations to be the most operate in the new efficient and add the most trading environment value to the front office that requires some initial outlay by they can for the future state.” buy-side and sell-side alike. To More fundamentally many cope with measurement of colpension funds, even some lateral and the drawing in and asset managers, still need to payment out of variation identify the CCP they will be margin on a daily basis, custousing to clear trades, Leveroni dians have been upgrading says, and to appoint clearing their technology to ensure the brokers to enable to them to right level of computing and use the clearing house. processing power is available “There have been buy-side which is seen as a cost of doing firms coming to us and saying business. To minimize further that they expect the regulacosts the banks have got tions to be pushed back, some together to work on a project to Photograph © Rolffimages/Dreamstime.com, supplied December even thought that a Romney reduce the challenge of inter- 2012. victory in the US election facing together.

“As a custodian we could potentially get hit by the cost of might lead to the Dodd-Frank Act being repealed,” he interfacing with a dozen clearing brokers,” says Martin observes.“These reforms were not driven by a political party, Higgs, senior vice president providing support and thought they represent a G20 initiative, so they are election agnostic. leadership for both internal and external clients relating to It will happen; regulators are going to insist that certain sederivatives and collateral at State Street. “An initiative run by curities are cleared and those firms will be pushed into one consultancy firm Sapient involving us, BNY Mellon, basket or another.”

If anything the Obama victory may mean that rules are not JP Morgan and some other sell-side firms has developed a standard format which will simplify interfacing for rushed through by the Democratic Party, creating a more anyone working with multiple clearing firms, including large stable but slower process of implementation. Critical buy-side firms. It isn’t just custodians or brokers it will decisions are still being made in the US which will affect the befit the industry generally. Outside of that every clearing support a buy-side firm needs; a decision to exempt FX broker and custodian has their own system; there isn’t a lot swaps and forwards from Dodd-Frank was announced by the US Treasury on November 16th 2012. Nevertheless, leaving of interfacing.”

There is still much to be done on the buy-side says Ted operational decisions to the last minute will be expensive.

“The rush for the exit is going to cost more,” says Ross Leveroni, executive director of derivatives strategy at posttrade systems supplier Omgeo, “For most buy-side partici- Whitehill, BNY Mellon managing director, global collateral pants work needs to be done on operations and technology. services. “Lots of people feel able to call up their clearing There are two approaches firms are taking. One is in essence broker on Friday afternoon and impress them into working a tactical approach, adding data feeds and links, putting in for them. But going forward the bigger brokers will begin to a piece of automation within their current operational infra- say they can’t take business on such short notice, but they structure and philosophy. Others are taking advantage of this know someone who can.” I

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FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

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20-20: REAL ESTATE FUNDS

Pre-2008, real estate enjoyed unprecedented popularity among alternative asset investors, with many institutions and pension funds funnelling up to 6% of their holdings into a mix of direct investments or, more commonly, funds targeting key real estate sectors and portfolios. The crash in property values that followed the plunge into economic crisis has stabilised and global real estate is regaining its allure. However, investors are cherry-picking from a variety of real estate acquisition mechanisms, says Mark Faithfull.

NEW INVESTORS RESHAPE PROPERTY FUND STRATEGIES NDEED, WHO INVESTS in real estate is having a fundamental influence on how they are investing in real estate. Sovereign wealth funds, insurers, high wealth families and high wealth clubs and private equity are replacing much of the traditional banking finance which had previously underwritten the real estate sector and they bring with them different priorities and different routes for placing funds. Notable among the new players is Norway’s $660bn sovereign wealth fund, fuelled by the country’s huge oil and gas reserves. The world’s largest, it plans to invest about $11bn as it enters the US real estate market.

The fund, mandated by the country’s finance ministry eventually to place 5% of its assets into property, announced in December around one-third of this will be directed towards the US. According to its latest quarterly report, as of the end of September, the fund held just 0.3% in real estate, compared with a circa 60/40 split between stocks and in bonds.

However, Yngve Slyngstad, chief executive officer of Oslobased Norges Bank Investment Management, which oversees the pool, said of the company’s plans:“The US is the next real estate market to invest in.”

He is not alone in backing recovery prospects for North American property.“For those who have the opportunity to allocate on a global basis we would pick-out the US,” says

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Simon Redman, managing director of client portfolio management for Europe at Invesco. Mark Meiklejon, investment director, real estate, Standard Life Investments, concurs: “The US took quick steps to address its issues and speaking generally it has the most attractive immediate outlook.”

For their part, sovereign wealth funds have become increasingly influential on the world property markets and while trophy assets have formed the major component of such transactions, increasingly these are giving way to prime and super-prime purchases. Hence Norway’s fund is focusing on conservative property investments, such as large office complexes in major cities and existing malls.

It has already bought commercial property in London, Sheffield, Paris, Frankfurt and Berlin and on 29th November made its first real estate investment in Switzerland, buying a Zurich office complex from Credit Suisse Group for $1.08bn. Among its headline acquisitions, it bought into the Crown Estates’s prime retail and office stretch along Regent Street in London’s West End and also into mega-mall Meadowhall, valuing the centre at over £1.5bn, reflecting a net initial yield of 5.09%.

Yet globally a cocktail of highly cautious investors and a lack of available prime real estate has caused a wall of equity to accumulate, with only a trickle directed towards real estate, in part because of a prolonged cat-and-mouse game

Following the smart property money “

roperty is quite poorly correlated around the world, which means that there are still opportunities out there for those with a global perspective,” says Simon Redman, managing director of client portfolio management for Europe at Invesco. “In addition, funds can take a strategic view over real estate allocations because property in different markets is influenced by the global economy but does not follow it directly. Issues such as population, location and catchment still apply.”

Redman notes that the focus is on core and prime, “which is really about predictability in terms of income and lease length, which will favour the best assets”, he stresses. “That is a global phenomenon, the desire for safe returns.”

He also points to a “dramatic difference” in the pricing between primary and core and secondary and tertiary in the mature markets. “But for the most part that is correct,” he says. “Investors wishing to take a risk can do it in the United Kingdom; they don’t need to go to markets [such as] Russia.

“There is an appetite for Asian investment but the perception is that funds are opportunistic and aggressive. We don’t agree with that, instead we feel that for those prepared to look deeper these are mature markets and sectors where, even with more muted growth, there are robust investment classes and such markets also have less problems to fix than in Europe.”

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DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

between vendors and buyers as the sellers attempt to protect valuations on their existing assets.

Andrew Friend, director of institutional business, Henderson Global Investors, reflects: “Raising money for real estate investment funds remains challenging and we see this continuing throughout 2013. There has undoubtedly been a polarisation of investors, with the largest players often deciding to make direct investments in partnerships with specialists of real estate investment trusts. We are seeing an increasing element of our business acting in such a way, with separate funds for major clients. Part of the reason for this is control—the major investors want a firm hand on the tiller.

“Medium-sized investors are looking for safe investments and in Europe Central London and prime retail schemes have benefitted. Where they look to investment funds, they are seeking for far more information, they require lower fees and in a lower return market there is a bias towards absolute rather than relative returns. Despite the fact that there are opportunities in certain markets, where they carry risk there is little appetite. It is a risk-off market.”

Institutions, private equity companies and high wealth families are largely replacing the banks, which have backed out of many of their holdings in the past couple of years, or are retaining assets in a so-called “extend and pretend” strategy. Some of the continent's key lenders, including Germany’s Commerzbank and Société Générale of France, have shelved all real estate lending.

“The global equities crash meant that many institutions became over-weight on property and this led to some sales but in particular to fewer institutions acquiring more property,” says Invesco’s Redman.“The recovery has helped and allocations are increasing. For funds, however, it is very difficult to launch new products. Investors are really favouring those funds with existing product and strong track records.”

Meiklejon adds:“The gap between real estate and gilts and government bonds has never been greater globally and while you could argue that bond yields are artificially low, this provides a compelling argument for property. However, with no risk appetite the market has tilted heavily towards core and prime. For secondary and tertiary we are very negative.

“An interesting market is the best secondary. Well located real estate which has perhaps under-performed because it needs a capital injection that the current owner does not have, or expertise in terms of tenant engineering, could create a much stronger market given the high price of prime.

For buyers it does not have to be all about capital expenditure, there are plenty of improvements which can be made through optimising a shopping centre or office complex, which bring added value and strengthen the income stream.

The most difficult aspect of this currently is how low transaction volumes are, which makes accurate pricing very difficult. And of course location is crucial because what we are really talking about is turning that secondary into prime.”

Wealthy individuals and families are also becoming more prominent and Friend describes as “notable” the size of some of the investments made by wealthy individual

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

The changing debt market for property he pace of real estate debt refinancing has begun to accelerate, according to Morgan Stanley, which estimates that European banks have hit 20% to 25% of their loan reduction targets of €700bn. Negotiations by banks became more urgent 18 months ago, ahead of a future tightening of capital requirements. Minimum levels of Tier 1 equity will start rising imminently under Basel III, when Tier 1 capital of 4.5% will be required.

Morgan Stanley says of the €140bn to €175bn in reductions so far, 55% has been achieved by borrowers repaying their debts, 20% from debt sales and the remaining 25% is the result of repossessions, particularly in Spain, plus write-downs.

According to the US bank, private equity funds worth $165bn are available to invest in the real estate sector, of which a fifth are dedicated to Europe. A survey by real estate trade association Inrev added that debt funds targeting €10bn have been launched over the past three years. Blackstone’s second real estate debt fund is the largest, targeting €4bn.

According to securities house Investec, insurance companies such as Aviva, Legal & General, M&G, Canada Life and Axa will provide property finance worth £7bn a year over the next five years. Andrew Friend, director of institutional business, Henderson Global Investors, adds: “In terms of real estate debt there appear to be real opportunities, especially in the UK and Germany and also in the Nordics. For many this is about underwriting wealth preservation and investors can often look to a 35%-40% fall in equity before they are exposed to any risk.”

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investors, with some at the £200m-£300m level.“They tend to favour real estate and there has been around a 20% increase in the level of real estate owned by such people and specialist investment funds and advisors catering to this sector,” says Friend.

In addition, corporate bonds, private placements and small retail bonds are replacing conventional banking loans in Europe, with estimates that European property groups raised about €15.4bn in the first nine months of 2012, almost double the €8.3bn raised for the whole of 2011. For example, Unibail-Rodamco, the French/Dutch real estate investment trust, issued €750m of five-year bonds at a coupon of 0.75%.

Most of the debt being raised is replacing existing bank loans rather than funding acquisitions or expansions.

Then again, for investors and funds it is existing stock rather than new build which will provide the building blocks for value creation. As James Brown, head of research for advisor Jones Lang LaSalle reflects: “Re-development is the new development.” I

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20-20: LOGISTICS

Photograph © Corepics Vof/ Dreamstime.com, supplied December 2012.

It’s all change in the European logistics market, where dedicated and hybrid distribution centre models are altering the shape, size and locational requirements for many retailers and specialist internet delivery providers on the back of the boom in online selling. These developments are not only rewriting the rule books for what has traditionally been a lucrative but distinctly unglamorous element of the retail and industrial sector but has transformed the investment appeal of such sites, although limited supply is frustrating the market. Mark Faithfull reports.

LOGISTICS SHEDS ITS IMAGE K GROCER TESCO’S futuristic collection of distribution hubs—sometimes better known as ‘ark stores’ —circumscribing the London orbital motorway the M25, are among those mapping a different sort of retail outlook. While Tesco’s conventional store performance might be under attack from rivals and its US operations may finally be waving the white flag, when the retailer opened its 11,000 square metre (sq m) online delivery facility in Enfield, north London, last year it was its fourth such dark store, created to meet online order demand in densely populated areas.

While its core, online grocery model remains picking in nearly 300 stores, and its first online-only store did not open until 2006 in Croydon, south London (now joined by Aylesford, Kent, and Greenford, Middlesex), the £30m Enfield site provides the highest level of automation yet, while Tesco plans to open a fifth such facility in Crawley early this year and Erith, near Dartford, in 12 months, while Tesco is now looking for sites in the Birmingham and Manchester areas. Ken Towle, online food and internet retailing director at Tesco, says that the retailer’s dark stores are now in its top ten sites by revenue.

Tesco aims to have “tens but not hundreds” of dark stores, marking a significant expansion of its online infrastructure.

Rival Marks & Spencer is also to open the UK’s largest dedicated e-commerce warehouse early in 2013. The 90,000 sq m distribution centre in Castle Donington will distribute clothing and home products direct to customers and to M&S stores across the UK. Darrell Stein, IT and logistics director at Marks & Spencer, explains: “Castle Donington is a key part of M&S’ strategy for the future and will help us deliver our goal of being a leading multi-channel retailer by 2015.”

Global online giant Amazon has also adopted a strategy to get closer to its shoppers, with a proposed 20-centre UK network. Expansion has been slowed by planning restrictions but the growth ties in with Amazon Europe Marketplaces, which opened in 2011, enabling sellers to list their products across all its European websites using one seller account. Products can now be stored in a fulfilment centre in one country and distributed across Europe.

Andrew Griffiths, managing director of specialist Prologis UK, reflects: “Retailers who deal directly with the public

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through e-commerce are looking for large distribution buildings over 50,000 sq m. There are very few buildings of this size currently available and not many sites that could accommodate them, but the main considerations for e-commerce occupiers is cost and labour availability and they will look at non-traditional distribution locations if necessary. ASOS [the online-only fashion retailer], for example, has taken a 50,000 sq m cross-docked warehouse at Barnsley.”

He adds: “For the pure e-tailer, they need large buildings because they have no other stock holding capacity and they need these facilities to function as efficiently as possible.

They tend to require a higher loading dock ratio and cross docks because parcels are smaller and the volume of reverse logistics is high. There is higher demand for mezzanine space, used to handle all reverse logistics; and more ancillary space, such as offices, social rooms and parking as staff numbers in e-warehouses are higher.”

Not surprisingly, investment has flowed into the market— especially the most developed on-line markets, plus the strongest real estate developments markets. However, while investment maintained its momentum in the third quarter of 2012, with around €2bn transacted, figures from advisor Jones Lang LaSalle mark a slight dip from the €2.2bn in Q2, largely as a result of continuing limited supply of prime product.

The UK, Germany and France accounted for almost 80% of total investment volumes in Q3, up from 71% in the previous quarter. Volumes in France and Germany were driven by a number of transactions, such as portfolio acquisitions by Segro and Blackstone in France and the new-build 100,000 sq m Amazon fulfilment centre in Koblenz (Germany), sold by developer Goodman to a US real estate trust (REIT).

Goodman will also develop a 90,000 sq m Amazon logistics centre at Lauwin-Planque in the Nord-Pas-deCalais region, the tenth facility to be developed by Goodman for Amazon in Europe. Jean-François Mounic, Goodman’s regional director for Southern Europe, stresses: “This is the third development that we have undertaken for Amazon in France. We were one of the first real estate businesses to recognise the potential of the e-commerce sector.” Outside the core markets, Poland and Russia have continued to

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

London Gateway and the age of the train? f sheds are enjoying a retail renaissance, then so too is rail distribution. The big beast and potential catalyst for greater change in Europe is DP World’s £1.5bn London Gateway development. Scheduled to open in the final quarter of 2013, it will become one of the world's most advanced deep-water container ports and will allow the biggest ships to import directly into the UK, instead of via rival European cities.

Alongside the port there is planning consent for one of the UK's largest logistics parks, which will include 865,000 sq m of rail-connected sheds, and Britain's largest privately owned freight and logistics company, Uniserve, is in advanced talks with DP World to take a 100,000 sq m shed. Marks & Spencer is also considering a 100,000 sq m shed at the site, while Tesco has also looked at the site for a potential rail-connected mega-shed. But the park is not only about large occupiers, with several multi-let sheds of up to 50,000 sq m to be located there as well.

