FTSE Global Markets

NAKHEEL COMES TO TERMS WITH CREDITORS

ISSUE 52 • JUNE 2011

Hedge funds make a slow and steady comeback Sberbank’s merger with Troika Dialog Can Hong Kong’s new Merc break new ground?

Block trading volumes rise but liquidity is strained

FINANSBANK

Managing great expectations ALT FUND ADMIN SERVICES UPGRADE IN AN AGE OF CHANGE

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FTSE GLOBAL MARKETS • JUNE 2011

HAT A STRANGE year 2011 is turning out to be. It may well be that future historians will mark it as a tipping point when the 21st century begins to take on its individual shape and character. We certainly seem to be sloughing off the last vestiges and shibboleths of the previous century. Unrest in the Middle East and North African region promises to rewrite the political landscape for the next 20 years. Equally, the catastrophic events in Japan are now tipping countries one side or the other in the nuclear debate with consequences on the evolution of the power industry in the western world which will reverberate for at least 50 years. Moreover, it is becoming clearer what the impact and sometimes unintended consequences of much of the incoming regulation is on the global financial markets.

This edition touches on many of the emerging themes that could very well influence market thinking over the coming years. Take our coverage on DRs for example. While the much-heralded globalisation of the financial markets is under way, it is increasingly clear that it continues to be dominated by one-way traffic; namely investment fund flows from west to east. East right now does not seem to be that interested in western or say Latin American entities hoping to harness potential cross-border investment appeal. The performance of foreign DRs in Asia appears to be the bellwether of the relative indifference of Asian investors in foreign firms’ equity (even highly successful ones such as Vale). It might be a temporal trend; it is likely not.

We also look at a number of trends across the securities services segment.

David Simons reports on at the rapidly evolving collateral management landscape. It seems that change in this segment will increasingly encourage investors to become far more skilled at managing entire collateral relationships across their total portfolio; or conversely link up with a one-stop shop that can manage the client’s spectrum of collateral calls and, when needed, provide collateral optimisation solutions. Meanwhile, Lynn Strongin Dodds reviews the still-dulled securities lending business and in particular highlights the ways that traders can extract value for those stocks in most demand that command the highest prices. It seems that while traders’ desks do less volume, the transactions they are required to complete are increasingly complex; a paradigm also visible in the equity trading markets. In this revolutionary landscape, investors are flying to quality and are looking for greater control over their investments. In this regard, managed accounts, particularly in the alternative investment space, are now de rigueur.

Perhaps the most significant development of recent years is the emergence of a shadow banking system, comprising hedge funds, insurers, collateralised loan obligations and all other sources of finance that do not require a banking licence. As Andrew Cavenagh reports, in the United States alone, this shadow system is now reckoned to be worth $20trn, almost double the funds in the traditional banking system. How that will rewrite future history is anyone’s guess right now. But the day may come (and sooner than you think) when the mantra might very well be: “Banks? Who needs banks?”

W

Francesca Carnevale, Editor, June 2011 Cover photo: Omer Aras, chairman and group chief executive, Finansbank. Photograph kindly supplied by Finansbank, May 2011.

1

CONTENTS COVER STORY

MANAGING GREAT EXPECTATIONS

..........................................................................Page 31 Finansbank has always punched way above its weight in the Turkish banking sector.

Marked by a willingness to change tactics (even mid-stream) to best leverage fluctuating market conditions, the bank has become something of a paradigm of the changing fortunes of Turkish banking. Francesca Carnevale talks to chairman and group chief executive Omer Aras about the bank's forward strategy.

DEPARTMENTS

MARKET LEADER

MEETING THE DR LIQUIDITY CHALLENGE ....................................................Page 6

SPOTLIGHT

SBERBANK TO MERGE WITH TROIKA DIALOG ........................................Page 12

Why are foreign firms finding the going tough in the Asian DR market?

Russia's first real investment bank starts to take shape.

HKMEX LAUNCHES AS CHINA GATEWAY

..................................................Page 14 New exchange sets a fresh agenda for China commodities trading.

IN THE MARKETS

IS PRICING FOR CORPORATE RISK TOO COMPETITIVE? ..................Page 17 Can syndicated loans maintain their pricing, which is below bond market rates?

NEW MARKET PROMISES TRANSPARENCY ................................................Page 20 NYSE Euronext launches new BondMatch MTF.

BANKING REPORT

GCC BANKING: A NEW CROSSROAD ................................................................Page 21

DEBT REPORT

FUNDAMENTALS STOKE HIGH YIELD ..............................................................Page 24

SECTOR REPORT

POWER STOCKS ON THE DEFENSIVE ................................................................Page 27

REAL ESTATE

NAKHEEL PROMISES TO STAND AND DELIVER ......................................Page 29

Can banks in the GCC rediscover boom times?

Is the potential for capital gains capped? By Neil O'Hara.

Vanja Dragomanovic reports on the challenges now facing nuclear power providers.

Nakheel comes to terms with restructuring.

TURKEY'S BANKS SET A 21ST CENTURY AGENDA ................................Page 34

COUNTRY REPORT

How and why Turkey's banks walk in two worlds.

INVESTMENT IN TURKEY TAKES A SOLID TURN ....................................Page 38 FDI looks to outrun short-term speculative inflows.

CALCULATING CRM OPPORTUNITIES

FACE TO FACE

..............................................................Page 42 Akbank deputy CEO Hakan Binbasgil talks through the bank’s retail growth strategy.

THE ALLURE OF THE DARK ........................................................................................Page 44 Lee Hodgkinson, CEO of Smartpool, explains the appeal of dark trading.

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JUNE 2011 • FTSE GLOBAL MARKETS

CONTENTS

OIL WILL DRIVE SECTOR AHEAD IN THE LONG TERM ....................Page 46

COMMODITIES

Vanja Dragomanovich explains the key trends.

THE GOLD OPTION IS NOT LOSING ITS APPEAL ....................................Page 48 There looks to be no serious reason why gold prices should lose their lustre.

FX VIEWPOINT

INDEX REVIEW

CAN BANKS COME TO TERMS WITH HFT? ..................................................Page 50 Erik Lehtis of DynamicFX, says high-frequency traders and banks need each other.

MARKETS STILL ADRIFT IN NEUTRAL DATA ..............................................Page 52 Simon Denham, managing director, Capital Spreads, takes the bearish view

FEATURES HEDGE FUND REPORT:

PRIME BROKERS PRAY FOR HIGHER RATES ..........................................Page 53 Low interest rates, leverage and trading volumes have left prime brokers sucking wind.

HEDGE FUNDS BOUNCE BACK ......................................................................Page 57 Neil O’Hara explains why the hedge fund industry is entering a new, mature phase.

BOOM TIMES FOR HEDGE FUNDS ..............................................................Page 60 Some 55% of US institutional investors look likely to increase hedge fund allocations.

ALTERNATIVE FUND ADMIN IN AN AGE OF CHANGE ..................Page 63 The current flight to quality does not guarantee a lock on market share. By David Simons.

TRADING REPORT:

CANADIAN REGULATORS RULE AND ROIL ............................................Page 69 Why Canada’s trading revolution might be muddied by regulators. By Neil O’Hara.

BLOCK TRADING STRAIN SPURS INNOVATION ..................................Page 72 Ruth Hughes Liley reports on the best ways to overcome strains on liquidity.

SECURITIES SERVICES:

MIXED FORTUNES FOR INVESTORS IN THE CEE ................................Page 78 Lynn Strongin Dodds reviews the changing provision of securities services in the region.

COLLATERAL MANAGEMENT: IN SEARCH OF SOLUTIONS ..........Page 81 David Simons explains why CCPs are not a cure for all ills.

SPECIALS DOMINATE A STILL DULLED MARKET ................................Page 84 Traders are under pressure to prove their mettle and extract value for specials.

DATA PAGES

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DTCC Credit Default Swaps analysis ..............................................................................................Page 87 Fidessa Fragmentation Index ........................................................................................................................Page 88 BlackRock ETFs ....................................................................................................................................Page 90 Market Reports by FTSE Research................................................................................................................Page 92 Index Calendar ....................................................................................................................................................Page 96

JUNE 2011 • FTSE GLOBAL MARKETS

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E info@gold.org

MARKET LEADER

ASIAN DEPOSITARY RECEIPTS: A TOUGH MARKET FOR FOREIGN ISSUERS

Photograph © Rolffimages / Dreamstime.com, supplied May 2011.

Meeting the DR liquidity challenge Asian companies accounted for the bulk of the global depositary receipt boom in 2010 and growth is expected to continue, market conditions permitting. The bigger question is about how local DR markets will fare. Brazilian mining group Vale made the news last December when it cross-listed its shares in Hong Kong. The brouhaha over the listing quickly faded as liquidity in the DR has not materialised. It is unlikely however that this fact will deter other companies hoping to raise their profile in the region. Lynn Strongin Dodds reports.

OU HAVE TO wonder. On average, just a few thousand Vale shares change hands each day in Hong Kong, compared with average daily trading volumes in the millions for the company’s shares in São Paulo and New York. “It is still too early to judge the success of Hong Kong depositary receipts (DRs) but there are signs of other non-Chinese companies looking to list in Hong Kong,” claims Gregory Roath, head of Asia-Pacific for BNY Mellon’s DR business. “This is particularly true of companies that have a connection [in the region] and want to align their company brand in certain markets such as those in the commodity or consumer industries.

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Miguel Perez-Lafaurie, global product head, depositary receipt services and head of Asia Pacific depositary receipt services at Citi, cautions over-zealous expectations of what the region might offer in terms of liquidity: “The success of some DR programmes doesn’t happen overnight. Level 1 DRs open with a zero balance and it takes several months (sometimes years) for these programmes to grow and attract investors.”

In the US, the Level 1 ADR programmes are the most popular. They are listed on the US over-the-counter market and not on a listed securities market. This means that the issuer does not have to provide full Securities and Exchange Commission (SEC) disclo-

sure, or report its accounts under US GAAP. By contrast, Level 2 and 3 are listed on an exchange such as the New York Stock Exchange (NYSE) or NASDAQ. Issuers can also use a Level 3 programme to offer new shares to US investors in a capital raising exercise.

Many companies go down the Level 1 route with liquidity being only one factor behind the decision-making process. Edwin Reyes, managing director and global business manager of DRs at Deutsche Bank, says: “Asian companies use a listing for the liquidity and to gain exposure to these markets. Asian firms are also looking to diversify their destinations and attract a wider investor base.”

This was the rationale behind Vale’s listing. The mining giant has no plans to raise capital but it does want to make its presence better known in a country that is one of the world’s biggest consumers of iron ore and accounts for over a third of its profits. The same driver is behind luxury brand Coach, which has set its sights on a Hong Kong DR listing at the end of the year. It is hoping to tap into the growing demand in the Chinese

JUNE 2011 • FTSE GLOBAL MARKETS

Send a strong signal to the global capital markets.

Who’s helping you?

Connecting issuers to investors is critical to the success of every depositary receipt program. BNY Mellon’s unparalleled expertise and outreach initiatives are central to this connection. Operating in 74 countries, we have opened a world of opportunities for issuers and investors — making us the world’s leading depositary bank.

Working together, we can help reach your strategic goals.

For more information on Depositary Receipts, please contact: Asia-Pacific: Gregory Roath +852 2840 9821 Central Eastern Europe & Africa: Anthony Moro +1 212 815 5838 Latin America: Nuno da Silva +1 212 815 2233 Middle East: Mahmoud Salem +1 212 815 2248 Western Europe: Marianne Erlandsen +1 212 815 4747 bnymellon.com/dr

Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. Depositary Receipts: NOT FDIC, STATE OR FEDERAL AGENCY INSURED; MAY LOSE VALUE; NO BANK, STATE OR FEDERAL AGENCY GUARANTEE. ©2011 The Bank of New York Mellon Corporation. All rights reserved.

MARKET LEADER

ASIAN DEPOSITARY RECEIPTS: A TOUGH MARKET FOR FOREIGN ISSUERS

market for “man bags” and other highend products. London-listed copper mining group Kazakhmys on the other hand, may sell up to $200m of new shares to “assist liquidity”.

Hong Kong though is not the only market developing its DR brand. Taiwan has enjoyed a burst of activity over the past two years with 18 DRs and an additional 15 are predicted for this year.

Meanwhile last year Singapore struck a partnership with NASDAQ OMX to launch a new ADR service called GlobalQuote. There are around 19 ADRs by Asian companies being quoted, ten of which have primary listings on the Hong Kong Stock Exchange.

India has also thrown its hat in the DR ring with Standard Chartered, the UK lender that generates at least threequarters of its profit in Asia, being the first company to issue an Indian DR. It is thought that the $590m issue was to help demonstrate the group’s commitment to the country’s regulators in anticipation of the eventual lifting of restrictions on the number of branches that foreign banks can operate.

Kenneth Tse, Asia Pacific head of JP Morgan’s depositary receipts group, predicts a continued emergence of local market DRs across Asia Pacific, as inbound global companies seek to better capitalise on the region’s growth story. “Taiwan, Singapore and more recently India have established domestic DR markets. In addition, markets such as Mongolia and Vietnam will begin to assert themselves on the global stage over the next 12 to 24 months as their domestic companies seek to raise capital in new markets in Asia and around the world. Amidst this increasing number of international companies who are interested in listing on the local DR markets, Hong Kong is evolving into a destination of choice. Offering a deep liquidity pool, a developed investor base as well as established regulations and market infrastructure, Hong Kong also enjoys a distinct advantage through its position as the gateway to China,” he says.

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Kenneth Tse, Asia Pacific head of JP Morgan’s depositary receipts group, predicts a continued emergence of local market DRs across Asia Pacific. “Amidst this increasing number of international companies who are interested in listing on the local DR markets, Hong Kong is evolving into a destination of choice,” he says. companies will list DRs, we see that a trend has formed and ultimately, we think the number will be strong [sic].”

The combination of these factors could also put a damper on this year’s DR crop of Asian companies looking to list overseas. The jury is still out as to whether 2011 will outperform 2010, which saw a 14.5% jump in the trading value of APAC DRs to $882bn from $770bn in 2009. Altogether there was a record 72 new APAC issuers that raised $5.4bn in capital through DRs in 2010, compared with 26 new issuers at $4bn in 2009, according to JP Morgan’s APAC year in review 2010 report. This reflected a drop in the average deal size of IPOs, most likely due to market volatility. China led with 36 at $4.1bn followed by India at 34 (valued at $959.3m) and Taiwan with two, worth a combined $298.8m.

Trading volume Gregory Roath, head of Asia-Pacific for BNY Mellon’s DR business. “There are non-Chinese companies looking to list in Hong Kong. This is particularly true of companies that have a connection [in the region] and want to align their company brand in certain markets such as those in the commodity or consumer industries,” he says. Photograph kindly supplied by BNY Mellon, May 2011.

Despite the outlook there are still words of caution. Tse says: “It is hard to predict the HDR market’s growth rate.

The impact of external factors such as the European sovereign debt crisis, the direction of interest rates, rising inflation and China’s monetary policy could weigh on capital markets globally. However, although it is hard to say how many

JP Morgan figures show that Chinese, Indian and Taiwanese companies were in front last year in terms of trading volume and value. Collectively, these three accounted for 77.7% or $672.6bn of the former and 76.3% of the latter.

According to the same data, China’s DR programmes accounted for 52.3% of APAC DR trading volume and 59.6% of value. Meanwhile, Taiwan generated 17.5% of volume and 6% of value, respectively, with India at a respective 7.9% and 10.7%. In terms of industries, semiconductors, alternative energy, internet and telecommunications were the most active sectors, representing 53.4% of trading value and 54.7% volume for APAC DRs last year.

Tse notes: “Chinese internet and IT companies that were backed with private equity or venture capital have been

JUNE 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

ASIAN DEPOSITARY RECEIPTS: A TOUGH MARKET FOR FOREIGN ISSUERS

among the most active ADR participants in the US but we are increasingly seeing other industries coming to the market.

This includes education because of the importance of the sector in China and consumer goods due to the expansion of the middle class.”

Reyes also points out that “Chinese companies started on NASDAQ, primarily internet and technology-based, because it was a market for start-ups as well as to be more in line with their international peers but we have since increasingly seen New York Stock Exchange listings as well”.

According to the JP Morgan report, NYSE, which accounted for 59.7% of APAC DRs traded in 2010, is the most popular venue, followed by NASDAQ at 35.8%, OTC at 2.9% and the London Stock Exchange (LSE) at 1.5%. In terms of value NYSE was also in front with 51.9%, NASDAQ came in second at 43.6% while LSE had 2.5% and OTC at 2%. As for unsponsored programmes, the JP Morgan report states that the growth will taper off because the programmes with the highest investor demand have already been created. This perhaps explains why the number of these programmes last year came in at 52, down from 77 in 2009. Conversion of unsponsored to sponsored Level I ADR programmes is expected to continue as companies see the benefits of taking control of their ADR programmes.

The pace of growth depends on market conditions, according to PerezLafaurie, and a high profile is not necessarily an indicator of demand. “For example, Renren, known as the Chinese Facebook, was launched on May 4th 2011 and is now trading below the original price of $14. This may be a short-term sell off or a reflection of a wider trend. We still have a strong pipeline of request for proposals (RFPs) and I think even if there is a slowdown in the overall number of Asian companies listing, China will still be active because companies want to attract a wider investor base.”

Roath also believes there will be more listings in the wider region.

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JP Morgan figures show that Chinese, Indian and Taiwanese companies were in front last year in terms of trading volume and value. Collectively, these three accounted for 77.7% or $672.6bn of the former and 76.3% of the latter. According to the same data, China’s DR programmes accounted for 52.3% of APAC DR trading volume and 59.6% of value.

Edwin Reyes, managing director and global business manager of DRs at Deutsche Bank.

“Chinese companies started on NASDAQ, primarily internet and technology-based, because it was a market for start-ups as well as to be more in line with their international peers but we have since increasingly seen New York Stock Exchange listings as well,” he says. Photograph kindly supplied by Deutsche Bank, May 2011.

Miguel Perez-Lafaurie, global product head, depositary receipt services and head of Asia Pacific depositary receipt services at Citi. “We still have a strong pipeline of request for proposals (RFPs) and I think even if there is a slowdown in the overall number of Asian companies listing, China will still be active because companies want to attract a wider investor base,” he says. Photograph kindly supplied by Citi, May 2011.

China and Singapore are this year expected to list DRs on the Taiwan Stock Exchange. He also thinks that the segment will see more innovation.

In fact, BNY Mellon has been one of the leaders in the development of exchange-traded funds (ETFs) based on DRs. In the past year there has been a flurry of activity with the WCM/BNY Mellon Focused Growth ADR ETF

launched as the first actively-managed international ETF, referencing BNY Mellon’s Classic ADR Index. This is the only index to track all DRs either traded OTC or on the New York Stock Exchange, NYSE Amex or NASDAQ. The bank also signed a memorandum of understanding with the Shanghai Stock Exchange to collaborate on ETFs based on its indices. I

JUNE 2011 • FTSE GLOBAL MARKETS

SPOTLIGHT

Sberbank on the acquisition trail Sberbank and Troika Dialog agree takeover and Russia’s first universal bank is created INEVITABLY, ANY CASH-RICH Russian bank worth its salt is always on the lookout for a good acquisition opportunity. The outright acquisition

by Sberbank of investment firm Troika Dialog at the end of May should come as no surprise. In fact, it had been expected for some time. The merger, first mooted in March, marks the emergence of Russia’s first universal bank. Herman Gref, chief executive officer and chairman of the board at Sberbank of Russia, notes the integration of “two mutually complementary businesses. It also confirms our commitment to maximizing the full range of opportunities and synergy the deal creates”. He adds: “The merger potentially allows us to effect major changes in the make-up of the Russian financial industry. We will be uniquely able to provide major corporations with universal banking services, and mid-cap companies and retail clients, with access to investment banking and wealth management services from the proven market leader.”

Sberbank is the largest bank in Russia, holding approximately 30% of the total assets in the domestic banking system, and employs around 240,000 people. Russia’s central bank remains the largest single shareholder (with a 60% holding). The remainder of the shares is dispersed among more than 260,000 individuals and legal entities. Sberbank also has the largest branch network in Russia, as well as subsidiaries in Kazakhstan, Ukraine and Belarus.

Founded in 1991, Troika Dialog was until the last week in May an independent, full service investment bank and asset management firm.

The company’s business consists of securities sales and trading, investment banking, private wealth

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Herman Gref, chief executive officer and chairman of the board at Sberbank of Russia. “The merger potentially allows us to effect major changes in the make-up of the Russian financial industry,” he says.

Photograph © Dvkorn / Dreamstime.com, supplied May 2011.

and asset management, retail distribution and alternative investment, working out of 21 cities across Russia plus offices in London, New York, Kyiv, Almaty and Nicosia.

However, for the next three years, Troika Dialog will continue to operate as a standalone entity, with Ruben Vardanian staying on as chief executive for the duration.

The deal is significant on a number of levels. The Russian psyche has

always worked on the assumption that bigger is better and the merger of the giant state-owned bank with the more fleet-of-foot Troika Dialogue should mix firepower and entrepreneurship. The merger should also reinforce Sberbank’s role in domestic, ruble bond sales; both institutions have noted debt capital markets (DCM) teams.

Much will also depend on the way that the merged entity wants to build out its DCM and equity capital markets (ECM) operations. Russian firms are showing a willingness to work outside the box and list their shares overseas and issue debt in foreign currency.

Equally, Sberbank itself is gaining in confidence as it travels on the acquisition trail. In February this year the bank acquired 5.6% of the voting shares in Moscow’s RTS exchange, which itself plans to merge with co-national exchange MICEX. The bank already owns a slug of MICEX and Sberbank will net itself a tidy sum if the merger (valued at $4.6bn) with RTS is concluded in 2012, followed by a public offering.

Finally, as a state-owned player, it is expected to play its part in helping the country establish Moscow as a global money centre by 2020, which can only be achieved if the country’s principal financial institutions can provide depth of service backed by strong balance sheets. In that context, consolidation will be a feature of the Russian financial markets for the remainder of 2011.

The Sberbank-Troika Dialog merger will take place in stages.

Sberbank will initially pay $1bn for a 100% stake in Troika Dialog to Standard Bank Group (which owns 36.427%) and the Troika Dialog Partnership (63.573%). Standard Bank will also be entitled to additional remuneration over three years based on 50% of the difference between Troika Dialog’s average yearly net profit from 2011-2013 multiplied by a coefficient of 13.5. I

JUNE 2011 • FTSE GLOBAL MARKETS

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ĂŶĂůLJƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

IN THE MARKETS

HONG KONG MERCANTILE EXCHANGE OPENS

HKMEx launches as a gateway to China commodities trade The Hong Kong Mercantile Exchange (HKMEx) opened for business on May 18th following authorisation by the Hong Kong Securities & Futures Commission to operate as an automated trading services (ATS) provider. The exchange began trading with a 32 troy ounce gold futures contract. Silver futures will be the next product launched on the exchange within weeks, and base metal, energy, commodities and financial futures look to be added in due course. Moreover, the exchange will offer both gold and silver products denominated in renminbi. However, the HKMEx can expect some hefty competition from existing and new players.

HE HONG KONG Mercantile Exchange (HKMEx) began trading US dollar-denominated gold futures on its electronic platform, with bold plans to dominate the Asian-Pacific commodities trade, sending a clear message to commodities bourses elsewhere that they have serious competition in the high-growth region. The exchange launched offering a 32 troy ounce gold futures contract priced in US dollars with physical delivery in Hong Kong. A silver contract is expected to start trading in July. Moreover, to leverage growing investor demand for China’s gradually strengthening currency, a renminbi-denominated gold futures contract is expected to launch by the autumn. Other products involving precious and base metals, agriculture, energy and commodity indices are also in the pipeline.

Moreover, although initial product launches centre around US dollarbased contracts, the exchange will move towards offering RMB-based contracts as the currency becomes more internationalised.

On the launch of HKMEx in midMay, Albert Helmig, the new exchange’s president, claimed: “We are on our way to becoming the world’s gateway for commodities trading with China. Asian countries, especially China and India, have been driving demand for global commodities and the new exchange is aimed at helping traders in the region have a bigger say in setting prices and having access to tradable products that

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View of Hong Kong at Victoria Harbour.

Photograph © Chuyu / Dreamstime.com, May 2011.

are better suited to local requirements.

Trading of gold and other major commodities has traditionally been dominated by exchanges in Chicago, New York and London. Our strategy is to deliver product that meets the region’s specifications and characteristics. We also have a keen interest in eventually delivering product denominated in renminbi.”

How aggressively the HKMEx is pursuing that goal is clearly evident by its long trading hours, ranging from 8am to 11pm Hong Kong time, thereby overlap-

ping commodity markets both in Europe and the United States. Hong Kong is 13 hours ahead of Chicago and seven hours ahead of London.“This helps to promote cross-continent trading and boost liquidity,” says Helmig. “It also offers participants extensive opportunities for hedging, arbitrage and effective risk management.”

HKMEx is owned in large part by shareholders from both mainland China and Hong Kong, including ICBC, the world’s largest bank by capitalisation. Other major shareholders include the state-owned China Ocean Shipping Group (COSCO) and Russia’s En+ Group, an investment company owned

by Russian Oleg Deripaska.

Originally planned for launch at the end of 2009, HKMEx was delayed due to difficult market conditions following the global financial crisis. It finally received authorisation to operate as an ATS provider on April 27th this year. The exchange began trading with 18 members, including 15 broking members, comprising names such as BOCI Securities Ltd, Celestial Commodities Ltd, and CES Capital International Co Ltd. HKMEx’s trading platform Pearl, supplied by Cinnober, has been designed to operate to international exchange standards. Round-trip latency is around 1.6 milliseconds with high-volume capacities. It supports the FIX 4.4 protocol on Hewlett Packard hardware and the exchange’s surveillance system is designed and

JUNE 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

HONG KONG MERCANTILE EXCHANGE OPENS

built by Scila. HKMEx is cleared by LCH.Clearnet. It is also supported by “a highly-skilled management team with immense regional expertise and direct experience with international futures exchanges,” says Helmig.

“When you start an exchange, its strength lies in its human assets.”

Helmig posits HKMEx as a “vital bridge between mainland China and the international commodity and financial markets, riding on Hong Kong’s world-class financial infrastructure, geographical proximity to China, and unique role as China’s offshore renminbi centre”.

The attraction of locating in Hong Kong was obvious, notes Helmig, given that its laws essentially mirror those of the United Kingdom and the US. He adds: “It is a great location, basically servicing the world’s fastest growing consumer of commodities in the world.”

Gold was also an obvious benchmark product for the exchange to offer, given that Hong Kong is one of the three top gold trading centres globally, along with London and New York.

Hong Kong itself is the gateway for 70% of the gold going into China and 100% of the fabricated gold sold by the mainland. Not only that, Helmig says the exchange is determined to provide its clients with access to global commodities, providing products that are tailored to the region’s specific needs.

Helmig explains: “A product such as WTI in the US is not necessarily, for example, a good hedging tool for physical oil delivery in Asia. It is essentially a land-locked contract.” Equally he points to the example of Rotterdam copper as not reflecting the proper basis risk (encompassing time, location and quantity) of transactions in Asia: “Therefore they do not always offer proper hedging tools to local Asian clients, and this is where we know we can add real value.”

HKMEx’s attempt to wrest market share of commodities follows rapidly on the launch of the Singapore Mercantile Exchange (SMX) in August last year. It too signalled its intent to leverage the

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Albert Helmig, president of HKMEx. “We are on our way to becoming the world’s gateway for commodities trading with China,” he says.

Photograph supplied by HKMEx, May 2011.

rapidly changing global economic order, led by Asian growth and the steady rise in demand for a wide range of commodities in the region.

The Singapore market is holding its own, trading some 1,000 or so contracts for gold, silver, copper, crude oil and currency futures worth in the range of $30m to $50m a day. So far however, the world’s largest commodity exchange, the CME Group—which itself has a presence in Singapore and continues to accumulate key commodity-based benchmarks upon which derivatives can be written and traded on its ubiquitous Globex platform—is hardly quaking in its boots at the competition, though it is building momentum in Asian-based currency futures. Most recently it has begun trading cash-settled AUD-USD and USD-JPY futures.

Thomas McMahon, chief executive officer of SMX, has however decided to leave the exchange at the end of June this year, continuing his association with the exchange as a member of its advisory board. The executive board meantime now has to find a new chief executive.

For its part, the HKMEx is betting its own boots on its nearness to mainland China and its ability to leverage existing trading business between Hong Kong and the PRC mainland. The mainland itself has three main commodity trading centres: in Shanghai, Dalian and Zhengzhou. Those markets are off limits to foreign broker/dealers and play no role in setting global commodity prices.

However, the government has gradually been encouraging a number of initiatives that play towards establishing a market-driven economy over the past year, which in the long run could translate into eventual direct competition for HKMEx. In April last year, for example, index futures were launched in China, a substantive step. Most recently, the Shanghai Gold Exchange (SGEx) announced plans to launch China’s first domestic gold ETF, though the finer details still remain to be ironed out with local regulators. As well, the Shanghai Futures Exchange is reported to plan to offer silver futures by the end of 2011.

For the time being HKMEx has the advantage of the backing of an internationally-recognised regulatory regime and the opportunity to offer any number of attractive derivatives based on key commodities, limited only by the vision of its product developers.

However over the longer term, the attractiveness of the wider region will likely draw competitors into the same sphere, like moths to the proverbial flame; and the question then is which trading venues will ultimately gain the competitive edge? Helmig thinks he has the answers, but is equally adamant he will not spell out the exact direction the exchange will take and give his potential competition any meaningful insight into his thinking.

“I will not be telling the market our strategic plan; let’s leave it at the obvious. Namely, that in the first instance, China has a phenomenal growth story that we aim to leverage.

The possibilities are therefore quite exceptional.”I

JUNE 2011 • FTSE GLOBAL MARKETS

SYNDICATED LOANS: PRICED BELOW BOND MARKETS

the banking market for their requirements. Kenneth Young, managing director of CVC Capital Partners financing team, recently confirmed that all $18.3bn of the debt that his firm had raised for its various portfolio companies so far this year had come from loans rather than bonds. The £1.55bn refinancing of UK gambling group Gala Coral’s debt in the first week of May included a £900m leveraged loan—the largest so far in 2011—and several big upcoming European acquisitions are confidently expected to go down the same route. They include the auctions for the French real-estate management company Astra Tech and the Swedish security group Securitas.

Beefing up capabilities

Photograph © Haywiremedia / Dreamstime.com, supplied May 2011.

Is pricing for corporate risk too competitive?

Banks are continuing to fight their way back aggressively into the corporate lending market this year from their all-time low point in 2008, when the unprecedented freeze on liquidity at the height of the financial crisis paralysed the system and drove companies across the credit spectrum to look for their needs in the bond markets the following year. Andrew Cavenagh reports on the bounce back of the financing segment.

HE LATEST FIGURES from Dealogic show that banks issued $351bn of leveraged loans by the end of the first week of May this year.

This compared with $207bn for the comparable period of 2010, and some analysts are now expecting this subsector of the loan market to top $1trn for the full year. This would be the highest annual total since 2007, when the level of activity reached $1.8trn.

Much of the capital-market debt that companies around the world put in place three years ago, with short to medium-term tenors, promises to be

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FTSE GLOBAL MARKETS • JUNE 2011

refinanced in the banking market over the next 18 months. Banks are once again clearly willing to price corporate risk a lot more cheaply than bond investors are prepared to do. “A lot of it is coming back to the bank market,” says Julian van Kan, global head of loans syndication and trading at BNP Paribas. “The loan market is priced substantially below the bond markets now—for lower investment-grade companies the difference can be 50100 basis points [bps].”

Large private equity firms are among those which have already returned to

Leading banks are meanwhile beefing up their capabilities to meet the growing demand. Credit Suisse, for example, has added six additional bankers to its leveraged-loan operation in London within the past year.

Considering the state of paralysis to which the banking market was reduced in 2008, the rate at, and the scale on, which it has returned to corporate lending has been remarkable. According to figures from Thomson Reuters, total global lending in 2010 amounted to $2.6trn, a 52% increase on 2009.

Although the figure for 2010 still represents just 45% of the market in 2007, lending volumes are sure to grow significantly again this year as the statistics for the leveraged-loan sector of the market up to early May imply.

Apart from the large-scale migration of companies back from the capital markets (where another $1.6trn of bonds will fall due for refinancing in 2012), the growth will be further fuelled by an estimated $1.5trn of existing loans that are due to mature in 2011.

In the Asian Pacific region, where syndicated-loan volumes rose from $171bn in 2009 to $260bn last year, bankers are looking for the market to surge again in 2011 as a “wall” of debt transactions that were put in place in 2006 mature over the course of the

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IN THE MARKETS

SYNDICATED LOANS: PRICED BELOW BOND MARKETS

year. Australia and Hong Kong are expected to be the hottest markets, with the level of activity in the former expected to possibly approach $100bn compared with $62.3bn in 2010. John Corrin, head of loan syndications at ANZ and chairman of the Asia Pacific Loan Markets Association, commented that it would be “reasonable” to expect the Australian market to grow this year by 30%-50%.

Meanwhile, the expansion of the corporate-loan business in Brazil promises to be even more spectacular, with the market expected to increase from just $5bn in 2010 to more than $30bn in 2011, as the booming levels of investment in the country’s infrastructure dramatically increases the demand for project finance in the leading Latin American economy.

Andre Fernandes Berenguer, head of global banking and markets at Banco Santander (Brasil), said in April that he expected the volume of business to overtake the record $29.9bn that was lent in the country in 2007 on the back of the likely requirement for structured finance. He explained that such debt had proved to be “the instrument that has served best for capital-intensive projects”.

Differences in loan market There are nevertheless some notable differences in the way the syndicatedloan market is operating now compared with 2007. Traditional underwriting of facilities by lead arranging banks, or groups of them (which disappeared immediately post-crisis as institutions could no longer afford to do it) has largely been replaced by a “soft form of underwriting”. Under this system the arrangers will guarantee to put up a significant portion of the debt required (say 40%) in full confidence that they will be able to raise the balance from additional participants at a later stage.

While the principle of syndication has returned (after a brief period in which banks could only put loans together on a “club” basis), as arrangers

18

sell on participation at various levels in their facilities, there tends to be noticeably fewer participants in each case than was the case four years ago. This largely reflects the shrinkage of the balance sheets of many institutions in the aftermath of 2008, which has frequently involved the enforced sale of loan books in their entirety.

Van Kan at BNP Paribas says the present high availability and aggressive pricing of bank debt was in part a reflection of how low the banking sector’s exposure to large companies had consequently become, relative to its historical levels. He maintains: “Banks are actually hugely under-lent at the corporate level.”

The aggression with which some institutions are pursuing the business, however, is causing real concern that they are sowing the seeds for a further banking crisis in the not-too-distant future. The levels of leverage on offer are virtually back to where they were before the crisis, with multiples of six common for a wide range of transactions and double-figure offers reported for certain types of infrastructure lending.

