FTSE Global Markets

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DEBT REPORT: THE RETURN OF THE JUNK BOND MARKET I S S U E E I G H T • J U LY / A U G U S T 2 0 0 5

CME sets new business benchmarks Blythe spirits in a bull run DMO sets the scene for long, long bonds

BNP PARIBAS’ RULE OF

CLEARSTREAM GAINS CONFIDENCE AS BUSINESS VOLUMES RISE

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTING EDITORS:

Karen Jones, Neil O’Hara, David Simons.

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edge funds have gone from being ‘alternative’ to being distinctly mainstream in just under a decade. There are over 8000 hedge funds operating around the world managing combined assets in the order of $1trn. Their emergence as a major force has had attendant consequences on the depth and range of investment services now provided by the world’s custodian banks. And, suffering from indifferent returns elsewhere, institutional investors, who traditionally shied away from highrisk hedge funds, are now focusing intently on them in an effort to achieve improved risk-adjusted returns and broader portfolio diversification. What this means is a paradigm shift in the core definitions of investment services provision by leading investment banks. Our coverage in this edition focuses on the different strategies employed by investment services providers to meet changing market requirements and questions the very definition of the term ‘custody’. With so much in flux and with a host of new products and market-participants, what is increasingly obvious is that nothing in the global investment services market will be quite the same ever again.

Coverage of the diverse trends in the world’s banking sector through in-depth profiles of individual institutions is a recurring theme in FTSE Global Markets. In this edition we highlight the confident growth of BNP Paribas. The bank is bucking trends at home and abroad and setting a distinctly hot new pace for European banks with global ambitions. The bank’s ability to successfully marry organic growth with an aggressive (and surprisingly successful) acquisitions strategy is setting a new performance benchmark. BNP Paribas’ chief executive officer Baudoin Prot explains the dynamics of the bank’s growth strategy and why he depends on the ‘Rule of 80’. On the retail side Bill Stoneman profiles the irrepressible US East Coast force that is Commerce Bank and looks at the ways in which the bank and its swashbuckling chairman, Vernon Hill, is redefining the methodology of new-customer capture.

In a dynamic financial world that is increasingly polarising between winners and losers, the incessant rise of the Chicago Mercantile Exchange (CME) now makes it arguably the world’s most successful exchange – ever. Riding a seemingly inexorable tide of derivatives trading and armed with at least a $700m cash war-chest the exchange is busy hunting for bear (and not just in Michigan). The question is where? We talk in-depth with CME chief executive, Craig S. Donohue on the global trends that are fuelling the exchange’s expansion.

In an exclusive feature, we profile AMC, one of China’s strongest emergent mutual funds. AMC’s view of the range of investment services provision available to it and its international ambitions reveals much about the real challenges and opportunities facing foreign institutions trying desperately to establish a strong foothold in the People’s Republic.

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Subscription Price: £399 per annum [6 issues]

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 5

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Contents COVER STORY THE RULE OF 80

................................................................................................Page 28 BNP Paribas has been on an upward trajectory for the last five years, propelled by a singular mix of organic growth and discrete acquisitions. CEO Baudouin Prot explains the alchemic mechanisms that have turned base metal into gold, including customer focus, ruthless corporate discipline and a highly effective customer management system.

REGULARS MARKET LEADER

APPETITE BUILDS FOR CHINA ETFs ..............................................Page 6

IN THE MARKETS

............................................................Page 10 The weak dollar could upturn traditional pricing strategies for industrial commodities, such as oil, argues Global Advisors’ specialist Russell Newton.

ETF assets have risen by 50% over the year. Dave Simons explains their appeal.

OIL PUSHED TO CONTANGO

NYSE TO MERGE WITH ARCHIPELAGO ................................Page 14 Karen Jones reports on the strategic imperative behind the high profile acquisition.

DTCC EASES WAY FOR ALTERNATIVES

REGIONAL REVIEW

..................................Page 18 The DTCC is looking at ways to process and settle alternative investment products.

CHINA AMC SETS THE PACE

............................................................Page 20 China’s leading asset management company explains its investment outlook.

NEW INDICES FOR AIM

..........................................................................Page 24 A new set of indices designed around the smaller growth company sector are launched.

ATHEX STAKES ITS CLAIM

....................................................................Page 25 Chairman Spyros Capralos outlines ATHEX’s emerging strategic goals.

BLITHE SPIRITS IN A BULL RUN

SECTOR REPORT

......................................................Page 64 Ian Williams explains why there is so much snap, crackle and pop in the spirit world these days.

COMMERCE BANKS SETS A NEW BENCHMARK ........Page 78 Bill Stoneman on the new standards in customer care offered by Commerce Bancorp.

CME AT THE NEW FRONTIER

DERIVATIVES REPORT

..........................................................Page 68 CEO Craig Donohue talks to Francesca Carnevale about the unstoppable force that is the CME today.

CDOS GIVE HEDGE FUNDS A HEADACHE

..........................Page 74 Neil O’Hara explains how CDOs have changed the credit markets forever.

THE BUILDING BLOCKS OF CORPORATE GOVERNANCE Page 82 INDEX REVIEW

2

Carl Beckley explains the design and construction of the FTSE ISS Corporate Governance Indices.

Market Reports by FTSE Research ................................................................................Page 86 Companies in this issue ..................................................................................................Page 85 Calendar ............................................................................................................................Page 96

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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INTEREST RATES

AGRICULTURAL

EQUITIES

METALS

CBOT

ZGG5

100 oz

Last: Change: Time:

Gold MARKET DATA

BUY ORDERS QTY PRICE 40 51 61 131 9 1 1 2 2 3

437.0 436.9 436.8 436.7 436.5 436.4 436.2 435.7 435.5 435.3

437.0 +4.4 12:14:18

SELL ORDERS PRICE QTY 6 3 2 72 60 121 1 10 4 1

437.2 437.3 437.4 437.5 437.6 437.7 437.8 438.0 438.7 438.8

Apr 29, 2005 12:14:18 PM

TAKE CONTROL – TRADE CBOT GOLD ®

CBOT

YGG5

mini-sized

Last: Change: Time:

Gold BUY ORDERS QTY PRICE 61 127 150 234 3 2 1 1 1 1

437.0 436.9 436.8 436.7 436.1 436.0 435.8 435.6 435.3 435.0

437.0 +4.4 12:14:18

SELL ORDERS PRICE QTY 3 3 3 159 161 221 1 4 4 10

Apr 29, 2005 12:14:18 PM

437.2 437.3 437.4 437.5 437.6 437.7 437.9 438.0 438.2 438.3

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Contents FEATURES THE INVESTMENT SERVICES REPORT

SERVICE IN THE ROUND

........................................................................Page 34 Leading providers now note conflicting demands on their business and the impact of further consolidation on pricing. Custodians are pressured to provide more for less cost. Francesca Carnevale assesses the emerging strains.

OUTSOURCING: THE SKY’S THE LIMIT

..................................Page 40 Custodians are under pressure to stake their claim in the latest trend entailing the transition of clients’ middle and back office operations. Tim Steele wonders if they can now sustain and build upon existing arrangements and keep their clients happy at the same time.

CONFIDENT CLEARSTREAM TAKES FLIGHT

......................Page 44 CEO Jeffrey Tessler outlines underlying market trends and the new products developed by the company to leverage the new business opportunities opening up in their wake Page 34

NEATLY PRESSED

Page 44

............................................................................................Page 48 Rekha Menon looks at demands now put on hedge funds to comply with SEC reporting requirements and how fund administrators have developed new product offerings aimed specifically at the alternative investment market.

JUNK BONDS TAKE CENTRE STAGE

............................................Page 51 The removal of GM and Ford Motor Company from the ranks of investment grade issuers revitalised the US junk bond market. Andrew Cavenagh looks at the long term market impact.

HOW THE JUMBO TOOK FLIGHT

....................................................Page 54 It is the tenth anniversary of the issue of the first Jumbo Pfandbriefe. Paul Whitfield looks at the history of the asset class and wonders, where can it go next?

LONG BONDS GAIN FAVOUR

..............................................................Page 57 The French are always setting fashion trends. Only four months ago Agence France Trésor came to the market with a 50-year bond. Now all European sovereign issuers want to get in on the act. Chris Newlands reports.

SMOOTHING THE PATH FOR ULTRA LONG BONDS

....Page 60 The UK’s Debt Management Office does not simply want to follow the French lead in issuing an ultra long bond, it wants to do it again and again and again. Francesca Carnevale looks at the DMO’s efforts to develop long term liquidity in a newly emergent asset class.

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J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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REGIONAL REVIEW 8

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Market Leader CHINA ETFs

Appetites rise for China ETFs Looking to find the right mix in a sideways market, investors jumped headlong into exchange-traded funds, combinations of equities linked to a particular index that trade like conventional stocks. ETF assets have risen nearly 50% since 2004, sparked by a host of new offerings from longtime index-based leaders such as Barclays Global Investors and State Street Global Advisors, particularly aimed at China. Dave Simons reports.

MONG THE NEW crop of ETFs are funds with a focus on emerging markets, including several that track businesses based in China, where strong growth and a soaring economy have created attractive investment opportunities.

Looking for a piece of the action in what many are calling “China’s century,” at the end of 2004 Barclays Global Investors (BGI – the industry’s ETF leader that began offering exchange-traded funds in 1996 – in conjunction with FTSE), launched the iShares FTSE/Xinhua China 25, an index comprising 25 China corporations (such as communications giants China Mobile and China Telecom).

Joining BGI is Hang Seng Investment Management HS FXI 25 ETF and PowerShares Capital Management’s Golden Dragon Halter USX China Fund, consisting of companies listed on the Halter USX China Index (such as China Mobile and China Petro). Also new to 2005 is the China 50, an ETF that tracks the 50 most liquid blue-chip stocks listed on the Shanghai Stock Exchange (SSE) 50 Index. Developed by China Asset Management Co Ltd.,

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(ChinaAMC – please see article on page 20), in conjunction with part-owner State Street Global Investors (SSGI), the China 50 ETF marks the first time that an exchange traded fund has been offered on the mainland.

The arrival of these China-based ETFs represents a significant opportunity for both institutional and individual investors who wish to establish a diversified foothold in the mainland’s burgeoning financial markets. “There has never been a more efficient, cost effective way to invest in China,” says Lee Kranefuss, chief executive officer CEO of BGI’s Intermediary and ETF Business. “In one trade, investors can gain exposure to 25 Chinese companies and enjoy the benefits that investors have come to expect from an iShares ETF – tax efficiency, diversification, trading flexibility, and the ability to buy and sell the fund in any brokerage account.”

Minimal Cost/Major Advantage With an expense ratio averaging less than 50 basis points or nearly half that of index equity mutual funds, ETFs rank among the market’s best bang for a buck. ETFs also have

Lee Kranefuss, managing director of BGI’s Intermediary and Exchange Traded Funds Division

minimal capital-gains exposure, making them a solid choice as a taxadvantaged investment option, and, for the most part, are also highly liquid instruments.

“One ETF transaction does it all, saving transaction costs as well as dealing hassles,” offers Winnie Pun, director of investments at SSGI Asia Ltd. For the individual investor, ETFs eliminate the need to have an in-depth knowledge of the market, says Pun. “Also, the benchmarks used by the current ETFs are constructed as bluechip indices, taking into consideration the investment worthiness of the underlying market, which is comforting to investors. They also provide an efficient means of implementing asset allocation calls.”

The minimal fees give China’s ETFs a major advantage, says Pun. The China 50 ETF, for instance, has an expense ratio that is roughly 40 percent of the average active mutual fund currently offered in China (currently an estimated 2.37%).

Additionally, says Pun, the China 50 ETF offers investors exposure to the China A-share market, as opposed to offshore-market H and B shares and red chips. “The China A share has

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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Market Leader CHINA ETFs 8

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Corporate Network in much better depth and The FTSE Xinhua Index Series Hong Kong and a former diversified sector exposure 130 vice president for Lehman than the China offshore 120 Brothers in Tokyo. The market,”she adds Pun. 110 influx of foreign In China, where 100 companies has helped price/earnings multiples 90 bring increased stability to currently hover around 11, 80 the market, say observers, one could easily make a 70 and has also contributed to case for jumping into ETFs 60 the ongoing bull market in (and Chinese equities in 50 Chinese stocks. general) on the basis Northern Trust’s ETF of valuation alone. specialist Steven Schoenfeld, “Something usually needs FTSE/Xinhua China 25 Index FTSE Xinhua A50 Index author of Active Index to go wrong to drive an Investing: Maximizing asset's valuation to near its Data as at June 05. Source: FTSE Group. Price Indices in US Dollars.

Portfolio Performance and historical trough,” wrote Minimizing Risk through Morgan Stanley in a recent assessment. “In the case of emerging partnerships with mainland Global Index Strategies, is particularly markets, however, more things appear companies. Last year, AIG Global pleased with the index-fund activity in to be going right than wrong, making Investment Corp.

(AIGGIC), China, especially the level of trough valuations especially puzzling. the investment arm of the involvement from major asset groups The usual cases for trough valuations insurance conglomerate American based in the US and elsewhere. “In – broad macro crises or an earnings International Group Inc., the largest emerging markets,” notes Schoenfeld, collapse – are not in the picture.” property insurance company in the “we can expect to see product world and China’s leading private- development follow many of the equity investor, announced a first patterns we’ve seen in major Money in the Mainland The potential for long-term foray into the Chinese mutual-fund developed markets, but with a faster unbridled growth has attracted business. AIG joins a growing list of ‘take off’…there is much room for foreign financial further penetration of indexing in hundreds of foreign financial China-based interests, many of whom have companies such as Fortis, Belgium’s Asia…and in almost all of the established mutually beneficial ranking financial-services group, emerging markets.”

Fund managers in the meantime which runs the Fortis Haitong Investment Management Co. Ltd., as have been busy identifying those Northern Trust ETF well as ING Investment Management industries with the largest breakout specialist Steven of the Netherlands and France’s potential. Though still in its early Schoenfeld Société Générale. The influx of capital stages, China’s Internet market has has in turn energised the equities the makings of a powerful markets, centered in Shanghai and distribution vehicle. Even more Shenzhen, as the Chinese robust is the country’s auto sector, government seeks to beef up the which has been growing by leaps and bounds. Already a leading steamrolling mutual-fund industry.

“China’s fast economic growth and producer of engines, transmissions high savings rate, along with a lack of and other auto parts, last year China diversity and sophistication of sold in excess of five million investment options within China, vehicles, making it the world’s third presents good business opportunities largest auto manufacturer. With to foreign fund management firms many new partnerships in the seeking to develop the Chinese works, China is expected to vastly market,” explains Connie Bolland, increase its exporting presence in regional economist for the Economist the years to come.

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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In the Markets COMMODITIES: OIL

Oil pushed to contango

in the New York Mercantile Exchange (NYMEX) WTI crude oil futures contract has risen by 60% (please refer to Chart 1: NYMEX WTI Oil Prices Jan Growth led demand for oil seems likely to moderate as a result of 02 to Jan 05). Large inflows, along with continued high prices; while strong forward oil prices have the accompanying excesses in pricing, encouraged producers to maximise production and raise exploration are essential in order to re-balance investment. The kind of price movements in industrial commodities supply with demand in energy and exhibited throughout 2004 are unlikely to be repeated in 2005 – metals for the next decade.

If other asset-class bubbles are particularly as the US dollar remains weak – writes Russell Newton, co-founder and fund manager at Global Advisors, the specialist anything to go by, then the current bull market in commodities could last quite commodities hedge fund. a long time. Capital inflows are the EMAND, DEPLETION AND encouraged producers to maximise response to a demand/supply the falling dollar created production and raise exploration imbalance, not the initial cause of it. massive inflows of capital into investment. Furthermore, the dollar’s Massive upstream investment is commodities throughout 2003 and downward spiral seems to have required to grow output of all industrial 2004 and into the oil sector in slowed for the time being. What this commodities, and high prices particular. Demand for oil has been means is that the kind of price encourage this investment by allowing rising at an unprecedented pace, led by movements in industrial commodities firms to hedge out the price risk on growth in Asia and the United States exhibited throughout 2004 are development projects that might otherwise be considered too marginal. and eroding OPEC’s surplus supply unlikely to be repeated in 2005.

At the same time, high capacity. As well, depletion prices for spot commodities of mature oil and natural NYMEX WTI Oil Prices January 2002 to January 2005 NYMEX WTI 60.00 800,000 will eventually have some gas fields means new impact on the demand side sources of energy have to 55.00 750,000 of the equation. be found to meet increasing 50.00 To date one of the most demand. Finally, the dollar 700,000 45.00 prominent effects of these weakness has served to 650,000 40.00 substantial speculative exacerbate the rising capital inflows has been to demand for commodities, 35.00 600,000 push the front-end of and again, oil in particular, 30.00 550,000 many commodity markets when expressed in foreign 25.00 into contango (a condition currency, as the normal 500,000 20.00 in which distant delivery mechanism for balancing 450,000 prices for futures exceed markets (higher prices 15.00 spot prices – often due to reducing demand) was 10.00 400,000 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 the costs of storing and broken by dollar’s WTI Front-month, roll-adjusted ($/bbl) WTI Dec 2008 ($/bbl) Total Open Interest (RHS) insuring the underlying downward trend. commodity. The exact Each of these factors Source: NYMEX & Logical Information Machines opposite is referred to as however, has now lost The commodity markets last saw backwardation). However, contango is some of its potency. Growth led demand seems likely to moderate as a large capital inflows (and heightened a term one would not normally expect result of continued high prices; while investor interest) in the 1970s. In the to hear when prices are in many cases strong forward oil prices (e.g. West three years from 1971, the Commodity near all-time highs.

It is also worth noting that the Texas Intermediate [WTI] crude oil Research Bureau’s metals sub-index prices for December 2009 delivery has rose over 150%. Over a similar period additional oil that has recently entered risen from $22.50/barrel in January starting 2002 prices rose 110%. During the market to satisfy demand growth 2003 to $48/barrel today) have the past three years, total open interest has been heavy, sour crude that only a

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In the Markets COMMODITIES: OIL 12

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(the ‘Trans-Atlantic limited number of refiners can handle 1990s discouraged new investments in spread and which yields a lot of heavy fuel oil. infrastructure. Since 2000 when arbitrage’) has trebled since 2000 As a result, spreads between light freight rates began to rise, new from 10c/bbl to 30c/bbl.

Prospects for oil this year remain products (such as gasoline and heating construction has increased but there is oil) and heavy products (such as fuel significant lag in bringing new good. Non-OPEC supply is expected oil) have widened immensely. It is capacity to market (please refer to to grow by approximately 1.3m questionable whether this trend has FTSE Global Markets, Issue Three, barrels per day, driven mainly by any further to go as refinery capacity September/October 2004, Door to Door increased production in former Soviet Union states, Africa and Latin will very likely be a bottleneck going Crude, p.52).

Finally, one factor which has been America. Meanwhile, consumption is forward – particularly for middle distillates where transportation especially important over the past likely to grow by around 1.7m to 1.8m few years has been the shift in barrels per day (b/d), virtually all of demand growth is very strong.

Another feature of the past couple voyage length. As China’s demand which will come from non-OECD of years has been the explosion in for basic materials has increased, countries – particularly in Asia and has been located the Middle East. Thus, the OPEC freight rates. For example, rates for a supply supply cushion should shrink Very Large Crude a little more, keeping prices Carrier (VLCC) from Growth prospects of oil likely to be repeated in 2005 underpinned at around $40 the Arabian Gulf to 300 per barrel for WTI. Looking Japan, which averaged 250 further forward, it seems just over $6 per tonne 200 unlikely FSU countries will be during the 1990s, 150 able to maintain the recent peaked at over impressive growth much $40/tonne in November 100 beyond 2005. Furthermore, 2004 before dropping 50 despite announcing plans to sharply to under 0 bring an additional 1.5m $10/tonne. They have barrels per day of production now stabilised at on stream by 2010, output around $20/tonne. from Saudi Arabia’s largest Freight markets are FTSE World Oil & Gas – Exploration & Production FTSE World Oil – Services FTSE World Oil – Integrated FTSE World Index oilfields is expected to begin to driven by a number of decline. It is also worth noting considerations: Data as at June 05. Source: FTSE Group (Price Index Values in US Dollars) that there is massive variation Tanker quality is a key consideration. Following headline- progressively further from Asia. in the projections used by analysts grabbing spills of the past few Consequently, China’s demand has when considering the prospects for decades, many oil majors have been increasingly for long-haul global demand growth this year. A tightened their quality requirements, crude oil. This effectively reduces the recent Reuters’ poll, for example, thereby restricting the supply of number of vessels available for yielded a range of 1.3m b/d to 2.4mn b/d. Much of the variation resulted vessels available to them at any one charter at any point in time.

High freight rates serve to isolate from differing assumptions about time. As quality demands rise, so should freight rates. Changes in regional energy markets: so-called China’s economic outlook and this is quality requirements can also drive ‘inter-regional arbitrages’, where sure to remain one of the key factors the degree to which old vessels are movements of crude oil or refined for commodity markets for the scrapped, potentially reducing product from, say, Europe to the foreseeable future. One of the main supply further. This tends to happen United States become much more problems here is the lack of reliable when owners think it is either too expensive to execute. In the past, this data. In short, commodity markets in costly to upgrade an existing vessel, has tended to lead to much higher 2005/06 are likely to differ from or if the vessel is so old that it simply levels of instability in prices and we 2003/04. It seems plausible that we not worth upgrading to meet would expect this to continue to be are entering a period of volatile where active the case in the current cycle. For consolidation modern standards.

Supply is another important example, the standard deviation of discretionary traders should outelement. Low prices through the daily returns of the WTI-Brent perform passive strategies.

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Regional Review NORTH AMERICA

NYSE/ARCHIPELAGO MERGER The proposed merger between the New York Stock Exchange (NYSE) and modern electronic rival Archipelago Exchange (AX) caught Wall Street by surprise. But, even without 20/20 hindsight, it was patently clear that the NYSE had to make a significant move into electronic trading following the United States’ Securities and Exchange Commission’s (SEC) approval of Regulation NMS. In a business beset with over-capacity and growing competition, offering customers an array of modes of trading via mergers makes sense. But will the merger really result in the best of both the old and the new worlds? Karen Jones searches for some of the answers in New York.

Harold Bradley, senior vice president at American Century Investments

HEN AND IF approved by the SEC, the merger between the NYSE and AX will create a new company called NYSE Group, Inc. It will be a publicly traded, for profit entity with the current owners of the NYSE’s 1,366 seats receiving a 70% stake (plus $300,000 a seat) and shareholders of Archipelago owning 30%. In his official statement, NYSE chairman John Thain says that in addition to the NYSE competing with “greater speed, efficiency and innovation”, the merger with AX would provide “a leading position in the over the counter

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(OTC) market,” as well as an electronic platform for trading exchange traded funds (ETFs), options and fixed income.” That was for public consumption. The NYSE has known for some time that it would have to undertake a merger play (at the very least) if it was to maintain momentum in a rapidly changing market. Its move was given particular poignancy by the fact that in the very same week the NASDAQ stock market announced its intention to buy Instinet – the Reuters-owned electronic trading business.

Coincidence? Perhaps. It might even

herald a new beginning of a spate of high profile exchange mergers.

In part driven by the deemed need for exchanges to become bigger, more cost effective and therefore electronic, the merger was also in some large part a result of Regulation NMS (see FTSE Global Markets, various issues).

Regulation NMS was proposed for comment by the SEC back in February 2004 and approved in April this year.

New rules regarding order protection are a key component of the proposal.

Effectively doing away with the contentious ‘trade-through rule’, which obligated that orders be sent to markets with the best price (NYSE 90% of the time) Regulation NMS clearly favors electronic or “fast”markets.

“The NYSE post-Regulation NMS was on life support. What John Thain just did was to pull out the paddles and shock the patient back to life,” says Harold Bradley, senior vice president at American Century Investments. American Century has $95bn in assets under management with both institutional and retail investors, including separate accounts, commingled trusts, sub-advisory accounts and mutual funds.

For 212 years the NYSE and its fabled trading floor have dominated the US equity markets. However, with the proliferation of electronic trading, the writing was writ very large indeed on the proverbial wall as to how long

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Regional Review NORTH AMERICA

the exchange could stay viable. NYSE could read and, never one to wait and let the flowers grow, chairman Thain introduced a ‘hybrid’market earlier this year, as an update of their unsuccessful Direct+ electronic trading platform to work alongside the floor.

With the approval of Regulation NMS, a much bolder move was called for. Thain did not disappoint but inadvertently walked into a lot of flak from NYSE members. A number of seat holders were angry that they were not consulted as to the terms of the deal.“I do not think the ratio of 70/30 gives us full value,” says Thomas Caldwell, chairman of Caldwell Financial Ltd. and subsidiaries Caldwell Securities, Ltd., Caldwell Management Ltd., and Caldwell Asset Management, who represents 13 seats on the exchange.

“My other concern as a member is the hold period which seems to be quite onerous for members,”he adds.

Caldwell says he plans to hold his seats as a long-term investment but is concerned he will not be able to pledge his shares or borrow against them for what could be up to five years.“It is like a dead asset. I do not think they have considered that. Also some members feel they should have more of a cash payment. I personally do not want a cash payment. I prefer to hold the stock. I have confidence in this organisation,”he concedes.

Not everyone feels the same.

Former NYSE director Kenneth Langone has tried to package a separate plan to purchase the NYSE. He is organising a group convinced the deal is undervalued. He is also concerned about perceived conflicts of interest for Goldman Sachs Group. Goldman acted as “advisor” to both NYSE and AX and owns 21 NYSE seats plus 15.5% of Arca’s shares. (John Thain is a former Goldman executive.)

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“Archipelago was started by a bunch of investment banks that also have seats on the NYSE. Goldman is largest. Anytime there is consolidation on Wall Street, it is not surprising Goldman is on both sides,” says Terry Hendershott, assistant professor at the Haas School of Business at the University of California at Berkeley.

As to Langone and his rebel faction, Hendershott says, “They have done nothing but meet. It is hard to understand why they can think they can value the John Thain, Chief Executive Officer [CEO] of the New NYSE more highly than this York Stock Exchange [NYSE] merger. How are they going Hendershott says that historically to run it differently and make it worth more? I do not know if it is a regulations have helped the floor by negotiating ploy.” He adds that some “forcing all the orders to go there.”That of the people involved in the group will now change. As the NYSE puts in “would not be looked on favorably by internal systems that will allow more the SEC so it is hard to imagine trades, particular in the liquid stocks, to viewing them as serious. I really want bypass the floor it remains to be seen them to explain why they think a what value they can really bring.“There different valuation of the NYSE is is reason to believe, for the smaller appropriate especially when we stocks and larger transactions, there is expect this big change to occur with a real value to the floor. Whether or not it can support its high cost structure the hybrid.”

While the hybrid is still set to move remains to be seen.”

Meanwhile, Bradley offers, “I could forward, there has been no initiative

by Thain to eliminate floor trading – care less whether the NYSE or for now.“The floor will be decided by NASDAQ exists in 10 years from now the functioning of the hybrid if a better or higher life form takes its platform, clients and reality, not this place. I want a market that is deal,”says Caldwell.“When the NYSE electronic, cheap, efficient and flips the switch on the hybrid, will the transparent.” He adds, however, if the orders go there or through the floor? NYSE/AX merger is done right, it is a He adds that if floor traders can prove “huge win” for institutional investors. they are providing value to the clients, “This is the first tree in the forest to they will prosper.“If they cannot prove fall that will lead us to convergence of that, it will all go electronic. Will an technologies and securities on a exchange floor exist 100 years from platform that I think could lead to far now? No. Will it exist five years from better risk management across the entire world,”he concludes. now? Quite possibly.”

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Regional Review NORTH AMERICA

DTCC eases way for alternatives While hedge funds and the alternative investment market have enjoyed substantial growth over a number of years, the industry’s antiquated manual processing is widely viewed as a deterrent to further expansion. That said, the Depository Trust & Clearing Corporation (DTCC), has formed an advisory committee to explore a standard automated platform for processing and settling alternative investment products. Karen Jones reports.

NN BERGIN, MANAGING director for Mutual Fund Services at DTCC and head of its advisory committee, says that last year alternative investment representatives asked the DTCC to offer proposals “to correct operational inefficiencies in the market.” In the mid-1980s the mutual fund industry found itself at a similar crossroads. In 1986, the NSCC (now a subsidiary of the DTCC) introduced Fund/SERV, the standard for processing and linking fund orders (purchases, redemptions and exchanges) and for linking fund companies with distributor partners. “If you look at how mutual funds were traded in the early days, it was very much a manual market. A dealer would phone or fax orders in and everything was costly,” says Bergin. Dealers came to what was NSCC at the time and asked if they could make trading more effective and efficient. “We did that. I can’t say the mutual fund industry has grown to $7trn to $8trn because of Fund/SERV, if not this, it would have been something similar, but it was able to get to this size and trade for as low cost as it does today because of this kind of infrastructure.”

Bergin confirms that the 16member industry advisory committee

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has been well received by the market and is moving quickly to put together a product addressing issues that are “an impediment to effective growth.”

An initial member survey explored a range of subjects including products deemed to be priorities for automation, current and projected transaction volumes for investment products and technology platforms.

The DTCC has “carved out first phase delivery,” says Bergin. This includes new accounts and purchases, redemptions and tender offers, commission payments, position reporting, valuation reporting and account maintenance.

Bergin anticipates by the first or second quarter of 2006 they will “have something operational on the street.”

Meanwhile, once the DTCC has the first phase completed, it will continue to work with the advisory committee “to bring more services out or enhance the functions of the goods and services that are already out.”

Committee member, Kirk C. Strawn, director of intermediary sales at Man Investments, Inc, which has $43bn under management worldwide, observes that today an advisor can use their computer workstation to effectively manage nearly all of a client’s portfolio, but not alternatives.

Ann Bergin, managing director for Mutual Fund Services at DTCC

“From their work station, they can allocate cash, bonds, stocks, mutual funds, separately managed accounts, options and futures. The moment they want to use a hedge fund, fund of fund or other alternatives, they cannot do that,” he says. What follows is often a time consuming mountain of paper processing all of which the DTCC is researching.“They are trying to do for the alternate investment world which they have already solved beautifully for

Kirk C. Strawn, director of intermediary sales at Man Investments, Inc

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the mutual fund world,”adds Strawn.

Josh Kernan, director of alternate investments at Schwab Institutional, a division of Charles Schwab & Co., Inc., which has $350bn under management, agrees manual processing for alternative investments is a barrier to entry. “If you are an advisor and you want to get a client into a fund, you have to fill out what could be a 40-page subscription agreement, plus our own agreement so there is a lot of paperwork the client has to go through to make that allocation.” For advisors who do not have the time or resources, the allocation goes elsewhere. “This is where the DTCC is so important. The

system they are building will allow us to plug in more automated systems our advisors can use to allocate to this asset class.” He adds that the DTCC could also act as a “conduit” between the three parties – investor, broker dealer and the fund – entering in client information.

Meanwhile, Kernan points to Harvard and Yale predicting “tremendous growth” of alternative usage at the institutional and endowment level.“We see our advisors following the lead of the larger institutions and endowments. They are looking at the investment management trends at the institutional level and applying those same

philosophies and procedures to their own individual client base.” As far as costs and fees pertaining to a new infrastructure, Kernan calls it a matter of scale. “We have been working with alternatives at Schwab for eight years.

We have found a lot of ways to work through a very manual process. If the DTCC provides a way to allow me to very easily make these allocations for my clients, I actually see our costs, in the long run, going down.”

Strawn concurs, “The hope for everyone in the industry is this will lower costs. If it wasn’t going to lower costs, none of us would be on this committee.”

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Regional Review ASIA

FTSE GLOBAL MARKETS EXCLUSIVE

ChinaAMC sets the pace Scoring firsts is something that China Asset Management Company (ChinaAMC), one of the first national asset management companies to be established in China, and which manages assets worth around RMB34bn (approx $4bn) is becoming accustomed to. Notable for launching China’s first domestic exchange traded fund (ETF) at the end of last year, the Fund is now building its international reputation, in readiness for further liberalisation of the Chinese investment market.