I UK retailer Tesco is shifting freight from road to rail on certain routes as the retail giant looks to halve carbon emissions for each case of goods delivered by the end of the year. The supermarket has partnered with local businesses to run a new rail freight service in Wales six days a week transporting ‘swap-body’ containers, which are delivered to the rail freight depots by lorry and simply lifted between lorry and train. The trains travel between Magor and Daventry, where Tesco has its main rail-connected UK distribution centre. Photograph kindly supplied by Tesco, December 2012.

attract strong interest and, driven by improving liquidity, they were the only two other markets to see transaction volumes increase over the first three quarters of 2012, up 77% and 40% year-on-year respectively.

However, continued lack of prime product is holding back transaction volumes and as a result full-year 2012 volumes are likely to remain around 20% below last year’s figure of €9.9bn. Tom Waite, associate director of European Capital Markets at JLL, reflects: “There remains a polarisation in transactional activity across the region with the larger, core markets such as Germany, the UK and France leading the way. Elsewhere, interest continues to increase in markets such as Poland, the Benelux and the Nordics, while trading levels in key southern European countries remain subdued.”

Karel Stransky, director of industrial & logistics for Colliers International corporate solutions, points also to the changing needs of occupiers: “Logistics facilities have traditionally been built for the B2B market; however e-tailers are now shipping directly to consumers, changing the design require-

Amazon distribution centre at Prologis Park, Marston Gate. Photograph kindly supplied by Amazon, December 2012.

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

ments for facilities. While the majority of large market players, such as Amazon, are expected to continue to operate in their own fulfilment centres, a growing number of companies are considering outsourcing their supply chain to a third party logistics provider. In coming years, we will see both online and multi-channel retailers rethinking their strategies.”

Andrew Schofield, director of research, property, at Henderson Global Investors, adds: “E-fulfilment is increasing the demand for edge-of-town sites, while proximity to the store portfolios remains more important for national distribution centres. Non-food retailers have been relatively quiet when it comes to the mega-sheds but there are signs that this is changing. There is simply no doubt that logistics is becoming more and more important.”

Targeting those core markets, in 2012 Henderson Global Investors raised €90m for its German Logistics Fund, a partnership between Henderson’s German property business and logistics real estate specialist Palmira Capital Partner.

With leverage, the fund has a spending power of €150m and remains open to further institutional investors with an eventual target size of €250m. Current investors comprise predominantly German insurance companies and pension funds, together with an unnamed Austrian institutional investor, Henderson says.

For landlords one hook is the significance of the investment in technology which major retailers and logistics providers are putting into their centres. Huge investments on carefully laid out catchment plans mean those retailers are unlikely to be going anywhere soon, providing the landlord with a strong and lengthy covenant. The shed might just have become sexy. I

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20-20: FX VIEW: US DOLLAR BANKS ON AN ECONOMIC UPTICK

A growing chorus of FX experts sees the greenback holding its own over the coming year, having survived the Fed’s latest round of easing and sustained by stronger economic expectations. From Boston, Dave Simons reports.

CAN THE GREENBACK MAKE A COMEBACK? A

T THE OUTSET things appear to be looking up for the buck: fiscal-cliff and EU sovereign-debt matters notwithstanding, economists see US GDP matching or eclipsing current-year levels, with strong growth presumably arriving during the second half of the year.

Assuming estimates are correct, many believe the dollar will be able to sustain itself, despite the counter-effects of the Fed’s quantitative easing program, as global investors scramble to grab a piece of stateside action.

Investors are naturally more circumspect in advance of the US fiscal cliff, as evidenced by some fairly brisk Treasury demand. Despite this, Samarjit Shankar, managing director, Global Markets at BNY Mellon, sees fund clients already making strategic allocations for 2013 based on the assumption that fiscal matters will ultimately be resolved, paving the way for equity market upside. In this environment, Shankar believes the US dollar will hold steady, and doesn’t rule out another leg up for the buck, particularly during the first half of next year. “We have been seeing some increase in risk appetite—equities are being supported by cash-rich companies with very strong balance sheets, the housing market seems to have turned a corner, and we believe the US unemployment rate will eventually start to trend lower as well. All of these ingredients should bode well for the dollar as we work our way through 2013.”

Using its iFlow web-based application, BNY Mellon analyses capital flows across numerous asset classes by monitoring global investor activity. It provides a granular overview, and shows that the US dollar has managed to hold its own, “particularly over the last six months,” says Shankar. Some weakness associated with the announcement of the Fed's QE3 program, for example, turned out to be nothing more than a short term blip, he adds.

To provide historical context, Shankar points to the movement of the volatility index (VIX), since 2007, along with the performance of the dollar over the same period. “As one might expect, as volatility goes up so does risk aversion,” says Shankar, “and the dollar has tended to benefit during those periods.” In contrast, volatility has

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been virtually moribund of late, and yet the dollar has been noticeably resilient—a Chris Probyn, chief economist at positive indicator going State Street Global Advisors. "Ben forward, suggests Shankar. Bernanke is prepared to take Of course, there is also a evasive action through further case for a greenback monetary accommodations, which pullback in 2013, particu- would expand the balance sheet larly if fiscal matters are un- even further and, in turn, lead to resolved early in the year. increased dollar weakness,” he says.

“Ben Bernanke is prepared Photograph kindly supplied by to take evasive action State Street Global Advisors, through further monetary December 2012. accommodations,” posits Chris Probyn, chief economist at State Street Global Advisors, “which would expand the balance sheet even further and, in turn, lead to increased dollar weakness.”

On the other hand, a flattened fiscal environment, the cessation of the Fed’s Operation Twist program, along with increased spending and a more buoyant housing market, raises the odds for a much stronger dollar, says Probyn, particular against certain global currencies. For instance, a change in the composition of the Bank of Japan’s monetary policy board (following the departure of two deputy governors in March and the governor in April) could make for an interesting dollar/yen relationship in the months ahead.“Having Japan in accelerated accommodation mode while the US eases back as its economy continues to grow would certainly bode well for the dollar, at least against the yen,” says Probyn.

Like others, Shankar also has at least short-term concerns around the euro, particularly. “Some of our clients have wondered why the euro isn’t already lower at this point,”says Shankar. The European currency has been hanging tough in part because of EU equity support, as well as the general desire among central banks to diversify away from the US dollar over the past decade. Given the likely resurgence of the US as an economic force, however, the latter trend is likely to change during 2013.“Accordingly, we see the euro essentially moving lower against the dollar going forward,”says Shankar.

The prospects appear much better for Canada’s dollar, particularly as the year wears on. During the first half Canada’s loonie could be vulnerable to some modest slippage against the US dollar, thinks Avery Shenfeld, managing director and chief economist, CIBC, as sluggish global growth dampens commodity prices and weighs on the country’s trade balance. However, any downside risk would be limited, “as foreign investors and central banks continue to pile into the Canadian dollar bond market, encouraged by the triple-A rating on the sovereign debt, a better fiscal outlook than the US, and less uncertainty over monetary policy, given that the Bank of Canada has not engaged in quantitative easing,” he says. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

20-20: RMB

It looks like the renminbi will continue to appreciate over the coming year as China’s central bank nudges it closer to its “real” value. Indeed, while the Western bankers’ consensus might see volatility and a free float as a sign of financial maturity, for many institutions, there are attractions in the implied stability of a currency under such sensible control by what appears to be a cautiously responsible government. Ian Williams reports.

WHEN CURRENCY CONTROLS DO THEIR JOB the bilateral swap lines to promote trade setLL INDICATIONS POINT to the retlement in local currencies may serve as a tirement of Zhou Xiaochuan, governor model for additional arrangements. This, of the People’s Bank of China (PBOC) coupled with the gradual easing of limits on in 2013.“It’s not clear who will succeed him, the capital account, is more practical and but local contacts suggest Shang Fulin, the seems to be what the Chinese are genuinely chief bank regulator, is a likely candidate. It interested in rather than aggressively may reflect the shifting emphasis of the new pushing for the RMB’s use as a reserve leadership. Institutionally, the PBOC has currency. Indeed, I’m not sure they want it! tended to support greater capital market libThey are being very cautious in widening eralisation, including currency appreciation, the use of the RMB, since they look back at against other ministries that advocate slower Photograph © Jianqing Gu/ the 1997 Asian currency crisis.” change,” states Win Thin, global head of Dreamstime.com, supplied Earlier in 2012 more gloomy types saw a emerging markets currency strategy at Brown December 2012. hard landing for the Chinese economy and Brothers Harriman.

“Data for November and December are solid as the equity a consequent crash in the RMB and their prophesies were market came back, but we have been pretty consistent on embodied in the forward markets. Nordvig comments“The our calls: the whole world is slowing down, Europe, US, and first thing to keep in mind is that although the Chinese Japan, and while China can’t swim against the tide, with all economy was definitely slowing in the summer it is now the political transition, Beijing can’t afford to see the picking up again. There was also a period of time where economy falling off a cliff. So that’s what we are seeing: there was concern that the appreciation of the RMB was modest stabilisation; slightly stronger growth, but not a lot.” beginning to slow, but it has come back up again. The However, some observers tend to give China’s incremen- market is now more normal with less divergence between tal steps towards reserve status more credence than reality the underlying trend and where the forwards predict it will will bear. They optimistically see an Asian RMB zone con- go. Most would agree that the RMB was extremely underdensing out of the bilateral agreements and payments in valued when they first de-pegged it, and now we have seen RMB between China and its neighbours. But no one seems a gradual depreciation over that period, and in addition to to recall seeing any of these countries using the Chinese how the currency has started to move, it is important to note currency to trade with each other, only bilaterally with China. that wages have started to move, which started to close an Nomura’s head of fixed income, Jens Nordvig is cautious “unfair” advantage. Before, appreciation was at 5-6% and “There are many aspects to this: The Chinese have a problem we think next year will be slightly slower with a continued with the amount, $3trn plus, in reserves that they hold, and appreciation trend of 3% to 4%. And we also think they will they are obviously not happy with some of the currencies continue to open their capital markets—slowly.”

In contrast to the moderate pushiness of China on the that they have to put their savings in. One thing they are doing is extending a lot of credit to emerging market financial front, its ambitions to move to reserve status are countries in RMB, so they accumulate RMB assets instead of hindered by a more aggressive politics. Nordvig points to the loans in dollars as in the past. It’s the supply argument - this situation in the China Sea, “The intra-regional conflict is is something the Chinese like to do, and the creditors want starting to develop, China versus Japan, Philippines, Korea even, and if that does not improve, it would make it very to borrow in whatever currency the Chinese will lend.”

Win Thin agrees but adds some fine-tuning. “It isn’t just difficult for other countries to sign up to a RMB bloc.”

He is echoed by Win Thin “While China has become the purely economic goals; there is an element of Chinese nationalism. Even so, China will continue to pursue the inter- single largest trading partner for a number of Asian countries nationalisation of the RMB but not necessarily as a reserve and is integrating into the global supply chains; developcurrency. The recent agreement with South Korea to activate ments on the political front are quite different. China’s terri-

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20-20: RMB

A world of multiple reserve currencies hile the world remains a dollar centric economy talk of the RMB becoming a reserve currency is more expectation than practicality in the short term. However, as selected high growth emerging markets become more and more prominent in global economic affairs the reality is that more currencies will become regional reserve currencies.

If a Mexican importer buys from China, more than likely he will pay in dollars. But if he is required to pay in CNH (RMB used in trade finance) he will equally likely buy dollars and then buy offshore RMB with which to pay his supplier. He does that because the spread (or cost) between the peso and the dollar is smaller than the spread between the peso and the RMB. And in this modern age, that fact helps define the US as a reserve currency.

Definitions of reserve currency fall into two halves: the first is function, the second is value. The dollar is the currency of denomination of half of all international debt securities. More than 60% of the foreign reserves of central banks and governments are in dollars. The greenback, in other words, is not just America's currency. It's the world's currency and in that regard its role as a global reserve currency remains sacrosanct.

This is compounded by the fact that most global trade continues to utilise the US dollar as a means of facilitating

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torial disputes with its neighbors, including Japan, India, the Philippines and Vietnam are potential flash points of crisis next year. This is especially true of Japan, where more nationalistic political forces are moving into ascendancy. This does not encourage neighbours to join any form of RMB bloc.”

More cautiously, Dr Huining Cao, finance professor at Cheung Kong Graduate School of Business which is contracted to research on reforms for the China Securities Regulation Commission agrees that“Political uncertainty will go against the trend towards the RMB becoming a reserve. But negotiations are in the mutual interest of all parties, so it is really just an adjustment due to China’s growing influence, and don’t think it will stand in the way of RMB becoming an international currency,” he says.

More pertinently, he thinks“that to become a full international currency China needs reform its banking sector and bond markets. That’s more crucial than outside forces.”

Indeed Cao is on the commission that is trying to reform Chinese markets to do just that, so he has a commitment to the process. Even he predicts it will take“at least another ten years, since Chinese banks still have lots of problems, and during the stimulus plan there were lots of bad loans, which have to be reduced [sic]. For the RMB to float, China has to open up its capital accounts so Chinese citizens can freely exchange into hard characters, presently only about 50K

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trade finance. Increasingly however, that will not always be the case and already the world is seeing the rise of strong regional currency leaders which play this role of trade facilitator (the euro across Europe, the RMB in Asia, the Turkish lira in the Black Sea region; the SAR in the southern African cone, for instance). The impact of such shifts could well be profound, with implications for, among other things, the stability of exchange rates and the ease with which the US will be able to finance budget and current-account deficits entirely in dollars.

Current woes aside, the role of the euro (for instance) as a facilitator of trade finance is well documented. While it is popular to discount the longevity of the euro, it will not disappear. Moreover, as China gradually internationalises the RMB more cross-border settlements will be made in the offshore currency.

Finally, there is the danger that the dollar's safe-haven status will be lost. Foreign investors buy dollars because they are secure, but as US federal debt approaches 75% of US GDP investors, and little is done to tackle the deficit, eventually, the dollar will have to share its safe-haven status with other currencies. In this new monetary world, moreover, the US government will not be able to finance its budget deficits so cheaply. Nor will the US be able to run such large trade and current-account deficits, since financing them will become more expensive.

per year. It must also open up its financial markets to fix the interest rates, must develop its bond market, it needs to change for bond market and interest rates.”

Another fear is that China will switch its reserves and destabilise international FX, but Cao reassures. “They want to preserve against depreciation, but can they switch from dollars to euros? They don’t have much choice [in terms of action]. The yen is highly overvalued and there is some animosity between Japan and China. The focus is on a mix of currencies, or maybe to invest in companies to have some form of diversification.”Indeed he recommends with a more open currency“It would be best to keep Chinese companies reinvesting worldwide rather than a small group of people investing trillions!”

Cao looks beyond 2013. “This year, Chinese government has already relaxed the exchange rate a lot with the dollar at RMB 6.24, closer to equivalent rate. I envisage that the RMB will appreciate at 5% level for the next five years to RMB5 to the dollar.”

However, the Japanese election of the LDP in December might disrupt some of the calm projections for the RMB if the nationalists pursue some of their threats to wage currency wars with the yen. In the words of the overused and now hackneyed pseudo-Confucian curse, we will live in interesting times. I

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20-20: ASSET SERVICING IN FLUX

At a time when regulatory initiatives are putting added pressure on profit margins, asset servicers are finding inspiration through integration—that is, bringing together compatible business offerings in an effort to boost agility while addressing client’s need for convenience and clarity.

Dave Simons reports.

THE NEW ASSET SERVICING JIGSAW TAKES SHAPE are closely affiliated with the custody VER THE YEARS, BNP Paribas’ space. ”At BNP Paribas, for instance, we Securities Services division has have the ability to source directly from continually sought to achieve a lending clients who are long only and better standard for the provision of asset have eligible collateral,” explains Sophie servicing, including the breadth of Gautié, head of strategy and corporate services covered. In an effort to reflect the development, BNP Paribas Securities size and diversity of its global clientele, Services. “We can also integrate clearing BNP Paribas’ 360-degree, front-to-back with fund administration and other services set sports a generous array of inservices that we regularly provide for our terconnected solutions, from clearing, colasset-management clientele.” Additionlateral management and structured ally, BNP Paribas is able to help clients finance to FX, transfer agency and more— comply with increasingly stringent reguwith the idea that clients whose needs are met under one roof are clients who Photograph © Rolffimages/Dreamstime.com, lations around the monitoring of collateral and counterparty exposures. are more than likely to stay put. supplied December 2012.

