GM Cover Issue 82.qxp_. 21/10/2015 10:21 Page FC1
DTCC STOOPS TO CONQUER MARKET RISK
ISSUE 84 • SEPTEMBER/OCTOBER 2015
FTSE GLOBAL MARKETS
What’s eating high yield markets? Derivatives governance and market innovation Why it’s bad to spoof the order book ISSUE EIGHTY FOUR • SEPTEMBER/OCTOBER 2015
Why everyone wants transactional risk insurance
Emerging markets in meltdown: A cycle or a crisis? WWW.FTSEGLOBALMARKETS.COM
SECURING TODAY’S GLOBAL MARKETS FOR A STRONGER TOMORROW. For more than 40 years DTCC, through its subsidiaries, has provided post-trade processing services that mitigate risk, reduce costs, increase transparency and promote greater market efficiency. Today, we process trillions of dollars of securities transactions each day and more than $1.6 quadrillion annually – serving as the centralized clearinghouse for the U.S. capital markets and operating the first and only global trade repository for derivatives. As changes in market structure and new regulations transform the industry, DTCC is proactively engaged to meet the complex operational challenges of an ever-evolving marketplace. For more information on DTCC products and services, visit DTCC.com.
EDITOR’S LETTER
I EDITORIAL Francesca Carnevale, Editor T: +44 207680 5152; E: francesca@berlinguer.com David Simons, US Editor, E: DavidtSimons@gmail.com CORRESPONDENTS Lynn Strongin Dodds (Editor at Large); Ruth Hughes Liley (Trading Editor); Vanja Dragomanovich (Commodities); Neil O’Hara (US Securities Services); Mark Faithfull (Real Estate). PRODUCTION Andrew Lawson, Head of Production T: +44 207 680 5161; E: andrew.lawson@berlinguer.com Lee Dove, Production Manager T: 01206 795546; E: studio@alphaprint.co.uk OVERSEAS REPRESENTATION Can Sonmez (Istanbul, Turkey) Adil Jilla, MEIAC, Dubai T: +971 4454 8690 FTSE EDITORIAL BOARD Mark Makepeace (CEO); Donald Keith; Chris Woods; Jonathan Cooper; Jessie Pak; Jonathan Horton PUBLISHED BY Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Switchboard: +44 [0]20 7680 5151 www.berlinguer.com PRINTED BY Wyndeham Grange Ltd Butts Road, Southwick, West Sussex BN42 4EJ T: +44 (0) 1273 592244 DISTRIBUTION Postal Logistics International, Units 39-43 Waterside Trading Estates, Trumpers Way, London W7 2QD TO SECURE YOUR OWN SUBSCRIPTION Please enrol on www.ftseglobalmarkets.com Single subscription: £87.00 which includes online access, print subscription and weekly e-alert
FTSE Global Markets is published 6 times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright Berlinguer Ltd 2014. All rights reserved). FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.
ISSN: 1742-6650 Journalistic code set by the Munich Declaration.
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 5
n an otherwise lacklustre year for the securities markets, two segments continue to excite the market: derivatives and post trade. As October opened, news emerged that the London Stock Exchange Group plans to launch a bank-backed effort to compete with Deutsche Börse and Intercontinental Exchange in the European futures market. CurveGlobal, LSE's biggest push into interest rate futures, is poised to debut in the second quarter next year. Exchange groups have been taking leaves out of the business handbook of successful post trade institutions that tied up customers by incorporating them as shareholders in mutual style structures that both secures business volume and ensures that the institutions remains an important market pillar. The LSE looks to be doing the same with CurveGlobal The project, called CurveGlobal Ltd., is a venture with six banks and the Chicago Board Options Exchange. The consortium wants to break the effective duopoly that Deutsche Börse and ICE enjoy in offering listed derivatives on European government debt. In this edition we kick off a three issue focus on the evolution of the financial markets, with extended coverage of post trade and in later editions, derivatives and data management. The evolution of the post trade landscape looks increasingly complex, with most of the major players in the midst of a land-grab battle. In the next edition we will look in more focus at initiatives such as Target-2 Securities and the complex network of alliances and strategic shareholdings that will determine the future provision of middle and back office services. In this issue we offer a few openers to begin to frame the overall discussion. Mike Bodson, chief executive of the US monolith, the DTCC, explains the institutions global outlook and its impact on the post trade providers’ global strategy. Elsewhere in the issue major themes balance the impact of the summer rout in emerging markets with growing pressures elsewhere in the market. Clearly the markets have factored in the downturn in the Chinese economy this year. Even so, investors remain nervous and sell at the slightest tremor. This protracted nervousness in part stems from the growing awareness that economic theories of markets are simply not acting the way they should any longer. Despite a massive quantitative easing programme in many developed markets, inflation is not complying and looks to be hiding. That in turn is encouraging further loosening of monetary policy in the hope of spurring some kind of revival both to domestic economies and global trade. The reason for the disconnect is, we venture that while QE is an active remedial strategy in many advanced markets, the reality is that funds are not circulating in the economy at large and in many countries QE has not been linked to massive investment in capital goods projects. (Large investment in the buildings of apartments and flats in city centres doesn’t count – particularly when many are sold to vacant landlords, many of them living abroad). In other words, central banks and governments are only implementing half of an expansionist Keynesian policy – the equivalent to the disbursement of Marshall Plan in the late 1940s funds, without spending on German economic reconstruction. Money is swishing around; but who is doing something concrete and positive with it? What happens next? Japan’s long time languish in the economic doldrums looks to now be repeated in many advanced markets unless some innovative thinking begins to take place and some of the more difficult questions now extant are answered. Contributions on a postcard please.
COVER PHOTO: Photograph © Btktan/Dreamstime.com, supplied October 2015.
1
CONTENTS COVER STORY
4: It’s been a summer of discontent, followed by an early fall of market jitters. Commodity prices are still low and markets should have factored in China’s current woes. Much still hangs on the intentions of the US Federal Reserve, which may now have lost momentum for a rate rise in the near term. What of emerging markets though: with Brazil’s rating downgraded and little rebound in Asia stocks, should we be worried? .……………………..…………..............…………………………………………………
MARKET LEADER
8: The post trade land grab: Winners and losers in the emerging post trade landscape 10: Bodson’s Choice: redefining DTCC strategies for a riskier world 11: Rate rises and the collateral conundrum
SPOTLIGHT
A selection of news stories from around the markets, including: 20: Demand for transactional risk insurance on the rise 21: New fundraising highest year on record ARE EMERGINGF MARKETS REALLY IN MELTDOWN? Page 4 Photograph © Altaoosthuizen/dreamstime.com, supplied October 2015.
VANTAGE POINT
24: Positioning for an inevitable rate hike
DERIVATIVES
26: Derivatives governance and product innovation: are they friends?
IN THE MARKETS
29: Spoofing the order book: US and UK regulators take aim 31: Avoiding the pitfalls of trading derivatives in Asia
BELVEDERE
32: John Bilton assesses the pressures on emerging markets
HIGH YIELD DEBT REPORT
35: Clouds on Europe’s high yield issuance market? 36: A growing divergence between US and European high yield?
ASIA VIEWPOINT
38: SGX scopes Asia’s investment benchmarks
PRECIOUS METALS
39. The uncertain future of precious metals
COUNTRY REPORTS
40: Testing the resilience of Qatar’s markets 42: Political uncertainty weighs on Turkey 43: Foreign banks still keen to enter Turkey’s banking market 44: Egypt opts for development funds
DATA PAGES
46: Market reports by FTSE Group Research
2
J U LY / A U G U S T 2 0 1 5 • F T S E G L O B A L M A R K E T S
Deutsche Bank Global Transaction Banking
Expect more from T2S 9KVJ VJG TKIJV RCTVPGT CV [QWT UKFG VJG TGCN DGPGɌVU QH TARGET2-Securities are within reach: reduced crossborder settlement costs, optimised use of collateral and richer funding opportunities. &GWVUEJG $CPM QɼGTU — connectivity in more than 80 markets including 33 with a local presence — a wide choice of operating models and value-added services — the kind of liquidity only a world-leading euro clearer* can provide Visit db.com/gtb, email gtb.marketing@db.com or HQNNQY WU QP 6YKVVGT "VCNMIVD VQ ɌPF QWV OQTG
*Voted No. 1 for Euro, Euromoney Cash Management Survey 2013, 2014. This advertisement is for information purposes only and is designed to serve as a general overview regarding the services of Deutsche Bank AG, any of its branches and affiliates. The general description in this advertisement relates to services offered by Global Transaction Banking of Deutsche Bank AG, any of its branches and affiliates to customers as of September 2015, which may be subject to change in the future. This advertisement and the general description of the services are in their nature only illustrative, do neither explicitly nor implicitly make an offer and therefore do not contain or cannot result in any contractual or non-contractual obligation or liability of Deutsche Bank AG, any of its branches or affiliates. Deutsche Bank AG is authorised under German Banking Law (competent authorities: European Central Bank and German Federal Financial Supervisory Authority (BaFin)) and, in the United Kingdom, by the Prudential Regulation Authority. It is subject to supervision by the European Central Bank and the BaFin, and to limited supervision in the United Kingdom by the Prudential Regulation Authority and the Financial Conduct Authority. Details about the extent of our authorisation and supervision by these authorities are available on request. Copyright Š September 2015 Deutsche Bank AG. All rights reserved.
COVER STORY
Photograph © Estudiomaia/Dreamstime.com, supplied October 2015.
Asian market see-saw reflects systemic shifts in emerging market fortunes You would be forgiven for thinking that slower than expected growth in China this year (6.9% rather than the 7% target) would by October have been factored in by investors. After a tumultuous summer in which one Chinese indicator after another hinted at a slowdown, the fall season seems to have brought little relief, although at the time of going to press the Shanghai index was 15 points above its summer nadir. Even so, the Chinese downturn will likely push back a Fed rate hike by some months until emerging markets show some sign of stabilising; though with Brazil’s recent downgrade by Fitch, there look to be only pockets of optimism right now. How dark is the outlook for emerging markets over the next eighteen months?
T
HE DETERIORATION IN Chinese manufacturing data to a 6-1/2 year low, the Volkswagen emissions brouhaha and Glencore’s indebtedness dealt serious blows to emerging markets as September drew to its close. Until eighteen months or so, emerging markets had pretty much sat in a sweet spot as easy global credit conditions and positive commodity prices helped support often hefty GDP growth numbers. All that has changed, as a summer of investor discontent has undermined confidence in China’s growth story. In some respects, things have been clearly overblown. China will after all, register growth of 6% this year, even as the country’s manufacturing output, exports and banking credit and stock markets have taken a concerted pounding. In general it has been a torrid twelvemonth for most emerging markets and
4
over the last two quarters China in particular. The slowdown in Chinese growth, coupled with the promise of a US interest rate rise and the gradual but steady unwinding of a slug of domestic credit in the banking system has resulted in a diminuition in global liquidity. It is a trend that warranted a strident polemic from IMF supremo Christine Lagarde at a recent Council of the Americas speech in Lima, requiring political leaders to strengthen policies to address the prospect of rising US interest rates, China’s slowdown, deceleration in the growth of global trade, and the sustained fall in commodity prices. Largarde also noted the impact of conflict and forced migration. Lagarde warned that global growth will likely be weaker this year than last, “with only a modest acceleration expected in 2016.”She also noted a modest pick-up in
advanced economies, but the“not-so-good news”is that emerging economies are likely to see their fifth consecutive year of declining rates of growth.“If we put all this together, we see global growth that is disappointing and uneven.” That has darkened the outlook for emerging economies and sent government bond yields higher, as foreign investors shed their holdings. Yields, which move inversely to prices, on fiveyear Indonesian government bonds rose steeply in the second quarter of this year to their highest since 2009, having risen 1.6 percentage points over the period to 9.767%. Malaysian five-year benchmark yields have posted their largest quarterly rise since early 2009. “Our view is that this drag is not as severe as many believe. When we talk about China’s collapse, most have focused on its manufacturing sector, which is in
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
COVER STORY
recession, a result of the country’s efforts to transition to a consumer-driven economy. At this point it’s estimated that roughly 40% of China’s gross domestic product (GDP) is consumption-related. This compares to about two thirds in the United States,” states Ruggero de’Rossi, portfolio manager at Federated Investors. “Consumption growth in China is proceeding at over 10% to 15% per year. This indicates that China’s overall economy is not collapsing but is likely growing at a rate of 5% to 6% per year. For the secondlargest economy in the world to have that rate of growth remains a positive and contributes to global growth, including in emerging markets (EM),” he adds. The dynamic of US rate uncertainty and the slowdown in China has pressured commodities, a mainstay of emerging market output. Many are priced in US dollars, and a stronger currency on expectations of higher rates has snuffed out demand as materials have become more expensive. Not only that, global demand has decelerated as markets such as China have opted to substitute imports by buying locally wherever possible.
Systemic trends According to a summer paper by Fitch Ratings, global export volume has grown by less than 5% since 2012, with structural and cyclical trends meeting to limit any recovery over the short term. Performance by value has been even worse due to the fall in global trade prices, led lower by commodities. By April this year, global export prices were down 16% year on year and have continued to fall since. “The 19% fall in global merchandise export volumes at the height of the GFC in late 2008 was the sharpest contraction in at least 60 years. There was also a nearsynchronised 23% fall in export prices, led by steep drops in commodities. In developed markets, where the crisis was centred, the year-on-year decline in volumes reached 22% in early 2009. The annual decline in emerging markets was only slightly smaller, at 17%. All regions of the world were affected by the collapse in trade, with annual declines in the US
6
dollar value of exports in mid-2009 ranging from 18% in emerging Asia to 39% in the Middle East,” noted Fitch. The ratings agency posits a number of important structural changes that promise to continue to dampen global trade flows. It suggests that emerging markets consumers (retail and corporate) are now buying local rather than international products, from clothing to components. It cites the World Trade Organisation’s reports of a return to restrictions on trade through national policies and often monetary policy (witness this year’s efforts by India to cut back on imports and its four part reduction in interest rates, for example). Investment spending is also down, contributing to lower demand for capital goods projects and by extension key hard commodities. Fitch concedes the resulting reduction in liquidity and trade will impact emerging markets severely. "Venezuela, Argentina, Turkey, Colombia, and Peru are the emerging market sovereigns that may be the most vulnerable currently to the combined effect of the three key risks of tightening global liquidity, financial deleveraging, and a Chinese slowdown. Mexico, Poland, and the Philippines appear to be least at risk," posits Moritz Kraemer, Standard & Poor's sovereign global chief risk officer. "Latin American sovereigns are, on average, more vulnerable than sovereigns in Asia in each of the three risk categories." Longer term, the dynamic is clearly with emerging and high growth markets, irrespective of the segment’s current difficulties. That aside, Fitch also posits the view that emerging markets are in a better position to weather the story these days in any case and while they are down, they are far from out. "We believe that over the past two decades the ratings on emerging market sovereigns have become more resilient to stress, in part because they have made significant progress in developing their domestic capital markets, increasing their external reserves, and making their monetary policy frameworks more flexible," says Standard & Poor's managing director Joydeep Mukherji. "Therefore, we do not
expect a materialisation of risks (comparable to the crises of the late 1990s) to lead to downgrades." A longstanding worry about Fed rate hikes and their impact on EM fixed income has been that higher US rates would result in devalued EM currencies, increasing inflationary pressures and, ultimately, slowing growth. According to de’Rossi at Federated Investors, “as a result of U.S. dollar strength over the past two years, we expect much less of a headwind. In fact, early in September, EM currency values reached their lowest levels in more than a decade. So, for the most part, that impact has already been discounted by the market. Also, the Fed has indicated that it will be very gradual in its rate adjustments. Nonetheless, when that first rate hike comes, markets may well overreact, but we would see that as a good time to hunt bargains”.
Opportunities? According to de’Rossi,“One of the major drivers of EM debt performance is the yield spread between EM debt and comparable maturity US Treasuries. Spreads of EM debt have increased from a low of 250 basis points to 420 basis points, which we believe offer attractive opportunities for investors able to carefully evaluate the risk/reward equation across a very diverse array of EM countries.” More specifically, the portfolio manager says he sees opportunities for local debt in countries such as Russia and Brazil whose monetary policies are running counter to that of the US. “On the currency side, we believe that there will be steadily improving opportunities over the next few quarters because many EM countries have depreciated their currencies well beyond what was necessary to re-establish balance on their current accounts. This would especially be the case if the Fed’s tightening process proceeds in a measured fashion. The yield differential that many of these currencies offer today is substantial. On average, five-year EM local debt offers an approximate 7% yield advantage over that of developed markets,” he says. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
J.W. Marriott 1331 Pennsyvania Ave Washington D.C. 20004
September 30 - October 2, 2015
1115 Broadway | NEW YORK, NY 10010 | 646-699-5996 | www.securitytraders.org
POST TRADE
Photograph © bigfoot/Dollarphotoclub.com, supplied October 2015.