Zhang Houqi, assistant president of ChinaAMC

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HANG HOUQI, ASSISTANT president of ChinaAMC, one of the largest national fund management firms in China, highlights three reasons for the firm’s growing success. “Our growth has been exceptionally steady throughout the last seven years, the management team is relatively stable and our investment process is now among the best in the country.” It is experience built up in a diversified portfolio of funds, says Zhang that has contributed to the firm’s pre-eminent role in China’s burgeoning investment market. That and a willingness to work closely with foreign institutions, adds Zhang.

ChinaAMC has the largest number of funds under management in a single firm in the country.

Headquartered in Beijing, with branches in both Shanghai and Shenzhen, as of the end of last year ChinaAMC had RMB30bn assets under management. ChinaAMC was set up with capital from four local sponsoring brokerages. ChinaAMC’s current shareholders include Beijing

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State-Owned Asset Management, South West Securities, Beijing Securities and China Sci-Tech International Trust Investment Co. Ltd in April 1998. The firm is notable for many reasons, not least that it was a pioneer in indexing in China, and soon after its inauguration in 1998, the company launched its first enhanced index fund, the Xing He Fund, in early 1999.

ChinaAMC’s latest product is the hybrid Dividend Fund, backed by an active asset allocation in high dividend equity, bonds and cash. The benchmark used is the Xinhua FTSE China 150 Dividend Index (for 60%) and the Xinhua FTSE Treasury Bond Index for 40%. Zhang explains that the firm regards the new fund as “higher risk than the firm’s bond and money market funds, but of a substantially lower risk than its pure equity funds.” The Dividend Fund will adopt an active asset allocation strategy, with equity assets accounting for a range of 20% to 95% of the total fund, while bond assets are held in a mobile range of 0% to 80%. Says

Zhang “to meet with investors’ redemption needs, the Fund will keep no less than 5% of the assets in cash and short term financial instruments including treasury bonds, with maturities less than a year.”The stock pool in the fund consists of companies which have distributed a dividend more than twice in the past three years, or which are expected to have a favourable dividend distribution policy or with new stocks with good investment value.

“The fund provides an investment in companies which generated real benefits to shareholders by distributing dividends. In our philosophy, which is also proven in the international markets, the ability of paying consistent dividend reflects that the companies had made good earnings, and also its good potential to produce higher shareholder values,” says Zhang. “The fund provides an investment in companies which generated real benefits to shareholders by distributing dividends.”

“By design, therefore, we felt that the addition of the Dividend Fund

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Regional Review ASIA 22

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ChinaAMC worked closely would fit very well in our The FTSE Xinhua Index Series with State Street Global overall portfolio,” adds 150 Advisors (SSgA) the first Zhang. It was not an easy 140 130 ETF in mainland China, decision, he explains. “As 120 based on the Shanghai 50 you know the Chinese 110 Index. “SSgA established a stock market has been 100 good reputation in China bearish since 2001. A 90 80 on the back of the project,” further consideration is 70 acknowledges Zhang. “Key the fact that the China 60 to working well in the Securities Regulatory 50 country is to work on a Commission (CSRC) has project basis. In this been trying to encourage instance, SSgA worked as a firms to distribute more FTSE Xinhua Bond Index FTSE Xinhua High Yield 150 Index technical advisor on the dividends to investors.

FTSE Xinhua A 600 Index development of the ETF. Our marketing campaign And ChinaAMC received around the latest fund has Data as at June 05. Source: FTSE Group. much valuable training in therefore focused on the cumulative dividends product design, system design and inclusion of firms which have paid out The distributed by the company have risk control.” dividends to investors.”

The ETF is made up of blue-chip ChinaAMC also manages five reached RMB4.6bn.

The cumulative dividends stocks listed on the domestic currency closed-end funds: the Xing Hua, Xing He, Xing Ke, the Xing An and distributed by the company have A-share index including Baoshan Iron the Xing Ye Funds; as well as six open- reached RMB 4bn. “It has been & Steel Co Ltd, China Petroleum & end funds, including the ChinaAMC important for us that the firm’s Chemical Corp (Sinopec), Huaneng Growth Fund, the ChinaAMC Bond performance has won the trust and Power International Inc and China Fund, the ChinaAMC Return Fund, support of investors. As well, in June Merchants Bank Co Ltd. In April 2004, Morningstar and the ChinaAMC Cash Income Fund, 2003, the National Council of the the ChinaAMC Large-Cap Select Social Security Fund officially began to Shanghai Securities News co-elected the “Best Fund Fund and the China 50 ETF. entrust Social Security Fund mandates ChinaAMC Management Company” in China.

ChinaAMC has also created and to ChinaAMC,”explains Zhang.

In the international markets, “The China 50 ETF is designed on a managed three mandates for the National Council of the Social ChinaAMC came to prominence typical ETF model that tracks an index Security Fund. Between 2001 to when it was appointed by the with good liquidity and allows in-kind 2003,“by net asset value growth, the Shanghai Stock Exchange in 2004 to creation and redemption,”says Zhang.

Xing Hua, Xing He and the Xing Ke develop and launch China's first ETF “In addition, ETF can be subscribed to Funds ranked as the top three as part of a strategy to widen the with cash or a combination of cash choices for both and stocks, which has been invaluable among all closed-end funds, all investment garnering the CITIC Five Star institutional and private investors and in building up individual investor ratings,” says Zhang.

In 2001 encourage them to view the Chinese interest in the product.”

ChinaAMC has actively and 2002, the Xing Hua Fund ranked stock market as a vehicle for longfirst among all China domestic funds term investment rather than short- cooperated with foreign institutions for two consecutive years. In 2003, term speculation. Back in 2002, to “fine-tune and advance business the Xing Hua Fund again ranked first ChinaAMC had been appointed by techniques, promote the research according to NAV growth among the Shanghai Stock Exchange to and development of new products, closed-end funds with a size of over conduct research on feasibility of implement international standards, RMB2bn. Since its inception in 1998, introducing ETF products into the as well as enhance and diversify our the accumulated dividends of Xing China market. Following regulatory product line to provide more Hua Fund is RMB1.175 Yuan per unit approval from the China Securities comprehensive service and products (par value is RMB1 Yuan per unit). Regulatory Commission (CSRC), to meet varying investor needs from

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the very beginning,” says Zhang. He points to early work that the firm undertook with Schroders back in 2000 “to develop our first open-end fund business.” That same year, ChinaAMC co-operated with Canadian firm CDP Capital, who acted “as our technical consultant to handle pension fund management systems.”Since then, ChinaAMC has established exchanges and personnel training relations with a number of overseas firms, including, Delaware Investment and SEI Investments in the United States, CDP Capital and McGill University in Canada, and Standard Life Investments in Britain.

“With the recent implementation of the QFII program (Qualified Foreign Institutional Investors), which enables licensed companies to invest in RMBdenominated equity and bond markets, many overseas asset management institutions have become active players in the Chinese markets: a trend which we believe will continue and accelerate,”says Zhang.

“Our outlook continues to be global and as China’s capital restrictions loosen, ChinaAMC is actively preparing our personnel, product R&D, back office operations, etc, to enhance our capacities for investment in global markets and start our overseas fund

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management business: making ChinaAMC a truly international fund management institution,”he adds As China follows through on its World Trade Organisation commitments, a new challenging and competitive asset management sector “will bring bright prospects and great development opportunities for ChinaAMC. We will continue to dedicate ourselves to bringing our QFII clients our unique and innovative conduit into the Chinese markets,” he concludes. As part of that process,“we continually look for opportunities to work with global institutions to add value into our domestic market.”

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Regional Review EUROPE

New indices provide

domiciled stocks quoted on AIM by market capitalisation. The FTSE AIM 100 Index will meanwhile comprise the 100 largest eligible stocks quoted on AIM, whether domiciled in the United Kingdom or abroad. “By working with FTSE to provide a choice of benchmark and tradeable indices, we should see an expanded range of investment opportunities A new FTSE AIM index series has been designed and constructed for investors as well an increase in following a wide-ranging market consultation carried out by the liquidity of AIM companies,” FTSE Group and the London Stock Exchange (LSE). The new index adds Graham.

Since the launch of AIM back in series will offer investors opportunities to invest in, and track the performance of AIM, the international market for smaller, 1995, it has emerged as one of the growing companies. The indices, say AIM personnel, will provide world’s most successful growth markets, involving both a more accurate measure of market performance. institutional and retail investors.

Since AIM opened in 1995, more TSE GROUP AND the London on both the main LSE market and than 1,300 companies have been Stock Exchange (LSE) have AIM increased to 2,865. This compares admitted and more than £11bn has introduced a series of new indices with 2,673 in 2004, of which 1,065 been raised collectively.

The FTSE AIM All-Share Index is a for AIM, the LSE’s international market companies were traded on AIM, up for smaller growth companies. The more than 30% on 2004, when some revision of the existing FTSE AIM FTSE AIM Index Series comprises 761 companies were listed on the Index that was created back in 1999 and has now been updated by three new indices: the FTSE AIM UK growth market.

Both FTSE AIM UK 50 Index and creating the three new indices that 50 Index, the FTSE AIM 100 Index, and the FTSE AIM All-Share Index “The the FTSE AIM 100 Index will be will meet the needs of today’s introduction of the FTSE AIM Index liquid, tradeable indices that can be investors. According to Paul Grimes, Series is a significant step in the used as the basis for index-related chief operating officer, FTSE Group, emergence of AIM as the world’s most investment products, such as “The new FTSE AIM Index Series will successful growth market and Exchange Traded Funds (ETFs). The allow investors to identify and access underlines the London Stock FTSE AIM UK 50 Index will consist the key performance drivers of AIM Exchange’s commitment to its of the 50 largest eligible UK for the first time. The index series should enhance the liquidity expansion,” says Martin of AIM, by increasing the Graham, Head of AIM at the The FTSE AIM Index Series transparency and profile of London Stock Exchange. the market and gives AIM gives companies 250 investors the tools for a from all countries and whole range of investment sectors access to the market 200 vehicles.”The FTSE AIM Allat an early stage of their 150 Share Index will consist of all development, allowing companies quoted on AIM them to experience life as a 100 that meet specified liquidity public company. The last 50 and free float requirements. year or so has seen a Companies included in the significant uplift in 0 indices must trade at least companies joining the 0.25% of their available market. By the end of FTSE AIM UK 50 FTSE AIM 100 FTSE AIM All-Share shares in issue in at least 10 February 2005, the total out of the last 12 months. number of companies listed Data as at June 05. Source: FTSE Group/FactSet Limited.

a boost to AIM

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ATHEX stakes its claim THEX HAS A strategic imperative ahead, maintains chairman Spyros Capralos, the market he thinks is “following the growth of the OMHX system in the Nordic zone. Invariably we have had to ask ourselves,‘Do we want to play a much more regional role?’The answer is a resounding yes. We think we can develop a much more important role for ATHEX in this regard.”

It is a confident assertion of Capralos’ positive strategy and one that finds resonance in both Greece and elsewhere. “It is a role Greece has to adopt, particularly in the southern European region,” says a banker in Athens. “It is a natural evolution for the market, one that builds on growing economic ties with the surrounding countries.” Capralos agrees: “We have already been establishing key relationships in the wider region, such as Cyprus, Belgrade, Bucharest and consulting with independent players such as Euronext, Deutsche Börse and OMHX, as well as exchanges in Milan and Madrid, swapping intelligence and ideas and garnering support.”

He stresses that “we are open to discuss the possibility of developing operations and new ventures with other exchanges,” expounds Capralos. It is a

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Location, location, location is becoming as key a consideration for the world’s stock exchanges as it is for property investors. The ability, or opportunity, to develop as a regional hub or focal point will ultimately decide the fate of many of the world’s current crop of exchanges. It is a destiny that weighs heavily on the Athens Stock Exchange (ATHEX) and its chairman, Spyros Capralos. With a welter of competitive experience behind him, his leadership may just be the edge that the exchange needs on its search for a regional, rather than simply a national, role. proactive approach that dovetails neatly with Capralos’ key strengths: he is a doer, clever, a natural multi-tasker and a practiced diplomat. A former general secretary for the Olympic Games for the Greek Government and executive director of the Athens Organising Committee (ATHOC) Capralos studied economics at the University of Athens and earned his master’s degree in business administration from the prestigious INSEAD University in France. In October last year, he was asked to take on the tough role of chairman of the ASE and also become chief executive officer of the overarching parent company, the Hellenic Exchanges Group. Capralos has an impressive curriculum vitae that encompasses a term as deputy governor of the National Bank of Greece (the central bank), chairmanships of various banks and insurance companies, managing directorships at EFG Balkan Investments and the Bank of Athens, and a 10-year international banking career at Bankers Trust Company. He is also a national swimming champion and has represented his country in the Moscow and Los Angeles Olympics in water polo.

Capralos was appointed after a six month hiatus while ATHEX and the government experienced some difficulties in the process of identifying a new chairman. In the event, Capralos was a popular choice, securing the endorsement not only of Pricewaterhouse Coopers, which led the executive search, but also the Athens

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

Exchange's Board of Directors and its main shareholders among banks and securities firms. Capralos is also known to have close relations with the Ministry of National Economy and Finance and Greece’s Capital Markets Commission – all important advantage to have onside to make a success of the job. And he has an important job to do, no mistake, with some key requirements. Stoking foreign investment is only part of it. Equally important is the restoration of confidence to the Greek retail market that has been largely absent from ATHEX since 1999. “We have taken a lot of effort to introduce as much transparency into the market as possible, to help restore retail confidence,” explains Capralos. “The message is starting to get through.”

The Athens Olympics themselves undoubtedly had a positive effect on foreign investment inflows into ATHEX acknowledges chairman Capralos. “As of the beginning of this year more than 36% of the market capitalisation of the exchange is owned by foreign investors – mainly from leading markets in Europe and the United States,” he maintains, “though we have started to notice increasing interest from nontraditional European markets.” He explains that the majority of investment activity is based around the FTSE ASE 20 bluechips, accounting for 70% of total market trading. A number of initiatives are underway, including private placements to foreign investors, roadshows in Europe and

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the United States which profile “some “Also, let us not forget that HELEX is a expansion into neighbouring markets. of the new, profitable and well run private company. Like any company, “Greece’s location provides comparative companies that are up and coming HELEX must optimise its operational advantages,” holds Capralos. “The and are deserving of investor efficiency to ensure its viability and contiguous markets are rapidly attention,” explains Capralos. He also competitiveness in a very complex and developing economies, which have a world.”

Capralos combined population of approximately thinks that once the government puts demanding its full weight behind the country’s maintains this is vital, particularly “as 100m people, while we enjoy both privatisation programme, then a spate there are so many developments in European Union and European of high profile initial public offerings Europe. Within this context, we need Monetary Union membership. Second, despite the fact that Greek businesses will also attract further investor to become more proactive.”

“We need to generate more are already market leaders in the area, interest at home and abroad. He points to the planned sell off of the visibility for high quality medium and there is still an enormous and untapped Hellenic Postal Savings Banks as an smaller companies. Let's not forget growth potential.This gives considerable example, “as well as power, that internationally, there are pools of advantages to companies that choose telecommunications and infrastructure capital dedicated to smaller stocks and Greece as a base to run their operations companies that already exist in the we need to make them aware of the in Southeast Europe.”

Moreover, the fact that our investment opportunities in Greece,” equity market,”he adds. neighbours are preparing to join the EU But the importance of Greece as an concludes Capralos.

– hopefully in the near future investment venue is not – lays the ground for further simply down to the Games, The FTSE/ASE Index Series economic growth in the he maintains. “It has also 250 region. Greece, through a been a result of substantial 225 modern and dependable economic progress made in 200 infrastructure, together with a recent years, the availability 175 mature financial and banking of EU structural funds, the 150 sector, can definitely play a continuing liberalisation of 125 key role in the economy of the markets, particularly in 100 Southeast Europe. telecommunications, energy, 75 In addition, ATHEX is transportation and 50 considering co-operations progressive privatisations of and alliances with other state enterprises. They have FTSE/ASE 20 Index FTSE/ASE Mid 40 Index European Union Exchanges contributed to the growth FTSE/ASE SmallCap Index FTSE/ASE 140 Index in order to expand the Helenic rate evident today in the capital market and increase its Greek economy. Greece Data as at June 05. Source: FTSE Group. liquidity. The increase of the offers today a high potential, market’s liquidity, within the which can be exploited in “Equally important,” he says, is the European Union framework, is a order to attract foreign capital and to reorganisation of HELEX’s internal prerequisite for the achievement of the entice local investors.”

With the confidence that these factors structure which was instigated in group’s effective operation, which will imbue, Hellenic Exchange’s (HELEX’s) February this year and which aimed to enhance its competitiveness against growth strategies are now tightly “upgrade the exchange’s technical other European Union Exchanges.

Of course, this is a project that focused on building both local and infrastructure, optimise business international business.“On a local level, operations, reduce cost and streamline cannot be realised just by the Exchange we must stress the need for the legal and regulatory framework to itself. Companies, brokerage firms and modernisation and expansion of promote investment, both domestic investment banks need to play their markets and products through the and foreign. We have placed particular role too. “I believe that enhancing the introduction of new listings of shipping emphasis on promoting good corporate visibility of the Greek stock market among foreign investors presents us companies, new freight derivatives, and governance and accounting practices.”

On an international level, meanwhile, with a serious challenge but also with a the enhancement of the corporate and State bonds market,”expands Capralos. growth is firmly predicated on regional significant opportunity,”says Capralos.

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COVER STORY: BNP PARIBAS

THE RULE OF

While many a European bank has aspired to become truly global very few actually succeed. It is a singular dream that is sometimes stymied in Asia and invariably scuppered in the United States. BNP is one of the happy few that have shown that particular cycle can be broken as it arcs its wings across the globe via a strategic mix of selective acquisition and organic growth. Its tactics are supported by intense customer focus, ruthless corporate discipline and a highly effective image drive.

Baudouin Prot, the bank’s chief executive officer (CEO), talks to Francesca Carnevale about the alchemic mechanisms that have turned BNP Paribas’ base metal into gold

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HE APEX OF a two hour interview with Baudouin Prot the expertise of its staff full square at the heart of its global is skewed near the end of the meeting. In reply to a expansion strategy. For Prot, it is a sine qua non, particularly question about his management style, he dips into his in an organisation that, he says, “is about leadership for top pocket and pulls out a multi-folded card. On it are the development. The bank empowers people … to foster the tightly printed names and contact details of 80 people, right entrepreneurial spirit – we have put a lot of emphasis designated as elemental to the running of BNP Paribas’global on training key managers to take the initiative.”

“Look, we are by no means perfect. We simply strive to network. It is a seminal, luminous moment. On the surface, it is a small gesture. But it pinpoints precisely the way in which consistently outperform or at least do better. That ambition the bank is run: the ability of Prot to dip in and out of any has driven the way we are now organised and the products department, sector or country at will; and the strong we have introduced,”adds Prot.

What the “Rule of 80”has achieved over the last six years “fellowship” (his word) which underpins the bank’s slick strategic spread across the globe.“I put a lot of emphasis on is notable. It is the first bank in terms of net income in the managers, so I take it everywhere,” he says as he looks at it Eurozone and the fifth largest in Europe in terms of market intently and suddenly a smile breaches a demeanour that has capitalisation. BNP Paribas Group now has one of the been enigmatic throughout.“Each of the 80 people has this largest international banking networks with a presence in card. It is about the way the bank’s leadership team works some 85 countries. Once a medium sized bank, it now enjoys key positions in corporate and investment banking, and interacts together. We use it a lot.”

Obviously it is a powerful tool – particularly in a bank private banking, asset management, insurance, securities which has put intense emphasis on lifting customer care to services and, of course, retail banking: with specific marketexceptional degrees, crossing the span of the bank’s leading expertise in project finance, syndicated credits in business, which includes retail, institutional, corporate and the EMEA region, European leveraged loans and Europrivate wealth. In turn, that requires high levels of denominated sovereign bonds.

Core to the bank is its domestic and retail business. The communication, collegiality and discipline concedes Prot: reason is elemental, “hence the immediate explains Prot. “Retail access that the card gives Bearing down on the US: – BNP Paribas, HSBC banking accounts for 53% to each of us. We also meet Holdings, ABN Amro vs. FTSE US Banks Index of the Group’s revenue and together for three days 175 53% of its gross operating each year to reinforce what 150 income. If you look at our we do and to brainstorm overall revenue, France still new ideas. It is an 125 accounts for 55%, 20% invaluable forum.”

100 comes from the rest of It is also telling of the 75 Europe, 17% from the man himself. Precision, United States and 10% order, activity appear to be 50 from the rest of the world.” at the heart of Prot.

25 In 2004, income from the Throughout the interview bank’s French retail he jumps up to find a piece BNP Paribas HSBC Hldgs ABN Amro Hldgs FTSE US Banks Index network reached €5bn, up of paper that he locates 4.1%, based on an increase within nanoseconds in any Data as at June 05. Source: FTSE Group/FactSet Limited. Price Index values in US Dollars. in both lending and one of the myriad documents neatly piled around his office to support what deposits and a contraction in gross interest margin. Sales and he is saying. There is nothing of the clear desk, broad brush marketing drives targeting individual customers continued at executive about him. The sense is that he likes to have a fast pace, according to the bank’s annual report for the year. everything close; data, trends, his contact card. Everything Individual loans were up by almost 17% on the year and rose is qualified, considered action. Everything is in the detail. significantly faster than the market, due in large part to the bank taking market share in the mortgage lending (with Prot, it seems, is a pure reflection of his bank.

No small surprise then that, rather like the US Marines, mortgage lending by the bank itself up 22.2% versus the first BNP Paribas’ staffers live by particular codes. The Marines three months of last year) market and increasing its retail have the totemic ‘God, Honour, Country.’ Today’s call to BNP customer base. “Certainly an important element of our Paribas staff is the rather less polemical: Ambition, strategy is to be consumer driven. A few months ago we Commitment, Responsiveness and Creativity. Nonetheless it is finalised a new front office design with nominated sales staff still effective. It is perhaps a little unfortunate that it does who can work closely with individual customers, whatever not have quite the same phonetic ring, or a convenient their requirements. We can see the difference,”he says.

What it means is that “we are more efficient, we can acronym, as the more emblematic “Ambition for Corporate Excellence” (ACE), that was the bank’s management focus on increasing market share as we build new customer watchword two years ago, accepts Prot. Nonetheless, they business and increase existing customer loyalty through a are forceful calls to action in an institution which has placed vastly improved and personal service. It is an entirely 5

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Return on equity in % 2004

2003

2002

2001

16.80

14.30

13.50

18.20

(*) Before restructuring provisions in 99 divided by the number of shares at 31/12/99.

Earnings per share in euros 2004

2003

2002

2001

5.55

4.31

3.78

4.64

(*) Before restructuring provisions in 99 divided by the number of shares at 31/12/99.

Market Capitalisation boursière in billions of euros 2004

2003

2002

2001

47.15

45.10

34.80

44.50 Source: BNP Paribas 2005.

customer driven strategy,” explains Prot, adding: “Before, frankly, it was something of a mixed bag.”

Getting to this point however has involved a process that was begun back in 2001 and is only now nearing completion. It has encompassed a total overhaul of the bank’s customer relations interface that takes in retail, through a multi-channel banking system that encircles customer call centres, interactive voice servers, customer relations management and specialist workstations and an intensive customer service programme implemented at branch level. It has also taken in private banking, banking services for professionals and entrepreneurs, business customers. Direct customer sales through these front end outlets is further supported by improved back-office and customer ‘after-sales’ service, which has not only increased customer loyalty rates but also encouraged more crossselling of services – a business accretion strategy now employed in every market segment serviced by the bank.

It is all the more remarkable in that BNP Paribas has grown into a cohesive and dynamic whole from what appeared to be, five or more years ago, a somewhat awkward agglomeration of parts. Prot explains the acquisition dynamic: “We like to build up positions, combining organic growth and selective acquisitions. It does not matter to us whether a company is small or medium sized, what is important is what it gives to us in building franchises in specialist areas.”

That disciplined approach is exemplified by a seemingly inexorable run of small-scale acquisitions that has been building pace through out 2004 and which will run through most of this year as well. “It is about creating market leadership through selective mergers and acquisitions,” says Prot, or at least isolating which institutions have the potential to help us develop that leadership position.”It is a long term strategy and one that builds in stages. In June of last year, for example, the bank announced a minority investment in Integrated Finance Limited, a specialised investment bank providing strategic advice for clients, founded in 2002 to develop and implement integrated solutions using leading

financial technology. The partnership will however enable IFL and BNP Paribas to combine their respective problem solving and execution capabilities to design optimal solutions for top-tier clients, especially in the area of strategic risk management and derivatives. In particular, BNP Paribas's equity derivatives and fixed income business lines will work closely with IFL in the new partnership, and, with the bank’s typical cross-selling style, leverage expertise in the bank's various investment banking teams.

In the bank’s consumer credit segment, the strategy has been slightly different. BNP Paribas has aimed to leverage market share through distribution organised in chains of sales outlets providing customers with easy access to credit offers. Its acquisition of Credisson in Romania, typifies this approach. The deal illustrates another element in BNP Paribas' growth strategy, which relies to a large extent on its specialised subsidiaries to ensure international growth in consumer services. Prot explains that one half to two-thirds of Cetelem’s business is now outside France and that creating a pan-European dominant position in consumer credit is now a backbone of its continental strategy. It is indicative of consistency in action.

However, while BNP Paribas manages to remain true in its approach and operational tactics its potential partners sometimes are not. In July, last year, via its subsidiary Cetelem, the consumer credit house, the bank agreed to take a 50% stake in Russian Standard Group’s financial arm, Russian Standard Bank, signing a deal with Rustam Tariko, the owner.

The deal fell through last December. BNP Paribas issued a formal statement on 22 December of last year.“To date some steps necessary for the execution of the agreement, which had to be taken by Cetelem’s counterparts in the agreement and not by Cetelem itself, have still not been taken. This situation is affecting the successful execution of the deal and is creating uncertainty as to its completion,”explained the official release.

“Consequently, BNP Paribas has decided to take appropriate actions, including legal actions, to protect its interests.”It is fair to suggest that it will be unlikely that any deal between them will now go ahead.

BNP Paribas was itself built on acquisition. Back in February 1999, Banque Paribas, as it was then, was in talks with Société Générale on a possible merger. About a month later BNP launched a simultaneous and (at the time) audacious takeover bid for Banque Paribas, offering 11 BNP shares for eight Paribas shares, in a hostile takeover, and 15 BNP shares for seven Société Générale shares. The supporting public relations campaign to support the double merger appealed strongly to Gallic nationalism.“Give France a European-scale banking group with a strong domestic base!”was rallying cry – and while not quite the timbre of the Marseillaise, it was equally stirring and revolutionary for the time. Much depended on the Conseil des Marchés Financiers, the French financial markets watchdog. In the event a full three way merger was too rich even for French tastes and at the end of August, BNP ended up owning 37% of capital and 32% of the voting rights of Société Générale, but 65% of the capital and 65% of the voting rights of Banque Paribas. The merger

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created one of the strongest forces seen in French banking. the intervening period included the establishment of its Andre Levy Lang subsequently resigned as chairman of wealth management business in 2002, the acquisition of Banque Paribas in favour of Michel Pebereau, who took on the Cogent from Australia’s AMP, followed by the establishment chairmanship of the combined banks. A combined General of BNP Paribas Ltd in China in November 2003.

While the bank has enjoyed quickening revenues and Shareholders’Meeting convened on May 23, 2000 confirming profits since 2003 one senses the creation of the new BNP that 2005 will be a year of Paribas Group, backed by net significant upswing – income of approximately “That disciplined approach is exemplified certainly if its first quarter €1.35bn and 77,000 by a seemingly inexorable run of small(Q1) results are anything to employees working in 83 scale acquisitions that has been building go by. Income in Q12005 countries around the world. pace through out 2004 and which will run alone is up by nearly 20%, From the outset then BNP through most of this year as well.” with the bank’s international, Paribas emerged as a giant financial services, and asset entity with even bigger management products aspirations. At the same general assembly, Pebereau also announced he would give up among the healthiest earning business segments. Prot the role of CEO in favour of Prot and move into the senses it too. In interview after interview Prot has stressed chairman’s slot by August that year. Prot had been a close ally that the bank’s growth is on an accelerating trend. Prot is particularly pleased with the bank’s asset management of Pebereau since he joined BNP in 1996.

The outgoing general president-director of BNP-Paribas segments, which saw net banking income up 17% over the had clearly designated his successor. Pebereau was a strong period, where “organic growth accounted for more than 10 entrepreneurial leader, who had managed to turn BNP and percentage points of that and corporate and investment latterly BNP Paribas into France’s biggest bank during his banking, where I think we are among the top industry ten year tenure (in his first five years running the bank he performers.”

That acceleration is directly the result of new sales and grew profits sevenfold). Prot has carried on the performance tradition. A long term hand at the bank, prior to becoming marketing systems applied across the globe and across CEO Prot had been managing director and was in the product groups. BNP Paribas’ willingness to restructure and forefront of the bank’s North American growth programme, restructure again until the right mix is achieved is one reason which was even then a practical mix of organic growth and for the bank’s ability to leverage new business. Prot provides selective acquisition – a tactical methodology subsequently the example of the bank’s fixed income business as a rolled out on a global basis once Prot took the helm. With a paradigm of the bank’s focus on the customer. Since 2001, its net interest margin ratio twice that of an average French fixed income business had been organised around three bank at the time, the portents were good, a fact the bank global product lines, interest rates, foreign exchange and leveraged to good effect as the pace of growth and credit. The approach was very successful; client revenues acquisition began to pick up. The footprint for today’s more than doubled in the last three years, generating an structure had been put in place early on, often by Prot, impressive growth of the bottom line. “In this context BNP through the expansion of the bank’s retail business in the Paribas has become a leader in problem-solving businesses United States through the acquisition of Bank of the West. In such as structured derivatives and debt capital markets, as the immediate aftermath of the merger with Banque Paribas, well as in flow-driven businesses such as credit bonds and the bank won a series of high profile securities services credit default swaps,”says Prot. However, he explains that it mandates which put the bank firmly in the number one slot was clear that the old operating model was reaching its limits. in France for securities services. These days it is Europe’s “Clients have been asking us to provide them with a more leading provider of securities services. Other milestones in integrated coverage across fixed income asset classes and product types,” he says, acknowledging that it had been “a service that our previous marketing organisation did not easily provide.”Although some recent organisational changes KEY FIGURES BY DIVISION had been made in the regions, he adds,“we believed that our sales structure needed to be further adapted in order to meet Net Banking income in millions of euros 2004 2003 more easily our clients’ requirements and our business Retail banking 9.979 9.636 targets.” BNP Paribas also felt it needed to adopt a more Private banking, asset management, insurance 3.019 2.476 integrated approach to taking risks across asset classes in Corporate and investment banking 5.685 5.818 order to capture more trading opportunities.

Just how far the bank has come is evinced by its growing Gross Operating Income in millions of euros 2004 2003 global reach. Within that overarching globalisation strategy, Retail banking 3.796 3.625 BNP Paribas’ acquisition tactics remain focused and tightly Private banking, asset management, insurance 1.066 803 disciplined. Most recently, the bank signed an agreement in Corporate and investment banking 2.442 2.434 early May to acquire the Asia Pacific equity execution Source: BNP Paribas 2005.

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business of Calyon, Crédit Agricole Group’s Corporate and Investment Bank. The transaction includes the corporate entity Credit Agricole Indosuez Securities Japan (CAISJ), and the assets of its related Hong Kong business. The acquisition allows BNP Paribas to expand its existing equities business into bespoke equity execution in the Asia-Pacific zone. Japan and Hong Kong are key geographic bases for the bank’s broader Asian strategy and significant investment is expected in CAISJ and its Hong Kong equivalent.

