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TRANSITION MANAGEMENT’S FLIGHT TO QUALITY ISSUE FIFTEEN • SEPTEMBER/OCTOBER 2006

Lenovo feels the heat Alcatel/Lucent: A merger of equals The rise of tri-party lending

Growth & the ISE: DAVID KRELL’s EXPANDING UNIVERSE THE FUND ADMINISTRATION & DISTRIBUTION ROUNDTABLE

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

HE INTRODUCTION OF a supportive real estate investment trust (REIT) regulatory regime in the United Kingdom by January 2007 remains on track and offers new opportunities for the growth of the property investment sector. Add to that incoming REITs legislation in both Italy and Germany and investors look set to have not only new investment vehicles, but real investment choices across the European Union. Americanstyle REITs generally carry out their investment activities tax-free provided they pay out a high proportion of their earnings in taxable dividends, usually making them high-yield stocks. These characteristics, and a booming underlying global property investment market, have made REITs one of the investment industry’s fastest expanding areas not only in the United States, but also in Japan and France where they were launched in 2001 and 2003 respectively.The issues of property investment however are wider than REITs and over coming editions we will be examining different property investment vehicles and their returns. In this edition—as is our wont—we provide a broad brush overview of selected elements of the property investment market. RBC-Dexia Investor Services’ John Wantz explains why Luxembourg is becoming a domicile of choice for registered real estate funds (REIFs). As well, we hone in on the new opportunities opening up in Europe for investors interested in REITs. Art Detman also chips in, profiling KB Home, California’s home house-builder of choice. After a period of electric upswing, the US home building market appears all-in: an unwilling victim of rising interest rates and oversupply. Can KB Home buck the trend? We also revisit another regular theme: the rise of the Islamic bond, or Sukuk market—an increasingly popular and lucrative market that is increasingly appealing to conventional banks, which are now beginning to set up Shariah compliant operations of their own. In spite of the uncertainty dogging the region’s conflict-riven hotspots; the Middle East’s debt and equity issuance markets continue to deepen and take on a character of its own—backed as they are by abundant windfall oil revenues and a widening raft of infrastructure projects that is sucking in project finance and foreign direct investment capital. We continue with our quarterly update of the latest trends in the region’s capital raising. Our investment services coverage has taken on various flavours and forms to help diversify the tempo and depth of coverage. In this edition, we concentrate on three key areas including transition management, which is itself undergoing a radical alteration. Dave Simons meantime looks at the growing sophistication of the US securities lending market. The third area is investment support services. There is a key development here we want you to note. Getting reader involvement in FTSE Global Market’s ‘Thought Leadership’roundtable series is a priority for us in the medium term, as we seek to deepen and improve the editorial range of the magazine. In this issue we invited an illustrious group of commentators who willingly shared their thoughts of the future of the investment services industry and on the changing needs of investment managers who are now redefining investment services support: particularly in the areas of retail and distribution. In future issues we will be looking at securities lending and transition management, together with a range of other topics, in separate roundtable discussions and we hope to invite you to join in.

Francesca Carnevale, Editorial Director August 2006

Contents COVER STORY COVER STORY: ISE’S EXPANDING UNIVERSE

..................Page 45 The International Securities Exchange (ISE) posted record profits in the second quarter this year as the electronic options exchange gained a stack of new institutional clients. A pugnacious ISE has seen a steady increase in volume, backed by an acquisition and a raft of new business initiatives at home, including the launch of a new exchange. The exchange is also casting abroad for long term expansion. Francesca Carnevale reports.

REGULARS MARKET LEADER

THE ALTERNATING FACE OF SOUTH KOREAN FDI ................................Page 6

INDEX REVIEW

THE EQUITY INFLATION MIX ..................................................................Page 12

Ian Williams reports on flap that could undermine US Korea trade talks.

Simon Denham, managing director, Capital Spreads, opens new a new, index review column.

LATENCY: A WAR MEASURED IN MILLISECONDS ................Page 14

IN THE MARKETS

Simon Nathanson, CEO of NeoNet, explains why the battle against latency is so important.

WIRED FOR SOUND ........................................................................................Page 18 Why Nymex put energy and precious metals contracts on CME's Globex. By Dave Simons.

FACE TO FACE

CLEARSTREAM AND EUROCLEAR TALK TOUGH ON HARMONISATION ..........................................................................................Page 22 Or why the EC now wants a market solution for European clearing and settlement.

THE BIO-DIVERSITY OF MIDDLE EAST FUND RAISING ..........Page 30

REGIONAL REVIEW

Why Middle East capital markets are gaining depth and diversity.

LUXEMBOURG FIGHTS BACK..................................................................Page 40 How Luxembourg is responding to the Dublin’s challenge. By Lynn Strongin Dodds.

DERIVATIVES DEBT REPORT INVESTMENT SERVICES INDEX REVIEW 2

KEEPING UP WITH THE FRONT OFFICE ..............................................Page 43 Neil O’Hara explains why back offices are racing to catch up with front office traders in the OTC derivatives market.

IS THE JUICE WORTH THE SQUEEZE? ..............................................Page 57 Andrew Cavenagh explains why emerging market sovereign debt is set to prosper.

KEEPING RISKS AND PROFITS IN STEADY BALANCE ........Page 70 Dave Simons reports on the latest trends in US securities lending. Market Reports by FTSE Research ................................................................................Page 94 Index Calendar ................................................................................................................Page 104

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Contents FEATURES TRANSITION MANAGEMENT

EVOLUTION AND MORE EVOLUTION

............................................Page 48 The arcane world of transition management is in metamorphosis, again. Not every transition management business can compete in this new world of complex management capability and seamless access to liquidity across multiple asset classes. Beneficial owners are also choosier about who handles their portfolio transitions—with good reason. Francesca Carnevale reports on a flight to quality.

DESTINATION T-CHARTER

..........................................................................Page 54 Is it time for everyone to sign up to a new code of practice in transition management? Francesca Carnevale reports.

THE INVESTMENT SERVICES ROUNDTABLE

............................................Page 60 Demands on the investment industry are shifting as the end investor, armed with greater wealth, is starting to ask for a different type of service. The onus is on the investment community to ensure products are relevant and to get them onto as many distribution platforms as possible. At the same time, investment firms are dealing with an infinitely more complex set of circumstances, given the mobility of capital and changing demographics in many countries. How will they cope with the challenges? A team of experts discuss some of the key challenges and possible solutions

THE REAL ESTATE REPORT

KB HOME: OR HOW TO BEATING A SLOWDOWN ................Page 75 After a decade of supercharged growth, the homebuilding market in America appears spent, the victim of rising interest rates and oversupply. During the boom, virtually all the industry’s major players looked smart. A severe slowdown will reveal which really are smart. Art Detman reports on why California’s KB Home thinks it will be one of them.

THE ALLURE OF REIFS ....................................................................................Page 79 John Wantz, director of business development, REIFs at RBC Dexia Investor Services, reports on why Luxembourg is becoming a domicile of choice for registered real estate funds.

REITS: A US PHENOMENON

........................................................................Page 83 The UK REITs market is expected to take flight next year. Francesca Carnevale looks at the evolution of the REITs market in the US.

LENOVO FEELS THE HEAT

................................................................................................Page 86 In May 2005 the Chinese computer maker took over IBM’s personal computer business to become the world's third biggest seller of PCs – and the inheritor of the manufacturing and design tradition which had launched the personal computer onto a waiting world. Apart from the scale of the acquisition, the deal is redolent with implications. The hybrid that has resulted is probably the world's most globalised big company. Ian Williams reports.

ALCATEL AND LUCENT: A MERGER OF EQUALS?

..........................Page 90 Summer has been unkind to corporate couplings in France. The government’s €70bn attempt to join Suez to Gaz de France and block its Italian suitor ENEL miffed European Union officials and triggered strikes. The uproar also sapped the government’s standing in the polls. The air in the mergers and acquisition division of France Inc. has grown more stifling as the days got hotter. Yet somehow, the AlcatelLucent deal sailed on. Joshua Jampol reports from Paris.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Market Leader SOUTH KOREA: FDI IN THE SPOTLIGHT

Union members of the Korean Exchange Bank wear masks during an annual shareholders’ meeting in Seoul, on March 29th this year. The South Korean banners read “Union Fight”. The photograph was taken by Lee Jin-Man and supplied by EMPICS/Associated Press, July 2006.

THE ALTERNATING

FACE OF KOREAN FDI Is South Korea now ambivalent about the extent (even desirability) of foreign inward investment? Analysts say the country remains a liberal economy; but the heads of some of America’s leading buyout funds may beg to differ on the definition of ‘liberal’. US buyout firms are under intense fire over the large profits they have enjoyed in the country and the extent of the public outcry raises concerns that a broader nationalist backlash could threaten one of Asia’s most dynamic success stories. Ian Williams reports on a growing flap that, worst case, could eventually spill over into the negotiations for a bilateral free trade agreement (FTA) between the United States and South Korea.

T ALL BEGAN so well. After the 1997 currency crisis, South Korea followed global economic orthodoxy and further opened up its markets. As Karl Sauvant, Columbia University professor notes, “The government has made various constitutional provisions to help foreign investors, and it has worked hard to attract them.” No matter the deep pile of the government’s official welcome mat; the local population has, it seems, become somewhat suspicious of foreign shareholders. Back in 1997, a Korea Development Institute survey found over 80% of South Koreans thought foreign takeovers would help rebuild a post-crash economy. Only 10 years later, surveys show that the same proportion now wants to protect local enterprises from foreign acquisition— not least because of a prevailing feeling that some of the American private equity investors, such as Warburg Pincus, the Carlisle Group, Newbridge Capital and Lone Star Funds, managed to snap up Korean assets at bargain basement prices. Even the Korea Chamber of Commerce and Industry and the Korea Federation of Industries is accusing the foreign funds of making “predatory profits”. American private equity firm Carlyle Group, for one, found itself under a microscope in April this year for allegedly not paying taxes on its $740m profit from the sale of KorAm Bank two years ago. Another firm, Lone Star Funds, a Dallas-based private equity firm, has come under particularly fierce fire of late. South Korea investigators are probing Lone Star over its takeover of Oehwan Bank, otherwise known as Korea Exchange Bank (KEB) back in 2003. In January Lone Star put up it stake in KEB for sale, provoking a public outcry. Rightly or wrongly, many South Koreans think that foreign

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Market Leader SOUTH KOREA: FDI IN THE SPOTLIGHT

investors were given unduly generous terms after the 1997 financial crisis. They point (in particular) to attempts by Lone Star to shelter profits from Korean taxes using international treaties originally designed to prevent double taxation of companies doing business overseas. Back in August 2003, Lone Star took a majority stake in KEB, for about $1.2bn in cash, as part of the general reorganisation of the South Korean financial sector. In spite of its then apparent lack of profits, KEB had particular attractions. It was South Korea’s sixth-largest bank, had 311 branches and is the country’s biggest provider of foreign exchange services, with 22% market share. The ExportImport Bank of Korea owned another 32.5%, while Bank of Korea held 10.7% of the bank’s shares. It seemed like a propitious pairing. Lone Start enjoyed a good record of accomplishment in Asia’s banking sector (having turned around Tokyo Sowa Bank in Japan) and in 2003, Lone Star was acclaimed as something of a saviour. KEB meanwhile had been in difficulties, reportedly posting one of the biggest first quarter losses among the country’s lending banks. By January 2006 however, the bank’s value had more than tripled to about $4.9bn (on assets of Won73trn) and everything looked rosy. KEB reported a quadrupling of its 2005 third-quarter profit (a record for the bank); and the bank’s shares rose in value by almost 2.5% to their highest level since July 1999. Lone Star itself had been on something of a roll. Throughout the second half of 2005, the buyout firm had divested its interests in golf courses, a bank and a credit card company in Japan. It was a bewitching confluence of events; and Citigroup was tabled to arrange the sale of KEB.

Lone Star Chairman John Grayken talks to reporters during a press conference in Seoul, South Korea, Wednesday, April 19, 2006. Grayken told the press conference that the US buyout firm will donate Won100bn (around $106m) as a “social contribution” to the Korean people. The photograph was taken by Ahn Young-joon and was supplied by EMPICS/Associated Press, July 2006.

Three local institutions duly lined up as interested buyers: Hana Bank, Shinhan Financial Group and Kookmin Bank (three of South Korea’s top lenders). All were eager to get a slice of KEB, which had been the only bank in the country still controlled by a foreign investment fund. Then, the wind changed. Kookmin Bank agreed to buy a controlling stake in KEB in mid-May but only six weeks later Kookmin Bank president Kang Chung-won and KEB president Richard Wacker were meeting to talk about ways to speed up the merger. Merger talks had stalled as Korea’s Fair Trade Commission (FTC) extended its deliberations on whether the merger violates the country’s anti-trust rules. Then, Korea’s all-powerful unions began to wade into the debate. The two banks were fighting on two fronts: the authorities and the unions, both of which seemingly opposed the planned sale. Additionally, the

ongoing legal investigations played straight into union hands. As the prosecution continued to question former KEB executives over allegations that they helped Lone Star buy the bank at a below-market price back in 2003, KEB unionists have stepped up their struggle against management. Kookmin and KEB tried to head off union trouble by signing an agreement that ensures the job security of all employees from both banks after the integration; but KEB’s union was not satisfied with the offer. A day after Kang and Wacker met, prosecutors raided KEB, seizing documents as part of an investigation into Lone Star’s acquisition of KEB— even though on the 19th June government auditors had officially cleared Lone Star of any wrongdoing. It seems that prosecutors were continuing to investigate allegations by state auditors that in 2003 former executives of the bank had exaggerated KEB’s bad debts and artificially lowered its capital ratio to below statutory minimums to ensure a quick sale to Lone Star. The auditors also claimed that Ministry of Finance and Economy officials had gone beyond their brief in rushing through the sale. In the wake of these investigations, two employees of Lone Star were reportedly arrested. Experts say the buyout firms have run into troubles that are (at least partly) of their own making. Lone Star says it does not owe Korean taxes because Korea Exchange Bank was purchased by the fund’s subsidiary in Belgium—a country with which South Korea has a treaty that alleviates its tax burden to Seoul. The firm also says it will pay taxes on the sale in Belgium, where tax rates are lower than those in South Korea. Carlyle did something similar with its sale of KorAm Bank, using a subsidiary in Malaysia, another treaty country. Colombia’s

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Market Leader SOUTH KOREA: FDI IN THE SPOTLIGHT 10

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barrier because of some of Sauvant says, “When Outperforming: Five-year performance of FTSE Korea Index the duties we have to pay for Lone Star acquired the vs. FTSE World Index 450 exports into Korea. Very Bank, no one knew how 400 soon they are going to be the thing [sic] could go, it 350 one of our largest was a fairly risky 300 subsidiaries in the world.” acquisition [and now]… 250 With economic growth that is creating some 200 rates this year projected to be questions. I do not know 150 between 4.5% and 5.5%, it whether they paid too 100 seems churlish of some little but there was a risk 50 analysts to sound so bearish premium involved. No about Korean prospects. Last one knew what would year, it attracted some $9.6bn eventually happen.” FTSE Korea Index FTSE World Index in foreign direct investment, In March, Lone Star Source: FTSE Group US Dollar price returns. Data as at August 2006 according to the Korea Tradechairman John Grayken Investment Promotion offered Won100bn as a Agency, equivalent to 1.2% of “social contribution” to In August 2003, Lone Star took a GDP. About half of that the Korean people in investment comes from order to blunt growing majority stake in KEB, for about $1.2bn industrial companies such as popular criticism. It in cash, as part of the general General Electric, Motorola achieved little. Indeed, at reorganisation of the South Korean and General Motors, which the end of June even as a financial sector. Headquartered in Seoul, have not been caught up in joint government, the bank had been operational since the current furore. industry and union 1967. In spite of its then apparent lack of On the face of it, South roadshow was in the US Korea has built such a trying to promote FDI profits, KEB had its particular attractions. competitive position that into Korea, prosecutors It was South Korea’s sixth-largest bank, even an overvalued currency were raiding KEB. had 311 branches and is the country’s does not seem to be It is not surprising that biggest provider of foreign exchange inhibiting export growth, wary investors in New services, with a 22% market share. which was a respectable 13% York were asking the in the year to this April. Korean delegation about South Korea is the 11th the events, nor that they were not entirely reassured by the watching the FTA talks very carefully. largest economy in the world, with the answer that foreign investors who did “Our corporate culture really fits very fifth biggest currency reserves, and its not break the law had nothing to fear. well in Korea in terms of employee growth rate is higher that that of many It certainly gave the impression that relations, environment, and all the of its OECD colleagues. However, whatever the official government other good things that have kept us while South Korea is moving policy on top, there was plenty of strong for over a century. Innovation is successfully into new, branded, high Korean chauvinism to go round a part of that culture, and engaging intellectual propertied products, it has aligned with an attachment to Korea in the innovative process has also excelled in the rustbelt industries traditional socially concerned ways of been very constructive.They have been that the US has been abandoning, such doing business that American FTA very good at protecting intellectual as autos, and shipbuilding (in which it negotiators may well consider atavistic. property rights, which is a critical issue has a 43% global market share). There is still a strong dirigiste culture with Other overseas investors have, for a technology company like us.” He adds,“We still export more than strong research and development nonetheless, managed to avoid negative headlines—perhaps because 50% of our sales there from the US, on investments from the government, their culture is closer to Korean values. the other hand, and that will be a very which has a clear sense of its industrial One such is 3M whose Washington important ingredient of the FTA, strategy. The question remains: can office head, Thomas Beddow, is removing some of the last remaining foreign firms still fit into it?

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Index Review THE BEGINNING OF A BEAR TREND?

The Equity Inflation Mix Notwithstanding May’s sell-off, indices have been in a bull run since March 2003. The FTSE 100 has rallied by nearly 80%, with an upward trend line indicating the slow rehabilitation of the equity markets. In the past, indices would have been taken as proof of the current wealth or growth prospects of the country in which the index was actually based. No longer: the bigger corporations are truly global and some 70% of the revenue in the FTSE 100 comes from abroad. Globalisation in the banking, telecoms and energy sectors has affected the ‘heavyweights’ in the FTSE 100 index of late, creating (oddly), in the UK, the best index indicator of world (rather than local) economic conditions. As global companies list on the London Stock Exchange, the FTSE 100 reflects that performance. GB plc could be going down the tubes but, if the global economy is doing well, the FTSE 100 could very well buck the local trend. Simon Denham, managing director of spread betting firm Capital Spreads, reports on index trends and expectations. QUITY MARKETS HAVE tended to be buffeted by nonmarket-specific events this year with investors managing to worry about nearly everything under the sun. Inflation, growth rates, interest rates, political instability, gold and oil prices have all caused fear in the minds of traders, but not, it seems concerns about a slowdown in company revenue growth. While the generally benign state of the world economy continues, combining steady growth with (currently) contained inflation, we are likely to see the major indices oscillate higher. A concerted attempt by central governments to bring runaway expenditure under control could upset the proverbial applecart. Money supply in the OECD nations has been rising at more than 12% a year for years. This huge injection of what is, in effect, cash

would, usually, have serious inflation implications. Luckily, the rise of cheap Far Eastern production capacity, big increases in productivity levels and the ability of retailers and manufacturers to source raw materials and produce from wherever it is cheapest, means this pressure has been dissipated from the high street into fixed assets. Any investment class that can demonstrate a low availability (housing/gold/oil) has increased substantially in value, whereas sectors where supply can be increased or remains liquid (equities/soft commodities/cash) has either stagnated or risen slowly. There are signs that this state of affairs is about to end. Real estate in the US has run into a brick wall; commodities have stopped their dramatic rise, and oil is pretty much the same price in August 2006 as it was in August 2005. Nonetheless,

Simon Denham, managing director, Capital Spreads. Photograph kindly provided by Capital Spreads, August 2006.

equities have continued to rally slowly but surely. In the UK the government has announced tight public sector wage controls for the next few years, Japan is finally raising rates from zero and this may begin to cut back on government spending levels. In Europe the main culprits of ‘print the money and worry about it later’, such as Italy, are finally being reined in. With the potential for lower money supply levels fixed assets could be just at their peaks and a period of ‘cash is king’ about to begin. Some analysts point to the recent pullback in the markets and postulate the start of a pronounced bear trend due to one or another of a myriad of technical reasons. Conversely, others say that, after almost three years of rising prices, a set back is well overdue and contend that the bull market will recommence in the second half of 2006. Analysts are like economists: get two in a room and you will end up with three different opinions! If interest rates in the US have indeed peaked, investors will be looking to better equity returns going forward—but possibly not just yet. Worries over growth will probably come to the fore during the next quarter which should cap world equity markets in the short to medium term. For now, the likelihood is for a minor slowdown which would put downward pressure on inflation and eventually help equity markets to advance once more.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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In the Markets LATENCY

A number of key developments have paved the way for today’s fast-paced trading environment. For one, exchanges have moved to adopt electronic order books; the first step toward making electronic trading a standard industry practice. Furthermore, exchanges are continually working to improve their platforms to increase capacity and speed of execution. Photograph of a grunge skull head in a war zone, kindly supplied by Istockphotos.com, July 2006.

Low latency is vital in today’s global trading environment, where ultra-fast electronic trading and razor-thin margins are the norm. Any delay in a trade can mean a lost trading opportunity and reduced earnings. In an attempt to tackle system latency, exchanges, market participants and their technology providers are working to improve their technical performance. The financial markets are now fighting a war— a war measured in milliseconds. Simon Nathanson, CEO of agency and direct market access brokerage NeoNet, reports.

Fighting a War of Milliseconds A RE MILLISECONDS WORTH fighting over? In the past, latency was not a significant issue for the global trading industry. These days, however, with the rapid growth of direct market access (DMA) and low-touch electronic trading, speed is critical. The rapidlyexpanding use of trading software and automated trading engines to identify and exploit trading opportunities invariably means that milliseconds really do matter. Exchanges have moved to adopt electronic order books; the first step toward making electronic trading a standard industry practice and continually work to improve their platforms to increase capacity and the speed of execution. The implementation of new messaging and trading systems by the London Stock Exchange (LSE) and the New York Stock Exchange’s (NYSE’s) plan to introduce a hybrid trading system are recent examples. The LSE has set

an aggressive target of achieving less than 10 milliseconds in trading system response time in order to meet advanced trading needs and bring the exchange to levels similar to those achieved by electronic communication networks (ECNs) in the US. The emergence of FIX as an industry message standard has played a large role in enabling straightthrough processing (STP) and supporting efficient electronic trading. FIX has forced sell-side systems, buyside order management systems, exchange systems and others to become more uniform, enabling previously isolated systems to effectively communicate with one another. Uniformity helps decrease latency, but it hasn’t stopped there. FIX Protocol Ltd recently launched a new standard for efficient distribution of market data called the FAST Protocol, to meet demand for ultrafast information to feed sophisticated trade engines.

Demand for unbundled and conflict-free trading – driven by investor demand for increased transparency – has also driven low latency through DMA. Investors gain a more cost efficient trading service, with a totally different character and speed compared to the traditional voice brokerage model.

Factors driving the need for speed Maximising performance of algorithmic or program trading means an increasing reliance on exact market data pushed through a rapid orderrouting channel to minimise delays. If the information is of low quality and too slow, decisions are based on old facts and the trade may not get filled. Algorithmic trading puts a bigger burden on connectivity and systems and generates a rising amount of order routing messages and market data as the number of trades increase. With the growing use of new trading

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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In the Markets LATENCY

patterns and automated trading engines, it is likely that future volumes of trade information will be much larger and even more complicated to handle than today. Therefore, it is important that this data can be managed and processed as quickly as possible. Even regulatory initiatives have locked onto the need for speed. In fact, low latency and speed is described as one aspect of best execution in the ‘Markets in Financial Instruments Directive’ (MiFiD). Asset managers and professional traders increasingly take advantage of trading and arbitrage opportunities on a global scale. Additionally arbitrage opportunities appear over a shorter period of time because of global competition, automated trading engines and increased advanced trading. It means that margins become razor thin. Therefore time-to-market and minimised latency becomes a critically important advantage.

send many orders per second, thereby further increasing the serialisation delay. The market is clearly moving to decrease latency.. Examples include bringing exchanges closer to investors by placing investors’ automated trading engines geographically closer to marketplaces. As well, the placement of time-critical parts of the trading system close to the location of the investor ensures the shortest distance possible between investor and an exchange. The longer the physical distance, the higher the latency, since the speed of light becomes a factor over larger distances. Finally, there is also an element of system architecture design. Trading systems need to be designed to have a distributed architecture where modules relating to the individual exchange are placed close to the market to achieve minimised delays.

Brokers: a winning tool Decreasing latency Efficient distribution of information is fundamental to success in today’s new trading tactics environment. Reducing latency requires a systematic and comprehensive approach applied to all links in the trading chain, including analysis of partner suppliers. Taking bandwidth as one of many sources of delays, there is a clear difference in introduced serialisation delay (the time it takes to submit data to a communication link) by using a low bandwidth connection instead of a high bandwidth one. This could partly be avoided by compressing packets by using new data distribution protocols such as FAST. When trading on an exchange or electronic network, with 10 milliseconds in response time, 70 milliseconds in serialisation delay represents a significant portion of the roundtrip time. This is especially true for automated trading engines, which

Choosing the right brokerage partner can also help. It’s important to consider the broker’s ability to tap into market data directly from an exchange, the efficiency of the broker’s distribution infrastructure, and the broker’s ability to place automated trade servers geographically close to marketplaces—if global trading is, in fact, part of that institution’s trading strategy. Neutrality is a factor in the speed of trading and something on which more and more asset managers are placing a paramount importance. Brokers with their own proprietary trading activities could, potentially, be in conflict with the investor’s trading strategy. Through real direct market access (DMA), where trades are executed on an agency basis only, an order would not be delayed by other internal practices, e.g. a broker’s internal matching engine.

Simon Nathanson, CEO, NeoNet. Photograph kindly supplied by Cognito, August 2006.

The demand on functionality is also closely related to the investor’s trading strategy and behaviour. An institution should seek the functionality that best fits its needs and trading style.. Lastly, given geographical investment scope, institutions should consider the marketplace coverage of their chosen brokerage provider. The ability to reach out to the key markets through one service makes cross-border trading easier and more integrated. Additionally, it enables the investment manager to take advantage of all possible trading or arbitrage opportunities independent of where they may be. Advancements in technology, thinning margins and competition will force market participants to innovate and invest in the systems and partners to enable ultra-fast trading at the right price. Investment managers need to capitalise on the opportunities provided by high-speed trading and closely examine every single link in their trading chain to identify areas where latency reduction is possible. By winning small battles, one can win the war.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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In the Markets NYMEX METALS & ENERGY CONTRACTS ON CME’S GLOBEX

Wired for sound Nymex’s refusal to replace its traditional method of open outcry with electronic trading on its energy or metal futures during the day put it at odds with competing exchanges, which have adopted the faster and more streamlined system of globally linked electronic trading screens. All that changed in April, when Nymex announced that it had agreed to allow the Chicago Mercantile Exchange (CME) to handle all of its energy and precious metals contracts using CME's Globex electronic-trading platform. Dave Simons reports. S PART OF a 10-year technology services agreement, the CME will gain a portion of Nymex’s lucrative revenue stream, expected to be approximately 35 cents to 50 cents per contract traded on Globex over the next two to three years, with pricing in several tiers based on volume levels. Full electronic trading capability was expected to transition to Globex during the third quarter, while all contracts traded on Globex will continue to be cleared through the Nymex clearinghouse. The conversion to the Globex system could affect nearly onefourth of Nymex’s broker roster (mainly those who operate on an execution-only basis), while a non-compete clause written into the agreement prevents CME from initiating its own energybased contracts. Nymex’s move to join the ranks of the wired is a necessity, given the tremendous increase in futures trading volume in general and the significance of oil and other energybased commodities to the investment community in particular. The Globex alliance allows Nymex to prevent any erosion of market share at the hands of e-based competitors such as London’s Intercontinental Exchangeaffiliated ICE Futures, which launched electronically traded WTI Crude futures contract earlier this year.

By listing energy contracts on Globex, Nymex increased its distribution much faster than if it had built its own capability, notes Nymex’s chief executive officer (CEO) Jim Newsome. "The agreement complements and enhances our open-outcry trading”while expanding the accessibility of Nymex’s benchmark energy contracts to investors worldwide and also allows us to build on [our] record electronic trading volumes,”he adds. Increasing distribution of Nymex contracts through Globex is also adds significant value to CME’s core customers and shareholders, affirms CME CEO Craig Donohue.“Providing third-party technology services is a key element of CME's long-term growth strategy," says Donohue,“and this service agreement will leverage CME's proven electronic trading platform and global distribution network to expand access to Nymex .... The addition of energy contracts on CME Globex further diversifies our product offerings." “You always need to ask yourself whether or not you are delivering value, and with the Nymex deal, it really is a win-win situation,” says CME’s Felix Carabello, director of alternative investment products. “We spent over a billion dollars to develop

our trading systems and build out our distribution. For an exchange like Nymex to start that kind [sic] of a process from scratch takes a lot of time and money. By taking our technology and our distribution, they really get a temporal advantage, while at the same time saving themselves the tremendous expense of having to create a similar set-up on their own.” Such deals are indicative of the rapidly changing face of the energy markets, says Carabello. “We have seen a huge growth in volume as well as a greater transparency in the markets particularly as we have migrated from floor-based trading to screen-based trading. Because of the technology [employed], we are able to provide more efficient markets, as our reach is much broader. As a consequence, you will probably see CME continuing to leverage its core assets. Where the old paradigm was to launch new products and then sell them to the same target audience, that is now changing. We will still launch contracts, but there are other things you can do to deliver value to current markets, in addition to new customers such as exchanges and so forth.”

Future games In July, Nymex filed a registration statement with the US Securities and Exchange Commission for a $250m initial public offering, with major equity backing from General Atlantic and Archipelago Holdings. The listing is likely by year’s end and is expected to raise the value of the exchange's 816 seats to around $4bn (roughly $5m each). Nymex’s decision to go public speaks volumes for the continued growth of the energy-futures market of late. Figures from the Futures Industry Association (FIA) show an increase in US energy futures and options contracts of 12.2% between

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

“Predictability is what I bank on.” DA N I E L O ’SULLI VA N Managing Director, Head of FX, Americas, HSBC Bank USA

For more consistent results in the face of global exchange rate ﬂuctuations, Daniel O’Sullivan relies on CME, the world’s largest regulated marketplace for foreign exchange trading. CME offers futures and options contracts on all major currencies — including the euro, British pound, Swiss franc and Japanese yen. They provide a cost-effective and credit-efﬁcient way for leading corporate and investment banks like HSBC to help customers manage foreign exchange exposure. By improving the way markets work, CME is a vital force in the global economy, offering futures and options products on interest rates, equity indexes, foreign exchange, commodities and alternative investments. For more about how CME can change your world, visit www.cme.com. CME®, the Globe logo and Chicago Mercantile Exchange® are trademarks of CME. Copyright © 2006 CME. All rights reserved.

