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OUTLOOK

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). PRODUCTION Andrew Lawson, Head of Production T: +44 207 680 5161; E: andrew.lawson@berlinguer.com Lee Dove, Production Manager T: 01206 795546; E: studio@alphaprint.co.uk OPERATIONS Christopher Maityard, Publishing Director T: +44 207 680 5162; E: chris.maityard@berlinguer.com CLIENT SOLUTIONS Marshall Leddy, North America Sales Director T: +1 612 234 7436, E: marshall@leddyassociates.com OVERSEAS REPRESENTATION Can Sonmez (Istanbul, Turkey) FTSE EDITORIAL BOARD Mark Makepeace (CEO); Donald Keith; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton PUBLISHED BY Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY Cliff Enterprise, Unit 6F Southbourne Business Park Courtlands Road, Eastbourne, East Sussex, BN22 8UY DISTRIBUTION Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION Please enrol on www.ftseglobalmarkets.com Single subscription: £87.00 which includes online access, print subscription and weekly e-alert A premium content site will be available from Feburary 2015 FTSE Global Markets is published 6 times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright Berlinguer Ltd 2014. All rights reserved). FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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2015 was always going to be a swing year. Not least because over 60 parliamentary or president elections take place this year (a touch over a quarter of the world’s countries). The sheer volume of choice being exercised in so many markets signifies substantive change. Nigeria, Turkey, the UK, Greece, Spain, Egypt, Argentina being some of the more notable countries facing the ballot box challenge this year. The year is calling out for change, not least because the overall global growth outlook remains moderate, with “uneven prospects across the main countries or regions,” says the IMF in a recent report. Certainly it looks a lot better than last year. There is a palpable sense that the outlook for many advanced economies is improving. The challenge this year will be whether frontier, emerging and advanced emerging markets can ease themselves out of the funk that looked to have mired them through much of 2014. Ironically, falling oil prices have not helped that much. It is not so much the fact that the IMF’s expectation for 3.5% growth this year is indicative of the general air of sluggishness, it’s more that the agency’s projections for 2016 is pretty much more of the same (with 3.8% growth pencilled in). The BRICs plus Turkey seem to be the most impacted, with the obvious exception of India (expected growth 7.5% in 2015). For its part, the IMF expects Brazil, Ukraine and Russia to find it particularly tough. Brazil’s outlook is impacted by drought, variable macro-economic policy and a continued weakening in private sector sentiment, with an expected 1% contraction in the economy. Commodity exporters in general look to be having a bad time, with the IMF projecting no change in outlook for at least the medium term. Russia's economy is now expected to contract by 3.8% this year; a downward revision of 0.8 percentage points since January. It is also expected to contract again by 1.1% in 2016. Neighbouring Ukraine's economy is meantime expected to bottom out in 2015, "as activity stabilises with the beginning of reconstruction work", with the economy projected to contract by 5.5%, according to the NGO. Inflation this year is forecast at 33.5%, reflecting currency depreciation. There is no change to the forecast for China, namely a continued slowdown to 6.8% this year and 6.3% in 2016. For all its much vaunted structural problems the eurozone’s outlook is marginally positive, with the IMF projecting 1.5% growth this year and 1.6% next, while the UK (relatively) looks on a roll with 2.7% growth projected this year and 2.3% next, while the US looks to be growing by 3.1% in 2015 and 2016, down marginally (by 0.5 and 0.2 percentage points respectively) on the previous forecasts. As may be expected, business sentiment in the United States looks to be positive. According to Deloitte’s Q1 CFO Signals survey of 100 CFOs indicates a ninth straight quarter of optimism regarding their organisation’s prospects, forecasts substantive growth in earnings and hiring. While CFOs expressed concern with challenges, such as the strengthening US dollar, a lagging global economy and US equity markets swings, they maintained a steadfast level of positive sentiment. Overall, net optimism increased quarter-on-quarter from 33.3% to 34.4% It is a backdrop that underpins much of the coverage in this edition, from David Simon’s look at the long term outlook for the US dollar through to the country reports on selected mid markets that typify the challenges facing emerging markets this year and next. In that context, decisions by voters as to who will lead countries through this swing time suddenly takes on new meaning and focus. Francesca Carnevale, Editor

COVER PHOTO: Options Clearing Corporation chairman Craig Donohue. Photograph kindly supplied by the Options Clearing Corporation, April 2015..

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CONTENTS COVER STORY

THE OCC STEPS OUT

..................................................................................................................Page 6 Armed with an augmented business team, a market in flux with new business opportunities opening, the Options Clearing Corporation now looks to a future of powerful consolation. The question is: how quickly will it get there?

DEPARTMENTS

MARKET LEADER VANTAGE POINT

CAN HEDGE FUNDS TURN THE TIDE IN 2015? .......................................Page 10 Hedge began the year with a bullet. Is the trend sustainable?

SECURITY SELECTIONS IN OIL ASSETS ...........................................................Page 14 In an inaugural column, Goldman Sachs Asset Management looks at the directional drivers of investment dollars.

SPOTLIGHT

GLOBAL AUM TOUCH €28TRN AT END OF 2014 ...............................Page 16

PENSIONS

WHY EUROPE’S QE BENEFITS DB PENSIONS

Developing a more dynamic approach to data applications.

...........................................Page 19 Paul Watters, senior director at Standard & Poor’s Ratings Services, explains why

IS THE END OF OPEN OUTCRY WORTH MOURNING? .......................Page 20 Hugh Cumberland, solutions manager, capital markets at Colt Technology Services says not

ASSET MANAGEMENT UNDER SCRUTINY

IN THE MARKETS

...............................................Page 22 Systemic risk is hard to eliminate. Now it’s the turn of asset managers to be under

WHO’S IN YOUR (PRIVATE EQUITY) TOP TEN? .....................................Page 24 Ricshi Kotecha, Pevara product manager at eFront, explains the rise of granular decile rankings

NSD PICKS UP THE PACE OF CORPORATE ACTIONS REFORM.....Page 25 Sanctions may be biting, but the NSD is no slouch in preparing for better days now

BELVEDERE

THE CONSEQUENCES OF FED DATA DEPENDENCY ....................

.....Page 28 In a new regular column, JP Morgan Asset Management assesses the influencers of i

FOREIGN EXCHANGE

THE BUCK STOPS – WHERE EXACTLY? ................................................................Page 30

ENERGY

WILL GLOBAL GROWTH UNDERPIN OIL PRICE RECOVERY? ..........Page 34

David Simons looks at a long term consequences of a too strong dollar Is global growth enough to revitalise oil prices?

WILL AQUIS CHANGE THE END OF DAY AUCTION? ..............................Page 37

TRADING

Flush with cash and looking for action: what’s an alternative investor to do?

RISK READINESS REVISTED ................................................................................................Page 38 David Simons looks at the broader challenges to banks and broker-dealers?

ASSET MANAGEMENT

THE GROWING CACHET OF GUERNSEY OPEN ENDED FUNDS

..Page 41

Why Class B Investment Schemes can compete head on with UCITs structures

IS IT NOW TIME FOR TURKEY TO REGAIN ITS MOJO? ........................Page 43

COUNTRY REPORT

Productivity is tailing and inflation is on the rise. What does Turkey have to do to turn things around?

EGYPT: LOOKING FOR NEW BEGINNINGS?

....................................................Page 45

So much is improving in Egypt and so much isn’t. What needs to change?

SECURITIES LENDING

CAN CCPS LEND A USEFUL HAND IN US SEC LENDING? ....................Page 47

POST TRADE

T2S & HARMONISED SETTLEMENT DISCIPLINE?..........................................Page 50

MARKET REFORM

SAUDI’S TAWADUL OPENS FOR INTERNATIONAL BUSINESS ........Page 52

MARKET DATA

Market Reports by FTSE Research ................................................................................................Page 54

Ruth Hughes looks at the benefits or otherwise of the new directive. The first of a series of reviews of aspects of Target-2 Securities The long awaited opening of the Saudi stock market to foreign investors

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03/04/15

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COVER STORY

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THE OCC LOOKS TO A BRIGHT CONFIDENT DAY This is a time in financial history when the post trade segment is truly coming into its own. Globally the segment is replete with institutions at a crossroads: some will fall by the wayside; some will be cowed by the change befalling the segment and dawdle in the doldrums and yet others will rise to the occasion. The US Options Clearing Corporation (OCC) is an institution that looks decidedly upwardly mobile. It has clearly validated its business model and even as it expects more leaders to enter the market place, it is looking to establish a more robust leadership role in the post trade services space, backed by enhanced risk procedures and liquidity. OCC executive chairman Craig Donohue spoke to FTSE Global Markets about the strategic imperatives now driving the corporation’s business.

HE US OPTIONS Clearing Corporation is stepping out. Armed with an enhanced management team, led by executive chairman Craig Donohue, the clearer has a more cohesive strategy focused on growth through expansion. The focus has been on three tasks to prepare the organisation for market change and increased competition. The OCC has been recapitalised, its management team has been strengthened and the corporation has undertaken a series of regulatory remedial objectives. The target is for the corporation to “broaden and diversify its liquidity facilities given regulatory changes in the banking industry and provide robust risk management practice,” explains Donohue, the OCC’s executive chairman. “Committed credit facilities from traditional financial institutions are expected to become increasingly expensive to obtain, and banks’ willingness to offer this product is expected to diminish over the next few years. OCC is committed to exploring a variety of liquidity options through various sources as long as they meet OCC’s credit and third party guidelines”. In terms of strategy, the coming decade is crucial for the OCC to establish its credentials in a changing and increasingly global, harmonised and competitive post trade landscape. Two irrevocable trends are governing the current direction of business. One, clearing houses are expanding their services to meet regulatory mandates for

centralised clearing of standardised swaps. Two, enhanced capital requirements has and continues to create incentives for market participants to seek greater capital and operating efficiencies by working more closely with clearing houses and custodians. Overarching strategy The OCC’s overarching strategy states Donohue is “to extend our capabilities to securities finance and OTC markets. OCC is the only clearing house for securities lending transactions where we guarantee return of stock or cash to bilateral and exchange-traded stock loan participants. This innovative solution maintains liquidity sources during times of stress. We also are working to introduce the same benefits to the equity repo markets. Finally, and most importantly, so our exchange partners see the emphasis we place on supporting them versus other initiatives, we continue to work with our exchange participants to expand the breadth of options and futures products cleared at OCC. The VIX and variance products that have become so successful, and now the new NQLX energy futures initiative with NASDAQ, are vivid examples of how we are innovating and expanding our product base. So I am excited about the opportunities that lie ahead for OCC”. A comprehensive and bold strategy needs a strong leadership to ensure effective implementation. Donohue has

been busy hiring and explains that he has increased the number of public directors to five,“to ensure that we have the broad perspectives that best support taking into account public interests when making decisions. Earlier this year we appointed two new public directors: Thomas Cardello of Venice Capital Group, LLC, and Robert Litterman, who chairs the Risk Committee at Kepos Capital. They are great additions to our board and they will enhance the diversity, skills and experience needed, especially in the critical area of risk management,” he says. Donohue holds that he is also utilising the best of the OCC’s legacy staff. The team, he says is committed and dedicated, “demonstrated by the promotions of Mike McClain to president and chief operating officer, John Fennell to executive vice president of Financial Risk Management, and Jim Kustusch to senior vice president of Operations”. It’s a wise mix and one that typifies Donohue’s approach to management. He rarely wastes a good resource and is a seasoned market strategist who has an eye for the main chance. He was instrumental in re-drawing the giant Chicago-based CME Group into a global rather than a national player. He brings the same expansive and forceful market outlook to the OCC. It will be an interesting rollout as the business set of the OCC is perforce more prescribed than that of the CME Group and is defined as much by strict regulation and risk controls as it is by today’s

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

dŽ ŐĞƚ Ă ďĞƩ Ğƌ ŚĂŶĚůĞ ŽŶ ƌŝƐŬ͕ ĐŽŶƚĂĐƚ͗ ǁǁǁ͘ĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ +44 20 7125 0492 ƐĂůĞƐΛĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

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COVER STORY

t h e o c c s t e p s o u t in t o c o n f id e n t d ay

more fluid macro-market opportunities. Right now, any clearer worth his salt will talk about the importance of liquidity and the pivotal role that clearing houses can play in the mix, particularly at a time when bank liquidity is at a premium and the repo market remains constrained. It’s a business reality that the OCC has taken to heart. The corporation has been active in working at the institutional level as much as it has at the national to secure a broad brush strategy that has encompassed working in cooperation with firms such as CalPERS and eSecLending to help manage liquidity resources as well as utilising the capital markets to shore up its liquid reserves. “OCC had a relationship with eSecLending from several years ago that was on-going. They had a relationship with CalPERS and they were the ones that brought OCC and CalPERS together,” explains Donohue. In a wider context, the OCC concluded a $1bn repurchase facility at the beginning of the year, which Donohue explains was “an important initial step in diversifying our liquidity sources while promoting an alternative we hope will be viable long-term. As we validate our model and as more leaders enter the marketplace, we anticipate that pension funds will become an increasingly attractive liquidity source to reduce concentration risk and overall pro-cyclicality, which will improve the resiliency of our markets”. That was added to some £350m in recently replenished capital resources. It adds up to a capital plan that strengthens the OCC’s resilience in the face of new market conditions. Donohue is frank about the reasons for such a fast and furious overhaul.“In early 2014 our board of directors and management team determined that OCC’s capital still remained too low for a systemically important institution that is part of the critical market structure supporting the US equity and options markets. We felt that we needed to accumulate significant additional capital in order to comply with the SEC’s proposed requirements. The capital plan that was approved by the SEC strengthens our capital base from a business per-

Options Clearing Corporation executive chairman Craig Donohue. Photograph kindly supplied by the Options Clearing Corporation, April 2015.

spective while also enabling us to quickly meet the heightened capital requirements that are critical for SIFMUs [such as] the OCC,” he states. Donohue has also driven actions which give the OCC market appeal. “The plan enables OCC to pay a refund of $33.3m from 2014 fees to OCC’s clearing member firms at a time to be determined by the board,” he says.“It also provides a new fee schedule resulting in a reduction of the average clearing fee of approximately 19% from current levels. Our financial analysis indicates that the clearing members are better off with this approach than the organic accrual of fees because it takes $530m in fees to achieve $364m in shareholders’ equity on an after-tax basis”. As Einstein kept repeating time and

speed of actions are relative. Clearly there’s Donohue time, market time and the regulator’s time, with each moving to its own particular beat. Donohue time often looks to outstrip all comers and so while the proposed fee reductions and refunds are ready for the get go, they have been postponed because of petitions requesting a review of the approval order that have been filed with the US Securities and Exchange Commission (SEC). “We are confident that this matter will be resolved expeditiously and we can move forward with the new plan. In our view the petitioners have not raised any new issues of fact or law. Once the plan is in place, we can increase our focus on critical remediation issues and SIFMU resiliency initiatives, and pass on operating efficien-

MARCH/APRIL 2015 • FTSE GLOBAL MARKETS

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COVER STORY

t h e o c c s t e p s o u t in t o c o n f id e n t d ay

cies that will reduce costs for all market participants,” avers Donohue. With liquidity and competitive strategy secured, the OCC turned to risk management, the bedrock of post trade delivery; every clearing house stands or falls by its guarantee function to protect clearing members and their customers. Moreover, as a SIFMU, OCC plays a critical role in promoting financial stability and integrity. A clear waterfall Donohue outlines a clear waterfall. The first line of defence against a clearing member default is membership standards, he avers. “We evaluate the initial creditworthiness of each potential clearing member through an application and approval process. Each applicant is assessed on operational capability, experience and competence of personnel, and financial condition in relation to predefined standards. This includes a minimum requirement equal to the greater of $2.5m in initial net capital or the applicable regulatory requirement of the clearing member applicant.” The process is ongoing, and all clearing members must demonstrate they maintain adequate facilities and personnel to transact business in an orderly manner. “Each clearing member is required to file monthly financial statements with OCC’s Financial Risk Management Department, where the clearing member’s financial condition is then evaluated in relation to predefined standards that are reviewed annually by our Risk Committee,” Donohue explains. OCC’s second line of defence is the defaulting clearing member’s margin deposits. In 2006, OCC introduced a proprietary risk management system called STANS. OCC’s margin system measures clearing member position risk and establishes margin requirements, which provides protection to clearing members and OCC against possible defaults. In 2013, STANS was enhanced to calculate initial margin requirements for futures customer positions so that the margin requirement is equal to the sum of requirements calculated for each individual customer account.

The third is clearing members’ contributions to the Clearing Fund, which provides OCC with a pool of highly liquid assets and which mutualises the risk of default among its clearing members. The Clearing Fund is available to cover potential losses in the event that a defaulting clearing member’s margin and Clearing Fund deposits are inadequate or not immediately available to fulfil that clearing member’s outstanding financial obligations. The Clearing Fund may also be used to reimburse OCC for losses sustained due to the failure of a bank or another clearing member organization to meet an obligation to OCC. “The financial crisis exposed major structural weaknesses in our financial market systems. One such problem was the fact that OTC derivatives markets had mushroomed to nearly $600trn in gross national exposures, which was equivalent to 10x world GDP in that same year. The OTC market had grown much larger than the supporting infrastructure and risk management mechanisms that it had utilised,” says Donohue. The Options Industry Council (OIC) most recent figures (December 2014) noted the rise in options per se [354,607,999 total options contracts traded in December, +10.74% YoY Dec] while volume over the year rose 3.75% over 2013 – the second highest volume on record. Specifically, last December equity options volume was 318,120,627 contracts, +9.7% more than the 289,995,333 contracts in the previous December. The OCC’s volumes are impacted by various factors, including turnover in cash markets, volatility, investor sentiment, and geopolitical and global macro events. It makes predicting volume a challenging business concedes Donohue. Even so, he says he remains “confident that our clearing and risk management services will be increasingly relevant to our market participants as we work with them to navigate the global landscape”. Since 2012, OCC’s cleared contract volume has averaged 343m contracts per month and in a range from 295m to 491m. Over the longer term (say the last decade) volumes have been sustained, with the 10 year CAGR for options in the

region of 13%. However, since those banner October 2014 figures, contract numbers have been falling. Donohue acknowledges increasing volatility,“beyond the natural level of market activity,”which he puts down to plunging oil prices, signs of an economic slowdown in Europe and “fear of Ebola on the downside; and strong corporate earnings with reassuring jobs market data on the upside”. Seasonality and market shifts Seasonality remains an issue: in clearing products that are used as risk mitigators and general trading vehicles, Donohue avers that it is natural that “we will see increased participation during periods of uncertainty. However, as a SIFMU we need to insure that we have a vigilant focus on our operating costs so that we can operate efficiently in periods with lower levels of activity while maintaining the capacity and operational wherewithal to meet the needs of our users in periods of heightened activity”. Moreover, there are systemic shifts in play. Over the past three years there has been less seasonality than has been observed on a historical basis says Donohue. “With the increased sophistication of market participants there is activity in the market year-round, and we don’t have the August lull that was common for so long. Part of that is a function of the expansion of shorter dated and month-end options that clients are using with greater frequency,”he explains. The US options market is clearly in flux, with now a multiplicity of exchanges competing for business. As with much of the post crisis financial world, the market is now more complex and fragmented. That puts much more onus on the post trade world to provide a solid bedrock or foundation upon which trading can be conducted with minimal risk, backed by reliable liquidity. Clearing houses are just one element of that post trade mix, but it is an increasingly important one and a business that will be increasingly interpolated into much of the capital and investment markets going forward. That’s exactly as Donohue at the OCC would have it. n

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MARKET LEADER

a f t e R a t o RRid 2014, c a n h e d Ge f u n d s o u t p e Rf o RM t h is y e a R?

Photograph ©kentoh /dollarphotoclub.com , supplied April 2015.

Can hedge funds turn the tide in 2015? According to Preqin, hedge funds have started this year with a bullet. The Preqin All-Strategies Hedge Fund benchmark posted a 2.49% return in February, the highest monthly return since January 2013. The performance is timely given that hedge fund performance was a concern in 2014. The challenge, and opportunity, still remains for hedge funds to continue the uptick in Q1 as equity markets look to be buoyant and commodity markets remain turbulent.

