FTSE Global Markets

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US SECURITIES LENDING: DEFINING THE NEW BUSINESS DRIVERS

ISSUE 80 • JANUARY/FEBRUARY 2015

FTSE GLOBAL MARKETS

Egypt: spurring the foreign investor Can Europe establish a cross-border private placements market?

CMBS: time for a comeback?

ISSUE EIGHTY • JANUARY/FEBRUARY 2015

Why commodities are hammering Latin American currencies

Will Greece stall the European project?

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OUTLOOK

L EDITORIAL Francesca Carnevale, Editor T: +44 207680 5152; E: francesca@berlinguer.com David Simons, US Editor, E: DavidtSimons@gmail.com CORRESPONDENTS Lynn Strongin Dodds (Editor at Large); Ruth Hughes Liley (Trading Editor); Vanja Dragomanovich (Commodities); Neil O’Hara (US Securities Services); Mark Faithfull (Real Estate).

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ike Wallace Stevens’ Jar, the US Federal Reserve and the dollar is taking dominion everywhere. The Fed’s Open Market Committee (FOMC) monetary policy statement in January tried hard to dispel any belief in interest rates rising in the near term. Additionally, given the FOMC’s explanation about its decision, it recognises that its inability to introduce even a quarter percent rise in the first half of this financial year is more about the over-strong dollar than any monetary policy stance.

Elsewhere, any number of central banks are trending towards easing. Central banks in Australia, Switzerland, Canada, Singapore and New Zealand have all kept to form either by cutting interest rates, easing policy through the currency or, as with New Zealand, removing its tightening bias. Others are crying ouch. Alongside the eurozone and Japan, Denmark enters the world of negative shorter-dated yield curves, becoming the first country to offer a negative interest rate mortgage.

In some ways, it could be looked at as a round of competitive currency devaluations by another name, with already apparent repercussions. Denmark has been forced to defend its currency peg against the euro and resulted in a temporary suspension of sovereign bond issuance (with the aim of lowering longer-dated rates), following three reductions to the deposit rate in January.

The fallout of the inability to raise rates is also being felt by US corporations in what looks to be a disappointing results season; all presentations hinting at a too strong dollar.

The other determinant of early year investment trends is the long term low oil price. Clearly there are winners and losers as the drop in prime energy prices is beginning to be felt across the board. OPEC’s target, to undercut the high cost oil shale producers is starting to have an effect and there are already signs that they are starting to rein in investments until prices look like rising again. That might be a long-ish wait. Cheap GCC producers are in no hurry to give North American producers a helping hand; though increased activity by ISIS in North Africa and northern Iraq, particularly Libya, might help to dampen total output numbers in the weeks ahead.

Nonetheless, few are looking at prices much above a $55-$60 range for much of this year. That’s been great news for importing nations, which have seen marginal improvements in their current accounts. India is a particular beneficiary.

Coupled with a growing commitment by many emerging economies to improve their economic and regulatory infrastructure, the question is now whether (over the medium term) it is enough to see a wholesale investment swing towards the emerging markets once more?Some investment houses certainly seem to think so and it is a theme that we return to in many different ways in this issue.

The overriding issue in this edition however must be what will happen to Greece?

It has been very apparent that since 2008, previous models of debt management have gone by the wayside. Solutions such as the Brady Plan, which essentially helped Latin American countries out of their debt mire (well, most of them anyway); have not had any traction among the heavily indebted nations in Europe. The strategy has always been amortisation by painful budget cuts. Seven years on, the pain has dragged on too long for some to no immediate benefit. By any other name however Greece has now raised the inevitable point that if over-indebted European nations are to have a scintilla of hope of restructuring their economy and getting back onto a growth path, more radical strategies might have to be employed.

This is clearly an anathema to euro-institutions, Germany in particular and the IMF. After all, no one likes a welcher. Nonetheless, a new route to managing the too weighty debt obligations of Europe’s southern sovereigns has to be navigated.

Who will break out onto a new path? What will the repercussions be? Those are the questions underlying this month’s cover story.

Francesca Carnevale, Editor COVER PHOTO: Photograph by Geert Vanden Wijngaert for Associated Press. Photograph kindly supplied by pressassociationimages.com, February 2015.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

1

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CONTENTS COVER STORY

GREECE’S DEBT BRINKMANSHIP

..................................................................................Page 4 There’s a yawning gap between promoters of austerity as a means of amortising gigantic sovereign debts and those that believe there is another way. It is not about who is right or who is wrong; it is more about who will win the argument.

Can the minnow (that’s Greece) truly beat the Leviathon that is now the European Union?

DEPARTMENTS

SECOND COVER

IS IT TIME NOW TO INVEST IN NON-EMU EUROPE?

MARKET LEADER

CORE EMERGING MARKETS: WORTH ANOTHER LOOK? ...............Page 12

SPOTLIGHT

UK SOVEREIGN BONDS GAIN IN APPEAL & OTHER STORIES .......Page 15

.........................Page 10 With all the problems with Greece, is it time to look at non-eurozone Europe?

It has been a raggedy year for the BRIC markets: can they regain their mojo?

The regular roundup of market views and news

IS US DOMINANCE A GOOD THING? .............................................................Page 26 The benefits, or otherwise, of tri-party collateral management structures

CHINA LEADS ON FDI INFLOWS .......................................................................Page 27

IN THE MARKET

Mehmet Gun reviews Turkey’s political economy.

THE US’S MOVE TO REAL TIME PAYMENTS STEP UP .........................Page 28 What happens when central bank forward policy unravels.

POLITICAL REFORM KEY FOR ITALY GROWTH SAYS OECD............Page 29 Why financial services think regulation is considered a strategic risk.

EUROPE REPORT

CAPITAL MARKETS UNION? HOW VIABLE IS IT?...................................Page 30

LEGAL

NZ’S SUPER-FUND VERSUS PORTUGAL’S CENTRAL BANK .............Page 33

TRADING REPORT

THE THEORY OF EVERTHING & TCA ......................................................................Page 34

What’s needed to ensure the EC’s new capital market initiative takes root?

What are the proper measures of growth?

Discovering the DNA of execution strategies

EGYPT AT THE CROSSROADS ..........................................................................................Page 36

COUNTRY REPORT

With elections looming: will Egypt’s new growth strategy receive proper backing?

CIB: THE NEW DASH FOR GROWTH ........................................................................Page 37 CIB is looking to leverage new retail growth opportunities

WILL CMBS NEW ISSUE LEVELS TIP UPWARDS IN 2015? ..................Page 39

REAL ESTATE

Issuance levels have been depressed since 2008: is it time for a change?

IS SUB-SAHARAN REAL ESTATE INVESTMENT ON THE UP?

..........Page 41

Specialist asset managers are finding traction: but are the risks too high?

INVESTMENT FUNDS

TRANSITIONING A MULTI-ASSET WORLD ..........................................................Page 42 The search for the perfect portfolio transition.

ICMA ISSUES NEW PEPP GUIDE: CAN EUROPE MAKE IT WORK? Page 44 The search for liquidity and high quality assets.

DEBT REVIEW

MIXED FORTUNES FOR OFFSHORE RMB ISSUANCE

..............................Page 46

It’s a very quiet start to the year for RMB denominated issuance: what’s the trouble?

THE RISE OF ALTERNATIVE LENDING IN THE MID-MARKET ..........Page 47 Can the euro private placement market break out of national boundaries?

FX OUTLOOK

COMMODITY PRICE DROP HAMMERS LATAM CURRENCIES

ROUNDTABLE

SECURITIES LENDING: DEFINING THE NEW BUSINESS DRIVERS

MARKET DATA 2

......Page 49

Neil O Hara explains why the euro crisis will change the MTN market forever Page 52

What Europe’s pension funds think about investment services provision Market Reports by FTSE Research ................................................................................................Page 66

JANUARY/FEBRUARY 2015 • FTSE GLOBAL MARKETS

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COVER STORY ASSESSING THE REPERCUSSIONS OF A GREEK EXIT FROM THE EURO

Greece's Finance Minister Yanis Varoufakis arrives prior to the European economic and financial affairs (ECOFIN) meeting at the European Council in Brussels, Belgium on February 17th 2015.

Photograph by Wiktor Dabkowski for pressassociationimages. Photograph kindly supplied by pressassociationimages.com, February 2015.

Beware of Greeks bearing bailouts?

The brinkmanship at the core of the tussle between the Greek and the EU’s position hangs around the best way to tackle seemingly unsurmountable levels of southern European sovereign debt. Whoever wins the battle could, ultimately, upend the Greek’s long standing commitment to the European project. “The debt problem cannot be ignored, but economic growth is key to recovery and Greece needs to broker a successor to its current bail-out package”, says Rowan Dartington Signature’s Guy Stephens. Is he right? If so, does it mean that Europe needs to rethink its approach to Greece entirely?

H

ERE’S THE RUB. The EU infrastructure (the Commission, the Parliament, the European Investment Bank, the European Central Bank among others) have been throwing around some big spending figures of late.

Yet, Greece is finding the going tough to persuade its Europroject partners that a progressive bailout program is the only way forward for the country to get back on track. Greece’s finance minister, Yanis Varoufakis, is doing the rounds in Europe, having been nominated as the chief negotiator with the EU following the election. Germany have already reiterated their stance that no further debt write off is going to happen and have added that social and fiscal reform has to remain as part of any deal.

4

February 19th was a long and volatile day for the Greeks. At 08.00 GMT, Greece was ready to submit its latest loan request; almost immediately the ECB announced that it would like to see Greece impose capital controls. Unsurprisingly, markets opened lower. By 09.30 Greece formally had submitted its request for a bailout extension and the Greek stock market rose 1% on the news. Some three hours later, Germany stated that the Greek’s proposal was insufficient and by 15.00 Greece has resumed its’ deal or no deal stance.

Whether it is the ECB leading the charge, or Germany, both seem keen not to allow the Greeks a six-month extension on its €240bn European loan agreement. The country will run out of money if the 19member eurozone countries do not accede

to Greece’s request.

Greece remains confident of a new bailout deal to avoid its exit from the euro.

Even German finance minister Wolfgang Schaeuble’s ubiquitous scepticism of a deal conceded that: “Every day there are different reports, and then when we are in a room together things sound completely different,”to a group of reporters a few days earlier. For its part the ECB has reportedly agreed to again increase its allocation of Emergency Liquidity Assistance (ELA), an emergency funding platform, to support the Greek banking system. It has offered a further €3.3bn, in addition to the additional €5bn it offered in the second week of February, bringing the total now to €68.3bn. Even that might not be enough to help the banks stem the outflow of

JANUARY/FEBRUARY 2015 • FTSE GLOBAL MARKETS

FRONT_80.qxp_. 20/02/2015 17:14 Page 5 _ _ q p_ y

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To find out more please call Chris Maityard at 44 (0) 207 680 5162 Or email: chris.maityard@berlinguer.com You can also find more information on our events at http://www.ftseglobalmarkets.com/events/ftse-gm-events.html

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FRONT_80.qxp_. 20/02/2015 17:15 Page 6

COVER STORY ASSESSING THE REPERCUSSIONS OF A GREEK EXIT FROM THE EURO

deposits from the banking system. The Greek central bank has requested a further €10bn to ensure the banks are properly shored up. Hence the cry from the European Central Bank for Greece to impose capital controls.

Yanis Varoufakis, Greek finance minister, would also like to find short term funding through a €10bn Treasury bill sale. This “bridge” financing would cover the next three months while a new bailout plan is hammered out over time and with cool heads. “However, according to sources, the ECB which controls terms of any national debt issuance, will not approve an increase in the current cap,” says Dartington.

Dartington suggests that there is“some light ahead in the form of a ‘Bail-out Two’ package which perhaps goes some way to explaining why the equity markets are relatively calm. It is clear that the current bail-out deal is not working and has only served to shrink the Greek economy which increases their debt as a percentage of GDP. It is also obvious that the US adoption of Keynesian economics, whereby a national government spends its way out of recession, has worked spectacularly well and this is the approach that the UK has also moved towards and growth is now also robust”.

Tom Elliott, International Investment Strategist at deVere Group, the independent financial advisory firm, takes a more cautious stance. He thinks that Greece is facing the “last chance to present its case before possibly finding itself abandoned at month end. Investors should be watching very carefully what happens at this ‘last chance’ meeting. Although Angela Merkel et al are seemingly taking the position that a euro without Greece would be manageable, investors should not be so relaxed. A breakaway from the eurozone could be expected to have a major impact on growth and capital markets in other regional economies, including France. A Greek exit [Grexit] is an unlikely outcome of Monday’s talks, but it may happen.

Is Schaeuble’s insistence on a comprehensive national restructuring and austerity program out of step with current thinking? “Yes, we know about the debt

6

problem,” concedes Dartington, “but without economic growth and a recovery in business confidence and employment, cutting spending and raising taxes only serves to cut off the legs of the economy when it is already on its knees. It will never recover in that environment and brings economic depression with it as a downward spiral takes hold. This was a key influence to Ben Bernanke’s thinking, who is seen as an expert on the failings of policy in the US Economic Depression of the 1930s. At that time interest rates were increased to defend the value of the dollar in a recessionary environment and this effectively shut down any signs of recovery for a decade”.

Strategies and exits?

Dartington is not suggesting a Latin American Brady Plan style package (part forgiveness, part rescheduling and part knocking the debt – much as the United Kingdom has done with recent long term gilt issues – into the long grass, for twentyfive years or more. In the case of Latin America it was thirty year zero coupon bonds). Dartington is more prosaic.“If the Greeks can broker a successor to the current bail-out package, which is available to other indebted nations, whereby interest payments are suspended and debt repayment and the resumption of interest payments are delayed until there are robust and concrete signs of economic recovery, then we may have something to look forward to.

Certainly, for now the market appears relatively sanguine over both the ultimate outcome (no one in Europe will allow, ultimately, Greece to default on its debt – the political risk repercussions would be too expensive, particularly with the ECB embarking on a comprehensive QE program.) As Tom Sartain, fixed income

manager at Schroders points out: “The principal systemic risk from a euro perspective comes from Greece and its possible ‘Grexit’. The market remains nervous of the situation in Greece, and should events unfold in a disorderly fashion, any expanded asset purchases will not be enough to prevent investors seeking a meaningfully higher risk premium on euro area assets,” deVere Group’s Elliott thinks a Europe without Greece could affect investors’ wealth : “It is unlikely that many private investors hold Greek bonds or equities.

However, a Grexit would impact investors because of its likely severe destabilising effect on the euro project and on the region’s capital markets”.

According to a new study, one in five (20%) investors polled in the UK remain confident that a ‘Grexit’ will not happen, while a third (34%) don’t believe it will have a significant impact on their investments, according to the latest Halifax Share Dealing Market Tracker. Of those industries investors feel will see the biggest impact, financial services, including investment companies, banks, insurance and property services, is top with two fifths (40%) of investors agreeing that these are likely to be impacted by a ‘Grexit’ situation.

However, it is yet to dampen demand for the sector, as it remains the second most popular, with two thirds of investors (67.7%) continuing to hold this stock, an 8.7% increase on the month before.

A bigger determinant of asset allocation remains oil prices which have been muted for some time. In consequence perhaps, energy and mining stock remain the most popular choice for investors for the third consecutive month. In fact, the number of investors has risen by 18.8% in the past year. Other big risers over the year include consumer and retail products (16%) and

Top five holdings in January 2015 by number of investors holding stocks in this sector

Jan 2014 Jan 2015

% change

Energy & mining eg: gas & oil

Financial services eg banks, insurance, property services, investment companies

50.2 % 59.6 %

69.0 %

18.8 %

Consumer & retail products: beverages, health, tobacco, pharmaceuticals

31.8 %

47.8 %

16.0 %

Consumer services: retailers, leisure, entertainment, media, transport

34.1 %

43.8 %

9.7 %

General industries eg: aerospace, defence, electronics, engineering Source: Halifax Share Dealing Market Tracker, February 2015

27.4 %

67.7 % 44.2 %

8.1 %

16.8 %

JANUARY/FEBRUARY 2015 • FTSE GLOBAL MARKETS

FRONT_80.qxp_. 20/02/2015 17:15 Page 7

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FRONT_80.qxp_. 20/02/2015 17:15 Page 8

COVER STORY ASSESSING THE REPERCUSSIONS OF A GREEK EXIT FROM THE EURO

general industries (16.8%). According to the market tracker service, “Looking ahead, these industries are also on the top of the wish list for future investments, with energy and mining (43.4%), consumer and retail products (39.6), financial services (34%) and general industries (34%) being the key sectors investors are looking to invest in over the next six months.”

“Concern over a possible Greek exit is growing, however a large number of investors remain confident that this is not going to have too large an impact, and confidence in the markets has actually rebounded in the past month,” concedes Joel Ripley, Halifax Share Dealing, who cautions that, “Considering the potential headwinds facing the economy in the event of a Grexit situation, it continues to be important for investors to do their research and understand the markets.”

For his part, Dartington thinks that the brouhaha around austerity measures are overdone. “I think it is interesting how the pro-austerity camp continues to push for social and economic reform, but hardly surprising that national governments are struggling to reduce welfare benefits with their unemployed electorate. The bigger picture on reform surely should be with regard to the fiscal structure within the EU itself,” he says.

Dartington says the Bank of England governor Mark Carney has been “quite vocal on the obvious flaws in mixing a single EU monetary policy with multiple national fiscal policies. The richest nations in Europe need to also accept that being part of the Euro club doesn’t mean you can selectively choose who to help and who to abandon to years of austerity. We all have wayward cousins, but because they are part of the family, we club together to sort the problem out with lessons learnt and a new way forward. The current status quo is one of zero tolerance.”

The question is whether the might of the austerity group will concede that the good of one is the good of all in Europe, particularly at this tipping point where so much of the Juncker Plan rides on the willingness of private investors to believe in the entirety of the euro-project. Any

8

A composite picture shows the letter of Greek Finance Minister Gianis Varoufakis addressed to the Dutch Minister of Finance and President of the Council Jeroen Dijsselbloem in Brussels on February 19th 2015. In the letter, Varoufakis is asking for an extension of the EU financial assistance for Greece.

Photograph kindly supplied by pressassociationimages.com, February 2015.

hint that Greece is left to the wolves will undercut the European Commission’s efforts to establish the region as a safe, risk free, capital market. Any default by Greece would feed investor security and fuel the polemic of the still rising power of the anti-European parties, such as UKIP, which will feed on Greece’s problems with a ravenous polemic.

Should Greece be forced to leave the euro some could question whether the single currency has an exit door for weaker members. Will any euro-member feel safe?

Could an exit foster an understanding that eurozone membership is conditional on ‘good’ behaviour, and that behaviour is defined by Germany? Should Greece leave, will it damage the dream of the euro’s founders, of the single currency as a path to closer union of European nations? More prosaically, will it lead to higher government bond yields among the weaker member states?

Newton Investment Management’s Paul Brain, fixed income investment leader, holds a different view.“Firstly we have to think what signal would giving into the Greeks send to other new parties across Europe. The accepted view is that it is the Northern European states

who want to play hard-ball with the Greek government.

Recently, however, comments from Madrid suggest it may be the governments that have put their citizens through the hardships of past austerity programs that have the most to lose. A recent rally in support of the Spanish anti-austerity leftist party Podemos shows the growing desire for change in these countries that have faced high unemployment for many years”.

Brain says that the concern in Northern Europe “is about the lack of reform in countries such as France and Italy. There have been repeated statements that the new ECB QE program should only be put in place where reform is ongoing. Not backing down and forcing the Greeks to go their own way (leave the euro and set up a new currency) can reinforce the remaining euro membership and possibly strengthen the euro”.

Very much a mixed bag of views then.

According to Standard & Poor’s an exit now would in the credit rating agency’s view be less financially risky for the remaining eurozone members than it would have been during the last Grexit scare in 2012 "All things considered, we

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COVER STORY ASSESSING THE REPERCUSSIONS OF A GREEK EXIT FROM THE EURO

believe that a Grexit would not lead to a degree of direct contagion that would drive other sovereigns out of the euro, not least because the eurozone rescue architecture is more robust than during the last Grexit scare in 2012," says Standard & Poor's credit analyst Moritz Kraemer.

Since then, he says, policymakers have introduced the European Stability Mechanism (ESM), which can financially support eurozone sovereigns under market pressure following any move by Greece to leave the euro. “The recent success of the Ireland and Portugal economic adjustment programs, financially supported by official creditors, has encouraged European governments to continue providing such assistance when needed, Kraemer says.

He also suggests that Greece's links with financial markets have been sufficiently reduced to make such a direct contagion less likely. According to data from the Bank of International Settlements (BIS), banks globally had gross exposure to Greek financial institutions of $77bn as of September 2014, versus more than $250bn five years earlier and $126bn at the end of 2011.

The disparity between Greek sovereign bond yields and those of other eurozone sovereigns, says the credit rating agency, also suggests that investors consider that redenomination risk of other eurozone sovereigns is currently low.

Whereas Greek sovereign debt yields have risen in recent months along with uncertainty about Greece's relationship with its lenders, bond yields of other socalled "periphery" sovereigns (which include countries such as Italy, Ireland, Portugal, and Spain) have fallen to alltime lows.

By contrast, in the six months leading to the Greek default in 2012 the periphery member states' bond yields tended to move in tandem. "We believe that the financial burden of a Grexit on the remaining 18 eurozone sovereigns would be moderate and absorbed over decades, and we therefore do not expect that a Grexit, by itself, would have significant rating implications for these sovereigns," concludes Kraemer. n

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Is it time for investors to look at buying ex-eurozone Europe?

The ECB changed the monetary policy game in Europe by committing to €60bn per month of asset purchases for 18 months starting in March 2015. The expanded asset buying program’s impact on markets is multifaceted and is only one among several related factors that will support better prospects for investors this year. Large scale asset purchases by the ECB create other dynamics in the market: pushing the Euro down, forcing investors into riskier assets, and supporting a more accommodative fiscal policy stance.

Unfortunately for investors however, the Eurozone is burdened by significant political risk (Greece being the latest example). David Stubbs, Global Market Strategist at JP Morgan Asset Management writes that investors may be well served to consider European countries outside the eurozone that can provide attractive equity and fixed income opportunities.

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CB PURCHASES OF government bonds should raise bond prices and therefore reduce their yield.

However, in some past instances of quantitative easing in the United States, bond yields were higher at the conclusion of the program than when it began. The common explanation for this is the increased inflation expectations that the policy induced. Indeed, the focus on such market-derived expectations has arguably been greater in the lead up to Europe’s quantitative easing program than before the Federal Reserve initiated its sovereign bond purchase initiatives. Hence, the mark of success for the program could, paradoxically, be higher bond yields, not lower, as investors require higher yields to invest in a future that they perceive is more inflationary than before.

Whatever happens to government bond yields, other asset classes seem sure to benefit through the “portfolio balance effect,”which occurs when investors who have sold their bonds to the ECB turn around and buy other assets. This is a key part of the transmission mechanism for quantitative easing. By pushing investors into other assets classes, policymakers are improving liquidity and pricing in those assets classes and, all else being equal, increasing the wealth of those holding

the assets. Equities are one such asset class that should benefit. Both directly, as investors sell government bonds and buy stocks (particularly higher-yielding ones in an effort to replace income streams) but also indirectly, as listed firms take advantage of the demand for corporate debt securities to issue new paper at low rates. This new debt can then be used to retire older and more expensive loans, or return capital to shareholders through increased dividends or buybacks.

This indirect channel is arguably the more important of the two, as most sellers of government bonds will be fixed income managers who are not able to buy stocks within their current mandate. If a sufficient amount of firms carry out this arbitrage then it can be expected to be a significant tailwind to push stocks higher.

However, an even more significant effect of QE is the impact it can have by depressing the value of the Euro, as around half of MSCI Europe earnings come from outside the Eurozone. The market had already priced in the ECB action by forcing the Euro lower in the months leading up to the announcement, and so the direct effect on foreign-denominated earnings can be expected to be apparent in company earnings throughout the coming year.

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The depreciating euro should boost the value of equity earnings from outside the single currency area. Together with lower energy costs, looser credit standards, improving loan demand and reduced fiscal contraction, the weaker currency creates a supportive backdrop for European risk assets.

QE is not the only fruit Despite the important impact of QE on equities, it is far from being the only determinant of asset class performance going forward, especially as its effectiveness is questionable given the low levels of interest rates already prevailing in the market. Oil’s headline-making decline has helped shape financial markets in recent months and, unless a rapid and sustained snap-back occurs, the impact will be felt throughout the year. As a net importer of oil, the Eurozone economy is a beneficiary of the decline in crude prices, even if it has exacerbated concerns over deflation.

Despite some increase in demand, as people change their energy consumption behavior, the decline in the price of energy should boost spending in other goods and services, fuelling growth and equity earnings away from the energy space.

Other past policy actions should also create a healthier climate for growth and equity earnings, particularly changes to bank supervision and more accommodative fiscal policy. Last year saw a series of actions taken by policymakers to assess the health of the banking system and set it up for a more stable and active future.

The combination of these efforts has now set the ground for banks to lend. Easier supply is being met by greater demand as shown by the ECB’s own credit demand survey. This combination should support growth going forward, and with it, corporate earnings.

Meanwhile, with the hard yards behind them, the sustainability of individual European country fiscal situations has certainly improved, allowing them to strike a better balance between supporting demand conditions and curbing public sector indebtedness.

On balance, we believe that the economic tailwinds in the, Eurozone are

David Stubbs, Global Market Strategist, JP Morgan Asset Management. Stubbs says that “By constructing a ‘Europe ex-EMU’ portfolio, we can assess just what these options provide an investor in terms of country and sector exposure. Our hypothetical portfolio contains six countries: the UK, Switzerland, Sweden, Norway, Poland and Hungary.” Photograph kindly supplied by JP Morgan Asset Management, February 2015.

now stronger than the political headwinds. However, Europe is more than just the eurozone, and investors who wish to maintain exposure to the continent whilst avoiding the single currency area have many options.

Building the portfolio By constructing a “Europe ex-EMU” portfolio, we can assess just what these options provide an investor in terms of country and sector exposure. Our hypothetical portfolio contains six countries: the UK, Switzerland, Sweden, Norway, Poland and Hungary. It may come as a surprise to investors, but the MSCI indices of these countries have a greater combined market capitalization than those of the Eurozone’s. The primary driver of this comes from the inclusion of the UK and Switzerland, which are the two largest equity markets in all of Europe. Not surprisingly, those countries make up a massive proportion of the exEMU portfolio: 84% to be exact.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

It is unlikely that an investor wishing for broad exposure away from the Eurozone would tolerate such country concentration. Hence, in order to analyze realistically attractive options for global investors, we constrained the portfolio in order to limit any country to no more than 25% of the portfolio. In doing so, we necessarily shrink the size of the investible universe. Our “Europe ex-EMU constrained” portfolio has a market capitalization of €3.3trn, which is still 99% of the size of the EMU Index.