I D E A S T H AT CHANGE T H E W O R L D™

In the Markets NYMEX METALS & ENERGY CONTRACTS ON CME’S GLOBEX

2000 and 2005. The total number of futures and options contracts (excluding futures, options and options on futures of individual equities) traded worldwide, meantime, reached nearly 7.5bn last year, up from 2bn in 2000. As if on cue, the price of light sweet crude for August delivery approached a record $80 a barrel on the week of the Nymex listing announcement. Some analysts suggest a period of consolidation lies ahead, others that any pullback would be short-lived. "It is difficult to construct an argument for lower prices as long as the situation in the Middle East persists," writes Fimat USA broker Mike Fitzpatrick in a research note. Somewhere between $100bn and $120bn has been invested in the energy markets worldwide since 2003, including $60bn in Nymex-based oil futures, according to figures supplied by the International Monetary Fund (IMF), leading former Federal Reserve chairman Alan Greenspan to observe, “With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.” While speculation may in fact increase demand and drive up the price of oil,“if Saudi Arabia or anybody else produces more oil, that means that more oil is available on the selling side of these contracts, and the lower would be the resulting equilibrium price,” counters James D. Hamilton, professor of economics at the University of California, San Diego.“If the Saudis do not find buyers for the particular grades of oil they are producing, they could either discount the price of that oil or lower production. Whatever they do is a choice the Saudis make, not the mysterious outcome of hedge fund speculation. It may well be that the Saudis are experiencing lower demand, but if so, it is their cutbacks in

United States vice president Dick Cheney, accompanied by Chicago Mercantile Exchange chairman Terry Duffy, left, delivers remarks on the economy to exchange members Friday, June 23, 2006, in Chicago. Somewhere between $100bn and $120bn has been invested in the energy markets worldwide since 2003, including $60bn in Nymex-based oil futures, according to figures supplied by the International Monetary Fund (IMF), leading former Federal Reserve chairman Alan Greenspan to observe,“With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.” The photograph was taken by M. Spencer Green and supplied by EMPICs/Associated Press, August 2006.

production that are causing the price to rise rather than fall in such a situation.” “Anyone who knows how futures markets work will realise that prices at Nymex reflect in a very accurate way the balance between supply and demand,” notes John Damgard, president of the FIA. Proposals that include greater reporting requirements for off-exchange transactions, new layers of oversight, and possibly even price limits, though mainly aimed at the energyfutures business, could cause lasting damage to the efficiency and attractiveness of the entire futures markets, he adds. At a hearing before the Committee on Agriculture held this past April, CEO Newsome reiterated that Nymex has seen no evidence to date to suggest that recent price rises in gasoline futures being traded on our markets are attributable to volatile activity.“Speculators do exist and they

play a valuable, even necessary role in the marketplace,” says Newsome. “They add liquidity to the market and enable commercial traders to get in and out of the market when necessary. By nature of their roles, speculative traders seek to participate in price trends that are already under way, but because they lack the capacity to either make or take delivery, they will never be in a position to be able to hold a market position through the delivery process. Thus, speculators create virtually no impact on daily settlement prices, which are the primary benchmark used by the marketplace. “The Nymex marketplace continues to provide regulated forums that ensure open, competitive and transparent pricing,” says Newsome. “We can only imagine the market uncertainty and further devastation to consumers if Nymex were unable to perform its responsibilities.”

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Face to Face EUROPEAN CLEARING & SETTLEMENT

Charlie McCreevy, the commissioner in charge of the European Union’s (EU’s) Internal Market and Services has analysed and dissected the reasons why cross-border clearing and settlement has been expensive by comparison with national systems for some years. In April 2004, the European Commission launched a consultation, seeking views on general objectives and actions required to deliver efficient cross-border clearing and settlement. During the last two years, a number of respondents have broadly backed the Commission’s original idea to issue an official directive. Both Euroclear and Clearstream made it clear to the Commission there was no case for a directive. But both parties have been supportive of harmonisation of market practices and national fiscal and regulatory regimes as the best route to market efficiency. Nonetheless, for many months, the market thought McCreevy would issue a directive in July that would provide a road map towards a solution. Instead, McCreevy settled for a speech in which he clearly states: “What is clear is that there is no single measure which I can propose that would bring about the changes necessary. We have to continue with an approach that is varied, proportionate and cognisant of the ongoing changes taking place in the market.” In other words, let market forces decide. Two of the most important infrastructure service providers in the European clearing and settlement space explain their reactions to McCreevy’s laissez faire approach: Pierre Francotte, chief executive officer (CEO) of Euroclear and Jeffrey Tessler, CEO of Clearstream. By Francesca Carnevale.

Let the market decide where it operates, says Clearstream Jeffrey Tessler, chief executive officer (CEO), Clearstream. Any arguments or discussions in a European debate about the efficacy of the “so called” vertical silo structure versus the horizontal structure model are now, he maintains, a dead end.” Photograph kindly supplied by Clearstream, August 2006.

HE WORLD ACCORDING to Jeffrey Tessler, chief executive officer (CEO) of Clearstream, the international central securities depository within the Deutsche Börse Group, is entirely market driven and as such, Tessler has welcomed McCreevy’s approach. Any arguments or discussions in a European debate about the efficacy of the“so called”vertical silo structure versus the horizontal structure model are now, he maintains, a dead end. “As far as fixed income securities are concerned, the market has moved way beyond it being an issue. They understand that over 85% of Clearstream’s business is dominated by international debt securities and that in fact there is competition between Euroclear and Clearstream”. Besides there is a bridge between Clearstream and Euroclear that allows our clients complete or total operability.”

Like Francotte, Tessler thinks that the days of talks of mergers between Clearstream and Euroclear are over. “ESForum did raise the issue, but six years on no one is talking of mergers anymore. The market likes and wants competition and we are convinced that market diversity must be the model going forward: as it looks to transparent interoperability and unbundling.” Within that context,“we compete with Euroclear, no doubt about it.” However, Tessler acknowledges concordance over the issue of market directives covering clearing and settlement. “Our view is that we should come up with market led solutions and the market itself should decide where it operates,” he says. The stance is credible in the context of a domestic market that is efficient: “It is in the cross-border equity element that difficulties emerge. In Europe, we are talking 12 to 15 languages; 12 to 15

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Face to Face EUROPEAN CLEARING & SETTLEMENT

different infrastructures and 25 legal to support the central bank feasibility area is characterised by high systems and tax regimes. To process a study: “many elements still have to be fragmentation, little standardisation and corporate action in Italy is vastly different defined but it is an interesting therefore operational risk.” Several proposition that could level the playing significant market participants have than in France.” been involved in the pre-launch product Tessler is convinced that the field in Europe,”thinks Tessler. He explains that in each European discussions, he says, including European Commission and Charlie McCreevy recognise“a need to continue country, the existing settlement systems distributors, promoters, transfer agents with harmonisation and in that context would interact with Target 2 securities. and trade associations such as EFAMA Clearstream is supportive of them.” “We would like to be very supportive of and ISSA. CFF will be launched in the Tessler points out that Clearstream the effort though I think it will take a second half of 2007 and a pilot participates in the work of groups set up further six or nine months, which will programme will start up at the end of by the European Commission to tackle take us into the first quarter of 2007, this year. Tessler also outlines a number the 15 barriers to a unified European before we have a clearer picture of what of other initiatives, such as multiple clearing and settlement infrastructure shape it will take and whether its releases under Clearstream’s collateral outlined by the Giovannini group. implementation is feasible on a pan management operations, which, he Other dedicated teams work with European basis” he adds. “Whichever acknowledges, “has been a major undertaking for us. In ECSDA and FESE and the September we will come out European Association of “…if competition exists, let it exist. At with re-use functionality for Clearing Houses (EACH) to least if we are going to make the market tri-party repo, he adds. Also, work on harmonisation in Germany we have been issues and to establish a more transparent and less complex; lets developing our clearing “Code of Best Practice and not make it less competitive,” says Tessler capability, which combined ways to encourage with collateral management, transparency, operability and unbundling as well as identifying way it falls, the initiative must involve to develop GC Pooling, and growth rates ways to create more efficiency in post both the European Commission and for this business have been very good,” he explains. Euro GC Pooling is a new the central bank, working together.” trading,”he says. As far as MiFiD is concerned Tessler is cash-driven general collateral segment For Tessler then, McCreevy’s latest speech recognises Clearstream’s efforts quite cautious “it is still very early to of Eurex Repo, introduced in March last to explain its model. “What I am most assess the potential impact of MiFiD in year and offering short term pleased with is the job we have done in terms of applicability and compliance. collateralised funding and collateral setting out our strategy and Implementation in national laws should management that enables participants underscoring our strength in be finished in early 2007 and full to utilise surplus liquidity from the Eurobonds. At the end of the day, if implementation is not planned before European Central Bank Tender.“In 2007 competition exists, let it exist. At least if the fall of 2007. Some of its proposed we will extend the service to the we are going to make the market more rules, —especially access to clearing and international markets, as at the moment transparent and less complex; lets not settlement facilities—may have an it only exists for the German market.” Like Francotte, Tessler’s vision is not impact on the clearing and settlement make it less competitive.” With the other CSDs and Euroclear, environment. So Clearstream is currently limited by the European theatre. Clearstream is also participating in the analysing ways in which these rules will “Everyone is interested in moving European Central Bank’s recently be implemented in the national law of eastwards, with opportunities in Russia, Asia—specifically China.” However, he announced initiative to pave the way for the respective member states”. Earlier this year Clearstream acknowledges, “it becomes more a common platform for securities settlement in central bank money, in the announced the launch of the Central difficult to tie down the exact Eurozone. “With Target2 the central Facility for Funds (CFF), which says opportunity in these markets. We were bank is providing an efficient cash Tessler, “will bring harmonisation and fortunate in the case of China, because payment infrastructure and now is standardisation to the Luxembourg we already had a presence there. In the actively trying to understand how funds industry,” the largest market in case of central and eastern Europe, we synergies with securities settlement Europe for mutual funds. Although the have no acquisition interests; though could be realised,” explains Tessler. industry is developing rapidly and has Deutsche Börse Group is open to Clearstream has setup an internal team enjoyed high growth rates,“its post trade opportunities when we find them.”

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

5 October 2006 The Dorchester, London

FT Commercial Property CONFERENCE Themes for discussion: f

ECONOMIC HORIZONS: IMPLICATIONS FOR PROPERTY The Economist’s View: What can the macroeconomic picture of the UK and Europe tell us about the fortunes for the property industry over the coming ﬁve years?

CALLING THE MARKETS, ISSUES, TRENDS: VIEWS FROM THE FRONT LINE The Real Estate Advisors’ View: A live interview with the big three leading property advisors, giving an insight into investment and occupier issues and trends for UK and Europe.

FROM KIEV TO KARACHI: WHERE NEXT IN THE WORLD? The International Investor’s View: High proﬁle investors will explain their choices – where they will be investing, what returns they expect, and why their choice is the best.

What are the prospects for property? What are the long-term outlooks for property investment and strategy in the UK and Europe? How is competition changing the market? Where should you put your money when building a global portfolio? The FT Commercial Property Conference is the place to take the pulse of property. This year’s event will kick off with a session entitled Economic Horizons – Implications for Property, the economists view of what we can expect to see over the next ﬁve years; this will be followed by insights into the UK, European and Global investment markets. Following an extended lunch for networking, the afternoon will begin afresh with Thoughts on Value Creation: Occupiers in 2010. The agenda will be completed with an all-star panel of leading CEOs who will give their personal views on Setting the Course Ahead. A cocktail evening will close the event. The conference is a must-attend for all commercial property investors and managers, brokers and agents, investment and asset managers, and law ﬁrms, who represent the key decision-makers and strategists in their sectors.

THOUGHTS ON VALUE CREATION: OCCUPIERS IN 2010

Speakers include:

The Occupier’s View: A panel of occupiers will focus on how landlords can deliver a better service to tenants and end-users and keep innovating in an increasingly competitive market.

Mr Chris Bartram, Chairman, Orchard Street Investment Management LLP

PROPERTY FORESIGHT: SPACE AND PLACE FUTURES The Expert’s View: Our panel of analysts will provide contrasting and thought-provoking insights into what lies ahead, both from the investor and occupier perspectives, e.g. the impact of changing lifestyle trends; technology; energy costs and sustainability.

Prof Andrew Baum, Professor of Land Management, The University of Reading Business School Mr Stuart Beevor, Managing Director, Grosvenor Fund Management Mr Stephen Hester, Chief Executive, British Land Company PLC Mr Alastair Hughes, Chief Executive Ofﬁcer, Europe, Jones Lang LaSalle Professor Tony Key, Professor of Real Estate Economics, Cass Business School Ms Liz Peace, Chief Executive, British Property Federation

SETTING THE COURSE AHEAD The UK CEO’s View: Our celebrity CEO panel from the UK’s leading property investment ﬁrms will return this year to give their personal views on the challenges and opportunities that lie ahead.

For additional information and to request a copy of the brochure, please contact:

Mr John Richards, Chief Executive, Hammerson plc Mr Francis Salway, Chief Executive, Land Securities Group PLC Mr Michael Strong, Executive Chairman – EMEA, CB Richard Ellis Mr John Travers, Chief Executive Ofﬁcer, EMEA, Cushman & Wakeﬁeld

Mr Tim Wheeler, Chief Executive, Brixton plc Mr Martin Wolf CBE, Associate Editor and Chief Economics Commentator, Financial Times

Elaine Wei Tel: +44 (0)20 7873 4874 Email: elaine.wei@FT.com

For more information please visit:

www.ftconferences.com/property

The organisers reserve the right to alter the programme and speakers as may be necessary © Financial Times Limited 2006

REF: XICP6

Face to Face EUROPEAN CLEARING & SETTLEMENT

Dismantle legal and tax barriers, says Euroclear

Pierre Francotte, chief executive officer of Euroclear.“We could be pompous and say we, ultimately, are the plan: Euroclear has merged with several CSDs, the same sort of strategy that the northern CSDs and LCH.Clearnet are pursuing. And, obviously, our market owners continue to push for platform consolidation.” he says. Photograph kindly supplied by Euroclear, August 2007.

HILE ACKNOWLEDGING THAT market forces will and should ultimately determine the future and structure of clearing and settlement in Europe, Pierre Francotte, chief executive officer of Euroclear, awaits meaningful action by the public authorities on issues they control that have a substantive effect on the underlying structure of European securities trading and settlement. “We need the market authorities to dismantle all the legal and tax barriers in Europe. We want to see as much progress in this domain as there already is in the private sector in addressing the Giovannini Group recommendations. The high costs of clearing and settlement are more a factor of fragmented laws and tax procedures than market inefficiencies,” he says. Nonetheless, he welcomes the

fact that Commissioner McCreevy recognised the importance of the issues facing European clearing and settlement, that improving the international competitiveness of the European capital market is paramount and that market solutions are, in fact, possible. “There is recognition by Commissioner McCreevy that the market is moving. He has also realised that the risk in being heavy-handed and prescriptive in the form of a directive could delay or jeopardise further market progress. I believe his instinct is not to interfere.” Many people in the market are still referring to the notion that Europe should have a single clearing and settlement superstructure on the lines of the Depository Trust and Clearing Company (DTCC) in the United States. The trend is clear, thinks Francotte: “If

you look at the three or four speeches Commissioner McCreevy has made over the past year, all say pretty much the same thing. He wants an open architecture. In particular, if you trade on a specific stock exchange, you should not be influenced to clear and settle in the post-trade operations owned by that exchange.” Even so, Francotte acknowledges that there has been a strong minority preference for a single superstructure. “We could be pompous and say we, ultimately, are the plan: Euroclear has merged with several CSDs, the same sort of strategy that the northern CSDs and LCH.Clearnet are pursuing. And, obviously, our market owners continue to push for platform consolidation. But remember, the US achieved consolidation over more than 20 years and is a market which did not have multiple sets of market rules, laws, cultures and languages. Perhaps there was an unduly Utopian view in Europe at the beginning that all problems could be resolved quickly to reap the benefits of a US-type market .” Euroclear had always believed that cross-border market consolidation would be a long process, he adds, with the engine of the Lisbon Agenda helping to set the background of change in today’s market. He thinks indeed, that the market, propelled by diverse forces, “is at the cusp” of meaningful change.“We could achieve a truly panEuropean securities environment,” he maintains. Cross-border transactions can become more efficient and the momentum towards this approach is strong. This is the year where Euroclear’s platform-consolidation programme establishes its foundation with the Single Settlement Engine. But, when consolidation is not yet feasible, interoperability is key: we’ve recently enhanced the Euroclear/Clearstream Bridge and maintain links with CSDs elsewhere in Europe and beyond. And

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Face to Face EUROPEAN CLEARING & SETTLEMENT

yes, we already have interoperability he wants to trade and settle, but that unbundled transaction fees, and is true for both clearing and settlement.” between the United States and Europe.” may not be in the same place. For Euroclear, believes Francotte, it is a There are additional challenges The higher the volume of business transacted cross-border, thinks ahead however. The Market in stark but simple choice. “If we are too Francotte,“the greater the need for the Financial Instruments Directive expensive the institutions would simply capital market’s back-office pipes to be (MiFID), which comes into force in avoid us. We have to keep reducing fees stronger and more robust, and at lower November 2007, is expected to end the and remove the incentive to cost.” If the NYSE were to merge with quasi-monopoly enjoyed by Europe’s disintermediate us.” It is a continuous Euronext or NASDAQ with the London stock exchanges and create a new set process – even now and across the range Stock Exchange, for example: “the of market paradigms. Article 34 of of Euroclear’s services. Euroclear Bank, question becomes how can a client of a MiFiD ensures that investment firms for example, reduced its safekeeping fees US exchange benefit from trading with in any member country have the right for international securities by some a European exchange member of access to clearing and settlement €20m in May this year, having operating in European time zones. If systems in another country, and all introduced a series of fee reductions either can trade outside normal hours, regulated markets must offer their totalling €50m during the previous three the question then becomes: how do we members or participants the right to years. Additionally its securities lending make available their cash or securities designate the system for the and borrowing fees were cut by €4m in without the loss of a day (due to time- settlement of transactions. “This will January while CRESTCo cut its fees for processing electronic order zone or post-trade book transactions by more processing timing The rise of algorithm-based trading, than 60% in the spring. differences)? We would Equally, Francotte thinks have to consider investing alternative trading platforms, cross-border that MiFiD also creates in greater interoperability mergers between stock exchanges and important opportunities. between Euroclear technological advancements are redrawing “Because MiFiD is setting and DTCC, according to the structure of stock trading, and all sorts of new rules, client demand.” inevitably clearing and settlement. “There governing areas such as Francotte emphasises are problems working with a CSD captured reporting and best that Europe’s securities execution, the directive will markets are undergoing within a vertical silo structure, but some invariably increase the focus substantive and structural of these structures will now be opening on settlement, not just the changes aside from the up,” concedes Francotte. cost of trading,” he says, intentions articulated by adding, “Therefore, traders the European Commission. The rise of algorithm-based trading, introduce more competition and drive will be asked tough questions about post-trading and will have to alternative trading platforms, cross- down costs,”Francotte maintains. Francotte believes that MiFiD will be a demonstrate an optimal post-trading border mergers between stock exchanges and technological significant agent for change. “Can it solution as part of the best-execution advancements are redrawing the change Euroclear’s role for stock- calculation. And it is in that context structure of stock trading, and exchange trade settlement? How much that you begin to understand inevitably clearing and settlement. stock-exchange business will be Commissioner McCreevy’s argument “There are problems working with a internalised by large trading firms? It is that MiFiD could also help change the CSD captured within a vertical silo too early to say, as many trading firms are post-trading environment.” Nonetheless, Francotte believes that structure, but some of these structures still considering their options. An will now be opening up,” he concedes. indication of the potential threat on post- McCreevy’s stance confirms the urgency But, it is within this wider context that trading firms is illustrated by the scenario that the European Commission places McCreevy’s approach and the wider that if large investment banks become on change. “He has not given the competitive picture begins to make internalisers of trading, will they not ask market a lot of time and has made clear sense and take shape. The most vital themselves: can I not do the same for that if what we do as a marketplace is issue, thinks Francotte, is clearing the post trading? That will put pressure on not good enough, the Commission will way for the customer to choose where service providers with uncompetitive or step in. Not only Commissioner

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

McCreevy, but also Competition Commissioner Kroes, has examined the industry and you can sense the development of a tactical coalescence of their powers,”says Francotte. Work on the dismantling of the Giovannini Group barriers has started to produce some good results, adds Francotte.“We all know what has to be done and that change will not happen overnight, but the plan is clear and already in the implementation stage.” Industry agreement has been reached on harmonising IT protocols, using ISIN codes for securities identification and common standards for settlement finality, for example. All of these

initiatives will help to integrate market and systems, and drive down costs by squeezing out unnecessary intermediary interventions”. Some progress, but not enough to say that the goal is within reach. Another important consideration that needs to be factored in is a recent announcement by the European Central Bank (ECB) proposing to process both securities and cash settlements within the euro zone on a single platform through common procedures. The European Central Bank announced that it was exploring further cooperation with central securities depositories (CSDs) and other market participants for this initiative. The

implementation of such a facility, which, according to McCreevy,“would be fully owned and operated by the Eurosystem [sic], could allow large cost savings as a result of the high level of technical harmonisation that this facility would entail for all market participants and would represent a major step towards a single Eurosystem interface with the market”. Francotte offers Euroclear’s view on the proposal by observing that “There are still too many unanswered questions about the ECB's proposal to offer a considered view on its ability to deliver greater settlement efficiencies for Europe. The scope, feasibility and cost to implement are still very vague.”

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Regional Review MIDDLE EAST: FUND RAISING

Debt issuance by local corporates has (to a degree) played second fiddle in a region dominated by an IPO and equity boom. That pattern looks to change however. A perceived lowering of political and credit risk, and improved corporate governance has fed growing issuer and investor demand for local debt paper; based around both Islamic and traditional structures. Additionally, increased volatility in local stock exchanges (where retail rather than institutional investors dominate) have combined to persuade companies looking for new capital to consider debt as the new security of choice.

Adel El-Labban, group chief executive officer (CEO) and managing director of Ahli United Bank in Bahrain. Photograph supplied by AUB, April 2006.

DEBT ISSUES TO THE FORE WASH WITH LIQUIDITY, issuers in the Middle East are increasingly spoilt for choice. Much more of the windfall profits from oil sales are being retained within the region than ever before. Reforms in both the financial and real estate sectors and an increase in infrastructure spending are attracting significant levels of retained capital. Additionally, local governments and regulators, such as the Bahrain Monetary Authority (BMA) are proactively promoting Islamic banking and finance, and are developing custom-built regulatory frameworks to support a more diversified local funding market. These changes have encouraged local entities seeking to raise money to keep their funding options open.“We are still studying all the options for financing our expansion projects,” Dubai World chairman Sultan Ahmed

bin Sulayem told local reporters earlier this summer. The Sultan was responding to rumours of an imminent combined listing of Dubai World subsidiary, DP World, the world’s third largest port operator, on both the London Stock Exchange (LSE) and the Dubai International Financial Exchange (DIFX). DP World’s approach is increasingly commonplace says Antoine Cahuzac, chief executive officer (CEO), Global Banking, HSBC Middle East Limited. Cahuzac thinks there are good opportunities now in the regions for banks to take on advisory roles in helping companies decide on whether equity or debt is the best route to market. “With equity they must have an equity story [sic] to tell to the market and talk about their ‘business case’. They must also consider which exchange, what sort of investor profile

they are seeking, what sort of distribution—local, regional, international—they want to achieve and the level of disclosure they are prepared to make. With the debt route, there is a question of what sort of debt structure, whether they want a domestic or international issuance and whether they want it to be Shariah compliant or conventional. There is much more for companies to consider than perhaps two or three years ago.” Local firms are increasingly going down the debt route: either utilising traditional debt or trying Islamic structures. Figures vary, but according to estimates by Barclays Capital; Middle East and North African borrowers raised a record $14.9bn worth of debt in 2005, a 70% increase on 2004. These figures look set to be dwarfed in 2006 with over $11bn being placed in the capital markets

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Regional Review MIDDLE EAST: FUND RAISING

over a three week period at the end of June and beginning of July. To put these figures in perspective, debt issuance in 2000 was a mere $3.9bn. “There is a big investor appetite for Middle East paper particularly from European and Asian investors keen to get exposure to markets such as Saudi Arabia and the United Arab Emirates (UAE),” says John Coverdale, managing director (MD), Saudi British Bank (SABB). Issuers in the region are increasingly looking to Islamic financing solutions according to Eisa Al-Eisa, managing director and chief executive officer (CEO) at Samba Financial Group. “Islamic bonds are increasingly seen as mainstream and Sukuk bonds that are open to foreign subscribers are not just attracting Middle Eastern and Asian investors, but increasingly European and US ones too.” Figures released by the Dubai International Financial Centre (DIFC), predict some $9bn of Sukuk bonds will be issued in GCC countries during the rest of this year. Meanwhile, figures from Bahrain’s Liquidity Management Center show that of the $18bn worth of outstanding Sukuk bonds in the wider region, just over 52% originates from GCC countries. Given that oil, gas and petrochemicals are the backbone of the Gulf economies, there has been a decisive lack of Islamic financing structures in these sectors. However, a $2.5bn project-financing package raised by Equate Petrochemical Company in Kuwait, which included sizeable Islamic tranches, to help finance the Greater Equate petrochemical project, is a notable exception to the rule. One reason is the lack of legal and regulatory frameworks that facilitate Islamic financial products. Most of the GCC countries, even Saudi Arabia, do not

Photograph of John Coverdale, managing director (MD), Saudi British Bank (SABB). “There is a big investor appetite for Middle East paper particularly from European and Asian investors keen to get exposure to markets such as Saudi Arabia and the United Arab Emirates (UAE),” says Coverdale. Photograph kindly supplied by SABB, August 2006.

Photograph of Antoine Cahuzac, chief executive officer (CEO), Global Banking, HSBC Bank Middle East Limited. Cahuzac thinks there are good opportunities now in the regions for banks to take on advisory roles in helping companies decide on whether equity or debt is the best route to market. Photograph kindly supplied by HSBC Bank Middle East.

have specific Sukuk laws: although Saudi Arabia is now passing legislation that will make Sukuk bonds easier to structure. These have to be backed up by trust laws and laws relating to the establishment of special purpose vehicles (SPVs) which are often used in Sukuk structures. Because of the complexity of the Sukuk bond, many corporates and banks have kept their distance, but as the region becomes more familiar with the structure, that nervousness will dissipate. Already, National Industrial Gases Company, an affiliate of petrochemicals giant Saudi Basic Industries (SABIC), has just signed a $320m Islamic loan agreement with Banque Saudi Fransi (BSF) to fund expansion of plants in Jubail and Yanbu. BSF will act as financial adviser and lead arranger for the facility. Governments and local issuers are beginning to take heed of the need to develop local debt markets. Also in July SABIC issued a 20-year Islamic bond to raise up to SR3bn ($800m). “The Sukuk was the first issued by a private Saudi firm and we hope will be a key step towards the ongoing development of the bond market here in the Kingdom,” says Coverdale at SABB, which holds a 40% stake in HSBC Saudi Arabia Limited. HSBC was the sole lead manager and book runner for the issue. Last year Dubai’s Ports, Customs and Free Zone Corporation (PCFC) had issued a benchmark $3.5bn Sukuk on the DIFX, and this was followed in June this year by the $460m Sukuk by the Aabar Petroleum Investment Company PJSC (AABAR). Nasser Alshaali, chief operating officer (COO) of the DIFX believes these issues are key milestones in the development of a regional market in Islamic bonds: “This is the second Sukuk to be listed on the DIFX. It reinforces the exchange as a

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Regional Review MIDDLE EAST: FUND RAISING Robert Eid, CEO and managing director at ANB in Riyadh.“We have a strong loan portfolio and financial fundamentals married with a conservative business strategy. This is reflected in our ‘A’ rating by Standard & Poor’s which in turn will translate into an attractive borrowing spread”. Photograph kindly supplied by ANB, August 2006.

listing destination of choice for Islamic securities as well as a wide range of equity, equity-linked, bond and other listings from countries across the region.” One of the most innovative Sukukas was Emirates Airline’s 2005 seven year $550m transaction, structured as a Musharaka (a joint venture) and listed in Luxembourg. Islamic finance is increasingly mainstream. “At first issuers were happy with small Islamic tranches;” explains Asad Zafar, managing director, Asset Finance Advisory Group, HSBC Amanah.“But over time the Islamic market has grown and the tranches have become bigger and bigger until now in most cases there is just the one jumbo tranche which is Shariah compliant.” Ehsun Zaidi, head of capital markets, Dubai Islamic Bank (DIB) thinks it opens an issue up

to more investors.“There is no stigma attached to Islamic bonds by international investors so a Shariah issue has the benefit of being open to the widest possible audience.” According to Philip Southwell, head of banking, CEMA, Deutsche Bank, there is also now little if any difference in the cost of funding between a Shariah and a conventional issue. ”The gap between them has now closed significantly and as more and more Islamic issues come to market there should eventually be no funding differential at all.” DIB’s Zaidi believes that in most funding cases the gap has already closed and is one of the primary reasons for annual growth in issuance of 100%. “This year we expect $5bn of new international Sukuks, up from $2bn to $2.5bn in 2005. While there is currently $16bn of outstanding international Sukuks, by the end of 2007 we expect this figure to rise to $30bn.” The sheer weight of the region’s infrastructure spending requirement will encourage a more diversified funding base. It is not just companies which require international funding as the international markets will increasingly be required to help meet a potential shortfall between local funding requirements and the large number of projects planned for the region. Industry estimates suggest Middle East companies are likely to execute projects worth $1trn over the next 10 years, in infrastructure, energy and property. As much as 70-80% of that could be raised through debt. Qatar alone will need $130bn in investment over the next seven years to develop its natural gas industry. “There is likely to be $200bn worth of projects that have been announced and are likely to come to fruition in Saudi Arabia over the next five years and whilst much of that will and can be funded by the government a

Eisa Al-Eisa, managing director and chief executive officer of SAMBA Financial Group.

large proportion of that will undoubtedly have to be raised on the international bond markets,” agrees SAMBA’s Al-Eisa.

Traditional debt structures Meanwhile, local financial institutions have dominated international bond issuance from the region, accounting for 39% of total volume and have usually opted for floating rate notes (FRNs) in European Medium Term Note (EMTN) programmes. One of the first UAE banks to tap the European markets was Emirates Bank which now has $2.4bn of outstanding debt following four issues as part of its $3.5bn EMTN programme. At the end of July, Emirates Bank International announced plans to raise up to $250m during the remainder of 2006 through privately placed medium-term loans to fund further growth. The loans will be broken down in issue sizes ranging between $20m and $50m and floated in different markets, currencies and maturities.“The primary drivers in our lending programme are to diversify our funding base and to align more

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Regional Review MIDDLE EAST: FUND RAISING

facilities. AUB is already listed on the closely the terms of our funding to the and the rest international.” Arab National Bank (ANB), for Bahrain Stock Exchange (BSE) and in length of our lending,” says John Eldredge, general manager, Group instance, looks likely to be the fourth June 2006, it was listed on the Kuwait Treasury, Emirates Bank. “We Saudi bank to approach the Stock Exchange (KSE). “We are traditionally lend long, through international debt markets and is currently seeking a third listing in corporate and projects loans, likely to seek up to $1bn in the third Qatar. As a regional bank, we are keen mortgages and personal loans. quarter of this year. Riyad Bank, SABB to list on the exchanges of the Gulf However, the longest notice period on and SAMBA, all have EMTN countries in which we operate to a savings account is likely to be 90 programmes. “Spreads are very allow as many of our customers as days at most.”The bank’s fourth (and attractive and we are keen to take possible to become shareholders and most recent issue) was priced in Euros advantage of this before the end of the benefit from the bank’s success.” BankMuscat took another capitalrather than US dollars, which resulted year,” suggests Robert Eid, CEO and in the bank achieving a much broader managing director at ANB in Riyadh. raising route when in October last year investor base notes Eldredge.“Around “We have a strong loan portfolio and it became the first organisation from 50% of the investors had not invested financial fundamentals married with a Oman and the first bank from the in the bank’s previous issues,”he says. conservative business strategy. This is GCC region to have its Global Depository Receipts The ability of banks and (GDRs) listed on the LSE. companies to raise “We already have an international paper has Arab National Bank (ANB), for instance, ongoing EMTN been greatly enhanced by programme but we also improving credit ratings looks likely to be the fourth Saudi bank to wanted to expand our and higher levels of approach the international debt markets equity investor profile from corporate governance and is likely to seek up to $1bn in the outside the region,” across the region. third quarter of this year. explains K. Gopakumar, “Traditionally perhaps Bank Muskat’s general there was a concern manager of wholesale amongst the rating agencies about political stability in the reflected in our ‘A’ rating by Standard banking. Originally seeking only region and a lack of regulation”thinks & Poor’s which in turn will translate $150m the final issue was raised to $163m after the issue was Cahuzac. “In recent years, however, into an attractive borrowing spread”. Ahli United Bank (AUB) is an oversubscribed with orders of over the political stability of the region has been proven through a number of experienced and highly diversified $1.5bn. Gopakumar thinks much of smooth leadership successions. issuer in the global capital markets. the interest in both their GDR and Additionally, business regulation has “Over the last four years the bank has their EMTN programme is due to their improved and growth rates are well raised over $1.1bn through two rights strong growth story.“Investors want to supported by high oil prices. Rating issues, one subordinated debt private know that you are going to use the agencies are now far more placement; one convertible preference capital for growth whether it is comfortable operating and assessing share issue and a lower tier II financing aggressive international risk in the region, with a net result of subordinated FRN. Using multiple expansion plans into markets such as higher ratings and an increase in the issues and different financial Saudi Arabia or whether it is helping number of rated companies.” instruments, has allowed us to access to strengthen a position in the Although a rating is not required for different markets and diversify domestic market in growth areas such an international placement it does investors while minimising earnings as funding small and medium sized have an impact on its attractiveness to per share (EPS) dilution”explains Adel companies (SMEs). Investors want to international investors according to El-Labban, AUB’s Group CEO and know the capital is going to be put to DIB’s Zaidi.” On an unrated basis, we MD. In addition, AUB has raised $900 good use.” In a region where mega-projects are find most investors (roughly 70%) are million in senior commercial debt from the Gulf. For rated issues on the finance for the parent bank and its UK grabbing the headlines the funding of other hand the ratio is reversed with and Kuwait subsidiaries during the SMEs is an area often overlooked only 30% tending to be local investors same period through syndicated loan believes Riyad Bank’s President and

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Regional Review MIDDLE EAST: FUND RAISING

CEO, Talal Al-Qudaibi.“If you look at most successful economies around the world the bulk of growth comes not just from large multi-nationals but from small dynamic companies. Some of those will always remain small but others will eventually grow to become the large multi-nationals of tomorrow. We want to fund those companies from their first day of business all the way through to their IPO and beyond. It is these small companies that must be supported to create healthy diverse economies which can sustain growth and employment long term.” Where local banks have led, the region’s large international corporates have followed. “While demand by European and Asian investors is so high it makes sense for those companies with significant international earnings to raise capital in foreign currencies on the international markets,” thinks SAMBA’s Al-Eisa. “This option however is only likely to be open to the region’s blue-chip firms international investor appetite is likely to be a lot less for smaller or less well known organisations,” he acknowledges. A number of the region’s big players now have wellestablished capital raising programmes. In 2004 Emirates Airline, the regions largest, issued its debut $500m Eurobond issue listed in Luxembourg. At the time the seven year, FRN paying 0.8% over six month Libor was the largest ever unrated Eurobond issue by an airline and the largest ever unsecured corporate issue in the GCC. In June this year Emirates raised S$400m with its debut Singapore Dollar bond issue comprised of three tranches over five and ten year terms.