The acquired business includes a team of 30 people located in Tokyo and Hong Kong. It concentrates on nonresearch driven cash equity execution in Asia Pacific, including functions such as Direct Market Access (DMA), program and block trading, sales trading and commission recapture (correspondent brokerage). It typifies the BNP Paribas sales and marketing approach, where the bank leverages local synergies and cost savings between different but related services and uses specific offices to cross-sell its products in the wider region. In this instance, it will also likely leverage its local broking business, BNP Paribas Peregrine with its equity derivatives flow business, which the bank has been pushing strongly in the region over the last year. “What is important,” continues Prot, “is that now we have a significant presence in China though we look at it from the point of view of Greater China – that is, China plus Hong Kong plus Taiwan.”The bank recently secured a banking licence to lend in Remnimbi as well as fortifying its position as lead arranger for Eurobonds.“We have established the bank as one of the top two bookrunners for Chinese loan syndications,”he adds.

In Europe too, BNP Paribas’s peculiar mix of highly focused acquisition and organic accretion of market share in discrete market segments has allowed it to build up a growing pan-European private banking franchise. This has been achieved by the acquisition of ABN AMRO’s Dutch private banking unit to BNP Paribas; 50% of Turk Economi Bankasi (TEB) in Turkey and further acquisitions in Spain, Monaco and Switzerland. In the case of TEB, it is not solely a private banking play, but also retail banking, trade finance and corporate and investment banking – indicative of BNP Paribas’ constant striving to develop cross-selling opportunities across its varied core businesses.

Perhaps the most significant achievement is, however, in entering the notoriously difficult and demanding US market. The structure of BNP Paribas North America mirrors that of the global organisation. Overall, the franchise offers a broad range of products and services in corporate and investment banking, trade-finance, capital markets and securities brokerage, asset management, retail banking, and international private banking.

In 1998, BancWest Corporation was created through the merger of First Hawaiian Bank with Bank of the West in California, which had been a subsidiary of BNP. In December 2001, BNP Paribas bought out the rest of BancWest’s stock for $2.5bn. In March 2002, BancWest Corporation acquired United California Bank, Los Angeles’s largest bank for $2.4bn, which had been the property of Japan’s UFJ Holdings.

Share Ownership Structure Share ownership of BNP Paribas as at December 31 2004 Institutional Investors – European – Outside Europe Public AXA Employees Other and unidentified

64.9% 52.7% 12.2% 6.9% 5.7% 5.1% 17.4% Source: BNP Paribas 2005.

In 2004 BancWest acquired the $5.5bn in assets of Community First Bankshares, Inc., whose Community First National Bank operates 155 branches in 12 states in the Southwest, Rocky Mountains, Great Plains and Great Lakes regions. At the same time BNP Paribas acquired United Safe Deposit Bank (USDB), which made BNP Paribas a meaningful force in California banking, as it absorbed the state's fourth largest deposit holder. All the banks now operate under the brand of Bank of the West.

The moves were canny. The cheapening dollar meant the deals were economic and it was a balancing counterpoint to the accretion strategies being employed in both Europe and Asia. As well, it was becoming apparent that it was much easier to cut costs, exploit synergies, and boost shareholder value in the US. BNP Paribas’s success is that it has kept to relatively small acquisitions in the market.“It makes it easier,” acknowledges Prot. And with each acquisition, “the bank is building up significant know-how and skills in the integration process. In every instance, we study execution risk very carefully indeed. It is all in the detail.”

HSBC, ABN Amro, BNP Paribas and RBS are four banks that have obviously made a success of their US acquisitions. Perhaps it is because they have all adopted reasonably similar strategies in the market focusing in large part on businesses such as credit cards, mortgages and consumer lending, where they offer long standing expertise. Prot acknowledges that BancWest is “an important footprint. It is now the seventh largest consumer bank in the Western USA, including Hawaii.”

Prot maintains the final element in the bank’s methodology is the attention it pays to “compliance, ethics and generally being a responsible company – particularly how we interest with different communities.”The bank, he says, is well aware of the different stakeholders in its business. “Customers, of course, are at the centre of this virtuous circle and central to the strategy of the bank.

Because we are a service company, it then naturally follows that BNP is a place where people want to work because of these core values.”For Prot, it ultimately boils down to the fact that “our shareholders are committed to creating value and the disciplined management of the bank’s capital.”So, it really is all about ambition, commitment, responsiveness, innovation, and creativity.

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A LFI A s s o c i a t i o n

o f

t h e

Luxembourg Fund Industry

&

The National Investment Company Service Association

nicsa

S eptember 13 & 14, 2005

Hemicycle of the Kirchberg Conference Centre, Luxembourg

THE 14TH ANNUAL EUROPE-USA Investment Funds Forum

For a conference programme with registration details and exhibitor information, please refer to the following websites: www.alfi.lu and www.nicsa.org

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INVESTMENT SERVICES: GLOBAL CUSTODY

The jigsaw that is the global custody market is in flux, as new market opportunities continue to appear, investors outline conflicting demands and further market consolidation remains a fact of life. Custodians are now compelled to provide their clients with a 360 degree service; which, in turn, is stretching the definition of latter day custody services beyond its traditional boundaries.

Francesca Carnevale reports.

service in the round T

Penny Biggs, head of corporate and institutional services at Northern Trust for the EMEA region

34

HE NEWS CAME softly in early June that Royal Bank of Canada (RBC) was to work in a 50/50 joint venture with Dexia Banque Internationale à Luxembourg (Dexia BIL) to combine their institutional investor services businesses, pending receipt of the appropriate regulatory approvals. Called RBC Dexia Investors Services (RBC Dexia IS) the venture will be headquartered in London, have approximately $1.8trn in client assets under custody and some €500m in tangible equity. Marc Hoffman, currently chief executive officer (CEO) of Dexia BIL and a member of Dexia’s executive board becomes chairman of RBC Dexia IS; while Jose Placido, until now executive vice president of RBC Global Services, will become CEO. The venture makes sense as custodians now vie with each other to offer the best offering of high-touch, integrated services. As Jose Placido noted at a tele-press conference ,“we will focus on achieving long-term growth by providing institutional investors with an integrated proposition of global custody, fund and pension administration, transfer agency and related services.” Placido conceded that it had been RBC that had made the first approach. It was “about a year ago. It had been obvious that both institutions had a client centric approach. It is a good strategic play,” he explained.

RBC’s global reach and Dexia’s expertise in hedge fund administration, transfer agency services and offshore business gives the relationship piquancy. Both firms will also benefit from “crossselling opportunities. Dexia,

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and the bank’s securities and for example, has just launched a new employee savings services for set of products for hedge funds, and it businesses.“It has been a sea change,” will be able to leverage RBC’s expertise he says, “driven largely by changing in securities lending,” explained customer requirements.”

Hoffman, “We expect a steep The interesting element, adds Closier development in the business.” is that he thinks that Europe will RBC’s rival CIBC Mellon was quick Robert Binney, become a key battleground for new off the block. The following morning it managing director, business for a number of reasons.“The sent out a biting missive to every Citigroup Global US market has already largely journalist that had asked a question at Transaction Services EMEA consolidated,” and on the European the conference call, intimating that the side, “I see only continued route that RBC was treading today, was one that CIBC had, in fact, carved out years ago (in 1996) fragmentation of the continental European marketplace for at when it similarly established a 50/50 joint venture with least the next five to seven years. After that, who knows?”This Mellon. It was also obvious that CIBC Mellon representatives means opportunity for the European style custodian over the had been listening in on RBC Dexia IS’s transatlantic press US style, he suggests. Furthermore, he adds, traditional terms call – an admirably aggressive move and a signal indication of of reference are also flying out of the window.“As a player, as just how competitive the global custody market has become. a company, we do not speak necessarily of profitability As Jeff Conway, head of State Street Investor Services coming from the size of the operations, but of the profitability of the combined value-added services that we provide.” explains: “custody is not for the fainthearted.”

Chakar at ABN AMRO Mellon thinks it a dangerous The emergence of RBC Dexia IS is also indicative of the changing definition of investment services provision. The route.“Irresponsible pricing is an indication that the sector provision of a limited range of plain vanilla custody services remains over-banked. We certainly understand price is no longer enough if, as an institution, you want to compete competition,”she says,“but at a fair margin. But we are also among the world’s top 30 providers. According to Ramy happy to walk away if the client is not content with the offer Bourgi, senior vice president and business executive for on the table.”It is a sentiment that Conway also espouses.“I JP Morgan Worldwide Securities Services in EMEA, “custody think it is a case of making sure that the customer fully as an element within the total value chain is undoubtedly understands the products and service quality that you are offering. Customers are today looking for transparency and getting smaller”.

Further, the fact that RBC looked to a European provider getting the right value and not necessarily the cheapest to partner with is also telling and points to a growing price. We have to be disciplined about price,”he says.

That thinking finds a willing counterparty in Citigroup. “I acknowledgement by North American custody houses that the diversity of the European landscape offers as many would agree that the custody element in investment services challenges as it does opportunities. As Nadine Chakar, is highly commoditised these days, “says Robert Binney, CEO of ABN AMRO Mellon Global Securities Services – managing director, Citigroup Global Transaction Services, but another transatlantic partnership that has shaken he stresses, it by no means ends there. But if clients can “save significant dollars from the European custody tree – would costs on process systems” he says, “why not?”“Let us be have it, “there’s a different feel and sense to this pragmatic. What is so glamorous about custody that it requires marketplace and its constituent parts. At first Mellon intensive hand holding and grooming of the customer?”It is a thought it would conquer the world from the US. But it was powerful rhetoric and highlights the stance of the US majors only through a joint venture with a major European that, almost as one, argue that if custody is commoditised, it provider – ABN AMRO – that the ability to service the allows investment services provider to really add value for complexity of each market and to localise our offering to their clients elsewhere and it is a lesson that their European suit each market’s particular requirements was achieved. competitors are adapting rapidly in their own efforts to build market share. Rising interest in offshore pooled pension funds That is sometimes lost on US providers.”

Certainly, says Andrew Tucker, partner responsible for is a case in point, thinks Binney.“Offshore capability will have Europe at Brown Brothers Harriman (BBH) Limited in significant resonance in the future,”says Binney,“It is not for London, “Europe and Asia would be considered as higher everyone, but for the large multinationals, a BP, Unilever or growth markets, compared with the North American Nestlé, can benefit.”

What this means for the global custody market over the market, with attendant differences in targets and service provision.”According to Alain Closier, global head of Société long term is still not clear, says Penny Biggs, head of Générale’s global securities services for investors (SG GSSI), corporate and institutional services at Northern Trust for the the European theatre is simply more demanding and forcing EMEA region. She concedes however that the marketing is the provision of a “360 degree service outlook.” It is a hardening as the US and European houses fight more development that SG GSSI took into account last year when aggressively for market share, particularly in Europe,“with it grouped together the activities carried out by Fimat, the offshore expertise a strong element within that.”She points group’s specialist broker, its entire investor services business out that “there are a lot of specialist investment firms that

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© 2005 Northern Trust Corporation. Authorised and regulated in the UK by the Financial Services Authority

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are anxious to gain access to a more sophisticated product set, for example alternative fund administration or investment manager pooling.”For one,“the middle market has still to fully emerge,” says Conway. “What attendant affects that will have is yet to be determined,”he continues.

The confluence of these factors is putting pressure squarely on investment services providers; evinced by the spate of restructurings in the market as some houses overhaul their infrastructure to cope with new market requirements. At JP Morgan Chase Bourgi thinks that the underlying dynamic rests entirely with the customer, who definitely “wants a one stop shop.” Outsourcing, he maintains is additionally“creating demand for bundling. It is about connectivity.”Recognising that the face of investment services has altered inexorably, JP Morgan Chase undertook an expansive restructuring of its investment services operations in April this year, which now works under the moniker of JP Morgan Worldwide Securities Services.

The integrated franchise brings together the former JP Morgan Investor Services and Institutional Trust Services businesses, and provides custody and investor services as well as securities clearance and trust services. Combined the new business will generate over $3bn in revenue and manage some $9.1trn in assets under custody. What it signifies, continues Bourgi is that “as our clients respond to changes in the industry and regulatory environment, we will be able to anticipate their needs and help them react even more quickly to the ever-changing demands. We think that the bundling of this array of services will be a winning hand.”

It is a theme that Tony Solway, head of BNP Paribas securities services in the UK, also warms to. He thinks the key driver to date has been the management of costs, which has been particularly difficult in the recent environment.”

While Solway explains that the drive by investment firms to reduce overheads has driven the current trend for outsourcing,“and which is now a growing business line for everyone,” he says, it has put pressure on the custodian to balance a consequent tendency to commoditise their offering in order to keep costs in check and at the same time provide a level of personal service. “Conventional wisdom had it that in bad times, cost reduction is a key driver and that in good times product capability is a key driver,” he elucidates.“These days you have a definite blurring of those distinctions. In a better market environment, clients are looking for savings and capability to support growth.”

Paul Stillabower, head of business development at HSBC cites the impact of client requirements to reduce costs at every level of the investment services spectrum, coupled with custodians’ desire, in particular US custodians, to expand outside their home market, especially in the European custody market. “The custody product is rapidly commoditising and, in that business model, just like cheque processing and cash payments business it increasingly gravitates to big global banks offering scale and geographic reach. The US market is a scale play, with relatively mature vanilla processing requirements,” he says. However, eventually, thinks Stillabower, that will change in Europe as

well, “as clearing and settlement infrastructure and tax harmonisation continue to converge,”he says.

While Biggs accepts that regional requirements play heavily on today’s custody provision, she is more sanguine about the whole process. “Everyone accepts that clients these days want to be treated as individuals.” At BNP Solway expands on this theme. “Given the growing strength and choice of service providers, customers are confident to demand a greater range of services from their processes. In the 80s, American service providers pushed down UK custody prices by 50 percent to gain market share – today we are seeing the same again in mid and back office services. The hope is that scale will result in future profitability from a provider’s point of view.”

Like Closier at SG and Biggs at Northern Trust, Christian Broger, head of global investment reporting at Crédit Suisse Asset Management (CSAM), thinks that the market is becoming more segmented and that it is the ability of Europe’s custodians to think and work “outside the box” that will ensure they will enjoy new business opportunities even while competition from US banks continues. He explains that “the US banks, for instance, have enjoyed an advantage with multi-national clients, but the growing strength in the European market is the ability of custody houses to provide services to non-traditional funds that want to outsource their mid and back office functions. It is not an automated business so far, and so has little appeal for the more commoditised houses.” Closier concurs: “It remains complicated and difficult for the US banks to come to each country and provide the same service to everyone.”

Tucker at BBH agrees that having a clear market segment is a vital focus for today’s investment services provider.“We are definitely focusing on two markets, providing fund administration services for asset managers and high net worth clients and non US financial institutions in Europe and the Far East,”he says by way of explanation. Underlying this approach is the fact that Tucker and BBH feel that the market is no longer a homogeneous business.“And unlike the larger custodians who are trying to be all things to all institutions on the planet, we believe that our discrete approach gives us immense traction.”State Street’s Conway thinks the picture is more straightforward.“Opportunity lies clearly across six or seven markets, the UK, France, Germany, Switzerland, Holland and Italy and then offshore products. We are focused and disciplined in our growth plans and where we place investment with regards to our regional strategy.”

According to Citigroup’s Binney, the market will remain diversified for some while. However, he strongly believes that the requirement for continual investment in technology will eventually favour the larger players and continued market consolidation will ultimately support this trend. Biggs at Northern Trust agrees.“The requirement in technological investment undoubtedly provides the current crop of major players with a cushion against newcomers,”she says and “there is no doubt the barriers to entry are rising all the time, particularly in technology. It is no longer a business you can enter from a standing start.”

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The long-heralded outsourcing boom is here, presaged by a number of headline grabbing ‘liftout’ deals – JP Morgan Investment Management, PIMCO, Scottish Widows Investment Partnership and Schroders Investment Management – entailing the wholesale transition of clients’ middle and back office operations. Custodians have found themselves under pressure to stake their claim in latest new frontier of the global asset servicing business. By late last year all had at least one mandate to exhibit. The question is whether they can sustain and build upon existing arrangements while satisfying their clients’ high expectations in respect of pricing, transparency, flexibility, integration and scalability? Tim Steele reports.

Outsourcing: THE SKY’S THE LIMIT HE IRONY IS that, after so many years of mounting expectation and speculation, it was only a matter of months for outsourcing to be officially proclaimed as boring. A panellist involved in a securities session at last year’s Sibos conference in Atlanta, Georgia, described it as “a little tiresome. It has not worked out the way it was supposed to”. If the first charge is arguably true, few would deny that the term has become as ubiquitous, and hence as devalued through repetition, as that other securities industry hobby-horse, straight-through processing. The second, however, is most definitely false.

False because fund managers are still striking new outsourcing deals with custodians. False because those clients are not exclusively drawn from the United Kingdom (which has been the hub of outsourcing) and increasingly business is being garnered from Continental Europe. False, because the recent shift in focus away from big lift-outs towards a more modular or component-based outsourcing model – of which more later – was not an admission of defeat but was, in fact, all part of the ‘Masterplan’.

In a research note entitled A Novel Look at Outsourcing in the Asset Management Industry: The Customer’s Perspective, published last summer, TowerGroup predicated that the number and scope of outsourcing contracts would continue to increase steadily through 2005. It also predicted that assets under administration will grow by 12% each year into 2007. “Outsourcing is consistent with many of the macro trends impacting the asset management industry,”notes the

T

report’s author, Tim Lind. After the heady bull market of the 1990s, the comedown was comprehensive, culminating in volatile markets, eroding margins, an inability to scale, bloated product lines and a generally slapdash, short-term approach to technology investment. As a consequence, it has triggered a fundamental reassessment of the established asset management business model.

As KPMG/CREATE noted in their 2003 survey Revolutionary Shifts, Evolutionary Responses: Global Investment Management in the 2000s, managers found themselves in the grip of “Darwinism with a vengeance”. As a consequence,“serious introspection overtook entrenched complacency”. Management consultancy KPMG/CREATE prescribes a dose of ‘lean production’ to cure these ills. Of course, outsourcing has a central role to play in that course of treatment – with global custodians, thanks to their longstanding buy-side relationships, depth of offering and expansive geographic reach, ideally placed to consolidate their position as the primary practitioners in this space.

“Outsourcing is a process, not a product,”says Ramy Bourgi, senior vice president, business executive investor services, Europe, Middle East and Africa at JP Morgan Worldwide Securities Services.“It is part of a natural evolution. Managers outsourced custody, then accounting, then performance measurement, then securities lending, and now their middle and back office activities. When someone is outsourcing their middle and back office, their chosen provider will be servicing their custodians, doing their accounting, their client reporting

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and so forth. All those activities fall within custodians’ core expertise, and we are therefore ideally placed to bundle them up into a cohesive and scaleable proposition.”

“Managers find themselves in a fast changing environment, the middle ground is being squeezed, and many large houses are losing their specialist managers to boutiques or start ups,”says Rob Wright, managing director and head of global fund services, institutional and investor services at RBC Global Services.“Such boutiques are largely virtual managers that focus almost exclusively on proprietary trading, they have no infrastructure so most everything else has to be outsourced, be it via a prime broker, administrator or custodian. However, we are now seeing buy-side firms more generally starting to look seriously at that virtual manager model as they seek to become nimbler and cut costs through a more specialised, focused approach.”

Steve Papulak, director of business development for Mellon’s Investment Manager Solutions business, points out, the challenges pushing asset managers into the warm embrace of outsource providers do vary depending on geography. “The fund management business is more expensive for European firms because of the diversity of products and the distribution issues they have to contend with,”he says.“As a result there is more focus on direct costs than would be the case with a US firm, who are more likely to be looking at outsourcing because of technology issues arising from legacy systems that need replacing. Meanwhile, Asian firms, like their European counterparts, are dealing with product and distribution arrangements that are far more complex than those found in the US market.”

Daron Pearce, managing director and head of fund managers’ sector at The Bank of New York, agrees that interest in outsourcing continues to grow, notably among large Continental firms.“Over there it is about large multijurisdictional houses looking for global platforms and real synergies through the operating and technology models,” he says. “In the UK it is still more about short-term cost savings, and there is less strategic thinking around it. Of course that may have been fostered by the consultant community, which still believes there are some attractive deals to be struck by buyers. However, the strong impression I get is that few, if any, providers are these days prepared to cut big cheques to secure deals.”

If costs topped the agenda between 2001 and 2004, Tony Solway, head of BNP Paribas Securities Services in the UK, believes other priorities are now coming to the fore.“Sure, no one is going to make the jump without a significant cost advantage, but it is no longer such a priority,”says Solway.

Like Papulak, he sees the need to upgrade technology emerging as a key driver – “outsourcing is a way of almost getting new technology thrown in for nothing” – he also highlights another area.“Having gone through a phase of consolidating their product ranges and eliminating the sub-scale stuff in recent years, managers are now looking again at new product development,”he says.“So there is a focus on innovation, and in our capacity as a partner within the outsourcing relationship we can assist them with that.”

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Tom Abraham, managing director at Citigroup Global Transaction Services

Frances Hudson, investment director, strategy at Standard Life Investments recently highlighted the importance of ‘cultural fit’ between the outsource provider and its clients.

The marriage analogy, so often applied to outsourcing over the past couple of years, remains right on the money. Hudson went on to add: “Less positive experiences of outsourcing have occurred where planning and management of process has been lacking… management of expectations within and outside the firm is critical to success.”

RBC’s Rob Wright concurs. “Outsourcing really requires you to become an extension of the asset manager’s operation,”he says.“It is about the custodian becoming more innovative, creative and responsive, and about collaborating in areas such as product creation and helping the client to build out the right business model and operational processes.”Indeed, clients must also be prepared to step up to the plate:“It is vital clients are a contributing participant in the process. Certainly we expect those we are working with to put in considerable effort up front, but we are confident that will pay off later on down the line.”

If managers’ long harboured suspicions regarding the ability of custodians to truly get to grips with the rigours and complexities of the asset management business, Tony Solway believes that outsource providers have now bridged that credibility gap.“It is very hard nowadays for people to say outsourcing is not going to work, or to suggest that it will lead them down a cul de sac due to lack of viable providers,”he says.

“Of course, over the past five years many areas of their business have become commoditised. With the AIIMR and Global Investment Performance Standards (GIPS), even performance measurement is becoming standardised, and that is a product we are selling to many people who were previously doing it for themselves. Similarly, people take it for granted now that we will do their fund accounting. So it is now far less intimidating to make the jump to outsourcing – even if firms need to recognise that they face a significant drain on their business in terms of time and focus during the six to 12 months it will take to effect the transition.”

However, Steve Papulak feels that managers’ deeply

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entrenched concerns about loss of control have yet to be However, lift-outs will not vanish: “[They] will continue to fully overcome. “Even if you can work out the pricing of a be a mechanism the custodians use to better control the deal to the client’s satisfaction, you will still end up spending environment and help manage the migration of systems,” a lot of time going over the issue of control,” he says. As he adds.“Providers will therefore continue to perform liftalready outlined, back in the early days of outsourcing outs, not because they need more infrastructure, but as a providers adopted the lift-out model as a means of attaining condition for winning the business.”

Much attention has been the intellectual, staffing and focused in the past year or so even technology capabilities “Outsourcing is a process, not a on so-called component or they typically lacked; once in modular outsourcing. place, that platform would product,” says Ramy Bourgi, business Predicated not on a ideally be the foundation executive for Europe, Middle East and wholesale migration of the upon which they could build Africa at JP Morgan Worldwide client’s middle and back their outsourcing business.

Securities Services. “It is part of a office, but rather on a more “Basically the model was to natural evolution. Managers outsourced focused, best-of-breed type lift out people, technology approach to addressing cost, and process and then custody, then accounting, then efficiency and process basically carry on in a similar performance measurement, then challenges, it is seen by fashion – what I would call ‘lift securities lending, and now their middle some as a way of managers and hold’,” says Tom and back office activities…” “dipping a toe” in the Abraham, managing director outsourcing ocean to see if it at Citigroup Global Transaction Services.“The advantage was that there was very is to their liking. Others contend that the component model must inevitably undermine the key tenets of little cost or disruption associated with a transition.”

The concern today is that in a number of cases custodians successful outsourcing – product synergies, economies of have undertaken multiple lift-outs but have then failed to scale – that generate the cost, risk and efficiency benefits consolidate those mandates within a single platform, resulting managers expect from such arrangements; nonetheless, in unnecessary duplication and overheads. Outsourcing there have been a number of deals whereby clients have should be about transformation, not replication.“We believe it outsourced aspects of their fund accounting or transfer is necessary to have a common platform in terms of process agency operations.

“We have built our product set to be able to bundle and and technology, and without that there is no hope of building unbundle across the logical lines of responsibility, breaking scale or long-term efficiencies,”says Abrahams.

“That has always been our philosophy, but initially we it down into areas such as post-trade processing, fund did not see the market going that way and so we preferred accounting or performance calculation,” says Steve to be stay on the sidelines. In retrospect I am happy to say Papulak. “The core activities – which include processing that was a good decision. As a provider you cannot squeeze trades, doing accounting and calculating performance – are out any more economies or savings by merely replicating every scaleable, but things do get very bespoke around the an existing platform unless the whole thing was really information that is needed to drive the client’s downstream miserably managed; meanwhile the client gets no benefit applications.”To accommodate this, Mellon has integrated because they are still subject to the same weaknesses and a data warehousing facility into our offering to ensure clients retain the control and flexibility they require. issues they had before.”

However, Papulak still feels a fully bundled approach is RBC Global Services has also eschewed the ‘big bang’ in favour of a more measured approach, says Rob Wright. preferable:“We work off a rate card, which means that if we “Taking on a limited number of more moderate sized are doing multiple product areas it not only gives rise to mandates and then building out a strategic architecture is operational synergies but is also more economical for the preferable,”he says.“Taking on one large cornerstone client client from a cost perspective.” Both Ramy Bourgi and would have required us to digest outsourced employees Daron Pearce agree. “For outsourcing to make sense you while grappling with all the technology issues that want to outsource more than one component because inevitably arise from such a fundamental transition. Our there is leveragability in doing so,” says Bourgi. “We also chosen approach may take longer, but it will also ensure find that people will outsource one component only to our model is robust and that we can provide a better client realise that there are interdependencies with other components. When you start pulling one thread in a back experience from the get-go.”

In his research note, TowerGroup’s Tim Lind argues that, office, the whole thing tends to come with it – it is too while lift-outs would continue in the short-term as integrated. So even if they start off with just one, they often custodians looked to expand the scope of their services, he move on to the whole gamut.”

For his part, Pearce says that while The Bank of New York expected this to tail-off by mid-2006. “Most of the key providers will be saturated with all the tools and the staff will consider component deals, normally in areas such as they need to take on additional business,” he says. trade messaging or trade confirmation, it is usually only on a

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temporary basis.“It is basically an introducer – we take on those responsibilities on the specific understanding that if we demonstrate the requisite competence we will be granted a preferential provider status for more extensive outsourcing,”he says.The debate over the component model versus a bundled approach underlines the fact that when it comes to asset manager outsourcing, it is very much a case of ‘horses for courses’. “Outsourcing is not for everyone, there are many factors which dictate whether a firm will benefit – are they a product of multiple acquisitions or mergers, have they have invested in their technology architecture in recent years, are they being held back by a platform which cannot support them in new areas such as alternative investments?,”says Pearce.

Certainly there is no ‘silver bullet’, no ‘one size fits all’ solution when it comes to outsourcing, says Tom Abraham, who also believes that there will be some shifts going forward in terms of who is outsourcing and how that is accomplished.

“Historically the big movers on the client side have been the independent asset managers and the insurance companies, but it will be interesting to see if universal banks move into this space,”he says.“However, it will be more complicated for them because by their very nature they are expected to do most of these services for themselves. So it will be interesting

to see if they change their attitude, although there have been relatively few jurisdictions in Europe where they have been under financial pressure, which contrast sharply with the situation for insurance companies.”

While concerns over the credibility and capacity of providers seem to have largely receded as more and more custodians have secured outsourcing clients, Daron Pearce nonetheless believes a reckoning will come in the medium term, drawing a parallel with the global custody industry in the 1980s. “Back then we saw a few years of exponential growth where it seemed like every week another global bank would announce its entry into the market,” he says.

“However, that was followed by a decade of consolidation: those banks would try it for a few years only to realise that to make it work in the longer term required enormous investment and scale.”

However Tony Solway argues that it is intellectual capital, not scale, which is the most potent weapon in any outsourcing provider’s armoury.“All the talk about needing scale and technology is a case of the bigger custodian banks talking up their own book,” he adds. “But this is a much less commoditised business than pure custody and so it is about the quality of your people, your transition skills and your ability to sustain the relationship.”

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To find out more, visit www.rbcglobalservices.com Custody | Securities Lending | Fund Services Treasury | Outsourcing | RBC BENCHMARKTM Analytics Transition Management | Online Services TM

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INVESTMENT SERVICES: CLEARSTREAM

JeffreyTessler, CEO of Clearstream International

CONFIDENT

CLEARSTREAM TAKES FLIGHT

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The Clearstream business model is predicated on partnering with customers to provide value along a clearly defined product chain. Buoyed by a strong management structure, product upgrades, product launches and the prospect of new international ventures, Clearstream International appears confident of its potential.

It is becoming a powerful polemic for its particular brand of investment services. Jeffrey Tessler, chief executive officer of Clearstream International, the settlement and custody division of Deutsche Börse Group talks to Francesca Carnevale about the key drivers in Clearstream’s 2005/2006 business strategy.

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LEARSTREAM HAS IT that growth of its custody to meet the market’s growing need for a full range of business is based on three pillars: high touch collateral management services, particularly in Europe customer service, strong market positioning in where the market is estimated to be worth €4.5trn. The growth areas such as Asia and the Middle East which GSF suite of products makes it easier and cheaper for are both enjoying upsurges in activity and perhaps, customers to access Clearstream’s ever-increasing pools of most importantly, collateral management services. “In securities and cash liquidity, thereby increasing settlement this area we have established a market leadership efficiency and lowering financing costs. Clearstream has position in terms of service and product innovation and already revealed plans to expand its service range in 2005 as this market develops we foresee it driving our growth with the introduction of an innovative ‘quad-partite in custody figures,” says JeffreyTessler, CEO of securities financing service’, which allows bonds stuck in domestic markets to be more easily mobilised for Clearstream International.

A groundswell in business has been bubbling for some financing in international triparty transactions. In addition, Clearstream is months, with the value of working with Eurex to assets held in custody rising deliver a general collateral more rapidly this year. In repo trading, clearing and April, for example, “While 2004 was in itself a strong year collateral management Clearstream reported €7.9trn for Clearstream, Tessler notes that “the service. “Here,” explains in assets under custody – up first half of 2005 has begun even better.”

Tessler, “we have partnered 2.6% on the month year on with key market players and year. By May, this total had we have opened collateral risen to €8.1trn, up 6.4% on accounts in key domestic the same month in 2004.

International transactions volume however continued sub-custodians to enable international market strong, rising to 1.52m for the month (equal to a14.4% rise participants to mobilise the domestic assets held with their sub-custodian. Added-value collateral management on May 2004).

While 2004 was in itself a strong year for Clearstream, services like this are key to the future of the industry.”

Clearstream International was formed in January 2000 Tessler notes that “the first half of 2005 has begun even better. We are seeing growth in assets under custody and in through the merger of Cedel International and Deutsche the number of international transactions that we process, Börse Clearing. The full integration of the two clearing which are the two traditional measures of our core operations was finally completed in July 2002. Offering a business. But newer areas are witnessing even stronger fully integrated infrastructure Clearstream claims it “is the growth with triparty repo volumes rising above 50% per only securities service provider to offer access to all key annum and a 30% upturn on investment fund volumes products and services, from trading and information too.” Triparty repo business falls within Clearstream’s products through to clearing, settlement and custody,” in strategically important Global Securities Financing (GSF) one place. As a key differentiator however, Clearstream’s services business. Triparty repo monthly average traditional customer base is firmly rooted in the over-theoutstandings totalled €177.9bn in May, compared with counter (OTC) fixed-income sector, which it deems to average outstandings totalling €111.2bn at the beginning provide it with apparently limitless growth opportunity of 2004, which is a rise of almost 60% across the 17 month over the near term.“Over 80% of our revenues come from period, reinforcing the strategic importance of the GSF this area and we are very pleased that the sector shows division to Clearstream. Along with triparty repo, GSF also continuing long term growth potential,” expands Tessler. includes securities lending and collateral management and “The international debt market operates in a global Clearstream says it has collected a series of industry awards environment with 24-hour OTC trading in securities now for its service levels in these areas. “The importance that worth over $12.8trn and with future growth rates collateral is playing in our industry should not be estimated by Mercer Oliver Wyman to be around 11% per understated,” says Tessler. “There is a growing need for annum for the next 5 years. This means that demand for institutions to efficiently manage their collateral as it can excellence in service will continue but we are very happy provide opportunities to fully utilise their assets and to take on that challenge.”

