markit magazine: autumn 2014

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magazine Issue 25 | Autumn 2014 | www.markit.com Bubble Trouble Dr. Jacob Frenkel’s warning Health dividends Life after Goldman Sachs Prudential valuation The Bank of England explains France The great austerity debate

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Page 1: Markit magazine: Autumn 2014

magazine

magazineIssue 25 | Autumn 2014 | www.markit.com

Bubble TroubleDr. Jacob Frenkel’s warning

Health dividends

Life after Goldman Sachs

Prudential valuation

The Bank of England explains

France

The great austerity debate

Page 2: Markit magazine: Autumn 2014

WELCOME

Autumn 2014

Total average net circulation 10,153.July 1 2013 - June 30 2014.

The European economy continues to face headwinds, and Markit’s Composite Purchasing Managers’ Index (PMI) fell to an eight-month low of 52.5 in August. France was a

particular concern, with the manufacturing PMI declining to 46.9, well below the 50 reading that separates expansion from contraction.

In the Autumn 2014 issue of Markit magazine we take a closer look at the challenges facing France and the wider European economy, and the growing debate between those supporting German calls for austerity and those in favour of a slower pace of deficit reduction and budget cuts. As the European Central Bank considers quantitative easing, it appears much work is required to cure Europe’s economic malaise.

Among the world’s most brilliant economists and monetary theorists is Professor Jacob Frenkel, who among his many roles is chairman of JPMorgan Chase International and leader of the Group of Thirty. As central bankers mull their options, Professor Frenkel talks to us about the power, and limitations, of monetary policy.

One area in which Europe is making progress is in understanding the risks faced by banks, and the UK and European authorities have taken a lead in codifying new

rules for valuation of assets held on balance sheets. The author of those rules is the Bank of England’s Ragveer Brar, and in an exclusive interview he gives his insight into how the changes will increase transparency.

Another area of concern for banks is digital security, and many are turning to military technologies to fend off the unwelcome attentions of hackers. However, it’s tough to get the balance right between easy access to services and guaranteed security. Bruce Tolley of Solarf lare Communications, a leading authority on data security, shares his experiences.

September is a landmark month for the credit derivatives market, with the first new set of Isda definitions in more than a decade due to come into force. We look forward to working with market participants in adapting to these.

Also in this issue we review what may be the most important account of the financial crisis: Stress Test by Tim Geithner.

Finally, as the northern hemisphere summer draws to a close we take a look in our Markit Life section at a former banker for whom the sun never sets. Kathryn Brierley walked away from financial markets to set up a healthy holiday company, and offers us a view of how her life has changed.

Europe’s travails

Lance UgglaChief executive officer, Markit

Editorial board Robert Barnes, TurquoiseBronwyn Curtis OBE Tim Frost, Cairn Capital Sal Naro, Coherence Capital PartnersLarry Tabb, Tabb GroupDaniel Trinder, Deutsche Bank

Markit editorial teamAlex BrogEd CanadayEd ChidseyEric MaldonadoWill MeldrumFleur SohtzRoger SpoonerJoanna VickersSally Yates

Industry contributorsBruce Tolley, Solarflare CommmunicationsPJ Di Giammarino, JWG GroupGavan Nolan, Markit

WritersNicholas DunbarDavid RothnieEdward Russell-WallingSolomon Teague

PublisherTeresa Chick

EditorDavid Wigan

Chief sub editorJennifer Laidlaw

DesignLemonbox

PhotographyJulian CivieroAmy FletcherJames McMillianShutterstock

[email protected], estimates and projections in this magazine constitute the current judgement of the author at the time of writing. They do not necessarily reflect the opinions of Markit.

Although effort has been made to ensure the accuracy of the information contained in this publication at the time of writing (September 2014), Markit does not have an obligation to update or amend information or to otherwise notify a reader thereof in the event that any matter stated herein changes or subsequently becomes inaccurate.

Markit shall not have any liability whatsoever to you, whether in contract (including under an indemnity), in tort (including negligence), under a warranty, under statute or otherwise, in respect of any loss or damage suffered by you as a result of or in connection with any opinions, recommendations, forecasts, judgments, or any other conclusions, information or materials contained herein.Markit is a registered trade mark of Markit Group Limited. Copyright © Markit Magazine. All rights reserved. Reproduction in any form is prohibited without the written permission of Markit.

Printed in England by Wyndeham Grange, Butts Road, Southwick, West Sussex BN42 4EJ. www.wyndeham.co.ukThe Markit Magazine ISSN: 1757-210X is published quarterly (March, June, September & December) by Markit and distributed in the USA by Mail Right International Inc, 1637 Stelton Road B4, Piscataway NJ 08854.Periodical postage paid at Piscataway NJ and additional mailing offices. POSTMASTER send address changes to The Markit Magazine, Markit c/o 1637 Stelton Road B4, Piscataway NJ 08854. To subscribe to the Markit Magazine, please log on to www.markit.com/Company/Markit-magazine

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Page 3: Markit magazine: Autumn 2014

CONTENTS

5 Autumn 2014

REGULARS

6 News All the latest from Markit and our partners

12 Country focus French lessons for Europe

44 Book review Timothy Geithner’s Stress Test,

reviewed by Nicholas Dunbar

FEATURES

14 Prudence defined The Bank of England’s Ragveer Brar talks

to Markit about the new rules

18 Strategic defences Using military tactics in network security

23 The changing face of CDS The new Isda definitions laid bare

28 Risk off The high cost of risk data aggregation

33 Liquidity vacuum Platform angst in the bond markets

39 Markit life Kathryn Brierley explains how leaving banking to

set up a healthy holiday company changed her life

COMMENTARY

46 Market insight Our analytics teams discuss prospects for the

coming quarter

58 Markit infograph What the numbers say about monetary policy

COVER STORY

The great monetary debate G-30 head Professor Jacob Frenkel offers a view from the summit of monetary policy

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Issue 25 | Autumn 2014

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39ON THE APP

VIDEO EXTRASThe Markit Magazine app has new video content, providing analysis of the asset classes we cover in our Insight section as well as indepth interviews. Look out for the app icon. Download the app via the App Store.

Page 4: Markit magazine: Autumn 2014

MARKIT NEWS

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MARKIT HAS PARTNERED with Alquity Investment Management, the socially responsible fund manager that returns a portion of its profits to the markets in which it invests.

Alquity will adopt thinkFolio, Markit’s software suite that offers portfolio modelling and trade management capabilities across asset classes.

Alquity, launched in 2010, runs an innovative investment model

focused on emerging and frontier markets, employing forward-looking Environmental, Social and Governance (ESG) screening to make investment decisions.

The firm donates up to 25% of its net management fees to fund microfinance in the countries in which it invests. The aim is to provide financial resources to entrepreneurs, helping create jobs and support economic growth, ultimately

returning money to investors.Markit’s thinkFolio offers

modelling, trade order management, compliance and cash management, across asset classes.

Alquity is run by ceo Paul Robinson, who has 20 years’ experience in financial services and fund management, alongside cofounder Paul Freer, who previously worked at Barclays, Lloyds TSB and the National

Commercial Bank of Saudi Arabia.“In Markit’s thinkFolio,

Alquity has found a partner that clearly shares our values,” says Robinson. “Early on the thinkFolio team engaged with Alquity’s ’transforming lives’ model and pulled out all the stops to win the deal to enhance our trading systems. Many lives will be improved through the work we do together, investing in a new and better way.”

Commission payment managementTHE RECENTLY completed first phase of the integration of Commission Manager and Vote offers customers an easier commission payment allocation process.

Customers can now retrieve broker vote results in Markit’s Commission Manager to make payments for value-added services with CCA/CSA credits.

Tom Conigliaro, global head of investment services at Markit, which include Markit’s Commission Manager, Vote, Calendar and TCA solutions, said, “The integration of Commission Manager and Vote is reflective of our core product development goals aimed at

enabling the buyside and sellside to collaborate more effectively around the provision of services and the value derived”.

Designed in partnership with leading global banks, Commission Manager allows customers to manage multiple client CCA/CSA credits and eligible payments with numerous counterparties on a single platform.

The integration will allow asset managers to use the results from Vote to identify the best way to allocate payments to their brokers.

Further integration of Vote and Commission Manager will be available in future releases.

Autumn 2014

Alquity teams up with Markit’s thinkFolio

Paul Robinson, ceo Alquity

Page 5: Markit magazine: Autumn 2014

MARKIT NEWS

MARKIT HAS PUBLISHED new index trading documentation ahead of the implementation of redrafted Isda definitions, set to come into force on September 22nd 2014. Details can be found on the Markit website.

All new series of Markit iTraxx and CDX indices launched after September 22nd will trade on the 2014 definitions as the standard contract. Legacy indices launched prior to September 22nd will follow the convention of the underlying single names constituents, as there are some CDS reference entities that are being excluded from the Isda protocol, the multilateral contractual amendment mechanism used to address changes to Isda

standard contracts since 1998. Legacy indices where all

constituents are excluded from the protocol will remain

on the Isda 2003 definitions, while legacy indices where all constituents are protocolled will move to the definitions.

Certain legacy indices will become “mixed baskets”, where some constituents remain on the 2003 definitions and other constituents move to the 2014 definitions. In all instances, the result would be only one standard contract for each index, reflecting a trade position where both counterparties have signed the protocol.

The Isda Credit Derivatives Definitions are an updated and revised version of the 2003 Isda Credit Derivatives Definitions, a document that contains the basic terms used in the documentation of most credit derivatives transactions.

BRIEFS

Kolby appointed head of investor relationsMatthew Kolby has joined Markit as head of investor relations, reporting to chief financial officer Jeff Gooch.

Matt has more than 17 years of corporate and advisory investor relations experience. He joins Markit from Deutsche Bank where he was director of investor relations, responsible for investor communications in North America.

We are pleased to have Matt join us in this essential role as Markit begins a new chapter as a public company,” said Gooch. “Matt’s depth of corporate and advisory investor relations experience will be immensely valuable to our stakeholders.”

Iosco compliance confirmedMarkit will administer its benchmarks in compliance with the International Organization of Securities Commissions (Iosco) final report on Principles for Financial Benchmarks.

The principles create a framework for benchmarks used in financial markets, and are intended to promote the reliability of benchmark determinations and address benchmark governance, quality and accountability mechanisms.

Markit will administer its benchmarks in compliance with the principles by the end of 2014, focusing on transparency, controls, governance and conflict of interest management.

“Markit fully supports the Iosco principles and evolving regulations regarding benchmark administration, which are consistent with the objectivity, transparency and governance by which Markit has always sought to administer its indices,” said Armins Rusis, managing director and cohead of Information at Markit. “Our new compliance framework will help our customers and contributors to efficiently and comprehensively adhere to the Iosco requirements. After extensive consultation with customers, we intend to apply the same approach to our custom index business which provides customers with indices of their own design.”

Isda 2014 definitions to come into force

JEFFERIES, a leading global investment bank, will join Collaboration Services, Markit’s open messaging network.

“With Markit’s network we are giving our team another tool with which to communicate and do business with clients,” says Marty DeMonte, managing director and chief information officer at Jefferies. “The innovation here is that we are not adding software

to our platforms, but rather extending the capabilities of our existing messaging systems.”

Markit Collaboration Services creates interoperability among messaging systems and provides the first vetted, central directory for the financial markets. The open messaging network launched by Markit last October now boasts more than 200,000 users.

7 Autumn 2014

Jefferies joins Collaboration Services

Scott O’Malia, ceo ISDA

Markit and TelecityGroup partner in AmsterdamMARKIT HAS started operations at a new colocation data centre in Amsterdam, built by TelecityGroup, Europe’s leading provider of carrier-neutral data centres.

Markit’s services refine and distribute billions of gigabytes of market, reference and pricing data every day.

Certified to ISO 27001 standard for information security management,

TelecityGroup’s Amsterdam data centre will guarantee the highest levels of security for Markit’s products and services.

“We work in an industry where every second counts, and the security of the data that our customers rely on us for is of paramount importance,” said Roy Flint, managing director and head of group technology services at Markit.

Amsterdam, Holland

Page 6: Markit magazine: Autumn 2014

TALKING BUSINESS

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As a former central banker and head of the Group of 30, Dr. Jacob Frenkel, chairman of JPMorgan Chase International, knows better than most the dangers of exceptionally low interest rates. Tracy Alloway reports.

Doctor Jacob Frenkel is smiling with Alan Greenspan, former chairman of the Federal Reserve. A glance right, and he is sidling up to Jack Ma, chief executive of Alibaba, the Chinese e-commerce giant; look left,

and he’s teaching a former prime minister of Israel how to use chopsticks at a stately dinner. Blink, and he is standing next to George Lucas and Steven Spielberg, two of the world’s most famous film directors.

In his office in New York, row upon row of photos show a cheerful Dr Frenkel mingling with a veritable ‘who’s who’ of the global finance and business elite.

Dr Frenkel may not be as well known as some of his compatriots in the

photos which adorn his office, but for decades he has been a major figure in the world economy, first as two-term governor of Israel’s central bank and then as head of the Group of Thirty (G30), a powerful cadre of economic policymakers and regulators.

Now ensconced as chairman of JPMorgan Chase International, a role that involves representing the banking giant to regulators and clients, he remains perfectly placed to discuss a defining trend of today’s

financial world: the enormous influence of monetary policy on markets.

Here, as Dr Frenkel puts it, “central banks have become the only game in town” by virtue of the trillions of dollars worth of unconventional monetary policies they have collectively unleashed over the past several years.

Unconventional policiesSo when Dr Frenkel smiles again and asks if I want to wager how long central bankers initially thought those unconventional monetary policies would last, I am reluctant to take the bait. Name a central banker, and Dr Frenkel surely knows them, their policies and their innermost thoughts about those policies.

“I’m willing to bet with you that if in 2008 each one of the central bank governors were to put in an envelope his guess on how long they would use unconventional policies, no one would have believed that it would last for over six years,” he says. “What was supposed to be very temporary has become, after several years, much more permanent.”

As a long-time central banker, one might expect Dr Frenkel to take an exceedingly enthusiastic view of the power of monetary policy. Certainly, he has been criticised for his optimism in the run up to the financial crisis and ensuing recession. He famously went head to head with Nouriel Roubini, the economist who is now

Let’s not kid ourselves. Interest rates are the most efficient instrument of monetary policy, period.

Bursting bubbles

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Page 7: Markit magazine: Autumn 2014

TALKING BUSINESS

credited with predicting the bursting of the US housing bubble and the scale of its impact.

But the Dr Frenkel I find on a sunny afternoon in August is not the rose tinted glasses-wearing policymaker I expected him to be. Instead he is more than keen to emphasise the limits of monetary policy’s restorative power when it comes to curing the ills of the global economy.

Zero ratesSince the crisis plunged much of the developed world into deep recession, the policy response from central banks has been to drop interest rates to practically zero and then balloon their balance sheets in an attempt to prevent a deflationary spiral.

“Interest rates all over the world have been reduced to very low levels and they have now reached levels that are very close to the ‘zero bound’. As a result, the potent policy measure of a further reduction of

interest rates ceased to be feasible,” says Dr Frenkel. “Policy makers ran out of conventional ammunition.”

While Dr Frenkel says he does not doubt the necessity of these extreme actions in the aftermath of what has proven to be a massive shock to the financial system and global economy, he is surprisingly wary of the legacy these emergency policies may leave.

“Monetary policy has performed extraordinarily important tasks, but we have arrived now at a situation where we must also understand that there are a lot of challenges in front of us,” he says.

Low rates and asset purchase programmes, known as ‘quantitative easing’ or ‘QE’, are supposed to force investors away from hoarding cash and kick start the wider economy, but now there are concerns that years of easy money have pushed markets into frothy territory. Indeed, Greenspan’s era of low interest rates has often been blamed for exacerbating risky investor behaviour in the run up to the crisis.

1991 Jacob Frenkel served as governor of the Bank of Israel from 1991-2000.

Autumn 2014 9

Page 8: Markit magazine: Autumn 2014

TALKING BUSINESS

Markets track bankers In more recent years the trend has been for markets to move sleepily in one direction for months until a comment about the potential winding down of the Fed’s QE or a theoretical interest rate rise suddenly shocks them out of their central bank-induced torpor.

Investors of all stripes now hang on the words of Janet Yellen, chair of the Federal Reserve, or Mario Draghi, head of the European Central Bank (ECB), for clues as to how long these unconventional policies will last.

It is not, in the words of Dr Frenkel, “a healthy situation”.

