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I S S U E S E V E N T Y • M AY / J U N E 2 0 1 3

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VOLCKER: WILL PROP TRADING REALLY FADE AWAY? AUSTRALIA: IS PARADISE LOST? MIDDLE EAST PROJECTS ON THE RISE THE ECONOMICS OF DARK POOLS

FRANCE: A CRISIS WAITING TO HAPPEN? www.ftseglobalmarkets.com

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F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

ARKET TALK OVER the near term will inevitably focus on liquidity.

Many stock exchanges have languished in the doldrums for too long as competition from new cross border venues and in-house crossing networks offered by global investment banks, fuelled by high voltage superfast technology, bites into traditional monopoly businesses.

Interestingly the Gulf is beginning to spark interest as the potential merger between Dubai’s Financial Market and the Abu Dhabi Securities Exchange is resurrected once more. It’s not a new deal; it was first posited a couple of years ago. Any work on unifying the GCC’s exchanges is clearly years away, if ever, as national interests still supercede any regional imperative. Nonetheless, some regional entities will benefit from if not outright merger, then at least strategic alliance with regional leaders or champions. The NASDAQ OMX Group has shown what can be achieved. Dan Barnes posits a similar set of questions in his analysis of the failure of ASX to merge with SGX, and its seeming inability to open the market up to meaningful competition. What is the right way forward?

In markets beset by regulation, still-low equity trading volumes and impending fragmentation and heightened competition in the post trade clearing and settlement space, consolidation at the front end looks increasingly promising as a way forward. We will be looking at this segment in depth in the September edition.

At this mid-year juncture, it is clear that the reverberations or aftershocks of the financial crisis remain strong. The tidal wave of regulation that is intended to bring new order to regional markets is still in motion; some of it imminent, others still to be refined before coming into force. One piece of legislation that has had an ocean of coverage is the so-called Volcker Rule. David Simons reports on the progress (or lack of it) on the Rule, which was designed to curb proprietary trading.

It looked like a done deal: one of those sets of laws that had a clear beginning and end. Yet the Rule (more formally Section 619 of the Dodd Frank Wall Street Reform and Consumer Protection Act) looks mired in nitpicking over its ambiguities, complexity and size. The five regulatory bodies debating it (Five? Really?) look beset by differences. Some say it is unframeable; others that legislators should guard against decreasing the competitiveness of US banks abroad.

That sounds like adept skirting around other more pertinent questions.

Legislators framing Volcker surely must have as their guide who they are framing the Rule for and why. Is it to protect the consumer from footing the bill of yet another financial crisis? Or is it to champion the populist view that commercial banking should be separated from investment banking?

Realistically, will Volcker achieve either goal?

Either way, the elephant is still in the room. No legislation tackles head on the fact that banks are too economically significant to be allowed to fail.

Until that is addressed, banks have carte blanche to not really behave like banks at all; which is precisely how they are behaving right now.

M

Francesca Carnevale, Editor French President Francois Hollande delivers his remarks during a press conference at the Four Seasons Hotel in Beijing Thursday, April 25th. Francois Hollande and Chinese President Xi Jinping pledged to push for a world free of domination by any superpower Thursday as the French leader visited the Chinese capital on a mission to boost trade amid his country’s worsening economic woes. Photograph by Andy Wong for Associated Press. Photograph supplied by PressAssociationImages, May 2013.

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CONTENTS COVER STORY

FRANCE: FORCE DE FRAPPE OR FORCE MAJEURE

........................................Page 4 Can France avoid the crush of its taxed economy? Government and consumer spending remain under the cosh and French banks are carrying the cost of lax debt policy in southern Europe. Can France hold out and get its house in order?

By Dan Barnes.

DEPARTMENTS

SPOTLIGHT

ISDA SERVICES IRISH FINANCIAL MARKET ........................................................Page 10

MARKET LEADER

TRI-PARTY REPO IN A REGULATORY DRIVE .............................................Page 14

News from around the global investment market.

Michelle Lindenberger looks at the effects of regulation on repo markets.

AUSTRALIA: IS PARADISE LOST?

IN THE MARKETS

................................................................................Page 16

Dan Barnes wonders whether Australia is too conservative for its own good.

VOLCKER REVISITED....................................................................................................Page 20 Was proprietary trading ever really under threat from Volcker? David Simons reports.

ON-EXCHANGE GAS, POWER & IRON ORE TRADING BOOST .....Page 25

COMMODITIES

Vanja Dragomanovich looks at the impact of OTC commodities trades moving onto exchanges.

IS ANOTHER DROP IN GOLD PRICES LIKELY? ...........................................Page 45 Vanja Dragomanovich speculates on the effect of potential central bank sell offs.

TRADING POST COUNTRY REPORT

ONE REPOSITORY TO RULE THEM ALL

.......................................................Page 27 Bill Hodgson of The OTC Space looks at the advantages of having all data in one place.

QATAR: BANKING ON PROJECTS .....................................................................Page 28 The growing pipeline of deals.

NEW FUNDING WARCHEST FUEL MIDDE EAST PROJECTS

REAL ESTATE BANK REPORT

...........Page 30

Mark Faithfull reports on the burgeoning real estate project market.

ISTANBUL’S FINANCIAL CENTRE TAKES SHAPE

.....................................Page 34 Mark Faithfull looks at the implications for Turkey’s real estate segment.

CANCELLING THE CYBER-FIGHTERS ........................................................................Page 36 David Simons looks at the impact of DDoS attacks.

CONSOLIDATION STALKS FIXED INCOME DCM

........................................Page 39

Andrew Cavenagh explains why fixed income bond desks are feeling the squeeze.

DEBT REPORT

ARE IMPROVEMENTS IN EUROPEAN RISK ASSETS IN SIGHT ..........Page 40 Stephen Zinser, CEO ECM Asset Management reviews the markets.

NAKED SHORT SELLING BAN CALMS MARKETS ........................................Page 42 Six months on, Andrew Cavenagh looks at the impact of the ban.

HOW MUCH LONGER CAN WSE GO IT ALONE? ........................................Page 48

TRADING

Lynn Strongin Dodds assesses the outlook for further exchange consolidation.

DARK POOL ECONOMICS UNDER THE SPOTLIGHT..................................Page 50 Dan Barnes assesses the viability of dark pools.

ASSET SERVICING DATA PAGES 2

EUROCLEAR AND BLACKROCK ALLIANCE SHAKES CSDS ................Page 53 Does this alliance presage a wave of competition in the post trade segment?

Market Reports by FTSE Research................................................................................................................Page 54

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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COVER STORY

FRANCE: WHAT CONSTITUTES A CRISIS?

France’s president Francois Hollande gestures as he speaks during the closing remarks of a meeting with French entrepreneurs at the Elysee Palace on Monday, April 29th this year.

Photograph by Michel Euler, pool photographer Associated Press. Photograph supplied by PressAssociationImages, May 2013.

France: too big to fail While the international press and analysts focus on Europe’s more prominent troubled economies, including Greece and Cyprus, which have had to take some stiff budgetary medicine to ensure that they remain within Europe and continue to receive funds to help meet debt obligations, reporting on the outlook for France has been decidedly muted. Even so, France’s economy faces several potential shocks over the coming year. The first is inevitable when government spending cuts come into effect; the second, a drop in consumer spending, trade revenues and investment, is widely expected but the degree of impact is debatable; the third is possible, that French banks’ exposure to southern periphery countries cannot be managed, but the effect that could have on the economy is unpredictable. Dan Barnes reports.

OR FRANCE TO enter a crisis in which it requires external help, it would have to see public sector debt reach unsustainable levels. No one believes this is likely, but the right combination of unfortunate events could make it possible, particularly if the situation in Southern Europe deteriorates.

What is defined as ‘unsustainable’ debt depends on the individual economy. In

F

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the early 1990s European countries settled on 60% of GDP as an acceptable median figure. During the ongoing economic crisis, what is ‘acceptable’ has become much more elastic.

On April 4th the International Monetary Fund (IMF) voiced concern that Ireland’s predicted debt levels would be unsustainable if they went beyond the planned 122% of GDP to reach

134% of GDP by 2018. Ireland’s 2008 bailout of its banks cost just over 36% of Irish GDP. In France, public spending as a proportion of gross domestic product (GDP) is the highest in the Eurozone at 56% and its public debt is expected to rise to 88.6% of GDP by 2014, according to the government’s own figures. Its economy is characterised by large, reasonably profitable corporates and small to medium enterprises (SMEs) the latter making up 99.8% of businesses and 59% of the value added to the economy according the 2012 figures of the European Commission (EC).

The economy is considered more closed than that of Italy, Spain or Germany as it is supported to a greater extent by consumer and government spending and proportionally less by trade. In fact both consumer spending, the second highest in the eurozone after Spain and particularly retail sales, the eurozone’s highest, have shown consistent growth throughout the crisis, a characteristic unique to France, according to Thomson Reuters’s Datastream.

To reflect the effect this has on the economy, Laurence Boone, European economist at broker Bank of America Merrill Lynch (BAML) cites the second report by the European Firms in a Global Economy, a project exploring how different national policies and regulatory systems affect firms’ performance and international competitiveness. She notes that “if France, Spain and Italy had the same industrial and firm size distribution as Germany, France would increase exports by 9% only, while Spain and Italy would see their exports increase by 24% and 37% respectively.”

This high public spending and relatively closed market has contributed to the country’s relatively good economic position, as it has left France less exposed to the repercussions of the global financial crisis in other countries. However it also means that there is limited upside to be had as the global markets recover, and reductions in

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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COVER STORY

FRANCE: WHAT CONSTITUTES A CRISIS?

spending in-country may have a more pronounced effect on GDP than in other markets.

Antoine Demongeot, analyst at Goldman Sachs said in a note on February 14th that,“We expect the French economy to enter in recession in the first half of this year owing to a significant fiscal tightening and the impact of rising unemployment on household income and confidence.”

Banking on recovery The recession is expected; what could tip the balance for France would be an unplanned shock.

“The really big risk for the French economy and for public finances is the banking sector,” says McKeown, “It is highly exposed to the Italian economy so if Italy remains in a deep recession or if things get worse and we see public or private sector defaults then that could hit the French banking sector quite hard and if France goes down the route of recapitalising the banks it would hit public finances too.”

Michael Symonds, credit analyst for financials at Daiwa Capital Markets Europe, concurs on the source the problem. “The main risk is a serious flare up of the sovereign crisis in Italy,” he says. “They are highly leveraged to developments in the [euro area] periphery, where a number have expanded significantly, particularly in Italy and now they face the potential downside risks.”

Extricating themselves from Greece proved lengthy and expensive for the French banks which points to potential difficulties in fire-fighting a further crisis in other countries. Credit Agricole signed off the sale of its Greek Emporiki operations on February 1st having started the process late last summer.

The sale was undertaken as part of the wider bailout agreement in Greece and Credit Agricole had to recapitalise the Greek bank before exiting. It booked a €2 billion loss on the sale of Emporiki bank for one euro.

“If you use that as a proxy and then consider the much larger exposure

6

BNP Paribas chief executive Jean Laurent Bonnafe listens to a question during the 2012 years results conference in Paris, Thursday, February 14th this year. At the conference, Bonnafe talked about the earnings slump (of some 33%) in the fourth quarter as the cost of provisioning a risky loan in its investment banking division weighed on the bank’s profits. The Parisbased bank reported net profit of 693 million for the October-December quarter.

Photograph by Francois Mori, working for Associated Press. Photograph supplied by PressAssociationImages, May 2013.

French banks have in Italy, it is no wonder there are concerns,” says Symonds. Data from the Bank of International Settlements (BIS) showed French banks had $315bn of total exposure in Italy as of the end of September 2012, and a further $180bn spread across Spain, Portugal, Ireland and Greece.

Exposure in Italy had been cut by almost 25% from its peak at the end of June 2011 when it reached US$416 billion. By comparison total exposure to Greece was $57bn at its peak. “The French banks have done a good job, at least outwardly, in reducing their exposure to the periphery by pruning sovereign debt portfolios, however those are tradable instruments and therefore relatively easier to dispose of,

albeit often at a high cost,”he observes.

“As we saw with Credit Agricole’s exit from Greece, offloading branch operations and private sector loan portfolios is significantly more difficult.”

The banks’ exposure to the private sector in Italy is significantly greater than their exposure to sovereign debt although, according to Moody’s, BNP Paribas still has an €11bn exposure to Italian sovereign bonds. In one sense this lack of bond exposure offers an advantage in that, should things go wrong, there should not be any immediate shock, such as an immediate bail-in or a debt restructuring. Deterioration in loan portfolios should be more gradual and more granular.

However it also means the banks are stuck with them. “There are very few well-positioned potential buyers for French banks’ operations in Italy,” says Symonds.

Home economics The trouble for French banks is not confined to overseas. As with most other European economies French banks are facing increased levels of bad debt and lower revenues back home, while under pressure to improve their capital reserves and liquidity ratios.

In a 25 February 2013 credit research note, Goldman Sachs warned that asset quality deterioration in the core French business was a concern for Société Générale, which had seen its net income from French retail banking in Q4 2012 fall 16% year-on-year to €254m, driven in part by a 27% increase in provisions. BNP Paribas saw a 3.1% decline in revenues for retail banking in that time, while Credit Agricole saw operating income from its regional banks and Le Credit Lyonnais fall to €333m from €425m, a drop of 21.6%, over the same period.

There are concerns about banks’ reliance on the use wholesale funding, which comprises interbank borrowing, bank deposits, short-term wholesale debt, and medium or long-term wholesale debt, and makes 35% of the balance sheets according to Moody’s.

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

COVER STORY

FRANCE: WHAT CONSTITUTES A CRISIS?

Many French banks have been reluctant to provide any disclosures on their liquidity coverage ratio (LCR). The LCR is the ratio of high quality liquid assets available set against the expected net cash outflows for the next 30 days, mandated under Basel III to be at 60% by 1st January 2015.

One observer asserted that the lack of communication“reflects the fact that they do not comply as of today. It will take some time for most of the French banks to adjust their liquidity profile to mean that they are above the 60% threshold that they need to comply with in two years.”

The French government has shown itself to be supportive of banks, backing Dexia, 3CIF and Banque PSA Finance although on the wholesale domestic side Dexia, now owned by the French and Belgian governments, has found itself on the receiving end of some expensive lawsuits.

The banks’ predicament has not been helped by the decidedly anti-bank rhetoric and taxation policies of Hollande. From the financial transaction tax (FTT), to the ring fencing of retail banking and ‘casino’ banking, the 75% higher rate of income tax, the president has been attacking the mechanisms of wealth aggregation.

“It is now more difficult for them to make a profit,” acknowledges Chris Broyden, of independent global professional services firm Alvarez & Marsal. “Interestingly though, some analysts are questioning how what has been put in place can be called banking reform, when it impacts such a small percentage of bank revenues. For example, under the existing plans for banking separation, it’s estimated that only 1-3% of most banks’ revenues would be segregated, whereas if the plans had required market making to be included it could have been up to 15%.”

Despite their exposure to Italy and their decreasing retail banking revenues, the level of longer-term wholesale funding has increased which is generally considered to be more

8

stable than short-term funding, as has the level of deposits.

Boone points out that the French banks have also been making progress in improving their position, through a significant amount of deleveraging.

“These large banks used to do lots of project finance outside of the Eurozone and when they had to deleverage they shed their assets,”she says.“They have gone a long way through the deleveraging process, and although these projects were profitable, it basically means their balance sheets are healthier than the average European bank.”

Between Cyprus and a hard place Moody’s posits two scenarios for French banks. In the first ‘central’ scenario it assumes a 65% haircut on Greek sovereign exposures, 43% for Portugal, 20% for Ireland, 6% for Spain, 6% for Italy and 2% for Belgium; loan-book losses reflecting further deterioration in operating conditions; and losses on legacy structured-credit exposures.

Under this scenario, the aggregate core Tier 1 ratio of the five largest banks ends up at 11.4, which the ratings agency says suggests a strong resilience to losses and adequate capital in relation to the risks assumed. Under its second ‘stress’ scenario, Moody’s includes a 90% haircut on Greek sovereign exposures, 50% for Portugal, 40% for Ireland, 12% for Spain, 12% for Italy and 4% for Belgium, as well as more severe loan-book and structured credit

losses. Within this scenario, the aggregate core Tier 1 ratio falls to 7.5%, which Moody’s notes as being a “relatively strong result”for the stress scenario.

A recurrence of the government’s previous capital injection, which it made through the Société de Prise de Participations de l’État (SPPE) in 2008 when it subscribed to hybrid securities issued by the large French banks, is not what is expected under either scenario

by Moody’s.

Capital Economics, which is expecting the eurozone crisis to worsen, with possibly Greece or Cyprus leaving the euro, is less sure. It calculates that if the French recession were to be worse than expected it could push the cumulative government debt up over 100% of GDP in 2014. Were either Spain or Italy to require a bailout with the IMF shouldering 20%, France could be expected to stump up approximately €72bn for Spain or €147bn in the case of Italy. If a bank bailout were then required, the government might be expected to contribute 1.5% of bank assets, or €125bn.

An unlikely combination of all these events together would push French government debt up to 118%, which Capital Economics notes is close to the “120% level beyond which the IMF has argued that the debt burden becomes unsustainable.” I *None of the French banks approached, or NYSE Euronext, was willing to offer comment for this article.

CANNIBALISING STATE FUNDS

I

n a somewhat convoluted arrangement Dexia (now state owned) is being sued by the local governments or collectivités térritoriales of Rhone and St Etienne for selling them allegedly toxic loans of €355m and €61m respectively, prior to the bank’s takeover by the French and Belgian governments. This follows a similar action from collectivité La-Seine-SaintDenis, which it won, forcing Dexia to cancel the interest rate that it applied to a loan, which would have equated to millions of euros in repayments.

While the collectivités are claiming they were mis-sold these loans, which are now 80% owned by the French Government, Dexia is appealing the latest decision.

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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SPOTLIGHT

NEW FINANCIAL MARKET ASSOCIATION FOR IRELAND

ISDA services Irish financial market

Photograph © Socrates | Dreamstime.com

The growing funding gap in Europe (variously estimated at €4bn) and a desire to provide a more formal and deeper infrastructure supporting the Irish structured finance and debt securities market has now led to the launch of the Irish Debt Securities Association (ISDA).

RISH MINISTER FOR Jobs, Enterprise and Innovation, Richard Bruton, formally launched the Irish Debt Securities Association (ISDA) at the Royal College of Physicians in early May. IDSA’s objective is to enhance the environment in Ireland for structured finance and debt securities and to promote the country as a leading jurisdiction for SPV’s.

“International financial services forms a key part of the government’s plans for jobs and growth, and through our

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Action Plan for Jobs we are targeting the creation of 10,000 additional jobs in this sector over the coming years.

We are putting in place a range of measures to support expansion in this sector, including the establishment of a new team in IDA Ireland to target investment and jobs from this sector and exploiting opportunities offered by high growth sub-sectors such as green finance, Islamic finance, structured finance and post trade services. Today’s

announcement is a major boost for the sector in Ireland; I commend all involved and wish them every success with this new venture”.

Underlying the association is an understanding that a more formal infrastructure now needs to be put in place in Ireland to help support an active international capital market in structured finance and debt securities. Around €500bn of SPV assets are already resident in Ireland, representing approximately 22% of all European SPV assets. Chairman of ISDA Turlough Galvin says ISDA’s mission is to promote high standards of professional conduct among industry service providers and “lead the industry activity to develop and provide a world-leading environment from Ireland for structured finance transactions and for the issuance of debt securities and other specialist securities.”

IDSA chief executive Gary Palmer deepens the explanation, adding that for many reasons the traditional means of raising finance is being challenged and other sources of capital are needed. This is especially so in Europe where, he says, “there now exists a funding gap of many trillions of euros and all of the discussion around this funding gap is concluding that this needs to be addressed in the non-bank financing areas of SPVs and securitised structures. Additional investment is required to encourage and sustain economic growth and clearly this requires substantial sums of money.”