Towards a single gateway for European post trade services Continuous innovation and a fight for market share looks to be shaping the global post trade landscape. Presenting the Eurosystem's 'Vision for 2020' project at the October 2015 Sibos, board member of the European Central Bank, Yves Mersch, stated at the assembly that the central bank is considering bringing together the processing of cash and securities across the Eurosystem on a single platform. The move is a signal indication of the growing confidence of the post trade segment; a move to bring together post trade services in a single entity in Europe and a growing land grab for market dominance among the sector’s leading players.
T
HE EUROPEAN POST-TRADE industry, despite its relatively small size of around €17bn in revenues, plays a vital role in the securities markets. The post-trade industry is highly specialised. Its mechanisms are not sufficiently transparent to outsiders. Even industry insiders have different views, for example, on the scope of the industry, and lack of a standardised terminology. Moreover, it is clear that the main firms in the post trade firmament are intent on securing their long term future through a dual process of business diversification and geographic expansion. In Europe, the market’s evolution is being redrawn through Target-2 Securities
8
(T2S), the European securities settlement engine introduced this year which offers centralised delivery-versus-payment (DvP) settlement in central bank funds across all European securities markets. European markets are now working towards the implementation of the socalled second wave of entrants to the platform, including Euroclear Belgium, Euroclear France, Euroclear Nederland and Portugal’s Interbolsa in March next year. The final wave of migration to the platform is estimated to be one year later in March 2017. Already the European central bank is thinking about growing the sweep of the service to bring both cash and equities trans-
actions settlement onto the same platform. Mersch suggests that doing so will allow the platform benefit from the standardisation of applications across a range of securities and services as well as messaging, such as the implementation of ISO 20022 standards. Migration to ISO 20022 in T2S was originally planned for November 2017, but bank discomfort at the upheavals created by the move led to the deferment of its application on the platform; though as T2S rolls out its implementation sooner rather than later cannot be ruled out. In that regard, Mersch was saying nothing new; however, his articulation of a roadmap for further post trade market
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
POST TRADE evolution points to the growing confidence of the T2S project team. In particular, of interest is the interest in setting up a common Eurosystem-wide collateral management tool. "With T2S, it is now possible to have a single, centralised, pool of collateral, making it much simpler and faster to move collateral from where it is to where it needs to be," stated Mersch. Also signalling yet another detailed round of market cooperation and consultation for taking the T2S project forward, Mersch stated:“"Our vision for market infrastructure integration is not, nor should be, ours alone," he said. "Following the success of our collaboration with the market during the development of T2S, we intend to take the same approach going forwards - to work together with the market to identify what its needs are and to draw on the expertise in both the public and the private sectors.” It is a bold accretive strategy, which will inevitably leave both banks and current market pillars asking: where now for us? Collateral and liquidity management in particular are particularly sensitive areas and a segment ripe for banks to establish market share. High-quality collateral is in greater demand than before the financial crisis, due to more prudent counterparty risk management as well as new regulations governing OTC derivatives and liquidity. Against this background financial institutions are currently reassessing their collateral management service set. The major global banking houses and trust banks are considering investing in collateral information systems, optimising their collateral allocation or transforming their collateral to acquire the desired collateral assets. Given that banks have determined that in the overall collateral service set, what’s really important is the ability of a firm to have access to the right kind of collateral at the right time, banks feel that they are best placed to provide this service. So do post trade institutions and now the European Central Bank. It will not be an easy battleground in which to fight for market share and dominance. For many financial institutions, collateral management remains manually intensive, timeconsuming and expensive. It is also prone
10
Photograph © bigfoot/Dollarphotoclub.com, supplied October 2015.
to errors and is a source of risk. New solutions and market structures look to be the order of the day. For instance, some of the larger, global custodian providers and Euroclear and Clearstream (among others) have been active in establishing new ventures with financial institutions to help them meet collateral requirements arising in triparty repos, CCP margining and other financing deals. When the counterparty is another banks, the funds do not leave the bank’s network, but are used in a virtual single cross-border pool.
MiFID II – the second game changer T2S isn’t the only game-changer in town. The second iteration of the Markets in Financial Instruments Directive (MiFID II), which will come into force in March 2017, also looks to create waves, particularly in the reporting segment, this time in the derivatives space. Similar strategies are in play here as well. MiFID II will have a significant impact on European financial markets, along the entire process chain. While MiFID I only applied to shares, MiFID II covers additional instrument classes, such as ETFs, certificates, bonds, structured financial products and derivatives. The objective is to make trading across all asset classes more transparent. For market participants, the challenge will be to collect all the necessary data, report it to the relevant authority on time and display it historically.
Moreover, most market participants trade on multiple organised market places as well as bilaterally. This fragmentation makes it difficult to meet the regulatory reporting requirements in an efficient manner. Post-trade reporting is set to play a significant part in this new order. As part of the general transparency requirements contained within MiFID II, pre- and posttrade details of orders submitted and transactions conducted on a trading venue must be disclosed. This could become a problem in particular for fixed income market participants that are already operating in an environment of higher costs and lower liquidity. Among a spate of recent initiatives announced in the post trade reporting space, Deutsche Börse says it has partnered with REGIS-TR to support clients in meeting MiFID II requirements. Deutsche Börse is offering clients two services here: firstly, the MiFID II Transaction Reporting Service, which enables clients to submit the relevant data (e.g. executing trader and reason for transaction) to the national competent authorities. This data must be reported through a so called “authorised reporting mechanism”(ARM). REGIS-TR will apply for ARM status and act as the ARM for the German exchange Group. Secondly, Deutsche Börse’s MiFID II OTC Trade Reporting Service is an efficient and straightforward option for clients to meet the transparency requirements for OTC transactions under the new directive. Transactions subject to these requirements will undergo quality assurance and be published in real time via an “approved publication arrangement” (APA). Deutsche Börse will be applying for APA status as soon as the competent authority begins accepting registrations. The reported trade information will be disseminated worldwide via Deutsche Börse's data feeds. REGIS-TR and Deutsche Börse say they are uniquely positioned to be the de facto European regulatory reporting hub. “It is very important for our customers to have a trusted partner who can help them meet their regulatory obligations in an efficient and cost-effective manner,” states the exchange group in an official statement.
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
INSIGHT – DTCC
DTCC: redefining post trade services for a riskier world
D
TCC’s sTraTegy is, according to Bodson, a considered, rather than a competitive, reaction to the opportunities that opened up. it evinces a somewhat functionalist view that social, economic and political order is best reached through the provision of high quality, safe services that oil the wheels of business, while reducing or eliminating the worst risks from the system. it is a concept of super Utility, though Bodson makes clear he is not saying DTCC is the super utility. rather, he says, the concept encompasses the combined focus of all the industry utilities. “We conducted a study of the post-trade ecosystem for sell-side firms, custodians and utilities, in both the United states and europe. The results were astonishing. The study by Oliver Wyman, found that of the $100bn spent annually on back office costs only 5% of it is accounted for by industry utilities.” Bodson says the findings contributed to his eureka! moment. “if the industry could more effectively leverage its utilities, such as DTCC,
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
Several years ago, The Depository Trust & Clearing Corporation (DTCC) outlined a new business strategy that at its heart envisioned a much larger role for itself. That role involves sometimes simple, sometimes complex multi-tasking in its approaches to helping the financial industry deal with today’s realities: new and increased regulation, the impact of globalisation, new business processes and the requirement to minimise market risks and lowering the costs of securities transactions. Putting its strategy to work has led to an expansion and evolution that has added new services and responsibilities for DTCC along the way. In doing this, DTCC has asked a lot of itself. How far has DTCC achieved its aim of becoming a global super-utility? What are the next steps? FTSE Global Markets spoke to Michael C. Bodson, president and chief executive of DTCC about the post-trade giant’s strategy and global outlook.
DTCC is sitting in a sweet spot these days: the potential for new business opportunity is substantial.
euroclear, sWiFT, the Options Clearing Corporation (OCC) and others, and if the utilities could collaborate to a greater degree than they have in the past, then we would see huge opportunities to centralise and standardise certain nondifferentiating process to drive down costs and risks through economies of scale.” The fact is, DTCC is sitting in a sweet spot these days: the potential for new business opportunity is substantial. Bodson does not run away from the reality. according to Bodson, the findings also point to wider systemic opportunity. “as we explored this further, we started to identify functions that are in today’s world redundant across banks and that no longer provide them with competitive advantage. These processes are ideal for centralisation within a utility. in fact, some of these processes actually could increase operational and reputational risk when managed individually by financial firms rather than in aggregate via a utility.” Clearly then a new approach was not only
11
INSIGHT – DTCC possible but also inevitable, as financial firms shrunk businesses back to profitable core operations. That’s because systemic change in financial markets was happening just as a phalanx of new regulation was upping the stakes in terms of operational requirements.
Taking a global view The drive to help align the industry with the goals of the regulators has underpinned DTCC’s global Trade repository (gTr) initiative, a global OTC derivatives reporting facility which includes gTr Hong Kong, gTr Canada, gTr europe and gTr australia, among others, including a U.s. data repository. “gTr now spans three continents, enabling users to report on their derivatives trading activity irrespective of where they are based across a single platform.” standardisation helps bring greater efficiency and cost savings to the markets. it also enhances transparency and was behind the g20 mandate related to derivatives markets. Unfortunately, new regulations were written at the national level, which has increased transparency at the regional level but not globally. DTCC is working with regulators to harmonize global rules to help achieve the goals established by policymakers in the wake of the 2008 financial crisis. globalisation has been a defining trend in the description of DTCC’s world over recent years. “Look, it is a very broad term; but ultimately globalisation is a genie that is well and truly out of the bottle. Markets might be volatile right now, and investors wary of current economic trends in some countries, but that won’t last forever. The larger trend of globalisation will reverberate for some long time to come and we have to respond to that.” “The majority of transaction volume today is generated by firms operating in multiple jurisdictions and/or globally,” Bodson added. “as a result, services that are limited to a particular region or jurisdiction are less beneficial to these firms, who are in need of global solutions that will allow them to manage their business more holistically. This represents the primary growth opportunities for DTCC.” “Clarient and globalCollateral are prime examples of how we are meeting the needs of global firms in multiple jurisdictions,” he said. in the case of client data, the industry was looking for a solution to reduce operational complexity and address evolving risk and regulatory require-
12
The drive to help align the industry with the goals of the regulators has underpinned DTCC’s Global Trade Repository (GTR) initiative.
“The majority of transaction volume today is generated by firms operating in multiple jurisdictions and/or globally,”
ments, including Know your Customer (KyC), Foreign account Tax Compliance act (FaTCa), european Market infrastructure regulation (eMir), and Dodd-Frank. in response, DTCC formed Clarient in partnership with 6 founding banks. “The banks bring a strong understanding of their needs in the client reference data space, and we leveraged that expertise in the design and development of the utility,” explains Bodson. “The same holds true of our joint venture in the collateral management space with euroclear that is related to collateral processing. DTCC-euroclear globalCollateral Ltd will help firms manage the capital and operational challenges that are expected from the increased volume and velocity of margin movements worldwide due to new regulatory requirements.” in the future, new infrastructure services will need a global or multijurisdictional footprint to be most successful. Bodson says he is pleased that there is increased understanding of the benefits and the risks of centrally clearing products, albeit not as a catch-all solution, but as a means of driving down into individual risks and mitigating them at every level. “a key point we are stressing is that each CCP must be understood individually, its risk profile, ownership structure and available resources, along with the products they clear and the risks they pose, are different. in that regard, a blanket approach that tries to compare multiple, highly disparate CCPs may be misleading. We remain engaged in dialogue with policymakers and market participants to promote these objectives,” he explains. “There are fundamental differences between for-profit, commercial firms and utilities. as an industry-owned and governed firm, DTCC is a true cooperative, and our responsibility is to provide our clients with a safe, secure and efficient way to conduct business,” Bodson said. “in addition, our Board of Directors and our shareholders are also our clients, which allows us to take a long-term view of risk management. Our primary goal is to mitigate risk and ensure market safety and soundness – not to increase shareholder value.” given DTCC’s focus on risk, it conducts an annual systemic risk Barometer survey, as a way to better understand the concerns of both its clients and a broad range of stakeholders from the global financial services industry. Headlining the most recent study from this past summer,
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
INSIGHT – DTCC cyber risk was nominated by respondents as a number one concern. some 46% cite it as the single biggest risk to the broader economy, while a whopping 80% of respondents identify it as a top five risk. almost half of all respondents include geopolitical risk and the impact of new regulations in their top five fears. Overall, 29% of respondents say the probability of a high-impact event in the global financial system had increased in the past six months, compared with a mere 13% who felt it has decreased. grexit, monetary policy, deflation and the global slowdown in economic growth and trade, each ground the survey in this year’s chronic worries. More pertinently perhaps for DTCC is that 73% of all respondents say they have increased resources allocated to identifying, monitoring and mitigating systemic risks over the year; a strong trend that was also identified in earlier surveys. Moreover, 65% of respondents admit to increasingly sophisticated methodology in their firm’s ability to identify, assess and manage emerging risks. according to Bodson, the sum of the super utility concept involves a continually creative and responsive process: “While operational and counterparty risks still represent a major cause of concern for the industry, the reality is that systemic shocks have become more frequent, more severe and more difficult to anticipate. The confluence of these and other dynamics continually prompt us to rethink our business – how we operate, our structure and how we could play a larger role helping the industry meet these challenges while reducing risks and costs.”. risk mitigation is the lifeblood of systemically important financial market utilities. “risk management has always been our most fundamental responsibility and is at the forefront of what we think about every hour of every day. We are here to protect the financial markets and our clients. We know if we don’t get that right, if we take our eye off the ball, we won’t be able to pursue new initiatives or products that can benefit our clients or the industry.” That imperative has spawned a series of interconnected initiatives designed to heighten market safety. Cyber-security has been high on Bodson’s agenda. “The environment is growing more dangerous and complex by the day and we need to keep raising the bar to protect ourselves. soltra edgeTM, an offering from our joint venture
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
The probability of a high-impact event in the global financial system had increased in the past six months.
While DTCC is taking a leadership role with regard to clearing tri-party repo, it has a much more collaborative role when it comes to shortening the settlement cycle.
with the Financial services information sharing and analysis Center (Fs-isaC) that we launched in 2014, is an example of how we have responded to these risks.” soltra edge provides the means of sharing of cyber-threat information through uniform messaging. Data and analysis can be lifted and quickly utilised by users. in essence, it creates a community approach to cyber security “in which one user can share intelligence so that we are all working in concert to protect against an attack,” Bodson said.
Innovation and collaboration provide industry solutions elsewhere in the business, DTCC has developed initiatives to reduce systemic and operational risks across the securities, derivatives and capital markets. it has either done this directly, or through its subsidiaries such as National securities Clearing Corporation (NsCC) and Fixed income Clearing Corporation (FiCC). “Having our clearing agencies designated as systemically important Financial Market Utilities, or siFMUs, raised the level of regulatory oversight and has prompted us to advance several new initiatives to strengthen our risk management capabilities,” he explains. He talks of FiCC recently expanding its membership types to include buyside firms (specifically, registered investment companies), as an instance. Moreover, DTCC has initiated work on setting up a centrally cleared institutional tri-party repo, “thereby providing counterparty risk mitigation between the sell-side and buy-side that does not exist today,” Bodson explains. While DTCC is taking a leadership role with regard to clearing tri-party repo, it has a much more collaborative role when it comes to shortening the settlement cycle. as part of the industry T+2 steering committee DTCC is working with other firms and organizations like siFMa to help move the initiative forward. “This industry initiative to move to T+2 is very important for reducing costs and risks in the U.s. marketplace,” Bodson said Just a few weeks ago, Chair of the securities and exchange Commission Mary Jo White announced full support for the timeframe developed by the industry steering Committee and the industry Working group to implement T+2 by the end of Q3 2017. gaining this regulatory certainty was crucial to move the initiative forward.