Last year’s ‘taper tantrum’ is a case in point. In June 2013 investors rushed to exit risky positions in bonds and stocks following comments from US central bank officials that they would begin to reduce their bond purchases. The episode worried many market watchers since it was viewed as a potential prelude to the turmoil that many predict will accompany the eventual removal of central bank stimulus.

“I think that there is a consensus that the early communication regarding the planned tapering was imperfect,” Dr Frenkel says of the episode. “Communication of central bank policy is one of the most important mechanisms by which monetary policy is impacting the markets. It’s the signal. And the signal must be very clear.”

In addition to these signalling sensitivities there is also the danger of an element of ‘mission creep’ that comes about as central banks find themselves having

to jump start more and more of the mechanisms that underpin the financial system.

Pottery shop syndromeFor this hazard, Frenkel has a catchy analogy: “I would call this phenomenon the ‘pottery shop syndrome’, because in pottery shops there is typically a sign that reads ‘Don’t touch. If you break it you own it’.”

With central banks taking on increasing amounts of responsibility in the financial system there is, in other words, the potential for potential for breaking a vase or two.

The growing clout of monetary policy “may be flattering to central banks but it is also a danger,” Dr Frenkel says. “The danger is that monetary policy may become overburdened; namely, monetary policy makers may end up taking responsibility for areas that go beyond the comparative advantage of central banking.”

That’s already apparent, he says, in places like the eurozone, where Draghi suddenly seems responsible for not only achieving price stability in the region, but also healing deep economic rifts within the political union. For months, investors have speculated about the potential for additional unconventional policies from the ECB as the eurozone’s economic recovery looks increasingly frail.

“The issue is not more loans from the ECB. The issue is structural measures,” says Dr Frenkel. “The role of the ECB in principle is to provide some oxygen for the transition in which governments do their part.

The G30 is extremely informal. While I wouldn’t say that we come with our jeans, there is a jeans-like frankness.

Page 9: Markit magazine: Autumn 2014

TALKING BUSINESS

11 Autumn 2014

But if the governments do not end up doing their part then you have given oxygen for somebody who did not use it well.”

Israeli experience Dr Frenkel’s views may be coloured by his own experiences as a central banker, having served as governor of the Bank of Israel from 1991 to 2000.

Arriving there from his position as economic counsellor and director of research at the International Monetary Fund, he took charge during a time of significant challenges for Israel: the collapse of the Soviet Union had led to an influx of immigrants and inflation was rising rapidly.

Dr Frenkel’s response was to embark on a series of reforms, including removing foreign exchange controls and encouraging rapid economic growth to stabilise fast-rising prices, and he is now largely credited with sparking a revival of the Israeli economy.

“It was not easy, let me tell you, because you know there are a lot of political biases towards greater expansion and larger deficits,” he says of his success at the time.

“The reason why central banks need to be independent is not because they have their own agenda (in fact that agenda has to be set by the government elected by the people), but because the use of the policy instrument must be entirely at the discretion of the central bank because that’s the only way to protect the system from itself.”

This may go some way to explaining why Dr Frenkel is now one of a three-person steering committee at the G30 charged with examining why “central bank independence is under increasing pressure” as part of the group’s latest working project.

His current colleagues at the G30 run the gamut of ex-central bank leaders, including Axel Weber, former head of Germany’s Bundesbank and Arminio Fraga, former president of the central bank of Brazil, as well as notable figures such as former US Treasury Secretary Tim Geithner and the economist Paul Krugman.

Dr Frenkel describes the group, where he now serves as chairman of the board of trustees, as the “cream of financial regulators, practitioners and policy makers plus several academics.”

Frank exchangesWhen I ask what the meetings are like; whether there is a scrum to talk inflation targeting or perhaps heated arguments over the efficacy of QE, Dr Frenkel describes an “extremely friendly and collegial atmosphere.”

“Normally when you have policymakers meet at the G7 or G8 or whatever, they come from the political echelons, so they come with their three-piece suit and script and all the rest. Here it is extremely informal. While I wouldn’t say that we come with our jeans, there is a jeans-like frankness.”

I imagine one thing stimulating much candid discussion among the group is the potential for ‘macroprudential’ policy tools, the latest buzzword in the seemingly ever-expanding toolkit for central bankers.

These tools are meant to allow central bankers to protect financial stability with targeted action that can rein in the kind of excessive behaviour that precipitated the financial crisis while allowing them to avoid a premature interest rate rise.

In July, Yellen praised macroprudential policies as a first line of defence for central bankers seeking to maintain financial stability in the face of potentially overheating markets. In Europe, Draghi has played down the danger of bubbles citing “explicit institutional attention to macroprudential tools.” Bank of England Governor Mark Carney has already deployed the tools in an attempt to deflate the housing market.

Asset price bubbles But Dr Frenkel is less than positive about the ability of macroprudential policies to pop latent asset price bubbles brought on by low rates. Arguably a monetary policy purist, he sees macroprudential tools as having little power to offset the comprehensive impact of interest rates.

“Let’s not kid ourselves,” he says bluntly. “Interest rates are the most efficient instrument of monetary policy, period. If the use of the interest rate instrument is limited due to the zero bound constraint, can you still operate with macroprudential policies? The answer is probably ‘yes’ but it will be less efficient. In order to be effective you will need to use macroprudential measures in a draconian way.”

That leaves markets facing two unsavoury possibilities; a brutal clampdown on their frothiest and most lucrative activities or asset prices that look increasingly out of sync with vulnerable economies.

“Asset market bubbles are more likely to occur under circumstances in which interest rates are kept at an excessively low level for an extended period of time,” Frenkel says diplomatically, the eyes of Greenspan peering out from a photo behind him. “In view of the current low levels of interest rates, such dangers should not be ignored.”

2015 The Federal Reserve is expected to start raising interest rates next year.

ON THE APP

Page 10: Markit magazine: Autumn 2014

COUNTRY FOCUS

12 Autumn 2014

France is the world’s sixth largest economy, the most visited country for tourism and the epitome – through its food, arts

and culture – of the European way of life. France, it appears, has it all. However, amid stagnant economic growth, it is also grappling with some of the most testing economic policy questions of the time, and for the moment is struggling to come up with the answers.

After two flat years, French growth came in at zero percent in the second quarter, as stronger domestic demand was offset by

weaker foreign trade. Markit PMI data for the manufacturing sector in August came in much weaker than analysts had expected, falling 1.3 points to 46.5 and remaining well below 50, the number that distinguishes expansion from contraction. Investors view of French risk reflects economic concerns and France five-year CDS were trading at 42bps in late August, compared with 20bps for the UK and for Germany, according to Markit data. Inflation is also dangerously low, with the CPI dropping 0.3% in July from June, leading to concerns over deflation.

Political toils The gloomy economic outlook has led to political fallout, and at the end of August French President François Hollande ordered his prime minister to form a new government excluding socialists who had demanded an end to austerity policies supported by Germany.

The move followed a political crisis sparked by the resignation of economy minister Arnaud Montebourg, who had attacked Hollande’s economic policies and Germany’s “Kafkaesque” oversight and “obsession with austerity”.

The row in France exemplifies a wider debate in Europe about whether fiscal austerity aimed at bringing debt under control is the

right policy at a time of economic stagnation. On one side is Germany, which advocates rapid deficit cutting to a target level of 3% of GDP, and on the other are the weaker European economies, of which France is the most important.

German meddling? In the eyes of some French politicians on the left, not only is Germany’s insistence on budget cuts incomprehensible, it is also irksome, because German austerity is by some arguments the cause of slow growth elsewhere in Europe. The German economy ran a current account surplus of €206bn in 2013, equating to 7.5% of gross domestic product, suggesting that Germans are keener to hoard their hard-earned wealth than spend it, a problem recognised by the US government.

“Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand,” says a US Department of the Treasury report published last October. “Germany’s anaemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment.”

The debate in France over the merits of economic austerity and reform reflect concerns felt across Europe. David Wigan reports.

French lessons

6th France is the world’s sixth largest economy.

12 Autumn 2014

Page 11: Markit magazine: Autumn 2014

COUNTRY FOCUS

13 Autumn 2014

Still, not all of France’s problems can be placed at Germany’s door. A key plank of Hollande’s strategy of cutting the budget deficit has been high tax increases, and the overall tax take has risen from 44% of GDP in 2011 to 47% in 2014, with companies hit hard. In one example, a temporary surcharge of 5% of corporate tax paid by companies with annual turnover of more than €250m implemented in 2011 was increased in 2014 to 10.7%.

High payroll taxes French business, meanwhile, is burdened by the developed world’s heaviest payroll tax of 43%. As a result, companies are loath to take on too many employees. In addition, the high cost of firing workers also make French firms less keen on hiring. Businesses in the UK pay a payroll tax of around 11%, and those in the US pay as little as 5%.

France is currently implementing the steepest spending cuts for four decades, comprising a €50bn reduction over three years, which if successful will reduce the annual rise in public spending from 1.3% in 2013 to 0.1% in 2015. However, officials said in August the country would miss its end-of-year deficit target of 4% of GDP (after posting 4.3% in 2013), and made it clear that growth would not be sacrificed at the altar of excessive

cost cutting. And while some of France’s

problems are economic, others are structural. French socialism has its origins in the revolution of 1789, and grew out of the Paris Commune and the subsequent birth in 1880 of the French Workers Party. Nowadays “les partenaires sociaux”, or unions, have just 10% of workers as members (far less than in the UK or the US) but wield considerable power. Any potential policy change can mean strikes and workers taking to the streets in their thousands. Meanwhile, regulated professionals such as taxi drivers, notaries and pharmacists were accused by financial watchdog Inspection Générale de Finances (IGF) in a July report of running closed shops and charging disproportionate fees.

Active stateThe French state maintains an active role in the economy, holding stakes in major companies such as carmaker PSA Peugeot Citroën, in which it bought a 14% stake in March, and telecoms provider Orange.

Concern over France’s entrenched ways of working has led to a bout of soul searching, and in April 2013 the French news magazine Le Point ran an article headlined ‘Are the French lazy?’ The answer was a resounding ‘yes’,

with the French working shorter hours, retiring earlier and taking more holidays than people in other European countries, the magazine said.

Of course many in France argue that it has the balance right, and that the freedom obtained by the country’s workers are what sets it apart from the ‘survival-of-the-fittest’ Anglo Saxon economies, which it should not be forgotten were the source of the global financial crisis. No French bank collapsed in 2008. Further, France has world class companies in the automotive, aerospace and railways sectors, as well as cosmetics, luxury goods, insurance,

pharmaceuticals, telecoms, power, defence, agriculture and hospitality. Also, the French have higher life expectancy than both the British and Americans.

All of which gives an indication of why the current economic debate in France, and across Europe, is about more than just the economy.

Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand.

€50bn France is implementing steep spending cuts, comprising a €50bn reduction over three years.

Page 12: Markit magazine: Autumn 2014

14 Autumn 2014

One lesson of the financial crisis is that the value of financial instruments is not necessarily what the owner states it to be, even when it comes to relatively liquid markets such as government bonds. In

fact, in many cases mismatches between assumed and real value were extremely wide, and for some banks poor valuation was a key element in their demise.

One of the first regulators to recognise the damage caused by aggressive valuations was the UK Financial Services Authority (FSA). In 2008 it wrote a letter to firms outlining its concerns, which it followed up with visits to 10 banks to assess product control functions. In its 2011 report into the failure of RBS, the FSA uses the word ‘valuation’ 114 times, for example saying that the rival banks collateralised debt obligation valuations were ‘significantly lower’ than those by RBS.

In 2012 the UK Financial Policy Committee

recommended that regulatory action be taken “to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights.”

Discussion paperIn the same month the European Banking Authority (EBA) published a discussion paper on prudent valuation, which led to a consultation and quantitative impact study last year, and the publication of final draft regulatory technical standards in March of this year, under article 105 of the Capital Requirements Regulation. Approval by the European Parliament is expected in the coming weeks, with implementation soon after.

“Historically the concept of prudence was central to accounting, but what we found as regulators was that both firms and auditors were often taking different stances on the interpretation of accounting standards that resulted in material valuation differences,” says Ragveer Brar, who leads the Bank of England’s valuation and controls team. “For example, we saw significant variances in approach (e.g. numbers of yield curve risk buckets used to represent the full curve) for the calculation of the bid-offer reserves, and

New rules will set out exactly how banks must adjust valuations of their fair valued financial instruments, writes David Wigan.

Prudence defined

2012 In 2012 the UK Financial Policy Committee recommended regulatory action on banks’ valuations of their assets.

Page 13: Markit magazine: Autumn 2014

PRUDENT VALUATION

15 Autumn 2014

anomalies like collateral disputes running into hundreds of millions of dollars with signed off accounts on both positions.”

The concept of prudent valuation relates to fair value positions, defined by international accounting standards, (such as IFRS 13) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This is sometimes referred to as the ‘exit price’. Of course, in the case of many illiquid securities the exit price is not easy to guess, and in those circumstances the concept of prudent valuation can be brought to bear.

Prudent valuation is also, in effect, the migration of regulatory oversight into accounting and is justified in that it aims to ensure that banks carry enough capital to offset the risk of the fair value positions, with a realistic level of accuracy.

“If a bank has a position valued at 50 and the market is liquid such that the range of plausible valuations is known to be somewhere between 49.9 and 50.1 or if the position is complex and the market is illiquid such that the range of plausible valuations may be somewhere between 20 and 80, then the accounting representation of value is often largely the same,” says Brar. “However from a risk and capital adequacy perspective it makes an enormous difference. Whereas accounting standards are looking at best estimates, the regulatory perspective is much more interested in downside risk.”

European regulationAlthough UK authorities have been somewhat ahead of their continental European counterparts on requiring banks to consider prudent valuations, the new European regulations are set to be meat on the bones of the UK approach, which was subject to complaints by UK banks over what they saw as an uneven playing field, in some cases leading to lively arguments with the regulator over the meaning of the word ‘prudent’.

The areas that were the biggest contributors to valuation uncertainty were market prices, close-out costs, model risk and concentrated positions, and firms' current prudent valuation adjustments are between 0.03% and 0.3% of the fair value balance sheet, according to the Bank of England.

However, in completing their returns, some poor practices were observed among UK banks, with for example bid/offer spreads or historic Invoice Price Variances used as a proxy for valuation uncertainty, and only IFRS level 3 positions (unobservable inputs)

looked at in detail, rather than a broader range of positions. There was also over-reliance on consensus data, without recourse to alternative pricing sources such as traded prices, broker quotes and collateral information.

The European rules aim to put an end to those doubts, setting out in detail how ‘prudent’ must be defined and laying out specific rules on the approaches banks must take to measure the value of their fair valued financial instruments.

In simple terms the prudent valuation adjustment is the amount by which available capital would need to be adjusted if the downside valuations were used instead of the fair values from a firm’s financial statements.

How firms reach those additional valuation adjustments (AVAs), however, depends on the size of institutions, with firms whose fair value assets and liabilities are below the €15bn threshold are permitted to use a simplified approach, under which the calculation of the required AVA is based on a percentage of the aggregate absolute value of fair valued positions held by the institution which amounts to 0.1%.

Larger firms meanwhile must determine AVAs under a core approach, with the following key features:l Each AVA shall be calculated as the excess of

valuation adjustments required to achieve the identified prudent value over any adjustments applied in the institution’s fair value adjustment that can be identified as addressing the same source of valuation uncertainty as the AVA.

l Where possible, the prudent value of a position is linked to a range of plausible values and a specified target level of certainty of 90%. In practical terms, this means that for market price uncertainty, close-out costs and unearned credit spreads, institutions are required to calculate the prudent value using market data and the 90% certainty level.

l In all other cases, an expert-based approach is specified, together with the key factors required to be included in that approach. In these cases the

The prudent valuation requirements pose considerable challenges to credit institutions.

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90% target level of certainty is set for the calibration of the AVAs.

Valuation uncertaintyThe EBA notes that for the majority of positions where there is valuation uncertainty, it is not possible to statistically achieve a specified level of certainty, but it says that specifying a target level is the most appropriate way to achieve greater consistency in the interpretation of a ‘prudent’ value.

Article 34 of the Capital Requirements Regulation requires institutions to deduct from Common Equity Tier 1 capital the aggregate AVA made for fair value assets and liabilities following the application of Article 105. A Quantitative Impact Study made in June 2013 by the EBA showed that on average the expected AVA would be equivalent to 1.5% of the Core Equity Tier 1 of institutions in absolute terms (on average €227m per institution), which is on average 0.07% of the value of fair valued positions on banks' balance sheets.