Palmer says that recent figures issued estimate a requirement/ shortfall in the region of €1.6trn to €1.9trn. “However, this does not include the requirement for infrastructure investment, and if you add the shortfall in bank funding the gap is estimated to be a further €2trn or so. Overall, we are looking at a funding shortfall in the region of €4trn. We think Ireland is very well placed, in terms of supporting regulation, in terms of tax treatment

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

(under Section 110 of the country’s tax provision) and the legal infrastructure. The country is committed to adopting best in class practice and legislation, adding to what is already available in the country, and enhancing the appeal of the jurisdiction. ISDA is an important catalyst in bringing all these elements together to help this market take off.”

Palmer is adamant: “As an open, transparent and tightly legislated jurisdiction with a foundation of existing industry expertise, Ireland has the opportunity to provide the products and solutions that the international industry is seeking at this important juncture. Up to now we have been encouraged and flattered by the receptiveness of the market to this initiative.”

Palmer concedes there is room for additional institutions to help deepen the debt securities market and to encourage the emergence of the jurisdiction as an internationally recognised centre. He points to the value of the expertise in the fund management, manufacturing, pooling and fund administration segments and thinks that this latest initiative is an important adjunct to building out the jurisdiction’s expertise in debt securities. However he is clear that Ireland does not seek to jostle the primary market debt issuance crowns of London or Frankfurt (or even Moscow); nor does the jurisdiction seek to replicate the more passive strategies of markets such as Luxembourg or the Channel Islands. “We are looking at somewhere between these two very different types of market. I think it is achievable.”

IDSA will operate as industry organisation whose membership is wide-ranging and which includes corporate administrators, trustees, audit firms, legal advisors, listing agents, and other parties involved in the structuring and management of Special Purpose Vehicles (SPVs) in the industry in Ireland, says Palmer.

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

A buoyant private equity secondary market The challenge of finding attractive opportunities in a transparent and crowded secondary market.

AST YEAR WAS another vibrant year for the private equity secondary market which continued the growth and maturation that it has experienced over the past decade. As recently as ten years ago the secondary market was worth $2bn and on the periphery of the private equity industry. At this time, the secondary market was utilised by only a few of the most sophisticated investors (as buyers), or investors that found themselves over-allocated to private equity or in need of liquidity with few other options (as sellers). Today the secondary market is a $25bn a year segment in the private equity industry and many institutional investors view secondaries as a critical and mainstream component of their overall private equity program writes Chason Beggerow, Partner at Altius Associates.

There is strong demand from institutional investors to invest in the secondary market. Cogent Partners estimates that there is currently $25bn of dry powder available which is focused on the secondary market.

Additionally, Preqin reports that there are currently 32 secondary vehicles in the market seeking an aggregate of $27bn in capital commitments. In 2012, AXA Private Equity raised $7.1bn, the largest secondary fund to date; a deal that eclipsed Lexington Partners’ $7bn fund raised in 2010.

While the largest buyers in the industry remain secondary funds and specialists, there are also a growing number of non-traditional buyers in the market (such as generalist fundof-funds or institutions participating directly in the market).

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Up to now, the high level of fundraising has been supported by an equally high level of secondary transaction value. As of September 2012, secondary transaction volume was on pace to exceed $25bn, the third consecutive year that transaction value has been over $20bn. Currently there is a good supply of deals, as European financial institutions are looking to shed private assets from their balance sheets due to regulatory concerns and public pension plans are utilising

Chason Beggerow, partner at Altius Associates. Photograph kindly supplied by Citigate Dewe Rogerson, April 2013.

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SPOTLIGHT

SWEDEN LEADS ON PROPERTY SERVICE LOANS

the secondary market to actively manage their private equity portfolios and exposure.

While the supply of transactions has been good, in the current market, the sellers are more strategic sellers— not necessarily “distressed” sellers.

As a result, pricing has remained firm. The supply of secondary transactions is expected to remain strong in the coming years—Cogent Partners estimates that financial institutions have in excess of $75bn of private equity on their balance sheets, much of which will make its way to the secondary market in the next two to three years due to regulatory reforms, or other related financial pressures.

Altius Associates does approach any market that has attracted large amounts of capital, as the secondary markets have, with caution. Further, as the secondary market becomes more mature and efficient, it is difficult to see how future returns in the secondary market can match the stellar historical returns that this segment has delivered.

However, mitigating these concerns is the robust supply that is projected in the industry in the coming years as more investors utilise the secondary market to actively manage their private equity exposure. If you look at the projections, the “overhang” of capital is quite low compared to other areas of the private equity industry. At first glance $25bn appears to be a large number relative to the size of the secondary market, it represents approximately one year of capital based on the run rate of the industry over the past few years. In addition to the regulatory concerns facing financial institutions, many investors have been rationalising their private equity programs, reducing the number of relationships, or simply flattening out the J-curve. This has resulted in a continuous supply of transactions and opportunities; a trend that will continue.

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The first property-secured bond loan in Sweden Klövern AB sets a new benchmark with the first propertysecured bond in a deal advised by Nordic Fixed Income.

Photograph © Nabil Zytoon/Dreamstime.com, supplied May 2013.

LÖVERN AB SET a new benchmark in the Nordic property finance market in late March with the first property-secured bond issue to a selected group of institutional investors; a deal advised

by Nordic Fixed Income, the specialist property finance advisory firm which is part of asset management firm Catella. Klövern’s five year bond is secured by properties in Karlstad, Sweden and carries a coupon of STIBOR + 300 basis points (bps).

The total issue volume is SEK700m (€83m).

“We are the first issuing house on the Swedish market that has structured a bond loan secured by an underlying property portfolio. There has been very great interest in the bond and I believe that interest in this type of note will increase in the future. It provides a fantastic riskadjusted return,” says Anna Ringby, head of Nordic Fixed Income. Nordic Fixed Income was lead manager in the transaction and bookrunner; while Catella’s corporate finance team advised the issuer. Klövern is one of the largest property

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companies in Sweden, focusing on commercial properties in growth regions in southern, eastern and central Sweden. In December last year, the firm’s property portfolio comprised 387 properties with a total value of SEK22.6bn. The issuer was anxious to diversify its source of funding, explains Ringby. “Up to now, Swedish property firms have mainly used banks to raise unsecured capital in the mortgage and bond markets,” she adds. “This is the first secured corporate bond in the real estate segment.”

The benchmark status of the bond is clearly indicated by the cost of funds. “The issuer does not have an official rating,” acknowledges Ringby, “but is generally regarded as a BB credit and in that context the issuer has achieved a good market price.”

The bond was sold to a discrete number of Nordic institutional investors and Ringby thinks that this financing structure will become increasingly popular, as the structure is valued by both investors and issuers. Nordic Fixed Income says it has a pipeline of issuers ready to tap the markets in similarly structured deals, and Ringby says that there is a pool of specialist investors in the Nordic real estate segment that are keen to see more deals of this type come to market. “There is strong demand, the returns are very good, so we are hopeful of a positive response to similar issues in the future,” adds Ringby.

Klövern’s shares are listed on NASDAQ OMX Stockholm Mid Cap platform and it is understood the issuer will apply for the note to be listed on NASDAQ OMX. I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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MARKET LEADER

REGULATION DRIVES EFFICIENT TRI-PARTY REPO

Increased scrutiny of the securities lending and repo markets continues as regulators fear that the behavior of market participants has the potential for systemic consequences in financial markets.

The recent firestorm of regulation has spurred efficiency and innovation in the repo market infrastructure resulting from the need to quickly conform and adapt to a new reality. By Michelle Lindenberger, managing director, Lindenberger Associates.

Tri-party repo market navigates a dynamic regulatory environment HE REPO MARKET has had to adjust in the face of regulatory pressure while simultaneously retaining its necessary functions of publishing prices and creating secondary markets for securities, as well as, acting as a means to adjust the risk profiles of firms, and aid in issues of liquidity.

However, what the Federal Open Market Committee (FOMC) highlights as the key threat to the functioning of the repo market is the amount of intraday credit extended to finance maturity mismatches. Many of the advances towards reducing intraday credit are due to innovative technologies and adjustments to the schedule of daily workflow that together reduce the time that securities need to be financed during the day.

Another item on the regulatory scope is the mitigation of risk transformation that results in the OTC derivatives market. There is a fear that counterparties might not be aware of their exposure to risk when OTC derivatives are sold to less regulated sectors. Due to mounting concerns over the vulnerabilities in the market, with regards to the way OTC derivatives trades were handled, the Dodd-Frank Act and the European Markets Infrastructure Regulation (EMIR) required that investors clear OTC derivatives through a centralised counterparty (CCP).

The clearing of trades through a qualifying CCP is designed, in part, to address some of the risk associated with the opaque nature of OTC derivatives trading. CCPs are restricted from accepting ineligible collateral types, and

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There is hope that the economic environment resulting from the Federal Reserve Bank’s monetary policy doesn’t foster complacency towards risk associated with securities: quality of collateral, leverage, and liquidity while changes in market infrastructure promote efficiency. It is prudent that expectations about the future direction of the market not distract from these considerations.

Photograph © Erengoksel/Dreamstime.com.

are required to make margin assessments throughout the day. Clearing through a central exchange, rather than bilaterally, additionally aids in revealing a price for these instruments and can provide regulatory bodies and market participants with additional insight into the OTC derivatives market.

The regulatory requirements for the use of specific types of collateral along with capital new requirements serve to further increase demand for eligible collateral, including Treasuries and agency obligations. Entities that currently hold CCP eligible collateral, could benefit considerably from this increase in demand while the tri-party repo market continues to provide a way to source high quality collateral.

As is the recurring theme since the 2007-09 financial crisis, collateral is

paramount, and the assessment and valuation of collateral is a consideration that continues to grow in importance for a growing number of market participants. The tri-party infrastructure continues to adapt to these changing needs.

The recent developments in the way that eligible OTC derivatives contracts are to be cleared through the use of CCPs has opened opportunities for current providers of tri-party repo products and services due in large part to their existing infrastructures. They are well positioned to provide the connectivity and automation necessary to reduce risk by decreasing the need for credit extension, by way of efficiency through automation.

Other concerns that could affect the tri-party repo market involve moneylike instruments issued outside of the financial markets, i.e. some forms of Asset Backed Commercial Paper (ABCP) issued by non-financial institutions. These instruments can have very real consequences for the market and are cause to consider whether an environment similar to the past, proceeding the 2007-2009 crisis where financial institutions were willing to take on more risk in search of higher yields, is once again looming.

At that time Money Market Funds (MMFs) invested heavily in these types of instruments. However, there is some evidence that they are acting more conservatively now with regards to short term financing via instruments such as ABCP despite the persistent temptation to search for yield in a slow growth environment.

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

There is hope that the economic environment resulting from the Federal Reserve Bank’s monetary policy doesn’t foster complacency towards risk associated with securities: quality of collateral, leverage, and liquidity while changes in market infrastructure promote efficiency. It is prudent that expectations about the future direction of the market not distract from these considerations.

Calls for urgency increase as worries about the European crisis persist and the sustained low interest rates in the United States are thought to encourage risky behavior that could spawn systemic problems in the economy. The Federal Open Market Committee (FOMC) has indicated that the federal funds rate would remain in the “exceptionally low range” at least until there is a marked improvement in the unemployment rate. Future projections failed to foresee a rise in the federal funds rate for four to five years in the future and only a modest expansion in the economy.

MMFs are now faced with navigating an environment of new regulation including higher capital buffers and withdrawal restrictions designed to delay rapid exits from the fund, with the hopes of preventing an investor run. While faced with the possibility that these developments will curb investment, and coupled with low yields resulting from sustained low interest rates, these funds must take their appetite for risk into careful consideration.

There is continued concern over MMFs’ exposure to European markets, and they remain vulnerable to runs due to perceived price disparities with regards to a constant net asset value (NAV) of $1.00. The run risks associated with maintaining a constant NAV in the event of a large dealer default could stem from the default causing the fund to “break the buck,” and then being forced to publish the variable NAV was causing investors to race for the door. Furthermore, a fund could be stuck with

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

securities that they are restricted from owning or that they don’t effectively have the capability to handle.

Though there are strategies being put in place to liquidate these securities, these actions could also have negative consequences; one being a drop in price of the securities in the event of a fire sale as well as other issues arising from the quick disposal of restricted assets. Additionally, MMFs are now forced to analyse the consequences of an arguably more transparent pricing regime, since some regulators have proposed a permanent switch to a variable NAV.

Excessive risk taking Among fears of excessive risk taking in a low interest environment; firms must consider if the availability of short-term wholesale funding from MMFs will remain constant, due to the their continued susceptibility to runs, and also the possibility for MMFs to stop investing in the financial instruments of firms due to credit concerns.

From the investor’s perspective, there is still motivation for investment in a fund that realises high yields unfortunately the benefit of “getting out first” has not yet been successfully mitigated.

International and national regulatory bodies have sought to improve the macroeconomic climate by targeting vulnerabilities in market infrastructure.

The reduction of intraday credit risk is a key component in realising the “Target State Environment” as envisioned by the Task force on Tri-Party Repo Infrastructure.

Already, several steps have been taken to fortify the tri-party repo market infrastructure against systemic risk. These include: more efficient management of maturities during the day, improved margining and marked-to-market capabilities, and other improvements in market efficiency intended to mitigate risk and improve transparency.

Continuing to adapt to changes will have necessary constraints on the triparty repo market in the short-run, however these could be offset by the

benefit of increased efficiency to reduce risk, and more transparency. Stability in the tri-party repo market will promote increased stability in the wider market as it is utilised by market participants, and also by the Federal Reserve Bank to enact monetary policy.

The tri-party repo market will continue to adapt as institutions make decisions regarding their level of participation, swayed in large part by collateral considerations, and where they can obtain the cheapest funding in this changing economic climate. The tri-party repo market remains well situated to provide depth and stability to the market.

Now, especially since the recent crisis, when people learned how much they were exposed to risk, due to overleveraging, many are looking to the repo market to source the high quality collateral that they need, and for overall collateral optimisation.

The economic climate has changed considerably since the 2007-2009 financial crisis that left in its wake sweeping reforms for domestic and international markets. The implementation of these reforms has been complicated, with vital elements of the market infrastructure being required to simultaneously adapt and conform while functioning.

The tri-party infrastructure continues to function well in this transitional environment. Technological development has played a key role in the necessary synchronisation of maturities with the overall goal of reducing intraday credit risk, without restricting the availability of the securities involved. The try-party repo market continues to provide the means to source high quality collateral needed to extend credit and fund investment.

The activities of MMFs and other financial institutions present some risk to the stability of the tri-party repo market, however they continue to utilise the tri-party infrastructure while steps are being taken to mitigate risk for the clearing banks as well as counterparties. I

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IN THE MARKETS

AUSTRALIA: OPPORTUNITY, BUT FOR WHOM?

AUSTRALIA: Is paradise lost?

Between 2008 and 2013 Chi-X Australia launched, AXE ECN did not. The proposed 2010 merger of the Singapore Exchange and ASX was rejected by the Treasury in April 2011; the potential launch of competition to ASX in the equity clearing space was delayed under review by the Treasury on 11 February; HFT made up nearly a quarter of market trading volume; twenty broker crossing networks (BCNs) had been launched with total dark trading accounting for 7% of market share. Photograph © Dedmazay | Dreamstime.com, supplied May 2013.

In January 2011, Australia had two new exchanges ready to launch, and a cross border exchange merger in the offing. Two years later it had no cross-border exchanges, one alternative to the incumbent exchange and it had quashed competition in equity clearing. LCH.Clearnet looked on the face of it to have achieved something of a foothold in the market as it received local regulatory approval to clear energy, commodity and environmental derivatives on FEX Global, the country’s derivatives and energy exchange, but a fully clearing and settlement facility licence is still some way away. Has Australia lost the global plot? Is there more to come that will bring the country into the global mainstream? Does it want to be there?

Or does it want to focus on the relatively local opportunity that the Chinese market offers? Or, is the reality that what had been a boldly expanding market is now shown up as a conservative heartland? Dan Barnes went in search of answers.

HE AUSTRALIAN EQUITY market is notable for its strong retirement or superannuation funds; the newly growing alternative exchange in Chi-X Australia; its volumes of high-frequency trading (HFT) flow which make up 22% of market turnover; the growing numbers of broker crossing networks which execute 4% of market turnover.

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These all suggest a progressive capital market structure, but they must be weighed against the measured approach the country has taken to change. Some of this caution has stemmed from the mistakes seen in similar developments across in the US and Europe; some has been purely political.

There had been signs of this tempering when the market first flirted

with breaking away from a monopolised exchange model. AXE ECN, an alternative exchange, applied in 2007 for an exchange license to operate but died in January 2011, over a year and a half away from the launch secured by the other alternative market, Chi-X Australia, which after several false starts got permission to launch in October 2012, having itself applied for its license in 2008.

Taken in isolation, a four-year waiting period to launch a new business based on well-established practices might seem excessively bureaucratic. But it would be unreasonable to consider the launch of these two alternative markets out of context.

Following their license applications, the financial markets went into meltdown.

The intervening years saw market events like the ‘flash crash’ on May 6th 2010, in which the Dow Jones industrial average fell 1,000 points, the biggest intraday drop in its history, in a 30 minute period before rebounding.

That sort of volatility accident, which US regulators identified as being triggered by an asset manager’s futures trading platform and exacerbated by automated trading systems in the equities markets, understandably upset regulators around the world.

It had become apparent that not only were firms in Europe and the US trading large volumes of equities based on machines’ decision-making capabilities, but they were also trading large volumes of equities away from the eyes of regulators in broker-crossing networks. As the market changed, the regulatory function of the central Australian Stock Exchange (ASX) had to be transferred to a separate regulator, the Australian Securities and Investments Commission (ASIC). In the middle of a financial crisis, changing the way that markets are regulated needs careful attention, especially when new threats are becoming increasingly apparent.

In any event, between 2008 and 2013 Chi-X Australia launched, AXE ECN did not. The proposed 2010 merger of

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

the Singapore Exchange and ASX was rejected by the Treasury in April 2011; the potential launch of competition to ASX in the equity clearing space was delayed under review by the Treasury on 11 February; HFT made up nearly a quarter of market trading volume; twenty broker crossing networks (BCNs) had been launched with total dark trading accounting for 7% of market share.

Speaking at a press conference on 18 March 2013, ASIC deputy chairman Belinda Gibson said,“Financial markets are always evolving. Electronic trading has been with us since the 1970s. It is now exponentially faster and regulation must move with it.”

Shifting sands These changes have not been universally welcomed. Gordon Noble, director of Investments and Economy at industry body the Association of Superannuation Funds of Australia (ASFA) says his members are concerned about the effect that dark pools and dark execution have on the liquidity of the lit market.

“While we understand that in deep and liquid US capital markets dark pools can play a role in reducing transaction costs, we are concerned that in the Australian context dark pools could impact on the level of liquidity of ASXlisted companies,” he says. “The need for the superannuation system to invest in liquid investments, which derives from the legislative and regulatory structure of superannuation, means that the Government should take particular notice of the emergence of dark pools. In considering the overall benefits of dark pools it is important to take into account the impact that the growth in this form of trading would have on liquidity in the lit market.”

Concerns have been raised on the issue of HFT as well. Even among those accepting of the more technologicallyadvanced new businesses, there are reasons to be cautious. Emma Quinn, head of Asia Pacific Trading at buy-side firm AllianceBernstein defends the

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

legitimacy of HFT firms to operate but warns they still have an effect on the market. “I am always a little frustrated when HFT firms claim to be ‘doing good’ with market making. If they have tightened the bid-offer spread but offer size has gone from 20,000 shares to 800 and now everyone can see I’m a buyer, that hasn’t really helped my cause. However that also doesn’t mean they can’t legitimately participate in the market.”

