Markit Adds Sensitivities Data to CDS Pricing Markit Has Supplemented Its End-Of- Comply with IFRS 7 and Other Regu- Measures and Manages Financial Risk

/6 Markit News Markit adds sensitivities data to CDS pricing Markit has supplemented its end-of- comply with IFRS 7 and other regu- measures and manages financial risk. day prices for credit default swaps lations that require management Armins Rusis, managing director (CDS) with a new sensitivities report. to disclose how the firm perceives, and global head of data, indices and This valuable information will help research at Markit, said: “CDS Sensi- users to understand how sensitive tivities is another example of how a particular CDS spread level is to Markit is expanding its core data sets changes in interest rates, credit quality to include derived data that provide and recovery assumptions, among more context for clients. Having other factors affecting CDS pricing. independent data to enable analysis The report is comprised of seven of the relationship between price variables and covers all 2,600 five- and variables like interest rates and year, single name CDS and CDS credit quality is very valuable in giving indices (on- and off-the-run) priced additional metrics for quantitative and by Markit. qualitative assessment of the potential Independent, objective data from volatility of a portfolio.” Markit CDS Sensitivities on how a CDS could respond to changing market conditions are important not only to traders, but to risk managers News in brief and the management of investment firms, which need tools to run sensi- BrightWire’s news coverage Armins Rusis tivity analysis on their portfolios and and PIA-First’s research are now available on Markit Hub, a web and iPad platform that gives users access to financial research and Lance Uggla lifetime content from global banks and third party providers. achievement award MarkitSERV is now transmit- ting confirmed trade records to the Depository Trust and Clearing Lance Uggla was Corporation’s new Global Trade honoured to receive Risk magazine’s 2012 lifetime Repository for over-the-counter achievement award. He interest rate derivatives. was praised for his visionary work in founding Markit and Markit has launched two new launching the world’s first Markit iBoxx indices designed daily CDS pricing service. to benchmark the performance of He was also commended liquid corporate high-yield bonds for expanding Markit’s prod- from issuers in over 30 countries, ucts and services across primarily in North America and asset classes, to improve Western Europe. Lance Uggla market infrastructure.

the markit magazine – Spring 2012 Markit News /7 MarkitSERV Markit Desktop It is often said that the difference between data and information is context. The latest Markit Desktop announces CCP (V2.5) provides users with new tools gateway for OTC to analyse data and put it in context. FX clearing MarkitSERV unveiled a gateway for are pleased to offer the connectivity foreign exchange (FX) industry partici- and tools the industry needs to effi- pants to route trades to central clearing ciently transmit trades to all FX clearing counterparties (CCPs) worldwide. The venues. MarkitSERV has over 2,500 gateway enables executing brokers, buy-side clients and we have been Bond screener showing liquidity clearing brokers and buy-side firms to careful to ensure that their requirements match, legally confirm and route OTC FX have been factored into the design of The new Desktop simplifies the transactions to the CCPs of their choice our clearing solution.” search for relative value within global from a single point of access. credit across CDS full curves, bonds The service was developed in close (including Markit iBoxx, evaluated consultation with major market partici- bonds and European ABS) and pants. Prior to the launch, MarkitSERV syndicated loans. Data can be completed industry end-to-end testing cycles and was certified by, or estab- screened by key criteria (e.g. sector, lished links to, CME, LCH. Clearnet region, rating) as well as by Markit’s and Singapore Exchange. MarkitSERV liquidity measures. This enables will continue to build connectivity to users to construct portfolios with other CCPs worldwide as they begin to specific liquidity profiles and monitor clear FX. risk over time. Keith Tippell, co-head of FX product management at MarkitSERV, said: “FX Markit CDS Sensitivities are also non-deliverable forwards and options available on the Desktop. are expected to be mandated for central clearing as part of the new regulatory If you are interested in a trial of landscape. As with other asset classes, Markit Desktop, please contact MarkitSERV’s middleware platform is [email protected]. Keith Tippell central to the clearing process and we

Markit and MarkitSERV kicked off around the current situation in local Launch of their annual conference series on financial markets and how global regula- the over-the-counter trading landscape tions will affect local market participation. in Singapore on February 28. These Forthcoming conferences include 2012 OTC conferences are designed to help Frankfurt (May 14), Paris (May 15), market participants understand and London (May 17) and New York (May adapt to new regulation. 31). Please email [email protected] if conferences This year’s discussions will revolve you would like to attend.

Spring 2012 – the markit magazine

Talking Business /9 The next best thing

NYSE Euronext may have been thwarted in its efforts to merge with Deutsche Börse, but that doesn’t mean that its strategists have to go back to the drawing board. Duncan Niederauer, CEO of NYSE Euronext outlines where it is headed

Q: Now that your tie-up with Deutsche Börse has • A more consolidated clearing and settlement been blocked, what are the key priorities for NYSE infrastructure will make it easier for market partici- Euronext? You recently made comments about pants to clear and settle trades across global pursuing smaller-scale acquisitions with a focus on markets. This in turn will help to provide transpar- technology and post-trade services. Could you elabo- ency and lessen systemic risk. We are focused rate on your strategy in this area? on enhancing our managed services capabilities for NYSE Technologies. Our technologies A: The proposed merger was a great opportunity to accel- business continues to make strong inroads into erate our strategy. It would have created long-term value Asia with our acquisition of Metabit and the for shareholders and provided substantial benefits with deepening of our relationship with the Tokyo regard to capital efficiencies. Stock Exchange. That said, we’re pleased with the progress we’re making • In the US, we will be launching new products in on our strategy to create a global capital markets community NYSE Liffe US and New York Portfolio Clearing that will empower our clients to innovate and collaborate. (NYPC). NYSE Liffe US gained momentum from the launch of interest rate futures as well as the • Our portfolio of post-trade services will be a key successful migration of the MSCI-linked index priority in 2012. We have a solid clearing footprint in futures. Since this migration in June, open interest Europe and the US which we will now build on. We in average daily volume and the MSCI products has will be completing the development of a post-trade nearly doubled, led by the emerging markets index solution for our European derivatives and cash product. In December, we passed a milestone – we equities businesses. exceeded 1m contracts of open interest. this was

Spring 2012 – the markit magazine /10 Talking Business

led by eurodollar futures where our open interest Q: Will NYSE list swaps alongside futures on its desig- now represents a 10 per cent market share. nated contract market (DCM)? Do you expect consolidation among swap execution facilities (SEFs) and Over the past year, we have also seen some interesting DCMs? M&A opportunities and we will now begin to look at potential complementary fits. A: We plan to launch options on interest rate futures late 2012. SEFs and DCMs will potentially be listing different products; for example a SEF cannot list a futures contract, only a DCM can. We will have differing execution methods “ A key objective for CTPs should such as a central order book versus wholesale execution methods. As a result, what we may see is a DCM operator be to improve the quality also looking to register a separate SEF – so, if anything, it is more of a divergence than a convergence between the of trade report data arising DCMs and SEFs.

from market fragmentation, Q: Four years after the Markets in Financial Instru- particularly in OTC trading.” ments Directive (Mifid), there is still no consolidated, affordable way to look at the overall activity in Euro- pean equity markets. The recent Markets in Financial Instruments Regulation (Mifir) proposals aim to make Q: Are you on track to deliver on NYSE Liffe Clear this data “consolidatable” by establishing formatting and year or will you look to acquire a clearinghouse in data quality standards. They also require the data order to compete effectively with other exchanges? to be made available in an affordable and unbun- dled format. Do you believe that consolidated tape A: We made significant investments in NYSE Liffe Clearing providers (CTPs) will emerge on that basis? through 2011, rolling out a new clearing processing engine, the Universal Clearing Platform. This technology invest- A: NYSE Euronext considers that the emergence of CTPs, ment programme will continue through 2012. Approved Publication Arrangements (APAs – for trades We have relaunched our project to convert NYSE Liffe executed on an over-the-counter (OTC) basis by invest- Clearing into a full-service central clearing counterparty ment firms) and Approved Reporting Mechanisms (ARMs) (CCP). This will expand the service to clear all of our Euro- will help address the issue of data fragmentation, ensure pean derivatives products and deliver operational and that brokers demonstrate best execution and deliver better capital efficiencies for customers. We will also develop access to information for investors. In the US, consolidated the OTC clearing capabilities and remove the reliance on tape plays an important role providing consistent, reli- third-party providers by introducing inhouse solutions for able, real-time transparent price information for all markets treasury management services. trading US stocks. In Europe, while post-trade transpar- European cash markets are cleared by LCH. Clearnet ency is not a substitute for pre-trade transparency, reliable in Paris and the current arrangements are due to expire at and timely market data available at a reasonable cost is the end of next year. No decision has been taken on cash crucial for investors as it allows efficient comparison of clearing and all options will now be reviewed to identify the prices and trades across different venues. most efficient, stable, secure and commercially appropriate solution. Q: What are the remaining hurdles?

Q: What are your plans for New York Portfolio Clearing? A: The key objective for CTPs should be to improve the quality Will NYPC expand the instruments, products and of trade report data arising from market fragmentation, markets that it covers? particularly in OTC trading. A set of clear guidelines on trade reporting should be developed for both APAs and the A: NYPC was created last year to evaluate, margin and clear reporting parties to ensure that trade reports are accurate. members’ risk on a portfolio basis across related cash and derivative positions. We are considering a number Q: Do users actually want or need a real-time consoli- of expansion opportunities for NYPC. For example, we dated tape? will launch new products on NYSE Liffe US and NYPC, such as the futures product based on DTCC’s GCF A: Yes, they do. The debate concerns the chosen model for Repo Index. its delivery: we believe that the competition successfully

the markit magazine – Spring 2012 Talking Business /11

enabled by Mifid 1 should be maintained by a competitive Q: Mifir proposes the creation of a new kind of trading framework for post-trade transparency, and thus support venue, the Organised Trading Facility (OTF). Which the European Commission’s proposals for competing issues is the Commission trying to address by commercial providers of a consolidated tape in Europe. creating this category? The market transparency issues in cash equities are the direct result of fragmentation and trades are reported from A: The Commission is addressing two issues: first, to bring a diverse population of platforms, with inconsistent prac- platforms which are not currently regulated as trading tices and interpretations of their reporting obligations. These venues within the scope of the cash equities legislative factors, coupled with a lack of specific guidelines and an framework; and, second, to help meet the G20 trading organised regime for facilitating the collection and dissemi- mandate in the derivatives markets. nation of post-trade data, results in poor quality informa- NYSE Euronext considers that the creation of any new tion that does not support investors’ ability to distinguish trading venue category must be contingent on having a relevant market activity from non-relevant events. legally enforceable definition of OTC for cash trading. If not, the efforts of the Commission to make the new legis- Q: Both European Market Infrastructure Regulation (Emir) lation “future-proof” will be in vain, as new types of trading and Mifid contain requirements for the provision of venues will continue to gravitate towards unregulated OTC open, non-discriminatory access, to clearing, trading activity. and benchmarks. Do you believe that these require- Once this legally enforceable OTC definition is in place, ments are necessary and useful? we believe that any new category must reflect a clear distinction between multilateral and bilateral trading. The A: The proposed changes could have far-reaching conse- two are fundamentally different and should be subject to quences for Europe’s financial market infrastructure. We different obligations concerning the matching of orders, are concerned that the proposals could undermine the access to the system, transparency and reporting. ability to manage financial risk at the clearing level and to If the legislator follows the rationale of a multilateral maximise liquidity at the trading level. OTF as proposed by the Commission, it will be critical to ensure a true level playing field between the OTF and other multilateral trading venues, notably in maintaining the proposal’s prohibition of trading on own account by the “ Futures markets have been OTF operator, while removing its ability to perform discretionary execution. This will ensure the new category is a a much needed stabilising properly multilateral venue. factor during the financial crisis, If the legislator wishes to attribute bilateral characteris- tics to the new category to allow it to perform client trade remaining liquid and orderly facilitation, for example, through the inclusion of own account flows alongside the proposed discretion, then throughout.” the OTF should be placed within the bilateral arena and appropriately regulated.

This is significant because futures markets have been a much needed stabilising factor during the financial Career in brief crisis, remaining liquid and orderly throughout. Whereas Duncan Niederauer has served as chief executive officer and a director of liquidity in many other venues dried up, futures markets NYSE Euronext since December 2007 and has served as a member of the continued to allow risk to be transferred between end- company’s management committee since April 2007. Prior to his current position, Niederauer was president and co-chief operating officer of NYSE users, financial intermediaries and others in a multilat- Euronext with responsibility for US cash equities. eral, open and transparent environment. The positions Before joining NYSE Euronext in 2007, he was managing director and created as a result continued to be valued, risk managed co-head of the equities division execution services franchise at Goldman, and collateralised on a daily basis by the relevant Sachs & Co. His career at GS spanned 22 years. Niederauer has served clearinghouses in a prudent and professional manner. on the board of Archipelago Holdings, LLC and Colgate University, and now serves on the board of Operation Hope, and the Congressional When insolvencies occurred – such as the default of Medal of Honor Foundation. His current memberships include the G100, Lehman Brothers in September 2008, and more recently the British-American Business Council International Advisory Committee, with MF Global – Europe’s clearinghouses managed the Partnership for New York City, the Committee Encouraging Corporate the financial consequences without recourse to the Philanthropy, the Shanghai International Financial Advisory Committee, finances or resources of other clearing members or the the Museum of American Finance, and Fundacao Dom Cabral in Brazil. He earned an MBA from Emory University and a BA from Colgate University. public authorities.

Spring 2012 – the markit magazine / the

Source: Shutterstock 12 markit magazine

Focus: FX clearing FX Focus: – Spring 2012 – Spring Focus: FX clearing /13

Clearing hurdles Clearinghouses are preparing to launch services for FX non-deliverable forwards to meet imminent OTC derivative regulations, but banks and regulators continue to grapple with the challenge of clearing FX options, writes Joel Clark

hen leaders of the G20 economies signed a commitment in September 2009 that all over- the-counter (OTC) derivativesW should be cleared through central counterparties (CCPs) where appropriate, it became clear to participants in the foreign exchange industry

Spring 2012 – the markit magazine /14 Focus: FX clearing

concerns led to a cranking up of the components of the Dodd-Frank Act but industry’s lobbying efforts to ensure mandate all products except spot to be sensible outcomes for the FX market, reported to a trade repository. Euro- with the formation of a new bank-led pean authorities have indicated they global FX division under the umbrella of will avoid the creation of opportunities the Association for Financial Markets in for regulatory arbitrage, implying they Europe (Afme). would look to replicate the US proposal Now, with the G20’s implementa- as far as possible, if and when it is set tion deadline looming at the end of in stone. the year, progress has certainly been Despite the element of uncertainty, made in securing sensible outcomes, the presumption that swaps and but the landscape remains riddled forwards will be exempt has driven with complexities and uncertainties. banks and CCPs to prepare for clearing Most senior participants recognise that of the non-exempt FX products, regulation will continue to be a defining including options and non-deliverable Jeremy Hill, head of foreign theme of the coming years as the rules forwards (NDFs). With a scenario now exchange and money market come into force and the necessary developing in which some FX products operations, RBS infrastructure is put in place. will be mandated for clearing and others “Foreign exchange is a fairly mature will probably be exempt, and multiple market so we don’t expect to see major CCPs will seek to capitalise on the new that they had a lobbying mission on change in client types or products, but business line, the post-trade FX land- their hands. regulatory change is clearly going to scape is beginning to look far more Central clearing may well be a miti- have a fair impact on this market,” said complex than ever before. gant of counterparty credit risk in OTC Jeremy Hill, head of foreign exchange “Even if the exemption is granted in asset classes such as credit and interest and money market operations at Royal the US and replicated in Europe and rates, they reasoned, but the FX market Bank of Scotland. “The FX market has Asia, segments of the market will remain interested in clearing products that are not mandated,” said Jonathan Butter- field, director of communications at CLS “ The FX market has already made progress in London. on both clearing and reporting, but both “With multiple CCPs offering clearing, the post-trade FX workflow will start to elements represent a considerable look as complicated as the pre-trade challenge.”

