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F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

ORMCORE MIGHT HAVE street cred right now, but the collective drive towards anti-trends this year is knocking the heart and soul out of the investment market. The Zeitgeist has rarely been so wan. It might be the depressing impact of the return of the Cold War; or the dulling of the investment services markets as it transits from being a commoditised and universal service solution to a more discerning and sophisticated product set. Or, it might be the relentless march of regulation and market directives that is punching the guts out of the old world as it redraws the new financial order. It is clear that everyone (and I mean everyone) is finding it hard to keep up with change and there seems to be a collective sigh that this year marks, not the beginning of the end of change, but rather the end of the beginning. The sheer volume of change impacting on markets right now is revolutionary in both depth and scope. The financial markets of 2017 will be very different to what they are now. While technically safer and more transparent, the global spread of LEIs means that every transaction will be monitored, tabulated, aggregated and any anomalies or concentration of risk will be honed in on and erased. Initiatives such as Target-2 Securities will also transfer trade settlement risk out of the financial markets and into the hefty arms of the European central bank. Along the way, sub custody in Europe will have its heart ripped out; business will increasingly coalesce around those large institution that offer cross-border reach and scale. However, these very same large institutions don’t want everybody’s business anymore; they want business that makes them measurable income from a more sophisticated service set. It begs the question: what will be the impact on the smaller investor? It looks like the future is about control; control of markets, control of risk, and control over the clients that banks will choose to serve. Too outlandish? Look at what is now the prime broking segment: this once catch-all, cutting edge service has now become a business incubator for the type of alternative investment firms that prime brokers have always wanted to serve. I may be old-fashioned but I worry that the effort to introduce safety and cheaper services might take too much of the cut and thrust out of the financial markets. Since the early Middle Ages when financiers sat on their benches (bancos) in city squares in Genoa and Sienna and took the risk of financing merchants that were travelling the Silk Road to Samarkand and beyond, the financing contracts and interest charges they drew up were based on the degree of risk they were prepared to assume. If the merchant was set upon by brigands or worse and their investment tanked well that was life. If they took on too many of the wrong risks, they were forced to take up and break their benches (banco rotto, which over the centuries transmuted into bankrupt) to signify they would trade no more. The many and varied contracts (bonds, leases, convertibles, options) they drew up centuries ago are still the basis of all financial market trades today. It would be shame if the blandness of Normcore came off the high streets of London and New York and settled into the global investment markets. Be safe, be good, but please don’t be bland. Don’t lose the cut and thrust of a daring trade, the well-earned achievement of a hefty return from a high risk deal. This issue speaks to all the trends and initiatives that could and should bring safety and efficiency to the global capital and investment markets. It also looks at the concerns of market makers and their clients about the pace and impact of change. Make up your own minds about the implications.

Francesca Carnevale, Editor COVER PHOTO: Dhaka, Bangladesh, April 19th 2014: Mother and child waiting to be admitted to the International Centre for Diarrheal Diseases Research (ICDDR) camp. In many frontier markets diarrhoea cases have been increasing in recent times due to rising temperatures and a shortage of pure drinking water. A makeshift camp of the ICDDR has been set up in Bangladesh to treat children. Photograph by Zakir Hossain Chowdury for Demoti/Demotix and the Press Association. The photograph has been supplied by pressassociationimages.com, April 2014.

CONTENTS COVER STORY

WATER: MANAGING SCARCE RESOURCES

..........................................................Page 6 The combination of climate change, severe weather events (which are a byproduct of it) and a fast growing global population have triggered a concerted process of planning, engineering work and spending on water infrastructure worldwide. Can the projects meet demand? Lynn Strongin Dodds reports.

DEPARTMENTS

SPOTLIGHT

COUNTING THE COST OF MERGERS & OTHER STORIES ...................Page 14 Topical stories from around the global capital markets.

EMIR TAKES HOLD

MARKET LEADER

.....................................................................................................Page 21 Ruth Hughes Liley reports on the status of EMIR’s implementation.

CHAOS BEFORE THE CALM: EMIR IMPLEMENTATION.......................Page 26 CCL’s Atma Dhariwal looks at the market implications of EMIR implementation.

TURKEY TALLIES THE COST OF A MOVEABLE IR POLICY ...............Page 28 Has Turkey’s central bank governor lost his conservative mojo?

EGYPT: MEASURING THE IMPACT OF NEW INVESTMENT LAW.....Page 30 Why is Egypt’s new investment law worrying local lawyers?

EU MOVES TO IMPROVE FUNDING & INVESTMENT ...........................Page 32

IN THE MARKETS

Explaining the rationale behind the EU’s new mission statement

REG NMS: THE VERDICT’S IN ...............................................................................Page 33 David Simons assesses whether the rule has spurred market competition.

HOW TO SHOVEL QUALITY INTO BANK BALANCE SHEETS .........Page 35 David Simons explains why it is not as easy a process as it sounds.

DIRECTIONAL SHIFTS IN FUND FLOWS INTO RUSSIA

.......................Page 37 Did the government really think its Ukrainian ventures would not have a price?

COMMODITIES

THE IMPACT OF THE UKRAINE CRISIS ON HARD COMMODITIES....Page 40 Vanya Dragomanovich says the market has factored in the crisis.

GATHERING MOMENTUM IN LONDON OFFICE SPACE

REAL ESTATE

......................Page 43

Mark Faithfull reports on the effect of rising provision in London office space.

HUBS STEP UP BATTLE FOR SHARI’A MONEY ..............................................Page 45 Why are financial hubs looking for Shari’a compliant funds?

INVESTOR SERVICES

IBOR, A SINGLE SOURCE OF TRUTH FOR THE BUY SIDE ....................Page 47

DERIVATIVES CLEARING

AVOIDING COLLATERAL DAMAGE ..........................................................................Page 51

Towards an effective definition of an investment book of records.

David Simons on the emergence of global margin standards.

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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CONTENTS DEPARTMENTS

EMERGING MARKET FLASHPOINTS V INVESTOR SENTIMENT......Page 55

ASSET ALLOCATION

Are investors now more sanguine about political risks?

ETP INFLOWS PICK UP PACE ............................................................................................Page 68 Emerging markets ETPs on the rise.

THE BEAR VIEW

NO FOUL, NO HARM ..............................................................................................................Page 57

MARKET TRENDS

SOLID QUARTER FOR EUROPEAN FIXED INCOME ....................................Page 59

The middle ground for the FTSE100.

Tradeweb looks at trading market activity.

CFTC AND THE TECHNOLOGY CHALLENGE ....................................................Page 60

REGULATION

Tyler Petersen reports on the impact of a technology driven financial market.

TRADES UNION QUESTIONS BUDGET CUTS .............................................Page 64 Italy’s pensions fund regulator under fire.

DEBT REPORT

HIGH YIELD STILL OFF PISTE .................................................................................Page 66 Lynn Strongin Dodds reports on lower than expected issuance volumes.

DARK POOL PONDERING ....................................................................................................Page 69 David Simons assesses the impact of the ‘trade at’ rule

TRADING

EMIR & THE DATA DETECTIVES ....................................................................................Page 84 Ruth Hughes Liley assesses the impact of EMIR implementation

THE BUY SIDE TRADING SURVEY ..............................................................................Page 90 The buy side trader comes of age

US REPO

REASSESSING US REPO .............................................................................................Page 71 Is repo still a viable funding and risk mitigation mechanism?

COLLATERAL OPTIMISATION

ROUNDTABLE

........................................................................................Page 73

Managing the cost, mobilisation and velocity of collateral.

T2S: THE COUNTDOWN TO IMPLEMENTATION ..........................................Page 99 In the run up to implementing T2S, a panel of experts assesses the progress of change.

COLLATERAL MANAGEMENT

COLLATERAL SHORTFALL: MOUNTAIN OR MOLEHILL? ...................Page 87

MARKET DATA

Market Reports by FTSE Research ..............................................................................................Page 110

Neil O’Hara thinks the scale of collateral shortfall is nothing to worry about

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

COVER STORY

WATER: AN INCREASINGLY SCARCE RESOURCE?

Nairobi, March 2014. Photograph of residents of Kibera slum in Nairobi, filling buckets with water. Kibera is Kenya’s biggest and poorest slum, with a population of around 1m residents. Most of the houses are wooden shacks with a mud floor and a tin roof, with no toilet or running water. Kibera has two mains water pipelines, one from the municipal council and one funded by the World Bank. Photograph by Thomas Campean for the Anadolu press agency. Photograph supplied by pressassociationimages.com, April 2014.

THE GROWING FIGHT FOR PURE WATER Samuel Taylor Coleridge’s Rime of the Ancient Mariner may describe life at sea but shifting weather and population patterns make it all too relevant today. Many communities will not have ‘any drop to drink’ as agriculture, industry and consumers all try to fish from the same relatively shallow pool. Private and public initiatives are being launched but much more money will be needed to be pumped in to ensure that the global well does not run dry. Are we at the start of a global crisis? Lynn Strongin Dodds asks some uncomfortable questions. HILE EACH REGION will have its own specific challenges, a report by Kleinwort Benson Investors succinctly highlights the important trend: less than 1% of the world’s water is available for use and this restricted supply is increas-

W 6

ingly threatened by pollution and the depletion of aquifers. Overpopulation and increasingly severe weather are also playing a role, leaving half the world’s population to face severe water shortages by 2030, according to a recent National Intelligence Council

forecast. As it is 1.1bn people already lack an adequate supply of clean drinking water while as many as 2.6bn do not have the most basic sanitation facilities. It increasingly looks like a crisis in the making. “The world is entering a period of escalating water scarcity that will likely intensify economic and social instability, as a result of continued growth in the global population and urbanisation rates, challenges in quantifying climatic effects and limitations for future infrastructure investment,” according to Warren Kreyzig, research commodity analyst at Julius Baer. “For example, in 1950, there were 86 cities with a population of over one million inhabitants. This figure now exceeds 468 and the number of people is projected to increase from the current 7.2bn to 9.6bn by 2050.” Convert this to resources and the World Bank estimates water supplies will need to grow by about half in

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COVER STORY

WATER: AN INCREASINGLY SCARCE RESOURCE?

order to meet the projected explosion in population. In many ways, the developing world will be the most affected because the bulk of the additional three million people will live in countries where water resources are already stretched and in cities which are poorly served by water and sanitation service infrastructure. For example, China is on the United Nations list as one of 13 countries contending with the most serious water scarcity. It is home to 21% of the world’s population, but only has 6% of its freshwater and severe pollution has compromised the quality of its water. In addition, a recent report by the National Intelligence Council (NIC) Global Trends 2030: Alternative Worlds states that,“climate change, urbanisation trends and middle-class lifestyles in China will create huge water demand and crop shortages by 2030.” Aside from its economic and public health costs, water scarcity also endangers economic growth. South Asia is also an area of concern as over-exploitation of water resources is being driven by a high—and still growing set of requirements. These include an intensifying population density, massive expansion of hydropower requirements, climate variability, regional political tension, poor water governance and widespread ecological collapse of freshwater systems. Other hotspots include Latin and South America where two thirds of the region is arid or semi-arid, including large swathes of central and northern Mexico, north western Argentina, northern Chile, and parts of Bolivia and Peru. Brazil’s largest city São Paulo, which is due to host the World Cup this summer, has attracted particular notice because its main reservoir slid to 20.9% of its capacity—the lowest level in a decade—after experiencing the hottest month on record in January. Temperatures have remained high as the region transitions into autumn and São Paulo state has not seen any rain throughout the month of April.

“Climate change, and severe weather events, which are a by-product of it, have triggered a process of planning, engineering work and spending on water infrastructure worldwide. Extreme weather events such as hurricane Katrina and Sandy in the US, floods in Thailand and droughts in California and Brazil have led to a new sense of awareness. Governments are now taking the issues much more seriously and water infrastructure has moved up the priority list,” adds Catherine Ryan, portfolio manager of Calvert Global Water Fund, Kleinwort Benson Investors. Sub-Saharan Africa is also on the danger list. It may have a low population density, but it is growing and the region is blighted by endemic poverty, inadequate infrastructure and a largely uncertain climate future. Overall the predominantly trans-boundary river basins in Africa are likely to be strained by the competing forces of agricultural, mineral extraction and hydropower development. The Middle East and North Africa (MENA) are also categorised as high risk by the Water Security Risk Index and map, developed by risk analysis and mapping firm Maplecroft. It shows that six of the 12 Organisation of the Petroleum Exporting Countries (OPEC) members, which include Algeria, Iraq, Kuwait, Libya, Saudi Arabia and the United Arab Emirates, are especially vulnerable. The problems though are not just confined to these regions. Parts of Queensland and New South Wales in Australia have also been struggling with drought conditions hitting alltime records thanks to a combination of low rainfall and high temperatures. In the United States meanwhile, California is operating under a state of emergency as water resources dipped to critically low levels. The health department reported that 17 rural areas were dangerously parched. Against this global backdrop, it is no surprise that water infrastructure has climbed to the top of the agenda. His-

torically, it has not been a major focus for many governments and investment has been sluggish. However, a study conducted by Booz Allen Hamilton showed that a staggering $22trn of expenditure would be required over a 25 year period (2005-2030) to modernise global water and wastewater systems. This is greater than the capital required for power plants, roads, railroads, airports, and seaports, combined. The money would not just be directed towards new projects to accommodate the growing populations of the emerging world but also maintenance of existing resources in the developed world. Take the US. It is the largest per capita consumer of water in the world but its water and sewer systems are crumbling. More than 72,000 miles of water mains are over 80 years old while around 250,000 to 300,000 miles of pipeline break annually. This translates into leakage of about six billion gallons of water each day, a figure equivalent to about 14% of the country’s total daily water usage. The US Environmental Protection Agency (EPA) estimates that the country will need to invest $300bn to $1trn over the next 30 years just to upgrade basic water systems. However, the migration of people from the Northeast, which has slightly more rainfall than other areas, to the dryer region of the Southwest will also necessitate spending into new infrastructure.

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

COVER STORY

WATER: AN INCREASINGLY SCARCE RESOURCE?

“The spend required for water infrastructure has been underestimated but the study by Booz Allen Hamilton shows that it will dwarf all other categories of infrastructure spend, such as rail, roads, seaports and power for many decades,” explains Catherine Ryan, portfolio manager of Calvert Global Water Fund, Kleinwort Benson Investors. “Climate change, and severe weather events, which are a byproduct of it, have triggered a process of planning, engineering work and spending on water infrastructure worldwide. Extreme weather events such as hurricane Katrina and Sandy in the US, floods in Thailand and droughts in California and Brazil have led to a new sense of awareness. Governments are now taking the issues much more seriously and water infrastructure has moved up the priority list,” adds Ryan. Regulators are also playing a role. For example, the European Union launched its Water Framework Directive, a comprehensive and coordinated framework to manage water bodies in

the region and to develop water standards by 2015. China has also introduced 71 national standards for drinking water and established a national inspection network to monitor water quality. Its latest five year plan also includes $71bn of spending on wastewater treatment and recycling as well as a 100% sewage treatment rate by next year. Meanwhile, the EPA in the US is being more proactive on the pollution front by reducing phosphate and nitrogen contamination from agricultural runoff and wastewater effluent as well as trying to regulate contaminants such as perchlorate and chromium-6. Public initiatives and rules though can only go so far. Many governments are strapped for cash and as with other infrastructure projects, they are looking for institutional investors to bridge the funding gap. “There is an enormous need for investments and public funding is just not going to make it,” says Patrick Mullen, principal water and sanitation specialist International Finance Corporation, the financing arm of the World Bank. “Pension and

Archive photo of dried up tea seedlings in Liangnong Town in Yuyao, which is in China’s Zhejiang Province last August. High temperatures and scarce rainfall over a two month period resulted in severe damage to agriculture and water shortages for the region’s 417,000 population. Photograph by Wang Dingchang for the Xinhua/Landov news agency. Photograph supplied by pressassociationimages.com, April 2014.

private equity funds are interested but the main challenges are whether the tariffs and regulatory frameworks are in place. Political risks can also be a problem and that impacts investments. For example, adjusting tariffs to meet cost recovery targets during an election season can be sensitive. That is why having an independent regulator in place is crucial.” The IFC is involved in a range of projects throughout the water cycle. These include loaning $11m and acquiring a $15m equity stake in Philippine based Manila Water, a new water and wastewater services firm as well as providing a $70m loan to China Everbright International, an investor and operator in environmental friendly businesses, to build three water plants in China. The IFC was also involved in raising additional finance along with WLR China Energy Infrastructure Fund and existing investors US-based RNK Capital and Austria’s Gamma Capital Partners for Hungarian wastewater treatment specialist Organica Water. The preferred route though for pension funds and other institutions to tap into water is through the listed market where there are at least 400 public companies worldwide operating in this space, with a combined market capitalisation of over $1trn. In general, there are four main sectors garnering the most attention—water treatment, management, infrastructure and supply as well as water friendly energy companies. The latter are involved in wind, solar and geothermal energy, coproduction of energy and water, combined power and desalination plants, alternative water sources for thermal power plant cooling, and energy recovery from sewage water. “Buying directly into water infrastructure is more difficult because most of the assets are in municipal, state or regional hands,” says Andreas Fruschki, portfolio manager of AllianzGI Global Water Fund which launched in 2008 and has $303.2m assets under management (AUM).

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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COVER STORY

WATER: AN INCREASINGLY SCARCE RESOURCE?

“Most countries have not privatised their water resources. Investors can, however, get exposure to the water theme, long term predictable cash flows and low volatility by investing in companies that operate or maintain water infrastructure, or that manufacture products needed for water supply such as water pumps, filtration or desalination equipment.” Simon Gottelier, water specialist at Impax Asset Management, whose water fund has AUM of $800m,believes there are four underlying trends that are creating long term investment opportunities.“They include urbanisation in emerging markets and the rising middle classes, under investment in infrastructure in the developed world, increasing regulatory oversight and changing weather patterns. All our investments are in quoted companies and we break them down into three categories: water infrastructure, treatment and utilities. The main attractions are forecastable cash flows, strong dividend yields and performance. Since our inception five years ago ending November 2013, we generated annualised returns of 19% which were 4% higher than the 15% of the MSCI World Index.” Clearly, investments in the water sector are delivering enhanced returns. That is the case too for the Kleinwort Benson Water Fund (sub advisor to the Calvert Water Fund), which has $1.3bn in assets under management, which its fund manager says has outstripped some major index benchmarks over the last decade.“Investors look at water as an alternative and consistent source of alpha in a global equity portfolio,” says Ryan.“It is a nice liquid and transparent way to invest in the global infrastructure story.” The Calvert fund which has a global mandate focuses on companies that produce pumps, pipes, plumbing products and valves for infrastructure projects as well as water utilities because they stand to gain from rising demand for these infrastructure improvements, consolidation of

Many governments are strapped for cash and as with other infrastructure projects, they are looking for institutional investors to bridge the funding gap. “There is an enormous need for investments and public funding is just not going to make it,” says Patrick Mullen, principal water and sanitation specialist International Finance Corporation, the financing arm of the World Bank. smaller utilities and the growing trend for municipal facilities to outsource operation and maintenance to private service providers. Technology companies are also firmly on its radar screen ranging from those that manufacture testing and measurement solutions to meet the more onerous regulatory requirements for higher water quality to advanced desalination and wastewater treatment processes. Desalination in particular is creating a great deal of buzz with studies projecting it could become a $41bn industry by 2025. Although many funds have these companies in their

portfolios, they have also sparked the imagination of private equity firms. The most recent example is Blackstone which hired two IFC employees, Lars Thunell, the IFC’s former chief executive and Usha Rao-Monari, who most recently oversaw the development agency’s investments in clean water and wastewater treatment projects to launch the Global Water Development Partners. The firm says it plans to invest”hundreds of millions of dollars” to build facilities that would convert salt water into fresh water and treat wastewater for industrial users in Africa, Asia and Latin America. I

FACTS ABOUT WATER • There’s roughly 326m cubic miles of water on earth says the US Geological Survey; but 97% of that is salt water. Of the remainder, 70% is frozen in the polar ice caps; the rest is present either as soil moisture or in underground aquifers. The global volume of stored groundwater is not known. • Today, groundwater sources provide as much as 20% of supply, much of it non-renewable. Worryingly, this share is rising fast, particularly in dry areas. • Irrigation uses up 67% of global water consumption, industry 11% and domestic use accounts for 22%, according to the UN’s 2012 World Water Development Report. • Water scarcity can roughly be divided into two categories: Apparent scarcity exists when there is plenty of water, but is inefficiently and wastefully used; real scarcity is caused by insufficient rain-fall or large populations depending on a limited resource. • UNESCO defines a nation’s water foot print as the total volume of freshwater, in both green (food) and blue (other goods and services) production. • The 10 largest water users (in volume) are India, China, the United States, Pakistan, Japan, Thailand, Indonesia, Bangladesh, Mexico and the Russian Federation according to the UN’s 2009 World Water Development Report.

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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SPOTLIGHT

MEASURING THE COST OF POST M&A INTEGRATION

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Firms underestimate post-merger costs Remark survey says 14% of deal value is spent on integration, thereby undermining the value-add of some mergers/acquisitions. &A IS BACK on the corporate agenda to help deliver growth and expansion, however, corporates around the world are finding that they have underestimated the costs and resources needed to complete a successful integration. While the integration phase of a deal may never grab the headlines, it is in many ways, the only way to properly evaluate the outcome of a deal, according to a new survey by sponsored by consulting firm EY and conducted by Remark, the market research division of the Mergermarket Group. Remark spoke to 200 firms involved in an M&A transaction over the past two years that had an enterprise value in excess of $450m. The company list was then filtered to include only firms with annual revenues of $800m or above. The right combination: Managing integration for deal success, a survey of senior corporate executives involved in the deal integration process, found that,

based on their most significant deals in the last 12 to 24 months, companies on average spent 14% of total deal value on integration. The average deal size for disclosed transactions in 2013 was €256m according to Mergermarket data, which suggests that the integration costs per deal averaged at €36m. However, while on the whole the survey results suggest companies are doing a good job of allocating resources to integrate functions, there is evidence that they are not spending enough on their integration budget. Over a fifth of those surveyed stated that, in retrospect, they would have increased the size of their integration budget. Of the respondents who had a budget of 10% of deal value, 38% said they would have increased their budget by up to 5% in hindsight. Companies may also be underestimating staffing requirements, with only 4% using 16 or more staff on their integration team, and 46% using fewer than ten people. According to Michel Driessen, UK and

Ireland head of Operational Transaction Services at EY: “Whether the reasons for a deal were geographic growth, diversification or market share, companies need to strike the right balance between budget, time and team size. This is even more important, as the right sequence of a transaction process is a mystery to many companies. If the integration process is done well, it can help businesses grow and succeed. However, if it’s done badly, it can result in significant loss of value.” Just 21% of executives identified acquiring skills and talent as a factor for undertaking their last major transaction. None of the respondents ranked it as the most important reason for a deal. The low priority placed on bringing in key people through M&A stands in contrast to the notion that in order to remain competitive and successful businesses need to win the “war for talent”. Respondents see bringing in new, talented staff as an“added bonus” of a deal rather than an underlying strategic driver. “Operating in a new market may require skills and local knowledge that the acquiring company lacks. Companies may need to place more emphasis on the talent that they are acquiring, and in particular put in place the resources to secure the commitment of individuals that are essential to the organisation’s future success. Without the right skills in place, a company could struggle to achieve its primary M&A goals, whether these are growth, geographic expansion or R&D,” adds Driessen.

Back office on the backburner Sales and marketing integration was the function identified by most executives as the key consideration for their last major deal, with 29% saying it was their integration priority, followed by operations (27%) and R&D (24%). However, back office functions such as finance (9%), human resources (7%) and information technology (6%) were ranked in the bottom three positions. “Executives are more interested in growth and less interested in cutting

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

SPOTLIGHT

DFSA ISSUES SCAM ALERT

costs and synergies. It is important, however, to recognise that organisations typically expect finance, HR and IT to be integrated as a matter of course,”explains Driessen, adding:“The successful integration of sales and marketing, which is linked to upside growth, is less certain and therefore more likely to be at the forefront of an executive’s mind. However, a failure to integrate back office functions can make it impossible to achieve other integration goals.” IT ranks as the top integration priority for just a handful of executives, however, more than a fifth end up allocating the top proportion of time and money resources to IT integration. This suggests that IT is under-prioritised in the integration process, and because of this, executives end up spending more on it than anticipated.”

Dubai’s DFSA issues scam alert Photograph © Skyfall/Dreamstime.com, supplied April 2014.

any financial products or services; furthermore, it is not located in the Dubai International Financial Centre (DIFC); and is not a DIFC incorporated company. The DFSA strongly advises that you do not contact ‘AlphaLeo Capital’, and under no circumstances should you send the firm any money.

BNY Mellon automates ETF related collateral calculations Automation and commoditisation will become key features of collateral management

Lessons learned

Regulator warns of impersonation of a DFSA licensed firm

The survey results suggest the best integration processes involve defining a clear rationale for the deal from the outset and ensuring that rationale set the agenda for the integration strategy accordingly. Following the integration, 45% of respondents said they conducted integration audits. Codifying past integration lessons and best practices was listed by 41%. If given the chance to do their last deal again, executives would integrate deals faster, improve communications and introduce a second wave of integration. Some 80% said they would have quickened the pace of integration, 62% would have introduced a second wave of integration, while 58% of acquirers would have communicated integration progress to their stakeholders. “Despite companies becoming better at acknowledging the importance of a coherent integration strategy and learning from prior experiences, improvements still need to be made. Corporates need to assess their integration budget and staff requirements more carefully as well as putting greater value on the importance of IT in the process,” says Driessen.

HE DUBAI FINANCIAL Services Authority (DFSA) has issued the following alert about a scam in which the scammers use the name, ‘AlphaLeo Capital’, and have established a fake website using the name alphaleo-capital.com/about.html. The name used is similar to that of a genuine DFSA regulated company, called AlphaLeo Capital Advisors Limited. However, AlphaLeo Capital Advisors Limited does not have a website. The DFSA is concerned that the scammers have deliberately stolen the identity of a genuine DFSA licensed Firm, and created a fake website, without authority and for a malicious purpose. On the website, ‘AlphaLeo Capital’ claims to be licensed by the DFSA to offer an “umbrella service” covering a range of financial products and services. The DFSA has asked that we inform the market that the claims made by ‘AlphaLeo Capital’ on its website are false and misleading. The DFSA does not authorise firms to provide an “umbrella service”;“AlphaLeo Capital” is not licensed by the DFSA to provide

HEY SAY IT is about efficiency and reliability and it may well be, but the fact of the matter is that as collateral management (including collateral optimisation and collateral transformation) become part of the mainstream, expect more banks to announce initiatives around the electronification of the calculations involved in collateral utilisation and, ultimately mobilisation of that collateral. At the end of the day automation and commoditisation will help cap the frictional costs involved in specialist or complex collateral management programmes. In late March BNY Mellon announced it is automating the calculation of collateral requirements in the exchange-traded funds (ETF) marketplace. The enhancement is designed to reduce errors in ETF transactions and improve the ability of Authorised Participants (APs) to manage and allocate funds. The primary market in ETFs is driven by APs which are large financial institutions/broker dealers that trade the underlying securities during the creation or redemption of ETF units. The bank has developed an automated process for calculating collateral requirements and reporting them to the APs on a daily basis. Prior to this enhancement, the APs were notified

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

through a manual process that was not as efficient as the new automated system. This additional functionality is a value add to the bank’s ETF Center offering, which is a global technology platform designed to serve the needs of APs on both the web and mobile applications.“More efficient and automated transactions will further enhance the reliability and attractiveness of the ETF marketplace,” holds Joseph Keenan, head of global ETF services for BNY Mellon. “Authorised participants that work with BNY Mellon will have better reporting and better management of the cash collateral they employ in the marketplace.” With many funds, APs have the option of delivering a basket of securities or cash collateral to an ETF servicer (for example, BNY Mellon) when creating new ETF fund shares. By posting cash collateral on the settlement date of an ETF order, APs can ensure that the ETFs shares are released in a timely manner even if some components of the ETF basket cannot be delivered by settlement date. The collateral remains in the ETF servicer’s account until delivery of the components of the basket covered by the collateral.

DTTC survey highlights systemic risks Financial firms increase spending on risk mitigation ESPITE AN APPARENT ease in fears of a systemic risk event happening in the next 12 months, a recent survey conducted by the US Depository Trust & Clearing Corporation (DTCC) shows that a vast majority of financial firms have increased spending on systemic risk mitigation. The DTCC Systemic Risk Barometer, a survey now in its second year, measures the financial industry’s sentiment on significant and emerging trends that impact the “safety,

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

Top 5 market risks to the firm The financial industry focuses on managing systemic risk Major compliance/governance event Distruption failure of market participant Significant business continuity event Cyber security Impact of new regulation 0

2014%

2013%

Top 5 risks to the broader economy Fears over recession begin to recede, failure of individual firms still a worry though Liquidity risk Disruption/failure of key market participants US recession Cyber security Impact of new regulation 0

2013%

2014% Source: DTCC, April 2014

resiliency and continued sustainability of the global financial system”. The Barometer analysed information provided by 218 respondents including broker/dealers, banks, service bureaus, mutual fund companies, hedge funds and insurance companies. This year, the survey was further extended to regulators, academics and members of research organisations globally. Only 9% of this year’s survey respondents, compared to about 37% in 2013, said they believed the occurrence of a highimpact market event in the next year to be “likely.” “Even though concerns about a near-term destabilising market event appear to be abating, it is gratifying to see that this has apparently not translated into complacency and that the industry is becoming more diligent about protecting itself from such occurrences. Of the individuals we polled, 70% reported that their firms had committed more resources into systemic risk management activities over the past 12 months. This trend might indicate that systemic risk protection is

becoming firmly embedded in corporate culture and standard business practices,” says Michael Leibrock, DTCC Chief Systemic Risk Officer. Estimated budgets for systemic risk mitigation ranged from less than $1m, for 36% of respondents; to $1m-$5m for 35%; to more than $5m for 29%. No individuals reported that their firms had decreased spending. Moreover, 63% of respondents classified their firm’s ability to identify, assess and manage emerging risks as “developing” and 33% ranked their firms as “mature.” Respondents ranked the impact of new regulations and cyber security as the first and second most relevant to their firms. The ranking did not change materially from the 2013 survey. When asked to rank the top risks relevant to the broader economy, the findings were similar, with though liquidity risk clearly continues to be a concern.“Our biggest challenge is all the industry and regulatory initiatives and their close due dates. We are addressing internal processes and re-evaluating resources,”

SPOTLIGHT

HONG KONG PLANS SUKUK ISSUE

noted one respondent. Another explained that:“Working hard to ensure excess liquidity is available and actively monitoring counterparty risk and exposure levels. We are also spending significant time and energy trying to make sure we are complying with regulatory requirements, and further documenting and enhancing procedures to provide comfort to auditors and examiners.”

Crimea’s banks in no man’s land?

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Is there scope for Russian banks to enter Crimean market? OME RUSSIAN BANKS are interested in expanding their business into the Crimea, Russian newspaper Kommersant reported, citing unnamed government sources. The paper suggests that Bank of Moscow (BoM), a unit of the majority state-owned VTB, the country’s second-largest bank by assets, is the most likely bank to open branches on the peninsula, probably through its subsidiary. Currently, 70 banks with offices and branches in the country are registered with the Ukrainian central bank. Most of those banks have seen their operations suspended, with repercussions for proUkrainian individuals and firms wanting to relocate out of the Crimea and local businesses seek cash flow support.“One

of the problems that individual and firms with accounts in Ukrainian banks are finding is that they cannot get access to their accounts,” states HIS banking economist Antonio Timoner Salva.“This follows reports earlier this week that the pro-Russian de-facto regional government of Crimea plans to create a central bank for the peninsula, using Bank of Moscow as a basis [sic], and to form a treasury on the basis of Simferopol’s Chernomorskiy Bank of Development and Reconstruction,”he adds. Timoner Salva suggests the halting of operations in Crimea could have come at the “urging of the National Bank of Ukraine, the central bank, which would no longer see itself able to exercise its supervisory and regulatory powers, including the traditional ability of central banks to offer liquidity discount windows or guarantee bank deposits. Cash shortages were reported as being among the main motives for Ukraine’s biggest bank, PrivatBank, to suspend its activities on the peninsula. It signals the retreat of Ukrainian interests in the Crimea.” While the move is a logical step, Timoner Salva believes it provides an opportunity for local pro-Russian authorities to occupy the supervisory and regulatory void, eventually contributing to the definitive exit of Ukrainian banks from Crimea. Russian and domestic news sources have quoted Crimean deputy premier Rustam Temirgaliyev as saying that the peninsula’s authorities will have fully established a local banking system by mid-April, and in the same month will officially drop the Ukrainian hryvnia as its currency in favour of the Russian ruble. The Russian government has also signaled that it will support Crimea financially and provide it with the infrastructure to integrate into the Russian financial system. It is unlikely, adds Timoner Salva that Russian banks would be willing to enter a regulatory void and if they move to gain a foothold in the Crimea it will “be because they are confident of central bank supervision and regulation.”

However he cautions that there is some doubt over the willingness of Bank of Moscow to enter the market or simply assist in the formation of Crimea's banking system. Major Russian banks VTB and Sberbank recently halted operations in Ukraine and it is not certain yet whether they will resume services in Crimea through a separate subsidiary. Meanwhile in late March the head of Sberbank, German Gref, said the bank was not planning to leave Ukraine.

Hong Kong’s planned Islamic bond Legislative body changes ordnances to allow Shari’a compliant issues ONG KONG IS moving now with plans to enable an Islamic bond (a Sukuk) to be issued through its Government Programme. (Please reference the Shari’a financing story by Mark Faithfull on page 47.) At the start of April, Hong Kong’s Legislative Council gazetted an ordinance to amend the Loans Ordinance so that monies raised through alternative bond structures can still be treated as money borrowed by the government and can be credited to the existing Bond Fund. According to Davide Barzilai, partner and Asia Pacific Head of Islamic Finance, Norton Rose Fulbright: “This step was anticipated and means that the Government can move forward with its plans to issue a Sukuk. The process will involve working with a suitably experienced financial institution to ensure that a suitable structure is fixed which will include identifying suitable assets which will underpin the issuance. Once that process is completed, it should just be a matter of market conditions as to when marketing would commence. We are hopeful that this can be achieved without material delays.”

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

Accessing Russia 2014 Market intelligence for the smart investor May 15th 2014

Join the discussion on May 15th 2014 at the Fishmongers’ Hall, London Bridge, London EC4R 9EL

The Accessing Russia Seminar is now in its fourth year, providing an invaluable insider’s guide to trading and investment in the Russian market. You will meet with the market’s leading broker-dealers, exchanges and trading venues, investors, corporations and post trade services institutions and learn the best ways to accomplish your trading and investment strategies in the Russian market. The tight panel driven format of the seminar minimises the time spent out of the office and maximizes the market intelligence you can gather from experienced and expert market practitioners. Audience interaction is encouraged and you will have plenty of opportunity to network with market makers and leading firms.

Among the topics discussed at this year’s seminar: • • • • • • • • • •

How has the crisis in the Ukraine impacted on trading volumes and trading strategies of seasoned investors and trading desks active in the Russian market? Why is Russia still a good investment story? What innovations are driving the new Russian securities markets? What are the most efficient avenues to access Russian stocks? Which securities are being swept up by foreign investors and why? How can your Russian trades be executed more efficiently and cost effectively? How should you minimize your market risks? How can technology and market innovation help you get the best out of the Russian capital markets? Where is the fight for new business and new investment opportunities taking place? Who’s winning it? Which brokers can optimise your trading experience and why?

Keynote speaker: Mattias Westman, Founding Partner, Prosperity Capital Management

To find out more please call Adam Benchehou at [44] (0) 207 680 5163 Or email: accessing russia@berlinguer.com You can also find more information on our events at http://www.ftseglobalmarkets.com/events/ftse-gm-events.html

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SPOTLIGHT

FALL OFF IN EM DEFAULTS

Moody’s Interfax rating actions

Photograph © Layilister/Dreamstime.com, supplied April 2014.

Ratings agency review NSRs, with FGC UES on review for downgrade OODY’S INTERFAX RATING Agency has taken multiple national scale rating (NSR) actions on Russian utility companies. Moody's Interfax has placed on review for downgrade the Aaa.ru NSR of FGC UES, JSC. The agency affirmed the Aaa.ru NSR of OAO AK Transneft and Atomenergoprom, JSC, the Aa1.ru NSRs of Russian Grids, JSC, RusHydro, JSC and Inter RAO, JSC. Moody's Interfax also affirmed the Aa2.ru NSRs of five rated distribution grid subsidiaries of Russian Grids, including IDGC of Center and Volga Region, JSC, IDGC of Urals, JSC, IDGC of Volga, JSC, Lenenergo, JSC, MOESK, OJSC. Moody's Interfax is majority-owned by Moody's Investors Service (MIS). The rating actions on the NSRs of the Russian utility companies follow the recent rating actions on their global scale ratings (GSRs) by MIS. Moody’s placed the Baa1 issuer rating of Transneft, the Baa2 issuer rating of Atomenergoprom and the Baa3 issuer rating of FGC UES on review for downgrade; the agency affirmed the Ba1 corporate family ratings (CFRs) of Russian Grids, RusHydro and

Inter RAO as well as the Ba2 CFRs of IDGC of Center [sic] and Volga Region, IDGC of Urals, IDGC of Volga, Lenenergo, MOESK. The GSR rating actions follow Moody’s placement of Russia’s Baa1 government bond rating on review for downgrade at the end of March. The affirmation of Transneft’s and Atomenergoprom’s NSRs reflects Moody’s expectations that the companies will most likely maintain their investment-grade global scale issuer ratings despite the current review of these ratings for downgrade. The review for downgrade of FGC UES’s NSR is in line with the review for downgrade of the company’s global scale issuer rating. If the latter were to be downgraded as a result of the review, FGC UES’s NSR would be downgraded as well.

Fall off in EM defaults

Photograph © Mike_kiev/Dreamstime.com, supplied April 2014.

