FTSE Global Markets by FTSE Global Markets

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ROUNDTABLE - CCP & SECURITIES LENDING: A PERFECT PARTNERSHIP?

ISSUE 78 • SEPTEMBER 2014

The UK’s new muni bond agency Industrialised capital markets The prime broking services reset Trading technology in a cold climate

IS THIS THE FACE OF TOMORROW’S INVESTOR? WWW.FTSEGLOBALMARKETS.COM

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 Finance Manager T: + 44 207 680 5159; E: qserve@berlinguer.com CLIENT SOLUTIONS Stuart Fear, Euopean head of sales T: 44 207 680 5163; E: stuart.fear@berlinguer.com Nicole Taylor, Special Projects T: 44 207 680 5151; 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, weekly e-alert and mobile app 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 2013 - August 2014: 20,525

FTSE GLOBAL MARKETS • SEPTEMBER 2014

HIS EDITION IS the last in a series of three publications which have looked at the effect of scarcer resources, new technology and geopolitical and high-tech risks on investment strategy and focuses on the impact of technology on the day to day operations of business and investment. There have been heavy hints of change in the air for some years. The velocity of money has clearly slowed. We know this because QE, for instance, is not trickling down and inflation is not rising near fast enough to meet with traditional economic theory. Banks no longer act like banks or want to be banks. EPS is not growing much either: because (the elite aside perhaps) not enough people have enough money to spend or invest in any meaningful way; and any big money there is has gone into asset inflation. CapEx in corporations is at a historic low. Export demand is no longer a driver of economic growth. Fracking notwithstanding, the usual geopolitical drivers of oil and commodity prices are simply not in gear. How do I know this? Energy prices have hardly shifted even as conflicts in the Middle East continue to ignite faster than a creosote bush and Vladimir Putin has his sanction-heavy hand on the energy tap of Europe. The West remains cripplingly indebted, which limits its manoeuvrability in times of crisis, and so we look to have paralysis in any economic system. What does it all mean? It hints at tipping points and to the displacement or even the breaking down of traditional business and political parameters. There are many things which rush to try to fill these gaps in times of uncertainty, including civil unrest, independence movements, wars, the rise of state infrastructure, new economic thinking and technology. We’ve not had too much new economic thinking of late, and few states these days can afford to take on proactive social and economic management. What is new is the emergence of new political thinking that is paying more attention to subsidiarity; in other words, government should act a level where it is most effective. Initially this was thought (aided by technology) to result in coordinated devolution to local control and networking to achieve more global goals. More latterly thinking is that it could go one of two ways: effective interlocking networks based on mutual benefit or system collapse (either full or partial). Should Scotland leave the UK, we will have a working template of how it might work in action. Either way the structures by which we govern our affairs continue to evolve and, like in every other century, the second decade marks the breakdown (either full or partial) of at least one dominant political structure (think French Napoleonic ambitions or the fall of the British Empire after the First World War). The marchlands between competing spheres of influence across the globe remain mired in conflict and that won’t change for (ooh) decades. The fate of Scotland will determine whether the little states of the world will rise again, and that won’t be clear for years. What’s left then is technology and right now its influence and acceleration are gaining incredible speed. The pace of change brought about by technology is revolutionary in its reach. However, no matter how exciting it is and how pleased we are with innovation, revolutionary times are not pretty and the outlook for many segments of business life is, in many ways, unattractive. Technology will mean that fewer and fewer people will be required in many businesses and we will have to live with the consequences of that change. As autumn stretches out its golden hand, hairy scary trends continue to exert their uneasy influence on investment strategy and the near term outlook. I also know that the world evolves in ways that are not linear and so accurate outcomes cannot be predicted. What is clear though is that technology will (again) change the way we live and work. The themes of this missive are writ large across the entirety of this edition; some hopeful, some worrisome. Take what you can from it. Francesca Carnevale, Editor COVER PHOTO: Cool cyber steel man Photograph © Vladislav Ociacia | Dreamstime.com, supplied September 2014.

CONTENTS COVER STORY

IS THIS THE FACE OF TOMORROW’S INVESTOR?

..........................................Page 6 We actually hope not. However, it looks like technology will help redraw the global investment landscape. In a trilogy of stories we look at the possibilities offered by innovation and new media outlets. It’s a story of substantial change; not all of it pleasant. On page 11 we look at IT adoption and on page 13 the new data challenge.

DEPARTMENTS

SPOTLIGHT

LOW BOND YIELDS HURT PENSION SCHEME DEFICITS ...................Page 15

MARKET LEADER

MANAGING TURBULENCE IN RUSSIA’S BOND MARKET .................Page 27

Topical stories from around the capital markets.

Natalia Markova of Cbonds looks at the issues raised.

THE INDUSTRIALISATION OF THE CAPITAL MARKETS .......................Page 29 Ryan Baccus of Sapient Global markets asks the question.

SOFTENING OF LONDON PROPERTY PRICES ...........................................Page 31 Will lower prices cool mortgage lending?

REASSESSING THE FUTURE OF CLEARING .................................................Page 32

IN THE MARKETS

Hans-Ole Jochumsen of Nasdaq OMX takes a look.

DIGITISATION OF DOCUMENTATION .............................................................Page 34 Ravi Sonecha and Stuart McClymont of JDX Consulting explain the mechanics.

ECONOMIC FEEDOM: WHY POLICY MATTERS .......................................Page 36 Marshall Stocker of Eaton Vance looks at the implications.

PROPORTIONALITY & UCITS V REMUNERATION ...................................Page 40 Lydon Shay of Matheson Asset Management and Investment Funds Group analyses the principles.

TURKEY: TURKISH BANKS REAP THE BORROWING WHIRLWIND....Page 42 How have Turksih Banks capitalised on the opportunity?

COUNTRY REPORT

BAHRAIN: THE FINANCIAL DISCONNECT ....................................................Page 48 An overview of islamic finance in Bahrain.

LEBANON: THE IMPACT OF INSTABILITY ON REAL ESTATE ..........Page 50 Bank Audi looks at the implications.

DEBT REPORT

SUKUK ISSUANCE RISES ........................................................................................................Page 52

FACE TO FACE

A FINE BALANCE BETWEEN REGULATION & BUSINESS NEEDS ......Page 58

REAL ESTATE REPORT

LONDON’S EAST END PROPERTY BOOM ..........................................................Page 60

THE BEAR VIEW

DRAGGING DEAD WEIGHT ..............................................................................................Page 64

ROUNDTABLE

CCPs AND SECURITIES LENDING ROUNDTABLE ..........................................Page 65

PROFILE

MARKETAXESS AND THE LIQUIDITY EQUATION ......................................Page 77

PRIME BROKING

PRIME COMPUTATIONS ........................................................................................................Page 79

MARKET DATA 2

An analysis of trends in sukuk issues in Asia and the Middle East.

EFAMAs President Christian Dargnat reviews the trends and interests A review of the London Real Estate market.

By Simon Denham, chief executive officer, Skrem Ltd.

European experts debate the key trends.

Dave Simons talks to Rick McVey, MarketAxess chief executive.

Dave Simons looks at the trends in prime services. Market Reports by FTSE Research ................................................................................................Page 82

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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Photograph © Vitaly Smolygin/Dreamstime.com, supplied September 2014.

I think its life Jim, but not as we know it In the last of our trilogy of publications focusing on the determinants of tomorrow’s world (resource management, climate change and technology), we now look at the impact of innovation on the future of the financial markets. The growing impact of technological innovation, threatens to upend the world as we know it. Most people think it will be about hot-desking, more job flexibility, working from home and super communications media available to all. Some of it will be. The reality is fewer people will have jobs, or at least meaningful jobs as more work is done by computers. Computers can take over jobs such as asset management, pensions, trading and financial services. In other words you. What does the future hold and what will it mean for the global investment sector?

t was a truth once universally acknowledged that global investment and all the activities that supported the industry was driven by people; super-intelligent people whose heightened instinct and honed skills could leverage returns through direct and indirect investments, securities

trading, derivatives (on exchange and OTC) and services. Business and investment growth ultimately depended on the happy coincidence of inherently inefficient markets and bright and engaged minds that knew how to leverage the resulting opportunities at home and abroad.

In the 21st century that changed. 9-11, global recession, scarcer natural resources, a tsunami of financial market regulation and the last vestiges of 20th century geopolitics have weighed on the global financial and political order as, at the same time, ancient civilisations have rediscovered their mojo. It has created an interesting mix. Against that backdrop, technology and technological innovation has only now begun to find its feet. Technological innovation is moving so fast these days that it has become a market force. Until the second decade of this century, technology was a tool that facilitated first the motorisation of industry, then communication and now global-wide social and economic interaction. It is a process that can only end one way: where technology does more and more for people to the point that it will redefine life as we know it. According to Gary Greenberg, head of emerging markets at Hermes Investment Management, “The theme of the future is automation and virtual companies. The progress of technology is so enormous that it will impact industry. Productivity will increase, but the trickle down to workers will become thinner. Up to now, technology has trickled down to the east. I think however that globalisation is over and looking ahead, automation will be king.” Now, as in the 18th century industrial revolution, machines are taking over a growing range of jobs for less cost, with fewer errors and at much greater speed. The number of traders involved in execution of orders has fallen sharply in recent years, for example, and is likely to continue to fall further in the future. The mix of human and robot traders is likely to continue for some time, although this will likely be tempered by other influential considerations, such regulation and the unwillingness of humans to step aside from the process. What follows is not a definite picture of the future. We are not prophets. We are simply providing pointers to what we think might be important drivers of change in various segments of the market.

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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COVER STORY

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Technology & the firm Technology is taking firms in two sometimes parallel, sometimes separate directions. On the one hand the modern economy is marked by a rapid shift to collaborative work structures, propelled by technology and competitive pressure. The second is the move from physical to virtual corporations, a trend that will only increase. How these two trends interweave will determine the structure of modern business. More people have virtual jobs than ever before. Telecommuting grew by 87% between 2005 and 2012 and that doesn’t even count people who are self-employed and working from home. While the majority of virtual workers are employed by traditional, office-based companies, virtual firms are on the rise, with distributed teams taking remote work to the next level. What’s not to like about it? Very little say proponents. Virtual firms don’t have a difficult job selling the concept to their workers who see the benefits of being able to work, move or live anywhere. Virtual working is made easier by several innovations that are modifying internetbased collaboration. The most promising right now is Web3D or Virtual Worlds technology that includes not only multiplayer games and avatars but also cloudcomputing platforms and solutions, such as software-as-a-service and next-generation networks. Besides speeding-up computations and reducing the cost of computing and software, these changes look to be encouraging a collaborative virtual working environment that foster exchanges among members of a department or project and helping to change the way that people work together even based in remote locations. The technology also looks to (potentially) change the way internal corporate training and education, product and service development, marketing and strategy creation and finance is conducted. As well, proponents say it will encourage interactive solutions and collaboration within and between firms. Utilising technology such as Virtual Worlds a modern corporation can distrib-

Photograph © Vitaly Smolygin/Dreamstime.com, supplied September 2014.

ute or receive knowledge and inputs from suppliers, employees, and customers in new ways. It also looks to encourage highly specialised small firms that can combine to create innovative products when opportunities arise. In its purest form, the virtual firm can fractionalise its operations; segmenting projects that are easily distributed, managed and/or tracked among both formal employees and outsourced project workers. You’ve heard of crowd funding. This is about crowd sourcing, pushing out work to the public at large rather than (necessarily) paid employees or dedicated independent contractors. The positive for firms is that they can recruit (full or part time or on term contracts) workers with the right skill set for a task or project. It also means in practice that not many people are on the payroll, so it is up to management to get the best out of the service provider while saving money for the company. There are several successful crowdsourcers already, providing organisations with platforms to find and recruit talent, including Crowdsource.com, eLance, and Gigwalk. The upside for contractors is that spe-

cialist skills providers can set their own price at levels that are not only competitive but higher than prices set by salaried staff (as the company saves on overheads, salary related tax, national insurance and other worker benefits). The downside? There is no job security and as competition for services bites, the pricing of skill sets will inevitably fall over the medium to long term. The applications to all kinds of businesses (outside of specific high-skills mass manufacturing) are manifold, encompassing asset management, trading, lawyers, advisory services, consultancy, as well as publishing, design and so forth. Already, some quasi-financial centres (think locations such as Lugano, Bermuda, and the Isle of Man) boast the provision of services for travel-happy financial experts; or those rich people who like to breeze between prestige locations. BSI, the Lugano-based wealth manager (as part of its overall service set) encourages its rich clients to work from any one of the jurisdictions in which it has offices, as they travel across the world, allowing its clients to either work from special offices provided in the bank for their use, or to log-on remotely to the firm’s electronic platforms to manage their investment portfolios from any location.

Technology as social manager In March this year, Facebook chief executive Mark Zuckerberg, announced his firm was buying Oculus VR, a leader in virtual reality technology. Within the Facebook business set, Oculus will concentrate first on immersive gaming. “Oculus already has big plans here that won't be changing and we hope to accelerate. The Rift is highly anticipated by the gaming community, and there's a lot of interest from developers in building for this platform. We're going to focus on helping Oculus build out their product and develop partnerships to support more games. Oculus will continue operating independently within Facebook to achieve this,” explained Zuckerberg at the time. However, he was quick to outline the downstream possibilities of the technology. “After games, we're going to make Oculus

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

COVER STORY

THE VIRTUAL WORLD ON GLOBAL TRADING & INVESTMENT

a platform for many other experiences. Imagine enjoying a court side seat at a game, studying in a classroom of students and teachers all over the world or consulting with a doctor face-to-face, just by putting on goggles in your home,”he avers. As more of the workforce struggle to find tenured work then the importance of palliative technology can only rise; first in providing interactive games, then more socially useful facilities, such as education/learning; conferencing services and database management. The positive side is that there are opportunities for cheap(er) home-based virtual education and training; and the worker of the future will likely have more than one string to their bow to gain even periodic work.

formula today is not what it was in the past,” explained Kevin McPartland, head of market structure research at the firm. Increased market complexity and multiasset trading will continue be a feature of the trading desk over the long term, but it does not mean that one trader will deal in multiple assets on a single platform. Demand for particular market expertise will still override the trend as the characteristics of commodity trading, FX trading, equity trading and bond trading remain very different in essentials. The trader of the future might happily cross-reference related asset classes, such as listed equity derivatives and cash equities, but is unlikely to master a mix of equities, bonds and commodities.

Technology & trading

Technology & the investor

New technologies mean that major trading systems can exist almost anywhere. Emerging economies may come to challenge the long-established historical dominance of major European and US cities as global hubs for financial markets if the former capitalise faster on the technologies and the opportunities presented, but the clear advantage of technological innovation is the creation (regulation aside) of a global, level playing field. First the obvious: computer based trading has clearly had a beneficial effect on liquidity (measured by bid-ask spreads and other metrics); transaction costs continue to fall (in part due to market infrastructure changes, but also better trading technology); market pricing is more efficient as computer based trading links ever more markets (DMA), facilitating price discovery. High frequency trading has been one clear market change as a result of improved technology and there are valid arguments that they have also upended the traditional structure of buy side (or client) trading. Unlike the majority of the buy side they operate with little capital, hold small inventory positions and are unencumbered with obligations to provide liquidity in times of market stress. The question is, after a decade of almost constant reinvention, innovation in the segment will cool down while everyone adjusts to new circumstance, or whether

Photograph © Vitaly Smolygin/Dreamstime.com, supplied September 2014.

this is the beginning of a long series of changes. The jury is out on this one. In the short term, the future of the trading set hinges on the level of uptake of electronic trading that in its purest form, could eventually negate the need for human intervention. In reality that might be some time away; as Newton discovered in the 18th century, every action has an equal and opposite reaction. As electronic trading has become more ubiquitous and spread its tentacles across markets, the value of high touch services has also increased. At a recent forum in July in NewYork Greenwich Associates presented a report to attendees highlighting that the overall percentage of trading which occurs electronically has not actually changed that much since 2009, remaining on or around 37%. The consultant found that a smarter, more client-focused sales-trading force, coupled with uncertain markets and a complex market structure are prompting buy side clients to pick-up the phone. “Brokers are pricing high-touch trading as a premium service. In a business still largely directed by relationships, putting in place sales traders who are both costeffective and can prove their value to clients on a daily basis is critical—but the

Technology really comes into its own in asset management. In recent years, the need to process and manage an ever-increasing deluge of market data and integrate it into internal research portals and portfolio management systems, compliance reporting and mobile applications has grown. Regulation also continues to be a driver of technology usage over the near to medium term. The requirement for market transparency across a broad brush of market activity has made reporting infinitely more complex. According to Ian Smith, financial services strategy partner with KPMG in the UK,“Asset managers still have a long way to go to recognise and exploit big data and data analytics. While IT is already attracting a significant amount of investment, it is not being channelled into the right areas”. He adds:“Many businesses are putting their efforts into trying to unpick the complex legacy of disparate systems and technologies while trying to make sure they provide the right level of control to meet increasingly stringent compliance. There is too little focus on building the architecture to meet the business needs of tomorrow. Platforms will need to be completely redesigned with the flexibility to support a much more diverse client base and deliver a step change in costs, control and client experience”.

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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Cloud technology is beginning to offer interesting solutions to market data management, allowing firms more flexible consumption of data across the company, and at the same time, utilise more cost effective data infrastructure, hardware, software, and maintenance to allow them to provide reports and analysis in close to real time. In other words, they gain scale, efficiency and agility. Accessing market data via the cloud enables investment management firms to incorporate broad sets of real-time and referential data quickly on demand within proprietary in-house systems and third party applications. Branding and data-rich mobile apps, mean that end investors can access performance data from asset managers anywhere, anytime. Right now, it continues to be both expensive and clunky. Microsoft Excel, for example, remains a central application in the investment management workflow. Incorporating market data can be cost prohibitive using Excel add-ins from traditional data vendors, and these add-ins don’t always include access to the full range of data required. Cloud-based market data solutions will eventually deliver seamless information into Excel via flexible web APIs. It will also change the asset managers’business model as they can avail themselves of quite sophisticated analysis and reporting at relatively cheap cost. With on-demand pricing where you only pay for the data that’s used, it can help investment management firms reduce market data budgets. Shifts in client demographics, technology and changing social values and behaviour will also have an effect on the asset management industry according to a July report from KPMG International. The report, Investing in the Future, predicts that by 2030 the client base of a typical asset manager will be different, as generation X approaches retirement, generation Y matures and the middle class expands in emerging markets. The report warns that current business models might not be fit for purpose. Tom Brown, global head of investment management at KPMG International thinks,“We are on the verge of the biggest

shake-up the industry has experienced; and the message to asset managers is clear—adapt to change or your business won’t survive. The two biggest issues that need to be addressed are the changing client base and technology, and asset managers need to get to work on these areas now. The successful asset managers of tomorrow must focus on building cradle-to-grave relationships with a dramatically different and more diverse client base from today, which includes much younger investors. They must also be mindful that women are increasingly controlling a bigger share of family wealth.” “Demographics are changing. People are living longer and taking greater responsibility for their own retirement planning. Younger generations will likely save more as they see their parents run out of money in retirement. We also expect to see a significant boost of new money from the growing middle class in China, Mexico, India, Nigeria and other developing economies over the next 15 years,”he adds. Of course, there is the risk that the global economy won’t or can’t grow fast enough to absorb the volume of savings needed to fund the needs of an ageing population, but that is for another analysis.

A critical role Remaining on the technology theme, KPMG’s Smith, is adamant that “Technology plays a critical role in the industry’s future. The clients of the future will be fundamentally different in terms of their needs and expectations. They will demand more personalised information, education and advice that will require asset managers to radically address their technology capabilities to really understand their clients and support this level of service.” According to Smith, “We could see technology companies or large retailers of the world becoming the next big powerhouses in investment management. As such, we expect to see mass consolidation in the industry and predict that within 15 years there will be half the number of players currently in the market.” It has always been difficult to understand what advances in quantum tech-

nology will mean for the financial markets. However over the coming decade, the likelihood is that its application to operational efficiency and concepts such as security and identity will bring the quantum world closer to our own. For example, quantum computers can create living security codes that are virtually impossible to crack as they constantly change form. Their applications are varied (passports, the undisputable transfer of securities or assets from one firm to another and data protection, for example). There is still some way to go in understanding what the impact of technology will be. The benefits of the digital world are appreciated by most, but it is doubtful whether endless choice and maximum convenience is all it is cracked up to be. Academia is now looking seriously at the implications of change. In the Marketplace of Attention, author James Webster explains that theories about the way we all use technology and new media does not always tally with how humans actually behave. When content is so abundant how do you ensure that you are receiving the messages and information you really are looking for? The answer may come sooner than most academics expect. Google recently announced it intends to build its own quantum computer, with the help of John Martinis of the University of California. It is doing this because a computer that can exploit its quantum nature could theoretically revolutionise applications such as searching complex and massive collections of data. As our world becomes more complex and the accumulation of knowledge expands, the danger is that we lose sight of important nuggets of experience or data Google thinks that its quantum computer will help analyse increasingly large amounts of complex data sets with applications in the physical sciences as well as the economic, financial and social sectors. Google is smart. Whoever can provide real time search engines that can successfully mine huge amounts of data, complex or otherwise, will have an important edge on information management going forward. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Picking up the pace of IT adoption

HE FINANCIAL CRISIS, the continued influx of regulation and the (still) low interest-rate environment has long since compelled many asset-management firms to gravitate towards technology solutions in an effort to maximize performance capabilities. While those in the asset servicing space also recognise the need to get up to speed, the pace of IT adoption has at times lagged others in the business. All of that is about to change, however. Today’s rapid-fire market movements can make mincemeat out of old-school tools like spreadsheets, making automation of asset-servicing functions essential; meanwhile, the continued flight of the buy side into alternative structures has forced asset servicers to re-think the usual approaches to portfolio accounting, data management, furnishing client reports, as well as handling other essential duties. And as the majority of servicers have a global reach, new solutions must also have cross-jurisdictional capabilities to help firms comply with regional regulatory demands. As the asset-servicing business has always been about scale, providers must be prepared to make significant, ongoing investments in technology in order to keep up with evolving client needs, concurs Rob Ferguson, senior vice president, Capital Markets and Product Delivery at Toronto’s CIBC Mellon. “In recent years, changing demands from regulators, boards and other key stakeholders have only increased clients’ appetite for more robust support around reporting, execution, compliance and governance,” says Ferguson. “At the same time, asset managers, beneficial owners and other clients are under tremendous pressure to shore up balance sheets, better deploy

FTSE GLOBAL MARKETS • SEPTEMBER 2014

Rob Ferguson, senior vice president, Capital Markets and Product Delivery at Toronto’s CIBC Mellon. Photograph kindly supplied by CIBC Mellon, September 2014.

resources and deliver returns to their stakeholders in a challenging low-interest rate environment. As a result, many clients are turning to asset servicing providers for support around information delivery, operational execution, and even the outsourcing of entire operational functions—none of which would be possible without relentless technology investment.” Leveraging technologies available through the firm’s parent organisations has also yielded positive results: the recent integration of the Toronto securities-lending operation with BNY Mellon’s global securities finance business has given clients seamless access to securities lending markets around the world, adds Ferguson. It appears that asset servicers are poised to open their wallets. A July report entitled Operations Under Pressure: The Need To

Make Data Mean Business from Bostonbased research and advisory group Aïte in conjunction with software solutions firm SunGard predicts that asset servicers will outspend their asset-management peers by a nearly 2-1 margin, with total IT costs approaching $50m by year’s end. According to the poll, more than eight in ten asset servicers currently maintain cross-jurisdictional operations (not surprisingly, more than a third of respondents cited lack of unified reporting as the main barrier to further cross-border expansion). Wading through the morass of local regulations and tax laws“is clearly a primary maintenance responsibility for both asset service providers and their accounting technology vendors,”notes Aïte, “and is driving the increased consolidation of technology solutions and services.” Even so, the segment continues to trail the industry in terms of system integration: according to Aïte, nearly two-thirds of asset servicers operate upwards of five different systems on a global basis (by contrast, 47% of asset managers report migrating to a single platform). Addressing ongoing siloed activity is crucial in order for firms to reduce reporting opacity, reconciliation conflicts and other inefficiencies, say experts. Meanwhile, the complexity fueled challenges of the asset management and servicing segments has proved fertile ground for a wealth of technology firms. To help streamline the to and fro, Linedata, the Paris-based solutions provider, has worked to get its products “white-labeled,” which allows the company’s systems to be delivered anonymously to the end client via a servicing team with whom Linedata has a pre-existing relationship. “We’re seeing a big uptake in these types of white-label

CAN TECHNOLOGY REDEFINE INVESTMENT SERVICES?

With virtually all others in the financial arena already benefitting from technological innovation, are asset service providers now finally ready to take the plunge? Banks such as BNP Paribas and others have been willing to white label services provided by technology vendors to help differentiate themselves from the pack, particularly in the provision of middle and back office services. What does the future hold? From Boston, David Simons reports.

COVER STORY

CAN TECHNOLOGY REDEFINE INVESTMENT SERVICES?

agreements,”affirms Matt Gibbs, Linedata product manager, “particularly around prime-services providers with whom we’ve been working for a number of years.” Using STP to coordinate the various fund offerings has been another driver. “It’s really all about scalability,”maintains Gibbs. “Managers want to bring aboard as many new clients as possible, without having to augment existing internal teams.” Only a few years ago companies would typically add personnel in order to compensate for an expanded workload. Now they’re increasingly “working smarter,”notes Gibbs, using strategies like exception based processing to streamline their client services. Developing scaleable solutions for effectively managing the full transaction lifecycle as well as asset-servicing activities remains the modus operandi for technology provider DST Global Solutions. Like others in the field, Geoff Harries, global head of asset servicing, has seen a marked ramp-up in both fund structure and investment complexity. The result, says Harries, is that basic applications and solutions are no longer able to adapt to the changing market infrastructure. “We’ve seen this with respect to derivatives processing, syndicated loans, indexlinked bonds, all of which have become elements of mainstream fund structures,” says Harries. As such, there is now a much greater emphasis on adopting comprehensive solutions that are flexible enough to move with these new instrument types. “This is very important in terms of market adoption, innovation and the ability to support business growth,” says Harries. Gibbs agrees that platform providers must be agile enough to adapt to a market in a perpetual state of motion. “There’s been a lot of movement within the industry around agile development techniques,” notes Gibbs, “but what we have found is that having agile releases is far more important. When you have the whole realm of fixed income, equity, currency and derivatives traders and portfolio managers all using different instrument types, there are going to be a lot of unique market requirements and

Matt Gibbs, Linedata product manager. Linedata, the Paris-based solutions provider. Photograph kindly supplied by Linedata, September 2014.

business practices that need to be kept in check. As such, clients need to have a way to obtain software releases quickly, and without having to endure numerous upgrades. So while we already have a very robust order-management system, what we really want is to get the software to the various end users as fast a possible in order to facilitate those changes.” At Linedata, one of the more noteworthy works-in-progress involves transforming the look and feel of the typical order-management system from being Outlook- or Excel-based into something akin to an “app store” for fund services. “You’d have an array of apps or widgets representing each of the different services at hand—portfolio management, trading, compliance, and so forth,” says Gibbs. “Best of all, we would be able to turn out the majority of these apps in a matter of weeks, and most would be versionagnostic. That way any new workflows, rebalancing algos, trading analytics or trend analysis could be incorporated quickly—and would be far more visually pleasing as well.” Given the torrent of data currently available, such a mechanism could prove enormously beneficial to the end user.

“When you consider all of the different trading strategies out there now—HFT, crossing networks, dark pools and the like—there’s real demand among clients who want to achieve best execution without telling everyone what they’re buying or selling at any given moment,” says Gibbs. “So when it comes to examining trends across different markets or time periods, as well as tabulating orders or benchmarking executions, having this kind of graphically enriched, tablet-oriented technology will make it that much easier for clients to make informed decisions based on their trading strategies and execution requirements, using real data that they can see right in front of them.” White labelling as a way of providing services without the necessary investment in new operations and technology is increasingly a way forward for firms, particularly for those wanting to differentiate themselves on the basis of innovative technology. There is still some way to go in institutional custody, but as a pointer of eventual trends, in the retail space, there are a host of white label providers, such as Equiniti Wealth Solutions; a dedicated service for the financial services, wealth management and retail stockbroking market. It provides centralised pooling of custody and business processes, as well as a customer interface. It is designed to reduce the cost of processing at the same time as reducing regulatory risk; enabling firms to focus on customer service and business growth. Larger banks already utilise white labelling services, particularly in the middle and back office. BNP Paribas has its own in-house white label solution SLIB, which focused on providing (among a broad range of services) middle office operational and risk management services, which replicate or mimic the services offered by CCPs and which utilise algorithms to manage risk, margin and collateral exposure. As banks seek to redefine their service sets, particularly in the investment space, openings for white label service providers can only increase as financial institutions seek to utilise internal resources more effectively. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Managing the new data challenge Tech providers believe that over the next five years the digital universe will double in size every (approximately) 24 months. In consequence, businesses will have to run hard to increase investment in technology (both hardware and software) to keep up. Investment in big data technologies will involve a big slug of this investment. The question is: does this investment both garner new business and provide a healthy return? What exactly is the relationship between data and business growth?

