/6 Talking Business

Nouriel Roubini – Résumé Present Roubini Global Economics, co-founder and chairman New York University’s Stern School of Business, professor of economics Crisis Economics: A Crash Course in the Future of Finance to be published by Penguin (2010) 1998 - 2000 White House Council of Economic Advisors, senior economist for International Affairs US Treasury Department, senior advisor to the Under Secretary for International Affairs

Dr Roubini has published more than 70 policy papers on international macroeconomic issues and co-authored Political Cycles: Theory and Evidence (1997) and Bailouts or Bail-ins? Responding to Financial Crises in Emerging Markets (2004). He holds a PhD in economics from Harvard University.

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Nouriel Roubini, the US economist, believes quantitative easing is a necessary evil and that crises are becoming more frequent and damaging Crisis? Which crisis?

Q: Since the start of the global credit crisis, governments I think recent opposition to QE2, especially those that around the world have injected an unprecedented have said it is a disaster, is totally wrong. Given the high amount of liquidity into the global economy. The risk of a double dip recession, ask yourself where would initial experience of quantitative easing suggests that the economy and risky asset prices be today if this had the increase in liquidity is positive for risky assets. not been done. Asset price reaction had already priced in However, the impact on the real economy is less QE2 from Bernanke’s speech in Jackson Hole well ahead clear. Do you think it has been effective in stimu- of the actual implementation. The stock market is about lating growth or should the Federal Reserve be taking 10 per cent higher. another approach? Roubini Global Economics wrote a paper concluding that another round of QE was appropriate; we even got A: Economic growth in the US and most developed econo- the $600bn estimate correct a couple of weeks before the mies is anaemic and below expectations. Measures of announcement. Unfortunately, the real economic effects inflation, both core and headline, are below the implicit and of this move are going to be modest at best. QE2 should explicit targets of the Federal Reserve. The scenario is low push industrial output next year from the baseline by only growth, low inflation and an unemployment rate close to about 0.2-0.3 per cent. We believe that potential growth 10 per cent. If one were to run the numbers, you get that should be about 3 per cent and the baseline is 2 per cent. the Fed Funds rate (FFR) should be around minus 5 per We also believe that 2.2-2.3 per cent growth is still below cent, but nominal policy rates have a zero lower bound. potential and thus there will still be deflationary pressure. Quantitative easing (QE) by the US and other governments The unemployment rate, when you include the under- has been increasing liquidity to effectively push the real employed, is effectively 17 per cent. The recent increase policy rate below zero. Some $600bn of additional liquidity of 150,000 jobs is not truly good news; it is only sufficient in QE2 is the equivalent of a reduction of about 50-60 to match pace with new entrants into the job market and basis points in the FFR. When Ben Bernanke says this is to prevent the unemployment rate from going higher. It just a variant of traditional monetary policy, I think that is does not bring it down. Labour has no bargaining power; correct, even if unconventional. if anything, employees are accepting lower wages just

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“ The concern about QE2 causing inflation is nonsense. How can you have inflation when there is such a slack in resources?”

to keep their jobs. Wages are growing less than produc- 6 per cent without proper guidance, so the markets expe- tivity and unit labour costs are falling. With labour costs rienced a shock. The Fed learned that lesson. As long as it comprising 70 per cent of production costs, this is essen- makes its intentions clear and takes a measured approach, tially fiscal deflation. exiting can be done properly. We should fight the wars of the The concern about QE2 causing inflation is nonsense. present and not the ghosts of the future. How can you have inflation when there is such a slack in resources? Base money has more than doubled in the Q: What is your assessment of the austerity measures US but M1, M2 and M3 credit growth is negative because that many European countries are taking to tackle banks are hoarding money. Regardless of the reasons, their deficit troubles? banks are not lending. Thus, there is no multiplier effect and it is not inflationary. If banks have not lent the first trillion A: Currently, every advanced economy is running a fiscal dollars of QE1, why would they lend in QE2? This is why the deficit which is eventually unsustainable. In the fourth real effect is limited. While I am not particularly sympathetic quarter of 2008 and the first quarter of 2009, global to QE2, it should reduce the tail risk and help prevent a economic activity was falling at a faster rate than between double dip. Quantitative easing is a necessary evil. 1929 and 1931. Massive fiscal stimulus in the form of payments, tax cuts, etc. reversed the freefall. Fiscal Q: Many governments have indicated a strong desire stimulus was necessary to avoid a depression. To save to begin removing some of that liquidity but have yet Main Street, the government had to bail out Wall Street, no to do so in a meaningful way due to concerns about matter how unpleasant that may be to the public. I am the deterring economic growth. What conditions do we first one to be critical of some of the excesses of those bail- need to see before the Federal Reserve can start to outs, but those who argue that we should have let destruc- remove liquidity? Do you think the conditions and tion take place by leaving things to market forces are timing are similar for the European Central Bank? misguided. Without intervention, there would have been a great depression. The rational thing to do today, assuming A: I think there will be more liquidity increases − after QE2, no political constraints or bond vigilantes, would be to plan there will be QE3, QE4 and QE5. This will be the case for long-term gradual cuts in spending backloaded over time. not just the US but globally. The European Central Bank Bond vigilantes in the eurozone periphery do not (ECB) is being really stubborn, but when there is a double care that those countries are in a recession. The finan- dip in the eurozone, they will add liquidity too. Draining cial markets are demanding that these countries make a liquidity was a popular topic of discussion six months ago, fiscal adjustment now or else lose access to the capital but not currently. We need to have growth for a number markets. Every study, including the most recent one done of years to take up the slack in the labour and goods by the IMF, suggests that austerity does not crowd in markets. It takes several years where growth is above growth, it crowds it out. Fiscal consolidation is deflationary potential to reduce the 10 per cent unemployment rate and recessionary. If the bond vigilantes demand it, then closer to the natural rate of 5-6 per cent. Unemployment the way to counteract it is through massive monetary must drop to 4 per cent before you see wage inflation. stimulus. The ECB should then be doing massive amounts Growth must be sustained at 4 or 5 per cent for three or of QE like the US, but it is resisting it. The result is the four years before tightening monetary policy would be peripheral economies will see a double dip (actually, they applicable. never really got out of the first dip), so it is an “L” rather Exiting is easy to do. Reverse repos or higher interest than a “W”. The euro is going to 1.40 from 1.20, which is rates on excess reserves and other technical tools to mop going to destroy any chance of recovery at the periphery. up liquidity are well known and available. Volatility in financial markets is feasible if the Fed is not careful in its approach. It Q: To what degree do you think the deficit situation for is easier to avoid volatility when the economy is growing fast many states and municipalities in the US resembles enough. In 1994, the Fed moved the rate from 3 per cent to that of European sovereigns?

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“ In terms of size of the problem, individual states in the US are in as bad shape or worse than some of the peripherals in the eurozone.”

A: In terms of size of the problem, individual states in the US EM within six to 12 months. Right now, a trigger to reverse are in as bad shape or worse than some of the peripherals the cash inflows is missing. in the eurozone. California and Illinois are good examples. Short $/long oil, short $/long gold, short $/long EM Some of the municipal spreads have widened but not yet currency, and short $/long EM equity or fixed income are far enough to cause the bond vigilantes to wake up fully. all basically the same trade. The correlations are close to The federal government has reduced some of the pain for one. It is the same idea. Once QE2 has fizzled and the real state and local governments via transfer payments. Some economy is not reacting, concern about double dipping in municipals are pursuing draconian fiscal adjustments the US will begin. The emerging markets are less liquid and similar to what is being done in Europe. the corrections tend to be more exaggerated. Municipal debt is 20 per cent of GDP overall, about $2,800bn. Additionally, implicit liabilities such as Q: The G20 round has just concluded with something state employee pension funds are estimated to be short of a formal agreement on currency targets. What $2,000bn-$3,000bn, another 20 per cent of GDP. We are the odds that a more binding framework will be put should ask if the federal government is going to guarantee in place to address current imbalances? any of this debt and, if so, to what extent? You cannot let states collapse as they are systemically important; A: There have been a lot of communiqués; essentially, we are however, the smaller cities, counties and agencies may be in a currency war right now. Every country cannot have allowed to fail to some degree. Let’s compare: Greece is a weak currency. The sum of all trade balances are zero. only 3 per cent of the eurozone GDP; California is one- We do not trade with Mars or the moon. Countries like the seventh of the US GDP. If Greece has implications for US and UK need real depreciation of their currency due global contagion risk, then so do many large states. to weak demand; the only way they can generate some growth is to depreciate the currency. The surplus countries Q: What investment opportunities do you see in the − China, Asia-EM, Japan and Germany − are either unable emerging markets? Are there any particular investment or unwilling to switch from being net exporters to net vehicles that you would recommend over others? importers. The currency war became a foreign exchange intervention war which became a QE war. Eventually, it is A: Emerging market (EM) recoveries are stronger than those going to be a trade war. of advanced economies for many reasons. Potential I do not think the G20 can do anything about it. China growth is higher; debt in the private sector is lower; fiscal wanted it both ways. They wanted to maintain a stable conditions are better; their banks are more sound, liquid value to the dollar and try to dump the dollar at the same and capitalised; and currencies are undervalued. However, time. That is mission impossible because the only way you this is not the case for all of them. Several Central and can maintain a peg to the dollar is to intervene aggres- Eastern European countries faced severe recession and sively. China tried to outsource the intervention by buying have financial problems. Due to the liquidity injections by Japanese bonds, yen and Korean won. This action irri- Western nations, significant capital has flowed to EMs tated the Koreans and Japanese, who then started to pushing up asset prices. The valuations are becoming intervene to retaliate. stretched. Price-earnings ratios and bond yields suggest To counteract Chinese intervention, if the Chinese are overvaluation in many cases. In my view, capital inflows trying to keep the renminbi weak, it is for the US to buy have not been discriminatory. Money is just chasing yields. renminbi and sell dollars. Capital controls and lack of a In South Africa, the currency increased by 30 per cent deep, liquid renminbi debt market make this impossible. yet growth is anaemic at 3 per cent. They have social and As the US is running a half-trillion current account deficit, labour strife and their current account deficit is rising. another country or countries need to be lending the US Market fundamentals compared with Asia are quite weak, these funds and own dollar assets in exchange. Between yet their stock market is near an all-time high while the the two evils of dumping the dollar and maintaining the bond yields keep on falling. There is the risk of a bubble in financing of the US, the latter is the lesser evil. For China

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“ The US needs a weaker dollar to promote export growth. We can no longer persist in being the consumer of first and last resort and have China be the producer of first and last resort.”

as well as the rest of the world, nobody can afford to pull 8m homes are at 95-100 per cent loan-to-value (LTV) ratios; the plug on the dollar. It becomes a game of hot potato an additional 5 per cent price drop puts them into nega- with everyone trying to pass off the intervention. The US is tive equity. The worst of the housing crisis is not behind trying to weaken the dollar via QE; everyone else is using us − it is ahead of us. There is a study by Laurie Goodman intervention to do the same. The intervention war has of Amherst Securities that focuses on prime mortgages. become a QE war. Forget about subprime or option adjustable rate mortgages where default rates are already 95 per cent. Take a state Q: What is your view on Congress’s recent action where unemployment is about 10 per cent (most US states regarding tariffs on Chinese imports? are above that now). Assume a loan-to-value ratio of 120 per cent. Today, the current default rate on prime mort- A: The US needs a weaker dollar to promote export growth. gages is 18 per cent. If you plug the numbers, the result We can no longer persist in being the consumer of is that 11.5m more mortgages will default in the next four first and last resort and have China be the producer of years. Previous estimates were 4m. If the average mortgage first and last resort. As we are spending more than our is $200,000 and you lose 50 per cent of that in foreclosure, income and running a trade deficit, we need real depre- then conservative expectations are for a further $1,500bn of ciation of the dollar. With both China and countries that losses ($100,000 x 11.5m homes). do not want to lose market share to China resisting dollar depreciation, the dollar cannot fall as much as needed Q: In the US, inflation seems to be quite tame for the and an effective currency war exists. The risk is degen- moment. In fact, some observers seem to be more eration into a trade war. I am not in favour of trade wars, concerned about deflation. Meanwhile, a lot of but if currency imbalances persist, nations may act to commodity prices are at relatively high levels histori- preserve their own firms. cally. What is driving the disconnect between high The tariff legislation has already passed in the House. It commodity prices and low inflation? Is it simply a still has to pass the Senate and be signed by the Presi- cloudy economic outlook combined with supply and dent. Everyone needs a weaker currency in a world where demand problems or do you see something more than there is not enough domestic demand. this at work?

Q: What is your outlook for the US property market? A: The first stage of rising commodity prices arose from global economic recovery and for non-fundamental A: The housing market is already double dipping. We have reasons. Oil rose from $70 to $148 in summer 2007 to artificially boosted demand for six months with the first- summer 2008. The 2008 financial crisis created a shock time homebuyers’ tax credit. As soon as it expired in April, to real disposable incomes; oil dropped to $30. Current demand collapsed again. The tax policy stole all the year’s fundamentals suggest a price of $65 to $75. Post-QE2, upcoming demand and front loaded it into April. While oil increased another $10. This level does not jeopardise demand is stalling, supply is increasing since the fore- recovery. Part of the inflated oil price is explained by a closure moratorium essentially delayed those homes from weakening of the dollar, but the net effect outside the entering the market. Prices will fall another 5-10 per cent US is small. Right now, US producers have fat margins above the realised 30 per cent drop. The improvement in and can absorb increased commodity costs. Weak the Case-Shiller index was only temporary. demand hinders their ability to pass these rising costs to Housing prices are declining again. There are 12m consumers, so there is minimal current inflationary impact houses that are under water with negative equity. Another from commodity prices rising. Not all the elevation in

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“ Most crises have the following things in common: economic and credit booms followed by asset bubbles, overspending, current account deficits and currency imbalances.”

commodity prices is based on the macro-liquidity story, have done so for the last 400 years. Financial crises have some is micro-based. For example, the drought in Russia occurred when there were central banks, when there were has raised wheat prices. no central banks; when there was fiscal stimulus, when Elevated commodity levels do not necessarily indi- there was no fiscal stimulus; when governments meddled cate inflation has reared its ugly head. Commodity price in policy, when they have not, etc. Booms and busts were increases can actually have a deflationary effect under the actually much worse when there were no central banks. right circumstances, which is occurring now in advanced At least now we can smooth the business cycle through economies. While there is a cost effect, there is also a real fiscal and monetary policy and backstop the financial disposable income effect in terms of trade that reduces system when excesses do occur. purchasing power and consumption. So those that say “let’s go back to the gold standard” The 1970s were different. There was stagflation are basically saying “let’s go back to a time when we because there was a negative supply side shock. In the had depressions every decade”. Between 1870-1913 Yom Kippur war, oil prices tripled overnight. In the Iranian we had four major depressions. So much for the gold Revolution, oil prices doubled. This time around there is standard! no negative supply side shock; there is a negative aggre- gate demand shock, because of the housing bust and Q: As a professor at NYU you have taught classes on credit bubbles. macroeconomics to graduate students. What topics do you focus on in the classroom? How does your Q: You served as the Senior Economist for International approach to analysing economies and the financial Affairs on the White House Council of Economic Advi- markets at Roubini Global Economics differ from what sors (1998-2000) during the Asian financial crisis. To you teach your students? what degree do you see similarities between those times and the most recent financial crisis in 2008-9? A: I am currently on sabbatical, but the course I have been teaching is for both undergraduates and business school A: Most crises have the following things in common: students. It focuses on international macroeconomic economic and credit booms followed by asset bubbles, policy and crises. I emphasise tail risks, a subject that I overspending, current account deficits and currency teach in the classroom and that we use in our research at imbalances. They also have idiosyncratic differences. The Roubini Global Economics. US was mostly a property bubble. Asia was a combina- You could have picked the best firm in the best sector tion of a property and equity bubble. The US technology of the Argentinean economy during the 2001 Argentina bubble in the 1990s was an equity bubble. crisis just like you can pick the best fruits from the best Crises are not black swan events, to reference Nassim section of an entire forest that is burning. Virtually every- Taleb. I would call most financial crises white swan events thing went wrong there: currency crisis, sovereign debt as they are predictable outcomes of macroeconomic and crisis, systemic housing crisis and systemic banking crisis. financial policies, vulnerability in excesses. Black swan You need a macroeconomic picture, even if you take a events are an outcome of a random distribution with a fat bottom-up approach. tail. They are random and unpredictable like an earth- Crises are not once in a lifetime events or one in 20 quake. This is not the case with financial crises. standard deviation events. They are not once every 100 There is almost no memory in the financial markets. years, but tend to occur in different places about every The traders today were generally just kids during the other year. In fact, they are occurring more frequently and Asian financial crisis. These patterns tend to recur and are more damaging due to increased financial integration.