Perhaps not surprisingly the mood music emanating from the banking community in respect of prudent valuation has been less than enthusiastic, implying as it does lower valuations (and hence lower capital resources) through the requirement to explicitly include early termination costs, investing and funding costs and administrative expenses. Also implied is increased operational complexity and potentially a revaluation of fair value assets held in both the banking book and the trading book, both of which are covered by the rules.

Need for implementationBanks approached for the purposes of this article declined to comment. However, with the European rules set to come into force in the coming months the time for debate has elapsed, and firms must now get on with the serious business of implementation.

One of the key differences between prudent valuation and other regulatory requirements is its often subjective nature. While market risk can be calculated using a model, valuation is often a matter of judgement within a prescribed framework, and that judgement can change from one month to the next.

“The prudent valuation requirements pose considerable challenges to credit institutions,” says Dr Andreas Werner, a partner at Frankfurt based consultancy d-fine, in a note. “The implementation is challenging as new measurement methods and business processes have to be developed and new market data sources have to be identified. Additionally, prudent valuation adjustments are pro-cyclical and may be significant with respect to tier one capital, thus posing challenges to risk management.”

Less liquid marketsOne of the biggest challenges for market participants will be less liquid markets, and where firms are unable to present a specific level of price uncertainty there is a work out enabling them to explain to the regulator the approach they have adopted.

“Banks now have a quantitative definition of prudent at the 90th percentile, with an element of qualitative assessment because we recognise that in some cases there will be insufficient data,” says the Bank’s Brar.

An example of the challenges facing banks is the measurement of accounting for credit value adjustments, for which some firms currently value

Banks now have a quantitative definition of prudent at the 90th percentile.

March The European Banking Authority published final draft regulatory technical standards on prudent valuation in March 2014.

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counterparty risk based on historic data and others use market implied numbers from credit default swaps. Whereas this may be acceptable for accounting standards, it also generates uncertainty, which is anathema to the regulator. However, it’s not only complex assets and liabilities that represent challenges – finding firm prices can be just as challenging for vanilla securities such as bonds, particularly those that are less liquid, e.g. emerging market bonds.

Where models are used for valuation purposes, institutions are required to estimate a model risk adjustment for each model.

“It’s incumbent on banks to demonstrate their appreciation of the range of approaches available, so when it comes to modelling if there are 10 models in the market then the theoretical ideal may be to build each of the models and put your valuation through each and then reach the 90th percentile of certainty,” says Brar. “However, in drafting regulatory policy we have ensured sufficient balance in order to avoid an unduly burdensome approach that may place too much pressure on resources. Therefore we have pragmatically left open the option for an alternative approach based on an expert risk assessment of the valuation models that firms use, including an assessment of factors such as liquidity, level of standardisation and size of position to determine an appropriate prudent valuation adjustment.”

Standards varyCurrently valuation standards vary considerably between and within banks, Brar says. Examples of

poor practice include firms relying unquestioningly on the same broker prices over a prolonged period, whereas at the other end of the spectrum some firms have developed systems that capture each market data point and reflect a hierarchy of sources. For the firms that have more work to do, operational changes may need to be accompanied by a change of culture, particularly in respect of the relationship between the front office and support functions.

“It is well known there have been concerns over front office dominance, and the ability at some banks of the control functions to challenge front office valuations. Now with firms having to report and justify their valuations to the regulator it is likely that the control functions will become more empowered to question the numbers coming from the front office and it is incumbent on firms to ensure that their control functions have the capacity and confidence to do that.”

US experience As European banks ponder the implications of the new prudent valuation rules, other financial institutions may be forgiven for looking on with a smile, having been spared similar rules in their own jurisdictions. There is, for example, no equivalent to prudent valuation for fair value in the US.

However, there are rumours that some large US banks are voluntarily producing prudent valuation assessments for their global entities because they realise the advantage of having a better understanding of their valuation processes and the degree of valuation risk the firm is exposed to.

Global regulators are watching the European example closely. “There have been discussions with global regulators and some will be bringing in these rules,” Brar says. “Two years ago it was the UK, and shortly it will be across Europe, so there is a trend. There are clearly concerns at the highest levels around valuation issues, and it would not be a surprise if prudent valuation is adopted globally in due course.”

Measurement challengesCompliance with prudential valuation obligations presents implementation challenges for banks that require new measurement methods, business processes and market data sources for hard to value and illiquid instruments.

“Over the past year we met with over 40 banks and regulators in Europe and initially everyone seemed focused on the most complex assets on the balance sheet,” says Leon Sinclair, director of evaluated pricing at Markit. “However, many underestimated the challenges and capital impact to their institutions when undergoing additional valuation adjustment (AVA) analysis for more liquid assets.

“We saw a sea change during the quantitative impact study in November, when anecdotally banks took between six and 10 weeks to complete the core approach. This was primarily due to the task of collecting data sets that hadn’t previously been part of Independent Price Verification/ Risk workflows.”

Banks must obtain all of the data they can access, both internal and external to satisfy the quantitative requirements of prudential valuation. For example, by acquiring the underlying raw data driving bond prices, customers can streamline the data collection process into their in-house methodologies while gaining access to statistics from institutional market markers.

Banks will need to demonstrate full transparency in their methodologies and range of inputs fuelling the underlying pricing data, as well as liquidity metrics.

Since the publication of the European Banking Authority Regulatory Technical Standards on prudential valuation in March some large European banks have lobbied over correlation and offset criteria, which they see as too punitive. The banks argue they could result in an uneven playing field between institutions subject to the rules and those outside the jurisdiction of the European regulators, says Sinclair.

Ragveer Brar, head of valuation and controls team, Bank of England

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The internet may have given us 24/7 connectivity, but it has thrown up a slew of security issues, resulting in the need for more advanced offsetting technology, and financial institutions are at the vanguard of

efforts to protect themselves. Security breaches have far-reaching consequences

throughout financial services because of the nature of the information they hold – be it consumers’ private information or details of corporate assets.

Security providers face a tough challenge as they must deliver relatively easy access to services while simultaneously serving the needs of internal stakeholders when implementing security. Securing these services is a difficult proposition and tradeoffs are often made, leaving the networks exposed and vulnerable to attack.

The network server is the number one target of all cyber attacks because it is where all crucial client and institutional data are stored. In multi-tenant cloud environments, financial institutions are also looking to protect the network server by providing the ability

Digital security providers are taking on a military approach in defending network security as more companies suffer from cyber attacks, writes Bruce Tolley of Solarflare Communications

Strategic defences

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to isolate customer traffic and services, and mitigating

against internal attacks and threats, misconfigured equipment and misbehaving applications.

A common saying in security is that the bad guy only has to be lucky once, while those protecting corporate and customer assets have to be lucky every time.

As a result, we are seeing a big push towards encryption from end to end. Some companies are starting to require every hard drive is encrypted, making it almost impossible for potential cyber bandits to access key data.

There is also growing demand for identity management. IT today is about providing the right (billable) applications and services to the right people at the right time and at the right level of service. Cloud service providers also want to ensure they know the customer on the other end and that all entities that are on the network, whether they be virtual, bare metal, or

in the cloud, are authenticated to be legitimate if not assigned specific policies and access rights.

Military strategiesDigital security practitioners often borrow from military strategies that have proven effective in defending valuable assets in the past. One common strategy is called ‘defence in depth’, or layered defences. Similar to how castles were built with cleared land, moats and strong high walls, digital security practitioners build networks that consist of firewalls at the outermost perimeter, routers with access lists, intrusion detection and host antivirus as you move further into the network. This approach assumes that the network will be breached, but the layers of defence will cause the attack to slow down, lose momentum and increase the chance that the attack becomes visible and stopped.

These are huge advances in technology as, traditionally, host systems have been left out of the

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Each tenant can be assigned a virtual machine or virtual server (VM)Policing and filtering can be executed at each virtual serverProtects servers from attacks that get past perimeter defencesSeparates and isolates by customers and by traffic typeMitigates against adverse performance impacts from badly behaving applications or misconfigured machines

Source: SolarFlare

Bruce Tolley, vice president Solarflare Communications.

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network ‘defence in depth’ paradigm due to the computational cost, technology tradeoffs required to deploy robust security and the monitoring of solutions on production systems at the edge of the network. Host systems can now perform high speed packet capture, filtering, bridging and denial of service defences, due to recent progress in computing power and software.

The industry is now organising around various infrastructure as a service (IaaS) cloud architectures such as Red Hat OpenStack and Apache CloudStack. The big server manufacturers are also promoting OpenStack, delivering to IT architects a way to build, manage and provision private and multi-tenant clouds from the network.

VirtualisationSecurity professionals need to leverage these host system capabilities in a virtualised environment. Virtualisation enables IT managers to consolidate workloads on fewer physical servers increasing the utilisation of each server and creating a more flexible, efficient and dynamic data centre environment. As a result, virtualisation can lead to lower capital and ongoing operating costs.

However, cloud networking and server virtualisation today require more than just the ability to support server consolidation. To meet customer requirements, cloud and virtualisation solutions must scale in performance, protect data integrity and support service level agreements, all while supporting the broad set of virtualisation and cloud features available from the virtual operating system providers and IaaS architectures.

In many virtualised and cloud environments, data centre managers need to separate and isolate traffic at each virtualised server, and need more flexibility than that allowed by the dedicated firewalls at the periphery of the network, the access control lists

available on the network switches, or other expensive switches, routers and dedicated security appliances. For example, Layer 2 through 7 filtering and policing can be deployed at each virtual server in private or multi-tenant cloud to separate and isolate traffic by service type and customer type. Such filtering and policing enables customers to implement security functions natively in the virtual server and enables security decisions to be made lower in the stack, improving efficiency. Using a virtualised environment, security managers are able to filter, log, alert on, or rate limit suspicious traffic at a per server level, which prevents attacks from impacting the host operating systems or host application performance.

Threat intelligence The trend in technology innovation and IT investments is also evolving. Now the emphasis is not just on slowing down cyber attackers who have breached any one private corporate network, but building sensors into the internet itself. These sensors, along with sophisticated data mining tools, enable bad behaviour to be identified before an attack.

Such a defence, based on data mining and analytics (as opposed to pattern recognition), to identify dangers on the internet is called live threat intelligence. This intelligence is used to build a feedback loop with corporate security defence mechanisms, so that IT systems can identify and stop cyber attacks. By combining live threat detection and other security policies with filtering and blocking on the server itself, an additional layer of security is inserted. Building another layer of defence at the server, combined with realtime updates with live threat intelligence databases, form an effective strategy to block the bad guys from accessing and stealing valuable data and improve IT security.

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Credit default swaps have been governed by the 2003 International Swaps and Derivatives Association’s (Isda) definitions for the past

decade, but a new set of rules represent the industry’s response to an understanding of default that has fundamentally changed since the financial crisis, particularly for financial institutions.

The 2014 definitions in force from September 22nd, aim to address three key issues: government action in bailing out financial institutions, asset package delivery for CDS auctions and the relationship between senior and subordinated debt.

Probably the most significant change is in respect of financial institutions bailed out through the new credit event titled Governmental Intervention. Examples of recent financial bail outs include those of Holland’s SNS Bank NV in February 2013 and Portugal’s Banco Espirito Santo (BES) in August.

The SNS event, in which shares and subordinated

bonds were expropriated by the government, were confirmation following the Greek credit event in 2012 that the 2003 definitions were no longer fit for purpose. The Isda Determinations Committee declared a restructuring credit event; there was clearly a reduction in principal because the subordinated bondholders received zero compensation from the government, but the Multiple Holder Obligation (MHO) wasn’t met. An MHO is defined as more than three holders of the bond, two thirds of whom do not consent to the event.

The new Governmental Intervention credit event aims to tackle the problems highlighted by SNS Bank. The event is similar to a restructuring credit event, but the trigger has to be a government or a governmental authority. The MHO doesn’t apply, nor does the reference entity have to experience deterioration in creditworthiness. Expropriation is explicitly included

The changing face of CDS New Isda rules on credit default swaps are a measured response to longstanding issues, writes Gavan Nolan, director of credit products at Markit.

22.09.14 ISDA 2014 definitions come into force.

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as a condition, as well as several other amendments that aren’t included under a restructuring credit event.

Governmental Intervention also allows for bond language that contemplates the possibility of principal write downs or other negative changes to terms. This is crucial in Europe, where the EU Bank and Recovery Resolution Directive, due to come into force in January 2016, will make bank resolution part of the landscape.

Asset package deliverySNS Bank demonstrated that the triggering mechanism in a restructuring credit event could fail when applied to government intervention. But it also showed that there were serious issues around deliverability. The value of SNS subordinated bonds after the expropriation was zero. However, because of the expropriation, there were no subordinated bonds to deliver into the credit event auction. The only available option was to use senior bonds to determine the final auction price, which didn’t reflect economic reality as the senior debt had relatively high recovery rates.

If the 2014 definitions had been in place, the SNS expropriation would almost certainly have triggered a Governmental Intervention credit event. This would in turn allow an asset package delivery, another key part of the new CDS documentation. Under the asset package delivery provision, bonds that are designated Prior Deliverable Obligations (existing bonds that

were deliverable before the bailout) will be deliverable into an auction after the bailout, whatever form they take after the amendments.

In the case of SNS, this means that the subordinated debt bonds – now worthless – would be used to determine the final auction price. The holder of subordinated CDS protection would have received 100% instead of the misrepresentative lower figure set by the senior bonds.

Splitting senior and subordinated debtUnder the existing Isda definitions, it was understandable why the expropriation of SNS subordinated debt resulted in a restructuring credit event, even if the legality was somewhat ambiguous. What was less clear was why both subordinated and senior CDS were triggered. The latter didn’t suffer any negative impact from the government’s actions; if anything, the senior debt’s creditworthiness was strengthened. But under 2003 rules, a restructuring credit event on subordinated CDS also triggers senior CDS.

Under the 2014 definitions, only the subordinated CDS will trigger if a Governmental Intervention or Restructuring credit event occurs on subordinated debt but not on senior debt. This would have made the CDS market function more effectively not just in the case of SNS, but also several other bank restructurings in recent years.

The default of SNS Bank undoubtedly prompted

2013 Rules governing the CDS market have not changed since 2003.

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many of the amendments to the Isda 2014 definitions. But a more recent example of a bank bail out highlighted how the documentation around succession events, as well as credit events, needed improving. BES, Portugal’s largest bank, in recent months found itself undercapitalised due to losses at its parent company. The government split BES into a “good” bank (called Novo Banco) and a “bad” bank, (the existing BES) with the senior debt residing at the good bank and the subordinated debt at the bad bank.

Isda ruled on August 8th 2014 that a succession event had taken place on BES, meaning the transfer

of all CDS to Novo Banco. In the case of a financial entity, this entails both senior and subordinated CDS. This means that the latter will be “orphaned”, i.e. there will be no deliverables on Novo Banca subordinated CDS as all the subordinated bonds will remain BES obligations.

BES’s subordinated CDS spreads tightened dramatically when it became clear that they were orphaned, in contrast with the cash market, which accurately reflected the worsening in creditworthiness of the subordinated debt.

Under the 2014 definitions, the result would have been quite different. The possibility of a good bank/bad bank split has been taken into account, so subordinated CDS would follow subordinated debt

Operational challengesThe existence of the protocol creates considerable operational challenges for the industry. Markit has responded through changes to its pricing, reference data and processing services.

Contributors to Markit’s CDS pricing services will be able to submit curves for the 2003 as well as 2014 definitions for entities that are excluded from the protocol. There may well be a basis between the two curves – some analysts have predicted that subordinated bank CDS trading on 2014 definitions may be as much as 50% wider than 2003 curves. CDS using 2014 documentation will be worth more to the protection buyer as it has the benefit of the extra credit event (Governmental Intervention), hence the probable wider spreads.

Markit will separate the two curves (2003 and 2014) through the DocClause (restructuring field). 2003 curves will be marked under the existing DocClauses (CR, MM, MR, XR), while 2014 curves will be designated using four new DocClauses (CR14, MM14, MR14, XR14).

All reference entities that are included in the Isda protocol will be priced using the new DocClauses.

The introduction of Isda 2014 definitions will also affect the construction of Markit indices, such as the CDX and iTraxx families. Please check the Markit website for full details.

