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David Wright, deputy director-general of Internal Market and Services at the ­European Commission, talks about his role in resolving the financial crisis and the EC’s aims for the long term In Brussels

Q Can you tell us a little about your career to date and ­Services, and his cabinet. Once the Commissioner has how you got into your current position? decided on a policy, we prepare all the proposals – whether they be legislative or non-legislative. A lot of our job is to A I am currently the deputy director-general in the European listen to other regulators and market participants and to Commission department that is responsible for the internal ­co-ordinate our work with these regulatory bodies. market. My job is to co-ordinate all the work on financial We also have to appear and defend our proposals in markets and issues, company law, accounting, auditing the Council of Ministers in the European Parliament – who and so forth. jointly decide on the Commission’s proposals. When they I have been in the commission for 31 years, and have are amended, we defend our proposals and sell our poli- Résumé had a number of different posts. I was in the think-tank cies, which involves a lot of public speaking. We have to 1977 – 1974 MA Politics, Philosophy and Economics (PPE): of Jacques Delors at the end of the 1980s; I was in the persuade people that what we are trying to do is good for Worcester College, Oxford ­cabinet of Leon Brittan in the mid-1990s; and was in the the European economy and good for financial business 1976 – 1977 work for MA Economics: Essex University 1975 – 1976 The Times newspaper, London cabinet of the president of the Commission, Jacques and consumers in general. Santer, in the second half of the 1990s. Career at the European Commission 1977 – 1982 Statistical Office of the European Communities Throughout that time I was working on trade matters, Q What do you see as the European Commission’s role in 1982 – 1987 Directorate General for Energy internal market, industry issues and particularly financial the current financial crisis? 1987 – 1989 Directorate General for Industry and Internal Market Affairs issues. Since 2000, I have been working basically on 1989 – 1992 adviser, Forward Studies Unit (attached to President Delors) financial market issues, primarily on integrating the capital A Some people do not realise that the biggest capital market 1993 – 1995 member, cabinet of Sir Leon Brittan 1995 – 1999 adviser, cabinet of Jacques Santer, President of the markets in Europe. in the world is Europe. It is, in fact, bigger than the US if European Commission you take all the member states together and all the ­different 1999 – 2000 adviser, Forward Studies Unit Q What does your current role involve? components and parts of the capital markets together – 2000 – 2004 director of financial markets banking, securities, asset management, insurance and 2005 – 2007 director of financial services policy and financial markets 2007 – present deputy director-general, Directorate General Internal Market A My current role is extremely varied. I have to work to the so forth. and Services, with overall co-ordination of financial services agenda of Commissioner Charlie McCreevy, who is the We have a major interest here to ensure that the effects Commissioner responsible for the Internal Market and of the financial crisis are as minimal as possible. We have

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“ Some people do not realise that A Our major priority is to contribute to stabilising the ­financial system, along with the central banks and regulatory and the biggest capital market in ­supervisory authorities of the 27 member states. The most important thing is to stabilise the situation, then carefully the world is Europe. It is, in fact, and in a calibrated way – respecting the ­better ­regulation bigger than the US if you take principles – make reforms to the current ­financial­ system where there have been failures or ­weaknesses that all the member states together.” need to be changed. For example, changing Basel rules, ­accounting rules, deposit guarantees and so forth. ­Commissioner McCreevy has taken an important ­ initiative recently to press the market to develop, quickly, a single central counterparty to clear the complex derivative ­markets. In the medium term, we want to strengthen our crisis management mechanisms: we are in a very fluid­situation and we are evaluating matters on a continuous basis. At a major role in the European Commission to ensure there the same time, we are thinking towards the future and is proper competition between markets. So, for ­example, considering what is the right programme of work for next all the huge injections of capital and ­guarantees into the year – that has not been decided yet. The danger is that ­banking system have to be checked by the ­competition acting too quickly could result in mistakes and we want to authority here to be sure that they are fair and in line with avoid that. the rules set out by the Treaty. Under the guidance of Commissioner McCreevy, we Q What is your biggest hurdle in achieving this? have also taken legislative initiatives; for example, the changes to accounting rules. Once the International A It is always very difficult to get agreements from 27 member ­Accounting Standards Board had made its changes, we states and the European Parliament, while trying to take had to introduce it to Community law quickly, giving banks into account all the interests of the industry, consumers and the possibility to use more flexible approaches to fair value investors. It is a very difficult balancing act. and the valuation of assets. But we have made good progress. I think we have made We have also made proposals to change the deposit some important changes. guarantee schemes in Europe and have pushed to move We are trying to get the incentives right in capital the bar up higher. We have made proposals to strengthen ­markets, this is very important. Whether we are thinking capital requirements for banks, which we believe are about credit rating agencies or securitisation products, ­necessary in the context of the current crisis. or whether we are talking about the valuation of assets, We are bringing forward proposals to require the executive pay or competition issues – you have to get the ­regulation of credit rating agencies (see box, P11). We have incentives right. These are all parts of the equation. a major strategic, political and economic reason to act The role of the Commission is not to try to shape together to ensure we have good rules in place to mitigate ­markets but to create the conditions for markets to ­function the difficult circumstances that we are in now. efficiently and competitively across borders. We do not Of course, we want to co-ordinate this as much as we privilege one sector over another. What we are trying to can at an international level as well – we always try to do is create an integrated capital market for everyone in do that. But the challenges that we face are enormous, and Europe, where capital can flow freely around the union, the economic damage very severe. We have been acting and where people can buy products that suit them at the under a great deal of pressure. best price. We get involved because, under the treaties, it is only the European Commission that can propose new laws – Q How would you like to see the European Commission’s the European Parliament or European Council cannot. We role evolve over the long term? have a role of propulsion and political initiative here. A Obviously, I want to see Europe become stronger economi- Q What is your department’s priority in the near-term – cally and politically, and I want to see our markets develop including and excluding aspects of the financial crisis? and thrive. I want capital to be available to all that need it,

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and I want to see markets that are properly regulated. the European Union, I want to see stronger integration and We have seen with subprime what can happen if all the benefits of available capital for growing companies, ­markets are badly regulated. It is important that people do innovative ventures and households. not take on loans or debt that they cannot afford, and it is Another thing that we have to ensure in the future is that important that there are rules and safeguards to ensure that all of us understand better what financial services are. I that does not happen. personally believe in making sure that finance is taught at This crisis has shown us that a problem that started in schools from a young age. the US has rippled around the world, and therefore I want After all, we teach students about Latin and cooking and to see Europe in a leading role with good regulation being gymnastics but not about how to manage money. If we can

Source: iStockphoto.com © Xavier Pironet Xavier © iStockphoto.com Source: copied by other jurisdictions. We need to work closely with do that all together, and strengthen the so-called demand- the US to shape and improve the global financial system. side of our financial products, I think that our markets will As someone who has spent most of his working life in function better in the medium to long term.

Statement of intent

On October 17, Charlie McCreevy, manage certain risks; for example, to markets today is such that we cannot European Commissioner for Internal ­limit foreign exchange or interest rate let this OTC ­market continue­ without Market and Services, issued the follow- risks in contracts. These ­derivatives ­adequate ­counterparty clearing. This ing statement on reviewing derivatives are by and large OTC ­derivatives – is ­particularly urgent for Credit Default markets before the end of the year. namely they are not traded through a Swaps. According to estimates of the stock ­exchange or other multilateral Bank for International Settlements, Time for regulators to get a better ­trading platform. Instead, the contracts the total notional amount ­outstanding view of derivatives are drawn up between dealers and for credit default swaps is almost $60 The market for derivatives has grown to ­corporate and institutional clients, in trillion dollars, that is 10 per cent of the around $600 trillion. It is a market little ­principle, tailored ­specifically for each total derivatives market. No one is able understood by those outside of it. In client’s need. This gives rise to ­concerns to say how these swaps will unwind. the current crisis, these complex and that in the event of the failure of a Regulators have little sight of ­potential often opaque instruments have come ­significant party to honour its­obligations, liabilities that could be ­building up for under the spotlight. Given their size, the there could be ­serious knock-on effects individual participants. The ­opaqueness question most frequently being asked for other ­financial­players. In current of these products leads to nasty is, do they pose unnecessary risks to ­fragile market ­conditions, such new ­surprises when things go wrong. financial markets? tremors could cause major damage. The failure of the Icelandic banks There are many types of deriva- I am aware of the many reasons is the latest in a line of credit defaults tives. Some are fairly standardised and why more of these derivatives are not in recent weeks. Already at least ­traded on exchanges. But the vast ­exchange traded. However, I am not one bank has had to write down a ­majority of derivatives are bespoke convinced that more derivatives could ­significant amount as a result of the financial products traded off-exchange, not be standardised. This is one of failure. The potential knock-on effect to i.e. over-the-counter (OTC) between the issues we need to look at in the other ­players in the market is obvious. two parties. Interest rate contracts time ahead. But there is a far more ­Regulators need to have a much better ­account for almost two thirds of the ­pressing need and that is to have a view of where the real risks in these ­total volume outstanding. But the central ­clearing counterparty for these instruments lie. derivative that has shown exponential ­derivatives. This has been underlined That is why I have decided to growth in the last few years is Credit by the collapse of Lehman which was ­convene all the main players ­concerned Default Swaps. These now account for a ­major counter party in the ­derivatives to work through this. I would like to around 10 per cent of all ­derivatives. area. In addition, there was also have by the end of this year concrete Unlike most ­interest rate swaps, ­considerable speculation on ­Lehman’s proposals as to how the risks from Credit Default Swaps can result in large default through the use of Credit credit derivatives can be ­mitigated. ­payments having to be made in the ­Default Swaps which again increase More generally, I also would like to event of a bankruptcy of a company. the ­counterparty risk in regard to have a systematic look at derivatives Derivatives were originally devised as these instruments. markets in the aftermath of the lessons an added measure to help ­companies At $600 trillion, the size of ­derivatives learned from the current turmoil.

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The banking business model is about to go through substantial changes as it adjusts to a new financial world order being carved out by governments across

Source: Getty Images Getty Source: the globe. William Rhode discerns where fresh opportunities are likely to arise Dawning of a new era

oliticians around the globe they will also be actively ­patronised are carving out a new finan- under the new financial order, since cial world order that could governments recognise the critical role Pherald in an era of heavy that these firms play as conduits. They regulation. Possible outcomes include will face less competition and should the establishment of a supranational achieve better loan margins. financial­authority, a global ban on credit “The banks that survive this crisis are ­derivatives, the scrapping of the Basel going to do extremely well in the future,” Accord, an overhaul of Bretton Woods, says Larry Tabb, founder and CEO of a variety of state-run banking systems the TABB Group, a financial markets’ and ­punitive regulatory measures for the research and strategic advisory firm. securitisation industry. Citing his October report, ‘Future The question is, how will the ­banking of Investment Banking: Subprime and business model change and what Its Impact on the Industry’, he adds: ­opportunities are there in the future? “While they will see their businesses The first port of call is to look at return to basics, the landscape will the banks themselves and try to have been cleared of competitors and ­understand what shape they will take in their mandate will be to dominate a the new world. There will likely be two ­deposit-based banking system. They ­incarnations, experts say. will also be able to aggressively cut The first will be the big banks that costs and improve profits as they lay off ­survive the crisis. Many of these banks the many thousands of structurers and will see their businesses go back to traders who populated their investment basics, along the lines of banking in the banking business franchises.” 1950s, taking deposits and lending out Julian Jessop, chief international at higher rates for profit. They will be economist at Capital Economics, the heavily regulated but, at the same time, macroeconomic research company,

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Figure 1: Credit Derivatives, 2002-June 2008 Notional Amounts $ trillions ­retention reform proposal and it seems agrees. “The big players are going to Jessop agrees with this theory. “I like the principal concern is to correct a get even bigger. And out of those I this polarisation idea very much,” he ‘misalignment of incentives’ in the think the Japanese names, like Nomura says. “There will be fewer big players securitisation chain between banks and 62.2 who ­purchased parts of the Lehman but they will be bigger. And then there investors. But we think this quantitative ­business, will do very well.” will be niche players that will specialise. 54.6 retention proposal attempts to align the As Tim Congdon, the founder of They will target a sector, say securitisa- objectives of banks with those to whom ­Lombard Street Research and an tion, and make it their only business. they sell securitised products rather economist, points out, “The banks that They will seek to attract the best people than targeting the checks and balances. have lost capital are going to be capitally and leverage their own capital to provide 34.4 There are a number of problems with constrained and so will charge more the best securitisation service. It will that approach, the most significant of for risk products, which should help the be a cleaner banking system because which is that it won’t actually achieve the

return on capital, as loan losses on old these firms will take more responsibil- 17.1 aim it has been designed to achieve.” business are being written off.” ity for their practices. They won’t risk Jens Conert of the German finance He explains that conflicts of interest their reputations and their own capital 8.4 ministry wrote in response to the EU pro- inherent to the bank holding company by allowing toxic assets to filter into the 2.2 3.8 posal: “While we are generally supportive model, whereby commercial banks system. There will be clearer delineation of exploring the use of quantitative re- bought investment banking franchises, in the banking business and it will thus June-02 June-03 June-04 June-05 June-06 June-07 June-08 quirements to ensure that the economic

have been exposed by the crisis. be easier to regulate.” As of June 2008, estimated gross MTM value is $1.9 trillion interests of originators and investors “Commercial banks participating in Julian Jessop, chief international economist, are aligned, we are concerned that the Capital Economics investment banking activity ran against The nature of assets Source: International Swaps and Derivatives Association proposal as it currently stands would not the very backbone of the Glass-Steagall And what of the markets themselves, achieve the intended result and might Act,” he comments. “There will be hedge funds, which regulators have experts ask? What kind of assets nents of netting arrangements and any The death of securitisation? possibly lead to competitive distortions.” ­enormous regulatory pressure to break traditionally not liked because they and securities underwriting will banks measure that can see the number of Most agree that securitisation was Tabb suggests that the securitisation up those conflicts of interest.” are seen to add nothing to the capital ­migrate to in the new world? outstanding notional values in credit a ­solid industry backed by sound industry faces deeper challenges than markets,” he says. “Investment banks, Clearly, credit is going through derivatives reduced,” he says. “I think it ­economic principles before it became just regulatory reform. “It’s a matter of Introducing the i-bank however, especially if operating on ­substantial upheaval and is being is a good idea to see a central clearing tainted by the subprime disaster. trust,” he says. This segregation of interests will see their own capital base, are seen as ­targeted by the regulators for reform. mechanism put in place.” Will regulators lump it in with credit He explains: “Everyone involved in the another type of bank emerge. Larry providing vital lubrication to the capital In order to understand where the Even though clearing houses are ­derivatives and restrict banking efforts securitisation chain has been tainted, Tabb expects to see a swathe of markets, most especially in the form ­opportunities are, or perhaps the lack often linked to exchanges, Metcalfe to revive it? The outlook does not from the mortgage originator through to ­mini-investment banks spring up, of ­structuring expertise.” thereof, experts say one has to look at says there’s no reason why over-the- look good. the banks who bought the loans, to the ­privately owned and run as partnerships, Adair Turner, chairman of the the proposals being mooted. One of the counter (OTC) credit derivatives cannot In his final year of office as European government agencies, the ­structurers, in much the same way that Goldman UK’s Financial Services Authority, in big question marks in the market is what continue to thrive in the new financial Union Internal Market Commissioner, the credit rating agencies and the Sachs used to operate, before its listing a ­presentation entitled ‘Beyond the lies in store for the credit derivatives world order. Despite the calls for greater it’s clear that Charlie McCreevy wants ­traders who sold the securities on – all of on the New York Stock Exchange. ­Current Turmoil: The Future Shape of industry. ­transparency in the financial markets, to make a lasting statement with a them have been shown to have been at “There’s a few forces at play that Global Finance’ to the International Richard Metcalfe, head of global he says that there is no real reason, ­securitisation reform proposal that will fault, sometimes even deliberately (see will lead to a flourishing of the smaller, Banking Seminar in Washington in policy at the International Swaps and in principle, or benefit to force credit see banks retain 10 per cent of the figure 2). I don’t see the securitisation more agile investment bank,” he says. October, said there will be significant Derivatives Association (ISDA), says: derivatives to be listed. “Transparency securitised products they devise and industry coming back from this because “First, there’s an exodus of outstanding deleveraging in the future and, with it, a “First of all, credit derivatives have done generally emerges where it is needed or so “keep a skin in the game” under the no one believes in it anymore.” talent from both investment banks and polarisation of banking institutions. exactly what they said they would do desirable. There is more transparency in “originate and distribute” (OTD) model. Congdon concurs. “If you believe the hedge fund industry, which have “The end point of the ­deleveraging on the tin, which is to provide a precise, this industry than its detractors like “McCreevy wants to punish banks for some of the reports, Bear Stearns, been squeezed out of business by the in terms of financial institutions is fairly targeted means of measuring and man- to think.” draining central banking liquidity,” for example, offloaded assets ban on short selling. These people are clear. A large-scale disappearance of aging credit risk. That’s why we continue Tabb, however, sees the OTC deriva- comments one industry body official onto their fund management clients going to set up things on their own. the very highly leveraged shadow to see new business growth even while tives markets in general faring poorly in who did not want to be named. “But, that they knew to be toxic. That was Second, there are large pools of capital, banking institutions – the SIVs and the economically offsetting trades are being the new regulatory environment and, as notwithstanding the fact that the the problem with the structured finance ­especially in commodity-rich nations, ­conduits – and the disappearance of torn up (see figure 1). To say that credit the calls for transparency mount, higher last thing markets need right now is to boom in bank holding companies, the which will need to find good use. I most independent investment banks into derivatives have failed would simply be demand for exchange-listed derivatives be disciplined, is the fact that the companies that mixed up ­commercial see human capital migrating towards either alternative ownership or default, wrong.” will emerge. idea is just plain stupid. Whatever the banking, ­investment banking and real capital, to form small investment the transformation of the remaining Metcalfe does agree, however, that “I see exchanges benefiting from the EU is hoping to achieve, will simply fund ­management. At some point ­banking partnerships.” ones into bank holding companies regulatory pressure for a central clear- credit crisis,” Tabb says. “There will not be achieved.” the ­investment bank wanted to get Tabb says the regulators are ­actively with lower leverage. And the ­increasing ing mechanism for credit derivatives is a be more demand for opaque ­derivatives Dianne Hilleard, a director at the failed ­issues off its balance sheet and promoting these kinds of firms and ­concentration of credit extension,­ good idea and is a likely outcome of the to be listed so that there is more London Investment Banking ­Association the temptation to dump high-risk, ­encouraging their growth. “These kinds ­trading and capital market activity into credit crisis. ­transparency.” (LIBA), says: “We’ve tried hard to ­low-quality securities on in-house of institutions will be very different to the very large universal banks.” “We’ve long been major propo- understand the motivation behind the clients was too strong. There was also

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Figure 2: Who can you trust? “London’s role in international capital ­ markets will continue to be critical. Fannie/Freddie Investor It has intrinsic advantages that will be Guarantee Mortgage buys paper very hard to take away.”

