FTSE Global Markets by FTSE Global Markets

GLOBAL INFLOWS RESHAPE PROPERTY ASSET OUTLOOK

ISSUE 77 • JUNE-AUGUST 2014

CLOs: on the comeback? The pitfalls of financial models Has everyone forgotten about fiduciary duty? Whither bitcoin

CYBER-WARS The investment upside of new cyber security

WWW.FTSEGLOBALMARKETS.COM

CHANGES ARE GOOD

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OUTLOOK

EDITORIAL Francesca Carnevale, Editor T: +44 207680 5152; E: francesca@berlinguer.com Andrew Neil, New media manager T: +44 207680 5157; E: Andrew.neil@berlinguer.com David Simons, US Editor, E: DavidtSimons@gmail.com CORRESPONDENTS Lynn Strongin Dodds (Editor at Large); Ruth Hughes Liley (Trading Editor); Vanja Dragomanovich (Commodities); Neil O’Hara (US Securities Services); Mark Faithfull (Real Estate). PRODUCTION Andrew Lawson, Head of Production T: +44 207 680 5161; E: Andrew.Lawson@berlinguer.com Lee Dove, Production Manager T: 01206 795546; E: studio@alphaprint.co.uk OPERATIONS Christopher Maityard, Publishing Director T: +44 207 680 5162; E: Chris.maityard@berlinguer.com Tessa Lewis, Finance Manager T: + 44 207 680 5159; E: Tessa.lewis@berlinguer.com CLIENT SOLUTIONS Patrick Walker, Global Head Of Sales T: +44 207 680 5158; E: Patrick.walker@berlinguer.com Nicole Taylor, Special Projects T: 44 207 680 2151; E: Nicole.taylor@berlinguer.com Marshall Leddy, North America Sales Director T: +1 612 234 7436, E: marshall@leddyassociates.com OVERSEAS REPRESENTATION Can Sonmez (Istanbul, Turkey) FTSE EDITORIAL BOARD Mark Makepeace (CEO); Donald Keith; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton PUBLISHED BY Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION Please enrol on www.ftseglobalmarkets.com Single subscription: £87.00 which includes online access, print subscription and weekly e-alert A premium content site will be available from October 2014 FTSE Global Markets is published 8 times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright Berlinguer Ltd 2014. All rights reserved). FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

CCORDING TO A new survey of 284 institutional investors by Credit Suisse, 97% of respondents indicated that they plan to be highly active in making allocations during the second half of this year, compared with the 85% who said they had already made allocations in the first half of the year.“The high percentage of respondents with strategic intention to actively allocate to hedge funds in the second half of this year could reflect a prolonged due diligence process, in response to high levels of market volatility back in March/April. Regardless, it does seem clear that institutional investors remain committed to hedge funds, as many see current equity and bond market valuations as high and are looking to further diversify their portfolios,” says Robert Leonard, managing director and global head of Capital Services at the bank. We quote from this survey because of the sheer size of it, compared to the 50 or 60 or so investors that seem to populate an increasing number of bank-led surveys these days as it does seem to represent a goodly cross-section of thinking in the market. We also quote from this survey because it rings one of the key themes running through the edition about investor intentions and the hurdles and opportunities they face in determining effective asset allocation strategies. Actually, there is something for everyone in this edition, which (one assumes) is just as it should be. You are especially pointed to a number of sections; the obvious one is asset allocation and the topic this time is bitcoin. David Simons looks at some of the theoretical and regulatory challenges around the segment, and we look at some of the emerging infrastructure that is supporting the asset class. Regulators appear cautious about adopting even rudimentary rules that might govern its rise as a fungible asset; quite why that is the case when they are consulting over and ruling on the very alphabet of financial transactions right now looks to be beyond reason. Go figure. While a study in the emergence of a new asset class for the 21st century, bitcoin throws up as many questions as it provides answers. Some elements of the market look to be out of an Austin Powers parody (involving underground vaults in remote mountainous regions; complex mutating equations; and a potential means to transfer valuable assets across borders—completely undetected, of course. Others are (thankfully) much more prosaic and everyday. We set out the case for both. Another highlight is Dan Barnes’ cris de couer over the seemingly parlous state of fiduciary duty in the very institutions which are meant to embody financial probity and security. The recent financial crisis should have reminded us that sometimes large monoliths have feet of clay. Regulators, particularly regulators in the US (where the concept of fiduciary duty is well defined in legal terms) seem to be in two minds about it. Certainly the US Labor Department has not covered itself in glory over its see-sawing over ruling over fiduciary duty in the retirement plan segment. The SEC meanwhile is still considering whether to revise its advisor conduct rules. The lack of clarity means that some firms will ride roughshod over the slightest cracks in the system. We highlight the low lights and efforts by the buy side to compensate for the lack of transparency in some parts of the financial system. Having said that asset managers and beneficial owners are currently under the regulatory spotlight. Under the aegis of Dodd Frank legislation, the Financial Stability Oversight Council continues to hunt for systemically important financial institutions (SIFIs) and its sights have now landed on the $86trn asset management industry. The implications of such an enquiry and perhaps the subsequent imposition of bank-style capital buffers are quite immense. Resulting increases in fees and lower long term returns are only a part of it. It would change the infrastructure of the asset management segment for a long, long, long time.

Francesca Carnevale, Editor

COVER PHOTO: Cyber soldier. Photograph © Jesse Lee Lang/Dreamstime.com, supplied July 2014.

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CONTENTS COVER STORY

COUNTING THE COST OF CYBER CRIME

................................................................Page 6 According to SIFMA president and CEO Kenneth E Bentsen, private industry and government need to work together to thwart cybersecurity threats. Up to now the high profile assaults by hackers has been directed at corporations, banks and governments. When might they start looking at beneficial owners and asset management firms? Are their systems robust enough to fend off attack?

DEPARTMENTS

MARKET LEADER SPOTLIGHT

ECB POLICY: HOW EFFECTIVE IS IT?

.............................................................Page 16 What is the impact on bond investors and the euro-economy?

COUNTING THE COST OF MERGERS & OTHER STORIES ...................Page 20 Topical stories from around the global capital markets.

DUBAI – PRETENDER TO THE ISLAMIC FINANCE CROWN? ...........Page 31 Ayman Khaleq & Victoria Mesquita of Morgan, Lewis & Bockius ask the question.

SRI LANKA EXCHANGE IMPLEMENTS NEW BUSINESS PLAN? .....Page 33 Andrew Neil looks at the extent of market reform.

UNDERSTANDING THE PITFALLS OF FINANCIAL MODELLING .....Page 35 Julian Edwards asks whether traditional financial models still apply.

MAKING PROFITS BY TRADING VOLATILITY ...........................................Page 36

IN THE MARKETS

Ben Few Brown provides a ready primer to the options available.

LOOKING FOR MARKET NOISE

.........................................................................Page 37 Mark Tinker, head of AXA Framlington Asia on the benefits of volatility.

EFFECTIVE MULTI-PARTY/MULTI-CONTRACT ARBITRATION .........Page 38 Nicholas Greenwood & Richard Ellison explain the pitfalls.

CLOS: ON THE COMEBACK TRAIL? .................................................................Page 39 Why CLO issuance is on a tear?

INNOVATION BOOSTS HEDGE FUND INFLOWS .....................................Page 40 Neil A O’Hara looks at the renewed vigour of US hedge fund strategies.

RENTALS & REFURBS ..................................................................................................Page 42

REAL ESTATE

The new UK property highlights.

GLOBAL INFLOWS RESHAPE REAL ESTATE OUTLOOK ......................Page 47 Mark Faithfull reports on the opportunities for institutional buyers.

WHO CARES ABOUT FIDUCIARY DUTY? ............................................................Page 50

REGULATION

Dan Barnes looks at the need to revise definitions and responsibilities.

WHAT, ME SIFI? ............................................................................................................................Page 55 David Simons reports on the coming oversight of asset management.

WHITHER BITCOIN......................................................................................................................Page 57

ASSET ALLOCATION

A cutting edge asset? Or a danger to the financial markets?

A STEP CHANGE IN BITCOIN MARKET EVOLUTION ................................Page 59 The emergence of bitcoin exchanges is creating a new market infrastructure.

JUNE-AUGUST 2014 • FTSE GLOBAL MARKETS

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CONTENTS DEPARTMENTS

THE NEW KNIGHT COMEBACK ....................................................................................Page 63 David Simons reports on the remaking of a broking brand.

TRADING REPORT

WINNERS & LOSERS IN THE NEW POST TRADE WORLD ....................Page 65 Ruth Hughes Liley on the changing post trade infrastructure in equity trading.

TIME FOR CHANGE TO THE POST TRADE WORKFLOW? ..................Page 69 David Pearson, strategic business architect at Fidessa talks the options.

DIVERSE STRUCTURES IN COMMODITY ETFs ................................................Page 70

ETPS/ETFS

Vanja Dragomanovich reports on an evolving market.

ETPs/ETFs: OUTFLOWS OUTWEIGH INFLOWS ................................................Page 73 The impact of bearish repositioning by S&L investors.

ASSESSING THE IMPACT OF AUGUST’S ELECTIONS ................................Page 74 Who will win the presidential election and what will be the aftermath?

COUNTRY REPORT

PROFILE: BORSA ISTANBUL STRIVES FOR GLORY

....................................Page 77

Is Borsa Istanbul the jewel in the country’s IFC offering?

FACE TO FACE WITH ODEABANK

............................................................................Page 80

High growth means high risk: how Odeabank manages to balance the two.

RISK

WHY RISK PARITY IS REALLY RISK WEIGHTING LIFTING THE ECONOMIC RATIONALE

...................................Page 84

..................................................................Page 85

Why Malta is punching above its weight?

A BUCKETFUL OF BUSINESS DEVELOPMENT

MALTA REPORT

................................................Page 88

FinanceMalta as catalyst for financial services market growth.

THE IMPORTANCE OF BEING EARNEST

..............................................................Page 90

Malta Stock Exchange: strategies for growth.

REGULATION: MANAGING THE EUROPEAN DIMENSION ................Page 94 Foreign investment inflows and the importance of regulatory rigor.

CLIMATE CHANGE

INVESTING IN THE GOOD EARTH ...................................................................Page 104

INVESTMENT

WHERE THE ACTION IS: WHITHER ACTIVE STRATEGIES? ................Page 109

Lynn Strongin Dodds looks at the investment opportunities.

David Simons asks whether investors really get what they pay for.

A CULTURAL SHIFT TO COMPLIANCE .........................................................Page 112

OPINION

Neil Herbert, director of HRComply looks at the role of the FCA.

T+2 SETTLEMENT: HARMONISING TRADING CYCLES .......................Page 113 Rakesh Jangili of Capital Markets Solution Group, asks if it is really possible?

MARKET DATA 4

Market Reports by FTSE Research ..............................................................................................Page 114

JUNE-AUGUST 2014 • FTSE GLOBAL MARKETS

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COVER STORY

FINANCIAL CYBER WARFARE Attorney General Eric Holder, accompanied by, from left, US Attorney for Western District of Pennsylvania David Hickton, Assistant Attorney General for National Security John Carlin, and FBI Executive Associate Director Robert Anderson, speaks at a news conference at the Justice Department in Washington, Monday, May 19th this spring. Holder was announcing that a US grand jury has charged five Chinese hackers with economic espionage and trade secret theft, the first-of-its-kind criminal charges against Chinese military officials in an international cyber-espionage case. Photograph by Charles Dharapak for Associated Press. Photograph supplied by pressassociationimages.com, June 2014.

COUNTING THE COST OF CYBER CRIME SIFMA President and CEO Kenneth E Bentsen Jr, said on Bloomberg Television’s Market Makers in late June that private industry and government need to work together to thwart cybersecurity threats. Bentsen said the matter was a “top priority for the securities industry and the rest of the financial-services industry”. Is he right? Although the securities industry has yet to suffer significant losses linked to cyber-crime activity, the interconnectedness of the exchanges, clearing agencies, broker-dealers and other key players is such that even a minute but well-timed disruption could lead to mammoth unraveling, severely impacting investors and consumers alike. Who’s watching out for whom in tomorrow’s financial markets? Dave Simons reports. HE US OFFICE of the Comptroller of the Currency (OCC) has again singled out cyber threats as a leading operational risk for US financial institutions. The OCC notes in its justreleased Semi-annual Risk Perspective for

2014 that banking institutions continue to be among the preferred targets for cyberattacks, and that recent attacks against the retail industry have only reinforced why banking institutions need to be diligent about cybersecurity.

Last year marked the first time the OCC named cyber-attacks as being among the financial industry’s top operational risks. In the July 2013 report, the banking regulator noted that ever-increasing cyber threats waged to commit fraud were among the industry’s top concerns. This year, the OCC notes that fraud linked to cyber-attacks is not necessarily banking institutions’ greatest concern. Deeper intrusions into banking networks, as well as other components of the financial and payments infrastructure, demand that risk mitigation become a top priority, the OCC's latest report notes. “There is concern that cyber-criminals will transition from disruptive attacks to attacks that are intended to cause destruction and corruption,”the OCC states. “These threats require heightened awareness and appropriate resources to identify and mitigate the evolving risks.” In particular, “Bankers should also ensure that risk management of thirdparty relationships is commensurate with the breadth, complexity and criticality of these arrangements,” the report states. Regulators look to be stepping up their efforts to encourage financial and investment institutions to step up their awareness and preparedness again cyber incursions in their business. In May this year, as part of its “Cybersecurity Initiative,” the SEC’s Office of Compliance Inspections and Examinations (OCIE) sent extensive cybersecurity document requests to more than 50 registered broker-dealers and registered investment advisers. The SEC provided firms with a sevenpage document asking firms to provide details about their technology infrastructure and operational policies and procedures as they relate to cybersecurity. The OCIE stated that its examinations are intended to provide to others in the industry “questions and tools they can use to assess their firms’ level of preparedness,” thereby sending the message to all registered firms that they should be taking steps now to assess and upgrade their data security infrastructure, policies, and procedures. According to a recent survey by PwC,

JUNE-AUGUST 2014 • FTSE GLOBAL MARKETS

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COVER STORY

FINANCIAL CYBER WARFARE

Cybercrime is the second most common type of fraud reported by financial firms. As many as 39% of the 1330 companies surveyed by the firm across 79 countries, said they had experienced cyber-attacks on their business; sometimes for financial gain, sometimes simply to disrupt the flow of business. Recent breaches at US firm Target are an indication how bad things can get. With reports of up to 110m customer accounts having been compromised, some estimates suggest the total cost to the company and its shareholders may top $1bn. A recent Detica report, in partnership with the Office of Cyber Security and Information Assurance in the UK’s Cabinet Office found that the cost of cyber-crime to the UK economy alone could be as high as £27bn a year; mainly the theft of intellectual property from businesses (which the survey values as costing as much as £9.2bn a year).“In all probability, and in line with our worst-case scenarios [sic] the real impact of cyber-crime is likely to be much greater,” says the report.

Simulations Clearly then, the risk of online attacks is increasing as customers move from traditional retail/financial and banking services to technology, data, communications and social media services. Over the years the securities industry has engaged in various simulations of the effects of a full-on criminal cyber-attack in an effort to prepare market participants for the real thing. In 2009 a Pentagon-sponsored cyber“war games,”carried out in the wake of the global market meltdown, focused on the rapidly shifting balance of power wielded by China and other global adversaries. Last summer the Securities Industry and Financial Markets Association (SIFMA) staged its own cyber stress test dubbed Quantum Dawn 2, intended to give financial-services firms and government agencies a virtual view of the havoc that could be wrought by both inside and external tech-savvy terrorists. As the results made clear, a cyber doomsday scenario isn’t out of the question—particularly if current vulnerabilities continue to be left unchecked.

Indeed, the numerous automationbased mishaps that have roiled the markets of late—2011’s flash crash, rogue algorithms, to name a few—prove that it doesn’t take much to take down the major indices. While not necessarily acts of terrorism per se, efforts by hacktivist groups to disrupt the private sector and capital markets on a major scale could nonetheless have equally disastrous outcomes. To wit, last year’s brief but alarming Associated Press Twitter hijack in which a hackster posted an erroneous headline claiming that President Obama had been injured in a White House explosion. The successful hack resulted in the Dow diving 100 points in less than two minutes. “A cyber-attack on an exchange or other critical market participant can have broad consequences that impact a large number of public companies and their investors,” concurs SEC commissioner Luis Aguilar, speaking at a March cybersecurity roundtable in Washington, DC. Given the extent to which the capital markets have become increasingly dependent upon sophisticated technological systems, noted Aguilar,“there is a substantial risk that a cyber-attack could cause significant and wide-ranging market disruptions and investor harm.” Cyber-crime is now systemic, affecting, according to some estimates, as many as 556m people globally every year, and is estimated to cost $100bn annually, according to the security firm Norton. Russia is by far the biggest source of cyberattacks, contributing to 39.4% of all cybercrime, while the US accounts for 19.7%. Nearly 40% of attacks relate to crime and stealing or defrauding victims of money or personal information, while 50% are protest hacks, 7% cyber espionage between corporations, and 3% cyber warfare between nation states malware and Trojans account for 50% of all attacks. China too is building as a cyber-threat epicenter, and regulators continue to focus on the growing legion of hackers residing within China itself or surreptitiously using the country's servers to launch strategically timed distributed-

denial-of-service (DDoS) attacks against Western securities and private-sector institutions. Other culprits include politically motivated groups such as Izz adDin al-Qassam Cyber Fighters (responsible for a string of DDoS attacks against numerous domestic financial institutions) and the Syrian Electronic Army (charged with last year’s AP Twitter ruse). However, perpetrators also run the gamut from cut-rate hired hackers to imprudent computer geeks, all intent on exploiting existing weaknesses in security firewalls.

Non-discriminating damage The damage that can be inflicted by any of these rogue elements is “non-discriminating”in nature, notes SEC chair Mary Jo White, threatening critical infrastructures that not only include the financial markets, banks and intellectual property holders, but also consumers’ private data as well.“What emerges from this arresting view of the cybersecurity landscape is that the public and private sectors must be riveted, in lockstep, in addressing these threats,” remarks White. The seriousness of the attacks is such that FBI resources earmarked for cyber-crime fighting activity is expected to exceed those dedicated to monitoring terrorist activity. The sheer number of cyber perpetrators at work has made it all the more challenging for institutions to devise effective defense strategies. According to Rohini Tendulkar, author of the 2013 International Organisation of Securities Commissions (IOSCO) report Cyber-crime, Securities Markets and Systemic Risk, online hacking has rapidly evolved in scope, motive, and type of actors involved, not to mention complexity, sophistication and frequency of the attacks.“This means that the full nature and extent of the threat is difficult to comprehensively and authoritatively pinpoint at any one point in time,” observes Tendulkar. In the rush to build a more efficient and competitive electronic marketplace, some believe that the global securities industry has become a more conspicuous target for cyber criminals.“Speed and convenience historically have had an inverse relationship with network security, and

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Archive photo of House Cybersecurity, Infrastructure Protection, and Security Technologies subcommittee Chairman Patrick Meehan, R-Pa., centre, talks to the witness panel on Capitol Hill in Washington, on Wednesday March 20th last year, before the subcommittee's hearing on cyber threats from China, Russia and Iran. From left are, Frank J Cilluffo Director, Homeland Security Policy Institute; Richard Bejtlich, Chief Security Officer and Security Services Architect at Mandiant; Meehan; Ilan Berman, vice president of the American Foreign Policy Council, and Martin Libicki, Senior Management Scientist at the RAND Corporation. Photograph by Jacquelyn Martin for Associated Press. Photograph supplied by pressassociationimages.com, June 2014.

that remains the case today,”says Michael DuBose, president and founder of CyDefense LLC, a Washington, DC-based cyber-security consulting group. Even so, the networks that feed the electronic marketplace aren’t the only— nor perhaps even best—targets for cyber activists. As the ongoing NSA leaks have infamously revealed, insider information, as well as the availability of proprietary research, non-public corporate merger intelligence and other forms of closely held data, all hold significant value to would-be manipulators. As DuBose observes, to date the two largest reported federal data breaches were both committed by insiders. Army intelligence analyst (Chelsea Manning, who was sentenced to prison last year for leaking classified Army reports) was one notable case. The other is NSA contractor Edward Snowden, who continues to seek asylum following last summer’s global surveillance leak, one of the largest of its kind in history.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

“Accordingly, every link in the data chain is a target,” concurs DuBose, “including law firms, brokerage houses, hedge funds and corporate databases. The security of the marketplace is only as strong as its weakest link—and there are still far too many weak links.” DuBose does not believe the Snowden affair has altered the perception of government network security, since, says DuBose, “Those perceptions have always been quite low.”If anything, the event underscored the reality that both government and corporate heads have long underestimated the power of the inside attacker.“Insider threat is at least as significant, if not more so, than the threat from outside hackers,” maintains DuBose. One thing is certain. The SnowdenWikiLeaks disclosures have put a whole new spin on the cybersecurity conversation. Even in the face of persistent Chinese hack attacks—which included numerous episodes of blatant domestic

intellectual-property theft—the United States had (seemingly) opted to take the high road. Last year, members of the US Senate turned aside efforts by the House of Representatives to pass a Cyber Intelligence Sharing and Protection Act (CISPA), which, argued critics, would have led to more invasive surveillance procedures. Subsequent revelations that the NSA had itself engaged in surreptitious cyber activity, not only against China but also several European nations, not to mention its own citizenry, helped rob the US of its diplomatic advantage and moral kudos. It also began to re-frame the global cyber warfare debate. Some fear that the leaked data could have even more serious consequences going forward. In an April address at the University of Connecticut, former Secretary of State Hillary Clinton charged that Snowden’s actions had in effect made the United States more vulnerable to cyber-terrorist infiltration. "I think turning over a lot of that material—intentionally or unintentionally, because of the way it can be drained—gave all kinds of information, not only to big countries, but to networks and terrorist groups and the like," remarked Clinton.

Cyber savers Meantime, the rise in cyber hacking continues to fuel demand for security services products and solutions specifically geared toward managing and protecting against DDoS interruptions and related assaults. The severity of the current threat is such that robust protection measures have become compulsory. By some estimates, recent DDoS-based attacks have been able to consume upwards of 50gbps of a targeted firm’s bandwidth, making run-of-the-mill mechanisms virtually useless. Ziv Gadot, senior security researcher for network security solutions provider Radware, argues that operating without an adequate line of defense is akin to “bringing a knife to a gunfight.” Moreover, botnet-based DDoS attacks represent just one of several weapons in the hackers’ arsenal, says Gadot. Advanced persistent threats (APTs) are

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COVER STORY

FINANCIAL CYBER WARFARE

marked by an increase in attack duration, often capable of lasting upwards of a month, and have been highly effective since many organisations have yet to develop the means to ward off this type of campaign. The length of these campaigns, however, makes it possible for properly equipped security experts to collect intelligence about the attacker in real time, says Gadot, including their identity and tools being utilised, thereby allowing organisations to deploy counter measures in order to halt the attack.

While the securities business has yet to suffer significant losses linked to cybercrime activity, the interconnectedness of the exchanges, clearing agencies, brokerdealers and other key participants is such that even a minute hacking interruption could create mammoth problems, ultimately affecting investors and consumers alike. A survey by the World Federation of Exchanges (WFE) conducted last year found that nearly nine in ten exchange operators considered cyber-crime to be a

potentially significant systemic risk threat. Thus, says SEC Chair White, it is imperative that industry leaders expand upon the strategies spelled out under President Obama’s Cybersecurity Executive Order signed into law last year, which seek to enhance government/private sector data sharing as well as improve risk-mitigation policies, with the ultimate goal of reducing the threat of cyber attacks. While regulators must continue to be vigilant in the face of persistent cyberattacks, some regulators, including SEC

DISRUPTIVE CYBER ATTACKS A GROWING CONCERN FOR UK ORGANISATIONS SAYS BT SURVEY Disruptive cyber-attacks are becoming more effective at breaching security defences, causing major disruption and even bringing down systems for whole working days, according to a new global study from BT. One-in-five organisations have had their systems taken down for an entire working day. T’S RESEARCH SUGGESTS 41% of organisations globally were hit by Distributed Denial of Service (DDoS) attacks over the past year, with more than three quarters of those (78%) targeted twice or more in the year. More than a third of UK organisations (36%) of respondents say they worry about an attack. Globally the worry is even greater, with almost twice as many organisations naming the attacks a key concern (58%). The new study explores the attitudes to and preparedness for DDoS attacks of IT managers from organisations in eleven countries and regions around the world. It reveals that despite the growing concern over the attacks, only about half of UK organisations (49%) have a response plan in place. Less than one in ten UK decision makers strongly believe they have sufficient resources in place to counteract an attack. DDoS attacks can cause major disruption for organisations; they can take down an organisation’s website, overwhelm a datacentre or generally cause networks to grind to a halt and become unusable. They are also increasingly becoming more complex and difficult for organisations to fend off. Nearly two thirds (59%) of those polled agree that DDoS attacks are becoming more effective at subverting their organisation’s IT security measures. Attackers are often adopting hybrid, or multi-vector, attack tactics which involve attacks through multiple platforms. These have increased by two fifths (41%) during the past year. Multi-vector attacks pose increased complexity and risk as they involve multiple attack methods deployed simultaneously. These often require a dedicated mitigation

team to track and combat the threat across multiple fronts, as automated systems are less likely to be able to offer adequate protection. Mark Hughes, president of BT Security, says: “DDoS attacks have evolved significantly in the last few years and are now a legitimate business concern. They can have a damaging effect on revenues and send an organisation into full crisis mode. Reputations, revenue and customer confidence are on the line following a DDoS attack, not to mention the upfront time and cost that it takes an organisation to recover following an attack. Finance, e-commerce companies and retailers in particular suffer when their websites or businesses are targeted.” “Organisations need a higher level security solution to protect not only the network infrastructure but the devices that initially provide protection,” he adds. Unsurprisingly, organisations see an increase in customer complaints when their network systems go down after a DDoS attack. Respondents said customer complaints and queries jumped by an average of 36%. The impact that DDoS attacks can have on organisations is felt in the length of time it takes them to recover from their most severe attack. On average, organisations take 12 hours to fully recover from an especially powerful attack – longer than an entire working day. In the UK, more than half of IT decision makers admit that DDoS attacks have brought down their systems for more than six hours – almost a full working day. The most efficient way to protect against the attack is raising awareness among employees and partnering with a trusted and capable supplier, says Hughes.

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COVER STORY

FINANCIAL CYBER WARFARE

INVESTING IN CYBER SECURITY T LOOKS LIKE the cyber security bandwagon is filling up with a wondrous mix of would-be passengers. Montgomery County in the state of Virginia, is clearly one, as it is trying to establish Bethesda as a cybersecurity hothouse, having recently launched a National Cybersecurity Centre of Excellence. The county’s business development bureau has only just gotten started but it appears eager to provide a mix of equity investments, tax credit and incubator space designed to nurture nascent companies. As a kick off for its newfound enthusiasm for the sector, the county funneled a somewhat modest $100,000 into Mobile System 7 a small growing cyber security firm; but you have start somewhere. The country is also prepping its Cyber Montgomery Forum, an initiative which it hopes to bring together leaders from the public and private sectors to discuss the cybersecurity’s potential impact on the region. The European Commission believes the threat to be strong enough to earmark some €85m this year to help develop private sector security, trust and privacy development projects under the Commission’s Horizon 2020 program. Elsewhere, initiatives are more modest. In the United Kingdom a group of companies in the Severn Valley (the area around Bristol), have been selected as winners in the latest Launchpad competition, organised by the UK's innovation agency, the Technology Strategy Board. The firms will benefit from investments worth £500k in total, to carry out research and development projects as part of the Severn Valley Cyber Launchpad competition, which is designed to draw investment and cyber security expertise into the area, to encourage collaboration and to strengthen the cluster of existing firms in the area. On the fund side, London based venture capital investment firm C5 Capital is raising a targeted $125m for a fund to help boost European cyber security companies, and is expected to close the first round of funding some point next year. The asset manager has already announced it has invested $8m in Balabit, a Luxembourg-based company which specialises in detecting insider threats. An example of how far the segment has come was apparent in March this year when private equity major Blackstone bought a majority stake in Accuvant, a 12 year old company offering cybersecurity and consulting services, alongside Sverica International. Accuvant management have also taken equity stakes in the $225m deal, which included debt financing. The private equity portion is reportedly worth $150m. Then, in late June venture capital firm Andreessen Horowitz (famous for having backed

Facebook), announced it was investing $90m in Tanium, which values the firm at some $900m. In a nutshell, the company's technology offers a near-instant snapshot of potentially malicious software in corporate-computing networks, then lets employees wipe out the unwanted software remotely. Last year alone in the United States, venture capital, angel, and private equity investors poured a reported $1.4bn into the cyber security market encompassing 239 separate deals. During the year firms, including AirWatch, WhiteHat Security and Nok Nok Labs received funding rounds in excess of $10m, according to venture capital research firm CB Insights. Nearly 80 cybersecurity start-ups have exited, either through acquisition or IPO, with a reported average tenfold return on investment. Notable deals include FireEye's IPO, which priced its initial public offering of 15.2m shares at $20 per share in September last year, raising about $304m. Just five months later, FireEye has a market cap of almost $10bn. Other recent notable transactions include the $1bn acquisition of endpoint security provider Mandiant; Cisco’s $2.7bn purchase of network security firm Sourcefire; and IBM's acquisition of cybercrime prevention firm Trusteer for $1bn. Investors are also paying more bang for their buck. The median deal size and pre-money valuation for security companies appears to have increased significantly over the past five years. The median valuation for security companies was $23.6m in 2008 but grew to $46.6m last year, an increase of 97.5%, according to Pitchbook data. Key to a successful investment in 2014 and beyond looks to be choosing firms that have the most relevant technology in what has become a fast changing arena where cyber-crime is at least as sophisticated and mutable as the systems designed to combat it. Some important new opportunities rising to the surface in 2014 include secure communications, especially in reaction to digital spying by both governments and corporations, information security, detecting and mediating zero-day threats inside network firewalls, engaging and defeating automated BotNet attacks (Active Defense), prediction and isolation of insider attacks (estimated to be the source of more than two-thirds of cyber breaches). Increasingly, market watchers think that today’s disparate cyber protection solutions will be integrated into command and control systems that can operate autonomously. According to the UK’s New Scientist magazine, quantum computing could also become something of a gamechanger in encryption and security.

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commissioner Aguilar, admit there is some ambiguity as to what that role should encompass. “The increased pervasiveness and seriousness of the cybersecurity threat raises questions about whether more should be done to ensure the proper functioning of the capital markets and the protection of investors,” noted Aguilar at the recent roundtable. Even so, the SEC intends to step up its oversight of asset managers’ cyberdefense capabilities, including measures used to safeguard against potential security breaches from vendors accessing their systems. "We will be looking to see what policies are currently in place to prevent, detect and respond to cyber attacks," Jane Jarcho, the national associate director for the SEC’s investment adviser exam program, recently remarked. “We will also be looking at policies on IT training, vendor access and vendor due diligence.” Efforts to put certain initiatives in writing are already underway. Under the Commission’s proposed rule on Regulation Systems, Compliance and Integrity

(Reg SCI), self-regulatory organisations (SROs) as well as larger alternative trading systems (ATS) would be required to test automated systems, business continuity and disaster-recovery plans for vulnerabilities as well as notify the Commission of any cyber intrusions within a specified time frame. White expects the Commission to move forward with the new ruling later this year. Along with investments in technology, improved informational channels linking government and private entities remain a core part of the cyber defense initiative. According to the Leesburg, Virginia-based Financial Services Information Sharing and Analysis Center (FS-ISAC), a collaborative forum covering security issues impacting the financial-services sector, institutions that have been targeted by cyber criminals have increasingly been working with members of the security community as well as government partners in an effort to defend against future attacks. Accordingly, inside jobs, though still a serious threat, should become more visible going forward, particularly as

federal and local government officials beef up privacy breach notification laws and enforcement regimes, suggests Tim Ryan, managing director and cyber investigations practice leader for New York-based Kroll Advisory Solutions. “There’s a tremendous amount of data compromised today where the act is never discovered nor disclosed,”says Ryan.“The insider threat is insidious and complex. Thwarting it requires collaboration by general counsel, information security, and human resources. SEC breach disclosure of ‘‘material losses’ may be the model for rules requiring a company to be more transparent and answerable for allowing bad acts to go unpunished.” The market now awaits the outcome of the Cybersecurity Information Sharing Act (CISA) which passed the Senate Intelligence Committee in early July. Detractors say it is not substantially different to an act that went through the House of Representatives last year called the Cyber Intelligence Sharing and Protection Act (CISPA). CISA is now on the Senate legislative calendar. n

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MARKET LEADER

ECB POLICY DIVERGENCE WITH THE US?

President of the European Central Bank (ECB) Mario Draghi (second right) and vice president of the European Central Bank Vitor Constancio (left) arrive for a press conference in Frankfurt am Main, Germany, June 5th this year. The European Central Bank cut interest rates to an historic low of 0.15% to spur economic growth and bank lending. Photograph by Arne Dedert, supplied by pressassociationimages, June 2014.

ASSESSING THE IMPACT OF ECB RATE CUTS In early June, the European central bank announced a combination of measures, including a ten basis point reduction in key ECB interest rates, targeted longer-term refinancing operations, preparatory work related to outright purchases of asset-backed securities and a prolongation of fixed rate, full allotment tender procedures. Moreover, the bank has suspended its weekly fine tuning of the liquidity injected into the markets under the Securities Markets Programme (SMP). The strategy has had mixed reviews from institutional investors. What will be the impact on the asset allocation strategy of specialist bond investors? CCORDING TO EUROPEAN Central Bank (ECB) governor Mario Draghi, the raft of measures introduced by the central bank in the first week of June, will “contribute to a return of inflation rates to levels closer to 2%. Inflation expectations for the euro area over the medium to long term continue to

be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%,” he told a press conference in Frankfurt on June 5th, stressing that the central bank is keen to safeguard this“anchoring”. It is clear from the European Central Bank’s decision to keep rates drastically

low that it intends to diverge policy from the United Kingdom and the United States for the foreseeable future. A few days following the ECB announcement, board member Benoit Coeure told France Inter radio that “we are going to keep rates close to zero for a long time,”adding later in the interview that the move is designed to help weaken the euro,“which is threatening economic recovery and importing disinflation.” Commenting on the ECB’s position, Scott Thiel, deputy chief investment officer of Fundamental Fixed Income and head of the Global Fundamental Fixed Income Team, at BlackRock notes that the reduction of headline policy interest rates (which involves cutting the main refinancing rate to 0.15% and therefore the deposit facility rate a negative -0.1%) makes the ECB, “the first major central bank to charge commercial banks for depositing money with it.” Thiel points out that concern has been growing (among commentators and the ECB itself) over low inflation levels in the eurozone, which in aggregate remained at the very low level of 0.5% through May according to figures from Eurostat. “In their new staff forecasts, inflation was revised down for the next three years. They now expect it to very gradually rise to 1.4% in 2016. Changes to GDP forecasts were mixed; with the outlook for 2014 reduced to 1.0% while 2015 was raised to 1.7%,” he adds. If Draghi was looking to find immediate support from the investment community that the central bank’s reduction in rates would be effective, he certainly found it. According to Steve Bell, chief economist at F&C Investments,“Much was expected from the ECB and they [sic] duly delivered. They did nothing that hadn’t been talked about extensively in the markets but the fact that they did everything has led to a significant positive reaction in the equity markets. Many on the ECB Governing Council, notably the President of the Banque de France, will be especially pleased to see that the euro has fallen in immediate reaction. I would also note that German bund yields rose [following the announcement]: the

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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

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MARKET LEADER

ECB POLICY DIVERGENCE WITH THE US?

market may be beginning to believe that ECB’s action will bring about an economic recovery in Europe”. The ECB has posited a number of related measures in addition to the cut in rates. First, the rate cuts in detail. The ECB cut the interest rate, effective June 11th, on the main refinancing operations of the eurosystem by 10 basis points (bps) to 0.15% and the rate on the marginal lending facility by 35bps to 0.40%. The rate on the deposit facility was lowered by 10bps to -0.10%. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem. To help spur bank lending (excluding mortgages) the central bank says it will conduct a series of targeted longer-term refinancing operations (TLTROs) that will mature in September 2018. Counterparties will be entitled to borrow, initially, 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding at the end of April 2014. The scheme is worth some €400bn, but will not be applicable to public borrowing. Two successive TLTROs will be conducted in September and December this year at fixed rates plus a spread of 10bps. Repayments can start on the essentially four year loans after 24 months. Additionally, between March 2015 and June 2016, all counterparties will be able to borrow, quarterly, up to three times the amount of their net lending to the euro area non-financial private sector, excluding mortgage loans, over a specific period in excess of a specified benchmark. Net lending will be measured in terms of new loans minus redemptions. The central bank has also extended the list of eligible collateral for use against any loans. According to Draghi, the central banks has also decided to intensify preparatory work related to outright purchases in the ABS market to enhance the functioning of the monetary policy transmission mechanism, which essential means purchasing simple and transparent asset-

backed securities with underlying assets consisting of claims against the euro area non-financial private sector. “Fourth, he adds, “in line with our forward guidance and our determination to maintain a high degree of monetary accommodation, as well as to contain volatility in money markets, we decided to continue conducting the central bank’s main refinancing operations (MROs) as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the reserve maintenance period ending in December 2016. Furthermore, we decided to conduct the three-month longer-term refinancing operations (LTROs) to be allotted before the end of the reserve maintenance period ending in December 2016 as fixed rate tender procedures with full allotment. The rates in these three-month operations will be fixed at the average rate of the MROs over the life of the respective LTRO. In addition, we decided to suspend the weekly fine-tuning operation sterilising the liquidity injected under the Securities Markets Programme.” F&C Investment’s Bell acknowledges that the “list of measures is long but it is the targeted LTRO which is the most complicated and gives us yet another acronym (TLTRO). This is a medium term measure, indeed the first TLTRO won’t be until September. Having pushed as hard as they can, the ECB must now sit back and wait to see if the economy responds. So far, the weaker euro is encouraging but only time will tell if there is broader economic response.” Assessing the implications, Abi Oladimeji, head of investment strategy at Thomas Miller Investment, notes that "In recent weeks, government bond yields in the Eurozone had fallen to multi-year lows, primarily driven by a combination of falling inflation and rising expectations for further monetary stimulus by the ECB. Recent data showed that inflation continues to fall and the pace of economic recovery remains muted. In this context, the ECB’s widely anticipated decision to cut both the main refinancing and deposit rates should reinforce the downward trend in bond yields while also boosting

European equities. In the currency markets, we expect the euro to remain under selling pressure”.

Monetary policy divergence? More broadly, monetary policy divergence will remain a dominant theme for markets for some time, thinks Oladimeji, whose analysis is very similar to that of the ECB’s Coeure.“This is because, unlike the Bank of England and the Federal Reserve Bank [in the United States], which are widely expected to begin raising interest rates next year, the economic backdrop in the eurozone should mean that the ECB maintains a loose monetary policy stance for the foreseeable future.” Just how divergent is still moot. How divergent is divergent and how far out is the ECB’s outlook? At best, the US Federal Reserve is not now expected to raise rates until at least July 2015, based on the CME Fedwatch (which tracks expectations of any interest rate rises via the CME’s Fed funds futures contracts). A recent Reuters survey of 18 US bond firms found that eleven out of the 18 firms that deal directly with US central bank expect the first rate increase to occur sometime between July 2015 and June 2016 (not very soon then). That conservative estimate is based on just released employment data, which suggests that while the US economy is on an upward trajectory, it is not a fast trajectory. The Fed meanwhile has been winding down its third round of bond purchases, though some public officials have warned against ending reinvestment of treasuries and mortgage backed securities (MBS) in advance of any increase in rates.

Effectiveness of ECB policy Some commentators remain unconvinced of the effectiveness of the ECB’s planning. Neil Williams, chief economist at Hermes Fund Managers, concedes the ECB moves are a step in the right direction, “but look too little, too late to snuff out deflation-risk and kick-start growth. The 10bps shavings off the refinancing and deposit rates are puny, and look more cosmetic than real. Any drop in

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MARKET LEADER

ECB POLICY DIVERGENCE WITH THE US?

the euro on the back of them would be welcome, but possibly short lived. The ECB hopes that the new, negative deposit rate will deter banks from parking cash at the ECB, instead passing it on to consumers and firms. But {sic] this may be a red herring, given still subdued credit demand, pressure for the banks to pass stress tests, and the fact that the bulk of reserves still gets the positive (0.15%) refinancing rate. These rates may have to be cut again. The ECB’s ground work on private asset purchases may help, suggests Williams, “but are not the ‘bazooka’ of unlimited sovereign QE it could have fired today [sic]. This preferably should be on a GDPweighted basis to overcome the Bundesbank’s scepticism. But, it’s clearly leaving its powder dry … Draghi’s hesitancy to use all his bullets today reflects how empty his policy tool box is. With demand subdued and the likelihood at some stage of rising bond yields, the ECB will have to capitulate on QE.” Tough words indeed. Others are much more sanguine.

Matthew Tatnell, head of liquidity at Aviva Investors notes: “Almost all the headline data is in line with our expectations and medium term money-market rates are largely unchanged. What did come as a surprise was the decision to stop sterilising SMP. We feel this decision may pull rates lower over the coming weeks as cash previously deposited with the central bank finds its way into the markets. Although the ECB would refute the suggestion, it could be argued that the SMP is now a vehicle through which banks could be placing a tentative toe in quantitative easing waters.”