She also notes that concerns around these businesses are driven by headlines as well as by the actual effect on the markets. “The reality of the cost to individual investors, from HFT and dark pools, is probably blown a bit out of proportion,” she notes. “Dark pools have always existed but historically in a different form, the ‘upstairs market’ within a broker. It offers the end investor the same thing now, lower information leakage and reduced market impact. I’ve never been very anti-HFT, there is a time and a place to interact with it and each buy-side firm has to take responsibility for its own orders.”

The free markets For ASIC, its evolution into a modern regulator has not been easy. The issue of funding became very thorny in 2012, when it was announced that exchanges —ASX and Chi-X—would be charged to pay for regulatory supervision on the basis of the messages that each generates. This was seen as being a particular blow for Chi-X Australia whose nascent business is supported by electronic market makers, firms whose speed of business requires them to post and then cancel may more orders than they trade.

Wayne Swan, Australia’s treasurer had said at the end of January in 2011, “The Government has no plans to introduce a financial transaction tax,” but many, including sell-side industry body the Australian Financial Markets Association, alleged that describing the levy as a ‘cost recovery’ device was misleading. Also at the time, Duncan

Fairweather, executive director at AFMA added, “ASIC is a profit centre for the Government that delivered non-taxation revenue of almost A$532 m in the form of fees to consolidated revenue in FY2010/11 which is well over A$100m in excess of what it costs to run ASIC.” Jason Keady, director of market and operations at Chi-X Australia says, “Cost recovery wasn’t expected, particularly at that time, and it had an impact on our market. Any transaction tax affects the market makers' model increasing the cost and risk of their business. They deal with that by increasing the spread, and the spread is still the largest part of the costs for a buy-side institution.”

ASIC has also had to manage the moving target that is the evolving market structure. From the start of 1998 to the end of 2002 it released an average 2.8 reports and market consultations a year. From the five years starting in 2008 and ending in 2012 it averaged 64.6 a year.

On January 14th this year, Greg Medcraft, chairman of ASIC highlighted the three areas of structural change, ongoing financial innovation and the globalisation of markets and products as the greatest challenges regulators face in the current trading environment. “Our overall feeling is that ASIC is good as far as regulators go,”said one agency broker who asked not to be named.“It is engaging in lots of active consultation; it is out and about, speaking to the different market participants; it has practitioners on board. It is trying to find that middle ground to balance agendas from lots of people across the market.”

Better to serve in heaven…

This apparently benign dictatorship has been under pressure from several sides.

There are traditionalists such as the incumbent market ASX, the superannuation funds and a certain demographic of politicians described by one interviewee as “shouty men from Woolagong.”There are innovators

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IN THE MARKETS

AUSTRALIA: OPPORTUNITY, BUT FOR WHOM?

such as pretender to the throne Chi-X and its backers, including many HFT firms and large brokers, keen to see more order flow moving into the market and inevitably captured by their crossing networks.

Then there are pragmatists such as the global asset managers and global brokers who have seen the ups and downs of other markets and are under no illusions about regulatory panaceas.

What ASIC has achieved is a level of balance between these players. As of the beginning of March all brokers have had to use both ASX and Chi-X Australia for their clients’ orders, dependent upon the route of best execution. It had allowed a grace period to exist so that all parties could get used to the new model but the principle of best execution was delivered as planned. In its review of HFT and dark pools issued on 18 March 2013, the regulator found that, contrary to popular wisdom, HFT was not significantly contributing to market disruption.

It noted that gaming behaviour and market instability were not caused by HFT or in evidence systematically. It found that automated traders of all sorts could be found demonstrating gaming behaviour and that order-totrade ratios in Australia “have been moderate compared with overseas markets, and other algorithmic traders operate at similar levels”. It also found that HFT do not appear to rest orders in the book for excessively short periods of time.

By contrast, its investigation into dark pools found supporting evidence for concerns about the effect that the venues have on market integrity. It noted that crossing networks were increasingly operating like multilateral facilities, as they extended bilateral connectivity between brokers, or aggregated flow. Eight firms were conducting principal trading via their crossing networks during Q3 2012, with principal trading making up 38% of the value traded or those networks over that period. To reduce the harmful effects of such behaviour, ASIC has

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proposed a series of market integrity rules to be implemented transparency, monitoring, systems and controls, fairness, conflict management).

The report also found that between Q3 2010 and Q3 2012 the number of block-sized dark trades fell from 32,000 to 10,000 while the number of below block-sized dark trades increased from 690,000 to 2.6m. ASIC had anticipated this and is already implementing rules that allowed tiered block trades (with order sizes permitted down to AUD200,000 from AUD1m at present) and demand dark trades to provide price improvement if they are below block size. Taking an evidence based approach has certainly gained favour with the pragmatically inclined market participants and although the results of this research may put some noses out of joint.

LCH.Clearnet & ASX

Emma Quinn, head of Asia Pacific Trading at buy-side firm Alliance Bernstein defends the legitimacy of HFT firms to operate but warns they still have an effect on the market. “I am always a little frustrated when HFT firms claim to be ‘doing good’ with market making.

If they have tightened the bid-offer spread but offer size has gone from 20,000 shares to 800 and now everyone can see I’m a buyer, that hasn’t really helped my cause. However that also doesn't mean they can’t legitimately participate in the market.” Photograph kindly supplied by Alliance Bernstein, May 2013.

LCH.Clearnet, the multi-national, multi-asset clearing house, was granted regulatory approval by the Australian Government to clear energy, commodity and environmental derivatives listed on Australia’s Financial and Energy Exchange, FEX Global at the beginning of April. LCH.Clearnet announced late last year that it would apply for an Australian clearing and settlement facility licence that would enable it to offer its SwapClear OTC interest rate swap clearing to Australian banks, allowing them to join the existing services used by its international bank members.

By February the government announced that it was postponing, for at least two years, any decision on whether allow competitors into the market for the clearing and settling of stock purchases. However, it said it still backed competition in the clearing and settlement of over-the-counter (OTC) derivatives. The move was underpinned by concern over higher costs and regulatory burdens on an industry already struggling with low sharetrading volume, Treasurer Wayne Swan said in a statement.

Even so, four of Australia’s five domestic banks reportedly submitted letters of intent to use LCH.Clearnet's SwapClear to clear interest rate swaps.

In the event, LCH.Clearnet accepted the halfway house solution to clear for FEX Global. The service is set to launch mid 2013. Alberto Pravettoni, chief executive officer, Repo and Exchanges, at LCH.Clearnet notes the move “reinforces our commitment to expanding our geographic reach and highlights the benefits of our open, horizontal clearing model. We look forward to working with FEX Global to deliver more transparency, liquidity and efficiency to this rapidly growing market.” No doubt while biding its time on achieving a full clearing and settlement facility license that will enable Australian banks to clear OTC interest rate swaps as members of the SwapClear service.

ASX responded within the month.

At the end of April it announced that it plans to extend its new OTC derivatives clearing service to its clients to “provide important new risk management controls to Australian asset managers.” I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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IN THE MARKETS

WILL PROP TRADING FADE AND DIE AWAY?

“London whale” fiasco is likely to strengthen the hand of Volcker supporters, and prompt agency heads to revisit existing loopholes.

Prop-Shop Cops

Archive photo of Paul Volcker, then chairman of US President Barack Obama’s Economic Recovery Advisory Board, looks on as Obama shakes hands following a speech at the US Chamber of Commerce in Washington, DC, dated February 7th 2011. In the speech, Obama said he thought that various loopholes and carve-outs distort economic decisions. He drew attention to the way that the deduction for interest encourages companies to borrow rather than invest with equity. Photo by Andrew Harrer for Bloomberg/ABACAUSA.COM. Photograph supplied by PressAssociationImages.com, May 2013.

VOLCKER REVISITED Will the eventual passage of the much-maligned Volcker Rule signal the end of the prop trade as we’ve known it? Will market liquidity suddenly vanish, as its detractors would have us believe? Or is Volcker actually the kind of medicine that a derivatives-addled industry has needed for years? From Boston, Dave Simons reports.

T WAS SUPPOSED to be a done deal by now, but a quarter of the way into 2013, the Volcker Rule— which seeks to outlaw the use of commercial-banking capital for proprietary trading purposes—remains just as it was a year ago: overly complex, much maligned, and still unsigned. By now most of the major banking firms have moved to dismantle their proprietary trading facilities in an effort to comply with the directive. Still, ongoing uncertainty has forced many in the industry to either take their best guess as to Volcker’s

I

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likely outcome, or merely sit back and wait. Said one executive recently: “It’s not like we can go to our programmers right now with a map of Volcker and have them build a system to match—because the fact of the matter is we still don’t really know what it’s going to look like.”

To date, the five US regulatory agencies charged with drafting a final version of Volcker remain at odds over portions of the bill, though have vowed to resolve their differences by year’s end. Meanwhile, a new Senate report detailing last year’s JP Morgan

Conceived in 2010 under the aegis of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Volcker Rule—named for former Federal Reserve Chairman, Paul Volcker—would prohibit banks from utilising their own funds for hedge fund and private equity sponsorship unless such activity can be tied to legitimate risk hedging, loan securitisation, or other constructive activity (and is limited to a three-percent ownership stake). Right from the start the proposal ran afoul of top US banking firms, but was also opposed by state and local agencies as well as foreign government officials vexed by the bill’s alleged bank-biased list of exemptions.

As Volcker continued to languish further modifications quickly piled up.

This succeeded only in making the bill increasingly convoluted while doing little to silence critics. Meanwhile congressional Republicans, knee-jerk opponents of nearly all Obamaadministration proposed regulation (Dodd-Frank’s passage was accomplished without a single GOP House vote), seem bent on keeping Volcker off the books.

Citing increased complexity, in November GOP House member Jeb Hensarling of Texas, the current chairman of the Financial Services Committee, along with former FSC chairman Spencer Bachus (Republican, Alabama), suggested that banks be granted a two-year period with which to become Volcker-compliant. “While the Volcker Rule promises little if any benefit,” they argued, “what little benefit it does promise will not be realised if regulators further fragment financial markets and ratchet up the costs of compliance for market participants with multiple versions of the Volcker Rule.”

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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IN THE MARKETS

WILL PROP TRADING FADE AND DIE AWAY?

Legislation recently proposed by California’s Republican Representative John Campbell calls for an increase in banks’ capital-adequacy requirements aimed at preventing future catastrophic failures, but only in exchange for a total recall of the prop-trading ban under Volcker (as well as other DoddFrank restrictions).

Such tactics have only fanned the flames of discontent among Volcker supporters. One group, the newly hatched Occupy the SEC, went so far as to file a lawsuit against the heads of the regulatory agencies for continuing to delay the implementation of Volcker.

For his part, Democratic Senator Carl Levin of Michigan, co-sponsor of the bill (along with Oregon’s Democratic Senator Jeff Merkley), noted that failure to implement the protections as proposed under Volcker leaves individuals, businesses and the overall economy “at greater risk of another financial crisis.”

Liquid Drain, Oh? Critics have long argued that any risk benefits provided by Volcker would be largely offset by a reduction in market liquidity resulting from the ban on prop-trading activity, particularly if a not-so-kinder, gentler version of Volcker is passed. Standard & Poor’s recently suggested that the eight largest domestic banks could shed upwards of $10bn in combined pre-tax annual earnings, roughly $6bn per year higher than S&P’s initial estimate.

“In our view, less strict rules would have a limited impact on banks’ earnings and business positions, so it’s unlikely that we would take any rating actions as a result,” commented S&P analyst Kenneth Frey Jr. Tougher legislation, however, could prompt the agency to consider lowering its ratings on certain banks, added Frey,“depending on how they adapt their business models to the new regulations and the degree to which we estimate the regulations might hurt earnings and business positions.”

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Democratic Senator Carl Levin of Michigan, co-sponsor of the bill (along with Oregon’s Democratic Senator Jeff Merkley), noted that failure to implement the protections as proposed under Volcker leaves individuals, businesses and the overall economy “at greater risk of another financial crisis.” Should banks persist in using the hedge argument, adds Levin, “they’ve got to be able to identify what is being hedged against, what are the assets being hedged, as well as what is the proof that it is a hedge.” Photograph kindly supplied by the office of Senator Levin, May 2013.

Volcker backers, however, refuse to be swayed.“There should not be a presumption that evermore market liquidity brings a public benefit,” remarked Paul Volcker himself in a letter to US regulators. “At some point, great liquidity, or the perception of it, may itself encourage more speculative trading.”

Surprisingly, the US effort to reign in proprietary trading has garnered few allies elsewhere. Last month, the UK’s commission on banking standards announced that it would not recommend imposing a similar ban on prop trading, due in part to the difficulties US authorities have faced while attempting to finalise Volcker. Even in regulatory hawkish Canada, government officials have frequently derided the proposal, citing restrictions that they believe would unnecessarily encumber Canadian banks.

In what may prove to be a key turning point in the Volcker volley, last

month the Senate’s Permanent Subcommittee on Investigations issued its findings on last year’s $6.2bn JPMorgan trading loss resulting from the derivatives activity of one Bruno Iksil, the so-called “London Whale.”

In an atmosphere of unprecedented ideological division, the 307-page report, entitled JPMorgan Chase Whale Trades: a Case History of Derivatives Risks and Abuses, was a rarity, a bipartisan display of resolve that highlighted the potentially significant consequences of ambiguous prop trades masquerading as legitimate risk hedges.

According to the report, the JPMorgan chief investment office (CIO) trade losses provide “a startling and instructive case history of how synthetic credit derivatives have become a multi-billion dollar source of risk within the US banking system” and serve as “another warning signal” about the need to increase oversight over banks’ derivatives-trading activity, “including better valuation techniques, more effective hedging documentation and stronger enforcement of risk limits.”

The report implores regulators to immediately begin the process of implementing the Merkley-Levin provisions in order to bring an end to“high-risk proprietary trading activities and the build-up of high risk assets at federally insured banks and their affiliates.”

Speaking on behalf of the subcommittee, Chairman Levin vowed to continue working for a final rule that will prevent such manipulations from being accepted in the name of hedging.

Should banks persist in using the hedge argument, added Levin,“they’ve got to be able to identify what is being hedged against, what are the assets being hedged, as well as what is the proof that it is a hedge.”

Propped up With banks shuttering their proprietary segments, what’s to become of the traders who once masterminded their operations? With the writing on the

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

AN 22 N nd UA L

International ^ĞĐƵƌŝƚŝĞƐ >ĞŶĚŝŶŐ ŽŶĨĞƌĞŶĐĞ 18 – 20 June 2013 /ŶƚĞƌĐŽŶƚŝŶĞŶƚĂů ,ŽƚĞů͕ WƌĂŐƵĞ

dŚĞ /ŶƚĞƌŶĂƟ ŽŶĂů ^ĞĐƵƌŝƟ ĞƐ >ĞŶĚŝŶŐ ƐƐŽĐŝĂƟ ŽŶ ǁŽƵůĚ ůŝŬĞ ƚŽ ŝŶǀŝƚĞ LJŽƵ ƚŽ ŝƚƐ 22nd Annual /ŶƚĞƌŶĂƟ ŽŶĂů ^ĞĐƵƌŝƟ ĞƐ >ĞŶĚŝŶŐ ŽŶĨĞƌĞŶĐĞ ŽŶ ϭϴ ʹ ϮϬ :ƵŶĞ ϮϬϭϯ Ăƚ ƚŚĞ /ŶƚĞƌĐŽŶƟ ŶĞŶƚĂů ,ŽƚĞů ŝŶ WƌĂŐƵĞ͕ njĞĐŚ ZĞƉƵďůŝĐ͘ EŽǁ ŝŶ ŝƚƐ ϮϮŶĚ LJĞĂƌ͕ ƚŚŝƐ ĐŽŶĨĞƌĞŶĐĞ ŝƐ ĂƩ ƌĂĐƟ ŶŐ ŝŶ ĞdžĐĞƐƐ ŽĨ ϱϱϬ ĂƩ ĞŶĚĞĞƐ ƐƵĐŚ ĂƐ͗ ƐĞŶŝŽƌ ŵĂƌŬĞƚ ƉĂƌƟ ĐŝƉĂŶƚƐ ĨƌŽŵ ďĂŶŬƐ͕ ďƌŽŬĞƌ ĚĞĂůĞƌƐ͕ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ͕ ďĞŶĞĮ ĐŝĂů ŽǁŶĞƌƐ͕ ŚĞĚŐĞ ĨƵŶĚ ŵĂŶĂŐĞƌƐ ĂƐ ǁĞůů ĂƐ ƐĞĐƵƌŝƟ ĞƐ ƌĞŐƵůĂƚŽƌƐ͘

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IN THE MARKETS

WILL PROP TRADING FADE AND DIE AWAY?

wall as early as 2009, many beat a hasty retreat from the financial establishment and opened up dedicated prop shops of their own. The exodus helped boost the supply of global hedge funds by as much as 5% through 2012, according to figures from Hedge Fund Research, Inc. It’s been anything but smooth sailing, however. Lower volumes and lack of liquidity, along with a more riskaverse institutional clientele with a penchant for larger, more reputable firms, have made it exceedingly difficult for under-capitalised newbie managers to find their groove, say experts.

Data from UK-based alt-investment research group Preqin appear to back this up: one-in-two hedge funds that failed post-2011 ranked near the bottom of the AUM scale. The recent list of prop-fund casualties includes Benros Capital, the event-driven start-up (operated by former Goldman-Sachs traders Daniele Benatoff and Ariel Roskis) that abruptly closed down in January after a mere 18 months.

Not that this is likely to deter other enterprising types, particularly when there may still be some purse strings attached. In some instances the new entities may be fully leveraged by the “mother company” through the prime-brokerage infrastructure, offers Sébastien Jaouen, head of global sales and trading community services at London-based Orange Business Services—Trading Solutions. “We have recently witnessed new funds with amazing amounts of assets under management in their very first year,” says Jaouen. “Without a doubt, these funds will continue to work closely with the financial institutions that were once their hosts.”

Those who do hang out their shingle will find plenty of companionship in the form of leading-edge solutions providers, many of whom, like Orange, have spent considerable time preparing for the anticipated boom in prop-shop activity. Last month Options, a provider of infrastructure products to the finan-

24

Sébastien Jaouen, head of global sales and trading community services at London-based Orange Business Services—Trading Solutions. “We have recently witnessed new funds with amazing amounts of assets under management in their very first year,” says Jaouen. “Without a doubt, these funds will continue to work closely with the financial institutions that were once their hosts.” Photograph kindly supplied by Orange Business Services—Trading Solutions, May 2013.

cial community, announced the opening of a new location in derivatives-friendly Chicago in response to increased demand from the area’s proprietary trade facilities. Late last year Switzerland’s UBS unveiled its Quant

HQ business platform, which leverages the technology and infrastructure capabilities of the firm’s Prime Services and Direct Execution businesses in order to support the unique requirements of the quant trader.

Although the markets may experience some fragmentation as a result of Volcker, from his vantage point Jaouen doesn’t see liquidity being seriously impacted, particularly as the incoming breed of funds continue to innovate and make use of new arbitrage opportunities, asset classes, and instruments.

“The traditional cash equities or exchange-traded plain vanilla derivatives may see liquidity stagnate to some degree,” says Jaouen, “but in general we do not anticipate a significant drain on current liquidity.”

Post-Volcker, investors are likely to continue allocating into hedge funds, given the persistence of historically low fixed-income yields. Still, Kenneth J. Heinz, president of Hedge Fund Research, warns that in order to attract new investor capital, incoming fund managers must not only be able to demonstrate superior performance and an innovative strategy, but also “increased organisational efficiencies of competitive fees, transparent structures, sophisticated risk management and satisfaction of extensive institutional due diligence processes.” I

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M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

COMMODITIES

IMPACT OF REGULATION ON CLEARING OTC COMMODITY DERIVATIVES

As the first batch of European regulation on mandatory clearing and reporting of over-thecounter derivatives came into force in March, the lucrative OTC-commodities markets started shifting on-exchange, with the biggest transition occurring in the $1.2trn gas and power market.

Under the European Market and Infrastructure Regulation (EMIR) all over-the-counter derivatives trades will have to be reported by some point next year and most of the OTC trades will have to be cleared within the next three years. By Vanya Dragomanovich.