Staying inside Europe but outside the Eurozone also opens up interesting fixed income opportunities. Again we constrain the country exposure to prevent excessive country concentration. The market cap of our constructed portfolio is still substantial at € 837 billion euros. However, our portfolio is a much higher quality than the Eurozone sovereign portfolio, with 74% of the bonds currently enjoying AAA status compared with only 20% in the single currency area. With higher yields and higher credit quality than bond markets of the Eurozone, European nations with their own currency could attract significant inflows as yields in the single currency bloc remain depressed.

Furthermore, investors would enjoy a premium of 0.17% at the 10-year maturity if they were to move money from the Eurozone to those European countries that are outside the currency bloc.

For investors considering their options in Europe, where a long list of catalysts stand to benefit equity markets, there is an attractive array of diversifying equity opportunities to be found outside the single currency area. Fixed income options outside the Eurozone also look appealing, with both higher yields and better credit ratings available in sovereign debt markets. n For reprints of this article, or any other article in the magazine, please feel free to contact: Chris Maityard Publishing Director TL: [44] (0) 207 680 5162 EM: chris.maityard@berlinguer.com

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MARKET LEADER EMERGING MARKETS: TIME FOR A RETHINK?

Photograph © Kasezo | Dreamstime.com supplied February 2015.

Core emerging markets: Are they worth another look?

Emerging markets have witnessed significant outflows of indirect investment capital as asset managers and beneficial owners have dashed for the ‘safety’ of more advanced markets; particularly as the US economy has reported positive indicators. However, seasoned investors in fast growth emerging markets now think that the segment might now have been oversold. Is the underlying heartbeat in the emerging market segment still strong and reliable enough to tempt back institutional investors?

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HE IMPACT OF the low oil price windfall and the continuation of market reform is beginning to create positive sentiment in high growth emerging economies, particularly among seasoned investors.

It is not the same story everywhere though. Even across the emerging markets, India, China, Russia, Poland and Turkey look to remain in the forefront.

Finding viable investment opportunities in the current market environment is not for the novice: however, experienced investors hold a positive outlook for equity valuations in the leading markets

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based on both the long term outlook and the continuation of market reforms in the main emerging economies.

Across the globe, the story is highly nuanced. In Asia, lower inflation trends across the region have led to central bank easing in a number of countries, instilling greater macro-economic stability relative to other emerging market regions. Macro indicators for emerging Asia (in aggregate) show real GDP growth of around 6% yearon-year last year, a current account surplus of nearly 3% and inflation around 3% (falling significantly from a near 5% level in 2013/2014), according to Heartwood In-

vestment Management.

“Of course, country selection is key and some economies hold better prospects than others within the region from a macro perspective. In many Asian countries, including India and China, we are seeing the confluence of fiscal stimulus, structural reforms, and easier credit conditions and rising real incomes that should support stronger domestic demand in 2015,” explains Jade Fu, investment manager at Heartwood.

In Asia, India looks to be the main beneficiary of lower oil prices. According to Fu,“Disinflationary forces should leave

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room for further central bank easing in support of growth, as headline inflation rolls over from a peak of 11% in 2013 to 5% at the end of 2014. The Indian economy is exhibiting greater macro stability (2014 real GDP was 6.6%) and should continue to attract strong capital flows into the country”.

Fu says the Indian rupee has withstood US dollar appreciation more ably than other emerging currencies. Moreover, as lower oil prices relieve pressure on import costs, India’s current account is also benefiting. Even so, short term cyclical drivers such as oil prices aside, Fu stresses that India remains “attractive because of the long-term structural drivers of growth; the most significant being prospects for reform.

This includes deregulating the labour market, a national goods and services tax (to remove trade barriers between certain states) and lifting caps on foreign direct investment flows into sectors of the economy (for example, supermarkets).

The investment case for China is perhaps more complex. According to Fu, “Investors need to pick their spots carefully, as certain sectors of the economy, such as property and financials, are still reeling from over-supply issues.

Economic momentum has slowed (GDP growth was still a healthy 7.3% in 2014), and we expect further monetary and fiscal stimulus measures to support the economy. Policymakers have been explicit in their view that they want to maintain stable growth (considered around 7%).

Export levels have stabilised recently (helped by a lower oil price), fixed asset investment in infra-structure remains robust (despite a slowdown in manufacturing and property) and retail sales growth has started to improve”.

Elsewhere, despite attendant political risks, particularly in Russia and to a lesser extent Turkey, Eastern Europe is also coming to the fore..

The macro environment however remains testing. The Minsk II agreement, for instance, is only a fragile accord between Russia and the Ukraine, while in Turkey increasing signs of political intervention in key financial institutions (the Istanbul bourse and Turkcell being

Photograph © Vs1489 | Dreamstime.com, supplied February 2015.

among the latest newsworthy institutions) is creating some uncertainty around sustainable corporate governance reform in the country.

The overall economic picture in the wider region moreover remains finely balanced. The latest figures from the European Bank for Reconstruction and Development (EBRD), for example, shows that western banks have scaled back funding to Central, Eastern and Southeastern Europe (CESEE) countries at a slightly faster pace in the third quarter of 2014, compared to the second quarter.

Credit grew in Turkey, Russia, and Poland, but was largely flat or contracting in most other countries.

Banks reporting to the Bank for International Settlements (BIS) reduced their external positions vis-à-vis the CESEE region by 0.3% of GDP in the third quarter of 2014. Excluding Russia and Turkey, the external positions of these banks declined by 0.4% of GDP, about the same as in the previous quarter.

However, according to balance of payments statistics, investment inflows other than foreign direct investment and portfolio flows remained positive for the

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

region, and for many countries, these flows show a more benign picture than the BIS data. The extent of decline between bank and non-bank claims varied by country, but for the region as a whole, the contraction was more in claims on non-bank borrowers than on banks, mirroring weak credit growth for corporations across the region.

In aggregate, domestic credit growth for the region looks to have decelerated on a year-on-year basis but, says the EBRD, remained positive in November last year. However, growth was still largely concentrated in Turkey, Russia, and Poland, while in most other countries credit contracted or remained flat.

Moreover, outside the European CIS countries and Turkey, overall domestic credit growth was mostly driven by expansion of credit to households.

The rate of deposit growth also slowed through 2014 (including in Q3), but continued to more than offset the decline in foreign bank funding for most CESEE countries. Nevertheless, due to rising non-performing loans and continued tightening in credit standards, recent surveys indicate that the improvement in overall lending conditions slowed in Q3.

Political considerations aside, the going has been particularly tough for Russia, which has seen a significant reduction in oil receipts and, as a consequence, suffered downgrades from the main credit ratings agencies (including S&P, Fitch and Moody’s). In late January S&P cut the Russian foreign currency sovereign rating into non-investment grade territory (from BBB- to BB+) The local currency rating was lowered by one notch to BBB- and S&P is now one notch below both Moody’s and Fitch. Moreover, the rating agency sees a risk of further deterioration, which could lead to another downgrade on a 12 month horizon. The next pre-announced review is scheduled for April 17th.

S&P says its action was justified by looming recession, a subdued outlook on economic growth, which it estimates to increase by a very modest 0.5% year on year on average between now and 2018, with attendant pressure on the country’s

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MARKET LEADER EMERGING MARKETS: TIME FOR A RETHINK?

fiscal and foreign exchange reserves.

These factors, says credit rating agency combine to limit the flexibility of monetary policy. Moreover, S&P has put an explicit focus on a weakening financial system “limiting the central bank of Russia’s ability to transmit monetary policy”, as the“central bank faces increasingly difficult monetary policy decisions while also trying to support sustainable GDP growth.”

However, Colin Croft, manager of the Jupiter Emerging European Opportunities Fund, avers that this challenging environment is more than reflected in share prices. Attractive valuations, coupled with ongoing improvements in market infrastructure and gradually improving standards of corporate governance present an “opportunity to buy into quality businesses, with sustainable and growing yields”.

Croft believes that while East European markets can be volatile, opportunities exist for long term investors as part of a well-diversified equity income strategy, as local corporations increasingly finance their expansion plans from cash flow and pay progressively higher dividends.

“Provided that dividend streams can be maintained, the low price of assets such as those of quality companies in Eastern Europe can potentially deliver high yields to investors, with increasing scope for payments to rise in the future as markets develop,” avers Croft.

He points to companies such as food retailer Magnit, as a template for his approach to the market. “This is still a company with considerable growth potential, in my view, due to the highly fragmented and under-penetrated nature of Russian food retail. Although it is the largest player, it still only has a singledigit market share. I believe it has significant scope to grow at the expense of weaker rivals that cannot match its bestin-class logistics and scale advantage in purchasing power. Magnit began paying dividends in 2009, paying a total of around $18m to shareholders. By 2013, this had grown exponentially, to just under $300m”.

The firm is a favourite among analysts

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Photograph © Vs1489 | Dreamstime.com, supplied February 2015.

focusing on Russia. It makes sense. Even if the firm’s buying power comes under pressure because of the recent decline in the value of the ruble (down by more than 46% over the last twelve months), food is the last item that people stop spending on. The company plans to open hundreds of new convenience stores, cosmetics stores and 90 hypermarkets this year, billionaire chief executive officer Sergey Galitskiy boasted to local reporters last month. Magnit has an approximate 6% share of Russia’s food retail market.

In that regard, Magnit, as a market leader is a safe bet. Even so, it is unlikely that it will be completely immune to the vagaries of the market. According to VTB analysts, Magnit’s net-income margin could slip a little (to 5.8/5.9%), compared with 6.1% two years ago; but still ahead of peer leaders, such as Walmart (3.3%).

“While rouble weakness is likely to provide a headwind this year, this could reverse if, as I expect, the oil price recovers to a normalised level,” thinks Croft.

At the same time, Croft says he has seen several instances in Russia where corporate governance has shown signs of improvement, “even at the state-owned enterprises that are not typically noted for being investor friendly”. However Croft is anxious not to overstate the case.

“The Russian government has encour-

aged several of the companies that it controls to increase their payout ratios, and while the blue-sky scenarios have not materialised, we have nevertheless seen some progress in this respect.

Gazprom, for example, had a single-digit payout ratio in the pre-crisis years, and paid barely $1.2bn of dividends in 2006.

Yet by 2013, its payout ratio had climbed into the mid-teens and it paid around $4.3bn to shareholders,” he says.

The story looks to have diffused across the energy segment. Russia's Rosneft says it will continue to pay out 25% of its net profit in dividends even in the current testing environment, according to an official statement from the company’s chief executive to the Interfax news agency in January. Rosneft has reportedly also changed the way it accounts for foreign exchange fluctuations, a move that avoids the cost of billions of dollars of debt hitting profits and depleting dividend payments to state coffers.

Croft holds that Russian oil companies are different. He explains:“When oil prices fall, they can benefit from a silver lining in the form of a weaker currency, as most of their operating costs are denominated in the rouble, which typically falls in line with the oil price. Their biggest cost items – mineral extraction tax and export duty – automatically fall, as they are set by formulae linked to the oil price. Russian oil companies generally have significant scope to cut capital spending, and are typically able to negotiate better prices from oil-field service providers, meaning that cash flows seem likely to prove even more resilient than earnings. Payouts have risen but from a very low base, giving some scope to maintain dividends in absolute terms by further increases in the payout ratio”.

Moreover, he adds: “share prices of Russian oil companies have fallen more or less in line with the oil price. So even if dividends were to fall in line with crude, the yield today appears attractive relative to other yield-producing assets.

For example, Lukoil’s prospective yield is well over 6%. This offers some margin of safety currently. Even at half these estimates, the yield would still be attractive, in my view”. n

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SPOTLIGHT

Photograph © archerix/Dollarphotoclub.com, supplied February 2015.

UK sovereign’s long term index-linked bonds gain in appeal 10-year UK government bonds rose a second day following the issue by the Debt Management Office (DMO) of £3bn ($4.6bn) of inflation-linked gilts due in March 2058 at the end of January. The order book was closed at £10.9bn and the securities were sold with a real yield of minus 0.8955%, according to the DMO. With real yields reaching these unprecedented depths this liquidity point was always going to be an interesting test of demand at these levels.

Why are the UK’s index linkers so popular among investors?

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RADITIONALLY, THE NATURAL buyer of index linked gilts is a large pension fund, where the trustees are looking to match long-term indexlinked liabilities. In return for a government-guaranteed hedge against inflation, investors are prepared to give up a degree of performance in the security.

From the point of view of pension fund managers and trustees, hedging against the risk of inflation has always been an important consideration. Funds of this nature have long-term liabilities, often linked to inflation or earnings and thus have a strong appetite for inflation-linked assets to put on the other side of the

balance sheet. Given the demand from the UK’s pension fund industry, the appeal of index linked bonds should not surprise. According to data from AXA Investment Management, up to £1,000bn of liabilities are still to be hedged by UK pension schemes, even though the supply of additional index linked gilts to sate this demand is expected to diminish in the next few years,.

“Not surprisingly therefore, the outcome just continues to highlight the resilience of demand at these very low real yield levels. This appetite stems from a range of different areas such as switches from other bonds, asset swap demand as

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

well as outright real interest rate and synthetic inflation only hedging,” holds Shajahan Alam, head of solutions research at AXA IM’s UK LDI team.

Demand in the UK market is also set against a largely supportive backdrop: disinflationary themes are prevalent globally and overall these same themes are supportive for fixed income.

Ultimately, the DMO closed the book at £10.9bn, faced with £16.6bn worth of demand. “Such high demand at yield levels that amount to paying the government for the privilege of lending them money (after allowing for expected inflation) is not surprising as there remains up to a £1,000bn of pension scheme liabilities looking for matching assets.

Projected supply is nowhere near these levels,” holds Alam, The level of demand at such low yields highlights a turning point where pension schemes are generally accepting that real yields may not rise much in the near future, thinks Alam, who points out too that ahead of the May elections in the UK, little supply is expected, therefore fuelling demand for the index-linked securities.

Certainly, there looks to be little long dated index-linked gilt supply planned for the remainder of this fiscal year after yesterday’s syndication other than the shorter dated index-linked gilt 2024 and 2037 auctions on February 4th and March 12th. It’s a view reflected by the DMO itself. The size of the sale was increased and so mini-tender sales for the rest of the fiscal year through March has been cancelled, it added in its statement announcing the bond issue.

“On the demand side we expect pension schemes to continue to hedge when opportunities arise. Money will be mechanically pumped into longer dated index-linked bonds when the 2020 indexlinked bond falls out of the ‘FTSE A over 5 year index linked gilt’ index on 16th of April [sic],” he states. The benchmark is widely used by index linked gilt funds.

With a market value of around £24bn, removing this gilt from the index will result in a benchmark duration extension of just over one year,“which is pretty significant and will mean that fund managers

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SPOTLIGHT IN ELECTION YEAR, THE DMO’S INDEX LINKED BOND RAISES QUESTIONS

may have to buy longer dated index linked gilts to neutralise the duration impact on their portfolios,” he explains.

For his part, Alam also thinks yields will remain low: no surprise there given the Fed’s stance and the expectation that even if the Bank of England does start to raise interest rates, it will be in very small increments over a period of years. “In the absence of positive geopolitical and economic news leading to higher nominal yields, we do not see much to support a significant rise in long dated real yields in 2015; indeed there is a distinct possibility that they could grind lower,” he adds.

DMO OPTS OUT OF REFERENCE PRICES: The DMO announced at month end January a strategic intention to withdraw from the provision of daily end of day Gilt-edged Market Maker Association (GEMMA) and Treasury bill reference prices, preferring the prices are supplied by an independent provider. It also suggests the development of commercial gilt and Treasury bill pricing services may have been constrained by the DMO’s free prices data.

As a first step towards withdrawing from the provision of these prices, the DMO says it will engage with market participants, data providers, market infrastructure providers and other stakeholders in order to explore with them the markets’ requirements for gilt and Treasury bill prices; to build stakeholder consensus around the conditions for the DMO ceasing to provide reference prices; and to help to identify potential alternative ways that requirements can be met on a commercial basis.

The DMO will continue to provide reference prices during the engagement and transition processes.

The DMO has been publishing reference prices for Treasury bills since September 2003 and these are intended to provide indicative prices for the purpose of CREST valuation of collateral transfers. These prices are calculated by the DMO from prevailing GC repo rates adjusted by a spread which reflects the results from recent Treasury bill tenders.

The gilt and Treasury bill reference prices, including those derived by the DMO, are

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published to the DMO’s wire services pages, on the DMO’s website, and transmitted directly to various stakeholders.

Changing regulatory requirements which could lead to additional costs and obligations on the DMO to comply with the relevant standards; the potential for a perceived conflict of interest in the DMO becoming an official administrator (in order to comply with administration best practice) while issuing and trading bonds and setting obligations for the Giltedged Market Makers (GEMMs); and the contributing GEMMs’ situation relating to the changing obligations and potential conflict of interest that they face as contributors of prices are some of the reasons cited for the policy change.

The DMO says it will begin its talks with the market in February and invites indications of interest from stakeholders that wish to keep abreast of the changes. n

Winners and losers from the rising dollar

In what turned out to be a banner year for Robeco Groep NV today announces its 2014 results, which the firm says has been a year of records. Asset under management increased by €40.8bn, resulting in an all-time high of €246bn of which 48% was institutional business. The firm also benefitted from a €18.4bn gain as a result of the appreciation of the US dollar. Not everyone has been as fortunate. How much higher can the dollar go? Will the Federal Reserve’s ‘go slow’ on interest rate appreciation help from keeping the dollar from appreciating too far?

The signs don’t look that good. According to the exchange rate analysts at BMO Capital, the US dollar is still weak relative to its historical inflation-adjusted average. “So it is far too early to start talking about a USD overshoot," says analyst Stephen Gallo.

Following the announcement in late January by the US Federal Reserve that it would maintain interest rates for the foreseeable future, there was mixed signals in trading the US dollar. The currency

gained against most of the major currencies, except the yen, ratcheting down to JPY117.55, following a brief rise to 118.26 earlier in the day.

Indications are the dollar will continue to strengthen, as foreign economies continue to reel and their central banks print more money to save them. The USD will not only benefit from foreign central banks knocking their own currencies down. Any expectation that the US’s own central bank would start to raise rates has now been touched into the long grass.

The dollar has been on an upward trajectory since Federal Reserve announced it would be reducing its monthly purchases under the QE3 program at year end. Once the central bank began winding down its stimulus program, the dollar began a steady rise, beginning in the second quarter of last year. Should the Fed reverse its current go-slow policy, the upward drive would be immense.Central banks walk a tightrope in keeping their currencies strong, but not so strong that exports are negatively affected. The advantage then shifts to the importers, as a stronger dollar increases their buying power and results in lower prices for imported goods.

While the Fed’s statement barely acknowledged the FX markets, it clearly perceives the threat of the currency rising in value faster than prices, making both exporters and importers viable for a while longer.

The question for investors is whether now that the dollar’s rise has definitely begun (and could feasibly continue for at least the next decade until interest rates return to their normal levels) and while several regions of the world are still under risk of recession, will investment portfolios witness a rotation, with still less weighting in some overseas markets and a slightly greater weighting in domestic companies.

Analysts cite the fact that 40% of the S&P500’s earnings come from overseas and the US dollar has risen 9% against the euro and 14% against the yen over the same period in 2013. On top of that, the drop in oil has had a particularly pronounced impact on the energy sector: “Consensus 2015 EPS numbers for the

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SPOTLIGHT WINNERS AND LOSERS FROM THE RISING DOLLAR

global sector dropped from -7% midDecember to -27% at the end of January, while for US energy companies, the equivalent figure was even -37%. The gap in earnings momentum between commodity producers relative to consumer sectors is at its highest level in at least 7.5 years,” says Patrick Moonen, senior strategist at ING Investment Management.

This combination of a rising dollar and falling oil prices will have a considerable negative impact on the US earnings outlook, he avers. “It should however be remembered that disappointing US earnings do not necessarily mean that the US market will underperform. The US does not have the same policy risks compared to the eurozone and its economy is far more resilient than in the rest of the world. It will nevertheless be an uphill struggle, especially if also the Fed would start to tighten monetary policy later this year. As a consequence we believe that in 2015 the global equity market will become gradually less UScentric and shift its attention to other parts of the world.”

There are also wider repercussions.

According to Remi Ajewole, fund manager, multi-asset at Schroders,“The US economy is currently the main growth engine for the global economy. Therefore, the big question is whether the slowdown in other parts of the world will contaminate the recovery in the US. We believe the improvements in the US labour market will be maintained, and view the recent decline in oil prices as beneficial for the US consumer. However, our fear is that the risk emanating from the other economies, the severity of the oil decline and the strength of the dollar could all have a destabilising effect on financial markets”.

An early sufferer was Royal Dutch Shell, which blamed write-downs and forex losses for making almost no money in oil production, its most powerful division, in the last quarter of 2014, causing the company to miss profit forecasts by more than 20%, in its 2014 earnings presentation at the end of January.

Shell, the largest of the European energy majors and a substantial contributor of dividend payments to UK pension

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Photograph © grapestock /Dollarphotoclub.com, supplied February 2015.

funds (around 8% of the total received by them), also announced a relatively modest three-year, $15bn cut in spending to help it weather the plunge in oil prices.

"We are taking a prudent approach here and we must be careful not to over-react," the firm’s chief executive Ben van Beurden noted at the results announcement.

The move is significant. Shell has one of the largest capex programs in the energy segment. This round of cuts involves the cancellation and deferment of projects through to 2017, and represents a 14% cut per year from 2014’s capital investment of $35bn.

The company's fourth-quarter 2014 adjusted net income of $3.3bn was weighed down by weaker than expected earnings from oil and gas production, known as upstream. Chief Financial Officer Simon Henry blamed the miss on a number of one-off items, including forex losses, exploration write-offs in North America and increased estimates of future decommissioning liabilities worldwide.

However, he said, those one-offs were unlikely to be repeated in future quarters.

Luckily for the UK’s pension funds, Shell maintained its fourth-quarter dividend unchanged from the previous quarter at $0.47 per share and in a rare move pledged to pay the same amount in the first quarter of 2015. Total cash dividends paid to shareholders in the fourth quarter 2014 were $3bn. During

the fourth quarter some 27.4m shares were bought back for cancellation for a consideration of $1bn.

It has not cut its dividend since 1945.

BP and Total have pledged the same, preferring instead to cut capex. Even so, they caution against cutting too much as it could derail long-term projects, destroy the value of companies and potentially even lead to an oil shortage in the future.

Noonan thinks the story will be the same across the board, “US equities face growing headwinds as lower oil prices and a rising dollar make their mark on earnings season,”he says.“Fourth quarter earnings season is in full flow and already the impact of lower oil prices and a rising dollar is beginning to show. Consensus growth estimates have continued to decline during the reporting season and are now below 1%. Global earnings momentum remains strongly negative with the US lagging behind Europe and Japan. These low expectations are in large part due to the US dollar’s appreciation during Q4 2014, a trend that’s likely to continue into 2015”. n

AEOI: Tax reporting doesn’t have to be taxing With so much attention on FATCA in recent times, the financial services industry could be forgiven for seeing it as the most obtrusive regulation ever to be imposed on them. This view will soon change. Once the Automatic Exchange of Information (AEOI) comes into force, financial institutions will have far greater challenges to overcome explains Colin Camp, managing director of Products & Strategy at Dion Global While there is no denying the large amount of data that needs to be collated under FATCA, it pales into insignificance in comparison to the customer information firms will need for AEOI. For starters, financial institutions will need to report eventually on over 80 different nationalities. Unfortunately, and unlike FATCA, AEOI has no minimum monetary thresh-

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SPOTLIGHT AEOI: TAX REPORTING DOESN’T HAVE TO BE TAXING

olds and firms cannot hide behind claims of not dealing with specific nationalities.

There is also a possibility of different countries requiring different levels of information. This calls for even greater demands of customer due diligence. No simple task, particularly for firms that opted for the quick fix approach under FATCA instead of looking for a more long term solution.

Under FATCA, many institutions with small numbers of U.S. clients are handling reporting requirements manually. These same firms are also banking on FATCA being handled by their head office, assuming only minimal internal reporting will suffice. As a result, they are relying on existing systems to do the job. This may have work under FATCA, but banks planning to replicate the same approach for AEOI are in for a rude awakening.

Reporting volumes are set to significantly increase. This is unlikely to be a small task, with separate reports on different client nationalities for each jurisdiction likely to be required. This puts an even greater strain on a bank’s IT systems.

This is why technology must not only meet the specific requirements of FATCA, but also the extended needs of AEOI, not to mention future initiatives. Client identification and classification, remediation and documentation, and reporting to the relevant fiscal authorities and clients must all be automated. Indeed, operating without a complete regulatory reporting engine will soon become untenable.

Data collection, modelling and storage will all need beefing up as will the creation, management and approval of reports and the ability to monitor changing global reporting requirements.

Appropriate governance must also provide the necessary foundations.

From FATCA to AEOI, who knows what the next move will be. And, with confirmation of exact reporting rules around AEOI still up in the air, there is still much uncertainty. The point is that those who continue to paper over the cracks instead of looking for a long term solution run the risk of non-compliance to local and global regulations and reputational damage. On the flip side,

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financial institutions that adopt flexible technology designed to cater for future unknowns, will avoid any headaches, and have capacity to explore how best to use the new AEOI/FATCA customer data. The silverlining, of course, is that once a firm’s AEOI infrastructure is in place, it provides a goldmine of customer data. Golden nuggets that could then be used for purposes other than keeping the tax authorities happy. n

Spain's weakest regions benefit from new cheap state funds

Fiscally-weaker Spanish regions will benefit from new, cheaper government funding, while some of their stronger peers have opted out to avoid surrendering control over borrowing to the central government and will continue to issue bonds in 2015, says Moody's Investors Service Espana, SA in a new report.

The new liquidity fund for Spanish regions, the Fondo de Financiación de las Comunidades Autónomas, includes the existing Fondo de Liquidez Autonomico (FLA), as well as a new sub-facility, the Fondo de Facilidad Financiera, targeting those regions that comply with government deficit objectives. New measures reduce the interest rate on FLA debt contracted over 2012-14 to 0%, from 1%. In addition, loans provided via the Fondo de Facilidad Financiera will have a 0% interest rate over 2015-17.