Standard reference obligationThe concept of Standard Reference Obligation comes into effect on September 22nd 2014. Its aim is to standardise contracts across cleared and bilateral contracts and introduce further clarification on the deliverability of an obligation in a default situation. The main drivers of SRO creation were clearinghouses that used their own preferred obligations to allow CDS market participants to be able to clearly identify the correct obligations with clarification as to their deliverability in the event of a default.

Isda has appointed Markit as SRO administrator to manage the SRO process and produce unique identifiers (SRO RED9) to denote the entity and seniority that the CDS is traded on. These SRO codes will be linked back to existing Markit RED 6 and RED 9 identifiers. All trades where SRO status has been designated by the Isda Determinations Committee will use these new codes. The SRO roll out will be a gradual process and at the go-live the focus will be on Western European financials.

ConfirmationsThe introduction of the 2014 definitions is the largest change to CDS processing and legal confirmation since the introduction of “Big Bang” and “Small Bang” protocols. MarkitSERV will legally confirm approximately 98% of all credit derivatives transactions electronically, resulting in a major market transformation.

The 2014 definitions do not apply to transactions automatically from September 22nd – they must be incorporated into the confirmation or other trading documents. Post September 22nd customers will be able to differentiate between transactions on both 2003 and 2014 definitions and reflect that value within the legal confirmation.

Following the introduction of new matrix types to the Isda Credit Derivatives Physical Settlement Matrix relating to the new credit event triggered by a government initiated bail out, MarkitSERV platforms are introducing new values to allow customers to trade and confirm referencing these new terms. Additionally various amendments to the operating procedures that govern the platform are being made in line with the revised definitions and additional supplements.

In the wake of the financial crisis, the Isda rules were found wanting.

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and senior CDS would follow senior debt. In the example of BES, subordinated CDS would reference BES and senior CDS would reference Novo Banco, which makes far more sense.

SovereignsThe asset package delivery provision in the 2014 definitions is designed to make credit events on financial reference entities more efficient. It will also bring sovereign credit events in line with economic reality. Change was needed after Greece’s default in March 2012. The Greek government enforced a mandatory exchange of domestic law bonds for new bonds (with a large haircut), GDP warrants and notes issued by the European Financial Stability Facility (EFSF). The binding nature of the exchange consequently triggered a restructuring credit event.

However, this hotchpotch of assets posed a problem for the credit event auction. Under 2003 documentation, only the new bonds were deliverable – the GDP warrants and EFSF bonds were not acceptable. Thus the auction settled off the price of the new bonds, which didn’t represent the true loss suffered by holders of the original bonds. Fortunately, the 21.5% final auction price was similar to where the old bonds were trading, so the result wasn’t wildly inaccurate. But the flaw in the deliverability rules was all too apparent.

If the 2014 definitions had been in effect, then asset package delivery would have been applied. As long as the restructured bond is deemed a Package Observable Bond (a list of securities published by Isda), all of the assets post restructuring will be deliverable. So in the case of Greece, the new bonds, GDP warrants and EFSF bonds all would have been deliverable. CDS would have paid out 100 minus the value of the total package, and a more accurate final auction price would have been determined.

Other changes affecting sovereigns have also been introduced. The possibility of a country leaving the eurozone has been taken into account, though the risk has diminished since ECB President Mario Draghi made it clear to the markets that the bank would stand by the single currency. The rules around sovereign succession have also been updated to align with the language on corporate CDS. Countries don’t split apart very often, though Scotland’s referendum on independence in September and Spain’s fragile federation show that it is conceivable.

Industry challengesGiven that the new definitions will have a significant impact on financials and sovereigns, there will be an economic difference between trades on 2003 and 2014 contracts. As a result, financials and sovereigns will be excluded from the Isda protocol that will amend

trades on all other entities to the 2014 definitions. A handful of corporates are also excluded

The new definitions will have a significant impact on financials and sovereigns.

Gavan Nolandirector of credit [email protected]@GavanNolan

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BCBS

29 Autumn 2014

T he Basel Committee’s principles for effective risk data aggregation and

risk reporting (BCBS 239) may be among the least well known components of the post-financial crisis reform package. Yet they could ultimately bring about the most significant changes to the world’s largest banks.

The 14 principles, (11 for banks, three for supervisors), due for implementation by January 2016, came about as a result of one of the great weaknesses exposed by the financial crisis, which was that systemically important banks lacked the ability to aggregate exposures and identify large concentrations of risk at group level, jeopardising the stability of the broader financial system.

Risk data aggregation is the process of defining, gathering and processing risk data to enable a bank to measure its performance

against its risk tolerance/appetite. That might sound a fairly humdrum practice, but in the context of a financial system that was proven to be dangerously unstable during the crisis, the Financial Stability Board identified the improvement of risk data aggregation as a priority in 2011.

Progess requiredFixing the problem remains a work in progress or, perhaps more accurately, a work in need of progress. The drafting of the 14 principles was a good first step, but only nine firms responded to the Basel Committee’s original consultative document in 2012. This illustrates the lack of awareness of the principles by the 30 globally

systemically important banks (G-SIBs) that must now implement them by 2016.

As that deadline edges closer, implementing the principles is proving to be a major challenge. That is partly because the principles are mostly qualitative in nature, setting a high standard for risk data aggregation, but failing to define precisely how it should be achieved.

The prevalence of adjectives such as ‘strong’, ‘accurate’, ‘reliable’ and ‘timely’ in the standards, without quantitative definitions of exactly what is required, has been cited by many banks as a key challenge. Whether it is the failure of the regulators or the banks themselves to be more specific, many practitioners are still scratching their heads over vague recommendations from consultants

over the best way to comply.The principles are split broadly

into four categories, covering governance and infrastructure; risk data aggregation; risk reporting; and supervisory review.

Risk off

Fixing the problem remains a work in progress or, perhaps more accurately, a work in need of progress.

The world’s largest banks face major challenges in implementing the Basel Committee’s demanding new principles for risk data aggregation by 2016, but risk hefty bills if they get it wrong, says PJ Di Giammarino, ceo of JWG Group.

Basel, Switzerland

01.2013 The Basel Committee’s 14 principles were finalised

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Overarching governance and infrastructure1. Governance—a bank’s risk data aggregation capabilities and risk

reporting practices should be subject to strong governance arrangements consistent with other principles and guidance established by the Basel Committee

2. Data architecture and IT infrastructure—a bank should design, build and maintain data architecture and IT infrastructure which fully supports its risk data aggregation capabilities and risk reporting practices not only in normal times but also during times of stress or crisis, while meeting the other principles

Risk data aggregation capabilities3. Accuracy and integrity—a bank should be able to generate

accurate and reliable risk data to meet normal and stress/crisis reporting accuracy requirements. Data should be aggregated on a largely automated basis so as to minimise the probability of errors

4. Completeness—a bank should be able to capture and aggregate all material risk data across the banking group. Data should be available by business line, legal entity, asset type, industry, region and other groupings, as relevant for the risk in question, that permit identifying and reporting risk exposures, concentrations and emerging risks

5. Timeliness—a bank should be able to generate aggregate and up-to-date risk data in a timely manner while also meeting the principles relating to accuracy and integrity, completeness and adaptability. The precise timing will depend upon the nature and potential volatility of the risk being measured as well as its criticality to the bank’s overall risk profile. The precise timing will also depend on the bank-specific frequency requirements for risk management reporting, under both normal and stress/crisis situations, based on the bank’s characteristics and overall risk profile

6. Adaptability—a bank should be able to generate aggregate risk data to meet a broad range of on demand, ad hoc risk management reporting requests, including requests during stress/crisis situations, requests due to changing internal needs and requests to meet supervisory queries

Risk reporting practices7. Accuracy—risk management reports should accurately and

precisely convey aggregated risk data and reflect risk in an exact manner. Reports should be reconciled and validated

8. Comprehensiveness—risk management reports should cover all material risk areas within the organisation. The depth and scope of these reports should be consistent with the size and complexity of the bank’s operations and risk profile, as well as the requirements of the recipients

9. Clarity and usefulness—risk management reports should communicate information in a clear and concise manner. Reports should be easy to understand yet comprehensive enough to facilitate informed decision making. Reports should include an appropriate balance between risk data, analysis and interpretation and qualitative explanations. Reports should include meaningful information tailored to the needs of the recipients

10. Frequency—the board and senior management (or other recipients as appropriate) should set the frequency of risk management report production and distribution. Frequency requirements should reflect the needs of the recipients, the nature of the risk reported, and the speed at which the risk can change, as well as the importance of reports in contributing to sound risk management and effective and efficient decision making across the bank. The frequency of reports should be increased during times of stress/crisis

11. Distribution—risk management reports should be distributed to relevant parties while ensuring confidentiality is maintained

Supervisory review, tools and cooperation12. Review—supervisors should periodically review and evaluate a

bank’s compliance with the eleven principles above

13. Remedial actions and supervisory measures—supervisors should have and use the appropriate tools and resources to require effective and timely remedial action by a bank to address deficiencies in its risk data aggregation capabilities and risk reporting practices. Supervisors should have the ability to use a range of tools, including Basel’s Pillar 2

14. Home/host cooperation—supervisors should cooperate with their relevant counterparts in other jurisdictions regarding the supervision and review of the principles and the implementation of any remedial action if necessary

Source: Basel Committee on Banking Supervision, Bank for International Settlements

Principles for effective risk data aggregation and risk reporting

Some principles are perhaps more challenging to interpret and implement than others. For example, the first principle tackles governance, requiring that risk data aggregation and reporting should be subject to ‘strong governance arrangements’. The Basel Committee provides some further detail on what kind of internal oversight is required, but it remains unclear precisely how banks should get senior management involved in the process of risk data aggregation. Some might choose to appoint an entirely new business function such as a risk aggregation officer. Others might decide to allocate the practice to the remit of chief data officer. The implication is a lack of consistency in governance arrangements.

The third principle deals with

the accuracy and integrity of risk data, requiring that data should be aggregated on a “largely automated basis” to minimise errors. The Basel Committee asks that banks create a data dictionary to ensure that data are defined consistently across the bank. Such a requirement could also be fulfilled in several different ways. It is also unclear what degree of automation is required, and what level of manual intervention in data aggregation would render a bank non-compliant.

Lack of clarityA similar lack of clarity pervades many of the other principles, but the inherent challenge underlying all of them is that risk data aggregation is a practice that spans so many different parts of a bank’s

architecture that it has proven difficult to find a single business function to take complete ownership.

The wide reach of the standards is crystallised in the fourth principle, which requires banks to capture and aggregate all “material risk data” across the group, spanning business lines, legal entities, asset types, industries, regions and other groupings. As most large banks typically operate thousands of legal entities, accurately capturing the risk data in a timely way is a monumental challenge.

The Basel Committee is clearly not blind to the scale of the challenge, and in December 2013 it published a progress report on the adoption of the principles. Based on a self-assessment questionnaire completed by 30 G-SIBs, the exercise revealed a

PJ Di Giammarino, ceo of JWG Group

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BCBS

31 Autumn 2014

varying state of readiness for the 2016 deadline, and the Basel Committee conceded that many banks are struggling to establish strong data aggregation governance.

National supervisors, the Basel Committee said, would investigate the root causes of non-compliance and use ‘supervisory tools and appropriate discretionary measures’ to get the banks in shape by 2016. Exactly what that means is as unclear as the principles themselves, and while the final three principles deal with the role supervisors will play in monitoring and enforcing implementation, there is no indication of the penalties banks might ultimately face for non-compliance.

Attention pleaseDespite the worrying lack of clarity, the Basel Committee principles require greater attention from all market participants, from the regulators themselves to banks not yet affected, as supervisors have been advised to consider applying the principles to domestic systemically important banks as well as G-SIBs.

While other regulations such as

the Dodd-Frank Act, Basel III and the European Union’s Mifid and Emir have received much greater mainstream attention in recent years, the principles venture much deeper into banks’ operating mechanics. Basel III, for example, broadly requires a higher quality and quantity of capital and liquid assets, but it is left largely up to the banks how they achieve that.

The more complex the current business and underlying enterprise model, the more we need integration to deliver the right regulatory reforms in a cost-effective manner. Factors that will affect complexity will include the bank’s products and services, target customer base and the jurisdictional framework.

Though the principles have not so far been as large a focus area as Basel III implementation, the principles are necessarily tied to it. This is not just because they share the focus on risk, but because they alter what needs to be considered in banks’ operational risk frameworks, such as the Basel III advanced measurement approach.

Costly As regulators have now laid out the principles and have an admission from the banks, via the progress report, of their inability to manage the standards, there is the potential for banks to be hit with capital surcharges for inappropriately calibrated operational risk frameworks. As the principles cross all of their business lines, this could prove incredibly costly.

The challenge is that there is no single ‘right’ answer about precisely which capabilities an individual regulator will expect of a firm for risk data aggregation, and it is unlikely we will see a definition of a ‘good’ implementation.

However, if firms invest in a proper implementation, the risk data aggregation principles could see banks spending much more on new governance than in the past. With the current scant level of detail from regulators, doing that effectively before 2016 is going to be an almighty challenge.

2016 The principles are to be implemented by January 2016

A JOINED-UP PERSPECTIVE IS REQUIRED

Risk regulationCOREP,

FINREP,

liquidity

metrics,

etc.

What does good risk data compliance

look like?

Risk data

regulation

BCBS RDA and

national guidance

Infrastructure standards

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COREP – the European Banking Authority’s common regulatory reporting framework

FINREP – Financial reporting under European rules

BCBS RDA – Basel Committee on Banking Supervision Risk Data Aggregation

RRP – Recovery and Resolution Plan

FIBO – Financial Industry Business Ontology

EDTF – Enhanced Disclosure Task Force

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33 Autumn 2014

Ask any corporate bond trader what keeps them up at night, and the issue of liquidity will be lingering somewhere in their nocturnal fears. As the US winds down its quantitative easing programme, and the

market prepares for a rise in interest rates, there is still no single answer to the question of how a sell off will be managed given the reduced role of banks.

Corporate bond inventories held by US primary dealers have fallen 80% since their $250bn peak in 2007, according to the Federal Reserve Bank of New York. Meanwhile companies are on a borrowing spree, with the amount of corporate debt outstanding rising to $9.6trn at the end of 2013, compared with $6.4trn at the end of 2008, according to the Securities Industry and Financial Markets Association.

As bank inventories have declined, the biggest managers of bond funds have mushroomed. Pimco, Vanguard and Fidelity Investments between them

LIQUIDITY VACUUMA dramatic imbalance in the corporate bond market is giving market participants sleepless nights. David Rothnie reports.

BOND TRADING

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BOND TRADING

34 Autumn 2014

manage 39% of all mutual fund-owned taxable bonds today, up from 18% in 1997, according to Morningstar Inc. data.

The bond market has caught the attention of the US Securities and Exchange Commission, which in June proposed regulations designed to make it cheaper and more efficient for investors to buy and sell bonds, such as increased disclosures on fees and more transparency on pricing, a move which the regulator hopes will encourage non-banks to provide more liquidity.

Basel IIIThe liquidity trap has arisen because of a combination of factors, such as new Basel III capital and liquidity

rules, which have driven up the cost of dealing, as banks must hold more capital against almost all assets and particularly against low-rated corporate bonds. Meanwhile restrictions on proprietary trading instigated by the Volcker rule have also reduced inventories.

In the meantime on the buyside, investors, who have become nervous about their ability to exit positions quickly in the event of a rate rise, have adopted more passive trading strategies such as exchange traded funds (ETFs), resulting in increased concentrations in a smaller number of Isins. Analysts say that in a market of 50,000 Isins or Cusips, trading is concentrated in fewer than 1,000 issues. Likewise,

Regulation has been a clear driver in reducing liquidity and driving up the cost of trading.

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dealer inventories have become concentrated around better known, well traded names, at the expense of less liquid or ‘off-the-run’ credits.

In addition, while liquidity has plummeted, investors have continued to pour billions of dollars into corporate bond funds, which have been an attractive asset class to invest in because they offer extra yield and relative safety in a low rate environment where it is difficult to generate alpha. In the past five years, holdings of bond mutual funds and ETFs in the US have doubled to around $900bn. The huge inflows from retail investors pose a particular danger because mutual funds and ETFs have to sell securities as soon as customers start to withdraw cash.

OutflowsIn August 2014, high yield bond funds suffered around $19bn of outflows within 24 business days as retail investors led a flight from higher risk assets. But the sell off, though significant, has so far failed to meet the market’s worst fears.

“We are seeing record outflows from high yield, but it doesn’t feel like a disorderly sell off. That’s partly because it’s isolated to high yield and partly because people are finding more creative ways of maintaining liquidity,” said Brad Rogoff, global cohead of credit strategy at Barclays in New York.