is predominantly short-dated and there- already made progress on both clearing fore exhibits very minimal counterparty and reporting, but both elements repre- risk. Moreover, the primary risk in the sent a considerable challenge.” very high-volume FX market is settle- The challenges stem from two key ment risk (the risk of non-payment on a issues – first, ongoing uncertainty about contract), which is already well covered the exact scope of inclusion of FX by the infrastructure of CLS Bank. products, and second, the complexi- The possibility that mandatory ties of implementation. Although most clearing could sweep into FX deriva- participants expect that FX swaps tives represented a real concern, as and forwards will be exempt from it would not only necessitate major clearing in the US, that is not yet a fore- investment to set up the infrastructure gone conclusion. needed to mitigate a minimal amount of The US Department of the Treasury risk, but it also posed questions about has still to officially finalise a key whether the introduction of FX CCPs proposal it published in April 2011 to Jonathan Butterfield, might complicate, or even compromise, exempt FX swaps and forwards from director of communications, CLS the crucial role played by CLS. Such the clearing and exchange trading

the markit magazine – Spring 2012 Focus: FX clearing /15 workflow, where banks face multiple on CCPs clearing options – a lengthy platforms generating orders and have task that means trawling through up to manage that flow and integrate it into to five years of historical data to come their risk and pricing engines.” up with accurate figures. Once those When it comes to clearing of options figures have been calculated, partici- and NDFs, however, the road so far pants believe it will be easier to come up has not been obstacle-free. During the with possible solutions. course of last year, it became increas- “It is now widely recognised that ingly apparent that clearing physically before deliverable FX products can settled products such as options was be centrally cleared in accordance going to be far more difficult than the with regulatory standards, we need non-physically settled NDFs, due to the to establish the size of the settle- emerging demands of regulators. ments that go through this market on In March 2011, a set of 24 proposed a daily basis, and what would happen standards for Financial Market Infra- in a CCP environment if one or more structures (FMIs) was issued by the clearing members were to default,” said Committee on Payment and Settle- Jason Vitale, global head of FX prime ment Systems (CPSS) and the tech- brokerage at Deutsche Bank in London. Jason Vitale, global head nical committee of the International “Once we have established that, we of FX prime brokerage, Deutsche Bank Organization of Securities Commissions can begin to look for solutions.” (Iosco). In the eighth standard, the high- The effort to assess the size of the level group of regulators and central market is an industry-wide process, banks insisted that FMIs must “provide co-ordinated in part by the FX division NDF clearing services, with plans to clear and certain final settlement, at a within Afme. Given the time it will take extend to client clearing in due course. minimum, by the end of the value date”. to obtain accurate figures and discuss Banks that are set to be direct clearing That principle was reinforced infor- potential solutions with central banks members of CCPs are busy pitching mally by a number of authorities last and key entities such as CLS, it is their putative client clearing services to year, posing an implicit challenge for now expected that options clearing is the buy-side. the clearing of FX options. The standard unlikely to begin before the second half “Our focus now is on making sure our would effectively demand CCPs to offer of 2013. infrastructure is ready to support client a settlement guarantee that even CLS has never come close to offering since it first went live nearly 10 years ago. “ Our focus now is on making sure our Where CLS guarantees that participants will always get their money back infrastructure is ready to support client in the event of a counterparty default, the CPSS-Iosco standard on settlement clearing.” finality would require CCPs to guarantee settlement in the purchased currency. For CCPs to offer that guarantee “FX options exercise into spot trades, clearing. This is effectively a whole new would require major liquidity backstops, so consideration needs to be given to business line for FX prime brokerage which could realistically come only from the settlement risk created by clearing and it’s more challenging than standard commercial banks or central banks. spot. Regulators, market participants bilateral client business because we That is a tough requirement in an age and any other interested parties need to have the uncertainty of regulatory dead- when banks are being required to ramp fully analyse the implications of settle- lines and product inclusion. We also up their capital adequacy and wind ment risk, and the FX market is looking need to leverage the full capabilities of down excessive balance sheet expo- at ways of doing this,” said Hill of RBS. the bank, from trading and clearing to sures, while central banks are seeking Meanwhile, clearing of NDFs is far our legal and regulatory affairs teams,” to avoid implicit guarantees of support closer to coming to fruition, largely said Deutsche Bank’s Vitale. to the sector after the financial crisis. because NDFs are not physically Buy-side firms have shown varied The consequence for the time being settled. A number of firms – including engagement with the regulations up is that market participants have been LCH.Clearnet, CME Group and the until now, with some getting involved tasked to assess the potential size of Singapore Exchange – are launching or almost as much as the banks them- the liquidity requirement that would fall gaining regulatory approval for interbank selves, and others taking a back seat in

Spring 2012 – the markit magazine /16 Focus: FX clearing

“ The concept of passing your daily trading business to a repository appears at face value to be fairly simple, but it’s actually quite a considerable challenge, and not something we have ever done in the FX market.”

the belief the responsibility lies entirely services they are planning to offer, real certainty is that the net effect of with the sell-side. But with looming and we will start testing the models both clearing and reporting will be a regulatory deadlines, particularly in the later this year with a view to choosing more complicated back office, particu- US, firms that have NDFs in their portfo- two providers. From a pure trading larly for the major banks. As trades lios will need to start looking closely at perspective it might be easier for us to will no longer be sent down a single the new landscape straight away. clear everything in FX, but absorbing pipe, banks will need to use whatever For Lee Sanders, head of FX and the cost of that as a business might technology is necessary to ensure money markets execution at Axa Invest- mean it doesn’t make sense to do so,” reconciliation is done promptly, so as to ment Managers in London, options and said Sanders. avoid backlogs. NDFs make up only around 10 per cent Beyond clearing, further challenges “Banks will need smart routing tech- of his book, but that proportion could lie on the horizon when it comes to nology to get trades to wherever they grow, particularly as Axa IM would like trade reporting, which looks set to need to go at different points in their to expand its presence in emerging be mandated for the whole of the FX workflow, be it a CCP, a repository or markets, which would necessitate market outside spot. Last year, a joint CLS. The business will not tolerate more NDF trading. The firm has already venture between the Depository Trust the costs associated with any kind of begun the due diligence process of & Clearing Corporation and Swift manual processing,” said Butterfield. speaking to prime brokers about their won the mandate to develop the FX In spite of the numerous challenges plans for client clearing. trade repository, following a selection ahead, few participants believe they will “We have had a lot of conversations process run by Afme’s FX division. be insurmountable. In an industry that with all of the main prime brokerage The new repository is expected to has always been commended for its providers about the client clearing begin testing within weeks, with a view ability to overcome competitive differ- to going live later this year. But, while ences for the sake of an effective market the concept of reporting trade informa- structure – from the earliest days of the tion to a repository might appear rela- FX committees to the creation of CLS – tively straightforward when set against it is widely hoped that the creation of the central clearing, it involves a major body infrastructure needed for clearing and of work to implement unique identifiers reporting will in time come to be seen in for reporting entities, product types and a similar light. individual transactions. “I have been pleasantly impressed “The concept of passing your daily by how quickly the industry has come trading business to a repository appears together to address the requirements at face value to be fairly simple, but it’s of the Dodd-Frank Act and address the actually quite a considerable challenge, issues that arise from its application to and not something we have ever done in the FX market. As banks, we have been the FX market. It’s a different ball game able to put aside competitive pressures to other asset classes because we have to help build this new infrastructure, such big trade volumes,” said RBS’s Hill. which will be a very positive thing in the With challenges confronting almost long term,” said DB’s Vitale. Lee Sanders, head of FX and every aspect of the regulation, and money markets execution, uncertainties around which products Axa Investment Managers Joel Clark is editor of FX Week. will be included and excluded, the only

the markit magazine – Spring 2012 /18 Focus: Deutsche Börse and NYSE Euronext

Cut down to size

Europe’s blocking of the largest ever exchange merger on competition grounds is likely to have far-reaching ramifications for the exchange business and the derivatives markets, writes Jeremy Grant

ight months. That’s how long it took Europe’s antitrust authorities to kill off the largest ever attempted exchange merger, the combination of Deutsche EBörse and NYSE Euronext. When the announcement came, on February 1, it was no surprise to many industry observers. The signals had not been positive in the preceding weeks, as it became clear that the European

the markit magazine – Spring 2012 Focus: Deutsche Börse and NYSE Euronext Euronext NYSE and Börse Deutsche Focus: Spring 2012 Spring – the markit magazine / 19

Source: Shutterstock /20 Focus: Deutsche Börse and NYSE Euronext

Commission’s antitrust department looking good for exchange consolidation. funds – known as Maple – to buy TMX had serious misgivings about the A string of proposed mergers had come Group, operator of the Toronto and market power the combined groups unstuck either through nationalist oppo- Montreal exchanges. The emergence would wield. sition in the home market of exchanges of Maple was a major factor in the But for much of those nine months, perceived as the targets of takeovers, or failure of yet another deal: the London there had been optimism – even the as antitrust authorities moved to stymie Stock Exchange and TMX’s attempt expectation – that the deal stood a combinations amid concerns they could to combine. strong chance of success. reduce competition. This toughened stance has come as After all, it seemed to offer compel- An attempted purchase of the ASX a surprise to seasoned executives in the ling industry logic: the creation of the exchange in Australia by SGX, the exchange business. Duncan Nieder- world’s largest company listings plat- Singapore exchange, was blocked by auer, speaking on a NYSE earnings call form; a claimed 3bn dollars in capital Canberra, while the US Department of two weeks after Mr Almunia blocked the efficiencies resulting from savings in Justice in April blocked an attempt by deal, summed it up thus: “This much margin collateral and other post-trade Nasdaq OMX and ICE to break up the anticipated consolidation was met with services; and the creation of a European NYSE Euronext-Deutsche Börse deal. much unanticipated resistance.” derivatives counterweight to the domi- US antitrust watchdogs argued Even now, the protagonists are sore. nant US derivatives player, CME Group, that the combination of the NYSE and In particular, there is frustration that Mr by merging Eurex and Liffe. Nasdaq listings businesses – which is Almunia’s department decided that, When the end came, European what had been proposed by Nasdaq when it came to defining the scope of competition commissioner Joaquín chief executive Bob Greifeld – would market for listed derivatives, the market Almunia, explained it by saying that the eliminate choice in the primary listings was European. combination “would have led to a near- business for would-be issuers. The fact The two groups had argued that their monopoly in European financial deriva- that BATS Global Markets only weeks two derivatives platforms that were to tives worldwide”. before had unveiled its plan for getting come together under the deal, Eurex and Liffe, traded futures that operated at opposite ends of the yield curve and thus barely competed with each other. “ These markets are at the heart of the They also argued that they would still face competition from CME Group; and financial system and it is crucial for the that the derivatives markets are global – whole European economy that they remain not regional. In a barrage of last-minute advertising campaigns, they tried to competitive.” make the case that the combined group would compete with the over-the- counter (OTC) markets. “These markets are at the heart of into that business appeared to count Those arguments were rejected by the financial system and it is crucial for for nothing. Brussels. Antitrust staff took the view the whole European economy that they The previous month, a planned that while the margin pools – in terms of remain competitive,” he added. purchase by BATS of Chi-X Europe, a customers – of Liffe’s flagship product, NYSE Euronext and Deutsche Börse pan-European share trading facility, was the euribor interest rate future, and reacted with barely concealed bitter- thrown into doubt after the UK’s Office CME’s equivalent at the short end of the ness. Perhaps not surprising, given how of Fair Trading referred it to Britain’s yield curve, the eurodollar, were corre- much work they had put in. In the end, main antitrust authority. That deal was lated to a degree, there was far more the failed merger cost NYSE Euronext eventually cleared. correlation between Eurex and Liffe’s 85m dollars and Deutsche Börse 82m But by then it was obvious that margin pools. euro, in expenses in 2011. antitrust scrutiny of market structures Brussels concluded that “derivatives The German group’s chief executive, had become far more robust since the based on eurozone interest rates are Reto Francioni, talked of “a black day for previous round of exchange deals five not substitutes for derivatives based on Europe and its global competitiveness years previously. US interest rates”. In other words, Brus- of European markets”. Indeed, in Canada, there are sels was saying that it was not a reflec- Why did it turn out like this, and what concerns that heightened antitrust tion of market reality to claim that the lessons have emerged? scrutiny could yet scupper one of CME’s eurodollar contract was a like- Looking back at the preceding the last deals left: plans by a consor- for-like competitive product for Liffe’s months, the signs were already not tium of domestic banks and pension euribor contract.

the markit magazine – Spring 2012 Focus: Deutsche Börse and NYSE Euronext /21

“ I think everyone should tread very carefully because I don’t get the sense there is similar momentum for change in North America, South America and Asia.”

NYSE Euronext and Deutsche Börse around ‘Europe’ you come up with mark a sea-change in the competitive still argue that many customers are one conclusion and if you extend that landscape for exchange-traded deriva- not so much interested in the currency perimeter to ‘global’, you come up with tives in Europe. sign as the trading specifics of the a different conclusion.” Arguably, the seeds for this change contracts and so use CME eurodollar Beyond the differences on market were sown in 2007 when staff at the US products as much as Liffe euribor definition, the decision to block the Department of Justice were assessing ones. They don’t use Eurex products merger has far-reaching ramifications the takeover by the Chicago Mercan- because these do not offer the same for the exchange business and the tile Exchange of the Chicago Board of trading opportunities. derivatives markets. Trade. That deal created a business On the OTC versus listed deriva- It signals that any further large- with an over 95 per cent share in trading tives question, Brussels was also scale, cross-border exchange deals of US benchmark futures. (The Eurex- clear. “Our investigation showed that are going to be difficult. Any exchange Liffe combination created a similarly exchange-traded derivatives and OTC contemplating redrawing the derivatives dominant player in equivalent bench- derivatives are simply different prod- landscape in Europe must now reckon mark European contracts.) ucts. Customers use them for different with an antitrust decision that makes Antitrust staff revealed in a letter purposes and in different circum- clear Europe wants structures that sent to the US Treasury Department stances. They are not substitutes. encourage competition. that they believed the time had come to “For example, some entities that That could be a positive for the force competition in exchange-traded trade on exchanges do not have a London Stock Exchange as it pursues derivatives. Yet the merger was ulti- mandate to buy derivatives over the its foray into pan-European futures. It mately approved – under political pres- counter. This is because OTC deriva- means operators like CME Group and sure from the White House of the day, tives are much more risky than deriva- ICE – often unjustly overlooked as a US many believe. tives traded on exchange and require player to rival CME globally – will have to Now, it appears European antitrust sophisticated risk management proce- think twice too. experts believe it has fallen to them to dures,” the Commission said. It also comes at a time when Brussels create a competitive environment for The two exchanges argued that is already pursuing a similar pro-compe- derivatives – even if that means forcing customers use OTC as well as listed tition agenda in G20 derivatives reforms fundamental changes to the long- when they want euro exposure at either embedded in the revised Markets in standing market structure in this market. end of the yield curve, “So why exclude Financial Instruments Directive (Mifid), Mr Niederauer, for one, believes OTC?” says one executive. Markets in Financial Instruments Regu- that this has created fresh uncertain- As for the contention that the CME lation (Mifir) and the European Market ties, since it is by no means clear that posed a competitive threat globally to Infrastructure Regulation (Emir). other regions will follow Europe’s lead a merged European derivatives group, Central to Mifir and Emir are as derivatives markets continue to Brussels concluded that there was proposals that allow for open access expand globally. “simply no prospect” that CME or any to clearing services across Europe, “Where it goes in the derivatives other player could exercise “a mean- including at exchanges that operate market remains to be seen. I think ingful competitive constraint” on Eurex “vertical silo” structures that combine everyone should tread very carefully and Liffe, due to Deutsche Börse’s execution and clearing. Clearinghouses because I don’t get the sense there is “vertical silo” clearing arrangements. must accept derivatives for clearing similar momentum for change in North While many users of the exchanges from any execution venue too, and America, South America and Asia,” Mr welcomed the decision, there have not discriminate in favour of execution Niederauer said. “Nor do I think there been voices expressing doubt. venues that may sit within the same will be in the near term.” Steve Grob, head of group strategy at group as the clearer. Fidessa, a trading technology company, Taken together, the antitrust decision Jeremy Grant is editor of FT Trading Room, a said: “I don’t think you can say anyone on NYSE Euronext-Deutsche Börse and section of the Financial Times website focused is wrong or right. If you draw a perimeter Europe’s version of the G20 reforms on market structures.

Spring 2012 – the markit magazine /22 Focus: Eurozone Source: Shutterstock Source:

Out of our league

If the eurozone had been structured along the lines of UK soccer’s Premier League, or even American football’s NFL, the current debt crisis might have been a completely different ball game, writes Gary Jenkins of Swordfish Research the markit magazine – Spring 2012 Focus: Eurozone /23

riting an article Wales. While it is owned by the member on a European clubs, there is a huge disparity between event for a quar- the financial standing of the members terly magazine and there is no salary cap to try and is fraught with ensure a level playing field. Thus, in the danger given last few years a wealthy owner can trans- howW much can change by the time of form a club’s success as has been the publication. Bond yields could have case with both Chelsea and Manchester increased to danger levels or they could City. All this has led to a league which is have retracted to safe-haven status as pretty much two tiered: indeed, of the the market moves raptor-like on to its 45 clubs that have been in the Premier next victim. League since its inception, only four Since being asked to write this article, have won the title: Manchester United, Greece has gone from calmly awaiting 12 times; Arsenal and Chelsea three a second bailout which would cement times each; and Blackburn Rovers once. its place firmly in the eurozone for the Contrast this with the NFL, which has next few years, to uncertainty regarding been evolving since 1920 but which had any such assistance, leading to specu- its last major overhaul in 1966 when the lation of a disorderly default, public NFL and AFL merger was agreed. There rows between politicians and riots on is a certain amount of revenue sharing the streets of Athens. And back again. I but the biggest difference over the last

“ To win the Super Bowl, you need to win at least three one-off games, which in itself would probably suggest a higher degree of volatility with regard to potential winners.”

have thrown away at least six drafts as few years has been the salary cap, which the situation was so fluid that whatever I has meant that every team can only pay wrote seemed to date before the ink on a set amount of cash and thus buying the paper was dry (or the word file was success is nigh on impossible. saved, to be more precise). To find inspi- Since the inception of the Premier ration, I let my mind wander by watching League, there have been 12 different a lot of sport. That led me to thinking Super Bowl winners. To be fair, this is that it would be interesting to look at not a direct comparison because the a couple of sporting institutions and Premier League is determined on a compare them to the eurozone to see if league basis only whereas in the NFL there was anything the latter could learn your finishing league position (over 16 from them. So, let us compare English games) either gains you entry to the football’s Premier League and American knock-out stage or it doesn’t. To win the football’s NFL with the EU. Super Bowl, you need to win at least The Premier League came into exist- three one-off games, which in itself ence in 1992 and is the highest level would probably suggest a higher degree of professional football in England and of volatility with regard to potential

