FTSE Global Markets

PRINCIPAL AT RISK PRODUCTS GAIN TRACTION

I S S U E 7 1 • J U LY / A U G U S T 2 0 1 3

The enduring appeal of Korean equity linked notes Preparing for T2S Asian securities lending steps up a gear Getting the best out of collateral management Fund admin: the rise of the middle man

TURKEY IN EXTREMIS

Turkey pulls back from the brink and why it matters www.ftseglobalmarkets.com

OUTLOOK EDITOR: Francesca Carnevale T: +44 [0]20 7680 5152 | E: francesca@berlinguer.com SENIOR EDITORS: David Simons (US); Neil A O’Hara (US); Ruth Hughes Liley (Trading) EDITORS AT LARGE: Art Detman; Lynn Strongin Dodds CORRESPONDENTS: Andrew Cavenagh (Debt Capital Markets); Vanja Dragomanovich (Commodities/Eastern Europe); Mark Faithfull (Real Estate); Ian Williams (Supranationals/Emerging Markets); Dan Barnes (Derivatives/FX) NEW MEDIA MANAGER: Andrew Neil T: +44 [0]20 680 5151 | E: andrew.neil@berlinguer.com HEAD OF NEW MEDIA: Alex Santos T: +44 [0]20 680 5161 | E: alex.santos@berlinguer.com PRODUCTION MANAGER: Lee Dove – Alphaprint T: +44 [0]20 7680 5161 | E: production@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton HEAD OF SALES: Peter Keith T: +44 [0]20 7680 5153 | E: peter.keith@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Istanbul/Turkey) FINANCE MANAGER: Tessa Lewis T: +44 [0]20 7680 5159 | E: tessa.lewis@berlinguer.com RESEARCH MANAGER: Sharron Lister: Sharron.lister@berlinguer.com | Tel: +44 (0) 207 680 5156 MIDDLE EAST SECTION HEAD: Fahad Ali: Fahad.Ali@berlinguer.com | Tel: +44 (0) 207 680 5154 EVENTS MANAGER: Lee White | Tel: +44 (0) 207 680 5157 PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD US SALES REPRESENTATION: Marshall Leddy, Leddy & Associates, Inc. 80 S 8th St., Ste 900, Minneapolis, MN 55402 T : (1) 763.416.1980 E: marshall@leddyandassociates.com TO SECURE YOUR OWN SUBSCRIPTION: Register online at www.ftseglobalmarkets.com Single subscriptions cost £497/year for 10 issues.

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

learly markets are at an important tipping point, just as we are edging towards a balmy summer. “We are approaching a fork in the road for global monetary policy and have had a rehearsal of the impact on markets,”says Ewen Cameron Watt, BlackRock Investment Institute’s chief investment strategist. According to Watt, investors should anticipate both increasing divergence in asset returns as well as a broader and more diverse range of risks through the rest of 2013.

Watt’s views are predicated on three pillars: one, that global monetary policy is diverging and the era of easy money is slowly ending.“Distorted markets are resetting but could overshoot,” he says. Two, is the general expectation that the US Federal Reserve is ready to wind down bond purchases if US economic momentum holds.

With this in mind, economic data and jobs numbers take centre stage. Finally, he believes market risk is increasing, including a potential emerging market funding crunch and a spike in real interest rates is likely. In other words, in the run up to autumn, volatility is back.

With this in mind, much of the content of this edition focuses on markets in transition.

In particular, our focus is on regulation and changes in market infrastructure continue to be writ large. Our focus on T2S in this issue provides a template for the changes in train.

David Simons looks at the implications of change spurred by the T2S project in Europe. A work in progress, it posits a centralised settlement platform. However, the work is a notable for who is not involved in the European-wide project (the United Kingdom has declined to join) as much as the project will shift the boundaries between the large global custodians and central securities depositaries. The latter are increasingly moving into space traditionally the preserve of the large global custody houses.

At hand is the issue what will most of Europe’s CSDs eventually do as business eventually coalesces around its two main post trading services institutions, namely Euroclear and Clearstream? There won’t be enough business to go around and the need for many of the smaller CSDs will simply disappear as investors choose not only where they trade, but also where they clear and settle. T2S looks to do for the post trade segment in Europe what MiFID did for the front end trading system. Only this time, the directional flow will be consolidation rather than market fragmentation.

Additionally, there will be repercussions for the traditional asset servicing market.

Already the larger custodian houses no longer describe themselves as providers of asset services, but have readily redefined their operational moniker as ‘investor services’.

That gives the larger operators carte blanche to move even further up the value chain, leaving the smaller houses trailing.

That goes particularly for the sub-custody segment. The likelihood is that as the back office becomes increasingly centralised, and more expensive to maintain, that many of Europe’s smaller sub custody operations will simply be priced out of the market as the need to upgrade in-house technology will force them either to step up to meet the investment required, or move out of the business altogether.

T2S and (hand in hand) CSD Regulation look to be game changers.

As Edwin de Pauw, head of T2S product management at Euroclear makes plain: “Waiting for a complete and final picture of a post-trade Elysium of the future is not a viable long term solution. You may decide to maintain your current post-trade arrangements, which is fine, as long as your provider has the scope and flexibility to evolve with T2S and your changing business needs. A provider offering multiple T2S access possibilities will be able to accommodate your final choice when you make it.”

C

Francesca Carnevale, Editor

Turkey's Prime Minister Recep Tayyip Erdogan defends riot police tactics in Turkey protests as he addresses members of parliament from his ruling Justice and Development Party (AKP) during a meeting at the Turkish parliament in Ankara, Turkey, on June 25th 2013. Photograph by Ankar for Depo Photos/ABACAPRESS. COM. Photograph supplied by PressAssociationImages, July 2013.

1

Contents COVER STORY

TURKEY: COUNTING THE COST OF DISSENT?

..................................................Page 4 Turkey’s pristine image took something of a battering over the late spring as the government showed it was uncomfortable with dissent. Unease about the rapid changes underway in the country spread overseas with repercussions on investor thinking about the country. What now?

DEPARTMENTS

MARKET LEADER

CORPORATE BONDS: CREDIT QUALITY TRUMPS RATES .................Page 10

IN THE MARKETS

THE STEADY APPEAL OF EQUITY LINKED ISSUES IN EAST ASIA

CREDIT

Neil O’Hara looks at opportunities for the smart money ..Page 16

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

IS IT TIME TO BUY?

...................................................................................................Page 18 Stephen Zinser, CEO at ECM Asset Management, looks at risk asset pricing.

FACE TO FACE

THE NEW PRIME OF INDEX INVESTING .......................................................Page 19

THE ALTERNATIVE VIEW

WILL REGULATION IMPROVE THE QUALITY OF MARKETS? .........Page 24

Donald Keith, deputy chief executive of FTSE Group outlines the main trends

New columnist Amir Khwaja, CEO of Clarus Financial Technology analyses the swaps market.

FUND ADMINISTRATION: THE RISE OF THE MIDDLE MAN ...........Page 27

ASSET SERVICING

David Simons ask whether fund administrators really look after the needs of the buy side.

NEW AGREEMENT SPEEDS UP COLLATERAL FLOW IN EUROPE .....Page 28 Three CSDs join to improve efficiencies in the repo and collateral management segments.

CLEARING AND SETTLEMENT

PREPARING FOR CHANGE: PREPARING FOR T2S ........................................Page 30

TRADING POST

ASSET PROTECTION ISN’T AS STRAIGHTFORWARD AS IT SEEMS ..Page 32

DEBT REPORT

PRINCIPAL AT RISK PRODUCTS GAIN TRACTION ........................................Page 33

ASSET ALLOCATION

WHY ADVISORS LOOK BEYOND ETF VOLUME............................................Page 35

Edwin de Pauw looks at the impact of T2S on the provision of post trading services.

Bill Hodgson, independent consultant at the OTC Space, looks at the key issues.

Issuance volumes look to turn around this year writes Andrew Cavenagh.

Jeff Torchon, VP & ETFs global markets manager, Interactive Data looks at the dynamics.

ASIAN SECURITIES LENDING: MARKET CHANGE & REGULATION ..Page 37

ROUNDTABLE

Six regional experts review the trends and influencers on securities lending in the region.

COLLATERAL MANAGEMENT: THE CUSTOMER COMES FIRST ................Page 55 How you make the best use of it, get it to the right place at the right time

GRASSROOTS CHANGE IN RUSSIA’S MARKETS ............................................Page 47

RUSSIA TRADING

Dan Barnes looks at the impact of moves to improve asset protection in Russia.

INVESTORS BENEFIT AS MARKET REFORMS QUICKEN ........................Page 52 Tim Bevan, head of international prime brokerage at BCS looks at the market’s structural changes.

EQUITY TRADING DATA PAGES 2

COMING TO TERMS WITH THE SLOW BURN IN EQUITY TRADING Page 66 Ruth Hughes Liley assesses the potential for better times in equity trading in Europe.

Market Reports by FTSE Research................................................................................................................Page 70

J U LY / A U G U S T 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

TURKEY: THE IMPACT OF DISSENT ON INVESTOR SENTIMENT

Turkish Prime Minister Recep Tayyip Erdogan addresses foreign ambassadors after a traditional iftar, the meal to break Ramadan fasting, in Ankara, Turkey, Thursday, July 18th 2013. Erdoğan explained his government's policies on the developments in Egypt, Syria and Iraq. Photograph by Adem Altan for Associated Press. Photograph provided by Press Association Images, July 2013.

Investors skittish on Turkey’s outlook Borsa Istanbul unveiled a technology deal with NASDAQ OMX in July that involves the NASDAQ OMX upgrading the Turkish exchange’s trading, clearing, risk management and market surveillance operations. The announcement, either deliberately or otherwise, was timely, as it provided some reassurance to international investors who had been discombobulated by several weeks of political unrest that upended (to a degree) some of the ‘feel-good’ sentiment that had built up around the country’s overall economic story. What now? orsa Istanbul played an important role as market standard bearer in July, as international investors reined in their allocations to Turkey. The stock exchange’s agreement with the NASDAQ Group follows a prolonged bidding process, which also included the London Stock Exchange Group’s Millennium IT in the running for the infrastructure upgrade contract.

Borsa Istanbul will integrate and operate NASDAQ OMX's suite of

B

4

market technologies for trading, clearing, market surveillance and risk management, covering all asset classes including energy contracts. Moreover, the two companies will actively collaborate in the region.

Essentially, it is a strategic partnership, which NASDAQ OMX says in its official release, “points to a long-term commitment which would benefit member firms and customers of both exchanges”.

It is thought to be something of a

milestone deal for the exchange, which despite some innovative developments (a Black Sea regional initiative, and the extension of the types of securities trading on the exchange’s platforms) has not taken flight. It should also be seen as an important extension of the sphere of influence of the NASDAQ OMX grouping, which has extended its reach across Europe and into the CIS. The addition of Turkey within its strategic sphere of influence is an important element in the group’s panEurasian ambitions. It also dovetails with the ruling AK Party’s plans to establish Istanbul as a regional financial hub, incorporating the socalled Black Sea sub-region. NASDAQ OMX chief executive Bob Greifeld acknowledged the agreement as a “significant moment for our company.”

Dr Ibrahim Turhan, chairman and chief executive officer of Borsa Istanbul states in the release accompanying the announcement: "Our objective is to position Borsa Istanbul as a leading integrated multi-asset exchange, and to provide a cutting-edge platform serving issuers, investors, and traders globally. We are delighted by this partnership with such a powerful global brand, which covers not only a technology and know-how transfer, but also cements a strong operating union to capitalise jointly the commercial opportunities in the broader Eurasia region. Together with the NASDAQ OMX team we will leverage NASDAQ OMX's best-ofbreed offering. Borsa Istanbul will have full control and deep knowledge of the technology and thus will be selfsufficient in this regard."

The Borsa is also the sole provider in Turkey, through its clearing and settlement subsidiaries (Takasbank and Central Registry Agency), of trading, settlement, custody and registry services for a wide range of securities. The exchange was demutualised and privatised following the ratification of the country’s most

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COVER STORY

TURKEY: THE IMPACT OF DISSENT ON INVESTOR SENTIMENT

recent iteration of its Capital Markets Law in December last year.

The agreement has additional piquancy in that in April the Borsa began its merger with the Turkish Derivatives Exchange (TURKDEX).

The merger has involved the migration of the futures contracts traded on TURKDEX to Borsa stanbul Futures & Options Market (VIOP), in entirety, with all futures and options contracts now traded on a single platform from August 5th onwards.

Some of the TURKDEX contracts with a low open interest or low traded volume were included on a special list and will not be transferred to the VIOP System and from August will be closed to trading.

The transfer of positions and collateral from TURKDEX to the accounts at the Borsa’s VIOP system are undertaken by Takasbank and now the system applied is portfolio based margining rather than contract based margining, which was used at TURKDEX. Portfolio based margining is handled by Takasbank using its SPAN algorithm.

Following the merger, only brokerage houses are authorised to trade single stock and index futures and options.

Banks are no longer authorised to trade in those contracts directly, but only as agencies of brokerage houses.

However, banks can retain the depository accounts for these contracts and/or act as clearing members. On the other hand, with the exception of single stock and index futures/options, banks are allowed to trade contracts and may provide intermediary services for client orders.

Ups and downs The question now is whether following a raft of exceptional reforms and upgrades of the country’s financial system, it can all be up-ended by government intransigence and simmering political dissent among a population split along secularist and proIslamic lines.

After more than a decade in power, Turkish premier Recep Tayyip Erdoğan

6

retains widespread popularity. The expansion of social services to a broader segment of society, outlined in the recent omnibus bill (passed by parliament on July 12th), highlights his credentials as a ‘man of the people’; and underscored his popularity with less well off segments of the Turkish population.

According to the bill, 100,000 current employees under temporary contract may become civil servants (under Article 4/B of Civil Servants Law No. 657 related to citizens serving at local administrations and some public institutions).

Moreover, monthly social security payments, to some 1.5m recipient citizens, have been increased from TRY119.62 to TRY233. The new law also provides 10m citizens who are either disabled, the family members of ‘martyrs and veterans’ with free use of public transportation.

Clearly, the government is implementing populist steps; a move highlighted by political opposition leaders. Speaking at a press conference in Parliament in early July, Nationalist Movement Party (MHP) parliamentary group deputy chairman Mehmet Şandır claimed the omnibus bill helps the government attract voters and hide the commitments that government has failed to fulfill. “This is the last omnibus bill before the 2014 elections. The ruling Justice and Development Party [AK Party] is using national economic resources to remain in power,” added Şandır; though he conceded that the changes “are in the public interest.”

And therein lies the nub in countering Erdoğan: his record speaks for itself. Whatever one thinks of his politics or his religious stance, his effectiveness as a political administrator is unquestioned. The unstated question as always in Turkey is how far the premier wishes to push what looks from the outside to be an antidemocratic agenda, in a country not necessarily noted for its democratic credentials.

Certainly, the government feels the money is available to dispense largesse; though in fairness there is a significant element within the Turkish population that have not necessarily benefited from the country’s economic success story. According to Finance Minister Mehmet Şimşek’s early July statement, the country posted a TRY3.1bn surplus in the first half of the year; though the current account deficit is already at $32bn for the first five months of this year.

Nonetheless, despite the generally benign economic backdrop, foreign investors have exhibited some skittishness over the country’s short term prospects following an early summer of not quite resolved unrest.

Official figures show a mixed outlook. According to Ministry of Finance figures for June, tax receipts which had started to accelerate in the last quarter of 2012 continued with a 22% rise in June. Moreover, the ministry noted that a 31% year on year jump in import tax collection is significant, while VAT receipts rose 38% in real terms in June, way above the monthly average increase of 16% in the first half of this year, with overall revenues across the treasury rising by 10% in the first half of 2013.

On the spending side, not interest expenses rose 10% year on year in real terms, led by a 33% rise in capital spending, “The gains from revenue increase and decline in interest payments is leading to acceleration in capital expenditures. Public investments have been rising in the first half of this year. We observed the positive contribution to GDP in first quarter figures. The same trend continues,” explains Mehmet Besimoglu, in Oyak Bank’s research department. “For 2013, the government targets to keep the budget deficit at 2.2% of GDP. Despite a revenue loss from the expiration of tax amnesty, the acceleration in privatisation and relative recovery in domestic activity help fiscal dynamics.

Clearly, performance is quite strong compared with 2012, with the budget

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

COVER STORY

TURKEY: THE IMPACT OF DISSENT ON INVESTOR SENTIMENT

at surplus. Primary budget surplus is also 24% above 1H12 in real terms.

Now, the policy choice will depend on the dilemma of 2013: maintaining strength in the fiscal side as a cushion against shocks vs. spending temptation towards three elections in two years (2014-2015). We expect the budget deficit to stay around 2.4% of GDP in 2013,” he adds.

In mid July, the Turkish central bank governor signalled a “measured” rise in the upper-band of the interest rate corridor in its monetary policy committee meeting, scheduled for July 23rd. The governor noted a “rise in global uncertainty and volatility had increased recently” and the [central bank] would not allow these developments to impact negatively on price dynamics and financial stability.

“Although the central bank mentions only to ‘increase’ the upper band of the interest rate corridor, this effectively means a rise in the funding cost for the system. The over night lending rate stands at 6.5%, versus inflation reaching 8.3% year on year in June,” explains a recent Is Invest research report.“The policy rate (one-week TRY repo funding rate) stands at 4.5%, but has recently become ineffective, as average funding rate of the CBT hovers close to 6. Meanwhile, the Real Effective Exchange Rate (REER) of the TRY has recently declined compared to other key emerging markets.”

Is Invest says the research team would normally expect a total 200bps hike in the upper band to 8.5%. The team thinks the widening process might be spread across the next two or three monetary policy committee meetings, with a 50 basis points (bps) to 100bps spread seen in July. The team also expects the end of month inflation report from the central bank to revise upwards its 5.3% inflation forecast and they expect the consumer price index to stay at 8% until the end of the year.

Foreign investment inflows/outflows Foreign investment purchases of Turkish

8

securities peaked twice this year. In the second week of January, foreign investors held over $78m in equities and a further $73m in bond (mainly government stock).

Following a dip in the third week of February, when foreign investors held just over $65m worth of equities and over $73m of bonds, the market’s appeal grew steadily reaching almost $80m in equities in late April and $82m in bonds.

By the first week in July, foreign investors held a relatively modest $60m of equities and $55m in bonds, according to figures issued by IsInvest, the brokerage arm of Is Bank.

To add to the skittish mood, Turkish corporations were hinting that they were pulling bond and equity issues (including real estate developer Emlak Konut, which is actually a state controlled company) because of the overall market uncertainty. Another Turkish stalwart, Ziraat Bank (the powerful state run bank which is also the state’s civil service paying agent) formally announced in mid July that it intended to issue bonds worth up to TRY600m (around $310m). The transaction is expected to be a bellwether of demand for Turkish risk over what looks to be a tense summer.

Even so, Turkey’s banking segment has been building an issue pipeline ready for the get go. In May Turkey's Garanti Bank issued a five year $173m and announced in early July that the Capital Markets Board had given its approval for a TRY500m bond issue, offering compound yield of 7.827% and a provisional issue price of 98.443, maturing on November 15th this year.

The last few years have seen Turkish banking issuers substantially increase the tenors of their issues, with Akbank announcing in late June that it intended to come to market with a $3.6bn TRY denominated bond with a maturity of five years. Denizbank too says its plans to issue $2.58bn worth of TRY denominated bonds, though the bonds will be of varying maturities.

The pipeline shows the increasing diversity in debt issuance among a

select sector of the market and, rightly, the banking sector remains the most popular segment of issuers among foreign investors.

Why a political settlement matters It is not simply a political issue. Much rides on the ability of premier Erdoğan’s Justice and Development Party to ‘walk the talk’ at a time of intense political upheaval in Turkey’s eastern hinterlands. Premier Erdoğan waxes lyrical on Turkey’s emergence as a regional leader, backed by a model democracy.

However, as well as managing economic development, Erdoğan will have to walk a political tightrope over the coming months if he is to effectively balance the agenda of his pro-Islamic party and the secular interests of a substantive portion of Turkish society.

His suspicion of the intentions of the military as guardians of democracy has resulted in the decimation of its leadership. On the other hand his handling of marginalised groups, such as the Kurds and his effectiveness in bringing their complaints into mainstream political discussions is exemplary. As is his handling of the ultrahot potato Syria, where he has stood firm against what (according to the traditional Western perspective) is a dictator that has turned against its people.

His unfortunate intolerance for dissent, his persistent intimidation of the Turkish media and plans to alter the Constitution (in order to strengthen the presidency) remain troubling.

Continued unrest could harm Turkey’s long-stalled bid to join the European Union, which was expected to take a step forward over the summer (though if again, it comes to naught, it is unlikely that Turkey will be too upset), and the country’s appeal as a tourist destination.

J U LY / A U G U S T 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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9

MARKET LEADER

BUYING OPPORTUNITIES IN CORPORATE BONDS

Photograph © Janaka Dharmasena/Dreamstime.com, supplied July 2013.

Corporate Bonds: Not Just Clipping Coupons The recent bond market bloodbath has been indiscriminate, slashing prices of everything from US Treasuries to distressed corporate debt. In times of market turmoil, investor psychology descends to sheep-like simplicity: the Federal Reserve is threatening higher interest rates, therefore all fixed income instruments are at risk. Reality is more complex, however; particularly for corporate bonds where credit quality is often more important than interest rates in determining value. For the smart money, panic selling creates opportunities to pick the pockets of the foolish. Neil A O’Hara reports.

HE CORPORATE BOND market has ballooned in size since the 2008 financial crisis.

Banks tightened their lending standards in order to rebuild capital, driving up the cost of loans. Companies turned instead to the capital

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10

markets, where they tapped a flood of money from retail investors seeking a safer haven after the bear market savaged their equity portfolios.

Institutions boosted their bond allocations, too, driven in part by revised pension funding requirements that

encouraged better matching between their assets and future payment liabilities, which are closer to debt than equity in nature.

“We’ve had huge new issue supply in the past couple of years,”says David Tiberii, a vice president and portfolio manager for investment grade corporate bonds, at T Rowe Price Associates, a Baltimore, Maryland-based money manager that manages $617bn, including $158bn in fixed income.

“Investors were looking for yield, taking a little more credit risk in investment grade corporate bonds and a lot more risk in high yield and emerging markets bonds.”

Although Standard & Poor’s downgraded the US credit rating in 2011 the markets still consider US Treasuries free of credit risk, which means for a particular maturity interest rates alone set the price. Corporate bonds trade at a spread over Treasuries to reflect the inherent credit risk embedded in instruments not backed by the government power to tax; the worse the credit quality the higher the spread.

Credit spreads fluctuate over the economic cycle with changing perceptions of risk—and the wider the spread, the lower the correlation between corporate bonds and US Treasuries of similar maturity.

Eric Takaha, director of the corporate bond and high yield group at Franklin Templeton, a San Mateo, California-based firm that manages $362bn in fixed income alone, notes that bonds rated investment grade trade at a relatively narrow spread to Treasuries, so the price correlation is tight. It’s a different story for high yield bonds, however. “When credit spreads are wider, the correlation with Treasuries tends to be lower and the correlation with equities higher,” says Takaha. “When spreads are narrower, the correlations are reversed.”

In the first four months of this year, high yield bond spreads hovered around 350-400 basis points (bps), the long-term average—and price correlation to Treasuries was zero or even

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BUYING OPPORTUNITIES IN CORPORATE BONDS

Eric Takaha, director of the corporate bond and high yield group at Franklin Templeton, a San Mateo, California-based firm that manages $362bn in fixed income alone, notes that bonds rated investment grade trade at a relatively narrow spread to Treasuries, so the price correlation is tight. It’s a different story for high yield bonds, however. Photograph kindly supplied by T Rowe Price, July 2013.

negative. Bonds were yielding 5%-6%, but the pure interest rate component (Treasury yield for the same maturity) was around 1.5%. “About three quarters of the yield came from the credit spread, not the Treasury curve,” says Takaha.“It doesn’t mean you can’t have a selloff, but the correlation in high yield tends to be higher with equities than with government bonds when that is the relationship.”

Equities did sell off in May and June, of course, but not as much as longterm Treasuries, where yields leapt from 1.6% to 2.6%. The fast money in high yield—often retail investors— jumped ship in a knee-jerk reaction that ignored the economic backdrop.

The Federal Reserve proposes to scale

12

back its bond purchases because the sluggish recovery is picking up steam, which implies faster growth and improving corporate cash flow.

“Defaults have been low, earnings are supportive, liquidity and cash flow is pretty good,” says Takaha. “Consequently it’s a bit odd to see prices fall due to a change in the Treasury market.

To the extent the sell-off is driven more by investor flows rather than a change in fundamentals, we think it’s an interesting opportunity to add some exposure.”

Year to date money flows underscore the difference in attitude between retail money, which can turn on a dime if performance flags, and institutional investors, who take a longer-term view based on economic analysis. A retail crowd disillusioned with equity markets after the financial crisis poured money into high yield bond funds over the past few years in search of income, but the tide has turned: retail funds have seen net outflows so far this year. Institutions joined the high yield party, too, but managers are still seeing net inflows from institutional clients.

Traditional managers such as Franklin Templeton focus on conventional bonds and floating rate bank loans, leaving hedge funds to exploit opportunities in more exotic credit instruments. In addition to high yield plays, Bill Crerend, chairman, chief executive officer and president of EACM Advisors, a $3.5bn fund of hedge funds based in Norwalk, Connecticut, says some managers in his firm’s portfolio have found hidden gems among the lower tiers of collateralised loan obligation (CLO) capital structures.

CLOs are instruments backed by pools of leveraged loans to belowinvestment grade credits; securitisation transforms the senior CLO bonds into investment grade credits atop a cushion of lower-rated mezzanine tranches and unrated equity exposed to first-loss risk. Prices tumbled during the 2008/2009 recession, but the

David Tiberii, a vice president and portfolio manager for investment grade corporate bonds, at T Rowe Price Associates, a Baltimore, Maryland-based money manager that manages $617bn including $158bn in fixed income “We’ve had huge new issue supply in the past couple of years,” says Tiberii.