The rating agency expects that the weakest regions, which are already using the government's existing Fondo de Liquidez Autonomico facility, will benefit the most from the new measures, although savings will be limited. "If all the Ministry of Treasury and Public Administration’s projected savings materialize, we estimate that the debt service of rated regions under the FLA would decrease to 22% of operating revenues on average from 24% in their 2015 initial budgets," says Marisol Blazquez, Moody's analyst for Spanish regions.

Fiscally stronger regions, on the other

hand, are generally able to access markets at favourable costs on their own and some have opted out of the new fund to avoid surrendering control over borrowing decisions to the central government.

Moody's expects that the new liquidity mechanisms will remain in place for at least the next three years. This assumption is based on the likely persistence of fiscal difficulties at least until 2017, when the government targeting is a balanced budget for all regions; Spanish regions’ high debt repayments; and their continued accumulation of unpaid bills to suppliers. n

Appetite for recoveries is growing as lenders/ investors eye significant returns

A landmark High Court judgment in the United Kingdom over the negligent valuation of commercial property is now making significant waves in the Commercial Mortgage-Backed Securities (CMBS) market, writes Georgina Squire, head of dispute resolution at Rosling King.

Following the Commercial Court judgment of Blair J last year in Titan v Colliers another CMBS valuer claim (Windermere X v Warwick Street) has settled with a sizeable payment to the Issuer and we shall now wait and see what happens in the Gemini v Warwick Street litigation Balance sheet lenders may have known about claims but seem to have had little appetite to pursue them before Titan proved they can achieve significant returns.

Distressed debt purchasers, private equity investors, special servicers and investors in CMBS structures have a little more appetite, but have still been slow to commit. What they are now discovering is that these claims are a way to make sizeable returns on their investments.

Claims against professional advisors on loans originated in 2006/7 are still being discovered. Now there is talk of more being pursued – and timing is extremely important. Time has not run out for such

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SPOTLIGHT APPETITE FOR RECOVERIES GROWS AS INVESTORS EYE SIGNIFICANT RETURNS

claims, as the Titan case has shown; they are not yet time barred. However, time to decide is not endless – it is running out and so decisions should be made sooner rather than later.

The key to success is to choose only the good claims and that decision will require an independent expert to give a view on the true valuation at the date of the origination of the loan. Valuation is not a science and valuers are afforded a margin of error – up to 15% as was shown in Titan.

However, Titan also illustrated how this is pretty much the ceiling. The building the subject of the claim was as difficult a building to value as any and the judge would not contend more than a 15% margin.

Provided the Judge decides that no reasonably competent valuer could have valued the subject property at the level of the original valuation, it will be deemed negligent. The lender will be entitled to the difference between the original valuation and the true valuation at the date of origination as a cap on their recoverable damages.

This was €32m in the Titan case, in addition to which Titan was awarded interest and its legal costs of the case—a significant recovery for the issuer- to be distributed through the waterfall when the current appeal process ends.

There are also lessons to be learned for new CMBS lending. Valuers may look to put caps on their liability or exclusions in their retainers. We see attempts to restrict liability to a multiple of fees. These restrictions may sometimes be effective, but on the whole are not. They need to be negotiated in detail and agreed before they have any chance of biting in the event of a claim.

Securitisation documents should ensure claims of this nature are catered for. Is the Special Servicer empowered to run them? Are they obliged in their agreement to be proactively looking for such claims? What happens if the loan has redeemed and there is a shortfall?

Should a Final Recovery Determination be issued or would it prohibit such a claim? What is the role of the issuer and

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the Note Trustee? What happens to the proceeds of any recovery? These are all issues which should be covered expressly in the documents.

There is life after Titan and the significant damages recoveries that are available should lead investors in CMBS to investigate opportunities before time runs out. n

Australia: NSW issues environmental planning policy amendment

The NSW Government has released a new State Environmental Planning Policy Amendment (Gas Exploration and Mining) 2014 (SEPP Amendment) which came into force in late December.

The implications are complex.

The SEPP Amendment introduces a new land acquisition and mitigation policy to formalise landholder protection from noise and dust for State Significant Developments (SSD) in the mining, petroleum and extractive industries.

The amendment means that decisionmaking bodies are now obliged to take into account the new 'Voluntary Land Acquisition and Mitigation Policy' in determining development applications. This policy provides guidance on measures to reduce the impact of noise and dust on adjoining properties from proposed new activities. It applies to all undetermined SSD applications and any future applications to modify existing operations.

The policy provides that the acquisition price to be paid by a proponent be an amount no less favourable that a 'market value' rate calculated as if the land was unaffected by the development and with reference to section 55 of the Land Acquisition (Just Terms Compensation) Act 1991 (Land Acquisition Act). This requirement is controversial as the Land Acquisition Act is a statutory scheme introduced for use by NSW government authorities during compulsory acquisition of private land for a public purpose.

The policy also has the potential to significantly impact proponents of SSD in the mining, petroleum and extractive in-

dustries, as it introduces voluntary land acquisition criteria for particulate matter applicable to the majority of workplaces on privately owned land.

Equally significantly, the consent authority maintains discretion as to whether or not to apply the particulate matter acquisition criteria to workplaces.

The requirement that the Land Acquisition Act criteria be applied to acquisition of some types of workplaces affected by dust has the potential to make smaller SSD applications and modifications unviable, as the cost of relocating and compensating a business owner could be substantial. n

IMF says bank deleveraging in Emerging Europe gains speed in Q3 2014

Western banks scaled back funding to Central, Eastern and Southeastern Europe (CESEE) countries at a slightly faster pace in the third quarter of 2014, compared to the second quarter, according to a new Vienna Initiative committee report. Credit grew in Turkey, Russia, and Poland, but was largely flat or contracting in most other countries, according to a new report from the IMF. Banks reporting to the Bank for International Settlements (BIS) reduced their external positions vis-à-vis the CESEE region by 0.3% of GDP in the third quarter of 2014. Excluding Russia and Turkey, the external positions of these banks declined by 0.4 percent of GDP, about the same as in the previous quarter.

The extent of decline between bank and non-bank claims varied by country, but for the region as a whole, the contraction was more in claims on non-bank borrowers than on banks, mirroring weak credit growth for corporations across the region.

According to balance of payments statistics, investment inflows other than Foreign Direct Investment and portfolio flows remained positive for the region, and for many countries, these flows show

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SPOTLIGHT GOLD OUTPUT FALLS IN US, GAP BETWEEN PRODUCERS WIDENS

Photograph © destina /Dollarphotoclub.com, supplied February 2015.

a more benign picture than the BIS data.

In aggregate, domestic credit growth for the region decelerated on a year-onyear basis but remained positive in November 2014. However, growth was still largely concentrated in Turkey, Russia, and Poland, while in most other countries credit contracted or remained flat. And outside the European CIS countries and Turkey, overall domestic credit growth was mostly driven by expansion of credit to households.

The rate of deposit growth slowed in 2014 (including in Q3), but continued to more than offset the decline in foreign bank funding for most CESEE countries.

Nevertheless, due to rising non-performing loans and continued tightening in credit standards, recent surveys indicate that the improvement in overall lending conditions slowed in Q3.

The CESEE Deleveraging and Credit Monitor is prepared by the staff of international financial institutions taking part in the Vienna Initiative’s Steering Committee and is based on the BIS’s International Banking Statistics published on January 20, 2015. The Vienna Initiative was established at the height of the global financial crisis of 2008/09 as a private-public sector platform to secure adequate capital and liquidity support by Western banking groups for their affiliates in Central, Eastern, and South Eastern Europe (CESEE). It was

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re-launched as Vienna 2 in January 2012 in response to renewed risks for the region from the eurozone crisis. n

Gold output falls in US, gap between producers widens

The United States is the world’s fourth largest gold producer, after China, Australia and Russia. According to the US Geological Survey (USGS), output in the US fell by 6% in October, compared with September production and an 11% decrease compared with that of October 2013. In part this is due to the start of seasonally lower gold production in Alaska because of cold weather, and lower gold production at Rio Tinto plc’s Bingham Canyon Mine in Utah caused by an increase in geotechnical issues on the East Wall.

According to USGS, based on unrounded data, the average daily gold production for US mines was 542 kg in October 2014, 591 kg in September 2014, and 578 kg for the first 10 months of 2014. Prices The average Engelhard gold price was $1,226.49 per troy ounce for October, a $14.04 per troy ounce decrease compared with the average gold price in September. The gold price decreased $14.53 per troy ounce on October 3 before increasing to the monthly high of $1,255.38 per troy ounce on October 21. The price decreased to the $1,166.83 per troy ounce at month end.

The gap between US production and production from the big three is widening, as is production totals between the US and South Africa. On the basis of the USGS figures to date, U.S. total gold production for the year is likely to be in the order of 211 tonnes as compared with 230 tonnes a year earlier. Declines in gold output from the US however is a longer term trend.

In 2013, for example, worldwide gold production was 3% more than that in 2012 owing to increases in production from Brazil, Canada, China, the Dominican Republic, and Russia, which more than offset production decreases in Peru, Tanzania, South Africa, and the United

States. Gold production in China continued to increase, and the country remained the leading gold-producing nation, followed

by Australia, the United States, Russia, Peru, and South Africa. Throughout the world, high-cost mines, expansion projects, and development projects were placed on hold because of the drop in the price of gold.

The USGS also produces some interesting data on the destinations of U.S. gold exports. The top four recipients of U.S.produced gold in October were: Switzerland with 17.6 tonnes, Hong Kong with 12.9 tonnes (17.8 tonnes in October 2013), mainland China with 7.4 tonnes (0.36 tonnes in October 2013) and India which took in 6.1 tonnes. Other significant recipients were Thailand (2 tonnes), the UK (2 tonnes), the UAE (1.36 tonnes) and Singapore with 1 tonne. The gold exported to Switzerland will have mostly been destined to be re-melted into kilo bars and shipped onwards – primarily again to China both via Hong Kong and directly.

Overall, output from the US is expected to continue to drop. n

Malta pension law comes on stream

The Retirement Pensions Act (Chapter 514 of the Laws of Malta) came into force on the 1st January. The Act repeals and replaces the Special Funds (Regulation) Act. The scope of the Act is similar to that of the Special Funds (Regulation) Act and provides for a regulatory framework for occupational retirement schemes, retirement funds, and service providers but specifically makes reference to schemes setup as personal retirement schemes. The Retirement Pensions Act, secondary legislation and Pension Rules also transpose the provisions of Directive 2003/41/EC of the European Parliament and of the Council on the activities and supervision of the institutions for occupational retirement provision (the IORP Directive). The IORP Directive had already been transposed in the Special Funds (Regulation) Act and all secondary legislation. Persons currently registered under the Special Funds (Regulation) Act have until the 31st December

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IN THE MARKETS NOT A GREAT ROTATION; RATHER GREATER DIVERSIFICATION

If markets had respected the ‘2014 playbook’ then US ten- year yields should be at 4% by now, European stocks would be 10% higher, and high yield spreads would be at 300 basis points (bps). Of the major asset classes, only the S&P is anywhere near where it was supposed to be. Even so, markets seldom respect the playbook. Last year’s biggest surprise may have been the 45% slump in oil; but undoubtedly the most costly one, given consensus short bond positioning at the start of 2014, was the 120 bps rally in US 30-year bonds—equating to a total return of 29.4%. What now? John Bilton, global strategist, JP Morgan Asset Management, gives outlook on 2015.

Can US economic dominance continue into 2015?

T

HERE APPEARS TO be an inherent contradiction in U.S. real Gross Domestic Product (GDP) growth edging towards 4% while 30-year bond yields are below 3%. But this is the very essence of the macroeconomic environment we face in 2015. The U.S. economy is accelerating sharply and may be boosted further by the recent drop in the oil price. Yet America is doing a poor job in exporting its recovery to the rest of the globe. By contrast, the U.S. is doing a great job in importing the rest of the world’s monetary policy. Weakness in commodity markets is symptomatic of chronic overcapacity and sclerotic growth elsewhere in the world. This in turn is causing a powerful disinflationary impulse which is holding down long-end yields, even as the US Federal Reserve (Fed) looks to start hiking rates in 2015.

The upshot is a US economy accelerating from an extended early cycle into a solid mid-cycle phase but with the business cycle elsewhere struggling to pick up. Divergent growth leads to divergent policy which, in combination with the disinflationary pressure coming from Europe and parts of the emerging markets, keeps long-end yields compressed. For economies with domestic growth momentum, such as the US, this creates a benign backdrop for equities.

Elsewhere, for stocks to perform, central bank stimulus remains key.

We expect the flattening trends of H214 to persist through 2015. In the US we expect rising front-end rates increasingly to drive this trend. Meanwhile in Europe and Japan we expect to see a persistent bid for duration, even with 10-year Bunds and Japanese Government Bonds (JGBs) at 65 bps and 35 bps, respectively. In part

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Photograph © CYCLONEPROJECT /Dollarphotoclub.com, supplied February 2015.

this reflects our expectations for continued monetary easing, but also our view that policy measures, at least in Europe, may fall some way short off what is needed to reverse deflationary fears.

As we enter 2015, we expect global overcapacity and stimulus to continue to hold down bond yields. Meanwhile, US equities remain underpinned by an increasingly powerful recovery that will likely elicit a Fed tightening later in 2015. Our conviction views are thus an overweight to US equity, a modest overweight to duration expressed through U.S. yield curve flatteners, and an overweight to Japanese stocks where the Bank of Japan (BoJ) is “all-in.” By contrast, we are increasingly cautious on credit and emerging market (EM) debt, where the ravages of the move in oil will likely lead to higher default risk. We remain underweight commodities, United Kingdom (UK) and EM equity, and Pound Sterling (GBP).

We believe that our central 2015 themes of a continued but gradual re-acceleration of the US economy, the start of Fed rate hikes, and rather uneven global growth will combine in the manifestation of a longer but flatter business cycle. Our asset allocation views are governed by this economic thesis but we are mindful of

the risks to this view.

To the downside, an over-zealous pace of Fed rate hikes could snuff out the nascent recovery and starve the world economy of liquidity. Equally a currency precipitated EM crisis, or the failure of Japan’s Abenomics experiment could prompt a swift decline in risk appetite.

We believe we are at the beginning of a dollar bull market, which has historically lasted seven to eight years.

Meanwhile to the upside, a broadening out of the U.S. recovery around the world, a smooth and successful rebalancing in China, or permanent removal of the “secular stagnation” risks would likely mean a sharp increase in risk appetite.

On balance, we see the global economy, led by the US, finally moving into mid-cycle—a backdrop that should remain generally supportive for risk taking. There will be bumps along the road and political risk will feature highly on the agenda for the next 12 months.

So what does this mean for investors – simply put, this is not a great rotation but the great diversification. Bond yields may be compressed, but there is value in credit as a carry asset, and bonds will always have a place in a balanced portfolio. As highlighted within our Long-Term Capital Market Return Assumptions* our central case expectations for asset class returns, volatilities and correlations over the next 10-15 years, and basis of our asset allocation for many client portfolios - UK equities will be weak, emerging markets is not cheap enough and 6% return for institutional investors is the new 8%. As a result, going forward diversification across asset classes, duration and geographies needs to be the new norm. n

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IN THE MARKETS

China now largest recipient of FDI inflows China has overtaken the US as the top destination for foreign direct investment (FDI), for the first time since 2003. In 2014, global foreign direct investment (FDI) inflows declined by 8% to an estimated $1.26tr, due to fragility of the global economy, policy uncertainty and geopolitical risks. Last year, foreign firms invested $128bn (£84,8bn) in China, and $86bn in the US. A large divestment in the United States also reduced the global level of FDI flows. Might it change this year?

A

CCORDING TO THE latest figures from the United Nations Conference on Trade and Development (UNCTAD), FDI flows to developed countries dropped by 14% to an estimated $511bn, significantly affected by a large divestment in the United States. FDI flows to the European Union (EU) reached an estimated $267 billion; this represents a 13% increase on 2013, but is still only onethird of the 2007 peak.

Flows to transition economies more than halved to $45bn as regional conflict, sanctions on the Russian Federation, and negative growth prospects deterred foreign investors (especially from developed countries) from investing in the region.

Nonetheless, developing economies witnessed a substantial increase in FDI inflows to reach a new high of more than $700bn, 4% higher than 2013, with a global share of 56%. At the regional level, flows to developing Asia were up, those to Africa remained flat, while FDI to Latin America declined.

In 2014, China, with an increase of 3%, became the world's largest recipient of FDI. Last year, China drew a record $119.6bn in foreign investment, while outbound investment grew 14.1% to a new high of $102.9bn. In particular, the growth in China's foreign investment has particularly benefitted the services sector, according to recent data from the Ministry of Commerce, as investments in manufacturing have slowed. Foreign direct investment in the mainland grew in January this year at its strongest pace in nearly

Photograph © pogonici /Dollarphotoclub.com, supplied February 2015.

four years, surging 29.4% on a comparison with January 2013, to $13.9bn.

Overall, foreign direct investment in the mainland rose by 4.5%, compared with December, the highest monthly total since June last year.

The top 10 investors, led by Hong Kong, South Korea, Singapore, Taiwan and Japan, made up for 96.5% of mainland China's foreign direct investment last month. Investment in China’s services sector touched $9.2bn, up 45.1% from a year earlier and accounting for 66% of total foreign investment inflows over the month. In comparison, the mainland's outbound direct investment totalled $10.2bn in January, up 40.6% from a year earlier, the ministry said.

The United States did not fare so well and fell to the 3rd largest host country with almost a third of its reported investment inflow levels in 2013, and now ranks behind China and Hong Kong. Among the top five FDI recipients in the world, four are developing economies.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

Cross-border mergers and acquisitions (M&A) also rose, by a substantial 19%, driven mainly by restructuring deals.

Announced Greenfield investment projects rose by 3% in 2014.

However, UNCTAD cautions too much excitement around these figures and avers that a solid FDI rise remains distant. A subdued global economic outlook, volatility in currency and commodity markets and elevated geopolitical risks will negatively influence direct investment flows.

On the other hand, the strengthening of economic growth in the United States, the demand-boosting effects of lower oil prices and proactive monetary policy in the Eurozone, coupled with increased liberalization and promotion measures, will favourably affect FDI flows. In fact, according to the agency, globally, foreign investment fell by 8% to a total of $1.26tn in 2014, the second lowest level since the start of the financial crisis, partly due to the "fragility" of the global economy last year amid rising geopolitical risks. Even so, the UN agency says the strengthening of the US economy and the pick-up in demand, helped by lower oil prices could favourably affect foreign investment this year.

LATVIAN FDI UP 2.9%: Latvian businesses received €7.259bn euros in foreign direct investment (FDI) in 2014, up 2.9% from a year before, according to Lursoft business database provider in late January.

The largest investments were made in companies based in the Latvian capital city of Riga, the central Latvian town of Jelgava and the south-western port city of Liepaja.

Some 4,824 companies registered in Riga report received investments from overseas. The value of FDI grew by €119.31m in Riga, €28.487m in Jelgava and €21.03m in Liepaja last year.

The largest FDI transaction (in Riga) in the country last year was valued at €104.536m invested by SPI Regional Business Unit in the share capital of newly-registered Amber Beverage Group.

Also, Estonian builder Merko Ehitus invested €62.177m in its Latvian subsidiary, Merko Investments. n

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IN THE MARKET US FED SETS OUT NEW PAYMENTS ROADMAP

Photograph © sakkmesterke /Dollarphotoclub.com, supplied February 2015.

The move to real time payments in the US takes a step forward The Federal Reserve has described its roadmap to overhaul the US payments system, which includes plans for faster settlement in all payment categories and near real time settlement for peer to peer payments. The announcement is the latest step in an initiative begun in 2012. The Federal Reserve’s end-to-end vision encompasses the full payment chain from the point of origination to the point of receipt, including payment notification, reconciliation and interbank settlement.

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HE US CENTRAL bank has spent the intervening years to engage with stakeholders in the US payments system (including banks, credit unions, software vendors, payment processors, government agencies, trade associations and consumer organizations and corporations large and small). The central bank says it has no plans, at this point, to mandate rules for faster payments, but instead wants to harness the private sector to implement its recommendations, and develop the technology required ensure

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real time payments are secure.

Following an extended consultation period, which included sponsored qualitative and quantitative end-user research to study the meaning and importance of payment speed and other payment attributes to consumers and businesses, the Fed reports that over 75% of participants agreed that the following attributes would be important in a (near) real-time payments system. Participation must be ubiquitous (in other words, everyone has to be involved); senders do not need to know

the bank account number of the recipient, confirmation of good funds is made at the initiation of the payment; sender and receiver receive timely notification that the payment has been made and funds are debited from the payer and made available in near-real time to the payee However, several commenters asserted that (near) real-time payments should be pursued only if a clear business case exists and is supported by demonstrated enduser needs in targeted use cases. Also, some commenters noted that only certain elements of payments need to be faster (such as confirmation of good funds, notification of payment status, posting to the payer and payee) and that the specifics will depend on the circumstances surrounding the payment. Some commenters also suggested that the speed of interbank settlement should be more explicitly addressed in this desired outcome.

The Fed then sponsored more research designed to refine its design of an optimal system. Studies covered issues such as the demand for particular payment attributes across different use cases; (estimates of the number of payments that are likely to benefit from and migrate to a faster payments solution; and alternative approaches to improve the speed of US payments, including a (near) realtime retail payment system.

The central bank says it learned that payment speed is important to both consumers and businesses, and faster payments features are generally preferred to slower ones. “The faster payments analysis demonstrated that increased payment speed would initially benefit at least 29bn transactions per year, which is 12%of the total for the country.

Additionally, Fed staff said they see opportunities for expanding the National Settlement Service, which allows private businesses, such as financial institutions, to exchange and settle transactions through master accounts held at Federal Reserve banks. These net settlement arrangements allow businesses to batch settle wires and ACH transactions throughout the day between 7:30 a.m. and 5:30 p.m. ET. Currently, approxi-

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mately 17 NSS arrangements have been established by financial-market utilities, check clearinghouse associations and automated clearinghouse networks.

By the end of 2016, the Fed plans to offer this type of net settlement on a 24/7 basis, essentially making NSS transactions real-time.

In a 58-page roadmap report, called Strategies for Improving the US Payment System, the Fed calls for establishing a task force that will advise the Fed about how to reduce payments fraud while also advancing resiliency of the payment system.

Payments security is a big worry for the industry, the report notes, pointing out that industry input collected over the last 18 months highlighted the need for the development of a fraud database. The Fed also notes that not all security and fraud concerns have yet been fleshed out, and that the security gaps noted in its report do not reflect a comprehensive list; more input from the industry is needed.

"Many [survey participants] suggested that the industry work together to develop a coordinated fraud database and to enhance other fraud information services," the report states. "Many also advocated for the development and adoption of standards for user and device authentication, tokenization, dynamic credentialing (like EMV) and encryption - especially if a (near) real-time payment solution is developed and implemented. Many believe consumers need better education and incentives to motivate them to make fraudreducing payment choices."

The Fed also plans to launch a task force that will focus on best ways to implement faster payment capabilities through collaboration with the industry and consumers, the report notes.

To begin the next phase of industry engagement, Esther George, president of the Federal Reserve Bank of Kansas City and a member of the Federal Reserve's Financial Services Policy Committee, and Federal Reserve Board Governor Jerome H. Powell, who will co-chair the initiative's oversight committee, are hosting teleseminars in early February to present an overview of the strategies. n

Italy: Reforms open new prospects for growth and jobs says OECD Changes to Italy’s political and institutional systems are crucial to ensuring the success of ambitious reforms currently underway to boost economic growth and raise living standards, according to a new OECD report. In its latest survey, the OECD estimates that if fully implemented, reforms introduced in Italy, should raise GDP by an additional 6% over ten years. However, the report adds that to achieve this, full and effective implementation of the reforms is necessary.

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ARTICULARLY IMPORTANT IN the steps required to revitalise the Italian economy are plans to improve the structure of parliament and the division of responsibility between central and regional governments - due to be completed this year, says the OECD. Political reform will ensure more efficient law-making and avoid delays in implementation and also ensure that future, necessary reforms, will have a better chance to be approved.

Presenting the report in Rome with Italian Finance Minister Pier Carlo Padoan; Labour and Social Policies minister Giuliano Poletti and OECD Secretary-General Angel Gurría told journalists. “Italy is progressing on an unprecedented path of reform, that will not only boost growth and employment, but that, being a core country, will also bring confidence at the systemic, European level. Strong political courage has been necessary to advance this agenda. The Italian government should continue with this determination to complete the work.

The reforms will also enable more resources to be directed to vital areas such as education, a fairer social safety net, improved support for job seekers and key infrastructure investment.”

The Jobs Act, adopted in December 2014, aims to rationalise employment protection, expand active labour market policies, make social protection more effective and boost women’s participation in the workforce. Full and effective implementation of the Jobs Act would

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further boost growth and employment.

They will also help overcome bottlenecks in job creation. The OECD has stressed that the reformed standard labour contract for new hires, with employment protection rising with job tenure, needs to be fully implemented and complemented with further improvements foreseen in the Act. Flexible hours, improved policy on parental leave and affordable, good quality child care should be introduced to encourage more women into the workforce.

Labour market reforms will improve Italy’s low productivity growth and will also help potentially high-growth, productive firms to overcome barriers to their development. Additional efforts should also be made to improve the skills of people that often do not match the jobs available.

In product markets, the report calls for stronger action to encourage competition into local public services and to continue to lower barriers to entry into the regulated professions and retail trade.

Alongside improving prospects for growth, Italy has made major efforts to reduce its deficit with the result that the debt burden should begin to decline next year, the report says. Fiscal plans need to be followed through and a tight rein kept on expenditure. Work is needed to improve value for money in public expenditure, with better transparency and effective action on corruption. Tax reform should include reassessing the wide array of special tax rates and exemptions. n

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EUROPE REPORT CAN THE EU ACHIEVE CAPITAL MARKETS UNION?

Jonathan Hill, EU Commissioner for Financial Stability, Financial Services and Capital Markets Union. Photograph kindly supplied by the European Commission, February 2015.

Redrawing Europe’s funding landscape

In a phalanx of related initiatives, the European Commission has now formally launched its landmark project to unlock funding for Europe’s businesses and to boost growth in the European Union with the creation of a true single market for capital, which it terms Capital Market Union (CMU) by 2019. How have investors responded to the initiative? What do they think needs to be done? Is it all possible?