Impact on asset allocation So what will be the impact of the ECB’s decision on asset allocation? BlackRock’s Thiel says that although the firm remains positive overall on the European periphery, it remains “cautious in the current environment and our positions in the region are now at their lowest levels in over two years. We are cognisant not only of the recent spread

compression for peripheral European government bonds but also the switch in market focus from fundamentals to the potential for QE in the eurozone.” Thiel explains that“holding Portuguese government bonds was a long-standing position for us over the past few months. We entered the position with the view that the valuations did not reflect the country’s improving fundamentals. A few weeks ago, however, we took profit on this position, given the strong compression that we witnessed in these bonds. We have retained some long positions in Spanish sovereign bonds versus Italy, which we currently favour on a relative value basis. We believe Spanish yield spreads may continue to tighten versus other peripherals driven by positive momentum and longterm fundamentals”. The centre is also a cause for concern, with an attendant impact on asset allocation. Thiel expects volatility and liquidity issues to reassert themselves once markets “begin to focus on the large im-

MIXED OUTLOOK FOR GLOBAL INFLATION Inflation is the unintended consequence of loose monetary policy that investors in global fixed income markets must consider, according to an inflation report issued by BNY Mellon Investment Management. The report, which includes insights from several of BNY Mellon’s investment boutiques, highlights the impact inflation is likely to have on inflation-linked fixed income instruments in the coming months. BNY Mellon investment boutiques say inflation expected to remain below historic levels in the US and the UK and fixed income investors must carefully weigh the implications of loose monetary policy in the developed world. early six years after the collapse of Lehman Brothers and the height of the global financial crisis, attention is focusing on the unintended consequences of the loose monetary policy in the developed world. “We expect inflation will remain below historic levels in the US and the UK,” confirms Paul Hatfield, chief investment officer and Head of Americas at Alcentra, the asset management and investment group focused on subinvestment grade debt capital markets in Europe and the United States. “The global economy remains in modest recovery mode in the developed world with the BRICs (Brazil, Russia, India and China) facing some real challenges. Overall, we think the inflationary outlook for both developed and emerging economies appears

balanced, though we recognise there are a few outliers. For example, Chinese data has been mixed in recent months, contributing to softer than anticipated inflation figures, though these are expected to normalise throughout the course of the year. Japan’s aggressive monetary actions are having a steady, albeit modest, positive impact on the private sector.” Applying his outlook to fixed income markets, Hatfield observes, “Falling prices could initially help to improve the cost structure of some companies but would also raise the real burden of high yield issuers’ debt. This could create another round of financial stress in the European high yield universe, especially among weaker capital structures, and lead to increased corporate defaults which are

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balances that have occurred from rates being so low for such a very long time, particularly by the US Federal Reserve and the Bank of England. Among our active currency views we remain long sterling and short on the yen. This is our preferred expression for further divergence between the British and Japanese economies and their respective monetary policies. We also remain short Swiss francs versus the euro as we expect to continue to see an unwinding of safe haven trades.” Williams at Hermes posits a similar outlook, “The biggest test will be when global yields start to climb, probably in 2015. Given two-thirds of euro-zone activity is long, not short-rate, driven, this will sap demand. Otherwise, the zone’s misery may be compounded by a stronger euro, doing nothing to allay fears that Japan is ‘leading the way’ in terms of deflation risk.” For his part, Draghi and his team anticipate a modest recovery in the eurozone over the near term, backed by

data showing weak GDP growth in the eurozone of some 0.2%, quarter on quarter, in the first quarter of this year. “Most recent survey results signal moderate growth also in the second quarter of 2014,” he concedes. “Looking ahead, domestic demand should continue to be supported by a number of factors, including the accommodative monetary policy stance, ongoing improvements in financing conditions working their way through to the real economy, the progress made in fiscal consolidation and structural reforms, and gains in real disposable income resulting from falls in energy prices. At the same time, although labour markets have shown some further signs of improvement, unemployment remains high in the euro area and, overall, unutilised capacity continues to be sizeable. Moreover, the annual rate of change of MFI loans to the private sector remained negative in April and the necessary balance sheet adjustments in the public and private sectors are likely to

currently near an all-time low but even if that happens, defaults are very unlikely to accelerate to a level that would cause us concern for the medium term. Higherquality issuers may actually benefit from deflation initially, although a prolonged deflationary situation would have a negative impact on the underlying economies and credit worthiness of all players in the sector. Looking ahead, stricter credit selection will be crucial.” Also in the report, Howard Cunningham at Newton thinks that while no dramatic changes are expected in either inflation or interest rates over the next 18 months, more subtle upward shifts may trigger fresh interest in UK index-linked gilts that can “guard against depreciating real term investment values … On balance we do feel index linked gilts are becoming more attractive …with developed economies such as the US and UK healing and with wage pressures starting to rise there are some signs that inflationary pressures may soon return, which could augur well for the index linked gilt market.” However, Paul Brain, fixed income leader, Newton, predicts that there will not be a significant turnaround in headline consumer inflation this year due to the restructuring of banking systems in the UK, Europe and the US. Brain highlights, “There remains a risk that if

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

continue to weigh on the pace of the economic recovery.” Not that much to be ecstatic about then. If however, the ECB and eurozone governments can keep to the modest forward projections of annual real GDP increasing by 1.0% in 2014, 1.7% in 2015 and 1.8% in 2016, then Draghi’s policies will be vindicated. A word of warning though: the projection for real GDP growth for 2014 has been revised downwards and the projection for 2015 has been revised upwards. Not the best of sentinels of recovery. Moreover, even Draghi concedes that the risks surrounding the economic outlook for the euro area “continue to be on the downside. Geopolitical risks, as well as developments in emerging market economies and global financial markets, may have the potential to affect economic conditions negatively. Other downside risks include weaker than expected domestic demand and insufficient implementation of structural reforms in euro area countries, as well as weaker export growth.”n

recoveries were to falter we could, if anything, end up with concerns over deflation. Where we are seeing inflation as a consequence of these particular monetary policy initiatives is in asset prices. Since its low in 2009 the US stock market has risen by around 180%. This asset growth has far outpaced the recovery in the economy.” Newton’s Brain adds, “Our current relaxed view about inflation and the ongoing risk of deflation has enabled us to look through the so called ‘unintended consequences’ of the loose monetary policy. This has allowed us to consider the positive effects of low interest rates and low economic growth to maintain a bias to corporate credit. That said, a sustained pick-up in wage inflation in the US could bring about an end to the easy monetary stance and undermine US dollar-denominated bonds. We will be adjusting our bond exposure during the year to accommodate a rise in interest rate expectations. This adjustment could include adding inflation linked securities and floating-rate issues to the mix later in the year.” Hatfield concludes: “We see a mixed overall picture for global inflation for the remainder of 2014. The US is at one end of the spectrum looking fairly settled, the UK has a middling, mixed outlook and the Eurozone remains unpredictable with a continued risk of deflation.”

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SPOTLIGHT

UK PENSIONS REGULATOR’S NEW CORPORATE PLAN

Interest rate liability hedging activity nears record high Interest rate liability hedging activity increased by 9% in the first quarter (Q1) of 2014 as pension schemes increased hedges and converted inflation hedges to real rate hedges, according to F&C Investments’ Liability Driven Investment (LDI) survey. Expressed in liability terms, interest rate hedging transactions represented £22.5bn of liabilities in the first quarter of this year. TRONG EQUITY PERFORMANCE has resulted in pension schemes having better funding levels and this has driven a move to reduce risk by adding liability hedges. In recent times, some pension funds have had a higher hedge percentage in inflation than interest rates, and those funds have been adding interest rates hedges to create a real rate hedge. As some of these schemes put their inflation hedge on at low inflation rates prior to 2013, by adding the interest rate hedge in Q1 2014 as nominal rates increased, they have achieved an attractive overall yield. Alex Soulsby, head of LDI for F&C Investments, explains that,“Interest rate liability hedging activity is not far off the record level of £23.4bn in Q3 2013, and whilst inflation hedging activity fell in the first quarter of this year, it still remains higher than those seen up to and including the second quarter of 2013. The survey, a quarterly poll of investment bank derivatives trading desks, shows that within interest rate activity there were significant flows in asset swaps as well, allowing pension funds to take advantage of movements in relative value between bonds and swaps by switching into the cheaper asset whilst maintaining an overall hedge. Inflation hedging activity decreased for a second quarter, accounting for some £15bn of liabilities. Asset swaps activity dominated inflation hedging activity

during the quarter, particularly around the 2068 syndication. In Q4 2013, inflation hedging activity among pension schemes totalled £20.5bn.“Much of the activity was driven by schemes taking advantage of the good performance of equities at the end of 2013, scaling back equity positions and implementing real rate hedges through the purchase of the 2068 index linked gilt syndication at the end of January,” adds Soulsby.

UK pensions regulator sets out three year plan The regulator outlines its strategic approach to regulating both DB and DC schemes, automatic enrolment implementation HE PENSION REGULATOR (TPR), the UK’s pensions’ watchdog has identified its priorities in its three year plan, published in late May. It includes the standard commitments you would expect from a regulator around good governance of pension schemes, secure outcomes for pensioners, employer compliance and market efficiency. More significantly though, the regulator looks to prioritise automatic enrolment duties among the country’s medium, small and micro employers, investigate pension lib-

eration activity and its extended remit of public service pension schemes. “Automatic enrolment is a core area where the biggest challenges still lie ahead. Tens of thousands of employers will reach their staging date in coming months and we want to ensure they have the information they need to implement the reforms successfully, avoiding non-compliance,”states Mark Boyle, TPR’s chair. TPR’s interim chief executive Stephen Soper explains that the regulator will not rigidly adhere to a“silo-based approach”, but focus instead on overarching corporate priorities outlined in the corporate plan. “Over the next few years we will be embedding the new growth objective into our DB work, helping DC schemes assess their value for money, and supporting SMEs in complying with their AE duties, among other activities. It is crucial that we approach these challenges with organisational flexibility if we are to regulate effectively in today’s everevolving pensions landscape.” In particular, the regulator is keen to support employers to comply with their automatic enrolment duties, focusing on preparing medium, small and micro employers to stage across 2014-2018. “Over this time we will continue to implement our compliance strategy and enforce against breaches where appropriate,”says the regulators corporate plan statement. Publishing an annual update of its business plan, the UK regulator, which is part tax-payer funded, said autoenrolment would shift to account for majority (52%) of budget. The body spent £56.8m (€70m) on regulating defined benefit (DB), defined contribution (DC) and auto-enrolment in 2013-2014, with the latter accounting for 37%. In its forecast for the current financial year (April 2014 to March 2015) autoenrolment compliance expenditure will increase by 90% to £40.4m. As a result, the regulator’s budget for DB regulation has been squeezed, falling by 10% to £20.9m, and seeing its share of TPR’s budget fall from 41% to 27%. The squeeze on DB spending comes as the regulator puts the final touches to its new Code of Practice which will be published in June this year.

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You’re in...

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SPOTLIGHT

IS THE EQUITY TRADING MARKET A LEVEL PLAYING FIELD?

IOSCO RAISES THE BAR ON MARKET BASED FINANCE he Board of the International Organization of Securities Commissions (IOSCO) met in Madrid in early June to drive forward its work on market-based finance. “Capital markets are emerging as a key source of the finance needed across the globe to drive economic growth. Through a work agenda focused on fostering markets as a trusted source of capital, IOSCO is playing an important role in supporting that growth,” holds IOSCO chairman Greg Medcraft. Discussions hung on ways to identify non-bank financial institutions, financial intermediaries and asset management firms that are active in the capital markets as well as the role capital markets and securities regulators can play in supporting long-term finance, including infrastructure investment and SME financing. To this were added the usual ingredients of IOSCO principles covering issues such as financial benchmarks, oil price reporting and supervision of commodity derivatives trading. Two interesting sub-texts were the desire by IOSCO to help reduce the reliance of asset managers and market

US and European traders worry about market ‘fairness’ Photograph © Skypixel/Dreamstime.com, supplied May 2014.

A new survey by the ConvergEx Group posits a nervous trading market as regulation, worries about HFT and market complexity bite EW YORK-HEADQUARTERED broker-dealer ConvergEx Group, released the results of its European Equity Market Structure Survey, in late May exploring the concerns and actions of 131 financial industry participants regarding high frequency trading (HFT), regulatory

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intermediaries on credit ratings, and to find ways to introduce credible deterrents in the market to improve investor protection and confidence in markets. Discussions also covered the results of the IOSCO Research Department’s latest market survey on market trends which highlighted the growing leverage in securities markets, the impact of cross-border capital flows on emerging markets, financial risk disclosure, collateral management, and potential counterparty risk in central clearing houses. Board members also examined policy measures aimed at building capacity in emerging markets and supporting the creation of strong regulatory frameworks for sustaining growth in both emerging and developed markets. The Board discussed possible capacity building projects and agreed to a proposal for a one-off fee from permanent Board members next year to start off the program. It also agreed to move forward on an IOSCO Global Certificate Program for Securities Regulators. IOSCO’s market survey will be released in late June.

oversight and market stability. Respondents included buy-side firms (asset managers, hedge funds), sell-side firms (banks, broker-dealers), trading venues, service providers and other financial industry participants. The European survey followed hot on the heels of a similar US survey of 357 market professionals conducted by the firm in April. The results of both reflect an increasingly nervous market place. The survey found that less than a third (28%) of respondents believe that European equity markets are currently fair for all participants. In the United States however a massive 70% think they are unfair. ConvergEx concedes the US figures reflect an unusually high level of nervousness in the market at the time of the survey, particularly around HFT that may have been heightened by marketadverse publicity surrounding the publication of Michael Lewis’s book Flash Boys, which (among its many themes) alleges that high frequency traders, exchanges and some brokers have rigged the US stock market. Joseph Cangemi, chief executive officer of ConvergEx Limited, a London broker-dealer and

ConvergEx’s European headquarters acknowledges its impact. “I think it fair to say that the US survey participants gave an emotional response,” he avers. “That is not to say that there aren’t major market structure issues which need to be resolved, but at the time the HFT book was just out [and] debate was heating up.” A particular bone of contention was HFT. “High frequency trading is part of MiFID II and the broader market structure conversation in Europe that includes the roles of multilateral trading facilities (MTFs) and broker crossing networks (BCNs),” explains Cangemi. In Europe 28% of respondents thought that HFT is harmful while only 14% think it is helpful. In the US more than a third (38%) think HFT is harmful, a further 13% think it very harmful; 30% remain neutral, 15% says it is helpful and only 4% think HFT is very helpful to the trading markets. Despite these concerns, more than two-thirds (67%) of European respondents and 71% of US respondents report that they have not made any changes to the way they interact with markets. Less

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good company

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SPOTLIGHT

ISRAELI HEDGE FUNDS REPORT 33% INCREASE IN ASSETS

than one-quarter of European respondents (21%) reported making any changes at all. Regulators in both jurisdictions have not been so sanguine. The EU has signalled its intention to control systemic risk in HFT by requiring traders to register their algorithms with regulators and, where applicable, apply circuit breakers. HFT traders will also have to maintain detailed records of their orders (both placed and cancelled) and be able to retrieve them for review by regulators on request. Meanwhile in the US, the Securities and Exchange Commission is now looking at introducing a requirement that would intensify regulatory oversight of the HFT segment, and heighten exchange reporting requirements of HFT activity. In Europe financial industry participants are almost evenly split on their view of regulatory changes. Only about one-third (34%) of respondents believe current levels of regulation are appropriate for today’s market structure. Respondents were also divided on whether European equity markets could withstand the volume resulting from a geopolitical crisis or other large volatility shock. Only 40% were confident markets could handle a large volatility shock, while 32% were not confident or not-atall confident that markets could handle a large volatility shock. “I think the split actually highlights a healthy response,” posits Cangemi. “I would have been worried with, say an 80/20 split. That would have told you that markets are really susceptible. Over or under confidence is never a good way to be in the equity markets,” he adds. “Market structure issues continue to dominate the financial discussion in 2014, both in Europe and the United States,” says Eric Noll, president and chief executive officer of ConvergEx Group. “Our European survey provides a snapshot of a financial community trying to understand and react to the impact of technology and regulation on markets. Worldwide, ConvergEx is helping its clients design and execute new strategies to address an evolving landscape.”

Israeli hedge funds outperform Small, but perfectly formed? Why the Israeli hedge fund industry has bite ZUR MANAGEMENT HAS released its latest survey of hedge funds in Israel, citing a 33% growth in assets since its last survey two years ago to $2.7bn in assets under management. The survey covers 89 fund managers operating in Israel, a 50% increase in the number of active fund managers over the past two years. Thirty new funds launched in 2013 alone according to the study. Tzur also announced the inauguration of the Tzur Capital Management Israel Index of Israeli hedge fund performance (TCMI), which has outperformed the hedge fund industry in 2012 and 2013 averaging returns of 13% and 17% respectively. Israel-focused hedge funds have also outperformed the TA-25 Index in each of the past three years. Tzur chief executive and founder, Yitz Raab says “considering the impressive performance of Israeli hedge funds in recent years, it is no surprise that we are witnessing substantial growth both in assets under management and in the number of funds currently operating in Israel.” Israeli managers appear to employ a wide range of strategies, but quantitative strategies dominate (with quant strategies used by 42% of survey respondents), a reflection Raab says of Israel’s strengths in high tech and academia. Quantitative hedge funds, however, are smaller on average accounting for only 26% of assets under management, while equity long/short funds hold the largest share with 46% of assets. Survey respondents however tend to look overseas for returns; the survey confirms that a majority of hedge fund managers have no investments in the Israeli markets, and about 60% of total industry assets are invested outside of Israel.

AfDB says African countries need to tap global markets more effectively

Photograph © Patrick Swann/ Dreamstime.com, supplied May 2014.

NGOs push for the establishment of regional and global value chains HE LATEST AFRICAN Economic Outlook, produced annually by the African Development Bank (AfDB), the OECD Development Centre and the United Nations Development Programme (UNDP), shows that Africa has weathered internal and external shocks and is poised to achieve healthy economic growth rates. The continent’s growth is projected to accelerate to 4.8% this year and 5%-6% next year, levels which have not been seen since the global economic crisis of 2009. Africa’s economic growth is more broad-based, argues the report, driven by domestic demand, infrastructure and increased continental trade in manufactured goods. “In order to sustain the economic growth and ensure that it creates opportunities for all, African countries should continue to rebuild shock absorbers and exercise prudent macro management. Any slackening on macro management will undermine future economic growth,” says Mthuli Ncube, chief economist and vice-president of the African Development Bank.“In the medium- to long-term, the opportunity for participating in global value chains, should be viewed as part of the strategy for achieving strong, sustained and inclusive growth,”he added. The report argues that more effective participation in regional and global value chains (the range of activities in different countries that bring a product from conception to delivery to the consumer) could

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SPOTLIGHT

RISING FOREIGN INFLOWS INTO AUSTRALIA’S NATURAL RESOURCE SECTOR

serve as a springboard for Africa in economic diversification, domestic resource mobilisation and investments in critical infrastructure. In order to do so, however, the continent needs to avoid getting stuck in low value-added activities. For instance, Africa’s exports to the rest of the world grew faster than those of any other region in 2012, but they remain dominated by primary commodities and accounted for only 3.5% of world merchandise exports in 2012. Avoiding that trap involves investing in new and more productive sectors, building skills, creating jobs and acquiring new technology, knowledge and market information. These interventions require sound public policies, as well as entrepreneurs that are willing and capable of helping achieve these gains. The report uses the example of South Africa, which achieved a remarkable turnaround in its automotive industry by removing obstacles and providing incentives for component producers and assembly lines. It also shows that the development of agribusiness value chains in countries such as Ghana, Kenya and Ethiopia has contributed to economic growth and job creation. “African economies have a great potential to build on their demographic dynamism, rapid urbanisation and natural-resources assets. The challenge now for many of them is to ensure that greater insertion into global value chains is achieved and has a positive impact on people’s lives,” explains Mario Pezzini, director of the OECD Development Centre. “Public policies need to be articulated in a targeted strategy that promotes more equitable economic and social transformation and an environmentally sound development,” he adds. The question is what type of investments need to be stimulated: private equity investment into key strategic segments might be one useful trend. The UK’s CDC has shown what can be achieved by working with specialist private equity investment firms. More than a sea change in financial inflows is required before that changes. It needs a paradigm shift in thinking about the drivers of development in the continent.

Russia starts to look east Sberbank Asset Management/ Invest AD Abu Dhabi Investment Company sign MoU T WAS ONLY a matter of time that liquid emerging/high growth markets would start treating with each other. Sberbank Asset Management CJSC and Invest AD Abu Dhabi Investment Company signed a memorandum in late May which establishes priority areas of cooperation between the two companies in Russia, the CIS, and Middle East and builds on an earlier agreement signed in December 2012. According to Anton Rakhmanov, Sberbank Asset Management’s chief executive, “We are certain that our partnership with Invest AD will open new horizons for both companies and help provide the region’s institutional and private investors with access to the promising investment opportunities in the Russian market and also give our companies additional expertise for creating new products.” InvestAD, the Abu Dhabi Investment Company, is government owned and focuses on managing third party assets in funds and separate accounts across fixed income, listed equity, and other asset classes.

Shifts in Australian capital flows Compositional changes in capital flows and relationship to the Australian dollar N A SPEECH to the Financial Services Institute of Australia in late May, assistant Reserve Bank of Australia governor, Guy Debelle outlined recent shifts in capital flows in the Australian market. He noted a marked reduction of net offshore debt issuance by the Australian banking sector, which he expects will “continue for a while yet”. He also notes sizeable capital inflow (at least no-

tionally) to fund the country’s resources investment boom. However, he posits that, ”As that investment boom is now transitioning into the production and export phase, these capital inflows may be expected to decline and their composition change”. Finally he pointed to a marked increase in foreign holdings of Australian government debt. According to Debelle, net capital inflows to the banking sector averaged around 5½% of Australia’s GDP in the decade preceding the financial crisis, but have subsequently averaged close to zero, for two reasons. The first is a shift in the composition of banks’ funding; the second is that credit growth has been slower. As a result, banks have scaled back the pace of offshore debt issuance, with net wholesale debt issuance averaging 1%−2% of GDP between 2008 and 2013 compared with average net debt issuance equivalent to about 5% of GDP over the previous decade. Ultimately it has also resulted in an increase in net capital inflows directly to the corporate sector, rather than the funding being intermediated by the banking sector. Net inflows to private non-financial businesses have stepped up from an average of around 1½% of annual GDP in the ten years prior to the global financial crisis to around 4% of annual GDP in the post-2007 period.“Investment in the resources sector has been the important driver of this shift. Since 2011, around 70% of foreign investment in the Australian private non-financial sector has been directed to the resources sector,” he notes. A significant share of the very large increase in investment in resource projects has been funded through foreign direct investment in the form of retained earnings. ”To the extent that resource companies have also used external funding sources, they have generally accessed offshore debt markets directly, rather than obtain funds through the domestic banking sector,” he adds. The third key development has been an increase in net capital inflows to the public sector, reflecting an increase in foreign holdings of Australian Common-

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Gross and Net Capital Flows Percent of GDP %

-10

-10 Foreign investment in Australian:

Banking sector Other sectors

Australian investment abroad by:

Banking sector Other sectors

-20

-30

-30 1997

2001

2005

2009

2013

Source: Reserve Bank of Australia, May 2014.

wealth government debt over recent years. Gross inflows to the public sector have risen from an average of close to zero in the decade prior to the crisis to around 2.5% of GDP, on average, over the 2008−2013 period. The increase in foreign purchases of Australian government debt has seen the

foreign ownership share of the stock of Commonwealth Government securities (CGS) increase from 50% in the early 2000s to be just under 70% currently, even as the stock of issuance has risen fivefold. At the same time, there have also been smaller net foreign purchases of Australian state government debt. But these

Gross Capital Flows* Percent of GDP %

Global**

Australia

10 0

0 1997

2001

2005

2009

2013

* Sum of gross capital inflows and outflows; excludes financial derivatives ** Sum of flows from reporting regions Source: Reserve Bank of Australia, May 2014.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

purchases have not kept pace with net issuance by the states, resulting in the foreign ownership share of state government debt declining from around 45% in 2008, to around 30% currently. “The increased foreign investment in Australian national government debt appears to have been underpinned by increased ‘official’ holdings of Australian assets by foreign reserve managers, including central banks,” explains Debelle. “I say ‘appears’ because we don't have any particularly concrete evidence of this. The ABS statistics do not break down the holders of Australian government debt. However, our analysis of information published by some of these sovereign asset managers suggests this is the case,” he adds. With yields on Australian government debt remaining relatively high compared to a range of alternative reserve assets, and the Australian government maintaining its AAA credit rating, asset managers appear to have regarded the risk-return trade-off and diversification benefits associated with holding Australian government debt increasingly favourably. Meanwhile,“the Australian dollar share of global reserve holdings is modest at less than 2% on average (for those central banks for whom information on the currency denomination of their reserve assets is known),” he says. Looking ahead, Debelle thinks that,“In terms of the banking sector, it seems unlikely that the pattern of capital flows will change materially any time soon. The banks are likely to continue with little net debt issuance in the period ahead; that is, only issuing enough debt to replace that maturing. To the extent that investment in the non-resources sector is more likely to be intermediated by the banking sector than resources sector investment, the RBA's forecast pick-up in investment in the non-resources sector might see some pick-up in business credit from its current low rate of growth. Even so, this would not require much of an increase in wholesale debt issuance given that deposit growth continues to outstrip lending growth by a few percentage points.”

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SPOTLIGHT

EC BEEFS UP ANTI-CARTEL CHECKS

Asset managers adapt as professional buyers pool resources A centralised European fund selection process helps managers exploit cross-border and cross-business relationships ENTRALISATION AND PREFERRED partnerships are affecting global distributors. A total of 70% of cross-border European asset managers said they were targeting banks with central selection offices, compared with 30% targeting those with regional selection offices, according to Cerulli Associates’ report entitled European Fund Selector 2014. The report says European fund selection teams are centralising across markets and regional office fund analysts are communicating more with fund selection headquarters. “Regional offices had a strong influence on selection, but they are now subject to global buy lists from a central selection office in London or Zurich. It’s not the tail wagging the dog anymore,” explains Philip Holton, analyst and main author of the report. Cerulli surveyed 110 fund selectors. More than 55% of respondents said they had a global selection team covering all business areas while only 9% said they were running teams independently. A further 16% run teams separately but with some synergies. The approach of a majority of fund selectors demonstrates the pressure they are under to centralise their research. The effects of cost and regulatory pressures have resulted in the proliferation of preferred partnerships. Switzerland is the top market in terms of securing preferred partnerships (7.6 on average), while in France asset managers have had roughly half the number (4.9 on average) of successful partnerships secured.“For crossborder asset managers, leveraging relationships across markets and business groups were voted the top criteria for improving relationships with private banks. However, with fund selection continuing to centralise, we see more scope for sales team to exploit

cross-business relationships than crossborder ones,” adds Barbara Wall, Cerulli’s Europe research director.

EC beefs up anticartel checks Photograph © Kheng Ho To/ Dreamstime.com, supplied May 2014.

Marshall Bailey, president of ACI International, the Paris-based trade association for the international foreign exchange markets. Photograph kindly supplied by ACI, May 2014.

Three more banks receive statement of objections from the EC N LATE MAY, the European Commission issued its statement of objections to Credit Agricole, HSBC and JP Morgan Chase as part of its continuing investigations into cartels in the financial sector. The three banks now have the opportunity to defend themselves. The Commission says it will “look carefully at all their arguments before taking any final decisions”. The Commission has been pursuing investigations into banking cartels for some time. It imposed fines (worth a combined €1.7bn) in December last year on four banks (Barclays, Deutsche Bank, Royal Bank of Scotland and Société Générale) which it claimed participated in a cartel for interest rate derivatives based on the Euribor benchmark. Robert Emerson, head of interest rates at SuperDerivatives, a provider of trade data and technology services, says, “The problems that have come to light in the wake of the Euribor, Libor and ISDAFIX scandals point to problems in oversight and in the processes used to generate these benchmarks, rather than problems in the benchmarks themselves. Emerson says that in the aftermath of

the Libor fixing problem people wondered if Libor itself is fundamentally flawed and should be replaced.“This was the incorrect question to be asking,” he avers. “For two reasons: first, Libor is the reference index for literally millions of financial contracts, and as such, the cost of a wholesale replacement of Libor would be staggering; and second, Libor does have natural value as a benchmark in that it represents the true cost of short term borrowing for the representative banks. There are, or have been, serious flaws in the determination of benchmarks fixings. These flaws fell into two categories: the processes by which they are determined, and the complete lack of oversight of those processes.” In parallel the Commission says it is also pursuing an investigation against a broker in the yen interest rate derivatives market. “We also continue to look into the Swiss franc interest rate derivatives market and the foreign exchange spot trading market. And we are still looking into possible collusion relating to benchmarks for oil and biofuels [sic],” says the EC in a statement. Marshall Bailey, president of ACI International, the Paris-based trade association for the international foreign exchange markets, asks for the establishment of a universal code of conduct “with comprehensive guidelines and best practice governance applied evenly to all, regardless of region or jurisdiction.

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SPOTLIGHT

RGM GROWTH 4.5% IN 2015: PUSHING URBANISATION

Urbanisation and big cities drive growth in rapid-growth markets Rapid growth markets (RGM) and according to EY, there are at least 25 of them, are expected to grow by a rather acceptable 4.5% in 2015. EY’s latest Rapid-Growth Markets Forecast (RGMF), a quarterly forecast covering 25 markets that according to the consultancy are becoming “more important globally” [sic] in terms of their overall weight in the world economy, posits the view that urbanisation is now an important economic driver in these economies. GMS HAVE RECOVERED somewhat from the financial turmoil in the second half of 2013 and early 2014, thinks EY. The consulting firm suggests strong investment rates and the rapid adoption of technologies, will continue to grow over the medium term. While political challenges continue to blight the economic prospects of some economies; in particular, EY cites the example of the conflict in Ukraine, which it says is weighing on growth prospects not only in the country, but also in surrounding countries in emerging Europe. On the other hand, in economies such as India and Indonesia, the firm says new political leaders with“strong credentials in governance have recently come to power and must now usher change for accelerating growth.” Rajiv Memani, EY’s chair of the Global Emerging Markets Committee explains, "While near-term growth in several emerging economies hinges on the political will to implement second generation of reforms; in the medium term, fastgrowing populations and increasing productivity are expected to lift growth, with cities especially in Africa and Asia, expected to be the epicentre of this growth.” According to EY’s report, the economic output of China’s 150 largest cities will triple from $8trn today to $25trn by 2030. China’s new urban development plan, introduced in March by the Chinese government, puts the urban consumer at the heart of its development,“with ambitious targets to improve rail infrastructure, reduce emissions and ensure its cities are fit for the next generation. A faster adoption of green technologies in

China has the potential to lift its growth by 0.7% per year on average from 2025 to 2030”. Another significant trend is the growing number of lower-middle income households with some disposable income, which the report says is set to exceed 30m by 2030 in Africa and South Asia. Before everyone gets too excited, the annual income expected average range remains modest (above $5,000 but below $10,000 in Africa and India). Even so, just this level of revenue increase will apparently help to create markets of scale for mobile phone airtime cards and other consumer goods and services.

Exponential growth of cities EY estimates that by 2030, China, Indonesia, Nigeria and Ghana will have more than two-thirds of the population living in cities, with the population in Lagos increasing by 13m. By this time, 40% of the 50 largest cities in the world (based on GDP by consistent prices) will be in China. Outside of China, Jakarta, Istanbul and Sao Paulo will all rank among the world’s top 20 cities in terms of economic output. In Latin America, it is estimated that between 2013 and 2030 Mexico City’s GDP at consistent prices will grow by more than 60%; faster than many European and Japanese cities. The green economy reforms the government is expected to sanction soon in Mexico will have a direct impact on this. RGMF expects these reforms to underpin medium-term growth of 4% a year. It is also estimated that Curitiba, Brazil’s sixth largest city, will be one of the fastest

growing cities in Brazil over the next 10 years, helped by urban planning reforms which promote greater sustainability. EY expects there will also be tremendous shifts within sectors in RGM cities. “Manufacturing will expand in cities with more space to grow, whereas financial services will accelerate in cities such as Beijing, Mumbai and Lagos. Industrial output in more space-constrained cities such as Hong Kong, Shanghai, Seoul, Bangkok and Sao Paulo, with relatively more expensive land and labour costs, will grow much more slowly than in cities like Jakarta,” says the report. Meanwhile, Mexico, Indonesia and China among others are grasping the opportunity to push forward ambitious reforms, including more sustainable technology and shifting their economies away from heavy manufacturing. Varying demographic trends in cities across the RGMs bring challenges and opportunities. For countries such as Russia, Poland, South Korea and China, it is estimated that there will be fewer than five workers supporting each elderly person by 2030. In contrast, it is estimated that India, Indonesia, Egypt and South Africa will still have almost 10 workers for each elderly person. For all the RGMs, this presents a challenge for the provision of urban public services. Mumbai’s working age population is forecast to expand by a third by 2030, while Tokyo’s will shrink by 7%. Aging populations will add to pressures on health services in Russian, Polish and South Korean cities. In addition, rising pollution and congestion is a serious concern in many Asian cities.

Looking ahead Memani concludes: “Investments are crucial to sustaining the demographical and industrial trends across rapid-growth markets. In our view, RGMs that demonstrate the political will to move ahead with second-generation reforms to attract investments in infrastructure, offer stability and predictability in their rules for doing business and take tough measures to achieve macro-economic balances can see a growth dividend in the future.” n

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IN THE MARKETS

Dubai: pretender to the Shari’a finance crown Egyptian interim Prime Minister Ibrahim Mehlib, centre, next to Sheikh Mohammed bin Rashid Al Maktoum, Vice-President and Prime Minister of the UAE and Ruler of Dubai, right, attend the opening of the Arab Media Forum in Dubai, United Arab Emirates, Wednesday, May 20th 2014. Photograph by Kamran Jebreili for Associated Press. Photograph supplied by pressassociationimages.com, June 2014.

MONG ISLAMIC JURISDICTIONS, Malaysia remains the leading hub for Islamic finance with $120bn in assets in 2012, representing 20% market share of Islamic banking assets worldwide. However, the United Arab Emirates (UAE) is quickly catching up. By 2012, the UAE had an estimated $83bn in Islamic assets, making it the third largest Islamic market globally, with an Islamic banking market share of 17% worldwide. This number also takes into account Islamic assets of larger conventional banks. There are many challenges associated with reaching pole position and becoming the global leader in Islamic finance. One of the biggest challenges Dubai currently faces is the standardisation of the rules and regulations applicable to Islamic finance transactions. Malaysia’s success as a leading Islamic hub has been heavily reliant on the development of a legal, regulatory, and to a great extent, operational

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

systems applicable to all Shari’acompliant transactions. This has provided legal certainty, transparency and standardisation to the Malaysian Islamic economy. The Islamic finance sector in Malaysia is supported by three, strong centralised pillars. They include the Central Bank of Malaysia, Bank Negara Malaysia and the Securities Commission Malaysia which are responsible for the implementation of the rules and guidelines applicable to Islamic finance transactions. Bank Negara Malaysia’s Shari’a Advisory Council is the only authoritative body in Malaysia ascertaining matters of Shari’a in relation to Islamic finance. Unlike Malaysia however, the UAE does not currently have a centralised Shari’a board of scholars or uniform Shari’a rules and guidelines. As a result, each Islamic Financial Institution (IFI) in the UAE has its own Shari’a board that is responsible for issuing a fatwa on a case by case basis, therefore establishing the Shari’a-compliance of each transaction.

The diversity of boards across IFIs in the UAE is prevalent. It is common for IFIs to have different interpretations of the same Islamic structures. Recent guidelines, regarding the issuance of sukuk, passed by the Dubai Financial Markets (DFM) represent a real effort to standardise regulations applicable to the asset class, but fall short of providing a complete set of binding rules applicable to Shari’a instruments generally. Clear Shari’a guidelines and an overarching decision-making body would improve legal certainty and the marketability of Islamic financial instruments while reducing transaction costs. This ultimately attracts Shari’acompliant investments to Dubai and allows small-to-medium enterprises to benefit from sukuk instruments.

Finance documentation Partly as a consequence of the lack of standardised regulations and guidelines applicable to Shari’a compliant instruments, as well as the absence of a central Shari’a board, is the lack of standardisation in Islamic finance documentation. IFIs and law firms in the Gulf Cooperation Council (GCC) countries tend to use their own precedents and structures which often differ from each other. The Accounting and Auditing Organisation for Islamic Finance Institutions (AAOIFI) has led the charge in developing a set of standards applicable to the classic Islamic finance structures. However, there is still no consensus on the admissibility of various Islamic techniques. For example, there are still differing views among scholars in the GCC as to the admissibility or Tawarruq and commodity Murabaha structures, with a split between the IFIs that allow it and those that do not. This often results in more than one Islamic tranche being used in Islamic finance syndicated facilities to ensure that they meet the requirements of each of the IFIs involved. This lack of standardisation of Islamic finance documentation is more apparent in Islamic derivative transactions. Conventional derivatives traded over the counter (OTC) are largely based on the International Swaps and Derivatives As-

CAN DUBAI BECOME AN ISLAMIC FINANCING HUB?

Since its establishment as a viable financial market in the 1980s, the Islamic finance industry has experienced staggering growth. In 2013, Islamic banking assets with commercial banks globally amounted to $1.7trn, suggesting an annual growth of 17.6% in the preceding four years. By 2017 assets are forecasted to double to $2.7trn. This growth compares positively against the less than 10% growth rate for nonShari’a-compliant loans. Dubai managing partner Ayman A Khaleq and associate Victoria Mesquita of global law firm Morgan Lewis & Bockius examine Dubai’s ambition to establish itself as the global Islamic hub.

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IN THE MARKETS

CAN DUBAI BECOME AN ISLAMIC FINANCING HUB?

sociation, Inc (ISDA) 1992 and 2002 master agreements. These agreements are highly standardised, allowing for the swift confirmation of derivatives trades, which are required for purposes of the fast paced derivatives market. The ISDA master agreements provide a framework agreement between two parties under which individual derivatives transactions may be entered into, incorporating standard provisions which the parties may choose to apply or not. The commercial terms of each individual derivatives transaction is documented by a confirmation exchanged between the parties each time a transaction is entered into. Right now, there is no widely accepted equivalent applicable to Shari’acompliant derivative instruments. The International Islamic Financial Market (IIFM) and ISDA launched an ISDA type Tahawutt Master Agreement in March 2010. However, there is disagreement among scholars regarding its admissibility, which has resulted in a lack of acceptance by IFIs in the GCC. Derivatives are key to companies and IFIs alike when it comes to hedging risk, and without a standard document supporting Islamic derivative transactions, the industry will be at a disadvantage, with companies availing themselves of Islamic facilities often opting to enter into conventional derivatives to hedge their currency or rate exposure.

Liquidity management of IFIs Another challenge for the development of Dubai’s Islamic finance industry is the issue of liquidity management of IFIs. The lack of a developed Shari’a-compliant money market and a market for short term, liquid, limited-risk and risk-free assets means that IFIs are currently forced to retain in their books, a proportion of cash and cash equivalent investments substantially above central banks’ statutory ratios. This is due to the weakness of available Shari’a-compliant instruments, such that IFIs prefer to retain excess funds in lieu of investing them, thereby forfeiting a return on those funds. In particular, there is a lack of tradable Shari’a-compliant money market instruments. The creation

of a sovereign or quasi-sovereign short term sukuk market, akin to the US T-bill or UK’s gilt markets, is, therefore, essential. Bahrain is the first GCC country to have addressed this issue, and subsequently has established a pattern of short term sovereign sukuk issues. However, these issues of short term sukuk are based on Salam, a debt-like instrument that cannot be traded in the secondary markets at a price other than par, as any premium or discount would give rise to Riba (interest), and render the instrument non-Shari’a-compliant. This issue is recurrent and applicable to most Islamic money market instruments that are largely based on debt-like instruments such as Murabaha and Salam. The consensus in the GCC jurisdictions, unlike in Malaysia, which permits Bay Al Dayn or the selling of debt, is that these instruments can only be traded at par. In Dubai, the launch of the NASDAQ Dubai Murabaha platform on April 1st this year is a positive first step to reaching these objectives. However, the tradability of these instruments at a premium or discount in the secondary markets is still likely to be limited. The interbank market presents similar challenges as well, whereby IFIs currently rely on commodity Murabaha transactions for the management of their own liquidity with other IFIs. However, not all IFIs accept dealing with these types of instruments and the transaction costs involved are rather high compared to their conventional equivalents. There is also a lack of a lender of last resort for UAE IFIs, as unlike other prominent Islamic jurisdictions such as Malaysia and Indonesia, the Central Bank of the UAE is yet to establish a Shari’a-compliant short term instrument for this purpose. The development of a standard Shari’a-compliant repo agreement is, therefore, fundamental. Notwithstanding the challenges set out above, Dubai offers remarkable opportunities for Islamic finance players, financiers and companies alike. Issuances of sukuk and syndications of Shari’acompliant facilities are consistently oversubscribed. Recent examples of demand for Shari’a-compliant instruments include

the Investment Corporation of Dubai’s $700m sukuk issuance (three times oversubscribed), Aldar’s $750million sukuk (three and a half times oversubscribed), GEMS Education’s $200m hybrid sukuk (oversubscribed before final pricing), and Al Hilal Bank’s $500m hybrid sukuk (three times oversubscribed). The short supply of Shari’a-compliant instruments is a determinant factor in the oversubscription of sukuk and syndicated facilities. The amount of total Islamic banking assets globally of $1.7trn is still less than 1% of total global financial assets. A growing number of Islamic funds and Takaful companies require increasing amounts of Shari’a-compliant assets to balance their portfolios with Shari’a-compliant fixed income type instruments. Further, there is a growing demand from international investors for instruments giving them exposure to the GCC and Asian debt capital markets, including sukuk and Shari’a-compliant instruments. This increased demand represents a great opportunity for IFIs looking to arrange sukuk and Shari’acompliant instruments, as well as companies looking for investors in their debt instruments. On the other hand, IFIs tend to have enormous amounts of liquidity, providing corporations with a robust alternative source of financing to conventional finance. Finally, the remarkable growth of the Islamic finance industry globally presents exciting opportunities for financial centers around the world. Dubai is centrally located where east meets west, making it more accessible than some Islamic economies, and has come very far in terms of cementing its position as a leading Islamic jurisdiction. However, to fulfill its ambitions of becoming the global Islamic finance hub, it is fundamental to establish a set of regulations (that also incorporate a global framework), develop short term, liquid, Shari’a-compliant markets, and establish a set of long term pillars. In addition, Dubai’s success is heavily dependent on the consumer’s level of understanding of Islamic markets and the economy, emphasising the importance of marketing and educational programs. n

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Foreign inflows Bolivia’s president Evo Morales, left, listens to Sri Lanka’s president Mahinda Rajapaksa during a meeting at the presidential palace in La Paz, Bolivia, Monday, June 16th this year. Rajapaksa visited La Paz, after participating in the G77 + China summit in Santa Cruz. Photograph by Juan Karita for AP. Photograph provided by PressAssociationimages,com June 2014.

Sri Lanka exchange implements new business growth plan Sri Lanka’s Colombo Stock Exchange (CSE) has been on a bull run since 2009. Significant post-war growth saw the exchange’s benchmark All Share Index (CSEALL) peak at 7,800 points in February 2011 and although a correction came shortly after, positive market sentiment and a conductive regulatory environment has driven market recovery since mid-2012. Strengthened by an improving economy, the stock exchange appears to be entering a new phase leveraged on strategy, innovation and a redefined business model. Andrew Neil reports. N 2009 THE Sri Lankan government formally declared an end to the 25year civil war after the army defeated separatist Tamil Tiger rebels. Since then, in the post-conflict economy, Sri Lanka has recorded some useful milestones. Per capita income doubled to over $2,900 in a relatively short period, the economy has grown to a robust $59bn last year, from about $24bn in 2004; inflation has been held at single digits for more than four and a half years; poverty levels are down to around 6% from about 15% and unemployment has been reduced to less than 4%. Clearly, the list of ‘have dones’ is an impressive one. Similarly, for the country’s capital markets, much has been achieved.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

As war came to an end, CSE’s market capitalisation was a mere $5.2bn with just 230 companies listed. However, since 2009, the market has grown up by 189% reaching a market capitalisation of $19bn. 59 new companies have been listed with the total number of listings reaching 289. The benchmark CSE All Share Index (CSEALL), on average, has outperformed some of the leading global and regional indices between 2009-2013, ranging between 5300 and 6500 in recent times. “There is undoubtedly positive momentum in the country and its capital markets,”says CSE’s chief executive officer Rajeeva Bandaranaike. “However CSE’s mission and strategic thrust extends beyond purely market performance.“The

Recent signs suggest that Bandaranaike’s goal of luring foreign money to Sri Lankan shores is well underway. 2012 saw net positive flows of foreign investments totalling LKR39bn (around $300m), signalling confidence in the country’s economic prospects after net outflows in 2010 and 2011. This positive trend continued into 2013 with net foreign inflows reaching LKR23bn. Data from CSE shows that most of last year’s foreign investment went into banks, finance and insurance. The banking sector’s total loan book has grown at 16% CAGR over 2009-2013 on the back of increased economic activity. In an effort to uphold the growth, the Sri Lankan government has extended several incentives to the financial sector. One proposal allows National Development Bank (NDB) and DFCC Bank to raise up to $250m each for foreign sources over a ten year period with the idea to provide longterm financing to key growth sectors. Foreign investment into beverage, food and tobacco was also positive, hardly surprising given that tourism remains central to Sri Lanka’s growth story. Post-war, the number of tourist arrivals has doubled, leading a boost in activity from retail firms and local and foreign hotel developers. “Hotels & travel, diversified food and beverage, food and tobacco sectors have consistently traded at higher P/E multiples than the market over the past four years, which reflects their growth trajectory,”says Bandaranaike. “Manufacturing, power, land and property still trade below the market, and present attractive investment opportunities.” Bandaranaike adds that CSEALL has little or no correlation with major worldwide indices, thus making it a good diversification option for investors.”

SRI LANKA BENEFITS FROM REFORM

exchange’s strategic direction, and its roadmap for transformation, constitute a four-pronged approach for growth. Our strategy encompasses capturing further investment flow, enhancing the CSE’s attractiveness as a fund-raising venue, transforming intermediaries and internal competencies to foster growth and developing into a world class organisation.”

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SRI LANKA BENEFITS FROM REFORM

Boosting foreign investment has been a major focus for the exchange. Together with the Securities and Exchange Commission of Sri Lanka (SEC) and Bloomberg Data Services, CSE has held “Invest Sri Lanka” forums in Mumbai, Dubai, Hong Kong and in London in order to take Sri Lanka’s value proposition global. “So far we’ve been pleased with the high numbers of institutional, high networth investors and fund managers showing interest,” adds Bandaranaike. “Three or four years ago we would be dealing with established emerging market institutional investors, now the interest is broadening to a wider number of players.” Foreign funds currently contribute almost 37% of trading. The likes of Wasatch Fund, BBH Mathews Asia Fund, Malaysia’s sovereign wealth fund Kazana, Aberdeen Group are among leading foreign funds who have invested the market. Speaking at the most recent Invest Sri Lanka forum in London, Gordon Fraser, fund manager and a member of the emerging markets specialist team at BlackRock noted that the long term prospects of investing in the country are the most attractive in the frontier market universe. “It is only in the last 18 months that we have put serious capital to work [in the country] and I would say that now is an excellent time to invest in Sri Lanka. I am very positive about the outlook of the economy. In my opinion, the best economic growth stories are supply side led. Here Sri Lanka can excel, adding infrastructure where it did not exist before,” noted Fraser. “The country is also adding port capacity to leverage its position on east-west shipment routes, transforming into a transhipment hub and working on the provision of more efficient and powerful power capacity. These very simple improvements will have a very large impact on the productive potential of the economy.”