S&P study says overall credit environment remains stable ESPITE THE HIGH volatility in emerging markets during 2013, the region’s rating stability and credit quality were relatively unchanged from 2012, and defaults decreased, according to the 2013 Annual Emerging Markets Corporate

Default Study And Rating Transitions report by Standard & Poor’s Global Fixed Income Research. “In 2013, the number of defaults in the emerging markets declined to 16 from 24 in 2012,” explains Diane Vazza, head of Standard & Poor’s Global Fixed Income Research. “This brought the emerging markets corporate default rate for all rated entities to 1.08% in 2013, down from 1.41% in 2012. The emerging markets corporate speculative-grade default rate also fell, to 1.96% in 2013 from 2.56% in 2012.” Defaults in the emerging markets accounted for 20% of the global defaulters by issuer count. In our 17-year history of tracking emerging markets defaults, this share has been more than 20% in only three years: 1998, 2002, and 2012. Standard & Poor’s study found a clear negative correspondence between ratings and defaults: The higher the issuer rating, the lower the observed default frequency. We measure this correspondence with movements in Gini coefficients. Among rated corporate entities based in the emerging markets, the one-year Gini coefficient was 83.33% in 2013, which is higher than the 32year global average of 82.27%. Moreover, the Gini ratio for emerging markets has steadily improved during the past six years. The period is also associated with a larger number of defaults in the region, says the report, with the implication that the majority of emerging markets defaults in recent years have come from the lower rating categories. This metric is based on ratings one year prior to default and not immediately preceding the default. Gini ratios measure the rank-ordering power of ratings over a given time horizon and show the ratio of actual rank-ordering performance to theoretically perfect rank ordering. If corporate ratings were perfectly rank ordered so that all defaults occurred only among the lowest-rated entities, the Gini coefficient would be 100%. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

MARKET LEADER

EMIR TAKES HOLD Europe’s post-trade landscape is being redrawn.US traders already have to centrally clear all their OTC and exchangetraded derivatives, and soon it will be Europe’s turn. Right now, the spotlight is on clearing and in March, NASDAQ OMX became the first organisation to be granted official central counterparty status by the European Securities Markets Association (ESMA). More authorisations will follow in the months ahead until the start date for the obligation to clear, now expected to be in 2015. Ruth Hughes Liley reports. S NEWS FILTERED through that NASDAQ OMX Clearing, the Stockholm-based multiasset clearing house received approval for its application as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), it became clear that the allimportant second step towards central clearing of most derivatives in EU markets has now been taken. The implementation of EMIR in Europe (rather as Dodd Frank has done in the United States) follows the decision by the political leaders of G20 in 2009 to mandate central counterparty clearing of OTC derivatives in order to help mitigate the systemic risk in the financial markets and increase stability. No sooner had NASDAQ OMX received authorised than questions were raised about whether trades would have to be ‘frontloaded’ into the system between now and the clearing obligation date. Richard Metcalfe, director of regula-

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

tory affairs, Investment Management Association (IMA), believes the system is being implemented from the bottom up as the industry works out which products are possible to clear and then ESMA will take the final decision.“It is going to take a little while. For example, if a clearing house is offering clearing in the same products that OMX is clearing, will they be subject to the same obligation?” Even so, the industry in Europe is more comfortable with the new market structure, according to UBS’s fourth annual OTC survey, published in March. It found 43% of European market participants have already started clearing ahead of the legislation and most are expecting to start clearing before the end of the year. How the clearing houses will relate to one another has yet to be ironed out, unlike in the cash equity space where traders have freedom of choice about where to clear. Under MiFID II,

DERIVATIVES CLEARING IN EUROPE TAKES SHAPE

Photograph © Trifon Kolev/ Dreamstime.com, supplied April 2014.

exchanges are allowed to delay ‘open access’ to their infrastructure and keep their vertical silos, where clearing is offered on the same exchange as trading, until up to 2018. John Wilson, global head of OTC Clearing at Newedge, one of the world’s largest derivatives brokers, says: “It is the case that the incumbent CCPs are not interoperating because of claims they make about the systemic risks involved if they connect. Also, they prefer not to interoperate because that helps enshrine their leading position while interoperability helps new entrants. Yet in the event one major clearing member firm were to default, it would mean simultaneous default at multiple CCPs because of the commonality of membership of clearing houses. Regulators need to think about a scenario where all CCPs might experience a member default against a backdrop of market turmoil.” Meanwhile the exchanges and central counterparties who are reapplying for their jobs as official CCPs are trying to outdo one another in their OTC client offerings as they prepare for the legislation. The two largest derivative clearing houses, Eurex Clearing and LCH Clearnet are both now offering clearing of certain OTC trades. In January, EurexOTC Clear, the CCP service for interest rate swaps, began onboarding 120 buy-side firms and 32 clearing members. Indeed, OTC swaps clearing looks like a new source of revenue for the exchanges and their siloed clearing houses. The UBS survey found that 29% of participants in the survey were more likely to direct their business to the futures markets because of lower capital margin costs. The survey states: “We believe capital/margin requirements for cleared swaps are in excess of two times what is found in related futures markets today, as initial margin for swaps is based on a 5-day liquidation period (vs one day for futures). Requirements for uncleared OTC contracts will likely be another multiple, with the Basel/IOSCO framework

MARKET LEADER

DERIVATIVES CLEARING IN EUROPE TAKES SHAPE

John Wilson, Global Head of OTC Clearing at Newedge. “It is the case that the incumbent CCPs are not interoperating because of claims they make about the systemic risks involved if they connect. Also, they prefer not to interoperate because that helps enshrine their leading position while interoperability helps new entrants. Yet in the event one major clearing member firm were to default, it would mean simultaneous default at multiple CCPs because of the commonality of membership of clearing houses. Regulators need to think about a scenario where all CCPs might experience a member default against a backdrop of market turmoil,” says Wilson. Photograph kindly supplied by Newedge, April 2014.

calling for initial margin to cover 99% of ten-day price movements.” Whether listed or OTC, technology will be key to providing flexibility, enabling firms to respond quickly to margin calls and allowing easy segregation of client collateral. Firms will choose clearing members with good technology and industry spending on technology is set to rise to more than $100bn according to analysts Ovum, making up for post trade underfunding they found 18 months ago.

Counting the cost Central counterparty clearing is expected to put up the cost of doing business as more and higher quality collateral will be demanded by CCPs for all OTC trades. Many bilateral

trades did not need to provide upfront margin before; plus, Basel III rules require banks to have higher capital to cover risk. Auditors PwC estimates that the funding gap could be as high as €262bn. TABB Group’s director of fixed income, Will Rhode, estimated at the end of March that buy-side firms will need to deposit around $2trn in cash and other eligible assets at CCPs to comply with the new clearing requirement for swaps in the US alone. Collateral optimisation will be the name of the game, as Rhode says: “Capital is a scare resource that cannot be squandered by overestimating a margin call. Efficient collateral usage will become an integral growing factor in a firm’s investment and hedging strategy as improved risk analytics come of age.” As firms face the challenge of managing two parallel streams of exposures for cleared and uncleared collateral trades, spotting a business opportunity, CSD firms are stepping up to the plate and offering clients collateral management services, such as Clearstream’s OTC Collateral, which offers contract administration, mark-to-market, margining, dispute management and portfolio reconciliation, among other things. Collateral transformation, where government bonds are quickly turned into cash and repo-ed out for variation margin, is another growth area. Metcalfe says:“We might see repo and collateral converge.” As for quad-party agreements where a buyer and seller access assets from a custodian through a CCP, Wilson says: “Quad is dead, long live tri. The idea fell over because it was predicated on the custodian saying they would hold the assets and give them up if requested. But there is mistrust over whether we as clearing firms would get the same rights as when we had possession of the assets. There are some excellent innovations from CSDs and triparty repo framework is an infrastructure we have been pioneering.” While some say the reported “collateral crunch” has been wildly

Guido Wille, Clearstream’s head of market development and executive vice president, says: “At a European level, T2S will harmonise settlement, make it more efficient and bring costs down, which is a clear goal for everyone.” Photograph kindly supplied by Clearstream, March 2014.

exaggerated, Metcalfe says: “There will probably be a shortage, assuming firms continue to use derivatives to the same extent. Some investors may view this shortfall as an opportunity to lend securities, boosting the return on them.” Wilson agrees:“Collateral is going to be the new asset class. This is where institutional investors will be looking to get yield enhancement and demand efficiencies in how collateral is managed and in doing so create a twoway flow by market participants using collateral. Asset managers have assets, but no cash for variation margin because they are fully invested, so there will be greater flow in the direction to people who want to post initial margin and who want to place collateral. It’s a fascinating new market. Newedge is pioneering an agency cash and collateral management (ACM) platform. It’s a multi-party trading venue supporting this radical shift in the market.” Higher capital requirements, fears the UBS report, will also force some participants out of the market as consolidation occurs, leaving fewer players. Wilson believes the proliferation of CCPs will contract “enormously”. “There simply isn’t the volume for

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MARKET LEADER

DERIVATIVES CLEARING IN EUROPE TAKES SHAPE

TABB Group’s director of fixed income Will Rhode. TABB estimated at the end of March that buy-side firms will need to deposit around $2trn in cash and other eligible assets at CCPs to comply with the new clearing requirement for swaps in the US alone. Collateral optimisation will be the name of the game, as Rhode says: “Capital is a scare resource that cannot be squandered by overestimating a margin call. Photograph kindly supplied by TABB Group, April 2014.

them all to service and make money. That presents a challenge because you have to make a calculated guess as to which to connect to or connect to them all at substantial expense. Also where are all these risk management expects coming from? The OTC market is cross border so people should connect internationally rather than corale domestic participants into their own national CCP.” Indeed, the post trade world is fragmented along national lines in Europe, but in the settlement of securities space, Europe has just embarked on testing its new pan-European settlement system Target2-Securities. This massive project (to give some sense of scale involved in the project, transactions worth more than one quadrillion euro were settled by CSDs in the past two years)will bring all of the fragmented European CSD securities pools together, it will be an opportunity to pool collateral. First off the blocks in June 2015 will be Bank of

Greece Securities, Malta Stock Exchange, Depozitarul Central Romania, Italy’s Monte Titoli and SIX SIS Switzerland. The second wave will follow in March 2016, third in September 2016 and the final wave in February 2017, by which time all settlement will take place regardless of national borders in Europe. The ECB, which is driving the project, promises it will cut settlement costs and foster economic growth. Guido Wille, Clearstream’s head of market development and executive vice president, says: “At a European level, T2S will harmonise settlement, make it more efficient and bring costs down, which is a clear goal for everyone.” Wille says his firm has identified and developed services for additional T2S benefits to the market, such as more efficient collateral management via access to Clearstream’s Global Liquidity Hub, its collateral management engine.“This helps customers optimise their use of collateral cross-border, as well as the best of both worlds, namely settlement via our T2S offering either in central bank money via our CSDs, or in commercial bank money via our international CSD.” In the short term, there are huge implementation costs. Last September, SIX Securities Services found that 68% believed T2S would increase settlement costs in the short term. Longer term, although auditors PwC, commissioned by Clearstream, found in August 2013 that banks would save up to EUR 33bn, the industry is sceptical, as only 38% in the SIX survey believed costs would fall long term. In contrast, all respondents believed T2S will help their firms optimise collateral management as T2S goes beyond the settlement layer, effectively decoupling settlement from asset servicing. In this regard, in March, Clearstream, announced a T2S asset servicing partnership model allowing customers to settle in commercial central bank money on the T2S platform via Clearstream, and benefit from domestic asset servicing through the firm’s

Richard Metcalfe, director of regulatory affairs, Investment Management Association (IMA). Metcalfe believes the system is being implemented from the bottom up as the industry works out which products are possible to clear and then ESMA, the European Securities Markets Association, will take the final decision. He rightly asks: “It is going to take a little while. For example, if a clearing house is offering clearing in the same products that NasdaqOMX is clearing, will they be subject to the same obligation?” Photograph kindly supplied by IMA, April 2014.

custodian bank partners, BNP Paribas Securities Services, Intesa Sanpaolo and BBVA, in France, Italy and Spain, respectively. Citi Group (for Greece) and Erste Group Bank (Austria) have also confirmed they will join the model. Euroclear and Clearstream are front runners. Clearstream for one estimates it will have 40% of the overall T2S market share based on today’s figures. Wille says: “Our business model is focused on what T2S will look like with an emphasis on us offering maximum choice for clients as a result of how we adapt to the future T2S environment.” While legislation treads a path to a safer world, risks remain, but as Wilson concludes: “Post-trade is in a state of flux and continues to evolve which presents challenges. It is not as necessarily as robust as it could be and some compromises are inevitable; but it is definitely in a different place now from even two years ago.” I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

MARKET LEADER

OPINION: CHAOS WILL CONTINUE FOR EMIR REPORTING

The European Market Infrastructure Regulation (EMIR) is the European Union ruling on derivatives, central counterparties (CCPs) and trade repositories. The regulation introduces new requirements to improve transparency and reduce the risks associated with the derivatives market, in addition to establishing common organisational, conduct of business and prudential standards for CCPs and trade repositories. Atma Dhariwal, principal consultant, CCL looks at the market implications of EMIR implementation.

Implementing EMIR: the storm before the calm MIR IMPOSES REQUIREMENTS on all entities that enter into any form of derivative contract, including those not involved in financial services, including non-EU firms trading with EU firms. From February 12th this year, all counterparties were required to report details of derivative contracts (OTC and exchange traded) they have concluded, or which they have modified or terminated, to a registered or recognised trade repository (TR). Under EMIR, both sides of a derivative deal have to report, rather than just the sell-side as Dodd-Frank requires. This means that technology changes are required for all market participants, including buyside investment firms, counterparties, delegated reporting third parties and the trade repositories themselves. It requires not only build out, individual solutions but also inter-operability between the various parties involved and it is clear that many firms are still not ready. There are five main requirements that must be complied with under EMIR. One, legal and contractual terms for non-cleared OTC derivative contracts must be agreed between the counterparties within specified timelines. Two, financial counterparties (FCs) and non-financial counterparties (NFCs) must agree in writing (or by other equivalent electronic means) with their counterparties the terms on

which portfolios will be reconciled. This agreement must cover key trade terms and valuation and the frequency of reconciliation. This responsibility can be delegated. Three, FCs and NFCs must agree detailed procedures and processes in relation to both the identification, recording and monitoring of disputes relating to the recognition or valuation of the contract and exchange of collateral and the resolution of disputes in a timely manner with a specific process for disputes outstanding by more than five business days. FCs are have to report any disputes between counterparties relating to an OTC derivative contract, its valuation or the exchange of collateral for an amount or a higher value than €15m and outstanding for at least 15 business days. Reports must be submitted via the EMIR web portal by the 15th of each month for the previous month. Four, the portfolio compression requirement applies to FCs and NFCs with over 500 uncleared OTC derivative contracts outstanding to a single counterparty. In such circumstances, the obligation is to analyse the possibility of compression twice a year and be able to provide a reasonable and valid explanation to a relevant competent authority if portfolio compression is not appropriate. Last, trade reporting requirements

were dependent upon the approval of trade repositories by the European Securities and Markets Authority (ESMA). Reporting requirements apply to all asset classes of both OTC and Exchange Traded derivatives. Trade reporting can be delegated to a third party but firms remain responsible for ensuring that reporting is done and is accurate. Reporting obligations also include ‘back-loading’ requirements, meaning that for transactions concluded on or after August 16th 2012 and still outstanding on February 12th this year, the grace period of 90 days does not apply. The whole process of compliance will be very fraught for a period of time, due to the fact that the various elements that are required under EMIR are still not yet in place. Repositories have only recently been authorised, legal entity identifier numbers have yet to be obtained from the many stock exchanges and some CCPs have not yet been properly authorised. As a result, some firms are struggling with the reporting requirements and delays in compliance are therefore inevitable. How will regulators check that firms are in compliance? The emphasis of OTC regulations such as Dodd-Frank and EMIR was to provide market transparency, yet on day one of EMIR reporting there was even less transparency than ever before, as firms rushed to get some data into each of the 80-plus required fields that the regulators desire. It is very likely that there will have been a far more inconsistent approach to this than the regulators would have been expecting and they will be left with the problem of trying to compare unreliable data. The chaos that has arisen may take several months to rectify and could create an operational risk that would end up as a self-defeating consequence of the regulatory changes that were originally conceived. An early dialogue with the interested technology partners would have helped to mitigate this risk. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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IN THE MARKETS

LIRA WEAKENS AS CB SUGGESTS IR MAY FALL

Turkish central bank modifies interest rate policy

Turkey’s central bank chairman Erdem Basçı speaks during a press conference in Ankara earlier this year. On April 30th, on the release of its quarterly inflation report, the bank signalled that it might begin to ease its interest rate policy. It has been four months of shilly-shallying by the normally fiscally conservative central bank. In January it signalled that it was preparing to raise interest rates to address higher inflation and a falling currency; by the end of April, it was saying that inflation would be at least one percent higher than the central bank had originally estimated. Even so, Basçı hinted that rates might ease. Has prime minister Erdogan won his point and his way about the need to keep Turkey’s exports competitive? Photograph AP Pool, supplied by pressassociationimages.com, April 2014.

In increasingly interdependent Europe Russia’s foray into Ukraine has drawn international ire and now, sanctions; equally concerns over political stability and corruption in Turkey in recent months has affected the volume of inflows into the country itself and into markets in its immediate hinterland, with investment funds specialising in Eastern Europe suffering outflows. Some of Turkey’s problems stem from the withdrawal of quantitative easing by the US Federal Reserve, but tensions in the Ukraine as April closed continued to exert downward pressure on the lira. What now for Turkey, for BRICS and European frontier markets? Will symmetry between emerging markets continue, or will the markets increasingly exhibit asymmetric tensions? URKEY’S LIRA EASED to 2.1380 to the dollar in late April, even as the central bank kept its main interest rates stable following its midmonth market review. Istanbul’s benchmark share index was down by over a percent at 71,261.33 points, in line with the emerging market index

which fell 0.15%. Investors had been waiting for the central bank's quarterly inflation report at the end of April, where it was expected the central bank would announce that it would revise its interest rate outlook upwards. In the event, the central bank said it had revised its year-end inflation target

upwards to 7.6% from the bank’s earlier forecast of 6.6%. Following the bank’s initial resistance to demands from the government to reduce rates, and the announcement in its mid-month market review that it intended to keep rates stable over the near term, central bank chief Erdem Basçı signalled something of a turnabout by hinting that the bank might begin to lower interest rates. "The next step could be a moderate and gradual decline in interest rates, though we will maintain tight monetary policy,”he told a press conference. Even so, he noted that the central bank could take steps to keep short term interest rates relatively higher than long term rates. Basçı went on to say that inflation would peak in May then decrease throughout the year to come in by year end overall as 5% as the impact of currency devaluation passes through the economy. Not surprisingly, the news brought the Turkish lira up against the US dollar to multi-week lows as the central bank’s Monetary Policy Committee decided on April 24th to leave the one-week repo rate on hold at 10% for the third straight meeting, a move signalling the central bank was still looking for significant improvement in the outlook for inflation. The central bank had also left the overnight interest rate at 12%, and the overnight borrowing rate at 8%, while the late liquidity lending rate was reduced to 13.5% from 15%. To be fair however, headline inflation had topped 8% in March, and therefore both the government and the central bank had some wiggle room in terms of explaining the stance on interest rates. Loan growth in Turkey, according to the central bank, continues to slow down in response to its tight monetary policy stance and “recent macro prudential measures”. In line with these developments, the central bank says data regarding the first quarter of 2014 indicates a level of deceleration in “private final domestic demand. Meanwhile, with the help of the recovery in foreign demand, the

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

IN THE MARKETS

MIXED FEELINGS ABOUT NEW EGYPTIAN INVESTMENT LAW

contribution of net exports to economic growth is expected to increase. The Committee expects that such a demand composition will support disinflation and lead to a significant improvement in the current account deficit in 2014”. “Emerging markets debt (EMD) assets have been in sharp focus since the Fed began tapering its QE spending last year and concerns over China’s economic trajectory increased. This was most obvious in February this year when the coalescence of these global issues with unrelated emerging markets-specific events such as the geopolitical crisis in Ukraine, unrest in Thailand and corruption scandals in Turkey. The combination saw emerging market debt assets sell off again,” explains a BlackRock fixed income team research paper issued at the end of April. Emerging market debt (EMD) remains cheap say the BlackRock team, relative to developed market credit. Hard currency debt is one of the best-performing fixed income markets this year they say, adding “while the spread compression will slow, it provides a much needed source of yield for fixed income investors. We are, however, moving from an era of indiscriminate buying in which EM countries and assets moved in unison, to one requiring much greater differentiation and a deeper understanding of each and every country. Context is everything, especially in local rates where FX-driven volatility remains a risk.” Flexibility in investor approaches then will be vital over a year that will demonstrate asymmetry in emerging market asset returns especially in local currency debt; the question is whether Turkey’s fortunes continue in line with approaches to emerging markets as a whole, or whether its fundamentals will allow it to decouple from the mainstream. Right now, it doesn’t look like it and currency and interest rate shocks look to be a feature of the country’s fortunes in 2014. I

A new draft measure that will prevent third parties from appealing government contracts with investors is “a very significant signal that we’re sending to investors—local and international—that contracts are protected and secure over the long term,” according to Egypt’s finance minister, Hany Kadry Dimian speaking to local press.

Mixed response to investment law amendments ECENT CHANGES TO the 1997 Investment Act are designed to help boost growth and reduce unemployment as the current interim government prepares for both presidential and parliamentary elections, scheduled for early May. Egypt’s courts have used the original investment law to nullify at least 11 business deals signed during the administration of former President Hosni Mubarak amid allegations that state land, companies, and other assets had been sold at below-market prices in privatisation deals. Some companies, including Mexican cement firm CEMEX and gold mining company Centamin, remain embroiled in court cases. “Centamin continues to discuss with its advisers the process by which the original claim in relation to the Sukari Concession Agreement, which was brought by a third party and is subject to an ongoing court appeal, may be dismissed under the provisions of this new law," Centamin said in an official statement following press details of the new law. Egyptian media reports say the new draft law—whose text, for some strange reason, has not been revealed to the public—means that Egypt’s Investment minister will have the authority to decide whether a criminal case against an investor’s licensed activities merits review by the Supreme Constitutional Court. The

amended law has yet to be ratified and approved into law by the president, pending a final parliamentary vote. The amendment has sparked controversy in Egypt because, to date, court challenges to government contracts have often been brought forward by third parties such as civil society activists, lawyers, and disillusioned former government officials. Some critics say the amendment protects corruption and infringes on the rights of courts to protect investors. The Egyptian Centre for Economic and Social Rights (ECESR) said in a recent statement that it has received a permit from the Administrative Court to challenge the constitutionality of amendments to the Investment Law, approved on April 22nd by interim President Adly Mansour, which would effectively prohibit the challenging of contracts between the state and investors. “Judicial oversight [of the rest of the government] does not exist unless… the right to litigation [against government decisions] is ensured.” The government remains vulnerable, contents the ECESR because of its continued engagement in bilateral agreements whose terms leave it vulnerable to litigation, while at the same time allowing “domestic legislation to reconcile with corruption and [abolishing] provisions in the judiciary which aim to expose corruption in privatisation cases and land sales”. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

IN THE MARKETS

EUROPE AIMS FOR EFFECTIVE MOBILISATION OF CAPITAL

The European Commission has released a mission statement on its plans to “improve long term financing of the European economy.” The statement covers six areas where the Commission thinks there is room for improvement and revision. The first covers the mobilisation of private sources of long term financing, which also involves the establishment of a prudential framework covering banks and insurance companies to help support long term investment in the real economy (sectors like real estate); mobilising more pension plans and personal saving schemes and encouraging the cross-border flow of investments and savings. Even an EU savings account is being considered.

EU moves to improve funding & investment UROPE HAS ALWAYS relied heavily on banks financing the real economy; in fact two-thirds of funding comes from banks, compared to one-third in the United States. However, as banks continue to deleverage, there is less funding available to all sectors of the economy. According to the EU, less than onethird of Dutch and Greek SMEs and only around half of Spanish and Italian SMEs received the full amount of credit they applied for last year and that trend is only going to worsen. The Commission's Green Paper consultation on the long-term financing of the European economy of March last year initiated a broad debate, and received from all segments of the economy. The EC’s late March communication on long-term financing builds on the responses to the consultation and on the contemporary debate in international fora such as the G20 and the OECD, identifying specific measures which the EU thinks will promote long-term finance. In a separate, but related initiative, the Commission has proposed new rules covering occupational pension funds (IORP II), which it says should contribute to more long-term investment. The proposal is designed to ensure that pension scheme members are properly protected against risks; the removal of obstacles to the provision of cross-border pension services; and to

encourage pension funds to invest in financial assets with a long term “economic profile”. Internal Market and Services Commissioner and Commission presidential hopeful Michel Barnier explains:“Occupational pension funds are at the junction of those two challenges. They have over €2.5trn of assets under management with a longterm horizon, and 75m Europeans depend largely on them for their retirement pension. Today’s legislative proposal will improve governance and transparency of such funds in Europe, improving financial stability as well as promoting cross-border activity, to further develop occupational pension funds as a key long-term investors.” The Commission is also looking to make better use of public funding and is looking in particular to foster the activity of national promotional banks (financial institutions, created by governments, that provide economic development financing—think KfW in Germany) and promoting better cooperation among existing national export credit schemes (institutions that act as an intermediary between national governments and exporters to issue export financing— think ECGD in the UK, or SEK in Sweden). Both these types of institutions play an important role in long-term financing; either in support of new development schemes, but more commonly in support of capital goods projects.

Acknowledging that Europe’s capital markets took something of a knock in the recessionary years following 2007, the Commission is looking to give the segment something of a fillip. One way it is looking to do this is by facilitating access to capital markets by SMEs, particularly to larger investment pools. It wants to do this “by creating a liquid and transparent secondary market for corporate bonds, reviving securitisation markets with due consideration to the risks as well as to the differentiated nature of such products, and improving the EU environment for covered bonds and private placement,” according to the EC’s statement. It also wants to improve SMEs’ access to financing. Raising awareness and providing information on projects are also among the key elements of the actions put forward by the Commission in a separate communication crowd-funding. Here the Commission proposes to promote industry best practices, raise awareness and facilitate the development of a quality label closely monitor the development of crowd-funding markets and national legal frameworks and regularly assess whether any form of further EU action (including legislative action) is necessary. The goal is to identify the issues that may need to be addressed in order to support the growth of crowd-funding. As a wind down the Commission’s final two objectives include stimulating private finance for infrastructure to deliver on Europe 2020: increasing availability of information on infrastructure investment plans and improving the credit statistics on infrastructure loans as well as enhancing the wider framework for sustainable finance: improving the corporate governance regime for long-term financing, for example regarding shareholder engagement (by revising the Shareholders' Rights Directive; a proposal due to be adopted shortly), employee ownership, corporate governance reporting, and environmental, social and governance (ESG) issues. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

The verdict is in on RegNMS Responding to calls for a more competitive trading environment a decade ago, regulators offered up Reg NMS— then watched as the ranks of US exchanges exploded and algorithm-pumped practitioners began ruling the roost. Now what? From Boston, Dave Simons reports. T WAS NINE years ago last month that the hitherto old-school New York Stock Exchange (NYSE) joined the ranks of the wired with the acquisition of electronic communications network provider Archipelago, a move that followed just days later by NASDAQ’s own purchase of rival ECN Instinet. The twin landmark transitions came in direct response to the impending Regulation NMS, a succession of rule reforms sanctioned by the Securities and Exchange Commission (SEC) in 2005 (and implemented two years later) with the intention of bringing the aging US financial-market architecture into the modern era. If Reg NMS paved the way for a

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

more efficient, electronically driven and lower-cost marketplace, it also helped foster an climate in which tic size grew increasingly smaller and spreads narrower. In the years that followed, pools of liquidity were spread across an increasingly lengthy list of trading venues, compelling participants to seek the most efficient execution arrangements possible—and, with processing power to burn, setting the stage for the proliferation of high-speed and arbitrage-based outfits with the tools necessary to optimise even the most minuscule of price anomalies. Today, thirteen public stock exchanges are joined by some 45 different dark pools, scores of

TAKING STOCK OF US TRADING

Archive photo of Mary Jo White, left, chair of the US Securities and Exchange Commission, and Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), as they arrived to testify before the Senate Banking Committee. Lawmakers were, at the time, looking at ways to mitigate systemic risk in financial markets through Wall Street reforms. The photograph was taken on Capitol Hill in Washington, Tuesday, July 30th last year. Photograph by J. Scott Applewhite, supplied by pressassociationimages.com, April 2014.

dealer-operated crossing networks, internalisers and other alternative trading platforms—a far cry from the slower but simpler pre-Reg NMS period. Whereas an estimated 80% of NYSE-listed stocks once traded onexchange, by 2009 that figure had dropped to just 25%. In the meantime, dark-pool and related trading soared, ultimately reaching upwards of 40% of daily volume. “Clearly, market participants wanted competition,” remarked SEC commissioner Kara Stein at February’s Trader Forum 2014 Equity Trading Summit in New York. And they got just that—a “brave new world” in which orders are sent to a perpetually expanding list of trading venues, each with a different role in the new market landscape. In many respects, however, the efforts to promote diversification and advance competition resulted in a whole new set of unusual and unforeseen consequences. Which begs the question: did Reg NMS and the various other electronic permutations of the time actually create more problems than they solved?

More structure needed If recent efforts by authorities to establish a more cohesive market infrastructure are any indication, the answer is at least a partial “yes.”These new mandates include an SECapproved, alternative trading reporting rule, requiring ATS firms to compile data such as weekly volume and total securities transacted for publication (on a delayed basis) on the website of Washington, DC-based Financial Industry Regulatory Authority (FINRA). The ATC rule, to be rolled out in early May, will enhance FINRA’s regulatory and automated surveillance efforts, allowing the agency “to obtain more granular information around activity conducted on or through alternative trading systems.” Coverage could be expanded to include the likes of broker-dealer internalised executions, as well as wholesale market-maker OTC trades executed

IN THE MARKETS

TAKING STOCK OF US TRADING

through order entry brokers, according to FINRA. The measure comes on the heels of last fall’s SEC-mandated Market Information Data Analytics System, (MIDAS) which analyses large quantities of market data extracted from consolidated tapes and proprietary data feeds with the goal of providing users with a better understanding of market trends in the making. As SEC chairwoman Mary Jo White opined during a recent Security Traders Association conference, taking the necessary steps to achieve a robust market infrastructure is essential to keeping individuals and corporations invested in today’s increasingly intricate markets, as it allows them to feel confident that “they will be treated fairly and that the system will work efficiently.” Without this kind of structure in place, markets can instead “act as a headwind that can impede capital formation,” contends White. Although securities now trade on a broader array of venues, volumes have nonetheless remained relatively muted, while random and often wild fluctuations in share price have become more commonplace, at times even affecting highly liquid, heavily active issues. Such blow-ups have typically been attributed to “inconvenient computer glitches, or unwise traders,” notes SEC commissioner Kara Stein, even as they continue to victimize hapless investors. With technology in a constant state of flux, even the most seemingly impervious trading mechanisms have a limited shelf life—therefore exchange operators must remain flexible and open to innovation in order to maintain the integrity of the markets, as well as the trust of the investment public. After all, says White, “challenging assumptions is a key part of the comprehensive review of market structure.” Using high-tech weaponry to monitor potential trading glitches in the making and contain possible damage to the markets remains a primary function at FINRA, notes Richard Ketchum, its chairman and

chief executive officer. In recent times, these safeguards have included singlestock circuit breakers that give participants a clearer view of positions, valuation models, and operational capabilities that may otherwise be obscured during periods of pronounced volatility. Additionally, last year the SEC approved an initial phase of a “limit up-limit down plan,” designed to curtail trading activity once stocks move beyond a “normal” price range.

Co-location crackdown Meanwhile, officials continue to hammer away at the high-frequency trading establishment, whose membership has been equally adept at scoring big gains while also wreaking unspeakable damage. In an announcement last month, New York’s Attorney General Eric Schneiderman promised a new oversight campaign that would focus on what Schneiderman deemed unfair and possibly illegal mechanisms that “give elite groups of traders’ early access to market-moving information at the expense of the rest of the market.” Schneiderman’s Insider Trading 2.0 list of offenders includes HFT vendors and platforms—which, in Schneiderman’s estimation, pose “one the greatest threats to public confidence in the markets”—and, in a twist, also points a finger at the exchanges for their part in helping to propagate potentially unfair trading activity. Accordingly, Schneiderman seeks to place limits on the largely unfettered practice of collocation, whereby HFT firms pay to situate their trading computers alongside the New York exchanges’ data servers in nearby Mahwah, New Jersey. Using the same sophisticated models that give HFT players their competitive edge, these collocated systems are the odds-on favorite to beat off-site trading counterparts to the punch, argue critics. It’s hardly the first time that regulators like Schneiderman have attempted such maneuvers. In the US, the HFT industry has for the most part managed to evade the long arm of the law

despite a lengthy list of high-profile implosions and market disruptions. By contrast, other regions have been considerably better at holding the firms feet to the fire; in Canada, for instance, HFT represents a much smaller portion of the overall trading picture, accounting for just 16 percent of volume according to recent figures from The Investment Industry Regulatory Organisation of Canada (IIROC). Of course, not all of the markets’ ills are purely the result of some isolated algorithm gone awry. All the more reason for venue operators and regulators to strengthen the lines of communication while working to improve coordination. In the case of the 2010 flash crash, said Stein, not only did the SEC lack proper access to data required to quickly and effectively analyze the event,“we also learned just how much investors’ confidence may be shaken by dramatic price swings, even if they are quickly corrected.” Accordingly, it is paramount that markets have the ability to withstand future glitches, said Stein,“whether they arise from a Kansas City-based institutional investor seeking to sell E-mini futures, a wholesale market maker that had a problematic software installation, or a Wall Street bank with a malfunctioning options program. One trader’s computer system should not be able to bring our capital markets to their knees. By the same token, if one execution venue’s data system sends out bad data, another venue shouldn’t crash.” Hence, the industry needs to continually assess the likely impacts of different types of trading strategies on the markets as a whole, said Stein, including, for example, whether or not high frequency trading adds meaningful liquidity to the markets, or, by contrast, merely creates excessive volatility. Ultimately, industry leaders “should be driven by the relentless pursuit of more robust, fair, and efficient markets.” If that means making modest reforms that can improve the markets right now, said Stein, “we should consider them.” I

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A feeling for quality As the campaign to stamp out excess leverage while fortifying bank capital rolls on, leading institutions have had no choice but to shovel even more quality assets onto their balance sheets—which, as many are finding out, isn’t quite as easy as it sounds. Dave Simons reports from Boston. S RULE CHANGES affecting the quality and quantity of bank capital as well as liquidity and leverage begin to take hold, the industry steels itself for the possible economic fallout. Inordinately rigid risk metrics could create borrowing problems for firms engaging in even slightly elevated risk activity, while also making it prohibitive for banks to hold securities from other financial institutions. Consulting group Deloitte has suggested that a more restrictive capital/liquidity landscape could potentially cut into bigbank business while boosting the fortunes of broker dealers, investmentmanagement firms and others poised to pick off divested assets.

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The move toward central clearing of OTC derivatives represents a potentially potent pain point for banks. As noted by JP Morgan in its recent Leveraging the Leverage Ratio outlook, regional regulators require CCPs to have access to sources of back-up funding in the event a clearing member suddenly goes belly-up; this would allow the CCP to immediately settle claims and subsequently extract its collateral value. Since this facility would likely be provided by members of the clearing community, this could further weigh on banks’ balance sheets and liquidity, suggests JP Morgan. Meanwhile, efforts to address off balance-sheet funding risk have made

BANK CAPITAL RISK METRICS CUT INTO BUSINESS LINES

Photograph © Paul Fleet/ Dreamstime.com, supplied April 2014

for an increasingly shallower pool of available liquidity, according to some observers. A once vital source of funding for a range of institutional players, repo market volume continues to recede, with average daily amounts outstanding currently in the $4.5trn range, well off its $7trn pre-crisis peak. Recent Basel revisions have sought to modify some of the restrictions around repo, as well as derivatives usage; still, these measures only go so far, charge critics. Faced with tighter capitalisation and liquidity demands, banks have had no choice but to shovel even more quality assets onto the balance sheets. If only it were that easy—in reality, banks must follow a specific set of criteria to ensure that their assets actually pass muster. For instance, under Basel III investments in one’s own capital instruments, as well as cross-holdings in another financial institution’s capital instruments, would serve as “deductions”against Tier 1 and Tier 2 capital. In the United States banks are required to raise capital through the issuance of common or non-cumulative perpetual preferred stock, rather than using taxbeneficial mechanisms such as debt securities, trust-preferred securities, or other alternatives. The new standards also increase oversight into index-based activity; while Basel III offers some leeway with respect to index securities held in other financial institutions, such is not the case for banks investing in their own indexed shares. Additionally, revamped risk weights have put a damper on securitisation practices. In the years since the crisis, agencies have taken an increasingly dim view of activity such as rehypothecation—off balance-sheet leverage derived from existing client collateral— as well as other recycling strategies. Though regulators have generally acknowledged the usefulness of securitisation as a financing tool under certain circumstances, the new weighting mandates nevertheless act as a deterrent going forward. “The new Basel III capital adequacy

IN THE MARKETS

BANK CAPITAL RISK METRICS CUT INTO BUSINESS LINES

requirements are making the balance sheets of banks more expensive,” offers Andy Hill, director for London’s International Capital Market Association (ICMA) and author of the European Repo Council initiative Collateral Is The New Cash: The Systemic Risks Of Inhibiting Collateral Fluidity. As such, “banks are having to rethink their business models and priorities. Low-margin, capital-intensive businesses, such as repo, are becoming less attractive.” Writing in the New York Law Journal report Banking in the 21st Century: Navigating Uncharted Waters,”Anna Pinedo and Oliver Ireland, partners with international law firm Morrison Foerster, agree that the imposition of tougher regulatory rules, as well as the hidden costs therein, could force banks to jettison less profitable lines of business.“The higher capital requirements, and the reduced number of ‘tools,’ are likely to encourage banks to focus more closely on the incremental cost of capital associated with particular activities.”