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HE DIRECTION WE need to take is clear: to build a single market for capital from the bottom up, identifying barriers and knocking them down one by one. Capital Markets Union is about unlocking liquidity that is abundant, but currently frozen, and putting it to work in support of Europe's businesses, and particularly SMEs,” says EU Commissioner Jonathan Hill, responsible for Financial Stability, Financial Services and Capital Markets Union.“The free flow of capital was one of the fundamental principles on which the EU was built. More than fifty years on from the Treaty of Rome, let us seize that opportunity to turn that vision into reality.”

Succinctly, Hill says he is tasked with linking investors, savers and growth. The story is one that the European Union is now moving ahead with a series of initiatives that both create a seamless capital

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market, but which builds on the investment initiative outlined last year by EU president Juncker.

In support of the initiative, the European Commission has launched a three-month consultation round, known as a Green Paper, the outcome of which will shape a specific action plan to help unlock non-bank funding. The purpose of the Green Paper on the Capital Markets Union is to kick-start a debate across the EU over the possible measures needed to create a true single market for capital. Additionally, two complementary consultations on 'high-quality' securitisation and the prospectus directive are also being launched today.

The Commission is seeking feedback from the European Parliament and the Council, other EU institutions, national parliaments, businesses, the financial sector and all those interested, who are invited to

submit their contributions by May 13th.

On the basis of the outcome of this consultation, the Commission says it will identify the actions that are necessary to improve access to finance for all businesses and infrastructure projects across Europe; help SMEs raise finance as easily as large companies; create a single market for capital by removing barriers to crossborder investments; and diversify the funding of the economy and reduce the cost of raising capital.

The Green Paper identifies a number of tenets, which the EC says must underpin CMU. It is looking to maximise job creation and growth; create a single market for capital by removing barriers to cross-border investment, be supported by a single rulebook for financial services that is effective and enforceable; enshrine investor protections and help increase European competitiveness and its attrac-

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tiveness to foreign capital.

In the build up to this launch, the EC issued an Investment Plan for Europe document last November which highlighted some measures that can be adopted in the short term, including the implementation of European Long-term Investment Funds (ELTIF) regulation, what it deems 'high-quality' securitisation, standardised credit information on SMEs, private placement and a review of the Prospectus Directive, which aims to streamline the listings/issuance process, while ensuring effective investor protection. A key focus will be to reduce the administrative hoops through which companies have to jump. The consultation will, among other things, consider ways to simplify the information included in prospectuses, examine when a prospectus is necessary and when it is not and how to streamline the approval process.

The EC is also looking to introduce an EU-wide initiative on 'high-quality' securitisation that will ensure high standards of process, legal certainty and comparability across securitisation instruments through a higher degree of standardisation of products. This would notably increase the transparency, consistency and availability of key information for investors, including in the area of SME loans, and promote increased liquidity. This should facilitate issuance of securitised products, and allow institutional investors to perform due diligence on products that match their asset diversification, return and duration needs.

The Green Paper also seeks views on how to overcome other obstacles to the efficient functioning of markets in the medium- to long-term, including how to reduce the costs of setting up and marketing investment funds across the EU; how to further develop venture capital and private equity; whether targeted measures in the areas of company, insolvency and securities laws as well as taxation could materially contribute to CMU; and the treatment of covered bonds, with a specific consultation in 2015 on a possible EU framework.

“These are areas where the need for progress is widely recognised with

potential to bring early benefits,”says Hill.

There’s clearly something for everyone in the Green Paper. “We're pleased to see that the green paper on the Capital Markets Union highlights the need for an improved ecosystem for SMEs, in order to further enhance European growth. It is our understanding that the paper focuses on removing any legal or other obstacles to an integrated Capital Markets Union. We'd like to underline the need for ensuring that local financial markets and ecosystems work efficiently, adapted to the specific challenges of SMEs in all corners of Europe”.

There is also a need for adequate incentives to foster investments, but also to simplify the life of listed companies,” comments Magnus Billing, senior vice president at Nasdaq: "In the Nordics we've accomplished something to be proud of. With the work in our IPO Task Forces we've focused on SMEs since that is where future growth has been identified. We've created a good infrastructure with our growth market First North where smaller companies can mature as listed firms. 2014 was a record year for IPOs, and the start of 2015 has been even better,” he adds.

The EC holds that the current environment is tough for businesses that remain heavily reliant on banks and relatively less on capital markets. The opposite is true in other parts of the world, states Hill.

One example of the opportunities the EC is fond is citing in any discussion about the CME is that if EU venture capital markets were as deep as the US, as much as €90bn euro more in funds would have been available to companies between 2008 and 2013.

“Banks will always have a major role in financing companies, but new sources of finance are needed too and Lord Hill’s plan rightly addresses this need in straightforward and practical steps. One of the reasons why the American economy recovered from the recession faster than Europe was that it had an active capital market to help provide finance for businesses at the time when its banks were under strain. In the US banks provide only 20% of business

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finance while in Europe this figure is 70%,” says Chris Cummings, chief executive at TheCityUK. With the CMU, the Commission also wants to clear obstacles that are preventing those who need financing from reaching investors and make the system for channelling those funds – the investment chain – as efficient as possible. "Capital Markets Union is the first structural initiative that the Commission puts forward under the investment plan. It will contribute to ensuring that the investment plan is more than a one-off push and has a durable positive impact on economic conditions in Europe,” explains European Commission vice-president Jyrki Katainen, responsible for Jobs, Growth, Investment and Competitiveness.

While some asset management firms, such as BlackRock have broadly welcomed the initiative, the thinking seems to be that the overall emphasis should be on creating conditions to stimulate investment across the region.

For its part, BlackRock states that it believes the focus of policymakers should be on connecting asset owners - individual savers and institutional investors such as pension funds and insurance companies - with the users of capital, such as companies and infrastructure projects. “It is our view that the more investor-centric the regulation, the greater the potential flows of capital that savers and investors will be willing to invest to their own and the economy’s benefit.

Many of the recommendations in the roadmap we set out will be met by pieces of legislation that are either in the implementation phase, or currently under discussion. However, there are some areas where further action from policymakers could be impactful, [including] putting the investor at the heart of the Capital Markets Union reforms – as investors are the ‘Capital’ in a ‘Capital Markets Union’.

Policymakers should look closely at how and why investors allocate their capital, develop an understanding of their specific investment needs, and ensure that their capital is treated fairly when invested in capital markets. Perhaps most important is the need for a coherent regulatory framework – certainty in this regard is

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one of the fundamental factors for investors in deciding how to commit capital, and the longer-term the holding period for the asset, the more important certainty becomes”.

BlackRock outlines what it says are the top five policy requirements: a ‘digital investment passport’ and minimum standards of financial guidance to democratise advice and guidance to European savers; a study on standardisation of certain aspects of corporate bond issues over €500m; a consistent, investorcentric, securitisation framework and appropriate risk weights in prudential rules; an ‘asset passport’ that would level the playing field between bank and non-bank private finance to encourage the take up of ELTIFs and the establishment of a market for investment in bank whole loans to increase the availability of bank capital for lending.

According to Richard Metcalfe, director of Regulatory Affairs at The Investment Association,“There is a big opportunity with CMU to bring the Single Market to retail investors and The Investment Association supports the Commission’s proposals insofar as they do that. Wholesale markets already have many measures for efficiency and risk reduction but the potential benefits of a ‘deep’, retail CMU are enormous, in terms of a virtuous cycle of investment driving growth, leading to better financial security for citizens over their lifetimes and a vibrant economy” Metcalfe says that ideally the EU “will follow the logic of the UCITS legislation and ‘complete’ the Single Market in panEuropean collective investment. That may require imagination, exploring how digital options could improve product availability and support investor decision-making. It certainly needs a consistent approach to investor protection, which does not currently operate to the same high standard for all investment products. It should also not ignore legal risks, including those inherent in cross-border chains of ownership.

“Of course, there are still issues in wholesale markets and The Investment Association intends to put forward proposals regarding the efficiency of the

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prospectus process as well as the role, and form, of private placements and securitisation. These will be important in ensuring that systemically benign finance can complement existing funding channels,” he adds.

Following the public consultation, the Commission will adopt an Action Plan this summer setting out its roadmap and timeline for putting in place the building blocks of a Capital Markets Union by 2019.

At the same time, Europe’s European finance ministers have ratified the suggestion that European Investment Bank Group will manage the European Fund for Strategic Investments (EFSI) within the EIB under the Investment Plan for Europe (the Juncker Plan) announced last November.

The fund, backed by the EU Bank and the European Commission, is intended to support €315bn of new investment across Europe over the next three years.

An extraordinary meeting of the EIB’s Board of Governors also held in midFebruary issued a statement recognising “the significant role of Europe’s long-term lending institution in supporting crucial investment during the [recent financial] crisis. Dr Werner Hoyer, EIB Group President, announced that overall EIB lending activity in 2014 amounted to nearly €77bn, with an additional €3.3bn granted by the European Investment Fund (EIF) to SMEs. How this will dovetail into Commissioner Hill’s CMU project that aims to mobilise capital more effectively to European corporations and SMEs has not yet been clarified.

For the time being, the EIB has been upping the ante in its efforts to mobilise additional capital across the region.

President Hoyer has reported that the EU Bank will reach its target for additional lending under the capital increase granted to the EU Bank by the Member States for the period 2013-2015 in the spring of this year, some six months earlier than anticipated. In addition to its regular lending activity, the €10bn capital increase will allow the EU Bank to finance projects worth around €180bn in total, well in advance of the end-of-the-year deadline.

“Investment in Europe continues to face

unprecedented challenges. The new Investment Plan builds upon the EIB’s unique lending and advisory experience, and has the potential to mobilise private investment crucial for Europe’s competitiveness” says Jeroen Dijsselbloem, Minister of Finance of the Netherlands and Chairman of the EIB’s Board of Governors.

“The EU Bank has worked closely with its shareholders, the 28 EU Member States, to make a strong contribution towards dealing with the worst economic and financial crisis in a generation. We have delivered on our commitments. In partnership with the EU Member States and the EU Commission, we can successfully tackle the current market failure in risk bearing and get investment going again in Europe. We take heart from the confidence expressed by the Board of Governors in the EU Bank. Making Europe competitive again in the globalised economy requires a joint effort. Structural reforms and regulatory simplification are as important as the new fund. The EU Bank is ready to play its part, and will now concentrate on launching the first projects under the Investment Plan already in the coming months,”adds Hoyer.

What is clear is the EU is now embarked on a substantive program of change. Long term questions remain about how effectively the various agencies of the Union can come together to help facilitate a more unified and efficient capital market. The United States is obviously providing some kind of template for the EU’s vision. Can it, however, achieve a deepening and widening of the corporate funding market in Europe across a broad spectrum of borrowers between now and 2019? It is a big ask perhaps.

Moreover, it will be implemented at a time of immense market change. How will the natural evolution of the financial and investment markets, as a function of social change, technology and innovation in distribution channels impact on the final outcome of CMU? Will it incorporate crowdfunding, new currencies such as Bitcoins, and the new, emerging digital communications/transmissions payment and technologies? n

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LEGAL

NZ Super Fund takes legal action over Oak Finance loan The New Zealand Superannuation Fund says it is taking legal action against the Bank of Portugal in relation to the transfer of Oak Finance loan obligations from Portugal’s Novo Banco to Banco Espírito Santo. The fund, which has a $150m exposure to the loan, wants to overturn a December 2014 decision by the central bank to retrospectively return the loan to Banco Espírito Santo (BES) after having transferred it, along with other senior debt obligations, to the ‘good bank’ known as Novo Banco.

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OLDMAN SACHS ARRANGED a loan by Oak Finance to Portugal’s BES on July 3rd last year. Oak Finance financed the loan by issuing bonds to a range of global institutional investors. However, on July 24th BES’s executive chairman and chief executive Ricardo Salgado was detained for questioning and released on €3m bail on suspicion of fraud, money-laundering and document falsification. The bank was found to be in financial difficulties and there had been irregularities in its financial accounts.

In August 2014, the Bank of Portugal decided to reorganise BES and transfer its operations and assets, including all senior unsecured debt, to a new statesupported ‘good’ bank called Novo Banco.

However, soon afterwards, the Bank of Portugal then looks to have decided that any party or affiliate with an interaction with BES would remain in BES and not get the benefit of the bailout and transfer to the state-supported Novo Banco. The central bank set a threshold for being an affiliate as being those that held a 2% holding in BES in the two years preceding transfer of obligations to Novo Banco and passed a rule to this effect on August 1st, with retroactive effect, so that former management and controlling shareholders in BES could not make claims against Novo Banco.

Goldman Sachs disclosed a 2% interest in BES in July 2014. However, the NZ Superannuation fund holds that the Oak Finance loan is not caught by this 2% rule.

This is because “it is Oak Finance, not Goldman Sachs, which is the lender under this loan. … Goldman’s equity shareholding in BES is not relevant to the decision as to whether the Oak Finance loan was properly transferred to Novo Banco. Oak

Adrian Orr, chief executive officer, New Zealand Superannuation Fund. Photograph supplied by NZ Superannuation Fund, February 2015.

Finance’s only major asset was a loan to BES and it owned no shares in BES,”notes the fund in a formal statement.

On December 22nd the Bank of Portugal announced that it had decided to retransfer the Oak Finance loan from Novo Banco to BES with retrospective effect. This decision, which was reaffirmed by the Bank of Portugal on February 18th is based, says the fund, on “a misunderstanding of both the nature of the Oak Finance loan and the application of the 2% equity holding rule”. “Oak Finance [is] an independent entity from Goldman Sachs International, says the fund chief executive Adrian Orr. “We understand that at no point did Goldman Sachs hold a participatory interest in more than 2% of Banco Espírito Santo’s shares.” On that basis, Orr holds: “Legally, the loan arranger’s shareholding in Banco Espírito Santo should not be the basis for treating the Oak Finance loan as related party lending.”

Orr says the decision is “very disappointing given [the central bank’s] written assurances that senior debts, such as the Oak Finance loan, had moved from Banco Espírito Santo to Novo Banco” and adds that it notes that “Novo Banco continues to have the benefit of the money that we

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lent. It will also be of considerable concern to any investor that the Bank of Portugal has not treated all senior debt holders equally. We understand that holders of senior bonds arranged and underwritten by at least one other financial institution have remained with Novo Banco when, unlike the position with the Oak Finance loan, the bonds were subscribed by a related party of a substantial shareholder in Banco Espírito Santo.”

Orr concedes the dispute could take some time to resolve.“While bond failures are not uncommon in the investment world, the circumstances of this case are highly unusual. First, we have been treated unequally and unlawfully. Second, our default insurance appears to have been inadvertently rendered ineffective due to the retrospective decision. We have a very strong legal case and a high level of confidence of success.”

Orr says the fund does not ascribe any value to the loan today. “Ultimately the value of the loan depends on the outcome of the court case as it depends on whether the loan rests with BES or Novo Banco,” states the fund in an official statement.

The fund had purchased credit protection insurance on BES and says that the International Swaps and Derivatives Association on August 8th 2014 determined that a succession event had occurred. As a result, the Fund’s credit protection therefore moved to Novo Banco in the same way that the Oak Finance bonds did. If the Bank of Portugal’s decision to move the Oak Finance loan from Novo Banco to Banco Espírito Santo is upheld, “it would be likely to make our credit insurance ineffective. The insurance follows the majority of senior debt, which remains in Novo Banco,”says the fund in an addendum statement. n

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TRADING REPORT TOWARDS A UNIFIED FIELD THEORY OF TRADING COSTS & BEST EXECUTION?

Photograph © kimihito /Dollarphotoclub.com, supplied February 2015.

The Theory of Everything and TCA Hollywood movie The Theory of Everything has its lead character Stephen Hawking laying out his vision of a single equation that explains all physical aspects of the universe. The scientist explains in lay terms the two broad areas of theoretical physics that have emerged over the last century – general relativity (as famously developed by Einstein) and quantum field theory (analysing the properties and effects of sub-atomic particles) – and the challenges of integrating both approaches in one overarching set of theories. One approach looks at very broad aspects of the universe and space and time, while the other focuses on infinitesimally small objects as the basis for broader theories and interpretation. Actually, writes Michael Sparks, director of analytical products and research at ITG, this rarefied scientific dynamic has echoes in the more prosaic world of Transaction Cost Analysis (TCA) in financial markets, where the availability of more granular data coupled with pressure from regulators has combined to drive a whole new wave of research and analysis.

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YPICALLY THE ANALYSIS of trading costs has focused on the big picture, identifying the implicit costs incurred in the investment process.

Now though a much more granular level of analysis is also both possible and

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required. There is a risk that these latest tools may be thought by some to be able to answer all the questions on trading costs and best execution. This is clearly not the case, and a combination of methods of analysis is vital.

Traditionally TCA was conducted at a relatively high level, focusing on the outcome of orders and looking at the implicit costs incurred by price movements caused by market impact or by delays in the execution process (as

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choice of those venues and their execution strategies to achieve best execution. While more traditional approaches to TCA tended to look at the context of the investment process and at high level trading data, the new requirements entail much more precision and forensic analysis of the tactics used at the most granular levels in terms of sizes, timing and venues of trades.

distinct from explicit costs such as commissions). This implementation shortfall can be calculated and analysed to determine where and when inefficiencies occur in the investment process. Fine tuning can lead to significantly improved investment performance within the context of an underlying process. Most leading institutions continually monitor their TCA data for trends, and aim to identify opportunities to make improvements. If left unaddressed, such hidden costs of trading can and do have a major impact on investment returns and rankings in the performance tables.

Execution strategies

Investment DNA Every institution has an investment process, which forms a sort of investment DNA for everything it does. It is reflected in activities such as portfolio construction, stock selection, decision timing and trading strategies. Some firms are valueoriented and incur relatively low transaction costs, as they are typically trading against the consensus. Others are more event-driven and momentum-oriented; inherently they need to trade more quickly than others, incurring higher impact costs in order to capture as much alpha as possible before others do so.

Similarly some portfolios are made up of many small positions which can be easily and cheaply traded, while others consist of fewer positions which may be highly illiquid, and cannot be readily and quickly traded without severe loss of value.

All of this should be reflected in the approach to TCA which a firm employs, and the metrics which are used to monitor efficiency in achieving optimal outcomes. There is no one-size-fits-all in this respect. There have been calls in some quarters for a standardised approach to TCA. Such thinking should be firmly resisted, given the wide range of needs and types of analysis. The high level analysis must take into account many aspects of the underlying process, since the costs will be highly linked to factors beyond the control of the trader.

However, then a whole new level of complexity was introduced to European financial markets. This reflected a number

Photograph: Michael Sparks, director of analytical products and research at ITG. Photograph supplied February 2015

of developments over the last decade, starting with the fragmentation of trading that resulted from the first MiFID set of regulations in 2007. This led to several new trading venues emerging in Europe, reducing the market share of the traditional exchanges and making the trading landscape considerably more complex. At the same time new generations of trading systems allowed asset managers to record and analyse details of every single fill that is generated by their orders. With algorithms often slicing a large order up into very small pieces, this can literally mean thousands of separate executions for just one order. The final element of complexity – albeit a welcome response to the need for better information - has been the increased use of data tags to track and report information on these individual fills.

Together these factors have driven a rapid evolution in analytical approaches which have recently taken on added urgency as a result of the publication of the FCA’s Thematic Review on Best Execution and the final draft of the proposed MiFID II regulations. These stipulate that investors must not just monitor the venues on which their trades are being executed, but require them to describe the steps they undertake in the

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The linking of venues to execution strategies is more than coincidental, and indeed is crucial. The way in which an algo is designed to route an order is inextricably linked to the execution strategy selected.

This may for instance be a fixed participation strategy, or liquidity-seeking, or aimed at trading only in the so-called dark pools or crossing networks. Each strategy will tend to execute in different venues, or in different sequences, or in different volumes at different times.

Hence it is essential for the latest applications of TCA to link the analysis of venues to that of execution strategies as it drills down into these details.

With this new granularity of data, new metrics also come into play. Looking at simple average price or implementation shortfall calculations is not necessarily as relevant in determining the efficacy of one venue versus another. Shorter term statistics on reversion or spread capture may be more revealing. Similarly the number and sequence of venues used can be analysed (basically the more venues used, the higher the overall cost), as can the costs or benefits of trading in lit or dark venues (with dark in general achieving better outcomes, particularly in larger sized trades). Traders now regularly use such data to monitor the ways in which their brokers execute their orders, for instance in the differing patterns of behaviour of smart order routers or algo strategies. And using this data it is also possible to predict what is likely to be the most efficient way to execute a given type of order. As with more traditional approaches to TCA, the post-trade data can become a vital input to pre-trade decision making. n

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EGYPT COUNTRY REPORT EGYPT BANKS ON STRUCTURAL REFORMS TO ATTRACT INVESTMENT

Egypt at a tipping point for growth in foreign investment inflows?

Structural reforms have the theme of the government of Abdul Fattah al-Sisi. Elections scheduled to be held in two phases, beginning 22-23 March are the final step of the transitional political roadmap outlined in July 2013, after the overthrow of the Morsi government. Egypt has been without its main chamber of parliament since 2012 after Morsi had transferred its powers to a consultative Shura Council pending fresh elections, but he was ousted before they could be held. Current president Sisi approved a constituencies law in December 2014, creating 567 parliamentary seats, of which 470 will be contested by individual candidates, 120 allocated to party lists and 27 assigned by the president. Sisi hopes the elections will show the government’s commitment to democracy and hope they will bring political and economic stability after the uncertainty caused by the 2011 uprising. Egypt is clearly at a tipping point. What now?

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TRUCTURAL REFORMS HAVE been at the heart of the Sisi administration. The focus continues on reforming the investment environment, rebalancing government finances and reducing state debt. A number of elements have made up the program, including a modest planned investment in infrastructure projects, worth an estimated EGP280bn (around $2bn). The government hopes that political stability will encourage a rebound in foreign direct investment, which it expects will touch $8bn or so in the 2014-2015 financial year.

At a recent press conference with Egyptian premier Ibrahim Mehleb announcing the country’s planned economic summit, which will be held in Sharm ElSheikh in mid-March, he said the summit is an important vehicle for dialogue with the country’s business partners. The roadmap strengthens investor confidence in the Egyptian economy and paves the way for implementation of real and comprehensive economic and social reforms, he stresses, adding: “Egypt is moving steadily toward economic recovery under its roadmap to improve the business climate. Egypt hopes to attract billions in foreign investment over the next four years, which will put Egypt on the right track through comprehensive and sustainable growth of the Egyptian economy.”

He said there will be work on three

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Prime Minister Ibrahim Mehleb announces that Egypt’s economic summit will be held in Sharm El-Sheikh from 13 to 15 March. Photograph kindly provided by the Egyptian Prime Minister’s office, February 2015.

main points leading up to the summit: including direct consultations with international institutions and partners; the effective settlement of investment disputes and formulating clear guidelines covering the rights of the investor and the state; and the third is the establishment of a special committee to review the effectiveness of current legislation in supporting new business development.“The most important aspect of this point is enacting laws that will attract invest-

ments, create more companies, combat corruption, bring the ‘one-stop shop’ investment window into force, fight bureaucracy, and bring about administrative reforms and transparency,” he stressed.

According to Hisham Ezz Al-Arab, Chairman and Managing Director of Commercial International Bank (CIB), Egypt’s largest private sector lender,“The economic DNA of the country is a free-market yet disciplined economy. This is a good time for the government to put the country’s DNA in front of the international investment community. The government has been doing all the right things with the reform program. I think that finally, people think that there is proper leadership in Egypt and that will make it attractive to foreign investors”.

He thinks that the investment in infrastructure in Egypt will pay long term dividends. “Projects such as the widening of the Suez Canal, will have huge implications for the country, with all the attendant downstream investment that will spur, including storage facilities, logistics, improved transportation links. These megaprojects are facilitators of change.”

There have also been steps by local market regulators to simplify listing rules on the Egyptian Stock Exchange (EGX).

The measures have included the release of rules for governing block trading as well as new rules governing the listing

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and trading of exchange traded funds (ETFs) on the exchange.

The Central Bank of Egypt (CBE) has also played an important role in the roadmap. Either by accident or design, it looks to have accepted that the Egyptian pound will gradually depreciate over the course of the year. At the end of January the CBE allowed the pound to depreciate against its de facto peg of $0.15/EGP1.00 to $0.13/EGP1.00 by the end of January.

To underscore the point, in January, the CBE’s Monetary Policy Committee lowered the interest rate for deposits to 8.75% and loans by 50 points 9.75%.

The central bank is also working to other dynamics. It has priced devaluation into the market as foreign exchange reserves have declined to a reported $15.3bn at the end of last year given there is no short term improvement in sources of foreign exchange in the short term, currency depreciation. According to CI Capital research, “The external sector will remain imbalanced with lower official transfers and a widening trade deficit negatively affecting the current account… Eventually, higher FDI and portfolio flows will provide support to minimise the pressure on the country’s external balance”.

A report published by DCode in partnership with EGX, in early February saw devaluation as a positive move to attract investors. The report said it “has been generally welcomed by the business community as it eases speculative pressure on the EGP, boosts the competitiveness of Egyptian exports in both goods and services (tourism in particular) and encourages investors and international financial institutions to consider increasing their investments in Egypt”.

As a paradigm of the change in outlook, the country’s banks are also readying themselves for a shift in focus.

Egyptian banks have highly liquid balance sheets with an aggregate loan to deposit ratio of 41% as of September last year, according to the central bank.

Moreover, asset deployment is expected to shift more in favour of loans than towards government securities amid the recovery in demand that is now expected for longer term corporate credits. n

CIB: THE NEW DASH FOR GROWTH In early February Egypt's stock exchange approved a request by Commercial International Bank (CIB) to raise its capital by EGP2.294bn ($300m). CIB, which is Egypt's largest private sector bank, has reported a 36% rise in fourth quarter net profits compared to the same period last year. Q4 quarter net profit was EGP1.03bn, up from EGP757m in the previous year's fourth quarter. Full-year profit rose 24% year-on-year to EGP3.74bn. FTSE Global Markets spoke to Hisham Ezz Al-Arab about the bank’s near term plans.

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HE COUNTRY'S LARGEST listed bank plans to increase its capital to EGP11.470bn. It will issue 229.4m shares, one bonus share for every four held, at a nominal value of EGP10 per share, according to the Egyptian Stock Exchange (EGX).

For Ezz Al-Arab, the strength to carry on as normal in the midst of apparent chaos is a mindset; and one that he has worked hard to instil in the day to day working culture of CIB “We work hard to align our business culture both with our shareholders and our staff; we look after them as we would a family. He explains that this cohesion has been built up over years and has involved some degree of ruthlessness. “Most failures are down to having the wrong people in place and you are shy of changing them; we have no such qualms at the bank.”

