FTSE Global Markets by FTSE Global Markets

GM Cover Issue 69 Impo_. 15/03/2013 13:41 Page FC1

WHY FUND MANAGERS SHOULD LOOK AGAIN AT INTEREST RATE SWAPS

ISSUE 69 • MARCH/APRIL 2013

FTSE GLOBAL MARKETS

Funds diversify asset allocations New take off for transition management? Daiwa back in the DCM front rank FSA still under fire

ISSUE SIXTY NINE • MARCH/APRIL 2013

EuroCCP/EMCF merger:

A new strategic clearing house says BATS Chi-X’s Hemsley www.ftseglobalmarkets.com

GM Cover Issue 69 Impo_. 15/03/2013 13:41 Page FC1

WHY FUND MANAGERS SHOULD LOOK AGAIN AT INTEREST RATE SWAPS

ISSUE 69 • MARCH/APRIL 2013

FTSE GLOBAL MARKETS

Funds diversify asset allocations New take off for transition management? Daiwa back in the DCM front rank FSA still under fire

ISSUE SIXTY NINE • MARCH/APRIL 2013

EuroCCP/EMCF merger:

A new strategic clearing house says BATS Chi-X’s Hemsley www.ftseglobalmarkets.com

Eds_Contents 69_. 18/03/2013 16:44 Page 1

OUTLOOK EDITORIAL DIRECTOR: Francesca Carnevale T: +44 [0]20 7680 5152 | E: francesca@berlinguer.com SENIOR EDITORS: David Simons (US); Neil A O’Hara (US); Ruth Hughes Liley (Trading) EDITORS AT LARGE: Art Detman; Lynn Strongin Dodds CORRESPONDENTS: Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Ian Williams (Supranationals/Emerging Markets); Dan Barnes (Derivatives/FX) NEW MEDIA MANAGER: Andrew Neil T: +44 [0]20 680 5151 | E: andrew.neil@berlinguer.com HEAD OF NEW MEDIA: Alex Santos T: +44 [0]20 680 5161 | E: alex.santos@berlinguer.com PRODUCTION MANAGER: Lee Dove – Alphaprint T: +44 [0]20 7680 5161 | E: production@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton HEAD OF SALES: Peter Keith T: +44 [0]20 7680 5153 | E: peter.keith@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) FINANCE MANAGER: Tessa Lewis T: +44 [0]20 7680 5159 | E: tessa.lewis@berlinguer.com RESEARCH: Sharron Lister: Sharron.lister@berlinguer.com | Tel: +44 (0) 207 680 5156 PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD US SALES REPRESENTATION: Marshall Leddy, Leddy & Associates, Inc. 80 S 8th St., Ste 900, Minneapolis, MN 55402 T : (1) 763.416.1980 E: marshall@leddyandassociates.com TO SECURE YOUR OWN SUBSCRIPTION: Register online at www.ftseglobalmarkets.com Single subscriptions cost £497/year for 10 issues. Multiple company subscriptions are also available FTSE Global Markets is now published ten times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2012. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

ISSN: 1742-6650 Journalistic code set by the Munich Declaration. Total average circulation per issue, July 2011 - June 2012: 20,525

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

ARCH LOOKS TO have been a mixed bag. After the ECB remained faithful to its client states and bolstered the markets after the emotional leakage of Italy’s election disaster; Cyprus and Hungary in demented style did their utmost to upend investor calm. The year had started well, with almost all benchmark indices outperforming expectations. It looked to be an indication that investors had calmly factored in another year where western sovereigns would still struggle with indebtedness. In the end it was half an island in the Mediterranean that finally brought a sharp end to the seemingly unseasonable rise in the equity markets. The question is: did Cyprus spoil everyone’s fun unnecessarily? Or did they ultimately do markets a favour by bringing investors back down to earth? A bit of both is most likely. It is unlikely that the Cypriot government has set a precedent for government action further up the eurozone rankings, and while this crisis will pass, it will pass slowly, as the country will be in investor minds for most of the second quarter. ICMA’s semi-annual report (see page 8) also raises concerns. The effects of the ECB’s Long Term Refinancing Operations (LTRO) are beginning to be felt as banks have been able to reduce their reliance on traditional repo operations as a source of funding. While the size of the repo market in 2012 remains well above the trough recorded in the association’s 2008 survey, ICMA reports a market worth €5.6trn, down 9.5% on 2011. Before investors look for a hole to hide in, I did say March was a mixed bag, and recent reports say that for the first time since 2007, the US real estate sector made a positive contribution to GDP in 2012. While real estate is now only 13% of the US economy, it is still a significant indicator and hopefully will presage better days ahead. Is the housing recovery here to stay? According to Paul Chew, head of investments at Brown Advisory,“Noncyclical factors are driving the recovery, which suggests the upturn is more than a temporary blip. The Federal Reserve has consistently maintained a low interest rate environment to entice consumers and corporations to borrow money and if banks continue to normalise their lending standards, we believe that loan volumes will stay on an upward trajectory,”adding that:“An improving housing sector has the potential to affect far more than just homebuilding stocks and we look to companies positioned to benefit from volume growth in the real estate sector, such as regional banks”. Two trends will dominate the markets in 2013. One will be a growing debate on what are the best ways to finally kick start growth in western markets. The other, is of course, regulation. Both issues run through this edition in a rich seam. Ian Williams gives his take on incoming SEC chair Mary Jo White. Much angst around the role of the SEC still remains. While market practitioners still regard the agency as a sharp market policeman; those not directly related to Wall Street are still baying for blood, looking for retribution from what they see as the crooked failings in the financial crisis. Will White be able to walk the sensitive tightrope that is the SEC? Ian posits some tough views.

Francesca Carnevale, Editor

Cover photo: Mark Hemsley, chief executive officer BATS Chi-X Europe. Hemsley thinks that the combined entity of EuroCCP and EMCF will be “a popular model for the market, because it will ensure a truly horizontal clearing entity. However, it could be difficult to replicate unless the exchanges start to divest their captive CCPs.” Photograph kindly supplied by BATS Chi-X Europe, March 2013.

Eds_Contents 69_. 18/03/2013 16:44 Page 2

CONTENTS COVER STORY

A CLEARER FOR ALL SEASONS

..........................................................................................Page 4 In mid March, EMCF and EuroCCP, two of Europe’s higher profile clearing houses announced their merger. Commentators say that mergers in the CCP space are no inevitable, given the highly competitive business environment. Others, like BATS Chi-X Europe, think quite differently. Who’s right?

DEPARTMENTS

SPOTLIGHT

ICMA REPORTS 11.9% REDUCTION IN REPO VOLUME ..............................Page 8

VOX POP

REHYPOTHECATION REVISITED .........................................................................Page 12

News from around the global investment market.

David Simons explains right and wrong in re-using client collateral.

WHERE CAN INVESTORS FIND RETURNS IN 2013? ..................................Page 16

IN THE MARKETS

Carey Olsen corporate partner Graham Hall looks for growth opportunities.

FSA PRE-SPLIT ASSESSMENT RAISES CONCERNS ......................................Page 18 A new internal audit gives low scores to the UK’s FSA. What does it presage?

DERIVATIVES

SHOULD FUND MANAGERS USE INTEREST RATE SWAPS? .............Page 22

COMMODITIES

WHAT BANKS DID NEXT: ALTERNATIVES TO PROP TRADING .....Page 24

DEBT REPORT

DAIWA IN EUROPEAN DCM FRONT RANK ...............................................Page 27

REAL ESTATE

HONG KONG’S CONFLICTED REAL ESTATE MARKET .........................Page 29

TRADING POST

DECISION SUPPORT IN A CLEARED WORLD .............................................Page 32

THE BEAR VIEW

STERLING ON LOW/FTSE ON HIGH............................................................................Page 34

REGULATION

CAN MARY JO WHITE REVITALISE THE SEC ....................................................Page 35

Neil O’Hara says they open up a plethora for alternatives for investors.

Vanja Dragomanovich looks at the way banks have diversified their revenue streams.

Andrew Cavenagh talks to Vince Purton, Daiwa Capital Market’s DCM MD.

Mark Faithfull wonders whether market trends will become clearer this year.

Bill Hodgson of The OTC Space looks at cost decisions in OTC trading.

By Angus Campbell, head of market analysis at Capital Spreads.

Ian Williams looks at what the noted prosecutor can bring to the regulatory party.

DARK POOLS BECKON IN CALMER MARKETS ..............................................Page 38

TRADING

Neil O’Hara explains why dark pools have grabbed a larger slice of the trading pie.

THE MOVEABLE FEAST THAT IS ALGO TRADING ......................................Page 41 Today’s trading tools are smarter and more flexible than ever.

ASSET MANAGEMENT

EASTERN EUROPEAN FUNDS FACE REALITY ..................................................Page 43 Paul Golden reports on the deepening of investment strategies in Eastern Europe.

THE IMPORTANCE OF CUSTOMISED COLLATERAL SOLUTIONS ..Page 47

ASSET SERVICING

David Simons explains why end to end solutions might be the best.

US SECURITIES LENDING ROUNDTABLE ..............................................................Page 51 The interplay of market change, regulation & harmonisation.

DATA PAGES 2

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

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

Eds_Contents 69_. 18/03/2013 14:06 Page 3

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GM Regional Review 69_. 18/03/2013 17:14 Page 4

COVER STORY

IMPACT OF THE EUROCCP/EMCF MERGER

For all the benefit that liberalisation, and consequent fragmentation, has brought to the European equity markets (increased competition, venue choices, cheaper front end trading fees) the back office (clearing and settlement) still has to fully deliver on its promise of more efficient and cheaper post trade services. Now though, all that looks to be overturned. Market consolidation is clearly underway in the clearing space. In mid March two of Europe’s higher profile clearing houses, EMCF and EuroCCP, announced their combination. What are the implications of change? Will the post trade segment now finally begin to deliver on its promise? Francesca Carnevale reports on the implications.

A CLEARER FOR ALL SEASONS? WO OF EUROPE’S higher profile clearing houses, EMCF, owned by Dutch bank ABN AMRO Clearing Bank and NASDAQ OMX, and EuroCCP, wholly-owned by The Depository Trust & Clearing Corporation, have announced they will combine. The new company, which will be called EuroCCP, will be based in Amsterdam with client-facing functions located in London and Nordic coverage provided from Stockholm. Diana Chan, chief executive officer of London-based EuroCCP, will be appointed to that role at the new firm, while Jan Booij, chief executive officer of EMCF, will be chief operating officer (COO). BATS Chi-X Europe is also involved, holding a 25% stake in the venture.“Our rationale for being involved in this deal is based on our equities/ETFs product set and ensuring a strategic, horizontal clearer that is sustainable,” says BATS Chi-X chief executive, Mark Hemsley. Some commentators say the merger is a response to increasing competition from larger rivals. Others say that mergers in the CCP arena are now inevitable following a long period of ultra low trading volumes over the last few years.Yet others that the combined entity will beef up the group’s share of the UK equities market, putting it on a near level footing with UK market leader LCH.Clearnet, itself a recent target of the London Stock Exchange (LSE). What is clear is that the combined entity is a new iteration of the current crop of pan-European clearing houses that have emerged in recent years to support the region’s diverse trading

platforms. EuroCCP, for instance, was initially set up to support Turquoise, the multilateral trading facility (MTF) now majority-owned by the LSE, while EMCF was initially set up to clear trades on Chi-X Europe, a leading MTF that was bought by BATS Europe (owned by a consortium of investment banks). Until last year, when Turquoise and BATS Chi-X Europe started to offer trading firms a choice of CCPs including EMCF and EuroCCP through interoperability, clearing houses have tended to have exclusive relationships with the trading platforms (exchange, MTFs or bank specific platforms) whose trades they clear. Trading firms have also been tied to those same clearing houses if they have traded on their tied venues. However, the combination of recent market initiatives offering three or four way clearing arrangements and official moves across Europe proposing unrestricted interoperability between clearing houses is proving to be a game changer. In the not too distant future traders will be able to consolidate their clearing business with a single provider. Inevitably, competition between clearers will escalate and prices will be pushed downwards as they compete for business. Those firms that can achieve scale and efficiency will be able to best leverage the changing market environment and in that light, the merger between EuroCCP and EMCF becomes really important. Diana Chan, chief executive officer, EuroCCP and a major protagonist in this entity, explains that for her part:

“The new CCP will lead the way in encouraging greater competition between all cash equity clearing houses while driving down costs. Following the launch of four-way interoperability, the industry must now consolidate in Europe to achieve economies of scale and respond to the changing needs of market participants. Combining our organisations will accomplish this.” According to Chan, the market has been pressing for change for some time, and she acknowledges that:“Frictional costs of trading still remain in the market, and this is one combination that will help introduce more efficiency in the post trade segment. By combining two entities in this way clients will enjoy greater economies of scale at the CCP, and through settling with a single CCP, rather than two. Bringing together EMCF and EuroCCP reflects the desire of many market participants to see sustained competition, consolidation and greater efficiencies in European clearing and post-trade processing.” EMCF CEO Jan Booij expands on the theme: “This is not only a transformational initiative for EMCF and EuroCCP but for the industry. It will enable us to provide more flexible and innovative clearing services to all clients, while our sustainable business model will ensure costs are kept low and will provide the very best in risk management, technology, settlement and client service. Substantial settlement cost savings resulting from increased settlement netting and reduced inter-CCP settlements, for instance, can now be achieved.”

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Regional Review 69_. 18/03/2013 14:03 Page 5

Post-trade made easy

GM Regional Review 69_. 18/03/2013 17:14 Page 6

COVER STORY

IMPACT OF THE EUROCCP/EMCF MERGER

Certainly, thinks Hemsley, “Participants will not be paying more. The combination of EuroCCP and EMCF will deliver a number of substantial cost savings in the areas of reduced settlement fees, decreased levels of margin and funding costs, as well as through the elimination of one set of exposure to loss sharing and the funding costs of the clearing fund, membership fees, IT and connectivity expenses.” There are also other operational benefits, explains Booij.“The new CCP will use the risk management framework and customer-service organisation of EuroCCP and it will run on the technology and operations infrastructure of EMCF.” “It is the best of both worlds taking the stronger elements of each party and merging them into one,” adds Chan. The new CCP is required to receive regulatory approval and once this has been secured, conceivably within this year, the business will move quickly to consolidate operations. In the immediate term, the new CCP will focus on cash equities. “Any long term diversification plans for the CCP will be determined by the supervisory board,” explains Chan. EuroCCP’s Supervisory Board will consist of representatives from ABN AMRO Clearing Bank, BATS Chi-X Europe, DTCC and NASDAQ OMX plus independent directors,“providing a broad and balanced representation of the market place,” explains Booij. “Some 33% of the board will represent users, and they will be represented by ABN AMRO and the DTCC, 33% will be represented by the platforms, in other words NASDAQ and BATS ChiX with the remaining third comprising independent board directors. No single shareholder or group of shareholders will have overriding control. The balanced board structure and business model are intended to ensure market focus, low costs, sustained competition, and that the CCP is financially robust. The firm’s risk committee and a participant advisory board will also have broad industry representation,” explains Booij.

Diana Chan, chief executive officer, EuroCCP and a major protagonist in the merger deal, explains that for her part: “The new CCP will lead the way in encouraging greater competition between all cash equity clearing houses while driving down costs. Following the launch of four-way interoperability, the industry must now consolidate in Europe to achieve economies of scale and respond to the changing needs of market participants. Combining our organisations will accomplish this.” Photograph kindly supplied by EuroCCP 2013.

EMCF CEO Jan Booij: “This is not only a transformational initiative for EMCF and EuroCCP but for the industry. It will enable us to provide more flexible and innovative clearing services to all clients, while our sustainable business model will ensure costs are kept low and will provide the very best in risk management, technology, settlement and client service. Substantial settlement cost savings resulting from increased settlement netting and reduced inter-CCP settlements, for instance.” Photograph kindly supplied by EMCF, March 2013.

The new entity is itself a game changer in many respects. From the outside, it looks like the hybrid business model evinced in the merged entity brings all interested parties, either directly or indirectly together in the revamped EuroCCP. As Chan cedes, it has something for everyone. If the new augmented EuroCCP comes into being it will do at least three clear things. One, it will help clear the path for efficient interoperability; and better that interoperability works between larger more efficient operations than a myriad small ones. Two, it will mean that competition between CCPs will rest firmly on their viability as a business model, rather than the luck of being tied with a popular and up and coming trading venue. The merged CCP will give LCH.Clearnet a run for its money. Not only that, the entity will have truly European wide reach. EuroCCP currently clears equity trades in 19 markets, and the trading venues it serves include BATS Chi-X Europe, Burgundy, Equiduct, NYSE Arca Europe, SIGMA X MTF, SmartPool, Turquoise and UBS MTF. It also has the mandate from GETMatched Europe and NASDAQ OMX Nordic Exchanges to provide competitive clearing. Moreover, it has developed a capability to clear over-the-counter (OTC) European cash equities trades. It currently clears trades matched on the Omgeo CTM platform and has

been mandated by Traiana and by SWIFT Accord platform to provide pan-European clearing. Meanwhile EMCF provides CCP services for BATS Chi-X Europe, Burgundy, CATS, QUOTE MTF, TOM, NASDAQ OMX Nordic as well as NASDAQ OMX First North. It’s a hefty list by anyone’s standards. Three, and this has implications more for BATS Chi-X rather than EuroCCP, it finally brings the BATS Chi-X Group fairly and squarely into the sphere of the large exchange groups with extensive, though subsidiary, clearing and settlement operations. This shareholding is important for the pretender to the European trading crown and this is an important jewel in that symbolic trinket. It will also be interesting to see once the merged entity takes shape, how BATS Europe’s interoperable clearing model will evolve. BATS Chi-X Europe introduced SIX x-clear AG as an additional central counterparty (CCP) alongside EMCF, EuroCCP and LCH.Clearnet Ltd as part of an interoperable clearing model last year. For now, Hemsley at BATS Chi-X is sanguine, and the value of his firm’s share in the new CCP business model is clear, “We think it will be a popular model for the market because it will ensure a truly horizontal clearing entity. However, it could be difficult to replicate unless the exchanges start to divest their captive CCPs.” n

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Regional Review 69_. 18/03/2013 14:01 Page 7

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GM Regional Review 69_. 18/03/2013 12:58 Page 8

SPOTLIGHT

LTRO CONTINUES TO WEIGH ON EUROPEAN REPO MARKET

11.9% reduction in repo business in 2012 says ICMA Association’s semi-annual report highlights the negative impact of the ECB’s LTRO on the repo market.

Photograph © Emeraldgreen/Dreamstime.com, supplied March 2013.

HE EUROPEAN REPO Council of the International Capital Market Association’s (ICMA’s) semi annual report on European repo shows a market continuing under stress. Continued weakness is thought to reflect the effects of the ECB’s Long Term Refinancing Operations (LTRO), which has meant that banks have been able to decrease their reliance on funding from traditional repo operations. However, the size of the market remains well above the trough recorded in the association’s December 2008 survey (€4,633bn). The association measured the amount of repo business outstanding on December 12th last year, which it sets the baseline figure for market size at €5,611bn, down 0.9% on the reported figure in June 2012. The figure also represents a 9.5% reduction in the repo business since the December 2011 survey.

The association’s analysis of a constant sample of survey respondents, using only the figures for the banks that participated in the last three surveys, reveals a more marked decline in market size of 6.6% since June 2012 and an 11.9% year-on-year contraction. Godfried De Vidts, chairman of ICMA’s European Repo Council thinks that the results show that the “future of this market is in jeopardy. The European Commission’s latest proposal for Financial Transactions Tax (FTT) comes at a time when the Basel Committee has guided interbank lending transactions away from an unsecured to a secured basis and when wholesale market participants, together with the Central Bank community, have moved to the repo market because it is the safest way of distributing liquidity throughout the European banking system. The FTT proposals to tax repo transactions put the

economic viability of repo, including triparty, transactions at significant risk, which will lead to less liquidity provision to the real economy.” De Vidts says, “The FTT proposals also put at risk the implementation of EMIR, which requires the use of collateral for centralised and bilateral clearing. As ESMA highlighted upon release of its first EU securities markets risk report on February 14th: the collapse of unsecured markets during the financial crisis, as well as regulatory initiatives, have led market participants to rely increasingly on collateral as a means of mitigating counterparty risk, stimulating the demand for collateral. Additional demand for collateral will exceed the additional supply of collateral in 2013-2014, making collateral comparatively scarcer.” He adds: “If the FTT on repo transactions (which facilitate collateral being available where it is needed) goes ahead, the regulatory collateral crunch will actually materialise. Is that what we really want to happen?” According to ICMA figures, the share of government bonds within the pool of EU originated collateral reached a high of 81.3% by December last year, reflecting greater availability of core eurozone government bonds and particularly of German government bond collateral, as investors stopped hoarding safe haven assets such as German government bonds following the improvement in market sentiment that followed the announcement of the OMT in September. Additional points raised in the report include: the share of transactions with more than one year to maturity decreased sharply from 13.3% in the June survey to 5.9% suggesting that this form of longerterm financing has been substituted by access to the three year LTROs. The share of all CCP-cleared repos—which includes those transacted on an ATS and automatically cleared across a CCP,

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Regional Review 69_. 18/03/2013 12:58 Page 9

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

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GM Regional Review 69_. 18/03/2013 12:58 Page 10

SPOTLIGHT

SEC RULES TO IMPROVE SECURITIES MARKET INTEGRITY

but also those transacted directly with a counterparty or via a voicebroker, and then registered with a CCP post trade—rebounded sharply to 31.7% from 26.1%, close to the high of 32.0% reported in December 2011. Finally, the share of transactions in the survey conducted electronically was broadly unchanged since the previous survey at 32.8%, but the share of voice brokers continued its apparent downward trend.

SEC proposes rules to improve system compliance & integrity Regulation SCI carries enforceable rules designed to better insulate the markets from vulnerabilities posed by systems technology issues.

Photograph © Natis/Dreamstime.com, supplied March 2013.

EW RULES PROPOSED by the United States’ Securities and Exchange Commission (SEC) — called Regulation Systems Compliance and Integrity (Reg SCI) — will formalise and make mandatory many of the provisions of the SEC’s Automation Review Policy that have developed during the last two decades. The

proposed rule applies the policy and proposes additional measures to entities at the heart of US securities market infrastructure to protect market infrastructure. Reg SCI will ensure that the core technology of national securities exchanges, significant alternative trading systems, clearing agencies, and plan processors meet certain standards; that these entities conduct business continuity testing with their members or participants and that the entities provide certain notifications regarding systems disruptions and other types of systems issues. “While it’s not possible to prevent every technological error that market participants may commit, we must ensure that our regulations are designed to minimize their impact on our markets and ultimately investors,” says SEC interim chair Elisse Walter. “Reg SCI will provide more explicit technology and control standards to help ensure that our markets remain resilient against technological vulnerabilities.” Under the proposed rule, each SCI entity would be required among other things to establish policies and procedures relating to the capacity, integrity, resiliency and security of its technology systems and ensure its systems operate in the manner intended, including in compliance with relevant federal securities laws and rules. Relevant firms must take timely corrective action in response to systems disruptions, systems compliance issues and systems intrusions and notify and provide the SEC with detailed information when such systems issues occur as well as when there are material changes in its systems. Written notices would be filed electronically on new Form SCI. They will also have to conduct an annual review of its compliance with Regulation SCI, and submit a report of the annual review to its senior

management and the SEC and designate individuals or firms to participate in the testing of its business continuity and disaster recovery plans at least once annually, and coordinate such testing with other entities on an industry, or sector-wide basis. In enhancing its supervisory role in this regard, SEC staff will have to be given access to a reporting firm’s systems to assess its compliance the new rules. The new ruling has been introduced because, says the SEC, “Today’s securities markets rely extensively on technology more than ever before. As with any industry, the consequences can be significant when technology goes awry. The high-speed automated trading that occurs both on national securities exchanges and alternative trading systems has heightened the potential for a technological problem to broadly impact the market.” Regulation SCI ultimately follows initiatives brought forward by the SEC following the Flash Crash in May 2010. The SEC approved a series of measures to help limit the impact of such technological errors. For instance, the SEC approved rules to halt trading when a stock price falls too far, too fast as well as rules to provide certainty in advance of when an erroneous trade would be broken and rules to eliminate stub quotes. In addition, the SEC approved a rule known as the market access rule, which requires brokers and dealers with market access to put in place risk management controls and supervisory procedures designed to manage the financial, regulatory, and other risks posed to the markets by a malfunctioning of their technological systems. The ruling now awaits feedback from the market. A 60-day public comment period now follows Reg SCI’s publication in the Federal Register.