CCORDING TO THE latest HFR Market Microstructure Industry Report, new hedge fund launches were down last year (in numerical terms, down 20 on the 1,060 funds launched in 2013). While launches have trended in a narrow range in recent years, they remain well below the peak of 2,073 funds launched in 2005, though nearly double the local trough of 659 launches in 2008. This is now the third consecutive year of decline, while fund liquidations saw their first drop since 2010. Hedge fund liquidations also fell as 864 funds closed in 2014, a decrease from the 904 fund liquidations in 2013. Prior to 2014, hedge fund liquidations had risen steadily since 2010 when 743 funds closed. The average asset size of funds liquidated in Q4 2014 was approximately $76m one year prior to closing. Hedge fund performance dispersion declined in 2014, with the average per-

formance of both the top and bottom HFRI decile falling from the prior year. While the HFRI Fund Weighted Composite Index (HFRI) gained 3% in 2014, the top decile of all HFRI constituents gained +27.37 % for the year, down from 41.6 % in 2013. The bottom decile of the HFRI posted an average decline of 19.53 % in 2014, slightly below the bottom decile decline of 18.93% in 2013. The 46.9 % dispersion between the top and bottom deciles of the HFRI is the lowest calendar year dispersion since HFR began tracking this statistic in 2000. Hedge funds with AUM greater than $1bn posted an average gain of 5.03 % in 2014, in-line with the average midsized fund ($250m-$1bn) gain of 5.16%. Funds with assets between $50m-$250m gained 3.66 % while the industry’s smallest funds (less than $50m) posted a gain of only 2.11%. Funds with $1bn have outperformed other AUM tiers on

an annualised basis for the past three, five, and ten year periods. Last year was painful for the hedge fund industry, not just in terms of returns on investment. The 25 highest-earning hedge fund managers and traders made a combined $12.5bn, some $11.8bn less than the top 25 earning hedge fund traders made in 2013, when they collectively earned $24.3bn as the stock market boomed. Questions of whether such salaries related to underperforming (relatively) assets are a sensible thing aside, it looks like hedge fund managers have got off to a strong start in 2015. Following a year which saw the average hedge fund deliver returns of 3.78%, managers have already returned 2.52% on average two months into the year. According to Preqin, all main hedge fund strategies generated positive returns in February 2015, with equity strategies posting the highest monthly return of 3.28%.

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The overall industry average management and incentive fees fell from the prior year, although fees for the vintage of 2014 fund launches rose over the prior year. Average management fees industry wide declined by 3 basis points (bps) in 2014 to 1.51%, while average incentive fees declined 40bps over the prior year to 17.8 %. Funds launched in 2014 had an average management fee of 1.57 %, an increase from the 1.42 % of 2013 but in-line with prior years. Similarly, the vintage of funds launched in 2014 had an average incentive fee of 17.35, an increase from the 16.99 from 2013, but the second lowest incentive fee by launch year since 2003. “Despite the global hedge fund industry having grown to a record capital level of $2.85trn, the competitive environment to launch new funds continues to be challenging, and funds which fail to perform are vulnerable to investor redemptions and, ultimately, closure,”states Kenneth J Heinz, president of HFR. “In order to be successful, new hedge fund launches must offer compelling, innovative strategies, favorable liquidity and fee terms, top quality structures and services providers, and most importantly, generate strong realized performance. New funds which are able to meet these demanding requirements are likely to emerge as a new generation of industry leaders that drive performance gains and industry capital growth in coming years.” The question is now whether hedge funds can regain their mojo in 2015. Frankly it is too early to tell. According to research firm Preqin, activist hedge funds generated their highest monthly return since January 2013 with average returns of 3.22% in February. This follows a month of negative performance for these funds in January, with -0.43% returns. Moreover, in February, credit funds posted average returns of 1.61%. Credit strategies have only generated two months of negative performance since July 2013. Funds of hedge funds have also posted their fourth consecutive positive monthly return of 1.72%. Over a 12-month period, these vehicles are up 4.78%. According to Preqin, 60% of fund managers

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

Photograph ©kentoh /dollarphotoclub.com , supplied April 2015.

surveyed at the end of 2014 predicted that in 2015 the Preqin All-Strategies Hedge Fund benchmark will be higher than in 2014, compared to 22% that believe it will be the same or lower (18% currently unsure). “Hedge fund managers have delivered a welcome boost to performance last month. The average hedge fund has returned 2.49% through February, following the worst year for hedge fund performance since 2011. Investors came into 2015 concerned with the average returns they had received on their hedge fund investments last year. Following some high profile institutional exits from hedge fund investment in 2015, the value of hedge funds within institutional portfolios has been increasingly scrutinised,” says Amy Bensted, head of Hedge Fund Products, at Preqin.

US dollar strength

Market headlines have been heavily focused on the US dollar for most of this year and on how its current strength could impact the Fed’s trajectory of monetary policy. The dollar has been on a surge for some time now, underpinned by sometimes robust US economic data, but this was particularly prevalent following strong non-farm payroll numbers in February. The downside of dollar strength has been the negative impact on exports and the inevitable downside movements in US equity markets. In this context, hedge funds as a whole have been adversely impacted on long equity exposure: even though many managers reportedly have become more cautious since the start of this year, de-

creasing their beta exposure and limiting their losses. However, some gains were posted on other asset classes. A stronger dollar means that global liquidity is drying up, bringing further pressure to commodity and emerging markets. CTA funds generally benefited from the decrease in oil prices over the period, being short commodities. Long-short Equity managers benefited as well since most funds are short on the energy sector. Concerns over emerging markets have yet to materialise by meaningful positions on more fragile countries, but some funds managed to post gains on short EM equity and currency positions, suggests Preqin. Although investors typically allocate to hedge funds for risk-adjusted returns over longer time frames, this short-term return to form, the highest in over two years, will go some way in allaying investor concerns. Even so, “Fund managers will now have the tricky task of continuing to capitalise on current macro opportunities to deliver the better performance promised in 2015, in order to prove the true value of hedge funds within a diversified portfolio,” adds Bensted. According to a new report Growing Up - A New Environment for Hedge Funds, published in late March by KPMG International, the Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA), the turnaround is, in part, due to a sea change within the industry. The hedge fund industry is transforming, says the report, with managers increasingly focused on customised products and solutions, new investors, and emerging markets. The report is based on global research with more than 100 hedge fund managers representing approximately $440bn of assets under management. Their views reflect fundamental shifts occurring in the hedge fund industry. The survey suggests that a majority of hedge fund managers expect a significant shift in their primary sources of capital to pension funds over the next five years. It adds that there is evidence that the growth of the hedge fund industry is

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REGIONAL REVIEW

a f t e R a t o RRid 2014, c a n h e d Ge f u n d s o u t p e Rf o RM t h is y e a R?

being driven today largely by institutional investors rather than individuals. A majority of managers expect a significant shift in their primary sources of capital, with most saying that pension funds – both corporate and public – would be their primary sources of capital by 2020. “The days of hedge funds simply being an investment tool for high-net worth individuals are over,” explains MFA president and chief executive Richard H Baker, adding: “Institutional investors like pension plans, university endowments, and charitable organisations now make up nearly 65% of the industry’s assets. These diverse partnerships help local economies and underscore the important role alternatives play at both the macro and micro levels.” Some 46% of managers said that over the next five years they would either alter their fund strategy or launch new products to attract capital from pension funds. Moreover, almost 70% of managers said they offer, or plan to offer, custom investment solutions. Nearly two-thirds of managers said there is increased demand for custom solutions from their investors. In fact, almost half said they already offer a ‘fund of one’ or managed fund solution with an additional 21% saying they intend to offer these solutions within the next five years.

With custom solutions come more customised fee structures. More than twothirds of managers said they anticipate using specialised fee structures as a means of attracting investment. Geographically, most capital invested in hedge funds still comes from North America and Europe, but the research suggests that the greatest percentage increases in inflows are coming from Asia-Pacific, the Middle East and Africa. More than four in 10 managers expect to change markets where they Photograph ©kentoh the /dollarphotoclub.com invest, , suppliedwith April more 2015. than a third of those targeting emerging and frontier markets. More than two-thirds of managers anticipate using specialised fee structures to attract investment and more than four in 10 managers expect to change the mix of countries where they invest, with more than a third targeting emerging and frontier markets. Regulation is seen as the biggest threat to the growth of the hedge fund industry, as cited by more than three-quarters of managers. According to Jack Inglis, chief executive officer at AIMA, a turnaround is on the books.“The global hedge fund industry, which has grown by over 10% a year since the financial crisis, is well positioned to maintain this growth trajectory over the next five years. The research shows that as the industry continues to evolve and mature, a com-

bination of institutionalisation and customisation will effect positive change and encourage ever greater allocations from pensions and other institutional investors,” he says.

Limits to growth Increased cost and complexity associated with running a hedge fund management firm will limit growth of the industry over the next five years according to the research, with more than three-quarters saying the number of hedge fund managers will decrease or stay the same. Regulation, cited by more than threequarters of managers, is seen as the biggest threat to the growth of the hedge fund industry. This is particularly the case in Europe and Asia Pacific, where more than 80% of managers cite regulation as the biggest threat to growth, while in North America it was cited by 67% of managers. “The research confirms what KPMG professionals see with clients, with a much greater focus on compliance,” explains Tom Brown, global head of Investment Management, KPMG International. “The good news is that while compliance obligations have increased operating costs, there are signs that these costs are flattening out, and fund managers can put more of their attention on growth.” n

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VANTAGE POINT

in c Re a s e d d is p e Rs io n o f Re t u Rn s in a s s e t s e Xp o s e d t o o iL Ma RKe t s

Kathleen Hughes managing director and head of Global Liquidity Sales and European Institutional Sales at Goldman Sachs Asset Management. Photograph kindly supplied by Smithfield Group, March 2015.

Security selections in oil assets In the first of a new column in the magazine, Kathleen Hughes managing director and head of Global Liquidity Sales and European Institutional Sales at Goldman Sachs Asset Management looks at the directional drivers of investment dollars. In this issue she focuses on the effect of oil prices on market conditions and behaviour and looks for value in E&P firms.

ENCHMARK CRUDE PRICES have in recent weeks retraced a fraction of their longer-term decline, sparking hopes that the market has moved off its lows; but we are not so sure. Recent

price action is more of a bounce caused by market positioning rather than a recovery, and we expect further volatility. Of course, this brings opportunity. In particular, we are preparing for increased

dispersion of returns in assets most exposed to the oil market, which is making security selection more important than it has been in recent years. This carries implications both for equity markets and fixed income, especially the high-yield market. The Brent Crude benchmark price, which enjoyed a near-term high of $115 a barrel as recently as June last year, had slumped to $46 in January, taking with it the performance of previously high-performing energy-related stocks. In February, this rebounded to more than $60, restoring the performance profile of energy assets in both the equity market and high-yield. We attribute this to a predictable reaction by oil companies to the recent price slump (rig count reduction and significant capex cuts) and the market’s reaction to that. This is just a short-term fillip though and not one that is likely to arrest the longterm decline in prices caused by efficiency gains and improved supply at a time when demand is stable rather than growing. Prices will find a higher equilibrium price than the market’s current lows, but one that is still meaningfully below the ballpark of only a few months ago. Therefore, companies exposed to the sector have difficult decisions to make on the amount of cost-cutting required for them to remain profitable, balanced against the requirements of guaranteeing future growth by maintaining or growing strategic assets. Investors need to decide how adept companies will be at navigating this terrain, as well as how well positioned they are going in to a downturn. Our conclusions are mixed. We remain negative on oil services firms adversely affected by capex cuts, and production cuts by the exploration and production

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(E&P) sector and those showing signs of stress before the recent slump in oil prices.

Opportunity in energy We are positive on E&P companies themselves and believe they may offer some of the best opportunities in the energy sector in both equity and high-yield portfolios. It is essential, though to take a company-by-company view. Our contact with management teams suggests many E&P firms anticipate a strong recovery in oil prices, to the high $70s. Anticipating that the price may stay sub-$70 area in the near-term, we look for companies that can weather a lower price regime, have a relatively low cost structure, have protected expected cash flows by actively hedging future production and have made cuts to capex that will result in steady production. We are especially positive on E&P companies in the high-yield market, where they represent one of the three core issuer categories, alongside midstream companies

and oil field service companies. Within high-yield, we are attracted to E&P firms’ position in the market: as the owners of the reserves, they appear most vulnerable to an oil price decline and as a result 21% of E&P bonds trade at distressed levels. This, we believe, is incorrect: they have real assets in the ground that produce cash flows resulting in economic rates of return under stressful scenarios; they enjoy lower service costs and improved productivity in producing oil and natural gas; and they have recently created added financial flexibility by accessing the debt and equity markets to lock-in longer-term financing. High yield E&P companies could become attractive acquisition targets for bigger and better capitalised investment grade E&P issuers. We are also positive on master limited partnerships (MLPs). They have declined alongside the energy market itself, albeit to a lesser degree than crude prices, but as a large portion of their asset bases are composed of infrastructure

Morgan Stanley offered £1bn for merchant oil trading business

Ra d in G h o u s e c a s t Le t o n c ommodities international has reportedly offered $1bn for Morgan s tanley’s oil trading business, including contracts and inventory, which has been up for sale for a good half year now. t he bank is the latest to scale back trading across a range of assets on their commodity trading desks in response to d odd f rank rules and a u s f ederal Reserve decision last s eptember that limits comprehensive involvement in key commodities such as energy (upstream and downstream) and raw materials such as copper in an effort to minimize systemic market risk. Goldman s achs has been a first mover in this regard, having already sold off its power plant division, while Jp Morgan reshuffled the make-up of

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

the board of h enry Bathmetals (which it acquired an interest in after its acquisition of s empra c ommodities back in 2010), so that the warehousing company qualified as a merchant banking investment. While divesting the trading division (reportedly to c astleton), Morgan s tanley which historically has one of the largest market share in the physical commodities segment, has tied itself more deeply into t ransMontaigne, with the extension of the oil terminal leases it holds with the company. it is clear that the banks are shifting their focus, but still retaining their interests, and looking to preserve their role in the commodities sector. t he bank already sold off its power plant group c ogentrix to private equity firm c arlyle Group, and now has a much reduced footprint

assets such as natural gas pipelines, refined product pipelines, and terminals their cashflows tend to be driven more by volumes and lease fees than underlying commodity prices.

High production volume These companies stand to benefit from continued high production volumes (although growth is likely to slow due to the oil price decline); the long-term nature of their contracts; and the diversification of their asset base – only a third of the energy infrastructure market is directly engaged in crude oil-related assets. However, MLPs are often more compelling for US based investors than Europeans due to higher tax costs and reporting requirements incurred through the structure in Europe. Longer term, we expect a lot of consolidation in the sector due to overcapacity and high debt levels. Should major integrated companies buy assets, we believe this could be highly positive for energy sector stocks and highyield bonds alike. n

in electricity generation. as oil and energy prices have fallen, it has been a less painful decision for the banks to divest or restructure their holdings. f or the time being Morgan s tanley will remain in negotiations with c astleton, as it is far from a done deal. Remember too that this is now the third time that the bank has been reported to be close to divesting its trading division. Back in 2012 it failed to secure agreeable terms with the Qatari sovereign wealth fund and then its efforts to sell the business to Rosneft late last year were scuppered on the back of political and economic sanctions on Russian business. a lthough a sale to a privately held commodity trading firm would reduce risk exposure in Morgan s tanley, it is debatable whether risk is entirely eliminated from the market when it is placed in a cross-border trading firm that faces less regulatory oversight and has fewer disclosure requirements. n

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SPOTLIGHT

a s s e t s u n d e R Ma n a Ge Me n t at a n a LL t iMe h iGh s ay s e f a Ma

Photograph © Cybrain/Dreamstime.com, supplied April 2015.

Worldwide investment fund assets reach all-time high at €28trn in Q4 2014

According to the European Fund and Asset Management Association (EFAMA) latest statistical release, investment fund assets worldwide stood at a new all-time high of €28.29trn ($34.35trn) at the end of 2014, up 9% over the end of Q3 figures and up 18.9% on 2013.

ORLDWIDE NET CASH inflows increased in the fourth quarter to €335bn, up from €290bn in the third quarter, thanks to strong net inflows to worldwide money market funds. Long-term funds (all funds excluding money market funds) recorded net inflows of €220bn during the fourth quarter, slightly down from the €223bn registered in the previous quarter. Equity funds attracted net inflows of €44bn, up from €24bn in the third quarter, while bond funds posted reduced net inflows of €6 bn, down from €79bn in the previous quarter, certainly nowhere near enough for a grand rotation out of bonds, but certainly significant and a sign of the times. Balanced funds also registered reduced net sales of €52bn, down from €72bn in the third quarter. Coincidently, long-term funds registered net inflows of €68bn in both the United States and Europe during the fourth quarter. Money market funds registered net inflows of €115bn during the fourth quarter, compared to €67bn in the third quarter of 2014. This result is largely attributable to positive net sales

recorded in the United States of €98bn, whereas Europe registered net outflows during the quarter of €10bn. No surprise there, as European investors are well aware that the ECB’s QE programme has only just started, while US based investors are working on the basis of a gradual normalisation of Fed monetary policy. Overall in 2014, worldwide investment funds attracted net sales of €1,169bn, up from €848bn in 2013. Worldwide longterm funds registered net inflows of €1,015bn last year, as all categories of funds registered net inflows during the year. The United States recorded net inflows into long-term funds of €302bn, with Europe registering net inflows of €471bn. At the end of 2014, assets of equity funds represented 40% and bond funds represented 22% of all investment fund assets worldwide. Of the remaining assets money market funds represented 13% and the asset share of balanced/mixed funds was 12%. The market share of the ten largest countries/regions in the world market were the United States (51.2%), Europe (28.2%), Australia (4.7%), Brazil (4.4%),

Canada (3.7%), Japan (3.1%), China (2.1%), Rep. of Korea (1.0%), South Africa (0.5%) and India (0.4%). n

New York Fed’s snapshot of US regional debt and credit trends

The Federal Reserve Bank of New York has launched a series of reports detailing trends in borrowing and indebtedness at the state and local level. The reports are based on data from the New York Fed’s Consumer Credit Panel, a nationally representative sample drawn from anonymised Equifax credit data. They find that New York, New Jersey and Connecticut have higher balances, on average, for mortgages, home equity lines of credit (HELOC), student loans and credit cards compared to the national average. However, the rate of overall consumer distress (having any seriously delinquent debt or third party collections debt) is lower in the tristate region than the nation. Other notable findings from the Snapshots suggest that borrowing for a home varies considerably within New

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SPOTLIGHT

a s X/t Ra d e p o in t La u n c h e s n e W Ze a La n d Ga s f u t u Re s

York State. Some 14% of New York City residents have a mortgage with the fewest (9%) in the Bronx and most (28%) in Staten Island. Meanwhile, in upstate NewYork, average mortgage balances are about $100,000 in the Buffalo, Rochester and Syracuse metro areas. The average mortgage balance in New York City is more than $300,000. Nearly 6% of mortgage borrowers in New Jersey have at least some seriously delinquent mortgage debt, nearly twice the national rate. New Jersey consumers have the highest levels of consumer distress in the tri-state area. Behind Manhattan, Fairfield County has the highest average mortgage balance in the region at nearly $360,000. n