Even more disturbing, arguably, is that the current margins on most corporate facilities are way below the cost of capital for some of the smaller banks that are participating in them—with the differential as much as 175bps over the Libor and Euribor benchmarks in the most extreme cases.

This situation is clearly unsustainable and is already starting to have a noticeable impact on return-on-equity (ROE) ratios in Asia, where investors in some of the region’s banks have seen their ROE fall from 14% to 11%. As the downward pressure on pricing has continued into the second quarter of 2011, bank analysts are waiting with interest to see what impact there is on European banks when they report figures for the period. “If this trend doesn’t correct itself, things at some point will go bang,” warns van Kan. “I find myself looking at deals today and asking myself whether 2008 ever actually happened.”

It is hard to see, however, how banks can continue to adopt this approach for much longer. Not only are their shareholders unlikely to accept a continuing erosion of their ROE, but the Basel III capital accords (which most in banking circles expect the EU to adopt with considerably less flexibility than some other jurisdictions, notably the US) will also exert a corrective influence on unsustainably cheap lending. The Basel III provisions on regulatory capital, for example, will make it far more expensive for banks to lend to lower-rated entities and will inevitably reduce the overall availability of bank credit.

A certain consequence would seem to be that, despite the aggressive manner in which they are currently trying to reclaim the business from the capital markets, banks will end up playing a reduced role in the provision of corporate debt in the medium to long term than they have historically.

Growth in shadow banking The growth of the “shadow banking system” which is made up of hedge funds, insurers, collateralised loan obligations and all other sources of finance that do not require a banking licence, will accelerate the process as it widens the range of alternatives for many companies. In the United States, this shadow system is now reckoned to be worth $20trn, almost more than double the $11trn in the actual banking system.

Cultural and historical differences will mean, of course, that there will continue to be significant variations between regions, and countries within them. This is already evident in Europe, for example, where Spanish companies, for the most part, clearly feel an obligation to support their national banks and are not transferring their business to foreign competitors who are offering cheaper terms. At the other end of the spectrum, French corporatists’ choice of bank seems to be driven almost exclusively by pricing, and the lending market there has consequently become extremely aggressive. I

JUNE 2011 • FTSE GLOBAL MARKETS

FTSE Group Extends Access to Alternative Asset Classes With the FTSE Infrastructure Index Series (FIIS) A Q&A Session with Mike Bruno, Director of Index Research, FTSE FTSE recently launched the FTSE Infrastructure Index Series. What is the potential benefit for investors (relative to other infrastructure investment products)?

The FTSE Infrastructure Index Series (FIIS) was designed to provide a set of benchmark indices, relevant for both institutional and retail investors, who will likely have different investment objectives. The Core Infrastructure Indices are built around FTSE’s definition of ‘infrastructure’ while the Infrastructure Opportunities Indices are built upon an expanded version of that definition. At the same time, the FIIS operates under several principles. Transparency – the FIIS is managed according to a transparent and publicly available set of rules. Representativeness – the FIIS is designed to avoid the sector concentration which characterizes some infrastructure investment products, leading to a more representative benchmark of the performance of global listed infrastructure assets. Additionally, there is an evolution in the market’s perception of what constitutes ‘infrastructure’ to include the networks, suppliers and support services essential to ‘core’ infrastructure industries. FIIS is the first index series to meet this changing definition. Liquidity – in contrast to products based on private infrastructure investments, the FIIS gains exposure via listed equities leading to enhanced liquidity and price transparency. Customizable – the FIIS is modular in construction and can be adapted to meet the needs of individual investors.

You mention FTSE’s definition of infrastructure. What’s different about this definition?

FTSE has worked with market participants to create a definition of infrastructure which includes companies that own, operate or manage physical structures or networks used to process and move goods, services, information/data, people, energy and life necessities. This definition focuses on the networks, conduits and thoroughfares that many investors commonly consider essential to a country or region’s infrastructure. We think of this as more of a ‘pure play’ on listed infrastructure investments. In addition, FTSE expands the definition to create a broader representation of infrastructure. This includes companies that provide the means of conveying those goods, services, information, etc. across the networks and conduits, as well as companies providing critical maintenance as support services.

Why did FTSE decide to launch this index series now?

The decision was in response to market demand. There is growing interest in infrastructure as an asset class as investors look for alternative sources of diversification and return. The asset class is benefiting from emerging market growth and government stimulus spending on infrastructure projects and so there is a requirement for better tools to benchmark and manage these assets.

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SOURCE: FTSE Group, data as of 31 March 2011

For more information about the FTSE Infrastructure Index Series, please visit: www.ftse.com/Indices/FTSE_Infrastructure_Index_Series/index.jsp

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Index provider of the year

Global markets grow more complex and interconnected every day. To stay abreast, you need a comprehensive index that can slice and dice markets the way you do. The FTSE Global Equity Index Series was the first benchmark to cover the world seamlessly with a single consistent and transparent methodology. Because FTSE indices are independently verified by a panel of market practitioners, you can be sure that they will always be in line with investors’ needs. Wherever you invest, FTSE gives you the clearest view of how you are doing. www.ftse.com/invest_world

© FTSE International Limited (‘FTSE’) 2011. All rights reserved. FTSE® is a trade mark owned by the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE under licence.

The FTSE Infrastructure Index Series is calculated by FTSE. FTSE does not sponsor, endorse or promote this product and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading.

Fundamental research on constituents in the FTSE Infrastructure Index Series is provided by LPX Group www.lpx-group.com.

IN THE MARKETS

CORPORATE BOND TRADING: NYSE BONDMATCH LAUNCH

While the financial crisis highlighted the importance of the corporate bond market as a funding source, it also exposed serious flaws in the system. At the height of the crisis—when funding was needed most—the market suffered a severe liquidity drought. The need for a more liquid, transparent, secure and automated bond market was made immediately apparent. Against this backdrop, NYSE Euronext is launching NYSE BondMatch, a revolutionary order-book-driven bond market that promises to bring transparency and new liquidity to corporate bonds trading in Europe. By Nathalie Masset, deputy director, European Debt Markets, NYSE Euronext.

Nathalie Masset, deputy director, European Debt Markets, NYSE Euronext. Photograph kindly supplied by NYSE Euronext, May 2011.

New market promises transparency HE EUROPEAN BOND market is extremely fragmented and lacks transparency. About 90% of European bond trading takes place on an OTC basis, usually over the phone and on electronic platforms, and investors gather pricing information through requests for quotes (RFQs) from a relatively small number of banks. Those are not the only characteristics.

The financial crisis resulted in a sustained reduction of liquidity in the secondary bond markets, which reduced investor confidence in some of the more opaque and complex products. In the interim, tighter lending rules have been imposed on banks, further reducing available credit. Against this backdrop, the bond market has emerged as an attractive source of financing for investors looking for a more manageable risk profile in the corporate capital structure. While equity investment has declined across the board in Europe, fixed-income new issuance has risen since the beginning of the financial crisis. In fact, euro-denominated corporate and financial issuance has increased by approximately 50% over the past two years, according to Dealogic.

Regulators have been spurred to implement measures to maintain market transparency and ensure markets work more efficiently.

Significant reforms to the secondary bond market are also being planned

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within the context of MiFID II, notably around the best execution rules for transactions for third-party accounts.

In 2009, the Cassiopeia Committee was formed, a French-led initiative that included international representation from key participants in the fixed-income markets. Its remit was to improve trading in the fixedincome markets and maintain liquidity in times of market turmoil.

The committee noted that current European fixed-income markets had no reference pricing, clearing, and that liquidity and transparency were lacking, which contributed to execution and valuation problems.

The committee concluded that a new European market was required, that was transparent and accessible to all qualified professionals, enabling them to negotiate corporate, financial and covered bonds. NYSE Euronext participated in the committee’s work and subsequently plans to launch NYSE BondMatch this year. The success of the platform will depend on the will of all participants to drive the market from the offset; including buy side firms, banks and brokers and also issuers.

NYSE BondMatch is designed for the wholesale market and will serve professional investors. A multilateral trading facility (MTF) platform, it will allow all professional investors to trade euro-denominated, investment-grade international corporate, financial and covered bonds on a transparent order

book with firm orders. That said, NYSE Euronext will continue to operate the retail-oriented, regulated active secondary bond matching service.

NYSE BondMatch’s electronic firm order book will allow order matching and enable the generation of reference prices based on actual transactions, thus bringing pre and post-trade transparency to this market. By allowing all buy side and sell side participants to contribute to the liquidity of the market, the NYSE BondMatch model is designed to boost liquidity, reduce risk and encourage greater participation by reducing dealing costs and making the market more transparent. This “all to all” model facilitates fair treatment, particularly for asset managers or brokers representing small and mid-sized investors seeking greater access to liquidity.

The MTF will be connected to a central counterparty (CCP) with links towards major National Central Securities Depositories (NCSDs) and International Central Securities Depositories (ICSDs). LCH.Clearnet will act as the CCP. Because clearing will be compulsory, trades will be guaranteed and the delivery and settlement risk for trading participants will be greatly reduced.

NYSE BondMatch will be powered by NYSE Euronext’s technology and will be supported by its surveillance systems and customer support teams to ensure fair and orderly markets. I

JUNE 2011 • FTSE GLOBAL MARKETS

BANKING REPORT

GCC BANKING: IMPROVING FORTUNES OF THE FINANCIAL SECTOR

Reaching a turning point?

Following a less than stellar second half year in 2010, the aggregate GCC banking segment is now looking to improved fortunes. According to research by Kuwait’s Global Investment House (GIH), GCC banking profitability, in aggregate, rose by 25% in the first quarter (Q1) this year, with provisions against bad loans (a major concern through 2010) improving. GIH’s report noted that: “Growth in GCC banks’ profits was not supported by the top line, as the net interest income of the banks showed a minimal decrease of about 0.7% in the first quarter compared with the previous quarter.” Can the GCC’s banks now return, after a sluggish interval, to their glory days once more, or will the rest of this year provide more of the same?

ANKS IN GULF oil producers recorded a 25% increase in net profits in the first quarter of 2011 over the fourth quarter of 2010, indicating the region’s banking sector is back on track after more than two years of uncertainty. The net income of banks in the six-nation Gulf Cooperation Council (GCC) also swelled by nearly 11.5% in Q1 compared with the first quarter of 2010, the Kuwaiti-based Global Investment House (GIH) noted in its May 2011 Banking Report. “It has been a while since we have seen a profitability increase in banking sector in all GCC countries,” notes the report, adding: “Aggregated profit of the GCC banking sector witnessed an increase of 25%QoQ and 11.5%YoY. [The] UAE exhibited a substantial increase in profitability in Q1 2011 of 66%quarter on quarter (QoQ), on account of ENBD 248% QoQ increase in profitability made through the sale of stake in Network International. In Q1 2011, the lowest profitability growth was witnessed in Kuwait and Oman which was 3% and 4% QoQ, respectively.

Kuwait profitability growth was affected by the low profitability of Commercial Bank of Kuwait which showed a considerable decline of 93% QoQ which was a result of high provisioning. The same story applies for Omani banks as provisions grew by 33%in 1Q11.

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FTSE GLOBAL MARKETS • JUNE 2011

Photograph© Galina Barskaya / Dreamstime.com, supplied May 2011.

GIH figures show that deposits grew by around 4.6% for the segment as a whole, while net loans rise by nearly 1.6%over the previous quarter. “In general we are expecting the GCC banking profitability to grow steadily in the second quarter onwards. We are anticipating that GCC banks will improve their top line performance through their loan to deposit ratios as the spread will still be an obstacle in the top line improvement.

For its part, global ratings agency Standard & Poor’s (S&P) maintains in its own recent review of the market Banks in the Gulf are on the way to recovery, but has the dust settled?, that many if not most of the banks in the Gulf are set for slow recovery because of “sluggish loan growth and difficult funding conditions,” and the financial profiles of most of the Gulf banks are relatively stable or on a path of steady but slow improvement.

While most of the GCC states have been relatively inured to the ructions tipping over the stability of many North African and Middle East countries, one noted casualty of rising popular discontent is Bahrain, which S&P suggests has now tarnished its image. “As our negative rating actions indicate, questions remain about how the country will regain its status as a stable financial hub,”said the report. Equally however, the debt overhang in Dubai is also cause for continuing concern, though some high profile debtors, such as construction major Nakheel, have made major strides in coming to terms with restructuring their massive debt obligations [Please refer to page 29].

Despite their strong integration with global financial markets, the overall impact of the crisis on GCC banks has been relatively limited and appears to be fading. While some risk may remain for individual banks, banks, as a sector, are expected to record a solid performance this year and over the medium term. Increased focus on managing risks, controlling costs along with an improving economic environment should continue to bolster both the business segment and bank performance. Moreover, banks will likely book lower provisions through this year, particularly in Saudi Arabian and banks in the United Arab Emirates (UAE). UAE central bank data shows that general provisions in February totalled AED12.3bn, specific provisions for non-performing loans outpaced that

21

BANKING REPORT

GCC BANKING: IMPROVING FORTUNES OF THE FINANCIAL SECTOR

significantly topping AED45.8bn in February (up from AED44.3bn in December last year).

Most Saudi banks exceeded the average net profit forecasts of banking analysts in the last quarter, among them HSBC affiliate SABB and Banque Saudi Fransi, part-owned by France’s Calyon. Saudi banks are likely to continue the rally of the fourth quarter.

Similarly, Qatar’s banking sector — which proved to be one of the most resilient in the region, helped by direct government support measures — will be boosted by spending plans in the region’s fastest-growing economy [please see FTSE Global Markets, Issue 51, page 34]. Qatar National Bank, posted a 34.8% increase in Q1 2011 profit, backed by substantial growth in lending, fees and interest income. Elsewhere in the country Commercial Bank of Qatar posted net profits of QR446m for the first quarter, up 9% on Q1 2010 In Q1, the bank has made progress towards

diversifying its income and to lower its cost of funds through efficient balance sheet management, according to Andrew Stevens, the bank’s group CEO. In Kuwait meantime, National Bank of Kuwait (NBK) reported a 6% rise in first-quarter profit of KD80.8m ($292m). The bank’s non-performing loans to gross loans ratio dropped to 1.69% at the end of March from 1.81%, while NPL coverage was at 202.8%.

The bank's total assets stood at KD13.9bn (just over $50bn) at the end of March this year, NBK reports. Profitability indicators remained strong with ROA at 2.44% and ROE at 15.8%.

Kuwait Finance House (KFH), the Islamic financing house, announced total revenues over the same quarter of KD192.5m, a 15% increase year on year, and total profit for the same period reached KD61.6 which included KD38.7m as profits for investor depositors. Net profit to shareholders totalled KD22.6m, while assets reached

KD12.753bn, up 9% increase over the same period last year.

Doha Bank Group chief executive officer R Seetharaman’s presentation at the Second Annual Arab Investment in Abu Dhabi in late May, noted that the current account balance of the GCC will be 124% of GDP at current prices on account of high oil prices in 2011.

Moreover, he said that individual countries now plan to support corporate growth, particularly at the SME level through a broad range of measures including, new tax incentives and the introduction of insolvency laws, which he says will ultimately feed through to the banking segment.

With GCC budgets once again in expansion mode, due to higher oil prices, and a comprehensive infrastructure investment agenda planned in most if not all GCC countries, the outlook for banking remains strong, he added, even if short term banks still have some way to go to return to buoyancy. I

AN END TO SHORT TERMISM IN GCC INVESTMENTS? T LOOKS LIKe a new optimism is returning to the Gulf Cooperation Council (GCC) countries. Regional instability in 2011 is one of the major contributors to short-term investment horizons along with the risk adverse approach currently being displayed by investors based in the GCC region, but it’s all set to change in 2012 claims the second Invesco Middle East Asset Management Study. One of the most striking findings is that over two thirds of responses from investors (69%)acknowledge they have a time horizon of less than five years for investments made in 2011, while less than one third (31%) of respondents have a horizon just beyond five years—investment horizons which are low when compared to investors in the West.

Multiple factors appear to have driven this short-term attitude; 23% cite the main reason as cultural preference, while 22% say lack of investor experience is the driver.

I

22

However, a similar number (21%) also stated regional stability as a key factor. The impact of these perceptions has shied GCC investors away from risk in 2011, with 27% decreasing their risk exposure. Almost a quarter (22%) of retail investors has done the same.

It appears however that this shorttermism is in itself a short-term issue, with nearly one in five (18%) of all investors indicating they intend to lengthen their investment time horizons in 2012.For 2011, just 4% of retail investors in the region said they intend to lengthen their time horizons, this jumps to 20% for 2012, along with just 7% of institutional investors who said they intend to lengthen time horizons this year, which jumps to 15% for 2012.

Nick Tolchard, head of Invesco Middle East says: “Lengthening of time horizons for the region’s investor community in the next year indicates Gulf investor sentiment is becoming

increasingly confident and optimistic moving into 2012 .... The shorttermism we are seeing going into 2011 may be unrepresentative and driven, we believe, by a combination of the tentative global recovery and regional political uncertainty."

Institutional investors seem to be spreading their risk across a much broader range of asset classes compared to retail, investing the same amount in private equity (10%) as in global equities. Local equities are the main choice for institutional investors in 2011—32% of assets have been invested in this asset class, more than any other. Cash and property are the next favoured asset classes for both retail and institutional investors in the region, with 16% of all assets across the spectrum being held in cash and 12% in property, tying in with the cultural preference of investing in tangible assets. Investors showed little appetite for commodities, local bonds and hedge funds.

JUNE 2011 • FTSE GLOBAL MARKETS

DEBT REPORT

HIGH-YIELD BONDS: IS THE POTENTIAL FOR CAPITAL GAINS CAPPED?

As we reported in last month’s issue, high-yield bonds have been on a tear since prices hit bottom in March 2009, racking up cumulative gains of about 90% in two years. The capital gains party is mostly over, though, and investors can expect little more than coupon payments this year. Those returns still look attractive relative to other asset classes—and high-yield bonds do offer some protection against higher interest rates. The Federal Reserve will raise interest rates only if the economy is strong, which is precisely when corporate cash flow and credit quality are improving.

In the early stages of an economic expansion, tightening credit spreads more than offset the adverse effect of rising interest rates, making high-yield bonds a relatively safe haven—for now, at least. Neil O’Hara asks how long these gains can be sustained.

Fundamentals stoke high yield HE REMARKABLE CAPITAL gains high-yield bonds delivered in the past two years occurred only because prices were battered so badly during the financial crisis. Mark Vaselkiv, portfolio manager of the T Rowe Price HighYield Strategy Fund, points out that the yield on the JPMorgan High Yield Debt index soared from 7.7% in March 2007 to 19% in December 2008; it then tumbled to 9% a year later and has continued to decline, reaching 7.1% at the end of March 2011. “It has been an amazing roller coaster,” he says. “In 2009 and 2010, this was the best yield game in town, and we were getting meaningful capital appreciation.”

Today, the high-yield indices are trading at a premium to par, which limits the potential for future capital gains. Unlike investment-grade bonds, high-yield bonds almost always have call features; the most common issuance is either a ten-year bond callable after five years, or a seven-year bond callable after four years. Call prices start at par plus half the annual coupon: a ten-year bond yielding 10% would be callable at 105 in year six, for example—so the bond price won’t go much above 105 no matter how low rates go. The issuer has every incentive to call a bond trading at a premium to the call price at the earliest opportunity and refinance at a lower interest rate.

Most investors buy bonds for income rather than capital gains anyway, and despite yields that are close to historical lows, the returns from clipping

T

24

Mark Vaselkiv, portfolio manager of the T Rowe Price High Yield Strategy Fund.

Photograph kindly supplied by T Rowe Price, May 2011.

coupons still compare favourably to other fixed-income assets. The credit picture looks good, too: companies that cut costs during the recession have improved their margins, refinanced nearby debt maturities and are seeing revenue growth kick in as the economy picks up steam. “The fundamentals are superb,” says Vaselkiv. “From that perspective, it is nirvana.”

Fund flows into high-yield bonds have been robust for the past two years as well, although the trend has started to weaken. The money has come not only from traditional high-yield bond investors but also from people who are frustrated by the low yields on other assets. That concerns Arthur Calavritinos, a portfolio manager at Manulife

Asset Management, who fears the newcomers will be quick to turn tail the moment market conditions go sour.

“They don’t have the skill set for junk bonds when the stuff hits the fan,” he says. “They have to keep minimum ratings in their portfolios, so they will be the first to sell when problems happen.”

Calavritinos does not anticipate a stampede for the exits any time soon, but the sell-off could be sharp when it comes. He specialises in distressed situations including bankruptcy reorganisations and prefers to buy bonds at a discount to par. In fact, he sees a better risk-reward trade-off in the equity of high-yield bond issuers than in the bonds themselves—an opportunity he is permitted to exploit in his funds. A bond yielding 7% could easily drop 15 points—the high-yield index fell 35% to the 2009 low—and it would take more than two years’ worth of coupons just to get back to break even.

A bond investor has limited upside and all the downside risk, while the benefit from strong cash flows will flow through to the equity. Most high-yield bond managers don’t have the flexibility to hold equities that Calavritinos enjoys, however.

High-yield issuers are getting away with easier terms in the current environment, too. Pay-in-kind toggles (which allow cash-constrained companies to issue more bonds to holders in lieu of interest payments) are back, as are zero coupon bonds issued by holding companies whose only assets

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DEBT REPORT

HIGH-YIELD BONDS: IS THE POTENTIAL FOR CAPITAL GAINS CAPPED?

26

Arthur Calavritinos, a portfolio manager at Manulife Asset Management. Photograph kindly supplied by Manulife Asset Management, May 2011.

Gershon Distenfeld, director of high-yield investments at Alliance Bernstein Investments. Photograph kindly supplied by Alliance Bernstein Investments, May 2011.

are equity in the operating subsidiaries, not the more creditworthy operating assets. “Right now, if you have a pulse, you can borrow,” says Calavritinos.

Investors tend to treat high-yield bonds as part of the fixed-income allocation, but Gershon Distenfeld, director of high-yield investments at Alliance Bernstein Investments, points out that the returns are more closely correlated to equities than interest rates. From the middle of 1983, when the first highyield bond index was created, high-yield bonds have returned 9.5%, not far short of the 10% return on the Standard & Poor’s 500 over the same period—but with half the volatility. “It is an asset class that can give investors most of the return of stocks, but lets them sleep better at night,” Distenfeld says. “We think people should value that attribute more in their allocation decisions.”

Distenfeld acknowledges that future returns may not match historical averages, but that applies to both asset classes. Recent structural innovations could impair the future returns on highyield bonds, however. Issuers have come to market with only three years of call protection instead of four on seven-year bonds, and some issuers now have the right to call up to 10% of the bonds every year at a modest premium, even during the non-call period. That means up to 40% of a bond issue can be retired before the first call date, which eats into the

bondholders’ yield and keeps a lid on capital gains. “Companies argue they are being prudent by paying down debt instead of spending the money on something else, but it reduces the potential upside for bondholders,” says Distenfeld.

High-yield bond investors can still reap capital gains in the current market if they focus on rising stars, companies whose credit quality improves to the point where they graduate to an investment-grade rating. The yield gap between BB and BBB bonds is significant, in part because the buyer base for investment-grade bonds is several times larger than the $1trn speculative-grade universe. In addition, if the bonds go into an investment-grade index, passive investors have to buy them, pushing the price up even more.

Upward crossover trades can be quite profitable, but Eric Gross, a high-yield strategist at Barclays Capital, says investors have to buy well in advance.

“Most of the performance comes within three months before the upgrade is announced,” he says.

Some of the most promising crossover plays are in the financial sector, where fallen angels such as CIT, Ally and Ford Motor Credit are desperate to recover their investment grade ratings. A high-yield financial company is at a huge competitive disadvantage to its peers in a business

that depends on the spread between the cost of funds and the rates charged on their loan book. “High-yield financials are an oxymoron,” says Dan Roberts, head of the global fixedincome team at MacKay Shields. “They either have to get back to investment grade where they can borrow at a lower rate, or go into bankruptcy.”

An uptick in short-term interest rates won’t have a big impact on high-yield bonds, at least for the first few months.

In fact, Barclays’ Gross says that, historically, credit spreads on lower quality high-yield bonds—everything below BB—typically narrow by more than the increase in rates, so prices of these bonds actually go up. “It is counter-intuitive that high-yield prices move in the same direction as Treasury rates, but high-yield bonds trade more like equity,” he says.

“If Treasury rates rise, the economy is getting better, fundamentals are improving and spreads compress.”

Higher credit quality shows up in lower default rates, which are hovering around 2.5%-3% per annum at present.

Roberts expects the rate to decline over the next 12 months to about 1.5%. The decrease further cushions high-yield bond returns, which on average equal the nominal yield minus the annual default rate multiplied by the percentage of par recovered on bonds that do default. Even though high-yield rates are close to historical lows, Roberts does not believe that will affect the traditional negative correlation between interest rates and high-yield bond prices. “Rates are low, but they are low for everything,” he says. “Treasury rates are so low they can go up a fair amount, and high-yield spreads are in the normal range so they have room to drop.” Roberts expects total returns of 8%-10% for 2011 as the spread over Treasuries narrows from 535 basis points at year-end 2010 to the mid-400 range.

The extraordinary returns of the past two years won’t be repeated any time soon, but high-yield bonds may still beat most other fixed-income assets this year even if the Fed does push interest rates up. I

JUNE 2011 • FTSE GLOBAL MARKETS

SECTOR REPORT

EUROPEAN UTILITIES: THE CHALLENGE FACING THE NUCLEAR INDUSTRY

Europe has an ambiguous relationship with nuclear energy at the best of times, but after the crisis at the Fukushima plant in Japan this has become more pronounced. There is no denying the implicit danger in nuclear power production. Chernobyl and Fukushima brought this home very clearly, but on a practical level governments realise that Europe and most of the world need a phenomenal amount of power to keep up with the pace of global economic expansion. Can they achieve a safe balancing act? Vanya Dragomanovich reports.

Power stocks on the defensive T IS NOT possible to have both a source of truly safe and preferably environmentally-friendly energy and to generate enough power to keep up industrial momentum. One way out of the power conundrum might be for consumers to start switching off light bulbs or buy fewer computers and smaller television screens, but that is not likely to happen any time soon.

With that context in mind, pity the UK’s Department of Energy and Climate Change, which forecasts that the country’s power demand will double by 2050 and has to find cost-efficient and safe ways to do it. The UK also has an escalating problem; a quarter of the UK generation capacity will need replacing within ten years because it is either too old or too much of a pollutant to comply with current EU emission requirements.

It is not just the UK’s problem. Europe has soaring energy needs as well. As a result both governments and the public in Europe keep bouncing between what they would like to see and what they think they need urgently, and the extreme depends on how far away they are from a crisis. After Chernobyl, Italy held a nuclear power referendum and decided to close all nuclear plants by 1990. In 2008 the decision was reversed in the face of rising demand for energy and a highly vulnerable level of dependence on gas supplies from Russia and Algeria. The country’s plans to revive nuclear power were put on ice once more for at least another 12 months following the Fukushima crisis.

Europe cannot afford a stop-start approach to nuclear power development. No one can. Nuclear power is not a fast industry. It takes at least ten years

I

FTSE GLOBAL MARKETS • JUNE 2011

Photograph © Anna Omelchenko / Dreamstime.com, supplied May 2011.

(and billions of dollars) to build a nuclear plant and in that sort of time frame, the impact of crises necessarily fades away. Although there has been a fairly forceful immediate reaction in some places in Europe, particularly in Germany where the government decided to close seven of its oldest plants, in other countries the reaction has been more muted and plans for construction are still going ahead.

In terms of investment, Peter Atherton, an analyst at Citigroup, says: “Utilities are already one of the worstperforming sectors and this has only reinforced the general negativity towards it.” Shares across the sector dropped in the wake of the Fukushima incident, affecting most of the companies with the largest nuclear exposure, such as Germany’s E.ON and RWE. The former is down 18% over three

months and the latter 20% as several of the plants being closed in Germany are run by them. John Musk, an analyst at Nomura Bank in London, says: “We consider the overall risk to E.ON and RWE to be negative, with increased uncertainty and political risk.” Companies that could benefit instead are fixed-cost generators that will reap higher margins from reduced capacity in the country such as Verbund or Drax.

France’s reaction was much more sanguine to the meltdown in Japan’s reactors. No surprise really given that 75% of the country’s power is generated by nuclear plants and there is no quick way to replace that capacity, says Atherton. Of the 143 nuclear plants currently operating in Europe, 58 are located in France. France has signalled that it would not put the nuclear industry under pressure and publicly president Nicolas Sarkozy has praised the safety of its nuclear technology.

France’s nuclear industry depends hugely on other countries because it not only exports its technology but also runs plants across Europe. Its largest nuclear operator EDF is set to benefit from the scale-back of nuclear power generation in Germany by increasing some of its own production.

Nomura says in a research report: “We estimate that the output gap left by the lost German nuclear plants is 67TWh [terawatt hours] of baseload power over a full year, and in the absence of any constraints, it would be reasonable to assume that EDF would be able to meet a significant part of the shortfall from its own nuclear fleet.”

French company Areva, which designs nuclear reactors, has signed a

27

SECTOR REPORT

EUROPEAN UTILITIES: THE CHALLENGE FACING THE NUCLEAR INDUSTRY

memorandum of understanding with Poland to provide technology for Poland’s first nuclear plant. The agreement was signed a month after Fukushima. Areva’s reactor design, which is expected to be used by EDF to build the first upcoming nuclear plant planned in the UK, is currently undergoing UK safety assessments. Nevertheless, EDF shares fell 11% and Areva’s shares have dropped 22% since February. “The upside is that shares are now cheap,” says Citigroup’s Atherton, and are bound to bounce back.

Nomura’s Musk adds that concerns on long-term nuclear viability are overdone in EDF, and to a lesser extent in Centrica. “New nuclear is not dead, and higher safety costs will ultimately be reflected in pricing via ARENH in France and feed in tariffs in the UK,” according to Musk. Overall, analysts believe that the Central and Western Europe power generation market remains an unattractive one for investment at least until 2014 when current capacity will no longer be able to keep up with demand.

Improved safety measures A long-term effect on the industry will be higher safety requirements for nuclear plants, which will have significant financial implications for utilities planning on building them. “There is one certainty: the cost of nuclear power plants will go up because regulators will require additional safety measures in the future,” says Atherton. He says the new safety regulations will be “bad news” for power utilities and that it will take months before it becomes clear how much it will cost to implement the improved safety requirements.

Because of the potential for a serious environmental disaster to occur in the instance of a meltdown, nuclear plants are built to high safety standards. Each and every nuclear power plant in the European Union (EU) had to undergo an extensive authorisation process before starting to operate. However, since the Fukushima incident the EU has revised its policies and has brought in tougher stress tests aimed at assess-

28

ing whether the safety margins used in the licensing were sufficient to cover unexpected events.

If a nuclear plant was built in a region where there was a risk of earthquakes, operators needed to prove that such a plant could withstand the magnitude of earthquake that, based on past experience, could be expected there. It is the same case for floods and other types of disaster. Now the margins will be increased so that a plant could withstand an earthquake of a magnitude of six on the Richter scale previosuly, it would have to prove that it can withstand a higher magnitude quake, even though the region may never have experienced one of such strength. In addition, power plants will have to prove that they have enough back-up power in place in case the power supply is interrupted.

Dealing with all the safety aspects is a costly issue and the question is how those extra costs will be financed. Also, the question of nuclear waste disposal is integral to any discussion on nuclear power and is an issue which receives little attention. The unpalatable fact is that even once a plant is decommissioned, nuclear waste remains a danger for hundreds of years. The waste has to be stored somewhere and this is typically done in underground caverns or disused mines, for example, which are then hermetically sealed; which is itself a highly expensive process.

At a utilities conference in London before the quake in Japan, chief executives of Europe’s largest power companies were already bemoaning the fact that they are expected to carry most of the financial burden of the UK’s power industry expansion, estimated to cost as much as £200bn over the coming decade, and said that outside investment, such as inflows from infrastructure funds or pension funds, has as good as dried up.

James Riddell, partner for infrastructure at Deloitte & Touche, explains: “Nuclear plants are not a focus for infrastructure funds. They will sooner invest in renewable energy projects because they give you regulated returns and foreseeable cash flows. Unlike nuclear,

green energy is tariff-protected.” The £200bn forecast covers not only nuclear but also renewable energy projects and upgrades to the power transmission and distribution network. Volker Beckers, chief executive of RWE npower, the UK subsidiary of German utility RWE, expects UK power companies “to finance only between 15% and 20% of that £200bn”. He describes the scale of the required investment is like “the American Apollo programme, the London Olympics, Heathrow’s Terminal 5, and the UK’s new High Speed 2 rail link put together”.

Who will meet the cost?

His peer Paul Golby, the chief executive of E.ON UK, is slightly more optimistic and believes that power utilities will cough up 30% of the required figure.

The power industry expects that the government will cover the shortfall but the government is currently somewhat preoccupied with other financial problems and is busy cutting public spending rather than increasing it.

It would be an easy assumption that shares in renewable energy companies would do well after what happened in Japan, but this is not entirely the case.

While shares in solar developers, such as Germany’s Conergy and Q-cells, initially spiked following the Japanese earthquake, both firms have since then lost all of those gains.

The companies that appear to have done well out of the disaster are Iberdrola Renovables and EDF Energies Nouvelles, the clean energy offshoots of large utility companies Iberdrola and EDF, because both parent companies have since decided to buy back the free float of the two offshoots. Iberdrola Renovables is up 18% on three months and EDF Energies Nouvelles up 20%.

Electricity companies are conscious of the fact that they are somewhat losing the publicity war despite providing a service which is fundamental to society. On their list of people to keep happy, shareholders will struggle to keep the top spot, which is why utilities will remain a defensive stock. I

JUNE 2011 • FTSE GLOBAL MARKETS

REAL ESTATE

DUBAI: DEVELOPER TO RESTRUCTURE DEBT

Palm Island in Dubai. Photograph © Mohamed Farhadi / Dreamstime.com, supplied May 2011.

Nakheel promises to stand and deliver Dubai-based developer Nakheel took the first tentative steps to restructure its $10.9bn debt last month as it began to set out the details of deals to pay back corporate lenders and to come to agreements with its trade creditors. With a string of unfinished projects, the tale of Nakheel’s tribulations has come to sum up many of the woes that have beset the United Arab Emirates. Even so, the company is now close to resolving the current impasse and it has plenty to do to rebuild its business, writes Mark Faithfull.

FTER MONTHS OF speculation, Nakheel’s redemptive offer has come in the shape of guarantees of real estate assets equivalent to the value of its loans, the company’s chairman Ali Rashid Lootah told United Arab Emirates (UAE) press in April. His offer to lenders is aimed at boosting their confidence, as Lootah announced that the proposition “stresses the company’s ability and commitment to all of its payments and financial dues under the time frame which both sides have agreed on”.