“At BNP, clearing and custody have It’s an idea that seems to have legs.

Last summer, JP Morgan embarked on its own brand of always been linked,” says Gautié. “So essentially, we view business blending, combining its investment banking, clearing as being a natural extension of the servicing world. treasury/securities services and global-corporate divisions When you enter into third-party clearing, you need to be into a unified Corporate & Investment Bank (CIB). Enhanced able to manage and segregate collateral, provide dedicated scale through the pooling of internal resources and technol- reporting and front-end tools, check calculations, understand ogy, as well as a global support team better equipped to CCP margin requirements, and more. In short, it is much assist clients during these tough regulatory and economic closer to the type of work that you are accustomed to doing times, are among the benefits that JPM’s own CIB will bring in processing or custody. Which is why this has been a natural fit for our services business from the start.” to bear, according to the firm.

Thibaud de Maintenant, global head of direct securities One might wonder how these strategies could impact the provision of asset servicing as a whole going forward. If services at Deutsche Bank, agrees that concern over regulaclients can truly benefit from having a fully integrated tion and the complexity of the clearing space continues to services environment—including, among other things, the shape client service offerings. Rather than pushing services potential for more efficient management of collateral—what product by product as has often been the norm within the other cost-reducing, convenience-enhancing strategies securities-services space, Deutsche Bank itself has opted to focus on a more unified, overarching-solutions approach. might firms have up their sleeves?

“Coming up with a unique package for each individual There is no doubt that the clearing components of Dodd Frank (as well as its EU equivalent, AIFMD), which favour an client has been a prime motivator for us,” says de Mainincreasing number of transactions going through clearing fa- tenant. “For example, offering market-clearing solutions cilities, have helped promote a more unified approach to that are capable of working across a number of asset types, asset servicing. Requiring counterparties to post significantly from securities and futures to OTC derivatives and more, is more collateral than in the past has fed client demand for a far more effective way of addressing the clearing challenges clearing solutions, and, in turn, services around collateral facing our clients,” says de Maintenant.

There are other examples as well. Whereas services such as management (including related services such as collateralmanagement outsourcing and collateral upgrade). As a result, direct market access (DMA) and custody were once comsecurities service firms will increasingly find themselves pletely separate entities, today they can be offered in a fully inhandling collateral duties on behalf of the asset management tegrated manner. By having DMA in closer proximity, clients world, including seeking out the most efficient pathways for are more likely to rethink maintaining a stock-exchange affilOTC derivatives clearing. Given these circumstances, the iation, says de Maintenant. “Using DMA means that clients most logical approach for clients is to partner with firms that won’t always be required to settle every single trade,”offers de

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Alex Buffet, director of middle office and derivatives, Société Générale Securities Services (SGSS). The ability to keep pace with collateralfacing regulatory changes in both the US and Europe remains front and center says Buffet. “For some buy side clients, the uncleared component can be as high as 80% of the total portfolio,” he adds. Photograph kindly supplied by Société Générale, December 2012.

David Linds, senior vice president, business development and relationship management for CIBC Mellon.”Today’s clients are looking for more timely data, as well as the ability to access far more detailed information on-demand,” says Linds. It is an indication of a demand for customised customer solutions. Photograph kindly supplied by CIBC Mellon.

Maintenant, “which of course can significantly drive down costs in the process. So you can see how this is a real win-win type of situation, as it not only gives clients trade efficiency, but boosts the provider’s business as well.”

The ability to keep pace with collateral-facing regulatory changes in both the US and Europe remains front and centre at Société Générale Securities Services (SGSS) as well, reports its director of middle office and derivatives, Alex Buffet.“For some buy side clients, the uncleared component can be as high as 80% of the total portfolio,”says Buffet. Not only will clients be required to keep significantly more cash on hand, they also need to be aware of new limitations governing which forms of collateral will be acceptable.

Accordingly, SGSS continues to promote asset-servicing solutions around the transformation and optimisation of collateral.“There are a number of opportunities in this area, including services related to netting as well as crossmargining, particularly with respect to some buy side clients but also banks with massive collateral volumes,”says Buffet.

Delivering middle-office service, pricing of complex instruments, as well as risk attribution and risk calculation on behalf of buy side clients is fundamental to the SGSS package. “Furthermore, all of these collateral and middleoffice services can be customised on a standalone basis,”says Buffet. With regulations in both the US and EU not yet set in stone, agility will be a leading attribute going forward.

“Because there is still a fair amount of uncertainty around regulation, asset servicers must learn to work with a lot of assumptions—and remain very flexible as well,” says Buffet.

The continued drive toward full front- to back-office delivery puts the onus on asset-servicers to map out forward-thinking concepts for enhancing efficiencies and standardizing platforms. As one might suspect, technology plays a central role in this effort, as investors clamor for more thorough reporting and risk-management capabilities

from their providers. As such, one can hardly ignore the potentially significant bottom-line benefits of having shared technology platforms, says de Maintenant. “Unlike in the past, providers really cannot afford to have any kind of IT duplication,”he says.“When you look at the reporting platforms from the different groups like global custody, prime brokerage and securities services, there tend to be some elements that can be easily shared among the various branches, with the ultimate goal of avoiding redundancy while lowering overall costs. So that is certainly fueling a lot of the integration strategies right now.”

The blending of services through JP Morgan’s new Corporate & Investment Bank unit is a particularly attractive proposition for sovereign-wealth funds, pension funds and large asset managers that use JPM as a counterparty, prime broker or custodian, says Nick Rudenstine, head of custody and fund administration for JP Morgan Investor Services.

“More and more we are finding that these types of clients want their services bundled in this manner,”says Rudenstine, “in part because they are in need of good counterparties, but also because regulation tends to be pulling many of these activities together.”

Even when clients aren’t specifically seeking a single counterparty, the vast majority would still like to have fewer of them, adds Rudenstine, and a unified-business model helps them accomplish this goal. “There are a lot of clients who historically have been custody-only, and who’ve never had to post collateral before and who must do so now,” says Rudenstine.“As a result, they now require a collateral-management agent. At the same time they may also be launching some alternative strategies, and therefore are interested in having prime-brokerage services as well. So while some of this has been driven by regulation, the other part is about clients’ desire to grow and the array of services that they will be asking for along the way.”

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Sophie Gautié, head of strategy and corporate development, BNP Paribas Securities Services. The bank is committed to a diversified service set. “We can also integrate clearing with fund administration and other services that we regularly provide for our assetmanagement clientele.” Photograph kindly supplied by BNP Paribas, December 2012.

Thibaud de Maintenant, global head of direct securities services at Deutsche Bank, agrees that concern over regulation and the complexity of the clearing space continues to shape client service offerings. “Coming up with a unique package for each individual client has been a prime motivator for us,” says de Maintenant. Photograph kindly supplied by Deutsche Bank, December 2012.

Some of the business benefits of integration are a bit more tangible than others, such as managing similar kinds of risks across Investor Services by leveraging the expertise in operational risk and market risk within each business.

“This is an important benefit in the new regulatory environment,” says Rudenstine.“Plus it gives us the opportunity to grow these services seamlessly under the same umbrella further down the road.”

BNY Mellon has also seen an increase in demand for integrated collateral management services among both buyand sell-side clients in response to heightened investor concerns around risk, counterparty exposures and general market volatility. Accordingly, BNY Mellon has worked to integrate and align its own service offerings; launched last June, the Global Collateral Services business (GCS) builds on the company’s existing institutional capabilities featuring end-to-end services around collateral management, collateral finance, securities lending, liquidity management and derivatives services, all housed within a single business unit.

Though scale and advanced technologies have helped reduce the cost of delivering traditional asset services, these savings have been offset in part by increased risk, governance, reporting and regulatory requirements. For instance, where monthly valuations once passed muster, “today’s clients are looking for more timely data, as well as the ability to access far more detailed information on-demand,” says David Linds, senior vice president, business development and relationship management for CIBC Mellon.

Finding more efficient means for managing collateral continues to pique client interest, notes Linds, “many of whom are realising that the regulatory and operational demands around collateral management can easily consume operational overhead.”

As a result, clients are looking to outsource the administration, documentation and technology investments associ-

ated with collateral management to their asset-servicing providers.“As the systems and expertise needed to support these programs are aligned with the solutions asset servicers have already deployed in support of client securities-lending programs, there are notable efficiencies to be gained here, such as through collateral conversions, which can provide new opportunities in this low-interest rate environment,” says Linds. “Outsourcing collateral management enables clients to focus on executing investment strategies, while leaving the operational, regulatory, and reporting and transaction requirements around collateral management to the custodian and collateral agent,” he adds.

While service, technology and execution will remain essential elements, clients will increasingly be looking to their securities-servicing teams to be problem solvers and knowledge leaders. “Clients are seeking new efficiencies, and they expect their providers to do the same,” says Linds.

CIBC Mellon is responding in part by building service models that are designed to meet the specific needs of the individual client. “A middle-market, single employer pension plan may want a very basic solution,”says Linds,“whereas a highly diversified banking entity has far more complex needs on a vastly different scale.”

While anyone could conceivably toss a handful of offerings into a pot, bring it to a boil and serve it up to clients, without the right kind of ingredients it isn’t going to be a very appetising entree.“These aren’t just random groups of things we’re using,” says Rudenstine. “Whether we see further uncertainty in the coming year or a much more stable environment, we feel our particular combination of services will be a distinguishing factor, and will help us meet the needs of clients who require stronger returns in order to achieve their goals. Inevitably, the better the delivery systems, the easier it will be for us to continue to innovate and build a stronger franchise.” I

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20-20: EUROZONE DEBT

The European Central Bank’s commitment to buy as much distressed sovereign debt as necessary and the more pragmatic attitude that Germany and the other leading EU countries adopted more recently towards Greece will hopefully see near-term fears over the future of the eurozone continue to subside in 2013, to the benefit of bond markets in general. Even so, uncertainty over political developments in the coming months and the depressed economic outlook for region mean there is no guarantee that the crisis will not flare up again over the next 12 months.

Andrew Cavenagh reports.

COULD SPAIN STILL UPEND THE EURO? HE LATEST RESTRUCTURING of Greek debt that the eurozone governments approved at the end of November clearly reduced the danger that Greece will leave the single currency next year, with the widespread (and unquantifiable) market chaos that would ensue. The extension of maturities on the EU/IMF bailout loans and relaxation of requirements to cut budget deficits means the government in Athens will not have to slash spending and raise taxes as aggressively as under the previous arrangement, which should prevent popular unrest from making the country’s continued membership of the euro impossible.“It seems unlikely that Greece’s tolerance of the euro will snap in 2013,”concludes David Watts, senior analyst at the international research firm CreditSights.

The removal of immediate risk to the single currency saw bond yields across all asset classes tighten further in November, with spreads on investment-grade corporate debt 150-161 basis points inside their levels at the end of 2011 and those on high-yield bonds down by 168bp to an average 438bp over German bunds at 438bp. The Bank of America Merrill Lynch euro high-grade index outperformed government bonds by 0.3% over the month to register a 7.6% outperformance for the year to date, while the highyield index outperformed sovereigns by 1.4%. Assuming that the assurance provided by the ECB and the more flexible approach towards financial restructuring of the beleaguered European states continue to keep a lid on the euro sovereign concerns, most investors and analysts expect this positive performance to continue through 2013. “There will still be pockets of volatility but there have been some important structural changes,” says Roger Sadewsky, investment director for absolute return funds at Standard Life Investments in Edinburgh.

Given the possibility that in 2013 the eurozone can avoid any sustained panic in the markets, CreditSights expects to see investment-grade debt deliver returns of around 5% in 2013 and high-yield credits as much as 9%.

The big if, however, will be political developments in some of the other impaired eurozone countries against an background of further economic decline, given that GDP

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across the eurozone is forecast to grow by just 0% to 0.5% over the year. In such an economic environment, even the ECB’s undertaking in September to buy “unlimited” volumes of peripheral country sovereign debt through its Outright Monetary Transactions programme cannot offer complete assurance that voters in Spain, Italy, and Portugal will not decide that the price of euro membership is too high.

While the general elections in Italy and Germany should not be discounted as a source of potential trouble, Spain probably represents the biggest threat. For the country will need to refinance about 20% of its outstanding debt in 2013, while the dismal outlook for the economy gives it no chance of meeting current budget-deficit targets. The deficit for the 12 months to June this year was running at 9.7% of GDP, compared with the target for 2012 of 6.4%.

This means premier Mariano Rajoy will surely have to seek assistance from the EU at some point in 2013, as the government continues to provide backing for Spanish banks and regions in 2013. Any support though, either through the OMT or a direct bailout via the European Stability Mechanism, will have unpleasant deficit reduction strings attached. That might prove counter-productive: “Applying more austerity measures is just going to plunge the economy into an even deeper spiral, which will make deficit reductions impossible to achieve,”says Marc Ostwald, bond strategist at Monument Securities.

Moreover, more austerity might also push the regions of Catalonia and the Basque Country to breaking point. Their pro-independence coalition governments are committed to hold referendums on independence in 2013. There is a real risk that Spain could apply for ECB support and fail to meet the conditions to receive it.“The result could be explosive,” says Ostwald.“In very short order, you could add 200 basis points to the yield on long-dated Spanish paper and more than double that to short-dated notes.”Inevitably, this would prompt an even more pronounced flight to safety than occurred in July and drive yields on risk assets to levels that would quickly undermine any gains made over the past 12 months. I

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20-20: EUROPEAN BANKING SUPERVISION

Europe’s finance ministers agreed in mid December to give the European Central Bank supervisory powers over lenders. The move is hailed as a signal they are taking concrete steps to uphold the integrity of the euro and, at the same time deliver a show of unity. The deal will put more than 100 large banks in Europe under the direct supervision of the central bank, leaving thousands of smaller banks primarily overseen by national regulators. But the ministers insisted that the European Central Bank would be able to take over supervision of any bank in the euro area at any time. What will that mean for the UK banking segment, which remains exempt?

UK on the edge as Europe moves towards banking union HE IDEA BEHIND Europe’s single supervisor is to make lenders less susceptible to political interference and ensure better risk management than has been the case under the present system of national supervisors.

The move raises any number of questions. Among them whether a formal central banking supervisor in Europe will stave off necessary restructuring of the European banking segment, or encourage it.“The formation of a central banking supervisor means that for the first time there will be an empowered decision-making body at the heart of euro land banking. Restructuring is also inevitable—bad assets need to be segregated off into bad bank structures, and bank investors need to be bailed in to reduce the burden on European taxpayers,” posits David Field, executive director, at consultant Rule Financial.

The move, thinks Field, will enable the surviving ‘good banks’ to start lending again.“The emergence of a central supervisor will enable these decisions to be made. But I don’t expect this to be precipitate. Unless Europe’s politicians are willing to countenance the failure of some major institutions, which they are not, banks still need to build their capital strength so that they are better equipped to cope with significant restructuring costs. With the current economic outlook, it doesn’t appear as though this will happen soon,” he says.

Agreement on a single supervisor is also a springboard for European leaders to work towards a broader banking union.

Agreement will cover common systems or approaches to the orderly closure of failing banks and continued measures to reinforce Europe’s economic and monetary union. However, it is not a foregone conclusion. The European Parliament and some national parliaments (read Germany) will have to approve any posited measures.