ESMA launches centralised data projects for MiFIR and EMIR

The European Securities and Markets Authority (ESMA) has launched two major projects at the request of a number of European national market regulators, now referred to as National Competent Authorities (NCAs), that have asked the European market regulator to provide a central facility in relation to instrument and trading data and the calculation of the MiFIR transparency and liquidity thresholds – Instrument Reference Data Project, and provide a single access point to trade repositories data under EMIR – the Trade Repositories Project. In agreeing that ESMA will develop these centralised solutions, NCAs have delegated some tasks related to data collection requirements under MiFIR and the Market Abuse Directive (MAR) to ESMA, as well as the creation of a central access point for regulators to data of the EU’s six trade repositories. Both projects will allow ESMA to collect data directly from market infrastructures (trading venues or trade repositories) in a more efficient and harmonised manner and make them available to NCAs and to the public through a centralised system. The Instrument Reference Data Project

will collect data directly from approximately 300 trading venues across the EU which will send their MiFIR/MAR data to ESMA who will then perform and publish the necessary transparency and liquidity threshold calculations. Once finalised, the database will allow NCAs, and financial market participants, access to all data for financial instruments admitted to trading on EU regulated markets or traded on MiFID venues (OTFs and MTFs). The Trade Repositories Project will provide ESMA and 27 NCAs with immediate access, through a single platform, to the 300 million weekly reports on derivatives contracts received from 5,000 different counterparties across the EU trade repositories. Both projects represent a clear EU cooperative solution producing central systems in support of the single market and are expected to produce important harmonisation benefits and real cost savings, compared with building similar systems in each country, which will mean a lower burden for the financial system and EU taxpayers. The projects are currently being developed by ESMA, with the Instrument Reference Data Project expected to go live in early 2017, and the Trade Repositories Project will go live next year. It should come as no surprise that more responsibility for gathering market data is being centralised in ESMA. The phalanx of market regulation in Europe is clearly overwhelming national regulatory bodies. Earlier this year, for example, ESMA conducted a peer review on the way that NCAs supervise and enforce MiFID provisions relating to investment firms’ obligations to provide best execution or obtain the best possible result for their clients when executing orders. ESMA found that the level of implementation of best execution provisions as well as the level of convergence of supervisory practices by NCAs is relatively low. NCAs have subsequently been asked by ESMA to prioritise best execution as a key conduct of business supervisory issue; for them to allocate sufficient resources to undertake this task and adopt a more

proactive supervisory approach to monitoring compliance with best execution requirements, through desk based and onsite inspections. n

Australian exchange launches NZ gas futures The Australian Securities Exchange (ASX) and emsTradepoint have launched ASX New Zealand gas futures. emsTradepoint’s indices will be used as the reference price for ASX’s new monthly and quarterly gas futures. The new gas futures are part of ASX’s expanding energy derivatives business, which is designed to meet the risk management needs of energy market participants in New Zealand and Australia. They complement the ASX’s existing New Zealand electricity derivatives suite, which has grown 70% year-to-date compared with the same time last year, from 7,002 to 11,934 contracts traded, or the equivalent of 77,000 MWh of electricity per day. In March this year alone, 379,000 GJ of gas was transacted on emsTradepoint, bringing the total of gas traded since the contract’s inception to over 1 PJ. ASX’s general manager of Derivatives and OTC Markets, Rohan Delilkhan says ASX is committed to supporting the development of New Zealand’s energy markets: “Our new futures products launched today will help New Zealand gas industry participants manage their forward price risk and provide greater price transparency to this important developing sector within New Zealand’s energy market.” emsTradepoint manager James Whistler adds that the natural gas industry has seen unprecedented changes in recent years, with growing diversity, competition, uncertainty and risk. “emsTradepoint’s efforts to establish a liquid underlying physical spot market for gas in New Zealand has proven successful, with positive trading activity and solid growth. The new ASX futures listing will allow gas industry participants to further increase their confidence in a market solution and enhance their ability to manage inherent price risk.” n

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PENSIONS

QE benefits few European corporate DB pension plans Economic developments are causing the funding conditions of corporate defined benefit (DB) pension plans to deteriorate, writes Paul Watters, senior director and head of corporate research for Standard & Poor’s Ratings Services. Yet the risk remains that a combination of weak growth – inducing the European Central Bank to continue with its aggressive monetary policy stance – and rising inflation could make a bad situation even worse.

ECENT ECONOMIC DEVELOPMENTS in Europe are conspiring to cause deterioration in the funding conditions of corporate defined benefit (DB) pension plans – especially for those that are already materially underfunded, with deficits greater than 10%-15%. Certainly, our analysis shows that DB pension scheme liabilities for the 50 rated companies with most material funding deficits will have increased by as much as 18% (equivalent to about €92bn) in 2014, driven by the sharp fall in longterm corporate bond yields and only partly offset by the fall in long-term inflation expectations. Liabilities are expected to climb even further in 2015 given the further material fall in long-term corporate yields already witnessed this year in anticipation of the European Central Bank’s (ECB) €60bn per month Quantitative Easing (QE) program. The risk that QE achieves nothing more than promoting stagflation in the euro area should not be discounted. Without careful risk management, these DB scheme deficits will become a more material negative credit factor over the next two years. To assess the potential impact of economic developments on pensions plan deficits, we analysed the funding position of the top 50 rated European companies that we consider to be most exposed; that is, those with DB pension plan deficits greater than 10% of adjusted debt and with outstanding adjusted debt greater than €1bn. At the end of 2013, this group had pension fund liabilities totalling €527bn. That, compared to plan assets of €356bn,

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

meant that collectively they had a DB plan funding deficit of just over 30% on average. So, how is this deficit likely to change? From a liability perspective, the net present value of future pension payments is most sensitive to fluctuations in the applied discount rate – which is determined by reference to high quality corporate bond yields (normally 'AA' long-term corporate bond yields). Therefore, due to the fall in corporate bond yields in 2014, it is estimated that the discount rates used to calculate the liabilities of euro area DB pension schemes will have fallen by around 1%1.25% from an average rate of 3.25%3.5% in 2013, increasing liabilities by as much as 16% to 20%. For example, the energy giant EDF reduced the discount rate assumption for its annual 2014 French DB fund calculations to 2.2% from 3.5% in December 2013, increasing pension liabilities by over €7bn. Similarly, Swiss global health-care company Roche reduced the weighted-average discount rate applied to its DB plans to 2.21% at the end of 2014 from 3.38% a year earlier.

Inflation, a modest offset? It is harder to accurately gauge the extent of any offset from downward revisions in inflation assumptions. However, a fall of 0.25%-0.5% in the long-term inflation rate assumption would seem to be reasonable, ultimately providing a modest offset of about 2.5%5% of pension obligations. Consequently, we expect the increase in liabilities reported in 2014 for our group of rated companies to range between about 11%-18% after accounting for

inflation. Indeed, this might be a little conservative, especially judging by the trend at companies that have already reported their 2014 annual results. For example, Roche's DB pension liabilities increased by 25.4% in 2014, while EDF's liabilities increased by 24.6%. Therefore, even despite decent 8%12% investment returns typically being achieved on plan assets in 2014, our view is that the fall in long-term yields, the degree of underfunding, combined with the mismatch between DB pension fund assets and liabilities will likely result in substantial growth in pension deficits for many of our rated companies in 2014. Clearly, economic developments last year were unfavourable for DB pension schemes. The challenge for companies in the future therefore will be how to adapt to the new post-QE low interest rate environment in Europe and manage the related risks associated with the increase in DB plan deficits. Whether it is by changing the investment strategy to generate higher returns, as well as, more likely, limiting future benefits to beneficiaries (i.e. freezing pensionable salaries, capping future pension increases, increasing the retirement age, and closing plans to new and even existing members), or by purchasing liability risk insurance, we would expect that mitigation strategies will attract more scrutiny where DB plan deficits are significant. Certainly, effective risk management will become even more important to enable companies to manage their pension risk exposures and to help mitigate any adverse impact on their credit metrics. n

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SPOTLIGHT

e Le c t Ro n ic t Ra d in G d o e s n ’t Re p La c e h iGh t o u c h t Ra d in G

Photograph ©Artur Zebrowski /dollarphotoclub.com, supplied April 2015.

Is the end of open outcry worth mourning? The Chicago Mercantile Exchange recently announced that it is to close its futures trading pits by the beginning of July this year, bringing to an end 150 years of open outcry trading. The sea of brightlycoloured jackets whose movements were once a barometer of market sentiment have now been replaced by the bluish glow of computer screens. What was the heart of the markets has now become an anachronism. Hugh Cumberland, Solution Manager Capital Markets at Colt Technology Services looks at the repercussions of change.

T HAS BEEN DECADES since these pits were the norm; the LME has the last open outcry floor in Europe. Electronic trading has come to dominate the landscape – it’s more efficient, you can trade multiple markets from a single screen, it’s less physically taxing and is arguably safer. So does this mean that voice trading will be relegated to the history books? While electronic trading is, thus far, the best way of both trading and ensuring compliance, there will always be a place for human interaction. Technology has simplified the process of trading, and has enabled modern traders to turn themselves into an advisory partner to their clients. When it comes to trading, trust is paramount and there will always need to be a voice at the end of the phone – after all, trading is probably one of the most relationship-driven capital markets functions. The need for human contact, whilst important, isn’t the main reason why voice trading will always be around. Electronic trading is perfect for vanilla trades but anything more complex than a simple swap or future needs to be communicated effectively and clearly. Voice is still by far the best method of a client explaining to their broker what they want and making sure they are understood. Although there

have been efforts to bring OTC trading onto exchange, many of the more complex structured products are still voice traded and this is unlikely to change. Indeed very large trades will generally be voice based as they need to be worked into the market. In spite of this, technology will inevitably play an increasingly important part in the daily lives of traders. Regulation is firmly focused on market surveillance, with Dodd-Frank and MiFID II stipulating that all information relating to certain trades is kept for a period of time and is accessible to the regulator on demand. Since voice trading is an intrinsic part of any trading floor, technology needs to work with existing methods, rather than seek to replace them entirely. Systems which can recognise and contextualise trade-related conversations are already being developed – once these are present “in the wild” they will be linked to systems which record electronic communications and will be able to build up a picture of a complete lifecycle of a trade. It’s not just in terms of compliance that technology has helped make markets more efficient. Traders can connect to any market anywhere in the world – they can trade at any time of the day, receive data the instant it’s published and act on that

data immediately. This globalisation of markets is not new, but it is a direct result of the advancement of technology. High speed connections between the world’s financial centres brought markets closer together, increased the number of participants and provided liquidity on a scale not seen before. This is, arguably, what started the decline of the open outcry trading floor and what we’re seeing from the CME is the end result of a process that started several decades ago. Clearly trading has moved on from the days of the pit trader and technology has had a huge impact. However voice will always have a place in a profession that is intrinsically relationship based. So should we mourn the demise of the open outcry trading floor? One only has to look at the way that exchanges themselves have changed to realise that this an inevitable and natural evolution. In the same way that the Royal Exchange in London, the trams in San Francisco and the Orient Express have become little more than tourist attractions, open outcry floors have ceased to be anything more than a window into the past. In the face of accelerated electronification, open outcry has been on borrowed time for many years. That time is up. n

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IN THE MARKETS

t h e d RiVe t o d iMin is h f in a n c ia L s t a BiLit y Ris K in GLo Ba L Ma RKe t s

IMF asks for greater scrutiny of investment funds

Photograph ©Victoria/dollarphotoclub.com, supplied April 2015.

Market regulators such as the US Securities and Exchange Commission (SEC), are considering revising their approach to the oversight of asset managers and the products they offer, including through stress testing requirements. This is clearly a paradigm shift for the asset management industry. Until recently, securities regulators have mainly focused on investor protection, with limited attention to financial stability risks. Now the IMF has jumped on the bandwagon and is asking for greater scrutiny of the global asset management industry. Even simple investment funds such as mutual funds can pose financial stability risks, it suggests, and regulators need to know more about them through hands-on supervision, and better data and oversight, according to new research from the agency.

ONCERNS ABOUT POTENTIAL financial stability risks posed by the asset management industry have increased recently as a result of the sector’s growth and diversification and because of structural changes in financial systems says the IMF. Not only has the relative importance of the asset management industry grown, but banks have also retrenched from many market-making activities, possibly contributing to a reduction in market liquidity, says the IMF. Consequently, large-scale trading by funds could potentially have a larger effect on markets than in the past. Moreover, the role of fixed income funds has expanded considerably and price disruptions in fixed-income markets have potentially larger consequences than large price swings in equity markets. In other words, now that the banks have been forced by regulation such as Basel III to bring their risk exposure to the minimum, attention must now be paid to institutions that move large amounts of money between countries and

markets. Moreover, the large scale paradigm shift which began just before the 2007-2008 financial crisis, namely the grand rotation of investment dollars out of equities and intro bonds/fixed income has now resulted in a worrying concentration of assets in a market segment that will be made vulnerable by shifts in central bank monetary policy over the near term. As the IMF notes in the report, “the prolonged period of low interest rates in advanced economies has resulted in a search for yield, which has led funds to invest in less liquid assets, and is likely to have exacerbated the risks described above. These considerations have sparked a policy discussion about intensifying oversight across advanced and emerging economies. In 2014, the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO) proposed assessment methodologies to identify investment funds that might be global systemically important financial institutions (G-SIFIs) and as such would be

regulated differently from the others (FSB and IOSCO 2014)”. Individual market regulators are currently running with these proposals and the terms of definition surrounding the prudential oversight of the more important (or, frankly larger) investment institutions is currently being refined. In March this year both the Financial Stability Board (FSB) and IOSCO began to refine approaches for identifying both investment funds and asset managers as G-SIFIs. In particular, market regulators such as the US Securities and Exchange Commission (SEC), are considering revising their approach to the oversight of asset managers and the products they offer, including through stress testing requirements. This is a clearly a paradigm shift for the asset management industry. Until recently, securities regulators have mainly focused on investor protection, with limited attention to financial stability risks. Reforms are already underway to address risks related to hedge funds (which can incur high leverage and engage in

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complex strategies with few disclosure requirements) and money market funds (some of which offer redemptions at a constant nominal value per fund share, making their liabilities similar to deposits and vulnerable to runs). In the latest research for the Global Financial Stability Report, the IMF says the debate about possible risks related to the industry is growing. It cites, for example, specific risks from some segments of the industry—such as leveraged hedge funds and money market funds and even suggests that there are inherent risks that have to be addressed, even in less leveraged, “plain-vanilla” investment products, such as simple mutual funds and exchange-traded funds investing in bonds and equities. “The new attention to possible risks related to asset management is motivated by the growth of the industry, its larger focus on less liquid bonds, and by concerns that in some advanced economies, many funds have increasingly been buying similar assets, while banks have withdrawn from market making,” says Gaston Gelos, chief of the Global Financial Stability Analysis Division at the IMF. The asset management industry currently manages over $75trn worth of assets globally, exceeding 100% of world GDP, the IMF says. In particular, bond funds have grown significantly, investing in lessliquid assets such as emerging market bonds and high-yield corporate bonds. This has increased the mismatch between the liquidity of funds’ assets and liabilities, because many funds allow investors to redeem on a daily basis. Large redemptions from these funds, possibly triggered by an external event, such as a faster-than-anticipated rise in interest rates in the United States, for example, may have a widespread market impact, especially if banks are unable or unwilling to step in to provide liquidity in such a situation. The sheer size of the industry suggests the IMF is an issue. “By now, the assets under management of top asset management companies (AMCs) are as large as those of the largest banks, and they show similar levels of concentration,” it says in the paper.

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

In its latest Global Financial Stability Report, the IMF provides a detailed analysis of various risk-creating features of the industry and suggests how to revamp oversight of the sector. The analysis highlights that it is important to distinguish conceptually risks that are introduced by the presence of funds from those that would exist even in their absence; that is if investors bought securities directly. The IMF paper puts forward a multitude of findings. Among them, it asserts that mutual fund investments affect asset prices, at least in less-liquid markets, such as emerging market bonds. Mutual fund flows drive price movements in these markets. Prices of assets that are held in a concentrated manner by funds drop more sharply during periods of market nervousness. It also suggests that easy redemption options offered by funds can exacerbate the risk of a run by investors wanting their money all at once, compared to a situation in which investors hold assets directly. Some funds have asset-valuation and share-pricing practices that provide a “first-mover” advantage to investors— investors redeeming earlier than others can recover more money. To some extent, this risk is mitigated by the fact that “riskier”funds—those investing in illiquid assets and more vulnerable to runs protect themselves by holding more liquid assets and charging higher redemption fees. And redemption fees are indeed effective in mitigating redemption pressures during stress periods. The IMF points out that the delegation of day-to-day portfolio management introduces incentive problems between end investors and portfolio managers. As a result, asset managers may engage in herding—trading in the same direction as their peers. The IMF says that measures of herding behaviour have risen in the past few years, possibly because of a generalised search for yield in a low-interest environment that drove these funds to invest in similar assets. Moreover, unlike banks, larger funds and funds belonging to larger asset management companies do not necessarily

contribute more to systemic risk. Rather, the nature of the assets they invest in appears to be relatively more important than size. This is an important factor to consider when trying to find the best ways to identify systemically important asset managers or products; an issue that regulators from around the world are discussing actively. The global agency says that the evidence calls for a better supervision of institution-level risks. Currently, the oversight of the industry focuses on investor protection and disclosure, and regulators conduct little monitoring in most countries. Securities regulators should shift to a more hands-on supervisory approach with better data, risk indicators, and analysis, including stress testing, according to the IMF. Establishing global standards on how to monitor and supervise the industry is essential. The IMF asks that macro-prudential oversight frameworks should be established to address financial stability risks stemming from the industry. These stability risks originate in price externalities that can be missed by micro-prudential regulators and asset managers. The roles and adequacy of existing risk management tools, including liquidity requirements, fees, and fund share pricing rules, should be re-examined, taking into account the industry’s role in systemic risk and the diversity of its products. Policymakers and regulators should adopt a macro-prudential approach to assess the impact of the industry as a whole on the stability of the financial system. In this context, supervisors and regulators need to re-assess the role and adequacy of existing risk management tools. “In particular, regulators should find ways to reduce the incentive for investors to withdraw their money when they see others exiting,”said Gelos.“This could be done, for example, by well-designed redemption fees that do not hurt investors overall, for example if the revenue accrues to the fund’s net asset value. Moreover, the pricing of fund shares should be set in such a way that exiting investors do not pass on the cost of liquidity to remaining ones.” n

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IN THE MARKETS

in Ve s t o Rs ’ GRo Win G t a s t e f o R p e Rf o RMa n c e Ra n Kin Gs

LP demands push decile rankings: Who’s in your top ten? Among investors in alternative assets, quartile ranking – where funds are split into four performance groups has long been considered the gold standard for assessing private equity funds by both LPs and GPs. During the past year, however, preferences for performance results have moved away from quartile ranking in favour of more granular decile ranking. Rishi Kotecha, Pevara Product Manager, eFront explains why.

ECILES AND QUARTILES have been around for a long time and have been used to rank everything from hereditary traits to student test scores to crime rates. First seen in 1882 and 1879 respectively, both terms are attributed to Francis Galton (1822-1911), the British mathematician, explorer and cousin to the considerably more famous Charles Darwin. Now their popularity is growing in the asset management space, particularly in alternatives. Over the last year or so, however, preferences for performance results have moved away from quartile ranking in favour of more granular decile ranking. Why the sudden migration toward deciles? Part of the answer lies in the inherent limitations of quartile ranking. To begin with, dividing all of your data among only four quarters can hide a great deal of detail and useful information. For example, if a fund ranks in the second quartile, there’s no way of seeing where it ranks within that quartile. It could be at the bottom end, near the median, or at the top end and, therefore, a better performing fund. Simply put, quartile ranking hides both good and bad variants and can obscure significant differences in performance. And in the current private equity space, so many of the funds are in the top quartile that the label becomes meaningless. On the other hand, decile ranking, with more than twice the available measurement buckets, is much more likely to reveal those outliers, especially those that would have been at the edges of the quartile buckets. So instead of comparing funds ranked only as not-so-good, pretty good, good and very good, a limited partner can

Photograph © sakkmesterke/dollarphotoclub.com, supplied April 2015.

make investment decisions based on quantitatively better information. However, simply switching to decile rankings is likely to show a disproportionate number of managers in the top 10%-20% of funds. But when you can combine this more granular ranking with a more consistent data collection practice—such as using LP cash flows rather than GP survey results to track return activity and with other differentiators such as geographic and investment stage and size focus—deciles can become a real indicator of performance rather than just another marketing tool. Despite these drawbacks, quartiles used to be sufficient. More recently, though, LPs have been faced with a new and vastly demanding environment. Consequently, LPs must perform more due diligence and, thus, need performance rankings that show much more granularity. LPs have also become much more sophisticated out of necessity. They want—and need—more

transparency and better tools for more precise analyses of alternative investments, where management and performance fees are typically high. Deciles enable LPs to meet these demands. One reason LPs are more selective is because the number and size of private equity funds has increased significantly since the financial crisis of 2008. Research firm Preqin estimated in late January that there are more than 2,200 private equity funds currently being marketed, an increase from just over 2,000 at the start of 2014 and 1,949 at the beginning of 2013. And 37% of private equity managers polled earlier this year said they planned on launching a new vehicle in 2015. Since limited partners today have a much larger network of general partners with which to invest, sorting out the performance data of firms and funds is more difficult. A quartile system would still present a burdensome amount of fund data to sift through to find the best performers. Deciles can quickly narrow an LP’s menu to only the best-performing options. While the choices available to limited partners have increased, pressure to perform has intensified. Particularly among the larger institutional pension funds, scrutiny of limited partner investments shows no sign of abating. LPs are now being asked to rank and quantify the returns they receive from every investment, particularly when they are paying large fees as they do for private equity funds. LPs need to justify each and every investment down to the last decimal point. With greater requirements placed on LPs for more detailed and useful rankings, there is a clear need for a universal benchmark that will serve to standardize performance assessments industry-wide. Adopting deciles as the standard ranking measure is a good start as we continue to develop the standards that will move the private equity industry forward. Ranking fund performance by decile rather than by quartile gives funds the chance to shine their brightest and meet the needs of an ever-moredemanding LP community. n

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IN THE MARKETS

NSD upgrades services to ease access to the Russian market

Photograph ©WavebreakmediaMicro/Dollarphotoclub.com, supplied April 2015.