The Dubai-based developer was buried under a debt mountain when it became a victim of its own grandiose plans and the global recession. Nakheel overstretched itself, building a host of

A

FTSE GLOBAL MARKETS • JUNE 2011

beachfront islands in the shape of palms and the world’s continents and a series of other ambitious projects. The depth of its financial woes came to a head in March last year when it was forced to announce a recapitalisation plan for its spiralling debt and liabilities through the government’s Dubai Financial Support Fund (DFSF), which committed to providing approximately $8bn to Nakheel to fund operations and settle its liabilities. In addition, the DFSF converted $1.2bn debt it was owed by Nakheel into equity.

Subsequently, Nakheel—which is part of state-owned conglomerate Dubai World—has spent much of the past year or so working through those commitments and looking to establish a

sounder financial footing, culminating in this latest round of debt restructuring.

Parent Dubai World itself recently completed a $25bn restructuring with banks.

Nakheel chose to hold separate debt talks with its bank and trade creditors and will eventually be separated from Dubai World to become a full government subsidiary.

In May, details of its proposed resolutions emerged and the developer offered lenders repayment after four and a half years at 4% above the London interbank offered rate (Libor) on part of its debt in a deal biased to favour the banks.

The terms of the restructuring, covering mainly bilateral loans and one $1.85bn syndicated Islamic loan due to mature in 2012, vary from the lender meeting in July last year at which Nakheel indicated that the repayment schedule would be over five to seven years, related to the syndicated loan, signed in 2007, in which 22 banks participated. An agreement sounds as if it is finally close and Nakheel announced in March that it hoped to conclude a restructuring by the end of the second quarter of 2011, with the same terms applying across some of the other facilities under the restructuring.

Local banks are believed to be the major lenders to Nakheel and a large part of the company’s borrowings has been made in the local currency, so a commercial rate of interest favours UAE banks, which lend according to

29

REAL ESTATE

DUBAI: DEVELOPER TO RESTRUCTURE DEBT

the emirate’s interbank lending rate.

The company’s coordinating committee is made up of National Bank of Abu Dhabi, Dubai Islamic Bank and Barclays Capital. An agreement with trade creditors is also thought to be close.

The deal put on the table means creditors are expected to get 60% of the repayment in the form of Islamic bond certificates, known as sukuk, carrying an interest rate of 10%, plus a 40% repayment in cash.

At the end of last year, Nakheel disclosed that 91% of its trade creditors had agreed to the debt deal, but the plan needed 95% approval before it could be implemented, which it is believed to have achieved recently.

Consequently, the restructuring agreements for trade creditors were sent out at the end of March and, under the agreement, creditors must appoint a bank as custodian. Nakheel was expected to start delivering its sukuk certificates by early May and UK-based lender HSBC has also issued a statement confirming that it will waive custody fees for six months for trade creditors who want to take delivery of the “forthcoming” sukuk certificates.

Path to redemption Not that everything has run smoothly.

Nakheel has been in dispute with some of its contractors over contract values and chairman Lootah issued a statement saying that claims made by contractors for the payment of AED8bn ($2.2bn) were highly exaggerated, adding that some of them had agreed to renegotiate claims and payment.

He said: “Autonomous financial advisers appointed by Nakheel to study those claims found that they are highly exaggerated. Many contractors have shown high flexibility in correcting their claims and bringing them down to reasonable levels … we expect to announce a deal to settle these claims this month.”

As for the future, Lootah reflected that for Nakheel, resolving the debts and claims is inevitably the first stage of the company’s path to redemption. The company is also focusing on delivering

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and completing a host of half-finished residential projects and finally increasing the company’s revenue through expanding its sales. Al Nakheel Properties has pledged to complete nine projects, with an investment of around $2.2bn, in a bid to conclude the Al Furjan housing project and Jumeirah Village, Jumeirah Park, Jumeirah Heights, Jumeirah Island and Vento, plus the Badra and Emarati Bersenks schemes across 2011 and 2012. The company has also stopped selling new plots, focusing instead on consolidating and completing its outstanding units.

Nakheel says that it had chosen to resume work on those projects where customers had made large payments or which were well under way, which means that longer-term projects, including Palm Jebel Ali, the Waterfront and The World Islands, are on the backburner. However, despite Nakheel’s claims of good progress on many of these projects, the local Dubai media features online complaints from people claiming their houses are still not ready or alleging Nakheel has failed to return their downpayments for projects stuck on hold.

Indeed, Nakheel is not alone. The number of real estate developments in Dubai facing cancellation this year has risen from 300 to 500, with a collective value of $272m, according to the emirate’s property watchdog. The projects and their backers are being assessed

by Dubai’s Real Estate Regulatory Agency (RERA) for financial viability and consultancy Jones Lang LaSalle (JLL) estimates that the supply of new units in Dubai in 2011 is likely to drop 31% from 2010 figures, with some 25,000 residential units expected to be released onto the Dubai property market. Meanwhile, new retail space will reach 140,000 sqm, down 31.7% on the previous year. Some 3,400 new hotel rooms will also become available, around 55% less than the 7,700 delivered in 2010.

At the same time, residential rents in some of Dubai’s most popular areas have fallen by around 30% in the past year, according to RERA, which in its

latest report confirmed that apartment rents in Palm Jumeirah and Discovery Gardens (both Nakheel developments) plus Dubai Marina and Jumeirah Beach residences had all seen significant declines since May 2010. Moreover, these drops look set to continue for a while, with Nakheel chief executive officer Chris O’Donnell predicting at the end of 2010 that the process could take as long as five years.

Craig Plumb, head of research at JLL MENA, reflects: “In the residential market there is an increasing amount of new supply entering the market, and while that’s a good thing for tenants and is pushing down rents, you’re probably looking at 20% to 25% of the residential supply being vacant at the moment.You would expect the residential oversupply to be absorbed over the medium term, between two to three years. It won’t be absorbed over the next six months, but it won’t sit there vacant forever.”

Project cancellations There are, however, some slivers of good news for Nakheel, as RERA increasingly gets tougher in order to restrain new projects across the emirate. A total of 220 projects are going ahead this year but RERA is still mulling fresh project cancellations in a bid to control supply, and any deemed economically unfeasible will face termination between now and 2016.

Real estate prices are still more than 60% off their peak and about half of the residential real estate projects in Dubai were cancelled or suspended after the market collapse. However, Dubai property transactions did increase by 20% in the first quarter of 2011, compared with the same period a year earlier, accounting for 10,552 transactions with a collective value of $8.8bn.

Just like the emirate in which it resides, Nakheel now needs to lick its wounds, repair broken bridges with its lending institutions and start the long and painful process of rebuilding its business with a lower debt burden in the hope that Dubai’s fortunes can rise again from the Gulf sand. I

JUNE 2011 • FTSE GLOBAL MARKETS

COVER STORY

FINANSBANK: REDEFINING RETAIL SERVICES IN A DYNAMIC MARKET

Omer Aras, chairman and group chief executive, Finansbank. Photograph kindly supplied by Finansbank, May 2011.

The keen measure of expectation Established in 1987 by Hüsnü Özyeğin and Dr Omer Aras, Finansbank came into being when Turkey was on the cusp of its latter-day transition to an emerging high-growth economy.

Finansbank has been a bellwether of the changes that have seared through the country’s financial markets ever since.

Although it stands a discrete player in the Turkish market, it has risen to rank within the country’s top five leading domestic banks. Finansbank has rarely stood still and has never been afraid to redefine its business remit to suit ever-changing market conditions. The bank has “great expectations” says Aras, now its chairman and group chief executive, and marries its bullish approach to business growth with a keen analytical eye; particularly in an era where the range of services a bank might offer is being totally redrawn. Francesca Carnevale spoke to Aras about its future plans.

ATIONAL BANK OF Greece (NBG), the country’s largest lender by assets, must be thanking its stars for its prescience in acquiring Finansbank in neighbouring Turkey back in 2006. While rightly NBG celebrates an uptick in 2011 first-quarter (Q1) profits of €157m, an increase of 39% on the year, it owes its performance in large part due to Finansbank, whose own Q1 profits of €151m rolled into NBG’s accounts. Since its launch in 1987, Finansbank has always punched above

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FTSE GLOBAL MARKETS • JUNE 2011

its weight in the Turkish market.

Launched at a seminal period in Turkey’s financial history, the bank was designed fill a gnawing gap in the wholesale banking market; which at the time was largely filled by foreign banks.“We began as a greenfield project and we assumed the mantle of corporate banking very readily. It was very much a lowcost/high-volume operation and we moved quickly into profit,” reminisces Omer Aras, Finansbank chairman and group chief executive.

The bank came into its own however in 1994 at a time of looming financial crisis in Turkey. Then premier Tansu Ciller moved quickly to spur the shutdown of several local banks, though Finansbank survived unscathed.“Although we were profitable, we had no deposits and the crisis highlighted that vulnerability,” notes Aras. “Notwithstanding the somewhat difficult market, we decided to move into the retail banking segment.”

Because of its wholesale banking credentials, the bank already had a strong name among the country’s high net worth community. Moreover, founding director Hüsnü Özyegin in particular knew the retail segment well, having for some years run Pamukbank, one of the country’s largest retail banks in the 1980s. For his part, Aras had honed his corporate banking and capital markets skills at both Citibank and Yapi Kredi and knew many of the leading industrial family groups in the country extremely well. “It gave us the opportunity to move into the retail segment selectively, focusing on high net worth individuals,” says Aras.

The subsequent banking crisis in 2001 saw Finansbank going into retail in a more concerted fashion. “Because of our conservative risk-management policies, we faced the crisis from a strong position and we started to look at establishing a substantial branch network,”he adds. By 2004, foreign banks began returning to the Turkish market in force, often

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COVER STORY

FINANSBANK: REDEFINING RETAIL SERVICES IN A DYNAMIC MARKET

through strategic purchases in domestic banks. “We started the bank with $5m initial capital and just less than 20 years later sold a controlling share to NBG for some $5.5bn. It was interesting for us and for the market because it was the largest investment ever made by a Greek institution in the country.”

In the event, NBG turned out to be a pragmatic owner: “I like to think it realised it had bought some good management along with the bank’s assets,” says Aras, who explains that the relationship is close yet disciplined. “They have input into risk management, audit control and financial controls. All other operations have been left entirely in the hands of local management. In fact there are only two expats working in the bank: one in risk, one in audit. It’s distantly managed and we do not rely on NBG for funding and this is a key differentiator between ourselves and other Turkish banks which have foreign shareholders,”explains Aras.

That relatively high level of independence was underscored recently as the bank began to talk of raising funds on the local stock exchange. Finansbank had been planning to come to market with a secondary public offering some time in the early spring of this year, acknowledges Aras. Some 20% of the bank’s shares were expected to be sold on the Istanbul Stock Exchange, and 50% of the revenues generated were expected to be added to the capital of the bank. However, since January, the stock market has increasingly decoupled from the country’s otherwise strong growth story. Banking shares have fallen 9.3% this year as the central bank has raised required reserve ratios to curb loan growth, which is up 35% year on year, according to official data.

Turkish stocks have also been affected by continued unrest in North Africa and the Middle East. Inevitably, the bank had to rethink its plans. “The Turkish stock market is down somewhat this year and our main shareholder did not want to do an offering at a discount,” acknowledges Aras. “We would like to complete the deal when the market

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Omer Aras, chairman and group chief executive, Finansbank. Photographs kindly supplied by Finansbank, May 2011.

level is back or better than it was in the fourth quarter of 2010.”

Although Aras maintains that corporate and trade financing remain strong in the genetic make-up of the bank, it sees additional opportunities in the retail and small and medium-sized enterprise (SME) segments, which Aras believes is a paradigm of the second stage of a high-growth economy. “When inflation began falling in the post-2002 period, naturally we saw a substantial uptick in the medium-term lending volumes; this meant substantial opportunities for us in mortgage lending, project finance—both in terms of real estate development and tourism—and it has to be acknowledged that trade finance remains a substantial portion of our business. Nonetheless, the retail banking segment has grown so much faster and we have built and continue to build out our mortgage, credit card and consumer lending business.”

There is still room for growth as the system “is still under-banked,” he says, pointing to internet and telephone banking as distribution outlets that continue to show particular promise. “I think you can look out on this market for at least another five to six years before you begin to see some maturity in terms of retail and where we will have to focus on new client building strategies. Right now, there is still a lot to play for.”

Aras maintains that the bank’s ability to punch above its weight rests on its tight focus on analytics. “We undertake extensive research on our hoped for and existing clients. It helps in both building out our sales and product development strategies, as well as ensuring that we keep collections at an optimum level. It is vital for a bank such as ours to know who is more likely to borrow what and pay us back,” he explains, adding that

Finansbank’s retail business has been built on score-card development, targeted marketing and efficient debt collection. In that regard, he notes,“corporate finance is so much easier”.

The family finance business is now the fastest growing portion of the Turkish retail segment, “a further sign of the growing maturity and sophistication of the market”. He adds: “Although family financing requirements span a wide variety of financing needs, such as housing, school fees, insurance and credit cards, for example, it calls for a strict and highly-focused sales approach.

Cross-selling is such a nice word, but essentially it is all about time-sensitive sales.You have to sell the right bundle of products at exactly the right time: you know the obvious one is mortgage finance and insurance. But this timely bundling is actually fundamental to our business approach.

“Our hope is now to build our investment advisory services on the back of a substantial and growing affluent demographic segment,” says Aras.

“We think this will give us increased stickiness with our customers, who we think we know well. Basic to this strategy is understanding the individual risk appetite of each of our clients, based on the level of deposits or savings, stock or gold that they hold.”

Aras thinks that Turkey is now on the cusp of a new era in banking services.

Historically, the country’s banking sector (contrary to popular belief) has always been extremely innovative and technologically advanced. It was one of the first countries to offer retail share trading through special facilities in bank branches. It was also a leader in telephone banking. However, Aras thinks that banks will become increasingly

JUNE 2011 • FTSE GLOBAL MARKETS

interpolated into everyday life, offering solutions for day-to-day problems and offer an ever-growing range of secondary services; all in the hope of increasing bank sophistication and creating customer stickiness.

Actually, Aras firmly believes that customer stickiness and product sophistication go hand-in-hand. “In Turkey every man on the street understands the value of money. Having lived in a high-interest rate and highinflation environment, individuals have honed their abilities to seek out good banking deals and as a consequence they tend to move frequently between banks. That in turn has put the onus on banks to offer very fast and sometimes very complex service packages. For instance, if customers put money with us for a month, they can enjoy seamless and intraday transfers of funds from one bank to another, with no compromise of the value of monies transferred.

Equally we provide a 24-hour emergency hotline to qualified customers, where we source emergency plumbers or electricians for instance; even going as far as providing dry cleaning services,” he explains.

“At the end of the day consumers have predictable, or let’s say, certain needs in a modern world and so we play to those requirements. We know that on average people have 2.5 credit cards in their wallets; so how to ensure that they use our card and not someone else’s? We had a very successful campaign where we gave customers who used our credit card for a defined percentage of their total spending a free cellular phone, as long as they kept their account with us for 12 months. It created demand for phones, demand for our cards and stickiness for 12 months. Key to winning that

FTSE GLOBAL MARKETS • JUNE 2011

business was our analytics, where we could discern trends and play to them.”

Inevitably then, the main challenge for executives such as Aras in a highcompetitive and fast-growing market is to create the sort of stickiness that lasts a lifetime. That invariably means getting customers when they are young and creating both brand awareness and brand loyalty. “Naturally we aim to become everyone’s first, or at least second choice of bank; though of course that would depend on the customer meeting our own requirements in terms of creditworthiness,”he says.

Aras says that going forward, it is imperative to keep developing the relationship across a number of distribution channels and communicating with various demographic segments through appropriate cultural channels. “That invariably involves social networking as well as the usual internet-based services. It is an important challenge for us to find innovative ways to access new clients,”says Aras.

As with other Turkish banks this year, Finansbank has been testing the waters as to what is possible in terms of capital raising: lifting either tenors or pricing.

Garanti Bank set a new ten-year benchmark with its $500m Eurobond in April, which was priced at 6.375%. For its part, Finansbank placed a $500m, five-year note on in early May, becoming the fifth Turkish bank to tap the Eurobond market for financing this year. The note was priced at 99.384 with a 5.5% coupon, or a spread of 355bps over midswaps. Market watchers say that the bank was disappointed not to have raised more money, but Aras remains sanguine. “We were pleased with the pricing the bank received and we maintain the facility was priced exactly on the

merits of Finansbank, rather than the market, or other factors. Frankly, I think you always pay something of a premium on a deal of this kind if it is the first you have done over this tenor. We were pleased with it.”

It was unlikely the market was going to penalise Finansbank for the difficulties its parent NBG was going through.

Most recently, on May 23rd, 2011, Fitch Ratings affirmed Finansbank’s ratings, including its long-term issuer default rating (IDR) at BBB- with stable outlook, despite the downgrading of NBG on May 20th to B+ with negative outlook.

Fitch acknowledged that Finansbank is exposed to low contagion risk given it has no direct financial exposure to NBG, or generally to Greece and that it is not dependent on funding from NBG which has only provided subordinated debt to support Finansbank’s growth.

Furthermore, Fitch expected that the Turkish regulator, the Banking Regulation and Supervision Agency (BRSA), would be unlikely to authorise significant transfers of capital or liquidity from Finansbank to NBG in the future, and would seek to ensure that Finansbank is ring-fenced from any problems at NBG. Fitch also believes that NBG has a strong interest in protecting the value of its Turkish subsidiary.

Aras says he looks to the future with “great expectations. We’re not the kind of bank to compare and contrast ourselves with others: we run our own course”. He adds: “What is important for us is to correctly read market dynamics and to react accordingly.

We’re well capitalised and armed with a very cautious approach to credit: our challenge is to leverage the tools at our disposal to gain new clients and, hopefully, market share in the process.”I

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COUNTRY REPORT

TURKEY BANKING: GROWTH, BUT IS IT THE RIGHT KIND?

Analysts burst Turkey’s banking bubble According to the latest RNCOSA research report on Turkey’s banking sector, banking assets are forecast to grow at a CAGR of some 10% between 2011 and 2014. Armed with an increasingly robust infrastructure, risk management and internal audit systems, the country’s financial system survived the financial crisis with barely the requirement of a backward glance. Turkey’s banks have always played a pivotal role in the country’s economic fortunes and deepening of its capital markets. What now for the sector as it comes to terms with some negative views from foreign commentators as to the sustainability of the current bull run in banking fortunes?

T THE END of May, telecommunications giant Turkcell, launched a co-branded prepaid card called Cep-T Paracard, together with Garanti Bank. The CepT Para service is a SIM based secure service that can be used with any handset to make payments anywhere in the world where Mastercard is accepted. Subscribers can transfer money to any operator’s mobile subscribers and withdraw their money instantly from Garanti ATMs by simply using a secure code sent to them, without a debit card.

It seems that Turkish mobile phone operators have found that by collaborating with banks, they can capitalise on NFC interactive technology. The venture is expected to process over TRY500m (around $0.55bn) in transactions over the next three years.

Speaking at a live press conference in Istanbul in early June, Garanti Bank’s general manager Ergun Özen noted that future expansion of the domestic banking system was dependent on the integration of mobile telephony and bank payment systems. The move points to a new era in Turkish banking, which integrates banking services with increased individual mobility and new communications technology/social networking. The move also reflected a

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growing confidence among Turkish banks, which have enjoyed continued business growth, particularly in consumer finance and retail banking, moretimes setting an agenda of product innovation that exceeds service levels in many advanced markets.

The venture contributed to a sentiment through spring that overall, Turkish banks were doing rather well.

Vakifbank typifies the trend. Birgül Denli, Vakifbank’s Executive Vice President, international banking, investor relations and structured finance explains: “There is still a lot of upward potential in terms of lending, especially in the key retail segments. In mortgage loans, our share in the banking system has increased from 9% to 10.3% in a rising market; residential mortgage lending volume is up 56% year on year and 12.3% in the first quarter of the year. General purpose consumer loans have risen 63.7% over the year and up by 10% quarter on quarter. It does of course bring its own challenges.”

Just how challenging became apparent in May: as the month opened, Citigroup announced it had downgraded four Turkish banks. The ISE National 100 index took the brunt of the decision, falling close to 1.63% lower over the day; though the index steadily rose through the month. Citigroup

downgraded Garanti, Halkbank, Isbank and Bank Asya to “hold”, while cutting price estimates for Halkbank, Isbank, Vakifbank and Yapi Kredi. The decision reverberated across local banking index .XBANK, which makes up 40% of the capitalisation of the ISE, and which fell 1.91% on the news.

To add to the pain, Turkish banks (including Garanti) began to report declines in first quarter profits as margins fell due to higher required reserve requirements issued by the central bank late last year. At month end Goldman Sachs followed Citigroup’s suit, lowering the price estimates of all six banks it covers in Turkey, citing weaker earnings and possible unexpected changes in monetary policy. In the event, the benchmark National 100 index fell on the day of the announcement by a manageable 0.2%, extending the overall fall on the index to 4.7% over the year to date; the effect of the announcement having been muted by Citigroup’s pronouncement early month.

Fall off in top line growth Top line growth at the banks is expected to decelerate through the remainder of 2011 thinks Goldman’s latest report, with banks negatively affected by possible unexpected changes in monetary policy given the country’s current account deficit. While the report was considered generally positive for bonds, the fall off in the Istanbul Stock Exchange was seen by some commentators as an indicator that the economy is losing momentum.

In fact, the segment has been unable to decouple from some of the less attractive economic indicators which have marred an otherwise burgeoning period for the sector. Turkish banking stocks have fallen by almost 10% so far this year, and elsewhere the Turkish lira (TRY) has also endured something of a battering in the first half, falling 3.7% against the dollar year to date, as the central bank intervened to reduce the lira’s carry appeal. Moreover, the government’s continued inability to cap

JUNE 2011 • FTSE GLOBAL MARKETS

COUNTRY REPORT

TURKEY BANKING: GROWTH, BUT IS IT THE RIGHT KIND?

and reduce the current account deficit (now around 7% of GDP and fed by less stable portfolio inflows and shortterm bank borrowing) continues to exacerbate the problem.

Goldman Sachs has also articulated its fears over general weakening in asset quality as banks rapidly expand their consumer lending businesses.

Annual loan growth is exceeding 35% right now compared with a central bank target of 25%, according to official central bank figures released at the end of the first quarter this year, accelerating way beyond the central bank’s own targets for the sector.

However Vakifbank’s Denli says the banks are suffering from a two-fold problem:“a mismatch in the maturities of deposits and loans. Banks are having to deal with customers putting money on deposit for less than three months and second, the cost of local funds is too high. In part it is encouraging banks to turn to the Eurobond markets where the cost of finance is falling and tenors are rising.”

Gloom is overblown According to SenizYarcan, senior executive vice president, treasury, investment banking and international relations at the Industrial Development Bank of Turkey (TSKB), some of the issues are perhaps over-blown. “For instance, the public sector borrowing requirement (PSBR) stands as one of the best in Europe and it has fallen sharply over the last three to four years,”she avers.

Indirect investment inflows have been impacted by recent events.“Institutional investors have been sensitive to market conditions for some time now. The share of foreign participation in the ISE was 68% of the total market only five months ago; it is now somewhere in the region of 63%. In these conditions, it has been difficult for the ISE to perform well. Even so, we must remember that over the last three years the market has been one of the best performers in the emerging market segment. A correction was inevitable. Similarly, adjustments in the banking segment to take account of new

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conditions are inevitable also,” she says.

Equally, the Turkish banking segment is coming to terms with a broadening offering as foreign banks re-enter the country in force and the range of bank’s competing for business is on the rise once more. By the end of 2010, of the 32 licensed deposit taking entities in the country, three were public banks, 11 private banks, and 17 foreign banks.

In addition, there exists a special insurance fund that accepts savings deposits.

The market also holds some 13 development and investment banks and four participation banks (these latter Islamic banks used to be called ‘special finance houses’, but their status was changed by the 2005 banking law). “There is still some way to go for the market to be truly diversified,” however, notes Yavuz Yetter, investment banking and treasury product development group manager at Kuveyt Turk, one of Turkey’s four participation banks and a subsidiary of Kuwait Finance House, the market holds increasing promise.“Compared to say a country such as Malaysia, offerings such as ours remain restricted and limited in Turkey. Even so, the total market share of participation banks such as ours is worth around 6% of the whole industry and we note that retail clients in particular are very sensitive to the evolution and diversity within the local market and harness it to good effect. They are still looking for competitive services. However, we are all aware that we need to deepen and widen the market’s service set,”he adds.

Equally, banks will have to continue with internal efficiency drives. Cost control is uneven throughout the sector, with the remaining public sector banks retaining too much bureaucracy.

Moreover, many sales management practices, contrary to executive pronouncements often stress volume over profitability, with an inevitable knock on effect on asset quality. According to a McKinsey report on the Turkish banking sector published in May, even the best-managed institutions tend to set volume targets for their branch networks instead of defining sales targets by profitability and market potential.

“Even in the strongest banks, good performance management often owes more to conscientious CEOs than to institutional capabilities. Given the decline of trading income and the narrowing of profit margins, banks need to make their business performance more transparent by calculating the cost of funds properly and by correctly allocating costs to products and customers.

Only then can banks create meaningful performance targets and effective incentive systems for employees,” says the report.

Election year As always in Turkey, there is a political element in play. It is election year. Turkey holds parliamentary elections on June 12th and another strong showing for the Islamic AKP is likely. If there is a wildcard, it is in the margin of its expected victory. The latest polls seem to indicate that it will come in on or near to its 2007 election performance, winning some 341 out of 550 parliamentary seats. It is a fine balance this time around, as a strong showing (say 370 seats) would encourage the party to introduce far-reaching constitutional changes without worrying too much about internal secular opposition. Any number significantly lower than that (say in the region of 320 to 330 seats) and the AKP will have to go to the country via a referendum to secure any significant constitutional changes.

Although the country’s administration is regarded as financially prudent, generally efficient and market friendly, a too-strong showing in the elections might just ignite internal tensions between supporters of constitutional reform and those in favour of retaining the country’s secular credentials, thereby tippling external perceptions of the country one way or another.

The question now is whether the banking segment can weather this short term challenge. Barring the raising of further reserve requirements in the immediate post election period, the banking sector seems prepared to make necessary amendments to get back on track. I

JUNE 2011 • FTSE GLOBAL MARKETS

COUNTRY REPORT

TURKEY: INWARD INVESTMENT TRENDS

Inward investment flows into Turkey are firming up; data from the Turkish treasury suggests that longer term investment is beginning to replace short term speculative flows. Foreign direct investment (FDI) inflows into Turkey jumped to $2.8bn in March, up substantively from the inflows worth $525m in March last year. While FDI inflows, worth $3.953bn in the first quarter (Q1) 2011 were up 254% over the same period in 2010. Moreover, there are signs that the domestic debt markets might be beginning to take off.

Investment takes a firm turn HE TURKISH CENTRAL Bank implemented an experimental policy by cutting benchmark rates and raising reserve requirements for banks as 2010 came to a close. Signs are that the government is getting serious about encouraging long term capital inflows into Turkey. According to Mehmet Sağiroğlu, chief executive officer at IEG-Global in Istanbul.“Significant for the markets right now is the new commercial code, which is also set to be particularly beneficial for foreign investors by saving them from double taxation. The new code is the most extensive reform within the government’s efforts to harmonise Turkey with the EU by securing compliance of trade law with the EU. Once the bill becomes a law, foreign investors will feel more secure as foreign investors prefer to be involved in a system that complies with the laws of their own country. I think the law will alter the foreign outlook towards Turkey, though I still have worries about the impact of this growing current account deficit and how the external world sees Turkey in this regard.”

The move is significant for Turkey, given that foreign investment inflows have tended to flow through the national stock exchange (foreign institutional funds are reckoned to account for over 63% of the Istanbul Stock Exchange) and flow directly out again, depending on market conditions. Creating stable pools of investment capital is fundamental to establishing the

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Seniz Yarcan, senior executive vice president of treasury, investment banking and international relations at TSKB. “Since there is still no requirement for independent ratings of locally issued bonds, it can be difficult for investors to analyse credit risk.

That has created a particular market where banks act as market makers for their own bonds,” she says. Photograph kindly supplied

by TSKB, May 2011.

country (in this instance, read Istanbul) as a long term viable financial centre. According to Ertunc Gurson, head of sales at TEB Securities Services, a joint venture with BNP Paribas which provides securities services to international investment firms active in the country. “Developments such as the new trade law and continuing liberalisation of the Turkish financial markets feed into a broadening of sources of

investment funds flowing into the country. We are increasingly seeing funds coming in not only from our traditional markets of the EU and the US, but also now investment inflows from China, Singapore, Japan and South Korea,” he says.

Sağiroğlu sees significant growth potential across three main segments: debt capital markets (DCM), equity capital markets (ECM) and M&A, which play both to the country’s growth story and which provide opportunity for foreign investors to enter the market. For its part, the recently established 50-50 German/Turkish IEG-Global joint venture, hopes to capitalise on these trends offering M&A, advisory and services in financial strategy, with a particular focus on the growth companies in the SME segment. The revitalisation of the country’s stop-start privatisation programme should constitute a substantial element of the spur to the country’s M&A and capital markets’ segments.

“Two years ago, these markets were dominated by local investors interested in opportunities to build market share through participation in the privatisation sell offs. Now I think it is the right time for foreign investors to take a new look at the market, which could be worth as much as $20bn per annum over the medium term.”

Sağiroğlu points to existing projects in the transportation segment; particularly around Istanbul’s port, as well as new opportunities emerging in health care, consumer focused industries and electrical distribution, either through private sales or official auctions. “The range is quite varied and includes firms such as Milipiango, the national lottery franchise which is also up for privatisation.”

Any number of privatisation projects is in train; including the road trans-

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COUNTRY REPORT

TURKEY: INWARD INVESTMENT TRENDS

portation projects and some toll bridges. Moreover, gas distribution projects serving key cities, such as Istanbul and Ankara are also on the bloc. A possible highlight of 2012 could be the sell-off of a portion of Turkish Airlines, though the precise structure this sale might take is not yet clear.

Certainly, holds Sağiroğlu, opportunities also abound in the private sector where: “local family firms are increasingly ready to accept foreign partners.

There is a growing realisation that if these family entities do not expand their shareholding to include foreign partners and import expertise, some of them will eventually wind down and disappear.”

Even so, he acknowledges that the development of an active local debt market will be integral to the sustainability of the country’s M&A market. It will not be achieved overnight. Traditionally, it has been difficult to establish a deep domestic capital market. For some years, high levels of government borrowing in the domestic market tended to crowd out domestic private sector bond issuance. However, Seniz Yarcan, senior executive vice president of treasury, investment banking and international relations at TSKB, says that as government spending is reined in, it should open up the domestic market to private firms seeking capital.

Yarcan thinks that local banks have an important role to play in deepening the local market and educating institutional investors. “Since there is still no requirement for independent ratings of locally issued bonds, it can be difficult for investors to analyse credit risk. That has created a particular market where banks act as market makers for their own bonds. Even so, volume is increasing.

Through 2010 we had TRY3m in domestic private sector bonds issued; and in the first quarter of this year, the volume was exactly the same, so that is a positive trend. More banks are entering the market, issuing bonds and they are now helping to create a secondary trading market in the securities,” she says.

In this regard, Gurson sees enormous potential from the establishment of new

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Ertunc Gurson, head of sales at TEB Securities Services, a joint venture with BNP Paribas. “We are increasingly seeing funds coming in not only from our traditional markets of the EU and the US, but also now investment inflows from China, Singapore, Japan and South Korea,” he says. Photograph kindly supplied by TEB Securities Services, May 2011.

Mehmet Sagiroglu, CEO at IEG-Global in Istanbul. “Local family firms are increasingly ready to accept foreign partners. There is a growing realisation that if these family entities do not expand their shareholding to include foreign partners and import expertise, some of them will eventually wind down and disappear,” he says. Photograph kindly supplied

by IEG-Global, May 2011.

institutions in the country that encourage risk management and points to plans by derivatives trading platform TurkDex to offer single stock futures on the ISE National 100 index as an example of a move in the right direction.

“If the market can offer a range of investible product, it will deepen the pools of money available for investment as investors need not move money out of the country to manage their exposure to risk,” says Gurson.

TSKB’s Yarcans thinks the markets should not expect a huge flow of fund raising deals, either in the debt or equity markets.“We will see some PPP transactions close, particularly those with international bank participation, and energy is a sector that is always highlighted in this market: it is natural given our large import requirement in this segment. There will, however, be some loosening after the elections,” she says.

Yarcans also thinks that FDI will likely coalesce around the country’s key growth sectors, which include energy, real estate, logistics, infrastructure, health, education and the textile sector, “which is actually recovering quite well.

However, health and education will need quite hefty levels of investment.”

She also points to the jitters that have beset the country’s stock market this year, which has caused a number of high profile offerings to be postponed. TSKB itself closed three IPOs last year, accounting for around one third of the total volume of offerings for the year.

“The markets were anticipating a robust $10bn IPO calendar to be posted this year. However, many offerings have been postponed, some to the latter part of the year, others perhaps next year.

Some quite high profile transactions have been withdrawn because of testing global market conditions. The participation of foreign investors is paramount to the success of any offering and so conditions have to be right.”

Key to sustaining both the ECM and DCM markets in Turkey holds Gurson is a substantial local fund industry which can mobilise significant levels of investment in the domestic market. However, he acknowledges that this is still some way away. The domestic fund industry accounts for a relatively modest 3% of GDP, he says. “Until we develop big aggregations of domestic assets the market will remain dependent on foreign investment inflows,”he says. I

JUNE 2011 • FTSE GLOBAL MARKETS

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You will hear a proud voice on the line, ready to lead you all the way.

FACE TO FACE

AKBANK: A RISING INTERNATIONAL PROFILE

Over the first quarter this year Akbank recorded a 9.2% increase in total loans and increased its market share by 30bps.

General purpose lending rose 9.5%, while mortgate lending increased 8.1% and consumer lending rose 8.8%, while SME and corporate loans were up 10.7%. Akbank will continue to focus on high-yielding areas such as SME loans and consumer loans as well as concentrating on growth in product areas with high cross-sell ratios, such as mortgage loans and corporate loans. The bank’s relatively low loan to deposit ratio (89.6%) and strong capital adequacy (18.4%) will be supportive of growth, says Akbank deputy chief executive officer Hakan Binbaşgil, who outlines the bank’s growth dynamics.

Leveraging CRM & the wider region TSE Global Markets (FTSE GM): Could you kindly outline in brief the growth strategy of Akbank this year; outlining which business sectors are key for the bank in 2011?