It is clear that 2005 is becoming a swing year for provide business growth. More and more we are seeing the need to realise yield potential on collateral held across Clearstream and the institution appears to be growing in various borders.” Tessler maintains that Clearstream is strength and confidence. Forged in a highly competitive ideally placed to facilitate this trend,“and our view is that battleground, in a European theatre which remains highly this efficient management of collateral pools will be a big contentious and fragmented, it has been a strong proponent of concentrating on the customer’s bottom line. driver of our future growth.”

Clearstream’s market share is rising in a market growing Although only five years old, there is a growing sense that at a rate of around 20% year on year. This business area is after four years spent defining and consolidating its a key focus for Clearstream in order to expand its services position as a structurally alternative model to Euroclear

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that Clearstream is finally in confident flight. Tessler’s approach is open and frank.“The relationship between us and Euroclear is an excellent one,” he avers. “We both understand that it is special – as we compete fiercely all day long! But also we cooperate on key infrastructural projects such as the recent implementation of the DayTime Bridge.

This was a critically important project to level the playing field between us and was completed exactly as planned.

But the competition between us is the real feature of the relationship and that will continue long into the future because that’s what the market wants.

As if to underline this fact Clearstream ended 2004 and started 2005 with a number of initiatives, some groundbreaking: one was operational, one was structural, one was a new product and the fourth was geographic.

In December of last year, CEO André Roelants handed over operations to Tessler and moved to become chairman of the Clearstream International board. He in turn replaced long time chairman Robert R. Douglass, who had also been chairman of its predecessor Cedel International since May 1994. Tessler had earlier been appointed to the Executive Management Board of Clearstream's parent company Deutsche Börse AG. Once the long term management structure was in place, it made sense to quicken the introduction of a series of general service upgrades in both the firm’s settlement and custody operations, although plans for the upgrades had been in place for some months. In settlement, Clearstream introduced real-time reporting that now delivers reports up to four times an hour on a 24 hour basis across all of Clearstream’s connectivity channels (including CreationOnline, CreationDirect and Creation via SWIFT).

The move improved processing efficiency and transaction management. As well, the "standing payment instruction functionality" on CreationOnline has been improved to offer customers the ability to save ‘withdrawal of funds’ instructions as a template. This makes the input of repetitive instructions easier, quicker and more accurate.

In custody meanwhile, a new “uninstructed balances service” for voluntary corporate actions and tax certification events was introduced that provides customers with a detailed breakdown of event-eligible securities balances, the related instructed balance and the remaining uninstructed balance.

Customers benefit from better exception handling support and quicker identification of missing corporate action or tax instructions. Clearstream’s Corporate Actions Notification service has also been enhanced. As well, the firm finalised the implementation of SWIFT 2005 standards and the Securities Market Practice Group (SMPG) recommendations across all of Clearstream’s interactive channels.

Shop-keeping aside, Clearstream turned to significant business development issues, and in late January, it launched its new Vestima+ Investment Funds service, which provides a multi-layered product model on a single platform. One of the key selling point of the new product, says Clearstream, is that in some cases it can deliver cost savings of up to 50% or more. The other is that it offers

asset managers flexibility and choice. The onus on developing the product arose directly from the diversity of the European landscape. “Markets within Europe operate differently and therefore need different elements of service,” says Tessler. Having understood this point, the next logical step for Clearstream was to provide an element of flexibility in its platform that could accommodate these differences in the service areas of order processing, transaction settlement and the safekeeping of shares.

Vestima+ is modular and therefore allows users to choose their preferred solution for each service and send a standard settlement instruction to the distributor's preferred settlement agent. “Of course this settlement agent could be Clearstream but it could be any other provider – the choice is open,”says Tessler.

Vestima+ is a single platform based service,“with a high level of flexibility enabling you to process transactions in domestic and off-shore funds,”explains Tessler.“We enable seamless processing of domestic funds through to central securities depositories and off-shore funds settling through transfer agencies or through Clearstream Banking Luxembourg.” The main features of the service include near-100% straight-through processing (STP), the ability for fund distributors to select their preferred settlement mode between delivery versus payment (DVP) or free of payment (FOP), and to choose their own optimal settlement route and custody providers.

Tessler explains the dynamic behind the establishment of the product.“As you know, we have been providing custody services for some years now in the fund business primarily to the offshore markets of Luxembourg and Dublin. But the market has asked us to do more and particularly in the larger domestic markets starting with Germany,”he says.

Continuing on his theme, he adds that,“However, we do not look at this from a custody point of view. We take a different view and have sought to listen to the market’s needs and seek to resolve them. That may help us in terms of custody but that was not our driving force for Vestima+.

What we did was work with the industry to understand the issues, consider solutions and then collaboratively we devised the open settlement model for the benefit of the industry. And here I should also mention our support of our adoption of the SWIFT standards in order to bring further automation this part of the value chain.”

Tessler expands that through 2004, Clearstream worked in close consultation with industry segments to gauge their requirements. As a result, the new Vestima+ platform“enables distributors to choose their preferred way of settlement and place of custody.This is a key differentiator when compared to our competitors and it has been seen by market players as a breaking factor.” Efforts to include the market in new product development initiatives invariably bear fruit and Vestima+ is no exception. Business volumes are up significantly, acknowledges Tessler. He points out that in 2004, Clearstream settled approximately 1.6m fund transactions, while in the first quarter of 2005 the company settled over 536,000 fund transactions, an increase of around 19%. “This is the strongest

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Once Vestima+ was fully launched and operational, Clearstream turned to more strategic issues and in early June Clearstream, and Chinaclear, the brand name for the China Securities Depository and Clearing Corporation Limited (SD&C) the securities depository for the Chinese capital markets, signed a Memorandum of Understanding (MOU) to explore the potential of delivering improved post-trade services to the Chinese market.

Chinaclear was established in March 2001, to manage China’s entire securities registration and clearing business. SD&C is China’s sole national securities depository, clearing and registration company providing services for the country’s two principal stock exchanges in Shanghai and in Shenzhen. Clearstream has a long-established presence in the region having an office in Hong Kong for many years.

Clearstream’s own business in Asia has grown strongly over the last several years with annual growth rates of 18% in assets under custody.

The MOU means that the two parties will enter into detailed discussions and share expertise on clearing, settlement and custody operations and to explore the opportunity of a combined initiative or operational linkage to deliver a wider range of efficient services to the local market. The Shanghai Stock Exchange, China’s largest equity market, already uses the Deutsche Börse Xetra technology as the core of its next-generation trading platform. “Outside of Europe, local presence and understanding of the market has always been critically important,” explains Tessler, and in China,“our market share is strong.”

“We have not altered anything structurally but concentrated our efforts on partnering with customers to really understand and address “Vestima+ is a single platform based service, their needs,” he explains. “This partnership “with a high level of flexibility enabling you to approach has been really appreciated and we process transactions in domestic and off-shore will look to extend this into the future. funds,” explains Tessler.”

With so much accomplished this year, Clearstream is confident of its future.“There is consolidation ongoing but there remain many, many medium to smaller sized institutions that require a certain level of service excellence to evidence we have to show the added value of the new support their businesses,” maintains Tessler. “It is easy to service,”he says.“Some customers have upgraded to the new forget these people as they do not grab the headlines but service and many are completely new to us. Importantly, we the truth is they exist and will continue to do so. I would have new customers preparing to implement also and all of also say there is a danger in grouping sections of the this is less than six months from our launch. On the funds industry together and offering ‘one size fits all’ services.” side, we are already working with more than 12,000 funds in With so much in hand, is an acquisition on the cards? It is a fully automated way and this is set to increase by about 25% unlikely ventures Tessler. “You must never say never,” he in the next few months. Based on this, it is fair to say the says.“But growth by acquisition is not a priority for us now as organically we see very positive trends ahead of us.” model has been extremely effective so far.”

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A growing interest in hedge funds by institutional investors, and increasingly scrutiny from the United States’ Securities and Exchange Commission (SEC), means that hedge funds and their administrations have had to upgrade transparency, investor reporting and valuations reliability. From providing monthly net asset value (NAV) calculations, they are now required to move to weekly – even daily calculations – as it is done in the mutual fund space. Not only do hedge funds need more detailed reports, they also need more frequent reports that are customisable. Without high-end technology solutions these requirements simply cannot be met. Rekha Menon looks at the new technology requirements for hedge fund administrators.

NEATLY PRESSED IVEN THE UNCERTAINTY of the world’s financial markets, it is no surprise that institutional investors are looking to hedge fund strategies to maximise their portfolios’risk-adjusted performance,”notes Gary Enos, executive vice president and head of alternative investment services for State Street. A survey commissioned last year by the bank to study the role of hedge funds in institutional investors’ portfolios revealed that while nearly one-third of the global institutional investors responding to the survey already had a portion of their portfolios invested in hedge funds, a majority of the respondents intended to increase their holdings to 10% or more over the next three years.

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Laurence O’Connell, chief operating officer of Man Investments, the funds management division of Man Group, calls this a paradigm shift in the hedge fund arena,“Whereas absolute return investing was previously dominated by high net worth individuals, mainstream institutional investors have started influencing the asset class more strongly, and consequently are shaping the industry.”

The trend is having a dramatic impact on funds and their service providers. Compared to individual investors, institutions have significantly different product demands and return expectations, and they require hedge funds to have business models that are more robust and resourceintensive than has been required thus far. Indicative of “a maturing asset class that needs a more sophisticated level of service than in the past, it is therefore imperative for hedge fund administrators to streamline their operations and invest in technology,”says Marina Lewin, a director of hedge fund services at Bank of New York (BNY).

Over the last couple of years, says Lewin, BNY has been strategically investing in enhancing its fund administration platform, which at present includes solutions for portfolio evaluation, proprietary systems for performance attribution and liquidity management, and a web-based solution for client reporting.“Five years ago it was acceptable for hedge fund administrators to use mainly spread sheets but that is not so now. With growing customer and regulatory demands, the number of funds being handled has increased exponentially and there is only a very limited qualified labour pool available. Without high-end technology solutions, fund administrators will no longer be able to service their customers satisfactorily,” comments Catherine Doherty, principal consultant at investment management consulting firm Investit.

With the ever increasing focus on transparency and client reporting, web-based reporting tools providing the full range of reporting, inquiry and information delivery services are now a standard feature of the service offered by leading hedge fund administrators. Recently, Citigroup Global Transaction Services launched HedgeLink, a webbased operating platform for both hedge fund manager and investor reporting. Fortis, a leading independent hedge fund administrator, too offers a web-based reporting system called i-Fund Reporting that can be used by both hedge fund and fund of hedge fund managers. “This is a state-of-the-art web portal and financial data warehouse that provides a single point of access to up-to-date portfolio information and e-reports. Clients can easily download data relating to positions, transactions and tax in a customisable format,”says Joost Löbler, chief commercial officer of Fortis Prime Fund Solutions. Löbler explains that in recent years, the hedge fund administration space has become very competitive. “Client demands are increasing and they are looking more for a partner than a service provider. Enhanced reporting suites, risk management tools and front-end trading tools that at one time were considered only a good-to-have offering, have now become an essential requirement”.

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Laurence O’Connell, chief operating officer of Man Investments

A major challenge facing hedge fund administrators is the rapid growth in the level of complexity in the hedge funds space, states Löbler, pointing towards the increase in the use of complex esoteric over the counter (OTC) instruments such as credit derivatives, weather and shipping derivatives. “Now, not only do fund administrators need to understand complex trading strategies, they need to independently value the growing breed of complex instruments as well.”

“Pricing these illiquid instruments is the biggest challenge for fund administrators. Everyone is struggling,”concurs Paul Smith, global head of alternative fund services for HSBC. Pricing is a highly skilled area, requiring in-depth expertise and most fund administrators subscribe to specialist thirdparty vendors for the same. However, Ian Duffy, managing director of Euro-VL, one of Europe’s leading fund administration providers owned by Société Générale, which has recently set up a dedicated pricing department to manage derivative instruments valuations, cautions, “Subscribing to external pricing services for complex instruments is a very expensive exercise. For small boutique fund administrators and asset managers, the cost of providing independent valuation can prove to be rather prohibitive.”

As Duffy indicates, technology or the lack of it is a big challenge for the smaller independent hedge fund administrators and asset managers who do not have sufficiently deep pockets or adequate in-house expertise to deploy the required systems. Not surprisingly, in the last two to three years, a number of small players have been acquired by financial giants looking to plug a gap in their securities services business. State Street acquired

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which has been active in the International Fund Services hedge fund administration (IFS), Bank of New York took “Laurence O’Connell, chief operating space since 1996. over International Fund officer of Man Investments, the funds BNP Paribas has deployed Administration (IFA) and management division of Man Group, calls its own fund administration Citigroup took over Forum this a paradigm shift in the hedge fund platform supplied by a Swiss Financial. More recently, technology vendor that HSBC bought Bank of arena, “Whereas absolute return investing services both its mutual Bermuda, JP Morgan was previously dominated by high net fund and hedge fund acquired Tranaut Fund worth individuals, mainstream institutional clients. “In addition to giving Administration and in investors have started influencing the hedge fund managers access February this year, Mellon asset class more strongly, and to the extensive system took over DPM. Bob Aaron, consequently are shaping the industry.” functionality enjoyed by chief executive officer (CEO) mainstream asset managers, of the newly formed DPM a key advantage of having a Mellon, says, “It was a winwin deal. Mellon gained from DPM’s specialist expertise, single platform is that it can deal with the requirements of while DPM benefited from the infrastructure, client base local markets such as Italy, Germany and Spain where locally domiciled hedge funds have started operating only and brand of the larger organisation.”

The entry of such mega-players has created new very recently. With a single platform, we can leverage our competitive dynamics in the hedge fund administration experience of working in these markets in the mutual fund segment that was till a few years back almost completely space,”explains Dundon.

Citigroup Global Transaction Services (GTS) is one of serviced by independent boutique operators. Not only do the global firms excel in branding, marketing and the few mega-players to have deployed a single technology infrastructure, one of the biggest strengths of technology platform for its traditional and alternative these merged entities is the ability to offer a one-stop-shop fund administration businesses. But this too is only for the full suite of fund administration services. This is deployed in Europe and Asia. “A single platform for all especially relevant in the context of institutional investors fund administration needs is the final pot of gold and no entering the hedge fund space, many of which use their administrator has yet got it right,” states Smith of HSBC. He hastens to add however that a single platform does services in the long-only world.

“Being an established player in the global fund not mean one technology solution to service administration arena is a key attraction for institutional requirements, which he claims is not feasible. Rather, the investors who can get both their mutual fund need is to integrate seamlessly all technology solutions to administration and hedge fund administration present a unified view to the customer. “So for example, requirements met through the same service provider. We while there may be multiple solutions for portfolio can easily leverage our expertise in the long-only arena evaluation for hedge funds, fund of funds, and long-only with regards to reporting requirements to meet our funds, there should be one look and feel of all the reports customer's needs in the alternative world as well,”explains generated for the end customer. There is no all-singingall-dancing technology platform that can meet all BNY’s Lewin.

“At HSBC, our strength lies in understanding the needs requirements,”he says.

Others view the market differently. Technology vendor, of the institutional investor and hence we are strategically focusing on ‘overlap’ institutional clients that require the Advent is in the process of extending its global investment servicing of both traditional and alternative funds,” states management solution, Geneva, which was focused till date HSBC’s Smith. At present, the bulk of HSBC’s customers only at the hedge fund market, into the mutual fund space. are still specialist hedge fund managers, but in the next two Robert O’Boyle, director of global accounts at Advent years, Smith expects institutional customers to constitute explains the strategy for Geneva which is deployed at several leading hedge fund administrators including up to 75% of its client base.

However, several industry practitioners argue that HSBC, Fortis and GlobeOp, “Seeing the way things are merely having an established presence in the traditional progressing, there is likely to be a convergence of hedge fund servicing and hedge fund servicing arenas is not fund and mutual fund administration styles and a single sufficient and that a single technology platform across fund accounting platform is the way to move ahead.”

Gary Enos of State Street agrees with O’Boyle. State both segments is required. “Without a unified fund administration platform, it is difficult to effectively service Street currently has a technology platform for hedge fund institutional customers. To date, most of these acquisitions administration and another one servicing institutional by global players have been an integration in name, rather pension funds and mutual funds, but has plans to merge than an integration of the technology platform,”states Alan the two.“There is no pressure now, but it is inevitable that Dundon, head of product fund administration and middle we will have to merge them within the next couple of office outsourcing at BNP Paribas Securities Services, years,”says Enos.

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DEBT REPORT: US BOND ISSUES

Kjerstin Hatch, portfolio manager at distressed-debt investor Madison Capital Management in New York.

Junk

bonds take

centre stage

The US corporate bond market experienced its most dramatic day since the Enron and Worldcom scandals on May 5 when Standard & Poor’s (S&P’s) cut its credit ratings on General Motors (GM) and the Ford Motor Company to junk status. The removal of these two American household names from the investment-grade ranks turned US$290bn of senior unsecured debt into junk bonds – the largest such transformation ever seen in a single day – and will influence the direction of the US bond markets for months to come.

Andrew Cavenagh reports.

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HE IMPACT OF S&P's ratings action, which lowered the long-term ratings GM and Ford from BBB- to BB and BB+ respectively, on the quoted debt of both companies, was immediate and savage. The following day, GM’s 2033 long-dated bond dropped more than four points to 74.5 cents on the dollar (bumping its yield up from the 8.375% coupon to 11.42%). In the meantime the shorterterm 2013 instrument issued by Ford Motor Credit, the auto maker’s finance arm, lost more than three points to close the week at 87 cents on the dollar. The extent of the reaction led one banker to comment: “If you look at the spreads on the short-dated bonds now, they look quite attractive.”

It did not take long for the knock-on effect to catch up with the US automotive supply industry. On May 18, S&P lowered its rating on Delphi from BB to B, having previously downgraded it on April 21 and also cut Collins & Aikman’s (C&A’s) further from CCC+ to CCC-. Within hours, C&A

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weeks. A lot of investors applied for court protection US Auto Sector measures impact of new junk bond status holding GM and Ford from its creditors under the 120 bonds are consequently US Chapter 11 bankruptcy 110 expected to sit tight. “That code of practice. means the process of Dramatic as the investor 100 shifting Ford and GM reaction was, there is little 90 [stock] is not going to risk that GM or Ford will happen in one go,”says the have to contemplate this 80 deputy head of credit course – at least in the near 70 strategy at one of the to medium term. While leading Continental most analysts believe that European banks in further downgrades are Ford Mtr Cr Co Cont Offer Bd Mtnf 7.100 09/20/13 London. “Personally, I eminently possible (S&P General Mtrs Corp Deb 8.375 07/15/33 think it is going to be has put both companies' Data as at June 05. Source: FTSE Group. relatively protracted.” ratings on negative watch) He adds that the sell-off could have a bigger impact on the they still have large cash positions and substantial undrawn bank facilities.“The companies have a lot of liquidity and that high-yield bond markets in Europe than in the US, given is a source of hope,” maintains Scott Sprinzen, the S&P that the downgraded debt of GM and Ford would account analyst in New York who covers the industry. “In the auto for a much higher percentage – about a third – of the market sector there have been examples of dramatic turnarounds.” on this side of the Atlantic.“I think over time the effect you Sprinzen adds that the big cash holdings combined with see will be more pronounced in Europe,”says the banker.

There is also a risk that the Ford/GM situation will blight relatively light profiles of maturing debt make it unlikely that either company could seek Chapter 11 protection in the next wider corporate issuance in the US. The latest figures from two years. “You have to be able to demonstrate that you’re the data provider Dealogic revealed a dramatic drop in new insolvent, and that’s hard to do when you are sitting on a lot issues from speculative-grade companies in the second quarter so far – 69% down on the comparable period of of cash,”he points out.

While the senior unsecured bond markets are probably 2004 – and a 7% decline in the volume from investmentclosed to both companies for the foreseeable future, they grade companies. This followed the pattern seen in the first can still raise further liquidity if required by selling more three months of 2005, where junk bond issuance dropped asset-backed securities. Almost all their main asset types 64% and investment-grade 18% on last year, but in part (retail loans, wholesale loans, retail leases) are securitisable. reflects stronger cash positions after seven quarters of Alternately, they can unload loan portfolios to third parties continuous profits growth.

There was also evidence that investor confidence in the in the whole-loan markets. Nevertheless, the loss of investment grade status for two motor titans will have senior unsecured sector was starting to ebb before S&P widespread ramifications for the corporate – and other – announced the Ford and GM downgrades. Spreads had bond markets. It has already led to the downgrading of certainly started to widen in March, after GM had warned several collateralised debt obligations (CDOs) in which that its profits for 2005 were likely to be 80% lower than Ford and/or GM bonds formed part of the collateral. previous forecasts. The month also saw the inflow of foreign Following a review of 561 European synthetic CDOs, S&P capital into US corporate bonds dive from about US$80bn in said 19 of the 745 classes required downgrading and a February to US$48bn, a development that aroused the interest of foreign-exchange analysts and dealers who further 25 needed to be placed on negative watch.

While much of the reaction to date has focused on the believe the subsequent Ford and GM downgrades can only CDO market – much of it down to hedge funds that accelerate this move. “I would have thought that that [the misread arbitrage opportunities in the derivatives of the downgrades] is ultimately going to put pressure on those equity and mezzanine tranches covering positions – credit markets going forward,” says Richard Franulovich, investment grade portfolio managers may well have to senior currency strategist at Westpac Banking Corp in New offload tens of billions of dollars' worth of the auto makers' York, “the next big adjustment is a further widening of spreads.” Franulovich adds that Ford and GM’s loss of bonds in the coming weeks.

The picture is clouded, however, by the impending investment grade status was also affecting the market for US change in Lehman Brothers' US Aggregate Bond Index, the Treasuries, with the yields on short term bills dropping as most widely used US measure for tracking investment low as 3%.“It is generating a flight to quality,”he explains.

The rating agencies are not forecasting a general decline grade credits. From July 1, the index will use the middle rating from the top three agencies (S&P, Moody’s and in corporate access to unsecured capital market debt at this Fitch) rather than the lower of S&P's or Moody's as it does stage.“We have not really seen it show up yet,”says David at present. Provided Moody’s and Fitch do not downgrade Hamilton, head of default research at Moody’s Investor the companies to sub-investment grade in the meantime, Services in New York.“The damage seems to be fairly well their bonds could become eligible holdings again in a few contained to pockets of distress at this point.” In its latest 31

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for risk over the coming months. monthly default report, Moody’s “The resilience of the market has also points out that while it expects not really been tested so far [in (12-month ahead) default rates to this crisis].” He adds that buyers rise from the current 2% to 3.3% by are likely to become more April 2006, this figure will still be selective. “I guess they are going below the 20-year average annual to become very much more rate of 4.9%. discriminating towards credit, and Standard & Poor’s (S&P) also there will be a lot more published a positive credit outlook differentiation between sectors.” for US corporate bonds in midHatch at Madison believes that April. The agency’s analysis the distressed debt market for revealed that in the first quarter of corporate debt is consequently set 2005 the ratio of downgrades to for spectacular growth over the total rating actions fell to 53% next three years in the aftermath of dropping well below the 18-year the high-profile cases such as average of 62%. It attributed the Enron, Worldcom and K-Mart, as improvement to the expanding external factors and a change in economy (US GDP rose 4.4% in corporate approach will produce a 2004) which had seen the profits of further wave of bankruptcy filings speculative-grade companies rise Diane Vazza, director of Global Fixed Income from middle-tier companies. On more rapidly than those of Research at Standard and Poor’s. top of the pressures of rising investment grade ones. The S&P outlook did caution, however, while most industries interest rates, commodity prices and increased competition seemed to be “extremely solid”a few still had problems and from foreign competitors, Hatch maintains that Chapter 11 highlighted airlines, petrochemical companies, retail and no longer carries the stigma it did a decade ago and that restaurant businesses as those most at risk. It said more some companies increasingly view it as a strategic tool to than 30% of the companies in these sectors had negative get rid of unwanted financial burdens, such as pension outlooks. Diane Vazza, managing director in global fixed- obligations, healthcare costs and expensive leases.

The most recent example was United Airlines’ successful income research at S&P in New York, adds that defaults among high-yield issuers will start to “tick up”as the credit court petition on May 10 to transfer US$10bn of pension quality of issuers deteriorates in what is an ageing bull liabilities from its four schemes to the Federal pension market. She points out that 50% of speculative-grade protection plan. Hatch believes the senior unsecured bonds issues this year have been rated B- or lower, with triple-C of companies that use the bankruptcy regime for these bonds carrying a 29% chance of default in their first year. purposes should offer better recovery rates. She points to the experience of the “slew” of companies that entered “Gains from here are going to be limited,”she concludes.

In the high-yield market, Moody’s estimates there are Chapter 11 over the past four years to seek protection from US$56bn of high-yield corporate bonds due to mature, and asbestos claims. “The recovery rates for those bonds are which need refinancing, over the next three years. The higher than for those [companies] with an honest to figure includes US$20bn of maturing debt in the goodness reason for going into Chapter 11.”

At the same time she cautions that overall recovery rates telecommunications, technology and media sector, which in the distressed debt market are likely to plummet as was the primary source of corporate defaults in 2004.

Investors in US corporates also expect to see some sectors higher interest rates, fuel costs and commodity prices make to suffer more than others. Kjerstin Hatch, portfolio manager the economic environment – and refinancing – more at distressed-debt investor Madison Capital Management in difficult. “It is not going to be as easy to rely on the next New York, says those that will come under the most stress churn.” In many cases, she says companies that enter over the next three years are automotive suppliers, airlines, bankruptcy proceedings will no longer have any textile manufacturers, and some of the traditional worthwhile assets to restructure and holders – or buyers – supermarket groups. They will struggle to compete on cost of their paper will need to revise their expectations with the low-wage Wall-mart model suggests Hatch.“Your accordingly. She expects recovery rates – as a percentage of old-time supermarket stores are still operating under a bonds’ par values - to drop from the current 50-70% range unionised system,”Hatch explains.“And I think we are going into the “teens and low 20s”. She believes the trend will work in the favour of the more established distressed-debt to see more pain in the airline sector – probably Delta.”

Meanwhile, Matein Khalid, the capital markets specialists, as these lower returns will drive many of the strategist and chief dealer at Union National Bank in Abu relative newcomers out of the market and reduce the Dhabi who previously managed global bond portfolios at demand for such debt.“I think as money flows out, you will Chase Manhattan and First Chicago in New York, says get the over-reaction and that will give opportunities to the the difficulties in these sectors will test investor appetite experienced investors.”

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How the

DEBT REPORT: JUMBO PFANDBRIEFE 54

Jumbo took flight

It is ten years since the birth of Jumbo Pfandbriefe propelled the antiquated covered-bond market from the relative calm of the backwaters of German finance onto the world stage. In that time the Jumbo covered bond market has grown from a gleam in a banker’s eye to more than €400bn today.

Meanwhile new issuance of covered bonds for 2005 alone is forecast to top €130bn. The number of issuing countries has grown from one (Germany) to seven and at the same time the share of nonGerman investors in the Jumbo Pfandbriefe market has risen from as little as 5% to almost 30%.

Where can the market go next? By Paul Whitfield HE SUCCESS OF today’s covered bond business seems a long way from the withering market into which a handful of German banking pioneers sought to pump life with the launch of the first Jumbo Pfandbriefe back in 1995. Then, a combination of small issuance size (typically less than DM60m; the equivalent of €30.6m) and an insignificant secondary market had squeezed liquidity out of the Pfandbriefe market driving spreads to insupportable levels. “Investors had to pay about 100bp over Libor,” says Claudia Vortmueller a covered-bond analyst at Commerzbank Corporates & Markets.

The extent of the market’s liquidity problem became painfully evident in the two years prior to the birth of the Jumbo market. In 1993, a Pfandbriefe bull market had attracted large amounts of both investors and issuers into covered bonds. However, when the market turned in 1994 investors found themselves trapped by the paucity of willing buyers.

The experience spooked investors. Foreign investment banks in particular were rattled and all but abandoned the market. By 1995 it was estimated that non-Germans held a meagre 5% share of the of Pfandbriefe market. Even in its homeland Pfandbriefe began to lose its appeal. From accounting for about half of the German bond market in 1990, Pfandbriefe had shrunk to nearly a third by 1995.

There is disagreement over what constituted the first Jumbo Pfandbriefe. Most agree that the first major step toward the new market, if not the birth of the Jumbo itself, came in May 1995, with the DM500 million Frankfurter Hypothekenbank deal, a 5.875% June 1999 public sector Pfandbriefe.

The deal was the first truly large Pfandbriefe but it lacked

T

many of the essential features that have been enshrined in today’s Jumbo market. Crucially the market maker was also the issuer – Frankfurter Hypothekenbank (now Eurohypo AG) – an arrangement which while necessary, given the lack of other options, meant the market lacked the transparency of today’s Jumbos.

The first Jumbo to incorporate most of the key features that sit at the core of today’s vehicles was an August 2005 issue by Depfa. The bond was far larger than the Frankfurter issue, at DM2bn, and, crucially, it had three lead managers who also pledge to create a secondary market and maintain tight spreads.

Since 1995 the Jumbo market has grown quickly. By mid 1996 the amount of outstanding paper topped €50bn. Within another two years it had tripled in size to €150m and by 2000 was approaching the €350m mark. Today’s outstanding volume of about €400 million makes the Jumbo Pfandbriefe market Europe’s fourth-largest bond market, behind the government bonds of Italy, Germany and France.

Yet, however spectacular the growth of Jumbo Pfandbriefe has been in Germany, the most interesting aspect of its success has been the spread of Jumbo’s beyond German borders.“It is wrong to think of this as a German product anymore, covered-bonds are now a European market and we will see the percentage share of the German market continue to decrease over time as European issuance grows,”says Vortmueller.

In 2000 about 90% of all new Jumbo issues originated in Germany, that percentage had fallen to 50% by 2003 and by the end of 2004 it had fallen to almost 30%. Investing in

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Jumbos is also no longer an exclusively German practice – a 10-year €1bn Jumbo covered bond issued in February by Austria’s Kommunalkredit was bought by investors in France, Spain, the Benelux countries, Scandinavia, China and South Korea, as well as Austria and Germany.

The attraction of Jumbo covered-bonds to foreign banks is easy to understand. On the supply side the bonds are popular with banks because they allow issuers with AA or A credit ratings to create instruments that typically enjoy ratings of AAA – making raising funds cheaper. On the buy side, the bonds have both the liquidity and size that are necessary to attract large investors. They also have the key advantage for banks of requiring only half the capital coverage of a bond issued directly by banks that issue mortgages. The reason for this, say regulators, is because the bonds are secured against stable long-term loans, making them particularly safe – though critics suggest that the narrow asset base means the bonds are not as safe as many think.

The financial advantages of Pfandbriefe, coupled with the new found success of the Jumbo format, led, in 1999, to the first non-German issuance of covered-bonds when Spain launched its cédulas hipotecarias and France issued obligations foncières. More recently they have been joined

by Austria, the UK (which in 2003 became the first country

to issue a covered-bond without specific legislative backing), Ireland, and in March 2005, Italy’s first Jumbo covered-bond – albeit one sponsored by the state rather than a private bank.

The ranks of Jumbo covered-bonds are expected to be further swelled by issues from Sweden, Norway and perhaps Portugal, all which could make their debut later this year, and, at a later date, Finland, Poland and Hungary.“The coveredbond markets have expanded into almost all the European countries, but although legislation has been implemented, covered-bonds have not actually been issued in all areas,” says Christof Juetten, executive director, responsible for covered-bond Origination at Goldman Sachs International.