“A lot of retail funds have used Markit’s CDX index as a liquid way of still being invested. Also, what’s changed is the definition of a liquid bond if you want to raise cash. A decade ago, that might be a 10-year BB bond or in investment grade an ‘on-the-run’ bond. Short duration bonds are becoming a cash substitute,” he noted.

Many fear the consequences would be much more grave in the event of a broader market sell off involving institutional as well as retail investors, and many point to the ‘taper tantrum’ in May 2013, when former Fed chief Ben Bernanke first raised the prospect of reducing the US government’s asset buying programme, as a test case for the new world order of lower corporate bond liquidity.

The result was a dramatic widening in credit spreads in high yield and investment grade credit, resulting in heavy losses for some investors. Fortunately, the sell off was relatively brief, but market participants have contrasting explanations. Some argue that bond market Armageddon was averted because Bernanke appeared to wrestle back control of the yield curve by promising that the Fed would continue to support the market. Others say that while the spike in volatility was exacerbated by the absence of relative value traders and the trading desks of big investment banks failing to step in to buy the market, its damage was limited by market dynamics.

“In the investment grade market, I worry about a disorderly sell off over a two to three month period, but anything longer than that I don’t because insurance companies represent half of the market and they will buy at higher yields,” Rogoff said.

Change in mentalityThe notion of a short, sharp sell off reflects a change in trading behaviour that has come about because of the transfer of balance sheets from the sellside to the buyside.

“There is a real change in mentality underway,” says Rob Vandenassam, head of investment grade at Pinebridge Investments in New York. “Whereas in the old days, broker dealers would be willing buyers, looking to flip a bond, buyside investors take a more longterm view, and that increases volatility, as opposed to the sellside which is more flow based.

“Under the new buyside mentality, not as many people will be willing to bid and that’s what we saw during the taper tantrum - it wasn’t that people were selling, but that they weren’t buying,” he says.

If the liquidity trap in the corporate bond market is

$250bn Total corporate bond inventories held by US primary dealers have fallen 70% since their peak in 2007 of nearly $250bn.

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nothing new and has been a slow train coming since the crisis of 2008, then it is perhaps surprising that the industry is yet to find a solution. Partly, this is because it has not had to. Central bank support has maintained a bond bull market and convinced investors that the US Federal Reserve and the European Central Bank will continue to stand behind the markets, a conviction that endures. Then there is the differing pace at which regulations are being adopted. While European banks have been early adopters of Basel III reforms, the US dealer

community has come later to the party. There is debate in the industry over whether the

downturn in the fixed income markets is cyclical or secular, creating a bifurcation in banks’ strategies towards the asset class. While bond behemoths like Barclays have reduced the size of their secondary bond operations, rival Deutsche Bank remains committed to the model, believing that profitability and trading volume in the asset class will snap back as interest rates rise.

“Regulation has been a clear driver in reducing liquidity and driving up the cost of trading, but there is also the reality that in a low interest rate environment it is not in dealers’ commercial interests to warehouse risk,” said Dominic Holland, global head of e-credit sales at Deutsche Bank in London.

“With companies scrambling to refinance at a highly attractive all-in cost of financing, the new issue market has been booming and that has diverted investor dollars from the secondary to the primary

market. There’s a strong argument that once interest rates rise, the result will be a much more vibrant secondary market.”

Meanwhile, there is something akin to a technology arms race as both the sellside and buyside search for new ways of trading bonds that will boost efficiency, reduce the cost of trading and solve the liquidity problem. The quest is to find new ways of doing business that do not use the long-standing request-for-quote model that makes the buyside reliant on the sellside to make prices.

Inspiration from equity The innovations borrow heavily from the equity markets, which moved from a principal to an agency trading model several years ago with the advent of electronic trading. Bond market participants on both the buyside and sellside have launched several initiatives to encourage investors that own the vast majority of bond inventory to submit orders on exchange-like platforms and provide liquidity through central limit order books - as happens in the equity markets. Meanwhile, banks have set up crossing networks to match client orders.

UBS was the first investment bank to set up such a network with the launch of its price improvement network in 2010, followed by rivals such as Goldman Sachs and Morgan Stanley. None of these platforms have significantly changed the landscape, and several have been quietly shelved.

Another concern is that the emergence of multiple platforms threatens to fragment rather than boost liquidity, and the industry cannot agree on whether it needs a revolution or evolution.

“Electronic trading has helped but if we have a bad day certain things go no bid. The major broker dealers remain the best source of liquidity and they are able to ‘work an order’. That is why voice will never be over-taken by electronic. The risk with electronic systems is that you show the world what you’re doing and it frightens the world,” Vandenassam said.

Buyside-to-buyside crossingIn 2012, BlackRock seized the initiative with the launch of its Aladdin Trading Network, designed to allow other participants on the buyside to cross buy and sell orders between themselves. Ultimately, the initiative failed and was spun off to MarketAxess in May 2013. The reasons are manifold; first BlackRock did not manage to sign up a sufficient number of asset managers to build a critical mass. Also, asset managers often faced the same way on a trade, and were unable or unwilling to take on the role of market makers.

Electronic trading has helped but if we have a bad day certain things go no bid.

Worlds apart Stocks Corporate bondsTotal market value $17trn $8.1trnEstimated listings 6,500 40,000Average daily trades 25.2m 40,280Average daily volumes $112.9bn $17.9bnSource: SIFMA, MarketAxess, TABB Group

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BOND TRADING

37 Autumn 2014

The dash for innovation has led to fragmentation - an estimated 32 bond platforms have sprung up. But the real problem that Aladdin showed was that dealer activity is still necessary to grease the wheels of liquidity.

In July, Tradeweb announced it is beta testing a US corporate bond dealing platform on which dealers will be required to stream a minimum number of price quotes. Tradeweb says investors will have a 95% certainty of getting their orders filled.

Culture shockCritics say the Tradeweb system will be a culture shock in the US, where around 14% of the corporate bond market is traded electronically, compared with around 45% in Europe, according to industry estimates.

Tradeweb’s arrival on the scene diverted attention away from other emerging solutions, such as the Oasis project led by Deutsche Bank. The aim of Oasis is to create a new protocol for motivated buyers and sellers, but which provides investors with anonymity to protect them against information leakage as to their intentions before posting trades in an open market.

Deutsche Bank’s Holland, who has been a driving force behind Oasis, says the answer lies in improving information, rather than a radical new model.

“There is a real consensus emerging that a protocol which brings together motivated buyers and sellers is likely to be the most effective solution in creating greater market efficiency,” he says.

“To do that, it’s about improving the quality of information to help clients find the other side of the trade. E-communication is about better connectivity, it’s not some revolutionary new model to be scared of. It’s about finding motivated buyers and sellers and finding pools of liquidity in discrete markets and cutting out the pre trade noise.”

One solution that purports to do just that is Algomi, led by Stuart Taylor, who previously launched UBS Pin-FI. Algomi works on the basis that in contrast to equities, corporate bonds are an inherently illiquid asset class unsuited to central limit order books or crossing networks. It aims to capture information on where liquidity is located among the bank’s customers so that the dealer can act on that information and work more effectively than a system that streams prices in the hope of getting a phone call.

Apocalypse now The recent high yield sell off doesn’t feel like the start of an Apocalypse to most market professionals, but then the market never anticipates the biggest crises.

“A year ago, people were very concerned that the exit door was getting smaller, but investors are still buying credit at these levels. It’s clear that there’s some froth in the market, and that retail is an overweight component, but I haven’t been able to find investors looking to exit or who are substantially overweight,” Holland added.

Meanwhile, it’s not just pre trade noise that is threatening stability. Banks, technology providers and

investors are engaged in an ongoing debate about how to solve the liquidity challenge. And regulators are coming up with their own solutions. In July, Fed chair Janet Yellen said in her biannual testimony to Congress that she sees no evidence of systemic risk.

“Electronic platforms can boost efficiency but can they be providers of last resort liquidity? No. Capital is the provider of liquidity,” Rogoff said.

“The only solution to the drop in liquidity in the corporate bond markets is that more money is managed with different lockup provisions and there are more sources of longer term capital.”

Until interest rates start to rise significantly the theories on the extent of the liquidity crisis are likely to remain untested. Many real money accounts are certain to rush for the exit when there is a reversal in fortunes. Who takes the other side of that trade will be the big question.

0%

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Retail owns 37% of US credit

20%

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1.2%

1.5% Credit market size Dealers’ est. holdings

$19bn In August 2014, high yield bond funds suffered around $19bn of outflows over 24 business days.

US credit by investor type

Market grows but dealers pull back

Source: RBS, Federal Reserve Bank of New York

Source: RBS, SIFMA, MarketAxess, Federal Reserve Bank of New York

Page 33: Markit magazine: Autumn 2014

MARKIT LIFE

39 Autumn 2014

It takes one to know one. There’s a good reason why Kathryn Brierley has built a successful business creating restorative holidays for burnt out bankers and lawyers. It’s because she was once a burnt out banker herself.Not any more. Her Healthy Holiday Company is

the umbrella for four slightly different travel brands that all do what it says on the box. They deal in ‘wellness holidays’. And one of the more satisfying outcomes is that Kathryn’s physical and mental well-being has prospered along with her new business.

Investment banking may have taught her about burnout, but it was at university that she discovered a taste for travel. She studied French and German at the University of Bristol, and the course included a working year abroad, first with a Paris law firm and then with Mercedes Benz. “I had this fantastic spell of living and working in France and Germany,” Kathryn says. “It was my first experience of foreign travel.”

Travel would continue to fascinate her, but in the meantime she needed a proper job. She had no intention of entering the world of finance; law, perhaps, or maybe advertising, but not the City. But fate decided otherwise when a graduate recruitment agency led her to the door of the Farringdon-based stock broker Smith New Court, which needed a research assistant with language skills.

It was 1992 and, although the transition to pan-European sector research had already begun, these were still the days of country-focused analysts who specialised in, say, Germany, Spain or Scandinavia. Her ultimate boss at Smith New Court was Nichola Pease, who had been hired to build the group’s European broking business. Pease went on to bigger and more visible things in the world of asset management, becoming ceo of JO Hambro Capital Management, and today she is a non-executive director

Former banker Kathryn Brierley responds to the needs of stressed out professionals by offering wellness holidays. Edward Russell-Walling reports.

Banking on burnout

Page 34: Markit magazine: Autumn 2014

40 Autumn 2014

45% Turnover has grown at an average compound rate of more than 45% a year

of Schroders.Kathryn worked with the German equities research

team, translating financial documents and helping the analysts plan their trips abroad. “I loved it and I pushed to learn more about what they were doing and how to do it,” she says. They recognised her interest and talent and so, having sat the requisite securities exams, she crossed the divide and became a junior analyst herself.

Poaching practices Teams were poached wholesale then, as now, and in 1994 the four members of the Smith New Court German equities research unit received a more lucrative offer from NatWest Markets. Kathryn and her colleagues followed team leader Ernie Ferriday to their new home in Bishopsgate. Ferriday, it’s worth noting, retired in 2009 to write books. He describes the central character in his debut novel as “a ruthless, alcoholic City investment analyst with no moral scruples”.

Kathryn took on her new responsibilities with great zeal, focusing on smaller, mid cap German companies and she looks back on this as an enjoyable time, working hard but playing hard as well, with lots of entertaining and going out after work. But fate again would lend a hand in changing her destiny.

Kathryn’s labours had attracted wider attention and in 1998 she received an unexpected call from a headhunter. Goldman Sachs was looking for analysts to build a European small cap team. She had her interview along with a NatWest colleague, although neither candidate knew if they were a double act or in competition.

“There I was, aged 28, walking into the Goldman Sachs building in Fleet Street, terrified by the imposing nature of the whole set up. I went through their well-known round of 25 or 26 interviews, because they work on a consensus basis and want everyone in the department to feel responsible for bringing someone in.” It was a great learning experience, she says.

To their mutual wonder and relief, she and her colleague, David Abraham, were both offered jobs, ultimately reporting to Robert Morris, global head of investment research, in New York. Goldman Sachs had

made the shift to sector-based research, but smaller companies were still looked at on a country basis, and Kathryn’s brief was to cover German small caps.

“I can’t say a bad word about Goldman Sachs,” she maintains. “I absolutely loved my time there. I was so impressed by the calibre of everyone in the department. It was clear they only hired the best of the best and the excellence of your colleagues had a knock on effect, upping the quality of your own game.”

Quest for excellenceThis culture of aspiration for excellence extended beyond the office, as Kathryn would learn. She

I wanted to have different memories and adventures, but when you’re sitting in the same office for 14 hours day after day, you don’t have different memories—you just have one.

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41 Autumn 2014

discovered that half her department was planning to run in the London Marathon. That spurred her to sign up and to run alongside them. She had tried to keep fit before by going to the gym, but this required a whole new level of physical intensity. “It was the start of my real interest in fitness on a personal level.”

When the firm created a new role for “specialist sales”, a sort of research/sales hybrid, Kathryn put her hand up and started working with the European retail and luxury goods teams. She says she loved that too, particularly the people she worked with, but she began to notice the pressure mounting inside the department as performance began to be monitored more closely. Each team was expected to regard itself as a business unit, accountable for the number of calls it generated.

It was a long working day, starting at 6.30am, catching up with the overnight news and preparing for the morning meeting, talking to clients, making US calls, monitored, of course, in the afternoon, and grinding on into the evening. “You did feel like a productivity machine, churning out the information,” she remembers.

Kathryn says it got to the point where she became so immersed in the culture, so enveloped in the pressures of working hard, that she started to lose touch with reality. She missed countless personal engagements, including a friend’s wedding, because she had to work instead. “I was losing touch with where I should have been personally.”

Growing pressureIn 2001 she managed to escape for a week in Tuscany, where she caught up on all the eating and drinking she had been missing. The upshot was that she got back to work feeling physically awful. “My system wasn’t used to it,” Kathryn explains. “And then it hit me, you have so little precious time away from your desk that it’s really important to use it to restore and replenish yourself.”

The next summer she went away with a lawyer friend who worked as relentlessly hard as she did. She suggested that they try to have a healthy week, with plenty of exercise and good sleep; everything the previous holiday had lacked. The trouble was that this kind of holiday wasn’t very easy to find, at least not in Europe.

“There were hotels with spas and lovely robes, but the prospect of a real wellness break was not really in existence,” Kathryn recalls. “There were far more developed destinations focused on wellness in the US and Asia.”

In the end they went to a resort in Spain that offered golf, salads and sun beds. “I remember lying on a sunbed thinking that there was definitely a gap in the market for stressed out lawyers and bankers in need of a holiday.” One or two yoga retreats had recently opened up, but Kathryn felt you had to provide more than yoga. “You had to offer delicious, healthy food, exercise, a real sense of relaxation and a real blast of health.”

She spent the next six months honing the idea, living a dual existence. After an achingly long day at the office,

she would go home to work on the business concept. By Christmas, things had come to a head. Pressures at work were increasing. Kathryn looked back at her five years with Goldman Sachs and tried to remember the key events in her personal life. It was just a blur.

“I couldn’t afford to have my life disappearing while I sat at my desk,” she realised. “I wanted to have different memories and adventures, but when you’re sitting in the same office for 14 hours day after day, you don’t have different memories, you just have one.”

Sleep deficitBesides which, she calculated, if she left Goldman Sachs, she would have three weeks more sleep every year. So in January 2003, much to everyone’s surprise, she resigned and started her first company, in:spa (www.inspa-retreats.com). The in:spa idea is to hire a beautiful villa or boutique hotel and to fly out a team of health and fitness specialists, a nutritionist, a massage therapist, a yoga teacher and a chef. These are all experienced professionals with their own businesses.

The holidays take the form of a health retreat. Clients join a group of around 15 in Marrakech, Andalusia or the south of France for a specially designed schedule that includes hiking, fitness training, yoga and massage. The food is healthy and detoxifying; no alcohol, caffeine or sugar, and no wheat, dairy, red meat or any other ingredient that places an “unnecessary burden on the system”. But no starvation either.

“We haven’t changed the formula for the last 12 years,” Kathryn notes. “People come through a natural detox and by the end of the week they are on an incredible energetic high, looking and feeling amazing.” The hope is that they will be feeling sufficiently fired up to continue the good work when they get home.

in:spa now organises around 12 of these weeks each year. There are, unsurprisingly, lots of bankers

People come through a natural detox and by the end of the week they are on an incredible energetic high, looking and feeling amazing.