Domestic investment Domestic investment is a high priority for the exchange, as Bandaranaike explains. “Education is a key element of creating interest in our market and promoting investment, especially amongst nascent

domestic investors. Over the year significant effort was put into understanding, educating and inspiring retail investors.” Last year CSE opened several new regional branch offices to capture a growing number of domestic investors. The exchange expanded its local footprint by setting up new branches in Anuradhapura, Ratnapura and Hambantota. Additionally the branches in Jaffna and Negombo were relocated to venues offering greater accessibility. Still, CSE’s market capitalisation of USD$19bn (around 30% of GDP) is low compared to that of most other emerging markets in the region. The regional average is 168% whereas the world average is 74%. Increasingly market capitalisation to 50% of GDP is seen as a key target, and formed the basis of a 10 point action plan introduced by Sri Lanka’s Securities and Exchange Commission (SEC), along with the CSE, in 2013.

Reform “Obviously the infrastructure is the starting point,” says Nalaka Godahewa, chairman of Sri Lanka’s Securities and Exchange Commission (SEC). “Though we were way ahead of our regional counterparts in the early 1990s in terms of infrastructure, we fell short during the last two decades. We are currently in the process of upgrading our broker back office systems for better management of information. Trading platforms are being enhanced particularly to handle the debt trading requirements. By the end of 2014 we hope to complete the implementation of a CCP system.” Increasing market liquidity is also a critical requirement. There has been a collective effort to boost the amount of listings on the CSE. Sri Lanka’s 2013 budget offered a 50% tax concession for companies who list before April 2014 and agreed to maintain a minimum 20% public float for the next three years. “Two major policy decisions that have been approved by SEC recently will also help those considering listing,” says Godahewa. “One is reintroducing the practice of listing by way of Introduction. Secondly we have agreed to allow BOI

companies to list on a separate board without having to wait three years to list on the main board. Both these policy papers have been extensively discussed both at CSE and SEC to address all possible concerns.” CSE chief Bandaranaike also says that talks have been held with the London Stock Exchange over setting up an AIMequivalent market for Sri Lanka, which would entice potential Sri Lankan SME issuers to view the market as a source of funding. The exchange has also revamped its Issuer Relations unit to focus more on issuer development through a process of direct and dynamic engagement. In late 2013 the exchange only had equity and debt instruments available and equity was almost 98% of the securities market. However, the SEC has recently drawn up several initiatives including the removal of the 10% withholding tax to promote Sri Lanka’s corporate debt market. “We were happy to note that companies have seen the potential and during 2013 there were 16 issues of listed debentures and several others are in the pipeline,”adds Godahewa. “But we like to see more products in the market such as derivatives. When market fortunes are fluctuating solutions such as short selling, futures , options etc are necessary to keep the market alive and expanding. All these are possible once we introduce a CCP.” Godahewa explains that the SEC has already drafted a new Act which was submitted to the Ministry of Finance in July 2013 to obtain the cabinet approval and the Ministry is currently studying the same.“The new bill has been presented to parliament,” he says. “The amendments give more teeth to SEC to take prompt enforcement actions by creating provisions for civil and administrative sanctions following global practices. The Act will also provide for the functioning of a demutualised exchange and a clearing corporation. Invariably the amendments to the 25-year-old SEC Act will bring about the policy shift to strengthen enforcement activities, enhance market transparency, increase market efficiency and liquidity, thus supporting the safety and soundness of the financial system.” n

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Photograph ÂŠ Cuteimage/Dreamstime.com, supplied July 2014.

Understanding the pitfalls of financial modelling HE PRINCIPLE AIM of fundamental value analysis is to comprehensively define a shareâ&#x20AC;&#x2122;s value. A simple definition of the intrinsic value of a company refers to the underlying worth of the company, derived from its core business functions. An extended definition would include the intangible aspects of the company, such as the companyâ&#x20AC;&#x2122;s management, which is more challenging to approximate. By calculating a shareâ&#x20AC;&#x2122;s intrinsic value, we are able to determine whether it is overvalued or undervalued, and thereby identify buying or selling opportunities. As with any financial model created for valuation purposes, the accuracy of the output relies heavily on the inputs used: the GIGO (garbage in, garbage out) rule applies. So what happens when the reliability of the required inputs is called into question? Additionally, where does that leave investors and traders who rely on reports and published research material to make their decisions?

FTSE GLOBAL MARKETS â&#x20AC;˘ JUNE-AUGUST 2014

In reality, research analysts combine several complex models that may rely on reams of data in order to draw a conclusion on the value and prospects of a company. A far more basic valuation model has been set out below to show how sensitive a model can be to the inputs used. As an example we will look at the Capital Asset Pricing Model (CAPM). The CAPM can be used to derive a required rate of return for an asset, given the relevant risks involved in the trade. This allows an investor to establish whether the possible returns on the trade are warranted given the risk they would be taking on in the position, using the following formula: đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x2013;) = đ?&#x2018;&#x2026;đ?&#x2018;&#x201C;+đ?&#x203A;˝đ?&#x2018;&#x2013;(đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x161;) - đ?&#x2018;&#x2026;đ?&#x2018;&#x201C;) The basic idea of the model is to measure the minimum required return an investor should expect from an asset by comparing its risk to investing in risk free instruments. The CAPM model uses 3 key variables:

FINANCIAL MODELLING

As with all fields of study, the foundation of the investment industry is governed by a set of theorems originally hypothesised by the industryâ&#x20AC;&#x2122;s practitioners and only accepted as the industry standard after years of application and testing. These theorems, developed over time, have formed the foundation of todayâ&#x20AC;&#x2122;s financial models and valuation techniques and as such are relied upon for investment decisions. Without a sound model to rely on, investors are left throwing darts at a stock list and hoping for the best. By Julian Edwards, trader at IGâ&#x20AC;&#x201D;a UK-based provider of spread betting.

đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x161;) = Expected Market Return The rate of return of the market, for example the return of the S&P 500 over a one year period. đ?&#x2018;&#x2026;đ?&#x2018;&#x201C; = Risk Free Rate (RFR) This is the rate of return that can be expected from an investment in Sovereign debt, such as a US government bond. đ?&#x203A;˝đ?&#x2018;&#x2013; = Asset Beta The Beta measures the unsystematic risk of an asset compared to the market. It is expressed as a correlation between the market and the asset in question, and depicts the expected movement of the asset given a movement in the market. Now, consider the following hypothetical figures for a supposed investment: đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x161;) = 12% đ?&#x2018;&#x2026;đ?&#x2018;&#x201C; = 5% đ?&#x203A;˝đ?&#x2018;&#x2013; =0.5 Which produce a required return of: đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x2013;) = 5%+0.5(12%-5%) = 8.5% Next, assume that the RFR was actually closer to 6%. This would produce a required return of: đ??¸(đ?&#x2018;&#x2026;đ?&#x2018;&#x2013;) = 6%+0.5(12%-6%) = 9% A difference of 1% is immediately multiplied fivefold: and this figure is merely a starting point, which would filter its way through a complete model. The seemingly negligible difference in required returns has the potential of being amplified through the multiple steps of a valuation model, and the difference in the final output may be vastly different given the two figures. As investors and traders, we rely on material published by analysts to make sound trading decisions; the average trader may lack the resources and expertise to successfully create or implement their own models. We should not, however, take information provided for granted, but instead accept the challenge to educate ourselves and develop a better insight into the models used by our preferred research houses. By doing so, we would have a better understanding of how figures we rely on are derived: the variables impacting them and possibly the pitfalls of the models in circulation. An informed trader participates in the market with less risk and more confidence, knowing that they have taken steps to safeguard themselves against bad decisions. n

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RESURGENCE OF VOLATILITY CREATES OPTIONS OPPORTUNITIES

Any memory of last year’s lowest recorded levels of volatility since the financial crisis has surely been erased by the usual suspects list of macro trends. These include, but are not confined to, uncertainty around the pace of growth in China, the trimming of quantitative easing in the US, and mounting concern over instability in a range of frontier markets, including the Ukraine and Syria. This mix has meant that 2014 has already been marked down as a volatile year. Even so, for some investors a volatile market does not have to mean market losses. Ben Few Brown, director, Arcanum Asset Management looks at the opportunities extant in the options market and provides a ready primer to the options available.

Making profits by trading volatility RADERS AND PORTFOLIO managers are no strangers to volatility. Since the financial crisis, hedging against volatility has been a major theme of risk management. Beyond this, however, a growing number of investors are actively making profits by trading volatility on equity indices through the use of options. Volatility is essentially a measure of uncertainty and the most common way to trade it is via options, as the expected future volatility of the underlying instrument is a key determinant of an option’s value. Specifically, the cost of an option depends on how much time remains prior to expiry, how close the option price is to the market price of the index (for example) on which it is based and, most significantly, the anticipated volatility in the price movement of the index over the life-time of the option. Calculation of the anticipated or implied volatility depends on a number of elements, including historic volatility over a certain time period, usually gauged in readings of around ten, 20 or 30 days back from one day’s closing price of the underlying instrument. While the past can provide some guidance to the future, this guidance is not infallible and experienced options traders make use of a series of sophisticated mathematical algorithms to assess the value of an option against its current market price. Professional options traders or investment managers tend primarily to be sellers, either of ‘call options’ (giving the options buyer the right to buy the underlying instrument at a predetermined price and time) or, conversely ‘put options’ (giving the options buyer the right to sell

at a predetermined price and time). These actions, however, are one dimensional; capturing and profiting from volatility requires more complex structures. For example, a short volatility trade could be a sale of both an out-of-themoney call option (that is, an option whose price, formally ‘strike price’, is above that of the underlying index) and at the same time sell an out-of-the-money put option (where the strike price is below that of the underlying index) and couple this purchase of both with a call further out on the upside, and a put further out on the downside. This type of trade, commonly known as an ‘Iron Condor’, is a limited risk, non-directional options trading strategy designed to have a high probability of earning a predetermined profit. How? The aim is to monetise the changes in the value of the implied volatility within an options price. In the example above which could apply to an index such as FTSE100 or EuroStoxx50, the seller receives money from the buyers of both call and put options and pays out less money to buy his own call and put options (cheaper because their strike prices are further away from the current index level) which provide insurance cover against extreme events (that is, major index gains or falls). Thus the seller’s income from the trade is ‘locked in’ whether the index goes up or down. Such a strategy is genuinely non-correlated to the index and has the potential to generate double digit annual returns.

Shares versus indices Exchanges list a broad range of individual equity options as well as index options but those professionals looking

for regular returns tend to focus on indices which diversify the risk of single company events. That said, single stock options have their place. For example, at the time of writing, options on Pfizer and Astra Zeneca shares are trading very actively! However, it is not just a question of what to trade but when to trade. Ultimately, the aim of any options trade is to find the sweet spot of the ‘time decay’ premium. As an option nears the end of its life, its value erodes quickly and, to an extent, predictably. At this point, professional options investors tend to apply a safety net, buying cover against unexpected events with cheap options priced away from the current market level. In some cases trading the volatility of index options has been proven to deliver annual returns in excess of 20%. Analysis by Arcanum Asset Management, an index options specialist, over a 30 year period has shown that there is an almost 90% probability that each month a trade will be profitable. For example, from January 1984 to December 2013, the number of times the FTSE100 and the EuroStoxx50 fluctuated within a 5% range in an eleven day trading period was 88%. It moved out of the 5% range only 45 times out of a possible 359. Spikes in market volatility can cause drawdowns but the evidence shows that the strategy rebounds quickly. As long as the probability model remains the same, the income will soon outweigh any losses. Investors have had their performance and yield expectations continually managed downwards over the last few years and in 2014 they are impatient to boost returns. n

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Looking for market noise N THE OLD cowboy movies the hero would get nervous because it was “too dammed quiet out there” and that is certainly the way people are feeling at the moment. There is a whole raft of commentators pointing out that things are expensive, but to my mind this is all part of the ‘wall of worry’ that equities traditionally have to climb. After a big sell-off, investors tend to shun whatever risk they perceive to be the problem and in the case of equity market sell-offs it is usually defined as equities themselves. It happened in 1987, 1994, 2000, and 2007. Certainly if you think there is something magic about the number 7 then surely we are due another one now? There is of course a business case for predicting a sell-off. Nouriel Roubini had been forecasting a crash for several years before 2008 came along and even though it was for a completely different reasons he achieved guru status. There is thus something of a scramble to issue warnings at the moment just to claim “I told you so”. Many of these commentators are pointing to the low level of the VIX index, often using the lazy shorthand of“the Fear Index”as evidence that something is amiss. The VIX is in effect the implied volatility from the price of options, realistically put options. If it is low then it tells you that there is low demand for versus supply of put options. Certainly if we look at the ratio of puts to calls it seems that those who are active in the options markets are more inclined to calls—the ratio of around 0.5 is at the low end of the long term range—but perhaps this is a new normal? We have only ever gone above 1 in extreme liquidity crisis moments in 2008/9 and 2011. The spread between bulls and bears on

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

Photograph © Alexmoe/Dreamstime.com, supplied June 2014.

the AAII US investor sentiment index is also positive (often seen as a contrarian indicator) but then again those pointing to it tend to keep quiet when it is negative—as it was in April, just before the S&P staged its latest rally. The favourite bear story back then was the high level of margin debt to market cap, but this too has fallen back. Perhaps then the reason the VIX is low is that the leveraged players are no longer in equity and thus have less need to buy protection? If people now own stocks rather than rent them, does that mean volatility drops permanently? Almost certainly not, but it does all add to the nervousness. Lately I have noted that despite lurid headlines of soaring and crashing, the S&P has had 38 straight days without a move of 1% or more, the second longest streak in 15 years. The latest violence in the Middle East is helping matters of course but apart from a spike in gold and oil prices, investors seem unsure how to ‘play’ this. Even the price of Iraq bonds doesn’t appear that worried and emerging markets generally seem to be more occupied in closing the value gap with the US than any possible changing circumstances. We need to watch this, it certainly suggests that parts of MEA need

a higher risk premium. Friday the 13th, a full moon and rumours of the Iranian Revolutionary Guard coming over to help control the latest bad guys are all pointing to a higher state of nerves. The question then becomes: exactly which risks do investors want to take? You have to take some and if you are receiving a return, the biggest risk is not knowing which risk you are taking. Much as I would urge long term investors to harvest the return from volatility, many are unwilling or unable to do so. Equally limiting drawdown risk and finding genuinely decorrelated assets are sensible ideas. At AXA Framlington we are consciously not taking as much credit risk as the benchmark. We do not hold anything lower than BB-, recognising that actually 80% of the return to the strategy is from equity and hence we want equities with growth prospects rather than distressed high yield or value stocks. In this instance, high credit risk is not something we need to take. For those able to accept more volatility, there is the attraction of global small cap, almost twice the volatility of convertibles since 1998, but almost twice the return as well. We know that size is one of the factors in Fama and French’s famous three factor model with the implication that the excess return is a function of the higher ‘risk’ you take with smaller companies. Certainly if you define risk as volatility it seems to be a trade off, but if you are a long term investor and can ignore volatility is this a risk free return? Intuitively the answer is no. For small companies the risk should actually be higher because smaller companies are more likely to fail, have limited access to financing and have other associated business and cycle risk. n

THE FREE EQUITY UPSIDE OF MARKET VOLATILITY

Markets are nervous because they are so quiet. Volatility in equities remains low, probably because all the leverage has gone once again into fixed income and these carry trades continue to distort the ability of market prices to tell us about the real economy. Which risk to take rather than believing return is available ‘risk free’ is an important discussion point these days. Mark Tinker, head of AXA Framlington Asia, believes those still concerned about volatility get a free equity upside with global convertibles while those happy to embrace it should consider global small cap.

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MULTI-PARTY/MULTI-CONTRACT ARBITRATION SCENARIOS

Partner Nicholas Greenwood and associate Richard Ellison, of global law firm Morgan Lewis’ London office litigation practice, provide an overview of the problems that can be encountered with regard to joinder and consolidation in international arbitration.

Effective multi-party/ multi-contract arbitration ISPUTES ARISING FROM multiparty and multi-contractual relationships frequently give rise to difficult issues in international arbitration. Most commonly, these occur when one or both parties to an arbitration wishes either to join a third party to the proceedings (joinder), or to consolidate parallel arbitral proceedings (consolidation) so as to avoid conflicting awards and the expense of multiple proceedings. The arbitration community is aware of the increasing demand for joinder and consolidation, and is taking steps to ensure that these are possible. However, parties should be aware of the difficulties involved, and it remains the case that joinder and consolidation are more likely to be successful in national courts than in arbitration. It should also be borne in mind that an arbitration agreement providing for joinder and/or consolidation may require the cooperation of the parties to a dispute at the time the dispute occurs—which may be the time that such cooperation is least likely to be forthcoming. Various problems can arise in relation to both joinder and consolidation, many of which stem from the fact that party consent is the cornerstone of the arbitral process. It is the parties’ express agreement to arbitration which empowers the tribunal and waives the parties’ right to invoke the courts’ jurisdiction; joining an unwilling non-signatory to the proceedings, or consolidating proceedings without the consent of the parties, is in direct contradiction with the consensual nature of arbitration. Although in certain cases consent can be deemed to be implied (for example, by conduct or in a group company context), the default rule is nevertheless that the consent of each party

must be unambiguously demonstrable if any resulting award is to be safely enforceable (notably, to satisfy the requirement for ‘agreement’ in the New York Convention). The right of the parties to participate in the selection of the tribunal is also fundamental, and can pose particular problems when attempting to join a party to existing proceedings where a tribunal has already been constituted. A request for joinder prior to the nomination of the tribunal will generally have a greater chance of success. The International Chamber of Commerce (ICC) Rules expressly require that a Request for Joinder will only be considered where it is made before the confirmation or appointment of any arbitrator). The draft updated London Court of International Arbitration (LCIA) rules, which are expected to come into force some time in 2014, and 2012 ICC rules give the supervising authority the right to nominate the tribunal in the absence of agreement between the parties. Delegating responsibility for nominating arbitrators to the institution potentially allows the appointment of the arbitrators to proceed regardless of further claims and interventions, although it can result in the appointment of arbitrators of questionable ability. A further means of achieving an equitable nomination process is to provide in the arbitration agreement that each side (of one or more parties) may choose one arbitrator, with the institution acting only if agreement cannot be reached. Alternatively (although potentially costly, and rare in practice), a five-member tribunal can be constituted. Joinder of parties to arbitral proceedings is possible under both the existing and draft LCIA rules, although both the applicant and the third party must

expressly consent to such joinder at the time it is requested. Joinder is also possible under the ICC Rules 2012. Consolidation, although permissible under the ICC Rules 2012 and the new draft LCIA Rules, should be approached with caution. The draft LCIA Rules allow the tribunal to order consolidation if agreed by the parties in writing and approved by the LCIA Court. Consolidation can also be ordered under the draft LCIA Rules where there are multiple arbitrations involving the same parties and only one tribunal has been appointed. However, LCIA approval is still required, and the tribunal should seek the views of the parties. Under the ICC rules, arbitrations can be consolidated if the legal relationships between the parties are connected, the parties are identical or either party has requested consolidation, and the terms of reference for both arbitrations are not yet signed. A significant obstacle to consolidation of concurrent proceedings is the inability of arbitral tribunals to bind other tribunals, even if the matters in dispute are the same. Each tribunal will in principle issue its own decisions. Although achieving joinder and consolidation cannot be guaranteed, the chances of success can be maximised in various ways: by choosing arbitral rules which expressly permit joinder and consolidation; by signing a separate standalone ‘umbrella’ dispute resolution clause; by incorporating a global arbitration agreement by reference into each contract; by including a materially identical arbitration clause in each contract in multicontract transactions providing for joinder and consolidation; and/or by agreeing that both ‘sides’ of a dispute will each jointly nominate an arbitrator. n

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CLOs: on the road for a comeback? “

ITH A CONTINUED favourable interest rate environment and strong investor demand, CLO issuance has been on a tear, and we’re very pleased at the opportunity to work with both portfolio managers and placement agents in bringing major deals to market,”says Elizabeth Hardin, partner at Millbank, Tweed, Hadley & McCloy, which advised BoA Merrill Lynch as initial purchaser in structuring and issuing the CLO securities. Hardin said.“The offering for Onex Credit was a milestone for the company and it is the largest CLO so far this year in the United States.” Milbank’s Alternative Investment Practice has advised on over 20 CLO transactions priced and closed in the US and Europe valued at approximately $10bn in debt and equity issued so far this year. Canada’s Onex (TSX: OCX) is a regular issuer in the CLO market. Its last deal before this one involved $420m of securities in a private placement transaction in March this year that included $43m from Onex. In addition to this latest offering, Onex Credit currently manages over $3.7bn in senior secured loans and high yield bonds in a variety of strategies, up from $3.3bn at the end of last year. The credit quality of both new and outstanding collateralised loan obligations (CLOs) in both the US and Europe has stabilised, after deteriorating somewhat in 2013, according to US and European CLOs: A Mid-year Sector Update, a new report from Moody’s. “In the US, CLO credit quality remains strong, having stabilised after some deterioration over the past year,” says Min Xu, a senior credit officer at the firm. Heavy bond and loan issuance in the US have allowed many companies to

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

Photograph © Zucker66/Dreamstime.com, supplied July 2014.

refinance and extend their debt maturity profiles, postponing the debt maturity wall to 2018. Robust investor demand has outweighed supply, which has resulted in looser underwriting standards for collateral loans and spread compression in CLOs. “Transactions have both strong collateral coverage and adequate buffers for their quality-test covenants, which has kept up the quality of CLO 2.0s (those issued after 2009), despite a decline in the credit quality of new leveraged loan issuers.” According to Moody’s, debt issuance with more issuer-friendly structures, such as covenant-lite loans, continues to increase. Moody’s latest research shows that the default rate of covenant-lite companies is no longer lower than that of the overall speculative-grade population, and that although the recovery rates for first-lien covenant-lite loans remain consistent with those for “covenant-heavy” loans, the debt cushion for covenant-lite loans is eroding. Nonetheless, the core fundamentals for most industries are stable and default rates for speculative-

grade debt are at historic lows, which helps buttress the credit quality of CLOs. “In Europe, the credit quality of CLO 1.0 deals has also stabilised, after a rather long period of deterioration following the financial crisis,” says Ian Perrin, a senior vice president at Moody’s. “As in the US, deleveraging continues to push over-collateralisation levels in CLO 1.0 deals up sharply. Moreover, the speculative-grade default rate has more than halved since December 2013, as the euro area economies continue to recover.” US CLO issuance has grown significantly over the last year and a half, particularly of late, and is on track to reach an all-time record this year. As of the end of May, 74 US CLOs that Moody’s rated had closed, amounting to $35.8bn. In addition, Moody's assigned ratings to two repackaging transactions of CLO tranches and six refinancing transactions. CLO issuance has picked up even more significantly in June, when Moody’s assigned definitive ratings to another 22 US CLOs and provisional ratings to 11 US CLOs. European CLO issuance has also picked up this year, after resurfacing in 2013 following a somewhat prolonged dormant period. By June, seven European CLOs that Moody's rated had closed, amounting to €3.2bn, up from €2.3bn for the same number of deals in all of last year. The refinancing needs of European companies, combined with the large percentage (more than 90%) of European CLO1.0 deals that are now in their amortisation periods, are main reasons for the pick-up in new issuance. Individual deal amounts have also grown considerably. The average deal amount so far this year is €456m, up from the €323m average for all of last year. n

WHY CLO ISSUANCE IS ON A TEAR

The Collateralised Loan Obligations (CLO—a leveraged structured vehicle that holds a diversified portfolio of loans and bonds funded through the issuance of long-term debt in a series of rated tranches) market is steadily regaining steam. Onex Credit Partners $1bn CLO is the largest CLO deal closed through the first half of this year. Onex Credit, which is the credit investing arm of Onex Corporation, will serve as portfolio manager. This was Onex Credit’s sixth CLO transaction and first to allow compliance with European Union Risk Retention requirements for affected investors.

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IN THE MARKETS

LEGISLATORS PUSH HEDGE FUNDS INTO MAINSTREAM

When Congress passed the JOBS Act in 2012 it swept all except the smallest US hedge fund managers into the SEC’s regulatory purview as registered investment advisors (RIAs). Hedge funds had become victims of their own success: they were too big to ignore but remained exempt from most SEC regulations. An industry renowned for creativity has turned a challenge into an opportunity, however. Managers have embraced their RIA status, launching new vehicles that meet the daily pricing and liquidity required of mutual funds but employ hedge fund investment strategies, albeit in modified form. The innovation has helped propel industry assets to new highs—$2.7trn at March 31—but a structure familiar to retail investors could attract some who do not understand the risks. Neil A O’Hara reports.

Innovation boosts hedge fund inflows CCELERATED GROWTH IN hedge fund assets was the last thing legislators’ intended, but they can take some comfort from the latest Hedge Fund Research figures on asset flows. Investor outflows in 2008 and 2009 totaled $285bn, greater than aggregate inflows of $249m in all subsequent years through March 31st, 2014. More than 80% of industry asset growth since the post-crisis low of $1.4trn derives from market price appreciation rather than fresh cash, while cumulative net inflows remain below the pre-crisis peak. The aggregate numbers disguise an important shift among investors away from funds of hedge funds toward direct investment in underlying funds. Funds of funds suffered $159bn in outflows in 2008/09 and another $60bn has seeped away since then. The drain has kept a lid on fund of hedge fund assets—at $665bn, they are now 17% less than the 2007 peak. Individual funds have grabbed all the new money and then some, plus a disproportionate share of market appreciation. At a time of historically low investment returns for many asset classes, the high fees funds of hedge funds charge have depressed performance and curbed investor appetite for the product. Among the various hedge fund strategies, event-driven has attracted the largest inflows in the last year or so. Within a category that includes activist investing, credit arbitrage, distressed/restructuring, merger arbitrage and special situations, Steve Vogt, chief investment officer at Mesirow Advanced Strategies, sees inflows focused on the latter. “Deal flow

Photograph © Sergey Khakimullin/ Dreamstime.com, supplied June 2014.

has picked up,” he says. “Companies are looking to grow, and given recent prices it has been much less risky to buy market share than to build it organically.” Equity long/short came a close second in the new money stakes. Vogt says investors want to participate in the equity bull market but in a conservative way that cuts volatility if the markets turn down. Performance has been strong, too; the binary risk-on, risk-off mentality that dominated investor sentiment for three years after the crisis has ebbed, giving stock pickers a chance to shine.“Correlations between stocks are much lower than they used to be,”says Vogt.“There is more idiosyncratic movement between stocks than we saw in the past. Among our own managers we see much more stable security selection alpha being created.” Even though hedge fund investors are more sophisticated than the retail crowd, they are not immune to herd behaviour. Neil Sheth, director of alternative assets research at Boston-based investment consultants NEPC, says money flows still tend to follow past performance—in the

past year or so, money has deserted global macro (a laggard in 2013) in favour of equity long/short, where a net long bias has helped managers post good numbers during the recent bull run. Activist investors have done well, too—a long bias and concentrated positions give them an edge in a rising market—but Sheth sounds a note of caution. “It is almost to the point where investors should question their commitment to activism,” he says. “It has done so well and become so commercialised. We prefer activism in small- to mid-caps and in certain geographic locations.” The herd instinct, never far beneath the surface, raised its head again during the recent rotation away from small capitalisation and technology stocks into large capitalisation value plays. Mesirow finds that size alone does not confer sophistication among investors, however. While Vogt credits some big players with a robust, forward-looking investment culture, others apply a less flexible, governance-oriented screening that requires specific criteria to be met before committing money. “Forward-looking investors tend to get in front of market moves more than those who take a mechanical approach,”says Vogt.“Special situations is a good example. The more sophisticated investors were positioned ahead of the deal flow.”

Analytical approach At Hewitt EnnisKnupp, a Chicago-based institutional investment consulting firm, the analytical approach is forwardlooking, although Angela Cantillon,

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senior consultant, liquid alternatives research, admits that clients do not always follow the firm’s advice. If a client is large enough to make direct investments in hedge funds, Cantillon recommends a diversified portfolio rather than concentrating on particular strategies. She steers smaller direct investors toward multistrategy funds, while funds of hedge funds are used for allocations too small to justify direct investment. Cantillon has seen strong client interest in credit strategies over the past two years, both in the United States and more recently in Europe. The attraction has been higher expected returns—credit assets offer a liquidity premium on top of the risk premium—but post-crisis regulatory changes created an unusual opportunity. “The asset supply has come from a change in capital providers,” says Cantillon.“Banks have exited certain businesses and are selling related assets in order to improve their capital ratios. The environment has been ripe for talented managers to take advantage.” Managers who have milked these credit trades have done so only through their traditional hedge funds. The assets are illiquid and sometimes hard to price, which renders them unsuitable for liquid alternative vehicles that comply with the Investment Company Act of 1940. The new funds must calculate a net asset value every day and permit investors to trade in and out at that price. In effect, investors in these funds must forgo strategies that offer a liquidity premium. “It’s a tradeoff,” says Cantillon. “These 40 Act funds cannot invest in some of the underlying securities or take some of the positions one would have in a hedge fund with more restricted liquidity terms.” Sheth at NEPC doubts whether 40 Act funds will live up to investor expectations. The liquidity constraint confines them to the most liquid hedge fund strategies: equity long/short and global macro. Even within equity long/short, the new vehicles have to stick to large cap and the larger mid-cap stocks; smaller mid-caps and small caps are off-limits. The need for liquidity rules out emerging markets, too. “The 40 Act funds have to invest in the

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

Steve Vogt, chief investment officer at Mesirow Advanced Strategies. “Deal flow has picked up,” says Vogt. “Companies are looking to grow and given recent prices it has been much less risky to buy market share than to build it organically.” Photograph kindly supplied by Mesirow Advanced Strategies, June 2014.

most efficient market segments,” says Sheth. “Historically, equity hedge funds have made hay in mid-caps and small caps, where they can capture an information premium and a liquidity premium. I expect returns on liquid equity long/short funds to be lower.” Among global macro managers, the biggest and best still charge a 2% management fee and a 20% performance fee for their traditional funds. To offer an identical strategy in a 40 Act fund for a simple 1% to 2% management fee would undercut their existing product and encourage investors to migrate to the cheaper vehicle. “No way will investors get the same risk/return opportunity in a 40 Act global macro fund,” says Sheth. Funds of hedge funds have embraced 40 Act funds in an attempt to revive their flagging fortunes, but an industry that has struggled to earn robust risk-adjusted returns from traditional vehicles faces daunting obstacles. Sheth says complex and less liquid strategies have been key contributors to hedge fund returns in the past and believes they will be even more important in the future.“How can funds of hedge funds deliver without a complexity

and liquidity premium?” asks Sheth. “A more retail-oriented investor base will expect sexy hedge fund returns, but in five years they may rue the high fees and low returns, albeit with low volatility and correlation. It’s a recipe for unhappiness.” At the opposite end of the liquidity spectrum, some Hewitt EnnisKnupp clients have invested in funds that look more like private equity vehicles than conventional hedge funds, including phased capital drawdown instead of immediate funding, an investment period and a harboring period for the entire lockup, which may range up to 10 years. The funds focus on illiquid assets for either buy-andhold strategies or opportunistic investing when prices are advantageous—during market dislocations, for instance. “Some clients are comfortable with these vehicles,”says Cantillon.“They appreciate the importance of aligning assets and liabilities and this type of structure allows managers to pursue investments that may be held for a few years.” Investor appetite for less liquid assets is also evident at Mesirow, whose research shows that complexity and illiquidity offer the best returns in current markets. The firm has devised new structures with longer lockups and back-end loaded performance fees to align investor and manager incentives. “We are trying to bridge the gap and allow clients to access less liquid assets in a more stable way,” says Vogt. Mesirow has chosen to stay away from 40 Act funds, which have little appeal for its institutional client base. Nobody will shed a tear if 40 Act funds gather money from high net worth individuals, who can afford the drag if returns prove mediocre and tolerate the loss if a fund runs into serious trouble. Another— and larger—pool of money beckons, however: defined contribution pension plans, which have become the principal retirement savings vehicle for private sector employees in the US. If a 40 Act fund stuffed with personal pension money were to blow up and decimate ordinary citizens’ savings, legislators may live to regret the unintended consequences of “clamping down” on hedge funds. n

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REAL ESTATE

UK PROPERTY: OPPORTUNITY KNOCKS?

Photograph © Cienpies Design/Dreamstime.com, supplied June 2014.

Rental & refurbishment: the new property highlights According to Ben Jones, manager of the M&G Secured Property Income Fund, at M&G Investments, pension funds continue to hunt in the real estate market for attractive long term cash flows and protection against inflation. No surprise then that the current low interest rate environment makes income available from the private rented and refurbishment loan segments attractive. According to IPD, the historic performance of the UK’s resident segment, has generated total returns of 10.1% a year between 2001 and 2012, compared with 6.9% for retail property, 6% for offices and 6.9% for retail. We look at some of the trends and trendsetters in the space. HAT OPPORTUNITIES ARE there for institutional investors in the UK property markets outside the traditional institutional investment sphere of commercial property? Plenty it seems. A mere 1% of the UK private rented housing stock is owned by institutions (compared with 17% in Germany and 37% in Holland, according to real estate specialist consultancy IPD). Until recently, institutional investment money in the rental market in the United Kingdom was pretty much the reserve of

funds with specialist expertise in the sector. Among the more high profile investors is Dutch pensions giant ABP, which has utilised its administration arm APG, to enter the UK housing market. At the beginning of last year, the firm allocated £158m to a mutual fund established by listed group Grainger. In January this year Legal & General Group, which has around £440bn in assets under management announced plans to build five new towns across the UK over the coming decade, involving an invest-

ment of up to £5bn. It was a massive fillip to a still under-resourced market segment. In April, the Greater Manchester Pension Fund (GMPF) together with Manchester city council signed a £30m joint venture that will involve the construction and refurbishment of new homes for rent managed by Places for People. More recently at the beginning of June Invesco announced it was investing £32.5m in the UK residential market, buying 118 rented homes in Hayes, London from be:here, a part of Regen, the subsidiary development division of construction firm Willmott Dixon. It is the first investment in the UK rental sector by Invesco Real Estate (IRE). The investor will fund the development and hold the freehold on the assets, while be:here will administer the lettings for a fee. Willmott Dixon is the contractor on the build. This is the third multi-family project the firm has investment in since it began its residential acquisition programme in the summer of 2013. IRE plans to expand into residential investments across Europe, having most recently invested £106m into two multi-family housing projects in Germany. Much of the institutional investment interest in property until recently has been focused on the long term characteristics of the commercial (retail and office space alike).“Institutional investors are attracted to the bond-like qualities a well-diversified long lease fund offers, particularly given the yield premium to index-linked gilts. We’ve seen increasing demand from pension fund clients with liability matching requirements who also like the capital growth that can be generated by the underlying real estate over the long term,” explains Jones. M&G is typical. The asset management firm looks to identify and exploit pockets of value across the long lease property market. The firm most recently acquired Sainsbury’s superstore in London’s suburb of East Dulwich, which had 25 years remaining on a 30 year lease. “What’s unique about it in the current market is the strength of the lease, which offers annual RPI rental uplifts with a valuable collar of 1.5% to 5%. The long

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term value of a site can also be measured by its future development potential, which is particularly strong in this case, given its location in a desirable residential area of London,” he adds.

A shift in outlook

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June 6th 2014. The former UK headquarters of News International in Wapping is demolished to make way for a new housing development. Photograph by Matthew Aslett/Demotix/Press Association. Photograph supplied by pressassociationimages.com, June 2014.

however the UK’s government’s piecemeal recognition of the possibilities available in the private sector and asset management industry, and the means to encourage them via tax breaks or other incentives, has not helped. Back in 2012, Sir Adrian Montague published a review of the barriers facing institutional investment in private rented homes. “We are satisfied that the rented housing sector offers potential investment opportunities of interest to institutional investors. There has been some activity

in the sector, but real momentum is inhibited by constraints affecting the supply of stock, by the treatment of rented housing schemes under the planning framework and by the need to create greater confidence among investors in the availability of good projects showing acceptable, secure returns,” he wrote.

Institutional investment to step in? There may be some systemic trends now in play which could encourage more institutional investment money in the UK

Lending for property refurbishment and development (£ million) Refurbishment and development loans (£million)

By 2021 there will be a requirement for “over 800,000 new homes” in London alone, but “the government’s latest attempt to address this crisis through increasing council borrowing capacity does not go far enough and has too many strings attached,” noted the London Council’s muted response to UK Chancellor George Osborn’s Autumn Statement, in which he announced an increase in local authorities’ borrowing cap by £150m in 2015-2016 and £150m in 2016-2017. Osborn expected that this initiative would fund up to 10,000 new homes. The Chartered Institute of Housing (CIH) pronounced it to be too modest a step, additionally voicing concerns that any gains from the increase in borrowing capacity could be offset by the attendant requirement to sell off higher value social housing through an expansion of the government’s Right to Buy programme. To be fair, the Chancellor’s autumn statement was not the only proposal in the works. Among other initiatives, in March last year, Mark Prisk (then housing minister) launched a £225m fund (part of a larger £474m Local Infrastructure Fund) to help unlock large scale local developments. As well, the government launched the Single Local Growth Fund as part of its 2013 Spending Round. Over 20152016 it will be worth $2bn in total, around which £1.1bn will come from transport budgets and £500m from skills. More recently in January this year, the government secured £500m from the European Investment Bank to help finance new home builds as part of its Affordable Housing Guarantees programme which enables housing associations to use a government guarantee to secure private investment at more competitive rates that they would otherwise achieve. Government intervention is not a prerequisite for increased institutional investment into the UK property market,

£1400

£1,287

£1200 £1000 £849 £800 £600 £512

£639

£593

£400 £200 £0 Aug12

Oct12

Dec12

Feb13

Apr13

Jun13

Aug13

Oct13

Dec13

Feb14

Apr14

Source: West One Broker Sentiment Survey, May 2014.

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REAL ESTATE

UK PROPERTY: OPPORTUNITY KNOCKS?

rented sector. For one, the private rented sector has outgrown the social rented housing sector for the first time According to data on the UK real estate market released by the English Housing Survey, some 4m people in England now live in private rented accommodation, in comparison with those in social rented housing (3.7m at the last count—a record high and twice as many as in 2000. The shift towards private renting also looks set to continue. “Aside from the simple fact that we are not building anywhere near enough houses in the UK, rising house prices and tougher financing requirements mean that people are renting for much longer before being able to buy

their own houses,” says Alex Greaves, residential fund manager at M&G Real Estate. “For institutional investors like ourselves this sea change represents an opportunity to tap into a growing market, capitalise on the experience of managing commercial property, as we have done for the past 150 years, and to invest in a sector with a history of strong returns,” he adds. The majority of landlords are still private individuals, explains Greaves, which he believes creates a“natural place here for institutional investors to add value in a fragmented sector. Short term rental agreements have been something of an issue for institutional investors, but it looks to be a

systemic trend across the property industry as a whole. Even the average commercial lease is now 4.8 years, compared with 25 years a decade ago. “Economies of scale will enable more and better facilities, higher levels of onsite services, energy efficiencies and lower utility bills. All these things are attractive to renters and will ultimately encourage them to rent for longer, resulting in a stable income stream and reduced operating costs for the investor,” says Greaves. For its part, M&G as a group committed over £300m in residential investment in 2013, including the purchase of a landmark residential development on the edge of the London’s Olympic Park and

SOVEREIGN WEALTH FUNDS EYE EUROPEAN REAL ESTATE ccording to a survey by international real estate advisor Savills, sovereign wealth funds in 2013 accounted for total investment volumes worth €5.5bn in key European markets (Belgium, France, Germany, Ireland, Italy, Netherlands, Poland, Spain, Sweden and the United Kingdom). The total is a year on year increase of 30%. The firm notes that the top five sovereign wealth funds identified by the report were from the Middle East and Asia, with an average deal size per investor group of €700m over the year, up from €247m in 2012. Among the firms surveyed is the Qatar Investment Authority, led by chief executive Ahmad Al-Sayed. Qatari money was used to build the Shard, London’s tallest building, while Qatari Diar Real Estate Investment Company is currently developing London’s Chelsea Barracks project, after finally having received approval from Westminster Council in late May this year. The project (initially proposed in 2008) is expected to be worth some £3bn. Qatari Diar bought the site from the Ministry of Defence in 2007 for just under £1bn. The two largest property deals of 2013 involved, Singapore’s GIC Private Limited which bought private equity major Blackstone’s stake in Broadgate, an office/retail complex adjacent to London’s Liverpool Street rail station for £1.7bn. The deal includes a 50% stake in 5 Broadgate, a new office building scheduled for completion in 2015, which will be let to Swiss bank UBS. Elsewhere Kuwaiti backed property firm St Martins, bought the More London office property estate from London Bridge Holdings, a Bahamas based company controlled by a group of investors led by Dikran Izmirlian, an Armenian businessman, for £1.7bn.

In terms of transaction volume Savills expects sovereign wealth funds to record similar investment volumes in 2014, albeit coming partly from sovereign funds in different countries. Marcus Lemli, head of European investment at Savills, explains that sovereign wealth funds “tend to favour low risk, core assets and will usually only target investments of at least €200m, which limits the markets in which they are active due to lack of suitable stock. However, we have seen this investor type broaden its investment spectrum looking for value in non-core deals as well as smaller lot sizes. In addition, a greater number of players are entering real estate investment.” Overall the report reveals that investment managers have the strongest presence across the markets surveyed in 2013 with domestic and international investment managers present in the top 10 of all countries monitored, particularly in the Netherlands and Germany. In these countries they represent six of the ten largest investors by volume over the year. In contrast, Sweden and Belgium look to be dominated by insurance and pension funds, usually domestic, with five of Sweden’s top investors by volume falling into this category, and three in Belgium. “This investor group tends to focus on office assets according to the analysis and, as they are usually domestic investors with local knowledge, their purchases are not restricted to tier one markets. The average deal size for this group of buyers is recorded at €80m,” says the Savills report. “We find that the pattern of dominant investors in Europe is changing as the share of global cross-border flows increases. Global buyers from the USA and Asia-Pac are reshaping

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three prime student accommodation blocks in the sea side resort of Bournemouth; the acquisition of a 534 home portfolio acquired from Berkeley Homes and the project financing of 233 residential units at Aberfeldy New Village, East London. While much of the investment activity has been in and around London, the need for new housing stock for sale or rent is extant across the country.“What we really want is our institutions to build private rented homes in the regions, to invest in healthcare, to invest in infrastructure,” noted Lynda Shillaw, director of real estate at SWIP at the Estate Gazette’s Who Owns the UK and Does it Matter? debate, held in March this year.

