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MENA ASSET MANAGEMENT SURVEY HIGHLIGHTS POLITICAL RISKS

ISSUE 68 â&#x20AC;˘ FEBRUARY/MARCH 2013

Supply side drivers move commodities prices Who will burst the bubble in Eastern European bonds? Russian equities in the political spotlight

FINDING A NEW ECONOMIC MODEL: Derivatives exchanges redefine their future www.ftseglobalmarkets.com

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FTSE GLOBAL MARKETS • FEBRUARY 2013

O MUCH HISTORY turns on a sixpence. UK premier David Cameron looked hopelessly out of touch as 2013 opened. Forced into a corner by the right wing of his party, he was levered into promising an In-Out referendum on Europe by 2017. In recent years, the UK right’s seeming intransigence on Europe looked increasingly out of date, as the continent led (again and again) on transformative market regulation (read AIFMD, MiFID I & II, EMIR to mention a few). Moreover, the EU project began to look much more promising at the start of this year. Markets had priced and factored in the continent’s sovereign debt overhang; the equity markets were having a good run and while nothing in the garden looked rosy; it looked as if it was manageable. Then a majority of Europe’s finance ministers authorised 11 euro-zone nations to implement a financial transactions tax (FTT) and the scales suddenly tipped. Some politicians are just plain lucky. Labour party premier Tony Blair was one such. David Cameron who, it is said, has modelled himself on Blair looks to be another. Propelled by the anti-European element in his party to offer the UK populace the right to opt out of the European project in a promised referendum in 2017, the UK premier’s hold on his party began to look shaky. Being buffeted by markets is one thing. Being buffeted by an anti-European flank in your own party is entirely another. Cameron and his coalition suddenly looked vulnerable as any negotiating hand he might have had with Europe looked strictly limited. Then, on January 22nd a majority of EU finance ministers authorised 11 eurozone nations to implement a tax on financial transactions; even though the voting bloc remains deeply divided over the efficacy of the tax to curb excess in the financial markets. The European Commission, the EU's executive branch, has proposed that trades in bonds and shares be taxed at 0.1% and trades in derivatives at 0.01%. The plan is to use the revenue raised from the tax, which could run into tens of billions of euros, to prop up shaky banks and help fill EU coffers. Projected annual revenues are pretty hefty; the EU Commission previously estimated such a tax across the 27-nation bloc could yield annual revenues of €57bn. Interestingly, the introduction of the tax is a clear indication of the effectively of Europe’s so-called enhanced cooperation mechanism, which allows a group of more than nine nations to go ahead separately on key initiatives. However, in spite of the seeming good intentions of Europe’s nomenclature, market commentators quickly lined up to cast their lot against the tax. Expected to be introduced by 2014, Angela Foyle, tax partner at BDO LLP notes that although limited to the eleven signatories of the agreement (which include Germany, Italy, France and Spain) the European business ground rules looked to be changed for the foreseeable future. “The FTT is one step closer to implementation, but I can’t see the UK changing its stance [against the tax] unless the rest of the world also implements the tax. The current agreement could reduce liquidity in the markets and adversely affect the wider economy, as international businesses will find it more expensive to do normal business hedging transactions.” Moreover, further complication lies in the fact that the eleven have not decided to adopt a ‘pan-EU model’. Instead, they have decided to“tailor the proposal to their country-specific needs, both the complexity and the cost of compliance for all parties involved will increase. This FTT might well be raising more revenue, but at what cost?” Foyle continues. When a similar tax was imposed on Sweden in the eighties, there was a reduction in home market liquidity and increased volatility as a result. Will we see a similar problem unfold with the current tax?

Cover photo: Intercontinental Exchange Inc. chairman and chief executive Jeffrey Sprecher, left, and NYSE chief executive officer Duncan Niederauer prepare for an interview on the floor of the New York Stock Exchange Thursday, December 20th 2012. The New York Stock Exchange is being sold to a rival exchange for about $8 billion, ending more than two centuries of independence for the iconic Big Board. The buyer, Intercontinental Exchange Inc., the Atlanta-based exchange, made clear that little would change for the trading floor in Manhattan's financial district if regulators approve the deal. Photograph by Richard Drew for Associated Press. Photograph supplied by pressassociationimages.com, February 2013.

CONTENTS COVER STORY

THE NEW ECONOMIC MODEL FOR EXCHANGES

..........................................Page 8 After a testing 12 months, derivatives exchanges are seriously looking for new revenue sources. Competition and consolidation between exchanges is changing the landscape. By 2014 there will be fewer exchanges, multiple low cost electronic markets and several bulked up clearing houses. What are the sector’s new economics? Dan Barnes reports.

DEPARTMENTS

MARKET LEADER

HEDGE FUNDS OPT FOR FIXED INCOME OVER EQUITIES ..........................Page 4

SPOTLIGHT

ETP INDUSTRY REACHES $2trn...........................................................................Page 13

Neil O’Hara looks at the implications of asset allocation shifts on securities lending.

News from around the global investment market.

SECURITIES LENDING IN FLUX ........................................................................................Page 15 David Simons reports on the changes in service levels to meet new market conditions.

IN THE MARKETS

EGYPT AT THE CROSSROADS ..........................................................................................Page 20 In extremis, the country is being fought over by competing spheres of influence.

HIGH GROWTH MARKETS? WHAT’S IN A NAME? ..............................Page 22 Why emerging markets need a new moniker.

TRADING POST

LEI OR CICI? CFTC v DTCC.......................................................................................Page 23

FACE TO FACE

HOW BEST TO MITIGATE MARKET RISK ...................................................Page 24

THE BEAR VIEW

WHAT’S BEHIND THE INDEX BOUNCE? .......................................................Page 27

COMMODITIES

SUPPLY SIDE DRIVERS TO THE FORE .............................................................Page 28

Will too many acronyms undermine post trade market transparency?

Greg Case, CEO, AON looks at the techniques investors employ.

Simon Denham, managing director of Capital Spreads, takes the bearish view. Vanja Dragomanovich says few commodities indices have shown meaningful returns.

EASTERN EUROPEAN ISSUANCE AT RECORD LEVELS

.....................Page 30 Simon Denham, managing director of Capital Spreads, takes the bearish view.

EASTERN EUROPE REPORT

WHO WILL BURST THE EASTERN EUROPEAN BOND BUBBLE? .....Page 34 The pursuit of yield by investors is favouring Eastern European bonds, but for how long?

WHAT NEXT FOR THE WSE?

.............................................................................Page 37 Lynn Strongin Dodds reviews the options open to the CEESEG group

MOSCOW EXCHANGE FLOATS RUSSIA’S CAPITAL MARKETS ........Page 39 Lynn Strongin Dodds looks at the opportunities and challenges of market change in Russia.

RUSSIA REPORT

POLITICAL RISKS STYMIE RUSSIAN EQUITY PERFORMANCE ........Page 41 Why investors continue to tread warily in Russia

SHAKE UP IN RUSSIAN BANKING REVITALISES LOCAL BROKERAGES..Page 43 Ruth Hughes Liley reports on the impact of market consolidation .

WHEN WILL VOLUME RETURN IN CASH EQUITIES?................................Page 46

TRADING

Laurence Bailey, CEO, Asia-Pacific, JP Morgan, discuss at Asia’s new business trends.

COMPETITION HEATS UP IN EQUITY OPTIONS? ........................................Page 52 Ruth Hughes Liley looks at the battle for advantage in the lucrative equity options segment.

MENA SURVEY

MENA ASSET MANAGEMENT SURVEY ................................................................Page 53

DATA PAGES

Market Reports by FTSE Research................................................................................................................Page 60 DTCC Credit Default Swaps analysis..........................................................................................................Page 64

Heightened political risks scar investment opportunities in MENA region.

FEBRUARY 2013 • FTSE GLOBAL MARKETS

MARKET LEADER

HEDGE FUNDS EMBRACE FIXED INCOME

At first blush, today’s securities lending market appears a pale shadow of its former self. Figures compiled by Markit Securities Finance (formerly Data Explorers), show the value of securities on loan dropped more than 50% from the December 2007 peak to about $1.4trn in early January 2013. It isn’t for lack of supply, either. While numerous lenders did axe their programs after the 2008 financial crisis, most have returned to the market—aggregate supply is just 14.5% off the March 2008 peak. It’s the major borrowers—hedge funds, banks and securities houses—that have pulled in their horns, driving the ratio of securities on loan to lendable securities down from 21.9% to 10.7%. Neil O’ Hara reports.

Hedge funds look to fixed income “

RELATIVELY SMALL percentage of portfolios are out on loan,” says David Carruthers, managing director, securities finance at Markit. “It demonstrates how much excess supply there is.” Such a dramatic increase in supply relative to demand typically decimates profit margins. Record low interest rates combined with more conservative cash reinvestment guidelines have in fact turned general collateral securities lending into a loss-making proposition for many market participants. Lenders and their agents are not crying in their beer, however. Their focus has switched from high volume, low margin general collateral lending to securities that have“intrinsic value,” i.e. for which borrowers are willing to pay a premium. Carruthers attributes weak borrower demand to a reduction in hedge fund leverage and market fluctuations dominated by macro trends. Long short equity hedge funds, whether directional or market neutral, account for the bulk of equity hedge fund assets, but in a risk-on/risk-off world the underlying strategy—stock picking based on fundamental analysis— doesn’t work. “We have seen a dampening down of demand for equities,” Carruthers says.

Photograph © Maciej Frolow/ Dreamstime.com, supplied February 2013.

Some hedge fund managers who used to short individual stocks to generate incremental alpha have switched to market hedges like general collateral baskets, ETFs and futures. Investors in both traditional assets and hedge funds have shifted their allocations toward fixed income, too. More money has flowed out of long short equity funds than ever before, according to Stu Hendel, head of global financing at Bank of America Merrill Lynch.“Generally speaking, fundamental long short equity managers tend to have less money to work with, and their leverage was down in 2012,”he says. Funds that used to run gross assets equal to 400% of capital now have just 270%, for example—and the shift to generic hedges has cut single stock lending volume even more. Record low interest rates have slashed profits on selling short, too. In

the United States borrowers put up cash as collateral for a securities loan, but the money is reinvested in short term money market instruments and the return (the stock loan rebate) split between the borrower and lender in a ratio negotiated between a hedge fund and its prime broker, typically around 80:20. If overnight rates are 4%, a market neutral equity hedge fund can earn more than 3% from the cash collateral on its short book even if the long and short relative performance cancels out. With rates at zero, the hedge fund makes nothing. “There is no free carry on the short side anymore,” says Hendel.“Managers have to be right.”If the securities borrowed command any intrinsic value, the rebate turns negative and the hedge fund will incur a loss on a flat book. While some market participants see today’s emphasis on intrinsic value as a permanent shift in the lending market, Paul Wilson, managing director, Investor Services at JP Morgan, is not convinced. Quantitative easing in the United Kingdom, Operation Twist in the US and the Long-Term Refinancing Operations (LTRO) in Europe have made cheap collateral and financing available to commercial banks directly from central banks, which are willing to accept relatively low quality collateral in exchange. In effect, the central banks have siphoned off demand for financing that used to be met through general collateral securities lending. “We won’t know for sure whether the market has moved to intrinsic value until interest rates go back to historic norms and central banks withdraw from the market,”says Wilson. “If volumes don’t pick up at that point, the change is probably structural. I’m still open-minded.” Utilisation of lendable equity portfolios has fallen from 17.2% to 7.6%, but demand for fixed income securities has held up a little better: government bond utilisation has only halved, to 25.4%, while corporate bonds are down a mere 40%, to 6.3%. The eurozone currency crisis played a big role, of

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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MARKET LEADER

HEDGE FUNDS EMBRACE FIXED INCOME

course. Macro and long short fixed income hedge funds circled like moths around a flame as managers bet on the spread between yields on German and French government bonds and those issued by countries in the troubled periphery: Greece, Portugal, Spain, Italy and Ireland. Some hedge funds that had no history of trading fixed income got into the game and are now looking for opportunities outside Europe, too. Even if the eurozone crisis eases (positive signs were evident in January 2013), demand for fixed income securities is likely to grow this year thanks to the new regulatory requirement to clear most OTC derivatives and the impact of Basel III capital rules. Many market participants who never put up initial margin against derivative transactions will have to do so when trades settle through a central clearing counterparty (CCP)—and they may not own the high quality collateral CCPs need to support their settlement guarantee. For example, insurance companies typically hold huge corporate bond portfolios, most of which do not meet CCP collateral standards, but own few government bonds, which are CCP eligible. Apart from fixed income arbitrage managers who trade high quality government securities, hedge funds are in the same boat: they are not natural holders of eligible collateral. The Basel III framework may boost demand for high quality fixed income collateral among commercial banks and prime brokers, too. Although regulators eased the new requirements in early January after banks claimed the initial proposals would inhibit credit creation and impair economic growth, the industry still expects a collateral shortfall. Owners of G7 government bonds, including pension funds, mutual funds and sovereign wealth funds, will be able to lend these assets in collateral transformation trades provided they are willing to accept lower quality collateral with an appropriate haircut in exchange and to lend for term rather than overnight.

Paul Wilson, managing director, Investor Services at JP Morgan, is not convinced. Quantitative easing in the United Kingdom, Operation Twist in the US and the Long-Term Refinancing Operations (LTRO) in Europe have made cheap collateral and financing available to commercial banks directly from central banks, which are willing to accept relatively low quality collateral in exchange. Photograph kindly supplied by JP Morgan, February 2012.

Stu Hendel, head of global financing at Bank of America Merrill Lynch. “Generally speaking, fundamental long short equity managers tend to have less money to work with, and their leverage was down in 2012,” he says. Funds that used to run gross assets equal to 400% of capital now have just 270%, for example—and the shift to generic hedges has cut single stock lending volume even more. Photograph kindly supplied by Bank of America Merrill Lynch, February 2012.

Therein lies the rub. Securities lending has always been an overnight game in which lenders can call securities back at any time. Even when asset owners grant prime brokers exclusive access to their portfolios for an extended period (often one year) the individual securities lent are still subject to overnight call. Asset managers won’t give up the flexibility to buy and sell at will—they make far more money from a successful investment strategy than from securities lending. Meanwhile, borrowers need a longer-term commitment to meet either CCP standards (collateral must be available through settlement date plus a grace period to cover buy-ins) or Basel III, which grants capital relief only if the collateral is available for at least 30 days. “Borrowers and lenders are not quite on the same page at the moment,” says Carruthers at Markit.“There is a trade to be done between the two but the market has not worked out the terms yet.” If the market does bridge the gap, collateral transformation could boost demand for high quality fixed income securities lending. Just how much is a matter of debate, however. JP Morgan recognises the potential opportunity but Wilson doubts that it will drive a significant increase in lending volume. Hedge funds and other investors who have to put up collateral do have alternatives: they can stop trading derivatives, build up cash balances to finance the required margin, or make better use of the collateral they already have. “There will be some demand for

collateral transformation,”says Wilson, “but I don’t think it will be the size people are talking about.” He is more optimistic about the scope for collateral optimisation, a service agent lenders are developing in response to the new regulations. If an asset owner needs high quality assets to pledge at a CCP but its eligible assets are in a stock lending program, should the firm could call those assets back rather than incur collateral transformation costs on available assets that are ineligible? Agents are still working out appropriate metrics and how to manage the process but see a significant business opportunity even though optimisation tends to reduce rather than increase lending volumes. “Asset owners want to margin themselves in the most effective manner,” says Wilson. “Optimisation will become an important characteristic of the market.” While the largest hedge funds will likely handle collateral transformation and optimisation in-house, most managers will turn to their prime brokers for help. BAML expects the business to start slowly and build up over time, but Hendel believes collateral services offer a chance for prime brokers to differentiate themselves and boost market share.“A robust OTC derivatives offering will include collateral optimisation and transformation,” he says.“There is a notion that OTC derivatives switching to central counterparty clearing will impact bank revenues and profitability, but they will likely be more than made up for in volume.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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COVER STORY

DERIVATIVES EXCHANGES: IS CONSOLIDATION THE ANSWER?

Derivatives exchanges are looking to new avenues for income; after a gruelling 2012 they will need positive market sentiment or some big changes to weather the year ahead. By the end of 2013 the global derivatives market is likely to consist of fewer, big exchanges; multiple low-cost electronic markets and several bulked-up clearing houses. The big four derivatives exchange groups; CME, Deutsche Börse/Eurex, NYSE Euronext and Intercontinental Exchange (ICE) were hit by the low volume of derivatives trading in 2012. The year ahead will see them transformed as they seek to limit further losses and generate new revenue. By Dan Barnes.

Can derivatives exchanges win the battle for new business? CE AND NYSE have proposed merging. CME is preparing to compete with its rivals more directly by launching an exchange in Europe. Eurex sees new instruments and geographies as a way forward. An unknown quantity is the instigation of centralised clearing for OTC derivatives this year. Firms with central counterparties will be building their post-trade business and some will seek to attract more swaps execution. However more traditional income streams will remain dependent on market sentiment. Exchange-traded equity derivatives saw a 20.4% drop in volume traded year-on-year in 2012, while interest rate futures and options trading volume fell 17% across the same period according to trade body the World Federation of Exchanges (WFE). Low investor confidence has hurt trading volumes in the underlying instruments, impacting derivatives. The WFE saw the 2012 turnover in equity electronic order books fall by 24.1% in EMEA, 23.3% in the Americas and 20% across Asia Pacific year-on-year. “The main factors [affecting volume] are the low overall volatility, below 20 for several months now; historically low yields for German government bonds—affecting Bund, Bobl and Schatz contracts; a stay-away-attitude among end-investors based on regulatory uncertainty and progress; as well as a still depressed economic outlook for many developed markets,” says

Terence Duffy, executive chairman at CME, which reported a 12% fall in average daily volume last year, believes that European debt issues dominated 2011 and US fiscal cliff issues dominated 2012 but the year ahead will see a return to trading based on fundamentals. “[The market] chased different crises [in previous years], but now firms are trying to trade based on corporate earnings not on government policy,” he says.“I do believe that will happen; I’m hopeful for the year ahead.”

Photograph © Rolffimages/Dreamstime.com, supplied February 2013.

Getting it together

Heiner Seidel, spokesperson for Deutsche Börse’s Eurex derivatives market, which reported an 18% drop in contracts traded in 2012 from 2011. “As long as these factors do not change significantly, volume growth is hard to imagine.” Martin Wilson, equity analyst at broker Bank of America Merrill Lynch, says there is cause to be positive for the year ahead. Of the four major drivers of volume growth—market capitalisation, pricing, market share and turnover velocity—he believes it will be turnover velocity that becomes the swing factor for equities in 2013. “Given strong market performance year-to-date, we start to see rotation from bonds into equities and this could be an inflection point,”he says.“As you see stronger cash volumes then derivatives volumes start to pick up.”

The cliff-hanger that ended 2012 was ICE’s announcement on December 20th last year that it planned to take over NYSE Euronext, offering cash and stock at $33.12 in cash per NYSE share, or 0.2581 of ICE common shares, a higher rate proposal than the one it made during the merger negotiations between NYSE Euronext and Deutsche Börse in 2011. At the announcement, ICE chairman and chief executive officer Jeff Sprecher says,“We believe the combined company will be better positioned to compete and serve customers across a broad range of asset classes by uniting our global brands, expertise and infrastructure.” Brad Hintz, equity analyst at Sanford Bernstein, saw limited potential, saying in a note dated December 21st 2012, “We are concerned the deal could be a breakeven financial proposition and only that if ICE’s management success-

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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COVER STORY

DERIVATIVES EXCHANGES: IS CONSOLIDATION THE ANSWER?

fully accomplishes the targeted cost saves, which entail navigating the significant execution risks of acquiring a very complicated company [sic].” The new entity would have a 40% European derivatives market share with little overlap between the two firms in the US, and Hintz notes that regulators on both sides of the Atlantic might be in favour of the deal “given a desire to promote competition against the Goliaths” of CME and Deutsche Börse. “While the deal brings strategic benefits (technology rationalisation, increased scale and diversification) ICE’s growth prospects, the complexity of its managerial task, the simplicity of its business model, and its cultural homogeneity have all been compromised,” he wrote. Wilson concurs with Hintz that regulatory approval for the deal will not trigger the same monopoly concerns that stopped the NYSE/Deutsche Börse deal and suggests if it were to go ahead it may spur on further M&A. “Clearly CME will be looking over its shoulder now at what is happening in the European listed derivatives space,” he says. “They are trying to build scale in Europe organically but that’s a slow burn. You could see the rationale behind a CME/Deutsche Börse combination.” Consolidation would enable cost savings through increased efficiency and increased stability by broadening a consolidated firm’s revenue base, but that would not resolve the challenging market environment says Fred Ponzo, principal at consultancy GreySpark Partners. “We can expect to have a relatively small oligopoly of global exchanges competing against one another,” he says. “If the question is whether, as a consequence of the merger, volumes would improve or profitability of the various constituents would improve, the answer is ‘no’. Also I can’t see a CME and Deutsche Börse deal happening. They are both predators, and going from predators to prey is a big psychological step. However I would

not be surprised to see Deutsche Börse make a bid for NYSE Euronext’s European equities business, which ICE said it would spin-off.” Duffy says that the outcome of the deal will not affect the CME’s own expansion plans having already experienced significant consolidation with the CBOT and NYMEX in 2007 and 2008. “I think we have already done what other exchanges are just beginning to look at doing,” he says. “We’ve created a lot of efficiencies for clients. I don’t see how [the merger] would hurt us from a competitive standpoint, they don’t have anything together that they don’t have separately.”

Hold on tight Generating organic growth by the usual routes of either product innovation (to create new volume; competition; or to get a greater share of existing volume) is difficult for the big exchanges. The instruments they offer are rarely fungible, in that they cannot be traded on rival exchanges even if they are identical products. If identical products are offered by a rival, an exchange can refuse to allow its products to be crossmargined with the rival’s products at a clearer; if a clearing house is owned by an exchange group, the exchange can refuse to clear trades for rival firms on an equitable basis. Without the ability to net off collateral from those orders, the cost of trading on the new venue’s smaller liquidity pool is high and often not worth paying. Liquidity can move in theory; it took approximately three days for Eurex to take over the bund future market from LIFFE in 1997, by offering electronic trading and cut-price clearing fees, but such a move is rare. Index-based derivative instruments are often not fungible between venues as the data used to price them is held as intellectual property or because similar products are prevented from being netted off together in clearing houses. “There is no fungibility because, from my standpoint, why would you allow

someone to put all this research into developing and listing a product if someone else could just copy it and take your liquidity? It would be a race to the bottom,” says Duffy. “There’s no doubt that if an incumbent has worked hard to build liquidity over the years and create efficiencies, for a firm that then lists the exact same product, it’s harder.” This lack of fungibility means big players across Europe and the US are in a position of relative security, as smaller players have significant barriers to entry. It would take a change in market rules to lower those barriers. “The reality is the listed derivatives market is between CME, Deutsche Börse, Euronext LIFFE, ICE and Singapore Exchange (SGX),” says Ponzo. “While there is the potential for new entrants to carve a niche for themselves in the listed futures market I wouldn’t put too much money on them.”