However, he is also a meritocrat: “In 2011 we kept to our promise to keep to full bonuses for all our junior staff; though bonuses paid to higher management naturally went down.”

All business sectors in Egypt were affected by the aftermath of the collapse of former president Hosni Mubarak’s regime, particularly the country’s banking sector, which in recent years has worked hard to improve liquidity, introduce tighter monetary regulations and adopt various reforms, says Ezz Al-Arab. “We work on the basis that we are a partner-

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with our regulator. In part it goes back to our business culture, of striving to do and be the best we can. In part it is because we are a private bank and we have a responsibility to our shareholders, 30% of which are in the US and 35% of which are in Europe and the United Kingdom.

They keep us on our toes.”

However, Ezz Al-Arab puts more fundamental drivers at the bank down to changes in the Egyptian corporate sector.

“After the financial crisis, corporations fundamentally changed the way they dealt with the banks, often opting to raise finance via equity rather than leveraged loans.

Credit demand still remains weak; but we have noticed that in the last three months or so demand for loans is beginning to rise once more, largely because of the growth in infrastructure and real estate projects spending,”he says.

The real estate segment has particular characteristics, he explains.“There has to be a lot of trust between the developer and the buyer and often the projects are financed through advanced payments. CI Capital research underscores Ezz AlArab’s point. The investment bank says that a broad based recovery in capital expenditure is now brewing.“Consolidated sector loans grew by 9% in the first nine months of 2014, attributed to an increase in retail lending and short term corporate loans. The oil and gas and real estate sectors have the lion’s share of the key

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EGYPT COUNTRY REPORT CIB IN EXPANSIVE MODE

Photograph of Hisham Ezz AlArab, Chairman and Managing Director of Commercial International Bank (CIB).

Photograph kindly supplied by CIB, February 2014.

loan deals announced through the second half of 2014.” On the basis of the data collected by the investment bank, these loans were worth a combined EGP38bn.

CI Capital adds: “Accordingly, banks under coverage budget an average increase in loans of 15-20% for 2015, versus a 2009-2011 average of 7%, where growth is expected to be driven by extending credit to infrastructure and energy related projects.”

Although in general terms Egypt remains under-banked (only around 15% of the population have bank accounts); over the last decade the sector has undergone substantial consolidation, and the number of banks has decreased from 57 to 39. Both private and public banks were closed during the 18-day uprising that toppled Mubarak, then closed again for a week due to workers’ protests demanding wage parity. CIB was the exception. Even at the height of the crisis CIB staff came into work to ensure that customer salaries were processed as normal. “We brought in our own security companies, to ensure that people needing cash could get it. The staff came in and secured our buildings over the worst of the crisis; it wasn’t a drill, but one of the best stress tests we could have had.

It showed we could operate in the most uncertain of times. I am proud to say that the staff had the courage to do it. The long

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term result of that time is that the staff have grown in confidence.”

While the crisis has been tough on the bank, the gradual recovery in local confidence as stability has returned, has been beneficial for the bank, concedes Ezz AlArab. Most lending is for mortgages and car loans; with corporate and business lending still a discrete business. “Most of this business is based around payroll and rolls through cards and personal loans,” says Ezz Al-Arab, adding that: “the business was launched back in 2009. After the shutdown, the business came through at expected limits; so we cannot complain.

The corporate side is a very deep culture at the bank and goes back to our Chase Manhattan days. I cannot think of any other bank in the Middle East based on Chase cash flow models.”

The Central Bank of Egypt waded in with support in April last year with a mortgage finance initiative, providing EGB10bn in support of bank lending. Retail banking remains the medium term driver for growth for most Egyptian banks, avers Ezz AlArab, given that it is still relatively underpenetrated, despite a pick up in new retail accounts over the last decade. According to CI Capital, some banks have already budgeted for between 25% and 40% growth in retail loans through 2015 and help overall bank profitability as the

expected decline in treasury yields refocuses the banks on new business development as the primary source of additional revenue.

There are also other considerations weighing on banks. This year the banking segment has also had to work towards adopting Basel requirements which, in practice, means banks have had to adopt broader measures of risk and demonstrate that they adhere to sound risk management practices that are publicly disclosed.

Basel III also solidifies the definition of capital and calls for stronger conditions for managing liquidity.

The Egyptian central bank has required banks to raise their capital to a minimum EGP1bn, either through mergers or share sales since 2012. What this has meant explains Ezz Al-Arab is capital adequacy running at 15%, double that of banks in the United States or Europe. We also run a liquidity ratio of 5%, which has given us the opportunity to grow. The financial strength of the bank surpasses Basel requirements.”

For Ezz Al-Arab, the business of integrating political changes and creating conditions for growth centres around trust: “which must operate at every level of society,” he states.

For the time being CIB is focusing on doing more of the same: “We continue to open new branches in Egypt. Our focus remains on the country, though we have recently opened a representative office in Dubai. We have a threshold in that if we do not think that we can secure a 10% market share in a foreign country, we simply do not leave Egypt, where we still believe there is opportunity to find further growth on the loan book and deposits,” says Ezz Al-Arab.

Ezz Al-Arab, remains optimistic about the long term:“Our focus is Egypt and we are sure that political changes will bring the accountability that the market needs and we believe this will all be in place within the next three to four years. When you are accountable it changes everything; because everything is done properly, by the book and business is about what you know, rather than who you know. That has to be a good thing.” n

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REAL ESTATE

Photograph © kentoh /Dollarphotoclub.com, supplied February 2015.

Can the CMBS market return to pre-2008 levels this year?

Clearly the CMBS market has been disrupted over the last seven or so years; a sea-change felt all the more keenly perhaps because the market looked to have reached a series of peaks in the 2005-2007 period and a comeback of the segment is clearly slower than everyone had hoped for. CMBS issuance in 2014 fell short of early projections by around 10%, according to the Kroll Bond Rating Agency (KBRA). The specialist TREPP database says there has been some $87bn of CMBS issuance last year. What’s the outlook for this year?

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MBS INDUSTRY ANALYSTS TREPP says that commercial real estate lenders, borrowers, and CMBS investors alike are looking at the next three years as a true test of the strength of recovering capital markets in general and CMBS in particular.

There’s much to hold out for, after all CMBS origination levels topped $166bn in 2005, $198bn in 2006 and $228bn in 2007. This three-year period was the only one in which US CMBS loan originations exceeded $100bn.

To do so in 2015 would be significant.

KBRA is not the only house predicting an uptick. Morgan Stanley holds that the CMBS market is moving full speed ahead as commercial real estate prices return to pre-crisis peaks, issuance accelerates, and

underwriting standards loosen. The investment bank recently suggested that 2015 issuance will be $125bn (of which $80bn will consist of conduit and $45bn of single asset/borrower issuance), though the final total could fly as high as $140bn in a“bull case scenario”as credit standards loosen and CMBS market share grows.

Tellingly perhaps, the bank’s bear case projections put the total much lower, at $100bn,“as insurance companies become more competitive for large loans against a backdrop of higher interest rates,” the bank explains in a research note.

KBRA forwards a number of reasons for a potential upturn. In the US, for example, as the economy continues to expand, “real estate fundamentals will remain stable across all of the property

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type segments, many of which will experience flat to modest growth. However, the multifamily and lodging sectors are standouts, having experienced marked gains over the past few years. The performance of these two sectors in many markets is at or above that experienced during the height of the last real estate cycle,” the firm explains.

That level is still way below the peak levels of issuance achieved in the 20052007 period. However, KBRA explains the large amount of longer term loan maturities at that time stemmed from the aggressive underwriting and high property values prevalent in those years. Since most of those loans have a ten-year term (the majority will mature in 2015-2017) analysts, including KBRA, say they will provide an unprecedented opportunity for CMBS conduit loan mortgage brokers to increase their origination volume over the near term.

With 2014 issuance just below $100bn and 2015 forecasts calling for a marginal increase, the CMBS origination engine will have to pick up the pace to digest the wall of maturities, especially in (according to projections) heavy 2016 and 2017 years. Over the next three years, for example, more than $300bn in Conduit CMBS loan balance will mature. That’s more than 2.5 times the amount that matured from 2012 to 2014 says industry data specialist TREPP. Headwinds however include the threat of rising rates, the end of quantitative easing in the United States, and the implementation of new risk retention regulations coming in January 2017. Fed governor Yellen has made clear that she is tired of QE. The question is: how soon will the Fed move to raise rates significantly?

There are also other considerations in play. Joe McBride, a TREPP analyst, for example, notes in various press reports that the non-extension of The Terrorism Risk Insurance Program Reauthorisation Act (TRIPRA) “may change the pricing of single asset loans and deals slightly and push their pricing back,”possibly tapering issuance throughout 2015. [TRIPRA was an act brought in during 2007 to reimburse insurers for 85% of losses

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REAL ESTATE 2015 OUTLOOK FOR CMBS/CRE

certified as terrorism events in order to encourage the industry to operate effectively]. McBride ventures a $105bn estimate for 2015’s CMBS issuance.

That sentiment was recently echoed by Fitch ratings. The ratings agency noted that “the failure of Congress to renew TRIPRA could have repercussions for the insurance industry and segments of the broader economy, particularly commercial real estate, mortgage lending and construction markets in 2015.”

“TRIPRA is an important component of the CMBS market and has become common in many transactions,” Fitch wrote in its report. “If TRIPRA is not renewed it would have a negative impact on ratings of office properties with loans in CMBS single-asset transactions, for example. The lack of TRIPRA could also affect some multi-borrower transactions, if the number and size of the loans lack sufficient coverage, or the risk of terrorism-related losses could not be mitigated by the rest of the pool.”

There are also some concerns around deteriorating credit standards in conduit deals, which could impact through 2015, according to Moody’s. In 2014, the result was higher credit enhancements. Loanto-values rose from an average of 95.4% at year-end 2013 to 101.1% this year, KBRA’s interest-only index increased from 26.9% to 33.2% and debt service coverage declined from 1.78x to 1.63x.

KBRA says it expects the interest only (IO) trend to continue “as the economy continues to expand and rates begin to slowly increase.”

KBRA also reports that the use of proforma underwriting ticked up throughout the past year. “Although the use of the practice was not as blatant as it was during the peak of the last cycle, we observed many instances where originators: averaged contractual rent increases for non-credit tenants through the loan term; included rental income from leases out for signature in total base rent; provided credit to income from master leases; and grew hotel RevPAR above the trailing 12-months,” according to the report. It also notes a number of cases in which “issuers provided credit for specu-

40

lative income growth or reduced expenses that lacked substantive support”.

CRE on more solid ground Corporate advisory firm Deloitte says that the commercial real estate (CRE) industry is on more solid ground than it has been for some time. As with MS, KBRA and others, the advisory firm believes that the US economy continues to improve, although concerns remain in Europe and in some emerging markets. Deloitte reports that investors are generally seeing solid performance and profitability improving across most property types and markets.

Improving economic activity this year should result in better occupancy rates across all major property types. According to Nomura Securities analysts, property prices are also expected to continue to rise, although at a decelerating pace, with future price appreciation likely to rest on increases in net operating income (NOI), rather than tightening cap rates. If this trend continues, transaction volume will likely rise alongside investor confidence, with additional equity flowing into the sector.

Real estate specialists Cushman and Wakefield says that thanks to stronger demand, UK commercial property yields continue to edge downwards now averaging 5.01% across all sectors. This is 50bp down on the year to date and the lowest yields have been since September 2007. Even so, yields still average 57bp more than at the peak of the last cycle and offer a healthy premium to bonds, with prime yields on average 274bp above the ten- year Gilt benchmark, more than twice the long term average.

Downward pressure will continue the firm adds, but in a more selective fashion as different sectors demonstrate their performance potential and encourage investors to be more competitive in their bidding. In the last few months for example, it has been the industrial sector where rental trends have encouraged higher demand in the UK. Cushman and Wakefield’s regional offices have also seen a notable turnaround on the occupier side and going forward other sectors will feature as corporate investment spurs demand (see

FTSE GM passim). Interest will also increase for higher yield and longer lease property if quantitative easing in the eurozone reaches its full potential – which would soak up income investment opportunities, displacing demand towards other markets including the UK. At the same time, investor buying power is still being boosted by the improving availability of finance, with high competition keeping lending margins under pressure, particularly at the prime end of the market.

Investment supply meanwhile has shown some signs of improving, partly opportunistically as some owners test the market ahead of the busy and pressurised year-end period. In many cases, however, this increase in supply is from a low base and still fails to match demand.

Loan sales will remain an important source of additional product to bridge part of this gap, with €22.7bn of UK CRE loan and REO sales so far in 2014, more than double the figure seen in the UK in 2013 as a whole. What is more, secondary sales are also now increasing as earlier loan and portfolio purchasers start to follow through on their business plan with a more active sales programme.

The outlook for arrangers What has this meant for arrangers? In Europe specifically, much will now depend on the European Central Bank (ECB). Globally though, the impact of Basel III/CRVD IV regulations, cannot be discounted and is becoming increasingly marked in the investor make-up of the global debt capital markets.

Scope Ratings and Moody’s see much wider differentiation of credit risks than the credit spreads would indicate. Investors will therefore need more transparency and information to take investment decisions.

This will be a key theme for both the securitisation and covered bond markets in 2015. While, all things being equal, the credit outlook for European structured finance and covered bonds is generally positive in 2015, spread compression may erode general risk awareness, making it more difficult for investors to discriminate between transactions. Even so, RMBS, auto

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and SME CLOs will likely dominate the agenda this year.

With this in mind, lender appetite to provide development finance for residential led schemes has rebounded strongly, with a number of bank and non-bank lenders active. However, in Europe, there are still very few lenders providing commercial development finance which, when available, is typically subject to a minimum level of pre-lets.

As with commercial investment finance, developers in the UK have increasing access to competitively priced debt for a range of gearing levels (up to 100% TLC), asset classes and geographies. Prior to the credit crisis some 95% of real estate related finance was provided by banks – but these days some 25% of lending is from non-bank institutions.

US investment banks, German banks, and UK banks dominate in Europe, which still retain the appetite and ability to underwrite single large tickets and hold exposure on their balance sheets.

Equally, last year saw the closing of a number of debt funds targeting Europe, accounting for as much as 50% of the equity raised globally.

Power is also shifting back to well capitalised borrowers and so pricing is ultracompetitive, with gearing levels up to 85% LTV and with tenures ranging from eight months to 25 years. Insurance companies are increasingly involved in longer term tenures, no doubt as a strategic investment as gilt rates remain ridiculously low.

In the UK, senior loans on prime commercial real estate has narrowed from 200-300 basis points (bps) to 125-200 bps. European CMBS’s big benchmark deal of late was the Westfield Stratford City Finance issue. The deal was priced at 101bps over 3 month Libor, well inside the banking market for UK commercial real estate (see FTSE GM website: www.ftseglobalmarkets.com passim).

Most significant though is the return of the syndicated loans market and the arrival of whole-loan debt providers able to write single tickets as large as £100m, which should provide a much welcome fillip to this market. n

Sub-Saharan African real estate: a growing asset class?

Is the African real estate segment taking off? Momentum GIM, is launching a $250m sub-Saharan real estate fund by June this year and says that a $50m first tranche has now been finalised.

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OMENTUM GIM, IN conjunction with Eris Property Group, has successfully closed the first tranche of its African Real Estate Fund with $50m of institutional, family office and HNW investor capital. The fund will focus on the development of retail, commercial and light industrial real estate in sub-Saharan Africa outside of South Africa, offering investors access to Africa’s strong economic growth and its emerging consumer. The fund is aimed at long-term institutional investors and it has a $250m fund raising target for its final close on 30 June this year.

Season emerging markets private equity investment Actis has also raised and invested nearly $500m in two real estate funds, with markets including Nigeria, Zambia and Mozambique, in recent months, targeting annual returns of 20 percent or more, around 5 to 10 percentage points more than returns seen in similar mainstream emerging or developed funds.

Momentum thinks the trend can only grow. As Africa's fast-growing population gains spending power and moves into the cities, demand for real estate will grow, fund managers say. The Momentum Africa Real Estate Fund is banking on growing investor interest in capitalising on Africa’s growing need for quality retail, office and industrial real estate. According to David Lashbrook, head of Africa investment strategies at Momentum GIM, said:“We believe that investing in the development of commercial real estate is an exciting way for investors to support and participate in the rise of the African consumer. The fund seeks to mitigate the key risks of property development prior to commencing construction and it targets a minimum internal rate of return of 18% in USD net of all fees over its eight year life.

“We have been working on developing

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relationships in countries such as Ghana, Mozambique and Rwanda in anticipation of the launch of the fund. We have [identified] good partners and are considering a number of potential transactions. One such example is SIC Financial Services in Ghana, who have both the skills and the network to contribute significantly to the Momentum African Real Estate Fund initiative,”explains Warren Schultze, chief executive officer of Eris Property Group, a property services and development company which specialises in property developments in sub-Saharan African markets states.

According to Schultze, “It is our intention to intensify our efforts in these countries in the next few months, as well as focus on additional countries including Nigeria and Tanzania, in order to explore additional projects. Our approach is to identify partners in these jurisdictions to assist us and participate economically in projects wherever possible, and we are seeking to expand our partner base, especially in the countries where we are not currently active.”

Projects earmarked for development include an office complex in Accra, Ghana, a retail centre in Maputo, Mozambique, an office / hotel in Kigali, Rwanda. The plans for the Kigali project include the use of plant life as organic air conditioning that will reduce environmental impact and running costs. A number of other projects are in the early stages of analysis.

The venture has already received great support from local partners in Ghana:“in the past few months we have had several discussions with Eris in Ghana and Johannesburg, and are enthusiastic about partnering with them on some exciting real estate projects in Accra which we hope to initiate in the next few months” confirms Alice Osei Okrah, head of corporate finance and research at SIC Financial Services Limited. n

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INVESTMENT FUNDS MORE REGULATION, MORE PROBLEMS FOR FUND DISTRIBUTION?

Fund distribution increasingly impacted by regulation Since the global financial crisis there has been a plethora of new regulation and legislation coming down the pipeline which is impacting international asset management. This includes the US’ Foreign Account Tax Compliance Act (FATCA), measures from the Organisation of Economic Cooperation and Development (OECD), such as the Common Reporting Standard (CRS) and the Base Erosion and Profit Shifting (BEPS) project, and the European Union’s Markets in Financial Instruments Directive (MiFID) and Alternative Investment Fund Managers Directive (AIFMD). How has Guernsey responded to the inevitable challenges presented by this phalanx of regulation? Sinéad Leddy, Head of Technical, Guernsey Finance outlines the strategy.

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T WAS THE COMBINED amount of new regulation and legislation which prompted Guernsey Finance to host a technical masterclass in London this January to showcase how the Island’s progressive response to these developments will ensure it continues to prosper as a fund domicile and service centre in the future. The discussions included FATCA, CRS, BEPS and MiFID but the bulk of the debate focused on AIFMD given Guernsey’s prominence in investment funds, particularly in alternatives.

AIFMD seeks to regulate EU-based Alternative Investment Fund Managers (AIFMs), managers of EU established Alternative Investment Funds (AIFs) and managers that market AIFs into the EU. So, in essence, if either the manager or the fund has a relationship with the EU then the Directive comes into play.

The initial ‘deadline’ for full legislative transposition of AIFMD was 22 July 2013 but research showed that only 12 of 31 EU and European Economic Area (EEA) Member States had transposed the Directive into national law and subsequently there was an inconsistency in approach from EU and EEA national regulators in how they were implementing AIFMD. The transitional year ended on July 22nd 2014 and a report from KPMG showed that at that time only 23 of the 31 EU and EEA Member States had implemented full legislative transposition of AIFMD. Spain is one such jurisdiction which has since transposed AIFMD into national law but others have still not done so.

As such, even European fund managers

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Photograph Sinéad Leddy, Head of Technical, Guernsey Finance. Photograph kindly supplied

by Guernsey Finance, February 2015.

cannot distribute funds into some EU/EEA Member States and we have also heard that the inconsistency of approach between national regulators is making life difficult for those using the passport. In this climate, it is no wonder that non-EU fund managers believe that AIFMD is too burdensome, with some citing it as creating ‘fortress Europe’ and therefore, choosing not to market funds into the EU. Guernsey is not in the EU (although it is in the European time zone) and therefore, is not required to implement AIFMD. A large proportion of business relates to the EU in some form yet we also have a substantial amount of funds business which originates outside of Europe.

As such, the Island has introduced a dual regulatory regime so that it is possible to continue to distribute Guernsey funds into both EU and nonEU countries: the existing regime remains for those investors and managers not requiring an AIFMD fund, including those

using EU National Private Placement (NPP) regimes and those marketing to non-EU investors; and there is an opt-in regime which is fully AIFMD compliant.

Guernsey’s opt-in equivalent regime which has been in place since January 2014 is appropriate for funds requiring full AIFMD compliance. However, Guernsey’s position as a third country means our managers and funds who want to access Europe continue to be able to use NPP regimes. The Guernsey Financial Services Commission (GFSC) has signed bilateral cooperation agreements with 27 securities regulators from the EU and the EEA, including the UK, Germany and France (see box). These agreements mean that Guernsey funds continue to be able to market to appropriately qualified investors in these key European countries through their NPP regimes.

Many have continued to use NPP regimes due to the reduced burden in comparison with AIFMD and they are working well. Figures from the GFSC show that as at 31 January 2015, 46 Guernsey AIFMs have used Guernsey’s NPP regime to market AIFs into 15 European countries. Indeed, it is understood that several Cayman Islands domiciled funds are being migrated to Guernsey to take advantage of the effectiveness of our route for distribution into EU countries using NPP regimes.

We expect that NPP regimes will continue to at least 2018 and that the European Securities and Markets Authority (ESMA) will recommend that the passport be extended to non-EU managers in due course. ESMA has been

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consulting on the current and future implementation of AIFMD and Guernsey has been closely involved in this process.

The total number of funds approvals in Guernsey has increased 33% during the last year.

Feeder and parallel funds The attraction of Guernsey for fund managers wishing to market into Europe is that it can provide a European platform but one which is not actually in the EU and therefore can offer a variety of options.

For those marketing into Europe, the NPP route will likely be favoured by many due to the depth and breadth of requirements that fund managers will have to satisfy under full AIFMD. Indeed, it is expected that full-blown AIFMD compliance will only be sought if there are particular commercial reasons to do so.

For example, it makes commercial sense for a fund manager marketing almost exclusively to Europe to have a fully AIFMD compliant platform. However, this does not have to be based in a mainland European domicile and, indeed, it could be a Guernsey platform because the Island has also introduced a fully equivalent, opt-in AIFMD route to market.

However, managers should look carefully at whether the pan-European passport offered is relevant to their investor base given that it is likely to be increasingly geographically diverse.

European Directives – such as AIFMD but also the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive – cater for European investors but add to compliance obligations and costs.

As such, if you do not need UCITS/AIFMD or only need limited access to them for certain investors, then it is possible to break the non-EU business away into a parallel or feeder structure for which AIFMD compliance would neither be required nor necessary.

Conversely, if a manager has a platform in a mainland European domicile then it will have to comply fully with AIFMD even if there were a large proportion of non-EU investors. European mainland platforms do not offer the ability to separate the reporting obligations away from non-EU investors, as with a Guernsey platform.

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

In addition, managers and funds with no connection to the EU continue to be able to use Guernsey’s regulatory regime which is completely free from the requirements associated with AIFMD and as such, it will have significant operational and cost benefits. For example, Investec Asset Management recently re-domiciled a US$1.2 billion fund focused solely on non-EU investors from Ireland to Guernsey to take advantage of our dual regime response to AIFMD. Guernsey has a huge advantage as a fund domicile in the existing standards we already employ regarding oversight and due to the substance which is already present in existing Guernsey domiciled structures. There are more than 50 fund managers, administrators and custodians servicing assets valued at nearly half a trillion US dollars.

Guernsey already plays host to a number of major asset managers, such as Apax, BC Partners, Credit Suisse, Investec, JP Morgan, Man Group, Mid Europa, Permira and Terra Firma which all have offices and staff in the Island. There is a range of fund administrators, from major international names such as Citco, Northern Trust and State Street to boutique, independent operations, coupled with a significant pool of qualified Non-Executive Directors who are experienced in providing management functions.

Quality of service is evidenced by the

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fact that Guernsey providers now administer or manage $130bn worth of assets from open-ended funds which are domiciled in other jurisdictions, typically the Cayman Islands, where there may be local substance challenges.

Unlike many competitor jurisdictions, Guernsey also already has well-established custody businesses. They are increasingly being complemented by administrators who are setting up depositary functions to service private equity and real estate clients new to the requirement for a depositary under AIFMD. However, it should be noted that those taking advantage of NPP regimes are able to access a lighter touch regime for non-financial assets compared to that which would be required under full blown AIFMD. AIFMD is just one piece of regulation which has come down the pipeline and there are plenty more on their way.

However, it is extremely important for the international asset management community and is having an impact on fund distribution.

Guernsey’s position as a third country, its dual regulatory regime and our experience and expertise is proving an attractive option for global fund managers. With new fund approvals up by a third in the year to the end of September 2014 compared to the previous 12 month period (see chart), it is clear that there is continuing vote of confidence as an international fund centre of the future. n

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DEBT REVIEW THE EVOLUTION OF A PAN-EUROPEAN PRIVATE PLACEMENT MARKET?

Can a pan-European private placement market emerge?

Even eight years after the blow up in the financial markets, access to alternative sources of capital for borrowers, particularly SMEs, remains strained. Much has been talked about the emergence of a shadow banking market; but that market is highly selective and is in no way ubiquitous. The European private placement market offers some potential, but it remains highly fragmented, still defined by domestic rather than pan-European issuance. Now capital markets agencies across Europe have come together to help define the operation of a pan-European capital market union; one in which the emergence of a pan-European private placement market is one stepping stone. Can it be achieved?

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HERE IS A HIGH level of interest in Europe to drive forward the creation of other national and a pan-European private placement market, evidenced by a growing number of initiatives between the issuer, investor and adviser/arranger communities across Europe, with industry bodies including the International Capital Markets Association (ICMA), the Loan Markets Association (LMA), the Association for Financial Markets in Europe (AFME) and the Association of Corporate Treasurers (ACT) actively promoting the need for a functioning and accessible European private placement market.

Among the latest crop of initiatives, the Pan-European Private Placement Working Group (PEPP Working Group) led by ICMA has launched the PanEuropean Corporate Private Placement Market Guide, which has been endorsed

by Europe’s leading central bankers and capital markets players. To this should be added favourable amendments to tax legislation in the UK and the introduction of new loan templates are regarded as positive steps towards the growth of the private placement market in Europe.