Russia’s National Securities Depositary (NSD) has picked up the pace of reform in the corporate actions space with the launch of new technology that allows users to better manage shareholder meetings and e-proxy voting. The NSD says it now fully complies with international standards providing standardised electronic messaging facilities to issuers, registrars and depositors and with the option of straight through processing (STP) of information at all stages of document circulation.

EFORM IN THE area of shareholder rights, services, corporate actions and compliance technology is part of an overarching strategy by the NSD to integrate seamlessly into the international markets and provide an efficient platform that can be utilised by domestic and international investment firms alike. The move also is designed to help reduce market risk and cost associated with shareholder activities, in this latest instance, corporate actions. The new technology simplifies interactions between securities market participants and guarantees them a high level of protection of their rights, says the NSD. Moreover, the use of ISO international standards makes the organisation of shareholder meetings and the e-proxy voting process more convenient, transparent and understandable for foreign and local investors.

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

Issuers which have registered accounts at the CSD are now required to offer shareholders the right to utilise e-proxy voting; though shareholders will still be able to vote by sending a paper ballot or by attending a general shareholder meeting in person. The new interaction formats have been developed in accordance with ISO messaging standards, such as ISO 20022; they are also based on international standards for organizing and conducting shareholder meetings and take into account peculiarities in the Russian securities market. Implementation of ISO 20022 will allow NSD to receive structured information about convened shareholder meetings and documents related to the meetings’ agenda items and results from issuers. The information received will be sent automatically in unchanged form to NSD’s depositors. The new

message format will be also used for transmission of electronic documents containing information about securities owners’ votes at shareholder meetings (eproxy voting). In addition, the NSD’s depositors that use SWIFT will be able to interact on the basis of ISO 15022 (NSD will be responsible for converting messages into ISO 20022/ISO 15022 formats). The new technology has been developed with the active participation of securities market participants: issuers, registrars and depositories.

Previous formats In 2014, legislative efforts were made to introduce an opportunity for securities owners to vote by sending electronic documents via their depositories. Up to this day, the e-proxy voting service allowed the use of internal message

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REGIONAL REVIEW

n s d p ic Ks u p t h e pa c e o f c o Rp o Rat e a c t io n Re f o RM in Ru s s ia

formats agreed with market participants. Since the new technology has been rolled out, more than 369 shareholder meetings have been initiated using e-proxy voting via NSD. In future, market participants will switch to the new technology step by step, in accordance to their technical and regulatory readiness for this switch. After that the exchange of documents in outdated formats will be phased out. According to Eddie Astanin, chairman of the NSD’s Executive Board,“Corporate actions represent a sphere which needed qualitative changes. All market participants, including foreign investors, agree with this. This sphere’s reform should have a complex effect by improving the market infrastructure, corporate governance quality and the investment attractiveness of Russian assets in general strategically. There are examples of this effect among emerging countries. For instance, in 2011, when e-proxy voting technology was introduced in Turkey, foreign investors’ attendance at shareholder meetings increased more than five-fold.” The initiative is the latest in a series of sometime complex changes to the legal basis for and technology supporting corporate actions processing. Market participants will be able to mitigate risks and reduce costs associated with corporate actions by eliminating the use of traditional paper documents, using electronic technologies and involving recordkeeping institutions. Access to deep pools of data and transparency of that data is integral to the evolution of an effective corporate actions segment. No surprise then that underpinning the NSD’s latest crop of initiatives is a joint project by NSD and the Interfax information agency, aimed at the collection, verification and distribution of corporate information. The key goal of cooperation of NSD and Interfax in the sphere of corporate information is to create a reference database containing all available data about Russian issuers and their financial instruments and develop a system that assesses the fair value of financial instruments.

Photograph Eddie Astanin © FTSE Global Markets, supplied April 2015.

The system will integrate official data of the record keeping system of Russia’s central securities depository, information disclosed by issuers via Interfax as an agency authorised to disclose information to the stock market, and up-to-date information about issuers and securities collected by Interfax. To ensure it meets international standards, a multi-level process of data verification will be used, information will be updated promptly,“the entire database and its components will be integrated directly into the clients’ information systems in a convenient way,” says the NSD in a statement. It is planned to launch the first information product created as part of the project within the month. Astanin explains that: “The project developed jointly with Interfax in the sphere of corporate information will allow replacing inconsistent and even contradictory data with a unified, reliable and standardized information source. With respect to the price center development, we see that creation of a national benchmark in the sphere of fair value of securities is a very important and widely demanded task for the market. Both projects contribute to a systemic minimization of risks associated with use of incorrect, untimely or incomplete information about Russian issuers and their securities.” Astanin further explains that, “The series of reforms undertaken by the NSD represents one of the most important transformations in the Russian financial market, along with the creation of the central securities depository itself and the opening of foreign nominee accounts. The

reforms have also played an important role in encouraging global players, such as Euroclear and Clearstream, to enter the Russian market. Additionally, the reforms also simplify the means by which foreign investors gain direct and convenient access to the Russian market. The opportunity to execute rights on Russian securities in a safe, centralised way and in an electronic format will benefit both the domestic and international market.” Additionally, the NSD has also been upgrading its settlement services. At the end of March the CSD announced that it had launched a delivery versus payment service that utilises Bank of Russia’s BESP (real time gross settlement) system. In other words, mirroring in part, Europe’s T2S project, the technology involves settlement in central bank money. Explains the NSD, the initiative “allows reducing counterparties’ costs associated with settlements due to mitigating an impact of commercial settlement organisations’ (banks’) risks on settlements Russia’s central securities depository, [and] provides credit organisations with an opportunity to conduct settlements on transactions with securities on the basis of DVP model 1 using correspondent accounts opened with the Bank of Russia. The new service expands a range of settlements available for NSD’s clients and combines the advantages of reliable DVP settlements with flexible cash management”. The new service allows settlements between NSD clients’ accounts opened with the Bank of Russia or between two accounts, one of which is opened with the Bank of Russia and another one – with NSD. “Implementation of the technology of settlement in central bank money is an important step toward development of the market infrastructure, bringing it into compliance with standards including the international ones. Thomas Murray, the international agency assigning ratings to central securities depositories, takes into account an opportunity of settlement in central bank money provided by a CSD to its clients,” explains Maria Ivanova, vice president, business development and client relations, at the NSD. n

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BELVEDERE

WiLL t h e f e d e Ve R Be Re a s o n a BLy c o n f id e n t e n o u Gh t o Ra is e Rat e s ?

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

Fed data dependency opens way for greater market volatility The new Belvedere column in FTSE Global Markets is the bellwether of shifts in market sentiment, propelled by either shifts in monetary policy or macro market trends. David Shairp, portfolio manager and global strategist in JP Morgan Asset Management’s Global Multi Asset Group sets the tone by looking at the impact of US Federal Reserve policy on interest rates on market sentiment and the inevitable consequences of an election in the United Kingdom which, in his view “appears to be a contest between the unacceptable and the unelectable.”

T THE LAST FEDERAL Open Market Committee (FOMC) meeting, the Federal Reserve (Fed) removed the word “patient” from the statement it uses to indicate when it will start normalising monetary policy. This decision was widely expected. In addition, the Fed lowered its forecasts for growth, inflation and unemployment for the 2015/17 period. The set of forecasts, known as the “dots”, imply a softer profile for the rise in US interest rates, with a median Fed funds rate of 0.625% at the end of 2015 rising to 1.875% in 2016 and 3.125% in 2017. The market is pricing in rates of 0.4%, 1.2% and 1.7% respectively. Yet within these averages, there is a wide variation regarding the direction of interest rates among FOMC members. In contrast, the range of estimates around economic growth and inflation projections are much smaller. At Fed chair Janet Yellen’s recent press conference, she was clear that any decision to raise interest rates would be a function of“reasonable confidence”in the Fed’s inflation outlook. In other words, the Fed would need reasonable confi-

dence that the rate of core inflation would move back to the 2% target over the medium term. She cited four factors to inform a sense of reasonable confidence: a further reduction in labour market slack; realised inflation; wage growth; and (rising) inflation expectations. With renewed emphasis on the dots, it is clear that monetary policy has become data dependent once more. Yet “reasonable confidence” is also an elegant way of keeping your options open. To give it more room for maneouvre, the Fed reduced its estimate for the equilibrium midrate of unemployment from 5.35% to 5.1%, implying there is more slack in the US labour market than previously thought. This compares to a current jobless rate of 5.5%, below the average of the last 20 years of 6% and the lowest reading since June 2008. While the labour market is arguably tight, and unit labour costs have started to accelerate, it is worth observing that these are lagging indicators of activity. The other reasons for keeping its options open is that the current quarter has been very weak, perhaps more than suggested by very cold weather and the West Coast port strike.

Indeed, the Atlanta Fed’s latest “nowcast” estimates that first-quarter 2015 real GDP growth is tracking at only 0.3% seasonally adjusted annual rate (saar). Despite changing little, the impact on markets was significant, with equities rising strongly, bond yields falling and the dollar weakening. Indeed, one of the largest reactions was in the FX market, where the European currencies rallied strongly, with the euro having an intraday trading range of 4.4% (the second largest in the lifetime of the single currency) while sterling was equally volatile, recording an outside day reversal, seen by some as a technical signal of trend exhaustion and a possible change in direction. A move to data dependency, combined with the shift from stable to gradually rising rates, suggests scope for greater market volatility. This seems particularly likely to hold true at the short end of the yield curve, where the sensitivity of two-year yields to economic data surprises was unusually muted between 2012 and 2014. Indeed, uncertainty about the Fed seems apt to persist for a while, beyond the (ultimately) minor issue of the timing of the first rate hike, as the debate shifts

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first toward the pace of tightening and then to the terminal funds rate and the size of the balance sheet, questions that have yet to receive a full airing in market discussions.

UK structural challenges masked The UK’s pre-election budget masks longer-term structural problems. The UK government delivered its last Budget prior to the general election on May 7th. Usually, pre-election Budgets in the UK have been an institutional form of bribery, to incentivise the electorate to vote in favour of the incumbent government. However, Chancellor of the Exchequer George Osborne’s room for maneouvre has been constrained by fiscal reality and his Liberal Democrat coalition partners. Instead, a broadly neutral budget was delivered, though it was laced with some modest electoral goodies in the form of savings tax relief for older voters and incentives for first time home buyers. The headline arithmetic had the UK budget moving back into balance by the

2019/2020 financial year, with expenditure falling as a percentage of GDP to 2000 levels. Despite the relatively upbeat tone of the Budget, the UK faces sizeable structural challenges over the next five years. As has been noted, the UK faces a productivity problem, where average output per head lags that of France by a fifth. This has probably been the single biggest reason as to why UK living standards have been slow to recover after the crisis. Some of these challenges are obscured by the official forecasts. Lurking in the projections made by the Office for Budget Responsibility was a rise in household gross debt, which is projected to rise from a current level of 146% of household income to 171% by the end of 2019— above the pre crisis peak of 169% in 2008. This suggests that household debt will grow at around 7% per annum and outstrip nominal GDP growth by approx 3% p.a. Assuming that most of this growth in debt will be bank financed (with a considerable chunk being mortgages), bank credit is

likely to grow much faster than forecast by bank analysts or by the banks’ own capital positions. If this forecast is achieved, it could bring further pressure on the current account – and potentially the currency – given a current shortfall of 6% of GDP. Alternatively, if household re-leveraging undershoots this forecast, then the growth outlook – and the UK’s fiscal profile – will deteriorate. All this sits uneasily with the looming general election, which promises to be inconclusive. At present, it appears to be a contest between the unacceptable and the unelectable, with no clear winner in sight given present polling trends. A period of uncertainty therefore awaits until a new coalition is formed. History suggests that a combination of deteriorating external fundamentals coupled with political risk tends to take a toll on sterling, which looks overvalued on a real effective basis. So, the remaining days of campaigning threatens to be volatile and could be bruising for UK assets. n

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FOREIGN EXCHANGE

u s d o LLa R: Wh y it Re Ma in s t h e c u RRe n c y o f c h o ic e

THE BUCK STOPS...WHERE?

Photograph © okalinichenko/Dollarphotoclub.com, supplied April 2015.

Three decades ago it took an international team of monetary specialists to finally put a lid on the US dollar's five-year joy ride. Once again, the USD is off to the races, and, barring a similar intervention, could conceivably maintain its present trajectory for as long as the existing US-EU divergence remains in place. What are the possible consequences this time around? From Boston, Dave Simons reports.

T THE END of March the US dollar looked to be on a strong footing, even as weaker than expected key economic data changed the rhetoric of the US Federal Reserve on its rate outlook. On March 27th a third and final estimate of US fourth quarter (Q4) GDP missed expectations showing quarter on quarter growth at 2.2% versus

expectation for a modest upward revision to 2.4%. “In terms of US dollar movements, yet again we saw 1.50 and 1.10 a bridge too far for both GBP/USD and EUR/USD respectively. After hitting a post GDP high on Friday March 27th of 1.4923, GBP/USD opened on the morning of the 30th a good deal lower at 1.4833 with near term support of 1.4690 firmly

in its sights. Similarly, the single currency is trading lower this morning from Friday’s 1.0939 highs back down to 1.0831. However, for numerous reasons discussed previously and the ever present Greek risk factor the outlook for EUR/USD has the potential to be more bearish. A close today below the 21 Day Moving Average of 1.0850 pushes downside traction towards

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1.0610,” says Paul Reilly, economist at Clear Treasury LLP. Last year the dollar gained significant ground against the world’s leading currencies, and with energy prices down, the US economic standard pushing forward and the Fed likely moving toward raising interest rates sometime this year, the greenback’s comeback may have longer legs than previously anticipated. Is this a good or bad thing? On the one hand, earnings figures during Q4 revealed the negative impact of rising export costs on a number of leading US multinationals; meanwhile in Europe, the surging dollar has intensified the impact of the ECB's newly launched easing program, which has weighed heavily on the euro since the stimulus plan was announced in January. Still, a buck with more bang could continue to fuel consumer confidence, keep inflationary factors underfoot, while also potentially support higher price/earnings (P/E) multiples for domestic equities. The US dollar is also figuring in the minds of seasoned investors in the emerging markets as well. Explains Pierre-Yves Bareau, chief investment officer for Emerging Market Debt at JP Morgan Asset Management in London currency volatility remains a huge factor for emerging markets. “We feel the bulk of the adjustments will continue to be felt in local currency markets and therefore prefer USD denominated debt. Overall the strengthening of the US dollar is general bearish for EM currencies and there is no reason to go against that trend, hence we are essentially hedged to be neutral to EM currency risk, with some important exceptions in areas like Mexico, Poland and India where we think there are interesting opportunities. However, for the most part, we think there is more pressure to come from emerging market currencies and whilst we may like local bonds we are constrained by the FX.” Considering the breadth of the current advance (which finds the dollar ahead some 25% on an annualised basis since last June) a period of consolidation cannot be ruled out; nevertheless, many see a continuation of the conditions that have

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

supported the dollar's recent surge, including falling commodities prices, consistent foreign investment inflows, as well as a divergence in growth between the US and other developed markets. Which of these scenarios will ultimately prevail? What affect, if any, might a stronger dollar have on asset-management strategy, including possible changes to portfolio allocations, going forward?

Currency conundrum When trying to assess the current trajectory of the dollar and its likely impact on economic and financial matters going forward, past comparisons aren't always the best indicators. Bull markets have occurred during both good and bad dollar environments, making equity correlations difficult; similarly, commodities prices have both paralleled and diverged from the dollar during periods of USD appreciation. The data does point to a fairly stark portrait of reduced corporate earnings expectations, at least on a short-term basis. A recent chart combining research from Bloomberg, MSCI and Northern Trust shows the three-month change in next-12-month earnings expectations falling incrementally in the US during periods in which dollar appreciation has exceeded 5%, though more substantially across the pond (due to dollar strength historically coinciding with European economic weakness). Expand the time horizon in order to view realised EPS, however, and a different picture emerges: in the United States for instance, over a five-year period EPS increased nearly 3% and 8% respectively on an annualised basis during the most recent two episodes of USD acceleration (1980 to 1985, and 1995 to 2001 respectively). Both periods were particularly kind to stock investors, who garnered returns of 9.7% and 15.2% respectively. "Despite short-term concerns over earnings, past periods of persistent dollar strength have been met with solid gains in the equity markets,” says Daniel Phillips, investment strategist at Northern Trust. No doubt, the rising dollar has intensified the impact of the ECB's newly

launched easing program, which has weighed heavily on the euro since the stimulus plan was announced in January. (In March the European currency fell to its lowest level against the dollar since 2003 before staging a mini rebound towards month's end.) "With the rise in QE purchases we could see further depreciation of the euro, as EU debt owners sell into the market and move directly into USD holdings," offers Phillips. The dollar is also weighing heavily on the emerging-markets private sector, a result of the USD-based debt to EM nonfinancial corporates ratio reaching its highest level since the late 1990s, according to David Absolon, investment director at Heartwood Investment Management. For the past six years the fixedincome markets have been the principal source of EM corporate liquidity, notes Absolon, "and if corporates are unable to service their debt obligations, liquidity is likely to dry up and that will create a lot more volatility across the fixed income asset class more generally." Still, the record shows that a stronger dollar is not always a harbinger of weaker non-US market returns, particularly over the longer haul. During the 1990s, for instance, developed ex-US equities outdistanced their domestic counterparts, even as the dollar was continuing to tick upward. By the same token, one cannot presume that the current spate of US bullishness will go uncorrected based solely on the dollar's outperformance (as anyone who continued to hold their Y2K dot-com positions will likely recall). According to Bloomberg Intelligence economist Carl Riccadonna, historically GDP is one area that has been consistently impacted as a result of dollar appreciation. "The export sector is obviously a key factor here, as it's just very difficult to remain competitive in foreign markets once the dollar begins to rise," says Riccadonna. The recent performance of domestic versus foreign auto makers paints a clear picture: with the dollar moving up some 20% relative to the euro, as an exported product the Chevy is now essentially 20% pricier than a Volkswagen.