Hakan Binba şgil (HB): In a low interest-rate environment, return on equity (ROE) will be lower in the Turkish banking sector due to the shrinkage in overall net interest margin (NIM), lower trading gains and the higher cost of risk. Investing in high-yielding areas, and concentrating on asset quality, operational efficiency, commission income growth and customer acquisition mark our strategic priorities this year.

New regulatory changes regarding reserve requirements bring challenges to banks in terms of cost and have other consequences, based on a bank’s asset-liability structures. Akbank seems privileged in this regard. The bank enjoys a high level of free capital, a low loan-to-deposit ratio and significant volume in its securities portfolio, which gives the bank substantial liquidity and the flexibility to invest in loans without the negative effects of increased reserve requirements. Because higher commodity prices could impact inflation, Akbank has ensured that approxi-

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mately 30% of its securities portfolio is invested in consumer price indexlinked (CPI-linked) securities which have a real coupon of around 5%, which provides us with a real hedge against inflation. Additionally we are trying to mitigate the pressure on NIM by shifting our asset mix from securities to loans. Additionally, we will continue to focus on high-yielding areas such as SME loans and consumer loans and increase our market share in product areas with high cross-sell ratios, such as mortgage loans and corporate loans.

Overall, asset quality and cost efficiency will be more important in 2011 and beyond. Akbank’s risk management capability, and the efficient way that we manage costs, are among our main competitive advantages. Moreover, we closely monitor new market trends, new technologies and changes in customers’ needs and expectations.

We continue to cater to the financial requirements of our customers by launching easy-to-use, innovative and modern products that help enhance their quality of life. Last but not least, developing new investment opportunities and helping in the establishment of trade relationships for Turkish companies and investors is also a key target for us.

Hakan Binbasgil, Akbank deputy chief executive officer.

Photograph kindly supplied by Akbank, May 2011.

FTSE GM: Which is the bank’s fastest growing business and why?

HB: Akbank plans to achieve 15% growth in commission income through its enhanced cross-selling capability.

Additionally, we are concentrating on asset management, bancassurance, cash management, consumer and credit card products. We have a sizeable branch and distribution network across Turkey. We have also been positioning ourselves as the “Innovative Power of Turkey” in our marketing campaigns. In addition, Akbank boasts a state-of-the-art CRM capability which provides invaluable support in our drive for customer acquisition and cross-selling opportunities.

FTSE GM: Akbank is renowned for the quality of its international borrowing programme. What are the salient elements of the 2011/2012 borrowing programme? What types of issues will the bank favour?

HB: We expect our international borrowing activities to centre around syndicated loan facilities and our existing future-flow securitisation programme. Potential wholesale funding activities this year will include Eurobond issuance and purpose loans from multilateral agencies. Syndicated loan facilities have been an important element of our international borrow-

JUNE 2011 • FTSE GLOBAL MARKETS

ing activity. We are proud of our strong global correspondent bank network and our leadership in the Turkish syndicated loan market. We raised $1.3bn on March 23rd this year, replacing our March 2010 deal. In addition we will tap the syndicated loan market in August to renew an existing one-year facility signed a year ago.

Also in March we successfully completed a benchmark transaction, with our seven-year $500m Eurobond offering, which is the first seven-year issue by a Turkish private sector company.

The issue generated substantial demand from a large number of investors across a wide spectrum of countries. Having had two successful benchmark deals this year and a warm investor response to these issues, we believe that the Eurobond market will continue to be an important source of long-term borrowings for Akbank.

The bank has also successfully built on its diversified payment rights securitisation programme, which it began in 1999, with total issuance amounting to $4.7bn over 11 years. Akbank enjoys close cooperation not only with commercial investors but also with multilateral institutions including the EIB and IFC. Our securitisation programme is an important element of our international wholesale funding activity and we may raise additional funding through the programme in 2011 and 2012.

Going forward, Akbank will continue to tap the “for purpose” multilateral funding pool on behalf of its clients.

Our prolific collaboration with highly reputable names including the EIB, IFC, EBRD and KfW, will play a major role in our international borrowing activities through this year and next.

FTSE GM: What are the key opportunities the bank sees in overseas markets in 2011/2012?

HB: While our main focus remains on the domestic market, we recognise that Turkey holds a key geopolitical location at the centre of the MENA regional market, which is expected to generate a combined GDP worth $26trn by 2015. Our country enjoys a leading role

FTSE GLOBAL MARKETS • JUNE 2011

in the region, and we think that role can be further enhanced thanks to Turkey’s growing economic strength, know-how, well established and well regulated economy and its robust financial sector. The increasing clout of Iraq in the Middle East, and the emergence of the Turkic Republics, including Kazakhstan, Turkmenistan and Azerbaijan as important energy suppliers, coupled with Russia’s potential accession to the World Trade Organisation this year, further enhances the potential of the entire region. We have a flexible Turkish business segment with expertise in crisis management and foreign operations/contracts. Our entrepreneurs have the ability to adapt to changing business landscape fast.

Turkey has also proven to be a leading provider of construction services in countries such as Russia and its near eastern neighbours in particular. Additionally, Turkey is increasingly utilising its expertise in developing the infrastructure in the wider region, which encompasses the Middle East. Turkish companies are used to operating in international environments and therefore they can easily help with the transfer of western technology and know-how to these countries.

It is clear that significant projects in areas such as infrastructure, energy and project finance will be undertaken in Africa, the CIS, and the Middle East in the forthcoming period. Moreover, as part of the Euro-Mediterranean partnership, there are plans to launch an investment and development bank, on the lines of the EBRD, that will specifically service Mediterranean countries, such as Tunisia, Algeria, and Morocco, and helping to finance long-term investments in the region.

Regarding opportunities outside Turkey, Akbank has been active in overseas operations. We conduct overseas operations through our subsidiaries in the Netherlands (Akbank NV), Germany (Akbank AG) and Dubai (Akbank Dubai Limited), along with a branch in Malta. We opened a representative office at the Dubai

International Financial Centre (DIFC) back in December 2009 and were the first Turkish bank to set up a representative office at the DIFC. We carry out the operations of our Dubai office under the “Akbank (Dubai) Ltd” commercial moniker.

Our Dubai arm has focused on further improving investment and strategic partnership opportunities in the region, with a particular focus on markets with significant growth prospects. Akbank Dubai Ltd acts as a catalyst in the development of enhanced economic cooperation and dialogue between Turkish companies and investors in the Gulf states. It serves both the needs of our clients in the region and in Turkey. We also act as a bridge between the funds in the Gulf region and Turkey, encouraging these funds to invest in the Turkish economy.

Our International Business Development Division continues its operations to enhance trade relations with other emerging markets, including Russia, the Turkic republics and North Africa, which are, in fact, some of our key markets.

FTSE GM: What do you think are the characteristics of a successful business strategy in these changing times?

HB: Internally, we have managed the global crisis successfully as a result of our robust banking sector, fiscal discipline and low leveraged yet growth-oriented market, and emerged stronger from the crisis. Our stable macroeconomic outlook induces investment both domestically and through FDIs. Sectors such as finance, energy, construction and automotives carry high-growth potential in the medium term. Despite the recent surge in financial services, financial products in Turkey are still underpenetrated. Moreover, the automotive sector has become a production hub especially for the European market.

Turkey is the only country in the region which can offer the know-how necessary for the tremendous project financing and infrastructure investment needs of the region. I

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FACE TO FACE

LEE HODGINKSON, CHIEF EXECUTIVE OFFICER, SMARTPOOL

OT ONLY DOES Lee Hodgkinson, chief executive officer of SmartPool, and head of European sales and relationship management, NYSE Euronext, believe that dark trading in Europe will reach around 10% by the end of next year, but he also foresees a proliferation of dark venues as MiFID II encourages brokers to internalise trades. “We could end up with 50 or more,” he says. “Don’t forget a lot of trading goes on over-the-counter markets at the moment. As regulators bring that within a regulatory framework, firms may have to register as MTFs, systematic internalisers or as organised trading facilities (OTFs) and that could bring the numbers up.”

SmartPool Trading was incorporated as a limited company six months before it became an MTF. The early groundwork was completed by Yvette Roozenbeek, who was in the strategic business development team at NYSE Euronext. She pulled together the consortium of banks, JP Morgan, BNP Paribas and HSBC, which owns SmartPool along with parent company NYSE Euronext, and got the regulatory licence.

Approval to create an MTF was granted in January 2009. SmartPool launched in February and Hodgkinson became chief executive in March, aged 36, reporting to Roland Bellegarde, group executive vicepresident and head of European execution, NYSE Euronext.

Earlier roles had seen Hodgkinson as chief executive officer of SWX Europe, briefly head of market development at the Cayman Islands Stock Exchange and, straight from school, a ten-year spell in market development at the London Stock Exchange. Hodgkinson joined SmartPool four months after the introduction of the Markets in Financial Instruments Directive (MiFID), which unleashed competition into European trading. A rush of firms set up new multilateral trading facilities, he explains, all trying to claim first mover advantage with their particular model.

Hodgkinson says: “MiFID liberalised the playing field for the European

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Lee Hodgkinson, chief executive officer of SmartPool, and head of European sales and relationship management, NYSE Euronext. Photograph kindly supplied by Smartpool, May 2011.

The allure of the dark Meet. Match. Trade. That is the current marketing slogan for the dark trading venue, SmartPool, the non-displayed multilateral trading facility set up by NYSE Euronext in 2009. In simple, one-syllable words, it explains what happens in a dark pool. With prices set at the mid-price of the local primary market, buyers and sellers dip into the pool, meet each other, and match their orders and trade. Lee Hodgkinson, chief executive officer of SmartPool, and head of European sales and relationship management, NYSE Euronext, is in his own words “a big fan” of dark pools. Hodgkinson talks to Ruth Hughes Liley about the prospects for the segment. market place, but it was more than that in reality. It encouraged intermediaries to revisit the core principles of how they interacted with the public markets.

Allied to that was a gargantuan growth in technology which served as the enabler of change, improving functional sophistication and speed.

Competition occurred as a result of these factors converging.”

According to Hodgkinson:“The best companies have a single vision shared among all stakeholders and in executing that strategy, they make trade-offs and choices. Our aim at the start was to become one of the leading European dark venues. Other MTFs were at the commoditised end of the spectrum— focusing their efforts on cost leadership and the quality of their technology. We wanted to have to offer higher-quality executions and to create a non-homogeneous dark liquidity pool, bringing together varied flows from the widest possible set of relationships in Europe

including the major investment banks as well as smaller brokers.”

With SmartPool a complementary service to the NYSE Euronext public limit order book and specifically targeted at trades larger than average size, the venue is less attractive to high-frequency traders because it charges a higher rate for trading in the dark.

SmartPool trades in more than 2,100 securities stocks, both blue chip and selected mid-cap, from 15 European countries including stocks listed on the four NYSE Euronext exchanges.

Between April 2009 and September 2010 it recorded six successive quarters of growth, measured in trading turnover based on the value of trades. By the end of last year’s third quarter (Q3), according to Thomson Reuters, Smartpool had matched volumes of €7.345bn (a rise of 28% on the previous quarter) with 855,770 trades (up 57.9%). However, by Q1 2011, this had fallen to €6.062bn from 801,595 trades. “We are very

JUNE 2011 • FTSE GLOBAL MARKETS

pleased that the market continues to support us, but we are still growing and the competition is strong. We can’t rest on our laurels,” says Hodgkinson.

In September 2010, Société Générale Corporate and Investment Banking (SGCIB) connected to SmartPool, extending the venue’s reach into France.

According to Thomson Reuters’ equity market share service, SmartPool reported record dark market share highs in France during September with a 22.2% dark market share of the CAC 40 and 19.74% dark market share in Euronext 100. By May 2011, this had fallen back to 14.8% and 12% respectively.

Stephane Loiseau, managing director, and deputy global head of execution services at SGCIB, says: “The rapid growth of volumes on SmartPool in Europe led the bank to add the venue to its algorithmic trading strategies to make that liquidity available to institutional investors.”

Platform migration Once SmartPool had migrated to the NYSE Euronext Universal Trading Platform in November 2009, it was able to provide access to a Europe-wide client distribution network of more than 220 firms which were already connected to the UTP. A high point in Europe in September 2010 recorded a 21.2% market share in Xetra DAX and 19.3% in MSCI Euro. One month later, SIX Swiss Exchange and SmartPool announced their agreement to jointly deliver “Swiss Block”, the non-displayed liquidity service for Swiss blue-chip equities. At the same time, SmartPool doubled its number of securities traded by extending its mid-cap reach by adding the FTSE All-Share Index (UK), CDAX Index (Germany), AEX All Share (Dutch) and CAC All Share (French). In March last year, Thomson Reuters’ reported record dark market share highs for SmartPool in the Nordic markets during the first two weeks of March, including a 10.4% market share in the OMX Copenhagen 20 Index.

“We’ve got a good footprint in Europe and have members from

FTSE GLOBAL MARKETS • JUNE 2011

France, Holland, Belgium, Sweden and Ireland. We’re getting our footprint out there and now need to penetrate Italy and Spain. It’s building nicely. But it won’t happen overnight because it is as much to do with the reinvention of the industry. As the industry gets more international, brokers start to look at their execution quality and they look further afield to get the best execution,” says Hodgkinson.

In fact, he believes execution quality is what firms are looking for above all.

“Execution quality is key. When a client comes on to your platform, they want a high-quality fill. Their algos are designed to return to venues which provided them with a good fill and so business begets business.”

In March last year, SmartPool unveiled MatchView, a new service to help traders interpret and navigate post-trade data published by European dark venues. It offers real-time access to aggregated data on a T+1 basis and an insight into what it calls the “personality” of each pool. Hodgkinson explains: “The opacity of post-trade data is particularly problematic in the dark space, where the desire from traders as well as other market users and regulatory agencies, for increased post-trade transparency is overwhelming.”

SmartPool’s current clearing house is EuroCCP, with which the firm has a strong relationship, says Hodgkinson.

While parent company NYSE Euronext has announced plans to build its own clearing houses in London and Paris by the end of 2012, the coming merger of NYSE Euronext and Deutsche Börse also complicates any strategy here. The announcement of the merger of the two exchanges stated the promise of “a progressive introduction of Deutsche Börse’s clearing capabilities”.

In February this year SmartPool confirmed Penson Financial Services as the latest firm to join the pool and the first member to do the dedicated work of offering an all-in-one execution, clearing and settlement solution. Penson claims to be the largest independent provider of clearing and settlement services glob-

ally, servicing over 430 “correspondents” worldwide. With its net revenues of $288m, SmartPool has a useful partner.

Penson’s membership will provide a low-cost solution for mid-tier broking firms to connect, execute, clear and settle.

Beyond blue chips The move further develops SmartPool’s journey beyond blue chips. Hodgkinson says: “This supports our strategy of widening our range of participants who can now connect without the need for major infrastructure build. It’s attracting European-based business too.” SmartPool’s relationship with its liquidity providers is crucial to the effectiveness of the dark pool.“Our stakeholders are robust and rightly so,” says Hodgkinson, who spent three months at Harvard Business School before taking the reins at SWX Europe. “It was a transformational experience and helped me communicate my vision for business to stakeholders at large. It also taught me that all good businesses are perpetually dissatisfied with the status quo. You allow yourself 24 hours of basking after an achievement and then you look to move on from there. Companies have to simultaneously meet the needs of their customers daily with excellence, while making sure that you are thinking about tomorrow and taking appropriate action for that now.”

Hodgkinson and his team are pushing ahead into other asset classes, following client demand, although he recognises that progress is slow. “There was a trend for MTFs to start moving into other asset classes during 2010, probably prematurely. However, clients want multi-asset and so we launched trading in ETFs but moving into multi-asset is slow-going.”

In fact, 32 exchange-traded funds based on indices in Europe, the US and Asia were added to the SmartPool platform in October 2010. Although it is Hodgkinson who will ultimately determine the future strategy of SmartPool, he believes in the team ethic: “I know what my strengths are and I know what my weaknesses are. I may be a figurehead to some, but I’m one of a great team.”I

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COMMODITIES

HEDGE FUNDS TAKE A HIT: MINI CRASH AS MARKET OVERHEATS

Photograph © Norebbo / Dreamstime.com, supplied May 2011.

Oil will drive sector ahead in the long term Analysts have been warning since March that oil prices were rising too high, too fast, that soaring commodities markets would start affecting the already fragile global economic recovery and that the upshot for other commodities such as base metals would be a slowdown in demand. Eventually the markets took heed, with a little bit of help from the CME, which raised deposit requirements on oil and silver, and commodities went through a mini-crash in early May in which some of the top commodity hedge funds lost up to $400m in less than a week. Vanya Dragomanovich reports.

T WAS A political move, holds Frank Holmes, chief executive of commodities investment management firm US Global Investors.“There was too much froth in the oil market.”

When US petrol prices reach $4 a gallon, domestic political pressure increases to stop them from moving higher. On top of that, “the mentality in the market is a little bit bi-polar,” he adds. When the trend is on the up speculators and funds pile in; CFTC data bears this out, showing record-

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high levels of speculative investment money before the mini-crash.

However, when the market turns, market players behave “as if the world is coming to an end,” Holmes adds.

The correction was fairly violent though short-lived. In the first week of May crude oil prices fell more than 12%, silver plunged 27% and the S&P GCSI TR commodity index dropped 11%.

Apart from the increased margin requirements and fears of a global slowdown, the sell off was also precipitated

by anticipation that the Federal Reserve may start taking liquidity out of the market after the latest (or last?) round of quantitative easing finishes in June.

The overbought situation in the oil market had been building up for a while. Oil’s fast rise this spring was initially fuelled by expectations that the global economy would continue to recover throughout the year and that transport demand in the West and industrial production across the globe would pick up. Then North Africa and the Middle East erupted into riots and conflicts, stoking fears about oil production being affected in countries such as Libya and that main transit routes such as the Suez Canal would be disrupted.

Prices rose more than 30% from January to peak at $125 a barrel, less than $20/bbl below their all-time high in 2008—a market cycle so painful for oil consumers that oil prices then plunged to about $85/bbl where they remained for the better part of two years.

At $125, oil was not only overbought but also the high price had implications for demand within all other commodities markets. While commodities tend to initially all travel up on the tailcoats of oil because a lot of large funds invest into the whole complex or into commodity indexes rather than single commodities, eventually high prices start to hamper global economic growth and with it start killing off the buying power of end users.

According to Deutsche Bank economists, a $10-a-barrel increase in oil prices lowers global GDP by about 0.4%, which given the bank’s growth forecast for this year of 4.3% would translate into growth of 3.9% instead. If oil prices were to rise $50/bbl this could depress global growth by as much as 2%.

There is also a strong correlation between global GDP growth and how much base metals the world uses per year, although metal demand tends to swing more violently than GDP because of inventory adjustments. When metals are cheap, big users such as China tend to squirrel away extra material to use during periods of high prices.

JUNE 2011 • FTSE GLOBAL MARKETS

Using copper as proxy for the whole base metals complex, Deutsche Bank analyst Daniel Brebner argued:“As GDP growth weakens so does demand for copper but at a slightly slower pace.”But once the global growth falls to about 1.5%“copper consumption growth falls to zero”. At Deutsche Bank’s current base-case GDP growth rate of 4.3% this year, Brebner estimates that copper consumption would be 4.2%. If oil prices rose $10/bbl and global GDP growth fell to 3.9%, copper consumption would fall to about 3.5%, leaving an extra 120,000 tonnes of unused copper on the market. If oil prices were to rise by about $50/bbl, copper consumption would fall to 0.8% and produce a copper surplus of 640,000 tonnes.

ING Investment Management’s senior investment strategist Koen Straetmans sees a silver lining in the fact that the rise in oil prices was driven by demand rather than actual supply disruptions. “A demand-driven oil shock will lower economic growth, while a supply-driven shock could well cause economic growth to become negative. Also, our research shows that equity market returns can be expected to remain positive in a demand-shock environment, while negative returns can be expected during a supply shock,” says Straetmans.

Escalating political risk in the Middle East still has the capacity to disrupt supplies from major producers such as Saudi Arabia, Iran and Iraq, although at this stage it is more likely to continue affecting the smaller suppliers such as Libya. “The base case of robust global economic growth remains intact, but uncertainty and downside risks have considerably increased on the back of the shifting nature of the oil shock,” notes Straetmans.

The commodities sell-off might have been bad news for commodity investors but central bankers across Europe breathed a sigh of relief as prices fell. European Central Bank president Jean-Claude Trichet told his peers at the Global Economy Meeting of the Bank for International Settle-

FTSE GLOBAL MARKETS • JUNE 2011

ments (BIS) the price fall was a healthy development for the world economy as it will have a direct impact on inflation all over the world.

Now that oil prices have corrected down, where do commodities go from here? In theory the response should be sideways, at least when it comes to energy commodities and base metals, but commodities don’t do sideways, at least not for any longer periods of time.

The dominant sentiment in all global markets remains one of nervousness— because Europe’s debt problems may worsen and threaten the pace of economic recovery in the region. Nervous, also, because China’s efforts to contain inflation growth may slow demand for imported materials. Nervous, too, because events across the Middle East may yet worsen and drive the price of oil to a level that also damages the global growth outlook. This means that investors are likely to tread carefully and potentially stay away from what they see as a risky asset class.

Escalation of violence In terms of prices, oil is likely to initially notch lower as late spring is typically the weakest period of demand during the year before the summer travel season and the switching on of airconditioning in the US. On the supply side, the escalation of violence in Libya has reduced the country’s crude production, and it is highly unlikely that there will be any form of stabilisation in the country in the short term. Although Saudi Arabia initially announced that it had sufficient spare capacity to meet any rise in global demand or supply shortfall it later said that it had cut its oil output in March from February.

ING’s Straetmans expects oil to trade between $110/bbl and $135/bbl with the potential to spike to $150/bbl in case of a serious supply disruption from the Middle East. Metal prices are likely to trade sideways in the short term with “volatility here to stay,” according to Robin Bhar, analyst at Calyon Credit Agricole.

Industrial demand is showing signs of slowing, although from a high base, and the strength of the dollar is likely to add to the slightly negative sentiment in the current quarter. At present, copper and nickel are among the most vulnerable metals and aluminium is in a slightly stronger position then the rest of the complex. But demand is expected to pick up in the third and final quarters of this year and into next year as long-term infrastructure programmes in countries such as China and India remain the main drivers. The current geopolitical situation and a dip in prices are also supportive for agricultural commodities as large grain buyers such as Algeria, Tunisia and Egypt stock up on their wheat and corn reserves. Iraq has also increased its strategic purchases and Saudi Arabia plans to double its wheat stocks within three years Japan, which is one of the world’s largest importers of corn, wheat and soybeans, is likely to have to increase its imports after its agriculture sector has been severely affected by its nuclear crisis. It already imports 17% of the world’s corn and this number is likely to go up this year.

In the longer run, however, grains will be dominated by weather in large producing regions such as Russia. “A positive impact of the oil price correction should be to remove some current fears in the market surrounding inflation and demand destruction,” says Bradley George, head of commodities and resources at Investec Asset Management. “We believe composure will return to commodity markets after the pullback and volatility in commodity prices during the first week of May as underlying, long-term fundamentals remain bullish.” He sees the pullback as an opportunity to reset exposures to commodities.

Investors looking for a clear trend and a predictable gain in the short term are likely to have little joy with commodities over the next few months, but the outlook remains very good into next year and going forward with demand not likely to seriously abate. I

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COMMODITIES

WGC: INVESTMENT IN GOLD CONTINUES TO GROW

The outlook is better for gold than other hard commodities, and there is no serious reason for prices to start going down. As long as there is uncertainty over the US economic recovery and the European debt crisis, investors will continue to flock to gold as a safe haven, the trajectory for gold prices look likely to stay at or rise above current levels for the foreseeable future. In the developing world gold continues to be a “love trade”, according to commodities investment management firm US Global Investor’s chief executive Frank Holmes, referring to the emerging markets’ cultural preference for gold and their consistently growing appetite for gold jewellery.

The gold option is not losing its appeal ECORD LEVELS OF government debt and quantitative easing programmes have heightened investors’ fears about future inflation and holding fiat currencies. They have been increasingly turning to gold, amongst other things, to its long history as an inflation and dollar hedge, notes Marcus Grubb, managing director, investment at the World Gold Council in London. He continues: “We expect levels of demand from investors for gold to remain strong, supported by continued economic uncertainty, especially concerns over US economy and dollar, the ongoing European debt crisis and future inflation expectations.”

Central banks in developing countries continue to increase their gold reserves as seen this spring when the Central Bank of Mexico bought 100 tonnes of the precious metal, following in the footsteps of the central banks of India and Vietnam. Meanwhile, China’s appetite for gold has grown by an average 14% a year since deregulation in 2001. However, demand in the first quarter of this year out of China has been particularly high. Jewellery is by far the most dominant category, according to World Gold Council (WGC) figures, accounting for almost 64% of all gold demand in China last year. Even

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so, it has yet to overtake India, which is the largest buyer of gold.

Over the last ten years, investment demand for gold has also grown substantially in high-growth markets, with China a particular market template. At the end of last year annual demand for gold in China as an investment totalled 187.4 tonnes, up 71.1% over 2009, says Grubb, “with the result that China was the largest physical bar and coin investment market during the quarter at 90.0 tonne”. It is a trend that will likely continue, given that in April the Shanghai Gold Exchange started a trial for overthe-counter trading, providing an easier tool for institutional clients to trade large quantities of gold.

With demand continually rising with this order of magnitude, Holmes believes that gold prices could hit $3,000 in five years time based on consumer and institutional investor appetites in both advanced and high-growth markets. In China alone, demand is expected to rise by 22%, according to China’s state-owned miner China National Gold Group, with national production rising to 400 tonnes by 2014.

China produced 351 tonnes of gold in 2010 and investors locally bought 571.5 tonnes, according to official data, for a gap of 220.5 tonnes made up by either imports or sales of existing stocks, adds

Grubb. Beijing’s move to consolidate the gold mining sector, improve technology and encourage exploration at depths exceeding 1,000 metres would combine to boost the country’s underground reserves and output over the coming years. Right now, the country is one of the world’s biggest gold producers, with an estimated 13% share of global output, closely followed by Australia, the US, Russia and South Africa, all in the 8% to 10% range.

There are also other compelling reasons for gold’s sustained appeal. A recent Mercer Consulting study of gold as an asset class for the institutional investor, for instance, issued in German in February this year, claims to show that having up to 5% gold in a portfolio considerably reduces the risk of loss. The Mercer study examines the effect of holding a certain proportion of gold on the performance of a portfolio of large-cap shares and government bonds. It defines two possible market situations: a normal market and then one in crisis. In a nutshell, investment in gold was shown to be a sensible diversification of a portfolio, particularly in times of crisis, and suggests that adding gold reduces the risk of loss in achieving any target return or that the expected return for any targeted risk of loss is higher.

JUNE 2011 • FTSE GLOBAL MARKETS

Photograph © Palerider / Dreamstime.com, supplied May 2011.

There is also the option for investors to buy into gold at one remove, which ultimately feeds into global demand.

“For institutional investors who are not permitted to make direct investments in gold for regulatory reasons... exchange-traded products (ETPs) [are] a suitable form of investment for participating as directly as possible in the performance of the gold price,” says Mercer’s Dr Heinz Kasten. “However, we should take into account whether this ETP is secured by physical gold and its market price is thus directly coupled to the gold price. In addition, investors should ask themselves whether the price of the ETP will

perform systematically differently from the gold price over time, for example through a certain fee structure.”

Deutsche Börse Commodities GmbH claims to have an answer to that particular conundrum with its Xetra Gold product, a 100% gold-backed bearer bond that represents the right to the delivery of gold, which it launched on the exchange in December 2007 and has now generated €1bn-plus of investments. The main difference between the bond and other similar products is that in this instance, the bank where the gold is held still charges a fee for taking the gold into its custody, but does not deduct the fee from the amount of gold held.

Because of that, says an exchange spokesman, the product has been “incredibly successful with investors”.

More specifically,“Xetra Gold is the only product on the market that is backed by physical gold and doesn’t show a tracking error because the management fees are not taken out of the portfolio,” says Martina Gruber, managing director at Deutsche Börse Commodities GmbH. “It’s inexpensive, flexible and very safe.”

While bears constantly warn against commodity bubbles and the inevitable catastrophes in their wake once they burst, according to the WGC’s Grubb: “What we are seeing in the gold market is not a short-term trend driven by transient market forces.

While gold has continued its upward

Marcus Grubb, managing director, investment, at the World Gold Council in London. Photograph kindly supplied by the World Gold Council, May 2011.

trend, by historical standards analysis shows that its price is not overvalued relative to other assets,” says Grubb.

Certainly, the resilience of gold through the recent volatility in the commodities market confirms the strength of the global gold market and its unique demand drivers. Adds Grubb: “High levels of investment demand from across the world, strong demand in India and China, the continued strength of the technology sector and central bank purchasing demonstrates the diversity of gold’s demand drivers and differentiates it from the commodities’ complex. We anticipate solid demand from across the global gold market in the rest of 2011.”I

Reported changes in central bank reserve holdings between January & June 2011 January 2002 (tonnes). Updated May 2011.

Country Belarus Czech Republic Greece Kazakhstan Malta Mexico Philippines Russia Thailand Ukraine

Comments Purchases and swaps Coin purchases and other changes Purchases and swaps Long-term sales programme and periodic additions to reserves Buys locally produced gold; may sell or retain reserves Mainly purchases of gold in the domestic market & other changes Purchase

Jan -0.1 +0.1 -0.1 +1.6 -0.2 -0.5 +0.6 -

Feb +0.3 +14.8 +3.1 -

Mar +2.3 -0.1 -1.6 +0.1 +78.5 +18.8 +9.3 +0.1

Source: World Gold Council website. Supplied May 2011.

FTSE GLOBAL MARKETS • JUNE 2011

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FX VIEWPOINT

BANKS MUST LEARN TO ACCOMMODATE HFT FLOW

The most important FX news in the past month or so was the decision by the US Treasury to exempt FX swaps and forwards from the provisions of Dodd-Frank. The collective financial markets had been holding their breath (and their budgets) for a while, waiting to see if they really had to read all 1,200 pages of the act. People who make their living in the spot FX market can breathe a sigh of relief: they won’t have to spend so much on legal advice or on IT and business process re-engineering. What now? Erik Lehtis, president of DynamicFX Consulting, looks at the consequences.

Can banks come to terms with HFT? ANKS CAN NOW return to the task of building their FX e-commerce infrastructure and high-frequency traders can wonder how to compete going forward. Hedge funds? Well, they will need to figure out if there are any other angles in Dodd-Frank that might create issues for the way they do their FX business.

However, I’m going to focus this month on the relationship between banks and high-frequency trading (HFT) firms. This is an area of real dynamic change in the market, and one that will drive a lot of the future process of price discovery in spot FX. The problem banks had with DoddFrank was the fact that they individually operate FX e-comm platforms which do not in any way comply with the definition of a swapexecution facility (SEF) given the lack of transparency in the price discovery process. No information about traded volume is represented to customers, nor is any order book detail. Prices are simply streamed out, and customer matches are executed at the pleasure of the bank. It is a very one-sided proposition, since the bank not only has exclusive control over whether the trade is executed, but also takes the other side of the customer’s trade.

Now that banks are free to continue with this business model, customers have to think about how they see their

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role in this ecosystem. Their alternative is to go to a venue that gives them access to multiple banks simultaneously (such as 360T, FlexTrade, Integral), or a multiparticipant exchange (Currenex, Hotspot, FXAll). The more sophisticated HFT players also trade on EBS and Reuters, traditionally sources of wholesale interbank liquidity.

These last two portals are now threatened by the trend towards bank internalisation of flow. Banks are actively seeking to steer as much of their flow to internal counter-parties as possible. This accomplishes several objectives: it hides their hand from the competition; it lowers transaction fees; and it increases the chances of a serendipitous match between buyers and sellers with the bank pocketing the spread. Implementation of this model is a sophisticated undertaking of great complexity, requiring much in the way of hardware and software, as well as quantitative intellectual property. Banks that do not have the resources to make this kind of investment are themselves becoming clients of the banks that can.

HFT players are finding that they are left out in the cold by this turn of events. Their recourse is to adapt and become part of the puzzle. What they have to offer is exceptional marketmaking and arbitrage capabilities.

Erik Lehtis, president of DynamicFX Consulting. Photograph kindly supplied by DynamicFX Consulting.

During the first wave of HFT between 2005 and 2008, many HFT traders took advantage of the clear inferiority of bank technology and made a nice living picking off slow bank feeds. For their part, the banks were so poor at not only making prices electronically but also analysing the results that by the time they realised what this activity was costing them, they threw the HFT traders out of the temple, so to speak.

Some banks have still not gotten over that thrashing, but several have made the investment to upgrade their technology and can now accommodate HFT flow in a profitable manner. This ability to resume relations with a significant market segment will separate the banks with a future at the top of the FX heap from the banks that will live a notch below and ultimately depend on the top tier for relevance and liquidity.

In this way, the leading FX banks and HFT players will discover they actually need each other. Like so many successful business relationships, there is a symbiotic nature to this arrangement, but that mutual dependency is what will enable it to work. FX has always been a relationship business. The more banks realise that they need to work with HFT traders rather than fight them, the better they will be able to perpetuate the existing FX bilateral trading and clearing model. The HFT traders who understand this and make the effort to incorporate the realities of the FX market space into their business model will find they have relevance in the future. I

JUNE 2011 • FTSE GLOBAL MARKETS

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INDEX REVIEW

CAN OPTIMISM RETURN TO A STAGNANT MARKET?

Markets are (excluding the Tsunami effect) near their lows of the year, the woes about over-indebted European economies continue to grind on and now it looks as though Italy is in the process of being dragged in to the morass as well. As if things were not bad enough, the UK has been downgraded by the little-known—but generally respected—Dagong Chinese rating agency and virtually every UK bank has been put on negative credit watch by Moody’s. Where will it all end? Simon Denham, managing director of spread betting firm Capital Spreads, takes a particularly bearish view.

Markets still adrift in neutral data HE EU IS likely to pump even more money into the sovereign debt problem, which will no doubt prop everything up for yet another turn of the wheel, but it must be speculated that at some point even our politicians must recognise the folly of borrowing more and more and more. Some nations now have burdens that even the most optimistic of pundits cannot really expect them to repay. Loading them up with even more just to keep them going (virtually, in the hope of “something turning up”) is a policy direction along the lines of a little boy putting his finger in a dyke, and we all know what happened in that story!

For all of the denials from central banks and politicians, we all believe that there is going to be either a haircut on a huge swathe of sovereign issuance, an expiry extension, some form of debt forgiveness or, more probably, a combination of them all. It is reminiscent of the 1980s Brady Plan that ultimately paved the way for over-indebted Latin American states to return to normalcy.

This would not matter quite so much if the same problem was not being experienced right across the western world. On the plus side, the US Fed has indicated that quantitative easing will finish this month. Even so, investors are not

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exactly going to hold their breath over the possibility that, at the first sign of trouble, the tap might not just be turned straight back on again.