The objective is that most European private placement transactions will eventually use the guide as the market standard. The guide sets out a voluntary framework for common market standards and best practices which are essential for the development of a pan-European

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private placement market aimed at providing medium to long term finance to European mid-sized companies, in close alignment with the European Commission’s goal of bringing about a Capital Markets Union.

Private placements are medium to long term senior debt obligations (in bond or loan format) issued privately by companies to a small group of investors.

The private placement market typically provides fixed-rate financing, most commonly for between seven to ten years.

With private placement deals providing longer maturities than many bank loans, which helps to release companies from the burden of refinancing bank debt every couple of years.

In Europe, the development of the private placement market has been defined by national rather than cross-border activity. The French and German (Schuldschein) domestic private placement markets issued approximately €15bn of debt in 2013, in addition to a further $15.3bn raised in the US private placement market by European companies. The US has an active private placement market, where different registered notes are offered to a small number of investors or a syndicate arranged by an investment bank.

In some cases the notes are placed with a single investor in a bilateral deal.

The notes normally have a fixed coupon and are denominated in US dollars, with maturities range between

three and 30 years. Issue sizes are flexible, ranging from $15m to $1bn. Borrowers do not require a public rating, but in the US, the notes are given a private rating by the National Association of Insurance Commissioners (NAIC). This rating is a particular requirement for insurance companies which are highly active in the private placement market as investors.

The US market is also tapped by non-US companies, which account for just under half the total volume in the market (around $51bn-$55bn a year).

That figure could rise substantially in coming years. S&P research indicates that there is €2.7trn of debt that will need to be refinanced by mid-sized companies between now and 2018, at a time when banks continue to retreat from long term lending markets. Because there is as yet no pan-European private placement market and so the guide has a role in kick-starting its evolution.

Both the Loan Market Association (LMA) and the Euro PP Working Group have recently published standard model framework documentation for both loans and bonds/notes coordinated within the PEPP Working Group, to which users of the Guide are directed. The PEPP Working Group is an umbrella European initiative led by ICMA that also currently includes the Association for Financial Markets in Europe (AFME), the European Private Placement Association (EU PPA), the French Euro Private Placement (Euro PP)

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Working Group, the Loan Market Association (LMA), TheCityUK and The Investment Association.

The initiative also brings together representatives from major institutional investors (including Delta Lloyd, Fédéris Gestion d’Actifs, KBC Group, LGIM, M&G Investments, Muzinich, Natixis Asset Management), and benefits from the participation of major law firms, including Allen & Overy LLP, Ashurst, Bonelli Erede Pappalardo LLP, CMS Bureau Francis Lefebvre, DLA Piper, Gide Loyrette Nouel AARPI, Herbert Smith Freehills, King & Wood Mallesons, Kramer Levin Naftalis & Frankel, Linklaters, Loyens & Loeff, Simmons & Simmons, Slaughter and May and White & Case. It also benefits from the support of the official sector participating in an observer capacity (including the Banque de France, the Bank of Italy, the French Trésor and HM Treasury).

M&G Investments is one of the largest European investors in the market and has been active since 1997, having invested €6.1bn in private placements over the years. Calum Macphail, head of private placements, M&G Investments, says, “There is strong demand for this type of long-term financing. European companies have long accessed the established private placement market in the US and some European investors have in turn invested in the US market. The development of the pan-European market should stimulate further growth, easing the process for more companies to access the capital markets in Europe and provide investors with a new investment opportunity”.

ICMA’s guide highlights the principle characteristics of a PEPP-compliant transaction as a private and unlisted debt product including ways in which it differs from other long term debt financing options, such as syndicated public bond issues, private placements under an EMTN Programme or bank lending. It also defined the roles and responsibilities of the borrower, investors, arrangers, legal counsel, essentially all parties to a PEPP transaction and the documentation required. According to Martin Scheck, ICMA Chief Executive, “The guide is the result of a remarkable col-

Photograph © JustContributor /Dollarphotoclub.com, supplied February 2015.

lective effort of the PEPP Working Group, bringing together major institutional investors, banks and key industry bodies as well as official observers, to establish internationally recognised market standards for PEPP transactions.

The PEPP Working Group will continue its work supporting the development of a fully-fledged PEPP market.”

Christian Noyer, governor of the Banque de France, adds:“All Paris financial centre stakeholders played a major role in the success of this initiative. I take this opportunity to reaffirm Banque de France’s support for this endeavour".

For many years, many mid-sized European companies have accessed the US private placement (USPP) market, making up a significant proportion of the nearly $60bn worth of annual issuance.

The popularity of private placements has accelerated since the onset of the financial crisis, with markets in countries such as France and Germany providing borrowers with a local solution. “As the financing landscape changes as banks de-lever, natural sources of longer-term finance, namely pension funds and institutional investors, are filling this gap. Pension funds are attracted to the characteristics of private placements – strong, stable cashflows and covenant protections similar to a loan. In addition to diversification and stronger documentation compared to public bonds, investors benefit from an illiquidity premium which can provide an enhanced yield as well as regular income over the medium to long term,” explains M&G Investment’s Calum Macphail.

However, until now, there has been no

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

pan-European private placement market.

The demand for private placements is set to increase as the EU’s approximately 200,000 mid-sized companies look to diversify their sources of funding away from the traditional bank loan market, and view private placements both as an alternative and as an intermediate step towards the listed bond markets. “An efficient private placement market widens the range of alternative finance available; it can play an important role especially for mid-size firms, complementing bank lending to these firms and rebalancing their funding sources,” notes Fabio Panetta, member of the governing board and deputy governor of the Bank of Italy.

The guide builds on existing practices and documents used in the European bond and loan markets, especially the Charter for Euro Private Placements developed by the Euro PP Working Group, a French financial industry initiative. The guide is expected to help expand cost-effective funding opportunities for European mid-sized companies; grow the European investor base for private placement transactions and lower operating costs by promoting the use of standardised PEPP transaction documentation, which has recently been released by the Loan Market Association and the European PP Working Group.

Going forward the PEPP Working Group will be further looking among others to promote investor-side incentives for PEPP financing and to lift remaining obstacles to its development. Andrea Leadsom, Economic Secretary to the United Kingdom’s Treasury, explains“With the government and the industry working together, the barriers that seem to have held back the private placements market until now are rapidly being dismantled. In December, we announced a new exemption from withholding tax for private placements. … With six major institutional investors now committed to invest around £9bn in private placements and other direct lending to UK companies over the next five years, following our action at the Autumn Statement, we are starting to see the beginnings of a lasting private placements market, which will support growth in the UK and across Europe”. n

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DEBT REVIEW OUTLOOK FOR THE DIM SUM MARKET IN 2015

A slow start for RMB issues

After a banner year for offshore RMB issuance volumes in 2014, with RMB587bn worth of securities issued, a quiet start to this year has set off alarm bells in some quarters. Others say that RMB can weather a downturn in January as the bonds have evolved from a simple one-way expectation of RMB appreciation to a more mature evaluation of credit quality and asset allocation diversification during the last twelve months. New research from FTSE Group thinks that the outlook is more balanced. Who’s right? The evidence looks rather mixed.

A

CCORDING TO FTSE Group, a diverse range of interlocking developments have contributed to the growth of offshore RMB bonds as an asset class in the past 12 months.

China’s wide ranging financial reform package – which aims to liberalise interest rates, widen the RMB’s trading band and gradually open the country’s capital account – has played an important role in galvanising investor appetite for RMB-denominated assets both regionally and globally. Riding the momentum of reform, China’s top corporations dipped into the debt markets to seek cheap funds early in 2014; issuance values for the half-year ended June nearly matched the amount issued for the entire previous year.

Despite these positive developments, FTSE cautions that risks in the outlook for the offshore RMB market remain. The RMB’s performance fluctuated considerably in 2014 following China’s decision to double the currency’s trading band in March last year, which allowed market forces to exert a stronger influence on the currency’s value. At the same time, growth momentum in the Chinese economy has frankly slowed of late, on the back of lower-than-expected export and manufacturing performance.

Over the next 12 months, reform efforts could remain focused on RMB internationalisation and interest rate liberalisation, says the FTSE Group.

Some analysts however are less sanguine. HSBC predicts an 8% fall off in new RMB bond issuance this year.

Certainly, the year has started with something of a whimper rather than a bang in the dim sum bond market. Volume was clocked by Thomson Reuters, including cer-

46

tificate of deposits (CDs), at RMB12.2bn across January, down more than 70% compared with January last year. It should know, HSBC was the top bookrunner for the dim sum bond market in 2014.

Standard Chartered too thinks that Dim Sum issuance is likely to decline in 2015 as the high cost of funding in the CNH market (relative to G3 markets) deters issuers.“We recently revised higher our USD-CNY forecast profile for 2015, and now expect USDCNY to peak in Q2 at 6.28 before ending 2015 at 6.12,”noted Kelvin Lau in a January 7th paper.

Funding costs in offshore yuan market have been on the rise mainly due to broader repatriation channels that drained the offshore pool and tightened liquidity here. Funding costs in Hong Kong's yuan market have climbed to 3.7%, versus around 3.2% on the mainland, analysts say, based on the one-year yuan/dollar forwards implied rate. ($1/RMB6.2592) says Standard Chartered. The landmark Shanghai-Hong Kong stock connect scheme that launched in November has already drained a net RMB67bn from HKD1trn worth of RMB deposit pools in the past two and a half months.

Even so, according to Standard Chartered’s Hong Kong research team, “The launch of the cross-border two-way renminbi sweeping programme via the Shanghai FTZ, and its subsequent expansion across China (albeit with more restrictions), has fuelled CNH usage by corporates [sic]. More importantly, as of November, more than 22% of China’s total goods trade was settled in renminbi, up from an average of 17% for the first three quarters of 2014 and 12% in 2013. The launch of the Shanghai-Hong Kong Stock

Connect programme in November 2014 was also a milestone in CNH development, boosting investor participation.

Moreover, CNH deposits in Hong Kong rose 3.2% m/m in November to CNY 974bn, says Lau’s team. “This was the fastest gain since January 2014, bringing deposits close to our year-end forecast of CNY 980bn. The upside surprise in November was largely due to Hong Kong’s relaxation of the renminbi retail conversion limit, in our view. Since the rule change, Renminbi converted at the retail level in Hong Kong no longer come from onshore but instead from the CNH pool. This may help to explain the 8% m/m drop in CNH deposits in South Korea in November, and the flat performance of deposits in Taiwan after a strong start to 2014”.

Market trends show traders expect the yuan to fall further given the strength in global dollar index and expectations that Beijing will ease monetary policy to boost the economy. Further out, a scheme expected to be launched this year to link up stock markets in Shenzhen and Hong Kong could add to the strains on offshore yuan liquidity. Bankers expect short-term rates in Hong Kong to rise further in coming months with the one-year rate likely to surge to about 4%, before possibly easing later this year driven by an improvement in liquidity onshore.

HSBC forecasts gross issuance of CNH bonds and certificates of deposit (CDs) in 2015 to be as high as RMB520bn and no less than RMB490bn. The bank says mainland financial institutions are likely to account for more than half of the 2015 supply as they continue to expand offshore networks and offer overseas financing for domestic enterprises going abroad. n

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The rise of alternative lending in the European mid-market The (French) euro private placement market has seen the emergence of a range of unlisted deals, attracting international borrowers. A pan-European private placement (PP) market looks to be evolving. In France in particular the euro PP market has seen a broad range of deals from international borrowers. The direct lending market-where dedicated credit funds lend directly to predominantly sponsor-owned businesses—saw more than €10bn worth of transactions last year, covering some 200 plus deals. How far can this alternative funding market grow?

T

HE ALTERNATIVE LENDER community is becoming increasingly relevant for European midmarket companies, says Deloitte in its quarterly Deloitte Alternative Lender Deal Tracker report, published in December last year. “In 2013, we saw activity strengthening from alternative lenders, in particular with the success of the unitranche product. As expected, this trend has continued through 2014, against the backdrop of a strongly improving economic outlook,” says the consultancy.

The last quarter of 2014 in particular set a new record of 73 deals. The majority of direct lending takes place outside the UK (63% worth in fact), with a 109% year on year increase in Q3 deal flow compared with the same quarter in 2013.

The rise of the alternative funding market is explained by the long term trend of continuing bank disintermediation across Europe. This trend can only continue as European banks will continue to shed at least another €2.7trn of assets by 2016, according to a paper by RBS, The Revolver – The deleveraging trap, can Europe pull itself out?, published in July 2013. Issuance of private funding for companies in Europe grew last year in many alternative funding markets to over €38bn in terms of value, including private placements and direct lending and this pace is expected to pick up in 2015, particularly as unlisted deals become more commonplace and the growing sophistication of the sector starts to define senior secured debt more clearly.

Alternative lenders consist of a wide range of non-bank institutions with

different strategies including private debt, mezzanine, opportunity and distressed debt. Investors range between larger asset managers diversifying into alternative debt to smaller funds newly set up by exinvestment professionals.

In the growing direct lending market, Standard & Poor's estimates in a special report on the European mid-market, that credit funds have raised a substantial €45bn of capital up to the end of 2014, “which we expect to be deployed mostly in sponsor-led transactions. Although this market is most active in London, the companies tapping into this capital are from a wide variety of countries in Europe”.

Most of the funds have structures comparable to those seen in the private equity industry with, typically, a three to five year investment period and an overall ten year life with extensions options.

Limited partners in the debt funds tend to be insurance, pension, private wealth, banks or sovereign wealth funds and during the last two years quite a few new funds have been raised in Europe. This has, in turn, led to an increased supply of alternative lender capital that has helped to provide greater flexibility and optionality for borrowers.

M&A continues to be the strongest driver of alternative lender transactions.

However, other trends are now clearly in play. The euro's slide against the US dollar is making exports from Europe somewhat cheaper, and, due to loose monetary policy, liquidity for corporates is still available at low lending costs. Moreover, adds Deloitte, “supply side dynamics against a backdrop of low M&A volumes

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

have resulted in some European borrowers securing lower pricing than comparable US companies.”

The structure of debt in this segment tends to be bilateral loans, secured on the operational businesses, with either a single lender, or club of lenders involved.

Three types of loan predominate. One, institutional tranches lent alongside traditional bank loans that have either a longer tenor or bullet structure. The bank loan tends to be a senior secured, covenanted amortising tranche. Two, a unitranche structure that completely replaces a bank facility; this is either a unitranche or stretched senior product. It invariably involves higher leverage, additional covenant headroom and a more flexible use of proceeds. Third is a junior or subordinated facility, often mezzanine finance or a payment in kind (PIK) facility.

PIK facilities became very popular, for example, in the US year before last. These are high yield securities that allow interest to be paid ‘in kind’ either by additional notes or by increasing the outstanding principle instead of in cash.

New developments Steps have also been taken, on the initiative of the Pan-European Private Placement (PEPP) working group, to build on the French Euro PP Charter and propose common market standards and best practices, which market analysts say is critical for the development of a Europe-wide private placement market, which (it is envisaged) will complement the well-established US market.

The Breedon Report identified a

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DEBT REVIEW THE RISE OF ALTERNATIVE LENDING IN THE EUROPEAN MID-MARKET

number of hurdles which were preventing the development of an active UK private placement market, including the lack of favourable tax treatment and standardised documentation. Some progress has been made, with the provision of a withholding tax exemption for the market which was announced in the UK Chancellor’s Autumn Statement, which was published early in December last year. Moreover, the Loan Market Association (LMA) in conjunction with the PEPP, has launched new loan and bond documentation for European private placements under English law, while the Euro PP working group has also launched revised documentation under French law.

The documentation is based on the LMA’s investment grade facility agreement which has been adapted to meet the specific characteristics of a private placement. Both the loan and bond formats of the documentation assume that the debt will be unsecured and rank pari passu with any other senior unsecured debt issued by the company. Meanwhile, in terms of tax: under existing rules in the UK, a corporate borrower is required to withhold tax at 20% from payments of interest on all but very short term debt (unless an exemption is in play, or a double taxation treaty is in place). The borrower also has to pay the interest on a gross basis.

The risk that a borrower is required to gross up interest payments to non-UK investors (which are subject to withholding tax through a gross up obligation) is, according to the Association of Corporate Treasurers a significant hurdle to the development of a UK private placement market. This is, apparently, because it contrasts unfavourably with both the bank loan and quoted eurobond markets, where interest paid receives a more favourable tax treatment for withholding purposes.

Draft legislation published by the UK’s tax authorities will come into force with the 2015 Finance Bill, which is expected to be in the Spring, but it is election year in the UK, so it is probably wise not to bank too much on that one. If it is passed, it will provide for payments of interest to be exempt from withholding tax if it is interest on a qualifying private placement.

48

Officially the authorities are now consulting with the market: an exercise that should finish by the end of February. There are also a number of uncertainties that need to be resolved before any regulation can be passed. The tax authorities want to restrict the application of the exemption to non-convertible securities that raise between £10m and £300m, and the securities must be issued by trading, rather than investment companies, have a maturity of less than 30 years and the assets must be held by regulated financial institutions (but does not define what those are).

Further initiatives hang on the expected introduction of template documentation in some European jurisdictions, and the expected launch of ICMA’s market guide in the first quarter of this year.

This builds on the growth of transactions outside of the French Euro PP market. For example, there were transactions from Italian, Belgian, and Spanish corporates publicly reported in 2014. In addition, deals below €50m have increased by 40% in 2014 and the median deal size has dropped 15%. According to the PEPP the European private placement market has been expanding but remains “fragmented, with pockets of regional activity, most notably in Germany and France, with a nascent market in the UK. Currently, the average size of issuance is €70m, the average coupon is 4.2%, and the average associated maturity is seven years.

Another new feature is in the emergence of unlisted deals on the Euro PP market, representing 45% of the number of deals in 2014, and €1.5bn by value. This is a drastic increase compared with the €350m of unlisted deals in 2013 by value, according to Standard & Poor's data.

The introduction of unlisted bonds or loans as eligible for private placements for French investors has meant that it has become much easier for a wider variety of companies including smaller ones to tap the newly developing market. For example, mid-market metal and glass container manufacturer Fareva last year issued a record €225m unlisted Euro PP bond with a seven-year tenor and a 3% coupon, combined with an unlisted Euro PP loan of €50m.

Although the possibility to issue on an unlisted basis has increased deal flow, it has also decreased transparency in this market, as unlisted companies do not have to make their transactions public. Standard & Poor’s says it has observed the emergence of senior secured debt, “Pari passu with bank loans, with public French infrastructure group NGE's €70m Euro PP issue in July 2014. This is a debt structure that speculative-grade companies typically use in the public markets. The appearance of this structure on the Euro PP market implies that it is starting to see a wider range of credit risk.

Issuing bonds via exchange platforms continues to be an increasingly open avenue for small and midsize enterprises (SMEs) seeking funding in sizes smaller than €200m. In the past year, the ExtraMOT PRO segment on the Milan exchange saw incredible growth, with more issuers in 2014 than all other European exchange platforms combined, led mainly by SMEs. Likewise, Madrid's Alternative FixedIncome Market or MARF also saw a pickup for smaller companies, attracting a similar number of issuers to the other, more established exchanges. And although the German exchanges did see a dip, because thinks Standard & Poor’s of the high default rate of German mid-market companies.

“Although these markets are open for companies with a wide range of credit profiles, there are those with higher risk, some of which have defaulted. In fact, in Germany a total of 21 issuers with publicly listed mid-market bonds between 2012 and 2014 have defaulted, out of a total 151 issuers that came to German mid-market bond platforms, according to Statista 2015 data”.

While there is still positive sentiment, European markets cooled down in Q3, directly impacted by the volatility witnessed in the high yield bond and equity markets in October last year.

Partly as a result of this, a number of transactions in the European markets are reported to have witnessed push back from investors which resulted in market flexes on structure and pricing. n

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FX OUTLOOK

Photograph © elen_studio /Dollarphotoclub.com, supplied February 2015.

Commodity price drop hammers South American currencies The decline in commodity prices and the rise in value of the US dollar is having a negative effect on the value of Latin American currencies. At the time of going to press the Colombian peso was at its lowest level against the US dollar in five years. The same is true for Chile, where the peso is at a six year low against the greenback following a severe drop in the price of copper. The list goes on.

A

FTER THE BOOM, the reckoning.

The effects of the US Federal Reserve Bank’s ending of easy money at the end of October last year is now being felt most strongly in South America. Liquidity which once flowed from developed to advanced emerging markets has now stopped, presenting the world with a new financial character.

Coupled with the slowdown in easy money, falling commodity prices, the downturn in demand from China and the consequent fall the prices of exports in many South American countries is exerting continued downward pressure on the region’s currencies, with no letup in sight through (at the very least) the first half of this year.

It has not been a smooth process because cheaper exports have coincided with a downturn in global demand for key com-

modities. The obvious influencer has been the fall off in oil prices, which has hammered exporters such as Venezuela and benefited importers such as Chile. The fall in oil prices will also reduce the value of oil reserves in Argentina, Brazil and Mexico.

Moreover, as the production of commodities is significant in the region, the drop in prices for other products, including copper, grains and iron ore, will pose additional challenges for many Latin American economies. According to the IMF economic growth picked up pace in the third quarter of last year in most of the South American economies. In particular, the economies of Bolivia, Mexico and Peru accelerated, while three economies, Argentina, Brazil and Venezuela, contracted.

Not everyone has viewed the impact of these cross winds negatively. Some market analysts, including Juan Ruiz, chief

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

economist for South America at BBVA in Madrid believe that the “positives of depreciation (a boost to the external sector) this time truly outweigh the negatives (some currency mismatches). In addition, inflation-targeting regimes have become more credible in the region, limiting the pass-through to inflation. Latin American currencies will continue to follow a depreciating trend going forward, as commodity prices will no longer rise as in the past decade, China engineers a controlled slowdown and the global liquidity that is dominated by the United States is tightened as Fed funds rates take off sometime in mid-2015.”

However, leading economies in the region have been counting the cost of market change. By the end of last year the Brazilian real had lost 12.5% of its value against the dollar in annual terms at the end of 2014 and the Mexican peso had weakened 13.1%. Sharp drops against the greenback were also recorded in the Argentinean (down 29.8%), Chilean (15.5%) and Colombian currencies (down 23.8%) by the end of last year. Consequently, most central banks and monetary authorities kept their policy rates on hold (Brazil and Peru were the only exception) and many are intervening in the currency markets to smooth volatility. Meanwhile, in Venezuela, where economic policy has tended to be somewhat unpredictable over the year, the official exchange rate had remained stable at the end of 2014. However, the economy is expected to go into recession this year.

The Brazilian economy expanded only slightly in Q3 last year, faring worse in Q4.

In November, economic activity recorded zero growth and industrial production contracted. Looking forward, 2015 is expected to be another disappointing year for the largest economy in South America. Low commodity prices are expected to weigh on export revenues and the country is experiencing a severe drought in agricultural areas. In an effort to bolster confidence, recently appointed finance minister Joaquim Levy has targeted a 1.2% primary surplus for 2015 and announced tax hikes and spending cuts. However, doubt remains as to whether the target is attainable. Levy faces a large amount of rigidity

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FX OUTLOOK LATAM CURRENCIES UNDER PRESSURE

in the budget since the vast majority of spending is attached to constitutionallymandated expenditure.

Mexico is a similar story. Economic activity slowed in November because of a deceleration in the industrial sector, in particular, manufacturing output contracted in December. November exports grew at the slowest pace in ten months, sending the trade balance into negative territory. The Mexican government unveiled the details of the first-round of bids for oil exploration in shallow-water blocks in December and confirmed that the country is on track to open the energy sector to private investment. Even so, in a time of ultra-low oil prices, any immediate benefit has been dampened. Nonetheless, Mexico says the exploration blocks will be allocated as production-sharing contracts, the first of which are expected to be awarded in the second half of 2015.

Growth prospects for Mexico remain fairly positive, but downside risks to the 2015 outlook persist. Lower oil prices will have a negative impact on fiscal revenues and, if prolonged, the slump could reduce the attractiveness of some of Mexico’s most lucrative opportunities for energy investment, such as deep waters and oil shale production, both of which have high break-even costs.

Argentina’s economy contracted 0.8% annually in the third quarter of last year following a flat growth in Q2. The contraction was mainly due to a sharp fall in private consumption, which hit a record low in Q3. Exports continued to decline, although at a slower pace than in Q2, while investment posted negative growth for the third consecutive quarter. Recent data suggest that the economy remains weak. Although economic activity increased somewhat in October, exports plummeted in November. The so-called RUFO clause finally expired on 31 December 2014. This means that the government is now able to negotiate with the holdouts without being forced to apply the same treatment to investors that entered the debt exchanges in 2005 and 2010. Most analysts do not expect an agreement any time soon. The government has little incentive to pay holdouts

50

in the near future as elections are scheduled for October and the country is already lacking access to international financial markets.

Colombia’s economy remains one of the most positive in the region, even though it experienced something of a slowdown, the economy registered solid 4.2% growth in the quarter (compared with 4.3% in Q2).

Consumer confidence remained solid in November. However, industrial production was subdued in October and in November falling oil exports prompted the steepest decline in exports in over five years. The drop in global oil prices, which will likely weaken the energy sector and drive down public revenues, prompted the government to revise down its growth and fiscal targets for 2015. In an effort to contain the deficit, the government enacted a tax reform recently that extends and modifies existing wealth and profits taxes and also extends a charge on banking transactions.

However, even the Colombian peso plunged to a five-year low in January as oil prices continued to fall in the month. Oil exports are the country’s key export and its most important source of foreign exchange.

The end of asset-purchasing in the United States has clearly come at a challenging time for emerging markets, with Currencies

Latest/

China’s economy slowing, the eurozone and Japanese economies struggling to stay out of recession. Stimulus policies from the ECB and the Bank of Japan have only served to strengthen the dollar in a flight to quality; but the US dollar is the currency in which most commodities are priced, which in turn creates pressure for sellers to lower their prices, even as demand is falling.

Investors will now be watching the fallout in the Latin American corporate bond market. In October, rating agency Moody’s downgraded the bonds of Brazil’s Petrobras to two notches above speculative grade because of the impact of falling oil prices and the weaker real on its debt. Growth prospects look brighter in 2015 relative to 2014, but a strengthening U.S. dollar, uneven global growth and weakness in commodity prices are skewing the risk toward the downside for the 2015 forecasts across the region.

