FTSE Global Markets

COLLATERAL OPTIMISATION: WHAT DOES IT REALLY MEAN?

ISSUE 73 • OCTOBER/NOVEMBER 2013

Prepping the buy side for EMIR Turning off, turning on commodity ETFs A slow return for REITs What will Craig Starble bring to eSecLending?

BRINKMANSHIP:

Counting the real cost of US debt www.ftseglobalmarkets.com

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FTSE GLOBAL MARKETS • OCTOBER 2013

HIS EDITION IS about exceptionalism. It’s actually a macro theme as well. As October matures questions are being asked of US economic policy, which looks to be predicated on unconstrained federal spending and this is the theme of our cover story. There’s brouhaha continually bubbling over the inability of the United States’ main political pillars to reach a majority consensus on budgetary issues. The facts are: the US debt ceiling ($16.7trn and counting) was breached in May, and the Treasury has fought since then to keep paying federal bills. If the October debt ceiling deadline is passed without an agreement or, as expected, it is deferred until December, then President Obama will have to choose which federal bills to prioritise in order to avert paralysis. Overdue fiscal tightening is then highly likely in 2014 too.

Ultimately, it will also affect Federal Reserve monetary policy, which (in turn) will be forced into maintaining its asset purchase programme at or near current levels (around $85bn) per month for some time to come.

At heart though there’s a really big question in play. Can US economic policy continue to be based on exceptionalism? Can the convulsions experienced

by Europe to bring its economic house in order continue to be trumped by a United States that looks incapable of fiscal discipline? Is the orderly progress of markets now predicated on a US that will become increasingly indebted?

Is that how discipline in the financial markets works? Really? It’s all questions, questions, questions and a paucity of answers. Someone needs to get a grip.

Unless the US starts to put its finances in order the rest of the world will trundle on in a half-world that is not quite out of recession for at least a few more years.

Aside from that we have a mixed bag of goodies in this edition. While much of the edition looks at the residual problems besetting the global markets: chronic sovereign debt issues, sporadic political risks and unease about the sustainability of high levels of growth in BRIC markets without resolution of some worrisome structural problems, actually a big slug of coverage hints at some bright shoots of growth (fall aside).

Mark Faithfull looks at real estate investment trusts and a burgeoning (if not overheating) UK real estate market. Investors look to be going back to basics and favouring real bricks and mortar once more. How sustainable is the trend? Elsewhere Neil O’Hara looks at the mixed fortunes of the CLO and structured products segments. The popularity of more complex debt instruments has taken something of a battering in recent years as investors have tended to opt for more plain vanilla debt structures, particularly sovereign debt issues. If there is a signal indication that the markets are really recovering we need look no further than the structured debt market: once that returns to better times, we will all know that things are finally getting better. Until then, we can hope and look for hopeful signs of change.

Collateral and collateral management remain uppermost in many investor’s business calculations right now. We make no apologies for continually returning to this theme in regular editions. David Simons highlights current thinking on collateral optimisation, while Euroclear’s Saheed Awan, explains how collateral is best mobilised and used. Enjoy.

T

Francesca Carnevale, Editor

COVER PHOTO: US President Barack Obama addresses a press conference at the White House in Washington DC on October 8th 2013. Barack Obama on Tuesday urged both the Democrats and the Republicans to work on their budget differences to end the fiscal logjam, saying he is willing to talk with the Republicans only after the threats of government shutdown and debt default are removed. In the event, both sides came to a patched up deal. Photograph © Xinhua/Zhang Jun/ XINHUA /LANDOV. Photograph supplied by PressAssociationImages.com, supplied October 2013.

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CONTENTS COVER STORY

COVER STORY: THE TRUE COST OF US DEBT

....................................................Page 4 With just hours to go before the Treasury Department’s October 17th debt-ceiling deadline, the US Senate voted to end a Tea Party-incited fiscal standoff that saw the government teetering on the brink of credit collapse. However, further battles are still in store, as nothing substantial has been agreed What is the true cost of political division on this scale?

DEPARTMENTS

SPOTLIGHT

DTCC UPGRADES DERIVATIVES REPORTING ...............................................Page 8 News from around the global investment market.

PREPARING FOR EMIR REFORM ..................................................................................Page 12 David Field, director at Rule Financial, looks at how the buy side is coping with change.

IN THE MARKETS

QATAR: BUILDING UP TO THE GAMES..................................................................Page 14 How far is Qatar on point on its infrastructure investments?

BONDS WITHOUT BORDERS ............................................................................................Page 16 Ross Pamphilon, CIO at ECM Asset Management on MAC investing

ARE YOU GETTING THE BEST OUT OF YOUR TRADES? ...................Page 19

TRADING REPORT

Ruth Hughes Liley talks to Lee Hodgkinson at NYSE Euronext about market quality.

THE TAIWAN STOCK EXCHANGE: THE WAY FORWARD .................Page 21 Ian Williams looks at the exchange’s business outlook.

GUERNSEY AND THE ILS ASSET CLASS .........................................................Page 23

CHANNEL ISLANDS

How Guernsey is leveraging the growth of insurance linked securities.

JERSEY BUILDS ON MARKET REGULATION ...............................................Page 26 How AIFMD brings opportunity to Jersey’s fund industry.

HIGH YIELD DEBT STAYS THE COURSE .........................................................Page 29 What happens though if the Fed starts to taper QE?

DEBT REPORT

INVESTORS SHOULD LOOK AT FUNDAMENTALS .................................Page 31 Lynn Strongin Dodds reviews the near term credit outlook

CLOs: FIRING ON THREE CYLINDERS .............................................................Page 34 Neil A O’Hara explains why regulation might strangle the asset class.

FACE TO FACE

WHAT CAN A NEW CEO BRING TO ESECLENDING? ................................Page 37

THE BEAR VIEW

TOO MANY QUESTIONS; TOO LITTLE GROWTH ........................................Page 39

David Simons talks to Craig Starble.

The return of Simon Denham, chief executive of Skrem Ltd.

A BETTER SLEW OF COMMODITY ETFs ................................................................Page 40

COMMODITIES

Are commodity ETFs are a good investment?

COMMODITIES, PRICES & CRISIS MANAGEMENT ......................................Page 42 Vanja Dragomanovich looks at the effects of politics on commodities.

DOES PROPERTY STILL HAVE THE REIT STUFF? ..........................................Page 44

REAL ESTATE

Mark Faithfull looks at the slow return of real estate investment trusts.

THE AMERICANS ARE COMING ....................................................................................Page 46 Why American investors like UK real estate.

THE NEW RACE FOR BUSINESS ....................................................................................Page 50

CANADA REPORT

Growing competition in custody and fund administration.

REGULATION AND SECURITIES LENDING VOLUME ................................Page 52 David Simons reports on the market outlook.

COLLATERAL MANAGEMENT DATA PAGES 2

WHERE BEST TO PUT YOUR COLLATERAL ........................................................Page 54 David Simons explains collateral optimisation.

PIECING TOGETHER THE COLLATERAL PUZZLE............................................Page 57 Saweed Awan, Clearstream on managing supply and demand.

Market Reports by FTSE Research ..............................................................................................................Page 60

OCTOBER 2013 • FTSE GLOBAL MARKETS

Post-trade made easy

COVER STORY

COUNTING THE COST OF POLITICAL DISSENT

House Minority Whip Steny Hoyer (Democrat, Maryland) speaks to the media following a meeting with President Barack Obama on the debt limit and reopening the government at the White House in Washington, on October 15th. Hoyer was joined by Rep. Chris Van Hollen (Democrat, Maryland) (L) and House Minority Leader Nancy Pelosi. Photograph by Kevin Dietsch for LANDOV. Photograph supplied by Press Association Images, October 2013.

With just hours to go before the Treasury Department’s October 17th debt-ceiling deadline, on the evening of October 16th the US Senate voted overwhelming to end a Tea Party-incited fiscal standoff that saw Federal agencies shuttered since the beginning of the month and the government once again teetering on the brink of credit collapse. In defeat, House Republicans, led by Speaker John Boehner, tacitly approved the measure, yet suggested that further battles may be in store.

The measure reopens government funding until January 15th of next year only, while raising the debt ceiling through February 7th. David Simons and Francesca Carnevale look at the implications of the debacle.

COUNTING THE COST OF US DEBT HILE FOREIGN OFFICIALS have repeatedly chided the US as a whole for its “dysfunctional” government, in reality the latest impasse—like most previous debacles—was the handiwork of a select group of 30-40 renegade Republicans, who have repeatedly sought to defund President Barack Obama’s sweeping healthcare reforms and other spending initiatives, at any cost. In the

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annals of American political history, seldom have so few attempted to hold sway over so many. In the end, however, the Tea Party-engineered shutdown and protracted debt-ceiling fight yielded virtually no gains for congressional Republicans, while inflicting an estimated $2bn worth of damage to the nation’s economy during the standoff, according to data from Bloomberg.

Nor does the end of the crisis signal an

end to the hemorrhaging; for the fourth quarter, Standard & Poor’s estimates a shutdown-related contraction of approximately 0.6% of inflationadjusted GDP, or about $24bn in lost revenue through the period.

What of the potential impact elsewhere? Given the ever-increasing interconnectedness of the world’s financial markets, one need not be a seasoned economist to understand the global implications of allowing the US to flirt with default disaster every couple of months. Given the role of the nation’s currency and Treasury securities on the global stage, the continuing threat of default could have catastrophic consequences, warns the Treasure Department, including frozen credit markets, a devalued dollar and skyrocketing interest rates.

Clearly, there are widespread international implications as well. Global fallout from the ongoing ideological divide was front and centre at the October meeting of the International Monetary Fund (IMF) in Washington, where a consortium of key finance heads underscored the need for American lawmakers to find common ground—and find it quickly. “The US needs to take urgent action to address short-term fiscal uncertainties,”opined the IMF global membership in a statement. Further upsets could send the dollar into freefall and may have a domino effect on other global currencies, warned the IMF. Even without experiencing an actual default, many believe the 16-day shutdown nevertheless dealt a glancing blow to the fragile US economy. Data issued by market-research group IHS Inc. mid-shutdown pegged the daily cost to the US in excess of $160m.

Citing the fiscal-cliff impasse of August 2011 that drove consumer confidence to its lowest level in more than three decades while weakening an already impaired labor market, the Treasury noted that even the prospect of default can be “disruptive to financial markets and American businesses and families.”

OCTOBER 2013 • FTSE GLOBAL MARKETS

&GWVUEJG $CPM &KTGEV 5GEWTKVKGU 5GTXKEGU

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COVER STORY

COUNTING THE COST OF POLITICAL DISSENT

With Congress set to revisit the funding and debt-ceiling issues in a matter of months, the likelihood of further fiascos could continue to weigh on consumers and financial markets alike.“If people are afraid that the government policy brinkmanship will resurface again, and with it the risk of another shutdown or worse, they’ll remain afraid to open up their checkbooks,” charged S&P analysts.

Speaking at an Institute of International Finance conference, JP Morgan Chase CEO Jamie Dimon was more blunt, reminding those on Capital Hill that with real global growth finally within reach,“let’s not shoot ourselves in the foot.”It remains to seen whether Dimon’s influence, or anyone else’s within the financial or political establishment, will have any measurable impact on the most ardent Tea Party affiliates, who have consistently looked beyond election results, opinion polls, even the admonitions of those within their own party, in an effort to promote their anti-Obama agenda. Despite suggestions to the contrary, a recent Pew Research poll found that more than half of Tea Party Republicans believed the global markets would suffer no ill effects should the debt ceiling actually be breached.

That is a massive lack of understanding of the intricate network that is now global finance and shows a lack of due diligence as to the nature of today’s globally intertwined sovereign debt market, where central banks, sovereign wealth funds, global banks and large asset gatherers, are massively exposed to the world’s fiscally incontinent governments. If that were not the case, why would anyone fuss about the debt obligations of Ireland, Spain, Italy and Greece? Or the US for that matter.

Much has been made of President Obama’s credentials as a world citizen, particularly after his seminal speech in Berlin in 2008 (with acknowledgements, of course, to President Kennedy’s “Ich bin ein Berliner” commitment to internationalism. He repeated this assurance some five years

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later, and yet there seems to be a disconnect among the current US political elite (on both sides) that internationalism is as much an economic statement, as a political one. In practice Obama’s internationalism has transmogrified into American ‘exceptionalism’: evinced by its independent line on key issues that butt against perceived American interests. In other words, we are all in it together, unless it doesn’t suit America.

That’s fine actually: few if any states would subsume their national interest to international considerations.

However, the current dynamics of international money flows and the fragile balance of the global economy right now necessitates more of Obama’s commitment to internationalism than his approach to debt management suggests.

If the US continues to rack up debt at current rates (and the increase when mapped on a graph looks steeper than the steepest side of an American skyscraper, you know that structurally, something is not quite right. America cannot fall back on exceptionalism in this instance. There is too much at stake. If Europe and the rest of the world are to be constrained by fiscal probity, the same must be true in America. Seventeen trillion and counting is a shedload of money: if that structure collapses through either technical or actual default next year then we are all in trouble.

Even if both sides of the US political divide come to terms on continued spending at current levels, expect trouble. The US currency was lucky this time round and no one really believed that a last minute patch up deal would not be concluded. Also, the markets banked on the fact that the US generally is a money making power house that can withstand massive shocks.

However the world is changing and long term a heavily indebted US economy, no matter how vibrant, will suffer. The Italian and Japanese economies are testaments to what happens if long term structural problems are not tackled early on. The ship’s

gears grind ever slower and each turn becomes harder to manage.

In the meantime, look for signs of change in 2014 that indicate what the long term effects of this impasse will be. One, you will see the rise of new reserve currencies. They are already in play for some regional trades, but this trend will take stronger route. The RMB will, despite the current growth glitches, impacting on China’s risk profile, will be the long term beneficiary. Look to see more RMB issues next year, particularly from sovereigns and larger issuers. That will indicate the fact that firms will now start to hedge their bets much more openly. The euro, current issues aside, will invariable go from strength to strength as the weaker markets make those all-important structural adjustments that will allow them to fit better into the euro-system.

The commitment to that system is undimmed, no matter what the US press says and European legislators are toiling at full pelt to deliver a remodeled and modernised European financial market. In that regard, the US is look slower and slower by the second.

QE tapering by the Federal Reserve Bank will also have to be postponed.

The markets might say that they are relieved that this is the case; some governments too (the UK coalition, for one, is banking on keeping interest rates low to prevent a meltdown in its retail mortgage market). But you can’t fight Irving Fisher’s inflation inducing formula forever. It’s like saying E no longer equals MC squared.

“We fought the good fight—we just didn’t win,” offered House Speaker Boehner the day of the October 16th defeat. Boehner missed the point: America didn’t win. No one doubts that American needs more fiscal probity, or that it needs to modernise its economy and financial systems; the question is how do their politicians want to achieve it? Conflict doesn’t always wring out the best solutions. Maybe it’s time to be audacious and rethink approaches, on both sides. I

OCTOBER 2013 • FTSE GLOBAL MARKETS

SPOTLIGHT

GROWTH IN CONSULTANT INTERMEDIATED FUND FLOWS

Consultant intermediated fund flows on the rise More than 60% of institutional flows were intermediated by consultants in 2012 says Cerulli report ORE THAN 60% of institutions’ asset flows were consultant-intermediated in 2012 with the rest coming from direct sales, according to a recent survey of institutional asset managers from Boston-based Cerulli Associates.

“Given the significance of investment consultants, just over half of the asset managers polled plan on placing an even greater emphasis on fostering consultant relationships,” states Michele Giuditta, associate director at Cerulli. “This percentage initially appeared low to us, but our discussions with institutional distribution leaders confirmed that many firms are already devoting substantial resources to these efforts and plan on continuing to do so. This explains the high percentage of firms that plan on dedicating the same level of emphasis on the consultant relations effort in the future.”

In the fourth quarter issue of The Cerulli Edge: Institutional Edition, the analytics firm looks at distribution trends, including the changing consultant landscape and growth of outsourced chief investment officers, retirement distribution dynamics, and passive investing. “Capital markets have become increasingly more complex, and the investment opportunity set has broadened to include more complicated investment products and vehicles,” Giuditta continues. “Given institutions’ growing needs, they seek more support and advice for their portfolios, which has led to an increase in the use of investment consultants.”

Cerulli reports that many investment committees are redefining their roles, delegating more of the day-to-day investment-related responsibilities to their gatekeepers, and

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focusing more on overall policy matters. “Consultant relations pro fessionals shoulder significant responsibility as investment consultants request more from their asset managers,” Giuditta explains.

Moody’s publishes guide to EMEA SME balance sheet securitisations Ratings agency defines balance sheet transactions and their structure OODY’S INVESTORS SERVICE has published a short guide to small and medium-sized enterprise (SME) balance sheet securitisations in Europe, the Middle East and Africa (EMEA). The guide includes a definition of EMEA SME balance sheet transactions and their structure, an overview of rating actions the rating agency has taken on these transactions over the past five years, and their key asset characteristics.

Moody’s defines EMEA SME balance sheet securitisations (also called SME ABS transactions) as bonds backed by a pool of secured and unsecured loans granted to SMEs domiciled in the EMEA region. Spanish and Italian SME backed securities transactions represent 84% of all EMEA SME backed securities transactions as of May 2013.

The EU categorises an obligor as an SME if its headcount is less than 250 and its turnover, between €1m and €50m. However, microenterprises (i.e., with a turnover below €1m) and large corporates with a turnover above €50m (although typically to a very limited

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extent) might also be part of EMEA SME balance sheet securitisations.

The securities, which are typically issued by a special purpose vehicle (SPV), are structured into a series of tranches, or layers, with different credit-risk levels. Cash flows from an EMEA SME balance sheet securitisation are distributed in accordance with a “waterfall” to the different tranches of the bond according to priority, or class. Payments flow from top to bottom, and losses from the bottom up. Moody’s notes that, over the past six years, EMEA SME balance sheet securities transactions’ ratings stability has been high, especially in countries with a Aaa local currency country risk ceiling.

Most of the tranches that were rated Aaa on or after July 2007 and that have been downgraded, were downgraded as a result of sovereign risk in the Eurozone. Looking only at transactions in Belgium, the Netherlands and Germany, more than 90% of the transactions that were rated Aaa on or after July 2007 retained their Aaa rating or retained it until their rating was withdrawn. No tranche initially rated Aaa/Aa was downgraded to Ca/C during the financial crisis, with just one A-rated tranche, and no principal loss has materialised in any European SME balance sheet securitisation notes rated.

Moody’s also notes that default on SME loans is highly pro-cyclical and sensitive to developments in the national real estate market, especially for borrowers active in the building and construction sector, which often account for 30% of the total SME portfolio.

Therefore, bankruptcy numbers have increased sharply since 2007. Unsurprisingly, this has had a significant effect on EMEA SME balance sheet performance, with delinquencies on the rise, especially in Spain and Italy. Moreover, the liquidity crunch has made refinancing more difficult, especially for SMEs domiciled in these two countries.

Moody’s notes that asset diversification in EMEA SME balance sheet

OCTOBER 2013 • FTSE GLOBAL MARKETS

transactions is split into two layers: diverse assets and diverse geographic composition. SME loans may be medium- to long-term secured loans and /or short- to medium-term unsecured loans to SME domiciled in a given country and active in different industries for working capital or investment purposes. EMEA SME balance sheet transactions will typically be backed by a pool of loans drawn from different sector activities, such as construction and building, food and beverage and tobacco (mainly the agricultural sector), hotel, gaming and leisure and capital equipment. This industry diversity helps protect against a downturn in one particular sector (for example, the real estate market) having a disproportionate effect on performance.

EMEA SME balance sheet pools are also diversified geographically across regions in a given country, which mitigates the risk of a regional slowdown having a disproportionate effect on performance.

JPMorgan China can distribute mutual funds to local investors Approval received from CSRC PMORGAN CHASE BANK (China) Company Limited, JP Morgan Chase Bank’s locally incorporated bank (LIB) in China says that it has received approval from the China Securities Regulatory Commission (CSRC) to distribute local securities investment funds to investors in China.

As one of the first foreign bank subsidiaries incorporated in Beijing to have received the fund distribution license, LIB will begin by first offering the CIFM RMB Money Market Fund (CIFM RMB MMF) to its institutional and corporate investors. CIFM RMB MMF is managed by China International Fund Management Co., Ltd. (CIFM ), a joint venture of JPMorgan Asset Manage-

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FTSE GLOBAL MARKETS • OCTOBER 2013

ment (UK) Limited and Shanghai International Trust Co., Ltd. Commenting on the approval of the license, Nick Huang, Head of JP Morgan’s Global Corporate Bank for Greater China, says“When it comes to investments, our institutional and corporate clients, local or international, are seeking to establish more robust investment policies and use a wider range of instruments, with a primary focus on fixed income. The fund distribution license will, over time, allow us to offer our clients the widest range of investment options from the rapidly growing asset management industry, combined with traditional bank products.”

JPMorgan Global Liquidity, the short-term fixed income investment arm of JPMorgan Asset Management (JPMAM), has worked with CIFM for some years. In 2005, AAA-rated liquidity funds in China were pioneered with the launch of the CIFM RMB MMF. In the past two years the fund has more than tripled in size to over RMB35bn ($5.8bn). In 2012, CIFM launched what is believed to be one of the first shortterm fixed income RMB separate accounts for a single institutional client in China.

Kheng Leong Cheah, head of sales for the LIB’s new fund distribution arm in China, says, “Institutional investors often focus on surplus cash first and we can now directly offer our clients in China, the most innovative RMB investment solutions. Some products, like the CIFM RMB MMF, already exist in the market, but other options which cater to the requirements of institutional clients, are still quite limited. As markets develop further, we will closely work with fund management companies to provide new asset management solutions with the industry that are relevant to our clients. From structuring investment policies to implementing them, clients will benefit from our investment insights and local knowledge to guide them through the rapidly changing local fixed income markets in China.”

JPMGL China aims to provide clients with access to the JPMorgan Global Cash Portal, a long-established online trading platform that will allow clients to manage their RMB investments with ease. With stringent security measures, enhanced reporting and consolidated balances across multiple accounts, clients can manage JPMorgan and RMB investment accounts in one place with global visibility of RMB investments in China and secure online trading access. “Execution is equally important for clients, and the Global Cash Portal combined with our client service team inside China and around the world will be a significant step forward in information access and security to execute transactions for RMB investments in China, from anywhere at any time,” adds Cheah.

Market sentiment rises in Swedish real estate Catella’s real estate debt indicator reports improved market sentiment in Q3 2013 ATELLA’S REAL ESTATE Debt Indicator (CREDI) for the third quarter (Q3) of 2013 says credit market sentiment in the Swedish market has improved again over the previous quarter. The CREDI main index moves 4.4 points to a new alltime high of 69.3 and the positive trend is visible in both indices for current situation and expectations. Following a summer with intense transaction activity in the Swedish real estate market, a majority of both lenders and borrowers shows that the current financing environment has continued to improve.“The increasing availability of loan financing has supported liquidity in the Swedish real estate transaction market. Since May we have seen a surge in transactions and it is evident that both banks and investors share a rising appetite for risk on the back of the broader economic

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SPOTLIGHT

DTCC UPGRADES SWAP EXECUTION REPORTING

recovery,” says Daniel Anderbring, research analyst at Catella.

In the listed property sector average loan-to-value increased 0.8 percentage points to 54.1 per cent in Q2 2013, a slight reversal of the deleveraging trend observed since 2009. “We believe that this is indicative of a shift among the listed companies to invest in growth potential as the availability of financing improves and the general economy recovers,”adds Niclas Forsman, capital markets analyst at Catella.

The next CREDI will be published in December 2013.

LCH.Clearnet SA and NYSE Euronext agree on clearing continental derivatives New clearing agreement supports product innovation while maintaining market stability CH.CLEARNET SA, THE Parisbased clearing house of LCH.Clearnet Group Ltd, and NYSE Euronext have signed a new five-year contract for LCH.Clearnet SA to clear NYSE Euronext’s continental listed derivatives until December 2018.

The agreement replaces the current clearing services terms and contract, which were due to expire at the end of March next year.

The agreement allows customers to maintain their existing trading and clearing connectivity and infrastructure, though both parties say the overall service is enhanced, as the new agreement is shaped by new commercial and governance terms.

Christophe Hémon, chief executive of LCH.Clearnet, says: “Stability is important for our members in this evolving regulatory environment and we are delighted to continue clearing NYSE Euronext’s continental European derivatives business. Our new agree-

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ment will provide continuity, while allowing us to work more closely with NYSE Euronext to improve service for customers, and continue to offer industry leading risk management capabilities in a secure and highly regulated environment.”