The Northern European states are stuck between a rock and a hard place. Their electorates are becoming increasingly angry with having their money continuously flowing south, but they cannot stop as this would bankrupt most of their financial institutions who hold billions in Greek, Portuguese, Spanish and Italian debt. Moreover, in the UK, for all of the public sector cost cutting, spending actually rose by 5% April/April year-on-year! This is obviously a definition of cost control that does not exist anywhere outside of the UK public sector. With various central banks still happy to keep the printing presses going, this is feeding into maintaining consumer spending levels, propping up growth while possibly creating longer-term problems with entrenched inflation.

The continued erosion of currency values is also pushing precious metals to stratospheric levels that are difficult to justify on an absolute basis.

My last comment written at the highs of the year (a massive 275 points in the FTSE 100 away!) indicated that traders were finding it difficult to justify buying at the top of the market. Today we have the same problem but in

Simon Denham, managing director of spread betting firm Capital Spreads. Photograph kindly supplied by Capital Spreads.

reverse. We are down at the lows but finding few sellers and dealers seem content to pick up stock on any weakness. UK equity index markets have had an awe-inspiringly boring year to date. Last year, by the end of May, the FTSE had traded in a 1000point range and people were saying that that was quiet! Excluding the temporary week of the tsunami, the FTSE has been stuck between 5800 and 6100 and, in truth, has never really looked like breaking out.

So why am I feeling just a tad nervous? The main problem I see is that we are falling to the lows, with weakness in many exchanges across the globe, on data that is, outright, neither bullish nor bearish. While this is a concern, logic suggests that markets drifting on neutral data should only be temporary. It is difficult to call an end to the two-year bull market which began in March 2009, and there is no indication that we have reached the end of this cycle. Looking at the fundamentals, stocks appear as cheap as they did six months ago and global economic growth remains robust.

In summary, cautious optimism is still the prevailing emotion, but with heavy emphasis on the caution. There is no obvious headwind either way but, as long as we do not find ourselves buffeted by a force ten gale precipitated by a real sovereign debt disaster, we may just begin to see some confidence creep slowly back into the investment community during this relatively stagnant market.

As ever, ladies and gentlemen, place your bets. I

JUNE 2011 • FTSE GLOBAL MARKETS

HEDGE FUND REPORT

Photograph © Jscreationzs / Dreamstime.com, supplied May 2011.

PRIME BROKERS PRAY FOR HIGHER RATES Prime brokerage firms took a one-two punch to the solar plexus after the financial crisis. Not only did hedge funds (their principal clients) shed one third of their assets but also the Federal Reserve pushed interest rates to historical lows and kept them there. Hedge funds assets have since bounced back to record levels. However, an ugly combination of low interest rates, low volatility, low leverage and low trading volumes have left the prime brokers sucking wind. At this rate, how long can they maintain service quality? Neil O’Hara reports.

EVENUES ARE STILL down 25%-30% from the peak, according to Alan Pace, head of prime finance for the Americas at Citi, who nevertheless acknowledges that business has ticked up from the low, when revenues were off 40%-50%. The emphasis has shifted toward a relationship that leverages the entire firm’s capabilities rather than the prime broker division alone. “Prime brokers are focused more on the client, offering complete financing solutions rather than specific products in a silo,” explains Pace.

The pain isn’t equally bad for all prime brokers, however.

The Lehman Brothers collapse touched off a scramble among hedge funds to diversify their financing sources by adding new prime broker relationships. Goldman Sachs and Morgan Stanley, the long-time industry leaders, saw their dominant market shares shrivel overnight as secondtier players elbowed on to their turf, led by JP Morgan, Deutsche Bank and Credit Suisse. Bank of America Merrill Lynch, UBS, BNP Paribas, Citi, Barclays and Fidelity also picked up significant market share.

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FTSE GLOBAL MARKETS • JUNE 2011

The pendulum may have swung too far in favour of multiple prime brokers, however. It is an operational nightmare even for large funds to aggregate incompatible data feeds to get a complete picture of their portfolio.

“Hedge funds expanded the number of prime broker relationships to six or even eight,” says Keller. “They found managing that many hard to do effectively. The pendulum has swung back to between two and four prime brokers that are held to higher operational standards.” Some funds have cut back because they could not afford to feed everyone from lower trading volumes, too.

The operational headaches led some hedge funds to take on new prime brokers for insurance without ever intending to use them except at a minimum maintenance level. The larger prime brokers aren’t interested in that business, however; they want to grab as much revenue as they can from a deep-seated relationship that encompasses the entire firm. “We were approached by some funds who essentially wanted a highly-rated institution to serve as a custodian,”

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HEDGE FUND REPORT

Ron Suber, head of global sales and marketing at Merlin Securities. “The low VIX and volume are crushing the prime brokers. You can feel the quietness around the trading desks on the Street,” he says. Photograph kindly supplied by Merlin Securities, May 2011.

says Lou Lebedin, co-head of prime brokerage at JP Morgan.

“We turned them down. We do not want people to leverage our name by dropping some money in and calling that a prime broker relationship.”

Prime brokers can also differentiate themselves through capital introduction, an increasingly important service even though relatively few new hedge funds are being launched.

Capital introduction used to mean events organised by the prime broker at which investors and fund managers had the opportunity to meet—in effect, a glorified dating facility.

Now, it is more targeted; prime brokers make an effort to match an investor’s needs with a fund manager’s expertise.

If a manager wants to tap pension fund money in Brazil, for example, a prime broker that has good contacts in that community will identify and arrange introductions to selected prospects most likely to be interested in that particular investment strategy.

Ron Suber, a Bear Stearns veteran who is now head of global sales and marketing at Merlin Securities, made capital introduction a priority from the outset. Merlin acts as prime broker to 530 hedge funds, most of which have less than $1bn in assets. Suber fired the incumbent capital introduction team which was “doing the same old cocktail party game that doesn’t work for either investors or managers”.

He targeted middle market investors, family offices and

54

managed account platforms that have more money to allocate than individual high net worth investors but less than pension funds and endowments. Merlin invited investors to share what types of fund they were looking for and promised to send them only prospects that fit those needs, forgoing any generic email blasts. The strategy worked. “People started to trust us. They knew we would never give out their name and would only send them what they wanted,” says Suber. “We found investors who put hundreds of millions with clients because they could focus and we didn’t waste their time.”

The terms on which funds will take money have changed, too. Suber says smaller managers have started to take firstloss capital, an arrangement in which the manager may put up $1m and the investor $9m into a separately-managed account. Gains on the $9m are split 50/50 and the manager keeps all the gains on his own money—but if losses occur, they come out of the manager’s hide until his capital is exhausted. In effect, the investor gets a free look at the manager’s capabilities, but he can yank his money at any time if things turn sour. “Hundreds of millions have come into the industry that way,” says Suber. “You would be surprised how many managers are taking first-loss capital but not talking about it.”

It is a way for smaller managers to build their asset base in a hurry. A manager who has $75m in a co-mingled hedge fund can jack-up firm assets if he is willing to risk $3m in a first-loss deal. An investor throws in $27m and the manager is over the magic $100m threshold below which some institutions won’t invest no matter how well a manager performs.

The money is likely be fickle, of course, although Suber says some managers acquire a degree of stability by ceding a larger share of the performance fee in exchange for a three or six-month commitment.

Capital introduction It isn’t just smaller funds that care about capital introduction, however. Lebedin, an industry veteran who went to JP Morgan when it acquired Bear Stearns, says even large funds that are nominally closed are interested in replacing flighty investors with more stable money. “Two or three years ago it was not as high a priority,” he says. “Now they talk to our capital introduction team. They want their capital base to be stickier and more long term. It’s something every fund, large or small, wants.”

Capital introduction helps build a prime broker’s asset base, but revenues depend even more on the level of interest rates. Most businesses thrive on low rates, but to prime brokers, which earn a spread based on short-term rates, they are a curse. On the long side, they charge a few basis points over the Federal funds rate on money lent to finance clients’ positions. The contractual spread has not changed, but hedge funds aren’t using as much leverage as they used to, so prime brokers make less money. They also earn a spread on clients’ unencumbered cash balances, but with Fed funds at just 25 basis points (bps) that spread has nearly vanished. Hedge funds have started moving surplus cash and unencumbered

JUNE 2011 • FTSE GLOBAL MARKETS

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HEDGE FUND REPORT

assets to custodial accounts away from the prime brokers, too, which removes another revenue source.

On the short side, the story gets worse. When a client sells short, the cash proceeds are held by the prime broker as collateral against the security lent. The cash is invested in money market instruments, and any interest earned is split between the broker and the hedge fund that borrowed the security. The money belongs to the hedge fund, so the ratio favours the client—typically 80:20.

The interest rate is negotiated, but Fed funds minus 50bps is par for the course. If Fed funds are at 1%, the cash collateral earns 50bps, the hedge fund gets a so-called short rebate of 40bps and everybody makes a little money. With Fed funds at 25bps, the arithmetic doesn’t work. The interest rate paid on short collateral is negative, meaning a hedge fund has to pay the broker to hold a short position even if it’s a general collateral name, never mind a hard-to-borrow security. Big surprise—hedge funds don’t want to hold large general collateral short positions any more.

Volume has slumped Prime brokers also make money from transaction fees, fixed charges levied on each trade ticket or corporate action they process. In revenue terms, it is an also-ran to financing and securities lending, but even here the news is bad: volume has slumped amid subdued volatility. After a sharp spike at the height of the European sovereign debt crisis in May 2010, the VIX index of volatility on the Standard & Poor’s 500—the “fear” index—has drifted down from 45 to just 15, below its historical average. When prices don’t bounce around much they are less likely to get out of line, and trading volume tails off. In April 2011, stocks listed on the New York Stock Exchange traded 79.9bn shares, down more than one third from 121.7bn in April 2010.

“The low VIX and volume are crushing the prime brokers,” says Merlin’s Suber. “You can feel the quietness around the trading desks on the Street.”

The trading that does take place is more concentrated in big liquid names, too. Many hedge funds were caught with illiquid positions when the credit crisis hit, obliging them to restrict redemptions. Investors now demand a better match between the liquidity of the instruments a fund trades and the frequency with which they can take their money out, forcing some managers to abandon thinly-traded securities in favour of large capitalisation household stocks—which are seldom hard to borrow. “Hedge funds are not as willing to play in illiquid names,” says Citi’s Pace. “Some people still play in those markets, where specials are more common, but there is not the same participation across the industry.”

Funds that want access to hard-to-borrow securities usually have to borrow general collateral they neither want nor need as well. The big custodian banks that dominate securities lending supply have always tied allocations of hard-to-borrow securities to how much general collateral borrowers are willing to take. In order to get what they want in hard-to-borrow names, hedge funds must take general collateral—even if they have to pay for the privilege.

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Lou Lebedin, co-head of prime brokerage at JP Morgan. “We do not want people to leverage our name by dropping some money in and calling that a prime broker relationship,” he says. Photograph kindly supplied by JP Morgan, May 2011.

Although hard-to-borrow stocks can generate big profits for the prime brokers—lending fees sometimes run to hundreds of basis points—they are not risk-free. Hedge funds rely on prime brokers to secure stock that will not be called back at an inopportune moment and force them either to cover a short at a loss or lift one leg of a hedged position. If, despite its best efforts, a stock is recalled, a prime broker must decide whether to call it back from the client or try to find another lender—sometimes even eating the difference if it costs more than it is charging the client. Morgan Stanley and its peers cultivate close relationships with the custodian banks to improve their chances of getting hard-to-borrow stock. “Our goal is to build a diversified portfolio of supply that allows us to tailor a borrow [sic] to match the pricing, duration and stability our hedge fund clients need,” says Keller.

In an environment where prime brokers are fighting for a bigger share of a smaller pie, hedge funds are getting better service than ever before. For prime brokers, however, the inconvenient truth is that industry revenues won’t match pre-crisis levels until interest rates rise to the point where they can make money from cash balances and securities lending the way they used to. “The sell side is holding its breath for the moment the Fed raises rates,” says Suber.

“Some of the extra basis points earned will go right to the bottom line.”I

JUNE 2011 • FTSE GLOBAL MARKETS

HEDGE FUNDS BOUNCE BACK

Photograph © Tanja Krstevska / Dreamstime.com, supplied May 2011.

Recessions and financial crises come and go but the markets manage to survive and hedge funds always seem to find ways to exploit the situations and opportunities that arise. The hedge fund industry has recovered from seeing assets plunge by 30% or more as a result of the 2008 crisis to climb back above the highs reached before then. It is an industry which also continues to mature as well as grow. Neil O’Hara reports.

EDGE FUNDS ARE nothing if not resilient, like inflatable punch bags that pop back up no matter how hard they are hit. An industry that saw assets tumble by one third from a combination of losses and investor redemptions has rebounded: assets under management recently topped $2bn, pushing the total above the peak reached just before the 2008 financial crisis. The experience has chastened hedge fund managers, however; the wounds may have healed but scars remain that have changed forever the way managers run their businesses.

Managers have become more cautious about collateral and credit risk, for example. Rather than leaving surplus cash on deposit at their prime brokers, they are sweeping any excess into a separate account at a custodian bank. Bill Crerend, chief executive officer of EACM, a $3.8bn Norwalk, Connecticut-based fund of hedge funds, says some funds keep unencumbered security positions out of the prime brokers’ hands, too. In an attempt to retain the assets within their firms, leading prime brokers have set up custodian affiliates that would be untouched if the broker-dealer filed for bankruptcy and able to act independently on margin calls, including any made by the parent—at least, in theory.

At times of extreme market stress, however, an internal Chinese wall may afford managers less protection than a third-party custodian. “The brokers are responding to the demand for custody but the market is not making a mad rush to adopt their solution,” says Crerend.

The Lehman Brothers collapse reminded managers just how dependent they are on prime brokers for financing.

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FTSE GLOBAL MARKETS • JUNE 2011

Even funds that did not have assets trapped in bankruptcy proceedings scrambled to diversify their financing sources by adding new prime broker relationships. The asset threshold at which managers want more than one prime broker plummeted from about $500m to $50m, while larger funds that already had multiple prime brokers added new names to their roster. The long-dominant leaders, Goldman Sachs and Morgan Stanley, saw their market share erode as Credit Suisse, JP Morgan, Deutsche Bank and other second-tier firms muscled in on their turf.

Managers soon discovered that multiple relationships come at a cost. Positions that offset each other must be held at the same broker, for example; if not, the manager has to put up margin on both sides because each broker looks only at the assets under its control, not the entire fund.

Managers also have to consolidate multiple data feeds that may not be in compatible formats to get a complete picture of the portfolio for risk management, accounting and financial reporting purposes. The operational hassles mean that in practice some managers still rely on a single prime broker. “People will set up a second, third or fourth prime broker but never trade through them,” says Judy Posnikoff, a managing director and co-founder of Pacific Alternative Asset Management, a fund of hedge funds firm based in Irvine, California. “They just have them on the books as a safety mechanism.”

Some managers do use multiple relationships, not least because the large prime brokers have little interest in being nothing more than a backstop. Prime brokers want to

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maximize their share of the available business, and managers can leverage multiple relationships to keep the brokers honest. “Competition among counterparties is a good way to ensure that the manager gets the best service,”says Steve Vogt, chief investment officer of Mesirow Advanced Strategies, a $14.2bn Chicago-based fund of hedge funds.

The preoccupation with counterparty risk extends to the nature and domicile of the legal entity in which the prime broker holds a fund’s assets, too. Some managers were caught off guard when they discovered assets held by Lehman Brothers in an offshore subsidiary were not subject to the strict segregation of assets rules that apply to US broker-dealers, leaving their money tied up in court proceedings for months or even years.

Hedge fund investors got a taste of the same medicine from the managers themselves. In late 2008 many hedge funds, including trophy names such as Tudor Investments, Fortress Investment Group and Farallon Capital Management, invoked their right to limit or suspend redemptions, arguing that forced asset sales into weak markets to raise cash would harm continuing investors as well as those who wanted out. Others shuffled impaired assets into a liquidating trust from which investors receive distributions whenever market conditions permit orderly sales. At Harbinger Capital Partners, a giant side pocket ended up with no less than $2bn in assets, 37% of the fund’s assets.

“The liquidity of the strategy and the instruments they traded did not always match the liquidity terms of the fund,” says Paul Chain, president of AIS Fund Administration.“That is why you ended up with gates and liquidating trusts.”

Investors were livid, particularly at managers who traded liquid instruments but put up gates anyway—as if the desire to preserve the fund’s asset base trumped the managers’ obligation to investors. In response, investors now insist on a better match between the nature of the fund’s assets and the gate clause. “Why does an equity manager require a gate?” asks Posnikoff. “That is silly.”

Liquidity strategies Driven by investor demands and their own self-interest, managers have revised their liquidity strategies. Some have shifted away from illiquid assets to eliminate the mismatch, while others amended their documents to tie the liquidity offered to investors more closely to the marketability of the assets they hold. The terms now run the gamut from monthly liquidity all the way out to quasi-private equity vehicles. A fund that invests in illiquid, distressed mortgagebacked securities, for example, may have an initial three-year lockup, sometimes with an option for the manager to extend the period under certain circumstances.

Governing document changes are not limited to liquidity provisions, either. Mesirow has seen managers alter valuation practices to incorporate third-party pricing agents for illiquid assets, or revise the way performance is calculated when the fund transfers assets to a side-pocket. Managers have redefined what constitutes a liquidity event that triggers the gate and how the gate operates, focusing on each

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Judy Posnikoff, a managing director and co-founder of Pacific Alternative Asset Management. “If funds raise outside money in size from institutional investors, they need to register. It does place a cost burden on the smaller firms, however,”she says. Photograph kindly supplied by Pacific Alternative Asset Management, May 2011.

investor rather than the fund as a whole so that one large redemption request is less likely to trigger a stampede for the exits.“The contract between investors and managers is tilted more in favour of investors today,” says Vogt. “The larger investors, both funds of funds and big institutions, are using their muscle to drive some of the changes.”

Investors who want complete transparency and control over liquidity have looked at separately-managed accounts as an alternative to a co-mingled fund. The concept was widely discussed after the market crash, but practical considerations have deterred all but the largest institutional investors from pursuing it. Chain says: “Everybody wanted to run to managed accounts but it is not economic to give managers $5m and expect them to go through an audit, have an administrator and handle the operational complexities for a managed account that small.”

Chain reckons $50m is the minimum managed account allocation for a simple strategy, but it can be up to $75m for more complex ones and higher still for a multi-strategy manager. A big player such as the California Public Employees’ Retirement System (CalPERS), which switched all its hedge fund allocations to managed accounts after 2008, can afford to hand out $300m at a clip, but few investors are in that league. Smaller fry face the same predicament as Groucho Marx, who “wouldn’t join any club that would have me as a member”. An investor with $100m to hand out to ten managers will have to settle for second or third-tier talent. “Investors don’t want to give their money to someone to whom $10m is important

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Bill Crerend, chief executive officer of EACM, a $3.8bn Norwalk, Connecticut-based fund of hedge funds. “When the transition from a bank-driven business to a commoditised environment occurs, there is more sunlight. Some of the vigorousness comes out,” he says. Photograph kindly supplied by EACM, May 2011.

enough to be meaningful but to managers who runs billions it is a nuisance,” says Chain.

Recent asset inflows have gravitated toward the bestknown names, most of which are multi-strategy funds. In part, this reflects a move among pension funds to switch from funds of hedge funds to direct investments, typically with large brand-name managers. A flight to quality may also be at work, however. Posnikoff says that after Bernie Madoff’s pyramid scheme was unmasked, many managers upgraded their service providers, including administrators and auditors as well as prime brokers. “People were using firms they had been with for a long time and felt comfortable,” she says.

“However, there was an investor reaction against smaller firms so managers felt they had to make the move.”

Investors have ratcheted their due diligence standards up a notch as well, in some cases appointing an officer whose job it is to oversee the process. It isn’t unusual today for potential investors in a fund that AIS administers to arrange a site visit to discuss what the firm does and how it operates.

Many are still wrestling with what questions to ask, though.

“They learn a lot but even the people we respect the most on due diligence end up asking what they are missing—what they should have asked and didn’t,” says Chain.

Hedge funds face more operational changes in the near future at the behest of regulators determined to prevent another market collapse. While the new rules are not yet final, greater regulatory oversight is inevitable. The DoddFrank Act, for example, requires US hedge funds to register as investment advisers either with the SEC (for larger funds)

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or state securities regulators—a requirement the SEC implemented through the back door several years ago until a successful court challenge stopped the agency in its tracks. The change won’t make much difference to large funds, most of which are already registered. “If funds raise outside money in size from institutional investors they need to register anyway,” says Posnikoff. “It’s a formality for them. It does place a cost burden on the smaller firms, however.”

Proposals to shift OTC derivatives from bilateral trades into central clearing houses won’t have much impact on hedge funds, which have always had to put up margins on these trades. Contracts will become more uniform because the clearing houses will dictate some terms that may be negotiated bilaterally, including the thresholds at which margin is due and the frequency of collateral adjustments. If anything, hedge funds will benefit from improved counterparty credit quality— a central clearer is by definition a better credit than any of its individual members. Trading costs are likely to drop, too.

“When the transition from a bank-driven business to a commoditised environment occurs, there is more sunlight,” says Crerend.“Some of the vigorousness comes out.”

The switch to cleared OTC derivatives will have a bigger impact on the banks, which also have to adapt to a curb their proprietary trading activities—the Volcker rule. Already, numerous proprietary trading teams have either jumped to existing hedge funds or left their employers to set up hedge funds of their own. It is not an easy transition, however. The track records of proprietary traders are often flattered by the amount of leverage banks or broker-dealers use and the manager’s ability to tap the parent for additional capital at times of market duress. “They are smart traders and investors but the way they have to operate is different from a prop desk,” says Vogt. “The biggest challenge for them is to manage a fixed pool of assets and an upper limit on the gross exposure or leverage.”

Lower net exposure Fund raising success for both new and existing managers depends on their strategies, too. The initial rebound from the March 2009 lows lifted asset prices across the board so that performance depended primarily on how much net market exposure a fund had rather than its prowess in asset selection. That has changed in recent months, and investors have taken notice. EACM is now focusing more on long short credit strategies with lower net exposure than the long biased players it favoured during the rebound. The firm has increased its allocation to long short equity as well, particularly event-driven managers who can exploit an expected uptick in corporate reorganisations. “We are making a shift in that direction,”says Crerend.“The multi-strategy funds are doing the same thing, too.”

Financial crises come and go but the markets survive and hedge funds always find ways to exploit the opportunities that arise. The industry continues to mature, however; and the largest funds today boast operational management every bit as professional as the august institutions from which they draw their money. I

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HEDGE FUND REPORT

BOOM TIME FOR HEDGE FUNDS

Photograph © Kvarfordt / Dreamstime.com, supplied May 2011.

Hedge funds are putting their heads above the parapet once more. Whichever way you look at it, hedge funds investing is at record levels as the hedge funds themselves become part of the establishment. One hedge funds industry report, Hedge Fund Research, estimated global assets at $2.02trn at the end of 2010. Another, hedgefund.net, recorded $2.473trn-worth of assets, up 3.7% over the year compared with a 6.7% decline in 2009. By the end of February 2011, this had reached $2.538trn. Investors put $22bn capital into hedge funds in February—10 months earlier this figure was just $3bn. Ruth Hughes Liley reports.

SURVEY BY Bank of America Merrill Lynch (BoAML) indicated that 55% of institutional investors in the US, Europe and Asia intend to increase their direct allocations to hedge funds over the next 12 to 24 months, almost six times the amount of those expecting to redeem from the space. The survey of 107 major institutional investors also showed 46% intending to increase allocations to hedge fund managers focused on the Asia Pacific rim.

Indeed, Hedge Fund Research (HFR) opened an office in Asia earlier this year “in consideration of the increasing significance of the Asian hedge fund industry” and says investors allocated more than $3.6bn in new net capital to Asian hedge funds in the first quarter, representing more than 10% of the $32bn in new capital globally.

Explaining the reasons, Kenneth Heinz, HFR president, says: “Hedge funds have offered investors performance driven by prudent use of leverage, transparency and longterm inflation protection.”

In parallel, there has been a movement of funds into safe, segregated depositaries. Even before the financial crisis, hedge funds had accumulated around $700bn assets in cash as at August 2008 in preparation for large redemptions. The trend has continued apace over the last 18 months. Around $5trn cash and securities have poured in to BNY Mellon, for one, which has seen use of its segregated custodian services grow from $20.7trn assets under custody and administration in September 2009 to $25.5trn in May. “The main reason for this growth is because clients want to diversify their deposit risk so they are putting cash on deposit with a safe institution or converting asset classes to

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the money market,” says Staffan Ahlner, head of broker dealer services, product management, BNY Mellon. “The good thing about cash is that it is very liquid and quick to handle, but the downside is you are exposed to the institution holding the deposit and the risk that goes with it. So firms with cash balances held at Lehman Brothers, their cash went down with the bank. If they had had securities properly segregated they would have got it back. From our side we are offering independence and segregation to hedge funds, either to outright investment clients who want custody or through our service to prime brokers.” More recently Ahlner has detected a slowdown in the rate of growth, although the direction is still upward.

Adam Wallace, head of hedge fund services, JP Morgan Worldwide Securities Services, has seen a “dramatic spike” in clients looking for custody of unencumbered assets.“What was once an unusual request has become a standard request now, and the majority of prime brokers have set up their own segregated custody platform.”

“Investors have more of a say, these days,” concurs Chris Barrow, global head of sales, prime services, HSBC. “There’s a lot more scrutiny and due diligence before investors sign the cheque. It’s not just ‘tell me’, it’s ‘tell me and show me’.”

Mairead Kenny, European head of capital introductions at Bank of America Merrill Lynch (BoAML), estimates due diligence on hedge fund managers is taking much longer: “Investors had a steep learning curve in 2009 understanding counterparty risk and the nuances of prime brokerage, including rehypothecation, but most are pretty savvy now.

The biggest move among investors is increased allocations

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from institutional investors. Pension funds for example, driven by the need to diversify their overall investment portfolios and the returns from alternative investment such as hedge funds, have seen the value in alternative investments such as hedge funds. Before the crisis, funds of funds were the most important investor group, now institutional investors are more interested in investing directly in hedge funds.”

Indeed, while capital inflows are high, leverage levels are still well below their three times asset levels peak in August 2007, at around 1.5 to two times asset levels today. In part, demand has been dampened by the cost of borrowing.

Rehypothecation—where a lender such as a prime broker re-uses collateral pledged by a borrower such as a hedge fund as collateral for his own borrowing—is definitely reduced, according to Chris Barrow: “Some investors are still nervous about allowing the prime broker to rehypothecate assets. From our side at HSBC, we can hold assets in a client custody account and we can still lend you some money against those assets but we might need to charge you more depending on your appetite for rehypothecation. It’s the banks with the strong balance sheets that should be able to give hedge funds the flexibility of borrowing money with or without having to rehypothecate.”

Ahlner adds: “Rehypothecation has had a bad reputation but it is a necessity. People forget that when people rehypothecate, they get something in return and that side of the transaction is often forgotten.”

One area of growth has been Undertakings for Collective Investment in Transferable Securities (UCITS) which institutional investors in Europe have been increasingly using as “hedge fund lite” vehicles. UCITS are an investment vehicle created by the European Union which wished to promote pan-European investment for the retail community. The European Fund and Asset Management Association (EFAMA) estimates that the number of these new institutional “Newcits” tripled after the financial crisis between 2007 and 2009 to 153, and a further 99 new funds were created last year. Most (51%) are domiciled in Luxembourg, with 19% in Ireland. According to Strategic Insight, funds launched after 2007 captured nearly three-quarters of net new flows during 2010 and in September 2010, UCITS assets, including funds of funds, stood at €114bn.

BoAML recently won an award for its UCITS platform, which has 12 live funds with $2bn assets under management, and the firm says it has a strong pipeline for 2011, expecting to host up to 25 funds and double its assets under management by the end of the year.

Indeed, European regulation looks set to change the hedge funds industry in Europe as the Alternative Investment Fund Managers Directive (AIFM), MiFID II and the new capital requirements laid out by Basel III are squeezing profit margins for prime brokers and pushing up funding costs for hedge funds. It may also drive business out of Europe and AIFM has been seen by many as a political move.

France’s finance minister Christine Lagarde and Wolfgang Schauble, German finance minister, are on record as saying: “At a time when our fellow citizens call for more safety and

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Adam Wallace, head of hedge fund services, JP Morgan Worldwide Securities Services. “What was once an unusual request has become a standard request now, and the majority of prime brokers have set up their own segregated custody platform,”he says. Photograph kindly supplied by JP Morgan, May 2011.

security, including on financial markets, they would not understand if we eased marketing conditions for hedge funds. It is therefore up to each member state to decide whether to allow the active marketing of off-shore funds to their national investors.”

However, not all regulatory change is going to impact banks or hedge funds in a negative way, as John Addis, head of global markets financing, Bank of America Merrill Lynch, points out:“The pending over-the-counter mandatory clearing proposals under EMIR are an opportunity for full service banks like us to further develop their business model by providing clients with clearing related services. This is something our futures and derivatives clearing service group has actually been doing for some time.”

Nonetheless, the AIFM directive, which had its text approved by the European Parliament in November 2010, looks set to limit leverage to one times capital assets in a fund, limit investment to within Europe except under certain circumstances, and increase transparency and supervision.

“AIFM is proving to be quite a complex piece of legislation,” says Wallace.“Reverberations from the financial crisis are still being felt. Not only was there a shift in the balance of power from fund managers to the investors, but there was also an increase in regulation. One result from the increase in European and US regulation is that we are seeing more ‘global’ hedge funds setting up outposts or even fully relocating to Asia, primarily Hong Kong and Singapore.” Barrow adds: “We have already seen increased levels of corporate governance and compliance rules, and that adds to costs for hedge funds. The whole hedge fund industry is becoming more institutionalised and better regulated. Absorbing these costs is putting pressure on smaller hedge fund managers and at a time when it’s harder for them to attract investors.

That trend is going to continue and get stronger.”

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HEDGE FUND REPORT

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John Addis, head of global markets financing, Bank of America Merrill Lynch. “The pending over-the-counter mandatory clearing proposals under EMIR are an opportunity for full service banks like us to further develop their business model by providing clients with clearing related services,” he says. Photograph kindly supplied by BoAML, May 2011.

Staffan Ahlner, head of broker dealer services, product management, BNY Mellon. “From our side we are offering independence and segregation to hedge funds, either to outright investment clients who want custody or through our service to prime brokers,” he says.

Photograph kindly supplied by BNY Mellon, May 2011.

Prime brokerage still lies in the hands of investment banks, but with six banks (Goldman Sachs, Morgan Stanley, Credit Suisse, Deutsche Bank, BoAML and UBS) now doing the work that two did before the financial crisis, the share of wallet has gone down for each.“All six have committed to a programme of significant technology investment,” says Addis. “A business like this requires a meaningful infrastructure base and so it’s not something that you can build up overnight. This, combined with the financing needs of hedge funds is likely to mean those banks with far-reaching infrastructure and balance sheet resource will dominate the prime brokerage space.”

“Certainly, our services to prime brokers are becoming more tailored to suit the client,” says Ahlner. In response, BNY Mellon has developed a specific broker-dealer services desk to service the hedge funds of the large broker dealers.

Deutsche Bank was its first service offering in December 2009 and Goldman Sachs joined in June last year.

This demand for more customised service is related to what Ahlner sees as the demand for flexibility from hedge funds. “A lot of custodians have sprung up to service institutions which don’t have such a high demand for close deadlines. Over the years, as demand for more last-minute negotiation for the best deals grew up, broker-dealers have set up their own prime services to meet this different demand. We are finding we have a need not only to leverage large-scale operations, but also to be tailored enough to meet hedge fund demands.

“If you are a large-scale custodian, it helps to have scale, but doesn’t automatically tick the box to be able to service hedge funds.You need to be able to service assets close to the

market deadlines. A one-stop shop is a compelling argument for hedge funds in their selection process, but it is not the only consideration.”

Wallace says he is looking for three essential ingredients in a hedge fund client before taking them on: an institutional focus, building for success and scale on a robust platform.

“The days of two guys and a Bloomberg terminal are long gone. Second, we also want to see a unique strategy that the fund can explain to investors, and third, we want to see a clear method of marketing to investors. It’s just not possible today to wait for investors to come knocking at your door.

You have to go and find them. It’s not usually through the big bang advertising, but the smaller and more intimate road shows and capital intro events that work best. We are glad to say we are seeing more funds coming to us with very welldeveloped business plans and cover a lot of these areas that are necessary for success.”

As he sees hedge funds becoming more institutionalised, Wallace says this is partly because investors are looking for increased transparency and the elements that go along with institutionalised firms such as appointment of an independent compliance officer, top tier service providers.“The whole corporate governance area has become a lot more focused, although it is more expensive and there are increased overheads in providing an institutional structure,”says Wallace.

With hedge funds becoming more institutionalised, they may, as in the past, find a way to reinvent themselves. As Kenneth Heinz says: “The industry has evolved to suit the requirements of sophisticated investors as an integral component of their portfolio allocations as they position for growth and global inflation in 2011 and years to come.” I

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ALTERNATIVE FUND ADMINISTRATION

Photograph © Valeriy Ivkin / Dreamstime.com, supplied May 2011.

UPGRADING SERVICES IN AN AGE OF CHANGE With institutional clients still calling the shots, alternative fund administrators see increased opportunity in support of the investment management process. Larger banks have capitalised on the shift towards fully independent fund administration, capturing a new client base and expanding their hedge-fund service offering. Yet by general consensus, the current flight to quality does not necessarily guarantee a lock-on market share for the biggest providers. From Boston, David Simons reports.

EW RULES HANDED down in the US and Europe calling for more frequent and detailed reporting data could prove costly for asset managers.

Combined with a sustained shift in investment psychology, a steadily increasing number of managers in the US has moved away from compiling valuation and other essential data in-house. Outsourcing can help clients meet the demands of tougher regulatory requirements, addressing areas such as securities pricing, fund valuation and risk management. As the alternative industry becomes increasingly institutionalised, managers will be compelled to provide investors with even more accurate and timely data around the performance and operation of their holdings, which will likely accelerate the move toward external administration further still. The challenge for administrators, then, is to deliver customisable, advanced solutions in the most efficient—and cost-effective—manner possible.

Hedge funds have shown remarkable resilience over the past year, and continue to gain strength due in large part to institutional-investor demand, remarks Marina Lewin,

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managing director and head of global sales, Alternative Investment Services, BNY Mellon.“Institutional investors are still seeking absolute/relative return strategies within their portfolios—interest rates are way down, and while the equity markets have performed well over the past 18 months, investors understand that conditions can change in a hurry.

As a result, they are looking for real diversification. Anecdotally, we are hearing that they are continuing to up their allocations to alternative assets.”