Local Markets While Middle East Firms are successfully tapping the international

bond markets, the fund raising in the primary role in most issues would be local markets have been slower to as an investor once a deal had been take off. One of the problems has structured by one or more of global been the lack of government issues. banks. Over the last 24 months, this “Governments in the region are flush role has been reversed. DIB now with funds. Income from high oil originates and structures many of prices is being used to pay down these transactions, sometimes as sole before inviting the debt,” explains Al-Eisa. In addition, arranger, the GCC domestic bonds markets are international banks to join us. ” Gopakumar has traditionally an illiquid buy and hold BankMuscat’s market, which in turn creates a lack of witnessed a similar process in Oman, liquidity and consequently pricing “It is about moving up the value history in the secondary market.“It is chain,”explains.“We are now involved very important that government’s in most if not all major projects in start issuing debt either through Oman from the very start.” In Saudi raising their own paper or by Arabia Al-Qudaibi believes that an encouraging state-backed evolution has taken place ” At Riyad organisations to issue thereby creating Bank we have been funding local a benchmark for the private sector,” businesses for many years and as their believes Declan Hegarty, managing funding requirements have changes director of global investment banking so our expertise has evolved to meet at HSBC in Dubai. If the local bond those needs.” market does develop further says DB’s Southwell it will reduce the need for international funding. “At levels of $60 to $80 a barrel for oil there is no shortage of funding for projects. What is missing are the instruments that will allow significant amounts of that capital to be recycled back into the region.” As the region’s debt markets deepen, so to do the capabilities of local banks. Zaidi at Riyad Bank’s president and CEO, Talal Al-Qudaibi. DIB, which was a “If you look at most successful economies around the world lead-manager on the the bulk of growth comes not just from large multiPCFC Sukuk believes nationals but from small dynamic companies. Some of those there has been a seawill always remain small but others will eventually grow to change in the levels of become the large multi-nationals of tomorrow. We want to expertise in local fund those companies from their first day of business all the financial institutions. way through to their IPO and beyond,” he says. “Even as recently as Photograph kindly supplied by Riyad Bank, August 2006. three years ago, DIB’s

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Regional Review WESTERN EUROPE: LUXEMBOURG

CITS III, COUPLED, with the growth of open architecture has resulted in a proliferation of funds listed in Luxembourg. During the past three years, the country has enjoyed annual double digit growth, with assets in Luxembourg-registered portfolios jumping 20% during 2005, according to a recent survey by Lipper Fitzrovia, the United States-based research firm. Lipper’s report revealed that total net assets for all Luxembourg funds jumped to almost $1.8bn at the end of last year from $1.5bn in 2004 while the total number of individual funds climbed from 7,777 to 8,434 and the number of stocks funds, which had dropped during the previous two years, rose to 2,997 from 2,909. Figures like these place Luxembourg as the world’s second largest investment fund centre, behind the US. Moreover, the country has cemented its position as Europe’s main cross border distribution hub with a 77% chunk of the UCITS III pan-European action. The numbers sound impressive, but the Grand Duchy knows it cannot rest on its laurels. Complacency was part of the reason that allowed Dublin to steal a march on the country in the hedge fund arena. It is ironic perhaps that Luxembourg had been dragging its heels, given that it was the first country to translate the UCITS directive of 1985 into national law. It also led the way on the UCITS III with legislation coming into force in 2002. Perhaps the collapse of high flying hedge fund group, Long Term Capital Management (LTCM) in 1998 left a bad taste in the fund management industry’s mouth and (because of it) Luxembourg was slower off the mark than Dublin in embracing hedge funds once they recovered from their fall from grace. As Didier Prime, a partner at PriceWaterhouseCoopers in Luxembourg, notes, “Many people

Didier Prime, a partner at PriceWaterhouseCoopers in Luxembourg, notes, “Many people including the regulators were not that keen to implement hedge fund legislation because of LTCM. It took time to convince the regulators that a new framework needed to be created while Dublin had already moved forward two to three years earlier.” Photograph kindly supplied by PriceWaterhouseCoopers, August 2006.

LUXEMBOURG

FIGHTS BACK Luxembourg is determined to maintain its stronghold as Europe’s pre-eminent offshore financial centre even as Dublin continues to bite at its heels, especially in the hedge fund space. The Grand Duchy is fighting back with new legislation and a more flexible framework to entice business. The biggest challenge for both centres is recruiting and retaining high quality staff who can meet today’s ever changing and complicated investment fund industry. Lynn Strongin Dodds reports.

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including the regulators were not that keen to implement hedge fund legislation because of LTCM. It took time to convince the regulators that a new framework needed to be created while Dublin had already moved forward two to three years earlier.” Vincent Beaujeu-Dumontel, product manager at Caceis Bank Luxembourg, adds, “Luxembourg slipped behind Dublin in the late 1990s because it did not realise as early as Ireland did that the hedge fund business was going to boom again. It came to a head in 2000 when the stock market crashed and the country realised that investors were looking more at alternative asset classes such as hedge funds and private equity to invest in.” By the time The Commission de Surveillance du Secteur Financier (CSSF) published an investment circular in 2002, clarifying its rules for Luxembourg domiciled hedge funds, Dublin had already carved out a substantial niche. Popular offshore hedge fund centres such as the Cayman Islands, and to a lesser extent, the British Virgin Islands (BVI) and Bermuda, had turned to the Irish Stock Exchange and Dublin’s service providers, respectively to list their funds and for their back office administration requirements. Not wanting to be left out in the cold, the CSSF cranked up the regulatory machinery a few notches in 2004 and lifted a major barrier by allowing the Luxembourg Stock Exchange to list foreign offshore funds including those established in Cayman and BVI. In the past, it was a time consuming and complex exercise. Now, a hedge fund provider wanting to list on the Luxembourg must belong to a group regulated and supervised in its home country. It also needs to publish an annual and semiannual report with annual financial

statements audited by an approved auditor. Also, specific risk diversification and risk disclosure parameters must be adhered to. However, in an effort to compete more effectively with Dublin for retail alternative asset products, there is no investor category or minimum investment limitations. Luxembourg’s hedge fund industry should get a further boost from legislation which is currently being drafted to replace a 1991 law on institutional investment vehicles. The new rules propose to extend the provisions of Sociétés d’Investissement en Capital à Risque (SICARs), or risk capital investment companies, such as the qualified investor, to hedge funds. SICARs, which are already used for private equity and venture capital structures, are regulated entities but with a lighter touch. Unlike other Luxembourg regulated structures there is no need for approval of the promoter and the investment manager, both of whom SICARs can also be very flexible. For example, there are no investment diversification requirements and normal rules on the paying in and return of capital are relaxed to avoid cash being trapped in the structure. “Luxembourg may have been slow at first to respond to the threat Dublin posed in the hedge fund industry, but the minute the government realised that business on the alternative side was starting to move, it reacted. The regulators demonstrated a flexibility and willingness to recapture the sparkle of the hedge fund and other alternative business,” according to Tina Wilkinson, executive director of BNP Paribas Asset Management and board member of Association of Luxembourg Fund Industry (Alfi). Despite the progress being made, it will take time for Luxembourg to catch up with its Irish rival. According

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to figures from Alfi, the country is home to about 39 providers of administration services to hedge funds and funds of hedge funds. At the end of 2005, there were 363 funds of hedge funds domiciled and/or administered in Luxembourg, accounting for assets of about €72.3bn ($90.7bn), a hike of 31% over €54.6bn ($68.5bn) in 2004. Assets of the 264 single manager hedge funds under administration clocked up a far more impressive growth rate of 131% to €39.7bn ($37.3bn) in 2005 from €12.9bn ($16.2bn) the previous year. Although there are no official figures on Dublin’s alternative investment industry, a recent survey published by the Dublin Funds Industry Association last December showed that the net asset value of alternative funds serviced more than doubled between March 2003 and June 2005, from $199bn to $474bn. Hedge funds were the largest component with. Single manager hedge funds accounting for $289.1bn or 61% of the total alternatives pool while funds of hedge funds represented $150.1bn or 32%. Prime of PWC believes the regulatory developments will make Luxembourg an even more appealing centre for hedge funds as well as other alternative assets. “It was important for the country to revamp its regulatory framework and introduce the qualified investor concept for the development of the hedge fund business. The difficulty in listing offshore funds on the exchange was widely seen as a disadvantage for the Grand Duchy by comparison with Dublin, but the listing of offshore funds to the Luxembourg Stock Exchange is now effective and very quick. However, in general, I believe there is enough business to go around for both Dublin and Luxembourg, and it is important

Regional Review WESTERN EUROPE: LUXEMBOURG

for administrators and fund promoters to have a choice.” Luxembourg is mainly known as a retail market for continental Europeans mainly due its geographical location and highly skilled and multi lingual workforce. Dublin, on the other hand, cut its teeth on money market structures and more recently alternatives. It is a favourite with the Anglo Saxon institutional crowd who prefers dealing culturally and linguistically with English speaking people. The differences, however, are beginning to blur. Geoffrey Cook, managing director of Brown Brothers Harriman (BBH) Luxembourg, says, “historically Dublin has had more institutional business and been known for money markets and alternatives. The country has had a large number of US promoters perhaps due to language and more familiar legal framework. Luxembourg was better known for cross border retail products, particularly those distributed in continental Europe. This more or less held true, if a little stereotyped, until the last couple of years. One of the main differences in the industry today is a significant broadening of and relative importance in investment in so-called alternative asset classes. This has led to a boom in new products such as real estate and private equity funds, liability driven investment vehicles, derivative funds, as well as tax look through structures including pension pooling. A further significant change is the emergence of the wholesale distributor substantially blurring the historical lines of retail and institutionally invested funds.” Looking ahead, it is doubtful that Luxembourg will lose its grip on the pan European cross border business. As Ian Baillie, managing director of Northern Trust’s Luxembourg office,

The Grand Duchy knows it cannot rest on its laurels. Complacency was part of the reason that allowed Dublin to steal a march on the country in the hedge fund arena. Photograph kindly supplied by istockphotos.com, August 2006.

points out, “It is costly to establish, manage and administer separate multi jurisdictional funds. As a result, a fund management company would prefer to develop a new product within its existing flagship range domiciled in Luxembourg instead of creating a completely new and separate fund for a particular country.” The Grand Duchy is also hoping to widen its circle and has been proactively marketing its fund administration wares to a wider audience in Asia and Latin America. The country has worked hard over the years to develop a certain cache and its efforts are paying off. Mark Kerns, managing director of fund management services in Europe at Bank of New York, notes “in the past two to three years, Luxembourg has made a big push to become a full service centre across multiple asset classes not just in Europe but across the globe. The country has long ago

shaken off its image of bank secrecy and has established a reputation as a stable, well regulated and innovative financial centre both here in Europe and internationally.” In order to keep its triple A rating, though, the Grand Duchy will have to persuade the best and the brightest to stay within its borders. Historically, both Dublin and Luxembourg have experienced a great deal of turnover in fund administration staffing as people gain experience and want to move up the ladder to the potentially more lucrative front office in the UK and US. Also, as a small country, it has to rely on the talent pool of its neighbours, particularly from Belgium, France and Germany, to fill its workforce ranks. Ravi Thakur, general manager of ABN AMRO Mellon Global Securities Services in Luxembourg, believes the Grand Duchy will only retain its competitive edge if it can attract and retain talented people. “The key to Luxembourg’s success is its brand name as well as the knowledge base and expertise it has built over the years. The biggest challenge facing the industry is resource constraints. Although the problem is not as bad as in other financial centres, Luxembourg has experienced high staff turnover and tightness in recruitment and it needs to be addressed through new recruitment sources and greater automation.” Cook of BBH agrees, adding, “They may be working in the back office but the increasing breadth and depth of an increasingly more complex product range means that we need people who are highly skilled. It is not that easy to find the appropriately qualified people to support this burgeoning product base. As a result, BBH is investing heavily in training and developing our own people to be able to support these products.”

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Jos Stoop, vice president and general manager of financial services solutions at Interwoven. Photograph kindly supplied by Interwoven, August 2006.

KEEPING UP WITH THE FRONT OFFICE Back offices are racing to catch up with front office traders in the OTC derivatives market. After regulators sounded the alarm about escalating paperwork backlogs three years ago, participants have speeded up trade processing for ‘plain vanilla’ versions of these exotic products even as trading volumes and outstanding notional balances have soared. Yet the struggle to keep up never ends. As fast as one instrument becomes standardised and trade settlement automated, product developers create something new that requires custom documentation. Neil O’Hara reports.

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OTC DERIVATIVES TRADING

ERIVATIVES SETTLEMENT SYSTEMS today are comparable to equities 15 years ago, according to Dushyant Shahrawat, research director at Tower Group, a financial services research firm based in Needham, Massachusetts. He estimates that for every $2 firms spend on front office technology development in equities they spend $1 on the back office. In derivatives, it’s closer to $5 on the front end for every $1 in processing.“The industry just has not invested in back office infrastructure,” says Shahrawat. Unconfirmed trade backlogs in credit defaults swaps (CDS) have been regulators’ top priority even though the $17trn notional balance is a mere fraction of the $213trn interest rate swaps market.The products’risk profiles are quite different, of course. In most interest rate swaps, the parties exchange fixed and floating rate payments and settle their mutual obligations quarterly. If one party defaults, the counterparty’s exposure is limited to the difference between the two rates since the last settlement, plus the transaction costs to replace the swap with a new counterparty. By contrast, CDS are a form of insurance. The buyer pays a premium to insure against a possible credit event: a rating downgrade or default by a specific borrower unrelated to the counterparty. If the borrower does default, the seller must make the buyer whole for up to the entire principal amount covered by the swap, a payment orders of magnitude greater than 90 days’worth of any likely interest rate differential. With CDS balances doubling every year, regulators worry that a major credit default could drain a swap counterparty’s capital and ripple through the financial system. Participants appear to have made huge progress since the clarion call went out. The 2006 Operations Benchmarking Survey by the International Swaps and Derivatives Association (ISDA) found that 50% of CDS confirmations went out by T+1 in 2005, up from 25% in 2003. Getting a confirm out the door is only the first step, however. The details still have to be matched with a confirm from the counterparty before the trade can settle. That is where the Depository Trust & Clearing Corporation (DTCC) has stepped in. In early 2004, DTCC launched its Deriv/SERV electronic matching and confirmation service for OTC derivatives. Janet Wynn, managing director and general manager for Deriv/SERV, says DTCC worked with the industry to identify the 20-odd critical economic trade terms out of about 160 data fields in ISDA’s long form agreement. When a trader has filled out those key fields the system generates a confirm, the equivalent of a signed fax. If the counterparty’s entries match, the trade proceeds to confirmation, otherwise the system flags unmatched fields for correction. The service caught on at once. DTCC now has more than 500 Deriv/SERV customers in 25 countries. Wynn says dealers estimate at least 70% of all CDS trades worldwide now flow through the platform. That success derives in part from the system’s flexibility; it allows interfaces of varying sophistication from direct links to basic batch files. DTCC works with about 20 other vendors, including e-trading platforms such as TradeWeb, MarketAxess and Creditex, to provide access.

OTC DERIVATIVES TRADING 44

Janet Wynn, managing director and general manager for Deriv/SERV. Photograph kindly supplied by DTCC, August 2006.

Dushyant Shahrawat, research director at Tower Group. Photograph kindly supplied by Tower Group, August 2006.

In the latest twist, DTCC has added a post-trade affirmation service for CDS, called AffirmXpress, in conjunction with three leading interdealer brokers—namely, GFI Group, ICAP, and Tullett Prebon. Instead of all three parties having to enter matching trade details, the broker enters details only once and submits them to the two dealers for review. The trade is either kicked back to resolve differences or (if the dealers agree) is affirmed and then confirmed through Deriv/SERV. DTCC can get involved only after a product has gained wide acceptance in the market, however. A new product has to generate sufficient volume for ISDA to create master confirmation documents and related Financial Products Markup Language (FpML) [sic] protocols. The market has to adopt those documents, as well. “We do equity options and equity swaps on our platform,” Wynn says, “But there is less market penetration of master confirmation agreements so we have lower volumes.”She notes that ISDA has accelerated its standard setting in recent years; its working group gets involved earlier in the product life cycle and coordination between legal and operations teams has improved. The volume of unconfirmed trades may exaggerate the credit risk, according to Karel Engelen, policy director at ISDA. A valid contract exists whether or not both sides have signed the confirm, after all, so firms will sign off only when every detail is correct.“You can get a difference in payments,” Engelen says, “It takes a lot of operational effort to settle these breaks even if the ultimate dollar amount is small.”He points out that banks look at other factors to measure risk, too: whether the counterparty is a regular trading partner or any payments have changed hands, for example. Kevin Sauls, president of KGS Financial Inc, a New York-based consultancy specialising in enhancing derivatives operational controls and training, faults securities firms for not spending enough on qualified operations staff, training and technology. “Although technology is essential, it can not replace proficient and experienced people,”he says,“The traders who have to pay for this do not always see the benefits.” From his experience cleaning up back office disasters, he is

John Burchenal, managing director of asset class expansion at Omgeo. Photograph kindly supplied by Omgeo, August 2006.

convinced that, despite ISDA’s best intentions, survey participants paint an overly optimistic picture.“Who wants to admit they have problems?”he asks,“They are not going to go out there and air their dirty laundry.” Trade processing is only part of the picture anyway. Behind every OTC derivative trade is a contract, either on paper or in electronic form. Somebody has to keep track of those contracts, which is where Interwoven’s Scrittura solution comes in. Its end to end document management system can handle everything from vanilla transactions that are DTCC eligible to paper and FpML. “You can see every confirm you ever generated or received all in one place,” says Jos Stoop, vice president and general manager of financial services solutions at Interwoven. He believes backlog problems typically emerge in the first year or two of a product’s life. Whenever a new instrument is introduced, it involves paper documentation and manual processing. As volume builds, ISDA jumps in to create document templates, but market participants may still modify them. Only when dealers agree to use standard forms can clearing services automate trade processing, Stoop explains. Despite the progress in automating CDS settlement, he expects processing backlogs to persist for some time. “It’s not as though at this point all they have to do is keep track of the new products that come out,” Stoop says,“There are backlogs in equity and commodities derivatives, for example. They haven’t dealt with the existing problems that are building yet.” No matter how hard the industry tries to automate settlement, John Burchenal, managing director of asset class expansion at Omgeo, expects some transactions will always settle manually. By the time a product qualifies for automated trading and settlement, it has become a plain vanilla instrument with high volume and lower profit margins for Wall Street.“Dealers are working as fast as they can to develop new, more sophisticated products as a way to differentiate themselves and make money,” Burchenal says, “There is always something new coming down the pike.” Like Sisyphus, the OTC derivatives industry is forever condemned to push the settlement rock uphill.

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

The International Securities Exchange (ISE) posted record profits in the second quarter of this year as the electronic options exchange gained a stack of new institutional clients as it steadily builds its lead over most of the competition, though not yet (it has to be said) the Chicago Board Options Exchange (CBOE) against which, the ISE is in a head to head race for market dominance. Nonetheless, a pugnacious ISE has seen a steady increase in volume, backed by an acquisition and a raft of new business initiatives at home, including the launch of a new stock exchange. ISE is also casting abroad for long term expansion. Francesca Carnevale reports. HE ISE AND the about-to-demutualise Chicago Board Options Exchange (CBOE) took the lion’s share of US options trading in July as volumes scaled to new heights and capped what looks to be a banner year for the options market in general and the ISE in particular. The CBOE maintained pole position for overall options volume with a 34.4% market share in July, ahead of the ISE’s 29.7% (compared with 31.8% and 28.4% respectively in June); although it should be noted that the CBOE’s trade is boosted by exclusive rights to popular US equity index options contracts, such as the S&P 500; a fact that the ISE has long railed against. Even so, the ISE has marked 2006 with a series of bold initiatives and a widening market vision that could set the exchange on an even more prosperous path over the coming decade.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

In part, the ISE’s growing success is down to rocketing trading volumes on all six US options exchanges. According to the Options Clearing Corporation (OCC), the issuer and registered clearing facility for all US exchange-listed securities options, even after a three year upswing, there is no sign of cooling off in the options market. Combined, the exchanges traded a reported 154.6m contracts in July, up 36.9% on July 2005. Last year broke all previous trading records, with 1.5bn contracts traded, according to the OCC, but this year looks to be another winner, with 1.16bn contracts traded already by the third week of July— up a massive 43.7% on the same period last year. In this already heady climate, the ISE also reported a record average daily volume of 2.4m contracts, up 49% on the same period last year. In a recent analysts briefing ISE president and chief executive David Krell explained ISE’s strategy, which is focused on growing its institutional business while adding complex order types, tailored for sophisticated strategies, and “premium” products, including a number of new index options. That has involved a consistent investment in new technology. In the summer, the ISE rolled out its latest initiative: a new front-end trading application for brokerdealers to access ISE’s markets, called PrecISE that includes embedded market statistics, order tickets, new pricing fields for delta neutral orders, newer and more complex order book filters. PrecISE also allows users to tap into liquidity on other options exchanges from a single workstation. According to Gary Katz, ISE’s chief operating officer. “PrecISE offers a fast and flexible way to support smarter trading across multiple markets through one interface.” Most importantly, PrecISE provides a basic building block for future service enhancements. These enhancements

COVER STORY: THE INTERNATIONAL SECURITIES EXCHANGE

LET THE GOOD TIMES ROLL

COVER STORY: THE INTERNATIONAL SECURITIES EXCHANGE 46

include initiatives such as Longitude, the exchange’s derivatives risk transfer platform, which it bought in April this year and which is also partially owned by Goldman Sachs; as well as the ISE’s plans to launch ISE Stock Exchange. Goldman Sachs has been using the Longitude platform since 2002 to clear risk and build liquidity for a range of auction products. Currently the products offered include options on economic data in partnership with the Chicago Mercantile Exchange (CME) and options on certain energy market statistics in partnership with Icap Energy and the New York Mercantile Exchange (NYMEX). The ISE has also launched a raft of new products, including quarterly options and options on exchange-traded funds that track major equity indices. Initially, the exchange will offer quarterly options expiring on the last trading days in September and December 2006, plus March, June, and December 2007 in a one year pilot program of quarterly options based on five Exchange Traded Funds (ETFs) including the Standard & Poor’s Depositary Receipts, Nasdaq-100(R) Shares, Diamonds (R) Trust Series 1, iShares Russell 2000(R) Index Fund (IWM), and Select Sector SPDRs - Energy “The quarterly expiration structure allows our customers to better align options expirations with their equity trading practices,”says Krell. Earlier this year, the ISE also launched two sets of index options; one set of cash-settled index options based on the FTSE 100 Index and the second set which trade on the FTSE 250 through innovative “Mini” contract structures whereby the Mini FTSE 100 and Mini FTSE 250 indices represent 1/10th of the value of the full-size FTSE 100 and FTSE 250 Indices. The FTSE 100 Index comprises the 100 most highly capitalised blue chip companies on the London Stock Exchange, representing approximately 80% of the UK market. The FTSE 250 Index is a capitalisation-weighted index of the most highly capitalised companies outside the FTSE 100. Constituents are selected quarterly as the 101st to 350th largest companies listed on the exchange. The products are significant in that it is the first time that FTSE 100 Index and the FTSE 250 Index options have traded electronically in the US. As the options market grows in stature, so does the competition between exchanges. Hotting up throughout the year is the growing competition between the ISE and the CBOE in particular; and in large part, initiatives by both exchanges are helping to deepen and restructure the market. It seems to be working. While the relative positions of the CBOE and the ISE remain relatively stable, both exchanges have continued to attract market share at the seeming expense of the American Stock Exchange (Amex) and the Boston Options Exchange, while the New York Stock Exchange’s Arca appears to have stabilised its nearly 10% share, according to OCC figures. In part, this change is being driven by new entrants. Historically, retail and active traders have been the main participants in the US options market, but institutional investors appear to be moving into the options market, in

large part due to the rising need to hedge risk. Krell told the analysts that the volumes derived from the exchange’s “institutional functionalities [sic] accounted for approximately 21% of our total average daily trading volume for the quarter.” In an interview with FTSE Global Markets, Krell explained that accelerating growth in demand for risk management and profit enhancement strategies, as well as new products, “in a period of increased volatility” should bode well for the exchange’s “continued growth in the institutional space.” Even so, notes Krell “the institutional portion remains small and growth in this particular aspect of the market is still in its infancy.”Over the longer term, adds Krell, the ISE’s business development desks will increasingly target the buy side of the business, “mainly hedge funds, through outreach programmes and seminars”. Additionally, the exchange has implemented additional functionality“that will appeal to institutional investors, such as stock and options trading together,”he explains. In fact, the ISE plans to enter the equity trading arena directly in the autumn through the ISE Stock Exchange, which ISE is launching in partnership with several Wall Street firms. The new equity market will start with a crossing platform, called MidPoint Match (MPM), in the autumn and offer a full electronic order book by the end of the year. MidPoint Match is a continuous, instantaneous, fully automated and anonymous matching platform that will automatically sell equities at the midpoint price of the national best bid and offer throughout the day. This structure will allow traders to benefit from continuous price improvement. ISE says the patentpending MPM trading platform will match and execute all round lot orders and is especially suited for orders generated by algorithms. Users can access MPM via their existing trading platforms and protocols, including FIX. ISE says the benefits to users include complete anonymity and the elimination of spread and market impact. Traders will maintain control over how their orders are managed, while taking advantage of the ability to access non-displayed liquidity. At the end of July the ISE announced that Nomura Securities, E*Trade Financial and Van der Moolen acquired stakes in its new electronic equities trading operation. The new investors join Bear Stearns, Citadel Derivatives, Deutsche Bank, Interactive Brokers, JPMorgan, Knight Capital and Sun Trading as minority owners of the new ISE Stock Exchange. However, the ISE will retain 51% ownership. These original investors have contributed $32m in capital to the project and will provide order flow and liquidity, while Nomura Securities, E*Trade Financial and Van der Moolen, will reportedly invest a further $11m in the venture. Krell says:“We have built a fully electronic exchange from the ground up that will promote competition, foster innovation, improve the overall market and transform the way that equities are traded.” The ISE is unlikely to have it all its own way. Only four days after the ISE announced the new raft of shareholders in the stock exchange, the CBOE released the news that it is teaming with a group of dealing firms to launch a rival securities trading marketplace. Like the ISE Stock Exchange project, CBOE is partnering with a number of broker-dealers to

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

launch the new marketplace; some of them the very same shareholders that are in ISE’s project. Interactive Brokers, LaBranche, Susquehanna International and Van der Moolen will collectively hold a 45% in the CBOE Stock Exchange (CBSX), which will be based on the exchange’s existing hybrid market model that combines elements of both screen and floor-based trading. CBSX is expected to launch early next year and will provide a venue for the trading of New York Stock Exchange (NYSE), NASDAQ and American Stock Exchange listed securities. Other than this, the interesting element in the battle between the ISE and CBOE to dominate the future of options trading is the CBOE’s decision to maintain a trading floor. The reluctance to give up a physical floor flies in the face of initiatives elsewhere to switch to all-electronic trading. The CBOE argues that its hybrid trading system has been highly successful in the extremely competitive US options industry; something that cannot be denied, as market share of total industry volume increased seven percentage points during the first half of this year, climbing from 30% in January to 37% at the end of June. There is a sense that the ISE is a young buck to the CBOE’s long experienced steer; with the former giving the long established Chicago exchange much to ponder. The ISE only launched the first fully electronic US options exchange in May 2000—the first registered exchange approved by the US Securities and Exchange Commission (SEC) for some thirty years. Founded by a pair of ex-New York Stock Exchange executives, David Krell and Gary Katz, the ISE turned the US equity options market on its ear with a then new paradigm: the first fully electronic options market. Since its debut in May of 2000 and trading only a handful of equity options, over the intervening years ISE has proved to be a formidable challenger to other US options exchanges tied to traditional trading floors. In the trend setting mood of the time, ISE announced its intentions to list only those options that represented 90% of industry volumes, prompting the multiple-listing of the most liquid options classes. It was a canny , in turn, improved prices and broke up the franchises that had enabled the floor-based exchanges to exclusively list options on most blue-chip stocks. ISE now ranks as the country’s second leading options trader, after the CBOE, though the ISE now has the edge on its Chicago competition in equity options. ISE was founded on the principle that technology fosters and infuses new efficiencies and operational innovations into securities trading, says the exchange’s official marketing blurb. “By creating a new market structure and eliminating the high overhead costs associated with a traditional floor exchange, we have been able to attract significant trading volume,” explains Krell. ISE’s business model attracted well-capitalised global financial institutions to join as members, he explains. “These firms previously viewed participation in the options market as costly and inefficient.”

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Photograph kindly supplied by ISE, August 2006.

In 2003, ISE implemented the technological and regulatory foundation to trade index options, which allowed the ISE to expand its product base. ISE also launched the ISE Sentiment Index (ISEE) that measures opening customer transactions in call and put options, providing investors with information on true customer buying and selling activity. “2003 was a significant year, in which we noted the first stirrings of institutional adoption of options,” notes Krell.“Our strategy to grow our institutional business and our premium products has proven to be successful and we continue to make solid progress. We will continue to focus on both of these areas as we further grow our business and build upon the momentum that we have achieved to date,”adds Krell. The ISE went public on March 9th, 2005 in a modestly sized offering, which involved 10m shares of the exchange’s common stock. Joint-book runners for the IPO were Bear Stearns and Morgan Stanley. Goldman Sachs, Banc of America Securities, Deutsche Bank Securities, Merrill Lynch and UBS Investment Bank co-managed the offering, which received $67m in proceeds. Put in context, the ISE generated $155.9m in total revenue in 2005, compared to $129.6m for the full year ending December in 2004. The outlook is now international. Krell says the exchange is following a “two-pronged approach.” Krell says his exchange may announce some kind of affiliation with another market later this year or in early 2007.“We would like to enter into exchange to exchange relationships and create electronic links. A call option on IBM, for example, is not traded in London. We want to create an opportunity whereby a buyer enters an order at the London Stock Exchange, as an example, or another exchange where it can be transferred from the local market and be traded instanteously.” The second leg is more formal linkage or a joint venture with a foreign market in order to support the movement of order flow between the US and Europe or Asia.“We are looking for the right opportunity where there does not exist a large derivatives presence and where we can bring in our technology and expertise to bear on the market. It is an exciting outlook.” Something for the CBOE to note also.