­Speaking to journalists at a ­conference in ­Dubai, Thain said: “The Middle East has a great amount of wealth that ­question of whether banks are able, ­committee will be an utter disaster. provides the ability to make investments Banker even in ­principle, to regulate ­themselves. Without independent regulatory bodies around the world. The region can take buys mortgages ­Questions over this theory, which there can be no competition of ideas advantage of these financial difficulties.” is ­epitomised in the Basel II Capital and the banking business model will be Stephen Green, chairman of HSBC, ­Accord, have emerged. And it is throw- ­extremely constrained.” told the same conference that the US ing the future of the business banking Metcalfe of the ISDA says: “We love subprime crisis and subsequent Mortgage broker model into doubt. regulation but we don’t think you should ­economic downturn have masked a makes subprime loan Turner of the FSA says: “Regulatory throw the baby out with the bathwater. fundamental realignment of the global regimes will, I am sure, demand more The principles behind Basel II are sound economy as power transferred from the capital in financial intermediation, both and should be maintained in the new US consumer to Asia and the ­Middle via higher capital requirements for banks financial world order.” East. He said that the fallout would ABS Engineer and via more effective steps to prevent power the long-term expansion of rival Securitises & Segments highly leveraged shadow banking enti- London’s burning financial centres such as Dubai, Mortgages ties escaping capital regimes. And there One final element of the picture is the Singapore, Hong Kong and Shanghai. will be more focus on liquidity prudential ­future of London as a financial­centre. However, he added: “London’s role regimes, and we will need to debate The head of European financial­sponsors in international capital markets will whether that is effected via principles at Goldman Sachs has added his continue to be critical. It has intrinsic and regulatory review and regulatory voice to a list of high-profile­bankers advantages that will be very hard to take Credit Rating Agency Trading desk ­discretion, or via quantitative rules.” who ­believe that the market turmoil away.” Turner of the FSA offered this Provides AAA Rating distributes European Union leaders have called and growth in emerging economies is perspective: “There are many emerging for the creation of international boards ­threatening the position of cities such countries, including the very big ones – Source: TABB Group to oversee at least the world’s 30 as New York and London as the world’s China and India – where the demise of ­biggest banks and financial institutions. leading financial centres. some New York investment banks is not This latest effort to step up regulation Responding to a question at a fundamental to their financial systems. this dressing up of low-grade issues into something much more complex, on-balance sheet lending. The answer to ­address the global financial crisis ­conference in London, John Waldron, “And while the newspapers of the US as something they are not.” much more opaque and much riskier is, not ­necessarily, Turner says. “What is based on a proposal by UK prime co-head of Goldman’s European and UK are full of comparisons with the Jessop says that to write off the [than what it used to be]. ­Securities instead we may see is a continuation ­minister ­Gordon Brown that could ­financial sponsors group, said: “I actually Great Depression, I think the chances ­securitisation industry entirely goes were packaged and structured and of the ­originate and distribute model, see a supervisory body consisting of think New York and London do have that we are going to face a disaster too far. “It was a good industry sliced. Derivatives were used to lay off but in a form more in line with the ­regulatory officials from big countries to worry about [losing their dominant remotely like the Great Depression are before subprime and it can be a good risks, with huge unsettled ­counterparty initial ­proposition – the packaging and and financial centres. position]. The velocity of talent moving close to nil… We do know that in the ­industry in the future. Securitisation ­exposures. And a large proportion ­distribution of credits to end investors in Brown has said the world needs a around the world is going to ­accelerate face of financial sector collapse, govern- serves an important role in the of the securities were not in fact a sufficiently transparent and direct and “new Bretton Woods”, a reference moving from west to east.” For this ments and central banks must take, and capital markets, not least because it is passed through to end ­hold-to-maturity simple form, that end investors, often to the 1944 conference in New reason, Goldman Sachs is seeking to have the resources to take, exceptional such an efficient way of managing and ­investors but held and traded on the of the hold to maturity variety, can truly ­Hampshire that set up the basic rules position itself to take advantage of the measures. These measures are being moving capital.” balance sheets of banks and on the understand the risk-return characteris- for international banking, finance rapid growth of cities such as Shanghai and will be taken to the extent needed. In his speech to the International off-balance sheets of banks (the SIVs tics of what they are buying, with fewer and monetary policy. The goal would and Dubai. Major changes in the financial system Banking Seminar, Turner of the FSA and conduits) and in the highly lever- layers of ­intermediation and trading.” be to enhance ­communi­cation and Waldron’s comments follow those will result in the developed economies. said: “Securitisation has been with us for aged and increasingly leveraged balance response plans for bank operations of Merrill Lynch chief executive John But the world will still have a growing several decades. But in the last ­decade sheets of investment banks.” Regulatory landscape worldwide, regulators say. Thain, who in October said that the economy, largely organised on market – with macro demand on the one side This raises the question of whether Governments are also turning their “I think this is a lousy idea,” says US ­economy is “rapidly contracting” principles – even if the financial sector and the creativity of financial sector that also means a reversal of the ­attention to the issue of ­regulatory ­Jessop. “The notion of having a and that the oil-rich Middle East could is regulated in a more effective way. We ­innovation on the other – it had morphed march of securitisation, a return to capital and the more fundamental ­single international authority ruling by benefit from the global financial turmoil. need to keep this perspective.”

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As the US and global governments begin their latest round of talks on how to get the credit markets ­functioning again, Denise Bedell looks at how current efforts – and the current crisis – compare with the experience of the Great Depression

Learning from the past

any commentators have ­ and curb the length and severity of the remarked on the ­similarity ­present turmoil. between the ­current The 1930s turned out to be the M­financial­crisis and the ­ ­proving ground for many of the situation that led to the Great Depression ­economic policies now taken to heart of the 1930s: both ­involved a collapse by legislators in the US and globally. To of confidence and both­necessitated put the situation in context, the 1920s extensive government ­efforts to calm were a period of strong economic market fears. Yet we should not be growth in the US. The country was riding quick to claim that the situation today high on the post-war boom and the will inevitably see ­economies spiral into stock markets were flourishing. a depression of 1930s’ proportions – for ­Consequently, in 1928, the Federal a start, today’s regulatory environment Reserve began driving up interest rates is entirely different. But we can still learn and ­rate-sensitive ­industries began to lessons from past crises that can help slow. As industries such as construction guide the success of current efforts ­stagnated, ­consumer spending slowed Images Getty Source:

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“ They didn’t provide any emergency ­lending, they “ The question is, how did we get to a place where provided no liquidity to these banks, which had assets those ­business models were ­actually ­implemented devaluing – and these were not junk bonds that and where we were ­seeing ­international banks were devaluing; they were Treasuries or railroad bonds holding sub-prime-oriented ­securities to the extent and the like.” that they were?”

States go to the wall. Bethlenfalvy con- ­provide government support for all these tinues: “It had 450,000 depositors and banks – so there is clearly a parallel there they let it fail. Three hundred banks had with what is happening today. Also, they failed by 1930 and the Fed did noth- created the FDIC, which ­insured deposits ing. They didn’t provide any emergency up to $5,000 – so again a parallel. And ­lending, they provided no liquidity to FDR suspended the Gold ­Standard, these banks, which had assets devalu- so they could provide interest rate ing – and these were not junk bonds that relief.” ­Abandoning the Gold ­Standard were devaluing; they were Treasuries and ­allowing the ­dollar to ­devalue was or railroad bonds and the like.” By this perhaps the single most important step point, the Fed could not lower interest taken, as it allowed money supply to rates because it had used most of its grow and curtailed deflation. credit supporting the Gold Standard in the 1920s. Risk management and the By 1933, when Franklin Delano mortgage markets Roosevelt became president, more than There are a number of similarities 9,000 banks had closed their doors, between the crash of the 1930s and leaving depositors and shareholders today. Nigel Myer, financial institutions Peter Bethlenfalvy, group managing director, global corporate finance, DBRS with about $2.5bn in losses – equivalent credit analyst at Dresdner Kleinwort, Paul ­Belanger, partner, business and securities groups, Blake, Cassels & Graydon to about $340bn today. Bank closures says: “The key similarities between this led many more to withdraw their savings and previous negative cycles are excess and normal lending and money supply asset prices and a crisis of confidence. collapsed. That – along with the need That was clearly evident this time and greater volatility was seen in period. “First, within six months of the to support the Gold Standard – led to around. It is perhaps even more ­evident ­business models underlying mortgage to sell them on and had to face the stock prices. stock market crashing, he put in place deflation. As with today, credit became in a service-based economy than an lending in the US over the last six years. ­consequences of their underwriting The culmination of this was the the Hawley-Smoot Tariff Act to raise scarce and ­consequently businesses industrial economy, as in previous Those business models propping up decisions. stock market crash of 1929, which tariffs – making imported goods more suffered, ­adding to the vicious cycle. ­negative cycles.” the subprime development were based Other contributing factors were the sent ­confidence plummeting. Herbert expensive,” says Bethlenfalvy. “His goal Bethlenfalvy says: “Then in 1933 with However, the main drivers of the crisis on the notion that people who ­originated risk management practices, ­increased Hoover was president at the time, and was to have US consumers buy more FDR and the New Deal, in the first 100 today are somewhat different than those the loans would either sell them on leverage and asset-liability ­mismatch his ­administration took a hands-off domestic product, but it ­actually days we had the Emergency Banking in the 1930s. First, the ­developments – and thus not have to worry about at global financial­institutions. ­Paul ­approach to guiding the markets. Peter had the opposite effect and trade Act put through – which shut all banks in the US subprime mortgage market defaults – or that house prices would ­Belanger, partner, business and Bethlenfalvy, group managing director, dropped off as other countries raised on March 4, 1933. They reopened on and across the US housing market keep going up and those defaults would ­securities groups at Blake, ­Cassels global corporate finance, at ratings and tariffs in response.” March 9 with treasury ­supervision; are ­unquestionably the mechanical never ­happen. When house prices & Graydon, says: “The question is, market analysis firm DBRS, says that In addition, in December 1929, the ­however, only three-quarters of the triggers for the market and banking did stop growing at a ­phenomenal how did we get to a place where many lessons came out of the Hoover Fed let the New York Bank of the United banks reopened. The goal was to crashes. House price declines destroyed rate, ­originators stopped being able those ­business models were actually

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about bailout package is TARP and the shouldn’t think this is going to be over “ I think the current bailout packages we are seeing are $250bn pledged from that to buy illiquid soon. The key issue for Asian countries Other crises proving absolutely ­necessary in order to stop the bank assets, governments around the is to prevent the banking crisis from world are providing economic stimulus turning into a currency crisis,” he said. Aside from the Great Depression, the complete crisis of confidence. With the packages, and supporting financial institutions by According to Belanger, all central US has faced numerous other banking they have the crash trolleys out and have applied the providing liquidity or buying their banks need to be focused on getting the and market meltdowns and has taken toxic assets. credit markets functioning more nor- lessons from those in dealing with defibrillator so the patient is at least alive.” The EC in October announced mally than they are right now. He says: the current crisis. In 1907, the stock €1,300bn to bolster banks and world “The risk premiums that banks must market fell almost 50 per cent after leaders have met on several occasions pay to borrow are extremely high – an a retraction of market liquidity from a to direct corresponding efforts. Belanger ­unprecedented high. They are aiming number of banks and the failure of the says: “I think the global co-ordination at getting that lever of ­monetary policy Knickerbocker Trust Company. has been impressive. I don’t think it is functioning again. Global ­co-ordination Loss of confidence by depositors easy to co-ordinate such efforts globally. is important because it is a global and the lack of a lender of last resort The fact that they have succeeded is a ­problem. And countries realise they led many regional banks to withdraw sign of how important this crisis is being have to convince the world at large that reserves. Order was restored when taken by global governments. There is systemically-important banks are not New York businessman John Pierpont a lot of fault to find that we are in this going to fail. They are trying to tell the Morgan pledged his own funds – and mess, but not a lot of fault to find with world that if you have lent money to ­convinced other financiers to do the ­implemented and where we were seeing banking sector and credit markets, the efforts to get out of the mess.” systemically-important banks then you same – to prop up failing banks. As a international banks holding subprime- it is clear that nowadays stimulus is One big focus seen today, that was are going to be paid. It is too early to tell result of the Panic of 1907, the Federal oriented ­securities to the extent that indeed a mandate of Congress. absent in the 1930s, is the ­recognition if it is successful, but by year-end we Reserve was created in 1913. they were?” that global bodies must work together should know.” However, this was not the first Belanger says that this demonstrated Global impact on banking and market supervision Adds Myer of Dresdner Kleinwort: major crisis faced by the US financial the huge system-wide failure of proper The big question is whether ­regulators, and on efforts to increase ­transparency “I think the current bailout packages system. Indeed, for the first 150 years risk management. “When Enron and and market participants, have learned and risk management. In Europe, we are seeing are proving absolutely after the creation of the US financial WorldCom happened, the government from the past and whether these José Manuel Barroso, the European ­necessary in order to stop the complete markets there was a crisis of some response was to implement Sarbanes- ­lessons are being applied to the present. ­Commission president, noted that crisis of confidence. With the packages, sort about every 20 years. Oxley. It was not really aimed at Enron Bethlenfalvy notes that in the 1930s EU-level banking supervision was they have the crash trolleys out and have The panic of 1819 was probably the and WorldCom – which were essentially the central banks didn’t play much of ­imperative. “It is essential to go beyond applied the defibrillator so the­patient first boom-to-bust cycle seen in the about high-level executive fraud – rather a role in supporting banks, providing the short-term measures and to put is at least alive. So now the global US. The panic of 1837 led to a five-­ it was aimed at risk management and ­liquidity and so on. He says: “So these into place a structured, truly European ­economy needs to be nursed back to year depression. The panics of 1857, internal controls. But it clearly wasn’t are good ­lessons learned in the 1930s response,” he said. health. But that will be a slow process.” 1873 and 1893 each saw bank failures, really up to the challenge, was it – given that are ­being applied today. The biggest Although the direct impact of the One London-based senior ­equity and the panic of 1901 saw the stock the failure of internal risk management difference is that today they have been ­crisis has only been felt minimally in ­capital markets banker says: “I think market tumble to unheard-of lows. and control that we are seeing now? monetising liquidity and illiquid assets.” Asia, at the Asia-Europe Meeting in they have decided that they will In the 1980s and early 1990s, the All the money spent on implementing The global responses to the current late ­October, more than 40 global ­succeed. They will do whatever it takes US faced another significant Sarbanes-Oxley was clearly completely Nigel Myer, financial institutions credit analyst, crisis are quite different from those in the ­leaders agreed to “undertake ­effective to succeed, they will repair the credit ­predicament with the savings and wasted.” Dresdner Kleinwort 1930s. In the 1930s, even though world and ­comprehensive reform of the markets, and if the current ­packages loan crisis. This was precipitated by Belanger points to the institutional use governments faced a global depression ­international monetary and financial aren’t enough then they will throw the housing market boom of the of risk management: “Were people truly and a global meltdown, there was no systems”. ­another log on the fire. I don’t think they late 1970s, followed by sinking using models to manage risk exposure, co-ordinated effort to solve it. Global At the meeting, UN Secretary ­General will have to nationalise banking systems property values in the mid-1980s and or were people essentially using the has been the government response and synchronisation has now become a Ban Ki-moon noted in an address that in order to achieve that. I suspect what asset-liability mis­­match as interest models to support the conclusions that the speed of action to curb the crisis. cornerstone of the current response developing nations may be hit next they have done will work, but if it doesn’t rates skyrocketed. they wanted to reach – which was that One Toronto-based capital markets by governments and central banks. by the crisis. He said that, although at then there is still more they can do in This, in combination with relaxed they would make greater compensation lawyer says: “In the 1930s it wasn’t For example, interest rate cuts were present developed nations are taking the guarantees of bank obligations. That regulatory oversight and new if the banks did these deals.” ­Congress’s role to provide stimulus – ­co-ordinated with the Bank of Canada, brunt of the financial meltdown, “we fear would be the next step.” ­speculative opportunities – in the form In addition to internal risk now that is clearly seen as their role.” Bank of Japan, ECB and the Federal Re- the next shoe to drop will be emerging When the markets have settled of deposit brokerages – led to the ­management, the risk models used by With the launch of the housing serve in early October. In addition, global economies”. down, the landscape will be dramatically failure of many S&Ls, the injection of rating agencies have been brought into ­package earlier this year, and the entities are providing swap lines and The Bank of China’s vice-president, changed. What companies take away about $160bn from the government to serious question with losses seen on ­Emergency Economic Stabilization supporting US dollars to each other. Zhu Min, at an Asia-Europe Business from the crisis and how business models prop up financial institutions and even highly-rated securities. Act of 2008/The Troubled Asset Relief Belanger points out that we are also Forum in October, also noted that change as a result will have much to say markets, and the closing of about Regardless of the drivers, the big Program (TARP) granting up to $700bn seeing a global co-ordination of liquefy- the global financial crisis will be felt in about who successfully navigates the 1,600 non-S&L banks. ­difference between the 1930s and today in funds to help stabilise the US ing assets. Although the most talked Asia over the coming six months. “We rough waters ahead.

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Extreme volatility has made complex FX derivative strategies more difficult to execute, as liquidity on the underlying options markets has dried up. Over the next six months a return to plain vanilla products is now likely. Michael Marray reports

Back to basics

he development of liquid The medium-term effect of all this ­options markets on emerging turbulence will be to get back to basics, market currencies has been both in terms of currencies being traded T one of the notable recent trends and the type of derivatives being utilised, on global FX markets, but the extreme against a background of risk aversion. volatility that certain currencies experi- Even the Japanese yen carry trade enced in autumn 2008 has underlined was being unwound in October, as the fragility of some of these products. investors such as hedge funds decided In late October, there was a single that the gains to be made by borrowing trading day when the South African rand in low yen interest rates and investing in dropped 9.5 per cent against the US higher-yielding assets elsewhere in the ­dollar, the Turkish lira fell 6.6 per cent, world was becoming too risky, exposing the Brazilian real 5.7 per cent and the them to huge losses in the event of big Polish zloty 4.9 per cent. A few weeks currency swings. The surge of the yen earlier, in just a couple of days, the against the Australian dollar – a favoured ­Icelandic krona lost more than 50 per play given high Australian dollar ­interest cent against the euro. rates – provides a case study for the Better-established currencies have risks inherent in carry trades. not escaped either. In three months the “The emerging markets currency ­Australian dollar fell 31 per cent against storm that began in Asia last May has the US dollar and 40 per cent against hit Latin America and is spreading to the yen. Clearly, after successive crises eastern Europe,” says Stephen Jen, in the credit and equities markets, head of currency strategy at Morgan ­followed by a systemic banking crisis, Stanley. “More than any other part of the the mayhem had moved into the emerging markets, eastern ­European

currencies market. currencies as a group are likely to Images Getty Source:

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­experience intense pressure – partly amount of liquidity on top of activity “We have been seeing carry trade knock out once a given amount of gain because of their large current account linked to more traditional corporate ­unwinds right across the has been accumulated on the structure. “ On the institutional side, we have seen a deficits, which have been accompanied hedging. The involvement of hedge emerging markets.” These were widely used by corporate massive reduction in ­appetite for new by extraordinarily high domestic funds brought large scale to FX trades He adds: “On the institutional side, treasury departments. housing credit growth, with a serious even in exotic currencies, which were we have seen a massive reduction in But the opaque nature of collater- ­complex structured product trades, but an currency mismatch.” beneficial to corporates and others ­appetite for new complex structured alised debt obligations (CDOs) led to increase in restructurings and unwinds of Jen notes that the dollar began a seeking hedging mechanisms. product trades, but an increase in ­investors in asset-backed ­securities broad-based risk aversion-induced rally restructurings and unwinds of ­existing (ABS) not fully analysing the risks they ­existing positions.” in May, and that this has set off a chain positions. The name of the game in the were incurring. This resulted in the reaction. “After an initial phase of denial, current market environment is much shock when big losses came though on domestic agents (exporters, ­importers more about provision of liquidity than underlying holdings of ­subprime ABS and investors) will need to realign coming up with the latest ­innovative tranches and monoline wrapped bonds, their hedging strategies with the new product ideas. Even if there was ­investor so corporate treasury ­departments and ­expected path of the exchange rate,” appetite, it would be difficult to­manage, players such as hedge funds will now he says. “The adjustment of hedging because many currency options markets prefer more transparent and simple ­strategies by local economic agents has have become highly ­illiquid and some FX derivative products where they been the single most powerful driver underlying spot markets have even feel that they fully understand all the behind the weakness in the Korean won, ceased to function for some ­currencies.” risks involved. Brazilian real and Mexican peso.” Now it is very much back to basics for The experiences of Hong Kong-based Corporate treasury departments are the FX market, notes Davison. “Instead Citic Pacific highlight the inherent risk in (US$1.88bn), though Citic was putting now scrambling to come to terms with of multi-currency asset ideas or ­liability such instruments. In late October, Citic on various new trades in order to lessen this new set of expectations. But they tools – such as target redemption Pacific had to put out a profits­warning the eventual impact of realised losses. too are becoming more risk averse and ­forward contracts – that were widely and arrange a standby loan from its In Europe, many corporates have also are looking for simple hedging ­products, used six months ago, now, whether it is 29 per cent owner, ­Beijing-based found themselves on the wrong end of where six months ago they were ­using on the corporate side or the institutional Citic Group, as a result of huge fast movements in the dollar against leveraged FX contracts, knockout side, clients are looking for very simple ­mark-to-market losses on leveraged the euro. ­barriers and other mechanisms. Stephen Jen, head of currency strategy, FX products.” FX contracts. “The euro is much weaker now, and For the bank arrangers of these Morgan Stanley “We were still seeing demand from It entered into these contracts with those that were unhedged are sitting products, the volatile environment institutional investors based on ­central the aim of minimising its ­currency there feeling very pleased with them- is also causing problems. Complex A notable trend in late 2006 and early and eastern European currencies in ­exposure on the company’s iron ore selves, while treasury departments that derivative trading strategies are difficult 2007 saw hedge funds and other asset the summer,” adds a Vienna-based ­mining project in Australia, which did have hedges in place are stuck to execute when the underlying options managers dramatically increasing their ­structured products banker. “But this requires heavy ongoing capital with hedge levels up at 140, 145, 150. markets cease functioning efficiently. exposure to emerging markets. Brazil, demand has dried up because of ­expenditure. Citic Pacific had­positions Because the market moved so far so For ­example, the rouble options market Russia, India, China (Bric) has been a ­extreme volatility in currencies such as including target redemption ­forward quickly, they have been difficult to re- dried up for big trades in October, while major theme for investors over the past the zloty.” contracts, enabling it to receive structure,” comments an FX structured option trading on the Icelandic krona five years, and this has widened out to Early in 2008, auto call structures ­Australian dollars against delivery of products arranger. ground to a standstill, followed soon more diverse themes such as central were popular with institutional ­investors, US dollars. The maximum deliverable “Volatility has scared people off after by the spot market. and eastern Europe and Latin America. utilising barrier options where once amount to the group under all James Davison, head of FX structuring, and made it impossible to get out of This is an even bigger challenge for As with most other asset classes, a particular trigger event is hit the ­Australian dollar target redemp- BNP Paribas, London large positions back up at 145, 150 FX derivative products aimed at hedge low volatility was a feature of global ­structure is redeemed and principal tion ­forward ­contracts is A$9.05bn, for euro-dollar, and on the institutional funds, institutional clients and high net FX ­markets in the years up to summer plus return is paid to the investor. These ­deliverable in monthly instalments up side the story is the same,” he adds. worth individuals. Rapid ­rebalancing 2007. A period of slightly increased were typically on single underlyings, with to October 2010. Citic’s problem was that the knockout “In August and September, people saw of portfolios as currency cross rates volatility in the period to summer 2008 many investors playing the ­appreciation Citic also had dual currency target under which the obligation to deliver out- huge opportunities in the market. Now in and ­interest rates change is the­ ­basis was viewed as an opportunity by many of the euro versus the dollar or its redemption forward contracts, under standing Australian dollar instalments to October they don’t really want to put on of these strategies, often driven by hedge fund investors, but that has reverse from spring 2008 onwards. The which it receives the weaker (versus Citic automatically ceased when a stipu- any new positions; they want to look at algorithms, but they can no longer now changed. appreciation of the Chinese yuan against the US dollar) of euros or Australian lated profit level was reached.­However, unwinding existing positions.” be ­efficiently executed as futures and “In August and September, institu- the dollar was another popular play. And ­dollars. These contracts were struck there was also a similar ­knockout feature It is this great global unwind which ­options markets become illiquid. tional investors and liability ­managers baskets of currencies were also used as at a ­weighted average price of 87 US for losses. is causing problems for many smaller were still viewing volatility in the FX underlyings. cents, and were protecting Citic as the Its leveraged FX contracts do not currencies, as it has created a one-way Hedge funds pull back ­markets as an opportunity, but as Also popular were target redemption ­Australian dollar rose relentlessly to- qualify for hedge accounting, and market where tight bid/offer spreads are The disappearance of institutional ­volatility further increased in October this forward-type hedging structures, which wards parity with the US dollar. But when ­accordingly they are marked to ­market impossible to provide on FX derivatives. ­investors and hedge funds will have a has been replaced by a general aversion are strips of leveraged forward contracts the collapse came it was very ­sudden, at the end of each financial period. The width of pricing has doubled in even sizeable impact on the FX derivatives to risk,” says James Davison, head of that give a hedge rate that is better than and by late October the ­Australian dollar As of October, these mark-to-market the more liquid markets, making ­hedging market, as they were adding a large FX ­structuring at BNP Paribas in London. the market rate at a given time, but that was down to 65 US cents. losses stood at around HK$14.7bn costs much more expensive, while in