Roland Bellegarde, Group EVP for European Equities and Equity derivatives at NYSE Euronext, adds: “This is a long-term commitment that means our customers can both maintain and invest in their infrastructure with certainty, accessing a robust, well-regulated clearing house within the Eurozone. The new terms pave the way for even closer cooperation between LCH.Clearnet and NYSE Euronext, which will allow us to bring new trading and clearing products and services to market responsively, quickly and in a safe environment, helping our customers to cope with the current and future challenges of regulation in derivatives.”

DTCC upgrades swap execution reporting Derivatives data reporting meets new CFTC reporting requirements HE DTCC DATA Repository (DDR) says virtually all provisionally registered swap execution facilities (SEFs) are now reporting to DDR’s data repository, leveraging the fact that their customers already report their derivatives transactions to DDR. Bringing together all the market participants in a unified platform, DDR provides a single consolidated source of data for regulators.

As part of the wider goals set out by the G-20 and the Financial Stability Board recommendations to improve market transparency, since October 2nd, SEFs have been required to conform to new Commodity Futures Trading Commission (CFTC) swap data reporting requirements for credit

T

and interest rate products. SEFs, who exercise the option of the CFTC noaction time limited relief, will have extended time to meet their reporting obligation for foreign exchange until October 30th and equities and commodity derivatives until December 2nd. Users of the DDR trade repository will be able to seamlessly add these to the portfolio of products that they are reporting.

“DDR is committed to working closely with SEFs in meeting regulatory demands for robust trade reporting in the global over-thecounter (OTC) derivatives market effectively,”says Marisol Collazo, chief executive officer for DDR.“The reporting of SEF-executed credit and interest rate products marks an important step forward in improving operational efficiency, transparency and risk mitigation in the trading of these instruments. In the first week of SEF trading, DDR reported more than US$450bn in notional for credit and interest rates, capturing the vast majority of the data executed by SEFs. Swap dealers have been reporting trade data to DDR since the end of 2012. Electronic execution platforms are now acting to fulfill regulatory obligations aimed at strengthening the infrastructure.”

DTCC provides live reporting across all five asset classes globally in jurisdictions including Japan and Asia as well as the US. It anticipates being able to provide a similar service in Europe under EMIR in early 2014.

“The WMBAA members are working their way through the SEF execution rule implementation and are committed to providing liquidity to the OTC markets,” states Shawn Bernardo, chairman of the Wholesale Markets Brokers’ Association (WMBAA). “DDR has provided vital support to the WMBAA members and we look forward to working together as the markets evolve. We continue to get the support needed as we work through the onboarding [sic] of our customers.” I

OCTOBER 2013 • FTSE GLOBAL MARKETS

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IN THE MARKETS

EMIR: PREPARING THE BUY SIDE FOR CHANGE

Regulatory reform has been a media hot topic since governments around the globe first announced their intention to regulate derivatives markets. Dodd-Frank and the European Market Infrastructure Regulation (EMIR) have taken years to draft and agree, after much consultation with industry participants, and they are now beginning to come into force. Despite this, it is apparent that unlike their sell side counterparts, many buy side firms are still not adequately prepared to comply with these regulations. David Field, executive director at investment banking consultancy Rule Financial, looks at steps the buy-side can take to ensure they are primed for this reform.

Preparing for EMIR reform HE EUROPEAN SECURITIES and Markets Authority (ESMA) has announced a six week delay in the introduction of mandatory reporting for over-the-counter derivatives, extending the deadline to next February, there are still a number of pressing matters for the buy side to consider. Not least of these are the regulatory obligations that are already in place.

A combination of the need to reduce operating costs and a comparative lack of involvement in the drafting process has left the buy side struggling to adapt and comply with regulations that impact every element of the derivative trade lifecycle. Both Dodd-Frank and EMIR influence execution, confirmation, clearing, margining, and reporting, however, there are many differences in their exact scope and requirements.

Additionally, extraterritorial issues between regulations add another layer of complexity to the compliance puzzle.

Institutions will need to ensure they are fully aware of jurisdictional regulations and that they capitalise on any opportunities for interoperability.

There is also Basel III to consider, which introduces more stringent methods for measuring overall risk exposures and forces banks to set aside additional risk-free capital in their reserves. Buy side firms should be cognisant that this will impact sell side institutions, their business model and the choice of which asset classes they participate in—all of which could have a significant impact on the buy side and require them to open new relationships in order to access markets.

These are just a few of the concerns plaguing the buy side. Other impor-

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tant considerations include the scale of regulatory reform being imposed. In order to remain competitive, firms must ensure that regulatory governance is regularly reviewed and that adequate programmes are in place to manage any operational change that is required.

There are also new trade reporting responsibilities to be considered. It cannot, for instance, be assumed that sell side firms will perform trade reporting and buy side firms must keep sight of the fact that they are still legally responsible for trade reporting, even if they have delegated the function Moreover, in understanding the changes that are required to address collateral segregation, it must be remembered that the rules vary between Dodd-Frank and EMIR regulation.

There will also be effects on operating models; in consequence some buy side firms are actually revisiting their operating model for the processing of OTC derivatives in light of the imposition of business conduct rules under both Dodd-Frank and EMIR regulation Efficient connectivity is now a must.

With implementation deadlines approaching fast, some buy side firms have yet to understand and implement the required connectivity solutions for new OTC services (affirmation and trade reporting for example), all of which require proper planning, implementation and testing Under Dodd-Frank, buy side institutions do not play a role in the submission to the trade repository but they are required to verify the accuracy of the record at the trade repository.

Under both regulations, a buy side institution has an obligation to either

submit or to verify the trade details submitted to the trade repository. This will require a control framework which can grow as data-sets fragment further, in an environment where the organisation has to reconcile submissions at multiple trade repositories.

Institutions should also be aware that there are other differing requirements under Dodd-Frank and EMIR. The latter requires a wider range of trade details to be reported, some of which may not be available through common trade execution standards, meaning that institutions must find a way to enrich or modify any reporting message sent to a trade repository on their behalf. As this must be completed within a specified timeline, institutions will need to assess the need for any infrastructure build and investment.

The collateral challenge The unifying principle between US and European reform is the reduction of counterparty risk. The creation of central counterparties (CCPs) and the mandatory clearing of eligible products are designed to mitigate this risk, and is a cornerstone of regulatory reform on both sides of the Atlantic. While central clearing reduces counterparty credit risk, initial and variation margin (often cash) will have to be posted at the CCP. For the buy side, ‘high-grade’ collateral may also come at a cost. This is either through increased costs of eligible collateral or because of the opportunity cost of depositing funds with the CCP. In the short-term, CCP requirements may drive margin requirements higher than bilateral agreements, and shift to daily and intraday calculations.

OCTOBER 2013 • FTSE GLOBAL MARKETS

As a result of new legislation it is estimated that over two thirds of current bilateral trade volume will be cleared through CCPs. This will lead to a bifurcated market that may be daunting to some buy side participants, increasing their operational processing and their operational risk.

Whilst accessing their own capabilities to manage a potentially more expensive and complex operational environment, institutions should also be considering alternative solutions in order to simplify the management of their collateral.

By engaging an independent collateral agent as part of this process institutions can gain support from triparty structures and systems that efficiently support ongoing collateral reallocation and intraday substitutions based on collateral values. Triparty agents are able to reduce operational risk and complexity, help manage counterparty exposure, and provide clients with a wide array of solutions to transform and optimise collateral.

However, choosing the right clearing agent can be challenging.

The right CCP/clearing broker The CCP mechanism, its financial strength and the selection of a clearing broker are crucial decisions for the buy side; it is also desirable to have an alternative in the event of broker default. If there is no direct relationship with the CCP then the clearing broker assumes the credit risk and acts as the intermediary. Buy side firms must familiarise themselves with the options available to them, as the collateral taker (the CCP) sets the parameters for the collateral it will accept from the collateral provider (the buy side firm).

Clearing brokers should also be reviewed for suitability and stability, as not only will they hold the firm’s initial margin but they will also help clear the firm’s trade in the years ahead. It is imperative that there is no repeat of instances where client funds come under risk (as happened with MF Global). Buy side firms may want

FTSE GLOBAL MARKETS • OCTOBER 2013

to consider which CCPs do they need to access and which clearing brokers can facilitate access?

Clearly it is important to consider the financial stability of a CCP and any potential access to central bank support. The CCP should also have adequate resolution arrangements in the event of a default. The most likely failure of a CCP would be driven by member default: that is, one very large member, or several smaller members.

To mitigate this, the CCP should have adequate admission policies to ensure all members are of good standing. In the event of member default, the initial correction waterfall starts with the defaulting member’s variable margin, then its initial margin, then its contribution of the default fund and finally the rest of the default fund. It is therefore important to be satisfied that the CCP has robust policies for the calculation of variable and initial margin, and an appropriate default fund policy.

With this in mind, segregation models are important, not only in the event of clearing broker or even CCP default and potential requirement to transfer or unwind assets and margin at client level, but also to facilitate the most appropriate collateral handling method. Fully segregated models may prevent cross margining opportunities for example.

Due to the increased costs of margining, there is also the likelihood that risky, long-dated and bespoke swaps will become uneconomical. This may drive participants towards using more vanilla products that are less volatile and easier to value. Indeed, it could also lead buy side firms to use the futures market to mimic their swaps trades given its lower margin costs and less stringent regulatory requirements.

However, given the imperfect hedging provided by futures contracts, many question whether the tailored nature of swaps will actually transcend the regulatory reforms.

Once CCPs are fully operational participants may be able to benefit from portfolio margining across products

which would allow them to offset risks and margin requirements.

For transactions that are not eligible for central clearing, buy side institutions should be aware of the reforms governing timely bilateral confirmation that will be phased in. These are being introduced in order to mitigate the risk of un-cleared transactions and will impose different requirements across asset classes. This again emphasises the need for straight-through-processing in all elements of the trade life-cycle environment and may require an institution to assess their ability to meet these requirements.

Due to the far reaching nature of the reforms, institutions will also be required to perform periodic portfolio reconciliations for non-centrally cleared transactions. The requirements here are determined by the portfolio size but impose another level of operational complexity, which institutions need to be aware of and prepared for.

Deadlines for compliance may at present seem fluid, but buy side institutions should be aware that the ability of all players in the market to on-board new clients, review and update existing documentation and implement new systems infrastructure all require preparation and lead-time. For many affected buy side institutions, implementing these changes will require a significant programme of work, an appropriate budget and a highly skilled team. Participants should also be aware that an unintended consequence of the scale of regulatory change may actually be an increase in the operational risk management profile of their derivatives business as all of the above require robust, scalable and automated control frameworks to ensure compliance.

If buy side firms wish to thrive in the post regulatory era, then they need to establish a firm understanding of the full operational impact of the incoming regulations and shape their compliance initiatives accordingly. The fact that some regulations have already come into force is testament to the urgency and importance of this task. I

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IN THE MARKETS

NEW UPTICK IN QATARI PROJECTS

Regulatory reform has been a media hot topic since governments around the globe first announced their intention to regulate derivatives markets. Dodd-Frank and the European Market Infrastructure Regulation (EMIR) have taken years to draft and agree, after much consultation with industry participants, and they are now beginning to come into force. Despite this, it is apparent that unlike their sell side counterparts, many buy side firms are still not adequately prepared to comply with these regulations. David Field, executive director at investment banking consultancy Rule Financial, looks at steps the buy-side can take to ensure they are primed for this reform.

Picking up the pace of projects in Qatar WASH WITH CASH, in 2008 Qatar announced a major $240bn project and infrastructure spending programme, the largest in the Gulf region that at times has appeared to lack necessary form and intention. This year has seen something of a turnaround in the country’s massive investment programme; some of it attached to its plans to host the 2022 World Cup. The project programme is driven by the country’s National Development Strategy, which is halfway through the current phase (NDS 2011-2016), worth $225bn in total, and the much more broadly defined Qatar National Vision 2030 (QNV). The availability of financing for the development of the country’s infrastructure is linked to Qatar’s massive hydrocarbon program (completed in 2011). Some $150bn of project spending in the seven year phase is borne by the government and state-owned Qatar Petroleum (QP).

The private sector, along with other public entities, is expected to finance the remaining portion (worth just over $100bn).

Some of the still to be awarded contracts in the overall plan include the Lusail City development, an integrated railway project, New Doha port, the Barzan gas development and World Cup 2022 football stadia.

Project financing has seen a steady uptick this year. Thirty-five contracts worth approximately $27.5bn were awarded in Qatar during the first half of 2013, up 30% on the volume signed in 2012. High value contracts finalised in the first half of the year were pre-

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dominantly local transportation works, including ground and tunnel work supporting three line networks in the $12.3bn Doha Metro project and commencement of the $9.9bn Barwa Al-Khor real estate development. All in, some $56.5bn of projects are expected to have been finalised by year end.

Most recently, Qatar’s Electricity and Water Company (QEWC) signed a $450mn funding package to back its new desalination plant, which included both conventional and Islamic tranches. QEWC secured the funds from a consortium of four banks, including QNB Group, Barwa Bank, Masraf Al Rayan and Qatar Islamic Bank. QNB was the mandated lead arranger and secured a $162m debt tranche, an $18m standby facility.

Meantime, Barwa Bank, Masraf Al Rayan and Qatar Islamic Bank lead managed the Islamic tranche, with each providing $90m towards the Islamic tranche, which totalled $270m.

The deal, finalised at the end of September, sets a new benchmark, as it is the first Qatari project financing in which a Qatari developer and Qatari banks have worked together without the support of any foreign lenders.

Also in late September, Bloomberg announced that the UK’s RBS is lead arranger for a planned $6.5bn petrochemical project, though the bank would not confirm the statement.

Financing is expected to cover the costs of the Al Karaana petrochemical complex, which will be built under the supervision of Qatar Petroleum in partnership with Royal Dutch Shell.

Qatar has invested heavily in downstream development and is regarded as a leading proponent of cracker technology. Al Karaana will involve construction of a steam cracker and mono-ethylene glycol plant, and will be the first iteration of a two part project expansion plan for the petrochemical complexes in Qatar’s massive industrial Ras Laffan complex.

Government funding The government has been funding its part of the development plan through budget management, while public sector entities and the private sector more generally have relied on a combination of debt issuance and bank credit. The budget for fiscal year 2013/14 is forecast to increase by 17% over last year’s estimates. Actual capital spending, however, has frequently fallen short of the government’s targets, by 22% in 2011-2012 and 33% in 20122013, according to a report by National Bank of Kuwait earlier this year.

The report says logistical and personnel constraints, coupled with challenges in managing a pipeline of projects on a massive scale and design changes were responsible for project delays and deferments. Even so, despite the fixed deadline of the World Cup in 2022, there a general belief that all the projects will be delivered on time. The government has reiterated its commitment to addressing many of the constraining issues such as bottlenecks in supply, shortage of project management expertise and the current, sub-optimal level of private sector involvement in the development plan. I

OCTOBER 2013 • FTSE GLOBAL MARKETS

ASSET ALLOCATION

IS MAC THE FUTURE OF CREDIT INVESTING?

Photograph © Kheng Ho To/ Dreamstime.com, supplied September 2013.

Bonds without borders How does multi-asset credit (MAC) work and how can it benefit investors? MAC strategies focus almost entirely on credit. The primary aim is selecting the right credit beta and adding excess returns through careful sector, rating and credit section, writes Ross Pamphilon, joint chief investment officer and portfolio manager at ECM Asset Management. Currency in particular is a separate asset class that deserves specialist management.

Is MAC the future of credit investing?

AC STANDS FOR Multi Asset Credit. Put another way, it also stands for freedom; because it is a strategy that allows the credit manager to roam across all areas of the bond market in search of returns, unconstrained by the constraining borders of tight benchmarks. The result is a flexible, unconstrained product that is increasingly being viewed as the future of credit investing.

MAC strategies aren’t the same as strategic bond funds, which typically derive a substantial portion of their returns from rates and currency, in addition to credit. MAC strategies focus almost entirely on credit. The primary aim is selecting the right credit beta and adding excess returns through careful sector, rating and credit section.

Currency, in particular, should be viewed as a separate asset class that deserves specialist management.

In an environment in which most major central bank rates yield less than 1% pushing real yields into negative territory, bond yields have become

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compressed. A MAC strategy might therefore be considered a replacement for a pension scheme’s typical fixed income allocation. However, unlike traditional fixed income funds, a true MAC strategy is unconstrained by a benchmark and is therefore able to make a pension scheme’s fixed income allocation work harder by being free to source beta and issue-selection opportunities.

There are four characteristics that define Multi Asset Credit strategies: they are flexible, unconstrained, interest rate hedged and currency hedged.

At the broadest level, a MAC strategy can allocate across the entire cash and derivative credit spectrum: from corporates to financials, from high yield to emerging markets, and even asset backed securities (ABS).

Expertise in macro, structural and thematic trends drive top-down asset allocation. Meanwhile, the breadth and depth of analysis of individual bond issuers and sectors drives bottom-up stock selection. Although typically set up as total return funds—where fund

returns generally rise and fall with the markets—they can also be established as absolute return funds—where fund returns have a low correlation and volatility compared with the market.

The flexibility of MAC strategies comes from not being tied to a benchmark index. Even where MAC managers use a reference benchmark for risk-management purposes, the manager is free to express their view through active asset allocation decisions. MAC strategies typically provide significant flexibility for interest rate risk management. This is important, as it means the portfolio manager is able to capture excess returns and ‘intended’ beta without seeing it wiped out by the impact of rising interest rates.

As with duration, MAC strategies aim to capture the excess return from credit management without the noise from currency markets distorting returns. So a MAC strategy should hedge out currency risk. As with duration management, currency strategies have their place in a diversified portfolio, but this is a separate asset class that should be managed by foreignexchange specialists.

MAC strategies allow the manager a wider remit and freedom to target those asset classes which are expected to perform best over the cycle and identify the individual sectors and issues that can thrive. Investors are able capture income and capital appreciation throughout different stages of the credit cycle. In addition to the ability to add value through asset allocation, MAC strategies aim to generate returns through strong security and sector selection.

An over-reliance on benchmarking contains risks. It can lead to ‘anchoring’, where a portfolio manager’s decisions are influenced by the weighting of a security in an index. An unconstrained approach removes this anomaly. Portfolio managers can approach an investment universe without preconceptions. Each eligible investment therefore has an equal opportunity of making it into the portfolio. And that

OCTOBER 2013 • FTSE GLOBAL MARKETS

ASSET ALLOCATION

IS MAC THE FUTURE OF CREDIT INVESTING?

TABLE 1: Asset allocation in action 100%90%80%70%60%50%40%30%20%-

Dec 2012Jan 2013-

Sep 2012-

Jun 2012-

Mar 2012-

Dec 2011-

Sep 2011-

Jun 2011-

Mar 2011-

Dec 2010-

Sep 2010-

Jun 2010-

Mar 2010-

Dec 2009-

Sep 2009-

Jun 2009-

Dec 2008-

0%-

Mar 2009-

10%-

Asset Backed Bank Capital Non-Financial Corporate Bonds Financial Corporate Bonds Emerging Markets High Yield • 2009 – a year of recapitalisations, refinancing & restructuring • 2010 – capturing performance from lagging asset classes • 2011/2012 – navigating the Eurozone sovereign crisis & managing tail risk Source: ECM 31st January 2013

should lead to a purer portfolio of best ideas. A MAC portfolio can consider an investment on its absolute merits. This is true not just at an asset allocation level, but also at a sector and stock level.

Managing a MAC strategy requires a broad manager skill set: expertise in identifying macro-economic and structural trends as well as breadth and depth of research combining industry specialisation and experience to deep dive into individual credits.

Selecting market betas for a fund is a key skill, and the main driver of MAC strategy returns. It has the potential to materially improve performance profiles from a risk and return perspective.

To illustrate this, the chart below shows

excess swap returns (i.e. interest rate duration hedged) across the various credit asset classes over the last seven years. It shows the wide dispersion and variation between the best and worst performing asset classes each year.

Being able to anticipate shifts in the market and nimbly adjust the portfolio allocation accordingly is a key aim of a MAC strategy. This ability is increasingly relevant today given the ongoing evolution of the fixed income market. For example, long-term deleveraging of the banking sector will lead to continued bank disintermediation bringing with it a larger investible universe of credit securities.

Bank recapitalisation and reregulation,

TABLE 2: One credit asset class can’t deliver great returns all of the time Credit Asset Class

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Investment Grade Corporates

-0.65

High Yield Sub Financials ABS Loans

2.32

1.31

0.19

0.48 -2.14 -13.92 10.38

-15.33 22.45

9.39

3.61

8.12 -4.55 -42.91 61.59 10.34 -7.10 18.02

-0.52

3.42

2.03

0.72

0.85 -4.21 -28.74 19.16

n/a

n/a

0.29

0.57

0.58 -7.41 -46.78

-5.32

9.74

4.69

3.28

3.07 -3.20 -34.76 46.25

0.67 -4.18

7.13

1.35 -14.53 23.78

8.73 21.58 -5.27 16.31 7.96 -1.83 10.03

Key: Best performing Worst performing Source: ML Lynch Data (EN00, HEAD, EBSU) 31/12/2012, Credit Suisse Loan (Credit Suisse Western Europe) and Barclays ABS (ABS Bond Index ex AAA ) 31/12/2012. Merrill Lynch returns are excess returns over swaps (no duration) Floating rate Loans and ABS are total returns excluding Euribor.

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while potentially less attractive for return-on-equity-focused shareholders, should be broadly supportive for credit investors. Meanwhile, after enjoying a 30-year bull market, being invested in government bonds at this point in the cycle presents the investor with an asymmetric payoff profile with limited upside potential. Being able to identify the key themes such as these at an early stage is vital since it allows the portfolio manager to optimise the topdown allocation, thereby facilitating efficient portfolio management.

MAC strategies require a careful approach to risk management, which is embedded into the investment process.

This ensures that this type of portfolio retains appropriate fixed income-like risk characteristics.

A combination of statistical analysis and ‘stress test’ scenarios are required, because major market trends only filter through into statistical models over time. Stress testing and risk budgeting, a qualitative assessment and the views of the manager tend to play the significant role throughout the investment process. The quality of credit analysis is the ultimate backstop for investors as strong issue selection can help avoid credit defaults.

If the MAC portfolio is investmentgrade focused, it may be used in addition to, or as a replacement for, a core bond allocation. Despite MAC strategies having more tools at their disposal, they still aim to achieve traditional bond-like objectives, such as managing downside risk, low volatility and portfolio diversification.

MAC strategies that focus on higheryielding credit strategies, however, may be kept separate from a traditional fixed income allocation. This is because of their higher risk/return and volatility characteristics, which stray far further away from a traditional bond allocation.

That said investors should not be too concerned with asking: where does a MAC strategy fit? That’s because now, more than ever, investors are asking: how can I make my fixed income allocation do more? I

OCTOBER 2013 • FTSE GLOBAL MARKETS

TRADING REPORT

EFFECTIVE MEASUREMENT OF MARKET QUALITY

In today’s challenging European markets, how should the buyside ensure the best outcome for a trade? The answer could increasingly lie in the measurement of market quality.

Lee Hodgkinson, NYSE Euronext, gives FTSE Global Markets his thoughts on why he believes market quality is so important.

ARE YOU ACHIEVING THE BEST OUTCOME FOR A TRADE? N SPITE OF abundant independent post-trade data, reliable market quality data is hard to come by and the buyside often have to compare apples with oranges as they look at their transaction cost analysis (TCA) and other pre- and posttrade indicators.

In January, research and advisory firm TABB Group produced a report calling for a more standardised approach to the measurement of market quality. In “European Market Quality: A Metric in Need of a Standard”, TABB principal Laurie Berke says: “Brokers are increasingly granular in their post-trade TCA analysis and are

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trying to come up with metrics that will differentiate the quality of liquidity and trading results in one venue vs. the other.”

Lee Hodgkinson, head of sales and client coverage EMEA and APAC at NYSE Euronext, says it’s easier to say what market quality is not:“It’s not just about market share, which is how most multilateral trading facilities (MTFs) measure themselves. The standard view is that platform X, Y or Z is good because it has so much market share and therefore liquidity. But market share is a different metric from quality.

Furthermore, although many smart order routers (SORs) do factor in

market quality metrics, other factors such as pricing or rebates—which can inflate a venue’s market share—can potentially cloud the influence that quality has on their routing logic.”