Spring 2012 – the markit magazine /24 Focus: Eurozone

in an orderly fashion is an option, or like “ ...the Greek debacle has led to a situation the NFL, in that the rules were there to be adhered to on a more level playing where the rules of the game have been field and a higher proportion of the reve- made up as we go along.” nues were shared. As it is, the Greek debacle has led to a situation where the rules of the game have been made up winners. Another difference is that there difficult for Greece to remove itself from as we go along. The EU has gone from is relegation from and promotion to the the eurozone from a legal, administra- a mantra of “no bailouts” to the biggest Premier League, whereas the NFL is a tive and currency perspective. Any bailout of all time. As for the government constant with no such changes (unless attempt to go it alone would probably bond market, it has gone from being new teams are admitted to the League.) result in a catastrophic default with the the paragon of virtue to a market where The eurozone came into exist- entire financial sector going bust and a 75 per cent writedown may be the ence on January 1 1999 and consists the economy imploding. From the EU’s new template and retrospective collec- of 17 member states that exist in an perspective, the problem is not just tive action clauses can be enforced economic and monetary union. There what kind of events would unravel in on investors. is the possibility of promotion to the Greece but the contagion impact across Sovereign CDS may not be fit for eurozone, however, not only is there no the rest of Europe. While it could be purpose. In the short term, the Greek relegation, there is not even a process argued that if one country left and found bailout may prevent a potential nega- by which any state can actually leave. itself in the midst of a social, economic tive contagion across Europe but the It is a bit like the mafia – once you join, and political change on an unprec- actions taken and the manner in which that’s it for life. It is not a fiscal union, edented scale, it might bind the others they have been taken may be leading us so there is no revenue sharing as such closer together, it might also be that the on to a much more dangerous path for and while there was the equivalent of a market would pick on the next weakest bondholders in the future unless there is salary cap contained in the Maastricht victim and decide that might be its fate a move towards a fiscal union. Indeed, Treaty, everyone ignored it. too – a move that could become a self- it might well be that in 100 years’ time, Since the European sovereign crisis fulfilling prophecy. At the same time, if historians conclude that it was the began there have been calls to amend Greece were to leave the eurozone and scale and depth of the crisis that led to the union to a fiscal one and small steps start to enjoy some kind of economic a United States of Europe. Or will they have been taken that might ultimately revival (assisted by defaulting on 100 state that it was the lack of structure at result in that being the endgame, but per cent of its debt liabilities), then it the outset and a lack of attention to the we are not there yet. The crisis has led may encourage politicians in finan- rules of the game that led to a messy to money being transferred from one cially challenged countries to follow the break-up? state to another, but this has been done same path. on a loan basis. In the Premier League Hence, the oft stated comment by and the NFL, there is a single winner European politicians that it is cheaper determined every year; however in the to keep Greece as a partner than to Gary Jenkins, founder, eurozone, up until the 2009 season, encourage it to leave, even though Swordfish Research everyone was a winner. Since then, these statements are never backed by many people claim that the only real any analytical projections. As I write this, winner over the full duration of the union the second bailout package for Greece has been Germany. In many ways it has just been signed off by eurozone could be argued that the eurozone has finance ministers, and while there are Career in brief adopted the worst measures of the still a number of steps that need to be Gary Jenkins is the founder of Swordfish Premier League and NFL, and it would taken before we can state that a disor- Research, a new company that specialises in coverage of the fixed income bond market. The be better off with both relegation and a derly default is no longer imminent, it company provides research and consultancy salary cap. is also clear that it is going to be very services on anything to do with bonds, from Another thing to note is that in the challenging for Greece to be able to both a macro and micro perspective. Previously Premier League if a team does get get its debt back on to a sustainable Gary was head of fixed income at Evolution Securities, head of fundamental credit strategy relegated, it gets payments for a couple path, even after a €100bn writedown of and European credit research at Deutsche Bank of years to assist it as it adjusts to a private sector-held debt. and global head of credit research at Barclays. new financial reality. When it comes In an ideal world, the EU would have He was voted as one of the 50 most influential to Europe, there is no mechanism for been constructed from the outset either people in the formation of the European bond market and has written two books about bonds. a country to leave and thus it is very like the Premier League, in that leaving

the markit magazine – Spring 2012 Focus: US election /25 Poll positions A US election year always prompts thoughts of change. Markit gathered financial policy experts from three American think tanks to discuss what key areas are at risk of overhaul

Otis Casey: What are the chances David Min: I would also add that a lot of David Min, associate director, financial that Dodd-Frank will be repealed or Dodd-Frank revolves around the Finan- markets policy, Centre for American Progress that neither of the namesakes will be cial Stability Oversight Council (FSOC). members of the next US Congress? If the Republicans win the presidential Mark Calabria, director of financial Are there particular areas of Dodd- election, the Council’s appointees will regulation studies, Cato Institute Frank that are more susceptible largely change over. This could change Peter Wallison, co-director of financial to change? the dynamics of the rulemaking process policy studies, American Enterprise and how Dodd-Frank is implemented. Institute Peter Wallison: It will depend on the Otis Casey, director, credit research, election. Every Republican candidate for Mark Calabria: The election will largely Markit president blames housing policy as the be fought on the US economy and cause of the financial crisis and wants whether too much regulation has all of Dodd-Frank to be repealed. If the slowed down recovery. US elects a Republican president, the chances of repeal are much improved. Otis Casey: Are there specific areas of If Obama is still in office, the chances of Dodd-Frank which are more suscep- repeal are non-existent, no matter what tible to significant change? happens in Congress. David Min: There are three areas which David Min: I think that chances of repeal could see changes. Firstly, the FSOC, with either a Republican or Democratic under a Republican administration, president are zero. Repeal is not a could veto the Consumer Financial winning proposition – polls confirm this. Protection Bureau (CFPB) rulemaking. Secondly, I think you’d see legislation Mark Calabria: Regulatory officials trying to change, or overturn, the deriva- are going to bend a bit to whoever is tive portions of Dodd-Frank as well as chairing their oversight committees. the continuation of withholding appro- If the Senate flips and Republicans priations. maintain the House, I think you’ll see the Thirdly, so much of the Volcker Rule behavior of the regulators change. is up to the discretion of the regulator Even with a Republican president, that it could be significantly different the chances for outright repeal are low. under a Republican than under Obama. Some elements may even get changed under an Obama administration, albeit Peter Wallison: The FSOC might actu- piecemeal and with a focus on tech- ally designate some non-bank firms as nical corrections. systemically significant before the next

Spring 2012 – the markit magazine /26 Focus: US election

some guidance from Congress. It only We’re likely to see some major inter- applies to bank holding companies, so pretive and implementation variances if you are a financial holding company, depending on who’s in power. you could be the old-style broker Most proponents of the Volcker dealer on Wall Street and do propri- Rule will begrudgingly be happy with it etary trading. because it will strip out a lot of propri- Those who saw this rule as a sort of etary trading activity. This satisfies the new Glass-Steagall will be disappointed; basic premise of Volcker which is you those who saw this as the destruction shouldn’t be allowed to gamble with the of commercial banking will be disap- taxpayer’s money. pointed too. Probably the biggest loopholes are in the statute itself, although Otis Casey: In constructing some of regulators have discretion over whether the requirements for swap execu- they exempt things like treasuries and tion, facilities and price reporting for agencies. I think that ultimately there will various instruments, do you feel that be accommodation of some sort made the regulators adequately took into Otis Casey for at least highly-rated sovereigns other account how these instruments work than the US but I don’t think that will be and are traded? Did they impose administration takes office. That will do expanded to corporates. an equity market model on to these considerable damage by suggesting instruments appropriately or inappro- these firms are too big to fail. Peter Wallison: This rule covers priately? Are there market dislocations much more than it was justified and disintermediation that we will see? Mark Calabria: There are some things in to cover. The original idea was to the statute that are hardwired and other prevent banks using insured deposits David Min: The issue here is whether areas where regulators are given extraor- to gamble on trading. It applies to these instruments can be appropriately dinary amounts of discretion. The things “banking entities”, which means banks standardized. That’s what the central that are most likely to change are where and any firm that owns a bank, and clearing premise is based on so that you regulators have significant discretion. thus goes far beyond what it was can centrally clear them and net these A Republican Congress will really try originally supposed to cover, and even positions down. to use the appropriations process, not beyond Glass Steagall. The argument from the dealers has simply setting levels of funding but also It will also have a major adverse effect been that their clients need a perfect introducing statutes authorizing change. on markets. Spreads will be much wider hedge and I don’t think that’s correct. I think that’s where observers should and there’s going to be less market You can have something that’s a near really watch for changes. liquidity. The issues of how you define approximation of a hedge and over- hedge it a bit. Increased standardization of these swaps can help improve “ The argument from the dealers has been pricing and improve liquidity. What you that their clients need a perfect hedge and I don’t think that’s correct.”

Otis Casey: Will the Volcker Rule be as proprietary trading versus hedging, how strong as proponents hoped? Some you monitor and enforce that, will be feel there are too many loopholes and very hard to resolve in drafting the rule. have argued that the rule doesn’t have Volcker will not be in effect by the time teeth. On the other hand, it seems like the election is over and if a new presi- many banks have already divested dent takes charge, it’s susceptible to themselves of a lot of their proprietary being taken down. trading operations. Have the proponents already won? David Min: I think that it certainly will be in effect some time later this year. Many Mark Calabria: The Volcker Rule is proponents of the Volcker Rule want to Peter Wallison a mix of discretion for regulators and see very little regulatory discretion.

the markit magazine – Spring 2012 Focus: US election /27 see right now in derivatives is opacity. Dealers make a lot of money through “ Bernanke has a real fear of a 1930s style this and unsurprisingly, they’re opposed to changes. deflation and a contraction in the money supply. It explains some of his willingness to Peter Wallison: It may well be that interest rate and currency swaps can prop up institutions.” be standardized, but there was never a problem with that part of the market. Credit default swaps were seen as a Peter Wallison: Credit ratings for indi- ratings have in the last decade served problem, but only one firm, AIG, got into vidual companies have worked well and as a good credit quality proxy for these trouble. CDS will be difficult to stand- are justifiably relied on. The problem people. Now that we’re seeing problems ardize without destroying their useful- came with the use of credit ratings on with rating agencies, it raises an enor- ness for risk management, and there will pools of mortgage-backed securities. mous challenge. be a lot of resistance to the added costs. I think that can be addressed through mortgage insurance which is much Mark Calabria: We need to be creative. Mark Calabria: The process is prob- more efficient as someone is actually This is one of those areas of Dodd- ably slower than the proponents would putting capital at risk. Frank where I think it’s particularly clear like, and quicker than some of us who on the guidance to regulators. It’s also are concerned with this would like. I David Min: There are two issues with probably one of the areas of the statute am concerned about not being able rating agencies. where regulators are least likely to to manage this risk any better if we The first is the internal conflicts – they comply. We have built up decades’ long centralize it all. have to try to provide good ratings to regulatory structure around the rating In this country, we’ve had some very churn up repeat business. The second agencies, regulators have a huge invest- close calls with exchanges but not problem is how do you get away from ment in that and it would require a lot of one has failed so far. Exchanges have rating agencies as the sole or primary work to change it. failed in other countries. I believe that judges of credit quality for AAA-rated I think Congress is not going to see an exchange may have a comparative assets? Rating agencies don’t have a what it wants implemented. The regula- advantage in pricing interest rate and problem with their ratings of individual tors should find a way to keep credit macroeconomic risk than a commercial corporations; they also don’t have a ratings a very large part of the regula- or investment bank does but an invest- problem with ratings that are non- tory process. ment bank writing a credit default swap investment grade as people tend to do is essentially underwriting. their own due diligence. Otis Casey: Do you think that the I’d rather see market partici- There’s a huge pool of money out Fed policy of near zero interest pants determine what belongs on there that doesn’t want to do inde- rates through the end of 2014 risks an exchange or not. Given that the pendent due diligence on dumb increasing inflation or creating an regulator has tremendous discretion in money-type investments. Higher quality asset bubble? If so, where do you this, if we do have a change of admin- think that asset bubble is? istration and a change of leadership in the CFTC I think you will see a broader Peter Wallison: I think it’s an irrespon- range of exemptions. CDS were not sible and foolish thing for the Fed to say the cause of the financial crisis and it’s that it’s going to keep interest rates at a not CDS that brought down Greece. I certain level through 2014. Their ability think the regulators are going to look at to predict what is going to happen in this and try to be open to having more the economy is no better than anyone standardized products that continue to else’s, as we have seen. I don’t think trade bilaterally. that Bernanke will be re-appointed if a Republican is elected president. Otis Casey: The rating agencies under Dodd-Frank were criticized for failing Mark Calabria: Bernanke has a real fear to foresee or predict the credit crisis. of a 1930s style deflation and a contrac- Where do you think the regulators are tion in the money supply. It explains going to go in terms of encouraging some of his willingness to prop up insti- David Min different risk metrics? tutions, not because of concerns about

Spring 2012 – the markit magazine /28 Focus: US election

type of negotiated outcome? If and than on the spending cuts side. More- when we get a budget deal, what will it over, I think the mood in Washington is look like in terms of spending and tax more populist and it will be harder to reform? Is Simpson-Bowles the best pass tax cuts that disproportionately blueprint to start from for a bipartisan benefit the investor class. Barring a effort? Do you think another down- sweeping win by the the Republican grade of the US rating is likely? Party this year, I think the extension of the Bush tax cuts may be a source of Peter Wallison: I doubt there will be any debate in the post-election environment. kind of debt limit deal before the elec- As for debt downgrades of the US, tion; the ceiling will just automatically be it’s unclear. One of the biggest factors raised. Neither side will want to disap- in our long-term budget situation is our point its base by appearing to give in to economic growth prospects, and those others. If the election turns out not to are looking slightly improved. have settled the argument – by giving a That said, we ought to realize that clear mandate to one side or the other – rating agency assessments of US cred- Mark Calabria a deal could come after the election or in itworthiness are not particularly impor- the early days of the next administration. tant. US debt is the most widely traded the institutions themselves but fear of I don’t think there will be another and deeply analyzed in the world. monetary contraction. downgrade unless there is a major So everything he’s doing really adverse change in the US fiscal outlook. Otis Casey: What are the chances of comes back to the premise that we some form of flat tax being enacted have to avoid deflation at any cost. Mark Calabria: Yes, we are likely to after this year’s elections? Deflation would cause the real value of see some negotiated outcome on any debts to increase relative to the assets hit of the debt ceiling especially if it Peter Wallison: I don’t see much chance underlying them, which could potentially happens before the election. Neither of a flat tax. I think Romney will get the force businesses into bankruptcy and side will allow the limit to be hit. There Republican nomination and his tax homeowners into foreclosure. will, however, be no real budget deal reform proposal is a conventional across I don’t agree with his actions but I do this year. The federal government will the board tax cut. Obama’s tax reform think that there’s a logic behind it. most likely operate under a series of proposal is even less like a flat tax. So if either is elected, there will be no flat tax.

“ Simple economics dictate that we’ll need a David Min: Simple economics dictate that we’ll need a major overhaul of our major overhaul of our tax code.” tax code. Whenever this happens, we’re essentially opening up a Pandora’s box, David Min: I disagree. The cause of continuing resolutions. I believe another and it’s unclear what the result will be. credit unavailability is the price of credit downgrade is possible over the next If the Republicans, who have increas- being too high, precisely what you do year, but unlikely before the election. ingly come to embrace a flat tax, see not want following a financial crisis. a sweeping victory, then the likelihood I don’t see a fear of a bubble. Every David Min: I don’t think there will be of a flat tax is much higher. That said, I indicator right now says we should be another debt ceiling showdown this think the chances of a flat tax passing concerned about deflation. I think we do year. Even if we do hit this ceiling, I are low, because it would either require have to worry about a bubble eventually would expect a “clean” extension to get a massive tax increase on the middle if the economic news continues to be us through until after the election. class or a massive increase in the good for the next three quarters. If that As far as long-term budget reform budget deficit. is the case, and Bernanke steps down, goes, I think Republicans will ultimately I suspect he will also ratchet down the regret not having taken the deals Presi- Mark Calabria: While I would like to see expectations around zero interest rates. dent Obama offered them last year, as I a true, one-rate flat tax with few, if any, believe those will have been much more deductions, I am not convinced any Otis Casey: Some have predicted conservative than anything they will Congress would enact it. I think there is that the next showdown over the debt likely be able to pass in the near future. a small chance of reform of the indi- ceiling limit could occur just before Basic math dictates that we ought to vidual tax code, but I expect it would the election. Are we likely to get some see much more on the tax reform side be modest.

the markit magazine – Spring 2012 /30 Focus: China’s economy Source: Shutterstock Source:

China’s policy dilemma The world’s second biggest economy must rethink its fiscal strategy in the face of slowdown, writes Jim Walker of Asianomics

the markit magazine – Spring 2012 Focus: China’s economy /31

eijing launched the biggest result, Chinese businesses are today monetary expansion of all facing much higher input costs and, in the major global econo- turn, much lower profits. mies – and perhaps the Faced with a potential slowdown of the largest in history – in Chinese power machine, the world has response to the downturn been wondering how hard the landing Bin trade triggered by the financial crisis could be and what policy response the in late 2008 (See Figure 1). These addi- Chinese authorities would adopt. tions to money and credit were directed According to official GDP data, the principally at local government infra- Chinese economy grew at 8.9 per cent structure projects but subsequently also year-on-year (YoY) in the fourth quarter started to have an impact on activity in of 2011. Industrial production growth the residential and commercial prop- expanded in December by a robust erty markets. After two years of growing 12.8 per cent YoY and investment in speculative excesses and investment in fixed assets has barely budged from 25 projects with little hope of ever gener- per cent YoY growth throughout 2011: ating an economic return, China began hardly a call for policy easing. the process of curtailing money flows However the privately-run HSBC in 2011. China Manufacturing Purchasing

“ Faced with a potential slowdown of the Chinese power machine, the world has been wondering how hard the landing could be and what policy response the Chinese authorities would adopt.”