TRANSITION MANAGEMENT

Competition is biting and the arcane world of transition management is in flux. Beneficial owners are moving more of their assets into diverse and sometimes exotic asset classes as long-only investment approaches take more of a back seat. In turn, transition management specialists are asked to provide seamless access to a broader array of assets as well as more sophisticated and complex project management skills. Not every transition management business can compete in this brave new world and asset owners are becoming more choosy about who handles their portfolio transitions—with good reason. Francesca Carnevale reports on a flight to quality.

The increasing sophistication and variety of transition is helping to coalesce new business among the industry’s leading players. Invariably, over the longer term, market consolidation will heighten this trend and change the structure of the market. Photograph supplied by istockphotos.com, August 2006.

A NEW FACE FOR TRANSITION MANAGEMENT?

HE DAYS WHEN a transition managers was the spoilt child of fortune are fast fading to grey. Scratch a transition manager these days and he’ll tell you that his house is a specialist for complex and intensively project-managed assignments. In other words, in spite of a marked and felicitous uptick in business, transition management teams are having to work a lot harder these days for their money. That’s because, “markets are much harder and more challenging, and consequently measurements are much harder and more challenging,” says Graham Dixon, managing director, transition management at Credit Suisse. John Minderides, global head of transition management at JP Morgan explains the underlying dynamic: “Investment portfolios are becoming more complex and allocations to less traditional strategies such as liability mandates are escalating. Coupled with this is an increase in allocations to more concentrated/specialist high alpha portfolios, with fewer securities. It has led to an growing need to be able to find liquidity with the minimum amount

of information leakage and corresponding market impact.” Tim Wilkinson, managing director, transition management at Citigroup maintains that there are:“multiple themes and a wide variety of reasons at work behind transition decisions. If there is a main theme, it is perhaps attacking high fixed cost bases – either through restructuring (to core-satellite models) or through merging funds.” The balanced manager portfolio approach “is on its way out,” agrees Gary Spreadbury, vice president, transition management at Morgan Stanley. “In particular, people are looking at more unconventional fixed income portfolios and are prepared to take on more risk in the fixed income space.” Emerging markets is another theme that is gaining ground and presenting its own set of problems to transition managers. According to Citigroup’s Wilkinson, there are three areas of sensitivity: “Market access, where there may be restricted licensing of non-domestic brokers; settlement, where rules are stricter and sometimes are not compatible with SWIFT; and in the use of synthetics, where there is a higher tracking error and less liquidity.”

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TRANSITION MANAGEMENT 50

While these cross-trends are combining to redefine the portfolios, managers often use currency overlays to manage market: the need to service these increasingly complex foreign exchange; while index futures are employed to help portfolio requirements has resulted in a notable flight to control asset class exposure. “In transitions that are quality, thinks Simon Hutchinson, head of transition benchmarked before the first day of trading, a derivatives management at Northern Trust Global Investments (NTGI). overlay can help minimise tracking error—in other words, “People used to talk of 25 or so transition management the difference between the performance of the benchmark houses, now the real players number around 16 or so in and the transition portfolio,”explains NTGI’s Hutchinson. Marchington at Lehman Brothers concurs, explaining London; then, of course there are others in the US.” Hutchinson thinks the market is coalescing between selected that today clients are looking for a transition manager to houses because clients are looking for “key differentiators.” show he can “cross correlate risk across asset classes and For one, explains Kal Bassily, division head, BNY global provide hedging techniques in a volatile market.” What it transition management, at Bank of New York, “clients are adds up to is a choosier and more selective client base that asking for fiduciary services more often. It is definitely often prefers to work with a regular panel of transition prevalent in the United States, less so in Europe and managers, to suit the circumstance of a transition and to practically unheard of in Asia. In Europe, it will increasingly best leverage a transition manager’s particular strengths. As if that complexity wasn’t enough to deal with, now become the norm and is a function of the significance and prevalence of global consultants in the decision making mix. Merrill Lynch, is once again threatening to raise the bar to a whole new level entirely. The It is one of the ways that house is already something of trends do travel.” a hybrid, having integrated Houses that can offer both a the transition management discrete range of project business of Merrill Lynch management skills and access Marchington at Lehman Brothers Investment Managers to liquidity across multiple explains that today clients are looking (MLIM) business, run out of asset classes are now winning London, with the investment out. Dixon at Credit Suisse for a transition manager to show he bank’s broker dealer, or sellthinks: “it is all about who has can “cross correlate risk across asset side transition management the best mix of components.” classes and provide hedging operations, run out of New Likewise, Paul Marchington, techniques in a volatile market. York. The merger of the two managing director, transition transition management management at Lehman operations was significant. It Brothers, in London, who set a precedent, showing how finds that “multi-asset the buy-side approach could transition expertise” is de-rigueur right now. Moreover, says Tim Wilkinson, managing happily co-exist with a sell-side operation. The merger also finally buried what had become a stale director of transition management at Citigroup, “You see this drive by incumbent houses, to incorporate broker services and barren debate about the relative benefits of the buydirectly into their own platform. Competition is encouraging side/sell-side models that had stymied the industry and houses to recalibrate their business model.” Minderides at JP which, by and large, left clients and market watchers rather Morgan adds: “firms with their own sources of liquidity and confused. In a US context, the solution was simplicity itself. direct access to markets will have an advantage.” Bassily at “The buy/sell side debate simply doesn’t matter for roughly Bank of New York, thinks that there is also another force in 80% of the liquid equity assets in most client transitions,”says managing director of transition play: “Three or four years ago, transition management was Charles Shaffer, regarded as an operations function.These days we deal directly management at Merrill Lynch in New York;“but it is critical to with chief investment officers and directors of investment. We the remaining 20% —the illiquid securities that cannot be transacted via an exchange—which generate the lion’s share have moved up the decision-making chain.” Others, such as Jody Windmiller, director of transition of the costs. For these difficult assets, you need a full service management at UBS are seeing changes of a different kind. operation that combines investment management and global “Although transition mandates are awarded by pension execution: that recognition is driving our growth strategy.” Having cut that convoluted Gordian knot, Merrill Lynch’s plan trustees, we are now getting more referral business from fund managers who recommend our service business transition management business is now moving further up the value chain. That move is helped in large part by the once they have won an investment mandate.” The prevailing winds are blowing towards the transition impending union of BlackRock, the publicly traded management houses, that offer strength in depth, through investment management firm with $464bn in assets under their trading capability, with value add-ons. These days, management, as of the end of June this year and MLIM. The explains Bassily, “clients are asking, ‘what can you do to merged entity (scheduled for completion at the beginning customise the transition strategy? How do you manage risk of October) brings two important elements into play: it will and what overlays can you put on?’” In transitioning create an independent investment management firm, with

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

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TRANSITION MANAGEMENT 52

Kal Bassily, global division head, transition management, at Bank of New York. Photograph kindly supplied by Bank of New York, August 2006.

Charles Shaffer, managing director at Merrill Lynch in New York. Photograph kindly supplied by Merrill Lynch, August 2006.

some $1trn of assets under management and the firm will rank as the number one fixed income manager in the US. The relationship with BlackRock means that Merrill Lynch’s transition team can talk softly because now it carries a really big stick; particularly when BlackRock’s extensive fixed income expertise and access will invariably be brought into play “It is a significant enhancement,” acknowledges Shaffer.“Agency trading in fixed income is a game that few can play because it requires an investment managers’ order management system and network of broker relationships.” As an example of what will be possible, Shaffer hones in on the long duration asset space. “The infrastructure and liquidity needed to support clients in the long duration space they increase their long duration exposure far exceeds the resources of any single broker/dealer. A single dealer may perform adequately on the easy 80%, that is, short duration, high credit; but it is remarkably naïve to assume a single dealer can navigate the issues associated with assembling portfolios with durations of 13 or more years. You want a proven fiduciary in your corner managing the brokers and extracting the most from them.” In tomorrow’s world then, while many are called to respond to a request for proposal (RFP); few, it seems will be chosen. While Spreadbury at Morgan Stanley, acknowledges the current skewed nature of the service: “Upwards of perhaps 70% of transition managers tend to have equity backgrounds. If you are asking them to manage multi-asset transitions, there’s a risk there.” Even so, he thinks that the fixed income card might be a tad overplayed. “In a transition, we might manage 90% of say a sterling bond portfolio against flow; and if we cannot provide liquidity in house then that last 10% might be provided by Barclays Capital or another provider. It’s all about finding the best price for the client.”Though it should be noted, that like Shaffer, he is talking from a position of strength. Even so, transition management is being assailed in crosswinds of change that could totally redraw the business’ lines. For one, the European financial markets are in the process of a long transformation, driven by intermittent efforts by the European Commission to encourage market harmonisation. That movement, led by a string of directives, will totally reshape the role that investment banks can play in the trading of securities over the coming decade and the

Paul Marchington, managing director, transition management at Lehman Brothers, in London. Photograph kindly supplied by Lehman Brothers, August 2006.

Tim Wilkinson, managing director, transition management at Citigroup. Photograph by Mark Mather and kindly supplied by Citigroup, August 2006.

implications of that change are only now becoming clear. Transition management will not escape. The impact of the Markets in Financial Instruments Directive (MiFiD) on transition management in Europe has not yet been outlined in depth. Inevitably, though: “It will affect transition management in a number of ways,”says Jody Windmiller at UBS. “MiFiD introduces a new client categorisation regime and the way in which a client is categorised dictates the level of protection to which they are entitled. This includes whether or not they are entitled to best execution.” MiFiD is something of a challenge, say transition managers, with some specialists believing that the directive will ultimately sort the men from the boys, at least in the European theatre. Additionally, clients could be facing an increase in the cost of a transition. Windmiller agrees: “MiFiD will force an overhaul of everyone’s systems. It will affect the records we keep (for up to five years). We need to know exactly what sort of records will need to be retained and how this information can be stored. Our legal teams are working on the issues right now,”she says. Second, the directive will invariably redefine European approaches to fiduciary responsibilities; which to date have been quite different to the definition of fiduciary responsibility in the US, which is clearly enshrined in law. Only buy side institutions in the US, for instance, can take on fiduciary responsibility, while in Europe definitions have been much looser and hang on a Napoleonic lawstyle commitment to always act in the best interest of the client. Irrespective of how it plays out in the coming years, Gary Spreadbury at Morgan Stanley thinks clients should always ask of a transition manager: ‘What does fiduciary mean to you? What does it give me and what am I paying for?’The biggest risk for the client is poor execution. They must ensure they hand their portfolio to someone who can capture liquidity and capture an opportunity, on a horizon of opportunities, at the right time.” Another emerging debate is whether transition managers should act as principal or agents in a trade. In a principal trade the entire portfolio is sold to a broking firm, that uses its own capital for the purchase. In the context of a transition, the risk of liquidating a portfolio is transferred to the broker in exchange for a higher, often fixed, commission. In instances in which the only principal bid

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

comes from a transition management firm, competitive pricing can be difficult to gauge. Agency trades, meantime, are orders executed on a primary exchange, such as New York Stock Exchange (NYSE), with the assistance of an agent who acts as an intermediary between the buyer and the exchange. In a transition, any securities that are left after in-kind transfers and crossing opportunities have been employed will be transitioned using agency trades and are completed at the discretion of the agency broker. If the transition manager uses one of the better trading desks as his agent, the trader may be able to add value in the transactions. Exchanges offer the greatest source of liquidity for most liquid equity securities,â&#x20AC;&#x153;but implicit costs, explicit costs, and potential for information leakage can be appreciably higher when trading in non-equity securities if your agent does not have a proven network and a state of the art order management system,â&#x20AC;? explains Shaffer at Merrill Lynch. Shaffer thinks the debate has moved beyond agency versus principal. â&#x20AC;&#x153;Fiduciary requirements would imply that a client require at least as much operating risk management and counterparty expertise from a transition manager as they do from an investment manager, but sadly they often require far less. Being an agent is easy. Replicating the clout with the broker/dealer community and operations expertise of a global fixed income manager is not.â&#x20AC;?

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For Credit Suisseâ&#x20AC;&#x2122;s Dixon, there are also other issues to consider. There is, he says,â&#x20AC;&#x153;a greater need and requirement for disclosure and transparency, a greater demand from smaller funds and a more rigorous approach to transition management research by consultants.â&#x20AC;? For Wilkinson the issue is more draconian. â&#x20AC;&#x153;Each transition is subject to cost benefit analysis. How much risk do we eliminate and a what cost to the client? From which, follows the question,â&#x20AC;&#x2DC;Is it worth it for the client?â&#x20AC;&#x2122;â&#x20AC;? As with Shaffer, Dixon and Wilkinson increasingly believe that transition management provides but one element in the value chain of a portfolioâ&#x20AC;&#x2122;s performance. â&#x20AC;&#x153;If a beneficial owner is planning to move a portfolio between managers, the impact of that move must be factored in before the restructuring begins,â&#x20AC;? says Dixon. â&#x20AC;&#x153;A good transition manager brings both management and measurement and this makes any risks more visible to the client, right at the outset.â&#x20AC;? A successful transition, involves a careful consultative process and proper management and analytics pre-trade thinks Minderides at JP Morgan, â&#x20AC;&#x153;Transition management is a service delivered in partnership with all parties in order to provide the plan sponsor with the lowest cost, lowest risk and lowest administrative burden solution of moving their assets from A to B.â&#x20AC;? How you get there now defines who you are in transition management, it seems.

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THE T-CHARTER

In December 2004, Credit Suisse’s transition management team approached Citigroup and Mercer Investment Consulting, with a proposal to confront the industry on a lack of standards and poor practice. Over almost two years of discussions, a code has been drafted, known as the T-Charter. What now?

DESTINATION T-CHARTER ARPE DIEM. CAN London’s transition management community seize the day and adopt a voluntary code of practice? This thorny question echoes around the hallowed corridors of the City’s leading transition management houses. For many, such as State Street, Citigroup, UBS and Credit Suisse, it is a resounding yes. For others, such as Goldman Sachs, it is perhaps a less obvious requirement. Graham Dixon, a founding father of the transition management business and currently managing director, transition services at Credit Suisse, who has led the debate is firm on why transition management houses should sign up to the code of practice says,“The T-Charter encourages disclosure and transparency. It has provoked an open debate on some questionable practices and provides a basis for clients to directly compare the services, cost estimates and fee proposals of competing providers.” The debate over the usefulness of the T-Charter hangs on the mounting complexity of the transition management offering and the difficulty clients and sometimes consultants have in choosing the right transition manager for the job. As Tim Wilkinson, managing director of transition management at Citigroup acknowledges, clients distinguish between transition managers,“with varying degrees of difficulty.The T-

Graham Dixon, managing director, transition services at Credit Suisse, has led the debate on why transition management houses should sign up to a code of practice. Photograph taken by Mark Mather and supplied by Berlinguer Ltd, August 2006.

Charter seeks to resolve this by introducing uniformity and by establishing a set of minimum operating standards… and to assist clients in knowing what to look for and what to expect from their transition manager. It also seeks to enshrine important basic principles fundamental to best practice.” Mercer Investment Consulting recently completed a seminal study of the transition management universe. Reportedly, the study outlines the relative strengths and weaknesses of each transition management house, based on client survey responses and years of experience of consulting within the industry. However, the document is only available to the consultancy’s paying clients. The lack of general availability is perhaps unfortunate, given a marked paucity of audited or independent market analysis of the transition management industry. True, there are those rather nice-to-have awards to help beneficial owners make decisions. Awards however are sometimes handed out like chocolates by publishing houses with no direct experience of the transition management business themselves. Moreover, they often require award nominees to contribute to the costs of the client research that underlies an award. Hardly independent. How is a client then able to distinguish between often equally capable

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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THE T-CHARTER 56

transition management teams; but which may have quite diverse skill sets? Should clients, for instance, choose a transition manager on price; or on what they believe, given an objective set of selection criteria, will be the best transition provider for their needs? Equally, what if a transition manager does win awards and mandates a-plenty, but then requires a client to contract out of best execution? Can that transition manager be said to work in the best interests of the client? Alternatively, if the client clearly does understand that he has been contracted out of best execution, does it matter? Then again, how can a transition manager truly guarantee best execution? Should they instead be working on a best efforts basis? This is not a comprehensive list of questions and there are no prescriptive judgements. It is simply a sample of some of the topics that the T-Charter is trying to address. These very shaded nuances have lain at the heart of the market’s response to the charter, which, frankly, over the last two years has been patchy and mixed. Perhaps some of the reason for the ambivalence rests with the early efforts of the charter proponents trying too hard to search for answers to some unanswerable questions. Jody Windmiller, managing director, UBS, explains: “the first drafts were perhaps too prescriptive and contained judgemental overtones about one business model over another.” Eventually though, discussions began to take a constructive direction, says Windmiller and has concentrated more on “raising awareness of relevant issues; on processes, the risks involved in a transition and the potential costs.” Lachlan French, managing director, transition manager at State Street, like Windmiller a loyal proponent of the T-Charter initiative from the very start, holds the view that: “My main concern was that we set standards at the highest possible level. I think the debates have been lively and good. Assuming we achieve this objective, I can’t quite see why someone would not want to sign up to it. Either we have got something drastically wrong, which I don’t think we have, or there are concerns out there that we can still discuss,”he maintains. A final draft of the T-Charter has now been circulated to transition managers, investment consultants and other interested parties. In parallel, according to Graham Dixon, “an external legal firm has been briefed to assist with finalising the code. The T-Charter should be launched before year end.” Off the record, one transition management specialist still maintains that “I doubt many transition managers will ultimately able to get their signature on the charter without input from their firm’s compliance people, and that may take the teeth out of the initiative.” Largely however there is a groundswell of opinion that the charter is “a good thing,” says Paul Marchington, managing director, transition management at Lehman Brothers. There are some limitations, he believes, such as a “dilution to a common factor,”but he firmly believes that it is outweighed by the efforts of the T-Charter initiative to eliminate the disparity in client protection in the market.

“For instance,” he says. “A client does not care if prehedging occurs within or outside the T-Charter. What he cares about is that there is no pre-hedging at all.” Some critics see the charter as an indirect marketing exercise by the people who raised the issue “giving added credibility to the people who are associated with it”; yet others say it that in important essentials, it remains light. Some transition managers concede that they appreciate the clarity of houses that require clients to contract out of best execution, even while not agreeing with it. Meanwhile others will tell you that sometimes a pre-hedge can help a client, though that particular transition manager explains that only clients who really understand trading and who know how to get the best out of a broker/dealer should even attempt it. As the market becomes more complex and sophisticated and complex derivative overlay strategies are employed to substitute or hedge positions to protect portfolio value, it is increasingly clear that transition management on both the client and the provider side, is no longer the preserve of the ingénue. Take heart, says Dixon, the T-Charter is already having an impact where it counts. “Even before being finalised, we already detect its influence in request for proposals (RFPs) and in the questions asked by consultants and clients. The onus is now on those transition managers set against the TCharter to explain just which aspects of the code they are unwilling to comply with.” Lachlan French thinks that as the nature of the business changes and clients themselves grow in sophistication, that interaction will set a new level of demand for more transparency and better practice in any case, and that the TCharter cements that development. “Increasingly clients are looking for deeper service relationships with transition managers and it is all part and parcel of that ongoing relationship,” he says. Tim Wilkinson at Citigroup adds a further dimension: I can’t see the T-Charter materially changing a client’s decision regarding whether or not to involve a consultant in the choice of transition manager, but I can see both clients and consultants alike insisting upon potential providers being signed up to the T-Charter.” It is perhaps still too early to say whether the charter will be finally introduced to the market as an agreed code by year end. What looks likely is that in Europe, the market will polarise around those houses that have signed up to the charter and who include their membership credentials in their marketing collateral and those houses that will be content to live outside its remit. For the time being, it is not an issue in the United States. According to Kal Bassily, division head, BNY global transition management at Bank of New York,“we are waiting to see if it actually kicks off or not. If everyone finally does agree with it then it will have gone a long way in becoming a new standard.” On Dixon’s part, he thinks it has been “uplifting to witness the support from so many transition managers, investment consultants and clients for this initiative. In such a competitive business, it is pleasing to see such scope for cooperation and constructive involvement.”

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

IS THE JUICE WORTH THE

SQUEEZE? As hikes in interest rates in all three of world’s principal financial markets - US, Europe and Japan - before the end of the year promise to curb the rate of global economic growth in 2007, the market for sovereign bonds in developed countries should prosper. Andrew Cavenagh reports.

HE COMBINATION OF rapid worldwide GDP growth (3.5%) and the sharp rise in commodity prices - particularly energy and metals - has focused the attention of the United States’ Federal Reserve, the European Central Bank and the Bank of Japan on the risks of inflation. For the first time since 1979, the three largest central banks are tightening monetary policy in unison. The US economy will lead the way as consumer spending retrenches under the win squeeze of higher energy prices and cost of debt, as the Fed is expected to raise its rates by further 25 basis points before the end of the year. The latest quarterly survey by the Bond Market Association (BMA) in New York, published in July forecast US interest rates rising to a peak in the third quarter of 2006 and t yields on US Treasuries falling by the end of the year. The survey respondents—representatives from the 20 primary US Treasury dealers who make up the BMA’s Government Securities Research, Analysis and Strategy Committee— expect the yield on the 10-year Treasury note to reach 5.15% by the end of September and then decline to 5.05% by the end of the year. They are looking for the yield on the 2-year note to come in more sharply over the period from 5.25% to 5.05% and that on the 30-year note to tighten from 5.2% to 5.15%.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

LEADING SOVEREIGNS

Photograph supplied by Istockphotos.com, August 2006.

The respondents also forecast that US Treasury issues in the third quarter would amount to $71bn, slightly below the level in the comparable period of 2005, and said the reduction reflected the expectation of a reduction in the budget deficit this year (to $290bn against the $319bn recorded in 2005). Michael Decker, senior vice-president and head of policy research at the BMA, says the results of the survey showed clearly the underlying fundamentals of the market remained strong. “Longer-term yields continue to be kept low by demand for longer duration assets, demand for dollardenominated assets outside the US and confidence in the Fed’s ability to manage inflation,” he concludes. The outlook for the US economy is influencing the approach of sovereign investors elsewhere. Jonathan Gibbs, investment director for fixed-income at Standard Life Investments in Edinburgh, says in his view the direction of the bond markets was likely to be “fundamentally driven”by expectations of the performance of the world’s largest economy. Gibbs expects the Fed’s strategy to produce a “gentle slow-down”in the US the second half of the year to the benefit of sovereign fixed-income markets.“We feel that will be positive for bonds,”he says. He added that the European Central Bank and the Bank of England were likely to err on the side of caution when it came to tightening monetary policy, and this should lead to a decrease in longer term growth and inflation expectations. “There will be a very good opportunity to buy these markets over the next couple of months,” he notes. Gibbs thinks the outlook for UK market was likely to be volatile, as the Treasury’s Debt Management Office (DMO) would continue to issue a “stream of gilts”over the next three years, for which there would remain strong demand as British pension funds

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LEADING SOVEREIGNS 58

below 4% as it struggles to were obliged to switch more Playing with sovereigns pays off improve competitiveness of their assets from equities 250 and introduce publicinto bonds. Robert 225 sector reforms in a Stheeman, the DMO’s chief 200 politically challenging executive, acknowledged in 175 environment. “I wouldn’t June that the annual volume 150 125 expect to see any sharp of issuance was likely to 100 slow-down in issuance remain around the £52.3bn 75 certainly among the big mark to which it had 50 countries,” says Brian climbed in 2005/6 from Coulton senior director in £26.3bn in 2002/3.“Forecasts the sovereign group at the indicate that these relatively FTSE Irredeemable Bond Index FTSE All Govt Stocks Index Fitch rating agency.“We are high levels are set to still in a relatively loose continue for some years.” Source: FTSE Group. Data as at August 2006 fiscal regime in most of Meanwhile, demand from pension funds for long-dated assets that match their those countries.” Rating agencies are also keeping a close eye on further liabilities has justified the DMO’s decision to recommence issuing 50-year gilts - both conventional and index-linked - in deterioration in nationals finances. Fitch put Italy’s double-A May 2005 after a 45 year hiatus following an extended sovereign rating on negative-watch in May, and Portugal’s consultation exercise with investors. “They were looking for remains on negative outlook in the light of a fiscal deficit of longer-dated assets than were currently available,”explains a 6% of GDP and a lacklustre outlook for growth. Belgium, by DMO spokesman. “We were convinced on the back of that contrast, has bucked the trend in reducing indebt ratio and response that there was a premium demand for this product.” was rewarded with a one-notch upgrading from Fitch to That demand proved so strong that it drove yields on the double-A plus in April. The European sovereign markets also face the prospect of instruments to record lows at the beginning of the year under 3.5% for the 50-year conventional gilt and below 0.4% some important structural change in the coming months. The for the index-linked version.“In January, there was an intense European Commission’s Competition Directorate, as part of period of buying but things have eased up a bit since then,” its wider initiative to introduce more competition into observes the DMO spokesman. The main reason for this is securities trading and post-trading within the EU, has targeted that the Treasury responded to market calls for greater the state prescription of specific platforms in order to qualify for flexibility in the DMO’s remit to react to prevailing market prime dealer status on sovereign issues. “From this point of conditions. For the 2006/7 programme, there is consequently view, the European [sovereign] markets are structured in a way a supplementary element of £2.5bn per quarter alongside the that is not very efficient,” says Austen at the BMA. The Competition Directorate is expected to take this issue quite pre-committed issuance of £53bn. The DMO can adjust the maturities and the type of bond seriously over the coming months. The EPDA’s preferred in this supplementary programme to suit market demand at option is to allow dealers the freedom of choice to select which the time, and the first such quarterly issue this year was all platform they wish to make markets. If this is supported by the assigned to conventional long-date gilts. The second member states and pushed by the Competition Directorate, announced at the end of May, by contrast, was split evenly Austen says that it would inevitably benefit the market by between conventional and index-linked bonds of the same reducing transaction costs as competition drives down costs. maturity. It certainly seems like the 50-year gilt is here to stay Similar moves are afoot to bring more cohesion to the clearing this time. Mark Austen, executive director at the BMA in and settlement process, and Austen observed that “anything London, says feedback from his membership indicates that that reduces clearing and settlement fees has a big impact on the market for the instruments is definitely sustainable as the overall transaction costs.” The move to open the market to competition between the advances in swap technology means investors could cover the long-term interest-rate risk.“I think that is by and large dealing platforms of the prime sovereign traders comes as a reflection of a change in attitude on the client side,”he said. several smaller institutions are paring down their involvement “I think most of them probably feel now that they can hedge in the business or even pulling out of it altogether.The Italian banks BNL (now part of the BNP Paribas Group) and that risk.” The leading Continental European countries will also Capitalia are two recent examples of the former, and Allied continue to provide high levels of sovereign issuance, as they Irish in Dublin one of the latter.“We’re seeing a lot of local continue to run substantial budget deficits and the ratio of dealers scaling back their activity, because they realise that public debt continues to rise across the euro area. Germany, with such time margins it is only the big volume players that for example, will have a deficit of 3% in the current year as can make money at it,”said Austen.“I think that is something the government will not want to jeopardise the fragile that is going to continue.” It is happening because of the tightening of spreads since recovery in the economy with harsh fiscal measure to balance the budget while Italy’s is unlikely to keep its deficit the advent of the Euro and the increasing tendency of prime

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

dealers to over-bid bond prices at auctions—ensuring that they will inevitably pass the instruments on to investor at a loss. In some markets, he says this was a“loss leader”strategy to secure other government business, such as advisory mandates on privatisations or securitisations.“The issue is that they are losing money based on the assumption that they will get it back at the other end.”While the end result is obviously good for investors in that it ensures liquidity in the market and keeps spreads tight, Austen said there was a risk that several larger banks could withdraw from the business in a downturn and leave the market dangerously uncompetitive. Meanwhile sovereign issuance in the emerging markets, which dropped to just 40% of the $155bn total in 2005, will continue to be characterised by a switch from US dollar issues to local-currency bonds as more external as economies strengthen, domestic capital markets mature and deepen, and more foreign investors are prepared to take the associated risks.“What a lot of those countries have been able to do is attract investors into local-currency denominated paper,”said Coulton at Fitch.“There is something of an interesting contrast going on there.” Curtis Mewbourne, executive vice-president of US specialist fixed-income fund manager PIMCO, the large specialty fixed income manager with $617bn of assets under management confirms the trend.“At PIMCO we have a seen a strong interest in these strategies from our clients, and our investments in local markets have increased from $3.3bn a year ago to roughly

$8.2bn today,”he said. Mewbourne says the strengthening of the institutions and local capital markets had enabled governments to source more of their borrowing requirements from these sources. In Mexico, the government has been able to finance its fully from such sources - in part thanks to the creation of a mandatory pension system in 1997 that now has over $50bn invested in peso denominated sovereign bonds. The risk of financial meltdowns - and defaults on sovereign debt – such as Russia’s in 1998 has also receded.“Russia had $3bn in foreign-currency reserves in 1998. They have $270bn now, against roughly $35bn issued in dollar denominated government securities,”he points out. Mewbourne says as the growth rates of the leading emerging market countries - helped by rising commodity prices surpasses those of the developed countries (the combined GDP of Brazil, Russia, India and China was larger than Japan’s last year and growing at 10% against 3%), their increasing economic importance should mean they achieve a much greater share of the global bond market over the next decade. This will invariably come through a combination of corporate and local-currency sovereign bonds as dollardenominated issuance continues to diminish.“It is not going to go away entirely, but more of it is going to be replaced.” Mewbourne thinks that such issues would become an intrinsic part of international bond investors’ portfolios. “I think it means that many of those countries will be part of any fixed-income allocation - just as France and Japan are today.”