13
INSIGHT – DTCC another avenue in the uating potential applications super utility strategy came a related to post-trade procouple of years ago with the cessing, but we cannot lose full acquisition of Omgeo, sight of the fact that market having previously shared infrastructures have ownership with Thomson developed in order to not reuters. The acquisition enonly lower costs but also to couraged DTCC to provide protect the stability and end-to-end solutions. as integrity of the marketplace Bodson explains, “we and the system as a whole.” continue to integrate the Technology for Bodson is Omgeo product suite into a tool rather than an end in DTCC’s to provide an cohesive itself. DTCC, he explains, set of solutions across the Photograph © freshidea/dollarphotoclube.com, supplied October 2015. looks to be a trend setter in post-trade life cycle to the market, but based on support our clients in a more holistic way.” Going forward, firm and reliable standards. “We continually Bodson added, “the Omgeo acquisition allowed Bodson anticidiscuss and debate technology and extrapolate us to address several key issues that we identified pates more, not the repercussions of change to help determine as essential to expand our support for the less change, the role we ultimately must play. This approach industry. it has allowed us to engage with our some of which has encompassed our thinking on initiatives such clients in a much deeper and more meaningful he thinks will as Clarient and legal entity identifiers (Leis) and contribute to way. in addition, Omgeo’s global footprint helped driven wider efficiencies in our firm. The further redesigns expand our reach into multiple new markets and hallmark, i would say, is the resiliency in what of the post-trade has played a key role in growing our ability to we do.” landscape. sell our global solutions, such as avox, Clarient Bodson said regulatory reform remains a sigand the global Trade repository. second, the acnificant driver in the trends toward greater risk quisition has been instrumental to our strategy management and increased utilitisation, which of driving greater collaboration among investhe thinks is the foundation for both a successful ment managers, broker-dealers and custodian market and the super-utility concept. “if you look banks to advance key industry initiatives.” at the Us market, it is the deepest and most The studies, the collaboration with like-instiliquid market in the world, precisely because it tutions and the constant review of the DTCC is highly and effectively regulated. regulation is service universe has involved a closer underessential and provides the protection, certainty standing of client requirements, Bodson notes. and transparency that provides investors with “We are much more service focused. We have confidence in the market. as new regulations combined our sales and relationship teams, continue to propel market structure reform, firms headed by Tim Keady, who sits on our manageneed to ensure increased efficiency across operment committee and who ensures that the ations to address evolving compliance and risk concerns of our clients are represented in our management requirements.” discussions. Moreover, we strive to provide a That, mixed with market innovation and new single, seamless, simpler and accessible interface technology will, inevitably feed into DTCC’s long for our clients to gain access to our products,” term business plan. Bodson is clear on the ophe says. portunity set. “The question for DTCC is: how do we apply new technologies in a way that further Preparing for more change ahead drives down risks and costs while still meeting Regulatory going forward, Bodson anticipates more, not less the high standards established through decades reform remains a change, some of which he thinks will possibly of market regulation and market practices? That significant driver contribute to further redesigns of the post-trade is part of the challenge that many institutions, in the trends landscape, but not yet. “There has been a lot of including us, continue to work through right now. toward greater discussion about how new technologies such as so we are focused on innovations that provide risk management blockchain and distributed ledgers will make the additional value by working closely with our and increased existing market infrastructures obsolete. The clients and collaborating with industry partners utilitisation. technology is intriguing and we are actively evalto deliver comprehensive, robust solutions.” n
14
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
COLLATERAL MANAGEMENT
Pending rate rises fuel need for collateral optimisation Eight years on from the global financial crisis, and banks continue to face a growing number of challenges. Many have ceased or significantly reduced proprietary trading, with the resulting reduction in both risk and reward. This period has also seen lower risk appetite among many investors and continuing global competition which has put pressure on profit margins. If this wasn’t enough, regulatory demands to tie up higher levels of capital have resulted in a reduction in working capital and smaller balance sheets. Tighter regulatory requirements for collateral and the heightened need to protect against counterparty default, coupled with an over reliance on cash collateral, has further reduced profitability. As and when global interest rates eventually start to rise, Mike Payne and Giles Kenwright of Delta Capita explain why the need to optimise collateral has never been more important and why getting to grips with growing volumes of data is key to this success.
W
ITH THESE CONSTRAINTS, it is unlikely that we’ll see a return to the record profit margins generated before the term ‘subprime’ entered everyday language. The Bank for International Settlements 2014/15 annual report recently stated “Globally, interest rates have been extraordinarily low for an exceptionally long time”. But with the Fed now suggesting that US rates may rise before the year is out, we could soon see global economic interest rates starting to rise from their unprecedented lows - which will further increase pressure on banks’ profitability. The 2015 ISDA Margin Survey indicated that cash still accounts for over 75% of the $5.01trn collateral supporting non-cleared derivative transactions, with USD and EUR comprising the bulk of this. A 1% rise in interest rates could therefore cost the industry more than $37.5bn in increased funding costs on cash collateral alone. This figure could increase further if the predictions of a significant collateral shortage, once the move to central clearing has been completed, are to be believed. Higher interest rates will also increase funding costs associated with the higher levels of regulatory capital now demanded by Basel III, as well as increasing the cost of financing the balance sheet. The continued high reliance on cash collateral indicates that collateral management
processes are still far from optimal. Due to the increasing costs, collateral optimisation is required to ensure banks deliver the least expensive assets to each counterparty while complying with regulatory constraints. These typically stipulate the need for high quality liquid assets and haircuts for most other collateral. Banks should be reducing their reliance on cash as collateral and increasing the utilisation of government bonds and high-grade corporate securities. Historically, collateral has been managed in silos, with each desk managing their own collateral pools. In order to be more effective, banks must have a firm-wide holistic view of collateral in near-real time. With access to timely and precise information, coupled with the appropriate analysis tools, banks can perform a pretrade optimisation assessment to give traders an accurate view of stock availability and the cost of the collateral associated with a trade. Delivering collateral effectively can therefore have a profound impact on the trading desks’ efficiency. For many banks however, the data on collateral and collateral management applications are fragmented across geographic and business lines. The first step in optimising collateral management processes is to ensure the technology supports a centralised and realtime view of all collateral that exists across the organisation.
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
The need to process ever-growing data sets which are high-volume, highvelocity and high variety is not unique to collateral management or financial institutions. The term “Big Data” is now widely used to categorise the challenges, approaches and tools which have evolved to address this challenge. Use of such tools can assist with the integration, processing and analysis of the large distributed datasets that contain collateral information across the organisation, providing a consolidated view for collateral optimisation and management purposes. These tools are typically layered over the underlying sources of data, and can therefore be implemented in an evolutionary manner, rather than requiring a complete replacement of existing technology infrastructure. This reduces time to market as well as implementation risk and cost. While tools and techniques are making big data easier to adopt, its implementation is still not a trivial undertaking, nor is success guaranteed. With the right business-aligned analysis framework, big data can deliver tangible value to collateral management and the wider organisation. Collateral optimisation is one area that banks can focus on to reduce the impact of the inevitable interest rate increases. Firms that grasp this challenge and harness their data effectively will undoubtedly reap the benefits. n
15
SPOTLIGHT
Photograph © tari767n/dolarphotoclube.com, supplied October 2015.
Cayman Islands confident of being granted AIFMD passport The Cayman Islands is confident that the pan-European marketing ‘passport’ will be extended to alternative investment funds (AIFs) set up in the jurisdiction, according to the Alternative Investment Management Association (AIMA), the global hedge fund industry association. Cayman, where a high percentage of offshore hedge funds are registered, still awaits assessment by the European Securities and Markets Authority (ESMA). The passport enables non-EU AIFMs and non-EU AIFs to be marketed across the European Union.
A
T THE END of July, ESMA issued its recommendation on the potential extension of the passports under the Alternative Investment Fund Managers Directive (AIFMD) to non-EU alternative investment fund managers (non-EU AIFMs) and non-EU AIFs. The Cayman Islands was listed as one of 22 jurisdictions identified by ESMA as both a domicile of non-EU AIFMs that currently market AIFs, and non-EU AIFs currently marketed in the EU member states examined. ESMA has so far recommended that the passport be extended to Switzerland, Jersey and Guernsey but has promised to further assess other jurisdictions including Cayman, the US, Hong Kong and Singapore. Nonetheless, AIMA says that Cayman is wellplaced to have a successful review in the near future. Cayman has already entered into the
16
requisite co-operation arrangements with the major EU investment securities regulators and the necessary tax information exchange agreements with EU governments as required by the AIFMD, AIMA said. In addition, the Cayman Islands Government has been developing an AIFMD compliant opt-in regime to ensure that the jurisdiction can continue to meet the needs of Caymanbased alternative investment fund managers who want to market funds into the EU under the passport. AIMA said it was in the interests of institutional investors in Europe and hedge fund managers globally that Cayman be granted the passport. Alan Milgate, Chairman of AIMA Cayman, explains,“ESMA’s decision should not be misinterpreted. Cayman has simply not yet been assessed, and has certainly not been adversely opined on, or excluded by ESMA. We look
forward to the Cayman Islands being assessed positively in ESMA’s ongoing review of additional non-EU jurisdictions and that AIFMs based in the Cayman Islands will continue to benefit from evolving legislation which is both flexible and adaptable.” ESMA decided to opt for a country-bycountry assessment of the potential extension of the AIFMD passport, and stressed that it will continue to work on its assessment of other non-EU countries not covered in its initial advice with a view to delivering further submissions to the European Parliament, the Council and the Commission in the coming months. There are 2,300 investment managers currently fully licensed or registered in the Cayman Islands. More than 11,000 regulated investment funds, as well as numerous other closed-end fund structures, are currently domiciled in the Cayman Islands. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
measure it understand it apply it sĂZ ƌĞŵĂŝŶƐ Ăƚ ƚŚĞ ŚĞĂƌƚ ŽĨ ƌŝƐŬ ĞƐƟ ŵĂƟ ŽŶ ĨŽƌ ďĂŶŬƐ ĂŶĚ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ But a single VaR number is not the whole story D ƉƉůŝĐĂƟ ŽŶƐ Excerpt ĚĞůŝǀĞƌƐ͗ ^ŚŽƌƚͲƚĞƌŵ ĂŶĚ ůŽŶŐͲƚĞƌŵ sĂZ hƐĞƌ ĚĞĮ ŶĞĚ ƌŝƐŬ ĂƩ ƌŝďƵƟ ŽŶ ŽŵƉƌĞŚĞŶƐŝǀĞ ŝŶƐƚƌƵŵĞŶƚ ĐŽǀĞƌĂŐĞ ƌŽďƵƐƚ ƐƚĂƟ ƐƟ ĐĂů ŵŽĚĞů ĂƐLJ ŝŶƚĞŐƌĂƟ ŽŶ ŝŶƚŽ LJŽƵƌ ŝŶǀĞƐƚŵĞŶƚ ƉƌŽĐĞƐƐ
dŽ ŐĞƚ Ă ďĞƩ Ğƌ ŚĂŶĚůĞ ŽŶ ƌŝƐŬ͕ ĐŽŶƚĂĐƚ͗ ǁǁǁ͘ĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ +44 20 7125 0492 ƐĂůĞƐΛĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ
dŚĞ D ĂůŐŽƌŝƚŚŵ ŝƐ ƵƐĞĚ ŝŶ ƌĂĚŝŽ ĂƐƚƌŽŶŽŵLJ ƚŽ ĐůĂƌŝĨLJ ƚŚĞ ŽďũĞĐƚƐ ƵŶĚĞƌůLJŝŶŐ Ă ŵĂƐƐ ŽĨ ĚĂƚĂ͖ ǁŝƚŚ ŝƚƐ ĂďŝůŝƚLJ ƚŽ ŚĂŶĚůĞ ŵŝƐƐŝŶŐ ĚĂƚĂ ĂŶĚ ƐŚĞĚ ůŝŐŚƚ ŽŶ ƵŶŽďƐĞƌǀĂďůĞ ǀĂƌŝĂďůĞƐ͕ ŝƚ ŝƐ ǁĞůůͲƐƵŝƚĞĚ ƚŽ ƉƌŝĐŝŶŐ ĂŶĚ ŵĂŶĂŐŝŶŐ ƚŚĞ ƌŝƐŬ ŽĨ ŝŶǀĞƐƚŵĞŶƚ ƉŽƌƞ ŽůŝŽƐ͘ dŚĞ D ƉƉůŝĐĂƟ ŽŶƐ ƌŝƐŬ ŵŽĚĞů ĂŶĚ ĂƩ ƌŝďƵƟ ŽŶ ƚĞĐŚŶŝƋƵĞƐ ĂƌĞ ďĂƐĞĚ ŽŶ ŽƌŝŐŝŶĂů ǁŽƌŬ ďLJ ů ^ƚƌŽLJŶLJ ĂŶĚ ƌ dŝŵ tŝůĚŝŶŐ͘
ĂŶĂůLJƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ
SPOTLIGHT
RBI’s Czech subsidiary to acquire Citibank’s Czech retail business Raiffeisen Bank International AG’s (RBI) Czech subsidiary, Raiffeisenbank has signed an agreement with Citibank Europe plc (Citi) today to purchase Citibank’s retail banking business and card businesses in the Czech Republic. the selling price and transaction details will not be disclosed. The transaction, which is still subject to customary and regulatory approval, is expected to close in the first quarter of 2016 and will have an insignificant effect on RBI’s capital ratio.
T
HE ACQUISITION OF Citibank’s retail portfolio by Raiffeisenbank is in line with RBI’s new strategic measures which we announced at the beginning of February. Although for the time being, our aim is to reduce our risk-weighted assets, we want to grow in selected markets which are in a strong position to generate sustainable returns. The Czech market is one of those, as it offers a stable economic and legal framework, there’s still catch-up and growth potential in the banking market, and our expectations regarding
profitability and risk are positive,” says Karl Sevelda, CEO of RBI. “Raiffeisenbank is in very good financial shape. It is a solid, strong and stable financial institution with ambitions for future growth, both organically and through select acquisitions,” says Igor Vida, CEO of Raiffeisenbank. He further explains: “Our focus lies on affluent clients who are interested in high quality services, active finance management, and professional advisory services.” RBI has been present on the Czech
market since 1993. Raiffeisenbank is the Czech Republic's fifth-largest bank by total assets and offers a full range of banking services to private and corporate customers. Other specialist companies provide services in the areas of building society, insurance and leasing. As of the end of the first half of 2015, Raiffeisen served around 397,000 customers through 125 business outlets in the Czech Republic and has about 2,700 employees. The bank’s range of outstanding services and their quality are regularly awarded. n
Stock specific strategies outperform indices over long term says BNP Paribas IP study of EM small cap stocks The long term favourable economic profiles of many emerging market (EM) countries are well documented. Emerging markets have delivered a ten year cumulative annual growth rate (CAGR) of 11.5% nominal GDP growth, compared with a 3.9% CAGR for the United States. What has not really been examined is the subsegment of emerging market small caps, which remains less efficient than the large cap segment.
A
NEW STUDY BY BNP Paribas Investment Partner, published in September, looks at the performance characteristics of emerging markets (EM) small cap stocks and their deviations from larger EM and developed market stocks; and, which suggests that it offers investors the opportunity to generate substantial alpha. The study suggests that with high single stock dispersions and positive risk/reward characteristics, EM smallcap offers a significant alpha-generation opportunity for active investors. However structural impediments, such as transaction costs, a lack of reporting and lower-quality analyst data can be a source of performance drag for more
18
passive, index-oriented strategies. Moreover, changes in benchmark composition have resulted in the standard EM equity benchmarks becoming more globalised. Specifically, country factors in returns attribution have declined, making a macroeconomic approach to investment in emerging markets less effective. In contrast, the EM small-cap asset class provides a significant opportunity for geographic diversification and provide less exposure to global cyclicals such as Brazil and China; greater exposure to information technolo9gy and countries with current account surpluses. The study uses as proof, Factset data that states that EM small cap exposure to
current account surplus countries is 72.1% of the index, compared with 65.8% for EM standard/ Meanwhile the stock-specific contribution to returns for emerging market small cap for EM small cap has increased, providing increased scope to generate alpha through active stock selection. If properly executed then, the study posits the view that investing in EM small cap provides numerous potential benefits for asset allocators. These include diversification, greater dispersion and strong risk-reward characteristics. Given the alpha-generation opportunities in EM small cap stocks, the asset manager says that neglecting them represents a meaningful opportunity cost for investors. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
Stay connected to a world of intelligence
You can download the Issuu app free from
For important updates and information on new access channels to our news and analysis please contact: Chris Maityard EM: chris.maityard@berlinguer.com TL: [44] (0) 207 680 5162 Photograph Š Daboost | Dreamstime.com
Find us on
SPOTLIGHT
Demand for transactional risk insurance still rising says Marsh Demand for transactional risk insurance continued to grow during the first half of 2015, with an overall increase of 15% year-on-year in terms of limits placed by Marsh. “The demand for transactional risk insurance on mergers and acquisitions (M&A) transactions continues to grow rapidly, as competition among acquirers continues to remain intense,” says Karen Beldy Torborg, global leader for Marsh’s Private Equity and M&A Services practice. “Dealmakers, both from the private equity and corporate space are increasingly using insurance capital to get deals over the line and we don’t see this trend subsiding anytime soon. This is true in the Americas, EMEA, and Asia-Pacific.”