Photograph kindly supplied by T Rowe Price, July 2013.

senior bonds soon bounced back when credit performance held up better than expected. The mezzanine layers lagged because they are much more sensitive to default rates and the percentage of loan principal recovered from loans that do default. The lower tiers in the capital structure are thin, too; a relatively small improvement in default or recovery rates can alter the outcome from zero to full par value payout. “Managers took positions in the subordinated tranches, including the equity, to get amped-up exposure to appreciation in those securities,” says Crerend. The gamble paid off as the economic recovery chugged on, albeit at a pedestrian pace.

Hedge fund managers went

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BUYING OPPORTUNITIES IN CORPORATE BONDS

bargain-hunting in Europe, too.

Changes to the definition of regulatory capital prompted United Kingdom and European banks to re-evaluate certain outstanding preferred and hybrid securities that no longer qualify for the critical Tier 1 capital buffer. Managers scoured the market for instruments that would become uneconomic for banks under the new regime—and likely to be redeemed if the issuers had the wherewithal to do so. “The European bank play is a specialised theme, but it’s still credit-related,” says Crerend.

Corporate credit has been a core allocation for EACM since 1994, but the firm upped its exposure to the asset class after the financial crisis. In the early stages of the market rebound, managers often made long-only bets on high quality instruments dumped at fire-sale prices by forced sellers, or bankruptcy recovery plays like Lehman Brothers and MF Global.

As prices bounced back over the past four years, the portfolio has shifted toward hedged relative value, reducing net market risk. “It evolved from traditional distressed toward long short fundamental opportunities, the equivalent of stock-picking in the credit space,” says Crerend. “We haven’t changed our allocation, but we have lowered our net exposure as credit instruments reached fuller valuations.”

Managers who want to short credit buy credit default swaps, either index tranches for a general hedge or single name credit default swaps for idiosyncratic plays. Even traditional managers like T. Rowe Price use these instruments. For example, Tiberii may buy index credit protection to cover a large anticipated withdrawal, or a single name credit default swap if he expects the company to make a sizable acquisition, issue a new bond or take other action that may impair the credit quality.

Credit default swaps offer greater liquidity than cash bonds, particularly in index tranches. In fact, trading cash bonds has become more difficult in

14

Bill Crerend, chairman, chief executive officer and president of EACM Advisors, a $3.5bn fund of hedge funds based in Norwalk, Connecticut. Crerend says some managers in his firm’s portfolio have found hidden gems among the lower tiers of collateralised loan obligation (CLO) capital structures. Photograph kindly supplied by EACM, July 2013.

recent years even though the market has grown. Retrenchment has caused the major banks and broker dealers to slash the capital devoted to marketmaking or facilitation—they typically don’t execute an institutional order now until they have lined up the other side of the trade.“The Street won’t buy bonds from investors and put them in inventory,” says Tiberii. “It’s harder for us to find the bonds we want. We see spreads widen based on the last trade, but instead of those bonds sitting in inventory waiting to be sold they have already gone to another investor.

The liquidity is sticky.” The absence of inventory erodes the dealers’ valueadded; electronic trading platforms account for a much higher proportion of T Rowe Price bond trades than before the financial crisis.

The growth in corporate bond ETFs has altered the trading landscape, too, although more in high yield than in

investment grade bonds. The total market value of investment grade bond ETFs is a drop in the bucket—less than $100bn vs. $2trn in index capitalisation, too small for cash flows to have a significant impact.“ETFs are used to manage institutional cash flows. If we have a large cash inflow and I want to get exposure the market quickly, I can buy the ETF and then sell it as I buy individual corporate bonds,” says Tiberii.

High yield bond ETFs represent a larger percentage of market value in the indices they track, so cash flows tend to whipsaw prices in index names, raising volatility. The ETF price may even trade at a premium or discount to NAV, especially in times of market stress—another opportunity for institutions to make money at the expense of less sophisticated retail investors. In corporate bonds, as in other financial markets, the smart money usually has an edge. I

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IN THE MARKETS

WON WINNERS: KOREANS EMBRACE EQUITY-LINKED SECURITIES

Asian investors have a penchant for equity-linked securities (estimated annual issuance volume is worth between $120bn–$150bn) but nobody more than the South Koreans.

The product has consistently delivered attractive returns, Korean investors bought $41.6bn of these securities in 2012, not far short of the $50bn sold in Japan. Neil A O’Hara looks at the asset class.

THE STEADY APPEAL OF EQUITY-LINKED ISSUES IN EAST ASIA

J

APAN HAS SEEN a surge in principal-at-risk equity-linked issuance in 2013, driven in part by the strong rally in the Nikkei 225 Index. One of the most popular products in Japan is a knock-in, knock-out note, generally two to five years in tenor. The coupon is much higher than for Japanese government bonds, but investors get their principal back only if the reference benchmark (typically the Nikkei) stays above the knock-in threshold (50%-60% of the value at issue).

If the Nikkei exceeds a knock-out threshold on a semi-annual observation date, the product is automatically called at par plus accrued interest.“The six month bull run in the Nikkei cleared out a huge amount of product issued over the past several years,” says Charles Firth, head of equity derivatives structuring for Asia-Pacific at Credit Suisse in Hong Kong.“Much of that money was reinvested in various equity-linked products, which boosted issuance this year in Japan.”

The high coupons associated with equity-linked securities appeal to Asian investors in search of long-term income. “In the developed markets— Hong Kong, Singapore, South Korea, Taiwan and Japan—the main driver is the hunt for yield,”says Renaud Meary, head of structured equity, Asia Pacific, global equities and commodity derivatives at BNP Paribas in Hong Kong.“In less mature markets, such as South

16

East Asian countries, capital protection while participating in growth is the main theme.”

Capital protected equity-linked notes work only if local interest rates exceed a minimum threshold. Issuers fund the principal guarantee through zero coupon bonds, which trade at a discount to par value; the difference pays for options to hedge the equity exposure. The lower the interest rate, the smaller the discount to par and the less money is available for the equity kicker.

In Japan and other low rate countries, these products are unknown—the numbers don’t add up.

Japanese equity-linked notes are often wrapped inside variable annuities, a $200bn market, second in size only to the United States. Meary says the financial crisis delivered a bodyblow to the variable annuity market; not only did investors lose money but the life insurance issuers, that had aggressive hedging policies, took a big hit to their balance sheets.

The life companies wanted new solutions that would better protect their balance sheets while still offering investors an attractive package. It is a tall order, requiring not only a hedge against the benchmark performance but also appropriate packaging, pricing and a hedge against actuarial and behavioural risks. “BNP Paribas is one of the very few players able to design and implement a full-fledged setup,”

says Meary. “It was a big investment, but it creates a privileged relationship with clients who can deploy their strategy with greater confidence in a scalable manner.”

BNP Paribas is a relative newcomer to the Korean market, obtaining a licence to sell equity-linked products only in 2011. The bank wants to replicate its success elsewhere in Asia in a country that boasts a large economy, high savings ratio, sophisticated financial system, a strong investment culture and sound knowledge of equity markets among both retail and institutional investors. “Korean investors have an appetite for new products,” says Meary. “There is increasing interest in foreign markets—China, the US, the United Kingdom and some emerging markets—in equitylinked products.”

The structure of choice in Korea is a “hi-five”security (technically, a reverse convertible equity-linked note), which typically has a three-year initial tenor subject to an automatic call every six months if the reference benchmark exceeds the knock-out trigger.

The benchmark is usually the worst performance of two references, often the local Kospi200 Index plus the Hang Seng China Enterprise Index, or sometimes two specific stocks—in which case the note will carry a higher coupon because the benchmarks are more volatile.

In one recent issue benchmarked to the two indices, the knock-out trigger starts at 95% of the benchmark value at issuance and steps down over three years to 85%, increasing the likelihood the call will kick in before the note matures. Investors receive an elevated coupon of 6.5%—more than double the yield on long-term Korean government bonds—but the return of principal is not guaranteed.

Only if the reference benchmark remains above the knock-in trigger (55%) does the investor receive par; otherwise, the principal repayment switches to the benchmark value, leaving investors exposed to market

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

Charles Firth, head of equity derivatives structuring for Asia-Pacific at Credit Suisse in Hong Kong. “The six month bull run in the Nikkei cleared out a huge amount of product issued over the past several years,” says Firth, “Much of that money was reinvested in various equity-linked products, which boosted issuance this year in Japan.”

Photograph kindly supplied by Credit Suisse, July 2013.

risk of the benchmark from the issuance until maturity.

For many years, Korean investors have been able to clip high coupons and get all their money back from equity-linked notes. Firth at Credit Suisse says most securities issued, even at the market peak in 2007, have paid off for investors.

Although Korean equities tumbled in 2008 along with markets everywhere else, the Kospi200 Index rebounded and set a new high before the 2010 maturity date—giving investors both the high coupons they were hoping for and a full return of principal. Most investors who did suffer losses after the financial crisis bought paper with worst-of-two single stock benchmarks, at least one of which failed to bounce back before maturity—Daewoo or LG Electronics, for example.

“The hi-five is a sensible structure, which has enabled investors to do well,” says Firth. “Having five chances for the structure to be called before final maturity gives more opportunity for

investors to get a good outcome.”

In other Asian countries, equity-linked notes may have a single automatic call, and if that one-time bet doesn’t pay off—as happened after the financial crisis—investors nursing losses are less inclined to reinvest in equitylinked notes.

Although high-five securities embody several interdependent variables—tenor; knock-in and knock-out triggers; and coupon—the investor in effect writes a put option on the reference benchmark. If the knock-out is never triggered but the knock-in is, the investor bears market risk on the principal—and the proceeds of that put option fund the generous coupons.

Korean investors may have enjoyed good returns, but the issuers have also done well. As Firth points out, it is not a zero-sum game; in fact, the issuer does not bet against the investor at all.

The issuing bank typically hedges its exposure through long options on the benchmark and maintains a deltaneutral position, reducing the hedge when the market rises and adding to it when the market falls. To keep the correct hedge, the issuer must buy low and sell high—generating profits that pay for the coupons.

If the note incorporates the common ‘worst of two’ benchmarks, additional hedging gains can accrue whenever the worst performance shifts from one reference to the other, allowing the issuer to pay higher coupons than for a single benchmark product. Provided the issuer has competent risk management, it can embed a profit margin for itself in pricing the notes based on forecast volatility. “These products are popular in Asia because they enable investors to monetise volatility, converting stock fluctuations into coupons,”says Firth.“Stocks in Asia are more volatile than in Europe or the US, so for some investors it is a way to convert an otherwise unused resource into cash.”

Korean investors have also benefited from the preferred local distribution method, which is through regulated

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

The high coupons associated with equitylinked securities appeal to Asian investors in search of long-term income. “In the developed markets—Hong Kong, Singapore, South Korea, Taiwan and Japan—the main driver is the hunt for yield,” says Renaud Meary, head of structured equity, Asia Pacific, global equities and commodity derivatives at BNP Paribas in Hong Kong. Photograph kindly supplied by BNP Paribas, July 2013.

onshore investment funds. A bank— typically a foreign global institution —executes a swap with the fund, which then issues equity-linked notes in its own name, insulating investors from counterparty risk of the bank. “When Lehman Brothers became insolvent, even though it had been active in Korea, the investors’ money was inside these funds,” says Firth. “Investors did not suffer any capital loss owing to the Lehman bankruptcy.” In some Asian countries, investors bought notes directly from Lehman, exposing them to losses even if the benchmarks had not tripped the knock-in trigger.

The disparate experience highlights the myth of an“Asian market.”Asia is a collection of independent countries with different regulatory regimes and market structures, which can have a big impact on which products appeal to local investors. Nothing succeeds like success, however, and Koreans who have reaped good returns from equitylinked securities keep coming back to the well. I

17

IN THE MARKETS

CREDIT REVIEW: EASY RETURNS REGIME NEARS ITS END

Stephen Zinser, chief executive officer and co-chief investment officer at ECM Asset Management, the $9bn multi-asset credit investor, asks whether the current selloff in rates and correction in risk asset pricing represents a buying opportunity.

Credit: Time to buy?

J UNE PROVED TO be a challenging month across the board. However the cause of the selloff in June differed substantially from market corrections in 2010, 2011 and 2012.

Prior period pullbacks were driven by European sovereign and bank credit concerns. This sell off was directly connected to Federal Reserve Bank’s QE tapering fears likely marking the beginning of the end of abundant global liquidity. The subsequent spike in USD interest rate volatility, rising Chinese banking fears and record outflows from US High Yield and emerging markets funds and ETFs had a distinctly nonEuropean flavour this month.

Losses in the global investment grade fixed income world in June will give investment committees good reason to pause and reflect over the summer months. Although rates stabilised in the final week of the month, the USD investment grade corporate index fell 3% and is now nursing a half year loss of 3.6. Sterling investment grade markets were hurt by structurally longer duration and dropped an eye watering 4.2% in June leaving the index down 1.1 % at the half year mark. Euro investment grade markets lost 1.7% in June leaving year-to-date index returns at a slightly positive 0.1%. The relative outperformance of the euro investment grade market reflects in part the outperformance of bunds relative to treasuries—a function of the region’s well publicised economic challenges and the fact that the eurozone has no QE to taper.

Many experienced were wrongfooted in June adding to nervousness among investors. Investors must now ask whether this selloff in rates and correction in risk asset pricing repre-

18

sents a buying opportunity. Nobody can be sure but we would argue that it depends on which credit asset class.

First, clearly the 30 year bull market in interest rate duration is over. There will continue to be selective buying opportunities, roll down or curve plays in government bonds and duration will still represent a good hedge against systemic risk. However, nearly five years after the financial crisis, as we move forward, interest rate winds are more likely to be in your face than at your back.

The changed “forward guidance” policies from both the ECB and the Bank of England will clearly impact the front end of the Euro and GBP yield curves. However, longer duration euro and sterling interest rates will more likely be swept along to a significant degree by the Fed’s actions. It was interesting that ten year bund and gilt yields barely moved despite the revolutionary nature of the European central bank’s current communications policies. So the easy returns regime is nearing its end.

Fixed income allocations should now take this likelihood into account.

Investors need to be aware of acutely crowded trades at a time when the Street’s ability to use balance sheet to recycle risk is structurally curtailed.

Emerging market hard currency and local currency fixed income comes top of our list. Growth concerns are rising particularly in China, commodity prices are depressed, weak EM currencies will bring a host of short term economic challenges and political risk is ascendant in many countries including Brazil, Turkey and Egypt.

Billions have flowed into emerging markets from retail investors via mutual funds and ETF’s. Only a tiny fraction of

this year’s flows and even less of prior years’ allocations have been reversed.

The institutional allocations to EM may be more stable but we are not convinced we won’t see further significant outflows from this sector through a very narrow liquidity window.

Third, while political developments are worth watching in Portugal, we are beginning to see some concrete evidence that a corner is being turned in certain periphery countries, particularly in Spain which reported this week the first positive (50 or greater) PMI data point in over 25 months.

This is not to say that Spain’s well publicised unemployment challenges and fragile banking system are likely to be solved in the near term. However we are clearly closer to the “inflection point” in numerous European countries which we believe will be helpful to sentiment, valuations and investor flows in European markets. In addition globally savvy investors will notice the degree of outperformance of the Euro credit markets in the first half of the year compared to US credit markets and consider incremental allocations outside core US markets.

ABS markets should remain lowly correlated with wider market volatility.

The implications for financial investors of the recently agreed EU burden sharing legislation have not yet been fully reflected in senior unsecured debt spreads and the sector is best approached from a specialist long short perspective.

In high yield, technicals need to be carefully monitored following recent record weekly outflows but given the extent of the selloff in June; returns should be solid from here with careful credit selection. We continue to favour the Senior Secured part of the subinvestment grade capital structure particularly for investors which can invest in both Loans and HY bonds.

Senior secured loans should retain their defensive and resilient status given ongoing positive inflows, floating rate coupons and favourable position in the capital structure. I

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

FACE TO FACE

DONALD KEITH, DEPUTY CEO, FTSE GROUP

THE NEW PRIME OF INDEX INVESTING

Photograph © Herrbullerman/ Dreamstime.com, supplied July 2013.

This year has witnessed strong bull and bear markets in index performance in various markets.

As subtle shifts in asset allocation continue to impact on investment flows into different asset classes, index based investments look to be enjoying something of resurgence. Donald Keith, deputy chief executive officer of FTSE Group outlines the main trends.

TSE GM: How is market complexity changing investor appetite for index-based investments?

DONALD KEITH (DK): FTSE’s experience is that index-based investing is growing rapidly, particularly since the financial crisis. Investment Company Institute (ICI) data confirms the size of the switch between active US mutual funds and exchange traded funds (ETFs) over the last three years. In 2012 alone, active mutual fund assets under management (AUM) fell $154bn while ETF AUM grew $187.2bn. Much of that growth, especially in the United States (but also in Europe) is due to the increased availability and use of ETFs. Europe has seen a compound annual growth rate of 42.5% over the past ten years and now has $385bn in ETF AUM, although it has some way to go before it compares with the $1.49trn ETF AUM in the US.

F

There are several reasons for investor disaffection with actively managed funds. They were, for example, impacted by the increased volatility post the crisis and low returns have been compounded by the higher fees charged by active funds—which can be typically ten to 20 times more expensive to own. ETFs also offer a simple, transparent and easily accessible means of investing in indices. Their structure enables investors to see what they are investing in, what the risks and costs are.

Since the financial crisis the range of indices has increased to include those that package previously active approaches in a passive form. So it’s not just market complexity, but a move away from expensive funds with low returns and high costs towards lower costs, ease of investment and disinvestment, and a growing range of ‘alternative’ indices tracking investment strategies which

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

would previously only have been available through active managers.

FTSE GM: Has quantitative easing (QE) augmented the utilisation of index based investment strategies, or undermined it (albeit unintentionally)?

DONALD KEITH (DK): QE was originally designed to shore up the capital structures of the banking system and to bring wealth effects to the economy by ploughing the excess liquidity into equities. The risk on, risk off rotation that has been a major feature of markets post the global financial crisis has encouraged asset allocators to use ETFs. The QE-induced financial repression (a period of sustained low real and nominal interest rates) has left many investors seeing equities as the asset class of choice given the yield enhancement they offer.

It would appear that, in the US, private investors are increasingly

19

REGIONAL FACE TO FACE REVIEW

DONALD KEITH, DEPUTY CEO, FTSE GROUP

using ETFs in their equity allocations.

QE has also disproportionately impacted equities in some countries, such as Japan, where currency fluctuations have led to a rise in equity prices. However, the recent sharp fall in equity indices globally following the announcement of proposed tapering of US QE shows that it has also become a source of volatility in equity markets.

The growth of index investing has also led to investors searching for more sophisticated analytical tools and the development of a new range of indices such as those designed to minimise volatility and others which aim to provide access to performance previously only available through active managers. While not a direct consequence of QE, this is a result of investors needing new, cost effective ways of accessing the markets and gaining exposure to available risk premia in a focused way but with all the benefits of tracking an index. These ‘investment strategy’ indices, also known as ‘smart beta’ or alternative’ beta indices, have make up an increasing proportion of the index universe.

In terms of fixed income, it is estimated that QE caused a 1% additional decline in bond yields (Bernanke, August 2012, Jackson Hole Symposium). At the same time, QE has had a much more negative knock on effect on emerging markets than that in developed countries. QE encouraged the use of emerging market currencies in carry trades. Now that there is talk of ‘tapering’ QE, those currencies are losing value rapidly.

FTSE GM: Have indices now diversified so much that they are a product for all seasons and all market conditions?

DONALD KEITH (DK): The range of indices currently available is huge compared with 1984, when the FTSE 100 started out. It now covers virtually all asset classes and a very comprehensive range of investment strategies.

Investors can focus on sectors, countries, regions, responsible investing,

20

cyclical and defensive, growth, value, volatility, commodities amongst others. But there is still plenty of room for innovation.

Today, there is more data available, the technology has advanced and developments in scientific analysis have all extended the range of possibilities for index providers. Working with partners in academia and in the financial sector gives FTSE access to some of the leading ideas across the indexing industry.

FTSE GM: Index providers have diversified the assets covered by their indices: does the utilisation of indices right now reflect the rotation of investment in recent years out of equities and into bonds?

DONALD KEITH (DK): We have seen some rotation out of equities into fixed income, but the switch to equities seems to have been funded by cash and not by bond redemptions. The recent rally in equities was not accompanied by big bond redemptions until June, when this accelerated.

The move into bonds was part of a liability driven approach to investment.

Bonds were attractive due to their predictable returns which meant that pension funds could be confident of this asset class’s contribution to its commitments. With low bond returns, other asset classes or investment strategies may offer better potential for closing deficit gaps.

FTSE GM: How much have ETFs revitalised the fortunes of index providers? Does the popularity of ETFs augment the argument for index based investment strategies?

DONALD KEITH (DK): ETFs are still only a small percentage of the total index funds available both in Europe and in the US; although it is higher in the US where they have been available for much longer and where the retail market for ETFs is more mature. So ETFs are only a small part of the market for index fund provision in Europe.

However, this is likely to change as European regulators implement changes to commission payments to

Donald Keith, deputy chief executive officer, FTSE Group. Since the financial crisis the range of indices has increased to include those that package previously active approaches in a passive form. So it’s not just market complexity, but a move away from expensive funds with low returns and high costs towards lower costs, ease of investment and disinvestment, and a growing range of ‘alternative’ indices tracking investment strategies which would previously only be available through active managers.

Photograph kindly supplied by FTSE Group, July 2013.

advisors, creating more interest in ETFs among intermediaries and retail investors, although there is still some way to go.

Index based mutual funds and ETFs both offer a relatively cheap way to gain exposure to a specific market. But ETFs offer high levels of liquidity and transparency, as well as a wide range of investment strategies, and can be easier to buy and sell.

FTSE GM: How has index construction changed over the last two to three years? Why was that change important and what have been the benefits for investors?

DONALD KEITH (DK): The index industry now produces many more indices which express a wide range of strategies. While the majority of indices still use the traditional ‘market capitalisation weighted’ approach, where the value of each constituent is based on

J U LY / A U G U S T 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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dŚĞ D ĂůŐŽƌŝƚŚŵ ŝƐ ƵƐĞĚ ŝŶ ƌĂĚŝŽ ĂƐƚƌŽŶŽŵLJ ƚŽ ĐůĂƌŝĨLJ ƚŚĞ ŽďũĞĐƚƐ ƵŶĚĞƌůLJŝŶŐ Ă ŵĂƐƐ ŽĨ ĚĂƚĂ͖ ǁŝƚŚ ŝƚƐ ĂďŝůŝƚLJ ƚŽ ŚĂŶĚůĞ ŵŝƐƐŝŶŐ ĚĂƚĂ ĂŶĚ ƐŚĞĚ ůŝŐŚƚ ŽŶ ƵŶŽďƐĞƌǀĂďůĞ ǀĂƌŝĂďůĞƐ͕ ŝƚ ŝƐ ǁĞůůͲƐƵŝƚĞĚ ƚŽ ƉƌŝĐŝŶŐ ĂŶĚ ŵĂŶĂŐŝŶŐ ƚŚĞ ƌŝƐŬ ŽĨ ŝŶǀĞƐƚŵĞŶƚ ƉŽƌƞ ŽůŝŽƐ͘ dŚĞ D ƉƉůŝĐĂƟ ŽŶƐ ƌŝƐŬ ŵŽĚĞů ĂŶĚ ĂƩ ƌŝďƵƟ ŽŶ ƚĞĐŚŶŝƋƵĞƐ ĂƌĞ ďĂƐĞĚ ŽŶ ŽƌŝŐŝŶĂů ǁŽƌŬ ďLJ ů ^ƚƌŽLJŶLJ ĂŶĚ ƌ dŝŵ tŝůĚŝŶŐ͘

ĂŶĂůLJƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

REGIONAL FACE TO FACE REVIEW

DONALD KEITH, DEPUTY CEO, FTSE GROUP

the value that the market assigns to it, recently launched indices often use other factors to rank constituents.

These ‘investment strategy’ indices can be built around virtually any measurable criteria for which there is enough data. For example, fundamental indices may use factors such as sales, profits and dividends to determine the ranking and weighting of their indices.

For investors, the benefits are that they have a wider range of options with which to access other risk premia or to dampen the effects of volatility, according to their strategies, but without the cost typically associated with traditional ‘actively managed’ funds.

FTSE GM: Has the index provider segment kept pace with market change? If so, in what way and how has this change impacted on the way that indices are developed and marketed.

DONALD KEITH (DK): FTSE has always been a key driver of innovation, both in terms of market practices and new concepts, developing new products to meet investor need. The majority of commercial index providers are members of the Index Industry Association, an independent body committed to ensuring common industry standards for independent governance and transparent index methodologies. The IIA recently published standards of Best Practice in Indexing and the membership of the Association, which includes most of the major index providers, abides by these Guidelines.

Both benchmark indices and investable indices have seen change— with benchmarks specific to fund managers’ markets being in demand— and more sophisticated investable index strategies becoming more attractive. Each has different users with their own informational needs and specific needs for marketing support.

FTSE GM: Are investors still looking for more customised indices? If so, what strains does that place on index providers?

DONALD KEITH (DK): FTSE’s expe-

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rience is that customised indices have a useful role to play. For example, when migrating a fund from one index to another, one or more intermediate indices may be needed during the transition to minimize the effect on the market. Although a vast range of indices is now available, customised indices may also be needed for funds with unique investment restrictions.

Creating individual indices requires highly experienced technical teams together with sophisticated technology as well as in depth knowledge of good governance as it applies to the new index or benchmark.

FTSE GM: Who is winning the fight between traditional and enhanced indexers and why?