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MARKIT LIFE

42 Autumn 2014

and lawyers, with a sprinkling of entrepreneurs and “exhausted housewives”. Some of them come every year. “It’s a wonderful mix of bright professionals, close to burnout on a functioning level, under heavy pressure. Most come on their own and we encourage that. It’s a fabulous opportunity to get away and focus completely on yourself.”

If the formula works, the delivery appears to be pretty faultless as well. In the 2014 Condé Nast Traveler Spa Awards, in:spa won the award for being The Most Consistent High Performer.

Since she used to analyse company performance for a living, you wouldn’t expect Kathryn to set up a business and simply hope for the best. Shortly after she opened

her doors, she took on a business partner, Simon Pardoe. She met Simon, a marketing consultant who specialises in the leisure industry, via one of his clients, Chelsea’s Harbour Club. Kathryn reckons his skills are very complementary to her own.

New brandsWith the credit crunch of 2007 and the 2008 crisis, in:spa experienced a distinct slowdown. At £2,000 to £3,000 a week, the holidays were not cheap and the target market of bankers and lawyers was now in thoroughly defensive mode. “We responded positively and created another two brands at lower price points,” Kathryn says. “The benefit of being a small business is that you can think creatively and do things immediately.”

The new brands were pared down versions of in:spa, but still focusing on fitness in their different ways. They were also a response to the rise of the more military-style boot camp holiday, of which Kathryn disapproves. “You want a more relaxing experience,” she insists,

“without being shouted at and risking injury.”One of the brands is Fitscape.co.uk, which offers

fitness holidays at hotels in the Dolomites in Italy and southern Spain. Guests can indulge in hiking, cardio training, Pilates, strength work, running classes and mountain biking. They eat healthily all the time, though detox is not on the agenda. These holidays cost up to £2,000 a week, and Fitscape organises about 10 a year.

Then there’s a yoga retreat business called Destinationyoga.co.uk. These holidays offer a week of dedicated yoga at locations in southern Spain, southern Italy, Morocco and India. Prices are from £500 to £1,500 and around 28 weeks are sold each year. “This has grown enormously,” says Kathryn. “Yoga holidays were quite new then, but now they are

mainstream, attracting more men and more people who have never tried yoga before.”

All the above represents what you might call “fixed night” business, which is to say that the holiday company sets the dates. If they don’t fit your own diary, that’s too bad. “What if you’re just finishing a deal, or you can’t get child care that week? We realised that we weren’t covering all the date opportunities and that group holidays with people you don’t know are not everyone’s idea of fun. And we were not offering anything for families.”

So Kathryn and Simon set up a new model based on a traditional tour operator, but with their own specialisation, catering for anyone at any time, meeting most budgets and providing ideas for a healthy break. The Healthy Holiday Company was launched in 2012 as a new brand, but was also adopted as the name of the overarching group. It offers bespoke holidays to a very broad spectrum of client types to just about anywhere in the world.

At the high end, the company has laid on a private villa and flown out a team including a personal trainer, yoga teacher, chef and masseur, for a couple who wanted their own private retreat experience. Less high-rolling packages have included trail running holidays for groups of young men in Mallorca, family surfing holidays in Morocco, or detox and yoga weeks in Thailand and Bali.

Growing competitionBack in 2003, when it came to pure wellness holidays in Europe, Kathryn had the field more or less to herself. Today there is a lot more competition, both at the tour operator and resort level. Ten years ago, a holiday hotel could get by with a small gym. Now it needs a yoga teacher. Even as more competitors look for a slice of it, the pie itself has grown considerably, with much greater numbers looking for fitness and health in their holidays.

After the crisis fallout, the top end in:spa business began to return to form in 2012 and 2013 and is, according to Kathryn, “in a really exciting place”. Run out of offices in London’s Notting Hill, the Healthy Holiday Company has a team of eight, including its two partners. It has not been problem free and there was a period when they were over-ambitious in terms of the number of weeks they were putting together. “As an analyst I have seen many companies make howlers,” Kathryn points out. “But the great thing about this business is its flexibility, which means you can immediately scale back if you need to.”

The company has now organised over 400 group holidays across the three fixed night brands and has arranged holidays for more than 5,000 clients across the whole business. As a good analyst Kathryn can report that its turnover has grown at an average compound rate of more than 45% a year.

And yet the guiding principle of the business is that work and profit are not everything. So perhaps we should mention that Kathryn has since run a total of four marathons and is now an advanced certified yoga teacher. “Immersion in the wellness holiday market has brought me great personal benefit and lifestyle improvements.” she concludes, as if to say that settles it.

5000+ in:spa has arranged holidays for more than 5,000 clients

Page 37: Markit magazine: Autumn 2014

MARKIT ROUND-UP

Nicholas Dunbar reviews Stress Test: Reflections on Financial Crises by Timothy F Geithner (Random House 2014)

If you had perfect foresight and were going to pick the best regulator or policymaker capable of dealing with the global financial crisis and its aftermath, who would you choose? You’d probably want someone with a track record of dealing

directly with crises, perhaps in emerging markets, and finding solutions to them. And you wouldn’t want someone too closely associated with the ideology of deregulation and virtuous markets that presaged the crisis.

Tim Geithner, who ran the New York Fed from 2004 to 2008 and then the US Treasury until 2013, embodied both qualities. Joining the Treasury as a career civil servant in 1992, Geithner cut his teeth dealing with Mexico’s tequila crisis of 1994 and the Asian crisis of 1997. He picked up important lessons on runs in market confidence and perfected skills in winning over policymakers concerned about the moral hazard of bailouts.

During this time he was singled out for promotion by two clever and influential mentors in charge of Treasury during the Clinton era: ex-Goldman banker Robert Rubin and Harvard economist Lawrence Summers. For all their brilliance, Rubin and

Summers, together with Fed chairman Alan Greenspan, were cheerleaders of financial innovation and stymied attempts to regulate over-the-counter derivatives. The three of them, dubbed the ‘committee to save the world’ by Time magazine in 1999, helped steer their relatively unknown young protégé into the New York Fed presidency.

Key banking supervisorWith responsibility for regulating the holding companies of J.P.Morgan, Citi and the New York branches of global firms like Deutsche Bank, at a stroke Geithner became one of the world’s most important bank supervisors. As he admits, he had no experience regulating banks and his team at the New York Fed has been singled out for criticism.

Geithner is particularly sensitive about his supervision of Citi, which would require a $45 billion bailout in 2008. When he joined the New York Fed, his former boss Rubin had been on Citi’s board for four years, a presence which Geithner says “tempered my scepticism” about the bank’s practices. In late 2007, as the bank was starting to implode, Citi even offered Geithner the ceo’s job, which he turned down.

That isn’t to say Geithner did nothing useful before the crisis. Although his attempts to get banks thinking about stress tests and systemic risks were ineffectual, he did push banks to fix backlogs in credit derivatives processing and confirms that may have mitigated the crisis when it came.

However, Geithner’s most effective defence against charges of failed banking supervision at the New York Fed is that other sectors of the US financial system were even more poorly supervised, or not even regulated at all. The book contains an eye-opening diagram showing how funding of US financial activity by so-called shadow banks grew from 37% in 1990 to 58% in 2007. As Geithner points out, much of this shadow banking was in short-term form and highly vulnerable to panics, and was not something he could do anything about.

SubprimeThe subprime bubble that triggered the crisis resembled an emerging market boom within US borders: with the help of Wall Street, the bottom 80% of Americans whose real income had stagnated for decades were offered mortgage credit which created the illusion of wealth. Like many others, the New York Fed missed the warning signs – Geithner cites a risk committee study in 2007 which tried to predict the impact of 14% subprime losses and concluded that only Wells Fargo and HSBC would be affected.

What Geithner calls a “failure of imagination” in thinking through the implications of market linkages and financial innovations came back to bite him from July 2007 onwards. The problems of Countrywide and Bear Stearns taught him about the weakness of the triparty repo market. Like many others, he got a crash course in asset backed commercial paper and money market funds. He learned that Citi had a lot more subprime exposure than it had let on.

Geithner’s experience with Mexico and Asia proved useful as policymakers struggled with the worsening crisis. In Federal Open Markets Committee meetings and elsewhere, Geithner

44 Autumn 2014

BOOK REVIEW

Geithner’s progress

Page 38: Markit magazine: Autumn 2014

45 Autumn 2014 45 45

Nicholas Dunbar is a financial journalist and author of The Devil’s Derivatives

argued forcefully for unrestricted measures to restore market confidence.

Bear StearnsThese measures may have started out as old fashioned monetary easing, but by the time Bear Stearns came to the brink of failure in March 2008, the Fed was invoking emergency powers that allowed it to take on the risk of Bear’s subprime assets via a special purpose vehicle. Through this period, and onwards to Lehman and AIG, Geithner gives a fascinating inside account of the Fed’s journey into uncharted territory.

After Bear Stearns, as Wall Street’s lender of last resort, Geithner became the de facto regulator of investment banks that had flourished under the lax regime of the SEC. He recounts how in 2008, Lehman was more preoccupied with softening the New York Fed’s stress tests than finding a buyer, while Merrill Lynch ceo John Thain couldn’t even remember his chief risk officer’s name.

Geithner implies that these firms deserved to fail, but during 2008 he did his utmost to protect them. Even with Lehman he depicts himself as trying to save it until the very end. As Lehman demonstrated, their interconnectedness made them too important to fail.

Geithner says that one of his motives for writing Stress Test was to provide a playbook for dealing with future crises. One of the lessons that Rubin taught him was to preserve ‘optionality’ in policy choices, maybe a reason Geithner rails against those who block off possible solutions to a crisis out of moral scruples.

He divides such scruples into two categories. First is what he calls the ‘Old Testament view’ of justice – the urge to punish wrongdoing by bankers. The other is an economic argument that protecting risk takers from losses gives them the incentive to take more risks in the future. Both of these scruples, Geithner argues, are wrong headed in a financial crisis when the overarching priority is to restore confidence. Whenever politicians allow fires to burn the results are disastrous, and as a result, such decisions quickly get reversed.

For example, the US government takeover of Fannie Mae and Freddie Mac, which backstopped $5trn of liabilities, effectively closed off the option of saving Lehman because it would have been politically toxic in Washington. However, the shock of Lehman’s bankruptcy made AIG’s bailout palatable. Likewise, the bankruptcy of Washington Mutual – in which senior bondholders suffered haircuts – convinced Federal Deposit Insurance Corporation chair Sheila Bair to support Wachovia further down the road.

Defending bailoutsGeithner defends the Troubled Asset Relief Program and other bailouts and backstops that dominated his transition from New York Fed to Treasury secretary. He points out that the US taxpayer made a net profit on the bailouts, and the US economy recovered faster than other nations that faced similar crises. The broader lesson is that forced creditor haircuts and asset deleveraging by financial institutions amount to a form of austerity during a recession. This shows why special measures by central banks – such as Europe’s ECB – have been such an important counterweight to the moral instincts of politicians.

Painting Geithner as a Wall Street stooge for his insistence on bailouts may have been unfair, but at times the free market ideology absorbed from Summers, Rubin and Greenspan played into the arms of his critics. One of his first challenges as Treasury secretary was the payment of millions in bonuses to executives at AIG Financial Products. Geithner backed the payments out of respect for ‘sacrosanct’ legal contracts and fears of a talent ‘exodus’. Apparently it was beyond him to think that AIG only avoided bankruptcy because of US government support, and in a bankruptcy – or near-bankruptcy – no contract or employee is sacred.

Financial reform It was a similar story with financial reform. Geithner describes how he helped channel outrage at the bailouts into political consensus for the Dodd-Frank reforms, which required Republican votes to pass Congress. However, he initially resisted the Volcker Rule having swallowed the lobbyist-friendly argument that proprietary trading made markets liquid. Only when President Obama came under attack from the liberal wing of his party did Geithner pivot round and support the Volcker Rule in order to bolster his boss’s populist credentials in time for the 2012 election.

It can be argued that Geithner’s foot-dragging didn’t matter in the end – for the most part the right reforms were enacted, and many of them at a global level via Basel and G20 agreements. His innovation of periodic regulator-imposed bank stress tests proved a

valuable tool that has been copied in Europe. Yet at some point the shifting mood left Geithner

stranded in the past. In his post mortem of the crisis, Geithner diagnoses its cause as exuberance coupled with leverage funded in runnable forms. He downplays the role of Wall Street wrongdoing or compensation practices and dismisses the suggestion that banks are too big.

This approach has led to the spectacle of megabanks paying multi-billion dollar crisis-related settlements from shareholder funds while individuals who perpetrated the wrongdoing go free. In a phrase he uses himself, perhaps it was a failure of imagination that prevented Geithner from seeing how much this would alienate the public.

It’s to Geithner’s credit that he is honest and thorough enough to give readers a chance to evaluate the positives and negatives in his legacy. This capacity for self-analysis makes his 500-page book one of the most compelling and important accounts of the crisis.

Timothy Geithner, former Federal Reserve chairman and Treasury secretary

It’s to Geithner’s credit that he is honest and thorough enough to give readers a chance to evaluate the positives and negatives in his legacy.

Page 39: Markit magazine: Autumn 2014

T he economies of Europe and the US seem to be heading in different directions,

illustrated by the most recent Markit PMI survey findings. While eurozone economic output slowed in August, US factory activity expanded at the fastest pace in more than four years.

The divergence in the fortunes of the European and US economies highlights the differing policies of the Federal Reserve and European Central Bank. While the Fed has enthusiastically embraced quantitative easing, European policy makers are reluctant to follow suit, perhaps inhibited by Germany’s resistance to the move. Now, as the Fed considers the timing of its first rate rise since the financial crisis, the ECB is cutting. It is also considering the limits of monetary policy; a debate that has most dramatically played out in France, with the dissolution of parliament in late August.

In our economics insight this issue we take a closer look at the debate over monetary policy ongoing in the US and Europe, and offer one view of what central banks may do next.

Elsewhere, with the new International Swaps and Derivatives Association credit derivative definitions set to come into force on September 22nd, the coming weeks are important for the credit default swap market. New rules on sovereign defaults and bank bailouts are likely to create trading opportunities, alongside uncertainty over events in Argentina and the Ukraine.

In the corporate bond space, high yield bond flows held up a mirror to events around the globe, with a summer selloff reflecting declining investor risk appetite. The biggest moves came in the retail space, with billions of dollars withdrawn from the most liquid ETFs.

The CLO market, meanwhile,

has had a busy summer, with August seeing a flurry of new issues; a boost for the loan market, in which prices have been on a downward trajectory. CLOs saw spread compression on vintage mezzanine tranches, driven by a higher call rate, our team shows.

Our dividends focus this issue turns to Indonesia, where a change of government has raised expectations that companies will make higher pay outs. Despite a struggling commodity sector, the 30 companies in the MSCI Indonesia Index are expected to award $6.5bn in dividends in 2014, up 6.6 % year-on-year.

Returning to Europe, and France in particular, our securities finance analysts observe that short sellers are conspicuously absent from French equities, with shares rising in the recent period on expectations of monetary stimulus from the ECB. As we have noted, it starts and ends with the central bank.

46 Autumn 2014

FOREWORD

COMMENTARY

MARKET INSIGHT

Central banks take centre stage

Armins Rusis and Chip Carver, cohead of Information at Markit

Page 40: Markit magazine: Autumn 2014

47 Autumn 2014

COMMENTARY

ECONOMICS

A stark reminder of the euro area’s ongoing woes was provided by Markit’s PMI

data for August. Four countries covered by the worldwide business surveys saw their manufacturing economies deteriorate in August, two of which were euro area founder members France and Italy. France was particularly notable in sitting at the foot of the rankings; an ignominy it has now suffered for three successive months. No longer just the ‘sick man of Europe’, France looks more like the sick man of the world.

The poor performance of the French business sector is not limited to manufacturing: its service sector has been either stagnating or contracting in recent months according to the PMI surveys. France’s all sector PMI has consequently lagged far behind that of the other major euro area economies throughout the year to date, followed not far behind by Italy.

Business sector in recessionAn increasingly bloated public sector has also masked the French private sector’s weak performance. P

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Europe is being held back by its second largest economy, writes Chris Williamson

46 47 48 49 50 51 52 53 54 55 56 57 58

France

Poland

Indonesia

Italy

Greece

Brazil

China

S Korea

Turkey

Austria

Russia

Germany

Netherlands

Mexico

Japan

India

UK

WORLD

Spain

Czech Rep.