Crawling from the leverage Despite the various drawbacks, regulators, having been burned once, appear determined to make the new rules stick. Last month, Federal Reserve chairwoman Janet Yellen suggested that even in its present form capital standards may not yet be rugged enough to protect the largest banks against a worst-case financial scenario, and that imposing even tighter capital and liquidity requirements would, on net, “provide economic benefits.” As the markets continue their recovery, regulators seem especially keen on keeping leverage underfoot. Primarily aimed at bank holding companies with at least $700bn in assets or $10tn in custodial assets, in early April the US Federal Reserve Bank, in conjunction with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), put the finishing touches on a supplementary leverage ratio (SLR), which raises the leverage ratio for the industry’s largest institutions as well as

their insured subsidiaries to 5% and 6% respectively. Banks have until the beginning of 2018 to meet the new objective, but must submit estimated SLRs by the first quarter of next year. The SLR is the latest move in the campaign to bolster the capital framework of the country’s biggest banking organisations, notes Fitch Ratings. As most firms have already begun the disclosure process and to date have maintained sufficient capital-adequacy standards, Fitch expects that all members will be able to comply prior to the due date. Even so, Fitch doesn’t rule out the possibility of some balance-sheet contraction along the way. Furthermore, by requiring banks to favor equity over debt assets, the new rules are a double-edge sword, since cash and lower-risk securities “earn next to nothing in the present interest rate environment, yet will attract a 6% capital charge at the banking subsidiary level,” notes Christopher Wolfe, Fitch managing director, financial institutions. Thus, while impacting all eight globally systemically important banks (GSIBs), the rule will likely have a more pronounced affect on larger trust and custody banks with higher cash levels. In its own SLR analysis, Zacks Equity Research agrees that the adjusted capital requirements could limit banks’ investment and lending flexibility, perhaps even slowing the pace of the global economic recovery in the process. “Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors—asset-quality troubles, mortgage liabilities and tighter regulations—will decide the fate of the US banks in the quarters ahead.” Still, conforming to the new capital regime will ultimately lead to greater stability and security for the industry as a whole, concurs Zacks, and despite concerns over long-term profitability, sector performance should not be materially affected during the coming quarters.

Also on the docket is a new shortterm liquidity coverage ratio (LCR), initially unveiled last fall as a way for regulators to gauge a bank’s liquidity stress level on a monthly basis (and marking the first time such a measure has been imposed on the domestic banking system). Under the new ratio, all net cash outflows for any given 30day period must consist of high quality liquid assets (HQLA) which are weighted according to their respective liquidity levels—cash and government-backed securities score a most-favored Level 1 weighting, while the likes of investment grade corporate bonds would net a lowly Level 2B (and be subject to a 50% haircut as well). Furthermore, under the LCR any product issued by a mutual-fund company or similar institution would be considered correlated and therefore would not count toward a bank’s qualifying HQLA; additionally, domestic banks would be prohibited from keeping a large percentage of HQLA outside of the US due to liquidity concerns. All of this presents an unusual challenge for banks that may be leaning toward more liquid, lower-yielding assets in order to make the LCR less onerous,“even though the supplemental leverage ratio may discourage the holding of these same assets,”observes Pinedo and Ireland in their report. It’s that kind of regulatory dichotomy that officials may want to consider before the ink on the new rules finally dries.“If banks find it economically inefficient, or are restricted by regulation from supporting the critical functions of sourcing, pricing, managing, and mobilising collateral, and the infrastructure is not in place for the efficient mobilisation of collateral, then the basic intermediation roles of banks and financial markets— that of maturity, risk, and credit transformation—would be undermined,”maintains ICMA’s Hill.“For all the good work and best intentions of financial regulation, we would be embedding systemic risks.” I

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DIRECTIONAL SHIFTS IN FUND FLOWS INTO RUSSIA What has been surprising over the last few weeks, given the political drama unfolding in Ukraine and Russia’s role in it, is not that there has been a brisk outflow of foreign investment from Russia, but how quickly directional flows reversed at the first signs of the crisis reaching—at least temporarily—a standstill. Vanya Dragomanovich looks at the longer term implications. OME 75% OF Russian stocks are held by foreign investors, as are about a quarter of local bonds. As the protests in Ukraine escalated and it became clear that Russia had every intention of getting involved, the withdrawal of foreign money from Russian markets was swift and dramatic. Goldman Sachs estimates that capital flight, especially in early March, topped between $45bn. Large asset gatherers and speciality funds, such as BlackRock Emerging Europe (which has a 54% allocation to Russia), Baring Eastern Europe (67%), JPM New Europe (69% in Russia) and Schroder ISF Emerging

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Europe (54%) lost roughly 20% of their value since the crisis started, mirroring, in broad terms, the performance of Russian stock market indices. The value wiped off the MICEX stock index in early March was a toppy $58bn, exceeding the $51bn Russia reportedly spent on the Winter Olympics in Sochi, according to Alex Dryden, global market strategist at JP Morgan. When it comes to investing in Russia some form of potential crisis comes with the territory—think back to the Russian financial crisis and ruble devaluation in 1998 or Russia invading Georgia in 2008. “Investors understand that emerging markets can be volatile,

THE INS AND OUTS OF INVESTMENT INTO RUSSIA

Russian Prime Minister Dmitry Medvedev, left, speaks to Crimean Premier Sergei Aksyonov while visiting Crimea in Simferopol, Crimea, on Monday, March 31st, 2014. On a surprise visit Monday to Crimea, Russia’s prime minister promised to quickly pour funds into the newly annexed peninsula so residents see positive changes after the Russian takeover. Dmitry Medvedev, who led a delegation of Cabinet ministers to Crimea, pledged that Russia will quickly boost salaries and pensions there and pour in resources to improve education, health care and local infrastructure. A special government ministry has been created to oversee Crimea’s development. Meanwhile, Russia’s stance in Crimea has cost it as much as $45bn in foreign investment outflows through March, with repercussions for the economy in 2014. Photograph by Alexandr Polegenko, for Associated Press. Photograph supplied by pressassociationimages.com, March 2014.

so the current gyrations are nothing new,” explains Ian Barrass, fund manager at Henderson Value Trust, which invests in listed and unlisted small and medium-sized Russian companies. What works in favour of Russia as an investment destination is that it is a major world economy with a good degree of financial strength and resources: “it has a lot of financial strength and natural resources which underpin its economy,” adds Barrass. This would partially explain the reversal in Russian stock indices, which was almost as swift as the initial decline. The MICEX and RTS indices have rallied 8.6% and 8% respectively since the mid-March low point, although they are still around 7% lower than at the start of the month. “Even though the threat of further sanctions remains on the table, the risk of moving into the economy-trade damaging category has eased considerably over the past few days. That should help Russian markets add further to the rally off the March 14th lows,” says Chris Weafer, analyst at Macro-Advisory.“[There are] still some important political and economic risks, but a resumption of “normal”market valuations in Russia is still a long way off. Investors will want to be sure that political risk really has eased—and that will only be after the May 25th elections at earliest—and also to get a better sense of the legacy damage to the economy from the events of the past four months.” For both of the indexes and for the majority of Russia-focused funds, the top holding in the portfolio is typically state-owned Sberbank, followed, in no particular order, by gas giant Gazprom, oil firm Lukoil, Mobile Telesystems (MTS) and nickel miner Norilsk Nickel. The value of their shares dropped on the threat of either trade sanctions against Russia, which would, for instance, hamper Gazprom’s or Lukoil’s ability to sell gas and oil abroad, and the threat posed by some form of foreign exchange or banking restrictions, both of which would be damaging to Sberbank.

REGIONAL REVIEW

THE INS AND OUTS OF INVESTMENT INTO RUSSIA

Thus far, this has not materialised and Western countries introduced only very soft sanctions in the form of visa bans and asset freezes for a small group individuals. The most serious move has been the freezing out of Bank Rossiya, a bank that caters to a group of very wealthy individuals close to president Putin, and a small group of other Russian banks which no longer can make use of Visa or Mastercard services. However, none of the banks involved is a top tier bank such as Sberbank and VTB and the restrictions are not serious enough to affect the business of Russia’s major banks. Although the EU will try and avoid more serious trade or business sanctions towards Russia because of its trade and business links with the country, the situation could change relatively quickly if Russia attempted some form of military involvement in Eastern Ukraine. “A real threat would be measures against the Russian banks. As it was articulated for the moment, such financial sanctions could include a possible ban on certain operations, or relations with some client groups, or asset freezes,” holds Andreas Schwab, analyst at Raiffeisenbank. This would not only be damaging for domestic banks but also Société Généralé, Unicredit and Raiffeisen, the three out of the four largest 100% foreign-owned banks in Russia. They have a 4.3% share of the domestic market and an 85% market share among the leading foreign-owned banks in Russia. In terms of crossborder exposures European banks represent around 75% out of some $240bn to $260bn of cross-border banking exposure, according to research by Raiffeisenbank. Gazprom and Norilsk have begun looking at redirecting their trade to China and other Asian countries and into introducing settlement of their China contracts in renminbi rather than in dollars, but if trade sanctions are introduced the change could not

happen quickly enough for the companies to avoid losing revenue. In terms of direct investment Russia ranked as the third most popular country in the world in 2013. Although understandably some shine has come off that, throughout the crisis private equity investment held up better than equity funds.“Contrary to popular perception, there has not been an exodus from Russian funds following the events in Ukraine,” says Jacob Grapengiesser, senior advisor at Swedish investment firm East Capital. “We, as one of the largest Russian asset managers, have seen only limited outflows from our funds,” he says. East Capital has focused on Russia and Eastern Europe since the early nineties, and achieved of the highest returns ever from the Russian market, with its Russia-only fund notching up returns of over 1,500% in the first decade of this century. Grapengiesser argues that the response from fund managers has not been as negative as expected because the worst case scenario has not materialised. “There has been no armed conflict and Russian troops have not invaded Eastern Ukraine. The Ukrainian leadership has acted with restraint and even though there has been a lot of strong rhetoric in Russia as well as in the West no drastic actions have been taken,” he added. However, looking at the broader investment field of funds involved in Russia as part of the BRIC countries allocations or an emerging market portfolio Russia is not likely to play a growing role for the rest of the year. Regardless of the crisis in Ukraine, for emerging markets this year did not start off well. The devaluation of the Turkish lira, the rand, the Brazilian real, the rouble and the Kazakh tenge have already caused outflows in January and early February and weaker economic data from China has also affected BRIC group investments. Add to this the reality that emerging markets as a group have been stagnating for the last three years and this would explain scepticism

even before the Ukraine crisis towards both emerging markets in general and towards Russia in particular. “Emerging market investors will remain sceptical towards Russia not because of the political risk—emerging markets imply a high political risk— but because of the underlying structural problems to do with growth,” holds Jade Fu, investment manager at Heartwood Investment Management. Heartwood, which was bought by Handelsbanken last year, has around $2bn of assets under management. “The most important issue when it comes to emerging markets is growth, and we don’t see a vibrant growth coming out of Russia. One of the key issues is structural reform. A lot of these [emerging market] economies have evolved to the point where they need a structural reform to continue on their growth path and the same is the case with Russia. That structural reform would need to come in form of domestic investment, such as infrastructure investment,” says Fu. Even before the Ukraine crisis Russia’s economy began slowing down and in the first two months of this year showed weaker-than-expected economic activity. Analysts now predict GDP growth of 1% this year, in part due to the deterioration of foreign investments to Russia. Other factors which could suppress investment activity would be the increased costs of internal and external borrowing and inflationary risks. If the ruble continues to decline domestic buying power would also drop causing a decline in retail sales.

Market volatility Going forward investors should be prepared for further volatility, in the region and across emerging market assets, says Alex Dryden at JP Morgan. They should also be mindful of potential contagion for some European banks and other companies with significant business interests in Russia and in Ukraine. There should be more clarity on the political front after 25th May when there will a general election in the Ukraine

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and much will depend on the tack taken by the new government there. Matthias Siller, manager at Baring Emerging Europe says he sees three possible scenarios.“In terms of regional stability, the best case scenario would include a post-election political outcome in which Ukraine is governed by a balanced, non-aligned government. The base case scenario would see Crimea remain effectively under Russian influence, while the worst case scenario would see an escalation in military mobilization with further separatism in the eastern part of Ukraine, where there is also a large ethnic Russian population, and sanctions being imposed on Russia.” Based on the initial data Goldman Sachs predicts that the full-year out-

flows could be as much as $130 billion, double the level in 2013 and close to the record outflow in 2008. The final number could end up significantly below that level if there is political stability during the rest of the year. What the crisis in Ukraine has demonstrated is that, although Russia made great strides in the last ten years in terms of economic growth and in terms of opening up to Western financial markets, while the generation that grew up on Cold War rhetoric is in charge of the country, Russia will forever remain only a step away from some sort of crisis. It will also remain an interesting investment destination but only for investors who treat it accordingly. Should you have even thought the

worst of the crisis is over, remember that there is the hanging question over the future of Transnistria, the Russian speaking enclave east of the Dneister River that broke from Moldova in 1991. The region is often lumped with other corners of the old Soviet Union that broke away from newly emerging nations into a semi-state (or unrecognised limbo). There’s NagornoKarabakh, an ethnic Armenian part of Azerbaijan, and Abkhazia and South Ossetia, which have separated themselves from Georgia with Russian help. “The question over Transnistria’s status may very easily become the next point of political tension between Russia and the EU,” says Chris Weafer. “It is certainly an issue for investors to watch closely.” I

EMERGING MARKETS – VALUE TRAP OR INVESTMENT OPPORTUNITY?

LL MARKETS CONTAIN value traps, according to Jason Pidcock co-manager of the Newton Emerging Income Fund, citing Russia as an example of where share prices are ‘cheap’ for a reason. “At Newton, we would rather invest in countries and companies in which we have greater understanding and trust, even if that means paying a premium to own them – we are happy to pay for quality,” he explains. While to some extent emerging markets can be a value trap, they also provide compelling opportunities, he adds. Active management is a key factor in emerging markets, says Pidcock. Speaking at BNY Mellon’s April Global Investment Conference, Pidcock and Sophia Whitbread, joint managers of the Newton Emerging Income Fund, discussed the opportunities and risks associated with investing in emerging markets. Since 2000, emerging market economies have grown by around 4% more than their developed peers, notes Whitbread. “Emerging markets boast a greater stability in dividend pay-out ratios than developed markets since the turn of the century and there is potential for pay-out ratios to rise further”. Dividends can encourage disciplined capital allocation, can highlight value and be a key part of shareholder return. Importantly, dividends can also indicate a regard for shareholders and corporate governance generally, which cannot always be taken for granted in emerging markets, she explains. “At the same time, emerging markets offer potential for high economic growth, high

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earnings growth and dividend growth which can be driven by that earnings growth,” she adds. Newton’s use of global investment themes is relevant when investing in emerging markets says Pidcock explaining that: “Our ‘population dynamics’ theme is pertinent with emerging markets leading labour market growth, while we are seeing massive expansion in the consumer class. By contrast, China’s labour force has started to shrink. This is a significant blow to the labour giant.” They also noted that investing in emerging markets involves stocks that often have the state as shareholder; pertinent in Russia, where some of the larger listed banks (Sberbank, for instance) carries a significant government stake. “Our ‘State intervention’ theme highlights the importance of knowing your fellow shareholders and of being wary of how you might be treated by a government as a controlling shareholder. Commodities and the banking sector are areas of notable vulnerability to state intervention,” Whitbread notes. Pidcock concluded by discussing China: “We remain cautious but are encouraged by the prospect of China beginning to have investment cycles – this will be a good thing for investors.” However, the country’s growth levels remain unsustainable and a slowdown will have ramifications upon other emerging markets; the effects of this will be felt more in some areas than in others. “For example, around 60% of Mongolia’s exports go to China but some emerging markets, in particular those which are not significant commodity exporters, such as Mexico, are likely to be less affected,” he says.

COMMODITIES

COMMODITIES VOLATILITY HERALDS PROBLEMS

In this image taken from Rossia 24 television channel TV, an injured Ukrainian military helicopter pilot is assisted by pro-Russian activists after he was shot down in Slovyansk, eastern Ukraine, Friday, May 2nd 2014. Pro-Russia forces shot down two Ukrainian helicopters on the Friday as Ukraine launched its first major offensive against an insurgency that has seized government buildings in the east. The Kremlin says Kiev's move against the insurgents "destroyed" hopes for peace in the region. Photograph taken by AP Photos from the /Rossia 24 Television Channel TV OUT. Photograph supplied by pressassociationimages.com, May 2012.

COMMODITIES IN THE SPOTLIGHT AS UKRAINE CRISIS CRANKS UP Commodities markets reacted violently—a spike and a drop— to the escalation of the conflict in Ukraine because of Russia’s dominant role as a commodities producer, but most of the “Russia commodities” including oil, gas, gold and nickel have returned to their pre-crisis level, indicating that other factors such as the weakening of the Chinese economy are playing a bigger role in the markets at present. Vanya Dragomanovich reports. IVEN THE VOLATILITY in commodities prices since the beginning of the year and the ever bubbling crisis in the Ukraine, it is no surprise that investors in commodities remain unnerved. Clearly, investment managers are keeping a close eye on the geopolitical morass of the Ukraine crisis, remaining at the ready should any major change occur. “The recent developments have done

little to reassure investors, already cautious about the prospects for emerging markets in the short term,” says Andrew Cole, Investment Director of the Global Multi Asset Group at Baring Asset Management. “However, from a fundamental perspective, we believe that other factors such as the slowdown in Chinese economic activity are of more investment significance in the long term.”

If Europe and the US introduce stricter sanctions on Russia further down the road the effects will be felt not only in commodity prices but even more by commodities businesses such as BP, Shell, Exxon or Eni, or companies which rely on certain commodities from Russia such as car makers or plane manufacturers like Boeing. Russia’s role in commodities markets cannot be stressed enough. It is one of the top global producers of oil and gas, gold, palladium, nickel, aluminium and steel. Likewise Ukraine, though much smaller, is also one of the largest exporters of wheat and steel. What is perhaps not obvious at first glance is how the production of commodities in Russia and Ukraine are intertwined, not only with one another but also with most of the manufacturing sector in Europe. Boeing, for instance, has a ten-year supply contract with Russian firm VSMPO Avisma for titanium supplies, a key component in making the steel for plane hulls. Russian steel makers make car bodies for Ford, Nissan, Renault and a number of other foreign car makers producing and selling in Russia. BP owns a 20% in oil company Rosneft and in the fourth quarter Rosneft contributed $1bn to BP’s revenues. ThyssenKrupp and ArcelorMittal have factories in both Ukraine and Russia and Ukraine is one of the top suppliers of stainless steel to Russia. There are also some surprising knock-on effects of the crisis. For example, Boeing and its partner Lockheed Martin in the United Launch Alliance (ULA) look to be caught in the cross-fire between rival firm SPACEX which wants a bigger piece of the satellite pie and the US air force. SPACEX says it is reportedly contemplating filing a lawsuit against the US air force for the right to compete for military launch contracts with ULA. "We're protesting and saying these launches should be competed," SPACEX chief executive Elon Musk said in a press conference on April 25th. SPACEX has launched private

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satellites and NASA cargo on its Falcon 9 rocket. The firm is seeking certification for military launches, which Musk says they could provide cheaply. He pointed out that ULA's rockets use Russian parts, which may prove problematic as tensions escalate over the situation in Ukraine.

Heavy sanctions threat Even if Russia took further military action in Ukraine Europe would try and delay bringing in serious trade sanctions because it would deal a damaging blow to a wide variety of industrial companies at a time when the European economy is recovering too slowly to make up the loss in revenues. However, the same does not apply to the US, which though linked in trade terms with Russia is far less dependent on the country. Russia is the world’s second largest oil producer, second only to Saudi Arabia. The bulk of its crude oil is exported to Europe—more than 70%— and when crude oil exports are combined with refined oil products Europe makes up almost 60% of Russia’s oil market. In that context it is surprising that Russia has been ready to take on the world over the Ukraine, as so much business is at stake.

Not that Russia has been backward about hedging its own position in the interim. The sanctions on Iran had already started changing the flows of oil supplies months before the Ukraine crisis as China started looking for a source of supply to replace Iran. For domestic economic reasons – the state of Russia’s economy is tied to the oil price and oil sales – Russia was keen to fill that void and in January Russia’s oil firm Rosneft agreed to increase its sales to China by 60%. In March, the prospect of economic or trade sanctions prompted Russian oil producers to look into speeding up sales to China but although they can divert more oil through existing pipelines—ESPO 1 and 2, the first and second phase of the East SiberiaPacific Ocean pipeline and a link between ESPO 1 and Northern China—the relevant pipelines will only be fully built by 2025, hence there is a limit on how much oil can be redirected away from Europe in the short term. For the time being however, it looks like a lose-lose situation if the Ukraine crisis continues to escalate. If Russia did stop supplying Europe with crude oil and oil products neither Saudi

Arabia nor all of OPEC would be able to make up the short fall because OPEC’s total spare capacity is less than half of what Russia supplies to Europe. “If Europe is heavily dependent on Russia (when it comes to oil), Russia is even more dependent on Europe,” thinks Michael Wittner, managing director and head of US Commodities Research at Societe Generale Investment Bank. “The key point for the oil markets is that, in sharp contrast to Iran, Europe and Russia have a gun to each other's head which should prevent either side from using the oil weapon and stopping oil trade flows,” adds Wittner. For investors the key now is whether there will be more sanctions on Russia in the future—which would be triggered if Putin opted to occupy other parts of Ukraine. George Soros pitched a curve ball at the oil market recently when he proposed that the US could punish Russia by selling some of America’s strategic emergency oil stockpile—which is now twice as large as required by international agreement. This could have the effect of lowering oil prices (potentially by as much as $10 a barrel from the WTI current price

RUSSIA WILL DEFINE AFFILIATION CRITERIA FOR COMPANIES

CCORDING TO LOCAL press reports and sub custodian news flashes, the Russian government is considering introduction of regulatory changes associated with elaboration of affiliation criteria for corporations. On April 23rd, the State Duma, the lower house of the parliament, approved in a second reading draft changes to the Russian Civil Code that envisage only general provisions on affiliation criteria. This is something of a turnaround, as previously it was expected that any explicit definition of corporate affiliation criteria would be incorporated in the country’s civil code. Given the intervention of the parliament, a more detailed approach in regards to the affiliation criteria is now expected to be introduced through subsequent amendments to the Law On JointStock Companies. The initiative is expected to better protect the rights of minority shareholders and further improve corporate governance and the overall

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investment environment in Russia. Presently, the government consults with investors and companies in order to elaborate an optimal approach towards defining the affiliation criteria and the scope of deals with interested parties that may be subject to certain restrictions. The regulatory changes have been driven by members of the International Financial Center (IFC) Working Group and private investors who proposed to enhance the definition of an affiliated person or business entity. Even so, according to a Deutsche Bank custodian briefing, local law firms have not been unanimous in welcoming the initiative. According to the note, the adoption of certain criteria under the proposed amendments may lead to negative consequences, though these were not specified, though they suggest that the new rules might provide too much strength to minority shareholders.

COMMODITIES

COMMODITIES VOLATILITY HERALDS PROBLEMS

of around $101/bbl) and would also reduce the volume of purchases from Russia. Russia could ill afford that as its budget is fine-tuned to oil - it breaks even as long as oil prices are close to $100 a barrel (at the time the story was written at the end of April). Soros’ proposal was heard by a congressional group in the US at the end of March. An increase in US crude stockpiles has helped investors shrug off the impact of new sanctions on Russia even as the Ukraine crisis has continued to escalate. The rise in supplies suggests demand is not as strong as expected. The American Petroleum Institute said at the end of April that US stockpiles of crude oil expanded by 3m barrels over the last week of the month, while a survey of analysts by energy specialist Platts, had been expecting a rise of 2.1m barrels. Steadily increasing oil exports from Libya, have (albeit modestly) contributed to the drop in prices. Analysts cite information from Libya's National Oil Corporation showing current exports at 285,000 barrels a day, up from 230,000 barrels a day in the first half of April.

The gas outlook Russia is an even bigger player in the gas market and its gas giant Gazprom is Europe’s biggest supplier. Russia supplies 100% of the Baltic and Finnish market and is the major supplier for Germany, Austria, Poland, Ukraine and Turkey In gas, similar to oil, the direct impact of further sanctions on gas futures prices would be limited, although the impact on European companies such as Eni and E.On, big buyers of Russian gas and also involved in building pipelines from Russia, would be much more significant. However, taking Henry Hub, the gas futures contract traded in the US, as an example: “it's unlikely that we shall see a sustained long-term trend to the upside,” says hedge fund manager Andreas Clenow, principal at ACIES Asset Management. “The spot price of natural gas has never been much higher and with the frack-

ing situation across the US, a dramatic price increase of domestic gas is not very credible,” he said. Some of the gas is used for heating but most of it is used to produce electricity and if those supplies were cut this would have a knock on effect on industrial production across Eastern and Western Europe because a large portion of the manufacturing industry is powered with gas-generated electricity. “The eurozone is in no condition to accept a sharp increase in energy costs, so outright trade sanctions look unlikely. The same would be true of the application of current energy competition law which would inhibit future gas supply,” according to Guy Foster, head of portfolio strategy at Brewin Dolphin. Big capital goods projects however have not escaped attention. The fallout of the Ukrainian crisis is already jeopardising the South Stream project, the pipeline intended to carry Russian gas to Europe underneath the Black Sea. European Commission Energy Commissioner Günther Oettinger said recently that negotiations on the project in which Gazprom holds a 51% share, Eni a 20% stake and France’s EDF and Germany’s Wintershall about 15% each, have been suspended. The laying of undersea pipes was meant to start in March but has now been put on hold. Brewin Dolphin’s Foster says, “The Russians are involved in the financing of a great many investment opportunities in the west to the extent that it is challenging to know who is reliant on whose capital.” He adds that there would always be plenty of sources of capital to finance development in the West but that “lasting damage has already been done to Russia as an investment destination.” Another major Russian export is palladium, a precious metal similar to platinum used in jewellery and to reduce car emissions. European car makers in particular are fond of using catalytic converters containing palladium, unlike their US peers who

mainly use platinum to reduce emissions. Russia produces around 40% of the world’s palladium, mainly as a byproduct of nickel mining, and holds significant reserves of the metal.

Palladium Palladium prices had already started rising at the end of January when miners in South Africa, the other major producer of platinum and palladium, started a strike which is now into its third month and still on-going. Michael Widmar, analyst at Bank of America Merrill Lynch, said that since the beginning of the strike in South Africa and the crisis in Ukraine “investors have bought a fair bit of palladium, mainly using their options positions.” He expects prices to continue to be supported by the threat of supply disruptions. One of the most direct ways to invest in palladium is straight palladium ETFs. There are a number of well-established ETFs both in Europe and in the US and in March, Standard Bank and Barclays’ subsidiary Absa have added two new palladium ETFs – Africa Palladium and Capital Palladium - listed on the Johannesburg Stock Exchange. Gold prices had a brief “golden” moment in March thanks to Russia, acting as a safe-haven buy but quickly slumped to a seven-week low as soon as the crisis was over. Though Russia produces some gold it is not a large enough player to affect supply and demand. The gold move was short-lived because underlying demand for the metal is declining this year, as the US economy continues to improve investors are switching away from what used to be seen as a“safe”buy and into higher-yielding assets such as US stocks and bonds. The trend is clearly visible in the heavy outflows from gold ETFs which were at their highest this year at the end of March. Geopolitics excluded, analysts believe gold prices will continue to decline and Goldman Sachs predicts that they could fall below $1,000 per ounce this year. I

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REAL ESTATE

UK REGIONS HOPE TO BENEFIT FROM LONDON EFFECT

London remains the property market that can do no wrong. Developers and investors clamour for scarce industrial space, particularly for retail logistics, the capital’s malls and prime retail streets are packed with growing international names and a host of big name hotel operators are preparing to open flagship outlets across the UK capital. Likewise, the residential sector is super-heated and the offices market (in the doldrums during the austerity years) is back to its pre-crash peaks. Mark Faithfull asks whether the rush for space in London can be sustained and whether other major cities around the UK can expect to benefit.

GATHERING MOMENTUM IN LONDON OFFICE SPACE G ATHERING MOMENTUM IN the Central London office leasing market last year has continued into 2014, with take-up of office space for the first three months of 2014 at 2.4m square feet (sq ft). While this is on a par with 2013, the real story is in the volume of space under offer: completed transactions plus space under offer was around 30% up on the end of the first quarter (Q1) 2013. Advisor Cushman & Wakefield estimates that there is around 3.2m sq ft under offer, the highest volume since the second quarter of 2007 and virtually double the five-year quarterly average. Space under offer has increased across all Central London markets, with four potential deals over 100,000 sq ft currently under offer. The transactions include Transport for London (TfL) placing circa 230,000 sq ft under offer at 10 Upper Bank Street, E14; Mizuho is under offer at 2 New Ludgate, EC4 (193,000 sq ft); Havas is under offer at 3 Pancras Square, N1 (160,000 sq ft) and Estée Lauder is under offer at 1 Fitzroy Place, W1 (140,000 sq ft). There are also a number of large active requirements in the market from traditional business sectors that are close to going under offer, including FCA, Société Générale, Rabobank and DLA Piper. Against a background of declining supply, pre-letting continues to be a major part of the leasing market. In the

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first quarter, 740,000 sq ft was let in advance of completion in ten transactions, equating to just under a third of all leasing volumes for the quarter. C&W predicts that there is a further one million sq ft of pre-lets under offer in 20 transactions across Central London, of which approximately 600,000 sq ft of these pre-lets are for developments in the West End, with King’s Cross the main focus. “The low supply environment that occupiers now face will force them to take earlier decisions,” says Andy Tyler, C&W’s head of West End office agency. “Preletting will become the obvious route to secure suitable space for those needing to move in the next 12 to 24 months.”

Demand ahead of supply Ben Burston, head of UK office research at JLL, adds:“Demand for best-in-class office space has run ahead of supply, and with London set to keep expanding rapidly, it will take time for this balance to be redressed through increased development and expansion to new districts.” Recently launched stock which is expected to sell in Q2 includes The Peak, SW1, for £210m, and BBC London’s former home at Marylebone Gardens, W1, for £60m. Damian Corbett, head of central London capital markets at JLL, says: “As the year progresses, we expect trading volumes to accelerate once more, as rising values motivate sellers to bring more stock to

market. Demand will still out-strip supply however, and we expect yields to remain firm, with potential for further compression for best assets.” Even so, the story in not only about London’s West End and City. Canary Wharf and Docklands recorded a major turnaround in occupier activity in Q1 2014. Leasing volumes stood at almost 420,000 sq ft, which equates to 85% of the total volumes let in the area throughout the whole of 2013 and is the highest quarterly volume recorded since Q4 2010. As well as the transaction to EY, MDU has signed for just under 60,000 sq ft at 1 Canada Square, E14. This resurgence is set to continue throughout 2014, with almost 530,000 sq ft currently under offer. This includes approximately 185,000 sq ft under offer at 25 Canada Square, E14. Current space under offer is 75% higher than the volume under offer at the end of Q4 2013 and is nearly three times above the five-year average. “Overall vacancy rates have fallen to under 5% and even at these levels they disguise the tension that is being felt in the market for Grade A and new space, where demand would appear to be exceeding supply,” says Bill Page, business space research specialist at Legal & General Property. “The amount of speculative space under construction has fallen over the year to around 6msq ft, although this does represent an increase of a third compared to 2010. We believe this current quantum is

REAL ESTATE

UK REGIONS HOPE TO BENEFIT FROM LONDON EFFECT

manageable and, currently, oversupply risks are negligible.” Page says that LGP expects a stronger “behavioural response” over the next year in response to the rising rents and compressing yields seen recently. “When completed, these imminent construction starts will take the steam out of rental growth from 2016, although not reverse it. This expected exuberance will, however, be tempered in part by rising build costs, more stringent building restrictions and a limit on the amount of “oven ready” development sites,” he adds. “It is also worth noting that the severe downswings we have witnessed in London over the years have been driven by demand shocks not, ceteris paribus, over supply. We cannot forecast shocks; but we can identify that currently the principal downside risks for London appear to be too much exuberance in the development pipeline combined with rising bond yields,”says Page. “These are already factored into our forecasts, with capital value growth drifting into negative territory towards the end of our forecasting horizon. Total returns remain healthy, however, with rental growth positive over the forecasting horizon.” The prospects of rising rents have led some occupiers to buy their own properties. A recent example is Qatar Islamic Bank which bought a new UK headquarters in the heart of Mayfair in a bid to avoid likely hefty rent increases. QIB (UK) is understood to have paid a private offshore fund just over £20m for 43 Grosvenor Street, W1 and Patrick O’Keeffe, senior director and head of London markets at GVA, says: “Notwithstanding the current high level of Mayfair office rents, where possible we may well see an increase in the number of occupiers purchasing their own buildings in order to make an investment, but also to hedge against further rental growth.” The surge in demand in London has spread to the wider South-East, although there has been something of a disconnect between the investment

market and the occupational market in the South East in the past five years according to Paul Till, business space director at LaSalle Investment Management. He notes that investors were hungry to snap up stock that was not there because new buildings were scarce and occupiers had little appetite for moving. That is set to change. Historically, major UK institutions have been the dominant players in the South East, though they now face competition. As examples, in December a Japanese buyer paid £8.4m, representing a yield of 6.19%, for 23,000 sq ft Crest House in Chertsey. And at the start of this year a private Middle Eastern buyer acquired the 200,000 sq ft Quadrant House in Sutton for £45.3m, equating to a yield of 8.79%. As a result some UK funds are proving prepared to look higher up the risk curve. There are key towns outside the Thames Valley (Brighton, for example) that funds will now consider, although the Thames Valley ranks as the area within the South East likely to see the most office activity. Even here, there has been a shift in occupation focus away from the Chiswick end of the M4 corridor, towards Buckinghamshire and Berkshire, notably Maidenhead and Reading, in part because of “the Crossrail effect”. To London’s east, where the northeastern arm of train link Crossrail will run in 2019, business space development has historically been far more limited than on the M4 corridor. Although Brentwood, the most promising of the Essex Crossrail towns, saw moderate office development in the last cycle, there is little sign of developers moving in to take advantage of the direct rail link to West London.

The UK regions Outside London, the UK regions remain at different points in the cycle. “We are in about year three of the leasing cycle, moved from recovery to growth in 2013,”says Mat Oakley, head of commercial research at Savills, of the Central London market. “Nearly 12m

sq ft leased in 2013, 45% up on 2012. Vacancy rates across Central London are down to 6%, and just 3.7% in the West End. The development pipeline is expected to stay below average over the next five years, which will put further downward pressure on vacancy rates and upward pressure on rents at 5%6% per annum for the next five years.” He points out that offices remain very popular with the risk-averse and those looking for large lot sizes, with ten-plus year leases rising again due to pre-letting and supply shortages. London offices are one of the few asset classes where a global fund can deploy £500m or more in one deal. “Prime yields beyond the South East have already compressed by circa 75 basis points (bps) over the last 12 months and more is expected to come this year as more investors (especially international ones) buy into the growth story outside London,” says Page. “Provided the economic growth story remains on track, LGP expects rental growth of 3.5% per annum during 2014-2018 for offices outside the South East, which will help deliver returns of around 8% per annum.” Longer term, UK cities further afield are also set to benefit. There are compelling infrastructure improvements, particularly in the North West, and momentum is building for HS2-led opportunities in Birmingham. “We favour strong occupational stories and where those characteristics which abide for employment growth, combined with some compelling micro market stories outperformance seems most likely,” says Page. “Of the ‘Big Six’ we particularly see this with Manchester.” To that end, larger cities should consume a greater slice of the investment cake across 2014 and 2015 and it will inevitably be those with more stock–liquidity which see most activity. “However, we expect to see performance differentials in the markets beyond the big six to widen and we have been doing a lot of work in understanding which of these many areas look best placed to deliver employment

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growth and therefore support investment returns,”says Page. Some of these include areas that would not be on a typical investor’s top-ten list, so LGP expects some savvy investors to announce some well–researched but atypical deals in the coming months. To optimise this potential, there must however be a greater focus on expanding the “knowledge economy” in the UK’s regional cities in order to best shape future real estate plans, says GVA. In its report Driving future growth: Core cities and the knowledge economy, GVA highlights Birmingham, Bristol, Leeds, Liverpool, Manchester, Newcastle, Nottingham and Sheffield as cities with scope for major development. However, it says that development would come only if these cities base their plans on a better understanding of the talent and skills held in those cities. The report also examined the presence of the“knowledge economy” in each city, looking at the performance of sectors including IT, business and engineering. Carl Potter, senior director and head of offices at GVA, reflects:“The knowledge industry, although categorised as higher risk, can provide a good balance between risk and reward as investors seek opportunities away from Central London.” “The UK’s major regional cities are in year one of the recovery, with take-up in 2013 up 30% to 40% dependent on location,” says Oakley. “Vacancies are steadily falling in the top seven regional city office markets and development pipelines are even more restrained than in London—the current pipeline is equivalent to less than 1% of stock. Although we expect to see more developments starting in 2014, this is unlikely to satisfy short term demand.” He also notes that many investors are looking for regional acquisitions, especially those priced out of London, or those that are looking to capture the early stages of the recovery.“Top picks are probably refurbishment or redevelopment in Manchester, Edinburgh, Glasgow, Leeds and Bristol,” he says.I

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Luxembourg and the UK are shaping up to provide them, Hong Kong is debating legislation which would make it a player, while South Africa is also under advisement. All want to attract Islamic finance and to establish themselves as Shari’a-compliant hubs away from the traditional Arabic countries. At stake are hundreds of millions of dollars and first mover advantage in a sector growing rapidly but which comes with its own set of complex rules and an in-built hunger for real estate, says Mark Faithfull.