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The decline of the Australian dollar filters in place, so that the most volatile ­currencies would be excluded from the “ At the moment, the main focus is simply on basket upon monthly rebalancing. But 1.00 getting through the current crisis, trying to arrangers warned investors that such AUDUSD = X indices could be hurt during sudden unwind positions and coming up with safer 0.95 carry unwinds, and that is exactly what strategies for 2009.” happened this October. At this point, such high-frequency 0.90 complex structured product trades have become very difficult for the­arranging banks to risk manage. A few carry 0.85 index trades, usually with 100 per cent

D ­principal protection plus a payoff, were

0.80 still being structured until recently.

AUD/US But this kind of business has now dried up and a few “leftover carry 0.75 trades” are attempting to unwind, usually with substantial losses being incurred. That will make it harder for 0.70 corporates in these countries to hedge their currency exposure efficiently, at a time when central and eastern European 0.65 countries have become more entwined Confidentiality and counterparty risk balance being adjusted (and interim than ever with foreign markets. Of course, for some big hedge funds, ­exchanges of currency amounts

0.60 “Clearly there was a fashion in asset executing a very large FX trade in one ­occurring) by reference to the actual Jan08 Mar08 May08 Jul08Sep08 classes, and commodities and FX were of the smaller currencies risks letting ­redemption of the notes that have in vogue in the first half of 2008. But ­competitors see the strategy that it is ex- a fixed amortisation schedule, thereby Sources: http://finance.yahoo.com now equities can offer interesting value ecuting. Investment banks ­offer ­products avoiding potential losses arising from again, provided things calm down a bit,” that spread these very large trades over over or under hedging. comments a London-based structured a week or more. The ­investment may In this way, Gazprombank allowed products arranger. even agree to assume some of the risk of Lehman Bothers Special Financing, as the more volatile currencies even the currency volatility. In December 2006, The IncomeEM index tracks the FX volume will likely take some time adverse movements during the period in swap counterparty, to assume underlying spot market has pretty much JPMorgan launched its benchmark VXY ­interest rates of the 20 emerging to recover in the structured products which the trade is taking place. ­prepayment risk on the underlying ceased to exist. Iceland was the best indices of implied currency ­volatilities, ­markets currencies, as well as their space. It is probably the case that hedge Meanwhile, counterparty risk has ­assets. Transaction trustees and example of this in October, but even which were showing very low ­volatility ­volatility against the dollar implied by funds or big institutional investors that become a major issue in the market lawyers around the world are currently pricing on the Russian rouble was hard for both G7 implied volatility and forward rates. Based on this ­information, do want to play the FX market will only ­following the September default working out all the implications of to get a quote for on some trading days. ­emerging markets currencies. the index rebalances every month to do so in the biggest and most liquid of ­Lehman Brothers and government Lehman going under, and new Against this background, a high invest in the five currencies offering the ­currency pairs. ­rescues of some European banks. currency swaps are ­being put in place. Carry trade ­volume of structured products were highest carry to risk ration, or the ­highest In its FX Flow Monitor in mid-October, Lehman featured in many currency and Counterparty risk issues are This illiquidity has impacted various being sold to institutional investors and interest rate spreads and the lowest UBS analysts noted that the yen was interest rate swaps which were part likely to see business spread around regional carry trade strategies. The some high net worth private investors, implied volatility. ­attracting decent inflows as the carry of deals ranging from structured more by corporates and institutional yen carry trade, taking advantage of increasing liquidity in markets for some Also in 2007, multi-currency carry trade sell-off continued. At the same ­products to project finance loans investors. But at the moment, the main low Japanese interest rates to ­borrow exotic currencies. For example, the trade products were launched by time, the US dollar was strengthening. and ­securitisations, as well as focus is simply on getting through and then invest in other currencies and ­Intelligent Carry Index was launched ­Dresdner Kleinwort, including one “With global policymakers and lawmak- direct hedging deals with corporates the current crisis, trying to unwind assets, gained popular media ­attention by Barclays in early 2007. It exploits based on movements between the G5 ers struggling to restore order to the around the world. positions and coming up with safer over the past few years. But it was carry trade opportunities within the G10 ­currencies (euro, Swiss franc, sterling, global financial system, we expect the For example, in summer 2007 strategies for 2009 – which promises to ­widely copied around the world, with ­currencies, and rebalances monthly. This dollar and yen). Many other structured G3 bloc to stay in demand,” UBS noted. Gazprombank issued a ­cross-border be a difficult year for many. With hedge funds and other ­institutional was followed by an emerging markets product arrangers were finding strong The major currencies enjoy the mortgage securitisation which ­featured ­operating losses looming for many investors looking for carry trade product, IncomeEM, which looks to demand for similar products. advantage of highly liquid derivatives an embedded FX derivative. ­Lehman corporates, and equity ­portfolios ­opportunities in a whole range of other benefit from carry trade opportunities in Quite large currency universes instruments with tight bid/offer spreads, Brothers Special ­Financing ­provided a in disarray for institutional investors, currencies. 20 emerging market currencies in Asia, were used, for example 20 pairs, with allowing investors to make bets in the rouble/euro ­fixed-for-floating­balance making the wrong call on currency The current situation is a contrast Europe, the Middle East and both long and short positions being knowledge that they can quickly unwind guaranteed swap. Its special movements could prove to be the straw to 2007 when a major driver was low Latin America. taken. Typically there were volatility trades if the market goes against them. ­characteristics included its notional that broke the camel’s back.

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Fragmentation of liquidity across European trading ­venues could make transaction cost analysis even more complicated than it is at present. But Robert Kay, md of GSCS Information Services, argues that this should not be the case

Dealing with fragmentation

raditional transaction cost About TCA analysis (TCA – see box) has a lot to answer for. First, the Trading is the implementation of to the total cost of ­implementation are T name has helped consign ­investment ideas. The costs of not ­independent of each other, making many buy-side traders into the realm ­implementation for institutional ­asset analysis complex. of ‘cost centres’ rather than legitimate managers can be significant,­often Transaction cost analysis (TCA) contributors to alpha generation. dwarfing commission costs, for supports asset managers by measuring The description as ‘analysis’ has ­example. Costs fall into three main each of these different costs in respect also encouraged non-specialist ­categories. The first is the spread of their own transactions and also ­senior ­managers to believe that the between the price at which the anonymously comparing their results ­review of data can lead to ‘actionable’ security can be bought (offer price) with those of other managers ­conclusions with measurable positive and the price at which it can be sold ­completing similar orders. This analysis benefits. To meet this objective, vendors (bid price) at the same point in time. allows identification of patterns, whether and broker-dealers – assisted by falling Second is the impact on the under­ by market, security, broker, trader or costs of data processing – have come lying price brought about by trading; portfolio manager where trading costs up with ever more sophisticated ways to pushing the price up on buying and are higher or lower than might be measure outcomes, while failing down on ­selling. Finally there is the expected. Interpreted appropriately, to differentiate effectively good from cost that arises from movements in these patterns can evidence a need bad or merely from the much more price that occur between the time to change behaviour in such a way common ‘indifferent’. of the ­investment decision and the that future overall transaction costs are final completion of the trade. The reduced and portfolio returns Something new ­contributions of each of these factors thereby increased. Into this mix is now added the ­growing Source: Getty Images Getty Source: fragmentation of liquidity in many

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Table 1 the basic components that are applied the benchmark requires little skill. the ­sell-side counterparty through do vary widely across different dealer ­within TCA, how these have responded Chart 1 illustrates this problem by ­superior judgment, trading skill or lower models and the standard deviations can Trading Period in the past and where the drivers of showing the breakdown of cost of ­commission cost. also be significant. Aug 25-29 Sept 22-26 evolution have come from. In this delay results based on the underlying Irrespective of the handicap used, Security % Fragmentation % Fragmentation ­connection it is important to recognise ­momentum of the trade in question. The The ‘handicap’ system TCA performance using ­implementation BP 25.67 24.43 that there are two significantly results come from the GSCS universe of To deal with this problem, brokers and shortfall ­methodology is ­usually Royal Dutch Shell 19.58 28.76 different approaches towards TCA, data, covering millions of transactions vendors have tried to establish what ­measured after ­adjusting for the HSBC 16.44 13.61 both of which have firm adherents and involving more than 100 managers and is in effect a ‘handicapping’ system. ­handicap. Therefore, the ­calculation Total 17.85 13.91 strong opponents. 200 brokers. There are two main ways in which this of the handicap arguably becomes BNP Paribas 19.12 11.58 Interestingly, these two approaches As the chart shows, when execut- ­‘handicap’ is established. One is to the most important factor in ­assessing AXA 18.74 11.17 parallel different approaches to ing trades with the most ­favourable look in a fairly generic way at the type of ­performance. In fact, it turns a Allianz 11.46 11.19 ­measurement of investment ­momentum, the average trade is trade (size, liquidity and market situation) ­theoretical ‘absolute’ ­performance Deutsche 19.54 12.39 ­performance. They may usefully be ­executed at a price that is more than to see what similar types of ­transactions back into a ‘relative’ performance Siemens 13.66 10.59 alluded to as ‘relative’ and ‘absolute’. 20bp better than the price ­prevailing have cost in the past. The second is ­assessment. Credit Suisse 7.60 4.18 when the trade was released. ­Equally, to use the pre-trade cost estimates UBS 6.41 4.23 Implementation does not always cost where the momentum is most ­available from brokers. These may be Fragmentation – handicap or excuse Nestlé 6.67 8.01 Using implementation shortfall as a ­unfavourable (i.e. the manager is static or dynamic, depending on the The further problem that arises from ING Groep 18.79 14.30 benchmark against which to assess ­‘chasing’ the market) the likely cost sophistication of software and hardware. liquidity fragmentation is that it will Fortis 15.55 11.41 execution performance is the TCA will be 80bp or more. Clearly the scale Pre-trade estimation tools are often make it even harder to measure two key Unilever 20.10 19.65 equivalent to the ‘absolute return’ of this factor dominates any ­modest used by proprietary trading desks of the ­elements. First, in assessing the price Source: GSCS Information Services ­approach of alternative asset managers. improvement in performance that can large securities dealers and therefore at a point in time, it will be possible to This methodology compares the price at be achieved by a buy-side trader or enjoy some credibility. However, they include or exclude some or all execution European markets. Following the early The second less consequential which the trade was completed against venues. This will make a small ­difference success of Chi-X, recent months have ­impact is how the performance, whether the price at a specific point in time in the to the actual result but will lead to seen the launch of Turquoise and Nas- of broker counterparties, buy-side execution process (most usually when Table 2 extensive discussion and debate about daqOMX, as well as the launch of many firms or traders themselves, should be the trade is ‘released’ by the portfolio Bid/Ask whether the ‘correct’ figure has been new multilateral trading facilities (MTFs) – ­measured. The real risk in terms of TCA manager to the buy-side trader, or when used to calculate the benchmark. Security Primary Chi-X Turquoise including some to be created by existing is that the real changes lead individuals, the trader in turn ‘releases’ the order to Table 2 illustrates some of the BP 397.250/397.625 397.750/398.550 397.000/397.500 stock exchanges in direct competition the companies that employ them the counterparty broker or market). ­differences in quotes seen at the same with each other and their ‘upstart’ rivals. and consultants to alter the latter Buy-side traders and the brokers that HSBC 854.500/854.75 854.750/855.000 854.500/855.500 time on different venues (exchanges, Table 1 highlights the liquidity fragmen- ­process of performance measurement work on their behalf seek to minimise AXA 18.455/18.420 18.465/18.485 18.440/18.505 MTFs etc). Further proliferation of tation already visible in a number of in ways that are not simply expensive this implementation shortfall, thereby Source: GSCS Information Services ­venues has the potential to make this major listed equities. but actually wrongheaded. allowing the portfolio to reap as much of more complex as time goes on. With more MTFs due to launch in the Precedents in this regard are, the theoretical ‘frictionless’ return Chart 1 The second, much more important near future, and the potential for ­existing ­however, not very encouraging. A look as possible. Minimising implementation ­effect will be on the calculation of the exchanges to launch MTFs of their at the evolution of TCA over its shortfall involves optimal balancing 100 appropriate ‘handicap’ that should own, the ­fragmentation is ­expected to ­two-decade lifespan shows a repeated of the cost of delay with market be applied. Existing generic handicap increase. Some market commentators history of complexity being added, impact cost. 80 ­systems suffer from the ­heterogeneous suggest that in due course consolida- often at the expense of real insight. The problem with this approach is nature of the transactions that are tion will ­occur, but this is by no means Just because the technology exists that success in beating the benchmark 60 ­included in the different averages. certain. The cost of ­entry into the MTF to count more things in more precise is heavily influenced by the nature of the The question for the future will be ­business will ­continue to decline and the ways, it does not mean that such a portfolio for which the trades are being 40 whether the execution venue on which ­prospective returns are likely to attract process is either worthwhile or valuable. executed. If the portfolio is ‘momentum’ trades were completed should also be 20 additional new entrants. The key element that all parties need to driven, then by definition it is going to be a factor in the creation of the relevant

Fragmentation of liquidity has two understand is the extent of the impact buying securities whose value is on an Cost of Delay (b.p.) ‘handicap’ groups. It is already clear 0 effects on TCA – one real and important, of the real changes to trading and how upward trend. that some venues attract a particular Q1 Q2 Q3 and one of much less consequence. ­measurement of performance should Given the likely high cost of delay, this type of client and business and hence -20 The real effect is that fragmented liquid- evolve in this new environment. makes it virtually impossible to ‘beat’ trade. Is the performance of these ity alters the way in which trades get the benchmark. Similarly, if the portfolio trades ­genuinely comparable with those -40 executed. This is not simply a question How did we get here? is value driven, it will be common to find Time Period ­completed on other venues?

of use of one venue versus another; in Any review of how TCA might evolve it executing trades that provide liquidity "Most Favourable" Momentum "Neutral" Momentum "Least Favourable" Momentum Similarly, pre-trade cost estimates many cases trades may be completed or recommendations concerning how to the market (selling stocks into a rising are likely to vary even more in the future using more than one execution venue. it should evolve need to understand market) – and in these cases ‘beating’ Source: GSCS Information Services as different dealers take more or less

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Chart 2: Trades in UK Securities volume weighted average price (VWAP) Interestingly, the much-derided Daily Chart 4: VWAP Algorithm Trades benchmarks. Usually these include VWAP measure produces similar mean 25 ­Interval VWAP and Available VWAP. performance results but shows 35 In some cases, where only ­limited an even higher standard deviation 30 20 time-stamp data is available, the Daily in ­performance. VWAP may be used as a ­benchmark. Chart 4 shows the results of VWAP 25 This methodology is similar to ­traditional ­algorithms against the same bench- 15 asset managers assessing their marks. This data is taken from a 20

­investment performance against the study conducted by GSCS on behalf 15 10 return achieved by a single market, of ­TradingScreen, a major vendor of 10 % of total value traded regional or global index. ­multi-asset class execution manage- % of total value traded 5 The problem with this approach ment systems to hedge funds and other 5 ­parallels that of the relative approach asset managers around the world.