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Aviva survey says equity fund managers more bullish Equity managers are far more confident about the markets than their fixed income peers, according a new Aviva run survey of managers with some £2.5trn in AUM.

Photograph © Franz Pfluegl/ Dreamstime.com, supplied March 2013.

HE MOST NOTABLE trend this year, according to the Aviva survey, is the chasm between the expectations of equity and fixed income managers. The majority of respondents, based in the UK, US and Europe, are more confident about markets than they were this time last year. Equity returns beat their expectations in 2012 and the overriding view is that the main central banks have done enough to calm markets. Even though fixed income managers generally agree with this view, only a minority of them share the enthusiasm of their equity peers (26%). The eurozone remains a major concern for investors, with 90% of fixed income and 71% of equity managers expecting continued uncertainty to affect markets negatively this year. Another risk factor that has surfaced is the US fiscal cliff, with opinions divided on whether the outstanding areas of spending cuts and an increase to the debt ceiling will be agreed in the first quarter (Q1) of this year. Just under half of fixed income (45%) and equity managers (37%) don’t believe it will. “It is interesting to note the important role that confidence plays even to professional investors,” says Peter Fitzgerald, co-head of multimanager at Aviva Investors. “While

equity investors are often those with a more optimistic view, the year on year change and divergence in sentiment is dramatic. On the back of a year of strong returns, equity managers have become more bullish and far more confident than their fixed income peers,” explains Fitzgerald. “Whilst risks have by no means dissipated entirely, as exemplified by the recent Italian election results, it does appear as though the investment professionals are expecting a rotation from bonds to equities.'' The survey also revealed that fund managers unanimously agree that IPO activity will pick up this year compared to 2012. Last year, only 17% were of this view. Equity investors are significantly more bullish on financial stocks. Over a third of the respondents (38%) are expecting them to deliver the greatest performance this year. In contrast, 44% of survey respondents were underweight in the sector last year. With only one manager overweight, this indicates that just over half of equity managers held index weights. Fitzgerald continues: “The survey results show clear signs of sector rotation in the global equity space,” explains Fitzgerald. “From being completely unloved last year, the financials sector is now expected to

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

contribute the most to returns in 2013. This is a dramatic change, but one we have witnessed in our own portfolios, with our external managers adding to bank positions in the latter half of last year and into this year. Political risk and its impact on the macro-economic picture remains by far the biggest concern, whilst respondents appear to think that there is scope for valuations to rise further.” Fixed income managers are significantly less worried about liquidity risk in corporate bonds, which was cited as the biggest risk factor last year (20% versus 77%). They are also less concerned about defaults in sovereign bonds (6% versus 64%). The majority, however, cite low yields and rising interest rates as the biggest risks to their asset class. In comparison, a small minority was concerned about interest rate rises last year. Compared to their equity peers, fixed income managers are less confident about market returns. While the overwhelming majority of fixed income managers (95%) expect positive returns of up to 10% for corporate bonds, they expect negative returns for sovereign bonds (62% vs. 23% last year). “It is surprising that liquidity appears less prominent in investors’ minds than last year as our external fund managers continue to tell us that broker inventories remain low and new supply is muted,” explains Ian Aylward, co-head of multimanager at Aviva Investors. “What is very telling, however, is that the vast majority expect negative returns for government bonds,” Aylward continues. “We have held no gilts in our multi-manager and fund of fund portfolios for 12 months now and have been moving into floating-rate areas such as MBS and loans instead. We believe diversifying sources of return in the fixed income space certainly makes a lot of sense in the current environment.” n

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VOX POP

WILL SEGREGATED COLLATERAL SAFEGUARD REHYPOTHECATION?

Under the right circumstances, rehypothecation—leverage derived from the re-use of existing client collateral—can provide brokers with optimised borrowing opportunities, while giving lenders a reduction in transactional costs. If handled improperly, however, the process can easily go awry—and in a pretty big way. How do you ensure you get it right? US Editor, Dave Simons gives us his view.

REHYPOTHECATION REVISITED IVE YEARS AGO last month I sat down with Kevin Davis inside the Manhattan offices of ill-fated futures brokerage MF Global, as the soon-to-be ex-chief executive officer laid out his plans for the newly launched spin-off of Britain’s Man Group. Describing the income MF Global’s team pulled in through clearing and execution regardless of which way the markets went, Davis concluded that “any news is good news—whether it’s good, or bad.” Just days later, one of Davis’s minions, Brent Dooley, who worked out of the firm’s Memphis office, went home and, in a single evening, racked up a $141m loss while recklessly trading wheat futures out of his own account, using the Chicago Mercantile Exchange’s (CME’s) orderentry system. By the time our inconveniently scheduled March cover story was out, MF Global’s shares were already off 70%; months later Davis was done, Dooley was on his way to court—and incredibly that was just the beginning. Two years later the company, now under the direction of Jon Corzine, the former governor of New Jersey, began an estimated $6.3bn wager on the bonds of various indebted European nations as part of an aggressive campaign to restore shareholder value. Still in a weakened state following the Dooley affair, the company nevertheless employed various hyper-leveraged strategies that by all accounts included the process known as rehypothecation—off balance-sheet leverage derived from the re-use of existing client collateral.

Photograph © Sureshr/Dreamstime.com, supplied March 2013.

Totally legit (in the United States, brokerages are allowed to pledge up to 140% of client’s liabilities), rehypothecation nevertheless has its share of pitfalls, including the need for borrowers to post additional margin on a moment’s notice in order to mollify dubious creditors and regulators. Though Corzine’s bet was right on the money—at maturity all of his eurobond picks paid in full—unfortunately he, nor anyone else at MF Global, would be around to claim victory. Kneecapped by a swift succession of credit downgrades and margin calls, MF Global collapsed in October

2011; unable to raise cash fast enough to stay afloat. Along the way an estimated $1.6bn in client assets went missing; miraculously, a court ruling finalised just last month paved the way for nearly all of the misappropriated funds to be returned to its rightful owners. MF Global was hardly the first to give rehypothecation a bad name (that list includes the mother of all meltdowns, Lehman), but in its wake critics have called for a thorough re-examination of rehypothecation regulation. To sceptics, rehypothecation is part of the same freewheeling, risk-taking environment that made it possible for a lone impulsive trader to deal a nearfatal blow to a $1.4bn operation, then allow a seasoned veteran to come in and finish the job. For starters, under rehypothecation it is possible for pledged collateral to be co-mingled with other assets on the balance sheet. Keeping pledged and non-pledged securities independently domiciled is key to preventing client assets from being re-hypothecated, say reform advocates, who see a need for greater clarity around asset segregation. A likely byproduct of current regulatory efforts, then, will be a true segregation of client collateral, thereby making it more difficult for unwanted rehypothecations to occur. In the recent Commonfund Institute report Managing Counterparty Risk in an Unstable Financial System, David Belmont, chief risk officer for Wilton, Connecticut-based financial-services firm Commonfund, noted a conspicuous lack of clarity around the types of assets used for rehypothecation. This

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has fueled demand for increased broker reporting, says Belmont, “including daily reports on where their assets are being held and which have been lent out or re-hypothecated.”

Benefits—and drawbacks Even so, proponents believe that rehypothecation can still be an attractive proposition for brokers who are keen on optimising borrowing opportunities, as well as lenders seeking a reduction in transactional costs. To avoid the mistakes of the past and maintain the integrity of the re-pledged collateral, rehypothecation requires the presence of transparent, fully automated monitoring systems and operational practices, including the use of segregated accounts. Under rehypothecation,“if someone is pledging a bond as collateral, the receiver of the collateral may be able to onward pledge that specific bond to satisfy a margin demand from a separate party,” says Judson Baker, product manager for Northern Trust’s assetservicing division.“They are essentially using the bond as if it were their own to help meet a margin call, as opposed to using their own trading assets for that margin requirement.” While reducing initial trade costs and related funding transactions, rehypothecation also facilitates increased velocity and liquidity around financing transactions, says Jean-Robert Wilkin, head of collateral management and securities lending products at Clearstream. “ICSD triparty agents [such as] Clearstream have offered collateral re-use for years, in a manner that is very transparent and is based exclusively on the settlement of securities which are subject to transfer of ownership,” says Wilkin. Rather than question the integrity of rehypothecation, industry members “should be able to clearly demonstrate its proper usage, including the manner in collateral information is reported to all involved.” Since cash can be easily segregated from other assets, rehypothecation

issues are less likely to arise. Things can become a bit trickier, however, once securities come into the mix. As such, a number of funds remain dead-set against using rehypothecation, due in large part to the inefficiencies involved. “They would simply rather use funds that are more accessible to them,” says Baker. If recent history is any judge, rehypothecation has the capacity to create more problems than it solves. “Rehypothecation requires that you have processes in place that allow you to easily track the whereabouts of that collateral,” says Baker. “And if your exposure to the first party swings to the point that they need to call in the collateral, you then have to then find an acceptable substitute to bring to Firm B in order to return the initial asset. Operationally, that can be a bit tedious.” Throw in a few extra nuances, and suddenly you’ve got the makings a quasi-serious settlement-risk issue. “For instance, when substituting collateral, some firms will insist that the re-pledged asset be of like value, and require that the asset is in their possession before they agree to release the asset. That’s when things can become operationally painful—particularly if all the right pieces don’t immediately fall into place.” For lending agents, rehypothecation does increase the amount of securities available for loan purposes, and as such could conceivably create more revenue, concurs Claire Johnson, head of marketing and product for CIBC Mellon. Providing access to higher-quality collateral is yet another potential benefit, adds Johnson, particularly at a time when US Federal Reserve asset purchases and sovereign-debt downgrades are making collateral harder to come by. Nevertheless, CIBC Mellon believes the risks outweigh the benefits, and, in line with Canada’s general regulatory stance, does not rehypothecate collateral within its lending program. “We have taken the position that the

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

James Malgieri, head of service delivery and regional management for BNY Mellon’s Global Collateral Services business. The bottom line, says Malgieri is that one cannot rehypothecate collateral without having the consent of the client. “If you buy stocks on margin in the US, you are required to sign a rehypothecation agreement that allows your broker to re-use those securities in order to raise financing,” says Malgieri. “This puts the onus on the lender to ask questions regarding the broker’s intent to rehypothecate, including with whom, what, when and how.” Photograph kindly supplied by BNY Mellon, March 2013.

prospective risks associated with having to unwind a multi-level series of collateral trades mean potential delays,” notes Johnson, “which could create challenges or even exposures in a rapidly-changing market environment. Operationally, the collateral could be substituted at any time, and on the loan side we would have to recall it. So there are also potential relationship and reputation concerns in terms of lending out clients’ collateral.”

Rehypothecation for Transformation In contrast, using rehypothecation as part of a broader collateral-transformation strategy, whereby an equity or lower-quality bond is upgraded in order to meet a margin requirement, has been generally well-received within the markets. “Dealers, clearing

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VOX POP

WILL SEGREGATED COLLATERAL SAFEGUARD REHYPOTHECATION?

Claire Johnson, head of marketing and product for CIBC Mellon. For lending agents, rehypothecation does increase the amount of securities available for loan purposes, and as such could conceivably create more revenue, says Johnson. Providing access to higher-quality collateral is yet another potential benefit, adds Johnson, particularly at a time when US Federal Reserve asset purchases and sovereign-debt downgrades are making collateral harder to come by. Photograph kindly supplied by CIBC Mellon, March 2013.

firms and custodians have all been seriously looking into this area,”says Baker. “At Northern Trust we have a very strong securities-lending arm, and because this process heavily leverages lending operations, we feel it is a natural fit for us. There are a number of ways for us to make this work—we can act as repo agent, serve as the trade counterparty, as well as line up clients who are holding long positions and are willing to pledge assets in return for higher yield.” Going forward, this will require that banks such as Northern Trust keep a much closer watch on liquidity ratios, as well as the credit on both sides of the trade, all the while carefully monitoring counterparty activities.

“While it may be a slightly different form of monitoring than we typically undertake, it’s not a new kind of service altogether,” notes Baker. “As a result, we feel we are in a much better position coming into this, compared to those who may be just starting from scratch.” Recognising the need to corral risk associated with rehypothecation, custody providers have increasingly extolled the virtues of tri-party arrangements, using an integrated prime-custody offering to connect prime brokerages with fund-manager clients. Rather than risk having their assets subjected to rehypothecation in the first place hedge funds have increasingly sought out zero-margin, long-only prime-custody accounts. At present nearly one in two hedge funds with assets under management (AUM) in excess of $1bn maintain prime-custody arrangements, according to a BNY Mellon/Finadium report issued last fall, up sharply from just 15% five years ago. The bottom line, says James Malgieri, head of service delivery and regional management for BNY Mellon’s Global Collateral Services business, is that one cannot rehypothecate collateral without having the consent of the client.“If you buy stocks on margin in the US, you are required to sign a rehypothecation agreement that allows your broker to re-use those securities in order to raise financing,” says Malgieri. “This puts the onus on the lender to ask questions regarding the broker’s intent to rehypothecate, including with whom, what, when and how.” As many of the problems associated with rehypothecation have been the result of introducing an “outside” third party, using a custodian as collateral agent gives clients the assurance that their assets will at least stay within the program, says Malgieri. “The key feature here is the ability to control the pledged assets—and in this situation, the collateral agent has the ability to bring bona fide transparency to the

Judson Baker, product manager for Northern Trust’s asset-servicing division. Under rehypothecation, “if someone is pledging a bond as collateral, the receiver of the collateral may be able to onward pledge that specific bond to satisfy a margin demand from a separate party,” says Baker. “They are essentially using the bond as if it were their own to help meet a margin call, as opposed to using their own trading assets for that margin requirement.” Photograph kindly supplied by Northern Trust, March 2013.

rehypothecation process. If you look back at some of the defaults that have occurred in situations where the dealer had the right to rehypothecate, very often the clients didn’t actually know where the rehypothecated securities were headed. Again, if a client is willing to post collateral to be re-used, they had better find out why and what the broker is going to do with it.” With proper transparency in place and the right kinds of questions asked, rehypothecation can achieve its stated goal of providing added efficiency, as well as more favorable lending terms for the client. “And keeping the rehypothecation within network is obviously key to this effort,” says Malgieri.” n

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IN THE MARKETS

FUNDS DIVERSIFY ASSET ALLOCATIONS

Investors come back to the markets in search of returns

Photograph © Xy/ Dreamstime.com, supplied March 2013.

The markets this year have started with a bullet. The current bull market hints that investor confidence might be rising as the debt crisis in Europe looks to be under control and the US is managing its fiscal cliff. What are the implications of this seachange? Carey Olsen, which advises on the largest total number of funds and assets under management in Guernsey, believes there will be slow and steady growth in both fund creation and the breadth of investments they adopt. Corporate partner, Graham Hall, examines where this growth will come from and what innovations investors and private equity houses are employing to realise returns. QUITIES HAVE STARTED to move this year. Having locked up money for four years, keeping their money in ‘safe’ investments, investors now look to be interested again in assets which they think offer potential for higher yields. There is, of

E 16

course, some residual skittishness but recent movement in the markets indicates there is a lot more confidence and enthusiasm. There have been rallies in the past which have not stuck and there is still a question mark as to whether (or how

long) this one will hold. However, the market does seem to think there is a way to go before there will be any sort of correction. If the past four years has taught anything it is that it often pays to be innovative and funds are seeking unusual opportunities where the risk is seen as manageable. With interest rates remaining at historic lows, investors are chasing yield and the focus is firmly on emerging, or high growth markets, particularly those with a history of under-investment. Eastern Europe is a particular case in point. Bulgaria, Hungary, Czech Republic, Slovenia, Poland, Slovakia, Estonia, Lithuania and Latvia joined the European Union club in the past eight years while Montenegro, Serbia, the Republic of Macedonia and Turkey remain in the wings, with EU membership only a function of time. In spite of some structural economic problems, growth figures across the region remain attractive. The Polish economy, for instance, grew by 3.8% in 2011; Austria grew by 3.3%, while Moldova, Estonia and Lithuania all grew between 6% and 7% in real gross domestic product (GDP) terms. These figures compare to Germany’s 2.7% growth and the Eurozone’s blended growth rate of around 1.6%, over the same year. The growth rates in the eastern European zone points to opportunities in the development of infrastructure and commercial property (where property values remain low, but high returns are predicted); it is an attractive combination for investors recently starved of promising investments in Western Europe and the United States. Debt is also attractive as banks get rid of their loan books and finance houses adjust their loan-to-asset ratios. Much of this debt is now being sold off, sometimes their whole debt portfolios. Debt books can be picked up relatively cheaply by smaller operators at significantly reduced rates. Of particular interest, but not openly discussed, are lease car debt books. These books are

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sold at significant discounts and it is an area of significant potential returns as the economy improves and the risk of holding this debt reduces. Hedge funds also have appeal right now. They are performing better than they have in a long while and investors are beginning to recoup, or certainly looking to, the losses of the past. Whether it means more money being invested in hedge funds remains to be seen. It is difficult to give a time frame on when we might see a return to more halcyon days because, while there are individuals and select funds rallying, it is the big institutional pension funds that are needed to ensure a true return to performance. This sector is traditionally cautious and, having been severely hit in the crisis, their return will be slow and steady. It is really only 10% of the market that is prepared to take a risk and they appear to be a lot more open to the idea this year. There was a flight to Luxembourg by many hedge funds during the economic crisis thinking they needed to be seen to be onshore. Many are now realising this was a false perception as Luxembourg is an expensive and bureaucratic place to do business which has an impact in the efficiency of the funds and the returns that can be made. These funds are starting to look at other jurisdictions that offer stability and pragmatic regulation without the expense or bureaucracy. As ever, Guernsey is ideally placed to reap these opportunities. According to the Guernsey Financial Services Commission, the net asset value of total funds under management and administration increased in the third quarter (Q3) in 2012 by £3.6bn (1.3%) to reach £274.4bn. For the year since 30th September 2011, total net asset values increased by £3.3bn (1.2%). Guernsey is indicative of the worldwide trend where the interest in open-ended funds has decreased by £1.6bn (-3.2%) over the quarter to £51.5bn. The closed-ended sector increased over the quarter, by £4.2bn

(3.3%) to reach £130.3bn. This represents an increase of £4.6bn (3.7%) over the year since 30th September 2011. The market recognises Guernsey’s proven operating model with highly skilled professionals across the board. It is up to Guernsey to ensure it does not become too expensive but this is a secondary consideration to investors with the level of expertise and experience being far more important. Investors and funds, now more than ever, want to know that a jurisdiction has breadth and depth. It would be overstating the case to suggest the fund markets are entirely out of the woods; but there are definitely strong ‘green shoots’. Guernsey certainly remains the most popular jurisdiction for private equity albeit with fewer funds being created. There is activity from global private equity houses investing in infrastructure (Terra Firma, Permira, and Apex). They continue to invest but at lower levels. For example, the focus has been on global farmland as a sound investment for some of these closed-ended funds with investments being made in cattle stations in Australia and New Zealand (beef and dairy) and in China. It is tighter market and funds are looking much harder at efficiencies and costs. It is harder to raise the money and it takes longer and funds are

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

Graham Hall, corporate partner, Carey Olsen, Guernsey. Hall believes there will be slow and steady growth in both fund creation and the breadth of investments they adopt. Photograph kindly supplied by Carey Olsen, March 2013.

launching with lower expectations which, arguably, is no bad thing. Closed-ended funds are the majority of the market now and will continue to grow. 2013 has started as a bull market. The driving sentiment is one of optimism. There is a movement away from bonds and corporate gilts but there will not be a return the pre-2008 activity for a long time—slow and steady seems to be this year’s watchwords. n

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GM Regional Review 69_. 18/03/2013 12:59 Page 18

IN THE MARKETS

FSA UNDER FIRE FROM INTERNAL AUDIT

Photograph © Laststory/ Dreamstime.com, supplied March 2013.

FSA should have performed better says internal audit report The UK’s Financial Services Authority (FSA) recently took action against Barclays, UBS and RBS for alleged failures in respect of LIBOR submissions. The action enveloped two distinct elements: one, lowballing in the LIBOR market, whereby firms reduced their LIBOR submissions during the financial crisis in an attempt to avoid negative media comment on their cost of borrowing; and two, manipulation of rates to increase position-taking profits. In other words, traders, whose bonuses depended on complex deals linked to LIBOR, had an interest in pushing LIBOR up or down depending on the deal. According to the FSA “webs of traders within and across banks systematically attempted to manipulate LIBOR to benefit themselves and one another”. Strong sentiment. Funny then that the FSA appeared not to notice what was going on at the time. So says a just published internal audit by the regulator itself. HE OUTGOING FSA has been rated by a final Internal audit report (the latest of three) which has identified clear examples of regulatory failure in its treatment of the recent LIBOR scandal, and going back further the failure of

both Northern Rock and RBS: both in the international capital framework and in the FSA’s own approach to supervision; and made recommendations that supposedly will help transform the performance of the FSA going forward.