Hubs step up in battle for Shari’a money UCH IS THE flurry of activity around Shari’a-compliant product at the moment that The Grand Duchy of Luxembourg has become the latest to move a step closer towards the issuance of a debut sukuk. The government has presented a draft bill to parliament to pave the way for the deal, proposing the issuance of a €200m-equivalent sovereign sukuk denominated either in euros or US dollars. The Luxembourg government has also identified three real estate assets to underpin the transaction. However, no timeframe has been set for the completion of a deal that has been under consideration for several years now. Other non-Islamic sovereigns have been linked with potential sukuk deals. In 2012 South Africa appointed advisor BNP Paribas, Liquidity House Management and Standard Bank to manage a possible sukuk offering, though a deal has yet to emerge, while France has also been slated as a potential sukuk issuer. In 2004, the German state of Saxony-Anhalt issued a €100m sukuk, while most recently the UK government made its intentions clear and it is currently looking to establish the first UK sukuk. The interest comes from the growing prevalence of Shari’a-compliant vehicles in the Gulf Region. Damac Real Estate Development is the latest poised to benefit from Dubai’s property

revival. A developer famed for offering free Lamborghinis, BMWs and Mini Coopers to luxury apartment buyers, it plans its first sale of Islamic bonds having had meetings in Singapore, the United Arab Emirates and London seeking to attract investors to its sukuk sale and Standard & Poor’s rated the proposed notes BB, two levels below investment grade, and expects a $500 million issue. The company, which raised $348 million in a share sale in London late last year, aims to build a string of luxury developments, including Donald Trump-branded golf course residences. Meanwhile, Emaar Properties’ Islamic bond is returning twice the average of sukuk across the six-nation Gulf Cooperation Council (GCC) this year, and the yield on Emaar’s 2019 Islamic bonds fell 68 basis points this year to 3.9% on 28 March. That compares to a 29 basis-point drop to 4.35% for Middle East sukuk. Only one dollar-denominated Islamic bond has been sold in the GCC this year, a $300 million issue from a unit of Dubai Investments, making this the slowest first quarter for sukuk sales since 2009. However, Damac said that 2013 profit tripled to $641.5 million as apartment prices in Dubai, its main market, climbed 43%. “There is no clear fragmentation of markets between traditional—or conventional—and Shari’a-compliant

REAL ESTATE

REAL ESTATE REALTED SUKUK ISSUANCE

assets. Islamic countries exist which do implement a Shari’a legal framework, but even in these markets, conventional and Islamic structures exist,”says Yahya Abdulla, head of Middle East capital markets, for advisor Cushman & Wakefield. “What type of structure is adopted is generally dependent on the type of investor rather than the particular geography or asset. Generally, the first filter to be applied by Islamic investors would be with regards to the tenant, avoiding those which are clearly in breach of Islamic values such as conventional financial institutions, leisure/hospitality—involving alcohol and pork—and arms manufacturing. It is worth noting that the same asset can be structured to suit the needs of an Islamic or a conventional investor.” “The investment horizon of Shari’a compliant assets is again dependent on the specific strategy of the investor,” he says. “The structure itself generally does not place a restriction on the investment period. Regarding accessibility to Shari’a-compliant investments, while the majority of the products can be sourced from Islamic institutions from the GCC and Malaysia, it is worth noting that various other nations are seeking to establish themselves as hubs for Islamic finance, including the United Kingdom and Singapore.” Others are looking to establish their own credibility in the field. At the end of March this year, Hong Kong legislators passed a bill to allow the AAA-rated government to raise around $500 million via sukuk, or Islamic bonds. A debut sukuk from Hong Kong would boost its Islamic finance credentials and help position the Special Administrative Region as a gateway between mainland China and investors in the Gulf and South-east Asia. The task of issuing that sukuk now rests with the Hong Kong Monetary Authority under the territory’s Government Bond Programme, which has a borrowing ceiling of HK$200 billion ($25.8bn). As of February, the programme had 14 listed bonds currently outstanding worth a com-

bined HK$94bn, with tenures of up to ten years. Hong Kong’s sukuk plan comes at a time of increasing competition among financial centres for a slice of Islamic finance business and at $500m would be larger than debut sovereign issues planned by Luxembourg and the UK, which are at different stages of development. The proposed sukuk issuance has been described as“inaugural”, suggesting it is not intended as a one-off. Sukuk proceeds would be placed with the territory’s Exchange Fund, which is managed by the Hong Kong Monetary Authority.

UK’s opening bid The UK made its opening bid last year to become a European hub for Islamic finance and capital London has taken in over £11.7bn worth of Islamic investment in the last ten years, making it the largest Islamic financial centre in the western world. Alongside this, iconic buildings such as The Shard, Chelsea Barracks and Battersea Power Station, have benefitted from investment from predominately Muslim countries. Earlier this year, HM Treasury appointed HSBC and Linklaters as external advisors to assist it in its work to develop a UK government sukuk, or Islamic bond. HSBC will provide expert financial advice on structuring the sukuk to ensure that it conforms with the principles of Islamic finance. It will also assist HM Treasury and the UK Debt Management Office in making the necessary preparations for issuance. Linklaters will provide commercial legal advice in relation to the capital markets, tax, regulatory and real estate implications of issuing a sovereign sukuk for the first time. It is anticipated that issuance will take place either this year or next by way of a syndicated offering. The appointment of these advisors is related to the Prime Minister’s announcement at the World Islamic Economic Forum on 29th October 2013 that HM Treasury was working on the practicalities of issuing a sukuk worth around £200m.

There have also been some on-theground examples of the growing influence of Islamic financing. Late last year, Gatehouse Bank issued a pair of seven-year sukuks, returning 4.25% and 6.25% annually. The sukuks each have a value of £8.2m and are secured against the BT headquarters in Leeds, a 134,000 sq ft, grade-A office building already owned by the bank and currently let to BT until 2020. This represented Gatehouse Bank’s second sukuk issue, and followed the launch of a 3%, five-year bond in December last year. The sukuk, which was secured against a property let to Fujitsu in Viables Business Park, Basingstoke, raised £6.9m. Youness Abidou, vice president, structured finance at Gatehouse Bank, says: “The previous successful sukuk issuance identified a new opportunity for the bank to expand its offering in this sector, and with this current arrangement the bank has further capitalised on the demand for well structured Islamic instruments in the UK.” Gatehouse specialises in originating, structuring and funding investments in a Shari’acompliant manner, and has a global portfolio of around £1.25bn, spread across real estate, term deposits and capital investment. However, the industry is also booming on a non-institutional level. Naomi Heaton, CEO of residential specialist London Central Portfolio (LCP), the only company to offer a Shari’acompliant residential fund in the UK, says:“We have seen a growing demand among consumers for Shari’a-compliant investment products in the UK as well as from the Middle East. However, these investors are still limited in their options and do not have access to the diverse range of products on offer to the conventional market. Our fund offers access to the private rented sector (PRS) in prime central London [a booming real estate sector, generally classed as an ‘alternative asset’ within real estate] and has proved a popular proposition, with a third of subscriptions coming from Muslim investors.”I

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INVESTOR SERVICES

IBOR: A single source of truth for buy-side firms There are many differing views of what constitutes an Investment Book of Records (IBOR), but the industry seems to be moving towards a definition: it is a continuous list of time stamped trade and transactional events that affect the position of any account. These transactions can then be aggregated up to give a view of the position of the fund(s) at any point in time; past, present (in real time) or future (based on information available at that time) writes Duncan Cooper, director, Sapient Global Markets. He explains that investment managers can spend too much time and effort to get an accurate view on where they are in the market and why an investment in IBOR may be well worth the implementation and design cost. ONSOLIDATING THE FRONT office and back office into a synchronised real-time system requires considerable time, expense and effort and may not deliver the business benefits that will make it worthwhile for all organisations. Investment managers with high volumes of subscriptions and redemptions, large equity portfolios or fixed income funds (with associated derivative instruments in the mix) will have heavy cash flow-sensitive instruments. They must bear the operational cost of

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

manually updating and synchronising their market exposure. It might also involve a missed opportunity cost of being fully invested or even a market opportunity because portfolio managers must spend time performing administration tasks to get an accurate view on where they are in the market. This traditional approach requires too much time and effort to update and keep in sync and an investment in IBOR may be well worth the implementation and design cost. As the industry in general moves

IBOR: EFFECTIVE MANAGEMENT OF FUND DATA

Photograph © 251355tatiana/Dreamstime.com, supplied March 2014.

towards a 24/7 operation with multiple global sites and handling issues such as “passing the book”, a single global position and consolidated regulatory compliance view is more imperative than ever. It is no longer sufficient to operate as multiple separate organisations or silos with one common brand. Firms must now function as a unified organisation with a single view of the world, able to react to changes in each market with speed and agility. To do this, firms need data—and not just data in various systems and databases separated by regions, assets and process. Instead, firms need a single source of accurate, timely and clean data that can be used throughout the organisation as “the truth”. Those with access to this data and the ability to use it to gain a competitive advantage will be most successful.

The IBOR options As with any problem, there are a variety of possible solutions, each with its strengths and weaknesses. It is important to choose the solution that fits into the firm’s ecosystem rather than the one that is cheapest. Outsourcing to third party administrators is a compelling approach for many organisations as they gain functionality without having to build a heavyweight technical solution from scratch. As always though, the devil is in the detail. Will you receive real time positions on demand? Can you easily find retrospective positions for an historical point in time? Can you source potential positions with all the information you have to hand today? Then there are implications for collateralised and segregated positions and their impact on cash flows. Complex derivative and structured products can require collateral and collateral management and involve complex cash flow patterns, all of which will affect current and future positional views. If your organisation does not have these complex demands, or if you administrator has these capabilities built into their solu-

INVESTOR SERVICES

IBOR: EFFECTIVE MANAGEMENT OF FUND DATA

tion then this could well be a compelling option to investigate. Purchases from software vendors are another route. It is useful to have all relevant information in a single location. Any number of firms now provide off the shelf and customised services that provide positions to the front office order management systems (OMS) in a start of day pattern and real time views as they move into the IBOR space. Using a single system ensures that all corporate action changes, cash adjustments and amendments, subscriptions and redemptions and reconciliation happen within a single system/database. This system acts as the golden copy for all operations, trading and portfolio management. A complete out-of-the-box single stop solution is a compelling quick win. These vendors should also be asked detailed questions. Do they handle complex instruments and cash flows? Do they provide the functionality that you need from either an IBOR and/or a PMS/OMS or accounting system? While an off the shelf solution sounds appealing and straightforward, there are some important considera-

tions to take into account. A single system in one office can be a sensible approach, but could be a challenge for a global operation with multiple sites, given that the impact and challenges around a 24/7 operation and single database/system are complex—with a very real single point of failure. Opting for a single system means firms are inherently tied to a single vendor; with that vendor’s product roadmap, features list and strategy. A firm may find that what is important to its business may not be important to the software vendor. The simple technical concerns of scalability and reliability can be mitigated to a certain extent with careful technical planning, but there is always a risk with a single system layout. Systems might not have the necessary functionally; for example, more exotic or complex workflows in the PMS/OMS space for SCD may be a challenge. Additionally, if a firm’s portfolio managers and traders are attached to their current workflows, they might find the capability and functionality of such a system difficult to adopt. Finally, it is important to consider the diversity

of the firm’s locations and operations. An Enterprise Service Bus (ESB) is a centralised architecture solution for synchronising many systems within a firm’s ecosystem. All systems (PMS/OMS/EMS, accounting, risk, PMA) connect into a centralised bus which transports, transforms and certifies data delivery from one system to another on an event basis—as opposed to batch delivery systems. This results in all systems having the same information at the same time. When an order is created, the trade moves through the OMS/EMS system. When its lifecycle in the OMS/EMS is completed, it is automatically extracted to downstream systems. As a solution, ESB is scalable. As the ESB takes care of delivery and reconciliation of the systems, the positions and information in one system will be in synch with all other consuming systems. It reduces manual processing and double key entry, thus also reducing operational risk. In addition, an ESB provides a federated distributed golden copy of securities to all systems, a common pain point for asset managers. Using an ESB allows firms to

A TEMPLATE FOR EFFECTIVE DATA MANAGEMENT External Data Sources

Real Time Dashboard and Reporting

Orchestration & Transactional Distribution Layer

Portfolio Modelling (Proxy Stub)

EMS (Proxy Stub)

OMS (Proxy Stub)

Settlement (Proxy Stub)

Compliance & Risk (Proxy Stub)

Portfolio Accounting (Proxy Stub)

PMA (Proxy Stub)

Application Specific Implementation (Proxy Stub)

Proposed Trades

Accounts Positions Securities

Portfolio Modelling

Executed Trades

Staged Trades

Execution Management (EMS)

Executed Trades

Proposed Trades Accounts Positions Securities

Order Management

Confirmed Trades

Executed Trades Accounts Positions Securities

Settlement (Confirmation/ Affirmation)

Accounts Approved Proposed Orders Confirmed Positions Orders Executed Orders Accounts Orders Securities Approved Positions Executed Orders Positions Securities

Compliance & Risk

Portfolio Accounting (Book of Records)

Accounts Positions Securities

Performance Management & Attribution

Source: Sapient, April 2014.

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select best-of-breed systems for PMS/OMS/EMS, accounting, risk and PMA. It also enables rapid implementation and the decommissioning of systems; thus a change of OMS is no longer a multi-year project. Even so, it is not all plain sailing. It is a companywide initiative, taking resources from all areas, requiring niche technical skills to implement. Complex implementations can take many months to implement and there is limited visibility into the actual business value that an ESB delivers. It is therefore often seen as a cost reducer and not something that creates a competitive advantage. Also, there is no “single system” of truth, unless investment is made to introduce a data warehouse or data store at the same time. As the overall timely data picture is now federated among many systems within the business, finding all aspects of what has happened, for example, in a trade lifecycle, still requires many checks to many systems. An ESB will not alleviate the reporting requirements of the many regulations coming into play for the investment management industry. Where an ESB really excels, however, is its ability to link together multiple dissimilar systems distributed globally. If a firm needs to verify what was traded on its portfolio in London and what its traders are trading on in New York, then an ESB might be a good solution. The firm can link to each OMS in each region and ensure that books and records are updated. Instead of reimplementing the global business to a single system, an ESB establishes a data integration layer that ensures synchronicity, allowing each geographic unit to use their preferred solution while also providing a single picture for the whole organisation.

A centralised data warehouse The most commonly used design pattern to solve data consolidation issues within investment management

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is the data warehouse. This is a technically simple solution through which, once a data model is derived, only ETL and traditional system integration issues need to be addressed. Much has been written about various data warehouse concepts—from data federation and data marts to de-normalised and star schema—but the concept is a single storage and access location for all trade, market and client data, which then becomes the “truth” in your organisation. The database will be designed for Online Analytical Processing (OLAP) as opposed to Online Transactional Processing (OLTP), meaning it can retrieve data quickly, but it is not as quick to store data from a transaction. A data warehouse is a solid concept. Nothing has radically changed in the design or delivery of data warehouses since the turn of the century. They are mature, reliable and scalable, with a number of vendors and resources that can design, deliver and support their use. A well-designed and accessible data warehouse can be the bedrock of an organisation supporting not just the PMS/OMS/EMS front-office world, but also making available trading trends, cost of trade and a whole gamut of useful operational statistics to analyse various costs within an organisation. But databases are slow in data terms. To get information from various systems into the database requires ETL functionality, which is typically used for large volumes of records on a minimal frequency basis. From a business perspective, there are benefits to a data warehouse; it uses mature, low-risk technology to deliver a single location for investment positions. However, when timely updates of the positions into the system are needed, the centralised location does not allow for quick reaction times. Nor does it add any additional business functionality into the processes like a single system would. As such, it is a low cost—but also low value—solution.

Distributed data fabric The typical design pattern of a data fabric is an in-memory data cache of operational data, these are common in the sell side, but are rarely seen within the buy side. They mitigate the issues of OLAP versus OLTP that can hit the data warehouse. Firms can load each transaction into the data fabric quickly without impacting performance or replication. Positions within the system are constantly updated with each trade, cash movement, dividend and corporate action. The data can be used on the fly to perform portfolio management systems (PMS) “what if” analysis, passed to risk calculation engines, real-time compliance checking or performance measurement and attribution (PMA). As a transactional data fabric, the operation can be likened to a data warehouse without the data warehouse’s weaknesses. Data is added on a transactional basis and interfaces from external systems (like FIX) can also update the positions. Ultimately, the view is like a database in a single location, but in near real-time operation on a distributed grid. Data fabrics are gaining a great deal of traction as a sell-side risk solution and are well suited to buy-side IBOR challenges. Data fabrics are very much cuttingedge technology to enable IBOR. As such, there is the inherent implementation risk of finding quality resources able to design and deliver an optimised solution that provides the needed operational value. Because data fabric and ESB solutions are seen as purely technical, the inherent issue with implementing them is one of project cost and duration, combined with the perceived value to the business. They require deep specific knowledge within a technical niche area, so resources are more expensive to source and projects are more complex to plan. While they may be the best“technical”solution, the business needs and organisation need to be explicitly defined so as to justify the expenditure to solve the problem. Data fabrics do provide business

INVESTOR SERVICES

IBOR: EFFECTIVE MANAGEMENT OF FUND DATA

value. As a single computation grid, the scalable risk calculation engines can leverage the data fabric to create slices for risk, PMA and what-if scenario analysis, making results available in real time to the business. Instantaneous calculations feeding into the PMS could be a major competitive advantage for some investment managers.

The near term future The IBOR space has increased in interest and importance over the past year. Could 2014 be the year of the IBOR?

The reaction of vendors, both software and services, as well as consultancies and business users to the possibilities that an IBOR offers suggests that this may be so. The systems used within an organisation can be viewed as commodity. There is little differentiation or competitive advantage in an OMS. What is unique in any investment manager is their data. This is the Intellectual Property of the organisation. Ensuring that this information can be accessed accurately, quickly and aggregated in the

manner in which the user wishes to process and consume it will be the competitive advantage to differentiate between the leaders and the also-rans. Ultimately, the key factors in choosing a solution involve the market a firm operates in, the impact that a lack of IBOR is having on the business and the speed in which a firm wishes to gain a competitive advantage in the market. In the end, the most successful firms will be those that strategically align their choice of solution with their business objectives for growth. I

EUROCLEAR & DTCC BREAK NEW GROUND WITH COLLATERAL PROCESSING JV Negotiations are now being finalised to establish a joint venture (JV) to deliver a collateral processing infrastructure that leverages and integrates the capabilities of both the US Depositary Trust and Clearing Corporation and Euroclear. What are the implications of the initiative?

HE JV WILL initially focus on launching a Margin Transit Utility (MTU) that will provide straight through processing to the settlement of margin obligations, and on piloting a Collateral Management Utility (CMU) to address the pressing problem of sub-optimal collateral mobility and allocation at a global level. “We will be addressing sub-optimal collateral mobility and allocation issues by creating the biggest open architecture collateral processing ecosystem, accessible to all market participants across the globe. By delivering tangible benefits to the industry, we will improve efficiency and mitigate risks at a time when regulatory change is expected to significantly increase the volume of margin calls and securities collateral settlement,” explains Tim Howell, Euroclear’s chief executive officer. The initiative builds on the May 2013 agreement between the two post trade heavyweights and sets up a major through point or thoroughfare for collateral movements. The MTU service has already received significant interest from the industry. The MTU will leverage development work being undertaken by DTCC and the CMU pilot will leverage current Euroclear technology. When fully operational, the utilities will be integrated to provide a seamless front-to-back collateral processing platform. “Collateral processing continues to become more complex, with margin calls expected to rise steeply and the need to seamlessly integrate collateral and spot market settlements similarly increasing. Firms are actively looking for global solutions to solve these issues. We look forward to working with Euroclear and the industry to drive operational improvement,

streamlined access to collateral and reduced risk in the years to come,” adds Michael Bodson, the DTCC’s president and chief executive officer. The JV will operate open architecture services, where DTCC’s and Euroclear’s settlement platforms represent two of many linked settlement locations. The intention is to extend access to other interested settlement platforms such as central securities depositories, custodians and settlement agents. The initiative also builds out DTCC’s ambitions in the collateral space. In October 2013 DTCC purchased the remaining 50% it didn’t own of OMGEO. The DTCC in effect now fully owns one of the bigger collateral management service providers in the market with a reach to over 6,500 end-user clients globally, which with this venture with Euroclear makes it one of the leading providers of collateral management solutions globally. The DTCC’s strategy was clearly delineated in its whitepaper published late last year, Trends, Risks and Opportunities in Collateral Management which stated, “The reality is that collateral challenges will be far more extensive than what has been reported thus far, and in many cases, fragmented solutions will only address certain parts of the problem… it is essential that strategic collaborative solutions are employed to the greatest extent possible. The final T&Cs have yet to be worked out, including definitive documentation describing the joint venture. Board approval is still required as are local regulatory approvals; however the venture marks the growing closeness between the two firms, a process that really got underway in 2012. Expect more initiatives between the two.

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DERIVATIVES CLEARING

Photograph © Philcold/Dreamstime.com, supplied April 2014.

Avoiding collateral damage ITH ITS TOUGHER eligibility rules and non-disputable clearing-exchange margin calls, today's revamped OTC derivatives-clearing regime not only poses significant challenges but also casts a much wider net than ever before; even those not encumbered by larger initial margin pledges will still likely require sufficient reserves to meet variationmargin demands. This raises questions as to which methods are best suited to

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move and maintain the right kind of collateral, given the situation at hand. Meanwhile, the emergence of newer trading venues and CCPs underscores concerns over further market fragmentation, and, in its wake, higher costs associated with the managing of margin requirements. Last September, the Basel Committee on Banking Supervision (BCBS) along with the International Organisation of Securities Commissions

LIVING WITH NEW MARGINING RULES

Those charged with devising plausible collateral-facing strategies must cover a lot of ground, from reducing sell-side silo activity, to helping buy side clients find proper solutions for calculating margin calls, all the while keeping pace with divergent global margin standards. Dave Simons reports from Boston.

(IOSCO) issued a basic framework for uncleared derivatives margining requirements, part of the ongoing campaign to mitigate the kind of blow-ups that occurred at the height of the financial crisis. While the EU margin rules follow a specific standard according to the governance of EMIR, in the U.S. regulators have been busy polishing up their own set of requirements, which, though similar in some respects to the European guidelines, nonetheless have a distinctly stateside flavor. Accordingly, those charged with devising plausible collateral-facing strategies must cover a lot of ground, from reducing dealers’ silo-based activity in order to improve operating cost and functionality, to helping buy side clients find solutions for calculating margin calls while stepping up the pace and accuracy of reporting—all the while keeping tabs on the divergent global margin standards. While past methods of moving margin and choosing counterparties may have required less thought, they also afforded clients far less risk coverage. Still, as the number of counterparts continues to rise and clearing standards grow more complex, clients without proper weaponry potentially face a whole new set of vulnerabilities, says Kelly Mathieson, global head of collateral management for JP Morgan. “Which is why we continue to focus on building out our tools and functionality from a collateral perspective in order to more accurately reflect a client’s risk profile,”affirms Mathieson. In this way, clients can be better equipped to round up assets they already have or need to acquire in order to respond to their counterparty in a timely manner. At the same time, providers need to remember the importance of maintaining separation of agency and principal roles, says Mathieson. “For instance, from a collateral standpoint we don’t want to cross the line and start becoming actively involved in the transaction process, whether it’s through the lending of securities or other type of

DERIVATIVES CLEARING

LIVING WITH NEW MARGINING RULES

transformation process. As a collateral agent, we can recommend certain asset types that would be suitable for fulfilling a client’s collateral obligations based on their particular profile, however, we’ll refrain from carrying out the transaction ourselves.”

Collateral solutions With more firms falling under the margin microscope than ever before, providers like the Depository Trust & Clearing Corporation (DTCC) have seen heightened interest in collateral solutions, particularly as participants become aware of the scope of the new requirements. “This not only includes internal tools, but also infrastructure and strategic solutions as well,” says Jennis. “There are many different approaches nowadays, from traditional collateral optimization to new methods of distributing collateral information between firms, to effectively matching margin calls and managing settlements, not to mention improved reporting transparency. As such, we’ve become more involved with all of the different participants, from dealers and custodians, to buy side firms and administrators, with the goal of bringing more value to the entire chain.” The growth of clearing, the need for initial margin, as well as the potential for margin calls around different types of currencies has led to increased fragmentation, and this is challenging firms’ ability to effectively manage collateral from a settlement, reporting and financing perspective, says Jennis. These and other elements have given rise to the Margin Transit Utility solution, which allows global participants to utilise straight-through mechanisms in order to reduce margin-related risk and cost. “From our perspective, the demand that we’ve seen suggests a much greater interest in obtaining front-to-back solutions as a way of improving the overall margin-related infrastructure,” says Jennis. While the buy side has required the lion’s share of guidance, by no means

does the sell side have all of their bases covered.“While it’s true that many large dealers have already automated, they may still be using different silos for different types of products,” notes Jennis. This has led DTCC to devise specific utilities for addressing silo-based activity with the goal of achieving proper integration of internal resources. “For dealers that are challenged to maximize their spreads, any kind of strategic, industry based solution that can address both cost and risk is going to be very attractive in the present environment,” says Jennis. For its part, BNY Mellon has sought to revitalise its optimisation technologies so that sell-side firms can make their collateral go that much further. “It’s been a labor of love for us,” offers Nadine Chakar, executive vice president for BNY Mellon’s global collateral services division. “By streamlining our service, we will be able to properly help these clients allocate collateral while providing the lowest possible delivery costs, as well as finding the best match for what they are trying to accomplish.” Servicing the buy side requires a multi-pronged approach, says Chakar. “In general larger firms tend to be better at getting up to speed, and we’ve seen many of them devoting a lot of time to mapping sources of collateral, taking into account both current and future eligibility. Global insurance companies or fund-management firms have their assets scattered everywhere—as a result, gaining visibility into what they have and where it’s located typically requires some heavy lifting. Which is why these firms are often looking to providers like us to serve as an aggregator if you will, to help them achieve an unfettered view of their collateral, no matter where it resides or what legal entity owns it.” Buy side players are also placing greater emphasis on determining the intrinsic value of that collateral, adds Chakar. “For example, insurance companies are required to pledge collateral in any state in which they serve as underwriter,” says Chakar. “Just a few

Kelly Mathieson, global head of collateral management for JP Morgan. While past methods of moving margin and choosing counterparties may have required less thought, they also afforded clients far less risk coverage. Still, as the number of counterparts continues to rise and clearing standards grow more complex, clients without proper weaponry potentially face a whole new set of vulnerabilities, says Mathieson. “Which is why we continue to focus on building out our tools and functionality from a collateral perspective in order to more accurately reflect a client’s risk profile.” Photograph kindly supplied by JP Morgan, April 2014.

years ago, firms might post anything they had on hand—cash, treasuries, you name it. Now they may be choosier, especially if a certain type of collateral would be better for settling an OTC trade, or perhaps used as part of a lending arrangement.” Realising that standardisation can lead to lower operational risk while boosting process efficiencies, buy side firms have become more interested in the specifications of their collateral agreements. “We’ve seen a lot of exploratory work for pension plans, where in many instances a CSA may not even exist,” notes Chakar. “As a result, a majority of these participants are now taking a fresh look at their agreements and are re-papering where appropriate. Which again can be a time-consuming proposition were they to go it alone.” Those lacking ample liquidity don’t want to be in a position where they are forced into a fire sale in order to quickly raise collateral, or convert securities into something that their clearing house will deem acceptable. This is a particularly salient point for futurestrading managers who must post cash

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collateral as variation margin to a clearing agent or futures commission merchant (FCM). “For instance, an FCM may initially accept a corporate bond or residential MBS as eligible collateral,” notes Dave Olsen, global head of futures & options, OTC derivatives, and securities clearing for JP Morgan, “while at the same time they would need to fund the obligation to the clearing house, perhaps using an external repo or other borrowing mechanism.” Should the markets hit a rough patch, however, the FCM could suddenly decide that the bond or RMBS is no longer kosher, and tell the customer as much with little to no advance notice. Eliminating all forms of collateral that aren’t pre-approved by the clearing house can help alleviate such problems in advance. But there are other strategies as well, including the optimisation, minimization and smart movement of collateral. “As an example, we can re-configure the client’s risk exposures in order to maximize the availability of offsets, thereby reducing their total collateral requirements,”says Olsen.“From there we can determine the most effective means of handling the collateral, with the aim of making the process that much more efficient.”

Eliminate portfolio inefficiencies While incorporating optimization and transformation techniques, clients should also take steps to eliminate existing portfolio inefficiencies. “Because of these new capital rules that banks and clearing agents are subject to, without an efficiently structured portfolio you could find yourself paying upwards of three to four times what it would cost to access the market otherwise,” says Olsen. “That’s a level of preparedness that we are only now beginning to see taking place among clients.” With a third-party margin agent, clients are effectively shut off once they exhaust their collateral supply. It is here

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that Bob Holland, senior product manager, fixed income and derivatives at Linedata, sees an opportunity in the making. Using an interactive margin facility, clients would be afforded some degree of collateral continuity. “For instance, we have a collateralmanagement tool that we’ve used on behalf of one of our main clients on a proprietary basis,” says Holland. “And there are likely many others out there who have the same kinds of workflows and could therefore benefit from a similar solution. And if this can be established as part of the core offering through a mutual partner, all the better.” With the majority of market processes already commoditised, clients are increasingly seeking collateral solutions that are universally accepted and easy to implement.“Particularly when you’re dealing with large, liquid, on-the-run type of swaps, firms don’t really want a bespoke product—they would rather have something that is already in place and being utilised by other clients, and therefore are very willing to modify their workflows in order to make it fit,” says Holland.“That way they can have the same out-of-the-box functionality, product upgrades and other benefits, rather than waiting for their teams to devise something specifically for them. The less customised the product, the easier and more cost effective it is for everyone involved.”

Gaining collateral clarity No discourse on collateral preparedness would be complete without including the need to streamline messaging processes. “In today’s world, collateral is something of an outlier in that margin calls remain very e-mail oriented,” says John Southgate, senior vice president at Northern Trust. Messaging solutions such as AcadiaSoft have made decent inroads within the sell side, as has the integration of automated collateral-management systems. “This is clearly the direction the market needs to be moving,” says Southgate.

Nadine Chakar, executive vice president for BNY Mellon’s global collateral services division. For its part, BNY Mellon has sought to revitalize its optimisation technologies so that sell-side firms can make their collateral go that much further. “It’s been a labor of love for us,” offers Chakar. “By streamlining our service, we will be able to properly help these clients allocate collateral while providing the lowest possible delivery costs, as well as finding the best match for what they are trying to accomplish.” Photograph kindly supplied by BNY Mellon, April 2014.

“As an asset-servicing firm, we are enhancing our tools to process those messages directly into our collateralmanagement systems in order to produce automated responses that can accept or reject margin calls, and, taken one step further, allocate the required collateral. So it’s a process that continues to gain momentum in both the EU and US markets.” Gaining insight into the various account structures that exist within the cleared world is key to improved mobilisation, transparency, and protection of collateral. “By putting these different structures in place, assets that are pledged into the clearing lifecycle can remain within our own custody account structure,” says Southgate.“By doing so, there’s no market settlement required, which removes a certain amount of risk due to potential delays in delivering the collateral. And because you can see where your assets are located at any given point in time, transparency is greatly enhanced as well.” The absence of regulatory harmonisation hasn’t helped clients who’ve yet to fully grasp the ramifications of the new order. “It’s really been unclear what the cost differences might be, say,

DERIVATIVES CLEARING

LIVING WITH NEW MARGINING RULES

when comparing the bilateral space to the cleared world,” says Southgate. Additionally, increased demands around regulatory capital requirements, margin standards for un-cleared swaps, and other rule changes in the making will bring with them their own yet-tobe-determined expense tally. “It does help explain the mixed response we’ve seen among certain firms,” says Southgate. Modeling, however, can help clients get a better feel for probable outcomes based on a number of variables. “By taking OTC elements of the portfolio and modeling them through clearing margin calculation tools, then adding in a number of historic market shocks, we are able to present a much clearer picture around likely initial margin requirements, as

well as how much variation margin or cash liquidity clients would need.”

Wait and see? While some have already incorporated these modeling strategies, others have elected to take a wait-and-see approach. Doing nothing, however, is risky business, says Southgate.“While in ‘normal’ markets collateral shortfalls may be minimal, it is cash liquidity that remains most vulnerable given current trends.” A pronounced interest-rate spike, for example, could require companies to have billions of dollars in the reserves, “especially if the movement occurred quickly and without warning.” By most accounts, the rulemaking limbo that has helped cloud the collateral space isn’t likely to pass anytime

soon. According to April figures from global law firm David Polk, nearly half of all required Dodd-Frank rules remain a work in progress; one-fourth have yet to be proposed. “We have clients who are still waiting for clarification over, say, whether a person is considered domiciled in the United States or abroad based on the type of trades involved,”says Holland.“It’s sort of like trying to change a tire while the car’s still moving—you can’t just stop everything until all the decisions have been settled. Which is why we’ve seen people instead choosing to address their most basic workflows and liquid trades, then continuing to move down the complexity chain as far they can reasonably go while awaiting further clarification.” I

SURVEY FINDS INDUSTRY LAGGING BEHIND MARKET REGULATION DEADLINES AS SEF TRADING TAKES OFF With the Dodd-Frank rule for certain swaps to be mandatorily traded on Swap Execution Facilities (SEFs) becoming effective, a new survey finds that the industry remains underprepared to meet the requirements of these new regulations, while individual firms push ahead to make themselves ready. IPC Systems’s survey, highlights the state of the industry’s preparedness for this new SEF model and potential impact on the OTC derivatives markets.

he survey was conducted during FIA Chicago in early November last year, with respondents from the front, middle, and back office and included people involved in both the business and technology sides of trading operations. More than half (58%) of the respondents indicated their firms were already trading swaps and other OTC derivatives, while 42% of the respondents said that they intended to begin trading swaps and other OTC derivatives in 2014 after the new regulations were put in place. Even with the interest in this market, the survey suggests that as a whole the industry is not on track to meet the requirements for SEF trading. Only 40% of the respondents thought the industry was on track to meet its deadlines, while another 40% felt the industry was “somewhat behind” and a further 20% were certain the industry was “significantly behind.” Some 39% of survey respondents said their own firms were behind on meeting the deadlines on SEF trading. Respondents were generally positive about the impact of SEFs, with more than 75% positing that swap execution facilities will have an impact on trading volumes and sizes, while at least 25% expect the value of the OTC derivatives market to grow. Meanwhile, 61% of respondents expect to

see a shift to the futures market due to the complexity and costs of regulations. “Over the last year, we have seen a lot of activity from financial firms that have been looking for additional or new network connectivity to many of the already registered SEFs or OTFs through Connexus, our financial extranet,” explains Ganesh Iyer, director, product marketing, Financial Market Network at IPC. “While the survey results suggest that the industry is underprepared for mandated SEF trading, we see this issue as more of a fear of uncertainty around industrywide implementation and regulatory governance. Individual firms, SEFs and their equivalent platforms are already planning connectivity, systems and processes to be ready to meet the new trading requirements.” “In response to the challenges brought on by the new regulations, many firms have chosen to leverage network connectivity and infrastructure as tools for overcoming some of the obstacles raised by the new rules,” adds Ganesh. Connectivity to SEFs or equivalent platforms are not only critical to meet compliance requirements but also allow firms to compete and position themselves for future opportunities as the market continues to evolve under the new regulations”.

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ASSET ALLOCATION

Sparks: emerging market flashpoints versus investor sentiment Each year global insurer Aon revisits the risk outlook for leading emerging economies. This year’s outlook identified an increased risk rating for all five BRICS, including political violence, government interference and sovereign non-payment risk. Is 2014 yet another testing year for cross-border investment? Or, are investors decoupling from risk and looking at other elements in making the investment decision? Bank of America Merrill Lynch’s monthly fund manager survey of 239 panelists with $674bn of assets under management (AUM) suggests that a net 66% of global fund managers believe the US is still the most over-valued equity market (little changed from March and February). That fact has many looking again at emerging markets (despite heightened political risk). A net 55% think these are undervalued, up from 49% in March and the highest reading ever. Only a net 2% would like to underweight emerging markets, down sharply from 21% in March. What does it all mean? ON HAS DOWNGRADED Brazil’s rating, as the insurer holds in its newly-issued risk map that political risks “have been increasing from moderate levels as economic weakness has increased the role of the government in the economy. This is of particular concern given this year’s World Cup and the 2016 Olympics.”The

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map, which Aon produces in conjunction with Roubini Global Economics (RGE), measures political risk in 163 countries and territories, highlighting exchange transfer, legal and regulatory risk, political interference, political violence, sovereign non-payment and supply chain disruption. Russia, as is made clear elsewhere in

ARE INVESTORS MORE SANGUINE ABOUT EM POLITICAL RISKS?

Photograph © Skypixel/ Dreamstime.com, supplied April 2014.

this and previous editions, is another flashpoint. The annexation of Crimea is only one element in the mix. Political strains and focus on geopolitical issues have exacerbated an already weak operating environment for business and exchange transfer risks have increased following the risk of new capital controls. “Russia’s economy continues to be dominated by the government, and economic policy deadlock has brought growth to a standstill and with it an increase in the risk of political violence,” says the insurer. This volatility is also affecting other former soviet states including Armenia, Belarus, Georgia and Moldova, adds the insurer. Even so, Ukraine is now a Very High risk country. Exchange transfer risks, which are already heightened, says the insurer, will be further increased by restrictions in the financial system. Further, the willingness and ability of the country to settle its debts may be affected. India’s rating too has been downgraded with legal and regulatory risks elevated by ongoing corruption and moderately high levels of political interference. Territorial disputes, terrorism, and regional and ethnic conflicts also contribute to elevated risks of political violence. Meantime, China's rating has been downgraded to moderately high. Aon says the deterioration in political risk, including an increase in political violence, has occurred at a time of slowing economic growth, which suggests that the economic policy deadlock and economic sluggishness are mutually reinforcing. South Africa's rating too is downgraded as well despite having strong political institutions, South Africa is struggling from recurrent strikes, which have become the major means of wage setting, and which weaken the outlook for business and raise financing costs. The outlook in other emerging markets is also peppered with nuance. The relative strength of the richer oil exporting MENA countries of the Gulf Cooperation Council (GCC) is contrasted in the Aon map with North

ASSET ALLOCATION

ARE INVESTORS MORE SANGUINE ABOUT EM POLITICAL RISKS?