The rebound in market returns, however, does not necessarily signal a reversal in investor psychology. “Large institutional players are still very much in the driver’s seat, the way it has been for some time now,” maintains Lewin.

With large institutional clients still calling the shots, the industry as a whole continues to see increased awareness around the infrastructure supporting the investment management process. In the US, in many instances investors will no longer allocate to any portfolio that still relies on in-house administration. Thus, larger banks have capitalised on the shift towards fully independent fund administration,

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ALTERNATIVE FUND ADMINISTRATION

Paul Stillabower, global head of business development for HSBC Securities Services . “If your assets are parked in this huge pool account and there’s a problem with one of the larger clients in the same account, it can affect everyone,” he says. Archive photograph FTSE Global Markets, supplied May 2011.

capturing a new client base and expanding their hedgefund service offering, says Marion Mulvey, head of alternative investments for EMEA, Citi Global Transaction Services.

“Investors are being drawn to the bigger names due to the brand visibility, large balance sheets, as well as the broad range of services that hedge funds now require,”says Mulvey.

As the client roster becomes more diverse, the product offering has followed suit and plain vanilla administration no longer passes muster. “For instance, an investor may have an Irelandregulated product and therefore needs to have the required fiduciary services, not to mention custody and banking as well,” says Mulvey. Those capable of fulfilling these types of requests will be rewarded with a bigger client roster and increased revenue stream. “Rather than look for multiple service providers, managers are finding it much easier to have a single conversation with just one organisation.”

Though not nearly as pronounced due to the ongoing focus on reducing opacity worldwide, historical differences between the alternative markets of the US and European Union (EU) are still evident, notes Elliott Brown, global product executive, hedge fund administration services, JP Morgan Worldwide Securities Services. “In Europe, thirdparty administration within the hedge-fund space has generally been mandatory for years, and in certain domiciles like Ireland and Luxembourg, there has been the need to have a fiduciary as well,”says Brown. By comparison, the US has not had the same kind of compulsory standard for third-

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party administration. “Part of this has to do with scale—it is often quite difficult to perform third-party administration duties on an enormously large hedge fund,” says Brown.

As a result, US legislators have tended to focus more on regulating instruments rather than individuals, such as the manner in which OTC derivatives are traded and cleared.

Hence, the need for administrators to utilise a single global platform capable of working within a variety of regulatory environments, says Brown. “From a technology perspective, our Dublin or European-based operational procedures are very much the same as those in the US. That way if we have a US-based fund that has to comply with European requirements, we are already able to leverage those services. The point is, you really only want to build something once.”

While third-party administration has long been standard practice in Europe, more stringent disclosure and reporting requirements continue to reduce the number of selfadministered US-based firms.“Whether or not a fund passes along these due-diligence responsibilities to a third-party administrator or performs the work themselves has been one of the main cultural differences separating the US and EU,” says James Pinnington, head of hedge funds for Misys Sophis, the UK-based global application software and services company. “For US managers, it comes down to how important it is to assume the lion’s share of responsibility in the name of ownership and control, versus dishing off to a capable third-party administrator that has been performing this kind of work for many years.”

Because they are already footing the bill for independent administration, European clients want a little more bang for the buck, says Pinnington. “For example, a number of our clients are already able to reconcile their NAV down to a few basis points, with the sophisticated intra-day valuation data at their disposal. However, recently there have been a number of clients looking towards their fund administrators with their wherewithal to handle those kinds of middleoffice duties on behalf of the client as well.”

With the pressure to disclose mounting, hedge funds the world over have attempted to provide investors with a much higher level of operational transparency—even if some have been more forthcoming than others. “Hedge funds are loath to reveal their individual positions for fear of losing their competitive advantage,”says Brown. As such, administrators must be able to provide adequate information to investors, while at the same time customising the level of disclosure to fit the individual needs of the fund manager. “Some may only want to provide basic NAV or perhaps include sector information, while others may be interested in going much further.”

In addition to offering these kinds of tailored solutions, administrators must ensure that information about derivatives and other sophisticated asset classes is web-deliverable, fully automated and as straight through as possible, adds Brown.“The fact that third-party providers now have much more responsibility, particularly with regard to the pricing of securities, is indicative of the higher degree of regulatory oversight worldwide.”

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ALTERNATIVE FUND ADMINISTRATION

Key acquisitions have been a large part of State Street’s alternative-services growth strategy for the better part of a decade. The Boston-based company jumped head first into the arena with the 2002 purchase of International Fund Services (IFS), a provider of fund accounting and administration services for the alternative industry. In 2007 the bank bought hedge-fund administrator Investors Financial Services Corp, following by the acquisition of Palmeri Fund Administrators (PFA), a New Jersey-based provider to the private equity industry. Early last year, State Street acquired offshore administration leader Mourant International Finance Administration.

Not surprisingly, State Street has been well equipped to respond to the surge in requests for transparency reporting across all strategies, says Patrick Hayes, senior managing director and head of hedge fund operations for State Street’s IFS division in Ireland.“From a back-office perspective, everything has really revolved around investors wanting more information related to the types of positions held by the fund and they want to be secure in the knowledge that pricing and reconciliation are being independently supported.”

Hayes agrees that the trend toward increased disclosure was a tougher sell at the outset for most hedge-fund shops that were normally accustomed to operating in a more opaque manner. “A balance now appears to have been struck between the investor demands and the hedge fund manager’s appetite to provide levels of transparency on their fund, without giving away the secret sauce. We understand that this is a very bespoke industry and one size does not fit all which is why we have developed a wide range of transparency reporting at State Street to satisfy the disclosure requirements for both investors and hedge fund managers.”

Best-in-breed provider According to Hayes, any manager charged with overseeing a fund with a large proportion of institutional investors has likely felt the pressure to direct administration services to a reputable global provider, rather than a smaller niche provider. “A client changing or selecting an administrator needs to be confident that investors will support the move.

Clients that have migrated onto our platform post the 2008 crisis have received a resounding seal of approval from their investors that they have a best-in-breed provider administering their fund,” he says, adding: “Over the last few years, hedge fund managers have been forced to listen to the voice of the investor more and act accordingly. That kind of scenario has really been a key driver behind this whole flight to bestin-breed administration during the last few years.”

Middle-office servicing remains brisk business as managers assess operational costs and subsequently slough off an increasing number of duties in an effort to boost the bottom line. “This trend has been particularly prominent among newer fund launches, which are often quite keen to outsource the entire middle office right from the get-go,” adds Mulvey of Citi. In many instances, middle-office outsourcing has already existed on the traditional side for many

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Marion Mulvey, head of alternative investments for EMEA, Citi Global Transaction Services. “Investors are being drawn to the bigger names due to the brand visibility, large balance sheets, as well as the broad range of services that hedge funds now require,” says Mulvey.

Photograph kindly supplied by Citi, May 2011.

years, giving players such as Citi a leg-up.“It really isn’t that big a leap to extend the same services to those in the hedgefund space, albeit incorporating specific technologies and capabilities required for administering complex strategies,” says Mulvey.

One of the key bellwethers of the new transparency era is the increase in demand for managed or segregated hedgefund accounts. Widely available since the 1990s, managed accounts have seen a surge in popularity due to the many benefits they offer, “such as access to liquidity and ownership of assets,”affirms Joanne Job, Moody’s analyst and author of the report Hedge Funds: Investing Through Managed Accounts.

“The financial crisis, coupled with many hedge funds imposing liquidity restrictions, prompted investors to look for fund offerings that gave them more control over their investments and managed accounts filled this market need.”

Since 2004, managed-account usage has nearly tripled; according to a recent report, some 85% of hedge-fund managers have seen an increase in requests for managedaccount structures. As of last year, estimates put managedaccount AUM in the vicinity of $41bn.

“If your assets are parked in this huge pool account and there’s a problem with one of the larger clients in the same account, it can affect everyone,”says Paul Stillabower, global head of business development for HSBC Securities Services in London. “Values may be falling, and yet because of the inability to quickly reconcile whose assets belong to whom, you could get stuck being unable to trade. As a result, clients are asking that their investments be segregated, not only from the pool of proprietary assets, but also from assets of the other clients.”

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Patrick Hayes, senior managing director and head of hedge fund operations for State Street’s IFS division in Ireland. “A balance now appears to have been struck between the investor demands and the hedge fund manager’s appetite to provide levels of transparency on their fund,” he says. Photograph kindly supplied by State Street, May 2011.

Managed accounts continue to gain traction among institutional investors that have flocked to hedge funds as an asset class, says Ron Tannenbaum, co-founder of GlobeOp Financial Services, a provider of business-process outsourcing, financial technology services and analytics to the buy side.

“Particularly as pension plans and insurance companies seek direct access to the hedge-fund sector, we’ve seen an increase in the need to keep assets segregated, which, as a concept, is very much in keeping with traditional asset management.”

Pre-crisis, many managers avoided putting managed accounts on the menu for investors due to the enormous amount of work involved in maintaining a segregated portfolio.“Madoff, however, pushed the institutional investor trend for managed accounts forward dramatically,”says Tannenbaum. Since that time, the need for investors to retain direct ownership of their portfolio assets, as opposed to having them pooled in a fund, has in effect made the offer of segregated accounts a bestpractice requirement for the hedge-fund community. “The power has shifted to the investor and their requirement for segregated accounts, and as a result, today nearly every manager in the world is taking on managed accounts in one way, shape or form,”says Tannenbaum.

Since 2009, managed accounts have come to represent a major engine of growth for GlobeOp. “In order to take on a managed account, fund managers require a bifurcated allocation process covering two separate pools of capital,” says Tannenbaum. “In many cases investors will hire us to handle both the segregated account and the administration of the entire platform for the group of accounts. GlobeOp is able to provide services to the fund manager to maintain the independent account and the investor also to administer the

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investment platform under the same umbrella and this has been great for us.”

Like many of her colleagues, BNY Mellon’s Lewin has witnessed a sharp increase in managed-account activity, including technologies and service capabilities in support of this kind of framework.“For the longest time it was mainly dialogue, but over the last half year in particular there has been real movement in that direction, as investors seek even greater control by keeping their assets segregated,” says Lewin.“It will be interesting to see how managed accounts evolve over the near term; all indications are that the growth trend could be quite significant.”

Though managed-account platforms may be able to provide transparency, “I think the industry has realised that the increased liquidity argument was always something of a myth,” says Chris Adams, head of alternative product management, BNP Paribas Securities Services. “If the assets within a given structure are illiquid, it really doesn’t matter what platform is used to service the assets—selling them or obtaining liquidity to acquire them is always going to be a challenge. Therefore I think what we have really seen is a convergence between managed account platforms and so-called traditional asset-servicing platforms as leading providers’ capabilities have become ever more sophisticated.”

The imposition of new regulatory structures has made administrators increasingly aware of their liabilities within the alternatives space, says Mike Hughes, head of alternative fund services for EMEA and Asia, Deutsche Bank, compelling them to become much more hands-on with day-today processes. Such has been the case with AIFMD, which makes the fiduciary depository or custodian more accountable for the safeguard of assets.

Regulation in the pipeline “In reality, that liability has always been implicit, even before AIFM,” says Hughes. “The regulation simply puts the letter of the law behind it, and also clarifies the type of responsibilities involved.” Packaging more of the value chain into a single, legal-entity product offering is the most efficient way for providers to stay on top of these fiduciary tasks, he says.

Meanwhile, tougher tax laws, including proposed legislation around the Foreign Account Tax Compliance Act (FACTA), remain one of the single-biggest factors in the move toward external fund administration. Hughes maintains: “The complexity of this kind of legislation is something that all managers must reckon with, particularly those in the US who are looking to invest in different parts of the world and therefore will have to account for numerous tax-withholding calculations. While these managers could conceivably retain a number of different people to handle those tasks on a case-by-case basis, the fact is that there are skilled administrators like ourselves who are already working hard to develop the systems, models and interfaces needed to properly capture that kind of data.”

Regimes such as AIFMD and Dodd-Frank will gradually change the nature of the business over the next 12 to 18 months, concurs Ian Headon, senior product manager for

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ALTERNATIVE FUND ADMINISTRATION

Ron Tannenbaum, co-founder of GlobeOp Financial Services. “The power has shifted to the investor and their requirement for segregated accounts, and as a result, today nearly every manager in the world is taking on managed accounts in one way, shape or form,” says Tannenbaum. Photograph kindly supplied by GlobeOp Financial Services, May 2011.

alternative asset servicing at Northern Trust.“Still, managers are nimble and they do not have to make any decisions just yet,” he says. “For the time being, improving performance and distribution are at the top of most managers’ agenda, and of course addressing transparency remains a priority issue, as it helps attract and retain institutional investors.”

Even so, the bank continues to be mindful of the bottom line. To that end, Northern Trust has transformed its fund of hedge fund capability from a monthly process to a daily realtime delivery and is continuing to develop its Hedge Fund Monitor tools to align to client needs. “Our clients’ route to market has become much more complex as they increasingly use structured products,”adds Headon. “Accordingly, we are spending more time examining these structures to be sure that they are regulatory compliant, including using scenario tests to determine what could happen should an unforeseen event arise.”

Despite the numerous rule changes affecting the industry, Adams sees many of the same attributes in place that have historically been required by clients.“These include the right kind of products, knowledge and capability of staff, robust systems and reporting capabilities,” says Adams. “Over the period since the start of the financial crisis, balance sheet strength, credit rating and asset protection structures have become evermore important as counterparty exposure across the entire spectrum of service providers has been vital.”

Ultimately, says Adams, the core of any good administration offering is fund accounting. “The maintenance of the books and records of the fund is the foundation on which

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everything else is built. Even as we emerge from the crisis and clients are demanding evermore sophisticated middle office, collateral management, and risk-reporting services, it is the sophistication and robustness of the underlying accounting capabilities that defines success.”

New capital-adequacy requirements included within the likes of Alternative Investment Fund Managers Directive (AIFMD), Global Investment Performance Standards (GIPs) and other regulatory initiatives will likely serve as a winnowing mechanism, forcing those with balance-sheet problems to either beef up or bow out. “This will most likely lead to a bottom-up type of consolidation within the alternative space,” says Stillabower. “In the aftermath of the financial crisis, investors are looking more closely at the size of the company—because if you’re very small and there’s an unexpected valuation blow-up, how are you going to foot the bill? Those are the kinds of scenarios that are ultimately pushing everything toward the well-capitalised firms.”

To date, the principal beneficiaries within the fund-administration space have been large, well capitalised organisations with diversified business models, which has enabled them to continue to invest in their services whilst leveraging expertise across their asset management and investment banking businesses to the benefit of their third-party clients.

Given the insatiable appetite for derivatives and other alphagenerating products, administrators must have the wherewithal to provide institutional players with accurate and efficient pricing data on a full-time basis, says Stillabower.

“Again, this benefits larger providers that have capitalmarkets divisions already valuing these kinds of instruments on a daily basis. Having that kind of expertise is far more attractive than simply taking on a few more fund accountants and/or pricing feeds.”

Flight to quality Given the increased complexity of working with various asset classes, can fund administrators hope to meet all of a fund manager’s reporting and compliance needs while simultaneously keeping a lid on costs? “The successful ones will have to,”maintains Adams.“The key to managing costs will be to mutualise the investments across as broad a scope of ‘traditional’ and ‘alternative’ assets as possible. There is no cheap solution, and the investments required will drive further consolidation in the industry.”

Yet the flight to quality does not necessarily guarantee a lock-on market share for the largest providers, says Adams, who believes that quality of the services provided is just as important. “A pre-existing relationship always helps, assuming of course that it is a positive one.”

Lewin agrees. On paper, the various regulatory obstacles and entry requirements should narrow the field of both managers and service providers, she says. “However, we’ve heard this line of reasoning before—and yet all along there have been many opportunities for good niche companies to stay involved.

While the barriers to entry may have become even more pronounced, we still should not underestimate the innovation that these administration specialists have to offer.”I

JUNE 2011 • FTSE GLOBAL MARKETS

CANADIAN TRADING

CANADIAN REGULATORS RULE—AND ROIL

Photograph © Melissad10 / Dreamstime.com, supplied May 2011.

Canada is blasting its own new path through the mountain of regulation that covers the financial services industry. The CSA in April asked for comment on a proposal that dealers offering sponsored access should take responsibility for risk controls. The transparency of the Canadian market will suffer if Canada adopts the SEC approach to this issue. However, some industry insiders argue that the CSA should consider the implications of unintended consequences if the rule is adopted. For instance, as drafted, one exception does not extend to US-registered broker-dealers. The progress and success of the trading revolution that has muddied the Canadian markets for the past few years is now down to the regulator. Neil O’Hara reports.

NVESTORS WHO USE sponsored access in Canada have always had to pass their order flow through a risk filter before it gets to market. Most high-frequency trading firms operating in Canada rely on their own systems to satisfy the requirement, but that may no longer suffice. In April, the Canadian Securities Administrators (CSA), an industry regulator, published for comment a proposed rule that requires dealers who offer sponsored access to take responsibility for risk controls on that flow. The approach is similar to a Securities and Exchange Commission (SEC) rule adopted last November—but not identical. Canada has once again blazed its own trail, albeit with a strong nod to its southern neighbour.

The debate over the merits of high-frequency trading has been unusually rancorous in Canada. While CIBC embraced the concept early on and built a sponsored access platform designed to accommodate high-frequency trading firms, the other four big banks held back. Scotia Capital, for example, does not offer sponsored access to its clients as a matter of principle. “We have taken a conservative approach as to whom we allow to interact under our broker number,” says Evan Young, the firm’s head of direct access and electronic trading. “We want to make sure the flow is not going to create unintended consequences for our clients.”

Scotia is leery of electronic market-makers who make their money primarily from rebates offered by the trading venues to liquidity providers. In effect, the rebate enables these firms to skim a profit off trades that would take place between the ultimate buyer and seller anyway, without intermediation.

“There is not much value added to the market in that case and we believe that this trading has in fact led to higher execution costs for many participants,” says Young It’s low-margin business that is only economic for the broker on a large scale, which is precisely what CIBC has. The “vast majority”of CIBC’s sponsored access clients in Canada are US entities already registered as broker-dealers who

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FTSE GLOBAL MARKETS • JUNE 2011

develop their own risk management controls, according to Thomas Kalafatis, head of Prime Services at CIBC. The wording of the proposed CSA rule considers the allocation of risk controls between two investment dealers if the order flow comes from another dealer that “may be in a better position to manage the risks associated with its trading because of its proximity to and knowledge of its clients.”As drafted, the proposal does not consider exemptions for US registered broker-dealers. However, Kalafatis argues that it should. “The regulators need to think about unintended consequences,”he says. “We would ask them to recognise dealers registered with the SEC, FINRA or other jurisdictions as dealers under the new rule,” he adds.

The idea is not without merit because risk management skills at high-frequency trading firms typically exceed those of even the most sophisticated securities houses. CIBC believes its US broker-dealer clients will not have to change the way they operate if they get a pass under the rule. If they don’t, they will have to run their orders through a broker or third-party filter, preferably one with the lowest possible latency—a nuisance, perhaps, but not fatal to any but the most latency-sensitive strategies. It remains to be seen whether the requirement will spark an exodus of highfrequency trading firms from Canada that could threaten the liquidity so essential to an orderly market.

The new CSA rule may not induce CIBC’s peers to set up competing sponsored access platforms either. Rather than fighting for a share of this high-volume, low-margin business, brokers could seize the opportunity to help their traditional clients avoid toxic order flow. “Institutional customers need to minimize transaction costs and information leakage,” says Laurie Berke, a principal at TABB Group, a capital markets research and consulting firm based in New York and London. “Who has the analytics, the smart order routers and algorithms that enable buy side traders to cope with high-frequency trading flow?”

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CANADIAN TRADING

Thomas Kalafatis, head of Prime Services at CIBC. Photograph kindly supplied by CIBC, May 2011.

Evan Young, head of direct access and electronic trading, Scotia Capital. Photograph kindly supplied by Scotia Capital, May 2011.

High-frequency trading firms that want to avoid a second risk filter could do so if they register as broker-dealers in Canada. Richard Carleton, who is responsible for the operations, technology and sales at Pure Trading, believes many will choose that path. “Instead of sponsored access clients, they would become co-located dealers,” he says. “Even a run-of-the-mill high-frequency trading firm has a very high standard of risk management expertise. The regulators shouldn’t have any concerns about that.”

Canadian securities regulations are principles-based and therefore less prescriptive than their US counterparts. Dealers that offer sponsored access will have some flexibility over how they implement what the CSA rule calls “policies and procedures to ensure adequate risk management controls are in place”. Under the SEC rule, screening must occur either at the sponsoring broker-dealer or at the trading venue, and while those solutions would qualify in Canada they are not the only options. “The filter could be a component of the sponsored access infrastructure at the client,” says Carleton. “It doesn’t have to reside at a dealer facility remote from the data centre where the market is located.”

Pure Trading, Canada’s first alternative trading system, was designed from the outset to accommodate the needs of high-frequency trading firms. It languished in the early years, accounting for less than 1% of trading volume. In the past 12 months, however, its share of trades in the S&P TSX Composite has soared to 4.40%, according to Fidessa’s Fragmentation Index and Fragulator as of May 6th 2011. Chi-X comes in at 12.08%, the third largest trading venue after the Toronto Stock Exchange (59.21%) and Alpha (18.93%).

Carleton says Pure has worked its way up the smart order routing tables through aggressive pricing. It has also attracted new liquidity providers because its average order size tends to be larger than at competing venues. “Users can lower their direct trading costs, but larger orders also reduce the number of tickets—a much bigger component of execution costs,” says Carleton.

Ticket costs have soared in every market where order flow has fragmented, and Canada is no exception. In the US, the brokers fought back by creating dark pools designed to cross as many trades as possible among the firm’s own customer base before sending orders out to external trading venues.

The public markets don’t see the liquidity that trades in dark pools, which tends to impair price discovery. Canada

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Richard Carleton, head of operations, technology and sales at Pure Trading. Photograph kindly supplied by Pure Trading, May 2011.

has never permitted exclusive broker-owned dark pools, however, as they must allow fair access. It relies instead on a broker preference order priority, which allows a broker to leapfrog over orders that have time priority (i.e. entered earlier) if it has the other side of a trade. Brokers can still internalise liquidity, but the order flow is visible.

The brokers would like to take internalisation to the next level through dark pools and it appears that Canadian regulators are now willing to let them. They recently approved the Alpha IntraSpread trading facility, which will offer dark execution of orders that provide price improvement over the national best bid and offer (NBBO). Goldman Sachs has applied for permission to launch Sigma X Canada, a similar dark pool, and Carleton expects Credit Suisse to follow suit with its Advanced Execution Services product. “It’s a logical response to the cost of execution in the public capital markets,” he says.

“We have to come up with a way to address those costs.”

Scotia acknowledges the cost pressures on brokers, but Young remains ambivalent about broker dark pools. The transparency of the Canadian market will suffer if Canada adopts the US model—but if no internalisation takes place, high-frequency trading firms have more opportunities to intermediate trades a broker could have crossed as a natural match. “Maker-taker pricing of liquidity and a protected order book create a perfect storm for high-frequency intermediation,” says Young. “Internalisation dark pools help to control costs and may ultimately prove necessary given our market structure, but we are concerned about their potential impact on price discovery.”

Dark pools in Canada still have to beat the NBBO price, sparking a debate about what constitutes meaningful price improvement. If regulators permit improvement of less than the minimum tick size, the public markets cannot compete and will lose market share to dark pools. On the other hand, a minimum tick threshold would prevent liquidity in names that already trade at the minimum spread on the public markets—typically the most liquid stocks—from ever migrating to dark pools. “We should be operating on the same tick rule as our friends who operate in the dark,” says Carleton. “It would be extraordinarily positive for the public markets if that is what happens.”

The future track of the trading revolution that has roiled the Canadian markets for the past three years lies in the regulators’ hands. I

JUNE 2011 • FTSE GLOBAL MARKETS

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BLOCK TRADING

Photograph © Mopic / Dreamstime.com, May 2011.

Block trading is a paradox. On the one hand it has never been more in demand. On the other, it has become much harder to carry out. Traders want to trade but they fear disclosing their hand. Following the US Flash Crash in May 2010, and its subsequent volatility together with falling volumes, the liquidity needed for block trading has been hard to find. Ruth Hughes Liley reports on the main trends.

BLOCK TRADING STRAIN SPURS INNOVATION OU WANT TO cross with as much anonymity as possible, says Frédéric Ponzo, managing partner, Greyspark Partners, but he adds: “It also needs to be fair and open to enough people. How many people do you share your intention with so you can get enough interest to get a fair price? Share with too many people and your order will create adverse market impact.” There is also the question of how to define a block: traditionally and in the US, it is defined as a deal of more than 10,000 shares. Ponzo adds: “Ten thousand shares sold in BT would not be significant, but 10,000 shares sold in a small stock on the Alternative Investment Market (AIM) could be proportionally massive.”

Richard Balarkas, chief executive officer, Instinet Europe, prefers to talk about problematic trades. “The majority of institutional trades are problematic in some way, usually as a result of their size. When a fund manager revises stock or sector weightings, the aggregated order is typically very large.”

Definitions aside, demand for block trading is at a record high. Liquidnet Europe, the buy side-led block trading venue, set a new quarterly record in the first quarter (Q1) 2011, rising 13% year-over-year in principle traded at $22.9bn or roughly $364.6m in principle traded daily. It was a similar story in Asia in Q1, where principle traded on Liquidnet Asia reached a record, rising 32% year-over-year to $4.95bn. In the US, Liquidnet saw a 19% rise in average daily volume (ADV) over the previous quarter. Liquidnet’s average daily executed trade size is $1.5m.

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Vlad Khandros, Liquidnet’s head of corporate strategy, says: “The buy side clearly has an appetite to trade blocks and is trying to increase performance for their funds. In Europe, you have many venues trying to gain critical mass.

But they are so focused on volume, volume, volume, and not focused on the quality of the liquidity and let everyone into the pool. So you end up cutting up trades which may not be advantageous for traders.”

Block trading models vary from Liquidnet’s buy side-led approach to Citigroup’s broker-crossing network, Citi Match, which launched in Europe in April 2009. In Q1 2011, it reported executing €22.8bn worth of trades, up by 90% over the same period last year from €12bn.

New electronic ways All this activity has spawned new electronic ways to trade blocks. In February 2011, Goldman Sachs Electronic Trading launched BlockStrike, a strategy to help clients search for block liquidity in dark pools while also using algorithms to work the order. The strategy uses algorithms to seek execution through “opportunistic”dark posting or it converts dark posting to block-only dark posting. At the same time, BlockStrike places a contingent order with a block-sized minimum execution in Goldman Sachs’ non-displayed ATS, Sigma X. In February, Sigma X reported an average of 125m shares crossed each day, of which more than 13% were in blocks. “In the past, traders had to decide whether to commit

JUNE 2011 • FTSE GLOBAL MARKETS

BLOCK TRADING

Vlad Khandros, Liquidnet’s head of corporate strategy. “In Europe, you have many venues trying to gain critical mass. But they are so focused on volume, volume, volume, and not focused on the quality of the liquidity and let everyone into the pool. So you end up cutting up trades which may not be advantageous for traders,” he says. Photograph kindly supplied by Liquidnet, May 2011.

their order to an algorithm or try to negotiate a block in a dark pool,”says Greg Tusar, managing director and co-head of Goldman Sachs electronic trading. “Clients now have the ability to accomplish both simultaneously, and all they have to do is to check a box.”

Meanwhile, in May, the trading system Pipeline was launching a new MTF platform in its 14 European markets, targeting a client base of around 150 firms. Added to its Alpha Pro and Algorithm Switching Engine technology, Block Board will enable clients to match and trade larger orders electronically while the engine can make predictions about the performance of other venues and pools and switch execution tactics accordingly. “Accepting orders of a minimum of 0.5% average daily volume of a stock into Block Board will prevent pinging,” says Marcus Hooper, executive director of Pipeline.

Hooper, who spent 17 years working on the buy side, has detected a backlash to the practice of fragmenting a large order into the public market place and believes buy side clients are changing their behaviour: “When you fragment orders into the market by using an algorithm that does not use predictive switching, it will create a pattern that will enable people to detect the order.”

BLOCK TRADING: STILL AN IMPORTANT PART OF THE TOOLKIT Demand for capital and the ability to trade on block remain as important to the buy side trader now as it was pre-crisis. Over the past three years, there have been significant changes to the types of flows generated by our clients, ranging from the shift from high touch to low touch and the increased use of Delta 1 products such as ETFs as a means to speculate or to hedge. By Mark Rice, global head of sales trading, and Andrew Parrish, head of client facilitation, at Société Générale Investment Bank.

RAGMENTATION HAS MADE the search for liquidity a constant battle. While all traders now have an abundance of tools in their armoury to allow them to sweep both dark and lit trading venues, the fact remains that an increasing percentage of daily turnover of high-frequency trading (HFT) and the rise in gaming of the pool means that finding genuine, actionable liquidity is more challenging than ever.

In general, the quality of indications of interest (IOIs) remains questionable and, despite industry

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attempts to self-police, as well as regulator involvement in some regions, many still believe they are perhaps a fishing exercise rather than industrialised trawling. The consequence of all of this structural change has meant that block trading has returned to the fore.

Client behaviour changed as commission pools contracted and it became apparent that commission payment was becoming more concentrated with sell side firms that provide services across the entire investment process, leading to the

peripheral brokers becoming marginalised. As market conditions stabilised post-crisis, the risk component of a trade (risk ratios) fell around 40% from mid-2008 to mid2009 as clients focused on retained revenues rather than gross commissions. During this period, average risk trade sizes halved and the number of requests declined. At the same time, the exchanged-traded fund (ETF) risk business grew substantially, both as a result of a more defensive environment as well as the growth of the product.

Since the end of 2009, we have observed the return of the stock picker but by now fragmentation has also started to take hold. Risk is on the increase again, and from 2010 onwards, risk ratios have returned to pre-crisis levels as traders continue to seek liquidity. Some of this may be the result of the lack of a consolidated tape, driving people to implementation shortfall as a benchmark rather than a volume-weighted average price (VWAP) or volume-derived measure. However, the renewed

JUNE 2011 • FTSE GLOBAL MARKETS

So Block Board uses a series of indicators—orange, yellow and black—to identify the status of liquidity in the Pipeline pool. Hooper explains: “It’s not electronic negotiation because when a match occurs, it trades instantly. The indicators also make the process more transparent, and regulators are in favour of transparency. If you make orders transparent in the right way there is a commercial advantage to doing it. Our view is ‘we can’t tell you everything, but we also won’t tell you nothing’. Saying nothing doesn’t help traders to get a match.”

Completing a large block trade quickly at a good price and without leaking information is the Holy Grail, says Balarkas: “Institutional orders are characteristically very large compared to the market, and fund managers are faced with a number of risks they have to balance. A fund may approach a friendly investment bank for a price on a block in the hope the trade will be done immediately, but if they can’t agree a price, the fund manager has just opened his hand to the bank and the cat is out of the bag. On the other hand the fund manager may be ultra-conservative and not want to risk any information leakage, in which case the order could be left in a buy side-only dark pool, with the risk

competitiveness of the cost of capital is equally significant in this trend, as the sell side tries to consolidate flow on their platform. Increasingly, the sell side has had to view their flow business as one platform rather than simply concentrating on a high touch, portfolio trading or an Algo/DMA model, and they must provide client value in the access to liquidity across the platform rather than focusing on one particular function.

Internalising flow is a key component to the success of any leading sell side cash and execution player. Centralising liquidity generated from derivatives, portfolio risk and agency, Delta 1, high touch and low touch cash into one pool provides clients with liquidity that is actionable and meaningful. This can lead to an increase in the value of flow to the platform, which in effect subsidises some parts of the business to the benefits of others.

Most clients agree that portfolio trading risk and electronic agency transactions are priced very aggressively compared to any stand-

FTSE GLOBAL MARKETS • JUNE 2011

that you sit in the dark on your own for days getting very little if anything done. In between these two extremes there’s a wide range of options.”

Indeed, people are searching for different ways to trade blocks. One is the practice of brokers searching each others’ dark pools to execute blocks more quickly. Instinet recently signed deals with up to seven investment banks, including Morgan Stanley, Credit Suisse, ITG and Nomura, to connect to their dark pools through an updated version of its Nighthawk algorithm, Nighthawk Plus. Instinet clients can now aggregate their fills into one ticket and save on the operational costs compared with the higher alternative costs of several “child” orders with different brokers.

Options and choice widening Balarkas wants to see dark trading becoming multiples of lit book trading. “When people talk about ‘block trading’ everyone thinks about executed volume. However, there is so much more business that doesn’t get done, that doesn’t even leave the fund manager’s blotter, because it’s too big for the market to accommodate. This latent liquidity pool that sits behind what is really traded is enormous and if it could

Mark Rice, global head of sales trading, and Andrew Parrish, head of client facilitation, at Société Générale Investment Bank. Photographs kindly supplied by Société Générale, May 2011.

alone, fair value model and question whether they can be profitable.

However, when the value of this flow is taken into account while looking at the liquidity that it adds to a sell side firms’ internal pools and its high-touch risk management, it makes the price (whilst still extremely competitive) somewhat more understandable.

Those firms still running separate silos will ultimately be sub-scale and not meaningful enough to attract the incremental flow to cover the cost of building infrastructure to achieve the efficiencies necessary to become an important counterpart.

Our experience suggests that, despite the dramatic change in market structure, regulatory change and the investment in technology, to function efficiently the markets still need capital to smooth out volatility and transfer risk for short time frames.

As a sell side firm, we have had to invest significantly in technology, but, just as importantly, across all areas of our execution platform, including flow and structured businesses, to enable us to provide natural liquidity from all flow venues, and efficiently price risk while also making optimum use of the balance sheet.

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be tapped into through one virtual dark pool, the upside for all market participants is huge.”

While the majority of block trades are either executed by cash desks or in dark pools, the options and choice of where to trade are widening. The launch of Credit Suisse’s Light Pool in the US this year is one such example. A lit electronic crossing network (ECN), it discourages opportunistic traders by forcing them to access the liquidity for trade-through purposes via another venue. “This simple act of slowing the trade down makes it unique,”says Chris Marsh, a managing director at Credit Suisse. “But we also have stripped it of other functionality, such as providing specific market data, which HFTs may take advantage of. It’s the ‘less-is-more’ theory. You are giving out less information and it’s safer.

Third, we are scoring our clients into ‘contributory’, ‘neutral’ and ‘opportunistic’. On our dark pool, Crossfinder, there is a choice to interact with any of these, but in the Light Pool, the ‘opportunistic’ trader would be kicked out.”