IG DATA TECHNOLOGIES, goes the thinking, will enable broader and better data analysis than ever before, leading to targeted event-driven, customercentric marketing, improved fraud detection, better risk calculation, and operational efficiencies. Those assumptions are based on an ideal business world where there is enough capital to invest and corporate structures and responses are agile. It also requires a new set of skills that effectively deploys data to achieve business success. Can it be done? According to a just released blue paper Big Data – Uncovering Hidden Business Value in the Financial Services Industry by Drs Karl Rieder, Ignasi Barri and Josep Tarruella, the volume of data available to organisations is huge (they say we add 2.5 quintillion bytes of information every day) requiring new technologies and processes to address it. Driven by the

FTSE GLOBAL MARKETS • SEPTEMBER 2014

adoption of technology changes around mobile devices, cloud computing, social media, and big data, the financial services landscape is evolving from a traditional model to a digital model alongside increased competition from both traditional and non-traditional players such as telecom carriers, retailers, and electronic payment providers, say the authors. Commenting on the study, Marika Lulay, chief operating officer at GFT, which published it, says, “Financial services institutions have to innovate to meet the changing needs of their everdemanding retail, corporate and institutional customers. In a highly competitive marketplace, firms must be able to manage their data today and develop new products and services in anticipation of their customers’ needs tomorrow.” The study holds that the financial services segment needs to address regula-

tory compliance; growing customer centricity (as technology allows service providers to offer more customised services); steady modernisation of the back office, and the need to remain cost efficient. These trends in combination also serve to add to the growing spectrum of data. Two reports cited by the authors give credence to the trend. Last year, IBM Institute for Business Value published an Executive Report that summarised research undertaken with Oxford University’s Said School of Business across 1144 business and IT professionals in 95 countries— including 124 respondents from financial services. The research honed in on the use of big data inside organisations, finding that most initiatives were being constructed around customer centricity (55%) and risk management (34%). The second, by Bearing Point, focused on insurance firms, finding that the segment appeared to be lagging in big data strategy adoption. Apparently 90% of insurance firms polled have yet to implement a company-wide big data strategy, despite more than two-thirds of participants believing that big data would play an important role in their future. The research also revealed that, while 71% said big data would be a top priority by 2018, less than Quarter (24%) said their company’s big data maturity was advanced or leading, and only 33% have begun a departmental or enterprise implementation process.“While the financial services sector is still in the early stages of big data strategy adoption, there is general understanding that the industry is at a crucial point and has everything to gain from moving forward with efforts to leverage big data to improve its public image and deliver excellence in customer service to its customers and clients,”write the authors. How fast and how extensive is adoption of big data management depends on the way that firms adopt their use: either evolutionary or revolutionary. However the use is brought into companies, its applications will clearly be widespread, covering issues such as operational architecture, warehousing, the creation of golden data sets, and its application is widespread

BIG DATA AND FINANCIAL SERVICES

Photograph © Dwlnd/Dreamstime.com, supplied September 2014.

COVER STORY

BIG DATA AND FINANCIAL SERVICES

through the entire financial services industry: from banking, through to pre and post trade services, capital markets, trading, collateral management. Essentially big data looks to potentially redraw the financial services set and the relationship between provider and client: involving the analysis of client interactions, feedback, uptake of services, creditworthiness, client scoring, and helping in the drawing up of more tailored services, client turnover management, and so on. In other words, a much improved version of a current customer relationship management (CRM) system. It also has implications for fraud control, and better cross-border client services. In particular, the authors suggest that big data models can also help generate new business models and revenue opportunities for retail banks, which could include the sale of non-identifiable data. “Both retail and institutional firms are looking to better manage their data in order to extract business insight, reduce costs and modernise back office operations. A wide range of opportunities are ripe for improvement, from client scoring, best offer calculations and a better interaction with customers in retail banking; trade data consolidation, analytics, risk monitoring and to meet the regulatory reporting requirements in investment banking; and premium calculation, customer engagement and fraud detection in the insurance industry,” explains Karl Rieder, one of the co-authors who is also an executive consultant at GFT.

Aggregated data Banks have a great deal of aggregate information, such as credit card usage patterns (without identifying individual customers) that can be useful for other types of businesses: average expenditure on a given street or in a given area over a particular period of time and times of day or days of the week when an area is busiest. “Obviously, such data must be completely anonymous to be sellable,” claim the authors. However, if it is used internally, then banks or services providers can significantly readjust

Cartoon provided by Dreamstime.com September 2014

“I am not sure this is what they meant by being overwhelmed by big data Mr Jones.”

business to suit client habits. Moreover, big data technologies allow banks to streamline operational procedures and compliance reporting. Over the decades, investment banking has generated a large number of silos for different types of products –fixed income, equities, foreign exchange, derivatives, etc. – effectively preventing a 360o view of any aspect of the whole business. Big data changes all that. Banks can now store huge volumes of data in a single data warehouse, permitting the creation of a bank-wide trade repository. “By taking advantage of distributed storage techniques, banks can also store historic views of the data, enabling trade and position data to be consolidated in a single data store,” say the authors. “By unifying data storage in this way, banks can centralise data functions, rationalise storage architecture, and ensure a consistent view of banking activity for both business planning and regulatory compliance purposes. This also represents a

huge cost savings for the bank thanks to reduced redundant processes, systems, and personnel”. Big data does not come without its costs and risks and the study also outlines some of the pitfalls that require management. “Big data systems are by their very nature distributed systems, normally with significant scale,” explain the authors. “This means that software architects must be prepared to deal with issues [such as] partial failures, unpredictable communications latencies, concurrency, consistency, and replication in the process of designing the system”. The probability of failure of a hardware component, for example, increases dramatically with scale. Scale also impacts the economics of big data projects. Big data applications also require massive computing and storage capacity; specialist staff and adequate security protocols. It also requires a highly structured approach to the implementation of data management/data analytics projects, which includes a rigorous set of data management principles, agreed controls, oversight and accountability. In other words, it requires significant commitment across the firm in terms of staff, resources and infrastructure.

Speaking to the zeitgeist Inevitably, studies of this kind while illuminating are also self-serving. GFT Technologies, is after all a consulting and technology services firm. However, right now it speaks to the zeitgeist and, in the overall context of this cover feature, is another element in the onslaught of technology on traditional ways of working, which inevitably will have to change as a result of innovation and progress. The last word is best left then to one of the authors of the report. “The potential to increase IT efficiencies is significant across all industries, not least given the accelerating rates at which data is produced and the new data sources are incorporated. The question is how best to get started; we believe that our study will help firms jump start and focus their big data programs,” says Rieder. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

SPOTLIGHT

Low bond yields hurt pension scheme deficits Mercer’s Pensions Risk Survey data shows that the accounting deficit of defined benefit (DB) pension schemes for the UK’s largest 350 companies increased during August. According to Mercer’s latest data, the estimated aggregate IAS19 deficit for the DB schemes of FTSE350 companies stood at £90bn (equivalent to a funding ratio of 87%) at 31 August 2014 compared to £73bn (equivalent to a funding ratio of 89%) at the end of July.

TSE350 PENSION DEFICITS increased by £17bn to £90bn through August, representing a fall in the funding ratio to 87% at month end (compared to 89% at the end of July). Even though asset values rose over the period, the uptick was overshadowed by higher increase in liability values driven by a fall in corporate bond yields to historically low levels. Mercer estimates the agregate combined funded ratio of plans operated

FTSE GLOBAL MARKETS • SEPTEMBER 2014

by FTSE350 companies on a monthly basis. This is based on projections of their reported financial statements adjusted from each company’s financial year end in line with financial indices. This includes UK domestic funded and unfunded plans and all non-domestic plans. The estimated aggregate value of pension plan assets of the FTSE350 companies at the end of last year was £561bn, compared with estimated aggregate liabilities of £617bn, corresponding to a funding ratio

of 91%. Allowing for changes in financial markets through to the end of August, changes to the FTSE350 constituents, and newly released financial disclosures, the estimated aggregate assets were £595bn, compared with the estimated value of the aggregate liabilities of £685bn. Even so, asset values at the end of the month were up £15bn on the end of July figure. Liability values were however, also up, increasing by £32bn on the July total. “Long-dated gilt yields and high quality corporate bond yields both fell sharply by around 30 basis points during August, leading to a 5% jump in liability values,” explains Ali Tayyebi, senior partner in Mercer’s Retirement business. “In the absence of any recovery in yields or asset out-performance, companies with 31 December year-ends may typically be reporting higher deficits at the end of this year compared to the end of last year. “The last time gilt yields were this low, back in May 2013, the yield spread between gilts and high quality corporate bonds was notably higher and arguably there was less confidence in the economic and financial environment. Clearly there are different forces driving the bond markets this time round and this gives rise to new challenges for those with their focus on managing the risk and financing associated with pension schemes,”adds Tayyebi. Adrian Hartshorn, senior partner in Mercer’s Financial Strategy Group, says “Short-term market movements provide a snap shot of the financial position of pension plans. Corporate sponsors of UK pension plans should look through these short-term market movements and establish a long term framework for making rational funding, investment and risk management decisions.” Mercer’s data relates to about 50% of all UK pension scheme liabilities and analyses pension deficits calculated using the approach companies have to adopt for their corporate accounts. The data underlying the survey is refreshed as companies report their year-end accounts, and is useful as an indicator of the required investment performance of thepension fund sector. n

THE IMPACT OF LOW BOND YIELDS ON PENSIONS

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

SPOTLIGHT

A NEW MUNICIPAL BOND ISSUER IN THE UK

Photograph © Adam Vilimek | Dreamstime.com, supplied September 2014

UK moves to set up municipal bond agency UK local government councils are looking to set up a new municipal bonds agency that will issue debt on their behalf. An interim project team has been appointed to set up the operational infrastructure of the agency, following an initial round of fundraising.

HE PLANNED MUNICIPAL funding agency, actually a limited company that will trade under the name of Local Capital Finance Company (LCFC) Limited, arose out of a business case set out by the Local Government Association (LGA) earlier this year which posited that a dedicated funding agency could save as much as £1bn in borrowing costs for councils investing in new infrastructure (such as homes, roads, business hubs). According to Aiden Brady, who is leading the project as interim managing director, the agency’s first bond could be issued as early as April next year. A tad over £4.5m has been raised in an initial fund raising round, with nearly 40 UK councils joining the Local Govern-

ment Association (LGA) as investors, with more to come. According to the LGA official release announcing the project the initial round, “significantly exceeded the target set for the initial fundraising and takes the agency well over half way to the full amount of capital required. Local authorities will continue to invest in the agency throughout the rest of this year to complete the raising of capital.” According to the LGA an inaugural meeting of shareholders in the agency, will take place on September 17th. Michael Lockwood, executive director of the LGA and a director of the LCFC, says: “All types of councils … have thrown their support behind the bonds agency. There is a genuine sense of excitement about the progress

made so far and the momentum is building up as we prepare for the agency’s official launch. There is still time for councils to become equity investors in the agency and we will be speaking to many more local authorities in the coming weeks.” Councils in the United Kingdom source as much as 75% of borrowing from the Public Works Loans Board (PWLB). The creation of a collective bonds agency, which the LGA says has the blessing of the UK Treasury, means that councils will have an alternative source of capital finance and “therefore have some protection from central interference with interest rates. It removes local government’s dependence on a single agency controlled by the Treasury. The proposed agency creates a structure that enhances the prudential borrowing code, allowing councils to develop policies that support economic growth and infrastructure development.” The LGA maintains that experience from other countries shows that a dedicated agency’s credit processes, “aligned with the incentive of lower borrowing costs and the oversight of peers, has strengthened the overall creditworthiness of the sector much more than governments could achieve on their own.” According to Brady, the agency is “at present designing our credit processes that is robust and which will support independent ratings of any bonds issued.” Brady concedes that the timelines for the agency are tight, “we have literally just received the letters of intent and we have completed an initial round of hiring professionals to populate the agency.” Some of these are high hitters. For instance, among the people joining LCFC is Markus Krebsz, who is the agency’s chief risk officer. According to the LGA release, he has experience in “global financial markets, particularly in ratings, structured finance and credit risk.” His is also a member of the UN Economic Commission for Europe Group of Risk Management Experts and an advisor to the World Bank. Tim Cavanagh, the interim chief operating officer, has worked at Citi and Deutsche Bank, and recently set up a regulated services company capitalising on the effects of market dislocation after 2008, including

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

measure it understand it apply it 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

SPOTLIGHT

A NEW MUNICIPAL BOND ISSUER IN THE UK

credit ratings, restructuring advisory and project management. The team will, in the early stages at least, work out of offices at the LGA according to Brady. The LGA has lofty ambitions for LCFC. “The agency will acquire expertise at the intersection between capital markets and local authority finance, which can be used to facilitate knowledge transfer, conduct research into public sector financing and consider economic factors that will impact on council finances and therefore the provision of services. This knowledge, and its position in the market place, would enable the agency, in due course, to provide advisory services to councils and facilitate inter-local authority lending,” says the association’s official statement. Brady believes that there is a definite opportunity for a quasi statial/private sector agency to enter the fray as a funding vehicle, which can provide cheaper funds by going directly to investors—especially if UK councils jointly guarantee the bonds to achieve an improved credit rating. The project is still at an early stage and right now, a priority is sorting the wheat from the chaff, working through important questions and honing the fine detail of lesser considerations. How will it be able to provide councils with competitive cost of funds in practice? How will the market respond to it? Will it run as a for-profit, or not for profit institution? Then the big ones: will the Treasury provide guarantees for any

borrowings by councils if any borrowings go south? Which institutions will regulate borrowing by the agency on behalf of councils? How will repayments be guaranteed? Finally, which institutions will regulate the agency? Brady says the big questions have been knocked into touch. It will be run as a for-profit operation. As regards a sovereign guarantee: well, it is implied but there’s nothing explicit, he says However, he points out that UK councils are inherently a good risk. “No local authority has defaulted in a thousand years,” he avers. Moreover, the agency is not required to be regulated or related to the UK Treasury.“Colleagues at the LGA spoke to the Treasury [about the agency]. The Treasury is not seeking to interfere. Also at this point in time this segment is not regulated, but will be under tight scrutiny from the market.” Moreover,“Institutions that buy the paper will be as tough on us as any regulator might be. The big questions we already know the answers to. It is the fine detail that is taking up our time, such as which banks will we choose to work with, and sorting out our IT,” he adds. He also says it is early days and that as the agency takes form, many of the outstanding questions will be tackled in turn; “but what is important is that we set the correct credit processes in place to ensure that investors in the bond feel secure.” Brady envisages the agency will focus on

plain vanilla borrowing, but also look at longer term bonds (a move that long term dated bond investors would welcome no doubt).“The market likes plain vanilla,”he says, “I can’t imagine us doing anything too sexy. In the beginning, we’d be looking at term bonds, fairly simple securities.” The market looks to be open to the idea. One fund manager that has gone on the record is Simon Bond, manager of the Threadneedle UK Social Bond Fund. “Since establishing our UK Social Bond Fund, we have been encouraging local authorities and other organisations to issue more bonds that target specific social outcomes. Local authorities used to commonly issue these to raise funds for public projects but, for a variety of reasons, no longer do so. In 2011, the Greater London Authority became the first to tap the capital markets in nearly two decades when it launched a £600m bond to help Transport for London finance the construction of Crossrail,” he explains. “We know that many local authorities would like to return to the fixed income market place. A municipal bonds agency could help facilitate this and at the same time benefit the wider economy and society by encouraging additional funding sources for social outcomes. Examples exist both in the US and in some French regions. The recent launch of the UK Retail Charity Bonds platform also illustrates how a new sector can be successfully established within the bond market.”n

Robeco outlines new Japanese growth strategy Since opening its first Asian office in Tokyo in 2005, Robeco has acted as an investment advisor and agent providing asset management strategies for Japanese institutional investors. The firm is now expanding its client servicing activities in Japan and hopes to have more than €5bn in assets under management within the next five years. Robeco Japan is planning to present an extensive range of active investment strategies to its clients. These include equity and bond strategies based on quantitative research, emerging market equities and emerging debt in addition to aggregate fixed income and high yield strategies. The funds that Robeco Japan

will offer integrate Environmental, Social and Governance (ESG) factors into the firm’s equity and bond analyses. Robeco believes this approach leads to better-informed investment decisions, mitigates risk and provides long-term investment opportunities. Roderick Munsters, chief executive of Robeco says that the firm’s 2014-2018 strategy hones in on “accelerating growth and Japan is an important element in this. We are confident that this new strategy and the support of our majority shareholder ORIX will enable us to realize substantial growth in Japan in the coming years. We are looking forward to offering Japanese clients our state-of-the-art investment capabilities and services.”

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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SPOTLIGHT

EXCHANGE TURNOVER FALLS IN CONTINENTAL EUROPE

Photograph © Daisy/Dreamstime.com, supplied September 2014

Exchange turnover falls in Q2, but market volume rises—just Trading in investment products and leverage products on exchanges in European financial markets fell in the second quarter of 2014. At €26.4bn, the trading volume was down 21% compared with the previous quarter. Exchange turnover was down 9.8% in comparison with the same quarter of 2013. The trend is highlighted by Derivative Partners Research AG after studying recent market data collected by the European Structured Investment Products Association (EUSIPA).

HE TRADING VOLUME of investment products on the European exchanges in the second quarter of 2014 was €9.4bn, equivalent to 35.6% of the total turnover. Exchange turnover was down 27.2% in comparison with the previous quarter and by 27.9% compared with the second quarter of 2013. In the first quarter of the year EUSIPA reported trading volume in structured products was up by 25.8%. In structured finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps. Low volatility and

low yields have made life tricky for structured product providers as conditions for structuring investible product remain challenging. Investors have not stopped looking for attractive yields, even as interest rates remain at or near historic lows and credit spreads remain tight. So far this year the market has continued to move from more complex/higher margin products to more straightforward or simpler/lower margin offerings. That’s not necessarily been a good thing for structured products as the trend brings them into direct competition with popular products such as ETFs (particularly among advisors and investors). As with other asset classes, there are consistent themes at work; increasing oversight in an already changing regula-

tory landscape, which is insistent on improved transparency and, inevitably, a preferment for standardisation. In that environment, providers that have made a difference are those that have been able to offer trading advisory and the trading of smaller and less liquid underlyings, together with a consistent offering of hybrid liability instruments. This year, report market commentators, there has been a greater interest in sector-specific investments in Europe, such as financial sector underlyings; also actively managed underlyings have also seen some traction. According to Derivative Partners Research exchange turnover in leverage products in the second quarter was €17bn, 64.4% of the total turnover. The trading volume of warrants, knock-out warrants and factor certificates was down 17.1% compared with Q1, but up 4.8% in comparison with the second quarter last year. Trading volume in investment products in the first quarter of 2014 was €12.9bn- up by just over 7% on the same quarter in 2013. Across EUSIPA member exchanges investment products accounted for 38.6% of total turnover. At the end of June, the exchanges of EUSIPA member countries were offering 485,140 investment products and 692,813 leverage products. The number of listed products was down around 2.6% in comparison with the first quarter of the year. The number of investment products listed was down 9.1% on June 2013, while the number of leverage products was up 12.4% year on year. The market volume in Austria, Germany and Switzerland at the end of June was €251.7bn. The outstanding volume was up 0.4% in comparison with the end of March 2014, and by 5.8% in comparison with the end of June 2013. By the end of June market volume of investment products was €238.8bn—an increase of 0.2% in comparison with the end of March 2014, and as much as 6.3% in comparison with the end of June 2013. At €12.9bn, the outstanding volume of leverage products was up 4.4% in comparison with the previous quarter, but down 3.1% in comparison with the end of June 2013.n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

good company

SPOTLIGHT

OPERATIONAL RISK LIMITS IN SPANISH BANKS’ RMBS

Operational risk limits in Spanish banks’ RMBS Operational risk was limited in Spanish residential mortgagebacked securities (RMBS) deals, after financially stressed Spanish banks were put under Bank of Spain administration between 2009 and 2014. "The risk of servicer disruption has been low, despite the servicers undergoing severe financial distress, due to the efficacy of the Spanish management companies acting as independent cash managers/trustees, as well as the support provided by the Bank of Spain," says Alberto Barbachano, a Moody's vice president - senior analyst. Institutions that came under public administration perform administration and collection duties for more than forty Spanish RMBS deals. The credit quality of these deals greatly depends on the efficacy of transaction parties, including the servicer, cash manager and trustee. Moody's does not expect any payment disruption relating to non-performance of a servicer, cash manager and trustee, because all Spanish RMBS transactions have a third-party independent cash manager and a back-up servicer facilitator. However, the overall performance of Spanish RMBS deals has deteriorated after the placement of servicers under administration. Banco CAM and Catalunya Banc SA deals, for instance, have experienced a material increase in arrears above Moody's Spanish 90+ RMBS index. The bank lacked effective back-up servicing arrangements, resulting in higher delinquencies and a lower recovery rate, says Moody’s. "Although the administration of servicers has mitigated the risk of payment disruption on notes in the short term, the risk could remain in the long term if the servicing has not been transferred," says Barbachano. "A disruption in servicing can lead to a decline in servicing quality and, ultimately, the credit quality of portfolios."n

Photograph © Hakan Doğu/Dreamstime.com, supplied August 2014

Reappraising the performance of the active investor Active managers are regularly criticised for their performance, but writes Simon Clinch, US Equities Fund Manager at Invesco Perpetual, the data referenced includes the performance of passive managers and closet indexers as well.

OMER SIMPSON ONCE said, “You can come up with statistics to prove anything… Forty percent of all people know that”. It is an interesting play on how data is often presented to the public. An edition of The Economist earlier this month included an article under the Buttonwood column (Practice Makes Imperfect, 9 August 2014) which reiterated the widely held view that active US equity managers, in aggregate, fail to beat the market on a consistent basis, referencing studies from sources such as the Financial Analysts Journal and Vanguard, a US investment company noted for its exchange traded funds (ETFs). As a believer in the benefits of active management in US equities, it is hard not to take these pieces personally. After digging a little deeper though, it doesn’t take long to uncover a common flaw in the data analysis that is conveniently glossed over. Active Share is an important phrase for the fund management industry that

emerged from a 2006 paper by Martijn Cremers and Antti Petajisto: How active is your fund manager? A new measure that predicts performance (Yale School of Management). Active Share is a measure of just how active a fund is, a figure representing how much of the portfolio is different to the benchmark. In his follow-up 2010 paper, Petajisto drew upon Cremers and Petajisto (2009) to set the closet-indexer cut-off at an Active Share of 60%. Petajisto’s research shows that, over the long-term, managers of US equity mutual funds with the highest Active Share outperform their benchmark indices even after fees and transaction costs, in contrast to underperformance by those with the lowest Active Share ratios (January 1st 1990 – December 31st 2009). The problem with the research referenced by the Buttonwood column is that it is based on datasets covering a broad universe of US equity mutual funds; as is much of the commonly-read material available on this subject. The question is:

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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SPOTLIGHT

THE IMPACT OF LOW BOND YIELDS ON PENSIONS

are these samples true representations of active portfolio managers? I write this from the perspective of an active manager with a current Active Share ratio of more than 87%. To put this in perspective, out of 397 US equity mutual funds benchmarked against the S&P 500, the average Active Share is 78.7%. At the firm in which I work, we believe that truly active managers should have an Active Share ratio of above 80% at the very least, and on this basis 188 of the funds in this group are “passive” or “closet indexers”. That means fewer than half of the funds can be considered truly active (in our opinion). Furthermore, if we look at the average annualised gross performance figures for the periods in Table 1 and 2 (performance figures are gross of fees, in USD, to March 31st 2014), we can see that funds with the

highest Active Share ratios (averaged quarterly from March 31st 2010 to March 31st 2014) have outperformed those with lower Active Share (< 85%), and indeed the group averages on a fairly consistent basis. Therefore, in the Buttonwood article the average performance of the sample of “active” managers is being dampened down by the inclusion of what we consider to be closet indexers. I would be the first to admit that the analysis above is hardly rigorous. Nonetheless, it needs to be shown that the basis for this negative view of active US equity fund management is questionable, at the very least. Our process is based on discipline and conviction, delivering a concentrated portfolio of around 40 stocks with an Active Share of 87.4% for the Invesco Perpetual US Equity Fund (as at August 14th 2014).

Table 1: Performance of US Mutual Equity Funds with High Active Share versus the group average Active Share

1 year

3 years

5 years

10 years

>85%

24.35%

14.43%

22.00%

9.36%

<85%

23.68%

14.54%

21.20%

8.42%

Diff

+0.96%

-0.11%

+0.80%

+0.94%

evestment data filtered as follows: included only those funds whose benchmark is S&P 500, S&P 500 (noon rate) or S&P 500 (NTR):excluded funds with no data for active share is derived from portfolio coverage figures. Source for portfolio coverage is Style Research as at 31/3/2014

Table 2: Performance of US Mutual Equity Funds with High Active Share versus those with Lower Active Share Active Share

1 year

3 years

5 years

10 years

>85%

24.35%

14.43%

22.00%

9.36%

Total average

23.68%

14.51%

21.43%

8.68%

Diff

+0.67%

-0.08%

+0.57%

+0.68%

evestment data filtered as follows: included only those funds whose benchmark is S&P 500, S&P 500 (noon rate) or S&P 500 (NTR): excluded funds with no data for active share on 31/3/2014; Average Share is calculated as follows: 100 minus portfolio coverage. Source for portfolio coverage is Style Research as at 31/3/2014. From 31/3/2014; used average returns for 1 year through to 10 yers of the resultant. Gross returns, US$

We are firmly in the camp of active managers, and by accepting the volatility and periods of underperformance that come with that style of management, we seek to deliver long-term outperformance. All we ask for is to be recognised as truly active managers, and not to be viewed alongside more passive strategies; and in the end, our performance will tell the story. n

CHINA RQFII Ashmore unveils new funds

Ashmore uses RQFII status to give investors greater and more flexible access to China securities, as the republic opens up its domestic equities market to foreign investors

nvestors are being offered greater access to domestic Chinese securities, a fact leveraged by Ashmore new trio of China focused funds. “China is in the midst of a storming change as it transforms itself from an export to a domesticled economy. We believe China's aggressive appetite for reform and forward-looking policies will place the country in a very strong position to grow in the future. We think the transformation of the Chinese economy will be especially positive for the domestic bond market which will play a central role macroeconomic policy. China's domestic bond market is one of the largest in the world and is set to become increasingly accessible to investors outside of China,” explains Jan Dehn, Ashmore’s head of research, explaining the background to the establishment of the new funds. In January Ashmore was awarded RMB Qualified Foreign Institutional Investors (RQFII) status by the China Securities Regulatory Commission (CSRC); the first manager outside of Greater China to be awarded this status. This followed the decision by the Chinese authorities in October last year to allocate an RMB80bn RQFII quota for London, after a decision

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

was taken to expand the pilot scheme beyond Asia. Hong Kong, Taiwan and Singapore are approved jurisdictions for RQFII. Ashmore has subsequently launched three new SICAV structured funds, offering access to local Chinese markets. The Ashmore Chinese Debt Fund seeks to access returns available from a strategy of Chinese debt securities issued by sovereigns, quasi sovereigns and public and private sector corporations denominated in RMB and traded on the China Interbank Bond market and/or the China exchange traded bond market; Ashmore Chinese Equity Fund will invest in Chinese A-shares listed on the Shanghai and / or Shenzhen stock exchanges and Ashmore Chinese Multi-Strategy Fund hopes to generate returns from a balanced strategy of the two previous strategies. “China is not only the world’s second largest economy, it is also one of the most difficult to access, with local markets having been largely inaccessible to foreign investors,” explains Christoph Hofmann,

Simon Clinch, US Equities Fund Manager, Invesco Perpetual. Photograph kindly supplied by Lansons PR agency, August 2014.

Ashmore’s global head of distribution.“The launch of these funds changes this dramatically, he avers. “Domestic Chinese equities and fixed income assets are significantly under-represented in most global portfolios and these funds will allow our clients to make dedicated investments in China and suitably diversify

their asset allocation,” he adds. This is a good time to buy Chinese securities think the Ashmore investment team, despite some questions over the pace of growth that the current government’s policies might achieve. “Local Chinese equities have been hit by poor investor sentiment amidst slower growth but we believe this has created a buying opportunity. Valuations are depressed, Chinese indices remain around 75% lower on a price-to-earnings basis compared to pre-crisis peaks and P/BV multiples are at near decade lows. This is despite a strong expected earnings recovery and the country’s strong fiscal position which means there’s huge firepower to stimulate growth if necessary,” says Dehn. According to the asset manager, the launch of the new funds has relied on Ashmore’s close relationship with both Northern Trust, which is providing fund administration services (through Luxembourg for the funds and HSBC who will act as the onshore sub custodian. n

US Fed promotes asset building in lower income US households US Federal Reserve Chair Janet Yellen spoke out at a recent assets learning conference on the need for more self-reliance among low and middle income families.