African countries which enjoy fewer financial resources with which to manage any shocks. Inevitably, they continue to have higher risk scores across all elements of political risk tracked by Aon. The three countries upgraded in 2013’s risk map (Bahrain, Oman and UAE), maintained their more resilient and lower risk outlook, while Jordan, where Syrian refugees have exacerbated domestic shocks, was downgraded. There are some improvements in Sub-Saharan Africa, notably in Ghana and Uganda which offset deterioration in South Africa and Swaziland, which were both downgraded. Although Ghana has fiscal overspending and rising inflation, which is weakening its macroeconomic stability, increases in revenues and investment reinforced its already strong political institutions. Uganda continues to suffer from an overly centralised government and significant human rights issues, the stabilisation of donor finance improved its ability and willingness to pay debts and reduced political interference.

Divergence Despite these flashpoints, according to Bank of America Merrill Lynch’s April fund manager survey investor confidence in global economic growth remains high even as expectations of higher short-term rates increase. The survey, taken between April 4th and April 10th suggests the number of investors believing the global economy will grow over the next 12 months was steady at a bullish net 62%, unchanged from March and higher than the 56% the bank noted in February. The same view supports expectations for profits. A net 44% of investors believe profits will improve over the next 12 months, up from 40% in March and the same as in February. The BofA Merrill Lynch survey throws up some interesting questions; not least why investors appear to have a more benign view towards emerging markets, given that the immediate effect of decision by ex UK Federal

Reserve Bank president Bernanke that Western monetary stimulus would not be available forever was that investors withdrew funds from emerging markets and reinvested them in the west. The reality is however that investments into emerging markets has been in flux for over a decade as the segment has become more nuanced and sophisticated. The latest IMF Global Financial Stability Report shows that the mix of investors in emerging markets stocks and bonds has evolved considerably over the past 15 years, which has made capital flows and asset prices in these countries more sensitive to events outside their own borders. The role of bond funds—especially local-currency bond funds— for instance, has been on the rise since the early 2000s. Savers in advanced economies now increasingly channel their money through global mutual funds that invest both in advanced and emerging market economies. The participation of sovereign wealth funds and central banks in these financial markets is growing as well. Back in the 1990s, by contrast, investing in emerging market economies mostly meant purchasing equity though funds specialised in these countries. The IMF says that investor approaches to the emerging markets are now more nuanced. During the sell-off of emerging market stocks and bonds in 2013 and early 2014, institutional investors such as pension funds and insurance companies with longterm strategies broadly maintained their emerging market investments. Retail-oriented mutual funds on the other hand withdrew their investments. Clearly then mutual funds —such as those focused on bonds and equity—also have much more sensitivity to global financial turbulence. “Knowing who the investors are is critical for understanding the evolving stability of capital flows into emerging markets, especially when the uncertainty over advanced economies’ monetary policy remains high,” says

Gaston Gelos, chief of Global Stability Analysis Division in the IMF’s Monetary and Capital Markets Department and the head of the team that produced the analysis. The analysis by the IMF team also found the share of more volatile bond flows had risen as more opportunities opened up to invest in emerging markets, and that larger direct foreign participation in local financial markets could transmit global volatility to local asset prices. Moreover, economic conditions in a country affect investment and local asset prices, says the IMF explaining that in the months following the initial sell-offs in May and June 2013, global investors started to treat economies with better fundamentals differently from those with weaker ones. However overall, the agency has found no evidence that investor choices in times of stress in recent years were driven any more by countries’ economic fundamentals than they were in crises in the late 1990s and the early 2000s. Additionally, the herd instinct is still strong and investment firms tend to mimic each other’s’ investment choices. If there is more stickiness from seasoned investment firms (that are not US mutual funds) in emerging markets investing then that, says the IMF, can be attributed to the fact that in addition to the strengthening economic fundamentals in many markets over the long term has also been supported by a measurable improvement in market infrastructure, regulatory oversight and better corporate governance. Moreover, the size of the domestic investor base— local mutual funds, pension funds, insurance companies, and banks—has grown, sometimes helped by direct participation of foreign investors in local markets. The IMF report shows that local financial systems with more domestic services, products, and liquid markets help reduce the sensitivity of emerging economies’ stock returns and bond yields to the changes in global financial conditions. And the reductions are quantitatively large as well adds the IMF. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

THE BEAR VIEW

NO FOUL, NO HARM, BUT NO EXCITEMENT Y ALL ACCOUNTS the domestic economy is performing far better than even the most optimistic were expecting; equally there appear to be few (unmanageable) storms on the horizon. So why the lag? It might be pertinent to look at the composition of the FTSE. Is it an index measuring the sate of the UK economy or, in fact, not even measuring much beyond the performance of its highest capitalised components? Most readers will be aware that the vast majority of the FTSE100 component stocks derive most of their revenue from outside Britain. In fact, it is now estimated that over 70% of turnover is external to the UK. This is hardly surprising when you note that many of the highest weighted stocks are global players for whom the UK is merely a stable and/or convenient regulatory platform in which to be listed. In fact, the mining and energy sectors derive close to zero core revenue from the UK and what they do get is mainly from domestic energy requirements and the financial sector increasingly finds their local operations have or will become merely the tail on the body of far larger international divisions. Equally, those same readers might not know that the top ten weighted stocks in the FTSE100 account for over 50% of the index as a whole and most are pretty much ‘as is’ from the start of the year (although HSBC and Barclays are struggling). Indeed many are essentially unmoved from the end of 2010.

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

Effectively the index is increasingly reflecting merely the current wellbeing of ten not particularly UK centric units. Added to this is the fact that three sectors (namely oil/gas, banking and mining) also comprise almost 50% and you get a good idea of why the FTSE has struggled to keep pace with the other Western indices. The UK financial sector is still suffering from the errors of the past, from the dead hand of the regulators in the present and from governments (of whichever hue) who see the sector as a sort of piggy bank to be dipped into whenever they need a bit of electoral ‘banker bashing’ kudos for the future. Envy blinds politicians and electors from the simple fact that while the financial sector pays out huge salaries, these monies are the reason for the vast invisibles trade surplus that the UK enjoys. Most of this money comes from abroad because London is the major centre for financial markets (as well as legal and corporate expertise). It is not ripped from the mouths of the working man. Allowing an envious Brussels to legislate away the UK’s single truly global centre of excellence is not good for Britain. Meantime, the energy has problems of its own; mainly caused by the massive increase in extractable supply from new offshore gas finds and the vast, but controversial, shale and fracking reserves. Prices are not helped by Iraq and Libya coming back into production. The US shale reserves are said

FTSE100: DOOM, BOOM (OR SOMETHING IN BETWEEN)?

For all of the unexpectedly good economic news over the past 12 months the rather surprising fact is that the FTSE100 hasn’t exactly gone into paroxysms of joy over the same period. In April 2013 the markets were at 6400 and they are now at 6650 a rally of less than 4%. It looks difficult, if not impossible, to push it above 6800 or, conversely, finding many sellers below 6400/6500. So what now?

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

to be enough (at current technology extraction levels) when they come fully on line to enable the States to be energy self-sufficient until the next century and this is without a probable slow but steady increase in renewable energy production. Added to this is the sharp climb in fuel efficiency that has dominated energy advances. To a certain degree this is effectively a classic example of the supply/ demand/technology tripartite equation. Supply is going up (as is overall demand) but efficiency savings mean we now need less fuel to deliver the increase in requirement. The global mining industry has geared itself up to deliver what was expected to be ever-increasing demand from the growing BRICS and smaller Asian economies. Unfortunately recent global growth has not been as strong as expected and nowhere near enough to take up the increase in supply. Unfortunately, it is beginning to look as if the heady BRIC growth numbers of recent decades are unlikely to return in the near to medium term. All this is probably good for keeping a lid on commodity and ‘excess lending’ inspired inflation but, overall, will not be so good for the FTSE100. It might also be a headache for those pension/insurance funds already under attack for their uninspiring returns over the last 20 years. That dead weight of 50% of the total weighting holding it back, the index is likely to continue to underperform other comparative global markets. So then, no harm, no foul, but no excitement either. The 1999 peak of 6930 is within touching distance but it may be just as far away today as it was this time last year. I

Market intelligence for the smart investor Have you made up your mind already? Of course not. Our opinions and views change and evolve according to our experience and what we learn from others. The opinions of others are always worth listening to; sometimes to compare and contrast with our own, sometimes because they influence our thinking. Whatâ&#x20AC;&#x2122;s certain is that in an increasingly complex and changing global investment market, ready access to the considered view of experts can be helpful. Each day our pool of carefully selected commentators and bloggers provide specialist insights into market trends and events. Is it worth a look? Of course it is.

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MARKET TRENDS – FIXED INCOME

Solid quarter for European fixed income and ETF products ORMER FEDERAL RESERVE chairman, Ben Bernanke, first hinted at a tapering of the US central bank’s stimulus effort in May last year. Eleven months on, the Fed has started trimming monthly bond purchases citing a more positive economic outlook. New chair, Janet Yellen, said on March 19th that the central bank would probably conclude its quantitative easing program this autumn, and could start raising interest rates as early as April 2015. That day, yields on ten-year Treasuries and Bunds closed higher by 9.3 and 2.8 basis points respectively, according to data from the European government bond marketplace. The European Central Bank (ECB), the Bank of England and the Bank of Japan, on the other hand, opted to keep their monetary policies unchanged. ECB president, Mario Draghi, played down eurozone deflation fears, but said that additional policy steps were being prepared to ward off any potential risks. Revised Eurostat figures released on March 17 showed that eurozone inflation fell to 0.7% in February, down from January’s 0.8% and well below the ECB target of just under 2%. March figures published at quarter end revealed an even lower inflation of 0.5%. The Fed’s withdrawal of stimulus, combined with internal political and financial crises, prompted emerging market central banks, including those of India and Turkey, to increase interest rates in January, in an attempt to combat sharp currency falls and alleviate outflows pressure. Softer Chinese economic data implying a growth slowdown added to emerging market concerns. Geopolitical tensions were also a

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

recurring theme during the quarter. The crisis in Ukraine culminated in Crimea joining the Russian Federation following a referendum conducted in the region. Ukraine went on to sign an association agreement with the European Union forging closer economic ties, while sanctions against Russia started to escalate. The World Bank has warned that further sanctions could cause Russia’s GDP to contract by 1.8% this year. Meanwhile, the International Monetary Fund announced on March 27th a $14bn-$18bn rescue package for Ukraine. The country’s ten-year bond closed the month at 8.6% and 45 basis points lower than January 2nd. Europe’s peripheral government bond markets rallied over the quarter, with mid-yields on their ten-year debt reaching pre-crisis levels. Irish yields closed below 3% on March 18 for the first time since June 2005, and Greek yields dropped to their lowest closing value (6.5%) for four years on March 31. Greece reached a deal with its international lenders on March 18th to unlock a €10bn tranche of bailout aid, while one of its biggest banks, Piraeus

FIXED INCOME Q1 2014 PERFORMANCE

Tradeweb looks at trading activity trends in the fixed income market in a quarter marked by central bank monetary policy decisions and emerging market concerns

Bank, returned to capital markets the following day with the launch of a three-year senior unsecured bond. Mid asset swap spreads for the bond widened to 408.9 basis points on March 27th, but finished the month tighter at 399.9 basis points.

Fixed income buys surpass sells First quarter data derived from trading activity on the European-listed ETF platform reveals a solid buying trend for fixed-income products over the time period.“Buys”in the asset class went up to 19% (as a proportion of the overall traded volume) compared to last quarter’s 14%. “Sells” remained flat at 10%. Commodity ETFs also enjoyed a stronger quarter, as their overall traded volume increased by two percentage points to 6%. Conversely,“buy”requests for equitybased ETFs dropped by eight percentage points to 29% from the previous quarter’s 37%; “sells” were up by one percentage point at 36%. Overall trading activity in equity-based ETFs decreased by seven percentage points to 65% from 72%. Similarly, the Q1 2014 buy/sell volume ratio on the European credit marketplace, as a proportion of the overall traded volume, was 50.48%/49.52%, while in Q4 2013 the ratio was 46.52%/53.48%. The buying trend was stronger in the automobile, consumer, telecommunications/ media and senior banks/financials sectors. I

Volume by ETF asset class – Q1 2014

Buy

Sell

29% (vs 37%)

19% (vs 14%)

4% (vs 1%)

10% (vs 10%)

2% (vs 3%)

36% (vs 35%)

Equities 65% (vs 72%) All figures in brackets refer to the previous quarter.

Fixed Income 29% (vs 24%)

Commodities 6% (vs 4%) Source: all data from Tradeweb, April 2014.

REGULATION

FUNDING THE CFTC Archive photo of past Federal Reserve chairman Ben Bernanke, centre, talks with Commodity Futures Trading Commission (CFTC) chairman Gary Gensler, left, and Treasury Secretary Jacob Lew during an open session of the Financial Stability Oversight Council, where cybersecurity and a presentation from the Office of Financial Research (OFR) on financial market developments were discussed, Monday, December 9th 2013, at the Treasury Department in Washington. Photograph by Charles Dharapak, and provided by Associatedpressimages.com, March 2014.

CFTC and the technology challenge Pressure has been mounting for Federal regulators as they are tasked with increased oversight of complex and dynamic markets. Jim Toes, chief executive officer, Security Traders Association (STA) speaks to the efficacy of financial regulators, stating: “It is imperative that regulators have data which is quantitative and qualitative. In addition, regulators need to establish working relationships with the participants they have oversight of and the investors they are charged to protect. A combination of these factors is crucial in order for any regulator to be effective.” Tyler Petersen reports on the implications of regulators working in an increasingly technology-driven financial market. HE COMMODITY FUTURES Trading Commission (CFTC) is charged with overseeing the US futures and options markets that have a notional value of approximately $31trn, and now with the previously unregulated swaps markets under its purview that has a notional value of $400trn, the Commission is under pressure to do more under tight budgetary constraints.

Trading volume of CFTC regulated futures and options contracts was 3,060m contracts in 2010 and that number has increased to 3,477m in 2013. The notional value of derivatives centrally cleared by clearinghouses was $124trn according to International Swaps and Derivatives Association (ISDA) data, and is now approximately $223trn according to CFTC data from swap data repositories (SDRs). The

Commission has also seen the total number of registrants and registered entities that it oversees directly rise approximately 40% over the same time period. In 2010 some $177bn of customer funds were held by clearing houses and futures commission merchants (FCMs). That amount has now grown to over $225bn. There has also been a marked increase in customer funds, in the form of cash and securities, being held by firms to be used for end-user margin payments. One of the primary designs of CFTC’s rulemaking is to protect these customer funds and recently there has been growing concern over risk associated with intermediaries, some of which are under the shared regulatory responsibility of the CFTC and a self-regulatory organisation (SRO). These very big numbers add up to the certainty that the Commission is now facing stiff challenges as with changing markets and its expanded regulatory scope meet head on. Moreover, there are many more entities falling under the CFTC’s regulatory umbrella and (most significantly perhaps) it is faced with an ever-evolving global and electronic marketplace where the need to collect, analyse, and disseminate data is more important than ever for the derivatives markets.

Market hold Market participants seem to hold a strong advantage in technological sophistication over the CFTC. The Commission is still working on aggregating swaps and futures data while participants trade in and out of asset classes at lightning speeds. The Commission receives data from swap data repositories (SDRs) like the ones parked at the exchanges CME Group and ICE, but it is not sufficient to provide a wide enough view of the markets to, for instance, give the CFTC sufficient insight into the effects of the financialisation of commodity markets. In other words, does the inflow of investment capital into the commodities futures markets distort commodities

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

prices? Neither is the data sufficient to provide the CFTC with the ability to track market trends, such as the growing market aversion to swaps, possibly due to new rules. Moreover, the Commission lacks the staff to fully access, review, and analyse the necessary data. Technology then is essential to the effective functioning of the Commission and heavy investment in this area is required if it is going to fulfill its increased responsibilities in constantly accelerating and expanding markets. The advent of high-frequency trading (HFT), as well as other technological and strategic advances in trading, are dynamically shaping markets and it is up to regulators to gain a comprehensive understanding of the current financial environment and protect the markets from fraud and abusive practices. The President’s Budget and Performance Plan Fiscal Year 2015 fell short on its investment in technology and was, according to Commissioner Scott D O’Malia’s Statement of Dissent, random and unfocused. The President’s budget request emphasises technology in theory but advocates for more personnel while actual technology investment is lacklustre. The President’s scaled back budget request estimates the need for an appropriation of $280m dollars and 920 staff years (FTEs), an increase of $65m and 253 FTEs over the FY 2014 levels. The original estimate submitted to the Office of Management and Budget was $318m. The CFTC has two sole programs (Information Technology and Salaries and Expenses) that encompass all of its activities. Of the total funds requested 18% is allocated to information technology and 82% percent to salaries and expenses. Data and technology accounts for 16% of total requested funds if broken-down by mission activity. While the Commission stressed that its focus would be on improving its data technology infrastructure, there was only a modest increase in funding for technology—only 7% or approximately $7m dollars over FY2014. The

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

Commission expects this to complement its prior investment in data collection, analytics and surveillance personnel. However, this was the smallest percentage increase out of all the mission-based priorities. The total technology estimate for FY2015 was $50m in non-FTE technology investments. The rest is divided up to support ongoing technology investments ($12.5m), such as litigation support and existing surveillance tools, and back-office support ($27m). From that $50mestimate, only $10.5m will go towards cutting edge technology tools that the CFTC deems essential to realise its priorities and mission directives to protect markets from fraud, manipulation and systemic risk, to protect customer funds, and, to ensure that the hedging and price discovery functions of markets are not impeded. The ability to achieve these essential Commission objectives is expected to accelerate as the Commission fulfills its commitment to improve its technology and data infrastructure.

Globalisation of derivatives The truly global aspect of the derivatives markets cannot be ignored and joint work has been done in coordination with other domestic and international regulators, i.e. addressing the intention of significant financial regulation including the Dodd-Frank Wall Street Reform and Consumer Protection Act and its provisions for swap data collection, and registration of foreign trading platforms as Foreign Boards of Trade (FBOTs). The Commission is progressing towards a more unified international regulatory framework especially with regards to CFTC regulated swap execution facilities (SEFs), and European Union regulated multi-lateral trading facilities. Work continues internationally to bolster the consistency and effectiveness of financial regulation in high-speed global markets, and the Commission is meeting regularly with the SEC, European Commission (EC) , and European Securities and Market

Authority (ESMA) in a strive towards the necessary global regulatory harmonisation required to limit regulatory arbitrage and market uncertainty at an international level. International policy accounted for only one percent of the total President’s budget request. The requested $4m and 50 FTEs will support the Commission’s international policy goals including; working closely with other regulators, continuing its representation in International Organization of Securities Commissions (IOSCO), addressing global concerns in commodity markets, working with the Financial Stability Oversight Counsel (FSOC) to designate and monitor systemically important entities, and other activities intended to increase stability in the market for OTC derivatives.

Strain on CFTC operations The level at which the Commission has been funded in recent years has caused some strain on CFTC operations and staff, and the disparity between funding levels for the Commission and the SEC could be an indicator of which regulatory entity is currently more highly favoured politically. SEC funding for FY2014 enacted $1,436m and the FY2015 budget requests $1,700m, an increase of $236m (or 16%). The Commission’s budget estimate, by contrast, for FY2014 was $215mand the current request for $280m represents 23% increase over FY2014. If these funding levels coincide with the perceived value of each respective regulatory body, that often monitor the same entities simultaneously, then questions have to arise regarding efficiency and waste resulting from redundant regulation. For market participants there are added costs and regulatory uncertainties due to the complexity of having trades of differing asset classes fall under the authority of the CFTC or the SEC, each with variable rules and requirements. And, costs and uncertainty associated with compliance to the joint efforts of the SEC and the

REGULATION

FUNDING THE CFTC

Commission who have worked to provide definitions for swaps and swap dealers. These definitions may be too broad for some market actors who have mounting concerns that their activities could cause them to be labeled as a swap dealer, and therefore subject to the necessary requirements of compliance with the new rules. This uncertainty has caused some to look for hedging alternatives and could be encouraging the migration from swaps towards futures contracts. These contracts are less flexible in their terms than standardized swaps, and therefore provide a less-perfect hedge, that could in turn, increase volatility. The complete effect of futurisation of the swap markets is unclear to the CFTC

due, in large part, to shortfalls in its technology infrastructure. Waning political support for funding the CFTC continues to spark interest in helping to fund it with transaction fees. The Commission is the only Federal regulator that doesn’t have transaction fees as a part of its funding structure and is finding it increasingly more difficult to stay fully funded given the rapidly changing economic environment. However, the Commission risks losing support from House Republican majority, many of which deem transaction fees as an unnecessary tax on market participants. However, there has been bi-partisan support for the idea in the past with the last four administrations considering it.

It is clear that for the CFTC to remain sustainable it must grow its technology capabilities in line with newly occurring market technologies. Support and funding for the Commission is likely to remain relatively stagnant in the near future if the CFTC cannot demonstrate that is fulfilling this need. In Commissioner O’Malia’s Statement of Dissent to the President’s Budget and Performance plan, he stressed the need for a clear strategic plan that realistically and concisely maps out the Commission’s technology and personnel needs. O’Malia touches on the nub of the problem:“The budget request perpetuates the futile strategy of hiring more staff to oversee a vastly complex, high speed, technology driven market,” he says. I

CFTC’S NUMBERS CRUNCH: A SLOW RATE OF FUNDING

he CFTC Office of Data and Technology has been funded at an extremely slow rate and has seen only a 6.8% increase between FY2011 to FY2014. The requested amount of funding for Data and Technology Support for FY2015 is $45m including $32m allocated to IT. In order to prevent the build-up of systemic risk, the CFTC must be able to effectively monitor markets, and lacking the data and technology infrastructure to do so will hamper the Commission’s effectiveness. The President’s budget requested $53m, including $20m in information technology for the Commission’s Surveillance mission. This mission is heavily technology dependent and reliant on data generated from market activity. The CFTC is in need of more robust hardware to ingest the huge volumes of transaction-level data it receives and it needs a message data and analysis system to assist its surveillance activities; instead of relying on transaction data that it receives from registered entities

which accounts for only 8% of order messages. The Commission is dependent on data to recognise trends and events in the markets and while the Commission has made some progress, that is, in the area of aggregating swaps and futures data, it lacks the technology infrastructure required to optimise and effectively utilise its data. Whereas, the surveillance mission is technology intensive by nature, the examinations mission is a personnel intensive mission. Examinations are intended to ensure the financial fortitude of clearinghouses and to promote competition and transparency in the markets. And, are possibly the best ways to deter fraud and encourage healthy risk management strategies for market participants. The President’s request would provide $38bn and 158 FTEs for examinations and the Commission’s compliance activities. This is an increase of $15m and 63 FTEs over FY2014. The President’s FY2015 budget and performance plan seeks to fund the Commission’s

enforcement activities at the level of $62m and 200 FTEs which accounts for 21% of the total budget request. Enforcement activities are personnel intensive with many resources devoted to investigation, forensics, discovery, and evidentiary analysis; all of which the CFTC is seeking to relieve through increased automation. The Enforcement Division is essentially “the cops on the beat” that politicians have been touting as a necessary component of Wall Street reform. While they seem to be receiving political accolades at the moment, the difficulty in achieving their objectives is further complicated by their increased jurisdictional and enforcement obligations resulting from Dodd-Frank legislation. The FY2015 budget requests $43m for Market Oversight and 184 FTEs this is a significant increase over the FY2014 estimate of $26m and 110 FTEs. Some $32m and 134 FTEs are requested for FY2015 for Swap Dealer & Intermediary oversight. Which is up from $20m and 82 FTEs in FY2014.

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

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REGULATION

ITALY’S PENSION REGULATOR UNDER FIRE

Italian premier and Democratic Party leader Matteo Renzi addresses a rally as he kicked off the electoral campaign for European elections in Turin, Italy on April 12th this year. Photograph by Marco Alpozzi for Lapresse. Photograph supplied by pressassociationimages, May 2014.

According to Maurizio Petriccioli, secretary of Italy’s Confederation of Trade Unions (Confederazione Italiana Sindacati Lavoratori, or CISL) plans to subsume the Commission for Supervision of Pension Funds (Commissione di Vigilanza sui Fondi Pensione or COVIP) the pensions funds regulator into Banca d’Italia (the central bank) is “wrong and dangerous”.

Trades union boss questions future of Italy’s pension fund regulator HE FUTURE OF Italy’s pension fund watchdog has been under fire for at least a decade, ever since Silvio Berlusconi’s finance minister Giulio Tremonti suggested COVIP come under the supervision of market regulator Commissione Nazionale per le Societa’ e la Borsa (Consob). In the event the Berlusconi government decided to let the regulators operate separately in the “interest of savers and investors”. Later, the so called executive administration of Mario Monti’s also attempted scrapping the authority for similar reasons during his tenure, which ended in 2013, but parliament voted against the proposal and COVIP lived to fight another day. One year on, the reforming government of Matteo Renzi is now looking for savings of some €5bn over the coming half year, which will involve the government taking on the country’s powerful and entrenched trade unions and finding ways to reduce the civil service overhead. Like Berlusconi’s and Monti’s governments before it, cutting the the

country’s burdensome civil service bill is a quick fix, popular with the IMF and the EC at large, but a hazardous path for a government facing (potentially) a strong backlash from the country’s trade unionists, which are masters of popular polemic. Trade unionists are finding a groundswell of support from a population that has seen living standards plummet in recent years. The headline jobless rate is running at a worrying 12.5% and for under 25s is as high as 40%. Initial soundings from the government that as many as 85,000 civil service jobs are at risk has sounded serious alarm bells in the country; particularly as Labour Minister Giuliano Poletti has repeatedly warned that 2014 will be yet another year of“suffering for the unemployed”. Public tolerance for government promises of reform is low, and Renzi walks a very fine tightrope. He is the country’s fourth premier in under three years Petriccioli issued a formal statement in early May that, the decision to reform the civil service in general and COVIP in particular is “bad” as the regulator of

pensions covers its costs from subscriptions from the country’s pension funds and not state coffers. He went on to say that the move was dangerous because “[Italians] face yet another attempt to confuse the retirement savings with the financial and banking sector [sic].” COVIP, he explained, was established in the early 1990s to oversee the operation of Italy’s second pillar pension segment. It has an annual budget of some €11.5m, of which the government contributes a modest €200,000 or so a year. Petriccioli, says in this context, any move to reduce the cost of the pension’s regulator is wielding a hammer to crack a very small nut. Moreover, he believes that the regulator’s independence is vital if it is not to fall under the auspices and therefore vagaries of Italy’s fast changing and sometimes unreliable political elite. Petriccioli adds: "The maintenance of a specific authority dedicated to the supervision and regulation of the field of supplementary pensions is essential to preserve the unity and homogeneity of the control functions in the field of supplementary pensions, ensuring recognition of the specific investment social security and its social purpose and non-speculative . As has already happened in the past, all those who have at heart the future of supplementary pensions, starting with the social partners and the European Parliament should call on the Government to review this decision so that in addition to not have no real effect on public spending, is likely to be functional only to the strengthening of some strong power, public and private, interested in putting their hands on the plate of the supplementary pension [sic]. Marianna Madia, Italy’s minister of public administration, told Italian TV at the end of March that the government had asked unions to propose alternatives to the plans, which include potential job cuts for thousands of public sector employees, but conceded that the government was running out of time to find ways to effectively cut the state budget. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

23rd ANNUAL

SECURITIES FINANCE AND COLLATERAL MANAGEMENT CONFERENCE 17 - 19 June 2014 | Ritz Carlton, Berlin, Germany

Join us in Berlin on 17-19th June 2014 for /^> ͛Ɛ ϮϯƌĚ ŶŶƵĂů ^ĞĐƵƌŝƟ ĞƐ &ŝŶĂŶĐĞ ĂŶĚ Collateral Management Conference. This is the only event of its kind in Europe that is ŽƌŐĂŶŝƐĞĚ ĞǆĐůƵƐŝǀĞůǇ ďǇ ŵĂƌŬĞƚ ƉĂƌƟ ĐŝƉĂŶƚƐ ĂŶĚ ŶŽǁ ĂƩ ƌĂĐƚƐ ŽǀĞƌ ϲϬϬ ĚĞůĞŐĂƚĞƐ͘

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DEBT REPORT

MOMENTUM SLOWS IN EUROPEAN CORPORATE BONDS?

Photograph © Rolffimages/Dreamstime.com, supplied April 2014.

HIGH YIELD STILL OFF-PISTE European corporate bonds, particularly the high yield variety, enjoyed a banner year in 2013 and many expected a repeat performance in 2014. However, the momentum has slowed as the refinancing theme has almost been played out and new drivers such as mergers and acquisitions have not yet materialised. While the party is not totally over especially with peripheral corporates, issuance will not be as stellar as many had envisioned. Lynn Strongin Dodds reports. AST YEAR A slew of companies switched from loans to bonds as European banks, which had accounted for about 80% of lending to corporates and households, were under pressure to shrink their balance sheets due to Basel III’s stricter liquidity capital requirements. In fact, the trend has been going on for some years, suggesting that Europe is increasingly assuming deeper characteristics of the US debt markets, which are more obviously driven by Basel III and Solvency II regulation rather than corporate sentiment. The reasons for the switch are manifold. Lenders are essentially required to

hold more capital to back loans (with $13m needed, for example, for every $100m credit, up from $8m today), impacting on return on equity. Not only will the capital requirement be higher, but finance will be more expensive to raise and be higher quality capital. According to Bloomberg data issued last year, global bond sales were up 7.6% in 2012 while loan volumes fell back by 14% in the US and 34% in Europe over the same period. The latest available figures, issued by Dealogic in late March this year, suggest that global club deal volume has fallen year-onyear and year to date (YTD) to $62.2bn, down 27% on the YTD record high of

$85.1bn signed in 2013 and the lowest volume since 2010 YTD ($50.9bn). Specifically, European club deal volume stands at $30.0bn in 2014 YTD and accounts for just 49% of global club deal volume, the lowest share for Europe since 2001 YTD (28%). Global non-club deals account for 91% of the syndicated loan market so far in 2014, representing the highest share since 2008 YTD (also 91%). [As a sidebar—the average tenor on global club deals stands at four years and one month in 2014 YTD, the lowest tenor since 2007 YTD (four years) and down from four years and three months in 2013 YTD and JPMorgan leads the book runner ranking for global syndicated loans in 2014 YTD, with a 12.5% market share. Bank of America Merrill Lynch and Citi follow, with 9.7% and 5.9% respectively.] In addition, fallen angels—companies that have lost their investment grade status—featured throughout 2013 most notably Telecom Italia which alone swelled the high yield ranks with €31bn worth of debt outstanding. “Given how much the market grew last year, it might have seemed sensible in December 2103 to extrapolate an additional €5bn to €10bn of gross supply in 2014,” says Peter Aspbury, portfolio manager at JP Morgan Asset Management. “However, there is a dawning reality that issuance might fall short of those expectations and could actually be €5bn to €10bn below 2013 levels. I don’t expect to see the same volumes of fallen angel issuance, of leveraged loans to high yield bond refinancing, or a big resurgence in European leveraged buyout activity. If sponsor exits from legacy investments pick up the pace, then we could see a rebound in LBO activity, but any high yield bond issuance coming out of this could be many months away.” Chetan Modi, managing director, corporate finance at Moody Investor Services, adds, “It would be difficult to have a material increase for the third year running, as the market grew by 50% last year. The market is now stabil-

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

ising in terms of bond volumes for a number of reasons; bank-funded leveraged buyouts (LBOs) from a few years ago have done most of their refinancing, and this structural shift has to end at some point. While the increase in initial public offerings should lead to further mergers and acquisitions (M&A) which could result in further bond issuance, it is difficult to forecast the pace.” Syndicated loans too should pick up again once there is a measurable revival in mergers and acquisitions.

2014 high yield volume Barclays’ Global Credit Outlook 2014 predicts that high yield issuance this year will come in at €60bn, down from 2013’s record breaking €69bn. The pace has already slackened while research from S&P Capital IQ Leveraged Commentary and Data (LCD), showing European high-yield bond issuance dipped to 11 deals worth €3.9bn in February from 17 bonds at €5.7bn the previous month. Only 5% of high-yield bonds were issued to take out bank debt this year, versus an average of roughly 27% for the 2009-2013 timeframe. Including bonds intended to replace existing notes or other types of debt, the refinancing category accounted for 35% of total volume, the lowest reading since 2008, versus roughly 50% in the prior two years. Sponsored issuance also saw a sharp year-on-year drop, to €1.8bn in 2014 versus €4.5bn last year, representing a 59% decline. In 2013, private equityowned companies relied on the high-yield bond market to refinance outstanding leveraged loans, and to that end they printed €2bn of paper in the first two months. Since the end of last year, however, the queue of companies switching to an all-bond structure has disappeared. In fact, S&P Capital IQ noted it has not yet tracked a single sponsored bond-for-loan takeout in 2014 as of February 28th. The one group that is still on the scene are peripheral corporates. They started to make their mark last year

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with high-yield issuance from Italy, Spain, Portugal, Greece and Ireland doubling to $24 bn from 2012, accounting for 27% of total issuance from the EU, according to research from Moody's Investor Service. They have grown in numbers on the back of rating stabilisation, with the percentage of corporate negative outlooks falling to 22% from 63% during 2013. Moody’s predicts the trend will continue this year due to ongoing refinancing needs as banks continue to deleverage. Although Italy will remain the principal issuer, it sees solid growth from Spain and a continued flow from Greece, supported by the shipping sector. Market participants also anticipate a strong showing from peripheral banks, which first made their capital markets comeback via covered bonds which require collateral and are seen as a safe form of lending. As confidence and investor demand for higher yield grew, they have turned to the unsecured end with Spanish banks leading the way last year with $9.3bn of issuance followed by Italian banks on $8.9bn. These two countries remain at the forefront with financial institutions issuing 40% more bonds to date than the $32bn that came to the market during the same period in 2013. Portuguese bank Banco Comercial Português created something of a stir with its three-year €500m senior unsecured bond, with a 3.3% coupon, following a multibillion euro bailout while Piraues bank also turned heads as the first Greek bank to return to capital markets in five years with a €500m benchmark bond. The three year senior unsecured bond, with a coupon of 5% was six times subscribed, underlining robust investor demand for a bank that was until recently emblematic of Greece’s financial woes. “Two years ago, no one would have touched these [corporations] but as the recent triple-C, three year bond from Greek bank Piraeus shows demand is very strong,”says Wolfgang Kuhn, head of pan-European fixed income at Aberdeen Asset Management. “This is

driven by more confidence in the eurozone and investors are buying into the higher spreads. The view today is that the European Central Bank saved the region once and it would do it again.” This improved outlook has also caught the attention of non-Europeans. “We have seen an increase in the number of US companies such as John Deere and Praxair tapping the European markets over the past year and I think the trend will continue into 2014,” says Gaurav Chatley, institutional European credit manager at M&G.“The cost of swapping liabilities back to the US has dropped to 2008 levels so it has become cheaper to issue in euros. Institutional investors also like the issuance from US companies as it offers diversification and spread pickup in most cases.”

Looking ahead Looking ahead, corporates are branching out into other areas such as corporate hybrid or subordinated market. These lower ranked bonds have some equity characteristics and can be appealing in an environment where central banks’ massive bond buying programmes have suppressed yields. They are also favoured by companies who are on the brink of a credit downgrade because rating agencies count them as half equity, allowing them to add more debt onto their balance sheets. In addition, their bond status makes them tax deductible. One of the main advantages for institutional investors is another source of risk adjusted returns at a time when high yield is losing its lustre. For example, last year, the BofA Merrill Lynch Euro High Yield index increased 10%, which was still attractive given the steepening of the yield curve, but sharply down from 27.2% in 2012. The average spreads have come in further as of March 11th 2014, dropping nearly a third year-on-year to 372 basis points (bps), down from 549bps in 2013 year to date and the lowest average since 2007’s 361bps, according to Dealogic. By contrast, the returns on subordi-

DEBT REPORT

ETP INFLOWS BUYOUT SAY ANALYST REPORTS

nated debt from financial institutions, albeit lower are holding steady. The average is 255bps, up slightly from the 253 bp during the same period last year. In terms of volume, European subordinated issuance from financials currently stands at $30.4bn in 2014, almost double last year’s issuance across the UK, European and US markets and the highest total since 2007’s $72.4bn. “Hybrids or subordinated debt issuance has already been strong this year,”says Anne Velot of AXA Investment Managers.“These instruments fit in between high yield and investment grade and they are very efficient for corporates wanting to optimise their capital structure. They are also cheaper than equity and the yield is about 200 basis points above senior debt. There is a healthy pipeline from the financial sector. The downside is that if a company falls into bankruptcy which is why name selection is crucial.” James Vokins, fund manager at Aviva Investors, anticipates an increase in the number of contingent convertible (coco) bonds this year due to the onset of the capital requirement directive (CRD) IV, the supervisory framework which reflects Basel III. “Banks are working their way towards meeting the new banking regulations and issuing these securities. They are mainly being bought by hedge funds and high yield investors who are in need of a higher yield premium.” These bonds were created in the wake of the financial crisis to absorb bank losses and avoid the need for taxpayer bailouts. Some cocos convert into equity when a bank’s capital ratio falls below a pre-agreed trigger. Others can be written off entirely. Banks are set to increase issuance in order to build buffers and improve their leverage ratios to comply with the new rules. To date, Dealogic research shows that European banks, including KBC, Barclays, Credit Suisse and UBS, have come to the market with a record $9.6bn worth of cocos from 10 deals so far this year, compared with $9bn for five transactions during all of 2012. I

April saw record fund flows into ETFs and ETPs as the overall economic outlook began to stabilise after a tumultuous first quarter says ETFGI, the research and consultancy firms established by industry expert Deborah Fuhr. ETFs and ETPs listed globally gathered $34bn in net new assets in April which, when combined with a small positive market performance in the month, pushed assets in the global ETF/ETP industry to a new record high of $2.49trn, says ETFGI’s April 2014 Global ETF and ETP Industry Insights report.