For the past year, NYSE Euronext has been publishing monthly data from independent data analysis firm TAG Audit. In their reports, they measure market quality by venue using a number of metrics including percentage of presence time at the European Best Bid and Offer (EBBO), tightness of spreads and market depth.

Hodgkinson says: “Much of the liquidity on MTFs is based on being inside the European Best Bid and Offer

Market quality against market share on CAC 40 Equiduct

Turquoise

Market share: 2%

Market share: 6%

Market quality: Presence time at EBBO: 21% EBBO with greatest size: 0% Spread: 32.19bps Displayed Market Depth: €13,094

Market quality: Presence time at EBBO: 46% EBBO with greatest size: 0% Spread: 11.76bps Displayed Market Depth: €12,597

BATS Europe Market share: 4% Market quality: Presence time at EBBO: 34% EBBO with greatest size: 0% Spread: 18.69bps Displayed Market Depth: €11,275

NYSE Euronext Chi-X Market share: 21% Market quality: Presence time at EBBO: 72% EBBO with greatest size: 5% Spread: 7.62bps Displayed Market Depth: €22,234

Market share: 67% Market quality: Presence time at EBBO: 76% EBBO with greatest size: 42% Spread: 6.35 bps Displayed Market Depth: €51,493

Data showing market share and market quality metrics April - September 2012. Data source: TAG Audit

FTSE GLOBAL MARKETS • OCTOBER 2013

19

TRADING REPORT

EFFECTIVE MEASUREMENT OF MARKET QUALITY

(EBBO) for a fleeting moment. Fleetingly tighter spreads alone are not sufficient for quality. You have to be there for a longer period of time.”

The percentage of NYSE Euronext’s presence time at the EBBO increased from 65% to 85% between January 2010 and April 2011 on its key blue chip indices stocks—those that belong to the AEX-Index, AMX-Index, BEL 20, CAC 40, PSI 20, and SBF120 indices. Since then it has fluctuated and in September 2012 was 72% compared with an MTF average of 35% of the time.

The TAG Audit figures are published monthly at www.nyx.com/marketquality, and are based on a snapshot of the European electronic order book, taking quotes from various venues based on one time stamp. A daily market quality indicator of a security is based on the average of the indicator for each millisecond. The figures look at the indices that are on the exchanges owned by NYSE Euronext and compare NYSE Euronext’s performance with BATS Europe, Chi-X Europe, Equiduct and Turquoise.

Hodgkinson says: “Our figures are fully transparent and independently verified and we are prepared to live by the results. The results have been evolving over time but we are happy with them as they demonstrate our diverse community. Other regulated markets may also come out quite well because they share the same deep characteristics as us.”

This ‘diversity of community’ Hodgkinson refers to (that is, the types of participants in a pool) tends to generate better market quality, he explains.

“The more diverse a client base, the greater likelihood of a higher quality market. We have material diversity in our client base, both in terms of user profile and geography. ” To get an even broader picture, LiquidMetrix Research’s Battlemap of the Exchanges looks at 11 European indices comparing spreads, depth of book, market share of volume, and best prices from the main exchange

20

order books. So for example during August 2012, Deutsche Börse’s Xetra performance on the DAX had the average tightest spreads at 5.03bps compared with other venues active in that index.

New rules While brokers produce data, it is generally proprietary and not publicly available. Hodgkinson admits: “As an exchange we can judge execution quality because that’s the key benchmark we can assess from our data set.

We don’t have access to end client data or knowledge of their individual strategies and intentions. Everybody can benchmark themselves against public data but it’s difficult to benchmark against other proprietary data.”

Currently legislation or guidance for market quality is piecemeal. In 2007 the Markets in Financial Instruments Directive (MiFID), set out an obligation on brokers to have a policy for best execution of client orders. In addition, Europe requires annual quality statistics from markets. Meanwhile, according to TABB Group figures, 51% of the buyside in 2011 was ‘heavily’ reliant on TCA reports and venue analysis to measure and compare their dark executions.

Hodgkinson says: “Current regulation allows intermediaries to adopt broad based policies, as long as they are transparent to clients. We would like to see a tighter definition of best execution in MiFID 2. We think it is in the interests of everybody in the community, particularly for the end investor.”

“In the great scheme of things, the introduction of MiFID I is a recent event and the proliferation of electronic trading in Europe is still relatively new.

We are now in an environment where institutional investors are asking: ‘How do I assess quality and ensure I am getting the best performance when my orders are routed to the market?’

There’s a greater and growing awareness out there.”

Execution sizes have fallen significantly over the past 15 years.

Lee Hodgkinson, head of sales and client coverage EMEA and APAC at NYSE Euronext.

Hodgkinson says: “An order for half a million shares in a blue chip equity in the late 1990’s needed little more than 15 to 20 executions, whereas today a broker needs more than 150 order book executions to complete the order. Limiting market impact has become much more difficult in today’s challenging trading environment. Fragmentation of markets has led to tighter spreads and lower explicit costs but with the consequence of much higher implicit costs.

In this environment, all market participants need to care about market quality when deciding where to trade.”

As firms have fought for first place in terms of market share, Hodgkinson believes that the next battleground will be on quality. “Institutional investors want to know their business will be protected and that they can trade with minimum market impact. It is challenging in the current environment for firms to ensure their trading strategies are implemented to maximum effect.

Part of the solution could be real-time market quality metrics built into broker’s order routing logic—and ideally a standardised way of measuring quality across Europe.”I

OCTOBER 2013 • FTSE GLOBAL MARKETS

TRADING REPORT

Eastern Promise: the prime of the TSE Michael Lin became president of the Taiwan Stock Exchange in July. His presidency begins at an auspicious time, notes Lin. He is banking on the feel-good factor in the government to enhance the role of the country’s capital markets and thinks he is supported by slow but steady market-liberalisation policies from the local regulator. Is his optimism justified? Ian Williams reports from Taipei.

HE TAIWANESE GOVERNMENT does not believe in letting the invisible hand take the helm of the island’s economy. Its dirigiste civil servants like to plan. That sometimes leads to tensions with its vigorously entrepreneurial private companies. For example, the long term government strategy to shepherd Taiwan into a post-industrial economy includes plans to turn the country into a regional financial hub; but its stock exchange, which would or should be at the core of such plans, is constrained by regulations designed to protect the country’s hyperactive retail investors.

Since the plans were drawn up, much has changed in the region. Shanghai has soared as a rival to Hong Kong and Guangdong as an international trading centre. Moreover, Taiwan’s businesses

T

FTSE GLOBAL MARKETS • OCTOBER 2013

have become more and more intertwined in an essentially symbiotic relationship with the mainland. It looks like time for accelerated change.

Taiwan, despite being one of the world’s most successful economies, puzzlingly remains on the emerging markets list of leading index providers.

It has been suggested by some analysts that Korea and Taiwan form such a large part of the emerging market indices that index providers are reluctant to promote. Whatever. The formal reckoning that keeps Taiwan below developed market status are the controls on financial trading designed to protect the economy. However, Michael Lin, the new president of the Taiwan Stock Exchange, eschews recrimination. “We talk to them, and they say the country is not friendly

TAIWAN'S STOCK EXCHANGE GOES FOR GROWTH

Michael Lin, president of the Taiwan Stock Exchange.

enough with pre-funding, and the New Taiwan Dollar is still not totally convertible. We need to care about what they are saying and try to solve the problems they raise, to make market access easier. ” The exchange itself has only limited options for changing the way it does business to attract customers and relies on discreet lobbying of the central bank and regulators. His presidency begins at an auspicious time he notes, “Since the financial situation has stabilised, it seems this is a good time to re-enter discussions with them. As you saw in September the chairman of the Financial Supervisory Commission (FSC) announced three more policies to open up the markets.”

The new measures allow day trading for the first time on select large and medium stocks, allowing short sales on some, and a relaxation of the previous strict limits on trading when stocks rise or fall more than 7% stop limit.“It is a good signal that the regulators are more open, and becoming more so. I have already seen signals since, for example the regulators are allowing even smaller companies, start-ups, to list on a new emerging market—a new board for professionals. Since we now already have such a system so we can develop the concept,” comments Lin, whose big concern is to boost turnover on the exchange.

Invariably, further loosening of the leash the FSC imposed on trading, is a cornerstone of the TSE’s hopes. “We organised a task force and they made a long list for the regulator to see if we can make some changes. But of course, since the financial crisis 2008 most regulators have been busy trying to solve the problems that emerged from the crisis—and the trend has been to stricter regulation.” In the past there had been public disputes between the financial services industry and the regulators, but now, he says,“We changed tack. Relations with the regulators are getting better. We talk to them privately and so we maintain good relations, which is key.”

21

TRADING REPORT

TAIWAN'S STOCK EXCHANGE GOES FOR GROWTH

Lin explains the underlying dynamics behind the authorities’ reluctance to introduce change.“For ten years we have been focusing perhaps too much on protecting the retail investors who have dominated this market. It used to be 92% of the market and now is still 70%. The regulators have been concerned with protecting retail investors and are really concerned about a too open policy allowing freedom of trading practices that might impact the retail side. So we are conservative about new products.”

The answer he suggests is to emulate other markets. “There is no reason for us to treat different kinds of investors the same way, so we can have different policies. In Japan and Korea, they already have investors’ classification— retail and institutional/professional depending on how much they invest or their experience. Some risky products can only be traded but by the professionals. He sees comparative advantages with rivals. “You could say that Hong Kong should be the first priority, for very big companies, for big finance and real estate, but Hong Kong investors don’t appreciate the high tech companies, their P/E ratio, so the turnover there is very poor, unlike Taiwan which is much better. In the past we opened the window for them, so some of them are coming here. We are going to find the mechanism, the vehicles to attract retail and local and foreign institutional investors.”

The other opportunity for expansion is Taiwan’s proximity to the mainland.

It has not always been such. Before the election of President Ma, the bristling presence of thousands of missiles pointing at Taiwan had an occasional dampening effect. But now the China factor has turned around. “Ten years ago PRC factor was negative because at that time our government restricted our listed companies from investing in China, which is why more than 150 Taiwan companies went to Hong Kong or Singapore. Of course, we still have some companies listing in Hong Kong, but fewer and fewer. Now the Main-

22

land is no longer negative for us. There is permission for China capital to invest here for example. Currently, the quota is only small, only $500m but the regulator is showing signs of being willing to make the quota bigger. If we can’t make this market more successful, the excuse can no longer be the PRC.”

T-shares Indeed, the exchange is actively wooing business on the mainland; and is finding a handy crop of clients. “The next big project for capital markets will be T shares,” he says. “Mainland companies registered in China but which come Taiwan to list. They need capital, but it is very difficult to get listed in China, where is a long queue, just too long to get listed. So it is a dilemma for the PRC government, for those younger start-up companies that really need the capital markets to grow, but if the capital start up markets are really hot there could be a bubble. The Chinese government is very clever so they encourage companies to go abroad just to register.”

“We already have close trade relations with China, so for cultural and historical reasons the two sides are very familiar with each other. Chinese companies feel very familiar if they come to Taiwan, more comfortable than going to say NASDAQ or the LSE,” he avers.

Indeed, he adds, the chairman of the TSE has only recently visited the Shanghai Stock Exchange to discuss cooperation. The initiative plays into Lin’s immediate objective, which is to build up new business volume. “My first priority is to expand the market to make the scale of fund raising, bigger but we cannot make it bigger by only relying on local companies. We already have successfully attracted 28 foreign companies to list IPOs in the TWSE. On average their profitability and dividend yield are higher than local companies, so Taiwanese investors really welcome them.”

It has also improved overall market quality, he explains.“Their turnover and P/E ratio are very good, so based on

that, we are quite optimistic about attracting more foreign companies. Our target for this year is 25, but we are confident of 20,”he say, while candidly admitting that many of them are, in reality, off-shored Taiwanese companies, although others come from markets as diverse as the United States, the Cayman Islands, China, Singapore and Hong Kong. “If we were only to rely on local companies and local capital it is very difficult to be sustainable and to compete with other financial markets,” he concedes.

“There is no way to avoid the trend towards internationalisation of Asia’s exchanges. Taiwanese people use a lot of money to buy offshore products and our companies go abroad to go public.

Whether we like it or not it happens. So to survive we must enlarge and welcome foreign capital, foreign products so the practice here needs to get more and more in line with global trends.” Above all, “Size matters!” he grins, qualifying, “In the development of financial markets around the world.

Global investors may hesitate to deal with over a hundred exchanges. Only those with a substantial size will attract them and so we need to care about whether we can expand the scale of the Taiwan capital markets.”

In the search for scale, the TSE will be regularly knocking on the regulator’s door; politely asking for more changes.

“For retail investors we only open retail accounts with brokers, but foreign institutional investors currently need to open an account in a custodian bank. It is costly, so it’s a huge obstacle.”

While Lin’s new business route is clearly signposted, he understands the need for patience and subtlety yet clarity on what is important to achieve.

“Our focus is to make the market bigger, attract more companies, and more capital so we need to find anything we can do to help that, to get rid the barriers to make it easier for the investors and companies to come here. He concludes briskly, ‘There is no excuse for failure. We must make it happen.” I

OCTOBER 2013 • FTSE GLOBAL MARKETS

CHANNEL ISLANDS

TARGETING ILS FUNDS AND THE ILS INVESTOR BASE

Fiona Le Poidevin, chief executive of Guernsey Finance, explores how Guernsey’s investment and insurance expertise mean it is capitalising on the opportunities presented by the growth of Insurance linked securities (ILS).

GUERNSEY—PERFECTLY PLACED FOR THE ILS ASSET CLASS NSURANCE LINKED SECURITIES (ILS) are growing in popularity among investors as an alternative asset class and with insurers as a means of accessing greater quantities of affordable risk transfer capacity. ILS permit an insurer to purchase additional protection for low frequency, high severity losses, including natural and non-natural perils, operating in the traditional insurance market, typically in the form of catastrophe ‘cat’ bonds or collateralised reinsurance. Investors are increasingly attracted to ILS because returns are non-correlated with the general financial markets.

What are insurance linked securities (ILS)? Standard and Poor’s says that they “are instruments through which insurance risk is transferred in a capital markets contract.” ILS are increasingly used to finance peak, non-recurrent insurance risks, such as hurricanes and earthquakes and other similar types of losses. ILS are significant because they are offered direct to the capital markets, which expands risk bearing capacity.

For investors, this represents a unique asset class which is uncorrelated with the general financial markets.

Fitch Ratings’ Alternative Reinsurance 2013 Market Update: Convergence Here to Stay (published on September 3rd) states that the demand for alternative reinsurance instruments is set to continue. This is due to the comparatively high potential returns of catastrophe risk through cat bonds and sidecar investments and the lack of correlation between catastrophe losses and returns on other major asset classes.

Brian Schneider, co-head of reinsurance at Fitch Ratings, notes: “The

increased allocation into ILS is putting pressure on asset managers to ensure that they have the capabilities to meet this need. What we are seeing is that a growing number are turning towards Guernsey to establish investment structures which offer exposure to ILS.

I

FTSE GLOBAL MARKETS • OCTOBER 2013

ILS: market convergence Photograph © Olivier de Moal/ Dreamstime.com, supplied October 2013.

convergence of the reinsur¬ance and capital markets is likely here to stay and should continue to grow in the near term.”

This is backed up by a report from Aon Benfield Securities, whose recent paper Insurance Linked Securities: Capital Revolution—ILS Market Expands to New Heights, published on August 30th this year, shows that in the 12 months to the end of June 2013, “the ILS market received record capital inflows from both new and existing investors.” Strong investor demand for insurance risks has resulted in more competitive ILS pricing in comparison to the traditional reinsurance product, which in turn has encouraged sponsors to bring more issuances to market.

Specialist cat funds remain the largest part of the ILS investor base, although they, along with hedge funds and reinsurers, have trimmed their investment in new ILS issuance during the last year. However, institutional investors remain a large and growing proportion, and mutual fund participation is up, with the report commenting that “we still see mutual funds as a future source for increased direct participation in the ILS sector.”

The demand from investors for

Guernsey’s great strength is that it has a long and strong heritage in both the investment funds and insurance sectors. As such, it acts as a centre where fund managers and promoters with capital to deploy are brought together with the transformation managers who understand insurance risk.

The Island has a well-established investment sector where the net asset value of funds under management and administration stands at £286bn.

This comprises a wide range of investments, including alternative and esoteric asset classes, such as ILS. For example, the Guernsey domiciled DCG Iris Fund has been established as a closed-ended feeder fund into the Low Volatility Plus Fund managed by Credit Suisse Asset Management’s ILS team.

Dexion Capital initially fundraised over £60m for the fund which is listed on the Main Market of the London Stock Exchange (LSE).

Guernsey is the global leader for non-UK listed entities on the LSE. Vehicles established in the Island can also access other global capital markets, including the exchanges in Frankfurt, Ireland, Toronto, Australia, Hong Kong and Euronext, among many others, as well as the Channel Islands Stock Exchange (CISX) which is based in Guernsey.

In fact, in 2012, the CISX became

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CHANNEL ISLANDS

TARGETING ILS FUNDS AND THE ILS INVESTOR BASE

home to the first private catastrophe bond listed on any exchange worldwide. Aon Insurance Managers in Guernsey—which has been involved with more than 80 ILS transactions since 2006—has worked with Swiss ILS manager Solidum Partners AG to establish Solidum Re Eiger IC Limited.

It is an insurance vehicle which listed bonds with a value of $52.5m on the Channel Islands Stock Exchange (CISX). It was the first CISX listing where natural catastrophe perils are the underlying exposure for ‘principal at risk’ notes and incorporated a dual listing with the Vienna Stock Exchange.

The legal advice for the transaction was provided by Bedell Cristin in Guernsey. Mark Helyar, Managing Partner, who completed the listing, said: “Guernsey and the CISX are ideally placed to support this business because of the specialist insurance and professional sectors able to provide a high quality, transparent marketplace for securitising catastrophe risk in a well regulated and respected jurisdiction.”

Cedric Edmonds, Partner at Solidum Partners and Director of Solidum Re Eiger IC Limited, said: “Solidum Partners chose Guernsey as a jurisdiction for its incorporated cell reinsurance company and private cat bond platform due to the Incorporated Cell Company legislation and the quality and ‘can do’ attitude of the service providers.”

The growth in ILS business within Guernsey is demonstrated by the fact that it is proving a significant factor behind the continued increase in the number of international insurance entities domiciled in the Island. There were nearly 100 international insurance entities licensed in Guernsey during 2012 alone and this growth has continued during 2013, with the net number of entities up 37 to reach a total of 774 at the end of July 2013. A large number of the new entities being established are Protected Cell Companies (PCCs), Incorporated Cell Companies (ICCs) or related cells.

24

Structuring options PCC and ICC structures provide a low cost, low administration vehicle to access returns from the reinsurance market and some ILS funds avail themselves of both within their growth strategies.

At the time of writing there are in excess of 50 protected cells established in Guernsey across four different PCC platforms having written fully collateralised reinsurance primarily covering property catastrophe risks, marine, crop and other classes such as premium reinstatement or prize indemnity. Protected cells in Guernsey are also being used to conclude International Swaps and Derivatives Association (ISDA) arrangements as an alternative to a reinsurance contract.

For ILS funds which prefer not to co-mingle their assets in one third party sponsored PCC, a dedicated PCC provides the security of a standalone, ring-fenced entity set up solely for the use of one ILS fund with the convenience of segregated cells for each separate transaction. There is flexibility in the type of reinsurance contract being entered into by each PC, provided that the cell is fully funded up to its maximum aggregate exposure by a combination of contract premium and investment funding injected by the ILS fund.

Creating a separate IC within an existing ICC structure or creating a standalone ICC company owned by an ILS fund has the benefits of providing lower establishment and running costs with complete legal segregation of assets and liabilities. A principal benefit for the ICC structure is managing counter-party risk.

Some ILS funds are limited as to how much capital can be invested with a single incorporated vehicle. As the PCC structure is a single corporate entity (despite the robust segregation of assets and liabilities within individual cells) this credit limit can be quickly exceeded. However, the ICC structure reduces the counter-party credit risk measurement to each cell allowing

Fiona Le Poidevin, chief executive of Guernsey Finance. Photograph kindly supplied by Guernsey Finance, October 2013.

much larger aggregate relationships to be built under the direction of a single board. Guernsey has a significant advantage over the competition in that it not only offers the PCC – which was pioneered in the Island – but also the ICC. Indeed, there is significant experience and expertise in utilising these structures across both the insurance and investment fund sectors in Guernsey.

Why Guernsey?

Guernsey’s greatest differentiator is that it is a jurisdiction with a leading investment funds sector as well as a world-leading insurance industry and as such, it is therefore no surprise that the Island is already home to increasing amounts of ILS business.

Guernsey offers the advantage of being politically and economically stable with no external Government borrowings. Its proximity to London and position in the UK time zone mean it is very well placed for interaction between the European and US markets. It also has a temperate climate and is not prone to significant natural disasters. These factors continue to serve Guernsey well in its evolution as a leading International Finance Centre

OCTOBER 2013 • FTSE GLOBAL MARKETS

(IFC) and in particular, as a growing hub for ILS business. However, the financial services infrastructure and expertise which have been fostered over more than 50 years are also key ingredients to the Island’s proposition for ILS. Indeed, a significant strength of Guernsey is that it can demonstrate substance already being present in existing structures. Both leading fund and insurance managers have offices and staff present in Guernsey and there is a large pool of qualified Non-Executive Directors (NEDs) experienced in providing management functions.

They are supported by multijurisdictional law firms and global accountancy firms as well as administrators ranging from the major

multinational organisations to independent, boutique providers.

Furthermore, the existence of 32 licensed banks means that a wide range of services are also on hand, including custodian functions and access to very competitive letters of credit.

In addition, Guernsey can also boast that it is widely respected for meeting leading international standards in terms of financial services regulation and tax matters: the Island was within the very first wave of jurisdictions placed on the OECD ‘white list’ for tax transparency and exchange of information; and the IMF has judged it to have a higher level of compliance with Financial Action Task Force (FATF) standards for financial services regulation than any other jurisdiction globally.

Yet, Guernsey is also keen to ensure that its supervision is not just robust but also pragmatic and as such, there is a focus on also ensuring that regulation is proportionate and speedy. For example, it offers a fast-track facility to the Specialist Fund Market of the LSE.

The right conclusion There are a number of outstanding factors which mean that Guernsey provides a unique proposition as a hub for ILS business. This is already being recognised by many in the market and we expect that this growth will continue as increasing numbers of fund managers seek to satisfy the demand from investors for the diversified and uncorrelated returns provided

by ILS. I

If you’re looking for an innovative financial solution there’s one place you should look...

here.

Find out more at guernseyfinance.com

FTSE GLOBAL MARKETS • OCTOBER 2013

25

CHANNEL ISLANDS

JERSEY: A CHOICE LOCATION IN A POST AIFMD WORLD

The long awaited EU Alternative Investment Fund Managers Directive (AIFMD)—perhaps the most fundamental international regulation to ever impact the funds industry— was, after years of build-up and months of analysing the finer points of its implementation, finally introduced this summer.

By Geoff Cook, chief executive officer, Jersey Finance.

JERSEY LEVERAGES OPPORTUNITY IN A POST-AIFMD WORLD HILE EU COUNTRIES are looking to bring the AIFMD into national law at their different paces, those alternative fund managers, administrators and service providers who have some sort of interest in or contact with the European market, are still trying to get to grips with exactly what the detail of the AIFMD means to them, and how they need to act to continue to facilitate alternative funds business.

There are three key ingredients the funds community are looking for currently: certainty about being able to raise capital in Europe; confidence in being able to effectively and appropriately service and support their funds; and flexibility in how funds can be managed should they be targeted at non-European growth markets.

Of course, the AIFMD has an impact on the role of those International Finance Centres (IFCs) that have earned reputations as specialist funds centres. As far as Jersey is concerned, the message is unequivocally that, thanks to the significant amount of hard work and preparation that has gone into gearing up for the introduction of AIFMD, it is very much business as usual for fund managers using the jurisdiction.

In fact, due to the distinct position it is in, in relation to the EU and the rest of the world, there is a strong argument that Jersey is even better placed now as a result of the regulation.

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As a non-EU ‘third country’ for the purposes of the AIFMD but a wellestablished jurisdiction at the centre of European funds business, the feeling is that the AIFMD will actually enhance Jersey’s appeal as a centre for structuring and servicing alternative funds— including private equity, real estate and hedge funds—in the long-term.