However, while the report identifies important areas where the FSA should have performed better, it does not suggest major regulatory failure on the scale identified in the Northern Rock (March 2008) or RBS (December 2011) reports. Nonetheless, the newly released report found 74 communications, of which 26 included a direct reference to lowballing in the LIBOR market. The report suggests most of these actions took place between April and June 2008, adding that while the remaining communications did not have a direct reference to lowballing, “they could have provided such an indicator, particularly when considered in aggregate”. The latest internal audit of the UK’s Financial Services Authority (FSA), covering January 2007 to May 2009, shows that (at all levels of management) the regulator was aware of severe dislocation in the LIBOR market in the period from summer 2007 to early 2009. However, says the audit, which covered some 17m records, 97,000 specific documents and interviews with 20 FSA employees, also concedes that the dislocation reflected market conditions, and would have occurred even if lowballing had not occurred. Even so, the audit report identifies however a number of instances where information available provided some indication that lowballing might be occurring. Of the 97,000 documents reviewed in detail, some 26 are judged as providing a direct reference to lowballing or a reference that could have been interpreted as such. The two clearest indications relating to a specific firm were telephone calls from Barclays in March and April 2008, which was included in the FSA’s Final Notice on Barclays, published on June 27th last year. Following the announcement of the Barclays’ fine, Barclays disclosed to the Treasury Committee 13 instances of communication between Barclays and the FSA which raised the question of whether the authorities ought to have been aware that firms might be making

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

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IN THE MARKETS

FSA UNDER FIRE FROM INTERNAL AUDIT

inappropriate LIBOR submissions in order to avoid negative media comment. The audit found that the FSA’s focus on dealing with the financial crisis, together with the fact that contributing to and administering LIBOR were not ‘regulated activities’, led to the FSA being too narrowly focused in its handling of LIBOR related information. Moreover, the report says the taking the information amassed by the FSA cumulatively; the regulator should have considered the likelihood that lowballing was taking place. As well, the information received should have been better managed. FSA chairman Adair Turner notes: “As the financial crisis developed in 2007 to 2008, the FSA’s bank supervisors were primarily focused on ensuring they understood the prudential implications of severe market dislocation. And the FSA had no formal regulatory responsibility for the LIBOR submission process. As a result, the FSA did not respond rapidly to clues that lowballing might be occurring. There are important lessons to be learnt about effective handling of information: these are identified in the Report and will be taken forward by both the FCA and PRA management. A particularly important lesson is the need to have staff focused on conduct issues even when the world rightly assumes that the biggest immediate concerns are prudential; and vice versa. The new ‘twin peaks’ model of regulation will deliver this.” “The report also reveals that while some information was available relating to lowballing, there is, for the period covered, no evidence of any information, direct or indirect, available to the FSA which indicated that traders were manipulating LIBOR for profit. All of the authorities, both UK and US and elsewhere only discovered trader manipulation as a by-product of enquiries launched into potential lowballing,” adds Turner. “This raises important issues about the regulatory tools best suited to identifying such market manipulation. More intense

supervision may not be the most appropriate lever. Better whistleblowing procedures, greater accountability of top management, and more intense requirements for self-reporting of suspicious activity may turn out to be more effective tools.”

Wheatley report The report cuts to the heart of the matter as to the role of regulators going forward: do they intervene to safeguard markets, acting as active policemen whenever any hint of malpractice occurs or do they rely on the good governance and auspices of market participants themselves, who should know better. As the Wheatley Review (published in September 2012) made clear, the FSA in this instance was blindsided as the process for setting and policing LIBOR was fundamentally flawed. The system had in-built conflicts of interest which were inadequately controlled by both the contributing banks and the British Bankers’ Association (BBA), the body responsible for overseeing LIBOR process. The system also lacked external accountability, said Wheatley, as the FSA did not regulate LIBOR and individual employees involved in the LIBOR process did not have to be approved by the FSA. The Wheatley Review highlighted the lessons of the LIBOR fixing scandal, and suggested ways in which the FSA might have better interpreted or responded to the information flows available at the time. In relation to derivatives traders however, this latest internal audit report found no evidence to suggest that there were any communications, or, pieces of information which might have alerted FSA staff to this issue. The question raised by the Wheatley Review is whether it would have been feasible to have a supervisory approach in which facts relevant to the derivatives trader issues would have come to light. It is not clear that it would have been, without an impractically intensive supervisory approach (in other words, regulators cannot have supervisors in every dealing room).

Clearly, some potential problems cannot be spotted by direct supervision in advance but should be policed by firms themselves on a day to day basis, supplemented by effective processes for the supervisory review of firms’ systems and controls. Equally, the Wheatley report noted these elements were subject effective whistleblowing and other procedures to bring problems to light; and exemplary post-facto penalties when offences do occur. The Wheatley Review made ten recommendations to the UK government, the British Bankers Association, banks and regulatory authorities, both in the UK and internationally. The UK government accepted the recommendations in full and introduced legislation, in the Financial Services Act. Wheatley recommended bringing benchmark-related activities within the scope of statutory regulation, including the submission and administration of LIBOR; creating a new criminal offence for misleading statements in relation to benchmarks such as LIBOR, as well as amending the language of existing offences; and enable the FCA to create a specific power to make rules requiring authorised persons to contribute to a specified benchmark (for example, LIBOR). In the event, LIBOR submission and administration will be regulated activities from April 1st this year and the FSA, together with the new LIBOR administrator, will agree appropriate market monitoring and oversight for LIBOR. That won’t be the end of the story though. The FSA will be replaced by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) this year, (as required by the Financial Services Act 2012), and it will be up to FCA and PRA senior management consider how such activities will be identified and assessed by the new regulatory authorities’ risk and governance frameworks, “so that risk-based prioritisation decisions can be made in relation to them”, says the FSA. n

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GM Regional Review 69_. 18/03/2013 12:59 Page 22

DERIVATIVES

INTEREST RATE SWAPS HELP THE BIG GET BIGGER

Photograph © Eteimaging/ Dreamstime.com, supplied March 2013.

Why traditional fund managers should look again at interest rate swaps The interest rate swaps market is huge. The Bank for International Settlements (BIS) tallied $379trn in notional amount outstanding in June 2012 (the latest available data), almost 60% of the total for all OTC derivatives. However, take up by traditional asset management firms has been slow. Neil O’Hara explains why interest rate swaps are worth another look. ORPORATIONS, BANKS, SECURITIES houses and fixed income-oriented hedge funds use interest rate swaps to hedge, alter duration, lock in financing rates, express speculative views and manage risk. Although such versatile instruments appear to be a natural fit for any bond portfolio manager, traditional asset management firms have been slow to adopt them. Even today, specialist boutiques and a few big players dominate interest rate swaps trading on the buy side—but these few have turned their know-how into a competitive edge. “Historically, asset managers have used cash instruments much more than

swaps,”says Mike Berczuk, head of US rate sales at UBS in Stamford, Connecticut.“A number of large managers do use interest rate swaps for duration management, yield curve management, overlay strategies and so on. More are moving in that direction but many managers still don’t have swaps in their toolkit.” The obstacles to trading swaps are administrative rather than philosophical. Asset managers often run commingled funds for managed accounts, but the investment guidelines for some participants may exclude derivatives. If the manager enters into a swap for the benefit of

clients who can trade derivatives, it must carve out a piece for those accounts that can’t—and then find a way to replicate the swap for those accounts in a permitted investment.“If a manager wants to go long the market, it is much simpler to buy tenyear notes,” says Berczuk.“It can more easily allocate that trade across all the accounts.” Swaps open up a plethora of alternatives for bond managers to tweak their performance. If they expect interest rates to rise and want to protect their portfolios against the decline in bond prices higher rates entail, managers need to shorten duration. They can either sell long-term bonds and replace them with shorter-dated paper in the cash market—or they can keep their existing bonds and execute a fixed-tofloating rate swap overlay to achieve the same result. In a simple example, a manager agrees to pay a fixed rate of 4% for ten years and receives in exchange threemonth LIBOR plus a margin that equalises the present value of the payment streams at the trade date. If rates do go up, the manager continues to pay 4% but receives higher payments because LIBOR has increased; offsetting the loss in capital value on the hedged bonds (provided the swap has the same duration). To take the opposite view on interest rates, or to unwind the swap, the manager executes a floating-to-fixed rate swap for the same maturity. Swaps trade across the entire maturity spectrum, creating a swap yield curve. Under normal market conditions, the swap curve tracks the government bond yield curve with a modest premium—the swap spread— to reflect the credit risk inherent in a bilateral contract between two private parties. In effect, the swap spread measures perceptions of counterparty credit risk. When investors become more cautious the spread typically widens, making interest rate swaps an excellent hedge for corporate bond portfolios.

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“If you own corporate bonds they could underperform government bonds in a period of rising risk-aversion,” says James Stuttard, head of international bond portfolio management at Pyramis Global Advisors in London.“Hedging is very much about movements in swap spreads.” Asset managers also use swaps to make directional bets on interest rates or isolate a specific part of the yield curve. Stuttard points out that the only liquid bond future in the United Kingdom is the ten-year contract; there is no equivalent to the 30-year long bond future in United States Treasuries or German Bunds. If Pyramis wants to take a view on long gilts, it will use a 15/15 year forward swap—a swap entered into today where the exchange of payments does not start for 15 years and runs for the following 15 years, an excellent proxy for long term rate exposure. Swaps can facilitate cross-border relative value trades, too. At a time when the Bank of England has signalled it is comfortable if inflation stays above target for the next couple of years, United Kingdom short rates are likely to remain low, but long rates could tick up. Meanwhile, the ECB is more worried about inflation, so while Euro short rates could go up, long rates may drift down. “A paying [fixed-to-floating] 15/15 UK interest rate swap against a receiving [floating-to-fixed] 15/15 German interest rate swap would be one way to play that,”says Stuttard. By market convention, “paying” and “receiving” refer to the direction of the fixed rate swap payment. Interest rate swaps are widely used in liability-driven investment (LDI) strategies to hedge long term pension and insurance liabilities. LDI managers commonly hold receiving interest rate swaps, against which they must maintain cash collateral sufficient only to cover mark to market movements. The balance of the notional amount can be invested to earn a premium over the floating rate the manager pays under the swap, a strategy similar to the

reinvestment of cash collateral in securities lending, albeit with a longer time horizon. While interest rate swaps may be the least risky of all OTC derivatives, they are not risk-free. In addition to counterparty credit risk—at the forefront of investors’ minds ever since the collapse of Lehman Brothers—swaps introduce basis risk. In 2005, for example, Dylan Roy, head of US rates trading at UBS in Stamford recalls that mortgage-backed securities managers were using interest rate swaps to hedge prepayment risk (if interest rates fall, homeowners are more likely to refinance their mortgages, shortening the average life and raising the price of MBS).“Swaps prices were more volatile than cash MBS prices,”he says.“Swap spreads widened when rates went higher and narrowed when rates went down, exacerbating the rate moves.”

Spread volatility The 2005 spread volatility made hedges more effective, but the opposite occurred in 2008. Long-term US Treasury rates fell during a massive investor flight to quality while swap spreads blew out on fears of counterparty risk. The abnormal move caught leveraged investors on the wrong foot, forcing some to unwind and push prices further out of line. “Hedging assumptions are fine until they are not and everyone is in the same boat,”says Roy. “If everyone is going the same way, the hedge will stop responding and then we get a period of extreme volatility.” For unlevered long-only managers like Pyramis, market dislocations often create exceptional trading opportunities. After Lehman failed, Stuttard (then at another firm) was able to buy twoyear interest rate swaps at a spread of 100bps over Treasuries. He was early— the spread peaked at 160bps—but held on until the spread returned to more normal levels (the historical average is about 40bps). “Swap spreads tend to revert to the mean in the long run,” he says.“It was a great opportunity for us to play tightening spreads.” Stuttard

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

made a similar play in ten-year Euro swaps in 2008—and again in the second half of 2011. Confidence in the creditworthiness of counterparties is critical when trading in stressed markets, of course. Fidelity (parent of Pyramis) has a separate division to analyse counterparty risk, which reports to senior management in order to maintain independence from the investment teams.“It helps that we are happy with whom we are trading, whether it’s an interest rate swap or credit default swap,”says Stuttard.“The firm has done the due diligence and met the standards the team sets for counterparties.” In addition to credit analysts, asset managers must hire lawyers (either inhouse or outside) to negotiate ISDA master agreements before they can trade swaps. They must set up collateral management systems (again, either internal or external) to handle mark to market payment calculations and flows. The resource commitment represents a significant barrier to entry, which may explain why only the largest managers have taken the plunge into swaps so far. Investor psychology raised the barrier after the financial crisis, too; managers not in the game must overcome knee-jerk conservatism about derivatives among their clients, a persistent legacy of the market meltdown. The ability to capitalise on market dislocations through misaligned spreads and similar anomalies in the interest rate swaps market gives asset managers who can trade swaps an edge when pitching for business to potential clients willing to use them. It allows Pyramis to meet relatively aggressive alpha targets—perhaps 100bps over a benchmark—without taking undue risk.“Having the flexibility to manage interest rate swaps or credit default swaps actively is important to achieving those targets,” says Stuttard. “Otherwise we would just be taking big bets on duration or corporate bonds.”For now, at least, swaps trading capability is helping the big asset managers who do it get bigger. n

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COMMODITIES

COMMODITIES TRADING

The first round of big changes to commodities trading that started two years ago with DoddFrank is now almost complete. Banks’ proprietary desks have mostly closed, trade finance has been pared down and the head counts have been slashed as banks adjust to regulatory changes, more demanding clients and less liquidity in the market. Proprietary trading has moved into unregulated territory into the hands of big commodities trading houses and hedge funds— though the latter segment has proved less successful than first thought. Meanwhile banks themselves have sought out new revenue streams from trading and storing physical commodities such as gold and copper. Where will it all lead? By Vanya Dragomanovich

COMMODITIES: WHAT BANKS DID NEXT? T LOOKS LIKE banks have not adapted to the new reality. Expectations are that commodities will continue to provide mega-returns; but that expectation is firmly grounded in the past. That is because more than once this decade commodities prices rose by as much as 20% or 30% in the space of a year. Going forward, these levels of price increases look unrealistic. Nonetheless, hope continues to colour the banks’ decisionmaking processes. There has been a seismic shift in commodities trading, kicked off by the introduction of the Volcker Rule, which at its core tries to restrict banks from speculative investments for their own gain. The rule effectively stops them from running proprietary trading. Even so, ever since Volcker entered modern financial speak lawmakers in Washington have been trying (and failing) to agree on its final version. The financial services industry has put up its best fight to date against the tide of regulation that threatens to engulf the markets, inundating regulators with more than 18,000 letters and comments. Right now, the rule, which also requires the sign-off from five US government agencies, seems unlike to be finalised any time soon. The Volcker Rule didn’t significantly dent speculative trading; it just moved it into less regulated territory. After the rule was first adopted (in a general sort of way) it became clear that banks would radically cut their commodities desks. No surprise that it resulted in the departure of many prominent traders, some of whom set up their own com-

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

modities hedge funds. Those hedge funds entered a market in which institutional investors were much more demanding and sceptical than they had been before the financial crisis. In other words, investors were more triggerhappy about pulling their money out at the first sign of weaker than expected performance. Then prices for oil, metals and gas stopped rising at their pre-crisis pace and in 2012 commodities recorded one of the segment’s worst performances in a decade. Consequently, commodities hedge funds lost about 20% of their assets last year and according to prime brokerage Newedge, they lost on average almost 4% in value. Two of the largest commodities hedge funds, Blenheim and Clive Capital, posted losses for the second year running. Other asset managers were not spared either; with Aberdeen Asset Management and Stenham Asset Management winding down their commodities fund of funds. Osvaldo Canavosio, head of commodities and

emerging markets manager research at FRM, a unit of Man group, attributes the weak performance to the lack of sustained trends in the most commodities and to significant short term volatility. “The highly correlated price action among markets generated difficult conditions that often resulted in whipsaw and [an] inability to hold positions through time,” says Canavosio. “These conditions tend to affect more negatively [those] managers with larger asset bases, [which] typically face more difficulties navigating choppy markets due to the size of their positions.”

Looking for returns Despite these problems, the trend to set up new commodities hedge funds is still alive and well—there are a number of hedge funds getting ready to launch this year—but it is becoming increasingly difficult for alternative fund managers to persuade investors to invest in them. Simply, it is no longer clear which commodities based strategies will be able to generate the returns seen a few years ago. Moreover, overall, commodity hedge funds remain much smaller players compared to large commodity trading houses which have taken on more proprietary trading.“Big trading houses do some hedging but they also trade more for their own books,” says Amrita Sen, analyst at Energy Analyst and a former commodities analyst at Barclays. This shift is a slap in the face of regulators which have very little oversight over unlisted companies such as Trafigura, Vitol, Mercuria or Cargill.

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

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COMMODITIES

COMMODITIES TRADING

Of the big trading houses only Glencore listed on a stock exchange. In consequence, it is the only trading house that has to inject transparency into its transactions and finances. “If you look at how profitable commodities trading houses are compared to banks with big commodities desk, even large ones [such as] Deutsche Bank or Barclays, they make the bankers look like amateurs,” claims a gold trader in London. Until recently five banks, JP Morgan, Goldman Sachs, Morgan Stanley, Deutsche Bank and Barclays, dominated the space, accounting for about 80% of the commodity business, be it derivatives, financing or warehousing. Among the big five Morgan Stanley and Barclays took the most restrictive view of where their commodities business was going. Barclays’ chief executive Antony Jenkins told investors in February that the bank has largely completed restructuring its commodities business, “to focus on core banking, financing and risk management and “smart” physical activity.”The bank cut the headcount in commodities by one third, stopped speculative trading of soft commodities and agricultural products and withdrew from being a ring dealing member of the London Metals Exchange (LME). Meanwhile, Deutsche Bank parted company with David Silbert under whose leadership it made around $1bn from commodities in 2011. The bank has filled his position internally, avoiding new hires. Elsewhere, JP Morgan took a knock when the US electricity regulator banned it from trading electricity in the US for six months and cut its derivatives trading positions. Amid all this shape-shifting Citigroup and Bank of America/Merrill Lynch started positioning themselves for a more active role in commodities. Unlike their peers, which have been in the throes of downsizing, the two banks are actively hiring and expanding. In November last year Citi hired former BNP Paribas global head of commodity sales Jose Cogolludo for a

new commodities position. Back to the top five, the biggest change in their commodities strategies has been to reduce their derivatives positions in favour of trading and storing of physical commodities. Barclays has already built the biggest new vault in the UK and Deutsche Bank is in the process of building one too, both to store gold and silver. JP Morgan and Goldman Sachs have bought large warehousing companies for storing industrial metals. In December JP Morgan also received approval to launch its first US copper ETF. “The extent to which individual banks have switched away from financial and into physical strategies is evident from their balance sheets,” explains Sebastian Walker, managing partner at Tricumen, a company which has analysed the performance of the top banks in the commodity space. Since the third quarter of 2010 Morgan Stanley has reduced its derivative position by 56% while JP Morgan by a comparably modest 19%. During the same period the top banks’ physical holdings surged. “At the extreme, Goldman Sachs has more than doubled its exposure,” says Walker.

Storage appeal Apart from the move from derivatives to physical commodities a second shift has taken place away from energy commodities (such as oil, gas, and electricity) into metals. According to Tricumen, for top commodities banks the revenue from energy commodities dropped by 20% since January 2011 while metals trading volumes have risen over the same period by 17%. “Metals have become attractive as an asset class to banks as they can gather information on the determinants of supply and demand such as knowing when mines will come to the end of their useful life, production margins, end-user demand, government policy and even likely commodity M&A activity,”says Walker. There is still some degree of prop trading within major banks and it remains difficult to unpick from the

outside where hedging on behalf of clients ends and speculative trading for the bank’s books begins. JP Morgan’s global head of commodities Blythe Masters defended the banks saying that onlookers misunderstand “the nature of our business.” “Our business is a client driven business where we execute on behalf of clients to achieve their financial and risk management objectives,” she said last year. As an example, she described how customers have metals stored in the bank's facilities,“they hedge it on a forward basis through JP Morgan who in turn hedges itself on the commodities markets. If you see only the hedges and our activities in the futures market but are unaware of the underlying client position that we’re hedging then it would suggest inaccurately we’re running a large directional position. That is not the case at all. We have offsetting positions, we have no stake in whether the prices rise or decline,” explained Masters. Goldman Sachs went a step further and actively started devising strategies that work around the Volcker rule. “TheVolcker rule has yet to be finalised, but it seems that Goldman Sachs' approach will be difficult to defeat,” says Walker. One way around the rule is the strategy of Goldman Sachs’ multi-strategy investing team which holds investment for longer than 60 days thus falling outside the scope of Volcker. “Even if regulators figure out ways to split prop trading from investments it would take a brave regulator to do anything that would seem to slow the flow of debt finance to mid-sized companies,” he adds. Though the first cycle of change is complete, new regulation could mean new rules of the game in the next year or two. But if those changes come into a market that is recovering, as it seems to be since the beginning of the year, regulators might be less keen to go through with all the proposed changes and what changes there are will be more manageable for banks in a climate of higher returns. n

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

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DEBT REPORT

DAIWA IN EUROPEAN DCM FRONT RANK HE DEBT CAPITAL Markets (DCM) division at the Japanese investment bank took a leading role—either as joint lead manager or joint book runner—on all three highprofile transactions, two of which broke new ground while the third matched a previous record. That was the first of the deals on January 9th this year when the state-owned Kommunalbanken Norway (KBN) equalled its largest ever dollar issue with a $2bn five-year bond that it placed successfully with more than 90 investors around the world. The following day, Denmark’s municipal debt association KommuneKredit launched its first ever five-year benchmark dollar issue, after increasing the size of the deal from $1bn to $1.25bn in response to burgeoning demand for the paper. The final and biggest of the three deals then saw the French state social debt agency CADES launch a $3.5bn five-year bond (its largest issue to date in the US currency) on January 22nd. The rise of Daiwa’s DCM operation to top-ranking status in the benchmark dollar market has taken place over the last three years. While the bank was certainly no stranger to large dollar deals before that, its involvement was restricted to about half a dozen issues (mostly for supranational institutions) a year; not enough to ensure that it was one of the banks that any prospective issuer would automatically approach as a matter of course. “You need to be doing one of these trades a

month to be in the core club, where you will inevitably be part of any [preissue] discussions—even if you do not ultimately secure the mandate,” explains Vince Purton, London-based managing director who heads DCM at Daiwa Capital Markets in Europe and the Middle East. At the beginning of 2010, Daiwa consequently took the steps necessary to enhance its capability to the point where it could achieve this volume of deal flow; a move that was much more about selective recruitment than a big increase in numbers.“We took an active decision that we would hire some very experienced senior professionals to head up our trading and origination desks,” Purton says. “It was an investment in quality rather than quantity.” It did not take long for the strategy to deliver the desired results. Daiwa took a lead role on 15 benchmark dollar transactions in 2011/2012, while the three deals in January brought its total to date in the current financial year to 14. “While we’re certainly not the largest house, we are now usually part of those early discussions,” Purton observed. One helpful attribute that Daiwa clearly had in the post-Lehman era, in which geographical diversity of funding sources has become a leading priority for issuers, was its strong historical ties to investment institutions in Japan and elsewhere in Asia. However, simply offering an Asian end for a deal’s distribution is no longer enough, and Purton said leading banks in the

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

DAIWA RAISES ITS STANDING IN THE BENCHMARK DOLLAR MARKET

Three large dollar-denominated issues from European public financial entities in January—worth a combined total of more than $6bn— provided ample confirmation, if any were needed, that Daiwa Capital Markets has now established itself as a front-rank player in the largest of global bond markets. By Andrew Cavenagh.