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

FTSE GLOBAL MARKETS’ THOUGHT LEADERSHIP ROUNDTABLE SERIES

INVESTMENT SERVICES

Roundtable Fund Administration and Distribution: The Way Ahead

ATTENDING Left to right back row: Dan O’Donovan, managing director, Setanta Asset Management Rob Wright, managing director, RBC Dexia Investment Services Francesca Carnevale, editor, FTSE Global Markets Left to right front row: Noland Carter, managing director, Rothschild Wealth Management Anthony John, managing director, IMS John James, managing director, CSTIM.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

ROUNDTABLE PARTICIPANTS Jeremy Charles, director, CSTIM Limited Jeremy Charles is a director of CSTIM, a provider of specialist management consulting to the investment industry in areas such as strategy formulation, operational change and operational review projects. Jeremy advises both private and wealth management clients and has extensive experience of most business models in use today. Prior to joining CSTIM, Jeremy was the global business manager for UBS’s Domestic Private Banking business and before that he was chief operating officer (COO) of the Coutts Natwest Group. In the 1990s he was COO of James Capel (HSBC) and head of the bank’s private client investment management business. He has also worked at Hoare Govett. Founded in the UK in 1998, CSTIM was acquired by Morse plc in April 2004. Antony John, managing director IMS Antony John is managing director and one of five principal shareholders of IMS, where he has been since 2003. Prior to working at IMS Antony was an executive vice president for five years at the private Swiss bank Lombard Odier Darier Hentsch, with wide ranging responsibilities within the bank’s European business. Antony also enjoyed a ten year spell at Hill Samuel Asset Management as head of retail business from 1988 through to 1998. He is a member of several professional bodies and a Freemason of the City of London. One of the longest established multi-management firms, IMS was founded in 1999 advising and managing several billion pounds of assets for clients ranging between corporate pensions, unit funds, institutional clients and family offices.The business is wholly owned by the directors and staff with one minority corporate shareholder. Multi-manager investment is IMS’s only activity and prides itself on its independence of operation and objectivity in selecting investments. Rob Wright, chief operating officer, RBC Dexia Investor Services As chief operating officer, Rob Wright is responsible for setting the strategic direction of RBC-Dexia Investor Services’ global operations and client service strategy. Rob is also responsible for the main operations centres for investment administration, custody, shareholder services as well as all regional geographies. Prior to this appointment, Rob held several leadership positions with RBC Global Services, Institutional Investor Services, including managing director of the bank’s Global Fund Services, where he was responsible for the development of the department’s business strategy. He also served as vice president, sales and relationship management. He is a member of the RBC Dexia Investor Services Australia Limited Board. RBC-Dexia Investor Services, an equally owned joint venture between Royal Bank of Canada and Dexia, ranks among the world’s top 10 global custodians, with approximately $2trn in client assets under custody. Dan O’Donovan, managing director, Setanta Asset Management Limited Dan O’Donovan is managing director of Setanta Asset Management Limited. A graduate of UCC., Dan has over 26 years experience at a senior level in treasury, stock-broking and fund management. He is former chairman of the Irish Association of Investment Managers. Setanta Asset Management Limited is based in Dublin, Ireland, and manages assets of over €5bn in assets, of which more than 70% are invested in Europe. Established in 1998 by Canada Life (now wholly-owned by Great-West Lifeco), Setanta is focused exclusively on asset management. Setanta is authorised under Ireland’s Investment Intermediaries Act 1995 and is regulated by the Irish Financial Services Regulatory Authority. Setanta’s relatively concentrated portfolios are run in which potential return is related to risk. Assessment of equities is on a bottom-up basis, with a growth at a reasonable price (GARP) style. Equities are evaluated in a sector context, facilitated by Setanta’s emphasis on cash generation as opposed to earnings. Noland Carter, chief executive officer, Rothschild Private Management Noland Carter is chief executive officer of Rothschild Private Management, the London-based private banking and wealth management arm of the Rothschild Group. Between 2000 and 2005 Noland established and was chief executive of Barclays Investment Services, with assets under management and advice of £60bn. Noland joined Barclays in 1997 as global chief investment officer of Barclays Private Bank and became chief investment officer for Barclays Retail Financial Services in 1999. Between 1993 and 1997 he was head of Global Equities at Ivory and Sime Plc and before that he was a founding partner and director of Johnson Capital Management, a specialist equity investment management company. From 1986 to 1990 he was an investment manager at Mercury Asset Management plc managing specialist equity institutional accounts and unit trusts. Rothschild Private Banking and Trust is an international family owned financial services group, advising on over $23bn in assets.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

FUND ADMINISTRATION & DISTRIBUTION ROUNDTABLE 62

MARKET COMPLEXITY FRANCESCA CARNEVALE (FC): How will you meet the challenges of the industry and how will investment services providers help you get there? ROB WRIGHT (RW): Our industry is changing faster than many of the investment services providers can keep pace with sometimes. Increasing complexity of product, growing competition in the asset-servicing sector; a growing number of distributors that asset managers are trying to employ to get their product on the shelf, and the globalisation of the industry in general are just some of the issues we face. We now support distribution across multiple geographies or jurisdictions, involving increasingly complex instruments and funds. Clients meanwhile are more demanding and want immediate results. It is imperative for these reasons that we stay close to asset management firms and become a strategic partner as they grow their business.To do that well, we have to be aware of important market trends and understand on the long-term impact on our business and decide where we put our investment dollars. JEREMY CHARLES (JC): Demands on the industry are fundamentally shifting as the end investor, armed with greater wealth, is starting to ask for a different type of service. What is service? Is it performance and the drive towards absolute return? Is it client reporting and a holistic approach to what is going on? What is ‘wrap’ and all that sort of noise? Alternatively, is it the client just saying:“I want my risk looked after”.That puts you into strategic asset allocation and a series of processes that are about giving better service to clients. DAN O’DONOVAN (DD): There is, of course, the issue of end user sophistication and increased wealth, which is going to gather pace. However, there is also the investment agenda that the investment community is being asked to deal with. This is infinitely more complex, given the abolition of exchange controls and the mobility of capital. We must ensure our products are relevant and to get them onto as many distribution platforms as possible. Clearly, the traditional manager will have to employ expertise in certain areas: for

example, a case in point could be China or India say. More generally, the infrastructure you need to have in place now to compete is significantly more sophisticated than before. ANTONY JOHN (AJ): In some quarters, there is almost a fear factor that if Group A is doing something, then we should be doing it too. Groups face fundamental decisions on how they react to these changes and invariably ask, “Do we manufacture, do we distribute or can we do both? If we do both, what is involved? Where do we want to do it? And do we self-build or do we outsource?” NC CARTER (NC): From a buyer’s perspective, the market has become confused. It used to be simple. There were institutional investors and there were private clients. Now I challenge anybody to identify who the end buyer is. Add to that, the demand for more transparency, and the fact that it is much easier now to disaggregate product. People nowadays ask, “How do people really make money”? It also leads you to the charge of mediocrity, because as an industry we are relatively mediocre. There is more transparency and we know so much more about how investment managers build their portfolios and how they have really performed against the benchmarks they have chosen.

LEGACY ISSUES & THE DEMISE OF TA DD: The problem with our legacy position is that we have mandates that go far and wide. It is virtually impossible to honour to those mandates in this environment, from the traditional resource base. AJ: What you did yesterday is not, necessarily, what you need to do tomorrow. There is a huge legacy problem in our industry. Do the dynamics have to change to a point where your margins are reduced on your legacy business where you are forced to change? In many instances, this is the case. DD: Moreover, an extraordinary thing is that while the bulk of your business relates to traditional mandates, the vast majority of your sales are coming in on

new products. So what do you do here? Furthermore, in an Irish context, we now have this extraordinary thing where the legacy product was created under conditions of a different currency and exchange controls. Now we are part of the Eurozone and the world is our oyster. It is implicit in the mandates. JC: Organisations are approaching change at varying speeds and can only handle so much change within their current business model. At a recent conference someone said there is still more money in ‘with profits’than there is in mutual funds. Intuitively, each of us would say that ‘with profits’ is a legacy product and you probably would not advise clients to go into ‘with profits’. However, the product is there. Coming back to Francesca’s original question, the service provider has to focus on the fact that manufacturers and distributors have completely different requirements in terms of service provision. How do service providers balance process between the two? At the same time that there is so much change is going on, the end client is demanding a fundamentally different service. FC: Is there a disconnect between buyer and provider? JC: You can be a manufacturer in one asset class and a distributor in another asset class. Ten years out from here, and what we call an asset class today might not be an asset class in ten years time. Therefore, considering where an organisation is in terms of this change process and how it deals with the legacy issue, while seeking their own core competency, means that everybody’s models are different. This was not the case in the 1980s and 1990s. AJ: A classic illustration of this point is transfer agency business. Because of the advent of internet platforms and fund supermarkets, transfer agency, in the traditional sense, is going to die within the next ten years. Yet most of us need some form of transfer agency today, not least because we need to fulfil our obligations, in respect of anti-terrorism funding and money laundering. Service providers can already see [what is going to happen] and are packaging it with something else, saying, “Look, we will bolt it on to something else because we

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

ANTONY JOHN, managing director IMS

know we have got to do it for some time yet, even though we know the industry has moved on but the regulatory framework has not.”

PLATFORMS RW: Our internal strategic discussions have in part centred on how much we should invest in a traditional transfer agency (TA) environment as we look to expand to other geographies—especially as platforms are now making considerable headway in owning the underlying records of the retail client base. Firms want to expand because they can now manufacture in many centres and distribute in others. Alternately, they can create offshore products that might require traditional TA. From our own experience in Australia, we know how powerful platforms can be. Do we balance the need to maintain our legal investments and services, while at the same time build platforms to meet future requirements? Does that involve a threeyear, ten-year or twenty-year evolution? We all face a similar dynamic, making the right investments at the right time. The question is the pace of change, and it will be the distributors, frankly, that will dictate the pace of change. JC: Yes. End distributors—especially those in the private client/wealth management space—have understood wrap for a long time, because they have

been trying to provide a more holistic service to their clients anyway. It is in the mass retail market that the definition ‘wrap’ is starting to emerge because that is what an independent financial advisor (IFA) might require; although in the past an IFA bought an investment service ‘wrapped’ as a life product or ‘wrapped’ as a pension from a fund manager. Nowadays, many organisations that offer ‘wrap’, but they offer it from a private client/wealth management perspective. In addition, what is a platform? There is no standard model. It is a method in which organisations differentiate themselves, and it is now done differently than it was in the 1980s and 1990s when we all tried to second-guess BP against Shell because we all sold the same segregated portfolio. NC: That is absolutely right! When you look at platforms available in the private wealth management industry, it is fascinating that all the big, institutional players are or have been trying to get into the game. No disrespect to any of them though, but nobody has yet found the solution to the complexities of the private wealth management industry. When a client looks to change, they think well, actually, it is no better anywhere else. AJ: That is because of the commercial imperative where a lot of the large providers are now working on such a transaction based model they know the price of everything and the value of nothing. There is a move away from a traditional service based culture. In other words, you get what you pay for, if you want a Rolls Royce, you had better be able to afford it. I make this observation because I see the increased commoditisation of services that, on the one hand, has meant that there is

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

massive transparency and better information flow through electronic media, but on the other hand, has disintermediated the client. Moreover, the client is none the wiser because he does not know how to interpret the broader data that he now has access to.

COMMODITISATION OR CUSTOMISATION FC: Is customisation a Holy Grail? JC: If you take the high-end wealth categories, or a family office, you can afford to offer a tailored service. The approach to a family office, and understanding the client’s appetite for risk and investment objectives and lifestyle goals, is the same as for the ‘core affluent’ in the street. However, you cannot offer the same segregated multiasset class process that you can offer the family office to the person in the street. The person in the street needs a commoditised offering. If you are offering multi-asset classes to the person in the street, you have commoditise. RW: This is also true of your institutional clients, where you are perhaps running multi-manager strategies or single strategies for them. In this instance, they are specifically buying your specialisation. These are the key differences. At the retail level, you have to compete more obviously within a specified price range and a manufacturing cost that is equitable for the individual. NC: All we have talked about is complexity. Actually, the person in the street does not understand any of this stuff. It is one of our biggest problems an industry, as we do not have enough bright people in our industry who understand business and understand investment products and so we get to your point exactly. On one side, we are disaggregating everything down to the commoditised level, but the bright people who are capable of mathematically developing that for us cannot then relate it back to the client and the client in that instance often does not have the business acumen (or the intellect) to be able to understand the product side of things. A shortage of capable people, then, is a major issue across our industry.

FUND ADMINISTRATION & DISTRIBUTION ROUNDTABLE 64

AJ: We see that reflected tacitly in government policy. We get a neverending cycle where government feels the need to dip in, introduce some inane products, and try to force it on the industry and not necessarily focus on the key issues from a client perspective. The whole debacle over stakeholder [pensions] is a classic example. It focuses on delivery at a price rather than encouraging people to save for the long term and understand what they are doing. Again, as an industry, the inevitable dialogue or lack of it, is an issue here.

EUROPEAN PERSPECTIVES FC: Is this true at the European level? JC: Each European country has a different model. MiFiD will change all of this, but before we turn to MiFiD, you should think about the fundamental mistakes legislators have made. They often do not understand the industry and bureaucrats tend not to have managed wealth and do not understand asset allocation. The hedge fund industry grew up because the regulator did not understand the fact that you can leverage a portfolio, as opposed to just investing every pound straight through. The whole of the unit trust industry has been built on a pound for pound investment process, whereas most professional investors and proprietary books actually use leverage and derivatives. Nevertheless, regulators have now woken up and have come up with UCITS III, which is a fundamental change to the way we can sell funds. However, these actions still lag far behind the industry, which is just ridiculous. AJ: Fifteen years too late! JC: Excepting best execution, the main focus of MiFiD is expressions about suitability and appropriateness which have come direct from the UK regulator, because no one had that in Europe. CESR openly says it has taken on board many FSA principles. MiFiD also focuses on best execution, which has not really been a problem in the UK securities market for a while. Then again, what is best execution in mutual funds? If it is all about price and consideration, does this mean that you, the advisor, are not giving best price if a

fund applies a 5% initial charge and a 2% to 3% carry, and when a multimanager, or a fund supermarket doesn’t charge this much. Will we standardise or institutionalise the whole of the pricing process because of MiFiD? Does the legislator really understand what they have done? Because they really did not have that discussion in the first instance. FC: Was there no consultation with CESR? JC: CESR are bureaucrats. It likes to say that there has been a lot of discussion with the industry. Often, much of this ‘communication’ is tablets of stone that are presented and you have time for comments but really the legislator is saying, “I want it this way anyway”. The industry does not spend as much time as perhaps it should do with the legislator. Perhaps also it knows it gets them nowhere! RW: We work closely with CESR and make presentations to the European Commission and we are members of other organisations, so the answer is yes, in a way. However, until you encourage more personal accountability for retirement savings, or long-term wealth management, things will not change. Second, it is a very difficult thing to harmonise the number of geographies you have in Europe, compared to say, Canada or the US. In Europe, it is much more complicated. Because Europe is not homogenous, I have to account for all kinds of different rules and regulations and tax regimes and client requirements for each jurisdiction—despite UCITS III. It also pushes up my costs. DD: The point made there about the glacially slow response from the regulator is correct. This ultimately results in you disengaging from the process. I remember being closely involved in UCITS I in the 1980s. We would say,“We could have this done in three months time”. Moreover, we were still saying the same thing two years later, with less confidence this time that the official deadline could be met. Letting the market provide the products, as it has done effectively to date, is probably the best model. Ideally, the less we have officialdom defining the rules of the game, the better.

AJ: Industry representation, such as it exists, is at best fragmented and worst case, ineffectual. It is also driven, to a certain degree, by vested interests from various industry sectors. You can have one trade body in the UK having a very different position to its equivalent body in Italy or Germany— sometimes for very good reasons—which adds a further level of complexity. FC: How much more problematic is this problem going to be as new countries come on stream in Eastern Europe, or is your focus still in ‘developed’Europe?’ AJ: You cannot ignore the broader European Community, but it will get more problematic. A perennial problem is the perception of fair play. Most of the European Directives from a UK and, indeed an Ireland perspective, are implemented fully and in a timely manner. Some other European countries have still to get their act together. Greece has a 63% implementation rate, Italy is around 70% and France is around the 50% mark in implementing European finance industry directives. DD: This business of regulation based on institutions, rather than activity, is also mistake. This distinction between institutions who straddle businesses compounds the problem. JC: There is a political philosophical point here. Europe comes from socialist regimes that want to protect the end investor rather than actually empower the end-person look after themselves. The pan-European process will only get worse if more countries come in, or if the French do not actually believe in implementing all the directives in the first place, because they want even greater protection. We all come at this from a completely different philosophical stance, and as an industry, we suffer from that. We also cannot change the legislator. RW: I have heard people talk about MiFiD and regulatory arbitrage, which is not a healthy conversation to have. You think you have a process that is supposed to harmonise and create access and people then talk about the potential for regulatory arbitrage. I repeat, it is not a term you

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

want to hear. Equally, the FSA has been very good actually at trying to follow these directives, but other jurisdictions interpret them differently, and maybe try to find a competitive edge for their indigenous manufacturers or distributors. AJ: Another aspect overlooked by regulators and trade bodies is the lack of true practitioner involvement in the process. No one is out there consistently asking practitioners key questions. There needs to be a much greater element of practitioner involvement in understanding what are the practical problems you face in giving advice, writing business and fulfilling your obligations for your clients. I do not see that happening. RW:To the credit of the FSA, they have gone out recently and actually recruited industry practitioners, more so than many European regulators have done. NC: You raise an interesting point. We do have more experienced and capable people, but they tend to be closeted most of the time in terribly complex cases, which is understandable because that is where all the volume is. I would just observe that smaller businesses, which seem to be doing better than bigger businesses, in terms of either revenue growth or asset gathering are able to do so perhaps because they are unencumbered by complex business models and regulatory activity that chains the rest. Is this industry is suited to large organisations? Having worked in both, I have a bias towards a smaller business, but I wonder … DD: It is a good question. My instinctive reply is no. Large organisations are directed towards commoditisation, they are organised on that basis. I tend to resist to going bespoke. If we do it for one, we cannot do it for the other two thousand, it is as simple as that. What you seem to have Noland, is a very well defined product and you are not confused by any broader institutional considerations. In a large organisation, however, you tend to be pulled into a whole lot of different issues and maybe the provision of asset management in some organisations is not as central as it might be …

CLIENT TRUST

RW: Trust might be a heavy word, but NC: In many industries, working on that is what we should aspire to. That the lowest common denominator basis we have their best interests at heart is the right way to create volume and might be a better terminology to use. create quality, but in ours, I am not sure. We focus on excellence of client service, Many banks with asset management excellence of relationship management capabilities see the retail world as a and delivering a very good product at a distribution channel. So, is the client competitive price. But we appeal to an industry segment that likes high touch, getting what is right for the client? feel commitment, less DD: I actually think that a core high challenge for people involved in the commoditisation. We all try to find our business of asset management is product niche, but I like to think that all demonstrating that we are actually doing my clients believe that we work hard for something useful. I have to say I was them and we do have their interests at disappointed as to how we as an heart in terms of the investments we are industry performed between 1999 and making in our business, and the service we deliver and that we are not right all 2003. It was abysmal. JC: Many clients are sceptical about the of the time. NC: And you are providing services quality of the industry. In fact, it is where this conversation started. There is to the industry and that industry is recognition in the industry of the need to knowledgeable. JC: This is absolutely the point. You look after the client and help them preserve and maintain their wealth. I may have tens of clients or hundreds of agree with Noland, that small can be clients, thousands of clients globally, better, the problem with small is that the but you know the reality is that it is a client does not know where to go to get it. B-to-B process, rather than the end NC: If a client that says they trust you consumer. The end consumer is the in the financial services arena you are in one who has slightly lost trust in the the top 10% or 20% of business. Clients industry. How many times has this go to a well-known name because they point been discussed by people like us? do not know where else to go. Or they It is a fundamental issue. go to somebody because they know that they have a reputation for performance— whatever that means. In that instance, it is not trust. It is, “I’m told that you can perform and if you can’t I’ll sell you and get rid of you”. This is not trust. It is a commodity. You buy something, and if it does not work, you sell it. However, I do not know how many clients say, “I have dealt with that accountant, or that solicitor, or that investment manager, for ages and I really DAN O’DONOVAN, managing director, Setanta Asset trust that person.” Management Limited

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

FUND ADMINISTRATION & DISTRIBUTION ROUNDTABLE 66

PRODUCT PROLIFERATION VERSUS PERFORMANCE DD: We do tend to suffer from product proliferation as an industry. There is not an awful lot that is new under the sun in asset management, yet year after year, we launch so-called new products. It is a sales driven exercise and this gets to the point of trust discussed earlier. The agenda clearly for lots of people in the industry is expansion through sales rather than expansion through added value. I have an ongoing concern about this sort of sales driven new product. AJ: We have gathered statistical evidence to support that view. Our figures say there is product turnover, or proliferation as we prefer to call it, of 25% a year in Europe. That means new products being launched, old products being closed, and increasingly products being merged for economic reasons. On top of that you have approximately 30% plus fund manager turnover. Why? Because 70% of the industry, on a rolling three year basis, does not outperform their respective benchmarks. As an industry, we are all fighting for that ‘magic’ 30%. And then of course, you’ve got the third aspect, which is on the increase, as we all seek to go crossborder, and that is corporate activity, be that, M&A, MBO, MBI, merger, demerger, or even break-up. DD: That clearly is a legitimate dynamic, but adjacent to that, you have to ask: what do we need to sell? AJ: We can actually learn a lot from the traditional consumer market place: teenagers, for example, know every phone deals on offer, but none of them knows they ought to start saving for their pensions and the reasons why. Moreover, if you look at financial advertising—because of financial regulation— it is extremely bland. If I see another picture of a fund manager in a tube station with a toothy grin saying “I’m good”, I will throw up. FC: Does mass advertising sit well with the more arcane elements of asset management? AJ: I think that we are missing an opportunity to educate our clients and give them some reasons why they should think about long-term savings.

And what we do at the moment is that we consistently create a star fund manager culture. We create the fund managers who are the greatest thing since sliced bread whilst they work for us and, when they leave us, we say,“Oh it was the team anyway.”It almost plays on the broad tabloid celebrity culture that has done so much to dumb down many other real issues. RW: Which is it? AJ: Well the truth is that it is actually a combination of both, why you are buying it and something about the efficacy of the organisation you are buying it from. It is actually understanding, what you are buying. JC: There is a massive amount of language here You can start thinking of the sorts of terms we see in the life insurance world or the pension world or so on. We have even had an Act brought in called Pension Simplification, which probably was an oxymoron. Americans do quite a lot of work on understanding Generation X and Generation Y and the buying patterns that are coming through. We are much more able to selfeducate around a language, and financial services. Whether the media is better or whatever it is, there is more awareness. It takes time and it does not happen overnight, but I think that Generation X, Generation Y, will self-buy much more than we do as a generation. RW: The creation of new investment opportunities by geography and by asset class is just phenomenal and fast moving. As is the distribution audience—whether it is Eastern European clients, or now retail clients in China (where there are maybe more millionaires than in the US). It creates challenges for infrastructure providers in respect of ensuring we keep in step with the speed of change in the market or are ahead of developments. If you take real estate investment trusts (REITs) for example, we were one of the first offshore providers out of Luxembourg to support the product range. While it is an exciting time to be in the industry, it is also an extremely challenging time to digest all the activity and synthesise it to the point where you add value at the retail, high net work or at institutional level and provide the infrastructure to

support it. JC is involved in a lot of that activity, especially on the retail side and it is challenging, to find people who can even do that, or even talk to those issues.

NEW GROWTH OPPORTUNITIES FC: Where do you see new growth opportunities and how you are preparing to leverage those opportunities? DD: We are in the early stages here in terms of wealth accumulation. Over almost 25 years in the business, I have experienced almost constant growth for savings products. Even so, we are still at a very early stage in the whole process. I see it acutely at home, where intergenerational financial wealth is being endowed on a scale that has never been seen before. You can also see that political stability in Europe over a long period is going to have a similar implication for wealth endowment in Europe (particularly Eastern Europe).The problem that we have as an industry in the context of this type of opportunity goes back to the quality of what we are doing. How much confidence do we have that our products have a sustainable relevance to people’s savings requirements in these circumstances. What we try to do is come up with products with unique features that do something for clients and have sustained value or usefulness to people within their portfolios. Then, hopefully, we will maintain a sustained relevance for people’s savings requirements. AJ: The dramatic rise of hedge funds, and they are now moving into the mainstream, has to be good news, as it will give much more to our armoury in terms of sources of value-added. Multimanager is another massive growth area. Dan referred to his disappointment with what the industry has done from 2000 to 2003. 2000 was the turning point, because it finally laid to rest the spectre that one house could be all things to all men in all asset classes. We had the end of the biggest Bull Run in history. Most of us had forgotten that the inherent risk was in the index, with 40% allocation to technology media and telecommunications. On March the 9th 2000, we sat back thinking this was

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

great. We had a low tracking error and a low risk portfolio against the World Index. We looked somewhat stupid on March 11th because of the implicit risk that we had in TMT. From that point, you have seen the beginning of the proliferation of the multi-manager industry, which is now accelerating, and which in the UK is growing by around 40% a year. There are new entrants, lots of hype and advertising. However, out of it will come a ‘norming’ phase, when people can really demonstrate clear and consistent performance. FC: Will you have to go outside Europe to get excessive growth? JC: Highlighting Dan’s point, there is a demographic problem in Europe. There will be a mass of us, all retired, trying to live off capital. If someone has not come up with a decent income product by then we are going to be champing at the bit. What will we do: live off capital only? Italy will be the first country that will have more pensioners than workers by 2020, which is only 15 years away. You will have completely different demands put on product manufacturers because of these issues. Where will you get portfolio growth? I think you will start to see product sets built around global sectors. You could start to build products around global thematic issues and you are starting to see that happen. As Noland says, we have some very bright people, but they are not always that good. But we will reinvent ourselves. The product sets, what is called an asset class, will look fundamentally different. NC:You are absolutely right. We know what is out there now, and product development is just being cleverer and cleverer about how we mix ingredients and what we get out of those. We need to look more to the sort of product that a retail investor, or a pension fund might need. Income is an area for which there will be growing demand going forward, particularly since we seem to be in an environment where returns realistically are likely to be in the single digits. Secondly, cash-plus type products are another opportunity, which is not quite the same thing as income, because it is serving a different purpose. The ability to manage a cash plus environment is paramount, though we don’t have it at

the moment and with the bond market not being all that attractive, there is more and more money in cash. How is that cash being managed? Pretty poorly now. Structured products, derivatives and global markets actually allow you to do some quite interesting things. RW: Is that commoditisation? NC: Perhaps, but it is quite interesting that many hedge fund managers have NOLAND CARTER, chief executive officer, Rothschild Private been, it transpires, Management buying beta. I had a conversation yesterday with a successful hedge fund manager who was wooing us. He was saying, “I know that I have got to start actually serving clients.” This is a man with whom, two years ago, you would have been lucky to get an audience. Now he comes and says he wants to figure out if he can manufacture products that might suit me. Ask yourself, why in the world is he doing this? Two years ago, he would not have even answered the JEREMY CHARLES, director, CSTIM Limited phone to you. He says he realises that his business needs LEVERAGE AND RISK to grow and develop and to do this he FC: There is a lot of opportunity out needs us. That is an honest answer, in Asia and the Middle East that you and if somebody with a great track can leverage … record is saying that, then you know AJ: The key word there is leverage. We that commoditisation is coming down are all becoming much cleverer at the pipeline. leveraging what we have and building RW: To a broader audience? deeper, strategic relationships over time. NC: To a broader audience, yes. Indeed, you will probably see leverage

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FUND ADMINISTRATION & DISTRIBUTION ROUNDTABLE 68

happening [here] more, as you have done in the US—with retail investors in particular. The retired market in the US is massive and has a huge influence on the retail investment programmes of asset management houses. There is a natural progression toward understanding where you have leverage and more importantly, where you do not. RW: In terms of our traditional TA business, we see a drive to create support and infrastructure for clients invested in places such as Taiwan, Korea and Thailand, which have slightly more mature fund management industries. We are seeing asset managers who are looking for opportunities to distribute products on a wider basis, however they choose to do it, and the infrastructure advisors like us are working on ways on how best to support that. In our case, it is a little easier, in that the manufacturers are coming from one centre, and are looking for distribution support in multiple centres with minimal infrastructure investment in their own world. Moreover, it actually helps reduce costs. If we help manufacturers stay in one centre and yet distribute in multiple centres for certain types of products, they gain broader access to sell more product across more jurisdictions but with minimal costs as, in effect, we are taking on those costs in their stead. DD: Once you have developed some good products, for example, an energy fund, or an income fund, they should sell anywhere. Of course, that is a great theory, but it takes an awful lot of work to get a good product, working effectively down multiple distribution channels—particularly across different geographies. AJ: We do not make it easy for ourselves. If you take the advent of defined contribution pension schemes in the UK, the take up on them in the main has been disappointing. You know it has been poor and when you look at where investors direct their investments, 80% of them do not make an investment choice and so go into default funds. FC: Is that because the UK government has been slow in articulating its position? AJ: It is not the populist policy to say

that we cannot afford to support the pension’s regime. What we are doing is effectively privatising pensions by stealth in the UK. It is a lack of joined up thinking and not taking into account the experience of other countries. Again taking North America as an example, you join the 401K plan unless you elect not to, so you have to make a positive decision to opt out. We do not even make fundamental choices like that easy for our clients. JC: I ran a seminar with a young group from a German bank, discussing this very problem with state and occupational pensions and poor savings regimes. Germany is still 40% into cash and then 20% into fixed income. Equity culture and growth is pretty small. Germany has a problem, as it cannot afford its defined-benefit state pension scheme. Tax rates are already high but they can only go higher to afford the future pension liability. The group said, ‘“Well, we might just decide to walk away from funding that”. We might have social unrest then in the future, because Generation X might say, “It is your problem. You did not save for the future and why should we pay tax rates to fund your pension?” Nationalism and xenophobia will also increase, despite the need for immigration to fund the demographic gap. Therefore, there is a huge impending problem coming that we have just started to perceive. DD: Also, this business of holding assets globally means that to a degree risk is underestimated at times. Local political problems may result in strange things happening to assets. They may be appropriated, for example, as recently happened in Venezuela. For portfolios excessively diversified away from stable, viable economies, this could be a very nasty experience.

INFORMATION TECHNOLOGY FC: Are you investing enough in IT? JC: IT is fundamental. IT and technology can enable everything we have been talking about—apart from the quality of some of the individuals. However, many organisations have not

spent a lot of money on IT because it is working to very short-term goals. In turn, a lot of the IT out there is rubbish because IT firms have not had the money, to spend on development and keeping up to date. Most of the major IT companies simply buy another IT company to get market share and again, they do not invest. Any good IT is coming from the smaller companies and you then have the problem of determining who and where they are. You get the IT you deserve, exactly in the same way that you get the legislator you deserve. DD: The model in our group is to sustain a number of asset managers within the group, everybody operating quite independently, but working off a common infrastructure. We aim to operate on a common front office, common back office and that model is very effective: we get access to systems and expertise of a very high standard. AJ: IT is the third largest spend item after personnel and property costs, because it has to be. In my business, if you are to get any scale to meet the needs of institutional clients and be effective, we not only have to have good quality IT today, but we have to constantly thinking about what we may need in the future. We outsource to several different administrators because of the nature of the clients that we deal with. Some of them have a global arrangement that we fit in with, although increasingly what we are trying to do is to leverage by pooling assets together NC: We have outsourced the back office and we have a middle office that bridges us. We have two outsourcing relationships. One for our UK business with a major US player, and the other for Switzerland, with a sister company that has developed a specific platform that we work with. Front office tools are relatively easy, because we are a small group. The issue is client reporting and front office tools. Partnerships are being created between front office and back office product providers and they are coming up with solutions, but the reality is that most of these are untested. JC: The major asset managers have to spend to create the demand and then you see the software suppliers come up with new software. Without that

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

complexities provide immediate service? FC: But if you talk to the banks as a journalist, they tell you they offer real time or virtual real time valuations, unless its private equity, where it might be periodic valuations. NC: There is a big difference between giving virtually real time valuations and giving accurate virtual real time valuations. Do I trust the numbers I see? RW: When ROB WRIGHT, chief operating officer, RBC Dexia Investor Services everything works, it is fine. What we are talking about here is spending, IT firms are not investing. FC: Are asset managers always going when things do not work. We run a to depend on banks to provide global organisation, working out of 15 different countries. In effect, we have outsourced services in future? RW: It depends. There are real major IT installations in London or differences involved in servicing the Luxembourg or Toronto. Then, in each of high net worth and the retail businesses, our countries, we have instituted a compared with tradition institutional second level of IT that can ideally respond business. We provide exotic reporting for to the client needs. Rather than waiting institutional clients, for instance, but for time zones, or other lags, it responds much less exotic reporting for retail or immediately and does not rely on the high net worth clients. We are working central IT zones. It is a challenge though. on this very issue with our very large The more global you become, the harder high net worth client base in Canada. As it is to manage your infrastructure. In you invest in new technology to support addition, if you run common IT traditional TA business and/or the programmes in 13 different geographies, generation of product from a platform, that is a complexity all of its own. you have to service what you get paid for However, I do agree, client service, is today, versus investing in what you going to be a key differentiator as to might be paid tomorrow and that is whether you will be successful in this always a tough challenge. We built our business or not. FC: Is this going to become more particular TA platform ourselves, which offers multiple jurisdictions and multiple important as regulators require more regulatory environments. It has involved marking to market? JC: Yes, it comes back to laggard a massive scale of investment. Then we distinguish ourselves based on our client effects. The fact that businesses can now service and product, much the way the manage money in a more dynamic style requires this. Many hedge strategies asset management environment does. NC: You have hit the nail on the head. need to be marked to market, but you go We deal with an organisation that is along to the main institutional asset servicing us out of three locations. They management IT providers and ask them react to our needs, but because these for their system that does real time different locations all play a part in the pricing and they do not have it. food chain, it might take 48 hours. How Therefore, mark to market is do organisations with their global fundamental. The whole pricing area

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER/OCTOBER 2006

within the hedge world is one of the risk areas, but IT actually has not caught up with where that is. That has to happen. FC: What is the most important issue you will face over the coming year that will affect your business over the next ten years? NC: For me it is easy, it is finding more clients. All the things we have discussed, the complications that are the nature of the industry, actually in our niche market play very nicely to us and we will to take advantage of all the problems that we have discussed. The one thing that we cannot get around is how you get into very rich people and persuade them to let you give them advice. They do not come to you naturally. Distribution into wealthy people has not been nearly as successful as some banks think it is. We can point to lots of examples in Europe that will support that. AJ: I would qualify my answer in that we are a fast growing business in one of the fastest growing sectors in the industry, and ours is a manufacturing based model, very much business to business. Given those parameters, it is continuing to maintain and managing growth effectively. We have grown at 45% per annum compound for the last four years and that takes a lot of management â&#x20AC;Ś JC: The big issue is finding core competency. It is all about making sure that you understand what bits you are going to do and what bits you are going to get someone else to help you with. The industry is complex and will become more so, and you have to go and find the bit you want to do. DD: The key challenge will be to exploit fully the opportunities that we have to use our distribution channels in Germany and Canada and to tap into the domestic market in Ireland. We need to keep our products well defined and to get them on to appropriate platforms. We will also need to tap into external expertise in a number of areas, such as I have already mentioned, in order to develop some of these products to their full potential. FC: Thank you very much.