Regulatory changes boost on-exchange gas, power and iron ore trade HE NEW REGULATION presents little more than an added burden for banks which are already struggling to generate revenues from commodities, partially because of post-2008 regulation such as Basel III and limitations on proprietary trading, but also because commodities prices have stopped rising. However, regulation has been a boon for exchanges which are now jostling to capture a portion of the OTC commodities derivatives volumes by offering new futures contracts to replace OTC swaps and by providing clearing for OTC trades.

Regulatory changes are creating an opportunity for exchanges to challenge the dominance of a handful of brokers in the gas and power market such as GFI, ICAP, Tullet Prebon and Marex Spectron, who handle the majority of bilateral derivatives deals.

Figures published by the Bank for International Settlements show that the swaps industry was worth $639trn at the end of June 2012, compared with $25trn for futures trading; although the numbers don’t show the portion made up of commodities swaps and futures, they are a good indicator of the comparative scales of OTC and on exchange trade. Most of the OTC trades are also not cleared. “Over three quarters of Europe’s gas and power derivatives trading is still uncleared but under pending regulations bilateral OTC trading is likely to become expensive and unattractive,” says Justin Bozzino, executive director of energy products at CME Group.

For large hedgers such as electricity companies, oil refiners or miners, bilat-

T

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

Apart from the mandatory clearing of derivatives there is a whole host of other items coming down the regulatory pipeline from Brussels which will affect commodities trading; one of them is a potential decision to limit positions. Evans says the LME already has a similar position limits regime in place and it monitors the market on a regular basis to ensure there is no abuse. Photograph © Paul Fleet | Dreamstime.com, supplied May 2013.

eral OTC derivatives with flexible date structures used to be a better hedge option than futures, but regulation on mandatory clearing is designed to change the cost structure so that tailormade swaps become the most expensive option.

For instance, customised swaps that are not clearable will be subject to capital requirements under Basel III and will likely require ten-day value at risk calculations for initial margin. Standard swaps that are required to be cleared will carry a 2% capital risk weight with a five-day value-at-risk margin and broker costs. In comparison, futures will have the lowest margin requirements, clearing and capital costs.

In response, the Intercontinental Exchange transitioned some 800 energy swaps to futures in October and at the same time the CME began

allowing some 500 cleared energy swap contracts on its ClearPort platform to be executed as futures block trades— privately negotiated deals over a certain size reported to the exchange.

Both exchanges clear the trades through their respective clearing houses and both of them say that the proportion of swaps cleared through the exchanges has risen dramatically. In case of ICE 97% of all swap trades were cleared in 2012, says Claire Miller, an ICE spokeswoman. On CME’s ClearPort about 90% of trade is now transacted as futures, compared with just 10% before the shift in October.

Some exchanges have targeted a particular segment of the market such as in the case of Oslo-based Nasdaq OMX. OMX has made a bid for a bigger stake of the German OTC power market, estimated to be worth around €260bn, with the launch of German power futures and options this spring. German OTC power contracts are mostly handled by ICAP, GFI and Tullet Pebon and although the Leipzig-based European Energy Exchange has been offering power futures for the last 13 years it has never been able to challenge the brokers’ dominance in this market. With the new regulation, however, a significant portion of the derivatives trade will have to come on exchange.

Similarly, the CME has developed OTC-cleared forward contracts for natural gas delivered into two of four major European hubs: National Balancing Point (NBP) in the UK and the Dutch Title Transfer Facility (TTF), according to CME’s Bozzino.

25

COMMODITIES

IMPACT OF REGULATION ON CLEARING OTC COMMODITY DERIVATIVES

In iron ore, most of the trade outside of Asia is not transacted on exchanges and although the paper market at present accounts for only 10% of all the seaborne iron ore market (as iron ore is mostly shipped from big producers such as Australia and Brazil into large consuming regions like China), liquidity is rising fast and traders expect it to double in 2013.

The ICE launched its first iron-ore futures contract in February but may struggle to wrestle a share of the markets from the Singapore Exchange which vastly dominates in the iron ore swaps market and at present clears about 90% of the global iron ore swaps trade including trade in the US. The appeal of iron ore for Western investors is that it is seen as proxy for China’s economic growth—China is the single biggest importer of this raw material used in steel making. The iron-ore swaps trade is booming in in Asia and has tripled between 2010 and 2011.

In the coal market exchange-traded contracts also comprise only a very small percentage of the market compared with bilateral deals negotiated by brokers.

However, Trayport, which provides technology underpinning 85% of Europe’s trade in power, gas, coal and emissions, says that since ICE and CME moved their swaps to futures in October last year block futures activity is increasing.

Base metals are a step behind in terms of changes. The London Metal Exchange, by far the biggest player in base metals, is currently focusing on setting up a clearing house by some point in 2014—at present LME trades are routed to the London Clearing House for clearing. Simultaneously the exchange is looking at launching new futures contracts which will be closer in their date structure to what is offered over the counter. One type of future would offer a monthly average price rather than a price for just a specific day as is the case with current futures.

“Our priority is to have the clearing house ready for next year,” says Chris Evans, head of business development at the LME. “We are also looking to

26

create specifications for new contracts so that they are ready as soon as the clearing house is operational,”he adds.

Apart from the mandatory clearing of derivatives there is a whole host of other items coming down the regulatory pipeline from Brussels which will affect commodities trading; one of them is a potential decision to limit positions. Evans says the LME already has a similar position limits regime in place and it monitors the market on a regular basis to ensure there is no abuse. Position limits exist in some agricultural commodities and NYSE Liffe, which is the biggest exchange for grains and soft commodities in Europe, recently introduced a new limit on European feed wheat in London.

Another regulatory item on the agenda is the European financial transaction tax (FTT) which is expected to be introduced in 11 European countries by 2014. If agreed on, FTT would mean that each buy and sell trade will be charged one basis point.

A downtrend?

“Last year wasn’t very good for commodities and we could be in four to five years of a down trend. Although this year has started off better we still expect a slowdown in the second half,” says Robin Bhar, metals analyst at Société Générale.“If you look at something like the transaction tax, you need an environment that is good for trading to be able to charge the tax and this environment is not it,” he says.

Bhar notes that while commodities used to bring in returns of between 10% and 15%, this year those returns are likely to be roughly between 4% and 5%, mainly due to a slow-down in Chinese demand, particularly for metals.

When it comes to asset allocation commodities have to compete with equities, which are much stronger since the beginning of this year, and rising bond yields, giving asset managers little reason to allocate money to oil, gold, or metals.

Regulation is putting extra pressure on banks, which have already slimmed

down their commodities operations because of restrictions on proprietary trading, or in the case of mediumsized banks have closed commodities operations altogether, because Basel III requirements made them prohibitively expensive.

Last year was particularly weak for commodities returns and even big players like Goldman Sachs and JP Morgan had double-digit reductions in their commodities income. Some big end users such as utilities companies are worried about the implications of not being able to use OTC derivatives to hedge their exposure. In the US, Dodd-Frank provides for an end-user exemption, allowing such firms to continue transacting uncleared trades, as long as they are hedging genuine commercial risks. There is a similar exemption in place in European regulation. However, due to the wholesale shift towards futures among trading firms, some markets will dry up, as counterparties shut down their swaptrading desks and focus on exchange-traded products.

Dan Smith, head of market development at Trayport says all of this is a significant cost and burden to nonfinancial firms. “This includes not just energy companies but all corners of the economy that use derivatives, from airlines, to food and chemical companies.

Non-financial firms have argued they don't pose a systemic risk and should not be covered by EMIR,” he adds.

The upshot of the regulation is that though the market will become more transparent and better protected against future shocks, in the case of commodities it is also likely to decline.

Banks and brokers will pass on the cost of additional clearing, reporting and potentially transaction tax onto their clients, such as big utilities or oil companies, and these in turn will pass them on to retail users.

“Companies buy services to manage risk and these services will become more expensive. This does not obviate the need to buy those services,” says LME’s Evans. I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

TRADING POST

One repository to rule them all?

I OSCO AND THE CPSS recently published a paper setting out suggested approaches to facilitate access to trade repositories by authorities around the world. The primary purpose was to outline ways to manage confidentiality, scope of access, but then went on to explain the many interesting ways data from a trade repository (TR) could be used. One paragraph stuck out as an amazing admission of the likely outcome of the proliferation of TRs around the world: “With the current structure of TRs, no authority will be able to examine the entire global network of OTCD data, at a detailed level. In addition, it is likely that OTCD data will be held in multiple TRs, requiring some form of aggregation of data to get a comprehensive and accurate view of the global OTC derivatives market and activities.

Absent that, the financial stability objectives of the G20 in calling for TRs might not be achieved.“ To understand the scale of the reporting problem, we need an estimate of the total number of OTC contracts in existence. One data point is published by LCH.Clearnet, their SwapClear service contains just over 2.5m contracts representing over half the total world notional of OTC contracts ($361trn out of $632trn, as reported by the BIS). If we assume the

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

same ratio of trades to notionals, then simply doubling to 5m contracts would be the total, but the ratio may not hold true for other assets classes such as Credit, Equities and FX, so let’s be generous and assume the total number of contracts might be 10m.

Next we estimate the data required to represent each OTC contract, using FpML. A typical vanilla IRS in FpML takes up no more than 8,000 bytes of space; if we are want more customisation of cash flows the XML file might grow to 30,000 bytes. Given that a customised rate swap is one of the more verbose contracts, we can assume Credit, Equity and FX contracts will be that size or less. Therefore, using an estimate at the high end, we must then multiply 10m by 30,000 to arrive at an estimate of the total storage capacity for the entire world’s OTC derivative contracts of 300,000,000,000 bytes, that’s 300bn bytes. In simple terms that’s a 300 gigabyte drive, available on-line for around £30.

The IOSCO paper state ambitious goals on the possibilities of having all the data in one place, including beginning to understand the systemic risks within OTC portfolios, monitoring trading venues as the source of trades and any market abuse, calculation of capital requirements, calculation of margin requirements, monitoring settlements by currency

THE EVOLUTION OF TRADE REPOSITORIES

Anyone familiar with the progress of trade repositories all over the world will know well that there isn’t a plan by any organisation to aggregate all the data in the many trade repositories into one place. Without this aggregate data source, analysis of the true exposures and inter-relationships of OTC derivatives users will be impossible to analyse. A recent IOSCO paper posits the ambitious goal of having all the data in one place. Is that likely? Bill Hodgson, principal at consultancy The OTC Space, ponders the options.

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

and pre-planning bankruptcy of OTC users. It is quite a big list, and the question begged is: whether any regulator has the people and systems capabilities to achieve even a small part of that list?

In Europe trade repositories are also required to receive and store data on Exchange Traded Derivatives products, which according to the World Federation of Exchanges was around 20m transactions per day in the EMEA region in 2011. Each ETD contract will take a lot less data than an OTC rate swap, but this flow will suddenly make the build and operation of a TR a much bigger problem, rather than one 300Gb hard drive per year, maybe one per week or more, not including backups and standby locations.

Scott O’Malia, commissioner at the CFTC gave feedback in public on the progress they had made in loading and using data from the US Swap Data Repositories: “The Commission now receives data on thousands of swaps each day. So far, however, none of our computer programs load this data without crashing,” CFTC Commissioner Scott O’Malia, a Republican, said in a speech. And of course this is without full scale reporting being carried out, nor including ETD products which aren’t required to be reported under the Dodd Frank rules.

Without a change in direction for the approach to gathering and analysing this deluge of derivatives data, it seems unlikely regulators will provide themselves with even the slightest chance of making strategic decisions about how the exchange and OTC derivatives markets might behave in a stressed market, completely eliminating the whole point of having the data reported in the first place. I

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COUNTRY REPORT

PROJECT FINANCE IN QATAR: BANKS MAIN BENEFICIARIES

Qatar Railways announced four design and build contracts worth QR30bn ($8.24bn) for Phase-1 of the ‘Doha Metro Project’ in early June, capping a year of mega project financings. The scope of work for the RLN comprises the design and construction of 13km twin bored tunnel, including seven underground stations. The awards cover the first phase of Qatar’s ambitious metro rail development, including three initial lines (Red Line North (RLN), Red Line South (RLS), Green Line (GLN) and associated stopping stations. The contracts are the latest in a massive round of infrastructure investment which is designed to deepen Qatar’s infrastructure as it takes its place in the hierarchy of modern day economies. But this entire infrastructure will come to little if the country cannot deepen its local capital and investment markets. How soon can that be achieved?

BANKING ON PROJECTS B ANKING HAS BEEN the main beneficiary of the funding requirements by the GCC in general and Qatar in particular. Credit facilities increased by 26% in 2012, pushing up banking sector assets by 18%. The public sector has been the key contributor to credit growth in Qatar. Credit facilities to the public sector increased by an average of 43% over the past three years, which can mainly be attributed to bank financed public spending on infrastructure projects. The real estate and construction sector was the second largest recipient of credit facilities in Qatar and grew by 10.5% in 2012 as growth in those segments picked up last year.

While bank financing has traditionally been the preferred source of funding for GCC government and institutional borrowers, they have in recent years begun to diversify their funding sources, through access to the capital/bond market. In 2012, a total of 919 bonds were issued in the GCC amounting to $111bn, according to data from Bloomberg. This is in comparison to the $107bn in credit facilities that were granted by GCC banks. Even as bonds have emerged as an alternative, bank financing will remain as the primary source of funding for institutional and corporate borrowers, according to QNB Group. This has limited opportunities for institutional fund providers looking for high

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quality assets in the region that can deliver reliable returns.

The stakes remain high: some $220bn of infrastructure projects are in train under the country’s Vision 2030, with much of the government led spending funded by oil and gas (mainly gas) exports, which in 2012 accounted for just over 70% of total state income.

It leaves limited opportunities for private sector investors wanting to secure participation, particularly in big ticket utilities and transportation projects (which carry follow on revenue generation). Another area of interest is the government’s spending on preparations for the 2022 FIFA World Cup, which will involve the construction (and in some cases dismantling, export and reconstruction) of at least 12 stadia, plus 90,000 hotel rooms and associated tourism infrastructure to accommodate at least 400,000 followers that are expected to visit the country during the tournament.

That’s not thinking laterally, explains Shashank Srivastava, chief executive officer, Qatar Financial Centre Authority (QFC), who spoke at a conference in the UAE on the financing requirements for projects in Qatar in the early spring, noted. “The contribution of the financial industry is an important part of the National Vision for 2030 [see FTSE GM passim]. Financial services help diversification away from excessive dependence on hydrocarbons. Qatar has already made long strides. Finance,

insurance and reinsure now account for 10% of the country's GDP.” This is a benchmark year in the country’s plans to update its international credit profile and its infrastructure. The government recently announced plans to boost spending by some 18% to QAR210.6bn ($57.8bn) in the 2013/14 fiscal year. The country is running a budget plan based on QAR218.1bn in state revenues over the period, which also includes a projected surplus of QAR7.4bn, though this is down from the QAR27.7bn surplus for the just concluded 2012/13 fiscal year.

These latest figures budget are based on an assumed oil price of $65 per barrel. Qatar is now seeking to raise its credit rating to AAA, the country is currently rated AA-. Add to this the expectation that the current project boom will continue for another four years before the government steps down the pace of spending, which it expects to do in the 2017/2018 period.

Aside from some small scale private sector real estate developments, which will largely be confined to local operators, overseas investors will in large part have to watch from the sidelines.

However it is not all bad. Qatar’s central bank has been consistent in offering foreign investors the opportunity to participate in its issue of some QAR3bn of conventional bonds and QAR1bn of sukuk in the local currency every quarter; though in sovereign borrowing terms these are miniscule amounts. I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

REAL ESTATE

MIDDLE EAST REAL ESTATE PROJECTS REIGNITE

There is an unmistakable air of bullishness about the Middle Eastern real estate sector once again. Dubai has announced a flurry of projects reminiscent of the heady days of the mid-2000s including Mohammed bin Rashid City, which will include more than 100 hotels, a theme park and the world’s largest shopping mall, as well as a new artificial island valued at $1.6bn in construction costs alone. The announcements come amid a double digit increase in passenger traffic through the emirate’s airport to more than 58m, while 19,000 new hotel rooms are expected to be added in the next few years. Neighbour Abu Dhabi has a similarly grandiose vision, while Qatar has become increasingly vocal about its plans as hosting the FIFA World Cup bolsters its infrastructure requirements. Mark Faithfull reports.

NEW FUNDING WARCHESTS FUEL NEW PROJECT ROUNDS HE INEVITABLE QUESTION is about finance. Qatar and Abu Dhabi have funding war-chests through their enormous energy reserves, Dubai has boomed and bust once already. Any return to the heady days is also a salient reminder of those very recent bad days. According to Standard Chartered, Dubai has $48bn in loans and bonds maturing between 2014 and 2016, much of it related to borrowing by government-owned entities during those buoyant times, although some of this debt may be restructured. In addition, ratings agency Moody’s in December downgraded the ratings of three Dubai banks including Emirates NBD, the emirate’s largest lender, citing concerns over problem loans.

However, Boston Consulting Group estimates that lenders in the Middle East saw a 6.9% increase in average revenues and an 8.1% rise in average profits in 2012, outpacing growth in international markets. Lenders in Qatar saw the biggest growth in revenues at 12%, while banks in the rest of the Gulf reported single growth digit rates.

Banks in the UAE, Kuwait and Bahrain achieved growth revenue of 5% or below, according to BCG. Bahrain’s sovereign wealth fund, Mumtalakat, is considering investing in some of the country’s stalled property developments to restart them.

Chief executive officer Mahmood Hashim Al Kooheji says the company’s real estate arm, Edamah, would invest

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Sowwah Central: This central Abu Dhabi scheme will be regionally funded and will open in 2017. Photograph kindly provided by Gulf Related/Mark Faithfull, May 2012.

in the part-finished projects if they were commercially viable. At least four significant developments—Bahrain Bay, Marina West, Marina Reef and the Villamar residential complex—have stalled since the onset of the financial crisis, which saw the average value of real estate in the country plummet.

However, much or of the infrastructure has been completed as well as some phases, but many of the commercial aspects such as hotels and restaurants are yet to be finished.

Two major retail-led schemes are being evaluated in Dubai as the retail development sector shows signs of reigniting. Developer Nakheel says that it is “evaluating finance options” in a bid to raise the nearly $900m needed to fund its latest Palm Jumeirah retail developments. The developer, which

wrote down the value of its real estate by $21bn from late 2008 through to mid-2010, got an $8.6bn bailout from the Dubai government in 2009 to help avoid default. However, the government-owned developer reported 2012 profits up 57% to $549m and revenue for the same period up 91% to $2.1bn.

The Nakheel Mall project will be built on the beachfront at the bottom of the trunk of the Palm Jumeirah at a cost of $700m and stretches over a land area of 100,000 sq m. Sheikh Mohammed also ordered the commencement of The Pointe project, overlooking the Jumeirah Beach hotel and the Atlantis resort at a cost of $220m. The Pointe will include shops, a marina and a public walk on the tip of the palmshaped island.

Nakheel’s plans for 2013 also include the handover of around 3,000 residential units to customers, investment of $1.8bn in new projects to be completed over a three year period, expansion of Ibn Battuta Mall and continued enhancement of existing communities with local facilities including shopping centres and parks.

Visitor figures to Dubai remain staggering. Tourist arrivals grew 10% and hotel revenues 19% last year as 10 million tourists visited and stayed in Dubai. Passenger traffic through Dubai International Airport increased 13.7% and by 2015 the airport is projected to handle 75m passengers. Those visitors come from just about everywhere, with

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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REAL ESTATE

MIDDLE EAST REAL ESTATE PROJECTS REIGNITE

ISLAMIC FINANCE AND THE WAY FORWARD

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ith the next wave of real estate transactions to be regionally financed, inter-bank loans for short-term liquidity using commodity murabaha, an Islamic Finance-compliant cost-plus-profit arrangement have come under scrutiny.