T
HE US EXPERIENCED dramatic growth in demand from all sectors, on the back of a record year in 2014. In Europe, real estate deals continued to drive demand, and we’re seeing a trend for dealmakers to include title insurance as part of the transaction. Larger deal sizes and a greater acceptance of this insurance solution buoyed demand in Asia. Private equity firms continue to be the heaviest users of transactional risk insurance as they seek ways to reduce indemnity requirements when buying and make clean exits when selling. Despite the trend, Marsh says corporations become more comfortable with using transactional risk insurance, particularly in the US and Asia-Pacific, and with companies that are buying or selling companies on a regular basis. Transactional risk insurance — including warranty and indemnity (W&I) or representations and warranties (R&W) insurance, tax liability, and other contingent liability solutions — is now widely available in most jurisdictions or geographies around the world and has become a common riskmitigation tool for dealmakers. The growth in capacity and availability of this niche type of insurance is yet another example of insurers expanding from traditional property and casualty lines into more complex, solutionoriented, specialist classes of insurance. North America continued to see strong demand for transactional risk insurance, with the market showing no
20
Photograph © maimu/Dollarphotoclub.com, supplied October 2015.
signs of slowing down after the explosive growth witnessed in 2014. So far in 2015, buyer-side policies have been predominantly driven by sellers using them as tools to make the sales process more attractive. Essentially, sellers are offering to fund part or all of the buyer-side policy as an inducement to proceed with the transaction and to limit their post-closing liability. “Auctions continue to drive the transactional risk market, with sellers increasingly sending out draft bids that include buyer-side coverage. We are also seeing corporate buyers becoming more interested in using this type of insurance to facilitate deals,” explains Craig Schioppo, Transactional Risk leader for
North America.“We think this trend will increase as corporate buyers realise they need to use insurance to help get deals finalized to better compete with private equity buyers in auction situations.” Demand for transactional risk insurance also continues to be robust across EMEA, with more innovative uses such as contingent tax liability, and in combination with title insurance, adds Andrew Hunt, Transactional Risk leader for EMEA.“We have also seen the median limit of insurance purchased per transaction across EMEA increase from $18m 2014 to $24m in 2015, which means more insurance is being purchased per individual deal – a trend we see continuing throughout the remainder of the year.” In comparison, in Australia and New Zealand, transactional risk insurance is more integral to corporate clients, evidenced by the higher proportion of corporate policies compared with other regions. Buyers are increasingly asking for — and receiving — zero retention and de minimis for title as part of their coverage terms from insurers.“We are seeing some interesting industry trends emerge across the region, with transactional risk insurance use increasing among deals in the mining, light manufacturing, animal care, and food and beverage sectors,” says Josh Roach, Transactional Risk leader for AsiaPacific.“We expect the second half of the year to show similar trends as the first half, with 2015 shaping up to show strong growth across Asia-Pacific. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
SPOTLIGHT
2015 AGM season: fewer headlines but major issues still remain, says NAPF The National Association of Pension Funds’ (NAPF’s) third Annual General Meeting (AGM) Season Report suggests much more purposeful and effective engagement between companies and investors – but there remain a number of exceptions and this year’s report highlights three areas to note:12 companies within the FTSE 350 where shareholders have for a successive year expressed discontent with particular governance arrangements; the top five FTSE 100 and top ten FTSE 250 shareholder rebellions on executive pay; and 17 companies in the FTSE 350 where re-election of individual directors drew shareholder dissent of more than 15%.
W
HILE IN PART THE examples mentioned above illustrate instances whereby individual directors have been held accountable by shareholders for decisions made through the year, says NAPF, more commonly however, the incidents demonstrate that proxies will often likely continue to be used for assessing a directors’ quality; these include his or her attendance at board meetings and assessments about their independence and impact on overall board composition. Looking back, 2014 was a year of significant change for UK listed companies. It was the first year of reporting under the new directors’ remuneration reporting regime which also included the introduction of a binding vote on a company’s remuneration policy at the AGM. Companies were also confronted last year with the introduction of a new strategic report replacing the previous business review and enhanced auditor and audit committee reporting. In comparison, UK companies this year have had no fundamental changes to the reporting structure with which to deal with. As such it was understandably expected that this year’s AGM season would likely be much quieter as companies have had time to settle into the new reporting framework and shareholder voting requirements. A quick look at 2015 might suggest it was a relatively quiet year on the corporate governance front. Limited regulatory changes and a General Election resulted in fewer corporate governance headlines. That said, the increased focus on corporate
governance is here to stay and there have been some notable moments this season: there were three shareholders’ resolutions at large UK companies and these are an uncommon occurrence in the UK, and elsewhere there were significant rebellions at approximately 20% of FTSE 100 and FTSE 250 companies,” says Will Pomroy, policy lead: corporate governance & stewardship, NAPF, The issue of executive pay continues to attract a lot of attention. While companies are not required, nor are they expected, to return to shareholders for approval of their remuneration policy every year the issue remains a lightning rod and proxy for wider governance concerns. In March this year the UK’s Department for Business, Innovation and Skills (BIS) published its review of the success of the new regulations. BIS found that most companies complied with the majority of the requirements in the regulations. However, it was reported that there was a significant level of non-compliance with the requirement to specify clearly, in monetary terms or otherwise, the maximum future salary that may be paid under the remuneration policy. On this aspect it should be noted that investors and their representative bodies (including the NAPF) have been relaxed about the lack of firm caps for salary increases instead welcoming the more flexible approach adopted which avoids potential unintended consequences. The BIS review also highlighted that in relation to the consideration of workforce pay when setting remuneration policies, a significant minority of
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
companies provided insufficient detail for shareholders to judge how such consideration actually works in practice. With the SEC in the USA adopting a rule this summer requiring public companies to disclose the ratio of the pay of its CEO to the median pay of its employees it is likely that pressure will grow for companies to be mindful of internal disparities in pay and to communicate more clearly how these considerations inform their arrangements for executive management. The NAPFs own Remuneration Principles highlight that it is not always clear why historically some executive directors receive NAPF 2015 AGM season report pay increases that are greater than those awarded elsewhere in the organisation, and which feed through to the bonus and long term incentive plan (LTIP) to widen the pay differentials within the company, or enjoy preferential tax treatment or far more generous pension arrangements – or cash in lieu – than less senior colleagues. The NAPF is clear that remuneration committees should consider whether they are able credibly to justify any such differential.“As ever, the issue of executive pay continues to attract a great deal of attention and often acts as a lightning rod or proxy for other wider governance concerns. In the current economic environment it is encouraging to see that some restraint on pay has continued this year with a third of CEO salaries being frozen, bonus opportunities and awards remaining static and LTIP opportunities and awards increasing only slightly,” says Pomroy. n
21
SPOTLIGHT
Photograph © Abstract /Dollarphotoclub.com, supplied October 2015.
Net fundraising highest on record over year to date Latest Association of Investment Companies (AIC) data suggests that net fund raising over the year to date for the sector is a record £3.9bn, a higher total raised than in any whole calendar year in history. The performance is in large part an effect of higher yielding companies in specialist sectors, as well as from Woodford Patient Capital, which raised £800m at launch and £30m subsequently through issuance activity.
S
TRONG DEMAND FOR investment company shares is perhaps also reflected in the latest discount/premium data, with the investment company sector, on average, shrugging off the August volatility over the year to date at least. The average discount widened out just 0.4% in August to 2.9%, which was only 0.5% off its all-time record low in June 2015. Annabel Brodie-Smith, communications director, Association of Investment Companies (AIC) explains that,“Despite the August volatility, investment company ratings are to date relatively unmoved, with record-breaking
demand clearly offsetting what has been a more challenging time for markets. It is the specialist, higher yielding sectors which continue to raise the most money and attract the highest ratings, but many of the strong performing-retail focused investment companies are also steadily raising money, including Scottish Mortgage and Witan. “Of course August is just one month, and it’s worth remembering that whilst investment company discounts can have a correlation with wider markets, this isn’t always the case. During the bear market of the technology bust from February 2000 to October 2002,
Net fundraising investment company sector – to September 14th 2015
investment company discounts were not discernibly any wider than they had been previously. “On the other hand, during the bear market of the financial crisis from 30 September 2007 to 28 February 2009, discounts widened out significantly with the average discount for the industry touching 18% at the end of December 2008. The record net fund raising levels and discounts remaining relatively narrow indicates that demand for the investment company sector remains strong with the sector continuing to appeal to investors with new investment opportunities.” n
Source: AIC Septemsupplied June 2014.
Excluding VCTs
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 year to 14/09/15
Total money out (£bn)
-3.23 -1.83 -1.67 -1.41 -3.10 -4.23 -4.57 -5.70 -4.02 -5.30 -2.87 -3.18 -2.86 -3.66 -2.99 -1.52
Total money in (£bn) Net fundraising (£bn)
Total IPO (£bn)
4.36 3.92 0.78 1.31 1.66 4.05 7.63 9.06 2.84 2.74 3.17 2.30 2.65 6.76 6.17 5.45 1.13 2.09 -0.88 -0.10 -1.43 -0.19 3.06 3.36 -1.17 -2.56 0.30 -0.89 -0.21 3.10 3.18 3.93 3.81 3.05 0.52 1.10 1.21 3.07 5.64 5.97 1.37 0.71 1.76 0.95 0.86 2.91 2.56 2.33
Total secondary 0.55 0.86 0.26 0.21 0.46 0.98 1.99 3.09 1.48 2.03 1.41 1.35 1.79 3.85 3.61 3.12 issues (£bn)
22
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
SPOTLIGHT TSX Alpha Exchange launches In late September TMX Group launched a new trading model on TSX Alpha Exchange (Alpha), designed to improve execution quality for natural investors and reduce dealer costs. The move is a milestone in TMX's initiative to improve the Canadian trading landscape and reduce market complexity Photograph © isoga/Dreamstime.com, supplied October 2015.
Australia’s hedge fund sector set to pass AUD100bn mark Treasury reforms, financial innovation and growing demand is driving interest in Australia’s hedge fund industry, according to the Alternative Investment Management Association (AIMA), the global hedge fund industry association. Currently managing AUD96.9bn ($67bn) in assets, according to the Australian Securities and Investments Commission (ASIC), renewed interest in the segment is set to drive more assets into Australia’s hedge funds.
T
HE SEGMENT HAS experienced strong growth as the value of assets managed by hedge funds increased by a touch more than 45% between 2012 and 2014. ASIC data also suggests that last year Australia’s largest hedge funds reported average returns of 15.6%, low levels of leverage and adequate liquidity.“Australia is growing strongly, with local AIMA membership having grown over 25% in the last 18 months. This reflects the region’s depth of hedge fund talent, tenacity and investor engagement,” says Jack Inglis, AIMA chief executive. “We’re at an inflection point where subdued equity and debt markets are setting an extremely positive backdrop for hedge funds to become the fastest growing segment of the Australian investment management market,” explains Paul Chadwick, AIMA Australia chairman.“With innovative strategies coming to market, from alternative beta to strategies that target the capital
lending functions once dominated by banks, we expect the number and types of hedge fund strategies to grow significantly,” he adds. Since Australia’s Investment Manager Regime (IMR) was legislated earlier this year,“we understand that a number of hedge fund management firms based internationally have been considering establishing operations in Australia. The certainty and clarity provided by IMR allows commercial considerations to be explored more fully, which is enormously encouraging for industry growth,” says Inglis. The IMR is part of Australia’s taxation legislation and sets out circumstances in which non-residents investing in Australian financial instruments will not be subject to tax in Australia. The IMR is similar to equivalent regimes in the UK and other international investment management centres. It was passed by the Australian Senate on June 19th this year. n
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
A
LPHA'S NEW FEATURES, which received Ontario Securities Commission approval in April, include a minimum size threshold for liquidityproviding orders, competitive pricing for active flow and a short order processing delay (speed bump). In addition to these changes, Alpha was migrated to TMX Group's high performance equity trading engine, TMX Quantum XA™. The opening auction on Alpha has been eliminated and Alpha's IntraSpread facility and TMX Select have now ceased operation. All changes came into effect at the open of the markets on September 21st. "We are committed to strengthening our client relationships and pushing forward with solutions to meet their needs," says Nick Thadaney, president and chief executive, Global Equity Capital Markets, TMX Group. "The new Alpha trading model is the product of vital and ongoing consultation with, and feedback from, our broad group of industry stakeholders. We continue to actively seek out ways to enable our clients to be more successful and enhance the attractiveness of Canada's markets." In October last year the TMX Group announced it was restructuring its equities trading offering in an effort to retain Canadian order flow, empower natural investors and other non-latency sensitive participants to trade with confidence and to reduce market complexity. The next step in this series of targeted changes is the introduction of TSX's Long Life order type, which is scheduled for November 16th this year. n
23
VANTAGE POINT
Positioning for a hike Current market conditions offer challenges for anyone with money to run. Divergent central banking policies, the recent volatility in Chinese markets and associated risks, continued instability in the Eurozone and the unpredictable behaviour of commodity markets all haunt investors in the small hours. But what if, as an investor class, you had an additional set of risks above and beyond the market backdrop? For Defined Benefit pension schemes, that is the reality. Goldman Sachs Asset Management’s Kathleen Hughes, managing director of the Investment Management Division, discusses the challenges faced by defined benefit pension schemes in the current and future investment environment
T
HE NATURE OF their mandate – delivering a predetermined income to scheme members, regardless of extraneous factors – throws up some highly demanding challenges, encapsulated in the concept of funding. Fundamentally, they constantly have to ask themselves:“are we sufficiently well-funded and invested to make those payments?” Even before they confront the problems with which all investors have to wrestle, DB scheme sponsors must confront a factor from outside the investment world
24
that, for most, is only a positive: longevity. The longer beneficiaries live, the longer payments have to be made to them. If longevity outstrips expectations, liabilities go up. Indeed, when the US Society of Actuaries issued new mortality statistics last year, gross reported liabilities for some schemes increased by 5% or more. The effect is three-fold: the greater the outflow through payments, the lower the funded percentage for under-funded plans; outflows also reduce the asset base of plans, leaving fewer assets to grow in
future; and greater demand for payments means liquidity needs go up, preventing schemes from investing in the illiquid asset classes that offer the highest longterm returns. Turning to investment, the prolonged equity Bull Run over the last four years has provided a much-needed boost to funded levels, but what the market has given with one hand it has taken with the other: record low interest rates since the financial crisis have increased the present value of obligations and dragged
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
on funding. Also, with many global equity markets trading near all-time highs early this year, the sustainability of returns in that market is in doubt. While improving economic indicators have primed some economies for a rise in rates, continuing low levels of inflation and the threat of volatility have given central bankers reason to delay lift-off for now, as we saw most recently earlier this month when the Fed kept rates on hold. The benign outlook on inflation has also led to questions as to how quickly longterm rates will rise when the tightening cycle begins at the short end. In markets where yields are relatively more attractive, the sheer weight of demand could keep a cap on investment income: US Treasuries, for example, offer higher yields than other government bond markets but as investors flock to the asset class for this reason, the demand will have a softening effect on the yield curve. A similar dynamic is evident in the UK, where there are £1.3 trillion in pension liabilities but only £600 billion in outstanding debt. These factors, combined with the liquidity constraints preventing many funds from investing in higher-yielding illiquid assets, leave scheme sponsors around the world with a series of questions. These include how to reduce equity volatility in portfolios; how to prepare for
the expected challenging environment in fixed income; defining the role of alternatives in portfolios; how to set and manage acceptable levels of liquidity risk; how to meet return assumptions in a lowreturn environment; how to exploit shortterm opportunities when investment committees meet infrequently; and how, in the case of well-funded schemes, to de-risk and thus evade large draw-downs in asset values and funded levels. To answer these questions, many of the schemes we advise are evaluating new strategies to cope with the headwinds coming their way. One of the most critical issues is how to navigate the unpredictable fixedincome market, in light of the policy changes that we know are coming. One solution is to position exposure in that asset class to anticipate a rising rate environment, with the flexibility to add long duration and liability-driven investment exposures to reduce interest rate or inflation risk. This could include incorporating unconstrained strategies allowing for tactical allocations; introducing more international and emerging market debt, as many plans have already done with equity portfolios; looking for floating-rate securities to hedge rates; and adding to long duration bonds while hedging duration, to reduce interest rate risk when credit
spreads appear to be attractive. Schemes should also consider reshaping equity exposures to reduce volatility and maximise potential returns. Options for this include deploying“smart beta” strategies to improve risk/return relative to traditional benchmarks; reducing home country bias through exposure to areas, such as emerging markets, where active management makes sense; and considering hedged equity strategies, given that markets are at historically high levels. Also within equity, scheme operators should assess the possibility of reducing beta risk through diversification. This could include investing in long/short equity hedge funds, a sensible option given the long bull run; exploring assets such as private equity and debt or real estate when there is capacity for illiquid assets and considering illiquid alternatives when it is absent. The final – and potentially critical – strategy schemes should consider is the use of strategic partnerships. These can be advisable when governance structures do not allow a plan to exploit tactical opportunities, or when schemes would like to expand into an asset class in which it has little experience. The right external advice can help schemes take full advantage of the range of investment options in the market. n
DRAWN A BLANK? If you need reprints for your marketing needs Simply call or email Contact: Francesca Carnevale Tel: 44 [0] 20 7680 5152 Email: francesca@berlinguer.com
We will be pleased to tailor our reprints to your specific requirements.
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
25
DERIVATIVES GOVERNANCE Photograph Š kentoh/dolarphotoclub.com, supplied October 2015.
Enabling product innovation for asset managers Typically considered an instrument reserved for hedge funds and complex investment strategies, derivatives are becoming far more common within investment portfolios and are increasingly desired by portfolio managers for exposure and risk management. The issues investment managers face to effectively and efficiently implement a new derivative instrument type are clear. Enabling the trading of a new instrument type to quickly support a portfolio manager request, while taking into account technology restraints and mitigating operational and reputational risks, requires significant due diligence and a robust yet flexible governance model to support the process. Geoff Cole, director of business consulting based in New York and Jackie Colella, senior manager business consulting based in Boston, at Sapient Global Markets outline the dynamics.