Refurbs: a new lease of life? Another segment of growing interest is the refurbishment and upgrading of existing real estate. It has become a significant business segment. Property refurbishment projects have seen funding more than double in the last twelve months, according to the latest West One Broker Sentiment Survey of over 250 financial intermediaries. Lending for property refurbishment and conversion now stands at £1.29bn a year, with short term secured loans providing the bulk of support. Brokers now expect refurbishment activity to grow faster than ground-up development. Short-term secured loans for property refurbishment, development and conversion totalled £1.29bn over the twelve

peripheral markets, often looking for core-plus opportunities, while newcomers to real estate investment, ranging from private investors to insurance companies, are looking for higher returns in a low-interest rate environment,” explains Julia Maurer, in Savills European research team. According to Savills’ report private buyers invested approximately €1.3bn in 2013. This represents slightly more than 3.5% of the total investment volume in Europe over the year, making them one of the biggest European investor groups. The remaining large-scale buyer types identified in the analysis include REITs, property companies, investment banks and corporate investors. The firm predicts that all the investor types (with the exception of private investors) will become less risk averse and the share of core-plus and opportunistic investments will rise. The firm believes buyers will become increasingly willing to consider opportunities in European fringe markets and secondary assets across the region. Sovereign wealth funds meanwhile are looking at property across the globe and the European element is just one pillar of an increasingly global property allocation. GIC Private Limited, for example, said at the end of May that it will invest $84m for a 14.4% stake in Neptune Stroika Holdings Inc, a hospital holding company, owned by Metro Pacific Investments Corporation (MPIC). The transaction also includes an option for FIC to buy an exchangeable bond from MPIC for a further 25.5% of shares in Neptune for a consideration of $149m contingent on various provisions. MPIC will allocate the bond proceeds to fund local capital goods projects. The deal is expected to be signed off some time in the next few weeks. The sovereign wealth fund is also reportedly interested in opportunities in Japan and Mexico.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

months to April supporting 2,800 separate projects. The total is almost double that of the previous twelvemonth period. Refurbishment loans also represent a growing proportion of all short-term secured lending. Loans for all forms of property improvement now represent 61% of total industry gross bridging lending, compared with 47% in September 2013 and 40% a year ago. “Property is in seriously short supply in the UK. Solving the gridlock will take serious imagination and better use of existing property, but at the same time, finance is becoming more flexible and more suited to this postrecession world. New lending practices are gradually bringing more properties into use—those which have been empty

Archive photo of His Excellency Ahmad Al-Sayed, chief executive officer of Qatar Investments Authority (QIA) during his address to guests, as the new amber and gold chandelier by Dale Chihuly, said to be worth over a million pounds, is unveiled, at Harrods department store in Knightsbridge, central London in February this year. Photograph by John Stillwell/PA Wire. Photograph supplied by pressassociationimages.com, May 2014.

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REAL ESTATE Last six months: Net proportion of brokers experiencing growth 60%

Proportion seeing more lending

52%

43%

45%

30%

26%

15%

0% Ground-up property development

Property conversions and refurbishments

60%

A net 57% of brokers expect growth in lending for property refurbishment and conversion, up significantly from the latest reported increase. By contrast, lending activity for ground-up development is set to grow more

57% 52%

45%

29%

30%

15%

0% Ground-up property development

Property conversions and refurbishments

Buy-to-let property purchases

Source: West One Broker Sentiment Survey, May 2014.

Buy-to-let property purchases

Source: West One Broker Sentiment Survey, May 2014.

Next six months: Net proportion of brokers expecting growth

Proportion seeing more lending

UK PROPERTY: OPPORTUNITY KNOCKS?

for too long,” says Duncan Kreeger, director at West One Loans. Short-term secured loans no longer mean purely ‘bridging’ between properties, explains Kreeger, who says that alternative lending is now much more sophisticated, “able to work in partnership with property developers to get the most out of their portfolios. New building is still significantly depressed from even its rather meagre precrisis peak, but this isn’t the only way forward. Conversion and refurbishment are just as critical to unlocking the supply of UK property. We need to make better use of the buildings we already have.” Considerably more brokers have seen growth in short-term secured property loans than have reported a decrease, according to West One’s survey. Over the last six months, a net 43% of intermediaries report growth in refurbishment and conversions. This is almost as positive as the net 52% seeing more ground-up property development than six months ago. However, this is soon expected to reverse. Conversions and refurbishments are set to overtake ground-up development by this measure within the next six months.

slowly, with 52% of intermediaries expecting growth—static from the previous six months. According to the survey, it is apparent that intermediary brokers are keen for lenders to do more to assist refurbishment projects, especially at the higher end. More than one third of brokers (36%) explicitly list property refurbishment and conversions as areas where they would like more product availability from lenders. Moreover, just under onein-five brokers (19%) say they originally started to offer short-term secured loans in response to the general recovery in the UK housing market. According to Kreeger: “Brokers understand the frontline of the property industry —and that is a scarcity of properties coming onto the market. Finance that can actually increase the pool of property in the system has always been even more useful than loans that simply facilitate purchases. Now this distinction is becoming even clearer. We need more homes in the places where people want to live, and more offices where successful firms can do business. In these cases prices are high and refurbishment can be very profitable. [However], only a handful of the most modern lenders have the flexibility and the funding lines to put the wheels in motion.” n

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Property development, infrastructure and much-needed housing top the agenda in the UK government’s plans to drive forward the British economy and to deliver a series of real estate projects around the country. Across every category of real estate, development lags the weight of investment capital looking to be placed and that money is also starting to emanate from an increasingly diverse investment world, notably Asia and the Middle East. Asian investors, led by energy-fuelled sovereign wealth funds, have spent the past 18 months snapping up properties, driving down yields and forcing traditional institutional buyers to look further afield for deals. Mark Faithfull reports.

Global inflows reshape major property asset outlook ERHAPS BANK OF England Governor Mark Carney’s recent words during his Mansion House speech might dampen enthusiasm but it seems there is little that can stop the inflow of capital into UK real estate right now, especially, of course, London. While Carney intimated that interest rates might rise a little sooner than anticipated, the

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

consensus remains that any upward movement will be in small iterations and in careful conjunction with the requisite improvements in the economy. Indeed, Carney will want to do little to derail a property industry he is reliant upon to deliver projects and particularly housing around the UK. Yet while UK private capital remains

cautious, the country has become a huge draw to international money and, notably, some of that overseas investment has started to move outside of capital London. Among deals indicative of a wider perspective, in February last year the asset and wealth management division of Deutsche Bank led a £142m deal to buy One Angel Square, a new trophy office block in Manchester’s commercial centre. Junior partner was Gingko Tree Investments, on behalf of China’s State Administration of Foreign Exchange, in its first European property purchase outside London. The acquisition was priced at an initial investment yield of less than 6%, a new low for deals outside the capital. Gingko Tree Investment, SAFE’s real estate unit, took a 49% stake in the property and the remainder was bought by Grundbesitz Europa, a real estate mutual fund managed by DWS, Deutsche Bank’s German fund management arm. The two have history: in August 2012, Deutsche helped Gingko buy Drapers Gardens, a 16-storey office building in the City of London that serves as the European headquarters of US asset manager BlackRock. Gingko has now been involved in more than £1bn of London office deals, including the £472m buyout of Ropemaker Place, EC2, with AXA and Korea Life. SAFE is far from the only Asian investor. In December, Singapore’s sovereign wealth fund GIC purchased a 50% stake in the Broadgate office complex in London for £1.7bn, in one of last year’s biggest deals. Christopher Morrish, regional head, Europe, GIC Real Estate said of the deal:“The estate will give us an attractive combination of stable long-term income with the potential to create additional value through active management, repositioning of the office buildings and by enhancing the retail and leisure offer.” The sovereigns’ buying power has helped push real estate prices in prime areas back to pre-crisis levels, with yields on recent deals in London and some prime German markets below 5%. They have been joined by the Chinese, who have, inevitably, focused on London but diversified in their sector investment. In

CAPITAL INFLOWS INTO REAL ESTATE

Photograph © Kheng Ho To/Dreamstime.com, supplied July 2014.

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REAL ESTATE

CAPITAL INFLOWS INTO REAL ESTATE

July last year, Shenzhen-based Ping An Insurance, China’s second largest insurer, paid £260m for the Lloyd’s of London building. The purchase of the iconic Richard Rogers–designed structure, was the first property investment by any Chinese insurance group outside the mainland and was described by Jon Crossfield, director at agent Savills which was involved with the deal, as a“confident entry into the market”. He added that the deal further illustrated the dominance of overseas investors in London.

Mixed use development In January, Greenland Group, a Shanghai¬based developer, bought former Rams brewery in the London Borough of Wandsworth from Minerva for about £600m.The project scope includes a 36 storey landmark tower providing 166 new flats and 9,500 sq m of commercial space of new shops, cafes, bars and restaurants. Greenland followed China’s largest property group, Dalian Wanda Group Co, which bought the Nine Elms development site at Vauxhall, in June 2013. It plans a £700 million development that will include a five-star Wanda hotel, London’s first Chinese luxury hotel. Indeed, hotels are a particular beneficiary of the overseas cash injection. Mayfairbased Grosvenor is also involved in what is probably the biggest news for London’s luxury hotel scene, with Hong Kongbased Peninsula Hotels spending £132.5m for a 50% stake alongside freeholder Grosvenor to redevelop 1-5 Grosvenor Place in Belgravia. Peninsula's parent company Hong Kong and Shanghai Hotels bought its stake from Derwent. “The luxury hotel sector in London remains very strong and there are high barriers to entry, so for us it felt like the right time. We feel it adds important balance to the Mayfair and Belgravia areas, so it is part of place making for the long term,” says Grosvenor development director Ian Morrison.“At 1-5 Grosvenor Place obviously the location is very significant and there was a real aspiration to build something significant.” This influx of money means traditional

Established institutions can find it difficult to compete for assets in central London, particularly when they are bidding against Asian pension funds that are looking for diversity. investors such as real estate funds, insurance companies and pension funds are starting to search further afield for value. A case in point is retail. The financial freeze post-2008 stopped European mall expansion in its tracks and in the subsequent period the market has fundamentally repositioned. The dash to prime meant that stakes in some of the biggest, most dominant malls have traded at extraordinary levels, while in the secondary sector finding interested bidders became all but impossible. In all, 14.1m sq m of new shopping centre space will be completed across Europe during 2014 and 2015, according to agent JLL, compared with 5.6 million sq m of new shopping centre space in 2013, itself an increase of 11.2% on 2012. The majority of the new schemes (50%) continue to be developed in Russia and Turkey. As a result, investors have begun to reappraise secondary centres and dominant regional malls and Robert Bonwell, CEO EMEA retail at Jones Lang LaSalle, adds: “Redevelopment is the new development for most established markets, as tired stock loses appeal and deferred capital expenditure comes home to roost.” There are a growing number of examples of cross-border investment, mostly through partnering with local players and specialists. Recent examples include AustralianSuper appointing TH Real Estate to invest in European retail, the Canadian Pension Plan Investment Board (CPPIB) buying into more prime schemes, Blackstone eyeing European debt opportunities and Simon Property Group entering the European designer outlet market. However, faced with a huge wave of competing capital from Asia, some domestic buyers are being forced out of markets where they have long been active players. Established institutions can find it difficult to compete for assets in central London, particularly when they are

bidding against Asian pension funds that are looking for diversity and see good value even at the high value end of the European market. Aviva and its peers — such as Standard Life and London-based asset manager TH Real Estate - have been advocating a move into smaller cities or asset management plays.

Non-domestic opportunity Ironically, that often means UK-based investors looking for non-domestic opportunities at both ends of the risk spectrum, from Germany to Ireland, where a post-crisis property bust forced the country to seek a bailout from the European Union and International Monetary Fund (IMF). Irish bad bank NAMA is likely to announce joint ventures on development projects in Dublin Docklands and in certain residential schemes in the capital "imminently", according to the agency’s head of asset management, Mary Birmingham. NAMA began inviting submissions from international and domestic firms for jv proposals in March this year, and has so far received around 120 expressions of interest, according to official statements. Ireland saw a huge uptick of foreign investment into property in 2013, which pushed overall transactions past the €2bn mark - the highest level recorded since 2006. “What we want to see now is European pension schemes investing, as this is longer-term money. Private equity investors are only looking at the shortterm. Also, institutions tend to buy with less debt, which is healthy,” warns Green REIT’s Pat Gunne. There was also a strong rise in the proportion (19%) of investors seeing Spain as most attractive for purchases in 2014, up from 6% in 2013. Madrid is now in second place to London as the most attractive city for investment. Peter Damesick, chairman, EMEA Research, CBRE, says:

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“This follows a strong proportionate rise in turnover in the Spanish investment market over the course of the past year, with sales totalling €5 billion in 2013 overall, more than double the level in 2012. We're seeing stronger interest in Europe's periphery markets generally, plus more global investment, especially from the Middle East and Asia.” Indeed, Middle Eastern investors are expected to spend $180bn in commercial real estate markets outside of their own region over the next decade, according to CBRE. The major increase in flows of Middle Eastern capital into global markets is emerging from the mismatch between the lack of institutional real estate in domestic markets and the huge spending power concentrated in the region. Europe is the preferred target with 80% of the $180 billion targeted for the region over the next 10 years. Close to $85 billion will flow into the UK, with $60 billion directed at continental Europe. France, Germany, Italy and Spain are among the key target markets. Global real estate markets have already seen a significant inflow of Middle Eastern capital with $45bn invested between 2007 and the end of 2013 – seven times the reported activity in its home market. With $20 billion invested outside their home region in commercial property in the last two years alone, Middle East SWFs are now among the world’s largest and most influential sources of capital, accounting for 35% of SWFs Assets Under Management (AUM) globally. When compared with Western and Asian SWFs, these funds currently allocate the smallest share (9% of total portfolio) to alternative assets. A further increase in allocation by Middle East SWFs, even by a small fraction, would represent an extremely large amount says Nick Maclean, managing director, CBRE Middle East.“The 'buy and hold' strategy adopted by many Middle Eastern investors within their home region and the resultant lack of deal flow opportunities leaves much unsatisfied demand here. Coupled with increased confidence in global markets and the need for diversification, overseas investment has grown strongly,” he says.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

Close to 90% of all Middle Eastern commercial real estate investment outside of the home region in 2013 was in Europe, in sharp contrast with Asian capital that has become increasingly diverse geographically in the last 18 months. While there will be an increase in allocations towards the Americas and Asia Pacific regions, the majority (80%) of direct Middle Eastern investment will target Europe as it offers diversification, cultural acceptance, high liquidity and market transparency. Jonathan Hull, managing director, EMEA Capital Markets, CBRE, adds:“The vast majority of Middle Eastern investors are long-term players looking for wealth preservation and strong high incomeproducing assets, rather than opportunistic investors playing the cycle for shortterm gains. This strategy favours prime buildings in core markets and often very large lot sizes. Offices feature heavily in their acquisitions.”

Race to deploy capital The race to deploy capital inevitably brings the risk of overpriced deals, both on the European periphery and in London. Agent Savills expects prime office property yields in Madrid will fall to 5% this year, after hitting 5.5% in the first quarter. The volume of transactions quadrupled in the first quarter from a year earlier, to €200m. Then, if the UK government really is to hit its property targets, there is the chronic under-supply of new housing. In the next 10 years £154bn is needed to meet private new housing demand in London, according to Knight Frank’s latest housing supply report. Examining all residential developments currently in the supply pipeline, over a period of 10 years, Knight Frank believes around 33,400 homes will be delivered on average each year. This is up from circa 28,000 as shown in last year’s London Residential Development Report. The figures reflect the increased activity in the market. Construction has picked up markedly over the last year in London, with a rise in planning applications seen in 2011 now filtering through to new starts. Head of UK residential research Grainne

Gilmore, says:“The average annual supply of new homes in London since 1980 has been around 16,000 a year. The city needs more than 52,000 homes a year. Activity is rising strongly, but there will still be a shortfall in the years to come.” Whether Asian and Middle Eastern monies can be enticed to such projects is another matter, as is whether infrastructure projects like the HS2 rail link speeding up connections between the UK’s major cities will be delivered by public or private capital. Chinese bank issues MBS sales after a six year hiatus: Postal Savings Bank of China came to market in mid-July with a $1.1bn mortgage-backed securitised notes. The issue by the state owned bank comes after a prolonged period of absence from the mortgage-backed securitisation segment, according to Chinabond, the capital markets data firm. The Chinese government suspended the issuance of mortgage backed securities just after the collapse of Lehman Brothers and the asset-backed issuance market. Actually, the asset-backed securities (ABS) segment globally went into freefall and is only now beginning to regain its mojo. Some press reports have it that the issue marks a wholesale return to the ABS segment but it is doubtful. However, the government has been casting around for means to revive what looks like a sagging real estate market. Nationwide housing sales in China fell 9.2% in the first half of this year, while home prices in 70 cities continued to slip in June for the second month, according to data from the People’s Bank of China, the central bank. The bank called upon lenders in May this year to step up mortgage lending, but the Chinese banking sector is reportedly burdened once more with a large slug of non-performing loans and appear reluctant to revive lending for housing at this stage. The postal bank launched the Youyuan 2014 on July 20th, pricing most of the notes to yield between 5.3% and 5.8%. The bank said the loans packaged into the securities were made to home buyers. n

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REGULATION

TOWARDS A RESPONSIBLE APPROACH TO FIDUCIARY DUTY

As the New York Attorney General’s office scratches Barclays to find out if it really did not provide sufficient safeguards to investors to protect them from predatory trading by high frequency traders and brokers fight tooth and nail over shrinking revenues, fiduciary duty looks these days to be a high profile casualty. Both the US Securities and Exchange Commission (SEC) and the US Department of Labor have been looking at the fiduciary issue for years. It’s a complex and wide-ranging discussion. The Labor Department, which oversees the regulation of retirement plans, withdrew a previous version of its planned rule in 2012, after fierce industry opposition about costs. It recently delayed its unveiling of a new proposal to early 2015. For its part, the SEC has also been considering whether to revise its adviser conduct rules. Concerned about potential conflicts between the two plans, trader associations have been pushing for coordination between the two to avoid conflicts between any resulting rules or regulation. So what does fiduciary duty actually require? Dan Barnes reports on the state of play.

New York State's Attorney General Eric Schneiderman speaks during a news conference to announce his office is filing a securities fraud lawsuit against the banking and financial services firm Barclays, Wednesday, June 25th this year, in New York. The suit alleges that Barclays told investors that it had set up safeguards to protect them from predatory high-frequency traders. But it says Barclays actually catered to those traders. The full story appears on www.ftseglobalmarkets.com. Photograph by John Mincillo, for Associated Press. Photograph supplied by pressassociationimages.com, June 2014.

Does anyone bother with fiduciary duty anymore? If not, why not? ELL-SIDE FIRMS complain about not being profitable but there are simply too many firms supplying similar services,” says Mark Northwood, global head of trading at asset manager Fidelity Investments. Corporate famine inevitably leads to corporate cannibalism, and the current excess of brokers will be

forced to consolidate as traditional revenues based on risk provision, proprietary trading and derivatives trading are eaten away. Yet in their desperate struggle to find supplementary revenue, brokers are crossing the line of fiduciary duty. Some are acting to the apparent

detriment of clients to such an extent, that their clients are trying to bypass the entire brokerage industry preferring to deal with rival asset managers. Trade routing is a good example. In the US and Europe the decentralisation of trading makes it harder to keep track of an order. That gives brokers an opportunity to take advantage of that order.“Our main concern when we started four years ago was around conflicts of interest,” says Simo Puhakka, chief executive officer at Pohjola Asset Management Execution Services. “Internalisation, maker-taker commission structures and venue ownerships. Things that were happening inside the broker infrastructure. We wanted to exclude the elements of how the broker was creating value from buy-side orders beyond being paid commissions.” Pohjola Asset Management Execution Services, a spinoff from the asset manager, has developed a smart order router (SOR) in Europe designed to help buy-side firms avoid having their orders routed by their broker. Similarly IEX, a stock exchange that launched in the US last year and is a subject of Michael Lewis’ book Flash Boys, was founded to prevent high-frequency trading (HFT) firms from being able to take advantage of buy-side orders using high-speed market data and market interaction— both supported by a two-tier technology structure within brokers and exchanges— which lets them effectively see price movements before other participants, and trade accordingly. The bond markets are even more dealer-led than the equity markets, with all trades, even those on electronic marketplaces, being bilaterally agreed

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between brokers and funds. This creates friction amongst buy-side traders, who ask why the same brokers who fight against exchange monopolies in equities will not support low-cost electronic trading of bonds. Blackrock set up a buy-side to buy-side bond trading platform, the Aladdin Trading Network (ATN) in 2011 in frustration at the lack of transparency in the dealer-led market, which traders say facilitates information leakage and conceals trading costs. "If possible everybody would move over-the-counter (OTC) markets like fixed income to regulated markets, but it is a long path,” says Christoph Mast, global head of trading at Allianz Global Investors.

Watching the watchmen Fiduciary duty has a natural tension with revenue generation, and the conflict between money and duty has rules. In the US fiduciary duty rules do not strictly apply to broker dealers, which leaves responsibility with the asset manager. The Financial Industry Regulatory Authority (FINRA, formerly the National Association of Securities Dealers), a sell-side selfregulatory body, determines how brokers ought to handle trade execution and conflicts of interest under Rule 5310. A spokesman for FINRA says,“FINRA’s rules apply specific requirements to broker-dealers that at times align with fiduciary principles and at times extend beyond fiduciary principles. While brokerdealers are subject to agency duties with regard to their broker activities, brokerdealers are not subject to a general fiduciary duty applicable under SEC or FINRA rules.” On May 29th this year, speaking to the FINRA's Division of Market Regulation, SEC Commissioner Kara Stein expressed the challenges faced in identifying conflicts of interest in the electronic markets.“One of the challenges we at the Commission face with our enforcement efforts is that most violations require proof of intent,” she said. “If a trader is knowingly conducting a strategy to manipulate or lure another trader into an order, then you might have phone record-

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

ings or emails to prove it. But what if the trader is a machine? Where’s the proof? Can you demonstrate intent by simply showing that the manipulative activity occurred over and over again?” There are simpler conflicts of interest that Rule 5310 addresses, yet which also present major dilemmas, such as payment for order flow (PFOF), in which a broker routes trades to market maker and receives payment back. The earnings can be significant. Charles Schwab, a major retail broker, says that it takes US$100 million a year in rebates, based on 2013 figures. Some countries take a tough line on the practice, for example the UK’s Financial Conduct Authority wrote in 2012 that;“The receipt of PFOF gives rise to a conflict of interest between the firm’s interests and the interests of its broking clients which may damage the interests of the clients… There are no obvious benefits save the one that the [broker] receives more remuneration from the provision of the execution services. However, this may be at the expense of the client.” The acceptance of payment from both the client—for whom the broker is acting as an agent—and the receiver of order flow, is an ethical problem. The logical challenge, is that if the market maker can provide the best price, why would a payment be necessary? Yet all major retail brokers in the US route trades to firms that pay for their order flow. Rule 5310 states order routing should factor in “the number of markets checked; accessibility of the quotation; and the terms and conditions of the order which result in the transaction.” The application of the rule appears to be easily sidestepped; Scottrade, a retail broker, recently went on record denying that Rule 5310 meant it had to route orders according to client demand.Yet the rule is: “If a member receives an … instruction from a customer to route that customer's order to a particular market for execution, the member is not … to make … determination beyond the customer's specific instruction”. Scottrade which also receives payment for routing its order

flow, would not provide answers to questions about its routing strategy or remuneration by trading destinations. Stein noted in her speech that banning practices where intent was hard to prove was one way to remove the threat of market abuse. She also challenged FINRA’s punishment of firms that violated rules, saying: “Your sanctions should be designed to deter misconduct and improve business standards. And recidivists should be treated more harshly. But, I fear the results, after months or years of hard work by you, are too often financially insignificant for the wrongdoers. Your enforcement cases must be impactful, and provide strong motivation for compliance. I would encourage you to examine your sanctions and update them.” FINRA did not provide responses to questions regarding rule 5310.

To err is human If the regulators are struggling to keep the sell-side in line, clients must do it themselves. Technology has helped buyside traders in this respect. Being ‘gamed’ by a human market-maker was as much a threat historically as HFT firms ever were. The New York Stock Exchange (NYSE) was forced to submit to external policing of its market-makers known as ‘specialists’, for the first time in 2005, having been chastised by market regulator the Securities and Exchanges Commission (SEC) after a series of specialists were prosecuted for front-running client orders. Criticisms were detailed in the song ‘Joey the Specialist’ (Box one) a ditty commissioned in 2005 by Jerry Putnam, the founder of NYSE’s rival startup market Archipelago Trading (Arca). Buy-side traders favoured the electronic Arca model enough that it was eventually bought by NYSE in 2007 after taking a good chunk of its market share. Even the current CEO of NYSE, Duncan Niederauer, famously said in his previous role heading electronic execution at Goldman Sachs that he did not want “five guys named Vinny executing my trades”, a reference to the NYSE market makers. Arca and other electronic communica-

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REGULATION

TOWARDS A RESPONSIBLE APPROACH TO FIDUCIARY DUTY

US Secretary of Labor Thomas Perez (Republican) attends a ceremony for 12,000 Chinese immigrant labourers who worked on the Central Pacific Railroad between 1865 and 1869 being inducted into the Labor Hall of Honor at the Department of Labor, in Washington D.C., the United States, on May 9th. The historical Chinese workers are the first Asian-Americans to receive the tribute since the hall was established in 1988. The Labor Department, which oversees the regulation of retirement plans, withdrew a previous version of its planned rule in 2012, after fierce industry opposition about costs. It recently delayed its unveiling of a new proposal to early 2015. Labor Department officials there have said they are concerned about potential conflicts of interest posed by advisers who suggest that clients roll over their workplace retirement plans into IRAs and then earn commissions from trades in those accounts. Photograph by Yin Bogu for the Xinhua/Landov news agencies. Photograph supplied by pressassociationimages.com, June 2014.

tion networks (ECNs) heralded the dawn of electronic trading; cheaper, more efficient and more transparent than voice trading. Europe saw competition between similar electronic trading venues develop from 2007 onwards. Trading electronically provided advantages by lowering costs; algorithms breaking down big orders into smaller pieces which reduced the overall market impact and that in turn reduced the workload on buy-side trading desks. It also allowed for better analysis of trading. Mast says, “With nearly all trades conducted electronically and measured with transaction cost analysis (TCA) tools it has become easier to analyse our flow in order to fulfil our fiduciary duty.” The shape of the challenge changed along with the market. Cheaper execution led to a boom in trading volume, facilitated by buy-side algo-

rithms, high-frequency trading and encouraged by the service providers. “The sell-side and exchanges are incentivised to encourage trading,” says Northwood. “This extends to other parts of the business too, such as derivatives, custody and clearing, the whole machine is hungry for transactions.” Brokers matched client orders up internally using automated crossing networks, reducing their need to interact with other brokers or pay execution fees to trading venues. They also funded alternative trading venues, including Chi-X and Turquoise in Europe. Their involvement both in the routing of orders and in the destinations themselves increased potential conflicts of interest while decentralised trading removed client certainty about the correct price to trade at. In the US a public price data disseminator, the Securities Information Processor

(SIP), was built to solve this issue with price formation. However the SIP has proven problematic; it releases data slowly and can freeze up, so venues and brokers only price trades with the SIP for institutional investors and retail investors, while HFT firms and purchasers of retail order flow used high-speed data feeds. That allows them to see prices move before the investors, and trade ahead of them. In Europe there is no consolidated feed of price data equivalent to the SIP, making price discovery even harder. Flash Boys, released in April 2014, generated a great deal of interest in the costs that asset managers were being exposed to in the execution process. One US-based head trader at a buy-side firm noted that end investors, such as the California Public Employees’ Retirement System (CalPERS), which has an investment fund of $288.2bn, were now asking questions about how its asset managers were dealing with the conflicted brokers. Buy-side traders ought to have a solid grip on their figures, says Nick Nielsen, head of trading at hedge fund Marshall Wace, but too often their analysis is rudimentary. “If you ask someone what their trading costs are they can typically tell you what their commissions are, but that is about 10% of their trading costs,”he says.“They also should know what their market impact is, what it should be, and what the variables are that influence their market impact.”

Back on duty Buy-side firms are striking back where they are being demonstrably misled by sell-side firms. If brokers display indications of interest (IOIs), non-binding trade offers that later cannot be traded on, asset manager Pioneer Investments bans them for six months. Gianluca Minieri, head of trading at asset manager Pioneer Investments says, “You need to have some discipline in your traders and set up clear rules of engagement with counterparties. On the cash instruments we have set up a system to penalise brokers with false indications of interest (IOIs); we only want to interact

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with people who have natural flows, especially when we execute in larger size.” Equally, bypassing brokers where conflicts exist around routing, as Pohjola seeks to do via its SOR can help. At the point where competition is not delivering a service from a service sector something is clearly broken. In the primary market, asset managers are seeking to improve broker transparency by using technology to the same effect that it has had upon the secondary market. A buy-side working group of the FIX Protocol an electronic messaging standard, is offering an opportunity to

automate the bidding process and remove any opacity over whom stocks are allocated to in big issuances. “Electronification has made the equity markets very transparent and we are supportive of the move to extend FIX to the elusive desks handling IPOs and syndicated block deals,”says Mark Northwood, global head of equity trading at Fidelity Worldwide Investment. “That is a business, coping with conflicting interests and huge order sizes, which is ready for the discipline that FIX would bring when investment banks are haggling over allocations to clients,” he says.

Regulators are looking into these conflicts. On June 17th, the US Senate’s Permanent Subcommittee on Investigations held a hearing, Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in US Stock Markets with representation from across the industry to discuss conflicts of interest. In early July, UK regulator the Financial Conduct Authority (FCA) is expected to release the results of its own investigations into best execution. Despite the dislike of enforced rules amongst industry participants, it seems likely that an intractable sell-side position will lead regulators to act. n

SEC ADOPTS MONEY MARKET FUND REFORM RULES The United States’ Securities and Exchange Commission (SEC) has adopted amendments to the rules that govern money market mutual funds, which involve some $3trn worth of investments. The amendments make structural and operational reforms to address risks of investor runs in money market funds, while preserving the benefits of the funds. HE NEW RULES require a floating net asset value (NAV) for institutional prime money market funds, which allows the daily share prices of the funds to fluctuate along with changes in the market-based value of fund assets and provide non-government money market fund boards new tools – liquidity fees and redemption gates – to address runs. With a floating NAV, institutional prime money market funds (including institutional municipal money market funds) are required to value their portfolio securities using market-based factors and sell and redeem shares based on a floating NAV. These funds no longer will be allowed to use the special pricing and valuation conventions that currently permit them to maintain a constant share price of $1.00. With liquidity fees and redemption gates, money market fund boards have the ability to impose fees and gates during periods of stress. The final rules also include enhanced diversification, disclosure and stress testing requirements, as well as updated reporting by money market funds and private funds that operate like money market funds. According to SEC chair Mary Jo White, the reforms fundamentally change the way that money market funds operate. “They will reduce the risk of runs in money market funds and provide important new tools that will help further protect investors and the financial system. Together, this strong reform package will make our markets more resilient and enhance transparency and fairness of these products,” she adds.

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

The final rules provide a two-year transition period to enable both funds and investors time to fully adjust their systems, operations and investing practices. Norm Champ, director of the SEC’s Division of Investment Management, notes that the reforms represents a significant additional step to “address a key area of systemic risk identified during the financial crisis. These reforms are important both to investors who use money market funds as a cash management vehicle and to the corporations, financial institutions, municipalities and others that use them as a source of short-term funding.” The SEC also issued a related notice proposing exemptions from certain confirmation requirements for transactions effected in shares of floating NAV money market funds. Additionally, the SEC re-proposed amendments to the Commission’s money market fund rules and Form N-MFP to address provisions that reference credit ratings. The re-proposed amendments would implement section 939A of the Dodd-Frank Wall Street and Consumer Protection Act of 2010, which requires the Commission to review its rules that use credit ratings as an assessment of credit-worthiness, and replace those credit-rating references with other appropriate standards. Reforms will not end there, according to White: “We will soon be taking up final rules for credit rating agencies and asset-backed securities, as well as continuing to implement the Dodd-Frank requirements for over-the-counter derivatives and executive compensation”.

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REGULATION

WHAT, ME SIFI? To keep a lid on risk, regulators have stepped up the effort to categorise certain high-profile financial firms as “systemically important.” Their latest target: the massive global asset-management business. Do fund companies really warrant the same level of scrutiny as their banking peers? Dave Simons reports from Boston. NDER THE AEGIS of DoddFrank, the Financial Stability Oversight Council (FSOC), a consortium of state and federal financial regulators, continually scours the markets in search of potential sources of systemic risk, issuing its findings to Congress and making recommendations for improved standards as needed. Key to this initiative has been the identification of certain “systemically important” financial institutions (or SIFIs). While the FSOC’s primary focus has been large banking or-

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

ganisations, the council is not opposed to adding the occasional non-bank name to the SIFI list (recent inductees include the likes of AIG, General Electric, as well as Prudential Financial). A study issued last fall by the FSOC’s Office of Financial Research appeared to signal a more concerted effort to monitor risk conditions within the $68trn global asset-management industry. Entitled Asset Management and Financial Stability, the study named various activities “that could pose a threat to financial stability

REGULATORS NOW FOCUS ON ASSET MANAGERS

Archive photo of Securities and Exchange Commission (SEC) Chair Mary Jo White attends the meeting of the Financial Stability Oversight Council (FSOC), Thursday, April 25th last year, at the Treasury Department in Washington, where the FSOC’s annual report and financial reform was discussed. White has questioned the ability of adjunct agencies such as the FSOC to definitively rule on assetmanagement industry matters, arguing that the SEC knows the territory better than anyone else. “It’s something we are constantly putting in play before all other regulators, some of whom have capital-market expertise, but for the most part are banking regulators.” Photograph by Carolyn Kaster for the Associated Press. Photograph supplied by pressassociationimages.com, July 2014.

by increasing risks across the funds that it manages or across markets through its combination of activities.”These include so-called “reach for yield” strategies that overweight higher-risk assets and thereby potentially accelerate loss in the event of an unforeseen shock, as well as unlimited redemption privileges that could quickly siphon fund liquidity and subsequently increase the likelihood of contagion. Large US fund companies including Fidelity, State Street and BlackRock are among the primary targets of the FSOC review. Meanwhile in Europe, the Financial Stability Board (FSB) has been similarly engaged in ongoing discussions over the identification of systemically important financial institutions (State Street is already a member of the FSB’s Global Systemically Important Bank list, or G-SIB). Asset managers flatly reject the notion that their actions pose any kind of systemic threat, pointing out that, unlike banks, fund companies do not leverage their positions nor put their balance sheets in harm’s way. According to the Investment Company Institute (ICI), the US association representing the interests of mutual funds and other investment firms, the average balance-sheet leverage ratio of US. SIFIdesignated banks is roughly ten times that of major domestic stock and bond funds. And while some asset-management firms have fallen on hard times or have bitten the dust, none have warranted the kind of emergency intervention or taxpayer backing that banks received at the start of the crisis. If it is the case that bank-style capital buffers are imposed on large asset managers, the impact on investors could be substantial, say SIFI opponents, including higher fees and lower longterm returns. All the more reason for regulators to carefully weigh the subtleties of the asset-management business, and to affect whatever changes they see fit using a scalpel, not an axe.“Given the degree of competition in the fund industry and investors’ sensitivity to fees and their effect on returns, it wouldn’t take much in

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REGULATORS NOW FOCUS ON ASSET MANAGERS

added fees or capital costs to distort the competitive landscape for funds,” concurred the ICI. Oversight agencies have long charged that certain esoteric fund products, including derivatives-based ETFs or those using active strategies, carry a higher level of risk than standard mutual funds and have been partly responsible for increased turbulence post-crisis. However asset managers worry about the impact on innovation that may result of these kinds of inquiries. Remarked one leading asset manager: “A big part of the problem is that policy makers tend to regard with suspicion anything in the financial world that isn’t a run-of-the-mill, brick-andmortar type of operation.” In its own assessment Nonbank SIFIs: Up Next, Asset Managers, PricewaterhouseCoopers (PwC) claimed that the FSOC findings fail to address the bigger question of whether applying the SIFI tag is the best approach to quelling risk, “or whether these threats are better addressed by other regulatory measures as referred to in the rule’s preamble.” Regardless, PwC believes that there is still a likelihood that several large asset managers will ultimately be proposed for SIFI designation, though probably not before the end of next year.

SIFI criticism At a conference hosted by the US Treasury Department in May, asset-management industry officials, along with independent experts, gathered to weigh in on the subject. While encouraged by the conversation initiated by the FSOC, Kenneth Bentsen, Jr, president and chief executive officer of the Securities Industry and Financial Markets Association (SIFMA), reiterated that putting asset managers under the same“systemically important” microscope as banks was not only counterproductive but also potentially detrimental to investors. “An activities-based approach is the most effective way to regulate the types of behavior that could impact financial stability,”offered Bentsen in a statement. Further, SIFMA believes that current SEC reform measures should be finished and

subsequently evaluated before advancing any new SIFI designations. Like others in the anti-SIFI camp, Bentsen pointed to the operational, legal and corporate differences between fund companies and their peers in the banking industry. Asset managers act in a fiduciary capacity, said Bentsen, making no guarantees with respect to anticipated returns or losses experienced by clients. In short, “the success or failure of an asset-management firm does not affect investor assets, and does not have a meaningful impact on financial stability.” In a post-conference note to SEC secretary Elizabeth M Murphy, Barbara Novick, vice-chairman, BlackRock and a conference attendee, argued that the inability for regulators to distinguish between roles held by asset managers and asset owners has helped inform policy proposals that, if implemented, may not actually address the root problem. For instance, randomly applying the term “systemic” to larger asset managers or collective investment vehicles (CIVs) may result in money moving between different managers and different funds, yet leave the issue of asset flows into and out of a specific asset class or fund type uncorrected. “Many asset owners manage their money directly, while others outsource management of all or a portion of their assets to external asset managers,” said Novick. Pension plans, sovereign wealth funds and insurance companies, for instance, maintain legal ownership of their assets and therefore make autonomous assetallocation decisions, she said. FSOC criticism hasn’t been limited to the asset-management community. In an unusually pointed jab, SEC commissioner Daniel Gallagher called the recent study “a botched analysis”that overstates or, in some instances“invents without supporting data the potential risks to the stability of the financial markets posed by asset management firms.” Even more noteworthy were remarks made by SEC chair Mary Jo White during a speech at an ICI conference held just days after the FSOC hearing. White appeared to question the ability of

adjunct agencies like the FSOC to definitively rule on asset-management industry matters, arguing that the SEC knows the territory better than anyone else. “It’s something we are constantly putting in play before all other regulators, some of whom have capital-market expertise, but for the most part are banking regulators.”

No Stone left unturned Despite the pushback, Mary Miller, Treasury Department undersecretary for domestic finance and chair of the Deputies Committee of the FSOC, told conference attendees that the FSOC will remain focused on developing tools to mitigate risks, and that conducting this kind of thorough examination “will strengthen the financial system while allowing innovation and competition to flourish.” Miller also took aim at the expertise issue, highlighting her two decades of experience overseeing portfolio management, research and trading on behalf of T. Rowe Price’s fixed-income division. “I know firsthand the crucial role that asset managers play in the economy, helping millions of Americans save for retirement while channeling trillions of dollars into the market that allow businesses to hire, invest, and grow,”she said. The financial crisis made clear the ramifications of sidestepping even the most seemingly innocuous elements of risk, said Miller, making it imperative for regulators like the FSOC to leave no stone unturned in the effort to identify potential threats, including how risk may be transmitted throughout the broader markets. While Miller admits that such fact-finding missions may not always reveal actual problems, discounting an entire sector or activity based on risk improbability “would be a dereliction of the duties Congress assigned the Council,”she said. Therefore, it is entirely appropriate for the FSOC to analyse all elements of the financial system—including the asset management industry—to determine whether they may impact US financial stability. After all, said Miller,“this is what the Council was designed to do.” n

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ASSET ALLOCATION

WHITHER BITCOIN? O SOME, IT’S as big a deal as the PC or the proliferation of the worldwide web. Bitcoin—the most recognisable name in the rapidly emerging digital-currency movement—is built on the premise that transfers of property can be safely undertaken without the need for a centralised third-party facilitator. Still in its nascent phase (bitcoin was devised in 2008 under the alias “Satoshi Nakamoto” and launched a year later), the bitcoin network employs “miners” equipped with sophisticated computer systems capable of crunching increasingly complex mathematical formulas that are used to generate new digital coins. In the absence of a traditional governing body, miners are required to account for all bitcoin transactions themselves using a master ledger known as a “block chain.” Bitcoin’s profile has risen to the point that key data keepers such as Yahoo Finance began tracking its movements earlier last month (under the ticker symbol “BTC/USD”). Not that the extra visibility necessarily helped—in its first 48 hours on the charts the currency’s price dropped 10%. Then again, investors who’ve bought into bitcoin since it vaulted out of the single digits two years ago know that it’s hardly for the faint of heart. During the last half year alone bitcoin has whipsawed from a high of $1100 in early January to just $400 a few months later (pricing as of June 30th was in the $640 range). Such wanton volatility has understandably brought out the cynic in many a market maven. While noting its viability as a payment tool, in a March interview with CNBC Berkshire Hathaway’s Warren Buffet nonetheless dismissed the notion that bitcoin should have a large intrinsic value as “just a joke." Jeff Currie, head of

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

Photograph © Asatta/Dreamstime.com, supplied June 2014.

commodity research for Goldman Sachs, blames unstable demand for the recent price fluctuations, which, notes Currie, undercuts the rationale for holding bitcoin as one would gold or other more stable, predictable currencies. It doesn’t help that bitcoin followers have included all sorts of unsavoury characters. In June the US Marshals Service put up for auction some 30,000 bitcoins obtained during an FBI raid of the operators of black-market website Silk Road; the cyber booty included over 144,000 bitcoins seized from the website’s alleged founder, Ross Ulbricht, aka Dread Pirate Roberts. Moreover, like most fledgling industries, the bitcoin business has been wracked by several high-profile blow-ups, among them Tokyo-based exchange Mt Gox, which was forced into bankruptcy after some $650m worth of investor bitcoins suddenly went missing.

More than just money Even with the bad press and wild gyrations, in real life bitcoin continues to dazzle. Bitcoin“wallets”such as Coinbase offer a substantial discount in transaction fees—up to two-thirds lower than standard credit-card companies per

month, or even free for some micro businesses. Accordingly, a growing list of merchants now accept bitcoin as a payment option, among them online travel agent Expedia, satellite TV provider Dish Network as well as web retailer Overstock.com. Further proof of bitcoin’s continued move into the mainstream came in March when the Internal Revenue Service handed down bitcoin guidance (saying that bitcoin should be treated as property, rather than currency, for tax purposes). While investors focus on bitcoin’s shortterm price action, others take a broader view, believing that bitcoin represents the leading edge of a more powerful, sustainable movement. To many, crypto-currency is the seen as the latest in a long line of grassroots efforts targeting an established oligarchy—in this case, the global monetary system. Just as digital-music upstarts optimised peer-to-peer file sharing to circumvent traditional distribution channels, bitcoin’s operations rely on similarly organic elements—it too utilises an open-sourced, P2P system, and is designed to prevent any one entity from achieving a majority stake; and like earlier uprisings, bitcoin is built on the premise that one need not overpay in order to line the pockets of a monopolising middleman. Nicholas Colas, chief market strategist for New York-based ConvergEx, calls bitcoin “the most fascinating intersection of technology, money, and human trust to come our way since the popularisation of the Internet in the 1990s.”The ability for bitcoin to serve as a disruptive technology in the world of global banking is a force to be reckoned with. “You can, in theory, transfer money around the world with a few mouse clicks or mobile phone swipes, all at a small fraction of the prevailing

THE RISE OF DIGITAL CURRENCY

Built on the premise that one should be able to transact goods or services without lining the pockets of a monopolising middleman, bitcoin is widely viewed as the latest in a series of grassroots efforts targeting an established oligarchy—in this case, the global monetary system. In order for bitcoin to truly succeed, however, it will first have to separate itself from the nefarious elements that have kept skeptics at bay and pricing volatile. Dave Simons reports from Boston.

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THE RISE OF DIGITAL CURRENCY

cost today,”says Colas.“The system’s core architecture is everything technologists believe is the way of the future. Its software is open sourced, it runs on thousands of computers around the world and therefore is virtually impossible to shut down, and all transactions are public, albeit without account information like names and addresses.” Even while debunking its value as an alternate currency, Goldman Sachs researchers Dominic Wilson and Jose Ursua admitted in a recent note that the payment technology supporting bitcoin holds promise. Though not yet widely accepted, “the ability to pay for goods and services using bitcoin is growing, and the fundamental obstacles to bitcoin being used more broadly in the payments system are arguably not insurmountable.” Speaking at the annual SXSW music and media conference in Austin last March, Fred Ehrsam, cofounder of Coinbase, said that those who view bitcoin exclusively as alternative money are missing the bigger picture. “One of the common missteps taken by the media is talking about it as a currency instead of a technology,” remarked Ehrsam. Rather, the process can be used to facilitate many different types of transfers, each one void of a middleman. “It is the first interesting thing we’ve tried doing, and there’s a great deal more to come,”offers Alex Waters, chief executive officer and co-founder of New York-based bitcoin business incubator CoinApex. Just as the crypto-currency model works for cash, it could also represent votes, data, friendship, or any number of other commodities, says Waters. The decentralised public ledger is the key, solving the age-old problem of how a community can organise itself beyond a few hundred individuals, adds Waters. “This is not some Orwellian future,”he says,“it’s a force that decimates centralisation through competitive advantage and redistributes value to the masses.” For every bitcoin backer there’s been an equally vociferous basher with a long list of gripes. Critics include lawmakers such as US Senator Joe Manchin, Democrat

from West Virginia, who has called for an outright ban on bitcoin, claiming that the same features that have fueled bitcoin’s rise have made it easier for cyber thugs to duck the authorities. In a letter to regulators earlier this year, Manchin says that “the virtual market has been extremely susceptible to hackers and scam artists stealing millions from bitcoin users,” adding that “anonymity, combined with bitcoin’s ability to finalise transactions quickly, makes it very difficult, if not impossible, to reverse fraudulent transactions.”