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Source: Getty Images 12 markit markit your hand your in China magazine Focus: US and China-related Investment Opportunities Investment China-related and US Focus: – Winter 2010 Winter –

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The days of low-hanging fruit may be over, but certain sectors could offer investors room for considerable growth, writes Lawrence Carrel

nvesting in China will continue to be it must focus on boosting internal profitable for the foreseeable future consumption by stimulating the growth but China faces numerous prob- of new service industries and moving Ilems, both economically and socially, from low-cost to high-end manufac- as it seeks to continue its growth and turing as other Asian countries begin to become a premier global financial undercut its labour costs. centre. “Almost every single thing has come So ran the message at the 16th to a tipping point. China has to change,” annual conference of The Chinese said Lei Zhang, president and founder Finance Association (“TCFA”) in New of Hillhouse Capital Management, one York in October. The recurring theme of China’s largest investment funds, with of the conference was that China $4.2bn in assets under management. cannot rely on exporting cheap goods, “Every single factor driving the China especially to the US, to continue fuel- story is now past its peak. There needs ling its fast-growing economy. Instead, to be a realisation about the Chinese

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economy. The days of low-hanging fruit gross domestic product grew 9.6 per are over. We think the Chinese economy cent from the year before, but slowed will see much slower growth and the from the first quarter’s 11.9 per cent economy will become more cyclical.” Of growth and the 10.3 per cent seen in course, even if you slow a jet down from the second quarter. 500mph to 450mph, it is still going very A lot of that growth came from fast. exporting cheaply manufactured prod- ucts to the US. But, with US demand Economic growth likely to slow down expected to remain weak as the country In the three decades since Deng comes out of its financial crisis, Zhang Xiaoping tossed Communist orthodoxy said China could not expect American overboard in favour of free market consumers to buy Chinese goods as reforms, China’s economy has grown they did in the past. Stephen Roach, more than 10-fold. Earlier this year, non-executive chairman of Morgan China passed Japan to become the Stanley Asia said he believed Americans second-largest economy in the world would pay down their debt and start and many experts expect it to over- saving money, in spite of another round take the US economy by 2030. The of quantitative easing by the Federal Chinese government has since begun Reserve and more deficit spending from taking steps to slow down its red-hot Congress. economy, with measures such as the “This will have repercussions for Stephen Roach, non-executive chairman, October interest rate hike. China,” said Roach. “China’s problem Morgan Stanley Asia Economic growth will slow down, but is under-consumption.” While personal not drop sharply, Daochi Tong, director- consumption in the US is 71 per cent of has served China well for the past 30 general of the China Securities Regula- the gross domestic product, in China years, said Roach, pointing to trade fric- tory Commission, said. He added that it is 36 per cent. Roach believes this tions and the remnants of the financial further interest rate hikes in the short imbalance was unsustainable. crisis. Strong signs pointed to changing term were unlikely and were restrained the economic model to one based on by low rates in the US. Meanwhile, Domestic consumption needs to grow internal demand, an area where growth inflation was peaking, but would not The next 10 years will present very stiff is extremely low. Just days before the fall sharply. In the third quarter, China’s headwinds for the export strategy that conference, the Chinese government released an outline for its 12th five-year economic plan that said it should focus more on domestic consumption. Such a move would create a more balanced and sustainable economic growth model. Currently, the largest driver of the Chinese economy is asset investment, followed by government spending, with exports the third-largest driver and personal consumption at the bottom. “I would like to see China be more aggressive in implementing a policy to drive personal consumption from 36 per cent to 45 per cent of GDP over the next five years,” Roach said. He targeted seven industries that would boost China’s internal consumption: “I would like to see China be more aggressive energy-efficient cars, environmental remediation, wholesale trade, retail in implementing a policy to drive personal trade, supply-chain logistics, hospi- consumption from 36 per cent to 45 per tality and leisure. He said a focus on developing large-scale service indus- cent of GDP over the next five years.” tries would “significantly” help China in

the markit magazine – Winter 2010 Focus: US and China-related Investment Opportunities /15 creating new sources of jobs. Currently, China’s services sector is around 40 per “We are great believers in China and in wind cent of GDP, or about half that of the US. power and it has become the leader in wind Roach also said the government needed to provide robust support for power technology. While the US talks about low-income rural families by means of it, China, in my opinion, has done a much tax reform, land reform and investment to help relocations to urban areas in better job of achieving it.” search of better jobs and wages. He recommended that China invest aggressively in a social safety net in order to stimulate domestic demand and focus on four things: social secu- rity, private pensions, unemployment insurance and medical insurance. Increasing the safety net would give the Chinese the confidence to lower their precautionary savings rate for retire- ment and raise their consumption. Building a large-scale services industry would boost labour absorption, while supporting rural household incomes, bringing about a more harmonious society. Currently, the Chinese save about 20 per cent of their income compared with Americans who save about 5.8 event. Ross has been investing in China energy sector, Ross expects electric per cent, according to Wilbur L. Ross, for years and has built a number of utilities to surge. With rural areas getting chief executive of WL Ross and one of automotive and textile factories in the electrical power for the first time, he the best known private equity inves- country. Ross believes that the indus- sees demand for electricity growing tors in the US. This high savings rate tries set for the most growth over the faster than the broader economy. His was the result of an aging population next five years are energy infrastruc- firm has formed a joint venture with with little in the way of an institutional ture, healthcare and technology. In the China’s largest electric power generator, safety net. Rural workers save about Huaneng Power, to fund investment in 23 per cent of their income, while the China’s clean energy infrastructure such higher-income urbanites save 28 per as wind farms. cent. Roach added that until the funding “We are great believers in China and levels in social safety nets picked up, in wind power and it has become the Chinese families would continue to save leader in wind power technology,” Ross out of fear of having nothing in their old said. “While the US talks about it, China, age. “However, if China does half of in my opinion, has done a much better these proposals, there will be a signifi- job of achieving it.” cant shift away from exports to internal Ross also picked technology to be a consumption,” he said. Ross thought growth industry as China moves away that consumption growth might also be from simple, low-cost products to more driven by expansion of consumer credit. value-added products. Finally, he sees He pointed out that only 10 per cent of the healthcare industry exploding, as Chinese cars are purchased with credit, China’s aging population requires the compared with 90 per cent in the US. delivery of more healthcare services. US companies are already taking Where to invest advantage of investment opportunities China still offers many investing oppor- in China. Ross said many US compa- tunities, said Ross in an exclusive nies have diversified overseas to such interview with Markit during the TCFA Wilbur L. Ross, chief executive, WL Ross an extent that more than half their

Winter 2010 – the markit magazine /16 Focus: US and China-related Investment Opportunities

invests in high-growth private compa- “The government is determined to develop nies in China. Most of the firm’s funds an alternative energy sector and deploy come from private entrepreneurs, while a third comes from the Chinese govern- energy-efficient technologies. China’s ment and related entities. Wu said the desire to invest around 4,000bn renminbi in three sectors he believed would experi- ence the fastest growth were financial renewable energy technology provides an information and services, the sustain- able environment industry and high-end example of opportunities available.” manufacturing. “The central government has announced a plan to turn Shanghai into an international financial centre by 2020,” said Wu. “And we think there are a lot of interesting investment opportu- nities in the information sector.” One of his firm’s top investments is Wind Infor- mation, the largest provider of finan- cial data and information services in earnings come from non-US sources. living in emerging markets means more China, serving more than 1,500 top-tier He said 54 per cent of the products commodity consumption. While values financial institutional clients. Of course, exported to the US from China were and prices would remain cyclical, Ross having the government as an investor from companies in which Americans said there was a strong secular growth has its advantages. Wind counts as its owned an interest. Most well-run US trend for higher prices in the future. clients 100 per cent of the local fund companies are global, said Ross, management firms and 100 per cent of emphasising that it is hard to find a Booming private equity the national commercial banks. Areas Fortune 500 company today that solely Hao Wu, president of TCFA, agreed with where Wind does not have a complete depends on the domestic market. Ross on most of his points. Wu is the lock on the market include domestic Ross was also very bullish on co-founder and partner of the Sino- securities firms of which only 85 per commodities as rising standards of Century Private Equity Partners, which cent use the provider’s information; qualified foreign institutional investors, where it has a market share of 75 per cent; and just 60 per cent of the local insurance companies. The Chinese Finance Association “China is facing enormous environ- mental challenges and energy short- he Chinese Finance Asso- organises the annual conference, ages,” said Wu. “The government is ciation (TCFA) is one of the its flagship event, to facilitate the determined to develop an alternative most successful and longest- exchange of ideas, knowledge and energy sector and deploy energy- T running Chinese professional information on education, research efficient technologies. China’s desire organisations in the world. It has more and financial market practice between to invest around 4,000bn renminbi in than 2,000 members worldwide, the US and China. It brings together renewable energy technology provides many of whom work at major invest- scholars and professionals in an effort an example of opportunities available.” ment banks, money management to help the development of China’s In the sustainable environment industry, firms, universities, research institutes, capital markets. More than 800 people Sino-Century invests in providers of governmental regulatory bodies and attended this year’s conference, an alternative energy sources, producers other financial services organisations. all-time high. TCFA also helps its of energy-efficient technologies and It was founded in 1994 and is head- members in their career development. the water treatment industry. Wu said quartered in New York with local chap- Many TCFA members have returned his firm was investing in Chaori, a solar ters in Boston, Washington DC, San to China after working on Wall Street energy company. Francisco, Chicago, London, Hong and now hold important positions in Finally, as wages increase, China is Kong, Beijing and Shanghai. government regulatory bodies and the losing jobs to countries with even lower The all-volunteer association Chinese financial industry. labour costs, such as Vietnam, Laos and Bangladesh. Wu said China needed

the markit magazine – Winter 2010 Focus: US and China-related Investment Opportunities /17 to move away from low-end manufac- turing, of products such as toys and “China is being vilified for problems that are shoes, and move into high-tech manu- our own doing.” facturing such as computer chip design and electronics instead. “The Chinese economy is expected to grow robustly over the next five years,” said Yibing Wu, president of Citic Private Equity Funds Manage- ment, a unit of Citic Securities, China’s largest listed broker. Wu said that China’s nominal gross domestic product, which was $1,800bn in 2004 and $4,600bn in 2009 will grow to $8,100bn by 2013. Wu said private equity investing in China was one of the fastest growing areas of the economy, but the overall penetration was very low at just 0.2 per cent of gross domestic product. He said private equity investment would continue to be driven by the govern- ment’s efforts to transform state-owned Challenges ahead the Chinese save too much and do not enterprises as well as China’s growing Of course, it is not all a bed of roses spend enough. demand for investment capital. Wu for China. The relationships between As the concept of a Chinese middle highlighted that China’s fastest-growing China and its biggest customer, the class becomes reality, it sparks the sectors were financial services, energy US, has its share of difficulties. In the potential for explosive growth in resources and basic materials, manu- wake of a massive trade imbalance, the consumption and pulls along the low- facturing and consumer retail. political rhetoric points to a trade and/ income, rural people desperate to partic- In particular, Wu said that because or currency war. In an effort to make US ipate in the country’s economic growth. of the relatively low penetration of the goods more competitive, and retali- The income disparity 20 years ago financial services industry in China ation for China’s refusal to revalue its was three to one in favour of the urban compared to its more developed peers, currency, the US House of Representa- residents, said Ross, now it has grown the industry would be a key beneficiary tives in September voted to impose to five to one. With 150m people living of the country’s economic growth and greater tariffs on virtually all Chinese below the poverty line, this is a big a suitable investment for large funds. imports. reason why people move to the cities. The drivers behind the energy and basic “It’s bad economics and bad poli- To absorb the large numbers of people materials sector’s growth would be tics,” said Roach. He strongly advised moving to urban areas, manufacturing China’s continuing trend of urbanisa- the Chinese to hang tough on their must expand rapidly. Ross said China tion and industrialisation. More factories currency and not give in to the US’s needed to grow 6 per cent a year just to will increase demand for energy and demands. Frustrated at the nation’s absorb the migration. resources. Wu said China’s manufac- high unemployment rate, US politicians The biggest risk to social stability is turing sector would also benefit from blame China for American jobs being wealth distribution. If people get upset this trend. shipped overseas. Roach said tariffs about the income disparity, there will be Finally, Zhang said you did not would result in China not buying US social unrest, which could hurt stock necessarily have to invest in China to goods or Treasury bills, while leaving and property markets. When the reces- benefit from China’s economic growth. the US public with higher priced goods. sion hit, the Chinese government took Sometimes the best way to express an Even then, the jobs would not return action to defuse any disaffected unem- investment point of view is to put money to the US, but go to another low-cost ployed in the cities by sending people into a country that is benefiting from country instead. back to rural areas. China’s growth, such as South Korea or “China is being vilified for problems that So, should things get out of hand, Indonesia. Zhang said that 40 per cent are our own doing,” said Roach, bringing “one good thing about the Chinese of his firm’s assets are invested outside it back to the fact that Americans spend government is it can act decisively”, the Chinese mainland. too much and do not save enough, while Ross said.

Winter 2010 – the markit magazine Focus: An EM by Any Other Name /19

The term ‘emerging markets’ is past its use-by date. Stacy-Marie Ishmael of FT Tilt suggests an alternative What’s in a name

sell-sider told me recently: as different from each other as CPDOs developed of nations, consistently “No matter how complex the were from C-3PO. ranks lower than China on measures of product, if you can come up There is now an industry devoted its citizens’ profiency in mathematics A with a snappy name, you can to flogging Brics, and the conference and science. Indeed, in October, sell it.” (See also: CPDOs). That has organisers, publishers, talking heads Chinese engineers built the fastest certainly been the case with emerging and fund managers who enthusiastically supercomputer in the world – much to markets, a phrase first coined nearly 30 trade on the name owe a debt of grati- the dismay (and shock) of their Amer- years ago by Antoine van Agtmael. The tude to Goldman and O’Neill. ican peers. financier, at the time an economist at The success of the term Brics, like It can also be a patronising term, the World Bank, wanted to woo inves- “emerging markets” before it, has because as financial professionals in tors who might otherwise have been put encouraged the development of a these economies are fond of pointing off by the unwieldy “less economically host of other acronyms. For example, out, their infrastructure (think airports developed countries” or the politically- there’s Civets, which was first used in and public transportation) put their charged “Third World”. April 2010 by Michael Geoghegan, chief crumbling counterparts at JFK, Charles More recently, the general tactic to executive of HSBC, to refer collectively de Gaulle or the London Underground selling emerging markets as an asset to Colombia, India, Vietnam, Turkey and to shame. class seems to have been to come South Africa. Sane, for Sudan, Algeria, This is not to say that emerging up with ever snappier brand names. Nigeria and Egypt, has been floating markets are necessarily bastions of Goldman Sachs’ Jim O’Neill famously around since at least 2006. And let’s not technological progress or human flour- dubbed Brazil, Russia, India and China forget the infamous Piigs, for the more- ishing. Brazil might be the economic the Bric nations. In so doing, he managed or-less troubled economies of Portugal, powerhouse of Latin America, but it is to closely affiliate four countries Italy, Ireland, Greece and Spain. also home to tens of millions of favela While there are drawbacks to using dwellers and has one of the highest a term such as Piigs − not least of homicide rates in the world. which is that it is wildly unpopular with Given the increasing number of the citizens of the countries to which it benchmarks, these emerging markets refers − even the seemingly innocuous look more developed than not. “emerging markets” has come to be This calls for a spot of brand re- seen as démodé and even patronising. evaluation. So here’s a suggestion: The phrase is démodé, because by replace “emerging” with “tilt”, to better more than a few metrics – including reflect the reality that economic and finan- per capita income – some so-called cial power is tilting away from the US and emerging markets are more advanced Europe and towards Latin America, Asia, than their western peers. The US, the Middle East and, yes, even Africa. which likes to think of itself as the most Tilt markets – how’s that for snappy?

Stacy-Marie Ishmael – Résumé Stacy-Marie Ishmael joined the Financial Times in 2006 as a graduate trainee, shortly after completing a BSc in International Relations at the London School of Economics. On FT Alphaville, she honed her love for complex acronyms. In 2008, she moved to New York to establish FT Alphaville’s New York bureau and to lead the blog’s coverage of Wall Street. In June 2010, she was appointed founding editor of FT Tilt, an emerging markets focused service launching in January. Stacy-Marie Ishmael, founding editor, FT Tilt

Winter 2010 – the markit magazine /20 Focus: Emerging Market Currencies

A second round of quantitative easing by the Federal Reserve and G20 summit discussions have strong implications for emerging markets investors, write Manoj Pradhan, Rashique Rahman and Alan Taylor A tale of two worlds

eveloping market curren- attempts from EM central banks, the cies have been bearing the steady, albeit gradual, appreciation brunt of the US dollar decline. of the CNY and macro-fundamental DSince September, emerging moderation in the EM. market (EM) currencies have not been The sharp moves in $/EM have been appreciating as much as comparisons accompanied by significant inflows of against the dollar would suggest. In capital that could have destabilising fact, most EM currencies, particularly in macroeconomic consequences should Asia ex-Japan and Latin America, have they be withdrawn quickly. Hence the depreciated against the euro since then, recent increase in interventionist meas- even though most have risen against ures from Brazil, Colombia, Korea and the renminbi (CNY). elsewhere. In the near term, expect lacklustre In the medium term, however, EM performance of EM currencies thanks to currencies are likely to see sustained market anticipation of intervention nominal trade-weighted appreciation.