The Institute of International Finance expects the strengthening of the dollar to have a divergent impact across the region, however, depending on trade and financial linkages. Given the effects of falling oil prices and a stronger dollar, some companies in the region, having issued record amounts of foreign currency bonds, may now struggle to service their debts. n daily %

YTD %

US dollar

change

change

Mexico peso

14.9308

-0.64

-1.25

Colombia peso

2383.04

Argentina peso (interbank)

8.6650

Brazil real

Chile peso Peru sol

Argentina peso (parallel)

2.8195 626.6 3.07

13.14

-1.52 -0.45 -0.75

-5.75 -3.22 0.21

-0.16

-2.96

0.30

6.54

0.03

-1.33

Source, Bloomberg, February 2015

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SECTION NAME

US Securities Lending: Defining the new business drivers THOUGHT LEADERSHIP ROUNDTABLE

(c) Natalya Guskova|Dollarphoto

The Expert Panel David Gurtz, Deputy Chief Investment Officer, Director of Risk Management, Massachusetts Pension Reserves Investment Management (PRIM) Board Susan Peters, Chief Operating Officer, Scorpeo Charles Rizzo, Senior Vice President, Chief Financial Officer For The John Hancock Family Of Funds And Chairman John Hancock Funds Risk Committee Craig Starble, Chief Executive Officer, eSecLending Chris Valentino, Director, Sales, EquiLend Robert Zekraus, Director, Prime Services, Scotiabank Global Banking & Markets Francesca Carnevale, Editor, FTSE Global Markets

Sponsored by

FTSE GLOBAL MARKETS • FEBRUARY/MARCH 2014

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ROUNDTABLE

AN INCREASINGLY COMPLEX MARKET: SECURITIES LENDING IN CONTEXT

CHARLES RIZZO, SENIOR VICE PRESIDENT, CHIEF FINANCIAL OFFICER FOR THE JOHN HANCOCK FAMILY OF FUNDS AND CHAIRMAN JOHN HANCOCK FUNDS RISK COMMITTEE: We have over 200 funds and half of those are authorised to lend. Frankly, our focus over the past year has been on the threat of rising interest rates and its impact on our collateral pool and lending funds collateral investment.

We have an in-house managed cash collateral investment vehicle that has always been managed conservatively, similar to a money market fund. With the prospect of higher rates, our focus centred on the general collateral (GC) balance our funds had outstanding, particularly given that reinvest earnings relative to the federal funds rate continued to decrease, and the risk return trade-off did not justify the GC balances. Consequently, a series of decisions were made to de-risk the lending program. At this point, we are not lending general collateral unless a minimum basis point spread is achieved. We are however lending specials because the spreads in our view are appropriate relative to the risks that our funds are taking on the lending side as a beneficial owner.

Craig Starble, Chief Executive Officer, Eseclending:

“Clearly, the market has changed.

The demand for borrowing is very different today than it was four years ago. Nonetheless, I see a good outlook for the marketplace. In particular, as Charles mentioned, we have noted a heightened focus on the intrinsic side of the business.”

CRAIG STARBLE, CHIEF EXECUTIVE OFFICER, ESECLENDING: Our goal is to grow our business and we do that in two ways: one is acquiring new clients as third party lenders; the second is expanding business with our current clients into new products, new markets and new opportunities. Some of those are on the collateral side; some of those are on the lending side.

Of all the trends impacting securities lending, perhaps regulatory changes are the most significant. Some of those changes impact our clients, especially in Europe; some of those changes impact our competitors through higher capital charges as an example. We have always handled indemnification in a different way than our competitors, using a sophisticated insurance policy that has an explicit cost, which is beneficial to our business as it allows us to control costs, especially in this particular environment.

Clearly, the market has changed. The demand for borrowing is very different today than it was four years ago.

Nonetheless, I see a good outlook for the marketplace. In particular, as Charles mentioned, we have noted a heightened focus on the intrinsic side of the business. These days, there is a lot of money to be made on specials. Moreover, in some cases there has been a move away from cash reinvestment. Elsewhere, clients are taking advantage of opportunities on the cash collateral side. One area of interest, which is of particular interest to eSecLending, is servicing the CCP marketplace. It has potential to be an important pillar in securities lending and we are now working on products and services to provide to CCPs as clients.

DAVID GURTZ, DEPUTY CHIEF INVESTMENT OFFICER, DIRECTOR of RISK MANAGEMENT,

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MASSACHUSETTS PENSION RESERVES INVESTMENT MANAGEMENT (PRIM) Board: Our current assets are approximately $60bn. We feel our primary focus should be on asset allocation while picking top tier external managers, monitoring them and trying to maximise returns while minimizing the risks.

Maybe a little history on why we have recently gotten back into securities lending might be useful. PRIM has been around since the mid-80s and we have gone in and out of securities lending participation throughout that time period.

Most recently we were in securities lending in the mid2000s but our investment committee in the fall of 2007 (just before the financial crisis really started) questioned whether we should be in securities lending.

We think it is good practice to issue requests for proposals (RFPs) to procure competitively most of our services. In 2007 we had an exclusive securities lending arrangement with Goldman Sachs and its contract was expiring at the end of 2007. The then CIO brought the RFP for procuring a securities lending agent to the investment committee for consideration and the committee decided that the revenues we were earning from this programme were not sufficient to justify the potential risks we were holding. As we all know, a few months later the financial crisis kicked off, and the Committee and Board were happy to not have incurred reinvestment losses related to securities lending which many other funds did.

Looking back, the programme we had in place was very conservative and would have performed well throughout the crisis as our collateral investment was in US Treasuries.

Fast forward to 2014 and a couple of new Investment Committee members suggested we get back into securities lending; or at the very least research it, and understand where others may have went wrong.

We undertook a detailed review, under the umbrella of an important internal initiative called Project SAVE. The SAVE element stands for Strategic Analysis for Value Enhancement, which caused an examination of all of our asset classes, processes, and infrastructure to ensure that we operate cost effectively and that whatever we do, or at least as much as possible of what we do, adds the greatest possible value at the lowest possible cost. We had a target goal for Project SAVE of $100m. One of the initiatives we undertook under Project SAVE, which helped us surpass our $100m goal was securities lending. Securities lending is a perfect example of adding value to an institutional investor like PRIM.

David Gurtz, Deputy Chief Investment Officer, Director of Risk Management, Massachusetts Pension Reserves Investment Management (PRIM) Board

“We had a target goal for Project SAVE of $100m.

One of the initiatives we undertook under Project SAVE, which helped us surpass our $100m goal was securities lending.

Securities lending is a perfect example of adding value to an institutional investor like PRIM.”

SUSAN PETERS, MANAGING DIRECTOR, SCORPEO US: Scorpeo enables portfolio managers to maximize the return that they gain from corporate actions associated with securities held in their portfolios. This strategy includes helping them manage corporate events such as optional cash stock dividends, tender offers, Dutch auctions and mix and match.

Particularly in the European markets, dividend strategies are becoming more and more complex. Value added revenue

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can certainly be captured through securities lending.

However, it can also be captured through a strategy that does not require moving the underlying securities into somebody else's hands or the risks associated with managing collateral.

Our research indicates that with respect to optional cash/stock dividends, for example, investment managers leave quite a bit of money behind due to sub optimal elections. This may simply be due to an index manager defaulting to cash simply because they do not want to incur tracking error.

Scorpeo’s method for optimising such revenue can complement an existing securities lending program or operate as a standalone strategy.

ROBERT ZEKRAUS, DIRECTOR, PRIME SERVICES, SCOTIABANK GLOBAL BANKING AND MARKETS: As a growing business in the prime services market space, one of our goals is to stand out, beyond our traditional Canadian footprint. This is a demanding and fascinating goal, the opportunity which in some respects is driven by regulatory changes impacting an already established order of banks in prime brokerage. The changes around incremental funding, the provision of stable liquidity and other scarce financial resources and heightened activity in the securities lending space are being re-evaluated.

Some of these elements are, naturally, a work in progress.

Around that we are mindful of the usual array of influencers on the business set, some of which have been outlined here (regulation, for instance and the challenges and changes around that from both a markets and jurisdictional perspective). Clearly we are looking at how it impacts clients; around securities lending and the growth of that business, primarily on the supply generation side and the impact that will have on collateral demands of the marketplace; and then, finally, on the growth of capacity on financing and funding away from wholesale funding and using collateralised transactions as a way to grow our footprint in that space.

Scotiabank has been in the prime brokerage business ten-plus years but it is only in the last four or five years that the bank has increased its market share. Therefore my current capacity here, four months in, is not dissimilar to what I experienced in previous roles helping develop a securities financing platform. The one major change being the marketplace and the environment has changed tremendously post-crisis.

CHRIS VALENTINO, DIRECTOR, SALES, EQUILEND: EquiLend has been a leading provider of trading and posttrade services for the securities finance industry since it went live in 2002. Two years ago we started a market data business called DataLend. I've been with the organisation for a little over two years. Covering our global client base is what I do on a daily basis. Our clients, who include many of the players in the securities finance business, are very serious about growing their business and utilizing technology, automation and market data to assist them throughout this process.

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As a provider of all of these things, we find ourselves in a very unique position within the market. We are constantly looking for ways to help clients gain efficiencies in both cost and time. Some popular trends we see in the market are with regards to more automation around trading and post-trade activities. Transparency provided through tools like DataLend is also a very popular trend. The market is thirsty for clean, concise and flexible market data.

HAS REGULATION AFFECTED MARKET PRACTICE AND BUSINESS VOLUME?

CHARLES RIZZO: We have pondered this question a lot lately. Clearly the impact of Basel III is something we have begun to actually witness now. Banks and dealers are much less willing to hold securities on their balance sheets given the capital implications and this, clearly, has had an impact on our cash collateral pool in terms of the availability of repurchase agreements.

It is pretty evident today that you need to get into a market a lot sooner with regard to your repo investments than you had to in the past given reduced market availability. The implications of liquidity ratios on short-term funding arrangements can have not only an impact on lending capacity, but also on the costs of providing such funding.

Knowing this, we have begun to evaluate our cash reporting process to determine if changes in the work flow can save time in reporting to the cash desk so that our investment managers can make cash investments even sooner. Additionally, given the risk element of rising rates we also shortened the duration and weighted average maturity of our collateral pool.

Moreover, we continue to track market developments closely and keep our eye on emerging regulations because of the potential impact on our lending program. Additionally, through last year we continued to monitor the progress of the financial transaction tax (FTT) in Europe. It hasn’t taken hold yet, but if it does, we will evaluate the profitability of making loans during the foreign dividend season and determine whether engaging in lending on these transactions makes sense.

We are also keeping track of Dodd-Frank’s Section 165 implications with regard to the amount of exposures our lending agent banks can have to a counterparty. That might limit the amount of borrowing our agent lenders can do on our behalf if they are too weighted towards one particular borrower, given the other financial activities they may have within the bank with that entity.

Clearly, there are many dynamics in play. Let me tell you, it is a challenge to keep up with it, but we have a very strong team and internal committee structure to oversee all aspects of the security lending program and are very much involved in industry committees to further our learning. We bring our agent lenders in for educational sessions during the year to try to keep abreast of impending regulation and regulation that is already in play and ways in which it could affect us over the near and longer terms as well as learn

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about developing industry practices.

Once we have all that in our pocket, our working group starts to make decisions about how we want to manage our lending programme. As I explained earlier, because of the interplay of all these elements, it makes sense to shorten the duration and weighted average maturity of our collateral pool.

Let me explain some of the mechanics and changes we are making. The way we manage our collateral pool assets is pretty unique. Currently, we have a 40-act vehicle that manages assets based on the old 2a-7 money market rules, not the money market reform rule amendments from 2010, which tighten liquidity requirements such as shorter maturity limits. Therefore we are able to apply the old rules in our cash re-investment strategy which gave us a lot more flexibility in a more favourable market and interest rate environment.

We recently made a decision to formalise our current strategy by changing our investment policies which will require the lending funds collateral assets to be managed like current money market funds. Therefore today we are well below 60 days weighted average maturity, and because of that we have less sensitivity to interest rate risk as we are managing on the short end of the yield curve. It is clearly a dramatic shift and we are comfortable that our current strategy aligns well with our view of the market.

FRANCESCA CARNEVALE: Charles has articulated substantive changes both in the management of assets that are allocated to securities lending and in the entire investment spectrum. How have service providers responded to that and helped client firms manage their risk exposure more effectively because of regulation?

CRAIG STARBLE: What Charles experienced is representative of what we have seen across the broader market. eSecLending has always been very focused on the intrinsic side of the business. We continue to do that. The way our auction process assesses the market for some assets is, in my mind, regulatory-friendly because it allows borrowers to bid on only the assets that they want to bid on, and does not require that they borrow a combination of specials and GC in order to accommodate those assets that are typically lent on a discretionary basis.

Even so, we have clients who are using minimum spreads.

That is a business model that is very reasonable and is used throughout the industry. We are working very closely with the borrowers because they are impacted on what they can or cannot borrow; and what they want or do not want to borrow. That involves working very closely with them on the reinvestment side of the business. Is there a way to give them appropriate funding which satisfies some of their liquidity ratios (or capital ratios) in a more reasonable way?

I think so. One of the benefits we enjoy is that we are not subject to Dodd-Frank 165. That is only impacting systemically-important financial institutions (SIFIs), and coincidentally, many of the major players in the securities lending space are designated as such. On the borrower side we are

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beginning to see business move away from the top tier borrower base. Clearly other prime brokers are going to benefit over time as hedge fund activity migrates away from the bulge bracket firms and migrates towards other smaller, nimbler firms. Finally, I see the same thing happening in securities lending; a portion of business (not all of it of course) is migrating away from the major players toward providers that are able to offer diversification.

There is a good reason for this dynamic; it works to the client's advantage. Moreover, as we begin to feel the effects of regulatory change, there will also be more discussions about the cost of indemnification and the long term impact of all these changes in the market.

FRANCESCA CARNEVALE: Craig has outlined a number of structural changes that are occurring in the market because of regulation: a flight to diversification, a flight to quality perhaps and liquidity, where it can be found. Is that your view as well Robert?

ROBERT ZEKRAUS: In the marketplace where regulatory changes are forcing people to re-evaluate their overall portfolio and book of business, in this case from a securities financing aspect we are seeing traditionally smaller market participants standing potentially to benefit from some of that change not only in the Americas—Canada and the US—but also globally as well.

Businesses are positioning themselves to capture market share. Even so, the overall universal model for this particular business may only be secured by a few of the larger industry players; yet even at those firms client re-pricing may take place and meeting internal return hurdles (i.e. returns on assets) are being more scrutinised.

Therefore some of the mid-tier and smaller players will have an opportunity to alter the landscape. From a Scotiabank perspective notwithstanding, other banks of similar size, with a strong balance sheet, credit and compelling offering, stand to benefit in the prime services/prime broker arena as well as in the agent lender and other market participant space.

FRANCESCA CARNEVALE: Susan, as a provider of quite diversified value-add/risk management services, how is regulation impacting on you. Does it provide you with additional business opportunities and what are beneficial owners looking for right now in terms of requirements?

SUSAN PETERS: Scorpeo’s business model is not an outgrowth of the regulatory impact of Basel III, it comes from beneficial owners seeking to maximize intrinsic portfolio value while incurring minimal risk.

I do think that a failure to understand the dynamics of the ebb and flow of liquidity is one of the root causes of the recent economic crisis and resulting regulatory change. The new regulatory environment has produced some odd results.

I recently opened the Wall Street Journal and saw that banks were rejecting cash deposits. What are banks for? Certainly

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the founders of some of the old white shoe firms must be rolling in their graves to hear that significant cash deposits are being turned away by major banks.

The regulatory impact of Basel III may indeed favour firms such as Scorpeo. One could argue that a favourable result of recent regulatory change is to place asset managers in the position of making active choices with respect to which route to market is best for them. In some cases, lending se curities may be the optimal choice, in others, the best route to market may be to optimize the revenue associated with corporate actions using Scorpeo’s methodology.

It strikes me that the regulatory environment fosters a process where investment managers must actively manage which route to market works for them, given their risk appetite, the available revenue, their tax position and desire to manage operational risk in day-to-day activity.

Charles Rizzo, Senior Vice President, Chief Financial Officer For The John Hancock Family Of Funds And Chairman John Hancock Funds Risk Committee

“The most recent amendments to the money market rules issued last year require floating rate funds for institutional money market funds. During the last five to six years we have had a floating rate NAV fund structure in our cash collateral pool.

We thought that was very innovative at the time.”

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CHRIS VALENTINO: Just building on what Susan said, from our perspective in the market we definitely see a desire from our client base for increased transparency within the market. Susan spoke about beneficial owners actively managing their securities lending programmes. We too now work with a number of beneficial owners who probably in the past would use a market data provider (like DataLend) primarily as a benchmarking tool to ensure that their agent lenders were acting in their best interests. There now appears to be a greater interest in utilising the data to identify and capitalise on intrinsic-value opportunities in the marketplace.

EquiLend and DataLend are trying to seize this opportunity by providing a level of transparency that perhaps doesn't exist elsewhere in the market, partnering with agent lenders and beneficial owners to help educate that community on potential opportunities. Clearly it is an opportunity for our business.

Charles has spoken about a reduction in the general collateral balance; however, we haven't seen evidence of that come across our pipes. We continue to add clients on both the trading and post-trade side of our business. Regulation has actually provided us with some new and rather interesting opportunities with which to add efficiencies and transparency for our clients.

ROBERT ZEKRAUS: Complementary to what Chris and his firm are doing within the market (and some of their competitors as well), there are a growing number of firms that are trying to replicate that level of transparency. I would call it almost a portfolio dashboard approach for the buy side, or the hedge fund manager, that might not have an in-house financing specialist within the fund but who nonetheless requires an overarching approach to manage financing across multiple prime brokers so they can make better and more informed decisions. Any number of considerations lie behind this trend: the changing regulatory environment; what impact regulation will have on their book of business with their prime brokers, particularly around funding and financing balances, not only on the securities lending side but on the margin lending side; and

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also they are aware there are risks in their concentration of positions across their multiple prime brokers.

Clearly then as this market continues to evolve there is opportunity for technology-savvy and forward thinking lenders to offer similar products for beneficial owners, asset managers, etc. and their broker-dealer counterparts that will help them manage their decisions more effectively.

CHARLES RIZZO: From the beneficial owners’ side, I am starting to see advances in dashboard type reporting and some movement towards providing increased transparency with regard to lendable assets that are in a portfolio. Now, the reason that is important is that it can allow me and members of my team to engage in a discussion with the fund manager to make sure that they are aware of where the opportunity is with regard to performance enhancement.

However, we do not interfere in buying or selling decisions.

We do not think it is our role to tell a manager how to manage the fund, we view our role with them more as advisory/consultative, but if we have the information, and through some of these automation tools we can engage in that conversation much more effectively, we can come across more as a trusted advisor collectively pointing out opportunities that exist to enhance the overall performance of our portfolios. That is where automation and advances in technology can really benefit not only the providers, but also the beneficial owners as our interests are clearly aligned.

DAVID GURTZ: As the asset owner at this table, all of these things are exactly what we are looking for. In terms of regulation, regulation might not impact PRIM directly but it certainly impacts our investment managers, it impacts the plumbing, so to speak, of the entire marketplace.

Therefore we are keenly aware of monitoring how our managers and how others are improving their compliance and improving their technology to deal with all the regulatory changes that have been taking place over the last five to seven years and are coming toward us in the near future.

At the end of the day, one of the things that we are really looking for as an asset owner is full transparency. We want to know as much as we can to make informed decisions and these kind of products that you guys are speaking about that allow us a better understanding of the return potential, and the risks involved are exactly what we want to be looking at and utilising going forward.

Susan Peters, Chief Operating Officer, Scorpeo

“One could argue that this is now a beneficial owner's fiduciary obligation, to find where the best value at the lowest possible risk and play a very active role in how they manage that opportunity.”

THE MACRO ENVIRONMENT: WHEN PATHS DIVERGE, CAN WE TAKE BOTH?

FRANCESCA CARNEVALE: As Charles intimated very early on in this discussion, against a regulatory background the macro environment is ready for change. Certainly in the United States, interest rates will start to rise this year with an attendant effect on most financial activity. Chris, how are you preparing for this change? Do you think that the new macro environment will provide a fillip for securities lending this year and/or collateral reinvestment? Or, do you

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think that this year is just another continuation of 2014 where extraneous risk factors have essentially determined the investment outlook?

CHRIS VALENTINO: I have a very positive outlook on the marketplace. Higher rates helps in terms of demand from hedge funds; volatility also helps. What we have seen in the last three months has been healthy. We have had fairly significant moves in all the major market indices.

That’s healthy. The real issue, I believe, from a lending perspective, is that the market has witnessed strong one-way directional sentiment.

When you think the market is going to appreciate over time, it is hard to get a lot of interest to take positions outside the norm. The fact that we have seen some volatility and higher rates might cause a few headaches for investment managers, but I believe it is good for the lending business.

It allows for more alternatives and will inherently create more demand from the borrower's side of the business.

A more robust marketplace makes banks healthier overall, which is good for our industry, and over time, you'll have more intriguing products to engage in. I can't predict what those are going to be, but when you have an interest rate curve in the marketplace, you at least have decisions to make.

Frankly, over the last four years, the market has been rather mundane, but over the last quarter at least, a much more robust market looks to be underway. The US market from a lending perspective had a very good fourth quarter, and I see this trend being a good one for clients and for those people who are participating in lending in 2015. I believe that regulation actually creates opportunity; you have to work at it a little bit harder, but that is what agent lenders are here for, and that is what the borrowers are there for. They have created opportunity, whether it is for their hedge fund clients or for their agent lending clients.

Don’t forget, securities lending is critical to the overall market, particularly from a liquidity perspective, and that won’t change, whatever macro trends are in play. It will improve in some quarters and deteriorate other quarters, but generally it appears we are on a good upward trend.

DAVID GURTZ: What's good for the securities lending industry is not necessarily so great from an asset owner’s perspective. As you mentioned Chris, high volatility, potentially rising interest rates, are in play and frankly, it's a challenging time to be an investor right now. It is particularly challenging from an asset allocation perspective. Even so, I have to stand with everyone around the table and acknowledge that these are good reasons to be back in securities lending. The rest of the portfolio might be challenged, but additional revenues from our securities lending programme will help, for sure.

CHARLES RIZZO: When you talk about decisions around changes in regulation firms may wish to contemplate how a floating NAV collateral pool fund may align with a particular lending philosophy. The most recent amendments to

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the money market rules issued last year require floating rate funds for institutional money market funds. During the last five to six years we have had a floating rate NAV fund structure in our cash collateral pool. We thought that was very innovative at the time.

We felt that a floating NAV fund is a good structure for a cash collateral vehicle because portfolio managers are used to a floating NAV for their funds they manage and when they make investment decisions they always have to think about risk and return, just like buying a stock or a bond and a security loan is no different. We didn't feel that in a stable rate cash collateral fund structure it made a lot of sense for us as the advisor, primarily because all the benefits of the lending programme were designed purposely to move to our funds. We wanted our shareholders to benefit.

We weren't in it to make an advisory fee on the assets.

For these and a host of other reasons, we went to a floating rate structure. Therefore now the opportunity is for many in the industry that manage their assets through existing stable value cash collateral vehicles to at least consider the benefits of moving to a floating NAV structure and for their cash re-invest program.

ROBERT ZEKRAUS: We have benefited from a five year trend in upward market appreciation but as Craig mentioned earlier, volatility does create other opportunities within our respective businesses and the markets have experienced more of that recently. Therefore investor sentiments where there were not as many shorts, and investment decisions were very much one-sided and directional, could now potentially change.

Last year saw an abundance of M&A activity in the marketplace, the highest levels since 2007, with a lot of cross border activity in which people were able to trade around and transact. Companies flush with cash on their balance sheet may continue to make investments and/or distribution decisions back to shareholders. Couple that with a changing macro environment and the US Federal Reserve Bank’s decision on interest rates and there could be momentum going forward, and opportunity for the securities lending business to be more successful. However, I would add a note of caution: firms will have to pick and choose where they intend to be involved, potentially developing more of a specialist mindset while working very closely with clients across the investment management spectrum.

CHRIS VALENTINO: Just to back up what Craig was saying with some statistics, spreads in the U.S. equity market in Q4 were quite strong and demonstrated a healthy upward trend. In fact, if you look at the whole year, spreads on average were up approximately 30% from January through December.

As Robert noted, in 2014 M&A activity was a catalyst for several securities lending opportunities. In 2015, potentially rising interest rates are at the forefront of many discussions we are having with clients. Volatility has injected itself back into the market, and we have already seen evidence of that within

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the energy sector. With the fall in the price of oil, you see a lot of opportunities in that particular sector starting off the year.

SUSAN PETERS: It certainly is a demanding environment that requires active management. It is also an environment that produces very interesting anomalies, as we saw with Tesla over the past year and a half. The prevailing theme that we have been discussing so far is that the beneficial owner and, indeed, whoever they partner with on either securities lending or other types of value-added products really has to be an active manager.

When I first began in the securities lending business, securities lending revenue was viewed simply as a method for offsetting custody fees and little attention, if any, was paid to the process. That is now very much in the past. Now we see asset managers in large programmes making daily decisions on whether to allocate assets to a securities lending strategy or, indeed, to some other type of value capture strategy that captures additional revenue, such as corporate action optimization strategies. One could argue that this is now a beneficial owner's fiduciary obligation, to find where the best value at the lowest possible risk and play a very active role in how they manage that opportunity.

CRAIG STARBLE: That is a great point. We are seeing a lot more interest from the beneficial owner to make sure that the portfolio managers, whether external or internal, are actively involved in the securities lending process. Years ago that was not the case. It was largely kept within the beneficial owner community and they did not give securities lending agents access to the underlying portfolio or the portfolio manager (PM).

Therefore to Charles' point earlier, he needs better information so he can communicate with his investment managers and his PMs about opportunities. It is a trend we are seeing among many of our clients and market players and we think it is a very good thing. It attempts to leave less money on the table for pure securities lending activity or alternatives, such as the services Susan's firm is offering.

To do this effectively however, you must have an active engagement with the portfolio managers, who are in charge of the portfolio. We have noted a genuine interest amongst beneficial owners to get us, and other folks like us, in front of their portfolio managers.

DAVID GURTZ: That is definitely how we approach securities lending at PRIM. This is a terrible analogy but I like to use it. We think of the beta of the market as the cake, the alpha by our managers as the icing and securities lending really should be the sprinkles on top of it. The sprinkles are additive, no doubt, but we do not want it to taint the icing on the cake. We do not want it to taint our managers' alpha.

Therefore, establishing effective lines of communication between our managers and our securities lending agent is the best way we ensure that securities lending, while additive, doesn't negatively impact our managers, which are the primary source of alpha.