HE CHRISTIAN BIBLE posits ‘to them that have shall be given; and to them that have not, it shall be taken away”. How apt then that Fed chair Yellen, is now admonishing America’s lower income earners to save more to protect themselves in bad times, because there is no one to bail them out. The financial crisis has, suggests the Fed disproportionally affected US lower income segment. Recent research by the Fed has highlighted the vulnerability of a large share of American families with too few assets to fall back on should times turn bad once more. Citing numbers from the Federal Reserve's 2013 Survey of Consumer Finances, published earlier this month the median net worth reported by the bottom fifth of households by income was only $6,400 in 2013. “Among this group, representing about 25m American households, many families had no wealth or had negative net worth. The next fifth of households by income had median net worth of just $27,900. These numbers represent declines from 2010. One reason is that income has continued to fall for these families,” she said. One reason is the lingering effect of the home equity crisis that dogged US house owners for years,“many of these

FTSE GLOBAL MARKETS • SEPTEMBER 2014

families have not yet recovered the wealth they lost in the housing crisis,”she concedes. However, on the upside,Yellen believes the housing market is “improving and housing will remain an important channel for asset building for lower and middle income families. But one of the lessons of the crisis … is the importance of diversification and especially of possessing savings and other liquid financial assets to fall back in times of economic distress”. In the US, financial assets, including 401 (k) plans and pensions, held by low and middle income families account for a very small portion of total assets held in these segments (according to the survey, only 8% of the total). Just how vulnerable this segment remains is highlighted by the Fed’s recent Survey of Household Economics and Decisionmaking, an unexpected expense of just $400 would prompt the majority of households to borrow money, sell something, or simply not pay at all. Yellen says the Fed, via initiatives such as the Community Development programs, the work of the central bank’s division of consumer and community affairs and its network of reserve banks, will encourage families to begin to accumulate considerable assets.n

SPOTLIGHT

THE GROWING INFLUENCE OF AIFMD

REITS & the AIFMD web The Alternative Investment Fund Management Directive (AIFMD) has entangled many property managers in the murky web of regulation for the first time, writes Michelle Bedwin, Senior Consultant, CCL.

HE ALTERNATIVE INVESTMENT Fund Management Directive (AIFMD) has had a significant impact on the alternative fund industry in Europe and beyond. The purpose of the AIFMD is to provide greater protection for the predominantly professional investors who invest in alternative funds. The requirements have been effective since July 22nd this year so you should have already submitted your application to the FCA if you are managing a fund marketed to European investors if it falls under the definition of an alternative investment fund (AIF). The Directive was primarily written for hedge fund and private equity fund managers but the definition of an AIF has also attracted the attention of property managers. So what is an AIF and does a real estate investment trust (REIT) fall within its scope? An AIF is any vehicle with a defined investment policy that raises capital from investors and is not structured as a UCITS fund. A REIT is simply a vehicle used for tax purposes. The structure of REITS varies considerably depending on the jurisdiction and many REITS would be defined as AIFs. From a UK perspective, if a vehicle is open to investment by investors then it is an AIF. The fact that these investors may be institutional is irrelevant as the intention of the AIFMD is to provide protection for the mainly professional investors investing in alternative funds. Furthermore, you do not escape the clutches of the AIFMD if the REIT is domiciled outside of Europe, since the Directive captures all funds that are being promoted to European investors. The AIFMD has entangled many property managers in the murky web of regulation for the first time. If you are managing a REIT or any other vehicle that you think may be an AIF, you should

Photograph © Bin Omanakuttan Dreamstime.com, supplied September 2014.

contact a compliance consultant or regulatory lawyer for advice as soon as possible. If you are considering the launch of an AIF, you will be investigating how the regulation may impact you. Assuming that you are in the UK, first of all you need to decide whether your company would like to be authorised as a full scope Alternative Investment Fund Manager (AIFM) or if you meet the criteria to be a smaller AIFM.Your company can be a smaller AIFM if the AIFs being managed across the organisation as a whole equate to less than €100 million or €500 million in some circumstances. The advantage of being a smaller AIFM means lighter touch regulation including less reporting obligations.

The passport regime

There is, however, a catch. Smaller AIFMs cannot benefit from the ‘passport’ regime established under AIFMD. One of the main benefits of the AIFMD for managers is that once you are authorised by your home regulator as a full scope AIFM, then you are able to apply for passports and promote your funds to other European

countries without having to rely on private placement. It should be noted that a passport regime does not yet exist for AIFs domiciled outside Europe (even if they are being managed by a European manager) and that an impact of AIFMD is that the private placement regime in many countries is tightening. Full scope AIFMs (even if they are managing AIFs below the thresholds outlined above) must appoint a depositary to safeguard the assets of investors. This function has to be separate from the function of manager and administrator. In practice for property funds, the fund passes the depositary fee onto investors and the depositary hold the ownership deeds of the properties. For smaller AIFMS, there are ‘depositary lite’ arrangements meaning the underlying investors pay less in charges for a service which many in the industry argue is irrelevant in the property world. Whether you decide to be a full scope AIFM or a smaller AIFM, you will be enmeshed in this new regulation.Your organisation must meet certain threshold conditions to be authorised by the Financial Conduct Authority (FCA) in the first place, then hold regulatory capital in case your company fails and have a robust senior management team responsible for overseeing arrangements and ensuring compliance with the FCA rules. As you will be well aware from recent headlines, FCA authorised firms and executives can and are sanctioned for breaking FCA principles including not acting with integrity, which is a difficult notion to contest. Deciding to be FCA regulated is not an easy decision, but if you want to manage a REIT that falls within the AIF definition then there is no option. Establishing a fund as an AIF is a powerful marketing tool and prospective investors will take comfort from the regulatory protection. With FCA’s willingness to sanction becoming increasingly apparent, you cannot take this decision lightly and must get it right to protect the reputation of your organisation and avoid falling prey to the regulator. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

MARKET LEADER

The primary debt market showed almost no signs of life in August. Political vicissitudes of the past few months have resulted in a lack of federal and regional placements, and left a mainly non-market imprint on transactions in the corporate sector,believes Natalia Markova, market analyst, Russia and CEE Fixed Income Group, at Cbonds. Sanctions have significantly reduced the attractiveness of Russian bonds for investors, she writes. However, that in itself would not have been too bad, if it had not been accompanied by growing internal problems in the Russian economy.

he situation in the government bond market is still determined by foreign policy risks. With those risks being so high, no one is surprised by additional placements by the Ministry of Finance in both the primary and secondary markets. The statistics are depressing. The Ministry cancelled OFZ placements six times in a row and only about RUB30bn (just under $27m) were placed in the third quarter this year, which is less than a third out of the planned RUB140bn of promised issuance. In total, since the beginning of the year, the volume of OFZ has increased by RUB137.6bn, and the redemption during this period equaled RUB181.3bn. OFZ are currently traded at yields of

FTSE GLOBAL MARKETS • SEPTEMBER 2014

over 9%; a level at which the Ministry of Finance will not come to market. What this means in practice is that the domestic financial system is threatened by a lack of liquidity. During the year, the instability of the national currency and the Ukrainian crisis induced the Ministry of Finance to press the pause button on new issues, though the market did not expect such a long lull. Deputy Finance Minister Sergei Storchak put forward the logic that bond prices in the market were not warranted by the country’s solvency risk and "contains too high a political margin". The demand for Russian bonds however is determined not only by external factors. OFZ yields were also pushed up by a statement by the Minister of Labour Maxim Topilin regarding an

Regional borrowers Regional borrowers, following the example of the Ministry of Finance, were also absent from the primary market through August. After an extensive preissue marketing campaign in July, the Republic of Bashkortostan and the Novosibirsk region backtracked on plans to issue in the primary market. The result was that the municipal sector froze. The entities were definitely ready for the placements, but the rates grew unacceptable; fortunately, bonds are not the only way out for regions that need money. Many regions across Russia continue to experience problems with refinancing, particularly as they have been priced out of the local bond markets. These same regions are now vying to replace commercial loans with cheaper, subsidised loans from the government, which has allocated some RUB230bn for this purpose. The move might be counterproductive, as it does not reduce the overall indebtedness of the regions, just moved the repayment risk from the market to the state. As well, the sheer volume of demand for these budget loans might also upend the very system that has been put in place to help. Another way to increase the revenues of the regional authorities is the introduction of sales taxes. According to First Deputy

MANAGING TURBULENCE IN RUSSIA’S BOND MARKET

Geopolitics & Russia’s primary debt market:

extension of the moratorium on pension through 2015. If the decision is made, the financial market (and especially the Ministry of Finance) will lose at least RUB650bn rubles of potential investments that would increase the cost of financing in general. However, it is unlikely that the ministry will completely abandon either domestic or foreign borrowing, and is hoping that geopolitical tensions will decline sufficiently between now and the end of the year to allow it to borrow up to $7bn in foreign markets in 2015. Moreover, before the year is out, the Ministry of Finance will have to redeem bonds worth some RUB135bn and the demand for liquidity has increased, so the Ministry is likely to come to the primary market. The question is on what terms will deals be done.

IN THE MARKETS

MANAGING TURBULENCE IN RUSSIA’S BOND MARKET

Finance Minister Leonid Gornin, a 3% sales tax, which can be introduced in the regions from the beginning of next year, will go some way to compensate the regions for a fall in income tax. According to the Ministry’s estimates, the additional income generated could be as much as RUB200bn. Despite larger doses of federal support, regional issues look to continue to find ways to raise money in the domestic bond market as well as subsidised loans. The Legislative Assembly of Chelyabinsk region, for example, has adopted a number of amendments to public debt management rules that will allow it to issue bonds in the commercial market. The region plans to debut in the bond market for a projected RUB10bn issue before the end of this year. The funds will be used to cover the region’s budget deficit, which is approximately RUB12.3b.

Corporate issuance still active Unlike municipalities, corporate borrowers were active in the primary market in August, and the volume of placements was more or less the same as in July. In a broader context however, issuance volumes are still depressed compared with last year and the volume in August was less than a third of the volume of bonds issued in August 2013. Over the month the volume of domestic corporate bonds increased by only RUB45.6bn, with the volume of redemptions equivalent to RUB60bn. Besides that, only half of the transactions can be referred to as market-based; investors have tended to opt for private placements. Geopolitical tensions are clearly being felt. Sanctions have not only closed foreign sources of funding to companies, but also highlighted inefficiencies in the domestic bond market. Demand is variable, as investors are holding out for expected increases in bond yields. UniCredit Bank’s placement of Series BO-22 bonds worth RUB10bn was the highlight of the month. Effective marketing meant the bank received 20 bids from investors worth more than RUB12bn. As a result, the issuer managed to lower, though slightly, the coupon

The volume of new Russian bond issues in 2013 – 2014 (RUB billions) Source: http://ru.cbonds.com/indexes/.

guidance to a range of 10.3%-10.4% and to place at the lower end of the range with a yield to put of 10.57% p.a. BK Region acted as a co-arranger. International sanctions not only caused a reduction in demand for Russian bonds due to the market slump, but also forced Russian investors to change the formal approach to the evaluation of assets. This is especially true for Vnesheconombank and pension funds, which have strict criteria on international ranking availability for the purchased bonds. At the moment, the rating agencies refuse to rate the issues of the sanctioned banks. As a result, mortgage programs of Sberbank, Gazprombank and VTB 24 were jeopardized. Deputy Finance Minister Alexei Moiseev believes that the best option for solving the problem is to create a domestic rating scale for Russian bonds. A temporary measure is considered to be AHML guarantee, which has the necessary ratings. Analysts do not expect any immediate market recovery since there’s a high probability of another "dead month"; though as the magazine went to press there were signs that the Ukrainian crisis had reached something of a turning point. Certainly, the market would appreciate an amelioration or at least some kind of solution of the Ukrainian question, as there are signs of pent up demand. The financial sector is in need of liquidity as are manufacturing companies that are planning investment programmes. For example, KAMAZ is planning to place

RUB35bn worth of bonds during next two years. The company has already received government guarantees for issues aimed at building a new automobile assembly plant. Government guarantees will help reduce the cost of funding, but so far the company has postponed the market entry until conditions improve. Bond rating: At the end of June, Moody's assigned a negative outlook to Russia's Baa1 government bond rating and confirmed the rating. Russia's local currency bond and deposit ceilings was lowered to A2 from A1. The negative outlook was triggered by the rise in Russia's susceptibility to geopolitical event risk and the deterioration of Russia's medium term economic growth outlook. The rating was confirmed against the background of Russia's strong fiscal and external accounts, which Moody's does not expect to be materially affected by the current geopolitical tensions related to the Ukraine and the lower GDP growth trajectory projected in the coming years. At the end of July, Moody's published a special comment on the impact of the US and EU sanctions on the Russian issuers. According to Moody's, the latest raft of US and EU sanctions will not produce an immediate liquidity crisis in Russia as most debt issuers have sufficient cash and financial buffers. However, they will amplify the gradual downward trend in the country's growth potential, which could lead to an erosion of creditworthiness across sectors. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

The business case for industrialisation of market utilities The notion of centralised infrastructure and services is not new. It has been used successfully in other industries for years. There is, however, a renewed interest in industrialisation within the capital and commodity markets. Many firms are once again considering how utilities could help increase efficiencies, reduce costs and, ultimately, improve their return on equity (RoE). In this incisive article, Ryan Baccus, vice president of Sapient Global Markets’ Regulatory Response operations, discusses the ways in which the industrialisation efforts of today are putting market utilities back in the spotlight, when they make most sense and what firms can expect in terms of benefits.

CCORDING TO A Morgan Stanley paper in Wholesale & Investment Banking, published in March this year,“The majority of IT, pro-

FTSE GLOBAL MARKETS • SEPTEMBER 2014

cessing and support behind banking services is delivered in house with platforms that are highly duplicative across players and offer very little by way

of competitive advantage. We estimate up to $7bn-9bn of industry costs could be pushed out into an external supply chain (with net savings of $3bn-$5bn) that can deliver scale economies as well as enhanced flexibility and potentially more innovation. We expect only part of this to be achievable within a two to three year time frame and estimate $1bn to $3bn of annual cost savings by 2014. The business case for any industrialisation effort can be complex. At the heart of these types of initiatives is an intuitive benefit model. However, due to the long term payback and a range of commercial models, there are a number of subjective elements, such as trade volumes, levels of straight through processing (STP) and delivery confidence (and so on). For organisations looking to meet ambitious cost reduction targets, industrialisation stands out as a viable option that can enable genuine business transformation. The concept of industrialisation and the potential of leveraging economies of scale to reduce costs and increase profits is not a new one. Outside of financial markets, there are numerous examples within manufacturing, telecommunications and even the airline industry (please refer to the Sabre example in figure 1), where organisations have been able to work together to standardise elements of the supply chain. There is also a rich history of events where firms have also co-invested in technical solutions that provided an enhanced service at a fraction of the cost compared to a scenario where each organisation would have individual built solutions. There have been a number of successful initiatives within the financial markets community to develop new concepts collaboratively that have resulted in the creation of market utilities and other central market infrastructure. These have typically occurred within a limited process scop where a business function was not already being performed and ther was an appropriate regulatory incentive acting as a catalyst. The industrialisation proposition, by its very nature, has a more commercial focus, which means that the conditions for

THE INDUSTRIALISATION OF THE CAPITAL MARKETS

Photograph © Sylverarts/Dreamstime.com, supplied September 2014.

IN THE MARKETS

THE INDUSTRIALISATION OF THE CAPITAL MARKETS

success are more complicated,. As such , it has traditionally been more challenging to mobilise market participants to collaberate and co-invest. One of the more high-profile examples of the industrialisation proposition within the capital markets is the JP Morgan Arcordia service. Created to drive greater industry standardisation, Arcordia, which was spun out of the JP Morgan back office in March 2000, was a provider of ASPbased post trade processing services for over the counter (OTC) derivative trading for use by other organisations. Widely recognised as a leading platform with rich functionality, the commercial operations of Arcordia were, however, wound down in November 2001 with a JPMorgan spokesperson confirming at the time, “Recent events and the continued economic slowdown have caused the firm to re-evaluate its external Arcordia business plan.” The Arcordia offering preceded years of rapid growth in the OTC derivative market and the general sentiment was that the market practices and dynamics were not mature enough at the time for the offering to succeed. As one would expect, the financial markets have undergone a major transformation in the years since the Arcordia offering. Are, however, market conditions any more stable now and, if so, what does the capital markets’ industrialisation roadmap look like?

Market conditions The current market environment is characterised by shrinking margins, increasing cost pressures and more exacting regulatory standards. This has created an environment where there is a significant focus upon opportunities for cost reduction and return on investment and where substantial funding has been channelled towards meeting global regulatory requirements. In parallel and through a number of successful internal and external initiatives, there is also a greater awareness and willingness to collaborate on common challenges faced by the marketplace. Together these two elements have created an environment that has the potential to drive

efforts for market wide industrialisation to a successful conclusion. Given these conditions, there is a greater willingness throughout the market to consider industrialisation initiatives. However, the scale of ambition across organisations varies depending on experiences and circumstance, with the challenge of balancing initiatives focusing on optimising sourcing and location strategy, internal group level functionalisation and market-wide industrialisation. Based on perceived delivery risk, there is often a portfolio of initiatives working towards different levels of standardisation at the same time. AS such, there seems to be greater demand for function-specific industrialisation effortrs rather than attempts at replacing entire post-trade service.

The focus on industrialisation What makes a function more suitable for standardisation? The following characteristics of a functions should be evaluated before determining whether to standardise it or not. First is competitive advantage associated to the function by clients. Second is market breadth, which includes the number and profile of market participants that perform the function. Third is the level of effort (often measure by cost) and inefficiencies associated with the function. The final element is stability, which is related to the likelihood of major change affecting the function in the short to medium term. Client reference data is an area that meets the criteria previously outlined due to its non-proprietary nature and the significant cost for market participants. This has been reflected in recent market offerings form the DTCC, Markit, Thomson Reuters and SWIFT. Another area that fits the suitability criteria is the potential for a central utility that could provide for netting efficiencies across margin and settlement movements, given the upcoming enforcement of market for uncleared trades for OTC derivatives and the market-wide demand. An area that was less straightforward was trade documentation. While it is largely considered to be a non-proprietary function, the changing landscape and un-

certainty around trade volumes make this an interesting function to explore. Can the trade documentation function be moved into a shared service that can ultimately drive reduced costs, increased controls and more effective compliance by creating greater levels of standardisation and enhanced transparency? While largely perceived as a non-proprietary function, trade documentation is still managed bilaterally in most instances. The analysis in the text box Industrialisation suitability assessment suggests that trade documentation is, in fact, a good candidate for standardisation. However, the uncertainty around volumes and processes could see the industrialisation take place gradually (potentially focusing on the issues of document exchange initially) to ensure that the perceived long-term benefits can be realised. Outside of core business functions, there are other opportunities for utilisation and where innovative solutions could help in terms of economies of scale. As an example, Goldman Sachs and Fidelity Investments have recently given their backing to the Open Compute Project, an initiative to open source hardware and datacentre designs. It is expected to transform the way in which infrastructure is designed and manufactured in the IT industry, Jay Parikh, vice president of infrastructure at Facebook has saved an estimated $1.2bn on IT infrastructure costs by doing its own designs and managing its own supply chain. Facebook CEO Mark Zuckerberg later added that on top of this saving, Facebook has saved enough energy to pwer 40,000 homes for a year and reduced carbon dioxide emissions at a level that is equivalent to removing 50,000 cars from the road for a year. For those organisations that make the commitment to industrialisation the benefits can be significant. While the initial design can be complex, given the inherent challenges around security and commercial models, the key to success is establishing the right governance model; one that is empowered and able to commit to long-term initiatives where there is the potential of materially impacting the organisation’s return on equity.n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Photograph © Sylverarts/Dreamstime.com, supplied September 2014.

The UK Council of Mortgage Lenders, whose members collectively undertake around 95% of UK mortgage lending, estimates that gross mortgage lending reached £18.6bn in August. The figure is 5% lower than July (£19.7bn) but 13% higher than August last year (£16.4bn) and the highest lending total for an August since 2008 (£19.3bn). There are 11.1m mortgages in the UK, with loans worth over £1.2trn, a level of exposure that in the run up to national elections in 2015 will rein in any exuberance by the Bank of England to tamper with interest rates, even as basic economic indicators in the UK continue to gently ameliorate. Even so, the council expects a gentle slowing in the market as the London market softens and the threat of rising rates over the medium term causes borrowers to take pause.

OMMENTING ON MARKET conditions CML chief economist Bob Pannell says, "The narrative of recovering house purchase and buyto-let activity continued through August.

FTSE GLOBAL MARKETS • SEPTEMBER-- 2014

However, it is important to be aware that this picture is being flattered by strong seasonal factors through the summer period. A gentle slowing of lending activity may now be in prospect, as a result of the continuing impact of tighter lending rules and a softening of the London market." According to the Council, there were 30,200 first-time buyer loans in July, up 3% on June, and 25% up on July 2013. By value, there was £4.6bn of lending to first-time buyers in July, 10% up on June and 39% higher than July last year. Lending to home movers also grew. In July, the number of loans advanced to movers was 37,500, 15% up on the previous month and 19% on July last year. By value, lending to movers totalled £7.2 billion, 20% up on June and 31% up on July last year. Re-mortgage lending remains muted compared with both first-time buyer and home-mover lending. The number of remortgages in July was 4% up on June but 15% down on July last year. The value of these loans (£3.9bn) was up 3% on the previous month and down 5% on July 2013. Buy-to-let lending grew 9% over the month to £2.4bn in July, and an increase of 26% from £1.9bn in July last year. Total gross lending in July grew to £19.7bn up by 10% on the previous month (18% up on July last year), according to the Bank of England. House purchase lending to home-buyers increased month-onmonth in July totalling 67,700 loans, up 10% compared to June and the value of these loans totalled £11.8bn, a rise of 15% on June. Compared to July 2013, the number of loans increased by 21% and the value of lending by 33%. The typical loan size for first-time buyers continued to rise to £127,500 in July, up

GROSS MORTGAGE LENDING STILL ON THE RISE IN THE UK

Softening of London property will cool mortgage lending

from £123,750 in June and the highest average loan size for a first-time buyer on record. The typical gross income of a firsttime buyer household also grew to £38,900 in July compared to £37,095 in June. First-time buyers' in July paid 19.6% of gross income towards covering capital and interest payments, up from 19.3% in June, but still significantly less than the recent peak of 24.8% in December 2007. Home mover lending continued to strengthen with stronger month-onmonth growth than first-time buyers. In July, the number of loans advanced to movers was 37,500, 15% up on the previous month and 19% on July last year. By value, lending to movers totalled £7.2bn, 20% up on June and 31% up on July last year. Home movers typically borrowed 3.03 times their gross income in July, compared to 3.08 in June. The typical loan size for home movers was £156,000 in July, up from £153,800 in June. The typical gross household income of a home mover was £54,400 in July compared to £52,000 in June. Home movers' payment burden remained relatively low in July at 18.7% of gross income being spent to cover monthly capital and interest payments, up slightly from 18.6% in June, but remains lower than the recent peak of 23.8% in December 2007. Re-mortgage lending, unlike house purchase lending, saw a decrease in both volume and value in July compared to the same month in 2013. However, a monthon-month comparison shows growth in both number and value. The market has shown steady growth in house purchase and buy-to-let over the past few months with general improvements in economic factors across the UK allowing for more people to enter the property market. "There have been many factors over the past year that could have caused disruption but the market has remained resilient and lenders have shown themselves adaptable to all this change. The CML will continue working towards making sure future initiatives affecting the market, such as the European Mortgage Credit Directive, are introduced with equally minimal disturbance to borrowers and lenders,”says Pannell.n

IN THE MARKETS

REASSESSING THE FUTURE OF CLEARING Photograph © Rolffimages/Dreamstime.com, supplied September 2014.

Reassessing the future of clearing The clearing landscape is in flux, undergoing substantive change. The ultimate goal is to create a safe, harmonised, stable, cost effective and transparent post trade landscape. The challenge is in achieving this while balancing the needs of participants with those of the market. NASDAQ OMX’s Hans-Ole Jochumsen, President, Global Trading and Market Services, reports on the implications of change.

HE CLEARING LANDSCAPE is at an important crossroads. Regulatory reform is prompting unprecedented change and the upshot will be a very different clearing regime to what we have today. The overall aim is well understood – to create greater stability and transparency. However, the real challenge

will be achieving this while balancing the needs of participants with those of the market and society as a whole. This will require some careful navigation of the detail and, crucially, a rethink of clearing practices. While regulators iron out the specifics, CCPs have an important and collaborative role to

play in defining this future. Three areas stand to have the greatest impact – capital efficiencies, investor protection and technology innovation. Achieving capital efficiencies will remain an important consideration as participants look for ways to do more with less. Today, this is largely related to margin levels but that’s all about to change. Decisions around what to trade and clear will be influenced not only by the product but also by the levels of margin required. This will become increasingly important with mandatory clearing, given that participants will clear more products while having to hold larger amounts of capital. Cross-margining has emerged as a valuable tool to tackle this challenge. Currently, this is done to varying degrees across the industry, whether it’s crossmargining across OTC and exchangetraded products or net margining across multiple asset classes. It is where many CCPs have been able to differentiate their offerings based on their risk appetites. However, regulations will harmonise margin levels. Therefore, most participants could, eventually, achieve the same levels of efficiency through margining, regardless of where they clear trades. As a result, participants will be on the hunt for other ways to make the best use of capital.

Optimising collateral Collateral management, while not new, will need to evolve to meet this need and it is this that will drive future capital efficiencies. Opinions and predictions differ on whether there will be a collateral shortfall and, if so, how great it will be. The reality will depend largely on how well these assets are managed. Therefore, the ability to optimise collateral in ways that are not related to margins will become highly valued. On the broker side, efforts to address shortfalls on clients’inventories or transform ineligible assets into suitable collateral will have a big impact. On the CCP side, there are several possibilities that could emerge. One of these is integrated calculations between margin portfolios and collateral portfolios. This would allow full offsets where a participant holds the underlying

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security when trading, for example, an equity option. Clearing systems calculating the exposure in a participant’s portfolio against their underlying collateral is true collateral management. Other opportunities include optimising cash, with total netting across all cash flows and full STP. This would apply to the entire cash flow, from instruction and confirmation to reconciliation of individual transactions. As a result, any excess collateral in cash could be used to cover cash settlement while a positive cash settlement could cover the margin requirement. Delivering better collateral management will be subject to certain constraints – such as the time it takes to transfer cash and securities between parties. It will also depend heavily on technology. Dealing with the complexity of clearing requires greater innovation and this becomes highly relevant when considering open access and interoperability. Whether the latter becomes a reality soon is not yet clear. However, the drive to increase competition in clearing means that innovation in collateral management will have a marked impact on what participants choose to clear and, importantly, where they clear them. Collateral management will also be driven by greater automation, standardisation and anything that improves efficiencies. Connectivity and the continual drive for STP is one example. The elimination of manual intervention of flows between the participant, client and CCP could well push through the standardisation of FIXML, FPML and Swift-based messaging. Automation would also deliver further capabilities, such as direct debit or credit transactions that automate the paying back of any cash surplus on a member’s account. When creating stability, the future of clearing must support the fundamental principle that investors should not have to bail out a defaulting CCP. Client segregation is vital for this. The reason that firms are still unpicking the collateral held at Lehman brothers and MF Global is evidence that segregated clearing was not in place. While client segregation is now mandated by the regulators, it is demand from participants that will drive future

FTSE GLOBAL MARKETS • SEPTEMBER 2014

offerings. They will want increasing levels of protection that give them confidence and peace and mind – and the regulatory minimum might not suffice. The Omnibus model is a case in point, with CCPs holding one account for multiple clients. This falls short of truly mitigating risk as it lacks transparency around what collateral and positions each client has. As such, they will prove difficult to transfer. More robust offerings are required, so the future will demand account structures affording different levels of protection, covering both ICA accounts and fully segregated structures. This approach has already proved its worth in real market circumstances. As with collateral management, technology will once again be the driver. In particular, this technology will need to include systems and account setups to manage a large number of these different segregation structures. The industry has a false impression that this level of true segregation is costly and complex. The reality is that it is not only a must-have, ensuring stability and investor protection, but also entirely accessible.

Recovery and resolution If we assume that all CCPs will eventually catch up on client segregation, then the real opportunity for change in investor protection will be through recovery and resolution. Getting this right could have the greatest effect on reducing systemic risk. Market infrastructure is important and there are some clear divides of opinion. On the one hand, a market with one or two large CCPs would be better for capital efficiency. On the other, it creates huge systemic risk because a single CCP default would have a massive impact on the financial markets. A palette of mediumand large-sized CCPs would allow for more robust recovery options – and that’s going to benefit the market and society far more. The roadmap to achieving this will need to address the commercial interests of all involved. However, it should evolve naturally as a result of regulations encouraging competition in the market. Recovery and resolution in this landscape of multiple CCPs would need to consist of

“Recovery and resolution in this landscape of multiple CCPs would need to consist of carefully considered tactics. Every recovery situation will be unique, so having a one-sizefits-all approach could have unwanted negative consequences.”

carefully considered tactics. Every recovery situation will be unique, so having a onesize-fits-all approach could have unwanted negative consequences. For example, forcing mandatory transfers of positions to another CCP would create additional risks if that CCP is not equipped to take them on. A more flexible and robust solution would be a voluntary recovery arrangement for fungible OTC contracts that are cleared by all CCPs. This would allow the market to find the best fit in any particular scenario. This would call for a high degree of dialogue and cooperation, which would be a big shift for the industry. However, it is a good example of where collaboration is essential to deliver real benefits to the market.

Technology innovation Ultimately, technology is going to be the driver for the future of clearing. In the past, the front office received most of the limelight. The future will be very different, with regulatory reform, increased competition and client demands affording clearing far more attention – and a new wave of innovation. What’s clear is that change is inevitable. Greater competition through regulation is a positive step – and with that comes greater choice. Participants will be looking for ways to tackle costs and deliver the most efficient and effective clearing processes. As a result, the industry must collaborate and innovate if it is to promote competition and make a more stable and transparent market a reality. n

IN THE MARKETS

DIGITISATION OF DOCUMENTATION

EFFECTIVE MANAGEMENT OF DOCUMENTS IN FINANCIAL SERVICES

As institutions fulfil their regulatory requirements, access to data to demonstrate and evidence ongoing compliance will be critical. Just how critical is illustrated by the fact that market estimates of the investment required to support document management and document lifecycle processing across the financial services industry across both buy- and sell-side firms runs into billions of dollars. Digitising data efficiently using a proven industry-wide data model alongside a comprehensive, tested support system (technology and resources) packaged as a managed shared service can provide a unique and effective solution going forward. Ravi Sonecha, consultant and Stuart McClymont, head of Market Infrastructure Services at JDX Consulting explain the mechanics.