L
ARGE INVESTMENT MANAGERS increasingly use derivatives in their portfolios to support the introduction of new, innovative products that seek to utilise more advanced methods for interest rate, credit and currency risk management, as well as provide unique exposure opportunities potentially not offered by or accessible to competitor products. This response is motivated by downward pressure on both fees and firm profitability, and concern of underperformance relative to benchmark-tracking passive strategies and exchange-traded funds. At the macro level, the prolonged low interest rate environment has made out-
26
performance within fixed income products particularly challenging, while the anticipation of global changes to interest rates and central bank policies has left institutional investors with few alternatives to appropriately manage the risk. Derivatives are increasingly used as an additional tool for portfolio managers seeking exposure to countries, currencies, or rate differentials which is driving broader, more complex derivatives usage to become a key enabler to product innovation and the way asset managers structure portfolios. Products and strategies that more intensively use derivatives, such as unconstrained bond funds or liquid alternatives,
are growing in number as another avenue for investment management firms to increase revenues, capture sophisticated investors’ assets, execute upon unique investment ideas from research teams, and manage risk more effectively. Additionally, as clients and products become more internationally distributed, more complex hedging strategies are required to reduce risk and return profits to local currency or protect against unfavourable future yield environments. The ability to better understand and govern derivatives usage has enabled investment management firms to not only execute derivatives at a lower cost but to also scale in terms of both volume and
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
ability to support complexity in the form of new product launches without significantly adding to the cost. Nimble governance structures can help asset managers unlock the full value of technology and operations in reducing time to market and giving portfolio managers access to a comprehensive range of tools at a reasonable, incremental cost. The evolution of traditionally sell-side oriented technology platforms to better cater to buy-side needs for derivative trade execution, risk and lifecycle management is an indicator of the blurring of the lines between investment managers and the dealer community. Lagging behind is investment in the on boarding and management of new derivative instrument types for client accounts, legal agreements and internal governance. From a governance and operational support perspective, the investment management industry is beginning to consider derivative as an asset class alongside equity and fixed income. Having a more complete range of derivative capabilities enables asset managers to nimbly manage risk, volatility and liquidity, as well as seek and execute upon numerous investment team ideas envisioned for their clients’ portfolios. With this evolution, firms are confronting more complex issues associated with trading and managing derivatives positions and new instruments, because the level of complexity and inconsistency industry-wide is greater than traditional cash securities.
Market complexity The complexities of derivatives and firms’ disparate individual abilities to implement and manage the operational risk associated with introducing new derivative instrument types into the investment infrastructure, exponentially increases the difficulties associated with the governance and onboarding of new derivative instruments into the front-to-back investment management infrastructure. The investment management industry is struggling to determine the proper level of operational and legal due diligence necessary to create a level of comfort appropriate for firms to trade new derivative products, while balancing investment
managers’ desire to be the first to market with a new product offering that offers a unique exposure or risk management approach. We’ve observed that operationalizing the trading of new derivative instrument types can extend the lead time of new product introduction by three to six months. The intricacies of trading derivatives across markets require large operational assessment efforts that can often delay the inclusion of a new instrument in a portfolio, leading to missed opportunities in the market.
Broader range Investment managers are seeking a broader range of exposures using an increasingly diverse set of instruments. When I have asked asset managers how they currently use derivatives and their future views on usage of derivatives within their investment products, three primary trends emerged. The primary use for derivatives is for hedging purposes, followed by generating alpha and liquidity management. The majority of investment managers will say that pooled vehicles hold most of their derivative strategies and investment products, followed by institutional as well as individual separately managed accounts (SMAs). All of the asset managers add that SMAs add a layer of complexity to implementing a new derivative instrument type, due to additional legal agreements required as well as coordinating client approvals. In addition, most firms expect an increase in derivative trade volumes over the next one to three years, based on market conditions and/or strategy diversification. Some firms expect sharp increases in volumes and trades as the multi asset/ sector space gains traction, while other firms expect to see unchanged volumes in anticipation of the impact of new regulations or a potential decrease in the number of trades as transactional size increases due to costs. Governance plays an integral role in on boarding and enabling a new instrument type for trading across the investment management technology and operations
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
infrastructure. Therefore, it is essential for firms to assess their current governance models and practices to identify strengths, weaknesses and limitations. Many firms have governance committee(s) responsible for approving the operational aspects of new instruments; however, the process for implementing the changes varies widely from firm to firm. In most cases, different committees are responsible for approving derivative usage on a portfolio or fund level, but most committees only approve operational capability. Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels to support the on boarding lifecycle. In addition, reviews should be conducted on a regular basis. The majority of firms review derivative usage bi-weekly or once a month, yet almost all say their committee convenes on an ad hoc basis to review any new issues that arise with a portfolio manager’s new instrument request. For all the firms we’ve spoken to, however, none felt they were fully resourced in staffing for on boarding new derivative instruments. Firms should also determine the level of efficiency in the current process for assessing their readiness to trade a new instrument type. Incorporating a streamlined process to approve and implement a new derivative instrument is paramount to mitigating operational risk and reducing time to market for new products and investment strategies. For many firms their governance structure is far from streamlined and that challenges and backlogs exist primarily in operations and technology. Asset managers are searching for the right balance between enabling portfolio managers and investment teams to express their investment desires through any means possible (including usage of derivatives) and achieving the optimum level of operational control and reputational risk management. However, major operational challenges occur in the process of assessing and approving new derivatives, managing legal agreements, meeting regulatory mandates, and achieving fast time to market for new in-
27
DERIVATIVES GOVERNANCE vestment products while controlling operational risk. Legal agreements, for instance, pose an interesting challenge for investment management firms. The due diligence needed to manage master umbrella agreements is cumbersome and requires qualified staffing with knowledge of the intricacies of derivatives documentation. When discussing legal agreements with asset managers, a small percentage say their clients negotiate their own agreements with counterparties. If an investment manager chooses to trade a new derivative not stipulated in the original client negotiated agreement, it may take weeks or months to have all the paperwork completed, delaying capitalizing on that derivative trade. The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes. The new regulatory requirements have changed the legal review and documentation process. Additional “touch points” requiring clients to sign off on each new requirement adds weeks to months for documents to be returned should now be in place. As well, extra legal team resources are needed to review regulatory changes as most changes occur only in the documentation. Because the regulatory environment may change, the process is largely “case by case” in which firms may “inform” rather than “request” approval from the client. Asset managers say that it can take anywhere from three weeks to one year to completely take on board a new derivative instrument type. The majority of firms also say that most instruments are traded with manual workarounds without taking into account post-trade operational processing, including settlement, collateral management and even client reporting. In many cases, an instrument that is too complex for existing systems can delay implementation for over a year and will sometimes lead to the decision not to make the instrument type available to portfolio managers at all. In addition, the majority of firms say they complete a full end-to-end testing
28
of any new derivative instrument. However, in some cases, this testing is completed for one specific business unit rather than firm-wide, which can increase operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade that newly enabled derivative instrument. Reliance on standard vendor packages for trading and risk management may provide out-of-the-box support for most instruments, but changes to interfaces and configuration may be more complex than anticipated or require close coordination with software providers. Essentially, each new instrument request becomes a joint business and technology project, requiring scope, funding and prioritization against all other IT projects, which can also prolong the period between the request to trade and the first execution.
Improving practice For asset managers looking to continually innovate, introduce new products and enable their investment professionals with a full toolkit of market access and riskmanagement tools, the time to enable trading of a new derivative instrument type must be significantly compressed. Revamping governance models and approval processes is required to streamline, centralize and balance the time-to-market push against operational risk. Additionally, investment in workflow tools for transparency and tracking, dedicated derivatives/new instrument due diligence teams and the active involvement of operations teams is necessary to inspire and enable the cultural change needed to support usage of more complex product types. These changes are often overlooked dimensions of a robust target operating model (TOM) initiative that can address the definition of roles, responsibilities and accountability, as well as identify opportunities for improvement and investment across a firm. As product innovation accelerates, fee and cost pressures persist, and competition for assets increases, asset managers must tie all of the capabilities, supporting derivatives, including legal, client service,
collateral management, risk management, reporting and project management, together in the form of a nimble and responsive governance model to enable a true competitive advantage. Improvements in governance models and practices must also take into consideration future industry, market and regulatory shifts. For example, asset managers are encouraged to consider a number of factors, such as determining if using Special Investment Vehicles (SIVs) across accounts is a viable option, preparing for BCBS 269 compliance and other regulatory change, and providing all personnel with appropriate derivatives education and training.
Opportunity knocks As product innovation accelerates and competition for assets increases, derivative usage will continue to grow in both volume and complexity. While most asset managers recognize this, the focus of investment and operational improvement has typically been directed toward frontto-back trade flow improvements. In order to support increased usage of derivatives, most firms need to refresh their governance, approval and operational due diligence process. Yet the majority of the investment managers interviewed have reactive governance structures, which is a major contributor to the time lag of assessing and approving a new derivative instrument. In addition, no investment manager was continuously improving their governance structures, suggesting that derivatives governance is not recognized as a vital investment area. Asset managers need new products and outperformance to compete, differentiate and win. Derivatives are a valuable tool for product innovation and delivering outperformance in a risk-controlled manner. The opportunity exists to refresh or realign governance structures to better support organizational growth in accordance with derivative usage plans. Adopting new practices for governance and operational risk management specific to derivatives can help asset managers reduce time to market and more quickly respond to portfolio managers’ needs. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
IN THE MARKETS – TRADING
Spoofing the order book: UK and US regulators take aim The US authorities continue to police the derivatives markets for unlawful “spoofing”— a sometimes awkward term that denotes entering orders for derivatives trades without the intent to execute them. Spoofing is rather vaguely defined in the law, both in Europe and the US; nonetheless regulators are increasingly prosecuting civil and criminal actions against market participants for alleged violations. Asset managers—already under the microscope in the United States—are also under scrutiny for possible illegal activity in this area. In the UK meantime (and elsewhere for that matter) asset managers are now reviewing their trading activities in increased regulatory pressure in this area. David Miller (New York), Josh Sterling (Washington) and William Yonge (London) partners in global law firm Morgan Lewis outline the repercussions.
S
POOFING IS A form of market manipulation in which the trader layers the order book by submitting multiple orders on one side of an exchange’s order book at prices away from the touch in order to move the price but with no intention to execute. The trader then executes an order on the other side of the order book to take advantage of the price movement, following up with a rapid cancellation of the orders submitted initially. In short, the market has been “spoofed” and the trader has thereby profited at the expense of other investors and the market’s integrity. The UK’s civil market abuse regime was first introduced in 2001 and amended in 2005 to implement the EU Market Abuse Directive, under which manipulative transactions constitutes a type of market abuse. Manipulative transactions include those that are likely to give a false or misleading impression as to the supply of, price of, or demand for, one or more qualifying investments and are executed without legitimate reason. In August 2009, the FSA (the Financial Conduct Authority’s [FCA’s] predecessor) publicised concerns about such order book conduct and behaviour at regulated firms offering their clients direct market access (DMA), believing the practice
could constitute market abuse. The regulator has since taken enforcement actions against perpetrators. Similarly, around this time, the London Stock Exchange (LSE) addressed this topic for its member firms, reminding them of their obligations under LSE rules to ensure they exercise adequate control over activity on its DMA platforms. In 2010, the United States’ Commodity Exchange Act (CEA) was amended to prohibit any person from engaging in any trading, practice, or conduct on or subject to the rules of a futures or swap exchange (or other registered entity) that “is of the character of, or is commonly known to the trade as,‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).”
Best conduct To clarify the type of conduct that is prohibited, the US Commodity Futures Trading Commission (CFTC) published guidance on spoofing and other disruptive trading practices. Among other things, the CFTC noted that a spoofing violation requires a market participant to act with some degree of intent beyond recklessness to violate the statute. Moreover, when distinguishing between legitimate trading and spoofing, the CFTC
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
explained that it intends to evaluate the market context, the person’s pattern of trading activity (including fill characteristics) and other relevant circumstances. Under the UK market abuse regime, both the FCA and the courts may impose an unlimited fine for spoofing. In the FCA’s words: “Abusive strategies that act to the detriment of consumers or market integrity will not be tolerated.” By way of example, in the Summer of 2011, the FSA obtained a court injunction against an English fund management company operating from a Swiss branch called Da Vinci Invest Limited, a related Singapore company, and a Seychelles company— along with three individuals resident in Switzerland and/or Hungary trading on behalf of those companies—to prevent manipulative activities concerning UKlisted shares. These defendants traded on a UKbased multi-lateral trading facility offering DMA, which reported its suspicions to the FSA. The FSA proceeded to bring a claim in the High Court for a final injunction and fine against the defendants. The defendants’ spoofing was shown to have consistently resulted in them buying shares at lower prices and selling shares at higher prices than would have been the case had the strategy not been
29
IN THE MARKETS – TRADING
employed. On August 12th this year, the court imposed fines against the defendants totalling £7,570,000. In May 2011, the FSA imposed a fine of £8m on Swift Trade for market abuse arising from spoofing. Curiously, the individual traders implicated in the Da Vinci case had previously traded on behalf of Swift Trade but were not defendants in the FSA’s action against Swift Trade. In other instances, the CFTC recently has used its new statutory authority to enforce a prohibition against spoofing and the DOJ recently brought criminal charges for commodities fraud against an individual for spoofing. Under the CEA, spoofing is punishable by a maximum sentence of 10 years’ imprisonment and a fine of $1m. A count of commodities fraud is punishable by a maximum sentence of 25 years’ imprisonment and a $250,000 fine. On October 1st last year Michael Coscia, founder of Panther Energy Trading LLC, was indicted in the United States on six counts of commodities fraud and six counts of spoofing in the first criminal spoofing case. The indictment alleges that Coscia and Panther engaged in spoofing by using a sophisticated computer trading algorithm to place trades and promptly cancel trades before execution to create the illusion of market interest, artificially moving prices in Coscia’s favour. After the market reacted to the non-bona fide trades, Coscia placed and filled real trades, realizing $1.5m in profits. Interestingly, the FCA had earlier investigated and taken action against Coscia, its inaugural enforcement action against a high frequency trader. In July 2013, the FCA fined Coscia as much as $903,178 for market manipulation of commodities futures on the UK’s ICE Futures Europe Exchange using an algorithmic programme he had designed to engage in layering. Notably, Coscia and Panther’s trading activity originated from the United States but involved the submission of orders to a UK-regulated market. More recently, in an example of its global reach, the CFTC filed a civil complaint against Navinder Singh Sarao, a London-based high-frequency trader,
30
Joshua Sterling, partner, asset management division, Morgan Lewis. Photograph kindly provided by Myddleton PR, September 2015.
David Miller, partner, asset management division, Morgan Lewis. Photograph kindly provided by Myddleton PR, September 2015.
William Yonge, partner, asset management division, Morgan Lewis. Photograph kindly provided by Myddleton PR, September 2015.
and his firm. The CFTC alleges that Sarao manipulated CME’s E-mini S&P 500 futures contract by placing—and then promptly cancelling or modifying just before execution—hundreds or thousands of “exceptionally large” trades. Sarao’s actions enabled him to prime the market, artificially moving contract prices in his favour just before placing and filling real trades, in order to net millions of dollars in profits. The CFTC also alleges that Sarao’s spoofing contributed to an extreme order book imbalance in the E-mini S&P market during the Flash Crash on May 6th 2010.
Compliance considerations Spoofing presents unique compliance challenges because the nature and scope of the offence remain ill-defined. Yet, spoofing is a priority among prosecutors and regulators, and brokers and exchanges are monitoring market participants for potential spoofing activities. Firms should assume that information they provide to brokers about their trading activities will be shared with regulatory authorities and law enforcement. Consequently, firms may wish to review their trading with the recent regulatory guidance and cases in mind. Such a review should focus on trading strategies that deploy algorithms, involve a high volume of market activity, or have lower fill rates. Firms also may consider instituting procedures for designing, testing, and introducing new trading technologies, algorithms or other system features or capabilities, and identify the types of changes that must be reviewed by appropriate compliance, risk, and operations representatives before implementation. Moreover, firms should identify specific trading trends, strategies, behaviours or positions that trigger mandatory business or compliance reviews. For example, unusual quoting activity—such as unusual volumes of quotes, modifications or cancelations or quotes submitted without a resulting transaction—or breaches of, or frequent changes to, risk limits could become subject to business and compliance reviews. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
adverts_for_july.qxp_EXTRA_PAGES 22/09/2014 09:37 Page 3
23,000 monthly unique website users, 22,000 magazine readers, 7,500 e-alert recipients, 28,000 Twitter followers, 3,500 Facebook likes and over 3,000 App users (but we have only just started that) ...you’re in good company. Look for us on: www.ftseglobalmarkets.com
For important updates and information on new access channels to our news and analysis please contact: Andrew Lawson, EM: andrew.lawson@berlinguer.com TL: [44] (0) 207 680 5154
Photograph Š Daboost | Dreamstime.com
BELVEDERE
READING THE TEA LEAVES: China, Japan and pressures on emerging markets After the Chinese government took steps in mid-August to weaken the renminbi, worries about a sharp slowdown in China, combined with spillover effects to other emerging market economies and ongoing declines in commodity prices, caused investors to question the outlook for growth in major developed countries. After all, China has become the world’s second largest economy and has contributed a disproportionately large share of global GDP growth in recent years. Deterioration in China specifically and emerging markets more generally will put only mild downward pressure on DM economies, and very likely will fall well short of causing recessions in those jurisdictions. While acknowledging increased downside risk, we forecast solid expansion in the U.S., euro area, and Japan, even as EM economies struggle. Against that backdrop, we do not foresee a repeat of the deflation scare that affected markets earlier in 2015. John Bilton, Global Head of Multi-Asset Strategy, JP Morgan Asset Management looks at the long term market outlook.