New kids in town Despite this hurdle there are challengers to the big markets. Turquoise, a multilateral trading facility (MTF) majority owned by the London Stock Exchange Group (LSEG) will be trying to expand its relatively small derivatives business in 2013. It currently has a Russian stock options market, and a fledgling European equity index market. It will build its pan-European derivatives franchise by working with FTSE to design new index derivatives and taking advantage of the expected approval of the LSEG taking control of central counterparty LCH.Clearnet to provide a more efficient clearing model for equity derivatives. However it is unable to cross-margin its FTSE products with the comparable FTSE products listed on NYSE LIFFE via LCH.Clearnet. Turquoise chief executive officer, Natan Tiefenbrun, expresses hope that the new regulation such as MiFID II may open up clearing access. “There are two key elements that could make the European derivatives market more competitive, attractive and help grow

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

10th Annual PASLA/RMA Conference on Asian Securities Lending PASLA and RMA invite you to join us in Hong Kong for the 10th Annual PASLA/RMA Conference on Asian Securities Lending. The conference will be held at the JW Marriott on 5â&#x20AC;&#x201C;7 March 2013. The PASLA/RMA Steering Committee have put together a business program important to our industry and the region. The conference will kick off Tuesday, 6 March with the Securities Lending Tutorial followed by a round table discussion on Current Operations and Technology Trends in the region led by members of the PASLA Operations and Technology Subcommittee and leading technology vendors. We are also pleased to have Dr. Kalok Chan, Department Head and SynergisGeoffrey Yeh Professor of Finance, Hong Kong University of Science and Technology lead an academic discussion on his coauthored paper, Short-sale Constraints and A-H Share Premiums. Other sessions include: s 2EGIONAL #OLLATERAL -ANAGEMENT AND 2EPO 5PDATE s 4HE &UTURE OF 3ECURITIES &INANCE IN THE !SIA 0ACIlC 2EGION s 2EGIONAL -ARKETS 5PDATE s ,EGAL AND 2EGULATORY )SSUES INCLUDING A TWO PART ROUND table discussion where representative counsel and senior business leaders will discuss the implications to our industry and how to react.

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COVER STORY

DERIVATIVES EXCHANGES: IS CONSOLIDATION THE ANSWER?

volumes,”he says.“The first is the right of venues to access the CCP of their choice. I may have invented the best instrument ever but unless I can clear it in a CCP where it can benefit from margin offset against other correlated products it could be inefficient from a capital standpoint.” “The second is that established industry benchmarks should be licensed on a fair and non-discriminatory basis,” he continues. “Not for free. The value of intellectual property should be protected, but fundamentally if the FTSE 100 or the Eurostoxx 50 is widely understood to be an industry benchmark then it should be available for other venues and CCPs to license.” The European Markets and Infrastructure Regulation (EMIR) that is expected to be passed in Q1 2013 has mandated a review of interoperability between CCPs which could allow firms to select the CCP they use to trade on an equitable basis. “I’m a bit sceptical of the LSE’s ability to grow its listed derivatives business organically,” says Wilson. “I think the ESMA review planned for 2014 could potentially be a game changer, but even if they recommend interoperability in futures there will probably be a couple of years of industry consultation.” There are new entrants launching in Europe during 2013 as well. Exchange operator NASDAQ OMX’s NLX MTF, which is expected to launch in early 2013 following regulatory approval from the UK’s Financial Services authority. It will go head-to-head with the big exchanges on both short- and long-term interest rate futures and options. It will try to win market share by offering up to 30% lower trading fees, with discounts for liquidity providers and a competitive clearing model that it claims could create margin efficiencies of 50%. CME is also planning to take on the big European players itself, with the launch of a new exchange, CME Europe, in late Q2 2013. Initially

Turquoise chief executive officer Natan Tiefenbrun. He expresses hope that the new regulation such as MiFID II may open up clearing access. “There are two key elements that could make the European derivatives market more competitive, attractive and help grow volumes,” he says. “The first is the right of venues to access the CCP of their choice. I may have invented the best instrument ever but unless I can clear it in a CCP where it can benefit from margin offset against other correlated products it could be inefficient from a capital standpoint.” Photograph kindly supplied by Turquoise, February 2013.

trading 30 foreign exchange derivatives and later migrating to the interest rate derivatives, it will be twinned with CME Clearing Europe, its central counterparty, which launched in May 2011 and will deliver OTC IRS clearing from early 2013.

Fresh product The established firms are not immobilised by the product stalemate. Regulation is delivering opportunity and driving innovation. Clearing of OTC derivatives, beginning in some markets at the end of Q1 2013, will be a shot in the arm for CME Clearing, Eurex Clearing and ICE Clear. LCH.Clearnet will potentially be able to boost the LSEG revenues via OTC using its SwapClear business, albeit on a reduced basis, says Wilson. “The challenge is the SwapClear governance arrangement; 85% of the profits of that business get repatriated by dealers, so if you have a stake in LCH.Clearnet as an LSE shareholder you effectively get 9% of the economics of the OTC derivatives business,”he observes. “It’s better than nothing but far from transformational.” The CME also expects to see new revenues from new products. It launched Deliverable Interest Rate Swap Futures in Q4 2012, which allow firms to sidestep some of the reporting requirements and clearing costs

imposed by the Dodd-Frank Act, gaining swap exposure and the benefits of futures in one product. It estimates that these standardised contracts will deliver margins approximately 50% lower than cleared OTC IRS. ICE similarly converted its cleared freight, iron ore and energy swap contracts to futures contracts in October of 2012. Dodd-Frank rules would have prevented many Singapore-based traders from dealing in swaps, so the conversion to futures was crucial. These products will continue to be listed and traded in the same manner on the ICE platform and cleared at ICE Clear Europe. Futures reporting will be conducted by the exchange reducing the burden on market participants. The success of these initiatives will be determined in the next 12 months, but with market rules such as those that determine how swap execution facilities will be run in the US are set, enthusiasm will be dampened by uncertainty, says Duffy, and the year ahead unpredictable. “A lot of firms are concerned about how these new regulations are going to affect their bottom line, and as a consequence you don’t see much activity,” he notes. “By the end of 2013 we will be 12 months wiser,” says Eurex’s Seidel. “A realistic forecast is not possible, as there are too many uncertainties.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

SPOTLIGHT

The size of the global Exchange Traded Products (ETP) industry has now surpassed the milestone figure of $2trn.

Photograph © Aurelio Scetta/Dreamstime.com, supplied February 2013.

HE ETP MARKET had a recordbreaking year for flows in 2012, attracting $262.7bn in assets globally and growing by 27% compared with the end of 2011. This momentum has carried into January and the industry reached $2trn in assets under management by mid month. Increased investment in ETPs is being seen in all major regions, as a broad spectrum of institutional, professional and retail investors are using the products to access asset classes in a cost-efficient and effective way, whatever the market conditions. At an asset class level, fixed income ETPs and emerging market equity ETPs set new records for their categories in 2012, recording net inflows of $70.0bn and $54.8bn respectively. Going past the $2trn mark is an important milestone for the ETP industry according to Dodd Kittsley, global head of ETP Research for BlackRock.“Hot on the heels of an impressive 2012, the market has continued to grow in the early months of

2013, and we expect this to continue during the rest of this year,” says Kittsley.“The dynamics of the ETP market are changing and developing. As ETPs become better known and understood in different regions and amongst different types of investors, uptake is fast increasing. “ETP providers are expanding and deepening their coverage of different assets classes and regions, allowing investors to put ETPs to use in new ways and employ them to access areas where they couldn’t before, such as emerging market debt,” adds Kittsley.“ETPs were once thought of as primarily equity-based funds for institutional investors, and today’s milestone proves this is certainly no longer the case. “It took the ETP industry 19 years to surpass $1trn in assets under management, which it did in 2009, and only a further four years to double this. We look forward to reaching and surpassing the next milestone, as more investors come to experience the variety of ways they can use ETPs to invest in the markets.”

Ireland targets Swiss asset managers Swiss funds look to Ireland for investment solutions N IRISH FUNDS Industry Association (IFIA) delegation led by former Taoiseach (Irish prime minister) John Bruton, held its first ever industry seminars in Switzerland in January following increased demand from local managers who are increasingly turning to Ireland for solutions.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

ETPs ATTRACT $2trn IN INVESTMENTS

ETP industry hits $2trn in AUM says BlackRock

The IFIA seminars, which took place in Zurich and Geneva, saw representatives from UBS, Credit Suisse, Source, Carnegie Fund Services and BrunnerInvest cite their own positive experiences of working with Ireland. Hosted by SIX Group (Zurich) and UBS (Geneva), the seminars were a direct response to the growing links between the Swiss investment management industry and Ireland. There are currently some 139 Swiss funds domiciled in Ireland, accounting for close to 4% of the total. With the incoming European alternative investment fund managements directive (AIFMD) and the increasing use of exchange traded funds (ETFs) this number is set to grow, with both being areas of significant expertise in Ireland. As it stands, one third of ETFs listed on the Swiss exchange have an Irish fund structure. Pat Lardner, IFIA chief executive says: “Given the role the Irish industry plays in connecting investment managers with clients all over the globe, there has been a notable increase in inbound enquiries from Swiss firms as they look for solutions that allow them to capitalise on the expertise in Ireland which also has a strong and long-standing reputation as a regulated centre of excellence in investment fund services.” In addition, Lardner explained that the industry in Ireland today, which has assets under administration of €2.2trn, has been decades in the making and now boasts capabilities across traditional and alternative asset classes with a recognised expertise in delivering the highest levels of service. Along with firms such as UBS and Credit Suisse, SIX Group has an established presence in Ireland and says that it sees “natural synergies” between what is happening in Ireland’s funds industry and the needs of the Swiss financial services industry. IFIA Chairman and Northern Trust executive, Fearghal Woods moderated the panel sessions which covered

SPOTLIGHT

GOLD MITIGATES EM FX RISK

topics from the impact of AIFMD on Swiss managers looking to avail of the impending EU passport for alternative funds, to the importance of the foreign account tax compliance act and what new local regulations may require of local managers when distributing cross border funds to Swiss investors.“We want to ensure the Swiss investment management community is aware of the scale, experience and expertise we have and that they consider us as potential partners going forward.” adds Mr Lardner.

Gold mitigates EM FX risk Investors in emerging market assets can use gold to reduce the risks associated with exchange-rate volatility NVESTORS IN EMERGING market assets can use gold to reduce the risks associated with exchange-rate volatility and benefit from significant cost efficiencies according to a new report from the World Gold Council. Exchange-rate risk is a serious and increasingly relevant issue as investors in the US and other developed economies look beyond their domestic markets to diversify their portfolios and pursue opportunities for greater returns. With the significant changes in the global economic landscape over the past decade, conventional wisdom about exchange-rate hedging has evolved. Robust growth in emerging markets and aggressive monetary policies in developed markets have resulted in expanded interest-rate differentials and, consequently, increased traditional exchange-rate hedging costs. Given the current trade-off between the costs of hedging and its benefits, many investors opt to leave their allocations un-hedged, exposing their portfolios to significant downside risks. Juan Carlos Artigas, global head of

Investment Research at the World Gold Council says,“Gold’s unique characteristics as an asset and currency hedge are particularly relevant to investors with emerging-markets exposure, where currencies and asset prices are more vulnerable to price swings and tail-risk events.” The study Gold and currencies: hedging foreign-exchange risk finds that using a gold overlay can reduce currency-related losses, without increasing the opportunity cost or negating the potential benefits of investing in emerging markets. Over eight periods of crisis conditions examined, including gold in currency-hedging strategies in an emerging-market portfolio offered cumulative outperformance of 2.4% above an un-hedged portfolio and over 1% above a currency-hedged portfolio. Adding a gold overlay to emerging-market assets reduced portfolio peak-to-trough declines over the past decade on average, to 9.2% from a 12.5% decline in currency-hedged portfolios, and a 13.1% decline in unhedged portfolios. The report also found the that costs of implementing a goldbased hedging strategy are smaller than those associated with most currency hedges for emerging market

currencies. The average costs of hedging a basket of emerging-market currencies is currently over 4% compared to less than 50 basis points (bps) on borrowing costs for a gold overlay. “Gold has a positive correlation to emerging market growth, and a negative correlation to the US dollar and other developedmarket currencies. Gold has a low investment cost relative to traditional foreign exchange hedges and is a proven hedge against tail-risk,” adds Artigas. Given these qualities, he believes there is a strong argument for complementing existing exchange-rate hedging strategies with gold. While this study focuses on emerging market investment and currency hedging from a US dollar perspective, its findings have wider ranging applications and are broadly compatible with other research on the merits of gold as a foundation to portfolios, from the World Gold Council and independent global advisory firms including New Frontier Advisors and Oxford Economics. There is now a substantial body of statistical evidence indicating that an allocation to gold between 2% and 10% is optimal across a range of risk profiles, economic environments and currencies. I

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FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

IN THE MARKETS

SECURITIES LENDING IN FLUX: A NEED FOR NEW APPROACHES

Entering 2013, the securities-lending business faces many of the same obstacles that marked the outgoing year, from perpetually paltry interest rates to an ambiguous global regulatory environment. All of this points to a need for new approaches—and the way providers choose to differentiate themselves could have a profound impact on their well being over the long haul. Dave Simons reports from Boston.

Market change springs new demands on securities lenders LMOST EVERY INSTITUTIONAL investor participates in a securities lending program, either directly or indirectly. While lending may not always provide more than a few basis points at the fund level, the returns are often substantial enough to cover the lion’s share of expenses incurred through the operation of an investment program, for example. Still, these have been challenging times to say the least—and despite a rosier outlook for the markets in general, lenders enter 2013 having weathered a prolonged period marked by reduced M&A, hedge-fund underperformance and historically low money market spreads, all of which conspired to place downward pressure on volumes (currently estimated at around $1trn annually). Incoming regulation remains an important consideration for all segments in the global financial markets, and securities lending is no exception. Any number of regulations will affect the industry in 2013 either directly or indirectly, among them EU shortselling rules and Solvency II. Meanwhile, the increase in demand for collateral transformation and, of course, the possible emergence of CCPs in the securities lending mix (including the risk profile and associated costs therein), have yet to be fully quantified. All of this points to a need for new approaches—and the way providers choose to differentiate themselves could have a profound impact on their well being over the long haul. Which

Photograph © Svetlana Gucalo/ Dreamstime.com, supplied February 2013.

strategies stand the best chance of helping clients work through this perpetually changing environment? In this dynamic market, customised solutions are becoming the order of the day. These cover many different aspects of the lending program, from its fundamental structure to the frequency, medium and content of reporting provided, and more. However, when it comes to client customisation, size doesn’t matter, claims Nick Bonn, head of the Securities Finance division at State Street.“From the biggest to the smallest, we simply comply, no matter what,”says Bonn.“If anything, we’ve been perhaps a bit too thorough in terms of looking after the needs of the individual client. However, the fact of the matter is that a number of clients suspended their programs following the crisis, and as they’ve re-emerged each one

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

has a unique set of new governance requirements and risk appetites, which often dictate how their programs will operate.” Needless to say, it has been something of a challenge for vendors to efficiently manage all of this operational, risk and reinvestment customisation. But as Bonn suggests,“If you really want clients to stay in the program, then you really have to do things their way, which, admittedly, has put the responsibility on us, as most clients have so many different needs.” Many of these variations are subtle and ideally require the use of automation in order to avoid violating one’s guidelines. “Because there are specific rules that you have to be conscious of from client to client, automating is really essential. You can’t just hang a yellow sticky note on a trader’s monitor so they don’t execute the wrong function!” he adds. Among the many forces currently affecting the markets, perhaps the most notable are the regulatory and capital rule changes that have already altered the securities-lending investment dynamic in a fairly substantial way. For instance, banks and brokerdealers are now placing a much greater emphasis on longer-term financing due to the regulatory incentives therein. This in turn has compelled lenders to make strategic adjustments accordingly. “One of the strategies we’ve been taking advantage of on behalf of our clients is to engage in some form of term lending, rather than just doing overnight loans,” says James Slater,

IN THE MARKETS

SECURITIES LENDING IN FLUX: A NEED FOR NEW APPROACHES

head of Securities Finance for BNY Mellon’s Global Collateral Services business. This can be accomplished without markedly altering one’s risk profile, says Slater; by lending the value associated with a particular type of security with the option to substitute the underlying assets later on, the investor reaps the benefits of lending to term without having to be locked in for the entire duration with a particular asset.

Collateral is king When looking at the various architectures and approaches to market, there is no disguising the fact that securities collateral has become a far more important component. This is nothing new, of course—unlike the US which historically has tended to favor cash, in Canada, Europe and other parts of the world securities collateral has long been the mainstay. “They say that cash is king, but these days that’s no longer the case,”affirms Slater. “In light of the fundamental changes that we’ve seen over the past few years, banks and dealers are now more conscious of their balance sheets—and if they can utilise assets they already have on hand as collateral, the whole process becomes much more efficient and cost-effective. So that too has become a driving force within the lending arena.” Emphasising collateral over cash was vital to Canada’s speedy recovery in the immediate aftermath of the crisis, and, in the years since, has helped give the country’s lending agents and their clients a leg up on the competition. It’s an example that other markets can learn from. “Where there have been losses over the years within the securities-lending business, it has usually been attributable to cash reinvestment,” says Slater, himself a veteran of the Canadian lending business who in his prior role served as senior vice president and head of capital markets for Toronto-based CIBC Mellon.“The fact is that the core securities lending transaction has held

Nick Bonn, head of the Securities Finance division at State Street. “From the biggest to the smallest, we simply comply, no matter what,” says Bonn. “If anything, we’ve been perhaps a bit too thorough in terms of looking after the needs of the individual client. However, the fact of the matter is that a number of clients suspended their programs following the crisis, and as they’ve re-emerged each one has a unique set of new governance requirements and risk appetites, which often dictate how their programs will operate.” Photograph kindly supplied by State Street, February 2013.

up remarkably well over the years—to my knowledge there have not been any agent-lenders or clients that have incurred losses as a result of counterparty risk in a securities-lending transaction, or were unable to liquidate non-cash collateral in order to buy back securities out on loan. I think that is something that tends to get overlooked when discussing problems within the business.” Any discussion of “new approaches” would not be complete without taking into account the importance of maintaining a flexible lending structure. This is particularly relevant with respect to collateral management, which has gradually evolved from a mild-mannered back-office function to a potentially major front-office revenue generator. The more flexible the lender is in terms of utilising acceptable collateral, the greater their revenue opportunities and penetration within the securities lending market, says Rob Ferguson, senior vice-president, capital markets, CIBC Mellon. Collateral profiles are also being driven by changing demands within the markets, suggests Ferguson.

“Margins are being squeezed on several fronts; so many borrowers are looking to use collateral more efficiently—for example, by maximising the use of less expensive forms of collateral where it is appropriate for a given opportunity.” CIBC Mellon sees the impetus for many loans moving from security demand to collateral supply, and there have also been new lending opportunities around collateral conversions, as investors become increasingly interested in transforming collateral, adds Ferguson. Hence, emerging technologies and systems remain essential ingredients for both borrowers and agent lenders. “Autoborrow features and contractcompare systems continue to play an important role, and we have also seen many clients electing to outsource collateral management as well,” says Ferguson.“In essence, new technology is making it possible for borrowers, lenders and agents to make better use of their human capital by allowing staff to shift their focus to highervalue tasks.” Offering collateral management and collateral transformation solutions is viewed as particularly fruitful for providers. EquiLend, a provider of global securities finance trading and post-trade services, in conjunction with BNY Mellon, recently embarked on an effort to provide automated triparty required value data (RQV), using BNY Mellon’s Triparty Automated Deal Matching (ADM) platform, with the goal of providing a more efficient post-trade environment for securitieslending clients (delivery is expected later in the year). Though the post-crisis period has been inordinately labor-intensive at times, it has also compelled the synthetic and cash markets to find ways to work together in order to achieve greater overall efficiency.“For instance, having OTC derivatives going onexchange will drive up demand for higher quality collateral,” says EquiLend CEO Brian Lamb. “Therefore, having all of these different

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

John Arnesen, head of agency lending at BNP Paribas Securities Services, “yet at the same time there are plenty of banks that are flush with cash and can still issue in the unsecured market relatively easily, and therefore have no interest in that kind of strategy. The point is, all of these institutions have remarkably different profiles—which makes the agents job all the more challenging,” says Arnesen. Photograph kindly supplied by BNP Paribas Securities Services, February 2013.

processes properly aligned can be viewed as a real positive for the industry as a whole.” Helping clients construct bespoke programs to fit their specific risk profiles and reporting requirements is also key. Using open architecture, for instance, lenders can modify their risk/return balances, as well as receive information needed to make more informed choices around counterparties and lending activities. Additionally, this approach allows participants to take advantage of potential opportunities in emerging regions, as well as diversify collateral or explore new trade structures in the making. “An open architecture approach to securities lending gives beneficial owners greater control and flexibility in their programs, which can increase

Rob Ferguson, senior vice-president, capital markets, CIBC Mellon. Collateral profiles are also being driven by changing demands within the markets, suggests Ferguson. “Margins are being squeezed on several fronts; so many borrowers are looking to use collateral more efficiently—for example, by maximising the use of less expensive forms of collateral where it is appropriate for a given opportunity.” Photograph kindly supplied by CIBC Mellon, February 2013.

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FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

IN THE MARKETS

SECURITIES LENDING IN FLUX: A NEED FOR NEW APPROACHES

transparency and returns while also reducing risk,” says Chris Jaynes, coCEO of Boston-based independent securities-lending agent eSecLending. “This can be achieved in a number of ways—by unbundling from a custodian to choose best-in-class service providers for custody, lending and cash management, by utilising multiple routes to market, or by customising the program to fit the client’s specifications.” Whatever the method, programs should be structured around the client’s specific goals, not around the goals of the service provider, says Jaynes. With the lending industry increasingly part of a broader collateral and liquidity discussion, Jaynes sees a continued merging of securities lending, financing, repo and collateral management activities.“Following the financial crisis, the existence of collateral and liquidity silos became evident within investment management firms, public pension funds and insurance companies. To optimise liquidity and collateral, these institutions are now moving towards a holistic approach of firm-wide liquidity and collateral management. New derivatives regulation requiring collateral as margin for central counterparties only increases the need for new solutions in this area.” While discussion around the use of CCPs continues to circulate throughout the industry, finding a model that can mitigate risk without materially increasing costs remains elusive, however. “Because they take the role of counterparty-to-all, CCPs tend to flatten the risk appetite across the system, and remove the ability of borrowers and lenders to set parameters for the profiles of the counterparties with whom they do business,” says Ferguson. “For many owners securities lending represents a reliable source of riskadjusted returns—therefore any proposed CCP that cuts materially into those returns would likely face resistance from participants.”

James Slater, head of Securities Finance for BNY Mellon’s Global Collateral Services business. By lending the value associated with a particular type of security with the option to substitute the underlying assets later on, the investor reaps the benefits of lending to term without having to be locked in for the entire duration with a particular asset, says Slater. Photograph kindly supplied by BNY Mellon, February 2013.

Chris Jaynes, co-chief executive officer of Boston-based independent securities-lending auction specialist eSecLending. “An open architecture approach to securities lending gives beneficial owners greater control and flexibility in their programs, which can increase transparency and returns while also reducing risk,” says Jaynes. Photograph kindly supplied by eSecLending, February 2013.