ETP inflows pick up, with EM ETPs benefiting large cap equity and T THE END renewed strength for of April 2014 non-US-based there were developed markets 5,241 ETFs/ETPs, with equity. April brought a 10,238 listings, from return to fundamentals 221 providers listed on based investment with 59 exchanges around the global economy on the world. The a more solid footing, ETF/ETP industry in say BlackRock’s ETP many countries and researchers, headline regions also hit record risks muted (excepting highs in assets at the end of April 2014 Photograph © Dmytro Grankin/ of course the growing crisis in Ukraine). The including: the United Dreamstime.com, supplied fact that the US States ($1.76trn), May 2014. earnings season also Europe ($449.7bn), Japan ($82.4bn), Canada ($61.1bn) got off to a good start helped and the and the Middle East/Africa ($41.4bn). volatility that characterised the “In April, as was the case in March, emerging markets over the last six investors continued to show a strong months has started to temper. BlackRock reports broad emerging preference to equity allocations. Equity markets were again choppy markets equity having gathered in April—the S&P 500 closed at an $5.9bn in April, the first positive all-time high on April 2nd but figure since October 2013. Moreover, ended the month up less than 1%. emerging markets debt ETPs The DJIA closed the month at an garnered a further $1.3bn, the best all-time high of 16,581. Outside the month for almost a year and a half. Non-US developed equity ETPs US, developed markets improved slightly, European equities continued remained popular, registering inflows to strengthen, while emerging of some $9.9bn, despite a flat March, markets remained flat for the a fact which suggests that a flight to month,”notes Deborah Fuhr, ETFGI’s quality is still happening. However, BlackRock points out that the market managing partner. Global asset gatherer BlackRock trend is towards value over growth as noted in its quarterly ETP report US value funds gathered $3.1bn, that flows into ETPs were broad while redemptions from growth ETPs based, led by emerging markets, US rose to $1.2bn. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

DARK POOL TRADING Photograph © Skylight/Dreamstime.com, supplied April 2014.

DARK POOL PONDERING Despite the accomplishments of various longstanding dark-pool aggregators, in recent years the market has been infiltrated by a host of upstart companies, many offering little in the way of verifiable price improvement. This has compelled regulators to maintain a vigilant posture, while furthering efforts such as the so-called “trade at” rule (which would increase tick size as a way of moving certain larger unlit trades onto the major exchanges). From Boston, Dave Simons reports. URING 2013, THE number of equities trading “offexchange”through dark pools as well as various“internalisers” operated by broker-dealers continued its upward trend. A one-month snapshot taken by New York-based Rosenblatt Securities last November found total US off-exchange trading reaching 37.5%, including some 14.5% of trades executed within dark pools. Meanwhile, critics ranging from regulatory heads to global exchange operators whose business has been impacted by the surge in dark activity continued to rail against the practice. In an effort to lure block-trading participants away from the dark side, the London Stock Exchange Group recently floated the idea of offering intraday auctions covering a number of highly liquid stocks, including those listed on the FTSE100 and FTSE250 indices. Meanwhile, regulators on both sides of the pond have put forth measures aimed at placing limits on dark trading. Recently, NASDAQ, along with NYSE Euronext, announced it would get behind a proposed pilot program’s inclusion of the so-called "trade at”rule, which would increase tick size as a way of reducing dark-pool activity. Proponents say such restrictions are necessary in order to expose those venues that may have profited from the rise in dark demand yet offer little in the way of tangible price improvement in return. While Securities Exchange Commission (SEC) chair Mary Jo White agreed that the trade-at program "would widen the quoting and trading increments and test, among other things, whether a change like this improves liquidity and market quality,” to date the regulator has yet to offer a ringing endorsement of the rule. Still, advocates such as Saoirse Kennedy, senior consultant for London-based capital markets consultancy firm GreySpark Partners and co-author of the new report Trends in Equities Trading 2014, maintain that dark pools represent a genuine relief mechanism for liquidity access concerns,

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

and therefore offer the potential for product innovation that lit venues do not have. “[Dark pools] perform best when volatility is low, and it is harmless to let orders rest on a dark venue—hence the growth of trading volumes on dark pools in the US and in Europe since 2012.”All of which begs the question: what constructive steps might be taken in order to preserve the integrity of unlit trading, while at the same time ferreting out those offering little in the way of actual value?

Dark due diligence No doubt, the recent spike in low-cost, unlit newcomers has helped perpetuate the negative perceptions that continues to dog the dark trading arena. It is paramount, then, for investors to be able to determine when a provider is offering a plausible service, versus one that is opportunistic in nature and possibly degrading the overall pricing structure. According to Per Lovén, head of EMEA corporate strategy and product for Liquidnet, the global provider of unlit block trading for the equities markets, many dark aggregators in existence today do not always live up to the value standards upon which they were created. “The idea behind Liquidnet was to serve an asset-management industry that was finding it increasingly difficult to implement investment decisions without suffering severe implicit market impact,”says Lovén. Effectively, these participants needed a venue that allowed them to source liquidity and interact, without subsequently having the markets turning against them. With the rise in dark pools—and the resulting increase in liquidity fragmentation—a number of liquid stocks began trading in much smaller increments. One could rightfully argue (as many regulators already have) that such transactions don’t necessarily need a dark environment for execution but should rather contribute to overall price formation, says Lovén.

DARK POOL TRADING

“When it comes right down to it, you don’t necessarily need a dark pool to trade 100 shares of a liquid stock at the touch,”says Lovén.“On the one hand we’ve seen some very pure models that have been able to address the problems of sourcing liquidity on behalf of asset managers. Having said that, at the same time there have been a lot of recent models in particular that have basically been conducting standard lit trading in a non-lit environment. And that is mainly what regulators have been trying to come to terms with thus far.” While having a stable regulatory framework may help determine who is adding value and who isn’t, by the same token the best players are fully capable of creating sound commercial offerings without the need of excessive oversight.“I question whether putting prescriptive rules and regulations in place in order to steer the markets in a particular direction is necessarily the best way to go,” opines Lovén. “Whereas having a method for ensuring that the markets are operating in a fair and equal manner, and having commercial powers subsequently build off of that guidance, is a much more intelligent approach.”

Dark world heroics The real heroes of the unlit world tend to do their best work in areas where liquidity is scarce, such as securities in emerging regions with typically wider spreads. “The less liquidity there is available, the greater the value proposition,” affirms Lovén. At Liquidnet, the lion’s share of investable assets remains centered in North America, yet evidence suggests that participants are increasingly looking abroad in an effort to achieve proper diversification, including opportunities in Europe and Asia Pacific. That said, the ability for dark aggregators to improve the implicit cost of trading isn’t necessarily tied to any one specific region—nor, for that matter, any particular trade size. To wit, some of Liquidnet’s most notable transactions have been the large-cap, big-block variety, which, despite their magnitude, may yield the same basic outcome as their smaller-cap, emerging-market counterparts. “You can have a disproportionately large buy or sell imbalance that the markets cannot easily absorb, anywhere at any time—it’s really about your trade and available liquidity at that particular moment,”observes Lovén. Hence, cloaking mechanisms could be equally beneficial for an exceedingly large trade in a highly liquid FTSE 100 name, as well as a relatively miniscule move involving an Israeli tech company with far less liquidity available. What it all boils down to, then, is the connection between what one is trying to achieve from an investment standpoint, and the liquidity that needs to be sourced in order to support that decision-making process. Despite the good that these dark stars have brought to the markets over the years, there’s no denying the fact that, to the layperson, Senate subcommittee member or any other skeptic, terms like“dark,”“cloak”or“unlit”have hardly helped the cause. At a recent House Financial Services hearing over stockmarket regulations, lawmakers squared off over the impact

Per Lovén, head of EMEA corporate strategy and product for Liquidnet, the global provider of unlit block trading for the equities markets, many dark aggregators in existence today do not always live up to the value standards upon which they were created. “The idea behind Liquidnet was to serve an asset-management industry that was finding it increasingly difficult to implement investment decisions without suffering severe implicit market impact,” says Lovén. Photograph kindly supplied by Liquidnet, April 2014.

of increased dark-pool trading. With dark volumes approaching 40% of average daily volume, such concerns were legitimate, argued Georgia’s Democratic Rep. David Scott. “It’s important for us to understand what these dark pools are,” said Scott. However, Erik Sirri, finance professor and former head of the SEC’s trading and markets division, countered that it is important for traders to have a level of secrecy that is typically found in dark pools, and may exit the markets should orders become too transparent. And while acknowledging the “sort of sinister connotation” behind the darkpool label, former SEC commissioner Roel Campos nevertheless reminded lawmakers of the enormous value that dark pools bring to institutional investors looking to trade large blocks of shares. “There is this lingering perception that because something is not completely pre-trade transparent and because everyone can’t fully interact with it, there must be something wrong,”concurs Liquidnet’s Lovén.“When in reality, it is just the opposite. And we’ve had this conversation so many times with so many different people. What it really boils down to is constructing a market structure that can work from both a wholesale and retail perspective. Does an individual require an institutional block pool to purchase $10,000 worth of shares? Of course not—this trade has minimal impact on market price, therefore it can be executed in a standard lit environment. If on the other hand you’re a pension fund or large asset manager, chances are you’re going to have this need, simply because the retail-oriented markets aren’t structured to accommodate that kind of extreme volume—hence it would be detrimental not only to the asset manager, but to the markets as a whole due to the ensuing volatility,” he adds. It is clear then that the market really needs providers that can properly handle these massive institutional orders of, say, a million shares, which require very different kinds of tools and strategies than someone trading a few hundred shares. “You can’t realistically expect these large-block traders to shop from the same venue or use the same basic equipment as their smaller retail counterparts,” concludes Lovén. I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

US REPO US Federal Reserve Chair Janet Yellen speaks at her debut press conference at the Federal Reserve in Washington DC, the United States on March 19th. Yellen was explaining why the central bank would not pause on its bond buying program, as there is sufficient underlying strength in the broader economy for it to keep taper on course. Photograph by Yin Bogu for the Xinhua/Landov news agency. Photograph kindly supplied by pressassociationimages.com, April 2014.

REASSESSING US REPO What kind of solutions are needed to quell regulators’ concerns and ensure that repo remains a viable funding and risk-mitigation mechanism? For that matter, what impact might the Federal Reserve’s closely watched reverse-repo facility have on the market as a whole? Dave Simons reports from Boston. IDELY CONSIDERED A vital source of liquidity by a range of participants, over the years the repurchase, or repo market has made it possible for banks, dealers and other institutions to quickly secure shortterm funding through the posting of securities that are held as collateral. Nevertheless, repo continues to rank high on the regulatory hit list, as more dubious souls look to close off perceived pockets of opacity. Over the years various repo reform efforts have included the imposition of three-way trade confirmation, as well as better oversight (including monthly reporting) around margining practices and collateral quality. Meanwhile, top clearing banks BNY Mellon and JP Morgan have themselves worked to reduce or eliminate the much-maligned practice of using intra-day credit within the tri-party transactional chain. If the numbers are any indication, however, recent measures have only furthered repo’s downward spiral. To date, volumes continue to recede, with average daily amounts outstanding hovering in the $4.5trn range, according to the Securities Industry and Financial Markets Association (SIFMA). Accordingly, dealers and institutions remain wary over the possible impact on liquidity resulting from inordinately restrictive repo reform measures. Within the realm of repo, the Federal Reserve's current testutilisation of a full-allotment, overnight reverse repurchase

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

agreement facility, or FRFA, has garnered the lion’s share of attention of late. The seeds for FRFA were sown last summer during a meeting of the Federal Open Market Committee (FOMC), when it was suggested that such a facility might be just the ticket for managing short-term interest rates, while the presence of a secured lending floor could help break the cycle of plummeting repos and collateral shortfalls. Using a reverse-repo platform, the Fed could temporarily siphon cash from the financial system, substituting overnight funds drawn from banks and other sources and using Treasury securities as collateral. Through this process the Fed hopes to prevent the build-up of excess cash, which under certain circumstances could artificially depress interest rates and therefore impede constructive monetary policy. After more than a half-year of testing, various Fed members appear to be sold on the concept. In the estimation of John Williams, president of the San Francisco Federal Reserve Bank, reverse repurchasing is a potentially “very useful tool,”one that could allow the Fed to more effectively and directly manage short-term interest rates even while carrying “a large balance sheet and lots of excess reserves.” Not that the initiative is a done deal by any stretch. Striking a more cautious tone, in March Philadelphia’s Fed president Charles Plosser indicated that the FOMC was still in the process of considering whether to utilise the facility to handle monetary policy on a full-time basis,

US REPO

adding there were no guarantees that the program would in fact be formally adopted. The Fed’s creation of a fixed rate repo facility is in part an acknowledgement of declining volumes in the overnight Fed funds market, explains Oscar Huettner, senior business consultant for research and advisory firm Finadium and co-author of the Finadium’s newly issued report The US Repo Market in 2014. It is also evidence that the Fed has come to view repo as a broad-based, exceedingly liquid market, one that is ultimately capable of providing a more reliable benchmark for short-term interest rate policy. It will also allow the Fed to implement monetary policy despite the dramatic increase in the Fed’s balance sheet resulting from quantitative easing. “Using repo, the Fed recognises that it will be in a better position to manage interest rates than it would by targeting Fed funds—it’s simply a sharper, more accurate tool,” says Huettner. Once a repo level has been set, the dealer community will then trade at a spread above the Fed’s established benchmark. Should the Fed feel the need to tighten, all that would be needed is to raise the repo rate accordingly.“This would immediately force dealers to pay a higher rate in order to properly fund their positions,” says Huettner. What impact might the Fed’s reverse repo facility have on the markets as a whole? One key byproduct of the program is the assurance of an adequate supply of collateral to the markets. “There have always been frustrations around the ebbs and flows of dealer inventories and the resulting impact on the market in the short-term,” says Huettner. Absorbing excess liquidity, however, will help offset problems resulting from dealers carrying lower inventories or having reduced balance sheets. “It really makes for a much more orderly money market, if you will,” concurs Huettner. As noted by John Vinci, managing director and head of product management and strategy for BNY Mellon BrokerDealer Services, while only in the “testing phase” it would seem that the new monetary tool“could be very effective in stabilizing rates and guarding against negative interest rates through by creating demand for funding when day-to-day borrowers have less appetite.” Despite these attributes, it remains to be seen whether any difficulties will arise“when and if participants become dependent on them,”adds Vinci.

The CCP factor Meanwhile the idea of employing central counterparties within the repo trade continues to gain favor. Hardly a new concept, CCP solutions for repo date back to the mid-1990s in the US; 1999 saw the advent of LCH Clearnet’s RepoClear product, the first multi-market centralised clearing and netting facility for Europe. With regulators increasingly embracing CCPs as a general risk-mitigation tool, its stature has grown in recent times. “Across a broad spectrum of markets, regulators clearly like what they’ve seen in the central counterparty model, including the standardisation of trades, mutualisation of risk, as well as prompt margin calls,” says Huettner.

The challenge for both the repo and securities-lending markets, then, is to find viable ways of utilising the CCP format in order to preserve balance sheet as well as capital. “The CCP strengthens the integrity of the repo market in that you have a very robust structure that can maintain proper margin, has well-defined rules about how people should behave and what their obligations are, and also uses a waterfall structure for determining how trades are backstopped,”says Huettner. Additionally, by using a central counterpart the repo market is afforded better capital treatment and also has the ability to net, key elements in the effort to maintain sufficient capacity.“It may not be a perfect solution,” says Huettner, “however it clearly does add support, which is why regulators have indicated their preference for the model.” If elements like capital adequacy and leverage ratios, along with CCP clearing, have combined to make repo a healthier place than it was five years ago, the potential for fire sale liquidations of collateral remains an area of concern. “If you go back to 2007-2008, a number of institutions were unable to meet their margin calls as their assets dropped in value, and they were subsequently forced to liquidate their positions,” says Huettner. “In the process, prices across the board fell precipitously, in large part because of the overall illiquidity of the securities on hand.” Accordingly, the Fed has begun to focus on establishing measures aimed at preventing similar fire sales in the future. To date proposed solutions have only addressed the liquidation of high quality liquid collateral; in the meantime, the market continues to look for ways to address potential issues around non-liquid forms of collateral, including corporate bonds, private label MBS and similar securities. As to the question of whether capital adequacy and other requirements could lead to a rise in alternative funding mechanisms, according to BNY Mellon’s Vinci “some firms may have an immediate response and alter their funding strategies and look to alternatives, but it’s also important to remember they will also not be inclined to limit their options. Most firms have an assortment of mechanisms at their disposal, and therefore can throttle activity across them based on a number of criteria.” From its vantage point, Finadium believes that the market for US repo will reach a turning point over the next two years as it absorbs the brunt of real regulatory change. Even so, the firm remains upbeat. “As a well-tested mechanism for risk transfer and funding of positions, repo will survive— t is in fact extremely important for modern financial markets and too useful to lose.” The key challenge going forward, then, will be to make repo safer while at the same time maintaining its overall structure. As the agency suggests, the last thing regulators or market participants want are changes that could reduce the flexibility of repo while impairing its ability to facilitate Treasury and other US financial-market trades. Time will tell if the markets can achieve the proper balance and ultimately set repo on the right track. I

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THOUGHT LEADERSHIP ROUNDTABLE

SECTION NAME

COLLATERAL OPTIMISATION Managing the cost, mobilisation and velocity of collateral

ROUNDTABLE PARTICIPANTS (from left to right) KARL WYBORN, managing director, head of sales for securities clearing and collateral management, JP Morgan BEN THOMAS, head of collateral, financial resource management, Deutsche Bank PETER LEFT, director, capital and collateral management, Lloyds Bank Commercial Banking DAVID BEATRIX, senior business developer, collateral access, BNP Paribas Securities Services SAHEED AWAN, global head, collateral management and securities finance, Euroclear Group MARTIN SEAGROATT, head of global marketing at 4Sight Financial Software

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SETTING THE TEMPO: NEW PRIORITIES SAHEED AWAN, GLOBAL HEAD, COLLATERAL MANAGEMENT & SECURITIES FINANCE EUROCLEAR GROUP: Our collateral management business is about building an infrastructure for mobilising and allocating collateral globally. Our priorities in collateral management are primarily to grow the connectivity that we have on the Collateral Highway, in terms of both sourcing and delivering both bonds and equities from around the world on behalf of our clients. Equally, we have to be able to allocate such securities collateral to an ever-expanding ecosystem of collateral receivers, liquidity providers and risk mitigators. They are exit or delivery points on the Collateral Highway. In practice, the targets and markets segments are tightly focused; in particular on central banks as the one of the key exit points for collateral and for providers of liquidity. However, we also connect with all the principal central clearing counterparties (CCPs) around the world. Our day-to-day business involves bringing more liquidity providers and CSA counterparts onto the Highway, whether they are corporate cash providers, insurance companies, securities lenders or commercial banks. KARL WYBORN, MANAGING DIRECTOR, HEAD OF SALES FOR SECURITIES CLEARING AND COLLATERAL MANAGEMENT, EMEA, JPMORGAN CHASE: I work within JP Morgan’s sales function for both the sell side and the buy side where collateral is concerned. I tend to look at collateral end to end, beginning typically at the global custodian and then ending up with potentially a liquidity provider or a CCP. The focus for the bank is increasing the velocity of collateral as it passes through that chain. We call it the collateral continuum. There are various different participants to the chain, and the speed with which collateral moves between them, we believe, is becoming far more important. Then, of course, we have to help them optimise that collateral. Optimisation can mean different things to different people. The buy side’s views about optimisation, for example, is very different to the sell side, in our experience. Therefore, increasing the velocity of collateral and improving optimisation are the two themes that we have prioritised. BEN THOMAS, HEAD OF COLLATERAL, FINANCIAL RESOURCE MANAGEMENT, DEUTSCHE BANK: Traditionally, our group has concentrated on collateral trading optimisation, capital and financial resource management, with a primarily equity division focus. The effort for us in the last, certainly twelve to 18 months, has been in trying to expand the scope of what we do across product and bringing together a bunch of desks across the investment bank that have similar optimisation roles into an integrated solution. The challenge we face is trying to pull the many elements involved in collateral optimisation together. As Karl intimates: what is true optimisation? How do we achieve broad agreement on what it means? Added to that are additional considerations, including optimising capital usage and the convergence of the collateral technology we employ across the investment bank platform.

Peter Left, director, capital and collateral management, Lloyds Bank Commercial Banking. “For us collateral optimisation doesn’t just mean the first order of posting the cheapest asset possible, but the secondary impact of the decision on us,” he says. Photograph © Berlinguer, April 2014.

MARTIN SEAGROATT, HEAD OF GLOBAL MARKETING AT 4SIGHT FINANCIAL SOFTWARE: 4sight is a provider of front to back office, cross product collateral management software. Our priority is helping our clients adapt to the huge volume of regulatory change that they face. This involves automating their collateral processes to deal with CCP margining and an increased volume of margin calls and collateral movements. We also continue to develop more advanced collateral optimisation algorithms. We see the market moving towards a much more detailed transaction cost analysis in response to regulatory pressures. In response, we are designing tools that offer a more holistic view of optimisation. This includes Basel III capital charges, balance sheet usage, trade type optimisation, collateral opportunity costs and optimisation of counterparty selection. PETER LEFT, DIRECTOR, CAPITAL AND COLLATERAL MANAGEMENT, LLOYDS BANK COMMERCIAL BANKING: For us collateral optimisation doesn’t just mean the first order of posting the cheapest asset possible, but the secondary impact of the decision on us. What is cheapest is not necessarily defined in terms of interest rate and repo rate. It is more around the natural client flow that provides me with that asset and I therefore don’t actually have to go into the market do a trade to source it, or even leverage the balance sheet. If I can find homes for natural client flow in pools such as initial margin and CSAs and BACS and CHAPS, that’s a value-add without grossing up the balance sheet. Invariably, it involves understanding the duration of some of those dynamic collateral pools or ‘syncs’ that we have, and utilising them to help us service our clients with the collateral transformation they are looking for. At the same time, we work with the Group’s corporate treasury division and the money markets desk to help them enhance or manage their liquidity and their currency gaps, and so forth. In summary, it is about trying to bring all these people in the puzzle together.

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DAVID BEATRIX, SENIOR BUSINESS DEVELOPER, COLLATERAL ACCESS, BNP PARIBAS SECURITIES SERVICES: My business group resides in the bank’s securities services division. Collateral Access is our suite of solutions related to collateral both for buy side and sell side institutions, providing a number of components in order to help our clients face the operational, velocity and liquidity challenge in derivatives, repo products, among others. Everything which falls directly under the new obligations prescribed by regulations such as EMIR and Dodd-Frank, as well as providing optimisation solutions or facilitating the transfers of collateral between parties involved in secured transactions.

DEMAND & SUPPLY: MANAGING THE NEW DYNAMICS KARL WYBORN: I would draw a distinction between demand and supply and optimisation. They are linked but are definitely not the same. From a demand and supply perspective, the sell side banks in general, focus on the buy side as sources of supply in the EMIR/Dodd-Frank environment where the demand for high grade assets is forecast to grow very significantly. Meanwhile, the buy side think they are going to be liquidity takers in that environment as well. The buy side believe they have a borrowing demand to meet their EMIR collateral, cleared margin requirements, and so both parties (sell side and buy side) are looking at each other as providers of liquidity. Actually, where the supply comes from is, as yet, undefined. We know where these high grade assets reside. We know they sit with central banks on commercial bank balance sheets, in pension funds, and in sovereign wealth funds, and to release that supply is one of the key challenges that we face as an industry. SAHEED AWAN: There are some numbers around which the industry is now coalescing. The initial forecasts were so wide-ranging that it became almost nonsensical. Collateral shortfall forecasts have ranged from $800bn to $10.5trn and anywhere in between. Now most observers would say that the forecast of new collateral required as a result of DoddFrank, EMIR and Basel III is somewhere between $3.5trn and $6trn. That’s the demand side. The supply side is, in theory, less worrying. The IMF reported in early 2013, that there is around $44trn from the G20 of sovereign debt, of which $33trn is governmental debt from OECD members. Then there is also about $2.5trn-$3trn held in lending pools. Markitt-Data Explorers says they report on some $14trn in securities lending programmes, of which about a third, or certainly a quarter, is in high quality liquid assets. Then there is (between JP Morgan, ourselves and the other two large triparty service providers) roughly $950bn to $1.2trn of cash available from the repo market. Repo is considered a collateral upgrade trade in that sense. So there is, on paper, ample supply. However, as Karl suggests, that supply is siloed and the biggest holders in that silo are the very regulators/central banks that have imposed the new collateral paradigm on the markets. The US Federal Reserve’s (the Fed’s) balance sheet has grown from $800bn before the crisis to $4trn now;

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Saheed Awan, global head, collateral management and securities finance, Euroclear Group. “If rates are at 3bps, or 5bps for GC, what would it take to get the big buy and hold long-term holders [of collateral] to release that supply into the market?”, he asks. Photograph © Berlinguer, April 2014.

elsewhere the Swiss National Bank has some $500bn siloed away in bonds and eurobonds and the Bank of England has done the same. They hold these assets as part of quantitative easing or as a currency peg. Therefore, releasing that type of supply into the market is going to be key; and the Fed is taking the first steps with its fixed rate reverse repo facility where it is releasing up to $50bn to 100bn a day into the market, at a current floor price of 3-5 basis points (bps). That floor price of 3bps for general collateral (GC) is really at the lower end of the scale. That said, GC rates when they get down to zero basis points, imply there is a shortage of collateral in the market. Therefore, those central banks involved in quantitative easing need to be conscious of the fact that the macroeconomic policies they have been pursuing are resulting in collateral shortages. This point is really important. If rates are at 3bps, or 5bps for GC, what would it take to get the big buy and hold long-term holders (sovereign wealth funds, central bank reserve departments, insurers and pension funds) to release that supply into the market? They certainly won’t do it at 5bps unless they get an insurance policy of some sort to indemnify them against risk, plus higher fees. To exchange corporate paper or indexlinked equities for high quality government securities you are looking at 50bps to 75bps, plus an indemnity to nullify the risk. That’s the issue. What is the level of comfort that these big holders are going to need to unload some of the supply to help the shortage? It is that risk versus reward trade-off. DAVID BEATRIX: If you look at ESMA’s report last year about trends, risks and vulnerabilities, if my memory is good, there is a €1.6trn scissor effect whereby supply increases more slowly than demands and encumbrance. By the end of 2014. The problem is that, globally, not everyone is doing the calculations based on the same assumptions; some take the runs on assets due to LCR effects, some don’t. Some take the initial margin requirements of CCPs, but with use different parameters. However, everyone agrees that it all adds up to scarcity. We have a real challenge in terms of making sure that it does not create trouble for the industry as a whole.

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KARL WYBORN: A missing element is the timeframe over which this demand will materialise. We have been clearing swaps now in the US for virtually a year. The volumes of collateral held against cleared swaps is increasing, but it is still a fraction of what’s held against futures and options in the US. To my knowledge, the US bond market is not yet influenced by the demand for high grade collateral to be posted against cleared over the counter (OTC) transactions. We can clearly track a steady and steep growth in the demand for these assets but, at best, we are forecasting a three-year period over which we are going to be achieving some of these very high numbers that are being spoken about. The fundamental question is: how do you unlock that supply? BEN THOMAS: We have witnessed three things: one, supply is there. There is plenty of supply. Two, that has meant that lenders of high quality assets have been somewhat disappointed over the last two years as asset transformation levels have not spiked as much as some had hoped. In some cases we have witnessed beneficial owners bring term upgrade exclusives to market and not receive bids anywhere near the range they were hoping for so they have backed away. The third element is there is somewhat of a mismatch between the supply and demand side with regards to term financing structures. Focus points such as your LCR ratio have increased the market’s desire to trade evergreen and extendable structures, many lenders do not have the required systems to trade capture and risk manage such structures appropriately. Clearly, there is a slight mismatch between demand for certain term financing trades and the willingness on the lender side to offer enough supply in anything other than open or term bullet trades. PETER LEFT: I’d like to pick up on the increase in initial margin and CCPs. There are obviously more participants needing to come up with collateral to satisfy that requirement. A lot of our clients have to start thinking about moving to the likes of LCH.Clearnet and CME, and they are concerned about the term at which they are going to have to post that initial margin (IM). For OTC, we are talking long-dated derivatives and they are going to be consuming collateral for much longer than we are conventionally used to. Not surprisingly, we are starting to see long-term trades in secured financing and as a result the significant steepening of the secured financing transaction curve. Because people are concerned about the term they potentially have to commit to placing the initial margin for, they are starting to have to think about getting that high quality collateral in for much longer. MARTIN SEAGROATT: As well as the supply and demand dynamics, there is also an element of the movement and velocity of collateral. This can be thought of as the plumbing of the system. There are a number of factors that might start to slow that down and cause blockages. For example, CCP account segregation, a financial transaction tax on the securities lending and repo markets, leverage ratios and restrictions around re-hypothecation of collateral. We will also see a lot of collateral sitting encumbered on balance sheets for Basel III liquidity coverage ratios. These

factors could cause the velocity of collateral to slow even further. Research by Manmohan Singh has estimated that in 2007 the rate of collateral velocity or re-use was around three times. That has since decreased to a velocity of around two in 2012. Further falls in reuse could cause real problems when combined with the added demand for collateral, and perhaps result in a scarcity. The new challenge for the market is now to mobilise collateral at a high velocity and in a way that minimises settlement costs, manual processing, and risk.

FINE-TUNING THE PLUMBING: BUILDING THE COLLATERAL INFRASTRUCTURE BEN THOMAS: Certainly for the large banking institutions, it is really about trying to peel everything you have back to day one. If you were starting a new business from scratch many banks would build it very differently. However, you are not going to perfect optimisation. Everyone agrees about that. It has been referenced time and time again in the past that there is a cost benefit analysis where you’re probably going to get 80% to 85% of the way there if you do a good job and integrate everything efficiently. That might be the case, but, in many cases the inventory that you are using is so dynamic, that by the time you have optimised the position data is out of date, assets have moved and you need to juggle everything again. The fundamental building block is to know, in real time, where your inventory is across the bank, globally. That, as a very fundamental starting point, is something that’s quite hard to achieve, but no matter how difficult it is, it is very much the initial focus. Then there are an ever-increasing amount of variables that need to be plugged in to calculate what is truly optimal. From a simplistic perspective, you’d start with what’s optimal for my product in terms of the cheapest carry.You then overlay points such as the opportunity cost of not having that asset available to collateralise a different product in a separate part of the bank. Now you might consider what’s the effect on my LCR? How has that decision impacted my CRDIV leverage ratio? It goes on and on and on, and actually it is a big challenge. There are so many variables to consider right across the bank that (and this point was made right at the outset) what seems optimal for one group often is not for others. FRANCESCA CARNEVALE: If collateral optimisation then means different things to different people, is collateral optimisation then going to lead to an increasingly fragmented service set? SAHEED AWAN: No. Big sell-side firms, such as Deutsche Bank and the bigger investment banks, have been moving away from a fragmented service set. Certainly in Europe they would tend to hold—and this is not a pitch for Euroclear—but they tend to hold their fixed income in Euroclear. We have the majority of the European market share for fixed income already for investment banks and global custodians. The pockets of fixed income assets that the investment banks do not hold in Euroclear are in places such as southern Europe, Italy and Spain for instance, where we

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are partnering with agent banks (Citi and BNP Securities Services, for example) to try and mobilise the remaining pockets. Even so, the frictionless mobility we are offering in terms of automation is added value in that, day in and day out, those clients of ours who use BP2S as their custodian in Italy or in Spain, are frequently and manually moving their assets in and out of domestic markets into the international market. All we are doing is helping them do it in a more ‘straight through processing’ way. The starting point, as Ben pointed out, is: what is my global inventory, and where is it? Having established that, then you can start the optimal allocation of those assets. In Europe, the big sell-side firms tend to have already made the decision to consolidate their assets in one, maybe two key locations. Our job is to make sure that we are able to mobilise the assets that are not in Euroclear, or give them a view, an inventory view, of where they are, not only in Europe but in Asia and in the United States by having links into those markets through domestic agents or CSDs. It also means having a real time view. Our objective is to present them with a view of their global bond and equities inventory and a list of obligations that they need to fulfil. And then we allocate optimally, using the usual rules, the lowest rated collateral first, and then all the way to the highest rated. The issue for the buy side is: how do they benefit from the huge infrastructure that a tri-party agent, such as Euroclear has if their assets are in a single omnibus account in the name of the custodian? Therefore, we work, and will continue to work with the buy side’s custodians or agent. That’s a clear statement of our position and strategy today.

WILL BUSINESS COALESCE AROUND THE FEW BIG, GLOBAL PLAYERS? KARL WYBORN: We are seeing from our sell side client base a consolidation across what were previously siloed parts of the bank, bringing their assets, from a collateral standpoint together, to be able to see all of the available positions, and using them in a more judicious way.You cannot optimise what you can’t see. This is true for the buy side as well as for the sell side. That, however, is the fundamental starting point. If that is the case, then inevitably, there is a concentration of activity in providers who can support those more holistic requirements. By that I mean historically triparty has been used in repo and to support repo and securities lending. Now we talk about tri-party in the context of cleared margin and various other activities, where people have become far more focused on the operational cost of supporting a collateral programme, and the benefits of moving that collateral more quickly through the system. From our perspective, the demand we see from the sell side is one of consolidation, and the demand that places on us is to expand our services to be able to support different lines of business from those which we have historically supported. BEN THOMAS: It is two sides of the same coin. The fewer providers from the sell side you utilise, the more overall optimisation you’re likely to get. Even so, does the market, by

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Martin Seagroatt, head of global marketing at 4Sight Financial Software. “The increased costs of compliance in the new regulatory environment will make it harder for smaller players who don’t benefit from large balance sheets and economies of scale to thrive,” he says. Photograph © Berlinguer, April 2014.

converging into two or three big providers, introduce added and undesired concentration risk? FRANCESCA CARNEVALE: Peter, you’ve done work on mobilising collateral for high risk trades. Is that a particular niche for you; or do you play in the same field as everyone else around the table? PETER LEFT: We have plenty of customers wanting services from us, despite us not being the huge one-stop shop. We have a role to play as a UK-focused entity in providing liquidity. There’s quite a diversification in bank counterparties; we have lots of new players in the UK coming on board. There’s JP Morgan, Citi and BNP Paribas, but there is also room for us to play and sit in between those pools of collateral and them. Most people are willing to do collateral transformation overnight, and this is kind of exactly what we are doing in the unsecured market. Banks borrow at threemonth Libor and they lend on a mortgage which is 20 years. That’s what old fashioned banking is, is changing the term of the deposits into the financing maturity people want. We are just seeing that change in management being applied to secured financing from unsecured. It is the biggest investment we are making in financial markets; to understand our inventory, the term of our inventory, the dynamics of our inventory and match them. MARTIN SEAGROATT: The increased costs of compliance in the new regulatory environment will make it harder for smaller players who don’t benefit from large balance sheets and economies of scale to thrive. This concentration of risk is one of the major unintended consequences of the move to central clearing. For the buy side, using a greater number of clearing brokers/FCMs/CCPs offers risk diversification but it also fragments order flow, reduces netting and increases costs. The service providers that can achieve efficiency by analysing true transaction costs versus P&L and optimising their business strategy and pricing around this will do well. This does include smaller firms who can adapt in a flexible way to the new environment and find a niche in the market by offering more bespoke services. We may

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also see some consolidation among CCPs as time goes on. There are a fairly large number of CCPs out there and, over time, this may shrink a little. Each CCP will clear more products and this will open up opportunities for netting efficiencies. That is why we may end up with a smaller group of better capitalised CCPs; but then, it will also result in a concentration of risk in the system, and obviously the implications of a CCP failing would be more significant in that situation. SAHEED AWAN: Lloyds has a nice, unique model which seems to work quite well. I’m wondering though Peter, if the demand from buy side for client clearing services has been one of disappointment, generally, in the marketplace. That brings me to the question: if banks, don’t have the balance sheet to give and clearing brokers are not able to offer them the collateral transformation services they are looking for, who is going to look after the buy-side, especially the medium to small firms? The rules, especially the leverage rules under Basel III are making it much more difficult for repo financing activities to carry on in the way they have been doing. Furthermore, the spectre of FTT is still out there as a threat to all of us. Does that mean that banks that provide financing of that type of intermediary services, will vacate this space because the regulators are constraining them and because they don’t have sufficiently strong balance sheets? That breach or gap will be filled by some of the newer, niche players. I’m wondering if that is going to create a scenario where we’ll see a hedge fund receive funding directly from a corporate treasurer. Secured.Yes? Or perhaps a hedge fund going to a sovereign lender directly, without, for example, JPMorgan in the middle. KARL WYBORN: There is now a far greater correlation between risk and cost for the buy side than there was ever before. For a fund, you could argue that the best value proposition to support its clearing requirement, for example, would be to use one clearing broker and clear everything through one CCP. This would provide a concentration of activity, best buying power with a clearing broker and best netting with a single CCP. However, this is a riskier solution. The alternative and less risky but more expensive is multiple CCPs and multiple clearing brokers. Where the buy side decides to sit on that curve, to some degree, will influence performance of the fund. Relative fund performance is a key driver for the buy side in terms of how they judge themselves and how they are judged by their clients. This is a very new dynamic. The sell side has a slightly different dynamic because it is almost cost versus reward. What’s my opportunity cost for what is now a very finite resource? As a collateral agent for both the buy side and the sell side, our objective is to break the direct correlation between risk and cost. It is also important to remember this is not happening in isolation. Other initiatives such as T2S are in train, which will help. T2S, for example is a great example of an initiative which ought to reduce transaction costs significantly across Europe. DAVID BEATRIX: At BNP Paribas Securities Services, as a depository bank, under regulations such as AIFMD and eventually UCITS V, we are liable for the restitution of col-

lateral that is received by our clients under full title transfer of property, and their assets that would be delivered to counterparties under a different regime from title transfer. We must incorporate that consideration into the picture. There is need to have a transversal view of the assets that are available, or the unencumbered assets that are available for collateral, across where those assets are located. We need also to ensure our depository duties whenever our client is in-the-money or out-of the-money on derivatives activities. So we are having multiple constraints here in terms of consolidation of assets together with their encumbrance status. Transformation has come into its own and is closely linked to optimisation in the sense that we have seen the emergence of individual segregated accounts that are more intensive in terms of usage of liquidity and transformation. Some of our clients that would have chosen an individual segregated account structure for OTC clearing also have to deal with concentration rules of the CCP, which they did not have to think about in the past because the clearer was doing the job of managing substitutions and posting collateral to a CCP. Now, some of the clients realise they could at some stage be in a position to post some collateral and find the CCP has reached its concentration limit. That comes to the velocity question. If our clients don’t want to pay funding charges, they need to deliver eligible assets in a timely manner, but can also encounter a refusal. So they need an alternative solution to source eligible assets as fast as possible, either in the available pool or via transformation. It is a concern for the buy side and it needs to be embedded in the optimisation landscape. Finally let’s take the example of firms that are traditionally not collateralised or collateralised on a unilateral basis only. They worry about Company Voluntary Arrangement (CVA) and Funding Valuation Adjustment (FVA) charges and wonder whether it would make sense to start collateralising. Corporates are by nature quite diverse in terms of being capable to mobilise liquidity very quickly. Some are purely averse to collateral due to treasury constraints and difficulties in posting assets; some have taken the point that CVA is an issue and are either already collateralising or seriously considering this, even though CRDIV exempts banks in Europe trading with corporates from the new regulatory CVA charges. Therefore, they need to find a solution to provide that liquidity.