Typically this is provided when a bank agrees to purchase merchandise for another bank, which pledges to buy it at an agreed mark-up. To date, the merchandise usually has been commodities traded through the London Metal Exchange (LME), although commodity murabaha has faced increasing opposition from some Islamic scholars because they are not sufficiently based on “real” economic activity.

The Dubai Multi Commodities Centre (DMCC) recently offered an alternative by launching an Islamic trading

inter-regional tourism, especially from Saudi Arabia, vital to the UAE economy, as are visitors from Europe, Russia, China and the US. Whether that will be enough to entice international money to invest in more retail is another question.

The US half of the joint venture at Abu Dhabi’s Sowwah Central, Gulf Related, says it expects its project to be regionally financed—and that may well prove the ongoing model for 2013 and 2014 at least.

That can also be seen in Egypt, where Dubai developer Majid Al Futtaim (MAF) Properties’ finally began construction of Mall of Egypt in February. Despite political and social unrest, MAF Properties has secured $450m worth of financing to fund Mall of Egypt from a consortium of banks led

by National Bank of Egypt and Banque Misr and Peter Walichnowski, chief executive officer of Majid Al Futtaim Properties, affirms: “Egypt’s strong economic fundamentals, such as its young and growing population, make it an attractive growth market. We are committed to building on our success in Egypt and investing in the country’s long-term economic growth.”

Similarly, Gulf Related has confirmed that its vision for a major urban mall in Abu Dhabi—a project larger than any

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platform. This tracks the ownership of commodities in a way which gives assurance that an actual exchange of commodities is occurring. Ahmed Bin Sulayem, executive chairman, DMCC, says: “The growth of the global Islamic finance industry, combined with Dubai's vision for the emirate to become a global hub for Islamic finance and economy, has highlighted the need for innovative and relevant sharia-compliant financial infrastructure.”

The International Islamic Financial Market (IIFM) is developing a standardised agreement for Islamic contracts such as wakala, where one party acts as an agent for another to manage a pool of assets. The IIFM has also developed standards for Islamic hedging and it is developing another for tradable sukuk (Islamic bonds) in liquidity management.

New plans for Dubai include Nakheel’s extension of the Palm Jumeirah. Photograph kindly provided by Nakheel/Mark Faithfull, May 2012.

European urban shopping centre—is likely to be regionally funded. Kenneth Himmel, co-managing partner of Gulf Related and president and CEO of Related Urban, was on a fund raising round within the Middle East earlier this year for the circa $1bn for the larger project. Gulf Related and Mubadala Real Estate joint funded the initial Sowwah Galleria project.

The scheme will open in 2017 alongside the initial smaller luxury mall, which will open this year in the UAE capital. Sowwah Central will be a 13ha retail-led mixed use development project in Abu Dhabi’s new central business district on Al Maryah Island.

When open in spring 2017, Sowwah Central will be connected to the 1.5m sq m of adjacent, completed and

occupied properties on Al Maryah Island, including the new Abu Dhabi Stock Exchange building and the new Cleveland clinic. The Elkus Manfredi-designed development follows the acquisition by Gulf Related of the Sowwah Central site from Mubadala Real.

Indeed, Abu Dhabi remains in the throws of a major master plan exercise, which will see the emirate attempt to compete with noisy neighbour Dubai and while a number of retail centres are planned to add to the current provision, Himmel is insistent that Sowwah Central’s position as a deliverable project in an established location would give it a major advantage over other prospective projects.

“This site has three hotels, office towers and a new health centre, all of which are either complete or will be completed well ahead of 2017,” he says.

While some developers are hoping to attract international funding for the next phase of growth, so fresh from the collapse in real estate values in Dubai and Bahrain in particular are we that it seems far more likely that the next wave of finance will be domestic, as overseas funds look for further signs of stability—and of how debt repayment and reorganisation is actually achieved—before committing. I

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ĂŶĂůLJƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

REAL ESTATE

ISTANBUL IFC: IMPACT ON REAL ESTATE SEGMENT

Istanbul is no stranger to grandiose schemes and far from all of them have yet seen the light of day. But by 2016 the mega-city should be inaugurating the Istanbul International Financial Centre which will allow it to sit on the same stage as the globe’s other powerhouse financial exchanges. The construction is part of the government’s plans to cement the importance of the eastwest bridgehead city, leveraging its geography and robust economy to take a pivotal position within the financial world.

The ailing health of the EU market to which Turkey so wants to be a part only underlines that what once looked hugely ambitious now seems very real, says Mark Faithfull.

Istanbul financial centre takes shape HILE IT MAY be little more than a dusty stretch of government land in the modern suburb of Atasehir, situated on the Asian side of Istanbul, within three years Istanbul International Financial Centre should be a patchwork of gleaming high-rise office buildings forming a new financial hub and, as Environment and Urbanisation Minister Erdogan Bayraktar said last year, the scheme will enable Istanbul to “assume its historical role as a global centre of commerce.”

A confluence of drivers has already propelled Istanbul to centre stage.

Straddling Europe and Asia, with 13m people within its borders, the city’s financial industry has grown along with the world’s 16th-largest economy. The geographical significance of its legacy east-meets-west location have been reaffirmed as the two halves of the world come together again, while Turkey’s thriving economy has put its economic performance in sharp contrast to the rest of Europe.

Currently, the heart of Turkey’s financial industry is in Istanbul’s Levent and Maslak districts, overlooking the Bosphorus from an elevated position on the city’s European side. Hit by its own banking scandals a decade ago, reforms put in place as a consequence have seemed prescient indeed and

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mean that the country’s relatively strong banks have shielded it from some of the economic instability plaguing Europe. According to the banking agency, Turkish banks have on average a capital-to-risk-assets ratio of 17%, more than double the legally required 8%. The assets of all banks licensed in Turkey grew six-fold to 1.27trn liras ($710bn) from 2002 to 2012, according to Turkey’s Banking Regulation and Supervision Agency.

The Borsa Istanbul, despite being just a quarter-of-a-century old, has become one of the top emerging markets exchanges in the world. Valued at TRY120bn (about $58bn), the Istanbul bourse, while tiny compared with the New York and London stock exchanges, is slightly bigger than Frankfurt’s ($51bn), larger than the stock markets of Greece and Egypt combined and nearly four times the size of Dubai’s. It expanded 26% last year and has more than doubled in size since the start of 2009. Moreover, strong finances have encouraged greater foreign direct investment in the country’s real estate assets.

The prosperity that comes with that kind of growth is transforming Istanbul. New construction is evident across the city, although real estate advisor Togrul Gonden, Cushman & Wakefield’s managing partner for

Turkey, notes: “There is hardly any high quality office supply outside Istanbul, apart from Ankara. Quality office stock could double over the next three to four years, mainly provided by domestic investors.”

He believes that demand for office stock will continue, despite the pipeline surge from the IFC.“There was a lot of take-up in 2012 as more and more international companies start operating out of Turkey,” he reflects.

First among the notable major projects due to inaugurate is the Zorlu Center, which will open in the third quarter of 2013, with a Performing Arts Centre, premium luxury hotel Raffles, plus a shopping mall and modern offices. Mehmet Even, the executive vice president of Zorlu Property Group, says the scheme will become an“international attraction centre with the best view of Bosporus and its 72,000 sq m of green areas” and has pledged the project to high levels of environmental sustainability.

Other parts of the real estate sector are more mature. To date, Istanbul has dominated the retail development of the country but this may be ripe for change. As Gonden points out: “The demographics in Turkey remain very strong compared with the rest of Europe and despite the influence of Istanbul, it now has 60% of the retail in Turkey but represents 40% of the country’s GDP. So there is scope for further growth outside Istanbul, especially as retail is so under-developed in many of the regional cities.”

Yet there is no doubt that the scale, glamour and opportunities offered up

by Istanbul are attracting more and more Turkish to the city to live and work. Research by global agent Colliers revealed that the Istanbul residential market is currently seeing a much higher quality of new housing projects, matched by a similar uptick in prices. “For high income groups the only places to be are in the city centre locations,” says Erdinc Varlibas, chief executive of developer Varygap. His company is undertaking a €768m

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Various views of Istanbul’s nascent financial centre development on the Asian side of the city. Building has already begun. The financial centre proper will start to take shape in 2014 when key government institutions, such as the central bank, moves its operations to Istanbul. Photograph kindly provided by Mark Faithful, May 2013.

mixed-use development in the Atasehir district of Istanbul, and he describes Istanbul as the “London of the Arab World”.

This new affluence is also what attracted high profile US real estate developer Donald Trump to develop his company’s first residential and office project in Europe. The $400m Trump Towers comprises two 150mtall skyscrapers in the Mecideiyekov district of the city and opened last April, providing 204 luxury apartments, plus a mixed retail and office scheme. He is thought to be looking at further opportunities with his joint venture partners.

Infrastructure investment is also coming into the city and in March last year Aeroports de Paris bought a controlling 38% stake in Turkish airport operator TAV Havalimanlari Holding for $874m. TAV runs Istanbul’s main Ataturk International Airport, the world’s 30th busiest, as well as terminals in Latvia, Macedonia, Tunisia and Saudi Arabia.

But the IFC is the poster child of this revolution and an instrument in Prime Minister Recep Tayyip Erdogan’s campaign to exploit the political and trade links of the city. Three years after he announced his plans for the IFC, Turkey’s political and business leaders are now lined up behind the $2.6bn project, which the government says will employ 50,000 people and provide a new home for the Istanbul Stock Exchange.

The scheme has already been substantially backed by government-

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

affiliated bodies. Government banks Turkiye Halk Bankasi and Turkiye Vakiflar Bankasi have purchased land on the site and other public financial institutions slated to follow include the Banking Regulation and Supervision Agency, the Capital Markets Board and the Banks Association of Turkey.

Citigroup, UBS, the Institute of International Finance and The CityUK, which represents the UK financial services industry, are advising the Turkish government on the project.

The Istanbul Finance Centre will be built on a 3.2m sq m footplate and the centre will also include a 3,000 capacity congress and exhibition centre, a library, a hotel, schools, a mosque, nursery, medical centre, fire station and police headquarters. With a residential population of 11,000, the I˙FM will become a living part of the city and is anticipated to become a 24 hour hub. The finance centre will also consist of smart buildings that are able to produce their own electricity, are environmentally sensitive and have low carbon emissions.

Importantly for the Prime Minister, the IFC is a tangible and, it would appear, deliverable scheme amid a raft of other megaprojects which are planned but which have not yet been completed. The much-mooted third Bosporus bridge, which is estimated to cost $2.5bn, remains in planning and is desperately needed to ease traffic congestion across the river. A third, $6.4bn airport is envisaged and the tender will be held in early May, while the Kanal Istanbul project, which will connect the

Black Sea and Marmara Sea on the European side, is intended to free the river from cargo ships and make it a playground for the city’s residents and tourists. Finally, there is the countrywide urban transformation project, which is intended to improve the quality of residential buildings in the wake of devastating earthquakes and which potentially involves 70% of the 1.6m buildings in Istanbul. Indeed, urban transformation does not only include earthquake-prone zones, but also covers historical areas that must be preserved such as Sulukule, Fener-Balat and Tarlaba¸sı.

There are yet further mega-projects in the offing: Galataport, which will cover 1,200m of coastline including Istanbul Modern; Haydarpa¸sa Port, which covers the historical Haydarpa¸sa railway station; and Yassıada, an island located in the Marmara Sea, which could be transformed into a congress centre, plus the giant mosque planned to be built on Çamlıca Hill.

For Prime Minister Recep Tayyip Erdogan, the credibility of many of these long-term plans is indelibly linked with seeing the IFC through to fruition. Eurozone-unencumbered, with a youthful population and sustained economic growth, Istanbul’s pretentions seem suddenly very achievable and as foreign investment and overseas offices flood in, the global importance of the city continues to rise. A financial hub will be vital to underpinning that proposition and delivering the IFC will be what the city banks on.I

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BANK REPORT

DEFENDING AGAINST DDoS

A string of distributeddenial-of-service (DDoS) attacks continues to stymie the financial-services sector, spurring calls for tougher defensive measures and, in the wake of the Boston Marathon bombings, renewing debate over the distinction between ordinary cyber crime and a more onerous brand of online terrorism.

Dave Simons reports from Boston.

portals, initially focusing on top-tier banks but subsequently hitting regionals and credit unions as well. According to the group’s Pastebin postings, the hacking campaign is in retaliation for a YouTube video excerpt from the film Innocence of Muslims, which the group deems “offensive.”

To date there have been no significant reports of loss or fraud linked to the Cyber Fighters activity, notes Leesburg, VA-based Financial Services Information Sharing and Analysis Center (FS-ISAC), a collaborative forum covering security issues impacting the financial-services sector.

Though DDoS response times have improved, the inability for banks to completely vanquish the enemy has many in the business on edge, as recent patterns suggest a more sustained and aggressive level of DDoS activity in the making.

Photograph © Olivér Svéd | Dreamstime.com, supplied May 2013

Mega data

CANCELLING THE CYBER-FIGHTERS ECHNOLOGY HAS LONG been the salvation of the financial world, allowing institutions to wring every last drop of efficiency out of their operating systems. Unfortunately, having the ability to move data faster isn’t the exclusive domain of the upright, and in recent times, those with malicious intent have increasingly used high-tech weaponry to bring webbased services to a standstill.

Over the past year, one of the leading cyber culprits has been the group Izz ad-Din al-Qassam Cyber Fighters

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(named for the anti-Zionist Muslim preacher of the 1930s), responsible for a string of distributed-denial-of-service (DDoS) attacks against numerous domestic banking and financial-services firms, among them American Express, Capital One, Bank of America, TD Bank, Wells Fargo and others.

Using a rapidly expanding chain of bots (which, by some estimates, has nearly tripled in size since the start of the year), Izz ad-Din al-Qassam has succeeded in temporarily snarling traffic to and from targeted firms’ web

While cyber-criminals have traditionally targeted firms for financial gain, Michael DuBose, managing director and cyber investigations practice leader for Washington, DC-based Kroll Advisory Solutions, says that the current campaign is largely motivated by political belief, rather than profit.“It reflects the growing trend of ‘hacktivism’— computer crime masquerading as civil disobedience or political demonstration,” says DuBose. “Because the spectrum of possible attack motives has grown immeasurably, financial service firms are now more at risk.”

Mike Plantinga, chief investment officer of Toronto-based CIBC Mellon, says that the attacks “have been more blatant and sophisticated than any we’ve seen in the past.”Unlike previous incidents which often coincided with anniversaries or market events, these attacks have been unpredictable, and nearly seamless. “As a result, participants must be on a perpetual state of high alert,” says Plantinga.

Moreover, the volume of data hurled by hackers has risen at an alarming clip.

Until recently, DDoS interruptions con-

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sumed roughly five gigabits (gbps) per second of the targeted entity’s bandwidth. However, that figure has since risen tenfold to around 50 gbps of data “noise,” rendering standard protection mechanisms ineffective. (In March, data volume associated with a DDoS attack on anti-spam provider Spamhaus reached an unprecedented 300gbps.)

Avivah Litan, vice president and distinguished analyst at Gartner Inc., the Stamford, Conn.-based IT research and advisory firm, says these high-bandwidth DDoS attacks are “the new norm” and will likely continue to grow in sophistication and effectiveness.“As a form of political activism, this type of hacking is clearly on the rise,” says DuBose. “And because the anonymity of the Internet insulates accountability for such attacks, they are virtually assured to continue.”

Attackers have been able to exponentially expand their bandwidth by taking advantage of improperly configured or “open”domain-name service (DNS) resolvers, say experts like Matthew Prince, chief executive officer of CloudFlare, the cloud-based web performance and security firm. Prince calls these open resolvers “the scourge of the Internet,”adding that the attacks won’t let up until providers “make a concerted effort to close them.”

In fact, by overwhelming sites with traffic, attackers may actually be creating a ruse designed to divert attention from the firm’s application layer, thereby exposing vulnerabilities that may be directly targeted in a follow-on attack. According to Gartner, nearly one-quarter of DDoS attacks are designed to disable the targeted firm’s system applications.

Defining the foe Though Izz ad-Din al-Qassam may be among the most notorious of hackivist groups, in the estimation of the Treasury Department’s Office of the Comptroller of the Currency (OCC) there are countless other perpetrators at work, each with a different set of objectives. Not all are tied to political

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

causes; in some instances,“fraudsters” and other financially motivated individuals may be using hacktivist activity as a cover to simultaneously gain access to customer accounts via automated clearing house (ACH) and wire transfers.

Meanwhile, cyber criminals have been able to plow through socialmedia security nets with surprising ease, wreaking almost instantaneous havoc in the process. A week after the Boston Marathon bombings, hackers calling themselves the Syrian Electronic Army were able to gain access to Associated Press Twitter accounts and post an erroneous headline claiming that a pair of explosions at the White House had injured President Obama. The fake tweet was quickly rebuffed, but not before the Dow fell over 100 points in under two minutes.

The ability for the media to act as an unwitting accomplice is obviously not lost on these rogue elements, says Alphonse Pascual, senior analyst, security risk and fraud at Pleasant, California-based Javelin Strategy & Research. Media-fueled speculation and negative sentiment over bank security breaches could conceivably lead to “a degree of fear not seen in more than 80 years,” suggests Pascual.

The surreptitious nature of the attacks, as well as the number of perpetrators involved, has made it more challenging to formulate viable defensive measures. In its third-quarter survey, Cambridge, Mass-based content-delivery network provider Akamai found that 41% of DDoS traffic originated in China (the US ranked a distant second at 10%, according to the report). However, the unauthorised use of Chinese servers may not necessarily be the work of those residing on the mainland. “For example, an individual in the US may be launching attacks from compromised systems in China,” said the report.

Nevertheless, a study issued in February by Alexandria, VA-based cyber security firm Mandiant blamed a single, possibly Chinese government-backed

Michael DuBose, managing director and cyber investigations practice leader for Washington, District of Columbia-based Kroll Advisory Solutions, says that the current campaign is largely motivated by political belief, rather than profit. “It reflects the growing trend of ‘hacktivism’; computer crime masquerading as civil disobedience or political demonstration,” says DuBose. “Because the spectrum of possible attack motives has grown immeasurably, financial service firms are now more at risk,” he adds. Photograph kindly supplied by Kroll Associates, May 2013.

source known as APT1 for a long list of cyber-espionage transgressions occurring over a seven-year period, using IP addresses registered in Shanghai. Mandiant’s findings coincided with the signing of the Cybersecurity Executive Order by President Obama, which seeks to create a “Cybersecurity Framework”, comprising numerous methodologies and standards with the goal of reducing the threat of cyber attacks. The executive order stopped short of the more sweeping and, according to some, invasive provisions of the Cyber Intelligence Sharing and Protection Act (CISPA), which was approved by the House of Representatives but failed to gain traction in the US Senate.

Particularly in the wake of the Boston Marathon bombings, debate has increasingly focused on whether the attacks should be treated as run-ofthe-mill cyber crimes, or a more onerous brand of online terrorist activity. Some, like Republican Mike McCaul (Texas), co-sponsor of CISPA, feel that “terror” is an apt description.

Speaking just days after the Boston incident, McCaul said that “in the case of Boston, they were real bombs; in this case, they’re digital bombs…and these bombs are on their way.”

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BANK REPORT

DEFENDING AGAINST DDoS

According to DuBose, there is ample evidence to suggest that DDoS attacks and other types of hacking “are being used by terrorist groups as a form of political activism to threaten, intimidate, and sometimes completely destroy data and technology assets.” While a DDoS attack may lack the violence of a bomb, says DuBose, “it can cause destruction no less significant to the victimised corporation or government.”

Others, however, prefer to strike a more cautious tone. “Distinction and nuance are critical,”insists Dan Kaplan, executive editor of SC Magazine. Those who freely and indiscriminately attach the T word to these activities are guilty of “textbook demagoguery,” says Kaplan. “At its best, it will drive up levels of fear. At its worst, it will be used as justification to pass overly restrictive and invasive laws that govern use of the Internet, while permitting increased surveillance and the seizure of personal information.”