A combination of specific property Managers’ Index (PMI), compiled by market cooling measures (which at first Markit, has been signalling a slight were distortionary as they just shifted contraction in the Chinese manufac- speculative and building activity away turing sector over the last few months. from first-tier cities to second and Reports from property developers third-tier cities) and tightened credit suggest an industry in crisis, and anec- conditions have resulted in a reduc- dotal evidence has been mounting tion in property transactions, a drop all year that small and medium- in primary market residential prices sized companies are facing a giant and a huge slowdown in new local credit crunch. government infrastructure projects. What to believe? We deem the anec- Prices and activity in these areas are dotal evidence, and that of the PMI, now contracting. to be much more reliable than official However, the explosion of property data. If that is so, then, the difficulty for activity in second and third-tier cities the authorities will be how to handle an pushed up the cost of labour in these investment-induced downturn when areas, with some of them witnessing the investment to GDP ratio is close minimum wage increases of between to 50 per cent. With investment being 30 and 40 per cent. In the meantime, the volatile component in the business commodity prices have appreciated cycle, it is downturns in this segment significantly thanks to physical demand that cause, what is referred to in invest- as well as financial speculation. As a ment circles as, “hard landings”.

Spring 2012 – the markit magazine /32 Focus: China’s economy

Figure 1: Money and Credit Inflation in China, RMB trillion 2008-2011 China’s monetary and fiscal policy options in the face of domestic and Additional Additional Additional M2 % of Previous % of Previous Fitch-adjusted % of Previous external slowdown are limited by the Official Credit (RMB Tn) Year’s GDP Year’s GDP Total Societal Year’s GDP (RMB Tn) Funding (RMB Tn) monetary overhang created in the last few years and the malinvestments 2008 7.3 27.5 4.0 15.0 6.5 24.5 that have been unleashed as a result. 2009 13.9 44.1 10.8 34.3 15.0 47.6 Its unwillingness to report slower 2010 12.1 35.0 8.8 25.5 16.5 47.8 than “acceptable” growth means that 2011* 7.2 29.0 7.5 18.7 17.4 43.4 exchange rate policy is a hostage to US

* Note: Annualised from the latest data except for the Fitch-adjusted total societal financing which was originally politics and is thus neutered in the same calculated in its July 13 report, Chinese Banks: Growth of leverage still outpacing GDP growth, and has been way as monetary policy. The growing updated internally since. problems in the banking system, as bad Source: Haver Analytics, Fitch Ratings debts from local government lending are recognised, adds another dimension to Beijing’s policy dilemmas. China needs a healthy dose of economic reality in order to take the In our view, the malinvestments ratio, which frees up space on the next steps forward in market reform. In caused by the combination of exploding balance sheet, will automatically be filled our view, it will receive precisely that in credit and inappropriately low interest by this loan transfer. 2012. We believe that the much-vaunted rates are too far advanced for China to We doubt whether the PBoC is stop-go credit rationing policies of the experience anything other than outright keen to rekindle lending activity at this past look likely to produce increas- recession. Coincidentally, this invest- stage. In order to address the perceived ingly volatile efforts to stimulate growth ment downturn looks set to be exacer- problem of money being channelled into and stamp down on inflation. Prepare bated by an export slowdown caused unproductive, inflationary and specula- for a turbulent ride and sharply lower by the implosion of China’s biggest tive uses, policy will have to stay tight real output. market, Europe. until the weak actors in targeted sectors

“ China needs a healthy dose of economic Jim Walker, founder and managing director, reality in order to take the next steps Asianomics forward in market reform.”

So what form will policy easing take – such as property development – are Career in brief in response to the downturn? There shaken out of the system. We would Jim Walker is the founder and managing director have already been leadership hints not expect any meaningful monetary of Asianomics Limited, an economic research at an incremental easing of monetary easing, in the form of credit quota and consultancy firm servicing the fund policy, as well as two 50 basis point increases, until the second half of 2012. management industry. Prior to establishing Asianomics in 2007, cuts in reserve requirements since Fiscal easing is also problematic. he was chief economist at CLSA Asia-Pacific early December. However, we doubt While it is claimed that the govern- Markets, which he joined in late 1991. He has that reserve requirement ratio cuts will ment has surplus revenues held at the achieved ‘best economist’ rankings in various actually constitute easing. It has to PBoC, any release of this surplus into Asiamoney, Institutional Investor and Greenwich surveys. He is best known for forecasting the US be remembered that banks are being the economy effectively constitutes 2007 downturn and financial sector meltdown in forced to bring off-balance sheet loans monetary easing. Fiscal injections can his series of ‘Apocalypse’ reports. made in the last two years back on to be spent on specific projects and social Before going to Asia, he worked in his native the balance sheet. They are unable provisions in the first instance but then Scotland as a research fellow at the Fraser of Allander Institute for Research on the Scottish to do this without reducing current just become money in the system open Economy, and then at The Royal Bank of on-balance sheet lending because they to the same credit multiplier effects as Scotland’s Edinburgh headquarters. He holds have no excess reserves held with the any monetary injection. a Bachelor of Arts Honours degree and a People’s Bank of China (PBoC). Any The most likely outcome of all this doctorate in economics from the University of Strathclyde, Glasgow. reduction in the reserve requirements is an increasingly incoherent mess.

the markit magazine – Spring 2012 / the Source: Shutterstock 34 markit magazine

Environmental: update Global – Spring 2012 – Spring Environmental: Global update /35

Rio revisited Much has been achieved since the 1992 Earth Summit, but as world leaders gather again to address sustainable development, the task before them looks just as onerous, writes Mike Scott

t is 20 years since the Earth Summit attended by 108 world leaders and in Rio de Janeiro introduced the produced the United Nations Frame- concept of sustainable development work Convention on Climate Change, to a wider audience. (UNFCCC) which led to the Kyoto The definitive description of Protocol and was followed by Europe’s sustainable development is widely Emissions Trading Scheme, the world’s Iattributed to Our Common Future, a first carbon market. In the 20 years report published by the World Commis- since, great leaps have been achieved sion on Environment and Development in the shift to sustainable development, five years earlier, which said: “Sustain- but notable failures have at times threat- able development is development that ened to derail the momentum. meets the needs of the present without The United Nations (UN) stressed compromising the ability of future that sustainable development is a fluid generations to meet their own needs.” concept but said that “a few common The original Earth Summit built on principles tend to be emphasised”. this philosophy and set an agenda for The first is a commitment to equity the last two decades in a way that is and fairness, so that priority is given to not often recognised. The meeting was improving the conditions of the world’s

Spring 2012 – the markit magazine /36 Environmental: Global update

poorest and decisions should account has a green spin on it, from fuel tax to actions to the scale we need with the for the rights of future generations. The waste collection.” speed we need.” second is a long-term view that empha- Nonetheless, many problems remain One way forward has been sises the precautionary principle, i.e. – science suggests that at current suggested by the UK, which says it “where there are threats of serious or rates of emission of greenhouse gases, will urge businesses and governments irreversible damage, lack of full scientific we are on course for a 3.5°C average at the summit to incorporate natural certainty shall not be used as a reason temperature rise rather than the 2°C capital into their measures of economic for postponing cost-effective measures we are aiming for, the world’s popula- activity, an idea it calls GDP+. Environ- to prevent environmental degrada- tion has just passed 7bn and is en route ment secretary Caroline Spelman said: tion”. Third, sustainable development to 9bn and resource constraints are “We are committed to achieving growth, embodies integration, and under- becoming increasingly evident. but this should not come at the cost standing and acting on the complex There is unfinished business and that of the natural resources we take for interconnections between the environ- is why, in June, business and (hopefully) granted, or at the cost of wellbeing. We ment, economy and society. political leaders will convene once more want to see countries acknowledging The “failures” of the sustainability in Rio for the Rio+20 summit. According the true value of nature to our economy, agenda – rows at international climate to the UN, the conference will focus on by reflecting its worth in their accounts. conferences between developed and two themes: a green economy – in the The UK is a world leader in this field, developing countries, disputes over context of sustainable development and and I will be making the case for all feed-in tariffs for renewable energy and poverty eradication, and the institu- nations to match our progress.” the threat of a trade war over European tional framework. The key challenge remains discon- plans to include aviation in its carbon Connie Hedegaard, the European necting economic growth – essential for market, for example – are high profile Union’s climate chief, said that the lifting millions out of poverty – from fossil and threaten to overshadow many of summit needed to change the current fuel use, said Damian Ryan, head of the achievements that have been made model of economic growth. “As the policy at the Climate Group. “We need since 1992. world recovers from the financial crisis, to ask questions about how to double The trillionth dollar of investment our focus is on growth and jobs. But the rate of energy efficiency each year, in clean energy was invested in 2011, which kind of growth and which kind double the rate of renewables deploy- according to Bloomberg New Energy of jobs? Restructuring is unavoidable, ment and increase the output of existing Finance, and renewable energy compa- so why not choose a path that makes energy generation technologies.” nies such as Vestas, the Danish wind long-term sense; a path that replaces However, as Yvo de Boer, the former turbine manufacturer, and Suntech, overuse with sustainability? executive secretary of the UNFCCC China’s solar power behemoth, said at this year’s World Economic Forum that these technologies will be competi- “ The world’s leaders must use the Rio+20 tive with fossil fuels without subsidies as early as 2015. Meanwhile, China summit in June to bring sustainable is establishing pilot carbon trading schemes as a prelude to a national development to the heart of the global scheme and Brazil has managed to drastically slow the rate of deforestation economic agenda.” in the Amazon rainforest – all of these things owe a debt to events in Rio two “The 21st century must have a more and now KPMG’s special global advisor decades ago. intelligent growth model, or else it’s on climate change and sustainability, “The progress that has been really difficult to see how we feed 7bn explained, it is far more complicated achieved has been quite dispersed but people now and 9bn people [by 2050],” than that. A KPMG report, Business sustainability is on the agenda world- she said in an interview with the UK’s Perspective on Sustainable Growth: wide for business and government,” Guardian newspaper. “The world’s Preparing for Rio+20, suggests that said Dr Richard Tipper, managing leaders must use the Rio+20 summit in it is very much in business’s interests director of Ecometrica, a climate change June to bring sustainable development to do so – it identifies 10 interlinked consultancy, and lead author of two to the heart of the global economic “megaforces” that could significantly reports on land use for the UN’s Inter- agenda,” she added. “This is where it affect companies in the future: climate governmental Panel on Climate Change belongs rather than in the environment change, energy supply volatility, mate- (IPCC). “It is part of so many things silo isolated from the key economic rial resource scarcity, ecosystem now – almost every new initiative now decisions. Only then can we bring the decline, deforestation, food security,

the markit magazine – Spring 2012 Environmental: Global update /37 water scarcity, growing populations, water, energy and material use – in in June, is James Cameron, now vice- wage inflation and urbanisation. order to drive innovation. chairman of investment bank Climate “Today’s leaders are struggling with For business to do this, investors Change Capital but at the time a lawyer complexity,” he said. “Until now, we will have to play a key role, argued who helped to draft many of the orig- found global trends on energy, water Nick Robins, head of the Climate inal documents. He is cautious about security and food scarcity complex Change Centre of Excellence at HSBC. the prospects for success of Rio+20. enough. The convergence of other Central to the success of the summit “Progress since 1992 has not lived up to forces such as population growth, is “whether Rio can convince investors expectations,” he said. However, he says deforestation and a surging middle that aligning asset allocation with the that the greater availability of informa- class is impacting business and the green economy will provide superior tion will make it easier for people to know world around us. Leaders are over- risk-adjusted returns to ‘business as what is going on and to hold govern- whelmed by the sheer scale of these usual’,” he wrote in a report for the bank. ments and businesses to account. problems and struggling to act.” One of the key themes of June’s gathering is likely to be the importance “ ...aligning asset allocation with the green of business in building a more sustainable world. “There are ways to solve economy will provide superior risk-adjusted these problems, and that includes harnessing the capacity of business,” returns to ‘business as usual’.” de Boer said. “Business affects the state of the “Investors need clear short, medium As Ryan of the Climate Group said, world, and the state of the world is now and long-term sustainable development by 2050 the world needs to have cut affecting business,” de Boer said at a targets, which have political clout and emissions by two thirds. This is a huge pre-Rio+20 summit. Many businesses are embedded in core macroeconomic economic opportunity for businesses are already leading the way, but “even and sector policies.” and governments willing to invest in active leaders with sustainable business HSBC calls for “green economy road- energy and resource efficiency and new practices will run into problems if the maps by global industry sectors, which low-carbon technologies. Such invest- policy framework does not create the if done seriously could provide a starting ment will protect livelihoods, create jobs right investment conditions”. point for long-term investor engage- and support global economic growth.” The summit called on policymakers to: ment and benchmarking” and also the Yet Ecometrica’s Tippett suggests establishment of a 10-year framework that “it is difficult to see Rio+20 being a • Provide long-term, stable and on sustainable consumption. watershed moment. It is difficult to say transparent policy frameworks and Another tool to help align the interests what it will achieve. The big issues are incentives to scale up investment in of companies, investors and society already known but, apart from climate sustainable development. has been proposed by the Corporate change, the targets we are trying to meet • Provide strong price signals on Sustainability Reporting Coalition, which to deal with them are very undefined.” resource scarcity and environmental wants a mandatory framework to make World leaders have their minds on impact in order to drive investment in companies incorporate information dealing with economic and political sustainable growth. about environmental, social and govern- problems so the summit is unlikely • Deliver new platforms for public- ance issues into their annual reports. to bring new impetus to the idea of private collaboration at the interna- “Integrated reporting improves the sustainable development, he adds. “It tional and national levels. dynamic within businesses because it is only when something big happens encourages different departments to talk that the political focus will return to it.” However, at the same meeting, to each other. We hope member states This could be another natural disaster Georg Kell, executive director of the UN will realise there are market inefficien- or perhaps the publication of the next Global Compact, pointed out that “most cies that can be corrected by disclosure IPCC report in 2014, which is likely to companies are not doing enough, and of these issues,” said Steve Waygood, firm up the science of climate change many are not doing anything to address head of sustainability research and and make even clearer the scale of the pressing challenges”. The meeting engagement at UK investor Aviva. challenge the world faces. also called on companies to reduce “We hope they will agree to develop a their focus on short-term performance convention that requires companies to Mike Scott is a business and environment in favour of longer-term sustainable produce integrated reports.” journalist who writes for publications including growth and to adopt stretching sustain- One participant at the original Earth the Financial Times and Bloomberg New Energy Finance. ability targets – for example to reduce Summit, who will be heading back to Rio

Spring 2012 – the markit magazine In Practice: Fair value /39 Source: Shutterstock Source:

The fairest of them all

The debate over whether or not to fair value he debate over fair value has existed since the splits the mutual fund industry but all sides launch of the first mutual appear to agree on the need for greater fund, and has been an transparency, writes Paul Kraft of Deloitte ongoing concern for mutual fund registrants, boardT members, regulators and plaintiff lawyers. As the industry grapples with how to fair value asset classes such as fixed-income securities and futures, it is useful to think back to when foreign equities were the focus of attention.

Spring 2012 – the markit magazine /40 In Practice: Fair value

In 2001, prior to the letter from the Two camps emerged from the policies governing fair valuation and US Securities & Exchange Commission assembled group. A clear majority specific procedures governing when (SEC) to the Investment Company Insti- felt that the combination of regulatory and how to fair value assets. Policyset- tute (ICI) by Doug Scheidt, many mutual requirements and the interests of long- ting starts with the board. Clearly fund registrants did not apply fair value term investors led their firms to broadly defining the board’s role in setting and procedures to foreign equity securities; apply fair value beyond foreign equities reviewing valuation policies is critical. in fact, very few included this practice to fixed income and OTC derivatives “We’ve tried to address our regulatory within their policies. In the Deloitte & as well. “Anything traded in markets burden by enshrining it in policy and Touche inaugural Fair Valuation Survey that close before 4pm EST is fair game maintaining diligence documentation released in November 2001, none of for fair value,” noted one firm. Several regarding our inputs and methodology,” the 47 survey respondents had a “zero” funds said that, internally, they strike a noted one fund at the round table. trigger policy for fair value. Some 86 fair value Net Asset Value (NAV) and a Some boards are more actively involved per cent of respondents had not yet non-fair value NAV, both of which are with the NAV process. In the ninth even established a materiality threshold. presented to portfolio managers and Deloitte Annual Survey, 23 per cent of Only 14 per cent had a policy in place to the chief investment officer, so that they fund families participating indicated that either hold an “immediate fair value (FV) can have a shared understanding of their funds had policies that required committee meeting” or an “analysis was price impact. board involvement prior to the use of performed” if the trigger was exceeded. Others, however, cite materiality and fair valuation, suggesting that, in some That means that the vast majority of other factors that, in their view, affect circumstances, the board is involved in funds would likely not have even gath- the decision of whether or not to fair the NAV process in real-time. ered to discuss fair value if a significant value a range of asset classes including Sound policies drive good valuations event occurred. foreign instruments. Part of the concern procedures and help ensure a consistent approach to applying fair value. To be effective, a fund’s approach to deter- mining whether to fair value a certain “ Policysetting starts with the board. Clearly asset cannot be arbitrary. It also cannot defining the board’s role in setting and be static. For example, if you were to fair value every asset in your portfolio and reviewing valuation policies is critical.” you ran a back test and found it did not move the NAV, this would not necessarily suggest that you can forget about In contrast, the Deloitte ninth Annual about price volatility after local markets fair valuing that particular asset class. Fair Value Pricing Survey released in close comes down to the materiality Judgment needs to be applied and the September 2011 found that, of the of the holding relative to the total NAV process of back testing needs to be 79 survey respondents, 35 per cent of the portfolio. If a portfolio contains revisited over time. “Think about the applied a “zero” trigger to the process a small number of foreign equities that volatility in the markets over the past few of fair valuing foreign equity securities do not comprise a significant portion years. If you tested something five years and of those, 96 per cent fair valued of assets, doubling or tripling their ago, you’d reach a very different conclu- their foreign equity securities “most to price (or reducing them) will not have a sion than if you did it three years ago. It all” days when an established trigger meaningful effect on NAV. On the other is an ongoing process,” said one fund was exceeded. Clearly, the industry has hand, if a portfolio has extensive use of family representative. come a long way, and the process of bonds or futures and the notional value Transparency is another important fair valuing foreign equity securities has of the exposure of the contracts versus component to the fair value process. become standard. net assets is large, then the materiality Regulators are calling for greater trans- Yet, in practice, fair value continues to is quite clear. For an index fund, for parency and both the Public Company be a challenge for the industry, espe- example, futures commonly comprise Accounting Oversight Board (PCAOB) cially for mutual funds that hold fixed- a significant percentage of notional. and the SEC, in recent speeches, income securities or over-the-counter Therefore, materiality is critical, and have required auditors and regis- (OTC) derivative instruments. This was it is important to consider fair valuing trants to ensure that they understand particularly evident at a meeting of those securities. valuation inputs and methodologies. treasurers and heads of pricing from This requirement extends to pricing many of Boston’s large mutual fund Fair value in practice information received from third-party families, hosted by Markit in February Mutual funds that are leaders in the vendors, brokers or other market this year. practice of fair value have in place clear participants. Today, it is common