MARKET CHANGE AND THE IMPACT OF RISING INTEREST RATES PETER LEFT: It is something we really need to understand, because obviously, conventional wisdom says rates rise and the value of the assets fall, so you have to go out and get more collateral. It might happen when you don’t just need more collateral because the price has fallen, but you actually might have bigger liabilities to fund with that less valuable collateral. We need to have a handle on that potential correlation. It is something that the PRA wants to know. So it is pretty important that we have a fairly good

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handle on it. You can see the direct analogy if you trade derivatives on interest rates that require collateral, and you have a big sell off. If you’re a fixed rate receiver then clearly your trades now are off side and you have to post more collateral. That collateral has just fallen in price because the rates have risen. You have this problem of a massive curve steepening and the economy recovers. Is there enough good quality collateral as liabilities increase? The question is compounded by the fact that asset values are falling at the same time. It is important then to be able in an inventory management framework, to be able to run through those simulations to understand the dynamics and simulate what might happen. FRANCESCA CARNEVALE: How well prepared is the market? SAHEED AWAN: Clearly, this is a sensitive topic. It is message that I have been hearing outside of Euroclear, and talking to the buy side, this is a very real nightmare for them. Mandatory clearing is a huge headache for the buy side. Insurance companies (solid insurance companies) which previously never had encountered such problems, are now being lumped in the same bucket as highlyleveraged hedge funds. They naturally ask: why are we paying the price for having to put up initial margins where we didn’t have to do it before? They all lived off variation margin until now and now also initial margin which is not low, but more like 10% or 12% depending on the time left to maturity of the gilt. Then, these buy-side firms have to set up new processes to manage their margin calls. Add these together and you can see why it is a nightmare. We are talking to one of these Scottish insurance companies and they say they remain concerned about the implications around the level of margin calls that are expected, post regulation, when mandatory clearing is in place in Europe. In the US, our partners, the DTCC, issued a white paper recently which forecast between a 500% to 1,000% increase in the number of margin calls throughout the day. These are phenomenal projected increases. Now, for a buy-side institution that used to record collateral calls on a spread sheet, and maybe after two days agreed on what needs to be delivered or what needs to be received for a single margin call, to move to an environment where they are going to have multiple margin calls throughout the day, and having to post high quality liquid assets that the CCPs will only accept as initial margin, it is a real challenge. Add to that, setting up the processes, linking into the SEFs and into the clearing brokers; then paying the clearing broker or the clearing charges and so on, when you add up all these costs, the buyside decision makers may conclude it is too expensive. My biggest fear in the future is that large numbers of the buy side withdraw completely on grounds of expense. They will then either use rough hedges through the futures market or they will enter into swap futures. The industry will be much poorer when that happens, because those buy side firm will go out of the market. What’s the answer? I make no apology for this statement. We all need to look at whether we are servicing the industry in the best possible way. Are we, because of the mandatory

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Ben Thomas, head of collateral, financial resource management, Deutsche Bank. “In terms of costs, looking at the securities lending market (and a typical GC borrow) gives you a good idea how the process has changed,” he notes. Photograph © Berlinguer, April 2014.

nature of these regulations, going to take as much as we can from the market, because they are forced to use these products? We did a comparison of collateral management costs, and we found that we are a third of the cost of some of our nearest competitors, and less than a fifth of the cost of some of our other competitors. The normal response during this time is to increase costs, but we refused because our sell side clients are having a hard time. We can afford to do it because we are a user-owned utility and because our business is a high volume and low margin model. However, CCPs will charge according to their business models and they are generally owned by profit-maximising companies. Moreover, G20 governments and regulators want more and more business to be put into clearing houses. However, I see signs of the opposite actually happening. The market is discovering there are options outside of clearing, that are cheaper, more cost-effective and they still get collateral in the tri-party market and the bilateral market. If the regulators are not concerned about this, they should be, because mandating that all this business should go into CCPs was akin to giving them and all the other intermediaries in the chain a blank cheque. KARL WYBORN: There is now a far greater correlation between risk and cost for the buy side than there was ever before. For a fund, you could argue that the best value proposition to support its clearing requirement, for example, would be to use one clearing broker and clear everything through one CCP. This would provide a concentration of activity, best buying power with a clearing broker and best netting with a single CCP. However, this is a riskier solution. The alternative and less risky but more expensive is multiple CCPs and multiple clearing brokers. So where the buy side decides to sit on that curve, to some degree, will influence performance of the fund. Relative fund performance is a key driver for the buy side in terms of how they judge themselves and how they are judged by their clients. This is a very new dynamic. The sell side has a slightly different dynamic because it is almost cost versus reward. What’s my opportunity cost for what is now a very finite resource?

ROUNDTABLE

As a collateral agent for both the buy side and the sell side, our objective is to break the direct correlation between risk and cost. It’s also important to remember this is not happening in isolation. Other initiatives such as T2S are in train, which will help. T2S, for example is a great example of an initiative which ought to reduce transaction costs significantly across Europe. DAVID BEATRIX: Let us consider the case where insurance companies hedge themselves with, typically, products such as CMS caps that currently only exist OTC and have very few chances to be cleared. There is likely no other choice than trading them OTC under a bilateral master agreement and CSA. What happens then once the initial margins become mandatory on the OTC market? It could be something to which, right now, the industry has no firm response. How do firms hedge themselves against the steepening of the slope of the rate curve, or any other parameter for which hedging through cleared derivatives does not exist or is imperfect, and maintain trading and collateral costs at a reasonable level? Still with the BCBS recommendation, one other example is the fact that (physically) settling FX forwards that will not be cleared on a CCP actually will be subject to a mandatory exchange of variation margin. From an operational perspective, it is also probably quite a burden for the industry. Things will also become more intensive in terms of operations. Firms will, for example, probably also have to redesign the infrastructures that people put around the FX forwards and swaps. Until now there was middle ground between derivatives and more vanilla highway products that was often excluded from collateral arrangements. Now they are clearly more in the derivatives environment, subject to the requirements in EMIR for example. BEN THOMAS: In terms of costs, looking at the securities lending market (and a typical GC borrow) gives you a good idea how the process has changed. In the past, you may have looked for a stock from a range of lenders with consideration given to fees, where you want to place the balance and a basic collateral cost assumption. Now we need to drill down on the collateral costs at the very trade level. What’s the cost and impact of funding the unsecured needed for the overcollateralization being posting, for instance? How does the cost differ doing the trade bilaterally versus tri-party? To the extent it is non-cash, what non-cash exactly is it? Where does it come from? Will it be there tomorrow? If not, how much will it cost to replace? Is the non-cash posted in the same currency denomination as the asset I’ve borrowed? How much balance sheet am I actually allocating that lender? What the effect on my CRDIV leverage? The list goes on. You bring all these sorts of questions together and you could get to the point where you will have ten people from across the bank sitting in a room for three hours to discuss which lender they are going to borrow 50k of Microsoft from. The market would collapse. It demonstrates that it is vital to have all of these variables systematically captured.You need to have real time ability to process the data and see what the true cost is at an individual trade level. Frankly, I

don't think many, if any, institutions can do that right now. SAHEED AWAN: Choosing a counterpart has now become crucially important, and optimising that relationship has also become key in addition to getting your collateral optimisation spot on. What Ben has highlighted is that the debate is actually beyond simply collateral itself. There are so many different factors that become involved. Martin wrote a paper about counterparty optimisation at the point of trade. Do I do this repo trade with a CCP, with a street counterpart or with a central bank? The central bank is probably the best because I don’t have to put up initial margin, and the risk to the balance sheet is the same as with a CCP. MARTIN SEAGROATT: This is something that is now involving an increasing number of factors and on a pre-trade basis, it is quite a data intensive calculation. It needs to include initial margin, collateral eligibility and haircuts, CCP default fund contributions, capital costs, including capital held against default fund contributions, CVA, netting benefits and a range of other inputs. This illustrates the complexity of optimising trading decisions in the new model. A good starting point is to analyse costs on a post-trade basis. You can look at your counterparties and ask: what were my capital costs for trading with this counterparty and how much balance sheet did they consume? What were my collateral costs? How much P&L did I generate from trading with this counterpart or client and what was the true cost of doing business with them? That could lead to optimisation of which counterparties you trade with or which CCPs you route order flow to. However, as processing power becomes faster and cheaper and it becomes easier to compute these optimisation runs on a pre-trade basis, we could see that start to change. There will be more scope to support decisions on who to trade with or what types of trades are more profitable. The reality is that only a small proportion of the market is even optimising collateral. This is firstly because most firms have focussed on initial compliance with the new rules coming in around clearing and on getting their new workflow up and running. Secondly, collateral costs have not really started to hit home yet, they have not yet started to bite in any major way, and that’s leading to a fairly slow demand for optimisation. Over the next few years, as demand gradually increases and collateral costs begin to impact the bottom line, then we could see the take up of optimisation increasing. PETER LEFT: I’ve observed quite a substantial difference in relative pricing already, in the top tier banks at least, and I like to think Lloyds Bank tries to reflect all the different values. The pricing of facing LCH.Clearnet as compared to facing CME as compared to facing a counterparty bilaterally, and then the effect of what can I pledge on that CSA has to be factored in and we try to incorporate that into the derivative price, the cost of funding the initial margin, compared to the cost of the capital consumed if we trade bilaterally. We have all raised significant concerns at the cost of collateral, but it is important to note that collateral costs come at the same time as we observe capital savings. I would argue, in certain parts of the market, that collateral costs are

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far less than the capital savings reduction. So, obviously, utilising collateral in certain credit areas of the market is far more efficient than when we used to have to hold a lot of capital against such a transaction, whether it is derivatives, repo or any type of trade. Sometimes, at least, Lloyds Bank is observing that the cost of funding collateral is less than the cost of the capital. Or, alternatively, we can make capital work harder elsewhere. That’s the choice. The really clever players are building all of this into the price of every trade and that’s how you can generate collateral, because if you do this trade you’re going to be receiving this kind of collateral and that suits you. You might pay a different price in comparison to somebody else who’s a bit naïve, and you might only have to pay half a basis point better, but that’s worth 5bps. Those people that are being smart right now and are building their balance sheet to suit the new regime are going to be much more successful. KARL WYBORN: It is interesting that the gap between the buy side and the sell side is now narrowing. We see huge demand from the buy side to understand pre-trade and what the impact is from a collateral standpoint or a margin standpoint might be if a given trade is executed. What would be the relative impact of clearing at one CCP versus another? Then, from an optimisation standpoint, understanding before the collateral decision has been made whether or not it would make sense, rather than giving securities as collateral, doing a repo to generate cash because the relative return on cost is better by doing the repo? Whether, the asset that you are giving is actually on special somewhere, so you’re giving away intrinsic value when you use that as collateral. We have developed platforms now that talk to all of those requirements. We see the application of these elements increasing almost exponentially as the values of collateral actually deposited against these instruments increases.

MANAGING THE OPTIMISATION PROCESS SAHEED AWAN: Unlike David, we have little direct contact with the buy side. Their service providers, their custodians, should be in the lead in helping the buy side get ready. I can tell you, apart from JPMorgan, BNP Paribas and maybe two others, custodians generally have not done the best job of educating the buy side. Partly, this is because collateral management is a new activity for them as well. They don’t have the built-in skills, the knowledge, and expertise. It takes many years to achieve in what is a very complex business. I worry about that because mandatory clearing in Europe is just around the corner. The movement of the buy side to get ready for this new environment is dependent on very powerful intermediaries, whose main business was not collateral management but safekeeping and asset servicing, foreign exchange and all that. There are a handful of exceptions, where certain custodians have taken a decisive step to get into that business and to try and improve the readiness of the buy side. However, the issue for the buy side is that the advice from those cus-

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David Beatrix, senior business developer, collateral access, BNP Paribas Securities Services. “Pension funds are traditionally among the most risk averse players and the protection of their assets is key for them,” he says. Photograph © Berlinguer, April 2014.

todians may not be as detailed, deep and as meaningful as from an entity which has been in this business for decades. Part of the problem is that the specialists, even in the custodians, tend to come, in terms of collateral management, from the derivatives world. However, derivatives traders when they meet a margin call give cash. They are not familiar with the use of securities as collateral. Even today, 80% or 90% of derivatives trades are still cash. KARL WYBORN: Asset managers who are pension funds are becoming increasingly sophisticated in how they think about collateral. They are educated by their custodians, CCPs, clearing brokers and from various other industry participants. There is an obligation on custodians to educate and develop solutions around how to move collateral more efficiently for clients. Generally I believe the buy side is doing well at enhancing their overall efficiency around collateral. DAVID BEATRIX: Pension funds are traditionally among the most risk averse players, and the protection of their assets is key for them. They are generally the ones asking: am I really 100% collateralised? Perhaps optimisation comes next. Also, whenever there is a dispute they want to make sure it is escalated properly and dealt with properly by their agent, thereby ensuring that they are never under collateralised with a counterparty. That is probably why those kinds of players are less involved in the optimisation aspect at the moment. They are naturally long with assets. Most of them hold usually things that are quite eligible in the matrix of their collateral agreements. Therefore, their biggest concern is to be sure that risk is mitigated every day. MARTIN SEAGROATT: We do have buy side clients that carry out cross product collateral management and optimisation. However, they tend to be in North America, which is a little further ahead of Europe in terms of central clearing, although the European clearing deadlines are getting closer now. We are also seeing demand amongst the buy side for hosted software as a service collateral solutions, which we are now offering. This allows buy side firms that don’t have a large IT footprint to use more advanced collateral management tools without the investment in hardware and IT infrastructure.

ROUNDTABLE

There is a big additional strain for the buy side in terms of more frequent margin calls and far more complex workflow. This is particularly the case for the derivatives market, where margin calls were a lot less intensive in the past. Many smaller firms were previously using spreadsheets for collateral management. That is now no longer viable for those trading more than a handful of agreements. All this raises questions for the buy side around how much of their collateral management to outsource or insource, and what technology deployment models to use.

REGULATION: HAS IT HELPED? DOES IT HINDER COLLATERAL OPTIMISATION? DAVID BEATRIX: One of the things I am quite curious to see, from my personal perspective, is what is going to come out in terms of re-hypothecation possibilities, from the working group on margin requirements, given the direction and lack of clarity of the BCBS recommendations. Therefore, trying to think of streamlining collateral between buy side clients, and hedging transactions is something that is probably not going to be very applicable in the real life, actually. It is going to be, interesting to see how the working group that has been set up is going to progress on this topic. BEN THOMAS: What you quite often find is that, in complying and optimising for one regulation, you make your position worse with regard to something else. Even when you look at something simple such as the haircuts on a highly liquid asset, you often see great variation in the haircut applied across the various different stress tests and regulations. We have so many variables in play, so it is not always easy to work out what is the optimum trade across the bank. You then have to transfer price the economics back to the relevant long holder. That’s in itself is another big challenge. PETER LEFT: It is great that everyone’s going to be moving to segregated accounts. I wouldn’t want my pension fund comingling its assets with a hedge fund, for instance. However, what it does do (essentially) is kill the opportunity; it kills optimisation because you can’t touch the assets any more. You can’t re-use them. All of a sudden your funding costs shoot up because what you receive is only a creditmitigant now. It can’t be used by you to cover the cost of placing on the other side for whatever the hedge might be. It does therefore increase the cost of whatever transaction it is that that segregated account is supporting but, frankly, perhaps that’s a cost we should be willing to pay. SAHEED AWAN: To David’s point about the buy side being very risk averse. They make sure that when they are in the money, they are fully collateralised and that they don’t take any additional risks. This now extends to other areas of concern. So if you are going to pledge assets for a cleared trade via your clearing broker, it has to be a pass through structure before it hits a segregated account in the name of the clearing house. There are two models and the

two extremes are: omnibus or full segregation and a number of options in-between. In Europe, ESMA has asked that clearing houses provide all the options they can to the buy side. The issue with that is that there are costs as you move to full segregation with individual accounts at a fund level. The clearing broker was, previously, able to use those assets, but can no longer touch them. Clearing houses then became so keen to attract the custom of the buy side that the sell side were all but ignored. That is now (hopefully) changing. Even so, the buy side has been shy in making use of the extraordinary number of new options available to them, probably because of the cost. The full segregation model is probably going to be prohibitively expensive. The other issue is that the buy side is coming in via the custodian, and EMIR 47.3 put another issue on the table for the custodians: that you cannot hold margin for a CCP at the custodian unless that custodian uses a securities settlement system (SSS), or is a CSD. So some custodians, or at least one, have become CSDs themselves. Others are saying, well, we’ll use a SSS such as Euroclear. Ultimately though, this will probably mean more cost for the buy side as the assets will have to move out of their custodian.

THE NEXT STEPS TOWARDS AN OPTIMISED WORLD BEN THOMAS: Much market infrastructure still needs to be developed and built. Personally, I feel as far as tri-party custodians are concerned, we eventually need to move away from the old concept of depo realigning to tri-party long boxes. Your first question is: where are my unencumbered assets on a real time basis? The second is: I need to maximise my funding of those assets around the clock, but can I do this without physically moving them? Third, if I do need to physically mobilise the asset, can I get instant access to it and efficient infrastructure to place it anywhere I want, globally? Collateral solution providers have to implement the plumbing that enables real-time re-hypothecation of collateral received in tri-party to maximise its value.You also need access within tri-party to more CCPs. That whole plumbing is going to be a big rollout and I don’t see that being either fully in place and/or fully adopted by collateral givers, certainly, for at least 18 months, probably more like two to three years. Additionally, from a bank point of view, most require a significant consolidation of systems and data internally. To give you an example, bringing together as a global bank all of your collateral schedules and putting them on a centralised system is an enormous task. It is a big task to do it for your sec lending and repo clients, then to consider all of your CSA agreements and CCP eligibility. It is going to take months, if not years. So I don’t see that we will have this conversation in 12 months and everyone agrees we are there. We’ll probably be another 10% down the road, but it is going to be a multiyear build out for both service providers and end users. MARTIN SEAGROATT: As Ben says, it is a fairly large undertaking to consolidate your inventory and exposures in

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one place, but it does provide huge benefits. Firstly, from a risk point of view, you can see all of your exposures in one system and see concentrations of exposures with each counterparty across business lines. From a collateral cost perspective, it then allows you to become more efficient. We are doing a lot of projects now that are just purely consolidating inventory and exposure management, as a first step. From there it is then possible to roll out the more advanced optimisation tools in a phased approach. We will start to see far more complex multi-factor optimisation algorithms that run big data simulations and process hundreds of thousands of collateral and capital optimisation runs pre-trade. Of course, there is a cost benefit trade off in all of this and it may not be suitable for every firm. In terms of infrastructure, the challenge for the industry is providing an efficient engine for unlocking collateral supply and matching it with demand. Having a consolidated feed of CCP eligibility schedules across all CCPs with daily updates in one place will provide benefits in matching perhaps less liquid collateral assets with CCPs that will take them. There is also work to do around helping suppliers of eligible collateral to identify any surplus assets once they have met their own margin needs. Then encouraging them to lend them to those who are short collateral. This is all about moving collateral in an automated way with straight through processing and minimal operational risk. From a data point of view, a benchmarking service for collateral costs would help the industry to identify cheapest to deliver collateral to pledge. Identifying accurate collateral costs is currently hard to do, particularly assigning an opportunity cost to collateral assets. In the longer term, maybe an exchange for collateral trading will evolve. Perhaps we could even see collateral turning into a derivative in its own right. So you could take out a contract for future delivery of CCP eligible collateral on a given date and, from a buy side point of view, that will mean they don’t necessarily have to hold those assets until they need to be delivered. This will allow the buy side to pursue their asset allocation strategies without the drag on returns of holding cash or government bonds for margin. PETER LEFT: Clearly, there is a massive education of the clients and a massive infrastructure development investment within the bank. To reiterate everyone’s points—it is a massive problem to solve. It is the same problem as managing the unsecured part of the balance sheet, it is exactly the same, being able to understand all the flows in and out. Being able to understand the impact of certain stress scenarios, you need all of that technology on the secure financing side across all the sources and all of the requirements of that collateral. KARL WYBORN: The variables might have changed and the stakes might have been raised, where collateral and capital costs are increasing, but it is nonetheless an ongoing evolution. It is a continuum, which, arguably, doesn’t have an endpoint. I agree with Ben that a lot of the initial challenges are around data capture, and about being able to see and configure a series of variables around what assets you have and the various competing demands on those assets. So data

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Karl Wyborn, managing director, head of sales for securities clearing and collateral management. “To the extent that you have your data capture layer completed, the next step is around operational efficiency and platforms and how collateral is moved,” he says. Photograph © Berlinguer, April 2014.

capture for all participants, is key. Finally, to the extent that you have your data capture layer completed, the next step is around operational efficiency and platforms and how the collateral is moved. This is going to be a key area of focus and it is a global consideration. T2S in Europe will alter that landscape very significantly. DAVID BEATRIX: For me, it all hangs around cost. It looks like probably it is not a one size fits all approach. It really depends on the institutions and their level of sensitivity to this approach. Probably there could be some middle ground, and having some kind of 80/20 rule whereby you could be at 80% of the functionalities with, say, 20% of the budget somewhere. Probably the answer really depends on the people you are talking to, whether you are talking to an investment bank, talking to a pension fund, talking to an asset manager. What is common to each is that you need to have a vision of your assets across the whole range of where they sit. You need to have a transversal view of collateral requirements too and also a good view of whether they are unencumbered and encumbered and subject to re-hypothecation rights, etc. Ultimately, the rules that you are going to put into the algorithms are probably dependent on the level of optimisation you really want to achieve, and that’s where most of the debate probably lies, actually, in terms of real optimisation. SAHEED AWAN: In terms of helping the buy side get ready, I say get yourself a good custodian that can really help you navigate the complexity that the new environment has created. Secondly, get yourself a good clearing broker that can also help you get ready for this and provide the full range of services, and that has the balance sheet to also help you transform your assets to get the right collateral to the CCP. I would also advise setting up a network of relationships that you may need to call upon when you need to get the right type of assets, be it cash through the repo market or through the securities lending market. Start developing those relationships. Put in the legal agreements, the master agreements, with those counterparts in the marketplace. Do it now. Don’t leave it too late. I

EMIR & TRADE REPORTING

Photograph © Xyzprojects/Dreamstime.com, supplied March 2014.

EMIR and the data detectives Some weeks after the deadline for the start of reporting all derivative trades to new European trade repositories, many firms are still believed to be non-compliant. Some believe the new system could take up to a year to bed down. Indeed, one leading figure said: “It’s just as well it was a soft launch, because if it had been a hard launch it would have been a disaster.” Ruth Hughes Liley looks at the impact of the implementation of EMIR. UROPE NOW HAS six trade repositories (TR) registered by ESMA where firms and businesses—any organisation conducting ‘economic activity’, even charities – must now report their trades under the European market infrastructure regulation (EMIR). This way, regulators can keep an eye on details of derivative contracts should they need to unwind a trade in case of a default. Signs are that there will be plenty of data to go after. On the first day of trade reporting, ICE Trade Vault Europe alone processed around 4.5m trades from more than 300 participants across segments such as energy, agricultural commodities, metals, credit, interest rates and equity derivatives.The inclusion of non-financial firms under the rules came as a surprise at the end of last year. Now the likes

of Shell or BP, for example, or a medium-sized business conducting the occasional forward, must also report each of their derivative trades to one of the TRs. The surprise inclusion of exchange traded derivatives and the large volume of reports, caught some TRs on the hop. Actually more problems rolling out the new system have stemmed from the sheer number or quantity of repositories in Europe (six in all). The six include European spin-offs of the US-based DTCC, ICE and CME, the London Stock Exchange Group’s UnaVista, Regis-TR from the Deutsche Börse Group and BME stable, and the Polish authority’s KDPW. The US is lucky in this regard, having only the one. That is not the only difference. Europe requires two-sided reporting, while only one party reports in the United States.

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Other delays stemmed from onboarding clients to TRs. Regis-TR, however, says it provided clients access to their test environment in 2012, and that it has fully onboarded all registrations with complete applications received ahead of the February 12th deadline. They are still taking applications from clients from small corporations and firms to large European clearing houses. Indeed, around 60% of Regis-TR’s client base is corporate. While some of the larger nonfinancial firms are setting up their own reporting systems, many others will delegate to TRs and this is expected to provide a new line of business for the repositories.

Delegated reporting Delegated reporting—where one counterparty delegates the reporting to the other counterparty—is permitted under EMIR and most of the larger broker dealers are offering delegated reporting services. HSBC, for example, states it produces a report both from its side of the trade and from the client side, generates a unique reference for each trade, sends the data to the TR and produces a monthly report of all reported trades. Furthermore, underlying clients do not need to be onboarded to the TR. So a broker can do the reporting for a number of underlying buy side clients, although the end user remains responsible for his side to be correctly reported. In Greece for example, the 33 member firms of Hellenic Exchanges Group will use UnaVista’s delegated reporting service to report all Greek derivatives trades to UnaVista, on behalf of up to 3,000 counterparties, or up to 32,800 market participants. Rob Friend, global business manager for FICC, Bloomberg, says: “From 12 February, whether you are a big dealer, a small buy side firm or a corporation, you have had to report your trades. The bigger financial institutions have the resources to be able to deal with it, but for medium and smaller firms it becomes more disruptive because they are not used to doing it.” In order for the system to work properly, each party and each trade has had to be accurately identified. European regulatory body, ESMA, originally left it to the market to work out much of the operational detail, including, for example, how unique trade identifiers (UTIs) should be constructed and generated. As progress was slow and open to interpretation, according to some, ESMA first extended the reporting deadline by six weeks and then updated their guidance on February 11th, the day before compliance day. This included new advice on which party was a buyer or seller in a swap, how to report complex contracts, and the fact that as both parties need to be uniquely identifiable, a trade would not be compliant if one party was established in a third country where laws restricted disclosure of identity.

LEIs and their role This last issue has been a“hot topic of debate,”according to Mark Croxon, Nomura’s global product manager for OTC clearing: “Each reporting party’s legal and compliance department has had to take a view: either not to report, which is a bad thing; or to give an incomplete report, which is less

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David Retana, managing director of trade repository, Regis-TR. There have been more than 200,000 registrations for pre-LEIs from 13 prelocal operating units (pre-LOUs), as at March 17th and this number will grow. Indeed, Retana says: “We are talking potentially of hundreds of thousands, if not millions of legal entities that have to register.” Photograph kindly supplied by Regis-TR, March 2014.

of a bad thing. There is something of an impasse although a number of interim proposals have been put forward to resolve it.” While in the US, a ‘no-action letter’ gives legal standing to firms who are working towards compliance, no similar function exists in Europe, although Croxon believes regulators have shown a degree of forbearance while the issue is sorted out and he believes fears about a dramatic decline in trades with those countries have not materialised. Indeed, the whole point about Legal Entity Identifiers (LEIs), the unique tag to each participant, is that they were supposed to provide a better measurement of risk in the financial system, enabling regulators to manage central counterparty exposure. Progress allocating the 20-digit alphanumeric code has been slow and so in the interim, firms are being issued with pre-LEIs, which will convert to LEIs later. There have been more than 200,000 registrations for preLEIs from 13 pre-local operating units (pre-LOUs), as at March 17th and this number will grow. Indeed, David Retana, managing director of trade repository, Regis-TR, says: “We are talking potentially of hundreds of thousands, if not millions of legal entities that have to register.” Friend confirms: “No-one really knows how many LEIs there should be or how many entities still require an LEI. It is quite possible many firms and corporates don’t realise they need to have an LEI.” The February 12th deadline also required the reporting of all outstanding positions of derivative contracts entered into before August 16th 2012 and still outstanding at February 12th—known as the back loading of data into the system. Each firm has had to match each trade with its counterparty, using the correct identity numbers. In an industry with notional amounts outstanding totaling and estimated

EMIR & TRADE REPORTING

$693trn at end-June 2013, according to the Bank for International Settlements, the work has been enormous. LCH Clearnet alone says it completed the back loading of 5.8m trades by the deadline.

Matches made in heaven Matching is a three-way discussion between the trade repository, the buyer and the seller and this creates work for operational staff in banks, although the responsibility for reconciling the two sides of the trade lies with the trade repositories. Friend says:“There are still lots of firms out there who haven’t even started talking about matching. It’s a vast amount of data being sent down the track.” “As expected, many of the trades we process for our customers will take time to be paired with the information registered by their counterparty, which could have been entered into an alternative trade repository. It can take participants time to collect missing data or to settle differences in the format/content of the data received. We are working with other trade repositories to achieve this pairing of registrations, which is the first step before reconciling the respective information,” adds Retana. This early reconciliation phase, he explains, will take some time to bed down; a useful benchmark might be to look at the Dodd Frank trade reporting experience in the US, which took some six to 12 months to finalise data refinement before it could yield optimal analysis for the regulator. In Europe, with dual reporting obligations, a“big bang”implementation and generally less prescriptive technical standards defined by ESMA, full harmonisation of the data set to facilitate high levels of reconciliation will, understandably, take time to achieve. In the meantime, as all parts of a trade must be reported, a new industry is springing up of firms helping organisations with their trade reporting requirements. Talking specifics, LSE Group’s EMIR reference data file covers 11m derivative contracts across 80 global exchanges with coding, contract size and commodity details dating back to August 2012. Xtrakter, a provider of market data, trade matching and reporting services, has launched TRAX Repository Link, based on the firm’s post-trade matching engine, to provide a single entry point for firms to report to CME European trade repository. Meanwhile, Bloomberg’s EMIR-compliant reporting service is integrated with the firm’s electronic trading and order management services. Users can also send their non-Bloomberg trades through the platform via Excel upload or real-time feeds. Services such as these will be needed because, from August this year, valuation and collateral information about OTC derivative contracts entered into since August 16th 2012 must also be included in the data. This daily mark-tomarket or mark-to-model information will provide insights and important market intelligence to regulators about the risk exposures of individual firms under their watch. It’s a level of safety, agrees the market (by and large) and few are voicing open concerns about the cost implications of the augmentation of reporting rules and the role of market oversight. Instead, other considerations weigh more

According to Mark Croxon, Nomura’s global product manager for OTC clearing: “Each reporting party’s legal and compliance department has had to take a view: either not to report, which is a bad thing; or to give an incomplete report, which is less of a bad thing. There is something of an impasse although a number of interim proposals have been put forward to resolve it.” Photograph kindly supplied by Nomura, March 2014.

heavily. Greenwich Associates reported in February, for instance, that two-thirds of all participants in a study say they prefer combined order and execution management systems, fuelled by the new derivative rules. Some 30% are considering the“potentially expensive and disruptive step” of changing their service desk technology, with fixed income investors (39%) most likely to explore new systems. As usual, all this costs firms money. Early on, Ernst and Young estimated between $15m and $25m in 2012 on OTC derivatives reform implementation. The EMIR regulation includes a mandate for all parties with a large portfolio of transactions to implement risk mitigation techniques and agree terms before an OTC trade is entered into. ESMA states that risk mitigation techniques include timely confirmation, regular portfolio reconciliation to identify discrepancies early, regular compression of larger portfolios; counterparties must have a plan in place to resolve disputes early, and finally marking-to-market and marking-to-model, and the exchange of collateral to cover exposures arising from OTC derivatives not cleared by a CCP must also be conducted. Many firms are up and running with this, although according to Richard Metcalfe, director of capital markets, Investment Management Association:“More than anecdotally, if you look back through banks’ experiences in the mid2000s, it showed a huge number of disputes about the population of portfolios. With portfolio reconciliation in place, you will be eliminating a significant number of potential disputes: as to what’s in and what’s out of the portfolio.” As the work continues, Croxon points out:“The reason for trade reporting rules is so regulators can get access to trade data and how inter-linked exposures might be. The next step is to see what regulators do with that data.” I

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

COLLATERAL MANAGEMENT

Ever since regulators first proposed that most OTC derivative contracts should settle through central clearing counterparties (CCPs) market participants have predicted a massive shortfall in the amount of high quality collateral available to meet CCP margin requirements. Doomsayers bandied about numbers of Brobdingnagian proportions—in the trillions—that would drive up costs, perhaps to the point where some derivative trades would become uneconomic. The clearing mandates began to take effect last year (at least in the United States) but so far the dire predictions have failed to materialise. The picture could change—the clearing requirements will not be in full force globally for several years—but the scale of any shortfall, if not Lilliputian, is unlikely to pose a major threat. Neil A O’Hara reports.

Collateral shortfall: mountain or molehill? ELIEF HAS COME from several quarters. On the supply side, CCPs, which used to accept only G7 government bonds or cash collateral to support their settlement guarantees, have expanded the eligible pool to include highly liquid equities and top quality corporate bonds. Governments in the developed nations have done their part to alleviate the shortage, too, albeit inadvertently.Years of outsize budget deficits in the G7 economies financed through bond issuance have flooded the market with new eligible paper. On the demand side, many asset owners have discovered they already own enough eligible collateral to meet the margin

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

requirements on their existing derivatives portfolios if the contracts had all been cleared. For example, when Northern Trust helped several of its larger pension scheme clients run the numbers through margin calculators provided by the CCPs, it found little or no shortfall in initial margin.“We don’t see a huge requirement for eligible securities clients cannot cover from their existing portfolios under normal market conditions,” says John Southgate, the firm’s head of derivatives and collateral product management in EMEA. It is still early days, of course. Mandatory clearing will not take effect in Europe until July 2015, and European pension

COLLATERAL MANAGEMENT

plans will have a further two-year grace period—and possibly a third year—which could delay the effective date for them until mid-2018. In the meantime, pension plans will have to decide whether to switch to clearing earlier—an option available from August 2015 on. Cost will be a factor in the decision, but nobody knows what the relative cost of cleared vs. bilateral trades will be. “Clients do not see any difference in execution costs so far,” says Southgate. “Some have prepared to clear, opened accounts with clearing members and put the legal infrastructure in place, but they are not clearing yet because they don’t know what will happen to pricing.” Other clients are watching and waiting, a riskier strategy given how long it takes to select a provider and set up a clearing relationship. In the US, only interest rate swaps and credit default swaps must be cleared at the moment; foreign exchange and non-deliverable forwards will follow later this year. Nadine Chakar, head of product development and strategy at BNY Mellon’s global collateral services, points out that the requirement to collateralise bilateral trades has not kicked in yet, either. “There seems to be plenty of eligible collateral available,” she says. “Most firms seem to have their needs under control for now, but they do anticipate some challenges in the months and years to come.” Meanwhile, BNY Mellon, in partnership with Bank of America Merrill Lynch, has implemented the new IEF4 program at CME Clearing, which for the first time enables clearing members to post high quality corporate bonds as collateral against listed futures and cleared interest rate swaps. BNY Mellon provides infrastructure to manage mark to market valuation, margin calls and, in the event of default, the ability to liquidate high quality bonds.“The point of IEF4 is to expand the universe of eligible collateral,” Chakar says. While IEF4 was designed in part to enable insurance companies to use corporate bonds as eligible collateral, CME Clearing does not accept lower quality credits, which often make up the bulk of those portfolios.“Collateral transformation takes high quality ineligible collateral and turns it into eligible collateral,” says Chakar. “It isn’t financial alchemy. We are not taking dirt and turning it into gold— that would fly in the face of proper risk management and all the new regulations.” Initial margin, typically posted using eligible securities, is only half the problem, however. Market participants must also put up variation margin based on mark to market valuations—and CCPs accept only cash for that purpose. When Northern Trust calculated variation margin calls under different high-stress market conditions, the demand for immediate liquidity could have embarrassed some institutions. “Clients need cash on a same day or next day basis,” says Southgate. “We see more concern about liquidity than access to eligible securities.” Under normal market conditions liquidity is abundant, but whenever the market goes haywire it tends to evaporate overnight. Bitter experience during the financial crisis demonstrated the importance of backup liquidity, and from more

than one provider. If Northern Trust stress tests identify gaps in a client’s liquidity profile, its collaborative collateral solutions group will steer the client toward both internal and external sources that could cover the potential need at short notice. The problem is more acute for asset managers focused on less liquid assets. In fact, some smaller Northern Trust clients are exploring whether to abandon the OTC derivatives market in favor of exchange-traded futures and options, which have lower collateral and liquidity requirements. It would be ironic if the regulations ended up forcing smaller shops to hedge using standardised contracts (for which expiration dates and amounts may not match their precise needs) rather than bespoke OTC contracts.“The whole point of central clearing was to protect investors,”says Southgate. “If participants move away from OTC, does that impair hedging quality?”