DONALD KEITH (DK): FTSE doesn’t see this as an issue because enhanced indexers typically follow the same benchmarks as passive funds, but differ in the implementation at the margin; for example, by not fully replicating the index in order to avoid liquidity issues, or by optimising stock lending. The aim is to increase returns by a few basis points at the expense of a little extra risk and a small increase in tracking error, but they still need an underlying index and not everyone will accept the trade-off between extra risk (or tracking error) and reduced costs.

FTSE GM: How important are indices in the opening up of new frontier markets to investors?

What benefits do indices bring in this regard?

DONALD KEITH (DK): FTSE works with a number of international exchanges to calculate their domestic indices, including frontier countries such as Morocco and Kenya. A country which is part of an index is easier to invest in. Being part of a FTSE index means that strict standards of governance apply, which gives investors confidence in that country.

Clear definitions of what qualifies a country as frontier, secondary or advanced emerging, and developed must be applied with stringent tests and independent market appraisal. This

makes sure that countries provide the market characteristics that investors want when they choose a particular type of market.

Over time, frontier markets generally enter the Emerging Markets category and finally qualify as Developed. South Korea is just one such example.

Investors who go into these frontier and emerging markets for the long term often benefit from this transition.

FTSE GM: What is the outlook for the index segment over the next few years: where do you expect the segment to bring in further innovation?

DONALD KEITH (DK): FTSE expects the market to go from strength to strength as new indices and new investors enter the market. Many of the trends that we see today will be expanded, for example, to include greater access to highly tradable, highly liquid subsets of existing indices. We also see scope for converting OTC transactions in assets such as currency into a range of indices, for use as currency overlays or as a source of return in themselves. So far, multi-asset class index-based investing has been relatively untouched and could be an exciting new class of index.

We also see greater interest in ESG indices as the world moves closer to a low-carbon economy. Recently we extended our Environmental Technologies indices, introducing a bigger Environmental Technologies index and a new sector to cover agriculture, food and forestry. We also plan to launch ‘green’ property indices and would expect to expand our range further in future.

As markets mature and investors look further afield for returns, we can also expect to see growth in the number and types of indices covering the Emerging and Frontier markets.

China is expected to deregulate its markets and the RMB is expected to join the international currency market so that China’s ‘A’ shares will join the Emerging Market indices, offering new indexing opportunities. I

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

THE ALTERNATIVE VIEW

OTC TRADING: WAITING FOR US INTEREST RATES TO RISE

The OTC Derivatives market is in the midst of massive regulatory change, in particular the Dodd-Frank Act in the US and the EMIR Directive in Europe, have introduced new benchmarks for transparency and functioning of these markets. Amir Khwaja, chief executive officer of Clarus Financial Technology’s new column will use data on OTC trading activity that is now reported to swap data repositories (and then publically disseminated) to highlight their characteristics and changes.

Amir Khwaja, chief executive officer of Clarus Financial Technology.

Will regulation improve the quality of markets?

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EN YEARS AGO, if you wanted to buy a house in the United Kingdom, you had to rely on the word of estate agents (real estate brokers) as to the correct price for the house. Today anyone buying a house can enter the postcode (zip-code) and instantly find for free exactly at what price and when a house was sold. The same analogy can be made for OTC Derivatives.

One year ago, only major swap dealers and inter-dealer brokers had

insight into the prices and volumes traded on a given day and there was a suspicion that these firms’ extracted out-sized profits from this privileged position.

Now however any firm (whether institutional client, hedge fund or regional bank) can get data on the prices and volumes traded. In the United States the public dissemination of trades has been live since January 2013 and in Europe it is expected to be live by the end of 2013.

The USD Interest Rate Swaps segment, is by most measures is the largest OTC derivative product. The SDR View screenshot below shows key information for a recent business day for vanilla USD Swaps; where one party pays or receives a fixed rate and the other party a floating reference rate—for example, LIBOR. From the chart we can see that trading takes place in many maturity tenors from one year to 30 years; that the largest volume is in five and ten

TRADING OF OTC INTEREST RATE SWAPS v TENORS

Traded Prices

4

12

3

9

2

6

1

3

0

0 1Y

2Y

30M

Cleared average price

24

Notional (USDbn)

Average Price

Product Volumes

3Y

4Y

5Y

Uncleared average price

6Y

7Y

Cleared notional

8Y

9Y

10Y

Uncleared notional

12Y

15Y

20Y

25Y

30Y

40Y

Source: Clarus Financial Technology, July 2013.

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

years, each with more than $10bn. This is followed in descending order by 30 years (30Y), 2Y, 3Y, 7Y and 4Y. Prices rise from 0.50% at 1Y to 3% at 30Y, which is a standard upwardly sloping interest rate curve. Finally, cleared trades dominate uncleared (more on this later).

Trades, liquidity and block sizes Looking at the trades behind the five year volume of more than $10bn, we see that there are in-fact only 222 trades. Of these 71 trades have a notional greater than $100m and 151 have a notional less than $100m. As current regulations allow for block trades greater than $100m to be reported only as $100+, the actual daily volume of USD 5Y Swaps is far higher than $10bn and probably at least $20bn.

Either way we can say that liquidity in the USS swap market is characterised by a low volume of high value trades. This liquidity is different

to but equally as important as that seen in the Futures markets where high volumes of low value trades are common.

in a more regulated, transparent and automated manner, much more similar to the Futures market.

Why is all this important?

Cleared and uncleared?

Another significant regulatory change has been the mandatory requirement for interest rate swaps to be centrally cleared by a clearing house or exchange. From the chart we can see that the vast majority of trades are now cleared. This means that a clearing house stands between both parties to the swap to guarantee performance, by firstly collecting daily variation margin from one and passing to the other and secondly collecting initial margin from both to protect from default of one of the parties.

In addition member firms of the clearing house are required to contribute to the guarantee fund and so mutualise any potential loss amongst the members. This means that posttrade the Swap market now functions

As the Federal Reserve starts to withdraw its extraordinary financial support, we will see interest rates rise.

Indeed USD 10Y Swap rates have already risen 100 bps in the last few months. The interest rate swap market is fundamental in allowing firms to hedge against the expected rise in interest rates and for other firms to position themselves to provide the necessary market liquidity.

Consequently it is imperative that the new regulations and transparency in the swaps market, actually improve the functioning of this markets for the benefit of all participants; whether sellside or buy-side. We believe that this is indeed the case, though we need to continue to focus on the data to check our view.

We live in interesting times ‌ I

DRAWN A BLANK? If you need reprints for your marketing needs, simply call or email Contact: Peter Keith Tel: 44 [0] 20 7680 5158 Email: peter.keith@berlinguer.com

We will be pleased to tailor our reprints to your specific requirements.

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

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ASSET SERVICING

FUND ADMINISTRATION SERVICES: THE BUY SIDE TAKES STOCK

As the business of fund administration continues to evolve and the field of larger players narrows, are the needs of the buy side still being met? Are services as tailored and timely as providers have often claimed? Or in this era of continued belt tightening and “headcount reduction” has standardisation become the dominant theme? If so, could this create additional openings for those in the middle market? Dave Simons reports from Boston.

Fund administration:

the rise of the middle man OR ASSET MANAGERS seeking to maintain profitability during these trying times, the provision of third-party services such as fund accounting, fund administration, and transfer agency has been undeniable useful, allowing firms to streamline their operations while keeping a tighter lid on risk. As regulators continue to pile on the rule changes, however, administrators find themselves juggling a growing list of duties while making additional strategic investments in an effort to keep fund-manager clients and their investors out of harm’s way.

“To fund managers, providers are increasingly viewed as chiefly responsible for ensuring that all regulatory measures are properly enforced and duly reported to the appropriate agencies,” says Edwina Easton, principal at Mercer Investments.

To remain competitive, administration providers have found it necessary to develop more efficient operating strategies using a much leaner budget.

In years past, custodians were able to depend on revenues derived from fees, net-interest income, securities lending, FX and the like. These days, however, many have been forced to explore other avenues, all the while cutting costs and reducing headcount to offset the financial constraints.

Given these circumstances, are providers still meeting their clients’ needs? Are administration services as timely and tailored as providers have often claimed? Or in this era of continued belt tightening has com-

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moditisation or “one-touch” servicing become the norm? If so, could this possibly lead to additional opportunities for niche administration market?

Unrelenting demand for transparency, along with a consistently stiff market headwind, has led some custodians to raise client fees, scale back certain traditional client-service models, while also diverting more functions to offshore operations centers, says Easton.

While these measures may have helped boost the bottom line, the caveat, says Easton, is that “all of these options are risky in the sense that they appear to ‘commoditise’ what was once viewed as a highly customised offering.”

Michael Galvin, global product manager for Linedata, a provider of financial information technology solutions, agrees that the current fund-administration model is largely built around bundled services designed to address the growing needs of the buy side. Despite client expectations for an increasingly sophisticated and customised reporting and analytics product, “it is inevitable that administrators, who are themselves feeling intense cost pressures, should try to standardise their product offering in order to boost economies of scale— horses for courses,” says Galvin.

Does a rise in commoditisation create an opening for smaller administration providers? According to Easton, a lot depends on the ability for these mid-tier and boutique players to offer best-in-class technology capable of streamlining managers’ business

processes while also meeting the rigorous demands of pending regulations.

Given the vast expertise of their global peers, smaller firms must also be able to demonstrate a mastery of all assetmanagement business lines, from 40 Act to unregistered products and more.

“Outsourcing is a long-term commitment,” says Easton, “therefore niche players must be able to meet all of these challenges in order to survive.”

Galvin agrees that increased standardisation has created additional opportunities for smaller players. In recent times Linedata has seen substantial growth in its mid-size and boutique fund-administration segment; these firms are winning new business by offering bespoke services such as customised reporting, quality web access and strong client support.

“Smaller generally does mean more flexible,”says Galvin.“Fund administrators do not compete on price alone, after all, and as a result certain buy-side players are willing to pay a premium for a more customised experience.”

Faced with a lorry load of regulatory rulings ranging from Form PF, FATCA and AIFMD, in many instances managers have had no choice but to continue to offload internal duties to third-party providers. Helping the buy side remain compliant by assisting with collateral-monitoring and clearing, providing advanced reporting, tabulating net asset values (NAV) while maintaining client data will serve as a key proving ground for qualified administrators going forward.

“Much of the responsibility for complying with these regulations is falling on the administrator,”says Galvin.“The financial crisis has ensured that managers can no longer get by with internal bespoke solutions—investors and regulators alike are demanding better technology and transparency. This is driving managers to look for fund administrators capable of meeting these needs.”

Under FATCA, for instance, managers must be able to reconcile their own data with that of their fund

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

raise the bar on expense analysis and cost control, administrators will need to outfit themselves with processing systems that allow them to increase their levels of transparency, accuracy and responsiveness while significantly improving efficiency of their operations, according to Confluence.

“To fund managers, providers are increasingly viewed as chiefly responsible for ensuring that all regulatory measures are properly enforced and duly reported to the appropriate agencies,” says Edwina Easton, principal at Mercer Investments. Photograph kindly supplied by Mercer Investments, July 2013.

Doubling Up

Michael Galvin, global product manager for Linedata, a provider of financial information technology solutions, agrees that the current fund-administration model is largely built around bundled services designed to address the growing needs of the buy side. Photograph kindly supplied by Linedata, July 2013.

administrator’s, making streamlined communications between the two parties crucial to the compliance process, notes advisory service provider Ernst & Young. Similarly, the impending Alternative Investment Fund Managers Directive (AIFMD), which will require alternative managers to provide increased disclosure around investment strategies and products, liquidity levels and risk-management principles, could have a profound impact on the administration space, as managers increasingly turn to providers to help them meet the directive’s lengthy list of objectives.

In fact, the sheer number of regulatory mandates affecting both traditional and alternative managers has compelled many service providers to devote additional capital to regulatory-specific technology investments. Speaking on behalf of Boston-based research and advisory firm Aïte Group, Lyn Marcrum, senior analyst and co-author of the report The Outsourcing Services Landscape for Investment Managers, says that“regulatory pressure will become a primary driver for investment managers considering outsourcing some or part of their operations.”

With consolidation further reducing the ranks of the administration space, adoption of technology will take on added importance, remarks Skip Smith, executive vice-president of product development for Confluence, the Pittsburgh-based automation-services provider. “Fund administration technology is coming of age and will provide forward-looking fund administrators with a strategic competitive edge,”says Smith. As funds continue to

Rather than take their chances with any single provider, hedge fund managers have increasingly sought a back-up firm to “shadow” the services of the primary administrator. Having such a redundant plan in place not only acts as an additional risk buffer for the fund, but also allows the manager to cross-check internal valuation data against figures generated by the administrator. In January, hedge-fund giant Bridgewater Associates tapped Northern Trust to oversee “quality checks” on certain middle and back-office functions performed by its chief administrator, BNY Mellon. Roughly nine in ten hedge funds currently employ some degree of “shadow accounting,” according to Northern Trust.

Though seemingly impractical from a budgetary standpoint, particularly for smaller funds, maintaining a“shadow” administrator is in fact becoming less of a luxury and more of a necessity, offers Linedata’s Galvin, “particularly now that auditors, regulators and investors require that managers have a fall-back plan that allows them to have continuity of service in the event the provider cannot do so themselves.”

Looking ahead, what can fund managers do to ensure that their expectations (and those of their investors) are being met? What kinds of challenges—and opportunities—do all this present to providers? While bolstering the day-to-day “blocking and tackling” regimen, leading administrators need to continually hone their client-relationship skills in order to bring real value to their service offering.

For instance, developing service level agreements (SLAs) that include key performance indicators (KPIs) gives

asset-management clients a level of governance and oversight that “not only ensures that the custodian is delivering on the services promised, but helps minimize errors with blocking and tackling while strengthening the strategic partnership,” says Easton.

While the provision of services around the manufacturing or commodity side of the business (including, among other things, NAV calculation) can serve as a differentiator, success in this area hinges on the quality of the provider’s internal processes and systems, controls and maker/checker functions.“Could a custodian become more of a manufacturing unit? We believe the answer is‘yes,’”says Easton, “but not without a thorough examination and focus on its technology and people.”

Building trust is also critical, adds Easton. Managers that continue to maintain separate records or insist on handling compliance and administration functions in-house will eventually be burdened with costs and cease to be competitive on overall fees.“Along with the increased expense, failure to allow the custodian to handle complete NAV functionality may lead to a rise in operational and financial risk,”says Easton.

Hence, it is up to the provider to instill managers with the confidence they need to fully relinquish these tasks. “Providers must continue to educate clients as to the overall benefits of outsourcing,” says Easton.

“However, it is unlikely that any asset manager will entrust a custodian with NAV manufacturing or any other administrative work should they consistently fail to manage even the most basic blocking and tackling duties.” I

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ASSET SERVICING

EUROPE MOVES TO GREATER INTEROPERABILITY IN REPO

Eurex Clearing, Clearstream and Euroclear signed a memorandum of understanding (MoU) in mid July with the ICMA European Repo Council agreeing to work together to improve efficiencies in the repo market. Essentially, the three European clearing houses and settlement houses agreed a deal that will to help the flow of collateral and funding throughout the financial system. It should be seen in the wider context of change in the European capital markets’ middle and back office infrastructure, which will streamline the accessibility of collateral, particularly for banks.

New agreement speeds up collateral flow in Europe HE AGREEMENT STRUCK in July between the ICMA European Repo Council, international central securities depositories Clearstream and Euroclear, and clearing house Eurex Clearing, is designed to improve access to liquidity in the triparty repurchase market, particularly for the GC Pooling market. The official blurb accompanying the news of the agreement states that: “Triparty interoperability must involve specific bridge enhancements that are integral to make it work so that the market can fully benefit from it. Today’s MoU also states the intention of Clearstream and Euroclear to work on these much needed improvements on the settlement layer.”

A triparty repo is a transaction for which collateral selection and substitution, valuation, settlement and custody during the life of the repo transaction is outsourced by the two trading parties to a third-party agent.

Eurex Clearing is a central counterparty (CCP), which defines the eligible securities for repo baskets, such as GC Pooling, which was launched as far back as March 2005 and clears triparty basket trades directed to it by repo trading venues. GC Pooling has is a highly liquid market for secured funding in both euros and US dollars.

The GC Pooling market allows banks to switch popular, high-quality fixed income securities into cash and vice versa, with trades guaranteed by Eurex Clearing. The international participants benefit from anonymous electronic trading through a central

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counterparty (CCP) with a real-time collateral management system.

Establishing triparty settlement interoperability with both triparty service providers is expected to improve the movement of collateral between the connected settlement locations in Europe. It will also reduce collateral pool fragmentation, which currently can cause technical fails, while allowing banks to supply liquidity to the real economy through the intervention of the repo markets. The initiative will increase the efficiency of collateral management for repo basket trading throughout Europe and will boost the fluidity of collateral across the euro zone.

The agreement, once finalised with establish a link between Clearstream and Euroclear, pending completion of feasibility studies and market consultations, by the end of 2015.“In order for the industry to fully benefit from triparty interoperability between Clearstream and Euroclear, we must also progress with enhancements to the settlement layer. Clearstream will work closely with Eurex Clearing and Euroclear on improving interoperability both between the two ICSDs and between the ICSDs and Clearstream Banking Frankfurt (the German CSD). The aim is to ensure the secure and seamless settlement of products across ICSDs and CSDs, commercial bank money and central bank money environments, prior to T2S implementation,” explains Stefan Lepp, member of the executive board and head of Global Securities Financing at Clearstream.

Interoperability is a key plank of the reforms and change in the Eurosystem.

According to Lepp, the agreement “marks a major milestone for the further improvement of interoperability between financial market infrastructures. It is sending a strong signal that we are committed to delivering this long-awaited market requirement that will also strengthen our collateral value proposition as part of our Global Liquidity Hub.” “This will strengthen the GC Pooling market and support our clearing members in reducing their collateral pool fragmentation, while keeping the high risk management standards of Eurex Clearing. This is an important task,”notes Thomas Book, chief executive of Eurex Clearing, in the statement accompanying the news release.

Change and reform in the European middle and back office is designed to ensure asset safety, transparency and free movement of money. This transaction should help reduce the fragmentation of collateral pools in Europe, and smooth the transfer of liquidity between different actors in the market. Up to now Europe’s various CSDs have on the whole tended to work independently. The introduction of a mass of regulatory reform, including the current topic du jour T2S, will result in a very different European landscape, both for post trade services and collateral management.

Yves Poullet, chief executive officer of Euroclear Bank, explains: “In the challenging environment we face now and in the future, market participants are

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

looking at us—their service providers— to collaborate more and offer innovative solutions to improve operational and settlement efficiencies. They want us to make the movement of vital collateral assets as fluid and as frictionless as possible across all market infrastructures globally. We fully support such a fundamental requirement and have been implementing this through our open collateral infrastructure called the Collateral Highway. This project, appropriately entitled Triparty Settlement Interoperability, is timely indeed.”

According to Eurex, the GC Pooling Market had €174.1bn worth of outstanding volume at the end of June 2013, 11% higher than the €156.5bn recorded a year earlier. Only the assets held at Clearstream (which like Eurex is

owned by Deutsche Börse Group, can currently be used for GC Pooling transactions. This means that even if a bank holds eligible GC Pooling assets in Euroclear, it had to go through the complex process of transferring these to Clearstream in order to participate in the GC Pooling market.

India continues its lukewarm approach to securities lending: In a separate development, India’s on-off relationship with securities lending received a fillip in mid July with the news the country’s India’s insurance regulator, the Insurance Regulatory and Development Authority (IRDA) has agreed to allow insurers to sell up to 10% of their holdings in a particular stock and further opening up the market to securities lending, as some

RUP50,000 crores may now be eligible to be on-lent to short sellers.

The arbitrage, price differential, between the spot prices of stocks and their derivative prices may also narrow with more stock available to meet delivery commitments. The regulations allow insurers to lend about 191 stocks listed in the futures and options segment for a maximum tenure of 12 months in securities that are part of the futures and options segment.

It remains to be seen whether the move will kick start more securities lending in the country, as securities lending volumes have fallen by as much as 40% this year, according to recent figures from the National Stock Exchange, to just above the volume recorded in 2011. I

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

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CLEARING & SETTLEMENT

DAY TO DAY IMPLICATIONS OF IMPLEMENTING T2S

For many financial institutions, especially those frequently trading on a pan-European basis, settlement and asset servicing remain intrinsically linked. The upcoming launch of Target2Securities (T2S) will effectively segregate settlement from asset servicing, and may well require a change in the post-trade modus operandi of many firms. Edwin de Pauw, Head of T2S Product Management, Euroclear, looks at the implications.

Preparing for change: preparing for T2S 2S PROMISES TO deliver considerable benefits. Even so, it is still work in progress and not all the market practice harmonisation initiatives will be accomplished by its launch.

When factoring in the need to also plan for compliance with new legislation such as EMIR, Basel III and AIFMD/UCITS V, the scale of the potential changes required becomes considerably more significant. Indeed, when also taking into account the investments required to grow the business, the sheer volume of change may push market participants to near breaking point. In that respect, it’s time to consider how best to prepare.

First and foremost, firms will need to consider the impact of T2S on their day-to-day activity. Inevitably, their focus will turn to ‘how’ they should adapt their business models to enhance their competitive advantages and increase profitability. Decisions will need to be made regarding the opportunities that T2S offers to centralise liquidity and cover more markets.

Perhaps it will lead to the withdrawal from non-profitable markets or alternative means to access those markets.

Identifying the opportunities is just part of the process. Managing the costs to profit from them is another. Here T2S poses a considerable challenge primarily because budgets are already stretched, especially if we include the concept of ‘time’ as a scarce resource.

Preparations to comply with regulatory changes, while simultaneously working on projects that deliver short-

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term savings, are likely to consume nearly all the resources that firms have available to them. Where will T2S fit into the equation; and can firms realistically hope to tackle everything alone?

Even with a centralised settlement platform multi-market asset servicing is, and will remain, a major challenge.

Other than the Belgian, Dutch and French markets, it is fair to say that other European markets have yet to harmonise market rules and practices to a common European standard. As T2S will not provide asset servicing or collateral management capabilities, firms will need to determine how they will take on the responsibilities to service the foreign assets they hold for themselves and/or their clients. Will they build capabilities in-house or is it wiser to work with one or more third-party providers?

Many financial institutions already work with agent banks, multiple central securities depositories (CSDs) and ICSDs to bridge market practice gaps.

Granted, T2S will provide the opportunity to rationalise some of these relationships and examine the need for large intermediary networks. That said, we believe it is highly likely that the large majority of banks and other financial institutions will continue to appoint an agent or ICSD to access multiple European markets because it simply makes good business sense.

Choosing a provider means asking additional questions. It may also entail an overall assessment of the strengths and the weaknesses of each provider in order

Edwin de Pauw, Head of T2S Product Management, Euroclear.

to determine which of them best meets the firm’s needs. Depending on their business lines and client base, firms are likely to look at a combination of factors.

In the past, price was seen as a determining factor. Although it still remains an important part of the decision-making process, widespread cost-cutting initiatives within the industry have already pushed prices down considerably making other factors more significant. The risk profile and asset protection provisions of a potential provider are good examples.

Having learnt the hard way about the need for rapid uninhibited access to liquidity during the financial crisis, many firms are also looking for a provider that can supply access to the widest possible liquidity pools. As the regulatory landscape evolves and OTC derivative trades are pushed towards the more secure world of central clearing, firms are increasingly seeking partners that can offer a proven collateral management infrastructure which not only covers trading exposures, but increasingly is used to manage collateral upgrades as well.

Added benefits?

Another element firms are likely to consider relates to how much additional benefit their provider’s services will add to their own, thus distinguishing themselves from the competition. Specifically, they are likely to look at market coverage in order to access as many markets as possible via a single access point. And they will look at the service levels they can expect to receive in order to fully and safely manage the foreign assets they own or hold for clients.

Firms are likely to place a great deal of importance on the concept of time, both as a resource and as a pre-requi-

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

site for success. In the search for the right provider to meet their needs, time and in particular a provider’s time-tomarket for new developments, will carry considerable weight in the decision-making process.

Although the roll-out schedule for T2S seems concretised, the technical and operational details are likely to change.

The ability to integrate potentially costly changes into projects with fixed budgets that are sometimes already underway will likely exceed the capabilities of many firms. Time has become so important in today’s business that delays in implementing necessary changes can place firms at a competitive disadvantage, a fact that will not be lost on clients and competitors alike.

The same is true for firms that are considering branching out from their core business. In order to remain competitive firms will need to consider how to make their core business even more relevant and/or expand into new areas.

Finding the right partner to support them on this mission is vital. T2S will commoditise settlement and change the post-trade landscape in many ways, some of which are still unclear.

Increased consolidation is likely to be one of the side-effects, and firms that want to survive in such a changing industry will need to work with a provider that is not only a market leader, but also has the capacity to adapt in line with its clients’ needs.

Where are you?

The decision-making process will differ according to the firm’s business type and aspirations. A broker dealer might opt to self-settle in certain markets, especially if they are a primary dealer.

From our conversations with the broker-dealer community, it is likely they will work with a large investor CSD or ICSD for asset servicing and to access T2S and non-T2S markets remotely. They are keen to benefit from centralised sources of liquidity, efficient collateral management services and easy access to multiple trading counterparties. And, of course, they will pursue

the highest level of settlement efficiency either by self-settling, or by opting for a provider that is able to meet the high standards of prime brokers.

A local institution, on the other hand, may decide to take different routes. It may want to position itself as a market specialist, leveraging of its local market proximity and expertise to foreign investors. Alternatively, it could position itself as an entry point for its clients to reach multiple European markets by increasing its market coverage. If the ambition is to expand, finding the right provider or partner that offers direct access to a large number of CSDs, as well as multimarket asset servicing, is likely to be the determining factor.

Global custodians have the advantage of scale. Their size and presence in multiple markets makes a compelling business case to centralise liquidity.