Lending opportunities

by M&A deal making. With the political and economic environment beginning to stabilise, the hope is that such activity will become more prominent.“There’s a lot of cash that’s been sitting on corporate balance sheets for quite some time now, and many believe this will eventually lead to increased M&A, particularly as organisations look to boost their growth through new acquisitions,” says Slater. “Obviously this development would be very positive for our business—as such, I feel that there will be more opportunities for us as the year progresses.” Rather than reaching for yield, clients are instead choosing to focus on extracting the intrinsic value from the assets they’ve loaned, remarks Slater. While volumes may be significantly lower than during the heyday of 2007-2008, spreads have recovered to roughly pre-crisis levels, making the business quite viable on a longer-term, risk-adjusted basis. Bottom line: if owners earn a decent incremental income without taking a lot of chances, their objectives are being met. Says Slater: “The absolute return itself may be relatively small, say $1m from a $2bn fund—but that’s certainly good enough to cover basic operational costs, and then some.” I

For all of the bright spots, sec-lending as a whole still has a fair amount of catching up to do. After reaching a near-term plateau in 2011, the numbers have since been more modest, culminating in an usually soft Q4 that saw lending activity impacted by concerns over the US fiscal cliff and other political matters. Though liquidity levels have been satisfactory, fluctuating demand from one borrower to the next has resulted in a very fragmented marketplace. “You may be executing billions in collateral-upgrade trades with one broker-dealer,” says John Arnesen, head of agency lending at BNP Paribas Securities Services, “yet at the same time there are plenty of banks that are flush with cash and can still issue in the unsecured market relatively easily, and therefore have no interest in that kind of strategy. The point is, all of these institutions have remarkably different profiles—which makes the agents job all the more challenging.” Nevertheless, with the general markets trending higher and optimism seemingly on the rise, lenders like their chances in 2013. In the lending world the big money tends to revolve around securities that trade “special,” which are typically driven

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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IN THE MARKETS

EGYPT SLIDES INTO JUNK BOND STATUS

Worsening political risk in Egypt claimed the scalps of the country’s leading banks last month as Standard and Poor’s (S&P) downgraded National Bank of Egypt (NBE), Banque Misr (BM) and Commercial International Bank (CIB) because of risks related to the government bonds they hold. The downgrade comes after S&P cut Egypt’s credit rating to the same junk level of Greece. Egypt currently holds a B- rating, six steps below investment grade, with a negative outlook, casting doubts on its ability to meet its obligations. S&P suggests that continued political unrest will cause the downgrades to remain resilient for the foreseeable future.

Egypt’s banks suffer from sovereign downgrade OLITICAL AND SOCIAL tensions in Egypt have escalated though the beginning of this year and are likely to remain elevated over the medium term, leading to a downgrade of those banks which the ratings agency deemed to have most exposure to the sovereign. Moreover, during the past two years, Egypt’s government borrowed heavily from the domestic market to cover its budget deficit, which is projected to reach some EGP200bn (around $33bn). “Increased polarisation between political forces is likely to weaken the sovereign’s ability to deliver sustainable public finances, promote balance growth and respond to further economic or political shocks,” noted S&P, adding that, “The negative outlook on NBE, BM and CIB mirrors the negative outlook on Egypt ... In our view, NBE, BM and CIB face significant sovereign risk because they hold a high amount of government debt compared to their equity bases and earnings capacity,” it added. The value of the Egyptian pound has also taken a pummelling, losing around 8% of its value since the beginning of this year. Egypt’s severe fiscal troubles were triggered by the instability that has followed as civil unrest continues unabated after the uprisings that resulted in the dismissal of president Hosni Mubarak in early 2011 and which

has taken a heavy toll on the country’s tourism and investment receipts. Egypt’s economic woes have been complicated of late by the sudden decision to postpone a much-needed $4.8bn lifeline from the International Monetary Fund (IMF) in December. The suspension of talks followed the decision by president Mohamed Morsi, on December 9th to reverse a raft of tax hikes—a core part of the government’s economic reform programme—less than 24 hours after enacting them, because of fears of popular revolt. Instead, the president launched a “social dialogue” to discuss the planned measures. The initiative clearly resonated with the IMF which, in early February, signalled it would resume talks with Egypt over the standby agreement once more; though the Egyptian side is trying hard to persuade the IMF to accept something of a deceleration in the reform process until the end of the 2013/2014 financial year. Any agreement with the IMF requires minimum foreign reserves of $19bn. Egypt’s foreign reserves fell below this level in early 2012, reaching a low point by year end of just over $15bn, helped by a $2bn loan from Qatar, which includes a grant worth some $500m. Qatar has also intervened in the currency markets to support the pound. Help also looks to be coming from another quarter. Following Iranian’s leader Mahmoud

Ahmadinejad’s visit to Egypt in early February, the Iranian government has said it is ready to provide a “big credit line”to help Egypt through the crisis. Ahmadinejad’s visit has discombobulated western observers. The offer was made by Iranian president, who’s on a three-day visit to Egypt, centred on an Islamic summit. It is the first trip by an Iranian leader after the two countries severed relations after the 1979 Islamic revolution. The reality is that with so much in flux in the country any number of groups and countries with different affiliations will be using the country’s vulnerability to try to exert their influence on the government. The Gulf States are certainly vying with Iran to bring Egypt into their sphere of influence. European banks, such as Société Générale and BNP Paribas, both under pressure to cut costs and bolster capital levels have found willing buyers among the Gulf states’ financial institutions. French banks Société Générale and larger rival BNP Paribas agreed to sell their banking arms in Egypt to Qatar National Bank and Dubai's Emirates NBD respectively in 2012. Confidence in Egypt’s ability to implement reform at a time of re-escalating political tensions in the country is at a crucial point. “The last two years were seesaw years when emotions and consumer sentiment in Egypt went up and down in reaction to the fast-changing political and economic landscape," says Ram Mohan Rao, managing director, Nielsen Egypt, the consumer sentiment data company, in its latest global consumer sentiment index. Consumer confidence improved in the first half of 2012 according to the agency, but dropped in the last quarter of the year as consumers responded with concern to doubts over the economic climate and the tough economic steps the government is contemplating to implement. If people do not see any quick improvement in the economy then it is possible that in the short term consumer confidence will continue to slide. I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

IN THE MARKETS

WHAT’S IN A NAME?: HIGH GROWTH, NOT EMERGING MARKETS

The surging growth of many emerging markets is changing the structure of the global economy. The trend is accelerating such that the term ‘emerging’ will increasingly cease to apply to many countries and a shift in categorisation will be required. In such a rapidly changing investment environment, investors must make the best tactical decisions to take advantage of the opportunities. According to FTSE Group, one key to this for index-based investment products is choosing well-constructed indexes that track macro trends in emerging markets with greater accuracy, resulting in more sophisticated and potentially profitable investment allocations.

CROSSING THE RUBICON POWERFUL COMBINATION of macro trends—each of them a possible investment theme— is driving the long term rise of emerging markets. These include the emergence of a vast new middle class, mainly in Asia, of around 4bn people by 2030; rapid urbanisation; the gradual move by many emerging markets from export-led to consumption-led growth; and an emphasis on the production of higher value-added products. Over the last decade emerging economies have seen a dramatic decline in net external debt with public debt as a percentage of GDP substantially lower than that of developed economies. Indeed, since the late 1990s, emerging economies have moved from net debtor to net creditor status. China is at the forefront of these changes. Over the last ten years China has soared from sixth to the second largest economy in the world; its foreign exchange reserves have increased from $250bn to $3.3trn. Yet the significant macro trend for investors may have been the decoupling of growth rates in emerging and developed economies. Until about 2000, such growth rates were reasonably comparable, which made the case for investing in EMs quite difficult to make. Since then, emerging market growth has moved to a consistently higher level and now stands at 6.2% compared with only 2.6% in advanced economies according to IMF projections.

While the advanced economies struggle under the burdens of recession and financial crisis, emerging markets have become the dominant drivers of global growth. In other words, emerging markets appear to have crossed a structural Rubicon. As investors formulate their own view of the future implications of these growth trend rates, faster EM growth likely means these economies will increasingly comprise a larger share of the global economy. For example, the OECD projects that China’s share of global GDP will soar from 17% in 2012 to 28% in 2030, and India’s from 7% to

The impact of compound arithmetic on GDP/capita: Developed/Emerging to become an anachronism? GDP / Capita 2009 ($)

2030 ($)

Asia – ex Japan

7,667

88,450

China

3,704

50,235

India United States

1,033

20,406

44,871

103,246

Source: Standard and Chartered Bank 2010

World Bank Country Classification 2011 GNI per capita ($) Low income

1,025 or less

Lower middle income

1,026 - 4,035

Upper middle income

4,036 - 12,475

High income

12,476+ Source: World Bank

11%; whereas the US share will fall from 23% to 18%, and the Euro area from 17% to 12%. Such rapid growth will inevitably have a dramatic effect on the wealth of people living in emerging economies. Just as Japan experienced a dramatic increase in GDP per capita from about 1955 to 1985, emerging markets are likely to follow a similar trajectory. On this basis, China may see GDP per capita of around $50,000 by 2030, compared with less than $4,000 in 2009, and other EMs may follow the same path. This raises the question of how should emerging countries be categorised as they achieve levels of individual wealth comparable to that of developed economies? The World Bank’s system of classification by gross national income per capita (GNI) puts any country with GNI above about $12,500 in the ‘high income’ category. South Korea and Taiwan achieved this some time ago and, from the projections above, it appears that China and others will soon follow. As they do so, traditional distinctions between emerging and developed markets will start to look anachronistic and irrelevant. We may have to start talking simply about ‘low growth/high income’ countries versus ‘high growth/high income countries’. In addition the potentially significant shift in GDP share (using OECD forecasts) poses questions as to how this will be reflected in the future geographical breakdown of global equity indexes. The US equity market currently constitutes about 45% of the FTSE All World Index and this is roughly twice the US share of global GDP of 23%. If the OECD projection is correct and the US share of GDP declines to 18% by 2030, how will this be reflected in the representation of the US in global equity market indexes? The repercussions of a decline in developed country and US weightings in global equity indices raises the question of which regions will be the beneficiaries of any reallocation. I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

TRADING POST

What’s in a name? LEI or CICI? NE OF THE aims of regulators to improve their oversight of the OTC derivatives market is to make available a complete inventory of all the extant OTC contracts in a convenient place. Progress towards this goal has been rapid, with a small explosion of Swap Data Repositories (SDRs) from DTCC, ICE, CME, REGISTR and others around the world. One giant SDR would logically meet that goal, and provide the easiest way for global regulators to retrieve the data they desire. Unfortunately commercial interests and national loyalty are diverting solutions away from this optimum, not withstanding the technical and operational challenges of building one SDR to rule them all, as it were. Initially ISDA ran a selection process to which bidders presented their solutions. There were five of these ‘competitions’ one for each major asset class being rates, credit, equities, FX and commodities. The outcome was a clean sweep for DTCC with a couple of partnerships in FX and commodities. A great result for DTCC with the potential to deliver a single global solution. One roadblock was the existence of a requirement under the Dodd Frank Act for an indemnity from foreign regulators to immunise the DTCC from any legal issues caused by their access to data in the US. DTCC in turn looked to regulators outside the US to provide the assurances necessary for DTCC to meet the CFTC indemnity requirement,

but was rebuffed as this was a request that regulators were not able to meet. The DTCC response was to split their SDR business down US and nonUS lines and only hold global data outside the US, making complete and comprehensive data access one step more complex. As time passed, firms who didn’t win any prize in the ISDA competition decided they wouldn’t be bound by that process and built their own competing services. ICE, CME and REGIS-TR (a Deutsche Börse subsidiary) all have their own offerings, and recent developments have brought this fragmented approach to a puzzling situation. The CFTC when drafting rules to implement Dodd Frank gave the reporting party the choice of SDR to report to, meaning a firm could ensure their entire portfolio resided in their chosen SDR. Keeping all data in one SDR would simplify technology integration, fees, and reconciliations. The CME felt this disadvantaged their own SDR offering, so challenged the CFTC in court to overturn this interpretation of Dodd Frank, and won. The CFTC published modifications to their rules enabling the CME to tie their SDR service to their parallel Central Clearing services for Rates, Credit and FX, removing the users’ choice. It is now DTCC's turn to express indignation in issuing a press release heavily criticising the CME, calling their move “illegal” and throwing down the gauntlet to the CFTC to

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

WILL TOO MANY MONIKERS SPOIL THE POST-TRADE BROTH?

As of December 2012 the CICI service has issued over 37,000 identifiers, and will continue to accrete new entities during 2013 until such time as all parties required to report under Dodd Frank have their own CICI identifier. The time line for implementing the FSB federated system looks to be well into 2014 before it is up and running, in which case most, if not all, entities needing an identifier may well have one. Plus ça change (plus c'est la même chose), as they say in Basle.

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

think again on the consequences of this approach. Some firms may wish to support the CME and avoid DTCC being gifted a monopoly position, and will actively deliver trade data to the CME’s SDR, whether or not they clear trades also. The converse is that to avoid the CME SDR firms must also avoid using their clearing services, a risk that CME will be aware of. In the background is another piece of the puzzle gently evolving, that of a standard global identifier for all legal entities, be they banks, pensions funds, investment funds, hedge funds or corporations. Again, this is a simple idea, one single 20 digit code, which can be used anywhere in the world banking infrastructure to clearly identify which entity is party to the contract. The simplest solution would be one large database into which everyone registered their entities, and received back their LEIs. By accident this is what the CFTC have begun to populate, using their CFTC Interim Counterparty Identifier (CICI) service. The CFTC got frustrated with global progress on creating an LEI service to underpin reporting requirements for Dodd Frank and CFTC requested bids to operate the CICI service which DTCC also won, and has been in operation now for some months. Meanwhile the Financial Stability Board have been inventing acronyms in place of an operational system, including ROC, COU, PSPG, IG, BOD, and LOU. The idea is that national organisations can issue their own LEIs, and somehow these get consolidated into one global system for ease of access, forming a devolved approach. This federated structure seems to exist to appease national interests, rather than being cheap and simple to operate. I

FACE TO FACE

GREG CASE, CEO, AON

Clearly definitions and approaches to risk management are becoming more nuanced and complex as the world works through this challenging decade. Greg Case, chief executive officer of Aon says that understanding and managing risk is a key component in the ability of corporations to sustain growth and profitability. That understanding “should be based on a comprehensive analysis focused on internal risk at a specific institution, and identifying any potential risk, which can be achieved by evaluating external data as well as loss scenarios,” he says. In this detailed Q&A, Case outlines the lessons learned from market disruption in recent years and the steps that financial institutions/corporations should put in place as a matter of course to help them navigate a rapidly changing business environment.

Minimizing the risk of market change TSE GLOBAL MARKETS: What are the lessons learned from the market disruption of the last few years? GREG CASE, CEO, AON: It has shown global CEOs, CFOs and risk managers that understanding and managing risk is a critical component to their ability to achieve sustained growth and profitability in today’s market. It also is essential for financial institutions and corporations to have a clear focus on quantifying and mitigating both current and emerging risk issues, and then embedding that in the culture of the firm. Key lessons have been learned by using a sound, scenario-based approach to examine corporate business practices, focusing on key and emerging risks (including external points of view) and embracing a culture of risk management. Once a firm has this risk management framework in place, they can adapt the analysis to remain prepared and responsive to the rapidly changing business environment. FTSEGM: How has the financial crisis and subsequent recession irrevocably altered the global marketplace and the ways in which financial institutions now think about risk? GREG CASE: Talking to clients and colleagues, I hear a constant theme: the magnitude, scope and complexity

of risk continue to rise around the world. Questionable loan underwriting criteria and a broken securitisation market were clearly exposed by the financial crisis. In the course of a global correction, underwriting has gotten much tighter and the securitisation market, at least for mortgage-backed securities, has a noticeable limp. Today, there is a clear focus on regulation and the resulting risk-related requirements have increased the cost of banking. While many bankers had a sophisticated pre-crisis appreciation of risk, there were limited regulatory penalties associated with excessive risk taking. That is no longer the case. Financial institutions have revamped their business and place a stronger focus on risk and regulatory compliance. Mechanisms such as stress-tests and robust risk-based capital management plans (mandated by Dodd Frank) have been introduced. They also face new corporate governance requirements, including executive compensation and rules related to whistleblowers and other internal controls. There's certainly a lot for corporate management to contemplate from a risk perspective, which makes an operational or enterprise approach to risk assessment and mitigation all the more important for financial institutions. Financial institutions increasingly come to us to help them

find new ways to manage their systemic risk while remaining in compliance with regulation. FTSEGM: How must the insurance and reinsurance industry change to meet these new requirements? GREG CASE: Longer term, we anticipate a growing trend toward institutions utilising insurance as more of a capital tool where they can align their insurance programs with their underlying risk profiles to demonstrate insurance more as an effective hedge and potentially offset regulatory and/or economic capital requirements. From a reinsurance perspective, the financial crisis revealed the relative strength of the insurance model over the banking models that led in many instances to a magnification of economic problems. By 2008, the industry had achieved consistency across the globe in modeling insurance enterprise risk, led by the top rating agencies for insurers and reinsurers. While the banking industry in 2008 was taking on more risk per unit of capital than they ever had, in contrast the insurance and reinsurance industry had reached new lows in their levels of risk per unit of capital. Back then, no-one knew what model would be most durable. Now though it is clear that insurers and reinsurers were correct to assume that risk—no matter how well modelled or stress-

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

Greg Case, chief executive officer of Aon. Photograph provided by Aon, February 2013.

tested—and high levels of leverage were a bad combination. Properly matching risk and financing durations were also well executed by insurers and reinsurers; very few insurers or reinsurers held many structured finance assets given the unpredictable nature of the timing of the underlying cash flows. They simply understood that these asset classes were not a match for insurance liabilities that are subject to variability in both timing and amount. However, areas where insurers and reinsurers did struggle were those where they began to adopt bank-like operations and practices. The insurance and reinsurance sectors learned a lot from the financial crisis and subsequent recession. The lessons include greater respect for correlated tails across multiple asset and liability classes; the impact of a recession on the municipal bond sector (US insurers for tax reasons have invested heavily in these sectors); the multitude of problems associated with mixed life and non-life platforms during any financial crisis (including several instances of highly leveraged life insurers bringing strong non-life operations near collapse through common ownership); and the potential ramifications of overconfidence in stochastic modeling.

FTSEGM: How are large corporations re-writing their approaches to risk management? GREG CASE: To sustain continued growth and profitability, organisations must respond to ever-changing risks, such as social media and cyber liability, by keeping on top of and assessing the latest information available, and implementing innovative risk management solutions. Social media has intensified the level of complexity in terms of how risk needs to be treated. Social media has eliminated the 24-hour news cycle but created instead a 24-second news cycle where everyone around the world is instantly aware of any potential issues. A company might have a fire at one of their factories which is captured on video and immediately posted on numerous social media platforms. So what was traditionally an operational or supply chain risk now has been transmuted into reputational risk. Aon helps its clients use social media as an effective risk management tool to solve supply chain problems. There’s a big difference between passively monitoring social media and actively gathering intelligence on social media and analysing the findings. We can examine what is happening to a firm’s

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

suppliers all over the world, capture and analyse data and distill risk-related intelligence so that our clients can address problems more quickly and apply innovative solutions. This type of intelligence, used the right way, is extremely useful in turning social media into an ally. FTSEGM: Large global catastrophes, such as Hurricane Sandy, invariably impact on the capacity of insurance firms. How ready is the industry to cope with these recurring events? GREG CASE: It is in very good shape. According to Aon Benfield’s analytics team, reinsurer capital grew by more than 10% in 2012 to reach record levels of around $500bn, and reinsurance supply continues to exceed demand in most, if not all, parts of the world. With their own strong capital position insurers are positioned well to absorb larger retentions, and this, as well as co-participations, puts further downward pressure on reinsurance pricing, which is good for our clients. Demand for reinsurance continues to be flat to slightly down in peak zones with insurers continuing to retain more risk as capital increases. Across US insurers, the ratio of ceded-to-gross written premium declined in 2011 for all lines, with the exception of property. Insurance continues to decrease its participation in the US economy—the largest insurance market—and we think it is representative of other mature economic regions. Insurer capital increased through the first three quarters of 2012 by 9%, an annual growth rate in line of historical norms for the industry. The insurance and reinsurance industries have faced several significant catastrophe events in the past two years. However, despite paying many billions of dollars in claims over this period, insurers and reinsurers still have very strong capital positions. This is supported by the fact that 2012 on the whole was a light year from a global catastrophe perspective, with insurers and reinsurers having more capacity than was being demanded following loss events.

REGIONAL FACE TO FACE REVIEW

GREG CASE, CEO, AON

FTSEGM: What risks does regulation throw up for corporations and financial institutions and what can be done to help mitigate these risks? GREG CASE: Banks are working to better understand and quantify their exposure to risk, especially in areas where an unknown vulnerability could expose the consumer. Cyber risk is a good example, where regulatory oversight from the US Consumer Financial Protection Bureau, the US Securities and Exchange Commission and others, makes it more important than ever for financial institutions to understand and mitigate their breach vulnerabilities. Generally speaking, the public perception is that financial institutions were heavily involved in causing the global economic crisis and regulators were, by implication, associated with this. As a result, regulators are now focusing on the business practices of financial institutions and fines for bad practices or poor controls are now being levied at levels that would have been unimaginable before the crisis. The recent $2bn anti-money laundering fine for HSBC is one such example. Basel II regulations, to some extent, anticipated this but many banks approached compliance as a ‘tick-the-box exercise’. Today, liquidity, capital and operational risk must be taken more seriously. We have established a global practice specialising in operational risk and are helping many of our clients manage, mitigate or transfer these risks through bespoke structured solutions. Basel III enforces a tightening of the liquidity rules. By looking inward to their own business practices, embracing good risk cultures and focusing on key and emerging risks with a sound scenario-based approach, financial institutions will not only reduce the need for more regulations but will ensure they are in a better position to weather the next storm. FTSEGM: Aon produces an annual global political risk report. In your view is the world becoming a more or less dangerous place?