market now not only needed the ability to sell an issue to investors around the world but also have to be able to adjust rapidly to changing trends in demand. “Right now, your investor profile on a dollar benchmark issue will be dramatically different from even a year ago, with more interest from Latin America, the Middle East, and Eastern Europe,” he says. The KBN issue in January provided a good illustration of the trend, as investors across the globe bought significant volumes of the bonds, with 30% of the total going to Europe, 22% to Asia, 20% to the US, 17% to the Americas, and the remaining 11% to the Middle East and Africa. Daiwa’s enhanced standing in the benchmark dollar market has also increased the volume of business it derives from other, smaller sectors of the bond market. For the regular discussions it holds with frequent benchmark issuers will often reveal that while the latter may have no immediate or short-term requirement for large amounts of dollar funding, they do have a need for smaller amounts of an alternative currency. “It would certainly be wrong to say now that we are only a yen and dollar house, as we have several other strings to our bow,” Purton said. “What we have done is use the status we have achieved in the dollar market to expand our offering in other currencies. If you were to compare Daiwa’s debt capital market operation now to five years ago, we have a greater variety of credits by whichever measure you care to use: rating, issuer type, currency, or geographical base.” So while dollar and yen issues clearly still account for the bulk of the business, the DCM team is a lot more active than it was in other currencies; recently including deals in Norwegian and Swedish kroner as well as the more obvious sterling and euro alternatives. The bank tends not to compete as regularly for benchmark SSA euro issues as for dollar, however, as Purton said it was more difficult to break into

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DEBT REPORT

DAIWA RAISES ITS STANDING IN THE BENCHMARK DOLLAR MARKET

that market without a primary dealing capability. When the bank decided three years ago to enhance its overall market presence, it was a key factor behind its decision to focus more on the dollar than on the single European currency. “We don’t exclude the euro by any means, and do some great trades there, but the primary dealer issue can make it awkward on some benchmark transactions for SSA names,” explains Parton. As a Japanese house, the market for Samurai bonds of course remains an important source of business for Daiwa. The appeal of tapping into the huge yen investor base has also grown for many non-Japanese issuers since 2008, as it offers a relatively straightforward and secure means of diversifying their sources of funding and provides a valuable alternative source of liquidity if for any reason other markets are experiencing short-term difficulties (as that for euros has intermittently since the sovereign crisis in the peripheral states began).“It can take the pressure off the core funding in euros or dollars when conditions in those markets are not favourable for whatever reason,” confirmed Purton.“That argument has gained increasing support among traditional euro and dollar issuers—all the more so with the rapid shifts you have seen in market sentiment over the past two years. We’ve seen very healthy volumes in the Samurai market since 2008,” he says. While the Samurai market remains relatively small in terms of the global picture—it still accounts for just 1% of the overall Japanese bond market— there is every reason to believe it will continue to grow, particularly as the institutional investors that buy the vast majority of the bonds are quick to adopt new names.“Once you’ve issued in the domestic [Japanese] market and your name becomes familiar, you’re definitely in the club,” Purton adds. Another growth area of business for Daiwa’s DCM operation over the past 15 years has been the Uridashi bonds that offer Japanese investors exposure

Vince Purton, London-based managing director who heads DCM at Daiwa Capital Markets in Europe and the Middle East. “Right now, your investor profile on a dollar benchmark issue will be dramatically different from even a year ago, with more interest from Latin America, the Middle East, and Eastern Europe,” he says. Photograph kindly supplied by Daiwa Capital Markets, March 2013.

to foreign-currency debt. Aimed predominantly at retail bond buyers, this market tends to focus on the highyielding currencies at any given time—the Turkish lira and South African rand being the two most favoured currently—and the volume of deals fluctuates accordingly, although its overall size is certainly growing in the long term. A segment of the Uridashi market that has proved particularly popular with Japanese retail investors is that for what Daiwa refers to as themed bonds, on which the issuer commits to ring fence the proceeds for specific projects or areas of activity; in much the same way as the so-called ethical investments that a growing number of US and European funds now offer.“We did the first of these trades

five years ago, and the market just took off,”explains Purton.“It appealed to an element in the Japanese psyche, I think.” Since the beginning of 2011, Daiwa has been involved in the launch of eight such issues, on which the proceeds have been designated for projects to improve the environment (including the supply of clean water), develop agriculture, expand micro-finance, and implement vaccination programmes. The latest such deal was an issue in February for Rabobank Nederland, split between tranches in the South African rand and the Australian dollar, to raise funding for the Dutch bank’s lending program to the agri-business sector in developing countries. The ZAR965m tranche offered a four-year investment in units of ZAR100,000, paying an annual coupon of coupon of 5.66%, while the A$109m tranche offered a one-year longer term for a coupon of 4.02%. Daiwa’s success in expanding its presence across the global bond markets may owe something to the fact that it is a Japanese institution. The period since the financial crisis has understandably seen investors place far more importance on stability and reliability, virtues that are more ingrained in Japanese culture than in the West. “We would be perhaps expected to have a slightly different view,” agrees Purton.“The Japanese view tends to be slightly longer term, and I think issuers and investors are recognising that there is a value to the long-term nature of such a relationship.” Purton is a good example of such enduring presence, having been at Daiwa for almost 30 years. None of his current counterparts at European or US banks would have anything like that longevity of service at a single institution. Daiwa itself offers a similar sense of permanence, as one of the only two Japanese banks that is still trading under the same name as it was in 1997 (Nomura being the other) before the big shake-out in the Japanese banking sector. n

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REAL ESTATE

Changing landscape for Hong Kong AST YEAR WAS a pretty torrid time for the office market, which began heavily impacted by the worsened global economy of late 2011, when many companies were forced to halt their expansion plans. Net space absorption dropped in prime Hong Kong business locations, especially the traditional powerhouse of Central/Admiralty. Rentals also saw a big drop between the fourth quarter (Q4) 2011 and Q1 2012, with Central/Admiralty again taking the hardest hit. However, other districts have been relatively stable, creating two distinct market trends in Hong Kong, where take up in Central/Admiralty and rentals continue to be sensitive to the uncertain outlook while other districts, in particular non-core areas, have benefited from increased occupier demand thanks to decentralisation. Indeed, the office market was nothing short of grim during the first half of 2012 as the trend of falling take-up since Q4 2011 continued. A strong rebound in Q3 meant that the overall take-up in Hong Kong did become positive at 381,376 square feet (sq ft) by year end, but this represents only about one-third of the total territory-wide absorption in 2011. What the market awaits is the next series of Chinese IPOs, which will require mainland-based companies to set up Hong Kong premises. Alva To, managing director of the

Hong Kong office of advisor DTZ, adds: “A major reason was the substantial drop in take-up in Central/Admiralty. Although the district remained the first choice for companies and trades that are location sensitive, the main occupiers—the financial sector—have been hit hard by the uncertain global economy. Many of these companies had to downsize, freeze their budgets for expansion or cut operating costs by relocating to non-core areas.” The overall vacancy rate of the Hong Kong office market fluctuated in the year, reaching a high of 5.0% in Q4, up by 0.9% from a year earlier, reflecting softened demand for business space, with Central/Admiralty the district with the highest vacancy rate at 6.5% to 6.7% throughout 2012. Office leasing was more active in other districts, with availability falling mostly in Island East (210,456 sq ft for 2012) and Kowloon East (458,006 sq ft). Notably, the yearly take-up in Kowloon East was 130% higher than in 2011. Despite a mild fluctuation in Wanchai and Causeway Bay’s monthly net effective rentals of around $45 to $47 per sq ft, and a mild increase in the rent per square foot in Kowloon East’s AAA grade buildings from $35 last year to $36 in 2012, rents in Sheung Wan, Island East and Tsimshatsui barely changed. Mark Price, DTZ’s head of business space, North Asia, reflects:“Hong Kong is subject to the same turbulence as

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

HONG KONG TRIES TO COOL OVERHEATING MARKET

Hong Kong is caught up in a conflicted real estate market, with regulatory bodies continuing to advocate possible further measures to cool an over-heated residential market that is threatening to spiral out of control. At the same time prime retail real estate remains the priciest in the world, threatening to deter further retail expansion, while many office occupants and investors are moving from the Island’s previously core areas for lower cost parts of Hong Kong in the aftermath of the banking crisis. Mark Faithfull asks whether the picture will clarify in 2013.

everywhere else and big voids were created when the financial sector moved back house operations to cheaper locations and downsized, but much of that capacity has now been absorbed. The financial sector, legal services and accountancies remain in the area and we expect to see strong demand for 3,000-5,000 sq ft offices as IPOs start up again, with new companies listed on the Hong Kong Stock Exchange.” The greater take-up seen in non-core areas like Island East and Kowloon East was testimonial to a keen demand for cheaper and larger floor plates, as the profile of Hong Kong occupiers continues to evolve. While the financial sector experienced more downsizing, many other trades were less affected by the global economic turmoil and continued to carry out expansion or relocation plans. The supply of office space in Hong Kong in 2012 amounted to 1.34m sq ft, less than half of the total supply in 2011. Most of the supply this year fell in Kowloon East and only a small parcel was located in Central/Admiralty. Office supply is likely to remain tight in 2013, at a forecast volume of 1.87m sq ft, and the forecast supply for 2014 will be small again at around 1.23m sq ft in what are some of the tightest office supply years for Hong Kong. This will not be relieved until 2015, when the forecast supply reaches close to 5m sq ft. By that time, the Kowloon East office area will extend to San Po Kong, and there will be new office locations like Shatin and Hung Hom which will provide more options for occupiers. By contrast, Hong Kong has retained its mantle as the world’s most expensive global retail market as wealthy Chinese tourists, luxury retail expansion and a shortage of prime space drive rents to record highs. Prime rents held steady during the fourth quarter of 2012 at $4,335 per sq ft per annum, according to advisor CBRE, to defy a second half deceleration in retail sales. Demand in Hong Kong has remained relatively muted as many retailers have grown less aggressive with their expan-

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REAL ESTATE

Future completion by district 9,000,000 8,000,000 7,000,000 6,000,000

GFA (sq ft)

HONG KONG TRIES TO COOL OVERHEATING MARKET

sion or entry plans given the market’s lofty rent levels. Retailers throughout Hong Kong have generally become more selective in their requirements and off-prime or secondary units are attracting less interest. Joe Lin, senior director retail, Hong Kong, CBRE, admits: “Elevated prime retail rents in Hong Kong are not only caused by the influx of tourists and luxury brands, but also the serious lack of prime retail space in core retail districts. There are very few new malls in the pipeline and so international brands are competing for limited shop space. With relatively promising economic expectations for 2013, luxury brands will continue to see Hong Kong as a profitable opportunity; however, when the rents become prohibitive, retailers act carefully.” After a concerning late year slowdown in visitors, the outcome of the sales performance from Christmas and last month’s Chinese New Year seasons will be eagerly awaited and give more clues to the likely pattern of visitor spending power and to the rental prospects of retail properties. On the supply front, as leasing contracts expire, retailers will have more choice of business locations. Given the tight availability of retail properties in attractive areas, once leasing increases to a higher level following an improvement in market sentiment, rentals are likely to follow the trend and could prompt another significant rental rise. By the same token, this may encourage some retailers to look beyond traditional retail pitches for better value. The situation makes for complicated reading for investors, RICS Asia senior economist Andy Wu, believes capital will likely continue flowing into Asia in 2013, driven by the region’s stronger growth prospects, global excess liquidity and risk appetite.“This should lead to a further pick up in real estate demand in key Asian markets like Hong Kong, from occupiers and investors,” he says. “Specifically, the expected economic recovery and increasing levels of business and con-

5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0

2007

2008

Central/Admiralty Kowloon West

2009

2010

Wanchai/CWB Tsimshatsui

2011

2012

Island East Hunghom

2013

2014

2015

Island South Shatin

2016

2017+

Kowloon East Kwai Chung Source: DTZ Research

sumer confidence in the region will likely result in higher-than-expected investment activity this year.” Price agrees and notes that European money continues to search for the limited opportunities available in Hong Kong, especially retail.“The retail sector is completely linked to the spending power of Mainland Chinese,” he cautions. “If there was a significant drop in that [level of spending] rental values would plummet.” What does seem clear for Hong Kong, however, is that this thriving economic hub is going through a fundamental re-profiling as major office occupiers seek cheaper accommodation in what were previously outer-lying areas and major retail tenants determine whether Hong Kong stores remain worth paying top dollar for. And all the while, a residential bubble floats above it all.

Residential costs concern A ballooning local property market has seen home prices double in four years, with the typical flat now costing 13.5 years of median household income. Norman Chan, the head of the Hong Kong Monetary Authority was recently moved to complain that household debt was close to a record high relative to the city’s gross domestic product, and warned that “the overheating property market” is the biggest single threat to Hong Kong’s economy.

His remarks were interpreted as a heavy hint that the HKMA might impose even tighter restrictions on mortgage borrowers in an attempt to reduce the risk. The first round of mortgage restrictions were introduced in October 2009 and followed in August and November 2010, with the most recent in June 2011. The concern in Hong Kong is that any rise in interest rates could throw many households into negative equity, although legislative moves should provide a significant buffer to this. Since August 2010, banks are supposed to have conducted stress tests to ensure that even with a two percentage point rise in mortgage rates—almost a doubling from current levels—debt service costs will take up no more than 60% of their customers' monthly income. Currently, the average loan-to-value ratio among new borrowers is just 55%, with the maximum loan to value fixed at 70%. In addition, non-permanent residents are subject to 15% stamp duty, although Hong Kong’s low interest rate environment, a robust local economy and the under-supply of premium residential property means prices are unlikely to dip, according to agent Savills. “While the recent Policy Address promised more supply-side measures, in the near term price pressures remain,” says Simon Smith of Savills Research. n

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

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16-18 April 2013 - London Excel

Over 500 Buy Side Attendees - Will you be there to meet them? 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GM Regional Review 69_. 18/03/2013 13:01 Page 32

TRADING POST

HOW COMPETITION IS FIRING UP

In the bilateral OTC trading environment prevalent today, would a trader concern herself with margin costs when pricing the trade? It is unlikely. Assuming a trade is subject to an ISDA CSA with simple margining on the net mark-to-market, is it even possible to determine a margin cost, given that traders always hope to make profit rather than loss? It’s doubtful. Given Dodd Frank and EMIR, the OTC market is moving either by regulation or voluntarily towards a mainly cleared market, with bilateral trades being the exception, and in this case the price of a trade and it’s routing via intermediaries to a choice of clearing houses will become critical to success. Independent consultant Bill Hodgson, The OTC Space, gives the world view.

Decision support in a cleared world OMPETITION BETWEEN CLEARING houses is giving investors choice of venue, and competition between trading venues is providing new choices on how to take or lay off risk, through futures style products, equivalent to those in the OTC bilateral market. The Chicago Mercantile Exchange (CME) and Eris now offer Interest Rate Swap (IRS) futures, which at maturity exercise into an OTC interest rate swap cleared within CME. The same underlying IRS trade can be executed bilaterally, sent to clearing at CME, and provide the same risk profile, yet receive a different regulatory treatment. The initial margin for the IRS future traded at CME exchange will require Initial Margin (IM) calculated using a one day holding period, whereas the same swap traded OTC and cleared also at CME will require margin with a five day holding period. A debate is raging between regulators and market participants on whether this difference is reasonable and fair, and relies somewhat on your beliefs on how a default should be handled and liquidity in the market under those circumstances. Given this difference, if you can provide the same risk exposure to an investor but via a route with lower margin, surely you would always choose the

IRS future? Unfortunately the IRS futures don’t exhibit the flexibility of a true OTC IRS, they deliver only on the IM months, rather than any business day to suit hedging needs or to offset back-to-back with another asset. Within the buy-side OTC market, each cleared trade must reach a clearing house via an intermediary such as an futures commission merchant (FCM) or Clearing Broker. This indirection brings cost saving opportunities for the informed and prepared, by examining carefully the effect of each trade on regulatory capital, economic capital, margin and CVA. Imagine a trader with perfect systems which can calculate the indirect costs of a trade over and above the raw market price. First step would be to consider which CCPs and which intermediaries could accept the trade, based on product eligibility and membership. For these routes, each will have an existing portfolio of trades and credit limits which apply to the portfolio. The CFTC insists that FCMs must prescreen trades prior to execution to prevent fat finger errors and avoid trades failing to clear. In this case the limit between an investor and their FCM is vital to measure and manage; otherwise the cost of tearing up a failed trade will be a penalty to avoid.

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

FCMs are likely to offer limits based on net or gross notional, PV01or full initial margin calculation, and in the case of CME, can delegate the calculation to CME itself who will speed up the acceptance process for the FCM. Pre-calculating the effect of each trade against these limits is one step in selecting which FCM to utilise. Each trade cleared via an intermediary has the benefit of clearing but it still regarded as a bilateral exposure, and therefore subject to capital and CVA calculations. Given a choice of two FCMs or Clearing Brokers, the effect of each additional trade needs to be calculated in combination with the existing portfolio giving more insight into the relative cost of each route. Finally of course the initial margin has its own effect. Each CCP has its own IM model, in many cases based on Value at Risk (VaR) but with a variety of optimisations and in some cases allowing offsets with futures products. Most CCPs offer software which will replicate their IM calculation, which a trading firm would need to access or replicate to enable them to model the effect of new trades. Given this complex pattern of routing and costs, when quoting a price or making a routing decision, firms are going to need some sort of calculation engine or scenario optimiser to enable them to quote a realistic fully loaded price, or else find themselves losing money through the effects of capital, CVA and margin. The CFTC is due to publish its swap execution facility (SEF) rules which may mandate price quotes to be fully loaded, if market makers aren’t already thinking about how to make the best decisions in a complex post-execution environment, now is the time to start.n

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THE BEAR VIEW

FTSE100 STRENGTHENS AS STERLING WEAKENS

The Great British pound has seen quite some weakness in recent months and if it wasn’t for the latest comments from the soon to retire governor of the Bank of England, it could conceivably be even weaker. By the time this column is published there’s every chance that the “cable” exchange rate (the nickname for sterling against the US dollar [GBP/USD]) could be back below the 1.5000 level. Our new Bear View columnist, Angus Campbell, head of market analysis at Capital Spreads, outlines the downside.

Down with sterling HE BANK OF England has been back-tracking, claiming there is no talking down of sterling to give exporters a fighting chance of competing in a global economy that is still nowhere near full capacity. Currency manipulation—sorry, I mean a weaker currency—is a double edged sword. It not only makes goods cheaper to the outside world, it makes imports more expensive and considering that there isn’t all that much going out on the cargo ships that leave the UK but a great deal coming in on them i.e. exports are dwindling and imports are not, higher prices are here to stay. The best example of this is the price of crude which has fallen some 8% from its peak, however due to the weakness in sterling, prices at the pump simply have not declined in conjunction with the lower oil prices. Where sterling currently stands is probably just about right as it’s at an attractive level versus the euro, a currency that remains vital to the UK economy due to the eurozone being such a large trade partner and has retreated to around its more natural historical level against the dollar. However, the future for sterling isn’t all that bright. The country’s economic prospects remain sketchy at best and before the handover this summer to incoming governor Mark Carney, we may yet see another round of quantitative easing. This is likely to make any recovery in sterling short-lived and continued

talk of a zero interest rate policy will also dampen investor sentiment towards the pound. If that wasn’t enough, the incoming Governor has been making it perfectly clear that he favours more action in the form of unconventional monetary easing which will keep the pressure on our currency. Many might claim that all this is baked into sterling’s cake considering the currency has declined 6% against the euro and 7% against the US dollar in 2013 alone. But you’ve only got to look at the US dollar which depreciated over 15% on two occasions when the Federal Reserve undertook renewed quantitative easing programs. This means that whatever Carney does when he takes up his place at the Bank of England it is likely to be to the detriment of sterling’s value. The greatest fear for many is that we are on the cusp of a Japanese style lost decade. Stagnant growth, high unemployment (although the UK labour market has been remarkably resilient in the past couple of years), a down beat consumer, dire manufacturing and industrial production and a barely expanding services sector means that there are plenty of deflationary pressures as well, so all this talk of “stagflation” is nonsensical. Even so, the FTSE100 has had a cracking start to the year, up some 9%, meanwhile the FTSE 250 has also

Angus Campbell, head of market analysis at spread betting firm Capital Spreads. Photograph kindly supplied by Capital Spreads.

impressed with a return of 11% so far in the first quarter. It’s certainly a far cry from the kerfuffle over the US fiscal cliff that we saw towards the end of 2012 and investors remain happy to pile into equities while the waters remain calm. The FTSE 100’s impressive performance however is arguably underdone since so many of the constituents earn their revenues in US dollars with only around one fifth of sales of FTSE100 companies being generated from the UK. This means there’s a strong argument to suggest that the lower the pound goes, the higher the FTSE goes. There is one thing that the chances of increase as the markets go higher and that’s the probability of a sharp correction to the downside and increased volatility. The higher equities go the further they have to fall. As ever ladies and gentlemen, place your bets … n While Capital Spreads attempts to ensure that the information herein is accurate at the date the information was produced, however, Capital Spreads does not guarantee the accuracy, timeliness, completeness, performance or fitness for a particular purpose of any of the information provided herein and under no circumstances are they to be considered an offer, solicitation to invest or be construed as giving investment advice.

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GM Regional Review 69_. 18/03/2013 16:39 Page 35

REGULATION

When President Roosevelt set up the United States’ Securities & Exchange Commission (SEC) back in 1935, he appointed Joe Kennedy, the father of President John F Kennedy as its first chair. In response to raised eyebrows the urbane president sardonically commented that you set a thief to catch thieves. Mary Jo White is no thief, but after decades of prosecuting some of America’s high profile banks and corporations she’s well aware of how complex institutions can bury ugly bodies. Her appointment looks apposite in an increasingly thorough regulatory universe. President Barack Obama, moreover, looks to be signaling his intent for the SEC to step up, or at least maintain the blistering pace of oversight put in place by Mary L Schapiro. Ian Williams looks at the build up to White’s confirmation and assesses what she might bring to the office.

CAN MARY JO WHITE REVITALISE THE SEC? ARY JO WHITE, President Barack Obama’s pick to be chairman of the Securities and Exchange Commission, will likely face tough questions when she faces senators about her decade of legal work representing some of the nation’s largest banks and corporations. Even so, after the Senate Banking Committee hearing is over (scheduled for the third week in March), White is ultimately expected to win confirmation from the full Senate and become

the first former prosecutor to lead the top federal regulator overseeing Wall Street. White will take over from Elisse Walter, who has been interim SEC chairman since Mary Schapiro resigned in December. White, 65, will assume the mantle of the SEC at a critical juncture in the regulator’s evolution. Following years when the SEC looked to be seriously out of step with a runaway financial system that ultimately resulted in the loss of Bear

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MARY JO WHITE ON THE CUSP OF LEADING US REGULATOR

Photograph © Drizzd/Dreamstime.com, supplied March 2013.