Considering the impact of AIFMD, global custodians are looking to shorten the chain of intermediaries to reach the issuer CSD. They have, in the past, been attracted to the largest pools of liquidity. T2S is unlikely to change this, so it is not unrealistic to expect them to maintain hybrid relationships, with direct CSD access in a number of the larger T2S markets while using an investor CSD or ICSD to access others.

If recent trends are anything to go by, we are also likely to see more and more partnerships developing between (I)CSDs and global custodians. Sharing expertise to achieve mutual benefit makes considerably better business sense than developing the required expertise oneself, particularly in today’s quick-win business environment.

The blunt truth is that there are simply too many different types of firms working in the post-trade space to create a universal solution to access T2S. Looking at more generic scenarios, we can expect to see some firms opt for direct (I)CSD access in high-volume markets while selecting their provider to manage their remaining indirect CSD relationships. In this case, the differentiating factors between providers

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

are likely to centre around access to the largest number of markets, both within Europe and beyond, while offering the necessary expertise.

The bigger picture Once T2S goes live and evolves, there will be increased pressure on custodians, CSDs and ICSDs to reduce their costs. As a result, we are likely to see new business models developing that will push some providers up the value chain whereas others will turn to partners with relevant expertise to meet client demand. Others may decide to exit some business lines completely.

Longer-term, this may lead to further consolidation within the post-trade industry with a handful of large-scale providers offering coverage of multiple markets. We also foresee a limited number of smaller-scale providers filling a niche role in offering greater market proximity and expertise.

Firms buying post-trade services will see increasingly fierce competition between providers to win their business. As prices decline, the business case strengthens to choose a single provider to access all T2S markets.

Some of the global providers are likely to develop further into a onestop-shop solution, offering unbundled product suites to meet all but the most niche requirements. As these providers will continue to invest in technological advancements and keep up-to-date on T2S developments, they will provide a welcome and ready-made solution for firms unwilling or unable to commit sizeable development resources of their own.

T2S is coming. Waiting for a complete and final picture of a post-trade Elysium of the future is not a viable long-term solution. You may decide to maintain your current post-trade arrangements, which is fine, as long as your provider has the scope and flexibility to evolve with T2S and your changing business needs. A provider offering multiple T2S access possibilities will be able to accommodate your final choice when you make it. I

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TRADING POST

EMIR: MANAGING THE TRADE OFF BETWEEN PROTECTION AND COSTS

CCPs and their clearing members (CMS) are driving the roll out of new EMIR segregation models. From a client perspective the new account structures will present them with a trade-off between protection and cost. The protection afforded by an Individual Segregated Account (ISA) brings new transparency to the relationship between asset protection and cost, but eschews any netting which would reduce Initial Margin (IM) amounts and related funding costs. The omnibus model gives considerable freedom to a CCP and clearing members to record and net business in different permutations which reduce IM and funding costs, but adding complexity to asset protection in a default situation.

Asset protection isn’t as simple as it seems NE AREA OF ambiguity is the effect of transit and transformation on client assets.

EMIR specifies various constraints on how a CCP must manage and control client assets, but yet the assets received by the CCP can be utterly different from those delivered to the clearing member by a client. Clearing members sit in the middle of a complex commercial arrangement, facing the CCP and fully responsible for all client liabilities on one side, and providing a commercial operational service for clients on the other.

This indirect relationship for a client means that while the CCP rules on eligible collateral apply to the CM, they don’t directly apply to a client, allowing CMs to accept any assets which are acceptable and then delivering something equivalent to the CCP to cover IM liabilities.

This transformation undermines the intention in EMIR to protect client assets, as unless a client signs an agreement to insist on ‘pass through’ of their assets to the CCP, in the event of a CM default, the assets at the CCP may well be different from those provided by the client.

I must point out that the quality of assets eligible at a CCP is high, so it

O

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is unlikely a CM would downgrade an asset, but if a client regarded a specific security as part of their investment portfolio and needed to retain control in a default, an explicit agreement would be needed to avoid asset transformation.

EMIR doesn’t tackle the other hidden risk, namely that of transit from the client accounts to the CCP accounts. The current custody model requires securities to be transferred from the client to the CM and then to the CCP in two steps. What happens if a CM fails during a transfer, and the Client asset never arrives at the CCP? One solution to this problem is to keep the securities in the Client’s custody account, and for the CCP to have a legal claim over the assets in the event of a default by the CM. This is referred to by some CCPs as “full physical segregation”, but the implementation of this approach adds more complexity and cost by including the client’s custodian, an ICSD, the Clearing Member and the CCP in a multi-step settlement process during which transaction costs will add up.

Eurex already offer a physical segregation model for their OTC CCP with

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

CME, LCH and ICE all pursuing plans in the same area, which given the common securities settlement infrastructure in Europe may well end up being operationally similar.

There is one other ambiguity which the members of ISDA and the FOA are debating with regulators. EMIR refers to the client’s assets and “Assets refer to collateral held to cover positions and include the right to the transfer of assets equivalent to that collateral…”

This provides wiggle room for the argument that a CCP is protecting the value of the assets delivered by the CM rather than the specific assets (which may have been transformed). It also leads to a means of managing collateral for a group of ISAs using one collateral account, rather than one per ISA. The operational implementation of a single collateral account per ISA means cost and complexity for each CM, which may be passed on to clients directly or indirectly in future.

Both ISDA and the FOA want to find common ground on less costly ways of managing ISAs—but time is short, as CCPs only have until September to apply for authorisation and cannot pin their hopes on a model which as yet is not agreed or approved of by regulators.

EMIR has thrown back the curtain on the mechanics of asset protection, and revealed a difficult set of choices for the buy-side. How much do they trust their CM in today’s economic climate? Also, how much will they pay to replace that trust with new protection models? Unfortunately, it may be our pensions which pay the price if they are obliged to clear the OTC trades they use to manage our hard won cash. I

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

DEBT REPORT

Principal-at-risk products gain traction as US stock markets rise RE STRUCTURED NOTES making a comeback? There have been clear signs of this trend taking hold in both Europe and the US during the first half of 2013, after three years in which principalprotected products have dominated the market. Since April, for example, the volume of structured notes linked to rising equity prices that have been traded on Switzerland’s Scoach exchange has risen dramatically.

Whereas such participation notes accounted for the equivalent of $693m of all trades on the largest European exchange for structured products that month, the figure more than doubled in May to $1.75m, almost half the $4bn monthly total (which itself was the highest for 21 months).

“There’s been a big increase in growth products that offer leveraged upside to the equity markets—typically with only one-for-one downside exposure— whereas up to the end of last year it was mostly income-type products,” said Andrew Cooper, head of structured products at RBC Wealth Management in London.“People really are now starting to believe that economies will grow, to the benefit of equities.”

US banks and distributors have been reporting a similar trend on the other side of the Atlantic since the start of the year, with principal-at-risk or participa-

A

tion products becoming increasingly popular as the US stock market has reached new highs in an environment where interest rates have remained at historic lows.

“There’s definitely more appetite now for notes with some element of principal at risk,”said Franck Bertoneche, the head of structured product sales for North America at BNP Paribas in New York. “At the same time, certificates of deposit and the principal-protected market have contracted.”

As well as buffered notes linked to equity indexes such as the S&P 500 (which has risen 15% so far in 2013) ‘steepener’ notes linked to yield curves that pay out when interest rates on long-term bonds increase relative to short-term rates are also in growing demand. Investors in these instruments are also typically banking on an economic upturn in the near to medium term. The universe of structured products has meanwhile continued to grow, despite the overall drop in volumes since 2010, as the listed markets for the instruments continue to offer issuers the opportunity to develop products that can both cater for both a wide range of investor riskappetite and benefit from diverse economic scenarios.

“There are alternatives that you can create with structured products that

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

THE SLOW COMEBACK OF STRUCTURED NOTES

The steady decline in the issuance of structured products since 2010 looks set to turn around this year. As investors appear to be gaining confidence that global economic recovery is finally underway, they are looking once again for products that will do more than simply protect their capital and offer a better yield than they can achieve with traditional forms of deposit. At the same time, concerns over the potential insolvency of issuers are receding. Andrew Cavenagh reports.

can plug any potential gap in the market,” explained James Harrington, head of structured solutions at Legal & General (L&G) Investments. “You can gear investments, for example, without increasing the risk on the downside.”

The European Structured Investment Products Association reported at the end of May that the volume of investment certificates and leverage products traded on its member exchanges in the first quarter of this year was up almost 20% to €24.9m. Meanwhile, the overall number of products on offer at the end of March totalled 1,062,184, an increase of 7.9% on the previous quarter.

If the more adventurous approach that has been seen from investors this year (in terms of the type of product they are now willing to buy) is grounds for optimism, however, there are still reasons to exercise a measure of caution in forecasting what is likely to happen in the months ahead.

One consideration is that investor confidence remains fragile, and sentiment is easily influenced by macro-economic events. This was evident in the reaction at the end of June to suggestions from the US Federal Reserve Bank (the Fed) that it might start winding down its massive programme of quantitative easing—which has pumped $85bn of liquidity into the domestic economy since September 2012—before the end of the year.

While the withdrawal of QE should not really been seen as an economic negative, given the US Federal Reserve is only likely to take such action once it is reasonably confident that sustainable economic recovery is underway—the drop in share prices and surge in US Treasury yields that followed its announcement had a negative impact on issuers with structured notes in the marketing phase. Several banks were obliged to revise the rates they were offering on their notes accordingly. Morgan Stanley, for example, had to increase the maximum interest rate on a 15-year note that was linked to the lesser performing of the Euro Stoxx50 Index or the Russell 2000

33

DEBT REPORT

THE SLOW COMEBACK OF STRUCTURED NOTES

Andrew Cooper, head of structured products at RBC Wealth Management in London. “There’s been a big increase in growth products that offer leveraged upside to the equity markets— typically with only one-for-one downside exposure—whereas up to the end of last year it was mostly income-type products,” says Cooper. “People really are now starting to believe that economies will grow, to the benefit of equities.” Photograph kindly supplied by RBC Wealth Management, July 2013.

Index to 7.25% from the 7.1% in the initial offering document.

The pick-up in the market for structured products has also not been universal. While note issuance in the Middle East and Asia may have boomed during the first six months of 2013— with Standard Chartered, for one, announcing that its operations in South Korea, Singapore and Hong Kong had raised the equivalent of a record $2.5bn by mid-June—the story has been very different in South America.

The most popular market for notes linked to bonds actually collapsed in June, when the Brazilian government scrapped the 6% (IOF) tax on financial transactions that it introduced in 2010 to discourage direct foreign investment in bonds denominated in reals (as a deliberate measure to prevent a flood of foreign inflows causing a sudden and uncontrollable surge in the value of its currency).

Heartened by the signals from the Fed that the end is in sight for QE (a move that will naturally reduce much of the “excess liquidity” that could potentially otherwise pour into high-

34

yielding real bonds) Brazilian Finance Minister Guido Mantega announced the abolition of the tax on June 4th.

The impact on issuance of structured notes that offer investors exposure to Brazilian bonds was rapid and severe.

After banks led by Barclays had sold $7.3bn of such instruments over the first five months of 2013, sales crashed to just $40m in June.

“Now the tax is gone, demand for credit-linked notes has fallen off the edge of a cliff,” commented Thomas Beatty, managing director of Latin American credit structuring at Citigroup in New York.“The fewer barriers to entry a country has, the less demand investors will have for structured products. It will be a permanent shift unless the tax comes back.”

The supply of structured notes in the UK, meanwhile, has been restricted by the Funding for Lending Scheme (FLS) that the Bank of England launched in July last year. As the FLS will provide British banks with all the capital they require up to the start of 2015 at ultra cheap rates, the institutions will clearly have no incentive to raise funding from structured products in the meantime.

Harrington at L&G Investments pointed out that the FLS had enabled banks to borrow at close to zero, when just 12 to 18 months ago they were having to pay around 400 basis points (bps) before the scheme was introduced, and there was no way for the structured-note market to compete with such cost of funding.“There is just no demand from the banks to raise money from structured products at present,” he explained. “Once the FLS stops, however, I’m sure there will be renewed demand.”

Any sustained recovery and growth in the market for structured products will also, of course, have to take place against the background of the tougher regulation that is going to apply across the spectrum of financial services and offerings in future. It emerged in April, for example, that the Securities & Exchange Commission (SEC) in New York has instructed five of the leading

James Harrington, head of structured solutions at Legal & General Investments. “There are alternatives that you can create with structured products that can plug any potential gap in the market,” he explains. “You can gear investments, for example, without increasing the risk on the downside.”

Photograph kindly supplied by Legal & General Investments, July 2013.

US banks, including JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley, to improve disclosure about the structured notes they sell to retail investors in the US. The SEC released the correspondence that it had had with the banks on the subject a year earlier, when it had expressed particular concern about the use of the term “principal protected”in marketing literature because the limitations of such protection were not necessarily clear. The regulator said banks should avoid terms that “stress positive features without also identifying limiting or negative features”, and all five banks now no longer use the term in marketing their structured products.“There’s understandably a lot more clarity required now in the way that you market these products,” comments Cooper at RBC. Harrington at L&G added that regulatory pressure—as well as public perception—was also likely to ensure that some form of capital protection would continue to be a“hugely important” consideration for structured products, notwithstanding the recent indications that investor appetite for risk was on the up. I

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

ASSET ALLOCATION

Why advisors are looking beyond ETF trading volume “

DON’T WANT to get caught in some illiquid market,” says Tom Sileo, branch manager of Raymond James’ Nashua, New Hampshire office.

However, he adds, there is more to analysing liquidity than just looking at trading volume.“That’s not all you have to do,” he says.

Why is that? Well for one thing not many ETFs trade every day or in very large amounts. In fact over 75% of the 1,448 exchange traded products listed on US exchanges have average dollar volume below $150,000 (Based on 30day average dollar volume for US listed ETPs as of 3/22/13. Source: Interactive Data). Therefore, if ETF volume is your biggest selection criteria your choices start getting pretty slim.

Sean Clark, chief investment officer for Clark Capital Management Group in Philadelphia, concurs: “You have to go much deeper than just looking at the trading volume on the screen.”And by looking more closely at some ETFs investors may find better ways to get into certain markets. For example, says Clark,“We will trade some low-volume ETFs, like some of the international ones, where there are pretty big constituents within those ETFs that make it palatable.”

Clark’s last point is an important one that is not widely understood by some

I

investors, nor is the related data easily accessible. How do the constituents of an ETF affect its liquidity? What other influencers are there?

As it turns out there are several things that can influence an ETF’s liquidity. While not an exhaustive list, here are some of the key market dynamics to consider.

ETF volume: There is no doubt that an ETF’s volume is a key driver of its liquidity. Just look at the ten most actively traded ETFs and their bid/ask spreads (the difference between the highest price a buyer will pay for the ETF and lowest price a seller will accept).in the table below. It’s a pretty diversified group of ETFs yet they all trade with spreads right at the market or just a penny wide.

When you plot all this on a chart,

and add in the ETF’s premiums and discounts for good measure, you can observe how they all cluster around a tight band showing very efficient market pricing.

Two-sided markets: To have good liquidity any security has to maintain a healthy balance of volume from both buyers and sellers, and ETFs are no exception. For example, if an ETF’s trading volume is coming primarily from the buyer’s side of the market, it may cost a market maker more to fill their sell orders. To compensate for their added costs and risks market makers may widen their spreads on the ETF. So looking at the size (number of shares) of the bids and asks to see where most of the volume is coming from can provide improved insight into an ETF’s liquidity. Also looking beyond level 1 quotes to see the bids and asks that were put out there but not taken (traded) can shed light on how balanced the market demand is for an ETF. ETF options: Many ETFs have options trading on them and market makers can use the options to help them hedge their risk when they have to take a large position on a particular ETF. If an ETF is not covered well in the options market the market maker can’t hedge their risk as well which may cause them to widen their spread.

Index futures: If an ETF doesn’t have a lot of options trading on it the market maker can choose to hedge against the ETF’s benchmark index instead, using index futures; assuming the index is

ETFs: 30-day average volume (shares) Ticker Name SPY VXX EEM XLF IWM UVXY QQQ EWJ VWO

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

ETF LIQUIDITY: ADVISORS EXPAND THEIR VIEW

Money managers certainly know the importance of gauging an ETF’s liquidity. In a Greenwich Associates survey of institutional managers last year 83% of them identified “liquidity/trading volume” as their top selection criterion for ETFs. Liquidity was mentioned more than an ETF’s expense ratio (74%) or it’s tracking error (72%). Jeff Torchon, vice president and ETF global markets manager, Interactive Data Corporation explains why it is necessary to understand the dynamics behind ETF liquidity.

SPDR S&P 500 Trust iPath S&P 500 VIX Short-Term Futures ETN Shares MSCI Emerging Markets Index Fund Financial Select Sector SPDR Fund iShares Russell 2000 Index Fund ProShares Ultra VIX Short-Term Futures ETF PowerShares QQQ Trust, Series 1 iShares MSCI Japan Index Fund Vanguard FTSE Emerging Markets ETF

30-day avg. volume (shares)

Spread ($)

115.733M 53.718M 52.597M 47.223M 33.618M 30.320M 27.911M 28.720M 17.226M

0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01

Source: Interactive Data, as of 3/22/2013.

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ASSET ALLOCATION

ETF LIQUIDITY: ADVISORS EXPAND THEIR VIEW

Tight spreads on the main ETFs EEM

SPY

XLF

IWM

EWJ

VWO

0.4%

Premium Discount

0.2%

0%

-0.2%

-0.4%

$-0.15

$-0.1

widely covered in the futures market.

It may already be clear from these four market dynamics why some ETFs trade with very thin spreads. For example, indices such as the S&P500 or the FTSE100/FTSE250 are among most covered indices in the world. Consequently, a market maker covering ETFs that track these indices often sees high ETF volume, balanced demand from buyers and sellers, options available on the ETF and futures available on the index. Given these dynamics, it’s unsurprising that some of these ETFs trade at the market.

Unfortunately, not all ETFs have all four of these elements working for them. Once you get beyond broad US indexes, creating liquidity takes a little more work, which leads to another critical mechanism facilitating ETF liquidity: the creation/redemption process.

ETF creation/redemption: When an ETF’s price moves above or below the value of its constituents, the subsequent trading activity helps create liquidity and keeps an ETF’s price in line with the value of its constituents.

ETFs have a unique creation mechanism which allows large trading firms (authorized by the ETF issuer) to swap an ETF’s constituents with the ETF issuer in exchange for the corresponding

36

$-0.05

$0 Spread

$0.05

$0.1

number of shares of the ETF. The process is called an ETF “creation” because the ETF issuer has to create shares of the ETF to give to the trading firm.

The trading firm makes a profit because they are trading the“cheaper” constituents in exchange for the “higher priced” ETF shares instead of buying the ETF on the stock exchange.

They can also effect the reverse and give the ETF issuer back the shares of the ETF (i.e., redeeming them) in exchange for the ETF’s constituents.

So, whenever an ETF price moves below the value of its constituents the trading firms can profit the other way.

By providing the capital markets with an additional source of ETF shares (and the profit motivation to use it) the creation/redemption process provides an additional source of liquidity for the ETFs. The availability of the creation/redemption process also keeps ETF prices in check with their underlying constituents. For example, if one authorised trader is selling an ETF low (basically mispricing it) another authorised trader will buy it because they can redeem the ETF shares directly with the ETF issuer at the higher price and make a profit. Eventually the authorised trader selling the ETF low will realise their mistake and bring their price back up when their own creation/

$0.15

$0.2

redemption calculations shows they are selling the ETF for less than the cost of creating it.

ETF creations and redemptions can only be executed in large block trades, typically a minimum 50,000 shares. The ETF issuer also charges the trading firm a fee for the issuer to create new shares.

Many institutional traders have realtime models and trading algorithms that constantly measure the cost of an ETF’s creation versus the ETF’s price and the value of the underlying constituents. These models help the traders move in quickly to make a profit, which in turn can add liquidity to the market and help keep the ETF’s price stay fair to its underlying constituents.

Knowing more about the different dynamics of an ETF’s liquidity can help advisors as they identify investment opportunities for clients, manage their execution costs in terms of bid/ask spreads, and maintain their clients’ confidence in their ETF selections. As Clark says, the more his clients learn about ETFs the more they ask about their liquidity. I This article is provided for information purposes only. Nothing herein should be construed as legal or other professional advice or be relied upon as such. © Interactive Data Ltd 2013

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

ASIA SECURITIES LENDING ROUNDTABLE

SECTION NAME

MARKET CHANGE & REGULATION DRIVES THE NEW SECURITIES LENDING BUSINESS IN ASIA

ROUNDTABLE PARTICIPANTS (from left to right)

Sponsored by:

PAUL SOLWAY, EQUITY FINANCE REGIONAL HEAD, ASIA PACIFIC, BNY MELLON ANDREW MCCARDLE, HEAD OF EQUILEND ASIA SEAN GREAVES, HEAD OF APAC SECURITIES LENDING CLIENT RELATIONSHIPS AT BNY MELLON JAMES ALDWORTH, DIRECTOR, GLOBAL PRIME FINANCE, DEUTSCHE BANK PAGET DARE BRYAN, HEAD OF ASIA PACIFIC DERIVATIVES/STRUCTURED PRODUCTS PRACTICE, CLIFFORD CHANCE MARTIN CORRALL, REGIONAL PRODUCT HEAD FOR SECURITIES FINANCE, CITIBANK/ CHAIRMAN OF PASLA The roundtable took place at The Mandarin Hotel, Hong Kong, April 2013.

The views expressed in this Roundtable are solely those of the Roundtable participants, and do not represent the views of their employers, or its representatives. The material is for general information purposes only and is not intended to provide or be construed as legal, tax, accounting, investment, financial or other professional advice on any matter.

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37

ROUNDTABLE

SETTING THE SCENE: MARKET DRIVERS/MARKET CHANGE SEAN GREAVES, HEAD OF APAC SECURITIES LENDING CLIENT RELATIONSHIPS AT BNY MELLON: Lenders are starting to have to work within an evolving regulatory framework, so it is an interesting time for them, particularly as market change sometimes pushes them in a different direction from where borrowers are heading.

UCITS funds offer a good example of this dichotomy in action; they are required to be liquid and term lending is very difficult for them. Borrowers on the other hand in contrast look at and want term financing. It is understandable then that lenders have concerns about their program and where it might be heading. Borrowers are also keen on collateral flexibility. Actually, it is a very hot topic right now and lenders are understandably mindful of the level of risk they sometimes assume.

Despite the opportunities in this region, it can be a tricky market—particularly considering some of the regulation in the pipeline, including potential increased capital charges on activities such as indemnification. If, say, lending agents are forced to withdraw indemnifications from their overall offering, some lenders might seriously question whether they should continue with their program. As you can see, it is a very interesting time.

Clearly, there are opportunities in the market. Equally, there are challenges that we will all face. Regulation will lead to both; particularly in Europe and to a certain extent in the United States.

JAMES ALDWORTH, DIRECTOR, GLOBAL PRIME FINANCE, DEUTSCHE BANK: Sean is right to point out many of the changes underway. With that in mind, we are doing more creation of inventory these days—bidding on exclusives for example. Moreover, during the last two or three years I’ve taken a much more active role in our system development. Essentially, we are rebuilding our entire securities lending system from the ground up. Given the nature of the business in Asia, particularly the fragmented nature across different markets, our people in the region have had a very large say in how we build out our new global system.

It has been interesting to keep up with changing regulations and incorporate new client requirements into our system to keep it scalable and keep the business growing. It is also indicative of the growing influence of the Asian operations in the bank’s global outlook.

ANDREW MCCARDLE, HEAD OF EQUILEND ASIA: Change is a constant. Therefore EquiLend offers automation and risk mitigation tools, along with market data, to help people grow their business in the current dynamic economic climate. The focus in this sector on regulation is very strong, and an important part of our work is helping our clients to understand the implications of incoming regulation on their operations. It has resonance for us as well as them as we all build out our businesses in the Asian region.

MARTIN CORRALL, REGIONAL PRODUCT HEAD FOR SECURITIES FINANCE, CITIBANK/

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Andrew McCardle, head of EquiLend Asia: “We’re uniquely placed in trying to make sure that we’re offering opportunities to both sides of the securities lending business. We sit in the middle of the large custodian agent lenders and the prime brokers. In that context, our business is about making sure that we’re providing the opportunities that make sense to both sides.”

CHAIRMAN OF PASLA: Like Sean, I work in the clientfacing side of the agency lending program. We pride ourselves on launching new markets and we launched India and Malaysia last year. From a securities lending perspective, Asia has fared better than other regions, in part because many clients have increased their focus on the region and have been keen to expand their lending in Asia.

Even so we’ve noted that clients rely less these days on custodial lending and are beefing up their agency lending programs. We’ve certainly picked up a number of third party lending mandates.

Securities lending used to be considered a back office operation. That’s now changed. It is regarded these days as more of a front and middle office function and in that regard the appointment of a securities lending agent is now akin to appointing a fund manager. This change means there is more focus on performance. It also means changes for service providers, as we work on building systems that enable us to track performance and provide enhanced reporting services to clients.

REGULATION: DO YOU KNOW IT ALL? PAGET DARE BRYAN, HEAD OF ASIA PACIFIC DERIVATIVES/STRUCTURED PRODUCTS PRACTICE, CLIFFORD CHANCE: Key to understanding the implications of regulation is also to appreciate that much of it is internationalised. It might be an initiative such as FATCA, or the Financial Transaction Tax (FTT) or involve transparency requirements or new short selling rules. Either way, regulation made in London, Brussels or the US now regularly has an impact on the securities markets here in Asia in a way not

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Martin Corrall, regional product head for securities finance, Citibank/ chairman of PASLA: “Securities lending used to be considered a back office operation. That’s now changed. It is regarded these days as more of a front and middle office function and in that regard, the appointment of a securities lending agent is now akin to appointing a fund manager. This change means there is more focus on performance.”

seen before. There is now a lot of work going on educating clients about these changes.