0 in fund management; it is possible to This also shows mean perform- 0 -99 -89 -79 -69 -59 -49 -39 -29 -19 - 9 0 10 20 30 40 50 60 70 80 90 ­perform well against the ­benchmark ance comparable with the measures of -99 -89 -79 -69 -59 -49 -39 -29 -19 - 9 0 10 20 30 40 50 60 70 80 90 to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to to -90 -80 -70 -60 -50 -40 -30 -20 -10 0 9 19 29 39 49 59 69 79 89 99 while watching the price move ‘human trading’ in the GSCS ­universe, -90 -80 -70 -60 -50 -40 -30 -20 -10 0 9 19 29 39 49 59 69 79 89 99 b.p. range of performance ­dramatically against the interests of but with less standard deviation. Such b.p. range of performance

Int VWAP Av VWAP the portfolio. So delay in execution of comparisons will no doubt lead to a Int VWAP Av VWAP a momentum-driven order would yield desire for further refinement in measures Source: GSCS Information Services a poor execution price but be seen as to allow more ‘excuses’ for ­apparently Source: GSCS Information Services providing adequate or in some cases indifferent or relatively poor human Chart 3: Trades in French Securities good performance against the relevant ­performance. Fragmentation Table 3 VWAP measures. To many traders and will once again be a useful tool in 20 Exchange Better Average b.p. Alternate Better Average b.p. portfolio managers these problems have further ­complicating an already Security for Purchases Improvement for Purchases Improvement No difference 18 rendered ‘relative’ measures unattractive ­obfuscated picture. BP 69.57% 5.81 30.43% 15.83 4.35% 16 as part of an execution process. HSBC 38.10% 4.43 42.86% 11.98 19.04% 14 What really counts? Royal Dutch Shell 41.67% 5.01 49.82% 9.17 8.51% Unloved but still widely used Table 3 shows some results of VWAP 12 Source: GSCS Information Services Nonetheless, VWAP algorithms remain calculations for different securities on 10 easily the most popular with traders a number of execution venues, most 8 and other ‘in-line’ execution ­strategies notably Chi-X and Turquoise and the of the benchmark than the actual brokers using TCA and the ­precise 6 % of total value traded ­continue to be pursued by many buy- stock exchanges on which the primary ­contribution to the results achieved performance benchmarks that are 4 side traders. This in part reflects a desire listing exists. In this case the differences by the traders and ­counterparties. used, there are two clear conclusions

2 to get many relatively small trades are again meaningful in terms of the The more legitimate alternative to be drawn in terms of the impact of ­completed at a ‘reasonable’ price. performance yardsticks that have ­measures that are available, the harder ­fragmentation. First is that fragmentation 0 -99 -89 -79 -69 -59 -49 -39 -29 -19 - 9 0 10 20 30 40 50 60 70 80 90 In addition, while not followed as been established. it is to ascertain what component could make much more complex the to to to to to to to to to to to to to to to to to to to to -90 -80 -70 -60 -50 -40 -30 -20 -10 0 9 19 29 39 49 59 69 79 89 99 an execution strategy, many trad- Fragmentation means that clients of the ­supposed outperformance or traditional processes that are used by all b.p. range of performance ers, ­portfolio managers, compliance may want to limit the VWAP calculation ­underperformance is down to the parties to ‘adjust’ performance to take

Int VWAP Av VWAP ­officers and clients like to confirm that to those exchanges in which they are ­measurement criteria and what is account of transaction characteristics of their trades were done ‘as well as able to participate, or alternatively to down to the skills and expertise of the the executions being evaluated. Second Source: GSCS Information Services the ­market’. This means that VWAP some other subset of the total level of ­individuals and institutions that are is that this complexity is likely to mean ­measures, often in conjunction with activity. This ‘custom’ comparison may being evaluated. more time is spent debating the merits implementation shortfall, remain a factor reflect a desire to choose a benchmark Given that much TCA is made of the process than trying to determine account of venues to which they are means for determining whether traders in the TCA process. that it is easiest to beat or may have ­available by broker-dealers in support actions that could be taken to actually connected and weight more prominently or counterparties have performed well. Charts 2 and 3 highlight ­performance more honourable and justifiable motives. of their desire to demonstrate superior improve performance. results from the venues they use most. The number of ‘excuses’ for apparently within the GSCS universe of trades with It is interesting to note that some MTFs ­execution, this additional complex- These two conclusions, taken This will make it more difficult for clients ‘poor’ performance will grow in line with different markets measured against are already finding ways to explain that ity runs the risk of making the analysis ­together, risk further undermining the to determine the most appropriate the growth in complexity in the process. ­Interval and Available VWAP. These their venue offers ‘superior’ execution – whatever its true motives – appear viability and credibility of TCA as a ­pre-trade cost estimates. Actionable analysis will become even show trades ‘normally distributed’ to that achieved elsewhere, with limited to be simply a self-serving sales and ­business. In an environment where Generating consistency in an harder to achieve. around the mean performance, which is detail on what the terminology means or ­marketing tool. ­buy-side firms are under pressure to ­overall approach given this additional similar in each case. the methodology used in the analysis. reduce expenses, this is dangerous. ­complexity will be virtually impossible. Is everything relative? However, the standard deviation of Once again, however, ­fragmentation Where now? The question that users and vendors Without consistency, however, TCA The equivalent ‘relative’ approach the performance against the ­Available will mean that performance results can Irrespective of the underlying alike should address in the near term becomes less and less useful as a in terms of TCA is the use of various VWAP measure is slightly higher. be influenced more by the­selection ­methodology employed by traders and is whether this additional complexity is

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US where fragmentation is greater than in Europe – the location where the “ Given this rationale for participating in ­largest volume of business is ­conducted. new venues, the right way to ­benchmark The closure of the LSE for almost an entire day on September 8 highlighted ­performance must be to compare the the fact that without the ‘price discovery’ ­execution result achieved using a mechanism of the primary exchange, few market participants were willing to Spreading ­benchmark based on the prices of trades put liquidity into alternative venues.

done on the indigenous primary exchange.” Making improvements, not making excuses To the extent that performance ­appears better or worse using alternative ­venues compared with using incumbent ­exchanges, then further more detailed the word analysis will definitely be required. This approach combines a surveillance role across all trades (“are we performing to a generally acceptable standard?”), with a more detailed multi-venue analysis of either necessary or desirable and, they deliver superior execution and/or transactions that appear exceptionally if not, what should be the response of lower costs. good or bad. As word of mouth spreads about exchange traded the ­industry to the challenge of The analysis will help ascertain ­fragmentation. The right answer ­whether the performance ­differential is funds (ETFs), increasingly more investors are asking Fortunately, an elegant solution Given this rationale for participating in the result of the characteristics of the about their uses and benefits.Axel Lomholt, head of is available. However, as long as new venues, the right way to ­benchmark transactions themselves, the skills of ­everyone has a potential self-interest performance must be to compare the traders and technology they use, or ETF products at iShares, takes an in-depth look at in a ­customised approach, the elegant the execution result achieved using a the underlying market ­microstructure, the instruments ­solution will be ignored. benchmark or benchmarks calculated including costs. Such analysis has The question that needs to be based on the prices of trades done on the potential to identify and ­quantify ­considered is why has fragmentation the indigenous primary exchange. If new the benefits accruing to clients from xchange traded funds (ETFs) exposure, regional indices and sectors. occurred and what is its purpose? The MTFs offer lower-cost execution, then ­fragmentation in ways that allow combine the advantages of The primary asset classes in which ETFs European regulators who created the the performance of those that use them ­replication across more transactions both index funds and stocks. are available include: framework (under MiFID) for competition will show up favourably against these and hence a progressive ­improvement They are liquid, easy to use E - Large cap stocks intended that national stock exchanges ‘traditional’ benchmarks. in performance. This ­combination and can be traded in any quantity just - Mid cap stocks should no longer enjoy a monopoly in Such an approach has three ­obvious of ­surveillance and ­continuous like stocks. At the same time, an ETF - Small cap stocks trading, so that costs would be reduced advantages over any other. First, it is ­enhancement of execution quality is ­provides the diversification, market - Growth stocks and performance improved. Similarly, cheaper as it does not involve any exactly what TCA should be seeking to ­coverage and low expenses of an - Value stocks those institutions that have launched ­material change to existing processes offer its clients. index fund. - Sector stocks and/or supported the new venues have and procedures. Second, it will show to If, over time, another venue assumes These characteristics combine to - International stocks done so in the expectation of their all parties the extent to which they the mantle of majority of traded ­volume create an investment tool that provides - Emerging markets stocks winning business by offering a superior have improved their trading by using and locus of price discovery, then the investors with the broad exposure they - Long-term bonds product, possibly at lower prices than alternative venues. ‘base’ benchmarks should reflect­ require, at the level they want and at the - Mid-term bonds incumbent exchanges. To the extent that many fund activity there. However, that ­eventuality moment they need it. As such, they are - Short-term bonds Finally, those institutions that are ­managers or brokers are satisfied that is ­probably well into the future. For the fast gaining a reputation as an ­innovative - Reits and listed property. using the alternative venues are their execution performance is benefit of the TCA business as a whole, investment solution – a claim greatly ­presumably doing so because they are ­enhanced, whatever methodology they everyone should recognise the value ­supported by the accelerated growth better, cheaper or both. In all cases, choose to measure it by, they will of using benchmarks of performance in ETFs. ETF growth however, there is nothing that requires ­determine the long-term success or based on a single exchange/venue In recent years, we have seen a According to the Barclays Global participation in new venues unless they failure of the new MTFs. Finally, it reflects rather than trying to customise a dramatic expansion in the number of ­Investors ETF landscape Q3, 2008 are superior. Participation is ­voluntary the reality of the fact that ‘price discov- solution that may make them ‘look indices, styles and asset classes covered ­report, significant activity continues to and therefore the only reason to ery’ still takes place on the ­primary better’ but ultimately will jeopardise by ETFs, with a particular emphasis on take place. Globally, there were 1,499 ­participate in the new MTFs is because exchange, which remains – even in the the business. country-related products, single-country ETFs, managed by 86 managers on

the markit magazine – Winter 2008 Winter 2008 – the markit magazine /38 Focus Focus /39

US where fragmentation is greater than in Europe – the location where the “ Given this rationale for participating in ­largest volume of business is ­conducted. new venues, the right way to ­benchmark The closure of the LSE for almost an entire day on September 8 highlighted ­performance must be to compare the the fact that without the ‘price discovery’ ­execution result achieved using a mechanism of the primary exchange, few market participants were willing to Spreading ­benchmark based on the prices of trades put liquidity into alternative venues.

done on the indigenous primary exchange.” Making improvements, not making excuses To the extent that performance ­appears better or worse using alternative ­venues compared with using incumbent ­exchanges, then further more detailed the word analysis will definitely be required. This approach combines a surveillance role across all trades (“are we performing to a generally acceptable standard?”), with a more detailed multi-venue analysis of either necessary or desirable and, they deliver superior execution and/or transactions that appear exceptionally if not, what should be the response of lower costs. good or bad. As word of mouth spreads about exchange traded the ­industry to the challenge of The analysis will help ascertain ­fragmentation. The right answer ­whether the performance ­differential is funds (ETFs), increasingly more investors are asking Fortunately, an elegant solution Given this rationale for participating in the result of the characteristics of the about their uses and benefits.Axel Lomholt, head of is available. However, as long as new venues, the right way to ­benchmark transactions themselves, the skills of ­everyone has a potential self-interest performance must be to compare the traders and technology they use, or ETF products at iShares, takes an in-depth look at in a ­customised approach, the elegant the execution result achieved using a the underlying market ­microstructure, the instruments ­solution will be ignored. benchmark or benchmarks calculated including costs. Such analysis has The question that needs to be based on the prices of trades done on the potential to identify and ­quantify ­considered is why has fragmentation the indigenous primary exchange. If new the benefits accruing to clients from xchange traded funds (ETFs) exposure, regional indices and sectors. occurred and what is its purpose? The MTFs offer lower-cost execution, then ­fragmentation in ways that allow combine the advantages of The primary asset classes in which ETFs European regulators who created the the performance of those that use them ­replication across more transactions both index funds and stocks. are available include: framework (under MiFID) for competition will show up favourably against these and hence a progressive ­improvement They are liquid, easy to use E - Large cap stocks intended that national stock exchanges ‘traditional’ benchmarks. in performance. This ­combination and can be traded in any quantity just - Mid cap stocks should no longer enjoy a monopoly in Such an approach has three ­obvious of ­surveillance and ­continuous like stocks. At the same time, an ETF - Small cap stocks trading, so that costs would be reduced advantages over any other. First, it is ­enhancement of execution quality is ­provides the diversification, market - Growth stocks and performance improved. Similarly, cheaper as it does not involve any exactly what TCA should be seeking to ­coverage and low expenses of an - Value stocks those institutions that have launched ­material change to existing processes offer its clients. index fund. - Sector stocks and/or supported the new venues have and procedures. Second, it will show to If, over time, another venue assumes These characteristics combine to - International stocks done so in the expectation of their all parties the extent to which they the mantle of majority of traded ­volume create an investment tool that provides - Emerging markets stocks winning business by offering a superior have improved their trading by using and locus of price discovery, then the investors with the broad exposure they - Long-term bonds product, possibly at lower prices than alternative venues. ‘base’ benchmarks should reflect­ require, at the level they want and at the - Mid-term bonds incumbent exchanges. To the extent that many fund activity there. However, that ­eventuality moment they need it. As such, they are - Short-term bonds Finally, those institutions that are ­managers or brokers are satisfied that is ­probably well into the future. For the fast gaining a reputation as an ­innovative - Reits and listed property. using the alternative venues are their execution performance is benefit of the TCA business as a whole, investment solution – a claim greatly ­presumably doing so because they are ­enhanced, whatever methodology they everyone should recognise the value ­supported by the accelerated growth better, cheaper or both. In all cases, choose to measure it by, they will of using benchmarks of performance in ETFs. ETF growth however, there is nothing that requires ­determine the long-term success or based on a single exchange/venue In recent years, we have seen a According to the Barclays Global participation in new venues unless they failure of the new MTFs. Finally, it reflects rather than trying to customise a dramatic expansion in the number of ­Investors ETF landscape Q3, 2008 are superior. Participation is ­voluntary the reality of the fact that ‘price discov- solution that may make them ‘look indices, styles and asset classes covered ­report, significant activity continues to and therefore the only reason to ery’ still takes place on the ­primary better’ but ultimately will jeopardise by ETFs, with a particular emphasis on take place. Globally, there were 1,499 ­participate in the new MTFs is because exchange, which remains – even in the the business. country-related products, single-country ETFs, managed by 86 managers on

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consider the likely impact of these extra “ The rapid growth of the ETF market has revenue sources. made it more important than ever to 3. Look inside liquidity ­understand how to differentiate between The liquidity of an ETF is another key products that, at first glance, appear consideration. The more liquid an ETF, the easier and more cost-effective it will very similar.” be to trade. Conversely, poor liquidity can translate into difficulties in entering and exiting positions, alongside higher trading costs. ETFs offer two levels of liquidity – traditional liquidity on-exchange or OTC (both referred to as the ETF secondary market) and the liquidity provided on the primary market by the ­­creation/re- demption mechanism. This creation/ redemption mechanism allows author- ised participants (APs) to exchange 43 exchanges and with assets of portfolio performance? Indices indicate ­baskets of securities or cash for ETF $764.1bn. In addition, there were 268 the health of a market on a daily basis. shares (and back again) without mean- equity trading permits (ETPs), with 521 Indices also form the benchmark for ingful impact to the underlying market. listings and assets of $58.3bn managed an ETF’s performance. It is therefore This ability to create or redeem shares by 26 managers on 14 exchanges. essential to understand the character- at any time maintains an ETF’s price in BGI forecasts the ETF industry to istics of an ETF’s underlying index and line with its underlying net asset value, grow in Europe to $200bn and globally whether this index is the most appropri- and ensures that liquidity is derived to $1,000bn in 2009, reaching $2,000bn ate for a client’s investment objectives. largely by the underlying securities within in 2011. The numbers of ETFs increased In many cases, there is no right or wrong the ETF. While most investors trade on in the third quarter of this year, and in index to use. the secondary market, both secondary the year to date, 356 ETFs have been and primary markets need to work well launched. There are plans to launch a 2. Consider total costs to ensure an efficient market with tight further 601 ETFs: 55 in Europe, 486 in The total expense ratio (TER) is only one spreads, translating into lower costs. the US and 60 in the rest of the world. cost factor to consider when owning There are two questions to ask when The rapid growth of the ETF market or managing ETF portfolios. Costs deciding the best way to trade an ETF: has made it more important than ever to are a key consideration when selecting understand how to differentiate between an ETF. - what is the spread? products that, at first glance, appear very Understandably, the TER – the The spread on the ETF is the difference similar. Choosing the wrong ETF can total paid to cover the costs of fund between the bid and the ask; it is the negate the advantages of the product; ­management, trustees, licensing and cost to the investor, imposed by the namely, the ability to access an asset operational costs – is an integral part of market-maker, of buying or selling the class cost-effectively and transparently. the decision-making process. However, ETF. The spread should be as tight as It is important that investors understand an ETF’s TER forms just one element of possible around the mid price to make the differences between individual ETFs its total costs. the purchase/sale competitive. to ensure that the right ETF is selected Investors should also consider the for client portfolios. ­impact of additional implicit costs, - what is the depth of the market? iShares believes that there are five such as trading costs and portfolio The depth refers to the size of order criteria to take into account when ­rebalancing. On the other hand, ETF an investor can execute. If the order ­evaluating an ETF. portfolio managers can also take a book indicates an investor can buy/sell number of actions that provide additional 10,000 units, then up to that amount of 1. Know what the ETF owns revenue which can be used to offset units can be bought without a need to What securities does the chosen ETF these costs. Any proper evaluation of consider any other method of execution. Source: Getty Images Getty Source: index contain and how will this impact the different ETF options should also Larger transactions (typically the higher

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of 20 per cent average daily volume or • Exposure to market risk of the asset (which can be different from the • More flexibility to issue products, i.e. five times the average order book) may class/index. ­underlying index securities) and an on single commodities and currencies “ The question ­portfolio managers should require one to trade OTC directly with a index swap. The swap counterparty • Possible access to structured ask therefore is not: ‘What is the best ETF?’ market-maker. Specific to in-specie ETFs are risk is limited to a maximum of 10 per product-type solutions. • Fund holds underlying securities in a cent of the value of the fund under Rather, the question is: ‘What is the right 4. Assess the structure ringfenced separate account expos- Ucits rules. The investor has recourse Table 1 highlights the differences ETF for this client’s portfolio?’” There are different types of ETFs, which ing the investor to no counterparty to the basket of securities in the case of ETFs and ETNs with an emphasis on carry their own unique exposure, risk risk of the issuer. In the case of failure of failure of the fund issuer counterparty risk. and tax implications, so ­portfolio of the fund issuer, the investor has • Structure allows compliance with ­managers need to research these areas recourse directly to the pool of under- Ucits rules on more indices than 5. Evaluate the provider before selecting the most suitable lying shares or bonds cash-based ETFs (i.e. commodity Experience matters. Size, scale, product for client portfolios. There are • High transparency with regards to the ETFs) ­expertise and commitment can vary three major types of exchange traded holdings of the fund • Tax advantages sometimes possible significantly between ETF providers and products: in specie-based ETFs (or • Opportunity for additional income (i.e. avoidance of stamp duty) these differences can impact on costs. cash-based), swap-based ETFs and to further reduce costs (i.e. through • While multiple market-makers can Portfolio managers should evaluate a ETCs (exchange traded commodities), ­securities lending inside the ETF) is price swap-based ETFs on and provider’s: also known as ETNs (­exchange better than for other ETPs, as in- off ­exchange, every creation and ETF providers should have extensive ­traded notes). specie ETFs hold index securities ­redemption with the fund • Scale of operations to minimise costs experience of managing index invest- ETF, not just cost. Evaluating ETFs often The following describes • Multiple market-makers can create company generally involves a single and manage market impact ments, proven portfolio management skills involves trade-offs. As an example, a exchange traded funds and exchange and redeem new shares with the swap counterparty. • Track record in index portfolio and dedicated research teams. However, client may prefer to invest in an ETF that traded notes. fund company, promoting a highly ­management, minimising tracking just as important should be the ETF pro- is very liquid, with a low trading spread, There are two main types of ETFs, ­competitive pricing, both on and off Specific to ETNs, ETCs ­error and trading costs vider’s commitment to educating primary even if it has a history of tracking error, namely in-specie and swap-based ETFs. exchange (“multi-dealer model”) • Investor owns a note, fully ­exposing • Dedication to providing ­servicing and secondary market investors on any because of its lower trading costs. In-specie ETFs are often also referred the investor to counterparty risk of the ­support and resources to ­investors, new developments within the sector. All clients have their own investment to as cash-based or physical ETFs, as Specific to swap-based ETFs are note issuer. This risk is ­sometimes re- intermediaries and market requirements and their own tolerance of they hold the underlying securities of • Fund holds a basket of securities duced through collateral or ­guarantees ­participants Conclusion risk versus return. The question ­portfolio the index. • Knowledge of index construction As we can see with the rapid growth of managers should ask therefore is not: Swap-based ETFs invest in a and methodology ETFs, there are a number of factors to “What is the best ETF?” Rather, “what is swap offered by brokerage firms and • Commitment to product ­development. take into account before selecting an the right ETF for this client’s portfolio?” banks to provide index exposure. The Core benefits fund holds the swap plus a basket of ­non-benchmark securities. The core benefits of exchange traded ­exchange, meaning that investors can ETNs are debt instruments and are funds are: buy and sell ETFs exactly as they Table 1 not funds, but they do share ­several would trade local shares – no additional Transparency – investors know In-specie ETF Swap-based ETF ETNs (ETCs) characteristics with ETFs, as both operational setup is required, as is ­exactly which securities are held by the (physical/cash-based) ­structures are linked to the return often the case with derivatives, and no fund at any given time. Structure Mutual Fund Mutual Fund Note of a benchmark index and trade on new accounts need to be opened. ­exchange. Special types of ETNs are Flexibility – ETFs are listed on stock Underlying Holdings Index securities Index swap plus a basket NA Liquidity – The unique primary and of non-index securities exchange traded commodities (ETCs), exchanges and can be traded at any ­secondary market mechanism which are linked to commodities or time the market is open, meaning Counterparty risk ensures that ETFs are highly liquid, ­commodities indices. Some ETNs are investors access continuous, real-time Fund/note issuer risk No No Yes and that liquidity will always be backed by physical assets, whereas prices throughout the day. mutual funds hold assets in ring- mutual funds hold assets in ring- bears full exposure to credit- available for investors looking to buy fenced segregated accounts fenced segregated accounts worthiness of note issuer ­others are backed by the issuer or Diversification – ETFs provide or sell ETFs. a guarantor. Swap counterparty risk No Yes NA ­immediate exposure to a ­diversified Cost effective – ETFs offer a cost- Limited to 10% under Ucits portfolio of securities, while also Product features common to ETFs, effective route to diversified market Other risk considerations Securities lending and dividend Securities lending and dividend NA ­providing access to a wide range of ETCs and ETNs are: ­exposure. The average total expense enhancement activity enhancement activity markets and asset classes that can • Exchange traded ratio (TER) for equity ETFs in Europe is Transparency Yes, full holdings disclosed Limited Limited help to diversify an existing portfolio. • Easy accessible investment vehicles 49bp, while the average TER for Exchange listed Yes Yes Yes for a wide range of asset classes Easy to use – ETFs are potent tools the average equity mutual fund in UCITS Fund Yes* Yes* No • Low tracking error which are traded over the stock ­Europe is 120bp (Fitzrovia 2008). • Low costs * with exemptions possible

the markit magazine – Winter 2008 Winter 2008 – the markit magazine /44 In Practice In Practice /45