While the Light Pool was not specifically built for block trades, it is expected to be beneficial for longer-term, more traditional traders looking to execute larger trades. The alternative, more traditional method of using a sell side cash desk which might involve risk pricing can be expensive, as banks may be more risk averse than they were before the financial crisis. Balarkas says: “As the buy side does more of its own trading, taking on simpler trades and paying lower commission rates through direct market access (DMA) and algos, when the bulge bracket do get asked to commit capital, it is for increasingly riskier orders, and the profitability of clients asking for capital becomes more volatile. When it comes to trading out of a risk position it doesn’t help the bulge bracket that market volumes remain depressed. Nor does it help that regulators are looking to shorten the length of time that banks have to trade out of the position before having to publish the block trade they took onto their books.”

Chris Marsh, a managing director at Credit Suisse. “We are scoring our clients into ‘contributory’, ‘neutral’ and ‘opportunistic’. On our dark pool, Crossfinder, there is a choice to interact with any of these, but in the Light Pool, the ‘opportunistic’ trader would be kicked out,” he says.

Photograph kindly supplied by Credit Suisse, May 2011.

Decline in gaming Volumes, too, have a bearing on the risk inherent in block trades. In the US, cash equity volumes on NYSE Euronext fell 30% between April 2010 and April 2011. So a trade that was a particular percentage of ADV in April 2010 would have constituted a higher percentage of ADV in April 2011 and therefore carried more risk.

The industry is waiting to hear how block trading in Europe will change under MiFID II regulation, later this year. Possible legislation may require public display of stub orders—the small part left after the majority of a block has been executed; enforcement of pre-trade transparency for actionable indications of interest (IOIs); and a minimum size threshold for dark pools using the reference price waiver.

An IOI should give some indication to the market place that a buyer or seller exists in a particular stock. However, they are reportedly used by unscrupulous traders to identify the existence of large blocks and use the information to gain a price advantage. Greyspark’s Ponzo believes they will fall into disuse over the next five years: “You will end up with block orders on dark pools and regulated orders on

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Marcus Hooper, executive director of Pipeline. “When you fragment orders into the market by using an algorithm that does not use predictive switching, it will create a pattern that will enable people to detect the order,” he says. Photograph kindly supplied by Pipeline, May 2011.

organised trading facilities. It is a question of ‘when does an actionable IOI become an order?’ If you have a situation where an actionable IOI becomes an order, then those IOIs will be traded and you will be left with IOIs which are genuine, but not actionable. If the only use of these IOIs is for gaming, then why bother with them?”

Ponzo is also concerned that visible stub orders will open up the market for gaming. “You put in your block and partially execute. As long as an order is beyond a certain threshold, you

JUNE 2011 • FTSE GLOBAL MARKETS

the US many years to learn took fewer for Europe and even fewer for Asia. So in Asia, they already see a need for a consolidated tape, limits, good post-trade data and the right regulatory framework.

“In Europe, lack of consolidated data makes it harder for the buy side and we have been working on MiFID II for a printing hierarchy with a very explicit set of rules setting out accurate data. The buy side needs the flexibility to source liquidity because they are trading on behalf of millions of households and pension funds. It is important to get this right because you need to be confident that the trade price you are seeing is accurate,”adds Khandros.

Exchanges in the space

Frédéric Ponzo, managing partner, Greyspark Partners. “Ten thousand shares sold in BT would not be significant, but 10,000 shares sold in a small stock on the Alternative Investment Market could be proportionally massive,” he says. Photograph kindly supplied by Greyspark Partners, May 2011.

can create another block order. However, if you are left with a stub order below the threshold, this is a grey area. Seen on the open market you could reconstruct a larger order and work out that it was a slice of a bigger order.”

Nonetheless, Ponzo has detected a decline in the amount of gaming in recent months and sees a cycle at work: “First you have new market, event or regulation; then it is exploited; then the cracks are filled and practices put in place to deal with the exploitation; then you have a mature market. Early on in MiFID, there were plenty of cracks and opportunities to arbitrage. The better the participants get at spotting the cracks, the harder it is to fall through.”

When Liquidnet moved into the new markets of Asia in 2007, its first block trade was between a Hong Kong member and a US member, trading a Japanese stock. Khandros believes that Asia is in a fortunate position. “Electronic trading happened first in the US and the lessons that took

The past two years have seen exchanges move into the block trading space and in January this year Liquidnet agreed to work together with the SIX Swiss Exchange, allowing each others’ members access to liquidity on the two platforms from Q2 2011. “This is a great opportunity for Liquidnet as exchanges haven’t really succeeded in the block offering even though they do a good job at aggregating order flow,” says Khandros.

In June 2010, the Australian Stock Exchange (ASX) launched block exchange VolumeMatch with 23 participants and by December 2010 had conducted AUD5bn-worth of trade. Prices are taken from the main ASX market and there is a minimum order size of AUD1m.

Peter Hiom, ASX deputy chief executive officer, admitted during an analyst briefing in February 2011 he was disappointed at the number of transactions but not discouraged.

He adds: “I think we didn’t underestimate the challenge of what we are taking on here, which is to try and provide a liquidity platform for large order execution that some market participants will use if it is liquid and other market participants will try and do everything they can to stop it working.

We continue to work with a number of participants on connectivity to that platform and I think we are confident in the longer term that whether it is in its current form, or in a modified form, ASX is going to participate in the space of large order execution.” I

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FTSE GLOBAL MARKETS • JUNE 2011

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SECURITIES SERVICES

Having slipped off the map in the wake of the financial crisis, investors are carefully treading back to Central and Eastern Europe. The economic prospects look brighter for a core group of countries and asset servicing firms are already there to welcome back existing clients as well as new entrants. So far, custody is the service most in demand but this is changing as markets evolve and develop in line with their Western Europe counterparts.

Lynn Strongin Dodds reports.

MIXED FORTUNES FOR INVESTORS IN THE CEE S A WHOLE, the Central and Eastern Europe (CEE) region, hard hit by the economic downturn, is thought to have turned the corner. The European Bank for Reconstruction and Development (EBRD) predicts an aggregated regional growth rate of 4.29% for this year.

Even so, individual countries such as Poland, the Czech Republic, Hungary and Slovakia are faring better than others due to the rebound in the German export market. Some, including Russia and the Ukraine, are benefiting from high oil and commodity prices although their market infrastructures continue to lag those in the European Union camp.

Many of these countries, particularly Russia, which is part of the exclusive BRIC club, as well as Poland and the Czech Republic, have also enjoyed record inflows as part of the general stampede into emerging markets. Actually, investment traffic has been two way; with local investors venturing outside their home markets for investment opportunities at a healthy clip.

Although the CEE’s prospects look promising, market watchers believe that it is important to take a country-bycountry approach. Chris Porter, regional executive for Central and Southern Europe at BNY Mellon Asset Servicing, notes: “Many people lump the region together but the individual markets have all gone through their own trajectory. It is a heterogeneous region which has been underscored by the different experiences each country has undergone during and after the financial crisis.”

Satvinder Singh, EMEA head of direct custody and clearing global transaction Services, Citi, agrees, adding:“There are significant differences and developments within the region.

Countries in the European Union such as Poland, Hungary and the Czech Republic are at a different stage than Russia.”

For example, Russia has set its sights on becoming an

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international financial centre by 2020 and although this is not a new goal, progress is finally being made. Lilla Juranyi, global head, investor services, ING Commercial Bank, says: “We are beginning to see some movement with the government recently announcing the creation of a mega-regulator that will oversee state policy related to the financial market.

President [Dmitry] Medvedev has also called for all companies and regulators to adopt international financial reporting standards.”

In addition, there are plans to introduce central securities depositaries (CSDs) and create an advisory council for financial reform with leading lights of the investment banking world, including Lloyd Blankfein, chief executive of Goldman Sachs, Jamie Dimon of JPMorgan Chase and Steve Schwarzman, co-founder of Blackstone.

Equally important is the merger of RTS and MICEX, which is to take place after months of negotiations. The move will not only improve access for the international investor but also help accelerate development of capital market infrastructure.

RTS is primarily an equity derivatives exchange, with 75% of its equity flow spread over just two stocks, financial services giant Sberbank and oil and gas supplier Gazprom.

MICEX, on the other hand, controls the main index for all stocks, with 70% of all executions generated domestically.

Retail investors account for more than 50% of that figure.

Overall, MICEX currently comprises 65% of all Russian instruments traded globally while RTS has a 20% market share. Russian depositary receipts that are traded internationally comprise the remaining 15%.

While these announcements are more than welcome, market participants are only cautiously optimistic. This is because the country remains heavily bureaucratic and while it

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Photograph © Kim D. French / Dreamstime.com, supplied May 2011.

is one thing to introduce regulations that mirror Western standards, it is another to actually implement them. According to Mathieu Maurier, global head of sales and relationship management at Société Générale Securities Services (SGSS) adds:“It is fair to say that Russia is lagging behind in terms of market infrastructure but it is important to remember that the securities market in Russia is only about 15 to 16 years old. It will take time to build the legal and settlement framework that investors expect in the more mature markets.”

Russia is also not the only one with grand plans. Vienna and Warsaw are also looking to be major players, particularly on the regional stage. The Vienna stock exchange, which has controlling stakes in the Budapest, Ljubljana and Prague stock exchanges, formed a holding company last year, called the CEE Stock Exchange Group (CEESEG). The group is in charge of the strategic and financial management as well as the administration of the exchanges.

Vienna is hoping via CEESEG it can further expand its reach across the region, merging with other markets. The group already pools data with Bucharest, Sarajevo, Banja Luka (in Bosnia’s Serb-run enclave), Skopje and Belgrade bourses and most recently announced plans to go live with a common central clearing solution in the second half of 2012. In addition, it is working to implement Xetra, the trading platform used by Deutsche Börse, and is developing a cross-membership scheme to enable members of one exchange to more easily trade across the whole group.

The CEESEG will have its work cut out competing with the Warsaw Stock Exchange (WSE), which has also been busy building a formidable presence. To date, it is Central Europe’s largest exchange with a capitalisation of more than €142bn compared to Vienna’s €94bn. The strictly-regulated exchange which went public last year boasts a daily turnover of at least €250m and has more than 400 companies listed.

Moreover, it created a class of Polish retail investors, which accounts for roughly 20% of the market’s turnover and has helped build up local investment funds.

The WSE has also been successful in attracting foreign investors, who currently comprise 47% of volume, plus increasingly non-Polish firms, most recently the Ukranian company Kernel Holdings and Lithuanian air services group

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Satvinder Singh, EMEA head of direct custody and clearing, global transaction Services, Citi agrees. “There are significant differences and developments within the region. Countries in the European Union such as Poland, Hungary and the Czech Republic are at a different stage than Russia,” he says. Photograph kindly supplied by Citi, May 2011.

Katalin Bota, head of sales for DSS in CEE and Austria at Deutsche Bank.

“The trading and settlement environment is constantly changing. MTFs and CCPs have emerged and received interest in Central and Emerging Europe, but clients have different strategies when accessing the market,” she says. Photograph kindly supplied by Deutsche Bank, May 2011.

Avia. Last year it struck a strategic partnership with NYSE Euronext to explore new trading, market data and business development initiatives. Part of the deal also saw the migration of WSE markets to NYSE Technologies Universal Trading Platform.

Although the WSE is the largest player in the region, the jury is still out as to which exchange will be the most success-

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Göran Fors, global head of GTS Banks at SEB, which focuses on the Baltics, Ukraine and Russia. “Since the financial crisis, clients are asking more questions about the safety of their assets and cash accounts. This is particularly true in countries such as the Ukraine and Russia where transparency is low,” he says. Archive photo FTSE Global Markets, May 2011.

Lilla Juranyi, global head, investor services, ING Commercial Bank. “The big question is whether the WSE or Vienna will become the leading stock exchange in the CEE region. I think the WSE is a good candidate because it is extremely liquid and seems to be able to easily attract many issuers,” she says. Photograph kindly supplied by ING, May 2011.

ful. “The big question is whether the WSE or Vienna will become the leading stock exchange in the Central Eastern European region, “ says Juranyi. “It is an interesting trend to monitor because, for example, Slovenia, a member of Vienna’s CEEGEG, was recently listed on the WSE. I think the WSE is a good candidate because it is extremely liquid and seems to be able to easily attract many issuers but Vienna is also pushing to be the exchange for cross-border listings.”

The stock markets are not the only ones jockeying for position. Multilateral trading facilities (MTFs) are also trying to get a piece of the action. Last year, NASDAQ OMX started trading blue-chip equities listed on the Budapest, Warsaw and Prague stock exchanges with EMCF as its clearer, while Turquoise, which is owned by the London Stock Exchange and uses Euro CCP, introduced trading in Hungary and the Czech Republic.

Against this dynamic background, it is no wonder that the custodians are gearing up for an increase in business. On one side are the global stalwarts such as BNY Mellon, Deutsche Bank, Citi, Société Générale and BNP Paribas, who can leverage the depth and breadth of their global offering, and on the other are the more regional players including ING, SEB, Unicredit and Raiffeisen.

“Some global asset servicing firms have struggled to define a viable Central and Eastern Europe strategy,”says Porter of BNY Mellon, which provides global asset servicing to institutions operating in the core countries of Poland, the Balkans, Czech Republic, Hungary, Slovenia, Croatia, Serbia and Slovenia. “Their greatest shortcoming is to look at the region in a static and not growth fashion. The region is developing and evolving in sophistication and as a result this model not only requires commitment and investment in technology but the ability to deliver a global and local

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Chris Porter, regional executive for Central and Southern Europe at BNY Mellon Asset Servicing. “The region is developing and evolving in sophistication and as a result this model not only requires commitment and investment in technology but the ability to deliver a global and local network,” he says. Photograph kindly supplied by BNY Mellon, May 2011.

network and product range that meets the changing needs.”

Katalin Bota, head of sales for DSS in CEE and Austria at Deutsche Bank, adds:“The trading and settlement environment is constantly changing. New trading venues (MTFs) and central counterparties (CCPs) have emerged and received interest in Central and Emerging Europe [sic], but clients have different strategies when accessing the market.

Account operator models, in-sourcing and white labelling allow for custodians and clients to consider a different range of services and products, including those which are built on global platforms and offer the possibility of integration into Target 2 Securities (T2S)” Göran Fors, global head of GTS Banks at SEB, which focuses on the Baltics, Ukraine and Russia, also sees the region following the Western fund management community in terms of their focus on operational and market risk. “Since the financial crisis, clients are asking more questions about the safety of their assets and cash accounts,”he says.“This is particularly true in countries such as the Ukraine and Russia where transparency is low. By contract, the Baltics have much more developed processes and systems.”

Custodians are hoping to help formulate and develop those structures. Singh of Citi, which has a direct custody business in Poland, Russia, Slovakia, Czech Republic, Hungary, Ukraine, Romania and Kazakhstan, though, believes that the global players need to be on the ground working with foreign and local fund managers as well as with the domestic stock exchanges.“We are members of local market working groups which focus on issues such as settlement as well as helping improve the clearing arrangements in local markets. We see our role as helping develop the local capital markets infrastructure by having a team on the ground which leverages our regional and global footprint.“ I

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COLLATERAL MANAGEMENT

Photograph © Oscarmp / Dreamstime.com, supplied May 2011.

The days of low-frquency, high-threshold margin calls are over. As a result, operational complexity must increase.

Will clients truly partner with firms that can take on these challenges and grow with them through this evolutionary cycle?

David Simons reports.

IN SEARCH OF SOLUTIONS IFFERENT METHODS OF derivatives processing, not to mention the proliferation of new collateral types, call for sophisticated valuation tools capable of tracking securities held in various locations across nonsynchronised settlement cycles and asset-protection regimes. While central counterparties (CCPs) may be able to address some of the risk issues associated with the OTC market, other kinds of services may be required to handle less-liquid forms of collateral.

Along the way, areas such as risk management, portfolio reconciliation, margining and data ownership will all likely be affected as the evolution in collateral management (CM) continues. Particularly as prime brokers and larger buy side organisations look to gain access to CCPs for the first time, it will be vital for them to be able to amend and leverage typical collateral-management processes and systems currently used to secure cash and listed derivatives markets in order to properly service OTC-related transactions. Increased crossproduct collateral management will ultimately enable these institutions to improve supply and demand, while also lowering costs and enhancing liquidity management.

With liquidity less abundant than in years past, having the capacity to efficiently manage the allocation of collateral has become an increasingly important job for Euroclear, the world’s leading provider of post-trade services, charged with moving over $750bn in collateral on a daily basis on behalf of financial institutions worldwide.“We want to provide our clients with automated services that span multiple instruments and serve a variety of transaction types, so that they can seamlessly get the right kind of collateral allocated at the right place and at the right time,” notes Cédric Gillerot, director, collateral services product management at Euroclear Bank. Using Euroclear Bank, a securities-settlement and asset-servicing provider with over 40 links to major markets across the globe, Euroclear clients can elect to settle their transactions and mobilise their assets as collateral for financing purposes. “In addition to providing STP and

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detailed reporting, it has been necessary to ensure that clients are able to optimise the collateral they pooled in our system,” says Gillerot.

In light of AIFMD and similar regulatory measures, Euroclear has sought to maintain an open dialogue with regulators in all of the markets where it is active, in order to highlight new practices and procedures.“It is fair to say that Euroclear has, and will, help influence the direction of both the collateral management and post-trading landscapes,”says Gillerot.“Due to the events of the recent financial crisis, regulators are determined to rein in the over-reliance on short-term funding, while increasing operational efficiency, particularly in the collateral management area.”

Improving counterparty risk standards also ranks high on regulators’ “to-do”list, and CCPs play a key role in promoting this initiative. “By definition, CCPs exist to mitigate counterparty risk covering many different types of instruments,”says Gillerot. “Here, Euroclear Bank already offers certain CCPs and their members’increased operational efficiency by offering scalable, efficient collateral-management services to help with the processing of CCPs’ margin calls.”

Clearstream has worked to establish new routes to liquidity and financing through the development of its Global Liquidity and Risk Management Hub, a system that delivers integrated securities lending, borrowing and collateral-management services in cash, fixed-income and equities to connected counterparties that include central banks, central securities depositories (CSDs), CCPs and others. While maximizing the opportunities for investors to work efficiently and in a secured environment, Clearstream must also cope with market pressures related to securing OTC derivatives, while at the same time responding to the growing impact on post-crisis regulations such as EMIR or BASEL III. “In the future, more collateral will be required—and yet collateral is already scarce today, which is why we are constantly expanding the range of financial instruments available for collateral use in our systems” contends Pascal Morosini,

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global head of GSF & broker/dealers sales and relationship management, Clearstream. Having introduced equity and gold certificates last year, in January Clearstream made available the use of funds as collateral. Morosini adds:“And we are currently assessing the eligibility of exchange-traded funds (ETFs) and bank loans as collateral.”

For market participants that are hesitant to move collateral unilaterally, Clearstream has forged partnerships with certain domestic CSDs. Its initiative with Cetip, Brazil largest clearinghouse, set to go live in July, will allow Clearstream to use its collateral management engine to optimise the collateral movements on Cetip’s domestic accounts, says Morosini.

Because CCPs must deploy a very strict risk-management regimen, not all parties will be able to have access, while those with access will be required to have high-quality collateral in place. “Hence, CCPs alone cannot be the entire solution,” says Morosini. Through its Global Liquidity Hub, however, Clearstream can offer many options and routes for counterparties to finance less liquid forms of collateral, in the process “giving everyone the opportunity to finance themselves and bridge liquidity pools from the same collateral management system”.

Collateral management has been a unifying theme among the client base of Linedata, a global solutions provider.“From an organisational infrastructure perspective, our clients have been investing in high-operational risk areas, adding not only human capital but also systems and automation,” says Joe Kohanik, Linedata’s vice-president of fixed income and derivatives. According to Kohanik, size and global reach tend to dictate a company’s approach to collateral management.

“Larger firms, for example, are identifying high-risk regions or business lines and implementing solutions in these areas first.

After successful implementation, the firm then rolls other high-risk regions into the new solution.”

Triparty repro For Linedata’s clients, collateral falls into two distinct categories—listed and OTC.“Listed markets, such as futures, are very straightforward, while a repo with ten securities as collateral is much more complex,” says Kohanik.“Hence, firms have tended to focus on the OTC market-collateralisation issues such as tri-party repo, as opposed to listed-markets collateralisation, such as interest-rate futures.”

Any company with collateral-management data stored in disparate systems is susceptible to firm-wide risk, says Kohanik.“Firms that we speak with want to have an application that harmonises all of these disparate systems, not only for reporting on firm-wide risk, but also allowing traders and managers to spot opportunities and act on them. Is it possible to build or buy a reporting tool to print daily and ad-hoc reports that bring all systems together? Absolutely—in fact, Linedata has had that capability for years.”

With the settlement landscape in Europe and elsewhere still largely fragmented, these methods of harmonisation can be effectively used to move a greater amount of collateral, faster and more efficiently.“Though local markets may be somewhat less fragmented in the future, nuances will

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Pascal Morosini, global head of GSF and relationship management, Clearstream. Photograph supplied by Clearstream, May 2011.

always exist. By having a harmonising firm-wide view on collateral, individual regions and profit centres can transact with the knowledge that collateral movements are being fed into a larger firm-wide picture of market and operational risk assessment,” says Kohanik.

Despite various efforts to reduce collateral risk through central clearing, the adoption of the CCP or exchange-driven model points to a sharp increase in the number of margin calls and collateral volumes as well. “Dealing with this issue without jeopardising trading volume poses a real challenge for the markets,” says Staffan Ahlner, managing director of Broker Dealer Services at BNY Mellon. Additionally, the sheer number of global clearing agencies raises questions about fragmentation, as does the interoperability that exists between the various CCPs. Still, Ahlner remains upbeat. “Had all of the creditdefault swaps and related instruments been cleared in this manner prior to the crisis, we probably would have had a much different outcome. Clearly, the market understands the need for this kind of approach,”he says.

Ahlner believes the future looks particularly bright for the equities repo market, in light of the 29% volume increase within BNY Mellon’s triparty collateral programme since the start of the crisis, noting: “The strength of these financing programmes is very encouraging, to say the least.”

Utilising a triparty mechanism to set aside collateral needed to cover CCP margin calls can help address these settlement issues, says Ahlner. BNY Mellon successfully employed this method while working with the Chicago Mercantile Exchange back in 2004. “This time around I think we will see a much stronger uptake, given the efficiencies needed to pass muster with these CCP requirements,”says Ahlner.

Jason Orben, global product head of derivatives collateral management for JP Morgan, believes that the arrival of CCP processing won’t signal the end of the bilateral OTC derivatives era. “The shift towards centralised clearing will take some time to develop, and is unlikely to account for 100% of the global markets—there will still be some activity within the non-centrally cleared space,” says Orben. Along the way, clients will have to deal with a bifurcated market and will require a practical means of operating within the two disparate arenas, adds Orben.

“Major financial institutions and swap dealers will be particularly impacted during this move toward central clearing, while corporations and other exempted end users will generally still be able to function outside of the centrally cleared space,” he says. Accordingly, collateral agents should be prepared to offer operational support for clients who have to

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Hélène Virello, head of collateral management services at BNP Paribas.

Photograph kindly supplied by BNP Paribas, May 2011.

Cédric Gillerot, director, collateral services product management, Euroclear Bank. Photograph supplied by Euroclear, May 2011.

contend with this bifurcated model. Orben points to the value of the so-called “enterprise-wide” method of collateral management, which allows a company to monitor and manage collateral across multiple product lines and the entire firm on a global basis.

As in other parts of the world, Asia’s institutional investors, among them pension and sovereign-wealth funds, have increasingly sought to boost returns via hedge funds, private equity and other alternative means, many of them for the first time.

“One of the main hedge-fund trends over the past year has been the flow of global managers opening offices in Hong Kong or Singapore, not only with the goal of raising capital from Asian investors, but also to invest in these markets and participate in the Asian growth story,” says Andrew Gordon, head of BNY Mellon’s broker-dealer services business in Asia.

“Some of this money that Asian investors put into global alternative strategies does find its way back to Asia, which is relevant as our collateral management activity in the region is driven by the needs of broker-dealers to finance their Asian securities inventory.”While these participants may also trade US government repo and other non-Asian securities from the region, post crisis, Gordon adds: “It is widely recognised that collateralised funding is a more stable source of liquidity than unsecured borrowing.”

Many of the region’s investors learned the hard way about the importance of independent price verification and transparency with regard to OTC products as a result of the Lehman debacle and subsequent global credit crisis.

Since that time, BNY Mellon’s collateral-management division has worked to provide these investors with much greater detail surrounding derivatives products.“This is an exciting growth area for us,” says Gordon. “The scale and scope of the changes in the derivatives markets has been immense, and it is not over just yet. Keeping up with the ‘new best practice’ as well as the pace of these changes has led many institutional investors to give serious thought to outsourcing. So it is our job to invest in the technology in order to keep pace with these changes, and to employ properly qualified staff as well.”

With evolving regulations in both the US and Europe, Asia often risks being caught between the two worlds, says Gordon.

“For example, at present there are a half-dozen markets in the region that have made it their goal to put their own CCPs in place for various types of OTC derivatives. This could lead to duplication and potential conflict between different jurisdictions where clients in one market trade with counterparties in

another. While this is not exclusively an Asian issue, it is somewhat amplified in this region.”

As part of its major global push, BNP Paribas Securities Services recently secured a mandate from the Kingdom of Spain to provide custody and collateral management for OTC derivatives. Tesoro Público, the organisation charged with implementing the government’s funding strategy, said that the “safety and security” of BNP Paribas’ servicing business, including the company’s reputation in both collateral management and custody, figured highly in the decision-making process. The Spanish mandate is illustrative of BNP Paribas’s ongoing efforts to help clients mitigate counterparty and operational risk throughout the entire post-trade lifecycle.

“Managing collateralisation across multiple counterparties generates operational risk and increases the need for collateraloptimisation requirements,”says Hélène Virello, head of collateral management services at BNP Paribas. With market complexity on the rise, mitigation of counterparty risk has become a high priority within the realm of OTC derivatives. “Hence, clients want someone who can manage these complexities on their behalf, using end-to-end solutions covering the entire value chain, from trade execution to middle office, with collateral services that include the management of collateral agreements as well as collateral optimisation solutions.”

The need for an impartial, independent body is especially crucial for government investment programmes like Tesoro Público’s that are continually striving to meet due-diligence demands, says Virello.“BNP Paribas does not approach collateral management from an investment-banking standpoint, and that kind of independence has been very appealing for these types of investors, given the current climate,” she says.

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New regulatory support Ultimately, changes in collateral management will compel clients to become far more skilled at managing entire collateral relationships across their total portfolio—or, conversely, partner with a one-stop shop that can successfully manage the client’s collateral calls, and, if necessary, support collateral-upgrade trades or secured financing to move collateral that may no longer pass muster under the new regulatory environment.

“When it comes to collateral management, you have three main choices: build it yourself, reach out to a third-party vendor, or outsource completely,” says Orben. In years past when collateral was mainly cash and moved less frequently, self-made CM solutions were more feasible and very attractive to clients,“since it allowed them to tailor solutions to fit their specific needs,”he says. I

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Photograph © Cla78 / Dreamstime.com, supplied May 2011.

SPECIALS DOMINATE A STILL DULLED MARKET The securities lending industry may be moving more towards electronic trading but there will always be more complicated trades that need the human touch. The more pressing challenge is the lack of demand and the reams of regulation that could put a damper on the business. Not surprisingly, traders are under greater pressure to prove their mettle and extract value for specials (those stocks in most demand that command the highest prices). Lynn Strongin Dodds reports.

N THE PAST, securities lending followed a natural ebb and flow with equity trades being driven by dividends, corporate activity, capital raising arbitrage and convertible bond issuance. Outside the seasonal factors, there were the hot stocks or specials. These patterns have been disrupted by the dearth of demand and although there has been talk that specials have been dominant, industry research shows that the special-to-general collateral ratio in terms of loan volumes was virtually the same from 2009 to 2010.

As for this year, the industry is following the same path with demand being dampened by impending and existing regulation. Hedge funds continue to bide their time and wait for more clarity before re-entering the market in force. According to a new survey by Finadium, a financial markets research and consulting firm, borrowing by the hedge funds community has plunged 40% since its peak in 2008. By contrast, supply has strongly rebounded, jumping from about $9trn to more than $12trn in the past two years.

“Seems like we’ve had more regulation in the past three years than we have had in the last ten,”says Wayne Burlingham, global head of securities lending at HSBC Bank.

“Although some of the rules are settling down, there are still more to come which will impact the market and it is difficult to predict the actual outcome. This could make investors— especially hedge funds—look for different, easier places to conduct business.” In the past year, there have been a slew of initiatives around short selling and not all were expected.

Australia is the latest country to have fired a surprise salvo.

The national regulator, the Australian Securities and Investment Commission (ASIC) recently issued a guidance paper

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recommending those involved in securities lending and borrowing to be required to disclose any substantial holdings in listed entities, defined as an interest of 5% of a firm’s stock.

The rules will also apply to prime brokers, who may have ongoing lending agreements in place with their customers.

Meanwhile in Europe, debates and discussion continue. In late May, European Union (EU) finance ministers agreed to a watered-down text which allows the five-month-old EU regulator for securities, ESMA, to impose restrictions or even an outright ban on short selling. However, the European Parliament would prefer instead to follow Germany’s example and ban only naked short selling of credit default swaps for government bonds, which politicians believe exacerbated sovereign debt levels.

Short-selling arena Outside the short-selling arena, there is a long list of international regulations such as the Basel III capital adequacy rules and Solvency II, which do not come into effect until 2013.

Nonetheless, their ramifications are being felt already. Add to this the already well-worn US Dodd-Frank Act and Europe’s MiFID II and UCITS IV, all of which exert some influence on the already weighted down securities lending business.

Naturally, beneficial owners have become much more focused on risk. As Gareth Mitchell, head of trading at Citi’s securities lending business, says: “There have been many initiatives and changes since the financial crisis. Before, securities lending was quite a vanilla business that had continually grown each year and reacted to annual events such as the dividend season in Europe. However, problems with

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cash reinvestment made everyone review their programmes and while we are now at the stage where the majority of lenders are back, they are much more risk averse. They want a flexible programme and have the ability to select their own collateral parameters and risk limits.”

As for the traders, Jonathan Lombard, executive director of sales at SecFinex, notes:“They are coming under increased scrutiny when putting positions on their books with capital usage and balance sheets under pressure owing to market conditions. New capital rules will particularly focus banks’ attention on business lines that use capital, monitoring returns and applying cost of capital to individual units. Pre2008, balance sheet-usage at quarter-end was probably the biggest concern for a securities lending trader. Now it is more likely to be client risk exposure, credit line consolidation and sustainable revenue stream.”

Mark Payson, global head of trading and asset liability management at Brown Brothers Harriman, also points out: “There is no one-size-fits-all approach but traders need to be quicker and more nimble. Securities lending is an execution and performance business and the trading function is critical to that.”

Traders have also had to become much more methodical.

Although all the major players have their own in-house research teams, most glean their information from a variety of sources, including Data Explorers and Bloomberg as well as SunGard’s Astec Lending Pit. It is a browser-based market information service that gives traders rebate/fee and loan volume information for a broad coverage of the equity and fixed-income issues on loans in every market.

Earlier this year, SunGard launched the new Lending Pit XL add-in which gives users access to more than six years of historical daily securities-lending market data. This helps provide greater transparency when maximizing securities lending spreads in a market that can feature widely divergent rebate rates and fees.

Information and analytics Market participants, though, do not just feed the information and analytics into their own systems but put their own spin on it. As Nicholas Bonn, managing director of State Street Global Markets, says: “We obviously use all of the data and information available in the marketplace, aggregate it and then add a significant layer of analysis. This allows us to put together a picture of the market that not only helps us understand current trends but also anticipates future events. In general, there needs to be a genuine understanding of the securities markets and to ensure that we are pricing loans correctly.”

Rob Coxon, head of international securities lending at BNY Mellon Asset Servicing, says: “The lack of demand and not supply is one of the biggest challenges today. Supply is back to pre-crisis levels and our inventory is broad and deep. However, we are waiting for the demand side to come back and in the meantime this is putting pressure on prices and rates. It is forcing traders to become much more analytical and while there is a temptation to hire a couple of

FTSE GLOBAL MARKETS • JUNE 2011

Wayne Burlingham, global head of securities lending at HSBC Bank.

“Although some of the rules are settling down, there are still more to come which will impact the market and it is difficult to predict the actual outcome. This could make investors—especially hedge funds— look for different, easier places to conduct business,” he says. Photograph kindly supplied by HSBC, May 2011.

analysts to help price the stock, it is difficult to justify the cost in the current environment.”

Coxon adds: “The tools have become much more sophisticated and the industry has evolved. It is not as opaque as it once was. There is a lot of information available to help traders determine a price and we employ IT resources who slice and dice the information for us. In general, we use a provider such as Data Explorers and then we compare its information with ours to see if we can spot any inefficiency.”

John Shellard, global head of equity lending trading at JP Morgan, notes: “Overall the trading desks are doing more business with less people and they are being asked to do more complex business. Today, on the higher intrinsic value trades or specials, it is less about writing the tickets and more about understanding the value of the transactions and negotiating the best possible deal. Clients expect us to have a detailed understanding of what is driving the trades, to ensure we price the trade accurately and extract the maximum value.”

Market conditions may be one driver behind these trends, but traders’ performance has also come under much more intense scrutiny. For example, Performance Explorer, which is part of the Data Explorers group, is a web-based tool that enables organisations and investors to compare and understand their performance against a peer group. Results can be viewed at programme, portfolio, asset class, security and transaction levels. The other major theme playing across securities lending is the increase in electronic trading. “We definitely have seen an increase in automation on the general collateral side since the financial crisis,” says Grant Mackenzie, head of trading, securities lending, at HSBC.

85

SECURITIES LENDING

Rob Coxon, head of international securities lending at BNY Mellon Asset Servicing. “The lack of demand and not supply is one of the biggest challenges today. Supply is back to pre-crisis levels and our inventory is broad and deep,” he says. Archive photograph FTSE Global Markets / Mark Mathers, supplied May 2011.

Grant Mackenzie, head of trading, securities lending, at HSBC. “We definitely have seen an increase in automation on the general collateral side since the financial crisis. Traders are spending more of their time and maximizing their efforts on bringing value to specials and dividends,” he says. Photograph kindly supplied by HSBC, May 2011.

“Traders are spending more of their time and maximizing their efforts on bringing value to specials and dividends.”

Activity though depends on the particular market.

According to Shellard: “On the one hand the business has become highly automated especially in the US and UK, where about 80% of our flow is automated. On the other hand, there are the smaller and more regulated Asian markets which are less mature and have less volume, which because they are more challenging to enter, have higher spreads and present good revenue opportunities. Continental Europe sits somewhere in between, although it depends on the market.

Overall, I would say outside of the US and UK about 40% of our business is traded electronically.”

the business—about 50% to 55%—that is still traded over the counter or on the phone. I think the same will hold true for securities lending. There will always be a part of the business that needs to be negotiated.”