Another consideration is that we have a lot of regulation arriving all at the same time: for instance, the on-going adoption of Basel III, which is changing the shape of banks; last year’s arrival of short-selling regulations in European markets; and the recent proposal of FTT from Europe. We also rapidly have to digest EMIR and the various initiatives for shadow banking. It is all coming at once and it is very hard for anyone to accurately predict how the markets will be affected by this cocktail of change over the medium and longer term.

Even against this backdrop, we’ve seen a pick-up in interest in securities lending and repo from organisations in Asia, such as insurance companies, Asia banks and hedge funds. This interest in the Asia Pacific securities lending and repo markets generally looks to be growing.

There are also other themes in play: one is ensuring the integrity of services such as custody and confidence in those systems that involve holding people’s assets. Lehman and MF Global showed regulators and the buy side that what they thought worked did not work as well as hoped in a crisis or insolvency. Therefore, part of the build-out now is looking to instil confidence in the systems, documentation and regulations that custodians and banks have in place and the ways in which assets are held.

SEAN GREAVES: As Paget suggests, the discussion is wide-ranging; and regulation and its impact is the number one query among clients, even in Asia. They want to know how the proposed Financial Transaction Tax (FTT) in Europe will affect their international business and they are looking for very specific answers. The question for us is: can you effectively quantify that? Can you put a number on it? Of

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course it is an extremely difficult calculation at the moment, as you can imagine. We don’t know yet if there’s going to be any direct impact on securities lending. Now, France is probably the one market that we can look at. Early analysis of volumes in the lending market in France since the imposition of the tax, suggests that volumes have come down slightly. It is too early to say whether that’s directly or indirectly related to the introduction of FTT, but it is an interesting development.

There is a lot of discussion in other markets as to which ones are likely to be affected. Clearly, Germany is going to be pivotal: it is where much of the volume will be in Europe; and it is where many of our clients make their money— either on the bond or the equity side. If Germany did introduce the tax it could potentially change the dynamics of securities lending in the country. Germany is the biggest fixed income market for securities lending in Europe and a lot of people see it as a safe haven. The imposition of a financial transaction tax of, say, only ten basis points could have a potentially devastating effect on the market. Though of late there are stirrings that the German government might not adopt the tax after all. The trend line is essentially the same, only to a lesser degree in other European markets that have or plan to adopt the tax.

Another problem is scoping the amount of regulation in play. An interesting observation is that in the early period of the financial crisis one of the first things that legislators tried to fix was short-selling. Actually, it took three years or so to do it. Specifically in Hong Kong we were affected by the publication of the IOSCO principles that were drafted in 2009. Those principles are gradually being implemented and now the rest of the world looks to be adopting regimes that resemble that of Hong Kong.

If there is a nuanced trend in play I would say that flows around how successful the banks and fund managers have been, and continue to be, in informing regulators and governments about what is achievable and what are the potential unintended consequences of regulation. Let me explain: short-selling regimes we can all manage. With FTT though, we look at it and think it actually has the potential to effectively eliminate the market in certain areas. We then have to ask: what replaces it?

FRANCESCA CARNEVALE: James, when regulation comes in—particularly in a market as diverse and fragmented as Asia—do you see borrowers and lenders dash to those markets where regulation is lightest? Or, do they make do with what they can do within a jurisdiction and rely on experts to help them make the best out of a situation?

JAMES ALDWORTH: All of the above. Invariably, higher volume will gravitate to those markets where participants find it easier to transact. Equally though we will also (inevitably) have to deal with, as Sean says, the unintended consequences of legislation. These unknown effects are some of the biggest impediments to business right now. If you’re unsure how these regulations will affect the business as a whole, it is very hard to build scale; or build a business in a way that is both compliant with all regulations and still

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provides clients with everything they need. That said there’s very good opportunities to be found in today’s markets as well.

If you can provide solutions that are scalable, that allow you to continue to offer the same type of services you did say five or eight years ago while still being fully compliant with all new regulations, and provide a little bit of foresight as to what might be coming down the line, you can be in a very good place.

Beneficial owners and hedge funds always look for opportunities to generate alpha returns. Equally, there are funds that are going to be super conservative and will tell you they only want to play in markets where they know exactly how everything will play out. If that means a smaller return, we have to deal with it. Other clients will ask us to go out as far as we can to deliver them better returns.

FRANCESCA CARNEVALE: Hedge funds (for instance) make money from arbitrage opportunities in the market. As a securities lending provider, do you also look for those differences to leverage, or do you require a more homogenised market state where there is a lot of commonality in regulation. Which is the best state for securities lending?

MARTIN CORRALL: Markets in Asia typically have their own anomalies, though clearly as an industry it would be much more straightforward if all markets acted the same way. In terms of getting our clients the right kind of access in certain markets, we have to think in terms that are wider than regulation. It also encompasses market infrastructure and processes that either conflict with or meet client preferences or concerns. As an industry association, we aim to promote a mechanism in each market that works for offshore lenders.

In markets such as India, for example, the securities lending framework is quite restrictive for offshore participation. It is difficult to recall securities, for example. In this instance, it demands particular behaviour from our clients PASLA has discussed with SEBI the way the market should evolve. Of course, the regulator listens to some of what we say; but they’ve equally made it clear that they want their market to evolve under its own dynamics. As time passes, markets such as India will change. In the interim, it is understandable that they have concerns about big offshore institutions muscling in and changing the local market.

There’s also an ad hoc element in this whole evolutionary trend. If you look at some of the short-selling restrictions we’ve seen around Asia in the last two or three years and temporary bans in Korea and restrictions in Taiwan, it is clear these actions are politically driven. Numerous studies show that banning short-selling has minimal effect if a market is falling in any case. Clearly, regulators have to be seen to be doing something, so they introduce a ban on short selling, whether it makes any difference to the market in the long term or not.

PAUL SOLWAY, EQUITY FINANCE REGIONAL HEAD, ASIA PACIFIC, BNY MELLON: After being in Asia for 13 years, some part of me wants to say that this complexity and diversity are what makes working in Asia so

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Paget Dare Bryan, head of Asia Pacific derivatives/structured products practice, Clifford Chance: “We have a lot of regulation arriving all at the same time: for instance, the on-going adoption of Basel III, which is changing the shape of banks; last year's arrival of short-selling regulations in European markets; and the recent proposal of FTT from Europe. We also rapidly have to digest EMIR and the various initiatives for shadow banking.”

enjoyable. We are also fortunate that we are based in Hong Kong, whose regulators have had the foresight to establish a robust local market, where pre-borrowing and shorting have clear rules governing their application. Not all markets are as lucky, but then that is our business, helping clients navigate through diverse markets. As we’ve seen, everyone looks at securities lending slightly differently. We’ve all pushed for more harmonisation, helped by local associations, such as PASLA, though it is sometimes difficult to convince regulators to accept the need for such harmonisation across markets. I have no doubt we will eventually get close, but it will take time, understanding and education.

TECHNOLOGY: IS IT FUNCTIONAL? OR IS IT JUST PLAIN FUNKY? FRANCESCA CARNEVALE: Andrew, how can technology help in an increasingly regulated environment? Can technology help harmonise a diverse marketplace?

ANDREW MCCARDLE: A number of people around the table have alluded to the stop-start nature of regulation in Asia. In that regard, the market is sometimes working in the dark. Look at what happened in 2006 in the United States with the SEC bringing in new requirements for Agency Lender Disclosure (ALD) reporting. Europe followed soon after, with a number of initiatives that would have taken place under the Basel II umbrella—though the UK’s FCA put a moratorium on its application in the market until a market consultation took place. We all took part in the resulting discussions, with ISLA and others, to help everyone meet Basel II requirements and bring in ALD for both repo and stock lending, and the realisation dawned on all of us that regu-

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THE REGIONAL CONTEXT: MUSICAL CHAIRS, OR SEPARATE TABLES?

Sean Greaves, head of APAC securities lending client relationships at BNY Mellon. “UCITS funds offer a good example of this dichotomy in action: they are required to be liquid, and term lending is very difficult for them. Borrowers on the other hand in contrast look at and want term financing. It is understandable then that lenders have concerns about their program and where it might be heading. Borrowers are also keen on collateral flexibility.”

lation is a very long string with no end of modifications in sight. With that in mind, clearly it is a challenge for all us of us to help clients best understand the meaning of some of the changes coming in.

In the meantime, we’ve seen an uptick in trading volumes, so in one sense we’ve had the luxury to focus on the more standardised or developed markets such as Japan, Australia, Singapore and Hong Kong. In those markets we’ve seen clients hone their focus on improved control of processes that can be done on systems such as EquiLend, to eke the maximum efficiency out of automation. People want to be able to look at their more profitable areas of business and/or spend time on value-added areas.

From a technology point of view, it is a bit of a mixed bag because we offer the opportunity to standardise trading, to automate it, which is great. However, in a changing regulatory environment, elements fall into the mix that are difficult to predict at the best of times. From our vantage point, it doesn’t make sense to be ahead of the curve. Instead, it makes sense to be working with our clients to make sure that we offer the products that they need. Increasingly, I see that our clients’ internal IT budgets are heavily weighted toward regulatory requirements.

Historically a lot of the tools that we provide have been automated. We have a number of tools now, whether it is the market data itself, via DataLend, or the daily trade and negotiation tools, via EquiLend and BondLend, that we see firms using in the markets here, because they suit some of the more developing manual processes that are currently in place. There is growth potential here too: making sure that where possible they can bring in efficiencies. The difficulty is making sure they comply with local regulations.

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FRANCESCA CARNEVALE: How individual is the Asian market? Is it evolving its own peculiarities? Is it decoupling from the West: in other words, do clients want a specifically Asian securities lending program? Or do they see a global program of which Asia forms an integral part?

JAMES ALDWORTH: It is an interesting question. Asia is in an interesting phase of development right now. There’s been a lot of personnel movement around the region, for instance. The region is fluid. Some firms have shut down operations in Japan and moved to Hong Kong; other firms have or are moving from Hong Kong to Sydney; yet others are moving from Sydney to Hong Kong. Everyone is looking to deploy capital and resources and depending on their specialisation opting for the market they think will serve them best. From a securities lending standpoint we are seeing markets still beginning to open up to the service and in that overall fluid context, Asia is becoming a bigger part of a global P&L if you will.

Asia is an important focus for many firms, particularly as some of its markets work up the development curve. Many countries have passed an important tipping point and markets, such as Taiwan, are increasingly part of the mainstream. The important element is that the region is on the move, and we will be saying the same thing about other markets in the region that we’re saying about Taiwan today.

India and China provide the exact same situation and you get a kind of cycle of increasing participation. Three or four years ago Taiwan was accessed by only a few niche players, and although challenging, the spreads were good and good money could be made. Now spreads have compressed as more players have entered the market; but this is a right and natural phenomena as the market develops. The result is the market is pushed up the curve.

SEAN GREAVES: From a lending perspective, the more markets the better. As far as new markets are concerned for the borrower side of the market, we hope and expect that we’ll continue to see new markets opening up from a securities lending perspective. Securities lending is an important activity in those markets that are seeking to upgrade their standing: it has been demonstrated in certain academic research to add liquidity and stability to a market and that is something that more markets in the region can benefit from. Interestingly enough, some markets did go ahead and develop their own program, such as Malaysia, which has a very successful domestic bond lending program.

PAUL SOLWAY: We continue to leverage the market change and evolution. As everyone is suggesting markets are fluid here and if there is a regulatory change in South Korea for instance, traders can quickly switch to Taiwan or Hong Kong. We saw that happen when South Korea introduced the short sell ban: clients were pragmatic, reducing flows in one market and adjusting to others. In this instance, both Hong Kong and China have been the main beneficiaries. That fluidity is not always apparent in other, more mature markets.

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ANDREW MCCARDLE: To Paul’s point, there’s been a much greater concentration of business as new markets emerge. If we compare figures for the first quarter of last year and the first quarter of this year, Hong Kong is up around 30% in daily average trading volumes, while Australia is up 15%. Japan is fairly flat, although the notional has gone up.

Then the business moves on to ensuring that clients gain the maximum efficiency from each market, as well as risk mitigation, particularly in the post-trade segment. Transaction analysis is important in this regard, and daily comparisons of files, books and records are a growing feature of these newer markets.

Historically, when EquiLend has gone into a company, we’ve invariably gone in and spoken to trading desks, and people have used us from a trading perspective first and then looked at all the other services that we provide. I would say the business remains a high-touch, manual process at the moment, a natural consequence of the newness of some markets and the comfort from having data from which to extrapolate meaningful analysis.

Even in more mature markets, change is underway. Last year we had our first purely domestic Japanese organisation sign up. There is a large domestic flow within Japan, which historically we have not tapped, but that is now changing, and it helps our clients in other markets who previously may not have had access to the market. That’s where we all see further growth.

JAMES ALDWORTH: With the increase of securities lending in markets, it has a knock-on effect for making just overall investment in that market cheaper and more efficient from a trading standpoint. If we can use the inventory on our books from our clients (either as stock that we can use to pledge as collateral or just internal inventory usage) it brings down the overall cost of business. In an environment where balance sheet usage is increasingly under scrutiny, trading on the long side in a market where that inventory is just dead on your books becomes a very expensive proposition.

ASSET DEMAND DYNAMICS: DEBT, OR EQUITY, OR IS IT SOMETHING ELSE? SEAN GREAVES: I have a complex answer to what is a straightforward question. That is because we tend to look at the situation more holistically. Instead of looking at Asian lenders or Asian borrowers only there are a number of global firms that have an Asian presence, and a number of very large financial institutions around the globe who have exposure to Asian securities but may not actually themselves be based in Asia. Complexity lies in the fact that we try to balance the needs and objectives of our clients to help them maintain and reach their own objectives.

Securities lending in the Asian region then is a combination of the needs of domestic or regional players (from both the lender and the borrower’s sides) but also a number of global financial institutions that need to be considered as well.

Again, regionally, we see that a lot of lenders are very keen to expand their exposure to Asia; but they are very wary of

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Paul Solway, equity finance regional head, Asia Pacific, BNY Mellon: “We’ve all pushed for more harmonisation, helped by local associations, such as PASLA, though it is sometimes difficult to convince regulators to accept the need for such harmonisation across markets. I have no doubt we will eventually get close, but it will take time, understanding and education.”

increasing risk because there’s still a lot of uncertainty in financial markets. Although generally lenders are keen to continue with their securities lending program and expand it, they don’t want to add additional risk. It ties back in with our original discussion on regulation. Clients typically expect to have some kind of indemnification from a lending agent (or another guarantee); it’s a very current discussion, particularly with regulation in mind.

For example consider a US pension fund with exposure in Asia: do they consider increasing or decreasing that exposure at the current time? Asia has been performing well, as we have noted, and there is a feeling that there is growing demand here in the region and that Asia is a great place for people to invest, given some of the weakness in the global economy. With that in mind we would expect the pension fund to continue to invest in Asia: feeding both demand and supply. In that sense these players are also contributing to the development of the market as they will bring their own expertise and investment to bear on the region.

MARTIN CORRALL: In terms of risk, there’s certainly a renewed focus on indemnification; but with some of the regulation coming into play, I question how we will manage to provide those indemnities when we will be vying for our own bit of the balance sheet with other parts of our firms.

Clients generally have been more conservative since the financial crisis. Having said this, we are beginning to see clients begin to explore alternative collateral options. Clearly, there is constraint in demand and clearly those clients that are more flexible with collateral are likely to see high utilisation. We are beginning to see clients become more adventurous, willing to take other forms of collateral such as equities, for example.

FRANCESCA CARNEVALE: Is Asia dominated by fixed income lending or is it equities-based?

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James Aldworth, director, global prime finance, Deutsche Bank. “If you can provide solutions that are scalable, that allow you to continue to offer the same type of services you did say five or eight years ago while still being fully compliant with all new regulations, and provide a little bit of foresight as to what might be coming down the line, you can be in a very good place.”

PAGET DARE BRYAN: If I receive a call or email about a transaction, it usually means this is a bespoke trade because the market works typically without Hong Kong law firm help on its flow business. I would say that I see Hong Kong as very much still an equities town. We see a lot of monetising of equities as a way in which to generate financing (and to do something else with the financing). For these deals, clients structure in such a way that they will see their assets returned at the end of the day. It is the same in Singapore, Indonesia and elsewhere in the region. On the bond repo side, we regularly see Chinese related counterparties and in Hong Kong and Japan repo structures, repo based structured finance or even embedding within them additional credit derivatives provisions. I would say that securities lending and reverse securities lending are still the more popular templates for structured trades in Hong Kong but parties looking to use repo documentation are catching up.

PAUL SOLWAY: Whilst having a strong equity background, joining BNY Mellon I am keenly aware our trading desk deals with a bigger demand volume for fixed income: either a straight borrow, or a collateral trade, or a collateral upgrade. Sometimes, it is difficult to tell what exactly a trade is for, but over time that will develop and become more transparent. Definitely, our repo and securities lending capabilities are being pushed together in Asia on the client side. It makes sense. It is efficient, and gradually I think fixed income demand will increase significantly. However, I would agree with Paget, that equities still dominate here.

COLLATERAL LIQUIDITY: BABY IT CAN DRIVE MY CAR MARTIN CORRALL: We have many clients in Asia that hold fixed income, particularly US treasuries or government

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securities from other regions and certainly the collateral transformation, collateral swap/downgrade, whichever way you want to look at it, has picked up. Post the financial crisis, the trade lending US treasuries versus cash and doing a reverse repo in agencies no longer exists due to low interest rates and QE. Since then, we’ve been looking at what we can do with those US treasuries. Clearly, with the increased need for high quality collateral, we have many clients interested in doing that trade.

PAUL SOLWAY: We want the market to trade fixed income securities in this time zone, rather than waiting for Europe or the US to come in to execute the trade. It is vital to be able to trade in the time zone during Asian hours; and I only see more demand in the pipeline.

PAGET DARE BRYAN: I often hear what desks think they want to do or what COOs think they’re going to be moving into or adding to their businesses a year or two in advance because we are asked to come in and provide product specific presentations. The topics I’ve been asked to talk about recently include collateral transformation services and with, for example, Hong Kong Exchange announcing in April the arrival of OTC Clear for Hong Kong, the structure and role of CCPs. Tied in with this is the development of LCR regimes as we see people looking to be ready to provide collateral, liquidity, clearing services and/or transformation services to clients. If they can provide both client clearing and collateral transformation services, they hope they’ll have a winning relationship with their clients looking to clear derivatives with them and offer other securities services.

We’re seeing a joining up of OTC derivatives and exchange-traded derivatives to other parts of the business such as repo and securities lending. These are effective ways in which people can find the assets they need and others can supply collateral or liquidity requirements to institutions. As clearing and new global collateral regulations go live over the next 18 months, we expect further institutions to look more into this business. Also, we see new markets opening in Asia and the arrival of new players. This includes Chinese and Singapore based-banks which traditionally up to now have not played a global role in derivatives clearing or derivativesrelated work. I think they now see themselves as having either an opportunity to be a provider of cash or liquidity, or be a provider of clearing services to their clients. It is a possible game changer especially around the local markets and we’ll see Asia’s need for high grade assets escalate if the requirements from local regulators and clearing houses are set in place.

JAMES ALDWORTH: It’s worth looking at the infrastructure in place that will support this development.

Essentially, we have either full CCP or CCP hybrid models out here already. We have India, which is a full CCP model, and then you’ve got a market such as Korea where you have the KSD acting as a de-facto CCP but which also allows bilateral trades.

It is something that we’ve been dealing with and we’ve been looking at the infrastructure from different angles, including credit exposure versus the ease of entry into a

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market. For instance in Korea it is relatively straightforward to borrow stock from almost anybody because you can both put your trades into the KSD and everything is handled for you. However, you’ve got a limited credit exposure appetite to a single entity there, and you need to balance that limitation against the ease of using the infrastructure.

In terms of kind of a single CCP or some kind of regionally central cleared model that appears to be developing in other regions, it is going to be very difficult to achieve in Asia, I would think. Considering the level of fragmentation among the various markets here and the myriad regulations supporting them, I think the potential for getting all of that into one cohesive whole is going to be pretty challenging even over the long term.

SEAN GREAVES: As far as infrastructure is concerned, it is quite interesting because we speak to a lot of the infrastructure makers in the region, such as the central banks and regulatory authorities. Very often they come to us to ask our opinion because securities lending is not a core activity for many of them and they’re more interested in finding out how the decisions that they make are going to impact this market. I find that very encouraging because it is nice to know that they are ready, prepared and interested to consult with the market before they actually push the regulations through.

Asia is still very much in the developmental stage. Some markets are further along than others. It is probably a little premature to start talking about CCPs for securities lending within the region. Normally lenders and borrowers look at a big market with a lot of participants. For example consider the Malaysian market, where there are eight or nine borrowers and lenders signed up to the market. It doesn’t really make any sense to have a CCP under that circumstance.

We also have to address the concerns of the lenders, and there is an argument that none of the CCP models have proven they can adequately address the concerns of securities lenders. For instance, a CCP doesn’t remove risk; it transfers it to other counterparties. From the lender’s perspective, they start to lose transparency against exactly who their risk might be taken against, from a counterparty perspective. Are they happy that the collateral might be placed at the CSD, as in Brazil, for example, where double collateralisation of lending trades is standard? There are many issues that have yet to be adequately answered from the lenders’ perspective.

Finally the CCP business has usually sought to benefit from large transaction volume and netting. This is something we don’t really see in Asia in securities lending. It is probably a little bit early. Do regulators and central banks want a robust market infrastructure? Yes, they do. And they also want to protect their markets from excessive volatility. As we’ve seen from our discussion on the imposition of shortselling rules, yes, the regulators do want to try to control movements within the market to some extent, but some market regulations are more developed than others. Are regulators successful in achieving all of their aims? I think there is still an opportunity for further development here.

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THE FINAL COUNTDOWN: OPPORTUNITY, OPPORTUNITY, OPPORTUNITY ANDREW MCCARDLE: From where we sit, we’re uniquely placed in trying to make sure that we’re offering opportunities to both sides of the securities lending business.

We sit in the middle of the large custodian agent lenders and the prime brokers. In that context, our business is about making sure that we’re providing the opportunities that make sense to both sides. It comes down to things such as risk mitigation: making sure that, here in the region, people have a full understanding and a full ability to utilise the tools that they’re using globally in other markets. Moreover, we’ve all seen some of the international lenders move to a position where as many risk mitigation processes are in place as possible before they will deal with counterparties.

We’ve also seen some people look at many of our tools such as Contract Comparison, or the daily comparison of your entire book of business between two counterparties to make sure that it is in line and take a stand, where they will only look to trade with people if that can be in place to reduce those risks.

The exciting thing for us is working with clients to ensure that their business complies fully with new regulations, market changes and market demand. While it may sound strange, there will be really important business opportunities that are going to come in along with the new regulation.

Regulation will bring opportunities as well as problems for everyone, and it is making sure that we work with our clients to help them maximise those. I had a conversation with someone yesterday and they said the one thing that seems to be consistent is that there’s always change. You don’t know what the change is, but it is always there, and it has been for some time.

From a personal perspective within the organisation, we see our growth in some of the more developed markets.

However, the interesting thing is that Asia is replete with opportunities, either in terms of organic growth or because business is shifting from one market to another. Those differences give us leverage to help our clients make money. As we’ve seen with China, we wait for ages for some new initiative, and then it all comes at once. It is often a case that the country announces a trial initiative, and suddenly it goes from nought to 100 miles an hour as a project. In that regard, it is an interesting region, and it is full of opportunities. The difficulty is trying to work out where the next big opportunity is: Is it China? Is it Indonesia, or Malaysia? The list is long and varied, but the opportunities in aggregate are very real indeed.

JAMES ALDWORTH: Many of the elements we have highlighted as problems are in fact, opportunities if you look at them the right way; if you are building out your processes and your systems and your platform the right way. As more lenders come into various markets, the breadth and depth of supply increases and it allows different kinds of trading than was previously available. We’re seeing a lot

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of interest from very large funds in the US, either quant funds or stat arb funds who are looking at markets in Asia for the first time. The liquidity is there, the volumes are there, the supply is there for them to deploy strategies that they’ve been using in developed markets for years now and they are starting to apply those same strategies to Asian markets.

We’ve got guys coming on the platform in Taiwan and Korea that three years ago would not have been able to trade there. Although the cost of trading in some of these markets is still prohibitive to certain types of strategies as they develop further and those costs are reduced, you’ll see even more interest from different funds with different strategies.

In terms of sources of supply, we’re starting to see more nontraditional assets come into play. There are domestic funds in Japan who are looking to lend across Asia for the first time; there’s money from China invested overseas that is not being utilised and that’s an opportunity. Moreover, at some point there’s going to be a lot more supply that will be brought into the market. That will be good news for everyone.

MARTIN CORRALL: We have made a decision to strengthen our Australian desk and so we now have two trading hubs, one in Hong Kong and Sydney. From a supply side we certainly see the Australian superfund industry is growing substantially. Funds across the region are becoming more interested in the securities lending service set. I hope for instance, that Indonesia will come on-stream at some point this year. Malaysia too, though that particular country may pick up when more supply comes online. India is an interesting case; who knows what will happen there.

Actually, we are just starting to write tickets in India. We launched the market late last year but we’re actually now finally booking trades.

There’s been a lot of increased activity around China recently. I’m going to put my neck out on the line here and say that I don’t think they will open it up for offshore participation in the near term, certainly not this year. However, they’re certainly starting to re-engage.

PAGET DARE BRYAN: I’ve seen the Asian markets develop into something far more substantial over the 10 years. International interest in the region continues to rise steadily. I can see however that you need a resilient infrastructure supporting securities lending and repo if, overall, the market is going to be a successful one. I think governments in and around Asia understand that. Equally we all know (as do regulators) that developments in Asia happen in fits and starts. For instance, look at some of the initiatives coming out of China. They sometimes seem to appear suddenly for no apparent reason. By way of example, NAFMII released its market repo documentation recently.

Now, this could have been introduced a couple of years ago, but the market had to wait its turn and we are only now beginning to respond to the introduction of new documents.