Single-mindedness Others have been more open minded. At a Senate banking subcommittee hearing, Senator Dean Heller (RepublicanNevada) said that congressional members“often do not know what these new advancements will develop into”and therefore should not just assume the worst. “While we must ensure proper safeguards, it is my hope that we can help maintain an environment that continues to promote new financial technologies and innovative growth,” said Heller. One of bitcoin’s most ardent supporters has been Colorado’s Democratic congressman Jared Polis, whose viewpoint reflects an enormously successful career as a web entrepreneur (Polis unloaded a pair of online start-ups, BlueMountain and ProFlowers, for over $1.25bn prior to turning 30). Polis applauded the recent decision by the Federal Election Commission (FEC) to allow donations of digital currency to political committees.“I am thrilled that the FEC has chosen to take a forward looking stance on digital currencies, recognising the rights of individuals seeking alternatives to government backed currencies to participate in our democratic political process,” said Polis.“Bitcoin, and other digital currencies, are just beginning to show the world what a tremendous tool they can be,”he said,“whether it is reducing transaction costs in developing nations, giving people more options for engaging in commerce, or sending Representatives dedicated to advancing personal freedom to Congress.”

Nicholas Colas, chief market strategist for New York-based ConvergEx. Photograph kindly supplied by ConvergEx, June 2014.

Into the light In order for bitcoin to advance to the next level of acceptance, it will have to separate itself from the nefarious elements that have kept skeptics at bay and pricing volatile. Bitcoin’s “unlit” architecture may help foster innovation, but it is also susceptible to further rogue infiltration, or, even worse, being used by terrorists as a funding mechanism. Such an occurrence, says Colas, “would make the push for banning bitcoin in the US much more likely, and without this market it would take bitcoin much longer to develop.” The notion of added transparency poses something of a conundrum for some bitcoin advocates, who want to be taken seriously, yet at the same time value the anonymity that has set bitcoin apart from the status quo. Not that everyone on the bitcoin frontline shares this philosophy, nor believe that bitcoin is even all that opaque. “It’s disappointing that people think [bitcoin] is anonymous, when it is really the most transparent network that has ever existed,” insists Coinbase’s Ehrsam. Still, analysts like Colas wonder how long bitcoin can continue to meet the demands of businesses and consumers while remaining outside of the monetary periphery. Bitcoin entrepreneurs will need to continually churn out solutions that are fast, user-friendly and innovative. While these businesses will have the support of the venture capital community,“this is the same investment approach which countenances dozens of failures to get one blockbuster success,” says Colas. “The order in which those come will be important to bitcoin’s long term success.”n

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New trading venue is a step change in bitcoin market evolution RANKLY, IT HAS taken a while for me to get my head around Bitcoins, not least because there is a lot of uber-hype around the subject. Bitcoins have variously been labelled volatile, experimental, and dangerous. Moreover, considering some high profile fails, such as the now-defunct online market Silk Road, and various stories about investors losing their bitcoin investments to computer hackers, the description dubious has, if I am honest, also sprung to mind.

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I have good reason. Even according to the self-styled Bitcoin Foundation, “we have all noticed barriers to its widespread adoption—botnets that attempt to undermine the network, hackers that threaten wallets, and an undeserved reputation stirred by ignorance and inaccurate reporting.”Hardly the most ringing of endorsements. The hope of separating fact from fiction was one reason why I wanted to speak with Hamblin, chief executive of bitcoin broker Netagio which has now taken a

NEW UK BASED EXCHANGE TO TRADE BITCOINS

It has been a month of first’s for the UK’s Bitcoin industry. In early July, Global Advisors, the Jersey based asset management firm, established a Jersey regulated open-ended Global Advisors Bitcoin Investment Fund. In the same week, Netagio, a digital currency broker, announced it had launched the first British exchange enabling both retail and institutional investors with the means to trade gold, bitcoins and sterling on a single peer to peer exchange platform. Francesca Carnevale spoke to Netagio’s chief executive Simon Hamblin about the rise and expectations of the asset class.

number of steps to insert a transparent and recognisable trading, clearing and settlement infrastructure around the asset class. The exchange is currently constructed around three order books. “Customers can build and trade a Bitcoin, gold and sterling portfolio, trade in and out of Bitcoin versus gold, versus sterling quickly, safely and easily on a 24-7 basis and from a single account,” he says. Netagio is a spin-off company from Jersey-based GoldMoney, a brokerage firm specialising in trading precious metals, founded in 2001 by James Turk, who honed his expertise, among other jobs, in running the commodity department of the Abu Dhabi Investment Authority. Turk is also chairman of the Netagio board. Hamblin says the exchange, backed by this expertise has the ambitious goal of being the exchange of choice for bitcoin trading. Time will tell. While it all sounds fine, Hamblin concedes that the exchange is something of a game-changer. Until now, in the UK the bitcoin segment has had “difficulty gaining traction because you need a bank account with which you can transact and these days that is notoriously difficult,”he explains. Netagio has circumvented this problem by utilising an intermediary, in this instance, Isle of Man-based Capital International Group’s Capital Treasury Services (CTS), which is licensed by the Isle of Man Financial Supervision Commission. Customers can send and receive international payments via the CTS, “which has the relationship with the banks and we have our accounts with CTS. As such, funds are directed through the British banking system, allowing for fast and cost-effective payments,” says Hamblin. The upside is: “We can get British businesses involved in the bitcoin world,”he adds, explaining that specialist traders have shown a lot of interest in the exchange as it offers a platform backed by a UK based payments system. Netagio’s exchange hopes to build substantial liquidity and offers a ‘maker-taker’ pricing model. Hamblin says the pricing model is designed to reward liquidity providers and one which “has proved highly effective in attracting liquidity onto

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NEW UK BASED EXCHANGE TO TRADE BITCOINS

many of the alternative equities exchanges,” claims the firm’s official statement on the launch of the exchange. Maker-taker is an exchange or trading platform pricing system. Its basic structure gives a transaction rebate to market makers providing liquidity (maker); and charges a transaction fee to customers who take liquidity out of the market (taker). In the United States, firms that post buy and sell offers are paid a fee, typically between about 20 cents and 30 cents for every 100 shares traded. Firms that "take" those shares are charged a fee. In the case of Netagio’s exchange the taker is “charged 0.5% across the entire

book (the normal charge is 2%) and if you are a maker, you get a 1% rebate back into your account,” explains Hamblin. One week after launch, Hamblin says Netagio is on-boarding its clients onto the exchange. The firm’s clients range widely, from high net worth investors, retail to some institutional investment firms and claims that customers originate from as many as 114 countries. “In line with expectations,”Hamblin says that the bitcoin/gold book is the hardest one to move,“and maybe ahead of its time.”The gold bars that Netagio trades are available in units of 100g. Even so, Netagio has been diligent in

building out an infrastructure that can accommodate real assets underlying trades on the exchange. This extends to the utilisation of specialist facilities in Switzerland to store gold bullion. It is a streamlined process, claims Hamblin. “We can deliver gold to our vault in Switzerland, paid for by one fee without touching any banking system. The fees are taken in bitcoin.” With such a high value asset (one gold bar currently equals seven bitcoins, which are worth at today’s prices around £2500), he concedes that customers require ‘goldstandard’ protections. “The vault is one element. In this regard, we act as agent or custodian: the legal entitlement to the

WHAT YOU MIGHT WANT TO KNOW ABOUT BITCOINS

and issue confirmations of trades in bitcoins. Clearly, there is a high barrier to entry: you have to have the brains, the computer programmes and the money to continually run these complex programmes. The infrastructure then is very expensive and as time goes by, the technology to mine bitcoins threatens to become something like a nuclear arms race. Each time one of the equations is solved, as a reward, a miner is awarded 25 bitcoins. The miner can then either store the bitcoin or sell it, whole or portions of it. It can be broken down into bits, down to eight decimal places, with the smallest denomination called a Sitoshi. Once all 21m bitcoins have been downloaded, then the role of miners will be reduced to confirming trades. “Technically,” explains Simon Hamblin, CEO of Netagio, “there is no reason to limit the production of bitcoins to 21m units, but if you did you would devalue them. Even if you did extend the production to more than 21m units you would need the consensus of the entire bitcoin community to do it.”

Who can download Bitcoins? Theoretically anyone, but you have to have a complex software programme that can solve immensely complex and mutating equations. These programmes are run by ‘miners’, who both exploit the bitcoins

Are miners important to the bitcoin industry? Apparently so. The mining community plays a vital role in Bitcoin, suggests Hamblin. They record and retain all the details of a bitcoin trade and issue trade confirmations. They are also guardians of massive data centres that feed information into a central ledger called a Block Chain, basically an active double entry book ledger that records debits and credits related to bitcoin trades. The data held in miners and the Block Chain have complex security guards and are therefore ‘censor resistant’. In other words, transaction data cannot be modified, it is either open or closed. A trade cannot be re-opened, only a new trade is entered with its own codes and identifiers.

Photograph © Download777/ Dreamstime.com, supplied July 2014.

hat are bitcoins? Often called digital currency, a bitcoin is a long string of computer code protected by a personal key which provides ownership and security, which can be downloaded. The protocol governing the software controls both the rate at which bitcoins are issued (or downloadable) and the total number of bitcoins that can be produced (21 million). Most projections say that the last bitcoins will be mined around 2140 – that might be optimistic as computers become more advanced, but you get the gist: it is ultimately a limited resource, which proponents of bitcoins say adds to their value.

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assets remain entirely with the customer. The third party vault provider will produce a validation list and this, from a bitcoin perspective, will also be validated by an ISAE audit. In our case we have hired BDO to provide auditing services for our bitcoin storage. This ensures that we have the funds we say we have, that we have access to those funds (with appropriate security keys) and that the right people have access to their respective funds,” he explains. Funds and assets are held in multiple locations across Europe and assets can be delivered to customers if they require it in one working day. Hamblin adds that the majority of

bitcoins that Netagio holds are held ‘off-line’. This is vital for security, as it protects the assets from hackers.“Only a small portion of our overall funds are held online.” Bitcoins are essentially a 21st century construct and reflect a market that is undergoing substantive change. It is not the only digital currency: others are rising fast, but bitcoins seems to have captured the zeitgeist and may be the spur for continued innovation in the global investment markets and even outside it. Block Chain technology appears to have applications in the selling of assets such as cars, in the production of passports and more

Who can trade in bitcoins? Anyone it seems. You can buy or sell them, but you cannot lend them. You can buy goods and services with them, or you can use a bank account to buy them directly from an exchange. The only pre-requisite is a bitcoin account, or ‘wallet’, which you can open at a broker and install as an application on your phone or access it via a computer. Your wallet stores the bitcoin and is the means of you buying and selling other assets. However, sensibly, bitcoins tend to be used as an investment and are bought and stored. Why are investors wary of bitcoins? Well, the asset class is not regulated in most countries. However, says Hamblin, “there is no regulator for investment grade bullion either. However, we all know that regulation will come, so the community is working to be ready for the guidelines to appear.” The Isle of Man and Jersey have accepted bitcoins as legal tender and the first bitcoin fund is now regulated by the Jersey financial services authority. In mid-July Benjamin M Lawsky, the superintendent of financial services in New York, proposed regulations for virtual currency companies operating in the city. The BitLicense plan, which includes rules on consumer protection, the prevention of money laundering and cybersecurity, is the first proposal by a state to create guidelines specifically for virtual currency. The new rules will cover bitcoin exchanges and for companies that secure, store or maintain custody or control of the virtual currency on behalf of customers. Merchants that accept bitcoin for payment, like Overstock.com, would not need to apply for a license; the rules however are not yet in place. Why do regulators fear bitcoins? One, the market is not regulated and is dependent on the self-imposed good governance standards of miners, specialist brokers and (now) exchanges trading the asset. Additionally, there is the

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secure bank accounts and the world can only wait on the imagination of developers to apply quantum based computing models to the question of security around ownership of assets and identity. The speed of the adoption of bitcoin into mainstream investing is largely dependent on the speed with which market regulators seek to capture its essence, potential and threats in its usage. So far, the message from regulators has been mixed. Canada announced in February this year that it was seeking to enact legislation that would protect against terrorist or criminal use of digital currency, but little that is concrete has

possibility (not yet tested) that investors could circumvent tax on cross-border movements of money by converting assets into bitcoins in one country, carrying the documentation (on a UBS stick even) across borders undetected and then converting the bitcoins into other assets on arrival in another country. It assumes of course, that the carrier can find a buyer at his/her destination; but the implication is that it could hide terrorist or drug cartel cross-border money transfers. Hamblin says yes and no. “Theoretically, it could happen, but the market is highly transparent and there is an immutable record of each transaction, so it would not be difficult for someone to track the trade if need be.” However he concedes that the transactions are inherently anonymous. How safe are bitcoins? There was a bit of a kerfuffle last year as some fund managers reportedly lost bitcoins to hackers. There was a famous case in Melbourne, where Sam Lee, co-founder of Bitcoin Reserve, an arbitrage fund, allegedly lost over 100 units (worth then around AUD70k) to hackers. The moral seems to be: keep your assets off-line. Then again, in October 2013 the FBI shut down online marketplace Silk Road, which traded in drugs and other illegal goods and took payments using "crypto-currencies", which has not helped the cause of bitcoins. The second moral is, of course: know your customer (KYC). These requirements are a must when it comes to being involved in the bitcoin market. As with all asset purchases, the warning caveat emptor should never be forgotten. Finally, only deal with proven and reputable firms. Many miners and reputable brokers have offsite storage facilities where bitcoins and bitcoin trading data can be kept (sometimes in underground vaults which are reputedly nuclear and natural disaster proof) where hackers cannot reach them and have security checks on clients.

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NEW UK BASED EXCHANGE TO TRADE BITCOINS

emerged in the interim, other than a set of intentions and topics to look at. In early July meanwhile Japan’s government said it would stop short of regulating virtual currency, instead calling for self-regulation until the authorities can structure a policy that is relevant and foolproof and does not stifle new market innovation in what it called a ‘fledgling industry’. "While we may need to be flexible in reviewing legislation in the future, we also have to have to stand back and allow this new sprout of industry to grow," said Takuya Hirai, who heads the LDP's panel on information-technology strategy. Also in July, European Union financial services chief Michel Barnier told Reuters in an official statement that it is "imperative" to look at possible EU regulation for virtual currencies. "We will now look into what can be done to possibly introduce regulation in this sector, particularly to address the risks of financial crime that arise from the anonymity that characterises many virtual currencies," the spokeswoman said in emailed statement. However, no timelines or further guidance has been issued to date. The recent announcement that the world’s first regulator-approved Bitcoin

investment fund has been launched reflects the changing face of investment, according to Carey Olsen partner James Mulholland. Mulholland and Carey Olsen associate, Rhona Atkinson, advised Global Advisors, a Jersey-based investment management company, on all the legal and regulatory aspects of the establishment of the Jersey-regulated open-ended Global Advisors Bitcoin Investment Fund (GABI), which will officially launch on August 1st. Global Advisors is a Jersey-based hedge fund company which usually specialises in commodities such as metals and oil. GABI has been certified by the Jersey Financial Services Commission, which the fund’s managers say means that pension and insurance companies can invest in bitcoins for the first time. However, the fund is not open to the general public. Waiting for Godot? The first Bitcoin ETF: The Winklevoss Bitcoin Trust, which is run by Match-Based Asset Services, an investment firm owned by Cameron and Tyler Winklevoss, is reportedly looking for regulatory approval of what might be the first Bitcoin exchange traded fund. According to the blurb filed with the Securities & Exchange Commission (SEC) investors with a brokerage account to

trade or buy bitcoin can invest in the asset without the requirement to secure ‘ownership’ or deal with bitcoin miners. Each tradable share in the ETF will represent an amount of bitcoin held by the underlying trust. The ETF price will also be based on a blended bitcoin price that reflects the volume-weighted average of top exchanges from across the world (the Trust’s words) whose current exchange rates can differ, and some of which may be difficult for investors to access. The ETF has been a long time in coming and might not see the light of day this year at least. Originally proposed in 2013, if successful would be the first signal that the SEC recognised the asset class. The Bitcoin Investment Trust (BIT) is also said to be angling to release an OTC Bitcoin ETF, that it says does not require approval from the SEC and is reported to be ready for launch in the final quarter of this year. Quite why investors would want to pay the recurring fees involved in ETFs in an asset such as bitcoin that have no underlying value is not really clear. However, should the SEC recognise the ETF, we will know the answer. n

MAKER TAKER UNDER FIRE T HE MAKER TAKER pricing model used by US stock exchanges to attract liquidity came under fire in midJune, as two US senators raised concerns about the potential conflicts it creates. In a Senate hearing, various market practitioners expressed support for ending the "maker-taker" model used to reward brokers who make offers to buy or sell stocks on exchanges, which they say will “reduce the conflicts inherent in such pricing schema”. The hearing before the Senate Permanent Subcommittee on Investigations came shortly after author Michael Lewis released a book that raised questions about payment for order flow and accused high-speed traders of rigging markets. Securities and Exchange Commission chair Mary Jo White also announced a series of proposed reforms to address high-speed trading, dark pool, and potential conflicts that may influence how brokerages route customer orders, such as maker-taker.

The maker-taker model came under scrutiny last year after researchers from the University of Notre Dame and Indiana University released a study suggesting that payment-for-order-flow practices may create conflicts and prevent customers from receiving the best price in the shortest possible time frame. The study looked at four discount brokerages that accept payments for order flow: TD Ameritrade (AMTD.N), E*Trade, Scottrade [SCTRD.UL] and Fidelity Investments. It found the firms tend to route "limit orders" to the exchanges that pay the highest rebate fees - a conflict that may prevent orders from being filled and violate best execution rules. The Senate panel's chairman, Democrat Carl Levin of Michigan, and its ranking member, Republican John McCain of Arizona, both said they were troubled by the findings, and McCain called for more transparency on the payments to brokers.

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NEW DAY FOR KNIGHT HORTLY AFTER THE flawed Facebook IPO in May 2012, a flummoxed Thomas Joyce, chief executive officer of US market-making firm Knight Capital, took aim at NASDAQ officials, charging that“operational issues” at the exchange were to blame for the botched launch. Joyce elaborated further that July, telling Bloomberg Television that the error had been compounded by “a series of decisions made after the technology failed that were unfortunate.” As Joyce would soon discover, catastrophic tech errors—and unfortunate decision making—can strike anywhere at anytime. On the morning of August 1st, a Knight Capital trading-software upgrade suddenly went askew, causing the firm’s automated routing system to flood the New York Stock Exchange with millions of errant orders. When the dust settled, the 45-minute barrage had carved a $460m hole in the firm, sending its share price into a 75 percent tailspin.

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Over the next few months Joyce, who’d spent the previous decade transforming Knight into a market-making dynamo, valiantly fought to keep the firm afloat, yet by year’s end ultimately agreed to a $1.4bn acquisition by Chicago-based market-maker Getco, one of several companies that had provided rescue capital in the days following Knight’s collapse. Thus was born KCG Holdings, the barely year-old securities dealer that currently sits atop the domestic market maker’s chart with an estimated 14 percent stake in US equity share volume. Ticker symbol notwithstanding, KCG today maintains few palpable ties to its past; save for a few passing references to “predecessor firms” in the company report, it’s like the morning of August 1st, 2012 never happened—par for the course for a restructured firm focused exclusively on its future. Under the helm of ex-Getco chief Daniel Coleman, KCG intends to build

A workable formula Though they’ve only been at it a few short quarters, as of now KCG’s formula seems to be working. In May, the company reported a Q1 net revenue increase of 23 percent quarter-to-quarter, while its market-making business rose 19 percent to $277m through the same period, largely on the strength of direct-to-client US equity market making activity. At the same time, average daily US equity share volume for algorithmic and EMS executions soared nearly 10%. All told, KCG earned 30 cents per share for the quarter, head-and-shoulders above Q4’s 16 cent per-share loss. The estimate-beating figures helped the firm partially erase a miserable month of April that saw its stock price tumble nearly 20 percent (due in part to negative sentiment stemming from Michael Lewis’ HFTbashing Flash Boys tome). Helping the cause immeasurably has been the company’s unusually steadfast

KNIGHT: A LESSON IN BRAND REBUILDING

After a rough start, newly minted execution specialist KCG—the product of merged market makers Getco and infamous tech casualty Knight Capital Group—appears to have hit its stride, notching a quarter’s worth of estimate-busting revenues while simultaneously wiping out over a half-billion dollars in debt. How long can they keep it up? Dave Simons reports from Boston.

scale; not only in areas such as designated market making (where it rubs elbows with the likes of Goldman Sachs and Barclays) but also agency execution (providing, among other things, outsourced electronic-trading capability for regional institutions). Additionally, it lists among its strengths its ability to access multi-asset class trading venues (KCG maintains a stake in Kansas City-based entity Bats Global Markets, the brokerowned exchange operator launched earlier this year from the merged Bats Global Markets Inc and Direct Edge Holdings LLC). In a recent note to shareholders, Coleman called KCG’s market making, agency execution and trading venue businesses“complementary offerings”that will allow the company to effectively share intellectual capital, trading technologies and costs, thus paving the way for innovation and expansion. “Our role in the financial marketplace is to reduce friction for investors, making it cheaper and easier for them to buy financial assets,” suggests Coleman.“The better we are across operations, technology and finance, the better prepared we will be to service clients.”

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approach to debt reduction. Using proceeds from the sale of its domestic fixed-income business (as well as other sources of “internally generated excess liquidity”) in April the company paid in full a $535m credit facility used to finance last year’s merger, thereby saving some $66.4m in interest expense. Closing the debt facility, said Coleman, will give KCG “added flexibility in terms of utilizing cash generated from day-to-day activities.”

Knight shadows Even with the facelift and fresh start, KCG has still been forced to reckon with the wreckage of its not-so-distant past, not to mention the leverage and liquidity pressures resulting from its rebirth. Last fall, the Securities and Exchange Commission levied a $12m fine against the former Knight Capital Americas LLC for failing to curb the August 2012 malfunction in a timely manner. Knight became the first company penalized for violating the SEC’s market access rule, which requires firms with direct market access to include mechanisms capable of defending against unforeseen trading failures. Meanwhile, the newly minted firm faces a regulatory environment that has grown increasingly intolerant of highfrequency trading practices. In its premerger assessment, Moody’s rated KCG a Ba3, reflecting in part “the risks of new regulation which may negatively impact high-frequency trading in general, and KCG's business model in particular.”With scrutiny on the rise, high-frequency profitability continues to wane; TABB pegs current-year HFT gains at around $1.3bn, well below the $7bn during the HFT apex of 2009. While rejecting the“irresponsible characterisations” levied by some market critics, Coleman nonetheless agrees there is room for improvement in areas such as market-center fee structures, ATS disclosures, market-data latency and marketmaker obligations.“We are pleased to see a more informed analysis begin to take place,”remarked Coleman during the May earnings call, adding that KCG continues to engage clients and policy makers in an effort to maintain an open dialogue.

Ex-Getco chief Daniel Coleman, KCG intends to build scale not only in areas such as designated market making (where it rubs elbows with the likes of Goldman Sachs and Barclays) but also agency execution (providing, among other things, outsourced electronic-trading capability for regional institutions) as well as through the operation of multi-asset class trading venues. Photograph kindly supplied by KCG, June 2014.

Reduced margins and market share have increasingly led HFT merchants to pursue new opportunities, and many have used their market-making agility as a gateway to the traditional investment world. Rather than be pigeonholed as a high-speed juggernaut, KCG, to its credit, has sought to build upon Knight’s once-successful institutional-based business structure, repositioning itself as a versatile liquidity and execution specialist, capable of serving a wide range of market participants. Among its various irons in the fire is a plan to introduce interest-rate swaps trading by year’s end, part of the effort to capitalize on the move toward swap execution facilities (SEFs). Designed to reduce OTC opacity through trade automation as mandated by Dodd-Frank, the trend bodes well for the likes of KCG and others seeking to expand an electronic footprint. Just how far KCG is willing to tread in swaps will depend on a number of factors, including consolidation among swap execution facilities (SEFs) as well as possible regulatory restrictions. Competition within the industry remains fierce, however, with market makers, specialists/designated market makers (DMMs) and electronic order books (EOBs) all vying for execution supremacy. While the MM segment has tightened or remained flat, by

contrast electronic order book business continues to gain favour. A March Celent survey found EOB market share reaching 59 percent, a threepoint rise since last fall; by contrast, market-maker share dropped to 7 percent from 10 percent last September, according to the consultant. Even so, during the final portion of 2013 KCG garnered a secondplace ranking in designated marketmaker execution speed, as well as third place for price improvement, according to Celent. Looking ahead, KCG’s fortunes will in large part be shaped by its continued effectiveness at leveraging the combined Knight-Getco market-making and execution facilities, while also maintaining a diversified client base and realising potential cost synergies in a timely manner, noted Fitch Ratings in its 2013 overview. Even so, in Fitch’s estimation successful execution on these fronts“will be counterbalanced by the continual need for technology re-investment, operational/reputational risks, and balance sheet risk associated with mid-frequency trading, intensifying regulatory scrutiny, and potential competitive pressures.”

Nothing left to chance Despite the company’s recent progression, Coleman isn’t leaving anything to chance. Among other things, Coleman plans further expense reductions through platform and process integration, which will help KCG maintain its footing going forward. “There is still much work to be done in order to fully optimize our performance and more evenly balance the contribution from our businesses, not only in market making but also in globalexecution services,” remarked Coleman during the May call. As a leading marketmaking intermediary, Coleman believes that KCG will be well poised to deliver additional cost savings to buyers and sellers alike. “These are critical services that have been valued by clients and regulators alike,”says Coleman,“and the appreciation for the unique role of market makers within the industry’s ecosystem is only growing.” n

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How will the buy side benefit from the emerging European post trade infrastructure? While US traders already have to centrally clear all their OTC and exchange-traded derivatives, soon it will be Europe’s turn. Following that, the IT project initiated by the European Central Bank that is Target2-Securities (T2S) will allow all trades to settle on one pan-European platform in central bank money, perceived as the least risky type of cash settlement. For now, the spotlight is on clearing and in March, NasdaqOMX became the first organisation to be granted official central counterparty status by 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 on the implications. O SOONER HAD NasdaqOMX been authorised by ESMA questions were being asked about whether trades would have to be ‘frontloaded’ into the system between now and

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the clearing obligation date. Richard Metcalfe, director of regulatory 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 NasdaqOMX 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, 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 re-applying 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. By January, EurexOTC Clear, the CCP service for interest rate swaps, began onboarding 120 buy-side firms and 32 clearing members.

THE IMPACT OF CENTRAL CLEARING OF DERIVATIVES TRADES

Photograph © Rudchenko/Dreamstime.com, supplied July 2014.

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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. “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 5day liquidation period (vs one day for futures). Requirements for uncleared OTC contracts will likely be another multiple, with the Basel/IOSCO framework calling for initial margin to cover 99% of 10-day price movements,” states the survey. 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. 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 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 oppor-

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. Photograph kindly supplied by Newedge, June 2014.

tunity, 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. [Even so, if] 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 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 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 experts 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 – 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.

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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, 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 NasdaqOMX is clearing, will they be subject to the same obligation?” Photograph kindly supplied by IMA, June 2014.

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.” He 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 crossborder, 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 Se-

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curities 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 €33bn, the industry is sceptical, as only 38% in the SIX survey believed costs would fall long term. In contrast, all respondents believed T2S would 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 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. Clearstream is a front runner. As Germany’s CSD falls within its franchise, it 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 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.” HKMA consults on OTC derivatives trade reporting: The Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) has begun a one-month consultation on the detailed requirements relating to the mandatory reporting and related record keeping obligations under the jurisdiction’s new over-the-counter (OTC) derivatives regime.

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

Hong Kong is Asia's third-largest OTC derivatives trading hub after Singapore and Australia. The bulk of OTC trades in the jurisdiction involve foreign exchange. Hong Kong this year launched a new legal framework that introduces mandatory reporting, clearing, trading, and recordkeeping obligations for OTC derivatives through amendments to the Securities and Futures Ordinance, which was enacted by the Legislative Council in April this year, but the details have yet to be drawn up. Following consultation, the proposed detailed requirements will be set out in subsidiary legislation to be made under the new regime. The requirements aim to enhance financial market stability by increasing transparency in the OTC derivatives market. The proposals have been developed in line with similar reform efforts in other major financial markets, and with input from the industry. The key proposals cover six main areas, including designation of the types of transactions that will have to be reported; which firms and individuals will be subject to reporting and in what circum-

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THE QUICK Q&A GUIDE TO DERIVATIVES CLEARING FOR THE BUY SIDE IN EUROPE W HO IS COVERED by EMIR’s clearing requirement? Trades between financial counterparties (FCs), non-financial counterparties (NFCs) and third country entities (TCEs). Are funds subject to derivatives clearing? Depending on the fund, yes if it falls into the definition of financial counterpary. UCITs have been caught in the net and alternative investment funds (AIFs) or really any fund registered under the AIFMD. How many CCPs have been authorised by ESMA to date? Nine as of the 7th July. These include NASDAQ OMX Clearing (Sweden); European Central Counterparty (EuroCCP – Netherlands); KDPW-CCP (Poland); Eurex Clearing (Germany); Cassa de Compensazione e Garanzia (CCG –

stances; any exemptions and reliefs that may apply; reporting timeframes and applicable grace periods; the form, manner and contents of reports and any related record keeping obligations The consultation marks the first of a series of consultations on the detailed rules for implementing the new OTC derivatives regulatory regime. The month-long consultation is one of several the HKMA and SFC expect to issue on the new legislation which focuses specifically on the trade reporting and record-keeping aspect of the new regime. The consultation period will end on August 18th. Omgeo partners with LSEG to support tri-party matching of synthetic equity swaps: Post trade specialist Omgeo is partnering with the London Stock Exchange Group’s (LSEG’s) UnaVista to support tri-party matching of synthetic equity swaps between executing brokers, prime brokers and investment managers. The offering links UnaVista, a global hosted platform for all matching, valida-

Italy); LCH Clearnet SA (France); European Commodity Clearing (Germany); LCH Clearnet Ltd (United Kingdom); Keler CCP (Hungary). How will counterparties clear under EMIR? The regulation provides three ways to clear: become a clearing member of a CCP; become a client of a clearing member of a CCP (which is what will most commonly apply to funds or asset managers), or enter into an EMIR-compliant indirect clearing arrangement. What documentation will you need to ensure complies? As a fund you will need to agree a documentation package with your clearing member. You will have to determine whether to continue to use your existing ISDA Master Agreement as the underlying trading document for OTC derivatives

trades or whether you will use another set of terms. There must also be supplementary documentation that makes your terms compatible with clearing: in Europe you have two options (either the ISDA/FOA client cleared OTC derivatives addendum; or the FOA Clearing Module). You have to do this because the ISDA Master Agreement makes no provision for clearing, so an addendum or module is needed. These addendums are usually in three parts: involving negotiable commercial terms; agreed structural changes to the underlying trading document that reflects the realities of clearing; and they must reference CCP rules (otherwise, what’s the point?). Some of these parts are negotiable, some not, so discuss carefully what will be required of you.

tion and reconciliation needs, with Omgeo Central Trade ManagerSM (Omgeo CTM), Omgeo’s strategic platform for the central matching of cross-border and domestic equity, fixed income, repos, exchange traded derivative and equity swaps transactions. The solution combines the workflow of both platforms and automatically connects investment managers on Omgeo CTM with their prime broker counterparties on UnaVista to match the economic details of the swap, and to communicate and match allocation breakdowns. It also supports matching of the give-up (hedge) trade between the executing broker and the prime broker. In addition to UnaVista’s existing community of prime brokers and executing brokers, the integrated solution allows executing brokers already on Omgeo CTM to leverage their existing interface to deliver the give-up to the prime broker. Finally, the combined workflow provides investment managers with new insights into the give-up status of swaps trades and allows

them to view all of their transactions within the Omgeo CTM environment. The solution currently supports any swap with an equity underlier. The terms of equity swap deals are clear to all parties to the trade while adding scalability to the synthetic equity swaps confirmation, allocation and matching processes. Users are able to better control their costs and reduce operational risk through post-trade best practice and exceptions-only workflows. The service also enables parties to match both legs of the trade on T+0 whilst providing additional consistency across equities and equity swaps for investment managers. “This new partnership allows us to combine Omgeo’s buy-side network with UnaVista’s prime broker network, providing one of the largest CFD communities on the market. The solution creates a scalable platform for all parties and the flexibility to meet multiple different needs,” says Mark Husler, global head of product management at LSEG. n

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POST TRADE

TIME FOR A NEW APPROACH TO THE POST TRADE WORKFLOW? OST-TRADE HAS traditionally been dominated by expensive, proprietary, outmoded technology or timeconsuming, inefficient manual processes. This is particularly the case for affirmations and confirmations, a vital function in the trade lifecycle. As long as processes were delivering for the most part, there was no imperative for radical change. Instead, firms have layered on more people, money and quick fix solutions. On the buy-side, this has resulted in a mesh of complex internal controls over crucial business processes. With infrastructures already operating at capacity the impact of greater regulation, intense cost scrutiny and shorter settlement cycles as T+2 is introduced in Europe in October will be profound. Firms with inadequate processes will not be able to take the strain. More robust regulatory structures, coupled with a real punitive approach, means non-compliance through a lack of appropriate controls and oversight has the potential to be dramatic, costly and hugely damaging to a firm’s reputation. A group of forward-thinking buy-side firms have recognised that by repurposing FIX in post-trade they can deploy a more efficient model for exchanging affirmation and confirmation messages with the sell-side. The definition of a direct affirmation workflow is perhaps the most significant shift in these firms’ thinking. Importantly, it is the adoption of open standards that is facilitating this move. They have found an alarmingly simple solution that applies FIX in post-trade on the buy-side, mirroring the existing sell-side workflow to deliver

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operational efficiency and increased transparency. FIX makes sense because, unlike other standards for post-trade, it follows the natural direction of the trade workflow. Work by the FIX Trading Community paved the way. By building on open standards in the front office, it opened up the possibility for firms to further disseminate and persist information all the way through to the back office. Affirming and confirming trades with the sell-side on a direct matching basis puts control firmly back in the hands of market participants, removing the need for fragmented and manual processes and unifying post-trade operations. The direct model is proving to be faster, cheaper and more accurate, achieving levels of efficiency that were previously unattainable. When the concept of an EMS emerged in the front office, it provided the workflow to sit on top of an open standard, delivering an effective and holistic way to manage orders across multiple brokers. This was just the beginning. The adoption of common workflow tools subsequently transformed the front office and led to new ways of working. The humble EMS now transcends its original design of simply managing and processing trade orders. It accommodates other applications, such as embedding broker algorithms and the analysis of counterparty flow. Similar levels of innovation are possible in post-trade. By adopting a standardsbased approach for affirmations and confirmations, firms are achieving all the immediate benefits of improved trading relationships, lower costs and reduced oper-

ational risk. Improved workflow outside of the front office will have a far-reaching impact. This will include better ways of working in other areas, such as the management of commission sharing agreements, regulatory reporting, and broker analysis. For the first time the buy-side will begin to see the emergence of a true ‘middle office’, bringing together innovative new solutions for the operations department that has depended for too long on tactical fixes. Having identified and proven a workable, scalable operating model, the next crucial step is to make this standardsbased workflow accessible to the broader buy-side community. For this to happen, other buy-side firms need a better way to access the sell-side community. The enabler for this will be technology and the emergence of a new class of posttrade application for the buy-side that would follow an industry-standard model to deliver comprehensive affirmation workflow. It would automate timeconsuming, expensive manual processes and allow many more firms to benefit from the latest innovations in post-trade. It would remove the operational risks associated with using a central single facility for a major part of the settlement process, enabling firms to reduce clearing and settlement times and re-use information captured in the front office. Greater visibility of the trade economics for both parties would increase the likelihood of successful matches and affirmations. Innovation has redefined the post-trade operation and a true buy-side middle office is being created. The revolution has started and it’s time to get on board. n

TIME FOR CHANGE: RE-ENGINEERING POST TRADE EFFICIENCY

Increasing regulatory demands and scarcity of capital mean that traditional ways of working are no longer sustainable. Simply finding cheaper versions of the same operating models will not deliver the real cost savings that firms need. As the post trade industry faces up to outdated regimes some firms have already reengineered their business models. David Pearson, strategic business architect, Fidessa and co-chair of the FIX Trading Community Post-trade Working Group, posits the view that the T+2 settlement initiative should encourage firms to look anew at legacy systems and processes and dare to change to meet new market requirements.

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ETPs/ETFs

WORSENING GEO-POLITICAL RISKS BOOST COMMODITIES

Commodity price moves are making headlines again after a relatively quiet period earlier this year. The intensifying crisis in Iraq is fuelling the rise in crude oil prices, the six-month long miners’ strike in South African has pushed platinum and palladium prices higher and gold is also attractive again as a safehaven buy. By Vanya Dragomanovich.

COMMODITY ETFs: THE MAKINGS OF A PERFECT PARTNERSHIP? OR MANY INVESTORS exchangetraded products (ETPs) are becoming the financial instrument of choice when it comes to commodities as they are easy to trade, they bypass some of the regulatory restrictions linked to futures and they come with relatively low fees. At the end of May assets in commodity ETPs stood at $136bn, only 5.3% of the phenomenally high $2.55trn in global exchange-traded funds (ETFs) and ETP assets, but clearly on the rise. According to ETF specialists ETFGI, in 2005 assets in commodity exchange-traded products were only $8bn but they mushroomed to $223bn by 2012. Since then there have been significant outflows during the periods when gold prices fell sharply but the levels this year are back to those last seen at the end of 2009. Although commodity ETFs in the US hark back to the early 1990s, and were introduced in Europe in 2000, initially institutional investors showed little interest in them. The upward spiral in gold, oil and metal prices which started in 2005 changed all that.“Up until then investors had typically 60% exposure to stocks and 40% to bonds and this was the threshold of their allocation. Investors started to take note only in about 2005 when there was a big run up in oil,”says a commodities trader who preferred to remain anonymous. European investors are still noticeably more in favour of commodity ETPs than their US peers. In Europe commodity ETPs make up 9.5% of total ETF/ETP assets whereas in the US this percentage is only 4.7%, according to ETFGI data. Precious metals, and gold in particular, are the most popular type of commodities

Photograph © Skypixel/Dreamstime.com, supplied July 2014

ETFs making up 70.8%, or $96.4bn, of global commodity ETF and ETP assets. Gold products alone have attracted a total of $68.8bn. The instruments available to investors fall into two main categories: ETFs, which trade on a stock exchange like shares and exchange-traded notes (ETNs), which are more akin to bonds. In the case of Europe, they are frequently UCITS compliant. ETFs frequently track the price of a single commodity, typically a future, or in the case of gold, the spot gold price. This type of financial instrument is used for commodities that are easily stored, such as base and precious metals, and is typically backed by the physical commodity which is deposited in storage and remains there as long as the position is open. Gold and other precious metals are stored in bank vaults, most frequently with HSBC, while base metals like copper and aluminium are held in London Metal Exchange (LME) warehouses.

The largest such ETF product is SPDR Gold Shares managed by State Street Global Advisors, which was for several years the second-largest exchange-traded fund in the world. Among the largest single-commodity ETFs in Europe are ETF Securities Physical Platinum Shares and ETFS Physical Palladium Shares. The other type of commodity ETP investors will come across is a swap-based structure, an exchange-traded note (ETN).“Basically a bank or perhaps an oil company will be tasked in delivering a return of a benchmark such as a commodity index, less the fee they charge for providing a swap,”says Neil Jamieson, Head of UK & Ireland, ETF Securities. Here, counter-party risk is addressed through the provision of collateral, such as AAA money market funds, T-bills or AArated G10 sovereign debt, posted with a collateral manager and marked-tomarket on a daily basis. These kinds of structures are more appropriate for commodities which are not practical to store, such as corn or coffee. Apart from the ease of access and a much lower regulatory burden than in the case of futures, what also appeals to investors is that both products have a significantly lower cost than comparable mutual funds. Mutual funds typically have a total expense ratio (TER) of between 1% and 3% while the TER for ETFs and ETPs is normally in the 0.2% to 1% range. For instance, the TER on the db Physical Gold ETC is 29 basis points (bps) per year, on ETF Securities single commodity ETFs it is around 45pbs. Although both structures are tried and tested there are few pros and cons for each. In the case of ETFs, investors don’t have to carry any credit risk, unlike with

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ETNs. However, in turn, ETNs fall under a far more favourable tax regime which has motivated investors - particularly in the U.S. - to try out commodity ETNs. In the United States ETFs investing in commodity futures are subject to the 60/40 rule, that is 60% of the gains and losses from selling this type of assets are taxed at a long-term gain rate of tax which is 23.8% and the remainder at a shortterm gain tax rate of 43.3%—the highest in the US. Owning commodity futures requires the investor to pay tax on the gain experienced by those futures regardless of whether the investor has sold the underlying futures or not. “This can be an administrative headache and even if you don't sell the futures you still have to pay tax on the gain every year. This is almost a full show-stopper for institutional investors in the US who want to have exposure to commodities,”says a London based commodities trader. In the case of ETNs there is no tax to pay until investors unwind their positions and then when they do sell the product they are subject to the more favourable long-term gains tax. However, what keeps some investors away from ETNs is that buying them involves taking on credit risk —albeit a very short term one. The investor buys a credit note from the bank stating that the bank will deliver the return on a, for example, diversified commodity index, but if the bank goes bankrupt, the investor will become a creditor of the bank. “Many investors, when they hear that, don't do the second level of analysis – the taxation and the massively favourable after-tax returns on ETNs versus ETFs – which is a shame. However, this is slowly changing as investors are getting more comfortable with credit risk again,” says the trader. ETNs can be redeemed every day at their net asset value, which means that effectively, although there is credit risk involved, investors have to carry the risk only for one day unlike in the case of bonds which can be for years. Investors less familiar with the ins and outs of the commodity markets frequently look to gain exposure by investing in oil or

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mining companies, or into commodity producing regions such as the Middle East, or Brazil for soft commodities. The choice will depend on the investor’s remit, but it is worth bearing in mind that fundamentally commodity companies, countries and commodities themselves are driven by different factors. “In the past investors may have taken positions in, say, a metals mining company in order to get indirect exposure to gold, but by using a gold ETC they can get exposure to the commodity itself without the equity correlation,” says Manooj Mistry, London-based head of exchange-traded products and institutional passive, EMEA, at Deutsche Asset & Wealth Management. For instance, although there will be some correlation between a share of BP or Shell and the oil price, the oil price will move much faster on the back of geopolitical news, such as unrest in the Middle East, while BP shares will react not only to the price of oil but also to company specific news such as large capital expenditure, mergers and acquisitions, or major disruptions like strikes and fires at platforms. “If you look at commodity returns versus commodity equities returns in the current situation in the Middle East it is pretty clear that things are going awry for companies working there while the oil price might be going up. Similarly if you look at the strike in South Africa, this is bad news for the companies facing the strike but good news for platinum and palladium prices,” says Jamieson. When it comes to regional exposure there could be reasons other than commodities price performance for why investors might want to invest, such as relatively low valuations compared to other countries. For instance Russia ETFs will typically have a large exposure to gas producers, oil companies and mining companies but the underlying index will also have exposure to banks and telecoms companies. The price/earnings ratios for companies in Russia ETFs are far lower than for most other emerging market or BRIC countries ETFs and in that respect could be an inter-

esting investment. Here three of the top three products are Market Vectors Russia ETF, the iShares MSCI Russia Capped ETF and the SPDR S&P Russia ETF. So why opt for ETFs rather than investing in commodity futures directly? Although investing in commodity futures is a more cost effective way of gaining exposure to commodities—the investor needs to only be able to cover the margins rather than the finance the full value of investment—investors who are not as active managers as for instance hedge funds, who don’t have the relevant expertise, or have to comply with certain regulatory requirements such as UCITS, may not be able to use futures at all. ETFs and ETPs neatly cover this gap. “Exchange traded products are easy to manage from an operational point of view, they trade and settle like equity and fixed income, and they are UCITSeligible,” explains Jamieson. Critics of ETFs have frequently cited the rollingover of contracts as one of the issues that can erode returns of such instruments. For instance, an ETF provider of a Brent crude ETF holds the underlying Brent crude oil futures. This contract is traded on a monthly basis and the provider has to sell the June Brent crude contract by the end of June and buy the July contract to keep his overall exposure to oil. If oil prices are rising, the provider will make a loss on the trade and this will be passed on to the investor, but the same will happen if prices are declining over the time curve. However, this kind of erosion is inherent to having exposure to a futures position and would be incurred by any financial instrument linked to futures.