GREG CASE: In advance of the launch of our 2013 political risk map, it is fair to say that with the magnitude, scope and complexity of risk on the rise, the world continues to be a challenging environment for business. Latin America still carries potential risks for multinational firms in several countries, with Argentina and Venezuela leading the list. Political violence and instability remain as concerns in the Middle East and in North and Central Africa as the Arab spring and various insurgencies play out. Issues pertaining to sovereign debt also exist; the Maldives’ recent termination of a major construction contract is an example. The market perceptions of political risk have shifted somewhat as demand for coverage in some European countries has increased substantially. Concerns about economic and other risks in the Euro zone have spiked as investors contemplate some sort of economic catastrophe. In sum, without some kind of hedge, the world remains a risky place to do business. FTSEGM: Market change is throwing up some entirely new risk sets: such as those related to social media; social disruption; high unemployment. How is Aon working with its clients to isolate and respond to some of these new challenges? GREG CASE: Our clients want to increase their level of connectivity and have a one-stop shop for information. They are increasing their use of technology to support insurance activity and risk management. There’s a tsunami of information out there and clients are seeking solutions to help them wade through all of this data and find the most accurate and reliable information. We have provided clients with a variety of innovative and industryleading data management tools, including Aon’s Global Risk Insight Platform (GRIP). The platform includes data from more than 1,000 carriers across 169 countries, leverages our international database of placement information to provide clients with the

most relevant and applicable data on market conditions, placements and rates to meet their needs. By monitoring the data and reporting the important findings to our clients, we’re able to keep our finger on the pulse of the industry and emerging risks that our clients are facing. FTSEGM: It has been almost a year since Aon relocated its corporate headquarters to London. Do you have any thoughts on it? GREG CASE: Moving our headquarters to London was the logical next step in the evolution of our firm. In addition to being the centre of the insurance world and the birthplace of risk management, London is the traditional and contemporary hub for our work in the UK, Europe, the Middle East and Asia. Many of our clients in Asia and Latin America seek their risk solutions in London. We were looking to achieve a further strengthening of our business operations in order to meet and exceed the goals of our longterm global growth strategy. The move has reinforced our ability to deliver superior value to clients and further differentiate Aon, and almost a year later, we already are seeing results in some of our key strategic growth initiatives, such as Aon Broking, Aon GRIP and Aon GRIP Solutions. The decision also is providing us with increased financial flexibility that is allowing us to make more significant investments in our global network, our broking capability, and in the continued development, retention and recruitment of key risk and HR professionals around the world in each of our primary and developing markets. On a personal level, I have been in London enough times to know to look right instead of left and to mind the gap. I have been using my umbrella more than my snow boots, and because of our sponsorship of Manchester United, I now understand the difference between overtime and extra time, and between the field and the pitch. So I am coping pretty well. I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

THE BEAR VIEW

Markets move to the upside as investors look for US recovery HE US TRADE deficit narrowed more than estimated in December and was accompanied by yet another set of positive corporate earnings surpassing expectations. Together they continued to fuel growing optimism that the world’s biggest economy is now on a path of sustainable recovery. No surprise then that the Dow reached its best level since 2007. Record oil exports in the US not only helped bring down the trade deficit but now there’s talk about energy independence. In Europe meanwhile banking stocks remain popular amongst investors as the sector reports in earnest now. Out of the banks that have reported across Europe so far this season over half look to have beaten analyst expectations and so the sector remains popular one, even if there have been some slightly mixed results. Calls are mounting from many angles for the Bank of England to ease monetary policy further in order to boost the economy and the incoming governor, due to be one of the most powerful unelected figures in the country, has been making it clear that he’s not worried about the inflation target, but would rather focus purely on growth. Such a shift would put it in the Federal Reserve’s camp where Ben Bernanke has set a bar of ending monetary stimulus when and only

when unemployment hits 6.5%. These measures unfortunately mean that high inflation is likely to remain with us for some time to come. The near focus is on the Bank of England’s Inflation Report where the bank’s wonderful fan charts project the possible course of growth and inflation. We can expect some sort of explanation for the bank’s higher growth forecasts than the one that was actually released to the market for Q4 which showed a contraction in the economy. There’s a chance that it might even reduce its forecasts in the quarters ahead which will make for grim reading for the UK Chancellor. In terms of inflation, unfortunately crude and soft commodity prices simply have not been getting any lower and so petrol and food are likely to keep inflation ahead of target going forward, for just how long in the BOE’s view will be important. Things are a little different across on the continent however where deflationary pressures are a little higher than in the UK. But with the single currency racing higher and LTROs being repaid leading to a normalising yield curve, the pressure on the ECB to cut its base rate is mounting. Banking stocks are also in the spotlight. Barclays is trying to lead a charge of change and by closing down its tax avoidance arm it is clearly revamping the bank’s image

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

MARKET OUTLOOK: INDICES ON THE REBOUND

By mid February the FTSE looked to be firmly above the 6300 level and in the US investors finally managed to push the Dow Jones to close above the 14,000 mark for only the second time. It was yet another round of better-than-estimated corporate results in the US that sent the Dow to its highest close since 2007. Investors’ bullish mood was also sparked by President Barack Obama’s State of the Union address which entertained the idea of reducing the budget deficit by pushing for economic growth. Simon Denham, managing director of spread betting firm Capital Spreads gives the bearish view.

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

from what Bob Diamond was attempting to build it up to be, an impressive force in the investment banking world. The new chief executive Anthony Jenkins is preparing the bank for a natural move away from many of the investment banking operations as well as trimming down some of its retail and commercial banking sections. After the departure of Bob Diamond the investment banking section was never going to be the same under new stewardship, but the landscape for investment banking as it once was is going through seismic change anyway. Not only are major cuts being made across the whole industry, with divisions such as equities among the worst hit, but the changing regulatory landscape is making things harder for them too. We are also unlikely to see the last of the scandals either, so the “bash a banker” rhetoric will persist for a while to come. As North Korea conducted its third nuclear test, investors moved into safe haven assets pushing gold prices up to $1651.1. It was a limited rebound as the overall investor sentiment is a rather optimistic one which works against the precious metals sending participants into riskier assets. Right now, there are few influences on the precious metal’s price apart from currencies and the price of oil. A stronger US dollar makes gold more expensive for holders of other currencies, while rising oil prices make gold more attractive as a hedge against inflation and so it continues to trade within a tight range. I

COMMODITIES

WILL GRAIN PRICES RALLY IN Q1 BEFORE A SHARP SELL OFF?

Photograph © Skypixel/ Dreamstime.com, supplied January 2013.

SUPPLY-SIDE DRIVERS TO THE FORE Commodities have done extremely well over the last few years but a look at the commodities indices in 2012 shows that overall few have provided meaningful returns. The outlook for agricultural commodities is clouded by global macroeconomic uncertainty, but even that uncertainty is unlikely to lead to a material slowdown in demand. Expectations for slow economic growth in 2013 points towards a repeat of 2012 where gains will be predominantly driven by supply side issues rather more than by a pick-up in demand. Vanya Dragomanovich reports. GRICULTURAL COMMODITIES WERE among the best performers in 2012. Ole Hansen, head of commodity strategy at Saxo Bank, notes that“grains are one of the few commodities which have brought back major returns [last year].” Wheat prices have risen from $650 a bushel in January to $850 in December, corn is up $200 on the year at around $750, and soybeans are trading at $1,400/bushel from $1,200 in January a year ago. Even so, how well index investors did however, depends very much on the index strategy employed.

The FTSE MFC Custom Global Agriculture Index was up 15.55% for the year to mid December. Compare this with the S&P Goldman Sachs Commodity Index, a composite index for long only commodity investment, which was down 2.1% on the year. When compared with prices only a few years ago, current grain prices are historically high; if this were the case with any other goods buyers would busily look for other alternatives. However, in the case of wheat, soy and corn, the staple food and feedstock, buyers may rotate between the three

commodities but can’t really substitute them with any other grains. Despite much discussion about commodities being at the end of a super-cycle, large pension funds still look favourably at the complex. According to a recent survey by ING Investment Management, European pension professionals say that they planned on increasing their allocations to only two asset classes next year: property and commodities, and to reduce their exposure to equities by about 4%. One of the key arguments in favour of commodities investing has always been diversification; while this no longer holds true when it comes to industrial metals and most energy commodities, prices for agriculture commodities are far more independent of equity and bond moves than any other asset class. Although the global economy plays a role in the demand for grains, weather, effective sowing and the health of crops dominate the agriculture and soft commodities markets. Of the three key grains—wheat, soybean and corn—wheat is likely to rise the most over the next three months before dropping off sharply in the second quarter of next year. When

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

it comes to corn, analysts are not in agreement; while US forecasters peg corn to rise over the course of 2013 European bank analysts say that corn prices will be lower by the end of the year than they are today. Wheat prices rallied last year in response to droughts in key producing regions, including Russia, Ukraine, Latin America and partially in the US. Traditionally a weak harvest in one part of the globe can be offset by a good one somewhere else, but this year most of the wheat growing regions have been affected. Russia has produced some 20% less wheat this year, Ukraine had to impose a ban on exports because the harvest was not enough to cover domestic demand, Australia’s harvest is expected to be lower because of minimal rain in Western Australia. In its monthly reports the US Department of Agriculture continues to downgrade its estimates for the coming harvest. “[The price of] European milling wheat is likely to stay high throughout the winter. Russia and Ukraine still have problems with their crop and although we might still see some exports this will not be enough to reduce prices,”says Ole Hansen at Saxo Bank. “However, come the spring and as new supplies come into the market, prices are likely to drop rapidly by between 5% and 10%.” In Europe, the benchmark wheat futures are MATIF milling wheat and feed wheat futures traded on NYSE LIFFE in Paris, while in the US the key contracts are CBOT wheat and Kansas Board of Trade wheat futures. Rabobank’s Nick Higgins expects MATIF wheat futures to peak at €278 a tonne in the first quarter of this year but says that high prices “will push importers to switch to other origins as it becomes too expensive.” He forecasts a decline of around 16% in the third quarter. Wheat produced in Russia, Ukraine, and Romania, the so-called Black Sea region, rather than being traded on futures markets, is sold directly to buyers such as Egypt, Iraq and Saudi

Arabia. The shortage of Black Sea grains pushes prices up for both European and US wheat because when supplies run out, as they did in December last year, buyers in Egypt, the world’s largest importer of wheat, started supplementing their imports from other markets, such as Europe and the US, thereby moving the futures markets.“Out of the 400,000 tonnes of wheat at the last auction, Egypt bought 60,000 tonnes of Canadian wheat, 280,000 tonnes of US wheat and 60,000 tonnes from Romania,” says Edgard Cabanillas, broker at Lido Isle Advisors, a US-based managed futures investment firm. Until recently US wheat prices were uncompetitive on the world markets but with a shortage of Black Sea wheat and high European prices, buyers like Egypt are turning to the US markets. “At the same time the weather in the US is worse than anticipated,” says Cabanillas, adding that traders in Europe are potentially underestimating the extent to which the drought in the US is likely to affect the current wheat crop. “Our forecast for March wheat is between $850 and $950 a bushel,” he adds. However, when it comes to corn, analysts are divided over outlook for next year. Goldman Sachs reckons there is potential for corn prices to remain elevated at least for the first half of next year. “We have a stronger conviction that corn prices are too low," and if the drought in the US continues corn prices may remain above $8 a bushel,” say the bank’s analysts. Given a weak harvest this year in the US and resilient domestic demand, corn prices will have to rise “to avoid inventories from falling to critically-low levels,”the bank says. However, Commerzbank analyst Carsten Firtsch believes that it is highly unlikely that corn prices will continue to trade at current high levels. “This year was unusual. You will not have a repetition of the same weather conditions next year and therefore it is very unlikely that corn prices will stay high.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

We expect them to trade around 620 cents a bushel,” he says. Broadly, in the case of all three grains, once the rallies in the first quarter of next year run their course prices are expected to decline for the rest of the year and finish 2013 at a lower level.“Using the S&P Agri Index as a proxy for our commodity forecasts we expect a decline in agricultural prices of around 10% between the first and last quarter of 2013. However, it is the lack of buffer stocks which leaves the market exposed to another season of extreme uncertainty and high volatility,” says Rabobank research.

Soybeans replicate price movements Other grains, such as soybeans, could replicate the move higher in the first quarter of next year but the extent of the rally will depend on the crop in Argentina and Brazil, two key production regions. Soybean supplies are likely to decline to critically low levels by Q1 2013 as the current pace of demand draws down US stocks to record low levels. The amount of price upside will depend on the export availability of the South American crop. China remains the key global soybean importer and demand from the country continues to rise slowly but persistently. The US Department of Agriculture forecasts that China will import 61m tonnes during the 2012/2013 crop year despite record high prices. The expectations for a move higher have been reflected in hedge fund activity in the market, says Saxo’s Hansen. “Hedge funds have been particularly active in grains over the last few months—in early November they pulled out of grains, dropping their level of investment to the lowest level since February, but in late November they started rebuilding their positions after concerns were raised about the South American crop and continued demand from China, which does not seem to have slowed down despite higher prices in 2012,” he says. I

EASTERN EUROPE REPORT

RECORD ISSUANCE LEVELS EXPECTED IN 2013

Companies in Central and Eastern Europe are issuing bonds at an unprecedented rate, as the combination of yield-hungry international investors, stronger macro-economic fundamentals than their Western European counterparts, and a squeeze on the availability of domestic bank debt have created almost a “perfect storm” of an environment for them to do so. Andrew Cavenagh reports.

EASTERN EUROPEAN ISSUERS RIDE THE TIDE Photograph © Pei Ling Hoo/Dreamstime.com, supplied February 2013.

AST YEAR SAW record levels of international and local-currency corporate bonds issued out of the region, and (if January was any guide) there is every prospect that 2013 will see more again, as the seemingly insatiable investor demand for assets that offer a real return continues to drive down yields on the debt (and increase the temptation for issuers to tap the market). Andris Kotans, who manages the Nestor Eastern European bond fund in Munich, says that corporate bonds offered more upside than their sovereign counterparts over the next 12 months. While the outlook for all capital-market debt in Eastern Europe was “benign”, given the huge inflow of funds into the region and its relatively strong macro-economic position, he explained that corporate debt was likely to be the stronger performer this year because there was “still room for catch-up with solidly performing sovereign peers”. Russian companies will dominate

the sector, as they did in 2012, with corporate issuers expected to sell around $35bn of eurobonds over the course of the year. While this will be slightly down on the $39bn recorded in 2012—a figure that represented an 80% hike on 2011—that is a merely a reflection of the diminishing funding needs of Russian banks, due to a decline in domestic lending and no significant requirement to borrow for foreign-exchange needs. Issuance from non-financial companies will climb again, as more second and third-tier Russian corporations seize the opportunity to join the country’s big investment-grade, staterun enterprises, such as Gazprom, Rosneft, and Russian Railways, in accessing the international capital markets. The decline in corporate lending by Russian banks, as a consequence of the tightening funding constraints they face, is inevitably spurring the process on. Corporate debt (including banks) now accounts for nearly three quarters

of the overall Russian eurobond market, which grew by more than 25% to $190bn more than in 2012, and this proportion will increase further this year as corporate issuance will greatly exceed the $7bn of additional debt that the Russian Government is currently planning to raise from the market. “It is the corporate sector where there are going to be large volumes of issuance, as the huge demand and compression of spreads makes the market absolutely attractive for issuers,” confirmed one London-based emerging-market bond portfolio manager. Privately owned enterprises such as the steelmakers Severstal and Evraz, the mobile-phone operator Vimplecom, and the iron-ore producer Metalloinvest have all tapped the eurobond market at increasingly lower cost over the past 12 months, and the inaugural US$1bn bond that the junk-rated petrochemicals group Sibur (with issuer ratings of Ba1 and BB+ respectively from Moody’s and Fitch) launched at the end of January provided further evidence of both the current strength of demand for such paper and the trend in yields. The five-year bond, on which Citi, JP Morgan, Royal Bank of Scotland, Credit Suisse, Gazprombank, and Sberbank CIB were joint book runners, was five times oversubscribed with orders from 280 different accounts and priced at par paying a coupon of 3.914%. This was 20 basis points inside the yield on the comparable debt of the similarly rated Severstal. The fertiliser company PhosAgro is expected to be among the new names that will come to the market in the coming months, possibly launching its planned $500m debut offering before the end of the first quarter. Meanwhile Rosneft will be the largest and most frequent issuer during the year, as it will need to raise an estimated further $7bn (on top of the $3bn it issued through a two-tranche offering in November) to help finance its $58bn acquisition of TNK-BP. The market for ruble-denominated

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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EASTERN EUROPE REPORT

RECORD ISSUANCE LEVELS EXPECTED IN 2013

corporate debt should also receive a significant boost by the end of February, once the arrangements are finally in place to allow trades in the debt to be settled through the Euroclear and Clearstream systems. The combination of relatively high domestic interest rates (about 7% on long-term bonds) and strong outlook for the currency have made rouble debt a choice pick of most emerging-market portfolio managers for 2013, and the additional liquidity that mainstream settlement will bring has led most to increase their allocations for the year. The leading Russian bank VTB estimates that this rebalancing exercise could see as much as a further S15bn$20bn flow into a market that grew by 25% in 2012 to RUB879bn ($29.3bn) The more immediate beneficiaries of any such inflow, however, are likely to be the higher-grade issuers (sovereign, quasi-sovereign, and investment-grade corporations), however, rather than the more recent high-yield market entrants. Benoit Anne, head of emerging market strategy at Société Générale, says there are two reasons why investors are likely to shy away from lower-rated rouble debt. One, while the valuations of investment-grade localcurrency bonds are broadly in line with their eurobond counterparts (in terms of their spreads over the relevant sovereign curves), the high-yield debt has tended to trade considerably tighter than its dollar-denominated equivalent. (The so-called exchange bonds, which account for around 30% of the market, will continue to be settled exclusively on the Moscow Exchange). A second reason to be cautious is the Russian central bank’s plan to tighten the rules on banks’ exposure to market risk (in line with the Basel II and III accords), which would substantially increase the risk weightings that the financial institutions would have to assign to any holdings of sub-investment-grade bonds. “The rationale for [foreign] investors to buy high-yield domestic bonds is clearly unconvincing,” he concludes.

Russia will certainly be the main focus of investment in Eastern European corporate debt in 2013, and companies in the smaller countries of the region are also set to issue more bonds than last year (when they raised a combined total equivalent to just under €9bn from domestic and foreign investors). Companies in Turkey and Kazakhstan, two countries with higher growth expectations than Russia, are expected to among the more active. The Turkish white-goods manufacturer Arcelik, for example, announced at the end of January that it had applied to country’s Capital Markets Board to issue debt worth up to $1bn. Poland’s largest bank, the statecontrolled PKO, is another of the larger corporate issuers that expects to return to the eurobond market in 2013, after raising $1bn and SF534.9m from two foreign currency issues last year. The demand for Eastern European corporate bonds has helped to avert the feared liquidity crunch in the region, as the Western European banking system otherwise cut back on cross-border lending to trim their own balance sheets. “That certainly hasn’t been as issue at all,”said another emerging market portfolio manager. “The capital markets are very much open for these companies to issue bonds, as a lot of them are well capitalised with EBITDA ratios that aren’t particularly challenging.” A recent study by Austria’s Erste Bank, which has a heavy presence in Central and Eastern Europe, and is the leading book runner for bond issues out of the region, shows that only Hungary really suffered from this syndrome. The bank says that the impact of de-leveraging in Croatia, Poland, Slovakia, Romania, and the Czech Republic has been relatively benign, thanks to relatively high levels of portfolio capital, rising levels of consumer savings, along with the inflows of cash from the EU. Erste Bank adds that these fundamental strengths, together with the generally low level of external financing

in the region (Hungary again being the obvious exception) should render it less vulnerable than Western Europe to any global slowdown of capital inflows that might occur if the markets move into a risk-off mode once more, as a result of a renewed crisis in the eurozone or other shocks. Andreas Treichl, the Erste Group CEO, also played down fears that companies in Central and Eastern Europe could be vulnerable to a decline in exports to large eurozone economies this year. “Exports in the region have been stronger than in the rest of Europe, and there is very little reason for us to believe that this performance should not continue throughout 2013 and the coming years,” he maintains. “The relative performance of this region vis-a-vis other regions of Europe is substantially better.” The low level of corporate defaults in the region so far would seem to support this contention. Standard & Poor’s reported recently that of the eight defaults in 2012 among the companies it rates in EMEA, Poland’s third largest building company PBG—which filed for bankruptcy in June—was the only one in Eastern Europe. The credit ratings of companies across the Eastern European region are also continuing to improve, even as the ratings of many of their Western European counterparts continue to decline. Even corporations in countries where the sovereign ratings are under pressure have managed to achieve upgrade. Fitch, for example, raised its rating on the Mryia agricultural company in Ukraine by a notch to single B with a stable outlook, for instance, the strength of its recent revenue growth and expectations of further improvement in performance. “For many of these industrial borrowers, the prospects are really not bad,” said Marc Ostwald, bond strategist at Monument Securities.“Many of those companies in Poland, the Czech Republic and Germany will continue to do well, for example, as long as Germany does.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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EASTERN EUROPE REPORT

BOND ISSUANCE: INVESTORS CONCERNS OVER PRICING

The current obsession of global bond investors to pursue yield above all else is enabling governments across Eastern Europe to borrow money at a lower cost that at any time in their history. They raised around $85bn from the international capital markets last year, and there is every prospect that they will exceed this figure in 2013—as the monetary easing policies of the US Federal Reserve and the European Central Bank continue to inject huge volumes of liquidity into the market while returns on safe-haven US and Western European sovereign debt remain paltry. But is this trend creating a dangerous investment bubble? Andrew Cavenagh reports.

IS THIS THE BEGINNING OF A DIP FOR EASTERN EUROPEAN BONDS? OME INVESTORS CERTAINLY seem to think the bubble in Eastern European bond issuance might be pricked sooner rather than later. They point to the pricing and spreads on Eastern European debt which they say increasingly reflects the burgeoning demand for any paper that offers a triple-figure yield rather than the underlying economic fundamentals of the countries in question. Mike Riddell, who manages M&G’s International Sovereign Bond Fund, is one who has decided to give Eastern European sovereign debt a wide berth for the time being for these reasons. “We continue to worry a lot about the region,” he explains. “At a macroeconomic level, it is heavily exposed to the spluttering eurozone economy and is continuing to be hit by aggressive deleveraging by the eurozone-based banks on which the region is reliant. Many Eastern European countries also now have to contend with what are arguably overvalued exchange rates. So we are very happy to avoid their sovereign debt.” The imbalance between supply and demand is certainly driving down pricing and spreads to the point where there is dangerously little potential

upside and a great deal of possible downside. Given the upturn in the market for Eastern European sovereign debt in most cases owes everything to investor hunt for yield rather than fundamental credit analysis—in common with other sectors of the bond market at present—the record levels to which yields are falling threaten to leave investors badly exposed when US and European monetary policy finally tightens and/or market sentiment changes. At the start of the second week in January, for example, Poland was able to launch a €1bn, six-year eurobond paying a coupon of 1.625% at a spread of 65 basis points (bps) over the midswaps benchmark to offer investors a yield of 1.705%. Later in the month, the Polish finance ministry also raised the equivalent of $4.4bn from its domestic bond market from a combination of two-year and five-year bonds that priced to yield 3.285% and 3.437% respectively, while the premium on the country’s ten-year sovereign debt over German bunds of the same maturity fell to a four-year low of 2.25%. Although Poland has so far managed to be the one European country to avoid recession since 2008, its economic prospects over the next 12

months (with a projected growth of slightly under 2% for 2013 heavily dependent on no serious decline in the country’s exports to the eurozone) hardly justify such a dramatic reduction in the government’s cost of borrowing. The Czech Republic, meanwhile, issued an admittedly much smaller volume of three and a half-year debt, CZK3bn ($157m), on January 23rd at an average yield of 0.63%; almost half that presently offered by Swedish sovereign debt of the same maturity. Given the important contribution that currency appreciation is expected to make to the performance of emergingmarket bond funds in 2013, the current overvaluation of some Eastern European currencies must also be a concern, as even the weaker countries in the region are looking to cash in on the seemingly insatiable appetite for capital-market debt that offers more than the minimal yield. A year ago, such countries would have had little option but to negotiate emergency loans from the International Monetary Fund (IMF) and accept the budgetary constraints and other conditions that always accompany such support. However, they are now finding that they can approach the markets for funding at a viable cost. Hungary, for example, has mandated banks to hold discussions with US and European investors over what would be its first international bond issue (probably to be denominated in dollars) since 2011. The government of Prime Minister Viktor Orban has been in constant dispute with the IMF since it came to power in 2010 and is clearly grasping the opportunity to free itself from the straightjacket of the fund’s lending terms as yields on Hungary’s junk-rated sovereign debt have fallen below 6%. The country has about $7.2bn of bonds to refinance and $5.9bn of IMF debt to repay in 2013, and if the Orban government can secure enough market funding in the early part of the year it will then be free to go ahead with the more expansionist policies it wants to pursue despite the IMF’s objections.