You are also seeing the development of Asia specific market standards/documentation around various securities markets and more opinions around securities lending

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

and repo. While some markets are small, we can see some others start to build an infrastructure that allows the business to deepen and develop. We are often involved in helping to prepare market standard templates or opinions often hand in hand with regulators or the local securities trade bodies.

These are very positive signs: an indication of a regulator’s support that wants to see the securities lending business grow; though in some countries real developments may still be two or three years away. Moreover, we are seeing many countries in the region participate in international initiatives such as G20 reform and IOSCO’s short selling regimes as well as Basel III and adopting similar principles, market structures and approach as other regulators in the larger markets in Europe and North America. In this regard, regulation is a driver of market change and evolution.

PAUL SOLWAY: Everyone is playing to their strengths right now. They have to because of constraints on resources and the need to introduce efficiencies into their businesses.

Luckily we are in a position where we can continue to invest in the Asian region. Earlier I spoke about our work in opening up new markets, and dealing with some of the inventory limitations in Asia. In these instances, I think we all agree that we should stick to the basics of the securities lending business, working steadily to secure a deeper inventory pool that can be utilised by our clients. In this regard, markets such as Malaysia and Thailand offer a lot of opportunity this year.

Collateral is a theme we will all return to again and again.

Automation and scale are other elements we need to keep in play. I would say our core strength is working hard to provide our clients with efficiency, choice, flexibility and competence. This is where we are focusing this year.

SEAN GREAVES: BNY Mellon took the proactive step of creating Global Collateral Services as a direct response to the challenge and hence opportunity presented by the global regulatory changes that we’re seeing. The initiative addresses the regulatory requirement counterparties face to deliver high quality collateral to CCPs which may result in a collateral shortfall in the market. In general, the market expectation is that there will be a demand for some form of collateral transformation.

There is an opportunity for clients to optimise the utilisation of their collateral. Are clients currently holding the right kind of collateral? If not, perhaps they need to speak to someone who can help them obtain it in the most costeffective way possible. There are advantages in using a large agent lender who can help them with access to securities to meet their collateral requirements.

BNY Mellon is examining a number of new products to help our clients achieve their objectives and to leverage the company’s market leading positions in custody, collateral management and securities lending. I think the market will be solutions focused for some time to come as regulation redefines what is possible; in that light we are committed to finding specific solutions that will help clients facilitate their lending with as much support as possible. I

45

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RUSSIA TRADING

Russia is seeing inflows of high-frequency trading, nibbling at the green shoots of change in its capital markets, however longer-term investment needs more serious reforms. Dan Barnes reports.

Grassroots change in Russia’s markets SSET PROTECTION IN Russia took a major step forward in Russia last year when the National Securities Depository (NSD) became legally recognised as a Central Securities Depository (CSD) under Russian law.

“This is probably the biggest single change the market has seen,” says Tim Bevan, managing director, Prime Services Sales at broker BCS Financial Group.“We now have a legally operating CSD in Russia, which centralises and consolidates settlement, adding clarity, surety and consistency to the whole post-trade environment in Russia.”

Russia is modernising its capital markets infrastructure in a multi-year project which is intended to attract increased investment from overseas, and potentially repatriate some of the funds that are invested in the offshore depository receipts (DRs) market that exists primarily in London.

“The customers interested in Russia a few years ago were seeking new opportunities at the fringe of the market— global hedge funds typically,” says Emmanuel Carjat, managing director, at low-latency infrastructure provider TMX Atrium.“Most of them have gone to Russia and decided to stay, finding opportunities trading there or in between there and the rest of Europe. Now we are starting to see the second wave of customers who are not the mainstream but are later adopters. The reforms in the market are prompting them to look again at trading Russia.”

The reform project actually consists of several moving parts. The two exchanges that had existed quite separately until December 2011—MICEX (primarily cash equities and foreign exchange) and RTS (primarily derivatives)—were merged into the single Moscow Exchange. Their post-trade infrastructures were also merged into the NSD. Carjat explains that: “Although the trading platforms are not merged you can connect to the new single datacentre for the exchange, M1, which is simplifying the infrastructure for people to trade into Russia on the group of asset classes.”

Despite overcoming some of the technological hurdles, there were still several barriers to trading in Russia.

A

Need for law Until 6th November 2012 there had been no legal framework in which a CSD could operate. The NSD had been regulated as a custodian The situation before, in which individual registrars were effectively equal to the NSD prevented many US asset managers from holding shares in

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

Russia under article 17f-7 of the Investment Company Act of 1940 which required the existence of a legally mandated place that provided centralised clearing, safekeeping and settlement, for firms to safe-keep their assets. When the government created the framework in 2012, and Russia’s regulator, the Federal Financial Markets Service, granted the NSD the status of CSD that opened the market up to many other investors.

“Banks [such as] JP Morgan have said that this fulfils the requirements of 17f so the market accepts that this is kosher and it works,” says Bevan. “It doesn’t deliver change overnight but it is fundamental in providing surety of transfer of legal title.”

A second impediment to trading into the country has been the use by Moscow Exchange of a T+0 settlement cycle for the equities market. A T+0 cycle allows no time for a fund to move cash or securities to a broker after it has made a trade. Instead the broker must already take the assets into its account from the fund in anticipation of a trade, which creates risk for the fund, or it must provide a borrowing facility for either cash or stock, typically using the repo market. For brokers like Otkritie this inefficiency created a need amongst clients, allowing them to offer a service by providing stock as required using their own inventory, bolstered by their access to retail investors.

Then on 25 March 2013, the Moscow Exchange introduced a T+2 trading session to run in parallel with the T+0 market for the top 15 stocks in the market.

“The T+2 order book will reduce costs for participants as funding costs come down,” says Roger Balch, director for direct market access at Otkritie. “Previously we offered a synthetic T+n delivery versus payment (DVP) product where there would be cost implications in the delayed settlement.

In the new T+2 environment these financing costs will be diminished. The Moscow Exchange has also taken steps recently to reduce execution costs.”

As the exchange is running the trading sessions concurrently there are effectively two order books on the go for 15 stocks, which creates a trading situation to be exploited by canny traders.

“There is the possibility of arbitrage between the two order book markets whilst the two markets are running concurrently and some of our more sophisticated clients are exploring it,” says Balch.

47

RUSSIA TRADING

Emmanuel Carjat, managing director, TMX Atrium. “The new single datacentre for the exchange, M1… is simplifying the infrastructure for people to trade into Russia on the group of asset classes,” says Carjat.

Photograph kindly supplied by TMX Atrium, July 2013.

Roger Balch, director for direct market access, Otkritie. “We have seen the first wave of HFTs arrive and now we see the second one coming,” says Balch. Photograph kindly supplied by Otkritie, July 2013.

Originally Moscow Exchange had planned to run the T+2 trading session as the sole order book from the end of June, and the prefunded T+0 market would be closed. However an announcement on 21 May stated that the next 25 most liquid names on the T+0 order book would be added to the T+2 trading session from 8th July, increasing the number of stocks running in parallel from 15 from to 40, until 2nd September 2013, at which point they would only be available on a T+2 basis. All other stock would gradually be migrated and from 1st January 2014, T+2 settlement will apply to all securities listed on the Moscow Exchange.

Joel Varpasuo, head of trading at Pohjola Asset Management which invests in European equities, including Eastern European and Russian equities, says, “My approach for the T+0 in comparison to the T+2 is that the latter’s real benefit comes from making it easier to trade the illiquid second or third-tier [stocks]. At the moment, it is only the [top] fifteen [stocks] that are trading with T+2 and the rest still with T+0 and really there has not been, from my point of view, any bigger change so far. Over time it should make life easier with the less-liquid [stocks] but personally I don’t believe in a quick fix.”

of stocks as investors are not constrained by liquidity in the equity repo market to sell stock via the order book.

There will be some unforeseen issues, warns Bevan, as the change in market structure takes time to bed down, however he notes this is this is par for the course in such a big operation.“In any market you have issues when you make a fundamental market structural change because you can’t foresee every eventuality,” he says. “There will be teething issues, yes, it will take at least a quarter to settle but it won’t fail. The initial impact will be a big uptick in the number of global sell-side organisations offering electronic access to the Russian market. Then the wholesale banks, that is for electronic execution and in time for prime brokerage platforms.”

That will mean a larger community of sell-side brokers will make Russia available for trade creating greater competition for the specialists currently in the market such as BCS. However Bevan sees opportunity in this change.“For every broker that can get access themselves there are two out there who need a partner,” he says. “The pie will grow dramatically, we will lose some of our potential market share of that pie and the margin compression will undoubtedly come through but there will be a much, much bigger market.”

Balch says,“Some of the global investment banks already have a presence in Moscow, but they are not necessarily focused on the same products. Direct market access, colocation and enhanced collateral management are areas where OSL have spent considerable time developing marketleading client solutions.”

Other reforms are evident that will also encourage investors to look at the market a second time, such as making International Financial Reporting Standards (IFRS) mandatory for state-owned enterprises, which also now have to provide a minimum 25% dividend pay-out of net operating income. Currently on the statute books, to be brought in on 1st January 2014, is the banning of retrospective record dates on dividends. Previously a record date

Cautious welcome “There is a lot of devil in the detail but there are really two reasons this is good for the market,” says Bevan.

“Firstly this is a move from 100% to fractional margining.

Secondly it is a move away from stock and cash margining to pure cash margining. That significantly reduces the cost of financing and removes the need to pre-locate stock for sells.”

Not only can this cut the effective financing costs for an OTC trade by 80%, the switch to pure cash financing has removed the need to pre-locate securities to be traded, reducing the reliance on stock borrower availability in the repo market. In addition to reducing the cost of trading, there could also be a broadening of liquidity down the list

48

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

RUSSIA TRADING

Nic Bertrand, head of Equity and Derivatives Markets, London Stock Exchange. “We welcome the improvements to the Russian market that a more efficient post-trade infrastructure will bring,” says Bertrand.

Photograph kindly supplied by the London Stock Exchange, July 2013.

Mark Hemsley, chief executive officer, BATS Chi-X Europe. “There is an arbitrage opportunity between the DR and the underlying,” says Hemsley. Photograph kindly supplied by BATS Chi-X Europe, July 2013.

would be set, when the date of the AGM would be announced to take place a few months later, then at the AGM the dividend rate would be announced but the original record date would apply to it. The change will not only make life easier in pricing equities it could have an impact on the development of Russian derivatives markets.

Nic Bertrand, head of Equity and Derivatives Markets at the London Stock Exchange, says he does not expect the increased access to harm the LSE’s prospects.

“We welcome the improvements to the Russian market that a more efficient post-trade infrastructure will bring,”he says.“Delivering these will only serve to heighten awareness of the opportunities available and so bring more international investment the market—in Russia and London alike.

That in turn will help build liquidity on both markets and help attract further issuers.”

Mark Hemsley, chief executive officer of pan-European exchange BATS Chi-X Europe, which also trades Russian DRs says that the fragmentation of the market creates further opportunity that is unlikely to subside due to improved high-speed access.

“If you just took the LSE and the Moscow Exchange there is an arbitrage opportunity between the DR and the underlying; when you add us in there are several markets for trading DRs so there are now several arbitrage plays,” he says. “Generally, our approach is to look at involving specialists, such as market-makers, to build up volume and then we find that we can expand trading of those products across all of our members due to the higher liquidity.”

Hemsley says that there may be some move towards trading on the ground in Russia he does not expect it to be substantial, as there are further operational issues that need to be resolved.

Bevan at BCS concurs, noting, “These things are evolutionary, you won’t see a sudden repatriation of DR liquidity back to Moscow—which some Muscovites expected—but [these reforms are] what they should be doing and they will reap the benefits over the next three years. The cost of trading will definitely come down, the breadth of liquidity in local shares will increase, the derivatives market will develop and rouble-denominated assets will increasingly become part of the global collateral pool.” I

A very modern exchange The change in settlement has already created opportunities for arbitrage between the two local order books, as Balch has noted. The modernisation of the Moscow Exchange has also assisted with the delivery of new arbitrage models. When the Moscow Exchange set up the M1 data centre in Moscow, it allowed latency-sensitive firms to co-locate in order to trade.

Its technology has not been upgraded—the equity and FX markets that were historically part of the MICEX Exchange run on the existing AFTS platform—however the old RTS futures market platform is expected to move to the ‘Spectra’ matching engine into the M1 datacentre in Q3 of 2013, delivering improved system performance in terms of latency and capacity.

The high-frequency trading (HFT) firms able to take advantage of this are an important source fo revenue for the sell-side. Balch notes that Otkritie constantly reviews its ability provide the fastest connections between Moscow and London, especially for participants who trade in the IOB depository receipts against local stocks as an arbitrage.

He says: “We have seen the first wave of HFTs arrive and now we see the second one coming as these firms look for new avenues of growth amidst a more challenging global environment. Therefore, we do expect volumes to increase fairly significantly over the medium to long-term.”

The depository receipt market that is run on the London Stock Exchange’s International Order Book (IOB) has long benefitted from the challenges of investing directly into Russia, but as those challenges are overcome it is natural to question the effect this will have.

50

J U LY / A U G U S T 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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RUSSIA – TRADING

The project to establish Moscow as a leading international financial centre was approved in 2009.

However, it took some time for the project to build momentum. Only at the end of 2011 were specific milestones announced, and only in this year have some concrete changes taken place.

Important but aggressive deadlines for the project (set by The Moscow Exchange) were regularly missed; a reflection perhaps of the complexities of what is being attempted. Tim Bevan, head of international prime brokerage sales at BCS Financial Group gives his personal view of the upgrading of the Russian trading market and assesses the implications of change.

Investors benefit as market reforms quicken in Russia TSE GM: What is the progress to date on the Moscow international financial centre project?

TIM BEVAN: The project to establish Moscow as an international financial centre was delineated in 2009. Following the articulation of the overall concept it took some time frankly to build momentum. It took until almost the end of 2011 for specific milestones to be announced, for example, and only this year are we experiencing real changes. Even so, what is being attempted is the building of a sophisticated market infrastructure and the complexity of the task is perhaps only now being appreciated. Things happen slowly in Russia, but they do evolve.

Many tangible changes are underway, which are sometimes undervalued by the market as a whole. Those issues that have (up to now) kept international participants out of the Russian market are being resolved, and the impact of these changes can now been seen in a lowering of both the costs and risks involved in trading in Russia. Three core areas of improvement are notable, particularly for equity market participants. These include improvements in the post trade infrastructure, the corporate actions regime and, of course, the move to T+2. These are real and specific areas of change, which have had measurable effects on the overall trading environment in Russia.

FTSE GM: Some of the most concrete developments have been in the back and middle office. Can you outline the changes?

TIM BEVAN: In the past, in the post trading space, before an asset manager or broker could deal in Russia, their legal and operational departments had to acclimatise to the local

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set up. This set up was complex. It involved a non-standardised settlement cycle, a high level of operational bureaucracy, and no small degree of opaqueness in shareholder rights. It resulted in higher trading costs and the acceptance of higher than normal market risk; these two elements were significant and without doubt deterred many international players from participating in the market.

In April this year, the new central securities depository, NSD became fully operational. Now Russia has a legally recognised and regulated CSD, as well as a mandatory settlement structure with the CSD as the only nominee at the trade registry. Mandatory electronic data interchange between CSD and all counterparts and mandatory reconciliation between CSD and registrars now prevails.

Additionally, changes in local market legislation enable Russian custodians to open securities accounts for foreign nominee holders. Further clarity is also expected with regards to tax treaty rates and voluntary corporate actions processing which will further streamline processes. Holding stock in Russia has never been easier. Access will be available to a much broader global audience. Major changes are in place and are being delivered. Investors should feel much safer trading in Russian securities than ever before.

FTSE GM: Can you outline the implications of new regulation in the corporate governance segment?

TIM BEVAN: The biggest single issue in the corporate space has been retrospective record dates, especially with regard to dividends. Historically, the gap between record and payment date could be up to five months. The system was often chaotic in terms of claims processing and accurate pricing.

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J U LY / A U G U S T 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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A new law requires a second record date, for receipt of dividends, to be announced no earlier ten and no later than 20 days after a company’s general meeting—and the pay date can be no later than 25 days after the record date.

Moreover, in the near future, Russia will implement a much clearer pricing environment for local equities via a standardised record and pay date mechanism. This is on the statute book, due for implementation at the end of the year.

FTSE GM: There’s still much to do in support of the trading regime; particularly in the run up to T+2 settlement. Where are the main fault lines and what is being done to shore them up?

TIM BEVAN: There has never been a market as such; simply postings of artificially wide prices which would often catch out the unaware. The ‘Classical’ market still exists today; however, you can see the spread at 400 basis points (bps) versus the true market (T+0 order-book line) of sub 1bps. Even a couple of years ago when the RUB lines were heavily referenced by the market, the spread was no better than 100bps. Theoretically, the argument is that the spread reflects the financing cost as liquidity would be sourced on the T+0 market and the trade financed four days until settlement. Even taking this into account, an estimated 8bps to 10bps might be added at the most, hardly a justification for a 100bps spread.

Even if a trade was executed perfectly, crunching down the settlement cycle to T+2 or T+3 (and looking at MICEX and RUB price and the prevailing FX rate over the lifetime of an order) it would still be difficult to assess a fair FX rate given daily movements. Therefore, it would be far too easy for a broker to justify a rate with 20bps-30bps slippage, depending on when and how the FX trade was done.

There are some residual doubts about moving to the T+2 settlement model. Frankly, there will be too many members and there is also concern about how the local market will cope. In terms of migrating to the new model, T+2 was launched (in parallel with the T+0) in late March, and is expected to expand to the top 50 stocks on the exchange in July. It is unlikely that the T+0 market will be switched off before the autumn so it is unlikely that liquidity will shift immediately.

FTSE GM: Do you think there is still work to do in better defining clearing arrangements?

TIM BEVAN: The exchange has taken the decision to manage risk by carrying out pre-trade margin checks on participants rather than create a robust Central Counterparty (CCP) and General Clearing Member structure.

There are a number of finer points to be ironed out, but two important achievements include the move to partial margining (which will mean a reduction in financing and clearing costs of up to 85%), and 100% cash margining, which will introduce the ability to freely trade a much broader range of stocks without the need to pre-locate.

FTSE GM: Is the Russian market looking closer to a standard model?

TIM BEVAN: To refer back to FX, structural changes in Moscow have enabled brokers to take a much more transparent approach when, for example, getting a clean USD price when trading a RUB market. The new model emerging

54

Tim Bevan, head of international prime brokerage sales at BCS Financial Group. “2013 represents a major milestone in the evolution of the Russian capital markets from the full deployment of NSD to the restructuring of the equity market and the changes to dividends represent fundamental, structural change and provide real impetus for further market reform,” says Bevan. Photograph kindly supplied by BCS Financial Group, July 2013.

includes comprehensive exchange fees, brokerage commission, clearing costs, settlement charges and FX. With these changes this is beginning to look like a standard market model. Additionally, each of these costs can be verified and checked which means a growth in transparent, cost-plus models being offered to the market.

FTSE GM: What have been some of the other tangible benefits of the recent reforms?

TIM BEVAN: We’re seeing a number of other tangible changes beyond the equity market including increased offshore trading of RUB from the adoption of sovereign bonds (OFZs) into Euroclear to the launch of fixed income derivatives and the launch of new instruments such as first ETF bonds. All of this builds a very convincing case that we are witnessing a serious game change. Clearly, change will take time. There are also still significant risks to take into account: for example, real improvement in corporate governance will require a change in grass roots culture and require the political will to tackle vested interests. Moreover, things need to improve in terms of ease of doing business.

Even so, what we are seeing is the establishment of a new platform on which a more developed and sophisticated financial markets sector can grow. We can confidently say that the costs of trading are coming down and will continue to fall.

We also expect a marked increase in international participation in the market over the next six to 12 months from both the buy side and sell side. A broadening of liquidity further down the equity order-book, an increase of RUB and RUB denominated assets in the global collateral pool, and a more developed derivatives market are also likely developments.

With all these elements in mind, 2013 represents a major milestone in the evolution of the Russian capital markets from the full deployment of NSD to the restructuring of the equity market and the changes to dividends represent fundamental, structural change. Together they provide real impetus for continued market reform. I Tim Bevan joined BCS Financial Group in 2012 as Head of International Sales, Prime Brokerage. He worked at the London Stock Exchange for eight years where he managed the Exchange Traded Fund as well as Exchange Traded Commodity and Securitised Derivatives segments. Tim was also heavily involved in the launch of Russian DR derivatives on EDX. He has also worked at RenCap, initially in delta-1 structuring and latterly in equity sales. Prior to joining BCS, Tim was Director of Global Electronic Trading at Otkritie Capital for three years.

J U LY / A U G U S T 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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ROUNDTABLE PARTICIPANTS (from left to right)

Sponsored by:

RICHARD GLEN, head of GSF sales & broker dealer relations, Clearstream RAJEN SHAH, global head of collateral management, Citi MATTHIAS LOEHLE, vice president, cash collateral management, Deutsche Bank JAYNE FORBES, head of securities financing, AXA Investment Managers PATRICK MCMANUS, head of collateral management, EMEA, Nomura JENS QUIRAM, head of business relations, Eurex Clearing

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LIQUDITY SERVICES RULES: OK? PATRICK MCMANUS: HEAD OF COLLATERAL MANAGEMENT, EMEA, NOMURA: The growing trend for operations is that we’re forever focused on our cost base.

We are focused on tasks to look at any sort of synergies and opportunities that we have within our infrastructure. The migration towards the CCP type model can only be an opportunity for the industry to deploy some smart thinking, some smart resource allocation, and some smart technical allocation. Collateral management underpins a myriad of products, which as a result, leads disparate silos and a lot of technical and procedural maturity in certain product types but less so in others. A convergence towards this sort of model will hopefully break down some of the barriers that we currently see in those less developed products or processes and hopefully promote greater efficiencies leveraging the consistent approach the CCP model would promote.

JAYNE FORBES, HEAD OF SECURITIES FINANCING, AXA INVESTMENT MANAGERS: We are a third party lending agent, not a custodian and our client base can be our AXA IM brand and non-AXA IM brand. Right now, 80% of my time is working on the impact of regulation.

EMIR is a huge initiative; it provides a lot of opportunities, but it also presents challenges. Our key focus is the performance of our funds. We look at how we can provide solutions for our funds—to be able to meet their obligation, but also ensure there is no impact on performance. There is adequate collateral in the market, but at what cost? So, as Patrick noted, these days the focus is on operational efficiency, ensuring you can meet your obligation and, from our end, ensure we can maintain our performance benchmarks.

However, I want to say the market will see an awful lot of joint ventures. There will be lots of synergies that will happen across products and we think this will be a really interesting period.

JENS QUIRAM, HEAD OF BUSINESS RELATIONS, EUREX CLEARING: Our focus is firmly on regulation and implementation of changes required by it and to align those amendments with client requirements and to provide new services. I am referring here to EMIR, Basel III/ CRD IV and, if that was not enough, as a European CCP, we are also being affected by the Dodd Frank regulation in the United States (as we are working with global clients).

We are also working on a different kind of expansion for our service, to make it easier and more efficient to use Eurex Clearing as a CCP. In addition we are getting in contact with a different set of clients. In the past, we had mainly contact with clearing brokers, but now we are also dealing with indirect clients directly (typically buy side); and clients that require account segregation. They have different requirements and we have to service them, so it involves developing new products and services. Like others around the table we are also working on the operational efficiencies and capital efficiencies (margin calculation, for example portfolio and cross-margining across asset classes). We understand that funding and collateral management will be vital in

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future. It is important to have an efficient and secured margin system to help to reduce exposures without reducing safety, and also enhance efficient use of capital, particularly in light of Basel III/CRD IV. MATTHIAS LOEHLE, VICE PRESIDENT, CASH COLLATERAL MANAGEMENT, DEUTSCHE BANK: Cash and collateral management at the firm goes across our clearing businesses, including both listed derivatives OTC clearing and OTC bilateral. We focus on both processes and systems, so that the bank can optimise the collateral pool that we use to pledge at CCPs and also at other counterparties. To make that efficient, we constantly look to improve our system landscape, with a focus on automation. At the same time, we are also looking at the most efficient way to implement our infrastructure from a cost perspective. We obviously have a key focus on financial targets that is made up of a variety of components. One, we need to keep our cost base low and keep our funding costs within a certain range.

Two, is effective balance sheet utilisation, not putting undue balances on our balance sheet. Finally, we apply effective internal cost allocation. The guiding principle behind it is regulation, be it here in Europe, the US or anywhere else in the world.

RAJEN SHAH, GLOBAL HEAD OF COLLATERAL MANAGEMENT, CITI: As everyone says, regulation lies behind much of what we do right now, as it affects the way we work out solutions for our clients. Right now balance sheet efficiency is an important consideration for our clients; being able to mobilise their assets as efficiently as possible, given the change to the size of collateral and the intra-day nature of collateral that needs to be moved around. So it is about optimising their inventory. An equal consideration is asset safety, not just using the collateral, but how can it be used; where clients feel it is safe, in terms of how it’s being used.

I really do feel that the days of Citi or anyone else almost providing these solutions independently are gone. It is very much around collaboration, open architecture, and integration. This calls for commitment for us all to work together in the interests of clients. If we don’t, realistically we cannot provide the kind of solutions that clients are now looking for.

RICHARD GLEN, HEAD OF GSF SALES & BROKER DEALER RELATIONS, CLEARSTREAM: The area of global securities financing has become much more important.

Our liquidity hub suite of services was created as a reaction to the financial crisis and, in broad terms, what we’re trying to do is to help our clients gain more effective access to inventory—either internally, through the Clearstream subcustodian network, or through partnerships with the likes of Citi, BNP and now Standard Chartered.

One of the things we’re keen to do is to make sure we can give our clients access to as many new counterparties as possible. In the spirit of partnership and collaboration, we’re working with a number of vendors, to provide traditional banking names with access to more of the new entrants to the market, at least on the European side. That includes insurance companies, asset managers, and corporations.