Defence mechanisms The growing sophistication of the attacks has led to the creation and growth of an information security “arms race,”featuring a rapidly maturing array of security services providers, products and solutions specifically focused on managing and protecting against DDoS. “In the past it was enough to have a firewall and a switch in place—today more robust protection is required,”says Plantinga. While authentication and other technical defenses are critical, of equal importance is raising information security awareness among the broader employee base. “At CIBC Mellon, we constantly monitor and assess our IT environment for potential vulnerabilities and threats,” says Plantinga, “and we also receive security information from our peers and the broader financial services industry, as well as our clients, law enforcement and a variety of public and private sources.”

Gartner advocates cooperation with industry associations to share intelligence that can be acted upon

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collectively and quickly, as well as enterprise investments in fraud prevention technology and the strengthening of organisational processes. Additionally, modeling may be used to distinguish “good” from “bad” traffic across networks and applications, says Gartner’s Litan, so that aberrational behavior can be easily spotted early on.

For its part, FS-ISAC has sought to provide best practices to its members in order to mitigate risk resulting from DDoS events. “Financial institutions should ensure they have reviewed their DDoS detection and mitigation plans, as well as recent threat intelligence shared by and through the FS-ISAC.” Targeted institutions have been working together with members of the security community and with government partners to help defend against the attacks. Information pertaining to tactics and techniques has been shared among these parties and with the broader FS-ISAC membership.

Still, Robert Hansen (CISSP) director of product management for WhiteHat Security, the Santa Clara, Calif.-based security services provider, says that companies need to be much better prepared in advance of attacks like DDoS. “The last thing you want to do in the midst of a crisis is try to figure out who is running the infrastructure that is under attack, or be formulating a last minute crisis management newsletter from scratch,” says Hansen, who designed a “DDoS Runbook” incident response plan to help firms detect problems associated with database/application servers, firewalls and other integral web functions should an attack occur.

To help gain ground in the battle for bandwidth, institutions would be well served to pool their collective resources in order to ensure adequate network capacity, says Pascual. Additionally, “network operators must be involved in the effort to identify infected servers and to subsequently stop the malicious traffic its source. And while intelligence support is a good start, the Federal

Mike Plantinga, chief investment officer of Toronto-based CIBC Mellon, says that the attacks “have been more blatant and sophisticated than any we’ve seen in the past.”

Unlike previous incidents which often coincided with anniversaries or market events, these attacks have been unpredictable, and nearly seamless. “As a result, participants must be on a perpetual state of high alert,” he says. Photograph kindly supplied by CIBC Mellon, May 2013.

government must identify those responsible and cripple their ability to continue this campaign.”

Yet another way to mitigate potential DDoS damage is to redirect or “offload” incoming traffic before it can overwhelm network capacity, says DuBose.

“This requires real-time monitoring technology that is different from using traditional firewalls and intrusion prevention systems. There are vendors who offer such capability, however even some of those could have difficulty handling 60gpbs of traffic from multiple organisations within the same industry sector, simultaneously.”Security providers can also help institutions fend off DDoS attacks in part by identifying and plugging application vulnerabilities, adds DuBose.

In the end, motivation, as well as region of origin, are largely irrelevant, concurs Plantinga. “Hacktivists with extreme political views, or those seeking illegal financial gain, all have the same goal: to gain unauthorised access to these accounts. Therefore our focus is on securing our systems and environment against intrusions of any kind, in order to protect information on behalf of our businesses and our clients. Hostile attacks will no doubt become more sophisticated and more intense, but we are likewise committed to continuous improvement.” I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

DEBT REPORT

Market consolidation stalks fixed income DCM OTING THAT THE market share of the top five banks in the fixed-income business has risen from 36% to 46% since 2007 in anticipation of the new rules, the Deutsche Bank report says their slice of the market is likely to grow by almost as much again over the next three as the implementation of further measures would drain $17bn of revenues—just under 10% of the present aggregate total—from banks’ fixedincome operations (as much of the activity switched to exchanges). “We think the next wave of regulation on OTC derivatives and clearing will take the top five concentration ratio over 55%,” the report concludes.

Furthermore, there are additional factors that mean revenue losses are likely to fall disproportionately heavily on the European fixed-income markets.

These include the different regional rates mix, which makes European rates businesses considerably more swapsheavy than their US counterparts, accounting changes (IFRS 9), and the possible impact of the EU’s proposed Financial Transaction Tax (FTT).

These developments suggest that European investment banks will continue to lose market share to their US rivals, and the Deutsche research team suggested that the fixed-income operations of any banks with a market share of less than 6% would be vulnerable.

Although the analysts did not comment on their own bank’s position, the clear implication was that in

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Europe it would only be Deutsche and Barclays that were offering clients a full fixed-income service in Europe in a few years’ time.

In an assessment of all the large global investment banks in the wake of their reported first-quarter earnings, senior JP Morgan banking analyst Kian Abouhossein recently picked out Deutsche was “an investment-banking winner in the long term”. He concluded that the bank’s strong FICC franchise meant it was “the best-positioned to benefit from a retrenchment of Tier II European investment banks”.

Although Deutsche is committed to slash a further €3.9bn of costs from its investment-banking business by 2014, improving the efficiency of the fixedincome operation remains a priority of the restructuring. This was evident from the bank’s announcement in November that it was setting up a new division for fixed-income and currencies trading under joint co-heads Zar Amrolia and Wayne Felson, who are respectively the bank’s global head of foreign exchange and markets electronic trading and global head of rates and flow credit trading.

Like other global investment banks, Deutsche Bank is not without its challenges as it approaches the midway point in the second quarter of 2013.

Continuing investigations by German and US regulators into allegations that the bank concealed losses on derivative positions during the financial crisis and threatened legal action by the author-

FIXED INCOME DEBT CAPITAL MARKETS ISSUANCE AT BAY

A raft of impending new banking regulation (particularly in Europe) will inexorably lead to further consolidation in the fixed income debt capital markets business as several smaller players either reduce their commitments to such operations or get out of them altogether. A report from Deutsche Bank in April highlights how tougher capital requirements under Basel III and the Dodd-Frank Act in the US and other measures will squeeze the revenues of bond desks. What now for the segment?

Andrew Cavenagh reports.

ities in Los Angeles over property repossessions forced the bank in March to raise its litigation reserves by a third to €2.4bn and cut its previously stated pre-tax profit for 2012 by €600m.

The benchmark annual industry study from the research-based consulting firm Greenwich Associates in January confirmed that the bank retained top position in the global fixed income market last year for the third consecutive year, with a 10.7% overall market share. Nearly two-thirds of the bond investors that the firm polled named Deutsche as an active counterparty. Given such status, it is only natural that Deutsche remains a first port of call for sovereign issuers around the world. While it may not yet have put its name to deals this year of quite the same magnitude as some of those on which it acted as lead manager in 2012 (notably the €35.5bn issue that the European Financial Stability Facility launched as part of the €206bn debt-exchange and restructuring package for Greece) it has nevertheless already racked up notable successes.

The $3bn issue for the Republic of Indonesia that closed in the second half of April, on which Deutsche was joint lead with JP Morgan and Standard Chartered, was not only the largest sovereign deal out of the region so far in 2013 but also the most tightly priced debt that the Indonesian government had issued up to this point in the format. The $1.5bn ten-year tranche of the issue paid a coupon of 3.375% and was re-offered at a 98.953% discount to deliver a yield of 3.5%; a highly respectable cost of funding for a credit that has minimum investment-grade ratings from Moody’s and Fitch and is rated one notch below by Standard & Poor’s.

The deal followed a $1.5bn bond for the Croatian government in March, on which Deutsche acted as joint lead with Bank of America Merrill Lynch, Goldman Sachs, and JP Morgan, which priced to offer a final yield of 5.625%, appreciably inside the initial guidance of 5.875%. I

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DEBT REPORT

WILL YTD RETURNS BE SUSTAINED THROUGH 2013?

Looking forward there will be two key drivers to fixed income returns for the balance of the year. Firstly will the US “soft patch” prove temporary? We think so and if we are correct then worries will accelerate as the year progresses on the timing of the Fed’s reduction of asset purchases. Credit spreads should hold in but year-to-date gains from duration are likely to be given back. Secondly will the recession in the eurozone periphery countries come to an end later this year? We are seeing some evidence that the bottom is closer, although it is more likely to be in Q4 rather than Q3 and any subsequent growth will be anaemic. If positive growth is re-established in the eurozone, this is likely to be supportive for European risk assets although credit gains may be offset by losses from core duration exposures. Stephen Zinser, chief executive officer & co-chief investment officer, ECM Asset Management states his case.

Are real improvements in European risk assets in sight?

ORMALLY A DECENT month in the equity markets produces a moderate sell off in core government rates. Not in April. Bund yields flirted with record lows and produced a 50 bps return on the month. US Treasuries and Gilts did even better returning 1% and 1.2% respectively. A strong rally in core bond yields must mean European periphery yields sold off on risk aversion? Nope. Italian and Spanish government yields rallied strongly producing stunning one month returns of 4.5% and 5.1% respectively. In euro credit markets at least excess returns in April were reasonably “normal” at 47 basis points (bps) in investment grade and 157bps in high yield (total index returns were higher from the rally in duration).

However, investment grade and high yield indices touched record low yields, a decidedly not “normal” state of affairs.

So what happened to European fixed income markets? Japanese institutional investors escaping negligible JGB yields? We have been sceptical that Japanese investors could move that quickly at the start of their fiscal year. Most Japanese institutional

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investors are heavily underweight Europe and quite exposed to US investment grade, high yield and senior secured loan markets. Some are understandably nervous that current US interest rate levels and excess market liquidity are likely to produce an increasing number of US shareholder focused corporate actions that will prove destructive to credit investors. As European systemic risk has receded, many Japanese investors will make allocations this fiscal year to European fixed income markets to balance their US exposure. However it is only now starting to happen.

The soft patch in US macro data, headlines from Japanese QE and modest underweight positions in both credit and core duration caused a scramble in the month for anything with a bit of yield. Capitulation is too strong a verdict but it felt a bit that way. May feels more rational with a modest sell off in core duration but risk assets remaining well bid.

Looking forward both investment grade and high yield credit spreads are likely to be in the tight end of near term trading ranges but equally the catalysts which will knock them significantly wider are harder to find.

Stephen Zinser, chief executive officer & co-chief investment officer, ECM Asset Management. Photograph kindly supplied by ECM Asset Management, May 2012.

Solid investor demand amidst plentiful liquidity continues unabated. In Europe the austerity versus growth debate increasingly favours policies which promote growth. But markets are right to be relaxed about this subtle shift. Missed or delayed EU budget deficit targets in Spain, Italy, France and Portugal are being rewarded with a rally in each country’s government bond market.

In the investment grade sector, corporate leverage is modestly creeping up but in Europe we are not likely to see credit destructive M&A for quite some time. In the investment grade financials sector senior unsecured bondholder burden sharing is rapidly creeping up the agenda and seems almost a given to be implemented well prior to 2018. However the markets already know this and are relaxed about the burden sharing risks for better quality banks, focusing instead on the net negative issuance volumes as banks continue to delever in Europe. In high yield markets it is clear that in the ongoing feeding frenzy, some of the new issues are becoming stretched in terms of leverage, structure and/or credit quality.

However investors are not likely to suffer the consequences in the near term—only when default rates pick up in a few years’ time. In the meantime ECM is becoming increasingly selective in sub-investment grade markets at some cost to near term performance. Our core focus remains on the senior secured loans and bonds in better quality credits. I

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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DEBT REPORT

IMPACT ON BAN ON NAKED SHORT SELLING OF SOVEREIGN CDS

Six months after the European Union imposed its controversial ban on the naked short-selling of credit default swaps (CDS) on government debt—with the aim of preventing hedge funds and others from destabilising the sovereign bond markets in the eurozone by placing bets on countries defaulting on, or being forced to restructure, their obligations—the jury is still out on what impact the measure has had to date and whether or not it will achieve its intended goal.

Andrew Cavenagh reports.

NAKED SHORT SELLING BAN LEADS TO CALMER MARKETS U LEGISLATORS WILL no doubt point to the relative calm that has prevailed in the eurozone’s core sovereign markets so far this year as evidence that the ban is having the desired effect. For spreads on both sovereign CDS and their underlying bonds in Western Europe have remained largely stable, despite three events that might previously have given rise to another bout of volatility—the Dutch government’s nationalisation of the SNS Reaal bank (expropriating shareholders and subordinate lenders) at the start of February, the inconclusive outcome of the Italian general election towards the end of the month, and the Cyprus bail-out at the end of March (which involved a levy on large bank depositors).

Although the CDS on Cyprus sovereign debt predictably widened out by 30% to 1,408 basis points at the height of the crisis, the real risk that the tiny island country could be the first to be forced out of the euro did not seriously affect the sovereign CDS (SCDS) on the critical eurozone countries of Italy and Spain. Both fluctuated for the most part within a range of between 250 and 300 basis points, while Ireland’s SCDS came in by almost 14% over the first quarter to 189bp.

It was a different story in Eastern (or emerging) Europe, however, where SCDS spreads widened by 16% overall to make the region the worst-performing region over the period. Concerns over the solvency of Slovenia’s banks saw the cost of the country’s sovereign

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protection soar by 58%, while that of Hungary and Croatia also rose sharply towards the end of the period by 41% and 33% respectively.

Jav Bose, head of derivative valuations at S&P Capital IQ, says sovereign protection levels in Eastern Europe will remain a key focus of global investors in the second quarter, given the potential knock-on effect the problems in the region would have on the eurozone. Whether the relative stability that the eurozone’s sovereign markets have experienced in 2013 can really be attributed to the ban on naked shortselling, however, is today the least debatable. For many believe that the undertaking from the European Central Bank in the first week of September to buy as much beleaguered-country sovereign debt as necessary—to ensure continued access to funding at sustainable cost and the survival of the euro—has been a much bigger contributor to market calm that has prevailed since then.

One clearly discernible trend since the introduction of the ban has been a dramatic increase in activity in the corporate CDS market, which the level of daily trading dwarfs that in the sovereign market in any case, as activity in SCDS has predictably fallen away.

Spreads on corporate CDS—particularly that on the senior debt of financial companies—have widened significantly as those on the latter have tightened, and the effect has been to diminish the historical correlation between the two.

The development has led some to conclude that hedge funds and other speculators, deprived of the ability to place their bets through SCDS, have turned to the CDS of financials as a proxy for SCDS—a trend that could prove just as systemically destabilising given the feedback loop between the finances of governments and banks.

Athanassios Diplas, a senior adviser to the International Swaps and Derivatives Association Board, articulated these concerns at the ISDA Annual General Meeting in Singapore at the end of April. He warned that the removal of a tool from investors in this way was likely to “create market shocks that in some ways that are unintended”.

Most analysts have been cautious, however, about reading too much at this stage into this apparent switch of allocation to the CDS of financial corporations as a substitute for the sovereign exposure that is no longer available. “It would be very easy to make that claim on the basis of the shift in activity, but I don’t think you can say that yet unequivocally,” says Barnaby Martin, credit analyst at Bank of America Merrill Lynch. “Six months down the line it’s just too early to say there’s been a meaningful change of behaviour.”

Martin pointed out that while investors looking to take macro-short positions through the CDS market could no longer do so in the sovereign arena, the SNS expropriation and the levy on deposits at the Cypriot banks were equally valid explanations for the

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

DEBT REPORT

IMPACT ON BAN ON NAKED SHORT SELLING OF SOVEREIGN CDS

significant increase in protection buying on bank debt. “Those were both potentially sea-changing events,” he explained.

JP Morgan’s global asset allocation team was also dismissive of the suggestion in a report it published in second half of April. The bank’s analysts concluded that there was “no evidence European bank CDS are being used as proxies to short sovereigns” based on an in-depth analysis of outstanding sovereign CDS positions. Their research showed a relatively strong correlation between the daily credit spread moves of the biggest bank from each country and its sovereign—73% in the case of Italy, 60% in Spain, 59% in France and 43% in Germany—but also that the net notional CDS of the two largest banks from all these countries had actually fallen over the past year. French banks, for example had seen their outstanding CDS fall by 12% since August—a decline that broadly matched that of the net notional CDS of the five largest US banks.

Critics of the ban, led by the Alternative Investment Management Association that represents the hedge funds, nevertheless remain convinced that the measure is a misguided political knee-jerk reaction that ultimately threatens to undermine liquidity in the sovereign bond markets—the very problem it was intended to prevent.

They point out, with justification, that the SCDS market is still a relatively small part of the wider CDS market.

According to the latest figures from the Bank of International Settlements, at the end of June 2012 the outstanding volume of SCDS stood at around $3 trillion against a figure of $27trn for all CDS. The outstanding SCDS is an even smaller fraction of the total outstanding sovereign debt of around $50bn and— for all the concern over systemic risks it represents—SCDS represents only about 1% of the daily trading volume of all CDS. The opponents of the ban have recently found an ally (perhaps rather surprisingly) in the International Mon-

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Barnaby Martin, credit analyst at Bank of America Merrill Lynch. “It would be very easy to make that claim on the basis of the shift in activity, but I don’t think you can say that yet unequivocally,” says Martin. “Six months down the line it’s just too early to say there’s been a meaningful change of behaviour,” he adds. Photograph kindly supplied by Bank of America Merrill Lynch, May 2012.

etary Fund (IMF), which devoted a chapter in the latest Global Stability Report on the role of SCDS. The IMF’s analysis suggests that while it was difficult to isolate the impact of the ban from that of other EU policy announcements, it had found “no pervasive evidence” that volatility in SCDS spreads (some of which may have resulted from speculative activity) had led to any increases in the cost of sovereign funding, one of the key arguments for implementing the ban.

While acknowledging that there were some signs that SCDS could “overshoot” their predicted value for

vulnerable European countries during periods of stress, the IMF said that “overall, the evidence here does not support the need to ban purchases of naked SCDS protection”. The organisation also warned that warned that such bans “may reduce SCDS liquidity to the point where these instruments are less effective as hedges and less useful as indicators of market implied credit risk”.

The IMF concludes that the regulatory reforms underway to improve the transparency of over-the-counter (OTC) derivatives trading in general were likely to offer “a better avenue” for correcting adverse effects in the SCDS market than outright bans.

The Alternative Investment Management Association (AIMA) was predictably quick to say the report “essentially vindicated” the industry position, but whether or not the IMF’s opinion will lead to any change in the EU’s position remains to be seen. The European Securities and Markets Authority, the EU’s leading financial regulator, is carrying out its own evaluation of the measure’s impact over the six months since it has been implemented and will present the results of its investigations to the European Parliament at the end of June. I

NAKED SHORT SELLING BAN EXPLAINED

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he EU Regulation “Short Selling and Certain Aspects of Credit Default Swaps” came into force at the beginning of November 2012. Its main aim is to reduce the risk of negative price spirals in sovereign debt caused by the uncovered (naked) short-selling and CDS protection buying.

Under the regulation, market participants can buy protection that references the sovereign debt of all 30 countries in the European Economic Area, including that of government agencies and regional governments, only if they hold the issuer’s debt or have exposures that are “meaningfully correlated with the relevant debt at the time of execution.

The regulation applies to transactions executed after March 25th last year, and its implementation and enforcement has been delegated to the relevant country authorities (although there are expected to be difficulties with enforcement in some cases).

The measure is similar to the ban on naked CDS short-selling that the German government implemented between May 2010 and March 2011, except that it is seen as a permanent measure.

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

COMMODITIES – GOLD

Photograph © Daniel Budiman/Dreamstime.com, supplied May 2013.

There was plenty of speculation in the media earlier this year that the gold price was being driven down by fears of a sell-off by the central banks of struggling Eurozone economies like Cyprus. Desperate to raise money (so the story goes) central bankers in Italy, Spain and Greece might also plunder their vaults, constituting a far more substantial combined holding than Cyprus, with dire consequences for the gold price. By Vanya Dragomanovich.