Coalescing of powers around the ECB looks as well to be a pre-requisite for debt constrained states to tap the

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FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

Greek Finance Minister Yannis Stournaras waits for the start of a meeting of eurogroup finance ministers in Brussels on Thursday, December 13th 2012. The European Union took a major step towards one of the most important transfers of financial authority away from national capitals when its member states agreed to create a single supervisor for their banks. Photograph by Virginia Mayo for Associated Press. Photograph supplied by PressAssociationImages, December 2012.

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20-20: EUROPEAN BANKING SUPERVISION

MARIO DRAGHI – EUROPE’S PILLAR ario Draghi put his reputation on the line in July 2012, promising to do whatever it took to save the euro project. While the euro dream has not yet shed some of its nightmarish qualities, Draghi’s steadfast commitment has arguably helped normalise the wider market’s responses to Europe’s chronic problems. While his vision of a Europe underpinned by mutual financial support in times of duress has bought the euro more valuable time, it will not be for another decade or two that the real impact of Draghi’s commitment to the European dream will have been deemed to have been the right move at the right time.

If by 2030 Europe has managed to revitalise its financial infrastructure and slough off recessionary aches and pains, then Draghi will be lionised as the champion of the modern European project. If by then, Europe remains a sclerotic confederation, he will be blamed. But for now, Europe has a chance and Draghi has been instrumental in the play.

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European bailout fund and inject rescue aid directly into their troubled banks. Even so, the system for the direct recapitalisation of banks is only likely to go ahead only once the supervisor is fully operating, and well after the German general election (scheduled for October 2013).“The stability mechanism would be stretched to breaking point if it had to deal with crises in Italy and Spain simultaneously. So they will do whatever they can to prevent that happening. At present, the most likely pressure point appears to be Italy, following Mario Monti’s resignation. Italy will need to consider what the potential repercussions of a re-election of Berlusconi could cause for the financial services sector,” thinks Field.

Hope springs eternal say the sages, and defying early summer expectations of a coordinated debt relief program for Greece, only hours after agreeing the banking supervisor framework, finance ministers also agreed to release a long-delayed €34.4bn aid payment to Greece after agreeing to a contentious debt relief plan. Antonis Samaras, the Greek prime minister, hailed the deal as historic.

Talks between Europe’s finance ministers were subject to a lot of horse-trading. France finally agreed to a formula where only banks holding €30bn in assets, or holding assets greater than 20% of their country’s gross domestic product, would be directly regulated by the central bank. It was a significant departure from its earlier insistence that all banks in the eurozone be subject to ECB supervision.

Germany had sought a reduced remit that would make the job of the supervisor more manageable and faced pressure from a powerful domestic banking lobby trying to shield

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Mario Draghi, president of the European Central Bank (ECB), attends the European Banking Congress (EBC) in Frankfurt Main, Germany, November 23rd 2012. The congress is a forum of the financial industry. Draghi succeeded Jean-Claude Trichet as president of the European Central Bank in November 2011. Previously the governor of the Italian central bank (2006-2011), in only a year has revitalised the euro project. Photograph by Boris Roessler for Associated Press.

Photograph supplied by PressAssociationImages, December 2012.

many small German savings banks from closer scrutiny. But Germany agreed to allow the central bank to step in and take over the supervision of any bank in the euro area at its discretion. Field remains optimistic overall.“Slowly, but surely, Europe’s banks are getting back on to the road to recovery.

If the global, and especially the European, economies start to recover, banks’ profits will slowly strengthen their capital bases, and they will over time be able to write down more bad debt and reduce leverage. But it’s a tenuous recovery,” he says. However, he concedes that continued “recession in Europe could precipitate some banks into crisis, which would need the authorities to inject more money in order to prevent catastrophe. At this point it could go either way.”

Britain, which remains outside the 17 European countries that form the euro zone, had been seeking assurances that it could be exempt from orders from the new supervisor that would affect its banks operating abroad and lenders operating in the City of London. Britain agreed to a formula that should allow it and other countries outside the system to block most, but probably not all, decisions on rule making taken by the ECB, and to oppose decisions in cross-border banking disputes it disagrees with. “A strong centralised regulator will want to strengthen and improve global confidence in the European financial sector by taking a tough regulatory stance. As the Bank of England takes on regulation of the UK banking sector through the Prudential Regulation Authority (PRA), it will be interesting to see who emerges as the toughest regulator,” posits Field. “On the other hand, I expect we will see more pro-euro land regulation emerging to the detriment of the UK.” I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

20-20: BORROWER PROFILE – IBERDROLA

Spain’s second-ranking energy utility Iberdrola has faced a battle this year to preserve a decent investment-grade credit rating and access to viable capital-market funding. The crippling recession in the country has put increasing pressure on its domestic revenues and profits.

Although the heavily indebted company (its net debt of almost €32bn is almost triple that of larger domestic rival Endesa) is arguably in a stronger financial position as 2012 comes to an end than it was than at the beginning of the year. The struggle to maintain investment-grade status is set to intensify over the next 12 months. Andrew Cavenagh reports.

THE TEST CASE: How far can Iberdrola de-risk?

LTHOUGH CONCERNS THAT Spain will be forced to seek an imminent EU bailout (along the lines of Greece, Portugal, and Ireland) may have receded in recent weeks, the government’s finances remain precarious. Few doubt that it will have to apply for support under the European Central Bank’s Outright Monetary Transactions (OMT) programme—through which the central bank has committed to make “unlimited” purchases of the peripheral country sovereign debt if necessary—at some point in 2013. The conditions attached to such aid will inevitably put further pressure on the Spanish economy and place the ratings of both the government and the country’s corporations under further pressure.

So far Iberdrola has managed to retain BBB+ and Baa1 ratings from Standard & Poor’s and Moody’s respectively— two notches higher than the agencies’ sovereign ratings for Spain—but both put the utility’s rating on review for downgrade in mid-October, given the worsening economic outlook for Spain. To address this further pressure, Iberdrola chairman Ignacio Sanchez Galan unveiled a plan on October 24th to cut the company’s debt to €26bn by 2014 and also to implement various cost-saving measures to improve its cash flows. These include the loss of 1,200 jobs, which will be a further unwelcome addition to the dire level of unemployment in Spain (hovering around 25%).

The company aims to achieve the debt reduction through a combination of non-core assets disposals (which are targeted to raise €2bn), reductions in capital expenditure, and use of government compensation payments for past tariff deficits. Given the company cannot be certain about timely payment of the deficit receipts, however, it has indicated that the disposal programme could be increased to €5bn if the payments do not materialise when expected as a result of worsening pressures on the government budget.

Galan affirmed that the disposal of non-strategic assets would underpin the debt-reduction strategy and added that the company had identified a number of divestment opportunities that were “ready to be executed”, even in the present stressed scenario. While Iberdrola has not yet specified which assets it is proposing to sell, Galan told analysts that it intended to retain its core businesses in Spain, the UK, the US, Brazil and Mexico. The company’s Scottish Power subsidiary is the third largest electricity distributor in the UK, while its $4.5bn acquisition of the integrated power group Energy East in 2008 made it the leading Spanish investor in the US.

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Should the tariff-deficit payments be delayed, however, Iberdrola might well be tempted to sell a minority stake in the UK distribution business to plug the gap. Infrastructure funds vie aggressively for such assets every time one comes to market, and a partial sale could comfortably raise up to €2bn in a single transaction.

Aside from the disposal programme, Iberola has been looking to “de-risk” its overall business profile. One way in which it has achieved this is by increasing the proportion of the company’s revenues and profits that come from regulated network activities as opposed to more volatile and risky power generation (with the exception of subsidised renewable power). Network business now accounts for 77% of the company’s total EBITDA, compared with 68% three years ago.

It is also reducing annual investment to around €3.5bn over the next two years (compared with €8.7bn in 2011 and €4.7bn the year before) and continuing to derive a higher proportion of its revenues from outside Spain. Non-Spanish operations accounted for 52.7% of overall EBITDA during the first nine months of 2012, against 48.1% for the same period of 2011.

The company’s efforts seem to have retained investor confidence, at least for the time being. While it was inevitably locked out of the bond markets for periods in 2012 when sovereign concerns over Spain were at their height, Iberdrola managed to sell €1.4bn of medium-term debt in two tranches over September and October at competitive cost. The later of the two, a €400m issue of six-year bonds in mid-October, paid a coupon of 4.25% and priced at a spread of 310 basis points (bps) over the mid-swaps benchmark, well inside the 360bps spread on the €1bn of same-maturity paper the month before. The larger deal had attracted orders of €3.5bn, and foreign investors accounted for 85% of the issue.

Meanwhile, the credit default swap on the company’s debt had almost halved by the end of October to 259bps from a high of 561bps four months earlier.

The recent bond issues boosted Iberdrola’s liquidity to €11.3bn (including more than €3bn in cash and more than €7bn in undrawn credit facilities that do not mature before 2015). This is enough to cover all its obligations for the next two years, even if a high-stress sovereign scenario shut it out of both the short-term and long-term markets over that time. It also has the option in future to issue bonds out of its overseas subsidiaries. I

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20-20: BARCLAYS

After the embarrassment of the Libor-fixing scandal, which led to a $290m fine from the US authorities and the enforced resignation of former chief executive Bob Diamond, the man in the street might conclude that 2012 had not been a great year for Barclays. Away from the sensational negative headlines, however, the bank has enjoyed a notably successful year in the capital markets. Andrew Cavenagh reports.

Barclay’s capital markets comeback HE BREADTH OF bond offerings that Barclays is able to provide has seen it feature prominently in all sectors of the market over the course of the year, as governments, financial institutions, and non-financial corporations in varied jurisdictions have all had their different funding issues to address.

Up to December 2nd Barclays ranked second only to JP Morgan in the league table for bookrunners on international transactions across all currencies, as Bloomberg credited it with deals valued at $241.6bn. Within that total, according to Dealogic, it had the leading position in international supranational, sovereign, agency, and regional (SSAR) issuance with $144.2bn, sterling-denominated debt (with £16.5bn), and covered bonds ($21.8bn).

It was also the leading non-US bank for dollar-denominated transactions (after JP Morgan, Citi, and Bank of America Merrill Lynch), with $142.9bn of accredited deals.

Barclays’ global trading, distribution and research platform gave it a clear advantage in the European sovereign market, where it was often important to exploit windows of opportunity swiftly as and when they arose during the course of the year for the more impaired governments in the eurozone. The €4bn issue for the Spanish government on which the bank acted as joint bookrunner in the first quarter of the year (shortly after the European Central Bank’s LTRO initiatives had seen the yields on Spain’s sovereign debt decline) was one example.

The bank’s activity in the SSAR arena included the launch of inaugural deals for supranational institutions, including two dollar bonds and a sterling issue for the Council of Europe as well as a sterling issue for the World Bank in the first quarter.

The scope of Barclays’s execution capability in the largest sector of the bond market was evident on June 26th, when the bank lead-managed five benchmark deals worth a total of $11.8bn on the same day across a broad range of currencies and tenors (from a three-year $3bn issue for the French agency CADES to an inaugural 30-year, €1.5bn offering from the Republic of Finland).

Barclays has also played a leading role in the booming primary market for corporate bonds in 2012, as companies in both the investment-grade and high yield sectors have taken full advantage of investor search for yield to lock into medium-to-long-term funding at highly attractive allin costs. In the year to the beginning of December, the bank was the third-ranked book runner for investmentgrade transactions in the euro market with deals worth

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€80.7bn, which gave it a market share of 5.8% (not far behind the 6.1% of the leading book runner in the subsector, Deutsche Bank).

Barclays’ activity in the corporate space included playing a lead role in securing viable access to the bond markets once more for leading Spanish and Portuguese companies, which had been shut out for several months as a result of contagion from their sovereigns.

The bank acted, for example, as global co-ordinator and joint bookrunner on the €1bn issue in September through which Spain’s second-ranking utility Iberdrola was able to alleviate concerns about its liquidity position by refinancing bonds due to mature in 2013 and 2014 with significantly cheaper ten-year debt. The new bonds paid investors a coupon of 4.25% compared with those of 5.125% and 4.875% on the earlier instruments. That sort of liability management has been another consistent feature of Barclays’ involvement in the corporate sector in 2012.

“Compared to 2011, it’s actually been a very vibrant year in terms of securing access to the market for issuers,” says Jonathan Brown, the bank’s head of bond syndicate for Europe. He added that the European corporations in particular had benefited from a large flow of capital back into euros from September onwards, after the European Central Bank’s commitment to buy unlimited volumes of beleaguered eurozone sovereign debt underpinned the market. “It is all about velocity of capital.”

Barclays has also continued to support innovative trends, such as the growth of retail bonds in the UK, an investment that now clearly offers small investors considerably better returns than bank deposits.

Brown stressed, however, that the development of this market would continue to be a gradual exercise, as it was vital for retail investors to be offered the debt of companies they recognised and trusted.“Our team is very careful about the choice of names we put in to that market to help with the long-term development of this asset class in the UK.” Looking ahead to 2013, Brown says the markets were likely to remain subject to much the same influences as this year, in terms of potential scares over the sovereign situation in the eurozone possibly creating short periods of market volatility and subsequent windows for issuance. However, corporations in general—particularly investment-grade names—would definitely enter the year in a stronger position than they began it, which should continue to ensure them access to funding as needed. “This feels a lot more robust,” he concludes. I

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20-20: EMERGING MARKETS

Emerging markets are supposed to enjoy superior growth prospects and stronger public finances than G7 countries. Even so, equity investors had second thoughts about this rosy scenario in 2012. Bond investors kept the faith even while the eurozone debt crisis played out, driving credit spreads on sovereign debt of many emerging economies below spreads on debt of every major European nation excepting Germany. Meanwhile, equity investors lost their nerve during the second quarter, sending emerging markets indices into a tailspin amid concerns that recession in Europe and a hard landing in China could stunt growth elsewhere.

Now that the worst fears over Europe have receded and the Chinese economy has stabilised, the stage may be set for equities to bounce back in 2013. Neil A. O’Hara reports.

High performance vehicles: beyond the BRICs Photograph © Welcomia/Dreamstime.com, supplied December 2012.

NVESTOR PREOCCUPATION WITH Europe and China reflects not only their individual importance to the global economy but also their mutual dependence. For all the rumblings in Washington over the outsized US-China trade deficit and alleged manipulation of the dollar-renminbi exchange rate, Julien Seetharamdoo, senior economist and investment strategist at HSBC Global Asset Management in London, points out that the European Union represents a larger export market for China than the United States.

The interdependency doesn’t stop there, either; a slowdown in Chinese manufacturing cuts demand for commodities, depressing the volume and value of raw material imports from Latin America, Eastern Europe and Russia.“It was a double-whammy in the second quarter,” says

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Seetharamdoo. “The Chinese economy was slowing and weak demand for commodities in general hit a lot of commodity export-oriented countries as well.”

One notable casualty was Russia, an economy heavily dependent on oil prices, which fell more than 20% during the second quarter. Growth slowed to just 1% in Brazil, too, although a faltering local credit boom had a bigger impact than weak commodity flows. Among equity markets in the BRIC countries, the one bright spot was India, where government initiatives to liberalise the economy cheered investors.

“The emerging markets outside the BRICs have seen stronger performance,” says Seetharamdoo. “They have a bit of catching up to do, and investors are becoming more open to investing in the wider emerging markets universe.”

HSBC, which ranks investments primarily by measures of valuation and profitability, sees opportunities in several emerging markets that are trading below their long term average price-earnings ratios, particularly in China, Malaysia and Thailand. Valuations look attractive in Central and Eastern Europe, too, but these markets suffer guilt by association through their proximity to Western Europe.

“When we get closer to the eventual resolution in the Eurozone, valuations in these markets will start to support performance,”says Seetharamdoo.“We have some time to go before that happens.”

Weakness in the BRIC markets has driven the forward price-earnings (PE) ratio for emerging markets down ten times, a discount of 15% to the developed markets. Todd Henry, an emerging markets portfolio specialist at T Rowe Price, a $574bn money manager based in Baltimore, Maryland, says valuations for the emerging markets as a whole have been this cheap only four or five times in the history of the asset class, but cautions that aggregate valuations disguise wide variations among countries and sectors.