Measuring risk

Marcus Schüler, md at Markit, considers how best to properties or, to be more exact, its level expectations and actual transactions of quality of credit spreads is, how credit of actual and measured credit risk, its all relevant market participants. spread information could be used in measure the risk properties of a financial product liquidity and its volatility. Credit ratings The use of a large and complementary practice, and also what actual measure traditionally focus solely on accurately set of relevant data to inform the of the credit spread should be used to reflecting credit risk, but neither the ­measures of credit risk, liquidity and avoid potential ­undesired side effects liquidity nor the volatility of the product. ­volatility of a financial product presents such as pro-­cyclicality or egulators and market trative costs, and experience elevated Removing references to ratings would material advantages. While some elevated volatility. ­participants alike are currently levels of uncertainty. The systemic ­effect hence enable market participants to additional research might be helpful in Markit collects millions of price considering whether and how could be very meaningful, with the have a fresh look at how best to ­measure forming a consensus judgment as to points on financial products from all Rto tackle the issue of “undue potential to impair the ability of investors all three of these risk parameters. whether and which market-based ­market-makers every day, ­ranging reliance” on credit ratings in their own to transact. Without a proper definition of risk measures are best suited as proxies for across markets including bonds, CDS rules. Potential rule changes aim to Prior to the removal of references to proxies though, investors will be left with these risk ­properties, the following is a and ABS to exotic derivatives across the ensure that credit rating information is credit ratings in regulatory ­requirements, not only the near-impossible task of summary of my thoughts on these topics. asset classes of interest rates, ­equities, but one input that informs a minimum market participants should explore deciding whether an instrument contains ­commodities, FX and ­structured standard of investor due diligence. ­alternative methodologies to ­evaluate “minimal” or “no greater than moderate” Measuring credit risk credit. We perform a number of ­cleaning Generally, the response from industry the risk properties of a product. While, credit risks, but also with the question of Credit markets incorporate all available ­algorithms, such as testing for stale associations as well as investors to most importantly, these alternative whether it is sufficiently liquid. To information processed by all relevant data, for flat curves or for­recycling, consultations on this issue has been ­provisions should be an ­accurate minimise the burden on investors, it is market participants at any point in time, in order to produce high-quality negative, which can probably be ­reflection of the risk parameters that thus advisable to determine whether the and provide a market clearing price for ­consensus pricing data across all asset explained by the fact that, while a clearly they are aiming to measure, they characteristics of credit risk, liquidity many names on an almost continuous classes and formats of exposure. defined benchmark is supposed to be should ­ideally also be forward-looking, and volatility are quantifiable, whether basis. Traded credit spreads hence may In credit default swaps, for ­example, removed, no credible alternatives are ­objective, observable, easy to source they can be easily measured and prove to be the most accurate measure approximately 3,400 curves are being offered in return. It is probably fair and simple to compute. Only this combi- whether there is a ready source for the not only of the current credit risk of a ­published every day, with spread history to say that assigning investors with the nation of attributes will maximise market relevant information. ­specific name but also a good predictor for many of them available from 2001. responsibility for judging whether a transparency and ­minimise the cost and The financial markets are highly of its future development. While the ­Furthermore, we capture current bid/ product is “eligible” creates a related potential for uncertainty­ of the process. sophisticated, and have evolved to ­approach of using actual credit spreads offer levels on many of these names requirement for the availability of clear provide independent indications of all to measure credit risk has been through intraday dealer quotes, and guidance on how to define and calibrate What do we actually want to measure? three required product characteristics, ­implemented by a number of market compute intraday credit spread curves alternative measures of the risk The decision as to whether a product including creditworthiness, liquidity ­participants and discussed in academic as an amalgamation of end-of-day ­properties of such eligible assets. qualifies as “eligible” for an investor and volatility. Market-based measures literature to a certain extent, I feel that ­contributions and quotes feeds. Without this clear guidance, investors should be based on an informed and are easily observable and transparent, further research might be helpful in The determination of credit risk could would likely incur significant adminis- thoughtful judgment of the product’s risk updated frequently and built on both the determining how accurate the predictive easily be based on this wealth of credit

the markit magazine – Winter 08 Winter 08 – the markit magazine /46 In Practice In Practice /47

which the measure of volatility should future liquidity for financial products credit. However, it will probably be very many others based on our cleaning “ The challenge consists in quantifying and be ­calculated. in an objective and accurate way. easy to receive quotes from a number algorithms; measuring this ­potential future liquidity ­ Often, in rules for investment firms, The ­measure should be ­observable, of market-makers and trade in size with • The freshness of the data, i.e. how reference to credit ratings is made to ­dynamically updated and forward- a tight bid/offer, close to the current recently the contributions were last for financial products in an objective and identify “high-quality money market looking, and it should be available for the ­market price, if you wanted to trade it. updated by the contributors; and instruments” with an unrated ­instrument majority of relevant products. Finally, as the recent past has shown, • The range of accepted contributions, accurate way.” not being considered to be of high Unfortunately, liquidity is not only an the actual turnover of a product can i.e. the difference between the highest quality. The usage of credit spreads as important risk property of a ­financial dry up suddenly depending on the and the lowest accepted prices. a credit risk measure would be much product, but it is also notoriously market situation, and past turnover has more accurate, and would be capable hard to measure. While some market therefore proved not to be a consistent All else being equal, a higher number of revealing that many unrated securities ­participants would propose using actual and accurate predictor of availability of of accepted contributors, a greater are actually less risky than rated ones. trading activity in the past to measure liquidity in the future. freshness of the data and a narrower In the area of the Capital ­Requirements potential liquidity in the future, the use Given the described issues, it is fair range of accepted contributions will lead ­Directive in particular it is worth ­noting of transactional volumes is exposed to a to say that – while it does have value as to a higher Data Quality Rating. that compared with the approach of number of theoretical as well as practical additional input – transactional data ­Importantly, it will also signal a higher ­using individual internal models to issues, making them rather ill-suited for alone will not suffice to measure future liquidity for this product, as more ­calculate capital requirements, a refer- the desired purpose. liquidity for the whole universe of market-­makers trade the name and will ence to market-sourced credit spreads Daily trading activity can only ever relevant products. Fortunately, there provide prices when needed, as they spread data sourced from the markets. burdening investors with the ­obligation could represent a more transparent, be observed for a very limited part of exists a more reliable and ­appropriate frequently update their prices. This However, using simply the current credit of ensuring that they are aware of ­simplified and standardised way to the universe of all tradable products, way to measure the expected future reflects the ability of an investor to spread as a measure of credit risk might any information that suggests that an achieve a similar result, while avoiding and only for a subset of these are trad- liquidity of financial products: the Data receive a number of ­tradable prices introduce an undesired level of volatility investment may not continue to present potential conflicts of interest inherent in ing volumes actually publicly available. Quality Rating, a parameter that we have quickly, and that there is little disagree- and runs the risk of occasionally being ­minimal credit risks – which not only allowing the usage of these models. Liquidity measures derived from actual been computing and publishing for ment about the current price (which exposed to technical pressures. It might requires continuous monitoring of the To summarise, using market-sourced trading volumes could hence only be many years based on the variety of daily implies that a tight ­­bid/offer spread for a hence make sense to compute rolling news services but also deciding whether credit spreads as a measure of credit computed for a small number of prod- market data contributions we receive. decent size should be expected). averages of credit spreads in a piece of news is relevant – ­investors risk and volatility would be beneficial to ucts, and could not really serve as the Markit’s Data Quality Ratings can be If all of these factors are in place, order to create credit risk measures could simply use the power of the market participants. Such a measure benchmark measure for liquidity for the used as a good proxy for the liquidity of they signal that the investor will likely be with ­higher stability. markets that perform the task of check- could support existing credit ratings, entire market. a product, given that they are derived able to liquidate a position quickly, and That said, there probably needs to ing for news and incorporating it into as input into dealers’ own models or as Even for products for which trading from the following input parameters: close to the current price. Data ­Quality be a discussion about the exact ­nature spreads anyway, on a constant basis the basis for a standardised, market- volumes are available on a more or less Ratings are dynamic and will reflect of the averages, where it might be and at no additional cost. wide measure as agreed with regulatory regular basis, additional information • The number of accepted pricing changes in the underlying variables on ­advisable to use exponentially weighted A number of market participants bodies. Needless to say, this approach would be needed to derive real liquidity contributors for the product, i.e. the a daily basis. A detailed description of averages to assign a higher importance and academics have already started would have the potential to significantly indicators. In CDS, for example, some ones that are accepted after rejecting the ­computation of Markit’s Data Quality to recent spread movements as they will ­producing and analysing market-based reduce regulatory compliance costs of the relevant questions would be: an incorporate relevant new ­fundamental measures of credit quality. A number for the affected market participants isolated trade of €1bn notional with a information for the name. Also, it might of rating agencies now even publish ­compared with alternative methodolo- one-year maturity really a sign of liquidity be worth considering whether the ­“Market-Implied Ratings”, and have gies. However, in an ideal world, the for this name in general? Should the weightings of such an average should ­already conducted studies demonstrat- measurement of the risk ­properties number of trades or the volume be used be static or whether they could change. ing that market-implied ratings have of a product should also cover its to measure liquidity? One option might be to allow regulatory proved to be accurate predictors for liquidity risk – actually an even more The fact that a product has not “ All else being equal, a higher number of bodies to review and potentially change changes of “actual” credit ratings. ­challenging task than the measurement traded in the recent past should not be the weightings or time periods of the Besides using market credit of ­creditworthiness or volatility. ­regarded as proof that it is not liquid, ­accepted contributors, a greater ­freshness ­averages being accepted in order to spreads to measure the credit risk of and the investor could not sell it quickly of the data and a narrower range of reflect special market situations or avoid an ­investment, the measurement of Measuring liquidity if he wanted to. Some products that any undesired pro-cyclicality of these volatility of investment products (another The ideal measure for the risk property might not trade today because there just ­accepted contributions will lead to a higher credit risk measures. relevant factor that should be taken into “liquidity” of a financial product should is not enough interest in them currently The approach of using market- account by investors when deciding on reflect the ability of an investor to sell the are ­potentially very liquid if you want Data Quality Rating.” sourced credit spreads would also their ­eligibility) could be based on the product in the market within a certain to trade. ­hugely simplify the ongoing task of same data set, where likewise the major time period at a level close to the current Think of a tight spread name in CDS: ­monitoring credit exposures on a timely ­challenge would not really be the data price. However, the challenge consists in it might not trade because no-one cares basis and at limited cost. Instead of input, but rather the exact way in quantifying and measuring this ­potential to buy protection on such a high-quality

the markit magazine – Winter 08 Winter 08 – the markit magazine /48 In Practice

Ratings is available on request. In addition to these three inputs, we are in the process of integrating quotes “ Certainly, a constructive dialogue with data – i.e. live bid/offer runs that we ­regulatory bodies and academics is needed receive from the market-makers – as well as transactional data, where we to explore how credit spread data could be have it, into this liquidity measurement concept. One way of doing so will be to used to conduct a study on the ­predictive give a higher liquidity rating to names qualities of credit spreads compared with that appear on a number of quotes runs every day, as it signals that this name is credit ratings, and on how a credit risk actively traded by multiple dealers. We measure based on credit spreads should are also working on ways to take the quoted bid/offer into account, with a ideally be defined and calibrated.” tighter bid/offer justifying a higher Data Quality ­Rating and expected liquidity. Based on the current data set, we publish Data Quality Ratings for more than 1,800 credit default swaps (five- year maturity point) and more than 3,300 bonds globally. In CDS, more than 10 per cent of the names achieve a triple-A ­rating for their liquidity, while in the universe of bonds – reflecting a smaller number of contributors, less frequent updates and a wider range of ­contributions – the majority of the bonds will fall into the triple-B and double-B categories, an indication of the generally lower liquidity of bonds compared with CDS. See Table 1 for details of current liquidity ratings. Table 1: Liquidity Ratings for CDS and Bonds Using a combination of market-based AAA AA A BBB BB B CCC credit risk, volatility and liquidity meas- ures will provide investors with accurate, CDS 219 817 455 192 128 40 23 dynamic and transparent measures Bonds 21 606 1918 611 488 of the major risk characteristics of a As of November 4, 2008, 5y point for CDS financial product, and will allow them to make a sound decision on its eligibility. on the predictive qualities of credit Instead of solely relying on credit ratings, spreads compared with credit ratings, implicitly assuming that a rating would and on how a credit risk measure based be highly correlated with the liquidity on credit spreads should ideally be and volatility of the product, a separate defined and calibrated. Also, an open measurement of these characteristics is discussion should occur with regula- feasible and will result in a more accu- tory bodies on how to best measure rate analysis of the overall risk of liquidity of a product based on a range an investment. of market-sourced inputs and how to Certainly, a constructive dialogue potentially further develop and refine with regulatory bodies and academics the definition of Data Quality Ratings to is needed to explore how credit spread make them most useful for everyone’s data could be used to conduct a study purpose to measure liquidity.

the markit magazine – Winter 08 /44 In Practice In Practice /45

Measuring risk

Marcus Schüler, md at Markit, considers how best to properties or, to be more exact, its level expectations and actual transactions of quality of credit spreads is, how credit of actual and measured credit risk, its all relevant market participants. spread information could be used in measure the risk properties of a financial product liquidity and its volatility. Credit ratings The use of a large and complementary practice, and also what actual measure traditionally focus solely on accurately set of relevant data to inform the of the credit spread should be used to reflecting credit risk, but neither the ­measures of credit risk, liquidity and avoid potential ­undesired side effects liquidity nor the volatility of the product. ­volatility of a financial product presents such as pro-­cyclicality or egulators and market trative costs, and experience elevated Removing references to ratings would material advantages. While some elevated volatility. ­participants alike are currently levels of uncertainty. The systemic ­effect hence enable market participants to additional research might be helpful in Markit collects millions of price considering whether and how could be very meaningful, with the have a fresh look at how best to ­measure forming a consensus judgment as to points on financial products from all Rto tackle the issue of “undue potential to impair the ability of investors all three of these risk parameters. whether and which market-based ­market-makers every day, ­ranging reliance” on credit ratings in their own to transact. Without a proper definition of risk measures are best suited as proxies for across markets including bonds, CDS rules. Potential rule changes aim to Prior to the removal of references to proxies though, investors will be left with these risk ­properties, the following is a and ABS to exotic derivatives across the ensure that credit rating information is credit ratings in regulatory ­requirements, not only the near-impossible task of summary of my thoughts on these topics. asset classes of interest rates, ­equities, but one input that informs a minimum market participants should explore deciding whether an instrument contains ­commodities, FX and ­structured standard of investor due diligence. ­alternative methodologies to ­evaluate “minimal” or “no greater than moderate” Measuring credit risk credit. We perform a number of ­cleaning Generally, the response from industry the risk properties of a product. While, credit risks, but also with the question of Credit markets incorporate all available ­algorithms, such as testing for stale associations as well as investors to most importantly, these alternative whether it is sufficiently liquid. To information processed by all relevant data, for flat curves or for­recycling, consultations on this issue has been ­provisions should be an ­accurate minimise the burden on investors, it is market participants at any point in time, in order to produce high-quality negative, which can probably be ­reflection of the risk parameters that thus advisable to determine whether the and provide a market clearing price for ­consensus pricing data across all asset explained by the fact that, while a clearly they are aiming to measure, they characteristics of credit risk, liquidity many names on an almost continuous classes and formats of exposure. defined benchmark is supposed to be should ­ideally also be forward-looking, and volatility are quantifiable, whether basis. Traded credit spreads hence may In credit default swaps, for ­example, removed, no credible alternatives are ­objective, observable, easy to source they can be easily measured and prove to be the most accurate measure approximately 3,400 curves are being offered in return. It is probably fair and simple to compute. Only this combi- whether there is a ready source for the not only of the current credit risk of a ­published every day, with spread history to say that assigning investors with the nation of attributes will maximise market relevant information. ­specific name but also a good predictor for many of them available from 2001. responsibility for judging whether a transparency and ­minimise the cost and The financial markets are highly of its future development. While the ­Furthermore, we capture current bid/ product is “eligible” creates a related potential for uncertainty­ of the process. sophisticated, and have evolved to ­approach of using actual credit spreads offer levels on many of these names requirement for the availability of clear provide independent indications of all to measure credit risk has been through intraday dealer quotes, and guidance on how to define and calibrate What do we actually want to measure? three required product characteristics, ­implemented by a number of market compute intraday credit spread curves alternative measures of the risk The decision as to whether a product including creditworthiness, liquidity ­participants and discussed in academic as an amalgamation of end-of-day ­properties of such eligible assets. qualifies as “eligible” for an investor and volatility. Market-based measures literature to a certain extent, I feel that ­contributions and quotes feeds. Without this clear guidance, investors should be based on an informed and are easily observable and transparent, further research might be helpful in The determination of credit risk could would likely incur significant adminis- thoughtful judgment of the product’s risk updated frequently and built on both the determining how accurate the predictive easily be based on this wealth of credit

the markit magazine – Winter 08 Winter 08 – the markit magazine /46 In Practice In Practice /47

which the measure of volatility should future liquidity for financial products credit. However, it will probably be very many others based on our cleaning “ The challenge consists in quantifying and be ­calculated. in an objective and accurate way. easy to receive quotes from a number algorithms; measuring this ­potential future liquidity ­ Often, in rules for investment firms, The ­measure should be ­observable, of market-makers and trade in size with • The freshness of the data, i.e. how reference to credit ratings is made to ­dynamically updated and forward- a tight bid/offer, close to the current recently the contributions were last for financial products in an objective and identify “high-quality money market looking, and it should be available for the ­market price, if you wanted to trade it. updated by the contributors; and instruments” with an unrated ­instrument majority of relevant products. Finally, as the recent past has shown, • The range of accepted contributions, accurate way.” not being considered to be of high Unfortunately, liquidity is not only an the actual turnover of a product can i.e. the difference between the highest quality. The usage of credit spreads as important risk property of a ­financial dry up suddenly depending on the and the lowest accepted prices. a credit risk measure would be much product, but it is also notoriously market situation, and past turnover has more accurate, and would be capable hard to measure. While some market therefore proved not to be a consistent All else being equal, a higher number of revealing that many unrated securities ­participants would propose using actual and accurate predictor of availability of of accepted contributors, a greater are actually less risky than rated ones. trading activity in the past to measure liquidity in the future. freshness of the data and a narrower In the area of the Capital ­Requirements potential liquidity in the future, the use Given the described issues, it is fair range of accepted contributions will lead ­Directive in particular it is worth ­noting of transactional volumes is exposed to a to say that – while it does have value as to a higher Data Quality Rating. that compared with the approach of number of theoretical as well as practical additional input – transactional data ­Importantly, it will also signal a higher ­using individual internal models to issues, making them rather ill-suited for alone will not suffice to measure future liquidity for this product, as more ­calculate capital requirements, a refer- the desired purpose. liquidity for the whole universe of market-­makers trade the name and will ence to market-sourced credit spreads Daily trading activity can only ever relevant products. Fortunately, there provide prices when needed, as they spread data sourced from the markets. burdening investors with the ­obligation could represent a more transparent, be observed for a very limited part of exists a more reliable and ­appropriate frequently update their prices. This However, using simply the current credit of ensuring that they are aware of ­simplified and standardised way to the universe of all tradable products, way to measure the expected future reflects the ability of an investor to spread as a measure of credit risk might any information that suggests that an achieve a similar result, while avoiding and only for a subset of these are trad- liquidity of financial products: the Data receive a number of ­tradable prices introduce an undesired level of volatility investment may not continue to present potential conflicts of interest inherent in ing volumes actually publicly available. Quality Rating, a parameter that we have quickly, and that there is little disagree- and runs the risk of occasionally being ­minimal credit risks – which not only allowing the usage of these models. Liquidity measures derived from actual been computing and publishing for ment about the current price (which exposed to technical pressures. It might requires continuous monitoring of the To summarise, using market-sourced trading volumes could hence only be many years based on the variety of daily implies that a tight ­­bid/offer spread for a hence make sense to compute rolling news services but also deciding whether credit spreads as a measure of credit computed for a small number of prod- market data contributions we receive. decent size should be expected). averages of credit spreads in a piece of news is relevant – ­investors risk and volatility would be beneficial to ucts, and could not really serve as the Markit’s Data Quality Ratings can be If all of these factors are in place, order to create credit risk measures could simply use the power of the market participants. Such a measure benchmark measure for liquidity for the used as a good proxy for the liquidity of they signal that the investor will likely be with ­higher stability. markets that perform the task of check- could support existing credit ratings, entire market. a product, given that they are derived able to liquidate a position quickly, and That said, there probably needs to ing for news and incorporating it into as input into dealers’ own models or as Even for products for which trading from the following input parameters: close to the current price. Data ­Quality be a discussion about the exact ­nature spreads anyway, on a constant basis the basis for a standardised, market- volumes are available on a more or less Ratings are dynamic and will reflect of the averages, where it might be and at no additional cost. wide measure as agreed with regulatory regular basis, additional information • The number of accepted pricing changes in the underlying variables on ­advisable to use exponentially weighted A number of market participants bodies. Needless to say, this approach would be needed to derive real liquidity contributors for the product, i.e. the a daily basis. A detailed description of averages to assign a higher importance and academics have already started would have the potential to significantly indicators. In CDS, for example, some ones that are accepted after rejecting the ­computation of Markit’s Data Quality to recent spread movements as they will ­producing and analysing market-based reduce regulatory compliance costs of the relevant questions would be: an incorporate relevant new ­fundamental measures of credit quality. A number for the affected market participants isolated trade of €1bn notional with a information for the name. Also, it might of rating agencies now even publish ­compared with alternative methodolo- one-year maturity really a sign of liquidity be worth considering whether the ­“Market-Implied Ratings”, and have gies. However, in an ideal world, the for this name in general? Should the weightings of such an average should ­already conducted studies demonstrat- measurement of the risk ­properties number of trades or the volume be used be static or whether they could change. ing that market-implied ratings have of a product should also cover its to measure liquidity? One option might be to allow regulatory proved to be accurate predictors for liquidity risk – actually an even more The fact that a product has not “ All else being equal, a higher number of bodies to review and potentially change changes of “actual” credit ratings. ­challenging task than the measurement traded in the recent past should not be the weightings or time periods of the Besides using market credit of ­creditworthiness or volatility. ­regarded as proof that it is not liquid, ­accepted contributors, a greater ­freshness ­averages being accepted in order to spreads to measure the credit risk of and the investor could not sell it quickly of the data and a narrower range of reflect special market situations or avoid an ­investment, the measurement of Measuring liquidity if he wanted to. Some products that any undesired pro-cyclicality of these volatility of investment products (another The ideal measure for the risk property might not trade today because there just ­accepted contributions will lead to a higher credit risk measures. relevant factor that should be taken into “liquidity” of a financial product should is not enough interest in them currently The approach of using market- account by investors when deciding on reflect the ability of an investor to sell the are ­potentially very liquid if you want Data Quality Rating.” sourced credit spreads would also their ­eligibility) could be based on the product in the market within a certain to trade. ­hugely simplify the ongoing task of same data set, where likewise the major time period at a level close to the current Think of a tight spread name in CDS: ­monitoring credit exposures on a timely ­challenge would not really be the data price. However, the challenge consists in it might not trade because no-one cares basis and at limited cost. Instead of input, but rather the exact way in quantifying and measuring this ­potential to buy protection on such a high-quality