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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EASTERN EUROPE REPORT

BOND ISSUANCE: INVESTORS CONCERNS OVER PRICING

Serbia is another beleaguered Eastern European country that is seeking to raise money from the bond markets, after the IMF froze a €1bn standby loan last year because the government had failed to meet budgetary commitments that were a condition of the aid. Heartened by the drop in yield on ten-year Serbian sovereign debt from 7.27% to 4.8% over the course of 2012, the country’s Finance Ministry has indicated that it intends to raise €4.5bn from the markets this year, including a seven-year Eurobond in the first quarter. If compressing yields and the region’s economic reliance on the eurozone are heightening fears of an Eastern European sovereign debt bubble, however, there are also mitigating factors. One important consideration is that most of the countries of Eastern Europe have impressively low debt-toGDP ratios relative to their Western counterparts, Hungary being the notable exception. Moreover, the growth outlook for most Eastern European economies means that they should be able to finance their obligations without having to increase these ratios significantly. “The outlook for those debt-to-GDP ratios is also fairly good,” maintained Grant Webster, portfolio manager for emerging-market debt at Investec Asset Management.“Nominal growth should finance the debt going forward, rather than additional borrowing.” The projected growth rates for the region certainly compare favourably with those for the eurozone, where no overall improvement is forecast for 2013 and even the German economy is not expected to grow by more than 1.1%. While weaker demand from most of the eurozone countries, which represent the main export markets for Eastern Europe, will clearly inhibit the rate of growth for some, others still look set to achieve far bigger improvements in their GDP than any of the Western European economies. Turkey and Russia are two of the brighter prospects. According to US

investment bank JP Morgan, both countries should achieve GDP growth rates of 3% or more in 2013 (which is almost double the bank’s 1.6% expectation for Poland and three times its 1.1% forecast for Germany). This should strengthen the Russian rouble and the Turkish lira (which has been under some pressure from Turkey’s current account deficit) to the benefit of their domestic bond markets (given the much greater contribution that currency gains are widely expected to make towards the performance of emerging-market bonds this year relative to 2012). Turkey also received the boost of receiving its first investment-grade rating for 18 years in November, when Fitch upgraded its long-term issuer default rating to BBB-. The agency cited the country’s moderate and declining government debt burden, sound banking system, favourable mediumterm growth prospects, and relatively wealthy and diverse economy as the reasons for its decision. There is every chance that Standard & Poor’s and Moody’s will follow suit in 2013, which would elevate Turkish sovereign debt into the investment grade indices. The Russian government, meanwhile, should have finalised all the necessary arrangements by the end of February to enable ruble-denominated fixed-income debt to settle through the Euroclear and Clearstream systems. This move is expected to boost foreign

GDP and debt forecasts 2013 Country

GDP growth

Debt-to-GDP ratio

Bulgaria

1.5

19.7

Czech Republic

0.0

44.5

Hungary

0.0

77.1

Kazakhstan

6.0*

15.3

Poland

1.6

57.5

Romania

0.8

37.5

Russia

3.0

9.5

Slovakia

2.0

46.5

Turkey

3.7

34.7

Ukraine

1.5**

39.5

Sources: JP Morgan, EBRD, OECD, and Erste Bank for growth forecasts;Standard &Poor’s for all debt-to-GDP figures

investment in the country’s $99bn market for local-currency debt from its present meagre level of around 8% to as much as 30%. The positive outlook for the Russian and Turkish bond markets this year suggests that the right asset selection will be the key to successful investments in Eastern European sovereign debt over the next 12 months. “I think that will definitely be the theme of the year: more differentiation,” says Richard House, head of emerging market fixed-income at Standard Life. “We have concerns from a macro perspective with respect to Hungary and Ukraine, for example, but Turkey’s a great story at the moment. We are expressing that view in domestic currency markets, specifically in inflation-linked bonds. I think it’s going to be one of the trades for this year.” Webster at Investec added that it would not just be a case of discriminating between countries, but also between individual asset classes, as the prospects for a given country’s dollar or euro-denominated debt could be very different from that issued in its local currency. He points to the recent example of Mongolia’s inaugural $1.5bn sovereign issue at the end of November, split between a $500m five-year tranche and a $1bn ten-year tranche, which almost immediately started trading at a discount although the issue had been heavily oversubscribed (the fact the issue, which priced to offer yields of just 4.125% and 5.125%, amounted to almost one fifth of the GDP of a country that experienced a sharp deceleration in growth over the third quarter might have prompted some revision of investor sentiment). While the Mongolian example may serve as a warning for those contemplating investments in the sovereign debt of the more impaired Eastern European countries, however, there will no universal bubble burst in 2013. There are clearly opportunities for strong out-performance elsewhere in the sector. I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

Ever since Budapest, Ljubljana, Prague and Vienna joined forces in 2010 to create the Central and Eastern European Stock Exchange Group (CEESEG) speculation has waxed and waned over a merger with main rival, the Warsaw Stock Exchange (WSE). The rumour mill is currently quiet but in the face of globalisation, there may be safety in numbers. Lynn Strongin Dodds. HE CONTINUING DEBATE these days among trading venues is whether merger with a like operation adds or detracts from inherent value in a business. The jury is out. Some mergers and acquisitions work; others don’t. However, successful stock exchange WSE has long been a target for the expansion plans of the CEESEG group. The WSE has so far rebuffed overtures from the CEESEG but together they could create a formidable force and perhaps fight off any potential takeover bids. Figures from the Federation of European Securities Exchanges shows that they are almost equally matched on the market capitalisation front with the CEESEG valued at around €125.9bn compared to the WSE’s €120bn. The WSE is way ahead though in the listing stakes with 740 listings compared to the Vienna led group’s much smaller company roster of 241. In the greater scheme of things, other pairings may take centre stage. At the moment there are no firm offers on the table but Herbie Skeete, managing director of Mondo Visione, does not expect any of the Mittel European exchanges to remain independent in the long term.“I would not be surprised to see Deutsche Börse make an offer for CEESEG at some point in the future. It could work in that all four exchanges are or will be on its Xetra trading platform. The other possibility perhaps would be Switzerland’s SIX Group

which is also small and may want to join Middle Europe. The WSE has made it very clear that it does not want to merge but the big question given the recent announcement of ICE’s proposed takeover of NYSE Euronext, is what will happen to them if other exchanges get bigger?” Other possible suitors mooted include NASDAQ OMX, the Istanbul Stock Exchange or Moscow Exchange which is poised to come to the market and could have $500m to spend. Another option would be for WSE and CEESEG to follow the example of other regional exchanges and form ties. Alexandra Foster, global head of strategy & business development, financial technology services, BT, notes,“Poland has worked very hard to achieve its position. That said, there are many benefits from amalgamation or some kind of alliance such as the initiative between Brazil, Russia, India, China and South Africa to cross-list benchmark equity index derivatives on each other's boards. The same is true of the ASEAN trading link which connects Bursa Malaysia, Singapore Exchange (SGX) and The Stock Exchange of Thailand. It not only reduces the cost but it also optimises the infrastructure that is needed for investors to gain exposure to these markets.” Not everyone believes a deal will be struck in the future.“The new European exchanges remain at a very early stage of development. Warsaw is currently

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

EASTERN EUROPE: CEESEG

Will the WSE continue to go it alone, or merge with CEESEG?

market leader west of Russia and has the momentum to expand its lead over Vienna, according to Patrick Young, head of DV Advisors, a securities exchange consultancy. “Nevertheless it is still too early to see western exchanges taking an interest in an acquisition in the region. There simply isn’t enough hard currency bottom line to justify the integration cost of eastern and western exchanges. Moscow, meanwhile, is focused on its own vast domestic opportunity with some optionality in the former USSR. However, any attempt to acquire Warsaw or Vienna in the near future would be politically challenging. Ultimately New European markets remain in the initial phases of their development. Everything is still in flux although Warsaw is the clear market leader in CEE/SEE (Southern Eastern Europe).” For now, the Polish exchange is dealing with the fallout of the suspension its high profile chief executive, Ludwik Sobolewski following a probe into claims he allegedly sought funds from listed companies for a film entitled Pharoah’s Curse which involved his girlfriend. According to Polish media reports, Sobolewski did not admit any wrongdoing and neither the exchange nor the treasury ministry, the dominant shareholder give any reasons for his dismissal. Despite the alleged scandal, the accomplishments of Sobolewski who became head of the exchange in 2006 are well recognised. He not only opened the WSE’s New Connect small companies market but also added energy and bond trading to its product stable. He also helped oversee the WSE’s privatisation three years ago, which saw the treasury’s stake in the bourse whittled down to 35%, although it kept a voting majority. The recent event is not expected to tarnish the WSE’s image with the general view being investors are more concerned about the size of the stock exchange, free float, a number of companies listed, initial public offerings, profits and dividends. “Stakeholders are very good at discerning personal matters and those of

EASTERN EUROPE REPORT

EASTERN EUROPE: CEESEG

the organisation, which is and has been running smoothly on all operational levels at all times,” says and Adam Maciejewski, who was appointed CEO at the beginning of the year. “Regardless of that, we are working on increasing the level of trust because it is beneficial to both investors and listed companies.” While Maciejewski is expected to continue pursuing WSE organic growth strategy, he is very clear about wanting to play a part on the wider exchange stage. “Historically, Warsaw Stock Exchange was quite adept in leveraging the potential of the national economy, and there is still scope for significant secular growth, with ratios such as free float, velocity, market capitalisation and nominal value of corporate bond issuance to GDP still at levels suggesting potential for convergence with developed Western markets. However, the long-term challenges will be less about focus on the local market and more about the dynamics in the European and global marketplace. Outside competition, commoditisation of equity trading, local and European regulation and, above all, technological change, which is a pre-condition for all those other trends to occur, will drive changes that will be unprecedented in scope and speed. We believe WSE has perhaps the most important role to play in the region amid this ever-changing landscape.” One of the most important developments and one that will help sharpen its competitive edge is the implementation of NYSE Euronext’s UTP trading system this April to replace its 13-year-old Warset platform. According to Maciejewski it will be accompanied by, new trading solutions and, later, auxiliary services that will make it more attractive to trade in Warsaw for an entirely new range of investors, including algorithmic traders. “What use will international and local investors’ make of those new functionalities will to an extent determine the scope for additional growth of investor activity at the Exchange in future years. As with any technological change,

however, we expect changes in demand for services to be gradual.” The WSE will also continue to strengthen its position in the derivatives space. It traded 9.09m units last year, making it the fourth biggest in Europe and the dominant player in CEE. Futures on the WSE’s large cap index, WIG20, had the eighth highest trading volume in Europe with 9.08m units while its WIG20 options ranked 13th in terms of turnover volume among European index options

WSE’s listing crown In addition, Maciejewski is intent that WSE maintain its listing crown this year. It topped the European league tables with 105 deals or 40% of the total transactions and placed fifth in terms of value in 2012, according to the most recent PwC IPO Watch Europe quarterly report, which tracks activity on the main European exchanges. The most notable deal was Alior’s PLN2.1bn ($673m) flotation, which was the biggest offering in the European banking sector last year. Also, Russian company Exillon Energy, which already sits on the London Stock Exchange, made the news when it chose the Polish bourse for its secondary listing. As for this year, it is still too early to predict any trends.“There are a number of offers in the pipeline,” says Maciejewski. “Their eventual success will be determined by market conditions. We will double the focus on large entities, which provide the necessary liquidity and are revenue-generating for the exchange”. CEESEG is also forging its own path. “We do think a stand-alone solution can work and our strategy has been to consolidate and integrate the four exchanges and capital markets,” says Michael Buhl, joint chief executive officer of VSE and CEESEG. “We are currently focusing on our own group but if there is possibility for future cooperation we are open to talks. WSE and CEESEG are the main players in the region because the other markets such as Zagreb, Sofia, Belgrade and

Bucharest are very small, accounting for about 2% of trading.”An important plank has been the upgrade to the Xetra trading system, which is based on licences used by 250 banks and investment companies and has 4700 registered traders across the world. Vienna was an early adopter in 1999 while Ljubljana went live in December 2010 followed by Prague last November. The Budapest Stock Exchange is next in line later this year. “It takes time—about a year—for the benefits to be realised,”says Buhl.“This is because Anglo Saxon banks won’t sign on until they see it up and running. However, in the end it does make the group as well the four exchanges more visible for foreign investors and enhances liquidity.” CEESEG is also busy developing data products. A new low-latency market data service has been launched that provides high-speed data to help highfrequency traders and other market participants using algorithms trade more effectively. All of the exchanges but Budapest are included but the Hungarian market will be part of the fold once it starts trading on Xetra. Indices are also a key part of the group’s product offering and to date it has between 130 to 140 issuers from 16 countries using their indexes as underlying benchmarks for a wide range of products including certificates, warrants, ETFs (exchange-traded funds) and other structured products. According to Buhl, selling index licences not only creates a source of income but it also provides benefits for its exchange partners through hedging opportunities which helps generating additional liquidity and volume in the market. “What we are trying to do is create as much harmonisation as possible which means leveraging the synergies between the four exchanges,”says Zslot Katona, chief executive of Budapest Stock Exchange. “However the group can only be strong if its local members are strong. We don’t want to centralise everything and we continue to develop our own products.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

RUSSIA REPORT

It has been a long time in the offing but the Moscow Exchange kicked off the year with a pledge to float its shares by June. The jury is out as to whether this will help fulfil the government’s long held desire to transform the city into a financial powerhouse alongside New York and London. Entry into this exclusive club is not easy and will take much more than a public debut. A weak corporate backbone combined with an immature pension fund industry has kept investors at bay but progress is being made. Lynn Strongin Dodds reports.

Moscow Exchange floats Russian capital markets make the market easier to access, ERGEI SHVETSOV, CHAIRMAN although it will take a lot of work at of the Moscow Exchange’s superboth the member and local participant visory board and deputy level. It will also make the market more chairman of the Central Bank of Russia, efficient, if they can address risk says, “The Exchange’s own listing is a management. The other big piece of key element of our strategy to promote news is the deal with Euroclear the development of the local capital regarding sovereign debt, which I think markets as well as to broaden the will also have a positive impact on the regional and international appeal of equities market.” Moscow as a financial centre. As a Last year, the government opened public company, Moscow Exchange will its doors to Euroclear Bank to offer be committed to demonstrating leaderpost-trade services for Russian OFZs, ship in corporate governance practices one of the most actively traded classes and transparency.” of Russian government bonds as well The exchange which was borne out as other Russian government and of the merger between domestic Photograph © Sky Pixel/Dreamstime.com, municipal and corporate bonds and market MICEX and derivative focused supplied February 2013. securities issued by foreign entities. RTS, is valued at between $4.2bn and $6bn and is planning to raise around $500m. Although that Previously, overseas investors were only able to trade in puts it near the London Stock Exchange (LSE) which is Russia’s roughly RUB3trn ($99bn) treasury market through valued at around $5bn, it lags far behind NYSE Euronext on local brokerage accounts. Liesbeth Rubinstein, manager of the Invesco Perpetual $8.1bn and Deutsche Börse worth about €9.2bn (over $12bn). The challenges though are not only in honing and Emerging European Fund, believes that the modernisation developing the exchange’s technology platforms, but also its of Russia’s financial markets continue to gain traction, image. As Carl Johan Wallin, global head of sales at Swedish drawing support from a government committed to reform based DMA puts it,“You can make changes to the platforms, and an economy showing further signs of maturity. The and regulations, connectivity and clearing, but it is much creation of the Moscow Exchange and a single platform has more difficult to change people’s perception of Russia. They also delivered benefits to the investment community in will not become comfortable overnight but the exchange is terms of reduced transaction costs.“We feel that the merger is part of a wider initiative to liberalise the financial markets on the right track.” Moscow Exchange, while reportedly mired in political and make it easier for foreigners to invest in the country. infighting, has nonetheless been a hive of activity in the past Opening the domestic bond market to outsiders, made year issuing new requirement for international accounting possible by the creation of the central depository, will make standards for listed companies as well as the creation of a it easier for foreign companies to access government bonds central securities depositary (CSD) which removes a key as well as local rouble bonds,” she says. Although all agree that the exchange has made great barrier for US investors that want to trade in Russia. It is in the process of upgrading its matching engine to a new strides, views are more mixed on its chances of becoming multi-asset class system for 2015 and also has plans to move a global financial centre.“The development and modernisato a T+2 settlement period, from the current T+0 regime tion of the Russian financial markets is a long term bet,” which required trades to be pre-funded before they were says Ales Prandsteter, investment analyst in CSOB. executed. “I think that the move to T+2 is seismic,”says Tim “The country has clearly taken some positive steps towards Bevan, managing director of BCS Financial Group. “It will greater market confidence and effectiveness. However, we

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

RUSSIA REPORT

do not expect it to become an international financial hub on par with London or New York”. Pavel Laberko, fund manager at UBP Investment Management, believes it might do better reining in its global ambitions. “I think at this stage it would be difficult for Moscow to become a global financial centre with the same calibre as London and New York. For now it should concentrate on becoming a regional hub by consolidating trading from companies of the former Soviet Union and perhaps in time acquire their exchanges. It will be a gradual process.” Per Lovén, head of international corporate strategy, at Liquidnet Europe, adds, “The exchange’s decision to list its shares in Moscow is a testament to its faith in its home market and this should have a positive impact on investor confidence. However, regarding Moscow’s importance as a financial centre, it is hard to speculate when or indeed if Russia has the potential to rival New York or London. A number of changes have to take place before it can become a truly global market. For example, Russia needs to further strengthen its corporate governance practices and, from a transactional point of view, deepen its pool of liquidity.” Jacob Grapengiesser, partner, East Capital, does think that “things have improved in the country over the past couple of years and there has, for example, been an increase in the number of independent board member. I also do not think it is any worse than any of the other BRIC countries such as China and India. The difference is that Russia is portrayed in a worse way.” Grapengiesser believes that a stronger legal framework which is expected to be implemented this year will help but the situation would greatly improve if Moscow could attract more local companies to list. Over the past decade, the LSE has been the venue of choice with Russian companies raising around $170bn through global depositary receipts compared to mere $19.5bn locally, according to Dealogic. Even when companies do opt for the home ground, it is often split between the two markets. For example, out of the five IPOs launched last year, two of the most high profile, Sberbank’s $5bn and Megafon’s $1.7bn were launched on both while the remainder were placed on London exclusively. One of the biggest problems comes when the IPO is launched via an offshore group established in Luxembourg, Cayman Islands or Jersey to circumvent the 25% cap on shares allowed to be issued outside of the country, according to Grapengiesser.“From a corporate governance standpoint, this means investors are facing multiple boards and it is unclear where the decisions are being made. If companies list 100% of its shares on the Moscow Exchange, it would lead to greater transparency,” he adds. Corporations also have to engage more on the shareholder front. “Investors compare stock exchanges’ best corporate governance practice and they will put pressure on them to ensure they are following the regulations,” says Martin Steinbach, head of IPO’s for Europe, the Middle East and Africa at Ernst & Young.“However, it is also up to the investor relations side of companies to talk to shareholders and build trust which will feed into the valuation of a company.”

Emmanuel Carjat, managing director, TMX Atrium. “The IPO puts the Moscow Exchange in line with other global exchanges ... and its desire to build liquidity in Moscow,” avers Carjat. Photograph kindly supplied by TMX Atrium, February 2013.

Liquidity is another key hurdle according to Emmanuel Carjat, managing director of TMX Atrium, a global HFT infrastructure provider that recently completed further expansion into Russia. “Competition is global and not just around their borders. They have to be able to attract enough flow to make it a centre where people want to trade and companies want to list. The merger last year was the step in the right direction and has given them a nice footprint in equities, fixed income, equity derivatives and FX. The IPO puts the Moscow Exchange in line with other global exchanges in that they are listed, but the fact that they are not offering depositary receipts makes clear the Moscow Exchange’s desire to keep building liquidity within Moscow.” While courting an international investor fan club will help, it will not be successful without a broad home base. Foreign investors currently comprise around two thirds of the Moscow Exchange and they consistently headed for the door if there is any shred of negative news. For example, Russian-dedicated equity funds posted an 11th week of outflows, losing $60m in the week ended December 19th which, to be fair, reflected worsening global macro conditions than any issues in the Russian market. Although pension reform is on the agenda, proponents suffered a setback when the government made a U-turn and proposed cutting the funded section of contributions from the current 6% to 2%. The result will be an even more miniscule pot available for assets. According to industry figures only 2.2% out of $60bn in supplementary pension assets is allocated to equities and current rules stipulate certain funds can’t buy the two largest companies: Gazprom and Rosneft. Insurance companies are banned from buying equities plus pension funds also have to guarantee a 12 month positive return. “Local buyers are very important for liquidity and stability because foreign investors retreat and are quite sensitive to macroeconomic issues.” says David Reid, analyst at The Eastern European Trust, notes,”They are there in the boom times but can potentially retreat during a downturn. This has a huge impact on the volatility and prices of the market.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

From right, Russian President Vladimir Putin, Kremlin’s chief of staff Sergei Ivanov and prime minister Dmitry Medvedev walk after Putin’s state-of-the nation address in the Kremlin in Moscow, Russia, in late December 2012. Russia’s president Vladimir Putin vowed mid-month to strengthen the country’s economy and its military might and rejected what he described as foreign lecturing about democracy and attempts at foreign interference in the nation’s internal affairs. Photograph for Associated Press/RIA-Novosti, Photograph by Dimitry Astakhov, Government Press Service, supplied by Pressassociationimages.com, February 2013.

Investors in Russian equities needed a strong stomach to ride the highs and lows of the Moscow Exchange last year. This year looks more promising, but despite the attractive valuations, institutions continue to tread carefully. Lingering concerns over the global macro-economy and the eurozone debt crisis cloud the picture but sentiment is also plagued by an underdeveloped local investment culture and questionable corporate practices. Lynn Strongin Dodds reports.