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FOREIGN EXCHANGE

u s d o LLa R: Wh y it Re Ma in s t h e c u RRe n c y o f c h o ic e

Clearly domestic firms with a larger book of overseas business have the most to lose as a result of the USD surge. However, even the likes of Proctor & Gamble and other multinational mainstays remain vulnerable. "Even if sales stay on track, foreign profits still take a 20% hit due to the shrinking currency value," says Riccadonna. This has already been reflected in the most recent GDP numbers, which included a 1.4% decline in profits during quarter four (Q4). Though exports comprise only around 12% of total GDP, there are other factors to consider as well, including the impact on domestic business. In contrast to the 10.4% surge in imports recorded during Q4, new ISM manufacturing survey data revealed nearly non-existent new export orders. "The domestic new orders component has also been losing ground, further evidence that domestic industries are being pinched," says Riccadonna. This is corroborated by anecdotal evidence within the Kansas City Fed's own recent survey, which found the margins of US companies being squeezed by the flood of cheap imports. Of course it is not the first time that the bouncing buck has wreaked havoc here at home. Back in the 1980s the dollar's run-up coincided with the first major leg down in US manufacturingno accident, says Riccadonna. "During that time West Germany and Japan were manipulating their currencies in order to make them excessively weak against the rising dollar, and the result was a flood of imported electronics, appliances, and automobiles," says Riccadonna. "As anyone who hails from the Rust Belt or any of the other major manufacturing centres knows, this is not something to be taken lightly." A less-discussed though equally important element is the effect on domestic labour costs. "If I'm a multinational producer with plants across the globe, I'm going to source production to wherever the labour is cheapest," says Riccadonna. "So, just as the price of a domestically produced auto export rises with the dollar, so does the cost of an American assembly line worker relative to a

European counterpart." While companies have been busy jobbing out to cheaplabour markets for decades, during periods of pronounced currency moves the cost gap becomes even more of a factor. Riccadonna cites Volkswagen's recent decision to scuttle a new factory in South Carolina in favour of a southwest Mexico facility. "People argue that the lower cost of importing raw materials will benefit manufacturers, however they're forgetting that the cost of labour is what matters most to.

Betting on the Buck So where does the buck stop? Thirty years ago it took an international team of monetary interventionists under the 1985 Plaza Accord to finally put a lid on the dollar's five-year ride. Baring a similar set of circumstances, the dollar could maintain its present course for as long as the existing US-EU rate-of-return differential remains in place. From his vantage point, Riccadonna sees the divergence stretching into 2016, if not longer. "Right now this is a multi-year development, no doubt," says Riccadonna. "If it suddenly looked like Europe was doing a lot better, including moving monetary policy in a more restrictive rather than accommodative direction, then yes, that would ultimately stem the tide, but at this point that appears unlikely. The dollar has made a very dramatic move over a very short period, and I don't believe that kind of momentum is sustainable. But even though the rate of change may shrink, the general trend is still likely to persist." For its part, Northern Trust began rotating into dollar-denominated assets beginning in Q4 of last year, based on the belief that the environment was conducive to sustained dollar appreciation (NTRS maintains a US equities and US high-yield bias, while underweighting non-dollar equity assets including major ex-U.S. and emerging market equities). However, Phillips believes that the economic chasm separating the US from the EU, though a key factor in the dollar's recent run-up, likely has a limited shelf life. "It's been our view that the divergence in growth between the

US and other developed markets may not extend beyond the current year," says Phillips, particularly as the ECB's aggressive monetary stance begins to pay dividends in the form of renewed European growth. Thus, a return to a more normalized US-EU economic environment could take some of the bang out of the buck going forward. Bottom line: even with current factors favouring US-tilted allocations, the long view supports a more diversified global portfolio as a hedge against sudden, unforeseen currency swings and other macro risks, notes Phillips.

Arbitraging the Dim Sum market The strong dollar has had an effect on the offshore renminbi bond market as various issuers have used the opportunity to help beat US dollar funding costs. Increased issuance in the Dim Sum market through March picked up the market, which had been in slump through February, which recorded a mere RMB4.3bn worth of new issues (compare that with the RMB17.8bn raised in January and you see the problem). Despite the market’s ups and downs the reality is that demand for offshore renminbi bonds has waned since China embarked on a policy of monetary easing at the end of 2014. Mainland issuers can now borrow at a lower cost onshore as the weaker RMB has coupled with lower domestic interest rates. However, attractive cross-currency basis swaps, have enabled foreign borrowers are able to price deals inside their US dollar funding costs, saving around 30-40 basis points once they have swapped back into dollars. In March BNP Paribas priced a Rmb1.5bn ($239m) 10 non-call five Dim Sum bond offering at 5.1%. The transaction might have marked the bank’s debut in the Dim Sum market, but it nonetheless quickly swapped the deal into dollars. It’s not a catch all as the deals have not been oversubscribed by much, suggesting that there is limited liquidity in the secondary bond market. However, as a stop gap and if you have the right deal, then the play might be worthwhile for seasoned issuers. n

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ENERGY

GLo Ba L GRo Wt h , e n e RGy d e Ma n d & p Ric e o u t Lo o K

IEA says global growth will underpin recovery in oil demand in 2015 Forecasters estimate that the world economy will grow by between 2.8% and 3.8% this year—about one percentage point lower than last year’s consensus forecasts. Yet as monitors of the global economy lower their expectations for 2015, executives are increasingly focusing on opportunities presented by diverging growth rates among regions, countries, and even sectors. Having bottomed‐out in the second quarter of 2014, global oil demand growth has since steadily risen, with year‐on‐year gains estimated at around 0.9m barrels per day (mb/d) for the final quarter of last year and 1.0mb/d for the current quarter, according to the International Energy Agency’s (IEAs) March Oil Market Report.

HE IEA’S FORECAST of demand growth for all of 2015 was raised by 75 kb/d to 1.0 mb/d, bringing global demand to an average 93.5 mb/d. Global supply rose by 1.3 mb/d year‐on‐year to an estimated 94 mb/d in February, led by a 1.4 mb/d gain in non‐OPEC output. Declines in the US rig count have yet to dent North American output growth. Final December and preliminary currentquarter data show higher‐than‐expected US crude supply, raising the 2015 North American outlook. The IEA’s view is supported in part by latest estimates of the International Monetary Fund (IMF), in October 2014, world GDP growth was measured at 3.3%. For 2016, the IMF and other organisations have lowered previous global GDP growth projections to 3.1% to 4.1%. Most forecasters expect a robust US economy to continue to lead the way, and the eurozone’s new program of quantitative easing is a sign the region is ready for expansion. And while falling oil prices weigh heavily on growth prospects for commodities-dependent Brazil and Russia, China and India are benefiting from easing inflationary pressures. According to the IEA, the IMF’s view that the global economy will grow by 3.7% this year will help oil demand reach 93.5 mb/d in 2015, an increase of 1% on 2014. The markets did not reach positively

or seem to share the IEA’s enthusiasm. Following the IEA’s statement, Brent futures for April lost 1.82% trading at $56.04 and WTI diving 4% to $45.17. All in all, the oil price has more than halved since June 2014. Nonetheless, the IEA revised upwards its demand growth forecast for 2015 by 75,000 b/d to 1.0 mb/d. This comes after oil demand came in better than expected during 4Q2014 and 1Q2015, which it says was likely a reflection of improving macroeconomic conditions and ‘one off’ factors such as the impact of colder weather in the northern hemisphere and a base effect boost from 2013. The forecast of demand growth for all of 2015 was raised by 75 kb/d to 1.0 mb/d, bringing global demand to an average 93.5 mb/d.

Supply in flux OPEC crude output edged down by 90 kb/d in February to 30.22 mb/d. The slightly higher demand forecast has raised the "call" on OPEC crude for the second half of 2015 to 30.3 mb/d, above the group’s official 30 mb/d target. Global oil production in February rose in annual terms by 1.3m barrels per day to 94m with an increase of oil production outside OPEC of 1.4m barrels per day, according to energy specialist Platts.

Omar Al-Nakib, senior analyst at National Bank of Kuwait, says the fall in OPEC output was its lowest level in two years. “The drop of 330,000 b/d compared to January was primarily a reflection of outages in Libya and Iraq. Libyan output declined further to 341,000 b/d in February as the conflict between the country’s two rival governments continued to impact oil fields and installations. Since last October’s high of 900,000 b/d, two thirds of the country’s oil production has been taken offline,” says Al-Nakib, adding: “In Iraq, meanwhile, storage constraints at the country’s southern tank farms and bad weather in the Shatt Al-Arab saw crude production decline by almost 260,000 b/d to 2.7 mb/d during the month. This is the second month in a row since December that production has fallen. Output had reached a 35-year high of 3.6 mb/d last December.” Saudi Arabian production was also down, by 44,000 b/d to 9.6 mb/d during February. Nevertheless, since OPEC’s Saudi-led decision in November to hold off on cutting output below the group’s official target level of 30 mb/d, the kingdom has steadfastly stuck to its strategy of protecting market share and kept its production relatively steady; even the loss of the 300,000 b/d Khafji oil field in the Neutral Zone, which Saudi Arabia shares 50/50 with Kuwait, was compen-

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Photograph ©WavebreakmediaMicro/dollarphotoclub.com, supplied April 2015.

sated by increasing production from other fields, explains Al-Nakib. “While February saw OPEC output exceed the 30 mb/d level for the tenth consecutive month, improving global oil demand this year should help narrow the OPEC supplydemand mismatch to 0.7 mb/d if OPEC maintains production at current levels for the remainder of the year. OPEC would thus need to cut output by 0.7 mb/d to 29.5 mb/d (the “call on OPEC crude and stock change) in order to balance expected demand this year. Often during the second half of 2014, OPEC was producing at least 1.2 mb/d in excess of the call,” he adds.

Price trends North Sea Brent crude oil spot prices decreased by $2/bbl in March to a monthly average of $56/bbl. This decrease followed a $10/bbl increase in February, the first increase in eight months. Several factors put upward pressure on Brent prices in February, including news of falling US crude oil rig counts and announced reductions in capital expenditures by major oil companies. This upward price pressure abated in March, as the combination of robust world crude oil supply growth and weak global demand contributed to an increase in the rate of global inventory builds. Inventory builds are projected to average 1.7m bbl/d through the first half of 2015. Total global oil inventories are estimated to have increased by 2.1mbbl/d in March alone however, compared with a 0.9mbbl/d increase in February. Despite concerns that inventories are rising rapidly, the IEA thinks that inventory builds will moderate during the second half of the year, as demand rises and nonOrganization of the Petroleum Exporting Countries (OPEC) supply growth slows, particularly in the United States, because of lower oil prices.

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

No surprise then perhaps that the monthly average WTI crude oil spot price decreased to an average of $48/bbl in March, down $3/bbl from February. WTI prices fell in March in large part because of commercial crude oil inventories in Cushing, Oklahoma, which increased to a record 58.9mbarrels as of March 27th. The record inventory levels have put downward pressure on the price of crude oil for prompt delivery compared with the price of crude oil for delivery in later months. EIA projects the Brent crude oil price will average $59/bbl in 2015, with prices rising from an average of $56/bbl in the second quarter to an average of $67/bbl in the fourth quarter. The Brent crude oil price is projected to average $75/bbl in 2016. However, this price projection remains subject to the uncertainties surrounding the possible lifting of sanctions against Iran and other market events (see analysis box below). WTI prices in 2015 and 2016 are expected to average $7/bbl and $5/bbl, respectively, below Brent. The Brent-WTI spread for 2015 reflects continued large builds in US crude oil inventories. The current values of futures and options contracts continue to suggest a high degree of uncertainty in the price outlook. WTI futures contracts for July 2015 delivery traded during the five-day period ending April 2nd averaged $52/bbl, explains the IEA, while implied volatility averaged 46%, which it says, “[established] the lower and upper limits of the 95% confidence interval for the market's expectations of monthly average WTI prices in June 2015 at $35/bbl and $78/bbl, respectively. The 95% confidence interval for market expectations widens over time, with lower and upper limits of $32/bbl and $97/bbl for prices in December 2015. Last year at this time, WTI for July 2014 delivery averaged $99/bbl, and implied volatility averaged 17%. The corresponding lower and upper limits of the 95% confidence interval were $85/bbl and $115/bbl,”

in its April STEO report. Given the high level of uncertainty in oil markets, several factors could cause oil prices to deviate significantly from current projections. Among them is the potential lifting of sanctions against Iran if a comprehensive agreement is reached. The level of unplanned production outages could also vary from forecast levels for a wide range of producers, including OPEC members Libya, Iraq, Nigeria, and Venezuela. The degree to which non-OPEC supply growth is affected by lower oil prices will also affect market balances and prices. On April 2nd, Iran and the five permanent members of the United Nations Security Council plus Germany (P5+1) reached a framework agreement that could result in the lifting of oil related sanctions against Iran. Most commentators believe that any lifting of sanctions could substantially change the short term forecast for oil supply, demand, and prices by allowing a significantly increased volume of Iranian oil to enter the market. “If and when sanctions are lifted, the baseline forecast for world crude oil prices in 2016 could be reduced $5-$15/barrel (bbl),” says the IEA. Iran is believed to hold at least 30m barrels in storage, and the EIA believes Iran has the technical capability to ramp up crude oil production by at least 700,000 bbl/day (bbl/d) by the end of 2016. This, in addition to even moderate levels of global inventories, means that global production continues to exceed demand. However, if the new framework agreement between the P5+1 and Iran results in a comprehensive deal and a lifting of sanctions, it could significantly change the short term energy outlook forecast for oil supply, demand, and prices, which still assumes that Iran’s production will stay close to the current level through 2016. n

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TRADING

AQUIS INTRODUCES COMPETITION INTO CLOSING AUCTIONS Pan-European equities exchange, Aquis Exchange, will introduce Market at Close (MaC), a new order type to offer an alternative to current end-of-day auctions at exchanges. MaC will allow Aquis Exchange members to enter orders for matching on its platform at the closing price of the market-oflisting end-of-day auction and will not be subject to Markets in Financial Instruments Directive II (MIFID II) restrictions on the use of reference price waivers. The move is supported, says Aquis by a number of asset management and trading firms, which it says will benefit from having competition in the market.

HE MOVE IS significant. According to the exchange, around 20% of European trading takes place in closing auctions, with fees between 50% to 100% higher than other times of the day. According to Aquis investment firms prefer executing trades in the last minutes of the trading day (the closing auction) as the closing price of securities or shares traded is regarded as a benchmark. It is the last element of the European trading market that remains in effect a monopoly and which has encouraged the exchanges to increase fees, because they can. The Markets in Financial Instruments Directive (MiFID) introduced competition in daily trading in European markets, with a substantial slug of that business now going to venues such as BATS Chi-X. In the closing auction, much of the fragmented trading returns to the main national market and it is this nugget of business that Aquis has set its sights on. Clearly it is a means of winning market share. Founded by a group of former ChiX executives and led by Alastair Haynes, more than a year ago, it wanted to shake up the European trading market with a subscription-based pricing model. The move to introduce Mac will in effect introduce competition in the market and will help differentiate the Aquis business model. The Acquis mechanism is essentially a matching algorithm for auction’s closing window. Aquis Exchange has built its business on a three pillar strategy; the efficacy of its order types, the quality of its technology and its subscription pricing model. Aquis holds that the move is a major de-

velopment for the market.“While MiFID I paved the way for new venues to compete against the trading monopolies held by national exchanges, the closing auctions had remained virtually unchallenged," says CEO of Aquis Exchange, Alasdair Haynes. Mac is said to meet pre and post trade transparency requirements and will not be subject to MiFID II restrictions for the use of price waivers. Because it is an entirely lit market, it also meets ESMA transparency requirements. Aquis says that UK market regulator, the Financial Conduct Authority (FCA) has given its approval. One of the firms that has gone on record supporting the move is SGCIB,“We are fully supportive of the Aquis initiative and will follow its development with great interest,” says Richard Hills, global head, portfolio trading and electronic trading at the investment bank. The auctions space is clearly gaining traction as a potential area for competitive advantage. Earlier this year the London Stock Exchange announced that it was introducing a mid-day auction, similar to the midday auctions in Germany, for all SETS equities, the largest and most liquid shares traded on its markets. At the time the initiative was announced, Brian Schwieger, head of equities, at the exchange said the initiative, “is in direct response to demand from buy-side participants for neutral, infrastructure-led solutions for trading in large blocks. The auction will allow participants to place orders in a truly confidential, yet price-forming environ-

ment via a well understood mechanism”. The intraday auction will go live in late 2015, giving market participants opportunity to update and reconfigure their own systems. As with the current opening and closing auction, there will be no additional fee or extra direct cost imposed on customers in order to take part in the auction. The auction will apply to all SETS equity securities.

Hong Kong to return to closing auction? Across the world, Hong Kong brokers are voicing concern over the possible relaunch of the closing-auction system for Hong Kong Stock Exchange. The exchange group is consulting the market until April 10 before deciding whether to reinstate the closing-auction market that it shut down after only 10 months of operation in 2009 following charges of market manipulation. The exchange proposes a 5% price limit for the closingauction period during the afternoon trading session. Another control measure involves the introduction of a random closing time so investors do not know when the auction will end. Stock markets in most countries use auctions to set closing prices through tenders by traders, with the most common order becoming the closing price. However, Hong Kong calculates the median price of the last five orders to determine the closing price. The HKSE is the only exchange in an advanced market that does not have a closing auction. n

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TRADING REPORT

Wh y Ris K Ma n a Ge Me n t n o W s e e p s in t o o p e Rat io n s

RISK READINESS REVISITED What challenges does a broader approach to managing risk present to banks and broker-dealers? What kinds of resources may be required to fortify trade-capture, surveillance and other capabilities? From Boston, Dave Simons reports.

Photograph ©István Hájas/Dollarphotoclub.com, supplied April 2015.

VER TIME THE risk-management regimen has gradually evolved, moving from a predominantly pre-trade function to one that seeks to address operational and risk issues spanning the entire trade life cycle. For sellside firms the Volcker rule, finalised in December 2013, remains a key risk rubric (as the recently announced two-year Volcker extension applies to covered funds only, the pace of the project will not be affected insofar as banks are concerned). Mitigating rogue-trading activity through post-trade surveillance is yet another pivotal area; during its recent onsite inspections of regional investment banks, for instance, the Hong Kong Securities and Futures Commission (SFC) focused specifically on the effectiveness of monitoring and pre-empting unauthorised trade activity by risk management

and compliance teams. Is there a way to achieve a "proper" balance between maintaining a robust market infrastructure and over-burdening financial institutions with too much regulation and capital-intensive risk tools? Pre-crisis, risk management was frequently handled one department at a time, or on whatever stage the transaction was occurring, be it front, middle or back office. As we now know, the consequences of this siloed approach to risk were dire. According to Laurence Wormald, head of research for SunGard's APT division, the unravelling of the credit markets in 2008 can be directly linked to the conspicuous lack of risk integration. "By managing risk unilaterally," says Wormald, "ill-fated companies like Lehman were powerless to determine the impact of their decision making on

different risk silos until it was too late." Today, a growing number of firms are able to monitor risk across multiple departments, as well as through the various stages that comprise the entire life-cycle of the trade. Mitigating rogue trading activity has been key to the integratedrisk evolution. "Some of the notable rogue trading activity has involved individuals with both trading and back-office expertise. In these situations, detecting the rogue behaviour was more difficult,” observes Jim Toes, president and chief executive officer of the Security Traders Association, the New York-based organization representing the interests of securities-industry professionals throughout the US and Canada. Even when the behaviour is bona fide, large firms may have difficulty monitoring their exposures across numerous departments,

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due in large part to the expense involved. "After all, you're not just considering exposures to a particular position, but also your counterparty risk," adds Toes. "As a result, we've seen a lot of investment in software designed to monitor this kind of risk as well." While predatory behaviour is nothing new, the rise in technology has made such opportunism more commonplace. All the more reason for firms to ensure proper stress testing of new systems prior to their roll out. "There will always be predatory elements within the marketplace," says Toes. "Thus, when firms invest in technology, they want to do so in such a way as to limit their chances of being victimised." Along with the perpetual threat of internal rogue activity, an increasingly challenging investment and regulatory environment that includes tougher capital-adequacy limits, broader collateral requirements covering OTC derivatives, as well as increased emphasis on stress testing has moved risk and reporting efficacy onto the front burner. This has compelled companies to think about more sophisticated and integrated approaches to managing risk, including preand post-trade risk assessment, scenario analysis modelling, as well as daily risk reporting. Through enterprise-wide risk management, all participants are afforded a common view of risk, says SunGard's Wormald, providing them with "increased granularity into portfolio positions, performance and risk exposures covering the entire realm of risk scenarios, including credit, liquidity, macro and political risk."