Canada

Taiwan

Ireland

US

Page 41: Markit magazine: Autumn 2014

While GDP is 1.2% larger than its pre crisis peak seen in the first quarter of 2008, the situation looks very different once government spending is stripped out. Excluding the public sector, GDP is in fact still 1.7% below its pre crisis peak. Government spending has risen by a staggering 11.1% since the start of 2008.

Like the PMI, official GDP data show that France’s private sector is technically back in recession.

France’s woes cannot therefore be blamed on austerity hitting demand in the home market. Nor can they be attributed to the global economic environment, in which other developed countries have fared well. The US and UK in particular are both booming, with policymakers increasingly eyeing tighter monetary policy.

France malaise contrasts with growth surge in Spain and IrelandEven other euro area countries are coping much better than France this year, according to the PMI surveys. Spain and Ireland have been the most impressive. While Italy and France languish, Ireland saw the fastest rate of manufacturing growth for 13 years in August, accompanied by a surging expansion of services activity. Spain is meanwhile enjoying the strongest period of expansion since the lead up to the global financial crisis.

It’s fair to say that other euro countries such as Germany and the Netherlands are not growing as strongly as before the recession, but this no doubt, at least in part, reflects the demand in key export markets; with France and Italy accounting for just over one-third of euro area gross domestic product, their lacklustre economies provide poor markets for neighbouring countries’ goods and services.

The PMI survey responses also reveal that the crisis in the Ukraine appears to have hit business confidence and spending across the region, causing a further setback to the single currency area’s fragile recovery. Euro area factory output growth slowed to near stagnation in August and growth of services activity remained agonisingly

subdued. Gross domestic product looks set to grow in the third quarter, but the pace of expansion is likely to be a modest 0.3%, according to the PMI readings, far from sufficient to bring about any marked drop in unemployment from near record rates.

ECB starts to dig deeperThe ECB in early September unexpectedly cut its key interest rates to a fresh record low, bringing borrowing costs to what central bank President Mario Draghi called the “lower bound” of close to zero to lift inflation and support the economy. The ECB said it will also start buying securitised loans and covered bonds, in a move widely seen as a first step towards full blown quantitative easing.

However, unless new products are launched, any impact is likely to be limited for the simple reason that there are not enough asset backed securities for the ECB to buy to make a material difference to the pace of economic growth.

With the survey data failing to revive as the ECB had hoped back in June, and inflation falling ever closer towards zero (prices were up just 0.3% on a year ago at the time of writing), pressure is building on the ECB to do more to boost the eurozone economy rather than wait to see what impact its recent actions will have.

At the Jackson Hole gathering of central bankers in August, Draghi raised the expectation that preparations were being made for full scale QE with sovereign debt purchases. In a departure from the prepared speech text, Draghi said that the central bank will “use all the available instruments needed to ensure price stability”.

Notwithstanding the political obstacles that still exist to ECB sovereign debt buying, a concern is that, even if implemented, the benefits of quantitative easing in the euro area could be less than seen in the UK and US, primarily because bond yields are already low.

The likelihood is, therefore, that even full scale QE might do little to reinvigorate the eurozone’s weakest performers, which is one of the reasons that the ECB has been consistently calling for accommodative monetary policy to be accompanied by structural reforms. These calls have a valid foundation. Poor productivity is clearly an issue in France, as

highlighted by Markit’s PMI-based productivity

indices. France has been lagging its peers to a significant degree in recent years.

The economic data for Spain and Ireland suggest that countries that have taken a more aggressive approach to implementing reforms and measures to boost productivity and competitiveness, as well as stimulating entrepreneurship and business investment, are reaping the benefits. France has a long way to go.

To draw on personal experiences as an illustration, the small French village in which I holidayed this year highlighted some of the problems symptomatic of France’s need to reform. The man running boat trips for tourists had undergone a soul-sapping two-year bureaucratic struggle to obtain the necessary licence. Another entrepreneur, hoping to establish a cycle hire company, had simply given up the fight and moved to the Netherlands.

Fiscal boost?However, it’s clear that reforms, even if implemented, will take a long time to take effect. In the meantime, the focus has shifted to the need for the additional support of a fiscal boost. Draghi’s speech at Jackson Hole suggests the eurozone needs to take a similar strategy to Japan’s “three arrows” policy of Abenomics, where loose monetary policy, structural reform and fiscal stimulus are combined to bring about a genuinely sustainable recovery.

In the case of the euro area, the latter presumably implies surplus countries (i.e. Germany) spending more on infrastructure projects across the region, which is unfortunately also something unlikely to be agreed to with any degree of haste.

There is no quick fix for France and the eurozone, but at least the discussion is moving in what appears to be a constructive direction.

COMMENTARY AND DATACOMMENTARY

48 Autumn 2014

Chris Williamsonchief [email protected]@WilliamsonChris

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Buenos Aires central business district

A n Argentinian default, conflict in eastern Europe and monetary policy jitters

have increased volatility in the credit derivatives market in the recent period, with a sharp selloff followed by an equally impressive retracement.

The European Central Bank was in the spotlight when the eurozone recorded no growth in the second quarter and the region’s inflation slowed from 0.4% in July to an early estimate of 0.3% in August, a five year low

Germany’s GDP shrank 0.2% in the second quarter and there is a growing expectation that the ECB will act to boost the region’s economy through quantitative easing, an ostensible positive for credit markets.

However, QE expectations appear to have been priced in, with the Markit iTraxx Europe and iTraxx Europe Crossover indexes tightening sharply over the recent period.

Ahead of the move tighter, Argentina’s default grabbed the market’s attention. After the country missed interest payments on its bonds, the International Swaps and Derivatives Association ruled that a credit event had occurred.

An auction to determine CDS payouts was initially planned for August 21st but was later postponed following challenges on two bonds in the deliverable obligations list. Those bonds were Japanese Yen denominated and priced relatively cheap, potentially

reducing the auction’s final price. The committee, however, decided to keep these bonds on the list.

The recovery rate on Argentine CDS has been volatile and increased gradually as tensions built ahead of Argentina’s default. Up until mid-June, the Argentine CDS recovery rate was priced slightly lower than 25 cents on the dollar, a typical South American sovereign CDS recovery rate.

The recovery rate of a CDS contract determines how much contingent payment protection buyers receive from protection sellers following a credit event. The contingent payment is calculated as a 100% minus recovery rate and multiplied by the CDS notional. Therefore, CDS protection buyers would benefit from a lower final price in a CDS auction.

COMMENTARY

49 Autumn 2014

May2014

Jun2014

Jul2014

Aug2014

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Argentina recovery rate

European indices

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290

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310

320

330

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360

200

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320 Spread (bps)

CDX EM CDX HY (Right Axis)

HY & EM credit indices

Source: Markit

Source: Markit

Source: Markit

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Summer defaultThe traditionally slow summer season was enlivened by concerns over Argentina, escalating global conflicts and signs of interest rate rises, writes Akif Ince.

CDS

Page 43: Markit magazine: Autumn 2014

Interest ratesThe fixed income markets have been relatively stable, amid a steady US Federal Reserve tapering of its asset purchase programme and historic low interest rates on both sides of the Atlantic. However, the low rate environment may not endure for much longer.

The Bank of England Monetary Policy Committee kept interest rates at 0.5% at its August meeting, but two of its members voted to increase rates to 75bps, the first vote for a hike since the policy committee’s July 2011 meeting. Across the Atlantic, the US Federal Reserve’s Federal Open Market Committee released minutes from its July meeting, which revealed the Federal funds rate could increase sooner than expected.

According to the FOMC report, market participants “continued to see the third quarter of 2015

as the most likely time” for an increase in the federal funds rate.

Emerging markets and high yield credit are the most prone to monetary policy changes and have become increasingly popular among investors seeking high returns in an environment of low interest rates. Speculation over interest rate hikes has led to volatility and widening in high yield and emerging market CDS spreads.

As Isda prepares to release a new version of its Credit Derivatives Definitions in September, an interesting case appeared in the Portuguese banking sector. Banco Espirito Santo (BES), Portugal’s second largest bank, is the latest example of a private bank restructuring through government intervention.

BES was in August split into a “good bank” (Novo Banco) and

a “bad bank” (BES) where the former assumed senior debts while subordinated debt was left with the latter. However, Isda decided that a succession event had occurred on BES with Novo Banca being the successor. This effectively meant that subordinated CDS were “orphaned”, indicating that no deliverables existed to settle a CDS contract. The new Isda definitions address this situation, as discussed elsewhere in the magazine.

As we approach year-end, there are many uncertainties that will likely have a negative

impact on market sentiment, with

rising tensions between the US, Europe and Russia and the emergence of the Islamic State (IS) militants in Iraq. Chuck Hagel, the US Defence Secretary, referring to IS, said “this is beyond anything that we have seen” and emphasised that IS “clearly poses a longterm threat”. This raises questions over how far the US will go to achieve its “clear and limited” objectives.

This lingering uncertainty is a rising risk to markets in the coming months, which alongside jitters over interest rates may pose some challenges for investors holding long positions through derivatives.

COMMENTARY AND DATAMARKET COMMENTARYCOMMENTARY AND DATACOMMENTARY

50

Akif Inceassistant vice-president, Credit [email protected]

Autumn 2014

Iraqi demonstrators protest against IS in front of the White House in Washington DC

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COMMENTARY

51

May2014

Jun2014

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0

50

100

150

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Spread between iBoxx USD high yield and iBoxx USD Corporates Spread between iBoxx EUR high yield and iBoxx EUR Corporates Spread between iBoxx GBP high yield and iBoxx GBP Corporates

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July 16 July 17 July 18 Juy 19 July 20 July 21 July 22 July 23 July 24 July 25 More

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iBoxx analysis

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Argentina default

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Argentina impact

Source: Markit

Source: Markit

Source: Markit

Autumn 2014

Frantz Castorassistant vice president, Fixed Income [email protected] Qianassistant vice president, Fixed Income [email protected]

High yield bonds have performed exceptionally well in the recent period, but

some risk averse investors decided to move out of the asset class this summer due to geopolitical tensions and lingering concerns about the global economy.

At the beginning of June, the spreads between the Markit iBoxx Global Developed Markets High Yield USD, EUR and GBP indices and their respective investment grade counterparts were below 150bps, less than half of that at the beginning of 2012.

New issues were also very active. The US high yield credit market recorded $138bn of new issuance until mid-June, similar to last year and nearly 30% higher than in 2012 or 2011.

But political tensions, notably between Russian and Ukraine, the crisis at Portuguese bank Banco Espirito Santo and Argentina’s debt default hit the market in July. The spreads in the high yield market jumped abruptly and massively with the Markit iBoxx Global Developed Markets High Yield USD, EUR and GBP indices trading at 64bps, 25bps and 48bps wider respectively versus their investment grade counterparts on a monthly basis.

In the wake of wider spreads, the US high yield primary market became less active, with an average of $848m of new issues priced in July, the lowest level of the year, compared to a high in May of $950m. However, the market is still higher than the $799m average amount reached at the same period in 2013. The average yield of new issuance increased, reaching 6.12% in July (compared with 5.11% in June) as issuers had to offer a higher premium.

Overvaluation concernsAlthough outside pressures triggered the drop, US high yield bond investors had been concerned about potential overvaluation of low quality bonds since early this year. The spread between the iBoxx Liquid High Yield CCC and BB indices widened from 320bps to 416bps year-to-date. Indeed, discouraging macroeconomic data in the first quarter might have caused investors to avoid risky assets. Currently, the market is weighing the impact of a possible interest rate hike on companies’ refinancing capabilities as the job market

shows sign of recovery.According to the distribution of

maturities of bonds in the iBoxx USD Liquid High Yield universe, most US high yield issuers have already refinanced themselves, taking advantage of historically low interest rates. Nearly 70% of the US high yield bonds will mature in five to eight years. In contrast, a significant number of euro-denominated high yield bonds are approaching their maturities.

Decent returnsWith default rates at historical low levels (around 1% annualised), current credit spreads are still offering decent returns for investors with risk appetite based

on market consensus models,

Euro BB rated bonds display an average senior spread of 300bps, which is almost six times the 51bps median implied spread for a default rate of 0.7%. The recent underperformance against investment grade also improved the sector’s relative valuations - the spread between bonds rated BB and BBB almost doubled in early August.

The yield of the Markit iBoxx Global Developed Markets High Yield USD index has pulled back by 60bps since August 1st to 5.2% while the spread over Treasuries is below 360bps again.

Although the reasons for the recent selloff are still being debated, it seems like the correction appears technical in nature rather than fundamental.

iBoxx spreadsMARKIT IBOXX INDICES

High wireInvestors are turning away from high yield bonds amid fears about the crisis in the Ukraine and the global economy, but they may have it wrong, write Jun Qian and Frantz Castor.

Page 45: Markit magazine: Autumn 2014

A s the summer sun fades, the outlook for the US loan market is clouding over.

Prices are coming under pressure, amid technical factors, sparking uncertainty among investors.

In recent weeks, investors have been selling off crossover accounts and closing loan positions as high yield and leveraged loan funds have been hit by redemptions.

Outflows are likely to have a negative impact on new deal flows, and exacerbate downward pressure on loan prices. Increasing risk of geopolitical shocks could also send prices lower.

Funds have been suffering from outflows for the first time in nearly two years. and at especially startling rates in the first week of August. With the primary market remaining active in July, before the cyclical late summer slowdown, investors did not subscribe to new issuances at expected rates, and the excess supply from July and loan fund outflows put downward pressure on prices in the secondary market.

Total returns for the Markit iBoxx USD Liquid Leveraged Loan Index (LLLI) dropped approximately 125bps in late July. With managers needing to close loan positions quickly, liquid names bore the brunt of the selling pressure.

In the primary market, issuers with deals slated for August had to sweeten investors with terms

such as flexing higher, covenants and call protection. A number of issuers delayed deals, and in some instances issuers pulled deals, citing adverse market conditions. Net new supply exceeded visible inflows by $7.7bn in July, according to S&P LCD.

Par loans Par loans are also coming under pressure, as can be seen in the sharp decline in the percentage of loans in Markit’s LLLI index pricing at or over par. The only 21% of liquid names over par in the second week of August was the lowest point since prices began their steady climb from the doldrums in the second half of 2012.

In the spring and early summer, with volatility at all time lows and what some would interpret as froth in the leveraged loan market, investors parked cash. With prices inflated above par for some time, key players felt the US loan market was due a correction. Now prices have declined across rating and price buckets, including stressed and/or defaulted loans. For example, Energy Future Holdings Corporation (TXU) traded higher in June after one of the largest defaults in US loan market history. Markit’s composite price on the massive non-extended term loan, a

tranche of approximately $16bn, dropped 8.5% from July 1st to August 20th.

CLOsComing off August lows, some investors have been looking to capitalise on bargain prices. CLOs in particular have seen the drop as a prime buying opportunity, especially since they have been holding excess cash and now have a mandate to spend it. These managers are now inking new deals at sub-par prices, which helped to stabilise loan prices in mid-August.

The deals that actually made it to market in early August were being watched closely, with the general

sentiment that bids would be lower on fresh allocations. Not every credit has been affected

in the same way, however, and those with fewer covenants or lower spreads were hit the hardest.

Several deals closed with paper undersubscribed, causing concern that arrangers may be left holding assets during the August trading lull. However, those fears abated with some signs of price stabilisation. The Albertson’s LLC TLB3 and TLB4, closing August 11th, are at the time of writing up 73bps and 90bps respectively from the bids at allocation. Still, despite the stabilisation, deals in preliminary talks are being discussed at much wider spreads.

There are concerns over the way the market’s direction is likely to deter some investors in the coming months, leaving a very uncertain US loan market for some time to come.

Dane Quigleyassociate, Loan [email protected]

52 Autumn 2014

Month/Year

May2014

Jun2014

Jul2014

Jan2014

Dec2013

Feb2014

Mar2014

Apr2014

0

0.5

1

1.5

2

2.5

3

Total return (%)

MiLLI LLLI

Jun 22014

Jun 302014

Jun 232014

Jun 162014

Jun 92014

Jul 72014

Aug 42014

Month/Year

0%

10%

20%

30%

40%

50%

60% > par

Jul 142014

Jul 212014

Jul 282014

Aug 182014

Aug 112014

Liquid loans hit harder

% of constituent loans in the MiLLI index priced above par

Source: Markit

Source: Markit

Pho

togr

aph:

Shu

tter

stoc

k

Loan pressure

LOANS

Pricing pressure in the US loan market means that new deals are likely to dry up in the coming months, writes Dane Quigley.