AFTER GOLD’S BIG STORM: ANOTHER DECLINE LIKELY BEFORE RECOVERY HE EUROZONE’S CRISIS can be blamed for many things but the recent sell-off in gold which saw over $250 taken off prices in the space of a month is probably not one of them. Instead, investors should look to the recovery in US stocks and the US economy in general, which seems to have had more to do with gold prices spectacularly dropping by around 22% since the beginning of the year. More intriguing still, 15% of that fall came in the space of two trading days in mid-April. It points to the end of a long love affair with gold on the part of institutional investors, and opens a big debate on gold’s future as an institutional portfolio component, and its true value in a more benign global economic environment.

“Speculative traders such as hedge funds, which tend to be quick on the trigger when changes are looming, begun losing faith back in September, from a peak net-long futures and options positions of almost 20 million ounces they started a gradual reduction that by mid-April had seen their positions dwindle to just 5.6 million ounces,” says Ole Hansen, head of commodity strategy at Saxo Bank.

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Hedge funds, the nimblest market players when it comes to picking up on trend reversals, started selling their gold positions last autumn. The sell off happened as US markets were beginning to exhibit the first signs of recovery and the Dow Jones Industrial Average had begun rising steadily, with the characteristics of an ebullient macro trend, rather than its previous more erratic behaviour.

Institutional investors with large positions in gold ETFs began to realise that the tide was moving against gold after the minutes of a Federal Reserve meeting in January which clearly showed that the Fed was thinking of slowing down or entirely stopping its program of bond purchases. The implication for investors was that the US economy was doing better and that the dollar would become stronger, both of which would be bad news for gold, a safe haven asset at times of financial crisis.

The sale of gold has accelerated since then and has showed no sign of stopping. Investors have sold the equivalent of over 350 tonnes of gold in ETF holdings since the beginning of the year, of that more than 260 tonnes from the

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COMMODITIES – GOLD

world’s largest ETF SPDR Gold Trust run by State Street Global Advisors. SPDR Gold Shares still holds about 1,023 metric tonnes of gold valued at $44.7bn.

The bulk of the sale came from large US investors.

Looking at the filings submitted to the US Securities and Exchange Commission over the last few months Northern Trust, BlackRock and Soros Fund Management are among the biggest players who have been pulling out of gold ETFs. These vehicles are also popular with institutional investors like pension funds, who see them as a cost-effective way to gain exposure to commodities prices.

However, the market (that is, speculators on the price of SPDR Gold Shares) were anticipating this fall; a number of market participant bought a large number of put options on the ETF that would not have come into the money had the market not dropped so spectacularly on April 12th.

Once the selling frenzy started in the US it was replicated in Europe, just on a smaller scale. Nicholas Brooks, head of research at ETF Securities, says that the total outflow of assets from ETF Securities’ gold ETFs this year has been $1.9bn, with $14.3bn still remaining in the company’s gold ETFs. Investors have also built up positions in ETF Securities Short Gold ETFs, but much smaller ones compared with long gold positions.

Brooks notes that of the three key types of investors with positions in gold ETFs; retail investors, medium to long term investors with a strategic view of the market and tactical investors, the first two groups have mostly held on to their gold ETF positions or have added to their existing holdings.

“Most of the selling came from tactical investors, asset allocators with a three to 12 month view of the market who react to changes in the market,” says Brooks. The move down was prompted by the fact that bond yields have been rising, as have stocks, and investors have started pulling out of gold and investing in higher-yielding assets.

In addition to the sale of gold ETF share, the futures markets also witnessed a spectacular fall over two trading sessions on April 12th and April 15th. On paper, the move was prompted by two factors, a downgrade of gold by Goldman Sachs analysts and the rumour that Cyprus might sell its gold reserves to repay the country’s debt. Cyprus itself was less of a worry but market participants were concerned that other Eurozone economies might follow suit. Italy alone holds 2452 tonnes of gold and in Europe only Germany has more gold reserves. A major sell off by Eurozone central banks would have serious consequences for the gold price.

Any predictions that Italy, Greece or Spain would sell their gold “are, frankly, ridiculous,” say Carsten Fritsch, analyst at Commerzbank. “If those countries are at all thinking about leaving the euro selling their gold would leave them with their hands tied behind their back because they would have fewer reserves to back their own currencies.”

Whether those were the real reasons for the bearish sentiments, and not pure speculative market play, is another matter. CME Clearing House delivery notices for COMEX gold futures around those days show that JP Morgan was

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behind 90% of the selling, some of it from their client account and majority from a house account. Moreover, once this one horse had bolted, the rest of the herd was not far behind.

Technical levels were breached, prompting stop-loss sales and automated selling from program-based trading schemes.

“The course was set and once the 1525 USD/oz support level was reached and breached, as if it did not exist, waves of selling orders from both the spot and futures market sent the price into a tailspin,” says Saxo’s Hansen. “During the initial hour of carnage on the Friday [April 13th], almost 9m ounces of gold futures had swapped owners.”

Gold then see-sawed for the rest of April, initially recovering but plunging back to $1,350/oz by mid May. In the meantime all the major banks have lowered their forecasts

Predictions that Italy, Greece or Spain would sell their gold “are, frankly, ridiculous,” say Carsten Fritsch, analyst at Commerzbank. “If those countries are at all thinking about leaving the euro selling their gold would leave them with their hands tied behind their back ...” to an average for this year and are saying that in the short term prices are more likely to head towards $1,100/oz.

To put it all into perspective, Gordon Brown sold a portion of UK gold reserves in 1999 for $275/oz. Though it may look shockingly low now, this was a reasonable price at the time.

Throughout the last decade prices have climbed steadily, reaching an all-time high of $1,920/oz in 2011. Mining output of gold has not significantly changed over the last decade and although there is an argument that it became more expensive, an increase in labour costs, electricity and transport still doesn’t explain an eight-fold rise in prices.

The price of gold started rising when first gold ETFs were launched in the early noughties and then accelerated during the financial crisis as gold ETFs became the safe-haven investment option. Initially, institutional money started flowing into commodity ETFs because of interest in the convenient way they offered access to commodities market diversification opportunities, and the strong case being made by commodities bulls. Subsequently, with the onset of the financial crisis, there were also considerable fears about inflation and precious metals holdings were viewed as one of the principal means for institutions to hedge against this threat.

While inflation in the UK and other developed markets has declined in recent months, from a global perspective it still remains a key consideration for long term investors, who will be less keen to reduce gold exposure. For major growing economies like Brazil for example, inflation has remained a key theme in the last six months.

Analysts have now almost universally lowered their gold price forecasts for the year to around $1,550-$1500/oz. Even so, the game has not been played through yet. It is becoming increasingly obvious that when trying to assess what the

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gold price will do next, the main movement to gauge is that of ETF investors. This is the case, even though cheaper prices will make the metal much more attractive to retail buyers who either buy jewellery, as is mainly the case in China and India, or bars and coins, as in Europe, the US and Australia.

In fact, since gold prices fell to around $1,400/oz or at times below that level there has been massive buying in China and India. Indian buyers have enthusiastically come back into the market particularly because late last year gold prices reached historically high levels in rupees terms; now that prices have dropped, several hundred dollars for gold is considered relatively cheap. It should also not be forgotten that both China and India are home to a large and increasingly affluent middle class demographic, and their buying will have more impact on the price at the cheaper end of the chart than ten years ago. Similarly, gold bars and coins remain a favourite investment among more affluent Europeans, particularly in Germany, where gold is still regarded as a solid store of value.

In the latest issue of its paper Gold Demand Trends the World Gold Council noted that the net outflows from ETFs obscured the strong rise in investment for gold bars and coins in the first quarter this year which stood at 377 metric tonnes, up from 342t last year in the same period last year, and gold jewellery buying which rose to 551t from 491t in the same quarter last year. This could create a fairly solid floor for the gold price, despite the institutional selling.

According to Saxo Bank, while the technical picture for gold points towards a target of $1,150/oz, “we look for

support to emerge towards $1,300/oz while any recovery from here will be met with fierce resistance at the old floor of $1,525oz,” says Hansen.

For the active investor, the sudden price moves represent a range of opportunities. For example, Société Générale’s Patrick Legland says that investors could sell a one year call option with a $1,800 strike and use the received premium to buy a one year gold put with a $1,440 strike. An alternative zero net premium option structure would be too short a one year gold call at a $1,700 strike and buy a one year put at a $1,550 strike.

The bottom line is that after all these moves the gold market is unstable. Most analysts expect that prices will initially drop some more before starting to recover later in the year, an expectation based on the fact that stock markets have moved up too far too fast and on the fact that the US has not yet left its economic problems behind.

“Tactical investors will remain bearish on gold until the interest rate cycle has peaked and the dollar has stopped rising. However, the underlying economic situation in the US has not dramatically changed, the US still has fiscal and debt problems and some investors may have over-anticipated a recovery,” says Brooks. Unlike tactical investors, other longer term investors are likely to stick with gold under those circumstances, he adds.

Also, there is currently a large build-up of hedge fund short positions in the market at present. All it would take is another sovereign debt crisis and the gold market would move against them. This is likely to keep the market volatile and without a clear trend in the near future, but unlikely to continue declining over the three-to-six month horizon. I

DIVERSE GLOBAL DEMAND FOR GOLD T he latest World Gold Council Gold Demand Trends report, which reports on the period January-March 2013, shows a market driven by diverse global demand, though overall total global demand for gold in the quarter was 963t, down 19% from Q4 2012, though in value terms demand fell 23% to $15bn. The average gold price over the period fell 3% to $1,632/oz.

Demand for gold in China and India led trends, with demand related to jewellery up 12% for the quarter year on year. In addition there was a notable increase in bar and coin sales, which rose 22% year-on-year in China and 52% in India. Central banks remained significant acquirers of gold, making purchases in excess of 100t (109t) for the seventh consecutive quarter. In the US demand for bars and coins was up 43% compared with the same quarter in 2012.

Globally, bar investment was up 8% while official coins (such as American Eagles and Canadian Maple Leafs) were up 18%. Gold held by gold-backed ETFs,

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which in 2012 accounted for 6% of the world’s gold demand, fell by 177t. That fall pushed the sum of ETF and total bar and coin demand to just below 201t.

Total investment demand was 320t in Q1 2013, flat compared with a year ago. “Gold-backed ETFs, which made up 6% of gold demand in 2012, have seen some holders, primarily in the US, collect profits and move into equities. While gold ETF holdings are down, this has been balanced by 378t of investment in bars and coins, an increase of 10% on the same period last year, and up 12% on Q4 2012,” explains Marcus Grubb, managing director, Investment at the World Gold Council.

“The price drop in April, fuelled by non-physical moves in the market, proved to be the catalyst for a surge of buying that has left many retailers short of stock and refineries introducing waiting lists for deliveries. Putting this into context, sales of bars and coins, jewellery and consumption in the technology sector still make up 81% of the market,” says Grubb.

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TRADING VENUES

Ever since Budapest, Ljubljana, Prague and Vienna joined forces in 2010 to create the Central and Eastern European Stock Exchange Group (CEESEG) speculation has waxed and waned over a merger with main rival, the Warsaw Stock Exchange. There is still no firm deal but these two regional powerhouses are ready to sit at the negotiating table. Lynn Strongin Dodds reports.

Can WSE keep going it alone?

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alliance such as the initiative N APRIL, THE Vienna Stock between Brazil, Russia, India, China Exchange (VSE) confirmed that and South Africa to cross-list Michael Buhl, joint chief benchmark equity index derivatives executive officer of VSE and on each other’s boards. The same is CEESEG planned to meet his true of the ASEAN trading link counterpart at the Polish exchange, which connects Bursa Malaysia, Adam Maciejewski, in the near Singapore Exchange and The Stock future, but did not elaborate further.

Exchange of Thailand. It not only The Warsaw Stock Exchange (WSE) reduces the cost but it also which has in the past rebuffed optimises the infrastructure that is overtures from the CEESEG, did needed for investors to gain not comment. Up until now, Vienna exposure to these markets.” and Warsaw have pursued Patrick Young, head of DV divergent growth strategies to help Advisors, a securities exchange stave off competition from alterna- Photograph © Skypixel/Dreamstime.com, supplied consultancy envisions a different tive trading venues and attract May 2013. scenario. “The New European greater participation from foreign investors. Together they could create a formidable force and exchanges remain at a very early stage of development. perhaps fight off any potential takeover bids. Figures from Warsaw is currently market leader west of Russia and has the the Federation of European Securities Exchanges shows momentum to expand its lead over Vienna. Nevertheless it that they are almost equally matched on the market capital- is still too early to see western exchanges taking an interest isation front with the CEESEG valued at around €125.9bn in an acquisition in the region. There simply isn’t enough compared to the WSE’s €120bn. The WSE is way ahead hard currency bottom line to justify the integration cost of though in the listing stakes with 740 listings compared to the eastern and western exchanges.

Moscow, meanwhile, is focussed on its own vast domestic Vienna led group’s much smaller company roster of 241.

Whatever the outcome of the talks between the WSE and opportunity with some optionality in the former USSR. CEESEG, further consolidation in the region is inevitable, However, any attempt to acquire Warsaw or Vienna in the according to Herbie Skeete, managing director of Mondo near future would be politically challenging. Ultimately Visione. He does not expect any of the Mittel European New European markets remain in the initial phases of exchanges to remain independent in the long term.“I would their development. Everything is still in flux although not be surprised to see Deutsche Börse make an offer for Warsaw is the clear market leader in CEE/SEE (Southern CEESEG at some point in the future. It could work in that all Eastern Europe).”

In the meantime, the Polish exchange is still dealing four exchanges are or will be on its Xetra trading platform.

The other possibility perhaps would be Switzerland’s SIX with the fallout of the suspension its high profile chief Group which is also small and may want to join Middle executive, Ludwik Sobolewski following a probe into Europe. The big question given the recent announcement of claims he allegedly sought funds from listed companies for ICE’s proposed takeover of NYSE Euronext, is what will a film entitled “Pharoah’s Curse” which involved his girlfriend. According to Polish media reports, Sobolewski did happen to them if other exchanges get bigger?”

Other possible suitors mooted include Nasdaq OMX, the not admit any wrongdoing and the exchange nor the Istanbul Stock Exchange or Moscow Exchange which is treasury ministry, the dominant shareholder gave any poised to come to the market and could have $500m to reasons for his dismissal.

Despite the alleged scandal, the accomplishments of spend. Another option would be for WSE and CEESEG to follow the example of other regional exchanges and form ties. Sobolewski who became head of the exchange in 2006 are Alexandra Foster, global head of strategy & business devel- well recognised. He not only opened the WSE’s New opment, financial technology services, BT, notes,“Poland has Connect small companies market but also added energy worked very hard to achieve its position. But that said there and bond trading to its product stable. He also helped are many benefits from amalgamation or some kind of oversee the WSE’s privatisation three years ago, which saw

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the treasury’s stake in the bourse whittled down to 35%, although it kept a voting majority. The recent event is not expected to tarnish the WSE’s image with the general view being investors are more concerned about the size of the stock exchange, free float, a number of companies listed, initial public offerings, profits and dividends.

“Stakeholders are very good at discerning personal matters and those of the organisation, which is and has been running smoothly on all operational levels at all times,” says Maciejewski, who was appointed CEO at the beginning of the year “Regardless of that, we are working on increasing the level of trust because it is beneficial to both investors and listed companies.”

Although WSE has been pursuing an organic growth strategy, it has also been vocal about its global ambitions.

Maciejewski says,“Historically, Warsaw Stock Exchange was quite adept in leveraging the potential of the national economy, and there is still scope for significant secular growth, with ratios such as free float, velocity, market capitalisation and nominal value of corporate bond issuance to GDP still at levels suggesting potential for convergence with developed Western markets.

Regional, not local dynamics However, the long-term challenges will be less about focus on the local market and more about the dynamics in the European and global marketplace. Outside competition, commoditisation of equity trading, local and European regulation and, above all, technological change, which is a precondition for all those other trends to occur, will drive changes that will be unprecedented in scope and speed. We believe WSE has perhaps the most important role to play in the region amid this ever-changing landscape.”

One of the most important developments and one that will help sharpen its competitive edge is the implementation of NYSE Euronext’s UTP trading system this April to replace its 13-year-old Warset platform. According to Maciejewski it will be accompanied by, new trading solutions and, later, auxiliary services that will make it more attractive to trade in Warsaw for an entirely new range of investors, including algorithmic traders. “What use will international and local investors’ make of those new functionalities will to an extent determine the scope for additional growth of investor activity at the Exchange in future years. As with any technological change, however, we expect changes in demand for services to be gradual.”

The WSE will also continue to strengthen its position in the derivatives space. It traded 9.09m units last year, making it the fourth biggest in Europe and the dominant player in CEE. Futures on the WSE’s large cap index, WIG20, had the eighth highest trading volume in Europe with 9.08m units while its WIG20 options ranked 13th in terms of turnover volume among European index options In addition, Maciejewski is intent that WSE maintain its listing crown this year. It topped the European league tables with 105 deals or 40% of the total transactions and placed fifth in terms of value in 2012, according to the most recent

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PwC IPO Watch Europe quarterly report, which tracks activity on the main European exchanges. The most notable deal was Alior’s 2.1bn zlotys ($673m) flotation, which was the biggest offering in the European banking sector last year. Also, Russian company Exillon Energy, which already sits on the London Stock Exchange, made the news when it chose the Polish bourse for its secondary listing.

As for this year, it is still too early to predict any trends.

“There are a number of offers in the pipeline,” says Maciejewski.“However, their eventual success will be determined by market conditions. In our efforts to attract new listings, we will double the focus on large entities, which provide the necessary liquidity and are revenue-generating for the exchange”.

CEESEG has also been busy forging its own path. “Our strategy has been to consolidate and integrate the four exchanges and capital markets,”says Buhl.“We are currently focusing on our own group but if there is possibility for future cooperation we are open to talks. WSE and CEESEG are the main players in the region because the other markets such as Zagreb, Sofia, Belgrade and Bucharest are very small, accounting for about 2% of trading.”

An important plank has been the upgrade to the Xetra trading system, which is based on licences used by 250 banks and investment companies and has 4,700 registered traders across the world. Vienna was an early adopter in 1999 while Ljubljana went live in December 2010 followed

by Prague last November. The Budapest Stock Exchange is next in line later this year. “It takes time—about a year—for the benefits to be realised,” says Buhl. “This is because Anglo Saxon banks won’t sign on until they see it up and running. However, in the end it does make the group as well the four exchanges more visible for foreign investors and enhances liquidity.”

In addition, CEESEG is developing data products with the most recent addition being a new low-latency market data service that aims to provide high-speed data to help highfrequency traders and other market participants using algorithms trade more effectively. All of the exchanges but Budapest are included but the Hungarian market will be part of the fold once it starts trading on Xetra.

Indices are also a key part of the group’s product offering and to date it has between 130 to 140 issuers from 16 countries using their indexes as underlying benchmarks for a wide range of products including certificates, warrants, ETFs (exchange-traded funds) and other structured products. According to Buhl, selling index licences not only creates a source of income but it also provides benefits for its exchange partners through hedging opportunities which helps generating additional liquidity and volume in the market.“What we are trying to do is create as much harmonisation as possible which means leveraging the synergies between the four exchanges,” says Zslot Katona, chief executive of Budapest Stock Exchange.“However the group can only be strong if its local members are strong. We don’t want to centralise everything and we continue to develop our own products.”I

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DARK POOL TRADING

Photograph © M.a.u./Dreamstime.com, supplied May 2013.

A dark pool offers its operator solid returns and increased customer interaction, for venue operators and brokers; however the competition for order flow is exposing economic weaknesses in their models. Dan Barnes looks at the economics of dark pools and assesses their continued viability.