For the time being the big three markets of Germany, Spain and France, collectively account for about 90% of all Jumbo covered-bond issuance. That high-rollers club may have to expand in the coming years, says Juetten.“We expect to see most growth from Italy. It is the last, large European economy which has yet to introduce covered-bonds on a significant scale.” Doomsayers had predicted that European-wide issuance of Jumbos would lead to thinner demand. In fact the opposite has occurred. Investors in new issuing countries have more than met their own domestic demand and begun to search in other markets.

MEMBER INSTITUTIONS OF THE ASSOCIATION OF GERMAN MORTGAGE BANKS

The Pfandbrief

AHBR Berlin Hyp Deutsche Hypo Deutsche Schiffsbank Dexia Hypothekenbank DG HYP Düsseldorfer Hypothekenbank Essen Hyp Eurohypo HSH Nordbank Hypo Hypo Real Estate Bank Hypo Real Estate Holding H y p o Ve re i n s b a n k Karstadt Hypothekenbank MünchenerHyp SEB Hyp Wa r b u rg H y p W L- B A N K Wü r t t e m b e rg e r H y p o Wü s t e n ro t H y p o t h e k e n b a n k

In 2005 the Jumbo Pfandbrief marks its 10th anniversary.

For a decade, the Jumbo Pfandbrief has been setting the standard in the international fixed income market. From a standing start, the Jumbo Pfandbrief has grown to a market of 400 billion euros and an average issue size in excess of 1.7 billion euros. The groundbreaking Jumbo segment has spurred the development of the pan-European Jumbo covered bond market worth nearly 600 billion euros.

The Jumbo Pfandbrief: quality, liquidity and a yield pick-up.

Find out what investors should know about the Pfandbrief

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www.pfandbrief.org

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DEBT REPORT: JUMBO PFANDBRIEFE

as a number of building It seems increasingly “The high-rollers club” – Germany, Spain and France societies are already likely that issuance of 160 pressing up against this covered Jumbos will soon 150 limit. If an upcoming spill out of Europe. A 140 liberalisation of the laws number of other countries, 130 governing issuers of notably from central and 120 Pfandbriefe in Germany South America, have been 110 leads to an increase in investigating the possibility 100 German savings bank of issuing covered-bonds, 90 issuance then the German while delegates from US regulator is expected to have also started to take an review its regulations. interest in the mechanics FTSE France Pfandbrief Index FTSE German Pfandbrief Index FTSE Spain Pfandbrief Index The actions of of constructing coveredregulators and legislators bonds. “It will get very Data as at June 05. Source: FTSE Group. will become increasingly interesting if nonEuropean countries come into the market, such as Mexico or important as the covered-bond market becomes ever more a South American country. And of course if the US enters the international and thus competitive. In such a market the impositions and protection afforded by regulators will go a mix then everything will change,”says Vortmueller.

The growth of a larger market in covered-bonds has long way to determine the availability and popularity of the added length and depth to the covered-bond yield curve – different nation’s bonds. Thankfully, the biggest regulatory in particular the Spanish cédulas have added mass and change facing the industry is likely to have a positive liquidity to the long end of the yield curve. Yet the market impact on the covered bonds market. The introduction of has also remained largely homogenous as a result of the the Basel II accord, tipped for 2008, will more closely align adoption of similar legislation across the issuing countries. banks’ capital requirements with the economic risk of holding different financial products.

That is not expected to change.

That will deliver a boost to fixed-income products in general.

Juetten says: “The economic principles that drive the development of the product are the same and therefore a More specifically it is good news for covered bonds because it convergence of covered-bond legislation has taken place.” will allow a lower risk rating for mortgages – make the issuing The exception to this has been Britain and Italy, both of of covered bonds more attractive and further securing the which have issued covered bonds without the backing of Jumbo market’s success for the next ten years and beyond. legal infrastructure – though in the case of Italy that looks like a one off with new laws expected to be enacted soon.

The success of the British bond has paved the way for more JUMBO PFANDBRIEFE BASICS like it and importantly it has shown a way forward for banks IRST ISSUED IN Germany over 230 years ago in other countries, without specific covered bond legislation.

Pfandbriefe (more or less pronounced fund brief) are “In (Britain and Italy) issuers have had to substitute the covered-bonds collateralised by long-term debt – either legislative framework with private law. Because they are mortgages or loans to the public sector. Despite an effectively using structuring techniques and every issuer increasing geographical diversity of issuers the principles has a slightly different documentation more caution is created in 1995 – with the launch of the Jumbo needed when comparing one covered-bond with another,” Pfandbriefe market - have been widely adopted as the says Karlo Fuchs, associate director Financial Institutions governing tenet of all of Europe’s Jumbo markets.

Ratings at Standard & Poor’s Frankfurt. The growth of The minimum standards for Jumbo Pfandbriefe were covered-bonds outside Germany has given rise to another officially adopted by German mortgage banks in 1997 notable trend, namely the growth of the mortgage sector in and updated again in 2004. They include: A minimum the market. This too is expected to continue. issue size of €1 billion, with a minimum initial issue size Throughout the 1990s, the covered-bond market was of at least €750 million. The average size tops the dominated by German public-sector lending collateralised €1.5 billion mark. bonds. While the laws in the new issuing countries allow for The use of only straight bond formats to create the issuance of both mortgage and public sector based Jumbo paper – i.e. fixed coupon payable annually in covered-bonds it is already evident that it is the former that arrears with bullet redemption. A minimum of three will dominate. This development could have a negative market-makers who are pledged to quote bid/ask (twoimpact on the market as it is attracting the interest of financial way) prices simultaneously for lots of up to €15 million. regulators, who are concerned that savings banks are issuing Market makers should also have agreed to maintain a debt that ranks higher than the deposits of customers. standard and pre-determined bid offer spread based on The UK regulator has already issued guidelines that no the residual life of an issue – for example the maximum more than 4% of total assets can be repackaged as debt. bid/offer spread for an 8 to 15 year maturity is 10bp.

This has put the brakes on UK issuance of covered bonds De c-9

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INCE AFT LAUNCHED its 50 year note back in late February of this year, just 16 days after appointing Barclays Capital, BNP Paribas, CDC Ixis, Credit Suisse First Boston (CSFB), Deutsche, HSBC, CCF and JP Morgan to gauge the potential market demand for such a bond, both Telecom Italia and the UK’s Debt Management Office (DMO) have brought ultra long notes to the market – and the investment community believes there will be many more deals to follow.“We expect to see a lot more issuance of very long-term debt,”says Mary John Miller, director and head of fixed income at T. Rowe Price.“Historically low interest rates make this beneficial for issuers and the increasing demand for long duration investments among certain investors makes 50 year notes appealing. Rising long-term rates might dampen investor demand but the focus on pension plan reform and asset and liability matching should keep certain parts of the market very interested.”

Wayne Bowers, head of global fixed income at Northern Trust Global Investments (NTGI), agrees: “We will see more governments following France's lead with Italy, Spain and others all likely to issue long maturity government debt, although perhaps not at the 50 year level. Expected and actual changes in pension legislation are driving investors’ demand for ultra long deals and, while these changes can take many months to filter through to trustee investment meetings, it should ensure that demand is maintained. Consequently, government borrowers will be encouraged to pursue an issuance programme that includes longer-dated notes.”

Indeed, in addition to the UK’s 26 May nominal deal, the DMO is also making plans to bring the world’s first inflationlinked 50 year bond to the market in either July or September.

Meanwhile the German government is to decide when and if it will issue 50 year deals before the end of this year. At the same time, AFT expects to increase its existing €6bn issue to somewhere between €10bn and €15bn and (after a four year absence from the benchmark) the US treasury is looking at the prospect of launching a 30 year note.

“We will examine if we have the flexibility to issue 30 year bonds while maintaining deep and liquid markets in our other securities,” said Timothy Bitsberger, the United States’ assistant treasury secretary for financial markets, in a statement.“We need to determine if nominal bond issuance is cost effective.”After taking public comments, the department will decide whether to issue the bond on 3 August. If the answer is yes (and the overwhelming expectation is that it will be) then the first auction will take place in February 2006.

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LONG BONDS GAIN FAVOUR

DEBT REPORT: EUROPEAN LONG BONDS

Agence France Trésor (AFT), the French public debt and treasury management agency, has never been one to take a back seat. In 2001 it issued the firstever government deal linked to Eurozone inflation and just four months ago – with the launch of its 50 year note – it brought the longest ever G7 government bond to the market. And it seems the issuer, which had to scale back €19.5bn of investor demand to price its €6bn 2055 deal, has started something of a trend. Chris Newlands reports.

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DEBT REPORT: EUROPEAN LONG BONDS

But continued demand from the European pension fund community and its appointed managers is crucial to the success of any future ultra long issuance. Analysis of AFT’s 50 year February deal shows that pension and asset managers made up more than 50% of the €19.5bn order book, while hedge fund investors, insurance buyers and banks made up just 18%, 14% and 13% of total demand respectively.

Philip Read, director of the €2.05bn pension scheme for Metal Box, the UK manufacturer, says: “It is very positive that any government wants to issue very long dated indexlinked bonds but there needs to be a lot more of it. There is no magic in a 50 year note, however. We have liabilities that go out 80 years and so having a 50 year note helps with that but it is not the be all and end all. What we need is a range of index-linked deals that stretch out as far as is necessary.”

The pension fund community in the Netherlands endorses this. Forthcoming changes to Dutch pension solvency requirements, entitled FTK, that are scheduled to come into effect at the beginning of next year, will force pension fund investors to mark their liabilities to market ahead of fixed rate usage. This shift to fair value accounting will sharply increase the volatility of their liabilities and it is widely expected that investors will beef up their exposure to very long-dated paper and become forced sellers of equities and shorter-dated deals in order to reduce volatility.

“The 30 year state-swap spread, which is already at historically tights, could narrow even further as a result of the new supervisory framework for pension funds and insurers that will be introduced in 2006,” says Bert Heemskerk, chairman of the executive board at Rabobank Nederland.“The rationale being that we expect the FTK to lead to a massive interest in receiving fixed ultra long swap

Arnaud Mares, Head of Portfolio Strategy, at the UK’s Debt Management Office

58

rates, which will push in spreads versus ultra long bonds.”

Indeed, Harvinder Sian, an analyst at ABN Amro, believes that more than €120bn worth of Dutch pension and insurance assets will flow into long-bonds as a result of the new requirements and investors’ need to match liabilities.

“Dutch pension funds should be big buyers of duration this year on regulatory factors,”he says.“Pension funds will want to hedge the risk in their long-term liabilities to avoid the most onerous regulation elements and we expect around €bn120-€150bn in [long-dated] buying.”

But even though investors in the Netherlands are expected to be large consumers of very long-dated debt – and interestingly, demand from the Benelux region made up seven per cent of AFT’s €19.5bn order book – the Dutch government is unlikely to issue a 50 year bond any time soon. The borrower did, however, issue its first 30 year bond in seven years at the end of April after instructing ABN Amro, Fortis and CSFB to investigate the potential market demand for the note. The Dutch State Treasury Agency had intended to issue a 10 year deal but found enough interest to price a €5.2bn 2037 deal that paid four basis points over German bunds and was 40% sold to pension and asset managers.

Erik Wilders, head of the Dutch State Treasury Agency, says: “There is obviously demand in the market for very long-dated bonds and the research from ABN Amro, Fortis and CSFB found that there was indeed room for us to come to the market with a 30 year deal. But issuing a 50 year bond is simply not an option for us right now,” he adds.

“You need a huge amount of outstanding debt to successfully launch such a deal and, at the moment, we do not have that. Our goal is to issue debt as cheaply as possible at a given level of risk.”

But it is precisely this attitude that makes many buyers worry that 50 year bonds are a much better bet for issuers than investors. “While moves to increase the availability of very long-dated assets are to be welcomed, we expect these deals to be a sideshow for most investors,”says Jeremy Toner, fixed income portfolio manager at Investec Asset Management. “Although governments are showing an astute understanding of timing by issuing very long-dated instruments when inflation and interest rates are particularly low, investors face the risk of capital losses unless the bonds are priced with the potential for higher future inflation.

Previous experience with very long dated bonds has been unhappy for investors. For example, the undated UK war bonds issued prior to WW1 and reissued at 3.5% in 1932 (another period of very low inflation and interest rates) have experienced significant capital losses to date.”

Denis Gould, head of UK fixed income at AXA Investment Managers, agrees: “There is clearly demand for ultra long maturities, especially from liability driven investors but we think the current craze for 50 years may wane. In government bonds, 50 year issues have the benefit of higher convexity, which is worth something, but investors receive next to no extra yield for moving out to a rather isolated point on the curve where liquidity could be

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poor. Worse, if many other countries follow France’s lead, demand could quite quickly become exhausted.”

Jon Little, chief executive officer at Mellon Global Investments is equally as critical. “There was definitely a herd mentality going on with the French deal and I would not be surprised if after few years some of those investors that bought into the bond begin to wonder what they got themselves into. The pricing left a lot to be desired.”

But this does not worry Benoit Coeuré, deputy chief executive officer at AFT. The borrower’s February deal attracted demand from at least 10 different countries including Italy, Germany, the UK, Japan, the US, Sweden and France, while its eventual size beat expectations by around 100 per cent. Indeed, the issuer plans to increase the size of that deal to somewhere between €10bn and €15bn and then has ambitions to launch an inflationlinked 50 year note once this has been achieved.

“We were definitely surprised by the amount of investor demand there was for our deal,”says Coeuré.“We expected and were committed to issuing a deal of somewhere between €3bn and €4bn but eventually brought a deal to market that was twice as big as we thought. What we learnt is that demand is very deep and that there is more than enough room for other issuers to come to the market. In fact the more that come the better and that does not just mean sovereigns. We would also like to see more non-sovereign issuers, such as utilities, bringing 50 year deals as this will add more depth and liquidity to the sector.”

Arnaud Mares, head of portfolio strategy at the UK’s DMO, also rubbishes Gould’s suggestion that the appearance of too many government 50 year bonds will dilute and ultimately extinguish investor demand. He believes that there is more than enough space for other ultra long issues and is unconcerned by the fact that there has been a spate of 50 year deals in a relatively short space of time.

“It was never an issue for us what the other governments were doing and whether or not we were the first into the market,”says Mares.“It is not a race. We know that there is significant demand out there from the pension fund community but demand is not restricted just to pension funds. ultra long bonds have a high convexity and this makes them appealing to other sections of the market, such as hedge funds and the trading desks of banks.”

But whether or not the demand for 50 year deals dries up over the next couple of years, right now investor interest in such bonds remains strong. Continued moves from the various European regulators to increase protection for pensioners and reduce their exposure to market risk is increasing the need for fixed income products – particularly long-dated instruments as countries move to fair-value liability accounting.

At the same time, national treasury agencies throughout Europe have been eyeing the opportunity to issue very long-term debt at a time when both interest rates and inflation are at relative lows. This demand and supply match-up looks set to mark the arrival of many more ultra long bonds over the next 12 months, despite investors’fear

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

Benoit Coeuré, deputy chief executive officer at AFT

of rising interest and inflation rates.

“Nominal 50 year deals are not as attractive as inflation-linked bonds but you can be sure that investors will jump into any deal if other investors are doing so,” says Read at Metal Box. “People do not like to be left on the sidelines and European sovereigns will not have a problem finding demand.”

“Interest in these deals will not wane,”adds Emeric Challier, global CIO for European fixed income at Fortis Investments “If governments become too active in issuing 50 year bonds we may see a fall in demand but this will only happen over the longer-term. Right now we are just at the beginning.”

Emeric Challier, global CIO for European fixed income at Fortis Investments

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DEBT REPORT: UK GILTS The Debt Management Office (DMO), the UK Government’s bond issuance office, an executive agency of the UK Treasury, is determined to build liquidity in 50year gilts following the first of its ultra long bonds being auctioned to investors in late May. Francesca Carnevale talked to Robert Stheeman, the DMO’s chief executive, about the market response to the auction and the agency’s issuance calendar for the remainder of the 2005-6 fiscal year.

SMOOTHING THE WAY FOR S MAY SLOWLY ground to a close the DMO sold via auction an inaugural 50-year plain vanilla bond which marked the longest dated bond the UK Treasury has brought to the market in more than four decades. At present, the longest issues out in the market with a finite maturity are for around 30 years (please refer to Table 1) – there are however some outstanding bonds (£3bn of ‘undated’ bonds, in fact) some stretching as far back as the nineteenth century.

The new ultra long offering comprised £2.5bn of 2055dated paper, carrying a coupon of 4.25% and issued at a yield of 4.21% (at the time of issuance, by comparison, the 30-year benchmark bond offered a yield of 4.33%). The bond was in large part deemed attractive by market commentators, given a healthy backdrop of investor

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demand and the expectation that UK interest rates will begin to fall in the autumn. The bond also marks only the first stage in the UK’s issuance of ultra long-dated bonds, according to Robert Stheeman, the chief executive of the DMO, who expects its success to be followed by at least one further issue later this year and another early next. It could, he acknowledged be extended from the second quarter of the 2005/2006 financial year to include an indexlinked offering.

The UK’s return to the long term gilt market has highlighted efforts by leading European sovereign issuers to lock-in low interest rates at a time when pension funds and insurers are clamouring for long-term assets. When France’s Agence France Trésor (AFT), for instance, issued a similar a €6bn 50-year bond through a syndicated offering it was more than three times oversubscribed, raising €19bn-worth of investor interest following a formal bookbuilding process.

While Stheeman smilingly acknowledges that demand for the UK ultra long bond might have been stronger (the auction was covered 1.6 times), he is sanguine enough to state that the issue was “very normal for a long dated auction. We are always pleased with our issues and this is no exception. We spent a long time building up to it. The French government has issued something of comparable length, but not by auction. I have to say that it [the auction] very much met our expectations.”A second intention was to ensure a well-run auction process. “I would stress that for us it was very important to run an open, transparent process”, adds Stheeman.

The DMO has long preferred the auction process over syndications. “It is a transparent and predictable way of issuing debt,” says Steve Whiting, the DMO’s policy advisor, continuing “while maintaining a level playing field for primary dealers and at the same time delivering value for money for the government.”

“An auction suited our purpose well in that case” explains Arnaud Mares, who is head of portfolio strategy at the DMO. “There are very good arguments for using syndication [sic], but it also raises issues” he adds.

FTSE All-Share Index vs. FTSE UK Gilts 150 140 130 120 110 100 90 80 70 60

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FTSE British Government Stocks over 15 years Index

FTSE British Government Index-linked over 15 years Index

Data as at June 05. Source: FTSE Group.

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

United Kingdom: Structure of the assets of pension funds and insurance companies (as % of total assets) 90 Securities other than equities: short-term Medium-term bonds Long-term bonds Listed equities Non-listed equities Foreign equities

80 70 60 50 40 30 20 10 0 96

97

98

99

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Source: Ixis CIB

Stheeman picks up the theme.“We would have to choose only a few lead managers for instance, so it could suggest we were favouring or giving status to a small group of banks. We try to treat all the gilt edged market makers (GEMMs) in an equal and transparent fashion. It is very important to us,”he says.

But while the DMO is happy with the take up of the issue, Stheeman admits he was after rather bigger fish. The DMO was keen not just to sell down one or more ultra long bonds in the year, it was also keen to develop a long term viable market for ultra long dated gilts. "Liquidity is important, and it is something we have focused on very carefully. We had to be sure that whatever we introduced was sustainable," he says. That requirement comes into focus strongly as Stheeman outlines the UK’s medium term borrowing requirements.“For the next four years we will average over £50bn – more than last year,” says Stheeman, while Arnaud Mares stresses that the DMO “has no particular concerns on the ability of the capital markets to absorb this requirement. The market itself has expanded, turnover has increased and liquidity has improved. We do not sense the market has a problem with the increased level of issuance.”

Stheeman’s ambitions for the ultra long dated bonds find a receptive audience among pension fund advisers who have warned that issuance of ultra long dated bonds must be substantial to avoid the problem of retirement funds locking away a limited supply of long dated paper and creating an illiquid market. In the late 1990s, for instance, when public finances were in surplus, trading in 30-year gilts became illiquid for a time, producing in turn wide price swings. The US, for another, even suspended issuance of 30-year bonds back in 2001 when its budget was in surplus. The US Government has, however, recently launched a consultation on the resuming issuance of 30-year bonds.

Ultra long dated bonds have a particular appeal to the investment community, for various reasons. Pension funds, for one, have largely been in favour of them.

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Interest in them by defined-benefit pension schemes, in particular, is being driven by ageing maturity profiles and legislation which encourages them to match their assets against their liabilities. Consequently as of the beginning of this year demand for long-dated bonds strongly outweighed supply, thereby creating a good climate for the UK via the DMO to return to the ultra long dated market.

“It is fair to say that the vast majority of this issue has gone

to the domestic market,”explains Stheeman, although this assessment is based on anecdotal evidence. It will be some time before the DMO gets a clear picture of the composition of buyers of the paper. “In a syndicated offering you get a better breakdown,”he acknowledges.

Historically, UK pension funds and insurance companies have been by far the largest buyers of gilts – in particular index-linked gilts. This trend is likely to continue especially

THE APPEAL OF THE ULTRA LONG BOND

T

HE IDEA OF a very long-term bond is not brand new, but it has become very popular in recent months. In some part this is because pension funds are undergoing rising regulatory pressure to match long-term liabilities and assets. As well, governments have also acknowledged that current financial conditions make long-term bonds a cheap way to grow funds.

The launch of the longest dated British Government securities ever issued – aside from undated gilts, which have no fixed redemption date – came in the aftermath of World War I. In June 1919 the Government launched two inaugural ultra long gilts on the same day: 4% Victory Bonds, which raised £287m and a further 4% Funding Loan dated 1960-1990 £288m. In today’s terms, the issues constituted a considerable operation for the time – equivalent to around £14bn in current money, according to Steve Whiting, a DMO policy advisor.

Issuing authority for the bonds was obtained from the House of Commons by the then Chancellor of the Exchequer Austen Chamberlain on 2 June. “There then followed several days of speculation in the press over the terms and conditions of the bonds prior to their official launch in the Guildhall by the Chancellor and the Lord Mayor, on the evening of 12 June 1919,” he explains. Although the Prime Minister, Lloyd George could not be in attendance, he telephoned a message of support, stating that in buying the bonds you “get the premier security of the world”. His comments were received with cheers by the audience when they were read out by the Chancellor. As part of the launch of the new bonds, a floral fête was also held in Trafalgar Square in celebration. “In addition, at the Prime Minister's request, over 120 MPs agreed to speak as advocates of the new bonds in their constituencies,” says Mark Deacon, senior quantitative analyst at the DMO. Investors could purchase the bonds for cash or by exchanging Treasury bills or other short-dated gilts, “the latter being part of a government drive to reduce the proportion of the government's debt that was in either floating rate or short-dated form,” says Whiting. When it was issued, 4% Funding Loan 1960-1990 had a 71-year maturity.

However, in practice it was redeemed early in November 1972, making it a 53-year bond. 4% Victory Bonds were redeemed in 1976, giving them a near 57-year maturity.

Other ultra long double-dated gilts were issued after 1919. For instance, in 1954 the government issued 3.5% Funding Stock 1999-2004. This was created as a result of a conversion out of another gilt issue. The yield at issue was 3.62% and so this was consistent with the 3.5% coupon. The highest price for this bond in 1954 was £99 3/16 and the lowest – at the end of the same year – was £95 1/16. Although this gilt was technically a 50-year gilt as its final maturity date was in 2004, it was actually redeemed early in 2003, making it a 49-year bond. Of the gilts currently in existence, the longest dated at issue is 5 1/2% Treasury Stock 2008-2012 which was issued in October 1960, making it a 48-52 year depending on its precise redemption date. “At the time, there was Mark Deacon, senior rather a lot of speculation in the press when this quantitative analyst particular bond was launched that one of the objectives of the sale was to absorb demand, which was reported as being large and showing signs of increasing,” explains Whiting. “The last double-dated gilt was launched in 1980 and nowadays the policy of the UK government is to concentrate issuance on large benchmark bonds with a vanilla bullet structure, in line with the products available in other leading international bond markets,” adds Deacon. The demand for bonds is set to continue, thinks Deacon, and to increase as European institutional investors still have a large mismatch between their need for bonds and what they actually have in their books.

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as more schemes try to address their matching shortfalls. However, many schemes have liabilities with maturities longer than that of the longest-dated gilts. Index-linked gilts, for example, extend to 2035, with only nine issues available (and, reportedly, most of the UK’s pension schemes have liabilities that extend well beyond that date). Further, the implementation of international accounting standards (IAS) as well as more constraining regulations is forcing life insurance companies and pension funds to better match their liabilities. By marking-to-market larger parts of their balance sheets, these institutions are motivated to reduce their duration mismatches if they want to reduce the risk of high volatility in their financial results. The UK market is a powerful indicator of the potential impact this trend towards longer dated investments can have on the bond market. In the UK, the changes in regulation forcing pension funds to better match the duration of their liabilities has resulted in a strong increase of the bond portfolio weight in the asset allocation to the detriment of equities.

The share of equities has fallen from 68% in 1998 to 52% in 2004 and the share of bonds has risen from 25% to 39%.

Since 2001, the UK institutional investors have been net sellers of equities and net buyers of bonds. The impact of the regulation change has been strong performance of long dated gilts and ultimately an inversion of the yield curve. As of the end of January 30-year gilts traded at a yield of 4.5% compared to 4.6% in the 10-year sector. At the peak of the inversion in January 2000, 30-year gilts yielded more than 1% less than the 10 year maturities.

In the period before the DMO kick-started the ultra long dated bond issuance process, a shortage of long-dated sterling bonds had, in the meantime, encouraged banks and other financial institutions to offer products such as inflation swaps to help retirement funds hedge exposure to future liabilities. But it is/was nowhere near enough to help.

No surprise then that the DMO ultra long inaugural bond was snapped up by the local market.

Finally, it was becoming obvious that UK sovereign issuance was on the rise as the shortfall between government spending and tax revenue has widened considerably in recent years. Chancellor Gordon Brown signalled his intent to issue 50-year gilts in his March 2005 Budget speech to the British Parliament, in a move that would “lock in low borrowing costs and simultaneously benefit taxpayers and investors”.

Even though it was well aware of this confluence of trends, the DMO had undertaken a lengthy market consultation process well in advance of the March budget to test the appetite of the larger investment community

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

Steve Whiting, Policy Advisor & Press Officer.

towards longer dated issues. “It is becoming a typical process for us and others are now taking our lead,”explains Stheeman. The consultation was spearheaded by Arnaud Marés, and Steve Whiting.“Arnaud and Steve kicked it off in an informal way last summer,” explains Stheeman.“We needed to understand the structural needs of the market and our own investor base. The formal consultation began in earnest in December of last year.”

Most of the dealers involved in the wide-ranging consultation process (taking in investment advisors, actuaries, pension trustees and market traders) gave preference to a 50-year issue, but some asked for a 40-year bond. Dealers also called for the DMO to re-open conventional bonds maturing in 2032 and 2038, and evinced an interest in launching a 2040 gilt, according to national press reports at the time.

The DMO is likely to come to market with a further ultra long dated bond later this year. Take up on the next gilt issue will be a bellwether of the success of the DMO’s effort to stoke up liquidity. A further milestone will also be achieved, if the DMO manages to meet demand for an ultra long dated index-linked bond.“It is fundamentally a different animal,” concedes Stheeman, “and so that may take longer to achieve. We will have to take the measure of the market and demand and the technical issues in structuring an index-linked facility over such a long tenor.”

Knowing the DMO, it will leave nothing to chance.

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SECTOR REPORT: DISTILLERS Philip Bowman, chief executive, Allied Domecq

Blithe Spirits IN A

= bull run

The spirit of capitalism is up and roaring – at least among the world’s distillers. The few remaining liquor giants today squint avariciously at each other’s brands, with a view to takeovers and amalgamations. Allied Domecq, the British-based company that is the world’s second largest liquor seller, having scarcely digested its spoils from the Seagram’s carve up of four years ago, is now itself on the slab awaiting the brand-hoarders’ hatchets.

Its shareholders are not complaining. Like a prize bull fatted for market, the carved up company is worth far more than on the hoof. Ian Williams considers the outlook for the industry.

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ODAY’S SPIRITUOUS FRENZY is a return of an Once a heavily taxed luxury, rising affluence and declining older cycle of trade. In the seventeenth and relative prices have caused spirit consumption to soar – eighteenth centuries, the distillation of brandy and especially in the branded varieties where the wiles of rum helped turn the engines of world commerce, leading marketers can persuade drinkers that there is enough to the development of the modern Atlantic economy. New virtue in a branded variety of pure ethanol and water to be Englanders traded their cod for molasses from the worth five times the price of a generic equivalent. Young Caribbean, which they made into rum. Apart from people in their twenties in particular are downing spirits. drinking lots of it themselves, it was a major article of trade Sales in the US for example are rising by 4.1% a year, while beer drinking, at 0.5% annual growth, these days can for the slavers.

Alcohol was also a major source of early trade wars since hardly raise its froth above the glass.

Marketers have successfully persuaded significant the French and Spanish tried to protect their domestic brandy producers from colonial competition by banning numbers of the bright twenties age group that only much the rum trade, and distillers worldwide used their more expensive super-premium brands have the necessary domestic clout to ensure that foreign rivals were taxed at a cachet. Furthermore, these days it is peer-group social death to be seen drinking lesser brands without the lore. As much higher rate.

People have always thought that tipple from across the a result Impact Databank, the alcohol sellers’ bible, sea was more exotic and chic than anything produced in assessed the value of the world's top 100 spirits brands as their hometown distilleries. Colonial Americans, for rising 5% to $56bn last year.

That price and worth are not necessarily identical is example, oft times paid a premium for Jamaica Rum over their local New England variety, while their contemporary suggested by American Sidney Frank’s sale of the “Grey British paid more for sometimes-smuggled French brandy Goose”vodka brand to Bacardi for $2bn last September. It is perhaps symptomatic that Frank began his career making rather than locally produced gin or whisky.

Eventually, that led to the development of global brands alcohol-based jet fuel. His “invention” of Grey Goose was recognised across the drinking world. In more recent times, based on sound economic principles. As he has explained,“A World Trade Organisation rulings and free trade bottle of Absolut sells for $20 a bottle.Vodka is just water and agreements have now cut back on the previous tariff alcohol, so if I sold a bottle for $30, the $10 difference is barriers that penalised foreign spirits, creating a real world almost all profit.” He knew that there is nothing as easy as market. Countries may tax drinking heavily, but they can parting a snob from his money, and made Grey Goose in France, to tickle American consumers’ sense of chic. no longer favour local distilleries.

There is indeed room for a little boy to do the emperor’s In the last ten years, as a result of these developments, the industry has steadily grown from a relatively high new clothes routine on drinks such as premium vodka. population of small family-owned enterprises to a much Dimitry Mendeleyev took time off from laying the Periodic smaller group of massive international companies. And, table of Elements to draw up the specifications for vodka just as in the buccaneering Rum era, French, British and for the Tsar in 1894. It comprised 60% water and 40% American giants are now playing a modern form of poker ethanol. So the major difference in premium drinks is the label on the bottle – and the price. Since most of the across the Atlantic table.

So far advanced is the process of consolidation that to drinkers add mixers or drink the vodka as part of a cocktail, stay one step ahead of the regulators, recent takeovers have any homeopathic differences between brands would need involved shuffling brands between rivals so that each can a gas chromatograph to identify. One envisages a world full maintain a balanced portfolio of products without of unscrupulous bar-owners decanting basic vodka into developing a monopoly in any one sector. Because this is a expensive bottles every evening.

But with the mysterious global business, companies alchemy of branding, Grey have to comply with Fizz and pop in the spirit world Goose has left former European and US anti500 450 premium brands behind, monopoly regulations, and 400 as mere cooking vodkas each merger and 350 for the undiscerning. It has acquisition results in a 300 also triggered a chain judicious reshuffle of 250 200 reaction as other firms brands as the companies 150 have sought to put alcohol try to assemble the hands 100 and water in pretty bottles they want to deal in each 50 0 that attracted superof the big markets. premium prices.