Political and corporate risk undermine Russian equities underperformance LTHOUGH THE EQUITY market started 2012 on a positive note, it ended the year with a relatively meagre 14% return within some of the main emerging market indices; at the bottom end of the scale, compared with average EM benchmark index returns of over 60% (Turkey), 46% (Egypt) and 43% (Philippines). Poland, Colombia and Thailand also delivered impressive 40%-plus increases while India led the BRIC pack with an almost 30% rise with China trailing behind at 9.68%. Brazil though fared much worse and was down 4.37%, one of the few emerging markets that came in at a loss.“Last year, Russia was one of the larger underperforming markets,”says Tim Wiswell, head of Russian equities at Deutsche Bank. “The country was on the back burner for a combination of reasons, one being various reactions of population after the presidential election last May as well as shareholder conflicts such as the one at Norilsk Nickel. Our clients pulled away due to this political risk combined with the corporate governance issues.” Any number of feuds of international renown typifies the issue. One involves mining giant Norilsk two largest shareholders Vladimir Potanin and Oleg Deripaska who found themselves embroiled in a four year dispute over board representation and dividend payments. Fellow Russian tycoon and Chelsea football club owner Roman Abramovich reportedly backed by the Kremlin helped broker a deal, resulting

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

in the largest golden parachute ever awarded in the country’s history. Vladimir Strzhalkovsky, a controversial chief executive who is allegedly also a former KGB agent and ally of Russian president Putin walked away with an eye watering $100m package to step down. This feud has been resolved; but little has been achieved on the Yukos problem. Yukos used to be Russia’s largest private company; reputedly worth over $4bn before tax authorities seized its largest production asset in 2004 in a case which analysts have linked to the opposition political activities of its founder, Mikhail Borisovich Khodorkovsky. His lawyers have lodged several complaints with the European Court of Human Rights seeking redress for alleged human rights violations. Two years ago, the Moscow City Court reduced his sentence from 13 and a half years to 12, but did nothing to address any of the procedural violations his lawyers have asked to be investigated by the courts since 2003.There is talk of Putin granting a pardon but market participants are doubtful. There are also the stop start hawkish statements from strongman Putin which reflect his ambivalence about the opening up of the country to foreign investment and business. In mid December last year, in a keynote speech, he vowed mid-month to strengthen the country’s economy and its military might and rejected what he described as

RUSSIA REPORT

foreign lecturing about democracy and attempts at foreign interference in the nation’s internal affairs. While these corporate and political risks are not new and help explain why Russia is one of the cheapest markets, last year corporate valuations sunk to new lows on the back of fears over the global economic picture. It has yet to recover and today (generally) valuations remain low. “There are a number of factors behind the low valuations,”explains Slava Smolyaninov, chief strategist at Uralsib.“The economy decelerated and the market was impacted by concerns over the eurozone and a slowdown in China. Russia was impacted because investors took money out of the whole region. However, we think the market data suggests that the macro situation has stabilised, the EU will stay together.” Gary Greenberg, lead portfolio manager and head of Hermes Emerging Markets also paints a brighter picture.“I think the market will be calmer mainly because a number of the tail risks have diminished specifically the US election and fiscal cliff issues. The eurozone debt crisis is less of an issue and China has also turned the corner. Russia is also in a stronger position, running an account surplus and a balanced fiscal budget.” Greenberg’s colleague, Elena Tedesco, portfolio manager, EMEA, Hermes Emerging Markets also believes the market should see a fillip from the government’s recent edict that all state companies, which comprise 40% of the MICEX index, have to pay at least 25% of their net income in dividends. This includes heavy hitters such as Gazprom, oil giant Rosneft, banks such as Sberbank and VTB, airliner, Aeroflot, cable group Rostelekom, pipeline monopoly Transneft as well as various energy groups such as RusHydro and the Federal Electricity Grid. Previously state and private companies engaged in share buyback programmes and invested in projects that did not seem to create value The stock market should also reap the rewards of the country’s entry into the World Trade Organisation. It may have taken 19 years of negotiations and reform will take time, but the country should follow the same path as China or Poland. The numbers crunched by the World Bank show that Russia’s economy could grow by $49bn (or 3% of gross domestic product) in the mid to long term.“One of the main reasons why Russia de-rated was because oligarchs took their money out of the country,”avers Tedesco.“WTO membership as well as the commitment from state owned companies such as Rosneft and Gazprom to pay higher dividends are important steps in the right direction and makes the country more attractive to international as well as local investors.” Equally important is the launch of its central securities depository (CSD) which aims to streamline the settlement process and crucially allow US firms to settle Russian under Securities and Exchange rule 17F7 which forbids investors to trade assets without a depository. Global investors across the spectrum also welcome the move to T+2 from its current T+0 settlement cycle which means that trades settle immediately at the point of the transaction. The majority of Europe is on a T+3 settlement, with the exception of Germany, which operates on a T+2 basis. MICEX is planning to move 20 of the

most liquid stocks from its order book to T+2 settlement in February, with the remainder due to follow by the end of July. There have been significant developments on the equities front and this should eventually allow global depositary receipts to be traded in Moscow, increasing liquidity and broadening the capital’s investment appeal, according to Liesbeth Rubinstein, manager of the Invesco Perpetual Emerging European Fund.“So far, we believe these concrete improvements have not yet filtered into Russian equity prices which continue to trade at discounted prices to their peers in the Western world from a valuation metrics perspective, as well as in the other regions of emerging markets. However, we believe that the improving investment climate in Russia, supported by an economy underpinned by strong macros, will eventually lead to a re-rating of the country.” Until then, volatility will remain a feature, although perhaps not as much as last year. As Pavel Laberko, fund manager at UBP Investment Management notes,“there are two main problems—an underdeveloped domestic market and lack of breadth in terms of the number of companies listed on the market if you compare it to the developed markets. There are around 27 names on the MSCI Russia index and they are heavily biased towards the energy sector. There is progress being made with the government’s privatisation programme and the line-up this year includes nonenergy companies from sectors such as transportation, construction and infrastructure.

Corporate sales slated The sale of 6% of Rosneft has been mooted with 5% of Russian Railways, 25.5% of VTB, and 7% of diamond miner Alrosa also slated for the block. Not everyone is convinced however that they will materialise as the sale of $100bn of state assets announced three years has not been smooth. In fact Rosneft $55bn purchase of 100% of TNK-BP last year seemed to turn the clock back with the largest nationalisation in post-Soviet history. The state in effect removed one of Russia’s last remaining private oil companies. Others such as Yukos and Sibneft were bought or bankrupted over the past decade under Putin’s rule. “There are really not that many state assets to be sold and for some companies such as VTB this is the second placement (11% was sold in 2011),” says Igor Danilenko, senior portfolio manager at TKB BNP Paribas Investment Partners. “Its shares have underperformed and it will be hard to convince investors to come in again. Rosneft has a much better story to tell. Overall though privatisation will improve liquidity and make the management at these state owned companies more efficient The far more interesting fact is the tax breaks that the government is giving oil companies for green field and offshore production. This will increase their profitability which has been stagnant plus it will have a knock on effect to other sectors such as oil services. Although, I think more could be done to diversify the economy from oil, we see opportunities in consumer goods and financials and especially infrastructure which the government has made a priority.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

Investment banks in Russia shook off the doldrums dragging on global merger and acquisition activity in 2012. Sberbank consolidated its takeover of investment bank Troika Dialog, and the MICEX and RTS exchanges bedded down together as Moscow Exchange. Otkritie announced its intention to become Russia’s number two private lender when it takes over Nomos Bank this year, and Onexim announced in November it was taking over Renaissance Capital. By Ruth Hughes Liley

Shake up in Russian banking revitalises broker-dealers HE SHAKE-UP HAS been accompanied by the state’s sale of shares in its two behemoth banks, Sberbank and VTB. In September, the sale of 7.58% of Sberbank raised $5.1bn in a secondary public offering in London and an impending SPO of VTB, Russia’s second largest stateowned bank, will reportedly take place this year, aiming to raise between $1bn and $3bn. Ultimately the Russian government plans to reduce its current holdings in both state banks to 50% plus one voting share. In a sign of Russia’s growing confidence in its financial institutions, the forthcoming Moscow Exchange IPO will be conducted on its own exchange rather than in London. It is expected to raise more than $500m. Against this backdrop of public offering activity and with promises by the government of IPOs in the pipeline worth $32bn, the heralded development of Moscow as an international financial centre looks on course. However, many of the predicted IPOs have been cancelled and not everyone is so optimistic as Denis Svechnikov, head of client relations, Uralsib Capital, says:“Sberbank has paved the way for future IPOs for Russian banks and that will have a knock-on effect on other banks’ IPOs, but government officials have been saying we can expect more IPOs for the last two years, and actions speak better than words. We don’t see any actions and we are waiting.” With the disappearance of Troika Dialog, one of Russia’s oldest financial names, Renaissance Capital (RenCap) has lost its closest competitor and RenCap’s takeover by Onexim, led by former presidential candidate and billionaire Mikhail Prokhorov, if approved by the regulatory authorities will be good news, says Damian Bunce chief executive officer RenCap’s Electronic Trading Group. “As far as electronic trading is concerned, the state banks have yet to make their presence felt. If they chose to, they could of course operate on a completely different scale, but for the next few years this is largely the territory of the smaller banks that are nimble and tech-centric.” Nonetheless, independent investment banks have come under increased competitive pressure from the expansion of Sberbank and VTB since 2007 to what one broker describes as ‘the full-blown investment bank model of the west’. Sberbank, worth $106bn in September 2007, clocked in at

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

$335bn at the close of 2011 and last year its profits rose 11% to reach RUB344bn. Similarly VTB gained RUB2.7trn ($85bn) to be worth $125bn in December 2011. Another pressure point has been low trading volumes— more of a problem for Russian banks than elsewhere as Ben Wood, managing director and head of international DMA at Otkritie explains: “It’s less of a mainstream market place. A lot of volume from traditional asset managers has to be done because of periodic inflows and redemptions, but when you are less mainstream market or a developing market, your volumes suffer first and often more when there is a general fall.” Oleg Achkasov, head of equity trading at VTB Capital says:“Volumes on MICEX dropped almost 45% year-on-year in 2012. If you add to that margin compression, then it is obvious that the weaker players will shut their operations and the number of players will shrink further. Otherwise, this business will not be sustainable even for the bigger players with significant market share. This line of argument is the same for both institutional and retail brokers.” Low volumes have in part led to some banks closing down their entire equity operations. ING closed down its equities businesses in Russia and the central and eastern European countries on October 1st, 2012 “for strategic reasons” with the loss of 130 jobs. They had held 28th position by market assets at the close of 2011 and as a leading player in Russian equities, the announcement surprised the industry. The bank has kept open its Moscow office to focus on its other businesses in Russia, including currencies, derivatives, bonds and treasuries. Now ING is focusing on equities and ECM in Benelux and retains its domestic operation in Poland. Similarly, UniCredit, Italy’s largest bank, had a 2.2% market share in Russia, and was ranked 8th by total local assets at end 2011 with 110 branches. However, in June 2012 it stopped its cash equities brokerage business and research in Russia, outsourcing the cash business to Kepler Capital Markets, although it still retains its equity capital market origination. The previous year it wrote down to zero the goodwill on Aton, the Russian brokerage it bought in 2006. Aton meanwhile, has been revitalised. Since the end of its agreement with UniCredit (instigated back in 2009),

RUSSIA REPORT

Aton claims to have set up 300 client accounts in only 11 months. It operates in 69 of the country’s regions and has local representatives in 15 regions. The company plans to open an office in New York later this year, opening up the Russian market to US clients. Currently its client base is mainly Russian local clients that gain DMA access to Moscow Exchange and also western markets. A spokesman at Aton says: “Our in-depth knowledge of DMA business brought us many international names that execute their orders on Moscow Exchange with us while sticking to the stringent conditions of keeping assets with their prime brokers.” Local brokers are in a better position to do this. Unlike international banks that are legally bound to maintain a physical presence in the country to conduct business, local banks already have market access, local knowledge and a wider access to the Russian client base including corporate clients to which they can offer corporate access and research. “Brokers that tick all those boxes have proved competitive versus global banks,” says VTB’s Achkasov. Moreover he believes that brokers with a mix of retail and institutional and those which have both cash and derivatives are in stronger positions. Meantime, Renaissance Capital has lived up to its name as 2012 saw a rebirth of the company focused on Russia, encouraged in June by Standard and Poor’s revised outlook from stable to positive. It has beefed up its electronic trading team including new Russian-based sales traders for EMEA. Following its migration to the Calypso platform and Gatelab trading engine, it topped the London Stock Exchange IOB with a 10% market share. All this took place before the takeover announcement by Onexim in November. A change of leadership in RenCap took place in December. The firm now has a new president, Alexander Merzlenko, and new co-CEOs in Igor Vayn and John Hyman, who also carries the mantle of chairman. While some are not convinced about RenCap’s strategy, Damian Bunce says the outlook is positive: “There is no change in strategy for the firm or for the electronic trading group. Our electronic trading strategy is simple and that is to provide a focused and sophisticated prime brokerage and high speed execution service to the high frequency trading community worldwide. We want to provide access to all the Russian liquidity pools the fastest and wrap prime brokerage services around that: risk management, stock inventory and leverage. On top of that, it’s to make sure that domestic and international clients can access correlated markets and instruments for arbitrage opportunities.”

Ben Wood, managing director, Otkritie. Photograph kindly supplied by Otkritie, February 2013.

Andrew Powell, director, international DMA sales, Uralsib Capital. Photograph kindly supplied by Uralsib Capital, February 2013.

Diversity the name of the game As part of a trend for banks to specialise and diversify as much as possible, “looking for greener pastures” is how Svechnikov describes UralSib’s diversification. One of those green pastures is the new DMA access to the MICEX cash currency market, which on its first trading day, traded $11bn. “We have been granted access and we see great potential for our currency market business,” says Svechnikov.

Oleg Achkasov, head of equity trading at VTB Capital. Photograph kindly supplied by VTB Capital, February 2013.

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Having a foot in both Russia and London also gives banks an advantage. Uralsib offers DMA access to London and Frankfurt for its Russian clients, while Andrew Powell, director, International DMA Sales, oversees the DMA business into Russia emanating from non-locals. “One of the local brokers’ biggest advantages is that they can be fast in adapting to the ever-changing market environment,” says Svechnikov. Uralsib has been selected as one of the brokers to test Moscow Exchange’s T+2 trading settlement infrastructure that the exchange plans to offer in July, initially on an estimated 20-30 of the top equities. Ben Wood at Otkritie sounds a note of caution about the move, pointing to anecdotal research into whether the larger investment banks without local Russian capabilities are ready for local T+2. The research found that many did not have it high on their list of projects and were consequently ill prepared for the move.“This could cause a few problems,” says Wood. Other developments for which banks must reconfigure their technology are longer trading hours, the recognition of the National Settlement Depository (NSD) as central securities depository, and the clearing of sovereign bonds through Euroclear. Tim Bevan, managing director, BCS, sees all these developments as having beneficial effects in the equities space. “Internationally, there will be better interlinking with the global market. The use of Euroclear will mean that Russian assets will be part of the global collateral pool.” However, local banks will not necessarily welcome this with open arms as Bevan explains:“The local community will guard aspects of the market. Local banks are used to a closed market and not everyone is going to welcome the international competition. There are always going to be tensions.” As Bevan concludes,“The map is changing. The power is moving towards the big state controlled banks as with the other main sectors in Russia. The degree of participation of the state and degree of control exerted by the state is well beyond anything we experience in the west. It’s a softer version of the Beijing model, but is still a long way from being open and competitive.”

Technology and HFT Better technology is encouraging high frequency traders, drawn by Russia’s arbitrage opportunities between the London Stock Exchange International Order Book (IOB) and the underlying stocks in Moscow and by the correlations with Russia’s energy firms. Aton is building its HFT services, aiming to provide clients with low-latency market access by building resilient infrastructure and offering scalable trading architecture providing DMA, co-location and special exchange programs. In January, technology firm, TMX Atrium announced an upgraded high-speed link between London, Amsterdam, Stockholm and Moscow and a new path from Frankfurt to Moscow to meet the growing demand they are seeing for ultra-low latency connectivity into Moscow.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

Tim Bevan, managing director, BCS. Photograph kindly supplied by BCS, February 2013.

“Initially those who are already in place in the Moscow market will have an immediate advantage. These brokers with existing relationships into Moscow Exchange are now targeting the large volume, low latency sensitivity traders,” says Emmanuel Carjat, managing director, TMX Atrium. Tim Bevan, managing director at Russian brokerage BCS confirms he is seeing interest from high frequency firms and quant funds as well as more traditional funds and technology based companies and global banks without a Russian desk. Similarly at Otkritie, where the takeover of Nomos Bank in 2013 will make it Russia’s second largest independent and publicly–traded financial group, Wood is busy courting business abroad and recently met clients in Canada and the US. He says: “Interest is coming from traditional asset managers, the wholesale market place to service the asset managers and from the latency sensitive clients because the exchange has made such great strides in providing world competitive infrastructure.” While the number of strategies is“quite large and doesn’t differ much from developed markets” according to VTB Capital’s Achkasov, he has seen a trend for more straightforward strategies as the hedge fund presence in Russia has decreased recently. BCS, which has the largest market share of equity trading on the Moscow Exchange (with around 10-15% of the market), aims to launch a new suite of algorithmic products by the end of March. At Moscow Exchange, more than 300 brokers systems now have certified access using international protocols including FIX. Reconfiguring matching engines to connect to the exchange and to offer algorithmic strategies is expensive, something which gives the bigger more diversified players an advantage. Indeed, Powell says smaller banks may simply be unable to afford the investment. “Banks need to present as big a product suite as possible. If you can offer multi-asset trading with algorithms on top, you are in a strong position.” I

EQUITY TRADING

With reported three-quarters of the buy side fearing indecision on regulation as the biggest impact on order flow in 2013 and other fears not far behind, it could be another year of uncertainty for cash equities. Macro-economic factors are not helping. The ‘fiscal cliff’ in the US is far from resolved. European sovereign indebtedness too remains a concern, with micro-state Cyprus currently testing the resolve of the EU to employ concerted refinancing tactics to hold indebtedness in check. What will 2013 bring for the cash equity market? Ruth Hughes Liley reports.

CASH EQUITY VOLUMES: What will re-ignite the confidence factor in equities?

We are quite likely to help other banks HILE EQUITY INDICES with their technology solutions.” performed well in January and Gerry Fowler, head of equity and detrading volumes in the month rivative strategy at BNP Paribas, makes a eclipsed those in December, the reality is distinction between discretionary that overall, trading volumes were still volumes with higher margin and lowlower than they were in January 2012. touch business which is done at much What’s amiss? “Around the world, confilower cost. “Yes, volumes are down, but dence needs to come back and investors they are still not down from mid-1990 need to see that governments are taking levels. In the 1990s there was less elecaction,” avers Adam Toms, chief executive tronic trading; now a large proportion of officer at Instinet Europe. “The fiscal cliff, volume is electronic and trades are done ratings agencies’ downgrades of at much lower commissions. Margins countries—there are lots of things in the have come down and that is what is system that could knock confidence and “The industry remains under serious really squeezing the cash businesses. The cause people to be a lot more cautious in stress,” said Jerry Avenell, European real problem is very high operational 2013. Until confidence comes back, co-head sales, BATs Chi-X Europe. leverage. Some of the larger firms have a equities will remain challenged.” Photograph kindly supplied by BATS lot of fixed costs. The ability of banks to At November’s European Exchanges Chi-X Europe, February 2013. generate revenues to support this means Summit in London, delegates spoke about cash equities being in ‘a very dark place’ with a ‘dramatic list that even a little downtick has a big impact on profitability.” While volumes have halved since mid-2008, the number of casualties’. Before the financial crisis, around €40bn to €50bn a day was being traded in Europe, according to of core brokers has remained largely the same, although Thomson Reuters. In November, Bats Chi-X Europe some on the buy side are concentrating their flow to try to save on commission dollars, according to TABB Group’s recorded an average of €25.4bn a day on exchange. “The industry remains under serious stress,” said Jerry latest European equity trading report: Changing the rules of Avenell, European co-head sales, Bats Chi-X Europe at the engagement. “With such little available revenue, both the summit.“Regulation is overwhelmingly coming down on us buy-side and sell-side must act swiftly,” writes author and and globally there are an estimated 45 banks or building TABB senior analyst, Rebecca Healey. The report highlights how the number of commission societies less since the crisis from bankruptcy, takeover or state ownership. It is a huge amount of loss in the industry sharing agreements has grown, as 56% of replying firms plan and we will start to see prices go up because financial service to increase CSA activity in 2013 with a further 20% waiting businesses are not able to run on sub basis point margins to see what regulation emerges. Furthermore, 42% now use CSAs to pay for independent research bills, highlighting with current trading volumes likely to stay for a while.” Toms believes that recent changes in the industry are the shift from bulge bracket to niche specialist research. Healey states: “As the payment for research becomes permanent and that people should be adapting their businesses accordingly. The change in the strategic decoupled from execution, true unbundling is finally deployment of Instinet, which is now the equities execution becoming a reality. CSA usage is driving change in execution arm for Nomura, “reflects us taking a view,” says Toms. models. An expanding research broker list is occurring at the “Execution is our business but there are a lot of oppor- exact time that counterparty risk is coming under increasing tunities for us to redefine ourselves as a service provider. scrutiny. All brokers will now need to establish a method to

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monetise their research capabilities and demonstrate this to all clients across the board—something which has not been easily achievable in the past.” Adrian Cattley, European equity strategist with Citi sees four pressures on cash equities: revenue from shares going down, the number of transactions down, the cost of transactions going up and a regulatory environment for financial intermediaries which is ‘more challenging’. In 1993, the average length of time a security was held was 25 months, Cattley states. This fell to just six months in 2007 but since then it has risen sharply and is currently back up to 20 months. “It probably won’t get much worse. It’s structural, as more passive fund managers are in the market and active funds are being less active, and it’s cyclical in that fund managers have fallen out of favour with equities and are trading less,” he adds. One unknown is the impact of expected lower issuance volumes through the year. Overall, the issuance of new loans and bonds from financials and corporates is expected to be €200bn lower than the amount of loans and bonds maturing in 2013. Fowler says: “The owners of these assets will have to find a new home for their excess cash and they naturally will either have to accept lower yields for the same risk profile or they will have to accept more risk for the same yield on that money. It could at least in part find a home in quality equities although there is more cash than investment opportunities, given monetary policies in Europe and the US, which are keeping default rates extremely low.” High frequency trading flow is often cited as providing needed liquidity, but whether that can step up to the plate to provide extra support for the cash equities sector is doubted. Cattley says: “HFT will continue to be an important provider of intra-day market liquidity, but it doesn’t generate much revenue for a cash equities business and the HFT firms will not act much differently next year from how they are doing now.” Furthermore, the regulatory attack on HFT is well under way. The European Parliament voted last October to support harmonised tick sizes, order-to-execution ratios and a minimum resting period of 0.5 seconds. However, the minimum resting time has since provisionally died out from MiFID, and market rumours have been that it could be included in an HFT law in Germany. Some believe it will affect all market participants indiscriminately. Tony Howcroft, director, equities sector trading, HSBC, says: “MiFID II as it stands will impact other asset classes more than equities. The biggest concern about regulation is over OTC equity trading which regulators want to push onto exchanges. It is a fundamental part of our business: if a client wants to buy into a large position, their bank might provide capital to give the client a good start to the order. Unfortunately, regulators look at OTC and see it as shadowy. Imposing pre-trade transparency on such trading would have an impact on smaller and mid-cap stocks where client might want to buy a day or twos volume. If it had to go through a lit venue, it would be incredibly hazardous in terms of market impact and the net effect is that end investors would be affected.”

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Alasdair Haynes, former CEO of Chi-X Europe, has used private money from around seven investors to set up Aquis, an exchange software provider and a lit pan-European equities trading exchange, which he aims to launch in Q3 2013. Photograph kindly supplied by Alasdair Haynes, February 2013.

Gerry Fowler, head of equity and derivative strategy at BNP Paribas, makes a distinction between discretionary volumes with higher margin and low-touch business which is done at much lower cost. “Yes, volumes are down, but they are still not down from mid-1990 levels. In the 1990s there was less electronic trading; now a large proportion of volumes is electronic and trades are done at much lower commissions. Photograph kindly supplied by BNP Paribas, February 2013.