HERE IS INCREASING demand across the financial services industry to access data attributes that currently exist only within paper documents. These may be relationship agreements, for example; Master Confirmation Agreements (MCA’s), Credit Support Annex (CSA’s) and Swap Execution Facility (SEF) agreements. Or they might involve transactional documents, such as trade confirmations or term sheets. Business-as-usual processing, risk management, regulatory response, execution speeds and/or the need for increased control have all intensified the need to access information accurately and in a timely manner. It is estimated that the investment required to support document management and document lifecycle processing across the financial services industry is approximately £2bn across buy- and sellside firms. However, given the increasing

cost pressures that firms are facing, this level of unilateral investment is not sustainable and therefore an alternative industry shared solution would appear to be the most effective way of achieving these shared goals. Processes to retrieve information accumulated as physical text continue to improve both in terms of functionality and accuracy. The transformation from an ordinary PDF scan to a sophisticated, searchable computer-readable file to access key data is through the use of Optical Character Recognition (OCR). OCR is the mechanical or electronic translation of scanned images of handwritten, typewritten or printed text into machine-encoded text. Modern-day, intelligent systems with a high degree of recognition accuracy accommodate for a large quantity of available fonts. OCR technology can still be quite rigid, hence there is often a need to ‘prepare’ a set of documents

before the OCR can be conducted. We term this preparation ‘pre-processing’. Pre-processing technology used before the OCR phase improves the character recognition accuracy and capture levels. Even with a dedicated product, however, a dedicated human involvement is often required as the documents set may be delivered to the managed service in a variety of formats. PDF scans can be illegible, document types incorrect or agreements delivered in a foreign language. Regular correspondence with a client to escalate and resolve these exception documents is a critical pre-processing component, requiring dedicated human resource. Of those documents that are eligible for pre-processing, techniques to preprocess include ‘de-skewing’ and ‘despeckling’ the document to make the lines of text perfectly horizontal and to remove spots; ‘normalisation’ to scale the

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

OCR AS AN END TO END PROCESS

Source: JDX Consulting, September 2014

document to the required ratio; ‘binarisation’ to transform the PDF from colour to greyscale; ‘layout analysis’ to identify columns and paragraphs; and ‘line removal’ if non-text boxes and lines are present. The prepared file is thus fed through the OCR system where sophisticated recognition technology digitises and extracts the text and data. Depending on the maturity of the technology, raw extraction from the OCR tool can vary between 80%-90%. Effort and time required for extraction is also highly dependent on the structure of the document; structured documents include those with a strict, systematic format where data input is largely inflexible, such as a tax form. Unstructured documents, such as MCAs/CSAs, contain fields that can vary from agreement to agreement making the extraction of specific data difficult.

Downstream users Downstream users of legal documentation / financial agreements such as; management, trading and risk departments, and regulators will require data extraction accuracy to be 100% due to reliance on the data to take commercial or risk decisions. A subsequent workflow involving human reviewers retrieving key missed data can therefore be created to complement the mechanised extraction post-OCR; this manual function is known as the 2eye/4eye review process. This

FTSE GLOBAL MARKETS • SEPTEMBER 2014

requires a document to be manually reviewed by two sets of“eyes”as an additional quality check to ensure no key data has been missed. The end goal is to create a disciplined and efficient end-to-end managed service with shared technology and resources for clients wishing to transform their paperstored data into computer-legible text. At present, a number of digitisation technologies are available, developed in silos within institutions without the operational support and skill-set that a managed service would provide. A dedicated, shared service across multiple departments providing the pre-process and OCR services would therefore drive down the cost of R&D and technology support whilst simultaneously providing a higher extraction rate. Once the document format has been identified (MCA, CSA, Long Form Confirmation etc.), a Business Analyst (BA) / documentation Subject Matter Expert (SME) can work with each client to ascertain and define the key clauses required by downstream users, further working with software developers to extract the key data into a custom-made User Interface (UI) to increase user-friendliness. After the technology has been adapted, the pre-processing and OCR phases can begin before the final 2eye/4eye review occurs to ensure 100% extraction rate. The managed service can support the tech-

nology and resources more efficiently and effectively at the most efficient cost point per document. As with the rapidly evolving technology space in general, OCR software will continue to improve over time. The longterm goal will be to completely remove the human element to document digitisation, establishing a service without preprocessing and with 100% extraction. However, this level of technology and process automation will take time. Therefore having the appropriate skilled resources surrounding the technology in a managed service as the technology evolves is critical. There is an opportunity for the industry to make use of such a managed shared service (technology and resources) to ensure maximum efficiency, at the optimal level of cost, and at the highest levels of quality. Most documents are between two parties and to minimize the costs to both parties documents should be digitised once and the data consumed by both parties. An industry managed shared service allows industry participants to benefit from technology proven by other parties, whilst also avoiding duplicative investment by both parties to a document, halving the cost. Using a managed shared service and not having to buy technology and resources individually reduces the portfolio of applications and number of resources within industry participants. n

IN THE MARKETS

Economic freedom: why policy matters

Country allocation, more so than sector and stock selection, remains the primary reason for why an international equity funds’ return deviates from a benchmark return. For this reason, investors should evaluate how international equity managers make country allocation decisions. To the outsider, this may sound contradictory as equity managers have committed tremendous resources to stock selection and sector analysis. However, empirical analysis demonstrates that a country’s political-economic policy changes correlate to investment returns: good macroeconomic policy developments correspond to excess equity market returns. Marshall Stocker, vice president, portfolio manager, and global macro equity strategist at Boston-based Eaton Vance Management, working with the firm’s global team, explains the mechanics. Recent elections in Egypt, India, and Indonesia necessitate the evaluation of the respective economic agenda of the new governments and their potential impact on the investment environment. Critical to successful analysis is understanding how the dynamics of liberalisation and market reform directly affects equity investment returns. A country’s economic policies relate to the key components relating to the valuation of the equity asset class, expected cash flow and discount rate. The summed cash flows represent the collective economic wealth created by the business activities of a country’s publiclytraded enterprises. From this, it can be deduced that country-level changes to tax rates, legislated wage levels, regulatory

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FTSE GLOBAL MARKETS • SEPTEMBER 2014

“Emerging markets have on average quite naturally a lower level of economic freedom. Thus, small changes in economic policy can represent a significant change in the level of economic freedom they experience. For this reason, the theory here is that political and economic factors play a moderately stronger role in determining returns of emerging markets as compared to developed markets”

relation to equity returns has not changed as a result of the new analysis presented here. Expanding the analysis to the 64 MSCI country indices with nine years of new economic data, as compared to my 2005 paper, demonstrates that equity markets where economic freedom increased outperformed those countries with policy environments of decreasing economic freedom. Country-level outperformance was 11% on an annual basis for the period 1970-2000. Clearly, the data is evidencing that change in economic freedom should be evaluated when making country allocation decisions. With a correlation coefficient of 0.30 for the forty year period (1970-2010), political-economic policy developments captured by changes in the level of economic freedom contemporaneously related to equity returns. In the 21st

century, the comparable returns between countries increasing economic freedom and those decreasing economic freedom have widened. Yet, a correlation of 0.21 suggests that on a yearly basis the relationship is marginally weaker. This, we believe, reflects that investment returns related to macroeconomic policy changes are longer-term effects which may be trumped in the shorter term by exogenous factors. Emerging markets have on average quite naturally a lower level of economic freedom. Thus, small changes in economic policy can represent a significant change in the level of economic freedom they experience. For this reason, the theory here is that political and economic factors play a moderately stronger role in determining returns of emerging markets as compared to developed markets. Separately, developed markets also naturally have a higher degree of trade and monetary policy integration which may make the country-factor marginally less powerful. Yet, developed markets which increased economic freedom contemporaneously experienced an equity market return 8.9% higher than those countries with negative macro-economic policy developments. The effect of macro-economic policy change was more pronounced in emerging market equity returns. Finally, the policy factors affecting equity market cash flows and discount rates had a more sizeable return segmentation effect during broad equity market declines. For investors concerned about drawdown rather than exceptional upmarket outperformance, this study indicates the country factor, quantified as changes in the level of economic freedom, may have an asymmetric relationship to country-level equity market returns.

Economic freedom & equity returns in practice: China The beginning of China’s meteoric rise in economic freedom dates to December, 1978. That month and during the Third Plenum of the 11th Central Committee Congress of the Communist Party, Deng Xiaoping assumed control of China’s

GOOD VERSUS BAD ECONOMIC POLICY

obligations, and international trade restrictions all directly affect the cash flows of a country’s publicly-traded companies. The discount rate is used to determine the present value of future cash flows. Its level reflects the uncertainties of receiving those cash flows, the expected inflation rate, and the cost of capital - all components affected by fiscal and monetary policies. Government policy developments which are increasingly erratic or specifically prejudiced against corporations cause the discount rate to increase, cash flow to decrease, and the value of equities to decrease. Understanding how government policies systemically affect the value of assets, through changes in cash flow or the discount rate, is how we can examine the impact of policy on equity returns. This is where the concept of economic freedom, an encompassing term relating to the concepts of free markets, free trade, entrepreneurship, the rule of law, property rights, and freedom of contract, comes into place. An article by Gwartney, Joshua & Lawson published in the annual Economic Freedom of the World Report measures more than 40 politicaleconomic variables which quantify government policies related to the size of government, the legal system and property rights, soundness of the money supply, freedom to trade internationally, and regulation. I believe and I have made the case in Equity returns and economic freedom in issue 25 of the Cato Journal that increases in economic freedom are correlated to above average equity returns. A related 2010 study by Roychoudhury & Lawson, Economic freedom and sovereign credit ratings and default risk in the Journal of Financial Economic Policy has found that the cost of a country’s debt is higher when the country has a lower level of economic freedom. In this piece, I have gathered and analysed an updated set of data on public policy changes, defined as changes in economic freedom, and country-level equity market returns. My view on economic freedom’s cor-

IN THE MARKETS

GOOD VERSUS BAD ECONOMIC POLICY

economic policy and accelerated the adoption of a market-based economy. Nearly three decades of increasing economic freedom ensued as China established itself as a key member of the global economy. With economic freedom having peaked in 2004 and China’s recent Keynesian spending habits leaving banks facing a credit cycle of uncertain proportions, another Third Plenum, this one 35 year later and held in November 2013, offers key insights to the future of economic freedom in China. For one, regulation of the economy is becoming less onerous as interest rate controls should decrease as the capital account slowly opens. Tax rates for small and medium-sized enterprises are being reduced and labour mobility is increasing through the reform and liberalization of the country’s hukou system of permissioned residency. With many other market-oriented reforms announced at the recent Third Plenum, economic freedom in China may be headed for further improvements. Meanwhile, equity market valuations appear to reflect the pressing, near-term issues relating to the current credit cycle. Trading at the lowest price-to-earnings valuations in the emerging market universe, save for Russia, China’s equity market may likely be buoyed by ambitious efforts to increase economic freedom— efforts, which according to the research presented here, should reward investors handsomely. Evidently, empirical analysis presented in academic journals continues to evidence that country selection is the primary determinant of an international equity fund’s excess return. To fully benefit from these findings from an investor’s point of view, differences between countries must be defined, monitored, and forecasted, and a specific focus is needed on the outlook for economic freedom. This makes particular sense when considering investing in emerging markets, where observing and analysing the disparate economic policies captured by a measure of economic freedom suggests even greater excess international equity returns.n

Will crowdfunding disrupt the mass market segment? Title III of the 2012 JOBS Act legalises equity crowdfunding for all types of investor segments, potentially unleashing a new wave of capital from mass market to ultra-high net worth (UHKW) individuals. Final regulations, however, have not been issued, and wealth managers are left guessing what the impact of equity crowdfunding will be. Given the proposed regulations, advisory firm Celent believes that equity crowdfunding is unlikely to disrupt the UHNW or venture capital markets, but will open new investment opportunities for younger and mass market individuals.

N A NEW REPORT Equity Crowdfunding: Title III and the Disruption of the Mass Market Segment, Celent provides an overview of equity crowdfunding, looking in particular at Title III, which enables equity crowdfunding for all investor classes and types. Historically, firms have issued private securities (securities not formally registered with the US Securities and Exchange Commission [SEC]) to the general public under the domain of Regulation D exemptions. Two provisions of the 2012 JOBS Act, Title II and Title III, create a paradigm for privately offering securities. Title II lifts the ban on public advertising for firms issuing securities through Regulation D. Title III deals specifically with legalising equity crowdfunding by creating an exemption that issuers can use to raise money from all classes of investors. While Title II’s regulations have been finalised and implemented, Title III remains in purgatory until the final regulations are released. While a number of online providers already act as intermediaries for start-ups to issue private securities, these platforms can only service accredited investors. Title III legalises crowdfunding for all types of investors, thus potentially opening new sources of capital for start-ups from new investors and the mass market. However, says the advisory firm, its proposed regulations are both ambiguous and stringent, creating a heavy regulatory burden.

Under Title II an unlimited amount of money could be raised from accredited investors only. Under Title III however, only up to $1m can be raised over any twelve month period from any type of investor. Issuers can however concurrently raise money through Regulation D. Existing coverage of equity crowdfunding swings between two extremes. According to Celent, reports either herald this as the end of venture capital and the democratisation of investing, or a disaster that will be stifled by poor regulations and bankrupt low information investors. The firm consequently argues that the effects will be much subtler, but important nonetheless. Additionally it provides a list of existing online platforms acting as intermediaries for start-ups seeking funding from accredited investors. Celent expects all of these platforms to take advantage of Title III once the final rules are implemented. The report provides a breakdown of opportunities for wealth managers and technology providers. Celent concludes by analysing how significant equity crowdfunding will be, and where disruption will occur. “Given the high regulatory burden and availability of other methods of raising capital, we are unlikely to see major disruption among venture capital businesses. Rather, opportunity will be found in previously underserved segments,” notes Isabella Fonseca, research manager for Celent’s Wealth Management practice and author of the report. n

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MiFID II is as important for Europe as Dodd Frank was for the US: financial institutions must establish an infrastructure that is malleable alongside evolving regulations

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IN THE MARKETS

UCITS V REMUNERATION

Photograph © Petar Zigich/Dreamstime.com, supplied September 2014.

UCITS V Remuneration: It’s time to talk about proportionality UCITS V is a done deal. The new legislation was published in the EU’s Official Journal on August 28th this year and must be transposed by the member states into national law by March 18th 2016. UCITS V amends Directive 2009/65/EC on undertakings for collective investment in transferable securities. Lydon Shay, a partner in Matheson’s Asset Management and Investment Funds group writes that while the UCITS V remuneration principles themselves are relatively stringent, “this stringency is tempered by the application of the principle of proportionality” and warms that if UCITS V’s remuneration requirements are applied without regard to proportionality, operational costs could result which would push managers “away from UCITS and towards other regulatory regimes.”

CITS V HAS a relatively narrow focus, addressing three issues: the role of depositaries; remuneration; and sanctions. However, its legislative passage proved controversial, particularly in so far as the provisions on remuneration are concerned. Most of the controversy surrounded a proposed bonus cap and performance fee restrictions (neither of which survived in the final version), but the application of the remuneration provisions to third country

managers was also an issue. As the dust settles on UCITS V, the focus is now turning to the European Securities and Markets Authority (ESMA), which is charged with drafting guidelines clarifying the UCITS V remuneration requirements. Much will depend on how ESMA approaches this task and in particular on how it interprets the concept of proportionality. In brief, UCITS V requires UCITS management companies, including self-

managed UCITS, to implement remuneration policies which respect certain principles, including principles relating to the retention and deferral of variable remuneration. They are applicable to all staff whose professional activities “have a material impact on the risk profiles of the UCITS they manage”. Generally, the UCITS V remuneration provisions reflect those contained in the Alternative Investment Funds Managers Directive (AIFMD). They also contain a number of requirements equivalent to those set out in the Capital Requirements Directive (CRD), with the notable exception of the bonus cap. While the UCITS V remuneration principles themselves are relatively stringent, this stringency is tempered by the application of the principle of proportionality. This is also the case for the remuneration requirements contained in both AIFMD and CRD. Part of ESMA’s task when drafting its UCITS V remuneration guidelines is to explain what this proportionality principle means in the context of UCITS. When doing so, in order to ensure consistency between the various remuneration requirements, ESMA must take into account its own guidelines on AIFMD remuneration policies and the work of the European Banking Authority (EBA) under CRD. While the desirability of ensuring consistency across different regulatory frameworks is self-evident, there is also a need for caution. Crucially, consistency requires not only the recognition of similarities, but also an acknowledgement of the differences between different types of investment funds and financial services. As phrased in both UCITS V and AIFMD, the proportionality principle requires managers to apply the remuneration principles,“in a way and to the extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities.” In this context there are key differences between UCITS and other types of investment funds which should impact directly on the application of the proportionality principle and as a corollary on the scope of the remuneration requirements.

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

One of these differences relates to the size of UCITS, which typically have more assets under management (AUM) than alternative investment funds (AIFs). For AIFMD purposes, ESMA has stated that where total AUM become systemically important, an AIF manager should adhere strictly to the remuneration principles. Evaluating systemic importance on the basis of AUM is generally questionable, but particularly so in the UCITS context. In this respect, the fact that UCITS are subject to a strict regulatory framework means that they are particularly unlikely to give rise to systemic risk, irrespective of their size, a consideration which ESMA should take into account when considering the application of the proportionality principle. Another difference relates to the fact that UCITS are largely homogenous and the activities carried out by UCITS managers may not differ substantially in terms of their nature, scope and/or complexity. ESMA will need to draft its guidelines so as to differentiate effectively between various types of UCITS. In addition, the assessment of complexity should be based on the inherent complexity of the relevant UCITS compared to other financial instruments and not as compared to other UCITS. Application of the latter approach would result in the imposition of a stricter remuneration regime to UCITS as compared to AIFs with an equivalent risk structure. Finally, because UCITS are highly regulated it is much more difficult for staff to have a material impact on their risk profile. In particular, UCITS are already subject to restrictions in terms of eligible assets, diversification and liquidity as well as being subject to extensive risk man-

Lydon Shay, a partner in Matheson Asset Management and Investment Funds group. Photograph kindly supplied by Matheson Asset Management, September 2014.

agement controls, including a prohibition on physical shorting and strict requirements where the UCITS utilises financial derivative instruments to implement its investment policy. Logically, this should mean that as compared to an AIF manager’s staff, fewer UCITS staff come within the scope of the remuneration provisions on a proportionality based assessment, a fact that should be reflected by ESMA in its remuneration guidelines. However it is noteworthy that ESMA recently updated its AIFMD Questions

and Answers to indicate that portfolio managers are likely to fall within the scope of the AIFMD remuneration requirements even if they are subject to a tight performance benchmark and oversight by the AIFM. Should ESMA adopt a similar approach in the UCITS context, it will result in the contradictory outcome that the various controls imposed within the UCITS regulatory framework will not be considered sufficient to prevent staff from being considered as having a material impact on the risk profile of the UCITS or its manager for remuneration purposes, despite the fact that this is the overall purpose of these controls. In conclusion, proportionality is key to the application of the UCITS V remuneration requirements which are not envisaged by the legislator as a “one size fits all measure”. The challenge facing ESMA is how to make sense of the proportionality criteria in the UCITS context and, when doing so, to ensure that UCITS are treated in a way which recognises and acknowledges the differences between them and other types of funds. It is imperative that ESMA meet this challenge. UCITS are a global brand, promoted by investment fund managers domiciled in the US, Latin America, Asia and elsewhere. While those investment managers are subject to prudential regulation in their home jurisdictions, they will not necessarily be subject to remuneration rules framed in the same way as EU requirements. To apply these requirements without regard to proportionality could result in operational costs which would push them away from UCITS and towards other regulatory regimes. n

FTSE GLOBAL MARKETS ON THE MOVE Over 2000 market professionals have now signed up via Apps to receive FTSE Global Markets on smartphones and Ipads. From September 30th if you are a sell side provider we will introduce a nominal £87.00 annual subscription fee to receive our content across all our distribution channels. Once you sign up, you can enjoy immediate access to all the ftseglobalmarkets.com content, including its 7,500 articles, blogs and features which are updated with at least 20 news stories a day and at least ten new blogs a week. If you need more information, please call Stuart Fear on +(44) 207 680 5163 or email him at stuart.fear@berlinguer.com .

FTSE GLOBAL MARKETS • SEPTEMBER 2014

COUNTRY REPORT

TURKISH BANK BORROWING RAMPS UP

In the post-election period Turkish banks exploit fund raising window It’s been a hectic start to September as a flurry of Turkish banks came to market. The latest (as the magazine went to press) was a one year dual currency-tranche syndicated loan package, worth $326m and $979m issued by Işbank on September 17th. The loan tranches were priced at Libor plus 0.9% and Euribor plus 0.95 respectively; fine pricing reflecting Turkey’s largest bank’s credit rating. The recent uptick in borrowing has been well received in the markets (of which, more later). However as Fitch Ratings pointed out in a mid-September release, the uptick in borrowing by Turkish lenders (an almost three-fold jump) has resulted in an equal uptick in the country’s external debt – over the long term

US Secretary of State John Kerry (on the right) meets Turkey's President Recep Tayyip Erdogan during Kerry's official visit at the Cankaya Palace in the capital Ankara on September 12th. Turkey is the big Muslim power that sits atop raging conflicts in Iraq and Syria, so it might be expected to take a leading role in the NATO coalition announced this month to take on the Islamic State group. Instead it told allies that it would stay quietly behind the scenes, keeping its soldiers out of combat operations and even declining to allow NATO to use its bases or territories to launch air attacks. Turkey’s enhanced political clout right now is based on the geopolitical understanding that it sits atop raging conflicts in Iraq and Syria. It had been expected that it would take a leading role in the NATO coalition announced this month to take on the Islamic State group. Instead it told allies that it would stay quietly behind the scenes, keeping its soldiers out of combat operations and even declining to allow NATO to use its bases or territories to launch air attacks. Photograph by Kayhan Ozer for Anadolu Press Agency. Photograph is provided by pressassociationimages.com, September 2014.

NVESTORS HAVE BEEN peachy keen on Turkish debt of late; particularly bank debt. Good job too, given issuance volumes in the month. Turkey has the sixth largest local currency bond market among high growth markets, with

some 23 US dollar issues outstanding worth a combined $44.5bn; six issues in euros, worth in total year to date €7.75bn; three issues denominated in Japanese yen, worth a combined ¥370bn and some 52 TYR denominated issues, worth just

over TYR388.2bn as of mid-September. Işbank’s syndicated loan, to fund trade deals, was backed by as many as 51 banks from 22 countries and will be used for financing international trade. Trade financing is the mainstay of activity backing the utilisation of the eurobond and global capital markets by Turkish financial institutions. The syndicated loan came to market even as the Turkish Treasury sold down a TYR1.3bn in 427day zero-coupon government bond sale at an annual compound interest of 9.22% and a one year JPY100m bond arranged by Daiwa Securities, Mitsubishi UFJ Securities International and SMBC, with a coupon of 1.05% and a yield at pricing of 1.05%. Türkiye Ihracat Kredi Bankasi (aka Turk Eximbank) also came to market midmonth with a $200m, seven year, bond, at an initial issue price of 99.493 and a coupon of 5%. Managers of the issue included Barclays Capital, Citigroup, JP Morgan and Mizuho Financial Group. The bond was listed on the Irish Stock Exchange. The coupon on this issue was slightly lower than a similar seven year transaction which the eximbank brought to market at the end of the first quarter this year (rated Baa3/Negative by Moody’s), also worth $200m, which was priced at 98.927, with a coupon of 5.875%. That deal was arranged by Barclays Capital, Citigroup, ING and Standard Chartered and was traded on the UK and the German exchanges. Impending transactions by the issuer

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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COUNTRY REPORT

TURKISH BANK BORROWING RAMPS UP

Archive photo from March 2012 when Turkish president Tayyip Erdogan, left, was still in the job of prime minister of Turkey and Central Bank governor Erdem Basci. Both are pictured displaying the symbol for the national currency, the Turkish lira (TYR), in Ankara. Photograph provided by pressassociationimages.com, September 2014.

include an unsecured medium note program from national export credit provider). Fitch Ratings has given the notes an expected rating of BBB-(EXP), in line with the export credit provider’s foreign currency long-term issuer default rating (IDR), and because the Eximbank is a state-backed institution is also linked with the Turkish sovereign's foreign currency Long-term IDR (BBB-/Stable) rating, reflecting its ownership (100% state-owned) and status as the country's official export credit agency. The notes are not guaranteed by the Turkish Treasury. However, the eximbank’s credit expansion targets, policies and objectives are defined by Turkey's Supreme Advisory and Credit Guidance Committee (SC), chaired by the Prime Minister and including high-level government officials and so the credit rating agency clearly assumes the state would step in if needed. Fitch is less concerned with the eximbank than it is with the level of Turkish bank lending at large; a fact which has butted the ratings agency (together with Moody’s) up against the country’s

president. Fitch points out in a recent paper that lenders’ borrowing has jumped by almost threefold and is a “main driver of the eye-catching rise in the country’s external debt”. According to figures provided by the agency, between the end of 2008 and the end of the first half of 2014, local banks’ foreign borrowing rose to $164bn, marking nearly a threefold jump. This [has] pushed the country’s total external debt to 38% from 20% some six-and-ahalf years ago, and banks have accounted for 71% of the increase in Turkey’s foreign debt over the period. Even at the short term end, the pace of increase has not abated, even in a summer where presidential elections dominated the political agenda and most banks appeared to retreat into a shell until the results were finalised. According to the latest data from the central bank Turkey’s short-term external debt stock increased 0.7% from the end of 2013 to $130.2bn (about €100m) at the end of July. The underlying concern of the ratings agency appears to be based largely on the possibility of a force majeure event that

could adversely affect the liquidity of the banks and push them back squarely on the resources of the central bank. The ratings agency warns this situation“leaves them [lenders] more vulnerable to extreme stress involving an abrupt and prolonged market shutdown.” The agency explains: “A sudden and prolonged foreign market closure would put significant pressure on banks’ foreigncurrency liquidity, particularly as there are potential constraints on the Central Bank’s ability to make available additional foreign currency beyond that placed under the ROM [reserve option mechanism]. The central bank would be likely to face several other claims on its limited reserves in a stress scenario, including servicing of corporate and sovereign external debt, outflows of portfolio investments and financing of the current account deficit.” Essentially, concern hangs around the expected end to cheap money due to tapering in the US Federal Reserve’s quantitative easing program, combined with a lower Turkish growth rate. That would cap any exuberance in bank borrowing.“Other aspects of banks' credit profiles would probably also weaken if Turkey's external liquidity tightens significantly. Capital ratios would be likely to fall, asset quality deteriorate and profit margins shrink for all banks, not just the ones that have borrowed extensively from abroad. This may also increase pressure on bank ratings,” suggest Fitch analysts. Moody's, which has a Baa3 rating on Turkey with a negative outlook, warned last month that Erdoğan's victory in the presidential election did not resolve the country's credit challenges and that uncertainty would persist over the medium term. It might also have an unwelcome knock on effect of a [currently] finely balanced corporate sector. Turkish corporations tend to look to local commercial banks for their financing, rather than bond markets or investment banks, which in turn puts pressure on local financial institutions to lend to the corporate sector. Turkish diversified group Net Holding’s

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

COUNTRY REPORT

TURKISH BANK BORROWING RAMPS UP

planned TYR600m domestic bond offering this month, typifies the trend. At the larger end of the market Turkey's white goods maker and consumer electronics manufacturer Arcelik reported in mid-September that it sold €350m ($453 million) in seven-year bonds to“qualified investors on the international markets”; signifying growing confidence among the country’s larger corporations to bypass the domestic bond market. In turn, it has little recourse but to borrow from the Euromarkets, where they have been able to raise competitively priced funds (available in part because of the quantitative easing programs of the ECB and the US Federal Reserve Bank). While the ECB looks to continue its programme over the near to medium term, the situation is more fluid in the US where the Fed is clearly looking for ways for QE to come to an end. Equally, internal factors may trump external trends: Turkey’s growth rate which is currently projected to come in at around 3.5% this year, signifies something of a slowdown, compared with expectations early in the year that the country would deliver growth in excess of 5% by year end. With that in mind, the glut of borrowing in September is likely to begin to peter out by year end to more conservative levels. Other economic indicators support the ratings agencies’ concerns. Turkey reported a budget deficit of TYR2.7bn ($1.2bn) in the first eight months of the year, compared with a budget surplus of TYR231m a year earlier, according to a recent statement from the ministry of finance. Moreover, Turkey's unemployment rate measured as a three-month average stood at 9.1% in the May-July period, up from 8.8% in three months through June, the Turkish Statistical Institute has noted. These considerations and the increase in external debt were some of the factors leading to the downgrade of Turkey's three largest domestic privately owned banks to 'BBB-', the same level as the sovereign, in June, a fact which did not escape either the notice or the ire of the president who, according to local press

reports, mumbled darkly about statements from the ratings agencies were "politically motivated" rather than based on assessments of the economy. "We stopped our cooperation with Standard & Poor's and if they continue on this path, I can tell the prime minister to stop cooperation with these two also. We haven't reached that point yet," leading daily newspaper Hurriyet quoted the president. The ratings agencies remain unconcerned. As Standard Poor's pointedly noted last year it had failed to reach a deal to offer a full rating for Turkey and would only issue "unsolicited" assessments - meaning it is not paid by Turkey to provide coverage but does so anyway to meet investor needs. Ultimately, Fitch’s position is a stress scenario and not one that seems to overly concern investors right now, which look to be reappraising Turkish risk. Clearly, investors don’t like uncertainty and over the quiet summer months very little happened of note. Once the presidential elections were out of the way and the cabinet appointed to run the country looked to be populated by economically competent technocrats, the banks and the country returned to the debt capital markets with alacrity. That concern can only increase over September as the country’s lenders look to be on a borrowing spree. Mid-month Garanti Bank sold TYR106.6m (about $48.2m) worth of non-performing loan portfolio receivables for TYR18.7m, while Denizbank reportedly applied the for regulatory nod to issue TYR200m (about $90m) in bonds with varying maturities. Separately, Finansbank placed privately TYR97.4m (circa $44m) in 87-day discounted bonds. The range of issuance was also varied. Aktif Yatirim Bankasi (Aktif Bank), for instance, issued $50m worth of 724-day bonds in lease certificates (sukuk) to qualified investors. Also coming to market in a more esoteric transaction, the asset lease unit of Turkish Islamic bank Türkiye Finans, says it will issue MYR150 m [Malaysian ringgits, equivalent to around $47m] in lease certificates, or sukuk,

maturing in up to five years. EBRD revises upwards its forecast for growth: The EBRD has revised up its forecasts for economic growth in Turkey for 2014, following a stronger-thanexpected performance so far this year, which the development banks says is driven mainly by rising exports and also supported by a reduction in central bank interest rates. The bank is predicting growth of 3% in 2014, compared with a forecast of 2.5% in May. It left its forecast for 2015 unchanged at 3.2%.The EBRD’s latest economic report warns however that Turkey’s export-driven growth may be muted later in the year because of increased tensions in Iraq, which is Turkey’s second largest export partner, and also because of still shaky growth in the EU. It also says the central bank’s easing cycle would continue with caution, if at all, as inflation remained high, at 9.5 per cent in July, well above a target of 5%. According to Turkstat, unemployment rate edged up to 9.1% in May-Jul from 8.8% the three months between April and June. Non-farm unemployment also increased to 11.1% from 11.6% in March. Meanwhile, according to Mehmet Besimoglu, at Oyak Yatirim Research, in seasonally adjusted (SA) terms- unemployment increased to 9.9% from 9.5% in May. This is the third consecutive rise in SA unemployment and highest level since January 2011. “Despite the rise in domestic political volatility in 2014 and the rate hike by the central bank in January, SA unemployment had been stable at around 9.1% in 1Q14. Nevertheless, due to a slow-down in private consumption led by macro-prudential measures and deceleration in public spending after the local elections; 2Q GDP growth slowed down to 2.1% from a revised 4.7% in 1Q,” he says. Similarly, 2Q SA unemployment increased to 9.5%. July IP figures were also in negative territory. Calls for further rate cuts to the CBT from certain cabinet members also confirm this trend, yet the weakness in TRL reduces the likelihood of monetary easing. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

COUNTRY REPORT

BAHRAIN: LEADING THE GCC IN ISLAMIC FINANCE?