Manoj Pradhan – Résumé 2005 - Present Morgan Stanley, global EM economist 2009 - Present Queen Mary’s College, London, advisory board, department of economics and finance 2000 - 2004 SUNY Stony Brook, New York, faculty of department of economics 1998 - 2000 The George Washington University, Washington DC, faculty of department of economics Manoj Pradhan, global EM economist, 1997 World Bank, China and Mongolia department Morgan Stanley

the markit magazine – Winter 2010 Focus : Emerging Market Currencies Winter 2010Winter – the markit markit

/ magazine 21

Source: Getty Images /22 Focus: Emerging Market Currencies

Exhibit 1: Private Capital Inflows to Emerging Market Economies

$ Billions 1,400

1,200

1,000

800

600

400

200

0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010F 2011F Year F= Morgan Stanley Forecast

Source: IIF, Morgan Stanley Research Rashique Rahman, chief strategist and head of EM fixed income/FX strategy, Morgan Stanley Exhibit 2: EM Current Account Balance/GDP vs. Real-Effective Exchange Rate Rashique Rahman – Résumé 50 2009 - Present Morgan Stanley, chief strategist and head of EM BRL fixed income/FX strategy 40 2007 - 2009 RBS, head of global EM research & strategy 30 2004 - 2009 HSBC, head of global EM CZK RUB fixed income research TRY 20 IDR 2000 - 2004 Citigroup, senior EM strategist ZAR CLP THB 1996 - 2000 Deutsche Bank, EM strategy 10 CNY RON INR PEN SGD ILS MYR PLN HUF 0 -10 -5 0 5 10 15 20 Looking beyond short-term considera- -10 KRW tions, perhaps the most important trend we are likely to observe is sustained EM -20 currency strength. The prospect of favour­ ARS -30 able growth and strong capital inflows 2010 C/A (% GDP, MS Forecast) to EM economies in the medium to long term suggests strong trade-weighted Source: Morgan Stanley Research nominal EM currency appreciation. There are two channels of these flows − cyclical and structural. Though cyclical flows can be more volatile, structural flows can be more “sticky”. Both are likely to be strong in EM econ- omies in coming months. Cyclical flows represent push and pull factors that influence capital flows into and out of economies. Capital flows “ The prospect of favourable growth and can be portfolio-related flows as well as strong capital inflows to EM economies in foreign direct investment and commer- cial bank-related capital. These cyclical the medium to long term suggests strong factors include global liquidity condi- trade-weighted nominal EM currency tions, EM growth (return) prospects and considerations of macro­economic, appreciation.” policy and political volatility.

the markit magazine – Winter 2010 Focus: Emerging Market Currencies /23

Private sector capital flows to emerging economies, based on cyclical “ Private sector capital flows to emerging drivers, could be as much as $1,100bn economies, based on cyclical drivers, could in the next 12 months. Perhaps less appreciated by the be as much as $1,100bn in the next 12 market are the structural flows that months.” represent relative portfolio allocation shifts. These are driven by long-term portfolio allocation decisions that are less sensitive to cyclical factors. We estimate that a 2.5 per cent increase in allocation towards EM asset markets and Exhibit 3: Emerging Market Appreciation vs. Renminbi away from developed market assets – a realistic expectation over the next 12-18 (June 2010 = 100) months – represents $500bn. 111 EM policymakers are likely to face BRLCNY MXNCNY TRYCNY sustained and heavy capital inflows in ZARCNY KRWCNY TWDCNY coming months and, though we argue 107 a good deal of these flows will be more “sticky” in nature, we cannot rule out more assertive attempts at stemming 103 currency appreciation. Investors may want to focus on expo- sure to currencies where there is less 99 incentive to intervene. In spite of official proposals coming out of the G20, some 95 EM policymakers are likely to continue Jun 10 Jul 10 Aug 10 Sep10 Oct 10 to lean against sustained appreciation Date pressures – until a more co-ordinated and concerted effort at redressing Source: Morgan Stanley Research global imbalances is attained. This is particularly the case for coun- Exhibit 4: EMFX Intervention Scorecard tries running external deficits and with currencies broadly considered to be Chile overvalued. Exhibit 2 shows current Czech Republic South Africa account balances against a measure of Israel valuation – deviation of the real-effective Poland exchange rate (REER). We highlight the Malaysia Brazilian real (BRL), the Chilean peso Romania (CLP) and, to a lesser extent, the South Hungary Indonesia African rand (ZAR) in this regard. These Colombia currencies have also seen most appre- Taiwan ciation against the CNY this year. South Korea At the same time, the market is likely Turkey to test policymaker resolve in coun- India tries with external surpluses, particu- Peru Brazil larly those with currencies considered Thailand broadly undervalued, for example the Russia CNY and the Korean won (KRW) and, Mexico to a lesser extent, the Malaysian ringgit -10 -8 -6 -4 -2 0 2 4 6 8 10 (MYR), the Singapore dollar (SGD) and Increasing macro/market justification for Decreasing macro/market justification for the Taiwan dollar (TWD). strong-side intervention strong-side intervention The Morgan Stanley EMFX interven- tion scorecard suggests that some Source: Morgan Stanley Research

Winter 2010 – the markit magazine /24 Focus: Emerging Market Currencies

Exhibit 5: $/EM 3-Month At-The-Money Implied Volatility for external deficit/overvalued curren- cies, particularly relative to those with $ external surplus/undervalued curren- 30 cies. This is due to uncertainty as to USDTRY USDBRLV 28 how policymakers with external defi- USDZAR USDMXN cits and/or overvalued exchange rates 26 USDKRW intend to engineer the necessary adjust- 24 ment in the face of still rising capital

22 inflows to their countries.

20 QExport 18 The IMF-World Bank meetings and the more recent G20 finance ministers’ 16 summit in Korea have not produced 14 any game-changing strategies to ease 12 currency tensions. A statement from the G20 summit urged countries to 10 Jan 10 Mar 10 May 10 Jun 10 Aug 10 “refrain from competitive devaluation” Date and to use available policies to reduce current account imbalances. This may Source: Bloomberg, Morgan Stanley Research not defuse a potential “currency war” that Guido Mantega, Brazil’s finance minister, warned about recently. Fortu- EM countries have more incentive to be less resistant to foreign exchange nately, what seems to us to be an intervene than others. It ranks Chile, appreciation. While we think the Central inappropriate focus on current account the Czech Republic and South Africa Bank of Russia will be comfortable balances (particularly surpluses) did not as having those central banks with the with further currency strength, there produce any measures to cap these most incentive to intervene in currency are other reasons to expect the rouble balances via new rules. markets. Mexico and Russia have the (RUB) to remain weak for the next few least incentive. months. Another notable exception is Symptom or cause? Based on this analysis, we think the Singapore, as the Monetary Authority The concern about global imbal- Mexican peso (MXN) can outperform of Singapore has recently widened ances is not new, and there remains given that the central bank is likely to and increased the slope of its currency considerable disagreement over policy band, allowing for additional appre- prescriptions. One view (the Lawson ciation. Meanwhile, the South African doctrine) suggests that no policy action Reserve Bank and the National Treasury is needed if current account balances have highlighted concerns over the reflect rational decisions underlying strength of the currency. Intervention is private savings and investment behav- costly but we think the authorities will iour, while the IMF approach advocates continue to lean against the wind. policy action. Like most pragmatic solu- We see still-elevated EM currency tions, the answer probably lies in the implied volatility as central banks remain grey area. According to Olivier Blan- interventionist. Furthermore, the EMFX chard, IMF chief economist: “Current volatility model indicates that EM volatility global imbalances appear to come is cheap. We expect realised and primarily from shifts in private savings implied volatility to remain elevated and investments... the shifts in private

Alan Taylor – Résumé 2010 - Present Morgan Stanley, senior advisor 1999 - Present University of California, Davis, professor of economics 1994 - Present National Bureau of Economic Research, faculty research fellow and research associate 2009 - 2010 Bank of England, Houblon-Norman/George fellowship 2005 - 2006 John Simon Guggenheim memorial fellowship 1997 - 1998 Stanford University, national fellow, Hoover institution 1993 - 1999 Northwestern University, assistant professor of economics Alan Taylor, senior advisor, Morgan Stanley

the markit magazine – Winter 2010 Focus: Emerging Market Currencies /25 savings and private investment which Exhibit 6: Capital Inflows Have Pushed Currency Values Higher Versus the $ underlie current imbalances are them- selves due, in part, to distortions.” In a 40% nutshell, current account imbalances are the symptom rather than the cause 30% of the problem. 20% Taken together, these points would suggest that the lack of action at the 10% G20 to impose hard current account targets is a welcome outcome for the 0% world at large. In our view, a better -50% 0% 50% 100% 150% 200% 250% solution would be to get policymakers -10% to try to eliminate the distortions that Local Ccy Appreciation vs USD US$ Local Ccy Appreciation drive and/or sustain global imbalances, -20% but this is easier said than done. In -30% effect, we are still close to where we Local Stock Market Return Over SP&500 were before the G20 – uncoordinated, uncooperative and uncertain, but less Source: Haver Analytics, Morgan Stanley Research so. The danger of an escalation in currency conflicts has by no means Exhibit 7: A Tale of Two Worlds dissipated. Mantega’s comments that an “inter- Industrial Production: Excluding Construction (Jan 2008 = 100) national currency war” had broken out Developed Markets sparked lively discussion. However, one 130 125 crucial ingredient that would suggest Official Beginning Euro Area 120 of US Recession UK we are in a currency war still seems to 115 be missing – retaliation. Instead, these 110 US currency movements and the under- 105 Japan 100 standable policy response are symp- 95 tomatic of a two-track global economy 90 85 where low-growth and easy monetary 80 conditions in developed markets has 75 led to capital flows seeking to benefit 70 65 from the robust domestic demand-led 60 recovery in EM. EM policymakers have, Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 as a group, deployed similar tools this Date year when faced with similar issues in a synchronised but not necessarily retali- Industrial Production: Excluding Construction (Jan 2008 = 100) atory fashion. Emerging Markets For EM countries, the combination of 130 rapid capital inflows, a need to tighten 125 Official Beginning monetary policy and the desire to keep 120 of US Recession currencies from appreciating suggests 115 110 that EM policymakers are battling 105 the trilemma – a three-way dilemma 100 95 whereby policymakers can choose only 90 two policies out of a trio of: pegged or 85 managed exchange rate, free flows of 80 Brazil India 75 Mexico China capital and independence of monetary 70 Korea policy. 65 Central banks have historically used 60 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 a variety of policies to get around the Date trilemma. The first victim of the trilemma has been monetary tightening as Source: Haver Analytics, Morgan Stanley Research

Winter 2010 – the markit magazine /26 Focus: Emerging Market Currencies

Two Stories of Currency Conflicts: The 1960s and the 1930s

Reserves, currency risks and the us more reason for optimism. The key A further risk is that pushing QE Triffin Paradox. The 1960s and now: unravelling of the gold standard came into emerging economies through Conflicts arose in the Bretton Woods when the two central players, the UK capital inflows risks stoking asset System between short-term national (in 1931) and the US (in 1933), left it. By price bubbles. Recycling the flow interest and long-term global benefits the mid-1930s, the remaining adher- back to the EM could risk a devel- for the “centre” country whose national ents to the gold standard had shrunk oping country boom-bust cycle as so currency was also the international to just a handful of countries in the often seen over the last 200 years. reserve currency – the so-called Triffin so-called gold bloc. The steps taken in the last ten years Paradox. Faced with economic difficul- In the countries that freed them- by emerging countries to solidify their ties, the “centre” country might want selves from gold, monetary policy macroeconomic and financial stability to run current account surpluses, expansion was possible, interest rates may have diminished these risks, but to boost its domestic economy. At fell, currencies weakened, economies a large financial inflow could still pose the same time, non-centre countries grew and unemployment shrank; in the problems. might also like to run current account gold bloc, money was tight, currencies For now, the net benefits of pushing surpluses, to build a stockpile of appreciated and recovery retarded, QE into the EM bloc are high. Faced reserve assets. Of course, these objec- sealing a divergence in fortunes with sand in the gears of its usual tives could not simultaneously be met: within the developed core economies. monetary policy channels, and non- the balance of payments within the Today, countries unwilling to play the existent fiscal policy support, the system had to balance. QE-G20 game will resemble the 1930s Fed would welcome external help Present currency tensions can gold bloc, with strong currencies but via a weaker dollar and higher infla- be seen against the backdrop of the weaker economies.2 In aggregate, tion expectations. It seems that the 1960s.1 The US would like an export global recovery will be stronger the latest item to be outsourced by the US tailwind while emerging economies smaller this group is. economy might well be its monetary would like to buy self-insurance given transmission mechanism. the run-down in reserves during Non-negligible risks. The complicated The US might wish a currency the Great Recession. Luckily for the interactions are certainly not without conflict had not started, but if it is present situation, the divergence risk. Aggressive easing by the Fed forced to fight when backed into a between emerging market (EM) and could be met by aggressive action by deflationary corner, it has “infinite developed market growth means that emerging economies in an attempt to ammunition” giving it a supreme emerging economies are a natural weaken their currencies. Such deterio- advantage on this battlefield, according destination for yield-seeking private ration in global co-operation could lead to Martin Wolf of the Financial Times. capital flows. A benign resolution of us down the path to currency wars, In itself, this plan of battle has favour- the global imbalance problem may yet or worse, trade wars. A less cheery able portents for global growth. But the emerge if the gross inward surge of lesson from the 1930s is that countries downside risk is obvious too: should private capital flows to EM can offset that found currency devaluation less war escalate into other theatres such the gross reserve purchases and be palatable were more inclined to adopt as trade, this may end up as a war wisely invested. protectionist policies.3 nobody will win.

Devaluation, interest rates and infla- tion expectations. The 1930s and 1 Zhou Xiaochuan (2009): Reform of the International Monetary System. BIS, Basel. now: The experience of the 1960s may 2 Eichengreen and Sachs (1985): “Exchange Rates and Economic Recovery in the 1930s”. Journal of Economic History 45, pp. 925-946. suggest a difficult road ahead. But 3 Eichengreen and Irwin (2009): The Great Depression and the Protectionist Temptation: Who Succumbed and Why? currency battles from the 1930s give Manuscript.

the markit magazine – Winter 2010 Focus: Emerging Market Currencies /27

many central banks have scaled back rate hikes. As currency appreciation “ Growth shocks to the G10, especially persisted, some EM central banks have the US economy, could result in dollar also chosen to use more subtle discre- tionary currency interventions rather weakness that could exacerbate the two- than institutionalise aggressive capital track nature of the global recovery.” controls. So far, interventions in the EM FX markets have generally been accom- panied by sterilisation to keep rising FX reserves from pushing up monetary aggregates in the domestic economy, but costs of sterilisation are high for economies where domestic interest rates are also high. Most EMs have tended to shy away from capital controls (except in times of crisis, e.g. Malaysia 1998). Recently, (QE). The same two-track global small for comfort or whose inflation is Brazil and, to a lesser extent, Korea economy that is exacerbating currency already a concern, could decide to let and Indonesia have instituted capital tensions in FX markets could also be a their currencies appreciate. Domestic controls. From a political standpoint, the great catalyst for the QE programme to expansion here would be more limited; scope for such measures is much wider be effective. Emerging economies are but US exports would still benefit, this than a decade ago. Now, in contrast, well placed to “import” QE from the US, time from an improved price advantage the IMF has endorsed the judicious use and then its goods and services as well (see Exhibit 2). of capital controls to manage surging to square the circle. Either way, the US wins. In a scenario capital inflows (IMF, Capital Inflows: The Fed could take advantage of the of this kind, boosting demand in EM The Role of Controls, February 2010). two-track global recovery by weakening economies in order to kick-start flag- Hence, levying capital controls at its currency or by raising inflation expec- ging growth in developed economies modest levels will not push us too far on tations, possibly simultaneously. An is exactly what a textbook model of the way to elevated currency tensions. unintended or unspoken, but not unwel- co-operative behaviour would have come, consequence of more QE would prescribed in the presence of asym- What could trigger a ‘currency war’? be to keep up the pressure for incipient metric shocks. The only difference is Growth shocks to the G10, especially US dollar weakness for a significant that we currently do not have a co- the US economy, could result in dollar period. The growth differential favouring operative framework, so this leaves weakness that could exacerbate the the EM world will also encourage a the Fed, as the de facto monetary two-track nature of the global recovery. continuation of capital inflows into those hegemon, to try to engineer such an Alternatively, a shock that resulted economies in search of yield. outcome in a more strategic manner. in weaker EM growth might lead to a EM economies will likely respond The success or failure of that strategy protectionist reaction from domestic in one of two ways. Economies with boils down to the international response policymakers. Another source of tension greater slack and less inflationary pres- in the coming weeks and months. would be divergence and conflict within sures will try to keep their currencies The risks of an escalation of currency the EM world, with slowing econo- from appreciating, either through FX tensions that lead to more serious mies trying to depreciate their currency intervention or, to a lesser extent, via the developments cannot be ignored. Inter- values but faster paced economies use of capital controls. These econo- national economic history has many unwilling to sacrifice exports and growth mies should see a boom and higher examples of international co-operation in order to pull them along. incomes, leading to an increase in the gone wrong. Surprisingly, not all failures Ironically, the two-track global demand for US exports. Other emerging of past international systems are harbin- economy will help quantitative easing economies, whose output gaps are too gers of doom.