Stearns and Lehman Brothers and plunged the world into half a decade of unmitigated recession, under Mary L Schapiro, the regulator looked finally to be getting its house in order. Nonetheless, Schapiro resigned before the final post-regulatory era really took shape and the appointment of White, a former prosecutor, looks to be a signal from a second term president that he expects the regulator to keep up pressure on the financial sector. They see the White House sending a “No more Mr Nice Guy” message to the financial community by appointing the indubitably tough lawyer and former District Attorney to the job; White is possibly a harbinger of a new era of criminal prosecutions. Certainly she carries an impressive array of credentials in her CV. Most recently, White led the litigation department at Debevoise & Plimpton, a prominent New York-based law firm. The firm’s clients include JPMorgan, General Electric, Microsoft and Toyota. Nitpicking senators might raise questions about possible conflicts of interest, though it is likely she will calmly shrug these off. The complexities of modern finance, and the inability of government to compete in salaries with the private sector do imply that it would be nearly impossible to get someone with the experience and acuity needed who had not been “tainted” by working the other side. White has reportedly promised in writing to step aside from any decision affecting a former client for one year after she represented them; a move in line with federal ethics guidelines for agency officials. In addition, she has also pledged to abstain from all decisions before the SEC brought by the law firm of Cravath, Swaine & Moore, where her husband, John White, is a corporate lawyer. John White has also committed not to directly engage with the SEC in its rulewriting, to sell his shares in several investment funds and to change his partnership in Cravath so that he

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REGULATION

MARY JO WHITE ON THE CUSP OF LEADING US REGULATOR

doesn’t share in the firm’s profits but receives fixed compensation. Tough and cool under pressure, White’s successes as a litigator over the last decade or so, highlights credentials; including the successful prosecution of high profile mafia crime boss John Gotti; high-profile convictions in the 1993 World Trade Center bombing and the 1998 terrorist attacks on two US embassies in Africa. White was also the first woman to serve as US attorney in Manhattan, where she specialised in white-collar crime from 1993 through 2002. The statute of limitations is rapidly catching up on whatever events led to the crisis, and the complete absence of any serious indictments resulting from the mortgage loan scandals and the resulting global financial scandal is still a public issue. The SEC’s preference has been for consent decrees with alleged corporate perpetrators in which companies “Neither admit nor deny” wrongdoing but pay settlements which, compared with their earnings and profitability, are more like a cost of doing business than serious penalties. The SEC has levied some $2bn in penalties and disbursements for firms’ bad behavior during the crisis, but no executives have stood in the dock as a result of its efforts. Indeed, last year an exasperated Federal Judge, Jed Rakoff, refused to authorise a consent decree between the SEC and Citigroup that would normally have been a rubber stamp job. Rakoff regarded the penalty as too light, not least when he scrutinised this and earlier consent decrees which included a standard pious promise not to sin again. Rakoff pointed out that they did, repeatedly, and that this was, in effect, contempt of court. His gesture did exact a promise from the SEC that it would try harder, but the Commission is almost on life support. House representatives with finance industry support have been trying to cut its appropriations, not least to try to strangle its ability to implement Dodds Frank.

Mary Joe White stands by as President Barack Obama announces in the State Dining Room of the White House in Washington, in this January 24th 2013 file photo, that he was nominating White to lead the Security and Exchange Commission (SEC). Mary Jo White, President Barack Obama's pick to be chairman of the Securities and Exchange Commission, was due to face questions mid month from senators about her decade of legal work representing some of the nation's largest banks and corporations. Photograph by Carolyn Kaster for Associated Press. Photograph supplied by PressAssociationImages, March 2013

Getting people directly involved in Wall Street to talk openly about May Jo White is not always easy. As one says (anonymously of course), “As a fund manager I have to be discrete in case I am ever under SEC scrutiny. I don’t want my name in an email crossing their desks!” But then, he added “The SEC is a hobbled entity, so I am not sure it matters who leads it. It has just been gutted as an agency, and its ability to do the job is compromised.” Another equally anonymous commentator says: “Without demeaning her, it is terribly difficult for someone who culturally and economically has been associated with an ethic that is utterly contrary to the SEC. Big firm law culture is, in the starkest terms, an enabler of bad conduct. It becomes part of your bloodstream to prove that clearly written laws and regulations do not mean what they say. Virtue is measured by the value of the billings, usually from large corporations.” Others more favourably disposed towards the SEC are less reticent. Peter Bible, chief risk officer of accounting firm EisnerAmper is one and he totally

approves of the nomination. Evoking FDR on Kennedy, he explains: “You need someone who speaks Wall Street language to operate properly, but she was a prosecutor so both those aspects will make her a good chair. It gives a balanced perspective from both sides. Sometimes there are probably people who were dragged in through no fault of their own, and others who really need prosecution.” Bible sees White’s government connections as important to her performance in office. “Obama is sending the message that there is a lot to do. There’s the rest of Dodds Frank to implement, and she fits [in with] that with the right presence and the right background to make it happen. He’s looking for a tough regulator and she fits that bill. The financial community is concerned about electronic trading being more closely regulated and she clearly has the right background and vernacular for that. The way Washington works, they will find a very high profile figure and prosecute to make a point. That will not change with her. She is neither light nor hard on white collar crime but someone who has the appropriate skills.” There’s also a cost to taking on the mantle of the SEC, which will have resonance for White. Long time shareholder activist Robert Monks claims, “I had met almost all her predecessors, back to Joe Kennedy,” and cites one who had been a director of four companies who complained, “When I finished I expected invitations to join more boards, but instead, not only did I get no invitations from new companies, none of my former companies invited me back to be a board member!” He parses, “When you get even the faintest unclubbable behaviour you don’t get invited back into the belly of the beast; and for ten years May Joe White has been in the belly of the beast, the most prestigious firms with the highest paying clientele.” Monks also cuts Obama some slack. “The SEC desperately needs a hand. It is a tragic remnant of what was

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a good idea in 1935. If it is going to restore respect it needs a special kind of leadership.” Arthur Levitt meanwhile is unequivocal in identifying White as an exception. “I can’t think of a better choice, she is smart, tough, knows the agency and really most importantly, she has run an organisation similar in some respects to the SEC; an enforcement agency so that is important. She has sat on both sides of the table.” As her predecessor as SEC Chair from1993 to 2001 Levitt, now with the Carlyle Group and tech investment startup Motif, was the longest serving chair in the office, renowned for sup-

porting ordinary investors. He adds “The most frequent mistake by a chair of the SEC is leaning too much to one side or the other. So they swing too much for the prosecutorial side in their approach and neglect the rights of the individual, or they’re captives of the industry that they came from and a vigorous enforcement program is not part of their portfolio. Mary Jo White has served on both sides and has a Rolodex that very few in America can equal. She has the durability to stand before Congress, and the leadership skills to mobilise the brightest in the agency.” He admits the cautions about the revolving door,“And I am sympathetic.

But my own career came after a 20 year history in the industry and running a stock exchange, I could easily have been savaged for that background but it is too facile to attack people for their previous job. The commission imposes its own standards, based largely on its traditions and its culture. Good or bad markets can make chairs look smarter or dumber than they are and the stature of a given chair is measured not by the rules they enact but by his or her ability to lay out basic principles in speeches and policy documents. It is very difficult to predict how a chair will perform, but Mary Joe White meets the bill in all these criteria.” n

IMF WANTS EU TO REPAIR AND REFORM THE FINANCIAL SECTOR

N ITS FIRST ever European Union-wide assessment of the soundness and stability of the financial sector, the International Monetary Fund (MF) has said Europe needs to step up regional efforts to manage financial crises and risks. “Restoring financial stability in the European Union has not been easy, and the priority is now to establish single frameworks for crisis management, deposit insurance, supervision and resolution, with a common fiscal backstop for the banking system, especially for the monetary union,” says Charles Enoch, deputy director in the IMF’s Monetary and Capital Markets Department and head of the mission that conducted the assessment. The IMF’s assessment of the EU draws on its analysis and findings in individual European country reports and visits to financial oversight institutions in November and December last year. The agency outlines three important financial risks facing the EU: declining growth leading to the deterioration of bank and government balance sheets; dislocations in the EU’s wholesale funding markets leading to adverse liquidity conditions and, finally, a further drop in asset prices. The IMF says policymakers and banks have made good headway to fix recent financial problems in the European Union. However, the region remains vulnerable, and policymakers and banks need to intensify their efforts across a wide range of areas. One, banks need to build strong capital buffers, says the agency. Greater disclosure requirements, especially of impaired assets, would buttress credibility in the improvement in banks’ health. National authorities and the prospective Single

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

Supervisory Mechanism (SSM) should undertake selective asset quality reviews, coordinated at EU level. This would add credibility to the stress tests envisaged by the SSM and the European Banking Authority (EBA). The IMF holds that establishing an effective banking union will anchor financial stability and ongoing crisis management. Allowing the European Stability Mechanism (ESM) to directly recapitalise banks could help break the adverse link between government finances and banks. It will be critical for the SSM to deliver supervision of the highest quality from the outset, adds the agency. Ultimately, its effectiveness will depend on strong governance and common safety nets in the form of a single resolution authority and deposit guarantee scheme. The agency is also looking for a stronger European financial oversight framework. Prompt passage and implementation of capital requirements and resolution directives and regulations, as well as strong coordination across the various oversight institutions are important to achieve policy consistency, including with national policies. Standards adopted through these directives should be well above internationally agreed minima, adds the IMF. The IMF assessment also found that the present weak economic outlook provides a challenge to the life insurance and pensions industries, parts of which have also been affected by exposures to weak banks and sovereigns. Careful attention will be needed by the supervisory authorities, particularly as the European Commission’s insurance supervision proposals are implemented, says the agency.

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US DARK POOLS

Photograph © Kimhoe/Dreamstime.com, supplied March 2013.

In an ideal world, no trader would ever betray a directional bias by crossing the bid-offer spread. Better to sit on the bid—or lurk in dark pools, where execution is often at the midpoint between bid and offer, revealing nothing. Time is of the essence, though, and delay increases the opportunity cost if the price moves against the trader. Little wonder that as market volatility has tumbled in recent months dark pools have grabbed a bigger share of volume in US equities. By Neil A O'Hara.

THE DARK SIDE BECKONS IN CALM MARKETS STRONG INVERSE CORRELATION between volatility and dark pool market share has been evident ever since Justin Schack, head of the market structure group at Rosenblatt Securities, began tracking these venues about five years ago. The anonymity traders crave in a dark pool comes at a cost: they give up any visibility into what is happening on the opposite side of the order book and have no idea when—or even whether— orders will be filled. Dark pools work best for passive orders where traders are prepared to wait to find a match. “It is easier and less risky to do that when volatility is low,” says Schack. “When volatility spikes, institutional investors have greater urgency to complete their trades. Funds may have to meet redemptions and portfolio managers may want to lock in gains or avoid losses.” Technology plays a part, too. Traders believe dark pools are neither as robust nor as reliable as the traditional exchanges and other lit venues. In fast markets, transaction and messaging volumes soar, response times slow, and, if the traffic exceeds system design capacity, the entire trading platform can crash. Schack says traders worried about the

opportunity cost of delay on urgent orders will redirect flow to the exchanges, where they have greater confidence in receiving a timely fill. The recent increase in dark pool market share—to 14.33% of US equity volume in January 2013—does not tell the whole story, however. Every dark pool is different and market shares shift over time, both among and within the four major categories: consortium-sponsored, market maker, independent/agency and bulge bracket. The big broker crossing networks account for more than half the volume in dark pools, but the platforms run by Deutsche Bank (Super X), UBS (UBS ATS) and Barclays (LX) have picked up market share relative to the long time leaders, Credit Suisse (Crossfinder) and Goldman Sachs (Sigma X). Indeed, LX volume eclipsed Sigma X in January for the first time, vaulting Barclays into second place. LX owes its ascent in part to liquidity profiling, which rates the order posting and execution behaviour of participants in the pool, groups them and lets users select which groups they want to trade with. The approach is more nuanced than selection based on labels; after all, some high frequency trading flow is benign while some institutional flow can be

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Justin Schack, head of the market structure group at Rosenblatt Securities. Schack began tracking these venues about five years ago. The anonymity traders crave in a dark pool comes at a cost: they give up any visibility into what is happening on the opposite side of the order book and have no idea when—or even whether—orders will be filled. Photograph kindly supplied by Rosenblatt Securities, March 2013.

Tara Muller, a managing director in the electronic trading group at Knight. "Clients access Knight Link and Knight Match, which are distinctive sources of liquidity, in particular for executions in small and mid-cap names," says Muller. "We work with clients to develop ways to minimize information leakage and make their routing more efficient." Photograph kindly supplied by Knight, March 2013.

toxic. “The focus on behavior makes more sense,” says Schack.“It is what you do, not who you are, that matters. It is an innovation in the space.” Behaviour may also lie behind changing attitudes toward both high frequency trading and dark pools among buy side traders. A recent survey by TABB Group, a New York and London based financial markets research and consulting firm, found that 31% favour more controls, while 9% believe the need depends on the type of high frequency trading flow. The same survey revealed growing caution about dark pools, too. A year ago, some traders said they would be happy to do all their trading in the dark, but now the number who find dark pools don’t always work for their strategy is on the rise. “They are more cautious regarding the venues,”says Rebecca Healey, a senior analyst at TABB Group.“Not all dark pools are viewed favourably. We don’t see a stampede toward the dark, but for passive flow in the current environment it remains beneficial.” With 19 dark trading venues in the United States to choose from, differentiation is one key to success. For example, Knight Capital, which runs two dark pools alongside its market making activities on lit venues, specialises in the interaction between retail broker dealer order flow and professional investors. Knight Link, the larger pool, accepts only immediate or cancel orders, which Knight fills as a market maker whenever it can lay the order off against retail flow and pocket the spread. Like other “ping” destinations, where the counterparty is always the market maker running the pool, Knight Link relies on algorithmic flow from smart order routers. Certain large clients also see indications of interest (IOI) posted by

Knight Link, which in this case are relatively benign. In most dark pools, IOIs reflect customer orders and are sent to multiple destinations in search of liquidity, which can give away vital information even when no fill takes place. On Knight Link, the other side of the trade is always Knight, but the firm is a proxy for retail flow that conveys no useful information to IOI recipients except the opportunity for a quick fill. The companion pool, Knight Match, accepts resting liquidity as well as flow orders, including orders Knight cannot match on Knight Link. To curb the advantage high frequency traders might otherwise enjoy due to speed alone, Knight Match forgoes conventional price-time priority in favour of price-equal split: everyone who has an order at a particular price gets an equal share of the fill regardless of order size. Passive orders offer scope for price improvement over the national best bid and offer, but, unlike Knight Link, participants must pay a small fee on each fill.“Clients access Knight Link and Knight Match, which are distinctive sources of liquidity, in particular for executions in small and mid-cap names,” says Tara Muller, a managing director in the electronic trading group at Knight. “We work with clients to develop ways to minimize information leakage and make their routing more efficient.” However attractive retail order flow is, Knight’s pools are not usually the first port of call for institutional orders. A bulge bracket broker has a compelling interest in minimizing execution costs to capture as much of every commission dollar as possible. It will typically tap its own dark pool first—designed to match up internal order flow—then move on to lit venues like NASDAQ BX, BATS BYX or EDGA that

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US DARK POOLS

Rebecca Healey, a senior analyst at TABB Group. “Not all dark pools are viewed favourably. We don’t see a stampede toward the dark, but for passive flow in the current environment it remains beneficial,” says Healey. Photograph kindly supplied by TABB Group, March 2013.

Kevin Cronin, director of global trading at Invesco, a $712bn money manager based in Atlanta, Georgia. “With large orders to buy and sell we face greater risk of information leakage and market impact from the sheer size of our trades,” says Cronin. Photograph kindly supplied by Invesco, March 2013.

offer rebates to liquidity takers. Next come the free “ping” dark pools like Knight Link and Getmatched (Getco), then dark pools that charge a fee, including agency venues (Convergex, Instinet) or competing broker venues, and only as a last resort will the order wind up on a lit venue where execution costs are highest. Managers that rely on the sell side for execution may not care if the routing is driven by the broker’s best interest rather than their own if the final result is acceptable. Sébastien Jaouen, head of global sales at Orange Business Services—Trading Solutions, says a significant portion of the buy side still works this way.“The broker may cross the order internally or send it to an external market,” he says. “The customer will look at the final quality of execution and the costs, including clearing and settlement.” The tools available to monitor execution are sophisticated enough today to keep brokers in check, at least in theory. A buy side desk executing its own orders has a different perspective, not least because it has access to block crossing networks that either excludes the sell side altogether or limits its participation. The average trade size on these venues is much larger—more than 41,000 shares on Liquidnet and 3,200 on ITG POSIT versus less than 200 on the leading bulge bracket pools—making them an obvious starting point for institutional orders. After that, the trading strategy may or may not include dark pools depending on the urgency and purpose of the trade.“We trade in the dark primarily to minimize the impact of our transactions,” says Kevin Cronin, director of global

trading at Invesco, a $712bn money manager based in Atlanta, Georgia.“With large orders to buy and sell we face greater risk of information leakage and market impact from the sheer size of our trades.” Traders always have to balance the desire to obscure their intent against the need to complete an order. For a value manager buying well ahead of an anticipated inflection point, a trader has time to accumulate a position passively in dark pools over days or weeks. If another manager is trying to capitalise on an imminent earnings announcement, the best bet may be a quick sweep through the block venues and then straight to the lit markets.“We may be less concerned about market impact and more about finding liquidity,” says Cronin. “Sometimes to find liquidity you do have to move the price.” Invesco’s traders try to devise an execution strategy appropriate for each particular trade taking into account the urgency, the expected return and the wide range of tools at their disposal. Cronin says general market volatility does not enter into the decision, but while a causal relationship between volatility and dark pool market share may not exist the correlation is clear. It should be no surprise that as the VIX index drifted to multi-year lows in recent months traders have heeded the call of the dark. Traders live in fear of information leakage, the risk that other market participants will figure out what they are doing and move the market against them. They inhabit a cloak and dagger world in which every partial fill threatens to expose the order size they take great care to hide. n

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TRADING

Photograph © Robertds/Dreamstime.com, supplied March 2013.

Algorithms have come a long way since the early days when traders used simple volume weighted average price (VWAP) routines to facilitate execution in large cap stocks. Technology has helped, of course; computers can now process so much data in near real time that programmers can incorporate feedback from the market to alter the way algorithms execute or route orders on the fly. Attitudes toward algorithms have evolved, too. Any lingering reservations—not uncommon among old-school traders—about how algorithms might perform during market dislocations were put to rest during the 2008/09 financial crisis. Today’s trading tools are smarter and more flexible than ever—and so are the users. Neil A O’Hara reports.

ALGO TRADING: A MOVEABLE FEAST HE PROPORTION OF trades now executed by algorithms is a movable feast depending on who is asked. A buy side desk may say it uses algorithms for 30% of its trading, counting only the orders it handles using direct market access or other electronic broker pipes. The other 70% of orders are called in to brokers, where the sell side trading desk will likely enter the flow into algorithms for execution. “Most US equity trading now uses some sort of algorithm,” says Scott Daspin, a managing director in the global execution group at ConvergEx. “The average block size continues to fall and appropriate execution requires a trading tool.” Growing confidence in algorithms has encouraged buy side traders to exploit more complex routines. While some players still rely primarily on VWAP—quantitative shops doing mass optimisations of market neutral trades, for example—this long-time favourite has given way to implementation shortfall routines designed to minimize market impact. Traders specify the degree of urgency and the algorithm tries to optimise execution within that time frame.

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Based on measures of liquidity in the name and where the liquidity is concentrated, the algorithm will select the best routing among venues and decide whether and when to cross the spread to obtain a fill. “Clients are moving toward implementation shortfall as their primary benchmark,” says Daspin. Average investment holding periods have come down in recent years, which has reinforced the focus on implementation shortfall. The shorter the time horizon, the more market impact costs affect the expected return on the trade. If a portfolio manager expects a 5%-10% uptick in price from a positive earnings announcement next week, the difference between 50 basis points (bps) and 150bps in market impact matters more than for a stock expected to rise 30% over two years. For sensitive trades that are not urgent, traders may prefer a dark aggregator algorithm designed to tap liquidity only in dark pools where the footprint of a large order is harder to detect. Some dark pools are darker than others, and some admit participants whose activities may be toxic to large

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orders so traders can exclude certain venues or order types on a particular venue. Jeffrey Bacidore, head of algorithmic trading at ITG, has seen attitudes toward dark aggregators evolve, too. At first, traders would designate where they were and were not willing to trade, but now they take a more nuanced approach. “Shutting a dark pool out completely means there is absolutely no liquidity in there a trader ever wants to participate in,” he says.“That can’t be true.” ITG and other providers have built more sophisticated algorithms that expose bigger size in clean pools but still show some interest, albeit with stronger safeguards against gaming, in more suspect pools. The buy side does not have the resources to monitor every venue in detail, which has led firms to lean on brokers to deliver an acceptable end result. “Brokers have to justify their decisions and provide good performance,”says Bacidore.“Clients find it hard to stay on top of the landscape. They have outsourced that to brokers and hold us accountable.” The buy side learned long ago that while brokers always claim to put clients’ interests first a broker’s own interests will take priority if the client suffers no harm, at least in theory. In the spirit of “trust, but verify” the buy side is demanding more transparency about how algorithms route orders and where they are filled. Convergex has just opened its kimono through a Web portal on which clients who enter a ticker symbol and size can see a forecast of the expected market impact, how long it will take to complete the order, where the trade will route and where fills are expected. When clients enter a live order, they can see in real time where the order goes and the fills come from. “When we demo this technology to people we don’t know, they fall off their chairs,” says Daspin. “We can practically see them reaching for the phone to ask their existing brokers how orders are routed.” The degree of transparency ConvergEx offers allows buy side traders to tweak their execution strategy based on hard data about which venues give the best fills in a name. Sometimes it requires just a change in the parameters entered into the algorithm, but Convergex will customise the algorithm if need be. “The beauty of transparency is that people can make the algorithm exactly what they want, which is not the same thing for everyone,”says Gary Ardell, head of financial engineering and advanced trading solutions at ConvergEx.“Transparency helps clients get the right tool for the right job.” The heightened transparency may tax the capacity of some buy side shops to make good use of it, however. Paul Daley, head of product development at SunGard’s Fox River Execution Solutions, says many clients struggle with the sheer volume of data generated in the full routing disclosure his firm provides and prefer to rely on monthly summaries instead. The snag? The summaries only includes trades done through Fox River, so users cannot compare the results with trades done through other brokers who do not offer similar transparency. Clients who use the complete data dump can see where orders went, whether they were ever routed from one venue

to another, how they were executed and whether they took or provided liquidity. “Over time, people are getting more into the logic of why a broker went to a particular venue, not just where it went,”says Daley.“People will use the tools and get their hands around the data.” He expects buy side trading desks to hire quantitative analysts with a grasp of trading who can use their programming skills to mine the data and suggest improvements in how the desk interacts with the market. The buy side trader’s role continues to evolve from the jumped-up order clerk of yore toward equal partnership in the investment process. Traders don’t have to watch the market all the time any more; they can focus on higher value-added tasks like picking the best execution strategy and leave implementation to the machines.“A human does not have to look at the screen, see the bid move up a penny and decide whether to cancel and resubmit the order,” says Bacidore at ITG. “The algorithm has already done that if it makes sense. The trader looks at the objective and works more closely with the portfolio manager behind the trade.” The nature of product development for algorithms has changed, too. Ten years ago, Bacidore says the main concern was to ensure the routines were robust and would not break down or go haywire. Today, those safeguards are a given and developers spend more time figuring out how to source liquidity as efficiently as possible. They also know other technology-savvy market participants like high frequency traders will try to reverse engineer or game their designs, a constant threat to buy side clients.“We have to have cutting edge technology,” says Bacidore.“We must be as smart and efficient as the best people in the market if we are to deliver good results to our clients.” While technical improvements in single name algorithms will continue, the bigger challenge is to perfect algorithms that can handle baskets of stocks. It’s a daunting task: not only must the algorithm process data on all the individual names but the trading in one name affects how other names are traded. In a market neutral (equal dollar amounts to buy and sell) basket of 1,000 names, for example, the algorithm must maintain balance so that buys and sells don’t run too far out of whack.“The algorithm takes into account portfolio level objectives and constraints,”says Bacidore.“It comes at a cost, though—they can’t be too dynamic.”If a block showed up in an illiquid name on an institutional dark pool, a human trader might grab it but the algorithm might not because a large fill would unbalance the basket. Another difficulty is the lack of industry consensus about how basket algorithms should work. The objective is clear: to minimize risk and maximize return on the trade—but opinions differ over what that means in practice. The uncertainty has hampered development efforts, according to Daley. Fox River could build an algorithm that made sense to its developers but if clients reject the logic it would be wasted effort.“We all agree what a VWAP algorithm is,”says Daley, “but we don’t necessarily agree what a basket algorithm is. There is a tremendous amount of unsatisfied demand in that space.” n

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ASSET MANAGEMENT Photograph © Soldeandalusia/ Dreamstime.com, supplied March 2013.