For the second year in a row, Bahrain has been named the Gulf Cooperation Council (GCC) countries leading Islamic finance market and second out of 92 countries worldwide, according to the ICD-Thomson Reuters Islamic Finance Development Indicator (IFDI). Bahrain was also ranked as having the best governance in Islamic finance in the world, with the report praising the well-established regulatory framework covering all sectors, and high levels of disclosure.

Bahrain leads the GCC pack in Islamic finance

The IFDI report, which was released in early September at a panel session at the Global Islamic Finance Forum (GIFF 2014) in Kuala Lumpur (Malaysia), is the only numerical measure representing the overall health and development of the Islamic finance industry worldwide. The IFDI is a measure of five components (including quantitative development, governance, corporate social responsibility, knowledge and awareness) that, say the report, in combination depict the picture of Islamic finance in 92 countries. In some ways it is belated recognition of the long standing work that Bahrain’s central bank has done over the years, through the extension of its financial rulebook in describing a comprehensive set of principals governing the structuring of Shari’a compliant securities that is on a par with Malaysia. Although Saudi Arabia has moved along the same path in recent years, the sheer depth of the CBB rulebook on Shari’a compliant securities puts it in a clear lead, at least in the context of the GCC. “In 2001, the Central Bank's predecessor, the Bahrain Monetary Agency, played a leading role in the development of regulatory regimes for the workings of Islamic financial institutions for more than two decades and contributed to the introduction of sharia-compliant products and became the first central bank in the world to develop and issue sukuk,” explains Rasheed Al Maraj, governor of the Central Bank of Bahrain (CBB). The central bank itself is a leading issuer of Islamic securities. A regular issuer of short term Islamic leasing bonds,

Bahrainis wave national flags during a protest march against the government in Sitra, on September 12th this year. Photograph by Hasan Jamali for AP Photo. Photograph provided by pressassociationimages.com, September 2014.

known as Sukuk Al-Ijarah, it has built a loyal following of investors. Its latest issue in early September was oversubscribed by 335%. Subscriptions worth BHD67m were received for the BHD20m issue, which carries a maturity of 182 days. The expected return on the issue, which began on September 18th and matures on March 19th next year, is 0.80 % compared to 0.77% for the previous issue which was released in mid-August. The nomination was a welcome fillip for a jurisdiction which has kept its light hidden under a proverbial bushel for most of this year. The sovereign has led the charge with a return in September to the international capital markets with a $500m 30 year bond. Certainly Bahrain has not had much to celebrate of late:

political unrest which erupted back in 2011 has resulted in subdued growth in the intervening years. Last year marked something of a recovery, with a relatively healthy 5.3% uptick in GDP (propelled in large part by the energy segment; the non-oil sector put in a disappointing 3% growth rate), though this year the momentum seems to have faded a little, and GDP is expected to grow by 4.7% over the year. However, according to the country’s Economic Development Board (EDB), the non-oil sector is gathering pace. The transportation and communications sector grew 4.4%, hotels and restaurants 5.9% and retail 3.3% in the first quarter of the year, according to recent figures issued by the agency. The government has put money and its hopes into infrastructure investments, with spending on housing, utilities and education estimated at $3.4bn over the next three years, with an additional investment in infrastructure over the period worth up to $10bn from the GCC Development Fund. Around ten project tenders have been awarded to date. Among them is the $5bn King Hamad Causeway linking Saudi Arabia. The King Fahd Causeway Authority is also set to complete a Saudi-Bahrain rail study by September 2014. The country’s trade and current account balance have remained positive, but volatile in the past few years, as high debt levels have increased as the country has remained vulnerable to oil price fluctuations. The fiscal balance has been negative since 2009 and stood at a deficit of $2.2bn last year, which analysts expect to widen this year as oil revenues remain flat even in the face of increased political risks in the Gulf region. The government is working to reform its finances, but faces resistance to cuts in welfare payments amid continued domestic political tension, which flares up regularly in the capital. Until the government finds a long term political solution to the demands of Bahrainis for more political and greater economic freedoms, all the work that the government and state institutions put in place to cement the country’s financial standing is undermined. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

COUNTRY REPORT

LEBANESE PROPERTY MARKET SEARCHES FOR CONFIDENCE SIGNALS

Commercial realty weighed down by regional instability Local political tensions and occasional security drifts have anchored a wait and see attitude among investors in Lebanon’s sorely tested real estate segment, according to Bank Audi’s annual real estate review. The real estate sales value in the country fell by 2.4% last year, from a low base before rising by 9.7% between January and July, after which time values began to slip as the region’s geopolitical tensions continued to mount. Even so, thinks Bank Audi, there’s value to be had for seasoned investors.

HE RESIDENTIAL SEGMENT in Lebanon’s fluid real estate segment continues to account for the bulk of market activity, driven says Bank Audi in its seminal annual report on the country’s real estate market, by a genuine need for a residence rather than capital gains. The share of Beirut in total real estate sales over the year to date has consequently increased by 29% compared with the increase (25%) registered over the same period a year ago. Real estate is still seen as one of the most lucrative businesses in Lebanon despite the slight fall in sales and rents in the past two years due to political deadlock, the spillover of the Syrian crisis into Iraq and neighbouring countries and a general economic slowdown in the country. In contrast the volatile regional political situation has impacted more on the commercial property side, which has witnessed a deceleration in demand for retail spots on behalf of companies operating locally and, in particular, office space. Although some property owners have remained rigid in terms of prices for corporate rentals, the majority have bowed to the inevitable and have begun readjusting rents to the downside, says the bank. Foreigners, particularly those coming from GCC countries, which used to purchase residences in Lebanon with alacrity have continued to shy away from the market over the last couple of years. According to figures issued by local property agency Plus Properties, foreign acquisition of property in Lebanon

Lebanese Prime Minister Tamam Salam, right, meets with UNDP Administrator Helen Clark, centre, and UNHCR’s Antonio Guterres, left, at the government palace, in Beirut, Lebanon, on Wednesday September 17th. Photograph by Hussein Malla, an AP Photo, provided by pressassociationimages.com, September 2014.

accounted for a meagre 5% of total demand last year and has plummeted by a further 20.3% over the period of the Bank Audi study. Real Estate has become a buyer’s market. According to a study published in August by Ramco Real Estate Advisors covering the Beirut realty market, as many as 277 new apartments built in 2013 were not sold by year end (an increase of 27% on the number of new apartments remaining unsold in 2012). Nonetheless, prices remain sufficiently high in central Beirut as to encourage potential buyers to look at upcoming suburbs and outlying areas such as Metn and Kerouan, which have benefited from a number of expansive real estate developments over the last few years. The central bank has tried to introduce

stimuli both last year and this to support the real estate segment through a system of subsidised loans. Commercial banks have also been active in lending to the real estate segment, with total loan exposure through 2013 rising by at least $1.3bn, according to recent statistics issued by the central bank, with the total housing loan portfolio held by banks in totality topping $8.5bn at the end of last year. Given the trends, it should come as no surprise that the number of construction permits has also fallen, measured in square metres, which Bank Audi says is more a reflection of a growing demand for smaller sized properties, especially in the residential segment. In contrast, construction permits per se rose by 9% between January and June this year (according to statistics from the Order of Engineers of Beirut and Tripoli). Positive news for the capital is that Beirut has witnessed a net increase in new construction permits through 2014, compared with a decline in the previous three years, accounting for 9% of the total permits issued so far this year. Bank Audi’s report stresses that the scarcity of land in Lebanon is one of the main factors which pushes up prices of properties.“One should not forget that the scarcity of land in the small country that is Lebanon is an undeniable factor that provides promising prospects for realty prices in the long term. The outlook for property market activity and prices thus remains, now more than ever, tied to the evolution of the security and investment climate in the country, and there are quite a few uncertainties in this respect.” Lebanese Prime Minister Tamam Salam, right, meets with UN Development Program Administrator Helen Clark, centre, and United Nations High Commissioner for Refugees (UNHCR) Antonio Guterres, left, at the government palace, in Beirut, Lebanon, on Wednesday September 17th. Guterres and Clark were visiting Lebanon to obtain a better understanding of the impact of the Syrian crisis in Lebanon, which hosts more than a million Syrian refugees, and discuss with authorities and donors the current response. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Grow Beyond Y Your our Potential

DEBT REPORT

NEW ISSUERS ENTER THE SHARI’A FINANCING SEGMENT

Hong Kong's Financial Secretary John Tsang speaks to the media during a news conference after delivering his budget speech in Hong Kong Wednesday, Feb. 26th this year. Hong Kong's finance chief forecasted that the economy of the Asian financial centre could grow up to 4 percent this year after expanding 2.9% last. For this article, Tsang also commented on Hong Kong’s debut sukuk earlier this month. Photograph by Kin Cheung for AP Photo. Photograph provided by pressassociationimages.com, September 2014.

Sukuk issuance rises as governments vie for influence The value of new sukuk issues this year is treading ahead of 2013, with some $86bn worth of deals, compared with $75bn this time last year, although the volume of transactions is down by more than 22% from 588 last year to around 460 deals according to Gulf publisher Zawya. Overall, both volumes and issue values remain small beer compared with traditional bonds, but there is a noticeable groundswell of new issues in the pipeline. Moreover, western markets look keener to get in on Shari’a finance, with Hong Kong the latest sovereign to come to market.

FFERINGS OF SUKUK worldwide have been steady this year, climbing to $32.1bn so far this year, compared with $43.1bn for the whole of 2013, but still off the record set in 2012 of $46.5bn compiled by Bloomberg. Sales from the six-member Gulf Coopera-

tion Council, which includes Saudi Arabia, the United Arab Emirates and Kuwait, represent 37% of the total, with Malaysia still accounting for the lion’s share of issuance. Meanwhile, Moody’s estimates that total sovereign sukuk outstanding now accounts for more than 36% of the $296bn

of outstanding sukuk as of July 2014. Moreover, it expects sovereign sukuk issuance will exceed 2013 levels to reach around $30bn by year-end, with the overall outstanding amount to reach $115bn. Following the UK government’s debut issuance of sukuk in early July this year, the segment has enjoyed something of a fillip. Reuters reported in early September that Goldman Sachs is revising plans to raise a projected five year $500m wakala sukuk. At the time of going to press representatives of the bank were in the Gulf meeting with potential investors. The last time a western bank issued sukuk was in 2011, when HSBC debuted in the segment with a $500m term bond. If it goes ahead it will be the bank’s second effort in the segment. Its first, at $2bn sukuk was mooted to be listed on the Irish stock exchange back in 2011, but in the event it never got off the ground. The assets underlying the bank’s planned sukuk issue are reported to be linked to commodities and crude oil. The sukuk is expected to be issued through a vehicle called JANY Sukuk Co and be guaranteed by Goldman Sachs and will be listed on the Luxembourg Stock Exchange. Abu Dhabi Islamic Bank, Emirates NBD, National Bank of Abu Dhabi and the investment banking arm of Saudi Arabia's National Commercial Bank appear to be the local banks involved in raising investor interest in the structure, according to local press reports. Elsewhere, both Societe Generale and Bank of Tokyo Mitsubishi are also preparing wakala sukuk issues in Malaysia, still the world’s largest Shari’a finance market. A Wakalah sukuk is structured around an agency contract whereby investors appoint an agent to invest on their behalf. Profits and losses are shared between investors while the agent is paid an agency fee by the investors. For all the brouhaha about the wider adoption of Shari’a compliant bonds, Malaysia still continues to set the pace. In early September, Khazanah issued, via Cahaya Capital Ltd, its Labuan incorporated independent special vehicle, a $500m mudarabah and murabahah seven year put

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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DEBT REPORT

NEW ISSUERS ENTER THE SHARI’A FINANCING SEGMENT

4 exchangeable sukuk priced at negative yield. The sukuk is exchangeable into ordinary shares of Tenaga Nasional Berhad (TNB), Malaysia’s largest electricity utility company. Khazanah is the strategic investment fund of the Government of Malaysia entrusted to hold and manage the commercial assets of the Government and to undertake strategic investments. Khazanah has undertaken repeat issuances of Islamic securities since its inaugural issuance of sukuk exchangeable into Telekom Malaysia Berhad (TM) shares back in 2006. Khazanah has offered five other exchangeable sukuk before this one (into TM, Axiata Group Berhad, PLUS Expressways Berhad, Parkson Retail Group Ltd. and IHH Healthcare Berhad shares). This issue is different because it is the first exchangeable sukuk structured based on the combined Islamic principles of Mudarabah and Murabahah, while Khazanah’s past issuances were based on Musyarakah and Wakalah structures. For clarity’s sake mudarabah is a profit sharing agreement between an investor and an entrepreneur whereby the investor supplies capital and the entrepreneur supplies expertise in a venture. Profit is shared between the investor and entrepreneur at a predetermined ratio while losses are borne solely by the investor. Murabahah is a profit margin contract whereby the seller of the asset sells to the buyer at cost plus a mark-up. Musyarakah is a partnership with two or more capital-contributing partners in a business venture. The risk and rewards are shared proportionately based on each partner’s capital contribution. Managing director of Khazanah, Tan Sri Dato’ Azman Hj Mokhtar says the sukuk reflects “Khazanah’s fund-raising strategy and long term commitment towards a progressive divestment of its investments. The issuance sets a benchmark for exchangeable sukuk offerings, providing future issuers with greater options to access a wider pool of investors. It also supports the Malaysia International Islamic Financial Centre’s (MIFC’s) initiative and reinforces Malaysia’s status as an international mar-

ketplace for sukuk offerings and leader of Islamic finance”. The sukuk will be listed on the Singapore Stock Exchange, Bursa Malaysia (under the exempt regime) and Labuan International Financial Exchange. TNB is the largest electricity utility provider in Malaysia and a leading utility company in Asia, with a customer base of approximately 8.4m in Peninsular Malaysia, Sabah and Labuan and is already listed on the main board of Bursa Malaysia. The sukuk, priced through an accelerated book-building process is priced at a -0.05% yield to maturity with a 15% exchange premium. The transaction drew a demand of 1.6x book size. CIMB, Deutsche Bank and Standard Chartered Bank are the joint book runners and joint lead managers.

Sovereign issuers The Hong Kong Monetary Authority (HKMA) raised $1bn in a five year debut sukuk from 120 institutional investors on its first offering of a sovereign sukuk, the Islamic equivalent of a bond, on September 11th. It is the first USD-denominated sukuk originated by an AAArated sovereign. The Sukuk was assigned credit ratings of AAA by Standard and Poor’s and Aa1 by Moody’s. Following a global roadshow that kicked off at the start of September, covering Riyadh, Dubai, Abu Dhabi, Doha, Kuala Lumpur, Hong Kong, Singapore, London and New York, the Rule 144A/Reg S USD sukuk was priced on September 10th at 2.005% (equivalent to 23 basis points [bps]over five year US Treasuries). The Sukuk saw strong demand from global investors, attracting orders exceeding $4.7bn and recording oversubscription of 4.7 times, allowing final pricing to tighten by seven bps from its initial price guidance. Pricing at a spread of 23bps over the corresponding yield of US Treasuries represents the tightest spread ever achieved on a benchmark USD issuance from an Asian (ex-Japan) government, setting an important new benchmark for Hong Kong and the rest of Asia. Almost half, or 47%, of the available debt was issued to

investors in Asia with a further 36% issued to investors in the Middle East, according to the official announcement by the HKMA. Investors were primary banks and private banks, sovereign wealth funds, central banks and 'supranational' companies, although 11% of the debt was purchased by fund managers and 3% by insurance companies. The issue was made possible by a legislative change in July 2013 which created a similar taxation framework for sukuk issuances to that for conventional bonds. The Hong Kong legislature then approved a bill in March this year that opened the door for the government to issue sukuk. Hong Kong's sukuk uses an Ijarah structure, under which investors receive a share in the agreed rental income of an underlying asset. The sukuk is underpinned by selected units in two commercial properties in Hong Kong, and has a maturity of five years. The sukuk was issued by a special purpose vehicle, Hong Kong Sukuk 2014 Limited, established and wholly owned by the HKSAR Government and is expected to be settled on September 18th. The sukuk is listed on the Hong Kong Stock Exchange, Bursa Malaysia (Exempt Regime) and NASDAQ Dubai. HSBC and Standard Chartered Bank acted as joint global coordinators, joint lead managers and joint book runners, and CIMB and National Bank of Abu Dhabi PJSC acted as joint lead managers and joint book runners for the offering. “We are pleased to see such strong demand for the HKSAR Government’s inaugural sukuk, as evidenced by the significant order book size and tight pricing,” noted John C Tsang, the Financial Secretary of Hong Kong. “The success of this transaction demonstrates that issuance of sukuk using Hong Kong’s platform is a viable fund-raising option and widely accepted by investors around the world. I hope that the sukuk issuance will catalyse the further growth of the sukuk market in Hong Kong by encouraging more issuers and investors to participate in our market.” Somewhat late in the day, both Hong Kong and the United Kingdom are both

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Indonesian President Susilo Bambang Yudhoyono, centre, sits with United Nations Secretary-General Ban Ki-moon, right, and East Timorese Prime Minister Xanana Gusmao during an opening ceremony of the United Nations Alliance of Civilization (UNAOC) meeting in Bali, Indonesia, Friday August 29th this year. Photograph by Firdia Lisnawati for AP Photo. Photograph provided by pressassociationimages.com, September 2014.

vying to become Shari’a-compliant hubs in a market with $2trn of Islamic banking assets. The city is the fourth Asian issuer of sovereign sukuk, following Malaysia, Indonesia and Pakistan, while Luxembourg and South Africa are reportedly planning inaugural sukuk sales this year. Moody's expects many new Islamic and non-Islamic sovereign issuers to continue to enter the market. Since 2001, 16 governments have issued sukuk instruments, motivated by their own financing needs and strategies. However, in addition to Hong Kong, South Africa and most recently Sharjah, at least eight other governments, including Luxembourg, Morocco, Tunisia, Egypt, Jordan, Oman, Bangladesh and Kenya, have expressed firm intentions to issue sukuk in the short to medium term. Countries such as Australia, the Philippines, Russia, Azerbaijan, and South Korea have shown moderate interest in the sector, but are unlikely to issue in the near term. Certainly from recent sovereign issues, there appears to be pent up investor demand for the asset. For example, Indonesia sold a ten-year $1.5bn dollar sukuk in early September that attracted

FTSE GLOBAL MARKETS • SEPTEMBER 2014

$10.23bn worth of bids (6.82 times the value of bonds on offer). The Baa3 rated debt (by Moody’s) was issued at a coupon of 4.35% and yielded 4.27% on launch. "Malaysia and more recently Indonesia have been driving the growth in sovereign sukuk with sales in their domestic markets," notes Christian De Guzman, a Moody's vice president and senior analyst. "Together the two countries account for around two thirds of total sovereign issuance as of July 2014 and the remainder of cross-border/international sukuk were offered by a wide array of sovereigns." he says. Moody's Investors Service says the strong growth momentum in the sovereign sukuk market should be sustained, as both Islamic and non-Islamic governments aim to tap increased demand for Shari'acompliant financial assets. The ratings agency also expects demand and liquidity in the market to improve as the sector attracts more global investors. Moody's analysis is in contained a September report Sovereign Sukuk: Issuance Rises as New Governments Enter Islamic Capital Markets. "The year 2014 has become a landmark year for sovereign sukuk, with

the UK issuing its inaugural sukuk, and with Hong Kong and South Africa expecting to conclude sales in September 2014. All three are major non-Islamic countries, and the transactions indicate a significant change in the potential size, depth and liquidity of this market," highlights Khalid Howladar, Moody's global head for Islamic Finance. In the UAE, the governments of Dubai, Abu Dhabi and most recently Sharjah continue active in the international sukuk market, driven by the US dollar currency peg, large financing needs and leverage appetite. However, given the state dominance of the economy, the majority of issuance has been from governmentrelated borrowers. These issuers collectively lead international issuance globally with over $26.8bn of sukuk outstanding and have attracted substantial global investor interest, thinks Moody’s. They have also stretched as far as possible the application of the principles of Shari’a financing. The government of Dubai led the charge early this year, with a $750m listing of its 15 year sukuk on the Dubai Financial Market (DFM) which is traded on the exchange’s OTC platform and trades in the security are settled through Clearstream and Euroclear, not DFM. It is a trend likely to continue. As Howladar explains: “While direct sovereign borrowing represents only $5.2bn of the total, the proportion of sukuk versus conventional issuance is rising. And similar to other GCC sovereigns, this trend is likely to continue given the Dubai government’s explicit ambition to become the centre of the Islamic economy [sic].” In Qatar, he explains the government has developed a sovereign sukuk yield curve by issuing large, long-term paper to support its Islamic finance policy goals and provide local Islamic banks with a liquid supply of Sharia compliant investments. Despite the small size of its domestic capital market, Qatar’s government is actively helping to deepen the sukuk portion of that market. Shari’a compliant issuance has also been adopted by NGOs, such as the International Finance Facility for Immunisation

REGIONAL REVIEW

NEW ISSUERS ENTER THE SHARI’A FINANCING SEGMENT

Co (IFFI), for which the World Bank acts as treasury manager, which says it has picked four banks for a potential US dollar-denominated sukuk. Rated AA by Standard and Poor's and AA+ by Fitch. IFFI has mandated Qatar's Barwa Bank, National Bank of Abu Dhabi, the investment banking arm of Saudi Arabia's National Commercial Bank, and Standard Chartered to arrange investor meetings in the Middle East, Europe and Asia. "Investors' growing comfort with relatively complex Islamic instruments, the increasing financing needs and leverage appetites of some Muslim countries, as well as a desire for stronger investment links with the faster growing economies in the Gulf and Asia are driving this growth," explains Howladar. Moody's also highlights how increased

international issuance will continue to attract global investors and improve the depth and breadth of this relatively new sector. The dollar-pegged economies in the Gulf will drive an increasing proportion of cross-border, hard currency sukuk issuance and attract more global investors. As they become more comfortable with this asset class, it will support their search for yield and portfolio diversification and their increased participation will improve demand and liquidity in the market. “The entrance of new issuers will support growth in sovereign sukuk, and increasing volumes — particularly from those of high credit quality governments — will help attract new investors to the sector and provide additional depth and liquidity to the sukuk markets,” says Christian De Guzman, a

Moody’s vice president and senior analyst. In Saudi Arabia quasi sovereign issuers drive strong domestic market growth. Corporations in Saudi Arabia issued a record SAR39.4bn ($10.5bn) of sukuk in 2013. This strong flow continued in 2014 with another $10.3bn issued between January and July this year. “We expect the Saudi sukuk market to continue to grow, holding its place as the second largest sukuk market after Malaysia. The record issuance was driven by strong investor demand, strong demand from local banks deploying their excess liquidity, increased financing opportunities with respect to the country’s largescale infrastructure projects and large quasisovereign benchmark issuances that have helped to set a yield curve in the country,” says Howladar. n

NEW RULEBOOK FOR SWIFT MT MESSAGES FOR ISLAMIC FINANCE SWIFT, in collaboration with The Association of Islamic Banking Institutions Malaysia (AIBIM) and the Malaysian Islamic financial community, say they will launch a new rulebook for the usage of SWIFT MT messages for Islamic finance.

HE SWIFT ISLAMIC Finance Rulebook will be available to the Message User Group (MUG) by the end of 2014. The MUG is a group of users that have registered to use specific messages within a controlled user community. The MUG is open to all markets, globally, that wish to utilise financial messaging compliant with practices in the Islamic finance industry. It is available for Islamic Finance practice covering all FIN MT messages. The MUG also acts as a good registration mechanism for adherence to this Islamic Finance Rulebook and enforces processing of messages in accordance with the Islamic Finance practice The rulebook will provide greater clarity around SWIFT MT message usage based on Islamic principles in order to enable straight-through processing (STP),“thereby improving efficiency as well as reducing risk and cost. It will provide an efficient platform for exchanging Islamic finance messages and further promote the usage of message standards,” explains the official release by SWIFT on the announcement.

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

"Globally, the growing interest in Islamic finance as a viable alternative to conventional finance has heightened awareness of the need to adopt international standards to automate paper-based Islamic finance operations," says Kiyono Hasaka, standards specialist, Asia Pacific at SWIFT. "With SWIFT's growing presence in Southeast Asia, we are well positioned to act as an enabler to bring the financial communities together, define market practice and automate Islamic finance processes using international messaging standards." SWIFT has been operating in Asia Pacific for over 30 years, starting in Hong Kong and Singapore. Since 2005, SWIFT has

opened three additional sales and support offices in Asia, bringing the total number of offices to nine across the region. This includes a Control Centre in Hong Kong and a new corporate services hub that opened in Kuala Lumpur last year. Since it opened the control centre, the SWIFT Asia Pacific Standards team has been working in close cooperation with the Malaysian Islamic financial community to develop STP-enabled financial messaging specific to the requirements of Islamic financial institutions. In 2010, SWIFT published the Murabaha Message Usage Guidelines describing the usage of MT messages for Treasury Murabaha, which includes a money transfer and a commodity trade, typically involving two banks and two brokers. "This initiative marks a significant development in furthering the level of efficiency for Islamic finance transactions particularly, in ensuring compliance to Shariah requirements," saysYusryYusoff, executive director of The Association of Islamic Banking Institutions Malaysia (AIBIM). n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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FACE TO FACE

FACE TO FACE WITH CHRISTIAN DARGNAT, PRESIDENT, EFAMA,

The fine balance between regulation and business needs The European Fund and Asset Management Association (EFAMA) represents some 27 member associations and 62 corporate members, which combined hold almost €17trn in assets under management (AUM). Of this, around €10.2trn is managed by 55,000 investment funds (as of the end of the first quarter this year). Just over 35,600 of these funds were Undertakings for Collective Investments in Transferable Securities (UCITS) funds. Acting as a representative of the buy-side, EFAMA regularly takes positions on a broad range of capital markets issues with the overall objective to promote market transparency and liquidity, two essential conditions to protect market integrity as well as the longterm interests of end investors. We spoke with EFAMA’s outspoken president Christian Dargnat about the overarching trends and interests of the industry. FTSE GLOBAL MARKETS: The scale of the regulatory change running through the European market is unprecedented. Does it present an opportunity, or threat? CHRISTIAN DARGNAT, PRESIDENT, EFAMA: Two key threats to our industry are over-regulation and the lack of a level playing field. The complexity of the current regulatory program means we are facing a long and costly process of compliance. The creation of a level playing field is essential to securing fair competition between bank, insurance and asset management products, and reducing investor confusion. As investors, the asset management industry is part of the solution to the threats facing our economy and not a contributor to its problems. Companies are calling for sustainable, long term financing solutions and the asset management industry is ideally placed to fulfil this requirement. The fund management industry is in a position to find alternative ways of financing the gap left by the [traditional] bank model. Additionally, European citizens are

suffering from a mis-allocation of their savings to non-risky and short term products. The fund industry can step in and provide access to capital markets for all investors; and we can offer long term, robust, transparent, liquid diversified and cost-efficient products. This Presidency will ensure that EFAMA has a strong and credible voice at EU level, representing the voices of all our members and ensuring the protection of the final investors. FTSE GLOBAL MARKETS: How seriously is investor safety taken at EFAMA and across the fund industry? CHRISTIAN DARGNAT: The fund industry offers viable long term solutions to the benefit of savers and the economy. Asset management should be identified as the long term investor that aims to allocate and channel savings to the benefit of the economy. This will enable governments and businesses to be more productive and be better prepared to respond to economic, social and environmental challenges. It will boost our industry, our capacity to innovate, and will improve our competitiveness.