the markit magazine – Winter 08 Winter 08 – the markit magazine /48 In Practice

Ratings is available on request. In addition to these three inputs, we are in the process of integrating quotes “ Certainly, a constructive dialogue with data – i.e. live bid/offer runs that we ­regulatory bodies and academics is needed receive from the market-makers – as well as transactional data, where we to explore how credit spread data could be have it, into this liquidity measurement concept. One way of doing so will be to used to conduct a study on the ­predictive give a higher liquidity rating to names qualities of credit spreads compared with that appear on a number of quotes runs every day, as it signals that this name is credit ratings, and on how a credit risk actively traded by multiple dealers. We measure based on credit spreads should are also working on ways to take the quoted bid/offer into account, with a ideally be defined and calibrated.” tighter bid/offer justifying a higher Data Quality ­Rating and expected liquidity. Based on the current data set, we publish Data Quality Ratings for more than 1,800 credit default swaps (five- year maturity point) and more than 3,300 bonds globally. In CDS, more than 10 per cent of the names achieve a triple-A ­rating for their liquidity, while in the universe of bonds – reflecting a smaller number of contributors, less frequent updates and a wider range of ­contributions – the majority of the bonds will fall into the triple-B and double-B categories, an indication of the generally lower liquidity of bonds compared with CDS. See Table 1 for details of current liquidity ratings. Table 1: Liquidity Ratings for CDS and Bonds Using a combination of market-based AAA AA A BBB BB B CCC credit risk, volatility and liquidity meas- ures will provide investors with accurate, CDS 219 817 455 192 128 40 23 dynamic and transparent measures Bonds 21 606 1918 611 488 of the major risk characteristics of a As of November 4, 2008, 5y point for CDS financial product, and will allow them to make a sound decision on its eligibility. on the predictive qualities of credit Instead of solely relying on credit ratings, spreads compared with credit ratings, implicitly assuming that a rating would and on how a credit risk measure based be highly correlated with the liquidity on credit spreads should ideally be and volatility of the product, a separate defined and calibrated. Also, an open measurement of these characteristics is discussion should occur with regula- feasible and will result in a more accu- tory bodies on how to best measure rate analysis of the overall risk of liquidity of a product based on a range an investment. of market-sourced inputs and how to Certainly, a constructive dialogue potentially further develop and refine with regulatory bodies and academics the definition of Data Quality Ratings to is needed to explore how credit spread make them most useful for everyone’s data could be used to conduct a study purpose to measure liquidity.

the markit magazine – Winter 08 Kit and Caboodle /49 Bare necessity

The pressure on investment firms to improve the quality, use and timeliness of data is intensifying. As data volumes grow, data management is becoming a necessity, not an option. Hardeep Dhillon explains

ata management is seen client classification, systematic as a vital and ­increasingly ­internalisers, pre- and post-trade ­indispensable exercise, ­transparency, and the ownership of D­because the ability to acquire market data. These obligations have clean reference and market data from had a significant impact on market data disparate sources affects the ability of ­provision, particularly in equity markets, office systems to monitor­investment and led to significant growth in the activity and manage risk. Data volume of information generated from ­management involves an array of issues, exchanges. Market participants are also from governance and oversight, data now required to maintain much more structures and definitions, to the storage, data long-term for ­compliance ­purposes movement and retrieval of information. and this has boosted ­reference The wide range of data types PJ Di Giammarino, chief executive, JWG-IT data ­requirements, such as revised ­encompasses reference data, such as ­documentation and ­classification data, corporate actions or instrument and and new types and sources of ­market ­client information, transaction data are not only battling against pressures data that had never before ­relating to market and deal information, to cut costs and reduce spending on been ­published. and unstructured data, which supple- ­information technology (IT) because of MiFID has also introduced greater ment analysis, such as agreements and the dismal market conditions, but they competition into the market, as evi- policy documents. In order to reduce the also face a ubiquitous deluge of denced by the early success of new volumes and improve quality, these types data ­volumes. As institutions move to trading venues such as Instinet Chi-X of data must be aligned, says ever more ­sophisticated investments and and new market data providers such as PJ Di Giammarino, chief executive of counterparty risk becomes a growing Markit BOAT. As more trading venues JWG-IT, the London-based financial concern, investment firms need more enter the scene, such as Turquoise, services think-tank. “Understanding how and more data across a wider universe of ­Equiduct, BATS, NASDAQ OMX and each of these data types is spread and content in order to research and identify SmartPool, the relentless rise of data used throughout the operating model areas of return or risk. volumes is set to continue. will be the first step to obtaining the right JWG-IT forecasts 2009 equity order information to tune a firm’s operating Markets in Financial Instruments levels in Europe to skyrocket by 1,600 infrastructure,” he says. Directive per cent to 191m orders a day. The Managing reference and market Markets in Financial Instruments number of venues has risen by 140 per data can be an expensive and complex ­Directive (MiFID) has brought about cent since 2006 and in equities alone, task – costing $30bn a year worldwide, ­far-reaching change within capital Europe is approaching two execution ­according to estimates. At present, firms ­markets concerning best ­execution, venues for every one venue in the US and

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is becoming more important in ­decision ­button to show exposure, a firm will need afford to have customer and counter- ­different types of data and ­information “ There is a danger that a lack of investment making or trading strategies and to call in forensic teams of accountants party risk information spread across all to ­discover context, meaning and could lead to technical bottlenecks that ­identification of opportunities for alpha, and actuaries to unwind a paper trail of the different disciplines. He believes that gain valuable knowledge. “The market given that volumes of data are growing contractual obligations across products, organisations need to be able to create recognises that different asset classes will slow down data – and potentially data at such a fast pace. counterparties and business lines. integrated views that cross the different interconnect and interrelate and that could be dropped and lost. Keeping up with “Data is the lifeline of the financial “CFOs and CROs need high-quality desks, geographies, systems and data movements in one asset class can services industry; without it you ­cannot data to feed their own financial and risk- have an impact on others,” he says. “A data is a technology arms race.” achieve much. Organisations have to reporting goals. If businesses cannot renewed focus on risk management continuously look at managing data; make use of and contribute to ­automated will force firms to put together the full those firms that are not, are doing and centralised data assets, they will picture and understand the direct and ­something seriously wrong,” he says. have to defer to expensive and error- indirect impact across asset classes Gert Raeves, senior vice-president prone manual alternatives,” he says. and markets so they can make informed of strategic business development Di Giammarino concurs there is a decisions about managing risk.” and marketing at GoldenSource, cost issue associated with data In times of stress, firms may be equates the outcome of failing to ­management, as cost income ­ratios ­unable to judge their total risk and credit invest in data ­management to ­delaying come under severe pressure as ­exposure by counterparty or product, car ­maintenance. Nothing dramatic ­revenues start to decline. Though the adds Raeves. He believes that gaining a will ­happen if you skip the usual cost of collecting, analysing and storing complete view of their total risk exposure ­service ­intervals and there is roadside data is going up ­exponentially, given that does require firms to put in place a local Asia, which together total 75 across all ­securities, Ned Myers, chief marketing ­assistance if the car starts breaking order-to-trade ratios continue to data management infrastructure, which is asset classes. Europe will host four times officer and vice-president of product down. But eventually the wheels will rise by the multiple, firms cannot afford no longer just an informational nice thing as many execution venues as the rest of strategy at Lewtan Technologies, believes come off – and the cost is not measured not to have access to what is going on to have. “The data management process world by the end of 2008. the best proxy for deal comparison and in the few extra minutes it took you to in the market. “A drop in investment has become more audit, compliance and The number of trades and quotes on analysis is to use data in bulk. “Credit get from A to B, but in the fallout from may not be the right avenue if risk management-driven than just look- the New York Stock Exchange (NYSE) ­performance data is serving more than total failure – you are going nowhere. firms really want to understand and ing for operational and cost efficiencies, surged to more than 494m in January just the middle-office credit surveillance “Data management is not like ­manage the data ­explosion,” he says. Gert Raeves, senior vice-president of and almost a necessary condition before this year, more than tripling the 133m functions and front-office trade support. It ­breakdown insurance; it won’t save you The quality and cost of reference strategic business development and marketing, you can undertake a lot of front-office GoldenSource ­figure from a year earlier. What’s more, is being used in other support functions, once you are by the side of the road. data present the greatest risk to ­trading. ­activities,” he says. there were more than 650m trade like audit, trade verification and account- Rather, it is like a maintenance plan that Without investment in IT, firms will be Many institutions are no longer taking ­messages on the NYSE on its busiest ing,” he says. ­ensures that your infrastructure is ready hard pressed to take ­advantage of any sources very quickly in order to manage a data silo approach but now turning to days, a considerable rise from the 2m-5m IT investment among European firms for ­anything that might happen,” he says. ­commercial opportunities ­presented their risk. a more integrated view and enterprise trade messages per day a decade ago. is forecast to remain flat or decline to By not investing in data ­management by the data explosion. Moving ­towards “Everyone has a little piece of the data data management. Firms want a more As tick sizes reduce, large trades are offset the financial market conditions, technology, Raeves says that firms may a higher performing/lower cost pie but it comes down to who owns all efficient cross-asset solution that can be unbundled, new sources of prices come which could create challenges for firms in encounter numerous business ­dilemmas. ­operating model will help tone a firm’s the data in the firm, who is responsible quickly and efficiently referenced by many online and trading volumes continue ­effectively managing the data ­mountain. For instance, the inability to move into ­infrastructure and Di Giammarino sees for pulling it all back together again, ­business units, and this is leading to to rise, trading data volumes will soar This requires firms to stay ahead of new product areas because operational a real ­opportunity to employ technology where those central utilities that allow greater adoption of an integrated pricing even higher. This is not only reference the curve by making sure that internal inefficiency will not allow it. This scenario to obtain a competitive edge by making people to undertake that are and how and reference market data platform. data due to instruments’ availability on infrastructures, systems, networks, is evident in the classic confirmation changes better, quicker and cheaper. are they funded,” he adds. “It is a very Raeves notes there is a move to more ­venues, but also in new arbitrage ­applications and support people can backlog that the ­industry has expe- “The quality, volume and ­integrity big challenge for many firms because ­create a single platform to source ­opportunities between venues. keep up with the relentless growth in rienced in fixed income,­equities and of data are the lifeblood of the organi­ if you do not understand whether your any type of data that is of value to the “The data explosion presents data, says Bob Cumberbatch, business derivatives over the decades. sation now and in the future. Those counterparty’s data is right, how are you ­business and where all the critical data, ­significant commercial opportunity lines ­director at Interactive Data (Europe). Also, the struggle to win customer ­infrastructure tools that fire the right going to understand how to operate whether customer, security or position, because a key differentiator between “There is a danger that a lack of mandates as sophisticated buyers of ­ammunition of better quality data, linked in the market when markets change? is centrally collected, stored and inter- execution venues is the tick size, or price ­investment could lead to technical services (execution, investment ­advice, together to make decisions, are more The reality hitting home is that these are linked. “When you are starting to pull granularity, available on them,” says ­bottlenecks that will slow down data – custody, research) are demanding likely to win the RegTech data war,” not theoretical problems any more and together a ­regulatory, total exposure or Di Giammarino at JWG-IT. He adds and potentially data could be dropped data transparency in order to compare he says. they’d better get sorted out.” ­financial report, you will need all those that firms need to be able to monitor and lost. Keeping up with data is a ­performance. Di Giammarino adds that there data ­elements. You also need to be and measure the performance of the ­technology arms race,” he says. There are also obstacles, in the form has to be renewed focus on enter- Infrastructure needs able to show that there are consistent, ­different venues, as they become more Control of and investment in data of fines or further mandates, put up prise risk and how to bring together Cumberbatch of Interactive Data adds ­professional and documented processes or less ­liquid, in order to make informed management processes is a challenge by regulators unless data auditability ­different ­disciplines of information and that a firm’s infrastructure needs to in place to source, validate the data and ­decisions about connectivity to venues. but imperative for investment firms, says is in place as well as the need to show ­operational risk management, record allow fast collection and ­dissemination create a single representation or a golden Because of the paucity of ­observable a consultant in New York. He believes exposure when things go wrong. Raeves keeping, business continuity with market of information internally to the right copy of the data, to distribute to down- price data for structured finance that the latency and accessibility of data adds that instead of being able to push a risk and credit risk. Firms can no longer recipients, but also analysis of the stream sources,” he says.

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Golden copy Cumberbatch adds that constructing keep multiple copies in ­synchronisation. Growth In European Trading Venues ­solutions for some stages of the Having a single trusted set, or golden a golden copy of real-time data can pose “That becomes more difficult and you ­process. For example, providers of ticker copy, of data within a central data a number of considerations for firms. have to make sure there is no loss or 160 systems can help firms consolidate and management platform accessible by all Choke points can arise in the application increased latency of data,” he says. absorb market data. divisions in a firm is the ideal scenario. where data streaming in from the many 140 Also, data distribution and manage-

Raeves explains that creating a golden disparate pricing sources meets the Outsourcing of data management 120 ment applications, as well as managed US & Asia total copy enables firms to­immediately output feed to internal recipients. “If it’s a Cumberbatch views outsourcing of data execution venues network providers, can ­provide ­threshold see the connections between all funnel into one application and a funnel management as an upcoming activity, as 100 monitoring and ­generate alerts for ­categories of data, the underlying links interest increases among software and capacity planning. “I stress that this is out to many, it can cause a bottleneck, 80 and ­dependencies and to understand which can result in data delays that can technology firms to provide­solutions. not a simple option, but it does help to the credit risk across all components lead to data being dropped and therefore He suggests this is driven partly by 60 ­overcome some of the problems of trying

and ­counterparties for a particular gaps,” he says. clients approaching firms to determine No. of trading venues to build tools inhouse,” says Cumberbatch. 40 ­product. “This ­allows rapid and ­accurate whether they have the competence to Myers of Lewtan Technology ­believes ­assessments of risk and ­profitability deliver. Also, he believes that a ­growing 20 that firms need to look at not just the for both plain vanilla and complex number of board executives view outsourcing of technology but also of 0 ­products, but also detailed insight into data ­management as a differentiating Dec 05 Dec 06 Dec 07 May 08 ­services. For instance, the trend for

the ­profitability associated with any ­commodity and are allowing their IT Fixed Income Derivatives Equities the buy-side to subscribe to several ­customer or instrument,” he says. capabilities to dwindle over time. ­pricing and information providers in Maintaining multiple data stores “Fewer organisations are ­making sure Source: JWG-IT analysis of CESR and ISO 10383 lists the ­structured finance market is­being increases costs, can create ­duplication they employ all the internal ­resources, ­supplemented by clients allocating of effort and result in inconsistent data ­infrastructure, solutions and ­technology European Exchange Trading And Order Volume Growth Trends ­additional money for consulting services ­quality. The consultant believes that to enable data management inhouse. to determine how to better ingest the ­taking a golden copy approach can Outsourcers are looking to exploit 2,500 9.0 information and reconcile one source ­improve data quality and management this ­situation and I believe they will against another. 8.0 by replacing a wide number of be ­successful in boosting revenues (millions) trades daily of no. Avg. Lewtan last month expanded its 2,000 ­decentralised data management Bob Cumberbatch, business lines director, ­because that is the way that IT is 7.0 ­credit surveillance and data analysis ­solutions with a ­centralised platform. ­Interactive Data (Europe) ­heading,” he says. 6.0 team to provide additional support for 1,500 He sees greater benefits from a He adds that some firms may draw 5.0 clients in understanding and analysing central location that houses, cleans and In constructing a golden copy of a a line and take charge of real-time data, the ­inherently complex instruments. 4.0 ­processes the data required throughout price, pricing sources are disparate and but hand over historical and ­reference 1,000 “There will be more of an enterprise an organisation. Sourcing data once very dynamic. The primary source(s) for data to another firm to house and 3.0 demand to ingest data in bulk for better lessens vendor costs, while cleansing each field for a record can change by ­manage. “This hybrid approach is a No. of trades (millions) surveillance and independent ­verification 500 2.0 data centrally can avoid the duplication of the second. This requires programmatic natural ­development in the migration from of credit risk, but it is also important 1.0 effort and reduce maintenance costs. rules that have to quickly make a decision ­inhouse to ­outsourcing as executives try to couple the data with deep industry 0 - “Centralising the process promotes on which provider is providing the best to ­identify what is dear and not dear to 2005 2006 2007 2008* 2009* ­expertise and to provide education, business clarity and supports strategic ­quality data to overwrite a field – but are their ­business,” he says. Trades Average daily trades * JWG-IT forecast additional value and a higher level of decision making by eliminating multiple also able to change very fast as the price The strategic and tactical needs of service to our customers,” Myers says. copies of the same data. Firms offering in the market changes. an organisation must be calculated 60,000 250 golden copy solutions are providing an Cumberbatch believes it is ­technically when considering whether to build Soaring volumes

50,000 (millions) orders daily of no. Avg. important utility for the industry,” he adds. easier to create a golden copy for or buy ­solutions for capture, ­storage 200 Soaring trade and market volumes Golden copy is heralded as a viable ­reference data, which is more static and ­dissemination of data, says will also mean that firms need better concept, but some believe the ­reality of in ­nature. Nonetheless, firms need to ­Cumberbatch. A single data vendor may 40,000 infrastructure and storage capabilities implementation is proving to be more ­consider the level of content coverage, be able to provide an infrastructure that 150 for streaming and historical data. ­Myers challenging. Di Giammarino sees a huge reliability, accuracy and timeliness can be used internally by the firm. 30,000 notes that firms are paying closer at- ders (millions) challenge for firms to prove that a golden of service. But this course of action may limit 100 tention to technologies that store and copy solution is the correct route and that In many instances, he adds, technical a firm’s access to alternative sources 20,000 maintain large amounts of historical data No. of or the cost of taking this path is justified. performance reasons on the output may of market data that are perhaps not and enable quick and efficient access 50 Management needs to judge whether not always make it possible for all the ­available from that market data provider. 10,000 to information. “Firms want low latency the balance and amount of sharing that internal applications in a firm to actually “I suspect that outsourcing the entire solutions that enhance the turnaround 0 - is required to make the concept work gain access to that one single copy of a end-to-end process may not be palatable 2007 2008* 2009* and utilisation of data in their trading will actually happen within firms. “I think record. This could require a version of the with many firms that have mission-critical Orders Average daily orders * JWG-IT forecast environment,” he says. the cost and the level of ­expenditure golden copy to be shared with other trading operations,” he says. Also important are ­capacity of ­getting to that reality has been applications, which highlights the issue of Nonetheless, there are many ­options Source: JWG-IT analysis of FESE, LSE, Thompson Reuters and Chi-x data ­management processes to ensure that ­disheartening for many,” he says. integrity of that golden copy and how to open to firms that can help provide NOTE: Trade volume forecast based on growth based on year-on-year growth trend from 2005-2007 data flows preserve low latency

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Upgrading The Organisation

Business - ceo, cfo - project management - trading heads - group/division heads

Risk management

Data echnology & data capabilities T management

IT & Operations CRO - applications - audit - infrastructure - legal/compliance - data - operational credit/ - operations Operating model change market risk

Source: JWG-IT

­distribution within an organisation the ­arrival or non-arrival of market data not only quarantined from any ­ongoing and are constantly monitored and and for internal distribution mechanisms. ­prioritisation exercises, but in most tracked, says Cumberbatch. Average Firms also need to consider quality cases they are being prioritised higher and peak ­watermarks for “normal” ­issues and make sure data is correct and ­effectively brought forward in the market ­conditions need to be and consistent. The consultant notes queue of things to do,” he says. ­established and monitored, and there that front-office trading environments will Di Giammarino adds that firms are needs to be an ­additional degree of be highly cognisant of the importance being compelled to take decisions on headroom to cater for unusual market that real-time data is reliable. how they are linking the data internally, conditions and times of high volatility. Reference data quality can be more whether that is unstructured, instrument “Firms need to monitor and manage problematic, as interpretations vary in or static data and not just market data. those thresholds on a continuous basis how to house, maintain and source They need to assess what data they and take action to maintain sufficient the information. “A common problem already own and will take in, so as to capacity in systems and applications, of ­alternative OTC investments in the obtain a view that gives them the ability networks and people prior to when it is ­market is getting details about ­securities to manage their risk. needed,” he says. and who the counterparties are; it “The fragmented market environment Other considerations for firms ­requires a concerted effort to bring all really now forces firms to look at how ­include having a high level of ­expertise that information together,” says they are pulling all their data together and and ­flexibility within their technical Cumberbatch. whether they are taking the right steps ­infrastructure, not just for systems and Raeves of GoldenSource notes there to build the right infrastructure, both in applications, but also for personnel is an emergence of a much stronger terms of cost and competitive advantage. who understand what good data is and corporate mandate to resolve the data This will then allow the chief risk officer to where to source it. Management tools management issue. “We have heard analyse and measure the overall health of are required to allow a firm to monitor that data management projects are the firm,” he concludes.