US SECURITIES LENDING

Once viewed as a second-line generator of revenue, securities lending has grown steadily to become a potent business interest for investment-management institutions and enterprising newcomers alike. While custodians rely on proven methods as well as alternative approaches to lending, concerns over minimising risk and maintaining profitability amongst a field of savvy competitors abound. From Boston, Dave Simons reports.

THIRD PARTY LENDING

TEES OFF ETER ADAMCZYK, MANAGING director, Global Securities Lending for AIG Global Investment Group, underscores the reasons for the growing interest in securities-lending activity. “The small but consistent returns generated by securities lending are seen by many as an effective way to offset custody and investment management fees,” says Adamczyk, “and the practice is fast becoming a vital piece of an overall investment strategy for the majority of institutional investors. The total size of the market has grown dramatically in the last few years and continues to grow at close to 10% per year in the United States and Canada.” Recent numbers support Adamczyk’s claim. Last year, State Street Bank reported $330m income from fees resulting from securities lending, and in the second quarter of this year, the Boston-based institution racked up an additional $113m on stronger-than-expected lending volume. At Chicago-based Northern Trust, securities lending fees totaled $60.9m in the second quarter, up 30% compared with last year’s second quarter, reflecting higher volumes and improved spreads on the investment of cash collateral.

Meanwhile, Pittsburgh-based Mellon reported that institutional trust and custody fee revenue, which includes securities lending revenue, jumped 26% to a record level of $244m due to increased spreads and higher volumes. Beneficial asset holders, many of them large public pension programs, have been able to significantly improve performance by making their pool of assets available to the borrowing market through a low-risk securities-lending arrangement. While a pre-existing custodial relationship has often been the simplest way for large lenders to access the market, increased competition from non-custodial players—including third-party agents and auction specialists—has irrevocably changed the face of securities lending. Custodians, however, view their business as a platform for cross selling into all kinds of client constituencies, including securities lending. The lower operating costs that are associated with pooling, for instance, allows smaller clients access to services like securities lending as well as commission recapture. Size and stability are seen as leading attributes by custodian lenders as well.

Photograph supplied by Istockphotos.com, August 2006.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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US SECURITIES LENDING 72

Unbundling

over $880bn in global equity and fixed income securities The past few years have since its inception just six witnessed a noticeable shift in years ago. In May, psychology among major eSecLending (recently beneficial owners, with many purchased by private equityfinding it advantageous to divide firm TA Associates) was custody and lending into separate entities with the goal of awarded $76bn in borrowing rights to the California maximising returns. Public Employee Retirement “Unbundling is inevitable,”notes Paul Wilson, product executive System fund (CalPERS). The company continues to see its for investment products at JPMorgan, “custodians have to auction-based model in top accept that, find new ways to demand, with new clients including a number of compete and emphasise those areas, such as operational leading domestic mutualfund houses. efficiency, where they excel.” While putting assets up While custodians have, to a for bid may not be for large extent, already begun the everyone, the recent unbundling process, many still struggle to manage consistent performance chart on CalPERS, one of the pricing schedules for the principal developers of services they provide, says eSecLending, is proof that Mark Bailey, managed lending the system is working. In director at Credit Suisse. “The the years since it altered its most extreme case that we have Kathy Rulong, executive vice president and executive director of lending strategy, CalPERS seen is where the price that the Mellon Global Securities Lending says “As beneficial owners has shot to the top of the custodian wanted to custody continue to gain better understanding of how lending can add beneficial owner chain, the assets resulting from a to the value of their portfolios, they will continue to seek out outpacing nearly nine in 10 third-party lender’s collateral refinements in the management of their lending programs.” of its industry peers. reinvestment activity was three Photograph kindly supplied by Mellon, August 2006. “The auction process has times higher than the rate it applied to regular custody of similar assets. In this case we achieved tremendous returns for CalPERS’ securities lending worked with the client and a second custodian to secure a program over the past six years,” affirms Dan Kiefer, opportunistic portfolio manager for CalPERS. “By actively custodial relationship for the client at a market level.” With asset owners increasingly seeking alternative routes managing our lending activities and continually re-auctioning to market, the impact of third party lending is much more the exclusive agreements, we were able to once again optimise apparent than ever before, says Bailey. “It is now an our return which is expected to translate into another record accepted route to market for most clients, and we believe earnings year for our securities lending program.” that consultants operating in this space have come to “We differ from traditional agency providers in that we realise that. This does not mean that one third-party lender do not utilise a pool or queuing system in our program,” is right for all clients, but it certainly means that the award notes Chris Jaynes, managing director of eSecLending, is not made by default to the custodian bank. Typically we who sees an increased acceptance of auction-based see clients and consultants inviting more third parties to lending after years of reticence. “Rather, each client is bid and have seen the custodian banks creating third-party treated as an entirely separate book of business. Also, lending capabilities.” unlike many securities lending providers, securities lending “The news in connection with third-party lending and on a third party basis is our core competency.” auctioneers is that neither is news anymore,” says Kathy With a growing number of beneficial owners actively Rulong, executive vice president and executive director of managing their securities lending programs, Jaynes sees Mellon Global Securities Lending. “As beneficial owners the trend towards the unbundling of securities lending in continue to gain better understanding of how lending can add the US from custody mandates accelerating over the to the value of their portfolios, they will continue to seek out coming years.“Lenders are increasingly viewing securities refinements in the management of their lending programs.” lending as an asset management and trading process rather than a back office or operational function,” says Jaynes.“Given this shift, more lenders are using third party Third party candidates The rapidly evolving lending market has been a boon for the providers and alternative routes to market such as the likes of Boston-based eSecLending, which has auctioned auction process.”

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

for every portfolio, and we Custodial lenders such as try to look at each situation Pittsburgh-based Mellon on an individual basis and have responded to the ramp Custodial lenders such as figure out how we can up in third-party activity by Pittsburgh-based Mellon have optimise the return for that augmenting traditional responded to the ramp up in thirdparticular client. However, I strategies with a full slate of party activity by augmenting think the industry overall is alternative platforms, traditional strategies with a full slate very committed to including telephone and of alternative platforms, including improving the technology, online auctions, which in theory does make collaborating with thirdtelephone and online auctions, it much easier to separate party lenders on behalf of collaborating with third-party lenders lending from custody. We trust and custody clients, as on behalf of trust and custody clients, were a pioneer in the well as acting as third-party as well as acting as third-party EquiLend arena, and that lenders themselves in order lenders themselves in order to has been a key part of our to provide specialised technology commitment. services or market insights. provide specialised services or We believe that service will “As these developments market insights. continue to gain momentum continue to evolve,” says in the market.” Mellon’s Rulong, “we have While portfolio size is not put an emphasis on working with our clients to better understand how to select the always a factor, for third party lending, bigger does tend to lending arrangements best suited to the specifics of their be better, says Van Grinsven. “Obviously with that kind of arrangement the securities are moving a bit more than they situation and the holdings in their portfolio.” Custodians who utilise auctions to strengthen their sec- are under a standard agent-lender situation, and lending capabilities frequently incorporate the advanced consequently you have additional transaction costs to deal technology and standardisation of the EquiLend platform, with. Although it is an investment-management decision, developed six years ago through a consortium of global most clients do not always want to track a vast number of financial institutions with the goal of optimising efficiency in securities-lending providers. As such, with a bigger portfolio, the more likelihood the securities-finance arena. they’ll have the kind of Using EquiLend’s AuctionPort blocks that are attractive to a system, State Street recently third-party lender.” completed a securities lending “It’s not as much about the auction for approximately size as it is about the $2.6bn in international assets composition of the portfolio,” for the Ohio Public Employees offers Tim Douglas, global Retirement System (OPERS). head of securities lending at “We work with our customers Citigroup. “We really care to establish innovative about the quality of the assets, securities lending programs is there demand for the assets, tailored to their specific and so forth. Securities investment objectives and risk lending is part of the capital parameters,” says Edward J. markets, and markets are all O’Brien, executive vice about supply and demand. president and head of The prospective client list that securities finance at State might be interested in Street.“We offer our customers securities lending is quite the option of an auction using substantial, and ranges from the EquiLend platform, which the largest players in the can be an excellent alternative world to significantly smaller when specific market and players. Our business model asset criteria are met.” has to be geared to adapt to all “We probably did over 100 shapes and sizes. As a result, I portfolios on an auction Edward J. O’Brien, executive vice president and head of securities try not to be biased about size basis last year alone,” says finance at State Street explains that: “We offer our customers the and not to set limits, and Mark Van Grinsven, head of option of an auction using the EquiLend platform, which can be an instead stress the value of the global securities for excellent alternative when specific market and asset criteria are marketplace itself.” Northern Trust.“It’s not right met.” Photograph kindly supplied by State Street, August 2006.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

US SECURITIES LENDING 74

The Hedge Edge

have always tried to make it clear to our clients that Experts see no end to the tremendous build up of hedge- although there is some moderate risk in this business; it is fund assets, which are expected to reach an estimated risk that must be dealt with nonetheless. People need to $2trn by the end of the decade. Securities lending be well positioned to handle operating risk, investment activities have increased with the growth of hedge funds risk and credit risk. Obviously those who can control the and related products, raising the pool of cash collateral in risk the best will be the ones who are most successful in the process. “There is no question about the role hedge the long run.” Of equal importance is having a thorough funds have played in the securities lending market in recent years,” says Mellon’s Rulong. “Mellon’s total understanding of the settlement and tax practices of the securities on loan have nearly doubled from the end of domestic markets, which make securities lending in the the second quarter of 2004 to the end of the second US unique to the rest of the world, adds Van Grinsven.“For instance, the US has the quarter of 2006, increasing largest and most mature from $95bn to $187bn. To securities-lending market, keep pace with that increase and has the highest in demand we’ve added penetration of automated staff and increased our level solutions. Another key factor of investment in our is that the US is much more operating platform.” heavily cash collateral With both institutional relative to other markets, investors and asset managers meaning that the cashmoving toward hedge funds reinvestment component is and hedge fund like products quite critical. On the other in greater numbers, hand, you have markets like it becomes increasingly the China, India and the important to be able to Philippines, markets that are provide support in that area, all much smaller in terms of particularly as the boundaries market value, and for people between traditional and nonwho are very early to enter traditional investing continue the game there is a lot of to blur. opportunity because the Earlier this year, spreads are much larger.” JPMorgan’s Worldwide Above all, the ability to Securities Services (WSS) offer a quality product division acquired the middlebacked by a history of and back-office operations of stability isn’t something that US-based Paloma Partners will become less valued, says Management Company, an Tim Douglas, global head of securities lending at Citigroup says Douglas. “While third-party investment fund manager. “Securities lending is part of the capital markets, and markets lending is a perfectly Aimed at helping the are all about supply and demand. The prospective client list that legitimate path to market company sharpen its hedgemight be interested in securities lending is quite substantial, and and somewhat keeps with a fund focus, the new venture, ranges from the largest players in the world to significantly broad industry trend towards dubbed JPMorgan Hedge smaller players. … I try not to be biased about size and not to set best execution and Fund Services, is a key limits, and instead stress the value of the marketplace itself.” transparency, I’m also a big component of the company’s Photograph kindly supplied by Citigroup, August 2006. believer in sec-lending as a Alternative Investment Services business unit, a suite of products that includes product unto itself. The way I see it, it’s all about the services for hedge funds, private equity funds, global lending—and we certainly take the view that if we have a derivatives and leveraged loans. Such initiatives may in fact custody client, sec lending is a great product to offer to that make it easier for certain hedge funds to consider bypassing client. If the industry wants to call that custody lending, so prime brokerages and borrowing securities directly from be it. To me, the source of the securities isn’t all that relevant, what matters is that they are an existing client of custodians, say observers. the firm, and I’d like to offer them a value-added service. By the same token, if the client does not use us for custody Custodian Quality Despite the emergence of third-party players and and wants to use us for securities lending, we’re happy to alternative lending programs, for customers who are do that, too—we do it all the time and it’s a significant part concerned about minimising risk, the track record of a of our operations. And if the industry wants to call that large custodian speaks volumes, says Van Grinsven. “We third-party lending, that’s fine, too.”

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

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WINNING FACTOR

REAL ESTATE REPORT: KB HOME

After a decade of supercharged growth, the homebuilding market in America looks to be spent—the victim of rising interest rates and oversupply. During the long days of the housing boom, virtually all the industry’s major players looked smart. A severe slowdown will reveal which homebuilders really are smart. Art Detman reports on why California’s KB Home thinks it will be one of them.

HEN BRUCE KARATZ, chairman and chief executive officer of Los Angeles-based KB Home talks about America’s amazing housing boom, he points to some impressive numbers for the US homebuilding industry: a 26.1% return on shareholders’ equity for 2005, 40.5% annualised growth in profits over five years, and 28.8% total annualised return over ten years. But perhaps most impressive of all are some stock price figures. From the beginning of 2000 through 2005, the Standard & Poor’s 500 Index rose a meager 3%, but the S&P 500 Homebuilding Index and the Dow Jones Home Construction Index both rose more than 350%. KBH itself, Karatz gladly notes, posted a 357% gain. This skyrocket performance reflects KB Home’s emergence as one of America’s preeminent homebuilders— diversified not only geographically but increasingly by product and price point. Founded in 1957 as a builder of entry-level homes in Detroit, Kaufman and Broad in 1961 became the nation’s first homebuilder to sell shares to the public. The firm relocated to California in 1963, opened a French operation in 1967, became in 1977 the first builder to build an aggregate total of 100,000 homes, adopted the KB name in 2001, and by 2005 had homebuilding operations in 39 of the top 75 markets in 15 American states and France.

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REAL ESTATE REPORT: KB HOME 76

Some economic forecasts predict that patience will pay. Along the way, it made more than a dozen acquisitions, perhaps the most important of which was the 1996 Value Line, for one, sees a slowing of economic growth purchase of Rayco of San Antonio, Texas. Unlike nearly all through early 2007. Housing starts will fall from last year’s other major builders that tended to build hundreds of 2.06m to 1.78m by late next year, partly in response to houses in the hope selling them, Rayco built a model home rising interest rates, and home prices will be flat to lower. and then built to order once a sale was made. KB adopted Not very reassuringly, Value Line says that a housing this same business model, and since then its revenues and market collapse is unlikely but “can’t be totally ruled out.” Clearly, a glum outlook except for one thing: KB still has profits have grown explosively. The company delivered fewer than 8,000 houses in 1996 a good chance of selling more homes this year, and earning compared with 37,140 for fiscal 2005 (ended November more money, than it ever has before. Kelly Masuda, senior 30th). Revenues rose from $1.79bn to $9.4bn, net profit from vice president and treasurer, has slashed the company’s $48m to $842m, and earnings per share from $0.60 to $9.53. earnings-per-share guidance from $11.25 to $10—but that KB’s net profit margin, an anaemic 2.7% in 1996, was 8.9% is still ahead of last year’s record $9.44. Part of KB’s in 2005, and its return on shareholders’ equity more than confidence comes from its geographic range. Yes, the doubled, from 14.1% to 29.5%. Little wonder that the stock company is in formerly hot markets such as Los Angeles, Phoenix, San Diego and Washington; but it is also in climbed from $5 to an all-time high of $85 last year. Alas, in a cyclical industry such as homebuilding, upturns markets that have not been overbuilt, such as Atlanta, are followed by downturns, the signs of which appear Chicago, Dallas and Denver. In terms of units delivered last year, 27% were in KB’s unmistakable. Price central region, 20% in the appreciation of existing southwest, 19% in the homes has slowed to single southeast, 18% on the digits, and in some markets Clearly, a glum outlook except for West Coast, and 16% in may be in negative one thing: KB still has a good France. territory. In once chance of selling more homes this Then, too, KB has superheated markets like year, and earning more money, than diversified beyond entryBeverly Hills and the San it ever has before. Kelly Masuda, level homes into move-up Francisco Bay area, sellers and luxury homes, as well of high-end homes are senior vice president and treasurer, as homes for “active cutting prices. New has slashed the company’s earningsadults” (i.e., old folks who housing starts fell in April per-share guidance from $11.25 to can take care of for the third month in a $10 — but that’s still ahead of last themselves). A new urban row. And in markets across year’s record $9.44. division specialises in the country, inventories of medium- to high-density unsold single-family developments in built-up houses and condominiums areas; its first undertaking have risen sharply from a year ago: up 91% in San Diego, 149% in Los Angeles, 230% is a 250-unit luxury condominium project in downtown in Washington, D.C., 236% in Miami, and 282% in Phoenix. Los Angeles. Additionally, KB plans to soon begin Overall, the number of unsold new homes reached 565,000 construction of nearly 800 homes in Jefferson Parish, just outside of New Orleans. units in April, a record (but still only a 5.8-month supply). KB’s partnership with the storied Martha Stewart is At KB, second quarter orders dropped 19%, the company laid off 7% of its employees, and the stock fell to the mid another plus. The idea was Karatz’s who, for a lawyer — he 40s, off more than 45% from its 2005 all-time high. “The joined the company in 1972 as associate general counsel problem is not demand,” explains Lawrence J. Horan, and became CEO in 1986 — has proven an imaginative and formerly an analyst with Janney Montgomery Scott in effective marketeer. For example, as head of the French Philadelphia. “Demand is still quite strong. What has operation in 1977 he installed a full-size model home on the happened is this: virtually all the markets that have had roof of Au Printemps, a department store. It made both him price appreciation substantially above the rate of inflation and Kaufman and Broad famous throughout Paris. Under the agreement with Stewart, KB will build a have cooled.” The reason, he explains, lies with speculators who bought new homes in hopes of reselling them at a number of tracts—they are now called “communities” in profit. Those with profits are selling now, while others who the homebuilding industry — that are co-branded and bought late in the cycle are holding back, hoping the market whose designs are “inspired by several of Martha Stewart’s will rebound. “This makes it particularly difficult for new personal residences.” First off the line is “KB Home’s Twin homebuilders,” says Horan. “Everyone knows that Lakes: New Homes Created with Martha Stewart”(no one appreciation has slowed and that speculators are putting ever said co-branding would be succinct), a tract of 650 product back on the market. So people are not eager to buy; homes in Cary, North Carolina, near Raleigh. “We launched this in March, and I think it was one of our they are looking for a bargain.”

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But the build-to-sell concept has serious drawbacks. Its most successful grand openings ever,” says Masuda. “We plan to build more Martha-branded communities very efficiency encourages overbuilding; after all, each throughout the country. We have a community called additional house reduces the average cost of the rest. And Hampton Oaks that is going to open in Atlanta this although buyers may have a selection of floor plans, summer, and additional communities are also expected to beyond that their choices are limited largely to paint colors open this year in Houston, Charlotte, Las Vegas, Orlando, and appliances. KB’s build-to-order policy calls for the construction of a Daytona Beach and southern California.” Martha Stewart will not be living in any of these places. handful of model homes to illustrate various floor plans. Once Once she sells her home in Westport, Connecticut — listed a buyer has signed a contract, he or she visits a “KB Home at $9m and the basis for some of the KB-Martha Stewart Studio” to choose not only paint colours and appliances but home styles — she’ll move to a 153-acre property, about literally thousands of other options, ranging from countertops 25 miles north of New York City. “The really incredible to an extra bedroom, higher ceilings, or a larger garage. For the thing about our partnership with Martha — and we saw buyer, it’s a way of not only customising the house to individual this in Raleigh— is the ripple effect. Not only was the needs but often doing so at considerably less cost than Martha Stewart community extraordinarily successful, we remodeling a finished house. An extra bedroom over the saw a pickup in traffic in other communities in the area.” Plus, says Masuda, he noted an uptick in subcontractors calling and wanting to work on KB projects and municipalities’ asking for a Martha-branded project in their area. “If you look at the drivers behind the housing market, they are still relatively healthy,” Masuda says. “There is still strong population growth, favorable demographic trends, low mortgage interest rates, solid job growth, and growth in personal income. Because inventory level has increased and demand has decreased over the short term, it will take time for the market to work through the current housing supply. And the market will move to a new equilibrium, which will provide the platform for continuing growth.” But perhaps the overriding reason for KB’s confidence is its “KBnxt” [sic] operational business model, which builds upon Rayco’s sell-then-build Some economic forecasts predict that patience will pay. Value Line, for one, sees a slowing of approach. Under KBnxt, the company economic growth through early ‘07. Housing starts will fall from last year’s 2.06 million to 1.78 follows a series of procedures to identify million by late next year, partly in response to rising interest rates, and home prices will be flat and acquire building sites in growth to lower. Not very reassuringly,Value Line says that a housing market collapse is unlikely but markets, and then design and construct “can’t be totally ruled out.” Photograph supplied by Istockphotos.com, August 2006. homes to meet local buyer preferences. The old“field of dreams”concept (that is, build it and they garage will cost much less now than adding it later and some will come) is still used by some builders, mainly small changes — nine-foot ceilings instead of eight — are simply not regional firms. Its advantages are undeniable. By designing feasible in a completed building. For KB, the Home Studio and building a large number of houses at a single site all at means not only a satisfied customer but a 45% gross margin, once, maximum construction efficiency was attained. It was about twice that of the base house, and an additional $1bn in Fordism for homebuilders, a concept proved after World annual sales. Another advantage: KB can price its base houses War II by William J. Levitt, who in just over a year built 6,000 low and let the buyer drive up the sales prices through small but wonderfully affordable homes on what had been customisation, whereas other builders include many extras and a 1,500-acre potato field on Long Island, New York. His may have to discount prices in order to sell homes. It is the build-to-order concept that gives KB such later projects — they were all named Levittown — included a washing machine and television in each home. At one confidence for 2006, for at February 28th it had the largest backlog of orders in the industry, 26,536 units, up 25% from point, Levitt was completing 150 houses a day.

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REAL ESTATE REPORT: KB HOME 78

a year earlier and worth $7.2bn — an average selling price of $304,000 per home. Unlike several other builders, KB has been able to achieve this without discounts or other incentives, although William G. Ferguson, an analyst with Value Line in New York City, says those might be necessary next year. “KB is the best merchandiser in the industry,” says Gregory E. Gieber, an analyst with St. Louis-based A. G. Edwards & Sons. “It also has one of the strongest management teams in the business, and is one of the few homebuilders that is run like a real company. It and Pulte Homes are the only two that conduct market research, if you can believe that, and KB is the only one with a formal executive development program. Its computer-based KB University provides outstanding training. I wish I could take that course. It would make me a better analyst.” Gieber also notes that KB may be the only major homebuilder that conducts its business according to a single business model — the KBnxt Playbook — across the entire country. It is also one of the few that uses just one brand name in all its projects. Little wonder that, according to the company, when responders were asked to name a homebuilder, nearly four times as many cited KB Home as the next Kelly Masuda, senior vice president and treasurer, has slashed the company’s earningsfive names combined. per-share guidance from $11.25 to $10 — but that’s still ahead of last year’s record KB is notable by other measures. It $9.44. Part of KB’s confidence comes from its geographic range. Yes, the company is in was the first of the major builders to formerly hot markets like Los Angeles, Phoenix, San Diego and Washington, but it is also adopt the National Housing Quality in markets that haven’t been overbuilt, such as Atlanta, Chicago, Dallas and Denver. In Certified Builder program of the terms of units delivered last year, 27% were in KB’s central region, 20% in the southwest, National Association of Home Builder’s 19% in the southeast, 18% on the West Coast, and 16% in France. Photograph kindly research center. Intended to increase supplied by KB Home, August 2006. efficiency and consistency in building practices, this program includes a third-party audit of Line’s Ferguson has compiled the key operating results of business practices and quality assurance systems. More the nation’s dozen largest publicly held homebuilders, and than half of KB’s operating divisions have been certified, in terms of revenues, operating margin, net profits, net and the others are in process. The famed quality surveys profit margin, return on invest capital and return on of JD Power and Associates has ranked KB among the top shareholders’ equity, KB does not stand out. But as the three builders in four markets. Karatz’s goal is to have KB storm clouds grow darker over the U.S. homebuilding ranked in the top three in every one of its markets, which industry, this picture could change radically. “Given the strength of the market over the past few is not unrealistic considering that its internally conducted years, almost all homebuilders performed quiet well,” says survey finds a customer satisfaction rating of 94%. Karatz also notes that the company’s share buyback Treasurer Masuda. “But as the market cools and demand program has returned more than $1bn to shareholders in comes back to more normal levels, there will be a the past seven years. Here, analysts aren’t impressed. differentiation among homebuilders’ financial results, “Earnings from share buybacks are low-quality earnings,” which is difficult to see in a very, very strong market.” Gieber of A.G. Edwards agrees: “KB has a lot going for Gieber says. “Shareholders are interested in a return on it, which we think gives the company a good chance of their capital, not a return of their capital.” And here Karatz may face his greatest challenge. Value outperforming its competition in a market downturn.”

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

THE LURE OF REIFs

REAL ESTATE REPORT: REIFS

LUXEMBOURG:

As alternative investments become a leitmotif for investors looking for absolute returns and reliable growth, investment in real estate through Real Estate Investment Funds (REIFs) is growing in importance. The concept is well developed. In Germany, for instance, the Bundesvertbank Investment und Asset Management eV (BVI) reports that 20% of all retail funds in Germany invest in REIFs. John Wantz, director of business development, REIFs at RBC Dexia Investor Services, reports on why Luxembourg is becoming a domicile of choice for registered real estate funds. ROWING DEMAND FOR real estate investment vehicles is a key driver behind the growth of REIFs — Luxembourg-based investment vehicles that have risen to prominence over the last few years. Changes in tax rules and the need to convert properties into liquid assets have also driven the business. By every measure, REIFs are booming. In 2000, there were just six regulated schemes, whereas today there are 60 already in operation or being readied for launch. Asset growth is equally steep; although industry estimates of $15bn may understate total holdings, because of the geared nature of the funds. Long seen as a good hedge against the volatility of shares, real estate can generate investment returns that offer better long-term protection against inflation than bond or money market assets. Even so, investors have not always found it easy to invest in property markets, especially on a cross-border basis. Moreover, while tax and favourable legislation have assisted the market, equally, tax and regulatory issues have sometimes deterred some investors from maximising their allocation to real estate, particularly in unregulated or unlisted schemes. Nonetheless, REIFs are set to capitalise on the market’s appetite for regulated real estate investment schemes.

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Based on Luxembourg’s Fonds Commun de Placement (FCP) — a vehicle that has recently come to prominence through its association with cross-border pension fund asset pooling — as well as on its increasingly popular Société d’Investissement à Capital Variable (SICAV) vehicle (please refer to the box entitled: A quick and ready guide to REIFs), the legal foundation for REIFs is common Luxembourg fund law. The implementing regulations add a good degree of flexibility to the concept.

The Luxembourg effect As a well-regulated, well-established offshore jurisdiction with a strong infrastructure and a reputation for a pragmatic and flexible approach to regulation, Luxembourg is an ideal location for REIFs. Overseas fund promoters have quickly recognised the potential for cross-border property funds run through the Duchy. Often REIFs are set up to invest in the South East Asian property sectors. Luxembourg can also offer a highly developed pool of real estate expertise, from tax advisers, lawyers and auditors to custodians, administrators and transfer agents. While regulated REIFs are likely to become a significant investment vehicle, Luxembourg already has a long history of hosting similar, but unregulated, schemes. Property fund

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REAL ESTATE REPORT: REIFS

promoters can profit from Photograph supplied by istockphotos.com, August 2007. the built-in tax efficiency of Luxembourg-domiciled participation and finance companies. These companies – known as Soparfis – benefit not only from double taxation treaties, but also from socalled ‘participation exemptions’ from the taxation of dividends and sales proceeds of underlying subsidiaries. Promoters can not only choose tax-transparent FCPs but also corporate structures in the shape of SICAFs and SICAVs, the two other types of mutual fund vehicles. Ultimately, the choice of structure will depend upon the precise expanded opportunities, as there is no cap on their requirements of the investors and fund managers. In potential to add new clients and assets. The success of the Luxembourg REIF market has keeping with unregulated schemes, the property investment process itself usually is managed through inspired other jurisdictions to try and replicate the Luxembourg Soparfis and local special purpose vehicles product. Dublin, which has been a strong competitor for (SPVs). Typically, there are two flavours of REIF: the self- pension fund pooling products with its common explanatory Fund of Property Funds and the Direct contractual fund (CCF), has so far struggled with crucial Holding Fund, where the direct investments in buildings tax and legal drawbacks. Under Irish law for instance, a are managed through a series of underlying Soparfis and trustee must be the owner of the property. It’s a SPVs. In both cases, they are funded via capital calls or requirement that is unlikely to be accepted by promoters of the fund because, when a fund owns a property drawdowns of the investors’ commitments. directly, valuable tax advantages are lost. At present, Luxembourg’s main competition for real estate fund An Evolving Market REIFs are beginning to show signs of broadening their business comes from Jersey’s limited partnerships, whilst appeal and moving beyond a previously narrow focus. the Netherlands has ambitions for the sector, but faces Fund promoters have started to develop tailor-made the prospect of having to unravel tax complexities that solutions, in which they work closely with small groups of present a significant barrier. Other European countries — most recently and notably, institutional investors to agree on investment strategy and policies. Whatever they agree, Luxembourg law does not the United Kingdom — are launching real estate investment trusts REITs). Typically, REITs are designed to mandate a payout ratio of earnings. appeal to domestic The market began life institutional investors, with mainly closed-ended REITs: A growing phenomenon and seem likely to invest institutional funds with a 140 primarily in domestic lifetime of between 10 to 12 property. The UK’s years, but that is starting to 130 proposed REIT, for change. The advent of example, has a tax open-ended REIFs, with 120 structure that will monthly net asset value 110 probably make it (NAV) calculations, is likely unattractive to overseas to attract more high net 100 investors, and the worth retail investors into 90 complexities of running this segment: contrast that cross-border investment with today, when between funds through such a 80% and 90% of REIFs are FTSE All-World Europe Index FTSE EPRA/NAREIT Europe Index structure may outweigh purely institutional. Openany advantages. ended REIFs will offer Source: FTSE Group US Dollar price returns. Data as at August 2006

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

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Presentations From Lenders, Agents , Borrowers, Consultants, & Business Leaders Discussing: N N N N

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THE ORIGINAL SECURITIES LENDING CONFERENCE -- DON’T MISS IT!!! Planning to Attend: For registration questions, call RMA, Kim Gordon, 215-446-4021 *E-Mail: kgordon@rmahq.org or visit our Web site at http://www.rmahq.org/RMA/SecuritiesLending Conference Co-Chairs Kathy Rulong Exec. Vice President Mellon Global Securities Lending Pittsburgh

Rory Zirpolo Director Credit Suisse New York

REAL ESTATE REPORT: REIFS 82

Back-office complexities One of the biggest challenges surrounding REIFs is custody. Although REIFs may be conceptually similar to mutual funds, the actual task of custody is considerably more demanding. The nominated custodian is ultimately responsible for the safekeeping of a REIF’s gross assets — regardless of their financing through equity or third-party loans — and for the control of all transactions undertaken by the REIF. Simply put, the custodian is held responsible by both the fund’s investors and the regulators. Dealing with bricks and mortar presents a special set of demands that go well beyond the usual requirements for the administration of other types of regulated funds. The physical safekeeping of deeds, contracts and insurance policies, as well as managing the specific characteristics of the funds, require specialised systems and processes and a higher degree of due diligence at the transaction level than for other regulated funds. Tailored administration systems and operating processes need to be deployed to deal with multiple service providers in multiple countries with diverse market practices and national laws. Accounting is similarly problematic. As SPVs are located in several different countries, they must each comply with their respective local reporting regulations and accounting principles: consolidating this diverse set of accounting data into one aggregated NAV calculation is a key challenge for the administrator. The conversion of the local GAAPs into the REIF’s GAAP within a narrow time-frame is therefore a major operational challenge. In the past, it has not been unusual for NAV calculations to take weeks, if not months, yet the new open-ended REIFs are now promoting monthly NAVs as standard. A further priority is a well-staffed legal department. Legal expertise is required to ensure that crucial analysis and verification tasks are properly and thoroughly carried out: the custodian, for example, needs to monitor cash and real estate transactions and to determine that all the legal documentation is binding in the relevant countries. Furthermore, the audit process is not the same as for a mainstream mutual fund. There are no securities portfolios, or NAVs or automated pricing feeds: the assets are the underlying bricks and mortar, and the independent appraisers must be able to carry out a yearly evaluation on that basis. The Luxembourg REIFs market is reaching an inflection point. As many of the early closed-end REIFs reach their maturity within the next few years, listing on a stock exchange will increasingly be considered as a viable exit solution. This will give retail investors the chance to enter a previously closed investment universe. This will coincide with the availability of a broader range of open-ended REIFs, specifically designed to appeal to retail investors, wherever they may be located. Astute fund promoters have already begun to capitalise on the benefits of the Luxembourg REIF regime, and we confidently expect many others to follow.