Economic Social and Governance (ESG) criteria will be the framework of these initiatives, and the solutions will involve tailored, long term investment funds. Banks have traditionally been the most important financial intermediaries but their changing or evolving role has created the need, and also opportunities, for other institutions and market-based intermediation. Asset management can complement the role of banks by channeling financing in a balanced way. Taking into account these opportunities, investor protection will remain the foundation of all our activity. Asset management is a client centric business which cares about clients and offer dedicated solutions and services. It is in our best interest to safeguard end-investors and acting with the end-investor in mind will continue to be the bedrock on which we will develop our solutions. FTSE GLOBAL MARKETS: Can we please talk about UCITs for a moment? Does Europe appreciate them as much as the Asian markets seem to do? CHRISTIAN DARGNAT: The objective of the original UCITS Directive, adopted in 1985, was to allow for open-ended funds investing in transferable securities to be subject to the same regulation in every member state without further authorisation. Managing €7trn in assets UCITS have proven to be successful and are widely used by European households. UCITS are also regularly sold to investors outside the EU where they are highly valued due to the high level of investor protection they embody. This year, we have seen amendments made to the UCITS directive, which have further raised the already high standards of investor protection offered by the product structure. By strengthening and making consistent the UCITS depositary regime, we are able to better protect clients’ assets. This progress confirms UCITS as a viable and secure investment structure for a global audience. There is huge potential for growth in emerging markets, especially in Asia. Despite developments in the creation of an ASEAN Fund Passport, we hope that continued improvements

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

Christian Dargnat, president. EFAMA. Photograph kindly supplied by Lansons PR agency, September 2014.

to UCITS will positively bolster international recognition of the brand as the vehicle of choice. We continue to work alongside regulators, particularly across Asia, to promote UCITS as the optimal choice for the international distribution of investment funds. FTSE GLOBAL MARKETS: UCITS look to be in a constant state of evolution. What, if any, are the benefits of constant reform? CHRISTIAN DARGNAT: We face an unprecedented wave of regulation and the distortions created by so many directives and regulations, which continue to have an enormous impact on both our industry and the people we are trying to serve – the end investors. In fact, we are repeatedly witnessing regulation trying to resolve problems in our industry that don’t exist. The UCITS directive has been 25 years in the making. After the first two UCITS directives which took nearly 16 years to put in place, the industry now must confront and deal with three separate and different directives in less than three years. Having just digested UCITS IV we are facing the unknown implementation of UCITS V – and now we are told UCITS VI is on way. If the regulation and supervision of the financial sector is to restore financial stability and confidence in the

FTSE GLOBAL MARKETS • SEPTEMBER 2014

markets, we must ensure calibration of new regulatory and supervisory frameworks to enable the financial sector to support the real economy. Regulation must be put in place to create a level playing field for financial products and consequently reduce investor confusion. Today our main competitors are banks and the insurance industry. They are offering products and services often in competition with asset management products. In this context, the rules of the game need to be harmonized to ensure fair competition. I implore European regulators to properly explain the rules of the game! FTSE GLOBAL MARKETS: Following on from the evolution of the UCITS structure, the funds industry is now facing increasing standardisation of cross border funds processing. What are the problems and the prospects of this trend? CHRISTIAN DARGNAT: Passporting essentially emerged with UCITS IV and later with AIFMD for institutional client and third countries. It is important to underline that asset managers have been focusing intently on being compliant with the high number of new directives and regulations impacting directly the core of their business (UCITS with the KIID and the translation or AIFMD implementation

and registration (reporting, data, licence, …)) as well as restructuration in their organisations to counterbalance the margin erosion through cost cutting initiatives and fund range reductions. Asset managers now need to digest and to seize the new regulatory environment in which they will have to work including the new tool at their disposal such as UCITS European passport or the master feeder structures development and the management company passport. This progress confirms UCITS as a viable and secure investment structure for a global audience. There is huge potential for growth in emerging markets, especially in Asia, and despite developments in the creation of an ASEAN Fund Passport, we hope that improvements to UCITS will positively bolster international recognition of the brand as the vehicle of choice. We continue to work alongside regulators, particularly across Asia, to promote UCITS as the optimal choice for the international distribution of investment funds. FTSE GLOBAL MARKETS: The asset management industry seems to yearn for a return to long term investment. What does it mean in practice? CHRISTIAN DARGNAT: In the face of an aging population, much importance has been placed on identifying solutions to provide adequate pension solutions by European policy makers. The industry has worked together to create a long-term savings culture and the vote in the European Parliament in favour of European Long-Term Investment Funds (ELTIFs) was a promising step in the direction of sustainable growth. EFAMA is engaged, alongside AFME, to favour SME long term financing through the securitisation market. Today, all agree—investors, companies and public authorities—that a market in securitised loans has a pivotal role to play in easing access to capital-market funds for unlisted companies. However, there is a clear and worrying gap between policymakers’ recognition of the benefits that securitisation can offer to SMEs and what policymakers actually do in terms of concrete actions. n

REAL ESTATE REPORT

LONDON’S EAST END PROPERTY BOOM

Prices in the UK’s property, particularly real estate continue to rise, even as numbers of local mortgage applications shows signs of slowing. Even so, demand for property continues to outstrip supply and London in particularly continues its dominance within the United Kingdom, in terms of residential prices. London’s East End has been a particular beneficiary of increasingly relaxed development rules and the eastward shift in the capital of business and financial innovation.

One-third of UK’s property value resides in London

ONDON MAKES UP 35% of Britain’s property wealth in 2014 and is set to reach 40% of property value by 2017. Homes in Hackney, Tower Hamlets and Southwark, some of the least salubrious of London suburbs, look to be worth more than all the homes in Wales, according to the latest research from London estate agents Stirling Ackroyd. Residential property in the capital is now worth a total of over £1.5trn and the trend does not look likely to change for some time. Property values are expected to top £2trn by 2017. Source: Sterling Ackroyd Heritage Report, September 2014 This compares with current property valuations totalling £2.24trn for boroughs is worth more than all the homes the rest of England, and a £4.31trn price- in Wales. Hackney, Tower Hamlets and tag on all of Britain’s homes. By 2017 Southwark together have homes worth London homes are expected to be worth £170bn, 5% more than Wales’ £162bn in a total of £2.1trn, closing the gap with the residential property. Since the liberalisation rest of England put together, and making of planning laws in 1987, the total value of up 40% of all residential property value homes in Hackney has risen by 864% – in Britain. By contrast, in 1987 London the fastest of any London borough. This is homes were worth a total of just £273bn, followed by Tower Hamlets and or 27% of all property wealth.“London is Southwark, with increases of 684% and a growing asset for the UK, in a multitude 668% respectively, since the same year of ways. From a city in decline with a which also saw the opening of City Airport falling population just thirty years ago, and the Docklands Light Railway. These our capital has rebuilt its place at the heart gains compare with the whole of Greater of the financial, cultural and technological London, with 453% growth in gross worlds,” Andrew Bridges, managing property value over the same period. The East End has also clearly benefited director of Stirling Ackroyd. The heart of the study focuses on the from the shift of the financial hub of East End of London. The findings follow London from the old City into Canary Stirling Ackroyd’s Heritage Report, which Wharf, which has had significant impact on details how the value of property in eastern housing prices and spurred massive investboroughs of the capital has outpaced more ments in new property builds in adjacent traditional stores of wealth in West London. suburbs, such as Southwark, Lewisham and Moreover, property in three East End Greenwich; but this has yet to produce the

same high level of increases in land and property valuations that have been witnessed in central London boroughs, such as Islington, Wandsworth, Lambeth and Westminster. Hackney, it seems has been the net beneficiary to date. Of all London boroughs, Hackney has seen the fastest individual house price rises, since 1987 saw the opening up of the local residential market. The value of an average home in Hackney now stands at £545,000 as of June 2014. This is 583% more than Hackney’s average residential property price of £79,700 in 1987. By the middle of 2017 Stirling Ackroyd research suggests a home in Hackney could cost on average £723,000, or 807% more than thirty years before in 1987. Second in terms of price growth is Kensington & Chelsea, with the average home now worth 549% more than in 1987. The average home was worth £1,284,000 in mid-2014, compared to £198,000 in 1987. Stirling Ackroyd puts that down to “At the time, the 1987 Town and Country Planning Order hardly seemed revolutionary – but this apparently dry document has proved profoundly effective. Hackney Council embraced the liberalisation of changes of use with particular gusto, at first through a desperate need for income, and later in a more organised way as the benefits became clear. And that is how Hackney – an unlikely candidate at the time – has led the London property market,” explains Bridges.“Price growth has been sharpest for homes on the threshold of London’s

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REAL ESTATE REPORT

LONDON’S EAST END PROPERTY BOOM

future – in boroughs like Hackney or Tower Hamlets that in 1987 were just the backdoor to the City. Creative industries, from the arts to technology, are still shifting London’s centre of gravity dramatically eastwards.” In absolute terms, says the report, residential property in Hackney was worth just £6bn in 1987, rising to £57.8bn as of June 2014, and set to reach £80bn by mid-2017 according to Stirling Ackroyd forecasts. Similarly the value of all homes in Tower Hamlets was £6.2bn in 1987, £48.5bn in 2014, and is set to reach £71bn by 2017. By contrast, residential property in Kensington & Chelsea was already extremely valuable in 1987, worth a total of £13.4bn, rising to £102.1bn in June 2014 and potentially reaching £138bn by 2017. Meanwhile, Westminster remains the most valuable borough in absolute terms, with gross housing wealth of £102.7bn. “Old hotspots like Kensington or Westminster remain enormously valuable. But now London is looking east. As the capital’s economic and cultural heart grows outwards and eastwards, the City fringes are demonstrating the greatest dynamism,” explains Bridges. “This is both a success story and a call to action. London is enormously valuable, but it is also a prime field of opportunity for developers. We expect a growing wave of new homes in the capital in coming years and under the right conditions, development could help to ease supply. This progress will add hugely to London’s value and in turn its dominance in the British property market,”says Bridges. Growth in the number of homes in London has been led by eastern-central boroughs. Tower Hamlets, Newham and Hackney have seen increases of 85%, 44% and 41% respectively in the number of residential properties since 1987. This is followed by Southwark, up 37%, and Islington, with a 34% increase in the number of local homes. Across the capital, this corresponds to 24% growth in the number of household units since 1987 – now totalling 3.4 million homes, as of 2014. This corresponds to an

average density of 2,186 properties per square kilometre. Since 1987, the population of Greater London has grown by over a quarter (26%) or 1.78m new residents, bringing the capital’s population to 8.6m people, as of June 2014. Moreover such growth is set to continue – with 400,000 new residents projected to take London’s population to a new all-time record of 9m by mid2017.This means each of the 32 London boroughs will need to supply homes for an average of 12,500 new residents over the next three years – or more than 100 new homes for every single square kilometre of Greater London. “Finding sites for new homes is a vital part of stimulating prosperity. And thanks to openminded planning rules, some boroughs have done a better job of this than others, says Bridges, “but conversions from one use to another are just as critical in providing the most useful – often the most valuable – types of property. This is the flexibility that allowed the development of Shoreditch as an artistic centre in the early 1990s. Mixed-use spaces allowed a working and living community of like-minded people, where before there were only dilapidated warehouses”. Institutional investors like residential investments, but barriers persist: Despite an increase in the number of organisations investing in private rented residential property, market fragmentation and supply shortages are preventing larger-scale investment, according to research from property investment managers Mill Group in early September. Compared with previous years the research, conducted among 60 institutions, found increased appetite to invest in residential, with the majority (85% - up from 77% in 2013) of respondents having already committed funds to the sector. The private rented sector (PRS) is, according to the research, twice as popular as student accommodation, and seven times more popular than social housing; sectors which combined are worth around £840bn. With institutional investors ac-

counting for less than £20bn of that, the sector looks to offer untapped potential. However, the survey also found that investor appetite is nowhere near the scale required to realise the critical mass required to overcome UK investor concerns. While London still remains the preferred investment for more than half (57%) of respondents, it faces losing out to other major UK cities, as rental yields in the capital are becoming less attractive than cities such as Birmingham, Leeds and Manchester. Moreover, a lack of housing stock is still a problem– with some international investors originally intending to invest into the UK reverting to their home markets for returns. The overpricing of assets is seen by 37% as a major risk to investment, particularly in London and the division of residential into sub-sectors means that although there has been significant growth in institutional investment in the PRS and student housing, both are still seen as niche markets. This contrasts with classification in other countries, where different forms of residential property are seen as a single asset class. The research also finds that 60% of respondents have invested internationally, with the USA, Germany and East/South East Asia the most popular areas of investment, although all three have dropped in popularity in the last year. Investors have simply shifted their focus towards markets seen to offer recovery opportunities following the global financial crisis. Andrew Smith, executive director at Mill Group, says: “This research clearly shows investors are more ready than ever before to invest in much-needed rented housing in the UK. They are committing resources to the sector, but progress is being held back by a lack of internal expertise and the limited supply of suitable stock.” “Accordingly,” he adds, “joint ventures remain a preferred route into the sector, with investors looking for management expertise and comfort in numbers.” The residential sector may already be larger than it is perceived. UK investors typically consider its component parts separately. In other countries residential is viewed more holistically in the real estate mix. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

THE BEAR VIEW

SYSTEMIC TRENDS UNDERMINING UK GROWTH FIGURES

For those with eyes to read and ears to hear the macro economic news for the UK has been startling. GDP growth is apparently leading (well, Europe, at least), business optimism has been strong, inflation low, pound strong(ish). So why does it all seem to be a bit of an illusion? Simon Denham, chief executive officer of independent City consultant Skrem Ltd, gives us the bear view.

Dragging dead weight

NFORTUNATELY WAGES IN the United Kingdom have not kept pace with even the minimal inflation seen over the last few years. Meaning that, while huge numbers of jobs have been created over the past 12 months, the benefits of a growing economy have not been felt. The global economic position also remains fragile (to say the least) and the gloomy fear is that we are one downturn from absolute disaster. In other words, the coffers continue to be bare and the UK is not the only nation with virtually no powder left to fight a new economic war. With growth much higher than expected one would have thought that the budget deficit reduction timeline might have been favourably adjusted. Somehow though tax revenues have failed to match economic growth. Indeed the UK’s budget deficit is actually higher for the first four months of the tax year 2014/2015 (April – July) than it was in 2013/2014. There are reasons for this state of play. These range from the usual below-inflation pay rises, a high sterling valuation, falling oil and gas receipts and the one-off windfall of Swiss tax receipts that came through last year. Against this must be set the unusually low PAYE and NIC numbers for July 2013 which should have made 2014’s numbers look good by comparison. Analysts predicted the 2014/2015 year would involve a reduction of £10bn in the annual deficit; but with the shenanigans of this wondrous year, we are looking at an increase in the deficit of £1.8bn. There is a clear and present danger: how can the UK now make significant inroads into its deficit; and what will the impact be on the UK’s borrowing cycle. Any rise in gilt yields would cause significant damage to

the government’s deficit reduction plan. The UK also has to worry about its neighbour’s economic condition. The EU is slowing down and several of the major euro economies are now either stagnant or back into recession. Into this mix the Bank of England, which a year ago had been indicating no probable rate hike until around 2016, has been ratcheting up expectations of a move as early as November or December this year. It might however forced into a sharp about face if, as is likely, business confidence slows, growth starts to fade and inflation remains weak. Raising rates just as the UK enters headwinds would do no favours to economic stability. Unfortunately economic commentators are obsessed with house prices and the potential for a ‘bubble’ and have dragged Mark Carney into the fray. Much of the ‘need’ for a rate hike has housing as its bedrock. Fortunately, rather neatly, the regulators have put a bit of a spanner in the works on this item as banks must now assess borrowers’ ability to support debt far more stringently than in the past. The onus on proving/approving affordability has been neatly moved from the borrower to the bank. Mortgage lenders do not want another PPI problem in the future with mortgage holders appealing to the Financial Ombudsman that they should never have been given a loan in

the first place. This is likely to have a far more effective breaking impact on house inflation than rate hikes. Previous commentaries have mentioned the poor performance of the FTSE100 relative to other global indices and although this situation has mitigated slightly through the summer it must be said that the United Kingdom is still way behind the curve. At the time of going to press, the index is once again hammering at the highs of the last two years (around 6875/6900) as the situation in Ukraine eases. However we are still only at the highs of 2013. Banks, food retailers (down over 30%), telecommunications (among others) have created an anchor to the index and it is difficult to see them suddenly surging to make up the difference. The big winners have been anything to do with health spending, including life insurance, pharmaceuticals, healthcare (up 36%), but the multiples here are now looking stretched. It is hard to see the index making solid inroads into the mid 7000’s (possibly a token flirt with 7000 is in order) but conversely the down side seems implausible as well. The support below 6550 remains very strong indeed and sellers quickly run out of steam below this level. Though as we have seen, within the overall stagnation of the index, the component parts have been as volatile as ever (healthcare and food retailers are the extreme examples) and it is more likely that returns are to be found in reassessing your sector allocations rather than expecting a universal move. With corporation tax rates falling in the UK it is not unreasonable to suggest that dividend payments may be more generous in the coming years and, with inflationary pressures remaining weak and growth likely to taper back a bit, companies with steady income streams and solid dividend cover may be worth a look. This all sounds a bit miserable but I fear OECD populations will have to get used to flat-lining living standards for a very (very) long time. As ever ladies and gentlemen. Place your bets. n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

THOUGHT LEADERSHIP ROUNDTABLE

CCPs & SECURITIES LENDING: A perfect partnership?

ROUNDTABLE PARTICIPANTS (from left to right) Dan Copin, head of securities lending & borrowing Europe, Natixis Remy Ferraretto, deputy head of global securities financing and Swaps, Candriam Régis Lavergne, global head of equity finance, Natixis Sébastien Bietho, president, Alcognis Richard Déroulède, head of trading, equity finance, Société Générale CIB Gerard Denham, senior vice president, clients and markets, Eurex Clearing

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EUROPEAN SECURITIES LENDING ROUNDTABLE

THE EXPERT PANEL - Biographical details

Sébastien Bietho, president, Alcognis Sébastien Bietho is founder and CEO of Alcognis, a consulting firm focusing on the Securities Finance industry. Alcognis covers all areas of the business from the trading desk, business strategy, regulation to systems.Prior to setting up Alcognis, Sébastien was Head of the SBL & Repo desk of ADI Alternative Investments, then joined Fortis Investments to set-up and manage the International Securities Lending & Repo business, and headed the Paris Agency Lending Desk of BNP Paribas Securities Services. Sébastien started his career as an Options & Futures broker with Pinatton Société debourse and was an analyst in the Derivatives Research department of Oddo Securities.

Dan Copin, head of securities lending & borrowing Europe, Natixis Head of Securities Lending & Borrowing Europe at Natixis. Dan has been a the bank for some eight years, and was instrumental in establishing its securities lending trading desk, having been responsible for operations, expansion of the customer base and defining pricing strategy. In particular, he was responsible for setting up securities lending operations on the bond portfolio and collateral financing operations as well as the implementation of a global product strategy.

Gerard Denham, senior vice president, clients and markets, Eurex Clearing Gerard Denham is responsible for Clearing Sales and Relations and Business Development for Eurex Clearing’s Lending CCP – its Central Counterparty (CCP) service for the Securities Lending market. Denham has 20 years’ experience of the Securities Financing and Collateral Management industry gained within the Asset Management, Capital Markets, Global Custody, Investment Banking, and IT sectors located in Chicago, Frankfurt, London and Zurich.

Richard Déroulède, head of trading, equity finance, Société Générale CIB Richard Déroulède joined SGCIB in 2005 to develop the Structured Equity Finance business; he took over the responsibility of the team in 2006 and further expanded it to structured and flow equity financing solutions. He became head of the Equity Finance Trading team for Europe in 2009 and has since developed the flow and structured business, adding Market Intelligence and Collateral Trading functions to the group. Richard is a graduate from Ecole Normale Superieure and ENSAE.

Remy Ferraretto, deputy head of global securities financing and Swaps, Candriam Remy Ferraretto graduated from Université de Paris and from the SKEMA Business School, He then joined CANDRIAM (formerly DEXIA Asset Management) in 2003 in the role of OTC derivatives middle office manager. In 2006, Remy worked for the Alternative Investments team and was appointed Deputy Head of securities lending, borrowing and financing in 2014

Régis Lavergne, global head of equity finance, Natixis Régis Lavergne began his career at Fimat subsidiary of Société Générale as Financial Controller in 1993. From 1995 to 1998 he then joined KPMG (a global network of audit services (Audit), tax (Tax) and consulting (Advisory). as senior banking auditor. In 1998 he became Director of Internal Audit at Fimat and from 2000 to mid-2006, he served as Managing Director of Natexis Arbitrage; after the merger with IXIS he was in charge of the service Equity Solution. Since 2009 Regis has had responsibility as Global Head of Equity Finance at Natixis.

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RICHARD DEROULEDE, HEAD OF TRADING, EQUITY FINANCE EUROPE, SOCIETE GENERALE, CIB: The development of our business is driven by three key elements: the automation of standard tasks, the search of innovative solutions to answer client needs and face new regulatory challenges, and the increase of our client database. We consider the topic of CCPs as being highly relevant to our business, as the services they offer could fit within these three axes. They will firstly help automating our flow business by concentrating operations in front of a single counterpart, without reducing the number of end users. Besides, they are offering solutions to the challenges posed by new regulation. And lastly, they could ease the operational on-boarding of new clients. Also, securities lending through CCPs should not be looked at independently from the other financial products traded on those platforms, namely derivatives products. It will be particularly interesting to see what type of netting effect will be allowed by CCPs and regulators between derivatives, securities lending and repo on the same underlying. SEBASTIEN BIETHO, PRESIDENT, ALCOGNIS: I hope to bring a particular perspective to this discussion that reflects the fact that I have worked on both the buy side and the sell side in the international securities lending business. I have run an agency lending desk at a Tier 1 bank and have also set up securities lending and repo desks and businesses for various hedge funds and asset management firms. Now I work both sides as an advisor; looking at the different issues in the restructuring of the securities lending market as a consequence both of regulation and the natural evolution of markets in the post recessionary period. A number of things are happening, particularly as a result of regulation and changes in market infrastructure. CCPs fall squarely into both developments. Along with the market I am trying to make sense of the direction of change, particularly in terms of the way we are going to trade instruments and securities: will we increasingly use swaps trading as a synthetic loan, for instance? Repo and securities lending are moving closer together every day; and now total return swaps (TRS) are coming into the loop with regard to securities finance. In common with others I am trying to understand what the new structure of the securities lending market will be. It is changing at a time when the business itself is quite mature and its very nature is shifting significantly. In the past, securities lending was very much a bilateral world. Now it is becoming electronic and an open market. These are substantially different characteristics and we do not yet fully understand the long term repercussions of this change. REMY FERRARETTO, DEPUTY HEAD OF GLOBAL SECURITIES FINANCING & SWAPS, CANDRIAM INVESTORS GROUP: I have been working for Candriam, formerly Dexia Asset Management, since 2003, when I joined the OTC derivatives middle office, before moving to the equity financing desk in 2006. The desk is based in Paris and runs several operations. For instance, we handle the coverage of our French alternative funds (which are also

FTSE GLOBAL MARKETS • SEPTEMBER 2014

based in Paris) but also manage the liquidity of these funds. Clearly, we are in charge of the firm’s securities lending (both equities and bonds) out of our Belgium and Luxembourg traditional funds. Recently, the firm increased its assets under management, since when the funds allotted to securities lending have increased accordingly. We are focusing a lot on development and innovation; the business is also becoming increasingly more automated. To be frank, as regards CCPs, we are still at the stage of talking about the implications of the structure within our business. In fact, although we are talking about it a lot, we are still some way from using them. REGIS LAVERGNE, GLOBAL HEAD OF EQUITY FINANCE, NATIXIS: I run several positions at Natixis. We are not a big prime broker, and have a more discrete offering than global players. Instead, we focus on equity derivatives, and our approach is highly integrated. What does that mean? We have an Equity Finance desk that combines Delta One and stock lending. Indeed, we have developed our business based on this very close interaction between those businesses; being present in both short-term and long-term flow, but also on the structural side. We have stock lending and repo flow business, where we are very active. Then for our clients in Europe and the US we have been developing specific services solutions, based on our knowledge of repo. So, for example, we have used repo and stock lending to devise a number of solutions for insurance companies, which enable them to comply with incoming regulation and risk coverage. We have leveraged this mix of business rather well. Indeed, we have a small but focused team, and we have found that the two sides of the business are in fact complementary. CCPs have become an important issue for us to address, as we now face more and more heavy and complex regulation and rules –the LCR ratio and the leverage ratio, for instance – which are forcing us down some very dynamic routes. Every day we are facing new constraints on the overall business – yet we still manage our return on equity, because at the end of the day, it all has to add up to clear profit. GERARD DENHAM, SENIOR VICE PRESIDENT, EUREX CLEARING: In Europe, three to four years ago, CCPs were not well established for securities lending. Eurex Clearing was in a fortunate position; we had a blank page on which to build our service offering. At this time, a very lengthy consultation process began that lasted a couple of years, which involved bilateral consultations on a working group level. Very early on in the process we were keen to collect the opinion of key market participants about the business model that would emerge. We have a guiding principle on consulting the market, and as a result of this, we have incorporated into our thinking as much of the character and characteristics of the current securities lending market as possible.

EUROPEAN SECURITIES LENDING ROUNDTABLE

It is widely acknowledged that in some ways securities lending remains behind the times compared to other, more mature markets such as exchange-traded derivatives and the cash equity market. In these markets CCPs are well established and they have very standardised transactions. Securities lending is not as advanced and we have had to adapt that fact into our Lending CCP service offering. There have been prior attempts in Europe to establish central clearing for securities lending, but these offerings have not been as effective as people would have liked. Eurex Clearing has been able to develop and implement a model that is flexible and sustainable and which will allow models to evolve as different types of assets, participants and new clearing members come into play. We have been mindful to include all of the typical elements of the business as well as ensuring that all of the market participants involved in the stock loan chain (either beneficial owner, agent lender, broker dealer, hedge fund, post-trade service providers, trading platforms or triparty collateral agents) have the opportunity to adapt and participate to the Lending CCP service. We believe this to be our strong point in delivering the Lending CCP model. We are also aware this service is a new concept for much of this market and our role has been to help educate and cooperate with as many participants as possible. Our consultation has involved an iterative, educational process and we partner with market participants to ensure that their structure and their setup (as it relates to us) is as good as it can be. We work with them over a period of time to get them up and running. That’s a good summary of the approach that we take. On the regulatory side of things, there is no clear directive that states: CCPs are mandated for securities lending transactions. However, there are certain rules within Basel III and Dodd Frank that make it more efficient for counterparties to look at their business models and reassess the best way to employ their capital structure and re-use that structure again and again to make their business more sustainable. This is where Eurex Clearing comes in as the central counterparty. DAN COPIN, HEAD OF SECURITIES LENDING & BORROWING EUROPE NATIXIS: I work in Regis’ team –in charge of flow trading in securities lending. As Regis says, this new market environment requires us to be more flexible and innovative; certainly these elements are becoming more important. We have been in talks for over a year with Eurex, looking at new ways to trade using CCPs. Indeed, we have been involved in extensive testing of the CCP-based model. That said, my particular focus is on the value of stocks and not on the collateral side. However, the changing market environment requires us to understand the synergies between both approaches, and be able to optimise all the points on our trading platform that now also incorporates CCPs, particularly in post trade. It will be interesting to see how this market evolves.