This is important for Jersey, given its persistent strength in the alternative investment funds market. Jersey has continued to demonstrate a significant degree of resilience across its funds sector, with figures for the second quarter of 2013 showing that the value of assets under administration in Jersey remains above the £200bn barrier for the second consecutive quarter, to stand at £201.3bn. Alternative asset classes continue to account for around 70% of that total, with some of the largest European private equity funds ever launched having been formed in Jersey in recent months.

First and foremost, Jersey is focused on offering the alternative funds community a long-term, stable environment. Having signed 27 bilateral ‘AIFMD’ cooperation agreements with EEA countries, including the UK, Germany and France, Jersey’s regulator (the Jersey Financial Services Commission) is already granting licenses for fund managers, enabling them to continue to access those EU markets through private placement arrangements.

An interactive online tool designed

Geoff Cook, chief executive officer, Jersey Finance.

to help explain and clarify the status of Jersey’s AIFMD cooperation agreements with European countries, including details of private placement arrangements and transitional provisions, has been launched at www.jerseyfinance.je/aifmd-map.

In addition, new regulations have been introduced to mirror EU requirements and allow for the creation of an ‘opt-in regime’ for managers wishing to comply fully with AIFMD requirements in marketing to European investors.

This essentially means that Jersey has not only achieved a ‘private placement’ regime under the AIFMD, but has also already implemented, ahead of time, the necessary mechanics to support an EU-wide AIFMD marketing passport, which is anticipated to become available for non-EU fund managers in 2015. This is not something that can be said for other IFC jurisdictions.

As far as the issue of ‘substance’ is concerned, in Jersey, there is already a regulatory requirement for Jersey entities to demonstrate substance, and so-called ‘letterbox arrangements’ that might be found elsewhere are certainly not the model in Jersey regulated fund structures.

In fact, Jersey’s deep knowledge of the alternative fund sector, including its experience in asset servicing, its tax, accounting and filing capabilities, and its governance expertise, mean that fund managers should take confidence in Jersey having all the ingredients to more than satisfy the AIFMD’s criteria for management substance. This is backed-up further by the immediate availability of a fully compliant depositary regime and infrastructure of institutional and independent depositary service providers where managers opt in to full AIFMD compliance.

Meanwhile, in the current climate,

OCTOBER 2013 • FTSE GLOBAL MARKETS

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CHANNEL ISLANDS

JERSEY: A CHOICE LOCATION IN A POST AIFMD WORLD

managers are understandably adopting global strategies and raising capital in growth markets around the world where wealth is being created and global investment opportunities are sought after.

With this in mind, using a non-EU but European time-zone jurisdiction such as Jersey, that is experienced and has expertise in handling non-European alternative funds business will be attractive—particularly given that it needn’t be touched by AIFMD regulation at all.

As a non-EU jurisdiction, Jersey offers a completely separate funds regime that lies outside the scope of the AIFMD, meaning that managers who don’t want to access EU capital can benefit from an element of flexibility and market their funds to the rest of the world—just as they do at the moment, using Jersey’s familiar and broad range of fund structures.

This flexibility puts Jersey in something of a unique position. As well as

offering a route that offers the same controls under AIFMD that would be offered by an EU Member State, at the same time Jersey offers managers the ability to market their funds outside Europe without the need to consider the impact of the AIFMD at all.

Fund promoters can establish all their management entities in Jersey and, from one location, meet EU requirements. At the same time, they can serve the rest of the world in a non-AIFMD compliant environment—with potentially lower costs. Offering both will not be available to EU Member States or to all IFCs.

Future Thanks to its approach to the AIFMD, Jersey’s position as a centre for ongoing administration and service support for private equity, real estate and hedge funds is positive. Thanks to its flexible approach, wherever the fund’s assets or investors are, Jersey provides a good option, offering the

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expertise, capability and experience to administer the structure.

Parallel ‘offshore-onshore’ structures may well become more common, for fund managers who need to satisfy a specific investor demand for keeping a fund onshore—albeit with the potential additional compliance costs that could bring. But this is not anticipated to replace funds ‘offshore’, which in Jersey’s case will continue to offer a good value, flexible, robust option to cater for all aspects of alternative fund business.

In fact, as AIFMD beds down, it is anticipated that Jersey will prove increasingly attractive for managers with an international focus on both non-European and pan-European funds. Jersey has risen to the challenge presented by AIFMD and, by offering a regime that offers a blend of certainty and flexibility, taken the opportunity to broaden its scope and appeal as a specialist alternative funds centre. I

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Jersey for Funds Jersey is at the forefront of delivering fund services, with the emphasis today shifting towards funds for institutional, specialist and expert investors.

Jersey has attracted a significant number of alternative investment funds and built up an experienced range of fund administrators, both as part of the services supplied by major custody banks and large specialist fund administration firms, and by boutique groups who can provide bespoke services to meet individual investor needs.

Clients have access to legal support from Jersey law firms who work closely with counterparts in the world’s major centres, to deliver structured products and specialist vehicles that meet diverse financial and investment objectives.

For further information, please visit www.jerseyfinance.je

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OCTOBER 2013 • FTSE GLOBAL MARKETS

DEBT REPORT

After surviving a mid-year fixed-income thrashing, high-yield corporate bonds, though well off their highs of last year, have nonetheless fared significantly better than their investmentgrade peers. Yet questions remain: what impact might the Fed’s eventual tapering have on the segment? Will credit fundamentals remain stable enough to keep high yield products on the plus side over the near term? Dave Simons reports from Boston.

HIGH YIELD STAYS ON TRACK C OMPARED TO INVESTMENT grade and other fixed-income strategies, spread-based products like corporate high yield bonds have historically been far less susceptible to sudden interest-rate gyrations.

But with Treasury yields nearly doubling over the summer due to speculation over a shift in Fed monetary policy, even high yield struggled to stay on track. After a stellar 2012 which saw total returns on certain indices in the 15% range, by comparison the Bloomberg Global High Yield Corporate Bond Index (BHYC) as of late September stood at a far more modest 3.89% year-to-date.

FTSE GLOBAL MARKETS • OCTOBER 2013

As it turns out, all that tapering talk was just talk, at least for the time being.

On September 18th, the Fed surprised many when it announced that it would maintain its bond-purchasing stance while it awaited “more evidence that [economic] progress will be sustained.”

The US central bank’s inaction was an immediate shot in the arm for corporate fixed-income products, high yield included. All told, during 2013 the segment has managed to outperform most fixed-income indices on both an absolute and excess-return basis.

“Relative to investment grade, higher yielding bonds have more of a spread cushion and therefore much lower

CORPORATE HIGH YIELD: BUCKING THE TREND

Potograph supplied by Shutterstock.com, October 2013.

Treasury correlation,”notes Chris Barris, managing director and global head of high yield for Alcentra, the Londonbased sub-investment grade corporate debt specialist for BNY Mellon. CCC and B-rated products have been particularly resilient during this time, says Barris, as have sectors such as chemicals, media and financials.

According to Richard Inzunza, senior fixed income portfolio manager for Chicago-based Northern Trust, the credit component within higher-yielding bonds tends to offset the negative impact of an increased yield curve, thereby giving these products a better batting average than other fixedincome investments, especially in a rising rate environment. By comparison, those closer to the investment-grade end of the spectrum haven’t fared nearly as well as issues in the B-CCC range. “Higher-quality bonds like BB may have as much as an 80-90% interest-rate correlation,”notes Inzunza. “Whereas the lower you go, the higher the average yield tends to provide a cushion for the bond.”

For managers, the unusually broad risk spectrum and wider range of investment choices make navigating the high-yield arena trickier than most, particularly during periods of pronounced turbulence. “Throughout the year our focus has been on minimising risk by reducing our exposure to more rate-sensitive products, while increasing our middle-market and yield-to-call weighting,” says Inzunza.

Though rising rates may have had a dampening effect on fixed income in general during 2013, experts like Barris prefer to focus on the story behind the climb.“The recent movement in Treasuries is due to expectations of a stronger economy, and, along with it, the Fed’s anticipated response to this data,” says Barris. “And if the economy is in fact growing, companies have greater leeway to service their debt loads—which in turn is supportive of sub-investment grade issuance.”

Brian Kinney, managing director at Boston’s State Street Global Advisors

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CORPORATE HIGH YIELD: BUCKING THE TREND

(SSgA), agrees that much of the downward pressure on high yield has been the result of crossover investors “dipping their toes in the water” then promptly running for cover once Treasuries began to move. The resumption of stronger inflows following the springsummer downturn, however, bodes well for the markets over the near term, maintains Kinney.

“The fundamental underpinnings in support of high yield—historically low interest rates, sound balance sheets and minimal defaults—remain in place,” says Kinney. “We experienced some consolidation earlier in the year, as a number of clients elected to move out of certain issues with a higher exposure to interest-rate sensitivity and into shorter-duration high-yield offerings.

Once the markets stabilised, however, issuance began to pick up again, which in turn has been followed by an increase in demand in both short- and longer-duration products.”

If anything, the Federal Reserve Bank’s decision to maintain its prostimulus stance had the biggest impact on the long-suffering crossover segment of the market. “Anytime you have a large reversal in risk sentiment like that, the issues that typically respond the fastest are the ones that performed the worst during the pullback,”says Kinney.“So it wasn’t a huge surprise to see the strongest rebound in products that straddle the investmentgrade/high-yield territories.”

Most heartening, says Kinney, has been the relative stability of corporatebond spreads throughout the year.

While market volatility impacted high yield on an absolute-price basis, by comparison spreads have remained in a tight range of around 425-475 bps (after starting the year around 500).

“Even when things had begun to tighten and yields were south of 5%, high yield never looked extremely rich to us on a historical-spread basis,”says Kinney.“I think that’s a very significant data point for investors.”

“Earlier in the year there was a fair amount of lower-coupon BB issuance,

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and those bonds have since fallen as much as 8-10 points,” adds Inzunza.

“Whereas a shorter duration, yield-tocall bond with a bigger coupon may only be down about two points during the same period. So there’s been a fairly pronounced difference in price decline from one sub-sector to the next.”

Float on Through it all, new issuance—the fuel for the corporate-bond engine for several years now—continues to defy conventional wisdom. In recent times conditions have been such that even businesses with ample cash on hand have been wont to issue new debt.

With rates rising, the Fed hedging, not to mention trouble in the Middle East brewing, one might expect to see highyield buyers finally retreating. Not so—in fact, according to Bloomberg figures, as of September the US registered just over $1trn in new bond sales, compared to roughly $953bn year-overyear. “By now one would think that cash balances would be lower and supply would start to outstrip demand,”says Inzunza,“but that really hasn’t been the case—to date, the markets have done a very good job of absorbing all of the new issuance.”

With speculation of a potential Fed tapering on the table, a number of companies have scrambled to get in on the issuance action while investors are still willing. Topping the list is Verizon Communications, whose early September $49bn bond bonanza became the largest of its kind in history (outdistancing runner-up Apple’s $17bn offering from last spring).

Verizon plans on using the proceeds to complete its $130bn buyout of wireless operator Vodafone.

If there’s a possible fly in the ointment, it’s the potential for a renewed round of excessive or overly aggressive financing behavior, fueled by seamless investor demand and historically favorable issuance conditions. “If there was suddenly a lot of LBO financing or similarly aggressive deal-making, returns could be impacted,” says Barris.

Meanwhile the strength of corporate balance sheets—another lynch pin for high-yield activity—also bears watching; though still generally healthy, observers like Barris have seen some balance-sheet degradation since the start of the year, the result of increased M&A, dividend deals and related activity.“In some instances, debt growth has begun to outpace earnings,”says Barris.

Unlike the pre-crisis speculative frenzy, however, for the most part issuance has remained constructive, including an estimated 60% tied to refinancing needs. And if earlier fears over a Fed-led rate spike have compelled even more companies to consider new issuance, investors appear more than willing to snap up the extra supply.

“Any pickup in issuance has been comfortably absorbed by the market,” concurs Barris.

Bottom line: so long as financing continues to be disciplined and investors remain hungry for product, the markets should be able to stay out of trouble. “At this point things continue to look quite positive,”says Barris.

“While there’s definitely been an uptick in more aggressive capital raisings particularly since the start of the second quarter, on balance we don’t feel that it is excessive or could negatively impact credit quality.”

Though it’s been a rougher ride than most investors may have bargained for at the start of the year, observers like Kinney nonetheless sees a resumption of the supportive environment that has propelled spread products in particular these past several years.

“The Fed has chosen to remain cautious for the time being, which obviously is good for the markets,”says Kinney. “Furthermore, balance sheets in both investment grade and high yield remain strong, and corporations continue to access the capital markets and offer new issue bond deals with favorable execution. While there are always geo-political factors to consider, in general I believe the outlook remains positive as we move into the end of the year.” I

OCTOBER 2013 • FTSE GLOBAL MARKETS

Investors urged to look at fundamentals The expectation that the US Federal Reserve Bank would begin to taper its quantitative easing (QE) programme in the fall and that Angela Merkel would lead another coalition government following elections in the same month have weighed on Europe’s sovereign bond markets for the bulk of this year.

Political analysts called it right on the German election; opinion was split on the Fed’s plans to keep QE flowing. Short term markets have been hypnotised by the US political spat and the nomination of a new Federal Reserve Bank governor. Equally important developments, however, are bubbling across the water in Europe, writes Lynn Strongin Dodds, that investors should watch with equal interest. She looks at the outlook for the fourth quarter (Q4) and Q1 2014.

NCE THE FED’S credit committee signalled no change in its money printing programme in September, bond markets across the globe yelped with muted delight.

Yields on ten-year US Treasury notes

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FTSE GLOBAL MARKETS • OCTOBER 2013

began dropping to 2.70% while the German Bund fell 8 basis points (bps) to 1.93% and the ten-year UK Gilt shed 10 bps to 2.91%.

Government securities in the advanced markets had started march-

EUROPEAN SOVEREIGN DEBT OUTLOOK

Archive photo of Janet Yellen, vice chair of the Board of Governors of the Federal Reserve System (right) and now nominee for the governorship of the US central bank, photographed with the president of The Bank of Tokyo-Mitsubishi UFJ Nobuyuki Hirano, left, chat at the International Monetary Conference in Shanghai, China, Monday, June 3rd 2013. Photograph

by Eugene Hoshiko for Associated Press. Photograph supplied by Press Association Images, September 2013.

ing upwards last year but they significantly spiked after the Feds signalled it might reduce its $85bn monthly bond buying shop. Almost every fixed income instrument rose higher, taking prices lower, and in some cases erasing gains in weeks that took years to earn.

The reprieve is of course temporary.

Moreover, views differ on when US monetary policy will tighten. Some analysts expect it to start at the next Federal Reserve Bank policy meeting in December while others believe that a decision will not be taken until Bernanke’s as-yet to be confirmed successor takes over the helm on January 2014 or even farther out into the year.

All agree the state of the economy, which is not as robust as many believed, will have the final say.

According to William Dudley, president of the New York Fed and vice-chair of the rate-setting Federal Open Market Committee, “The economy has not picked up forward momentum and a 2% growth rate—even if sustained— might not be sufficient to generate further improvement in labour market conditions.” That fact alone might push back QE tapering even further; a situation not helped by the current spat (as this magazine went to press) between the US’s main political parties over the form and substance of the US’s government’s management of the federal budget.

Given the confluence of these developments, the surprise is the magnanimity of investor approaches.

The second is the general acceptance that tapering is still a long way off. “I think one of the problems was that markets were listening but not hearing what the Fed was saying in May,” says Bill Street, head of investments, EMEA, for State Street Global Advisors. “The devil was in the detail and their ability to taper was always going to be predicated on whether fundamental data met their expectations. At the time they were optimistic but when it came to the meeting, the broader economic conditions were not there and they did

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DEBT REPORT

EUROPEAN SOVEREIGN DEBT OUTLOOK

not want to do anything that would hurt the green shoots of recovery. I do not think it will start until the first or second quarter of next year.”

The Fed’s decision was seen as being good for Europe, according to Jack Kelly, investment director for global government bonds at Standard Life.

“This is because it alleviates the pressure for other central banks to review their monetary policy. However, the region is not out of the woods yet. So far, the European Union has taken the path of least resistance. European Central Bank (ECB) President Mario Drahgi’s pledge last year ‘to do whatever it takes’ and the outright monetary transaction bond buying programme has kept yields relatively well behaved but there has been no real progress in addressing the structural problems such as banking union.”

Most bond investors think that resolve will be tested over coming months as Europe still convulses as its tries to adhere to a one currency fits all strategy. Up to now both problems have been costly. Since late 2011, the ECB has handed out over €1trn in three-year loans to hundreds of struggling banks, who were having trouble borrowing money through the traditional interbank funding markets.

Actually, European banks have repaid over €330bn of the loans but there have been fears that if repayments continued then short term rates would rise, potentially choking off any (albeit fragile) economic recovery that began in the second quarter.

This is the thinking behind the Money Market Contact Group’s (an ECB advisory panel of bankers and analysts) recent warning shot that the maturity of these loans in early 2015 is a “cliff” that is weighing on the confidence in financial markets. The minutes of the meeting released by the ECB at the beginning of September shows that several of the panel members have called for another round of long-term loans early next year, when the remaining maturity of the existing ones falls below a year.

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Draghi ready to comply Draghi has signalled that he is ready to comply if needed but has also stressed that simply pumping money into the system will not be enough to restore the eurozone’s fortunes and prevent the bank collapses that forced Ireland, Cyprus and Spain into international rescues.

He along with other market participants believes part of the solution lies in the creation of a European banking union. Progress has been made with the ECB recently winning approval from the majority of the European Parliament to oversee around 6,000 banks in the 17 eurozone countries and a three stage framework has also been set in placed involving a single bank supervisor, a single resolution mechanism and a single deposit-guarantee scheme.

However, not surprisingly, this ambitious project is not without its critics especially on the sovereignty front. For example, Germany has already voiced its concerns regarding over-centralisation and won backing from the UK, Sweden and Spain in its argument that the single market treaty article underpinning banking union should be completely changed. In addition, one of the major planks—the establishment of a joint European authority to unwind or restructure banks that also has the financial muscle to conduct bailouts—still faces several legal and political hurdles.

“It is not clear how it will evolve into a robust European banking union,”says Andrew Mulliner, co-manager on the Henderson Total Return Bond Fund.“It looks as though it will still end up as national banking regimes. We are still a long way from knowing how a banking union will be structured and who will be in charge of the unwinding of the banks. In Henderson Overseas bond fund we hold Belgium and France but not Germany because we expect the flight to quality premium in German government bonds to unwind.”

The economy also remains a major concern. Andrew Balls, head of Euro-

pean portfolio management at Pimco, adds,“The ECB move to become lender of last resort cut off the tail risk but it is still quite unclear how Europe is going to ensure long term stability and growth. We do not think the eurozone crisis is over and there does not seem to be a plan for mid-term stability. We also do not expect the German elections to be a game changer. As result, we are cautious about the peripherals.”

Southern Europe Peripheral countries especially Spain and Italy had benefited in the first half due to the quest for yield but exuberance died down after the Fed decision and outcome of the German elections.

The recovery of Southern Europe is once again dominating the agenda.

Political risk is also a hot topic although apprehensions have abated over an early Italian election next year due to Silvio Berlusconi’s criminal conviction for tax fraud. The former prime minister has promised to continue leading Italy’s centre-right party outside parliament but stepped back from carrying out a threat to withdraw from the coalition government he formed with Prime Minister Enrico Letta.

On October 2nd Enrico Letta’s leftright coalition faced a parliamentary confidence vote that could, under normal circumstances, have sunk it.

Silvio Berlusconi, the now disgraced conservative leader, had said his People of Freedom (PdL) party, would vote against Letta in the Senate. Following a mutiny of sorts in the PdL Berlusconi found himself and his plans adrift and was forced to give Letta his support. The government won the day by 235 votes against 70 against, thereby rescuing hopes that the 2014 budget will be implemented and safeguarding (as much as it ever can be in the country’s skittish politics) Italy’s road to recovery.

“I think there is more theatre than politics in Italy,”says Gareth Colesmith, fund manager at Insight Investment.“I do not see a central case for toppling the government and if there was an

OCTOBER 2013 • FTSE GLOBAL MARKETS

election then it would probably be a similar result. There are more political risks in Greece. The incumbent two party coalition government (conservative New Democracy and socialist Pasok parties) intends to continue but it is fragile and if there is a contest it could open the door for the Radical Left to come in.”

Greek Finance Minister Yannis Stournaras has already embarked on talks with the European Commission, the International Monetary Fund and the European Central Bank—known locally as the troika—on a broad range of issues including the execution of the 2013 budget. The negotiations represent the latest round in the regular quarterly inspection visits that have accompanied the country’s almost four-year-long debt crisis— and will decide on whether to unlock the country’s next aid tranche of €1bn ($1.35bn).

Corners turning New budget and growth data show Greece may be turning a corner albeit slowly. Second-quarter gross domestic product (GDP) which had been in tailspin—falling at an annual pace of 3.8%—actually rose on a seasonally adjusted quarterly basis while unemployment fell for the first time since the crisis. Although the country still has a long way to go, fund managers are more concerned over the fate of Portugal which could need additional support before its current €78bn three-year rescue programme ends in mid-2014.

Standard & Poor’s surprised the market by putting the country’s longterm debt rating of BB on negative watch which means there is a 50% chance that it will be downgraded in the coming months.

Part of the blame lies with the political turmoil in the summer when the highly regarded Finance Minister Vito Gaspar resigned due to political squabbles. This led to the coalition hanging in the balance as minority party leader Paulo Portas announced his “irrevoca-

FTSE GLOBAL MARKETS • OCTOBER 2013

Italian Prime Minister Enrico Letta on the TV show “L’Intervista” in the studios of La7 Sky Tg 24.

Letta’s coalition government survived an attempt by Silvio Berlusconi to derail his government and Italy’s fragile path to recovery. Photograph by Tiziano BRODOLINI / Demotix/Demotix.

Photograph supplied by Press Association Images, October 2013.

ble”resignation while President Anibal Cavaco Silva tried to force a new crossparty government of national unity.

Ultimately Prime Minister Passos Coelho re-emerged at the head of an unchanged coalition, but investor confidence was damaged.

Matters have been further exacerbated by Passos Coehlho calling for an easing of the budget deficit target of 4% of GDP to 4.5% in order to give the government more breathing space to get its economic house in order. This is unlikely to be granted as it is thought the troika of lenders will not be sympathetic to its cause.

“Portugal is one of the chief challenges,” says Axel Botte, fixed income strategist at Natixis Asset Management.

“The economy is not low cost enough to compete with emerging markets nor does it offer the high value-added products of Germany. As for the other peripherals, we are cautious about Italy because of the political situation but like Ireland because they are farther along in the rebalancing of their economy and restructuring of liabilities linked to the banking crisis.

However, it is common knowledge that some large asset managers and the ECB hold big chunks of the Irish bond market. This keeps volatility artificially low and contributes to restrain trading volumes.”

Nick Gartside, international chief investment officer for fixed income at JP Morgan Asset Management, on the other hand, is being tactical. “There were two unexpected announcements —the Fed and Portugal being put on watch. What this demonstrates is that investors need to focus on the fundamentals. They are tempted to forget that but when I look at Europe I see the key risk flashpoints of weak public finances, bank fragility, political and economic risks. Growth is not as strong as expected and it will take much longer to get debt ratios back to normal. This broader backdrop lends itself to volatility and you have to be able to take advantage of the opportunities. For example, the yields on Spanish and Italian ten year bonds have come down versus German bunds and that offers good value.” I

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DEBT REPORT

WILL HIGHER INTEREST RATES DAMPEN CLO ISSUANCE?

Photograph © Igor Nikolayev/ Dreamstime.com, supplied October 2013.

CLOs: FIRING ON THREE CYLINDERS Collateralised loan obligations (CLOs) were among the first segments of the securitisation market to bounce back after the financial crisis. Prices tanked in late 2008 and early 2009 when investors feared the recession would push up corporate default rates—but the concerns proved overblown. Although returns on CLO equity varied by manager, the credit support mechanisms built into the structure kept even the worst deals current on their debt capital. Robust performance resuscitated investor interest in CLOs, but regulators could stall the revival. By Neil A O’Hara.

LOS POOL SECURED bank loans to below-investment grade companies in a special purpose vehicle financed by a floatingrate capital structure. Cash flow from the loans trickles down in a waterfall: each capital tranche receives payments only when the tranche above has received its due in full. Provided the structure has sufficient subordinated capital, the rating agencies deem the senior notes (typically at least 60% of the capital) AAA—and assign progressively lower ratings to the junior tranches. The bottom layer of unrated equity offers the highest potential rate of return to investors in return for the highest default risk: should any loans in the pool turn sour, losses hit the equity tranche first and then move up the capital stack in reverse order of priority.