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REGULATORY DRIVERS RICHARD GLEN: Certainly regulation is bringing more transparency to the market. The interesting flipside of that is that it is also bringing additional layers of granularity. When I joined Clearstream eight years ago, counterparties who were setting up tri-party eligibility schedules, based them around a country’s ratings, asset classes and issuer types. In broad terms, that was pretty much it. When a trader looked at the schedule and worked out how much they could finance with a particular counterparty, it was a relatively simple decision to make.

Regulation has made that decision more difficult; partially because counterparties have become more wary about the different types of collateral that potentially would be mobilized under classical triparty categories. At the same time, counterparties have also become more selective as to who they deal with and (more importantly) which collateral they take from that counterparty. It has inevitably made the traders’ decisions more difficult, in terms of how they choose to position their business, and also finance themselves. Even so, they are also relying on infrastructure providers to provide them with a piece of technology, which can give them the visibility over what they hold and that makes their decision making a lot easier.

JENS QUIRAM: Regulation essentially defines the level of security in the market, to make it safer and more transparent so that from a CCP perspective you will always know exactly who the owner of the collateral is. This goes hand in hand with the requirements of account segregation as we have implemented with the Individual Clearing Model. This will make it possible, if it comes to a default situation that a CCP like Eurex Clearing can identify the respective owner of the position; but it’s also possible to identify the respective collateral. Not only that, an important element is the portability of the assets (position and collateral), to ensure liquidity in the market.

In the past, in a default situation, we have seen that it is difficult for clients to get access to the market, and afterwards, it is unclear what transaction belongs to what counterparty. After all, default situations will still exist. In this regard, security and ownership are vital elements to secure if markets are to maintain their integrity. This is the primary goal of regulation and the work we have done as a CCP in the last month and years.

FRANCESCA CARNEVALE: Might initiatives like LEI help?

PATRICK MCMANUS: A lot of the intention in setting up these regulations was around ordinary default; one in which everyone can quickly re-establish market conditions and where contagion is limited. In order for this to be achieved, collateral management best practice needed to be performed and adhered to, regardless of product. Ultimately knowing where and what your collateral is, who it’s with, whether the eligibility sets are being adhered to all need to be identified and defined at a very micro level and on an intra-day basis.

For instance, the market evolution and adoption of automa-

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Richard Glen, head of GSF sales and broker dealer relations, Clearstream: “Certainly regulation is bringing more transparency to the market. The interesting flipside of that is that it is also bringing additional layers of granularity. When I joined Clearstream eight years ago, counterparties who were setting up tri-party eligibility schedules, based them around a country’s ratings, asset classes and issuer types.

In broad terms, that was pretty much it. When a trader looked at the schedule and worked out how much they could finance with a particular counterparty, it was a relatively simple decision to make.”

tion make things that were not necessarily able to be performed on a bilateral basis can now be performed on a tri-party basis. As a result, everyone having a standard way of identifying counterparties via a unilateral agreed identifier would mean that participants, regardless of product, can quickly establish who and what they’re trading. The LEI code provides that common identifier meaning participants and regulators can benefit from this standard identifier, enabling the aggregation of information from various sources to achieve greater operational efficiency along with a consistent view of risk on an “on demand” basis.

FRANCESCA CARNEVALE: Is the lack of standardisation behind some of the difficulties people faced around famous defaults, such as MF Global?

RAJEN SHAH: Certainly, one of the areas found wanting was around standardisation, be it MF Global or Lehman’s before that. Without standardisation you end up with more exposure that’s not collateralised. You end up with more disputes and confirmations not having been matched in the right time frame. The valuations that one party would use, versus another, the close out rules, and how they were worked, all of these types of things were caused because of a lack of standardisation. Regulation is definitely upping the ante on standardisation, which will certainly help in a future MF Global type of situation.

Another important element is around transparency and segregation. In the case of MF Global, one of the issues was that MF Global’s underlying clients felt that unencumbered assets that they had held at the firm would be safe, even when the firm went down. However, they were co-mingled with MF Global’s own assets and used in a way which the underlying client didn’t know, and so therefore, again, the regulations are at least giving the underlying clients the option of having a very segregated path. However, that involves increased costs. Regulation at least provides clients

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with the choice of deciding on the level of safety and or risk that they want to assume and the relative costs involved.

Regulations are addressing the areas which the experiences of the likes of Lehman and MF Global caused.

However, one of the things that concerns me and concerns a lot of clients that I talk to, is really around the unintended consequences of regulation, especially if you put the various regulations together. Any single piece of legislation be it Dodd Frank or EMIR might look pretty logical in terms of its application and reach. However, take Dodd Frank and EMIR, and add on Basel III, add on the Financial Transaction Tax (FTT), and it is a different matter altogether. Do they work in harmony or against each other? In tandem do they help or exacerbate problems in the market?

MATTHIAS LOEHLE: It is a great point. Much of the regulation now impacting the markets was born out of the financial crisis, which left lots of clients struggling to get their hands back on their assets, which they thought were safe, or would be segregated, when brokers or banks became bankrupt. Regulators have sought to come in and reassure the market, setting up safety nets for investors (from the small retail investor to the large institutional firms). Regulators felt perhaps there was too much complacency; people weren’t doing what they should do, so they came in with much more prescriptive rules.

Obviously from a clearing broker’s perspective, we always knew who the clients were. We always knew where their securities were or are. However, the client may not have paid much attention to it all, because they believed perhaps that the clearing broker was doing the follow up for them. Now, under EMIR, each security has to be flagged, all the way through the system, up to individually segregated accounts at the clearing house. On the one hand, it gives the client a lot more transparency, but at the same time, it will result in substantially increased costs. To provide that level of reporting, and flagging of securities, and segregation of the securities, will be a costly and time consuming process. Then again, clients themselves have to take more responsibility for what they are doing, as they cannot leave it to the broker anymore to manage their inventory in the best possible way.

Therefore, if an individually segregated model is chosen, there will be repercussions: including increased costs and more limited options for clients as they will have to hold larger pots of assets; though they can then allocate them where they want them to be.

THERE’S COLLATERAL MANAGEMENT AND THEN THERE’S GOOD COLLATERAL MANAGEMENT JAYNE FORBES: What do people around the table think about the new current round of regulations regarding collateral? Obligation and ownership of collateral are essential. I ask this, because in securities financing, a client will always want to be aware of all outstanding collateral positions. Collateral ownership has to be known at all times despite the method used to meet this obligation.

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I agree clients need to be even more confident regarding the location of collateral. Operational efficiency and consolidated collateral management functions are important service provisions. This maybe a contentious subject considering who is around the table today, however the issues of liability for these services is also under review; roles and responsibilities need to be clear. If anything should go wrong, the capacity to act quickly is imperative.

In the next set of UCITS regulations, custodians have even more responsibility for assets in their safe keeping. The regulations are strengthening the concept of safety and giving confidence to clients but, as an industry, we’ve always done this. It is just that now it is mandated and we are looking more closely at the minutiae.

I have to say that, when Lehman happened, the tri-party agents we dealt with at that time were diligent, super accurate and very proactive in revaluing and releasing assets.

I have the highest praise for the industry.

RAJEN SHAH: I would say, Jayne, that especially in the securities finance world, I would consider that it’s quite sophisticated. Collateral is a fundamental part of the trade.

However, the segment is not going through the same kind of tectonic change that maybe, for example is occurring in the OTC derivative space. In the OTC derivative space, collateral was not mandated. Organisations that (at the end of the day) for hedging purposes may only have to do a handful of these trades, ended up thinking: Okay, we now take or have collateral management in place, so we can tick the box, and so we must be safe. But then, they wouldn’t really be doing a margin call every day, it might only be once a month, or even less. They wouldn’t be looking at their collateral eligibility and saying: Hold it, the market’s moved and look at what’s happened in Europe. I should no longer be taking these government bonds.

There is no badge that says, you do collateral management and therefore you are safe. The likes of Lehman’s showed very clearly the soundness of that thinking was wanting.

People were not safe. They didn’t have practices that existed in securities finance. Other parts of the market are just beginning to adopt the practices and processes that securities’ financing has used, but many firms are still in transition in terms of fully complying with regulations.

JAYNE FORBES: I take your point. Do you think though that if we had a platform that you could take and apply the lessons and the good practice that you have within securities financing, that you can then use that in complying with EMIR? PATRICK MCMANUS: As Raj intimated, there is a big distinction between collateral management and good collateral management. I’d be very surprised to see that people are still performing collateral management now to the same standard they were in 2008. It is a vastly different market. To that extent though, the view on collateral is now taken from an enterprise perspective around people doing it properly and doing it efficiently. The scrutiny is now as such that everyone is going to that next level of collateral management regardless of product, as having a consistent risk view of your

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exposure is critical. As Jayne mentioned the securities financing industry has always done it well on a day to day basis with daily market to market and same day collateralisation as standard. It will be interesting to see how the new pieces work out that are coming up in the OTC derivatives world: will practices converge?

RICHARD GLEN: My experience in securities financing has shown that a lot of the business historically has been done on the basis of relationship, on trust. Much of what the regulators are trying to promote in terms of transparency is also about understanding who your key relationships are, as well as encouraging diversity. That same concept of trust still holds relatively true throughout our business. Historically, while lines and agreements determined who could trade what with whom, traders were happy to make specific decisions on the basis that the person that they’ve dealt with was a person that they regularly met. Therefore, a bond of sorts built up.

The critical change now is that you have this overarching risk management area, which says: I can’t trust that your relationship and need to formalise the basis of trust. Therefore a framework with clear rules about what you can and cannot do is now in place. It makes our business more transparent but it also makes it a more inflexible and impersonal.

PATRICK MCMANUS: You are right, trust isn’t scientific and it’s not a tangible. From a risk management perspective, it’s very difficult to put in an algorithm. Therefore, from a scientific point of view it doesn’t necessarily equate for a good business decision in that regard. Strong and credible relationships are heavily influential in the securities financing industry in particular.

JAYNE FORBES: Securities finance is not built on relationships alone. I know from my own programme, that we can’t trade purely on trust. The decision about who you trade with is not just within the hands of the business. What is in our hands is the fact that we have a defined list of relationships and they are all equal. The transacted activity is based on who offers the best bid however this is only accepted if other key risk mitigants are within range i.e. concentration/credit lines/collateral etc. If the framework is not met, we cannot trade. So, the controls that you have (and I understand that a security financing has this reputation of being about relationships) must always take precedence.

RICHARD GLEN: To be honest is it maybe because in terms of the clients that you service and the business that you do, the segment was already relatively tightly regulated before the crisis and therefore maybe the terms of engagement were more tightly defined from the outset? That might not have been the case elsewhere in the market.You see, that may be also why that part of the business is now more representative of the mainstream financial world going forward.

Maybe this is also the reason why a lot more buy side institutions are being incorporated into the wider wholesale financial network.

JAYNE FORBES: That’s a good point, but it is consolidated risk.

PATRICK MCMANUS: The other thing is that we could

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Rajen Shah, global head of collateral management, Citi: “I really do feel that the days of Citi or anyone else almost providing these solutions independently are gone. It is very much around collaboration, open architecture, and integration. This calls for commitment for us all to work together in the interests of clients. If we don’t, realistically we cannot provide the kind of solutions that clients are now looking for.”

mention that where we go to a CCP model, maybe relationship does partly become a differentiator. It also helps in ensuring performance and delivery, in particular the political and potential economic impact of a failing transaction.

Having good faith in whom you’re dealing with, having historical reference points that allow you say that your counterpart have consistently performed and delivered goes a long way to mitigate any potential downside and would be a factor in determining business flow.

FRANCESCA CARNEVALE: Jens, there’s obviously this struggle between personal relationships or experience and the need to formalise trading activity. Is it a good thing that the market is becoming more formalised?

JENS QUIRAM: Totally, at least from my perspective. We always act in a completely standardised way. We need to have these standards, to ensure that everybody is dealing with the same legal framework under the same rules, and in terms of the main purpose of a CCP, we have to ensure a smooth and standardised default handling. We have to know exactly what collateral is transferred to us and what collateral is assigned to us for client Collateral, to ensure a smooth liquidation and default management process. This standardisation ensures also portability of client assets to a new clearing member. So we totally are in favour of standardisation to give our members always the maximum transparency and clarity of processing and rules setting.

RISK AND COLLATERAL PATRICK MCMANUS: People are looking at their inventory, their balance sheet with ever increasing scrutiny, in particular to maximise the balance sheet utilisation where possible to drive additional revenue or mitigate inefficiency though unencumbered inventory. Effectively, the collateral transformation transactions that we’ve been speaking about take lower grade assets to convert into higher grade. The ability to finance them is critical for balance sheet management and managing your portfolio directly, so you would

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expect to a certain extent. In the market there should be enough supply to meet demand although opinion seems to be mixed as to whether the supply is readily available in order to achieve that. For most firms having accurate data to derive the quality of an asset is vital. Making sure that data is consistent, making sure the pricing is consistent, and making sure you tie that in with internal stakeholders, such as credit and risk managers, is critical. It makes the day to day operation easier, enabling the focus and attention to be on processing on exception management as opposed to general flow.

RAJEN SHAH: Regulations definitely are ensuring that clients are looking at their collateral assets and ensuring they are commensurate with the type of risk that those assets have associated with them, on a whole host of fronts.

Therefore, for example, going forward haircuts will be driven more by the credit and volatility associated with the assets being used. Basel III capital charges, for instance, that would be incurred, are going to be driven by the type of assets deployed with the users penalised more if they were using assets which have greater volatility for instance. It points to a much more granular look at the deployment of asset as collateral, just to ensure that if they are used as collateral, that there is some other safeguard mechanism in place. Regulation is insisting that a standard of care is applied in the deployment of collateral; and insisting that these standards are employed across the whole market rather than individual segments, such as Jayne’s securities finance business.

JAYNE FORBES: That’s all well and good, but not everyone has a consistent view of what is good collateral. When ESMA, for example, uses quality as a definition, how do we then translate quality collateral into actual asset classes? I have to say, it is a challenge.

RICHARD GLEN: What the regulations are trying to do is to try and place a formalised definition around the definition of the term ‘liquid’. Historically, looking at clearing, most central counterparties now have a relatively standardised collateral schedule, and therefore you can infer that the collateral that they accept is liquid to a certain extent. Equally, the FSA (now FCA) also makes a strict definition of what it deems to be liquid.

CRD IV and Basel III also come up with slightly different interpretations, as do the other European regulations. Can we eventually reach a common standard, not only in terms of individual countries and regions, but also a global standard perhaps? It won’t be easy. For example, are KFW’s deemed to be liquid or not? From a regulatory perspective, it sits in the grey zone between the high grade government bonds and everything else.

RAJEN SHAH: Confusion is understandable, because what is or what is not good collateral may simply be defined by a point in time. What may be liquid today, in a real market crisis, might not be liquid. This pro-cyclicality of collateral is going to become much worse going forward. What I hear a lot is that with all of these regulations in normal times it might all work, even with the extra collateral we all now need to post, because it is the kind of collateral that probably everyone can sustain. However, when a big crisis hits,

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suddenly CCPs may well be saying: I need to have much more collateral. How are people going to cope with that type of pro-cyclicality then? Particularly when everyone who you thought will help you fill the extra requirement is no longer willing or able to.

MATTHIAS LOEHLE: There is also another consideration.

In the past, many firms didn’t have an obligation to post collateral, and the collateral posting was generally high quality, such as government bonds. In that regard, the market was very simple. Now, with the expansion of the clearing requirement and the requirement to post collateral, has come an expansion of the collateral set. Suddenly a lot of security types have been introduced into the collateral management scheme, which in the past were only dealt with by specialist desks, be they corporate bonds, be they bonds with certain pay out profiles, or be that even equities.

Also in the past the management of these securities was the responsibility of special trading desks dedicated to the more exotic collateral and the markets they were traded in.

Now, the collateral desk has to deal with all types of securities, and needs to build up specialist knowledge of how these more exotic markets behave. In the equity market, for example, the pricing mechanism works quite well, because an equity price might just very quickly drop, until it finds a new price, and then suddenly becomes liquid again. A corporate bond however might not behave in the same way, so it may just become illiquid, because there is less interest to trade the security in a falling market.

There are a lot of different dynamics, which together with the liquidity aspect that we looked at, may impose other risks, so the obligation to post more collateral, if that goes hand in hand with the widening of the subset of collateral use, might not necessarily achieve a more stable market.

HELPING THE CLIENT MOBILISE INVENTORY RAJEN SHAH: Help is on three fronts. The first is helping the client mobilise and optimise the broadest pool of inventory that they have. That’s where things like our collaboration with Clearstream and the Liquidity Hub, come into play and being able to let a client, no matter where they have their assets globally, utilise any of its available assets. Two, is the acceptance of a wider range of assets. Europe looks to be contracting in terms of good quality collateral, but there are regions, such as Asia, and particular countries in Asia, where there are government bonds that can now be utilised effectively. In the past, those kinds of assets might not have been thought of as useful collateral, or perhaps they might not have been deemed to have been the right quality. Irrespective, now they are playing a part in providing liquidity to the market. However, to mobilise those assets, you need specialist solutions such as the Liquidity Hub, to be able to leverage them.

The last element is collateral transformation. I don’t think there is one panacea, you have to offer clients multiple routes, to give them choice and to give them flexibility. So, for example, we’re working quite hard on bringing new cash

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lenders, such as cash rich corporations, that could bring a lot of new supply to the market.

FRANCESCA CARNEVALE: These innovations must involve increasing the cost of collateral.

MATTHIAS LOEHLE: Yes, absolutely it does. That’s because holders of government securities suddenly have a pricing path, although it’s a vast market. It is a type of security that the whole market wants, because as Rajen intimated the market in general is contracting. We live in a region where we have too high budget deficits in a lot of countries, so therefore holders of high quality assets are very much in demand. At the same time, what is also very much in demand, is exactly that ability to build those networks, to mobilise the assets, so participants in the market, who have the ability to connect, to either providers of assets, takers of assets, the custodian, the custodian network and even other asset managers, are themselves, very much in demand. Not necessarily as a custody service in itself, but definitely as a key participant, that will be approached by probably most of the collateral desks in this room.

FRANCESCA CARNEVALE: Will that lead to a concentration of business into the hands of a few players that can access this new collateral pool because of their global network?

RICHARD GLEN: It does in some respects encourage a concentration of business and it’s primarily driven by cost and the ability to manage scale. Our approach in terms of the collateral management world is less about having the ability to have one collateral management engine that does everything out of one location. We’re looking to see where we can deploy that technology effectively, not only for a wider international market, but also with our local agents and partners.

We’re working together with Citi and other partners so that they can leverage the technology (which we’ve paid for and developed) for the benefit of their and our clients. It helps them utilise a broader array of collateral that we now need to manage.

As you inferred earlier, the hidden agenda in the collateral management world is the cost of cash as collateral. Cash is still the most common means of paying for variation margin to clearing houses in a low interest rate environment. The question is, what other type of assets could they take as collateral?

Many people would prefer to take government bonds but the counterparties on the other side looking to raise that cash might not have the government bonds to give because they’re being used in other products. Clearly, there is still something of a mismatch in terms of the way that regulators want the market to react by saying you need to increase your access to cash liquidity but, at the same time, if you don’t have the assets to get access to cash liquidity, you then need to perform additional collateral transformation. However, an important corollary is whether that collateral transformation agent physically is able to take the collateral that you have, to be able to undertake the transformation that you’ve asked for?

JENS QUIRAM: From a CCP perspective it’s always important to ensure liquidity in default management process. If a default happens, it is vital to ensure CCP

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Matthias Loehle, vice president, cash collateral management, Deutsche Bank: “Under EMIR, each security has to be flagged, all the way through the system, up to individually segregated accounts at the clearing house. On the one hand, it gives the client a lot more transparency, but at the same time, it will result in substantially increased costs. To provide that level of reporting, and flagging of securities, and segregation of the securities, will be a costly and time consuming process. Then again, clients themselves have to take more responsibility for what they are doing, as they cannot leave it to the broker anymore to manage their inventory in the best possible way.”

liquidity and to determine the overall asset value of the defaulting Clearing member In the end, CCPs have two approaches: either they have a very strict list of eligible collateral, just to ensure that collateral is liquid in a default situation. This would definitely lead to higher costs for these kinds of securities. Or as Eurex Clearing, they have a relatively broad list of eligible collateral, approximately 25,000 different ISINs. We have a daily evaluation, flexible and dynamic haircuts on these securities, which will not prevent us from serving the market in a default situation but gives our client for flexibility to cover their exposure and reducing funding costs. These approaches vary from CCP to CCP. In practice, a big benefit for Eurex Clearing is that we have access to central bank money, which means we can extract liquidity from the central bank for the collateral received from our clients. With this in mind, Eurex Clearing can ensure liquidity in such a situation.

PATRICK MCMANUS: Some of the high grade securities issues are not in the general domain, having been bought back by the ECB for instance. Or is that a misconception?

MATTHIAS LOEHLE: That’s a very good point, and a very, very controversial issue; whether the central banks are becoming a one way street. What I mean is that in the search for safety—and at the same time with the issues of collateral location—it could be that clients are forced to come up with high quality securities, which somehow they have to borrow from central banks. Then, they will go through the clearing broker into CCPs. For the CCPs to remain as safe as possible, they will look to get central bank access and will place it again at the central bank. A new circle of business seems to be developing which starts and ends in central bank that looks to be an emerging pillar of a new financial framework. Is this development intended? Or is it a temporary trend? These are important questions with no definitive answer as yet.

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RAJEN SHAH: Let’s put some numbers around some of what we’re talking about: you’ve got to bear in mind that there are $32trn worth of high quality OECD government securities out there. The regulations are such that it is new activity, which will have the regulation applied to it, not for example, the current $650trn book of OTC derivatives. A third point is that there have been many estimates done on what will be the additional collateral that will be required.

There is a broad range of these estimates out in the market, but one that I value quite a lot is some of the work which the Bank of England has done. It has analysed stressed situations, and in a stress situation, the central bank’s view is that there will be around $2trn of additional collateral required.

These are big numbers and while these numbers are worrying, we just need to remember that maybe there is a lot of concern about something that might not happen.

COLLATERAL MANAGEMENT AS A FRONT OFFICE FUNCTION RICHARD GLEN: Many clients have tended to manage collateral in silos. Our view, certainly now for over seven years, is that we’ve looked to offer a collateral management system and an engine, which allows counterparties to aggregate their operational activities, where they feel they can, and where they feel it also brings them benefits and synergy. We are seeing a gradual change across the market.

Certainly a lot of the bigger banks have now started to set up collateral optimisation units, and this group then takes a view on what collateral that institution has available, where it’s held, what they could use it for and then, more importantly, how they could then mobilise it in the places where it needs to go at the right time. I do think that collateral management has shifted a lot more, from being a pure operational driven process, to a front office decision-making process. A lot of that is driven by the cost (and physically needing to understand what that cost is) before you print any tickets. Operations teams that have been doing collateral management now for a number of years are still an intrinsic part of that process and if we look at the direct impact of the financial crisis on a lot of banks, a lot of the back offices have either been scaled back or outsourced.

Even though much of the decision-making is with the front office side, you still need the experience of the operational team to manage exceptions and to help you understand why collateral doesn’t necessarily move in the way it does. So we’re trying to work with both areas of the institutions, ensuring we make the right data reports available to the front office so they can make the decisions that are right when they need to. Equally, we also help the operational teams to streamline the underlying processes.

PATRICK MCMANUS: Enterprise collateral management has been bandied around for a while, but the Utopian state of doing that for a lot of institutions means overcoming barriers in terms of product silos and, more practically, functional team splits within firms. We have had, as Matthias previously alluded to, independent product aligned collateral

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Jayne Forbes, head of securities financing, AXA Investment Managers “Securities finance is not built on relationships alone. I know from my own programme, that we can’t trade purely on trust. The decision about who you trade with is not just within the hands of the business. What is in our hands is the fact that we have a defined list of relationships and they are all equal. The transacted activity is based on who offers the best bid however this is only accepted if other key risk mitigants are within range i.e. concentration/credit lines/collateral etc. If the framework is not met, we cannot trade.”

management groups, supporting independent products.

Nowadays, the aim is a different, to be a collateral management function that is product agnostic and to view and operate holistically at a firm level. This also aligns itself with the regulatory requirements; however there are cost implications in achieving this, particularly if you have a collateral team that isn’t necessarily affiliated or solely supporting with a particular product.

If you are looking at collateral management at a macro level you can also drive efficiency at a cost per trade level as well, providing optimal best execution information to aid decision making around how and what will be the cost of trading. added with a risk based settlement or its type or its asset class, in terms of collateralisation, definitely something that operationally we can give, but fundamentally the big decision making is done at the level where the risk is, which is in the front office side, but I definitely see it as a very collaborative point.

The point being that there is a plethora of information that an operations group can provide but you can get reporting or analytics to suggest one thing, but the practical application of that may not necessarily be something that you can do. Therefore, expertise in of some of the nuances that exist and a practical interpretation, particularly made in some of the less established emerging markets, are definitely something that operations can work with front offices o aide and contribute to their decision process.

JAYNE FORBES: I agree with all of you, but it is an obligation which has to be met and performance also needs to be maintained. Potentially, the historical approach has been a random method of collateral selection; it could be the first eligible asset on a list? In this case the front office needs to value the list to ensure there is some trading space, because (we’re all in agreement) products are now overlapping. Meeting the obligation and not hindering

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performance is imperative. If the cost of collateral rises, clients could change strategies.

MATTHIAS LOEHLE: Jayne makes a key observation: at what point does the cost of the collateral management service become detrimental? When might clients remove their positions and shift their trading strategies to avoid costs? Does it ultimately mean that clients will refrain from the trade altogether? From that perspective, the collateral management business, although from an analytics perspective, from a knowledge perspective, from a trading capability perspective, most certainly is a front office task. In terms of revenue maximization, it is a very critical equation, because the more the business tries to squeeze out of the collateral management service, the more it may hamper other parts of the market, other parts of the bank. It is something that the whole industry struggles with: the relationship internally of the collateral desk with the trading desk. Although a front office trading function, but it cannot maximize profits in the same way that all the trading desks can do, by taking directional risks, for example.