Investment strategies At present several commodities present an interesting buy. The situation in Iraq is keeping the oil market on its toes and there is no promise of a quick solution, which means that oil prices could trend higher over the coming months. In South Africa, which is the biggest global producer of platinum and the second largest palladium producer, miners have been on strike since midJanuary. There are now signs that a deal

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ETPs/ETFs

WORSENING GEO-POLITICAL RISKS BOOST COMMODITIES

to end the strike is close to being signed but nevertheless, five months of production have been irrevocably lost this year and the short fall will not be easy to make up. The two metals are not only used for jewellery but are also a key component used by the car industry to reduce emissions. Among base metals, nickel is the most interesting buy and has already rallied almost 50% since the beginning of the year. The metal is widely used to make

stainless steel and consequently has applications in construction, car making, airplanes, shipbuilding and infrastructure. The trigger for the rally came from Indonesia after the country introduced an export ban on exports of nickel ore this year. This ore was mainly bought by Chinese steel makers who now have to look for alternative sources of supply, leading analysts to anticipate that prices will continue to rise for the rest of the year.

In addition, the tensions in Ukraine are also spilling into the commodities markets particularly as an escalation of fighting could eventually lead to tougher sanctions against Russia and could potentially disrupt Russia’s sizeable exports of gas, oil, nickel and palladium. Deutsche Bank, UBS, ETF Securities and a number of others provide ETPs with exposure to all of these commodities, either as a single commodity or within a basket. n

On July 21st in separate initiatives, both Turquoise and BATS Chi-X Europe (BATS) extended interoperable clearing to include exchange-traded funds (ETFs) and exchange-traded products (ETPs). Both Turquoise’s and BATS’s trading participants will be able to select one of three central counterparties (EuroCCP, LCH.Clearnet, or SIX X-Clear) to clear their trades executed on their respective order books. The change, which brings the clearing and settlement treatment of ETFs and ETPs in line with other equity trading activity, will allow participants to net their ETF/ETP trades across multiple clearing venues.

INTEROPERABLE CLEARING OF ETFS IN EUROPE HE MOVE TO interoperability will help make the trading of ETFs more efficient, goes the thinking. “The European ETF market is around a tenth of the size of its US equivalent, and changes to simplify market structure will enable it to grow in size and efficiency. We pursued our Registered Investment Exchange license, which is now a year old, with the explicit intention of improving the European ETF market and the momentum we’ve achieved so far reflects our commitment to reform this critical element of the market,” explains Guy Simpkin, head of business development at BATS. Given as much as 70% of all European ETF trading occurs over-thecounter, BATS has also made the interoperable model available to participants using the Exchange Trade Reporting capabilities within BATS’ BXTR suite of products. This will allow customers and their clients to realise significant collateral, risk and cost benefits. “We are encouraged that

regulators have realised its huge potential in reducing cost and increasing market efficiency in the European module is needed. These addendums are usually in three parts: involving negotiable commercial terms; agreed structural changes to the underlying trading document that reflects the realities of clearing; and they must reference CCP rules (otherwise, what’s the point?). Some of these parts are negotiable, some not, so discuss carefully what will be required of you.” CCP interoperability is an arrangement that links different CCPs, allowing participants of one CCP to seamlessly deal with participants of another CCP. This can make it cheaper for traders to participate in a wider range of financial markets, and can facilitate competition between CCPs by opening up participant networks. While interoperability introduces flexibility and market transparency; it can in some instances also introduce financial stability risks, primarily by creating dependencies between the

linked CCPs. Interoperability arrangements are currently in place between some CCPs serving European equity markets, and another type of arrangement is in place linking several US CCPs. Until the initiatives by BATS and Turquoise in Europe the same ETFs and ETPs were listed across multiple markets but were also only cleared at the CCP tied to the venue they were traded on. This required firms to post collateral at multiple clearing houses to cover trades in the same instrument. What interoperability means is that collateral posted at one CCP can also be harnessed at another to help clear or cover trades and thereby help lower costs. Interoperability is already offered in the equities marks and those exchanges that up to now do not offer multiple clearers, such as Deutsche Börse, will have to do so under incoming rules under the second iteration of the European Markets in Financial Instruments Directive (MiFID II).

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Global AUM falls as investors cut positions CONTRARIAN STANCE BY S&L investors took hold over commodities, as sharp falls in natural gas futures accompanied bullish flows in natural gas ETPs, while the marked rally in silver futures coincided with bearish flows in silver ETPs, according to BOOST ETP. The assets under management of S&L ETPs stood at $60bn at the end of June this year. Since the beginning of the year AUM rose 168%, matched with trading volume close to $1bn over the same period. According to Viktor Nossek, head of research at BOOST ETP, A WisdomTree Company: “June saw S&L investors cutting their exposure to equity and debt markets and in the process have repositioned more bearishly. The persistent uptrend in major equity markets globally is likely to have triggered a more cautious stance. Nevertheless, despite the flows in equity ETPs being underpinned by the unwinding of relative large long positions, S&L investors’ equity allocations in US, Japan and European region focused equity markets continue to remain biased towards a bullish stance, even as they remain overwhelmingly bearish on bonds. Opportunistic repositioning in June occurred mainly on the margin in UK and French equities, where bullish flows coincided with falling equity market prices there, and in commodities, where there is a strong contrarian conviction.” Investors increasingly use S&L ETPs for a variety of reasons. There is wider product availability, greater product knowledge from improved educational resources, and increased demand for hedging tools and leveraged instruments available. There is also a move towards in-

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dependent, transparent and exchange traded instruments such as ETFs and ETPs. “Globally, there are $41.5bn of assets held in S&L equity ETPs and $4bn of assets held in S&L commodity ETCs,” says Nossek. Investors in S&L ETPs express bullish as well as bearish sentiment by investing in either a leveraged or a short ETP, and therefore, says BOOST, assets under management of S&L ETPs “can reveal a broader range of investor sentiment than flows or AUM data for mutual funds and other ETPs. Since S&L ETPs tend to be held for shorter periods and used more for tactical positioning, AUM and flows data for S&L ETPs can provide valuable insight into the market sentiment of a relatively sophisticated set of investors” says the BOOST Short & Leveraged ETFs/ETPs Global Flows Report, which highlights the key flows and trends in S&L ETPs across asset classes and geographies.

Bearish sentiment In cutting their exposure across major equity markets, most notably in Japan, US and Europe, S&L investors repositioned bearishly in June. Bearishness was most pronounced in Japanese equities, where $780m in long positions were redeemed. Similar bearish repositioning by S&L investors also took hold over US equities and European country focused equity ETPs. Within US equity ETPs, $535m redemptions in long ETPs accompanied $298m creations in short ETPs. Within European equity markets, the inflows into short ETPs with a leverage factor of -2x coinciding with outflows from long ETPs with a leverage factor of +2x underscored S&L investors’ strong bearish

conviction in Italy and Germany, says BOOST. In contrast, the flows in UK and French equity ETPs were bullish.“Having seen major bearish repositioning in May amidst lacklustre equity markets in France and the UK, S&L investors took a contrarian bet in equity markets there in June. US debt ETPs saw $1.3bn of outflows from long positions, a marked reversal from the $1.9bn of inflows in May. Upbeat producer and consumer sentiment indicators for the US, combined with the Fed’s confident tone in justifying the trimming of QE by another $10bn per month may have driven S&L investors to cut their long positions,” says the report. The contrarian stance taken by S&L Investors in silver and natural gas underscored sentiment in commodities. The sharp fall in natural gas futures accompanied bullish repositioning in natural gas ETPs, while the marked rally in silver futures coincided with bearish repositioning in silver ETPs. Despite these flows however, S&L investors remain predominantly bearishly allocated in natural gas (30% of AUM held as long positions) and bullishly allocated in silver ETPs (87% of AUM held as long positions). In terms of asset allocation, equity ETPs are the most popular with 69% of total AUM ($41.5bn), followed by debt (18%, $10.9bn) and commodities (7%, $4bn). In equities, most of the AUM is focused on the US (US large cap, US small cap and US sector equities of $22.3bn) and European equities ($6.2bn). In Europe, broad European indices excluding sector focused ETPs are the most popular ($2.5bn in AUM), followed by Germany ($1.3bn), Italy ($665m) and France ($574m). n

S&L ETP INVESTORS CUT THEIR EXPOSURE TO EQUITIES

Short & Leverage (S&L) exchange traded product (ETP) and exchange traded funds (ETFs) investors have cut their exposure to equities as outflows overwhelmed inflows in US, Europe and Japan ETPs. BOOST ETP’s, latest S&L ETP report suggests $60bn of assets under management (AUM) is held in S&L ETPs as at the end of June, down 1.7% from the end of May and up 3.5% from the end of December 2013. Outflows in US debt ETPs also exceeded inflows into German debt ETPs. Bearish repositioning by S&L investors has underpinned flows in equity and debt ETPs, with Japan recording $780m in redemptions of long ETPs, according to the firm.

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COUNTRY REPORT

ASSESSING THE IMPACT OF PRESIDENTIAL ELECTIONS IN AUGUST

Turkish Prime Minister and presidential candidate of the ruling party in the August election, Recep Tayyip Erdogan addresses his supporters in Istanbul, Turkey, Friday July 25th. Photograph by Emrah Gurel for AP. Photograph supplied by pressassociationimages.com, July 2014.

Upcoming elections in Turkey (the first round is scheduled for August 10th) will likely see current premier Recep Tayyip Erdoğan (who has led the country as premier for the last 12 years) assume the presidency. What might happen once he takes on the presidential mantle? No one in the country will go on the record in commenting on the election and its possible aftermath. It is certainly a tipping point in the country’s outlook. The elections come at a time when Turkey looks to have exhausted its patience and momentum in its efforts to join the European Union; it is looking to establish itself as a viable capital markets and investment hub for its near region and where the government is possibly losing its status as a democratic model for the Middle East. How might foreign investors react to the inevitable shifts in government and foreign policy that might now ensue? Francesca Carnevale looks at the possible outcomes.

TURKEY AT THE TIPPING POINT? A S CONFLICTS IN Iraq and Syria threaten to spill their contents into eastern Turkey, and domestic political opposition melts into anonymity, the omens of fortune look good for Turkish premier Recep Tayyip Erdo˘gan on the eve of his almost certain elevation to the presidency. It is a critical turn in Turkey’s road to modernity, as Erdo˘gan’s

ascension most likely will signal the end of the secular, republican legacy of Mustafa Kemal Ataturk. If Erdogan ˘ achieves a reformed US-style presidency (and if his current reformation of the country’s regional boundaries and administration is anything to go by, this looks like his aim), he could end up leading the country for another generation at least.

Up to now, Erdo˘gan has encountered little meaningful opposition; any dissent or dissembling from his world view have been deeply discouraged through show trials, imprisonment and harassment. His position to the outside world looks invincible, as he is bolstered by encouragement from the United States (as Turkey is regarded as a key bulwark against armed an ‘radicalised’ Islamic movements in the Levant and Iraq) and widespread popular support at home (outside the more ‘sophisticated’ intelligentsia concentrated in cities such as Istanbul, that still hankers after Turkey’s recent secular experience). According to recent polls, Erdogan will likely secure the presidency in the first round of voting as he has support of around 55.0% of the votes. For someone with such an extensive and supportive caucus, the man remains unnervingly paranoid. He regularly tours the country, railing against “the enemy within”, as he commonly refers to his critics. He constantly whines that Turkey is under attack from ‘spies and traitors’ and particular venom is reserved for the pro-secular military and a now exiled Islamic cleric Fethullah Gulen. Recent municipal elections in March added up to a personal victory for Erdo˘gan, who despite not running on a specific ticket, dominated the campaign. The AKP’s share of the vote was up six points on 2009, at around 45%, while the main opposition trailed with around 29%. On the other hand, the AKP total was 5% down on the last general election, when it polled 50% of all votes. The measure of support he garners has hardly dulled then, even as a series of corruption scandals have seriously pricked at his selfdescribed image of probity; and his heavy handed methods in suppressing last summer’s Gezi Park protests in Istanbul caused some to wonder why he is unable to handle disagreement in any form. It seems unlikely that on ascending to the presidency that Erdo˘gan will accept someone in a more [constitutionally] powerful position than him as premier. In other words, the elections for president could presage a wider struggle for the heart and soul of the country. The

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question becomes ever deeper: should Turkey accept arbitrary or autocratic rule if economic growth is such that it will override, in the minds of the population, all other considerations? It’s an important philosophical consideration for voters and for foreign investors. What is clear is that in rapid growth markets (RGMS) the social dimension is increasingly complex. In high growth emerging markets you rarely find too much angst over the corruption of officials and government actors. Moreover, the 21st century seems to be an era where popular support for the traditional western definition of secular democracy appears to be waning (even in the UK, the template for parliamentary democracy, barely a third of the eligible population can be bothered to vote, even in national elections, which only come around once every five or six years). Erdo˘gan ’s tacit position seems to be: if it works, why tamper with the realities of modern day politics and the extra-curriculum revenues political positions generate for politicians, their families and friends? As long, of course, as the general population also finds themselves beneficiaries of one-man, one-party rule.

Derliverables: economic outlook The country’s economic sub-text has weakened over the last few years, but not enough to upend Erdo˘gan’s standing as a deliverer of economic munificence. The first half of 2014 has been something of a mixed bag: with the country’s main economic indicators deteriorating heavily in both April and June, though industrial production looks to have accelerated over April, but then decelerated again in May. The country’s current account balance was $3.4bn in deficit through May (and over $16bn in deficit over the year), well down on April’s $4.8bn deficit and the $7.6bn deficit in May 2013.The deficit was less than the $4bn deficit that market analysts had expected and brings the deficit equivalent to 7.2% of GDP. The growth in exports has also slowed, according to May’s figures, growing only 3.8% over the month, but this was counterbalanced by a massive 9.9% reduction

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in imports over the month, bringing down the trade deficit from $8bn in May 2013 to $5.3bn over May this year. Interest rates too continue to fall, albeit slowly, but still in line with Erdogan’s ˘ preferred policy. At its July 17th monetary policy meeting, the central bank cut the one-week repo rate by 50 basis points (bps) to 8.25%, which followed the previous month’s 50 basis points cut. The bank also lowered the borrowing rate by 50 basis points to 7.50%. Conversely, the CBRT decided not to change the marginal funding rate (12.00%) and the overnight lending rate for primary dealers (11.50%). The decision was in line with market expectations; but the central bank has come under pressure from Erdogan ˘ to ease up on interest rates to help cut the TYR exchange rate and spur exports. However, the difference between the yield on five year government bonds (8.5%) and the policy rate continues pretty close and has been since March. It is therefore a difficult balancing act for the central bank, as it will want to stay in Erdo˘gan’s good books by keeping rates low, but unnecessarily lower rates could put further downward pressure on the TYR and the central bank’s disinflation programme. The upshot is that unemployment is still hanging around 9%, neither rising nor falling over the first half of the year. What it all adds up to is an overall benign if not exciting economic backdrop to the incoming president’s first term of office; with 2015 expected to provide much of the same.

Foreign investment inflows Investor approaches to Turkey have also been relatively benign. There is a core of committed foreign investors with specialist knowledge of the country that keeps money there, regardless of short term political risk factors. The fact that the underlying level of foreign indirect investment inflows into the stock exchange have remained around the 63% benchmark (come rain or shine in the economy), gives Borsa Istanbul and the government an important level of confidence in the robustness of the country’s equity capital market offering to the foreign investment

community. Any indirect inflows above this level tends to be hot money; coming in at times of perceived opportunity and fleeing once more at the slightest nudge in market conditions. In terms of direct investments, the situation is much more nuanced. According to recent figures released by the Economy Ministry, foreign direct investment inflows have benefited some 30,851 companies over the last half century (1954 to 2013), while just over 6000 Turkish firms have partners with foreign companies. This brings the number of Turkish companies (mainly wholesale/retail and real estate) with foreign capital up to 36,950 over the same period; most (just under half coming from the European Union, with Germany accounting for over 5,500). Of course, direct foreign investment has also impacted on Turkey’s banking segment. Foreign investors have a major presence in the banking sector as well. Out of the country’s 49 banks, foreign financial institutions hold stakes in 37 of them. According to a recent survey by the Istanbul Chamber of Certified Public Accountants, the $20.5bn invested in shares of 21 banks between 2001 (the year in which the banking crisis encouraged most local banks to find foreign partners to ensure their survival) and 2014, some $17bn has been returned in profits, with the value of the initial stakes rising to more than $27bn. About 25% of Turkey’s banking system today is held by foreigners. In 2006 and 2007, the FDI Turkey attracted stood at $20.1bn and $22bn respectively before dropping to $19.7bn in 2008 with the arrival of the global crisis. The real impact was felt the following year, when FDIs dropped sharply to $8.6bn. The figure rose to $9bn in 2010 and then again to $16bn in 2011. New inflows fell off to $13.2bn in 2012 and $12.7bn in 2013. The FDI level in 2014 will be crucial, for it will signal whether the regression continues or whether an upward trend has begun. Optimism currently prevails on the issue.Two trends are clearly apparent: foreign direct investment inflows into Turkey are more related to global macro trends than internal

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COUNTRY REPORT

ASSESSING THE IMPACT OF PRESIDENTIAL ELECTIONS IN AUGUST

Turkey’s current president Abdullah Gul with a Palestinian foulard, second right, listens to a citizen after dawn prayers on the first day of Eid al-Fitr, in Istanbul, Turkey, Monday, July 28th. Monday marked the beginning of the three-day Eid holiday, which caps the Muslim fasting month of Ramadan. Muslims usually start the day with dawn prayers and visiting cemeteries to pay their respects to the dead, with children getting new clothes, toys, shoes and haircuts, and families visiting each other. AP Photo. Photograph supplied by pressassociationimages.com, July 2014.

issues: something which Erdogan ˘ is keenly aware of. Ever hopeful, the Chamber of Accountants posits the view that FDI inflows will again top $16bn this year. If that is the case, then the AKP polity will claim game and set. In particular, the downturn in direct foreign investment is more related to the status of the civil wars in Syria and Iraq rather than the outcome of the presidential election. This will work in two ways for the incoming president: one it will bring Turkey closer into the American sphere of influence and palimony, as the president shows no signs of accommodating his stance against the newly emergent Islamic power factions. Second, it will play to the country’s increasingly localised political rhetoric, which encompasses the Black Sea region, and is also populated with autocratic rulers and resource rich economies, in which Erdo˘gan finds a sympathetic polemic. He wins either way.

Not quite game, set and match It is not match-play yet, as there is one final element that needs to fall into place for Erdo˘gan’s path to life-presidency to become reality. If the current president Abdullah Gul were to decide to run for the premiership, then the president’s position in the overall power structure of Turkish politics might not actually change that much. Gul too is a seasoned politician and could, if he wanted to, give Erdogan ˘ a run for his money and use the constitution to temper the powers of the new president. However, if Gul did throw his hat into the ring as premier and is successful elected, it is not clear whether he would assume the mantle of say a Medvedev and be a soft alternative to a much stronger political partner, who would be the real hand on the country’s political tiller. Or, whether Gul feels confident enough of his own credentials to run as leader of the AKP and run the

country as premier with his own agenda. No one is sure. There is another nuance too. Should Gul try to run and Erdo˘gan manages to block his ally’s path to assuming the reins of the party and government, then a frustrated Gul could create a constitutional crisis. Presidents, even in modern day Turkey, are meant to be above the fray and if Erdo˘gan were to overplay his hand in this regard, then it might upend his plans to run Turkey for generations to come. Even so, he might yet do it, as over the years, through fear and coercion and emollients, Erdo˘gan has built an extensive and powerful feudal network, that incorporates bankers, the press, religious groups and business organisations and corporations whose fortunes are dependent on his largesse and contracts and who do his bidding without complaint. Moreover, there is no guarantee that Gul will run at all. If Gul decides not to run for the premiership, then Erdogan’s ˘ path is wide open. The likelihood is that he will choose a puppet premier who would do his bidding and he would use the immediate post-election period to introduce formal changes to the constitution that would enable him to transform Turkey into whatever political system suits his interests. For the West (read the United States) that would not necessarily be seen as a bad thing. Although politically divisive, pro-Islamic and autocratic, Erdo˘gan’s is essentially a pro-western politician who has no truck with the more radical Islamic pressure groups across the globe. However, he has lost patience with Europe’s seeming intransigence in allowing Turkey to join the union, and the general chatter among the country’s intelligentsia is now very much that the country is better off out of it than in it. Besides, its Capital Markets Board, one of the country’s financial regulators continues to keep a close eye on regulatory initiatives elsewhere and has encouraged the government to introduce market reforms that help the country in step with principal rules and taxes extant elsewhere. Much more of the same then. n

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PROFILE: BORSA ISTANBUL

Turkey’s stock exchange, Borsa Istanbul (BIST), has been on the rise in recent weeks following a turbulent few months. Francesca Carnevale spoke to Huseyin Zafer, the exchange’s director of finance and communications about its near term outlook and strategy.

BORSA ISTANBUL: LOVE IN A TIME OF CHOLERA? T HAS BEEN a tumultuous year for Borsa Istanbul; buffeted by the same cold economic winds that have impacted on all emerging markets since the US central bank signalled a gradual tightening of monetary policy in May last year. That, added to the Gezi Park protests, has lowered the temperature of investor sentiment in emerging high growth markets per se and Turkey in particular over the last year or so. Even so, Borsa Istanbul has big ideas and big dreams. The Istanbul International Finance Center (IFC) project aims to make Istanbul a financial hub where local and international market partici-

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pants are located, and Borsa Istanbul one of its star attractions. The government and the country’s central bank and Capital Markets Board have been working overtime to define a comprehensive financial, legal and technical infrastructure upon which the country’s unique selling point can be defined. It is still a work in progress. In line with the IFC dream, the Borsa has also stepped up its efforts to turn into a global exchange that is highly liquid, offering a diverse issuer/investor base, state of the art technology and a rich product mix. It’s a big ask, but the exchange remains adamant it is up to the task.

TECHNOLOGY UPGRADES BRING IFC DREAM CLOSER

Huseyin Zafer, Borsa Istanbul’s director of finance and communications. Photograph kindly supplied by Borsa Istanbul, July 2014.

A large step change occurred in August last year, which brought the exchange’s aspirations closer when it signed an agreement with NASDAQ OMX whereby Borsa Istanbul has obtained up to date technology, supporting a multi-asset, multi-currency platform, that will be integrated into all trading and post-trade functions, with customary key features such as connectivity and risk management. The agreement was a pillar on which the exchange could build its credentials as a regional capital markets hub and the venture is now becoming entrenched in the exchange’s day to day operations According to Zafer,“In light of heightened competition and the significant role of technology in the exchange business, the strategic partnership agreement with Nasdaq OMX to renew its technological infrastructure makes sense. Borsa Istanbul will also have the right to make changes and improvements to the technology, which will enable us to develop and maintain our competitiveness over the medium and long term.” In terms of timing, implementation of the first phase covers cash equities and is scheduled to be completed by the first half of 2015. The second phase includes all other asset classes and is scheduled to be completed by the first half of 2016, explains Zafer.“As we move forward with the project, efficiency will be significantly enhanced. For example, we will be able to accommodate 100,000 orders per second by mid-2015. This enhancement means we can work to attract more institutional investors onto the exchange, with an attendant increase in trading volume.” The Borsa has not rested its laurels just on this relationship. MoUs with exchanges such as the Japan Exchange Group, NYSE Liffe and the Vienna Stock Exchange took place under the exchange’s previous incarnation as the Istanbul Stock Exchange (IMKB); but none were as inclusive as the deal with NASDAQ OMX. Even so, Zafer explains that: “As an exchange which aims to be the technology and finance hub of the region, Borsa Istanbul continues to establish new relations with exchanges and financial institutions all around the

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PROFILE: BORSA ISTANBUL

TECHNOLOGY UPGRADES BRING IFC DREAM CLOSER

world [sic]. For this purpose, we have signed MoUs with various exchanges in the Balkans, Central Asia and MENA region. Joint product and technology development schemes, connectivity projects, exchange of personnel, and education are major areas of cooperation with other exchanges and we continue to work with them on progressing new projects.” The exchange appears aware of the fact that becoming a financial hub is not possible without strengthening linkages with other exchanges and extending presence in other regions.“In this context, we acquired a 24.4% stake in the Montenegro Stock Exchange in 2013. Accordingly, the exchange group now holds strategic stakes in four stock exchanges, including the Kyrgyz Stock Exchange, Baku Stock Exchange, Sarajevo Stock Exchange and Montenegro Stock Exchange,” explains Zafer. “Furthermore, by developing one-to-one close linkages with various exchanges especially in the near region, Borsa Istanbul aims to be a gateway for those institutions which aspire to open up their markets to international investors.”

The importance of DMA Nowhere have the vagaries and challenges of the last year been more evident than in the share of foreign money in the Borsa. In the first half of January last year, foreign inflows reached a peak accounting for 73% of trading on the exchange and in less than a month had fallen to 62.08% (a level below that of the 2008 financial crisis). Since then the country has not been able to revitalise the level of foreign involvement on the exchange at that peak level. Only one month after the peak, investment fell to 62.08%, below even its lowest level during the 2008 financial crisis. Foreign investors, however, began to return in rather modest numbers after the March elections this year. According to Is¸ Yatirim figures, foreign investment amounted to 63.81% in early May. “Foreign investors have made significant contributions to the development of Borsa Istanbul and are quite active in our

markets,” acknowledges Zafer. “They [currently] hold around 64% of free-float and their participation in initial and secondary public offerings of Turkish companies is at quite high levels as well. The increase in foreign ownership in freefloat from 43% in 2002 to 64% today shows both the strong interest from foreign investors and improved access to the Turkish market.” Improved technology and market access are keystones of the exchange’s strategy. “We believe that DMA will further boost the share of foreign investors in trading as the technological infrastructure of our trading platform is enhanced. Institutional investors will be more likely to participate in the Turkish market and we will also be able accommodate HFT trading and more algorithmic trading as well. Volume tends to jump after exchanges put DMA into effect,” he says. Key to further inflows of foreign money is growth in the number and range of the exchange’s listed securities. There are 421 companies currently listed and some 96 initial public offerings (IPOs) were realised between 2008 and 2013 yet the exchange’s market capitalisation to GDP ratio stands only at 29% (at the end of 2013).“Considering the fact that only 126 out of 1000 largest industrial companies in Turkey are currently listed, Borsa Istanbul’s focus will be on attracting more blue chip firms. This will help boost the market capitalisation of the Turkish stock market and, at the same time, also encourage small and medium size enterprises to come on board,” acknowledges Zafer. ”Our target is to increase the market cap to GDP ratio to 60%-70% levels,” he stresses. Borsa Istanbul has also stepped up its efforts to encourage more IPOs through a planned schedule of roadshows, organised events, on-site visits and media campaigns. “We are fully aware that a higher level of participation of companies in Turkey’s capital markets will only be possible if there is a shift from family-run business models to a more institution-led or corporate business model. We believe that if we can truly communicate to

Turkish firms the benefits of going public and increase the awareness about opportunities offered by the capital market, then the number of listed companies on our platforms will rise substantially,” says Zafer. He also mentions ListingIstanbul, a new initiative of the exchange, to help attract foreign companies to list on the exchange and a planned venture capital platform (pre-IPO) that will hopefully lead to more public offerings in future.

International companies Integral to the exchange’s intentions to develop as a regional listings hub is attracting a well-spring of companies in the hinterlands around the Black Sea and beyond. “We are fully aware that we have to diversify our issuer base. For example, at the London Stock Exchange, more than 20% of listed companies are foreign companies and that is what makes London a truly global financial centre,” explains Zafer. He also notes that the exchange ranks third among world exchanges in terms of share turnover velocity and has the sixth highest equity market traded value among emerging markets as of 2013. “These figures demonstrate that we have vast liquidity to support both domestic and international companies that want to be listed on our platform,” he adds. “Moreover, in the ListingIstanbul initiative, we work closely with our program partners to promote Istanbul as a fundraising hub”.

New products Zafer believes that time is on the exchange’s side. “According to IMF predictions, the share of emerging markets in global output will increase from 37% in 2000 to 55% by 2018. Accordingly, an attendant increase in capital flow to developing markets is expected to materialise as the new economic powerhouses emerge,”he says.“At this critical juncture, the financial markets that will benefit most from such structural change will be ones that provide investors with the broadest product mix on efficient, reliable and transparent platforms.”

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Istanbul wants to become a regional and global international financial centre, with Borsa Istanbul one of its star attractions. Photograph by Eren Kalinbacak/Dreamstime.com, supplied July 2014.

Accordingly, Zafer explains that the Borsa is increasing its product mix to “meet different needs and demands of investors. Companies may now trade in currency options to better manage risk, while index and single stock derivatives are available for investors who want to undertake leveraged transactions, or hedge themselves against adverse market conditions. We also aim to offer Islamic debt securities. Considering our geographical position and cultural ties with the region, Islamic finance could be an important business line for us. Moreover, we have taken important steps in energy and metal trading as well. As a country which is a part of natural resource rich region, we will soon offer energy derivatives and base metals trading on Borsa İstanbul platforms,” he says. “These initiatives are expected to draw more diverse investment groups from different regions while also supporting the participation of local investors in Turkish financial markets,” he adds. The country’s new Capital Markets Law has been a very significant step forward for financial markets.“It is the first time that the functions and responsibilities of different financial institutions are defined in the law. It has brought in new regulations which will make things easier for

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both investors and issuers and creates a market-friendly environment,” he says. The law also led to the demutualisation of the Borsa. “This is a growth factor on its own and will lead to improved operational efficiency and better corporate governance. Just to give an example, initiatives such as the partnership with NASDAQ OMX or the IPO of Borsa Istanbul in 2015 would not be possible without the new structure of the Borsa. Extending the available product mix and initiation of new business areas are important elements of the Borsa Istanbul’s strategic roadmap. Among the recent initiatives adopted by the exchange, currency options on dollar started trading in May on its platform. “Borsa Istanbul will also establish a venture-capital platform where early-stage companies will meet potential institutional investors such as venture capital, angel investors and private equity,” explains Zafer. “Such a move will not only make it easier for startup firms to access capital but also boost the number of IPOs as investment firms in those start- ups might prefer to turn their investments into cash through public offerings,” he says. The upcoming Turkey Energy Exchange is another line of business. “We are a shareholder and the platform operator of

energy trading in Turkey. In addition to futures on electricity, other energy contracts (for example, natural gas) will be available to trade in Borsa Istanbul’s trading system. In addition to energy derivatives, in an effort to extend the product offering on the commodity side, Borsa İstanbul is establishing a metal derivatives market where base metals including steel are to be traded,” Zafer explains. Fixed income is also a promising segment in terms of growth potential for the exchange. “In the last four years corporate debt issuance jumped to $29bn in 2013 from almost nowhere. As Turkey accommodates more to the low interest environment and the private sector looks for more alternative financing sources; corporate debt securities segment will flourish,” says Zafer. Another business line is Islamic debt securities.“Consistently, sukuk issuances by the Turkish government are significantly over-subscribed. Although it is not a mature business yet, funding needs and large infrastructure investments in Turkey will be the main motivation behind the current momentum in the Turkish sukuk market over the medium term. Larger and frequent issuances will also support the liquidity of such instruments,” he adds. n

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FACE TO FACE

HUSEYIN OZKAYA, GENERAL MANAGER & BOARD MEMBER, ODEABANK

Backed by Lebanon’s Bank Audi, in less than two years of operation Odeabank has stomped the banking league tables in Turkey (from 49th to 14th place, with assets of TYR16.1bn at the end of the 2013 reporting period. The bank’s performance is set against a volatile, yet still vibrant economy. In June Odeabank’s general manager Hüseyin Özkaya met with Francesca Carnevale to talk through the salient trends in the bank’s fast growth trajectory. Özkaya remains buoyant about the prospects for the economy, stating; “As much as the first half of 2013 was positive in terms of the financial indicators in the Turkish economy, the second half was equally negative with the sharp worsening in the risk appetite towards developing countries. Within this framework, even though short term uncertainties make it difficult to predict, we still project that the risk premiums will improve in the second half of 2014.”

Leveraging Turkey’s growth potential RANCESCA CARNEVALE, EDITOR, FTSE GLOBAL MARKETS: You received your banking licence back in October 2012, beginning operations soon after (January 2013). When I met with you last year, you had plans to open 13 branches in 2013, growing to 100 outlets over a five year period and to become a top 15 bank. What have been the main achievements/benchmarks since that meeting? HUSEYIN OZKAYA, GENERAL MANAGER, ODEABANK: Actually we’ve made quite a powerful, or perhaps a better word is dramatic, entrance into the sector. Don’t forget we secured the first banking license in Turkey for at least fifteen years, so we had a lot to prove. We kicked off at 49th place in the country’s banking sector rankings, and as I promised you, we climbed pretty rapidly through the ranks to 14th place among deposit banks. That’s a fast and satisfying growth trajectory. By May this year our retail loan book reached almost TYR 1.1bn (about $520m) while SME loans reached to TYR1.6bn and the total loan book is

close to TYR 13.4bn as of May. Our total asset size is at TYR19bn and customer deposits are at TYR15.3bn. We achieved these numbers in less than two years thanks to a really committed group of people, including shareholders, the bankers we hired who have been top notch and our investment in value-added technology. I have asked the staff to continue putting us on a high growth footing and will continue to invest in technology to support that. At this point we have 1,200 determined and experienced bankers on board, each with clear business targets and a 42 strong branch network. We are ahead of track. FRANCESCA CARNEVALE: You literally started the bank from scratch: what have been the main lessons of the exercise? HUSEYIN OZKAYA: The opportunity to install a subsidiary in Turkey [the bank is owned by Bank Audi] from scratch was the most viable development option, compared with (say) making an acquisition and paying a goodwill/premium to the seller. Bank Audi has invested $1.1bn to date in the bank. Had our share-

Huseyin Ozkaya, general manager and board member, Odeabank. “Clearly, there is a huge profitable growth opportunity for all banks in Turkey in the retail loans market as the household income per capita and access to finance continues to increase. Recent macro-prudential measures to curb domestic demand by the authorities will have a negative impact on retail banking in the short term but in the long-run the potential is still there in my view,” says Ozkaya. Photograph kindly supplied by Odeabank, June 2014.

holder’s opted to make an acquisition instead, probably it would have cost at least around an incremental $500m in the form of goodwill to acquire a bank of comparable size. Another advantage of building out from scratch is that we had the opportunity to bring in talented and motivated people who were fired up by the challenge of building a new bank brand. We hired highly experienced banking leaders and encouraged them to build their ideal bank: it’s given us something of an edge I think in winning new business; and I can boast that have achieved this amazing growth performance. We believe that our biggest capital in Odeabank is our employees, it will always be that way with us.

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market, we have demonstrated the difference in our services by establishing a sound, and I would venture, superior technological infrastructure, in line with requirements of today’s information age, which offers very easy access to information. Certainly, the ease and speed of access to reliable/accurate data/account information is an important part of our service offering. FRANCESCA CARNEVALE: For a bank that has only been around for 20 months or so, you’ve won quite a few awards: did you expect that response? HUSEYIN OZKAYA: Our product portfolio is significant. It has to be to meet our client’s increasingly sophisticated requirements of providers of banking services. We delivered a first-of-its-kind platform in April 2013, launching our Fund Distribution Channel. This involved the analysis of the 400-plus investment funds currently managed in Turkey measured against 20 independent performance criteria. We then went out and signed distribution agreements with the best of those funds. The fund basket we created with this model offers our customers a selection of mutual funds of prominent investment companies that are accessible via a single channel. Moreover, we constantly update the funds listed in line with our investment strategies and market estimates. I say this because it is a hallmark of our overall offering: outstanding service levels, built on well-thought processes, a strong technological infrastructure and qualified and experienced human resource. We also benefit from a range of synergies created by the international reach of Bank Audi. These are the pillars on which our performance in attracting international recognition is based. We won, in turn, The Most Innovative Bank in Turkey and The Best New Bank of Turkey by Global Banking and Finance Review, a leading global title. Then we won the Jury Special Award in the 2013 Banking Technology Awards and the Most Innovative Bank Award in International Finance Magazine Awards 2013. Furthermore; we have been included in the World Finance 100 best companies ranking. It is good

to see the team’s efforts paying off in this way. FRANCESCA CARNEVALE: You recently entered the SME segment and signed a deal with the IFC, worth $75m to help finance trade in the segment. Trade and trade finance are key pillars of the Turkish banking system. How have market changes impacted on your business build in this market segment? HUSEYIN OZKAYA: In recent years there has been a discernible shift in the pattern of Turkey’s trade, with emerging market countries, especially those in the MENA region, becoming progressively more important. At the same time, the EU’s share in Turkey’s total trade has declined. Imports between Turkey and MENA have increased nine times and exports by a factor of 12 in the last ten years. Given that Bank Audi has a presence in major MENA countries, including Qatar, UAE, Jordan and Saudi Arabia, synergies are readily generated across the group as a whole. Additionally, our bank is well positioned to act as an intermediary between investors in the region keen in increasing their exposure to the Turkish economy. Turkey’s cost efficient, high production quality, geographical and cultural proximity were the main drivers behind the increase in trade volume with MENA. In 2001 Turkey was running a trade deficit with MENA countries and from 2003 Turkey became a net exporter to the region. MENA region is the one and only region that is creating a trade surplus for Turkey. Over the last decade, Turkish exports to MENA increased by seven times while exports to EU increased twice over. In 2013, the trade between Turkey and MENA was recorded as $72bn. Some $46bn worth of exports was executed in 2013, creating a positive trade balance of approximately $20bn dollars. Our remit is to provide bank and country risk coverage, to leverage limited trade lines in challenging markets and to build low risk based new correspondent bank relations in these regions. Again, we have the backing and experience of Bank Audi on the ground in many countries to help us with this. Moreover, we have worked hard

HUSEYIN OZKAYA, GENERAL MANAGER & BOARD MEMBER, ODEABANK

FRANCESCA CARNEVALE: The Turkish banking sector is well entrenched, but there is still a lot of opportunity in the segment for upcoming institutions such as yours. What are the unique selling points/the business proposition of the bank that you think distinguishes it from your competitors? Additionally, how saturated is the Turkish market and which is the most competitive segment: retail/commercial or corporate? HUSEYIN OZKAYA: You’re right. There is rigorous competition in Turkey in terms of banking. However, we think that Turkey still has so much potential. In reality it remains under-banked. Low household indebtedness and favorable demographics help. Compared with the population and lending dynamics in other European countries, it is clear that there is still huge potential in Turkey for the right bank. I think that is why foreign banks find this market so attractive; Turkey benefits from this competition, the choices it brings with it and the technological innovation that results. Let’s focus on some elements of this answer. The banking sector’s penetration into the Turkish population is still very low compared to most EU countries and we expect to see double digit loan growth over the short-to-mid-term. There remains huge growth potential especially in retail banking, trade finance and SME banking. Retail loans are more profitable compared to corporate loans, while the share of retail loans in the total loan portfolio is below EU average as well as most of the peer emerging market economies’ averages. Clearly, there is a huge profitable growth opportunity for all banks in Turkey in the retail loans market as the household income per capita and access to finance continues to increase. Recent macro-prudential measures to curb domestic demand by the authorities will have a negative impact on retail banking in the short term but in the long-run the potential is still there in my view. Overall our objective is to exist in every segment of the industry, including retail and SME. Since our entry into the Turkish

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FACE TO FACE

HUSEYIN OZKAYA, GENERAL MANAGER & BOARD MEMBER, ODEABANK

to put in place a number of agreements with international financial institutions such as the IFC, and establish strategic partnerships with its trade finance programs. Confirmed LCs and LGs, structured through our regional correspondent bank network and offer bank and country coverage are de rigueur and, of course, pricing is rational compared to risk eliminated. FRANCESCA CARNEVALE: Clearly risks have heightened in the near east (Syria, Jordan and even Lebanon); how are you helping Turkish corporations manage risk? HUSEYIN OZKAYA: Turkish companies have an appetite to secure business in lucrative overseas markets, and given the importance of the MENA region to our exporters, most of them have specialist sales teams with a special focus on these countries. Especially after the Arab Spring, there have been a lot of opportunity for Turkish contractors to provide engineering, sourcing and construction services in MENA, in the GCC countries in particular and across Africa. Of course lucrative overseas markets mean high returns are often coupled with greater risks. Therefore, in order to minimize the country, political and commercial risks associated with these countries, most of the Turkish companies doing business in risky regions closely follow the latest structures and trade finance products offered by banks or by credit insurance agencies. After being doubly hit by the financial crisis and the Arab Spring, Turkish exporters are looking for maximum security in trade transactions with MENA, resulting in increased demand for confirmed export LCs, trade credit insurances and counter guarantees. Old trading habits die hard though and rather than structured trade products, cash and advance payments still dominate trade with MENA. In this harsh market, in order to minimize the risk, we are trying to route our customers to safer structured trade products with the support of our group banks and our correspondent banks as mentioned above. FRANCESCA CARNEVALE You have three main business lines: retail, com-

mercial and corporate. For our purposes might we focus on the corporate segment please? What are the main challenges facing the corporate segment in Turkey? How as a bank are you helping Turkish companies manage these issues? HUSEYIN OZKAYA: In the current context of the economic environmental challenges; Turkish corporations are naturally hesitant and there is a definite sense that some are holding back from making new investments. Our corporate culture puts our clients in the category of business partner and we strive to serve their needs diligently via customised financings which gives them the flexibility to utilise the money when they need it. We also have to recognise that we live at a time of extreme market volatility, particularly with regard to foreign exchange and interest rates. Key challenges for Turkish corporations, as in other developing markets these days, are managing their FX risks, which we help them manage via diversified hedging strategies and tailored products, such as cash/noncash loans for foreign trade transactions and working capital needs, structured trade finance loans, project and investment loans, cash management services and deposit transactions. Leveraging the capability of providing fullfledged services, we offer both pro-active and customised solutions to clients. FRANCESCA CARNEVALE: It is a time of immense change in the Turkish capital markets: how have recent reforms, such as the opening up of the market to new financial instruments helped the bank’s business growth strategy? HUSEYIN OZKAYA: I believe the local bond market in Turkey provides a good example of how capital markets helped our Bank’s growth plans. While our main funding source is customer deposits, we value opportunities in wholesale funding domain. On May 26th, we closed our debut 6-month bond issuance for TRY 150 million which allowed us to diversify our funding base and stretch average maturity of TRY denominated funding. As you may very well know customer deposits in Turkish banking system tend to be short

term but evergreen in nature; wholesale funding exercises such as bond issuances contribute to our Bank’s funding mix as a new source of liquidity for Odeabank. FRANCESCA CARNEVALE: What is the bank’s forward growth strategy? What are the main elements and achievement benchmarks that you have set? HUSEYIN OZKAYA: I want us to be in the premier league of Turkish banking, essentially a top ten bank. Our objective is to exist in every segment of the industry including retail and SME. Technology is the main tool we aim to continue to use effectively, in order to meet banking needs easier for our customers. We will also grow organically through branches but more through reaching customers by mobile channels. The key benchmark for us would be excellent reputation among creditors and market, top of the market customer satisfaction and strong financial performance by cost efficiency and prudent credit risk management, ultimately with satisfactory shareholder returns. FRANCESCA CARNEVALE: Might we please look at some of the trends in the Turkish market and have your opinion on their significance please? HUSEYIN OZKAYA: Our research team was one of the few that correctly forecasted the rate cut by CBT in May. Even though annual consumer inflation rose from 7.40% in 2013YE to 9.66% as of May due to high food inflation and more than 25% (year on year) depreciation in TYR, we expect it to ease gradually during the rest of the year thanks to the tight liquidity stance of the central bank. In 2014, food inflation (not only in Turkey, it must be noted, but also in most of the emerging countries) has been posing upward pressure on consumer inflation due to unseasonal weather and drought conditions. This brings a supportive base effect to 2015 inflation. Therefore, we expect inflation in Turkey to ease to 6.7% in 2015 from around 8% in this year. FRANCESCA CARNEVALE: In terms of the country’s balance of payments, the current account deficit looks to be improving, with exports on the rise, especially to the EU. Do you expect the

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Istanbul’s Levent district at night. In recent years there has been a discernible shift in the pattern of Turkey’s trade, with emerging market countries, especially those in the MENA region, becoming progressively more important. At the same time, the EU’s share in Turkey’s total trade has declined. Imports between Turkey and MENA have increased nine times and exports by a factor of 12 in the last ten years. Photograph © Nexus 7/Dreamstime.com, supplied July 2014.

decline in the current account deficit to be significant this year? On the ground, as it were, how do you see this reflected in the bank’s support for exporters? HUSEYIN OZKAYA: Thanks to the economic program which has been implemented since late-2010, the Turkish economy has curbed its huge current account deficit (excluding gold items) from 6.9% in 2012 to 6.5% in 2013, with a comparatively higher GDP growth rate of 4.0%. We expect this trend to become more evident through recovery in the EU, which is still the country’s main trade partner. The 12-month rolling current account deficit declined significantly from $65.1bn in 2013 to $56.6bn as of April and further improvement is expected during the rest of the year. Unfortunately, further evident improvement in the current account deficit in Turkey mainly depends on international oil prices as we are an energy-import dependent country. FRANCESCA CARNEVALE: On the other hand, macro–prudential measures introduced by the government to curb

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

domestic demand and to boost exports have had a direct effect on banks’ asset allocation in favor of investments and export credit against consumer credit. HUSEYIN OZKAYA: Risk appetite to emerging countries increased significantly in the last couple of months thanks to weaker than estimated growth in the United States in the first quarter on the back of heavy cold weather and further expansionary measure signs by the ECB. Furthermore, TYR also has been appreciating through CBT’s decisive rate hike decision at the January 28th interim meeting and easing worries regarding political stability. We think this is a correction following overreaction of the markets to FED tapering in December 2013-February 2014 period. From now on, appreciation in TYR is projected to remain limited due to ongoing uncertainties both domestically and globally. That said, we believe CBT’s flexible monetary policy and continuing strong fiscal balance and well-capitalised banking sector will restrain risks in the forthcoming period.