CLOs are too often confused with collateralised debt obligations (CDOs), which held mostly mezzanine tranches

C

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of mortgage-backed securities—an indirect but highly leveraged bet on the housing market. While most CDOs defaulted on one or more classes of debt—often all the way up to the AAA-rated senior notes—CLO debt holders came through the financial crisis unscathed.

Little wonder that the CDO market remains dead in the water, while CLO issuance has rebounded, especially in the US Market participants expect CLO volume in 2013 to reach $65bn-$80bn, a sizable uptick from $54bn in 2012 although still shy of the $100bn peak in 2006.

CLOs transform illiquid low-quality bank loans into highly-rated marketable securities for which investors will pay a premium. While the arranger must sell the equity at a discount to par value, under normal market conditions the sum of the parts is worth more than the whole, creating an arbi-

trage profit that drives the transaction.

CLOs are not static pools, however.

Bank loans to less creditworthy companies are expensive—300-600+ bps over LIBOR—so if borrowers thrive they often repay early.

CLOs have a reinvestment period, during which managers apply prepayments of principal to purchase additional bank loans of comparable credit quality to the existing pool instead of redeeming outstanding notes early. Managers may sell existing loans and replace them with other qualifying collateral, too, which can make a huge difference to the returns for equity investors. When Matt Natcharian, head of structured credit at Babson Capital, a $182bn asset manager based in Springfield, Massachusetts, and his team analysed 279 CLOs issued between 2004 and 2007 they found the average net realised loss of principal was 2.3% through July 2013, a haircut to the 8-10% equity in these deals.

“There was a wide distribution around that average,” says Natcharian.

“The best managers increased the principal by 3% or more through purchases of assets at a discount to par value, while the worst lost more than 10%— but even the worst probably trapped enough cash in the structure to avoid losses on the debt.”

The various tranches of CLO capital appeal to different investors, and as risk appetites have evolved the buyers have changed. Pre-crisis, SIVs were big buyers of AAA paper, but they are gone forever. Banks bought the senior notes, too, yet while the US and Japanese banks are still active today regulatory pressures have squeezed European banks out of the market. Life insurance companies are opportunistic buyers of the AAA tranche as well, according to Marc Steinberg, managing director of fixed income at Guggenheim Securities, the broker dealer affiliate of Chicago-based Guggenheim Partners.“US life insurance companies were a very large AAA buyer two years ago, but as yields compressed they

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DEBT REPORT

WILL HIGHER INTEREST RATES DAMPEN CLO ISSUANCE?

moved down the stack,” he says.

“Banks have begun to replace them at the AAA level.”

Life insurance companies have always dominated the market for AA- and A-rated CLO tranches— and still do. They have backed away from the lower-rated tiers since the crisis, however, as have the Japanese banks and pension fund managers, leaving the BBB, BB and equity tranches to hedge funds and credit investment specialists.

The smaller universe of buyers has pushed up yield spreads on the AAA tranche. Joseph Moroney, senior portfolio manager for senior credit at Apollo Global Management, an $113bn New York-based alternative asset manager, calls current AAA CLO spreads “stubbornly high” relative to both fundamental measures of corporate creditworthiness and other AAA-rated paper.“There are cash buyers who want to own AAA notes on their balance sheet,”he says.“It is a more stable buyer base but not as deep.”

Apollo invests in lower-rated CLO tranches, but through its private equity arm the firm has also become one of the largest CLO managers. Other top CLO managers, including GSO, CIFC and Carlyle Group, are now affiliated with private equity shops, which snapped up CLO management contracts from distressed bank and boutique sellers during a post-crisis shakeout. Five years ago, a manager that handled eight deals worth $3-5bn in total was a big player, but managers now need 20+ deals to crack the top ten. Even though the top managers have grown bigger, the total number has shrunk little as new boutiques have replaced many managers absorbed through consolidation.

Apollo issued one of the first postcrisis CLO deals in May 2010. The terms were more conservative than legacy transactions: 4x leverage at the equity level (versus nine to 12x leverage) and an 18-month reinvestment period (versus five to seven years). Five months later, another Apollo deal had 6x lever-

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age and a two-year reinvestment period. "By late 2012, leverage was close to 10x leverage although investors still demanded shorter reinvestment periods," says Moroney. "In the current environment, four years is typical.”

Changes in rating agency methodology obliged issuers to tweak the CLO structure, too. The agencies demanded a fatter cushion for an AAA-rating— Natcharian at Babson reckons the 38% subordination in a recent deal would have been closer to 25% before the crisis—and a thicker equity tranche, which cuts leverage. “Most recently we have seen the addition of a new B-rated tranche in some deals, which gets the leverage back to where it was in 2007,” says Natcharian. “Investors were comfortable with the leverage and cash-trapping mechanisms in the older structures, especially in the hands of a good manager.”

New CLOs have tighter documentation, too, including a cap on “covenant-light”loans that do not have the full covenants customary in bank loans to investment grade borrowers.

The cap varies by manager from 40-65%, although almost 75% of underlying loan originations are covenant-light so pressure for a higher limit is building.

Some $47bn of new CLOs were issued in the U.S. this year through July, but activity tapered off in recent weeks.

The demand for new money is lower— perhaps only $5-10bn—because so many legacy CLOs have been called by their investors and redeemed.

Another $75-100bn of legacy transactions will roll off the books in the next two years, which is likely to affect spreads on new issues and the demand for underlying collateral. The early “version 2.0” CLOs have passed their reinvestment periods, too, although unlike legacy CLOs these can be refinanced and repackaged, in effect extending their lives.

One regulatory cloud lurks on the horizon: US rules requiring managers to retain a portion of CLO risk on their own book. European regulators have already imposed a requirement for

managers to hold a 5% vertical slice of the capital structure, which Natcharian blames for crimping CLO issuance in Europe. Only $5bn came to market this year through July despite robust demand for euro-denominated CLO paper.

“Most asset managers don’t have a balance sheet to invest in risk retention,” says Natcharian. “A substantial portion of fixed CLO fees are at risk, ranking just above the equity, and the back-end incentive fee depends on lifetime performance. That’s significant skin in the game the regulators have ignored.”

The latest proposal from US regulators will require managers to retain either a 5% vertical slice or 5% of the nominal value in the equity slice, equivalent to half the equity in a deal levered 10x—but the rule won’t take effect until late 2015. A flurry of issuance is likely before the rules take effect—and another round of manager consolidation.“It could cause a significant contraction in the number of managers,”says Natcharian.“We might benefit—Babson Capital would have a larger share of a smaller market—but we’d prefer a healthy market with sensible risk retention rules.”

Higher interest rates could put a damper on CLO issuance, too.

Although the assets and liabilities are all floating rate, an uptick in LIBOR will clip returns to equity holders. Most loans today have a LIBOR floor, typically around 1%, but the LIBOR-linked capital does not, so if LIBOR is below the floor equity holders get the difference. “A rising rate environment helps the senior and mezzanine levels, benefiting absolute yield-driven life insurance companies and asset managers,” says Guggenheim’s Steinberg, “but it hurts equity, as the value of the loan rate floor diminishes.”

Without the bonus, equity returns on CLO paper could slip just when managers will have to hold more of it—which could keep the CLO market running on three cylinders instead of four. I

OCTOBER 2013 • FTSE GLOBAL MARKETS

FACE TO FACE

CRAIG STARBLE, CHIEF EXECUTIVE, ESECLENDING

Fronting an independent lending shop has been a long-term goal for industry veteran Craig Starble, the newly appointed chief executive officer for Boston-based securities-lending agency eSecLending. Starble spoke to David Simons about his plans for the firm. Starble thinks the company is poised to capitalise on changes in the securities lending business and is looking to build out the firm’s capabilities. Can it be done and is he the man to do it?

STAKING ASSETS ON CHANGE S IT TURNS out, in 2009 Craig Starble exited State Street Corp after a four-year stint as the firm’s executive vice president and global head of securities finance, then made plans to launch his own thirdparty start-up, Premier Global Securities Lending LLC (PGSL). The move didn’t sit well with Starble’s former employer, however, and in 2010 State Street filed suit alleging that Starble, along with ex-State Street seclending confederates Peter Economou and Paul Lynch, had violated the firm’s confidentiality protocol. Though the case was eventually settled, PGSL never made it out of the box, and by 2012 both Lynch and Economou had joined forces with none other than eSecLending (Lynch as chief operating officer, Economou as chief risk officer) Undeterred, Starble signed on as advisor to private equity firm Parthenon Capital Partners (with whom Starble had become affiliated during the PGSL period), and was instrumental in handling the due diligence duties that eventually led to Parthenon’s acquisition of eSecLending this past August.

In doing so, Parthenon replaces former eSecLending backers TA Associates, the private equity firm that had acquired the company in 2006. With Starble assuming the role of chief executive (and co-investor), Chris Jaynes, the company’s founder and co-CEO since its inception, moves into the president’s chair; co-CEO Karen O’Connor has retired from the firm.

This month eSecLending—the industry’s largest independent securities-lending agency—turns thirteen, having auctioned some $3trn in assets along the way. As an alternative to traditional custody style lending,

A

FTSE GLOBAL MARKETS • OCTOBER 2013

eSecLending has sought to bring added transparency and customisation to its institutional client base comprising asset managers, pension funds, insurance companies and others. While the company’s basic operating principles have remained consistent throughout, its menu of services has become more diverse, expanding from an almost entirely agency exclusive-based program to include the likes of discretionary trading, treasury and financing, risk management and other solutions.

Starble believes that eSecLending is poised to capitalise on and adapt to changes affecting the securities lending industry, and has already made plain his intentions to further develop the company’s list of client-facing capabilities. The question is whether he can diversify both the firm’s client base and its service set over the all-important short term (this is, after all a private equity play, which trends towards the short side rather than the long). As well, the current climate continues to be challenge for all participants in securities lending, which is now a business marked by lower turnover and more restrictive global regulatory oversight.

Five years on from the fall of some high profile institutions on Wall Street, many beneficial owners remain at best neutral over the service, in part due to lingering questions over the state of collateral arrangements, in part due to diminished demand for borrowed securities, in part a result of some questionable risk-management practices by some agency providers.

In such a risk-averse environment, there’s often a flight to safety that overrides normal market openness to alternative ideas. A recent Londonbased webinar (that included

eSecLending’s participation) found that many of those who are lending out their assets look to be seeking conventional routes to market, despite evidence that alternative approaches can yield positive results. What strategies might eSecLending undertake in order to meet these challenges over the near term? Is the ability to offer customisation of service—including the likes of open architecture and similar bespoke programs—one provider of future success?

A stake in the firm It’s a complex question that few firms are giving simple answers to. Starble’s gut is in play in this instance and you have the sense he is banking on a wholesale pick up of the business per se. It’s an expert’s play, evinced by his putting his own investment dollars in together with the investment stake taken up by Parthenon. “It’s basically been steady as she goes these last few years,”he acknowledges,“nevertheless, I believe there’s plenty of reason to be positive—and a good part of that is having the wherewithal to adapt to investor needs.”

Despite the difficulties that have beset the global lending industry in general, Starble says that the forward-thinking strategies and lean organisational structures of third-party providers that give companies such as eSecLending a distinct advantage over larger custody based players. Additionally, beneficial owners often give boutique-type firms higher marks for their operational transparency as well as quality of client service. “In that respect, I think that eSecLending’s historical approach to working in partnership with clients will become even more attractive as we move forward,”says Starble.

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REGIONAL FACE TO FACE REVIEW

CRAIG STARBLE, CHIEF EXECUTIVE, ESECLENDING

When the talk turns to regulatory rulings in the making, Starble prefers to take the high road. He believes that such changes can often lead to opportunity, as providers respond in kind through the formulation of new products and services. To that end, the nimbleness of eSecLending’s boutiquestyle management and business culture will allow the firm to make the necessary adjustments as these changes begin to take shape.“It is difficult to say exactly how the new regulations will shake out,”says Starble,“however, I feel that ultimately it’s up to the agentlenders to come up with workable solutions for helping clients navigate the markets once these rulings are in place. From our perspective, there is a lot of excitement around resolving issues that clients may have as a result of regulatory change,” offers Starble, “as well as seeking different methods for accessing the market in order to meet the demands of these rulings.”

New solutions The need for lenders to augment their product offering has become even more important in light of the persistently low-volume lending environment. To that end, eSecLending is prepared to diversify in order to accommodate client needs. For instance, as a smaller, independent firm, eSecLending is well positioned to take on the expected ramp-up in collateral optimisation activity, says Starble.

“At one point or another virtually all of our clients will require some form of collateral optimisation, and therefore everyone wants to know what it is and how it can work for them,”says Starble.

“Because we have no conflicts of interest, I believe we fit really well inside that niche,”he says.“If a client requires a collateral upgrade or downgrade, for instance, we can perform that transaction, while at the same time help them build an internal system that they can use to track all of the information.”

Such services also require a fair amount of individualised discussion, says Starble. “When you’re talking

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about collateral optimisation and transformation, every client has a different need and, therefore will likely require a very specific type of solution to address their agenda. As such, it’s really impossible to roll out a standardised product and hope that it will suit everyone involved. So while it’s always been our goal to build a core solution for any particular product, ultimately we want to be able to customise that solution on a case-by-case basis.”

Starble believes that the auction technology developed for eSecLending’s core operations could be applied to other aspects of the financial business.“Regardless of what happens with regulation, a greater number of entities will want to have some form of master compliance-reconciliation covering the entirety of their ongoing business activities,” says Starble. “I believe that the transparency of our auction process really fits well with that trend. So I feel we have the capacity and the knowhow to handle many of these client requests as they come forth.”

State of Independents Even as eSecLending enters its next year of operations, the market for independent lending is anything but a sure bet. A recent poll of institutional investors conducted by networking group myInvestorCircle found that more than half were not currently lending. Of the firms who are still lending many continued to favour the perceived safety and familiarity of the large traditional lender. Starble fully understands this rationale.

“Custodians are very good at what they do, and I think it’s perfectly reasonable for clients to want to maintain those conventional routes to market,” he states. “That said there is evidence that both large, sophisticated players as well as their smaller counterparts are interested in redirecting some of their custody based exposures towards alternative channels. Using eSecLending’s auction process, clients can achieve real performance diversification, particularly those with higher-value portfolios.”

Craig Starble, chief executive, eSecLending.

The question is whether Starble can diversify both the firm’s client base and its service set over the all-important short term (this is, after all a private equity play, which trends towards the short side rather than the long).

Photograph kindly supplied by eSecLending, October 2013.

Particularly as regulation continues to alter the lending business, beneficial owners who incorporate a broader range of lending agents will be in a better position to reduce their risk exposures, says Starble.

With the general markets trending higher and the economy beginning to stabilise, looking ahead there is plenty of cause for optimism, as Starble suggests. Even so, all agents will have to work that much harder in order to prove themselves to their clients, concurs Starble.

“Having top-shelf services and solutions is one thing,” he says, “but when all is said and done, it’s performance and value that matters most—after all, clients have to go back to their management and show that this is a viable business that is capable of generating a meaningful amount of revenue within their defined risk parameters. So from an agent-lender perspective, going forward I think the real winners will be those who can adjust the fastest to the changing lending environment. While I don’t feel that the influx of new rules will be nearly as restrictive as some have suggested, one way or another they will affect how the industry operates, and as such we will be required to find alternative solutions and strategies in order to adapt. Because of our independence, I believe that we have the capacity to properly respond to these changes as they occur—and therefore be able to keep our clients out of harm’s way in the long run.” I

OCTOBER 2013 • FTSE GLOBAL MARKETS

THE BEAR VIEW

POLITICS AND MARKETS DON’T ALWAYS MIX

At the moment we are stuck in a tale of two possibilities. One is unlikely, but apocalyptic; the other signifying nothing very much. We speak of course about the US funding spat. By the time you read this column, likely it will have passed into political history. Moreover, rightly or wrongly, the consensus is that the spat will come to a timely but fudged conclusion and the US will pay off its debts on time, if not this month then in a constructed new deadline in December. That’s all right then, or is it? Simon Denham, chief executive officer of independent City consultant Skrem Ltd, marks his return with the bear view.

Too many questions; too little growth N THE FINANCIAL world, as we all know, one dollar rarely means just one dollar; there’s always a chain of linked obligations. In that regard, there’s a lot at stake if the United States were to slip into default, technical or otherwise, as a result of the political impasse in which (at the time of going to press) it finds itself. If receipts are not forthcoming from the US Treasury then companies will be forced to sell other assets to cover their debts. Most will be unable to borrow to cover a short term liability as they will not have the credit lines to do so, or they might just be constitutionally barred from borrowing anyway. Nor, in all probability, would banks lend on such a basis. If the US, of all people, were not paying its debts any bank board approving an increase in its loan portfolio under such a scenario might be risking personal future legal prosecution.

There are other implications too. US Treasuries form the backbone of the multi-trillion dollar repo market.

Financial institutions of all types use piles of US T-Bonds as collateral against other obligations and (read the small print) most repo contracts will not allow the use of defaulted stock, technical or otherwise.

Additionally, maturing Treasury debt and coupon receipts will be required to pay off obligations elsewhere: that includes pension payments, collateral on loans, debt refinancing, life insurance returns and the hits go on and on.

The US will (almost certainly) not go down this route as ‘sanity’ will eventu-

I

FTSE GLOBAL MARKETS • OCTOBER 2013

Simon Denham, chief executive officer of independent City consultant Skrem Ltd.

ally win the day, but it should be noted that the argument has now turned into a costly farce where face saving will trump a realistic solution. The right wing clearly see this as an opportunity to deal a deadly blow to their opposition; the left wing are standing ground saying much to reduce state debt has been done. The public (with sympathies on both sides), and the markets, think it a complete waste of time, which is probably why no one has sunk into meltdown mode.

Of course, as we close in on the October 17th deadline (the first redemption date) the pressure on political parties to finally agree will become intense. Invariably, something

of a fudged solution will be agreed and the problem will be deferred until the next melting point in a few years’ time.

Could we have done without it?

Probably. Particularly as, in the rest of the world, the equity markets are once again in a funk. The UK’s FTSE100 is a bellwether and appears stuck in the global gloop. Since the rally of the first three months of 2013 we have gone pretty much nowhere as ‘wealth-less’ growth has taken root in the UK. Salary increases continue to lag behind cost of living rises which has put significant pressure on the high street. Worldwide GDP looks hardly likely to take up any slack and despite some heartening inflows into equity based ETFs in recent weeks, markets remain listless.

Everywhere are anaemic stirrings of activity that never quite seem to rise into anything dynamic. The continued attraction of dividend returns had looked reasonably certain to at least bolster equities over the medium term; but there have been an unnerving number of slightly worse than expected results reported in recent weeks.

Investors must now fear that bottom line growth might encourage boards to be cautious over dividends.

Even so, divvy returns still look very attractive versus virtually all other asset classes which should prop up the markets hopefully until the strength of the recovery starts becomes clear. For the time being then, the 6200 to 6700 range for the FTSE100 looks like the peak of ambition. I

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COMMODITIES

THE NEXT GENERATION OF COMMODITIES ETFs

There is still a good investment case for commodity ETFs but in the current environment of declining prices careful selection of the right ETF is imperative, rather than opting for the simplest basket-only approach. Older generation ETFs have lost their shine of late; no wonder then that a new slew of sleeker, more sophisticated ETPs have been launched that claim to be an improvement on previous ETP structures. Are they right for the times? Vanya Dragomanovich reports.

A BETTER SLEW OF COMMODITY ETPs? OMMODITY ETFS BECAME very popular with investors during the commodities price boom, attracting everybody from retail buyers to large scale asset allocators.

They appeal to investors because of the straightforward route they offer to an asset class which until recently has been dominated by futures trading.

Commodity ETFs also offer the benefit of diversification away from equities and bonds and can act as an inflation hedge.

In a strong economic environment, commodity prices are as good as guaranteed to rally. However, as global growth has slowed commodity ETFs gradually began to lose significant ground this year. China, the key driver of demand for a whole host of commodities including gold, metals, oil and iron ore, started showing early signs of slowing growth, with commodities prices sinking into a downward spiral in response. Gold also lost its allure as a safe haven investment for institutional buyers.

In August alone investors pulled $1.08bn from precious metals ETFs and ETPs, and the total net outflow from all commodity ETFs was $911m, according to specialist ETF research firm ETFGI. “Investors' concern and uncertainty over the impact on markets of a potential military conflict in Syria and when and how the Federal Reserve will begin QE tapering caused investors to net withdraw from (all) ETFs and ETPs in August,” says Deborah Fuhr, managing partner at ETFGI. August though was a poor month for ETFs full stop, with the largest outflows on record for the segment, though overall ETFs came in with a net

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Photograph © Paul Fleet/Dreamstime.com, supplied September 2013.

$53bn inflow through Q3. The seemingly quixotic flows were down to US equities drawing in investor interest, though bond ETFs fared indifferently.

Europe had the fastest growth of any equity category, bringing in $8bn for the quarter, with both Vanguard FTSE Europe ETF and iShares MSCI EMU Index each receiving more than $3bn over the three month period. In particular selling within the precious-metals category pressured the commodities category group, having experienced net redemptions.

When it comes to acting as an inflation hedge, “commodities usually underperform in periods of low inflation and outperform when inflation is high, allowing investors to maintain their purchasing power,” explains Abby Woodham, Morningstar analyst.

“Generally, commodities shine at the beginning of a recession and at the end of an economic expansion. As for risk, commodities are a high-volatility asset class.”

In the post financial crisis world the high-volatility element of commodities has worked against them as large insti-

tutional investors started shunning the assets. In addition many investors have been disappointed by the lower-thanexpected returns from commodity ETFs caused by the cost of rolling forward the underlying futures contracts—a practice by which a commodities future close to expiry is sold and a new contract, typically for the next month, is bought. If the forward future is more expensive, which is the case more frequently than not, the performance of the ETF is impaired.

Both ETF providers and commodity index developers have met with disillusionment among investors and, not surprisingly, have begun to counter with a response involving a host of new generation products designed to address both the volatility and the roll loss issue. In August, for instance, iShares, the world’s largest provider of ETFs launched the iShares Dow JonesUBS Roll Select Commodity Index Trust (CMDT) on the NYSE Arca, the first ETF based on the Dow Jones-UBS Roll Select Commodity Index.

The main appeal is that the ETF is designed to minimise the costs of closing expiring futures contracts and replace them with new ones. Typically, when the futures contracts come close to their expiry date the index replaces them with the next available contract— either the next month ahead or three months ahead. This works well when forward contracts are cheaper than existing contracts but frequently this is not the case.

Even so, the new generation of indexes allows a more sophisticated way of choosing the forward contract to roll into (as it will not opt necessarily for the immediate next contract but will

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FTSE GLOBAL MARKETS • OCTOBER 2013

year so have little track record, making it difficult to assess their performance.

In Ossiam’s case, the SG index the ETF is based on was developed in February this year. However, Bourcier said that Ossiam ran the model with existing commodity prices going back ten years and found that had the ETF been operational that long it would have generated returns of 11.7% while the S&P GSCI Index would have generated returns of 9.6%. Also, the volatility of Ossiam’s ETF would have been 13.9% versus the S&P’s commodity index 23%.

In the meantime in June S&P launched its own roll-adjusted version of its main commodity index, the S&P GSCI Roll Weight Select, which operates in a similar way to the SG index.

In terms of strategies there is some variety among ETFs including long, short and leveraged, but the vast majority of ETFs are positioned long only, a strategy that backfires in a declining market. Some investors may opt for this strategy nevertheless simply to replicate the move of the underlying commodities.

Investors turned to commodities for portfolio diversification and to protect themselves against risk such as inflation and rapidly changing supply and demand dynamics but so far,“long-only commodity indices have not provided a good solution since they have become highly correlated with equities and have experienced sharp drawdowns,” says John Mulvey, chairman of DPT Capital Management. Mulvey has worked with the FTSE group on creating the FTSE Target Exposure Commodity Index series; a set of rules-based long-short indices which allocates commodities based on quantitative tactics and avoids large concentration in certain commodity sectors.

Unsurprisingly, single commodity ETFs have performed much better than broad-basket ETFs because the baskets follow anywhere between 15 and 24 commodities and those commodities will frequently trade completely irrespective of each other.

THE NEXT GENERATION OF COMMODITIES ETFs

potentially chose a contract further away in the future); key criteria being that the forward contract is not only cheaper but it also has sufficient liquidity.