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Markit’s product development team provides a detailed explanation of how it took a set of operational challenges facing participants in the OTC derivatives and cash markets and turned them into a service that has broad appeal to dealers and buy-side alike Markit Valuations Manager: solving industry-wide challenges

t is no secret that operational unconfirmed trades, to a need for more ­challenges continue to test the world timely valuations and a lack of data of over-the-counter (OTC) deriva- processing standards, the industry’s Itives trading. Many of these issues infrastructure often groans under the were highlighted earlier this year in the weight of some of these hurdles. report by Henry Paulson, US Treasury Although recent market volatility has ­secretary, on financial market turmoil.1 led to a slight decrease in notional The sheer size of the OTC market outstanding, due to a global wave of ­creates unique challenges. According to deleveraging and the tearing-up of the International Swaps and Derivatives offsetting trades, the OTC derivatives Association’s Mid-Year 2008 Market business remains enormous, and a key Survey, the total notional amount underpinning of the financial markets. As outstanding across asset classes was a crisis of confidence has overtaken $531,200bn.2 From working to reduce world markets, these challenges have

1 http://www.ustreas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf, March 2008. 2 http://www.isda.org/press/press092508.html

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price verification are in place – a sort of Figure 1: The Valuations Manager Dashboard: a snapshot of system status product management. The spring and “ As regulatory scrutiny continues to ­intensify, valuations hierarchy. The degree to summer of 2008 saw a series of there exists a degree of litigation and which they have the ability to do this has ­requirements reviews with the launch become a key differentiator among banks and buy-side prospects. ­reputational risk when it comes to pricing fund administrators. The launch feature set was agreed securities.” The time is clearly right for an upon, and development efforts for the ­industry-wide platform to tackle this beta release are now complete. most recent set of challenges facing the industry. Markit Valuations Manager is a Valuations Manager: a product tour multi-dealer, multi-asset class, global Valuations Manager is a web-based valuations distribution platform which application, accessed via http://www. aims to do just that. markit.com, which provides aggrega- tion of counterparty positions and marks From concept to product in a consistent format, with consist- In spring 2007, and in conjunction ent timing of position data. Valuations with a number of major banks, Markit ­Manager also provides access to researched the feasibility of building a Markit’s ­independent valuations service, platform for aggregating counterparty so that counterparty marks can easily be come to the forefront for those asset significant IT efforts and associated marks. This platform was to achieve the ­compared with the independent mark. managers and dealers trying to navigate ongoing maintenance costs. goal of relieving dealers from handling The product leverages our existing an extraordinarily challenging numerous daily ­valuation requests, and Portfolio Reconciliation technology, ­environment. The increasing importance ­ providing the buy-side with all their which serves as its backbone, and from In particular, buy-side firms that trade of independence counterparty marks and – optionally – which a good deal of the Valuations with multiple dealers often receive their The recent credit crisis has also Markit’s independent ­valuations along- Figure 2: OTC Valuations: aggregated counterparty position details, with optional Manager interface and functionality counterparty trade and position data in a ­demonstrated the increasing ­importance side them. This effort kicked off nearly Markit independent valuations was derived. In fact, the two products variety of formats. The timing of of independent valuations on OTC two years of research and development, will soon be fully integrated into a ­statement delivery can be inconsistent derivatives and cash bonds. Given which, at the time of writing in late Oc- new offering. across counterparties. the current environment of heightened tober, is about to culminate in the beta The standalone Valuations Manager It is easy to see how this can become ­regulatory pressure, a single counter- release of Markit Valuations Manager in product has three main components: a significant operational burden, particu- party mark is often no longer sufficient Q4 2008. the Dashboard, OTC Valuations and larly for larger asset managers. If an to satisfy regulators, fund managers, One of the first tasks was a market Cash (Fixed-Income Securities) entity trades with three different desks at investors and external auditors. research project to interview a number ­Valuations. The Dashboard (see Figure 12 counterparties, the result could be 36 As regulatory scrutiny continues to of buy-side firms and gauge the level of 1) is a snapshot of the system status, so different statements that must be intensify, there exists a degree of interest in such a concept. A representa- that both the buy- and sell-sides can see aggregated, collated and fed into the litigation and reputational risk when it tive cross-section of firms was inter- which files have been successfully appropriate downstream risk and P&L comes to pricing securities. In 2003 the viewed, and virtually every one strongly processed through the system. systems. There is significant room for SEC charged Heartland Advisors with agreed that the operational issues Also included is an exposure error, particularly because today this the mispricing of securities in two of its mentioned above were problematic and ­snapshot, which displays an entity’s total process is predominantly manual. bond funds, among other violations.3 As that a solution would be welcome. exposure to all of its counterparties on On the sell-side, desks are a result, civil penalties of $3.9m were The next step was to conduct a small, the system. Additional status indicators ­overburdened with pricing and valuation issued against the firm and certain of its controlled pilot test. In summer 2007, point for counterparty marks. Client Markit then syndicated the concept are shown. For example, mapping tables requests from clients, which consume officers and directors.4 The introduction Markit conducted such a pilot, with a statements for both cash bonds and to a group of dealers, and limited the are built as part of the process of the time of highly-compensated of FAS 157 in November 2007 was also group of buy-side firms and dealers. The OTC derivatives were produced, initial launch group to a manageable onboarding a new client, so that a client ­employees such as traders. In addition, a major milestone, and has raised goal of the pilot was to prove the including independent valuations number to work with to build out the and its counterparties are speaking the data must often be sourced from awareness regarding valuations and concept that dealers could send their from Markit. platform.6 Markit is in various stages of same language on the platform. If a multiple systems to produce collateral their source. clients’ data to Markit, have Markit Clients were given the opportunity to discussions with several other major client subsequently starts to trade a new and valuation statements, resulting in Valuations are also an acute problem aggregate the data, produce an challenge marks from either their banks, and it is expected that the product which hasn’t previously been for fund administrators, who manage ­independent valuation for each position, counterparty or Markit, and in a small number of dealers on the platform will mapped, it will show up as unmapped operations on asset managers’ behalf. and distribute statements to clients in a number of cases chose to do so. Both double by the end of 2009. in the Mapping Statistics section of 3 http://www.sec.gov/litigation/admin/2003-171.htm Fund administrators are increasingly timely fashion. the clients and the dealers agreed that The internal Markit team was staffed the Dashboard. 4 http://www.sec.gov/news/digest/2008/dig012808.htm looking to source valuations from A combination of manual and the pilot was a success and the decision up with members for project It is a very simple process, then, to 5 http://www.fasb.org/st/summary/stsum157.shtml 6 http://markit.com/information/news/press_releases/2008/ multiple venues including counterparties ­automated processes was used to test was made to invest in the development ­management, onboarding, software map the unmapped item. All data february/21.html and vendors so that several layers of the concept of a central aggregation of the platform. development, a QA team, sales and displayed in the Dashboard is

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Figure 3: Disputing a counterparty mark online even more seamless. (see Figure 4). The history of each position is stored The stage of a dispute is also tracked “ The addition of foreign exchange and online, and can be accessed in one of online. The normal lifecycle of a dispute ­commodity derivatives is planned along with two ways. Clicking on the red chart icon, is as follows: on the right side of Figure 2, will show a richer set of cash bond instruments.” Disputed  Reviewing  Pending OK the history of that particular position.  Resolved Clicking on a date in the calendar widget, in the upper right, will show the However, a dispute may also travel entire portfolio as of the selected date. “backwards” through the stages, Ninety days of daily history, and 13 depending on the circumstances. months of month-end history will be The third major component of stored online. This feature is also Valuations Manager is the cash extremely helpful to auditors, who may ­valuations section, for fixed-income need to review day-by-day snapshots of securities (see Figure 5). Although similar the portfolio. in concept to the OTC valuations screen Workflow tools are also a key in the sense that users can view their Figure 5: Cash Valuations: provides composite prices for cash portfolios feature of Valuations Manager, allowing portfolios and valuations, there are secure, auditable communications some key differences. between clients and their dealer First, the default prices shown will be ­counterparties (or Markit). Currently, composite prices constructed by Markit, disputes are handled over a combination based on contributed prices from the of email and phone, neither of which is participating dealers. Contributed prices ideal. Email is relatively insecure and will be run through Markit’s proprietary easily misforwarded. Telephone and cleaning algorithms, and a single voicemail are more secure but are not composite price will be published for easily recalled for audit trail purposes. each fixed-income security. Valuations Manager provides a highly Markit is also working on an ­evaluated Figure 4: Disputed Valuations: the status of all disputes currently in the system secure, reliable and auditable set of bond service that will offer independent workflow tools for both counterparties to valuations on cash bonds and will be communicate with each other and integrated into the Valuations Manager resolve any disputes that may arise offering. online. Also, a recurring theme in our Also, unlike the OTC side where market research was the burden of audit Markit will be processing sell-side files confirmations – a pain point for the on a daily basis which contain all the buy-side which we hope to eliminate positions of a particular buy-side client, with Valuations Manager. on the cash side it will be the Should a buy-side firm disagree with ­responsibility of the buy-side client to ­commodity derivatives is planned ­reconciliation worthwhile. Smaller clients either the counterparty mark, or Markit’s maintain its own portfolio of CUSIPs/ along with a richer set of cash bond without the need for online reconciliation independent valuation, a dispute can be ISINs within Valuations Manager. ­instruments. Prices for both cash and will still be able to access Valuations initiated by clicking on the yellow triangle Cash prices can be disputed just like OTC will be T+1 initially, with both a daily Manager as a standalone platform. at the far right of the OTC or Cash Valua- OTC valuations. However, as Markit is batch and a separate month-end batch In keeping with the Markit tradition of tions screen. This action results in a the source of both Composite and process, to allow extra time for month- streamlining the flow of financial data dispute pop-up, where the details of the Evaluated prices, disputes on the cash end updates from dealers. ­between the dealer community and the ­context-sensitive and secure. Both the description, counterparty valuation, and dispute can be entered, and the appro- side are directed to Markit only. In the first half of 2009, Valuations buy-side, we are excited to see the buy- and sell-sides have views into the optionally, the Markit independent priate party will automatically be notified Manager will be fully integrated with culmination of nearly two years’ worth of system, for those positions they have valuation and calculated differentials (see through the application (see Figure 3). Conclusion Markit’s existing Portfolio Reconciliation effort in research and development with their respective counterparties who Figure 2). This data can be downloaded Disputes can be commented on at Valuations Manager is currently ­being service, allowing for field-by-field come together in an industrial-strength are also on the system. into a CSV-format file so it can be fed any time, by either side. Each side’s rolled out into beta, with the ­ability reconciling of trades, as well as the product. We are very much looking The second major component of into downstream systems, streamlining comments are visible to the other. All to support credit, equity and rates comparison of three marks: the forward to adding convenience and Valuations Manager is OTC Valuations, the flow of data and eliminating the comments are stored online and easily ­derivatives on the OTC side, and with ­counterparty’s, the buy-side’s and aiding operational efficiencies for both which displays key position data for manual re-keying which continues to retrieved, via the Disputed Valuations support for corporate, government and Markit’s independent mark. banks and clients with the introduction each of the OTC trades that a given occur at some shops. API access will be queue. This enables both the buy- and agency bonds on the cash ­securities The combined product will be of of Valuations Manager. entity has with counterparties on the available shortly, which will make sell-sides to see, at a glance, the current side launching shortly ­thereafter. interest to clients with a sufficiently large David Wilusz, vp product management, system, including: identifiers, notional, integration with Valuations Manager status of all disputes on the system The addition of foreign exchange and book of trades to make online Markit

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To a large extent these fears have proved unfounded. provide the capital. Hence the government had to step in. Recession looms in the US, UK and many countries in The media underestimated, or were unaware of, the strides The Troubled Asset Relief Programme (TARP) was flawed Europe. The only question is how long and how deep. The Credit the CDS market has taken in recent years in addressing from the beginning, but the dire situation demanded ­action ­authorities have shown they are ready to use monetary ­operational issues. Lehman’s default, which had the press and it was better than nothing. After much wrangling in policy aggressively, helped by the receding threat of inflation. ­anticipating a bloodbath, was handled smoothly through a ­Congress, the bill was passed but its shortcomings hindered ­However, with deleveraging still under way, confidence has yet Over the years, credit derivatives have become more familiar credit event auction. The auction, conducted by Markit and its ­effectiveness. Across the Atlantic, the UK faced its own to return fully to lenders, thereby limiting the impact of ­interest and understandable to financial professionals, though even Creditex in conjunction with 14 major CDS dealers, allows banking crisis. Banks such as RBS and HBOS were under­ rate cuts. The next step is likely to be fiscal stimulus, and within the industry they remain inscrutable to some. Where participants to cash settle as well as physically settle. This capitalised. State action was the only answer. But the UK the markets will be among the many looking for the next US once the proverbial man in the street was unlikely to bring solves some of the operational problems associated with the ­government came up with a superior, more comprehensive plan ­President Barack Obama to lead the way. credit derivatives up in conversation over a drink in a pub, traditional physical settlement-only credit event mechanism. to the US. Banks would have their balance sheets repaired by to the surprise of many bankers, this is exactly what has Washington Mutual, two weeks later and with far less media the government injecting funds in return for equity stakes. The Gavan Nolan, vice president, credit research, Markit ­happened in recent months. Credit derivatives have become attention, was also ­settled in this manner. government would also guarantee short- and medium-term ubiquitous in the mainstream print and broadcast media. Another misconception in circulation is the size of the CDS debt. The UK plan was deemed more likely to succeed and was ­Politicians of all stripes are opining on their use and abuse. market. The oft-quoted figure of $54 trillion, sourced from an replicated by many countries (including the US). How did this situation come about? ISDA survey, caused many uninformed voices to speculate that One effect of this was a sharp deterioration in government The answer lies in the financial shocks of September and it was “out of control”. But though the ISDA survey is relatively finances. The bailout of banks came at a hefty price, and October. US mortgage giants Fannie Mae and Freddie Mac were accurate in describing gross notional outstanding, it is flawed the cost to governments can be seen in their CDS spreads. taken into “conservatorship”, a form of administration, with them in representing total risk. Figures published by the DTCC give a The UK now has the widest spreads in the G7 bar Italy, while Economics teetering on the brink of insolvency. This constituted a default truer picture. Figure 2 shows that the total net notional – which ­Ireland, which guaranteed its whole banking sector, has seen under a standard ISDA CDS contract, in spite of the underlying offsets long and short positions within the same ­institution, its spreads rise by more than fivefold. DTCC figures indicate credit risk improving (their bonds were now ­guaranteed by the thus giving a more accurate figure of risk – is only a small that sovereigns are now among the most widely traded names Global economic growth has deteriorated at an ­alarming rate in US government). Then Lehman Brothers was allowed to fail after ­fraction of the total gross notional. This is because the ISDA in the CDS universe. recent months. In many countries, indicators of ­expansion have takeover talks broke down. Only days after, the government survey counts the same position several times and doesn’t come in not just below the average of ­economists’ forecasts, ­performed a volte face and bailed out AIG, the insurer. The take into account aggregate risk. Figure 3: Multinationals Gaining From Overseas Exposure but have even exceeded the most ­pessimistic expectation. The ­collapse of Washington Mutual, the nation’s largest thrift, Global Purchasing Managers’ Index for example, compiled for Developed Countries CDS spreads followed swiftly after, culminating in a sale to JP Morgan. Figure 2: CDS Notionals Outstanding (week ending 31/10/08) 140 JPMorgan by Markit, which covers both manufacturing and UK Unsurprisingly, these events had an unsettling effect on the service sectors, plummeted in October. The PMI tracks global Products Net Notional Gross Notional % Gross 120 USA credit markets, and the financial sector in particular. Figure 1 ($bn) ($bn) Notional GDP well, and suggests that the global economy may ­contract 100 Ireland shows the spread widening in financials during September. Total Single-name CDS 1,756 15,381 46% in the final quarter of 2008. 80 Spain Uncertainty reigned, and the phrases on everyone’s lips were Total CDS Indices 1,434 14,768 44% bps 60 Italy “systemic risk” and its sibling “counterparty risk”. Markets were Total CDS Index Tranches 3,410 10% Figure 1: Global Economic Growth 40 afraid that the collapse of one financial institution would have a Total 3,190 33,558 100% 20 PMI index GDP, %q/q, saar ripple effect, potentially bringing the whole system to its knees. Source: DTCC 0 66 6 Some posited that the most likely catalyst for such an outcome would come through the CDS market. Lehman and AIG were Gross notional in the CDS market has itself decreased 5 61 01/01/08 01/02/08 01/03/08 01/04/08 01/05/08 01/06/08 01/07/08 01/08/08 01/09/08 01/10/08 01/11/08 major counterparties in the CDS industry, and some feared ­significantly in recent months. This is due to compression 4

that their demise would expose the flaws in the asset class and ­exercises conducted by Markit and others, which allow Source: Markit 56 3 cause serious damage to the system. ­offsetting trades to be torn up. 2 This not to say the CDS market is blame-free. There are Unfortunately, the financial crisis has not been contained, 51 Figure 1: Markit Sector Curves clearly issues around counterparty risk and regulation. The in spite of the efforts of governments and central bankers. At JPMorgan/Markit Global PMI Global GDP 1 opaqueness of the market contributed to the uncertainty the time of writing, it has become clear that the real ­economy 46 Single A 5y Spreads 0 400 in the recent crisis. Industry figures are currently in talks to is at the beginning of a painful period. Survey data has Financials 350 ­create a central clearing house, which would solve most of the ­indicated for some time that output was falling and unemploy- 41 -1 Basic 2000 2002 2004 2006 2008 Materials 300 ­problems around counterparty risk. ment rising (see economics article, below). Official data has Consumer Source: Markit 250 Services So was there a real issue with systemic risk? Yes, but not since ­confirmed the gloomy picture and CDS spreads have

s 200 Health Care solely related to the CDS market. A series of banking insol- ­responded in kind. No sector has been spared, but cyclical bp vencies, through whatever reason, would have had serious ­industries such as retail have suffered more than most. The Global growth was led down by the US, where the 150 Technology repercussions on the real economy. Ben Bernanke, the Federal materials sector, previously one of the strongest, has also ­manufacturing sector contracted in October at the fastest rate 100 Industrials Reserve chairman, has written extensively on this subject in widened sharply (see Figure 1). Oil and other commodity prices since 1982. Elsewhere in the developed world, output 50 relation to the Great Depression. His unorthodox efforts to pro- have fallen steeply after it became clear that the decoupling shrank at record, or near-record, rates in the UK, Japan, 0 vide liquidity to banks earlier this year can be seen in this light. theory was just that – a theory. China and other emerging ­Germany, France, Spain and Italy, as well as a number of However, they proved insufficient, and the government was ­market countries have signalled that they are heading for other smaller countries. 01/01/08 01/02/08 01/03/08 01/04/08 01/05/08 01/06/08 01/07/08 01/08/08 01/09/08 01/10/08 01/11/08 forced to recognise that solvency was the main issue. Banks slower growth, confounding those who thought they would Trends were more varied in developing markets, but Source: Markit were undercapitalised, and the private sector was unwilling to make up for a slump in the developed world. ­emerging market manufacturing output has now contracted