the markit magazine – Spring 2012 In Practice: Fair value /41 practice for auditors to request informa- said a broker. “There are no cookie not move the NAV by a penny today, tion on how fair value was calculated cutter approaches.” that does not mean you can forget and to perform a review of underlying about it and assume it will not move the data like trade and cash flow informa- Next directions in fair value NAV by more than a penny tomorrow.” tion, spreads, yields or credit enhance- What is the case for applying fair value What is clear is that the discussion of ment. “In fixed income, there’s not as beyond foreign equities, to other asset fair value today for asset classes such much observable data, and auditors classes like futures or foreign bonds? In foreign bonds and futures resembles may not have the same information Deloitte’s 2011 Fair Valuation Survey, 96 that for foreign equities back in 2001. As as [the fund], so we need to provide per cent of the respondents noted that The Deloitte Fair Valuation Survey will trade information or other information they were not using a tool to evaluate continue to track fair value practices by mutual funds and, if past performance is any indication of future performance, we would expect that fair value practices “ ...the expectation is that the vendors’ for asset classes such foreign bonds pratices are completely transparent.” and futures will become more broadly and consistently applied. Let the fair value debate continue… supplied by brokers,” said another fund significant events for foreign corporate debt, at the meeting. FAS 157, which came although 30 per cent indicated that their into effect in the last few years, raises valuation policies and procedures incor- the level of transparency and requires porate a daily review of significant events. funds to leverage observable data to the Some 40 per cent indicated they had Paul Kraft, lead greatest extent possible. such valuation policies for sovereign debt. client service partner, For registrants that use special- However, the increased frequency Deloitte ized vendors in the fair value process, of significant events that affect foreign the expectation is that the vendors’ bonds, such as European sovereign practices are completely transparent debt and bonds issued by European Career in brief and that registrants understand the banks and corporations affected by the Paul Kraft is lead client service partner at vendors’ processes and controls. sovereign debt crisis, makes a compel- Deloitte. He serves the firm’s largest investment “It’s good to understand models and ling case for mutual fund registrants and advisory, insurance and banking clients and inputs and if they’re reasonable for board members to consider fair value provides counsel and solutions on a range of market participants who trade these for other asset classes like fixed income. accounting, financial reporting, operational, international and regulatory compliance instruments, but at the end of the day, As one participant suggested: “If you matters. Kraft also directs Deloitte’s annual Fair the keys are the quality of your top- have 20 equity funds and five bond Valuation Survey. Prior to joining Deloitte, Kraft down controls which ensure that the funds and they all hold foreign securi- was assistant chief accountant in the SEC’s values are appropriate,” said a fund ties, it is difficult to argue you should fair investment management division in Washington DC and his responsibilities included assisting participant. “For example, have you value the equity funds and not the bond in the development and communication of the benchmarked a bond to traded prices, funds if the tools are available.” SEC’s positions and regulatory requirements bids that your desk is seeing, Trade Many funds know they are using stale related to advisers and investment companies. Reporting and Compliance Engine prices, for example, the 2am EST bond He received his BBA in accounting and finance from the University of Wisconsin. data, or indices that are an indicator of prices from Tokyo, and putting them that security? You need to understand into the 4pm EST NAV every night. The the bottom-up components but you time interval between those two events also have to demonstrate a consistent alone creates a case for fair value. And Calling all mutual funds: top-down approach.” those who might point to price as a Regulators are raising the bar for counterargument must keep in mind Markit invites professionals involved registrants at the same time as instru- that market condition can change in valuation – treasurers, heads of ments are becoming more complex. quickly and dramatically. As one round pricing and valuation, compliance Evaluations are now the starting point table participant put it: “You have an and risk officers – to participate in a of the NAV process, not the end point. obligation to fair value these instruments roundtable discussion on fair value “You have to look at all the data that’s at exit price.If you can get it right to to be held in New York on April 24. available to you and if there’s some- within a penny, you’ve met your obli- If you are interested, please email thing that compels you to dig deeper, gations. But again, price volatility can [email protected] you need to use that information,” change over time, so if fair value does

Spring 2012 – the markit magazine R&D: Municipal bonds /43 Source: Shutterstock Source:

Talk of the town

Municipal bonds surprised many by here was both good news and bad news for the enjoying strong performance last year, but municipal market in 2011. the muni market remains nervous about First, the good news: defaults and investors still face relatively Meredith Whitney was wrong. Or, if you want to light new issuance, writes Gavin Murphy beT charitable about it, maybe her timing was a little off. Whitney’s much hyped prediction calling for a wave of municipal bond

Spring 2012 – the markit magazine /44 R&D: Municipal bonds

defaults came in late 2010. The finan- November 2010 to June 2011 about This forced investors to move farther out cial analyst, famous for a prescient 50bn dollars was pulled from muni on the curve and buy lower-rated bonds report in 2007 predicting dire troubles mutual funds. Newly frugal politicians in a desperate hunt for yield. for banking giant Citigroup, warned that decided that maybe it wasn’t a good With tax-exempt bonds yielding more 2011 would be a year of calamity for time to borrow money and they would than taxable Treasuries, investors were munis. But the big crash never came remain stingy with debt as the year finding value in munis despite absolute and muni bond defaults, always a rare progressed, even as interest rates fell low yields. Crossover buyers weren’t occurrence, remained isolated events. to record low levels. fazed by the efforts of the Obama Though Whitney has been back in the Deals did get done. Gas pre-pay administration to curtail tax exemp- headlines recently – she is writing a deals came back from the dead. tion for munis. They saw value in munis book about financial troubles in the Tobacco bonds got sold. Banks yielding more than 100 per cent of municipal sector – most experts believe bought directly and brought their Treasuries. A weak economic recovery there will be few actual defaults. But that balance sheets to bear to make things made the typical alternative investment, doesn’t mean there aren’t some cracks happen. There were century bonds US stocks, less attractive. in the foundations. and springing liens. Bonds were Over the course of the year, yields would fall more in percentage and even in absolute terms for triple-A, double-A, and single-A rated bonds than for triple- B bonds. The spread between triple-A “ ...most experts believe there will be few and triple-B increased, prompting some actual defaults. But that doesn’t mean there analysts to recommend that investors look to longer dated, lower-rated bonds aren’t some cracks in the foundations.” for better returns. Bank of America Merrill Lynch said as of December 23, muni bonds had outperformed all but one other class of There have been high-profile Chapter issued to build airport terminals and fixed-income assets, with an after-tax 9 municipal bankruptcy filings and more bridges – and generate jobs. Deals return of 8.74 per cent for 2011. The only hard-pressed communities are studying were done to build hospitals and asset to exceed this return was taxable the option. Recession-wracked state convention centers. Babs, which had an after-tax return of and local governments still face severe In late 2010, issuers were scram- 13.65 per cent. This seemed to defy budget challenges and credit markets bling to sell taxable Build America predictions that Babs would become remain vulnerable to exogenous shocks. Bonds (Babs) and other bonds an orphan child of the market when the As 2012 unfolds there are fresh attacks created under the federal stimulus program expired. on the very notion of tax exemption for program before a year-end dead- The Bond Buyer 20-Bond Index municipal debt. line. After Babs went away, new began the year at 5.08 per cent and by issue municipal issuance contracted year-end had fallen to 3.88 per cent. The crash that never happened dramatically in early 2011. The Bond Buyer 11-Bond Index began Spooked by Whitney’s predictions and A flight to quality sent investors the year at 4.84 per cent and ended at headlines about gaping state budget spooked by the debt crisis in Europe 3.62 per cent. The Bond Buyer Revenue deficits and huge pension obligations, flocking to US Treasuries and high- Bond Index started the year at 5.44 nervous retail investors at the begin- grade municipal bonds, still consid- per cent and finished at 4.97 per cent. ning of 2011 decided it was time to ered among the safest of investments The 10-year Treasury had plunged from dump tax-exempt bond funds. Talk despite Whitney’s call. As the year wore 3.42 per cent to 1.90 per cent, and the that the US government could default on and supply remained sparse, yields 30-year Treasury from 4.54 per cent on its debt didn’t help matters. From on the short end fell to record low levels. to 2.90 per cent. Total new issuance

the markit magazine – Spring 2012 R&D: Municipal bonds /45

of long-term municipal bonds was the mendation from Bill Gross, founder, another tax giveaway to the wealthy, lowest since 2001 at about $288bn, managing director and co-chief invest- issuers strongly oppose curtailment down about 30 per cent from 2010, ment officer at bond fund giant Pimco. of tax-exempt debt, fearing it will drive according to Thomson Reuters. Gross recommended buying munis their borrowing costs higher. in January but warned that investors Proponents of replacing tax-exempt What a difference a year makes should avoid municipalities with pension munis with federally subsidized taxable As 2012 got underway, analysts were or funding issues. municipal bonds, mainly Democrats, predicting a gradual increase in supply States continue to face budget chal- have submitted legislation to renew the with a commensurate bump up in lenges and analysts have expressed Babs program. Republicans oppose yields. But those hoping for a buying specific concerns about local govern- resurrecting the program, which opportunity at lower prices have been ments that rely heavily on state funding. was created as part of the federal

“ Yields have bounced around at the low levels established at the end of last year as many issuers remain on the sidelines.”

disappointed. Yields have bounced With states in cutback mode, more economic stimulus effort at the end around at the low levels established at expenses are being pushed to the local of 2010. Those in the bond business the end of last year as many issuers level. And the housing bust has taken and many borrowers would love to see remain on the sidelines and the Federal a big bite out of property tax revenues. the program revived but so far they Reserve continues its ultra-low interest But there are some signs that the fiscal have been disappointed and there rate policy. With new issuance scarce, outlook is stabilising. Sales tax reve- is little indication Babs will be back traders report strong demand in nues have been slowly rebounding and anytime soon. the secondary market for whatever the consensus among analysts is that Democrats also would like to estab- bonds are available. Market observers most states have made painful adjust- lish a federal infrastructure bank to continue to suggest that low rates will ments to bring revenues and spending finance major infrastructure projects but eventually stimulate more borrowing but more into balance and are finally the idea isn’t popular with Republicans. some traditionally big borrowers, such taking steps to address underfunded Some in the municipal bond industry as California, show no signs of signifi- pension plans. question the need for such a bank. They cantly boosting issuance. Lately all eyes have been on Wash- say such projects can be financed in the In a change of heart, individual inves- ington DC, where the municipal existing public finance market. tors have been aggressive muni bond bond market has become caught up Also on the regulatory front: market fund buyers early in 2012, perhaps in the debate over raising taxes on participants are waiting to see how hoping for a repeat of last year’s low the wealthy. President Obama has regulators address long-awaited rules double-digit returns. They are likely to proposed a cap on tax exemption for pertaining to the registration of munic- be disappointed, according to most municipal bond interest for those in ipal financial advisors. Regulators also prognosticators, who predict that the top tax brackets. While experts continue to study ways to improve muni funds will see positive returns but say such legislation is unlikely to pass, transparency, disclosure policies and won’t repeat last year’s surprisingly the market remains concerned about liquidity in the muni market. strong performance. efforts to eliminate tax exemption for There are some high-profile bulls. municipal bonds. While critics of tax- Gavin Murphy is editor in chief at the Bond The year started out with a buy recom- exempt munis say they amount to yet Buyer newspaper based in New York City.

Spring 2012 – the markit magazine Kit and Caboodle: Clearing in Asia /47

Asia in the starting blocks

Forthcoming moves to regulate over-the-counter derivatives will have a particularly strong impact on Asian markets, writes Donna Bales of Balmoral Advisory

wo and a half years ago, pressure and the widely-held view representatives from that derivatives had been a significant the G20 countries made source of uncertainty during the global commitments to improve financial crisis. With the deadline fast the regulation and supervi- approaching, the proposed regula- sion of over-the-counter tions are now beginning to take shape (OTC)T derivative markets by the end of in markets around the world. As these this year. These commitments were made new regulations are analysed, one can in response to growing international only hypothesise about how different

Spring 2012 – the markit magazine /48 Kit and Caboodle: Clearing in Asia

markets will feel the impact of these interest”. The amount of open interest it is constructed so that it satisfies changes. One thing is certain however, is often abysmally low, which reflects the global mandate without adversely these regulations will challenge the the short term and speculative nature affecting the current dynamics of the status quo. of retail participation in markets such as domestic markets. Many exchanges The consequences of these regula- India and China and, to some extent, in Asia are considered “national treas- tory changes for Asia are of particular South Korea. ures” and operate as quasi government interest because regulators are faced Yet there are products and markets entities, which means that sovereignty with the task of meeting objectives that that stand out. The OSE Nikkei 225 and issues may outweigh some of the are perhaps too advanced in detail the HKEx Hang Seng index are active, practical consequences of disparate and scope compared to the current mature products and volumes in futures regulatory policy across Asia such as stage of market development in the and options on the KRX KOSPI 200 are increased costs and fragmentation region. Unlike the US and Europe, Asia enormous. In markets such as Thailand, of liquidity. is made up of multiple markets each at Malaysia and Indonesia however, the The industry continues to recom- different stages of their development life onerous controls on OTC trading may mend that the most effective and cycle: some markets are firmly estab- well stifle these products in their very efficient way to reduce systemic risk lished, while others are still finding a early stages of development. would be for local market financial foothold. Regulators have to perform These market structure nuances institutions to clear through a global, a delicate balancing act as they try to will have wide-reaching implications well-capitalised and maintained central juggle domestic and global interests for market participants and exchanges counterparty (CCP). At this stage, it and objectives. as they position themselves ahead of is unclear how the majority of coun- Furthermore, many of the markets regulatory change. Ultimately, Asian tries in Asia will position their policy, in Asia have a long way to go before OTC trading only accounts for 7 per however, it appears that many are they can be considered mature deriva- cent of global volumes and half of this adopting a “domestic market” model tive trading centres with market depth is in Japan. There is simply not enough whereby a local independent CCP and liquidity comparable with that of activity to justify separate facilities in is established with no offshore inter- established western markets. Much has each country. Also, cost pressures operability. Supporters of this model cite financial stability concerns and access issues for local participants as reasons for requiring clearing through a “ Asian markets will feel the most impact domestic CCP. The more “mature” financial markets from the Financial Stability Board’s in Asia – Australia, Hong Kong, Japan recommendation that all OTC standardised and Singapore – have all come out with a preliminary stance on how they will derivative products are cleared centrally.” construct their policy to meet the G20 objectives. Unfortunately, discrepancies in policy stance are already evident. been written about the growth in Asian will force market participants to make Both Hong Kong and Japan have derivatives volumes with such sensa- decisions to support markets that will outlined their intention to establish their tionalist headlines as “Asian futures provide the best return. own clearinghouse. The Hong Kong volumes surpass the US”. The reality is Asian markets will feel the most Exchanges and Clearing Limited (HKEx) somewhat different. While it is true that impact from the Financial Stability is establishing a new clearinghouse that pure volumes are high, three critical Board’s (FSB) recommendation that all will serve as a CCP for the Hong Kong factors are usually overlooked. First, the OTC standardised derivative products market. In its consultation paper, issued bulk of the region’s trading volumes are are cleared centrally. Mandatory central in October 2011, it proposed to phase in in China and India where the markets clearing of OTC derivatives is a discus- the introduction of mandatory clearing are awkward to access or inaccessible sion that is well advanced around the starting with interest rate swaps (IRS) to outsiders and are dominated by retail globe. Asian regulators have partici- and non-deliverable forwards (NDF). investors. Second, the contract size pated in this discussion yet still find In Japan, the Japan Securities is “tiny” when resized and compared themselves with complex decisions Clearing Corporation (JSCC) began with western equivalents. Third, the that must take into account domestic clearing Markit iTraxx Japan credit true health of a futures market is more interests, market realities and global default swap contracts in July 2011 and accurately assessed by the amount of demands. It is not a question of whether is expected to begin clearing IRS soon. outstanding positions known as “open a policy is put in place but rather how According to information released in the