The range of investment options available to local and foreign institutional investors across central and Eastern Europe (CEE) is matched by the disparity in performance and development of individual markets. Writing in UniCredit’s CEE report for Q1 2013, the bank’s chief Eastern Europe, Middle East and Africa economist Gillian Edgeworth says the predominant theme across CEE last year was the influx of foreign liquidity via portfolio flows. Part of this inflow was structural in nature, reflecting a shift in asset allocation from developed to developing markets, but the remainder was cyclical as investors searched for yield in the face of record amounts of G7 central bank liquidity. Paul Golden reports. Paul Golden reports.

EASTERN EUROPEAN FUNDS FACE REALITY HE DANGER OF viewing central and eastern Europe (CEE) as a homogenous market was highlighted in the aftermath of the global financial crisis, when Poland emerged as the only country in the region whose economy expanded during 2009 while its Baltic neighbours experienced significant falls in GDP. Professor Krzysztof Rybinski of Warsaw’s Vistula University refers to the degree of fiscal easing, the scope of public investment and the degree of cross-border financial leverage available to individual countries to explain this disparity. However, with EU guidelines on public debt levels limiting the scope for fiscal stimulus and investment moving away from large scale construction projects, he warns that no part of region will be immune from the effects of economic turmoil in the European Union in 2013. Various funds are more than aware of the continuing impact of macro trends on the performance of local funds. Even so, the growing diversity of fund investment strategies is a clear indication of the deepening of the asset management industry across the sub-region. Schroders manages the ISF Emerging Europe fund, which is mainly invested in Russia, Poland and Turkey but also in Hungary, Slovakia and the Czech Republic. The fund has been in existence since 2000, is in the first quartile for its peer

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group and is one of the five largest funds in the region at around €500m. Lydia Malakis, the firm’s director for central and Eastern Europe says there are no local restrictions around investment in liquid securities. Many CEE asset managers still tend to focus on their local market, mainly because they can generate strong performance for their clients by staying purely domestic, particularly in the larger markets of Poland, Russia and Turkey. “They don’t see the need to look outside their own markets for capital growth because these markets are still growing and there is a pool of IPOs and corporate bond issuance yet to come to the market,” she explains. The sophistication of the CEE institutional investor base varies significantly. For example, Poland has a welldeveloped pension fund system, whereas Russia pension funds are virtually non-existent. Institutional investors generally identify investment opportunities in the region by doing their own research, analysing economic and company specific data and meeting with finance ministers, central bankers and prominent local businessmen to gain an understanding of local regulations and political dynamics, says Andrey Popel, director Greylock Capital Management. “CEE offers opportunities for index trackers, pension funds, insurance companies, corporate bonds managers and hedge

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funds. In the Russian bonds market, for instance, there is a wide selection of liquid investable assets in the sovereign, quasi-sovereign and corporate space, although in some jurisdictions—most notably Hungary, Serbia, Croatia, Georgia and even Ukraine—corporate bond supply is quite limited.” Despite these limitations, Popel says his firm continues to identify interesting distressed and high yielding opportunities in Kazakhstan, Hungary, Russia and Ukraine. These opportunities are often company or country specific eventdriven investments (a hedge fund investment strategy that seeks to exploit pricing inefficiencies that may occur before or after a specific corporate event) and have lower correlation with the broader market. Dainius Bloze, fund manager at Bank Finasta observes that some international investors choose to rely on publicly available company information and make investments from outside via bourses, while other are brought into the market by investment bankers.“Value investing and strategies that combine tenets of both growth investing and value investing (known as ‘growth at a reasonable price’ or GARP) are employed, but in general there is little discrepancy between strategies in this region compared to developed markets,”he observes. “CEE markets are smaller and less liquid than developed markets so strategies have to be adjusted and generally require more involvement from investment managers, since publicly available information is scarce and imperfect. Russia stands out as a market that is very much event driven and dependent on commodities.” While having local expertise is important, it is also possible to tap into investment opportunities through global asset managers. That is the view of Stefano Pregnolato, head of portfolio management EMEA at Pioneer Investments, whose equity and fixed income products are managed in London and Vienna while its emerging markets analysts leverage portfolio managers and analysts based in the region. “Foreign investors usually prefer internationally available funds when they invest in CEE, whereas investors from within the region tend to prefer local domiciled products,” he states. “Fixed income strategies are much more popular than equities, but that is not unique to this region. Different interest rate environments and risk levels in each country affect the structure of institutional investor mandates.” There are fewer specialised managers focusing on Russia or CEE than on other emerging markets such as China according to Albin Rosengren, partner East Capital, who describes a broad eastern European or in some cases a Russia fund as the most common ways of accessing the market. “There are around 100 funds that focus on Eastern Europe, very few of which are run by independent specialist asset managers and most of which are based outside the region. In addition there are perhaps 20-30 focusing purely on Russia. Many of these funds belong to banks and are run by smaller and often non-specialised teams.” There are a few investment houses in Russia and other parts of Eastern Europe, but most assets come from outside the region, he continues, “These assets come mainly from western Europe, although some US endowments have

Lydia Malakis, Schroders’ director for central and Eastern Europe. Malakis says there are no local restrictions around investment in liquid securities. Many CEE asset managers still tend to focus on their local market, mainly because they can generate strong performance for their clients by staying purely domestic, particularly in the larger markets of Poland, Russia and Turkey. Photograph kindly supplied by Schroders, March 2013.

Miroslav Kub˘enka, head of equity research at Generali PPF Asset Management. Kub˘enka says foreign investors account for roughly half of total equities turnover on each of the CE3 (Czech Republic, Poland, and Hungary) stock markets but that this includes institutional investors from other CE3 countries who view these three nations as almost a single ‘domestic’ market. “Over the last couple of years, the attractiveness of the CE3 equity market region has been decreasing for outside investors. These countries do not enjoy superior growth compared to Western Europe anymore.” Photograph kindly supplied by Generali PPF Asset Management, March 2013.

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invested and pension funds in Latin America and Middle East sovereign funds are increasingly looking at opportunities in central and Eastern Europe.” Rosengren points out that some institutional investors have opted for passive alternatives and that ETF exposure to the region has increased. He believes this can be explained at least in part by two years of ‘risk-on-risk-off’ where political decisions and macroeconomic events have almost been more important than the performance of individual companies. Rosengren reckons that most investors are not overly concerned about falling commodity prices but still want exposure to CEE that is not driven by commodities, which is why his firm launched a Russia domestic fund last year that excludes investments in commodities or companies reliant on exports. “Central and Eastern Europe is still mostly a general broad strategy equity play, but we are seeing the emergence of some plays on different parts of the economy (such as consumer funds) and there are also a few fixed income funds emerging. However, regionally specialised bond funds have not yet generated a large volume of transactions.” Rosengren suggests that very narrow country funds have struggled to raise assets compared to wider regional funds. “Turkey was a major theme in 2012 on the back of its credit rating upgrade and better than expected economic development. Growth this year is again looking strong and the market is not expensive.” Erste Asset Management managing director Paul Severin estimates foreign participation in the Polish bond market has risen above 40% compared to approximately 30% this time last year.“Assets managed by local investors (pension funds, insurance, investment funds) have also grown and local market participants have become much more sophisticated, although local fund managers usually cover only one country. There are also some large domestic players in the shape of real money accounts, banks and hedge funds.” In general, foreign investors are comparing different countries from a fundamental perspective, analysing structural and cyclical issues and trying to find under- and overvalued markets/securities, he explains. Severin refers to increased interest in local FX bonds (both sovereign and corporate) with the Russian local fixed income market being opened to foreign investors, but adds that private equity is still a very small part of the market. “Global emerging market funds dominated investments last year and emerging Europe accounts for 10-15% of these portfolios. ETF funds captured flow in 2012. Investors use a wide range of investment strategies, from relative country comparison to single name relative value trades, depending on the asset class and assets under management.” Miroslav Kubenka, ˘ Generali PPF Asset Management head of equity research says foreign investors account for roughly half of total equities turnover on each of the CE3 (Czech Republic, Poland, Hungary) stock markets but that this includes institutional investors from other CE3 countries who view these three nations as almost a single ‘domestic’ market. “Over the last couple of years, the attractiveness of

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Radomír Já˘c chief analyst at Generali PPF Asset Management. Já˘c says that in contrast, participation of foreign investors in the government bond market has risen over the last three years although they still account for less than 50% of outstanding bonds in the CE3 countries with the majority held by domestic banks and pension funds. For instance, “In Q4 2012 non-residents held just over 46% of all Hungarian government bonds, with domestic banks holding around 30% and pension funds the remainder. In Poland, foreign investors control between one third and half of government bonds, compared to 23% by domestic pension funds, 17% by banks and just over 10% by domestic insurance funds,” he says. Photograph kindly supplied by Generali PPF Asset Management, March 2013.

Paul Severin, managing director at Erste Asset Management. Severin estimates foreign participation in the Polish bond market has risen above 40% compared to approximately 30% this time last year. “Assets managed by local investors (pension funds, insurance, investment funds) have also grown and local market participants have become much more sophisticated, although local fund managers usually cover only one country. There are also some large domestic players in the shape of real money accounts, banks and hedge funds.” Photograph kindly supplied by Erste Asset Management, March 2013.

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the CE3 equity market region has been decreasing for outside investors. These countries do not enjoy superior growth compared to Western Europe anymore.” Generali PPF Asset Management considers low liquidity to be a major drag on foreign institutional investment, adds Kubenka. ˘ “The Prague stock market is a great example. Its equities turnover last year fell to the lowest level since 2003 and several international banks have already closed their equity trading departments in the city.” His colleague and chief analyst Radomír Já˘c says that in contrast, participation of foreign investors in the government bond market has risen over the last three years although they still account for less than 50% of outstanding bonds in the CE3 countries with the majority held by domestic banks and pension funds. “In Q4 2012 non-residents held just over 46% of all Hungarian government bonds, with domestic banks holding around 30% and pension funds the remainder. In Poland, foreign investors control between one third and half of government bonds, compared to 23% by domestic pension funds, 17% by banks and just over 10% by domestic insurance funds.” According to Kubenka ˘ it is relatively easy to identify investment opportunities in central and eastern Europe without going through local fund managers.“Foreign institutional investors can choose from a wide range of local brokers and banks, whose support includes research conducted by local analysts. Also, many international banks cover blue chip firms in the CE3 countries and are able to arrange calls with analysts, investor visits, etc.” He sees little variance in the investment strategies and objectives of institutional investors located outside CEE and those based within the region. The biggest difference between the two is that CE3 equities represent a significant part of the total equity exposure for domestic institutions. CEE sovereigns have taken advantage of the liquidity window created by low government bond yields in many developed economies to raise cheap funding to finance postcrisis budget deficits and improve maturity profiles. Ukraine, Hungary and Serbia in particular have significantly increased their reliance on international bond funding and have been able to postpone fiscal and structural adjustments. Malakis reckons there are about 60 emerging Europe equity funds and agrees that emerging market debt has received a lot of attention from fixed income funds in recent years.“One notable difference from the rest of Europe is that you have a lot of smaller companies that cannot raise finance through the capital markets, which encourages private equity structures.” Property structures are another non-listed option, although she acknowledges that real estate investment performance in CEE is a “mixed bag”. According to Malakis, local investors in Turkey have been favouring hedge fund-type absolute return strategies investing in local fixed income, equities and money markets. Closed ended, tax optimised strategies were well received in Poland last year, whereas in Russia there is much interest in FX-type strategies and commodities.

Albin Rosengren, partner East Capital. “There are around 100 funds that focus on Eastern Europe, very few of which are run by independent specialist asset managers and most of which are based outside the region. In addition there are perhaps 20-30 focusing purely on Russia. Many of these funds belong to banks and are run by smaller and often non-specialised teams,” he notes. Photograph kindly supplied by East Capital, March 2013.

Stefano Pregnolato, head of portfolio management EMEA at Pioneer Investments. While having local expertise is important, notes Pregnolato, it is also possible to tap into investment opportunities through global asset managers, whose equity and fixed income products are managed in London and Vienna while its emerging markets analysts leverage portfolio managers and analysts based in the region. Photograph kindly supplied by Pioneer Investments, March 2013.

“Local deposit rates are also a factor in terms of what you recommend to clients because they may need to hedge their currency risk,”she adds.“Many of our CEE clients are asking for hedged strategies back into their local currency.” It is clear that CEE is not a ‘one size fits all’ market when it comes to investor preferences. However, for all the regionspecific recommendations and warnings, Rosengren concludes that CEE allocation decisions are based on the same factors as for any other region—growth prospects, risk and valuations. n

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Are end-to-end collateral management solutions the answer for clients coping with the added stress and extra cost of current regulatory changes? With fragmentation and bifurcation still an issue, which strategies are most effective at mobilising collateral faster, and more efficiently? Dave Simons reports from Boston.

CUSTOMER CHOICE: CUSTOMISED OR COMMODITIES COLLATERAL MANAGEMENT SOLUTIONS? While those who only dabble in S CERTAIN DERIVATIVES derivatives may not have the same transactions are not suffionerous margin requirements, they ciently standardised for will still need a considerable stash clearing through an organised of cash in order to meet variationvenue, a continuation of bilateral margin demands. For these players, over the counter (OTC) trading a mechanism for raising liquidity seems inevitable. Meanwhile, the on a moment’s notice is paramount, ongoing proliferation of new says Baker. trading venues points to sustained All of these issues point to an market fragmentation in Europe, as increase in collateral optimisation, well as other regions. With a fullusing approaches that allow firms fledged recovery still apparently a to potentially reduce their collateral ways off, many on the buy-side obligations. This includes determinremain wary of higher costs assoing which CCPs have the most ciated with an increasingly sophis- Photograph © Kazeyanus/Dreamstime.com, supplied attractive cross-product netting ticated set of collateral-manage- March 2013. positions, and/or the lowest ment responsibilities. An extended period of bifurcation would appear to bode possible collateral requirements (for instance, the Chicago well for “enterprise-wide”collateral management platforms, Mercantile Exchange (CME) allows firms to margin cleared including those that cover the likes of derivatives, securities interest-rate swaps and then offset the risk using cleared lending and tri-party repos, offer services such as collateral futures products held with the exchange). Having a system agreements and collateral optimisation, while also spanning that is supple enough to support the vast majority of collateral-management strategies from one organisation to the numerous global jurisdictions. Having top-tier tools for corralling collateral is one thing; next is essential, says Baker. “As all of our collateral-management clients have varying however, with margin requirements becoming more restrictive by the minute, platform providers must also be agile needs, we try to create solutions that can be used for other enough to adapt to a market in a perpetual state of motion. clients with similar specifications,” says Baker. “It is a good Along with changes to bilateral or OTC swaps trading, example of how standardisation comes head-to-head with margin complexities tied to the mandatory clearing of customisation.” Across the pond, the European Securities and Markets derivatives remain principal stumbling blocks for many clients. “Not only are clearing exchange margin calls non- Authority (ESMA) has made it clear that collateral on disputable, margin eligibility rules have become more strict margins used for central clearing must be segregated at the as well,” says product manager Judson Baker, who covers CCP level, using either a designated securities settlement derivatives and collateral management for Northern Trust’s system (SSS) or a central securities depository (CSD). asset-servicing division. To some firms, the amount of the However, all of this extra leg work is being met with some initial margins can be a real burden—those with directional resistance from some buy-side professionals, notes Saheed strategies such as LDI managers are particularly vulnerable Awan, global head of collateral management and securities to larger margin pledges, at least compared to what they’ve finance services for Euroclear. “Firms are telling clearing been accustomed to in the past. “The good news is that brokers and CCPs: Look, we really want to avoid transit risk. most will be able to satisfy these obligations through the Therefore, if you want my collateral, you need to go to my likes of government-backed securities or even investment- custodian to get it. First of all, not all custodians carry the SSS or CSD designation, and second, it’s impractical for CCPs to grade corporate bonds,” says Baker.

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have accounts with all of the different custodians around the globe. This is why CCPs are looking to us to streamline the collateral management process.”

Collateral highways Such was the impetus behind Euroclear’s global “Collateral Highway,” launched in July of last year. Designed by Awan (who joined the Brussels-based ICSD in 2012 following three years as an independent consultant after a 15-year tenure at Clearstream), Euroclear’s Collateral Highway links member CCPs with clearing members and the buy-side’s agent banks for the purpose of transferring collateral for use as margin for central clearing, as well as bi-lateral clearing of OTC derivatives instruments and more.“In this way, we can directly address the bifurcation issue, without having to involve all of the different parties using numerous relationships and accounts,” says Awan. Current regulatory trends point to a more expensive trading environment for derivatives, says Awan.“In meeting after meeting, I keep reminding my colleagues and clients that, as infrastructure providers, we need to be very cognisant of how we respond to the buy side. At some point, these market participants are going to look at all of the different costs they have to bear down the line and if we aren’t careful, they will say, ‘enough—we’re withdrawing from the market altogether,’ and instead go to an alternative that mimics these kinds of contracts on the futures market. Obviously, the business will suffer greatly if that happens.” Therefore, it is crucial that the industry take the right steps to keep services and fees affordable in order to prevent such a mass-exodus of the buy-side from occurring. “Not that the service should become a loss-leader, mind you,” says Awan, “cutting our fees to a point where it is totally unfeasible from an economic standpoint is not what we want either.” Much of the problem, says Awan, stems from a lack of a single, industry-wide entity that can address all of the links in the chain, from the buy-side and custodian, all the way down to the broker-dealer and the CCP. “That’s the real issue, right there—nobody is taking a top-down view of the process in order to understand the actual cost impact on key market participants,” says Awan. “And because we are all operating at different points along the chain, we’re essentially missing the bigger picture—and that’s part of the risk of the process becoming exorbitant.” Economies of scale are only possible through increased participation, says Awan, which in turn will lead to higher levels of liquidity. If, however, the bar is set too high from a cost standpoint right from the start, then there will be no liquidity and no economies of scale. “Just because central clearing is going to become mandatory doesn’t mean that we can go out and charge whatever we want,” offers Awan. “I think we have a responsibility to end-investor clients to make this as attractive an environment as possible. If we don’t, it will likely come back to haunt us in the long run.”

Saheed Awan, global head of collateral management and securities finance services for Euroclear. “Firms are telling clearing brokers and CCPs: Look, we really want to avoid transit risk. Therefore, if you want my collateral, you need to go to my custodian to get it. First of all, not all custodians carry the SSS or CSD designation, and second, it’s impractical for CCPs to have accounts with all of the different custodians around the globe. This is why CCPs are looking to us to streamline the collateral management process,” says Awan. Photograph kindly supplied by Euroclear, March 2013.

Regulatory changes have created new challenges within the industry, asserts Jean-Robert Wilkin, head of collateral management and securities lending products at Clearstream, the European supplier of post-trading services. This is compelling providers to revisit existing arrangements as well as responsibilities around the post-trade processing of OTC derivatives and related collateral management. “Investors are now more willing to delegate their collateral-management responsibilities to their preferred custodian or collateral agents, covering both cleared and uncleared transactions,” says Wilkin. “The challenge for all of us, then, is to quickly define new standards, communications channels and collateralisation processes that can be re-used for all types of transactions, covering both the buy side and sell side, their respective collateral agents, down to the CCPs. As such, commoditisation is necessary to streamline post-trade operations and mitigate risk, while also reducing costs for all involved.”

Central clearing With many more asset classes moving toward central clearing, requirements for all clearing options must be centralised in order to achieve collateral optimisation, says Matt Gibbs, product manager for Paris-based solutions provider Linedata. “A sound collateral-management solution must include a comprehensive front-office and compliance component,” says Gibbs. “Fund managers and compliance officers need real-time collateral utilisation and counterparty exposure information at their fingertips.”

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As a single margin call can produce roughly five messages, another must-have is automated messaging, says Gibbs. “Having 100 percent STP needs to be the target. The question is: can a single system provider perform all of the necessary tasks? Will portfolio managers change their ordergeneration tools for less functionally-rich platforms in order to manage collateral? If not, firms may have to explore inhouse solutions, or opt for plug-ins instead.” Given the idiosyncrasies of collateral activity, clients need precise reporting mechanisms capable of delivering consistent, transparent data across multiple assets and multiple time zones. For collateral managers, having inventory management tools that are capable of handling multiple data feeds, as well as provide numerous ports to transmit data, will be essential for approaching any real-time data repository, says Mat Gagne, managing director, product development for Boston-based securities-lending agent eSecLending. “While technology providers in general can address access and egress points for data, as well as the database structure to support a real-time environment, the biggest challenge may be the communication from asset servicers and the ability to integrate multiple relationships, ranging from custodians to tri-parties, into a real-time environment,” says Gagne.“Perhaps more challenging will be the management of disparate settlement cycles and deadlines across counterparties, settlement systems, and clearing venues, as well as the ability to report on the status of collateral at any given time, including pending corporate actions, delayed/failed returns, and cost.”

Efficiency and customisation Expanding regulatory requirements around collateralisation is just one of many factors facing plan managers and asset owners, says Claire Johnson, head of marketing and product, CIBC Mellon. This is leading many participants to outsource their collateral-management needs to a third party resource such as an asset servicer.“By leveraging a specialised provider to deliver technology and operational execution, institutional investors can instead focus on their core investment activities,”says Johnson.“Scale can mean substantial efficiencies—for instance, many of the risk mitigation and governance structures that asset servicers use to support client securities-lending programs are also suitable for overseeing an outsourced collateral management solution.” In the end, service solutions should be able to provide both efficiencies as well as customisation opportunities, suggests Johnson. Again, this points to the ability to make substantial investments in technology, and, above all, have sufficient scale as a provider.“When you have a large client base, you are able to amortise the investment across tremendous scale,” says Johnson. “This allows you to deploy modular programs, as well as provide products and solutions that are right for each client’s business profile.” Regardless of whether a derivative is cleared or not, margin will still need to be posted, no matter what.“I think this is something that has been lost in the discussion,” says

Mat Gagne, managing director, product development for Boston-based securities-lending agent eSecLending. “For collateral managers, having inventory management tools that are capable of handling multiple data feeds, as well as provide numerous ports to transmit data, will be essential for approaching any real-time data repository,” says Gagne. Photograph kindly supplied by eSecLending, March 2013.