RENTD Control Once again, Volcker looms large on banks' regulatory to-do lists, with many working feverishly to meet a late-July deadline ensuring that banks' trading desks meet the proper exemption standards under Volcker's proprietary trading rule. Those who choose to exempt market-making activity face a particularly gruelling preparatory regimen, including the ability to comply with a strict set of risk and position limits under Volcker's reasonably expected near term demand of customers standard, or RENTD, thereby proving that

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

stand and effectively utilize this newer and more streamlined approach to risk management.

Balancing Act

Photograph ©István Hájas/Dollarphotoclub.com, supplied April 2015.

a desk's market-making positions are in fact linked to bona fide customer activity. With the compliance clock ticking down, integrating the rule’s exceptions as system enhancements in order to support RENTD is likely the most prudent approach for most banks, observes PricewaterhouseCoopers in a recent report. Accordingly, going forward centralization of processing systems will be key, given the increased demands on banks for trade-capture and data-analysis capabilities. Banks with a large number of market-making trading desks as well as disparate trading systems face especially daunting strategic implementation challenges, "as they need to produce more data, slice it into even more subsets, and enhance more systems," notes PwC. While acknowledging that the technology needed to become RENTD ready won't come cheap, once implemented banks will have a potent risk-management weapon at their disposal, one that can clearly demonstrate to clients the ability to keep prop trading in check. Furthermore, firms will be able to obtain other benefits from the RENTD data, suggests PwC, including learning how to better facilitate and enhance customer services and products. Above all, requirements like RENTD underscore the need for entities to "institute a change in culture" to ensure that all business segments under-

While much of the legislation that has emerged under the auspices of DoddFrank, Volcker and similar programs has been reactive in nature, it's hard to say whether all of these measures would have actually prevented the kinds of events that led to their creation in the first place. Not that the various efforts to deflect some of the regulatory impact have necessarily helped. Take the recently enacted Regulation Systems, Compliance and Integrity ruling, or Reg SCI, designed to ensure regular testing of automated systems, business continuity and disasterrecovery plans for vulnerabilities in the wake of the 2012 algo-based meltdown at New Jersey's Knight Capital as well as other tech-related blow-ups. While including the likes of self-regulatory organizations (SROs) as well as larger alternative trading systems (ATS), curiously the rule stops short of imposing the same maintenance regimen on large broker-dealers, alternative trading venues and various market-making outfits (including Knight itself, reborn in 2013 as KCG Holdings), much to the consternation of leading regulatory hawks. In a statement issued shortly after the debut of Reg SCI last November, SEC Commissioner Kara Stein argued that by omitting these entities some $14tn in equity trades remains vulnerable. In short, while necessary to preserve order within the financial markets, making regulatory adjustments without sacrificing choice and innovation is often a tricky proposition. "Investors benefit the most when there's a healthy balance between regulation and competition," maintains Toes. "Yes, regulation can make one safer, but if you designed a market place based solely on preventing a doomsday type of scenario, you would restrict innovation and competition to the detriment of investors." Because technology spend typically isn't a revenue-producing proposition (at least not right from the get-go) it can be

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TRADING REPORT

Wh y Ris K Ma n a Ge Me n t n o W s e e p s in t o o p e Rat io n s

a particularly tough pill for management to swallow. Yet as the record shows, such pre-emptive measures can pay exceedingly large dividends over the long haul. To wit, much of the risk-facing technology implemented between 2005 and the start of the credit crisis was largely due to companies fighting to maintain market share in the face of rising high-frequency trade activity.Yet it was those same system upgrades that allowed the equity markets to keep normal business hours and settle trades as usual in the immediate aftermath of the '08 collapse, while subsequently demonstrating to the rest of the industry the benefits of streamlining risk-management practices in the years that followed. "In other words, I'm not sure that we would have seen that kind of investment activity had HFT not been a factor in the years leading up to the crisis," says Toes. Of course, the push toward an electronically driven and lower-cost market-

place that began with the SEC's sanctioning of Regulation NMS a decade ago is itself viewed with some scepticism by certain critics, who contend that the rise of HFT, arbitrage trading and the various other permutations of the wired era helped foster a whole new raft of unforeseen problems. Not that anyone would willingly turn the clock back in order to keep the likes of HFT off the table at this point. "While there are a lot of people who are critical of today’s market structure, I don’t know anyone who wants to return to the market place we had in 2010, never mind pre-Reg NMS,” says Toes. In short, having all of these capabilities can sometimes make things feel worse than they really are—simply because there is much more transparency into the problems. "Glitches, outages, trading errors or trades gone bad have always existed-it's just that no one ever knew about them because that kind of granularity wasn't previously available," says Toes.

Of all the elements that help feed investor confidence, none are more crucial than the operational capability of the markets. Thus, fostering that capability should be of upmost importance for any regulatory or legislative body with oversight into the machinations of the financial arena. "It is imperative that such entities ensure no demands are made on the operational capacity of the industry that result in its being unable to deliver the services it purports to offer," affirms Toes. "Furthermore, behaviour which stresses the operational capability of our markets should be identified and reviewed by the proper regulatory agency. Our markets need to be open to serve a wide range of market participants with varying business models. Therefore, it is critical that behaviour which is deemed potentially harmful to the overall operational capability of our markets not be allowed to exist unimpeded." n

CHINA TO EXTEND ACCESS TO MAINLAND MARKETS Hong Kong Exchanges and Clearing Ltd’s chief executive Charles Li was reported by local press as saying the trading limits on the Shanghai-Hong Kong Connect services is to be increased by mainland Chinese regulators. He also suggested that the increase would be substantial, in excess of 30%. The move is still some way away as regulators in both Hong Kong and China will need to agree on increasing the quota, and the authorities are also reportedly developing plans for one more trading connection between Hong Kong and the Shenzhen exchange, he added.

HE EQUITY LINK with the Shanghai exchange started in November with an RMB550bn overall limit on the value of equities investors can hold, and also has a daily cap of RMB10.5bn on the value a stocks that can be purchased on any one day. After the launch of the service in November the volume of business led many to suggest it might be a damp squib. This year however, as Chinese regulators have increasingly relaxed rules for Chinese mutual funds to buy into Hong Kong shares, the Connect service has never been busier, pushing up the Hong Kong index to new highs. However any further relaxation is unlikely to emerge any time in the next few months.

“Regulatory authorities have been discussing quota expansion for a while,” it is reported as saying. “The quota will not be adjusted instantly following an abrupt market move. It will be an orderly adjustment and the market should wait patiently.” Currently, mainland investors are allowed to purchase a total of RMB10.5bn of Hong Kong stocks on a trading day, while global investors are permitted to buy a daily total of RMB13bn worth of shares trading in Shanghai. Among the changes currently mooted, is the relaxation of the requirement that mainland investors have RMB500,000 (about $80,000) on account to qualify for trading via the link. A recent move to allow Chinese mutual funds to buy in Hong Kong through the program sent

the market rallying 7.9% last week. So much money has flooded into the Hong Kong market that the local regulator, the Hong Kong Monetary Authority (HKMA) has had to sell the local currency to keep it from rising beyond the top edge of a trading band against the US dollar. The success of the Shanghai-Hong Kong Stock Connect is vital to both mainland and Hong Kong as it enables mutual market access by investors in the two markets through an orderly, controllable and expandable channel. It also secures Hong Kong as Asia’s most liquid market and is an important milestone in the opening up of the mainland’s capital account and will help the government establish the RMB as a global convertible currency sooner rather than later. n

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ASSET MANAGEMANET

The growing cachet of Guernsey open ended funds Photograph ©boomingpie/Dollarphotoclub.com, supplied April 2015.

With capital so portable in today’s world, investment dollars continually seek to find homes where it makes most economic sense acknowledge market experts. With confidence gradually returning to the global investment markets, it is no surprise that jurisdictions are dusting off their offerings, upgrading them and actively competing once more for new business. Guernsey is no exception and the jurisdiction is banking on the appeal of its range of investment structures, which it hopes will help it compete effectively against strong fund brands (such as UCITS), particularly in the open-ended fund segment.

UERNSEY BOASTS IN excess of a trillion US dollars’worth of funds under management and administration, of which a touch above $140bn is held in open-ended fund structures. The bulk of open-ended funds active in the island are in alternative assets and again, most utilise the open-ended Class B Scheme investment fund structure. Open ended fund structures are now regaining in popularity. For more than 15 years, open ended funds gave way to closed end fund structures as more private equity firms domiciled their funds in Guernsey. The 2007/2008 financial crisis however spurred something of a rethink as investors found that their funds were tied up in vehicles that either had gated or suspended redemptions. Retail or institutional investors looking for more flexible investment terms are gravitating towards open-ended structures once more, with the caveat that these funds are liquid and invested in assets that can sell quickly. As Paul Wilkes, group partner at Guernsey based law firm Collas Crill explains, it is not a black and white equation and investors have to understand exactly what it is they are invested in. “Some investors in either closed end funds and open ended funds found they could not redeem their invest-

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

ments easily because of the type of assets that were held by the fund. Whether it is a closed or open ended fund, if you are invested in weird and wonderful assets in some far off jurisdiction, it is not as easy to get your money out as it would if the fund invests in, say the European equities or bonds or securities that are easily transferred. So since 2008, we’ve seen the more successful open ended funds being those that are more liquid, more transparent and which offer liquidity if not on a daily basis, then at least a weekly or monthly basis, and where the investor has more chance of getting their money back on a rainy day.” With that in mind, the issue then becomes why invest in an open ended fund that is domiciled in Guernsey and not, say a Dublin or Luxembourg domiciled UCITS fund? That’s been a killer question for jurisdictions such as Guernsey and since UCITs fund structures have gained immensely in popularity in recent years, it has become increasingly trenchant. It has encouraged Guernsey to develop and enhance its own set of investment schemes and rules with which it can compete on a global basis for investment fund dollars. The jurisdiction has a fourpronged investment infrastructure, named rather functionally the Class A

scheme, the Class B scheme, the Class Q scheme and the fourth being the island’s registered funds regime. Class A scheme funds, which are broadly equivalent to UCITS III structures, are essentially designed for retail investors; the Class B Scheme meantime is designed for the institutional and high net worth markets but can also be used as a retail alternative. It is marketed as a highly flexible structure, with no pre-prescribed investment rules other than those described in the fund’s set up documentation. “In this regard,” explains Christopher Jehan, chairman of the Technical Committee, Guernsey Investment Fund Association, “the Class B Scheme is better than a UCITS structure as it covers a very broad range of funds, from plain vanilla equity funds through to very sophisticated hedge fund strategies. The key is transparency. The establishing documentation must spell out exactly the investment strategy and set its own investment rules. Of course, it must be approved by the regulator.” Additionally, the island offers a Class Q Scheme, which is essentially similar to the B Scheme but for more sophisticated (‘experienced’ investors is the term utilised) that can accept more risk involved in more complex investment strategies as well as traditional registered funds.

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ASSET MANAGEMENT

Gu e Rn s e y : o p e n e n d e d f u n d s

Guernsey also offers a dual or multiregulatory regime. The island’s existing regime remains for those investors and managers not requiring an AIFMD fund (including says investors using EU national private placement regimes and those marketing to non-EU investors). In other words, managers with elements of EU and non-EU business, who require a single domicile for their products, can place non-EU business in a parallel or feeder structure for which AIFMD compliance and the associated costs would not be required. It also offers an opt-in regime which is fully AIFMD compliant. “This provides a set of options which can be utilised according to specific circumstances. The choice is solely a commercial decision driven by distribution policies, and full-blown AIFMD compliance should only be sought if there are particular reasons to do so. Figures from the Guernsey regulator demonstrate the continued popularity of the Guernsey NPP route under AIFMD,” explains Dominic Wheatley, chief executive of Guernsey Finance, the jurisdiction’s business and investment promotions service. “Funds not solely focused on Europe should consider parallel or feeder investment structures whereby EU and non-EU business can be separated to achieve cost efficiencies.” According to Wilkes the duality of the regime should not be misinterpreted as regulation-lite.“Although firms have more options before them, the focus is rightly on proper disclosure of both the investment strategy and the risk involved, as well as setting it against a rigorous regulatory background and allowing the investor to get his or her money back should market conditions necessitate such a move.” Among recent high profile moves in the open ended segment, Investec Asset Management, helped by law firm Mourant Ozannes, migrated and redomiciled a $1.2bn open ended fund from Ireland to Guernsey in the summer of 2014. The move involved a complex system of approvals (from the Irish Central Bank, existing investors in the fund and the Guernsey Financial Services Commission) and changes to the fund

Photograph of Dominic Wheatley Kindly supplied by Guernsey Finance April 2015.

documentation to remove the fund from Ireland and authorise it as a Guernsey Class B open ended Unit Trust. At the time, Grant Cameron, managing director of Investec Asset Management Guernsey Limited, noted,“the ease with which this re-domiciliation process was managed given the complexities involved; some of the work performed on the re-domiciliation was ground breaking." The move is also indicative of the growing quality of the asset management segment in Guernsey and its international reach. Wilkes explains that the days are “long gone where an equity trader from a bulge bracket institution set up an asset management operation on the back of some good stories from the trading desk. These days end investors look very intently at track records, experience and market skill. They want asset managers who genuinely understand the asset class and have a clear and professional investment strategy. We are working with established clients in the UK in particular, but also increasingly from Switzerland, Germany and the Nordics; these are groups that bring immense value and expertise to bear on the market.” Jehan meantime is looking at the growing business opportunity outside Europe. He explains that Guernsey has a strong business proposition in regions such as sub-Saharan Africa and the Middle East in addition to its traditional strengths in Asian markets. “In South Africa, for instance,” explains Jehan,“Guernsey is the third most utilised jurisdiction for foreign registered funds after Ireland and Luxem-

bourg. We need to start capitalising on that strength in contiguous markets such as Botswana and Namibia. The Middle East too holds promise. The Saudi market is increasingly open, as is the rest of the GCC and we see more of an effort to work with us on a reciprocal basis. The opportunities are plenty and growing.” Wilkes at Collas Crill also sees a greater internationalisation of the market on the cards. “We have a discrete but growing business from South America, which is keeping us busy and which is opening up the opportunity for Brazilian asset managers to raise funds via Guernsey; and our operations in Singapore and Cayman continue to feed new business back here primarily from South East Asia and South America respectively. China and India are, of course, more difficult markets to access, but we are working to make inroads and we are seeing some success.” With so much opportunity in sight, the outlook looks rosy. If there is one teenytiny blip, if you can call it that, it centres on branding. Jehan at the Guernsey Investment Fund Association concedes that perhaps the moniker Class B Investment Scheme doesn’t have quite the same cachet or ring to it that say UCITS has, despite it being a more flexible and international structure.“Look, your average UCITS is distributed in three European markets (can actually range between anything from one to twenty-odd). Guernsey’s Class B Scheme has seen funds registered in anything up to six European markets under AIFMD placement rules. The rigour and the reach of the structure is there for investors to leverage. There is, perhaps, a need to find a moniker with some zip or pizazz that reflects the quality and range of the structure more effectively now, particularly as the global market has become more fluid and competitive. We’ve actually been working on it and have some ideas. We’ll keep you posted,” he says. There’s an obvious punchline about roses, other names and sweet smelling scents; so we’ll avoid it and wait for the roll out of the rebranding of Guernsey’s fund structure range. Seems like a good place to wait it out. n

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COUNTRY REPORT

TIME FOR TURKEY TO REGAIN ITS MOJO

Photograph © Hikrcn | Dreamstime.com, supplied April 2015.

It is a testing time for the Turkish economy. In the run up to mid-year elections, the country has come to something of an impasse. The Turkish lira (TYR) has weakened to a new record low, extending this year’s losses to 12% against the ever-strong US dollar. Despite the fall in the value of the currency and weaker oil prices, Turkey is struggling to take economic advantage; unusual in such a strong export-led and entrepreneurial economy. What’s the beef? Productivity is falling off while inflation is rising. For years Turkey has been the banner emerging market, showing an enviable market agility and willingness to tackle sometimes difficult market challenges. Not so much this year. Is it a short term lull? Or does it signify something deeper? These are important questions in the run up to mid-year elections. Can the country regain its momentum and lift itself out of its current economic funk? What does it need to do?

CCORDING TO THE president of the Turkish Industrialists and Businessmen's Association (TÜSİAD) Cansen Başaran Symes Turkey’s economic success story has been deteriorating“for a while and the country needs to change this atmosphere by means of comprehensive reforms in various fields” [sic], in a speech to attendees of a conference on inflation trends in the economy organised by Koç University and the TÜSİAD Economic Research Forum in early April. Symes noted that “modern rules and an improving investment environment, all of which played a great role in writing the [country’s] success story, have recently been replaced by negative conditions which challenge the success story. The EU membership target is now vague and the rule of law is weakening. A slower structural-making process is now in place,”she noted at the conference. It is not just in intangibles. Industrial production decelerated to 2.6% in 4Q14, after averaging 4.1% in 3Q14, notes Mehmet Besimoglu, chief economist at Oyak Securities.”Thus, the average rise

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

in industrial production (IP) stayed at 3.6% in 2014. Due to the weak performance in agriculture, GDP growth lagged IP figures in 2014, staying at 2.9%. 2M15 figures do not give a strong signal for the general outlook, either. Ex-gold exports have declined 12% year on year (YoY) in Q1 2015 due to a weakening euro and delay in eurozone recovery. Exports to neighboring countries, Iraq and Russia have also been hurt by the turmoil in these markets. Furthermore, declining commodity prices have also effected trading volume. Meanwhile, currency depreciation continues to upset consumer confidence. First quarter IP performance is likely to stay flat, creating downside risks to our 3% GDP growth forecast for 2015,” he says. Has Turkey lost its mojo? Is it now past its prime and in an economic funk? Between 2003 and 2007, Turkey’s economy grew at an average of 7% annually and manufacturing growth touched similar trends. 2010 and 2011 were then banner years with economic growth touching 12% and then the country hit a wall. Growth in the manu-

facturing industry went down to 1.7% in 2012 and although it recovered slightly in 2013, output stayed at 3.7% over 2013/2014. Inflation is also on the rise; a challenge to both economic growth and market competitiveness. Turkish consumer prices rose 7.61% year-on-year in March of 2015, up from 7.55% in February as food prices rose at its fastest pace in four months, according to central bank figures. Figures came above market expectations of a slowdown in inflation. Year-on-year, cost of food and non-alcoholic beverages recorded the highest increase (14.12%, from 13.7% in February) and prices of housing and utilities rose 8.03% (7.5% in February). Additional upward pressures came from hotels, cafes and restaurants (12.76%), miscellaneous goods and services (8.44%) and health. In contrast, transport prices fell 1.47% (-1.49% in the previous month). The central bank had expected inflation to be 5.5% by the end of 2015, dragged down by lower oil prices. However, consumer prices have continued to edge up for the second straight month in March,