the markit magazine – Spring 2012 Kit and Caboodle: Clearing in Asia /49

requirements. Inconsistent risk manage- “ Market participants...may take advantage of ment frameworks may eventually pose greater risks to the market. clearing through CCPs that are less strictly Co-operation among regulators will governed or have more relaxed capital and be essential for success. There are still some questions that must be answered. margin requirements.” Are the regulators equipped to handle the increased regulatory responsibility? What will mutual co-operation look like in practice? Financial Instruments and Exchange Act The proliferation of multiple CCPs There is no doubt that the proposed (FIEA), stability concerns are stated to across Asia poses many concerns regulations within the region will take be key influence in its decision regarding for regulators, exchanges and market on many shapes before the end of year which products will require mandatory participants. Multiple domestic CCPs deadline. There is no perfect answer clearing, however, the exact products within the region could limit choice for for any market in Asia and regulators will not be revealed until the end of the market participants, lead to fragmenta- will need to consider a multitude of year. For products that do not require tion of liquidity, reduce netting benefits factors to ensure they do not curtail mandatory clearing in Japan, trades and increase costs for institutions growth by implementing policies that can be cleared through a foreign CCP currently clearing through foreign CCPs. are too expensive. provided it is recognised by JFSA, the A poorly run CCP could introduce more Clearly, a more open regulatory Japanese regulator and an interoper- systemic risk – exactly the opposite of policy in each market and a more ability arrangement exists between the the intended outcome. uniform approach among Asian regu- foreign CCP and a domestically author- Asia is already a region made up of lators will benefit the whole of Asia. ised CCP. many market silos, which complicates However, other factors such as capital The Monetary Authority of Singapore trading. By introducing further frag- market development, market access, revealed an even wider policy stance mentation, overall derivative activity current exchange infrastructure and in its recently released consultation could be impacted. Global participants general liquidity are important compo- paper. It believes that supervisory may decide to be more selective in the nents that will help define the overall co-operation and co-ordination can markets they trade and limit their CCP winners and losers of this game- address financial stability concerns and membership. Local participants may changing global mandate. therefore it will not limit central clearing be restricted to trading with certain to domestic CCPs. It will create a counterparts due to their inability to recognition framework for foreign access foreign CCPs, which could curb CCPs thereby introducing a “choice local market trading activity. Differing model” for market participants. Similar eligible collateral requirements among Donna Bales, founder and managing to Hong Kong, it will take a prudent Asian CCPs may have the unintended director, Balmoral approach and phase in the clearing consequence of increasing the amount Advisory obligation, and will most likely start with of collateral market participants must IRS and NDFs in selected currencies. post, thus inflicting significant liquidity It is worth noting that the Singapore constraints and funding costs on them. Stock Exchange already has a well- All these issues may lead to market Career in brief functioning CCP. participants deciding to “opt out” of Donna Bales is a product development and In July 2011, the Australian Council certain markets, which will ultimately business professional with a proven track record of managing complex capital market industry of Financial Regulators issued a discus- impact trading volumes and profits initiatives during times of significant market sion paper but no official stance has and reduce the global relevance of change and market structure reform. been made public since then. It will be smaller exchanges. Bales is the founder and managing director interesting to see how the Australian Diverse models also introduce poten- of Balmoral Advisory, a Singapore-based position evolves given they rejected the tial legal, regulatory and financial arbi- consultancy providing comprehensive market research intelligence and advice on “go SGX/ASX combination on the grounds trage concerns. As CCPs compete to to market strategy” to businesses that are of “national interest” and the absence of provide clearing services, market partici- expanding their presence in Asia. a local clearinghouse. pants with cross-border trading activities In addition, she acts as a strategy advisor to South Korea, China and India seem may take advantage of clearing through an international communications firm, College to be leaning towards domestic models CCPs that are less strictly governed or Hill Asia. Bales holds a Bachelor’s degree in Economics from the University of Western Ontario. starting with mandatory clearing of IRS. have more relaxed capital and margin

Spring 2012 – the markit magazine /50 In the Spotlight: OTFs Source: Shutterstock Source:

Organised

fter the financial crisis, over-the-counter (OTC) derivatives were enthu- climb siastically denounced as the instigator of the The Organised Trading Facilities model appears meltdown. The regula- tionA of these instruments has since to offer a solution to the issue of how to make been regarded as a litmus test of official the derivatives market more transparent and resolve to make markets safer. better regulated, but national governments are Rather than legislating derivatives into oblivion, however, policymakers divided on the matter, writes David Wigan have sought to push them away from OTC trading and on to electronic venues, where they can be observed and monitored. In designing the new regulatory architecture, politicians have come

the markit magazine – Spring 2012 In the Spotlight: OTFs /51

legislation, will either fold into the OTF Marston, head of ecommerce sales at classification or sweep up products not Deutsche Bank. “The platforms are a caught by the alternatives. key tool for banks in interacting with The trading venue to attract most their clients, so, depending on how the controversy to date has been the OTF. regulations play out, we will need to First proposed in December 2010, it adjust our strategy.” is designed to capture sections of the Under the proposals, single-dealer market, such as bilateral standardised platforms could continue operating as derivative trades and broker crossing SIs. However, that would not allow them networks, that escaped the reach of the to deal in standardised derivatives, other categories. which may only be traded under

“ The trading venue to attract most controversy to date has been the OTF.”

With some 90 per cent of the notional the legislation on exchanges, MTFs value of derivatives still traded over- and SEFs. the-counter, OTFs are expected to do In response to the proposals, dealers the heavy lifting in moving complex have asked the European Commission products to electronic platforms and to consider making allowances for their clearing. In less liquid asset classes, platform models, either by amending such as credit, they appear to be the definition of own capital, perhaps the most appropriate model, offering recognising capital as facilitatory rather greater flexibility for pricing transpar- than proprietary, or allowing banks to ency and discretion over trading proto- use a separate entity for trading, which cols, seen in many cases as a prerequi- would be capitalised by the bank and site for creating order flow. would feed funds into a trade as if it In October, the European Commission were a client. published revised proposals for OTFs, In its response to a questionnaire but as the market digested the blueprint sent out by German MEP Marcus it became apparent the revisions would Ferber, who is official rapporteur for the work better for some sections of the Mifid review, the International Swaps financial community than others. and Derivatives Association (Isda) The group most at odds with the made clear that it was unhappy with up with a variety of models, with US new Mifid architecture was the dealer the potential impact of the proposals on efforts focused on Swap Execution community. Before October, many banks single-dealer platforms. Facilities (SEFs), currently the subject had assumed that they would be able “We believe that the requirements of a drawn-out process of rulemaking, to convert existing single-dealer plat- associated with OTFs could be helpfully while Europe has focused on revising forms into OTFs, retaining control of amended to ensure that they are suited the Markets in Financial Infrastructure the lucrative OTC derivatives business. to OTC derivative and other non-equity Directive (Mifid). However, the revised proposals expres- markets,” Isda said. “As for the struc- The result in Europe has been an sely prohibited firms designated as OTFs ture of the OTF regime, we believe that alphabet soup of trading venues, from using proprietary capital to fill trade the proposed ban on an OTF operator comprising Regulated Markets orders from clients. The restriction put an executing client orders against his own (exchanges), Multi-lateral Trading Facili- end to dealer platform convertibility, and proprietary capital overlooks the vital ties (MTFs) which are many-to-many blocked the simplest route for banks into role that investment firms’ risk capital venues, and Organised Trading Facili- electronic trading under Mifid. plays in facilitating client business and ties (OTFs), offering more discretion on “For single-dealer platforms it may thus enhancing liquidity.” pricing and transparency. be that some policymakers did not Dealer balance sheets play a vital Systematic Internalisers (SIs), a have a real insight into the impact that role in ensuring complete markets, dealer-broker legacy of earlier Mifid the proposals would have,” said Serge Isda added, for example, in bridging

Spring 2012 – the markit magazine /52 In the Spotlight: OTFs

the time lapse between clients’ sell and can decide how client orders are filled. “On execution protocols, what the buy orders. There is still confusion in some quarters rules are attempting to recognise is The UK regulator in January also over what that means in practice. that a one size fits all electronic central added its voice to objections: “We esti- “It is clear for us as an MTF operator order platform will not be sufficient to mate that over 95 per cent of dealer-to- what non-discretionary means,” said maintain liquidity in important wholesale client trades in the European interest Eric Kolodner, managing director at markets,” said Matt Woodhams, head rate swaps market – by far the biggest dealer-to-client platform Tradeweb. of ecommerce at interdealer broker GFI. category of derivative – are against “What is not so clear is what is meant by “You can electronify some conversa- the dealer’s own capital,” said David discretionary for an OTF.” tions but sometimes you need to overlay Lawton, FSA Acting Director of Markets. Another area where some players are that with a voice negotiation.” “We therefore have concerns that, as looking for more clarity is multilateral Once voice broking is introduced, currently drafted, there will be significant trading, Kolodner said. electronic levels of pre-trade transparency withdrawal of liquidity in those markets.” In place of a restriction on dealers employing their own balance sheets to provide liquidity, the Commission might “ For MTF operators, what is paramount is consider a rigorous conflict management process, Lawton said. that there is a level playing field across the One area in which single-dealer plat- MFT and OFT universe.” forms would still thrive is where Mifid provides an exemption to the requirement that derivatives be traded on SEFs “If you look at the concept of multi- are necessarily impacted, Woodhams and be centrally cleared. That may be lateral trading, in our world that means said. The key is not to have identical either where a large trade is contem- bringing together multiple buying and transparency rules but to have rules that plated, as is common in sovereign selling interests,” he said. “However, are “equivalent”. debt markets, or where an instrument under the current Mifid draft there As the debate over the shape of OTF is traded on non-standard terms. The is potentially some lack of clarity on protocols continues, market players are market awaits definitions on both. what it means to be an OTF from the keeping an eye on the political land- Another approach may be to connect perspective of how multilateral you scape in Europe, where there has been single-dealer platforms to existing OTFs need to be.” some suggestion that national govern- through a web portal, with the single- For MTF operators, what is para- ments in the EU Council are divided dealer platform acting as a conduit to mount is that there is a level playing over OTFs, after some German, French OTF pricing, and charging a broker fee field across the MTF and OTF universe. and Italian members of the European for the service. Alternatively, dealers If regulators seek to capture different Parliament said there was no need for may set up virtual OTF aggregation activities within separate types of the designation. The Federation of Euro- services, building screen real estate and trading venues, they argue, then where pean Securities Exchanges (FESE) has pooling liquidity from an array of plat- they provide the same service the also demanded the European Commis- forms into one location. regulations should be identical. This is sion drop OTFs from the list of venue UBS recently became the first major important in areas like pre- and post- categories permitted to trade standard- dealer to launch such a facility, through trade transparency, where a lighter ised OTC derivatives. its Price Improvement Network for the touch regulator for one type of trading “I am not sure that is going to credit default swap markets. The dealer venue could drain order flow from happen, but if it did, the likely effect said in February it had around 50 clients the other. would be that business is driven trading on the platform. The group that appears to be most offshore or that liquidity in some prod- Away from dealer concerns, the content with the Mifid proposals is inter ucts completely dies off,” Woodhams central debate over how SEFs will work dealer brokers, where the business said. “ An alternative is that they could has focused on discretion over trading model is almost a perfect match to the look to expand the MTF category to protocols and pricing transparency. protocols covered by the OTF designa- include wholesale intermediation.” Discretion in the context of election, particularly with respect to voice

tronic trading refers to the way in which trading and levels of discretion, which David Wigan is a freelance journalist focusing on market participants interact with the would accommodate broker fixings, capital markets, derivatives and economics. He rules of the venue. MTFs step out of the matchings and trade work-ups (where has written for publications including the Financial trade and have no discretion as to that additional buyers and sellers join a trade Times, Risk, Reuters, Creditflux, FOW, Financial News, Euromoney and Institutional Investor. interaction, whereas an OTF operator in progress).

the markit magazine – Spring 2012 /54 Markit Commentary & Data Economics he all-pervading gloom that seemed to permeate the global economy late last year appears to be lifting. October may have represented a low point, as the economic data have generally started Markit Commentary & Data to move in the right direction ever since. Economic forecasts, which have been ratcheted down Tover the past year, look set to become a little brighter.

even in countries such as China. A new and Germany are suggesting that reces- credit squeeze was also becoming a distinct sions have been averted in both cases, possibility, with banks seeking to rebuild although a slip back into recession still capital buffers rather than lend. Not surpris- looks a distinct possibility for the eurozone ingly, appetite for risky eurozone sovereign as a whole. Meanwhile, the PMI for China debt slumped, and yields soared, increas- has defied widespread expectations of a ing the risk of default. steepening downturn, hitting a four-month Double-dip recessions looked all but high in February. Chris Williamson inevitable for the eurozone and the UK, chief economist and a better than expected fourth quarter More medicine [email protected] for China – where the annual growth rate What has changed since October to cause @WilliamsonChris slowed from 9.1 per cent to 8.9 per cent the improvements in the PMIs? – was widely expected to be followed by First, we should note that not all countries Economic gloom lifts a disappointing first quarter of 2012 as are enjoying a return to growth. Greece, Official data have confirmed the worryingly exports slumped in the face of weak Spain and Italy are still contracting at steep weak picture that was painted by the busi- demand from Europe. rates. However, these countries are under- ness surveys late last year. In October, going severe austerity programmes, which the J.P. Morgan global PMI – produced Global PMI hits 12-month high explains the lack of domestic demand. More by Markit from worldwide business However, since hitting a low in October, importantly, the appointment of caretaker surveys of manufacturing and services the Global PMI has risen for four straight governments in Greece and Italy has companies – fell to its lowest level in nearly months reaching a 12-month high in Feb- boosted confidence that structural reforms two and a half years. ruary. The US has been the star performer, will be taken seriously. The eurozone and the UK both con- but clear improvements have also been Second, central banks have once tracted in the fourth quarter of 2011, and seen elsewhere. PMI surveys for the UK again ridden to the rescue. In the case some countries – notably Italy – were already back in recession, defined as two Global GDP and the PMI consecutive quarters of falling gross domestic product (GDP). Even German PMI GDP Annual % Change output fell. It was not all bad news, with 65 7 the US showing surprising resilience. 60 5 However, with growth rates also weaken- ing in many emerging markets, especially 55 3 China, global GDP rose at an annual rate of only 1.7 per cent in the final quarter of 50 1 2011, just half the rate of a year earlier. The headwinds facing many countries 45 -1 late last year were clearly developing into Global PMI Output Index forces that many feared would drive devel- 40 -3 Global GDP oped economies back into recession. The 35 -5 escalating eurozone debt crisis and aggres- 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 sive, demand-sapping austerity measures Year implemented in many countries hit confidence and demand, affecting export growth Source: Markit

the markit magazine – Spring 2012 Markit Commentary & Data /55

Back in Recession? Time to revise up your forecast? Economics forecasts were ratcheted GDP Growth in 2011 Q4 Change Since Depth of Recession down as the survey data disappointed

GDP (Quarterly % Change in 2011 Q4) GDP (% Change from Recession Low) last year, typified by the International Mon- etary Fund (IMF). At the start of 2011, the Denmark Sweden IMF expected the eurozone to grow by United States Canada 2.5 per cent in 2012. By September, this Markit Commentary & Data Norway Germany forecast had been ratcheted down to 1.1 Canada United States per cent and in January the fund decided France Switzerland that the region would instead contract by Greece Norway 0.5 per cent. The impact of the eurozone Switzerland Japan debt crisis would be far-reaching, accord- Germany Denmark ing to the IMF. Advanced economies United Kingdom Belgium would grow by only 1.2 per cent in 2012, Belgium France rather than the 1.8 per cent predicted Spain United Kingdom back in September and 2.5 per cent that Eurozone Eurozone was forecast a year earlier. The global Japan Netherlands economy is set to grow by 3.3 per cent Netherlands Ireland as a result, down from a forecast of 4 per Italy Italy cent made back in September. Sweden Spain However, the recent upturns in the PMIs Portugal Greece suggest that economic forecasters are Ireland Portugal likely to become a little more upbeat. -2% -1% 0% 1% 2% -2% 0% 2% 4% 6% 8% 10% Caution will no doubt prevail, and “uncertainty” will remain a key watchword. The Source: Markit eurozone periphery still seems a long way off from returning to anything like robust of the European Central Bank (ECB), they flagging recovery and the US Federal growth. At the time of writing, a disorderly are fighting with a vengeance. Not only Reserve made an unprecedented move Greek default and its unknown conse- did the ECB’s new president, Mario by announcing that it expected to keep quences remains a key risk to global Draghi, reverse two interest rate hikes interest rates below 1 per cent until at financial and economic stability. The rising made by his predecessor earlier in 2011, least 2014. In Asia, the Bank of Japan price of oil also threatens to derail fragile but he also announced in October the continues to print more money and the recoveries. However, for now, the data provision of unprecedented access to People’s Bank of China has begun to are clearly moving in the right direction, long-term ultra cheap credit for banks. cautiously loosen policy, reducing banks’ and 2012 has seen a far better start than In a shrewd move, the ECB also sought reserve ratio requirements. many had anticipated. to remove any stigma that might be attached to a bank accessing what could PMI Survey Output Indicators normally be seen as emergency loans. Banks took advantage of the offer to the PMI Output Index (Manufacturing & Services) 70 tune of some €500bn, effectively remov- UK Japan 65 ing the threat of a credit crunch while at Eurozone China the same time providing funds for banks 60 United States to buy sovereign debt again. Tellingly, 55 the ECB had felt the need to intervene in sovereign debt markets late last year, 50 but made no purchases in January. 45

Another offer of cheap loans was made 40 by the ECB in February, with demand 35 exceeding that seen back in December, taking the total to €1,000bn. 30 2007 2008 2009 2010 2011 2012 The Bank of England, meanwhile, Year injected another £50bn into its asset purchase programme to help boost the Source: Markit

Spring 2012 – the markit magazine /56 Markit Commentary & Data European CDS he opening months of 2012 in the credit markets were a tale of tentative optimism chimed with nagging uncertainty. Spreads continued where they left off in 2011 and rallied strongly. But in the Markit Commentary & Data background, the feeling that the rally could come to a shuddering halt was palpable. Risk – financial, Teconomic and political – hadn’t been forgotten about; it was only less acute than during the more volatile months of last year.