E
ARLIER THIS YEAR, we expected Chinese growth to average 7.3% in the final three quarters of 2015, with other EM economies running at a 2.8% clip. We now look for 6.7% growth in China and 2.1% elsewhere in emerging markets, with further deceleration in the former during 2016 and only mild improvement in the latter. The gap between EM and DM growth, which has narrowed steadily since its peak during the global recession, has reached lows last seen in the early 2000s, before the secular bull market in EM assets took hold. Emerging economies are affected by a broad range of pressures, many of which have been in place for some time, including weak terms of trade (due to lower commodity prices), an apparent
32
end to the globalization process (signified by weak growth in international trade relative to economic activity), and sluggish DM business investment in high-tech equipment (a particular problem for EM Asian manufacturing centers). We expect little change in this trend during the coming year. Meanwhile, a new drag has recently appeared. EM economies as a group experienced a large-scale credit boom in recent years, partly facilitated by the low global interest rate environment, which is now reversing. Credit outstanding in emerging economies, particularly to corporates, has risen sharply as a share of local GDP. With growth lower than both borrowers and lenders had expected, leverage at uncomfortable levels in many
places, and with international financial conditions set to tighten as the U.S. Federal Reserve heads toward a hiking cycle, the rate of credit expansion across EM has begun to slow. Still, for EM economies as a whole, credit continues to grow faster than nominal GDP. That will likely lead to an increasing drag on growth as lenders further rein in their activity. In fact, we see a fairly high probability of a broad-based deleveraging cycle across EM economies, resembling the recent DM experience. Such a phenomenon would likely weigh on EM economic growth for several years to come. China, which experienced by far the largest surge in credit among EM economies, is now experiencing the turn in the cycle. The unwinding of a domestic
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
property boom that saw housing-related activity swell to represent an unusually high share of GDP is exacerbating this reversal. China also appears to be suffering excess capacity in many industrial sectors (itself partly the consequence of the government encouraged lending boom that followed the global financial crisis). The authorities have been attempting to steer the economy away from reliance on industrial investment and toward consumption spending, but many of their initiatives have weighed on growth in the short term, a difficult proposition for a high-leverage economy. At the same time, the Chinese effective exchange rate has appreciated sharply over the past year due to the peg to the U.S. dollar, in turn damaging export prospects. We believe that the small renminbi devaluation in August represented an attempt by policymakers to introduce more flexibility into the currency market in anticipation of another leg in the dollar rally. Poor communication about the move, coming in the wake of the government’s clumsy efforts to support the plunging local stock market, damaged the authorities’ credibility in the eyes of many market participants, helping touch off broader growth fears. While we expect ongoing gradual deceleration in Chinese growth and – given the enormous leverage build up – cannot rule out a more intense slowdown, we do not think China looks vulnerable to a typical EM style crisis. The country is a large net creditor internationally and runs a current account surplus, reducing the threat that capital flows will dry up. While local governments have run up considerable debts, the overall public sector balance sheet looks solid. Moreover, the household sector has not borrowed significantly, and asset-liability currency mismatch issues do not appear pervasive across the economy. We therefore assign a low probability to a dip into negative growth. Assuming the pace of Chinese growth takes another leg lower, or at least fails to pick up from its current pace, other EM economies will feel knock-on effects. These will mostly appear in the form of
lower prices for commodities in which China represents a major share of demand and also via reduced imports from key EM manufacturers. Transmission to major DM economies, though, will likely prove more muted, for four reasons. First, direct trade exposures from developed markets to China remain fairly low, notwithstanding China’s dramatic emergence onto the world stage in recent years. Gross exports to China represent 2% of GDP or less for the euro area, the U.S., and the UK, and less than 4% for Japan. Second, much of the hit through the trade channel has likely already occurred, with EM import growth having slowed dramatically around the start of this year. Real Chinese imports, for example, have been falling in year-onyear terms since early 2015. From the perspective of DM exporters, for example, China has already entered recession. Of course, Chinese imports could weaken further, but significant weakness of Chinese imports is already reflected in current DM conditions. Third, financial links between DM economies and China – given the latter’s closed capital account and net external creditor position – appear minimal. DM economies could take a hit if major EM economies more closely connected to the international financial system themselves come under pressure, but this kind of stress does not seem widespread at the moment. Fourth, developments in China are producing some offsetting effects that will benefit DM economies, most obviously weaker commodity prices and, at the margin, lower bond yields. For these reasons, we have shaved our DM GDP growth forecasts only marginally, with the biggest moves in Japan and much smaller revisions in the euro area and the U.S. Japan recently has come into focus for reasons beyond its relatively high exposure to China. Its economic performance this year has been disappointing, especially following the steep decline in activity that took place after the 2014 consumption tax hike. To be sure, GDP growth averaged 1.7% in the first two quarters of 2015, similar to the euro area and not far below the U.S. The composition of growth,
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
though, has looked somewhat weak. Exports and private consumption both contracted and it was inventory accumulation that supported GDP. More generally, the data flow has conveyed a sense that Abenomics has lost momentum in several respects. First, despite what looks to be a very tight labor market, wage growth has yet to accelerate convincingly, undermining prospects for a sustained upturn in consumer spending. Second, the level of exports has not trended upward despite the yen’s significant depreciation. Third, inflation itself has stalled, with core measures generally moving sideways around zero and showing no further progress toward the 2% target of the Bank of Japan (BoJ). Finally, the authorities have not demonstrated any real ability to fire the so-called third arrow of Abenomics, structural reforms to boost the economy’s potential growth rate. These developments have called into question the future of the overall program. We are a little more hopeful, at least about the prospects for growth and inflation over the next few years. Recent weakness in wages mostly relates to bonus payments that were likely held down by the economy’s erratic performance. Meanwhile, growth of scheduled wages has moved steadily into positive territory despite headwinds from demographics and the composition of the workforce. The drop in oil prices, meanwhile, has weighed on the price level. Non-energy inflation has not accelerated recently, but it has shown no sign of slipping back below zero. Both with respect to wages and prices, then, Japan appears to have exited its decadelong deflation. Although the recent shortfalls in exports and consumption are somewhat worrisome, survey data suggest medium term optimism from both households and businesses, whose profit margins have moved to historical highs. We do not expect much from the “third arrow”and believe Japan’s potential growth rate will remain weaker than its DM peers, but we think the favourable shorter-term dynamic generated by rising prices, strong corporate profitability and easy money will remain in place for a while. n
33
DEBT REPORT
Clouds on Europe’s high yield horizon? Chronic low prices in the energy sector have contributed to a spate of defaults in the energy, metals and mining segments. US high yield has been particularly affected. Up to now European high yield has looked relatively sheltered from the storm, but for how long? The US market has been particularly affected, with the US default rate set to rise from 2% last year to 4% this year. How much more battering can the US high yield segment sustain?
C
REDIT YIELDS THAT had been declining early in the year have seen that trend reversed with yields rising since May.“Most outspoken has been the rise in yields in the riskier buckets of spread products - emerging market debt (EMD) and HD - as broad risk aversion manifested itself,” avers Koen Straetmans, senior strategist, multiasset at NN Investment Partners. “With EM, China and commodities at the heart of the recent turmoil unsurprisingly EMD and HY have been in the line of fire. While yields around 6% or over 7% for EMD HC and US HY respectively may appear tempting in the low interest rate environment created by expansionary developed market monetary policies, the levels are probably there for a good reason. Indeed, in line with the steep decline in oil and industrial metals’ prices the respective segments within US HY underperformed while the same commodity weakness, EM macro weakness, FX depreciation and EM capital outflows weighed on EM categories within spread products,” he adds. Data from Merrill Lynch generally confirm the trends, showing European currency high yield bond market returning -0.9% in August (total return, sterling hedged), with BB bonds returning -0.8% and CCC and below 0.0%. US High yield bonds, which have higher exposure to the energy sector returned – 1.8%. European investment grade corporate bonds returned -0.7%. High yield bond issuance was low in the late summer with Barclays estimating just €1.3bn issued in all European currencies, compared with €1.8bn in August 2014. In comparison says S&P Capital IQ/LCD, dollar-denominated high yield debt amounting to $8.6bn was issued in the week
Photograph © LoFfofora/Dollarphotclub.com, supplied October 2015.
ended September 11th, bringing the total US dollar-denominated issuance of high yield debt to $215.2bn this year year-to-date (YTD, down by 8.5% compared to the corresponding period of 2014. Acquisition deals have, particularly in the US, outnumbered all others in both volume and by value. Up to now the market has seen defaults in the energy segment, which has affected sentiment on US high yield rather than European high yield says Tim Dowling, head of credit investments & lead portfolio manager Global High Yield at NN Investment Partners. Default levels look contained right now by historical standards, but recent predictions by Royal Bank of Scotland suggest the US default rate will increase from 2% to 4% per annum by the end of the year. Elsewhere in the market, junk bond exchange traded funds ETFs also look vulnerable to declining oil prices, as investment managers concede that as oil prices remain south of $60 per barrel, more defaults are on the cards; although energy specialists increasingly argue that US shale oil producers have become more efficient and innovative over the last few years, reducing output costs. “The energy sector is about 15% of the US HY market, whereas in Europe the exposure is not more than 2%. Perhaps a greater risk to European HY are investment flows, which are probably even more important for European than for US
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
HY paper. Whereas US HY has witnessed outflows this year and last, European HY attracted +16% of assets under management in inflows so far in 2015, after inflows of +10% in 2014.” Given market capitalisation and historic inflows, they probably pose a bigger threat to European HY, adds Dowling. “At a time with low market liquidity in spread products, investor flows can carry a big impact. And while European paper has outperformed US in the HY category, contagion risk has recently increased,”he says. The liquidity risk is to a large extent priced in says Dowling.“Part of the widening in spreads reflects the need for more compensation to cover the increased cost of entering or exiting the credit markets associated with the decline in dealer-provided liquidity. Although the lower liquidity conditions are not expected to result in any type of systemic stress, volatility in fixed income returns will most likely be higher than in the past. Considering that the factors creating lower liquidity conditions in the fixed income markets are not about to reverse, the larger, more liquid bonds are looking more attractive than the less liquid types of paper. The premium required to own smaller issues has increased and we think many of these smaller issues are very attractive at today’s lower prices,” he says. While commodity prices and the M&A segment continue to exert their influence within the high yield sector, a further discombobulating element is the growing clamour around a Fed rate hike. While some market observers still see value in high-yield bond ETFs, risks remain as junk bonds could see a sell-off during a rising rate environment after years of low interest rates encouraged investors into speculative-grade debt in search of yield. n
35
DEBT REPORT
Photograph © fredmantel/dolarphotoclub.com, supplied October 2015.
Divergence between the US and European high yield markets? In spite of a definite pall over the high yield segment, both in Europe and the US for most of this year and an uncertain risk outlook in 2016, more than half (54%) of respondents to NN Investment Partners’ new survey of 103 institutional investment managers expected investor’ allocation to European high yield debt to increase over the next three years, versus 18% who expected it to decrease. The findings are a testament to the cross trends in the segment. Another signal of diverse fortune? Lipper reported net outflows from high-yield bond funds touched $2.2bn in the week ended September 30th compared to inflows totaling $17.7m the previous week, bringing total outflows for the year to date to $5.9bn.
D
ESPITE THE RELATIVE optimism of NN Investment Partners’survey respondents, it has not been an easy year for the high yield segment. Through the summer investor outflows out of high yield continued steadily even as the fixed income segment continued to attract investor allocation, even though yields on bonds in the high-yield sector excluding energy and mining companies broke above 6% for the first time this year. With defaults gaining ground over the summer and the ever present promise of a
36
US rate hike hovering in the background, the downturns in both commodity prices and global trade, have put a pall on markets and the high yield sector has also suffered. NN Investment Partners’ survey seems to suggest that the eurozone offers better valuations for high yield bonds than any other region in the world. Some 27% of respondents rated eurozone valuations as strong or very strong while the US was cited by 22%, the UK and Japan by 18% each and Asia ex-Japan by 16%. The survey suggests that valuations were the
most attractive attribute of European high yield bonds overall, with nearly two in five (38%) of institutional investors saying this makes them significantly attractive versus other bonds, justifying the additional risk. Another 26% of investors said falling default rates in Europe were supportive while 12% believe the credit fundamentals of European high yield makes the sector attractive. There are notable differences between the US and European markets. The European high-yield debt market is less
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
developed than that in the United States and, according to analysts, contains generally higher quality debt, with about 62% of issuers are rated BB, or toward the upper end of the quality spectrum, says Moody’s. In contrast, US speculative-grade issuers are distributed at much lower CCC ratings. Almost no energy company has issued in the European high yield market, while the energy (oil and gas) account for around 20% of outstanding high yield bonds in the US, as producers began to require funding as they began adjusting to lower oil prices. However, in line with NN Investment Partners’ survey findings, credit risk analysts certainly expect more issuance in Europe as the ECB continues to extend its quantitative easing program. “Credit spreads widened from May after risk aversion increased. However, they are still above what would be considered normal in the current cycle so some value may therefore appear in spread products. Investors will expect more than just value though – they will want to see fundamentals improving as well. In Europe, ECB monetary policy will no doubt be supportive but investors clearly recognise that credit fundamentals and falling default rates are supportive,”explains Sjors Nonetheless, Haverkamp acknowledges that the high yield sector can be challenging. Credit fundamentals and liquidity are often problematic, for example, and he says, “Investors need to partner with asset managers that have the experience and processes in place to analyse these sophisticated markets.” However, until there is any policy action from central banks, Kames Capital’s fixed income specialist Adrian Hull thinks that most areas of fixed income outside of safe-haven government bonds look vulnerable. “Fixed income has a problem at the moment as few investors favour it. Some areas – such as high yield and emerging market debt – now look attractive on valuation grounds, but sentiment remains poor,” he explains. “When you combine that with the impact of outflows on the sector, it is not creating a great backdrop to increase your allocation to fixed income.”
High yield, as with all markets right now, remain in hock to US interest rate policy. According to Hull, markets have little to fear from any change in rates by the Federal Reserve Bank. “The first rate hikes by central banks will not cause liquidity in fixed income markets to evaporate, and may actually improve trading conditions by removing uncertainty,” he avers. Hull thinks in practice, growth concerns have pushed back rate rise expectations, although he still expects the US to hike rates at the turn of the year, with the UK following in the middle of 2016. “While there are concerns the first rate hike could impact bond markets by sparking a rush for the exit [any] move to begin normalising interest rates may provide a boost to fixed income markets. Liquidity has worsened in the last three months, but while it is not going to return to anything like pre-crisis levels, a rate hike will not make it worse,”he adds.“On the contrary, there is an argument that rate rises in the US and UK may actually improve liquidity by removing the uncertainty that pervades markets. Safe havens such as US Treasuries and UK gilts have seen yields move sharply lower in the last three months as investors grow more concerned about the outlook for global growth”. Certainly, says Moody’s, reflecting this mood, the high-yield bond market in Europe, the Middle East and Africa continued to see muted activity in September and early October, with rising spreads and yields making issuers reluctant to access the market. On a wider basis, according to data from S&P Capital IQ dollar-denominated high-yield debt amounting to $39.6bn was issued in the third quarter this year. The issuance volume in the quarter nosedived 57.8% compared to 2Q15, which had seen issuance worth $94bn. New issuance in the high-yield market had slowed substantially in July, with just $10bn in new paper coming to market, the lowest monthly volume since December, according to S&P Capital IQ. As the third quarter came to end, highyield bond issuance was $1.4bn in September, marking the lowest
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
September reading since 2010. Rated leveraged loan volumes for September at $0.35bn also fell, well behind the $7.60bn recorded in September last year. "Highyield market activity failed to recover after the Fed vote in mid-September and has remained very low into October," explains Peter Firth, a Moody's Associate managing director. "Limited activity reduces the likelihood that deal flow will return strongly before the end of the year, although it could rebound like it did in the one-week surge at the end of July if conditions improve." Despite low bond and loan volumes, M&A activity in the high-yield market remains active. Acquisition financing bolstered what activity there was in the high yield segment in the quarter. Of the 59 deals priced in the quarter, 29 were for acquisitions (compared with 38 out of 163 deals in the second quarter). Nonetheless, some of the quarter’s deals were noteworthy. One highlight in the segment was the $6.6bn worth of junk bonds issued by Frontier Communications to fund its acquisition of Verizon Communications in California, Florida, and Texas. The bonds were the largest issue in the quarter and the fifth largest junk bond issue ever. Elsewhere Netherlands-based Altice issued junk bonds worth $4.8bn in September, while Japanese telecom provider Softbank Group came to market with a $2bn value issue. In EMEA issuers increasingly consider maintaining existing capital structures where possible and preserve favourable existing interest rates. “Companies are also using the portability clauses that became popular in 2013-2014 to avoid refinancing debt at possibly higher interest cost in the current market environment,” thinks Moody’s. Firth says that overall, the credit quality of EMEA high-yield issuers has remained solid in 2015 although downgrades rose in September again after a five-month period of upgrades exceeding downgrades. While Moody's does not expect a widespread decline in credit quality, the upgrade-to-downgrade ratio is likely to be more balanced going forward. n
37
ASIA VIEW POINT/SGX
Scoping Asia’s investment benchmarks In a new regular column, Geoff Howie, chief economist at SGX, will provide an invaluable 36,000 foot view of Asia’s securities markets. In this debut piece, he outlines this year’s performance trends and the emerging relationship between the region’s market benchmarks.