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COUNTRY REPORT

t u RKe y ’s s h o Rt t e RM e c o n o Mic o u t Lo o K

remaining well above the central bank target due to a weakening lira and higher food prices. On a monthly basis, consumer prices rose 1.19% in March, the highest rate in five months. At the conference Symes underlined in no uncertain terms, the concerns of the business community:“inflation, continuously missing the target of 5% that was set by the government and the central bank, has caused expectations for the future to deteriorate. Uncertainties regarding inflation increase the risks of backward-looking pricing, as was the case during periods of high inflation in the past. Examples from the past are still present in our memories, and this is of great concern [sic].” The writing has been on the proverbial wall for some time and indications are that Turkey will have to address a number of structural issues in the economy if it is to break out of the current economic impasse. “Thanks to lower oil prices, Turkey will achieve significant external rebalancing in 2015 with the current account projected at 4.5% of GDP and inflation coming down to 6.7%.” holds senior World Bank economist Kamer Karakurum Özdemir. However, the bank cautions that renewed weakness in the currency shows, once again, that Turkey is vulnerable to a change in investor sentiment and that the room for monetary policy maneouvre is consequently limited. While private consumption is expected to return to being the main driver of growth, political uncertainty and the volatility in global markets will continue to weigh on investor sentiment and the country’s economic outlook. As World Bank country director for Turkey Martin Raiser puts it: “Turkey’s growth prospects beyond 2015 depend on the recovery of private investment and a resumption of productivity growth. For this, a signal of the government’s commitment to a level playing field for all investors is needed. The new ‘Transformation Programs’provide such an opportunity, but moving beyond announcements to implementation will be critical.” At the end of last year Prime Minister Ahmet Davutoğlu launched the so called second Package of Preferential Transformation Programs, part of the 10th Devel-

opment Plan for 2014-2018. The second package consists of eight areas of focus for the government including increasing production efficiency, promoting domestic savings, getting the Istanbul finance centre project off the ground, introducing efficiencies in public expenditure, improving public revenues, promoting business and investment development, improving available statistical information and ensuring the contraction of the country’s black (or unrecorded) economy. The priority, explained the prime minister at the launch was an uptick in industrial production, which he said would also involve “improving competitive power and expediting economic growth. Only 0.3% of the growth rate, which was around 4.3% (on average) between 1981 and 2014, was due to the increase in total factor productivity [sic]. Therefore, during the term of the 10th Development Plan, achieving an increase in competition power and high and stable growth is aimed at also increasing efficiency,” he noted. A precondition for the successful implementation is“stable and high growth rates” and is clearly stated in the programme’s preamble. Additionally,“investments should also be stable in order to facilitate healthy, stable growth. Turkey's domestic savings rate, which is currently around 15%, is lower than other countries at the same economic level and within the same income group, as well as other rapidly growing countries. While the economy does not face any problems in accessing foreign financing, it is crucial to take precautions to increase savings in order to establish stability in investments and growth”. The success of the plan will be predicated on the ability of the government to increase the ratio of private sector investment-to-GDP to 19.3% by the end of 2018; enable the amount of cumulative foreign direct investment – excluding real estate – to reach $92.8bn during the plan's period; for Turkey to be in the list of top 40 countries in the Ease of Business Transaction Index and relieve bureaucracy and improve internal efficiencies to help spur in Davutoğlu words, an “increase in the amount of allocation for investment

places by means of improving processes.” In any language, it is a big ask of the country right now. This is a general election year in Turkey, which the government concedes has “has made several domestic and international investors go into ‘wait and see’ mode”, conceded the premier and after three years of relative stagnation under an increasingly autocratic presidency and government, the wherewithal of the people is waning. Few bankers will now speak on the record unless they are saying words that support a government measure for fear of triggering reprisals. With such a key sector cowed, is it any wonder that Turkey is struggling to write a new growth story? So far the government has squandered money on funding short term populist measures which have not contributed to sustained growth and have been an illadvised use of government time. Erdogan and his government is clearly capable of better. What’s required now of Erdogan are some bold moves to revitalise the country’s stressed financial institutions and fire up confidence in international markets. It’s needed because for its much vaunted appeal, the country is more vulnerable than most to both domestic and international market shifts; foreign portable investment dollars invested in Turkey remains skittish and beyond a core group of specialised and experienced investors, that remain committed to the market over the longer term, hot money remains a significant feature of the stock market and even FDI. Whether fair or not, it places considerable strain on leadership to continually come up with initiatives that keep the country full centre for international investment dollars. The central bank has been consistent that comprehensive structural reforms remain a requirement this year if the current account deficit and inflation is to be kept under control, unemployment among the country’s under25s population is to remain manageable, savings rates are revitalised and overseas borrowing is reduced. If that happens in 2016 and beyond the country has a strong story; if the government and the country pulls in its horns then it might be another year of funk. n

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Egypt: in search of a new start

Moody's upgraded Egypt's issuer and senior unsecured bond ratings to B3 from Caa1, with a stable outlook in early April, signalling an improvement in the country’s macroeconomic performance and a reduction in external vulnerabilities and a continuing commitment by the government to fiscal and economic reform.

S IT BRIGHT CONFIDENT morning for the Egyptian economy? Moody's expects real GDP growth in Egypt to recover to 4.5% year-on-year for the current fiscal year 2015, which ends in June, and then to rise to around 5%-6% over the coming four years. This expected level is based on an assumption that domestic political stability will continue, as will improvements in the business environment. At the same time, Moody’s also upgraded a slew of Egyptian banks in April on the expectation that the country’s improving macroeconomic performance will support increased lending opportunities. The rating agency expects mid-double-digit loan growth for the system.“The higher economic activity will likely also improve local borrowers' repayment capacity, which will benefit the banks' asset quality,” says Moody’s. The upgrades reflect Moody's view of a strengthening in the capacity of the government to provide support to the banks, if needed. Specifically, the upgrade of the three wholly government-owned banks'

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

LC deposit ratings to B3 from Caa1 also reflects the improved capacity of the Egyptian government to support the banks in case of need, as implied by the upgrade of the sovereign's bond rating. Although the rating agency continues to assume a very high probability of government support for CIB and a high probability of government support for Bank of Alexandria, the deposit ratings of these two banks are rated on par with the government on a standalone basis and, as such, do not benefit from any support uplift. At the same time, the reduced credit risk associated with the government of Egypt has improved the quality of the banks' government-related assets, including their liquidity reserves. The rating agency highlights that the Egyptian banks' large exposures to government securities imply a high convergence between their credit risk profile and the sovereign's credit quality. According to the latest available financial statements, says Moody’s, government securities accounted for 11.2x of NBE's tangible

common equity, 8.3x for Banque Misr, 6.7x for Banque Du Caire, 5.1x for CIB, and 2.3x for Bank of Alexandria. From a liquidity standpoint, the linkage between the quality of the reserves and the sovereign creditworthiness is also high, with a ratio of liquid assets to total tangible assets ranging between 50% and 70% at the five banks. The bulk of these liquid assets are government securities. Adjunct to the improving outlook however, is the consideration that a full return to bright confident day in Egypt is still some way off. Egypt's B3 government bond rating remains primarily constrained by the weak level of government finances, marked by still sizeable deficits and elevated debt levels, “which both will continue to exceed the median for B3-rated peers,” concedes the credit rating agency. It is not all ponderous news. The country’s net international reserves appeared to have stabilised at $15.5bn at the end of February 2015, providing ample coverage for external debt payments due in 2015. The central bank

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COUNTRY REPORT

e Gy p t ; a s s e s s in G t h e pa c e o f Re f o RMs

has also benefited from the substantial currency deposits from governments in the Gulf Cooperation Council (GCC), namely Kuwait, Saudi Arabia, and the United Arab Emirates. GCC member countries pledged a total of $12.5bn in official aid and investments at Egypt’s recent Economic Development Conference in Sharm el Sheikh in mid-March. Together with the approximately $38bn in reported signed investment deals, the support will help mitigate external vulnerabilities and reduce balance-ofpayments risks. The aid has been vital for a government in stasis and has provided Egypt with breathing space at a time of meagre tourism receipts and near-absent foreign investment. The package is also enabling the government to repay $3bn to Qatar, a supporter of the ousted Morsi regime, with whom relations have now worsened. There are also structural improvements in play. The government has cut back on subsidies, and capped public sector costs, as well as overhauling the country’s tax structure, which will include the introduction of VAT over the course of the financial year. The overall plan is for the government to cut the country’s spending deficit to around 10% of GDP this year

and to 9.3% next year. The support from GCC donors has let the government adopt an expansionary fiscal policy to help stimulate the economy and create jobs and allowed the government to launch a modest infrastructure-dominated stimulus package worth $3.2bn. Government debt is also expected to reduce to 90% of GDP during 2015-16. “In addition, lower government borrowing costs on the back of declining inflation rates, and maturity lengthening measures, will help to reduce Egypt's very large government borrowing requirements. Going forward, the government is planning to diversify its sources of financing -- which will further help lower the cost of debt -- by issuing dollar-denominated bonds as well as tapping into the sukuk market,” says Moody’s. Set against that backdrop, the country could have reasonably been expected to have turned a corner at the end of the first quarter of the year. As it is the country has much to reflect upon. News filtered through in early April, unconfirmed as the magazine went to press, of the demise of ex-president Hosni Mubarak. The news should have perhaps set a seal on the passing of an unwelcome

period of adjustment in the country’s political make-up. As it is little, in practice, remains resolved. Egypt has been without any kind of parliament since July 2013, and without a sitting lower house since June 2012, when a set of electoral legislation was deemed unconstitutional. A similar decision was reached in March this year by the country’s high court which appears to have pushed planned elections (originally scheduled in two stages in March and April) until the late autumn at the earliest. A series of authoritarian laws passed by the Sisi presidency have led a number of opposition parties in the country to boycott any democratic process, claiming it is impossible to campaign amid a continuing crackdown on dissent. Moreover, while government effectiveness has improved and risks to policy making are diminishing, the country is still suffering from elevated security risks, with continuing terrorist attacks -- particularly in North Sinai -- and due to Egypt's exposure to regional sectarian violence. In addition, declining yet high unemployment rates create social pressure which translates into ongoing demand for comparatively high levels of recurrent government spending. n

EGX UPGRADES OTC MARKET TO STIMULATE EGYPT’S CORPORATE SECTOR THE EGYPTIAN EXCHANGE (EGX) launched the second phase of improving the exchange’s over the counter (OTC) market mechanisms in late March, which the exchange says represents an important step in EGX’ trading system, where investors can put the sell order for non-listed companies without the need to have the other side of the transaction. The restructuring process involves the market becoming fully computerised, allowing parties wishing to implement buy and sell orders of the shares of non-listed shareholding companies to add them on private screens without a prior agreement between parties. According to Dr Mohammad Omran, EGX chairman, “This is a strategic step for EGX and means that the stock market [will] strongly contribute to improve the investment climate in Egypt, as this step could facilitate the access to finance because the investor has now more confidence in the existence of smooth exit opportunities which is an important indicator in measuring the investment quality in any country [sic]”. EGX launched the first phase of its restructuring of the OTC last year. Omran says the decision to upgrade the OTC market

was designed to ensure that the stock exchange plays a proactive role in supporting the Egyptian corporate market. According to Omran, “thousands of Egyptian joint stock companies will be able to implement buy and sell operations easily, and will provide mechanisms to facilitate exits which will benefit in turn the investment climate in general”. He also notes that the improvements in the OTC market will contribute to activating and developing new opportunities for acquisitions and mergers between non-listed companies, and to attract local and foreign new investments, “as this system will help to attract new investors who were not able to direct their investments into productive portfolios, and they were directed into hoarding due to the lack of high liquid investment opportunities where they are able to exit at any time,”he explains. Equally, he notes, “the existence of a mechanism to implement those transactions will help to enter the buy and sell operations in the formal system, thus preserving the shareholders and the state’s rights while minimizing the size of disputes.” n

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SECURITIES LENDING

CCPs lend a hand in US securities lending Will increased demand for more efficient capital-management solutions—not to mention the potential to reduce counterparty default protections—help centrally cleared lending make its stateside breakthrough? To date, what factors have helped keep interest in CCPs relatively muted among stateside participants, at least compared to their European counterparts? Dave Simons reports from Boston.

S STRICTER CAPITAL requirements under Dodd-Frank and Basel III take hold, the added transparency offered through CCPs operating within a central marketplace has continued to win over lending participants: in a survey conducted last year, securities-finance research and consulting firm Finadium found that 44 percent of asset managers and insurance firms believed using CCPs to clear securities on loan could eliminate the need for borrower default indemnification altogether. In its own institutional investortargeted report Securities Lending Best Practices, Boston’s eSecLending noted the potential for CCPs to gradually alter the lending dynamic, particularly given their ability to offer borrowers some degree of capital relief under Basel III. Much of the enthusiasm has been confined to the EU, however, as to date only a single CCP lending outfit (the sellside only Options Clearing Corporation) operates within the US. Enter Europe's top clearing agency, Eurex Clearing, which has enlisted the services of BNY Mellon and State Street in an effort to fill the CCP stateside gap through an expansion of its Lending CCP securitieslending program. Launched three years ago, Eurex's Lending facility currently includes equities from Belgium, France, Germany, the Netherlands and Switzerland, along with a range of international fixed-income instruments and exchangetraded funds. The lending platform seeks to provide beneficial owners with greater capital efficiency and liquidity, while also offering cross-margining of securitiesfinance transactions using its other Eurex Clearing business lines. James Slater, executive vice president and BNY Mellon’s global head of Securities Finance, says that central clearing is

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

Ed Oliver, managing director for Boston-based securities-lending agency eSecLending. "Lenders want to maintain their existing bilateral relationships, and therefore would prefer not to have to appoint a third-party institution in order to provide access to the CCP," says Oliver. While this will eventually change, it is the main reason why the US continues to lag Europe (where the Eurex structure has generally succeeded in maintaining those relationships). Photograph kindly supplied by eSecLending, April 2015.

viewed as "a key additional distribution method" supporting market demand for clients’ securities, particularly as participants seek to navigate the various regulatory and structural changes affecting the lending industry. Whether or not the risk-reducing merits of central clearing will ultimately pass muster within the entrenched US lending space remains to be seen. By general consensus, the CCP's best shot at success lies in its ability to potentially reduce the cost of raising capital needed to satisfy new leverage-ratio demands on custodians and broker-dealers under the likes of Dodd-Frank and Basel III. If one accepts the notion that capital optimisation can help keep the lending wheels in motion, the CCP model has a future. Thus, in the same way banks are weighing alternatives for capital cost man-

agement, attitudes toward securitieslending CCPs continue to evolve as well, notes Finadium's Josh Galpin, who believes that the CCP platform is capable of delivering an array of benefits to the market, including a reduction in capital costs as well as improved straight-through processing of lending transactions. "Regulators are also in a CCP-frame of mind across all products," offers Galpin. "The more that market participants themselves decide to reduce risk and support transparency by using the CCP, the happier regulators that appear to react." The question remains: can such benefits offset lingering doubts over CCP's ability to effectively reconcile risk, safeguard lending collateral, identify counterparty sources and other such concerns?

Sizing up CCPs While providers generally believe that beneficial owners should have a wider range of lending models to choose from, many nonetheless remain skittish over the prospect of CCPs within the lending space. To many borrowers and lenders who have maintained a number of trusted, long-term relationships, using a CCP for securities lending could result in fewer choices and decreased flexibility when selecting counterparties. Additionally, US-based products do not have a structure that typically meshes well with the preferred approach of domestic lending agents, notes Ed Oliver, managing director for Boston-based securities-lending agency eSecLending. "Lenders want to maintain their existing bilateral relationships, and therefore would prefer not to have to appoint a third-party institution in order to provide access to the CCP," says Oliver. While this will eventually change, it is the main reason why the US continues to lag

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SECURITIES LENDING

c c p s : e f f e c t in G s t Ru c t u Ra L c h a n Ge in s e c u Rit ie s Le n d in G

Europe (where the Eurex structure has generally succeeded in maintaining those relationships). "We should not forget that the European CCP structure is still in its infancy, so the market is still responding to this capability," adds Oliver. From eSecLending's standpoint, one of the advantages of central clearing going forward is the opportunity to increase distribution for clients’ portfolios. "This is particularly true for any client that is currently challenged under the Agent Lender Disclosure (ALD) regime, where borrowers struggle to get an effective netting opinion on a specific lender," says Oliver. "The use of a CCP should alleviate some of these issues and provide more opportunity for those lenders." Industry chatter around the Leverage Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR) and other spin offs of DoddFrank and Basel III have been on the radar for some time now, however the conversation has become more advanced, remarks Brian Lamb, CEO of New York-based EquiLend, a provider of trading and operations services for the securities finance industry. Even so, there's no avoiding the fact that CCP providers on both sides of the pond, from Chicago-based OCC to Eurex Clearing, LCH.Clearnet and others, only offer bespoke solutions, each with unique methods of calculating variation margin and initial margin, different user and connection costs, management styles, and other distinctions. As one might expect, the lack of standardization has helped keep many in the industry on the sidelines. "Our ownership group for one doesn't think it's such a good idea to build five different pipelines," says Lamb. "We'd like to try and standardise the process, though at this stage it's not entirely clear if that's possible. Which does explain why many participants have been sort of tentative about CCPs to date." That hasn't prevented players like EquiLend from at least furthering the discussion. "We continue to be actively engaged with the various clearing parties, because once the market embraces a solution we intend to be a big part of it," says Lamb. "The fact of the matter is that all of these new regulatory measures that

capital use versus regulatory requirements." Though a securities-lending CCP frontrunner has yet to emerge, it is clear that Canada will not go it alone. "As other global jurisdictions move toward CCP adoption, I would expect for Canada to join the consensus approach," says Ferguson, "so long as it meets the needs and expectations of the country's regulators and market participants."

Lingering questions Brian Lamb, chief executive officer, EquiLend. “The fact of the matter is that all of these new regulatory measures that are now in place have created significant issues for the industry at large, and therefore borrowers and lenders are motivated to find a workable solution to maintain proper asset flows, net their positions to achieve suitable balances without consuming too much of their capital, and in general keep the business moving forward,” says Lamb. Photograph kindly supplied by EquiLend, April 2015.

are now in place have created significant issues for the industry at large, and therefore borrowers and lenders are motivated to find a workable solution to maintain proper asset flows, net their positions to achieve suitable balances without consuming too much of their capital, and in general keep the business moving forward." With some of the highest participation rates in securities lending globally, Canada would be one of the key proving grounds for a CCP groundswell. While many have been engaged in discussions and assessments of various domestic and global CCP models, to date Canadian market participants have yet to coalesce around a single approach, remarks Rob Ferguson, senior vice president, capital markets and products delivery at CIBC Mellon in Toronto. "Some participants are moving in this direction, but other players remain somewhat skeptical," says Ferguson. "Proponents of CCPs point to the potential for benefits around efficiency, transparency and riskreduction, while others argue that CCPs only make sense if they can achieve these goals without unduly driving up costs or delivering other benefits such as enhancing

Short of a regulatory imperative mandating central clearing of securities lending transactions, it is unlikely that lending agents will themselves turn to a CCP without some assurance of having operational and risk protections that are at least comparable to existing processes, in addition to receiving some kind of economic benefit. "Therefore, the move to CCPs will only happen if any such 'lingering questions' are adequately answered," says eSecLending's Oliver. Whether or not beneficial owners will embrace the CCP as an indemnification alternative remains to be seen, says Lamb. "There has certainly been some movement in that direction, however it is early days. At this point, there are a number of very large lenders who firmly believe that indemnification will never completely go away, in part because at least in the US there are various fundamental issues that must be dealt with beforehand, including gaining some clarity around ERISA, understanding the legal construct of the loans themselves, as well as having a better sense of how the dayto-day collateralization and other structural processes would work through a CCP." Still, with regulation continuing to sharpen the focus of industry participants, demand for these kinds of capital-efficient solutions is likely to continue, adds Lamb. Oliver also agrees that the promise of capital savings remains an attractive proposition for the borrower base, and the primary driver of CCP usage going forward. "If the community keeps demanding CCP-led solutions, in the US or elsewhere, eventually that will lead to increased CCP involvement in the lending space." n

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For important updates and information on new access channels to our news and analysis please contact: Chris Maityard, EM: chris.maityard@berlinguer.com TL: [44] (0) 207 680 5162

Photograph ÂŠ Daboost | Dreamstime.com

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POST TRADE

TARGET-2 SECURITIES: A PILLAR FOR EUROPEAN MARKET HARMONISATION

Towards a June rollout of Target-2 Securities Only two months remain until Target-2 Securities (T2S) goes live in June 2015, when a first group of five central securities depositories (CSDs) will migrate to the new European settlement platform provided by the Eurosystem. By February 2017 a further 19 CSDs will have joined them. Underpinning the project is post trade harmonisation and a central tenet of this is settlement discipline. This is the first in a series of reports on the progress of the Target-2 Securities project and its impact on the market. In the run up to launch of the First Wave of the project, in this edition we look at the question of whether all T2S markets achieve compliance with the T2S harmonisation settlement standards before they migrate to T2S. The outlook is positive; even so, some small niggles remain.