Looking ahead, it is no surprise that regulation is a main cause for concern. “One of the biggest challenges facing the industry is keeping ahead of the various market regulations and the impacts they could have on the business,” explains Mitchell. “Execution will be important but the emphasis will be on content, reporting and new risk management solutions.”

Rebecca Nordhaus, global head of regulatory strategy for securities lending, Brown Brothers Harriman, believes that “securities lending, like all other financial market products, will certainly be affected by the recent spate of regulatory activity but there remains tremendous uncertainty as to how”. She adds: “Regulatory focus has shifted somewhat from the lending side of the transaction to the collateral side.

One area of emphasis is on ensuring sufficient disclosure to lenders regarding the risks inherent in cash collateral reinvestment. Depending on the final rules, other regulation not explicitly focused on lending could also impact the product, for example swaps regulation, European short selling rules, Basel III, and even AIFMD [Alternative Investment Fund Managers Directive].”

Although every market faces an onslaught of new rules, differences will remain. As Lombard at SecFinex, points out: “The US probably has an advantage in that it has a single currency and settlement location. The majority of lending is versus cash collateral and it is a single jurisdiction for taxation and regulation. Conversely, in Europe, we have only one thing in common, a single currency in certain markets.

Cross-border settlement and taxation issues and differing non-cash collateral requirements make it a rather more challenging environment to operate in.”

Even so, Lombard believes: “There are certainly many elements working towards smoothing these differences across Europe such as Target 2 [sic], MiFID II, Basel III and EMIR (European Market Infrastructure Regulation), so we would expect to see efficiency and benefits derived from a truly single market place in Europe, in time.” I

Record results To date, the three major platforms on offer are Quadriserv, SecFinex and EquiLend, of which the latter is viewed as the market leader by participants. In February EquiLend boasted record results of 24,564 trades with a total value of $19bn from around 43 firms across 27 markets. This was the highest figure since its inception ten years ago. In the first quarter of 2011, EquiLend’s average daily trade volume was 16,900 with US equity accounting for the lion’s share at 76%. US fixed income was 6% while non-US equity comprised 17% followed by non-US fixed income at just 1%.

“We’ve had our ten largest trading days in the past six months,”says Brian Lamb, chief executive of EquiLend. “The activity was predominately US activity because that’s the biggest market. Although it is difficult to put a figure on electronic trading volumes relative to non-electronic volumes, I would estimate overall, including ourselves and others, it accounts for more than 60% of trading. One of the main reasons is that traders are being asked to do more with less and they need an automated solution.”

David Raccat, head of global markets at BNP Paribas Securities Services, believes there will always be a segment of the market that needs the personal touch.“It is reasonable to think that up to 50% of equities will be traded electronically but I am not sure about fixed income. If you compare the industry with foreign exchange there is still a chunk of

86

JUNE 2011 • FTSE GLOBAL MARKETS

(Week ending 20 May 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Sov Sov Sov Corp Corp Corp Sov Sov Corp Corp

16,655,151,570 9,066,035,683 6,391,210,586 4,318,185,009 5,595,898,518 5,180,312,885 19,015,765,467 26,010,413,830 11,490,890,101 2,711,832,856

182,459,566,760 124,849,244,575 143,471,007,381 87,543,686,865 77,719,378,837 81,049,636,417 164,190,071,870 283,927,804,667 100,010,374,565 70,475,170,311

12,269 9,815 8,827 8,674 8,333 8,231 7,899 7,858 7,790 7,300

Americas Americas Europe Americas Americas Americas Europe Europe Americas Europe

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government Government Government Government Government Government Financials Government Government Government

Sov Sov Sov Sov Sov Sov Corp Sov Sov Sov

26,010,413,830 20,476,736,659 19,015,765,467 16,803,270,235 16,655,151,570 11,946,899,325 11,490,890,101 9,066,035,683 8,147,687,846 7,416,107,765

283,927,804,667 101,420,159,583 164,190,071,870 95,291,941,482 182,459,566,760 62,416,026,458 100,010,374,565 124,849,244,575 46,485,994,345 50,422,873,856

7,858 4,982 7,899 3,071 12,269 4,544 7,790 9,815 4,991 2,657

Europe Europe Europe Europe Americas Europe Americas Americas Japan Europe

Federative Republic of Brazil Government United Mexican States Government Republic of Turkey Government MBIA Insurance Corporation Financials Bank of America Corporation Financials JPMorgan Chase & Co. Financials Kingdom of Spain Government Republic of Italy Government General Electric Capital Corporation Financials Telecom Italia SPA Telecommunications

Top 10 net notional amounts (Week ending 20 May 2011) Reference Entity

Republic of Italy French Republic Kingdom of Spain Federal Republic of Germany Federative Republic of Brazil UK and Northern Ireland General Electric Capital Corporation United Mexican States Japan Kingdom of Belgium

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 20 May 2011)

(Week ending 20 May 2011)

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,303,939,200,416

425,743

Kingdom of Spain

6,806,446,100

360

Sovereign / State Bodies

2,677,763,303,775

199,322

Republic of Italy

4,177,903,290

136

Corporate: Consumer Services

2,171,324,327,335

352,990

Federative Republic of Brazil

2,913,097,980

160 135

Corporate: Consumer Goods

1,626,816,954,862

252,349

United States of America

2,433,821,468

Corporate: Technology / Telecom

1,349,326,356,624

204,239

French Republic

2,369,910,510

76

Corporate: Industrials

1,303,373,918,383

217,415

Federal Republic of Germany

1,765,277,493

54

Corporate: Basic Materials

1,013,715,165,711

159,464

Portuguese Republic

1,752,104,765

142

Corporate: Utilities

800,284,072,950

122,920

Kingdom of Belgium

1,675,889,989

91

Corporate: Oil & Gas

484,622,822,139

86,022

The Goldman Sachs Group, Inc.

1,206,395,977

123

United Mexican States

1,032,600,000

69

Corporate: Health Care

349,722,432,038

59,631

Corporate: Other

146,472,387,405

15,170

CDS on Loans

70,380,581,517

18,519

Residential Mortgage Backed Securities

67,097,188,680

13,058

Commercial Mortgage Backed Securities 19,595,549,466

1,783

Residential Mortgage Backed Securities*

8,223,522,570

563 739

CDS on Loans European

5,223,872,283

Other

1,320,689,270

86

Muni:Government

1,252,400,000

130

Commercial Mortgage Backed Securities*

215,572,374

20

Muni:Other

115,000,000

4

Muni:Utilities

30,650,000

12

*European

FTSE GLOBAL MARKETS • JUNE 2011

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data Š 2011 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

87

The Fidessa Fragmentation Index (FFI) was launched to provide a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative lit trading venues. In short, it shows the average number of lit venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue.

Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues. Once a stock’s FFI exceeds 2, liquidity in that stock has fragmented to the extent that it no longer “belongs” to its originating venue.

The Fidessa Fragulator® allows you to query several billion trade records to get a complete picture of how trading in a given stock is broken down across lit venues, dark pools, systematic internalisers and bilateral OTC trades.

FFI and venue market share by index Week ending 6th May 2011 VENUES

INDICES

INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.46

1.68

1.92

2.03

9.23%

1.91 3.02% 4.12%

4.57% 0.01%

4.58%

7.71%

29.11%

21.15%

6.87% 15.75%

19.20%

0.25%

1.53%

Europe

Amsterdam BATS Europe Berlin Burgundy Chi-X Europe Deutsche Börse Dusseldorf Equiduct Frankfurt Hamburg Hanover London Munich NYSE Arca Europe Paris SIX Swiss Stockholm TOM MTF Turquoise Xetra

16.69% 75.67% 0.02% 0.06% 0.54% 0.06% 0.01%

55.54% 0.09% 0.08%

0.26%

0.08%

65.91% 67.00% 69.82% 0.03% 4.23% 0.01%

5.61%

VENUES

2.20%

2.89%

6.10%

VENUES

INDICES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

4.70 11.01% 3.88% 0.04% 0.47% 5.60% 7.99% 28.91% 3.33% 3.01% 0.99% 20.99% 0.11% 13.67%

4.43 11.00% 3.77% 0.10% 0.41% 5.63% 7.20% 26.61% 3.38% 2.13% 1.03% 24.27% 0.19% 14.40%

FFI

2.27

2.26

Alpha ATS

18.93%

17.76%

BATS BYXX CBOE Chicago Stock Exchange EDGA EDGX NASDAQ NASDAQ BX NQPX NSX NYSE NYSE Amex NYSE Arca VENUES

INDICES S&P ASX 200

HANG SENG

FFI

1.00

1.00

Asia

INDICES

ASX Trade Match Australia Hong Kong

99.90% 100%

Canada*

DOW JONES

US

INDICES

S&P TSX 60

Chi-X Canada

12.08%

13.12%

Liquidnet Canada

0.29%

0.19%

Omega ATS

2.25%

2.54%

Pure Trading

4.40%

3.73%

TSX

59.21%

59.59%

TriAct MATCH Now

2.83%

3.06%

VENUES

INDEX NIKKEI 225

INDICES FFI

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

Chi-X Japan JASDAQ Kabu.com Nagoya Osaka SBI Japannext Tokyo ToSTNet-1 ToSTNet-2

1.25 1.78% 0.00% 0.02% 0.00% 0.00% 1.52% 89.34% 7.33% 0.00%

Figures are compiled from lit order book trades only. Totals only include stocks contained within the major indices. *This index is also traded on US venues. For more detailed information, visit http://fragmentation.fidessa.com/fragulator/.

88

JUNE 2011 • FTSE GLOBAL MARKETS

COMMENTARY

By Steve Grob, Director of Group Strategy, Fidessa

O

TC TRADING CONTINUES to be the subject of much interest and debate. Whilst it is widely accepted that there is a degree of duplication in the way OTC trading volumes are counted, the current MiFID reporting rules make it difficult to assess the precise level of that duplication.

Nevertheless some insight can be gained by looking at the overall trends over time. The charts below show the mix between lit and non-lit trading since May 2008.

For the week ending 29th April 2011, OTC share (by volume) for the main European indices reached 46.39%, its highest level since May 2008 (chart 1).

remained relatively stable since then. OTC volume share for this index also closely mirrors lit volume share.

Chart 3: Volume %, FTSE 100 DARK

LIT

OTC

SI

90% 80% 70% 60% 50% 40% 30%

Chart 1: Weekly volume %, Europe* DARK

LIT

20%

OTC

SI

90%

10%

LIT: 29 Apr 2011 49.01%

80% 70%

0% M y May 2008

Oct 2008

Mar Mar 2009

Aug g 2009

Jan 2010

Jun 2010

Nov 2010

Apr p 2011

Looking at the patterns for smaller, less liquid stocks, (FTSE 250, for example - chart 4) an even more interesting picture emerges with OTC accounting for a little over half of all volume.

60% 50% 40% 30%

Chart 4: Volume %, FTSE 250

20%

OTC: 29 Apr 2011 46.39%

10% 0%

DARK

OTC

SI

70% May Aug Nov 2008

Feb

May Aug Nov 2009

Feb

May Aug Nov 2010

Feb May 2011

60%

* AEX, BEL 20, CAC 40, DAX, FTSE 100, FTSE 250, FTSE MIB, IBEX, ISEQ, OMX C20, OMX H25, OMX S30, OSLO OBX, PSI 20, SMI

50%

The majority of European indices show high volatility in volume breakdown across all trading categories (as is clearly illustrated in the case of IBEX, chart 2) which makes it impossible to identify any real trend.

40%

DARK

OTC

60% 50% 40% 30% 20% 10% Mar Mar 2009

10%

Aug Aug 2009

Jan Jan 2010

Oct 2008

Mar Ma 2009

Aug g 2009

Jan 2010

Jun 2010

Nov 2010

Apr p 2011

SI

70%

Oct O ct 2008

20%

Mayy May 2008

LIT

80%

May 2008

30%

0%

Chart 2: Volume %, IBEX

0%

LIT

80%

Jun 2010

Nov 2010

Apr 2011

However, for the FTSE 100 - the most fragmented European index - we can clearly see that OTC volume share increased sharply in the year following the introduction of MiFID and has

If lit volume shares are genuinely down, as it appears, then the lit venues will continue to compete for an ever-decreasing slice of the liquidity pie.

As long as the OTC reporting rules remain as they are it will be difficult to establish if what we're seeing is a genuine shift in liquidity. Given that we are not able to reliably distinguish real liquidity from "artificial" volumes in the OTC space, we can't ignore the possibility that these patterns are simply the result of reporting practices. It's equally possible that regional differences could be attributed to this factor, too.

Whatever the real numbers, two things are clear. Firstly, non-exchange trading remains a very significant part of the overall trading mix. And, secondly, regulators should focus their attention on standardising and clarifying the reporting regime for the benefit of all market participants. I

All data © Fidessa group plc.

All opinions and data here are entirely the responsibility of Fidessa group plc. If you require more information on the data provided here or about Fidessa’s fragmentation tools, please contact: fragmentation@fidessa.com.

FTSE GLOBAL MARKETS • JUNE 2011

89

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM As at end April 2011 Index Provider MSCI S&P Barclays Capital STOXX Russell FTSE Dow Jones Markit NASDAQ OMX NYSE Euronext Hang Seng Topix Nikkei EuroMTS WisdomTree PC-Bond Grupo Bolsa SSE Indxis Structured Solutions Intellidex CSI Morningstar S-Network BNY Mellon ISE Zacks Other Total

No. of ETFs 418 345 90 275 74 170 149 123 61 45 13 54 10 29 35 18 13 19 6 31 36 32 26 15 18 10 11 544 2,670

Total Listings 1,485 619 217 930 110 414 276 350 119 88 34 67 18 113 42 22 14 20 11 40 46 38 26 36 19 10 13 844 6,021

April 2011 AUM (US$ Bn) $374.4 $337.5 $119.3 $105.4 $88.5 $63.3 $56.2 $48.6 $38.8 $17.4 $16.2 $14.8 $14.0 $10.4 $9.8 $8.3 $7.9 $7.7 $7.6 $6.8 $3.4 $3.4 $2.3 $2.3 $2.3 $1.9 $1.0 $100.2 $1,469.8

% Total 25.5% 23.0% 8.1% 7.2% 6.0% 4.3% 3.8% 3.3% 2.6% 1.2% 1.1% 1.0% 0.9% 0.7% 0.7% 0.6% 0.5% 0.5% 0.5% 0.5% 0.2% 0.2% 0.2% 0.2% 0.2% 0.1% 0.1% 6.8% 100.0%

ADV (US$ Bn) $8.1 $25.5 $1.8 $1.9 $6.5 $1.2 $2.0 $0.3 $3.5 $0.7 $0.1 $0.0 $0.1 $0.1 $0.1 $0.0 $0.2 $0.2 $0.0 $0.2 $0.0 $0.1 $0.0 $0.0 $0.0 $0.0 $0.0 $1.7 $54.5

No. of ETFs 28 30 6 -8 4 9 11 11 -2 4 0 1 1 0 0 0 0 5 0 6 0 1 16 0 0 0 0 87 210

Total Listings 155 53 6 -51 9 29 18 38 16 4 0 3 2 2 0 1 0 5 4 9 7 5 16 3 0 0 1 131 466

YTD Change AUM (US$ Bn) $36.6 $36.4 $8.1 $15.7 $8.0 $8.4 $8.6 $3.5 $7.0 $0.8 $0.9 -$1.8 -$0.7 $1.0 $1.4 $0.7 $0.2 $1.2 $1.8 $1.0 $0.6 -$0.2 $0.4 $0.6 -$0.4 $0.9 $0.2 $17.5 $158.4

% AUM 10.8% 12.1% 7.3% 17.5% 9.9% 15.2% 18.1% 7.7% 22.2% 4.7% 5.8% -10.7% -4.7% 10.3% 16.2% 8.5% 3.2% 18.8% 32.0% 17.9% 19.4% -5.3% 21.8% 35.3% -13.6% 83.1% 21.6% 21.1% 12.1%

% TOTAL -0.3% 0.0% -0.4% 0.3% -0.1% 0.1% 0.2% -0.1% 0.2% -0.1% -0.1% -0.3% -0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.0% 0.5%

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 5 global ETF providers by average daily turnover As at end April 2011 Average Daily Turnover (US$ Mil) April 2011 % Mkt Share Change (US$ Mil)

3.6%

Provider

Dec-2010

% Mkt Share

Change (%)

SSgA

$18,667.3

40.3%

$23,424.8

43.0%

$4,757.5

25.5%

iShares

$14,028.5

30.3%

$16,100.5

29.6%

$2,071.9

14.8%

PowerShares

$2,413.3

5.2%

$2,904.1

5.3%

$490.8

20.3%

ProShares

$2,660.7

5.7%

$2,567.9

4.7%

-$92.8

-3.5%

Direxion Shares

$1,860.7

4.0%

$1,975.6

3.6%

$114.9

6.2%

Others

$6,710.2

14.5%

$7,501.8

13.8%

$791.6

11.8%

Total

$46,340.7

100.0%

$54,474.7

100.0%

$8,133.9

17.6%

Direxion Shares

13.8% Others

4.7% ProShares

43.0% SSgA

5.3% PowerShares

29.6% iShares

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 20 ETFs worldwide with the largest change in AUM As at end April 2011 ETF iShares MSCI Emerging Markets Index Fund SPDR S&P 500 PowerShares QQQ Trust Vanguard MSCI Emerging Markets ETF iShares MSCI EAFE Index Fund iShares S&P 500 Index Fund db x-trackers DAX ETF iShares MSCI Japan Index Fund iShares S&P MidCap 400 Index Fund iShares DAX (DE) iShares MSCI Germany Index Fund Energy Select Sector SPDR Fund iShares S&P 500 Vanguard Total Stock Market ETF iShares MSCI Canada Index Fund Vanguard REIT ETF Technology Select Sector SPDR Fund Vanguard Dividend Appreciation ETF iShares Russell 2000 Index Fund Vanguard Europe Pacific ETF

Country listed US US US US US US Germany US US Germany US US UK US US US US US US US

Bloomberg Ticker EEM US SPY US QQQ US VWO US EFA US IVV US XDAX GY EWJ US IJH US DAXEX GY EWG US XLE US IUSA LN VTI US EWC US VNQ US XLK US VIG US IWM US VEA US

AUM (US$ Mil) April 2011 $41,760.0 $95,287.1 $27,244.7 $49,449.5 $41,350.5 $29,024.4 $6,638.8 $7,625.8 $12,019.8 $8,316.5 $4,222.0 $10,448.1 $9,933.5 $20,237.9 $6,591.7 $9,274.4 $7,570.3 $6,308.9 $19,144.0 $6,946.5

AUM (US$ Mil) December 2010 $47,551.5 $89,915.3 $22,069.9 $44,569.8 $36,923.1 $25,799.2 $3,693.1 $4,883.3 $9,332.0 $5,917.7 $1,881.7 $8,396.4 $7,905.8 $18,236.0 $4,622.1 $7,503.7 $5,849.3 $4,608.9 $17,498.4 $5,304.0

Change (US$ Mil) -$5,791.5 $5,371.8 $5,174.8 $4,879.7 $4,427.4 $3,225.2 $2,945.8 $2,742.5 $2,687.8 $2,398.8 $2,340.3 $2,051.7 $2,027.7 $2,001.9 $1,969.6 $1,770.8 $1,721.0 $1,700.1 $1,645.6 $1,642.5

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

90

JUNE 2011 • FTSE GLOBAL MARKETS

Global ETF listings As at end April 2011 ASSETS UNDER MANAGEMENT (US$ Bn)

CHANGE IN ASSETS

No. of No. of Exchanges Providers (Official)

No. Primary Listings

New in 2010

New in 2011

Total Listings

2010

April 2011

US$ Bn

%

US Europe Austria Belgium Finland France Germany Greece Hungary Ireland Italy Netherlands Norway Poland Portugal Russia Slovenia Spain Sweden Switzerland Turkey United Kingdom Canada Japan Hong Kong China Mexico South Korea Australia Singapore Taiwan South Africa Brazil India New Zealand Malaysia Thailand Saudi Arabia UAE Indonesia Chile Botswana Egypt Israel Philippines Sri Lanka

972 1,128 1 1 1 262 397 3 1 14 23 16 7 1 3 1 1 12 23 120 12 229 180 84 47 22 19 87 24 23 14 26 8 18 6 4 4 2 1 1 -

173 268 55 59 1 12 2 1 3 1 13 58 3 60 51 12 18 8 6 15 15 12 3 3 4 1 1 2 1 -

76 82 5 27 4 1 2 5 9 22 23 4 7 7 25 5 2 2 1 2 -

972 3,952 21 28 1 477 1,193 3 1 14 530 115 15 1 3 1 1 68 78 651 12 739 211 88 76 22 349 87 45 81 17 26 8 18 6 5 4 2 1 1 50 -

$891.0 $284.0 $0.1 $0.1 $0.3 $59.9 $110.7 $0.1 $0.0 $0.4 $2.5 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.2 $2.8 $38.0 $0.2 $66.7 $38.4 $32.2 $26.3 $10.1 $8.2 $5.3 $3.9 $3.6 $2.8 $2.3 $1.9 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$997.3 $328.2 $0.1 $0.0 $0.3 $66.6 $126.8 $0.1 $0.0 $0.4 $3.0 $0.4 $0.8 $0.1 $0.0 $0.0 $0.0 $1.5 $3.2 $47.8 $0.2 $76.9 $43.1 $29.4 $27.9 $11.7 $8.6 $6.8 $4.0 $3.7 $3.0 $2.8 $1.9 $0.6 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$106.2 $44.2 $0.0 $0.0 $0.0 $6.7 $16.1 $0.0 $0.0 $0.0 $0.5 $0.1 $0.1 $0.0 $0.0 $0.0 $0.0 $0.2 $0.4 $9.8 $0.0 $10.2 $4.7 -$2.8 $1.7 $1.6 $0.3 $1.4 $0.1 $0.1 $0.2 $0.5 $0.0 $0.2 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 -

11.9% 15.5% -18.4% -2.8% 5.9% 11.3% 14.5% -2.0% 29.7% 8.4% 18.8% 16.4% 17.3% 15.2% 10.5% 16.3% 3.4% 19.0% 15.7% 25.7% 4.6% 15.3% 12.3% -8.8% 6.3% 15.7% 4.0% 27.1% 3.7% 2.9% 6.3% 20.8% -0.7% 47.1% 2.3% 0.3% 1.3% 63.5% 2.5% 5.5% -

29 39 1 1 1 9 10 2 1 2 4 4 2 1 2 1 1 2 2 7 5 9 4 7 10 16 3 13 6 8 2 8 2 7 2 3 3 1 1 1 -

2 23 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 2 2 1 1 1 1 3 1 2 1 1 1 1 1 1 1 2 1 1 1 1 1 1 1 -

886 63*

ETF total

2,670

593

236

6,021

$1,311.3

$1,469.8

$158.4

12.1%

140

48

1,055

Location

*Includes three undisclosed Ossiam ETFs. To avoid double counting, assets shown above refer only to primary listings.

Planned New

18 2 1 20 1 5 6 3 4 15 1 16 0 3 0 1 4 0 0 1 1 2 1 1

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only.

This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the Global ETF Research and Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Affiliated companies of BlackRock may make markets in the securities of ETFs and provide ETFs in the form of iShares. Further, BlackRock and/or its affiliated companies and/or their employees may from time to time hold shares or holdings in the underlying shares of, or options on, any security of ETFs and may as principal or agent buy securities in ETFs. The opinions expressed are those of BlackRock as of April 2011, and are subject to change at any time due to changes in market or economic conditions.

They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed by BlackRock and accordingly does not make any remark on their suitability. Prospective investors should take their own independent advice prior to making an investment decision. This document does not provide investment advice and the information contained within should not be relied upon in assessing whether or not to invest in the products mentioned. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this commentary may not be suitable for all investors. BlackRock recommends that investors independently evaluate each issuer, security or instrument discussed in this publication and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. The value of and income from any investment may go up or down and an investor may not get back the amount invested. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We also remind you that the levels and bases of, and reliefs from, taxation can change and is dependent upon individual circumstances. Although BlackRock endeavours to update and ensure the accuracy of the content of this document BlackRock does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from the ETF Providers and confirm any relevant information with ETF Providers before investing. Neither BlackRock, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. © 2011 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded.

FTSE GLOBAL MARKETS • JUNE 2011

91

Global Equity View 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100) FTSE All-World Index

FTSE Developed Index

FTSE Emerging Index

FTSE Frontier 50 Index

180 160 140 120 100 80 60

11

Ap r11

Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

9

Oc t0

Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

08

7

-0 8 Ap r

Ja n-

Oc t0

-0 7

07

Ju l07

Ap r

Ja n-

Oc t06

Ju l06

40 Ap r06

MARKET DATA BY FTSE RESEARCH

GLOBAL MARKET INDICES

Global Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100)

160

FTSE RAFI Developed 1000 Index

FTSE Developed ActiveBeta MVI Index

FTSE EDHEC-Risk Efficient Developed Index

FTSE DBI Developed Index

FTSE All-World Index

140 120 100 80 60

Ja nJa n-

Ap r11

Oc t10 Oc t10

11

Ju l10 Ju l10

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

08

-0 8 Ap r

Ja n-

7 Oc t0

Ju l07

-0 7 Ap r

07 Ja n-

Oc t06

Ju l06

Ap r06

40

Global - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100)

250

FTSE EPRA/NAREIT Global Index

FTSE Global Government Bond Index

FTSE StableRisk Composite Index

FTSE FRB10 USD Index

200

150

100

50

Ap r11

11

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

-0 8

-0 8 Ap r

Ja n

Oc t07

Ju l07

07 Ap r-

07 Ja n-

Oc t06

Ju l06

Ap r

-0 6

0

Source: FTSE Group, data as at 29 April 2011.

92

JUNE 2011 • FTSE GLOBAL MARKETS

USA MARKET INDICES USA Regional Equities View 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100) FTSE USA Index

FTSE All-World ex USA Index

140

120

100

80

60

11

Ap r11

Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

9

Oc t0

Ju l0

09

Ap r09

Ja n-

Oc t08

Ju l08

-0 8 Ap r

08

7

Ja n-

Oc t0

Ju l07

07

-0 7 Ap r

Ja n-

Oc t06

Ju l06

Ap r06

40

USA Alternative/Strategy View 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100)

160

FTSE RAFI US 1000 Index

FTSE DBI Developed Index

FTSE EDHEC-Risk Efficient USA Index

FTSE US ActiveBeta MVI Index

FTSE All-World Index

140 120 100 80 60

Ap r11

11 Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

08

-0 8 Ap r

Ja n-

7 Oc t0

Ju l07

-0 7 Ap r

07 Ja n-

Oc t06

Ju l06

Ap r06

40

USA - Across the Asset Classes 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100)

140

FTSE Americas Government Bond Index

FTSE FRB10 USD Index

FTSE EPRA/NAREIT North America Index

FTSE Renaissance IPO Composite Index

120 100 80 60 40

Ap r11

11 Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

08 Ap r-

-0 8 Ja n

Oc t07

Ju l07

07 Ap r-

07 Ja n-

Oc t06

Ju l06

Ap r

-0 6

20

Source: FTSE Group, data as at 29 April 2011.

FTSE GLOBAL MARKETS • JUNE 2011

93

Europe Regional Equities View 5-year Performance Graph (EUR Total Return) Index level rebased (28 April 2006 = 100) FTSE 100 Index

FTSE Nordic 30 Index

FTSEurofirst 80 Index

FTSE MIB Index

140

120

100

80

60

11

Ap r11

Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

9

Oc t0

Ju l0

09

Ap r09

Ja n-

Oc t08

Ap r

Ju l08

-0 8

08

7

Ja n-

Oc t0

-0 7

Ju l07

07

Ap r

Ja n-

Oc t06

Ju l06

40 Ap r06

MARKET DATA BY FTSE RESEARCH

EUROPE, MIDDLE EAST, AFRICA (EMEA) MARKET INDICES

Europe Alternative/Strategy View 5-year Performance Graph (EUR Total Return) Index level rebased (28 April 2006 = 100)

140

FTSE RAFI Europe Index

FTSE4Good Europe Index

FTSE EDHEC-Risk Efficient Developed Europe Index

FTSE EPRA/NAREIT Developed Europe Index

FTSE All-World Index

120 100 80 60 40

Ap r11

11 Ja n-

Oc t10

Ju l10

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

Ap r

-0 8

08 Ja n-

7 Oc t0

Ju l07

-0 7 Ap r

07 Ja n-

Oc t06

Ju l06

Ap r06

20

Middle East and Africa View 3-year Performance Graph (Total Return) Index level rebased (30 April 2008 = 100)

140

FTSE JSE Top 40 Index (ZAR)

FTSE CSE Moricco All-Liquid Index (MAD)

FTSE Middle East & Africa Index (USD)

FTSE NASDAQ Dubai UAE 20 Index (USD)

120 100 80 60 40

1 Ap r1

11 Ja n-

Oc t10

Ju l10

Ap r10

0 Ja n1

9 Oc t0

9 Ju l0

Ap r09

-0 9 Ja n

Oc t08

Ju l08

Ap r-

08

20

Source: FTSE Group, data as at 29 April 2011.

94

JUNE 2011 • FTSE GLOBAL MARKETS

ASIA-PACIFIC MARKET INDICES Asia Pacific Regional Equities View (Market-Cap, Alternatively-weighted and Strategy) 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100) FTSE Asia Pacific Index

220

FTSE RAFI Developed Asia Pacific ex Japan Index

FTSE EDHEC-Risk Efficient All-World Asia Pacific Index

200 180 160 140 120 100 80 60

11 Ja nJa n-

Ap r11

Oc t10 Oc t10

Ju l10

0

Ap r10

9

Ja n1

9

Oc t0

Ju l0

09

Ap r09

Ja n-

Oc t08

Ju l08

Ap r

-0 8

08

7

Ja n-

Oc t0

Ju l07

07

-0 7 Ap r

Ja n-

Oc t06

Ju l06

Ap r06

40

Greater China Equities View 5-year Performance Graph (USD Total Return) Index level rebased (28 April 2006 = 100) FTSE China A50 Index

600

FTSE Greater China Index

FTSE China 25 Index

FTSE Renaissance Hong Kong/China Top IPO Index

500 400 300 200 100

Ap r11

11

Ju l10

0

Ap r10

9

Ja n1

Oc t0

9 Ju l0

Ap r09

09 Ja n-

Oc t08

Ju l08

Ap r

-0 8

08 Ja n-

7 Oc t0

Ju l07

-0 7 Ap r

07 Ja n-

Oc t06

Ju l06

Ap r06

0

ASEAN Equities View 18-month Performance Graph (USD Total Return) Index level rebased (30 October 2009 = 100) FTSE ASEAN 40 Index

FTSE Bursa Malaysia KLCI

STI

FTSE SET Large Cap Index

200 180 160 140 120 100

1 Ap r1

1 M ar -1

-1 1 Fe b

11 Ja n-

-1 0 De c

10 N

ov -

0 Oc t1

p10 Se

-1 0 Au g

0 Ju l1

0 Ju n1

-1 0 ay M

Ap r10

ar -1 0 M

Fe b10

-1 0 Ja n

De c09

ov -0 9 N

Oc t09

80

Source: FTSE Group, data as at 29 April 2011.

FTSE GLOBAL MARKETS • JUNE 2011

95

INDEX CALENDAR

Index Reviews June 2011 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

Early Jun

KOSPI 200

Annual review

08-Jun

30-Apr

Early Jun

IBEX 35

Semi-annual review

13-Jun

31-May

Early Jun

OBX

Semi-annual review

17-Jun

31-May

Early Jun

OMX C20

Semi-annual review

17-Jun

31-May

Early Jun

ATX

Quarterly review

30-Jun

31-May

03-Jun

AEX

Quarterly review

17-Jun

30-Apr

03-Jun

PSI 20

Quarterly review

17-Jun

30-Apr

03-Jun

BEL 20

Quarterly review

17-Jun

30-Apr

03-Jun

S&P / ASX Indices

Quarterly Review

17-Jun

27-May

03-Jun

CAC 40

Quarterly review

17-Jun

31-May

03-Jun

DAX

Quarterly review

17-Jun

31-May

07-Jun

FTSE China Index Series

Quarterly review

17-Jun

23-May

07-Jun

FTSE Vietnam Index Series

Quarterly review

17-Jun

31-May

n/a

FTSE Renaissance Asia Pacific IPO Index Series

Quarterly review

17-Jun

31-May

07-Jun

FTSE MIB

Quarterly Review

17-Jun

31-May

07-Jun

TOPIX

Monthly review - additions & free float adjustment

30-Jun

31-May

08-Jun

FTSE Italia Index Series

Quarterly Review

17-Jun

31-May

08-Jun

FTSE UK Index Series

Quarterly review

17-Jun

07-Jun

08-Jun

FTSE techMARK 100

Quarterly review

17-Jun

07-Jun

08-Jun

FTSEurofirst 300

Quarterly review

17-Jun

07-Jun

08-Jun

FTSE/JSE Africa Index Series

Quarterly review

17-Jun

07-Jun

09-Jun

FTSE EPRA/NAREIT Global Real Estate Index Series

Quarterly review

17-Jun

31-May

09-Jun

FTSE Global Equity Index Series (incl. FTSE All-World)

Annual review - Emgng Eur, ME, Africa, Latin America

17-Jun

07-Jun

09-Jun

FTSE Bursa Malaysia Index Series

Semi-annual review

17-Jun

31-May

10-Jun

FTSE SET Index Series

Semi-annual review

17-Jun

31-May

10-Jun

DJ Global Titans 50

Annual review of index composition

17-Jun

31-May

10-Jun

Dow Jones Global Indexes

Quarterly review

17-Jun

31-May

10-Jun

S&P / TSX

Quarterly review

17-Jun

31-May

10-Jun

FTSE TWSE Taiwan Index Series

Quarterly review

17-Jun

31-May

10-Jun

NZX 50

Quarterly review

17-Jun

31-May

10-Jun

OMX I15

Semi-annual review

30-Jun

31-May

10-Jun

S&P Europe 350 / S&P Euro

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P Topix 150

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P Asia 50

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P Global 1200

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P Global 100

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P Latin 40

Quarterly review - shares

17-Jun

03-Jun

10-Jun

S&P US Indices

Quarterly review - shares

17-Jun

09-Jun

13-Jun

S&P BRIC 40

Semi-annual review - constituents

17-Jun

20-May

Mid Jun

VINX 30

Semi-annual review

17-Jun

31-May

17-Jun

31-May

Mid Jun

OMX N40

Semi-annual review

Mid Jun

Russell US & Global Indices

Annual consituent review / Quarterly IPO additions

24-Jun

31-May

Mid Jun

OMX S30

Semi-annual review

30-Jun

31-May

Mid Jun

OMX B10

Semi-annual review

30-Jun

31-May

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poor’s, STOXX

96

JUNE 2011 • FTSE GLOBAL MARKETS