Nadine Chakar, head of product development and strategy at BNY Mellon’s global collateral services, points out that the requirement to collateralise bilateral trades has not kicked in yet, either. “There seems to be plenty of eligible collateral available,” she says. “Most firms seem to have their needs under control for now, but they do anticipate some challenges in the months and years to come.” Asset owners are concerned not only about the amount and nature of their collateral needs but also what happens to the assets they pledge. In a conventional arrangement, the buy side delivers collateral to a clearing member, which has the right to re-hypothecate those assets. The CCP looks to each clearing member for an aggregate margin call across the member’s entire client base, a smaller amount than the gross call the member makes on clients because some trades offset each other. Now, however, clients want more visibility into what happens to their assets.“We are seeing clients revoke rehypothecation and insist the clearing member pass the assets through to the CCP,” says Southgate. “More asset owners want their securities held in a segregated account, ideally throughout the clearing life-cycle.” Northern Trust is investigating whether it can set up a series of accounts to enable owners to pledge collateral without the assets ever leaving the bank’s custody umbrella while still giving clearing members and CCPs the security interests they need. If the idea pans out, it would eliminate settlement risk—collateral would move through journal entries alone—and give owners full transparency over where their assets reside. The proposal faces obstacles in Europe, where the European Securities and Markets Authority has decreed that

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

John Southgate, the firm’s head of derivatives and collateral product management in EMEA. When Northern Trust helped several of its larger pension scheme clients run the numbers through margin calculators provided by the CCPs, it found little or no shortfall in initial margin. “We don’t see a huge requirement for eligible securities clients cannot cover from their existing portfolios under normal market conditions,” says Southgate. Photograph kindly supplied by Northern Trust, March 2014.

Mark Daniels, head of listed derivatives execution and clearing sales at UBS Americas. Daniels says banks have started to favour assets that carry a lower balance sheet hit and charge a different price for cash versus non-cash collateral. The new pricing model could stimulate demand for collateral transformation, particularly when additional products become subject to the clearing mandate, as clients seek to optimise use of the assets they own. Photograph kindly supplied by UBS, March 2014.

CCPs must hold collateral in a registered securities settlement system, i.e. a central securities depository (CSD) like Euroclear or Clearstream. If giving the CSD appropriate control over an account at Northern Trust does not satisfy ESMA, Northern Trust may set up a CSD in Europe instead. “We have not written off becoming a CSD,”says Southgate, “but we are working to see whether it is necessary.” Other custodians have taken a different tack. In 2012, BNY Mellon set up its own CSD in Belgium to create a regulated entity in which buy-side clients can post collateral in segregated accounts. Chakar believes ESMA’s insistence on a CSD was driven less by enhancing the CCP’s ability to liquidate collateral in a hurry than a desire to ring-fence collateral and ensure easy portability in case of need. “We are one of the largest players in collateral management,” she says.“We felt it was complementary to invest in market infrastructure, hence the CSD.” No matter how it is structured, eliminating the right to rehypothecate collateral deprives clearing members of the associated revenue at a time when they face additional regulatory capital costs from implementing Basel III. Mark Daniels, head of listed derivatives execution and clearing sales at UBS Americas, says banks have started to favour

assets that carry a lower balance sheet hit and charge a different price for cash versus non-cash collateral. The new pricing model could stimulate demand for collateral transformation, particularly when additional products become subject to the clearing mandate, as clients seek to optimise use of the assets they own. Clearing members may take another hit to revenue when client trades migrate to SEFs. While UBS has seen fewer dealer-to-client transactions on SEFs than expected, Daniels expects activity to pick up as more products fall within the clearing mandate. Banks are well aware it is only a matter of time before spreads come under pressure and are looking for alternative revenue sources.“Clearing members are introducing charges for allocations of large trades among asset managers’ sub-accounts, collateral fees for corporate clients and SEF fees, including for aggregation of orders and sponsored access,” says Daniels. It may take another year or two before the market settles on appropriate pricing under the new regulatory regime, which in turn will determine how much demand emerges for collateral transformation. At this point, though, the collateral shortfall that once loomed like Mount Everest has shrunk to a molehill. I

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

THE BUY SIDE TRADING SURVEY

This report reflects the results of a detailed telephone survey of 118 buy side traders across the EMEA region. The survey is dominated by trading desks of long only investment firms (48.1%), though the range of assets traded is, according to one trader, “growing all the while”. What comes across from the survey is a market segment that understands the growing complexity of the trading landscape and is confident working within it. Regulation is taking its toll and the buy side trader is having to be aware of a plethora of market trends and developments. The good news is, they are on top of it. What does this mean, long term, for the sell side? Francesca Carnevale summarises some of the findings and puts them in the context of market change. For information on the rest of the survey findings, please visit: www.ftseglobalmarkets.com for access to the full report.

Bright, confident day: the buy side trader comes of age T HE BUY SIDE trading desk is increasingly focused on multipleassets (see Chart 1). In a survey of 118 buy side traders, the majority of which service long only investment managers (see Chart 4) are taking more risk averse positions and are investing in a broader range of assets. According to Chart 5, buy side respondents believe the trend is irreversible and that in future trading multiple assets will be typical. In preparation for this eventuality, or (at least) in the interests of building skill sets, we asked the buy side which skill set they thought would be essential to meet the demands of a modern-day trading desk. Chart 5 outlines the responses. Over half (52.17%) of the respondents think quantitative skills will be imperative, as will a good grounding in finance (50.43%). While not expecting to have to write computer programs themselves, a goodly third also ventured that computer science skills would stand them in good stead. The reasons for the change are clear: mounting regulatory pressure, the multiplication of alternative trading venues and the preponderance of algorithmic and statistical trading. Moreover, in an increasingly

SUMMARY SURVEY RESULTS 80.87% of respondents think that buy side traders will need to hone their risk management skills as trading markets become more complex 79.6% are concerned about the rise in market volatility over the last twelve months Speed of execution is the salient reason for buy side traders to utilise a trading platform 74.5% of respondents have seen the overall cost of trading fall over the last six years 75.5% of respondents think HFT leads to market volatility 76.8% think HFT improves market liquidity 69.9% of respondents think HFT leads to predatory trading behaviour 87.2% think trading technology vendors need to better understand clients’ needs 76.1% rate reliability as the main consideration in differentiating between providers of trading algorithms

cost conscious environment, the buy side trader has not been immune from the need to reduce headcount and make existing trading headcount work harder. While buy side traders are not quant analysts, they are taking increasing steps towards active management of their desks, using direct market access, smart order routing and algorithmic trading strategies. It is a skill that involves understanding the benefits and/or pitfalls of the various execution venues, lit, semi-lit and dark pools of liquidity. As the buy side has become more technical in its handling of trades, it has also become more predictive: how much should a trade cost and where should trades be sent to ensure best execution? Clearly then, the buy side has become better at understanding how much of the implicit cost of a trade is being affected by the type of algorithm used, the investment style of the fund manager and the trader itself. Today’s trading tools enable the buy-side trader not only to measure his or her own performance but also offer the portfolio manager some guidance on the best way the order should be executed. That means how quickly it should be filled and over what time period. In other words,

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

Chart 1: Is the buy side trading desk now multiasset? (117 responses) Assets traded

% Response

Derivatives Equities Bonds Other securities of which FX

47.01 78.63 54.70 22.22 6.84 1.71 1.71 3.42

Structured products CFDs Commodities

Chart 2: In the move toward multi-asset trading do buy side traders need to become more familiar with derivatives & FX trading? (113 responses)

9.28%

support among respondents. Trading markets have become more complex as have investment styles (particularly among long only firms) and the buy side trader is increasingly aware of the need to manage both trends effectively: be that through the use of synthetics and structured products; or through a greater appreciation of the nuances of market liquidity and the cost of accessing it. The trends are confirmed by Chart 7, where ‘the ability to manage trading risks’ and ‘knowing where and when to trade’ received the highest percentage of recognition by respondents. The challenge then for today’s buy side trader is not only to gain an edge over competitors, but also providing informed feedback to their portfolio managers and brokerdealers. Buy-side traders are no longer order takers or dispatchers, relying on portfolio managers on timing and broker-dealers on strategy; they are increasingly taking a guiding role themselves, with inevitable long term consequences for the sell side trading operation.

No Yes

Chart 4: Typical investment outlook of the portfolio manager (118 responses) Investment style

Don't know

90.72%

% Response

Long only Primarily long but mixed Value Hedge fund Other of which

48.31 33.09 11.83 11.02 9.32 Short term FX trading Structured products Commodities

Chart 3: Will buy side traders still focus on a single skill or trade multiple assets? (116 responses)

Chart 5: What skills will the buy side trader need in coming years? (115 responses) Skill set

Muliple assets Single asset 41.38% 58.62%

1.69 1.69 1.69

% Response

Quantitative Engineering Computer Science Finance Multi-disciplinary skills All of the above Other

52.17 10.43 32.17 50.43 43.48 32.17 Common sense

0.87

Chart 6: Which technical skills will the buy side trader need in future? (115 responses) Skill set

the buy side traders’ role is moving towards a more quantitative function. The results are confirmed by Chart 6, where we asked the buy side which specific technical skills they anticipated they would need to augment. The ability to trade multiple assets; big data analytics and risk management were the dominant themes, particularly risk management, which garnered 80%

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

% Response

Big data analytics Artificial intelligence Visualisation Risk management Understand hedge fund strategies Ability to trade multiple assets Other of which

59.13 29.57 32.17 80.87 56.52 77.39 2.61 Financial skills

2.61

THE BUY SIDE TRADING SURVEY

Chart 7: What is the most valuable skill a buy side trader has needed in these changing times? Skill set

Chart 10: What are the top three factors driving your choice of electronic trading platforms? %

% Response

Knowledge of market micro-structure Transaction cost analysis (TCA)/Analytical skills Good relationship with sell side firms Good understanding of trading algorithms Ability to manage trading risks Knowing where and when to trade Other skills Trading strategies Macro market understanding (fixed income) Patience Adaptability

62.07 63.79 56.91 65.52 82.76 72.41 6.03 2.59 1.72 1.72 1.72

54.6% 52.7% 44.4% 40.7% 34..3% 31..5% 26.8% 18..5%

16.7% 9.2%

Program trades

Requests for quotes

7.4 %

Program trades

Requests for quotes

25 20 15 10 5 0

Less than 10%

20% 30% 40% 50% 60% 70% 80% 90% 100%

Order management Questions then shifted to look at the way the buy side routes orders into the market. The electronification of trading is well established now across the EMEA region. By far, the largest bulk of respondents (36.9%) across EMEA say less than 10% of equities flow is directed to brokers by non-electronic means (please see Chart 8). Just over 17% of respondents route less than 10% of program trades electronically, while 24% route between 90% and 100% of their program trades electronically. This is much lower (8.5%) for requests for quotes. In other words, the buy side still prefer voice trading to electronic execution for primary price discovery,

Total transaction costs

Multi-broker access

Liquidity

Range of assets covered Ease of integration with other OMS/trading engines

Global coverage

Market data quality

17.6%

Chart 8: % of orders routed electronically (best estimate by respondents)

Speed of execution

Trading history Compliance and trading controls

Installation/infrastructure requirements Other (of which)

and “customised trading strategies”, according to one buy side trader in the Nordic region. Other respondents anecdotally report that voice trading is still “preferable” to electronic trading; though the majority of respondents note that electronic trading continues to gain significant ground. There is still some ambiguity in the minds of respondents about the efficacy of electronic trading; with no one respondent appearing to believe that it is a cure for all trading ills. However, a number of respondents point out that receiving multiple quotes might confirm that the price at which a trade is undertaken is the best available from those market makers approached, it does not provide any certainty that it is the best price in the market as a whole. However, most of the buy side respondents felt that diversification and the receipt of multiple quotes was the best policy overall. Speed of execution, liquidity, multi-broker access and the totality of the costs of trading are the leading reasons driving the choice of electronic trading platforms by buy side respondents. The responses highlight the fact that while the number of trading venues has increased, delivering market competition and lower transaction costs, market fragmentation (and the growing presence of high frequency trading) is driving the buy side to worry about speed to market. Electronification is one solution, integrating pricing monitors, trade analytics, and risk management, for example. With trading volumes less than impressive in recent years, the need for efficiency is paramount to the buy side trading desk, the buy side says it is looking for choice (more broker-neutral platforms), and access to liquidity at a cost effective price.

Chart 9: What is your best estimate of equities flow directed to brokers by non-electronic means? %

Less than 10%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

36.9

4.8

9.5

4.8

8.3

9.5

3.6

7.1

3.6

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

The survey then moved apace to look at the way that the buy side looked at the market itself. No surprise in these near post recessionary years, that 79.6% have witnessed an increase in market volatility across the EMEA region, with 65.5% noting extreme price movements over the last year. We also asked about the cost of trading. Generally, costs fall into two broad segments on the buy side trading desk: processing costs, which involve the commissions paid to brokers, taxes and fees that are predictable and easily measured. The second set is market impact costs (the price paid to liquidity providers to accommodate trades) are intrinsically difficult to measure yet probably represent the bulk of the total transaction cost. Even so, some 60.2% of respondents have noted a marked increase in the market impact costs of portfolio rebalances. Respondents were also asked about their views on market integrity resulting from the growth in automated trading and whether they had noted more ownership and oversight of automated order processing (AOP) and direct electronic access (DEA) client processes by market participants or regulators. A number of jurisdictions across the world (Australia, the US, Canada) have in recent years introduced heightened regulatory regimes covering (or trying to minimise) the risks to market integrity resulting from the growth of automated trading, the rise of high frequency trading, risks to price

Chart 11: In the last year have you seen? A rise in return correlation? An increase in market volatility? Increased market impact costs of portfolio rebalances Extreme price movements More ownership & oversight of AOP & DEA clients processes by market participants

Yes

Don’t know

48.6 79.6

17.4 13.3

34.0 7.1

60.2 65.5

14.8 28.3

25.0 6.2

21.2

11.5

67.3

formation and the quality of public markets. Possibly as a result of the highly fragmented nature of the EMEA market, a high preponderance of respondents“didn’t know”or were not aware of any enhanced market oversight. It is a surprise given that high frequency trading (HFT) and dark trading are two crucial aspects of current market design. Highly controversial in some circles, praised in others, these twin issues have dominated the debate about the evolution of the trading markets in recent years. Numerous studies (Karpoff 1987/Gallant et al, 1992) have examined the return correlation among different markets and the relationship between stock returns and trading volume. Clearly, the price-volume relationship remains important (there’s the old adage, for example, “It takes volume to make prices move”). What we wanted to know was if the buy side felt that information about trading volume is useful in improving forecasts of price changes (returns). Nearly half (48%) claimed to have noted an increase in return correlation. Chart 11 outlines the general results.

Confirming the trends Following on from the general macro-outlook, the survey began to delve into the particulars of the way that the buy side viewed the evolution of the trading markets. We asked 15 separate questions that we felt provided a significant and consolidated view of the buy side’s perception of the efficacy of the current market structure and single initiatives within it. The results are outlined in detail in Chart 12. To quickly summarise the main considerations: more than half (54.1%) do not think that the markets have become so complex that electronification of trading is a necessity; the options to utilise high touch services, voice trading and personal relationships remain key to a successful trading strategy. Half believe that their desk has benefited from the fragmentation of order flow, while an overwhelming 74.5% have noted a measurable reduction in the cost of transactions over the last half decade. Less are certain about whether market

Chart 12: Rating the status of the trading market Thesis

% Yes

% No

% Don’t know

Trading is so complex these days it is better handled by computer

42.3

54.1

3.6

Have you benefited from the fragmentation of order flow?

50.0

43.8

6.2

Overall, has the cost of trading really fallen over the last six years?

74.5

18.2

7.3

Does market fragmentation encourage market instability?

46.4

39.1

14.5

Is competition for order flow the right competitive model?

52.3

26.1

21.6

Has maker-taker pricing fallen out of favour

36.4

29.1

34.5

Is paying for liquidity and charging for immediacy a fair business model?

58.7

23.9

17.4

Are you confident in the current market structure?

76.1

18.3

5.6

Do you advocate a minimum dark trade size?

45.8

44.9

9.3

Should orders which are pre trade transparent have time priority over those that are hidden?

48.6

31.2

20.2

Should there be more granular reporting of orders and trades?

72.0

19.6

8.4

Would you like more feedback on the benefits or otherwise of market makers and ELPs?

61.1

25.0

13.9 47.1

Are LEIs a good thing?

42.5

10.4

Have you seen your trading strategy change over the last year because of new regulatory requirements?

55.9

39.6

4.5

Do you think that competitive electronic trading requires cross-asset internalisation?

43.3

22.1

34.6

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

THE BUY SIDE TRADING SURVEY

fragmentation has contributed to market instability in recent years (46.6% think yes, while just under 40% say no). However more buy side traders believe that competition for order flow is the right competitive model. Only 26% demur. There has been a flurry of debate in recent months, particularly in the North American market, about the efficacy of maker-taker pricing. Maker-taker essentially involves providing a transaction rebate to market makers providing liquidity (makers), charging a transaction fee to customers who take liquidity out of the market (takers). The makertaker model contrasts with a customer-priority model, where any account identified as customer goes to the head of the queue for priority of fill, without paying a transaction fee to the exchange. The exchange stays in business by charging market makers fees for transactions and payment for order flow. The payment for order flow is paid to brokerage firms as an inducement to send their orders to a given exchange. Critics of the maker-taker model say the fees provide brokers with incentives to prioritise maker-taker fees over trade execution quality. A recent study by US consulting firm Woodbine Associates highlighted some of the potential conflicts of interest in the maker-taker pricing model. Meanwhile, in a speech in April US Securities and Exchange Commission (SEC) commissioner Luis Aguilar suggested the commission entertain "a pilot program in which maker-taker rebates would be temporarily prohibited for certain securities.” In Europe, our buy side respondents are split on the matter. Some 36.4% say it has fallen out of favour, while 29.1% say not and over a third (34.5%) say they are undecided or don’t know. However, 58.7% say they are fine with paying for access to liquidity and paying for immediacy. Regulators take note: it’s all about how you frame the question. The buy side is also split over both their views on the efficacy of minimum dark trade sizes and whether orders that are pre trade transparent should have time priority over those that are hidden (see De Winne & D’Hondt 2007/Bloomfield, O’Hara & Saar, 2012). While most trading systems throughout the world have moved towards greater transparency, the use of dark trading is now widespread. For a trading venue, the use of hidden quantity poses a sharp trade-off between liquidity and transparency. It encourages market participants to provide liquidity when they might be reluctant to disclose their trading interests. In return, the presence of hidden volume reduces the pre-trade transparency level of the market. It is going back some way, but back in November 2010, the International Organisation of Securities Commissions (IOSCO) published a consultation report on Issues Raised by Dark Liquidity. IOSCO’s headline recommendations from its press release at the time reflected existing best practice. What it did do was outline the following principle: “In those jurisdictions where dark trading is generally permitted, regulators should take steps to support the use of transparent orders rather than dark orders executed on transparent markets or orders submitted into dark pools. Transparent orders should have priority over dark orders at the same price within a trading venue.”

In the intervening years IOSCO has hedged its bets and later went on to emphasise that rather than simply restrict dark orders, regulators should instead look at ways to incentivise market participants within the regulatory framework to use transparent orders,“the key interest is in taking steps to ensure that there are adequate transparent orders in the marketplace.” In Europe, the introduction of the Markets in Financial Instruments Directive (MiFID) has also sought to promote transparency by banning most hidden and discretionary orders in lit books. However, rather than encourage the use of transparent order types this tougher stance eventually spawned the creation of discrete dark books (both MTF and brokeroperated) which are isolated from lit orders books. The effect has been to demote transparent books in the order routing hierarchy for certain types of flow. We wanted therefore to find out what the buy side made of this long standing and still largely unresolved debate. It seems the buy side is as conflicted as the market: 48.6% remain firmly in IOSCO’s camp, while just under a third don’t agree. A goodly 20+% don’t know. Again, question framing became important, because most of the buy side respondents (72%) were dead keen on increased granular reporting of orders and trades by all market participants.

Agnostic on LEIs Continuing on the theme of transparency we asked respondents whether they thought that the introduction of legal entity identifiers (LEIs) was a good thing for the market. The Legal Entity Identifier (LEI) initiative is designed to create a global reference data system that uniquely identifies every legal entity or structure, in any jurisdiction, that is party to a financial transaction. It is an initiative originally kicked off by the G20, and drawn out by institutions such as the Financial Stability Board (FSB) with the intention of providing improved measurement and monitoring of systemic risk. Global, standardised LEIs (essentially 20-digit reference codes) will enable regulators and organisations to more effectively measure and manage counterparty exposure while also resolving long standing issues on entity identification across the globe. To aid global allocation of LEIs, Local Operating Units (LOUs) have been formed and must be sponsored by local regulators to assign and maintain LEIs to firms on a cost recovery basis. Most recently, the use of the LEI has been mandated by the European Securities and Markets Authority (ESMA) for the reporting of derivative transactions to Trade Repositories under European Market Infrastructure Regulation (EMIR). When Lehman Brothers collapsed in 2008, financial regulators and private sector managers were unable to assess quickly the extent of market participants’ exposure to Lehman or to explore quickly and fully how the vast network of market participants were connected to one another. Subsequently, the financial crisis exposed the depth of the problem of identifying financial connections and underscored the long-standing need for a global system to identify

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

and link data, so financial regulators and firms can better understand the true nature of risk exposures across the financial system. When industry adopts the global LEI, data reported both externally to supervisors and internally for risk management purposes should be more reliable. For such an important initiative which has been taken up on a global basis, the survey results show a surprisingly high 47.2% of respondents do not profess to know anything about LEIs; just over 42% think they are a good idea, while 10.4% think they are not. Again, in a linked question (albeit indirectly) our survey pool was asked whether incoming rules and regulation had changed or impacted on the trading strategies they employed over the last year. Just over half (55.9%) say they had noticed changes, while just under 40% say they did not. Again, it is a surprisingly high number. The operation of endogenous liquidity provision (ELP) is a central tenet of the modern stock and derivative markets, where liquidity is supplied by limit orders in computerised auctions. Anand and Venkataram (Sydney University, 2013) found that ELPs are active participants during periods of high volatility and days preceding earnings announcements. However, when market conditions reflect high inventory risk, such as periods with low volume or one sided order flow, ELPs exercise the option to withdraw from the market. Under these conditions, direct market makers (DMMs) earn smaller profits, assume higher inventory risk, and commit more capital,“suggesting that liquidity contracts oblige DMMs to participate in undesirable trades, especially in less active stocks, where they are the only reliable counterparties available to investors”say the authors. With that in mind we asked respondents whether they would like more feedback on the benefits or otherwise of market makers and perhaps not surprisingly, some 61% of respondents would be grateful for more quantitative assessments of the role of ELPs and DMMs. Consistent with the findings in the early part of the survey, overall, the buy side is happy and confident then in playing

Chart 13: Does high frequency trading lead to: Trends

Effective spreads A decrease in posted spreads Market volatility Time to access posted spreads Noise in trade prices Quote informativeness Price discovery Liquidity Volatility in liquidity Trade volume Potential for stabilisation Adverse selection for slower trades Adverse selection for faster trades Predatory trading behaviour

Response (%) Yes 69.1 54.8 75.5 45.1 58.7 34.0 49.5 76.8 64.5 74.7 37.2 48.4 33.3 69.9

F T S E G L O B A L M A R K E T S • A P R I L / M AY 2 0 1 4

No 22.3 29.0 16.0 30.8 26.1 43.6 36.6 17.9 22.6 17.9 45.7 24.7 38.7 16.1

Don’t know 8.6 16.2 8.5 24.1 15.2 22.4 13.9 5.3 12.9 7.4 17.1 26.9 28.0 14.0

in a dynamic market (at least 76.1% say so). With that thought in mind, and taking into consideration comments over the years by various buy side traders around the impact of the high frequency segment on the trading patterns of the buy side, we decided to ask in detail what the buy side thought about the involvement of high frequency traders (HFT) in the market. Chart 13 provides the consolidated view. The results were much more positive than perhaps regulators might imagine, though the perceived negative aspects of HFT were also highlighted by the research. Just a tad under 70% thought that predatory trading behaviour was associated in their minds with high frequency trading. Moreover, over 50% (54.8%) think that there has been a decrease in posted spreads since the advent of HFT; contrast this however (remember, it’s all in the question), with just under 70% suggesting that HFT is responsible for more effective pricing spreads. The role of HFT in recent years in bolstering volume (74.7%) and liquidity (76.8%) is also acknowledged, with over 58% attributing HFT with more noise in trade prices. Moreover, the large majority of respondents also believe that HFT is also responsible for market volatility, specifically volatility in liquidity.

Trading and technology The survey then turned to technology. In the first set of questions we wanted to understand which technology elements were important to respondents. The findings are consolidated in Chart 14: How the buy side ranks technology services. Respondents were asked to rank a number of elements in importance, with 5 being the most important and one being the least important. System reliability clearly, for obvious reasons, scored the highest, though it is Chart 15 which threw up the most interesting findings. Almost 88% of respondents felt that technology vendors needed to have a better understanding of their clients’ requirements and over 78% noted that the financial markets knowledge of technology vendors needed to be upgraded. Following on from early findings about the increasingly multi-asset character of the modern day trading desk, over 90% of respondents wanted technology vendors to be cognisant of the need for any solution to provide support across multiple products and/assets. Also, perhaps as a pointer to the growing independence of the buy side trading desk, traders/respondents wanted technology vendors to simplify the ability to construct customisable trading algorithms. Technology vendors should take note, the buy side is more proactive in making decisions about investment. When asked how often the buy side trading desk is upgraded, 64.49% responded that upgrades take place as and when required, while 23.36% reported upgrading their technology at least once a year; only 12.15% say they are more dilatory in upgrading their trading technology and do it less than once a year. We also looked at the level of automation on the buy side trading desk (Chart 16) and latency. Clearly, the buy side

THE BUY SIDE TRADING SURVEY

Chart 14: How the buy side ranks technology services Ranking (1-5, with five the most important and 1 the least) (% of respondents in each segment) Technology element System software reliability Technology vendor support Technology vendor responsiveness to service refinements The overall quality of vendor technology services to the buy side

0.0 1.0 0.0 1.0

2.9 1.9 4.8 2.0

12.4 24.0 21.9 11.9

32.4 50.0 52.4 61.4

52.3 23.1 20.9 23.7

Yes

Don't know

87.2 78.2 73.4 83.0 90.8 79.8

8.3 17.3 22.9 6.6 3.7 11.9

4.5 4.5 3.7 10.4 5.5 8.3

Chart 15: Do you think that trading vendors Need to have a better understanding of client needs? Need to improve their knowledge of the financial markets? Should try to improve system speed? Simplify the ability to construct custom algorithms? Should ensure their systems support multiple products? Should build more dynamic systems?

trading desk is becoming increasingly automated, with more than 77% of respondents reporting that more than half of the trades they conduct are electronically generated. The buy side respondents were also generally comfortable with the speed with which they bring trades to the market and close them. Over 38% said they rated their speed of trading as the same as their competitors, only 8.7% thought it was worse and 30% thought it was way better. However, 22% said they didn’t know either way. We also looked at whether the buy side would increase their use of trading algorithms over the coming year and asked them to outline the main reasons why they used algorithms. Charts 14 and 15 tabulate the results. Some 48.9% of respondents expect to increase their use of trading algorithms over the coming year, while only 3% say they expect to reduce their use. The balance of respondents expect their

Chart 16: How automated is the buy side trading desk? (Response (%) 20

10%

20% 30%

40%

50%

60%

70%

80%

90% 100%

use to remain more or less the same. So why are algorithms so important to the buy side and what type of algorithms are most commonly used? Speed of trading, consistency in trade execution and cost are the most predominant reasons for the popularity of algorithmic trading. Traders today are very familiar with the advantages of leveraging algorithms for buy-side trades. The use of trading algorithms alone, however, does not necessarily guarantee better order execution performance; however selecting the most advantageous algorithm for a given order can significantly improve performance, a fact reinforced by a number of respondents. Support for this view was recently published in a paper by Bloomberg Tradebook’s Liu & Phadnis in the Journal of Trading, which outlined the findings of a study of some 270,000 buy side trading orders that utilised 150,000 trading algorithms. They organised their study under the general umbrella of four widely recognised types of algorithms: scheduled, participation rate, dark and implementation shortfall. Bloomberg Tradebook’s US study found that although three out of every four small orders, with low participation level are executed using scheduled algorithms, Implementation shortfall algorithms provide better average performance and smaller pricing risk, they noted. Moreover, the Bloomberg Tradebook study found that when placing medium orders, traders appear to prefer scheduled or participation rate algorithms with low or mid participation rate. Analysis of performance shows that scheduled and participation rate algorithms are the worst performing type for medium orders, and dark algorithms show the best performance regardless of participation rate. For large orders traders favour scheduled algorithms. Because of the opportunistic nature and capability of getting blocks in dark pools, implementation shortfall algorithms and dark algorithms provide consistently better results than scheduled algorithms. Our modest remit by comparison was to isolate among our community of respondents which trading algorithms were most commonly utilised in the

A P R I L / M AY 2 0 1 4 • F T S E G L O B A L M A R K E T S

Regulation and its impact

Chart 17: Why does the buy side use trading algorithms 47.8%

39.9%

36.2%

34.1%

23.4%

5.3%

Execution consistency

All of the above

Trader productivity

32.9%

Cost

32.9%

A reduction in market impact

29.8%

28.7%

Speed

Ease of use

Price improvement

Anonymity

Other reasons

EMEA region. Participation algorithms predominate, with over 71% of respondents say they utilise them regularly, closely followed by VWAP (64%) and implementation shortfall (55.7%). The most important considerations in opting for various algorithms were the considerations of reducing market impact (by over 75% of respondents) and gaining greater traction over the overall trading process (74.2%). Refining the findings further we asked respondents: what makes a good trading algorithm for you, customisation and/or price improvement? Some 74.4% marked price improvement as an important measure, while 64.8% noted the importance of customisation. The next set of questions hung around ease of access. Some 40% of respondents noted that it was easy to incorporate new trading algorithms into their overall trading strategy, while only 13% said it was too difficult; though another 30% said it was not easy at all. The balance (15.4%) found the process very easy indeed.

Chart 18: What type of trading algorithm is most commonly used by the buy side? Type Yes Volume weighted average price (VWAP) Implementation shortfall - single stock Participation Dark liquidity seeking Implementation shortfall Internal crossing Time weighted average price (TWAP) Other (stated) Customised algorithms Pair orders

64.0 55.7 71.6 48.3 37.5 36.0 39.8 3.0 3.0 3.0

F T S E G L O B A L M A R K E T S â&#x20AC;˘ A P R I L / M AY 2 0 1 4

Attitudes to the sell side We were very clear with respondents. We were not interested in developing a sell side beauty parade and instead wanted to focus on the relationship that was evolving between the buy side and the sell side and any changes or shifts in that relationship. Clearly the buy side is extremely well versed in the makeup of the sell side broker dealer universe and prefer larger rather than smaller broker lists. Only 11.54% say they trade entirely themselves without recourse to a sell side brokerdealer; while almost 29% say they work with between one and five brokers on a regular basis. Around a third (33.65%) work

Chart 19: What makes a good trading algorithm? Successful elements

Response (%) No Don't know 24.7 30.7 17.0 37.1 47.7 48.3 48.9

We polled our respondents in detail to find out where their concerns lay in regards to incoming regulation changing the nature and breadth of the market. We asked respondents again to rank topics in order of importance, with a score of five being the most important and one being the least. Chart 20 outlines the consolidated responses and it is clear that there is a growing cluster of concern (any score in excess of 40% and a rating of 3, which was deemed important) around the Financial Transaction Tax (FTT); high frequency trading (HFT), and specific regulation, most notably, AIFMD, T2S and interoperability as well as the move to T+2 settlement. In terms of clusters around the high score of 5 (most important) the issue category switches and around a third of respondents felt that a consolidated tape, regulatory compliance, counterparty risk and market conflicts of interest kept them up at night. If the scores of the last three columns are combined (ranking 3-5, important, very important and most important), then the tempo shifts slightly once more. Compliance and counterparty risk garner most focus (with more than 94% of respondents in both cases). Equally the issue of free market access is â&#x20AC;&#x2122;important to most importantâ&#x20AC;&#x2122; to 93% of respondents. Only regulation on shorting and T+2 settlement scored below an 80+% level of recognition among respondents, scoring 78.2% and 79.8% respectively. Both dark pools and market conflicts of interest were important to more than 88% of respondents.

11.3 13.6 11.4 14.6 14.8 15.7 11.3

Yes Assist trading in size Eliminate the need to split orders to find liquidity To help calibrate minimum & maximum limits To gain greater control over trading Help me reduce market impact Cost efficient trading Achieve market anonymity Execution consistency Speed

Response (%) No Don't know

71.6

15.9

12.5

65.2

23.6

11.2

60.7 74.2 75.3 63.6 62.9 71.3 76.7

30.3 20.2 15.7 27.3 28.1 14.9 17.8

9.0 5.6 9.0 9.1 9.0 13.8 5.5

THE BUY SIDE TRADING SURVEY

Chart 20: Regulation: what are the buy sides' top concerns? Issue

Ranking (1-5, with five the most important and 1 the least) (% of respondents in each segment) 1 2 3 4 5

A consolidated tape for market data Compliance Counterparty risk Conflicts of interest Shorting regulation The financial transaction tax Market access Dark pools High frequency trading MiFID II EMIR AIFMD SLD CSD Regulation T+2 settlement T2S Interoperability

6.7 1.9 3.0 5.7 8.9 3.1 1.9 5.1 9.1 4.5 3.5 6.0 8.8 6.5 7.4 6.1 6.4

6.7 3.8 3.0 5.7 12.9 9.2 4.9 8.1 10.1 1.1 11.6 9.6 16.3 10.8 12.8 12.2 11.5

25.0 20.2 34.7 24.8 37.6 44.9 25.2 36.4 40.4 51.1 45.3 57.8 53.8 54.8 44.7 59.8 62.8

23.1 38.5 26.7 27.6 30.7 17.3 35.0 28.3 27.3 35.2 32.6 22.9 20.0 19.4 22.3 17.1 12.8

38.5 35.6 32.6 36.2 9.9 25.5 33.0 22.1 13.1 8.1 7.0 3.7 1.1 8.5 12.8 4.8 6.5

with between six to ten brokers and then there is a big fall off as 11.54% say their work with as many as 11-15 brokers and 14% say they regularly work with more than 15 brokers, though these responses are mainly confined to global investment houses with a highly diversified trading desk. In terms of outlook, 27.7% say the number of brokers they expect to work with over the coming year is expected to increase; the majority (a little under 65%) say there will be no change and less than 8% say they expect to reduce the number of broker-dealers they work with. Linking this section of our survey questions to our findings about the use of trading algorithms, we asked the respondent community about their top three considerations in differentiating between providers of trading algorithms. The consolidated findings are in Chart 21.

In conclusion This inaugural buy side trading survey shows that the workload is shifting from the sell side to the buy side as technology (FIX connectivity, order routers, sophisticated and customisable trading algorithms) advances. Regulation also seems to be working in favour of the buy side, promoting ever greater market transparency and providing curbs on more challenging (albeit useful) elements in the markets, such as HFT. Execution consulting experts have been saying for months that as the trading industry matures, the link between the buy side trader and the portfolio manager is shortening all the while, with trading now having a measurable impact on portfolio return. The sell side has been working hard to provide the buy side with enhanced reporting, focusing on trade cost analysis that provides a benchmark for the buyside trading function. Survey respondents acknowledge the change, but seem to require broader metrics to better measure the activity and (perhaps even relevance) of the buy-side desk.

Chart 21: What are the main considerations in differentiating between providers of trading algorithms? Successful elements Yes Customisation Reliability Product offering Trading analytics Fees Relationship Execution consulting services

59.3 76.1 48.8 51.8 41.2 42.4 33.3

Response (%) No Don't know 33.7 19.3 46.5 43.4 52.9 52.9 63.0

7.0 4.6 4.7 4.8 5.9 4.7 3.7

Additionally, up to now the value placed on the buy side trading desk has varied significantly between investment firms. Some asset management firms are very focused on trading, viewing it as integral to the overall investment process. Others think research and quantitative data as the drivers of alpha and execution is simply a functional process in the investment decision. Clearly, the survey universe see their role in a very dynamic context: increasingly bridging the gap between these two very different positions. Hence the growing importance of quantitative, big data and risk management skills to the buy side. It will be interesting to see how this develops in practice. There are some things however that the buy side is not having to struggle for. The survey shows that the buy side exercises much greater choice these days, particularly around when and when they want to execute a trade. At the same time however, there is more strain on the buy side trader as investment firms look for more internal cost efficiencies; and that, ultimately brings technology into play. The survey shows that the buy side is cognisant that the trading desk of the future must be multi-disciplinary and multi-functional. There is a recognition that the skills required of the fixed income trader might be quite different from a small cap equity trader. There is a clear demand for technology vendors to provide platform solutions that however can contend with both skill sets and there is perhaps a recognition that these interests are not yet fully aligned in todayâ&#x20AC;&#x2122;s technology offerings. The survey shows that the buy side clearly recognises the tensions in the trend towards multi-asset portfolio investments and the operation of a trading desk: how that dynamic might be resolved will no doubt form the basis of much trade magazine comment over coming years. For now, this survey asks technology vendors to be more cognisant of the growing diversity on the buy side trading desk and the changing support they require. This was clearly evinced at the recent Trade Tech conference in Paris, there was a clear delineation between technology vendors anxious to leverage the maturing of the trade execution process, positing that the future would (at one extreme) require no intervention at all by a dealer. Along the spectrum other vendors continue to position the buy side trader at the heart of the trade decision. Whose view will eventually win out? I

A P R I L / M AY 2 0 1 4 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

THOUGHT LEADERSHIP ROUNDTABLE

SECTION NAME

TARGET-2 SECURITIES: THE TRANSFORMATION OF EUROPE’S POST TRADE LANDSCAPE Photograph © Dan Collier/ Dreamstime, supplied May 2014.

T2S

Market experts at the 2014 thought leadership roundtable on TARGET 2 SECURITIES (T2S) JO VAN DE VELDE, head of product management, Euroclear GRAHAM RAY, director, global product management, direct securities services, Deutsche Bank ALAIN POCHET, head of clearing custody & corporate trust services, BNP Paribas Securities Services. TOM CASTELEYN, managing director, BNY Mellon RICHARD SCAVETTA, T2S programme director, Citi ERIC DE NEXON, head of strategy for market infrastructures, Société Générale ALEX DOCKX, executive director, product strategy, regulations and market infrastructures, Corporate & Investment Banking, JP Morgan AXEL PIERRON, head of capital markets, Celent FRANCESCA CARNEVALE, editor, FTSE Global Markets