“The smaller and peripheral markets have outperformed the BRICs by massive amounts,” he says. “The question is: where do they go from here?”

For T Rowe Price, the best opportunities exploit rising disposable incomes among the rapidly expanding middle class in developing countries. Consumer staples have had a good run but are beginning to look expensive in some markets. Henry still likes the domestic consumption story, but he is shifting the emphasis to more cyclical plays like discretionary consumer goods, which are “not as well-owned and the valuations not as stretched as for staples.” He likes financials tied to the domestic economy, too, capitalising on increasing credit penetration and loan growth to local individuals and corporations.

Geographically, T Rowe Price favours Asia (56% of the portfolio) over Latin America (21%), in part because Asian markets have underperformed their Latin cousins over the past decade (through November 30, 2012, the MSCI indices show Latin America up 18.4% compound over 10 years vs.

11.9% for Asia). Although Henry sees good opportunities in Mexico, Chile, Colombia and Peru, the dominant economy is Brazil, which has benefited from improved economic management and lower inflation.“Brazil has been a great story.

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It has been a tremendous beneficiary of the rapid industrialisation of China. We still like Brazil, but is Latin America going to be the best performing region in the next ten years?”

Nicholas Paul, an investment product asks Henry. specialist at MFS Investment In the near term, Management, a $156bn money manager Nicholas Paul, an investin Boston, Massachusetts, expects ment product specialist at Brazilian equities to do well in 2013 MFS Investment Manbecause the market will not face the a $156bn headwinds—high interest rates, inflation agement, money manager in fears and a strong currency—that Boston, Massachusetts, hampered performance in 2012. expects Brazilian equities Photograph kindly supplied by MFS Investment Management, December 2012. to do well in 2013 because the market will not face the headwinds—high interest rates, inflation fears and a strong currency—that hampered performance in 2012.

He believes most investors misunderstand the Brazilian economy, which is not the commodity export-driven model exemplified by Vale and Petrobras. In fact, exports account for just 15% of Brazil’s GDP, and only half the exports are commodities. “Brazil is a local economy,” says Paul. “That is not the perception in the market, and perception often drives performance.”

Like T Rowe Price, MFS focuses on domestic consumption stories, but with a different twist. A bet on Brazilian healthcare has paid off through diagnostic companies, which benefit from more consumers being able—and willing—to pay for whatever preventative tests doctors recommend.

Secondary education companies have done well, too, serving people who work full time but go to night classes to advance their careers.“Less than 10% of Brazilians have the equivalent of higher education,” says Paul. “Those who do make nearly three times as much as those who don’t; there is a strong incentive for people to step up.”

These examples illustrate the growth MFS looks for in its emerging markets portfolios: structural, not cyclical. Paul sees the shift under way in China from an industrial exportoriented economy to one driven more by internal consumption as a natural progression even if it implies slower GDP growth than the recent past.

Uncertainty about the ten-yearly political leadership transition and its policy implications weighed on Chinese equities this year, too, but Paul is upbeat for 2013.“We could see some volatility through year-end, but 7.5%–8% growth is still pretty good,” he says. “We think there is pent-up demand. We see a potential acceleration of growth in China next year.”

Growth could pick up in other regions, too. Gustavo Canonero, head of emerging markets economics research at Deutsche Bank in New York, expects incremental GDP growth in Latin America, Asia and even Eastern Europe, the region most affected by the Eurozone crisis. In

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Brazil, for example, growth could jump from 1% in 2012 to 3.5%–3.8% next year as a $60bn economic stimulus package announced in August kicks in, while Chile, Colombia, Mexico and Peru will Julien Seetharamdoo, senior continue their robust economist and investment 2012 performance. strategist at HSBC Global Asset Canonero thinks Management in London. growth in Asia will accel- Seetharamdoo points out that the erate next year, too— European Union represents a larger and not just in China and export market for China than the India. “The rest of Asia United States. Photograph kindly is closely linked to supplied by HSBC Asset global trade, which should Management, December 2012. improve as a result of reduced uncertainty in the developed economies,” he says.

The emerging markets remain heavily dependent on the developed world even though inter-regional trade among themselves has doubled in the past five years. Manufacturing centres in Asia do draw increasing volumes of raw materials from Latin America, Eastern Europe and Russia, while trade in manufactured goods within Asia has also grown. These new flows give the developing economies some resilience but they cannot offset weakness in the industrialised nations. “The major economies still represent three times more trade than other emerging markets,” says Canonero. “Developed economies are still very important and the dependency will remain.”

Economic dependency has not stopped fixed income investors from recognising that many emerging nations have stronger public finances—balanced budgets, lower debt to GDP ratios and current account trade surpluses—than their developed counterparts. Reduced risk premiums on sovereign debt have not spilled over into equity markets, however.“We have a long way to go before we can compare the quality of a stock in the United States or Europe with the big names in Brazil, China, India or Russia,”says Canonero.

“Regulations and the rule of law need to converge to the standards in the main economies. We are years away from that, but to some extent compensated by stronger fundamentals and better economic prospects than many developed economies.”

It may take time, but if the regulatory disparities between emerging markets and developed nations do erode investors could benefit from lower volatility and a permanent rerating of an asset class that offers access to the world’s faster-growing economies. Stock selection can add significant value, too, in part because even the largest local companies are often no more than mid-caps by international standards. “The underlying fundamentals of individual companies matter dramatically,” says Paul at MFS. “When you look across the board at growth, valuation and quality, there is a strong case for emerging markets today.” I

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20-20: EMERGING MARKETS BONDS

Over $40bn of foreign investment has flowed into emerging-market bonds this year, as excessive levels of sovereign debt and negative real interest rates in the G7 continue to drive fixed-income investors to increase their allocations to other jurisdictions. Even so, while indexed investments in such debt have delivered another year of spectacular returns in 2012, there is now concern that the asset class may lose some of its shine in 2013. Andrew Cavenagh reports.

WILL EM BONDS KEEP THEIR SHINE IN 2013?

HE STRONG PERFORMANCE this year of indexed investments such as the iShares JP Morgan dollardenominated Emerging Markets Bond ETF (which to the end of November had provided investors with a return of 15.9% in 2012) to some extent constitutes its own warning for 2013. Four years of impressive gains, with returns over the previous three years ranging from 15.4% in 2009 to 7.6% in 2011, has clearly limited the index’s potential for further upside.

There are also worries about the near-term economic outlook in the BRIC countries, whose sovereigns and corporations dominate the market for emerging-country debt.

Economic growth is slowing down in China and Brazil, while the budget deficit in India continues to balloon, which is tending to crowd the private sector out of the financial markets. Moreover, the re-assertion of state control over key sectors of the Russian economy has raised question marks over its future performance.

Given all emerging-market economies will also not be immune from further negative developments in Europe and the US, it is hardly surprising that several investors and analysts are advocating a measure of caution over the next 12 months.

Tristan Hanson, head of asset allocation at investment manager Ashburton’s, pointed out that spreads on hardcurrency, emerging-market bonds were now approaching the lows that they reached in the pre-Lehman credit bubble, while at the same time a collapse in real interest rates were also making local-currency debt a riskier proposition.“Bond market performance may become more divergent, and currency movements will likely become the dominant driver of returns,” he warns.

This will constitute an interesting change in the dynamics of investing in emerging market local-currency debt, as foreign-exchange movements have made very little contribution to overall performance over the past three years, with most of the gains coming from carry and bond capital gain. Given any resurgence of inflation will be felt in emerging countries first and some central banks are more willing to let their currencies appreciate than others, identifying those with the best potential to appreciate will be the key driver in achieving outperformance in 2013.

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“I think that is going to be the major change for next year —the sources of return from investing in local bond markets,” says Richard House, head of emerging market fixed-income at Standard Life. He identifies the Mexican peso, the Indian rupee, and Russian ruble as currencies that are likely to perform strongly over 2013.

In the case of China, the call is obviously more difficult. For yuan exchange rates will continue to be influenced more by government policy rather than economic fundamentals. In the longer term, however, the outlook for emerging-market debt as an asset class remains highly positive, as bond markets in developing countries grow to reflect the shift in the balance of economic power away from G7 countries. This will see the markets for local-currency bonds —which presently account for about 10% of the global bond market—become a deeper and more liquid source of funding for governments and companies, as both continue to reduce their exposure to foreign-currency debt.

“They are all trying to issue more locally to try and cut, at least at the sovereign level, their foreign currency liabilities,” says a senior credit analyst in London.“Over time, that [local currency debt] will start to absorb money that would previously have been allocated to Western-country debt.”

China is inevitably taking the lead in this respect, rapidly developing a market for yuan-denominated bonds that will soon cover the spectrum of asset classes from Chinese sovereign debt to asset-backed bonds—and also become a growing source of capital for non-Asian issuers.

The Latin American regional development bank Corporación Andina de Fomento (CAF) completed its sale of a RMB600m ($96m), three-year bond at the beginning of December, and the Canadian province of British Columbia is likely to become the first foreign local government to issue such debt early in 2013.These trends will see the debt of the bigger emerging market issuers at least become increasingly accessible to global bond investors. From January, for example, Russian fixed-income debt will be able to be settled through the Euroclear and Clearstream systems, a development that should see foreign ownership of the US$97bn market for ruble-denominated bonds (with its relatively high yields) increase at least five-fold from its current level of just 5%. I

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20-20: MENA INVESTING

Capital markets in the MENA region generally, and in the GCC region in particular, are gathering momentum. Investors are showing more interest in investing outside their own country and they are more willing to rebalance their portfolios between equities and bonds and diversify into instruments such as ETFS and derivatives. As the latest FTSE Global Markets MENA Asset Management Survey (please refer to FTSE Global Markets, October 2012 edition) shows, however, there is still a long way to go before regional capital markets realise their potential and there is much that the authorities can do to smooth the path. By Yosuf Al Jaida, director, banking and asset management/strategic development at the Qatar Financial Centre Authority.

MENA ASSET MANAGEMENT: a strong regional focus T

business and setting up in a country, HE POSITIVE TRENDS are quality of local staff and coordination clear.

Although MENA of regional policy (especially in investors show a marked prefthe GCC). erence for local providers, for These are basically matters of example investment managers and official policy. Systematic and coordicustodians, they are prepared to nated official action remains the key invest more abroad, even if abroad is to unlocking the potential of capital defined as within the region. This is markets in the region. One of the notably true of the GCC, where reasons that survey respondents regional political and economic coranked countries such as Saudi operation is probably more advanced Photograph © Olivier de Moal/Dreamstime.com, Arabia, Qatar and the UAE as low than among groups of countries supplied December 2012. risk is that their regulatory systems elsewhere in MENA. The development of a pan-Gulf capital market may be command confidence. Political stability is a necessary embryonic but it is a positive sign that the GCC, which condition too but it is not sufficient by itself to underpin ranks among the world’s top twenty biggest economies, is capital market development. A striking finding from the beginning to acquire the ability to allocate capital more survey is the strong feeling among investors that there needs efficiently than is possible when markets are confined to to be greater coordination between national capital markets national silos. This is especially important in the context of for a region, the Gulf for instance, to grow to the next stage the behaviour of investors elsewhere in MENA who—like of maturity.

The need to overcome the obstacles to the further develinvestors in other parts of the world—see the GCC as opment of MENA capital markets is acquiring greater relative stable.

Whether investing at home or abroad, investment urgency as the shift in the balance of the global economy and managers are also growing more sophisticated in their trade towards emerging markets proceeds. South-south choice of instrument. Diversification and risk management, trade has consistently grown faster than world trade for for example by using derivatives, help to reduce investors’ many years. Capital flows tend to follow trade flows. The risks and costs and to increase returns. One of the charac- Gulf is strategically located between the mature markets of teristics of a mature capital market is the wide range of Europe and North America and the fast expanding markets instruments and strategies available to investors. Creating of Africa and Asia. The region and its financial centres such choices will be important for the GCC eventually to therefore have the opportunity to provide capital and financial services required as the new global economic play its full role in global capital markets.

The fact remains, however, that despite these encourag- geography takes shape. There are also indications that the ing trends MENA capital markets are small, separated, Gulf region, long seen as a capital exporter, is becoming an fairly illiquid and restricted to a limited number of actors. investment destination as its fast-growing economy There are, of course, technical measures which can be becomes more complex.

Improving the depth and breadth of the region’s capital taken to assist in addressing these issues, such as making it more attractive for investors to trade on regional stock markets is plainly critical. In many places, the policy and exchanges. Even so, the respondents surveyed were in no market foundations have been laid. The priority now is to doubt about the main questions: regulation, ease of doing continue building on them.I

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20-20: KUWAIT

After a torrid few years, most Kuwaiti banks, having undertaken substantial restructuring and recapitalisation programmes, have rebuilt their franchises up and out this year. Even while 2012 has delivered many of the same challenges that beset the country’s banking market in 2009-2001, the banks are beginning to break out of their restrictive moulds. Michel Accad, chief executive of Gulf Bank thinks the 2012/2013 period will be a tipping point for the bank where it has completed the establishment its ‘fortress balance sheet’ to help it withstand further market shocks and normalise business. “We can now afford to be ambitious once more,” he notes.

GULF BANK AT A POSITIVE TIPPING POINT UWAIT'S BANKS HAVE been through the crucible of late and look to have emerged a bit battered perhaps, but certainly stronger for the experience and not out.

The reasons are manifold and (perhaps too) well worn. The eurozone crisis, for instance, has stretched its icy fingers across the Gulf Cooperation Council (GCC) region, and sprinkled its own little bit of frosting across Kuwait to boot.

Kuwait also remains nervous about its politically restive contiguous neighbours (Iran and Iraq), which continue on and off to ratchet up their own brand of regional tensions and political risk. The impact on business of the so-called Arab Spring has not helped either: though of all the countries in the MENA region, Kuwaiti politics are the most democratic (in a Western sense, if you will), even if they do remain rather fractious.

Other elements however are much closer to home. Ever since 2008, some of the country’s leading investment companies, for instance, which had operated with high levels of leverage, experienced difficulties as their real estate and capital markets investments went south and weaknesses in their funding structures were exposed. Those Kuwaiti banks with credit exposures to these entities were sorely tested as the quality of their assets deteriorated.

Even so, throughout 2010 and 2011 Kuwaiti banks, such as Gulf Bank, worked hard to increase their capital levels, work out and through their non-performing loan (NPL) book and develop new business strategies to cope with a changed business outlook. The bank, which was rescued by Kuwait’s central bank in 2008 after suffering big losses related to derivatives trading, made a KD30.6m ($110m) profit last year, compared to $19.1m in the previous year, thereby underscoring the bank’s steady turnaround in fortune.“We brought in an entire newly management team in the second half of 2009, to help us rebuild trust and profitability. We had to take huge reserves and provisions,” explains Gulf Bank’s chief executive Michel Accad.

Gulf Bank collided with crisis in October 2008 when a client was unable to settle a substantial derivatives trade.

Rumours of severe losses spread and the lender suffered a run, an event that had no precedent in Kuwait. As a result

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of losses on derivatives, loans and investments, the bank posted a loss of KD359.5m that year. The Kuwait Investment Authority (KIA) the local sovereign wealth fund subscribed to an emergency KD375m rights issue, which gave it 16% of the bank’s shares. It was the beginning of a turnaround.

The bank’s chairman was replaced; the bank’s board was revamped and new management, led by Michel Accad, a Citibank veteran, who was appointed chief executive.

His leadership has changed the bank and set it on a new growth path.

Gulf Bank’s Accad explains some of the underlying dynamics. “Our two year rebuilding plan is now largely behind us and we can now focus on our forward three to five year business strategy, which is built on the concepts of solidify, accelerate and surpass. In other words we need to solidify the gains we have made to date, initiate and implement growth and then expand the current limits on business. This last element involves either massively upgrading existing business sets or moving into new areas entirely. In this regard, project finance is one example. And with Kuwait now embarked on an infrastructure enhancement programme, we are well positioned to leverage this business opportunity. Gulf Bank is increasingly active in the project segment, and already we are involved in helping to finance a number of energy projects.”