Other similar ETFs listed on the London Stock Exchange are the db Commodity Booster ETC based on the S&P GCSI Index but roll-optimised by a proprietary Deutsche Bank process and the Lyxor ETF Broad Commodities Optimix TR which tracks the SGI Commodities Optimix TR Index.

Another new ETF which has addressed both the roll-yield and the volatility issue is the Ossiam Risk Weighted Enhanced Commodity Ex Grains TR UCITS ETF. This is the first risk-weighted commodity ETF and it is based on Risk Weighted Enhanced Commodity Ex Grains index created by Société Générale and published by S&P. The ETF is also UCITS4 compliant. “The feedback from investors has been that they are less keen on volatility so we are using an index in which weigh-allocation in not based on production levels, as was the case in the past, but is inversely proportional to the volatility of a commodity,” says Isabelle Bourcier, Head of Business Development at Ossiam.

This means that while in the traditional commodity indexes such as the S&P GCSI Commodity Index or the DJ-UBS Commodity Index oil is the most prominent component with an allocation of about 65%, in Ossiam’s case the allocation to oil—a volatile commodity—is only 25%. Instead, there is a larger allocation to base metals and some other commodities other than grains.

“The index is looking at the one-year volatility for every commodity and adjusts the weighting accordingly,” Bourcier said. Also, when it comes to rolling contracts forward the index looks 24 months ahead and selects a contract that is a combination of the most liquid and cheapest according to a proprietary process.

The new generations of ETFs and the indexes they are based on have to a large extent only been launched this

For instance price moves in coffee or pork belly futures are almost completely unrelated to oil and gold prices, meaning that the average price move across a basket of commodities will be much smaller than its best performing components.

According to Morningstar data all of the top US-based broad basket commodities ETFs have had negative returns so far this year. In contrast, the iPath S&P GSCI Crude Oil Total Return Index ETN is up 12.4% year-todate and the United States Oil ETF returned 11.5% since January. Gold and silver ETFs have dropped between 20% and 30% with only palladium ETFs holding up.

Although typically ETFs perform less well than the underlying futures, this has not been the case this year for natural gas and corn. ETF UNG has done almost 7% better than futures and corn ETFs had 2% higher returns.

Oil was almost on a par, while wheat and coffee ETFs performed worse than their futures equivalents.

Looking ahead, analysts are tipping platinum ETFs as the next big thing.

Platinum is used not only in jewellery but is a key component in catalytic converters which reduce car emissions.

Investments in platinum are being driven by the anticipation of a gradual recovery in the global economy, but in particular in the European Union, where there is a large market for diesel-powered cars which use a significant amount of platinum in their converters, says Robin Bhar, analyst at Société Générale.

“The other element working in favour of this precious metal is the shift away from investment in platinum mining companies in South Africa because of their high costs and the undercurrent of difficult labour relations, and the associated migration into platinum ETFs,” adds Bhar. The New Plat fund launched only in April this year is now the largest in the platinum ETF space, accounting for nearly a third of all the platinum ETF holdings globally. I

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COMMODITIES

COMMODITY PRICING: NEW DYNAMICS

With Syria dominating the headlines commodities, especially oil and gold, are yo-yoing in sync with the news. Though this makes fertile trading ground for short term investors, for long term investors it is harder to separate the “noise” generated by the sabre-rattling from where long term commodities prices could realistically be. What’s the solution?

By Vanya Dragomanovich.

COMMODITIES, PRICES AND THE CRISIS AFTER THIS HE LAST FEW years have been thick with crises and conflict situations in the Middle East: Syria, Libya, Egypt and Iran, while Europe and the US have dished out their own market-moving contributions in the form of the Greek debt crisis, US debt ceiling negotiations and quantitative easing. All of the above will move commodities markets (mostly oil and gold) in the short term, typically up to 10% and occasionally, and then very short term, up to 20%.

Société Générale Investment Bank analysts have dissected the factors that influence the price of 22 commodities and found that a crisis will increase the degree to which the fundamentals of supply and demand will influence markets.

In a normal situation, that is, a market not driven by geopolitical or important financial news or fundamentals (such as barrels of oil produced versus oil consumed by cars; or ounces of gold mined versus ounces of jewellery bought) will play the biggest role in price variations.

Before the collapse of Lehman Brothers supply and demand accounted for about 80% of the price variation for commodities and the rest was made up from macroeconomic data, currency strength and market liquidity.

The financial crisis disrupted this pattern and after Lehman the average percentage of the price move explained by underlying fundamentals fell to 71%. However, as the global economic outlook is beginning to improve fundamentals are starting to play a bigger role again. “Our analysis shows a clear

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Photograph © Kirsty Pargeter/ Dreamstime.com, supplied October 2013.

regime change this summer in terms of what is driving commodities,” claims Michael Haigh, SGIB analyst in New York. Fundamentals now account for 83%, the highest level in the last seven years. News like that from the Middle East will tip the balance even further in favour of fundamentals, not only because there is an actual disruption in supply of oil but also because there is a threat of future disruptions.

“A couple of serious supply constraints in recent years confirm what we are seeing as a result of the Syrian crisis and uncertainty—the explanatory power of fundamentals because of geopolitics, for example, picks up when there is supply uncertainty,”says Haigh.

Before the chemical attacks in Syria in late August 2013, fundamentals explained 55% of Brent crude’s price movements but by late August, at which stage the Syrian conflict threatened to take on international proportions, fundamentals drove a highly significant 95% of the price. There was a similar pick-up for Brent crude during the Arab

Spring in 2011 and for the grains markets in 2012 when the drought in the US was in full flow.

For instance, for gold, the role of supply and demand on average constitutes 81% of the price variability but can spike as high as 95%, according to SGIB. For Brent crude oil fundamentals make up on average 65% of the price and for copper 69%. For aluminium and silver this number is around 80% while for soft commodities such as coffee and cocoa, or grains and livestock, fundamentals account for over 90% of the price.

Other influencers are the dollar exchange rate, macroeconomics and market liquidity. The on-going normalisation of the global financial system after the 2008 meltdown suggests that the dominant role of fundamentals will stay in place for the foreseeable future.

“If so, commodities should trade mainly on their respective fundamentals, allowing for significant dispersion between individual commodities and between commodities and other asset classes,” adds Haigh.

Gold & black gold When it comes to oil the fundamentals are driven beyond anything else by national interest.

The two top producers, Saudi Arabia and Russia, each producing around 13% of the global oil supply, have their national budgets linked to the price of oil and both are for similar reasons happy to have the oil price trade between $110 and $150 a barrel. Russia’s budget depends heavily on the country’s

OCTOBER 2013 • FTSE GLOBAL MARKETS

exports of gas and oil and as long as the country is careful with its domestic spending the budget breaks even when oil prices are around $100/bbl.

In Saudi Arabia the cost of oil production is not far from $20 a barrel, yet because of heavy domestic spending the country as the lead producer of OPEC polices the price of oil so that it is never far from $110/bbl. If oil prices start falling Saudi Arabia (and potentially the rest of OPEC) can cut production by one million barrels a day in a relatively short period of time.

Equally, if prices start to rise too fast, the country can release another one million barrels into the global market.

In addition, both the US and Europe hold large strategic oil reserves which would be released in the case of either a significant shortage or prices rising so high that they hurt the macro economy in those countries. “One natural stabiliser for global oil markets is strategic petroleum reserves. Low commercial inventories could prompt a coordinated release of these government stocks just as we saw in the aftermath of the Libya crisis in 2011. At 1.6bn barrels (of OECD crude oil reserves excluding the US) this safety valve remains ample,” says Francisco Blanch, commodities strategist at Bank of America Merrill Lynch.

In addition the Arab Spring has resulted in the Saudi government pumping billions of pounds into social projects and welfare in order to prevent domestic unrest, “which means that it is now no longer happy with oil prices at $100/bbl or below but at $110/bbl, says Haigh. With political decision makers battle ready when it comes to oil, there is not much scope for prices to move below $100/bbl. That doesn’t mean that prices will not continue to gyrate in reaction to crises like Syria but it does mean that those moves are not likely to be long lived.

Bank of America Merrill Lynch’s Blanch estimates that oil could rally to $120/bbl, not just in reaction to Syria but also because of workers’ protests and port closures in Libya, pipeline

FTSE GLOBAL MARKETS • OCTOBER 2013

attacks in Iraq and oil theft and pipe vandalism in Nigeria. If the Syrian conflict spread into the rest of the region, Turkey and Iraq, then prices could even spike to $150/bbl.

“However, you would only see such a large spike in prices if there was a major escalation of conflict. Otherwise it is much more likely that the price will move up some $10/bbl and that for a short period,” says SGIB analyst Jesper Dannesboe.

When it comes to gold, financial crises will play a much bigger role than geopolitics because demand is spread across the globe in very different ways.

For instance demand in the US stems to a large extent from ETF investors, in Europe key buying is roughly evenly distributed between ETF investors and bar and coin buyers, while in India and China jewellery is the main reason to buy gold.

Financial crisis David Lamb, managing director, Jewellery, at the World Gold Council says that although demand for physical gold rose sharply in the second quarter of this year, particularly demand for jewellery, bars and coins,“overall uptake of gold was down 12% on the year.”

Signs of economic recovery in the US followed by a sparkling rally in equities and bonds meant that ETF investors were no longer looking for safe-haven assets and have been pulling out of gold. According to the latest quarterly report by the World Gold Council jewellery demand, bar and coin demand and ETF purchases accounted for inflows of $26m, $23m and an outflow of $18m, respectively, in the last quarter. Interestingly, at 110,000kg (3,536,582 troy ounces), US gold production was 8% lower in the first half of 2013, compared to the first half of last year, according to a US Geological Survey (USGS) report. Nevada mines produced less gold during the first half of this year compared to the second half of 2012“as a result of lower grades and recoveries in Mill 5 and Mill 6 and lower grade at the Twin Creeks

autoclaves,” said the USGS. “Some of the losses were offset by new production at the Emigrant Mine and higher throughput at the Phoenix Mine.”

Since the conflict in Syria started making the headlines gold prices have risen 20% to just over $1,400 an ounce, but the bigger factor has been the Federal Reserve and its plans about quantitative easing and bond buying which has meant that ETF speculators, already negative about gold, are continuing to pull out of the yellow metal.

What then outside of a conflict situation can investors use as a reliable indicator in the sea of information about supply and demand? For oil, this would be weekly inventory data such as the change of inventory levels reported by the US Department of Energy. Analysts will typically look at the year-on-year change to remove seasonal influences, such as spikes in demand during the summer holiday season when more people travel and petrol consumption goes up. A rise in inventory level will point to either oversupply or lack of demand and either way will result in a decline in prices.

Similarly in base metals a reliable indicator is the level of stocks held in London Metal Exchange warehouses or cancelled warrants—stocks which are due to leave warehouses in the near future. Although this number does not explain how much copper or aluminium is produced or consumed globally at any given time it is a very good indicator if there is spare material in the system.

This should provide a good enough idea of where the base-line price for commodities should be and allow for adjusting for a crisis situation. At present all eyes are on Syria, but the crisis in the pipeline is likely to be cause by weakening of emerging markets currencies. If, for instance, the Indian rupee weakens significantly it would stifle the buying of not only gold and oil but of a whole host of metals and raw materials. The only question is will Europe and the US have enough time to recover by then to counteract a drop in demand. I

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REAL ESTATE

WILL REITS SURVIVE QE TAPERING UNSCATHED?

Real estate investment trusts (REITs) have been the poster boy for investment and real estate recovery in the US but indications that quantitative easing will taper off, with the subsequent prospect of higher domestic interest rates, sent a jolt through the REIT market this summer. As institutions and private investors weigh up the likely future direction of US interest rates the question is whether a rebalancing towards equities will downgrade REITs or whether a more buoyant economy will bolster their value. The second half of 2013—traditionally a strong period for REITs—will be a crucial period in determining their ongoing popularity. Mark Faithfull reports on the outlook.

Does US property still have the REIT stuff?

FTER FOUR YEARS of outperformance, the FTSE NAREIT All REIT Index saw its total returns drop 6.2% in August, trailing the broader market, with the S&P 500 down 2.9% in the same month. Equity REITs were down approximately 7% in August, while mortgage REITs fell roughly 3.5%.

Brad Case, NAREIT’s senior vice president for research and industry information, aptly called August a “tough month” for REIT investors and pointed out that although REIT investors had not been missing out on significant gains in the stock market, REITs have still under-performed throughout the summer. “The market has been having a tough time, and REIT investors have been having a little bit tougher time,” says Case.

The infrastructure and self-storage sectors enjoyed the best performances in August. Meanwhile, apartment REITs were the hardest hit. “Investors just don’t have a good sense for how strong the demand is in rental housing,” adds Case. “That strong demand for rental housing is going to continue.”

Despite the summer wobble, Case believes investors should maintain their faith in REITs.“If you look at how REITs have been performing since May 21st, that’s really about concerns that interest rates would go up higher as the economy strengthens,”he says.“But if we look historically, we know that REITs don’t do badly when interest rates go up, and that’s because interest rates tend to go up when the economy is strengthening. That strengthens the demand for commercial real estate and the earnings from owning commercial

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Photograph © Marish/Dreamstime.com, supplied September 2013.

real estate. REIT investors generally do well when the economy is strengthening, and that is going to continue. And they do well when interest rates go up, because that goes along with a strengthening economy. That’s the real story that investors are going to see over the next several months.”

Andrew Jackson, real estate fund manager at Standard Life Investment, concurs and says that the house view is that a rise in interest rates would be “neutral”for REITs in the USA.“On the one hand any prospective rise in interest rates is potentially negative for REIT valuations,”he concedes.“However, we have to look at the underlying reasons for a rise. It’s broadly a positive indicator about the economy and that should mean income growth and capital appreciation for real estate. So our feeling is that one factor should balance out the other.”

REITs hit the wall in May when US Federal Reserve chairman Ben Bernanke began talking about reducing

the central bank’s massive government bond-buying programme later this year. As investors look ahead to higher rates, they are selling bonds and stocks they see as vulnerable, including REITs. Perhaps investors have simply become too used to surging REIT performance. US REIT stocks out-performed the broader equity market for the fourth consecutive year in 2012.

The FTSE National Association of Real Estate Investment Trusts (NAREIT) All REITs Index, which includes both equity and mortgage REITs, delivered a 20.14% total return for the year, and the FTSE NAREIT All Equity REITs Index returned 19.70% compared to the S&P 500’s 16% gain.

The FTSE NAREIT All Equity REITs Index’s 2012 gain came on top of total returns of 8.28% in 2011, 27.95% in 2010 and 27.99% in 2009. The S&P 500 returned 2.11%, 15.06% and 26.46%, respectively, in those years. Among equity REITs, the top performing sector in 2012 was Timber, with a 37.05% total return. Other high-performing equity REIT sectors were Industrial with a 31.28% total return, Infrastructure, with a 29.91% return, and the retail sector, which delivered a 26.74% total return, led by the Regional Mall segment’s 28.21% return.

“REITs have a strong track record of delivering income,”says NAREIT president and CEO Steven Wechsler.“It is an attribute that has become increasingly important in our continuing low interest rate environment, especially for those who are preparing for or are in their retirement years. They provide the income and potential for capital appre-

OCTOBER 2013 • FTSE GLOBAL MARKETS

ciation that characterises real estate investment along with the advantages of moderate leverage and, in the case of listed REITs, complete liquidity. They also are a critical conduit that channels investment capital to support the growth of the real estate market and the broader economy,” he maintains.

Indeed, US REITs began 2013 strongly too, but the August drop had been coming. Although US equity REIT stocks were up 6.7% for the year through until the end of July, this marked the third consecutive month in which REITs had trailed the broader market. Data from the FTSE NAREIT US REIT Index showed that US equity REITs posted total returns of 0.83% in July. The S&P 500 was up 5.09% for the month, and the NASDAQ Composite returned 6.56% for the same period.

Anthony Paolone, an analyst with JP Morgan, adds: “What I think is most important about the stock performance over the last couple of months is that the market is obviously very focused on the move in interest rates. You’ll have a lot of generalist investors who are not going to have a good feeling about commercial real estate and deploying capital into REIT stocks—for right or wrong—if they feel that interest rates are going higher over the near term.”

Case also feels that the recent noise about an increase in interest rates has had an impact on the REIT market because of how some investors view commercial real estate. “We’ve seen some discussion that kind of treats commercial property just like bonds,”he says.“If interest rates go up, the value of a bond will fall. But that’s because a

bond is a fixed-income instrument.

Commercial property is not.”

However, he believes that the stock market is “not fully appreciating the history of REIT returns during the period when the economy is strengthening.”

Case stresses that rising interest rates do not necessarily mean that the economy is overheating and points out: “Generally speaking, when interest rates are going up, it’s because the economy’s strengthening, and that’s certainly what we’re seeing now. In the mid-1990s and the early part of the last decade, what we’ve seen is that REIT returns have been very strong during those periods where interest rates were rising because the economy is strengthening.”

While the market adjusts, REIT performance has become markedly more variable across the sectors, with those characterised by shorter lease durations generally performing better when interest rates are rising.

Even so, underlying fundamentals support commercial real estate as an investment class. The most recent (26th August) National Association of Realtors’ (NAR) quarterly commercial real estate forecast predicted commercial vacancy rates nationwide will decline 0.2% in the office sector and 0.6 points in both the industrial and retail sectors.

Lawrence Yun, NAR’s chief economist, says: “Office vacancies haven’t declined much because total jobs are still below that of the pre-recession level in 2007, but rising international trade is boosting demand for warehouse space. Consumer spending has been favourable for the retail market, and rising construction is keeping

REITs performance: FHY 2013 (up to 28th June 2013) YTD (28.6.13) One Year Three Years Five Years Ten years 20 Years 25 Years

All REITs (%) 5.41 9.71 17.97 7.94 10.02 10.09 9.46

Equity REITs (%) 5.79 10.21 18.46 7.72 10.96 10.54 10.67

S&P 500 (%) 13.82 20.60 18.45 7.01 7.30 8.66 9.75

NASDAQ (%) 12.71 17.92 17.29 8.22 7.69 8.20 9.00

Source: FTSE NAREIT (September 2013)

FTSE GLOBAL MARKETS • OCTOBER 2013

apartment availability fairly even, though at low vacancy levels.”

NAR is estimating that vacancy rates in the office sector will decline from a projected 15.7% in the third quarter of 2013 to 15.5% in the third quarter of 2014. Industrial vacancy rates are projected to fall from 9.3% in the third quarter of this year to 8.7% in 2014.

Retail vacancy rates are expected to decline from 10.6% in the third quarter of this year to 10% in the third quarter of 2014.

When it comes to rental growth in the other sectors, NAR expects office rents to increase 2.5% this year and 2.8% in 2014. Industrial rents are expected to grow by 2.4% this year and 2.6% in 2014, and retail rents are likely to increase 1.5% in 2013 and 2.3% in 2014.

Of all the casualties of the Q2 correction, none has fallen as sharply as US mortgage REITs. The dominant exchange traded fund (ETF) in the sector, the iShares Mortgage Real Estate fund, which accounts for almost 90% of passive money in the asset class, saw its assets under management fall by just over 26% in the quarter to the end of August, from $1.26bn to $931m. That followed a 12month period in which assets under management quadrupled.

Mortgage REITs provided, for a period, effectively a triple play on quantitative easing. Mortgage backed securities (MBS) benefited from both a central buyer (the Federal Reserve), and being eligible for repo because of the collateral drought caused by Federal buying. They also benefited from accelerated mortgage payoffs, as US home owners took advantage of record low rates to pay down 30-year mortgages, a factor which explains why, unlike corporate bonds, the outlook remains unclear.

Further uncertainty about US interest rates will continue to play on the collective minds of REIT investors. The sector will hope that the summer was nothing more than a reactive dip and that confidence in the economy will translate to confidence in bricks and mortar. I

45

REAL ESTATE

EQUITY FUND POURS INTO EUROPEAN REAL ESTATE

Equity funding for real estate has poured into Europe from North America over the past 18 months, as US funds recapture their enthusiasm for European property. A lack of continental banking finance, the sense that European property is more realistically priced compared with US opportunities and the feeling that the market may finally be on the move have all contributed to the momentum from west to east. By Mark Faithfull.

The Americans are coming N

ORTH AMERICAN INVESTMENT in the European retail property market surged in the first half of this year, as investors from the US bought a net €1.6bn in the sector, reversing their €1.2bn net withdrawal in the whole of 2012. Research by real estate investment adviser CBRE showed that, based on acquisitions alone—rather than acquisitions and disposals combined—North American investment totalled €2.39bn between January and June, more than the €2.08bn seen in the full year 2012.

Total retail property transactions in Europe rose to €15bn in the January to June period, up 17% from the same period last year. However, this was still lower than the second half of last year, when €21.5bn of deals were completed.

Investors from North America focused their acquisitions on Russia and the UK, while also making purchases in major Western European markets including Germany and France.

And there is little sign of let-up. In September Lone Star Funds, the world’s biggest buyer of delinquent mortgages, increased the target on its newest fund by 10% to $6.6bn in response to investor demand and Lone Star expected to have completed the first round of capital pledges for the new fund—which focuses on commercial real estate debt and equity—by the end of September.

Lone Star’s new fund is the biggest being raised for real estate private equity but it has been joined by firms including Carlyle Group, TPG Capital and KKR & Co in seeking more money for real estate and capitalising on investors’ search for higher returns than those offered by benchmark fixed-

46

income assets. Blackstone Group last year collected $13.3bn of pledges for the biggest-ever real estate opportunity fund.

In Europe, Blackstone Group’s real estate unit is close to completing a restructuring of Dutch retail specialist Multi Corp that would give it full ownership of the debt-laden European mall developer. Blackstone, the biggest manager of private-equity property funds, has amassed more than 90% of Multi’s €900m of corporate debt and a similar share of its equity in the past 15 months, despite resistance from the Multi board. The New York-based firm is understood to be in talks to buy the rest of Multi’s loans and stock from a German lender, and once the purchase is complete, Blackstone plans to forgive the debt and use Multi to acquire shopping malls and other retail properties across Europe. Blackstone believes Multi is in a position to capitalise on a wave of retail property sales triggered

by Europe’s ongoing economic issues and Multi would also give Blackstone exposure to the Turkish market.

In July, Commerzbank, Germany’s second-biggest bank, agreed to sell its Eurohypo UK real estate lending unit to Lone Star and Wells Fargo & Co to comply with European Union state-aid rules following its bailout. Lone Star will buy about $2.1bn of non-performing loans, which were sold for about 3.5% less than book value.

Lone Star’s new investment pool is called Lone Star Real Estate Fund III. In May the firm finished raising a residential-focused fund, Lone Star Fund VIII, with $5.1bn. Much of that money is being used to buy residential loans from Europe’s banking crisis.

Moreover, opportunities are emerging even in the most distressed markets. Miami-based private-equity firm HIG Capital has bought a majority stake in a package of 939 homes known as Project Bull in Spain. The property deal was one of the most closely monitored in Europe this year and priced the portfolio at €100m. The properties were transferred to a Bank Asset Fund, which provides a favourable tax regime to investors, as HIG’s Bayside Capital agreed to take a 51% stake in the fund. Spain’s ‘bad bank’, the government-run asset-management firm known as Sareb, will retain a 49% stake.

HIG Capital beat rival bids from Lone Star Funds, Apollo Global Management, Colony Capital and a joint offer by Centerbridge Capital Partners and Cerberus Capital Management to secure the deal and the agreement is a benchmark because it is likely to set precedents on price levels for transactions carried out by Sareb, which was set up by the government as part of last year’s €41.3bn European Union bailout of the country’s banks. Sareb took on foreclosed property and bad loans to real estate developers from the weakest Spanish banks.

“The quality of the bids submitted shows the confidence that investors have in Sareb and in the recovery of Spain’s real-estate market,” says Belén Romana, president of Sareb. Juan Barba, Sareb’s director of real estate assets, adds that the deal“allows us to be optimistic with regards to the portfolios we plan to put on to the wholesale market over the second half of the year.”

In the summer the Blackstone Group agreed to buy 1,890 rent-controlled

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REAL ESTATE

EQUITY FUND POURS INTO EUROPEAN REAL ESTATE

apartments in Madrid from the city's government, for a total of €128m. And France’s Axa Real Estate recently purchased 13 office buildings from the Catalonian government for €172m.