Figure 2: Spreads Rally on Low Volumes

Millions 30,000 Markit iTraxx Europe 25,000 Markit iTraxx Senior Financials 20,000

15,000 Gavan Nolan 10,000 director, credit research 5,000 [email protected] @GavanNolan 0 21 Sep 21 Oct 21 Nov 21 Dec 21 Jan 21 Feb 11 11 11 11 12 12 Nonetheless, there was no denying the Date strength of the rally, whatever its vulnera- bilities. Was it justified? Bullish investors Source: Markit could point to two factors. First, there was a tangible improvement in the US economy. in September 2011 and accelerated in the 9.1 per cent in August, this was a real The stagnant labour market – for so long fourth quarter. The trend continued in 2012 positive indicator. But unemployment was a drag on aggregate demand – finally – by January, the unemployment rate had still high historically. In September 2008 started to pick up. The improvement began hit 8.3 per cent. Bearing in mind that it was – hardly a time of economic optimism – it was 6.1 per cent. Other indicators were Figure 1: Banks Outperform Sovereigns more mixed, so the bullish sentiment was understandably tempered. Spread (bps) So, in Europe at least, it was the second 400 Markit iTraxx Senior Financials factor that was instrumental in driving 350 Markit iTraxx SovX Western Europe spreads tighter. In Q4 2011, the market Markit iTraxx Europe was awash with fears that some of the 300 region’s banks were in danger of a funding 250 crisis. This could have systemic implications; in other words, another credit 200 crunch. The Markit iTraxx Senior Finan- 150 cials soared wider, and in November hit

100 a record level of 353bps. To put it in context, at the peak of the financial crisis 50 in March 2009 the index was at 210bps,

0 then a record level. By the end of the year 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 10 Feb it had tightened to 275bps, and at the end 11 11 11 11 11 11 11 11 11 11 12 12 of February it was at 206bps. Date Such a rally doesn’t happen without Source: Markit external intervention, as we have learned

the markit magazine – Spring 2012 Markit Commentary & Data /57

during the last few Figure 3: Portugal Decouples from the Peripheries years. Fiscal stimuli from governments Spread (bps) and unconventional 1,600 monetary policies Portugal 1,400 almost saved the Ireland world economy from Italy 1,200 Markit Commentary & Data a deep and painful Spain depression. This 1,000 time around it was the turn of the Euro- 800 pean Central Banks (ECB) to save the 600 day. In December, it 400 conducted a three- year Long-Term Refi- 200 nancing Operation (LTRO). Previously, it 0 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 10 Feb had held shorter- 11 11 11 11 11 11 11 11 11 11 12 12 dated LTROs, and Date they had been grate- fully received by Source: Markit banks struggling to source funding. But a three-year operation that the rally was on low volumes. Figure peripheral economy. Its spreads ballooned was of a different magnitude altogether. 2 shows that activity in the main credit wider and its CDS started to be quoted At the time it was uncertain just how indices declined during Q4 2011 and upfront – a sure sign of a credit in distress. banks would avail themselves of the facil- struggled to recover in the first months Along with long-standing laggard Greece, ity. After all, it could be interpreted as a of 2012. it had now decoupled from the other sign of balance sheet weakness if a bank The eurozone debt crisis and the des- peripherals. Ireland was being rewarded had to rely on a central bank for liquidity. perate fiscal conditions in the peripheral for its stoicism and a significant improve- In the event, it proved far more popular economies have, of course, struck a ment in its external position; Spain and than expected. A total of 523 banks bor- critical blow to bank balance sheets. It Italy – the latter in particular – were enjoy- rowed just under €500bn gross, €193bn was noted above that banks outperformed ing the extra liquidity being pumped into net (some of the funds from the short- other sectors, and it can be seen in Figure the system by the ECB. Domestic banks dated operations were rolled into the new 1 that sovereigns lagged behind financials. were using the funds to buy sovereign facility). Unsurprisingly, banks in the euro- This is somewhat surprising given how debt, as well as shoring up their own zone’s periphery accounted for the bulk the two are intertwined. But the sovereign balance sheets. of the borrowing. These institutions were market is particularly affected by political So, are the credit markets set to con- having trouble selling senior unsecured risk, and it has been all too prevalent in tinue on an uninterrupted rally throughout debt, so the LTRO was a lifeline. recent months. Greece’s position within 2012? Only the most optimistic of inves- And there was more to come. Spreads the eurozone was now in serious doubt, tors would predict such an outcome. The rallied in anticipation of the second three- and the second EU/IMF bailout was eurozone debt crisis is still a long way year LTRO, held on February 29 2012. It proving difficult to secure. At the time of from its denouement, and growth is was an even greater success: 800 banks writing, it was still uncertain what would anaemic at best in many developed borrowed €529bn gross and €310bn net. transpire: private sector bondholders were economies. Austerity policies are going Smaller banks clearly took advantage of being asked to take large losses through to make economic expansion challenging; the relaxation of collateral eligibility – a debt exchange but it was unknown how they may well keep weaker countries in another crucial ECB intervention – and many would participate. If the necessary recession for years to come. This creates perhaps felt less stigmatised during the amount wasn’t achieved, collective action a fertile environment for political instabil- second round. Bank spreads outper- clauses could be invoked and a CDS ity with commensurate risks for financial formed every other sector during this credit event triggered. assets. Volatility has been a hallmark of period but their systemic importance The uncertainty over the Greek bailout the credit markets in recent years and we meant that they pulled the broader credit had a knock-on effect on Portugal, can expect more of the same over the market along with them. It should be noted perceived as the next most vulnerable coming months.

Spring 2012 – the markit magazine /58 Markit Commentary & Data US CDS ive-year CDS spreads for US government debt have continued to tighten and in the last couple of weeks seem to be hovering at levels not typically seen since before last year. This has happened Markit Commentary & Data even though the US is no longer a pure ‘AAA’ credit since S&P’s downgrade last August, and there Fare indications that S&P could downgrade the US again within the next 24 months. However, many in the political world believe that the agency would wait until after the elections, if not the first 100 days of a new administration.

US CDS (5Y)

Spread (bps) 70

Otis Casey 40

director, credit research 30 [email protected] 20 Nov 20 Mar 20 Jul 20 Nov 20 Mar 20 Jul 20 Nov 20 Feb 09 10 10 10 11 11 11 12 @OtisCasey Date

The debate over raising the debt ceiling Source: Markit and a subsequent downgrade was of course the reason behind spreads widen- Muni CDS general credit improvement. After showing ing over much of the second half of 2011. The municipal bond market was one of the some follow through in the early part of this The deal struck over the debt ceiling did best performing asset classes of 2011; year with significant spread tightening, accomplish one significant thing, aside despite dire predictions of a significant spike spreads have remained relatively flat. from raising the ceiling itself – it made it in defaults from famed analyst Meredith Part of that is down to the fact that extremely difficult to generate a result Whitney and the related fallout from the issuers have stepped up issuance in order other than an automatic increase of the downgrade of the US sovereign credit rating. to take advantage of low rates, with many ceiling. To prevent this from happening, Similarly, municipal CDS spreads reflected looking to save significant money simply Congress would have to pass explicit the cash market trend from last year of by opportunistically refinancing rather than legislation to block it. To their credit, Congress and the High Beta State GO Muni CDS (10Y) President demonstrated that they can reach a compromise – even in an election Spread (bps) year. Of course, the policies may need a 400 base of bipartisan agreement and the 350 political stars have to line up, but it can 300 250 be done. This was demonstrated in Feb- 200 ruary with the extension of payroll tax cuts 150 and unemployment benefits by strong 100 California New Jersey voting margins. Of course, whether the 50 New York State Illinois parties, or even the American public, can 0 reach an agreement on the broad ques- 20 Nov 20 Mar 20 Jul 20 Nov 20 Mar 20 Jul 20 Nov 20 Feb 09 10 10 10 11 11 11 12 tions of priorities leading to some combi- Date nation of tax reform and spending cuts remains to be seen. Source: Markit

the markit magazine – Spring 2012 Markit Commentary & Data /59 issue because of funding needs. This not move much during the last week even The resulting changes and standardization increased supply has market participants though Stockton, California’s city council of contracts will make municipal CDS wondering whether it can all be absorbed voted 6-1 to miss certain bond payments more fungible and hopefully more liquid. without significant price disruption, and enter into negotiations with creditors Some market participants may have been despite strong demand. in an effort to avoid Chapter 9 bankruptcy. on the sidelines waiting for the contract Another factor is that the municipal Volumes may improve following the changes. Most of the changes will take CDS markets, despite no noticeable standardization of municipal CDS con- effect after the next roll of the MCDX in Markit Commentary & Data uptake in volumes, may be showing more tracts. On March 5, Isda opened the US April and it will be interesting to see if signs of maturity. Indicative quotes did Municipal CDS Protocol for adherence. volumes pick up in their wake. Markit iBoxx Indices he story so far this year has been the rally behind risky assets. January saw a quick rally as the European Central Bank’s announcement of its Long-Term Refinancing Operation (LTRO) programme helped to add much needed liquidity to the European financial system and cut off one major Tartery in which contagion from the continent’s sovereign debt crisis could travel.

The programme’s use of sovereign debt announcement in December last year to seen first in the government indices with for collateral essentially encouraged banks late February, from roughly 600bps to US Treasuries and UK Gilts both showing to buy sovereign debt, which helped bring close to 400bps. After all, the main intent year-to-date losses while European sov- down sovereign yields. This was critically of the LTRO programme was to stabilise ereigns show a gain. Financials have important in helping Spain and Italy move bank balance sheets and offer banks a outperformed non-financials across euro, away from the 7 per cent territory, a rough low-cost source of financing. sterling and dollar-denominated debt. guideline of where government debt financ- The impact of the LTRO has also had Similarly, within financials across the ing becomes unsustainable. The increased a noticeable effect on performance three currency denominations, subordi- demand seen in auctions has helped Spain figures. By muting, but not eliminating, nated debt has outperformed senior. get well ahead of schedule for its 2012 some of the worst-case scenarios for High yield has outperformed investment financing needs. contagion, and the existence of a low-rate grade and emerging markets, even in As this article went to press, the environment, investors are essentially EMEA. In fact, within emerging markets, markets were waiting to hear from the being pinched into riskier assets, the EMEA has been the best performer with ECB about future plans regarding the demand for which has driven price per- an 11.36 per cent year-to-date return to LTRO. While it seems likely that the ECB formance. The appetite for risk can be February 24. may pause for now to assess the impact on markets and make sure that the added LTRO Leads to Convergence in Spreads Between EUR Snr Fins & Sub Fins liquidity does not spark off a surge in Spread (bps) inflation, the bank’s departure from its 900 tradition of fighting inflation over and above 800 all other concerns has demonstrated that Spread Difference it can and will act decisively when it deems 700 Markit iBoxx EUR Senior Financials Markit iBoxx EUR Subordinated Financials it necessary. Thus, a continuation of a 600 market rally is not necessarily dependent 500 on a continuation of LTROs. The impact of the programme so far 400 can be seen clearly in the narrowing of 300 spreads between senior and subordinated 200 European financials. The chart of annu- 100 alised spreads over the benchmark for 1 Nov 15 Nov 29 Nov 13 Dec 27 Dec 10 Jan 24 Jan 7 Feb 21 Feb the Markit iBoxx EUR Senior and Subor- 11 11 11 11 11 12 12 12 12 Date dinated Financials indices narrowed con- siderably since before the LTRO Source: Markit

Spring 2012 – the markit magazine /60 Markit Commentary & Data

Total Return Performance – Government Total Return Performance – Inflation Total Return Performance Total Return Performance Index Month-to-date Year-to-date 1 Year 3 Year Index Month-to-date Year-to-date 1 Year 3 Year Inflation Government US -0.11% 2.18% 11.92% 26.20% US Treasuries -0.79% -0.36% 9.78% 14.61% UK -2.96% -2.79% 15.58% 29.09% UK Gilts -1.53% -1.09% 17.01% 24.90% Germany -0.47% 0.11% 5.88% 15.35% Europe Sovereigns 1.09% 2.96% 6.88% 12.11% France 0.32% 2.88% 3.15% 13.21% Markit Commentary & Data Source: Markit Source: Markit

Of course, downside risks remain. The Greece’s debt exchange has prompted include implementation risk around the last few weeks in February have seen speculation that the recently enacted next Greek bailout. Buoyant economic investors take a more cautious approach. collective action clauses will be trig- data, particularly from the US, could Uncertainty about participation levels in gered, leading to a credit event that will reverse if tensions with Iran increase. The trigger Greece CDS. recent rise in oil prices has reached ter- Uncertainty about the ritory not seen since last year’s Arab Total Return Performance – Investment Grade capacity in the EU Spring. While Saudi Arabia has made Total Return Performance Index Month-to-date Year-to-date 1 Year 3 Year bailout fund and level efforts to replace the supply from the Investment Grade of IMF participation European embargo of Iranian oil, it seems USD Overall -0.32% 0.59% 9.05% 21.79% Financials 0.70% 3.93% 5.88% 41.98% has also prompted to have had little effect. If Iran fulfils its Banks 0.61% 4.53% 5.04% 39.22% investors to be a little threats to block the Strait of Hormuz or Financial Services 0.63% 3.12% 8.38% 43.30% Insurance 1.25% 4.72% 8.66% 63.22% wary of secondary there is a pre-emptive Israeli air strike on Senior 0.55% 3.85% 6.16% 37.31% markets. To the extent Iranian nuclear facilities, the oil markets Subordinated 1.27% 6.03% 5.71% 57.92% Non-Financials 0.47% 1.85% 12.15% 40.82% they have added risk could get jittery. Even if these risks never Basic Materials 0.66% 2.99% 10.33% 54.31% in corporates lately, materialise, the strong start to the year Consumer Goods 0.06% 1.07% 10.86% 35.40% Consumer Service 0.79% 2.10% 14.46% 45.34% it has been in the has prompted some investors to take or Health Care 0.11% 1.53% 12.83% 33.47% primary markets. lock in profits which may make March a Industrial 0.24% 1.50% 11.27% 38.31% Oil & Gas 0.79% 2.06% 14.10% 48.14% Risk factors that month in which the markets consolidate Technology 0.41% 1.44% 10.47% 31.34% could derail the rally a little. Telecommunications 0.69% 2.57% 11.79% 37.75% Utilities 0.11% 1.45% 12.82% 40.11% GBP Overall -0.94% -0.02% 14.20% 29.24% Total Return Performance – High Yield Financials 1.54% 6.02% 5.27% 44.88% Banks 1.74% 7.22% 4.61% 39.37% Total Return Performance Financial Services 0.52% 2.09% 10.57% 52.29% Index Month-to-date Year-to-date 1 Year 3 Year Insurance 2.07% 6.33% 2.00% 63.05% High Yield Senior 0.70% 3.49% 9.49% 38.61% Subordinated 2.50% 9.00% 1.34% 49.92% USD 1.82% 4.75% 7.43% 72.91% Non-Financials 0.29% 1.59% 12.39% 38.71% EUR 3.13% 9.81% 2.68% 91.54% Basic Materials 2.27% 4.13% 12.78% 62.14% Consumer Goods 0.22% 1.34% 13.45% 42.26% Source: Markit Consumer Service -0.38% 0.23% 12.89% 39.36% Health Care -1.73% -0.27% 19.57% 38.97% Industrial 1.23% 2.24% 9.47% 48.36% Oil & Gas 0.18% 1.57% 11.58% 34.73% Total Return Performance – Convertibles Telecommunications 0.94% 2.56% 11.24% 35.05% Total Return Performance Utilities 0.21% 1.63% 11.87% 35.47% Index Month-to-date Year-to-date 1 Year EUR Overall 1.02% 2.99% 6.63% 15.84% Convertibles Financials 1.12% 5.45% 4.08% 32.48% Banks 1.07% 5.46% 4.32% 30.65% 1.48% 4.00% -0.61% Financial Services 1.24% 3.96% 6.64% 37.59% Source: Markit Insurance 1.45% 6.90% -0.34% 42.55% Senior 0.69% 3.69% 5.93% 22.70% Subordinated 2.50% 11.31% -0.82% 56.12% Non-Financials 1.23% 2.89% 7.0 8% 26.09% Total Return Performance – Global Emerging Markets Basic Materials 1.17% 2.68% 7.20% 30.52% Consumer Goods 0.79% 2.13% 6.74% 25.50% Total Return Performance Consumer Service 1.59% 3.47% 7.15% 29.01% Index Month-to-date Year-to-date 1 Year 3 Year Health Care 0.44% 1.49% 8.40% 23.58% Global Emerging Markets Industrial 1.82% 3.84% 6.10% 29.05% Oil & Gas 0.80% 2.46% 7.86% 30.09% Global 2.31% 9.11% 5.90% 5.90% Retail 1.75% 3.49% 7.10% 26.27% Asia 0.95% 5.64% 8.02% 8.02% Technology 0.91% 2.02% 5.45% 32.74% EMEA 3.85% 11.36% 0.76% 0.76% Telecommunications 1.54% 3.30% 7.27% 23.67% Utilities 1.25% 3.03% 7.28% 23.38% Latin America 1.41% 9.92% 12.44% 12.44% Source: Markit Source: Markit

the markit magazine – Spring 2012 Markit Commentary & Data /61 Loans he US leveraged loan market has continued apace from its rapid progress last year, equalling the gains seen year-to-date in 2011. This may bode well for the loan market in 2012, as the feverish Markit Commentary & Data pitch in the first half of last year fuelled a large swathe of new primary issuance that helped to Treinvigorate secondary trading. On the other side of the pond, however, the European loan market continues to struggle amid the weight of the sovereign debt crisis.