EVOLVING THE COLLATERAL EQUATION RICHARD GLEN: Much of this collateral equation will be driven by budget. Most of the entities around this table here are suffering from more constraints than we have ever had to deal with. For that reason, we’ve got to be careful about using the money that we’ve got as sensibly as we can. On the Clearstream side, people often come to us as the infrastructural layer to try and provide a market-ready solution. So rather than individual entities having to invest the same amount of money to do an isolated technology change or a product launch, if they can streamline and bring that benefit to the market, it spreads the costs over a much wider base.

In that regard, we are listening intently to what our clients ask for and trying to develop innovative solutions, whilst living within our budget as much as possible. Equally, at the same time, we’re also trying to embrace partnership and collaboration where we think it makes commercial sense.

We have talked about the partnership that we have with Citi as part of our Liquidity Hub Connect venture and how that conversation started on the basis that we have a piece of technology that we can use and we can deploy outside of the traditional Clearstream world.

Could we franchise that and license it to Citi so that they can provide a collateral management service to their clients, which we in turn can also leverage for the inventory locations? Can we also potentially leverage that same technology to start to mobilise collateral for the buy side? It is only on the basis of conversations like this that people start looking around the market and thinking if they can do that with them, they can do that with me. Maybe I can do this on the back of what they’re doing? And again, it comes down to the fundamental basis of cost.

RAJEN SHAH: Going forward, there is just going to be a much greater tie between collateral and the overall financial

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Jens Quiram, head of business relations, Eurex Clearing: “From a CCP perspective it’s always important to ensure liquidity in default management process. If a default happens, it is vital to ensure CCP liquidity and to determine the overall asset value of the defaulting Clearing member In the end, CCPs have two approaches: either they have a very strict list of eligible collateral, just to ensure that collateral is liquid in a default situation.”

system than there has been in the past. Collateral now acts as some kind of valve around the financial system, and around liquidity in the financial system. Many of the regulations we’ve talked about encourage standardisation and help create efficiency, which means if the market grows, collateral will be mobilised and used much more efficiently and transparently.

It will help create confidence, which in turn will bolster the markets. The question is: will growth in future be curtailed by the availability of collateral? In other words, have we enough collateral to sustain growth? What happens, for instance, if there’s a big shift into the equities market, and so therefore less fixed income out there? Well, at some point, if that happens, and you haven’t got sufficient fixed income there for people to feel comfortable, that will be the valve which will regulate the markets.

FRANCESCA CARNEVALE: Does that mean we are entering a period of controlled market growth?

RAJEN SHAH: That’s a very good way of putting it; there will be more controlled growth.

MATTHIAS LOEHLE: Absolutely, the control overall is obviously stipulated by the regulation, going back to our very beginning, which leads to this, but it is quite strange, isn’t it, to have to ask whether the market can cope with growth in the market? Obviously, it can because as soon as growth and confidence comes back, the market in itself will be very willing to invest into that growth.

The issue we face at the moment however is not growth.

The issue we face at the moment is a crisis in investor confidence; in other words, uncertainty. That means all the financial market institutions are very cautious in what they do, so nobody is in the market to do bold, adventurous investments. It is all maintaining and coping with what is out there, rather than in the boom years, going and building on their expectation of a bigger market. I think that if the market does turn into a growth phase the investment will be there, and the firms will be able to deal with it.

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COLLATERAL MANAGEMENT

JENS QUIRAM: Right now we are talking to our clients about the handling of collateral procedures. In the last one or two years, we have had many more discussions about collateral management and how we can improve our procedures and our functionalities than years ago. It really does involve very specific items. It points to the fact that despite regulation, despite market conditions and developments, for our clients, it is vital that they integrate collateral management into an efficiently functioning business and therefore there is this emphasis on operations and procedures. It means a lot of change for us to offer our clients from the sell and buy side functionality and operational procedures to reduce funding costs and operational effort and risk (as changes of cut-off times, direct deliveries, tagging segregated collateral).

Even in a wider market context, and talk about market confidence, it is important for us to provide the right legal and risk management framework that our clearing members and new clients can use to comply with regulation.

JAYNE FORBES: We are trying to ensure we have a future proof solution. A shift in investment is not an overnight decision: constant reviews and where required procedural amendments ensure operational excellence. This will entail a complete review of existing collateral management organisations and the readiness to change. Governance is obviously important, it works hand in hand with the optimum operational framework—validation of eligibility criteria, daily mark to market values, updated Insolvency procedures and transparency. It is a total package and without that whole package in place, you will not achieve client confidence. I think implementation capabilities and vision is also important, in order to be able to respond to the current and expected regulatory changes.

PATRICK MCMANUS: There are a number of threads to bring together. To Jayne’s point, Operations groups must accommodate all of the above as operational excellence continues to be a focus point. Competition for spend in this area has been challenged as in the last 18 months it has been widely difficult for market participants to allocate investment.

Regulatory change has meant that anything with mandatory tag has taken up a lot of any spend but the increase, frequency and ambiguity of what these regulations are and how they should be interpreted has meant that this has been, and continues to be, an expensive and time consuming exercise. So part of what’s needed is an element of certainty around what needs to happen and what we need to do.

There are a lot of industry bodies out there that are tirelessly working with various regulators, market participants, CSD’s on a global basis with a view to drive an element of consistency around the whole issue of regulation and collateral. Once we get some clarity around agreed process and definitions, it will make adoption and adherence by all operations groups far easier with a common approach.

FRANCESCA CARNEVALE: What’s the global dimension of these developments and trends? Are we just talking about Europe and the US? RAJEN SHAH: It is not as if collateral is purely a Western concept. If you look at the Latin American countries and the

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Patrick McManus: head of collateral management, EMEA, Nomura “The growing trend for operations is that we’re forever focused on our cost base. We are focused on tasks to look at any sort of synergies and opportunities that we have within our infrastructure. The migration towards the CCP type model can only be an opportunity for the industry to deploy some smart thinking, some smart resource allocation, and some smart technical allocation. Collateral management underpins a myriad of products, which as a result, leads disparate silos and a lot of technical and procedural maturity in certain product types but less so in others.”

Asian countries they have been using collateral just as long as we have in the West. It is just that they are clearly more knowledgeable about local assets, they understand the nuances and risks better and which local asset to use as collateral. Perhaps though there hasn’t been the same kind of squeeze that has hampered markets here. Certainly, the collateral management segment is becoming more global in that I can use assets which I hold elsewhere, whereas previously I had an abundance of US treasuries, and an abundance of European government bonds.

RICHARD GLEN: Until now, banks did not need to look further than local or regional markets. In Europe, in particular, as sovereign ratings have been downgraded, people have been forced to look at markets such as Australia and Canada and other triple-A rated countries for higher grade government debt. This has set a number of new initiatives in motion simply on the basis that people recognise that there is an international financing environment, which a lot of the dealers and the larger banks have really controlled. And, at the same time, there are local markets that are reliant on local liquidity and this has encouraged us to use our expertise and help both the local markets as well as the bigger international markets to say if we can improve the efficiency and the liquidity in the local market then that has to have a positive effect on the way the international market is viewed.

I had a conversation yesterday with a client about Turkey.

Historically, a lot of Turkish assets have been held and financed locally but because of the demand for Turkish government bonds specifically, we’ve now managed to develop our tri-party services to cater for that demand. It is only when you take those little steps, that you work out that there is a lot more global demand for wider ranges of inventory. It’s just a question of how you can make the best use of it, and get it to the right place at the right time. I

J U LY / A U G U S T 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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Ewen Crawford, Global Head of Cash

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Iain Scott, Head of ETD and OTC Clearing EMEA, State Street Global Markets

Bilgehan Aydin, Global Head of Collateral Management & Valuations Ops, HSBC Bank

John Emerson, Managing Director, Global Head of Operations, Renaissance Capital

Marcus Zickwolff, Executive Director and Head of Program Management, Eurex Clearing

Saheed Awan, Director and Global Head Collateral Management and Securities Financing Products, Euroclear

Soraya Belghazi, Secretary General, European Central Securities Depositories Association

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EQUITY TRADING A grand rotation back into equities is as far away as ever and equity trading volumes remain muted, equity broker dealers are living in-extremis and the query is: can equity trading regain its mojo any time soon? At the same time, the infrastructure of the capital and trading markets is in flux, with sweeping changes running through the markets: in part driven by current and impending initiatives such as T2S, T+2 settlement, CSD Regulation, EMIR, AIFMD, MiFID II and UCITs V. What can the equity trading market look forward to over the coming months?

Ruth Hughes Liley went in search of some answers.

Photograph © Albend/Dreamstime.com, supplied July 2013.

THE SLOW BURN IN EQUITY TRADING F A WEEK is a long time in politics, 14 years is a lifetime in the equity markets. Traders just starting out on their career in 1999, were handling around 225,000 trades a month on the London Stock Exchange (LSE). Today these now senior heads of desk are handling around 14m a month, which over the past 12 months have been worth around £4bn every day across multiple venues. Even so, it is a different story looking at volume levels over the same periods. Since 2008, volumes have been on a downward trend and are now little more than half what they were in 2007—an ‘abnormal’year according to several commentators

I

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in the business. Thomson Reuters Equity Market Share data estimates that EMEA electronic order book trading fell from €1.4trn in January 2008 to just over €706bn in January 2013.

While the number of trades has grown, prices have fluctuated. The FTSE100 index has broken through the 6,000 barrier over three periods since 2000 and yet in between, in 2003 and 2009, it stood around 3500. So in the last seven years it has nearly doubled and then halved again.

On top of this, European equity trading as a proportion of all global trading has been falling this year, according to World Federation of Exchanges (WFE). Compared with the

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first six months of 2012, the value of Europe and the US share of electronic order book trading fell to around 8% compared with its growth in Asia of some 30% or more (albeit from a low base). Meanwhile, the number of trades showed a similar trend, although looked at over the last three years (from January 2010 to January 2013), Thomson Reuters says Europe’s share has been fairly constant at around 17%-18%.

With that kind of even low level stability, there’s a growing sense that: “There’s a new structure, a new normality,” explains Paul Squires, head of trading, AXA Investment Managers.“The period leading up to 2008 was an abnormal peak in activity. The sovereign debt crisis has had a significant effect on money coming into European equities—if you are a US investor, Europe may no longer be a region you want to be invested in. The Japanese, UK and US authorities have instigated significant quantitative easing programmes, but the European central bank has not been seen to react and therefore does not look as market friendly.”

An interesting barometer of the health of the equities market is the trading industry conference franchise TradeTech. It was first held in 2000 in Paris and, along with the industry, grew in size until in 2011 it moved to the enormous Excel centre in London. However, this year the event was a pale shadow of its former self, with at least one buyside house “boycotting” it. From 2014, the event is going back to its roots, moving lock, stock and smoking stands, back to Paris in the hope it will breathe new life into the event.

Whether it will is moot. Indeed, brokers and the buyside alike are talking in terms of the equities market being at the height of a cycle or “the end of a 15-year bubble” as one broker puts it. The bull market between January and May this year has certainly given markets a boost, but it was fragile and the FTSE 100 lost 846 points between May 22nd and June 24th. In spite of the bull market, volumes remain stubbornly flat. Brian Gallagher, head of electronic trading Europe, Morgan Stanley, is pessimistic: “We have been through a cycle with a tremendous amount of leverage—the industry is going to get smaller.”

Many firms have been prepping for that very eventuality.

With volumes flat and the commission pot smaller, dealing desks have been cut (some severely) since 2008. A handful of the bulge bracket investment banks are still shedding thousands of jobs, while smaller ones are merging.

Estimates vary, but the Centre for Economics and Business Research predicted the UK’s financial sector would constrict to some 237,036 employees, its lowest level for 20 years, this year, following depressed trading across all asset classes, and as it is challenged by the so-called ‘flat white economy’ (as in ‘flat white’ coffee – of London’s technology and creative sectors).

The number of member firms registered with FINRA, the US independent securities regulator, had fallen 13% since 2008 from 4,895 firms to 4,248 by May 2013. Some brokers think it an inexorable trend: Gallagher says:“Looking ahead, there will be even more consolidation. It has been a very

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Tony Whalley, head of dealing at Scottish Widows Investment Partnership (SWIP), points out. He sees trades now as “straight onefor-one trade; not geared. The likes of the larger hedge funds are now very similar to the big institutional fund managers. Yes, there are new entrants, but there is only so much money to go round now. There was more money sloshing [sic] around years ago.” Photograph kindly supplied by SWIP, July 2013.

difficult five years at every element of the cycle. You are seeing exchange and sell side mergers, and the big buy side firms are getting bigger. Each one of these mergers removes counterparty.”

Reasons for the decline are several. For one, leverage is reduced, especially among key hedge fund clients, as Tony Whalley, head of dealing at Scottish Widows Investment Partnership (SWIP), points out. He sees trades now as“straight one-for-one trade; not geared. The likes of the larger hedge funds are now very similar to the big institutional fund managers. Yes, there are new entrants, but there is only so much money to go round now. There was more money sloshing around years ago. It is getting increasingly difficult to get risk trades done. Brokers are becoming less and less willing to commit capital unless there is a good reason to do so. Five or six years ago, they could make money out of capital, but they have taken the view now that bid-offer spreads are tighter and it is harder to make money.”

For another, more money has been flowing out of actively managed funds into passive funds such as exchange-traded products, over the past decade and particularly since the crisis. Globally, the number of exchange traded funds (ETFs) has risen from just 450 in 2005 to 3,415 on 13th May 2013 according to research firm, ETFGI, and flows have risen at a similar rate with global assets now at a record high of over $2.1trn. Paul Squires at AXA-IM lists the rise of ETFs as investment products as opposed to fundamental portfolio management, as one of the key challenges to his business.

Instinet Europe’s CEO Adam Toms adds to the mix: “More inflows to passive exchange traded funds gradually [affects] the marketplace given lower turnover. There’s less money going into active management, which consumes

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EQUITY TRADING

Paul Squires, head of trading, AXA Investment Managers. “The period leading up to 2008 was an abnormal peak in activity. The sovereign debt crisis has had a significant effect on money coming into European equities – if you are a US investor, Europe may no longer be a region you want to be invested in. The Japanese, UK and US authorities have instigated significant quantitative easing programmes, but the European central bank has not been seen to react and therefore does not look as market friendly,” he says. Photograph kindly supplied by AXA Investment Managers, July 2013.

Instinet Europe’s chief executive officer Adam Toms. Globally, the number of exchange traded funds (ETFs) has risen from just 450 in 2005 to 3,415 on 13 May 2013 according to research firm, ETFGI, and flows have risen at a similar rate with global assets now at a record high of over $2.1trn. “More inflows to passive exchange traded funds gradually [affects] the marketplace given lower turnover. There’s less money going into active management, which consumes more research and other services and so on. So there’s a changed dynamic,” explains Toms. Photograph kindly supplied by Instinet, July 2013.

more research and other services and so on. So there’s a changed dynamic.”

Regulation also poses challenges as politicians and regulators fail to make quick decisions. Much of the Dodd Frank regulation in the US is still being finalised, while in Europe the year for implementation of MiFID II rolls further into the future (2018 has been mentioned) as politicians debate more pressing macro-economic issues [Our reckoning is that MiFID II will be like UCITs II, it won’t happen and it will be usurped by MiFID III]. These delays are costly for firms trying to set up software solutions to meet the regulations.

risen in the past month in spite of market instability and a 2.5% fall in world equities over the survey period,”reads the report. It appears that despite the variable macros environment, Europe is starting to benefit from a modest but marked rebound. According to the report, equity allocations are rising and optimism is highest in Europe where 45% believe the economy will strengthen in the coming year.

Interestingly this market fluidity is creating a heap of work for seers, prophets, consultants and compliance. Thomson Reuters estimates that in the UK, 31% of compliance professionals spend more than ten hours a week tracking and analysing regulatory developments, a rise from 25% last year. Included among the concerns of the industry is a proposed limit on the size of a trade on a dark venue, using the reference price waiver for pre-trade transparency.

Liquidnet and UBS MTF, to name one dark MTF, could both be severely restricted by this rule.

Another concern is that high frequency trading will be regulated, shutting off anywhere between 40% and 60% of the available liquidity. Although more traditional traders try to avoid here-today gone-today liquidity (aka HFT), Adam Toms says:“If new legislation were to remove all HFT activity, then you are talking about 40% less in revenue for exchanges, and a substantial increase in implicit transaction costs for end-users such as pension funds. That’s a very extreme picture to paint, but there are an awful lot of moving parts, which are raising a lot of questions about the size of the market in the future.”

The financial transaction tax (FTT) is also causing concern.

Already introduced in different forms in France (where it relates to the most liquid names) and Italy (where a decision

A glimmer of hope & change On the other hand there is a glimmer of hope and change in the air. Consolidation is creating larger firms who can leverage scale; clearly the future belongs to big hitters; and even the buy side is trying to match fire power with fire power. In early June, for instance, the UK’s Office of Fair Trading gave its approval to BlackRock’s merger with Credit Suisse’s exchange traded funds (ETFs) business, a market segment particularly predicated on scale. At the mid-market end there’s action aplenty too: with more high frequency trading firms merging; the latest being the estimated $1.4bn Getco/Knight Capital reverse takeover, finalised on July 1st, creating KCG Holdings.

Equally there’s some change at the asset allocation level (which ultimately feeds into the buy side’s buy list). Bank of America Merrill Lynch’s June fund manager survey found that its universe of investors were returning investment dollars back into Europe as they retreated from emerging markets and Japanese equities. “Investor confidence has

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Martin Ekers, head of dealing, Northern Trust Global Investments (NTGI). While some believe the FTT is driving trades away from Europe, Ekers has a contrarian view: “The EU tax will not get off the ground once the authorities realise they are going to damage the industry. Regulators want to curtail excesses, not penalise genuine long-term investors. I sense the drip feed to Brussels is finally paying off,” he says. Photograph kindly supplied by NTGI, July 2013.

Brian Gallagher, head of electronic trading Europe, Morgan Stanley, is pessimistic: “We have been through a cycle with a tremendous amount of leverage—the industry is going to get smaller.” Many firms have been prepping for that very eventuality. With volumes flat and the commission pot smaller, dealing desks have been cut (some severely) since 2008. A handful of the bulge bracket investment banks are still shedding thousands of jobs, while smaller ones are merging.

Photograph kindly supplied by Morgan Stanley, July 2013.

to apply the tax to derivatives has been postponed until 1st September) the main concern lies with a proposal spanning eleven member states. Estimates say it could create revenues of up to €35 billion a year. As it stands the tax could be demanded from any trade where one party is in the tax zone.

While some believe the FTT is driving trades away from Europe, Martin Ekers, head of dealing, Northern Trust Global Investments (NTGI), has a contrarian view: “The EU tax will not get off the ground once the authorities realise they are going to damage the industry. Regulators want to curtail excesses, not penalise genuine long-term investors. I sense the drip feed to Brussels is finally paying off.”

Nonetheless, in this environment, others believe volumes will keep going down as legislation continues to be driven by political forces. Brian Gallagher says this is where brokers’ crossing networks become important.“If everything is forced on to a lit book, it could be counterproductive. Our philosophy on all execution venues with clients comes down to two simple elements—transparency and choice. We believe that dark trades should be transparent post-trade but there needs to be better flagging of data to understand what is dark versus what is OTC. What our clients want is choice in where and how they execute but if you shut dark pools you eliminate the element of choice. Trading on a lit book is different from five years ago. FESE and the exchanges have been opposed to the introduction of MTFs within MIFID, as they feel dark pools have grown and may have the potential to damage price formation. There has yet to be any study that price formation has been damaged, in fact spreads have never been better.”

Ekers thinks that regulation of the buyside by the Financial

Conduct Authority (FCA) will be a ‘game changer’. He continues:“There are a third of fund managers where power is in the centralised dealing desks, paying execution rates and adding on commission for research and it is all transparent.

There’s a third who are not accountable, such as hedge funds that don’t have fund holders and where the fund manager totally controls the output. But there is a large swathe in the middle who have never grasped the nettle of unbundling—there are vested interests; and yet it is simple if you are prepared to be accountable: you can pay only three basis points for execution-only rates and pay for research separately—we embraced it from the word go."

As equity managers ponder where the market will go after the first half bull run, Whalley says confidence is critical.

“It takes a long time to build and only a short time to shatter.

Fear and greed are the two things that move it.” Backing up this point, in February, early in the recent bull run, the American Association of Individual Investors (AAII) survey, which highlights how people think the market will move, showed that bulls outnumbered bears, 48% to 24%. The picture is changing and in the week ending June 19th, bulls outnumbered bears only by 37.5% to 30%.

Yet, in the June Bank of America Merrill Lynch fund manager survey, 56% of global investors believed the world economy would strengthen over the coming year, up from 48% in May. Equity allocations increased from 41% to 48%.

What do the cross-currents presage? Tony Whalley is an optimist:“Let’s not forget that equities have returned 4% in dividends since 1999, so in terms of absolute returns it was close to its all-time high earlier this year. In the long term you have to take the view that there is reasonable value in equities.” I

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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%

-2.7 -1.3 -5.3 -4.2 -4.9 -4.9

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

20.3 20.8

0.1

7.9 0.6

-11.0 -7.6

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)

1.3

-3.6 -2.3

-2.7 -3.0 -1.6 -2.1 -2.4

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

1.6 6.3

-3.3 -2.1

FX - TRADE WEIGHTED USD GBP EUR JPY

-10

-5

16.0

7.6 9.2 0.0 0.4 0.1 1.7

-15

52.1

10.9

-22.7 -12.5

-1.8

16.4 14.5 21.8

0

0.0 -19.9

5

7.5 6.8

-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)

0.1

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

-4.2 -4.9 -4.9 -5.3 -6.8

-8

-7

-6

-5

-4

-3

-2

-1

0

52.1

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

-1.3 -2.5 -2.7

1

21.8 21.8 20.8 20.3 16.4 14.5 7.9 3.1

0

10

Developed 1M local ccy (TR) Japan USA Australia Developed Israel Switzerland Canada Netherlands Denmark Singapore Norway Germany Belgium/Lux Finland France Sweden UK Hong Kong Spain Korea Italy -10.7

-12

-6.9 -7.0

-10

-8

-1.3 -2.1 -2.5 -2.7 3.3 -3.7 -4.3 -4.3 -4.4 -4.5 -4.5 -4.6 -4.8 -4.8 -5.2 -5.3 -5.3

-6

-4

-2

0

2

0.2

0

Emerging 1M local ccy (TR) Malaysia Taiwan Thailand India Mexico South Africa Indonesia Chile Russia Emerging -7.4 China -9.5 Brazil Turkey -11.2

-12

-10

-8

-1.8 -2.4 -2.5 -2.6 -2.8 -2.9 -3.3 -4.4 -4.9

-4

-2

0

40

50

60

52.1

30.0 28.8 24.6 23.9 21.9 21.8 20.8 20.6 19.1 18.6 17.3 16.4 14.3 13.2 12.8 11.0 7.9 6.5 5.8

10

20

30

40

50

60

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

0.3

-6

30

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

0.1

20

2

27.7 21.8 20.7 17.2 16.5 14.2 10.5 7.9 5.2 2.3 -0.1 -1.9 -9.1

-20

-10

0

10

20

30

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

70

J U LY / A U G U S T 2 0 1 3 • 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 Japan Europe ex UK

US Emerging

UK

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

Asia Pacific ex-Japan

130

Basic Materials Consumer Services Technology

Industrials Consumer Goods Telecommunications Utilities

120

120

110 110

100

100

90 80

90

70 60 Jun 2011

80 Jun 2011

Oct 2011

Feb 2012

Jun 2012

Oct 2012

Feb 2013

Jun 2013

Oct 2011

Feb 2012

Jun 2012

Oct 2012

Feb 2013

Jun 2013

BOND MARKET RETURNS 1M%

12M%

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

-2.7

UK (7-10 y)

-3.6 -2.3

-3.0

Ger (7-10 y)

-1.6

Japan (7-10 y)

1.6 0.6

0.2

France (7-10 y)

6.3

-2.1

Italy (7-10 y)

16.0

-2.4

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

-4.7

Euro (7-10 y)

5.7 9.4

-2.8 -3.3

UK BBB Euro BBB

7.6 -2.1

UK Non Financial

9.2

-3.9

Euro Non Financial

4.8 5.8

-1.9

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

1.4

-5.1

-6

-5

-4

-3

-2

-1

0

1

-5

0

5

10

15

20

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 Jun 2010

Dec 2010

Jun 2011

Dec 2011

Jun 2012

Dec 2012

Jun 2013

2.50 Jun 2008

Jun 2009

Jun 2010

Jun 2011

Jun 2012

Jun 2013

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

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

71

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

130

130

125

125

120

120

115

115

110

110

105

105

100

100

95 Jun 2012

Sep 2012

Dec 2012

Mar 2013

95 Jun 2012

Jun 2013

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

FTSE UK

Dec 2012

FTSE US Bond 160

145

145

130

130

115

115

100

100

85

85

70

70

55

55

Mar 2013

Jun 2013

FTSE US

40 Jun 2009

Jun 2010

Jun 2011

Jun 2012

1M%

Jun 2013

Jun 2008

Jun 2009

3M%

FTSE UK Index -5.3

-2.1

FTSE USA Bond

-2.0

-5

-4

-3

0

-4

Jun 2013

34.9

13.9

41.1

-1.9

41.8

-3.0

-3.3

-1

Jun 2012

5Y%

2.8

-3.1

-2

Jun 2011

7.8

-1.3

FTSE UK Bond

Jun 2010

6M%

-2.0

FTSE USA Index

-6

Sep 2012

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

160

40 Jun 2008

FTSE US

-2

0

2

4

-5

30.2

0

5

10

15

0

10

20

30

40

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

72

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

50

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