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CCPS: DO THEY ADD VALUE TO THE SECURITIES LENDING MARKET?

CRAIG STARBLE: Well, first of all, we are very positive and encouraging of the CCP model and the future of CCPs as far as being an intermediary. I am a big believer that it is a route to market, just like a lot of other types of transactions or appropriate routes to market. Eurex has done a good job in pushing the CCP agenda forward in Europe and they are far closer to doing pure securities lending, stock loan with client assets, than we are here in the States. It is evolving here and hopefully, one day we will get there, but we are some way behind Europe in this discussion.

A couple things we should note: as agent lenders, we cannot advocate a CCP model to our clients unless we fully understand the impact of it. We know, for better or worse, the effects of a default in a traditional bilateral securities lending trade. We understand how to manage through it, based on the Lehman crisis.

We understand how to manage our clients' business and we know how to indemnify that risk. We understand all that. As for CCPs, how does it work if there is a default?

And what are the processes involved? As I said, Eurex has done a great job of explaining these elements. Therefore, we now better understand the waterfall and the impact of potential defaults and we can then communicate that to our client. That is the first issue.

CCPS are also great from a capital perspective as they provide huge capital relief for the borrower. Therefore as an opportunity, I am in favour of it. I also believe, however, that it should be financially beneficial to our client. I am hopeful that in the US, the OCC will have a model that works for clients over time, and I do think it is an appropriate route to market, but it will not involve all of the securities lending business. Instead it will involve a portion of the business, just like discretionary lending and exclusive lending, and all the other things that we do today in the marketplace.

Regulation is helping CCPs; it is mandating their use.

Borrowers should want to borrow through the CCP and agent lenders should benefit from it and clients should therefore benefit from it as well over time.

CHRIS VALENTINO: CCPs are certainly a topic that comes up often. We are conducting all of the necessary due diligence. After all, we are a partner with the industry, so when the industry feels that the timing is right, we will move in tandem with it.

FRANCESCA CARNEVALE: Charles, have providers spent time explaining effectively what, if any, benefits CCPs can bring to the securities lending market?

CHARLES RIZZO: Sure. We have had ongoing discussions. I can tell you today there aren't any allocations of our loans going through a CCP. There are still areas that beneficial owners have some concerns about. I'm not sure that

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the counterparty risk has been entirely eliminated compared to the bilateral trade that we do today and we still have to interface with a clearing house broker. On the positive side, it is clear that you do get transparency, so I guess if you were to allocate, a portion of your loans on a clearing house type platform, you would be comfortable that you have a market price.

Therefore, there is a good discovery mechanism when you trade through the market between a willing borrower and buyer and that is a positive. However, I also think that one of the benefits of an agency type relationship is the strong relationship that exists with their borrowers and that could be very beneficial to a beneficial owner during times of market stress particularly if there are instances of margin calls, where agent lenders can work with the portfolio manager to help manage the performance risk of having to sell securities in a bad market. Clearly then, that opportunity exists and the duration of loans can be perhaps managed more effectively in a bilateral type trade.

There are definite benefits to the clearing house type model. However, it hasn't really caught hold yet. We will just have to keep monitoring it but right now we do not really feel that there is a tremendous advantage of moving off our existing model.

Chris Valentino, Director, Sales, EquiLend

“Volatility has injected itself back into the market, and we have already seen evidence of that within the energy sector.

With the fall in the price of oil, you see a lot of opportunities in that particular sector starting off the year.”

ROBERT ZEKRAUS: For the right book of business it may make sense to progress and move forward using a CCP such as the OCC for a portion of your balances to mitigate counterparty exposures, potentially minimise haircuts, help with the capital structure regime of your bank and potentially reduce margin posted.

To date I know a few tier one firms on the broker dealer side, prime brokers, who are actively engaged but at the same time others of similar size are not engaged or not pushing the envelope forward on that. Overall, from an OCC perspective, since the early 1990s the stock loan/hedge programme has expanded in terms of volumes and increases in operational efficiency. As a result the CCP continues to attract more participants for a variety of reasons.

FRANCESCA CARNEVALE: David, for PRIM is an initiative such as the establishment of a central counterparty as an intermediary between yourself and the other side of the trade, is that important to you? Is the saftey element important to you?

DAVID GURTZ: Not really. We rely on our advisor lending agent to keep us abreast of these market changes. To Charles’ point earlier, counterparty risk still exists, whether it is a bank or another entity, and there still needs to be a process in place to monitor your counterparty risk and understand who the counterparty is and the risks that they have and what measures are in place to mitigate those risks. We are agnostic at this point as we have a very plain vanilla programme, so we are probably not at the forefront of this issue. We are just monitoring at this point without considering any actions or any opinions on it.

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SUSAN PETERS: What interests me about central counterparties is that they are founded on the notion that risk is better managed from within a counterparty backed by a larger group. Not all risk is predictable; risks that are well understood and managed may not be the risks that ultimately cause losses. It is the risk that was overlooked or not well understood or comes from a confluence of unlikely events.

I would caution overreliance upon central counterparties as a substitute for active management and it sounds like the mood in this room is that people are not doing that. My fear is that CCPs will bring about a form of complacency.

CRAIG STARBLE: The issue with the CCPs, though, is that every other market has gone towards a CCP model or has been mandated to do so. I do not disagree with what you are saying; I like being able to manage it and touch it and I have been challenged by trying to understand the CCP model, but the reality is every other financial instrument has been mandated to clear through it. Therefore, we probably are going to have some role in that going forward.

I do not think it is going to be mandated or legislated, but I do think that there is going to be an effort to move us there.

At the very least, as an industry, we need to understand it better because right now, many of us do not understand the model. We have to get comfortable with the nuts and bolts of exactly how the waterfall works, how you get paid, how the operational structure works in a default and we must get down to the real details. We understand how a bilateral default works now because we have all experienced it in the industry before, but we do not clearly understand how it works as it relates to securities lending in a CCP. All the CCPs were greatly impacted by MF Global and others. Therefore they know how it works, we just have to apply it appropriately to what we do, and it is, I believe, incumbent on the CCPs to educate us on what it means to clear and transact through the CCP. It will certainly be an interesting path.

CREATING VALUE IN A COMPLEX MARKET: DOES SEC LENDING HELP?

ROBERT ZEKRAUS: Over the short term, when you look at the impact and the challenges that everyone seems to be faced with, a positive consideration is that people now have to recalibrate and figure out where they can create value for their client base and for their book of business in order to differentiate themselves.

Therefore an area of continuous growth opportunity is around collateral expansion. That being said, there are market initiatives and discussions ongoing in the US around the use and expansion of equities as an acceptable form of collateral in relation to rule 15c3-3. The growth of collateral expansion, in particular out of the US, is quite important for the marketplace. In Europe, it is more the norm and an established practice which has been documented and evidenced throughout the financial crisis and the post crisis period. In other markets/other jurisdictions traders have continued to use non-cash collateral in a trades to meet

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

margin requirements, funding needs and newer regulatory demands. In the US we still have an opportunity to develop this aspect.

The redistribution of balances based on the impact of balance sheet constraints and, standardisation of capital calculations could be helpful for smaller firms to win market share. Then there is the furthering of the relationship between the broker-dealer and the agent lender where changes in the market can create unique opportunities in financing as a consequence to the shift in prime brokerage balances and regulatory shifts. It could be anything from white labelling to funding structures to exclusives.

Therefore we really think the theme is around collateral expansion, the redistribution of balances, and the partnership with clients and counterparts around market initiatives.

DAVID GURTZ: We have a very plain vanilla programme, so in the immediate future I see us continuing to grow the programme only ever so slightly. We focus 100% on specials.

We do not have any general collateral lending at this point in time, and I do not see that changing in the foreseeable future. We do have a large hedge fund portfolio, so we do have players on the other side of the table, and speak with them about their views. If volatility increases over the coming months/quarters, I expect an uptick in the borrowing of securities by hedge funds in general.

I do think it is a good time to be in securities lending. In regards to our reinvestment of collateral, while we have heard and talked a little bit about doing equity for equity, we are going to focus on low-risk securities and continue down that path. Because we have a very vanilla programme, our risk appetite is very low. Therefore we are going to stick with very traditional reinvestment of collateral but I do think the overall environment for sec lending should improve over the next coming quarters.

CHARLES RIZZO: In a mutual fund context, we have a fiduciary responsibility to optimise value generation but also to balance risk and that, first and foremost, when we look at any opportunity and was one of the reasons that we are only lending specials today, because that equation got out of balance. We felt that there was more risk than there was opportunity, given the low spreads we were seeing on the GC side.

Having said that, as part of that process to adjust our investment management strategy, we also increased our minimum basis points requirement. Therefore we will always earn a spread relative to Fed funds that is sufficient based on our funds’ risk. I could see a decision to lend general collateral again in the future if reinvestment returns increased. With regard to specials, we have a mandate that all specials in the markets that we have approved should be lent out. We have worked in certain markets between our investment managers and our agent lenders to provide prenotification as early as possible in any securities sales so that we do not run the risk of causing fails in a no fail type market There is a lending opportunity in emerging markets

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but clearly there is a lot of risk too if you do not have that process built and controlled right. Therefore we may take a look at other markets and make decisions whether or not those markets are fit for purpose in terms of loaning securities. Therefore we'll keep our eye on that.

We'll continue doing what we have been doing on taking advantage of earnings on foreign dividends. That has been a great value generator for our international funds. The other thing that we keep an eye on, quite frankly, too is there is a tax component when you lend, particularly when dividends are being paid.

Those in lieu of payments aren't qualified dividend income from a distribution standpoint under US tax law. For those funds that have, let's say, more tax-efficient strategies, you have to pay attention to that, otherwise, the shareholders who are getting distributions will end up paying more taxes and so while there are opportunities, certainly, in the international markets, the tax impacts need to be considered.

Sometimes it may make sense not to lend a stock in a particular market and take that stock dividend and file a reclaim on withheld taxes with that country, or sometimes it may make sense to take the income from the in-lieu of payment and not have to wait to get paid on the foreign reclaim which can take years in some cases. Therefore there are many dynamics in play.

SUSAN PETERS: Early on in this discussion we talked about how beneficial owners are being more careful about managing the sources of their revenue, and that level of coordination is exciting because asset managers are making active decisions about lending their securities or not or whether another route to market may make more sense.

THE INTERPLAY OF COLLATERAL AND SECURITIES LENDING

CHARLES RIZZO: In a mutual fund there are many instances where collateral comes into play. For example, repurchase agreements are commonly used for overnight investments and collateral is received by the counterparty, similarly on a reverse re-purchase agreement collateral is given to counterparty in order to offset the lending risks that the counterparty has. Derivatives that trade through a clearing house or that are bi-lateral require collateral as well. As we have noted earlier, collateral is a central feature of security lending constructs. Therefore you have all these collateral dynamics at play and many of them could be at play within the same fund strategy.

I see opportunity, quite frankly, for a system that provides functionality and transparency to be able to more effectively manage all these different types of collateral so that optimal collateral strategies assets of the fund and collateral decisions can benefit the fund and possibly improve earnings.

However, I haven't been presented with that type of system yet and because of that, I would say collateral optimisation processes and systems remain manually intensive.

It requires automation and it needs a system and a process

62

but if we had some type of front end that allows us to see the different types of assets in play, we could make better decisions on collateralising the right type of asset, offsetting the right type of exposure that our funds have, optimising the assets in the fund with the objective of trying to maximize the earnings potential. I think it is a tremendous opportunity, given all the changes in regulation that have happened over the past few years and somebody will seize on that and it will be a pretty neat product.

CRAIG STARBLE: It is very challenging to come up with a collateral and liquidity management system and roll it out to the industry because everybody, including Charles, has different custody agents/custody banks, and he has different profiles. We might think that another asset manager looks a little bit like him, but in reality we find that he is very different.

Therefore, this theme is really about clients and beneficial owners looking for more of a customised approach and when you look to build technology, beneficial owners do not want to pay millions of dollars for the very something they are looking for. You want to be given something that works for you, that is provided to you and the agent lender can create transactions as a result of that collateral transformation. That is really the optimised thing to do and, you are right, it has not happened yet. We think about it a lot and we think about how to create it and it is something that needs to be done from an industry perspective.

CHARLES RIZZO:You are also going to need regulatory support because in Europe we know that we can use securities lending as a means to get funding into funds to collateralise derivatives to support liquidity needs on margin requirements.

I think securities lending could be a structure to leverage for those managers that have derivatives, have to clear and need collateral to post to counterparties. The cost of financing for cash collateral may be less expensive than the opportunity costs of holding cash and/or short term investments. I think that lending can present an opportunity in the right situations to facilitate the liquidity needs of funds.

SUSAN PETERS: I'm sure Robert is smiling because he's probably saying: welcome to my world. This has been the broker dealer challenge for years. I find it inspiring that asset managers are looking at value added methods from a similar perspective.

ROBERT ZEKRAUS: I agree, although it is a significant challenge in most banks and in most organisations. When you start looking across asset classes, it really gets down to the data, the quality of that data and where the data is warehoused. It is also about the clearing mechanics, the sophistication of your architecture and technology platform, that an overarching theme of a central collateral management business utility function within an organisation, that is not new by any means; it is been around for a long time

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and how people perform and how they execute that strategy in that plan, it has a lot of investment. It is not cheap, it is very costly but it is a very important part of the business.

As Craig mentions, we need to solve this as an industry. It can either come out of an existing platform that someone's already built or we start from scratch. As Charles says, there is a real opportunity out there.

CRAIG STARBLE: What has not been addressed is the internal transfer pricing that goes along with all this. There has to be a mechanism to transact appropriately between legal entities, at the right price. The right way to do that is with a third party player, right? It’s- such an obvious requirement that it seems impossible to believe that a third party has not been more actively involved; but there it is, it is clearly very challenging.

For a public pension plan with one legal entity, the equation may be a lot easier than an investor with say Charles’ 200 funds. That may be a little bit more challenging right? However, that does not mean it should not be worked on and developed.

CHARLES RIZZO: There is an opportunity for a systems solution that can address some of these issues. It think it would be very well received in the industry.

CHRIS VALENTINO: The conversations that EquiLend has with its clients are somewhat of a leading indicator for the direction of the market and the opportunities that may exist. These opportunities include increased automation around equity for equity trading and fixed income trading via our BondLend product. An opportunity exists in synthetics and swaps where there is very little automation and standardization. New markets are also of interest. Australia, for example, is a new market for EquiLend. Brazil presents opportunities as well. Repo data and additional transparency in the fixed income space is yet another opportunity.

CRAIG STARBLE: Over the long term, access to collateral is going to have the biggest impact on securities lending.

With that in mind, do we migrate toward a model that is focused only on specials lending, because specials lending will always be lucrative. How do we better source and use appropriate collateral?

The reality is that regulators are mandating the takers of cash to take cash longer term, while the providers of cash want to invest that cash short term, which in turn creates a disconnect and a challenging environment. Some clients will respond with more aggressive reinvestment strategies, others will opt to remain with their current strategy. For our part, eSecLending will move toward being more of a utility in the marketplace. We want to be an advocate and provide solutions to our beneficial owner clients and also to the CCPs. CCPs require default management solutions, they need liquidity financing, and they need opportunities, just like

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

beneficial owners need them, just like the borrowers need.

Yes, we may use them as a conduit to do stock loan but they also have other needs in the marketplace as well.

Therefore I see the market moving more towards providing the beneficial owners with more dashboards. We are going to have to give those who want to transact on their own the ability to transact on their own. For instance, we will have to give portfolio managers the opportunity to lend their own stock if they choose to do that transaction, or let them be a middle office, if they want to do that.

The more tools we give clients, the more they are going to use them - but we have to do it in an appropriate riskmanaged way, and everyone is going to have to be different.

As is the case today, we will continue to see customisation in this business because everyone has a different philosophy, everyone has a different risk profile and you cannot run a securities lending programme as a programme anymore, you have to run it as a series of client accommodations.

Clearly, the movement towards communicating with portfolio managers and asset managers directly is a huge change in the industry. It gives firms such as Susan's the opportunity to talk directly to the decision-makers; it gives eSecLending the opportunity to make sure operational considerations, such as the timing of sell notification, are handled properly. If you do that, you can make more money in the emerging market space; but you cannot do that unless you have a risk profile in place that is going to allow that to be done in an appropriate way. Therefore, more transparency and communication will lead to a lot of interesting opportunities for beneficial owners and the industry as a whole.

EVOLUTION AND INNOVATION: WHERE WILL YOU FIND IT?

SUSAN PETERS: Securities lenders should look to the future and expand beyond the mundane and partner with providers of value-added products that enhance revenue.

If I were to look at it from the perspective of the beneficial owner, providers should look at securities lending in terms of not just simply providing one product that is intended to accommodate all routes to market but to acknowledge, enhance and facilitate routes to market that may even involve a decision to seek another route to market. The real winner among the lending agents will be the ones that provide the platform where this type of decision-making can take place.

ROBERT ZEKRAUS: We think the industry is very healthy and will continue to go through changes. We think an education process that explains those changes and what they mean for the various participants is vital. In terms of our own business, we will continue to look for partnerships (where it makes sense) either through technology solutions, through banks and broker dealer solutions or through our

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own proprietary solutions to make this business grow and maintain sustainability while managing the inherent risks.

Securities finance plays an important and vital role in the marketplace. Market evolution is also pretty interesting right now.

There looks to be a little continuum that is encouraging convergence between investment strategies, where longonly index managers will eventually look more like a hedge fund and a hedge fund will look more like a long-only manager and that will continue to create more business and opportunities in the securities lending and financing space, both for prime brokers and agent lenders.

CHRIS VALENTINO: The business itself is still day-today very manual, so in order to free up the resources to analyse these higher-margin type opportunities, there is a lot of manual flow that still needs to become more automated. There are still tons of spreadsheets, Bloombergs [sic] and emails going back and forth between lenders and borrowers. Our Next Generation Trading initiative at EquiLend looks to inject additional automation into this day-to-day flow. Our goal is to move beyond the traditional general collateral trade and create efficiencies in the warm and hot space.

DAVID GURTZ: Asset owners are better positioned than they ever have been. Even so, asset owners’ (and here I’m talking of the large endowments, foundations and middle to large public pension plans) portfolios are exceedingly complex. While these organisations are getting more sophisticated in an effort to keep up with the investment market space, quite honestly, to keep on doing that you need the right tools, advisors, systems and products to keep alongside the curve.

At the end of the day, what are we trying to do? We are trying to maximise returns while minimizing risks and as you become more complex, you need better tools in order to achieve this. With that in mind, I believe securities lending will continue to evolve and become more complex, but I also believe the systems and tools will become that much better. Even so, going back to my original and horrible analogy, it is still the sprinkles on top of the cake.

We do not want to harm the larger cake, or the icing because of securities lending. We realise that, like everything else, things will become more complex and the better systems and tools that we need will be required in order for us to continue with securities lending. If it does begin to harm the other work we do, we will again step away from the securities lending programme, as we have in the past.

Being optimistic, for sure, as a business segment, over the long term securities lending will evolve and prosper. I hope we'll have a very successful programme and the sprinkles will be abundant and delicious!

FRANCESCA CARNEVALE: How much will firms like yours Charles drive this move towards greater transparency?

How important is to for you to fully understand your coun-

64

terparty, to manage your collateral exposure more effectively? Or, are you dependent on the willingness of providers to anticipate and meet your requirements?

CHARLES RIZZO: One of the benefits of having a service provider offer collateral optimisation solutions is because of the scale benefits across multiple clients, which then can give beneficial owners like ourselves a commercially viable (or cost-effective) product.

Now, we could spend a lot of money internally and try to build that system ourselves, but I'm not sure that that is the best use of shareholder assets, given the scale of our lending programme. Therefore, it is very important to have more automation to provide funds with additional capabilities.

Certainly broad based industry solutions offer a more consistent approach and avoids large IT spend and development cost. Given the fast pace of technology and regulation, could mean many internally developed system would be out of date in a very short period of time.

Regulatory change is a constant right now. It makes it more challenging to undertake effective forecasting, as it is not clear sometimes which way regulators are going to turn.

Then, if you are a global business, regulation is not standardised around the world. So there are already many variables in the system to contend with. We also touched on areas where collateral optimisation solutions can benefit asset managers. Set against these considerations, some level of standardisation is good and would benefit all asset managers and shareholders alike, though it will to take some time FRANCESCA CARNEVALE: Thank you for a very interesting discussion. n

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GM Data pages 80.qxp_. 19/02/2015 15:32 Page 66

MARKET DATA BY FTSE RESEARCH

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

12M% -1.0 -0.3 -0.2 -2.2 -0.7 -2.0 -2.7

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

9.8 13.3 10.3 0.6 2.1 7.5 7.2 -48.4

-22.9

-5.5 -9.7

1.5 -0.7 -11.0

-24.6

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

0.2 1.2 1.2 1.1 1.1

8.4 12.1 13.7 15.0 19.5

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

0.8 0.3

10.5 9.1

FX - TRADE WEIGHTED USD GBP EUR JPY

1.6 1.4

12.2 3.7 -3.9 -10.1

-1.2 0.5

-30

-20

-10

0

10

-60

-40

-20

0

20

40

EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 12M local ccy (TR)

Regions 1M local ccy (TR) -0.2 -0.3 -0.7 -0.8 -1.0

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

-2.0 -2.2 -2.7 -4.0

-5

-4

-3

-2

-1

13.3

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

0

10.3 10.0 9.8 7.5 7.2 2.5 2.1 0.6

0

4

-6

-4

-2

0

Israel Denmark Belgium/Lux Sweden USA Finland Switzerland Canada Japan Developed Spain Singapore Netherlands Australia Italy France Hong Germany UK Norway Korea -6.9

2

4

-0.1 -2.1 -2.7 -3.0 -3.1 -6.0 -8.4 -23.7

-25

-20

-15

-10

-5

0

31.8 13.8 13.3 12.8 12.4 12.1 10.3 10.0 9.0 8.3 8.3 5.7 4.8 3.7 3.3 2.9 0.6 0.1

0

10

20

30

40

Emerging 12M local ccy (TR)

1.5 1.4 0.9

-30

16

23.4 19.6

-10

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

12

Developed 12M local ccy (TR)

Developed 1M local ccy (TR) Australia 2.0 Singapore 0.9 Sweden 0.7 Norway 0.2 Belgium/Lux 0.0 Japan -0.2 Canada -0.3 USA -0.3 Israel -0.5 Developed -0.8 Netherlands -0.9 Germany -1.6 Finland -1.6 Switzerland -1.7 France -2.0 UK -2.2 Denmark -2.7 Korea -3.2 Hong Kong -4.2 Spain -4.3 Italy -5.2

8

5

India Indonesia South Africa Taiwan Thailand China Emerging Mexico Brazil Malaysia Russia -46.5

-60

32.5 29.6 17.4 16.9 16.5 8.4 7.2 2.0 -3.5 -5.2

-40

-20

0

20

40

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

66

JANUARY/FEBRUARY 2015 • FTSE GLOBAL MARKETS

GM Data pages 80.qxp_. 19/02/2015 15:32 Page 67

PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World

Global Sectors Relative to FTSE All-World

130

Oil & Gas Health Care Financials 130

120

120

110

110

100

100

90

90

80

80

Japan Europe ex UK

USU Emerging

UK

Asia Pacific ex-Japan

70 Dec 2012

Apr 2013

Aug 2013

Dec 2013

Apr 2014

Aug 2014

70 Dec 2012

Dec 2014

Basic Materials Consumer Services Technology

Apr 2013

Consumer Goods Industrials Telecommunications Utilities

Dec 2014

Aug 2014

Apr 2014

Dec 2013

Aug 2013

BOND MARKET RETURNS 1M%

12M%

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

0.2

8.4

UK (7-10 y)

1.2 1.2

Ger (7-10 y) Japan (7-10 y) France (7-10 y)

0.9 1.1

Italy (7-10 y)

1.1

12.1 13.7 4.6 15.0 19.5

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

1.0

Euro (7-10 y)

12.0

0.9

UK BBB

15.3

0.8

Euro BBB

10.5 9.1

0.3

UK Non Financial

1.2

Euro Non Financial

12.2 9.5

0.5

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

10.3

0.5

-1

0

1

2

0

5

10

15

20

25

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

Corporate Bond Yields

US

Japan

UK

Ger

France

Italy

U UK BBB

7.00

Euro BBB

6.00

6.00 5.00 5.00 4.00

4.00

3.00

3.00

2.00 2.00

1.00 0.00 Dec 2011

Jun 2012

Dec 2012

Jun 2013

Dec 2013

Jun 2014

Dec 2014

1.00 Dec 2009

Dec 2010

Dec 2011

Dec 2012

Dec 2013

Dec 2014

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

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2015

67

GM Data pages 80.qxp_. 19/02/2015 15:32 Page 68

MARKET DATA BY FTSE RESEARCH

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

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

FTSE UK

FTSE US Bond

110

FTSE US

115

110 105 105 100 100

95 Dec 2013

Mar 2014

Jun 2014

Sep 2014

95 Dec 2013

Dec 2014

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

FTSE UK

FTSE US Bond 220

140

180

120

140

100

100

Dec 2010

Dec 2011

Dec 2012

Dec 2013

1M% FTSE UK Index

-0.2

-1

Dec 2011

1

-2

Dec 2013

0

2

5.7

105.0

5.8

28.3

1.9

4

Dec 2014

44.9

1.9

0

Dec 2012

5Y%

3.8

-0.1

-2

Dec 2010

-1.2

0.7

FTSE USA Bond

Oct 2014

FTSE US

4.7

FTSE UK Bond

Sep 2014

6M%

-0.3

-3

60 Dec 2009

Dec 2014

3M%

-2.2

FTSE USA Index

Jun 2014

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

160

80 Dec 2009

Mar 2014

6

-2

0

2

25.2

4

6

8

0

50

100

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

68

JANUARY/FEBRUARY 2015 • FTSE GLOBAL MARKETS

150

GM Cover Issue 80.qxp_. 20/02/2015 17:51 Page FC1

US SECURITIES LENDING: DEFINING THE NEW BUSINESS DRIVERS

ISSUE 80 • JANUARY/FEBRUARY 2015

FTSE GLOBAL MARKETS

Egypt: spurring the foreign investor Can Europe establish a cross-border private placements market?

CMBS: time for a comeback?

ISSUE EIGHTY • JANUARY/FEBRUARY 2015

Why commodities are hammering Latin American currencies

Will Greece stall the European project?

Debt management versus the euro WWW.FTSEGLOBALMARKETS.COM