James Malgieri, head of service delivery and regional management for BNY Mellon’s Global Collateral Services business.“I have had clients who were under the impression that if it doesn’t go through a clearinghouse, they would not be required to put up margin. Unfortunately, that’s not true.” Unlike the vast majority of sell-side firms and alternative asset managers who have worked the derivatives circuit for years and may already have collateral solutions in place, insurance firms, pension funds and other traditional buy side participants need help working through these new requirements. This is where end-to-end collateral-management solutions can make their mark, says Malgieri. “Because the custodian is the one holding the asset, the question becomes: How does one help the client mobilise that pool of assets in the most efficient way possible? Using end-to-end solutions provides the client with a number of options, from collateral segregation and optimisation, to performing upgrade trades in order to achieve the ‘right’ kind of collateral, to record-keeping and other monitoring tools for verifying one’s collateral exposures at all times. These types of services are clearly lacking among many of the buy side organisations at present—which is why we see a real opportunity for firms like ours to come in and create efficiencies where they are needed,” expands Malgieri. He acknowledges that the increased cost of compliance must be shared among market participants.“The challenge for providers, then, is to create value-added tools that allow people to continue to participate in this space,”he says.“It’s been our view for some time that we are uniquely positioned to offer solutions for moving and maintaining clients’ collateral, purely due to our standing as a custodian—after all, the assets are right here.” n

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SECURITIES LENDING ROUNDTABLE

SECTION NAME

HOW THE BUY SIDE BENEFITS FROM THE INTERPLAY OF MARKET CHANGE & REGULATION

ROUNDTABLE PARTICIPANTS (from left to right) ROBERT CROSSEN, cash management officer, Illinois State Treasurer’s office DAVID CARRUTHERS, managing director, Markit Securities Finance PATRICK DOYLE, head of funding and liquidity, AVM Ltd DIANE SPURLIN, manager of investment operations, State of Louisiana Department of the Treasury PAUL WILSON, managing director, agency securities lending, investor services, JP Morgan CHRISTOPHER R JAYNES, co-chief executive officer, eSecLending JESSE PICUNKO, portfolio manager, Tennessee Consolidated Retirement System (not photographed) The roundtable took place at the IMN Securities Lending Conference in New Orleans, February 2012.

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market overview CHRISTOPHER R JAYNES, CO-CEO, ESECLENDING: There are several factors impacting the market today; one of them is regulation. Regulation is impacting both our clients and the demand side of the business. The repercussions on the overall industry have been greater than expected and its final impact is still not known since several of the major rules are still evolving. As clarity around specific elements of regulation come into play it has two effects: in the short term it creates uncertainty, which constrains demand. Then, once the impact of regulation is digested, or absorbed, this uncertainty fades and constraints on demand start to lift as a result. Right now we are still at that early stage and it will take more time for certainty to return. Until that happens we will see a continued lack of conviction among borrowers, hedge funds and other trading counterparts, with the attendant impact on demand. On the other side of the equation are the beneficial owners (the supply side). Their concern centres on how to best manage programs in this uncertain environment. The industry experienced significant pull back by different clients across the market in the immediate post-crisis period, whether by restricting program parameters or suspending them altogether. Many of those clients have since come back to the market; and while they remain cautious, many are now looking to reshape their programs. We had a lot of discussions with our contacts and clients about the evolving market in the latter part of 2012 and we are seeing the impact of new thinking around approaches to the business for clients to capitalise on opportunities presented by the changing market. Among the developments we’ve noted are that clients are looking to broaden collateral profiles or add new markets to their programs. We’re also seeing them evaluating new distribution channels, and utilising multiple providers to diversify risk and benefit from different approaches and routes to market. All in all, we see more change and a more forward-looking approach from the beneficial owner community. This is a significant turnaround compared to 2009/2010. It is much more positive recently. DAVID CARRUTHERS, MANAGING DIRECTOR, MARKIT SECURITIES FINANCE: It is increasingly clear that one of the main impacts on securities lending will be the move to towards OTC central counterparties, and (potentially) stock lending moving on to exchanges in due course. Moreover, as Chris notes, in terms of securities financing, the biggest single impact is regulation. In Europe for example, the financial transactions tax (FTT) will likely have a big impact on the dynamics of stock lending. That is because historically lending related to dividends in one form or another has been an important part of the business. Regulation has also had a significant impact on hedge funds: for instance, regulators have been asking for more transparency, oversight and declaration of short positions in the US and it potentially affects every trade that is transacted. In Europe there are thresholds for disclosures, and there’s public naming of funds that exceed those thresholds. In-

Christopher R Jaynes, co-chief executive officer, eSecLending.

evitably then this has had an effect on people’s willingness to transact—certainly from the point of view of stock lending—to support short selling. Two other dynamics are also in play. One, pension funds have increasingly allocated funds into alternative strategies in recent years, which has been good for stock loan demand. Two, is the so-called collateral shortage. There's an enormous range of estimates as to how big this could be. I've heard everything from $500m up to as much as $15trn, and if that latter number really is the case, it will have a devastating effect on the OTC derivative markets. Massive change in the collateral space is clearly underway, which probably just means opportunity for lenders, especially in segments such as corporate bonds, and government fixed income. It will be a significant business driver. In insurance companies, asset management firms and banks, the collateral teams, stock lending teams, and repo teams are all being moved closer together, even joined up. It is also becoming more of a front office function. Again, that's probably going to be good news for those who are ultimately supplying stock. Securities lending is often seen only as a support for short selling. I think that is the wrong way to look at the business. I would argue strongly, that stock lending and repo, between them, have an extremely and increasingly important economic function. For example, back in 2008 there were some quite serious issues with the commercial paper market, as a result of money not flowing in to cash reinvestment funds. Moreover, if quantitative easing comes to an end and interest rates begin to rise once more, and government support in the market falls away, repo markets will become increasingly important.You need collateral to function in the repo market, which potentially means stock demand, as well. The long term outlook remains good in that regard. PAUL WILSON, MANAGING DIRECTOR, INVESTMENT SERVICES, JP MORGAN: Two trends will influence securities lending from the perspective of profitability. One is tax harmonisation in Europe.Yield enhancement is one of the most profitable transactions that lenders

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undertake across Europe. Tax harmonisation is actually good news for beneficial owners, as they don’t have to engage in the yield enhancement trade. However, and we need to be clear about this, this will drive a great deal of profitability out of the industry. The time horizon for harmonisation is much closer now as well. Previously we all thought of it in terms of a five to ten year outlook; now beneficial owners should be thinking in terms of a three to five year horizon. Two, we should not underestimate the amount of government (read central bank) participation in the markets, particularly at the front end of the curve, whether it's Project Twist, quantitative easing or LTRO. This intervention has driven a large amount of investment activity as the market is so long in cash at the moment. Regulation aside, and none of us as Chris rightly points out, is clear as to the long term impact of the new rules being contemplated, it will be interesting to note how markets react once the economy starts to recover and government participation starts to reduce. We had a decent year in 2012. The supply side of the market remains healthy. We find our clients willing to engage with us in order to look at additional ways to generate incremental returns on their lending activities within their risk framework. We are seeing clients interested in collateral flexibility and emerging markets, and specifically places such as Brazil, Russia, and Taiwan. We think these are really interesting markets, where the returns are in the percentages not basis points. Moreover, you don't have to lend in large volumes in these markets to generate a healthy return.

THE BUY SIDE VIEW: MORE COMPLEXITY & NEW PRODUCTS ARE DOWN THE ROAD: THE CHALLENGE IS THE VOLUME OF AVAILABLE FUNDS & HOW THEY ARE EMPLOYED ROBERT CROSSEN, CASH MANAGEMENT OFFICER, ILLINOIS STATE TREASURER’S OFFICE: It took us a number of years to get an effective securities lending program off the ground. Legislation was passed back in 1994, to help us do it; but nothing came of it. Then the state tried again in the early 2000s; again nothing came of it and it was shelved for a number of years. In 2007 interest in securities lending was revived as a new administration pushed it through the statute books and every since then we have had an active program. Our approach is pretty straightforward. We are a government entity, we try to keep things as simple as possible, and our securities lending agent has helped us tremendously with this approach. Our limitation, if you want to call it that, is that we are strictly a fixed income shop. We are part of the state government, so transparency in everything we do is really important. Securities lending is a complex business. We are continually learning and adding to our knowledge about the business; as are our auditors, who monitor everything we do. As I stated, we have tried to keep things very simple; both

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David Carruthers, managing director, Markit Securities Finance.

in terms of lending and collateral reinvestment. We have kept things simple we did very well through the financial crisis. We had no problems, no hiccups. We shortened the duration of loans; kept everything below 90 days and we’ve stayed with that strategy. The strategy is working very well for us. Of course we are impacted by regulation: not only in terms of collateral, but also the counterparties in our cash free investments and even with our securities lending agents. The ways securities lending agreements are structured are undergoing change; going forward, for instance, indemnifications will be an issue. Up to now, we’ve worked hard to keep abreast of regulatory and industry changes, but there is no doubt more complexity is just down the road. We will be spending time identifying and reviewing regulatory and industry changes that may have an effect on our program. Separately, just looking at asset classes, we don’t lend equities as there are none in or portfolio. Our program reflects our securities holdings which are only high quality fixed income securities. Over time this has proven to be an effective strategy and has worked well in the post crisis environment. There has been a high level of demand for fixed income, in this risk on/ risk off environment, particularly around quarter ends and year ends. In the US we have seen our lending percentage drop in terms of available securities around quarter end and year end. As new regulations and guidelines are implemented by regulators we see the dialogue focused on securities lending provider balance sheets; and that has been a real challenge. Ultimately these considerations will have an impact on our program. PATRICK DOYLE, HEAD OF FUNDING AND LIQUIDITY, AVM LTD: As a manager of leveraged funds, and also as a broker dealer, we've looked at all the trends in the market. We’ve looked at bank balance sheets, both sides of the sec lending market, as well as the hedge funds, which are levered up and trying to get access to these securities, or trying to finance and use the repo markets for leverage. As we all know this pipeline is broken and the tragedy is that the banks are not going to come back in force to this

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segment. So, we've been spending the last three, four years trying to look at alternative pipes. We've tried to develop new products, and new ways of obtaining leverage or obtaining the stocks or securities that we need. We're primarily fixed income but we also dabble in equities. We have one thing that we've looked at to change the course of this product, and it's called direct repo. Robert mentioned quarter ends and month ends. It's actually smoothed out because of some of the regulations going through the market. You're not seeing big spikes, like we used to see in the past years. What we're seeing now is that we can get these new pipes built directly between entities. For example, a state government can face a very large publicly traded transparent REIT. There are some impediments, and it's taken a while to establish this as a credible vehicle. There has also been the challenge of educating clients, for example around ways of defining and minimising credit risk. The way we look at the world, is that you’re diversifying risk. We also talk about incremental pick up. We've worked with several of the securities lending programs; especially on the cash reinvest side. We're telling clients: you can diversify your risk away from SIFIs, diversify away from concentrating all your cash and assets into Wall Street firms and get it into other industries, such as the REITs industry, or international banks. We’ve gotten into this direct repo business ourselves and introduced our clients to it. Our clients are mostly pension funds by the way. The attraction of these new vehicles is that although they have large cash needs, they are way less leveraged than say the banks; and from a credit point of view it is appealing. The dealers are maybe 20, times leveraged; banks, are maybe 15 times leveraged; hedge funds are maybe seven to ten times leveraged and REITs, five to ten times leveraged. DIANE SPURLIN, MANAGER OF INVESTMENT OPERATIONS, STATE OF LOUISIANA DEPARTMENT OF THE TREASURY: External issues are impacting our activities. I’m not sure we’re expecting much change in our outlook for the coming year. We have other issues to deal with. The state is drawing down our general fund balance rapidly due to repeated annual budget shortfalls. The state is pulling every dime it can out of the treasury, and we are hanging in there hoping to maintain whatever level of securities on loan we have. I don’t think we will succeed and our security lending funds will drop. With that in mind, I’m not sure that we’re in the position to do much more in terms of securities lending; or at least get involved in more diversified activity. Ultimately our manoeuvrability will depend on cost. Our security lending is done with a lump sum. All of our fixed income securities are transferred to our securities lending program, whose current balance is $4.6 billion. If we had to pull down more funds, the value of our program could probably be reduced. All of our Treasury and Agency fixed income securities are in the securities lending program: it encompasses Our General Fund and three large trust funds. So in that regard, external

Diane Spurlin, manager of investment operations, State of Louisiana Department of the Treasury.

developments or factors will impact our securities lending activities in the near term; and I would think that a number of other state treasuries are in the same position. JESSE PICUNKO, PORTFOLIO MANAGER, TENNESSEE CONSOLIDATED RETIREMENT SYSTEM: We’re about three years into our attempt to start of our securities lending program. We’re very close, but not there yet. The Tennessee program is an admirably conservative fund. We don’t have huge alpha targets. We are just trying to reasonably beat our benchmarks. In terms of the securities lending decision you have to ask: is it worth the risk? One number we're looking at is a $200m lend, which would be 1% of the portfolio and we think we can generate about $4m. That's 2% yield, for a zero duration asset, or a zero duration arrangement. Conversely, we might be able to make $8m on a $2bn lend. Well, then you're looking at 0.4% yield. Well, that's not attractive, but 2% sounds pretty good, and so we can play around the edges. In other words, do we reduce the intrinsic spread and maybe try to get more out on lend, or maybe do we target a yield that makes sense? Considering where we are at this point, without having long experience in securities lending, and not wanting to engage in something with a cloud of systemic problems, we're comfortable with that very low $200m lend, and we’ll figure out the future from there. Actually, $4m is about one basis point of annual alpha, so to get cute, when it involves one basis point or two basis points, it just doesn’t make sense to have $2bn on lend. It's not meaningful for the fund in any given year. However, when you look at the number over ten years, and let's say we're making $10m a year, then $100m even over ten years, that's a great number. So it comes down to how we get there, and I reckon it's going to be a little bit of trial and error, and to see how comfortable we are with our agent. We're not looking for anything esoteric right now. PAUL WILSON: Robert alluded to the fact that volumes are still probably 40% below historical highs, and there's a question mark of whether we're ever going to get back to those historical highs. Right now it’s a tough call. Even so,

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revenue generation did recover fairly well in 2012, and on a very simplistic risks-adjusted basis, 2012 was a great year for beneficial owners. They made more money than they did in the past, with a lot less on loan. That’s generally a good place for them to be, particularly for those beneficial owners that have started to participate in securities lending for the first time. I would say that now is a really good time to think about lending for the first time, because the dynamics are actually quite different than say pre global financial crisis. In summary, 2013 will be much like 2012. Clearly, we remain cautious to a shock or Black Swan event, given the markets and economy have not fully recovered. So, this should be borne in mind as beneficial owners restructure or make changes to their programs for 2013.

TENESSEE WARS: LESSONS FROM A HIGH PROFILE RFP

Jesse Picunko, portfolio manager, Tennessee Consolidated Retirement System.

FRANCESCA CARNEVALE: I’m really interested Jesse. Almost every single lender under the sun bid for your business. What were the drivers behind the choice of agent lender? How realistic were the bids? JESSE PICUNKO: We have gone through the process of choosing a lender and right now it's going through legal. There are probably three categories of lenders out there. There are the very big guys; then there are small, niche players, and then, the confused in-betweens, and we've tried to find a lender that was receptive to our conservative nature, and responsive to the fact that we didn’t want to be a plug and play type program. What scared us with some of the bigger lenders is that we would be pretty much anonymous. We didn’t have the confidence that if there was a problem that we would be a high priority. Also, with the bigger lenders, given that they are systemic risks, if anything did happen, they have so much on lend, they have trillions on lend, are they going to be the ones most nimble and able to take care of us in a crisis event? So it took us a long time to figure out what we wanted. Actually we are still not entirely sure we are going down the right track. At the end of the day, we don’t think there's going to be a systemic failure, and most of the lenders could have given us exceptional service. It just came down to the tail risk; what's the best for us in a worst case scenario? PAUL WILSON: One of the positive things about the securities lending industry is the choices available to beneficial owners. It is good that not every service provider looks the same and each has differences and varying strengths . Good, bad, ugly, pretty, it doesn’t really matter. Choice is a remarkably important thing, and that gives Jesse a fantastic opportunity to make a considered choice from a range of options before him. That is absolutely the way it should be: a reasoned choice to make a decision about a firm that you feel is the right partner for you; it’s invaluable. Right now though, I feel very positive and wouldn’t want to be anybody other than JP Morgan. I say that unashamedly, because we have significant balance sheet and capital

strength, a fantastic reputation and brand and generally the way in which we approach things as a firm, speaks for itself. We have our strengths, and generally they match what beneficial owners are looking for and if they don’t then that’s fine with us. Nonetheless, in this industry I will always caution beneficial owners that sustainability is going to be really important over the next three to five years. We’ve all alluded to issues of liquidity and profitability; and some here today have talked about the possibility that the profitability of providers is going to come under strain because of tax harmonisation and regulation, etc. With that in mind, I suspect over the next few years the industry, from a supplier perspective, will look remarkably different. You also raise interesting points regarding predictability of income. That's one of the biggest challenges that any buyer of securities lending has. Ask ten providers for a revenue estimate and you will get 15 different numbers! I am reminded of an RFP we recently responded too where the client had created a model portfolio, involving just 20 or so stocks. The client gave us clear criteria and then asked for revenue estimates. Notwithstanding the clarity, some bidders estimated revenue based upon a look-back, others had done them on a look-forward, and others on a combination thereof. In the event, the mandate was awarded for other reasons other than revenue; and that is the nub of the story. While revenue is important, ultimately it is trumped by other considerations: it probably does feature in the top three requirements, but it probably isn't number one and number two, to be honest. JESSE PICUNKO: Some lenders included in their revenue estimate the Citigroup trade from a couple of years ago, which was the trade of the century, but it was a one-time thing. To include that in the estimate was just spurious; it created some bad will for me towards some vendors who did that. PAUL WILSON: I wouldn’t say we've got a monopoly of getting it right, but we try to be as transparent as possible,

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detailing what we think is going to come from general collateral, what will come from specials, what the value of the specials is at that moment in time and what's coming from yield enhancement, for example. We might give different estimates based around different collateral mixes, involving say non cash versus cash both invested only in overnight investments or six month investments I am not sure what else the industry can do, to be honest, around coming up with a more standardised way for lenders to present estimates. It must be said, in this context, that sometimes consultants are not particularly helpful. They are often in a unique position to help beneficial owners make sense of the options before them and help them compare like for like elements in any estimate. DAVID CARRUTHERS: Historically, the way that performance was measured in the stock lending world was very different from the way it was done in a conventional risk management set up. Obviously performance measurement has to be modified to some extent to take account of vagaries in the stock lending business, but that's something, which we're actually working on. Like Paul and some of the other providers in the industry, we are working hard on this problem and in fact, this year we could see a new market standard emerging, which allows you to, at least on a lookback basis, see exactly where returns came from, and how much of it was influenced by macro factors which were perhaps beyond the control of the lender. Ultimately it could mean that you will be overweight in one stock and underweight in another, right down to the kind of micro level, a little bit like trading cost analysis (TCA), but for the stock out in the lending market. It is the search for that kind of framework or industry standard that is important to both lenders such as Paul and the client side, like Jesse. It will certainly make the selection process a lot easier. CHRISTOPHER R JAYNES: Picking up on some of these points: it is important for beneficial owners, if they are going to go down a path of looking at estimates, to have all agents using the same assumptions and providing granularity around the different components driving returns. Beneficial owners should ask agents to specify how much of the earnings are derived from dividend related opportunities; how much from specials; how much from general collateral trades; how much from cash reinvestment, etc. Equally important are all the underlying assumptions that lie behind these projections. Are these assumptions backward looking, or forward looking? Is the agent determining figures based on estimated changes to future market conditions and demand or basing their figures on market conditions today? We've seen agents adjust their estimates upward by assuming that demand is going to pick up 30% over the course of the year or the stock market will rise 15% as an example. Basing a decision on a 12-month forward estimate, when no agent has the ability to accurately predict what any portfolio is going to be worth over the next 12 months, is a flawed way of selecting a provider.

Patrick Doyle, head of funding and liquidity, AVM LTD.

Revenue estimates should be used as a tool to help beneficial owners understand how much revenue you may be able to generate based on your specific assets and guidelines, and to understand how program revenue is expected to increase or decrease based on potential changes to your guidelines or risk tolerances. However, estimates should not be used as the key decision criteria between agents without first making sure all providers are using the same assumptions. I recommend that beneficial owners focus on the agent’s philosophy and approach to lending, and the process they utilise to affect their approach, and whether those elements match what you want to accomplish in your program. Business should not be conducted on the basis that whoever makes up the highest number wins. JESSE PICUNKO: In our questionnaire we did not include a revenue estimate, just because it’s difficult to equalise that.