Driving the present barIts very simplicity is room brawl is the growing what makes vodka perfect popularity, and even faster Allied Domecq Pernod–Ricard Constellation Brands A Diageo Fortune Brands FTSE Beverages Index for this form of cogrowing profitability, of modification. However, premium branded spirits.

Data as at June 05. Source: FTSE Group/FactSet Limited (Price Index values in US Dollars) 4

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SECTOR REPORT: DISTILLERS

Ricard worked together to global companies need a full pick over Seagram in a $8.7bn range of spirits, single malts vivisection that gave each of and aged rums and brandies “If Pernod-Ricard can pull off the them the brands they wanted even before you get to the Allied Domecq takeover, it will be selling and they thought that the modern liquid candy 77m cases of spirits a year, and own 20 regulators would let them get confections striving for of the top 100 brands, even after away with.The effect has been market share. Bacardi’s to shuffle the pack of the top purchase of Grey Goose and divesting some of the Allied Domecq’s brands, and more cards are other brands such as brand portfolio to Fortune brands. It now about to change hands.

Bombay Sapphire and would also double Pernod-Ricard’s share Pernod-Ricard – eagerly Dewars shows that it realises of the American market to over a building up its portfolio since that the fairly generic white quarter and make it the second biggest it decided that its eponymous rum that it is usually spirits company in the world.” anise flavoured drink alone associated with does not pull was not going to conquer the in the growth and dollars it world – added Seagram’s gin, wants. Bacardi, itself one of the world’s most recognisable brands, has also grown Chivas Regal and Martell Brandy to its cabinet to give it 12 apace, but not perhaps as fast as its rivals, or indeed as fast of the world’s 100 biggest spirits brands.

In the end, while Bronfman would undoubtedly have as the family. There are constant hints that its 600-plus (and increasingly extended) family shareholders may want been better off sticking with booze than chasing a dot.com to go public so they can take a quick shot from the stock dream with Vivendi, there is a distinct hint of bubble markets. Bacardi executives meanwhile are looking economy about the spirits fad. The Super Premium brands, askance at their declining market share as the major, stock- creations of astute marketing as they are, require heavy investment in brand maintenance, especially as others try market-funded giants merge and acquire.

And of course, to add a little spritz to the mix, Bacardi has to recreate their success. No less than 130 new brands of been fighting its own grudge fight against Pernod-Ricard vodka were launched last year, each of them hoping to over the American rights to Havana Club. Pernod-Ricard knock Grey Goose off its precarious perch.

However, high maintenance costs raise the entry has the worldwide rights, except in the USA, where the courts and Congress share the Bacardi family’s antipathy to premium for new brands, and in the modern world global brands tend to dominate. Size does matter in the booze Fidel Castro.

Some cynics also suggest that Havana Club’s distinctive business. Smaller brands wilt. The giant multinational nose shows up the blandness of Bacardi – which might drinks businesses often do not even make their own explain how, without selling a single bottle legally in the drinks, but market and distribute other companies’ world’s biggest marketplace (i.e. the USA) Havana Club productions, assembling brands to make up a balanced sales have been steadily rising until it is now 44th in the global liquor cabinet.

That is the background to current takeover battles world’s top hundred spirits list.

Among the quoted spirit companies meanwhile, the when, in April, Pernod-Ricard and Fortune Brands bid present reshuffle began when Edgar Bronfman Jr decided to $14bn for the hearts and spirits of Allied Domecq, pull out of the family’s Seagram’s spirits empire, whose Diageo’s British rival.

If Pernod-Ricard can pull off the Allied Domecq takeover, success had been built on the proximity of Canadian distilleries to Prohibition-era America. Diageo and Pernod- it will be selling 77m cases of spirits a year, and own 20 of

Net turnover by business area % Year end figures, August 2004.

Trading profit by business area % Year end figures, August 2004.

Total £2,611m 1.

2.

3.

4.

5.

6.

7.

Spirits & Wine North America Europe Latin America Asia Pacific Premium Wine Other Quick Service Restaurants Total

Total £657m £m 632 734 268 226 475 50 226 2,611

% 28 28 10 9 18 2 9

Source: Allied Domecq’s Press Pack 2005.

66

1.

2.

3.

4.

5.

6.

7.

Spirits & Wine North America Europe Latin America Asia Pacific Premium Wine Other Quick Service Restaurants Total

£m* 183 139 44 68 98 16 86 634

% 29 22 7 11 15 2 14

*Excludes £23m of Britannia Source: Allied Domecq’s Press Pack 2005.

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the top 100 brands, even after divesting some of the Allied Domecq brand portfolio to Fortune brands. It will also double Pernod-Ricard’s share of the American market to over a quarter and make it the second biggest spirits company in the world.

Fortune will also double its US market share, and it is widely felt that the deal is its last chance to get within stalking distance of Diageo, the British company whose size haunts the spirit world in the US as well globally. It would make Fortune (whose flagship hooch at the moment is Jim Beam bourbon) the fourth largest spirits company in the world.

However, the perception that Allied Domecq’s takeover and dismemberment will lock up market share for a long time to come has now prompted a counter-offer from American company Constellation Brands backed by Brown Forman.

Constellation Brands lacks any major international spirits brands to balance its stronger beer and wine portfolio, while Brown Forman has been building up from its flagship Jack Daniels bourbon with Appleton’s rum and Finlandia vodka and could doubtless complement that cocktail with a few more international brands.

To add to the tension, Diageo, Pernod-Ricard’s former partner in dismembering Seagrams, could not make an offer for Allied Domecq without bringing monopoly regulators crashing down on it. But it is hovering around offering spare cash to whichever bidder will allow it to cherry pick further brands from Allied Domecq’s cabinet.

That would help it blunt the threat from the PernodRicard/Allied Domecq merger which would bring the resulting company closer to Diageo’s hitherto unassailable position as the world’s number one barkeeper.

And just to complicate the issue further, Bacardi, clearly trying to expand from its rum base was also rumored to be interested, whether in concert with the others, or even a direct bid of its own that would fulfill the desire of some of the family shareholders to get a stock market listing by inheriting Allied Domecq’s position in London.

Of the interest in Allied Domecq’s overall portfolio, the keenest is perhaps in Allied Domecq’s premium brands.

Although, they only make up a third of Allied Domecq’s sales, the premium brands contribute to half of its profits and have built the company up to its present size – thereby making it such a desirable prize.

There may well be more mileage in the long run in the merely premium aged spirits but for now the attractions of a quickly made product selling at very high multiple of its production costs will certainly maintain attention on the white spirits, in particular vodka. It is a lot easier to add a fruit flavour to alcohol fresh from the still than to nurture a malt whisky or cognac for quarter of a century in expensive oak casks.

While the “brown” spirits are steady earners, for the foreseeable future, the high spirits of the twenty something generation are going to be the effervescent force in the global liquor stakes. There are many more hands to be played, and brands to be reshuffled.

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

Patrick Ricard, chairman and CEO of Pernod Ricard.

SPIRITED PLAYERS AND THEIR HANDS

W

hen Allied Domecq folds, its hand includes Ballantine’s, Beefeater, Kahlua, Malibu, Stolichnaya, Centenario, Teachers, Tia Maria, single malt brands including Laphroaig, Glendronach, Scapa and Tormore and “fun” brands such as Midori, Caribe, which would go to Pernod-Ricard while Canadian Club, Courvoisier, Maker’s Mark,Teachers and Sauza would go to Fortune Brands.

Fortune Brands already owns Jim Beam and Knob Creek bourbons, DeKuyper cordials, Starbucks™ Coffee Liqueur, The Dalmore single malt Scotch, and Vox vodka Pernod-Ricard already has Wild Turkey Bourbon and Seagram’s Gin and distributes Chivas Regal, Jameson Irish whiskey, Havana Club, Martell Cognac, Wódka Wyborowa, Viuda de Romero tequila, as well as its original Pernod and Ricard anises.

Diageo’s hand currently includes, Smirnoff, Gilbey’s, Gordon’s Tanqueray gin and vodka, White Horse, J&B rare, Pinch (Dimple), Crown Royal, Seagram’s, Buchanan’s, Cardhu, Bailey’s, Myers, Captain Morgans, Hennessy, Romana Sambucca, José Cuervo, Don Julio, and an array of Classic Malts.

Bacardi, apart from its own array of rums, has Bombay Sapphire gin and Martini & Rossi vermouth, Dewar's Scotch whisky, DiSaronno Amaretto and now of course, Grey Goose as well.

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DERIVATIVES REPORT: CME

Craig S. Donohue, CME CEO

at the new

CME frontier As market boundaries flounder in the wake of globalisation, stock and derivatives exchanges have oft-times struggled to redescribe their role in the new financial order. Not so the Chicago Mercantile Exchange (CME) which, since demutualisation back in 2001, has swelled in confidence, strength and reach. Armed with a $700m war chest, big could get bigger as the CME scouts for strategic acquisitions, joint ventures and growth. Chief executive officer (CEO) Craig S. Donohue talks to Francesca Carnevale, about the seemingly unstoppable force that is now the CME.

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O SURPRISE THAT in Illinois, which now boasts an economy greater than that of Russia, CME MONTHLY AVERAGE DAILY VOLUME (In Thousands) testosterone-charged numbers are de rigueur at the Executives’ Club of Chicago’s early-bird monthly breakfast May 2005 May 2004 Percent meetings. The sometimes biting elite of Chicagoan Change corporate society has gathered this day to hear Craig S. CME PRODUCT LINE Donohue, the CME’s urbane CEO, explain why “The Interest Rates 2,385 1,878 27% Future is in Futures”. In the sometimes catty table talk E-Minis 1,205 1,238 -3% before his speech, more than one person pointedly remarks Equity Standard 102 95 7% that the CME, which has a market capitalisation of some Foreign Exchange 296 163 82% $7bn, is but only one of the top 25 companies in Chicago.

Commodities 53 45 16% Yet even this number-jaded clique, looks up in conceded Sub Total 4,041 3,420 16% surprise when Donohue eventually lobs his own fat trakrs 22 86 -74% statistics into the mix.

Total 4,063 3,506 18% Last year more than 800m contracts were traded on the VENUE exchange, with a gross value of $463trn. That is over 10 Open Outcry 1,054 1,516 -30% times the current annual gross domestic product (GDP) of CME Globex (Ex trakrs) 2,942 1,868 57% the United States (US). Put another way, in the first two Privately Negotiated 45 36 25% weeks of January, the CME traded more in notional value Source: CME June 1st 2005 terms than the New York Stock Exchange handles in a full year. It is an indication of just how far futures and options markets have come. Today it is a global growth industry setting the organisation’s vision and developing growth which boasts “compounded annual growth of 38% during strategies to expand the exchange’s core business and the last three years, compared with the relatively flat global distribution.

It is a particularly good time to be CEO at the CME. Over growth for the world’s stock exchanges,” according to Donohue. His well-practised delivery bears fruit, even the last five years, it has morphed into the largest futures among Chicago’s uber-moneyed city fliers. “He seems to exchange in the US and the world’s largest clearing house know what he is talking about,” says one of the for futures and futures options contracts. The exchange’s breakfasters, if a tad grudgingly. It is a back-handed products have sounded a particular resonance to compliment that Donohue would laughingly appreciate, contemporary investors, providing as they do a means for with the sort of gracious ease that masks years of driving hedging, speculation and asset allocation relating to the risks associated with interest-rate movements, equity hard work and a sometimes ruthless strategic focus.

A 17-year veteran of the CME, he does indeed know the ownership, and fluctuations in foreign currency (FX) values business very well. Still barely in his forties Donohue took and the prices of commodities – including cattle, hogs and over as CEO of CME Holding and the CME itself only in dairy. The CME launched the first of its stock index futures January 2004, but to many market watchers, he was a contracts based on the S&P 500, back in 1982. Today, it natural choice for the job. He succeeded James J. McNulty trades Eurodollar contracts and futures and futures options who stepped down after steering the CME through on an ever-widening variety of indices, including the demutualisation, an initial public offering (IPO) and the NASDAQ-100, S&P/BARRA Growth and Value Indexes, and the Nikkei 225, as well early rise of electronic as its electronically traded trading via the CME Globex “Increasing Market Share at the Expense of the E-mini S&P 500 and Eplatform.

Donohue European Exchanges” – Chicago Mercantile Exchange mini NASDAQ-100 entered as a general vs. Deutsche Bourse and Euronext contracts, that are among counsel back in 1989, with 400 the fastest growing a list of academic and legal 350 products in the industry’s qualifications almost as 300 history. long as this article. He 250 Most recently the CME joined from the local law added futures contracts on firm of McBride Baker & 200 three of the largest and Coles where he had 150 most popular exchange specialised in corporate 100 traded funds (ETFs – and securities law. Steadily 50 baskets of securities working through one designed to track an senior management index). The move is position after another, in Chicago Mercantile Exchange Deutsche Bourse AG Euronext significant.

The fast each role Donohue played growing US ETF market is an important part in Data as at June 05. Source: FTSE Group/FactSet Limited, US Dollar price indices.

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90% of all US futures reported to have combined CME Outperforming Peers 5 contracts. “Our electronic ETF assets under custody trading business of some $226bn (as of the 4.5 – CME continues to grow rapidly end of last year), with the 4 due to our focus on S&P 500, NASDAQ-100 3.5 – Eurex expanding functionality, and Russell 2000 ETFs 3.0 – CBOT 3 capacity, distribution and accounting for about one access to our CME Globex third of that amount.

2.0 – Euronext.

2 liffe trading system,” says New CME ETF futures Donohue.

“As new contracts that are based on 1 electronic trading groups those indices began and individual electronic trading on the CME Globex 0 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q traders continue to emerge electronic trading platform 03 03 03 03 04 04 04 04 05 05 through in markets globally, CME in June. Futures on the May is competing to attract S&P 500 and NASDAQtheir business.”

100 indices continue to NOTE: Based on futures and options on futures. Excludes individual equity options.

The CME has also trade exclusively at © Chicago Mercantile Exchange Inc. All rights reserved. ridden a flow tide of CME. “Equity market participants want access to a broad array of products and business. According to the most recent Futures Industry markets, and the growth of our CME E-mini S&P 500, Association report, the volume of global futures and CME E-mini NASDAQ-100 and CME E-mini Russell 2000 options trading grew 8.9% to total 8.89bn contracts in contracts makes the ETF products a natural addition,”says 2004, with even more growth expected this year. FuturesDonohue. The move also portends a broader long term only volume, for example, topped 3.5bn contracts, up marketing initiative by the exchange. The addition of the 16.3% on the year. Options trading grew more slowly ETF futures means, “we will be able to attract more new however, rising 4.6% to 5.4bn contracts, mainly due to customers, particularly sophisticated retail equity lower levels of trading in Korea’s Kospi 200 index option.

Although volume rose in all sectors, trading in FX grew investors,”he adds.

Aggressive accretion of market share, wherever it might the most, surging 35.4% to 105.4m contracts worldwide. be, has been a priority for the exchange since at least the The largest volume in this category was, in fact, the Bolsa turn of this century. Between then and now the CME has de Mercadorias & Futuros’ US Dollar futures contract (up assumed a more uncompromising character. It is a 42.7% to 23.9m contracts for the year). In context, transformation kick-started by demutualisation in volume on the CME’s Euro FX futures product almost November of 2000 and a subsequent successful IPO in doubled over the same period, rising 82.7% to 20.5m December 2002 with shares priced at $35 (these days the contracts in the year.

Interest rate products apparently maintained their lead exchange’s shares trade in a high low range of $181 to $235). Contiguous developments include virtually as the world’s most active futures contracts. And while the continual product and technology innovation, expanding CME’s 3-month Eurodollar future gained an additional global distribution and the establishment of strategic 42.5% to 297.6m contracts to remain the world’s largest futures contract, in a countertrend, Eurex’s Euro-Bund partnerships in Europe and Asia.

The results are impressive. 2003 and 2004 were banner declined slightly, down 1.9% to 239.8m contracts. years. The exchange’s net revenues rose 37% last year to Meanwhile, in the dynamic top ten derivatives exchange reach $733bn, with net income up 80% to $219m based league tables, the CME moved past Euronext.liffe in on an operating margin in the year of 50.1%, compared December last year to become the world’s third-largest with 38.5% in 2003. But 2005 threatens to outclass even global derivatives exchange.

Performance records aside, in the sedate setting of the that performance. The trend, for the moment is but one way. Donohue explains that record volumes across all CME’s South Wacker Drive’s offices, Donohue muses over major product groups were and are “spurred by the the emerging view of the CME as a latter-day Galactico phenomenal growth of electronic trading.” In particular, among global exchanges.“Conversion from a membership the exchange’s performance reflected the additional organisation to a publicly traded company fundamentally revenues generated from clearing Chicago Board of Trade transformed us,” declares Donohue, though he concedes, (CBOT) transactions (of which more later).“Not bad for a the going has not been easy and back in 2001, nothing was company that began modestly in 1874 with the certain. Though bullish on “the future of our industry,” he establishment of a private association in Chicago to help stresses “it was not always so.” “Everyone says,‘well, it was easy, or that it was well timed.’I tell you, it was not obvious butter and egg dealers,”he smiles.

The CME also currently manages more than twice as to us. The risk of failure was real enough. It was out there.”

Challenges were becoming apparent even as the century many futures and options on futures contracts than any other futures clearing organisation in the world, and over opened and the global financial markets began to assume Average Daily Volume (round turns, in millions)

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a more sombre cast (well before 9/11 in fact). The competitive game in which the CME was playing was in flux. Competition between futures exchanges intensified and the stage became global, rather than national or regional. Although liberalising legislation via the Commodity Futures Modernization Act of 2000 (CFMA), had given the CME added impetus with which to face the future, advances in technology and a more favourable regulatory environment simultaneously encouraged European exchanges – namely Euronext.liffe and Eurex – to mount a competitive charge on the benchmark products of the US futures market.

The CME found that it faced a clear and present danger, perhaps for the first time. The specialist derivatives media added to the pressure. Chicago’s exchanges were simply not up to growing competition from abroad, they said and CME would be forced to cut trading fees to non-economic rates to encourage more volume, or that its mix of users would change and alter its profitability. Ironically, all that did happen, but not quite in the way the doubters expected.

The CME realised it needed to overhaul not only its business structure and strategy, but also its international ambitions. Its response was rapid, accelerating changes that were already in motion, such as migration to electronic trading and a reduction in trading costs. “We always thought about competition in terms of three major industry trends: deregulation, rapid advances in technology, and globalisation of intermediaries and customers,” explains Donohue. “We built the financial strength and critical mass necessary for executing our long-range strategy of expanding our core business, broadening our product range, providing third-party transaction services and exploring new business opportunities and that process continues.”

Investment in technology was intensified, as a priority. ”We spend more on technology today than was our entire operating budget five years ago,”says Donohue.“In the last 8 years we have invested over $1bn in technology and gone from having 125 or so technology specialists five years ago to employing around 450 today … the processing capabilities that we have, the global distribution network, even the backup and disaster recovery facilities point to us being more attuned to technology than ever before.”

“Today, we have marketing offices, telecommunications hubs and customer support capabilities in major financial centres, including London, Milan, Amsterdam, Frankfurt, Gibraltar, Paris, Dublin and Singapore,” expands Donohue. In preparation for that, over the last decade, CME has developed, enhanced and refined, its electronic trading platform. “Our order Return Delivery Time is 25 milliseconds, among the fastest in the industry. CME Globex is also accessible virtually 24 hours a day, longer than any other electronic platform.” CME had launched the industry’s first electronic trading platform (or system), back in 1992. CME Globex revolutionised derivatives trading by delivering much faster trade execution and

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trading anonymity. It also eliminated CME membership requirements for traders. Originally based on a DEC platform developed by Reuters, CME upgraded to its present multiplatform environment in 1998 – the service is built on top of a heterogeneous environment of IBM and Tandem mainframes, Solaris and Linux systems.

Investment in enhancing transaction rates means more than just faster processing. The company makes money by charging for executing trades and then charging to settle those trades. Therefore, the faster its systems are, the more trades it can handle, and the more profitable the CME becomes.

Migration to electronic trading has also spurred efficiency. Late last year the CME estimated that the average rate per trade (an important profitability measure) is around 77 cents for CME Globex products, compared with 52 cents for products traded via open outcry. The CME then simply earned 60% more revenue when a contract is traded on electronically than on the floor. Electronic trading is therefore elemental to earnings growth and simultaneously provides the CME with more room to compete with other exchanges on fees. As a consequence a number of fee cutting initiatives have been underway, particularly aimed at European customers, Asian banks and hedge funds.

There are also other related initiatives. For instance, “we have expanded the market maker program to nonmembers, and non-member firms, so that an electronic proprietary trading group or electronic trading arcade that would like to meet our market making requirements can do so at very reduced fees,” acknowledges Donohue.

Recent press reports would have it that around 80% of the market by transaction volume is trading electronically in CME Globex Eurodollars for between 14 cents and 18 cents, compared with prices anywhere between 50 cents and 80 cents on the open outcry floor, because of brokerage costs and the scale of the trade. Donohue concedes that few, if any, exchanges can compete at its lower price levels.

Outrageous fortune has not come without its slings and arrows. Eurex US which to date has not succeeded in setting up a strong foothold in the North American market filed a second amended antitrust complaint with an Illinois District Court against the CBOT and CME in March this year. Eurex US had also filed an antitrust action against the two exchanges back in October 2003 for alleged anticompetitive behaviour. The complaint included allegations that the CBOT and the CME have violated the Sherman Act by lowering transaction fees to predatory levels and allegedly attempting to keep Eurex from obtaining clearing services. The CME dismisses the charges.

The move nonetheless illustrates Eurex’s frustration over the difficulties in breaking into the US market, particularly as it was the first foreign exchange to establish a US subsidiary and enter into direct head-on competition with the incumbent exchanges. Eurex has however succeeded in establishing partnerships with important local institutions.

In its home market, Eurex has been a champion of vertical integration, but in the US it has railed against the vertical

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silo created at the CME. However Eurex did not take the measure of the ruthless drive of the US exchanges to undercut any market solutions that Eurex was touting. The CME and the CBOT clearly understood their own turf and what they could and could not do to withstand any assault on their market. But, stresses Donohue, the picture is greyer than market watchers often paint it. Developments in the market have been utilised to cooperate with other exchanges as well as compete with them. Recognising, for instance, that demands for greater efficiency have a wider application that the CME can also leverage to mutual advantage, Donohue claims that the exchange has led the trend toward standardisation and consolidation. “For example, Euronext.liffe uses CME’s Clearing 21 System to clear and process the majority of their securities and derivatives products. In the area of risk management CME literally created the industry standards when it developed its proprietary SPAN Margining System,” he recounts.

SPAN, which allows exchanges to monitor risk exposure, has now been licensed to some 47 exchanges and clearing houses, including the Shanghai Futures Exchange. It is, says Donohue “an important step for China in the process of moving toward global industry standards.”Not least, he points to the “historic clearing processing agreement with CBOT,” as an “example of our willingness to seek standardisation and consolidation benefits that have reduced performance bond requirements for market users by more than $2bn and has saved our joint clearing member firms more than $200m in capital”.

Utilising CME’s own clearing house, it was officially launched at 7:00 p.m. on Sunday, November 23, 2003 when CME began providing clearing and settlement services for a number of CBOT products, including agricultural, Federal Reserve funds, swap, municipal and Dow futures and options on futures contracts. The CME clearing house is now the world’s largest derivatives clearing organisation.

“The funds we hold in custody dwarf anything held by any of our nearest competitors by a wide margin,” claims Donohue.“We hold about $40bn in collateral, and we move about $1.5bn to $6bn of collateral each day. I am confident that the $2bn savings that we provide dwarfs what can be offered by our competitors.”

It was an imperative for the CME to achieve vertical integration, for four elemental reasons: It creates value, maintains Donohue, “and the ability to manage every aspect of how we deliver value to our customers. The CME can now manage all elements without being dependent on third party partners or service providers,” he explains.

Equally, he expands, “I do not want to see us outsource critical functions because we would deprive ourselves of the opportunity to create and leverage our intellectual capital and lose our innovator’s advantage.” Three, Donohue is content that the Clearing House means that “we now have every major financial futures and options product cleared in a single clearing facility.” Last but not least, it was an effective nuclear deterrent. Two exchanges that would rather cheerfully run over each other suddenly

began talking and acting like long lost friends. Had they been to Damascus? Or had they realised either by luck or by judgement that the initiative was a highly effective counterpunch to Eurex’s planned product launch at the beginning of 2004? Donohue answers indirectly,“both the CBOT and the CME have increased market share at the expense of the European exchanges. There has been a sea change. We are now seen as setting the pace of growth.”

Perhaps the clearest indication of the direction of the CME’s near term strategy came in mid-April of this year when it announced that it was enhancing its strategic planning and corporate development capabilities and appointing Ann Shuman and Kendal Vroman as co-heads of corporate development. The appointment of two heads, rather than one to replace the work of outgoing managing director Scott Robinson indicated that the CME was bringing strategy into greater focus.

Both Shuman and Vroman played key roles in the clearing agreement with the CBOT and the distribution partnership to provide CME FX on Reuters, Donohue explained at the time. The announcement was given additional piquancy when the same release mentioned the appointment of Johannes Zhou, as director of Asian business development. Zhou previously served in high executive positions in the Hong Kong Futures Exchange.

Undoubtedly his experience of the operation of Chinese markets and his contact book will come in very handy for the CME. Just how handy became clear last year as the CME began to establish a bridgehead in the all-important China market. A Memorandum of Understanding (MOU) was signed in June last year with China Foreign Exchange Trading System and National Interbank Funding Centre (CFETS), a subsidiary of the People’s Bank of China, the central bank. It was a canny move. Regulated by China’s State Administration of Foreign Exchange, CFETS already provides an electronic bidding system for matching spot trading of the Renminbi (RMB) against the world’s main currencies and also operates markets for RMB interbank lending and RMB bond trading.

Under the MOU, CFETS provides CME with local market intelligence and in turn the CME helps CFETS become “more familiar with the international FX derivatives markets practices”, products and regulations, according to the CME’s press blurb. “Expanding global distribution of our products and adding new customers in Asia is part of CME’s long-term growth strategy,” explains Donohue. Another similar MOU, this time with the Shanghai Stock Exchange (SSE) followed in March this year. “China’s exchanges can gain enormous growth and acceleration benefits by collaborating with global exchanges like CME to utilise its extensive infrastructure, trading and clearing platforms, and industry standardised business practices,”says Donohue, acknowledging that the CME’s long-term growth strategy is to expand global distribution of its products and to add new customers throughout Asia. He adds “We had introduced an Asian

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Incentive Plan to make our products more attractive to new customers from the Pacific Rim. We also launched a telecommunications hub in Singapore designed to make our markets more cost-effective and accessible.”

To unseasoned observers, these appear small steps to cross huge chasms. But the significance of the relationships has not been lost in the region itself, which has been awash with a growing network of strategic alliances including not only exchanges but also regulators and governments. It indicates that the CME is playing for big stakes in a politically very savvy regional league. Just a few examples of extant market-to-market arrangements are the MOU between the Online Commodity Exchange of India and Malaysia Derivatives Exchange, the strategic partnering arrangements between Singapore Exchange and Bursa Malaysia, and the understanding between Sydney Futures Exchange and Hong Kong Exchanges and Clearing Ltd. Each relationship sees itself as a major power hub with much broader regional pretensions.

One of the forces driving this interest in regional agreements has been structural change in the exchanges.

More and more institutions in the region have taken the demutualisation route and, at the same time, derivatives and securities businesses have been rationalised. Everyone in the Asia Pacific region, it seems, is learning to play the CME’s game. In Singapore, Hong Kong and Korea, for example, the separate exchanges have been combined into a single market operator. A similar example is the Australian Stock Exchange, which recently announced plans to move its futures, options and stocks products onto a single technology platform by 2006. This trend has encouraged these consolidated, for-profit entities to focus on the opportunity to grow their share of regional and indeed world trading.

For the time being, in Asia, the CME is playing the role of learned benefactor. In a speech earlier in the year to the SSE, for example, Donohue had stated that the CME’s purpose “is not to threaten or overtake the internal development of China’s emerging futures markets.”Just so.

It is an unusually benign statement from a highly competitive operator and most people agree that competition made the CME. The exchange’s ability to successfully respond to the challenge from its European competitors; its willingness to ruthlessly cut costs so that it could equally ruthlessly cut prices; and its single minded focus on global expansion, has forged the successful entity that it is today. A number of questions however, still hang over the exchange. Will it merge with the CBOT? Will it acquire in Europe or Asia, and if it does acquire, will it buy another derivative exchange?

Donohue is not drawn on specifics and instead emphasises that the CME’s merger and acquisition strategy is not limited to exchanges, securities or otherwise.“We have a well thought out strategy and if we were to do something it would be to create shareholder value, not because of someone’s idea of what we should be.”That’s telling us.

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Looking South on Madison, Chicago

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DERIVATIVES REPORT: CDOS

CDOs GIVE HEDGE FUNDS A HEADACHE In 10 short years collateralised debt obligations (CDOs) have transformed the credit markets, allowing lenders and investors to manage their credit exposure as never before. But these complex securities, which reallocate cash flows from debt instruments in tranches exposed to different degrees of default risk, contain traps for the unwary – including sophisticated investors such as hedge funds. Neil A. O’Hara reports from Boston.

EDGE FUNDS TRADING the synthetic CDO market suffered a rude awakening in May when Standard & Poor’s dropped its rating on the debt of General Motors and Ford below investment grade. The so-called “correlation trade” – long the equity tranche of a CDO and short the mezzanine tranche – was supposed to be a sure bet. If defaults stayed low the return on the equity tranche would outstrip losses on the mezzanine, while if defaults ticked up gains on the short mezzanine position would more than offset equity losses.“The premise for the trade – that the two tranches will always be correlated in your favour – is particularly puzzling,” says Jeffrey Gundlach, president of TCW Asset Management Company and head of the firm’s fixed income operations,“It is flawed logic. There are outcomes where the equity goes to zero and the mezzanine does not.”

CDOs are pools of debt instruments, often rated below investment grade, divided into senior, mezzanine and equity tranches entitled to cash flows from the pool that bear increasing exposure to the risk of default. The senior tranche can qualify for an Aaa rating because defaults must wipe out both the mezzanine and the equity before investors suffer any loss. The mezzanine layer, which has only the equity shield against losses, often carries a Baa rating while the unrated equity bears first dollar loss risk.

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Bill May, a managing director in Moody’s derivatives group

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CDOs trace their origins to the late 1980s but the market really took off in 1996; (see, for example, data for CDOs rated by Moody’s in Figure 1: CDOs: Dramatic Growth to Record Levels in 2004). The early transactions were cash flow CDOs that allowed financial institutions to lay off credit risk through repackaged high-yield bonds but the structure soon spread to other asset classes. In today’s market, the assets most commonly securitised are high yield corporate loans and asset backed securities, but collateral extends from investment grade bonds to bank and insurance company preferred stocks and real estate.

Cash flow CDO transactions dominated the market in the United States until the past couple of years, according to Drew Dickey, managing director and head of the structured credit team at Babson Capital Management, LLC. The absence of actively traded cash collateral bred a synthetic market in Europe, where credit risk was concentrated in banks rather than bonds. A synthetic CDO holds high quality near cash collateral and adds credit exposure through a portfolio of credit default swaps, which are effectively put options on default risk.

CDOs challenge the efficient market hypothesis: why will investors pay more when the overall risk in a CDO equals the sum of the risks in its collateral portfolio? The structure adds value by facilitating the transfer of credit risk. Bill May, a managing director in Moody’s derivatives group, cites CDOs based on middle market bank loans as an example.

The individual loans are relatively small and unrated; an institutional investor cannot afford to monitor enough companies to build a diversified portfolio. The lenders, who do track the companies, repackage the loans into CDOs, although they retain some exposure to each loan so investors know the sponsor has some skin in the game if a loan goes bad. In effect, CDO investors outsource the credit research and monitoring.“It gives investors an opportunity to invest in an asset class that they could never do on their own,”says May,“And it gives these small companies access to capital they could otherwise never get.”