DARK POOL ECONOMICS OW TRADING VOLUMES in the equity markets are driving dark pools out of business. The biggest brokers are taking home hundreds of thousands in revenue per month, others are taking tens of thousands if they are lucky. Despite having a significant differentiator from the lit markets, the sheer number of non-displayed liquidity pools means they are inevitably drying up. “Equity volumes are down across the board,”says Fred Ponzo, managing partner at consultancy GreySpark. “The flow required to operate a dark pool hasn’t changed, but the number of pools sharing that flow will have to decrease.” Trading stock exchange you can see the current bid and offer prices and the depth of book. Trading on a dark pool, a venue where that data is not published carries risk. You have less chance of filling an order and the model obfuscates the type of order flow that you are interacting with.

However that same lack of data mitigates other risks.

When a trade is placed on a lit market, the order is visible for all to see. Large fund managers, who trade huge amounts of stocks in a single trade, find that their positions are exposed on lit markets; announcing that they need to buy ten million Vodafone shares, for example, would spark a buying frenzy,

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with every purchaser confident that there is a big buyer to whom they can sell their acquisition at a profit.

Seeking to limit the information leakage and the subsequent price movement, or ‘slippage’, caused by other front running their orders, buy-side firms have sought alternative ways to trade in the market.

A human could break an order down and trade it in pieces but this would reduce his or her productivity so brokers began providing trading algorithms to automate this task.

Using algorithmic platforms, large orders are broken into smaller parts and automatically traded against a benchmark to ensure that they do not underperform. For example the volume-weighted average price (VWAP) of the stock might be used to deliver a consistent trade execution, throughout the day. If buy trades are lower than the VWAP (and sell are higher) then execution is exceeding normal performance.

However, algorithms can only go so far in mimicking human behaviour; once identified as an algorithm, the trading pattern is not too hard to front run. Dark pools ostensibly provide a greater degree of protection, as no pretrade data is visible and therefore they offer greater protection from front running.

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Filling the pools The model works. Rosenblatt Securities, a broker which tracks the performance of dark pools in Europe and the US, found that in January 2013 the 18 pools it tracks in Europe made up 4.96% of consolidated regional trading; the 19 pools it tracks in the US made up 14.33% of total volume.

There are conditions for optimum use. The lower likelihood of an order being filled quickly means that they are best used when markets are not volatile.

The big success stories have been the broker pools of which there are two types; multilateral trading facilities (MTFs) and broker crossing networks (BCNs). It must be noted that the comparison of MTFs and BCNs is not an even one: BCNs can include proprietary trading and market making business with in their volume figures which MTFs cannot. BCNs also typically accept order flow from broker supplied trading algorithms.

“The model becomes very attractive when you mix proprietary flow and client flow,”notes Ponzo.“Your clients get the matches they want and then your prop desk, or your hedging flow, or your ETF market-making gets marched without crossing the spread on the open market.”

Taking Rosenblatt’s European data as a sample, with both broker crossing networks and MTFs included, Credit Suisse Crossfinder saw €517m average daily value traded (ADVT), making it the largest pool by that measure. Following that were Deutsche Bank SuperX with €366.9m ADVT and BATS Chi-X with €312.7m ADVT for the month.

UBS processed €300.6m via UBS Multilateral Trading Facility (MTF) and although it does not report the volumes from its crossing network UBS PIN to Rosenblatt, we can surmise that if PIN took an even 33% share of the €609m€762m ADVT that it and the other two non-reporting BCNs (Morgan Stanley’s MS Pool and J.P. Morgan's JPM-X3) made, then UBS could be the largest combined dark pool operator. Goldman Sachs had a combined €356.7m ADVT from its SIGMA-X Broker Crossing Network (BCN) and SIGMA-X MTF.

The pitch The bonuses offered to the provider are many, depending on the type of firm; they are typically run by a broker, an interdealer broker or a trading venue operator.“The benefits are mostly strategic if you are a big bank,” says Justin Schack, managing director at Rosenblatt Securities. “You have a massive amount of flow coming into your electronic trading business. To execute those orders you have a bunch of choices. You can send them to exchanges or other venues that charge fees, or try your best to send to venues that won’t charge you fees. But the best option is to cross as much as you can internally free of charge before looking elsewhere to execute.”

In the US, banks are able match orders in a single pool with client, algorithmic and other broker order flow all mixed up. In Europe there are limits on the segregation of order flow, which led UBS and Goldman Sachs to offer separate crossing networks and MTFs.

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These two firms and their segregated models provide an example of the different returns that brokers can see from dark pools. In both cases the MTFs have their management and governance clearly delineated from that of the execution businesses, which houses the BCNs. They both allow dark orders to be sent at the bid and offer, rather than just the midpoint, as a number of other dark pools do.

UBS MTF takes 0.1 basis points (bps) a side or 0.2bps a trade, and so would have seen delivered a revenue of €128,453 in January, based on Thomson Reuters volume data. SIGMA-X MTF, which up until March 2013 had seen 0.25bps on each side of a trade, would have seen in revenue €171,268 on its smaller market share (it has dropped its fee to 0.1bps between March 1st this year to August 30th).

Within Sigma X MTF, clients are able to specify the order size they interact with to minimise concerns around HFT, and orders are matched on size/time, as price is pegged to the primary market. Sigma BCN matches on a price-time priority basis.

UBS MTF, launched in November 2011, also allows the user to set a minimum order size to interact with. UBS PIN, the BCN, only has order routed to it via UBS algorithms, there is no directed flow and as a result there are no explicit charges for users or revenue line for it. “My primary objective is performance of client orders,”says Owain Self, global cohead of direct execution and global head of algorithmic trading at UBS.“We monitor the performance of crossing for clients and we find it is beneficial for them. We also find that generally it lowers our cost of execution because we save on fees, but I must qualify that; there are some venues which would reward us for providing order flow so in some cases we are increasing our costs.”

The supporting costs for the trading venues vary even in these similar examples. The technology for the Sigma X MTF is a NYSE platform that GS outsources, and is hosted in the Basildon data centre. It has both fixed and variable technology support costs; one source estimated costs at “within the low millions” although Goldman Sachs would not comment.

UBS uses different instances of the same technology platform for PIN and its MTF which saved on its initial cost of development and deployment.

In both cases the MTF carries a significantly higher cost than the BCN; they each have separate technology stacks, management, supervision and compliance, while the BCN costs are factored into the execution units.

“The overhead of running the MTF in addition to PIN has been well worth it,”says Self.“We have brought a significant amount of liquidity to our clients that they otherwise couldn’t access. That has helped with their performance as the primary objective and secondarily it has helped in a market where volumes are low, commissions are tight and we need to optimise our costs of trading where possible.”

The mixer For brokers, under pressure in a low volume market, the combination of cutting costs and making both sides of a

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trade is a commercial life saver. For a trading venue or interdealer broker (IDB) the model is somewhat different. “The key distinction between broker and other pools that I would make, is that for the major brokers and banks the dark pools don’t exist in a vacuum,”notes Schack.“They are outgrowths of the electronic trading business. All of these firms have very large institutional broker businesses offer order routing and algorithms having a dark pool allows them to cross a lot of that order flow internally, without paying fees to exchanges or other execution venues. So it boosts their profit margins.”

For venues or IDBs, dark pools can also offer a differentiated revenue stream from their lit order flow which is increasingly, if not completely, commoditised.

Jerry Avenell, European co-head of sales of BATS Chi-X, says,“There is no rebate in the dark; the two non-displayed order books that we operate—the former Chi-X Delta book and the BATS Dark book—have models that charge both passive and aggressive orders so we derive a fee from both sides of the trade.”

In the Chi-X dark book, orders that are aggressive in intent or IOC takers are charged 0.3bps of notional value and orders that are providers of liquidity are charged 0.15bps. The net take is around 0.375bps-0.38bps as there are a larger number of passive orders. On the BATS dark book it is 0.15bps per side, resting or taking, giving 0.3bps per trade netted out. Comparatively the lit books’ net takes are 0.15bps making executions on the dark book more profitable.

Chi-X dark book would have taken about €10,746 average per day in January or €247,158 in revenue for the month. The BATS book took an average of €6505 per day, or €149,615 for the month based on Thomson Reuters’ data, and counting 23 working days in January.

Both the BATS and Chi-X lit books look to net 0.15 bps for trades, so they would have taken around €19,587 and €76,190 respectively per day (€450,501 and €1,752,370 per month respectively). So proportionally, volume on the ChiX dark order book realises just 5.6% of the volume that is achieved on the lit order book (ignoring large in size hidden orders), but ring in the equivalent of 14.1% of revenue. For BATS books’ dark proportionately delivers 16.1% of the volume found on the lit book but 33% of the revenue.

What’s in it for me?

Clearly running a successful pool is good business, but how can one maintain it in such an arid market? Buy-side firms typically have mixed views about dark pools, based upon their judgement of trading against unknown counterparties versus information leakage.“Even if you have a new and interesting idea, volumes aren’t great and firms are reluctant to connect to new systems,” warns Schack. “There’s a bit of fragmentation fatigue.”

On the one side dark MTFs are seen as a safer pair of hands due to the regulatory framework of MiFID that they sit within; on the other they are unable to be discretionary about order flow unlike BCNs, which means BCNs can offer a ‘safe’ environment. That is crucial in attracting the right type of flow. Avenell says there that participants on the

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Owain Self, UBS’s global head of algorithmic trading, explains the dynamics. Photograph kindly supplied by UBS, July 2012.

BATS Chi-X dark order books are usually more traditional firms.“The rebate hunters don’t post to dark books as there is no rebate to be had,” he says. “However there is some posted activity from proprietary firms, but broadly this tends to be the delta hedge for a futures trades, so it there is less concern about best execution (as there is no client behind the order), and more about getting the fill. The bulk of the rest of the order flow in our non-displayed order books is made up of traditional investment banks operating algorithms on behalf of their clients; in other words for other brokers and institutional investors.”

Getting order flow of any type is tough. March 2013 sees the shutting down of Nomura’s NX MTF as the firm retrenches and cuts costs across both Nomura and Instinet brands. Blockcross, ICAP’s crossing network, was closed in September last year despite having “the cleverest business model”, according to one commentator; its cost base was too high. Despite the draw that both firms have in terms of brand, converting that into order flow can be tricky.

“Some of the latest movers have found it difficult to get into a space that at this point is pretty well saturated,” says Schack. “It’s tough to offer something unique, there isn't much new under the sun in terms of dark pools in the US or Europe. Block-focussed pools like Liquidnet have been out there for a while and more recently the brokers and exchanges have developed an array of pools that cater to the smaller size algo flow, so it’s tough to break into the market right now.” I

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CSD WARS?

Asset gatherer BlackRock and Euroclear have announced a new alliance that means that iShares ETF trade processing and settlement across Europe will be funnelled through Euroclear Bank, the international central securities depository (ICSD). “We are at a very advanced stage. BlackRock plan to launch the first iShares ETF under a new international securities structure in July.

BlackRock has a strong family of ETFs that would benefit from the new processing arrangement,” explains Ivan Nicora, director, product management at Euroclear.

Euroclear and BlackRock agree post-trade model for iShares’ ETFs URRENTLY, ALL CROSS-exchange listed ETFs in Europe, including iShares’ ETFs, are issued and traded on one or more national stock exchanges and are settled in the national central securities depository (CSD) in the jurisdiction where the trade is executed. By using a single settlement location, BlackRock and Euroclear say they expect the centralised post-trade arrangements will help improve trading liquidity, ease cross-border ETF processing and significantly lower transaction costs for investors.

However, both parties acknowledge that clearing arrangements remain the same.“The protocol focuses on the settlement solution,” says Nicora. “Obviously, for settlement to work it requires the trading and clearing pieces to fit into the jigsaw, but the clearing stage of the iShares ETFs will remain with different central counterparties (CCPs).”

“ETF trade processing across borders in Europe has long suffered from inefficient, complex and labour intensive posttrade processes,”claims Tim Howell, chief executive officer of Euroclear. Howell has high hopes for the venture.“We believe the new international ETF structure will transform ETF trading and settlement in Europe,”he says, because it centralises settlement of ETF trades conducted on multiple venues.

From a distance, this looks like something of an attempt to carve up a section of the market; and the question is: will the market now see more strategic alliances of this kind in specific market segments and CSDs in Europe or elsewhere?

The duo remains tight-lipped, but Nicora says: “Euroclear and BlackRock share the same community of international clients which are all looking for efficiency in the ETF space.

With that in mind, we’re natural partners. Euroclear has a very long history in settling cross-border transactions. Our model has been designed to treat ETFs as international securities. We are an international CSD with a global reach and consider ourselves as the natural choice of settlement for ETF trades conducted on multiple trading venues.”

Clearly, BlackRock and Euroclear enjoy first mover advantage. “We consider it to be unique and on course to unlock the huge growth potential in the European ETF market, which currently stands at $300bn, still four times smaller than the US ETF market of $1.2trn,”says Nicora. Are similar agreements in the pipeline? “Not at all,” he says.

“Right now, we’re focused on generating an increase in the number of ETFs using this structure. We are confident that the pilot in July will demonstrate to the ETF community that

C

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

this is the structure for future and will change the post-trade environment in the ETF market for the better.”

Inevitably, following an announcement of this kind, the market should expect similar responses from market players such as the DTCC or Clearstream. It could be that this kind of alliance will fire competition between CSDs, either regionally, or globally. It makes sense. In light of this agreement will there be an increase in competition between CSDs? Nicora puts his case: “The service has been designed to be complimentary not competitive to CSDs. While cross-border settlement will occur at the international CSDs, settlement for domestic trades will continue to take place at the local CSD.” The arrangement reflects a cultural shift, claims Euroclear’s Howell,“that clearly recognises ETFs as internationally traded securities,” that will help broaden investor appeal as well as providing improved post-trade arrangements. Howell thinks the move will help propel the growth of ETFs in Europe.

Certainly ETFs have done well of late, particularly compared to traditional equities, where trading volumes still remain muted. Nicora says that low volumes in equity trading are not the driver here, or that Euroclear needs to secure alternative sources of revenue. “This is a solution system developed in response to settlement inefficiencies highlighted by our clients. We’ve been getting signals from our client base facing sizable problems in settling cross-border ETF trades. Through the partnership with BlackRock, we believe we are addressing key concerns on ETF liquidity, fragmentation in Europe, ease of cross-border ETF processing and the lower transaction costs for investors,”he explains.

In many ways the move was straightforward, he avers.“We are actually using well-tested infrastructure. For ETFs traded on multiple exchanges, the challenge was to ensure that other industry participants, the likes of MTFs, CCPs and broker dealers, were behind the new arrangement which, we are confident, will further broaden investor appeal to ETFs in Europe and provide the optimal post-trade arrangements,”says Nicora, adding:“BlackRock’s research has highlighted the cost savings this solution could bring. After looking at the benefit of implementing the solution on purely BlackRock ETFs, they estimate that savings across Europe will be around €200m each year.”

The additional nuance is that the arrangement also has a global application.“The solution is very much exportable, but for now our priority is Europe,” says Nicora. I

53

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%

2.6 2.0 0.6 2.2 2.9 0.7

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

18.3 17.1

12.6

16.9 14.4 23.3 8.1 -13.6 -11.3 -16.6 -5.5

-5.5 -7.6 -5.2 -4.0

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)

1.5 0.9 0.6 2.3

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

4.9 6.0 5.4 13.4 19.3

5.8

2.5 2.1

FX - TRADE WEIGHTED USD GBP EUR JPY

-0.2

-5

13.4 10.6

1.1 2.0

-4.5

-10

48.8

0

7.2

-3.0

4.0

-17.7

5

10

15

-30 -20 -10 0

10 20 30 40 50 60

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

Regions 12M local ccy (TR)

12.6

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

2.9 2.8 2.6 2.2 2.0 1.0 0.7 0.6

0

2

4

6

8

10

12

48.8

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

14

23.3 19.6 18.3 17.1 16.9 14.4 8.1 3.6

0

Developed 1M local ccy (TR) Japan Italy Spain Australia Finland France Singapore Developed Switzerland Norway Sweden Hong Kong USA Germany Denmark UK Netherlands Belgium/Lux -1.0 Canada -2.4 Israel -2.4 Korea -3.4

-5

7.5

4.9 3.6 3.3 3.2 2.8 2.6 2.3 2.1 2.0 2.0 1.4 1.1 0.6 0.5

0

5

9.2

10

12.6

15

-4

-2

-10

3.1 2.8 2.7 2.2 1.2 1.1 1.1 0.7

2

4

30

40

50

60

3.7

0

10

33.3 32.6 31.0 24.9 24.8 19.6 19.6 18.6 17.4 17.3 17.3 17.1 16.9 16.8 16.4 16.1 11.3

20

30

40

48.8

50

60

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

4.0

0

20

Developed 12M local ccy (TR) Japan Belgium/Lux Switzerland Spain Australia France Sweden Developed Netherlands Finland Germany Denmark USA UK Hong Kong Singapore Italy Norway Canada Korea -2.8 Israel-6.5

Emerging 1M local ccy (TR) Thailand Malaysia India Taiwan Indonesia Turkey China Brazil Emerging -2.1 South Africa -2.2 Russia -2.7 Chile Mexico -3.4

10

6

52.6 22.6 20.8 13.0 12.8 12.7 11.1 8.1 7.8 5.0 0.7 -5.3 -7.5

-20 -10

0

10

20

30

40

50

60

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

54

M AY / J U N E 2 0 1 3 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World

Global Sectors Relative to FTSE All-World

125

Oil & Gas Health Care Financials 130

120

120

115

110

Japan Europe ex UK

US Emerging

UK

Asia Pacific ex-Japan

110

Basic Materials Consumer Services Technology

Industrials Consumer Goods Telecommunications Utilities

100

105

90

100

80

95

70

90

60 Apr 2011

85 Apr 2011

Aug 2011

Dec 2011

Apr 2012

Aug 2012

Dec 2012

Apr 2013

Aug 2011

Dec 2011

Apr 2012

Aug 2012

Dec 2012

Apr 2013

BOND MARKET RETURNS 1M%

12M%

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

1.5

UK (7-10 y)

4.9 6.0

0.9 0.6

Ger (7-10 y) Japan (7-10 y)

5.4 3.2

-0.9

France (7-10 y)

13.4

2.3

Italy (7-10 y)

19.3

5.8

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

2.4

Euro (7-10 y)

2.3 2.5

UK BBB Euro BBB

14.5 14.7 13.4

2.1

UK Non Financial

10.6

2.6

Euro Non Financial

12.7 8.2

1.3

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

10.4

-0.7

-2

0

2

4

6

8

0

5

10

15

20

25

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

Corporate Bond Yields

US

Japan

UK

Ger

France

Italy

UK BBB

8.00

Euro BBB

7.50

7.00 6.50

6.00 5.00

5.50

4.00 4.50

3.00 2.00

3.50

1.00 0.00 Apr 2010

Oct 2010

Apr 2011

Oct 2011

Apr 2012

Oct 2012

Apr 2013

2.50 Apr 2008

Apr 2009

Apr 2010

Apr 2011

Apr 2012

Apr 2013

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

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 1 3

55

MARKET DATA BY FTSE RESEARCH

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

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

FTSE UK

FTSE US Bond

120

120

115

115

110

110

105

105

100

100

95

95

90 Apr 2012

90 Jul 2012

Oct 2012

Jan 2013

Apr 2013

Apr 2012

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

FTSE UK

Oct 2012

FTSE US Bond 145

130

130

115

115

100

100

85

85

70

70

55

55

40 Apr 2008

Jul 2012

Jan 2013

Apr 2013

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

145

FTSE US

40 Apr 2009

Apr 2010

Apr 2011

Apr 2012

1M% FTSE UK Index

Apr 2013

1

2

2.5

0

2

16.9

17.1

48.1

4.2

35.3

4

Apr 2013

30.2

2.1

1.5

Apr 2012

28.2

2.7

0.9

Apr 2011

5Y%

7.2

0.5

0.5

Apr 2010

12M%

2.0

FTSE USA Bond

Apr 2009

3.8

FTSE USA Index

FTSE UK Bond

Apr 2008

3M%

0.6

0

FTSE US

6

8

0

10

20

30

40

3.2

50

0

5

10

15

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

56

M AY / J U N E 2 0 1 3 • F T S E G L O B A L M A R K E T S

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