A QUICK AND READY GUIDE TO REIFS

EIFs satisfy the three important criteria: they are tax-efficient, regulated and flexible. REIFs allow investors to benefit from the long-term potential of a diversified portfolio of properties and different risk/return profiles. Most REIFs are listed on a stock exchange even though they are open ended. Real Estate undertakings for collective investments (UCIs) can be set up either in corporate form ( that is, a Société d’investissement à capital variable (SICAV), an open-ended collective investment scheme, that are similar to open ended mutual funds in the US, or a Société d’Investissement à Capital Fixe (SICAF), or as mutual investment funds (FCP). In January this year a survey by Ernst & Young analysed why so many top level promoters chose Luxembourg as a domicile for unlisted vehicles directly investing in real estate. Among the results announced by Ernst & Young: 1. There were 33 funds in 2005. The number of funds has grown at 50% per annum over five years and, based on Ernst & Young’s experience of current market activity, the number of funds is set to continue to grow rapidly for the foreseeable future. Opportunity and value-added funds represent 21% of the market each, with core and core plus funds making up the remaining 58%. Target Internal Rates of Return range from 7-10% for core funds to 18+% for opportunity funds. 2. The FCP structure (an unincorporated UCI similar to a mutual fund) is by far the most popular, with 64% of the market, followed by the SICAV. The SICAR structure, launched in 2004, is growing in popularity with 6% of the market today. 3. Most direct real estate funds have a single asset strategy such as offices, retail, warehouse, outlets or car parks. 37% were diversified funds, investing mainly in retail, followed by offices and warehouses. 4. The bulk of investments continue to be in the European Union 15-countries, which represents 55% of total direct real estate investments, with the UK and France being prime destinations in Europe. EU new member states represent 18%, with European Union-25 and global strategies representing 6% each.

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UK property is forecast to deliver a return in excess of 16% in 2006, according to the latest predictions by leading fund manager, Henderson Global Investors, with more moderate returns showing as the year ends. What does that mean for European investors that have been queuing up to invest in long anticipated UK real estate investment trusts, which are scheduled to come to market in early 2007? In addition, what can UK investors learn from the experience of the mature US REITs market? HE LATEST FINDINGS by Henderson Global Investors’ property specialists acknowledges how the buoyancy of investment demand and improving rental growth have underpinned a return of 9.6% on the UK commercial property in the first half of 2006. Henderson is one of Europe’s leading property asset managers with over €9.3bn (as at 31st December 2005) of property funds managed across Europe. The property business manages pooled and segregated accounts that invest in properties offering core and value-added returns. In addition to investing across all commercial sectors, Henderson’s property business also manages funds with sector specialist and/or regional themes. While remaining bullish, Henderson now believes that growing investor caution will produce more moderate returns in the second half of the year, while accepting the risk that the high weight of money currently chasing property could push down yields in spite of the recent interest rate rise. According to Patrick Bushnell, director of property investment and research at Henderson Global Investors,“The short term risk is that markets perform even more strongly in the short term than our 16% plus forecast suggests. If this occurs, we would expect lower than forecast returns in the following few years. From 2007, attention will inevitably focus on those markets with greatest rental growth potential and on driving through management initiatives to deliver the best portfolio returns”. According to Bushnell, in the absence of yield driven capital growth, well constructed portfolios backed by the best management capability will outperform more aggressively. Highlighting the key trends in each of the main sectors across the UK, the company indicated that retail returns are weakening in line with slower growth in the

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

REAL ESTATE REPORT: REITS

REITS: THE ATLANTIC CROSSING consumer economy. In contrast, office returns are benefiting from improving rental growth and Central London offices in particular are forecast to be the best performing market sector over the next three years. Because of their relatively high income return, the industrial sector is expected to only slightly under-perform the all property average over the next three years, despite anaemic rental growth. That’s good news for investors looking to harness real estate investment trusts (REITs) in the UK when they come to market in the early part of 2007. A REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. The REIT structure was designed and has its origins in the United States, where it was developed to provide a similar structure for investments in real estate. REITs can be publicly or privately held. The US REITs market has largely acted as a template for the UK’s upcoming REIT regime: with good reason. According to a recent Ibbotson Associates report, a firm specialising in asset allocation research, “found that by adding REITs to a diversified portfolio of stocks, bonds and T-bills, you increase portfolio returns and reduce risk, thereby increasing the efficient frontier,” says Abby McCarthy, senior director of industry information statistics at NAREIT, the official US REITs industry association in Washington. The return characteristics of REITs are not highly correlated with other stocks and with bonds, explains McCarthy, although REIT stocks do have some of the same characteristics as both (as stocks, they provide liquidity and the opportunity for price appreciation, while their high dividends give them bond-like characteristics).“It is really a story about the structure of REITs, which are required to distribute 90% of their taxable income

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Index Value Rebased (31 Jul 01 = 100)

REAL ESTATE REPORT: REITS

in the form of dividends,”she explains.“It means a consistent public entities buying public entities,”she adds. The recent and reliable income generating investment, which can either deal between SL Green Realty Corporation and Reckson be drawn down as income, or reinvested in the company.” As Associates Realty, is typical. SL Green will acquire Reckson a sideline, UK REITS will have to distribute 95% of income. for around $6bn, which includes the assumption of They must be a close-ended investment trust and be UK Reckson’s outstanding debts, which are reportedly in the resident and publicly listed on a stock exchange recognised by region of $2bn and prices each Reckson share at around the Financial Services Authority (FSA). The attractiveness of $43.31. Current Reckson stockholders will end up owning REITs in the US market has meant that it has been an around 15% of SL Green. The sign of the times is written in the volume of mergers investment of choice for both retail and institutional firms “in about equal measure,” according to McCarthy. “Retail and acquisitions this year. Some $60.8bn worth of investors invest in REIT companies directly or via mutual transactions have closed in the seven months of this year, funds that own REITs,”which, according to Lipper, the mutual compared with just under $30bn worth of transactions fund tracker, has been among the market's best performers concluded in the 2004/2005 period. According to McCarthy for the last six years. In the first half of this year, the average there are a number of reasons for the spurt in volume. For one, although rising, overall the interest rate regime is REIT mutual fund surged 12.7%, says Lipper. US REITs have benefited from rising interest rates, which generally favourable and consequently credit markets are have bedevilled the US retail housing market and home “very favourable right now to issuing debt. Additionally, builders sector of late. That is because REITs don't buy homes. she points out that companies are seeing value in the assets Instead, they invest in commercial buildings, (offices, rentals, of portfolio companies and are pricing them higher than shopping centres and car parks) and commercial properties in “Wall Street is. So if you are a company that is strategically the US appear to be holding up well relative to house prices. trying to get a large portfolio of assets, acquisition can be According to McCarthy,“one of the best performing sectors this the most effective route to achieving that goal.” However, despite all the upside, REITs are also affected year is the apartment sector. It is a direct result of the rise in interest rates that is turning people away from mortgages and negatively by rising interest rates. REITs are yielding 4.25%, into rentals.” Additionally, the commercial real estate sector is below the 5.18% yield on 10-year US Treasury notes. There not subject to the same kinds of risks as the residential sector, are also concerns about how higher rates will affect acknowledges McCarthy. “Interest rates do play a factor,”she consumer spending and, by extension, how they'll affect notes, “however, there are many other things to take into REITs that own shopping centres and malls. In the UK, the REITs market will compete directly with account, such as the reliability of rental income and dividends. Moreover, the commercial real estate business is led by Property Unit Trusts, which have been the investment vehicle seasoned professional management teams working to a whole of choice for UK property investment firms. In the US, REITs different set of criteria than an individual homebuyer.” have had to compete with Real Estate Operating Companies, Investors, then buy REITs not just for dividends but also for which are similar to REITs but which work to a different growth. According to Lipper, US REITs have enjoyed a solid dividend rule and operate as a plain vanilla public real estate first half because of a boom in mergers and acquisitions in the investment vehicle. These pools of money, says McCarthy – sector. Although, points out McCarthy, the trend speaks to a insurance companies, pension funds, etc—have always made broader economy than simply real estate. Nonetheless there is direct investments in real estate and, as such, competed with growing interest from private firms, such as Blackstone Group REIT companies for individual properties. However, they do and Brookfield Properties. Blackstone Group bought Carr not compete with REIT companies for investors’dollars. The so far comfortable world of US REITs then is being America, in a pure public to private deal, for $5.6bn earlier this year. Having private buyers ready to scoop up REIT stock gradually assailed by the emergence of new property companies, either insurance companies which are using establishes a "floor" for the shares. property as an investment “When we looked at the hedge or which operate as data in a historical Tracking the performance of global listed real estate and REITs direct developers. Either perspective, we found that 300 way, on both sides of the US equity leveraged 250 Atlantic, investors will be buyout firms are active in able to access a broader all sectors of the US equity 200 range of investment vehicles markets and the real estate 150 that can utilise tax efficient experience is not unique,” vehicles, such as REITs, or adds McCarthy. “We have 100 high end returns companies seen public REITs go 50 that use alternative private and we have seen strategies. For most them bought outright by investors that is a good buyout firms. But the FTSE EPRA/NAREIT UK Index (TR) FTSE EPRA/NAREIT Global Index (TR) thing: offering more, rather majority of mergers and FTSE EPRA/NAREIT Europe Index (TR) than less choice. acquisitions activity is Source: FTSE Group price returns. Data as at August 2006

SEPTEMBER/OCTOBER • FTSE GLOBAL MARKETS

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LENOVO

LENOVO FEELS THE HEAT If they celebrate May 1 at Lenovo, it is because in May 2005 the Chinese computer maker took over IBM’s personal computer business to become the world’s third biggest seller of PCs – and the inheritor of the manufacturing and design tradition which had launched the personal computer onto a waiting world. Apart from the scale of the acquisition, the deal is redolent with implications. The hybrid that has resulted is probably the world’s most globalised big company. Ian Williams reports HINA’S LARGEST PERSONAL computer maker, Lenovo Group Ltd, bought control of IBM’s PCmaking business for $1.25bn, completing IBM’s retreat from the business it created in 1981. By undertaking the acquisition Lenovo became the world’s third largest PC manufacturer, after Dell and Hewlett-Packard/Compaq. IBM holds on to a strategic 18.9% stake in Lenovo while Stephen M. Ward Jr. from IBM took over as the new Lenovo chief executive officer (CEO). The sale of IBM’s PC desktop and notebook computer lines frees the company to focus on higher-margin businesses such as computer services, software, more powerful server computers, and storage as well as computer chips. Lenovo, formerly known as Legend, took ownership of the IBM “Think” trademark family, including its ThinkPad notebook brand and its ThinkCenter desktop line. Lenovo also hired some 10,000 IBM PC employees — including about 2,300 in the United States. Founded in 1984, Lenovo was the first company to introduce the home computer concept in China, and since 1997 has been the leading PC brand in China. It was a very logical deal. If American-owned PC companies could sell machines mostly made in China, then it made great business sense for Lenovo to move up the value chain and sell in the US and worldwide as well. By buying IBM’s PC business, Lenovo gained access to a ready-made distribution and development global network. Before the company re-branded itself as Lenovo it was

Lenovo Group Ltd. chairman Yang Yuanqing wipes his face as he speaks during a signing agreement ceremony that expands the strategic cooperation between Microsoft and Lenovo, at Microsoft headquarters, Monday, April 17, 2006, in Redmond, Washington. Microsoft’s Windows operating system has long been popular in China, the problem has been getting Chinese users to pay for legitimate copies. On the eve of Chinese President Hu Jintao’s visit Tuesday to Microsoft’s Redmond campus, company officials hope things are changing. Before the company re-branded itself as Lenovo it was known as Legend and was already a success story, with a large and loyal consumer following in China. Its founders back in 1989 were a group of engineers from the Chinese Academy of Sciences, and they pushed out the envelope for Chinese. The photograph was taken by Elaine Thompson and was supplied by EMPICS/Associated Press, August 2006.

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known as Legend and was already a success story, with a large and loyal consumer following in China. Its founders back in 1989 were a group of engineers from the Chinese Academy of Sciences, and they pushed out the envelope for Chinese entrepreneurship in those early days of reform. The Academy had put RMB200,000 in the enterprise, and in a revolutionary move for China, it followed the Silicon valley tradition by granting the founding engineers a 35% stake for their brainpower. Floated in Hong Kong in 1994, Legend became one the big players on the Hang Seng index with a corporate reputation for transparency rare among the mainland companies As part of the integration process, Lenovo sent 50 Chinese executives to the USA and dozens of listed there – most of which had Americans to the mainland. It even examined how the different cultures reflected in management come from the secretive state-owned behaviour at meetings. It exhorted Chinese executives to break with traditional deference and to tradition. In the meantime, in seven speak up at meetings instead if waiting to be asked. Conversely Westerners had to learn that silence years it moved from 3% to 30% of the did not necessarily mean assent, and so they had to canvass actively for opinions. Photograph considerable and growing Chinese supplied istockphotos.com, August 2006. domestic PC market — incidentally beating several government-sponsored rivals in the process. other major manufacturer in the US. Gateway has It was in the course of dealing with the many overseas suffered major erosion in the last few years and many shareholders that Legend built the negotiating and analysts expect Hewlett-Packard will exit the PC business managerial skills to merge with IBM’s PC division. While in within the next few years. How well Lenovo will respond terms of ownership, it was indeed a takeover, in terms of to these challenges is not yet apparent, say analysts. management so far it has been a merger, with a mixed, and Nonetheless, the integrated entity has as much truly cosmopolitan executive team. As one symbol of how opportunity ahead of it as downside and the Chinese this was more a case of a Chinese company going global shareholders have been more than willing to embrace rather than Beijing snatching an American icon, Lenovo change: a positive move in itself. Although like IBM before it, for instance, Lenovo’s local chairman Yang Yuanqing moved to the U.S. last year and five of the twelve directors are American. None of them is operations use local languages, and the working language from the Chinese government, nor even from the founding of the company is not Mandarin, but English as a pragmatic recognition of the role of English as a lingua franca rather Academy of Science. Indeed, even in terms of ownership, the Academy’s stake than any concession to nationalism. Equally important, of course, is what the management is now diluted to 27%, with the balance held by shareholders from across the globe, including IBM, which say to each other, in whatever tongue, and Ray Garland, took a stake as part of the deal, not to mention three U.S. Lenovo’s spokesman in the US enthuses that,“Lenovo can help us grow in areas where we were not strong before. The private-equity investment firms with substantial holdings. As part of the integration process, Lenovo sent 50 heritage of the IBM PC was dealing with large business not Chinese executives to the USA and dozens of Americans to small businesses, so there’s a lot for us to learn from the the mainland. It even examined how the different cultures Chinese colleagues who drive a transactional business with reflected in management behaviour at meetings. It small business needs.” Peter Hortensius, head of Lenovo’s notebook division, exhorted Chinese executives to break with traditional deference and to speak up at meetings instead if waiting to and another veteran of Big Blue, claims that far from the be asked. Conversely Westerners had to learn that silence move leading to a rush to the lifeboats by former IBM did not necessarily mean assent, and so they had to canvass staff, “the retention rate is tremendous: more than historically. People are staying because they want to stay. actively for opinions. However, the new acquisition is not all plain sailing and If you worked in PCs at IBM, you did it because PCs are a some analysts would have it that Lenovo is entering fascinating business and you wanted to be in it. Now you treacherous waters. Dell’s emphasis on cost control and are in a company that is totally focused on them and aggressive direct marketing have swamped nearly every that’s wonderful.”

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He also claims that the former IBM team is “falling in love successful in retaining IBM customers, the hint was soon with the rate and pace at which we can make decisions, at taken up with a burst of xenophobia. This May, following in the similar Dubai Ports World which we can get things done, and conversely, the former Lenovo team is seeing the power and scale of a worldwide crisis, in what the New York Times called “a drive-by business. I now have an organization that makes decisions smearing,”Congressmen raised the alleged security risks of much faster, because it is a PC company, whereas before it allowing Lenovo’s “Chinese” computers into sensitive was part of IBM, a company which made all kinds of things, government areas after the State Department’s purchase of so we always had to worry about the implications and it took 16,000 Lenovo computers. Two members of the United many layers of management and meetings to get what we States-China Economic and Security Review Commission, wanted.”The new company now has quick and easy access to the body that had scuttled the CNOOC takeover bid for a global perspective which, Hortensius says,“if we were only Unocal last year, had raised the concerns. Although rational in the US and only dealing with Americans would lead to voices pointed out that almost all so-called American rival decisions that don’t fly elsewhere because they do not have brand computers are also made in China, rationality is no the breadth.” There are no complaints about conditions at defence in the face of prejudice. Hortensius meanwhile Lenovo, whose stock points out that the State options and compensations “Lenovo can help us grow in areas Department has its own are not in any way worse rigorous IT testing than IBM – the contrary in where we weren’t strong before. The protocols, and that IBM fact, Hortensius says. heritage of the IBM PC was dealing had always been a pioneer “Lenovo was unique in with large business not small on the security of PCs, as how it rewarded businesses, so there’s a lot for us to befits their inventor. “The performance, it expected learn from the Chinese colleagues reality is that we are very and received performance, confident in the security of and its performancewho drive a transactional business our systems: we are a oriented culture taught us with small business needs.” leader in that technology, from IBM something on so from that perspective those lines.” we have full confidence in Not everyone Lenovo: Driving a transactional business. Can it get back what we do.” appreciates this hybrid to the top? 160 Washington responded, cosmopolitanism. A Dell announced that the sales representative 140 government would exclude greeted the launch last year 120 the allegedly compromised with emails tarring the 100 machines from any company as Chinese80 sensitive functions. In fact, government-run. The the administration leaked emails caused a 60 reallocated 900 of them huge reaction in China 40 from classified work, in a with their chauvinist claims move somewhat akin to that “As you know Lenovo pandering to superstitions is a Chinese government Dell Lenovo Hewlett Packard FTSE All-World Technology Price Index IBM about the tooth fairy. owned company that For Chinese recently purchased IBM’s Source: FTSE Group US Dollar price returns. Data as at August 2006 commentators it desktop business. While the US government has given its stamp of approval to exacerbated the suspicion that even when an originally continue to purchase these units, people must understand Chinese company like Lenovo plays by the rules, and that every dollar clients spent on these IBM systems is indeed has gone far farther than any American multinational to distance itself from its roots, it still meets directly supporting/funding the Chinese government.” Lenovo also draws comfort from the implication that discrimination in the USA. Luckily for Lenovo also, the their American rival is rattled by the threat posed by the allegations were so self-evidently preposterous to anyone new company, an impression that was reinforced when who knows about computers — which of course includes Kevin Rollins, Dell’s CEO, indulged in some more most IT purchasing officers — that if anything, it attracted seemingly gratuitous Lenovo-knocking this May, accusing sympathy from the customer base. Although the charges them being “very China-centric”. He was clearly unhappy may well inhibit US government purchases of Lenovo that Bill Amelio, who had directed Asia-Pacific operations products, the company has retained most of its (90% it for Dell had defected to become CEO of Lenovo. While the claims) previous IBM customers,. That is a surprisingly good result in such a controversial resulting furore possibly did more harm to Dell in China than to Lenovo in the US, which has been remarkably sales climate, and with the switch away from a legendary

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brand name. In addition, the company been concentrating on integrating the management teams, and the real test is now to come as it tries for increased market share – and profitability. Ray Garland, Lenovo spokesman admits “the first year we spent really trying to work on how to get our organizations and now we are focussing on how to grow, like the Lenovo 3000 launch.” Industry analyst Rob Enderle concurs,“They did lose some market share, but it was much lower than we expected, a lot of IBM staff were happy to go across to Lenovo — and the deal is working better for Lenovo than IBM. They have to recover from the mistake that IBM made a few years ago in pulling out of the retail market. So they have to rebuild the international retail channel. They

have to fully integrate the company, which is the best way of getting round this nationalistic garbage [sic] in Washington, and turning themselves into a truly international company, and they have a good chance because in reality that’s what they are: much more so than most American firms.” Congress permitting, the Lenovo IBM deal is significant as a harbinger of things to come, as Chinese companies moved up the value chain and seek to recycle their tidal wave of dollar export earnings into more productive and profitable uses.The corporate cross breeding involved in the integration of Chinese enterprise in manufacturing and American business methodology in producing profitability, could be an awesome hybrid to loose upon a waiting world.

A POCKET HISTORY OF LENOVO

enovo Group Limited, whose pinyin name is Liánxiang Jítuán Youxiàn Gÿngsi, was founded in 1984 by a group of eleven engineers headed by Liu Chuanzhi in Beijing, but the listed holding company was incorporated in 1988 in Hong Kong, now a Special Administrative Region of China. Its headquarters are in Purchase, New York, in the United States. However, the company plans to move its headquarters to Raleigh, North Carolina, the home of IBM’s former ThinkPad group. Lenovo” is a portmanteau word formed of “Le-” (from Legend) and “novo”, pseudo-Latin for “new.” Along with desktop and laptop computers, Lenovo sells servers, handheld computers, imaging equipment, and mobile phone handsets. Lenovo also provides information technology integration and support services, and its QDI unit offers contract manufacturing. Hoping to reach the many Chinese not yet online, Lenovo also offers Internet access through its FM365.com portal. The company employs more than 19,000 people worldwide. In 1981, IBM founded a new unit within IBM, the Personal Computing Division (PCD), which virtually invented personal computing. PCD then quickly advanced the state-of-the-art of computing with a series of innovations ranging from the very first laptop computers to the new high-security technologies, such as the built-in “air-bag” that protects data, and biometric identification that protects user identity. PCD also created the icon of notebook computing, the ThinkPad, and the unique software tools, known as ThinkVantage Technologies, which increase user productivity. In 1984, meanwhile 11 computer scientists in Beijing decided to create a company that would bring the advantages of information technology to China. With RMB200,000 ($25,000) in seed money and the determination to turn their research into successful products, the 11 engineers and researchers set up shop in a loaned space – a small, one-story bungalow in Beijing. The company they founded, Legend, opened a new era of consumer PCs in China. Legend first introduced PCs to Chinese households, then promoted PC usage in China by establishing retail shops nationwide. It also developed the pioneering Legend Chinese Character Card that translated English operating software into Chinese characters, and achieved its own proprietary breakthroughs, such as PCs with one-button access to the Internet. By 1994, Legend was trading on the Hong Kong Stock Exchange; four years later, it produced its one-millionth personal computer. Also in 2003, Lenovo introduced a self-developed collaborative application technology, which heralds the strategic role Lenovo would like to play in the computer, communications and consumer (3c) electronics era. Then in early 2005, Lenovo made a bid for IBM’s PCD operations and the deal was finalised in May of the same year. The combined operation is expected to enjoy some $13bn in annual revenue and a global market. Globally, the company offers customers the award-winning ThinkPad notebooks and ThinkCentre desktops, featuring the ThinkVantage Technologies software tools, as well as ThinkVision monitors and a full line of PC accessories and options. In China, Lenovo now commands more than one-third of the PC market, covering all segments. Its range of PCs include the Tianjiao and Fengxing consumer desktops and Yangtian and Kaitian enterprise desktops. Lenovo also has a broad and expanding product line encompassing mobile handsets, servers, peripherals and digital entertainment products for the Chinese market. Lenovo and IBM now claim to have a strategic alliance designed to provide a best-in-class experience for enterprise customers. The companies have entered into significant, long-term agreements that give customers preferred access to IBM’s world-class customer service organisation and global financing offerings, and that enable Lenovo to take advantage of IBM’s powerful worldwide distribution and sales network. Lenovo’s customers, meanwhile, are able to count on the entire IBM team – including sales, services and financing – for access to IBM’s end-to-end IT solutions. As part of a five-year commitment, IBM will also provide Lenovo with warranty services and offer Lenovo customers leasing and financing arrangements.

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ALCATEL/LUCENT

New Jersey-based Lucent CEO Patricia Russo, right, and Alcatel CEO Serge Tchuruk chat during a joint press conference in Paris, Monday April 3, 2006. Alcatel SA’s shares jumped 6% following the announcement of a €11.1bn ($13.4bn) stock swap with Lucent Technologies Inc. that will create a powerhouse in a consolidating telecommunications industry. The combined business will be based in Paris, and will work to capitalise on fast-growing offerings such as “triple-play” Internet, phone and TV packages that have become popular in the telecommunications field, said the companies in announcing the deal. This photograph was taken by Christophe Ena and is supplied by EMPICS/AP, July 2006.

Alcatel-Lucent: a merger of equals? C This Summer has been unkind to corporate couplings in France. The government’s €70bn attempt to join Suez to Gaz de France and block its Italian suitor ENEL miffed European Union officials and triggered strikes. Mittal’s second, sweeter offer for steelmaker Arcelor met with shareholder activism, and an alienated workforce slammed the deal as a victory for market tactics over industry. The uproars even sapped the government’s standing in the polls. Has the air in the mergers and acquisition division of France Inc. become stifling? Some analysts think so. Somehow, the Alcatel-Lucent team has gone through unassailed. Joshua Jampol, reporting from Paris, explains how.

ORPORATE DISCRETION PROBABLY helped the Alcatel-Lucent merger. The project was kept quiet and out of the press. Alcatel even refused to provide comment for this article and Lucent did not answer emails. Both firms only issued releases outlining the merger, layered with techno-talk, such as “Alcatel and its directors and executive officers may be deemed to be participants in the solicitation of proxies from the stockholders of Lucent in connection with the transaction described herein.”That was back in April of this year, and if the communiqués were meant to lull the media, they did the job really well. Since then, Alcatel’s chief executive officer (CEO) Serge Tchuruk did grant an interview to the French and international, English-speaking press, but only once, in mid July. That, however was for a different reason. Lucent’s shares had fallen by 6%—their biggest fall since the Spring—after the firm announced that sales had slipped 15% in the quarter ending June 30th Apart from this brief dance in the spotlight, a single, four-line statement was the

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acquisition of Telica (2004), only printed update in both Ascend Communications French and American papers, (1999) and Yurie Systems announcing US antitrust (1998), were all US enterprise clearance in early June. focused. Now Lucent itself In hindsight, both Alcatel looks to be on the other end of and Lucent had played their an acquisition. Lucent could hand well. Their reticence was become a subsidiary of Alcatel an acknowledgement that by Christmas for a price tag of forces more powerful than €13.4bn. commercial caution were at It is not the first time the pair work on the deal. Call it has tried to tie the knot. Both ‘economic patriotism’—a term Forces more powerful than commercial caution were at work were forced to rethink their that Premier Dominique de on the deal, and it makes you think the French are on to global strategies and sought a Villepin contrived last year, something. Call it ‘economic patriotism’; a term Prime union after the dotcom when he was riding high in the Minister Dominique de Villepin contrived last year, when he blowout in 2001. The blowout polls, after thwarting Pepsico’s was riding high, after thwarting Pepsico’s bid for Danone. drove investment by telecom bid for Danone. Dirigisme, it This photograph of an Alcatel employee working on a new operators to an all-time nadir. seems, is not dead and while it satellite was taken in December 2005 and was kindly IDATE, a European telecoms is often condemned by supplied by Alcatel, July 2006. analytics firm, estimates the investors as ineffective, market sagged by some 18% economic patriotism still plays between 2000 and 2002, and well in France. A June poll by has remained sluggish ever market researchers Sofres, for since; in spite of the mobileexample, shows 65% of 1,000 phone explosion in Asian people surveyed believe it is markets. In hindsight, the their government’s job to stop rationalisation of the industry foreign bids. Yet one in seven and the cost-cuts made by Gallic workers is paid by a many firms meant that 2001 non-French firm (the ration is was, in fact, the wrong time to one in 10 in the United honeymoon. Kingdom and one in 20 in the They do say that love is United States). It is an better the second time around; imbalance that prompts alien and this deal is not an commentators to accuse the exception to that rule, Pacôme state of practicing a sort of Revillon, managing director at globalisation à la française. Euroconsult, the Paris-based “Economic patriotism is think tank, says, “The merger a modern concept,” An Alcatel engineer runs a network management test on corresponds to an end-ofThierry Breton, France’s optical platforms at the firm’s network integration centre at crisis strategy. Lucent’s minister for the economy Vimmercate in northern Italy, in December 2005. revenues stood at $29bn in acknowledged recently. Photograph kindly supplied by Alcatel, July 2006. 2000, but fell to $9.5bn in 2005; Perhaps it is best then to Alcatel’s dropped from swerve to the parties in this particular deal. Alcatel is an while equipment-maker for fixed and mobile networks and €31.5bn to €13bn.” The number of employees shrank by world leader in Asymmetric Digital Subscriber Lines 175,000 for the two companies over the same period. (ADSL), a modem technology that converts existing Revillon and others believe the merger follows long-term, twisted-pair telephone lines into access paths for industrial logic. The battles between the duo have cooled; multimedia and high-speed data communications. ADSL in their place has emerged common cause. It has come about since equipment providers such as access—a business worth €13bn in sales last year—built itself up by purchasing non-Gallic companies, such as ITT Alcatel and Lucent have watched the market propel their (US) in 1987, Rockwell (US) in 1991, Teletra (Italy) in 1992, customers—both systems operators and telecom carriers— Nortel Submarine & Cables (United Kingdom) in 1994, toward unification. “At a time when we are pushed by DSC (US) in 1998, Genesys (US) as well as Newbridge market events, and especially by the fact that our customers are consolidating rapidly, it is normal we take Networks (Canada) in 2000. Lucent Technologies also designs systems, services and the same route,”says CEO Serge Tchuruk. Tchuruk, 68, will software for communications networks and likewise grew become non-executive chairman of the new group, though from acquisitions—but mainly homegrown ones. Its he is due to retire in 2008. Patricia Russo, Lucent’s CEO,

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will head the unified firms.“This combination is a strategic Ericsson-Marconi with €20.8bn, but behind Cisco-Scientific fit between two experienced, respected global Atlanta with €28.5bn. (Please refer to box: The world’s top ten communications leaders, who together will become the telecommunications equipment providers). Nokia and Siemens announced their own tie-up two months after leader in convergence,”she adds. What is convergence? Pierpaolo Andriani, senior lecturer Alcatel-Lucent, in the third industry deal in less than a year. in technology management at Durham Business School, Nokia-Siemens also said they would cut up to 15% of the explains the impact of market and technology 60,000 positions in their new company. By contrast, the convergence. “Say consumers want to check emails over Alcatel-Lucent merger, which together employs 88,000 their mobiles, and expect media content over their mobile people, expects to slash around 9,000 jobs. This round of coalition building is just the start.The Francoor fixed phone systems [it] requires carriers such as AT&T or Vodafone to become one-stop communication providers. American merger will invariably have an impact on Japanese, Consequently, equipment vendors such as Lucent and Korean and especially Chinese firms, sparking linkups there. Alcatel are forced to expand their range of products and In fact, any number of acquisitions may be on the horizon as operators seek to grow their customer bases. Equipment competencies if they want to remain viable suppliers.”. Andriani’s theory resonates in the Alcatel Lucent deal. In vendors must expand or die, so look for Motorola with a 5% fact, Tchuruk repeated the basic strategy behind the market share and China’s Huwaei with 4% to pair off next, or nuptials in his July interview.“First, our two companies are go after Nortel, which has a 10% market slice. A side bar: Nortel was apparently on perfectly complementary, Alcatel’s to-buy list before it which will let us grow our Alcatel/Lucent: A merger of more than equals opted for Lucent. What it businesses faster. And 140 all adds up to is that we are what it will potentially save 120 moving into a leaner, us is equal to our 100 meaner telecom world with combined operations.” 80 more price competition, yet Umesh Ramakrishnan, 60 one that remains vice chair of technology 40 somewhat depressed. and telecoms at Paris search 20 Lucent’s sales force and firm Christian & Timbers, 0 US market strength are sees another benefit: other big draws for the flexibility for Alcatel outside French. Eager to extend its the rigid French system. Lucent Technologies Alcatel FTSE World Telecommunications Index enterprise business in “They can use the Lucent North America, Alcatel has base to offshore to China Source: FTSE Group US Dollar price returns. Data as at August 2006 struggled against Cisco, and India,” he says. “From that perspective, it is a defensive move.”Ramakrishnan is not Nortel and Avaya. The US sales culture should spawn more alone to label the union an immunisation against Chinese aggressiveness. Geographically, the Gallic market competition. China’s telecommunications and broadband represents only 12% of Alcatel’s total revenues; 29% come market is expanding speedily for both fixed and mobile, and from the rest of Europe with 59% from outside Europe. it is a growing industrial power in the sector. Manufacturers Lucent is the reverse: 63% of its cash comes from inside the Huawei and ZTE have begun to occupy strong positions US, 37% from outside. When in place, the new group’s globally. ZTE, for instance, signed a large contract for France revenue stream will look more balanced: one-third each Telecom’s DSL equipment, while Huwaei has done deals from the U.S., Europe and the rest of the world. The new firm, to be headquartered in Paris and named with BT,Vodaphone, KPN and others in the last two years – business which traditionally would have stayed in the West. later, will be worth €30bn, based on closing prices dated 31 In 2005, both manufacturers closed $5bn in contracts with March, two days before the stock-for-stock transaction was announced. Alcatel shareholders will own 60% of the new operators outside China. “Chinese competition is based on price dumping and company and Lucent shareholders 40%. These shares will this will continue, but the merged large companies should continue trading on Euronext and the NYSE. The pact, be able to combat this through global economies,” notes approved by both boards, creates a global communications Pierpaolo Andriani. Gallic firms, in particular, seem to have solutions provider, present in 130 countries, holding a vast grown savvier about competing in the international arena. wireless and services portfolio, and roughly half the global “The merger also allows Alcatel-Lucent to resist pressure market share for ADSL access. If finalised, Alcatel-Lucent will occupy a plum position from Ericsson and Cisco, who are trying to dominate the for defining next-generation networks. This is important, sector,”Andriani adds. Creating a rival to Cisco, which bought Scientific Atlanta in for along with consolidation, the industry is heading February, could be another reason for getting together. By the toward sizeable transformation of network technologies, numbers, Alcatel-Lucent will be the world’s second network applications and services. The decisive factor here is equipment provider, with €25.7bn, according to IDATE, before summarised in one word: research.