2S HAS THE potential to make settlement across all participating central securities depositaries (CSDs) safe, efficient and harmonised; but it is also a necessary pillar for the successful integration of the European project across multiple capital and investment markets. T2S is the future IT platform of the Eurosystem for the settlement of securities transactions in central bank money, and is set to start operations in June 2015. The platform will help overcome the current fragmentation in the securities settlement layer of the European post-trade landscape, making an important contribution to the establishment of a single market for post-trade securities services. The five markets migrating to T2S in June this year include Italy (via Monte Titoli), Romania (via the Depozitarul Central), Malta (led by the Malta Stock Exchange), Switzerland (SIXSIS) and Greece via the central bank, the Bank of Greece. In the run up to the rollout of the First Wave of participants in the platform, the current focus of the T2S constituency is securing the extent to which this potential will materialise. It is supposed to bring benefits to central securities depositaries, their users and the entire European posttrade industry; though because T2S is a project based on voluntary buy in, it greatly depends on all stakeholders adapting to and using T2S in a harmonised way, particularly with regard to settlement discipline. Fundamentally, T2S will accommodate on a single platform the securities accounts held by the CSDs on behalf of their customers as well as the dedicated cash accounts kept by national central banks for their participants. This so-called

integrated model will allow settlement in delivery-versus-payment mode; in other words, the real-time, safe and final settlement of all transactions. Additionally, by settling in central bank money and offering a number of highly advanced facilities, such as auto-collateralisation, continuous optimisation, T2S is designed to eliminate the financial exposure in cross-CSD settlement. Of course, it is a project with a much wider remit. In the run up to the First Wave of T2S rollout, discussions between the various stakeholders in the project have been working to create a single rulebook for post-trade processes (messaging protocols, operating hours, regulatory and legal rules, for instance) across the 21 European markets and 24 CSDs that will ultimately connect to the platform. The reality is that itâ&#x20AC;&#x2122;s impressive that so much has been achieved given the fragmentation of the European post trade landscape The project has involved coordination and discussions between at least 19 T2S National User Groups (NUGs), which have remarkably reached agreement on very detailed implementation plans. These have included public dates for testing and migration readiness, and the adoption of facilitating regulation in individual markets that ensures, or will ensure, compliance with T2S requirements. According to the latest report on the progress of T2S, issued in mid-April, an important result is the agreement among the T2S stakeholders on the Settlement Finality I rule (SF I). This rule covers the moment when transfer orders are declared to have entered the system and are therefore protected against insolvency procedures.

There are essentially four activities relating to settlement finality that aim to ensure that all participating T2S systems have a harmonised definition of the moment of entry of transfer orders into the system (SF I), the moment of irrevocability of transfer orders (SF II), and the moment when settlement becomes irrevocable and enforceable (SF III). The other priority legal harmonisation activity refers to the authorisation of CSDs to outsource their settlementrelated IT to a public entity. These four activities presented below are clearly connected to already existing or ongoing international and EU legal harmonisation agreements/initiatives, such as the Settlement Finality Directive, the ESCBCESR recommendations, the CPSSIOSCO principles and the CSDR. These activities are crucial to ensuring legally sound and seamless settlement at cross-CSD level. The report says that a coordinated SF I framework is in place for the safe launch of T2S, with harmonised rules for both the securities settlement systems (SSSs) run by CSDs on the one hand, and the payment systems run by national central banks on the other. Moreover, CSDs and central banks are now engaged in jointly developing a more advanced solution, which will define a single SF I rule for all T2S stakeholders, valid for both securities and cash. This is important as the Eurosystem national central banks will define SFI in their systems (i.e. TARGET 2), as currently prescribed in the TARGET2 Guideline (that is, SFI=SFII=SFIII). The CSDs and the central banks in T2S are currently working on a collective agreement with the ultimate goal of

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achieving a single SF I rule for all systems (both CSD systems and central bank systems). The ultimate objective is for all systems to define SF I in their rules as the moment of validation of a transfer order. In other words, the agreement reached so far is enough to ensure safe and efficient cross-CSD settlement in T2S, at least for the time being. Only one gap remains, which regards the definition of harmonised standards for the high-priority T2S harmonisation activities: the standards relating to settlement discipline. These are expected to be adopted by the EU public authorities in the second half of 2015 “within the context of the CSDR level 2 legislation”. Separately, the European market regulator ESMA, invited comments on a consultation paper that it had issues on the CSD-R’s technical standards. The T2S Advisory Group (AG) subsequently invited ESMA to avoid regulating certain commercial and technical implementation choices available to the CSD industry (for example.IT platforms to potentially develop a jointly managed cash penalty system). The AG especially notes that there should be no divergences between T2S markets regarding the definition of SF I. The AG highlighted some issues of con-

sistency between the proposed standards and some existing standards at global or EU level, for example ISO messaging standards and corporate actions management standards. It also emphasised the need to avoid regulating certain commercial and technical implementation choices available to the CSD industry. Additionally, the AG has reportedly called for an appropriate extension period for the entry into force of the new rules, and pointed to the risk of generating instability in the European market infrastructure if this were not granted. A harmonised settlement discipline regime is needed in T2S in order to avoid the risk of multiple, inconsistent or incompatible regimes that would create operational complexity, in particular for cross-CSD settlement. It is also needed at the EU level to ensure a level playing field and avoid the risk of “regulatory arbitrage”(in other words, the shift of volumes to markets with softer regimes and sanctions). Weak or non-harmonised settlement discipline regimes could also lead to a high number of failed transactions and might thus have an impact on financial stability. In principle, the target date by which all T2S markets should have converged towards harmonised rules is their migration to T2S

(depending on their migration wave). However, current regulatory developments in the EU combined with the complexity of implementation will likely require a postponement of the convergence date. The latest T2S report notes that “It is clear at this stage that it will not be possible to finalise the EU settlement discipline regime before T2S goes live, despite its being a high-priority harmonisation area for T2S. The AG recognises that although this outcome is suboptimal, it is still manageable. It means that, for the time being, and until the relevant EU regulatory standards are in place, CSDs and their participants will continue operating within the existing national discipline frameworks. The AG would welcome an implementation timeline whereby the migration of all T2S CSDs and the expected development of crossborder settlement activity will be followed by the establishment of a harmonised EU settlement discipline regime.” The range of T2S is immense, much wider than the initial perception of its reach. For instance, it covers issues as diverse as corporate actions, and cross-border shareholder transparency and registration as well as the more obvious considerations such as market access and interoperability. n

THE ROLLOUT OF T2S: THE FOUR WAVES T2S will become operational in June 2015. Following consultation with the market, it has been decided that the connection to T2S will be arranged by groups of CSDs, over a number of

waves to ensure the gradualness and safety of the “migration” process. The migration plan – involving four migration waves over 21 months (see table below).

First wave 22 June 2015

Second wave 28 March 2016

Third wave 12 September 2016

Fourth wave 6 February 2017

Bank of Greece Securities Settlement System (BOGS)

Euroclear Belgium

Clearstream Banking (Germany)

Centrálny depozitár cenných papierov SR (CDCP) (Slovak Republic)

Depozitarul Central (Romania) Euroclear France

KELER (Hungary)

Eesti Väärtpaberikeskus (Estonia)

Malta Stock Exchange

Euroclear Nederland

LuxCSD (Luxembourg)

Euroclear Finland

Monte Titoli (Italy)

Interbolsa (Portugal)

Oesterreichische Kontrollbank (Austria)

Iberclear (Spain)

SIX SIS (Switzerland)

National Bank of Belgium Securities Settlement Systems (NBB-SSS)

VP Lux (Luxembourg)

KDD - Centralna klirinško depotna družba (Slovenia)

VP Securities (Denmark)

Lietuvos centrinis vertybinių popierių depozitoriumas (Lithuania)

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

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MARKET REFORM

CMA ANNOUNCES IMMINENT OPENING OF MARKET TO QFIS

Photograph © Elgru/Dreamstime.com, supplied April 2015.

The long awaited opening of the Saudi stock market to foreign investors In mid-April, the Saudi Capital Market Authority (CMA) announced that on May 4th it would publish rules that will open the Tawadul to qualified foreign institutional investors (QFIs), with a projected start date of June 15th. The Saudi Arabian stock market capitalisation is some $528bn (around two-thirds of Saudi GDP) and is marginally larger than all the other GCC stock markets combined. The move comes at an already propitious time for the Saudi economy in any case. What will the move mean in practice?

ACK IN AUGUST 2014 the CMA set out draft rules for the participation of investors in the Tadawul. Included in these draft rules are strict limitations on qualified foreign institutional participation in the Saudi stock market. The main points of the CMA bulletin asserted that QFIs wanting to participate in the Saudi stock exchange must have a minimum $5bn in assets under management (AUM) and have been operational for a minimum of five years; though most commentators expect that this requirement might be relaxed somewhat. Each QFI (including affiliates) can only hold a maximum of 5% of issued shares of any one listed company. All foreign investors (including resident and nonresident, swaps and QFIs) have a combined ceiling of 49% ownership of issued shares, in any one listed company. QFIs together can only own a maximum of 20% of issued shares of any one listed company. Swaps and QFIs can only own up to a maximum of 10% of aggregate stock market value of all listed companies. The move has been expected for some

years and is a logical response by the authorities to the requirement to normalise the Tawadul, which is dominated by Saudi retail trade, and which is sometimes Quixotic. It has been a testing time in some respects for the market. The steep decline in oil prices, by around 50% since the middle of last year has inevitably negatively affected many oil exporting countries with all GCC countries indices being down in the last six months to April 2015 In the case of the TASI, the benchmark Saudi market index, any losses have been the result of panic selling by retail investors who believed that lower oil receipts would result in cuts in government spending and lower corporate profits. The fall in the TASI was also fuelled by investors selling off securities in order to free up cash to deleverage from margin calls, according to local press reports. As oil prices began to stabilise at the end of Q1 and the country has seen the benefits of an expansionary fiscal policy, a smooth accession of a new king and an increase in government handouts (with salary bonuses

paid to public sector employees) investor fees have been calmed and the TASI has since recovered lost ground. The requirements issues by the CMA are clearly designed to spur institutional trading on the exchange. “Saudi Arabia is a very large, liquid market. It will potentially be the seventh largest Emerging Markets (EM) equity market by market capitalisation, which places it just behind South Africa ($543bn), but ahead of Russia, Malaysia, Mexico and Indonesia. The Tawadul trades on average $2.4bn per day across 162 listed companies and offers a rich selection of opportunities ranging from banks to consumer-driven businesses,” holds Jan Dehn, head of research at Ashmore. Meantime Khalid Al-Rabiah, chairman of Tadawul, in a news conference in midApril said that the exchange would organise a series of roadshows focusing on North America and Europe to help spur foreign institutional investment in the country. The potential for the exchange is substantial he noted, as foreign investors currently hold less than 1% of the market capitalisation on the exchange.

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In supplementary questions, the chairman was also asked if the Tawadul had plans to privatise. Al-Rabiah told journalists that the government’s Public Investment Fund, which owns all of Tadawul, would have the first and final say on any initial public offer of shares, and that an IPO process had not begun. “Once Tadawul has a robust cash flow that guarantees sustainability, the owners will look into it,” he said. For the time being the Tawadul says that the opening of the exchange to foreign investors will encourage more Saudi firms to list on the exchange. The Tadawul has reportedly held meetings over the last two years with more than 250 companies interested in a Saudi listing. Additionally, it was announced that the exchange will replace its existing NASDAQ OMX trading platform with NASDAQ’s XStream INET system. The new system is expected to be introduced to the market by the third quarter of this year.

Good timing The move to open up the Saudi market comes at a time when the market is growing and diversifying even as it is buffeted by indifferent oil prices. The country’s GDP has doubled since 2006 and hopes to double again within the next five years. Investment inflows remain abundant. According to the Saudi Arabian General Investment Authority’s (SAGIA’s), governor, Abdullatif AlOthman, SGIA’s governor, “The total value of FDI in the kingdom amounted to almost $208bn by the end of 2014.” Moreover, government spending on projects in the country amounted to over $300bn last year. SAGIA also reports issuing a growing number of project licences in the Kingdom over the year. It issued 350 project licences in 2014, valued at SAR24.9bn, an uptick of some 66% in terms of volume, but still 33% lower in terms of value over the previous year. SAGIA says the fall in value is related to the types of licences applied for, with the service sector dominating last year’s round of applications and which it holds signifies a growing level of sophistication in the market.

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

Other financial sectors are booming as well, providing a deeper financial market against which opening of the stock exchange now makes more sense. For instance, Saudi Arabia's insurance market is the second-fastest growing in the Gulf Cooperation Council (GCC) and has good potential for further gains due to its low insurance penetration levels, according to Moody’s Investors Service. Saudi Arabia's insurance market had premiums worth $8.1bn last year, the second biggest in the GCC. Saudi Arabia was also the GCC’s second-fastest growing insurance market in 2014, with an eight-year compound annual growth rate (CAGR) of 20.3%. Insurance premiums grew by more than 20% in 2014, helped by premium rate increases in the medical and motor sectors. However, Saudi Arabia's insurance penetration levels (1.1%) are still significantly below those of most advanced economies. "Despite this significant growth, Saudi Arabia has the lowest insurance density in the GCC and one of the region's lowest penetration levels," says Mohammed Ali Londe, Moody's analyst "This suggests that there is a high degree of untapped potential in the market." While medical and health insurance dominate the Saudi insurance market right now, Moody's expects other types of cover, including life and non-life insurance, to gain ground in the coming years. The Saudi population's increasing wealth and greater awareness of the benefits of insurance are likely to fuel this growth. Given that the opening of the market is taking place against a relatively benign backdrop, the benefits of increased indirect investment flows is expected to be felt sooner rather than later. According to Dehn, “Technicals are strong and valuations are likely to re-rate higher over several stages, particularly when the market is included in the main benchmark indices. Fundamentally, the market offers attractive exposure to petrochemicals and consumer stocks with the latter strongly supported by countercyclical policies recently announced by the government.” “The opening of the Saudi market will

widen the foreign investor base, which is currently less than 1% of total holdings. Given the size and depth of the market, we expect Saudi Arabia to be included in the main EM equity benchmark indices by mid-2017,”holds Dehn, though he says this requires the authorities to further lift restrictions on access to the market. “Should this happen, billions of dollars will flow into Saudi Arabia over the next few years, in our view. Judging by other precedents in the region, such as Morocco, Egypt, UAE and Qatar, Saudi Arabia’s market is likely to re-rate when it becomes included in EM indices. Indeed, we see analogies to the opening of the Indian market for foreign equity investors and the on-going opening of the onshore Chinese stock markets,”he avers. Dehn holds that from a fundamental perspective, the opportunity in Saudi Arabia is exciting because it offers long term benefits and offers access to a diversified stock market. Investing in Saudi Arabia does not mean that you are confined to the energy sector.“In fact, not a single oil company is listed on the Tawadul,” he explains. “Petro-chemical businesses have some correlation with oil, but they are exceptionally profitable given their access to low feedstock costs and offer less volatile earnings streams than other chemical businesses in other markets. Banks are also attractive with the country’s peg to the US dollar making them beneficiaries of rising rates. Large parts of the stock market consist of consumer businesses, whose earnings are determined by domestic conditions.” He also thinks that the new Saudi King’s affirmation of the country’s commitment to domestic spending and development and job creation creates favourable tailwinds for consumerfocused sectors. With that in mind, he sees opportunities for consumer stocks, “similar to those found in some African or Asian markets, but at much more attractive multiples, because of Saudi Arabia’s very favourable demographics. The population distribution has a very low average age, which points to sustained consumer demand for years to come”. n

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MARKET DATA BY FTSE RESEARCH

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

12M%

5.7 5.8 8.0 3.5 3.3 7.4 3.8

COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index

FX - TRADE WEIGHTED USD GBP EUR JPY

-43.9 -29.5

-8.5 -16.3 7.1 9.7 12.2 14.1 19.0

0.3 0.4 2.2

-1.6

10.2 8.5

0.8 0.1

-0.8 -1.8

-10

28.8

16.7 16.5

6.9 5.5

-2.3 -2.7

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

5.7 8.4

26.3

-5.5

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)

15.2 15.2

3.2

5.6

-10.8 -7.3

-60

-40

-20

17.1

EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 12M local ccy (TR)

Regions 1M local ccy (TR) Japan Europe ex UK Developed USA FTSE All-World BRIC Emerging UK Asia Pacific ex Japan

3.8 3.5 3.3

8.0 7.4

5.9 5.8 5.7 5.2

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

8.4 5.7

1.1 0.4

-0.4

-2

2.4

9.1 8.7 8.0 7.9 7.8 7.7 7.4 7.2 7.2 6.6 5.9 5.9 5.8 5.1 4.3 3.9 3.5

Belgium/Lux Sweden Japan Finland Netherlands Denmark Israel Germany France Spain USA Developed Australia Italy Canada Singapore Norway Switzerland Hong UK Korea

3.9 3.8 3.3 3.3 2.6 1.1 0.7

-1.2

-5

38.4

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

23.9

9.3 7.5

29.5 28.8 26.9 26.8 24.4 22.6 18.2 16.4 15.2 15.2 15.0 14.7 13.9 12.5 12.4 9.2 8.7 8.7 5.7

-2.7

-10

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

Developed 12M local ccy (TR)

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

28.8

16.7 16.5 16.3 15.2 15.2 15.0

0.4

-25.1

-40

-20

24.1 23.8 22.0 19.9 17.2 16.5 15.2 9.0

43.5

Source: FTSE Monthly Markets Brief. Data as at the end of February 2015.

MARCH/APRIL 2015 â&#x20AC;˘ FTSE GLOBAL MARKETS

GM Data pages 81.qxp_. 23/04/2015 13:34 Page 55

PERSPECTIVES ON PERFORMANCE Global Sectors Relative to FTSE All-World

Regional Performance Relative to FTSE All-World

130

Oil & Gas Health Care Financials 130

120

Japan Europe ex UK

USU Emerging

Asia Pacific ex-Japan

Basic Materials Consumer Services Technology

Consumer Goods Industrials Telecommunications Utilities

110

100 100

80 Feb 2013

Jun 2013

Oct 2013

Feb 2014

Jun 2014

Oct 2014

70 Feb 2013

Feb 2015

Jun 2013

Oct 2013

Feb 2014

Jun 2014

Oct 2014

Feb 2015

BOND MARKET RETURNS 1M%

12M%

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

-2.3

UK (7-10 y)

7.1

-2.7

9.7

Ger (7-10 y)

0.3

Japan (7-10 y)

12.2 3.1

-0.3

France (7-10 y)

0.4

14.1

Italy (7-10 y)

2.2

19.0

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

-1.7

11.3

Euro (7-10 y)

0.9

UK BBB

14.0

-1.6

10.2

Euro BBB

8.5

0.8

UK Non Financial

-2.5

11.6

Euro Non Financial

9.1

0.5

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

6.9

-2.1

-3

-2

-1

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

Corporate Bond Yields

Japan

Ger

France

Italy

U UK BBB

7.00

Euro BBB

6.00

5.00

5.00 4.00

4.00

3.00

2.00 2.00

1.00 0.00 Feb 2012

Aug 2012

Feb 2013

Aug 2013

Feb 2014

Aug 2014

Feb 2015

1.00 Feb 2010

Feb 2011

Feb 2012

Feb 2013

Feb 2014

Feb 2015

Source: FTSE Monthly Markets Brief. Data as at the end of February 2015.

FTSE GLOBAL MARKETS • MARCH/APRIL 2015

GM Data pages 81.qxp_. 23/04/2015 13:34 Page 56

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

120 115

105

110 100 105 95

100

90 Feb 2014

May 2014

Aug 2014

Nov 2014

95 Feb 2014

Feb 2015

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

FTSE UK

FTSE US Bond 220

140

180

120

140

100

80 Feb 2011

Feb 2012

Feb 2013

Feb 2014

1M% FTSE UK Index

FTSE USA Bond

-1.6

-5

Feb 2011

4.1

5.8

-1.7

Feb 2012

Feb 2013

Feb 2015

54.9

5.9

111.5

3.7

26.1

2.2

Feb 2014

5Y%

2.4

0.9

Feb 2015

FTSE US

3.3

0.8

Nov 2014

6M%

3.5

FTSE UK Bond

60 Feb 2010

Feb 2015

3M%

FTSE USA Index

Aug 2014

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

160

Feb 2010

May 2014

23.1

100

Source: FTSE Monthly Markets Brief. Data as at the end of February 2015.

MARCH/APRIL 2015 • FTSE GLOBAL MARKETS

150

GM Cover Issue 81.qxp_. 17/04/2015 12:02 Page FC2

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