Photograph © Sergey Victoria/Dreamstime.com, supplied October 2015.
M
ORE THAN ONE-fifth of the global economy is represented by three Asian economies – China, Japan and India. Together the three countries represent just less than onefifth of the combined market value of all primary-listed stocks across the world. Of the three countries, there are no surprises that China maintains the highest Gross Domestic Product (GDP), in addition to stock market value. However the number of primary-listed stocks in China still lags that of India and Japan. Hence, market development and capital formation continues to evolve in China. The recent slew of market reforms in China have coincided with significant swings in its equity indices over the past 12 months. The FTSE China A50 Index has generated one year volatility of 40%, while the FTSE Japan Index has generated one year volatility of 19% and the FTSE India has been the least volatile of the three with 16% volatility. Yet, despite the swings seen in China, price ratios of the FTSE China A50 Index to the key Japan and India Indices have recently reverted back to their 12 month mean. For the 12 months through to the end of August, the FTSE China A50 Index had generated a 37% price gain versus a 21% gain for the FTSE Japan Index and 2.1% for the FTSE India Index. Exemplifying the aforementioned volatility, in the course of its 37% return the FTSE China A50 Index moved from 7,144 to 15,047,
38
then back to 8,574 before ending August at 9,818. Thus, at the end of the 12 months, the price ratio of the FTSE China A50 Index to the FTSE Japan Index had only gained 15%. For investors, the relationship between China and Japan stock markets is tradeable. Firstly, the FTSE China A50 Index is the underlying for a highly liquid futures market at Singapore Exchange (SGX). Secondly, the FTSE Japan Index is highly correlated to the Nikkei 225 which is the underlying index for the SGX Nikkei 225 Futures. The correlation of the two Japan indices varied from 0.98 to 0.95 over the past 12 months. Thirdly, narrowing investment parameters to the relative value between the indices of two countries within Asia can introduce new dynamics while reducing some of the broader nuances.
FTSE China A50 Index & Nikkei 225 Index Based on end of August levels, the price ratio between the two indices stood at 0.52. The FTSE China A50 Index at 9,818 was approximately half the level of the Nikkei 225 Index at 18,890. Twelve months prior, the price ratio was 0.47, before rising to 0.70 in early January 2015. The price ratio then fell to 0.52 in March before returning to above 0.70 in June. Investors who had matched the dollar value of the smaller sized SGX FTSE China futures contract to the dollar value of a short position in the
Nikkei 225 would have stood to gain as the price ratio moved higher, and stood to lose as the price ratio moved lower. Statistical overlays can be applied to the price ratio in addition to standard deviation analysis. The key caveat to reversion or diversion of the price ratio to its mean is that fundamentals behind the indices can change over time. While economic links exist through interconnectedness of investment flows, key fundamental differences exist throughout Asia. Sure, the big Asian economies such as China and Japan are well linked by trade flows. Bilateral trade of goods and services between China and Japan reached $344bn in 2014 – accounting for 8% of China’s total trade value. This is lower than levels from ten years ago nonetheless Japan is China’s second most important trade partner after the United States. However, trade can be a useful indicator of economic difference – one country exports or imports from the other what it does not have while pursuing economic growth. Notice how G20 meetings over the past 12 months have focused on using trade agreement levers to spur more global growth? Investors making economic contrasts within Asia now have a wide range of indices and markets to choose from should they wish to articulate a view into a relative value investment. The performance scope of Asian markets in recent years is extensive and moving. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
PRECIOUS METALS
Precious metals still face an uncertain market Although money managers increased their net long position in precious metals in late September, supporting a small rally in gold, silver, platinum and palladium amid signs of a drooping global economy. The expectation is that slower global growth and a too strong dollar will encourage the Federal Reserve to hold off raising rates for another month. However, the reality is that the precious metals segment is still nowhere near a lift off in outlook
A
S OCTOBER DAWNED, the general thinking was that bad news about the global economy was good news for precious metals. If that was really the case, then the IMF had signalled testing times all through late summer and that had not stopped as much as a reported $8bn being wiped from the value of exchange-traded funds (ETFs) backed by precious metals this year through September. There had looked to be glimmers of positive sentiment. Reuters reported in the first week of October that gold futures for December delivery rose 1.7%. Silver also climbed 3.6% in the week, but it was the first consecutive increase since August. Platinum rose 7.9%, the most since October 2011, while palladium added 1.5% for a fifth straight weekly gain. Combined net-long positions in gold, silver, platinum and palladium increased 38% to 95,104 futures and options contracts in the week ended October 6th, according to U.S. Commodity Futures Trading Commission (CFTC) data released three days later. The Bloomberg Commodity Index rose 3.5%, and the MSCI All-Country World Index of equities added 4.4%. The Bloomberg Dollar Spot Index fell 1.4%, while short holdings in palladium dropped 32 percent, the biggest decline since December. One sparrow doesn’t make Spring and the general air of disappointment in the segment continued to generate bad news. The latest casualty of the extended downturn in the precious metals segment was that news reports in London suggested that Mitsui will close its precious metals businesses (involving 50 or so traders) in London and New York at the end of this year, a direct result of
Photograph © Sergey wacomka/Dollarphotoclub.com, supplied October 2015.
importune commodity prices and more stringent regulation. Mitsui is the latest in a growing line of broker/dealers in commodities to bow out of the segment as profits and prices continue to tumble. Mitsui trades precious metals on the Tokyo Commodity Exchange (TOCOM) in Japan and is part of the twice-daily auction setting the London silver benchmark run by the Chicago Mercantile Exchange (CME) and Thomson Reuters. Its withdrawal would leave only five banks to set the price. Mitsubishi UFJ Securities International withdrew from its London based commodities business last year, while Barclays, Deutsche Bank, Credit Suisse, JP Morgan and UBS continue to cut back in the segment as revenue continues to shrink, by some estimates by as much as $900m to $2.6bn in the first half of this year. Mitsui is also caught up in newly announced investigations by the Swiss competition watchdog WEKO, which announced it had launched a year-long investigation into possible collusion in the precious metals market by several banks at the end of September. Global precious metals trading has been under regulatory scrutiny since December 2013. Even though
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
the market has moved to reform the process of deciding on its price benchmarks, accusations of manipulation have refused to go away. Switzerland’s Weko watchdog said its investigation, the result of a preliminary probe, was looking at whether UBS, Julius Baer, Deutsche Bank, HSBC, Barclays, Morgan Stanley and Mitsui conspired to set bid/ask spreads.“It [Weko] has indications that possible prohibited competitive agreements in the trading of precious metals were agreed among the banks mentioned,” the commission said in a statement. The investigation adds to an already beleaguered segment that has been under scrutiny this year also by the US Justice Department, the CFTC and more latterly the European Union which launched its own investigation in anti-competitive behaviour in precious metals in August. Heightened regulatory scrutiny has encouraged the remaining players to move trading and pricing onto electronic platforms. Despite the increasing probes and changes, Britain’s Financial Conduct Authority (FCA) warned in early September in its latest Market Watch newsletter that commodity-trading firms that they were failing to adequately monitor the risks of market abuse. The FCA reviewed the control structures and practices at a sample of 12 firms: brokers, interdealer brokers and commodities trading firms across the oil, energy, metals and soft commodities sectors. The emphasis of the review was on front office and market abuse controls. As a result of its review, all firms (including banks which have a commodities business) should expect a renewed focus from the FCA on potential misconduct and inadequate controls in relation to commodities trading and brokering. n
39
COUNTRY REPORT – QATAR
Testing the resilience of Qatar’s markets In September, FTSE Group announced that Qatar will be upgraded from frontier to secondary emerging markets within the FTSE Global Equity Index Series in two equal tranches in September 2016 and March 2017, after the index provider confirmed that the country had now passed its key liquidity criteria for Secondary Emerging Market inclusion. Despite the plunge in oil prices, Qatar has held up relatively well in the current rout in emerging market stocks. Although with the exception of the FTSE upgrade, there remains a lack of immediate catalysts for Qatari stocks, even so Qatar maintains its edge as the government continues to spend freely, even as energy prices remain depressed. Does positive thinking about the kingdom’s prospects have legs?
S
o far, so good. The kingdom of Qatar appears to be weathering the gathering storm in emerging markets. Despite still depressed energy prices, Qatar is expected to post a limited low single-digit budget deficit in both 2015 and 2016. Nonetheless, there remain stresses in the market. Qatar's gross national income (GNI) plunged 17.2% year-on-year to QR150.81bn in the second quarter (Q2) of this year, according to official figures. The GNI fell 3.4% in the second quarter, the Ministry of Development Planning and Statistics said in a statement. The country's gross national savings declined 29.9% year on year to QR77.15bn and it was down 4.2% against Q1, 2015. The gross saving ratio to nominal GDP (gross domestic product) in Q2, 2015 has been estimated at 50.4% compared to 58.2% in the previous year period. The comparative figure for Q1, 2015 was 50.5%. Moreover, vacancies in Qatar's property market have grown in the past six months because of rising job losses in the oil and gas sector, according to a new report by real estate consultants DTZ Qatar. Its Q3 2015 market report, the consultant highlights the impact that the government's revisions of its spending plans has had on Qatar's real estate market. The report suggests that despite the increase in vacancies, rents have remained strong during Q2 and Q3, primarily due to an increase in population. Population growth is expected to remain strong as infrastructure spending attracts expatriate workers. The population of Qatar touched 2.37m in May, up 9.2% year-on-year as
40
Photograph © SmirexonDreamstime.com, supplied October 2015.
job opportunities in non-hydrocarbon sectors such as finance, hotels, restaurants, and trade and transport open up. However, according to recent government statements, Qatar's long term infrastructure spending will continue, driven by low gearing, accumulated budget surpluses and Qatar having one of the lowest break-even oil prices for its oil production in the region. Notwithstanding investment related to the FIFA World Cup, that Qatar's GDP is expected to continue to grow by at least 5% over the mid-term, backed largely by government led spending in infrastructure. The government has been keen to diversify its economy and reduce its dependence on LNG sales, with an inevitable impact on the country’s trade balance. Qatar's total exports (valued at free on board) had fallen 34.3% year on year to QR86.41bn in Q2 mainly due to lower shipments of mineral fuels, lubricants and related materials. Exports had fallen 4.6% the previous quarter. Exports constituted 56.5% of nominal GDP in Q2
compared to 69.5% in same quarter last year. The corresponding share for Q1 this year was 56.7%. Total imports (valued at cost insurance freight) also showed 5.8% decline y-o-y to QR54.88bn in Q2, on higher intake of crude materials, inedible, except fuels, transport and communication service. It had however expanded 5.6% compared to Q4, 2014. Imports were 35.9% of nominal GDP in Q2, against 30.8% in the previous year period. Its share was 32.6% in Q1. According to the Ministry of Development and Planning, Qatar's GDP increased 4.1%in Q1 2015 compared to Q1 2014 (using a new base year of 2013) driven by non-hydrocarbon growth. Compared to Q4 2014, GDP grew by 3.4%. In the first quarter, the hydrocarbon sector contracted by 0.1%, compared to Q1 2014, while the non-hydrocarbon sector increased by 8.9% because of an increase in construction (up 11.4%), trading, hospitality and financial sector activity. The financial sector (which includes finance, insurance, real estate and business services) rose by 9.8%, while the trade, hotels and restaurants sectors (combined) grew by 9.3% in the quarter, compared with the same quarter last year. The ministry also reports that an increase in sovereign spending is in line with the rise in production of public goods and services to cater to the kingdom’s growing population. In consequence, the government’s consumption expenditure (GFCE) looks to have grown by 10% year on year to QR29.7bn in the second quarter of this year. It also suggested a 1.5% rise against spending in Q1. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
COUNTRY REPORT – TURKEY
Political uncertainty weighs on Turkey A survey of 947 respondents in Turkey by Washington think tank PewCentre Research suggests Turks are dissatisfied with the direction of their country. Rising prices, crime and inequality are concerns. Moreover after years of quasi-Islamic rule that has been antipathetic to the military; survey respondents say the military is the only group with a “good influence on the country”. Opinions of the police, national government, religious leaders and the courts are mixed, while views of the media tilt to the negative. More pertinently perhaps, 52% of Turks think their children will be worse off financially in the future. The findings come as voters are scheduled to revisit national government elections on November 1st after the AKP party failed to form a coalition government in June. The upcoming elections will be closely watched, both as a bellwether of wider change in the eastern Mediterranean and as an indicator of the near term prospects for a lynchpin emerging market.
T
URKEY IS ALWAYS one of the curate’s egg markets: good in parts. In spite of an expected second half year slowdown in the economy, the World Bank in early October revised upwards the country’s end of year growth forecast of 3.2%. Seasonally adjusted GDP grew by 1.3% quarter-on-quarter in the second quarter. With +3.8% GDP growth in the second quarter 2015 versus last year, the economy is doing better-than-expected. Corporate earnings have also come in better than expected for the first half of 2015. “Private and public consumption continued to lose momentum as expected but, private investment unexpectedly surged and became the main driver of growth- an indication that the private sector front-loaded investment spending before the June election or realised previously postponed investment, anticipating elimination of uncertainties after the election,” the World Bank told journalists at a briefing. That might be a bridge too far. Politics has never been far from Turkey’s economic equation; more so perhaps in recent years as the country and the central bank has been under the iron rule of Tayyip Erdogan and his AKP party. The AKP caucus is banking that voters will now flock to its banner in light of growing unrest on its borders and its leading cities as both PKK separatists and the rapidly expanding ISIS theocracy impinge on the country’s security. If PewCentre’s report is correct, the next set of elections will not result in a clear victory for the AKP. Erdinç Benli, co-
42
Photograph © ProMotion/Dollarphotoclub.com, supplied October 2015.
head of GAM’s global emerging market equities team, looks to agree. “In this round of elections, the public pressure for political parties to form a coalition government and reach a consensus will be much higher. Forming a coalition government is a chance for Turkey to metamorphose and work in different political views. But it will be a bumpy road. Chances are high that the new coalition government won’t hold for long due to the polarising political views. There is a possibility of the coalition breaking-up and a renewed election in 12-18 months’ time,” he says. It is an outcome however, with scant benefit to anyone. “The most proeconomic outcome is AKP keeping its votes from the June election (41%) and forming a coalition government. However, the stability of this coalition will be questionable over the longer-term. Political differences will lead to setbacks from time to time; AKP is not sufficiently amenable to other parties’ views. An important question remains over whether government figures will be sitting on key
decision-making chairs regarding the economy and central bank,” adds Benli. “Further economic weakness is highly likely if no sustainable government can be formed as the risk of downgrades by rating agencies is heightened,” he says. Turkish equities are currently trading at multi-year lows in US dollar terms, making them one of the largest lossmaking markets this year, underperforming the overall emerging markets (EM) complex by some 15%, according to Benli. Moreover, the World Bank concedes that credit growth momentum fell below the Central Bank`s reference rate of 15% by mid-September. Moreover,“continuing political uncertainty and tensions in Turkey’s south-east make it difficult for the private sector to sustain the investment spending witnessed in the second quarter. Businesses are likely to cut investment spending from the second quarter and postpone investment decisions until a new stable political equilibrium is reached. External adjustment should continue, as lower oil prices will likely bring the current account deficit down by another $5bn in the remainder of the year,” noted the World Bank in its press briefing. “Turkey’s real effective exchange rate recently fell to its lowest levels in 10 years, which should help export-oriented companies as well as tourism – an important source of foreign currency. But, increased terrorist attacks on or near Turkish soil could seriously affect the country’s tourism sector – a major income generator,” adds Benli. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
COUNTRY REPORT – TURKEY
Foreign banks still keen to enter Turkish banking market The make-up of shareholders in Turkey’s banking segment has always been a touchstone of wider market change. The country has always been a swing market and the banking system has remained vulnerable, even with an improved capital base, as it has an ultra-high dependency on foreign funding of lending. That vulnerability has resulted in some significant changes in the investment in the country’s banking segment by foreign financial firms who have shown little stickiness in the country when the going gets tougher.