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for three successive months, with the rate of decline ­gathering in easing rates, and that the size of the recent cuts have been But will rate cuts actually boost growth? A key concern is that the The wide CDS spreads are a key factor explaining why momentum over this period. The PMI survey for China was justified by the data. Professor David Blanchflower, ­membera impact will be limited because money markets are still not working ­commercial lending rates remain elevated compared ­ notable in signalling the steepest downturn of both ­production of the Bank of England’s Monetary Policy Committee and properly and – as the charts below show – economic growth is clearly with central bank rates. The Libor-OIS spread and TED and new orders in the four-and-a-half year survey history. long-standing interest rate “dove”, has suggested that his linked to credit market confidence. The Markit CDX and iTraxx credit spread, for example, remain far above levels seen prior to the Growth also slowed sharply in India. fellow members had placed insufficient weight on surveys default swap indices for North America and Europe indicate historically financial crisis. such as the PMIs, which were signalling the start of a serious wide spreads, meaning fears of default persist in the credit markets. Without a return in confidence among financial institutions, Figure 2: Manufacturing PMI Output Index downturn more than a year ago. Policymakers, distracted by these spreads are set to remain wide, meaning the world’s ­major high oil prices, have left interest rates too high for too long, Figure 5: US Economic Growth And Credit Markets economies are like cars stuck in mud. Reductions in central bank 65 according to the PMIs. Sterling even rose initially in reaction to base rates may merely make the wheels spin, and further meas- PMI Output Index (50 = no change on previous month) CDX NA IG Index (spread - inverted) 60 the 1.5 percentage point rate cut by the Bank of England on ures are likely to be needed to boost lending and provide a sound 65 0.0% ­November 6, reflecting widespread relief that the Bank was footing for economic growth to gain traction. 55 willing to make bold moves to stimulate the economy. 60 0.4% 50 Chris Williamson, chief economist, Markit 55 0.8% 45 Figure 3: UK Base Rates And The PMI Eurozone Emerging markets 50 1.2% 40 sa, 50 = no change Movement m/m, basis points US 65 100 45 1.6% 35 ISM PMI Output Index (all sectors) Markit CDX North American IG Index (inverted) 60 50 40 2.0% 30 JMMJSNJMMJSNJMMJSNJMMJS 2005 2006 2007 2008 55 0 35 2.4% J MM JSNJMM JSNJMM JSNJMM JS 2005 2006 2007 2008 Source: Markit 50 -50 Source: Markit Dividends 45 -100 Worryingly, analysis of order book data for the PMI surveys PMI Whole Economy Activity Index (LHS) indicates that domestic demand has cooled substantially Monthly movement in UK base rate (RHS) Figure 6: European Economic Growth And Credit Markets 40 -150 in emerging markets. This is of concern, as it suggests that Since the distribution of our dividend article in Markit PMI Output Index (50 = no change on previous month) iTraxx Europe Index (spread - inverted) hopes of a “decoupling” of emerging markets from the west 35 -200 ­Magazine’s Issue 2 – Autumn 2008, the banking sector has 65 0.0% look to have been overly optimistic. Domestic demand in Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 experienced an unprecedented shake-up, which has affected countries such as China and India has not been sufficiently Source: Markit 60 the core of the industry. Many countries have designed bailout strong to sustain growth to the extent previously anticipated by packages for their domiciled banks, in order to avoid the 55 0.5% many. This adds significantly to the risk of a global ­ecession,r The chart below illustrates the situation in the eurozone. ­possibility of even more pain, and possible extinction. Below as not only will emerging market GDP itself be hit, but emerg- The region’s PMI, compiled by Markit and widely cited as a key 50 is an analysis prepared by region, as to current, and possible ing market demand for goods from Europe and the US will also indicator of ECB rate decisions, began to turn down sharply future, implications. As this saga changes on a daily basis, 45 1.0% be affected, meaning a deeper contraction of GDP in western towards the end of last year and is now at a record low. The Markit European Union PMI Output Index below is the most up-to-date information available at the time Markit iTraxx Europe Index (inverted) economies. What’s more, with oil prices falling, growth in oil- policy prescription was for aggressive rate cuts. Instead, the 40 of writing. exporting territories such as Russia and the Middle East is also ECB hiked rates in July, fearing the entrenchment of elevated 35 1.5% likely to weaken further. A synchronised global downturn is inflation expectations. In spite of the recent cuts by the ECB, J MM JSNJMM JSNJMM JSNJMM JS United States now well and truly under way. rates still look far too high when compared with the slowdown 2005 2006 2007 2008 Following the escalation of the credit crisis to the international The good news is that the spectre of inflation has­withered indicated by the PMI. Source: Markit banking system in September, the US Treasury and the Federal away as fast as economic growth has deteriorated. For Reserve introduced the Troubled Asset Relief Programme ­instance, average prices paid by manufacturers for their inputs Figure 4: Eurozone Interest Rates Figure 7: TED Spreads (TARP) to encourage banks to resume lending and unfreeze were rising rapidly in the summer but, with crude oil prices now the credit markets. Under the $700bn bailout plan, JPMorgan, 3-month LIBOR minus 3-month Treasury Bill yield (monthly ave.) 63 per cent below their July peak and prices charged for many ECB base rate (%), CPI (YoY%) PMI Citigroup, Wells Fargo and Bank of America (including Merrill 6 70 3.0 other commodities tumbling amid weak global demand, these TED spread (US) Lynch) will receive $25bn each, Goldman Sachs and Morgan Base Rate CPI All sector Output PMI TED spread (UK) input prices actually fell on average in October, according to 5 65 2.5 Stanley $10bn each, Bank of NY Mellon and State Street $3bn PMI surveys. and $2bn respectively, while many other banks are expected to 2.0 Prices charged for services are now also falling in some 4 60 join the programme. countries, notably Spain, Italy and France, as firms offer 1.5 The Government will receive stakes in the companies in the 3 55 discounts to boost sales. As a result, consumer price inflation form of non-voting Senior Preferred stock paying dividends of 1.0 rates have started to fall. 2 50 5 per cent for the first five years and 9 per cent after, payable

Now that inflation fears have diminished, central banks have 0.5 quarterly. The Treasury will also receive warrants to purchase a 1 45 more scope to cut interest rates, and the shocks of recent number of shares of common stock and require restrictions on 0.0 economic data were matched by the surprisingly large cuts 0 40 JMMJSNJMMJSNJMMJSNJMMJSNJMMJS executive compensation. delivered to base rates in October and November. Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 2004 2005 2006 2007 2008 On November 23, the Treasury, the Fed and the FDIC an- The PMIs suggest that central banks fell behind the curve Source: Markit Source: Markit nounced an additional rescue package for Citigroup following

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a dramatic decline in its stock price. The Treasury will invest United Kingdom annual ­dividend growth to 5 per cent, from a current level with most of them being nationalised. $20bn more under TARP, on top of the $25bn already injected, In September, institutional distress in the US ­heightened of 10 per cent. in Citigroup preferred stock and receive an 8 per cent dividend ­systemic risk in the UK banking sector, leading to a Standard Chartered has stated that its operations remained Far East in return. Additionally, Citigroup will issue an incremental $7bn ­government-endorsed takeover of HBOS by Lloyds TSB. well diversified. The group saw a steady deposit inflow in the Singapore in preferred stock to the Treasury and the FDIC in payment for By the end of September, Bradford and Bingley had been third quarter, and its conservative balance sheet and geo- The market is likely to remain volatile as more negative news the government guarantee of $ 306bn of securities, loans, and ­nationalised, and at the beginning of October, Santander graphic scope should allow the bank to maintain double-digit is expected. In Singapore, although the loan growth is still commitments backed by residential and commercial real estate ­completed its £1.26bn takeover of Alliance & Leicester. dividend growth, covered at least 2.5 times by earnings. ­positive, the concern hovers around how much banks will and other assets. With economic conditions deteriorating and banks ­being choose to set aside in provisions as a buffer against losses from The initial US bailout plan prohibits participating banks from affected by falling asset prices, tighter credit conditions and Europe bad loans in the months ahead. With global growth ­slowing increasing dividends during a three-year period without the a distinct lack of liquidity in the global interbank market, Following the UK example, banks in continental Europe have sharply and the local economy sliding into ­recession, the Treasury’s consent. While the government has defended using on ­October 8 the Treasury announced a scheme aimed at taken steps to enhance their capital positions, measured with ­upcoming third-quarter results may not reflect fully the impact the bailout funds to pay dividends to shareholders (except for ­providing stability to the sector. Core Tier 1 ratios. These ratio targets have increased, usually on earnings as the situation in Singapore has not ­deteriorated Citigroup), the plan has been controversial. Many believe the The package included an injection of £200bn into the in excess of 8 per cent through new capital issues, cancellation yet. Although the proportion of non-performing loans is still funds received should be used strictly to start lending again, ­interbank market to improve short-term liquidity and an initial of cash dividends or payment of dividends in shares. This is the low, investors are watchful of asset quality across all classes of and it has been debated whether participating banks should be £25bn (potentially rising to £50bn) to help banks improve their case of Italian banks, with Unicredit announcing the payment ­assets, and they may already be bracing for future loan losses. restricted on their dividend payments. capital ratios. The government also guaranteed to assist in in new shares of the full-year dividend, or Intesa Sanpaolo, The other concern would be regarding the banks’ ­reputation Citigroup is not expected to return to profitability until at refinancing wholesale funding obligations for three years. which will not pay a cash dividend in 2009 and postponed any and its ability in securing its depositors’ confidence. For least the end of 2009, given expectations of sharp deteriora- Banks requiring assistance in recapitalising were warned decision on potential stock dividends to next year. The Italian ­instance, DBS Group Holdings expects to spend up to S$80m tion in consumer ability to pay credit cards debt. During the that any capital issuances would have to “appropriately reflect government is discussing the details of the intervention. compensating customers who have had investments in third quarter, the company announced it would raise $10bn the commitment made by taxpayers” and that dividend policies More generally, we have lowered our dividend projections ­structured notes linked to bankrupt US brokerage Lehman in common equity and reduced its quarterly dividend, for the would come under scrutiny. for European banks with cuts in the range of 25-50 per cent for Brothers Holdings. The compensation amount is only about 3 second time this year, to $0.16 per share in order to maintain The banks participating in the scheme are Royal Bank of 2008 and up to 60 per cent for 2009. per cent of the current earnings forecast for 2008 of S$2.3bn, the company’s strong capital position. In return for the No- Scotland, HBOS and Lloyds TSB. For each bank, recapitalisa- However, there are a few exceptions, such as Spanish thus Singapore banks are well-capitalised and can cope with a vember 23 bailout, noted above, Citigroup has agreed to pay tion involves the issuance of 12 per cent preference shares to banks, on which the subprime crisis has had limited impact financial crisis and brand damage control may also prove to a dividend that would not exceed $0.01 per share for three the government and the issuance of ordinary shares under- so far. BBVA and Banco Santander have maintained their be crucial. years effective from the next quarterly dividend payment. The written by the Treasury. While the preference shares remain dividend policies, outperforming the majority of their ­European agreement also provides that an executive compensation plan, outstanding, participant banks are precluded from paying counterparts. Santander has so far been regarded as an India including bonuses, must be submitted and approved by the dividends on ordinary shares. example in the industry with its selective acquisitions policy State-run banks in India account for 70 per cent of assets and US government. RBS’s substantial funding gap led it to seek £20bn, £5bn of and its ­business relying heavily on retail banking, risk quality, liabilities, which requires the banks to hold nearly a third of Bank of America reported a 68 per cent decrease in its third which is in preference shares. The group says that ­operating ­geographic diversification. their deposits in government bonds and cash reserves with the quarter net income to $1.18bn and, consistent with Markit’s cash flows will dictate how soon the preference shares are Elsewhere in Europe, Fortis, ING and KBC Group were Indian central bank. This more conservative approach seems to forecast, BofA announced a 50 per cent dividend cut to $0.32. repaid (and dividends resumed). The ordinary share issue could among the banks requesting capital injections from the Dutch be the factor that shelters Indian banks from the direct impact Additionally, nervous customers looking for a safe bank in- see the Treasury owning 58 per cent of RBS. and Belgian governments, which have bought core Tier 1 of the global credit turmoil. creased BAC deposits by $21bn during the third quarter. Both Lloyds TSB and HBOS are seeking £5.5bn and £11.5bn ­securities entitled to coupon payments should the banks However, even though Indian banks have a small exposure helped increase its Tier 1 capital ratio up from 7.5 per cent to r­espectively, which could result in the Treasury holding a 43.5 ­decide to resume dividends. to the western financial world, comments about the future of 8.0 per cent. While BofA is still digesting the massive acquisi- per cent stake in the enlarged group. Post-merger, once The German government introduced a banking rescue Indian banks need to be made cautiously as the global banking tions this year, including Merrill Lynch, we expect the bank Lloyds-HBOS is able to recommence dividends, a 40 per cent package worth €500bn with restrictions including caps on sector is still in the storm. The fate of Indian banks in the near to maintain the dividend at the reduced amount of $0.32 for payout ratio will be targeted. ­executives’ salaries of €500K, no bonuses and no dividend future seems to be tied closely with the credit quality. 2009, saving approximately $1.5bn per quarter. Barclays has once again chosen to buck the trend, and payments. While Deutsche Bank has so far avoided applying to State Bank of India, the largest in India, and the only Indian JPMorgan’s acquisition of Washington Mutual is expected is raising £7.3bn without government support. Instead, a the state plan, no dividends for this year or next are expected bank appearing in the Fortune Global 500, has become one of to create long-term value for shareholders while also being im- ­combination of convertibles, perpetual securities and ­warrants for Hypo Real Estate, which first applied for funds worth the very few outstanding: profitability grew 40 per cent for the mediately accretive, adding $0.50 per share to 2009 earnings. will be offered to private investors. The board will also forgo €15bn, nor for Commerzbank which will receive €8.5bn. quarter ending September while huge losses were reported by Its net income dropped to $527m for the third quarter from paying its final dividend. Dividends are expected to be French banks will receive liquidity through a €265bn fund western banks. $3.4bn in the same period last year. However, JPM is expected ­resumed in 2009, payable on a quarterly basis. guaranteed by the government. The state will not take any The breakdown of SBI’s financial results shows the growth to maintain its comparatively high Tier 1 capital ratio at 8.9 per HSBC and Standard Chartered have both confirmed their stake and the impact on dividend policies for the banks of loans is well above 20 per cent. This signals danger and SBI cent, mainly thanks to its $11.5bn capital raise, and keep its capital positions and liquidity, adding that recapitalisation ­accepting this plan should be very limited. We have lowered has thus increased the funds for delinquencies on loans more dividend at its current level of $0.38 per quarter. is not required. Both banks have a strong presence in our estimates further over the last weeks to reflect the bleak than sevenfold to Rs6.1bn. The last two major investment banks in the US, Goldman ­emerging ­markets, where performances in this year have outlook but we consider that banks will still be able to pay Sachs and Morgan Stanley, saw their applications to become remained strong. reduced dividends. Reino Truumees, head of global dividend research, Markit bank holding companies approved on September 21. The That said, HSBC reported recently that revenue growth Swiss UBS will receive government capital injections and conversion allows for a large deposit base and permanent ac- has slowed in Hong Kong and margins in the rest of Asia are confirmed no dividends for 2008 while Credit Suisse will raise cess to borrow money from the Fed, although stricter capital being eroded as economic growth moderates. The current money from private investors. requirement regulations will also be applied. ­expectation is that that there will be a slowdown in Lastly, Icelandic banks are among the worst hit by the crisis

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European CMBS (3-5 yr WAL)

1,800 CMBS AAA Structured Finance 1,600 CMBS AA 1,400 CMBS A

) 1,200 The outlook for European ABS worsened during October as 1,000 CMBS BBB ­defaults and credit rating downgrades increased. Spreads 800 reached record wides and cash prices fell to distressed levels as Spread (bp 600 400 bids disappeared across countries and market sectors. 200 The recent market on two prominent UK deals, Permanent Mas- 0 ter Trust and Leek Finance 18, provides an example of a disconnect Oct-07 Dec-07 Feb-08 Apr-08 Jun-08Aug-08 Oct-08 between pricing and collateral quality. The Leek non-conforming European Auto Loan/Equipment Lease ABS

RMBS deal saw noticeable ­deterioration year to date which has 1,800 Auto Loan AAA ushered in new wides with no ­surprise; 90+ day ­delinquencies 1,600 Float (1-4) 1,400 Equip Lease AAA more than doubled from the end of last year’s 3 per cent to the 6.9 Float (1-4) ) 1,200 per cent observed in August’s ­investor ­reporting. However, when 1,000 Auto Lease AAA Float (1-4) 800 comparing the starkly ­superior ­collateral performance of the UK Auto Lease A Prime RMBS ­Permanent Master Trust to its observed spreads, we Spread (bp 600 Float (1-4) 400 Equip Lease BBB remain with a similar picture. While the deal continues to perform, 200 Float (1-4) spreads on the AAA, 5A class ended October in the mid 400 basis 0 Auto Loan BBB Oct-07 Dec-07 Feb-08 Apr-08 Jun-08Aug-08 Oct-08 Float (1-4) point range though throughout the previous quarter spreads did not breach 200. As investors act less on the ­forecast of ABS collateral, Source: Markit it is a lack of buyers driving new record wides.

LEEKFIN18 18 A2a GBP vs PERMANFIN9 9 5A GBP (fix/floating) and currency swap counterparty which put­pressure on

700 8 Spread such securities holders. This is especially true if the hedge is needed Leek (bps) 600 7 at the payment date. Additional risks Lehman brought to the syn- 6 Spread 500 Permanent (bps) thetic ABS market upon its default included the need for rehedging ) 5 400 from its counterparties of all short positions held against the firm. As % 90+ day 4 delinquencies 300 firms previously facing Lehman sought out new dealers, the synthetic 3 Leek (%) Spread (bp 200 market pushed wider than any ­widening seen on cash. 2 90+ day delinquencies 100 Mortgage bond spreads remained the widest in Spain and the 1 Permanent (%) 0 0 UK and tightest in the Netherlands. House price indices explain Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08Jul-08 Oct-08 these trends. The Halifax House Price Index for the UK showed a Source: Markit 13.7 per cent year-over-year decline in October.

European AAA RMBS (3-5yr WAL) When reviewing the AAA-rated UK non-conforming ­mortgage 1000 UK SPRMBS 900 bond sector more broadly, some names are found to be traded UK PRMBS 800 below 40 cents on the dollar. This is not only due to the poor 700 Spanish RMBS ) 600 quality of the collateral that backs these deals, but because Italian RMBS 500 there is an absence of buyers in the market. In an expected 400 Portuguese RMBS Spread (bp worst case scenario, investors in a $100m deal with senior notes 300 Dutch RMBS 200 having a 25 per cent credit enhancement and a 60 per cent Irish RMBS 100 ­recovery rate, investors should expect to lose 15 per cent of 0 French RMBS their principal if they bought bonds at par. Oct-07 Dec-07 Feb-08 Apr-08 Jun-08Aug-08 Oct-08 But of course, actual recovery rates remain unknown Source: Markit ­until they are realised and expected recovery rates will vary ­depending on individual assessments of the future of the On the other hand, central bankers have already started to ­housing market, a key variable at this point. drastically lower interest rates and the Troubled Asset ­Recovery To date, residential mortgage-backed securities have been Program in the US could perhaps become ­profitable. In­Europe, the biggest losers of this financial crisis. The commercial the Spanish government is taking action at the borrower level ­mortgage and car loan ABS sectors have also come under by allowing some families to delay half of their monthly payment ­pressure on concerns about a possible recession. for mortgages from January 1 until December 31 2010. These Following the bankruptcy of Lehman Brothers, a new risk ap- ­developments should ultimately benefit borrowers and bring peared affecting cash and synthetic ABS investors. ­Lehman Brothers buyers back to the property and ABS markets. was present in many deals as an interest rate swap Philippe Pagnotta, vp structured finance, Markit

the markit magazine – Winter 08