However, implementation of MiFID II could be delayed until 2015 and in the interim uncertainty exists over market structure. In October, the European Parliament agreed that another category of trading platform, an organised trading facility (OTF) would apply only to non-equities. It now appears both the European Council and the Commission would like to see OTFs used by all asset classes. If OTFs come back into play for equities, many foresee a proliferation of venues as MiFID II encourages brokers to internalise trades on venues registered either as multi-lateral trading facilities, systematic inter-

EQUITY TRADING

nalisers or OTFs. Broker crossing networks would have to re-register as one of the three. Rebecca Healey states in a recent paper on the subject:“It is critical that market participants use this opportunity to build market structure that illustrates benefit to the end investor by offering a price or size improvement. Otherwise, the argument that the elimination of [broker crossing systems] will lead to higher market impact costs will become diluted, and we will have no one to blame but ourselves if the regulator attempts to force all trading back onto the lit markets.”

The role of IPOs One area which could help push up cash equities volumes is the knock-on effects of initial public offerings (IPOs), rights issues or mergers, which according to new figures from Ernst & Young are expected to pick up, led by the US and followed by Europe and Asia later in 2013. Globally the number of IPOs slumped 37% in 2012 to just 768 in the first 11 months, with 50 more expected before the year end. This was down from 1225 deals in 2011. In Europe, the value raised by exchanges also fell 63% in the same period. Instinet’s Toms says: “Primary activity is always good. It’s a sign of confidence in the market. So we will watch these larger IPOs with interest. If there is a lack of deal flow it won’t help markets.” Indeed, there is still pessimism about volumes. In a show of hands at the TradeTech Liquidity conference in London in November, most of the 200 delegates believed that volumes would stay the same during 2013 or fall further. Furthermore, according to the annual pensions Purple Book, from the Pension Protection Fund and the UK pension regulator, allocation to equities in UK pension funds has fallen to 38.5% in 2012 from 41.1% in 2011, hinting at systemic rather than cyclical changes in asset allocation. Nevertheless, in spite of the gloom-mongers, innovation is still occurring and new firms are still entering the cash equities field. Squawker, a block trading negotiation platform, is due to go live at the end of Q1 2013. It will aim to combine an electronic trading environment with social network principles so that anonymity is maintained and the user keeps control of the process. Alasdair Haynes, former chief executive officer of Chi-X Europe, has used private money from around seven investors to set up Aquis, an exchange software provider and a lit panEuropean equities trading exchange, which he aims to launch in Q3 2013. Haynes says Aquis, which he says has already sold its first proprietary technology kit to a new firm outside Europe, believes exchanges need to change the way they charge fees and wants to introduce a subscription-based model: “If you want to get the equities market to grow, the model needs to be changed. Rather than having fees based on the value of the trade, they should be based on the number of messages used. This would be a very transparent method of charging for the industry and would allow the industry to grow.” He adds: “The real issue is that there are a lot of national exchanges across Europe and one MTF. Together they hold

95% of all trading in Europe, so it’s a duopoly and the market doesn’t want a duopoly. The market needs another provider otherwise we will see prices rise and the market doesn’t want that.” One senior banker thinks that introduction of a consolidated tape and interoperability of clearing houses are two developments that would support cash equities. “Everybody will benefit from a consolidated tape of prices. All investors benefit from a record of reference as it will answer questions such as: Am I doing well? Where is the liquidity? Getting access to data at a reasonable cost is the key and we need the data to be provided in a comparable format. It’s the one thing that MiFID I missed. We need a prescription of the etiquette: how should trades be flagged, should they all be time-stamped?” In November last year, Graham Dick, former head of business development at Chi-X Europe, and Mark Schaedel, former global head of market data at NYSE Euronext, announced an initiative to nail down this ‘etiquette’ of reporting. The COBA project, which has received industry and regulatory support, builds on FIX Protocol standards and sets out a practical and commercial way to set up a consolidated tape. While better post-trade reporting would help transparency in the markets, firms are looking for different ways to find liquidity and with half of value traded on platforms that offer some form of interoperability, some believe extra flow will come on board if central counterparties are linked up. Cross-asset trading may also help flow and buy side traders have led the way restructuring their desks to trade multi-asset. Broker dealers have had some catching up to do but are beginning to move away from separate desks for equities and fixed income, for example. Société Générale has begun an integration of their index futures and fixed income futures into one desk and Mark Goodman, head of European electronic trading, says this means clients do not have to discuss their orders with two or three different desks if they want to trade electronically.“There has been a trend for buy-side heads of dealing in equities to be given multi-asset responsibility. The old-fashioned model of sell-side banks isn’t reflecting the buy side structure any more. It’s important for us to keep understanding from clients the other assets they want to bring to us to trade.” Andrew Crane, head of European equity flow trading at HSBC, says coming from a derivatives background makes it easier to work cross-asset.“Trading is moving towards crossasset as each individual has responsibility to be able to multi-task cross-product and I think that trend will continue. Banks are focused on costs and part of that is to get individuals to do more.” Crane is optimistic about equity markets in the long term. “Investors will continue to search for yield and that will encourage people to move into the equity markets, although volumes will continue to be dampened as it depends on retail coming back to the equity markets and that won’t happen in 2013. The man on the street is still focused on paying down his particular debt rather than investing in the market.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

EQUITY OPTIONS TRADING

Competition heats up in equity options

Photograph © Alhovik/Dreamstime.com, supplied February 2013.

The Netherlands is a fraction the size of the US, but it could prove to be a crucible for the development of equity options trading in Europe as the battle for advantage in the growing and lucrative listed options market heats up. By Ruth Hughes Liley. N JANUARY, AMSTERDAM-BASED pan-European trading platform, The Order Machine (TOM), began trading options based on the AEX-Index, using its own smart order router to compare prices, putting the firm head to head with NYSE Liffe Amsterdam. It comes just a year after TOM launched with a handful of single stock options, which it expanded in October to all major Dutch stocks. During 2012, TOM took 15% market share from competitor exchange, NYSE Liffe in Dutch single stock equity options listed on both markets. Chief executive officer, Willem Meijer believes this is just the start: “We are the first MTF to challenge the incumbent in the options area and we expect market share in options to reach 30% to 40% by the end of the year [sic]. We know this because we know our client base and our figures are based on the volume currently done by our clients on Euronext. Turnover will move to us.” It is tough talking. Nonetheless, while new platforms will face a tough job to unseat the top two exchanges, Eurex and NYSE Liffe—the AEX-Index option, already accounts for half of all index option volume on NYSE Liffe. “For the first time, incumbents should not take the new competition lightly,” says a new report from Celent. Eurex

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

traded 765.6m equity index contracts in 2012, down from 954.7m in 2011, but still retains more than 60% of the market. NYSE Liffe in Amsterdam, Paris and London combined accounts for a further 22%, while NASDAQ OMX traded 46m contracts in 2010. Meijer believes MTFs will take over more options market share from incumbent exchanges than they have done in equities, but he says if an MTF took market share of above 50% the incumbent exchanges would feel the burden of their vertical silo clearing models.“All of a sudden, it might be to their advantage to create an “open”open-interest pool. As soon as real competition opens up and there is a chance of losing market share, then change will come.” One difference between the Amsterdam model and other countries’ lies in the amount of retail flow which is traded. In the Netherlands, retail flow makes up 25-30% of NYSE Liffe trading. Meijer believes that as retail flow is captured on TOM, professional market makers will follow. The length of maturity and risk of an option will also have a bearing on where an end-user takes a contract. Ade Cordell, executive director, head of equity derivatives, NYSE Euronext, says: “We believe that end users are more

EQUITY OPTIONS TRADING

inclined to place options that have lengthy maturities, say the FTSE five-year index option, on trusted established platforms rather than on MTFs.” BATS Global Markets, which famously launched with a loss-making strategy, opened an options exchange in the US in 2010, but in Europe, BATS Chi-X Europe is still eyeing demand before it decides to move into listed equity options. Turquoise, the London Stock Exchange’s MTF, has both an equities and a derivatives platform, trading single stock, index and dividend derivatives based on pan-European and International Order Book equities. Of the larger exchanges, CME Group confirmed in August it will introduce other asset classes after it launches CME Europe to trade FX products and CBOE is to establish a futures hub in London later this year. ICE, the Intercontinental Exchange, is buying NYSE Euronext for $8.2bn, with NYSE Liffe, the London International Financial Futures and Options Exchange, the jewel in the options crown. ICE has its own London-based clearing house—ICE Clear Europe—which NYSE Liffe will move clearing to. Bystanders believe the merger will have implications throughout the derivatives industry including options as equity volumes continue to shrink and as diversification offers new revenue streams. Furthermore, the NASDAQ OMX purchase of TOM, as it expands its shareholding to 50.1% in the future, is expected to lead to technological innovations in equity and options trading with low latency connectivity and greater orderprocessing capacity. In spite of a 36% compound annual growth rate in the value of listed options globally between 2009 and 2011, latest figures from the World Federation of Exchanges show that for the first time since 2004, the number of on-exchange equity derivatives contracts traded in 2012 fell by 20.4% to 14.9bn. The WFE pins the probable blame on the ‘significant’ decrease in volatility during the year. Volumes tend to be positively correlated with volatility and last year saw a sharp drop in the Chicago Board of Options Exchange Volatility Index (VIX), closing down 26% year-on-year. The drop also mirrors a decline in electronic order book share trading, down 22.5% among its members. Gary Wishnow, managing director, derivatives sales and trading, Rosenblatt Securities, says:“Equities has seen three straight years of falling volumes, but I would be surprised if we saw another drop in the US options market. Any bump in volatility, whether driven by the Fed raising interest rates or other macro events, should result in increased activity and that should once again return the options market to its pattern of year-on-year gains.” Europe made up 10.2% of global options volume of 14.5bn contracts in 2011, according to TABB Group. Compare the US, which then had a 47.1% market share and its biggest year on record. Last year it drew breath slightly as ADV slid 12.5%, but still recorded its second biggest year with 4bn options contracts traded. Indeed, while the US market experienced a 19% compound average growth rate in the decade to 2011, Europe’s CAGR was just 6%.

Des Peck, head of product at technology firm TMX Atrium. “We are seeing regulators saying you must hold sufficient margin in place to do the trade. If this is a multi-asset trade and if you are able to clear on multiple venues you can post less margin under cross-margining. So, trading participants are very keen on this,” says Peck. Photograph kindly supplied TMX Atrium, February 2013.

In Europe every market is different from its neighbour. With little multiple listings of the same option and little liquidity in some options, traders are led to pick up the phone and trade OTC. In fact three-quarters of trading in Europe is OTC, with just 25% on exchange. In the US which has 11 options exchanges, the figures are reversed. While options trading has more variables—strike price, put, call—unlike a straightforward cash equities transaction, technology is ready for electronic trading, says Des Peck, head of product at technology firm TMX Atrium:“A lot of the information required to calculate and trade, already exists within existing mathematical functions such as deltas and gammas. So you can set up a strategy using combinations of individual elements. We will see an increase in electronic trading of options.” Currently, European investors conduct 10% of listed equity options trading in the US, according to Andy Nybo, principal and head of derivatives research, TABB Group. In his paper, European demand for US listed equity options, he finds they are drawn by the attractiveness of using centrally-cleared exchange-traded instruments, reduced counterparty risk, deeper liquidity, broader participation; transparency and depth of market as well as tighter spreads. While the strength of the US market is not about to be overturned any time soon, 90% of those interviewed by Nybo did not think the development of the European options markets and alternative instruments would make any impact on US flow. Even so, the European options market is changing, led largely by changes in the clearing space. As new EU regulations force ‘eligible’ derivatives on to trading platforms and standardised over-the-counter (OTC) options to central clearing, competition will come into the clearing space, although not before mid-2014, according to latest estimates from the European Securities and Markets Authority (ESMA) with implications for infrastructure developments. The ‘vertical silos’ in Europe mean that

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

AES OPTIONS AT

Focus. Execute. Deliver. Advanced Execution Services® Options

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Gary Wishnow, managing director, derivatives sales and trading, Rosenblatt Securities, says: “Equities has seen three straight years of falling volumes, but I would be surprised if we saw another drop in the US options market. Any bump in volatility, whether driven by the Fed raising interest rates or other macro events, should result in increased activity and that should once again return the options market to its pattern of year-on-year gains,” says Wishnow. Photograph kindly supplied by Rosenblatt Securities, February 2013.

Gary Delany, European director, Options Industry Council, believes it will be the speed with which clearing houses react to the new rules which will determine how fast options catch up: “Clearing houses are starting to make progress on interoperability, but progress takes time. Also, most clearing houses in Europe are owned by exchanges and thus generate an important income stream,” says Delaney. Photograph kindly supplied by the Options Industry Council, February 2013.

trading an option on one exchange will bind the trader to that exchange for clearing and for returning at expiry. “This can consolidate liquidity, but it stifles competition and innovation,” says Nybo. As options move on to exchange, technology vendors are gearing up to deal with the new world. TMX Atrium’s managing director, Emmanuel Carjat, says: “Technology is needed to measure exposure to risk. So much OTC is stored on paper or Excel spreadsheets in a bank. So regulators want an overall transparent view which is part of the reason for the move to interoperability of clearing houses.” Gary Delany, European director, Options Industry Council, believes it will be the speed with which clearing houses react to the new rules which will determine how fast options catch up:“Clearing houses are starting to make progress on interoperability, but progress takes time. Also, most clearing houses in Europe are owned by exchanges and thus generate an important income stream. The more clearing houses involved in a trade, then the higher the capital commitment tends to be if there are no offsets available. Conducting a multi-asset trade using multiple clearing houses will require more capital than if just one clearing house had been involved.” In this situation, cross-margining is becoming critical, according to Peck. “We are seeing regulators saying you must hold sufficient margin in place to do the trade. If this is a multi-asset trade and if you are able to clear on multiple venues you can post less margin under cross-margining. So, trading participants are very keen on this.” Carjat adds: “We are seeing a convergence of the technology which initially was quite different in terms of venues and software to represent the evolution and pricing of instruments. We are seeing more and more multi asset strategies. So you have a number of platforms starting to provide

multi-asset classes so they can respond to the needs of clients. It’s critical that you don’t have to move to another screen if you are operating arbitrage strategies and if you have one leg in equities and one in options. At the back-end you want to be able to connect to venues in a similar fashion. Several trends could come together to drive the options market this year. First there are more asset managers using options. In the US, for example, they accounted for one fifth of the listed options markets in 2011, compared to 5% in 2006, according to TABB. This growing demand for options will accelerate as the buy side continues to use options for risk management and exposure. Another trend is the growing use of weekly expiration options, which made up 8.3% of all listed equity options volume in the US in 2011 with peak months of just under 12%. Volumes of S&P 500 weekly options, the most actively traded index options in the US, grew by 270% compared to 2010, and accounted for 10% of the average daily volume of all S&P 500 options. Shorter duration options, some with a daily expiration date, are expected to pick up in popularity as exchanges expand their lists. NYSE Liffe, for example offers daily options on the AEX index. It also offers weekly contracts on a number of blue-chip stocks. Furthermore, the International Securities Exchange, ISE, has confirmed it will start trading mini-options on March 18th, 2013. Mini options represent 10 shares of the underlying stock, whereas standard contacts usually represent 100 shares. Although some believe short-term and mini options are too speculative, Wishnow is more positive: “These initiatives may help stop the drop in volume and encourage new entrants into the options market place, including retail participation.” I

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

MENA SURVEY

The quarterly survey of the asset management industry in the Middle East and North Africa region has three aims: to describe the investment outlook of a diverse range of asset management firms in the Middle East region; to assess the perception of political/economic risk within the region and to outline current thinking among the asset management industry as to what infrastructure is important to the proper functioning of their businesses. These elements still remain core to the findings in each quarterly survey. Even so, each has its own character: in part determined by macro-issues; in part determined by the range of respondents

MENA investors cite heightened political risks and patchy market liquidity as key concerns alisation and a substantive population S THE MARKETS in the and largely youthful population unMENA region have taken on KEY SURVEY FINDINGS derscores the long term potential in widely different characteristics the country. as political unrest heightens in Egypt 1. A strong and growing concentration Qatar and, in particular the UAE, are and the Levant, investors look to be inof assets in the GCC. also strong contenders for inward creasingly sensitive to shifts in political 2. Saudi Arabia is emerging as the indirect and direct investment flows. risk. As far as possible this latest survey regional leader. For the first time in this survey, a of asset managers in the MENA region 3. Respondents most optimistic about number of respondents cited the optries to reflect some of the differences the outlook for the UAE. portunities in Qatar linked to the in outlook among investors in different 4. Heightened political risks in the upcoming 2022 World Cup; the sub-regions. For this purpose, the region remain a key concern among country’s investment in medical markets are divided into three the majority of investors. services and downstream diversificasegments: The Middle East-Levant, 5. The need for more regulation tion from gas production and continucomprising Lebanon, Jordan, Syria, supporting good corporate ing opportunities in infrastructure. Palestine and Iraq); the Gulf Cooperagovernance and market The rising fortunes of the UAE tion Council (GCC) countries compristransparency is an equally meantime, according to respondents ing the UAE—essentially Abu Dhabi important requirement. are based around perception of and Dubai, Bahrain, Oman, Saudi 6. The need to encourage market growing trade volumes, the rise of Arabia, Kuwait, and Qatar); and North liquidity and revitalise the region’s Dubai as an entrepôt and improving Africa, comprising Egypt, Libya, IPO market remains an important real estate values. The Dubai residenAlgeria, Morocco and Tunisia. concern for investors. tial property market, which had been The survey shows a discernible 7. Branding and image management suffering through 2010 and 2011 from increase in high growth market is becoming a key consideration a supply-demand mismatch, will (HGM) to high growth market capital for investors. benefit the most as the population is flows (East to East). The survey highlikely to more than double over the lights the emergence of financial hubs in the region, most strongly defined in Saudi Arabia right next decade and more jobs are being created. An increasingly now; though over the longer term, it looks like the UAE will diversified economy in both Dubai and Abu Dhabi, give the Kingdom a run for its money, with rising confidence continued population growth and well run infrastructure is, in the Emirates a marked feature of this iteration of the according to respondents expected to have a positive impact survey. This is particularly challenging issue for the GCC on retail, hospitality and the residential market. Equally, the findings hint at rapid shifts in asset allocation nations. Which one of them will ultimately achieve the regional crown and what will be the response/reaction of which up to now has favoured fixed income instruments and other GCC nations? For now, Saudi Arabia looks to be bonds; but which looks over the longer term to encompass multi-asset investment strategies, increased usage of derivtaking an increasingly dominant role in the GCC. The confluence of liquidity in the Kingdom is predicated atives and highly fungible securities (such as ETFs). Clearly a paradigm shift in the mobilisation of capital is on a number of elements, cited by respondents. Privatisation, investment in infrastructure, slow but steady market liber- underway in the region, influenced by a confluence of

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

MENA SURVEY

factors: the creation of new liquidity pools, heightened risk and risk and collateral management. In part, this trend is driven by regulation; in part it is driven by liquidity constraints in some markets and the concentration of new business opportunities in others (again, Saudi Arabia, Qatar and the UAE were regularly cited in this regard. Investors also look to be factoring in political risk in investment decisions. This is pertinent for the MENA asset management industry, as it is now encircled on three fronts with incipient political instability (in the southern Sahel and subSaharan region/the Syrian civil war/the continuing IsraeliPalestinian dispute) and by a resurgent Iran. Equally clear is a small but marked change in the function/role of post trade institutions which will increasingly propel them to the forefront of effective capital management in asset management firms in the region. At this stage, the Middle East and North African region is still formulating its overall post trade landscape; though in large part the end result will mirror structures that are emerging in developed markets. This has major implications for asset management firms in emerging markets; elements of which are beginning to be highlighted by the survey. CSD and CCPs and new, expanded CCP business models will become important pillars in local and international financial markets related activity. Virtually all respondents mention the growing importance of regulation and regional regulatory ‘harmony’. This desire for regional regulatory and process harmonisation looks to have gained further momentum in this iteration of the survey. With so much flux in the international investment markets, and the continuing challenge of a global economy still reeling from the aftershocks of the 2008-2009 financial crises, the asset management sector in the Middle East is clearly at a watershed. The evolution of the market is finely tuned: immense potential mixed with equally immense (and rising) political risk. Nonetheless, the survey continues to highlight that whatever the outcome (and it will be different in each country), if any nation wants to develop as a top ranking financial market in this century, then a significant strengthening of the asset servicing and asset management industry will form part of any meaningful strategy. Overall, with slightly over three-quarters of the responses, the survey remains dominated by the outlook of asset managers in the GCC sub-region and is a reflection of the

Chart 2: Respondents by sub-region Middle East -Levant 13%

North Africa 11%

GCC 76% (68 respondents)

growing investment momentum gathering in the GCC countries. Within this sub-grouping, as in previous surveys Dubai dominates in terms of asset gatherers and asset managers; although many of the funds surveyed have a lower volume of assets under management (AUM). Asset managers in three new markets have entered the fray: Morocco (3), Tunisia (1) and Jordan (1), adding to the spread of the research findings. A number of sovereign wealth funds responded to the survey but were unwilling to tell us the exact value of assets under management. The 72 respondents claim to manage just over $172bn. The GCC is clearly the largest aggregator of assets with reporting funds saying they hold just over $133bn. The survey results illustrate the somewhat tight definition of ‘international’ by investors in the Middle East. In terms of regional investment preferences, there is a concentration of responses and investments in the MENA region. Within that broad brush approach, the survey shows the GCC region has witnessed a massive concentration of investments by local asset managers. Within the GCC, Saudi Arabia and Qatar have been the preferred invest-

Chart 3: Assets under management by respondents Middle East - Levant 16%

North Africa 3%

Chart 1: Respondents by country (as a percentage) Country Abu Dhabi

Respondents

Country

Respondents

Lebanon

12%

Bahrain

14%

Morocco

Dubai

27%

Oman

Egypt

Qatar

Jordan

Saudi Arabia

Kuwait

12%

Tunisia

7% 12%

GCC 81% (AUM$139bn)

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

Chart 4: Asset allocation by geography Respondents, investments in MENA and other regions: (ratio of firms invested in specific countries versus total respondents)

Investment in selected countries

0.7 0.6 0.5

Note the concentration of investments in selected countries in the GCC

0.4 0.3 0.2 0.1

B Sa ahra ud in iA rab ia Qa tar Om an UA E Ku wa it Eg yp Le t ba no n Jo rd an Ira q Sy r Mo ia roc co Tu n Ma isia ur ita nia Lib ya Alg eri a Tu rke y Ind ia Gl ob al S No om rth ali Am a eri ca Eu rop Au e str ali a Ind ia Ke ny a Su da n

0.0

Country

ment destinations, with the UAE in third position. Three developments are noteworthy since the survey started. The firsts is the growing interest in Turkey and the pulling in of the country into the wider Middle East hinterland. We expect this trend to continue, with investors from Saudi Arabia continuing to plan to increase their allocations to the country. Second is the increasing willingness of respondents to invest in frontier markets: Libya, Algeria, Kenya and the Sudan were mentioned for the first time. Investments in these markets tend to be direct investments, rather than indirect, with particular companies and sectors favoured. Telecommunications was often mentioned by respondents. Third is the growing spread of investments among the more globally focused firms; whose investments now stretch as far afield as Australia. For the most part however, the concentration of assets within the region is marked and the GCC countries are the principal recipient of these funds. Opinion on Bahrain and Kuwait is much more positive than it was in the Q2 and Q3 2013 survey and would seem to suggest that investors, which cognisant of some underlying problems are generally willing to accept that the investment regimes are broadly favourable. While we would expect that the concentration of investment dollars in the GCC would gravitate to local markets; the survey findings show that this pattern of investment is broadly consistent both across all three regions and across individual countries. In other words, investors in the Levant, in North Africa and the GCC itself are largely focused on the potential returns available in the GCC. A Ricardian-style centre-periphery effect looks to be evident in the survey geography. There is a marked propen-

FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY/MARCH 2013

sity to invest in the immediate hinterland of the GCC (namely Egypt, Lebanon, Jordan, Iraq and Syria, with an outer-zone (periphery) encompassing Turkey, Somalia and selected North African countries. This trend is clearly evident in Chart 5. The survey also looked at the investment intentions of the respondents in 2013 to see if their plans to increase investments in selected countries mirrored or modified this underlying pattern of investment flows. As the following chart shows, the pattern is broadly the same: however, Saudi Arabia and the UAE look to be the most popular investment destinations in 2013, with Qatar coming third. Another question is how political instability in the sub-region will continue to influence intra-MENA investment flows. Already a number of respondents have indicated that investments have been withdrawn from Egypt, for instance. According to some of the respondents the rise in extremist religious movements across the region is beginning to impact on asset allocation. An important consideration in 2013/2014 is how far instability might spread and what continuing impact it will have on cross border asset flows in the region. Will it increasingly concentrate assets in the GCC markets; or will those assets be spread across a different geography? The answers will be evident in future surveys. The evidence, albeit from a small sample in the overall survey is mixed right now (please see Chart 6). Egypt, Lebanon, Jordan and Syria, in line with the risk sentiment index look to be vulnerable to shifts of capital out of their markets. However, so does Bahrain, Saudi and Qatar. Anecdotal evidence from respondents is that it is a

MENA SURVEY

Chart 5: Investment intentions in 2013 Number of respondents planning to either start or increase investments in selected countries in 2013

35 30

Invested

25 20 15 10 5

B Sa ahra ud in iA rab ia Qa tar Om an UA E Ku wa it Eg yp Le t ba no n Jo rd an Ira q Sy ria Mo roc co Tu nis Ma ia ur ita nia Lib ya Alg eri a Tu rke y Ind ia Gl ob al No Som rth ali Am a eri ca Eu rop Au e str ali a Ind ia Ke ny a Su da n

Country

reduction of substantial investments in these markets as part of an investment diversification programme in the GCC markets, rather than money seeking refuge in safer markets. Only one respondent (from Saudi) was shifting money from Saudi into Australia, rather than into neighbouring markets. Bahrain, however, looks to be vulnerable to disinvestments in 2013. Once the geography of investment became clear, the

Chart 6: Disinvestment intentions 2013 Where investors plan to decrease investments in 2013

Number of investors

4 3 2 1

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Sy ri

Country

ba no

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survey began to focus on the asset allocation preferences of investors. While the results show a propensity to diversify asset allocation across multiple asset classes, a clear shift has taken place over the year with equities and bonds dominating the investment landscape. There is a clear divergence between investments outside the GCC and investment preferences within the GCC countries. Investors in non-GCC countries show a marked preference for bonds (particularly sovereign bonds), while investors in the GCC show a tendency to invest in equities. This extreme variation might be related to the political risk outlook; as the largest concentration of buyers of sovereign debt is in the Middle East/Levant region. In part these figures are skewed by one large investor, however even the smaller firms mirror this strategy. Future surveys will look in more detail at the drivers behind asset allocation strategies in the region. It is clear from the survey results that the regionâ&#x20AC;&#x2122;s investors are highly focused on intra-regional cross-border investments to achieve both tax efficiencies and improved returns on invested assets. It is resulting in the concentration of liquidity in selected markets and rising regionalism. Nonetheless, both routes to market and directional trade flows remain in flux: with a marked tendency for funds to gravitate to key markets. However, compared with previous surveys, investors are showing a marked tendency to diversify routes to market. While traditionally investors in the Middle East have concentrated on real estate, private equity, bonds and equities as mainstay asset allocation strategies; investors are showing a marked tendency to adopt more flexible and encompassing investment strategies. Money market funds, futures, hedge

FEBRUARY/MARCH 2013 â&#x20AC;˘ FTSE GLOBAL MARKETS

Chart 7: An increasingly diversified asset allocation profile Asset allocation intentions: Asset allocation (January 2013) ($m)

70000 60000

Value of investments in US$

50000 40000 30000 20000 10000

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the IPO market, which they feel is a pre-requisite for a more vibrant equity market. Although strong targets for inward investment, the stock markets of the GCC remain quiet; with investors now looking for alternative investments to provide returns. Trading volumes remain muted and the challenge in the GCC, as elsewhere is how to kick start a wholesale

funds as well as Shariâ&#x20AC;&#x2122;a compliant investments are an increasing feature of the market. However, a majority of respondents state that this diversification is constrained by the limits on usage of derivatives. A number of investors mentioned anecdotally that they hope that local governments will try to revitalise interest in

Chart 8: Differences in approach to investment: GCC versus non-GCC investors Variance: GCC v non-GCC asset allocations across multiple asset classes

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FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY/MARCH 2013

MENA SURVEY

Chart 9: The risk outlook of investors in the MENA region From negative to positive. Indication of investor perceptions of political risk in the MENA region.

70 60

Number of investors

50 40 30 20 10 0 10 20

The risk outlook The Middle East and North African region continues to be shaken by sustained civil unrest in Egypt and Syria; resurgent terrorist activity and still nervous strains between the GCC states and Iran. The survey shows that shifts in capital flows in the region are increasingly complex in scope. Iraq, while still mired in conflict is seen as a market with substantial potential. Equally Jordan, which to the outside observer appears to offer a more benign political risk environment consistently features as a market susceptible to increased political risk. Jordan suffers perhaps from

Chart 10: Investors look for improved liquidity and lower market risk MENA services and infrastructure requirements (all respondents) Service requirements

Rating Rating Adjusted Overall Midpoint total MENA mean ranking

More market liquidity

127

1.5

Lower political risk

127

1.5

Increased market liberalisation

144

1.7

Better clearing & settlement services

187

2.1

Portable cross-border investment products

182

2.1

Improved risk management services

185

2.1

Improved fund administration services

206

2.4

More derivatives

227

2.6

Greater choice of custody provision

229

2.6

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its nearness to the chronic instability evinced in Israeli/Palestinian relations; and its nearness to Syria. But anecdotal evidence points to more than that; with investors seriously concerned about the countryâ&#x20AC;&#x2122;s internal political strains. Against that background the survey polled respondents on their attitude to risk. We asked respondents how they viewed the overall political and economic risks of doing business in the various countries of the Middle East. The overall results can be found in Chart 10: Investor sentiment index for the Middle East in 2013. The view of investors in Q4 2012 was more benign than in Q3 2012. Syria scored a resounding negative, with a rough negative sentiment score of -53 in the third quarter of last year; in the last quarter this improved to -20, though still in the negative zone. Bahrain also showed an improvement, moving from -9 in Q3 to plus 9 in Q4. Europe too fared much better, moving from -16 in Q3 to plus 15 in Q4. The risk ratings for Lebanon remained largely the same. Syria remains a worry, both to investors and the international community which cannot seem to find any workable short term solution to its problems. Iraq remains the wild card with respondents noting the long term attractiveness of the market. North America did surprisingly well out of the survey, which the respondents viewed much more positively than South America. Asia and Africa also received rather respectable scores, while in the Middle East, the UAE and Saudi Arabia scored particularly highly as low risk investment regimes; the UAE faring the best of all in this Q4 survey. The UAE has bounced back strongly in the last 12 months.

FEBRUARY/MARCH 2013 â&#x20AC;˘ FTSE GLOBAL MARKETS

Chart 11: Setting up operations in MENA: What investors want Set up considerations

Ratings total

Adjusted mean

Overall ranking

Ranking GCC

Ranking N Africa

Ranking Levant

Local regulatory environment

127

1.5

Quality of local staff

157

1.9

Ease of setting up operations

156

1.9

Ease of doing business

162

2.0

Size of local HNW community

198

2.4

Size of local capital markets

195

2.4

Immediate investment opportunity

198

2.4

Ease of access to the local distributors

194

2.4

Depth of local retail investment market

208

2.5

Ability to attract expatriate staff

205

2.5

Anecdotal input from respondents say they are particularly interested in real estate and private equity. Saudi Arabia is also viewed positively, with ten respondents mentioning infrastructure and private equity as areas of particular interest. According to respondents, Qatar also offers long term potential (five mentioned opportunities related to the country’s hosting of the World Cup as offering investment opportunities; the first time that the event was mentioned by respondents). This will be an area that we will return to again and again in the updates, and we hope to deepen the analysis in forthcoming editions to more clearly illustrate any direct correlations between market performance and local investor risk perceptions in the intervening period. The most significant part of the survey results are perhaps to be found in the chart outlining what investors want in terms of services, investment environment and infrastructure within their relevant jurisdiction. Respondents were asked to score their concern, with one being the most urgent and five showing a low level of concern. We then totalled up the scores and then divided the result by the number of respondents: this gave a rough average from which we could extrapolate some analysis. We thought that any score lower than two, signified meaningful concern over the lack of a sufficient infrastructure supporting their business. Lower political risk and the need to increase liquidity levels in the stock exchange in some jurisdictions continue to be the main worries for investors. The need for continuing market liberalisation (pretty much across the board), and an improvement in the level of local provision of investment services (such as risk management) are also important considerations say respondents. Market liberalisation was cited as an important pre-requisite for firms in the survey region to “remain competitive” according to one respondent. Approaches to the provision of custody services varied widely. Among the larger firms, concerns over the extent of back and middle office support was strong; however smaller firms said that local banks helped them manage their back

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

office requirements more than adequately. Larger asset gatherers cited the need for local regulators to allow derivatives and more risk management products into the region; though many acknowledged that this was difficult for both cultural and religious reasons.

MENA operations—what investors rate The survey looked at the requirements for investors looking to set up in the region, highlighting those factors which governed the choice of domicile. The quality of the local regulatory environment scored highly in all the sub-regions of the survey. Interestingly, the immediate investment opportunity did not score in the top three considerations that investors took into account when setting up in the region. Instead infrastructural considerations (quality of local staff, ease of setting up operations and the ease of doing business) were more pertinent considerations. Respondents were asked which considerations were important to them in building their brand. Good corporate governance resounded strongly among all respondents. The importance of good management, that was fully transparent, was the prime consideration for the majority of firms. No surprise then that measurable returns and quality staff were immediate follow on requirements. Distribution capability ranked fourth. The pattern of responses indicates growing attention to the importance of image. The ownership of the funds is also highly diversified, though at least a quarter of the funds polled, while operating largely independently, remain supported by or are part of larger commercial bank holding groups. In the past, the link with banking often propelled asset managers into dedicated single-strategy funds, with for example a strong emphasis on private equity or real estate investments. It is clear however that while some of these entities remain specialised; others have diversified significantly. While future surveys may take into account dedicated funds investing in the Middle East domiciled in other jurisdictions, this survey is entirely focused on funds domiciled in the countries surveyed. We do acknowledge however that many funds that service the region are

MENA SURVEY

domiciled outside the region in jurisdictions such as Guernsey, Luxembourg, Bermuda, the British Virgin Islands, the Cayman Islands, the United Kingdom and the United States. Moreover, there are signs that dedicated Middle East funds are rising in number in jurisdictions such as South Korea, Singapore and Hong Kong. How these funds might be incorporated into future surveys has yet to be determined; and will likely provide a sub-set of ongoing analysis. Variable responses to the survey obviously curtail the effectiveness of the overall results. With that in mind and with an emphasis on transparency at all time, all data presentations are either in actual numbers or if presented as ratios or percentages, the calculated are precisely shown, so as to highlight the relevance of the data. However, it should be noted that while many funds were reticent about the value of assets under management, as the survey progressed an increasing number of asset managers were responsive to particular questions (particularly the ratings questions involving branding/operations/and risk. Of notable interest are the key variations between countries and sub-regions, particularly in terms of the way that investors perceive political, economic and investment risk (both in the region and outside) which are highlighted in the both the political risk and asset management infrastructure sections. While no discrimination was imposed on whether firms were domestically or internationally focused, what has

become apparent from the responses is a keen sense that international macro-factors continue to exert a strong influence on investment decisions both at home and abroad among respondents. Moreover, the definition of international is (outside of the larger asset gatherers) regionally biased. It seems that in the Middle East, while the spread of investments is rising across the region (albeit slowly); the globalisation of investment dollars is still some way off. Equally, there is a growing sense that regional and international investment expertise is becoming increasingly important as both a keystone of each firm’s own understanding of its own strengths and brand identity; as well as an acknowledgement that the Middle East asset management industry is increasingly confident about its ability to invest cross-border across a variety of investment vehicles and utilising a broader range of securities.

Chart 12: The growing importance of brand BRAND IDENTIFIERS

Rating Rating Adjusted No Overall Midpoint total MENA mean response Ranking

Transparency & corporate governance

116

1.3

Quality of local staff

130

1.5

Measurable returns

136

1.5

Management of investment product

160

1.9

Distribution capability

178

2.0

MENA ASSET MANAGEMENT SURVEY: TERMS AND CONDITIONS he survey was conducted between December 1st 2012 and January 24th 2013. The research period was punctuated by year end and religious holidays. Some 375 firms were approached for information of which 90 responded, either by phone or fax. From these returns we have extrapolated the analysis in the survey. This presentation is a draft of the full survey, which will be made available from mid-February this year online. A précised version will be published in the February 2013 edition of FTSE Global Markets. The research honed in on a diverse universe of asset gatherers/managers, to achieve the widest possible response from a broad brush of market participants. This was thought to be particularly useful as all segments of the asset management business are represented, and which we hope provides a suitably broad cross-section of opinion. The survey involves sovereign wealth funds, mutual funds, dedicated funds, and private equity and real estate funds. This survey update is marked by the introduction of respondents from Morocco and Tunisia. Twenty-three respondents were entirely new to the survey. Over the four surveys conducted through 2012; some 130 respondents have contributed to the analysis; which we think is a good basis going forward. Of the respondents who participated

in the Q3 2012 survey, some 17 were unable to participate in this round, either because of work commitments (5) or because of travel (7). A further five were unreachable for comment. The asset management segment, as defined by the remit of this survey encompasses firms with a minimum $5m under management, with no upper limit. In previous surveys we had approached firms with a minimum $25m in assets under management; but ultimately we felt that the value of funds under management in no way reflected the ability of asset managers to provide us with comment and/or market analysis. In that regard, size (we felt) did not matter. The end results show a wide variance in the value of funds under management in different firms; and this was equally applicable whether the firms invested in multiple assets or in particular asset classes, such as private equity or real estate. While in subsequent surveys we may refine the value of assets under management (AUM) that qualify a fund for inclusion in the survey, we felt at this stage it would be more useful to be as inclusive as possible. While three sovereign wealth funds participated in this update, all three refused to acknowledge publicly the value of their assets, which has resulted in a reduction in overall reported asset values.

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

MARKET DATA BY FTSE RESEARCH

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

12M% 4.8 5.3

16.8 16.9 9.4

28.4

6.6

15.4 15.0 19.4 12.7

3.0 4.3 2.1

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

3.9

3.5

-0.7

-4.3 -1.3

3.6 4.2

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

2.9

-1.6 -1.7 -2.3

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

1.8 2.6 3.3

-0.5 -1.2

FX - TRADE WEIGHTED USD GBP EUR

8.9 9.3 1.2

-3.6

4.2

-1.0 3.8

-6 -4 -2

5.3

10 12

-10

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

Regions 12M local ccy (TR)

9.4

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

6.6 5.3 5.2 4.8 4.3 3.0 3.0 2.1

28.4

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

19.4 17.4 16.9 16.8 15.4 15.0 12.7 10.3

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

-0.1 -0.1

-2.1

-4

6.6 5.8 5.8 5.6 5.3 5.2 5.1 4.8 4.1 4.0 3.6 3.0 2.6 2.4 2.3

-2

8.1 8.1

9.4

-4

-10

3.4 3.2 3.0 3.0 2.1 1.9 0.5 -0.3 -0.6

34.6 33.5 28.4 27.3 24.8 20.8 20.2 19.1 19.0 17.9 17.4 16.9 15.4 15.3 15.0 12.4 9.8 7.3 5.1 3.1

Emerging 12M local ccy (TR) Turkey Thailand Mexico South Africa India China Emerging Indonesia Taiwan Malaysia Russia Chile Brazil

4.6

Developed 12M local ccy (TR)

6.3 5.7

-2

Denmark Belgium/Lux Japan Switzerland Hong Kong Germany Australia Sweden France Netherlands Developed USA UK Norway Singapore Italy Finland Spain Canada Korea Israel -6.3

Emerging 1M local ccy (TR) Russia Chile China Indonesia Thailand Mexico India Emerging Taiwan Turkey Brazil South Africa Malaysia -3.4

41.7 31.1 22.5 20.4 18.3 15.1 12.7 9.6 8.6 7.8 6.4 5.4 2.3

Source: FTSE Monthly Markets Brief. Data as at the end of January 2013.

FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY/MARCH 2013

MARKET DATA BY FTSE RESEARCH

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

US Emerging

UK Europe ex UK

Global Sectors Relative to FTSE All-World Oil & Gas Health Care Financials 130

Asia Pacific ex-Japan

115 110

Basic Materials Consumer Services Technology

Industrials Consumer Goods Telecommunications Utilities

120

105 110

100 95

100

85 80

70 Jan 2011

75 Jan 2011

May 2011

Sep 2011

Jan 2012

May 2012

Sep 2012

Jan 2013

May 2011

Sep 2011

Jan 2012

May 2012

Sep 2012

Jan 2013

BOND MARKET RETURNS 1M%

12M%

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

-1.6

UK (7-10 y)

-1.7

Ger (7-10 y)

1.8 2.6

-2.3

Japan (7-10 y)

3.3 3.4

0.5

France (7-10 y)

11.0

-1.9

Italy (7-10 y)

18.8

1.9

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

-0.6

Euro (7-10 y)

9.8 13.8

-2.2

UK BBB

-0.5

Euro BBB

8.9 9.3

-1.2

UK Non Financial

-1.3

Euro Non Financial

7.2 7.3

-1.4

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

6.8

2.2

-3

-2

-1

BOND MARKET DYNAMICS – YIELDS AND SPREADS Government Bond Yields (7-10 yr)

Corporate Bond Yields

Japan

Ger

France

Italy

UK BBB

7.50

Euro BBB

7.50

6.50

5.50 4.50

5.50

3.50

4.50

2.50 3.50 1.50 0.50 Jan 2010

Jul 2010

Jan 2011

Jul 2011

Jan 2012

Jul 2012

Jan 2013

2.50 Jan 2008

Jan 2009

Jan 2010

Jan 2011

Jan 2012

Jan 2013

Source: FTSE Monthly Markets Brief. Data as at the end of January 2013.

FEBRUARY/MARCH 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

115

FTSE US

110 110 105 105

100

95 90 Jan 2012

95 Apr 2012

Jul 2012

Oct 2012

Jan 2013

Jan 2012

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

FTSE UK

FTSE US Bond 145

130

115

100

55 Jan 2010

Jan 2011

Jan 2012

Jan 2013

Jan 2008

Jan 2013

FTSE US

FTSE USA Index

-2

22.6

1.6

-0.5

Jan 2013

30.0

16.9

-0.9

Jan 2012

15.4

7.0

FTSE UK Bond -1.0

Jan 2011

5Y%

9.4

5.3

Jan 2010

12M%

6.6

Jan 2009

3M%

FTSE UK Index

-2

Oct 2012

40 Jan 2009

1M%

FTSE USA Bond

Jul 2012

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

145

40 Jan 2008

Apr 2012

40.5

1.4

32.5

Source: FTSE Monthly Markets Brief. Data as at the end of January 2013.

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2013

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts (Week ending 8 February 2013) Reference Entity

Republic of Italy Kingdom of Spain Federative Republic of Brazil Republic of Turkey Republic of Korea Russian Federation People’s Republic of China United Mexican States Banco Santander, S.A. Japan

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Sov Sov Sov Sov Sov Corp Sov

404,446,801,147 219,003,751,611 156,849,520,009 145,783,502,367 87,849,928,458 115,237,622,517 76,834,944,287 118,529,358,318 65,644,573,275 80,850,407,176

20,807,766,744 12,370,712,959 16,976,810,843 7,767,540,176 6,316,617,186 4,905,871,444 7,772,426,014 7,927,031,177 2,258,010,413 9,183,567,308

13,488 10,335 9,584 9,575 9,329 8,972 8,438 8,403 8,108 8,026

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

Top 10 net notional amounts (Week ending 8 February 2013) Reference Entity

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

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

404,446,801,147 156,849,520,009 181,600,933,621 160,901,265,239 219,003,751,611 80,850,407,176 79,162,962,728 118,529,358,318 76,834,944,287 145,783,502,367

20,807,766,744 16,976,810,843 15,428,908,025 14,538,305,469 12,370,712,959 9,183,567,308 9,068,105,217 7,927,031,177 7,772,426,014 7,767,540,176

13,488 9,584 7,802 6,072 10,335 8,026 6,070 8,403 8,438 9,575

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

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 8 February 2013)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Sovereign / State Bodies

3,038,176,529,736

220,778

Republic of Italy

7,400,830,410

375

Corporate: Financials

2,993,045,291,389

423,749

Kingdom of Spain

4,815,968,488

278

Corporate: Consumer Services

1,637,150,429,077

290,014

Morgan Stanley

4,635,310,526

211

Corporate: Consumer Goods

1,425,713,664,178

244,996

Federative Republic of Brazil

3,628,063,000

324

Corporate: Industrials

1,072,458,922,371

196,366

Republic of Turkey

2,474,579,432

202

Corporate: Basic Materials

Gross Notional (USD EQ)

Contracts

789,129,939,099

136,491

United Mexican States

1,834,600,000

125

Corporate: Telecommunications Services 731,090,863,326

117,008

Commerzbank Aktiengesellschaft

1,301,919,537

185

Corporate: Utilities

601,970,567,126

102,103

Dell Inc.

1,289,751,956

616

Corporate: Energy

456,141,204,009

83,525

Vodafone Group Public Limited Co.

1,233,719,606

155

Corporate: Technology

315,383,353,532

61,072

Intesa Sanpaolo Spa

1,223,157,323

203

Corporate: Healthcare

286,457,302,078

52,285

Corporate: Other

121,260,750,577

12,991

Residential Mortgage Backed Securities

31,078,773,694

5,889

Muni: Government

20,416,300,000

1,706

CDS on Loans

20,074,592,040

5,372

Commercial Mortgage Backed Securities 10,882,323,844

1,195

Residential Mortgage Backed Securities*

6,966,293,302

425

CDS on Loans European

1,917,215,668

314

Other

1,577,843,816

197

Commercial Mortgage Backed Securities*

660,322,777

Muni: Utilities

43,764,033

*European

Sector

Government Government Government Government Government Government Government Government Financials Government

All data © 2013 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

FEBRUARY/MARCH 2013 • FTSE GLOBAL MARKETS

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