Artificial restrictions that require many investors to hold only rated instruments contribute to the repackaging arbitrage. “These portfolios are fairly diverse,” says Sivan Mahadevan, executive director and head of structured credit research at Morgan Stanley,“You can get investment grade ratings for a lot of the tranches that have even a little bit of subordination.” Rated CDO tranches command a premium because they appeal to a broader market.

Senior CDO tranches find a home among pension funds, insurance companies, banks, and conduits set up by banks that use the high-quality assets as collateral to support commercial paper issued to money market mutual funds and other cash market investors. The mezzanine notes go to insurance companies, banks, mutual funds and hedge funds. Equity tranches appeal to banks and insurance companies looking for assets that offer leveraged returns relative to their regulatory capital requirement. Other investors willing to accept the risk (including hedge funds) buy equity for the high potential return.

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Drew Dickey, managing director and head of the structured credit team at Babson Capital Management

CDOs challenge the efficient market hypothesis: why will investors pay more when the overall risk in a CDO equals the sum of the risks in its collateral portfolio?

The allocation of losses in a CDO pool turns the equity and mezzanine tranches into leveraged plays on default risk – with price volatility to match. Hedge funds compounded that volatility by trading on margin. When the expected correlation between the equity and mezzanine tranches broke down, margin calls loomed as funds faced mark-to-market losses on both sides. “If you buy something on mark-to-market leverage you tend to give up the freedom to have your own view of the world,” Babson Capital Management’s Dickey says, “You can think that pricing is completely absurd. It might be absurd.

But that doesn’t really matter when you have to put up more collateral.”

In theory, correlation refers to the probability that if one credit in a CDO pool defaults other credits will also default.

In practice, correlation is not a measurable input to the pricing model, according to Dickey. Companies don’t default often enough to generate reliable data on credit

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synthetic CDO typically correlation, and even if includes more than 100 they did the theoretical reference entities so one or price would not match the two downgrades have little market price. “Correlation impact on the CDO’s is an observed plug overall credit risk.“GM and number that expresses Ford have not defaulted. what's implicit in the There are no credit events model,”he says. associated with them,” he Powell Thurston, vice says, “Investors have not president and CDO lost a dime as long as they product manager at don’t sell.” His attitude PIMCO, likens the role of reflects Moody’s focus on correlation in CDO pricing default probability and to implied volatility in recovery after default, a options pricing. Just as service aimed at investors options traders use who buy and hold to implied volatility to maturity rather than account for the traders worried about daily unexplained difference mark-to-market value. between the theoretical Powell Thurston, vice president and CDO product manager at PIMCO For senior tranches, the price of an option and its default risk depends market price, CDO traders rely on correlation to express the residual value. mostly on the performance of the asset class represented “Correlation does not drive the market,” he says,“It is the in the underlying collateral; likewise the mezzanine and equity tranches in a static CDO, for which the collateral other way around: the market drives correlation.”

The correlation trade encapsulates the view that credit pool is fixed at the outset. Dynamic CDOs have actively spreads will widen – causing the mezzanine price to drop – managed collateral, which introduces an additional risk, but not cause any defaults that would diminish the equity according to TCW Asset Management Company’s value, Thurston explains. “The hedge funds thought they Gundlach – manager performance. While some CDO could handle the mark-to-market risk,” he says,“In reality sponsors do their own collateral management, others farm it out to third party managers such as Babson, PIMCO and they could not. They simply unwound their positions.”

A stampede to the exit drove prices to extremes. TCW.“The equity tranche holders are really exposed to the Desperate hedge funds not only dumped equity tranches manager,” he says, “If there is negative alpha they are but also chased up the price of credit default swaps that going to have a very bad outcome even if the premise of would hedge the affected credits. Meanwhile, the the asset class works.”

Gundlach claims the rapid growth in CDOs is “correlated” mezzanine price rose on short covering. “The movements were largely driven by supply and demand and attracting collateral managers who lack experience. He is not just talking his own book. TCW manages some CDOs not by fundamentals,”says Thurston.

The turmoil in synthetic CDOs highlighted the that include tranches from other CDOs in their collateral difference between cash flow CDOs and synthetics. The pool, so poor third party manager performance could secondary market in cash flow CDOs is much less active adversely affect TCW's own collateral.“We try to create a and prices didn't budge.“It is not a derivative market. It is diversified pool where we hope we can select managers a cash market where typically all parts of the deal are sold with high standards,” he says, “It is not that easy. The so there is no residual risk left,”explains Morgan Stanley’s CDO market has a lot of inexperienced, under-funded, understaffed participants.”

Mahadevan,“It is fully distributed.”

Cross-ownership among CDOs reached a new level in Notwithstanding the dramatic impact on some hedge funds, Standard & Poor's' move had minimal effect on so-called CDO-squared (CDO2) structures, in which CDO ratings despite the widespread use of GM and Ford existing CDO tranches represent the entire collateral for a as reference credits in synthetic CDOs. While the agency new CDO. The underlying collateral pool is more had rated 561 synthetic CDOs in Europe covering 745 diversified; if each synthetic CDO contains 100+ credits a tranches that referenced at least one of the affected credits, synthetic CDO2 pool references indirectly thousands of it downgraded just 10 tranches (1.3%) as a result, in each credits. To compensate for compounded structural leverage, case by a single rating notch. It placed another 27 tranches the rating agencies demand a larger cushion beneath the (3.6%) on CreditWatch with negative implications, though Aaa rated senior tranche and more equity under the rated it suggested they were likely to recover within three mezzanine tranches. “We look at what tranches they are months in the absence of other negative credit experience. buying and how correlated those tranches are to others,” That came as no surprise to May. He points out that a says Gary Witt, another Moody’s managing director, “Do

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$ Billions

Others disagree. Witt they have a lot of overlap?

Figure 1: Dramatic Growth to Record Levels in 2004 sees more risk in the Do they have the same 100 250 collateral behind each credits in them or not?”

90 segment of the market.

Senior Aaa and Aa 80 200 He focuses on CDOs that CDO2 tranches appeal to 70 hold asset backed insurance companies, 60 150 securities, some of which conduits and banks in 50 have become Europe and Asia, 40 100 concentrated in according to Dickey.“They 30 residential mortgage are rating sensitive 20 50 backed securities. “If investors looking for 10 house prices go down things they believe have 0 0 1988 1989 1990 1991 1992 1993 1994 19951996 1997 1998 1999 200012001 2002 2003 2004 those deals are not going low credit risk but offer Rated volume (Left Axis) Number of Transactions (Right Axis) to do very well,” he says, more spread,”he says. The “But not because they extra structural leverage in Source: Moody’s Investor Services, June 2005 bought other CDOs. It is CDO2 equity and mezzanine reduces the number of potential outcomes for going to be because their underlying risk is home loans.”

Mahadevan at Morgan Stanley suggests investors have those tranches: they become closer to all or nothing bets.

Gundlach believes cross-ownership among CDOs learned from the last downturn in the credit cycle from creates a contagion risk.“The CDO market could fall victim 2000 to 2002, when they discovered more overlapping to mad cow disease,”he says,“A lot of CDOs own equity or credit exposure among CDOs than expected; it turned out mezzanine in other CDOs. They are feeding on each other, to be a key risk factor. Morgan Stanley believes default risk so if a few go bad you’ll find it poisons a bunch of others.” today is low among investment grade credits because Even though CDOs that permit cross-ownership often corporations have healthy balance sheets and relatively low limit other CDO tranches to 10% of their collateral leverage. Spreads have widened across the credit markets portfolio the problem could spread quickly if defaults in recent months, but until that translates into defaults Gundlach’s mad cow hypothesis will remain untested. increase across the board.

GETTING THERE IS EASY FTSE Global Markets is your passport to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers.

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BANK PROFILE: COMMERCE BANCORP

Executives with Citibank and Chase Manhattan Bank – heavyweights in the financial business worldwide – could be forgiven if they paid scant attention to a modest-sized New Jersey bank when it said, five years back, that it would open branches in their backyard, in New York City. They are probably paying attention now. Commerce is setting a new standard in customer care – can the big banks keep pace? Do they want to?

Bill Stoneman reports.

Bending the Benchmark of customer care

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Vernon W. Hill II, the chairman and president of the company

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OMMERCE BANCORP INC., which had just $7bn in assets when it announced its foray into New York in August 2000, now tops $32bn, placing it among the 40 largest banks in the United States (US). Although it is still a relative minnow when compared with the size of Citi’s parent, Citigroup (with $1.5trn in assets), or Chase’s parent, JP Morgan Chase & Co. (with $1.2trn), Commerce’s easy entry into New York, where it quickly picked up $16bn in deposits, is contributing big time to an extraordinary record of growth.

Not only has the bank quadrupled in size over the last five years, net income has risen at an annual rate of 34% between 1999 and 2004, while earnings per share rose on average 24% over the same period. And so when Vernon W. Hill II, the chairman and president of the company, says (as he does regularly) that he intends to surpass $100bn in assets by 2009, he is hard to ignore. But perhaps the biggest reason to pay attention to Hill is that Commerce has achieved all of its growth in the slow-growing Northeast of the US and all that without an acquisition in years or ever a large one. In other words, Commerce gets pretty much all of its business by taking it from someone else. While other financial institutions talk about winning market share, constant mergers and acquisition make it difficult to tell which, if any, really do.

Commerce, it appears, takes market share by following Hill’s retailing instincts and by rejecting big chunks of banking industry conventional wisdom. Not only does Hill shun mergers and acquisitions, Commerce does not even talk all that much about its lending business. Attractive rates on deposit accounts are not part of its value proposition. It does not endlessly try to “cross sell”

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4

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3

4

t-0

Oc

Ap r-0

3

2

t-0

Oc

Ap r-0

1

2

t-0

Oc

Ap r-0

t-0

1

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

Oc

0

Ap r-0

t-0

Oc

Ap r-0

0

customers additional accounts. On top of that, its expenses away. Even commercial business is drawn in by Commercestyle retailing, Hill says, explaining that owners of small and are well above industry standards.

Instead what Commerce does is focus on attracting mid-sized businesses are not going to stay with banks consumer depositors with an array of conveniences, where their spouses or children have bad experiences.

Hill, 59, launched the bank in 1973 when he was only 27 gimmicks and services that other banks do not offer [or, at years old, after running a least do not make a big site development business deal about]. Most visibly, The quest for growth – turning an “amazing customer for a few years for retail Commerce keeps longer experience” into an “amazing investor experience” – chains such as hours, including opening Commerce Bancorp vs. US Banks McDonald’s Corp.

In on Sunday, than virtually 350 addition to his 4.46% all of its competitors. It 300 stake in Commerce, he is a lures people into its 250 partner in a group that owns branches with free coin 200 47 Burger King restaurants counting machines.

150 in the Philadelphia area.

Branches are stocked with 100 He says that he thought dog biscuits for customers from the beginning that a who bring their pets in.

50 government charter, And the bank will take care 0 effectively a license to of all the rote work accept deposits, nearly associated with moving guaranteed that he would online banking and bill Commerce Bancorp NJ Citigroup JPMorgan Chase & Co make money. He did not payment from a Bank of America FTSE US Banks Index always expect that his competitor’s account. The bank would grow so large. many touches – or Data as at June 05. Source: FTSE Group/FactSet Limited.

But now he is so confident “extreme culture” and “fanatical execution,” in Hill’s words – seem to add up in that he is practically daring competitors to stop him.

With a base in the suburbs of Philadelphia, and now 178 the minds of consumers.

“Commerce has differentiated itself from the other branches in the New York City area, Hill expects to open 10 players,” says Charles B. Wendel, a banking industry to 15 branches in and around Washington this year and 200 consultant in New York. And that is something few other over the next few years. He has said that either the Boston banks have done, he adds. While banks endlessly proclaim area or Florida will be next; analysts expect him to that they care about their customers or that they are their announce which it will be this summer. One of the big customers’ friend, Commerce is unusual in backing its reasons that he can march into new markets, he says words up with delivery of a distinctly different level of brashly, is that so many competitors do more to annoy their customers than please them with their constant mergers service, he explains.

And that is exactly the idea. “The customer cares about and acquisitions. “My competitors are in the cost-cutting the retail experience, rather than the highest rate,”Hill said business,”Hill says.“I’m in the top-line growth business.”

Whether the characterisations are fair or not, Commerce recently, during a visit to a mid-town Manhattan branch that sits not much more than 100 metres from offices has performed quite well. It has produced an annual owned by the four largest US banking companies, Citi, average return to shareholders of 31% over both five and Chase, Bank of America Corp. and Wachovia Corp. Indeed, 10 years through the end of March. That compared to seemingly illustrating the point, the branch, on Avenue of compound annual average decline of 3% for the Standard the Americas at 55th Street, has booked $267m in deposits & Poor’s 500 over the past five years and an 11% annual since it opened in September 2001 – a large number for a gain for the S&P 500 over a 10-year period.

The big question for investors, however, is whether mature office, let alone one less than four years old. In fact, beyond the results of one particular branch, Hill appears to Commerce can keep up the pace – of apparently successful be building a business around the premise that if a bank new branch openings, of entry into new markets and of willingly, maybe even eagerly, pays for all the pieces of an continued growth in its longer-standing markets – or attractive retail experience, then customers will not mind whether competitors learn to do a better job of holding that the bank does not pay especially competitive interest onto their customers. At $28 in mid-May, the company’s on deposit accounts. With low-cost deposits flooding into stock traded on the New York Stock Exchange for about 16 new branches and flowing at a more measured pace into times the trailing 12 months’ earnings, suggesting healthy, mature branches, Commerce is able to maintain relatively but unspectacular, expectations of investors.

A common view among analysts who follow Commerce good interest-rate margins. Then, as long as overall deposit is that the company has at least several good years of levels grow rapidly, earnings grow at a fast clip as well.

US consumers, Hill asserts, are nearly universal in their industry-leading growth ahead. “They are very good at dislike for their banks, making it rather easy to peel them taking market share,” said Claire M. Percarpio, an analyst

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BANK PROFILE: COMMERCE BANCORP

with Janney Montgomery Scott Inc. in Philadelphia, adding that unlike most banks, Commerce doesn’t depend on its own share price to fuel acquisitions and therefore growth.

The bank attracts business, analysts said, because it stands apart from others in its hiring, its training and follow-through. Legend has it that job candidates are deemed unsuitable if they do not smile with the first 30 seconds of an interview. At the other end of the process, “mystery shoppers” visit Commerce branches 100,000 times a year, meaning that someone is sizing up each of more than 300 branches and writing a report about each one of them nearly every day.

Not everyone, however, is convinced that the growth and market share gains are sustainable. For example, Thomas Monaco, an analyst with Moors & Cabot, a Boston-based brokerage firm, says that consumer deposit growth comes mostly from opening costly new branches. Once they are open a year or two, he said, consumer deposit growth trails off. That has been masked, he said, by a growing government deposit business. And the government business may have trouble ahead, he adds.

Two Commerce executives were convicted in May of conspiracy charges in a municipal corruption case in Philadelphia. The executives were charged with helping a city official get personal loans on favorable terms in exchange for his steering city business to the bank.

Whether Commerce backs off from pursuit of government business or local governments shy away from Commerce, the impact could be big, Monaco expands. Other analysts say they fear that additional improprieties in soliciting government business could surface, tarring the company directly next time around.

In addition, analysts have expressed concern that a relatively unusual balance sheet could cause trouble if interest rates rise sharply. With loans on Commerce’s books totaling just 35% of deposits, the bank has a large portfolio of fixed-rate securities. The value of these securities could plummet if rates rise. That would deplete the equity that the bank needs to continue opening branches, Monaco adds.

The biggest reasons for concern might be the possibility that the industry giants are getting their retail act together.

NEW DEPOSIT ACCOUNTS Wilmington Trust Credit U 2% 3%

PNC 9%

Wachovia 12%

Bank of NY 2% WAMU 3%

North Fork 2%

Fleet/BOA 8%

HSBC 3%

Commerce 32%

24 21 18

39%

15

sit G epo D e rag Ave

12

$7.4

9

th row $20.7 270

34%

224

42%

184

$5.6 150

6

120 3

2.38%* 0

1999

2.84%* 2000

2.25%*

.82%*

.84%*

2003

2004

1.34%*

2001

2002

# of Branches * Deposit Cost of Funds

Analysts and consultants also say that banks that grew large through acquisitions have vastly improved their customer service in the last few years, partly in response to Commerce and other smaller banks taking business from them. Big New York banks just did not believe that Commerce’s approach to retailing would resonate with consumers, says Wendel, the industry consultant.

Now, Washington-area banks appear to be gearing up for Commerce’s arrival. For example, PNC Financial Services Group Inc. of Pittsburgh, which just moved into Washington with an acquisition, said in April that it would extend its weekday hours and add Sunday hours in the nation’s capital. To be sure, just about everything that Commerce does to attract customers can be copied. In addition to keeping longer hours, a few other banks have installed coin-counting machines in their branches.

Working in Commerce’s favour, however, is the strong possibility that creating a retail experience and a brand identity that complements that experience by imitating an original thinker is not so easy and that competitors are not really committed to it anyway.“Most of the banks that have tried to do this have implemented one, two, three or four of the kinds of things that Commerce does,” says Mark T. Fitzgibbon, co-director of equity research for Sandler O’Neill & Partners LP, a New York-based investment bank

– Results in millions

Average Suburban Branch

Average First Two Manhattan Branches (annualized)

Total Deposits

$100.0

$250.0

5.2

12.4

Total Branch Operating Expenses

(1.3)

(3.7)

Net Pre-Tax Income

$3.9

$8.7

Total Income Other 28%

319

$14.5

$10.2

AFSB 2% PNC 2%

Other 26%

Repeat Sales

Wachovia 4% Commerce 31%

41,705 Accounts

45,745 Accounts

87,450 Total Accounts

80

27

Chase 10%

Citi 7%

Repeat Sales

$27.7

30

Metro New York

Fleet/BOA 6% Citizens 4%

Sun Bank 1%

Billions $ 33

BRANCH PROFITABILITY ANALYSIS

– January 2005

Metro Philadelphia Sovereign 3%

DEPOSITS

Fully allocated support costs approximate 1.50% of total deposits

JULY/AUGUST 2005 • FTSE GLOBAL MARKETS

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that specialises in financial companies.“But they have not implemented the other 65.”

So, even when competitors borrow an idea, they do not necessarily pull it off with the same élan. It is one thing, for example, to install machines in branches that quickly count huge quantities of unsorted coins. Commerce’s machines look like arcade games, with sounds and flashing lights. And just to make it amusing, Commerce invites visitors to try to guess how much all their coins are worth. If they are close, the bank gives them token prizes, such as a plastic piggy-bank “C” in Commerce’s trademark red.

But that is not all. Wendel discovered when he took his young son and a huge jar full of coins to a Commerce branch, intending to have some fun counting the money.

The coin counting machine was broken the day they visited, but the branch manager was not about to let the youngster go home disappointed, Wendel said. Without missing a beat, the manager called another branch, to make sure its machine was in working order, and then gave Wendel money to cover a taxi ride to the other office.“That was an amazing customer experience,”Wendel says.

Competitors might dispute Hill’s assertion that he is the only one pursuing revenue growth. They would be hard pressed to argue, however, that Commerce does not spend generously, on items large and small, in that pursuit. For example, Commerce only takes the best locations when it opens new branches, says Jacqueline Reeves, a bank stock analyst with Ryan, Beck & Co., a New Jersey-based brokerage firm, even though it invariably pays more for them than other sites around town. One such site gives Hill a chance to chuckle occasionally at Chase’s expense. A photograph in Commerce’s standard analyst presentation shows a building at the corner of Fifth Avenue and 14th Street in New York. Commerce signs adorn the windows on the first floor, immediately below Chase signs. Chase, Hill explained, gave up its lease on the first floor, presumably to cut its sky-high Manhattan occupancy costs, and held onto space it had on the second floor. Commerce moved into the first-floor space, which is more accessible to customers and prospective customers walking by. The Commerce branch

ASSET QUALITY

2004 SUMMARY 12/01

12/02

12/03

12/04

Top 60 Banks

$30.5B

+34%

27.7B

+34%

9.3B

+27%

Total Revenues

$1,392.9M

+28%

Total Expenses

938.8M

+23%

Net Income

273.4M

+41%

$1.63

+26%

Total Assets Total Deposits

Non- Performing Assets

.17%

.11%

.11%

.11%

Charge-offs

.19%

.18%

.16%

.19% 0.537%

Loan Loss Reserve 1.46% 1.56%

1.51%

Non-Performing Loan Coverage

has $59m in deposits, more than thousands of bank branches around the US that have been open for many years longer than Commerce has been in New York.

At the more modest end of the spectrum, where other banks tether a pen to a counter for customers to prepare routine forms, Commerce fills boxes with dozens and dozens of writing implements. Hill says the bank gives away 1m pens a month and would be happy to push that figure to 2m.“The average bank would say,‘How do we get our pen costs down,’ ”he says. Only time will tell how long Commerce’s high-cost approach to business can generate outsized earnings growth. Unless the model falters badly, however, it is unlikely that big banks will take Commerce for granted again.

The Citis and Chases and Banks of America of this world regularly boast that their vast branch systems and even vaster networks of automated teller machines give unparalleled access to their customers’ accounts. But Commerce, which calls itself “America’s Most Convenient Bank”, appears to have neutralised that big-bank advantage and given clear meaning to what could easily be an empty slogan with a new costly program recently. The bank announced in March a wide-scale program to rebate automated teller machine fees that machine owners and other financial institutions charge its customers. It said it would cover the cost of using all machines, worldwide, for customers who have $2,500 in their checking accounts.

Clever slogans are not necessarily hard to come by. But it certainly difficult for competitors to argue that cost-free access to customer accounts around the world is not pretty convenient.

398%

640%

515%

1.43% 413%

0.60%

1.52% 278%

Total (Net) Loans

Net Income Per Share

Credit Rating: A-2/P-1

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

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THE

Building Blocks OF CORPORATE GOVERNANCE

These days corporate governance is an essential feature of the investment management process.

A key business discipline contributing to the financial stability and growth of corporations, if ignored it can lead to the downfall of corporations both large and small. Carl Beckley, director, FTSE Group, examines the design, construction and performance of the FTSE ISS Corporate Governance Index (CGI) Series, and shows how it can be used by investors as an effective risk management tool.

N COLLABORATION FTSE and Institutional Shareholder Services (ISS) have created FTSE ISS CGI, the first global corporate governance indices. The series comprises two separate elements – a set of rankings, supplied by ISS, in which each company in the universe is scrutinised against five corporate governance themes, and a set of six equity indices, based on these rankings, covering developed markets. The ratings allow investors to understand corporate governance risk on a specific company, country and sector basis, while the overall index allows investors to see how corporate governance practice impacts their overall portfolios.The index series is the culmination of a full-fledged process that has harnessed FTSE’s expertise in index formulation with ISS’s specialist knowledge of the salient elements in corporate governance that have most relevance for today’s market.

The index series is designed to raise awareness of corporate governance as an investment risk; encourage the collection and dissemination of accurate, high quality data on individual company corporate governance practices and highlight those companies working to high standards of corporate governance.

Market research conducted by both firms throughout the whole of last year confirms a growing interest in the management of corporate governance risk. The majority of respondents (88%) from the various sections of the investment community expected interest in corporate governance to increase over the next two years. And it is the specific feedback from this consultation that has guided the construction and methodology of the new index series.

I

Designing the FTSE ISS CGI Series Six indices (please refer to Table 1: FTSE ISS Corporate Governance Indexes vs. Their Respective Benchmarks) have been developed in this initial phase, with the objective of closely tracking the structure and pattern of the FTSE Developed Index and the FTSE All-Share Index. The first step was to decide the universe of stocks which would form the FTSE ISS Corporate Governance Index Series. To ensure global coverage, the CGI family covers large and mid-cap stocks in developed markets. This universe currently contains over 2,000 companies. The FTSE AllShare Index (which contains large, mid and small cap stocks) was used as the starting universe in the FTSE ISS UK CGI. The FTSE All-Share index is the main benchmark for UK institutional investors and was a natural choice as the basis of this particular index.

For each of the six indices ISS collates all of the raw corporate governance scores for each constituent. FTSE, in turn, use ISS’s raw data to produce a cumulative score for each constituent. In order to make the scores more accessible the cumulative scores are normalised so that all scores fall between 0 and 100. A score of 0 represents the lowest corporate governance rating, while 100 is the highest score that can be attained.This is referred to as the CGI Final Score.

In each index universe every constituent is classified into one of the 18 Industry Classification Benchmark (ICB) Supersectors and within each Supersector each constituent is ranked by its CGI Final Score. Constituents representing only the top 80% by investable market capitalisation in

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each Supersector are eligible for inclusion in the index. Any remaining constituents in the lowest 20% by investable market capitalisation are excluded. This process is repeated for each of the Supersectors. Finally, Supersectors are combined to form the Regional or Country FTSE ISS Corporate Governance Index.

This review procedure inevitably narrows the number of constituents in the FTSE ISS Developed CGI universe to 1,350 constituents, down from the original 2,089 constituents. In comparison, the FTSE ISS UK CG Index is focused on some 315 constituents (compared with the 578 in the FTSE All-Share Index universe).

During the market consultation exercise FTSE assessed various different methods of producing an appropriate index series that accurately reflected the corporate governance performance of the world’s listed companies.

Three choices of methodology were available to the index design team. They could adopt an exclusion policy or they could retain all the traditional index constituents, but overweight companies with good corporate governance performance and underweight the poorer performers.

Alternately, they could produce best and worst in class indices with a limited number of stocks.

Before a decision was taken, each of the options was thoroughly investigated. Difficulties became obvious very quickly. The overweight versus underweight methodology, for instance, did not give major differences to the exclusion policy.

The reason was simple. Removing a proportion of stocks is just another way of radically underweighting them, which then will automatically overweight the remainder. Any resulting performance would therefore be more reliant upon the particular mix of stocks that are included (or excluded) from the index. This mix relates to both relative market capitalisation sizes and then individual stock performance.

The other issue on exclusion is that of turnover. The more constituents that are excluded from the index the higher the turnover can potentially be. This has an influence on deciding what level of market capitalisation could be excluded from the index. Removing a large amount of market capitalisation may have more influence on performance but would theoretically lead to higher turnover.

Removing less than 20% would not have had a sufficiently

useful effect, but removing more would begin to have implications for turnover. Having looked at this issue it was clear that an 80/20 split gave the right balance between inclusion and exclusion.

Indeed it is this last point that ensured that at least in these early stages our third option of producing the “best” and worst”indexes could potentially lead to high turnover.

In the end, the team opted for an exclusion methodology. The majority of participants in the market consultations process had suggested that for the first phase of the Corporate Governance Indices, investors were most interested in an index where constituents that tended towards poor corporate governance practices were excluded.

Exclusion Performance The FTSE ISS CGI Series aims to track its underlying benchmark indices very closely. This is helped by its sector neutral approach and by removing only 20% of the underlying market capitalisation at review.

As a result of using this methodology, we would expect similar historical correlations and performance as the underlying benchmarks. The main issue with looking at historical performance is determining constituent changes in corporate governance practices.

FTSE used FactSet software to run a series of backcast index values to highlight any performance differences. The backcasts are based on a current set of constituents for each index and are calculated backwards for a period of five years. As this methodology does not take into account constituent changes throughout time the same methodology was applied to the relative underlying benchmarks to remove any calculation biases.

The analysis is mixed as to whether corporate governance has an overriding effect on company performance. Equally, the evidence of a clear link between corporate governance standards and share price performance is mixed. The FTSE ISS UK CGI outperforms its equivalent FTSE index over one and three years, and the FTSE ISS Developed CGI, FTSE ISS Japan CGI, and FTSE ISS US CGI outperforms over a five-year period. The FTSE ISS Europe and Euro CGIs underperform their respective

Table 1: FTSE ISS Corporate Governance Indices versus their respective benchmarks CG Index

Stocks Net Market Net Market Cap Cap (Local (USD Bn) Curr. Bn)

FTSE ISS US CG Index 412 FTSE ISS UK CG Index 315 FTSE ISS Japan CG Index 353 FTSE ISS Developed CG Index 1,350 FTSE ISS Europe CG Index 347 FTSE ISS Euro CG Index 194

9,048 2,176 1,647 17,600 5,590 2,892

*Excludes Investment Companies

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

9,048 1,140 172,988 17,600 4,259 2,203

Benchmark Index

Stocks Net Market Net Market Cap Cap (Local (USD Bn) Curr. Bn)

FTSE US Index* 743 FTSE All-Share Index* 578 FTSE Japan Index* 479 FTSE Developed Index* 2,089 FTSE Developed Europe Index* 502 FTSE Eurozone Index* 277

12,216 2,713 2,077 22,828 6,985 3,516

12,216 1,421 218,217 22,828 5,321 2,678

Data as at 3rd March 2005

83

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INDEX REVIEW: CORPORATE GOVERNANCE

benchmark indexes although the underlying differences are marginal with high correlations. Each index is closely correlated to its underlying benchmark index. Over a fiveyear period the tracking errors are higher with the individual country indexes, while the regional indexes of FTSE ISS Developed, FTSE ISS Europe, and FTSE ISS Euro CGI show a five-year tracking error of 1.09%, 1.32%, and 1.11% respectively.

Although separate from the index methodology, analysis based around a sample portfolio containing the top 50 and bottom 50 constituents from each theme within the FTSE US Index universe has shown that the bottom 50 underperform the top 50 in four out of five themes over a five-year period. The analysis based on equally weighting the portfolios on a daily basis using FactSet Software, shows this out-performance when using the overall company CGI rating. Apart from the theme Board Structure each bottom 50 portfolio also under-performs an equally weighted FTSE US Index. The Compensation theme interestingly has a negative performance over the period of one year, with the highest volatility of all the themes over the five-year period.

Given the level of specific information available at present, there is no definitive link between corporate governance and stock returns. The performance analysis on the US is only a starting point, and by no means conclusive over a five year period. But, over reasonable time periods it is likely that governance factors will show themselves in investment returns. There are a number of reasons put forward for this. One is that sufficient information to make detailed decisions by all investors has

not been available. Analysis of corporate governance is a skilled affair and the general investment community encompassing asset owners and managers does not have the necessary skills or resources to carry out such investigations across all of their investments.

Further, corporate governance is not a one-off due diligence exercise. It is a continuous process. Having carried out the initial work on a company, the corporate governance risk then takes on the mantle of a watching brief. As a consequence, there is a requirement for continual monitoring of corporate governance due diligence.

Another consideration is that there have been some high profile investment firms that take corporate governance very seriously and have done so for some years and applied their views to their investments. In the main however many investors (and legislators) only really began to tackle these issues in the wake of scandals such as WorldCom and Enron. Any corporate governance effect would only have been noticeable at some stage after these events.

In short, it can be argued even now, that any corporate governance implementation will at best be applied in a somewhat unstructured way particularly across a number of markets. This will help to dissipate any potential “return effects”. Differing legislation and codes of practice can affect the returns within a country. If all companies within a country fall into line then the issues that the rules are meant to rectify will in effect be removed from that market.

As time goes by it is fair to assume that a more cohesive implementation by market practitioners around the world will come into play. When this occurs there may well begin to be noticeable return effects.

The FTSE ISS Corporate Governance Index Series Review Universes

The FTSE ISS Corporate Governance Index Series Construction Methodology

Universe Index

FTSE ISS CGI

FTSE All-Share Index

FTSE ISS UK CGI

1

FTSE Japan

2 Basic Resources

Chemicals

Construction & Materials

Rank by Corporate Governance (CGI) Final Score

Oil & Gas Review Process

FTSE North America Index

FTSE ISS Developed CGI

FTSE Developed Asia Pacific ex Japan Index

4 Cumulative Investable Mcap

3

FTSE Developed Europe ex UK Index FTSE UK Index

Oil & Gas

Highest

Lowest

80%

20%

5 Oil & Gas

Basic Resources

Chemicals

Construction & Materials

FTSE Japan Index 6

The design process aims to capture 80% of the market cap within each Supersector

84

FTSE ISS Japan CG Index

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Page 85

Company Name

Page

ABN Amro

32

Company Name

China Merchants Bank Co Ltd China Mobile

Page

22 6

Company Name

Fortis Fortis Haitong Investment Management Co. Ltd.