Winter 2010 – the markit magazine / the

Source: Getty Images 28 markit markit magazine

Focus: Central Clearing – Winter 2010 Winter – Focus: Central Clearing /29

Asia Pacific G20 members are engaged in dialogue with standard setting bodies to meet central counterparty clearing commitments by 2012. However, regional fragmentation and the relatively small size of national credit derivatives markets will mean that the Asian central clearing industry will follow different paths to its western peers. Joti Mangat reports Clearing uncertainty

ith Asia Pacific overtaking while Singapore increased its share of North America as the the global market to 2.9 per cent, to world’s largest exchange become the fourth most active centre Wtraded derivatives market for the asset class, according to BIS in 2010, according to the Futures data. Industry Association, the significance While high levels of political motiva- of the region for the global derivatives tion and sufficiently large, integrated market is clearly accelerating. Further- markets allowed European and US more, the preliminary results of this authorities to take the lead in agreeing year’s Bank of International Settlements and adopting rules governing clearing (BIS) Triennial Central Bank Survey relatively quickly, rollout in most Asia show that trading activity also increased Pacific countries is taking longer as in over-the-counter (OTC) markets local regulators wait for international across the region over the past three bodies to finalise guidelines for the years. China, Hong Kong, India, Japan, implementation of market structures Korea, Malaysia, Philippines, Singapore and risk management methods. A key and Thailand all increased daily average developmental issue has been the small turnover of OTC interest rate derivatives, size of OTC markets across the region:

Winter 2010 – the markit magazine /30 Focus: Central Clearing

some of these countries have only process and has moved aggressively SGX argues that the city state’s regulatory recently opened for OTC interest rate to position itself as the regional leader. and technical approach building derivatives, while others do not yet have First steps include approving SGX market structures reflects conserva- credit default swap (CDS) markets. With AsiaClear to centrally clear the city tive assumptions and risk management the exception of perhaps Hong Kong, state’s local OTC commodities trading approaches. Ang says that despite Japan, Singapore and Sydney, trading and freight markets. In addition, the operating outside of G20 channels, of OTC derivatives in most countries Monetary Authority of Singapore (MAS) Singapore’s desire to provide leader- within the Association of Southeast has approved regulatory capital relief ship in these fields has pre-empted the Asian Nations (Asean) is still too small for banks’ exposure to SGX Derivatives outcome of the international debate. scale an activity to provoke popular Clearing, Singapore’s central clearing “What the Singapore Exchange concern about a high level of systemic counterparty (CCP) for OTC financial offers is certainly in line with what risk. derivatives. regulators seek to promote,” says “The impending regulatory changes Ang. “The expansion of Singapore Pre-emptive strike in the US and Europe to OTC derivatives Exchange’s clearing service is aligned Ironically, the jurisdiction that has made will mean that the Asian arms of global with global recognition of the benefits demonstrably the greatest progress financial institutions operating in Singa- of CCP clearing for OTC contracts. toward central clearing of OTC deriva- pore will come under the same rules as CCP clearing reduces counterparty tives is not even a G20 member, the parent,” says Christina Ang, senior credit risk and thereby benefits market suggesting that centralised clearing is vice-president within the clearing serv- participants. [AsiaClear’s platform] more than the focus of western public ices group at the Singapore Exchange. ensures that risks are mitigated through policy, and has now become part of the “An established CCP facility as offered adequate collateralisation of exposures required infrastructure for any national by Singapore Exchange will enable firms and these are marked to market daily financial market seeking to attract to continue with their operations and using industry accepted pricing and participants. Having endorsed the G20 businesses efficiently.” valuation methodologies.” commitments, Singapore has been less Echoing the views of some Singapo- In October, the provider extended constrained by the consensus-building rean participants on the Basel III debate, its coverage to US and SGD interest rate swaps (IRS). According to SGX, AsiaClear plans to extend coverage to currency options and forwards in the near future. The platform’s member- ship already includes 10 global banking institutions, which according to Ang, together make up 90 per cent of the $80bn-equivalent SGD IRS market. Although China is a G20 member, Hong Kong is not. Like Singapore, it harbours ambitions to become the leading gateway into the region, specifi- cally China, for global participants. It is interesting, therefore, that the region has been conspicuously quiet about its CCP. Kelvin Lee, a spokesperson for the HKex, says: “We are still in the feasibility study stage of the OTC clearing initia- tive and many of the issues have not yet been finalised.” Nonetheless, as one of the few regional centres with signifi- “ The impending regulatory changes in the cant flows in OTC IRS, FX and CDS, it US and Europe to OTC derivatives will is reasonable to expect that Hong Kong faces many of the same challenges mean that the Asian arms of global financial which Singapore overcame, namely institutions operating in Singapore will come regulatory motivation and a viable inter- operability framework to gain critical under the same rules as the parent.” mass for global banks.

the markit magazine – Winter 2010 Focus: Central Clearing /31

Global drivers Despite Singapore’s moves, regulators “ We are not contemplating regulation as a in most regional centres are waiting competitive tool, but as a way to create a for international consensus on risk management prescriptions to emerge sustainable operating environment.” from bodies like the BIS’s Financial Stability Board and Committee on Payment and Settlement Systems (CPSS) and the International Organiza- tion of Securities Commissions (IOSCO). For these countries, adherence to G20 commitments is the key driver for the adoption of central clearing, a top-down dynamic which means that rule making can move forward only as fast as infor- mation flow from international bodies allows, affording more aggressive regions a first-mover advantage. “We are not contemplating regulation as a competitive tool, but as a way to create a sustainable operating envi- ronment,” says Makato Seta, deputy director within the Japan Financial Serv- ices Agency (JFSA) Financial Markets Japan indices and single-name CDS. ended June 2010, according to Bank Division. “This exercise is being driven He indicates that the forthcoming rule of Japan data, will be open to inter- by international regulatory dialogue, and changes will likely require IRS clearing national players. The JFSA’s indiffer- through these channels we are getting by domestic or foreign CCPs, or a joint ence between foreign or domestic IRS an idea of how best to go forward.” venture between domestic and inter- CCPs raises difficult competitive issues He says that although the Japa- national providers. However, the JFSA for potential domestic providers with nese government legislated on central takes a more protectionist view of CDS little experience of the global OTC IRS clearing before Europe and the US clearing. The opportunity for potential markets. Takeshi Hirano, head of stra- with May’s amendment to the Finan- conflicts between legal jurisdictions in tegic planning in the clearing and settle- cial Instrument and Exchange Act situations of default is driving current ment department of the Tokyo Stock (FIEA), the agency is still finalising rules regulatory thinking toward making Exchange, majority owner of the Japan stipulating which products must be domestic clearing mandatory for CDS. Securities Clearing Corporation (JSCC), centrally cleared and, more importantly, “If CDS spreads widen significantly for says that market demand for improved the margining requirements and risk whatever reason and a credit event IRS counterparty and operational risk management practices that clearing- related to the derivative contract is management systems is the immediate houses must adopt. declared, it may materially influence driver of its current strategy. As a result, “At present, the amendment to FIEA the underlying asset,” says Seta. “In JSCC is focused on engaging estab- only sets a framework for OTC deriva- extreme circumstances, divergent legal lished CCPs from mature OTC markets tives regulation. We are in dialogue with frameworks between CDS and the to explore ways in which it might trade repositories and market partici- underlying asset can cause serious, become interoperable with those plat- pants in order to establish rules that undue consequences. Therefore, for forms to achieve the multilateral netting balance growth with a systemically safe products referencing entities that are and risk management services that environment,” he adds. subject to Japanese bankruptcy law, we major derivatives players require. The JFSA is building its under- feel that it is more appropriate to use a “Linkage between CCPs for JPY standing of the counterparty risk Japanese clearing organisation.” IRS products is a critical issue and we dynamics of the OTC market, which are striving to pave a way for the first prior to the crisis it largely considered a Critical linkage linkage between a major European bilateral matter for trading parties. Seta JPY CDS will probably have to be clearing house and Japan which will is focusing attention on product catego- cleared by a domestic organisation, but allow existing LCH.Clearnet users to ries only large enough to pose systemtic the much larger JPY IRS market, which clear JPY IRS while Japanese banks risks, chiefly yen IRS, the Markit iTraxx grew to $33.1bn-equivalent in the year who have not yet participated in foreign

Winter 2010 – the markit magazine /32 Focus: Central Clearing

“In addition to margin requirements, “ The major issues we face are understanding SGX has set up other safeguards, the rules that are likely to emerge from the including a clearing fund, to which both clearing members and SGX contribute,” European and US regulatory debate, as well she explains. as how to calculate prices in illiquid markets However, it appears that the regula- tory community is currently more occu- like Japanese CDS.” pied by the possibility that CCPs amplify rather than mitigate systemic risks, as illustrated by recent BIS reports. Meanwhile, established clearinghouses seeking Asian market access argue that they currently follow best risk manage- ment practice under present rules, with LCH.Clearnet pointing to the fact that its risk managers worked through 60,000 trades to handle the $8,000bn Lehman IRS default in September 2008. Although it is aware that competitive pressures may induce a CCP to lower the cost of doing business on its system by reducing margin requirements, the JFSA is confident that the international CCPs can also access the system,” he is still discussing the risk management framework will address this issue. “We says. framework,” adds Hirano. “The major would expect market participants to The lack of actionable detail from issues we face are understanding the attempt to obtain clients by cutting domestic regulators means that rules that are likely to emerge from the transaction costs, this is normal from potential CCPs face a significant European and US regulatory debate, as a market efficiency perspective,” says degree of uncertainty as to the risk well as how to calculate prices in illiquid Seta. “The international regulatory management standards they will be markets like Japanese CDS.” community therefore will need to put in expected to meet. “The risk manage- place minimum requirements that would ment working group, which includes Risk guidelines set prevent excessive competition among market participants and related entities To prepare, G20 members could do CCPs resulting in an excessive accu- worse than consider the risk manage- mulation of risks, while enabling healthy ment culture emerging within the competition.” Singapore Exchange’s CCP. According to SGX’s Ang, the company operates Developing market solutions a standardised risk framework across A relatively closed financial system its exchange traded and OTC deriva- compared with Hong Kong, Japan and tives business area. “We apply stringent Singapore, India is a G20 member that admission criteria for our membership pre-empted the global focus on coun- and monitor our participants for ongoing terparty risk with its own version of CCP financial adequacy in meeting their obli- clearing for OTC products. According gations to the clearinghouse,” she says. to Siddharta Roy, chief risk officer with For margin requirements, Ang the Mumbai based Clearing Corporation explains that SGX manages collaterali- of India (CCIL), the Indian experiment sation of exposures using daily marks with CCP settlement for OTC trading to market based on industry accepted markets began in 2001 as the country pricing and valuation methodologies. started to liberalise its financial markets. “Singapore Exchange administers Roy explains that CCIL already acts as industry-accepted VaR methodologies a CCP for Indian government securities for its margining and accepts collateral and interbank foreign exchange trading,

Takeshi Hirano, head of strategic planning, in the form of cash and government adding $/rupee FX forward clearing clearing and settlement, Tokyo Stock Exchange securities,” she says. from December 2009. He says that

the markit magazine – Winter 2010 Focus: Central Clearing /33 the CCIL will commence $/rupee IRS clearing shortly. “ For banks in India, trades which are centrally “For banks in India, trades which are cleared enjoy lower capital requirements centrally cleared enjoy lower capital requirements and this has helped in and this has helped in significant manner in significant manner in starting central starting central clearing for foreign exchange clearing for foreign exchange forwards trades and the same should also be forwards trades and the same should also helpful in starting CCP settlement for interbank IRS,” he says. “The benefits in be helpful in starting CCP settlement for terms of cost and risk reduction to the interbank IRS.” users and some amount of regulatory nudging has been the main driver for the adoption of central clearing for OTC trades in the Indian market. “When trades happen in an anony- mous trading system where a CCP accepts those from the point of trade itself, bilateral limit setting is not required, as acceptance of trade is based on margin or other available limits. This brings in enormous effi- ciency to the market. These dynamics have been observed in the government securities and CBLO markets in India.” Although India does not operate in the derivatives market, but at a cost drives optimal systemic risk reduc- an interbank CDS market, Roy says it to smaller players. “Only a few local tion, the sharp divergence between the soon will and urgently requires a CCP institutions will have the credit quality to size of derivatives markets structures structure to intermediate to augment directly participate in markets with major in the West and Asia Pacific poses local credit and liquidity. “The market is global players and settle trades on their several challenges for the prospect of expanding at a rapid pace and coun- own account through a global CCP. industry consolidation. For example, terparty exposure-related limitation can These institutions’ trading capability will the multilateral netting benefit of central restrict liquidity among counterparties also be constrained by the setting of clearing across interlinked platforms so it is imperative that a CCP system is small bilateral limits by larger players or may only really be relevant to the large made available for effective manage- through denial of access to the trading global financial institutions already using ment of this exposure. This will become system. However, if rules allow them to central clearing as smaller local insti- much more relevant in India because access the global CCP system through tutions may not be able to meet the the presence of most global financial other clearing members, bilateral limit eligibility critieria stipulated by the major services firms is likely to be through setting is not required, as acceptance platforms like LCH.Clearnet. For these subsidiaries which would not enjoy the of trade is based on margin or other players, the prospect of domestic plat- credit standing of their parents,” he available limits. Small institutions will forms with membership critical mass says. thus be forced to take significant settle- will depend largely on the depth of local Despite regulatory hopes to rein ment related exposure to the clearing markets, without which they will be in excessive competition on margin members,” he adds. reliant on indirect access through other costs, it remains a major priority for Roy flags the importance of clearing members. Roy’s customers. “Exposure to a CCP addressing the IT needs of banks that “Consolidation of central clearing in the form of margin is one of the may not be set up to connect with CCP services is desirable only up to a point major considerations for foreign banks systems, nor to manage shifting counter- but beyond that limit, further consoli- clearing in India. Cost of margin is also party exposure values from the original dation would probably not be feasible. another important factor,” he says. entity to the CCP. “Technology is one If it is pushed for, it will be against the If Indian regulators allow smaller area where considerable attention and interest of a large number of market domestic players to access central investments is required,” he adds. players in the developing markets and clearing through clearing members, the As academics and regulators debate possibly in developed markets too,” system could foster broader participation which arrangement of interlinked CCPs concludes Roy.

Winter 2010 – the markit magazine /34 Focus: Client Onboarding

Round table attendees quoted in this article: Tim Harris, associate director, Alternatives & Derivatives, Hermes Fund Managers Chude Chidi-Ofong, head of operations, Eton Park International LLP Yancy Hoyos, vice-president – Credit Investments Group, Credit Suisse Jeremy Smart, chief operating officer for European fixed-income distribution, Morgan Stanley Julia Sutton, global head of customer accounts and onboarding, Royal Bank of Canada Caroline Palmer, vice-president – GBS Client Onboarding, Deutsche Bank Stuart McClymont, managing director, global head of market initiatives and business architecture, Deutsche Bank Bill Meenaghan, product manager, Omgeo ALERT

the markit magazine – Winter 2010 Focus: Client Onboarding /35

Representatives from leading financial institutions discuss the operational challenges which arise when buy-side and sell-side firms have to formalise new trading relationships Shock of the new

nboarding – the process by Swaps and Derivatives Association which sell-side firms perform (ISDA) Master Agreement, then it could Know Your Customer (KYC) take anything from a matter of a few Ochecks and open accounts days to two weeks to be onboarded. for new funds – remains a manual The more of a pain you are, calling and labour-intensive process prone to and emailing your broker, the quicker delays which can lead to trade failures things get done. It should be a very and ultimately loss of revenue. Markit streamlined process but often it’s not. brought together leading market partici- In my experience, what gets results is pants and asked them about the opera- knowing who to call. tional challenges that exist when funds are onboarded by their counterparties, Chude Chidi-Ofong: It should take barriers to progress and what can be no longer than two or three days to done to make the process easier. onboard a new fund. However, the launch of our latest special purpose Markit: Can you give us an indication vehicle (SPV) was delayed for a week of the number of new funds you launch due to onboarding problems. and the kind of information you need Non-standard checks can take a lot to update with your counterparties for of time and hold up the process. regulatory and administrative reasons on a monthly or annual basis? How long Yancy Hoyos: We launch approximately does the onboarding process take? three to four fund structures per year and onboarding with broker-dealers and Tim Harris: We launch around one or agent banks can span several days to two new funds each month and the several weeks. On some occasions, the onboarding process varies from broker onboarding process has taken up to to broker − some are very quick and seven weeks. some aren’t. When it comes to adding Depending on the jurisdiction, KYC a sub fund to an existing International and tax documentation will need to be