EFFECTIVE MANAGEMENT OF THE SECURITIES LENDING PROCESS: MANAGING RISK AND RETURN EXPECTATIONS FRANCESCA CARNEVALE: Robert, your lending programme is based around fixed income, which must create an element of predictability, in terms of expectations around returns. Are issues such process and risk management important to you? ROBERT CROSSEN: Yes, they are. We try to focus on the fact that revenue from securities lending is incremental income. You mention alpha and for us it turns out that the alpha generated from the security lending, because of the zero interest rate environment, is fairly good. We didn’t expect that. The concern—if you want to call it that—is on the one hand, that if we're going to get away from that zero interest rate level. We don’t quite know what the impact will be. Is alpha going to decline? Second, we don’t look to take on too much risk; you can tell that from the fact that we are a fixed income shop with a buy and hold strategy; so if the alpha falls we are

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limited as to what we can do to generate return. We have invested in US treasury bills, so it's very good for collateral right now. We're getting a very good return. It’s usually been if the general collateral is just popular, and we're going to probably move away from that, but again, what's that volume going to be? How’s that going to work, moving forward? However, we are managing now in cash crunch mode, because while money is coming in; it is also flowing out quite quickly and a key concern is trying to predict what our revenues will be this year. As Debra highlighted early on in the discussion, in Louisiana we've got this tremendous pressure to draw down general funds so that we can sustain spending, particularly in healthcare. For now the cash flow is there; as we benefited from the rise in income tax, but there was a lot of outcry against that, so we can’t revisit that option in a hurry. Then there is government money, that came out of the American Recovery and Reinvestment Act of 2009 (ARRA). It’s an economic stimulus package, worth over $800bn, enacted by Congress back in February 2009. The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions. There was a ton of money put into the state because of ARRA. Tracking how much has come in and how much has gone out, what remains and trying to think about how quickly that may be dispersed is taking up a lot of time. We are four years into this and while money is still coming in these days there’s a lot less of it. We are trying to get a handle on how much is still left over so that we can manage what is going to be spent over the next two years. It's hard to determine because of the way the money is received, and the way it's dispersed, so our risks are kind are related to daily cash flow and measuring it on a monthly, quarterly, semi-annually and then annual basis. DIANE SPURLIN: Our major problem is the new regulations impact on repo. Our custodian is BNY Mellon as of now; but money doesn’t come into our account until 3.30pm in the afternoon, which often leaves us with a daylight overdraft. What that means is that any cash we might reinvest now has to sit in our account to cover positions. Like Robert, we’re governed by strict state laws, and we have to go to the legislature just to change anything, or to do anything different. Moreover, given recent statements by the US Federal Reserve, it looks like things will become even stricter. PAUL WILSON: Until these reforms took place, all of the intra-day risk pretty much resided with two clearing banks. That was truly systemic risk. When two counterparties agree to enter into a repo trade the risk should sit between the buyer of the repo and the seller of the repo. It should not sit with the clearing bank, which is a processor and settlement facilitator of the transactions. The Federal Reserve reforms among other things, pushed back settlement. Previously in the US, every repo unwound every single day regardless of maturity, at six am, and both sides of the trade had intra-day risk to one of the

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Paul Wilson, managing director, agency securities lending, investor services, JPMorgan.

two clearing banks. That is just not right. Now, with the 3:30pm settlement, it’s made the overall system and process far more appropriate from a risk perspective. Unfortunately, securities lending will not resolve these types of issues. Securities lending isn't an activity where beneficial owners should be taking significant maturity or asset transformation. If beneficial owners want to do these types of transactions, then they should probably change their asset allocation and buy the underlying securities outright Securities lending is a voluntary activity to add a small amount of incremental return, with relatively low risk that doesn’t get in the way of a beneficial owners underlying investment activities. If they have cash flow challenges, securities lending activities need to be structured appropriately, given that on any given day they might need some relatively large amounts of cash or assets. It's relatively straightforward. However, securities lending is not going to resolve some of the broader issues that are being talked about here, but the small amount of return will definitely be helpful in terms of additional income, but it's not going to resolve some of those underlying issues. PATRICK DOYLE: The tri-party repo reform has definitely put a big dent in the way business is done, as you mentioned Paul, in not getting your money back. We have seen a lot of people switching back to a delivery versus payment (DVP) system or bilateral repos, where they actually take securities into their custodial account and invest in cash. Any number of banks that you can be used as a custodial not just BNY Mellon or JP Morgan. So DVP was one answer that we saw to that. I will say that the reforms will have an even bigger impact on DTCC cleared securities. That is because the dealers on the other side of that trade have to pre-fund it and get zero credit for any securities, so if you're involved in reinvesting cash into corporations, for example, it's much more difficult for the dealers to fund their corporations in a tri-party market than it used to be. Now they have to pre-fund what they get. BNY Mellon gives them zero credit, so they can't borrow

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ROUNDTABLE

intra-day against the collateral in the box, as they call it. So we're seeing a crunch on there too. Moreover, we are seeing a lot of switches over to the traditional DVP format, where collateral comes in and cash comes in. What we're also seeing in this tri-party repo reform, and much like the swaps market, is a push towards a centralised counterparty, and this is something about which we've had detailed discussions with the Federal Reserve. The way tri-party used to work was the cash went back to the investor in the morning and the securities were held by the custodian all day unfunded until the end of the day when the cash investor re-invested. This left an intraday exposure the custodial bank had to the dealer or collateral provider. This was unacceptable risk to the Federal Reserve and a main component of tri-party repo reform. There is a push or at least open discussion for repo markets and securities lending activity as a result, to get into a centralised counterparty system for that instantaneously settled transaction. The Fed currently wants a three seconds delay. They don’t want: “here's the cash at the end of the day, what collateral do you have?” This is certainly one of the most intelligent regulatory pieces I’ve seen to date; and there are very few of them. However we're not out of the woods yet. They're still in the middle of the repo reforms. I know the Fed has pushed on BNY Mellon and JP Morgan, and from what I understand they actually have people sitting in their offices, watching the daily processes, and basically kicking those banks to get these reforms in place and implemented. PAUL WILSON: We are not adverse to a CCP in the industry, we just do not see the sense in it being mandated as the only way to transact a securities lending transaction. We generally feel that the economics and incentives to use a CCP will drive their usage; that is, if it becomes cheaper to transact in a CCP because of balance sheet and/or netting, participants may navigate towards a CCP. We can see some potential areas where this may work, However, while we don’t envisage regulators mandating the mandatory use of a CCP, if they did, we could see at least 50%-70% of the current supply drop out of the market immediately. It's that high. FRANCESCA CARNEVALE: Why is that? PAUL WILSON: Because beneficial owners will not be able to get a fully customised program. CCP’s apply standard haircuts, there would be no indemnification. This is contrary to the way the industry has evolved with beneficial owners demanding highly customised bespoke programs. There are also structural issues that need addressing, and transparency requirements regarding how CCPs calculate risk, their haircuts, and there may be a concern that a beneficial owner has a high concentration of risk to a CCP. However, for the vast majority of beneficial owners their risk is not the CCP, but the clearing member, which is a bank. So in most lending programmes today, beneficial owners probably have loans across more than 10 counterparties. If they move to a CCP, they will have just one bank that they will need to clear for them, with all the risk concentrated

with that one bank (not the CCP). It changes the risk dynamic dramatically, so we need to make sure beneficial owners really understand that, because everybody seems to think their risk will be the CCP. It won't be. As I have already stated, I can see certain instances where a CCP could operate in the securities lending market. Certainly, collateral netting and balance sheet netting will drive certain transactions that way. However, mandating a CCP is another thing entirely and as stated we believe that 50-70% of the current supply will just drop out of lending tomorrow. That is one of the unintended consequences of it. PATRICK DOYLE: There is a CCP in place already, the Fixed Income Clearing Corporation (FICC), which is part of the DTCC. It does help in terms of being able to customise. If you want to do a GC programme or something that might fit well on to a centralised counterparty. There's a lot of customisation, so you could never kill the DVP or all the other types of securities lending reinvest side that is are out there; but the CCP does work well for certain things. FICC is one of them, and one of the Fed pushes was also to open up the doors to the FICC, and other similar institutions. It’s just another option, and as Paul says, it should never be mandated.

LOOKING FORWARD: WHERE IS NEW BUSINESS COMING FROM? CHRISTOPHER R JAYNES: Over the last couple of years the industry has been slowly returning to normal and looking forward again. We’ve seen slow but clear increases in returns and demand, throughout 2011 and 2012. Most market participants experienced higher revenues in those years than they had seen in 2009 and 2010. Opportunity for further growth sits in several different places, but the mix of opportunities will be different from one beneficial owner to the next depending on what assets they hold, what legal jurisdiction they operate in, what their own internal risk frameworks are, and their investment guidelines. As noted earlier we see increasing opportunities for clients with emerging markets exposure. For those who have exposures in certain markets such as Korea, Taiwan, Malaysia, or Brazil, there are opportunities to add significant revenue. Certain clients also have opportunities to increase program returns and diversify risk by expanding their collateral profile. Again, this does not apply to every firm based on individual legal/regulatory requirements and the beneficial owner’s internal risk framework; but those clients that are able and interested in exploring different collateral options can both diversify their risks as well as generate incremental returns. There is opportunity in the reinvestment space as well. Again this does not fit all clients but for those who are able to modify guidelines and want to look at alternative routes to market (such as AVM), this can diversify risk, and add incremental value to their program. We also see beneficial owners in the market looking at utilising multiple providers

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Editorial 69_. 18/03/2013 16:43 Page 59

for their program, based upon their desire to explore different route to market, or benefit from a specific skill set or expertise that a new provider can bring. The opportunities available to each beneficial owner is a function, organisation-by-organisation, of what the goals are for their program, what their risk tolerances are, and what their asset mix is. There are many opportunities for beneficial owners to enhance their programs and generate incremental returns, but it has to match with their risk framework and overall goals of what they are trying to accomplish. FRANCESCA CARNEVALE: Building on Chris’s theme’s, where do you see new innovations/new pipes developing Patrick? PATRICK DOYLE: New pipes are developing on several fronts. We work with both the buy side and the sell side to support securities lending and the benefits of direct repo. Right now you have huge amounts of collateral looking for huge amounts of cash, and these people are just starting to meet each other. In the old days, and I'm sorry if this sounds repetitive, but there was a guy that stood in between, and took out a big slice of that pie. Now we are saying: you don’t need that guy in between. I mentioned REITs, international banks, pension funds the list goes on and on and on. We invest a lot of cash ourselves as a hedge fund. We have a lot of cash we're putting out there, and we're one of the first to go out and take advantage of direct repo. What the product offers is, to us, especially in this low interest rate environment, makes it even more attractive, a significant yield pickup, and a significant risk reduction, and you really haven't changed anything you’ve done. I have to thank you, Chris, for the AVM mention, but it’s become quite popular. It's been a long time project, though. We've been working on since 2008. FRANCESCA CARNEVALE: Jesse, you said that when you entered into the securities lending space that it was governed by very measured expectations, and a very conservative underlying conservative approach, but once you enter the securities lending market it must broaden your horizons. How do you think it will open up new vistas for you, and, you know, what will be the lessons that you will be looking to learn from your entry? JESSE PICUNKO: We hope to learn no lessons. Generally you learn lessons when you do something wrong. Certainly there's going to be a lot of temptation to first reduce our rebate spread. That will probably be the first thing that we go through; possibly non-cash collateral. The problem for us is we don’t have the manpower to run a program. We're going to have one person, who is probably going to work 20 minutes a day on this. You don’t get innovative when you have a quarter of a person’s day paying attention to the program. If we wanted to make a lot of money, the money is there to justify paying for an individual to do securities lending exclusively. It's not so much the risk management aspect of it, where we know to be checking who our counterparties are, what they're invested in, what our spread is, and all those

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

ROBERT CROSSEN, cash management officer, Illinois State Treasurer’s Office.

generic things that you must do. We're concerned instead about the things that are not quantifiable. With that in mind, I don’t think at this point we're comfortable taking advantage of what is out there. It is going to be a small programme to start off with. DIANE SPURLIN: Like my counterparts around this table, we are happy with our program and it is a very straightforward one. Actually, one person does handle it. I guess it's called the London way of doing things. We just basically give our service provider our stuff, and they pay us, and it's very simple. So it’s easy to keep up with collateral and everything on that side; but we're open for better ideas, more money, just like anyone else. We do business with Morgan Stanley, and it's basically been through them that I've learned everything I know about securities lending. We've done the same program for 20 years, and it’s brought us quite a bit. Over the years it's expanded and brought us close contact with others; but we are very keen to learn other approaches to the market. FRANCESCA CARNEVALE: So we’ve heard quite a lot from the state treasuries about their approaches to business. Conservative; loyal, treating securities lending as a useful adjunct to their day to day business; but it is not an overriding priority right now. However, from what the sell side are saying there is rising demand for customised and more complex services. Are we seeing a bifurcation in approaches to stock lending among beneficial owners? PAUL WILSON: Yes, it has the potential to become bifurcated. The really important thing is that beneficial owners have a clear idea about what they want, and where their program sits and the priorities they have. I am not sure it will develop into two clear segments; sophisticated on the one hand and vanilla on the other. There will be many shades of grey in between. I was thinking about some of the trades that we undertook for beneficial owners last year—discretionary lending, oneoffs, auctions and exclusives; principle trades, net stock loan and reverse equity structures, collateral upgrades and down-

GM Editorial 69_. 18/03/2013 16:43 Page 60

ROUNDTABLE

grades. Now 80% of those things might not be applicable for 80% of beneficial owners, but it gives you an indication of the range and variety in the market. Innovation is only innovation if a beneficial owner values what we are developing. Ultimately, it is about getting the balance right between what we can offer and what our clients want. Given the amount of time any beneficial owner dedicates to securities lending we need to make sure our engagement and interaction with them (including providing new ideas) is appropriate. Some beneficial owners do want a low touch approach and the moment the amount of touch and effort outweighs the reward, they will consider whether lending remains worthwhile. Equally, if the market becomes overly complicated, for whatever reason, and/or revenues and returns fall significantly, again you could see some beneficial owners withdraw from the market . If this were to happen, the industry may become smaller in terms of the number of participants, but each with maybe a greater slice of the market. I'm not suggesting that's a good thing, by the way, but that's one of the unintended consequences. DAVID CARRUTHERS: In every beneficial owner’s mind right now is a decision about which direction to follow. This is true, not so much in the stock loan world, where regulation has been relatively light touch, but in other areas such as margin for OTC interest rate swaps, which could have a big impact on beneficial owners’ approach to asset liability management. Regulators face something of a trade off: how far do they go towards controlling systemic risk versus imposing impossible costs of doing business? In the end these costs will are passed on to, ultimately, policyholders and pensioners, which the regulators are supposed to be trying to protect. It is a delicate balancing act that the regulators have got to get right. Regarding stock loans, provided the regulators continue to be relatively light touch, I am fairly optimistic about the future. If you excise some of the issues with cash reinvestment a few years ago, stock loans have in fact been a very safe place to make money. However, the industry is changing. Patrick has highlighted some of the matching taking place between new participants or groups and the role of new intermediaries in the mix. Equally, Jesse has pointed to the calculations that sometimes result in better returns if you are selective about the assets you deploy on loan and hedge funds continue to need term arrangements if they are to run sustainable positions. Mix all that up and you will see substantial changes in the underlying dynamics in the industry. It's a very big ocean, and these boats have all got to find each other somehow, and with the kind of work that companies like Patrick’s are doing, helping everybody fund each other, will certainly help the market become more mature, more efficient, and hopefully you'll end up with, instead of just everything focusing on rates, you'll have more sustainable revenue for everybody. I would hope that that's where the market is going.

CHRISTOPHER R JAYNES: I don’t think we're at a tipping point where the market either grows or shrinks. In fact, we remain confident that the market will grow over the medium term. We're not looking for (and I don’t think people should expect) a big bang and the sudden emergence of a booming market. There are too many cyclical elements in play on the demand side that remain at cyclical lows; be they interest rates or equity trading volumes for example. How quickly the markets will move off these lows is not known but several key drivers are ultimately cyclical in nature and will improve over time. Tax harmonisation, as Paul mentioned, will continue in select markets; but among the main drivers of revenue and demand that's the only one I see today that likely has a negative trend over the next few years. Emerging markets, on the other hand, are a growing opportunity for all market participants. Beneficial owners are going to be making more money in emerging markets over the next few years as they get more comfortable with the risks involved and as those markets themselves change and modernise and put in the type of controls and regulations with which investors are comfortable. Looking ahead to the next three years, we're confident we're going to see a bigger, more profitable market emerge. It will take time; but the trend is clearly positive over the medium to long term. RICHARD CROSSEN: The key here is to be nimble. Our program launched at the inception of the financial crisis. In other words, we stumbled right into crisis; even so, it’s been a very good program and we have earned higher incremental income than initially expected. We've had a very good agent/ service provider. Even so, as time passes more continued uncertainty will remain: when interest rates start to rise, what will that do? What kind of dynamics does that create for us? In the context of having a rather conservative mandate, there are a lot of different risks going forward that we will have to take into account. There’s also political risk. Our state treasurers are elected, and they don’t want hard lessons to carry into an election campaign; so we have to be mindful of the implications of that political reality. It’s a pretty obvious statement; but we need to have a successful program. So, I would like us to continue to see our program continue to be utilised in the way it is now. However, we know that several changes are coming down the pipe: and we increasingly rely on our agent/provider and other industry sources to continue educating us in ways to mitigate risks and retain control of the program. The worst thing, in a time of change, is not knowing (or understanding) what is really going on. We have to be educated. Our senior managers have to be educated. We all must understand the implications of the changes coming in the markets. Ultimately we are still a cash collateral shop and with all these changes coming down the pipe, it is likely we will stay that way. However we will be working closely with our agent to help us move in line with market developments. n

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Data pages 69_. 18/03/2013 16:59 Page 61

MARKET DATA BY FTSE RESEARCH

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

12M% 1.1 1.3 1.9 1.3

0.1

12.8 13.5

3.7

-2.1

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

-4.0 -3.5 -3.7

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

5.6

1.2 1.1

3.6 4.0 5.4

2.1

1.2

-2.2

10.5 9.9

0.8 1.2

FX - TRADE WEIGHTED USD GBP EUR JPY

8.4 8.2 2.7

-2.6 -1.5

-5 -4 -3 -2 -1 0

19.7

-8.5 -5.9 -7.7 -5.5

-1.9

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

13.0 11.4 14.1

0.5

6.5

-3.0 1.8

-11.1

-20

-10

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

Regions 12M local ccy (TR)

3.7

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

-2.1 -4.4

-6

-4

-2

19.7

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

1.9 1.6 1.3 1.3 1.1 0.1

14.1 13.8 13.5 13.0 12.8 11.4 5.6 0.4

-5

Developed 1M local ccy (TR) Belgium/Lux Australia Korea Japan Switzerland Sweden Finland Israel UK Canada Developed USA Denmark France Norway Singapore Germany Hong Kong Spain Netherlands Italy -9.0

-10

-0.1 -0.2 -1.3 -2.1 -3.6

-5

8.9 1.7 1.1 0.8 0.7 -0.5 -1.4 -2.1 -3.0 -3.4 -4.1 -5.7 -5.7

-10

-5

27.8 25.4 21.4 19.7 14.7 13.9 13.8 13.7 13.7 13.5 13.0 10.7 10.5 6.6 5.7 5.4 5.0 2.6

-0.6 -2.1

-20

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

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

7.2 5.8 4.4 3.7 3.6 3.1 2.4 2.3 1.9 1.6 1.6 1.3 1.2 0.4 0.2

34.9

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

36.0 22.4 21.6 17.7 15.8 7.2 5.6 5.6 4.0 2.2 -1.2 -4.3 -8.3

-20

-10

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

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

GM Data pages 69_. 18/03/2013 16:59 Page 62

MARKET DATA BY FTSE RESEARCH

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World Japan Europe ex UK

US Emerging

Global Sectors Relative to FTSE All-World Basic Materials Consumer Services Technology

Oil & Gas Health Care Financials 130

Asia Pacific ex-Japan

115 110

Consumer Goods Industrials Telecommunications Utilities

120

105 110

100 95

100

85 80

70 Feb 2011

75 Feb 2011

Jun 2011

Oct 2011

Feb 2012

Jun 2012

Oct 2012

Feb 2013

Jun 2011

Oct 2011

Feb 2012

Jun 2012

Oct 2012

Feb 2013

BOND MARKET RETURNS 1M%

12M%

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

1.2

UK (7-10 y)

3.6 4.0

1.1

Ger (7-10 y)

2.1

Japan (7-10 y)

5.4 4.0

0.7

France (7-10 y)

10.5

1.2

Italy (7-10 y)

9.9

-2.2

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

1.2

Euro (7-10 y)

10.4 13.4

2.1

UK BBB

0.8

Euro BBB

8.4

1.2

UK Non Financial

8.2

0.9

Euro Non Financial

7.7 6.8

1.3

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

8.2

1.5

-4

-2

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 Feb 2010

Aug 2010

Feb 2011

Aug 2011

Feb 2012

Aug 2012

Feb 2013

2.50 Feb 2008

Feb 2009

Feb 2010

Feb 2011

Feb 2012

Feb 2013

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

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Data pages 69_. 18/03/2013 16:59 Page 63

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

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

FTSE UK

FTSE US Bond

115

FTSE US

115

110

105 105 100 100

95 90 Feb 2012

May 2012

Aug 2012

Nov 2012

95 Feb 2012

Feb 2013

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

FTSE UK

FTSE US Bond 145

130

115

100

55 Feb 2010

Feb 2011

Feb 2012

Feb 2013

FTSE US

FTSE USA Index

Feb 2010

-5

28.3

2.5

40.8

2.8

-0.4

Feb 2013

31.8

13.5

-0.2

0.9

Feb 2012

13.0

7.7

1.0

Feb 2011

5Y%

9.3

1.3

Feb 2009

12M%

1.9

FTSE UK Bond

Feb 2008

3M%

FTSE UK Index

Nov 2012

40 Feb 2009

1M%

FTSE USA Bond

Aug 2012

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

145

40 Feb 2008

May 2012

31.8

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

FTSE GLOBAL MARKETS • MARCH/APRIL 2013

GM Data pages 69_. 15/03/2013 14:18 Page 64

DTCC CREDIT DEFAULT SWAPS ANALYSIS

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

Republic of Italy Kingdom of Spain Republic of Turkey Republic of Korea Russian Federation Federative Republic of Brazil People’s Republic of China United Mexican States MBIA Insurance Corporation Japan

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Sov Sov Sov Sov Sov Corp Sov

415,759,336,730 223,116,003,911 143,318,202,899 88,867,558,757 116,472,749,087 148,453,215,286 77,942,077,722 113,931,875,028 77,862,668,741 82,311,284,432

20,554,424,280 11,989,409,703 7,747,588,244 6,446,791,920 4,919,006,174 18,362,985,965 7,326,342,651 8,482,706,769 2,074,856,960 9,297,512,466

14,280 10,668 9,587 9,309 9,059 8,865 8,415 8,064 7,988 7,936

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

Top 10 net notional amounts (Week ending 8 March 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 Republic of Turkey Berkshire Hathaway Inc.

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Financials

Sov Sov Sov Sov Sov Sov Corp Sov Sov Corp

415,759,336,730 148,453,215,286 182,739,409,417 164,194,691,358 223,116,003,911 82,311,284,432 77,148,851,623 113,931,875,028 143,318,202,899 36,216,640,890

20,554,424,280 18,362,985,965 15,312,973,060 14,397,398,062 11,989,409,703 9,297,512,466 8,728,540,708 8,482,706,769 7,747,588,244 7,625,280,344

14,280 8,865 7,860 6,176 10,668 7,936 5,838 8,064 9,587 3,419

Europe Americas Europe Europe Europe Japan Americas Americas Europe Americas

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 8 March 2013)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Sovereign / State Bodies

3,057,053,700,125

221,664

Republic of Italy

5,014,022,546

409

Corporate: Financials

2,964,753,038,131

421,238

Federative Republic of Brazil

4,030,384,434

238

Corporate: Consumer Services

1,666,235,458,389

296,256

Kingdom of Spain

3,154,531,253

210

Corporate: Consumer Goods

1,428,357,254,782

246,491

Federal Republic of Germany

2,353,707,677

Corporate: Industrials

1,081,351,529,378

198,583

United Mexican States

2,090,824,305

206

1,844,214,467

154

Corporate: Basic Materials

795,954,598,839

139,267

Portuguese Republic

Corporate: Telecommunications Services 731,771,168,017

118,215

Peopole’s Republic of China

1,298,182,597

138

Corporate: Utilities

611,952,013,346

104,250

MGIC Investment Corporation

1,255,835,000

362

Corporate: Energy

464,666,117,134

84,998

MBIA Insurance Corporation

1,228,441,000

252

Corporate: Technology

312,929,882,306

60,163

Arcelormittal

1,136,514,241

176

Corporate: Healthcare

290,367,213,332

52,678

Corporate: Other

121,241,052,207

13,037

Residential Mortgage Backed Securities

30,478,584,951

5,775

Muni: Government

20,748,300,000

1,725

CDS on Loans

20,163,856,043

5,383

Commercial Mortgage Backed Securities 10,768,924,377

1,179

Residential Mortgage Backed Securities*

6,753,298,924

423

CDS on Loans European

1,865,028,837

314

Other

1,480,519,570

191

Commercial Mortgage Backed Securities*

640,598,039

Muni: Utilities

43,600,615

*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

MARCH/APRIL 2013 • FTSE GLOBAL MARKETS

GM Cover Issue 69 Impo_. 15/03/2013 13:41 Page FC2

Securities Lending

FTSE All-World Index Review

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The announcements above appear as a matter of record only. J.P. Morgan is the marketing name for JPMorgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities LLC is a member of NYSE and SIPC. ©2013 JPMorgan Chase & Co. All rights reserved.

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Countries

clients beneﬁt from customized and comprehensive lending options and onestop access to a range of solutions, supported by the world-class expertise and

95%

of the world’s equity market capitalization

execution of our entire ﬁrm.

jpmorgan.com/securitieslending

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

Professional investors can register online and download today at www.ftseall-world.com FTSE_AWIR_GM_278x210_AD_COLOUR - 11189 copy.indd 1

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