due by 2015 (and Markit iBoxx USD Leveraged Loan Index Returns two thirds by 2016) by Year which has caused a rush into the high- % 10 yield market to 8.02% adjust maturity pro- 8 files in order to 6

provide financial 4 2.59% 2.63% breathing room for 1.36% Colin Brunton 2 0.94% many issuers. 0 vice president, loan pricing -2 [email protected] The US versus the -4 European market -6 Loan market performance and trends Though the overall -8 -6.68% The loan market is off to its best start institutional loan 2007 2008 2009 2010 2011 2012 since 2009, when it gained over 8 per market has returned Year cent up to February 22, according the to a state of relative Markit iBoxx USD Leveraged Loan Index, health, the Euro- Source: Markit the only loan index to incorporate real-time pean loan market market data and up-to-date reference and continues to lag behind its US counterpart. price differential to return to levels not seen corporate actions data. So far this year, Historically, European institutional loans since the worst of the recession. the market has recorded a 2.63 per cent tended to trade roughly on par with US The average European institutional loan total return, with a good portion of the institutional loans – averaging between price now hovers between 7 and 8pts return coming in the form of principal 2pts below to 2pts repayments. Nearly $12.7bn has been above US loan Institutional Loan Amounts Outstanding, by Maturity Year repaid in the first 53 days of the calendar prices. In the depths year, representing 2.4 per cent of the total of the global reces- % amount outstanding in the entire index. sion, this relatively 35 Many high-profile widely-held institu- stable relationship 29.6% 30 tional loan flow names such as UPC, was torn apart when Ineos, Realogy and Spanish Broadcasting European loan 25 have all accessed the bond market to pay prices fell to an 20 17.7% 18.5% down much of their loan financing this average of 10pts 16.2% year. Issuers are taking advantage of the below US loan 15 13.8% open high-yield bond market to refinance prices in 2009. The upcoming loan maturities. The so-called relationship returned 10 loan “maturity wall” (in which large deals to historical norms 5 2.4% from the 2006-07 boom years are coming in the first half of 0.5% 1.3% 0 due over the next few years) has been 2011, until the US 2012 2013 2014 2015 2016 2017 2018 2019 pushed out several years by recent matu- sovereign debt crisis Year rity extension amendments. Yet over one beginning August third of outstanding loan issuance is still 2011 caused the bid Source: Markit

Spring 2012 – the markit magazine /62 Markit Commentary & Data

Average Bid Differential Between US and Average Bid, Institutional Loans, by Region European Institutional Loans Average Bid Points 98 12 US 96 10 Europe

8 94

Markit Commentary & Data 6 92 4 90 2

0 88 -2 86 -4 -6 84 3 Jan 3 Jan 3 Jan 3 Jan 3 Jan 3 Jan 3 Jan 3 Jan 31 Dec 28 Feb 30 Apr 30 Jun 31 Aug 31 Oct 31 Jan 05 06 07 08 09 10 11 12 10 11 11 11 11 11 12 Date Date

Source: Markit Source: Markit

below the average US institutional loan implications for secondary trading and In all, the European loan market remains price. While US loan prices have recovered primary market issuance in the European subdued as a result of the turmoil. Com- since the initial US-debt downgrade sell-off market. Indeed, the only institutional loan paratively, the US market has rallied over (to an average of 95 bid now from its nadir currently in the European deal pipeline is 2.6 per cent year-to-date, just off its YTD in late August at 90 bid), European loan the €610m tranche backing CVC’s takeo- high of 2.68 per cent total return. Many prices have barely improved from their own ver of Ahlsell. One can likely expect the issuers are taking advantage of the concurrent decline. price gap between US and European recently-heated high-yield bond market The leveraged loan market has not loans to persist until there is more certain to finance bond-for-loan takeouts and escaped the ramifications of the European visibility around a resolution of the current modify their capital structure maturities. sovereign debt crisis. The issues affecting situation. There may be a rally waiting The sovereign debt crisis continues to Europe continue to depress bids in the upon conclusion of the crisis, with the bid hamper European loan primary and sec- European loan market, and to a greater gap set to contract to historical norms ondary markets and this trend looks set extent than the US loan market. This has relative to US loan prices. to continue as long as the crisis does Structured Finance n January and February, the European ABS market enjoyed its strongest rally since April 2009 across all ratings, countries and sectors. This strong performance can be attributed to strong macroeconomic Idata as well as the sector’s correlation to other debt instruments.

Granite, the benchmark of the European euro investor buying sterling in April 2009 ABS market, has been also improved sig- without hedging the currency risk would nificantly since the end of last year. The A, by now enjoy a return of around 1,200 per B, M and C tranches are now traded at 95.7, cent. This would be a dream return for 84.3, 75 and 60 cents. It seems that 96 many distressed funds and could easily cents and 65 cents are strong resistance be achieved given the fact that Granite points for the A and C tranches respectively. Master Issuer issued around €6.5bn worth Our research shows that a Granite C of that type of C bond before 2008. Philippe Pagnotta tranche trade is one of the most profitable For many investors, the spread at which director, European structured finance European ABS trades that could have Granite bonds are currently traded is in [email protected] been executed since January 2009. A line with similar UK non-conforming secu-

the markit magazine – Spring 2012 Markit Commentary & Data /63

Granite Master Issuer C Tranche Return European AAA RMBS (3-5yr WAL)

Spread (bps) Spread (bps) 1,400 1,600 UK SPRMBS UK PRMBS Spanish RMBS Dutch RMBS 1,400 1,200 Italian RMBS Irish RMBS (Single A) 1,200 Portuguese RMBS (Single A) French RMBS 1,000 Australian RMBS 1,000 800

800 Markit Commentary & Data 600 600 400 400 200 200 0 0 20 Apr 20 Aug 20 Dec 20 Apr 20 Aug 20 Dec 20 Apr 20 Aug 20 Dec Jan May Sep Jan May Sep Jan May Sep Jan 09 09 09 10 10 10 11 11 11 09 09 09 10 10 10 11 11 11 12 Date Month/Year

Source: Markit Source: Markit rities, but they offer more liquidity and still AAA Total Return Jan 2009 provide a very interesting return. On the housing front, the Halifax House Spread (bps) Price Index indicated a 0.6 per cent 130 UK PRMBS AAA 125 Dutch RMBS AAA increase in UK house prices between Spanish RMBS AAA December and January compared with 120 Global European ABS AAA 115 Irish RMBS AAA a 0.2 per cent drop recorded by the 110 Nationwide index. On a year-on-year 105 basis, the Halifax index showed a 1.8 per 100 cent drop compared with a 0.6 per cent 95 increase for Nationwide. 90 Meanwhile, the Markit/CIPS UK Con- 85 struction PMI posted 51.4 in January, Jan Jul Jan Jul Jan Jul Jan 09 09 10 10 11 11 12 showing an increased rate in growth in Month/Year UK construction activity. The growth can mainly be attributed to strong commercial Source: Markit activity which came in at 53.2. On the other hand, we are seeing some contrac- House Prices tion in the housing activity index, which PMI Housing Index Halifax HPI (Annual % Chg) came in at 49.4. 80 35 The primary market remained active during this period with UK Primes, Dutch 70 25 RMBS and Auto Loans/Leases being priced. 60 15 The biggest surprise was the issuance of 50 5 new CMBS deals covering UK loans. Tesco 40 -5 raised £450m in the fifth sale and leaseback 30 -15 CMBS in Tesco Property Finance 5 Plc UK Construction PMI Housing Activity Index 20 -25 which involves 11 supermarkets. Halifax House Price Index, All Houses Deutsche Bank also issued DECO 2012- 10 -35 MHIL to refinance the £210m loan to 1998 2000 2002 2004 2006 2008 2010 Year Queensland Investment Corporation (QIC) which was removed from DECO 12 last Source: Markit, Halifax summer. The QIC loan is backed by a 50 per As for the rest of the credit market, the ABS market to keep tightening and become cent stake in Westfield Merry Hill which positive tone in the European ABS market increasingly liquid, offering more funding is valued at around £1bn. We are currently will remain only if a viable and long-term solutions for issuers and a new source of marking the £145m AAA tranche at solution is found for the Greek crisis. If that investment for those who exited this market around 97 per cent. happens, then we can expect the European a couple of years ago.

Spring 2012 – the markit magazine /64 Markit Commentary & Data Dividends ith the sovereign debt crisis and grim economic outlook, it is no surprise that the dividends of eurozone corporates are faltering. Markit expects 10 EURO STOXX 50 companies will Markit Commentary & Data decrease or suspend dividend payments during the current reporting season, compared with Wjust one decrease in the same period last year.

none has been able EURO STOXX 50 Dividend Contributions for 2012 to increase dividends in relation to the full year (FY) 11. Banco Santander 11% 15% and BBVA, the Spanish banks, 16% have shown par- 13% ticular resilience in Thomas Matheson spite of tough con- assistant vice president, dividends ditions. They have [email protected] managed to main- Banks tain their dividends 46% Oil & Gas The pressure on dividends is not solely a by offering scrip Others by-product of the downturn in company options in order to Telecommunications performance. More and more exogenous conserve cash, Utilities factors, and in particular political risk, are which has saved impacting corporate dividend policy. them billions. Source: Markit Uncertain on how macro events will Unsurprisingly, this develop, companies are now hoarding trend has now been followed elsewhere, and increased costs, stretching balance surplus cash in reserves and delaying with BNP being the latest to announce sheets and facilitating increased capital investments until the situation is clearer. such a scheme. French banks were hit investment into renewable energy. Markit This is unusual, as historically, companies particularly hard by the situation in Greece. expects E.ON to cuts its FY11 payment have shown themselves far more likely to Société Générale has suspended its by 40 per cent and RWE by 33 per cent. be borrowers than savers. dividend for this year in order to strengthen Government intervention is also proving Three sectors in particular have com- its capital position while BNP Paribas has costly for Enel, which estimates the impact manded the most attention: banks, utilities proposed a cut of 43 per cent to its annual of Italy’s Robin Hood tax at around and telecoms. When combined, Markit is payout. In Italy, Unicredit was also forced €400m. This has led Markit to forecast a forecasting them to contribute over 40 to suspend its payment, although Markit 7 per cent reduction in the FY11 total per cent of dividends on the EURO STOXX expects Intesa Sanpaolo to maintain it. dividend, and, looking ahead, the 50 in 2012. Deutsche Bank has already confirmed it company has confirmed that no interim Not only have European banks had to will keep its payment flat. payment will be made in respect to FY12. cope with significant haircuts on their The disaster at Japanese power plant The telecoms sector has had its image peripheral eurozone exposure, they have Fukushima Dai-Ichi and the ensuing back- as a dividend safe haven seriously dented also had to adapt to increasingly demand- lash against nuclear power has weighed by a series of high-profile policy U-turns. ing capital requirements as demanded by heavily on European utilities. E.ON and The first and most significant came from the European Banking Authority and Basel RWE, the German energy behemoths, Telefónica, which announced a reduction 2.5. France and Germany have also con- are the most high profile casualties, with in its future shareholder remuneration firmed their desire for a Financial Transac- their imminent dividend cuts set to topple targets. The rationale for the change is tion Tax, which would impact profits and them from top of the pile as the most that there has been a material change in could therefore put further downward significant dividend payers in the sector. the economic and operating environment pressure on dividends. Of the seven banks Germany’s pledge to phase out nuclear and financial market conditions, as well that are included in the EURO STOXX 50, power plants by 2012 has eroded profit as a need to build up financial flexibility

the markit magazine – Spring 2012 Markit Commentary & Data /65

for its strategy of sustained investments 30 per cent from FY10, half of the EURO EURO STOXX 50 Dividend Actions in the business (including spectrum acqui- STOXX 50 has still managed to announce, Action 2010 2011 sition) to capture growth opportunities in or are forecast to announce, its markets. However, it is interesting to increased payments. Initiated 1 0 note that management also indicated that The ever-important oil and gas sector, Increased 35 25 since the market was not giving it any the third largest sector by dividend con- Maintained 13 15 reward for its remuneration policy, it would tributions to the index, saw increases

Decreased 1 8 Markit Commentary & Data be better served using the cash to improve from both ENI and Repsol. Total kept its financial flexibility and accelerate the payment flat as it moved to its new quar- Suspended 0 2 process of achieving its medium-term terly payment schedule. Markit is fore- Total 50 50 target for net debt to ebitda. casting all three to raise their payments Source: Markit France Telecom has since followed in respect to FY12. suit and reneged on its dividend com- But it is no surprise that the major Euro- This sector has thus far been immune mitments for FY12, claiming that more pean dividend growth area for FY11 is from government cash calls on high cash reserves are needed to face the expected to come from a sector driven by profits. Sectors unpopular with the public region’s debt crisis. Markit expects a Germany – Automobiles. Daimler has been have provided more susceptible targets, similar announcement from Telecom Italia the first to report a dividend hike and with utilities and financial services sectors in due course, with the company already Markit forecasts it to be followed by strong bearing the brunt of the Robin Hood tax conceding that its current targets were growth from BMW and Volkswagen. Sales and Financial Transaction Tax. However, established in a different economic continue to be boosted by the high level while European sovereigns continue to context. This leaves only Deutsche of demand for German exports in emerg- look for ways to shore up their balance Telekom sticking to its guidance. ing markets. Daimler reported FY11 net sheets, political risk remains an important However, not all is doom and gloom. income jumped by over half to €1.79bn, concern, and it will be interesting to see Although the number of companies and consequently grew its annual dividend whether other sectors come under increasing dividends in FY11 has dropped almost 20 per cent. increased scrutiny. Markit Boat uropean OTC volumes remained strong over the holiday period and into the new year. Volumes reported to Markit BOAT, the trade reporting platform, between December 2011 and February 2012 were 17 per cent higher than during the same period last year. The oil and gas, basic materials Eand telecommunications sectors in particular saw volumes rise by 59 per cent, 32 per cent and 15 per cent respectively between December and January.

OTC reporting in Europe, taking a 70 per On January 12, British retail giant Tesco cent average market share for all Mifid shocked the market with its first profit OTC turnover in 2011 and strong regional warning in 20 years, following poor trading market shares in the UK (94 per cent), results over the Christmas period. The Switzerland (93 per cent) and Luxembourg news saw trading on Tesco’s shares jump (87 per cent). to over 200m, well above the daily average Between November and February, of 6m. The news also impacted trading firms in the oil and gas sector saw trading on the shares of WM Morrison and J volumes increase by 39 per cent from Sainsbury, which saw trading volumes 10 Thomas Axup 4.54bn to 6.33bn compared with the same and five times above their normal levels associate, Markit Boat period last year. Volumes traded on Petro- on that day compared with average [email protected] plus, the Swiss refiner that went into daily volumes. insolvency on January 24, were up 200 Shares in Carnival, owner of the Costa The Thomson Reuters Monthly Market per cent between the September to Concordia cruise liner which ran aground Share reports show that Markit Boat con- November and December to February early in the morning of January 15, saw tinues to be the preferred platform for time periods. large volumes of their shares traded in

Spring 2012 – the markit magazine /66 Markit Commentary & Data

Mifid Turnover % Share Retail Daily Trading Volumes

Market Share % Volume (Millions) 100 250 Tesco WM Morrison J Sainsbury 90

80 200 70 Markit Commentary & Data 60 150 50 40 100 30 All European Equities Swiss Equities 20 Luxembourg Equities UK Equities 50 10 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 0 11 11 11 11 11 11 11 11 11 11 11 11 12 Jan 12 Feb 12 Month/Year Month/Year

Source: Markit Source: Markit

the week following the disaster. That AstraZeneca, Anglo-Swedish pharma- stock in January and February increase week, 12.8m shares were traded repre- ceuticals group which has pledged to buy by 42 per cent on the same period last senting a weekly increase of 940 per cent. back €3.4bn of its shares this year, saw year. This increase was mirrored some- January volumes were 300 per cent trading on its stock increase by 65 per what by luxury firms Compagnie Finan- greater than in January 2011. cent in February compared to January. ciere Richemont and Burberry which saw Trading volumes on Xstrata’s shares, The healthcare sector as a whole saw a trading increase on their stocks by 9 per which entered into merger talks with Glen- fall in volumes with 1.77bn reported in cent and 8 per cent respectively. core on February 2, soared by 49 per cent December to February this year in com- Finally, trading volumes on telecom- between December and February against parison to 2.06bn in the same period munications firm Cable and Wireless the same period last year. With an esti- last year. Worldwide (CWW) soared on the news mated value of €65bn, the combined In the consumer goods sector, buoyed that Vodafone was considering bidding company would rank as the fourth largest by strong demand from China, luxurious for the beleaguered group. The announce- mining company in the world by market good companies continue to post strong ment on February 13 saw trading on capitalisation after BHP Billiton, Rio Tinto results. French multinational LVMH Moet CWW’s shares increase to 21m, 8.5 times and Vale. Hennessy saw trading volumes on its the average daily volume of 2.24m.

AstraZeneca Daily Trading Volumes Telecommunications Daily Trading Volumes

Volume (Millions) CWW Volume (Millions) Vodafone Volume (Millions) 5 25 180 Jan 12 CWW 4.5 160 Feb 12 Vodafone 4 20 140

3.5 120 15 3 100

2.5 80 10 2 60 1.5 5 40 1 20 0.5 0 0 0 Jan 12 Feb 12 Start of Month End of Month Month/Year

Source: Markit Source: Markit

the markit magazine – Spring 2012