Winter 2010 – the markit magazine /36 Focus: Client Onboarding

updated on an annual basis. This is the and Exchange Commission or Hong case for tax residence certificates in Kong Monetary Authority requirements. Spain and Italy, for example. This is very reasonable but it clearly There is also the KYC requirement to adds a layer of complexity to onboarding have information on the ultimate benefi- accounts as most client entities operate cial counterparties on triparty trade across multiple jurisdictions. confirms for loan trades and borrower As we move to a centralised counter- SPVs used for loan debt buybacks. party (CCP) structure for over-the-counter SPVs in general require onerous KYC (OTC) derivatives, it is clear that we will checks as most onboarding teams will have to re-negotiate ISDAs for every- need to drill down to trust levels. body. This is going to be another docu- mentation challenge. We may also have Jeremy Smart: We open, on average, Tim Harris, associate director, Alternatives & to change the entities we use to book about 600 new accounts, including sub Derivatives, Hermes Fund Managers our transactions, which will have a direct accounts, each month. The busiest impact on how we onboard accounts. times are when we onboard a new asset process again and comply with a totally manager. On these occasions, we could different set of regulatory requirements. Stuart McClymont: We as an industry have 200 to 250 sub accounts to open. It is a very time and labour-intensive still do not have a standard and effi- Onboarding is a very time-intensive process but we have to get it right. cient counterparty onboarding and process and prioritising workload is static data infrastructure. This leads important. Like every firm, we have Caroline Palmer: We could reduce the to wide variances in the time it takes priority account lists based on commer- timeframes and diminish duplication of to onboard funds and set up client cial realities. The more revenue we can effort if we had standardised informa- static data. One reason for this large generate from a particular account, tion requirements up front. We need gap could be the regional differences the greater precedence it receives. to process information received effi- in content and requirements. We need However, we have adequate resources ciently, as we gather requirements for to normalise these regional differences to open every account when requested. a multitude of departments internally, and establish global standards. At Around one in five accounts we deal including, but not limited to, our credit the same time we need to also stand- with do not fall within a set process due and legal departments. There is a lot of ardise the steps in the process, the to issues over capacity, legal require- co-ordination needed internally. messaging format and communication ments or terms in the Credit Support When we receive an onboarding mediums to deliver a robust, scalable Annex (CSA). We have clear escala- request from a client, we make sure we and efficient infrastructure. We can tion procedures and very clear rights of have the relevant constituent documen- then achieve a more timely process, sign-off, which along with prioritisation, tation and understand their product which, is necessary given the regula- helps enormously in opening new and requirements and whether legal agree- tory pressures on other areas of the tricky accounts. ments are needed. We also work with trade lifecycle process. the clients to ensure downstream Julia Sutton: Globally, we take on in the matters are considered, such as setting Markit: Why have we not had the region of 30 legal entities a month. Most up the requisite ISDA Master Confirma- developments in infrastructure that are of our clients want to trade in multiple tion Agreements (MCAs) or configuring needed? jurisdictions so we have a lot of rules to our trade matching systems. comply with. It is quite time-intensive and we share our clients’ pain in getting Markit: What pressures are the industry through this process. Royal Bank of facing due to the changing regulatory Canada will launch a new account environment? opening tool in December that will allow us to manage the multitude of requests Jeremy Smart: There is no global we get everyday much better. standard for opening accounts. National We have had instances where we regulators are today less happy to rely on receive a request to set up a new their counterparts in other jurisdictions. account domiciled in New York and then So, if you work in London, you still need at the end of the process we are told to meet and comply with Financial Serv- that the client wants to settle in Canada. ices Authority regulatory requirements, Chude Chidi-Ofong, head of operations, We then have to start the onboarding even if you have satisfied US Securities Eton Park International LLP

the markit magazine – Winter 2010 Focus: Client Onboarding /37

Stuart McClymont: Reference data are the DNA of trade processing and “ There isn’t a set model that works every impacts almost every part of our proc- time as different banks have various grades esses. It is therefore hard to change and there is often no single owner both of KYC requirements for different fund or accountable and responsible for it. equity structures.” There are so many providers, consumers, and even consumers who are themselves providers, that under- standing where and how to make moving, which is probably not the right have those roles and responsibilities in changes is very complicated. It is there- way of doing things. place. fore very difficult to budget, prioritise and get traction to improve reference data. Yancy Hoyos: There isn’t a set model Jeremy Smart: Ultimately as a sales- that works every time as different banks person, it is my responsibility to Julia Sutton: There is no standard have various grades of KYC require- onboard the account, take ownership around counterparty static data ments for different fund or equity struc- and drive that process. We are respon- currently and the quality of your static tures. The approach that has worked sible for revenue generation and that data depends on who runs it. Once we the best is to set up a core set of KYC means trading with as many accounts resolve that, it will be easier to address documents which most banks require and with as little risk as possible. latency and other issues. at fund inception and communicate Having said that, it makes complete Good static data start with how you actively with counterparties on tailored sense to have a centralised team that onboard a client and what information requests. From this process one can gathers the right documentation and you collect from the client. If you do it also derive which are the more onerous information and undertakes the opera- right the first time, you are on the right jurisdictions for KYC approval as well as tional onboarding. track. which institutions have more rigorous and extensive KYC processes. This Julia Sutton: That does not exist in Markit: How do delays in onboarding can help us assess which accounts will most places, which is the problem. affect opportunity, risk and require a lot of work to onboard and relationships? should therefore be at the top of our Stuart McClymont: The accountability priority list. for the relationship with the client is Tim Harris: If a client wants to put on or with sales. If, as part of that relationship change the risk strategy of a particular Julia Sutton: The key is finding the right building process, we can very early on portfolio in a very short time, we will go people at your counterparty who can request and source the appropriate data, with brokers that can process those help process your request. It could all get them set up centrally and filtered changes quickly and efficiently. be done quite quickly if you know with through the organisation, trades can be You know which brokers miss things whom to discuss onboarding and docu- processed efficiently further down the line. and those that have streamlined the mentation requirements. We are working onboarding process and can act quickly on getting sales to include our group Markit: What thoughts do you have when we launch new sub-accounts or as part of their conversations whenever about how we move towards documen- funds. There are brokers who get more they book a trade with a client. tation standardisation? than their fair share of the trade and activity because they do this well. Chude Chidi-Ofong: We also find it difficult as buy-side firms to identify Markit: How do you communicate who in a sell-side firm is responsible for successfully with a broker-dealer? Is opening our accounts. There is no clear there a particular model that works? definitive line on whose responsibility it is to send us documentation. Tim Harris: It really does just depend on the people and there is no particular Julia Sutton: We are saying that sales model or one perfect solution that own the relationship with the client and works across the board. Sometimes it we, as documentation and onboarding is difficult to find the right contacts or specialists, have responsibility for the know who to contact. We tend to go integrity of the data. We have found it Yancy Hoyos, vice-president – Credit Investments back to the front office to get things much quicker and more efficient if we Group, Credit Suisse

Winter 2010 – the markit magazine /38 Focus: Client Onboarding

Julia Sutton: We are centralising the SSI process globally. We have around 120,000 legal entities and about 300,000 sub accounts and there are several hundred to a thousand changes to that set of settlement instructions every week. Unless you automate it, it becomes a huge overhead.

Caroline Palmer: It would be great to see the twinning of onboarding requests with the SSIs because a lot of the time Jeremy Smart, chief operating officer for European we cannot process onboarding requests Caroline Palmer, vice-president – GBS Client fixed-income distribution, Morgan Stanley until we get the updated SSIs. Once Onboarding, Deutsche Bank ISDA agreements and the CSAs are final- Julia Sutton: There is a core set of docu- ised, we look to set up client accounts updated legal entity data including ments that is required by everyone, regard­ and we need SSIs readily available. identifiers. less of regional or internal differences. Bill Meenaghan: One reason why Stuart McClymont: By doing this we Yancy Hoyos: Minimum standardisation accounts are not opened is that potentially run the risk of exacerbating is key as a first step. In the loan market, although investment managers add the problem. For every additional inde- it will be very helpful to have a repository them to Omgeo ALERT, brokers tend to pendent provider of counterparty static of administrative details with up-to-date wait until the first trade before they take data, we move further away from a stan­ contact information. Knowing with whom in data for the SSIs. That is not very effi- dard golden industry data set. Each diff­ to initiate the KYC process can save time cient. It does not make sense to trade erent provider of counterparty static data in the vetting process for both sides. first and then start to set up retrieve and counterparty identifiers has built The second step would be to have a SSIs as well as initiate the KYC process. independent infrastructure over the years. market-wide minimum standardised KYC We are currently working on updating Generally, most of these products have requirement list per jurisdiction (starting legal entity data for the investment been built to deliver against a particular with the UK) and for each portfolio managers at the access code (fund) asset class, sector, or type of counterparty structure (i.e. separate accounts, CDOs, level and for broker-dealers at the data, creating their own format, content, hedge funds and SPVs) in general. model level and have a partnership with communication and messaging mediums. Avox where the legal entity data will As an industry, we need to take a step Caroline Palmer: It comes down to be taken in, confirmed with the invest- back and design a solution that consoli- transparency and capture of onboarding ment managers and broker-dealers, dates and standardises this data to requests as well. We need to improve verified by Avox and then re-certified create a single golden industry source. the management of the onboarding every year. Omgeo ALERT will carry process and information flow by certain legal entity data fields and this Julia Sutton: Regardless of which coun- decreasing reliance on email and paper- will go live early in the third quarter next terparty static data provider a particular firm based interaction. year. Subscribers will be able to receive may settle on, having standards for static data including name and address should Chude Chidi-Ofong: I would like not be open to debate. We need to speak consistency across the sell-side. I do the same language across these core data. not want to trade converts with one bank and fulfil its data requests, then Stuart McClymont: The current US also trade credit with the same bank legislation around OTC derivative reform which then asks me for different KYC are proposing unique counterparty documents. This does happen from identifiers across asset classes so they time to time. can consolidate counterparty reporting across differing asset class repositories. Markit: Do the same people that handle Without this standardisation and use of Standard Settlement Instructions (SSIs) unique counterparty identifiers globally, also manage account reference data or Julia Sutton, global head of customer accounts all regulators across the globe will find it is it a different process? and onboarding, Royal Bank of Canada very difficult to consolidate reporting.

the markit magazine – Winter 2010 Focus: Client Onboarding /39

Chude Chidi-Ofong: How is the poten- Chude Chidi-Ofong: The biggest tial Markit Document Exchange (MDE) immediate hurdle is the legal docu- and Omgeo ALERT tie-up going to mentation. We have spent the last four work? Would you potentially have the years trying to put in place managed bank maintain MDE with the correct compliance agreements for MCAs for static data and then we just link it into equity derivatives with everyone in Omgeo ALERT? every single region to streamline the process of trading equities. We have Markit: Bringing our two communi- found there have been divergences ties on to a combined set of interfaces among banks and their willingness to will help achieve critical mass. Further, do that. combining Omgeo ALERT’s dataset We need a greater willingness on with our own will enable us to pair the sell-side to have standard docu- Bill Meenaghan, product manager, Omgeo ALERT different identifiers used by different mentation, particularly in equity deriva- market participants. If we can let the tives. European equity options are across each individual product and end clients manage their own data, the one of the simplest products you can across each individual client. Simply resulting data will be of a higher quality. look at, but try to do something in Asia moving one transaction from one broker This obviously works only under the outside Japan and it is a complete to another is extremely difficult. Throw condition that everyone is on board and nightmare. CCPs into the mix and you are talking updates their data regularly. about even more complex data and Stuart McClymont: Only 35-40 per cent documentation requirements having Bill Meenaghan: We have nearly 500,000 of equity derivatives can be confirmed to be standardised across potentially a access codes (funds) in Omgeo ALERT electronically on electronic confirma- dozen CCPs. and hopefully the tie-up with MDE will tion platforms today compared to 98 What worries me is that we are improve the number of accounts we per cent for credit derivatives and over moving to a world of less standardi- cover. The combined platform will have 80 per cent for rates derivatives. These sation rather than more. We may be a critical mass of users. There is a lot of high percentages and the reduction moving towards standardised docu- benefit to the industry if the big invest- in risk, increased control and overall ments within individual jurisdictions ment managers buy into the idea of efficiency that came with them, was a and also within individual products but populating their documents and static result of the industry coming together probably not within our global OTC data in MDE and having connections to under ISDA to standardise the process, world. Omgeo ALERT’s settlement instruction the messaging format, standard and the management interface. We will implement communication infrastructure and tack- Stuart McClymont: Globalisation has a process to ensure that the fund codes ling the issue globally. very rarely been part of conversa- used in Omgeo ALERT will be transferred tions across the industry over the last to MDE so that users and broker-dealers Jeremy Smart: It is all about stand- 18 months. Unless we take a global will be able to reference the same fund ardisation around processing, because approach to counterparty static data, identifier when retrieving documentation. otherwise there are different standards we will only continue to breed frag- mentation and move further away from Markit: Are there any other key trade standards. processes or infrastructures where the industry should be more closely Markit: To summarise, we require aligned? greater standardisation and clearer communication. It also seems that the Stuart McClymont: Clearing trades intra buy-side and sell-side have different day in real time means that we need to perspectives on the process. There are get the industry trade processing infra- a few challenges, such as the impor- structure operating in a way that is both tance of counterparty static data that timely and efficient. The counterparty are not always that clear to people on data flowing through these systems the other side. But, from our discus- must therefore be accurate. It is critical sion, it seems that the entire industry that industry trade processing tools are could benefit from debating and trying Stuart McClymont, managing director, global head fed this standardised golden counter- of market initiatives and business architecture, to develop standards to address these party data automatically. Deutsche Bank issues.

Winter 2010 – the markit magazine /40 Focus: Investment Climate for ‘Cleantech’

The days of abundant funding for clean technologies may be over but there is still much activity in the sector as investors seek out innovations and a wave of consolidation beckons, writes Mike Scott

Clean bill of health

he great expectations that All in all, it would seem that the clean preceded last year’s climate tech sector is experiencing mixed change conference in Copen- signals, yet many involved in the field T hagen and which fizzled out in are cautiously optimistic. “In the long disappointment are in stark contrast to term, our perspective is quite positive,” the muted hopes ahead of this year’s says Albert Fischer, managing director gathering in Cancun. But then the last of Yellow&Blue, a Netherlands-based year has been sobering for the environ- venture capital (VC) firm. “The drivers for mental lobby. After the disappointment the introduction of clean technology are at a lack of accord in Copenhagen, the still there. There is still a need for faster, credibility of climate science was chal- better, cheaper, greener companies. I lenged in the wake of leaked emails see opportunities for very good returns from a UK university’s climate science in this field.” department. Then there were the errors In fact, a number of recent reports in the last report of the Intergovern- have reasserted that the fundamen- mental Panel on Climate Change (IPCC), tals remain the same – i.e. that climate while the recent mid-term elections in change is almost certainly man made the US banged the final nail in the coffin and that failing to deal with it will have of prospects for a federal cap and trade severe consequences.” “By over- carbon pricing scheme. whelming consensus, the scientific

the markit magazine – Winter 2010 Focus : Investment Climate for ‘Cleantech’ for Climate Investment : Winter 2010Winter – the markit markit

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Source: Getty Images /42 Focus: Investment Climate for ‘Cleantech’

that a global deal on forestry, known Meanwhile, China, the world’s biggest as Redd (Reduction of Emissions from polluter and consumer of energy, has Deforestation and forest Degradation), come up with ambitious targets for its could create a new asset class and a next five-year plan on clean energy market worth billions of dollars. and reducing the carbon intensity of its This optimism is partly the result of economy, including pilot carbon trading another global agreement on preserving schemes and renewable energy quotas. biodiversity and ecosystem services India, which is seen as the most that was signed in Nagoya in October. reluctant of the large emerging markets The Nagoya Protocol calls for an to sign up to a global climate deal, increase in the amount of land that is is set to see a record year for clean part of nature reserves to increase from energy deployment in 2011, according 13 per cent to 17 per cent, and sets to Bloomberg New Energy Finance, out a plan to halt the destruction and while in Australia, the policy environ- degradation of natural habitats including ment for carbon trading is now much forests. The combination of a price for more favourable following the ousting protecting ecosystem services and a of former prime minister Kevin Rudd by price for reducing carbon emissions his deputy Julia Gillard. Plans are also makes forest land more valuable and proceeding for carbon trading in Japan. Albert Fischer, managing director, Yellow&Blue is a powerful driver for a new market in In Europe, European Union (EU) forest credits. targets to have 20 per cent of energy community agrees that climate change There is also a feeling that more consumption derived from renewable is real. Greenhouse gases (GHG) have progress can be made outside the sources, a 20 per cent improvement in increased markedly as a result of United Nations (UN) process, where energy efficiency and a 20 per cent cut in human activities and now far exceed trying to craft a deal that pleases 197 emissions by 2020 continue to drive poli- pre-industrial levels,” says Rajendra countries with vastly differing circum- cies and incentive regimes that provide Pachauri, head of the IPCC. HSBC’s stances proved so problematic last a big boost to clean energy companies, Climate Confidence Monitor, a global year. A number of countries continue to ranging from the EU-wide Emissions survey of consumer attitudes to climate press ahead with domestic legislation Trading Scheme to feed-in tariffs. change, reveals that, after a slight dip that sometimes belies their international Meanwhile, a number of countries last year, climate change is again one reputation for intransigence. In the US, used a significant proportion of their of the top three world concerns. The for example, 30 states have renewable stimulus packages following the finan- bank’s Climate Change Centre of Excel- portfolio standards in place, a Califor- cial crisis to increase the emphasis on lence predicts that the low-carbon nian proposal that would have effectively clean technology. A total of $470bn was energy market will triple to $2,200bn killed the state’s GHG reduction plans directed towards investment in critical over the next decade. was defeated, and the Environmental infrastructure such as rail, grids, water, Protection Agency is gearing up for the buildings and renewables, according Policy implementation of rules governing the to HSBC. The biggest green spenders At the global level, the downbeat expec- amount of GHGs industrial installations were the US, China and South Korea, tations for Cancun may turn out to be can emit (although this is facing legal which allocated more than 80 per cent helpful. In particular, there are hopes challenges from opponents). of its economic aid to green measures.

Funding Nonetheless, it is clear that the days of abundant funding are over. Life has changed for investors and companies at every stage of the game. Early-stage “ By overwhelming consensus, the scientific investors are struggling to raise money, community agrees that climate change is says Tom Whitehouse, CEO of Carbon International, a communications and real. Greenhouse gases have increased fundraising consultancy. “This means markedly as a result of human activities and that they cannot grow, which in turn means a dearth of opportunities for now far exceed pre-industrial levels.” late-stage investors,” he says.

the markit magazine – Winter 2010 Focus: Investment Climate for ‘Cleantech’ /43

“ The commercial rationale is strong. These companies are taking advantage of the fact that they have a lot of cash and that cleantech companies are much better value for money than they were before the crisis.”