Accad’s point is keen, particularly as Kuwait has seen its prestige in the region increasingly overshadowed by countries such as the United Arab Emirates and Qatar as they continue to steam ahead with financial reforms and mega investments in urbanisation, telecommunications and infrastructure, with modern transportation facilities and sleek airline fleets. That slippage has cost the country dear, with the Kuwait Stock Exchange, the local bellwether of prosperity languishing at an eight year low.

Like any self-respecting rich high growth market, Kuwait has ambitions to shed its conservative coil, become a regional trade and financial hub, find ways to sustain economic development and diversification (through direct and indirect inward investment) and buoy GDP growth. Specific projects to be implemented under the plan include: a new business

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hub (Silk City) at an estimated cost of $77bn; a major container port/harbour and a 25km causeway; railway and metro systems; additional spending on new cities, infrastructure and services (in particular health and education); and some KD25bn worth oil sector investments to raise energy production capacity. Private sector involvement in the plan is envisaged through 20-year Build-OperateTransfer (BOT) project financing schemes, which share risk between contractors, project sponsors and project operators and which have a tightly drawn funding structure that (in turn) appeal to banks. In this regard, Kuwait’s banks were expecting a lending bonanza, in a corporate lending market which is still dominated by domestic rather than international banks, says Accad.

Aircraft financing is also another departure for the bank.

Gulf Bank has now lead managed two deals for Jazeera Airways, the latest in mid-December, which the bank coarranged with Commercial Bank of Kuwait. Earlier in the year, Gulf Bank arranged an export credit backed financing for new aircraft for the carrier. The bank “plans to pursue more structured transactions under its new corporate finance strategy,” explains Accad.

Gulf Bank in is focusing entirely on the potential of Kuwait itself. “We have aspirational growth plans,”explains Accad,“and we have decided to continue with a clear focus on domestic retail and commercial banking and step by step expand those business boundaries. Right now we are focusing on ten separate new business initiatives: four which build on existing business, two which feed our growth plans and four blue sky projects.”

“Our strategy has its pluses and minuses: on the plus side we have extreme clarity of purpose,”continues Accad.

“It allows us to work constantly to upgrade our internal systems. It enables us to ratchet up our client services offering such as upgrading our internal credit scoring system so that we can make ultra-fast decisions on credit facilities, within the same day for consumers; it takes a little longer for corporations,” he says.

One of the blue sky projects is Accad’s Dream Banking Initiative.“Will we need banks in future?” he asks rhetorically. “We think so and we think we know how it will look.

Mobile banking is simply one offshoot of this future bank another is customised branches, we don’t believe all branches will look the same; some customers will never need a branch, others will but each branch will reflect customer needs. We are beginning to describe an exciting future and, frankly, we are revitalised by this process and are keen to implement some of these ideas. Many of our competitors think that future banking is all about automation; some of it will be but we are now challenged to think outside the box. It is an exciting time for us.”

The bank’s new business focus is already working, says Accad.“Our volumes on the consumer side are up 50% and we are leading all other banks in the country in generating new consumer loans,”he adds.“There’s a buzz now around the bank and we are building out the brand at every opportunity.” I

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Hisham Ezz Al Arab, chaiman of CIB. Photograph kindly supplied

by CIB, December 2012.

Hisham Ezz Al Arab, chairman of Commercial International Bank (CIB) talks of the challenges of working in a market in transition. Egypt has been at the crucible of change in Arab politicaleconomic affairs through 2012; and the residual tensions from the Arab Spring.

Those tensions are not over.

BANKING IN THE CRUCIBLE TSE GM: OBVIOUSLY this has been a very challenging year in the Egyptian political economy. Even so, CIB’s results have been extremely positive with a marked business uptick.

What elements have underscored the bank’s resilience and business growth?

HISHAM EZZ AL ARAB: Despite the tough market conditions in which we have operated, CIB was able not only to retain but also to enhance its reputation as a bank to trust and significantly increase its market shares.

For many years, the Bank has been viewed as a local model for international standards and is keen to leverage on its prime local position to acquire more market share especially in the underleveraged segments, namely the Retail and Mid-Cap businesses.

CIB has been working for the past several years to change the culture of the institution, to break the “silo mentality”, to develop a corporate culture that is receptive to change and to become an internationally renowned institution. We have spent these past years preparing for this change and studying opportunities in the local and international markets. Today, our country has undergone

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a fundamental transformation and has the opportunity to become the Egypt we hoped it could be. CIB is uniquely positioned to grow and help our country achieve its potential going forward. Through its customer focused strategy and best understanding of the local market, CIB has been consistently achieving sound financials, thus ensuring the sustainability of achieving the highest possible profits among Egypt’s banking sector; with solid growth in all core revenue generating units.

FTSE GM: Where have you seen the fastest business growth this year and why? Will you be able to leverage the same trends in 2013?

HISHAM EZZ AL ARAB: We have been operating in the Egyptian market for more than 30 years. Over these years we have established long term relationships with our customers and that has provided us with a stable and still growing business set. CIB was able to differentiate itself in the market by adopting International best practices in risk management and corporate governance. Our unrivalled market expertise and longstanding relationships on the institutional side of business ensures beneficial outcomes for clients and the bank alike.

We are a favourite partner to Egypt’s corporate sector, providing services to over 100 Fortune 500 companies and over 700 of Egypt’s largest corporations. We are also determined to extend the same leadership to the retail and midcap segments, where the bank now has a special focus.CIB aims not just to be the best provider of conventional banking services to corporate clients, but also to retail customers and mid-cap companies in Egypt.

We have undertaken a sustained effort to improve the quality and breadth of our products and services, which has allowed and will allow us to move into new segments. On the consumer banking side, going forward we expect growth to be substantially higher. We have done a lot of preparatory work in this regard and have recently completed an integrated and structured programme that will allow us to offer a world-class consumer service. This has involved process re-engineering including centralising operations, setting up new internal reporting processes, building customer care units, enhancing service quality, and boosting customer satisfaction and turnaround times.

The bank has a strong customer focused strategy and, combined with its understanding of the local market, CIB will capture a significant portion of the growing consumer lending market. The events of the revolution and the ensuing days proved to be the ultimate stress test of our readiness.

FTSE GM: After positive gains in the first three quarters of this year, the Stock Exchange has seem tremendous volatility in this last quarter. Is the underlying Egyptian business growth story still a good one, or are rising tensions going to scupper many of the gains of the first three quarters of the year? Where are good investments still to be found in Egypt?

HISHAM EZZ AL ARAB: The ambiguity of many investors is clearly mirrored in the performance of the country’s

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

capital markets. Certainly, the stock exchange has seen roller-coaster like climbs and falls since it reopened after the revolution. Share prices have suffered from a lack of investor confidence, which caused the benchmark index to jump back and forth. Trading volumes have been much lower than usual and have dropped significantly which means investors are in “wait and see” mode.

As the situation in Egypt began to stabilise at the time of parliamentary and presidential elections, which took place peacefully and without any violence, the stock market staged a recovery.

The current situation in Egypt remains fluid and complex with a wide range of potential political and economic outcomes. However, it is important to remember that not much has fundamentally changed; Egypt has always had positives and negatives as is the case in any emerging market. The country has always had high levels of inflation, a large disparity of wealth distribution as well as other risks typically associated with emerging, high growth markets.

Although only limited investments came into Egypt throughout 2011 and 2012, the diversity of the local economy meant that the economy enjoyed some resilience.

We feel that we are half way through the turmoil, where political stability becomes a core pillar that ensures market stability and security. Even so, I would say the financial sector in the country continues to be robust with healthy liquidity levels and high capital adequacy ratios. Furthermore, in terms of Basel III, Egyptian banks look very healthy due to the high levels of liquidity in the system.

All these factors combined lead to the conclusion that the underlying Egyptian business growth story is still a good one and that good investment opportunities are still to be found in Egypt.

We believe that CIB is uniquely positioned to grow and help our country achieve its potential going forward. In fact, the bank is in a prime position to capture new business opportunities that could emerge in the long term out of Egypt’s political turmoil e.g. funds raising for CAPEX investments, privatisation, FDI inflow, as well as enhanced levels of personal savings into new investment products.

FTSE GM: The fortune of the bond market in Egypt has been variable this year. What appetite is there among Egyptian companies to raise finance through the debt capital markets in the country? How active has CIB been in funding Egyptian corporate growth this year?

Where are the pressure points for Egyptian corporations and how is CIB helping them?

HISHAM EZZ AL ARAB: One of the effects the revolution had on the banking sector and economy was a freeze of CAPEX investments and loans. Over the course of last year, and 2012 thus far the bulk of borrowing has been limited to working capital facilities, and we expect the return of CAPEX demand coming in late 2013/early 2014 as there is now more than two years of pent up demand. There continues to be immense opportunity for retail lending in Egypt, and this is where we see large potential for growth.

As security continues to improve in Egypt so will confi-

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dence, resulting in an increased demand for retail borrowing. We also view an increase in capital market activity in 2013/2014 with more IPOs and M&A activity.

FTSE GM: The retail segment remains buoyant and full of opportunity in Egypt. How is the bank leveraging its strength in this regard?

HISHAM EZZ AL ARAB: The 80m people in Egypt are its most precious resource. This fact has underpinned our strategic decision (some three years ago) not to expand regionally, but rather to become the dominant player in Egypt. This same belief is at the heart of our long term endeavour that has seen us transform CIB (in less than a decade) from a niche, corporate-focused bank into the nation’s largest private-sector financial institution, helping individuals, small businesses and major corporations alike creatively mobilise the capital they need to grow.

In that regard, the launch of high-quality customer focused services has been a priority. For example, we recently launched a pilot project, CIB Business Banking, which offers a constellation of services that address the financial needs of small and medium enterprises. CIB Business Banking Services provides companies with the opportunity to conduct a wide range of financial services including money transfers, online transactions, trade financing, electronic payroll and overdraft with reduced time, effort and fees. Building on the concept of partnership, CIB Business Banking provides clients with professional financial solutions through dedicated relationship managers.

As mentioned earlier, the events of January 25th were the ultimate stress test of a consumer banking strategy that was both customer-focused and driven by unrivalled insights into the dynamics of the local market. The bank expects growth from consumer banking to be substantially higher over the coming year and has positioned itself to leverage this untapped segment. CIB is working to continually expand its product offering as well as provide a vital bridge between our clients’ needs and our in house skills. Despite challenging conditions in 2012, the bank achieved growth in its consumer assets book with no significant deterioration in credit quality thus far.

FTSE GM: What are the main strands in your 2013 growth plans? What should we be looking out for?

HISHAM EZZ AL ARAB: When I look at the results in 2012, they are not only stronger than 2011’s corresponding period, but are even stronger than that of 2010. Such solid performance reveals that the bank is on the right track and is able to adjust to the changing environments well.

We feel that CIB has demonstrated its leadership of the sector time and time again and is well positioned to take advantage of opportunities more rapidly than some of its peers. In fact, being a major local player enables CIB to be more nimble. That gives us a valuable edge on our competitors. I

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Lebanon’s Bank Audi began its overseas expansion in 2005 and has operations across 10 countries in the Middle East region, including Syria and Egypt. Despite some setbacks as a result of rising tensions in the region, the bank is looking to the long term and Turkey now looks to be a key focus as the bank expands its eastern Mediterranean remit. We asked Samir Hanna, Bank Audi’s Group chief executive officer about the bank’s 2013 outlook.

LOOKING TO THE MIDDLE EAST’S LONG TERM PROMISE 012 HAS CHALLENGED the Lebanese political economy. Even so, Bank Audi’s results have been resilient with a marked business uptick. What elements underscore the bank’s business growth?

SAMIR HANNA: The years 2011 and 2012 actually witnessed relatively tougher operating conditions for Lebanon, amid domestic political uncertainties and the spillover effects of regional turmoil and global sluggishness, translating into a slower economic growth than previously witnessed. The bank has been highly flexible, activities and revenue streams and its geographic distribution; this has enhanced the bank’s financial standing and resilience in the face of unforeseen political and economic developments at home and abroad. The bank was able to increase its consolidated assets to $ 29.2bn by the end of Q3 2012, despite the contraction of assets of Bank Audi Syria at end-September 2012 to a third of their December 2010 levels (around $1.3bn). This was possible thought a sustained growth in Lebanon and other markets in which it is present.

In Lebanon, the bank benefitted from the notable growth in assets realised over the 2008-2010 period, to improve significantly its interest margin achieved primarily by lowering the cost of funds while subsidiaries abroad adopted effective asset utilisation policies. The improvement in interest margin was met also by an improvement in the non interest income generation across all business lines (private banking, retail banking, treasury and capital markets) except for corporate and commercial banking witnessing setback tied to the impact of the

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regional uncertainties on trade finance and syndication business across the region.

FTSE GLOBAL MARKETS: Moody’s says that the outlook for the country’s banking system looks strained with rising problem loans and subdued fee generation.

Is this a realistic or over-negative view?

SAMIR HANNA: It is true that Lebanon’s banking sector has been facing tough operating conditions over the past couple of years. The slowdown in the economy has affected fee income generation. Moreover, adverse security developments in neighbouring countries where some of the larger banks have operations have weighed on loan portfolio quality. However, Lebanese banks remain solid and well able to withstand external and domestic shocks. They have already taken any necessary loan-loss targeted provisions, in line with their rather conservative business strategies and rigorous risk management strategies, which have increased their resilience to any spillover from regional developments.

On a consolidated basis and as per the latest available statistics covering the Alpha group of banks (those with deposits above $2bn), Lebanese banks maintain resilient asset quality metrics. The gross doubtful loans to gross loans ratio barely edged up in the 12 months to September 2012 to 6.1%, remaining well in line with regional and global averages. Besides, around 83% of doubtful loans were provisioned for at end-September 2012, a level deemed to be more than comfortable in absolute terms and in line with international benchmarks. Collective provisions rose by a significant 63% year-on-year in the first nine months of 2012, underlining banks’ accrued provisioning efforts.

The precautionary measures undertaken by banks at the level of loan portfolios did not come at the expense of profitability. As a matter of fact, net profits of the countries Alpha banks managed to pull out a positive 4.8% growth over the first nine months of 2012, with relatively healthy lending growth despite sluggish fee income generation, tight spreads and growing provisioning requirements. Additionally, the Lebanese banking sector as a whole continues to remain highly liquid, with close to half of banks’ deposits covered by primary liquidity (that is, placements at the central bank or banks abroad). This is not only noticeably higher than global benchmarks, but also provides Lebanese banks with sufficient room to extend new credit despite the tough operating conditions. The country’s banks have low leverage, as reflected by its loan-to-deposit ratio of less than 35%.

Similarly, Lebanese banks remain adequately capitalised with a Basle II capital adequacy ratio of close to 12%, above minimum requirements, and continue to benefit from a stable and sticky deposit base accounting for more than 80% of total balance sheets.

FTSE GLOBAL MARKETS: What are the main elements in your business growth strategy?

SAMIR HANNA: Despite the short term set backs resulting from the outbreak of the regional turmoil, the strategic objectives of the group continue to revolve around being the leading Levant bank in the MENAT region, whereby Lebanon, Egypt and Turkey constitute the main development

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

pillars over the coming few years. The resilience of our franchise in the face of the recent developments particularly in Egypt as well the management’s belief in the economic and banking growth potential in the region is supported by the availability of abundant human and natural resources.

These resources could ensure, in a post settlement era, self sustained economic growth prospects, triggering significant requirement for financial services.

We hope to consolidate the group’s leadership in Lebanon by increasing the penetration of large corporations and deepening SMEs relationships on one hand and developing innovative retail distribution channels and products range on the other. Particular focus will be on efficiency enhancement and improvement of productivity gains. Second we hope to strengthen the group’s market positioning in Egypt.