FRANCESCA CARNEVALE: Are there any other points you would like to raise that I have not given you the opportunity to discuss? HUSEYIN OZKAYA: In 2014 we will continue to grow swiftly thanks to the power fueled by our shareholder as well as our efficient and qualified human resource and our technological infrastructure. We aim at opening new branches and recruiting more employees. Within this conjuncture; we excitedly structured our service processes with an understanding through which each of our customers will feel special, in the structure, where we were focused on providing a fast, productive service in such a way our customer can gain maximum benefit in all segments of banking. I am fully confident that we will continue to create platforms where we can establish long-term, trust based relations with our customers thanks to the importance we place both on human resources and technology combined with the diversified product range. FRANCESCA CARNEVALE: Thank you.

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RISK

WHY RISK PARITY IS REALLY RISK WEIGHTING

Photograph ÂŠ Lightkeeper/Dreamstime.com, supplied July 2014.

Risk parity is a term that has become associated with multi-asset strategies where the risk is naively allocated equally across asset class. Unfortunately this simplistic view of risk parity has distorted its real potential and has caused some in the investment community to force any such multi-asset strategy into its own box. This is unfortunate because risk parity is a technique that should be more properly called risk weighting and is just another form of asset allocation argues Edgar E Peters, partner and co-director of Global Macro at First Quadrant, LP.

Risk parity is just another flavour of diversified growth ISK WEIGHTING SHOULD take its place among other asset allocation techniques such as capitalisation or equal weighting. In fact, risk weighting is just another form of optimisation that relaxes one common and binding constraint: no leverage. The focus on the dangers of leverage has sidetracked investors from realising that risk balanced portfolios are merely another version of diversified growth, but one that is focused on diversifying both growth and risk to achieve a higher return at lower risk. It also does not mean equal risk weighting is necessarily applied making the parity part of the risk parity label misleading.

In fact, looking at the investments inside of a typical risk parity fund and any popular diversified growth fund finds that there is only one real difference: the duration of the bonds that are in the portfolio. The goal of multi-asset risk parity portfolios is the same as a diversified growth portfolio. That is, equity-like returns at reduced risk. Risk parity portfolios do this by not only diversifying the assets which grow when the economy grows but also includes a significant allocation to an asset that will reliably grow during economic decline and deflation: long duration sovereign bonds created synthetically in the futures markets.

Thus a multi-asset risk parity portfolio is expected to give diversified growth in all phases of the business cycle because it contains not only cyclical assets but counter-cyclical assets. Traditional diversified growth funds rely exclusively on tactical asset allocation (TAA) methods to reduce the exposure to risky assets during such times through their own skill. Interestingly, risk parity managers also use TAA, but do not exclusively depend upon such methods to hedge the portfolio against economic decline or a sudden tailrisk disaster like a terrorist attack or a large earthquake. Sovereign bonds are not only countercyclical, they are a natural flight-to-quality asset during times of uncertainty regardless of the interest rate. During the Japanese earthquake of March 2011 Japanese stocks fell and Japanese bonds rose even though the bonds yielded slightly more than 1%. But the only way that such holdings can truly hedge against equity tail-risk risk is if they have a long enough duration and such a duration can only be achieved by leveraging sovereign bonds in the futures markets. Risk allocation techniques allow diversified growth portfolios to include assets that grow when the economy declines and also hedge against unexpected tail-risk events when a TAA move will be too late.

Diversifying risk So risk parity is an asset allocation technique for truly diversifying risk, not an investment strategy on its own. Putting multi-strategy diversified growth portfolios that use risk weighting techniques into a separate box puts investors at a disservice. By diversifying risk in addition to diversifying growth, a multiasset risk parity portfolio can hedge against market conditions such as those that have prevailed in 2011 and 2008 while participating in the growth of 2009 and 2010. What is commonly and erroneously called risk parity is just another flavor of diversified growth, but it is one that diversifies both risk and growth to achieve equity like returns at lower volatility. Isnâ&#x20AC;&#x2122;t that what investors need in these uncertain times? n

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MALTA OVERVIEW

Malta’s second decade as a member of the EU looks to be one where the island jurisdiction could outshine. The island’s vision is to lift itself into the upper echelons of the EU, offering an economy that has a buoyant financial services sector; a world leading servicing export segment, and a steadily improving standard of living. By 2018 it will become a European Capital of Culture; by 2017, it will hold its first presidency of the European Union, giving it first-hand access to EU decision making and agenda setting. It is a future of powerful consolation; what will it do with it?

LIFTING THE ECONOMIC RATIONALE IKE GERMANY AND only a handful of other states (think Poland and the Baltics); Malta is one among a rare set of countries that finds membership of the European Union and the eurozone utterly beneficial. EU membership has garlanded the island, taking away concerns over currency conversion risk and bringing the jurisdiction squarely into the EU’s long term financial revolution (involving market harmonisation and a strengthened capital markets and investment infrastructure), driven by a bucketful of incoming regulation. For its part, the Maltese government has maintained an open market mentality, backed by a prudent macro-economic, supply-side framework. The government’s economic and fiscal strategy rests on a number of key policy planks, that includes sustainable public finances, improving the labourforce to include more women, raising educational standards, enhancing market competitiveness, reducing bureaucracy and safeguarding and promoting the island’s burgeoning financial and financial services sectors. In its Budget for 2014 the government expects growth between 1.7% and 2%, supported by “a stronger domestic demand component. The macroeconomic forecast for 2014 and beyond are based on a no policy change approach. The changes announced in the Budget, including the overall increases in public expenditure of €200m together with reducing tax bands for families, the cost of living adjustment and reduced energy bills for households will all contribute to increases in domestic demand during 2014.” Since then the European Commission has upped the stakes predicting Malta’s GDP will grow 2.3% this year and 2.1% next year mainly thanks to domestic demand, making it one of Europe’s fastest growing economies (confirmed GDP growth was 2.4% last year). The country’s budget deficit, which this year was lowered to 2.8% is expected to fall further to 2.5% by the end of this year (well ahead of last year’s EC’s requirement that the country reduce its deficit to 2.7% of GDP). No change is forecast in unemployment levels while employment growth is expected to fall to 2.1% from 3.1% in 2013. Fitch Ratings in April affirmed Malta’s long-term foreign and local currency Issuer default rating (IDRs) at ‘A’. The ratings agency said the affirmation and the stable outlook

FTSE GLOBAL MARKETS • JUNE-AUGUST 2014

reflected among trends, the fact that the country’s GDP is expected to outperform eurozone average in 2014-15. At 6.5% the unemployment rate is in line with the ‘A’ median and well below the eurozone average, while the employment rate has risen, underpinned by the increasing female labour market participation rate. Focusing on the financial services industry, Fitch expects the banking sector’s performance to remain resilient. Moreover it assumes that “in case of need, the government of Malta would be predisposed towards supporting the core domestic banks, which are systemically important”.

Financial sector growth The financial sector in Malta has experienced unprecedented growth in recent years, mainly due to the accession in the European Union in May 2004, which provided Malta with the spur it needed to attract new investment opportunities to the island. Besides, investment services in Malta started to benefit from passporting rights since UCITS schemes can be registered in Malta and passported to any EU country. In turn, it has provided fertile ground for fund services providers. Typifying the trend, compliance and regulatory services provider Cordium, which is owned by UK private equity buy and build specialist Sovereign Capital, acquired Zodiac Advisory Services a provider of compliance, risk, accounting and governance services in Malta. The acquisition of Zodiac provides Cordium with a Maltese subsidiary that enables its UK-based regulatory hosting and risk management subsidiary, Mirabella Financial Services, to offer hosted AIFM solutions to non-EU firms. The acquisition also continues Cordium’s structured expansion strategy of acquiring specialist companies globally while simultaneously investing in organic growth. Michel van Leeuwen, group chief executive officer of Cordium, explains “While the impact of AIFMD has been muchdiscussed within Europe, it has understandably drawn less attention elsewhere. Yet the regulation carries significant consequences for non-European alternative investment firms looking to access the lucrative European market. A Maltese base will enable us to offer a suitable solution— AIFM-hosting—to this conundrum facing non-EU firms.” Along with the MFSA’s membership in the European

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MALTA OVERVIEW

Security and Markets Authority (ESMA), these two guarantee a sound regulatory and legislative framework which inspires confidence in investors and entrepreneurs. Moreover, the Euro adoption in 2008 helped Malta remove the exchange rate risks, allowing businesses and individuals to start enjoying previously unprofitable trades. All of this, coupled with the present government's vision to ascertain Malta’s position as a European Centre for excellence in financial services and international business by 2015, provides an optimum operating environment for business ensuring the island’s placement on the radar of the international finance industry. Malta has emerged as a credible and respected fund domicile and servicing centre; steadily expanding the financial services product set. The fund industry’s growth is attributable to a confluence of trends: a low cost base compared with rival jurisdictions, an open-door attitude (plus tax incentives) encouraging firms to bring in highly-qualified expatriates to complement a generally well-educated and skilled local workforce, a regulatory approach that combines rigorous oversight with flexibility legislative drafting and innovation in product design, and a pro-entrepreneurial attitude among its governing departments and business promotion agencies. More than 120 investment firms, 120 trusts and 70 fund

managers established on the island in recent years, with an average annual 24% increase in the number of funds entering the jurisdiction. Moreover, the government has established a favourable personal tax regime that has encouraged market professionals and covers income arising in Malta for expatriates occupying a position of seniority within a fund management or other financial services firm. That has not only encouraged expats to move to Malta with their families but has a positive effect on local employment in the sector. Fund management and fund services are not the only pillar on which the jurisdiction is building its financial centre aspirations. It is also developing as an insurance hub, with a number of global funds domiciling their captive insurance companies in the jurisdiction and putting people on the ground (including Aon, Willis and Marsh). Solvency II will likely establish higher capital requirements for investments in non-EU funds, thereby encouraging EU insurers to move money from non-EU funds to EU funds. Malta is pinning its hopes on the fact that since it offers advantages in terms of efficiencies and cost savings, it will encourage fund managers using non-EU domiciles to consider the domicile. Treasury centres and corporate pension schemes, and the banking sector have also seen growth in recent years. n

BANKING ON AIFMD UROPE’S ALTERNATIVE INVESTMENT Fund Management Directive (AIFMD) offers potential for increased business to investment services providers working in the Malta. AIFMD rules on marketing of alternative funds offer an incentive for managers based outside Europe to consider a domicile within the EU in order to gain immediate and guaranteed access to the directive’s ‘passport’ for distribution to sophisticated investors throughout the 27-member union. A number of financial services firms are setting up new sales operations overseas that are targeting asset gatherers outside of the EU, which can make use of Malta’s cooperative funds regime and lower cost location and its suitability for managers starting out with resource constraints. Yet others are re-defining their AIFMD service set. Alternative funds run by managers authorised under AIFMD must normally use a depositary—a bank in the case of assets that can be kept in custody—in the fund’s domicile jurisdiction, although Malta can if it chooses obtain a derogation from this rule until 2017. However, there is confidence that more global custodians will soon set up operations on the island, which will also increase its appeal for the establishment and servicing of UCITS funds. Sparkasse Bank Malta launched ‘Depositary Lite’ solutions

targeting alternative investment fund managers (AIFM) seeking to promote their non-EU funds within the EU in June this year. The offering is being made available as a standalone service within the bank’s AIFMD suite of services as the bank seeks to expand its offering internationally to EU and non-EU fund managers managing and seeking to market their non-EU funds on a private placement basis within the EU. The Depositary Lite regime comes out of Article 36 of the AIFM Directive (conditions for the marketing in member states without a passport of non-EU AIFs managed by an EU AIFM), which states that the AIFM must ensure that an entity is appointed to perform depositary duties to the fund. The duties must be performed by a credit institution and include the provision of bank accounts, cash flow monitoring, safekeeping of assets and oversight duties. The bank sees this as a stepping stone to attract further business. Sparkasse’s CEO Paul Mifsud says the initiative is an opportunity to attract further business as it positions both the bank, as well as Malta, well among managers who may eventually seek full integration of their funds into the EU. “The bank is encouraged by the overwhelming response it has received in this regard and is very optimistic,” he added.

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FINANCE MALTA

If Malta has successfully emerged as a credible and respected fund domicile and servicing centre, it is down to a confluence of elements, including good regulation, an understanding and flexible but rigorous regulator, the usual interplay of happy geography, trade links, communications and an ultra-hardworking business development agency. FinanceMalta fills that role in buckets.

A BUCKETFUL OF BUSINESS DEVELOPMENT brings together and harnesses the HE LATEST FINANCEMALTA edresources of the industry and governucational clinic in late June this ment to ensure Malta maintains a year, organised in collaboration modern and effective legal, regulatory with the Malta Funds Industry Associaand fiscal framework in which the tion (MFIA) and held at the Malta financial services sector can continue to Financial Services Authority (MFSA), grow and prosper. focused on Shari’a-compliant funds. The board of FinanceMalta is headed During the education clinic some of by chairman Kenneth Farrugia, who is Malta’s existent 27 fund administrators Photograph © Pressureua/Dreamstime.com, also chief officer fund services at Bank of discussed how to apply the rules of supplied July 2014. Valetta and also includes Joe V Bannister, Islamic finance transactions to the country’s financial regulations. It seems that the suite of in- FinanceMalta’s vice-chairman who leads the Malta Financial vestment vehicles offered in Malta resonates well with Services Authority, the island’s financial markets regulatory, Islamic investors who are being encouraged by the island’s a position he has held since 1999. The role of agencies such as FinanceMalta are these days business development specialists to set up their funds as Special Purposes Vehicles (SPVs), Undertakings for Collec- akin to the work of the UK’s Department of Trade and tive Investment in Transferable Securities (UCITS), Alterna- Industry which, when it can, promotes the work and tive Investment Funds (AIFs), or Professional Investor Funds business of the UK firms it represents. The advantage of (PIFs). In line with Malta’s current efforts to build expertise being in a discrete jurisdiction such as Malta means that its and services in the insurance sector, Shari’a compliant work can be much more inclusive and effective than, say the Takaful funds are particularly encouraged to view the island UKDTI’s which often struggles for recognition and promotional funds as larger, more powerful government departas a jurisdiction of choice. FinanceMalta does not stop there. To create further ments suck up the day to day energy of government. That’s awareness about this sector, a new series of FinanceMalta not the case in Malta, where Farrugia and his team actually Sector Guides will be published in January 2015, one of which work and create new business opportunities for the country in addition to their normal day jobs. In that regard, other will now focus solely on Islamic finance. To put Malta’s efforts in this regard in context, European countries should perhaps look at what FinanceMalta Islamic funds currently represent 8.3% of the global Islamic achieves in terms of geographic reach and visibility (relative fund industry, with Ireland and Luxembourg accounting for to its size) in the wider European context. It punches way 7% of it. Ireland has taken the lead so far in the segment above its weight. Moreover, compared to other national business develop(having almost 50 Shari’a compliant funds domiciled in the country, with more than $2bn of assets under management). ment operations, which often go in for more irreverent Taking those numbers into account, it is easy to see the efforts (such as the Qatar Financial Centre Authority’s taxi rationale for FinanceMalta to push this particular business service at recent Fund Forum events in Monaco), Financesegment. Malta has any number of states promulgating Malta concentrates on the important job in hand: promotion Islamic finance (think North Africa and the Middle East) of the island’s strengths in financial services provision. As within easy range. It already has a highly developed asset such it takes its work very seriously indeed. Malta may be small, and not yet perfectly formed: but you management segment, supported by a burgeoning fund administration sector. Why shouldn’t Malta compete on at have to admire the efforts of these smaller jurisdictions that often have to work twice as hard, and offer a much higher least equal terms with Ireland for this business? Publications, industry events, clinics and roadshows, standard of work and services, to continue to play with promotion of the island through sponsored publications are much larger, richer and sometimes more cavalier players. the bread and butter of FinanceMalta, the not for profit, Long may these discrete markets continue to set benchmarks official financial sector business development agency. It for the rest of us to follow. n

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MALTA STOCK EXCHANGE

Photograph © Tetyana Shylo/ Dreamstime.com, supplied July 2014.

The Malta Stock Exchange is replete with new business ideas and initiatives, backed by a robust regulatory structure. Even so, business volumes remain thin. What can be done?

The struggle for liquidity ITY THE DISCRETE stock exchanges of the world, struggling despite valiant efforts, to find their place in the growing pantheon of trading venues. There is a lot of guff written about these exchanges, usually in sponsored sections on island or small jurisdictions anxious to lay their wares to the global investment community. The reality is stark: even with the best set of credentials, the struggle or fight for liquidity is paramount in an age where buy side and sell side traders enjoy direct market access to stocks through a variety of means. The Malta Stock Exchange was set up in November 1990 under the then Malta Stock Exchange Act which provided for the exchange as both operator and regulator of the Maltese capital market. The Financial Markets Act (which came into force in 2002) changed all that. Regulatory oversight transferred to the Malta Financial Services Authority (MFSA), and the exchange attained the status of a recognised investment exchange and it retained day to day oversight of the trading market. However, a“two tier”process was created in respect of listing and admission whereby “admissibility” or the approval of the issue of a prospectus fell within the remit of the Listing Authority, which was now the MFSA, while granting of admission to any of its recognised lists fell within the remit of the exchange. Since then, the exchange has been one of the main pillars of the island’s search to become a global financial hub. However, the exchange has not managed to lift itself out of the norm for smaller jurisdictions and liquidity on the exchange remains limited. It is not so much a question of market quality or the quality of listed securities. The Luxembourg Stock Exchange is a salutary lesson for the smaller exchange community. Replete with a fabulous array of eurobonds and secondary listings, the exchange constantly struggles to lift trading volumes. In the case of the Malta Stock Exchange, no kind superlatives can

hide the following stark numbers. In 2012, only 1.22% of all equities listed on the exchange were actually traded. In one day in June this year, trading activity on the borsa slumped to a new 2014 low with just under €20,000 worth of shares changing hands across three equities. At the end of July, the exchange fared barely better with 56 individual trades registered on July 31st. Even as the MSE Share Index turned for the better on the last day of July, recovering from a two day negative performance, it edged 0.6% higher to 3,374.88 points as a mere four equities closed higher. Bank of Valletta plc had advanced by 1% to the €2.10 level on volumes of 18,236 shares with Lombard Bank Malta plc jumping 13.33% higher to the €1.70 level over a single trade of only 580 shares. Really: it is a case of the girl can’t help it. Perforce, the inherent size of the Maltese capital market is small. Initial public offerings on the exchange are dominated by retail buyers and institutional presence is very thin.

Valiant efforts The sad fact is, it is not for the want of trying. The Malta Stock Exchange has shown itself more valiant than most and over the last year and three quarters has employed a dizzying range of initiatives, which under normal circumstances, would result in much more success. In October last year it published new rules governing the operation of market making. The role of market making is new to the Maltese financial services environment and is designed to help increase market liquidity. This in itself is not a bad distribution and allotment strategy, since the distribution of ownership of one’s capital or debt among a broad Maltese retail demographic helps to foster confidence in the market. However, the exchange’s efforts are hampered by the fact that Maltese retail investors are buy and hold merchants, thereby limiting an active secondary market in share trading.

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MALTA STOCK EXCHANGE

One promising statistic is the appeal of government stock to investors, either retail or institutional; though only 12% of the total government stock listed on the exchange is, on average traded in a year. The second leg of the exchange’s strategy is to achieve connectivity with other markets. The Maltese depositary established links with Clearstream a couple of years ago where cross-European post trade interoperability was the flavour of the day. Ultimately, that didn’t amount to much in the greater scheme of things, though both sides say they noticed an increase in cross-border transactions in Maltese securities, and initiatives around interoperability have now been subsumed into the ECB’s greater Target-2 Securities (T2S) project, which the exchange committed to back in 2008. In July 2012, the borsa also began utilising the Xetra trading platform designed by Deutsche Börse. Advanced trading technology and platforms are de rigueur in today’s still bleached and ultra-competitive equities trading environment and theoretically should be an important business enabler. As long as people access the market in substantial numbers, that is. Another initiative was the joint venture with the Irish Stock Exchange (ISE) that involved the European Wholesale Securities Market (EWSM), a market for wholesale fixed income debt securities that is regulated by the MFSA. The ISE owns 80% of the new market with the Malta Stock Exchange having a 20% shareholding. The EWSM offers issuers and arrangers of wholesale fixed-income debt securities access to an EU regulated market and is supported by the expertise of a dedicated listing agency service. It had its first listing in June 2013, when Grand Harbour IBV, an issuer registered in the Netherlands, listed seven classes of securities on the platform. In late July, Malta Finance announced the first Exchange Traded Instrument (ETI) issued under the Malta Securitisation Act went live on the platform. The “Dynamic Trading Strategies ETI” is linked to and backed by a performance linked bond issued by ETI Securities a Special Purpose Acquisition Vehicle allowable under the Securitisation Act of Malta and holding managed accounts at Interactive Brokers LLC and Sensus Capital Markets plc. Argentarius ETI Management is the arranger of the transaction. The SPV also benefits from special tax arrangements. Andreas Woelfl, Argentarius’s chief executive explains that,“This really is a first for Malta and clearly demonstrates the advantages of Malta as a domicile for the issuance of Exchange Traded Instruments backed by and linked to the performance of Alternative Investments” This particular issue is the first of its kind in Malta because the ETI is linked by way of a performance bond to the underlying assets and so its performance is derived from a special management account that comprises various commodity futures contracts. The ETI is also an eligible asset class for a UCITS fund even though the commodity futures contracts do not qualify as eligible assets under the UCITS directive. Argentarius can offer a diversification into additional asset classes, especially alternative investments asset classes with a reasonable cost structure.

The ETI structure has been confirmed by the European Commission as falling within the definition of an eligible UCITS security regardless of the eligibility of the underlying assets as long as certain criteria are met. Issuance on a regulated market such as EWSM is one of those criteria and so the availability of this exchange in Malta is a key factor for UCITS Fund Managers that seek to increase diversification within their funds. For Argentarius this heralds the launch of their Europeanwide expansion “We are currently talking to many of the leading advisers to the fund industry in Germany, Malta, Switzerland and the UK and we are looking at several new issues currently” notes Andreas Woelfl. The listing of the ETI on the EWSM must perforce be bitter-sweet. Sweet for the emergence of the platform as a venue for innovative debt structures; bitter in that the exchange could well do with those sorts of listings. It cuts to the dilemma facing smaller exchanges right across Europe right now and requires fundamentally new thinking to define a workable new business strategy, particularly as continuing market reforms look to increasingly consolidate volume onto fewer and fewer platforms. One only has to look at the inexorable rise of BATS Chi-X Europe which is becoming a dominant player in the liquid markets in Europe as to the terms of the immediate trading trends. It is frustrating for the Maltese as they have all the credentials of virtue, but in terms of stock market liquidity, little to show for it. The jurisdiction, for example, has secured its place as one of the European Union’s best performers in the 28th edition of the Internal Market Scoreboard issued by the European Commission in mid-July. The Scoreboard benchmarks Member States’ efforts in the implementation of Internal Market Law by recording the transposition deficit, which is the gap between the number of Internal Market laws adopted at EU level and those in force in the Member States. Malta’s transposition deficit is therefore just two Directives short of a 0% deficit which is considered a perfect score. The Scoreboard also places Malta as the member state which takes the least time in transposing EU measures, where a previous average delay of 19.2 months in the previous edition was reduced drastically by 15.6 months to just 3.6 months. This kind of recognition however is scant compensation to the exchange; what is needed is wholesale commitment by institutional traders to the market. For exchanges such as the Malta Stock Exchange then, their future depends on either finding the right market niche in which they can excel and therefore bring in that all-important market liquidity. Finding the right strategic partner, who can funnel new business and liquidity onto the exchange, or merging outright with a larger organisation that can utilise the jurisdictions strengths and tax regime are two possible options. Others involve attracting DR issuers to list on the borsa, rather than say in either London or Frankfurt. As Malta moves ever closer to a harmonised Europe those kinds of strategies look harder to implement; but the search for a viable strategy will no doubt continue. n

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SECTION NAME

Malta corporate MALTA...TRULY MEDITERRANEAN M A L T A ’ S

L E A D I N G

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P R O P E R T Y

D E V E L O P E R S

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MALTA—CAPITAL MARKETS REGULATION

Regulation a key driver in Malta fund segment

Photograph © Mallinka/ Dreamstime.com, supplied July 2014.

According to Joseph Bannister, chairman of Malta Financial Services Authority (MFSA), growth in the asset management services sector stepped up as general trading conditions continued to ease and growth began its slow return in the larger European economies. “Growth and new licences were registered across the range of the industry,” says Bannister. “The fund services infrastructure in Malta continued to build up in 2013, with the issuance of more investment services licences predominantly at Category 2 level.” This means that much of the new fund and funds services activity is, in fact, in line with European AIFMD regulation. What does that mean for Malta long term? HE FUND MANAGEMENT and fund services sector in Malta continues to grow at a clip. Statistics published recently show that over the past three years, 80% of foreign direct investment into Malta has been in financial services. Malta’s financial centre boasts that it enjoys greater credibility when compared to past years through the interaction of a number of trends. The jurisdictions financial stability was tested like others during the financial crisis, but the island withstood the global financial turmoil relatively well. The conservative policies which Maltese financial institutions adopted in the running of their business, with regards to lending policies and borrowing in a traditional retail funding model, have in fact safeguarded Malta’s financial stability from systemic events, adversely encountered in other economies

Accession to the European Union back in 2004 also helped; providing Malta with the spur to develop new investment. Moreover, the financial services sector immediately began to benefit from passporting rights since UCITS schemes can be registered in Malta and passported to any EU country. MFSA’s membership in the European Security and Markets Authority (ESMA), provides a solid grounding for the jurisdictions regulatory and legislative framework and the adoption of the euro as the national currency in 2008, actually benefited the island as it removed currency exchange rate risks from investment and capital goods and export trades. The jurisdiction has also made a concerted effort to encourage fund inflows, through a flexible regulatory regime which also incorporates all current EU financial regulation. The MFSA uses both formal regulation and requirements

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based on a flexible and regularly expanding rulebook. The regulator claims to work in a very open and transparent basis and all companies seeking to establish themselves in Malta must meet personally with the regulator. This proactive approach is more formally referred to on the island as ‘innovation through regulation’. This approach is evinced by the introduction of specific initiatives, such as recent efforts to promote reinsurance special purpose vehicles (SPVs). Moreover, Malta has worked hard to define workable rules covering the remuneration of managers and liability of custodians. In particular, Malta’s regime has encouraged smaller, more discrete hedge funds into establishing in the jurisdiction. Additionally, in late February the Authority launched an ad hoc rulebook regulating collective investment schemes which are authorised to invest through loans. The approval and licencing of the loan fund is regulated by the island’s Investment Services Act which regulates collective investment schemes, subject to any additional rules the MFSA may impose. The MFSA used AIFMD as a basis for the provisions in the rulebook and also took into account recommendations by the Financial Stability Board (FSB) on the regulation of

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shadow banking. The rules also draw on relevant local banking rules that cover issues such as risk management. The MFSA has sought through the new rules to mitigate against the transmission of unwarranted credit risk. Accordingly, loan funds are required to follow strict credit assessments and fund managers must also satisfy special competence and remuneration requirements. Loan funds are also restricted from lending to credit or financial institutions and must carry out credit assessments at the point of acquisition of any loan portfolios. In order to mitigate against liquidity risks, loan funds must be closed ended or at least make use of appropriate redemption gates. PIF or AIFM structures can be utilised.

Fund approvals By the end of last year the MFSA had approved some 125 investment services licences, a net increase of almost 11% on 2012. Also during the year, the regulator licenced 135 new Collective Investment Schemes (including sub-funds), a slight increase over the previous year. Meanwhile the number of new licensed professional investor funds (PIFs) remained almost at the same level as the previous year. PIFs are Malta’s primary investment fund vehicle, typically

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MALTA—CAPITAL MARKETS REGULATION

catering for most types of alternative investment fund (AIF) products, which include hedge funds, real estate funds, private equity and other traditional funds that are not registered as UCITs. A PIF can be structured as an investment company (SICAV) or INVCO, a contractual fund, unit trust or limited partnership. All are governed by Malta’s Companies Act. The plethora of regulatory activity in Europe had been expected by the regulator and by Malta’s fund industry to boost the island’s fortunes. Specifically, that regulation such as Europe’s Alternative Investment Fund Managers Directive (AIFMD) would feed into the jurisdiction’s wide-ranging fund regime and emphasis on corporate governance and investment rigour over the years, as the directive establishes a quality AIF-brand for AIFMD compliant investment products. More latterly Shari’a compliant funds (mainly Ijaara funds, commodity funds and Murabaha funds) can also be established as PIFs. MFSA launched its revised Investment Services Rulebooks by way of final implementation of the Alternative Investment Fund Manager Directive (AIFMD) and relative commission delegated regulations on in late June last year, making Malta one of the first European Union (EU) Member States to begin processing AIFMD applications. This has brought forth fundamental changes to the Maltese regulatory framework in the financial services sector, which affect both EU and non-EU alternative investment fund managers (AIFMs). Apart from regulating EU AIFMs managing both EU and non-EU alternative investment funds (AIFs) marketing themselves within the EU, the AIFMD also seeks to regulate non-EU AIFMs working in the European Union. The application of AIFMD in Malta has seen the introduction of specific and comprehensive rules and requirements for AIFMs in relation to remuneration, conflicts of interest, risk management, liquidity management, delegation of duties, and the appointment of functionaries in respect of the AIFs and their managers. AIFMD also provides a lighter de minimis regulatory regime for managers of AIFs whose total assets under management do not exceed €100m, and those that manage AIFs whose total assets under management are below €500m (and specifically whose portfolios are unleveraged and have no redemption rights exercisable during the first five years following the fund’s establishment). In Malta, regulation under the AIFMD lighter regime involves the relevant de minimis alternative investment fund managers of Professional Investor Funds (PIFs) which, like AIFs, are promoted to professional investors, but which, unlike AIFs, do not fall within the scope of the full AIFMD regime. De minimis AIFMs are regulated by specific rules issued by the MFSA for this purpose, and the regulation of PIFs has not seen any substantial changes with the transposition of the AIFMD. Whilst de minimis AIFMs do not enjoy the EU passporting entitlements granted to fully AIFMD compliant managers, the former may nonetheless avail

themselves of existing EU Member States’ national private placement regimes in order to market PIFs, however only insofar as such regimes are retained by the respective EU Member States. Most PIFs are in the scope of the AIFMD directive and will be required to ensure that an authorised AIFM is appointed, or it must comply with the requirements of the directive as an internally managed AIF. In other words, AIFMD does impose additional requirements on PIFs, relating to the fund’s depositary, valuation function, reporting and disclosure to investors and regulators, though many of these requirements are already inherent in existing rules governing PIFs.

Connotations Clearly incoming European regulation has important connotations for the Maltese fund industry, given the growing ease with which asset managers under AIFMD and UCITS can passport funds across the continent.“The new approach presents significant challenges to the industry [per se—not Malta specifically],” notes Bannister in the MFSA’s July report. “They aim to lay the foundations for a more stable, robust and competitive finance industry”, adding: “Confidence is the critical element, and fundamental to the EU’s ability to remain globally competitive in financial services.” Malta remains, continues Bannister,“more advanced in enshrining new EU legislation in law that any other EU nation. Malta was the first jurisdiction to complete the transposition of AIFMD. The new legislation and regulations coming into force will, particularly in the early years, put very considerable demands on the people and resources of the MFSA.” The regulator has now decided to review the conduct of business regulatory regime on the island with particular regard to the investment services sector. The primary goal notes Bannister in the July missive,“is enhancing customer protection”. The consultation paper has already been issued and was comprehensive in its intended reach. It addresses, for instance, definitions of customer types, the measurement and management of risk and dissemination of KYC tests, standards of care, records and disclosures, and professional standards among a range of questions. MFSA says it is now reviewing the feedback it has received. “it will be a challenge for us all to apply the new regimes and keep an eye open for threats and opportunities that arise from implementation and revision across Europe,” notes Bannister. For the moment, UCITS structures look to be leveraging the Maltese fund regime. The MFSA licensed 135 new Collective Investment Schemes—including sub-funds—a slight increase over the previous year. While the number of PIFs (at least last year) remained at almost the same level as in 2012, the number of new licensed UCITS funds doubled over the same period. Additionally, there were 188 non-Malta domiciled funds administered by Malta-based fund administration companies at the end of last year, a 31% increase. Retirement pension schemes were the most popular, rising by 88% in number over the year. n

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MALTA REPORT: SPONSORED SECTION

Malta: a cool climate that’s hot on the quality‐of‐life index t’s official. Malta has the best climate on earth.

Malta was one of two countries that were tied for first place with the title of Best Climate, according to the Quality of Life Index issued by the International Living (IL) magazine last year. Sharing top honours was Zimbabwe. Yet a Mediterranean climate (over five hours of sunshine a day) isn’t all that Malta has to offer. Malta’s many other virtues in the nine categories of the IL index combined to earn it third place overall in the index, pipped to the post by the United States and New Zealand. That ranking speaks volumes for the size of Malta’s quality offering relative to the island’s land mass of just 122 square miles. How about a stable government, economy and a modern health service? These factors carry a lot of pull for wealthy English and Europeans looking to get away from their frosty climes. In fact, frost and snow are unknown in Malta with shirt sleeve order and temperatures of 70 degrees Fahrenheit (21 degrees centigrade) in November. Additionally, flights to many European capitals are just three hours away. Crime is low, education levels high, the locals hospitable and English‐speaking with 48 English language schools. As a result, homes and apartments here have now attracted the international set. So has the historic harbours, five‐star hotels, restaurants and summer nightlife. However, overseas domestic buyers aren’t the only ones to recognise the reputation of the island’s property potential. Malta’s success in attracting City hedge fund managers to redomicile to the island as a result of a well regulated and cost‐competitive jurisdiction has spurred more demand for high quality homes in the sun. Back in 2000, it wasn’t like this. Sure, the island had a loyal following of repeat overseas visitors but nothing that one could call gold standard. Despite its geographic location and abundance of sun and sea, Malta's lifestyle as an up‐market destination had little relevance for the aspiring overseas home buyer. That was until Portomaso was built.

George Fenech, the Tumas Group’s chairman, pioneered the lifestyle concept in Malta. He had a multi‐ million euro dream. He wanted to enhance the quality of life for those buyers who could make the right invest‐ ment decision. His vision of the Portomaso marina would bring Malta to the attention of the international property market with an Oscar of the property world—Gold Award in the Best Marina Development Category in the 2005 International Property Awards. As a result, Portomaso was acclaimed the most exclusive address in Malta and became home to the well‐heeled, international celebrities and footballers. Those that bought in 2000 have seen the value of their property rise by over 300%. Rental income has also risen, in many cases giving a return of up to 6%. (See Panel of benefits) Out of the Portomaso mould have been cast two more luxury developments in the north and south of the island, both a stone’s throw from the Med. They are already reaching completion, thanks to Tumas Developments, the Group's property arm. As both properties websites rather prosaically state, these two new residencies ‘offer lifestyle

Day shot of Portomaso. True recognition by the international property market. A whole clutch of awards for Best Marina Development was won by Portomaso in 1999, 2000, 2001 and Gold in 2005.

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Photo of Ta’Monita residence. City fund managers and international footballers also recognise the value of good property standards in Malta.

choices of the highest standards’. More to the point, poured into these two moulds are all the expectations of luxury, safety, tranquility and, you’ve guessed it, lifestyle. Tas Sellum and Ta’ Monita have been designed to suit most pockets. Tas Sellum offers a one‐bedroom apart‐ ment of 97 square meters starting at €215,000 going up to a million plus for larger apartments whilst Ta’ Monita offers apartments of 73 square metres starting at €104,000 going up to a million plus. Both residences are termed Specially Designated Area, allowing the buyer to purchase more than one property in Malta and Gozo for private use or for business.

Contact details Portomaso Residence telephone : (+356) 2138 6802 ; (+356) 7949 7504. Email : info@tumasdevelopments.com Web : www.tumasdevelopments.com

The benefits of buying property in Malta • New Global Residence Program & Citizenship Scheme • Exciting New Pension Scheme • Attractive Tax advantages personal / company • Relief through 58 double taxation treaties • No annual Rates or Property Tax • Mortgage to purchase a property available to non‐residents • Safe environment with a low crime rate

Night shot of Tas Sellum property with lights in the distance. The value of Portomaso property has risen by 300%. Might this reflect property expectations by overseas buyers for Tas Sellum and Ta' Monita residences, too?

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NAMESERVICES & BUSINESS DIRECTORY MALTASECTION – SECURITIES

Legal Experts

Contact: Alexia Demicoli, business development executive l Email: alexia.demicoli@camilleripreziosi.com Address: Level 3, Valletta Buildings, South Street, Valletta VLT 1103 Malta. Web: www.camilleripreziosi.com l Tel: + 21238989 A leading Maltese law firm with a commitment to deliver an efficient service to clients by combining technical excellence with a solution-driven approach to the practice of law. Camilleri Preziosi is a specialised practice, advising on domestic and international transactions with a focus on corporate and commercial law, and the financial services sector. The firm provides both transactional and regulatory advice and assistance to clients. We take a multi-disciplinaryy approach to our practice and all our lawyers advise across a broad range of areas, which enables us to give practical and effective advice to clients.

Securities Services

Contact: Micheal McGreal, Managing Director l Email: micheal.mcgreal@customhousegroup.com Address: 25 Eden Quay, Dublin, Ireland Web: www.customhousegroup.com l Tel: +353 1878 0807 Multi-award winning Custom House Global Fund Services, parent company of the Custom House Group of Companies, is a leading global independent fund administrator with two and half decades of experience in providing an extensive range of services, coupled with a very personal approach. We combine our technology, expertise and worldwide infrastructure to deliver a customised package of services to our clients through our network of nine offices around the globe. Custom House and its subsidiaries are fully ISAE3402 and SSAE16 compliant and its offices are fully regulated, as required, by the relevant authorities in their jurisdiction.

Contact: Stephanie Heitkemper, deputy head business development division l Email: stephanieheitkemper.vfs@bov.com Address: TG Complex, Suite 2, Level 3, Triq il-Birrerija, L-Imriehel, Birkirkara, BKR 3000, Malta Web: www.vfs.com.mt l Tel: +356 2122 7148 Valletta Fund Services Limited (VFS), incorporated in 2006, is the leading provider of fund administration services in Malta. VFS consolidates the BOV Group’s expertise in the fund administration business supporting the Group’s growth strategy in the light of the fast changing developments taking place in Malta positioning the island as an internationally renowned financial centre. VFS is very well positioned to provide to the fund management industry with an integrated range of high quality fund administration solutions. Its strengths are derived from a strong complement of experienced employees coupled with the significant investment that has been made in state-of-the-art technology. VFS is recognised to provide fund administration services by the Malta Financial Services Authority.

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SECTION NAME MALTA – SECURITIES SERVICES & BUSINESS DIRECTORY

Securities Trading

Contact: Cliff Pace, Product and Business Development Manager l Email: borza@borzamalta.com.mt Address: Garrison Chapel, Castille Place, Valletta, VLT 1063, Malta Web: www.borzamalta.com.mt l Tel: +356 21244051 l Fax: +356 2569 6316 For over 20 years, the Malta Stock Exchange has successfully fulfilled its role as an effective venue to raise capital finance. The Exchange provides a structure for admission of financial instruments to its recognised lists which may subsequently be traded on a regulated, transparent and orderly secondary market place. The Malta Stock Exchange also offers a comprehensive range of Central Securities Depository services including maintenance of registers, clearing and settlement and custody services. The Exchange enjoys international accessibility on both fronts, through its relationship with Clearstream Banking, and the use of the XETRA trading platform. The Exchange offers a personalised, professional, swift and cost-effective solution to companies seeking a listing in an EU jurisdiction. Consultancy

Contact: Steven Williams, Team Lead - Career & Executive-Search Consultancy Services l Email: p5@emd.com.mt Address: Vaults 13-16, Valletta Waterfront, FRN 1914, Malta Web: www.p5.com.mt l Tel: +356 2203 0000 l Fax: +356 2123 7277 If you are looking to establish a financial services operation in Malta, P5+ (www.p5.com.mt) is the one-stop shop you will require to get started and grow your business. P5+ is the HR Consultancy & Project Management arm of EMD, a multi-disciplinary firm specialising in legal, tax, business advisory and corporate services (www.emd.com.mt). With its complement of 70 professionals specialised in law, tax, accounting, project management, recruitment and talent management, and ICT implementation, EMD/P5+ is well positioned to offer its esteemed international clients high level market intelligence, rapport with the relevant authorities relevant to the operation being set up, and an efficient and effective process of implementation with minimum timeframes from project brief to start of operation. Banking

Contact: Paul Mifsud, Managing Director l Email: info@sparkasse-bank-malta.com Address: Sparkasse Bank Malta plc, 101 Townsquare, Ix-Xatt ta' Qui-si-Sana, Sliema SLM3112, MALTA Web: www.sparkasse-bank-malta.com l Tel: +356 2133 5705 l Fax: +356 2133 5710 A banking partner you can rely on – giving you the power to succeed. Designed for Financial Practitioners, Corporate Service Providers and their clients’ individual needs, our services deliver private, personal and efficient solutions supported by a highly skilled and dedicated team of Private Bankers. For Account Openings, Payment Services, Forex, Investment Services or Fund Custody, contact us by email on info@sparkasse-bank-malta.com or call now on 2133 5705.

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t2s_eve

MALTA – SECURITIES SERVICES & BUSINESS DIRECTORY

Real Estate Development

Contact: George Bonnici, sales and marketing director l Email: gbonnici@tumas.com Address: c/o Spinola Developments Co. Ltd, Portomaso Business Tower, St Julians, STJ 4011, Malta. Web: www.tumasdevelopments.com l Tel: + 356 7949 7504 A spirit of enterprise, creativity and innovation. Described as Malta’s most enterprising and exciting entrepreneur in property development, Tumas Developments has been instrumental in developing many of the island’s most prestigious projects. Lauunched in the 1960s by Timas Fenech, the company grew quickly based on its values of ingenuity, expertise and skill ... and successfully revolutionised the local property industry. There have been numerous milestone projects over the years, froim the magnificent, unique multi-million Euro investment, international award-winning Portomaso – St Julians marina, Hotel, Leisure and Residential development to the tranquil, seaside Tas-Sellum – Mellieha in the north and ta Monita – Marsascala in the south.