There are about 10 VC funds in Europe Many early-stage technologies are that are backed by utilities, he adds. too risky for many people, adds Etienne For utility-backed firms, profit is Pollard, member of the VC team at not the only driver, Fischer says. “The Good Energies, so many investors are utilities want start-up technology to be looking for later-stage companies. “If used for the sector as a whole – that you have money to invest, you are in a way the risk is spread more thinly.” good position. A number of investors Raising funds from private or insti- are having to preserve their capital to Tom Whitehouse, CEO, Carbon International tutional investors still takes a long time support their existing portfolio because with half of funds spending up to three companies that would have expected to With banks more reluctant to lend years on the road, according to the reach profitability by now have struggled to companies with unproven technolo- Yellow&Blue chief. after the financial crisis,” he points out. gies, big corporations have stepped “Last year was very difficult for raising WHEB’s portfolio is a mix of late-stage into the breach. “We are seeing a lot money,” says Megan Bingham-Walker, venture companies within a year of profit- more corporate venturing from compa- principal of WHEB Partners. “Things are ability and buyouts of companies that are nies such as Siemens, GE and Bosch,” improving, but it is still very difficult to struggling to raise debt. “There are some Whitehouse adds. raise funds.” In 2006, she points out, the very attractive buyouts at reasonable Yellow&Blue is an extension of this cleantech market for VC was $2.5bn. This valuations of companies that are already idea – the fund, which focuses mainly on rose to $8.5bn in 2008 but fell back to profitable,” Bingham-Walker says. There investments in Western Europe, is backed less than $6bn in 2009, with 2010 looking are also opportunities among compa- by Nuon, the Dutch utility which is itself to be flat or even seeing a slight fall. nies that would previously have listed on owned by Sweden’s Vattenfall. Another However, funds with access to the smaller exchanges such as the Alterna- Netherlands-based fund, Icos Capital, family wealth market are finding it easier tive Investment Market (AIM). is backed by Dutch groups Imtech, the to raise money, she says. WHEB has engineering group, and CSM, the world’s good connections to the high net worth largest maker of bakery products. market thanks to founding investor Ben This is not corporate social respon- Goldsmith, whose father was the billion- sibility, Whitehouse points out. “The aire entrepreneur Sir James Goldsmith. commercial rationale is strong,” he says. The firm recently announced the final “These companies are taking advan- closing of its second clean technology tage of the fact that they have a lot of fund, with investors committing £105m, cash and that cleantech companies are of which £80m-£90m came from family much better value for money than they offices. “Family offices often represent were before the crisis.” industrial families in sectors that may In general, financial investors prefer become customers for some of these to go to the US because VC returns products,” Bingham-Walker adds. are better there, says Fischer of The difficult funding environment Yellow&Blue, adding: “But at the same means life is very difficult for early- time, there is a need for innovation in stage companies looking to raise cash. Europe. For utilities, funds such as ours “New companies with sound business are a way of gaining access to innova- models but with an element of financial tion, trying out new technologies and and technical risk are struggling to find having a view of what is in the market.” investors,” says Whitehouse. Megan Bingham-Walker, principal, WHEB Partners

Winter 2010 – the markit magazine /44 Focus: Investment Climate for ‘Cleantech’

Figures from Bloomberg New Energy renewable energy. This, together with Finance show that VC and private equity substantial commitment from industry investment is on a downward trend for and the sheer scale of its natural 2010 − $2.9bn was invested in the first resources, means that its position as three months of the year, $2.4bn in the top spot for renewable energy invest- second quarter and $1.4bn from July ment is well merited,” says Ben Warren, to September, although it has almost Ernst & Young’s Environment and surpassed the amount of investment for Energy Infrastructure Advisory Leader. all of 2009. The US, by contrast, lacks consistent “It is investment in projects that is policies and government support, as driving the sector at the moment,” says exemplified by the forthcoming aboli- Thomas Rottner, MD of private equity tion of a Treasury grant programme house Platina Partners. “It is very diffi- at the end of this year, with no guar- cult for venture firms to find funding antee of renewal – a development that because most of the industry is not comes on top of the failure to enact a interested in new technology – they federal Renewable Energy Standard want something that is proven.” this summer. “Although the US remains Pollard of Good Energies agrees. a highly attractive location for inves- “If you have high quality ideas, good tors in renewable energy, it is clear that management teams and good tech- Etienne Pollard, member of the venture capital recent events have stalled momentum,” nology – something that really serves team, Good Energies Warren says. “The US market continues a market need – then you will still get to have significant potential but requires funded,” he says. says Bruce Jenkyn-Jones, managing consistent political support to provide Further up the funding chain, there director at cleantech investment fund investors with the long-term confidence is far more mergers and acquisition Impax. More than half of the 14 IPOs in they need.” activity than there is on public markets. clean energy in the third quarter of 2010 This lack of constancy also plagues Here again, large corporates are taking came from China and Taiwan, says projects in Europe, particularly in the advantage of their strong balance Bloomberg New Energy Finance. Those solar sector, which is characterised by sheets and reasonable valuations to companies that have issued shares two key factors – an overwhelming reli- snap up bargains. Companies such as in Europe or North America have not ance on incentive regimes and high but GE, Constellation, Cisco and Exelon, seen their shares perform particularly rapidly falling costs. Reconciling these which bought the renewable assets of well. Enel Green Power, the renew- two trends is proving problematic for John Deere, have been active, while able energy unit of the Italian utility, national governments and leaves inves- Emerson, the US tech group, bought saw its share price fall on its debut in tors chasing the subsidies. Chloride, the UK power storage group. November, for example. While public markets remain essen- China was recently named as the tially closed for cleantech firms in most attractive destination for renew- Europe and North America, in Asia – able energy investments by Ernst & particularly in China – there is a strong Young, surpassing the US for the first appetite for initial public offerings (IPOs). time. “China’s surge to pole position “Since the start of 2009, more than has been underpinned by strong and 60 per cent of IPOs have been in Asia,” consistent government support for

“ If you have high quality ideas, good management teams and good technology – something that really serves a market need

– then you will still get funded.” Thomas Rottner, managing director, Platina Partners

the markit magazine – Winter 2010 Focus: Investment Climate for ‘Cleantech’ /45

A report from HSBC highlights the importance of subsidies – Germany “ Building intelligence into the electricity remains the dominant force in the solar network is one of our favoured topics. Most sector, accounting for more than 50 per cent of the market, thanks to its long- grids are under pressure and demand for running and stable feed-in tariff regime. electricity is growing faster than centrally- Germany, the Czech Republic, France and Italy accounted for 65 per cent of generated power plants can be built.” global sales in 2010. Spain, which was one of the biggest markets, has seen a big drop in demand after it moved to cut its solar subsidies because they were costing too much. In 2008, Spanish solar photovoltaic capacity was capital intensive projects,” says Steve Walker of WHEB Partners. “We like 2,758MW but in 2009, it slumped to Mahon, chief investment officer at Low energy efficiency and storage, clean 60MW, according to Ernst & Young. Carbon Accelerator. “Energy efficiency industrial processes, water treat- “Investors need to play off the various projects are retrofittable, they can be ment and desalination, and materials incentive regimes in Europe. Some fitted quickly, they are capital efficient recovery.” The firm’s investments range countries are closed for now but may and there is a quick payback period.” from Torqeedo, a manufacturer of reopen in the future. Feed-in tariffs are a The vogue for efficiency encom- electric outboard motors, to Exosect, very blunt instrument,” says Rottner. “If passes a range of technologies and which provides an environmentally- you set them too low, nothing happens sectors including industrial efficiency, friendly alternative to traditional but if you set them too high, you have lighting, building materials, lightweight pesticides. a gold rush.” Investors expect tariffs materials and batteries for vehicles and Mahon also predicts a growing to fall over time as the cost of solar smart grids. “When times are tough, the interest in distributed generation rather technology decreases and the industry payback periods of these technologies than centrally-generated power, particu- pushes towards grid parity. “That is are very attractive,” says Jenkyn-Jones. larly in emerging markets, where the expected, but what is not acceptable There is also considerable interest in weakness of grid infrastructure is one is to cut tariffs retrospectively. It is a water infrastructure and water saving of the biggest bottlenecks. The smart breach of faith and there will be legal technologies, recycling and resource grid is another strong area, he says. repercussions,” he warns. recovery, along with waste-to-energy “Building intelligence into the electricity Changes to subsidy regimes in technologies. network is one of our favoured topics. countries such as the Czech Republic “We have always defined clean tech- Most grids are under pressure and next year are likely to see solar sales in nology quite broadly,” says Bingham- demand for electricity is growing faster Europe drop 35 per cent in 2011, says than centrally-generated power plants HSBC, with relatively strong demand can be built.” in Germany driven by subsidy changes He is optimistic about the prospects the following year. Increasing demand in for the sector. “There is a big appetite China and the US will not be enough to to back those businesses that have offset this decline and the global market survived the recession and showed is likely to shrink by some 15 per cent that they have the technology and the next year. management that the market wants,” The wind sector has also slowed he says. However, he also predicts down, says Jenkyn-Jones of Impax, a period of consolidation, with many because of political and financial uncer- smaller players joining forces or being tainty in Europe and low power prices in bought by bigger companies. “There the US. The advent of large new supplies are many high-tech start-ups that have of shale gas has made utilities reluctant been around for three to five years. They to sign power purchase agreements. have their own unique selling points but they are all selling to the same Technology focus customers – the utilities – and it does The strongest theme in clean technology not make sense for them to remain as today is energy efficiency investments. Steve Mahon, chief investment officer, Low standalone companies. This part of the “People have moved away from highly Carbon Accelerator cycle is about consolidation.”

Winter 2010 – the markit magazine /46 In Practice

2010 has laid the groundwork for far-reaching reforms in the over-the-counter derivatives market, but the devil remains in the detail as Europe, the US and Asia move to finalise the new rules.Marcus Schüler, head of regulatory affairs at Markit, summarises key developments and considers the implications for the industry Brave new world

ust over a year ago, a new era still much uncertainty about how the was ushered into the over-the- global OTC derivative markets will func- counter (OTC) derivatives market tion and this has only been exacerbated J– one that promised to be more by the recent power shift in US Congress. transparent, mitigate systemic risk and protect against market abuse. The OTC derivatives regulation in the US initiative emanated from the very top In July, following months of congres- of the financial world, with G20 leaders sional discussions about re-regulating agreeing in Pittsburgh in September the financial industry, the Dodd-Frank 2009 that all standardised OTC deriva- Act (DFA) was signed into law. Despite tive contracts should be traded on its size (the Act ran to 2,300 pages), exchanges or electronic trading plat- the DFA dealt with most issues on a forms, where appropriate, and cleared fairly high level and required the rele- through central counterparties by the vant regulatory authorities, mostly the end of 2012. They also agreed that OTC Commodity Futures Trading Commis- derivative contracts should be reported sion (CFTC) and the Securities and to trade repositories and non-centrally Exchange Commission (SEC) in the cleared contracts should be subject to area of OTC derivatives, to promul- higher capital requirements. The Finan- gate numerous rules within a short cial Stability Board (FSB) and its relevant timeframe. The commissions quickly members were asked to assess the set about working on their respective implementation of these commitments mandates and have now proposed and judge the effort’s success. rules. Those most relevant to the OTC So where do we stand on these derivative markets are shown in Table 1. issues today? While there has been a In addition, the following rules are high level of international co-ordination, expected to be published over the com- Marcus Schüler, head of regulatory affairs, Markit and progress has been made, there is ing weeks (Table 2).

the markit magazine – Winter 2010 In Practice /47

Real-time reporting Table 1: Proposed Rules Among the rules that have been CFTC SEC proposed so far, those dealing with the Swap Dealers (SDs) and Major Swap Participants (MSPs) real-time reporting of swaps have been Registration and duties of SDs and MSPs most heavily anticipated. Conflict of interest policies by futures commission merchants The CFTC proposed that all transac- (FCMs) introducing brokers, SDs and MSPs tions in swaps, cleared and uncleared, Chief compliance officer, compliance policies and annual regardless of form of execution, need reports of FCMs, SDs and MSPs to be publicly reported. Such reporting Derivatives Clearing Organisations (DCOs) should include the contract type, asset Proposed rules on Mitigation of Conflicts of Interest for DCOs, Ownership limitations and governance requirements for Designated Contract Markets (DCMs) and Swap Execution Security-Based Swap Clearing Agencies, Security-Based SEFs class, tenor, payment frequencies and Facilities (SEFs) and National Securities Exchanges with respect to security- based swaps other relevant fields “to provide mean- ing to the price of the swap” and should Security-Based Swap Data Repositories (SDRs) occur “as soon as technologically Registration and regulation of SDRs Security-based SDR registration process practicable” after execution. Report- Duties and core principles of SDRs ing delays will only be allowed for large General Issues trades, for example 15 minutes for block Interim final rule for reporting unexpired pre-enactment swaps Interim final rule for reporting security-based swap transaction data trades1. The CFTC is seeking comments Swap data recordkeeping and reporting requirements Reporting and dissemination of security-based swap on the delays that should be applied for information large transactions in customised swaps. Process of review for swaps for mandatory clearing

Portfolio margining

Europe Segregation and bankruptcy The legislative proposals for OTC deriva- tives are contained mainly in two separate Table 2: In the Pipeline rule works, European Market Infrastructure Date Rules Regulation (EMIR) and Markets in Financial December 1 (CFTC) • Position limits Instruments Directive (MiFID). • Core principles for DCMs and DCOs • Business conduct standards The recently proposed EMIR legisla- December 9 (CFTC) • SEFs tion requires the centralised clearing • End user issues of eligible derivatives through central • Business conduct standards December 16 (CFTC) • Capital and margin counterparties (CCPs). The new Euro- • Large trader reporting pean Securities and Markets Authority December (SEC) • Mandatory clearing of Security-Based swaps (ESMA) will determine which classes of • End-user exceptions • Clearing agencies for Security-Based swaps derivatives should be centrally cleared • Registration and regulation of Security-Based swaps • Registration and regulation of Security-Based swap dealers and will address the issue of classes and security-based major swap participants of clearing-elible contracts that do not, January (CFTC) • CFTC Meeting to be determined as of yet, have an authorized CCP to January - March (SEC) • Conflict of interest for clearing agencies, execution facilities clear those contracts. Eligibility criteria and exchanges include the impact on the reduction of systemic risk, the liquidity of the con- tracts, the availability of reliable pricing The EMIR proposals also require is being reviewed with plans to widen information and the CCP’s capabilities derivative trades in the EU to be reported its scope to include OTC derivatives. A and level of client protection it provides. to trade repositories which will be regis- MiFID Review consultation is expected For those derivative contracts that tered and supervised by ESMA, and will from the European Commission soon cannot be centrally cleared, market par- make detailed information available to with legislative proposals to follow in ticipants shall measure, monitor the regulators and aggregate information 2011. and mitigate risks through the timely available to the public. confirmation, marking-to-market, rec- Separately, the existing MiFID leg- Differences between US and onciliation and collateralisation of their islation which includes trading and European proposals derivative portfolios. transparency requirements for equities, Regulatory authorities in the US and in Europe have coordinated their regulatory thinking on OTC derivative regulation 1 Block trades are transactions in swaps that are available for trading in swap markets above a certain minimum size, closely to avoid creating any oppor- i.e. both larger than 95 per cent of all transactions and five times the largest of mean, median and mode for that category of swap over the previous calendar year. tunities for regulatory arbitrage and

Winter 2010 – the markit magazine /48 In Practice

to ensure a level playing field. Regular executed either on exchanges or on transparency of all trades, including visits of Gary Gensler, CFTC chairman, Swap Execution Facilities (SEFs) if those that are not centrally cleared, to Brussels as well as trips by Michel they are “available for trading”. While by the end of January 2011. Barnier, EU internal market commis- the discussion about the definition of sioner, to the US highlight this commit- SEF has been intense, at the time of Challenges ment and have reinforced transatlantic writing, it is still unclear what exactly Over the next couple of months, convergence. However, certain differ- will or will not be captured in such a numerous challenges need to be ences have become apparent between definition. In contrast, views on such tackled so that regulatory authorities can the two regions, namely: trading requirements in Europe and proceed to setting technical standards. Asia are more restrained. For example, • The requirement to conduct certain recommendations from CESR do not Central Clearing activities in derivatives that are include a requirement for trading on As relates to central clearing, a balance perceived as particularly “risky” electronic platforms. In order to needs to be struck between a range of − e.g. non-cleared CDS, equity achieve a globally consistent approach often conflicting objectives: to ensure the derivatives and non-gold or silver on this issue and acknowledging that sound risk management of each CCP; to commodity derivatives − outside the it needs to be “carefully considered”, increase the number of centrally cleared insured banking entity, and restric- the FSB has directed The International products; to avoid mandating clearing tions placed on proprietary trading Organization of Securities Commis- products that are not suitable or cannot activities of banks (Volker Rule) form sions (IOSCO) to identify the costs be risk-managed; to encourage compe- part of the DFA but not legislative and benefits of trading on organ- tition among the CCPs and avoid the proposals elsewhere. However, some ised platforms by the end of January emergence of dominant vertical silos; to Republicans in the US have already 2011, including those benefits that establish open-access requirements and voiced their intention to make these are incremental to those provided by interoperability for CCPs; to increase the requirements less restrictive. standardisation, central clearing and number of direct and indirect clearing • The mitigation of potential conflicts reporting to trade repositories. members; and to control the cost of of interest at execution and clearing • The need for post-trade transpar- clearing while maintaining the efficiency venues. While the so-called “Lynch ency. The CFTC and SEC proposals of the workflow. All these goals must be amendment” was not implemented in require real-time reporting for all achieved while delivering the over-arching the DFA, it still required the commis- swaps but CESR recommends objective of reducing systemic risk. sions to promulgate rules that “might this only for cleared CDS. Also, the Equally challenging is the fact that include numerical limits”, which notion that too much transparency regulators have been tasked with set- were included in proposed rules. In can damage liquidity, particularly ting margin and capital requirements for contrast, while the European EMIR in the case of products that trade uncleared swaps at levels that encour- proposals recognise the need to deal infrequently, is fairly established in age central clearing while avoiding mak- with potential conflicts of interest Europe. Any European post-trade ing customised products prohibitively for CCPs, they reject the usefulness transparency regime is therefore expensive for hedging and risk manage- of limiting voting ownership for this more likely to be liquidity-calibrated, ment purposes. purpose. similar to what exists for European • The increase in trading of swaps on equities. To resolve this divergence Trading “electronic platforms” has been a in views, the FSB has asked IOSCO The US approach of mandating trading significant focus in the US, with the to explore the benefits and costs of of OTC derivatives on “many-to-many” DFA requiring that cleared swaps are requiring public price and volume venues such as exchanges and SEFs reflects a desire for execution to occur in a transparent and competitive environ- ment. However, since there are many standardised OTC derivatives that rarely trade, concerns have been raised that forcing a certain type of execution might damage the liquidity and efficiency of this market. So far, any indications of “ The increase in trading of swaps on the meaning of SEF and “available for ‘electronic platforms’ has been a significant trading” have been vague and views on the usefulness of such requirements focus in the US.” diverge between regions and countries.

the markit magazine – Winter 2010 In Practice /49

To ensure global consistency in this area, the FSB has mandated that IOSCO identify “ In the area of public post-trade reporting, the costs and benefits of trading on regulators need to address the open organised platforms including standardi- sation, central clearing and reporting to questions of the potential liquidity calibration trade repositories. Hopefully, a globally of any regime.” consistent approach will be found that will improve transparency and competition while allowing for more efficient execution.