Meanwhile US private equity firm Cerberus, which missed out on the Spanish residential opportunity, has successfully bought two portfolios consisting of 19 retail assets in Germany in a bid to boost its footprint in the German real estate market. The portfolios were bought in two separate transactions. An affiliate of Cerberus acquired the Phoenix portfolio, consisting of nine shopping centres with a combined floor space of 92,000 sq m, from Wells Fargo. In addition, affiliates of Cerberus bought ten German retail properties—known as the Monsoon portfolio—out of administration.

The Phoenix portfolio was divested in a private sale, enabling Wells Fargo to remove the non-performing loans associated with these properties from its balance sheet, and the insolvency administrator was BBL Bernsau Brockdorff & Partners. The ten retail properties in the Monsoon portfolio were purchased by Cerberus affiliates on an all-cash basis through a multilevel tendering procedure led by Dutch insolvency administrator Barend de Roy van Zuidewijn of law firm AKD. The properties have a combined floor space of 263,677 sq m.

Lee Millstein, senior managing director at Cerberus, says:“The acquisition of these portfolios further enhances Cerberus’s footprint in the German real estate market. These mutually beneficial transactions enabled the sellers to obtain fair value, while providing us with the opportunity to inject fresh capital and spearhead the turnaround of the properties.”

Cerberus is understood to be weighing up an initial public offering of its German retail-property assets after hiring three banks to manage the sale.

The company has been an active investor in Germany since 2002 and last year the firm acquired the 300,000 sq m Rebound portfolio of 47 retail and

48

Metropolis Mall. Photograph © Mark Faithfull, supplied September 2013.

mixed-use properties from FMS Wertmanagement. Earlier in the year, Cerberus acquired the distressed assets of Speymill Deutsche Immobilien Company for about €224m, covering properties mainly leased to Kaufland and linked to the Epic (Drummond) CMBS. In 2011, Cerberus acquired a 900,000 sq m portfolio of Metro Cash & Carry wholesale retail properties located in urban centres throughout Germany. In Germany’s largest initial public offering that year, Cerberus and a co-investor listed Berlin-based GSW Immobilien on the Frankfurt Stock Exchange following the successful restructuring of the company and improvement of its assets.

Shopping centres made up threequarters of North American investors’ retail acquisitions by value in the period, says Iryna Pylypchuk, associate director of EMEA research at CBRE, adding: “This is very much in contrast to Asian and Middle Eastern capital, which, while acting across a wide range of geographies, has shown a clear preference for high street retail.”

She reflects: “North American investors stayed firmly focused on the shopping centre segment, which matches their preference for large deal size and their familiarity with the shopping centre sector.”

One of the largest examples of this focus saw Morgan Stanley Real Estate Investing acquire the Metropolis shopping centre in Moscow in what is believed to be the largest-ever transaction in the Russian commercial real estate market. Terms of the transaction were not disclosed, but

the deal is believed to have been worth around €1bn.

A fund managed by MSREI purchased the 205,000 sq m Metropolis Shopping and Entertainment Mall from Kazakh developer Capital Partners and the acquisition follows on from Morgan Stanley Real Estate Fund VII’s $1.1bn purchase of the Galeria mall in St Petersburg in the first quarter of last year. Developed by Capital Partners, the Metropolis Mall opened in 2009, featuring 82,000 sq m of retail space. Brian Niles, head of MSREI EMEA, says of the deal: “The acquisition is consistent with our strategy of investing in high quality assets in Russia, a market that should continue to benefit from strong growth in consumer demand.”

With further divestment of property holdings expected by European banks as they continue to lower their holdings in real estate and property debt, further opportunities are likely to come to market and the influx of US money shows few signs of abating. “Europe’s lending market requires more diversification and we expect to see a growing number of lenders enter the market,” explains Anne Breen, head of real estate research and strategy at Standard Life Investments.“In the next five years we expect to see much broader ownership and the banks playing a lesser role.”

The broad range of options, improved pricing and the weight of money collected but not yet invested suggests the US will join Australia and Canada in becoming a major incoming investor into the continent. I

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CANADA – INVESTOR SERVICES

Canada’s asset management industry emerged from the global financial crisis relatively unscathed; even so the segment remains under pressure, marred by continuing uncertainty in the global financial markets and shifts in regulation and end-investor behaviour. This has directly impacted costs, margins and growth potential. With that in mind, the story for providers of investment services in Canada, is no longer about whether one has the ability to custody assets and settle trades—but rather the speed and efficiency with which providers can deliver these mission-critical services, at a cost effective price, while also supporting clients’ rapidly changing business and investment needs. How hard is the balancing act? Dave Simons reports.

The new race for business N CANADA, CUSTODY and fund administration providers find themselves at a critical juncture. New regulations and heightened competition threaten the integrity of old business models, forcing many to review their commitment to the asset-servicing arena. The need to develop optimal technology solutions for a faster-paced marketplace is also producing new challenges. Custodians that currently operate multiple platforms must consider the feasibility of consolidating into an all-in-one system, particularly as investment styles/markets become increasingly complex.

The market itself has become increasingly competitive, even as challenges in servicing the asset management industry in Canada become clearer. Size is clearly an issue, with attendant knock on effects on returns on investment for those services providers anxious to maximize their foothold in the market. In the alternative space, for example, Canadian hedge funds manage, according to recent data from Royal Bank of Canada, between $35bn and $40bn in assets. Compare that with the United States, where cumulatively, over $1.6trn in assets is managed by alternative fund managers. Consultant and intelligence gatherer Towers Watson’s 2013 global pensions study estimated that total assets in pension funds in Canada were worth $1,483bn, compared with $2,736bn in the UK and a whopping $16,851bn in the United States. The competitive order of play therefore is in inverse proportion to available assets under custody, either in traditional or alternative investments. Most global custodians and fund administration firms compete for business in the jurisdiction against incumbent providers such as RBC and others.

Meanwhile, client expectations continue to ratchet upward; once considered premium services, execution and safekeeping are now standard features, with the likes of on-demand reporting, transparency, performance and portfolio measurement increasingly viewed as essential addons. “In today’s industry, custodians offering full service solutions are expected to understand all of the changes around new laws, governance and adherence to all the financial market regulations being imposed,” says Edwina Easton, principal at Mercer Investments,“and are viewed by many fund types as the responsible party for ensuring all regulation is enforced and reported to the appropriate regulatory agency, accurately and on time.”

For Canada’s asset-servicing players, then, the story is no longer about whether one has the ability to custody assets and

I

50

settle trades—but rather the speed and efficiency with which one can deliver these mission-critical services, while also supporting clients’ rapidly changing business and investment needs. Accordingly, Canadian providers find themselves moving beyond basic custody and instead offering clients real-time access to information and reporting around the full range of investments and strategies, including shorts, overlays, alternative investment vehicles and more tailored services.

One of the few nations to boast a triple-A rating, Canada’s creditworthiness has resulted in sharply lower borrowing costs for provincial governments and other associated parties, notes Alistair Almeida, vice president, business development and relationship management for Toronto-based CIBC Mellon, which, says Almeida, “has led to healthier ratings for major Canadian institutions as well.”Meanwhile Canada’s infrastructure includes a robust banking system with capital well in excess of Basel requirements—“key benefits for all market participants,” adds Almeida.

In Canada, on-the-ground expertise, as well as knowledge of local-market intricacies, continues to score points for wellplaced providers.“The efforts of our service teams, relationship managers and risk professionals are solely focused on the Canadian markets and the impacts on players within this space,” says Almeida. “This enables us to engage in regular conversations with industry stakeholders and regulators, and to work with our clients in order to keep them informed about current and emerging changes in the marketplace.”

Even so, with concerns over global-market instability as well as regulatory compliance costs rising to the fore, Canadian providers face growing pressure from their clients to shoulder the burden of additional risk reporting, assessment and management.“Clients are increasingly looking to asset servicing providers for support and assistance,” says Almeida.“For providers, this represents a real opportunity to deliver enhanced services, and there is increased recognition from clients that stronger support in this area is worth paying for. As a result, asset servicing providers are differentiating themselves based not only on the strength of their internal controls, operational risk management and support, but also on their ability to deliver information and support that positions clients to more efficiently satisfy regulatory and reporting needs.”

Faced with tighter margins, however, providers must be cognisant of the costs associated with controlling this risk—

OCTOBER 2013 • FTSE GLOBAL MARKETS

hence the importance of working one-on-one with clients in order to find the right balance between risk mitigation and financial outlay. “As with most things in the business, building strong relationships and engaging in clear and detailed dialogue with both current and prospective clients is central to shared success,” says Almeida.

Global players such as State Street are continually looking to increase efficiency in the region through innovations in technology while ensuring that existing products and services are continuing to add value. “Asset servicing firms are interested in growing their business where there is strong alignment between the firm’s value proposition and the needs of the client,” says Robert Baillie, newly appointed president and CEO of State Street Trust Company Canada.

“This alignment helps form the basis for a strong foundation from which to grow the relationship.”

In the current environment, efficiency is paramount, adds Ballie. “There is no question that cost effectiveness is a big driver for us—ours is a business of scale, and having an efficient operating model supported by a single accounting engine is a key foundation of that scale. We feel that investors of all sizes can benefit from having partners that can help them achieve true operational efficiency.”

Rather than cater exclusively to larger fund clients in order to maximize cost efficiencies, having product depth allows providers to cover the entire spectrum of client size and need, from global financial institutions to single-employer pension plans. By leveraging the technology of parent company BNY Mellon, CIBC Mellon has been able to deliver services in a manner that is appropriate for the designated client, claims Almeida.

“Sophisticated international players can meet the needs of the Canadian market using robust information delivery and technological solutions,” says Almeida, “yet we have been able to efficiently support smaller investment plans as well, using a suite of products and services that suits their needs.

In Canada, marketplace rules don’t discriminate by size—as such, we’re committed to providing client services not only at the top of the scale and across the middle market, but to cost-focused single corporate plans as well.”

Going global Historically, Canada’s burgeoning pension market has often favored domestic issues like energy, materials and financials.

More recently, however, plan managers have increasingly looked beyond the border in an effort rake in additional alpha. In its most recent fiscal year ending in March, Canada Pension, the country’s number two public pension manager, registered a 10 percent return due in part to an increase in foreign-market allocations. Meanwhile, a new survey from Statistics Canada found that nearly one-third of the country’s employer-sponsored pension plans were themselves invested in foreign issues.

As these allocations continue to grow, plan managers will likely place even greater emphasis on service providers who can offer the guidance needed to navigate this territory.

“While Canadians may have experienced less turmoil at

FTSE GLOBAL MARKETS • OCTOBER 2013

Alistair Almeida, vice president, business development and relationship management for Toronto-based CIBC Mellon. Canada’s creditworthiness has resulted in sharply lower borrowing costs for provincial governments and other associated parties which, says Almeida, “has led to healthier ratings for major Canadian institutions as well.” Meanwhile Canada’s infrastructure includes a robust banking system with capital well in excess of Basel requirements—“key benefits for all market participants,” adds Almeida. Photograph kindly supplied

by CIBC Mellon, October 2013.

home during the depths of the financial crisis, today many institutional investors are putting more of their capital into the global marketplace,” affirms Ballie. “However, anyone who is involved this market needs to understand how they may be affected from both an investment and compliance standpoint. In the EU alone, there are nearly 60 regulatory initiatives that were created in response to the financial crisis that could have an impact on asset managers, either directly or indirectly.”

Alternative strategies also continue to gain favour within Canada’s institutional marketplace, challenging providers to offer better data and analytics, including, among other things, more support around regulatory reporting and compliance.

“In the current environment, compliance needs to be fully understood and properly interpreted for clients,”says Baillie.

This can be resource intensive smaller firms, however, leading many to partner with those who have specialist knowledge, expertise and ability, says Baillie,“thereby allowing managers to use their resources for their benefit of their clients.”

As the global markets become more tightly intertwined, rule changes affecting the use of capital, collateral and other financial instruments in the US, EU and elsewhere will be keenly felt on Canadian turf.“The US is our biggest trading partner, and our economies are interdependent, with many major Canadian securities being inter-listed,” says Almeida. “So the experience here is much the same as it is elsewhere.” As such, cross-border regulation will remain a critical area for providers, particularly as rules and guidance continue to evolve. Even in the absence of a US-Canada inter-governmental agreement overseeing the exchange of tax-related information, market participants will continue their efforts to bring systems and processes into better alignment, adds Almeida. I

51

SECURITIES LENDING—CANADA

While a rebound in volume remains elusive, in Canada securities lending continues to play a prominent role within the fund management space—and as regulations around derivatives clearing fuels a rise in demand for high quality collateral, things could get better still. Dave Simons.

MIGHT A REBOUND IN VOLUME BE LINKED TO REGULATION? OLLOWING A TEPID 2012 that saw global on-loan securities-lending balances fall roughly 3%, Canadian lenders hoped for a rebound in the current year. At the outset, there were numerous reasons to be cheerful; last fall, the Canadian government gave the green light to a proposed amendment to section 260 of the Canada’s Income Tax Act that would add the likes of exchange traded funds (ETFs) and real estate investment trusts (REITs) to the list of eligible securities-lending products. Moreover, despite the imposition of more restrictive rules governing short sales and failed trades that went into effect a year ago, to date securities-lending directional trading has yet to feel any ill effects.

Through the second quarter (Q2) of this year Canada’s lender-borrower dynamic remained virtually unchanged, evidenced by the consistency of fee volatility from quarter to quarter, according to financial information services firm Markit. Borrower demand for the country’s $400bn inventory also stayed within a tight range of $70bn-$80bn during the same period, reports Markit.

While higher volumes remain elusive, securities lending nonetheless continues to figure prominently within the Canadian fund management arena, due in part to new regulations requiring that more derivatives products be routed through central clearing facilities, which in turn is likely to fuel demand for higher quality (and greater quantities of) collateral.

If 2012 was a“decent”year for Canadian securities lending, to date 2013 has been even better, says Jeffrey Alexander, vice president, global securities lending at Toronto-based CIBC Mellon. Merger/acquisition activity has been buoyant through the first nine months, marked by consistent borrower and lender participation, which is expected to continue into 2014. “The markets seem to be holding up quite well,” adds Alexander. “Economic data out of Canada has been positive, and the markets continue to have sound fundamentals, with healthy regulation and a roster of wellregarded financial-services players.”

In terms of revenue generation, certain securities that have traded “special” have been among the brightest lights so far, says Alexander.“BlackBerry, for instance, has been very active this year, with demand driven by ongoing headlines, including a directional play regarding the survival of the company and whether the recent bid by Fairfax Financial to take the company private will go through.”

As in years past, Canada’s vast resources sector looms large on the domestic lending front. “Global demand for resources has grown,”notes Alexander,“though the sector’s performance has to some extent been hindered by the

F

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slower-than-expected global recovery.” The alternative energy space (which includes players like Vancouver-based alternative-fuel technologies developer Westport Innovations) has been another area of opportunity, says Alexander, “with directional interest driven by opposing views regarding the short- and long-term prospects for the industry.”

Additionally, as one of the few nations boasting a tripleA rating, it’s not surprising to find Canadian fixed income on the lending leaders list, with record balances fueled by demand for the country’s sovereign debt issues.

Expectations for a shift in global revenue streams over the next several years will likely present Canadian lenders with some of their tough challenges, but also robust opportunities. “For instance, European financial-transaction tax changes may result in lower revenues in impacted markets,” says Alexander. “Nevertheless, it is our goal to offset these fluctuations by rotating into the likes of emerging markets and other areas with stronger revenue-generating potential.”

At the Canadian division of Equilend, the global provider of trading and operations services for the securities-finance industry, Alexa Lemstra, vice president, sales for Torontobased EquiLend Canada, is equally upbeat about the industry’s near-term prospects.“Canadian securities lending feels sturdy, and continues to be a vital product for the financial markets,” says Lemstra. Like others, Lemstra lists Blackberry as a top revenue generator, and also includes Loblaws, the Canadian supermarket giant.

“From EquiLend’s standpoint, we see firms allocating budget and focusing on investment in technology, either through implementing new front-end systems, consolidating trade communication, prioritising straight-through processing or enhancing data reporting to underlying clients. Trading desks want to have tools that can allow a trader to focus on rate negotiation instead of book utilisation and maintenance.”

Canadian Equities on Loan: Sector breakdown by percentage 7% 4%

2%

8% 9% 4%

24%

4% 1%

37%

Utilities Telecommunication Services Materials Information Technology Industrials Health Care Financials Energy Consumer Staples Consumer Discretionary

Source: DataLend, supplied October 2013.

OCTOBER 2013 • FTSE GLOBAL MARKETS

Jeffrey Alexander, vice president, global securities lending at Torontobased CIBC Mellon. Merger/acquisition activity has been buoyant through the first nine months, marked by consistent borrower and lender participation, which is expected to continue into 2014. “The markets seem to be holding up quite well,” says Alexander. Photograph kindly supplied by CIBC Mellon, October 2013.

With client need on the increase, agents will find it necessary to stay abreast of new systems and trading tools, says Lemstra. “Beneficial owners are requiring more transparency in their performance,” she says,“while hedge funds are requiring data as they become more sophisticated in pricing and data analysis. Technology focus is required to adjust systems and strategies to account for more collateral flexibility and interact with counterparts in the US, which sometimes can be ahead in terms of technology investment.”

As always, responding to the continued influx of regulatory changes, both at home and abroad, remains a front-andcenter issue for CIBC Mellon. “Canada’s commitment to maintaining a strong regulatory environment comes with many benefits, but also requires consistent participation within the industry,” says Alexander.

To that end, the Canadian Securities Lending Association (CSLA) continues to maintain a partnership role, “working with regulators, market participants and other stakeholders to help ensure the long-term viability of the Canadian securities lending business, as well as the adoption of best practices,” says Alexander.

For agents and borrowers alike, making preparations for new rules that have yet to be finalised—and that may or may not actually become law—can be particularly vexing. Case in point: the proposed changes to the reporting threshold, triggers and disclosure requirements under Canada’s early warning reporting regime (EWR), put forth earlier this year by the Canadian Securities Administrators council (CSA).

Aimed at increasing transparency around “significant holdings of issuers’ securities,”the CSA amendments would include lowering the existing reporting threshold from 10% to 5%, as well as requiring disclosure of both increases and decreases in securities ownership of 2% or greater. Speaking on behalf of the council, CSA chairperson Bill Rice said that such adjustments were necessary “in light of the increased use of derivatives by investors.”

FTSE GLOBAL MARKETS • OCTOBER 2013

Alexa Lemstra, vice president, sales for Toronto-based EquiLend Canada, is equally upbeat about the industry’s near-term prospects. “Canadian securities lending feels sturdy, and continues to be a vital product for the financial markets,” says Lemstra. Like others, Lemstra lists Blackberry as a top revenue generator, and also includes Loblaws, the Canadian supermarket giant. Photograph kindly supplied by EquiLend, October 2013.

The proposed changes, however, could lead to an increase in compliance costs, not to mention greater reporting volume, suggests Margaret Grottenthaler, a Toronto-based partner with Canadian business law firm Stikeman Elliott.

Additionally, says Grottenthaler, under the new rules lenders would be required to distinguish between what is and isn’t a specified securities-lending arrangement, implementing separate reporting processes for each.

“There are many such areas where rules are evolving or where regulatory guidance has yet to be issued,” adds Alexander. Even so, agents must be ready to adapt, not only to the possibility of regulatory changes at home but across the globe as well.

A stronger platform By responding to client and regulator demands for clearer, more objective information, the securities-lending industry has been afforded a much stronger platform than in years past, suggests Susan Pike, global head, market services for RBC Investor Services. As Pike notes in RBC’s recent report “Demystifying Securities Lending,” at present securities lending “has never been so well understood, so transparent and so important.”

Rather than serving as an impediment, the increased focus on transparency will lead to greater usage of securities lending and lending data among fund managers whose goal is to optimise portfolio construction, achieve diversified returns and inform the timing of their trading decisions. As a result, going forward,“more managers will view securities lending as a diversifying investment asset class, and manage it accordingly.” Furthermore, with margin requirements changing, RBC believes that clients will increasingly turn to securities lending as a viable collateral resource. Thus, for beneficial owners in possession of eligible high-quality assets such as government bond portfolios, “the potential to generate strong returns has never been greater.”I

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COLLATERAL OPTIMISATION

While those who only dabble in derivatives may escape the brunt of Dodd-Frank’s more imposing margin rules, others may require new methods for helping to determine what kind of assets to use and when. A job for collateral optimisation? From Boston, Dave Simons reports.

WHERE BEST TO PUT YOUR COLLATERAL comparison, these firms have conESIGNED TO ADDRESS siderably less volume,” says lingering opacity within Malgieri, “nevertheless, as these the mammoth OTC regulations begin to take hold derivatives space, Title XII of some degree of optimisation will the Dodd-Frank Wall Street be necessary.”

Reform and Consumer Protection Whether or not buy side Act brings forth new mandatory companies begin to address colclearing and trade execution lateral-facing issues sooner than standards governing various later remains to be seen. “By and interest-rate and credit-default large counterparties continue to swap products. As the reality of allow firms to post cash as increased margin requirements variation margin,” says Malgieri. under Dodd-Frank hits home, Photograph © Behjan Juhusi/ Dreamstime.com, supplied “And of course the need to fully a growing number of buy October 2013. optimise will vary depending on side clients have begun exploring strategies for dealing with these impending the type of firm—if for instance a client doesn’t have a huge changes—including, among other things, collateral optimi- swap book, chances are they will be more than happy to keep on posting cash.” sation solutions.

However, as Malgieri points out, using cash as collateral Determining the various types of collateral that will pass muster with the relevant counterparties is a fundamental isn’t always the smartest choice. “If you’re a large pension piece of the optimisation equation. Also, knowing which fund or other asset manager, posting cash to satisfy your CCPs may offer the best netting positions and/or lowest CCP’s margin requirement can be a real drag on returns. For possible collateral requirements is a vital consideration. As that matter, if you’re an insurance company, you may not one observer puts it, “If you’re going to use your collateral, even have a lot of cash on hand to post as collateral in the you’ll need to know where to put it in order to achieve the first place.”

Whether optimisation is a pressing need or simply best best value while fully meeting your obligations.”

To the sell side, the concept of collateral optimisation is practice depends largely on the nature of the company, nothing new. Larger firms in particular have long pooled holds Judson Baker, product manager for Northern Trust’s their collective inventories into a single bucket of collateral, asset-servicing division.“There are firms that are so well capthen subsequently employed techniques to best utilise the italised and have such a high degree of quality assets that collateral based on the nature of their obligations to securi- these newer, more imposing margin and eligibility rules ties lenders, repo counterparts or other trading partners. shouldn’t be a real concern,” he says.

Under the new regime, however, others may find it more “Accordingly, firms have typically employed someone such as BNY Mellon to handle these duties as part of the global difficult to utilise the existing mix of assets without disruptcollateral-management service,” explains James Malgieri, ing trading strategies. These include liability driven managers executive vice president and head of service delivery & as well as firms with a higher-than-average derivatives regional management, global collateral services for BNY weighting. “These are the types of players that are likely to Mellon. By understanding what kind of collateral is in use as be more interested in collateral optimisation,”says Baker,“at well as the client’s obligations for that collateral, providers least from the standpoint of addressing the use of assets to can devise algorithms that can determine the best strategies meet margin calls without affecting their standing in the for collateral placement. That says Malgieri, “is the essence OTC-derivative or cleared-swap space.”

The most recent installments of Dodd-Frank (impleof collateral optimisation.”

Will the buy side require the same level of preparedness mented in June and early September), along with greater in order to comply with the new clearing standards? “By detail around Europe’s EMIR and EFSMA regulatory initia-

D

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OCTOBER 2013 • FTSE GLOBAL MARKETS

tives, have helped turn “informational discussions” around collateral-facing issues into actual activity among US institutional buy-side players, remarks Kelly Mathieson, JP Morgan’s global head of collateral management.

“Participants are now asking serious questions about how CCP-pledged assets are being held, including whether or not assets are properly segregated, what the different collateral structure types look like, and more,” says Mathieson.

“So while the dialogue may not have changed, the emphasis has definitely shifted towards dealing with this new level of complexity.”

Optimisation options Granted, the majority of buy side firms won’t actually be clearing themselves—instead, many will retain the services of a clearing broker or futures commission merchant (FCM), who in turn will provide access to the various CCPs.“So what it really boils down to is the margin requirements imposed upon the firm by the FCM,” says Malgieri. “Based on those parameters, firms can then determine what kind of collateral can be posted.”