COMMENTARY AND DATAMARKET COMMENTARYCOMMENTARY AND DATACOMMENTARY

Page 46: Markit magazine: Autumn 2014

SECURITIES FINANCE

53

To short or not to short

Autumn 2014

F rance is having a hard job pulling itself out of a long period of stagnant growth,

and things are not getting any better. Real GDP growth has been non-existent over the first two quarters of the year and the flat July composite Markit PMI numbers indicate this will continue in the second half. The embattled French government has abandoned its public deficit target, as an economic turnaround remains a long way off.

Yet despite this, the French government’s benchmark 10-year bonds have been trading at their lowest yield ever, as investors bet that the latest spate of weak economic numbers may herald further ECB monetary easing to jumpstart the eurozone’s growth.

Equity markets flatPoor growth has been having an impact on the French equities market, as the benchmark CAC index has traded roughly flat since the start of the year. However, just like their bond counterparts, equity investors are positioning themselves ahead of any further ECB action. The index of French large cap shares has climbed by nearly 3% since the start of August on expectations of further monetary easing.

Short sellers are also conspicuously absent from the picture. The French constituents of the Stoxx 600 index have seen their average short interest figure fall to historical lows over the last year. The current average demand to borrow shares in the 82 French firms in the index is 1.84% of shares outstanding, a quarter lower than a year ago and a 18% decline since the start of the year. Demand to borrow constituents of the overall Stoxx 600 index has been relatively flat. As a result, 82 French equities have reversed their above average short position over the last few months despite the recent set of bearish numbers. This echoes the US market a

Month/Year

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5 Percentage of shares on loan

Stoxx 600 Average Demand to Borrow French constituents

Jan2014

Feb2014

Mar2014

Apr2014

May2014

Jun2014

Jul2014

Aug2014

Mar2013

Apr2013

May2013

Jun2013

Jul2013

Aug2013

Sep2013

Oct2013

Nov2013

Dec2013

Average short interest

Source: Markit

Sep2013

Nov2013

Jan2014

Month/Year

Mar2014

May2014

July2014

0

10

20

30

40

50

60

70

80

90

0

5

10

15

20

25

30

Percentage of shares on loan Share price

% Shares Outstanding on Loan Price

Ingenico

Source: Markit

Short covering positions on French equities are at all-time low levels on concerns over running against the European Central Bank’s monetary easing policy, reports Simon Colvin

Photograph: S

hutterstockCOMMENTARY

Page 47: Markit magazine: Autumn 2014

couple of years ago when short sellers retreated in anticipation of easier monetary policy in spite of gloomy economic numbers.

Most shorted constituentsThe three most shorted French constituents of the Stoxx 600 index are the ones driving short covering. The three firms with more than 10% of their shares out on loan in

early 2014 have seen their average demand to borrow more than halve in the last seven months.

Leading the covering is carmaker Peugeot, which started the year with 15.2% of its shares out on loan, a number which has fallen by two thirds since then. This drastic short covering came in the wake of a government rescue which saw the French

government take a 14% stake in the ailing carmaker. Peugeot shares have since risen 38% making it the best performing French Stoxx 600 constituent.

Another example is Ingenico, the most shorted company at the start of the year. Its shorts have halved since the turn of the year.

On the momentum side, the 16 firms whose share prices have fallen by more than 10% year to date have also seen their average demand to borrow fall, showing that shorts have little appetite to chase falling share prices.

Short sellingDespite the recent fall in overall average demand to borrow, several

French companies are still fuelling

the heaviest borrowing demand. Three French firms currently feature amongst the 15 companies seeing more than 10% of their shares out on loan.

The standout firm in this space is seismic survey firm CGG which has suffered from a fall in demand for its services, leading to a $364m net loss in the first two quarters. This has seen the firm’s shares tumble by over 48% year to date, which has prompted short sellers to add to their already high positions.

Another company seeing a shorted surge in the wake of disappointing results is Alcatel Lucent. It has enjoyed a rebound in short interest after its shares pulled back from a rally last year.

Simon Colvinvice president, Securities [email protected]@Simon_MSF

54

Sep2013

Nov2013

Jan2014

Month/Year

Mar2014

May2014

July2014

0

2

4

6

8

10

12

14

0

5

10

15

20

25

Percentage of shares on loan Share price

% Shares Outstanding on Loan Price

Peugeot

Source: Markit

Autumn 2014

ON THE APP

COMMENTARY AND DATAMARKET COMMENTARYCOMMENTARY AND DATACOMMENTARY

Page 48: Markit magazine: Autumn 2014

T he recent period has been surprisingly active in the CLO market,

given disruptions in other asset classes, boosted by a packed programme of issuance. Demand for paper and the right market environment for CLOs helped drive new issuance on both sides of the Atlantic. A downward move in loan prices also provided impetus.

What really stood out was the compression of spreads across the mezzanine part of the capital structure on 1.0 vintage US CLOs.

Likely to be contributing to this is the increased velocity at which deals are being called, which would be a boon for the holders of tranches in these deals. According to Wells Fargo, over 30 deals have been called this year. Most industry participants expect this number to grow towards the end of 2014. If current trends continue, we will likely see later 2006 and 2007 deals come into a situation where it makes sense to exercise the call in the coming quarters as well.

The movement lower in loan prices has also had an impact across various facets of the CLO market. According to Markit data, loan prices have fallen from 99.45 in late June to 99.1 at the end of August. Lower rated tranches, including equity,

might offer attractive relative returns for some investors who previously felt that segment of the market was priced too tight. On average the 2.0 equity price has fallen to 89 at the end of August from 93 at the end of June. The prices also are helpful for managers looking to get deals done, and new supply seems to be absorbed by investors, even in the summer months, albeit at slightly wider spreads. However, spreads are currently much wider than a year ago, when they averaged in the 125-135bps range.

There continues to be a clear bifurcation, with experienced shops pricing the AAAs in the low and mid 140bps ranges and some newer managers falling wider, in the low 150s area. Spreads are also likely to remain off the tights we saw in Q1 and Q2 2013 as the pipeline for new issues remains robust across the street.

New dealsDespite the usual summer lull, particularly in Europe, a good number of deals came to the market. In fact, the first week of August was one of the busiest weeks in terms of issuance, with roughly $5bn coming to market, bringing the total this year to almost $80bn.

As we head into the final stretch of 2014, we expect a

continued and robust new issue pipeline.

Different parts of the capital

structure will offer better relative value opportunities as loan prices stay muted and deals continue to be called.

Matthew Fiordalisodirector, Securitised [email protected]

STRUCTURED FINANCE

55

100

110

120

130

140

150

160

170 Avg price

AAA DM

Jun2013

Jul2013

Aug2013

Sep2013

Oct2013

Nov2013

Dec2013

Jan2014

Feb2014

Mar2014

Apr2014

May2014

Jun2014

Jul2014

Aug2014

Month/Year

Month/Year

Jan2014

Feb2014

Mar2014

Apr2014

May2014

Jun2014

Jul2014

Aug2014

98.8

98.9

99

99.1

99.2

99.3

99.4

99.5

99.6

AVG(BID)

Jun 302014

Jul 72014

Aug 42014

Month/Year

250

255

260

265

270

275

280

285

290DM

1.0 BBB

Jul 142014

Jul 212014

Jul 282014

Aug 112014

Aug 182014

CLO investors snap up new issuanceThe CLO market took no holidays in the summer, with August being one of the busiest months for new issues, writes Matthew Fiordaliso.

AVG(BID)

Average loan prices

1.0 BBB tightening

Source: Markit

Source: Markit

Source: Markit

Autumn 2014

COMMENTARY

Page 49: Markit magazine: Autumn 2014

Indonesia’s recent presidential elections have rekindled optimism over the country’s

future. The archipelago’s new president, the popular Joko Widodo, won on a corruption-free ticket and his determination to push through badly needed structural reforms. He is also the first president to come from outside the country’s political and military elite.

Turning Indonesia around is a tall order, and Widodo faces major challenges in kickstarting the spluttering economy. The Indonesian economy notched its slowest growth since early 2009 in the second quarter of this year, recording 5.1% growth. The International Monetary Fund forecasts 5.4% growth for 2014, down from 5.8% recorded in 2013, due to slowing exports and investments. The Rupiah is also coming under pressure from Indonesia’s high current account and fiscal deficits. To tackle this, the authorities may have to undertake tighter monetary policy and introduce cuts in fuel subsidies. This in turn may have an impact on economic growth.

Impact on dividendsPotential policy changes introduced by the incoming government are likely to have important implications for the 30 companies in MSCI Indonesia in the coming fiscal year. The companies are expected to pay out a total of $6.5bn in dividends in 2014, up 6.6% year-on-year. This comes after total dividends paid out dipped 9.9% in 2013.

Four sectors dominate dividend payouts in the index - banks, telecommunications, automobile/parts and personal/household goods. Together, they are projected to pay out $4.2bn in 2014, or 63.7% of overall dividends. Banks will keep their position as the top paying sector, with projected $1.8bn in dividends this year. With the exception of Bank Danamon, the sector earnings outlook is positive, resulting in an estimated 8.3% growth in full-year dividends. Telecom operator Telekomunikasi Indonesia leads the index as the top dividend payer with a projected $932.3m to be distributed, a 4.8% rise year-on-year, on the back of positive EPS growth projections.

Strong domestic demandResilient domestic demand remains a bright spot for the economy. Household consumption expenditure accounted for 55.8% of GDP in the second quarter, while the country’s growing middle class continues to underpin consumption. Cyclical sectors like automobiles/parts and retail stand to gain from this trend. Markit forecasts 5.9% higher dividends for automotive distributor Astra International this year. At $802.8m in dividend payouts, the company is projected to be the second highest dividend payer in the index. Matahari Department Store recorded strong earnings growth in the first half of this year, driven by increased demand and improvements in merchandise offerings. Markit forecasts 40.3% higher dividends per share (DPS) in 2014.

Certain sectors stand to gain from policies introduced by Widodo’s government. Widodo’s plans to boost infrastructure development and Indonesia’s Ministry of National Development Planning, in its 2025 economic master plan, estimates that at least $60bn of additional infrastructure spending is required each year over the coming years. Given these favourable factors, there are potential benefits for the construction and materials sector, in terms of earnings and dividends outlook. The 23.7% forecast decline in the sector’s dividends is largely due to cement manufacturer Indocement Tunggal’s exceptionally high payout ratio of 66.1% in 2013, which Markit expects to revert to its usual level of 35% this year. Widodo also plans to introduce free inpatient and outpatient services with Healthy

Indonesia Card, requiring the construction

of 6,000 community health centres with inpatient facilities. If implemented, this could have a positive impact on the outlook for pharmaceutical company Kalbe Farma.

Lower commodity pricesA notable trend has been the shrinking dividends paid out by basic resources companies. Although the sector dividend pay out is expected to rise 3% in 2014, this comes after drastic 35.9% and 40.3% declines in 2012 and 2013 respectively. The sector’s downturn can be attributable to two main factors – lower demand for Indonesia’s resources exports, mainly from China, and lower commodity prices. Coal miners Adaro Energy and Indo Tambangraya managed to record upticks in earnings in 2014, after suffering significant slumps last year. They are expected to pay out slightly higher DPS in 2014. Looking ahead, risks to the sector’s recovery include tighter monetary policy and cuts in fuel subsidies, which may slow down investments in commodity-related industries and lower consumption respectively.

All in all, there is a positive outlook on dividends for MSCI Indonesia, with favourable demographic conditions underpinning growth in the near term. However, it is imperative that the incoming government resolves the country’s critical structural problems to ensure longterm economic growth.

Lim Jun Jie Associate, [email protected]

56

MSCI Indonesia dividend payout trend

5.4

5.6

5.8

6.0

6.2

6.4

6.6

6.8

7.0

FY11 FY12 FY13 FY14e

USD Billions

Special dividends Ordinary dividends

Source: Markit

Autumn 2014

Photograph: S

hutterstock

DIVIDENDS

Betting on IndonesiaThe election of a new president in Indonesia is ringing in changes for the country’s economic policy, which will likely have an impact on the dividends of MSCI Indonesia-listed companies, writes Jun Jie Lim.

COMMENTARY AND DATAMARKET COMMENTARYCOMMENTARY AND DATACOMMENTARY

Page 50: Markit magazine: Autumn 2014

ETPs

57

High yield bond ETFs have in recent weeks seen a recovery from a summer

sell off in which nearly 10% of assets under management (AUM) exited the asset class. An inflow of $1.09 billion has helped ease concerns that a few weeks of negative flows may turn into a market rout.

Over a four week period in July, high yield bond ETFs saw $4.3bn in outflows, an eye watering amount that was more than a third of net inflows in the prior 12 months.

Given the fact that corporate bonds are exposed to equity markets and the impact of monetary policy, they provide a good barometer of wider appetite for risk, and high yield bond ETFs have seen strong inflows since coming onto the market in 2007, amassing over $47bn in AUM.

The ETFs HYG, JNK and HYS combined represent more than $26bn in AUM, and by the end of July there had been almost $3bn in outflows from the three. The selloff came quickly and the market was left to speculate over not only the cause of the outflows, but also the implications.

High yield bonds are often viewed as hybrid investments because of their propensity to trade in line with equities. However, they are also influenced by interest rate movements. Growth in the asset class over the past few years can be attributed, among other things, to improving economic data, weak wage inflation, a dovish Federal Reserve and a low default rate. There has been a tightening of spreads for high yield bonds to near 2008 pre crisis levels, and average default rate expectations are currently around 2%, well below the thirty year average default rate of nearly 6%.

While high yield bond ETFs benefit from a strong economy, because of lower default rates, one of the largest risks for the asset class is if economic activity picks up faster than expected. This could result in a rise in interest rates to keep inflation under control. With spreads already tight, the yields on sub-investment grade bonds would potentially become overwhelmed by higher benchmark rates, causing them to lose favour among investors.

Rising interest rates would also have an impact on demand for capital for acquisitions and buybacks. If the cost of capital exceeds the potential return made on the borrowed capital, it would shrink the bond market, and the gap would be squeezed from both directions.

Sensitive to the FedThe recent selloff may be attributable to factors such as increased geopolitical risks and a normal correction in the marketplace, but given tight spreads and expectations that the Fed will lift interest rates

soon, the high yield bond ETF market is sensitive to Fed announcements.

After each of the five Federal rate announcements made this year, HYG (iShares iBoxx $ High Yield Corporate Bond ETF) has seen large outflows.

The Fed has continued to taper its buyback programme at a consistent rate and has kept the target range for the federal funds rate at 0-0.25%. It’s now not a question of if the Fed will lift interest rates but more a question of when. That may result in a large exodus from the high yield market as investors worry that the premiums will be eroded by rate rises. HYG investors will watch the Fed closely for signs of the timing of any rate rise, and we can expect high yield ETFs to provide a swift illustration of how the market interprets the Fed’s signals.

ETF outflowsHigh yield bond ETF flows are a barometer of broader market risk appetite, writes James Hohorst.

James Hohorstassociate, [email protected]

Jan2014

Feb2014

Mar2014

Apr2014

May2014

Jun2014

Jul2014

Aug2014

Month/Year

$220

$222

$224

$226

$228

$230

$232

$234

$236

$238

$240

-$700

-$600

-$500

-$400

-$300

-$200

-$100

$0

$100

$200

$300 Millions

HYG flows Markit iBoxx USD Liquid High Yield Index (USD, total gross return) Rate announcement

HYG flows vs benchmark

Source: Markit

Month/Year

0%

1%

2%

3%

4%

5%

6%

YTD

ben

chm

ark

grow

th

HYG JNK HYS

Jan2014

Mar2014

May2014

Jul2014

Aug2014

High yield Bond ETF YTD benchmark return

Source: Markit

Autumn 2014

US Federal Reserve

Pho

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Page 51: Markit magazine: Autumn 2014

MARKIT INFOGRAPH

Monetary Policy

58 Autumn 2014

All data correct at time

of going to press

Key numbers providing a snapshot of monetary conditions

19%Fed funds rate Jan 1981

19 years Time UK left interest rates unchanged (1932-1951)

Minus 0.004%

First ever negative Eonia rate,

August 2014

17%UK Interest rate

Nov 1979

0% Interest rate in

Japan since 2010

1.3 × 1016%per month

Hungary inflation 1945-56 (prices

doubled every 15 hours)

25%Malawi current

central bank rate (highest globally)

6.2%US rate of

unemployment July 2014