Page

8

Company Name

Page

Northern Trust

36

Northern Trust

8

ABN AMRO Mellon Global Securities Services

36

Agence France Trésor

61

China Petroleum & Chemical Corp (Sinopec)

FTSE Group

24

OMHX

Agence France Trésor

57

Huaneng Power International Inc 22

General Motors

74

Global Advisors

10

Online Commodity Exchange of India

73

Goldman Sachs

16

OPEC

10

Greece’s Capital Markets Commission

People’s Bank of China

72

25

PIMCO

76

22

8

Northern Trust Global Investments 57 25

AIM

24

China Securities Regulatory Commission

Allied Domecq

64

China Telecom

American Century Investments

14

China’s State Administration of Foreign Exchange

72

Haas School of Business

16

PNC Financial Services Group Inc 80

Citibank

78

Hellenic Postal Savings Banks

26

PowerShares Capital Management 6

CITIC

22

Citigroup

78

Hong Kong Exchanges and Clearing Ltd

73

Citigroup Global Transaction Services

HSBC

57

42

HSBC

32

Clearstream

44

HSBC

38

Clearstream International

45

Illinois District Court

71

CME Holding

69

ING Investment Management

Cogent

31

INSEAD University

25

Commerce Bancorp Inc

78

Instinet

14

Janney Montgomery Scott Inc

80

Japan’s UFJ Holdings JP Morgan

AIG Global Investment Corp.

American International Group Inc. Archipelago Exchange

8

8 14

Athens Organising Committee

25

Athens Stock Exchange

25

Babson Capital Management

75

BancWest Corporation

32

BancWest Corporation

32

Bank of America Corp.

79

Bank of Athens

25

Bank of the West

32

Bankers Trust Company

25

Banque Paribas

30

Commodity Futures Modernization Act

Baoshan Iron & Steel Co Ltd

22

Commodity Research Bureau

Barclays Capital Barclays Global Investors

57 6

22 6

71 10

Community First Bankshares, Inc. 32 Community First National Bank

32

JP Morgan Worldwide Securities Services

Conseil des Marchés Financiers

30

KPMG/CREATE

Crédit Agricole

32

Lehman Brothers

BNP Paribas

57

BNP Paribas

28

BNP Paribas

32

BNP Paribas Securities Services

41

Credit Agricole Indosuez Securities Japan

32

Brown Brothers Harriman (BBH) Ltd

36

Credit Suisse First Boston

57

Burger King

79

Debt Management Office

60

Crédit Suisse Asset Management 38

Bursa Malaysia

73

Debt Management Office

57

Caldwell Asset Management

16

Delaware Investment

23

Caldwell Financial Ltd

16

18

Caldwell Management Ltd

16

Depository Trust & Clearing Corporation

Caldwell Securities, Ltd

16

Deutsche

57

Calyon

32

Deutsche Börse

25

CCF

57

Deutsche Börse AG

46

CDC Ixis

57

CDP Capital

23

Cedel International

45

Dexia Banque Internationale à Luxembourg

34

Cedel International

46

Economist Corporate Network

8

Charles Schwab & Co., Inc

19

EFG Balkan Investments

25

Chase Manhattan

53

Eurex

71

Chase Manhattan Bank

78

Euronext

25

Chicago Board of Trade

70

Euronext.liffe

71

Chicago Mercantile Exchange

68

European Union

26

Executives’ Club of Chicago

69

China Asset Management Company 20

First Chicago

53

China Foreign Exchange Trading System

First Hawaiian Bank

32

Ford

74

China Asset Management Co Ltd

6

72

Deutsche Börse Clearing

FTSE GLOBAL MARKETS • JULY/AUGUST 2005

45

8

RBC Global Services

42

RBS

32

Reuters

14

Royal Bank of Canada

34

Russian Standard Bank

30

Russian Standard Group

30

Ryan, Beck & Co

81

Sandler O’Neill & Partners LP

80

Schwab Institutional

19

32

Securities and Exchange Commission

14

57

SEI Investments

23

Shanghai Stock Exchange

72

36 40 8

London Stock Exchange

24

Madison Capital Management

53

Malaysia Derivatives Exchange

73

Man Investments, Inc

18

McBride Baker & Coles

69

McDonald’s Corp

79

McGill University

23

Shanghai Stock Exchange

22

Sidney Frank

65

Singapore Exchange

73

Société Générale

30

Société Générale

8

Standard & Poor’s

74

Standard Life Investments

23

State Street Global Advisors

6

State Street Global Advisors

22

Sydney Futures Exchange

73

T. Rowe Price

57

Mellon’s Investment Manager Solutions

41

Mercer Oliver Wyman

45

Ministry of National Economy and Finance

25

Telecom Italia

57

77

The Bank of New York

41

80

TowerGroup

42

Morgan Stanley

75

Turk Economi Bankasi

32

Morningstar

21

Union National Bank

53

Shanghai Securities News

21

United California Bank

32

NASDAQ

14

United Safe Deposit Bank

32

25

University of Athens

25

Moody’s Investor Services Moors & Cabot

National Bank of Greece

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

TCW Asset Management Company 74 TCW Asset Management Company 76

National Interbank Funding Centre 72

University of California

16

New York Mercantile Exchange

10

Wachovia Corp

79

New York Mercantile Exchange

10

Wall-mart

53

New York Stock Exchange

14

World Trade Organisation

23

New York Stock Exchange

69

85

Au st F FT TS rali SE E A a A C Be us lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A n FT C m SE ar k F A FT inla C n S FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC I ta FT FT ly SE SE A FT Ne Jap C SE th an er Ne la AC nd w Ze s A a FT C l a SE nd A FT No SE rw C P ay FT SE ortu AC g Si ng al A a C FT por e S FT E S AC SE pa F i FT TSE Sw n A e SE Sw de C n Un i ite zerl AC a d Ki nd ng AC d F T om SE A US C A AC

%

86 FT SE ob

Gl

al Al AC l-W or ld In de FT x SE La rg e Ca p FT SE M id Ca FT p SE Sm FT al lC SE ap De ve FT lo SE pe Ad d AC v Em er g in FT g SE AC Em er FT gi SE ng Al AC l-E m FT er SE gi ng La AC tin FT Am SE e M ric id a dl AC e Ea FT st SE & No Af FT ric rth SE a As Am ia er Pa ica cif AC ic ex Ja pa n FT AC SE Ja FT pa SE n AC De FT v SE Eu Em ro pe er gi AC ng Eu ro pe AC

FT SE

c-0 4

31 -M

ay -0 5

r-0 5

ar -0 5

30 -A p

31 -M

-0 5

3:34 pm

28 -Fe b

15/6/05

31 -Ja n05

31 -D e

MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 8

Page 86

FTSE Global Equity Index Series – Global, Year to Date

31st December 2004 - 31st May 2005

FTSE Regional Indices Performance (USD) 120

FTSE Global AC

115

FTSE Developed Europe AC

110

FTSE Japan AC

105

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

95

FTSE Emerging Europe AC

90

FTSE Latin America AC

0

-5

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

4

2

% 0

-2

-4

-6

-8

FTSE Developed Country Indices Capital Returns

15

10

5

Dollar Value

Local Currency Value

-10

-15

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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FTSE All-Emerging Country Indices Capital Returns 70 60 50 40

%

30

Dollar Value

20

Local Currency Value

10 0 -10

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col A u ec C h mbi Re a A p FT ub C li S FT E E c A SE gy C Hu pt A n F T ga C FT SE ry SE In AC In dia do A n FT e C SE sia AC I FT sr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor A SE oc C Pa co AC ki s FT FT tan SE SE AC Ph Per u ili F T p p i n AC SE es AC Po F FT TS lan SE E R d A So us C sia ut AC FT h A SE fric FT Ta a A S E iw C Th an F T a i l AC SE an Tu d A rk C ey AC

-20

FTSE Global All Cap Sector Indices Capital Returns (USD) 15 10 5 0

Capital

% -5

Total Return

-10 -15

Co

ns

tru

ct

io

n

&

M O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca i s ev le ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log b y M r ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies n e h E & olo er sta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-20

Stock Performance Best Performing FTSE All-World Index Stocks (USD) Orascom Telecom Holdings 115.5% Orascom Construction 101.7% Dacom Corporation 101.4% Mitac International 95.7% Thai Petrochemical Industry 88.7%

Overall Index Return FTSE Global AC FTSE Global LC FTSE Global MC FTSE Global SC FTSE All-World FTSE Asia Pacific AC ex Japan FTSE Latin America AC FTSE All Emerging Europe AC FTSE Developed Europe AC FTSE Middle East & Africa AC FTSE North Americas AC FTSE Japan AC

Worst Performing FTSE All-World Index Stocks (USD) Doral Financial -76.5% Elan Corporation -71.7% LG Card -60.0% TD Banknorth -59.9% Pacifica Group -53.9%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7,793 1,102 1,868 4,823 2,970 1,870 173 84 1,512 171 2,656 1,327

299.66 293.78 392.94 352.51 179.40 345.26 486.64 429.89 315.63 393.05 283.44 300.90

2.0% 1.5% 3.0% 3.3% 1.8% 1.5% 6.8% 1.7% -0.2% -1.5% 3.6% -1.1%

-3.2% -3.1% -2.4% -3.8% -3.1% -4.9% -5.7% -13.6% -6.0% -9.4% -0.8% -5.4%

-2.0% -2.5% -0.2% -2.0% -2.0% 0.3% 3.5% 0.7% -3.1% -7.1% -1.3% -4.9%

2.12% 2.27% 1.79% 1.73% 2.17% 3.02% 3.73% 2.04% 2.91% 2.75% 1.71% 1.16%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 5

87

88

tr

uc

tio

n

M

ed

op

ve l

De

FT SE

Al l-E m er gi De ng ve lo p FT ed SE ex De US ve FT lo pe SE d FT De Eu SE ve ro De lo pe pe ve d lo As pe ia d As Pa ia ci fic Pa ci fic ex Ja pa n FT SE Eu ro zo ne FT SE FT SE De ve US lo pe FT d SE AC De ex ve US lo p e FT d SE LC De ex ve US lo pe FT d M SE C De ex ve US lo pe d SC ex US

FT SE

FT SE

%

O inin & il Bu & g ild Ch G in em as g F St or M ica ee es at ls El Ae l & try eria ec ro O & ls tr on Di sp the Pa ic ve ace r M per & rsi & e t f En Ele ied D als gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca i e s ar re & ve les m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M L ra ba y ed ei l R cc ia su e o & re tai En & ler Su ter Ho s pp ta tel or inm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s g p ic at Re or i o ta t n Se iler rv s U t E l ic i l i e c es tie tr s icit -O y th In B er ve L In an s s i tm fe ur ks In fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e c O ar h t al ies e no he Es & lo r ta Co gy Fi te m H nan pu ar c te dw e rS a er re vi ce s

ns

c-0 4

95

FTSE US (LC/MC)

90

FTSE Developed Asia Pacific ex Japan (LC/MC)

31 -M

ay -0 5

r-0 5

ar -0 5

30 -A p

31 -M

3:34 pm

-0 5

15/6/05

28 -Fe b

31 -Ja n05

31 -D e

MARKET REPORTS BY FTSE RESEARCH

Co

MARKET REPORTS 8

Page 88

FTSE Global Equity Index Series – Developed ex US, Year to Date

31st December 2004 - 31st May 2005

115

FTSE Developed Regional Indices Performance (USD) FTSE Developed (LC/MC)

110

FTSE Developed Europe (LC/MC)

105

FTSE Developed Asia Pacific (LC/MC)

100

FTSE All-Emerging (LC/MC)

FTSE Developed ex US (LC/MC)

FTSE Developed Regional Indices Capital Returns (USD) 8

6

4

2

0

-2

-4

FTSE Developed ex US Indices Sector Capital Returns (USD)

10

5

0

% -5

-10

Capital

-15

Total Return

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

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Page 89

Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD) Chiyoda Corp 65.1% Sembcorp Marine 51.6% Daido Steel Co 44.6% Kingboard Chemical Holdings 44.0% Sembcorp Industries Limited 37.6%

Overall Index Return FTSE Developed ex US (LC/MC) FTSE USA (LC/MC) FTSE Developed (LC/MC) FTSE All-Emerging (LC/MC) FTSE Developed Europe (LC/MC) FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed AC ex US FTSE Developed LC ex US FTSE Developed MC ex US FTSE Developed SC ex US

Worst Performing FTSE Developed ex US Index Stocks (USD) Elan Corporation -71.7% Pacifica Group -53.9% Paperlinx -52.3% Henderson Group -51.1% Privee Zurich Turnaround Group -49.6%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

1,362 740 2,102 868 512 776 298 3,710 527 1,868 4,823

189.68 490.22 176.26 264.95 190.43 175.58 289.98 318.45 299.21 364.79 394.70

-0.2% 3.3% 1.7% 3.4% -0.3% -0.7% -0.2% -0.2% -0.3% 0.3% 0.1%

-5.5% -0.5% -2.8% -6.6% -5.9% -5.2% -4.1% -5.5% -5.4% -5.5% -5.9%

-3.5% -1.0% -2.2% 0.7% -3.5% -4.3% -0.8% -3.1% -4.0% -1.3% 0.1%

2.59% 1.75% 2.13% 2.80% 2.97% 1.90% 3.50% 2.54% 2.70% 1.79% 1.73%

FTSE Global Equity Index Series – Asia Pacific, Year to Date 31st December 2004 - 31st May 2005

FTSE Asia Pacific Regional Indices Performance (USD) 110

FTSE Global AC FTSE Developed Asia Pacific (LC/MC)

105

FTSE Developed Asia Pacific ex Japan (LC/MC) 100

FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC

95

FTSE Japan (LC/MC) 5 31

-M ay

-0

5 pr -0 -A 30

31 -M

ar -0 5

05 b-Fe 28

-Ja n05 31

31 -D e

c-0 4

90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 5

89

MARKET REPORTS 8

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2

0

% -2 -4

Gl ob al AC FT ia S Pa E D ci e fic ve De (L lop ve C/ e lo M d p ex ed C) Ja A pa sia n P (L ac FT C/ i f i M c SE C) A As llia Em Pa er ci gin fic g FT AC SE As D FT i a ev SE Pa elo Ja ci pe pa fic d n AC In de x FT ( LC SE /M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC As

FT SE

As ia

FT SE

Pa c

ifi c

AC

-6

FTSE Asia Pacific All Cap Sector Indices Capital Returns (USD) 15 10 5 0

Capital

%

Total Return

-5 -10

io

n

&

Bu

M

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea P Bi r l t h ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-15

Co

ns

tru

ct

MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD) Dacom Corporation 101.4% Mitac International 95.7% Thai Petrochemical Industry 88.7% High Tech Computer 83.3% Korea Investment Holdings 80.2%

Worst Performing FTSE Asia Pacific Index Stocks (USD) LG Card -60.0% Pacifica Group -53.9% Paperlinx -52.3% Privee Zurich Turnaround Group -49.6% ReignCom -47.0%

Overall Index Return FTSE Global AC FTSE Asia Pacific AC FTSE Asia Pacific (LC/MC) FTSE Asia Pacific LC FTSE Asia Pacific MC FTSE Asia Pacific SC FTSE Developed Asia Pacific ex Japan (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia Pacific (LC/MC) FTSE Japan Index (LC/MC)

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7793 3197 1335 497 838 1862 298 776 559 478

299.66 319.40 180.93 305.97 352.57 369.71 289.98 175.58 204.15 111.52

1.95% 0.13% 0.26% 0.36% -0.15% -0.91% -0.21% -0.67% 3.66% -0.88%

-3.15% -5.15% -5.13% -5.18% -4.96% -5.03% -4.05% -5.15% -5.13% -5.66%

-2.01% -2.54% -2.94% -3.34% -1.40% 1.63% -0.76% -4.25% 1.97% -5.78%

2.12% 2.03% 2.05% 2.11% 1.82% 1.90% 3.50% 1.90% 2.59% 1.15%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

90

J U LY / A U G U S T 2 0 0 5 • F T S E G L O B A L M A R K E T S

ns

tru

ct

io

n

&

Bu

M

%

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap c er e M er & si & e En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s e v ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r Ut El vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

Co

Eu ro pe SC

M C

LC

AC

AC

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 5

5

ay -0

-M

31

5

pr -0

-A

5

ar -0

-M

30

31

05

05

n-

b-

-Fe

28

-Ja

31

4

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31

3:34 pm

Eu Al ro l-E pe m er AC gi ng Eu ro pe FT AC SE Eu ro FT zo SE ne De AC ve lo pe d ex Eu FT r SE UK ope Eu AC ro fir st 30 0 FT SE ur of irs t8 FT 0 SE ur of irs t1 00

ed

op

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De

FT SE

Eu ro pe

Eu ro pe

Eu ro pe

al

ob

Gl

15/6/05

FT SE

FT SE

FT SE

FT SE

FT SE

FT SE

MARKET REPORTS 8

Page 91

FTSE Global Equity Index Series – Europe, Year to Date

31st December 2004 - 31st May 2005

FTSE European Regional Indices Performance (EUR) 110

FTSE Global AC (EUR)

FTSE Developed Europe ex UK LC/MC (EUR)

105

FTSEurofirst 300 (EUR)

FTSE Developed Europe AC (EUR)

100

FTSEurofirst 100 (EUR)

FTSE Eurozone LC/MC (EUR)

95

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

12

10

% 8

6

4

2

0

FTSE Developed Europe Sector Indices Capital Returns (EUR)

20

15

10

5

Capital

0

Total Return

-5

-10

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

91

MARKET REPORTS 8

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR) Vestas Wind Systems 44.4% Allied Domecq 41.2% Metso Corporation 39.4% RCS Mediagroup 35.5% Deutsche Boerse 34.9%

Overall Index Return (EUR) FTSE Global AC FTSE Europe AC FTSE Europe LC FTSE Europe MC FTSE Europe SC FTSE Developed Europe AC FTSE All-Emerging Europe AC FTSE Eurobloc AC FTSE Developed Europe ex UK AC FTSEurofirst 300 FTSEurofirst 80 FTSEurofirst 100

Worst Performing FTSE Developed Europe Index Stocks (EUR) Elan Corporation -68.9% Henderson Group -46.2% Benetton -24.3% Invensys -24.2% Alcatel -22.5%

No. of Consts

Value

1M

3M

YTD

Actual Div Yld

7793 1596 211 358 1027 1512 84 745 1031 300 80 100

299.66 295.57 329.86 358.10 372.33 294.36 400.92 303.77 305.64 1105.55 3843.64 3679.79

1.95% 4.41% 4.11% 5.06% 5.25% 4.38% 6.29% 4.84% 4.92% 4.25% 4.63% 4.06%

-3.15% 0.94% 1.17% 0.88% 0.78% 1.08% -7.08% 0.46% 0.97% 1.25% 0.01% 1.06%

-2.01% 6.73% 5.69% 8.68% 10.43% 6.67% 10.83% 5.51% 6.17% 6.12% 3.86% 5.70%

2.12% 2.90% 3.05% 2.54% 2.40% 2.91% 2.04% 2.88% 2.73% 3.01% 3.17% 3.24%

FTSE UK Index Series – Year to Date 31st December 2004 - 31st May 2005

FTSE UK Index Series Performance (GBP) 120

FTSE 100

115

FTSE 250

110

FTSE 350

105

FTSE SmallCap

100

FTSE All-Share 95

FTSE AIM 05

5

FTSE techMARK

31

-M

ay -

pr -0 -A 30

31

-M

ar -0

5

-0 5

-Ja n05

-F eb 28

31

31

-D

ec

-0

4

90

FTSE All-Share Sector Indices Capital Returns (GBP) 20 15 10 5

%

0

Capital

-5

Total Return

-10 -15

Co

ns

tr

uc

tio

n

M

O inin & il Bu & g ild Ch Ga in em s F g or M ica El S ec te es a ls t e tr on Ae l & try eria ic ro O & ls & sp th Pa p En Ele ace er M er gi ctr & e ne ic D ta er al ef ls Ho in Eq en us Au g & ui ce pm eh to ol mo Ma en d c Fo Go bile hin t od s od & ery Pe Pr s rs & Par od on Te ts u a ce Ph l Ca rs Be xtile ar re & ve s m & r P ro age ac H ce s eu ou ss tic se o al ho H rs s & ld ea Bi Pro lth ot d ec uc hn ts Ge o ne To log M L ral ba y ed ei R cc ia su et o & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le oo co d er nt v m & m D Tra ice un ru ns s ic g R po at e rt io ta n ile Se rs r U t E l vice ili ec s tie tr s icit -O y th e B r In ve L In ank st ife sur s In m A a en ss nc fo Sp rm e t C ur e at cia om an So ion lity p ce ftw Te & Re an ar ch Ot al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

-20

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

92

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4

2

0

-2

-4

FT SE

AI M

g

FT SE

ed Fl FT SE

al Sm FT SE

gl in

Al l-S ha re

ap lC

35 0 FT SE

25 0 FT SE

FT SE

10 0

-6

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP) Stanelco Oxford Biomedica BTG Elementis Edinburgh Oil & Gas

Overall Index Return

No. of Consts

FTSE 100 FTSE 250 FTSE 350 FTSE SmallCap FTSE All-Share FTSE Fledgling FTSE AIM FTSE techMARK 100

100 250 350 343 693 323 673 100

Worst Performing FTSE All-Share Index Stocks (GBP) AEA Technology -59.3% Homestyle Group -55.4% Danka Business Systems -54.7% Games Workshop Group -53.6% Gresham Computing -52.7%

388.4% 75.7% 71.6% 66.8% 57.8% Value

1M

3M

YTD

4963.97 7114.30 2528.33 2827.00 2483.35 3226.73 957.57 1159.80

3.4% 5.7% 3.7% 0.9% 3.6% 0.3% -4.6% 7.2%

-0.1% -1.9% -0.4% -3.9% -0.5% -6.2% -16.4% -1.3%

3.1% 2.6% 3.0% 2.5% 3.0% 2.4% -4.8% -3.1%

Actual Div Yld

3.31% 2.82% 3.24% 2.12% 3.21% 2.27% 0.53% 1.67%

Net Cover

2.11 1.92 2.08 1.50 2.07 -1.76 0.29 -

P/E Ratio

14.33 18.43 14.79 31.41 15.06 0 651.37 -

FTSE Xinhua Index Series

MARKET REPORTS BY FTSE RESEARCH

FTSE UK Index Series - Capital Return YTD (GBP)

31st December 2004 - 31st May 2005

FTSE Xinhua Index Series Performance (RMB/HKD) – Q1 2005 135

FTSE/Xinhua China 25 (HK$)

130

FTSE Xinhua All-Share (RMB)

125 120

FTSE Xinhua Small Cap (RMB)

115 110

FTSE/Xinhua China A50 (RMB)

105

FTSE Xinhua 600 (RMB)

100 95

FTSE Xinhua China Bond Total Return Index (RMB)

90

5 -M ay 31

30 -A

-0

5 pr -0

5 ar -0 31 -M

28 -Fe b

-0 5

05 -Ja n31

31

-D

ec

-0

4

85

FTSE Xinhua Index Series Index Name

FTSE/Xinhua 25 (HK$) FTSE/Xinhua China 50 (RMB) FTSE Xinhua All-Share (RMB) FTSE Xinhua 600 (RMB) FTSE Xinhua Small Cap (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

Consts

Value

1M

3M

YTD

Actual Div Yld

25 50 995 600 395 29

8105.44 3692.61 2023.97 2185.26 1441.61 94.23

-1.5% -10.8% -7.6% -8.5% -2.4% 1.12%

-7.6% -16.2% -19.8% -19.1% -23.8% 4.31%

-2.28% -11.73% -17.28% -16.34% -22.25% 7.52%

3.20% 2.34% 1.82% 1.98% 0.90% 3.54%

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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FTSE Hedge Management Styles (USD) – 5-Year Performance 160

FTSE Hedge

140

FTSE All-World

120

Directional

100

Event Driven Non-Directional

80 60

5 ay -0 M

04 No

v-

4 ay -0 M

03 vNo

3 ay -0 M

02 vNo

2 ay -0 M

01 vNo

1 ay -0 M

00 vNo

ay -0

0

40

M

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

FTSE Hedge – Management Styles & Strategies (NAV Terms) Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro Event Driven Merger Arbitrage Distressed & Opportunities Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value * Based upon indicative index values as at 31 May 2005

Index Level*

1 mth

3 mth

Ann Return (5-Year)

Volatility (3-Year)

2973.83 2041.82 1983.03 1848.44 3064.03 2014.21 2067.18 2957.64 1905.84 1971.36 2000.14

0.9% -0.1% 1.3% 3.4% 0.2% 0.5% 0.0% -0.2% -0.1% -0.5% 0.1%

-2.1% -1.8% -2.6% -2.6% -1.2% 0.7% -2.8% -0.5% -3.3% 0.1% 0.5%

7.9% 7.4% 10.5% 6.5% 3.5% 1.8% 4.9% 4.0% 7.5% 4.6% 1.9%

5.0% 4.3% 15.8% 6.9% 4.6% 1.8% 7.6% 1.7% 5.2% 2.7% 1.3%

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Index Series Performance (Total Return) – Year to Date

120 115

FTSE EPRA/NAREIT Global Total Return Index ($)

110

FTSE EPRA/NAREIT North America Total Return Index ($)

105

FTSE EPRA/NAREIT Europe Total Return Index (€)

100

FTSE EPRA/NAREIT Eurozone Total Return Index (€) FTSE EPRA/NAREIT Asia Total Return Index ($)

95

5 M

ay

-0

5 r-0 Ap

5 ar -0 M

-0 5 Fe b

05 Ja n-

De

c-0

4

90

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name

Consts

Value

1M

3M

YTD

Actual Div Yld

274 134 78 30 62

2186.29 2720.17 2292.34 2442.75 1517.22

1.9% 3.4% 7.0% 7.7% -1.2%

2.6% 6.6% 8.3% 11.5% -3.1%

0.04% 1.16% 11.99% 17.19% -3.17%

3.98% 4.65% 3.15% 4.15% 3.28%

FTSE EPRA/NAREIT Global Index ($) FTSE EPRA/NAREIT North America Index ($) FTSE EPRA/NAREIT Europe Index (€) FTSE EPRA/NAREIT Eurozone Index (€) FTSE EPRA/NAREIT Asia Index ($)

FTSE Bond Indices FTSE Bond Indices Performance (Total Return) – Year to Date FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbrief Index (€)

104 103 102 101 100 99 98

5 ay

-0

5

M

M

Ap

ar -0

r-0

5

5 -0 Fe b

5 -0 Ja n

De

c-0

4

97

FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥) FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

FTSE Bond Indices (Total Return) Index Name

Consts

FTSE Eurozone Government Bond Index (€) FTSE Pfandbrief (€) FTSE Euro Emerging Markets Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Gilts Fixed All-Stocks (£) FTSE US Government Bond Index ($) FTSE Japan Government Bond Index (¥)

252 312 42 334 9 29 116 220

Value

1M

3M

152.90 175.90 200.47 142.28 1883.11 1848.96 146.59 111.00

1.09% 0.89% 1.68% 1.06% 0.87% 1.65% 0.94% 0.07%

3.12% 2.69% 1.52% 1.76% 2.56% 3.59% 2.26% 1.26%

YTD

3.79% 3.08% 2.77% 2.68% 1.99% 3.11% 2.59% 1.21%

Actual Div Yld

3.29% 3.00% 4.54% 3.66% 1.78%* 4.31% 4.12% 0.96%

* Based on 0% inflation

FTSE Research Team contact details Carl Beckley Director, Research & Development carl.beckley@ftse.com +44 20 7448 1820

Bin Wu Senior Index Design Executive bin.wu@ftse.com +44 20 7448 8986

Jamie Perrett Senior Index Design Executive jamie.perrett@ftse.com +44 20 7448 1817

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7448 8013

Gareth Parker Head of Index Design gareth.parker@ftse.com +44 20 7448 1805

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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CALENDAR

Index Reviews July-Oct 2005 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

1-Jul 7-Jul

TOPIX New Index Series

Semi-annual review

28-Jul

17-Jun

TSEC Taiwan 50

Quarterly & annual review

15-Jul

30-Jun

25-Jul

OMX H25

Quarterly review

29-Jul

30-Jun

1-Aug

CAC 40

Quarterly review

1-Sep

End of Jun 30-Jun

12-Aug

Hang Seng

Quarterly review

9-Sep

17-Aug

MSCI

Quarterly review

31-Aug

31-Aug

FTSE All-World

Annual Review / Japan

16-Sep

Aug/Sep

NZSX 10

Quarterly review

Sep

Early Sep

ATX

Quarterly review

30-Sep

Early Sep

S&P US Indices

Phase 2 float adjustment

16-Sep

1-Sep

SMI Index Family

30-Jun

31-Aug

Semi-annual review

30-Sep

02-05-Sep S&P MIB

Semi-annual constituent review

19-Sep

31-Jul

5-Sep

DAX

Quarterly review / Ordinary adjustment

16-Sep

31-Aug

7-Sep

FTSE/Hang Seng Asiatop

Semi-annual review

16-Sep

31-Aug

7-Sep

FTSE UK

Quarterly review

16-Sep

6-Sep

8-Sep

FTSE All-World

Annual review / Developed Europe

16-Sep

30-Jun

9-Sep

NASDAQ 100

Quarterly review / Shares adjustment

16-Sep

9-Sep

FTSE techMARK 100

Quarterly review

16-Sep

9-Sep

FTSEurofirst 300

Quarterly review

16-Sep

2-Sep

9-Sep

FTSE eTX

Quarterly review

16-Sep

2-Sep

9-Sep

FTSE Multinational

Annual review

16-Sep

30-Jun

9-Sep

FTSE TMT

Annual review

16-Sep

6-Sep

13-Sep

S&P MIB

Quarterly review - shares & IWF

19-Sep

14-Sep

STOXX

Quarterly review

16-Sep

1-Sep

14-Sep

STOXX Blue Chips

Annual review

16-Sep

1-Sep

14-Sep

DJ Global Titans 50

Quarterly review

16-Sep

14-Sep

14-Sep

S&P US Indices

Quarterly review

16-Sep

14-Sep

S&P Europe 350 / S&P Euro Quarterly review

16-Sep

14-Sep

S&P 500

Quarterly review

16-Sep

14-Sep

S&P Midcap 400

Quarterly review

16-Sep

14-Sep

S&P / ASX 200

Quarterly review

16-Sep

14-Sep

S&P TSX

Quarterly review

16-Sep

31-Aug

15-Sep

Russell US Indices

Quarterly review

30-Sep

31-Aug

Sep/Oct

CAC 40

Quarterly review

Oct/Nov

Oct

Nikkei 225

Annual review

Oct

Oct

TOPIX New Index Series

Introduction of free float factors (Phase 1)

28-Oct

13-Oct

TSEC Taiwan 50

Quarterly review

21-Oct

30-Sep

Oct/Nov

FTSE/ASE 20

Semi-annual review

30-Nov

30-Sep

24-Oct

OMX H25

Quarterly review

31-Oct

24-Oct

31-Aug

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

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Sharpen up.

At FTSE we believe in providing cutting-edge products that give you the opportunity to outperform your competitors.

The FTSE Global Equity Index Series benchmarks 98% of the world’s market capitalisation, the broadest coverage available. Designed for precision, it can be cut any way you require to mirror your portfolio. Ultimately it enables you to make better decisions.

If you’re going to benchmark your performance, measure yourself against the best.

A free trial is now available from FTSE Group or via one of our vendors.

To find out more please visit www.ftse.com/trial BOSTON +(1) 617 306 6033 FRANKFURT +49 (0) 69 156 85 143 HONG KONG +852 2230 5800 LONDON +44(0)20 7448 1810 MADRID +34 91 411 3787 NEW YORK +(1) 212 641 6166 PARIS +33(0) 1 53 76 82 88 SAN FRANCISCO +(1) 415 445 5660 TOKYO +81 3 3581 2811 ©FTSE International Limited (“FTSE”) 2005. FTSE is a trademark of the London Stock Exchange Plc and the Financial Times Limited and is used under license by FTSE International Limited. All rights in and to the FTSE Global Equity Index Series are vested in FTSE.

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