Creating useful transparency Increasing transparency in the OTC derivative markets appears to be a universal goal. However, the big chal- Readiness of regulatory authorities transaction volumes or unanticipated lenge will be to ensure that any addi- To add to the challenges, many regula- risks. As a consequence, liquidity tional transparency is truly useful and tory authorities now in charge of setting is likely to be very low and, unless a avoids simply adding to costs, not technical standards for OTC deriva- daily process is established to collect, to mention other unintended conse- tives have not been exposed to these aggregate and publish pricing data from quences such as a reduction in liquidity. products previously and will only be participants, market prices will be dif- Trade repositories will be the main able to perform the task if equipped ficult to observe. transparency providers to regula- with sufficient resources and expertise. The plans in India are somewhat simi- tors who will need to delineate what In Europe, there is the additional chal- lar although the CDS reference assets information will be captured, which lenge that the setting of most technical will be restricted to bonds only. As most fields counterparties shall report to standards has been assigned to ESMA, corporate liabilities in the Indian credit trade repositories and how posi- a body that does not exist as yet. market are loans, this requirement is tions across trade repositories will likely to limit liquidity when this market be aggregated. The FSB has started Developments in Asia comes into existence early next year. addressing these issues by stating that In contrast to steps being taken in the When launching their domestic CDS the dataset should consist of affirmed west to curb OTC derivative markets, markets, authorities in India and China sides of each transaction which should both India and China recently announced have aimed to enable credit risk trans- be paired. The dataset should also plans to launch their domestic CDS fer between participants while avoid- be as complete as possible to allow markets, with the first contracts in China ing potential concentration of risk and regulators to perform the tasks of (i) trading in early November. While this detachment of the notional amounts systemic risk assessment, (ii) market news created a flurry of excitement in the of CDS from those of the underlying surveillance, (iii) supervision of market press, it has to be seen in the context of assets. These objectives are generally participants, and (iv) the performance fairly restrictive regulatory constraints. understandable, but many market par- of resolution activities. Trade repositor- In the case of China, origination of ticipants expect that limited activity will ies should be able to not only provide CDS contracts will be limited to 17 constrain the practical use of the prod- notional volumes and transaction event institutions and end users will only be uct, even for hedging, unless the rules (flow) data but also market values to able to buy protection to hedge bonds that determine who can sell protection, allow for effective monitoring of coun- or loans they own. Trades must be con- and how much, are modified. How- terparty exposures. ducted through the Shanghai interbank ever, one can expect the authorities to In the area of public post-trade clearing system and reported before maintain a cautious stance until there is reporting, regulators need to address midday the day after trading. There are sufficient evidence about how the new the open questions of the potential limits on both the amount that any one markets are functioning. liquidity calibration of any regime, dif- dealer can trade and the total notional ferentiation between asset classes and outstanding. Furthermore, only a subset Conclusion products, and the information reported. of the dealer group can sell naked pro- While a significant amount of proposed As to the fields that are reported, a tection, and only on highly-rated refer- legislation and regulation has already balance needs to be struck between ence entities. These rules are designed been published, the global OTC deriva- reporting information that can be to create a market focused on hedging tive market reforms are still evolving. digested easily by the public while pro- rather than trading and to help ensure It will be interesting to see if and how viding sufficient information about the that local authorities will not be caught some of the diverging views will be pricing of a transaction. off guard by the emergence of huge resolved over the coming months.

Winter 2010 – the markit magazine /56 R&D

High frequency trading is under the spotlight following May’s ‘flash crash’, and, asHuw Gronow and Stuart Baden Powell argue, systemic issues should be examined

Fast and furious

he flash crash of May 6 led In our view, the lessons for investors many to question the stability can be found by examining the wider and structural integrity of our market structure and how HFT affects T dynamic system of capital basic characteristics of the market. To markets. Much of the debate has borrow from the field of engineering, focused on causality. How did this structural stability is at the nucleus of happen and can it be stopped from any dynamic system (think of a concrete happening again? The empiricist’s column), small moderations (or struc- view is that some action, or activity, tural deflections) of the initial condi- must have caused the chain of events tions can magnify subsequent stresses, which precipitated a calamitous and ultimately, in some cases, leading to rapid drop in US equity prices that a buckling of the system (or column). day, implying that the playing field Bringing this understanding back to is level and sound, and that rogue financial markets, we can see that struc- activity caused a significant disloca- ture is critically important. tion, however temporary. That is when As institutional traders, we embrace high-frequency trading (HFT) entered the advance of suitable trading tech- the spotlight. nology. On the one hand, the buy-side

the markit magazine – Winter 2010 R&D /57

High-Frequency Trading (% of Turnover by Volume) The Naked Truth

US Europe Percentage of stock market daily volume accounted for by naked access and access % % filtered through a broker‘s computer system 70 70 % 60 60 40

50 50 Naked Access 30 Filtered Access 40 40

30 30 20

20 20 10 10 10

0 0 0 2005 2006 2007 2008 2009 2010* 2005 2006 2007 2008 2009 2010* 2005 2006 2007 2008 2009 Year *Estimate Year *Estimate Year *Estimate

Source: Tabb Group Source: Aite Group

is positioned to demand those serv- percentage of the market. Suitability they reach a tipping point, questions ices; the sell-side, on the other hand, and appropriateness of innovations and are asked, and often action is required. sets a differentiated agenda with the products are central to stability. Having When regulators consider intervening, supply of highly intelligent and appro- a technological innovation does not prevention rather than cure should be in priate product development. HFT now always mean it should be auto-utilised. the forefront of their minds. accounts for over 50 per cent of turn- As we can see from Aite’s chart above over by volume in the US equity market (The Naked Truth), naked-sponsored Liquidity, volume and white noise and for nearly 40 per cent in Europe, as access accounted for almost 40 per Many will note that HFT has increased shown in the chart above. It is crucial cent of trading in US equities before the the volume of transactions, improved that products interact effectively and US Securities and Exchange Commis- liquidity and narrowed bid-ask spreads efficiently with what is a significant sion (SEC) banned the practice in as a result. However, a closer look shows November. From a regulatory stand- that many HFT practices have, at best, point, was the 40 per cent number a neutral effect on liquidity and, at worst, too high to finally install a ban? Like reduce liquidity. Indeed, an analysis1 of many things in life, good or bad, they the May 6 flash crash published by the are accepted in moderation, but once SEC and US Commodity Futures

“ A closer look shows that many HFT practices have, at best, a neutral effect on liquidity and, at worst, reduce liquidity.”

1 Findings regarding the market events of May 6, 2010: Report of the staffs of the CFTC and SEC to the joint advisory com- mittee on emerging regulatory issues. Published on September 30th 2010.

Huw Gronow – Résumé 2004 - Present Principal Global Investors, head trader – Europe 2001- 2004 Blackrock International, equity trader 1999 - 2001 TT International, equity trader Huw Gronow, head trader – Europe, Principal 1996 University of Cambridge, MA in Natural Sciences Global Investors

Winter 2010 – the markit magazine /58 R&D

Stuart Baden Powell – Résumé 2010 - Present Royal Bank of Canada Capital Markets, vice-president, sales and strategy 2008 - 2009 NYFIX Euro Millennium, head of buy-side execution 2007 - 2008 Coalition, senior global strategy consultant – London/New York 2005 - 2007 Reuters, financial application specialist – London/Dubai 2003 - 2005 Bloomberg, equity analyst 2003 London School of Economics, MSc Organisational Psychology 2001 University of Durham, MA Management 2000 University of Southampton, BSc (Hons) Geography

potato’ volume effect”. The end result of associated with hitting the reduced this activity was that just 200 contracts size. were net bought in that frenetic period. Beyond the effects of actual HFT Is that liquidity? trading activity, many of the underlying This observation reflects what is trading theories employed by HFT are widely known among traders: that computerised advancements from the despite all the volume of the tape, some technical trading world and give an orders cannot be completed. As a insight into the new liquidity dynamic. result, liquidity watchers need to focus These technical trading tools are either Stuart Baden Powell, vice-president, sales and on net executable volume as the key momentum or oscillation-based. The strategy, Royal Bank of Canada Capital Markets variable to examine when evaluating latter are the most interesting as oscil- how HFT affects liquidity. The same lations are essentially periods of noise Trading Commission (CFTC) noted that applies to the spread. Market depth and deemed random where no trend “high trading volume is not necessarily a at the higher end of the book is ulti- is possible. Underlying many tech- reliable indicator of market liquidity”. The mately important as is the actual ability nical analysis models, like the Bollinger report also uncovered that in a 14-second to execute against smaller sized and Band model, are stochastics (in the period during May 6, more than 27,000 better priced quotes. So while spreads Bollinger case, the %beta) which are contracts of the S&P 500 E-Mini future in the definitive price sense have used to recognise trading patterns were traded. The report subsequently decreased, we all need to be cognisant and subsequently for predictive fore- referred to this as “generating a ‘hot of the execution and signalling risks casting on mean reversion, for example. Advances in models and computational power have enabled HFT systems to detect patterns even during oscilla- tory periods, times when most feel the market is characterised by uncorre- lated movements in prices. Difficult to uncover, these patterns are known as “white noise”. For strategies using mean reversion oscillators like Bollinger Bands, these noise readings are highly valuable. The underlying mathematics here is also stochastic, which enables the user to effectively create a readable path through signals in what is an otherwise randomised environment. The well- known Monte Carlo method is a core model to simulate stochastic proc- esses such as randomised sequences “ Market depth at the higher end of the book and is used in tools such as Value at Risk (VAR) assessments as well as high is ultimately important as is the actual ability frequency and quantitative trading. to execute against smaller sized and better Central to Monte Carlo is the notion that, as the sources of uncertainty priced quotes.” increase, so do the derived benefits.

the markit magazine – Winter 2010 R&D /59

As electronic trading investment intensifies, the ability to integrate quanti- “ As electronic trading investment intensifies, tative formulae such as Monte Carlo into the ability to integrate quantitative formulae HFT strategies more effectively has led to a new source of arbitrage opportuni- such as Monte Carlo into HFT strategies ties and price predictive technologies. more effectively has led to a new source of However, as more firms operate similar systems, the oscillation band and spec- arbitrage opportunities and price predictive trums are squeezed downwards having a knock-on effect on profit margins. As technologies.” a result, much of the liquidity we see in the spread is cancelled within a short space of time. Indeed, Aite research has shown that some computational models have cancellation rates of up to 99 per cent. The chart on this page shows the messages and trades on the NYSE between 2000 and 2009 to illustrate the point further. The message to trade ratio on whether HFT provides more liquidity not recognising the transient nature of has risen from 8.85 in Q3 2000 up to or not misses part of the point, because liquidity, it does not place requirements 74.73 in Q3 2009. This particular “noise” it is the nature or type of liquidity that is for the preservation of liquidity. Brokers, is of concern to a wide number of buy- important to the buy-side. exchanges and new venue entrants side institutions who have reservations How did we get there? While tech- must prove that price incentives are over price testing mechanisms and nology has of course played a part, of benefit to the end investor. The increased execution risk. so too have critical changes in market Usain Bolt of the algo world makes its If we take a step back and recall the structure. The emergence of the ultra-low-latency round trip trade in 16 engineering metaphor used earlier, “maker-taker” model for new venues microseconds. Blink your eyes. That we saw that a small or medium sized (and indeed some old ones) incentivises took between 300-400 milliseconds. external market force is too insignificant participants to provide liquidity, but by The retail investor, waiting a minute or to bring the system down on its own. However, amplification of these small moderations can create sufficient insta- bility for material impact. This amplifica- tion process is the hallmark of a mecha- nism called “stochastic resonance”. NYSE Messages vs NYSE Trades (2000 - 2009) Crucially, stochastic resonance occurs in systems that contain two main charac- Millions Millions teristics: both an information carrying 450 30 Messages signal and also internal noise. The central 400 point to this mechanism is that the noise Trades 25 350 strengthens the signal significantly and in turn magnifies the resonance, causing 300 20 the system to buckle. 250 15 The SEC/CFTC report implies that 200 Messages 256,666,776 stochastic resonance is a worrying 150 10 example of how an external force with a signal attached can enter the system 100 Trades 400,494 5 and when interacted with noise can 50 Messages 3,543,277 Trades 3,434,576 become amplified to the extent that the 0 0 system is affected, like the scenario that Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 unfolded on May 6. Quarter/Year Despite these realities about HFT, from a buy-side perspective, the debate Source: Rosenblatt Securities

Winter 2010 – the markit magazine /60 R&D

“ What is intriguing is that a concept known as market impact makes up the majority of total trading costs and yet widely used market impact calculation models assume that the general stock price is random.”

two for his trade to be confirmed, might trade side has become a major focus for While we can improve the input quality, breathe a sigh of relief to see his price, the buy-side. In Europe, most discus- there may well also be sufficient need given that thousands of trades may sions on TCA revolve around the quality to increase the magnification of the have taken place in that period. of data input into the TCA systems. The analytical lens they use. debate about a post-trade consolidated No longer is it wholly adequate to Transaction cost analysis tape and flagging of trades also arises, measure a posteriori a set of executed If certain members of the market are as part of the quest for accurate data on trades versus a theoretical bench- able to create highly complex pattern price movements and volume tracking. mark. Fluctuation analysis and noise recognition programmes, for example As important, however, is the ability to screening may be taking the exercise by reading “white noise” within oscil- convert inputs into valuable outputs too far – or does it? If it is suspected latory environments, the question for through a meaningful production that a great deal of the market activity is many other participants who cannot process. We have observed that the noise, then examination and analysis is would logically be how much it is analytical models central to TCA share self-evidently required. costing them. a reliance on a limited range of math- More than trend evaluation, or yet, As noted in a Knowledge@Wharton, ematical theories. This is in contrast, trader evaluation, the opportunity exists Wharton Business School 2009 for example, to economic forecasting for clients to ask their TCA providers paper; “[HFT] profits were estimated where often similar inputs can result in for more. Venue analysis is on the set at between $8bn and $21bn in 2008.” radically different outcomes. of keys that unlocks the answer. Do While some would note that HFT profit What is intriguing is that a concept some brokers route to some exchanges is net new industry profit, others would known as market impact makes up the more favourably over others? If so, why say that it is alpha capture that should majority of total trading costs and yet is that? Are brokers transparent about be benefiting the long-term investor. The widely used market impact calcula- their pricing structures and routing question of where the costs are incurred tion models assume that the general capabilities? In fact, do they “smart is not so much with direct costs − these stock price is random. As we have seen, route” at all? indeed have declined. The issue is with however, certain trading strategies are Then, how does one evaluate one’s tracking the indirect costs, those that capable of de-randomising the market participation versus suspected preda- are more difficult to compute. Some through, for example, reading the “white tory strategies? Widespread assur- more simple measurements such as noise”. As such, many questions need ances of anti-gaming, nuisance bands, “adverse ticks” are at market-wide high to be asked of TCA suppliers about the minimum dark-crossing fills are only levels and are generally regarded as quality of the production processes they valuable once accurate momentum and indicating a toxic trading interaction. deploy. However, the output users see reversion analysis takes place. Exam- As a result, transaction cost analysis may well be a very fair reflection of the ining what happens in the market after (TCA) both on the pre-trade and post- data that is inputted into the system. your order goes hand-in-hand with

the markit magazine – Winter 2010 R&D /61 examining what happened during your NYSE and FTSE Average Holding Period (1940 - 2005) order. The foundation on which all of this Years Years must be built is accurate and correctly 14 8 reported data. The ability for institu- 12 7 tions to gather and analyse data on 6 the lifecycle of their market participa- 10 tion becomes vital as trade sizes shrink 5 8 and signalling risks on every piece 4 of liquidity capture increase. Double 6 and triple reporting are not condu- 3 4 cive to good analysis, nor is delayed 2 or untimely publishing. A manda- 2 1 tory consolidated and standardised reporting tape in fragmented markets is 0 0 1940 1960 1980 2000 1966 1976 1986 1996 long overdue. Year Year