CCPs: NEW WINE SERVED IN OLD BOTTLES? OR THE EMERGENCE OF AN ENTIRELY NEW VINTAGE? FRANCESCA CARNEVALE, EDITOR, FTSE GLOBAL MARKETS: The market looks to be moving away from (essentially) an OTC bilateral model into one which is much more diversified. A number of you point out that the role of the CCP in stock lending is still in its early stages. Perhaps it is useful to spend a few minutes looking at really what it means for a CCP to be in the securities lending segment, and how it might change the existing or established order. GERARD DENHAM: From the start, Eurex Clearing’s intention was not to radically change the marketplace. Our goal is to provide a service that enhances the current market structure, and to provide the value-added services that a CCP can offer. In Lending CCP, both lenders and the borrowers still transact in exactly the same way that they do right now in the bilateral market. We have simply provided them with an alternative route to market, the option to transmit trades directly via trade capture platforms and flow providers, or by trading electronically and by connecting to exchange-traded platforms and MTFs. To do this, a number of service partners such as Eurex Repo’s SecLend Market and Pirum’s Real-Time CCP Gateway have been connected to the service. These platforms not only introduce electronic trading but also allows the bilateral way that participants trade right now. The CCP simplifies the counterparty structure for both the lender and the borrower. What is the benefit of the structure? Initially, a CCP makes things simpler from a credit perspective; it also allows for a broader distribution. What do I mean by that? It is about the way that banks and lenders interact with each other and it’s to do with legal agreements and credit approvals. The reality is that there may not necessarily be significant amounts of credit available within a bank for all of the counterparties that it might want to trade with or have an existing legal relationship with. It is the same for lenders as well. They might restrict or select a certain number of banking institutions that they want exposure to. When Eurex Clearing takes over the role of counterparty, then immediately there is a wider range of opportunities available. Eurex Clearing carries out its prudent risk management and admission requirements from a membership point of view; it means that any counterparty that’s a member and has the facility to transact using our service, can begin to make use of the Lending CCP. In the meantime, it is the trading relationship that remains active on a bilateral basis. On the one hand, we innovate and provide a more standardised service, and on the other hand we maintain much of the existing market characteristics. In simple terms, the CCP provides credit intermediation, brings standardisation and automation to a very manually intensive business. SEBASTIEN BIETHO: The securities lending market is clearly mutating. CCPs are pivotal in this change. From the

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

operational and credit risk perspectives, CCPs are a game changer. With regard to risk, the role of the CCP is clear: on the operation side, the CCP releases the operational burden that securities lending carries and that we have been living with for a number of years. However, CCPs are not the only outcome in this process of evolution; there are other tools that are developing or entering the market. Electronic trading is on the rise. The tri-party environment is also evolving, and although triparty collateral management has been developing for a while, the collateral management product offering has been significantly extended to ease collateral access, mobilisation and velocity. On the technology side a lot has happened since the early days of the securities lending market. Pirum, which helps lenders and borrowers matching their trades or billing, has also helped increased operational efficiency. Collateral management systems and securities finance trading systems are now mature and efficient. On the business side, there are clearly two elements to the market. It involves both the broker-dealer and the lender sides. However, while communication between them is extensive, the reality is that they do not trade in the same way. It is relatively straightforward, for the broker-dealer to incorporate CCPs into the work flow. Lenders appreciate the structure too, but tend to look at it in a very different way. There are new processes that will emerge as the lender side comes to terms with CCPs and most likely, regulation will put meat on the bones of that emerging relationship. The market is in a process of evolution and all three elements: the new players, lenders and brokers will all put their mark on it; though regulation is probably the most important driver of market structure over the near term. In summary then, the securities lending market is multifaceted, bilateral and trilateral, and most likely we will also witness the emergence of a multi-lateral facility. The market then will be a mix of the three. FRANCESCA CARNEVALE: Richard, as a traditional broker-dealer, listening to those comments, and the influences on market evolution: is the CCP structure in synergy with the agent lender side, or might it evolve into competition with it? RICHARD DEROULEDE: Agent lenders haven’t been spared from regulatory changes threatening their business model. In particular, they now have to put up capital for the indemnification provided to customers, in the case of loss through a default by the borrowing counterparty. This forces agent lenders to reduce the credit exposure in order to maintain their profitability. As CCPs receive a better capital treatment credit wise, they could represent a beneficial solution for them. FRANCESCA CARNEVALE: Regis, do you see the emergence of CCPs as creating a level playing field between institutions that are active in the market? CCPs look to have a role in diminishing the credit risk of some of the counterparties in securities lending trades, particularly smaller players which will be able to work on the same basis as larger players. Is that ultimately beneficial for everybody?

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REGIS LAVERGNE: It’s a good question, and of course, if you introduce CCPs, and theoretically open the market to a large number of participants, then this could affect pricing in the expected margin. At the end of the day, if you want to trade, even if you trade through a CCP, you will be asked for initial margin. If you are a clearing member, then there are very strong constraints about what you can or cannot do. If you do not want to be a clearing member, you will have to work through a clearer, and open a credit line. If you are a small player, meanwhile, you will have to provide enough credit to trade on the market. Even so, although the CCP becomes the counterparty to both sides of the trade, if you are a small player you still have to work with the same capital constraints as a larger player with your clearing member service provider. Irrespective of size then, everyone has to work with the same margin and collateral requirements. The introduction of CCPs will facilitate and open the market. Yet where large nominal remains traded (and especially for stock lending) you still have to post the initial margin, and, I venture, it will be very hard for a small player to act on this market if they do not have access to a huge balance sheet. GERARD DENHAM: Francesca, you hinted that agent lenders might see a more competitive landscape in future, with some of that competition coming from CCPs. We all need to be realistic, and everybody is around this table, that we know that CCPs will take a while to be fully embraced by all market participants. The reason for that is in Europe, along with the coverage we have for fixed income securities, Eurex Clearing covers five equity markets at the moment, there’s a number of other CCPs around the world that cover individual equity markets; the US and Brazil are two examples of that. Securities lending is active in all of the major markets and it will take some time to roll out to new markets for Eurex Clearing. We have a number of equity markets on the horizon over the next year or so, and beyond that, there’s over 30 other markets globally where securities lending is active. Moreover, I expect there will also be consolidation in the market as to which counterparties will maintain their position, or stay in the market, particularly on the lender side, as the indemnification issue comes to the fore. For some lenders it might be too problematic and no longer cost-effective. FRANCESCA CARNEVALE: Would you mind explaining that? Why is it problematic? GERARD DENHAM: For a long while agent lenders have provided a guarantee to their underlying beneficial owners; that in the event of a borrower going into default, their position is protected and the agent lender would make whole any loss. In addition, regulators have voiced their concerns about some of the cash re-investment programmes that were in operation in relation to securities lending transactions, there has been more focus on that side particularly from the regulators in the US, and globally by the Financial Stability Board (FSB). The regulators are trying to devise ways to ensure that all lenders engaging in securities lending are aware of the risks involved and are adequately supervised.

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As a result, with the new Basel III and Dodd Frank directives taking effect agent lenders now have to account fully for the indemnification they provide to their beneficial owners. It is no longer a free guarantee any more. Agent lenders have to put up capital against the indemnification now, and that’s an added cost for them. Agent lenders also need to look at their underlying beneficial owners and ask themselves: can I really maintain this level of service with them, at the same price? Do I have to start charging more? Some of those lenders, those that perhaps are not as fully engaged in lending may say: well, it’s not worth the return, for the risk that we are taking. Others will. This is what I mean when I talk about consolidation and that will happen regardless of CCPs. Eurex Clearing does not feel that we are competitive towards agent lenders because we have designed our Lending CCP model in such a way as to bring them wholesale into the process. Whereas before (and particularly in the US) in the model that’s employed for US equities, agent lenders have to go through a broker-dealer. It is a full clearing member model, which adds cost for them, and agent lenders do not get the benefit of the direct exposure to the CCP. Their exposure is against their broker-dealer clearing member. Eurex Clearing’s solution is to introduce a membership model that is directly suited for both agent lenders and beneficial owners. We sincerely believe Eurex Clearing’s model effectively brings the CCP right into the existing business process and is therefore a much greater benefit to them. It gives them the safety and security of the CCP as we guarantee the return of the loan securities to the lender. This supplementary security aspect of the Lending CCP enables the agent lender to maintain the current levels of the business they’re doing, as well as retain their existing clients they have, while having the potential to increase their utilisation levels as well as providing a more cost-effective service for their clients. SEBASTIEN BIETHO: The demand structure for securities is changing due to regulation, including Basel III/Dodd Frank and EMIR. As a result the market needs to adapt to the new requirements, and CCPs is part of the answer to that. Another initiative that will simplify securities lending operations in Europe is Target-2 Securities (T2S). Gerard, you mentioned that there are only about five markets available to you right now, but with T2S coming in, that situation is probably going to change quite rapidly right? That should allow you access to any market: am I right? GERARD DENHAM: Yes, for equity markets and we are looking at that very closely. That will be a factor in the next phase of development over the next one to three years, given the timeline of T2S coming in. Right now though we are still working on the business of each individual equity market in Europe, and that can be time-consuming and costly. Once T2S is fully implemented, as you suggest, it does make it a lot easier as it provides one central access point via a single CSD, which then, has the right to access multiple markets within Europe. So we will go from five to seven, and then further equity markets in Europe, within a reasonable time-frame. Whereas if we had to work on each one of those markets individually, it would probably take a

longer period of time to implement. In addition to this, other markets outside of Europe are also under analysis as our clients would like to view the benefits of the Lending CCP replicated on a global basis. DAN COPIN: I also would like to add a word or two about the idea that the CCP structure could be a danger for the whole industry. I’ve worked for more than ten years in this sector; and I believe that this is a hugely important and a very promising market. Why? Because it’s a highly flexible product. Look at the market growth, the rise of tri-party agents, and our ability to trade on either a bi-lateral or triparty basis. I look at CCPs in the same way —it is simply another way to trade. We will be trading on CCP with some of our clients partly because of regulatory requirements, and partly because of various other reasons. That is a side issue as far as I am concerned. I believe that in this industry we have to focus on the individual value a security lending trade can provide. Now, for some of the reasons already explained, these individual trades might become less interesting in terms of income. However, if we look at the growing volume of trades it becomes increasingly more interesting and important. Taking into account the changes in the market we have to present clients with new ideas that do not involve credit risk, or process risk. I have to present profitable solutions to them and if I am true to the flexibility that this industry offers us all, we can and should discuss with clients the possibility of working through a CCP. SYSTEMIC RISKS: WHERE SHOULD THEY SIT? FRANCESCA CARNEVALE: Doesn’t the interpolation of CCPs into the securities lending business simply transfer systemic risk from one place to another? Regulation has not eliminated the risk, simply changed where it sits. Is a CCP the right place for this risk to sit? How resilient are CCPs? RICHARD DEROULEDE: These questions have been widely discussed across the industry in the context of EMIR for derivative products, and the Shadow Banking stream of the FSB for securities lending and repo. Does the introduction of CCPs reduce systemic risk? Common sense dictates a diversification of credit risk, as opposed to high concentration into a single pot. Besides, if going through a CCP is not compulsory for everyone, and there is a chance to end up with institutions of lower credit ratings going on CCPs, reducing the overall quality of the CCP participants. Regulators have chosen a middle route by imposing strict rules to CCPs, and creating capital incentive for banks to concentrate more flows through CCPs. In the particular case of securities lending, one must not forget that the market has organised itself around three safety elements that highly mitigate the credit risk of each transaction. The first is that principal is fully collateralised with a physical transfer of assets; two, haircuts are added depending on the liquidity of the underlying and three, margin calls are performed on a daily basis. In the case of Eurex’s securities lending set up, these safety elements have

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been retained with even stricter conditions. This doesn’t mean the failure of a CCP in a securities lending transaction would have no consequence, but it severely reduces the overall impact for financial markets. Beyond the question of risk concentration, we must also think about the effects of standardisation and transparency that will be brought by CCPs on the securities lending market. Indeed, trading securities lending through CCPs means that terms and conditions of each transaction must be highly standardised, leaving very little room to operational issues, such as failing settlement, a late margin call or an un-reconciled transaction, that could arise in the OTC world. There is no doubt standardisation will reduce the operational risk. With regards to the transparency that a public order book will provide, we can only hope that it will bring trust and confidence and that will convince highly rated institutions to participate in this market. TRANSPARENCY, COSTS & PRICE DISCOVERY: A NEW TRINITY FOR MODERN SECURITIES LENDING? FRANCESCA CARNEVALE: Remy, taking into account everything that Richard says, do you look forward to a world where this standardisation, this transparency, gives you effective price discovery; effective benchmarking of your transactions? Is that one of the key benefits? REMY FERRARETTO: I strongly believe that transparency is the key point in this business. This is something we have always provided to our customers, via our funds and counterparties. From our vantage point as a lender doing standard collateralised trades, with regard to the cost of quality collateral and the constraints that you already have due to the regulations in force, the costs of the lending business are bigger than a few years ago. Also, from a lender’s point of view, we have not really factored CCPs into our business outlook at the moment. However, as a lender, I must protect the interests of our funds, and one of my responsibilities is to select quality collateral and select the right counterparties. I firmly believe that CCPs provide good service and more security, and that this can help increase the standing of, and volume in, the business overall. However, on start-up trades, where spreads may be sometime lower, the use of a CCP does not mean that there is a big cost involved compared to all other costs that you already have today to monitor this business. REGIS LAVERGNE: As you all know, over the past five years, the cost of production has increased dramatically in our industry; in part due to regulatory constraints(new ratios), in part due to the costs of compliance and risk linked to those regulatory constraints. For us it has been a key challenge. In the past it was easier certainly to be much more profitable. In the current market environment cost management is vital and cost control is monitored very closely. The involvement of CCPs in the business could be, as Richard says, a very interesting way to add value to transactions and, at the same time, decrease the cost of the ticket.

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Therefore, any reduction in the cost of production is vital for us. There are also considerations around initial margin collateral. Clearly we will reduce our Risk Weighted Assets (RWA) by using a CCP. However, we should also have the ability to post a larger asset class of collateral in order to monitor costs. Yet this is not the case, for example, on the Delta One side where we are now posting initial margin versus cash, or government bonds, which is quite expensive. Due to the sophistication that a CCP provides on the monitoring of risk, it could be interesting to have CCPs broaden the scope of assets that they can accept as collateral. FRANCESCA CARNEVALE: There seems to be a sense of an inherent cost of having the CCP structure in the system. Is that inevitable? When you speak to the providers of asset servicing, the question of cost is something that is always to the fore now. As markets become more complex, as risk is mitigated in various and different ways, it has become like insurance. If you want really good cover, you’ve got to pay for it. Is that an inherent feature in the system going forward? Or, will we end up with a bifurcated market where, you will end up attracting only certain types of trades, and not others? Gerard? GERARD DENHAM: We are aware of the fact that market participants think that not every transaction is appropriate for the CCP model. Over time that thinking will evolve and change, particularly when the volume/intensity increases. As Richard points out, there needs to be high volume and a sustainable amount to make it more cost effective. Certainly, if you look at cost in total isolation, yes, the CCP model does bring more cost into the transaction, purely from what you need to do in order to transact via the CCP—that is, additional margin on collateral costs. However, if you offset some of those costs against the benefits that you get from the reduced capital charges, then the calculation becomes quite different. We have done the analysis, along with Oliver Wyman consultants and we produced a study recently that highlights the capital efficiencies and the benefits from going via the CCP outweigh the initial costs from a risk perspective. We are always reviewing the overall collateral and the appropriate risk appetite that we have as a clearing house; it’s constantly being monitored. We are obviously directed by regulation on what we do as a clearing house. We have to balance that out. The debate that has been going on for a long while however and which has become more intensive recently, due to the Basel III regulations coming in, hangs on the question: where is equilibrium as far as economic benefits and costs are concerned? We believe there are still substantial benefits for participants. SEBASTIEN BIETHO: We are perhaps a little biased, historically, as regards to how securities lending works. If we are talking about lenders, indemnification has been in the mix for a while; but there is potential for evolution in the way lenders will approach securities lending going forward. Regulation around securities lending has had the merit of bringing our business to the forefront, helped bring debate into the open and initiate a shift in the perception of the business across the financial industry. Just in the wording

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used in discussions these days shows there has been an important evolution in the way securities lending is approached. We have moved from “Shadow Banking” to “Efficient Portfolio Management Technique”. That speaks for itself. Securities lending then is no longer a behind-the-scenes activity, but is now part of the portfolio management business, which is essentially a business of risk and return. In turn, this means that if one is looking at full indemnification, one would get close to zero return. Therefore this concept of being insured for doing lending, at some point will become less important than it has in the past. I say all this because the primary purpose of a CCP is not to provide guarantees to the individual structure that is using the CCP, but instead it provides guarantees to the market. Basically, its job is to call in margin every day, and make sure that the market is matched up, and that it’s not going to collapse tomorrow. Should one party not meet its margin calls, all its positions would be closed immediately and the concerned party would be excluded from the market. It is a little bit more complex when we are talking non-cash collateral, but the general idea is the same. Individual protection is a result of market security. CCPs also offer efficiencies, both in terms of cost and operations. Right now, the market is carrying a host of legacy costs from the old historical structures that have been in place for a long time and will have to absorb the cost of introducing the new structures. Once this is finalised, then we will be able to leverage operational efficiency and reduce costs. Gerard is right, the cost of utilising a CCP needs to be balanced with its “return”. The very next driver for the broker-dealer community is the full implementation of the Tier 1 Capital ratio in January 2015. Considering the risk weighted assets (RWA) gain in using a CCP (hence the lower cost of equity) it might be worth switching part of the bilateral business into the CCP model. That aside, I would like to know from Remy what he thinks the value of a CCP will be for the lender community. Is the involvement of a CCP in their business something that makes sense? If their borrowers want to use the CCP, would they be keener on the subject? CCPS AS A CATALYST FOR MARKET CHANGE: FOR BETTER OR BETTER? REMY FERRARETTO: Clearly we are, as we always seek to be competitive. If our counterparties require us to use CCPs, this is something we must take into account, because we cannot afford to be excluded from the market. So we must have a view, always a view, to remain in the race, and not to be excluded. The most important part of utilising a CCP is the risk coverage. Again, when you are a lender, you must know your risk, and CCPs look like a good solution in this regard. GERARD DENHAM: Remy, do you think if there are funds and asset managers who don’t participate in securities lending right now they will be more encouraged to enter

the market, or re-enter the market, if a viable CCP model is in play? REMY FERRARETTO: From a credit and a risk perspective, having, or being part of, a global CCP is certainly a good thing for most situations and will likely increase the transparency we already provide to clients. DAN COPIN: To add to Remy’s answer, some clients will be encouraged to enter the market, others will leave because they will not find it economic to remain. Others will have different strategies. It will depend on the risk appetite of the client. Some focus on security and therefore they will be drawn to Eurex, whilst others are actively looking for risk. The latter group will continue to work in the bilateral segment, because you don’t have to work with excessive haircuts and the collateral policy will be large for them in a way they like and understand. RICHARD DEROULEDE: If we look at what happened on the stock exchange market, the market was previously highly intermediated, with high entry cost and low transparency. The electronification and standardization of the market has attracted more participants, higher competition and provided more transparency with widely spread real time quotations, forcing actors providing market access to change their model. Focus has therefore been on innovation, advisory as well as integration with other services of the bank like derivatives. We could draw a parallel with the securities lending market and imagine that the development of CCPs will have the same kind of impact on the market, with vanilla products being highly standardized and traditional actors being forced to develop more valuable services to their customers. Some actors will disappear, because they won’t be able to adapt their business model to this new deal. Some others will move on to other types of business, like advisory, structured transactions, etc. Not a bad thing if market participants can dedicate more time on adding value to customers rather than on operational issues! FRANCESCA CARNEVALE: Will we end up with a bifurcated market? On one side, where higher risk, higher return and more sophisticated OTC structures, will dominate? On the other, a much more plain vanilla market? Is this what you want? Or do you want a universal securities lending market where people can utilise CCPs when relevant and other structures when it’s not-relevant? REGIS LAVERGNE: You can use CCP for doing much more complex transactions. And at the end of the day, you reduce the cost of the transaction. Indeed, access is simplified and you can easily trade with clients who are not necessarily familiar with the stock lending market. This is because they simply have to open an account with a clearing member. I see the CCP model as a means of reducing transaction costs, and, of course, one that enables us to offer the stock lending product

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more easily to a wider range of clients. After that, it is how your innovation can introduce added value for your client and make the transaction profitable for you. SEBASTIEN BIETHO: In the past trades used to be value trades, where there was intrinsic value in the stocks being borrowed. Nowadays the market is different. Today we are essentially looking at collateral trades or liquidity trades and these types of trades will become more predominant over the coming year, driven by the Liquidity Coverage Ratio (LCR) implementation. From a CCP perspective, this development makes sense because we are talking volume trades where operational efficiency matters. Of course the RWA point is still valid in that trade. Are we saying value trades have disappeared forever? I do not know. What I know is that short selling has shrunk since 2008. Now, hedge funds’ assets under management are back to pre-2008 levels, setting the potential for specific securities demand to rise. When we are talking standardisation, I think this is more about industrialising operations. When we are talking about trading, we are not talking about just lending securities versus cash or non-cash, right? We are talking about structuring trades. This is where the CCP does help us in terms of what we are doing with our time. So the question for lenders and borrowers is: where do I achieve value? Sure, CCP comes with a cost, but if you spend more time actually building trades that bring better value, then it might be worth it. GERARD DENHAM: On a positive note, there is light at the end of the tunnel as far as the regulatory side is concerned; at both the national and international level. For example, the Financial Stability Board (FSB) recognises the important role that securities finance transactions bring to the capital markets. The regulator knows that it brings liquidity to the market and then, on top of what Richard says about the encouragement of securitisation and financing, to be led more by the market side, rather than the central banks, that’s the direction in which it is going. This also tallies with Sebastian’s position that the market is now more about financing trades, rather than just value trades as before. So where do CCPs fit into all of this? I think the future has much more potential for a new structure than maybe the market thought was possible even three years ago. We are not there yet; we will have to encourage market participants to look at CCPs again and again. We also welcome competition in the CCP space to round it all out and make it work globally. We have posited a lot of questions: we all agree it will take a bit of time before we can fully illustrate how complex financing structures will fit into the whole picture. What I can say is that the Lending CCP simplifies the trade, standardises it and makes it much, much easier for the market to access. The service is available immediately and the market participants who understand the opportunities available now will gain an advantage as first-movers in the market.

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REGIONAL ADOPTION OF CCPs: THE DOs & DON’Ts & THE BEST OF THE REST FRANCESCA CARNEVALE: Do you think that the securities lending market in Europe will increasingly evolve differently to that in the United States and Asia, because in Europe we are taking the CCP model, and the potential of the CCP model, a lot more seriously. RICHARD DEROULEDE: If I understand things correctly, the netting effect between derivative and securities lending is pretty efficient in the United States. It is too early though to compare the model that works already in the US with the model in Europe, which is still a work in progress, especially with regards to the netting effect between derivatives and securities lending, that is still to be defined by regulators. We can simply keep in mind that a lot of innovation in finance arriving from the US is only taken up in Europe many years later. GERARD DENHAM: On a wider basis, the CCPs in operation for certain Asian markets are an in-force model, so there is not a lot of option to do anything else but trade via the CCP and that’s also the case in Brazil. In the US, it’s purely a broker-dealer model involving a limited range of US equities against equity options that they can offset. It is a model that works very well, it is in place, but it doesn’t involve the whole chain, as far as beneficial owners and agent lenders; it is purely on a broker-to-broker basis. HITCHING YOUR STAR TO THE CCP MODEL: MY WAY OR THE HIGHWAY? FRANCESCA CARNEVALE: Could the European model ultimately become one where everybody accesses the CCP? GERARD DENHAM:Yes and that’s what is evolving, and will evolve over time. In the US, for example, a more open approach is now being evaluated. I understand they are looking at some of the aspects we have introduced in Eurex Clearing’s model, which they’re trying to replicate in the US. Easier access points for both agent lenders and brokerdealers are essential for a successful and sustainable model. SEBASTIEN BIETHO: In the US the model is very different from Europe. At the time it was set up, the point was to allow clearing members to use borrowed/loaned securities to reduce Options Clearing Corporations (OCC) margin requirements. So the usage and participants has been very specific, and the model was built with the primary requirement in mind. Additionally, I believe the OCC is only involved in cash-collateral transactions. This is not very surprising; the stock lending business is very different from that in Europe. In the US it has been a cash-collateral only market, mainly due to regulation. Things have changed a little bit but we are still at a level of about two-thirds of cash-collateral transactions. In Europe noncash collateral is the dominant form. RICHARD DEROULEDE: It could change though, very quickly. SEBASTIEN BIETHO: It could change yes and when you have a CCP structure to work with it is a lot easier to work with cash rather than non-cash. However, the European

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CCP model has been set-up with the most flexible options available and can adapt to a market shift. FUTURESCAPE: THE LENDER/COUNTERPARTY RELATIONSHIP WHAT WILL DEFINE IT? FRANCESCA CARNEVALE: Will the terms of reference focus more on risk management going forward; and would that happen whether CCPs were in the mix or not? RICHARD DEROULEDE: I don’t expect any dramatic change. For sure, the intermediation through CCPs will trigger some evolution, but I expect most of the business to be negotiated OTC and novated through CCPs, maintaining the essence of our market: knowing the counterparty in which you can place your trust. Will that trigger more focus on risk management? The set up requires some change in the traditional management of a book, but nothing too complex here. More importantly, we need to make sure that the benefits of going through CCPs outweigh the attached cost. We say previously that the benefits are to be found not only on the capital side but also in the reduction of cost linked to operations. The cost of running an OTC business with a high number of counterparties is indeed very high, and has increased with the new regulation. Let’s hope that the centralisation of operations towards one CCP will free-up some resources along the operational chain, including the front office, which will enable them to focus more on the additional service they can offer to their clients. REGIS LAVERGNE: On the client side, when you’re discussing the advantages of the business with a client that has never been involved in stock lending or repo business, you have to be aware whether they have the internal back office and accounting means. You also know the difficulties of signing a stock lending contract. On our side, we need to be able to provide the client with a process that is simple and fool proof. If the client has already an account with the clearer, it is easier: you explain that the set up will be the same, and that it will be a real advantage for us and to them that they enter into the business. However, the client must have the capacity to trade, must have the capacity to post collateral (depending on which side of the transaction he is on), and of course, stump up the collateral if required. FRANCESCA CARNEVALE: Remy, from the point of view of a beneficial owner, from an asset owner, your commitment to securities lending is not on a single transaction basis, is it? It is on a term commitment, if you lend securities, you do not just lend them for a day, and that’s it, be it a short term transaction or a week or a month, it is a long term commitment, relatively, in market terms. Might that have to change? If it does, how will it colour your view of securities lending? REMY FERRARETTO: Certainly this is a long-term relationship business, on both the market and on the beneficial owner side. Concerning the market side, we work over the long term, that’s the only way to exist in this business; anyone without a long-term perspective is ultimately

rejected from this market. So the counterparty relationships we have are very important to us and they are relationships that we nurture on a daily basis; in fact, we work very hard to keep our relationships going over the long term. This brings me to your previous question about regulations. These days, we delegate or outsource quite a lot of business so that we can focus on performance. You will never be able to delegate 100%, because you will always need some people on your side to manage what you delegate. That means constant communication and quality communication and operations (on both sides). If you spend time dealing with issues, it is not a good thing in this business – it means that there is a big problem somewhere; so you are constantly trying to ensure a smooth flow of business in and business out. SEBASTIEN BIETHO: Will CCPs change the relationship between lenders and borrowers? Well, that’s definitely in the hands of lenders, rather than borrowers. Long term relationship is definitely something we need to build trades. Actually knowing your counterparty is what matters, understanding the business structure of your trading counterpart is the basis for profitable trades. That says the nature of the relationship will depend on how CCPs are approached. Are they approached for the operational efficiency? Or for credit mitigation? If it is operational efficiency, then the market will probably stay the same; with the long term bilateral relationship being essential for building trades. If on the other hand it’s from the credit mitigation perspective, then obviously it opens doors to more liquidity in the market, to more liquidity for everybody: both lenders and borrowers. That changes the deal. The way the market is currently structured requires that we build trades for, say, a year, or in a long term relationship. If we have a liquid market in the securities lending business and an efficient operational process, and we know that we can replace our trades instantly, even though they are closed-out, or returned, then it changes the way the market is going to work in the future. That gives us the opportunity to reallocate our resources to deepen and extend relationships whilst working on the valuable elements of the trades. FRANCESCA CARNEVALE: Listening to everyone Gerard, it is clear the securities lending market is replete with nuances and everyone seems to be looking at the business and CCPs in a very different way. How do you manage all these different views and make an economic case out of it? GERARD DENHAM: That’s exactly it. That is why it’s been a long process to get where we are today. There has been a few years of consultation, then the development, then the implementation, now we are at the first step as far as generating the volume and the interest. Sebastien is right: there are two steps involved and at the moment, it’s not known how long the first phase will last for, and when the second phase of the evolution will even begin. One common element is that everybody has noted how key relationships are. We are in sympathy with that and it has been a core guiding principle with us from day one.