We aim to rank among the top ten institutions in the Egyptian banking sector, particularly in view of the available organic growth opportunities. As a priority we hope to implement an aggressive growth plan in Turkey and finally, build on our existing footprint in the GCC, with a focus on private banking. We will also consider any other corollary development needed for the completion of the strategy such as, but not limited to, seeking a license for limited branch network in Iraq for Odeabank. Bank Audi’s ultimate objective is to become the most integrated bank in the MENAT region by both business lines and countries of presence and one of the privileged partners of individual customers and corporate.

FTSE GLOBAL MARKETS: Lebanese debt is still better priced than many countries in the Mediterranean and MENA region. Fiscal stability has been a regular feature of the economy, which always seems to bounce back rapidly after any challenge. Do you think that Lebanese debt stock still has sound underpinnings, even with escalating problems in near neighbouring countries?

SAMIR HANNA: The Lebanese model is in fact an atypical one, which helps the country demonstrate some resilience to external and domestic shocks and bounce back after various downturns. This might be surprising to some, given the country’s structural fiscal imbalances. Lebanon’s public finance deficit is indeed undeniably elevated and needs to be cut, but there are a number of factors to be taken into consideration when addressing Lebanon’s public finances and fiscal drifts. Although the country has elevated debt ratios, the underlying dynamics over the past few years have been favourable. Public debt to GDP, which was as high as 180% in 2006, now stands at around 135% today. This amelioration in public indebtedness ratios compares with a net deterioration worldwide in debt ratios, as the average advanced countries debt to GDP ratio increased by more than 30% over the same period.

No less important is the improvement in Lebanon’s debt profile as foreign currency debt which used to account for more than 50% of total debt, now accounts for 40% of it, with what this entails in terms of redemption capacity on behalf of the Lebanese debt government that has control over its local currency. Also, contrarily to countries that are

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currently facing debt issues, Lebanon’s debt is domestic to a large extent, with the proportion of the debt held by Lebanese investors accounting for about 90% of total debt. Those Lebanese individual and institutional investors are well acquainted with domestic risks and do not exit at the first unrest signal, which provides some support to the outstanding debt papers in difficult or uncertain times.

Among those investors are Lebanese banks which hold more than half of total government debt. While they have been gradually reducing sovereign exposure in recent years, their high liquidity status actually comforts their ability to renew their portfolio holdings at maturity dates and engage in new debt issues.

Another consideration is related to the country’s very good external position. Lebanon’s Central Bank foreign assets are at a high of close to $36bn (excluding gold).

When adding gold, BDL foreign assets exceed the $50bn threshold, almost 2.5 times Lebanon’s FX debt. Even when considering the Central Bank’s net foreign assets (including gold reserves), such reserves exceed Lebanon’s FX debt. This is not to say that there are no challenges to Lebanon’s high indebtedness at the horizon. In the absence of a soft landing scenario, Lebanon’s public finance imbalances would not actually be sustainable in the medium to long term. However, the country has managed so far to avoid a debt trap and escape a vicious circle that could jeopardise its financial stability.

FTSE GLOBAL MARKETS: The bank has strength in depth in terms of its corporate lending and advisory business. How has this fared in the near period and what are the prospects for 2013 please?

SAMIR HANNA: Despite recent regional challenges, Bank Audi’s corporate business is currently in “growth mode” across some selected regions. At the end of November 2012, the bank began operations in Turkey, which we see as having huge growth potential for our bank. Turkey is one of Europe’s fastest-growing economies, and Bank Audi is currently focused on expanding its corporate portfolio. Our strategy is to develop a sustainable and long lasting franchise based on trust serving not only our customers’ borrowing needs but also their trade finance, advisory, cash management and treasury needs; all of which are opportunities to grow the bank’s profits and deposit base. We strive to differentiate ourselves by enhancing the Turkish-Arab commercial activities, by fostering greater cooperation, financially and operationally, between our Arab and Turkish client base.

Even so, the bank is also still focused on Lebanon and Egypt, which have shown great resilience in light of the regional difficulties. The two countries remain key markets for the group. We will continue to serve and lend to our customer base to support their operational needs while maintaining our portfolio at relatively stable levels. In Syria, the bank’s strategy last year was to significantly reduce our exposure to the country, while preserving our network, whereas in France, Jordan and Qatar, we will continue to moderately grow our corporate portfolio. I

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The IMF forecasts the GCC economy growing by 3.25% in 2013, though this is well below the 6.1% achieved in 2011. The slowdown is attributable to a moderation in oil output. GCC economies are still energybound, and though lucrative when oil prices are high, it is a limitation when they are stable. There are clear investment opportunities in the region including downstream energy development, financial services, and demand-driven sectors such as health and education. Can the region’s banks help diversify the GCC?

GCC BANKS FIND THEIR MARK HE FUNDAMENTALS FOR growth remain but investment and consumer spending in the region is muted due to political instability wider region, which includes not only other GCC member states, but also Syria, Iraq and of course Iran. The case for continued regional economic reform remains strong, to allow the private sector to grow, to encourage the region’s asset management industry, to diversify from oil, and create jobs.

The challenge for the sector is to deepen the range of financial services to accommodate a region in flux.

Bahrain’s Ahli United Bank (AUB) typifies the trend of the region’s new look banks. While AUB’s sources of funding are diversified, in recent years measures have been adopted to further broaden of the customer deposit base.

The results of these actions were clearly evident in 2011, which saw interbank borrowings contract significantly, while in H1 2012 term debt was repaid with no adverse impact on liquidity. Over time, the growing contribution of customer deposits to total liabilities should continue to enhance the bank's funding profile and improve concentration risks. AUB's liquidity is improving and rests on a growing pool of customer deposit funding. Profitability continues to grow at both operating and net levels on the back of sustained growth in net interest income together with close cost control. The bank’s sources of non-interest income are well diversified reflecting a broad product mix.

Important now is whether AUB like other banks in the GCC can enhance their capital goods financing operations once more to help stimulate infrastructure diversification projects across the Gulf region. Bahrain in particular requires a refit, both in terms of international public relations and infrastructure. Opportunities abound for those financial institutions prepared to be at the forefront of economic change. I

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20-20: ZENITH BANK

Zenith Bank has appointed JP Morgan to help it list a GDR on the London Stock Exchange (LSE), which is expected to be listed in early 2013. “The GDR will help us improve liquidity in the bank’s shares,” explains the bank’s chief executive officer Godwin Emefiele. “Listing on the LSE creates new opportunities for increasing liquidity in our securities and diversification of our investor base; it also increases our global visibility.”

ZENITH BANK REACHES OUT B UOYED BY THE recent decision by ratings agency Standard and Poor’s to confirm the bank’s BB- rating, Zenith Bank is charging ahead with plans to increase its profile to international investors. According to S&P, the bank has strong revenue growth,“a strong risk position underpinned by Zenith’s prudent underwriting standards and moderate loan growth target; as well as has stable core deposit base with strong liquidity indicators”.

The bank’s business and financial profile will remain relatively unchanged over the next 12 months, says S&P anticipating that the positive economic prospects in Nigeria will support Zenith’s financial performance.“We would raise the ratings on Zenith if we were to raise the ratings on the sovereign, provided that the bank maintained a stand-alone credit profile (SACP) of at least ‘bb’,” it said.

The GDR is important for Zenith, asserts chief executive officer Godwin Emefiele,“It increases our ability to use the international debt/equity market for future capital raising and helps lower the cost of capital. It also gives comfort to investors as a result of our adoption of London exchange’s corporate governance standards, increase coverage by international analysts and raise the demand for Zenith Bank stock from international Gem investors, which will we hope will enhance liquidity overall in our stock. Of course, we also hope investors will perceive us to be best in class in terms of our commitment to and application of corporate governance.”

Nigeria’s Zenith Bank has big ambitions.“We are the sixth biggest bank in Africa by assets,” Emefiele, “and in the vanguard of the drive by the government and the central bank to improve standards and increase transparency in the Nigerian banking system.”

Emefiele is committed to being at the forefront of change.

“It has had far-reaching implications for the bank and we continue to engender the commitment to upgrade our services across the bank’s business culture. On the one hand we have adopted international reporting standards and on the other have encouraged an entrepreneurial and clientfacing banking culture.”

Zenith specialises in financing SMEs, agri-business, telecommunications and manufacturing businesses in addition to its extensive retail banking franchise. Established in 1990 the bank has grown steadily and“entirely organically,”explains Emefiele.“We have avoided acquisitions as we feel they weaken brands and rarely bring added value to shareholders.”

The bank’s success also rests in its culture which Emefiele stresses is “nurturing. For us it is about responsibility. We feel

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responsible for the people that work with us and we want them to feel responsible towards the community they support. In this regard, we have the largest graduate work programme in Nigeria and one of the largest community outreach programmes”.

However, that does not detract from the demands of business and Emefiele is adamant that the bank’s commitment to social responsibility also has strong political and entrepreneurial facets. “There is a lot of scope for growth in Nigeria and we are strong adherents of the government’s efforts to modernise and upgrade the country’s infrastructure. We see clear opportunity in areas such as electricity generation and distribution.”

Emefiele concedes however that the going has not been easy. “The Nigerian capital market has suffered like other high growth emerging markets from the global recession. As a leading institution in the country we will not support reckless speculation; however we are mindful that we need to work to help grow the local stock exchange and the local bond markets and we will continue to do our part to help market the opportunities that Nigeria offers to foreign investors. We are beginning to see the fruits of these efforts and have noted an increase in foreign investment interest in the country and a slow, but noticeable improvement overall in local market liquidity.”

Private equity is a particularly fruitful segment, acknowledges Emefiele.“The returns in Nigerian have been some of the best in Africa,” he states, adding that, “we continue to help encourage the inflow of foreign direct investment as a way to best mobilise resource for sustainable growth.”

S&P’s ratings also highlighted issues the bank needs to tackle. It’s weaknesses, says S&P lies in moderately high single-name and industry loan concentrations; high economic and industry risk associated with operating in Nigeria; and limited geographic diversification. Emefiele is frank.“There is still some way to go,”he concedes. However he points to important initiatives in train, such as the recent biometric project rolled out by the Nigerian central bank, allotting firms and companies unique number identifiers.

“Your credit identifier will always be with you and is entirely transferable between credit institutions. It gives a very clear indication of the creditworthiness of firms and individuals and it will encourage the deepening of the Nigerian consumer credit industry. In that regard, it shows how Nigeria is harnessing social responsibility and good governance principles across the banking segment, banks deepen their service offering. It is a good mix.” I

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Putting geopolitics for once on the back burner, the oil and gas market is focusing instead on the fundamental supply and demand picture, which over the coming months will be heavily influenced by the resolution of the US fiscal cliff crisis and the pace of economic growth in China.

Vanja Dragomanovich reports.

OIL’S NEW ECONOMICS: Slow growth & new supplies change oil’s price dynamics L

euro, he estimates. The dollar’s OOKING AT THE year weakness against BRIC currencies ahead through the prism of will be bullish for commodities, global economic growth, while the strength against the euro price moves in the energy futures will be bearish. market promise to be relatively slim Within the crude oil complex, compared with recent years.

US futures West Texas Intermediate Among the energy futures most crude oil futures, which for the last pronounced moves can be expected couple of years have been trading at in benchmark US WTI crude a discount to London-quoted Brent futures, which are likely to rally as crude oil of over $15 a barrel, are oversupply in the US Midwest is expected to start rallying in the first resolved with new infrastructure, quarter of next year as oversupply at and potentially US natural gas the key delivery point in Cushing in futures depending on the export the US is eased by the expansion of decisions of US policymakers. the Seaway pipeline from Cushing On a deeper level, however, the to the Gulf Coast. The pipeline has oil and gas market will continue to been operational since May 2012 undergo a more profound transand so far did little to dent the overformation, driven by the expansion supply in US Midwest but by early of shale gas production in the US 2013 the throughput of the pipeline and China’s continued industrial Photograph © Zoya Federova/ Dreamstime.com, will almost triple from 150,000 growth, both of which will change supplied December 2012. barrels a day to about 400,000b/d. the energy landscape over the next two to five years. “Moving into the holiday season and “For this reason we expect the price spread between Brent into the new year, we expect commodities will be torn and WTI to narrow to $10 per barrel by end of 2013 despite between continued improving Chinese data and a US a further increase in US oil production,”says Carsten Fritsch, economy barreling over a self-created political fiscal cliff. On analyst at Commerzbank.

He also notes that the upside potential for US natural gas the one hand, China has already begun bouncing off its cyclical bottom and will likely continue to show stronger prices is probably exhausted for the time being, with higher economic data over the next two quarters. On the other prices having a dampening effect on demand. At present US hand, the US is technically only a few weeks away from policymakers are arguing over whether or not to allow bouncing itself off the fiscal cliff, though some have exports of US natural gas surplus. A growing number of cautioned that it is more of a slope than cliff,” says Jeremy companies are seeking approval from the US Department of Friesen, Cross Commodity Strategy analyst at Société Energy to export liquefied natural gas—the DOE has to grant automatic approval to most countries that have free Générale Investment Bank (SGIB).

Friesen expects relatively flat energy futures prices trade agreements with the US but it reviews export requests through 2013. Until the US fiscal cliff is resolved the dollar on a case-by-case basis to non-FTA countries depending on is likely to be fairly volatile, but past it the US currency what is seen as public interest, including the US need for the should weaken against emerging market currencies, partic- natural gas and threats to the domestic security of supply. ularly BRIC countries, while gaining ground against the Before the election policymakers were reluctant to make

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20-20: SHALE OIL

decisions on this domestic hot topic but now with Obama safely in the White House for another term analysts believe that the DOE will start approving export requests.

“If the US was to export some of its production, natural gas prices in the US would likely rise as the glut caused by increased shale gas production is reduced,”says Nicholas Brooks, head of research and investment at ETF Securities.

He noted that ETFS Leveraged Natural Gas has recently seen the strongest inflows since February this year.

The China equation On the demand side, China will play by far the single biggest role in the growth of demand for gas and oil.

“While oil demand growth forecasts look modest relative to recent history, with the exclusion of 2012, it is what nothing that China will be the largest contributor to global oil demand on a growth basis, equal to 40%,” says Soozhana Choi, analyst at Deutsche Bank.

The country itself spelled out ambitious plans for growth. Victor Zhikai Gao, chairman of the Beijing Private Equity Association, says China wants to double the size of its GDP by the end of the decade from its 2010 level of RMB49.8trn ($6.3trn). For this growth to materialise it will need massive amounts of electricity—currently generated using domestically mined coal—and gas for transport. According to Zhikai Gao China is looking not only to buy the raw material crude oil but is looking at US and Canada to buy producers and refiners of oil.

The amount of energy China will need to buy will come with a phenomenal price tag, something that is not lost on the Chinese and the country is looking for solutions closer to home.“The way forward for us is shale gas. We have large reserves of shale gas, we don’t have the required technology yet but this will change in a few years,” says Zhikai Gao. Before China’s expansion into shale gas takes place the country will likely to mop up any excess oil and gas production being freed up by the US’s new found energy independence.

Taking all of this into account, energy futures are likely to offer modest returns in 2013. But with the shale gas expansion happening across the globe the most interesting investments will be in companies that have developed technology for this type extraction, companies which are buying land rights in areas with shale gas and oil deposits both in the US and in Europe companies which build pipelines and storage for oil and gas. Such companies include little known US-listed companies such as Enbridge, involved in the Seaway pipeline from Cushing, Lin Energy, which has large gas-equivalent reserves, oil transportation company NuStar Energy which operates two pipelines from the Eagle Ford shale gas deposits and oil producers Murphy Oil and Valero Energy. In the UK, the focus will shift on developers such as IGas, particularly after Exxon expressed an interested in buying a stake in the company.