The company has its finger on the pulse of where the property market should be heading, and is resolved to set new standards, both in Malta and overseas. A proven track record guarantees that these aims are achieve. Malta Business Development & Investment Promotion

Contact: Bruno L’Ecuyer, head of business development l Email: info@financemalta.org Address: Garrison Chapel, Castille Place, Valletta, VLT 1063, Malta Web: www.financemalta.org l Tel: +356 2569 6399 l Fax: +356 2144 9212 FinanceMalta, is a non-profit public-private initiative, set up to promote Malta’s international Financial Centre. The organisation brings together, and harnesses, the resources of the industry and government, to ensure that Malta maintains a modern and effective legal, regulatory and fiscal framework in which the financial services sector can continue to grow and prosper.

Wh • • • • • • • • • •

For more information about classified advertising in FTSE Global Markets please contact: Patrick Walker Global Head of Sales Tel: 0207 680 5158 email: patrick.walker@berlinguer.com

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T2S Join the discussion on 4th November 2014 at the Trinity House, Tower Hill, London EC3N 4DH

Who will attend T2S: • • • • • • • • • •

Post trade services (CSDs/ICSDs/ECB) European politicians and civil service executives Beneficial owners (plan sponsors /pension funds) Consultants and market intelligence providers Corporations Fund management firms Investment banks (custodians, fund administration, T2S integration) Central banks IT back office integration professionals Stock exchanges Trade associations

To find out more please call delegate sales at (44) (0) 207 680 5163 or email: t2s@ftseglobalmarkets.com You can also find more information on our events at http://www.ftseglobalmarkets.com/events/ftse-gm-events.html.

Find us on

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CLIMATE CHANGE

After years of being in the margins, climate change is finally having its day on the page thanks mainly to President Barack Obama’s vocal support for the Environmental Protection Agency’s (EPA’s) announcement that it would propose limits on carbon emissions from power plants. Climate change industry supporters have been waiting years for the US to take the lead in the climate change management debate and in June their wish was granted; particularly as other high carbon emitters, such as China are now firmly on the emissions capping bandwagon. Has the new found enthusiasm for the wellbeing of the Earth come just in time or too late to really make a difference? If climate change can be delayed or averted, which firms are in the front line to benefit from a more munificent approach to climate change management by G20 governments? Lynn Strongin Dodds reports on the hope and the glory.

Investing in the good earth PEAKING AT THE University of California, Irvine graduation ceremony, the US president noted, “The question is not whether we need to act. The overwhelming judgement of science, accumulated and reviewed over decades, has put that to rest. The question is whether we’re willing to act.” The answer is still not straightforward. There have been reams of scientific research showing that the planet is definitely getting warmer. The latest is a report from the United Nations Intergovernmental Panel on Climate Change (IPCC) which blames human activity as the major contributing factor to an increase in global emissions of greenhouse gases (GHG). They have grown more quickly between 2000 and 2010 than in each of the three previous decades and it warns that if action is not taken temperatures will jump to

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dangerous levels. Avoiding this scenario means cutting GHG emissions by 40% to 70% from 2010 levels by mid-century and to virtually nothing by 2100 in order to keep temperature hikes to manageable levels of 2 degree Celsius. At current rates, temperatures are on track to increase by 3.7°C to 4.8°C by 2100. New research from the federal agency National Oceanic and Atmospheric Administration (NOAA) in the United States adds credence to these findings. It shows that 2013 was the fourth warmest year on record. Last year was also the 37th year in a row in which global temperatures were higher than the 20th century median. In addition, most of the planet’s land and ocean areas were warmer than average, or broke heat records throughout the year. Evidence of these facts can be found in, for example, Australia which

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underwent the hottest year on record over 104 years and Botswana and Namibia which suffered their worst drought since the 1980s. Translating this into a financial cost is difficult and studies vary but according to the NOAA, the US experienced seven severe weather and climate disasters costing at least $1bn or more in 2013 alone, while globally, there were 41 billion dollar disasters, second only to 2010. This includes the severe floods that hit parts of the United Kingdom earlier this year, which the country’s Federation of Small Businesses estimates the cost to affected businesses to be in the region of $1.3bn. Looking at the bigger picture, the IPPC report cautions that world gross domestic product could shrink by as much as 2% annually if global temperatures rise by a widely predicted 2.5°C. The accumulated cost of crop losses, rising sea levels, higher temperatures and fresh water shortages could mount to between $70bn and $100bn a year, at the very least, in developing countries alone. However, despite a large and growing body of evidence for climate change, there are still many sceptics who believe that climate change is cyclical rather than systemic. In consequence, they decry any action that they regard as having no overall effect on climate but which, they say, will hurt the pockets of individuals and corporations. For example, political opinion is divided in the US over the EPA’s plan to cut 30% of emissions from US power plans over the 2005 and 2030 period. It is the most ambitious programme to date and the agency is adopting a flexible approach with each state being allowed to set targets based on their individual circumstances. Some lawmakers have rejected the Obama administration’s approach as an outright threat to the economy and there is criticism over the cap and trade system whereby the government issues emissions permits which companies can buy and sell according to their needs. The United States already has two schemes: the Regional Greenhouse Gas Initiative (RGGI), covering nine states in the northeast and a programme in California. They have though become a proxy for broader political fights over energy and the environment. For example, legislation to introduce a federal cap and trade programme failed in Congress in 2010, and Republican opponents have said such systems create a new tax on electricity, consumers and businesses. Chris Christie, the governor of New Jersey, pulled his state out of RGGI in 2011, claiming it had no discernible impact on the environment. The US is not alone. The European Union, home to the world’s biggest cap and trade scheme, is also facing opposition. The EU just reported its greenhouse gases in 2012 were 19% below 1990 levels but carbon prices in the nineyear-old scheme have flagged since the eurozone crisis, denting its effectiveness. In addition, countries are arguing over a plan to strengthen the system. Meanwhile, the jury is out as to whether China will deliver on its objectives. The country’s National Energy Administration has been applauded for its efforts to lower

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Britain’s Secretary of State for Energy and Climate Change Edward Davey talks to reporters at the end of the G7 meeting for Energy in Rome, Tuesday, May 6th this year. Photograph by Riccardo De Luca. Photograph supplied by pressassociationimages.com, June 2014.

coal's share of energy use to below 65% this year from 2013’s 65.7%, three years ahead of schedule while twelve of the country’s 34 provinces are aiming to reduce consumption of the fuel by 655m metric tons by the end of the decade. This would cut carbon dioxide emissions by 1,300m by 2020, according to research from Greenpeace. The success of the initiative will hinge on whether China can develop renewable energy such as wind and solar to complement nuclear and natural gas to displace coal power. Although this capacity can be built, it is expensive, and provincial authorities as well as industry have little incentive to switch to costlier power sources. “The politics of climate can be challenging,” says Vikram Widge, head of climate finance and policy at the International Finance Corporation (IFC). “There was a shift away from a sense of urgency in the wake of the financial crisis but it has come back on the agenda and governments are looking to shift to a low carbon environment due to the costs incurred if we don’t invest in new technologies and solutions today. I think we will also see more activity over the next 15 months in the run-up to the UN Climate Conference in Paris next year.” Hans Mehn, Partner at Generation Investment Management, believes that significant progress is being made but there is still a lot more to do.“In the last six years, there has been a real discrepancy between the headlines and the trend lines regarding the transition to a low-carbon economy. Leading up to 2008, there was great enthusiasm that new technologies would be able to emerge quickly to solve the climate crisis. The emotional euphoria turned to despair with the financial crisis and created a perception

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that green businesses could not be successful businesses. The reality has been that, in aggregate, there has been a steady drumbeat of adoption for renewable energy, energy efficiency and other solutions. The business case has been demonstrated through a very challenging period and solutions businesses have achieved success and scale in incumbent industries such as energy, buildings & lighting, transportation, etc. However, penetration of these vast, global markets is still in the early days, and there is a long runway of adoption to be realised in order to have a significant impact on the carbon intensity of these sectors.”

The investors’ view James Cameron, non-executive chairman of asset management and advisory firm Climate Change Capital agrees, adding,“One of the biggest challenges is that we have been pretending that climate change is an issue for the future when the evidence over the last 30 years has shown that it is a problem now. There have been many reasons for this– science works by disagreement and there is political and economic power vested in the status quo. However, I think now there is a strong resolution to act on the evidence.” Some of the world’s largest corporations have taken matters into their own hands, launching sustainability pro-

CLIMATE/GREEN BONDS, A RISING ASSET CLASS The discrete asset class of green labelled bonds is rising steadily in stature. Some $20bn of green bonds have been issued so far this year; with some benchmark issues, such as GDF Suez’s recent benchmark $3.5bn issue (the largest green bond to date) and China’s CGN Wind’s RMB1bn which is linked, through pricing, to carbon emission management, punctuating a banner year for the segment. T HAS BEEN a banner year for green bonds. High growth markets such as China are beginning to cash in on the segment, in line perhaps with increasingly government recognition of the importance of long term carbon emission management. The private sector is leading right now in China, and on tap in June came China’s CGN Wind, which issued its debut RMB1bn ($161m) five year green bond to help finance wind energy developments in Inner Mongolia, Guangdong and Gansu provinces. Lead underwriters on the deal were SPD Bank and China Development Bank. Pricing on the securities is comprised of both fixed and floating rate tranches, with the floating rate tied to China Certified Emission Reduction (CCER). In a special structure, the floating rate element, which is set within a range of 5 basis points (bps) to 20bps, is linked to the reduction of carbon emitted [namely the China Certified Emission Reduction (CCER)], by five subsidiary wind energy projects that the bond will help finance. The blended interest rate on the bond is 5.65%. The bond will be used to help finance the Inner Mongolia Shangdu Project that has an installation capacity of 49,500 KW, the first stage of Xinjiang Jimunai

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Project, the Gansu Minqin Water Well Project, the second stage of Inner Mongolia Wuliji Project, and Guangdong Taishan (Wencun) Wind Field that has an installation capacity of 35,700 KW. Emerging market municipalities are also entering the segment and municipal green bond issuance is expected to become a growing feature in the market. The City of Johannesburg’s recent ten year green bond, rated BBB

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grammes to cut their own carbon footprint as well as develop new technologies. “Sustainability has become mainstream and many companies are looking at how they can create business solutions and turn it into a competitive advantage.” says Charles Perry, a director at sustainability group Anthesis-SecondNature. “In each sector, there are leading companies ranging from consumer group Unilever to retail giant Walmart as well as General Electric, M&S, Waitrose and Nike.” General Electric started down this path before it became fashionable and has reaped the benefits. For example, an investment of nearly $2bn in research and development for

worth around SAR1.5bn ($139m), received positive investor response, and was oversubscribed. This is the third time the municipality has raised finance through the bond market this year, but the first via a green bond. Pricing was set at 185bps above the 2023 South African sovereign bond rate. The deal was underwritten by Standard Bank. Also in May Sweden’s City of Gothenburg issued its second green bond with a six year SEK1.8bn ($271m) issue that was mostly sold down to Swedish investors. The city issued a similar SEK500m bond last year. The underwriter on both deals was SEB. In similar vein, the county authority of Stockholm (Stockholms Läns Landsting) issued a AA+ rated SEK1.1bn six year bond in May to help finance hospital upgrades and rail transportation projects. Both transactions were underwritten by SEB. Meanwhile Rikshem, the real estate development company owned by Swedish pension fund AP4, issued a model SEK100m ($15m) bond linked to ‘green property’. The bond ended up as a private placement, and the terms of the deal remain private. However Rikshem has agreed to provide an annual investor letter which will include updates on the green projects it finances. The big deal of the year to date was May’s debut in the green bond market by French utility GDF Suez’s debut with its $3.5Bn bond linked to ‘renewable energy and energy efficiency projects that contribute to fight climate change’. GDF SUEZ chairman and chief executive Gérard Mestrallet stated at the time of the deal that: “This unusually large issue will serve the strategic priorities and sustainable growth strategy of GDF SUEZ in renewables and energy efficiency in Europe and throughout the world. Last week, this strategic priority was confirmed by GDF SUEZ winning the competitive tender for offshore wind farms in France. Projects financed by this bond issue will enable the Group to address the great energy and environmental challenges we face: meeting energy needs, ensuring security of supply, combating climate change, and optimising natural resources.”

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sustainability innovation two years ago translated into roughly $25bn in revenue as of mid-July 2013. Meanwhile, four years ago, Walmart, the US’ largest private consumer of electricity committed to cutting 20m metric tons of GHG— equal to taking 3.8m cars off the road for a year—from its global supply chain by 2015. In the UK, supermarkets such as M&S and Waitrose as well as the Co-op and Tesco have taken the lead, introducing programmes that set carbon reduction targets, improve water and energy usage through efficiency measures in shops and across the supply chain, as well as investment in renewable energy to power their stores.

The bond carries GDF’s credit rating of A1/A-. The bond was issued in two tranches: a six-year tranche valued at €1.2bn with a 1.375% interest rate, and a 12year tranche worth €1.3bn with a 2.375% interest rate. The biggest single issue green bond before this was EDF’s €1.4bn last November. Credit Agricole CIB was sole structuring advisor and along with Citi was also coglobal co-ordinator of the deal. Book runners included BNP Paribas, Unicredit, Mitsubishi UFJ Securities, Natixis and Société Générale. The average coupon amounts to 1.895% for a 9.1 years average duration. The bond was three times oversubscribed. French, German and UK institutional investors dominated buying of the bond, with demand coming from investors focused on environmental and socially responsible investing which GDF says bought 64% of the issue. According to the firm, 69% of the six year tranche was bought by asset managers, and 12% by pension funds and insurers. Banks and central banks bought 9% and 6% respectively. UK-based buyers took the biggest share, opting for as much as 21% of the issue, followed by France and Austria. The 12-year tranche saw 51% bought by asset managers and 43% by insurers and pension funds. French buyers accounted for 35% of the issue, followed by German, Austrian and British. Credit Agricole said that the pricing of the bond was “in-line with the curve of GDF’s mainstream bonds”, although there was a small “new issue premium” of four bps for the six-year tranche and two bps for the longer dated tranche. Specialist IGOs are also on the green bond bandwagon. The last issue is by the IFC, the private sector funding arm of the World Bank, which has issued an RMB500m ($47m) green bond, the first such bond issued by a multilateral in the offshore RMB market. The deal was bought up by investors from both Asia and Europe says the IFC. The multi-lateral is following in the footsteps of the EIB, which tapped the Eurobond market in May with its €350m ($470m) five year green bond, which was priced at 1.375% Proceeds are earmarked for renewable energy projects.

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One of the biggest challenges, according to Perry is “investors on the whole are currently not analysing sustainability. This is why the work being done by Carbon Tracker (a non-profit organisation) on stranded assets is so valuable.” The concept is that listed oil, coal, mining and other fossil fuel companies that have embedded carbon reserves will become“unburnable”because of public policy restrictions on carbon. They account for over 10% of the worldwide equity market value. Putting this into an investment context, a study from the stranded assets programme of the University of Oxford’s Smith School of Enterprise and Environment estimates that equity divestment of oil and gas companies could range from $240bn to $600bn, and about half that figure for debt holdings out of the $12trn assets of combined US, UK and other regional public pension funds and university endowments. To date, only a small but growing number of investors, including Rabobank, the Netherlands-based lender and Norwegian insurer and pension fund Storebrand, which has around $80bn assets under management, have divested these stocks. However, they are minnows compared with those that have stayed the course, such as CALstrs, the $176bn pension fund for Californian teachers. A turning point could be if Norway’s sovereign wealth fund, the world’s largest with over $840bn assets under management, decides to shed its fossil-fuel stocks, which comprise around 8% of its portfolio. It has recently established a working group to consider the matter. “When assessing the risk of stranded assets, investors will be looking closely at each company’s marginal cost of production”, says Ian Simm, founder and chief executive at Impax Asset Management, which manages about £2.6bn, with about a quarter of that in the renewable energy sector across both listed equities and private equity infrastructure. “As the EPA and other agencies prepare to impose restrictions on carbon dioxide emissions, many institutional investors are rationally apportioning a higher risk premium to the ownership of some fossil fuel assets.”

Next generation companies In the meantime, investors seem more interested in the new generation as well as more traditional companies that are mining new opportunities borne from the shift to a low carbon economy. Simm believes there are good prospects in companies involved in renewable energy such as solar and wind, sustainable food and agriculture, and water infrastructure. It takes a global view with its top holdings ranging from US based water technology group Pall and waste management company Clean Harbour to Irish buildings energy efficient firm Kingspan Group and China Longyuam Power. Generation, on the other hand, has a climate solutions fund that invests in small cap companies at the growth stage to high profile firms such as SolarCity, a leader in rooftop power systems and 20 year old Finnish group Vacon, a global manufacturer of variable-speed AC drives for adjustable

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control of electric motors, and inverters for producing energy from renewable sources. “Through this period not all businesses or solutions have succeeded, but the aggregate effort of innovation has led to increasing adoption of low-carbon solutions. Simply providing a green product is not sufficient. Successful innovators also need to deliver a compelling economic proposition to their customers with high quality products or services. It has largely been these leading business innovators who have catalysed the initial phases of the transition to a low-carbon economy since policy has been anything but consistent over the last years.” “We are definitely seeing a growing number of opportunities and funds that invest in low carbon infrastructure and renewable energy, such as solar and wind,” says Kate Brett, a responsible investment consultant at Mercer, the consultancy. “There are also other ways investors can hedge climate risks, such as passive carbon-tilted indices, which strip out the most carbon-intensive stocks from the benchmark. In addition, there is a growing market for climate or green bonds, those issued to raise finance for environmental projects.” These have included financing for renewable energy, energy efficiency (including efficient buildings), sustainable waste management and land use (including forestry and agriculture), biodiversity conservation and clean transportation and water. Until recently almost all climate bonds were issued by multilateral financial organisations such as the World Bank and the European Investment Bank, but there has been a recent spate of corporate activity. The most notable and the largest ever green bond, worth $3.4bn, was recently issued by GDF Suez, the French power company. The Climate Bonds Initiative, a non-profit organisation that promotes investments to combat climate change predicts that total green bond issuance from all sectors will reach $40bn in 2014. Corporations could account for half of this figure based on issuance to date, according to ratings agency S&P. Although supranational organisations welcome the company in the green bond market, they have also stepped up their efforts. For example, in 2013, the IFCC made $1.6bn in climate-related investments; more than ten percent of its overall commitments for the year. Projects included solar facilities in Morocco, South Africa and Latin America as well as advisory work with governments in emerging markets to develop insurance products that can safeguard farmers' assets as well as cover bank risks in order to promote increased lending to farmers. The most recent partnership was with the Centre for Agriculture and Rural Development Insurance Agency to support the development of typhoon index insurance for hundreds of thousands of its farmer clients in the Philippines. “We are definitely seeing greater interest in climate change initiatives from emerging market countries as they become wealthier and there is a greater demand for energy, transport and houses,” says Widge. “We are also seeing examples of smart policies such as in Morocco and this is creating a shift in thinking.” n

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INVESTMENT Bucking the perception that cheaper funds fetch the fattest returns, higher-priced active managers—who strive to beat benchmark indices using a hand-picked mix of assets—have been forced to sharpen their skills to prove that investors really can get what they pay for over the long haul. From Boston, Dave Simons reports.

ACTIVE INVESTING: IS IT WHERE THE ACTION IS? IKE NEARLY EVERYTHING else in the modern era, participation in the financial markets has increasingly become a do-it-yourself proposition—today even the most basic handheld makes it possible for any Tom, Dick or Mary to connect to the exchanges in seconds and execute trades at a sliver of yesterday’s broker-assisted costs. Such rapid advances continue to threaten the livelihood of many a stock-picking stalwart. Though still dominant, in recent years active fund managers—who endeavor to beat targeted indices using a carefully chosen blend of portfolio assets— have struggled to maintain their past luster. In a market where the biggest winners often have the thinnest margins, the elevated fee structures of many active funds—upwards of 1.5%, historically—have become a thorny issue for valueseeking investors, many of whom have flocked to lower-cost ETFs, index mutual funds and other passive shops offering better deals. This has forced active operators to sharpen their skills in order to prove that investors really can get what they pay for over the long haul. Even with the influx of trading innovations, data from PricewaterhouseCoopers finds traditional actively managed

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funds still accounting for roughly two-thirds of assets worldwide. However, active growth will likely be surpassed by passive and alternative strategies by decade’s end, and total actively managed assets under management may in fact contract through the period (by contrast, alternative assets are expected to surge more than 9%, reaching $13tn, according to consulting giant PwC).

Pension pinchin’ With fund expenses often the make-or-break point, active managers find themselves facing a rising tide of scrutiny among global regulators and institutional investors. Government officials in the UK, for instance, have sought greater transparency into net-of-fee returns generated by active funds, and have provided plan sponsors with information around lower-cost, passive alternatives. Data from the Centre for Policy Studies estimates that some £85bn ($144bn) in pension assets are currently held in actively managed funds, while a separate study by UK consulting group Hymans Robertson pegs asset-management costs covering the entirety of pension schemes at approximately £790m ($1.34bn).

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The notion that your average active fund might turn out to be an expensive index tracker in disguise hasn’t helped matters. Recent studies revealed that a number of funds identifying themselves as benchmark beaters were in fact comprised of many of the same issues found within the targeted index. According to estimates, active portfolios with measurable benchmark deviations account for only 20% of the total market at present. To provide investors with better insight into how active an active fund really is, several years back Morningstar devised its “active share” rubric, which examines the degree of separation between a fund’s holdings and the benchmark it seeks to outpace. Industry consensus holds that funds with an 80% differentiation ratio or higher are the most active, whereas those scoring 60% or lower are active in name only. It’s hardly a perfect formula, as several studies have since noted: for instance, an index with a large chunk of assets dominated by a small number of companies could easily skew the “share count.” Further, while higher share value is typically associated with better performance, having fewer“safe”index-based assets may also increase the fund’s exposure to downside risk. Antti Petajisto, a BlackRock portfolio manager and former assistant professor of finance at Yale University, argues that funds with the lowest active share—which Petajisto defines as “closet indexers”—are the worst offenders, as they perform like index funds (meeting, rather than exceeding, stated benchmarks) yet still charge like active funds. In a Financial Analysts Journal study entitled “Active Share and Mutual Fund Performance,” Petajisto insists that the problem isn’t so much about low active share itself, since, he argues, “a rational investor could well combine a position in a very active fund with a position in an index fund”and still achieve positive results. Rather, it’s the higher-than-normal fees that make these less-than-active funds“very expensive relative to what they offer.” Since only the fund’s active positions can possibly outperform the benchmark,“it is very difficult in the long run for a closet indexer to overcome such fees and beat its index net of all expenses,” says Petajisto. A number of factors have conspired to make pure active approaches difficult to maintain. Cost, of course, is a big one, particularly in the face of price-busting ETFs (many of which bear expense ratios as little as one-tenth of one percent). Meanwhile, broader institutional participation in alternative strategies such as OTC derivatives and private equity has resulted in a more homogenous marketplace, making stock picking an increasingly arduous task for active funds. And with competition fierce and consolidation thinning their ranks, profit-hungry active managers have been much less willing to stick their necks out (for fear of being axed by their biggest institutional benefactors). Which is not to say that it’s all been doom and gloom. Within the past year a number of top fund firms have reported unusually robust active-management activity. In 2013, JP Morgan’s fleet of actively managed funds recorded nearly twice the level of net inflows achieved during the previous 12 months. In a report issued earlier this year,

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Greg Behar, senior vice president and director of global equity investment strategy at Northern Trust Asset Management, sees the ongoing evolution in active management as a continuation of the trend that began during the early days of the financial crisis. “Investors are now more diligent about addressing portfolio risk and underperformance, and many have sought index-based strategies as part of that effort,” says Behar. Photograph kindly supplied by Northern Trust Asset Management, July 2014.

BlackRock said that over half of its active fundamentalequity products beat their targeted benchmarks, compared to just 1 in 3 during 2012. And a newly released study from Wilton, Connecticut-based Commonfund Institute that focused on endowment-investment strategy concluded that active fund management was indeed capable of yielding superior returns, provided that endowment heads use performance measuring analysis to weed out the active achievers from the closet indexers. Stephen Beinhacker, CFA, managing director, global head of equities for asset-management provider SEI, believes that the favorable conditions that propelled actively managed returns in 2013 will remain in place through the current year. Beinhacker bases his assumption on several historical factors, including concentration, correlation and dispersion. “We are looking at the backdrop as to where, when and why active management might offer competitive returns versus passive alternatives,”he says. For instance, a less correlative environment tends to favor active strategies, since managers find it easier to choose between issues when everything isn’t moving in lock step. Similarly, markets with lower concentration have also been historically better for active funds, as they allow managers to apply their skills to a broader opportunity set, adds Beinhacker. (By contrast, active management usually assumes a lesser role during bubbles such as the microtech boom of the late ’90s, when the ability to distinguish between good and bad companies is less obvious.) In an effort to lure investors burned by high-price funds with sub-par performance, active-management models have become more malleable, and include“hybrid”or“engineered” products that blend active, passive, alternative, even sectorspecific approaches, and which can be tailored to the specific goals of the individual client. Greg Behar, senior vice president and director of global equity investment strategy at Northern Trust Asset Management, sees the ongoing

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STRONG Q2 INFLOWS INTO HEDGE FUNDS Total hedge fund capital surged to an 8th consecutive quarterly record in 2Q14 as investors allocated across most hedge fund strategies, according to the latest HFR® Global Hedge Fund Industry Report NVESTORS ALLOCATED $30.5bn of new capital to the hedge fund industry in 2Q14, surpassing the $26.3bn that was allocated in the first quarter this year and the largest quarterly inflow since investors allocated $32.5bn in the first quarter of 2011. The inflow of $56.9bn in the first half of this year pushed up total hedge fund industry capital globally to over $2.8trn, a record. Inflows for 2Q14 were led by fixed income-based Relative Value Arbitrage (RVA) strategies, which received $18.3bn of new investor capital, increasing total assets invested in RVA hedge funds to $742.6bn globally. Through the first six months of the year, inflows into RVA strategies reached $29.5bn (the most popular strategy for investors), while the HFRI Relative Value Arbitrage Index leads industry strategy performance year to date, with a gain of +4.8%. The largest component of recent

evolution in active management as a continuation of the trend that began during the early days of the financial crisis. “Investors are now more diligent about addressing portfolio risk and underperformance, and many have sought index-based strategies as part of that effort,”says Behar. “As investors focus more on efficiently targeting their investment goals, factor-based engineered equity strategies enable these same investors to use specific tools to help them achieve the desired outcome, based on their unique risk and performance objectives. Such an approach gives investors a costeffective alternative to pricier, fundamentals-based active strategies,” says Behar, allowing them to directly access specific market factors. Whereas an endowment or insurance firm may want to maximise income through equities investing, by contrast a defined-benefits plan that is focused on addressing current liabilities will likely choose a much different route. “A lowvolatility strategy, for instance, tends to have a higher correlation to liabilities than traditional market-cap weighted indexing,”observes Behar. This kind of approach would help protect against downside risk while still offering some upside participation in equities, says Behar, “therefore helping the plan manager preserve the overall funded status, which is the primary goal.” As subtle variations may exist within any one investment strategy, it is crucial that investors know exactly what they’re getting into before selecting an active manager. “This is where fund design really counts,” says Behar.“For example, at first glance strategies that are labeled ‘low-volatility,’‘lowbeta,’ or ‘risk-weighted’ may all appear to do roughly the same thing. However, once you look a little closer at their construction and methodologies, you can see that they are designed differently and can perform differently under certain market conditions. In other words, if investors want

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inflows into RVA strategies was to Credit Multi-Strategy managers, with investors allocating $9.7bn over the second quarter and $19.4 billion in the first half of the year. Meanwhile the HFRI RV: Multi-Strategy Index has gained +3.2% year to date. According to the data provider, investors were encouraged by the accelerating M&A environment and dynamic shareholder activist trends. Investors allocated $11.7bn of new capital to Event Driven (ED) strategies in 2Q14, bringing inflows to $15.7bn over the first half of this year. Recent inflows and performance gains increased total ED capital to $756bn globally. The largest ED inflows were to Activist and Distressed sub-strategies, with Activist receiving inflows of $5.9bn over the quarter and $9.4bn for the first half, while Distressed saw inflows of $3.4bn and $4.4bn, respectively, for Q2 and the first half of the year. something that is truly volatility resistant, they should examine whether the strategy not only reduces absolute risk, but also reduces the unintended biases inherent in many of these strategies. It is our duty to ensure that investors efficiently capture exposures that suit them best.”

Popular innovation One of the more popular innovations has been the actively managed exchange-traded fund, which combines the enhanced-performance potential of active strategies with the cost-effectiveness of ETFs. State Street’s first batch of actively managed ETFs were launched in 2012, and continue to do well from both a performance and asset-gathering standpoint, notes Scott Ebner, senior managing director of State Street Global Advisors (SSgA). Earlier this year State Street expanded its active ETF menu to include a trio of equity funds developed in cooperation with partner MFS Investment Management that utilise both fundamental and quantitative stock-picking methodologies. “We recognise that most investors now have a combination of active and passive products within their portfolios,” says Ebner. “Which is why it’s been our goal to maintain several teams that can each focus on a different strategy, while also offering multiple solutions that can be easily accessed by our clients.” While admittedly“a very small part of a very small part of the overall market,” the actively managed ETF segment has nonetheless been one of the industry’s fastest growers of late, says Ebner. “Even among investors who are typically more inclined to seek passive strategies, these kinds of offerings have been quite attractive,”says Ebner.“I think the long-term outlook for these products is such that, in years to come, it will become more difficult to label ETFs as exclusively passive.” n

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Since its formation in 2013, the UK’s Financial Conduct Authority has made it clear that it is less interested in routine compliance processes. The FCA’s focus is now on how a firm’s compliance department or senior management team, training and competence (T&C) programmes and broader compliance culture deliver the best customer experience and market outcomes, writes Neil Herbert, director of HRComply.

A cultural shift to compliance T

open to claims of market abuse. It O EFFECTIVELY REGULATE seems the FCA will be the judge of the industry the FCA has what is or isn’t appropriate. With adopted a new supervisory careers and reputations at stake, model that is more pre-emptive than who would be a market maker in reactive. This means dealing with unthese circumstances? derlying causes rather than just Given the consequences that such symptoms and is focused more on enforcements can have on businesses firms doing the right thing, rather and on individuals (not to mention than just complying with specific reputational damage and the damage rules. Where firms go wrong, the FCA to the industry as a whole) this says that the cause is usually not a situation would at best appear to failure to comply with specific rules Photograph © Skypixel/Dreamstime.com, supplied be worrying. but rather there is a fundamental flaw July 2014. in the firms’ business models, culture or business practices. Addressing conduct risk at its root At a practical level then, the FCA has made it clear that the The greatest challenge facing compliance and risk profesfocus will be on the outputs not the inputs. What are those sionals is trying to determine the acceptable levels of outputs? They include achieving appropriate customer conduct in the multiple markets, investment and client outcomes and the highest ethical performance of all sectors that the FCA regulates and then monitoring these. customer-facing staff. This means that they are technically The process involves identifying conduct risks before they competent to advise and provide the most suitable advice in have consequences and dealing with them efficiently. There any given scenario and with regard to each individual client, have been many recent references in FCA speeches or press whilst exercising the highest levels of integrity and conduct. releases about the need for senior management or compliThe FCA indicates that achieving appropriate customer ance professionals to be aware of everything that happens outcomes is heavily dependent on firms having a culture on their watch. Much rhetoric and recent legislation has that views the interests of the customer—and the integrity been directed at holding these senior individuals accountof the markets—as paramount. This needs to be led from the able for any of their staff’s misconduct and shifting the top, instilled in clear business practices that can be easily burden of evidence to being one of ‘unless you can prove understood and guide all levels of management when you did something to stop it, you are as guilty as the perpejudgements need to be made about what is acceptable and trators themselves’. Realistically in large organisations with what is not. huge trading floors and wealth management desks, this is The problem of course with much of this is that it is simply impossible. relatively arbitrary. Without clear rules or benchmarks, The recent industry response has been to recruit more and how can firms ensure that they are satisfying the expecta- more compliance staff and this has driven up both demand tions of the regulator? Increasingly it seems, the FCA is and salaries. There continues, however, to be little evidence exercising powers to enforce against both firms and that the issue of conduct risk is being addressed at its root. individuals that are driven by its own subjective judge- Neither is conduct risk being put at the top of the agenda by ments and agenda rather than by black and white regula- enough boards, with the resultant absence of conduct and tory rules or guidelines. compliance strategies being embedded from the top down. For example, in recent enforcements against Regulators around the world are giving the management ‘market abuse’ the FCA has relied upon Section 118(5) of and mitigation of conduct risk a high priority, yet no univerthe Financial Services Act, dealing with trading activity that sally agreed definition of conduct risk exists. In response gives a false impression of the supply, demand and price of therefore, compliance officers, risk managers, senior maninvestments. The FCA does not, however, impose compar- agement—and, crucially in my view, HR—need to establish ative quantum caps concerning how much of a bond or what ‘good’ looks like for their organisation. They then need stock can be held. This leaves the whole process of pricing to put in place the systems, controls and infrastructure to bonds (particularly in relatively narrowly traded markets) effectively manage and attain that standard. n

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Over the last decade, there has been a significant improvement in the securities trade execution times. These times have decreased to micro seconds and advances in technologies such as laser link are trying to further reduce the times. However, the settlement of the executed trade takes days to exchange cash for securities. Depending on the type of security and trading venue, the settlement day will differ. Rakesh Jangili, senior consultant, Capital Markets Solutions Group, Virtusa, looks at the settlement cycles of different markets and assesses the likelihood of harmonisation of settlement cycles across the globe.

Towards harmonisation of global trade settlement cycles I

moved to T+1 cycle back in March N THE MID-NINETIES, the settle2012. Markets moving to shorter setment cycle for US stocks, tlement cycles might see more settlemunicipal and corporate bonds ment failures if they don’t prepare was changed from T + 5 (T refers to well for the transformation. The BCG trade date) to T +3. Over the last 20 report mentioned eleven different years, despite changes in technology, enablers; these enablers involve the settlement cycle hasn’t changed. changes in back and middle office The 2007/2008 global financial crisis operations such as same day affirand liquidity problems have led to mation, match to settle, cross increased focus on risks in trade industry standing settlement instrucclearing and settlement processes. The Photograph © Madmaxer/Dreamstime.com, tions and infrastructure for near-real risk on outstanding exposure to supplied July 2014. time processing. counter parties in settlement process is dependent on the settlement time and market volatility, therefore the need for increased focus on shorter settlement Wave of changes cycles has emerged. Trades are already settled on a T+2 cycle in many Asian Shorter settlement cycles will result in cost savings, due markets. Some of the other markets (such as the Chinese to optimal capital, and reduced risk. Lower clearing fund re- markets) already trade at a T+1 cycle on A Shares (settled in quirements as a result of shorter timelines will result in RMB) and T+3 cycle on B Shares (settled in US dollars). lower interest costs, the benefit will be even larger in high Among the developed markets in the region, Japan and volatile periods. Tighter timelines provide flexibility to Australia are evaluating a move away from their existing T+3 reinvest cash quickly. Settlement process involves credit cycle. Across Europe different settlement cycles are followed, risk, where counter-party may default prior to completing most of the major markets follow the T+3 settlement cycle settlement on the unsettled amount at any given time. except Germany. Recently the acceptance of CSD RegulaThe shorter settlement cycle will decrease the amount of tion by the European Parliament has opened the way for outstanding unsettled trades, which in turn would decrease standardising the T+2 settlement cycle by January 2015. the credit exposure. The correlation between clearing fund On January 14th this year Euronext announced the shortrequirement and counter party credit exposure with ening of the settlement cycle from T+3 to T+2 for all secuincrease in settlement timelines can lead to adverse rities on its cash markets across Europe, effective from outcomes. The effect of this correlation will be lessened by October 6th this year. shorter timeframes. The US markets look to stick in the near term to the T+3 With similar lines of thought, settlement cycles of T+ 0 may settlement cycle. The DTCC conducted a detailed cost benefit look ideal but it is difficult to achieve, as it means that the analysis of T+2 / T+ 1 settlement cycles in 2012 and drafted a trader must have the full amount of money at hand even roadmap to achieve a T+2 cycle by 2016. After that it plans to before placing a trade. This very restrictive funding time-line evaluate the benefits of moving to a T+1 cycle. A direct move leads to lower volumes, lower liquidity and lower leverage in to T+1 may not be ideal in the current circumstances as the markets and might lead to higher settlement failures. FX settlement cycle is T+2. Recently, financial services lobby According to a 2011 report by Omgeo, settlement failures group SIFMA supported the move to T+2 cycle. Looking at all were very high in both Russian and Israeli markets, which these developments, the T+2 settlement cycle will be the were operating on a T+0 settlement cycle. Since 2013, way to go. In the long run, this harmonisation in settlement Russia has been moving to T+2 settlements and Israel cycles can give a huge fillip to cross border trading. n

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MARKET DATA BY FTSE RESEARCH

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

12M%

1.6 2.1 -1.2 -0.6 -0.8

3.3

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

15.7

2.8

-0.2 -0.6

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

-0.4

FX - TRADE WEIGHTED USD GBP EUR JPY

13.0

6.8 9.5 18.6 7.2 9.1

0.8 -2.1

-0.9

1.4

-0.4

-5

3.3 1.6

0.9 1.4 2.1

25.3

10.7

6.8 4.6

6.2

1.8 1.8

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

21.5 25.1

13.0 12.2 14.2

5.0

0.1

9.8 0.7

-4.4

-10

EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 1M local ccy (TR) Japan BRIC Emerging USA FTSE All-World Developed Asia Pacific ex Japan Europe ex UK UK

Regions 12M local ccy (TR)

5.0 2.1 1.6 1.4 -0.6 -0.8 -1.2

-2

-1

25.3 25.1

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

4.2 3.3

22.0 21.5 16.5 15.7 14.2 13.0 12.2

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

-0.3 -0.6 -1.0 -1.1 -1.2 -1.3 -1.5 -1.8 -1.8

-3 -2 -1

4.0

2.8 2.4 2.1 1.6 1.5 1.4 1.0 0.6 0.2 0.2

4.8 4.6 3.7 3.5 3.5 3.4 3.3 0.8 0.6

49.2 45.6 45.2 40.0

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

6.0 5.6

30.8 27.9 26.2 25.1 23.6 23.5 23.2 22.3 22.0 20.6 17.6 15.5 15.2 13.0 12.2 9.5 8.6

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

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

5.0

33.9 31.9 20.9 15.7 15.0 12.2 7.4 7.1 6.6 5.1 3.6

Source: FTSE Monthly Markets Brief. Data as at the end of June 2014.

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GM Data pages 77_. 30/07/2014 13:04 Page 115

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

US Emerging

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

Oil & Gas Health Care Financials 120

Asia Pacific ex-Japan

140 130

Consumer Goods Industrials Telecommunications Utilities

110

120 110

100

90 80

70 Jun 2012

Oct 2012

Feb 2013

Jun 2013

Oct 2013

Feb 2014

Jun 2014

Oct 2012

Feb 2013

Jun 2013

Oct 2013

Feb 2014

Jun 2014

BOND MARKET RETURNS 1M%

12M%

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

-0.2

UK (7-10 y)

3.3

-0.6

1.6

Ger (7-10 y)

0.9

Japan (7-10 y)

6.8 3.9

0.3

France (7-10 y)

1.4

9.5

Italy (7-10 y)

2.1

18.6

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

-0.4

7.8

Euro (7-10 y)

11.4

1.0

UK BBB

-0.4

7.2

Euro BBB

9.1

0.8

UK Non Financial

-0.4

5.7

Euro Non Financial

7.2

0.8

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

2.1

-0.9

-1

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

Corporate Bond Yields

Japan

Ger

France

Italy

UK BBB

8.00

Euro BBB

7.00

6.00

6.00 5.00

5.00 4.00

4.00

3.00

2.00 2.00

1.00 0.00 Jun 2011

Dec 2011

Jun 2012

Dec 2012

Jun 2013

Dec 2013

Jun 2014

1.00 Jun 2009

Jun 2010

Jun 2011

Jun 2012

Jun 2013

Jun 2014

Source: FTSE Monthly Markets Brief. Data as at the end of June 2014.

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GM Data pages 77_. 30/07/2014 13:04 Page 116

MARKET DATA BY FTSE RESEARCH

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

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

FTSE UK

FTSE US Bond

FTSE US

130

115

125 110

120 115

105

110 105

100

100 95 Jun 2013

Sep 2013

Dec 2013

Mar 2014

95 Jun 2013

Jun 2014

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

Sep 2013

Dec 2013

Mar 2014

Jun 2014

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

FTSE UK

FTSE US Bond

200

FTSE US

260

180

220

160 180 140 140

120

100

100 80 Jun 2009

Jun 2010

Jun 2011

Jun 2012

Jun 2013

1M% FTSE UK Index

FTSE USA Index

-1

90.0

137.9

2.0

1.7

21.7

2.7

Jun 2014

7.2

0.3

-0.2

Jun 2013

5Y%

5.2

-0.6

Jun 2012

1.7

2.1

-2

Jun 2011

6M%

3.2

FTSE USA Bond

Jun 2010

3M%

-1.2

FTSE UK Bond

60 Jun 2009

Jun 2014

24.5

100

Source: FTSE Monthly Markets Brief. Data as at the end of June 2014.

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150

UPCOMING EVENTS With Poland as a key financial and economic hub of Central Eastern Europe, this event aims to provide an understanding of the rapidly developing Polish market. It will allow delegates to listen to the key issues discussed between the main players in the market through a series of panel discussions. Utilising FTSE Global Markets successful Accessing brand, the half day seminar with networking drinks afterwards will ensure that attendees gain a thorough understanding of the domestic market, how international investors view the market together with opportunities that exist based upon the technological and macro factors that will also be covered. To find out more about this interesting event please register at www.ftseglobalmarkets/accessingpoland2014 or visit the website at www.ftseglobalmarkets.com/events

Providing an in-depth analysis of the Target 2 Securities changes that will transform the market, this event will allow delegates to listen to key stakeholders involved in the changes through a series of panel discussions. Utilising FTSE Global Markets successful Solutions brand, the half day seminar with networking drinks afterwards will ensure that attendees gain a thorough understanding of the changes, how it will impact market participants and the challenges and opportunities that exist in terms of technology and regulation. To find out more about this crucial event please register at www.ftseglobalmarkets/T2S or visit the website at www.ftseglobalmarkets.com/events

Focused on providing an understanding of the rapidly developing Turkish market, the second annual Accessing Turkey event will allow delegates to listen to key stakeholders in the Turkish market through a series of panel discussions. Utilising FTSE Global Markets successful Accessing brand, the half day seminar with networking drinks afterwards will ensure that attendees gain a thorough understanding of the domestic market, how international investors view the market together with opportunities that exist based upon the technological and macro factors that will also be covered. To find out more about this interesting event please register at www.ftseglobalmarkets/accessingturkey2014 or visit the website at www.ftseglobalmarkets.com/events

FTSE Global markets breakfast briefings are designed to be both thought provoking and highly targeted and provide delegates the opportunity to listen to key stakeholders and participate in the discussion aswell as network. Topics cover both FTSE Global Markets Accessing brand (for emerging markets) and Solutions brand (for key regulatory or process changes) and are undertaken globally, providing delegates with an opportunity to participate wherever they are based. To find out more about the events being held near you and to register your interest please visit www.ftseglobalmarkets.com/events/breakfast briefings

FTSE Global Markets roundtables are based upon thought leadership discussions between industry leading participants which seek to discuss the key issues and trends that are shaping the Global Financial Markets. They cover such topics as regulation including AIFMD and EMIR and product and service issues such as ETFs, Collateral Transformation and Prime Broking. Often lively, the roundtables challenge convention and provide the reader with an insight into how industry leaders are looking at the market and what they thinking. Participants too benefit from the roundtables "The roundtables always have lively debates with top class engagement from respected market professionals. They have great reach aswell," says Alan Cameron, Head of Global Strategic UK Broker-Dealers and Bank Relationship Management and team member of the Client Development Management Committee at BNP Paribas. To find out more about these events, visit our website at www.ftseglobalmarkets.com/events/roundtables

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