Source: New York Stock Exchange Source: London Stock Exchange Final thoughts When it comes to the equity markets, speed and democratised access have been held up as the torch bearers of is key. If the investing community, inexorably, the spectre of economic progress and celebrated as competition whether the majority or an influential damage looms. As Mary Schapiro, drives down costs. minority, takes the view that the system SEC chairman, has noted: “Equity But, will regulators become of capital markets has become unfair, markets are a vital engine of economic concerned that holding periods for that the main players have become the growth.” Little wonder, then, that the equities have declined rapidly? (see casino, then the greatest risk is that new UK government, while imposing chart on this page). Does it matter? confidence and trust become eroded. austerity measures to revive the Are listed corporations really agnostic Once that happens, our metaphorical economy, has commissioned a study about who owns their common stock column begins to topple. into the effects of high velocity tech- and for how long? Whatever the motive When fairness is seen to erode, nology-based trading. Practices such for engaging in the capital markets, the cost of capital rises and equities as naked sponsored access, flash short-term or long-term, confidence become a less attractive investment; orders, “quote-stuffing” and order transience are already in the spotlight in the US. As investors, regulators and politi- cians examine the issues, one of the primary questions must be who the secondary markets exist for. John Maynard Keynes once noted that “The market can stay irrational longer than you can stay solvent.” Is it any wonder that today’s technologically advanced computer systems combined with quantitative financial techniques attempt to rationalise the market to stay “ Double and triple reporting are not solvent over very short periods of time? There is no quick answer to today’s conducive to good analysis, nor is delayed difficulties; while naked access has now or untimely publishing. A mandatory been banned, studies into other areas will continue and the implementation consolidated and standardised reporting of a suitable set of uniform regulatory- tape in fragmented markets is long based solutions will ensure that the pillars of our market structure remain overdue.” standing, as they must.

Winter 2010 – the markit magazine /62 In the Spotlight

Latin American debt is of increasing interest to investors as part of their emerging market portfolio. Joseph Mariathasan reports on how the development of local currency debt indices could fuel its popularity

Debt of nations

atin American debt is riding the throughout the developing world, who wave of interest in emerging are the natural buyers of sovereign market debt. EMD originated bonds issued locally, has also played a L as a hard currency debt market part. As a result, there are more natural but today it is the local currency issu- buyers of local currency debt than hard ance that dominates the sovereign currency so that when the credit crunch debt market. While hard currency panic spread to the EMD markets in issuance in 2007/8 was 70 per cent 2008, it was the dollar-denominated corporate, as of December 2009 hard debt markets that performed worse. currency amounted to $1,400bn and Not surprisingly, this move towards local currency $6,800bn. The stronger, local currency issuance is also reflected more developed regulatory frameworks, in the growth of local currency bond which local regulators and supervi- management by fund managers and sors have worked on in the past few in the fact that new searches by insti- years, have helped the growth of local tutional investors for EMD managers currency debt. The development of are predominantly for local currency. local financial institutions such as insur- As Peter Eerdmans, head of the EMD ance companies and pension funds team at Investec, says: “The beauty of

the markit magazine – Winter 2010 In the Spotlight /63

hard currency off-benchmark positions. returns for dollar-denominated debt Clearly, such permutations all have their issued by emerging market sovereign drawbacks and perhaps the clearest and quasi-sovereign entities, including message is that current index bench- Brady bonds, loans and eurobonds. Yet marks are now straying so far away from adopting a hard currency benchmark managers’ actual strategies that their may constrain a manager unduly when it usefulness can be questioned. Yet the is local currency that offers most oppor- long established domestic local currency tunities. However, allowing managers bond indices seen in Latin America are leeway in taking off-benchmark positions not integrated into global bond indices has its own drawbacks. It means it is and, as a result, would tend to be difficult to control and monitor their risks ignored by international investors. But and reduces the role of the index to a developing suitable global local currency mere performance comparison indicator, indices is not straightforward. rather than an integral component of risk The key subcomponents of the EMD management. universe are the original hard currency Capitalisation weighted bond market sovereign debt, followed now by local indices of any type suffer from a major currency sovereign debt and increas- conceptual flaw − the more debt an ingly hard currency corporate debt. At entity issues, the greater the proportion Peter Eerdmans, head of the EMD team, Investec some stage, local currency corporate in the index, although more debt issu- debt may also come to have significant ance is usually associated with a weak- local currency debt is that as countries size, although the markets have not yet ening credit. Nowhere is this truer than in improve and grind down in yields, new developed to that stage. EMD indices. Historically, managers who countries get developed and enter the The two questions that need to be stuck closely to the J.P. Morgan EMBI universe at a yield of say 12 per cent. addressed when considering the role of weightings found themselves experi- We have a universe of 40 countries that an EMD bond index is first, what should encing a train wreck in slow motion as we follow, but there are another 150 its composition be, and second, how they increased their weightings. J.P. countries out there that are not even closely should a manager be asked Morgan subsequently issued indices that covered as yet.” Peter Marber, head of to stick to it. The international market have 10 per cent caps to the weighting EMD at HSBC/Halbis, echoes this view: originated in hard currency sovereign any single issuer can have within the “We believe that there is now enough debt and not surprisingly the most index. Such limits to specific exposures economic momentum in emerging prominent benchmark has been the J.P. are a pragmatic solution, but suffer markets that there will be the opportu- Morgan Emerging Markets Bond Index from the lack of any theoretical frame- nity to benefit from credit compression Global (EMBI Global), which tracks total work behind them. Yet indices have also and currency appreciation for the next 10 to 20 years.” The problem that now exists both for Latin American local currency debt and more widely in emerging market debt, is that while countries such as Chile, Mexico and Brazil have had local currency bond indices since 1995, inter- national investors with global portfolios face a number of issues when it comes to adopting suitable benchmark indices. Hard currency sovereign issuance has been overtaken to such a large extent by local currency that it is now looking “ We believe that there is now enough anomalous to have a hard currency economic momentum in emerging markets sovereign benchmark with the ability for managers to take local currency off- that there will be the opportunity to benefit benchmark bets and there may even be from credit compression and currency a better case for reversing this; having a local currency benchmark index with appreciation for the next 10 to 20 years.”

Winter 2010 – the markit magazine /64 In the Spotlight

performed a useful role for investors in presenting the asset class in a way that “ In the local currency universe, a big market could be analysed in depth as part of capitalisation is not a sign of weakness as a systematic approach to asset alloca- tion. The J.P. Morgan EMBI Global has in the developed markets, but a sign of proven to be one of the best performing development. If a country gets into the local financial indices in the world, according to Marber of HSBC/Halbis. Its phenom- market index, it is a good sign.” enal performance has been a key factor in the growth of interest among institu- tional investors in EMD. Yet, unlike most bond indices, it is not characterised by a credit rating and while a decade ago it was seen as an alternative to high-yield debt, 60 per cent of its composition is now investment grade, says Marber. More recently, J.P. Morgan has intro- duced local currency indices but, as Marber points out, local currency indices are still at an embryonic stage, adding: tion weighting and practical arguments namely capital controls and taxation “We are investing in around 30 coun- of allocations that reflect the size of the which are given a weighting of 35 per tries rather than just the 13 in the index.” investable universe. cent; liquidity and efficiency, also given At Investec, Eerdmans can have 30 per The GEMX local currency indices a weighting of 35 per cent; and regula- cent of the strategy in off-benchmark produced by Markit are sponsored by tions and market infrastructure are given positions using a local currency universe the World Bank as part of its attempt to a weighting of 30 per cent. of 40 countries. As he argues: “In the develop local bond markets in emerging The index looks very different from its local currency universe, a big market markets. It has tried to take a prag- competitors, with weightings of 30 per capitalisation is not a sign of weakness matic approach that achieves a balance cent for Latin America, 31 per cent for as in the developed markets, but a sign between the conflicting constraints, Asia and 39 per cent for EMEA. Mexico of development. If a country gets into although this process means that some is at the limit of 10 per cent with the next the local market index, it is a good sign.” debate exists over the methodology. The largest being Brazil at 8.8 per cent and Designing a local currency index has indices attempt to embed a strategy of Colombia at 5.2 per cent. Adopting the therefore to achieve a balance between objectivity, transparency and independ- investability criterion to adjust weights, theoretical arguments against capitalisa- ence, through having a provider not even if done in an objective manner, tied to an investment bank, using prices gives rise to disagreements over coun- from multiple providers and a trans- tries with, for example, weightings of 7.1 parent and structured approach to index per cent for China and 7.7 per cent for construction. The country weightings India which are seen by some managers are produced by multiplying a country’s as not reflective of the ease of access base weight based on capitalisation, with to those markets where capital controls a cap at 10 per cent, by an “investability” make it all but impossible to get direct score, which denotes how accessible exposure to local bond markets. and liquid the market is for non-domestic Latin American debt is clearly likely to investors. Countries eligible for inclusion be of increasing interest to international in the index are defined as those that investors. However, it will inevitably be are declared as low or middle income seen as part of a global EMD portfolio by the World Bank. They must have a and demand for it may therefore be local currency sovereign debt rating and highly dependent on the construction the country must not be in default. The and methodology of widely acceptable bond market must meet the investability local currency debt indices. The current criteria and be larger than $3bn equiva- lack of such universally applicable lent and have at least five eligible bonds. benchmarks will certainly be a barrier The investability criteria of a bond market for many investors, although it may Peter Marber, head of EMD, HSBC/Halbis are seen as dependent on three areas, provide an opportunity for some.

the markit magazine – Winter 2010 Markit Commentary & Data /65

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Winter 2010 – the markit magazine /66 Markit Commentary & Data

Global Economic Growth [OLYLMVYLYLTHPUZHRL`KYHNVUYLJV]LY`WYVZWLJ[Z(OPZ [VYPJHSJVTWHYPZVUVM740KH[HZOV^Z[OH[[OLZS\NNPZOQVI 740 .+7(UU\HS *OHUNL JYLH[PVUHWWLHYZ[VILHZPTWSLYLÅLJ[PVUVM^LHRKLTHUK   MVYNVVKZHUKZLY]PJLZ3V^LYPU[LYLZ[YH[LZ[OL[OLVY`   NVLZZOV\SKIVVZ[KLTHUKPU[OL<:^OPJONP]LUP[ZYVSL  HZ[OL^VYSK»ZSHYNLZ[JVUZ\TLYZOV\SKHSZVILULÄ[[OL    NSVIHSLJVUVT`     US rises to top of export growth table    (SSVM[OH[PZMHPYS`\UJVU[YV]LYZPHSI\[YLZLU[TLU[PZILPUN .SVIHS7406\[W\[0UKL_  Z[VRLKI`[OLMHJ[[OH[[OLWVSPJ`HWWLHYZ[VILILULÄ[PUN[OL  .SVIHS.+7  <:H[[OLL_WLUZLVMV[OLYJV\U[YPLZ(UHKKP[PVUHSLMMLJ[VM   8,^HZH^LHRLY<:KVSSHY^OPJOH[[OL[PTLVM^YP[PUNOHZ           Z\UR[VH[^V`LHYSV^VUH[YHKL^LPNO[LKIHZPZ(X\PJR @LHY HUHS`ZPZVML_WVY[[YLUKZMYVT740Z\Y]L`ZOPNOSPNO[Z[OL :V\YJLZ!4HYRP[174VYNHU0:4 PTWHJ[(Z\YNLPUL_WVY[ZMYVT[OL<:OHZTV]LKP[[V[OL [VWVM[OLNSVIHSL_WVY[NYV^[OSLHN\L[OL[VWOHSMVM^OPJO Global growth slowdown arrested? PZUV^KVTPUH[LKI`KL]LSVWLKTHPUS`>LZ[LYUUH[PVUZ;OL 0U[OLZ\TTLYLKP[PVUVM;OL4HYRP[4HNHaPUL^LUV[LKOV^ V[OLYLUKVM[OL[HISLPZTHPUS`WVW\SH[LK^P[O,4JV\U[YPLZ [OLYH[LVMNSVIHSLJVUVTPJNYV^[OOHKWLHRLKPU[OLZLJVUK THU`VM^OPJOHYLUV^ZLLPUNL_WVY[ZMHSSPUN X\HY[LYHUK^HZZOV^PUNZPNUZVMZSV^PUN;OPZLHZPUN HWWLHYZ[VOH]LJVU[PU\LK\W[V:LW[LTILYI\[[OL^VYSK Export orders – Developed Nations ^PKL7\YJOHZPUN4HUHNLYZ»0UKL_740Z\Y]L`ZZOV^LK[OL ÄYZ[\WSPM[PU[OLWHJLVMNYV^[OMVYZP_TVU[OZPU6J[VILY;OL 7405L^,_WVY[6YKLYZ0UKL_$5V*OHUNLVU7YL]PV\Z4VU[O Z\Y]L`KH[HOH]LYHPZLKOVWLZ[OH[HZL]LYLZSV^KV^UHUK  WV[LU[PHSZSPKLIHJRPU[VYLJLZZPVUOH]LILLUH]LY[LK  >OPSL[OL\W[\YUPZ^LSJVTLP[OHZILLUHJJVTWHUPLK I`PU[LYUH[PVUHSWVSPJ`[LUZPVUZLZWLJPHSS`PUYLSH[PVU[V 

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the markit magazine – Winter 2010 Markit Commentary & Data /67

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Winter 2010 – the markit magazine /68 Markit Commentary & Data

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the markit magazine – Winter 2010 Markit Commentary & Data /69

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Winter 2010 – the markit magazine /70 Markit Commentary & Data

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Technology

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the markit magazine – Winter 2010 Markit Commentary & Data /71

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Winter 2010 – the markit magazine /72 Markit Commentary & Data

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the markit magazine – Winter 2010 Markit Commentary & Data /73

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Winter 2010 – the markit magazine /74 Markit Commentary & Data

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the markit magazine – Winter 2010 Markit Commentary & Data /75

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Cash (Non Financials) and Dividend Amount for S&P 500

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Winter 2010 – the markit magazine /76 Markit Commentary & Data

Total Return Performance Emerging Market YTD Bond Returns

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the markit magazine – Winter 2010 Markit Commentary & Data /77

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Winter 2010 – the markit magazine /78 Markit Commentary & Data

Recent Growth in Commodity ETF AUM

AUM Millions 1,250 SIVR 1,125 SGOL 1,000 PPLT 875 750 The Markit Commentary & Data Team 625 500 325 250 125 Chris Williamson 0 2 Aug 16 Aug 30 Aug 13 Sep 27 Sep 11 Oct 25 Oct 8 Nov chief economist 10 10 10 10 10 10 10 10 Date

Source: ETF Securities

each share represented 0.03 ounces of gold, 1.1 ounces of Gavan Nolan silver, 0.004 ounces of platinum and 0.006 ounces of palla- vice-president, credit research dium. Unlike competing exchange traded notes (ETNs), each share represents a beneficial interest in the trust, which holds physical allocated gold, silver, platinum and palladium bullion in vaults at J.P. Morgan in London and Zurich. In the two- week period from November 1 to November 15, GLTR saw Haider Awan AUM increase 135 per cent from $31.5m to around $74m. associate, Markit BOAT Two days later, Market Vectors launched its Rare Earth/Stra- tegic Metals Fund (NYSE: REMX). Forty-nine elements in the periodic table are considered rare earth/strategic metals. They include cerium, manganese, titanium and tungsten. REMX holds a basket of 24 globally diverse, publicly traded compa- Jeremy Reed nies that mine, refine and manufacture these rare earth/stra- vice-president, loan pricing tegic metals. The launch of REMX comes off the back of Global X’s dive into the rare earth metals market. Global X Lithium (NYSE: LIT) and Uranium (NYSE: URA) have been wildly suc- cessful as investors attempt to get in on the ground floor. The launches of NYSE GLTR and NYSE REMX are exciting Samir Bhatt for investors for two reasons: first, investors who want an director, head of structured finance indices alternative to the dollar can achieve this goal without having to purchase an “overcrowded” gold fund; and second, investors currently holding gold and silver have an opportunity to diver- sify their metals holdings further. With the demand for alternatives to fiat currencies rising, Otis Casey we look forward to seeing what the ETF world has in store for vice-president, credit research us next. Jeremy Kross, vice-president, equities, Markit

Jeremy Kross vice-president, equities

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the markit magazine – Winter 2010