Shale gas will be the buzz word for years to come. I

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

Oil cartel OPEC has acknowledged the growing importance of unconventional ‘shale’ oil reserves. The cartel is expected to generate spare crude oil capacity in excess of five million barrels per day (mbpd) by 2014. No surprise then that that OPEC said it expects shale oil production to be beset by “several constraints and challenges, such as environmental concerns, questions over the availability of equipment and skilled labour, rising costs and steep well-production declines”.

Photograph © Nelli Valova/Dreamstime.com, supplied December 2012.

SHALE OIL CHANGES THE GLOBAL SUPPLY LANDSCAPE HE LATEST INTERNATIONAL Energy Administration (IEA) projections, published as part of the 2012 World Energy Outlook, predict that the USA could become the world’s leading oil producer as early as 2017. Over the last few years the US has undergone a massive expansion of its domestic gas production thanks to new technology that has made it possible to extract gas from shale deposits. Hydraulic fracturing—the process of injecting high pressure liquid into rock formations, colloquially known as fracking—now allows hydrocarbons that were previously out of reach to be released from shale and other rich sedimentary rock.

Rather than traditional methods of drilling, which required a drill to be positioned right on top of a well in order to be able to extract oil and gas, the new technology allows for horizontal exploitation which means that a deposit can be found even if it is not directly under the drill.

The upshot has been that North Dakota, for instance, the home of one of the large shale deposits, has overtaken Ecuador, the smallest OPEC member, and is about to surpass Qatar in terms of oil production, says Leo Drollas,

T

75

20-20: SHALE OIL

chief economist at the Centre for Global Energy Studies, an industry think tank. It has gone from producing 100,000 barrels per day in 2008 to 700,000 bpd in August this year.

And North Dakota is only one of the states producing shale oil and gas.

The United States consumes 22% of world oil production, much of that coming from the Middle East and South America. New developments in oil extraction technologies are predicted to end the US reliance—at least temporarily— on imported oil.

Furthermore, North America as a whole is set to become a net energy exporter by 2020, producing more raw fuels than it requires to meet total energy production needs. “The US is projected to become the largest global oil producer— overtaking Saudi Arabia until the mid-2020s,” the IEA says.

“The result is a continued fall in US oil imports, to the extent that North America becomes a net oil exporter around 2030.” These forecasts would have been considered outlandish as recently as five years ago, when US natural gas production was slumped at historic lows and traditional oil production was falling, amidst a continued demand for fossil fuels and a lack of real political enthusiasm for renewables.”

Shale formation Numerous US geologic shale formations contain high levels of shale oil. The current quoted figure for recoverable shale oil reserves in the US stands at 33 billion barrels, and the largest North American deposit (the Bakken field) yields oil at around $55/barrel. This compares favourably to other less developed fields across the continent, but production levels are being ramped up through intense investment and development (currently US shale oil production alone is over 1m bpd—the same as Qatar’s total production level).

However, OPEC urges caution over recoverable volumes, noting in their 2012 world oil report that provable reserve figures quoted by the US government’s Energy Information Administration may be overoptimistic and liable to be revised downwards. “[EIA states] recoverable shale gas resources of 480 trillion cubic feet.It is worth mentioning that this level is almost half that reported (827 tcf) the previous year. It is a further indication of the large uncertainties still associated with shale recoverable resource estimates.”

In a decade hence, if the USA is to be freed of its reliance on imports to meet domestic energy needs, the flow of global oil trade changes. Two of the top three US oil suppliers are Canada and Mexico. With the loss of their main bordering customer, these countries are likely to turn to Europe as the next biggest importer. This in turn will reduce European demand for Russian and OPEC oil—and these big producers will turn eastwards, to the still expanding, resource hungry economies of India, China and Indonesia. “Oil from the Middle East will always find a home,” Kuwaiti oil minister Hani Hussein confidently stated in a recent Reuters interview, “We are already in a situation now where the Middle East export surpluses are not big enough to cover the Asian market’s import deficits,”says John Mitchell, an energy specialist at London-based Chatham House. The IEA states

76

that 90% of the Middle East’s oil flows will be to Asia by 2035: “The global energy map is changing, with potentially far-reaching consequences for energy markets and trade.”

Shale Oil might not be the permanent fix to US energy addiction that the EIA might envisage however. According to Neil Beveridge at Bernstein Research, “shale liquid plays are far rarer than their related shale gas plays and already we are seeing decline in some of the core areas of the Bakken oil field highlighting the early onset of maturity.”

There is early evidence that shale oil wells become tapped out more quickly than their non-shale counterparts, and more quickly than resource estimates suggest; casting some doubt over the claims of an energy independent US within the next fifteen years. Furthermore, even if shale oil is fully realised, the IEA predict the boom will be short-lived. By 2036, Russia and Saudi Arabia will have reclaimed global leadership, and the US will return to pre-shale levels of production. This will be jointly due to shale sources becoming quickly depleted and conventional wells struggling to recover dwindling oil reservoirs.

Even the more pessimistic predictions of shale oil growth depend on the environmental risks being negated; fracking uses both acids and vast quantities of water to extract oil from the rock at high pressure. France, Romania and Bulgaria have issued moratoriums on fracking due to concerns of water depletion and groundwater contamination. If the environmental evidence proves compelling, even energyhungry America may have to leave shale oil where it is.

Only about five years ago the US was busy building ports that could import liquefied natural gas from countries like Qatar, Iran and Russia. Now with the abundant gas at home those terminals are being converted to export domestic gas.

This will not only change the finance of oil but will vastly reduce the political importance of the Middle East for the US. On top of the shale gas, and oil, produced domestically the US is importing more oil produced from the oil sands in Canada, where production has also been ramping up over the last few years.

Poland emerges The shale gas trend is not confined to the US, in Europe Poland is already busily working on developing its deposits and in early December the UK government also lifted restrictions on fracking, the method of extracting gas from shale rock. There are dozens of sites in the UK which could be licensed over the next few years. The first on the list is at Anna’s Road in Lancashire, near three exploratory wells which were closed after two minor earthquakes last year.

Shale gas is not without its problems: Germany has not given the green light on any fracking project over the last two years because of fears about what environmental side effects the practice can cause. Chemicals used in drilling can contaminate local water supplies and the fracking itself can generate minor earthquakes. But with huge potential financial benefits at stake companies involved in shale gas extraction are looking hard at addressing environmental concerns in order to gain licenses for extraction in Europe. I

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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

12M%

1.5

14.8 16.3

0.6 5.5

9.9 11.1

2.0 2.0

16.6 17.8

2.7 1.6

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

14.0

1.3

0.4

-0.5

-1.8 2.8

1.5 0.3

1.9

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

1.1 0.8 0.9

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

6.8 7.8 9.4

0.5

12.9 14.2

1.1

FX - TRADE WEIGHTED USD GBP EUR

0.6

-0.6

2.0 3.7

0.9

-1

0

1

-2.9

2

3

4

5

6

-5

0

5

10

15

MARKET DATA BY FTSE RESEARCH

ASSET CLASS RETURNS

20

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

Regions 12M local ccy (TR)

5.5

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

2.7 2.0 2.0 2.0 1.6 1.5 1.5 0.6

0

1

2

3

4

5

17.8 16.6 16.3 14.9 14.8 14.0 12.3 11.1 9.9

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

6

0

5

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

-1.0

2.7 2.7 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 0.9 0.6 0.5

-0.1

-2

0

4.1 3.9 3.9 3.4

2

5.5 5.1

4

4

2.0 1.9 1.6 1.2 0.8 0.6 0.5 0.3 -3.2 -3.3 -3.9

-6

-4

-2

0

2

4

6

8

20

41.6

30.4 27.8 24.0 22.1 19.4 18.5 18.2 17.7 16.3 14.9 14.3 13.2 11.1 9.9 8.5 8.3 7.7 4.5 3.3 2.0

0

10

20

30

40

50

Emerging 12M local ccy (TR) Turkey Thailand India China South Africa Mexico Taiwan Emerging Malaysia Indonesia Brazil Chile Russia

6.3 5.2

15

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

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

10

39.4 33.1 21.3 18.6 17.4 15.9 15.4 14.0 10.8 10.4 7.5 -1.0 -3.1

-10

0

10

20

30

40

50

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

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

77

MARKET DATA BY FTSE RESEARCH

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World

Global Sectors Relative to FTSE All-World

120

Oil & Gas Health Care Financials 130

110

120

Japan BRIC

US Emerging

UK Europe ex UK

Asia Pacific ex-Japan

Basic Materials Consumer Services Technology

Consumer Goods Industrials Telecommunications Utilities

110

100

100 90 90 80

80

70 Nov 2010

Mar 2011

Jul 2011

Nov 2011

Mar 2012

Jul 2012

70 Nov 2010

Nov 2012

Mar 2011

Jul 2011

Nov 2011

Mar 2012

Jul 2012

Nov 2012

BOND MARKET RETURNS 1M%

12M%

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

1.1

UK (7-10 y)

6.8 7.8 9.4

0.8 0.9

Ger (7-10 y) Japan (7-10 y)

4.8

0.6

France (7-10 y)

15.6

1.9

Italy (7-10 y)

30.5

3.3

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

1.0

Euro (7-10 y)

13.0 27.7

1.5

UK BBB

12.9

0.5

Euro BBB

1.1

UK Non Financial

14.2 12.2

0.6

Euro Non Financial

11.8

0.7

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

7.1

2.0

0

1

2

3

4

0

5

10

15

20

25

30

35

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)

UK BBB

7.50

Euro BBB

7.50

6.50

6.50

5.50 4.50

5.50

3.50

4.50

2.50 3.50 1.50 0.50 Nov 2009

May 2010

Nov 2010

May 2011

Nov 2011

May 2012

Nov 2012

2.50 Nov 2007

Nov 2008

Nov 2009

Nov 2010

Nov 2011

Nov 2012

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

78

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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

120

120

115

115

110

110

105

105

100

100

95 Nov 2011

Feb 2012

May 2012

Aug 2012

95 Nov 2011

Nov 2012

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

FTSE US

Feb 2012

May 2012

Aug 2012

Nov 2012

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

FTSE UK

FTSE US Bond

160

160

145

145

130

130

FTSE US

115

115

100

100

85

85

70

70

55

55 Nov 2007

Nov 2008

Nov 2009

Nov 2010

Nov 2011

1M%

0.5

1

2

2.5

-1

7.8

0.2

0

1

45.2

39.5

1.0

0.5

1.5

Nov 2012

11.0

9.3

-0.7

0.8

0

Nov 2011

12.5

1.4

0.4

Nov 2010

5Y%

3.6

0.6

FTSE USA Bond

Nov 2009

6M%

2.0

FTSE UK Bond

Nov 2008

3M%

FTSE UK Index

FTSE USA Index

40 Nov 2007

Nov 2012

2

3

4

0

2

4

6

8

10

12

14

0

10

20

30

40

50

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

FTSE GLOBAL MARKETS • DECEMBER 2012/JANUARY 2013

79

THE LATEST MARKET HIRES & NEW BUSINESS BUILDS

ENTRANCES AND EXITS

AMERICAS Jack Ehnes, CEO of the California State Teachers’ Retirement System (CalSTRS) will become the new chairman of the FTSE Environmental Markets Committee. The announcement comes on the fifth anniversary of the FTSE Environmental Markets Index Series and its partnership with Impax Asset Management, the environmental markets specialist.

Ehnes replaces Winston Hickox, who is stepping down after chairing the committee for five years.

KPMG is boosting its alternative investment funds practice with several new hires covering hedge funds, private equity and real estate funds: Martin Griffiths has joined the Los Angeles office as a principal in the Federal Tax practice. Peter Ritter has joined as a principal in KPMG LLP’s San Francisco Federal Tax practice and Daniel Prager has joined as a managing director in its Federal Tax AIF practice, based in Los Angeles. Meantime, Hinton has joined KPMG’s San Francisco AIF practice, as a seconded partner with a focus on the hedge fund industry. Graeme Fletcher has joined as a principal in International Corporate Services, transferring from KPMG’s Atlanta office to San Francisco.

The move makes sense says the firm, as the alternative investments industry faces a series of challenges resulting from the evolving global regulatory landscape. In particular, the Foreign Account Tax Compliance Act (FATCA), private fund systemic risk reporting (Form PF), and the Alternative Investment Fund Manager’s (AIFM) Directive place substantial new reporting and disclosure requirements upon alternative investment funds.

The Securities and Exchange Commission says that general counsel Mark Cahn will leave the agency at the end of the year to return to the private sector. Cahn has served as the SEC’s General Counsel during a period of unprecedented enforcement and regulatory activity. He was deeply involved in developing the Commission’s rules to establish a Whistleblower Program, for instance. “Mark has always provided the Commission clear and thoughtful legal advice as we set out to better protect investors,” says SEC chairman Mary Schapiro, who also recently announced she intended to leave the regulator.

EUROPE Royal London Asset Management (RLAM) has hired Rob Williams as head of distribution. Williams joins in the New Year and will report to Andy Carter, RMLA’s CEO. Williams was previously chief sales and marketing officer at Skandia Investment Group.

Société Générale Securities Services (SGSS) has

80

appointed Gabriele Pollastri to the newly-created position of head of sales and relationship management for Italy and Spain. Based in Milan, Gabriele Pollastri is part of the SGSS sales and relationship team led by Mathieu Maurier.

DC Advisory, the pan-European corporate finance subsidiary of Japanese investment bank Daiwa Capital Markets, has hired Stefan Jaecker as CEO for Germany. He will join the firm in April 2013 to further expand DC Advisory’s business and strengthen the company’s leading position in Germany and German speaking markets. In the executive management team Jaecker will succeed Ernst von Freyberg who left the firm at the end of 2012. Jaecker worked at Dresdner Kleinwort in both Frankfurt and London in Corporate Finance (M&A/ECM) from 1996. At the time of the takeover of Dresdner Bank by Commerzbank he was Managing Director and Co-Head Strategic Advisory (M&A) Germany.

ASIA BlackRock appoints Andrew Landman as Australia alternatives head. Landman will be responsible for positioning BlackRock as a leader in alternative investments in Australia, the firm says. Landman comes to BlackRock from Ascalon Capital, a subsidiary of BT Financial Group, where he was CEO. He noted in a statement that Australian investors are increasing their allocation to alternative assets.

Chi-XAustralia Pty Ltd has appointed of Jamie Crank as head of market operations. Jamie joins from the London Stock Exchange, where he was most recently head of commercial management, equity & derivatives markets. He brings extensive experience in market operations and global market structure knowledge.

Mercer’s Asia-Pacific Head Promnitz to retire: Peter Promnitz, Mercer’s head of Asia Pacific, will retire at the end of the year and take on a new role as independent non-executive director. Promnitz will take up roles as Marsh & McLennan Companies chairman for Australia and non-executive director of Mercer’s Australian enterprises. He is currently a non-executive director of SFG Australia and will join the board of Australian Unity in January.

Northern Trust Hires Zaf Kardaras as Australia and New Zealand tax manager: Northern Trust has hired Zaf Kardaras as tax manager for Australia and New Zealand. In his role, Kardaras will be responsible for supporting financial and tax reporting for clients. He becomes the lead tax specialist in a fund administration team of 60 professionals providing fund accounting, unit pricing, financial reporting and tax services.

DECEMBER 2012/JANUARY 2013 • FTSE GLOBAL MARKETS

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NEGATIVE YIELDS ON GOVERNMENT DEBT LIKELY IN 2013 SAYS RLAM

ISSUE 67 • DECEMBER 2012/JANUARY 2013

FTSE GLOBAL MARKETS

The 20-20 Review The rising cost of collateral New asset servicing models Gulf Bank sets a new pace ECB takes the euro lead The return of Barclays Moscow exchange reaches out

ISSUE SIXTY SEVEN • DECEMBER 2012/JANUARY 2013

Can Bersani solve Italy’s €430bn debt conundrum?

INVESTORS FLOCK TO LOW VOLATILITY STRATEGIES