T
O BE FAIR, a strategic stake in Turkey’s Finansbank has been up for grabs for some time as controlling shareholder, the National Bank of Greece has had to contend with seismic changes in its homeland. The Greek lender has been reluctant to divest its shareholding in one of the country’s more successful banking brands. Forced however by European regulators to shore up its capital position, as much as 40% of Finansbank looks to be for sale. Qatar Nationol Bank (QNB) has confirmed that it is in talks to acquire a strategic stake in the bank. The Qatari lender has been anxious to enter the Turkish market for some time and has been linked to a now stalled bid for HSBC’s Turkish operations, with a reported $4bn in assets. Netherlands’ ING appeared to have secured a sale earlier this year, though in September news emerged that the deal had stalled and HSBC remains in talks with a number of potential buyers (reported by local press to include BNP Paribas and Arab Banking Corporation). The ING approach made sense in that the lender already has a banking network in Turkey (of around 300 branches) and some $15bn in assets and the acquisition would have provided the Dutch lender with much needed scale. If QNB secures its stake in Finansbank it will have entered a highly sophisticated and competitive market. For its part, HSBC has found it difficult to gain profitable traction in the country, even with the 13th largest branch network in the country, particularly after the government successfully introduced legislation capping interest rates on credit cards and overdrafts. Moody’s lowered the longterm local and foreign currency deposit
Photograph © ProMotion/Dollarphotoclub.com, supplied October 2015.
ratings of its HSBC Bank AS, the bank’s Turkish arm, to Ba1, the highest junk rating, from two levels and one level above junk respectively, in June. Both ratings were given on the basis of a negative outlook. Moody’s cited a potential reduction in support from the parent bank because of the sale process as motivation for the downgrade. The market remains attractive because of the country’s demographics. Turkey has a large population under 25 and an estimated 35% of the population still does not utilise bank accounts. However the market remains competitive and the country’s largest five lenders, including Isbank and Akbank continue to maintain market dominance. Any new entrant says Moody’s must take on a change in business complexion in the country as global markets conditions no longer remain accomodative. Turkish banks may slow their lending growth in 2015-2016, as foreign currency funding will likely become more expensive, thinks the ratings agency. "Turkish banks' rapid rise in lending over the past five years has been largely funded by foreign currency funding inflows, as domestic deposits have not kept in step with credit growth," explains Irakli Pipia, vice president and senior credit officer at Moody's. "However, reduced foreign
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
investor sentiment is making banks' access to funding harder and resulting in higher risk premiums at a time when profitability is already facing downward pressure." Most of the foreign-currency funding is short-term, which could result in higher costs of refinancing, suggests Pipia, although banks have sufficient liquid assets to cover almost 100% of FX wholesale liabilities maturing until end2016. However, foreign funding may also become scarcer over the next 12 to 18 months as higher rates in the US will likely result in weaker flows of international funds into emerging markets such as Turkey. Going forward, says Pipia, Turkish banks could decide to scale back their lending to the rate of, or below, customer deposit growth, at 11% in the first half of 2015. This compares with an average credit growth rate of 25% since 2010, which outpaced domestic savings growth averaging 16% of GDP in 2014. Moody's data shows that Turkish banks' capital market borrowing more than doubled to $152bn at H1 2015 from $66bn at the end of 2010. Total lending by Turkish banks increased to $540bn from $356bn over the same period. Nonetheless, Turkish banks are nothing if not resilient and diversified in their funding strategy. Finansbank, for one, at the beginning of October announced it would receive $100m in funding to help its SME business; the bank has a strong lending franchise in the agricultural regions of Turkey. The funds are being extended via an investment in BBB+-rated loan notes under Finansbank’s Diversified Payment Rights (DPR) programme, an established market instrument used by Turkish banks to raise longer-term funding in capital markets. n
43
COUNTRY REPORT – TURKEY
Egypt opts for development funds For the third time this year, the Central Bank of Egypt (CBE) has depreciated the Egyptian pound against the dollar in a foreign exchange auction in mid-October, taking the currency's decline for the year to 9.8%. The pound fell 1.3%(10 piasters) to 7.93 per dollar sell side and 7.88 buy side according to a report by the state-owned Middle East News Agency, which announced that the CBE offered $40m at a regular dollar sale to local lenders. Can the country pick its way out of the blues?
T
HE CENTRAL BANK’S latest move comes amid news of a drop of $2bn dollars in the nation's foreign reserves, which stood at $16.335bn at the end of September, reportedly because the government repaid $1.25bn for 10-year bonds that had recently matured. The central bank has determined, in the current emerging market rout that it is better to sacrifice the pound rather than the country’s flailing reserves. Foreign currency reserves, which stood at about $36bn before the 2011 uprising, have more than halved and were $16.335bn at the end of September. At the same time the country has embarked on a round of borrowing, mainly from multinational lenders. Egypt will have raised $1.5bn in loans from the World Bank and African Development Bank (AfDB) by the end of 2015, as part of efforts to boost foreign currency reserves and bolster the economy. The African Development Bank currently has commitments worth up to $1.96bn in Egypt covering 35 operations/projects. Among the latest tranches of that lending, Egypt secured $50m from the Africa Growing Together Fund (AGTF), which in turn is funded by a special $2bn fund provided by China and managed by the AfDB to co-finance bank operations. This latest loan agreement complements earlier signed agreements of a $90m loan from the development bank’s loan window and a further $1.8m grant from the Middle Income Countries (MIC) Technical Assistance Fund. That funding round was entirely earmarked for the Sharm ElSheikh Airport Development Project. The Sharm El-Sheikh Airport expansion project, whose total cost is estimated at $671m involves the devel-
44
opment of a new terminal building, construction of a new runway and new control tower with associated airfield works, installation of electrical and navigational equipment. The Egyptian government is targeting EGP37.8bn in investments for the infrastructure sector during the new fiscal year (FY) 2015/2016, of which EGP25.5bn will come from the state budget. The latest figure represents a 19.5% increase from FY 2014/2015 according to an early October statement from the Ministry of Planning. The volume of investments targeted for the transport sector in the new budget amounts to EGP11.9bn, where EGP7.7bn (or 64.7%) will be directed to construct and establish main road networks and bridges. A further EGP 4.6bn (34.1%) will be allocated to develop metro lines, EGP 100.8m (0.8%) will go towards raising the efficiency of river transport, and EGP48m (0.4%) will go to develop maritime transport. The private sector too is harnessing current goodwill among multinational lenders as a substitute for private market financing. The European Bank for Reconstruction and Development (EBRD) is providing a $50m loan to the National Bank of Kuwait-Egypt (NBK-Egypt) to support lending to small and medium sized enterprises (SME’s). Nonetheless, this private sector initiative dovetails precisely with current government priorities. SMEs account for over 90% of enterprises in Egypt and as a segment provide the largest share of jobs in the economy. Access to finance for SME’s however remains constrained. The SME credit line will be supported by technical cooperation activities funded by the Southern and Eastern Mediter-
ranean Donor Account (SEMED) and the EBRD Shareholder Special Fund. Egypt has struggled to revive its economy since the 2011 revolt removed Hosni Mubarak from power and ushered in a period of economic and political turmoil and still looks to be locked in the development bank funding cycle. The country’s investment requirement is substantial. The Planning Ministry says that the industry and foreign trade sector needs EGP287.6m in investments, while exports development investments would need a further EGP40.7m. As a backdrop, GDP growth is expected to reach 5% during the new fiscal year, compared to 4.2% during the current fiscal year. The draft budget, approved by the cabinet has set the target for the deficit in FY 2015/2016 at 9.9% of gross domestic budget (GDP), or around EGP281bn. The budget deficit for FY 2014/2015 stands at 10.8%. In essence, the budget is targeting a 22% increase in spending on health to EGP64bn, an 8.3% increase for education to reach EGP 120bn. The budget allocated for petroleum subsidies for FY 2015/2015 is EGP61bn, while EGP38.4bn will go to supporting the food commodities’ subsidies. The government is banking that if FDI and foreign indirect investment inflows are down, it will as much as possible, pick up the slack through lending from development banks. For now, it looks a reasonable strategy. Egypt's external debt rose from 4.3% to $48.062 at the end of the fiscal year 2014/2015 compared to the year before according to the Central Bank of Egypt Although the value of the debt rose, its percentage of the gross domestic product in the previous fiscal year, which ended in June, dropped to 15% compared to 16.4% the year before. n
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
Market intelligence for the smart investor Have you made up your mind already?
Of course not.
Our opinions and views change and evolve according to our experience and what we learn from others. The opinions of others are always worth listening to; sometimes to compare and contrast with our own, sometimes because they influence our thinking. What’s certain is that in an increasingly complex and changing global investment market, ready access to the considered view of experts can be helpful. Each day our pool of carefully selected commentators and bloggers provide specialist insights into market trends and events.
Is it worth a look? Of course it is.
Simply visit www.ftseglobalmarkets.com and stay connected to a world of intelligence The
Market Review
The
Forex Review
by Jonathan Sudaria, by Alfonso Esparza, Senior Currency AnaDealer at Capital lyst, OANDA Spreads
The
Regulatory Update
The
Vantage Point
by Deborah Prutzman, by Kathleen Hughes, CEO, The Regulatory- Managing Director of Fundamentals Group. the Investment Management Division Goldman Sachs Asset Management Find us on
ASSET CLASS RETURNS 1M% EQUITIES (FTSE) (TR, Local) FTSE All-World USA Japan UK Asia Pacific ex Japan Europe ex UK Emerging
12M%
-6.6 -6.0 -7.7 -5.8 -8.3 -7.8 -6.8
COMMODITIES Brent Crude Oil Gold Copper Credit Suisse Commodity Index
1.2 0.3 23.0 -4.6 -8.5 8.9 -9.1 -53.4
-10.8
-11.9 -26.6 -37.7
3.6 -1.4 0.3
GOVERNMENT BONDS (FTSE) (TR, Local) US (7-10 y) UK (7-10 y) Germany (7-10 y) France(7-10 y) Italy(7-10 y)
-0.4 -0.9 -0.7
3.8 5.2 3.0 2.3 5.1
CORPORATE BONDS (FTSE) (TR, Local) UK BBB Euro BBB
-0.9 -0.5
3.0 0.7
0.6 0.4
FX - TRADE WEIGHTED USD GBP EUR JPY
-0.6 -1.6
17.3 5.0 -7.3 -7.8
1.6 2.2
-15
-10
-5
0
-75
5
-50
-25
0
25
50
EQUITY MARKET TOTAL RETURNS (LOCAL CURRENCY BASIS) Regions 1M local ccy (TR) UK USA Developed FTSE All-World Emerging Japan Europe ex UK Asia Pacific ex Japan BRIC
Regions 12M local ccy (TR)
-5.8 -6.0 -6.5 -6.6 -6.8 -7.7 -7.8 -8.3 -8.9
-8
-6
-4
-2
23.0
Japan Europe ex UK Developed FTSE All-World USA UK Asia Pacific ex Japan Emerging BRIC
0
2
4
6
8.9 2.3 1.2 0.3 -4.6 -8.5 -9.1 -12.0
-20
Developed 1M local ccy (TR) Israel Canada Korea UK USA Denmark Switzerland Developed Italy Sweden Japan Australia Norway France Belgium/Lux Spain Singapore Germany Netherlands Finland Hong Kong
-12.1
-10
15
0
-20
-11.2
-10
-8
-6
-4
-2
20
30
30.1 26.6 23.0 18.6 18.0 12.8 10.8 9.9 9.6 5.8 4.5 2.3 0.3
0
10
20
30
40
Emerging 12M local ccy (TR)
-4.1 -4.7 -5.1 -5.2 -6.0 -6.7 -6.8 -8.1
-12
-10
South Africa India Mexico Taiwan China Emerging Thailand Indonesia Malaysia Brazil -23.1 Russia -27.2
-2.2 -2.6
-14
10
Developed 12M local ccy (TR)
Emerging 1M local ccy (TR) Mexico South Africa Thailand Taiwan Russia Indonesia India Malaysia Emerging Brazil China
0
Denmark Israel Japan Belgium/Lux Netherlands Sweden France Germany Italy Finland Switzerland Developed USA Spain -2.4 Australia -3.5 UK -4.6 Canada -7.1 Norway -7.7 Singapore -10.6 Hong Kong -11.2 Korea -13.8
-3.6 -4.3 -4.8 -5.8 -6.0 -6.1 -6.2 -6.5 -6.7 -7.0 -7.7 -8.1 -8.2 -8.3 -8.4 -8.6 -8.7 -8.9 -9.0 -9.3
-15
-10
0
-30
4.3 3.5 -3.1 -7.0 -8.0 -9.1 -9.7 -11.2 -13.3
-20
-10
0
10
Source: FTSE Monthly Markets Brief. Data as at the end of August 2015.
46
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
PERSPECTIVES ON PERFORMANCE Regional Performance Relative to FTSE All-World Japan Europe ex UK
US Emerging
UK
Global Sectors Relative to FTSE All-World Basic Materials Consumer Services Technology
Oil & Gas Health Care Financials 130
Asia Pacific ex-Japan
130
Consumer Goods Industrials Telecommunications Utilities
120 120 110 110
100 90
100
80 90
70
80 Aug 2013
Dec 2013
Apr 2014
Aug 2014
Dec 2014
Apr 2015
60 Aug 2013
Aug 2015
Dec 2013
Apr 2014
Aug 2014
Dec 2014
Apr 2015
Aug 2015
BOND MARKET RETURNS 1M%
12M%
FTSE GOVERNMENT BONDS (TR, Local) US (7-10 y)
0.6
UK (7-10 y)
3.8
0.4
Ger (7-10 y)
5.2
-0.4
3.0
Japan (7-10 y)
1.9
0.3
France (7-10 y)
-0.9
Italy (7-10 y)
2.3
-0.7
5.1
FTSE CORPORATE BONDS (TR, Local) UK (7-10 y)
-0.7
Euro (7-10 y)
4.1
-0.7
UK BBB
1.0
-0.9
Euro BBB
3.0 0.7
-0.5
UK Non Financial
-0.5
Euro Non Financial
4.3 0.8
-0.7
FTSE INFLATION-LINKED BONDS (TR, Local) UK (7-10)
1.5
-0.6
-1.0
-0.5
0
0.5
1.0
0
1
2
3
4
5
6
BOND MARKET DYNAMICS – YIELDS AND SPREADS Government Bond Yields (7-10 yr)
Corporate Bond Yields
US
Japan
UK
Ger
France
Italy
U UK BBB
6.00
Euro BBB
6.00
5.00 5.00 4.00 3.00
4.00
2.00
3.00
1.00 2.00
0.00 -1.00 Aug 2012
Feb 2013
Aug 2013
Feb 2014
Aug 2014
Feb 2015
Aug 2015
1.00 Aug 2010
Aug 2011
Aug 2012
Aug 2013
Aug 2014
Aug 2015
Source: FTSE Monthly Markets Brief. Data as at the end of August 2015.
FTSE GLOBAL MARKETS • SEPTEMBER-OCTOBER 2015
47
COMPARING BOND AND EQUITY TOTAL RETURNS FTSE UK Bond vs. FTSE UK 12M (TR) FTSE UK Bond
FTSE US Bond vs. FTSE US 12M (TR)
FTSE UK
FTSE US Bond
110
110
105
105
100
100
95
95
90 Aug 2014
Nov 2014
Feb 2015
May 2015
90 Aug2 014
Aug 2015
FTSE UK Bond vs. FTSE UK 5Y (TR) FTSE UK Bond
FTSE US
Nov 2014
Feb 2015
May 2015
Aug 2015
FTSE US Bond vs. FTSE US 5Y (TR)
FTSE UK
FTSE US Bond
180
225
160
200
FTSE US
175 140 150 120 125 100
100
80 Aug 2010
Aug 2011
Aug 2012
Aug 2013
Aug 2014
1M% FTSE UK Index
-4
-2
0
44.2
109.3
0.3
-10
-5
0
17.7
1.1
0.5
2
Aug 2015
5Y%
0.0
0.4
-6
Aug 2014
-5.3
0.2
FTSE USA Bond
Aug 2013
-7.6
-6.0
FTSE UK Bond
Aug 2012
6M%
-9.5
-6.0
-8
Aug 2011
3M%
-5.8
FTSE USA Index
75 Aug 2010
Aug 2015
5
-10
-5
0
15.2
5
0
50
100
150
Source: FTSE Monthly Markets Brief. Data as at the end of August 2015.
48
SEPTEMBER-OCTOBER 2015 • FTSE GLOBAL MARKETS
GM Cover Issue 82.qxp_. 21/10/2015 10:21 Page FC2
GM Cover Issue 82.qxp_. 21/10/2015 10:21 Page FC2