Here’s where it gets tricky, says Malgieri. “Do managers shoulder the responsibility of choosing the ‘best’ collateral to deliver, perhaps with the help of their custodian, or do they simply allow the custodian to handle it for them? Therein lies the whole optimisation conundrum—that is, comparing the cost of performing these tasks in house, versus employing someone on an outsourced basis.”

From Malgieri’s perspective, having a service that can determine the best approach to collateral delivery, based on the situation at hand, is undeniably important. “Does the fund manager post cash versus a corporate bond, or perhaps do a transformation in order to swap one asset for another?

In short, being able to meet clearing house or OTC swap counterparty collateral requirements in the most efficient way possible makes optimisation a truly valuable resource.”

The cost savings derived from using properly pledged assets can be substantial, adds Baker, particularly for those with more sophisticated investment strategies.“For instance, a client may have a triparty repo or securities-lending situation set up, and therefore wants to ensure that they are getting their special or higher-demand assets into that arrangement,’ says Baker.“Or perhaps a client would like to determine the costs associated with borrowing certain securities, which is often a job for collateral transformation.”

Of course, the whole notion of what constitutes properly optimised collateral can vary greatly from one organisation to the next.“A very simplistic form of optimisation may work just fine for many companies,”says Baker. In general, though, having automated solutions to help determine applicable collateral eligibility rules, as well as the availability of assets needed to comply with these rules, can be highly beneficial for all participants.“Rather than constantly reviewing the requirements, one would have systems that would present an array of possible options for what to pledge out,”says Baker.

Given the expanding reach of OTC clearing, enterprisewide solutions, once considered a luxury, are fast becoming

FTSE GLOBAL MARKETS • OCTOBER 2013

Kelly Mathieson, JP Morgan’s global head of collateral management.

“Participants are now asking serious questions about how CCP-pledged assets are being held, including whether or not assets are properly segregated, what the different collateral structure types look like, and more,” says Mathieson. “So while the dialogue may not have changed, the emphasis has definitely shifted towards dealing with this new level of complexity.” Photograph kindly supplied by JP Morgan, September 2013.

compulsory for many participants. As such, the ability to consolidate one’s view of obligations across numerous transaction types, including required value, initial margin as well as variation margin, remains a key focus of JP Morgan’s optimisation efforts.

“Historically, much of the counterparty collateral- and risk-management activity took place after the fact,” says Mathieson. In light of recent changes, however, handling such duties post-settlement is no longer optimal.“When you consider the amount of collateral that would need to be posted in this manner, the inefficiencies would just be staggering,” says Mathieson. “So for the buy side especially, having that ability to view collateral almost as an asset class unto itself, covering not only outgoing obligations but also client funds due back from the counterparties, is tremendously important.”

In some instances, optimised borrowing opportunities may involve the use of alternative methods such as rehypothecation—that is, leverage derived from the re-use of existing collateral. Under rehypothecation, “if someone is pledging a bond as collateral, the receiver of the collateral may be able to onward pledge that specific bond to satisfy a margin demand from a separate party,” says Baker.

“They are essentially using the bond as if it were their own to help meet a margin call, as opposed to using their own trading assets for that margin requirement,” he adds. In addition to reducing trading costs and related funding transactions, when used properly rehypothecation can lead to increased speed and liquidity around financing transactions.

Rehypothecation is not without its share of settlement risk, however, and therefore requires a higher degree of operational agility, including advanced monitoring techniques (not to mention the use of segregated accounts). Despite the caveat, buy side firms have been gradually “warming up” to the idea of using rehypothecated pledged assets for meeting margin calls, notes Baker.

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COLLATERAL OPTIMISATION

Margin of error As mandatory clearing begins to take hold, the market could potentially see a ten-fold rise in the number of margin calls, putting an even greater strain on manual margin processing, remarks Peter Axilrod, managing director and head of strategy and business development, Depository Trust & Clearing Corporation (DTCC).“By and large, the manner in which margin is moved today is extraordinarily inefficient,” says Axilrod. As a result, larger buy side investment managers may already be experiencing as much as a 3%-5% fail rate, and that number could rise as margin requirements weigh on market liquidity.

To help address such issues, DTCC recently announced plans to create a joint collateral processing service in conjunction with Brussels-based ICSD Euroclear, which will include automated transfer and segregation of collateral in an effort to boost transparency and collateral efficiency while reducing the risks commonly associated with OTC derivatives activity. The initiative will leverage DTCC’s Margin Transit Utility (MTU), a straight-through-processing platform slated for release in 2014, along with Euroclear’s existing “Collateral Highway,” which links member CCPs with agent banks for the purpose of transferring collateral to be used as margin for central clearing and bi-lateral clearing arrangements. The service will be available to all custodians, CSDs, ICSDs and other collateral-processing agents.

“Using the central margin transit initiative, dealers and clearing firms, on behalf of their buy-side clients, will be able to feed agreed-upon margin calls directly to the MTU platform, which would automatically enrich the margin calls with pre-determined settlement and segregation data,” says Axilrod.

By bringing together all available collateral into one pool, firms can be make better decisions about what collateral they release and when, says Ted Leveroni, executive director of derivatives strategy for post-trade services provider Omgeo,“so that higher quality assets are used as effectively as possible.

This is where technology and automation is critical.” Using sophisticated collateral management processes, buy-side firms have the ability to calculate their counterparty exposures more frequently, thereby helping to identify exposures that are under- or over-collateralised.

“Collateral transformation is one way of dealing with an expected collateral shortfall,”says Leveroni,“however, not all brokers may be able to provide these services to all of their clients. As a result, collateral optimisation is set to become the most widely used alternative to collateral transformation, explains Leveroni,“It allows funds of all sizes to be smarter about how they use their collateral.”

While the move toward CCP-cleared OTC derivatives products (and the heightened margin requirements therein) may be the prime motivator, other factors underscore a greater need for optimised collateral. According to a 2011 Accenture study commissioned by Luxembourg-based ICSD Clearstream, up to 15% of collateral available to financial institutions was left idle due to process inefficiencies, resulting in an estimated $5.4bn annual loss to the global industry.

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Judson Baker, product manager for Northern Trust’s asset-servicing division. Whether optimisation is a pressing need or simply best practice depends largely on the nature of the company, holds Baker. “There are firms that are so well capitalised and have such a high degree of quality assets that these newer, more imposing margin and eligibility rules shouldn’t be a real concern,” he says. Photograph kindly supplied by Northern Trust, September 2013.

Such data helped give rise to initiatives like Clearstream’s Global Liquidity Hub, a system designed to help customers achieve collateral optimisation through integrated securities lending, borrowing and collateral management services in cash, fixed-income and equities.

“The continuous and inevitable migration from unsecured to collateralised lending/funding compels all participants to drastically improve their collateral allocation processes,” notes Jean-Robert Wilkin, head of product management, global securities financing for Clearstream. “Until recently, many have prioritised cash as collateral on the basis of it being less expensive and easier to handle,” says Wilkin, “however, higher volumes may result in a shift towards non-cash collateral.”

Above all, collateral optimisation is being driven by regulators’ overarching desire to de-risk the markets, says Wilkin.“Better collateral management on the part of market participants will ensure better safeguards against future systemic risk.”

Learning from the lessons of the past is a big part of the optimisation package. Flash back to the start of the credit crisis, when risk management was designed to ensure that one would be adequately collateralised at all times, “and that any reallocations that occurred would be handled quickly in order to avoid any errors in decision-making,”says JP Morgan’s Mathieson. The problem says Mathieson, was that the tools typically only acted on one or two different factors—which, under normal circumstances, might be fine.

“However, when you consider the complexity, the number of counterparties, the time sensitivity as well as the sheer magnitude change in the amount of collateral required, you begin to see the economic value that optimisation can bring,”agree Mathieson.“In short, when it comes to meeting these obligations, it’s not just about getting the collateral out the door quickly—it is about getting the best collateral out the door as well.” I

OCTOBER 2013 • FTSE GLOBAL MARKETS

COLLATERAL MANAGEMENT

Although the absolute supply of high-grade collateral should be sufficient to address the increase in collateral demand, this theory is dependent on firms being able to source their inventories in a centralised and efficient manner. Unfortunately, the capital markets are far from perfect and there is genuine concern that there will be mismatch between where the high-grade collateral is held and where it is needed. It should read Saheed Awan, global head of collateral services, Euroclear, looks at some of the solutions on offer.

Photograph © Adam Villimek/Dreamstime.com, supplied September 2013.

PIECING TOGETHER THE COLLATERAL PUZZLE INCE THE ONSET of the financial crisis following the collapse of Lehman Brothers and Bears Stearns, collateral (and in particular the use of high-grade securities collateral) has assumed a more prominent role in our capital markets. This change was brought about by two main identifiable factors. One, inter-bank trust evaporated meaning that financial institutions were swept up in the ‘flight to quality’ phenomenon, hoarding their high-grade and liquid collateral reserves. Two, regulators on a global level began the Herculean task of restoring public confidence in the financial sector.

Initial reaction from the banking sector was one that prophesised an uncertain future. A very real concern was that these two developments would result in a spike in demand for high-grade securities collateral that would clash with the on-going sovereign issuance rating cuts, and bring about a mismatch that risked destabilising balance sheets across the globe. However, after an initial period of uncertainty, the true problem affecting the supply and demand for high-grade securities collateral was formally identified— collateral fragmentation.

Prior to the financial crisis, liquidity was plentiful and credit was easily available. Even in situations where it became more difficult to obtain funding through traditional channels, the shadow banking system was able to provide a

S

FTSE GLOBAL MARKETS • OCTOBER 2013

cheap alternative. As a result, financial institutions freely ran their business lines however they chose.

The result, in evidence to this day, is that firms will usually opt for a hybrid solution. Financial institutions with a truly international presence often choose to hold their assets across geographic locations and service providers depending on their business needs. Astute business acumen supported the approach of using a mix of ICSDs, CSDs, local agents and custodians to safe-keep and service assets.

The problem encountered by firms today is that the financial crisis has propagated a movement of the goalposts.

The Basel Committee on Banking Supervision intends to use Basel III to introduce two novel concepts. The first is the Net Stable Funding Ratio (NSFR), which is aimed at achieving the second objective of the Basel III liquidity standards, i.e. promoting longer-term resilience by encouraging banks to fund their activities with more stable sources of funding. The second is the Liquidity Coverage Ratio (LCR), which targets shorter-term resilience by requiring banks to have enough high-quality assets to survive a significant stress scenario that lasts for one month.

In addition, firms are facing a potentially major impact on their business models through the influence of Dodd-Frank in the US and EMIR in Europe. After the onset of the crisis in late 2008, OTC derivatives were identified by regulators as

57

COLLATERAL MANAGEMENT

an unquantifiable and thus unacceptable source of risk. To address the issue, an attempt was made to tackle the problems with one proverbial stone. By requiring the bulk of OTC derivatives trading to occur within the (arguably) safe confines of a risk-averse central counterparty (CCP) serving as an intermediary and risk-centralising agent, governments hoped to quantify and thus exert a degree of control over the risks impacting the capital markets.

The theory seemed sound. However the impact on financial firms is proving far from negligible. The need to support, amongst others, their OTC derivatives activity requires that initial and variation margins be posted at each CCP where a firm is active. CCPs are traditionally risk averse, which is reinforced by regulatory remit, suggesting that the quality of eligible assets they accept as collateral needs to rank in the uppermost echelon of asset classes. Some of the largest CCPs have understood that the strain placed on the securities inventories of firms is increasing, and have already taken steps to relax their collateral eligibility criteria, albeit with high margins for securities such as equities. Nonetheless, it would certainly not be stretching the truth to suggest that firms with fragmented securities inventories face an uphill battle to meet the collateral requirements of the modern-day capital markets.

Making the most of what you have Although the absolute supply of high-grade collateral should be sufficient to address the increase in collateral demand, this theory is dependant on firms being able to source their inventories in a centralised and efficient manner. Unfortunately, the capital markets are far from perfect and there is genuine concern that there will be mismatch between where the high-grade collateral is held and where it is needed.

In a perfect world, securities for use as collateral would be easily tracked, sourced and realigned via a sophisticated and centralised collateral management tool. Collateral shortages in one market would be automatically rectified by moving the required amount of eligible surplus collateral from another.

The need for centralised inventory management to meet an increasing number of cross-border collateral demands has begun in earnest. A new holistic approach to inventory management with coverage across collateral silos and geographic locations is becoming the new norm as capital market participants strive to ensure no asset in their inventories sits idle.

The only way to survive is to make all available capital reserves sweat.

An important aspect of the changing collateral landscape relates to the regulatory changes imposed on the capital markets. Although collateralising exposures is the crux of the issue, the liquidity as well as the quality of the securities used as collateral is also under scrutiny.

The main reason for the focus on liquidity stems from the events that brought about the collapse of one of the biggest investment banks in the world in 2008. At the time when Lehman Brothers needed liquidity, it became almost mythical in its inability to be found. The new liquidity regu-

58

lations are aimed at ensuring these events do not reoccur, but some market experts remain sceptical.

Liquidity regulations require a classification of the various asset classes used as collateral. Regulators, however, have been unwilling to venture too far into this sensitive domain.

Using an example mentioned above in reference to Basel III, the LCR clearly targets the use of government bonds as a prime source of liquidity. But, how are we to differentiate between different government bonds? Are they all equally liquid? Moreover, how do government bonds compare with top-rated corporate debt? How liquid is an AAA-rated corporate bond versus a lower rated government bond?

The same arguments can be applied to the treatment of equities as collateral. Main index equities are highly liquid, but suffer higher risk weightings under most regulatory collateral frameworks. Some collateral takers have excluded them as an asset class altogether. The liquidity of an asset class is key in defining whether or not a security is deemed to be ‘good’ quality collateral. In order to enable clients and collateral service providers to comply with the regulatory demand for collateral, a clearer definition of what is deemed to be liquid seems necessary.

There are a number of ways to assess and haircut the liquidity of a piece of collateral; for example, the quotation age of a security and/or the last date on which the security was traded. Our clients often use this type of information to dynamically adjust the haircut they apply to the collateral they accept. Typically, the further in the past the quotation date, the bigger the haircut and therefore the lower the collateral value of the security. Trading volumes or turnover of the security within a specific time period, in addition to the quotation age, can help further refine the liquidity profile of a piece of collateral.

Regulatory changes require financial institutions and corporations to hold ever-increasing quantities of highly liquid assets on their balance sheets. Indeed firms may hoard these assets for use during periods of duress. From a business perspective, this may create yet bigger problems. Typically, returns on the most liquid and high-quality government bonds are the lowest. Simply holding these securities has a real opportunity cost. In order to compensate for lost revenues, firms may be tempted to take on seemingly lucrative investment opportunities and thus once again expose the financial markets to unacceptable levels of risk.

The potential impact on securities lending In a similar vein, the quality of the collateral for securities loans is also becoming increasingly important. Securities with higher ratings have always been popular with beneficial owners and lenders—second only to cash collateral—as a means of insurance against the default of a borrower. Precrisis, lenders were often willing to compromise on ratings in order to increase their revenues.

Those times are behind us and lenders have resorted to asking for, and getting, more complex collateral schedules as an alternative to receiving highly rated securities collateral to secure their loans. As an illustration of how this complexity

OCTOBER 2013 • FTSE GLOBAL MARKETS

has grown over the past few years, Euroclear’s global Collateral Highway allows users to set their eligibility criteria from amongst 210 different rules (up from 100 rules precrisis) on concentration limits, ratings and a host of other attributes—testament to the fact that risk managers now call the shots at most firms.

This has led to the propagation of the ‘collateral upgrade’ services which have long been a staple of the capital markets.

Most repos are nothing more than an upgrade or a bondborrowing transaction. Under normal market conditions, such transactions happen all the time and in great quantity.

But, what would happen to this business if the markets became distressed?

Lenders may resort to any one, or combination of, the following techniques to help manage and reduce their exposure to risk. They can increase the haircuts on the bonds or equities they take as collateral, effectively making it more expensive to borrow eligible securities. They can also reduce the range of bonds or equities they are willing to accept as collateral. This will make it harder for borrowers to obtain the securities they need, especially if their securities portfolio does not include enough securities that meet the lender’s collateral criteria. And finally, lenders can flat-out refuse to accept new business, effectively shutting off the primary source of high-grade collateral for many banks and financial institutions.

The after-effects of one or all of the above are likely to be considerable. The price of eligible assets for use as collateral may spike, resulting in a squeeze on the market. By refusing to take lower grade securities as collateral, lenders could force banks to sell off ineligible assets to raise cash collateral to pledge in exchange for eligible securities, effectively driving down the price of ineligible assets even further. The most extreme of the possible repercussions would be that some firms close open positions so as to avoid receiving margin calls they know they will be unable to meet.

Moreover, the systemic risk implications of collateral upgrade trades during distressed market conditions are now getting the attention of the regulators—and rightly so. Will they recommend or mandate that securities lending transaction also require a CCP, just as they have done for OTC derivatives? Our guess is that the transparency they seek— through more frequent and regular reporting of transactions like securities lending upgrade trades—will be the first mandatory step in that direction, meaning that central trade repositories for securities lending may well be making their appearance in the not-too-distant future.

Promising and innovative solutions The industry as a whole has been going through an intense period of adaptation and innovation. Triparty collateral management providers with sophisticated systems have expanded their offerings to help their clients meet the requirements imposed by the changing regulatory environment.

One of the first service attributes a firm tends to look for when selecting a provider is the ability to seamlessly track

FTSE GLOBAL MARKETS • OCTOBER 2013

asset positions across geographic locations, ideally in real time. They will also expect their provider to access most (if not all) of their existing pools of assets and automatically move the appropriate assets to be used as collateral to the required locations, i.e. to the collateral takers, in a timely manner, no matter the time zone or geographic location.

Once such a re-positioning of assets is accomplished, firms will also expect their service provider to be able to optimise the use of their collateral. In other words, using the firm’s entire book of available assets to the fullest extent and, when required, performing collateral upgrades, which means turning ineligible assets into eligible collateral. Naturally, collateral optimisation builds on the provision of basic collateral management tasks like daily mark-to-market valuations and securities substitutions to satisfy trading needs.

And finally, firms using third-party collateral management agents will expect top-notch asset servicing capabilities, which include the detection and reporting of upcoming corporate actions on securities used as collateral.

For any firm considering outsourcing this extremely sophisticated business, the largest, most experienced and arguably most secure providers will be the natural first port of call. Unsurprisingly, global custodians will be close to the top of the list for many. Already holding vast securities inventories and boasting two decades of experience in collateral management, the advantages they offer potential clients are obvious.

For those who wish to go one step further, the ICSDs present an even more attractive option. As market infrastructures, they perform roles of such systemic important that one could argue that they are too crucial to be allowed to fail, and thus a safe haven. Both ICSDs can point to extremely high ratings, with Euroclear Bank edging the ratings contest by virtue of its AA+ rating from Fitch Ratings. Euroclear has also attracted liquidity to its global ‘Collateral Highway’, which is based on an open infrastructure model encouraging greater co-operation amongst financial institutions. As an ICSD it is unique in successfully avoiding incestuous ties with a single stock exchange, trading platform or commercial bank, thus benefiting from a perceived neutral status. ICSDs tend to compete primarily with each other, thus ensuring that potential clients of their services need not focus on concerns about potential conflicts of interest.

Firms with international aspirations will inevitably be faced with an important decision at some point in time relating to collateral management. A good first step has already been taken by shifting the focus from concerns about collateral scarcity to managing collateral fragmentation.

From any and all perspectives, the collateral problem is more complex than many had initially thought. The industry successfully resolved the initial disparity between perception and reality, scarcity versus fragmentation, and suggested a theoretical solution requiring heavy investment and expenditure. Implementing the proposed solution necessitated a level of resources high enough to thus far restrict this business domain to a select group of collateral management providers. 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% 3.9 3.3

20.9 20.1 8.3

0.9 5.1 4.7

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

-5.9 -4.7

-2.3 -25.0 -11.2 -5.2

3.0

-2.5

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)

-0.1

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

-4.5 -4.1

1.4 0.5 1.1 1.1

0.0 2.5 10.3

0.7 0.6

FX - TRADE WEIGHTED USD GBP EUR JPY

-2.1

-10

-5

3.6 5.4

2.6

0

6.8

-0.8

0.4

-1.4

65.9

17.3 14.3 23.9 7.1

3.5

8.1

-21.8

5

10

-40

-20

0

20

40

60

80

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

Regions 12M local ccy (TR)

8.3

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

5.9 5.1 4.7 3.9 3.8 3.5 3.3 0.9

0

1

2

3

4

5

6

7

8

9

0

2

4

6

11.2

8.3

5.9 5.7 5.6 4.8 4.8 4.1 3.8 3.6 3.6 3.4 3.3 3.2 2.2 2.0 1.7 1.1 0.9 0.5

8

14.1

10

12

14

6

8

10

30

40

50

60

70

28.7 27.1 25.2 24.9 24.1 23.0 22.7 20.1 20.0 19.6 17.3 15.2 13.8 11.9 11.3 7.8 6.8

65.9

43.8

10 20 30 40 50 60 70 80

Emerging 12M local ccy (TR)

3.0 2.5 1.8 1.6

4

1.4

-10 0

South Africa China Malaysia Taiwan Emerging Thailand Russia India Brazil Indonesia Mexico Chile

6.5 5.9 5.4 5.4 5.2 4.7 4.2

2

20

Developed 12M local ccy (TR)

16

10.3

0

7.1 6.4

10

Japan Finland France Switzerland Australia Spain Sweden Netherlands Developed USA Germany Belgium/Lux UK Italy Hong Kong Denmark Norway Canada Singapore Korea Israel -2.7

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

23.9 22.7 20.9 20.1 17.3 14.3

0

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

65.9

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

12

20.4 14.0 11.1 8.3 7.1 6.5 3.3 2.4 1.3 0.5 -0.5 -9.4

-15 -10

-5

0

5

10

15

20

25

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

60

OCTOBER 2013 • FTSE GLOBAL MARKETS

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MARKET DATA BY FTSE RESEARCH

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World

Global Sectors Relative to FTSE All-World

120

Oil & Gas Health Care Financials 120

110

110

100

100

90

90

80

80

Japan Europe ex UK

US Emerging

UK

Asia Pacific ex-Japan

70 Sep 2011

70 Sep 2011

Jan 2012

May 2012

Sep 2012

Jan 2013

May 2013

Sep 2013

Basic Materials Consumer Services Technology

Jan 2012

May 2012

Consumer Goods Industrials Telecommunications Utilities

Sep 2013

Jan 2013

May 2013

Sep 2013

BOND MARKET RETURNS 1M%

12M%

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

1.4

UK (7-10 y)

-4.5 -4.1

0.5

Ger (7-10 y)

1.1

Japan (7-10 y)

0.0 1.5

0.5

France (7-10 y)

2.5

1.1

Italy (7-10 y)

10.3

-0.1

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

0.9

Euro (7-10 y)

0.9

UK BBB

2.3 4.1 3.6

0.7

Euro BBB

5.4

0.6 0.6

UK Non Financial Euro Non Financial

1.2 3.0

0.5

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

0.9

0.4

-1

0

1

2

-10

-5

0

5

10

15

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

8.00

7.00

7.00

6.00 6.00

5.00 4.00

5.00

3.00

4.00

2.00 3.00

1.00 0.00 Sep 2010

Mar 2011

Sep 2011

Mar 2012

Sep 2012

Mar 2013

Sep 2013

2.00 Sep 2008

Sep 2009

Sep 2010

Sep 2011

Sep 2012

Sep 2013

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

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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

125

125

120

120

115

115

110

110

105

105

100

100

95

95

90 Sep 2012

Dec 2012

Mar 2013

Jun 2013

90 Sep 2012

Sep 2013

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

FTSE US

Dec 2012

Mar 2013

Jun 2013

Sep 2013

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

FTSE UK

FTSE US Bond

175

175

160

160

145

145

FTSE US

130

130

115

115

100

100

85

85

70

70 Sep 2008

55 Sep 2009

Sep 2010

Sep 2011

Sep 2012

1M% FTSE UK Index

Sep 2013

3.3

4

-2

62.4

8.7

33.9

0

26.8

-2.6

0.7

3

2

4

Sep 2013

60.3

-3.2

1.3

2

Sep 2012

2.9

-0.1

1

Sep 2011

5Y%

5.7

0.4

0

Sep 2010

6M% 5.0

FTSE USA Index

FTSE USA Bond

Sep 2009

3M%

0.9

FTSE UK Bond

Sep 2008

6

0

20

40

60

80

0

20

40

60

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

64

OCTOBER 2013 • FTSE GLOBAL MARKETS

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