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Having been involved in both lending and borrowing, I know how key this aspect is. I will say that I think roles will essentially stay the same, because everyone provides a specialist role. The beneficial owners need their agents acting on their behalf to provide that specialist information on a very sustainable and also a very stable model. Likewise on the borrower side, there needs to be that constant demand and that constant expertise and information being fed throughout the market. That will remain regardless, everyone respects the specialist role that everybody has and the relationship aspect will stay. It is too early to say how far that will evolve into a future state at the moment. As you say, we are here to facilitate, we think that what we have done so far is the right approach, and we know that we’ll be asked to react continuously as the market changes. THE MACRO-OUTLOOK & ITS IMPACT ON VOLUMES AND TRANSACTIONS FRANCESCA CARNEVALE: This year seems to be something of a swing year, in terms of outlook, where we have the promise of the speeding up of tapering in the US; we have a realisation and a growing debate in the UK of the need to return to a real interest rate environment and real economics. Do you think that the return of interest rates, the return of a much more confident hedge fund sector, the slow return of the money markets, is something to look forward to next year, or do you think that we will all continue to live in the moribund shadow of the global recession for another year? GERARD DENHAM: It is too early to say, but the outlook is more positive. SEBASTIEN BIETHO: It is definitely too soon to make meaningful comment about the interest rate environment. However, Francesca you made a reference to money markets. One interesting thing that happened in the last few years is that what we used to call the money markets is now the securities finance market. Basically, whether you are a broker dealer or beneficial owner, they all need to begin centralising the use of their securities. We are starting to see the emergence of collateral funding desk within broker-dealer institutions to help optimise the use of the assets. Most likely this trend will gain momentum in the coming years, driven by capital cost and liquidity requirements. In turn, that has an impact on how we use CCPs to do that, how we use the tri-party agent structure, the new market infrastructure, to be able to build that desk and get all the relevant guys to work together. From the lender perspective there’s ESMA – defining acceptable collateral for UCITs – and more latterly EMIR, which requires the asset management industry to now collateralise their OTC business. Generally speaking, that means these funds need to find eligible collateral for this type of transactions. This is creating a need for collateral transformation and this is an area in which a lot of new work and thinking has to be done.

FTSE GLOBAL MARKETS • SEPTEMBER 2014

SECURITIES LENDING: A MORE SOPHISTICATED PRODUCT SET IN STORE? FRANCESCA CARNEVALE: Do you see the securities lending product set as a whole becoming much more sophisticated, then, over the next year to two years, to take account of increasing cross-fertilisation or use of assets in a firm? RICHARD DEROULEDE: Yes, for sure. The securities lending industry has been impacted by many new regulations, concerning not only banks but also UCITS funds. Funds have to report more details to their shareholders. Banks have to manage more carefully the liquidity and capital utilised by securities lending transactions. In many banks, securities financing desks are doing both stock loan and derivatives, which increase complexity as some regulations apply only to one or the other. Securities lending traders have to master these new constraints for their day to day business, but also when they want to innovate or answer to non-standard client requests. New regulation is also contributing to the emergence of a new type of securities financing business, the so-called collateral trading activities, in which the front office has to price collateral schedules, get more involved in systems and solutions to transfer more efficiently and more quickly assets from one place to the other, secure non-cash margin calls, etc. In other words, the securities lending product is becoming more sophisticated not only on the principal of the transaction but also on the collateral utilised. A third point is about the type of underlying assets that are coming into our business and the various wrappers utilised. On top of government bonds and main index equities, one has also to deal with corporate bonds, convertible bonds, and shares of funds; each underlying having the possibility to trade not only through stock loan and derivatives, but also repo and pledge structures. We have a lot on our plate to play with. It all adds up to new set up, new risk models, including some fairly complex valuation models, to handle all these developments properly. It is also good news because it offers additional business opportunities (advisory, new trading ideas, new products) to generate revenues. REGIS LAVERGNE: We have, as Richard says, plenty of new opportunities and new assets which are coming in to the market. We have of course to be completely client focused, but in another way, we have to reduce RWA, and use a clearing and CCP. Of course, in stock lending you can demonstrate that you are facing one particular client, which is not as easy for some other transactions, such as futures. Another constraint on the perfect world ahead could be the tax constraints which are coming, especially the financial transaction tax (FTT). It affects the client more than the bank. But the net effect is the same, indeed, it will constrain volume. With these constraints in mind, it’s becoming more and more difficult to manage and to retain our profitability however those regulations are bringing new opportunities. That said, in reality, we have much more business which is bringing in more assets to work with. So, who knows how it will develop.

EUROPEAN SECURITIES LENDING ROUNDTABLE

FRANCESCA CARNEVALE: Remy: one provider thinks a golden age of securities lending lies ahead. Another, that the world is a continuation of where we are now, but more complex and one hampered by regulation and tax? Which world view are you looking forward to? REMY FERRARETTO: Certainly one that is much more complex, with regard to all the regulations, including those still to be defined. I think a golden age is light years away but it can come back at any time as it depends a lot of the market changes. The securities lending, which is still well profitable, has a lower profitability than ten years ago, and this constant change in the market is good in one way and bad in another. Today you have more players to deal with, as well as complex regulations and, honestly, I do not believe it is always in the interest of the market. It has been said that regulations will provide new business opportunities, certainly but for example with LCR, it is difficult to combine it with the obligation that you have, as a lender, to be liquid at all times. I am hoping for some new regulations and for the brilliant people that work in the market to come up with new solutions and innovations to help us out and make the business profitable for some time to come. DAN COPIN: The challenge, as everyone is alluding to, is not just change, but the frequency of change. Indeed, new regulations, new processes, new products and our working lives right now are one of continual adjustment to new circumstance. SEBASTIEN BIETHO: I think the future is about how you want to take the opportunities that are in front of you as a result of market change. This includes the new look CCPs, electronic trading platforms, tri-party agents and, of course, T2S. Regulation really does provide opportunities on the basis that you are set up and ready to build the trades that regulations require. AIFM Directive does change the game a little bit, as it opens doors to everything that is not a UCITs fund to gain a European passport. ESMA regulation would not apply as such to those funds and maybe there is potential there for new business. Also there is a growing business set around collateral, and collateral management that has evolved massively over

the last ten years. So there is plenty of scope to extract value from the market and the new environment of the business, as long as you are efficiently set-up. That’s why we all agree that the market will be a mix or hybrid of the older and newer structures. To optimise asset usage, one will need to be able to work efficiently with the several types of structures. FRANCESCA CARNEVALE: Gerard, clearly the market, whether you intended it or otherwise, is, or at least a portion of the market is moving in your direction. This must surely put tremendous strain on you developing a business model, and the proper risk management systems to handle that demand, and to provide a straight through processing and market efficiency. Is it a boon, or is it a pain? GERARD DENHAM: Obviously it’s a boon. At the recent ISLA conference in Berlin, regulation was a key theme and what was important was the response among the audience and the market at large. Over the years, it has evolved, it has been innovative in its development; and there is resilience. This is why securities lending is such a great industry to be in. It was clear at the conference that everyone is looking for new ways to maintain their existing levels of business, and still look for new ways to develop and grow. We have only scratched the surface of a number of related asset types and market segments such as ETFs, money market funds and derivatives that cross over with securities lending, I see scope there for the future. Collateral optimisation is obviously a big segment, and how we all develop that will be valuable and interesting for all of the market. We are fortunate that Eurex Clearing has introduced a CCP service model that is responsive, flexible and sustainable. In that light, it does bring a positive aspect to the market, not only in its current state, but in the future as well. As I said, not everyone at the moment is looking towards CCPs, and some will only move a certain proportion of their current business to a CCP. Either way, we have to ensure that it is a smooth transition, and the right procedures and processes are in place to ensure we can support a future that presages growth in the market. I think it is an extremely positive outlook n

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SEPTEMBER 2014 • FTSE GLOBAL MARKETS

PROFILE MARKETAXESS

Rick McVey chief executive, MarketAxess. Photograph kindly provided by MarketAxess, September 2014.

MarketAxess plugs the liquidity gap In the absence of large dealer participation, New York-based MarketAxess has sought to plug the liquidity gap with its proprietary electronic trading platform, providing investors and broker dealers with streamlined access to an array of fixed-income products, Dave Simons talks to Rick McVey, MarketAxess chief executive, about the opportunities and challenges of the segment.

HOUGH DESIGNED TO reduce risk while bringing added transparency to the secondary markets, fresh restrictions placed on dealer market-making capacity have profoundly altered the face of the fixed-income space. Therefore, in what has become an exceedingly vast and opportunistic credit market in recent years, large dealers have been noticeably reticent and secondary market liquidity in short supply, even as levels of stateside corporate debt outstanding continue to reach new highs. Enter MarketAxess, the New York-based electronic trading platform operator, which has sought to fill the liquidity gap by providing institutional participants and broker dealers streamlined access to a wealth of fixed-income products, from US high-grade corporate and high-yield and emerging markets bonds, to asset-backed and preferred securities. Last fall the company was granted temporary clearance by the Commodity Futures Trading Commission (CTFC) to begin operating a swap execution facility, MarketAxess SEF Corporation, including peer-to-peer anonymous trading via an Order Book as well as Request-for-Quote (RFQ) system. In the absence large dealer participation, fixed-income investors have increasingly sought alternative sources of liquidity in order to counteract the shortfalls experienced by traditional providers. Such has been the impetus behind MarketAxess’ Open Trading all-to-all electronic platform for dealers and institutional investors. “Our Open Trading strategy is designed to meet the expectations of clients who wish to use our strategies in new FTSE GLOBAL MARKETS • SEPTEMBER 2014

and different ways,” remarks Rick McVey, MarketAxess chairman and CEO. Whereas the lion’s share of institutional client trading was once handled by a small contingent of large dealers, post-crisis the demand for increased liquidity has led the company to expand its roster of market makers, from some 35 dealers pre-crisis to around 90 at present. “We feel that’s been a huge success not only for institutional players but also our newer, alternative dealers, as evidenced by the tremendous number of trades as well as trading volume we’ve recorded of late,” he explains. Through MarketAxess’ platform, dealers have been able to handle the incoming stream of Tier 1 order flow far more efficiently—which, notes McVey, was really the first tangible evidence of how an electronic network can foster new counterparties and sources of liquidity.

Dealer market making

While helping to offset some of the declines in dealer market-making activity, electronic trading solutions can also serve as a conduit linking participants who otherwise have never been directly connected before, says McVey. “Using MarketAxess, dealers are now sending orders directly to investors, investors are sending and receiving orders with other investors, and so forth,” says McVey. “In other words, there are disparate segments of the credit market that are all coming together and interacting seamlessly as a result of these open trading tools.” Unlike the market for government-backed issues, standardisation is non-existent within

PROFILE MARKETAXESS

the corporate-bond segment; in the US high-grade market alone, there are some 50,000 unique products currently available for trading, all bearing different sizes, features, and maturities. This poses something of a challenge for electronic-trading mavens like MarketAxess, which requires a vast menu of trading protocols in order to address the disparate nature of these securities. “When we first started out 14 years ago, we had the advantage of being able to design specific solutions for different facets of the credit markets,” says McVey.“The fact is, you can’t just take your cross-matching solution or government-bond solution, plug it into the corporate markets and expect it to work. So the challenge for us has been to understand how the different segments of the market operate, as well as having the expertise to build these very focused, dedicated types of solutions.” Nor does it hurt to have deeper pockets, particularly when it comes to fueling the R&D machine. “We have spent hundreds of millions on our electronic infrastructure since the outset,” says McVey, “and we continue to invest in the system, rolling out enhancements and new protocols nearly every quarter in order to keep up with the changing needs of our clients.” Current debt outstanding in the combined US high-grade and high-yield markets hovers in the vicinity of $10trn, or roughly $4trn higher than pre-crisis levels. Without the various restrictions imposed, large dealers would be investing more in the secondary credit markets, not less. McVey sees this trend as counterintuitive. “In effect you’ve severely reduced the ability for bond manufacturers to act as bond market-makers,” he says. From a glass-half-full perspective, there are likely to be new opportunities aplenty going forward, concurs McVey. “As long as we all work diligently at creating these new secondary market solutions, there is every reason to believe that the secondary market will continue to grow, and, along with it, the number of prospects for leading credit-market participants. Open trading will not replace the important position held by primary dealers within the secondary market, but it can certainly help augment that role, particularly from a liquidity standpoint.” Still, it may yet take some time for the idea to fully catch on. Recent data (from Greenwich Research and others) suggests ongoing sluggishness in fixed-income electronic trading adoption, with investment grade and treasuries faring somewhat better than corporates, notably in the United States. Meanwhile, cost pressures linked to Central Securities Depository Regulation (CSDR helped keep MarketAxess’ SEF profitability in check during the second quarter (Q2) this year, despite a nearly eight-fold increase in SEF volumes quarter-to-quarter. In early August the firm also announced that it had updated the default settlement dates on its trading platform in line with market convention post October 6th this year, as part of CSDR. It will be updating the default settlement date to T+2 for cash instruments with European or Eurobond ISIN prefixes subject to exceptions for government bonds that already settle on T+1. Buy-side

clients will continue to be able to request non-standard settlement dates. It is likely, however, that the electronic trend could begin to gain momentum once rates rise and/or volatility increases. Last year’s brief but unsettling fixed-income hiccup—which saw Treasury yields nearly double due to speculation over a shift in Fed monetary policy—offered a preview of the potential new order. “As recent fixed-income pullbacks have shown, the liquidity challenge is real,” says McVey, “thus when rates or credit spreads start to move, we’ve seen even more volatility due to the absence of a buffer in dealer balance sheets. What we’ve also experienced during such periods is an increase in demand for electronic trading, the result of investors seeking greater access to different counterparties and additional sources of liquidity.”

Longer term rate jumps

Though 2013’s mini-crisis was immediately followed by a return to lower yields and reduced spreads, astute investors know that it’s just a matter of time until a more permanent shift begins to take hold. Thus, many are interested in taking action now in anticipation of longer-term rate jumps. Which is why MarketAxess continues to invest heavily in enhancing its trading protocols, as well as expanding the number of available counterparties.“We feel we’re continuing to make progress,”says McVey.“Electronic market share is moving incrementally higher, we’re seeing a greater adoption rate for the new tools we’ve developed, and each quarter has reflected increased activity in our alternative open-trading module. Everything we have designed in open trading allows traditional dealers to intermediate orders on behalf of their clients just as they always have.” Though admitedly a different approach to the principle-based modules many have been accustomed to using, McVey nevertheless sees dealers continuing to move in that direction, particularly as it is helping to reshape their trading business, enabling them to act as both agent and principal on behalf of their clients. “We have been in this incredibly benign market environment marked by low volatility and compressed spreads, which, to some degree, has helped soften the blow of higher capital and liquidity standards, as well as other material regulatory impacts,” notes McVey. “But that doesn’t mean that benign will be here forever. Today, firms are managing much larger portfolios including more credit exposure than at any time during the last several years, while at the same time offering clients daily liquidity. And whether it is mutual funds or ETF portfolios, the fact of the matter is that it can be very difficult to move out of those positions on a moment’s notice. So what we are seeing is a desire among our investor and dealer clients to work to develop new liquidity solutions now in order to stay a step ahead of rising liquidity risk once the market changes for real. We know it will happen—this is not a normal interest-rate or creditspread environment by any means. And when it does change, we want to be ready.” n

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

PRIME BROKING

ssssssLiquid alternative funds, which seek to deliver hedge-like returns using a more mainstreamfriendly investment approach, remain among the strongest members of the prime-services spectrum; over the last five years assets have nearly quadrupled, according to Morningstar research. Photograph © Rancz Andrei/Dreamstime.com, supplied September 2014.

Prime computations As regulators turn up the heat, prime-service providers have responded in kind by trimming the fat and optimising current tools, while also emphasising the same old “client-centric” concepts of the past. From Boston, Dave Simons reports.

VER THE LAST few years, prime broking has found itself in a constant state of flux, marked by a perpetual shift in key product and service offerings. At the same time, lower leverage, along with higher capital expectations, have added pressure to the industry, in some instances forcing a severing of ties with smaller, less profitable hedge-fund clients. The recent purge by top-ranked provider Goldman Sachs serves as a bellwether for the business. During the second quarter this year, Goldman targeted some $56bn in excess assets as part of its ongoing effort to strengthen its leverage profile. Under new US rules issued last spring, leverage ratios for the industry’s top-tier institutions as well as their insured subsidiaries will have to increase to 5% and 6% respectively by 2018. It’s a minefield, not least for the plethora of acronyms now introduced into a market, already battered by Basel requirements. The Fed’s final Enhanced Supplementary Leverage Ratio (ESLR) essentially disadvantages the largest US banks versus their foreign peers, going beyond Basel’s leverage ratio. For clarity’s sake: the ESLR includes a 2% buffer at the bank holding company (BHC) level for US Global Systemically

FTSE GLOBAL MARKETS • SEPTEMBER 2014

Important Banks (G-SIBs) and a 6% supplementary leverage ratio (SLR) requirement for their insured depository institutions (IDIs) to be considered well-capitalised. The 2% buffer, which increases the SLR ratio for US G-SIBs to 5% from the 3% required of other Advanced Approaches BHCs, will act similarly to the capital conservation buffer under the US’s implementation of Basel III capital standards by limiting capital distributions and discretionary bonus payments if the buffer is not met. However, for Comprehensive Capital Analysis and Review (CCAR – the Fed’s primary supervisory mechanism for assessing the capital adequacy of large, complex BHCs) stress testing purposes, the SLR’s 3% base requirement will serve as the minimum for G-SIBs. Firms affecting by the rules will be required to submit estimated supplementary leverage ratios (SLRs) by the first quarter of next year. Accordingly, many see a gradual opening for not-quite-so-big prime players in the not so distant future. Big or small, prime providers have strived to maintain a healthy rotation of value-added services, running the gamut from execution consulting and securities lending, to synthetic and cash-prime offerings, pre- and post-trade execution and more. What factors are propelling the current

PRIME BROKING

PB iteration? With other divisions increasingly falling into the commoditised pot, is it necessary for prime to remain a standalone operation?

Efficiency, efficiency

From the perspective of both provider and client, efficient deployment of capital remains key to a successful primeservices offering. “It is really defining what the future of prime broking will look like,” offers Kurt Woetzel, president of BNY Mellon Markets Group,“particularly in terms of how clients think about the leverage they’ll need in support of their alternative-investment activities, how it is financed, where credit balances may be stored, and more.” The firm’s newly formed Markets Group brings together a suite of offerings that include prime-brokerage solutions, global markets services (such as FX and derivatives trading), as well as global collateral services (liquidity, securities finance, collateral management), under the auspices of the company’s Investment Management division. Woetzel says that the synergies linking the group’s various components will greatly benefit clients. “Take collateral financing and collateral management, for example—when your duties include financing collateral obligations, you must also have the management to support that service as well,” says Woetzel. “You really need to look at your relationships from both an equity and capital-return perspective, which compels you to focus on your product set in order to determine the best ways to support your clients, while at the same time ensuring a consistent level of return on your servicing segment. So bringing forth a holistic solution set while enhancing the client experience is really the driving force behind this business.” With a few notable exceptions, interest-rate movements, as well as volatility—both historic drivers of prime-brokerage profitability—have remained relatively stable these past few years. That all could change, however, particularly if Europe and the U.S. continue to go their separate ways economically. “With domestic interest rates beginning to rise while remaining flat or even entering negative territory elsewhere, that alone could being to shape investment strategy, perhaps leading to an increase in directional bets and creating additional volatility in the process.” After a prolonged period of ambiguity, an even safer bet would be the impact of the myriad regulatory changes that are only now beginning to take hold, both at home and abroad. “We expect that both buy-side and sell-side clients will continue to reposition and refine their business models in order to maximize the core value they deliver and to be better prepared for future regulatory changes,”says Woetzel. “The good news is that there is now a lot more clarity on the rulings, including how they will specifically impact financial firms’ operations—whereas even just six months or a year ago there was still uncertainty as to how some of these would shake out. As a result, clients are finally in a position to make those bets with a clearer line of sight.” Things continue to be upbeat over at New York-based ConvergEx Prime Services, which saw its year-over-year

Kurt Woetzel, president of BNY Mellon Markets Group. From the perspective of both provider and client, efficient deployment of capital remains key to a successful prime-services offering. “It is really defining what the future of prime broking will look like,” offers Woetzel, “particularly in terms of how clients think about the leverage they’ll need in support of their alternative-investment activities, how it is financed, where credit balances may be stored, and more.” Photograph kindly supplied by BNY Mellon, September 2014.

revenue increase by more than 20% during 2013 on the strength of higher client assets under management (AUM). Along the way, ConvergEx has worked to optimise its integrated prime platform that includes such advanced features as algorithmic-trading strategies as well as derivative execution-management technologies. Even so, Douglas Nelson, chief executive officer of ConvergEx Prime Services, remains an ardent disciple of the old-school model devised by ‘70s prime-broking forerunner Furman Selz, whose blend of investment banking and securities services became the industry prototype. “A decade ago when the markets began to move from having a few hundred hedge funds to eventually thousands, the big banks adjusted their models accordingly,” recalls Nelson,“to the point that if your firm didn’t have a sufficient amount of assets or couldn’t offer some unusual product with higher margins, you didn’t make the cut.” Nelson, then serving as SVP for Neovest, saw an opportunity in the making. “By that point the banks were really moving upstream, and we had a lot of research clients who were already trading with us and were asking if they could just place their funds with us. So that’s when the light bulb went off—from there we pitched the model to several clearing firms, whereby they would be in charge of custody and clearing only, and all other daily service and technology needs would be handled us.” Ten years on, that same “client-centric” prime-services

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

PRIME BROKING

concept remains intact. “At ConvergEx, we’ve always seen ourselves as an extension of the back office, which we believe has been a real differentiator for us over the years,” says Nelson.“The ability to bolt on the various ConvergEx product offerings has been a very attractive value proposition for our clients—we own our own algo rack, we can offer options routing and execution, not to mention a very deep, independent research network.” To that extent, the core components of prime brokerage haven’t changed much since the Furman Selz era. “At the end of the day, our overall responsibility is to provide custody for the bulk of the fund, to ensure that trades are properly cleared, and to provide accurate reporting in real time.” While portions of the prime services platter might be easily commoditised, the lion’s share remains specific to the individual needs of the client. “Unlike other providers relationships, most clients interact with their prime broker on an almost daily basis,” says Nelson.“So while there is a big service aspect to it, it is also about how the different businesses are structured. If yours is a simple, long-short equity, options and futures firm with less than $500m, our brand of capital-introduction services would be very appealing—the flexibility of having your assets spread across several different clearing firms using a single service team, trading platform and reporting system enables the client to diversify custodial risk while at the same time avoiding the potential complications of having disparate systems and meeting numerous minimum requirements. Whereas if you require more creative types of financing or lines of credit beyond what basic portfolio margin can handle, you’re probably going to be better off going directly to a bank.”

Prime movers

Despite the notion that scale trumps all, the landscape remains doted with successful firms that aren’t necessarily out to conquer the world. “We’ve seen many sub-$150m hedge funds that have done exceedingly well by their clients,” says Nelson. “These kinds of limited partnership pooled funds are attractive to set up and operate, and at this point investors can choose from an assortment of providers covering a number of different strategies. So I don’t see that market going away any time soon.” Liquid alternative funds, which seek to deliver hedgelike returns using a more mainstream-friendly investment approach, remain among the strongest members of the prime-services spectrum; over the last five years assets have nearly quadrupled, according to Morningstar research (at ConvergEx, such funds account for one-third of the company’s prime business at present). “From a prime-brokerage standpoint, these kinds of funds not only require a trust bank, but, since they’re using alterative strategies such as shorts, options, futures or leverage, they’re going to need a firm like ours that can outfit them with the right kind of technology in order to make their processes as efficient as possible. So that’s obviously been one of the leading drivers for us and the industry at large

FTSE GLOBAL MARKETS • SEPTEMBER 2014

Douglas Nelson, chief executive officer of ConvergEx Prime Services. Nelson remains an ardent disciple of the old-school model devised by 1970s prime-broking forerunner Furman Selz, whose blend of investment banking and securities services became the industry prototype. “A decade ago when the markets began to move from having a few hundred hedge funds to eventually thousands, the big banks adjusted their models accordingly,” recalls Nelson, “to the point that if your firm didn’t have a sufficient amount of assets or couldn’t offer some unusual product with higher margins, you didn’t make the cut.” Photograph kindly supplied by ConvergEx, September 2014

over the past few years.” Going forward, entities that have been traditionally responsible for overseeing key financial transactions as well as supplying adequate liquidity to the system are likely to change as well.“CCPs act as financial intermediaries on behalf of the various market participants, allowing transactions to seamlessly flow from one to another, warehousing risk, and so forth,”says Woetzel.“But there could be other entrants as well, including those who may not necessarily have the same degree of regulatory capital attached to that activity.” The Federal Reserve's utilisation of a full-allotment, overnight reverse repurchase agreement facility (or FRFA) is one such example; by temporarily siphoning cash from the financial system and substituting overnight funds drawn from banks and other sources while using Treasury securities as collateral, the Fed hopes to prevent the build-up of excess cash, which under certain circumstances could artificially depress interest rates and therefore impede constructive monetary policy. “That kind of intermediary role has typically been the domain of the prime broker,” says Woetzel. “So I think we’ll see more of this kind of dislocation going forward. Which is really the main impetus behind us bringing all of these related and strategic capabilities together under one roof.”n

MARKET DATA BY FTSE RESEARCH

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

12M% 2.6

-1.1

17.1

2.1

-0.4

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

21.1 25.3

4.0

1.8

-4.3

9.8 13.1 18.8 21.3

2.8 -11.6

0.4

-1.8 -1.3

4.3

-5.2 -0.9

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)

6.3 5.4 10.4 13.1

2.0 2.8 2.3 2.2 2.0

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

8.5 10.1

2.2 1.3

FX - TRADE WEIGHTED USD GBP EUR JPY

-6

-4

-2

1.8 2.2

0.9

-0.8 -0.7 -0.4

-1.2 -6.0

19.7

-20

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

3.1 2.8 2.6 2.6 2.1 1.8

-0.4 -1.1

-2

-1

Regions 12M local ccy (TR)

4.0

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

9.8

Developed 1M local ccy (TR) Belgium/Lux USA Netherlands Switzerland France Developed UK Finland Canada Israel Germany Sweden Australia Denmark Norway Spain Italy -0.3 Hong Kong -0.6 Singapore -1.0 Japan -1.1 Korea -1.6

-2

0.7 0.6 0.4 0.3 0.2 0.0

-1

3.3 2.9 2.8 2.6 2.1 1.8 1.8 1.3

4.2 4.0

-0.1 -0.5 -1.6

-4

-2

1.3 0.3

9.8 6.7

27.9 27.0 26.6 25.3 23.2 21.1 20.6 18.1 17.1 17.0 16.4 15.6 15.6 14.8 13.4 13.2

36.8 35.7 35.3

Emerging 12M local ccy (TR)

9.8

4.6 3.9 3.6 2.9 2.8

25.3

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

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

13.1

21.3 21.1 21.1 20.9 18.8 17.1

India South Africa Indonesia Taiwan Brazil Emerging Thailand China Mexico Malaysia Russia -6.0

-10

45.9

7.9

30.4 29.0 25.3 24.2 21.3 20.5 17.3 16.9

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

SEPTEMBER 2014 â&#x20AC;˘ FTSE GLOBAL MARKETS

PERSPECTIVES ON PERFORMANCE Global Sectors Relative to FTSE All-World

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

US Emerging

Basic Materials Consumer Services Technology

Oil & Gas Health Care Financials 120

Asia Pacific ex-Japan

150 140

Consumer Goods Industrials Telecommunications Utilities

110

130 120

100

110 90

100 90

80 70 Aug 2012

Dec 2012

Apr 2013

Aug 2013

Dec 2013

Apr 2014

70 Aug 2012

Aug 2014

Dec 2012

Apr 2013

Aug 2013

Dec 2013

Apr 2014

Aug 2014

BOND MARKET RETURNS 1M%

12M%

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

2.0

6.3

UK (7-10 y)

2.8

Ger (7-10 y)

5.4

2.3

Japan (7-10 y)

10.4 3.2

0.3

France (7-10 y)

2.2

Italy (7-10 y)

13.1

2.0

19.7

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

2.5

Euro (7-10 y)

9.4 14.5

2.4

UK BBB

2.2

Euro BBB

8.5 10.1

1.3

UK Non Financial

2.8

Euro Non Financial

8.3 8.9

1.4

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

5.8

3.1

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

Corporate Bond Yields

Japan

Ger

France

Italy

U UK BBB

8.00

Euro BBB

7.00

6.00

6.00 5.00

5.00 4.00

4.00

3.00

2.00

1.00 0.00 Aug 2011

Feb 2012

Aug 2012

Feb 2013

Aug 2013

Feb 2014

Aug 2014

1.00 Aug 2009

Aug 2010

Aug 2011

Aug 2012

Aug 2013

Aug 2014

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

FTSE GLOBAL MARKETS • SEPTEMBER 2014

MARKET DATA BY FTSE RESEARCH

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

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

FTSE UK

FTSE US Bond

110

FTSE US

130 125 120

105

115 110 100

105 100

95 Aug 2013

Nov 2013

Feb 2014

May 2014

95 Aug 2013

Aug 2014

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

Nov 2013

Feb 2014

May 2014

Aug 2014

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

FTSE UK

FTSE US Bond

180

FTSE US

220

160

180

140 140 120 100

100 80 Aug 2009

Aug 2010

Aug 2011

Aug 2012

Aug 2013

1M% FTSE UK Index

65.9

118.7

2.5

0.5

22.2

1.7

Aug 2014

8.7

1.5

1.2

Aug 2013

5Y%

4.7

1.8

Aug 2012

2.4

4.0

Aug 2011

6M%

0.7

FTSE USA Index

FTSE USA Bond

Aug 2010

3M%

2.1

FTSE UK Bond

60 Aug 2009

Aug 2014

23.7

100

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

SEPTEMBER 2014 • FTSE GLOBAL MARKETS

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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