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

Equipment builders such as Alcatel and Lucent are desperately seeking new means to innovate and create value for their customers.“The ability to reach a critical size in R&D capability will be the key to competitive advantage,” says Euroconsult’s Revillon. The digital revolution reshaping the telecom market is still less than 10 years old, and many services remain to be developed in the years ahead. “R&D is the only sound strategy for maintaining market share in the long term,”he notes. In a field with too many players and uniform customer behaviour, the future belongs to the firm able to distinguish itself through imagination and offer services others do not. This is where Bell Labs comes in. The 26,000 engineers that make up Lucent’s star innovation engine will likely be the pump that gets the creative juices flowing throughout the new confederation. Bell Labs has since 1925 produced 40,000 inventions and all but led development of 20th-century technology. The millions of chips in cars, banks, gas pumps, phones, and computers and just about anything else out there are all descendants of the first transistors invented there in the late 1940s. Today’s average home or office has numerous products stemming from Bell Labs’ discoveries, from touchtone phones and faxes to lasers in CD and DVD players. Research and development (R&D) is the live-or-die domain for everyone in the industry today. One telecom specialist in the United Kingdom, a director of technology research who agreed to contribute to this article under conditions of anonymity, says,“Every operator has the same slide. It shows usage going up and prices coming down. The big gap in the middle is value-added services. Nobody knows what they are. I have had the same discussion in Europe, Japan and Korea. Will it be TV on mobile or broadband? Everybody has their finger in the wind.” “It is simply a matter of time before someone dreams up a new killer business idea. It could be in access technology, interoperability, or a hardware device. “At the end of the day, there is just so much you can do in any merger or acquisition to get at parts of the value chain,”the specialist says. North American operations for the assimilated companies will be based in New Jersey, where Bell Labs will remain. Its president, Jeong Kim, will continue to lead the outfit, which will keep its name. “There will be equal board representation from both firms in this merger of equals,”Alcatel’s press releases promise. Yet analysts wonder if, in the current political climate, the US manufacturer will let itself be piloted by its larger French rival. So far, the Gauls seem to be in line for most top management jobs. However, objections could come from higher up. National security issues could surface; Congress and defence officials could side against foreign ownership because of Bell’s contracts with Uncle Sam. Not to worry, vows Alcatel. The new corporation intends to form an independent US subsidiary that will contract with government agencies. A board of three, independent US citizens will separately manage the spin-off—a type of structure often used to protect sensitive programmes in mergers involving non-US players. Combining a French

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

Serge Tchuruk, outlining the future strategy of Alcatel at the company’s June 2004 shareholders meeting. Both Alcatel and Lucent were forced to rethink their strategies and sought a union after the dotcom blowout in 2001, which sent investment by telecom operators to an all-time nadir. IDATE, a European telecoms analytics firm, estimates the market sagged 18% between 2000 and 2002, and has been sluggish ever since - despite the mobile-phone explosion and growth of Asian markets. In hindsight, its resultant rationalisation and cost-cuts made 2001 the wrong time to honeymoon. The photograph was taken by Pierre-Francois Grosjean and was kindly supplied by Alcatel, July 2006.

firm and a US firm with military activities is certain to spark debate.Yet the marriage is far from being an exception, and the firms’ common competencies and international cultures may facilitate (even solidify) their hookup. “This looks different than the first unsuccessful endeavour in 2001,”notes another industry observer.“They seem to have addressed the sensitive issues early on.”This time, not only the principals are talking about a merger of equals. Even so, that is not easy to manage, and we are not even there yet. Whether Lucent becomes the Daimler or the Chrysler in this deal remains to be seen – if it gets that far. Alcatel shareholders, at their annual meeting on Sept. 7 in Paris, will have final say on this latest episode in the ongoing French saga of economic nationalism.

TOP 10 TELECOM EQUIPMENT PROVIDERS WORLDWIDE (2005 TURNOVER IN $BN) Cisco Systems/Scientific Atlanta Alcatel/Lucent Ericsson/Marconi Siemens Nortel NEC Motorola Nokia Huawei Fujitsu

28.5 25.7 20.8 15.5 10.9 8.1 8.1 7.9 5.7 3.9 Source: IDATE, July 2006.

Au st F FT TS rali SE E A a A C B e us lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A FT nm C SE ar k Fi AC n FT l S an FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC I ta FT FT ly SE SE A FT Ne Jap C SE th an e Ne rla AC nd w s Z FT eala AC SE nd A FT No SE rw C Po ay FT rtu AC SE g Si ng al A a C FT por e S FT E S AC FT SE pai SE Sw n A Sw ede C n itz A er la C FT nd SE A C U FT K SE AC US AC

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 15.qxd Page 94

FTSE Global Equity Index Series – Global

30 December 2005 to 31 July 2006

FTSE All Cap Regional Indices (USD) 140

FTSE Global AC

130

FTSE Developed Europe AC

120

FTSE Japan AC

110

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

FTSE Emerging Europe AC

FTSE Latin America AC

FTSE North America AC

FTSE All Cap (AC) Regional Indices Capital Returns YTD (USD) 20

-5

FTSE All-Emerging Country All Cap Indices – Capital Returns YTD

Dollar Value

-5

Local Currency Value

-10

-15

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

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FTSE All-Emerging Country Indices Capital Returns YTD 40 30 20

% Dollar Value

10 0

Local Currency Value

-10

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col ec om AC h b Re ia A p FT ub C li S FT E E c A SE gy C Hu pt ng AC F a FT TSE ry SE In AC In dia do A FT nes C SE ia A C FT Isr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor AC SE oc Pa co AC ki s FT FT tan SE SE AC Ph Per u i li FT ppin AC SE es AC Po F FT TS lan SE E R d A S o us C sia ut AC FT h A SE fric FT Ta a A i SE w C Th an FT ail AC SE an Tu d A rk C ey AC

-20

FTSE Global All Cap Sector Indices – Capital Returns YTD (USD) 25 20 15 10

Capital

Total Return

0 -5

Eq u

ip m

O S e il & rv G ice as s Pr & o Di du st ce r In C ibu rs du h tio Co st em n ns r ia ica tru l M ls El Ae ctio et ec a r n o tro sp & Min ls ni ac M in c & Ge e & ate g El ne D ria e In ctr ral efe ls In du ica Ins nce du str l E ut st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa He Ho od ver rts Pr ag al u t se od es Ph h C Pe hol uce ar are r s d G rs m on o ac Eq al od eu uip G s tic m al en T ood Fo s & t ob s od B & ac S & iot er co Dr ec vic h Ge uug no es Fi ne Re log xe ra ta y d l R ile Li et rs M ne ai ob Te Tra le ile lec ve M rs Te om l & ed le m Le ia co u is m nic ur Te So Gas m a e ch ftw , W un tio no ar a ica ns lo e ter gy & & E tio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl ife B ent Li In an Eq f s e u ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

-10

Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Shanghai Zhenhua Port Machinery (B) CHN 190.8 CNPC Hong Kong (Red Chip) HK 160.2 Zijin Mining Group (H) CHN 140.6 BRAZ 121.9 Cosan On Arcelor FRA 115.6

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

Worst Performing FTSE All-World Index Stocks (USD/%) ITV PCL THAI -66.3 Yukos RUS -66.2 Privee Zurich Turnaround Group JA -60.9 Westwood One USA -59.1 NHN KOR -58.4

No. of Consts

Value

3 M (%)

7,888 1,177 1,728 4,983 2,905 1,811 209 116 1,514 212 2,686 1,340

355.28 342.44 480.19 425.16 212.24 430.80 771.10 762.28 399.86 528.50 311.77 393.45

-4.2 -3.0 -5.6 -8.4 -3.6 -7.6 -7.9 -9.7 -2.2 -16.8 -3.5 -8.6

6 M (%) 12 M (%)

0.8 1.5 -0.5 -2.0 1.2 0.2 -2.5 2.0 6.9 -13.8 -0.9 -5.2

12.8 12.1 14.3 11.6 13.0 15.1 42.8 51.3 20.6 21.5 4.8 29.4

YTD (%) Actual DIv Yld (%)

6.1 6.0 5.5 5.6 6.1 6.9 13.5 18.3 14.2 -2.9 2.7 -0.6

2.13 2.27 1.83 1.69 2.19 2.90 3.10 1.52 2.83 2.82 1.78 1.05

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

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

% FT SE De

FT SE

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MARKET REPORTS BY FTSE RESEARCH

MARKET REPORTS 15.qxd Page 96

FTSE Global Equity Index Series – Developed ex US

30 December 2005 to 31 July 2006

130 130

FTSE Developed Regional Indices – Large/Mid Cap (USD)

125 125

FTSE Developed (LC/MC)

120 120

FTSE Developed Europe (LC/MC)

115 115

FTSE Developed Asia Pacific (LC/MC)

110 110

FTSE All-Emerging (LC/MC)

105 105

100 100

FTSE Developed ex US (LC/MC)

FTSE US (LC/MC)

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices – Capital Returns YTD (USD) 14

FTSE Developed ex US Sector Indices (LC/MC) – Capital Returns YTD (USD)

Capital

Total Return

-5

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

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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Page 97

Stock Performance Best Performing FTSE Developed ex US Index Stocks CNPC Hong Kong (Red Chip) HK Arcelor FRA Shenzhen Investment (Red Chip) HK UK Lonmin Falconbridge CAN

Overall Index Return

(USD/%) 160.2 115.6 102.3 97.2 86.5

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Privee Zurich Turnaround Group JA -60.9 Invoice Inc JA -57.9 Hikari Tsushin JA -56.9 Softbank JA -56.4 OMC Card JA -55.7

No. of Consts

Value

3 M (%)

FTSE Developed ex US Index (LC/MC) 1,325 FTSE USA Index (LC/MC) 707 FTSE Developed Index (LC/MC) 2,032 FTSE All-Emerging Index (LC/MC) 873 493 FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) 769 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 285 FTSE Developed ex US AC Index 3,698 FTSE Developed ex US LC Index 555 FTSE Developed ex US MC Index 1,728 FTSE Developed ex US SC Index 4,983

241.93 529.08 206.04 369.32 239.48 227.64 358.15 407.01 378.50 482.05 513.11

-3.4 -2.7 -3.0 -10.2 -1.7 -6.7 -3.9 -3.9 -3.1 -4.7 -7.9

6 M (%) 12 M (%)

3.6 -0.5 1.5 -3.5 6.8 -1.8 3.7 3.3 3.8 3.0 1.2

21.7 3.8 12.0 26.7 19.9 25.8 14.0 21.8 20.8 25.4 22.5

YTD (%) Actual Div Yld (%)

10.1 2.2 6.0 7.1 13.7 3.5 10.3 10.1 10.0 10.6 9.4

2.49 1.84 2.17 2.51 2.92 1.72 3.40 2.42 2.58 1.83 1.69

FTSE Global Equity Index Series – Asia Pacific 30 December 2005 to 31 July 2006

FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 125

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

115 110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105

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

100

FTSE Japan (LC/MC)

06 -Ju l31

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

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

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12 10 8 6 4

2 0 -2 -4

Gl ob

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al AC As FT ia S Pa E D ci e fic ve De (L lop ve C/ e lo M d ex ped C) Ja A s pa ia n P (L ac FT C/ ifi M c SE C) Al As lE ia m Pa er ci gin fic g FT AC SE As D FT ia ev SE Pa elo Ja ci pe pa fi c d n AC In de x FT (L SE C/ M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC

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O S e il & rv G ice as s Pr & o Di du st ce r In C ibu rs du h tio Co st em n ns r ia ica tru l M ls El Ae ctio et ec a r n o tro sp & Min ls ni ac M in c & Ge e & ate g El ne D ria e In ctr ral efe ls In du ica Ins nce du str l E ut st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & s Fo Be Pa He Ho od ver rts Pr ag al u t se od es Ph h C Pe hol uce ar are r s d G rs m on o ac Eq al od eu uip G s tic m al en T ood Fo s & t ob s & od B ac S & iot er co Dr ec vic h Ge uug no es Fi ne Re log xe ra ta y d l R ile Li et rs M ne ai ob Te Tra le ile lec ve M rs Te om l & ed le m Le ia co u is m nic ur Te So Gas m a e ch ftw , W un tio no ar a ica ns lo e ter gy & & E tio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl ife B ent Li In an Eq f s e u ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Sector Indices – Capital Returns YTD (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD/%) Shanghai Zhenhua Port Machinery (B) CHN 190.8 CNPC Hong Kong (Red Chip) HK 160.2 Zijin Mining Group (H) CHN 140.6 Eternal Chemical TWN 105.2 CHN 105.0 Jiangling Motors (B)

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) ITV PCL THAI -66.3 Privee Zurich Turnaround Group JA -60.9 Invoice Inc JA -57.9 Jet Airways IDA -57.2 Hikari Tsushin JA -56.9

Overall Index Return No. of Consts

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

7888 3151 1300 526 774 1851 285 769 531 484

Value

3 M (%)

355.28 408.84 233.41 396.44 444.96 444.66 358.15 227.64 258.96 147.58

-4.2 -8.2 -7.4 -6.9 -10.1 -13.8 -3.9 -6.7 -10.0 -7.8

6 M (%) 12 M (%)

0.8 -2.8 -2.0 -1.0 -6.3 -9.5 3.7 -1.8 -2.5 -3.9

12.8 22.5 23.7 24.4 20.5 13.4 14.0 25.8 17.0 31.5

YTD (%) Actual DIv Yld (%)

6.1 2.7 3.7 4.9 -1.6 -5.1 10.3 3.5 4.6 0.9

2.13 1.89 1.89 1.91 1.79 1.91 3.40 1.72 2.47 1.03

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

SEPTEMBER/OCTOBER 2006 2006 • FTSE GLOBAL MARKETS

% FT SE

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MARKET REPORTS 15.qxd Page 99

FTSE Global Equity Index Series – Europe

30 December 2005 to 31 July 2006

FTSE European Regional Indices Performance (EUR) 115

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

105

FTSEurofirst 300 (EUR)

100

FTSE Developed Europe AC (EUR)

FTSEurofirst 100 (EUR)

FTSE Eurobloc AC (EUR)

FTSEurofirst 80 (EUR)

FTSE Europe All Cap Indices – Capital Return YTD (EUR) 10

-2

-4

FTSE Developed Europe All Cap Sector Indices – Capital Returns YTD (EUR)

Capital

Total Return

-5

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

MARKET REPORTS 15.qxd

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR/%) Arcelor FRA 99.3 UK 82.2 Lonmin UK 69.8 Xstrata Euronext FRA 59.4 Thyssen Krupp GER 55.5

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

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Ladbrokes UK -62.3 Tietoenator Oyj FIN -39.5 Rank Group UK -35.7 Carnival UK -35.0 Atos Origin FRA -34.7

No. of Consts

Value

3 M (%)

7888 1630 225 332 1073 1514 116 769 1064 300 80 100

355.28 365.08 396.28 461.72 487.01 360.81 687.83 373.67 379.18 1338.32 4638.26 4352.64

-4.2 -3.5 -2.7 -4.2 -6.9 -3.4 -10.8 -4.8 -4.8 -2.9 -3.9 -2.2

6 M (%) 12 M (%)

0.8 1.7 1.3 2.7 2.5 1.7 -3.0 1.2 1.2 1.4 0.7 1.2

YTD (%) Actual Div Yld (%)

12.8 15.4 12.7 20.6 20.7 14.8 44.0 13.7 14.9 13.5 11.7 10.9

6.1 5.7 4.5 8.3 9.0 5.5 9.3 5.5 5.3 4.9 3.9 4.2

2.13 2.78 2.98 2.37 2.11 2.83 1.52 2.91 2.72 2.90 3.28 3.15

FTSE UK Index Series 30 December 2005 to 31 July 2006

FTSE UK Index Series (GBP) FTSE 100

125 120

FTSE 250

115 110

FTSE 350

105

FTSE SmallCap

100

FTSE All-Share 95

l-0 6 31 -Ju

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FTSE techMARK

FTSE All-Share Sector Indices – Capital Returns YTD (GBP) 50 40 30

Capital

Total Return

0 -10

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-20

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

100

SEPTEMBER/OCTOBER 2006 • FTSE GLOBAL MARKETS

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FTSE UK Indices – Capital Return YTD (GBP) 8 6 4 2 0 -2 -4

AR F K TS 10 E 0 te

ch M

FT Al SE l-S A ha IM re

g gl in Fl ed

Sm FT SE

FT SE

Al l-S h

lC a

ar e

0 35 FT SE

25 0 FT SE

FT SE

10 0

-6

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) Ashley (Laura) Holdings Aquarius Platinum Lonmin Drax Group London Stock Exchange Group

Overall Index Return FTSE 100 Index FTSE 250 Index FTSE 350 Index FTSE SmallCap Index FTSE All-Share Index FTSE Fledgling Index FTSE AIM Index FTSE techMARK 100 Index

No. of Consts

100 250 350 331 681 265 1126 100

Worst Performing FTSE All-Share Index Stocks (GBP/%) iSOFT Group -84.0 Stanelco -65.1 Plasmon -58.0 Instore -54.8 Alba -48.8

106.0 91.5 81.3 80.6 79.8

Value 3 M (%) 6 M (%) 12 M (%)

5928.33 9355.56 3059.83 3383.55 3004.28 3764.14 1046.19 1339.33

-1.6 -5.3 -2.1 -6.7 -2.3 -8.5 -16.8 -6.8

2.9 2.0 2.8 -3.1 2.6 -4.2 -8.2 -10.5

YTD (%)

12.2 23.0 13.7 11.6 13.6 10.1 -0.7 7.0

5.5 6.4 5.6 2.4 5.5 0.4 0.0 -6.5

Actual Div Yld (%)

3.11 2.45 3.02 1.97 2.99 1.92 0.59 1.55

Net Cover

2.54 2.40 2.53 1.93 2.52 -1.10 -0.34 -

P/E Ratio

12.62 16.99 13.1 26.29 13.31 -

FTSE Xinhua Index Series 30 December 2005 to 31 July 2006

FTSE Xinhua Index Series (RMB/HKD) 140

FTSE/Xinhua China 25 (HK$) FTSE Xinhua All-Share (RMB)

130

FTSE Xinhua Small Cap (RMB)

120

FTSE/Xinhua China A50 (RMB) 110

FTSE Xinhua 600 (RMB) 100

FTSE Xinhua China Government Bond Total Return Index (RMB) 6 l-0 31

-Ju

n30 -Ju

ay -0 -M 31

6 pr -0 30

31 -M

-A

ar -0 6

06 b-Fe 28

-Ja 31

31 -

c-0

FTSE Xinhua Index Series Index Name

Consts

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

25 50 966 600 366 37

Value 3 M (%) 6 M (%) 12 M (%) YTD (%)

11590.71 4928.52 3132.12 3338.96 2401.09 96.19

13.1 2.9 15.7 13.2 32.1 -0.5

10.5 17.9 35.5 33.6 47.7 -0.7

27.1 23.1 57.3 53.5 82.0 1.9

25.9 26.2 48.6 46.6 61.2 0.3

Actual Div Yld (%)

2.30 2.43 1.74 1.85 1.05 3.15

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

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

101

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

FTSE Hedge*

140

FTSE All-World Directional*

120

Event Driven* 100

Non-Directional* 80

l-0 6

Ja n

l-0

-0

Ja n05

l-0 Ju

Ja n-

3 l-0

03 Ja n-

2 l-0 Ju

Ja n

l-0

-0

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

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

Index Level*

3M (%)

6M (%)

12 M (%)

5280.24 3126.96 2193.19 2014.26 1873.71 3324.47 2149.23 2277.22 3099.19 2038.88 2119.98 2043.40

-2.5 -5.6 -5.2 -5.3 -7.4 0.3 2.7 -1.7 0.3 1.2 1.0 -0.5

0.2 -2.8 -2.1 -1.0 -7.6 2.8 4.1 1.8 2.9 4.8 5.2 0.7

4.6 3.6 4.2 3.0 2.5 7.0 5.9 8.0 4.1 5.1 7.6 1.6

YTD 5-Year Ann 3-Year (%) Return (%) Volatility (%)

2.2 0.3 1.1 0.2 -3.6 4.8 5.9 3.9 3.3 4.5 6.7 0.6

4.8 6.3 6.3 7.8 4.7 3.5 1.4 5.5 3.3 6.6 4.1 1.2

3.2 5.5 5.1 11.6 6.8 3.0 2.2 4.6 1.6 3.3 2.4 1.5

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Indices (Total Return Basis) 125 120

EPRA/NAREIT Global Total Return Index ($)

115

EPRA/NAREIT North America Total Return Index ($)

110

EPRA/NAREIT Europe Total Return Index (€)

105

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

100

6 l-0 -Ju 31

-Ju

-0 6 -M ay 31

pr -0 -A 30

ar -0 -M 31

6 -0 -Fe b 28

-0 6 -Ja n 31

-D

-0 5

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

102

SEPTEMBER/OCTOBER 2006 2006 • FTSE GLOBAL MARKETS

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

Consts

Value

3 M (%)

320 139 97 42 84

2965.66 3573.60 3108.39 3266.42 2134.28

3.7 6.1 4.7 2.4 -1.6

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

6 M (%) 12 M (%)

10.3 10.0 14.2 14.4 4.9

24.4 16.8 30.6 23.8 31.1

YTD (%)

Actual Div Yld (%)

17.6 17.4 20.4 21.9 10.4

3.48 4.09 2.43 2.82 3.27

FTSE Bond Indices FTSE Bond Indices (Total Return Basis)

FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbriefe Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥)

104 103 102 101 100 99 98 97

247 358 40 307 11 29 122 238 37

152.41 175.31 209.13 142.24 2036.74 1925.99 146.78 108.59 96.19

1.1 1.0 0.3 0.9 3.4 1.4 1.6 0.2 -0.5

-Ju 30

ay -0 -M

-A 30

l-0 6

3 M (%)

FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

31 -Ju

Value

Consts

pr -0

ar -0 6 M 31 -

6 -0 Fe b 28 -

-Ja n31

31 -D

-0

FTSE Bond Indices (Total Return) Index Name

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

6 M (%) 12 M (%)

-1.0 -0.5 0.0 -0.4 -0.1 -1.2 0.2 -1.3 -0.7

-1.0 -0.9 2.5 -1.0 7.0 3.3 0.8 -2.0 1.9

YTD (%)

Actual Div Yld (%)

-1.8 -1.1 0.2 -1.2 1.2 -0.5 -0.4 -1.6 0.3

4.04 4.05 4.93 4.50 1.47* 4.39 5.13 1.75 3.15

* Based on 0% inflation

FTSE Research Team contact details Andy Harvell Head of Research andy.harvell@ftse.com +44 20 7866 8986

Andreas Elia Research Executive andreas.elia@ftse.com +44 20 7866 8013

Kamila Lewandowski Index Development Executive kamila.lewandowski@ftse.com +44 20 7866 1877

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

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2006

103

CALENDAR

Index Reviews September – December 2006 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Early Sep Early Sep Early Sep 1-Sep 4-Sep 4-Sep 6-Sep 6-Sep 6-Sep 6-Sep

ATX CAC 40 S&P MIB SMI Index Family DAX Nikkei 225 FTSE/JSE Index Series FTSE Asiatop/Asian Sectors FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World)_ FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE eTX FTSE Multinational FTSE4Good Index Series FTSE Global Islamic FTSE Global 100 NASDAQ 100 NZSX 50 S&P MIB DJ STOXX DJ STOXX Blue Chips S&P US Indices S&P Europe 350/ S&P Euro S&P 500 S&P Midcap 400 S&P/ ASX 200 S&P TSX Russell US Indices FTSE Xinhua Index Series TSEC Taiwan 50 OMX H25 FTSE/ ATHEX 20 Hang Seng MSCI CAC 40 ATX IBEX 35 OBX OMX C20 DAX FTSE JSE Africa Index Series FTSE All-Share FTSE UK Index Series FTSE techMARK 100 FTSE Euromid FTSEurofirst 300 FTSE eTX FTSE Global Equity Index Series (incl. FTSE All-World) NASDAQ 100 NZSX 50

Semi-annual review / number of shares Annual review of free float Semi-annual constiuent review Semi-annual review Quarterly review/ Ordinary adjustment Annual review Quarterly review Semi-annual review Quarterly review

15-Sep 22-Sep 18-Sep 30-Sep 15-Sep Late Sept/Early Oct 15-Sep 15-Sep 15-Sep

31-Aug 31-Aug

Annual review / Developed Europe Quarterly review Annual Review Quarterly review Quarterly review Quarterly review Annual review Semi-annual review Semi-annual review Quarterly review Quarterly review / Shares adjustment Quarterly review Quarterly review - shares & IWF Quarterly review Annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Semi-annual review Semi-annual review Quarterly review Quarterly review Annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review

15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 29-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 15-Sep 30-Sep 20-Oct 20-Oct 8-Oct 30-Nov 8-Dec 30-Nov 15-Dec 15-Dec 1-Jan 15-Dec 16-Dec 15-Dec 15-Dec 15-Dec 15-Dec 15-Dec 15-Dec 15-Dec 15-Dec

30-Jun 31-Aug 1-Sep 1-Sep 1-Sep 1-Sep 30-Jun 31-Aug 25-Aug 31-Aug 31-Aug 31-Aug

30-Nov 30-Nov 30-Nov 1-Dec 5-Dec 5-Dec 30-Nov 1-Dec 1-Dec 1-Dec

Annual review / North America Annual review Quarterly review

15-Dec 15-Dec 29-Dec

30-Sep 30-Nov 30-Nov

6-Sep 6-Sep 6-Sep 6-Sep 6-Sep 6-Sep 6-Sep 6-Sep 6-Sep 8-Sep 11-Sep 12-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 13-Sep 15-Sep 11-Oct 12-Oct 13-Oct Oct/Nov 10-Nov 16-Nov Early Dec Early Dec Early Dec Early Dec 1-Dec 4-Dec 6-Dec 6-Dec 6-Dec 6-Dec 6-Dec 6-Dec 6-Dec 6-Dec 8-Dec 11-Dec

31-Jul 31-Aug 1-Sep 31-Aug 5-Sep

15-Aug 31-Aug

31-Aug 31-Aug 15-Sep 29-Sep 29-Sep 29-Sep 29-Sep 31-Oct 30-Nov 30-Nov

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

104

MARCH/APRIL 2006 • FTSE GLOBAL MARKETS

Unlock China.

At FTSE Xinhua Index we believe in developing the products that can unlock China for you. The FTSE/Xinhua China 25 and FTSE/Xinhua China A50 are the leading tradable indices for the world’s fastest growing market. They are part of the most comprehensive index data set available, giving you access to the market using the internationally recognised standards you understand and rely upon. If you are entering the Chinese market, we hold the key. To find out more about the FTSE Xinhua Index Series, visit www.ftsexinhua.com email info@ftse.com or call. FOR FURTHER INFORMATION VISIT WWW.FTSE.COM, E-MAIL INFO@FTSE.COM OR CALL YOUR LOCAL FTSE OFFICE: BEIJING +86 10 6515 9265 BOSTON +(1) 888 747 FTSE (3873) FRANKFURT +49 (0) 69 156 85 143 HONG KONG +852 2230 5800 L O N D O N + 4 4 ( 0 ) 2 0 7 8 6 6 1 8 1 0 M A D R I D + 3 4 9 1 4 1 1 3 7 8 7 N E W YO R K + ( 1 ) 8 8 8 7 4 7 F T S E ( 3 8 7 3 ) PARIS +33 (0) 1 53 76 82 88 SAN FRANCISCO +(1) 888 747 FTSE (3873) SHANGHAI +86 21 3401 5526 TOKYO +81 3 3581 2840 “FTSE™” is a trade mark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE under licence. “Xinhua” is a trade mark of Xinhua Finance (“XFN”) and is used by FTSE under licence. The FTSE/Xinhua Indices are calculated by FTSE in conjunction with FXI and XFN in accordance with a standard set of ground rules. The FTSE/Xinhua Indices are the proprietary interest of FTSE, FXI and/or its licensors. Neither FTSE, XFN or FXI shall be responsible for any error or omission in the FTSE Xinhua Indices. Distribution of FTSE/Xinhua Indices index values and the use of the FTSE/Xinhua Indices to create financial products requires a licence with FXI.

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